GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES EDITORS SHAHID YUSUF M. ANJUM ALTAF KAORU NABESHIMA GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES SHAHID YUSUF M. ANJUM ALTAF AND KAORU NABESHIMA Editors A copublication of THE WORLD BANK the World Bank and Washington, D.C. Oxford University Press © 2004 The International Bank for Reconstruction and Development / The World Bank 1818 H Street, NW Washington, DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org E-mail: feedback@worldbank.org All rights reserved. 1 2 3 4 07 06 05 04 A copublication of the World Bank and Oxford University Press. Oxford University Press 198 Madison Avenue New York, NY 10016 The findings, interpretations, and conclusions expressed herein are those of the author(s) and do not necessarily reflect the views of the Board of Executive Directors of the World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. 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All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, World Bank, 1818 H Street, NW, Washington, DC 20433, USA, fax 202-522-2422, e-mail pubrights@worldbank.org. ISBN 0-8213-5620-8 Library of Congress Cataloging-in-Publication Data Global change and East Asian policy initiatives / edited by Shahid Yusuf, M. Anjum Altaf, Kaoru Nabeshima. p. cm. "A copublication of the World Bank and Oxford University Press." Includes bibliographical references and index. ISBN 0-8213-5620-8 1. East Asia--Economic policy. 2. East Asia--Foreign economic relations. 3. International trade--East Asia. 4. International finance--East Asia. 5. Globalization--Economic aspects. I. Yusuf, Shahid, 1949­ II. Altaf, M. Anjum, 1950­ III. Nabeshima, Kaoru. HC460.5.G66 2004 337.5--dc22 2004042228 CONTENTS Preface ix Contributors xi Abbreviations and Acronyms xiii 1 What Globalization Means for East Asia 1 M. Anjum Altaf and Shahid Yusuf 2 Hanging Together? On Monetary and Financial Cooperation 25 Barry Eichengreen 3 Trade and Foreign Direct Investment: A Role for Regionalism 63 Eisuke Sakakibara and Sharon Yamakawa 4 New Regional Trading Developments in the Asia-Pacific Region 121 John Gilbert, Robert Scollay, and Bijit Bora 5 Harmonizing Competition Policies 191 Peter Lloyd, Kerrin Vautier, and Paul Crampton 6 The Public Sector 239 Carles Boix iii iv CONTENTS 7 Corporate Governance, Industrial Policy, and the Rule of Law 293 Dwight H. Perkins 8 Governance and the Internet 337 Richard Rose 9 Education for Growth: Deepening or Widening? 365 Howard Pack 10 Venture Capital Industries 391 Martin Kenney, Kyonghee Han, and Shoko Tanaka Index 429 About the Editors 451 Figures 3.1 Trade Intensity Index: Intraregional, 1980­2001 82 3.2 Foreign Direct Investment in ASEAN by Source, 1995­2001 86 3.3 Shares of East Asian Foreign Direct Investment Flows to ASEAN, Asian Newly Industrialized Economies, and China 90 6.1 Public Revenue of General Government, 1950­93 241 6.2 Total Expenditure of Central Government, 1970­98 242 6.3 Debt of Central Government, 1970­98 243 6.4 Budget Balance of Central Government, 1970­98 244 6.5 Evolution of Public Revenue as an Interaction of Economic Development and Political Regime 270 6.6 Evolution of Subsidies and Transfers as an Interaction of Economic Development and Political Regime 275 8.1 Links to Telephones, 2002 340 8.2 Internet Usage 343 8.3 Openness to Information 355 9.1 Beginning Monthly Gross Wages in Singapore, 2001 382 Tables 2.1 Monthly Nominal Exchange Rate Volatility 31 2.2 Monthly Reserve Volatility 32 2.3 Monthly Interest Rate Volatility 33 2.4 Volatility Ratios 34 CONTENTS v 3.1 Openness and Global Integration Indicators 69 3.2 Import and Export Shares, 2001 73 3.3 Trade Shares, Selected Economies and Selected Years 74 3.4 Intraregional Trade: Merchandise Exports within Regional Group 76 3.5 Trade Intensity Index, 2001 79 3.6 Top Five Trading Partners for East Asian Economies Based on the Trade Intensity Index 80 3.7 Distribution of FDI in Selected Developing Countries 88 3.8 Intraregional Foreign Direct Investment Flows in Developing Asia, 1999­2001 92 3.9 Main Instruments Involving East Asian Countries and Dealing with Foreign Direct Investment, 1948­2003 96 3.10 Home Countries and Regions of the Top 50 Nonfinancial Multinational Corporations from Developing Economies 105 3.11 Structure of World Trade in Major Product Categories by Region, 1985 and 2000 108 3.12 Intraregional Imports of the Automobile Industry 110 4.1 Distribution of Imports and Exports of Northeast Asian Economies 124 4.2 Welfare Effects (Equivalent Variation Basis) of Bilateral Preferential Trading Agreements 136 4.3 Welfare Effects (Equivalent Variation Basis) of Steps to an East Asian Trade Bloc and APEC Liberalization 137 4.4 Welfare Effects (Equivalent Variation Basis) of the Free Trade Area of the Americas 138 4.5 Welfare Effects with Agriculture Excluded 145 4.6 East Asian Economies' Value Added by Sector at Market Prices 148 4.7 Production Effects by Sector for East Asian Economies: ASEAN 3 Free Trade Agreement 149 4.8 Production Effects by Sector for East Asian Economies: APEC Most-Favored Nation 150 4.9 Production Effects by Sector for East Asian Economies: APEC Preferential 151 4.10 Production Effects by Sector for East Asian Economies: ASEAN 3 Free Trade Agreement 152 4.11 Production Effects by Sector for East Asian Economies: APEC Most-Favored Nation 153 4.12 Production Effects by Sector for East Asian Economies: APEC Preferential 154 4.13 Estimated Gravity Coefficients for Proposed Regional Trading Agreements: Pooled Data by Sector 168 vi CONTENTS 4.14 Estimated Welfare Effect of Proposed Regional Trading Agreements: Equivalent Variation 171 4A.1 Estimated Gravity Equations: Total Merchandise Trade, 1986­98 (at 3-year Intervals) 178 4A.2 Estimated Gravity Equations: Manufactures Trade, 1986­98 (at 3-year Intervals) 180 4A.3 Estimated Gravity Equations: Agricultural Trade, 1986­98 (at 3-year Intervals) 182 4A.4 Estimated Gravity Equations: Pooled Data by Sector 186 5.1 Competition Laws: A Functional Overview 206 5.2 Main Conduct Regulated 208 6.1 Distribution of Public Spending in East Asian Countries, 1993­96 245 6.2 Size of State-Owned Enterprises in East Asian Countries, 1970­96 247 6.3 Public Revenue of General Government as a Percentage of GDP, 1950­93 262 6.4 Public Consumption of General Government as a Percentage of GDP, 1960­99 263 6.5 Total Expenditure of Central Government as a Percentage of GDP, 1970­99 264 6.6 Nonmilitary Expenditure of Central Government as a Percentage of GDP, 1985­97 265 6.7 Subsidies and Transfers of Central Government as a Percentage of GDP, 1970­99 266 6.8 Wages and Salaries of Central Government as a Percentage of GDP, 1970­99 267 6.9 Effect of Unionization and Income Inequality on the Size of Subsidies and Transfers 279 6.10 Budget Balance of Central Government as a Percentage of GDP, 1970­99 280 6.11 Size of State-Owned Enterprises as a Percentage of GDP, 1970­85 282 6.12 Forecasting the East Asian Public Sector 283 7.1 Control of Publicly Traded Companies in East Asia, 1996 301 7.2 Industrial Concentration Ratios 314 7.3 Business Groups Concentration Ratios: Share of 100 Largest Firms in Total Manufacturing 317 7.4 Alternative Measures of the Rule of Law 322 8.1 Opportunities for Internet Access, 2001 341 8.2 Contextual Influences on Internet Use 344 8.3 Classifying East Asian Systems of Government 351 8.4 Web Presence of East Asian Governments 353 CONTENTS vii 9.1 University Graduates by Field 367 9.2 East Asian Comparative Indicators, 2000 368 9.3 Changes in Work Practices Required to Assimilate Computer-Based Production Strategies 378 10.1 National Venture Capital Pools in Asia 402 10.2 Sources of Venture Capital Commitments in Asia and the United States, 2000 404 10.3 Import and Export of Venture Capital for Various Asian Nations, 2000 416 10.4 New NASDAQ-Like Stock Markets in Asia 420 PREFACE This is the fourth volume in a series of publications from a study cospon- sored by the government of Japan and the World Bank to examine the sources of economic growth in East Asia. The study was initiated in 1999 with the objective of identifying the most promising path to development in light of global and regional changes. The first volume, Can East Asia Compete?, was published in 2002. It pro- vides a compact overview of the relevant strategic issues and future policy directions. Innovative East Asia, the second volume, was published in 2003. It analyzes each of the main issues and consequent policy choices, drawing comprehensively on recent empirical research and the findings of firm surveys conducted for the study. Its principal message is that sustained economic growth in East Asia will rest on retaining the strengths of the past (stability, openness, investment, and human capital development); on overcoming the sources of current weaknesses in the financial, corporate, judicial, and social sectors; and on implementing the changes required by the evolving economic environment, particularly with respect to technol- ogy development. The third volume, Global Production Networking and Technological Change in East Asia, is the first of two volumes of papers com- missioned for the East Asia study. It presents detailed information, analy- sis, and case studies showing that economies in East Asia need to adapt to the changing character of global production networks and to nurture and develop technological capabilities if they are to sustain their growth prospects. This volume, Global Change and East Asian Policy Initiatives, includes a set of papers that examine some of the key institutional weaknesses iden- tified in Innovative East Asia. Contributors to this volume explore in depth topics ranging from regional issues arising from monetary and financial ix x PREFACE cooperation, trade, and harmonization to national issues of public expen- diture, corporate and public governance, the legal system, tertiary educa- tion, and finance. They also offer a wide array of policy options of value to East Asian economies. Some, if not all, of these issues are relevant to every country in East Asia. Both volumes complement Innovative East Asia and are addressed to researchers, students, and policymakers. The financial backing of the government of Japan through its Policy and Human Resources Development Fund provided vital support for this project, as did senior public officials who gave generously of their time. We are deeply grateful to Haruhiko Kuroda, Naoko Ishii, Masahiro Kawai, Kiyoshi Kodera, Rintaro Tamaki, Junichi Maruyama, and Takatoshi Ito. The staff of the World Bank's Tokyo office facilitated the reviews and seminars, and we greatly appreciate the assistance provided by Yukio Yoshimura, Shuzo Nakamura, Mika Iwasaki, Tomoko Hirai, and Hitomi Sasaki. We owe special thanks to K. Migara De Silva for his en- thusiastic and tireless support in organizing the seminars in Tokyo and participating in them. The papers in this volume were presented at seminars and workshops in Cambridge, Massachusetts; Tokyo; and Washington, D.C. The comments received helped the authors revise their drafts. We would like to thank all those who participated in the seminars, along with the many reviewers of the entire manuscript and, in particular, Esra Bennathan. At the World Bank, the Development Research Group has provided us a conducive environment for this study since its inception. In addition, we are grateful for the support provided by the East Asia and Pacific region. We are especially indebted to Jemal-ud-din Kassum and Homi Kharas for their guidance and strong encouragement. The study team was ably supported by the research skills of Soumya Chattopadhyay, Farhan Hameed, and Yifan Hu. The manuscript was pre- pared by Paulina M. Flewitt, Marc Sanford Shotten, and Rebecca Sugui; and we thank Patricia Katayama, Ilma Kramer, and Janet Sasser of the Office of the Publisher for their expert management of the editorial and print production of the volume. CONTRIBUTORS M. Anjum Altaf is a senior economist in the East Asia Urban Develop- ment Sector Unit, World Bank, Washington, D.C. Carles Boix is an associate professor in the Department of Political Science, University of Chicago. Bijit Bora is a counselor in the Economic Research and Statistics Division of the World Trade Organization, Geneva. Paul Crampton is the head of the Outreach Unit, Competition Division, Organisation for Economic Co-operation and Development, Paris. Barry Eichengreen is the George C. Pardee and Helen N. Pardee Professor of Economics and Political Science, University of California, Berkeley. John Gilbert is an assistant professor in the Department of Economics, Utah State University. Kyonghee Han is a visiting scholar in the Department of Human and Community Development, University of California, Davis. Martin Kenney is a professor in the Department of Human and Com- munity Development, University of California, Davis. Peter Lloyd is an emeritus professor in the Department of Economics, Faculty of Economics and Commerce, University of Melbourne, Australia. Howard Pack is a professor of economics and professor of business and public policy at the Wharton School, University of Pennsylvania. xi xii CONTRIBUTORS Dwight H. Perkins is the Harold Hitchings Burbank Professor of Political Economy and director of the Harvard Asia Center, Harvard University. Richard Rose is the founder-director of the Centre for the Study of Public Policy, University of Strathclyde, Glasgow, Scotland. Eisuke Sakakibara is the director of the Global Security Research Cen- ter, Keio University, Tokyo. Robert Scollay is the director of the New Zealand APEC Study Centre and a senior lecturer in the Economics Department, University of Auckland. Shoko Tanaka is a consultant in the Department of Human and Community Development, University of California, Davis. Kerrin Vautier is a senior lecturer in the Department of Commercial Law and International Business, University of Auckland, New Zealand. Sharon Yamakawa is a research associate at the Global Security Research Center, Keio University, Tokyo. Shahid Yusuf is a research manager in the Development Economics Research Group, World Bank, Washington, D.C. ABBREVIATIONS AND ACRONYMS ACFTA ASEAN-China Free Trade Agreement ADB Asian Development Bank AFI Asian Financial Institute AFTA ASEAN Free Trade Area AIA ASEAN Investment Area ANZCERTA Australia­New Zealand Closer Economic Relations Trade Agreement APEC Asia-Pacific Economic Cooperation APVCA Asian Pacific Venture Capital Alliance ASEAN Association of Southeast Asian Nations ASEM Asia-Europe Meeting B2B Business-to-business BIS Bank for International Settlements BVCA British Venture Capital Association CAP Collective Action Plan CER Closer Economic Relations trade agreement CGE Computable general equilibrium CMI Chiang Mai Initiative (chapter 2) CRFTA Cross-regional free trade areas DG IV Directorate-General IV ECU European currency units EMEAP Executives' Meeting of East Asia­Pacific Central Banks EMS European Monetary System EMU European Monetary Union EPZ Export processing zone xiii xiv ABBREVIATIONS AND ACRONYMS EU European Union EV Equivalent variation EVCA European Venture Capital Association EVSL Early Voluntary Sector Liberalization FDI Foreign direct investment FECL Federal Economic Competition Law (Mexico) FTA Free trade agreement FTAA Free trade area of the Americas FTSE Financial Times Stock Exchange (Index) GAO U.S. General Accounting Office GDP Gross domestic product GDPPC Gross domestic product per capita GTAP Global Trade Analysis Project HPAE High-performing Asian economy IAP Individual Action Plan ICT Information and communications technology IMF International Monetary Fund IPAP Investment Promotion Action Plan IPO Initial public offering IT Information technology ITU International Telecommunications Union JAFCO Japan Associated Finance Company JBIC Japan Bank for International Cooperation JSEPA Japan-Singapore New-Age Economic Partnership Agreement KDIC Korean Development Investment Corporation KED Kyoto Enterprise Development KOSDAQ Korean Securities Dealers Automated Quotation KTAC Korean Technology Advancement Corporation KTB Korea Technology and Banking KTDC Korea Technology Development Corporation MERCOSUR Southern Cone Common Market (Mercado Común del Sur) MFN Most-favored nation MITI Ministry of International Trade and Industry (Japan) MNC Multinational corporation MOF Ministry of Finance MOTHERS Market for High-Growth and Emerging Stocks MTI Ministry of Trade and Industry (Republic of Korea) NAFTA North American Free Trade Agreement ABBREVIATIONS AND ACRONYMS xv NASDAQ National Association of Securities Dealers Automated Quotation NGO Nongovernmental organization NIE Newly industrializing economy NTEFC New technology enterprise financial companies NTEFS New Technology Enterprise Financial Support (Act) NVCA National Venture Capital Association ODA Official development assistance OECD Organisation for Economic Co-operation and Devel- opment OTC Over-the-counter PC Personal computer PECC Pacific Economic Cooperation Council PPP Purchasing power parity PTA Preferential trading agreement R&D Research and development RPN Regional production network RTA Regional trading agreement SBIC Small business investment corporation SCU Surveillance Coordinating Unit SEACEN South East Asian Central Banks SEANZA Southeast Asia, New Zealand, and Australia (Group) SESDAQ Singapore Dealing and Automated Quotation SMEs Small and medium-size enterprises SMESS Small and Medium-Size Enterprise Start-up Support (Act) TFP Total factor productivity TIF Technopreneurship Investment Fund TII Trade intensity index TNI Transnationality index UN United Nations UNCTAD United Nations Conference on Trade and Develop- ment VC Venture capital WTO World Trade Organization CHAPTER 1 WHAT GLOBALIZATION MEANS FOR EAST ASIA M. Anjum Altaf and Shahid Yusuf T he recent economic performance of East Asia draws a large share of its dynamism and some of its occasional turbulence from the march of globalization. The growth of trade has provided the region's liberalizing economies with the pull of market opportu- nities for an ever-widening range of manufactures. It has also intensified competition, thereby forcing exporters--as well as producers for the do- mestic market, which are now exposed to the threat from imports--to raise productivity (Lawrence and Weinstein 2001). To the gains from trade must be added the benefits from the transfer of knowledge and technolo- gies arising from tightening global integration, a process that is also asso- ciated with a steady expansion of foreign direct investment (FDI) flowing mainly from the industrial countries to the emerging economies. Along with trade, FDI is an important vehicle for technology transfer, and together with an increasing supply of human capital, it has been a force supporting industrial upgrading.1 FDI has been vital for the export-led development of Singapore, China, Malaysia, Hong Kong (China), and Taiwan (China), and it has played a significant role in exposing those economies to the international circulation of knowledge. Although researchers still debate the benefits of openness, the extent to which East Asian countries have lowered import barriers, and the growth impetus derived from trade, the weight of research spanning the past three decades suggests that trade-mediated global and regional integration has 1. Hsiao and Shen (2003) establish that FDI leads to growth, which then attracts more FDI and so on in a virtuous spiral. According to Hermes and Lensink (2003), the effects of FDI are mag- nified by an efficient financial system. And Miller and Upadhyay (2000) show that openness and human capital together contribute to the growth of total factor productivity. 2 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES supported growth and investment.2 Similarly, the empirical evidence gen- erally points to productivity-enhancing technology transfer, perhaps more through vertical transmission mechanisms rather than through horizontal spillovers (Nabeshima 2004). Furthermore, for many countries, FDI is a source of industrial funding and in some cases--as in China--offsets distortions in the domestic capital market (Huang 2003). There is a less positive side to globalization. The integration of trade and the increase in flows of portfolio capital have subjected East Asia to considerable buffeting. In 1997­98, the region was left reeling from ex- change rate and financial crises. The suddenness of these crises and their quick spread across markets and countries were rooted in the scale and volatility of capital flows. East Asian economies are also undergoing rapid shifts in the competitiveness of major exports, changes in international production networking, and significant reconfiguration in the geographi- cal composition of production systems that have provided the foundation for the region's growth. These changes have been coupled with demands for social safety nets, which are generated by the increasing openness of East Asian economies and are supported by the emergence of political institutions giving people greater voice (World Bank 2000b). Sustaining dynamism in East Asia requires policy initiatives to contain the risks from shocks and to manage the ongoing shifts and changes in ways that enhance both the competitiveness of firms and the stability of the economies. Research published over the past few years has exhaustively analyzed the causes and the nature of the 1997­98 crisis. Taking the crisis as a point of departure, researchers have also begun examining changes in the finan- cial sector, in corporate governance, and in innovation capability; the shifts in comparative advantage that have resulted from the integration of China into the global economy; and the working of global value chains triggered by the evolving strategies of multinational corporations (Hanson, Mataloni, and Slaughter 2001; Lardy 2002; Yusuf and Evenett 2002; Yusuf, Altaf, and Nabeshima 2004; Yusuf with others 2003; World Bank 1998, 2000a). Most East Asian economies have registered broadly positive per- formances during 2000­03, and several have grown vigorously over this period. Future development, however, will depend on the quality and timeliness of policy actions. This volume provides an assessment of the 2. See, for instance, Baldwin (2003) and Srinivasan and Bhagwati (1999) for a review of the evidence linking growth with openness, Wacziarg and Welch (2003) for a recent and positive reading of the empirical evidence, and Rodríguez and Rodrik (2000) for an earlier and trenchant critique reiterated by Lee, Ricci, and Rigobon (forthcoming). A wide-ranging assessment of East Asian development through the mid-1990s can be found in Leipziger (1997). WHAT GLOBALIZATION MEANS FOR EAST ASIA 3 prospects of the middle- and higher-income countries in the region and an exposition of specific policy responses that could enable those countries to capitalize more fully on regional and global integration while containing the risks of economic, political, and technological turbulence. The volume covers a number of themes, with each author having a specific thematic focus. In this sense, the range of the volume is wider than that of a typical conference proceedings; however, it has a thematic hinge, which is global- ization and the associated competitive pressures. The multiplying links between East Asian countries are increasing the need for coordinated policy measures and for steps toward a harmoniza- tion of market institutions. The former can support cooperation and coordination with the aim of minimizing the risk of crises spreading from one country to its neighbors, facilitating trade, and maximizing the economies of scope. The latter can address domestic concerns relating to governance, corporate restructuring, the transition to innovative economies, and social protection against volatility in the future. The East Asian crisis drew urgent attention to a number of areas where regionwide initiatives were needed. These areas are the focus of the first four papers. In chapter 2, Barry Eichengreen deals with the legacy issue of monetary and financial links, which are at the heart of the crisis of 1997­98. He proposes cooperative mechanisms for increased stability. Then, in chapter 3, Eisuke Sakakibara and Sharon Yamakawa examine the natureofcooperationneededtopromotetradeandFDI,whileinchapter4, John Gilbert, Robert Scollay, and Bijit Bora chart the welfare implications of the emerging alternatives for regional cooperation. Finally, in chapter 5, Peter Lloyd, Kerrin Vautier, and Paul Crampton highlight the importance of harmonizing competition policy across the region if the benefits of cooperative policies are to be fully realized. The second set of papers addresses domestic policies and institutional development to complement what is done at the regional level. This set of papers is devoted to situation assessments and policy initiatives needed within individual countries. As Bordo and others (2001) and Eichengreen and Bordo (2002) have noted, global integration has exposed countries to more frequent shocks since 1973 and to the greater likelihood of twin crises--in banking and currency. This observation is, in turn, leading some groups to demand a widening of efforts by the state to provide income security (Rodrik 1997). In addition, it has underscored the importance of corporate and governance reforms that reduce the likelihood of crises. In this context, Carles Boix assesses in chapter 6 the status of public spending on social welfare and predicts a need to protect vulnerable groups. Dwight H. Perkins and Richard Rose address the issues of corporate and political 4 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES governance, respectively, in chapters 7 and 8, while Howard Pack assesses in chapter 9 the demands that would be placed on higher education to support reforms in governance and accountability. Although such institu- tional changes can serve to promote stability, perhaps of even greater sig- nificance for the future welfare of East Asian nations is the flexibility and resilience that can derive from measures augmenting efficiency and inno- vation capability.3 As discussed at length in Yusuf with others (2003) and further underlined by Pack in this volume, higher education is a key to de- sirable outcomes. Finally, in chapter 10, Martin Kenney, Kyonghee Han, and Shoko Tanaka survey the availability in East Asia of venture capital, which is a vital ingredient in the success of innovative economies. In the balance of this chapter, we will first present a framework within which to view externally driven changes affecting East Asia and to high- light the cross-cutting themes that run through the chapters. We will then provide an overview of the principal messages of and the links between the themes explored. Finally, we suggest future directions of research on some of the topics covered in this volume. POLICY AND INSTITUTIONAL RESPONSES TO GLOBALIZATION Economic integration is affecting the East Asian region at two levels. The first level is integration with other parts of the world, starting primarily with the industrial countries but extending increasingly to developing countries. The second is integration within the region, as proximity and rapid income growth induce trade as well as flows of capital and labor. This process is inexorable. As Basu (2003, p. 898) observes, "Globalization is a bit like gravity. We may discuss whether it is good or bad, but the ques- tion of not having it does not seriously arise. We have to live with it . . . [and] a world like the one we have today but without globalization is diffi- cult to imagine." It is in everyone's collective self-interest to make global- ization work better. Until the late 1990s, much of the focus of globalization was on charting the trends in trade and in capital flows and on the factors affecting those flows, mainly trade barriers and regulations affecting capital mobility. The East Asian crisis of 1997­98 forced policymakers and researchers to begin rethinking the easy certainty about the benevolence of globalization and to focus on managing the volatility of factor movements and on minimizing 3. On the attempts by Taiwan (China) and the Republic of Korea to build economies capable of innovation, see Amsden and Chu (2003) and Keller and Pauly (2003). WHAT GLOBALIZATION MEANS FOR EAST ASIA 5 the disruption from inevitable shocks. The crisis also greatly sharpened concerns about the sharing of the gains from globalization within and among countries. A mapping of trade and factor flows and an analysis of their determi- nants continue. These efforts are helping us better understand the me- chanics of integration. However, at the same time a literature is emerging that is beginning to sketch policies for an integrating world. This litera- ture delineates institutions that will determine the quality of globalization and suggests why--and how--an integration of certain institutions is es- sential for a globalization that all nations can profitably embrace. This vol- ume offers a unified perspective on this new thinking that brings out the interlacing of trends, policies, and institutions. How globalization unfolds and the nature of its developmental consequences will depend on the craft- ing of policies and institutions. Moreover, East Asia, which is the fastest- growing and most rapidly integrating region in the world, provides a lens into the defining and plaiting of policies and institutions in four areas: 1. Trade and growth 2. Crisis avoidance and management 3. Safety nets 4. Market institutions. Trade and Growth Arguably, flourishing trade has been the defining characteristic of develop- ment in East Asia. It is also the principal vehicle for East Asia's close links with the global economy and, more recently, for the tightening regional integration. Starting with policies aimed primarily at promoting exports, East Asian economies gradually liberalized imports in conjunction with the various General Agreement on Tariffs and Trade rounds. Although coun- tries continue to implement the commitments made as a part of the Uruguay Round, in the past few years interest in regional and bilateral trading agreements has surged. This interest was partially initiated and is now increasingly sustained by the enormous expansion of intraregional trade.4 In the process, a host of regional institutions have emerged. These institutions sustain trade policies that are strengthening the ties among countriesaroundthePacificRim.Whetherthetradepolicieswillconstitute 4. For example, Japan and Singapore have signed a free trade agreement, and so have China and Thailand. Furthermore, China and the Association of Southeast Asian Nations have signed an early harvest agreement ("East Asia: ASEAN 3" 2004). See also Urata and Kiyota (2003) for an account of these agreements and estimates of their effects. 6 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES "building blocks" for another stage of globalization is still being debated, but there can be no denying their integrating effects in East Asia, both directly through trade channels and indirectly through the stimulus such institutions have provided to FDI and policy coordination in other areas. Crisis Avoidance and Management Whether the East Asian crisis proved contagious primarily because of trad- ing links among East Asian countries, because of capital flows, or even because the countries shared the same neighborhood, the fact is that the crisis highlighted the shared interests of East Asian economies in prevent- ing shocks and containing turbulence. The result has been much greater attention to policies affecting the size and composition of external debt, the scale of reserves, and exchange rates. The leading East Asian economies have all successfully cut down their external obligations--particularly their short-term debts--and have vastly enlarged their reserves. Several have also adopted more flexible exchange rate policies, although the currencies of China and Hong Kong, China, remain pegged to the U.S. dollar. In ad- dition, East Asian countries are also seeking institutional guarantees that will buttress national policies. Exchange swaps, albeit on a limited scale, are a step in this direction, but there is interest in formal arrangements for co- ordinating macroeconomic policies and in surveillance arrangements to monitor compliance. The possibility of creating an Asian Monetary Fund was discussed in the immediate aftermath of the crisis, and although it is no longer under active consideration, the sense of interdependence now apparent in the region means that such institutional pegs for achieving greater stability are beginning to figure on the agenda of policymakers. Safety Nets Globalizationandtheshiftsincomparativeadvantagehavesensitizedwork- ers to the threat of unemployment. Although the crisis of 1997­98 resulted in an unemployment spike that dissipated within a couple of years, with greater openness certain industries or regions within countries can experi- ence a secular decline that leads to persistent unemployment. Industries in China and Japan are having to cope with such a decline, and governments are forced to face the social and political costs of structural unemployment. In the future, this problem is likely to be compounded in some East Asian countries by a bulge of retirees from an aging labor force. Thus, for East Asian countries, the need for a social security system adequate for the changing circumstances is rising in urgency. Singapore already has a system WHAT GLOBALIZATION MEANS FOR EAST ASIA 7 in place, as do Japan and the Republic of Korea, but such structures are less well developed in the other countries. Although macroeconomic policies offer some protection, East Asian economies will need to augment the safe- tynetsforthemorevulnerablesegmentsofsociety.Formanyofthesecoun- tries, this effort must go hand in hand with fiscal initiatives to mobilize the resources needed to finance a solid social security system. By and large, the level of fiscal effort in the middle- and lower-income countries is modest relative to that in the Organisation for Economic Co-operation and Devel- opment (OECD) nations. This situation provides room for maneuver, but it also calls for fiscal reforms that are politically contentious, difficult to im- plement,andpossiblydeleteriousforcompetitiveness.However,withglob- alization, the pressure to reshape and strengthen the tax system to augment revenue elasticity, to respond to actions of trading partners, and to take account of e-business, for example, cannot be avoided.5 Market Institutions The pursuit of stability and security under globalization must be comple- mented by institutions that will maximize the economic benefits. Many of these institutions affect economic performance through their influence on market functioning and on the degree of competition. From a growth per- spective, five types of institutions are of special significance. They are institutions 1. That determine the efficacy of the legal system in protecting economic rights 2. That affect the quality of corporate governance and the degree to which it protects the rights of minority shareholders 3. That underpin the financial system (in particular, capital market institu- tions that mediate access to finance, supply of risk capital, and availabil- ity of a variety of financial instruments) 4. That control the flow and volume of information, thereby influencing transactioncostsandaccountability(mostrecentlybywayoftheInternet) 5. That define the ground rules for market interaction, such as competi- tion and investment policies and rules for mergers and acquisitions. With globalization, each of these types of institutions has taken on a heightened significance, because these institutions are the arbiters of competitiveness. If some countries are using information technology (IT) 5. The complexities of tax harmonization in the face of trade integration and agglomeration effects are modeled by Baldwin and Krugman (2000). 8 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES more creatively to reduce transaction costs, others must follow suit. Weak legal systems and distorted financial markets are a brake on growth and discourage FDI. Moreover, as the region integrates, instituting competi- tion policies, standards, and codes and harmonizing these measures with the institutions of regional partners can be advantageous in the long term. Sustained attention to policies and institutions will be necessary for integration to yield widely shared gains and to contribute to growth in the region. A round of globalization in the early twentieth century foundered in part because the leading economic powers failed to take the needed policy and institutional steps. How East Asia proceeds will be only one factor influencing the course of globalization, but given the rising impor- tance of the region, its weight can only increase, which is why the policies and institutions described by the contributors to this volume deserve a close reading. REGIONAL POLICY INITIATIVES Monetary and Financial Cooperation The most striking manifestation of the 1997­98 crisis was the monetary and financial instability and the contagion that threatened to engulf the entire region. This vulnerability and a heightened realization of interde- pendency triggered regionwide initiatives to create a zone of stability for the future. This resolve provides the starting point for Barry Eichengreen's analysis of regional policy alternatives in chapter 2, "Hanging Together?: On Monetary and Financial Cooperation." He argues that more could be achieved collectively than individually but asks whether regional institu- tions can play an effective role and reinforce the contribution of multilat- eral institutions in an age of seamless globalization. Eichengreen comes out categorically against any attempt to establish a system of collectively pegged exchange rates. He argues that they would not be able to withstand the pressures exerted by high capital mobility and more democratic politics. Industrial development now requires raising productivity and pursuing innovation and not holding down wage costs. Furthermore, monetary and exchange rate policies do not act directly on productivity as they do on wages. Eichengreen believes, as others have also noted, that the case for financial cooperation to strengthen the super- vision of banking systems is stronger than the case for monetary coopera- tion to stabilize intra-Asian exchange rates. In keeping with that argument, Eichengreen recommends cooperation on initiatives to upgrade prudential supervision and regulation and on WHAT GLOBALIZATION MEANS FOR EAST ASIA 9 fostering financial transparency and creditor rights. For this purpose, set- ting up an Asian Financial Institute (AFI) could be a way of establishing standards,6 identifying policies, coordinating initiatives, monitoring com- pliance, and enforcing agreements. In Eichengreen's view, the Association of Southeast Asian Nations (ASEAN), plus China, Japan, and Korea ( 3), would be the most appropriate entity to pursue such an initiative. The AFI would need to fit into the global framework by ensuring that the strategies it promotes do not conflict with those being promulgated at the global level. As a regional body, the AFI would have the flexibility to vary the mix of financial standards to suit the local context: the mix could be different (for example, looser restrictions on portfolio concentrations could be offset by tighter restrictions on capital requirements), but the overall effect need not be any less stringent than that mandated by global standards. This method is one way a regional agreement could add value to existing global agreements. Trade and Foreign Direct Investment Trade and FDI have played a major role in the development of emerging economies in East Asia and other parts of the world. Hence, it is natural to ask if regional cooperation could promote them further as contributors to regional prosperity. Given the ongoing reconfiguration of global produc- tion systems mentioned earlier, the barriers to cross-border flows have also assumed greater importance, because these barriers can interfere with a country's participation in such networks and can discourage FDI. In chapter 3, "Trade and Foreign Direct Investment: A Role for Regionalism," Eisuke Sakakibara and Sharon Yamakawa state the consen- sus view that trade promotes FDI, which, in turn, leads to more trade. However, they argue that, in an emerging global production system, the old way of analyzing the links may no longer be the most useful. The main question today is where do firms choose to locate in order to organize pro- duction and access resources as profitably as possible for national, region- al, or global markets? The location determines where they invest, where they trade from, and where FDI is directed. Sakakibara and Yamakawa contribute to the evidence showing how China is influencing the region's trade and FDI patterns while multinational corporations (MNCs) from both inside and outside the region shift operations to tap China's markets and to benefit from production cost advantages. Not only have companies 6. This point is picked up by Lloyd, Vautier, and Crampton in chapter 5. 10 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES such as Seagate, Intel, Dell, and Flextronics relocated their operations in China, but numerous firms from Taiwan (China), such as Quanta; from Thailand, such as Charoen Pokphand; and from Korea, such as Samsung, have set up production facilities to service China's burgeoning demands. In this dynamic context, Sakakibara and Yamakawa present two ap- proaches to promote trade and FDI in East Asia: regional agreements and regional production networks (RPNs). First, they survey existing regional agreements and note the transition from separate trade and FDI agree- ments to combined agreements. This trend is reflected in emerging free trade agreements (FTAs), such as the proposed ASEAN-China and ASEAN-Japan FTAs. It could indicate that policymakers are recognizing that MNCs are moving away from the old model, which starts with ex- porting and proceeds to FDI, to a more integrated one that is built around international production networks and involves the consolidation of pro- duction facilities in a few locations and the building of a base of suppliers geographically oriented to efficiently serve the needs of those facilities. Sakakibara and Yamakawa acknowledge that larger trade groupings might be more welfare enhancing, but they support bilateral agreements as a move toward broader multilateral agreements. This thinking is in line with a major strand in the literature which views FTAs as stepping stones (see Frankel 1997).7 Sakakibara and Yamakawa conclude that trade and FDI would benefit from including both developing and industrial coun- tries in the agreements, choosing partners with care, and aiming for com- prehensive agreements that allow coordination of trade and FDI policies. Sakakibara and Yamakawa's second proposal is more radical. They ar- gue for the establishment of regional production networks along the lines of global production networks. The authors show that the number of East Asian MNCs from the emerging economies is increasing, but such MNCs are considerably smaller than those of industrial countries and do not have as extensive a geographical reach. Thus, except in a few cases such as Samsung and Hyundai, it is difficult for them to benefit from markets in industrial countries. Limited RPNs emerged in East Asia when Japanese firms began invest- ing in Southeast Asia, especially following the appreciation of the yen after the Plaza Accord in 1985 (Hatch and Yamamura 1996). The most obvious example is the network of automobile assemblers and their suppliers, which has allowed the industry to grow in the region beyond the confines im- posed by limited national markets. Regional production sharing can bring 7. On the nature and possibility of dynamic gains in the ASEAN Free Trade Area, see Fukase and Winters (2003). WHAT GLOBALIZATION MEANS FOR EAST ASIA 11 similar benefits in other industries as well, where producing the entire product at the national level is still common. It would allow specialization at the firm level, while permitting firms to participate in a wider regional market, which might be easier to accomplish than trying to compete in the global market from the outset. Sakakibara and Yamakawa acknowledge the difficulties in establishing RPNs simply because, for large MNCs, there is a broader set of choices globally than regionally. However, they feel that the East Asian regional economy is now sufficiently large and diverse to allow the comparative advantages of individual countries to be brought together so as to maxi- mize the advantages of the region as a whole. Cultivating a regional environment appealing to MNCs would take considerable cooperation in policymaking.8 Policies obstructing cross- border production would need to be eliminated or modified, and stan- dardization of products and customs regulations would help reduce costs and facilitate the flow of goods.9 The task of creating an environment con- ducive to networked production by firms is clearly more complex than the mere removal of trade barriers. Political will would be needed to accept possible declines in the importance of certain industries in individual countries as a consequence of leveraging regional comparative advantage. Sakakibara and Yamakawa see a regional approach as a stage between a national and a global approach, which is consonant with their perspective on regional FTAs as stepping stones to multilateral agreements. Choices among Regional Trading Agreements It is quite clear that all regional trading agreements cannot be equally effective and that there is need for a systematic evaluation of the various alternatives. In chapter 4, "New Regional Trading Developments in the Asia-Pacific Region: Implications for East Asia," John Gilbert, Robert Scollay, and Bijit Bora complement the chapter by Sakakibara and Yamakawa. They provide a quantitative assessment of the net benefits of the various possible regional preferential trading agreements (PTAs). Gilbert, Scollay, and Bora reiterate that, since 1999, there has been a strong trend in East Asia favoring the formation of PTAs. This trend was stimulated by the crisis and by the experience of the European Union, as 8. It could form one item on the agenda of the AFI recommended by Eichengreen in chapter 2. 9. This observation, too, links to the recommendations made by Lloyd, Vautier, and Crampton in chapter 5. 12 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES well as by trends in the Americas.10 In contrast, in the mid-1990s, the Asia- Pacific Economic Cooperation (APEC), with its nonpreferential ap- proach, was considered the main instrument for regional integration. The willingness of large northeast Asian economies to enter PTAs is consid- ered a major break from the past. It reflects a marked shift in long-term perceptions of mutual gains from trade and currency unions, as well as a move by the United States toward a dual-track approach assigning equal importance to free trade and to PTAs. Using computable general equilibrium model simulations, Gilbert, Scollay, and Bora assess the welfare effects of various regional trading agreements, ranging from bilateral PTAs to an East Asian trading bloc. The purpose of the simulations is to determine whether the new agree- ments are likely to be building blocks or stumbling blocks in long-term moves to achieve free trade in the Asia-Pacific region.11 The results indicate that bilateral PTAs within East Asia will have min- imal regionwide welfare effects and possible negative effects for excluded economies. Their proliferation could also complicate the regional trading environment. Economic integration would be better served by PTAs in- cluding larger groupings of East Asian economies such as the proposed ASEAN 3 PTA, which seems to be the most favorable alternative. How- ever, if the decision between ASEAN 3 PTA and a China-Japan-Korea PTA were based on welfare effects alone, these three countries would be indifferent. Trade liberalization within the APEC framework yields better welfare outcomes than East Asian PTAs, including the ASEAN 3 PTA, because the gains for China and Japan are more significant under the APEC frame- work and outweigh the slightly reduced gains of Southeast Asian economies. Within APEC, two alternatives have been evaluated on the basis of preferential or nondiscriminatory most-favored-nation (MFN) liberalization. Preferential liberalization offers larger welfare gains, but MFN liberalization avoids the negative welfare effects on non-APEC economies and could, therefore, be considered more in line with a multi- lateral trading system. Overall, the simulations using the welfare criterion identify three dom- inant alternatives: ASEAN 3 PTA, APEC MFN liberalization, and 10. These trends reflect the acceleration in the formation of PTAs since 1995. Between 1995 and 2001, the World Trade Organization was notified of the formation of more than a hundred PTAs. 11. PTAs are more likely to be building blocks "insofar as they impel or consolidate policy reforms within the members; are open to outsiders; tackle the issues that are too complex for multilateral negotiations; influence negotiations towards free trade; and give non-members unconditional MFN status" ("Regional Trade Agreements" 2002). WHAT GLOBALIZATION MEANS FOR EAST ASIA 13 APEC preferential liberalization. Gilbert, Scollay, and Bora note that con- fidence in the ability to achieve APEC MFN liberalization is currently low, but they consider it to have some advantages over the other two options and see it as a potential building block toward an open multilateral trading system. Whether the other PTAs will turn out to be building or stumbling blocks cannot be predicted with equal confidence. Harmonizing Competition Policies Regional integration requires agreements on standards and the removal of obstructions to cross-border production and trade, as indicated by Eichengreen in chapter 2 and by Sakakibara and Yamakawa in chapter 3. One aspect of this discussion is taken up by Peter Lloyd, Kerrin Vautier, and Paul Crampton in chapter 5, "Harmonizing Competition Policies." They define deep integration as the harmonization of policies that are "beyond the border" and contrast it with shallow integration, which is restricted to traditional trade protection measures at the border. Regula- tory policies are good candidates for deep integration.12 Lloyd, Vautier, and Crampton focus on harmonizing competition law and its benefits, because although many East Asian countries do not have national competition laws, they are increasingly competing in each others' markets, and intercountry trade in goods and FDI are set to increase rap- idly under the liberalization schemes identified in previous chapters. The importance of cross-border aspects of competition policies and law can only become more acute over time.13 Proceeding from the theoretical benefits of competition and from limited evidence from measures that were taken in the European Com- munity, Lloyd, Vautier, and Crampton focus on competition-promoting policies, of which antitrust law is a subset. The essential principle that they stress is that of competitive neutrality (that is, a level playing field for all businesses to compete on equal terms). Harmonization of competition law is defined to include the development of national laws in countries that have none, the selection of core standards in all countries, and the convergence of standards for the elements in the core where benefits can be shown to result from such convergence. Harmonization does not nec- essarily mean uniformity of standards. 12. Regulatory policies are also important at the sector level, and later chapters deal with their relevance for finance, telecommunications, and venture capital. Policy convergence at the sectoral level would also be beneficial for the regional economies. 13. For a discussion of competition policies, particularly in small open economies, see Gal (2003). 14 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES The chapter draws on global experience in harmonizing competition policies and recommends steps that could be taken by East Asian economies. The experiences of the European Community (and later the European Union), MERCOSUR (the Southern Cone Common Market or Mercado Común del Sur), and the Andean Community show that it is possible to arrive at competition policies with a regional coverage without preexisting national laws in all countries and to derive decent returns from the enforcement of these laws (Yusuf and Evenett 2002). The sequencing may indeed be an advantage that allows easier standardization or conver- gence of important laws. NATIONAL AND SECTORAL POLICY RESPONSES In parallel with regional initiatives, there are policy issues that need to be addressed within each country. These policy issues range from strength- ening social safety nets, to improving corporate and political governance, to promoting economic efficiency and innovation. These areas have be- come more urgent in a global economy, which is more open, more com- petitive, more volatile, and more demanding in terms of transparency and accountability. The remaining chapters in the volume deal with the na- tional or sectoral aspects of policy reform. Social Protection The advantages of embeddedness in the global economy and closer links with neighboring countries are accompanied by greater exposure to exter- nal shocks, more rapid transmission of disturbances, less control over poli- cy instruments, and, consequently, greater volatility of household incomes. For this reason alone, East Asian countries need to devote attention to the extent and robustness of social safety nets for the future. The priority is raised in the context of a growing political voice of middle-class voters and of aging populations. In chapter 6, "The Public Sector," Carles Boix as- sesses the state of public sector spending in East Asia from this perspective. The principal finding is that East Asian economies have a public sector that is small both in absolute terms and in relative terms, given their level of development. The average East Asian public sector (excluding that in Japan) is about half the average OECD public sector and about a third smaller controlling for per capita income levels. In addition, welfare spending remains fairly modest in most of the countries: until the late 1990s, compared with an average OECD allocation of more than 20 per- cent of gross domestic product to transfers and subsidies, the spending was WHAT GLOBALIZATION MEANS FOR EAST ASIA 15 about 8 percent in Korea and less than 5 percent in the Southeast Asian economies. According to historical patterns, East Asian countries are likely to see a significantincreaseinthesizeofthepublicsectorsimplybecause,inhigher- income countries, public spending has tended to grow with moderniza- tion. However, the growth of transfers is linked with the increase in democratization, and so far redistributive pressures remain fairly muted in East Asia compared with European countries, for example. Boix posits a formal model based on a global dataset to test these hypotheses. His results confirm that the public sector grows as a result of economic modernization, regardless of the political regime, because of increased expenditures on public goods and investments. But increases in transfers and other welfare benefits depend strongly on the extent of democratization. The model is used to generate a broad estimate of trends in public ex- penditures in East Asia looking forward to 2015. Total public outlay shows an upward trend, which is driven by an aging population and economic modernization, with the high-income countries (Japan and Korea) show- ing a stronger spending pressure compared with the other countries.14 The increasing size of the public sector and of welfare expenditures is politically unavoidable, and for most countries in the region, it could be fi- nancially supported despite fiscal deficits, which are currently squeezing social spending in some countries, and contingent liabilities, which could constrain future spending in others. On the basis of the small size of the public sector in relative terms, Boix considers that the scope for growth exists and that there is likely to be political support for such an expansion if East Asia follows the OECD pattern. East Asian governments have gen- erally proved quite adept at dealing with economic shocks, and there is no reason to think that any demand for higher levels of public spending, were it to arise, could not be managed through fiscal actions tailored to the cir- cumstances of individual countries. Corporate and Political Governance The role of the state in industrial policy and issues of corporate governance became much discussed topics following the East Asian crisis. Crony capital- ism became a popular term to describe a major problem in the region, and corporate reform was a key item on the reform agenda. The recent string of corporate scandals in the United States has weakened the credibility of the conventional reform proposals being introduced in East Asia and has 14. The model does not predict well for Singapore. 16 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES given some pause for thought. In chapter 7, "Corporate Governance, In- dustrial Policy, and the Rule of Law," Dwight H. Perkins makes use of the opportunitytoexaminetheissueingreaterdepthandinitshistoricalcontext. Perkins points out that Western corporate financial practice rests on a system in which governments make rules that structure and regulate mar- kets but are not directly involved in the functioning of markets. Nor are governments involved when the rules are violated; legal systems or inde- pendent regulators perform the necessary functions. The concerns of cor- porate governance are to protect investors from predatory managers and to ensure a fair return on investment, without which capital markets, which depend on minority shareholders, would be underdeveloped. In East Asia, during the early years of catch-up development, governments had a defensible activist role in industrial policy. Most firms were financed either by family or by state capital, and judicial systems were quite weak. Thus, expecting a Western style of corporate governance was not realistic. This situation has been changing as East Asian countries have devel- oped and have become more integrated into the global economy. But the situation has not changed fast enough, because the focus of competition policy has been on how to create internationally competitive firms, not on how to curb domestic market power. This focus, too, would need to change in the future, but given the close ties established over years be- tween governments and large enterprises, both public and private, it is not simple to initiate the process. Who exactly should change the system, and how should it be done? Perkins concludes that reforming the economic system might entail a parallel reform of the political system and its financ- ing, which is a much more complex undertaking. Perkins's main message is that East Asian economies in the emerging global order would need to rely less on government intervention and more on the market, but that the latter will not deliver without judicial or regula- tory bodies strong enough to enforce the rules that govern markets. A set of institutions is needed that can independently, efficiently, and fairly enforce therulesofamarketsystem.TheinformalinstitutionsthathaveservedEast Asia in the past would prove increasingly inadequate for economies want- ing to integrate fully into a complex global economy. Although democracy is not a panacea, strengthening the institutions of democracy and giving greater freedom and independence to the press15 might provide the only secular force consistently moving the system in the desired direction. 15. See Dyck and Zingales (2002) on the influence of the media and corporate governance. On the effects of an independent media on voter turnout and political competition, see Besley and Burgess (2002). WHAT GLOBALIZATION MEANS FOR EAST ASIA 17 Democratization is also a factor in mediating the impact on political governance of disruptive technologies like the Internet. Like Perkins, Richard Rose is not sanguine about the prospects for rapid political change driven by advances in information and communications technology (ICT) and the potential of e-governance. In chapter 8, "Governance and the Internet," Rose argues that the effects of the Internet on political gover- nance depend on the existing state of openness, accountability, and bureaucratic preparedness for the effective use of IT and the rule of law within a country. In the framework Rose presents, the Internet's effects will vary with the extent to which political accountability and rule-based administration exist within a country. Where both are low, governments will see the In- ternet's promotion of openness and information flow as a threat and will aim to suppress its spread. Where both are high, the Internet will deliver gains in efficiency and convenience, but the political implications will be marginal. The more interesting cases are those in which one of the two attributes is high and the other is low. Where rule-based administration is high, but political accountability is low, Rose speculates that the determinant of changes would be the rising expectations of citizens from their govern- ments. The Internet would have a marginal role to play, if any. In the oth- er case, institutions of political accountability provide dissatisfied citizens the avenues to challenge inefficiencies and violations of rules. In such a sit- uation, the Internet could be an effective tool for bureaucratic reform. However, in all cases, the direct link from IT advances to improvements in political governance is weak. Economic prosperity and political democratization could reasonably be expected to increase the demand for better governance, greater rule of law, and more efficient delivery of services. But servicing this demand would not follow automatically. In chapter 9, "Education for Growth: Deepen- ing or Widening?," Howard Pack makes the point that people with very specific skills and training would be required for the purpose. Pack argues that the emphasis on manufacturing and export markets has led to a neg- lect of skills needed for the functioning of economies, which are becoming too complex to allow the neglect to continue. The focus on increasing the efficiency of banks, on improving the quality of governance and trans- parency, and on instituting competition policies and the rule of law has implications in terms of a derived demand for specialized skills needed by providers of producer services. These skills have been underproduced un- til recently in almost all of the emerging economies because the emphasis has been on the manufacturing sectors. 18 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES Pack makes the case for increasing the supply of accountants, auditors, risk specialists, underwriters, actuaries, lawyers, and regulators. As the number of smaller firms increases, more management and executive skills will also be needed. And flexible labor markets will require skills in indus- trial relations and in the design of portable pension systems. Increasing numbers of start-up firms will call for skills in venture capital provision and in bankruptcy and intellectual property law. The main message is that the fascination with manufacturing technology and the temptation to con- tinue following a successful strategy whose objective is the export of stan- dardized industrial products should not obscure the somewhat mundane need for a host of softer skills that are essential for the functioning of economies that are becoming integrated into the global market system. Promoting Efficiency and Innovation The commoditization of many manufactured products and the emergence of China as a lower-cost producer have forced the realization that manu- facturing firms in the middle-income countries of East Asia have to both become more productive and move up the value chain by relying on prod- ucts based on proprietary technology (see Yusuf with others 2003). Such a transition requires investment in productivity-enhancing technologies and the coming together of an innovation system that comprises not just technical innovation but also a variety of institutions and services. These range from institutions required to increase the pool of innovative work- ers and finance innovative start-ups to services required to protect and market proprietary products. The two remaining chapters address these aspects of efficiency and innovation in East Asian countries. Education is an obvious starting point. However, Howard Pack cautions against a one-size-fits-all policy. A large country such as China and a more advanced one such as Korea can invest in institutions of higher education of a quality needed to become a steady source of innovative research. Oth- ers may find it more cost-effective in the short run to rely, at least partial- ly, on advanced training abroad for basic research, while promoting local schools and research entities to work with industry to generate knowledge for applied research. Whether it is tertiary-level training or research, re- turns to investment will be maximized through international collaboration that allows East Asian countries to draw on knowledge and expertise from elsewhere in the region as well as from the industrial nations. The need for East Asian economies to become more technologically innovative is generally accepted. How to get there remains the critical issue. The intense research on the causes of innovation during the recent WHAT GLOBALIZATION MEANS FOR EAST ASIA 19 dot-com bubble in the United States suggested a close association be- tween innovation and start-up firms in the high-tech sectors. But this model is not necessarily the only one, and the choice of model has impli- cations for supporting policies and institutions. The model associated with dynamic start-ups is a highly decentralized one, which is based on large investments in numerous high-quality research universities, continuous public funding of basic research, public funding for cutting-edge defense-related research and applications, an intensely competitive market economy, and an effective structure of intel- lectual property rights protection. Such a system can be established only over a long period of time. Promising ideas for commercial spin-offs from public and defense-oriented research are brought to market for funding by entrepreneurs, and venture capitalists provide the seed funding to nurture them through the development phase. Thus, private venture capital is a critical component of this system. Many East Asian economies do not have the elements of such an inno- vation system in place, nor could one be created instantly even if the fund- ing were available. The alternative to the "wide and shallow" model is the "narrow and deep" one in which the state jumpstarts the innovative process in strategically chosen sectors of the economy and through large firms chosen for the purpose. The examples of Samsung, Hyundai, and Daewoo in Korea and of Taiwan Semiconductor Manufacturing Company and UMC in Taiwan (China) come to mind (Amsden and Chu 2003; Mathews and Cho 2000). The latter model, often the only feasible one at the outset, is much more risky and can fail more often than it succeeds (for example, Indonesia's gamble on the aircraft industry or Malaysia's invest- ment in the automobile industry). But there have been notable successes in Japan and Korea. Private venture capital is of much less importance in this model. The most helpful outcome is if such an initiative becomes the nucleus for the evolution of a wide and shallow system through accumula- tion over time.16 Martin Kenney, Kyonghee Han, and Shoko Tanaka have the wide and shallow model in mind in chapter 10, "Venture Capital Industries." In that chapter, they assess the status of venture capital in the region. It is not surprising that they conclude, "If one adopts a Silicon Valley definition of venture capital [VC], then probably only Taiwan, China, would qualify." Kenney, Han, and Tanaka note important differences 16. Taiwan, China, could be considered an intermediate case in which the state invested in the research infrastructure and the timing coincided with the availability of venture capital from the Taiwanese diaspora in Silicon Valley. 20 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES between VC in the United States and VC in most East Asian countries. In the United States, there are a large number of nonprofit institutional fund- ing sources but no direct government investment. In contrast, East Asian countries rely more on funding from industrial corporations and direct government investment. The objectives of VC are also different in East Asia. Both in Japan and Korea, VC subsidiaries were first formed by financial institutions, not to seek capital gains through start-up investments, but to develop long-term banking relationships with the firms they funded. This situation began to change only after the Internet boom in the United States, but it slowed down again after the collapse of the boom in 2001. In Korea, the objective at the outset was the establishment of a funding body by the government to assist the transfer of research from state institutes to small and medium- size enterprises, quite different from the U.S. model. Kenney, Han, and Tanaka elaborate on the essential features of VC in four country groups that share similarities within East Asia: (a) Japan and Korea; (b) Hong Kong (China) and Singapore; (c) China; and (d) the re- maining countries (Indonesia, Malaysia, the Philippines, Thailand, and Vietnam). The key requirement for U.S.-style VC to emerge is to have a large enough number of deals to make the VC industry a viable proposi- tion (that is, a competitive market with many more small firms). Allowing pension funds to invest a percentage of their assets in start-ups would pro- vide a boost to the VC industry, but such a change would need to be phased in carefully to prevent a glut of capital and a consequent drop in returns. Establishing a private VC industry also requires the same reforms in corporate governance as noted by Perkins, without which venture capital- ists would feel at a disadvantage in interactions with the owners of the firms. Effective bankruptcy laws and credible and securely regulated exit options in the form of secondary stock markets for launching initial pub- lic offerings are also needed for U.S.-style VC to take root in East Asia. The recent economic downturn has posed a major challenge for the VC industry in East Asia, but it also provides the breathing room to reappraise policies, including those related to second stock market boards, and to make the policy changes necessary for the industry to play its part when growth rebounds. CONCLUSION AND RESEARCH DIRECTIONS The elements of a future growth agenda for East Asia are gradually falling into place. High on the list are regional measures to minimize shocks and turbulence, to facilitate trade, and to take advantage of the evolving global WHAT GLOBALIZATION MEANS FOR EAST ASIA 21 production networks. The domestic agendas are dominated by reforms in corporate and political governance, by the transition to efficient and inno- vative economies, and by movement toward social protection in keeping with the greater volatility of the global economy, of which East Asia is an increasingly integral part. In each of those areas, the chapters in this vol- ume offersuggestions that will contribute to the informed discussion that is needed on the issues. Policies and institutions that are driving growth and integration in East Asia are central to all of the chapters in this volume. The authors draw on the available literature to provide a careful description and rigorous as- sessment. However, as is typical with topics as complex as the ones cov- ered, many questions remain to be addressed by future research. Here we briefly touch some of the issues that deserve the attention of scholars and policymakers over the medium term. We are well aware that exchange rate policy and the liberalization of the capital account have been intensively studied. But a lack of clarity regard- ing the future directions for East Asian countries with respect to exchange rate policies remains in the face of continuing economic integration and fluctuation in the parities of key currencies. There is a similar lack of clar- ity about the sequencing of capital account liberalization, especially when delaying liberalization can perversely lead to a slowing of financial reform. Policymakers need more precise guidelines in both these areas, not just a range of options. China's integration into the regional economy and its accession to the World Trade Organization have spurred trade with other East Asian coun- tries and have raised hopes that exports of services to China will also rise. However, it is important to determine whether other East Asian countries can anticipate rising exports as more of the component and machinery production shifts to China. Moreover, how easy will it be for China to implement the liberalization of trade in services if trade reform in the rest of East Asia is slow? We still have only the haziest idea as to how other countries in the region might reshape their industrial sectors to ac- commodate China's growth and competitiveness across a broad array of products. This concern takes us to issues regarding industrial organization governance and competition policy in a more integrated world. With the Japanese and Korean forms of industrial organizations viewed with skepticism, and with those of the United States and Europe also seen as flawed, should East Asia be experimenting with hybrid forms of organ- ization and governance? And, if so, what kind of competition policy would be appropriate, and should there be a push to harmonize among countries? 22 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES In this volume, we discuss how IT can, in the context of organizational and procedural changes, lead to greater governmental transparency and lower transaction costs for business. However, no one has yet attempted a rigorous and in-depth comparison of IT use in Korea and Singapore to show how it has affected political competition, individual rights, account- ability, and transaction costs. In the absence of such work, it is difficult to show how IT use can improve governance. Finally, in view of East Asia's need to upgrade products and enhance in- novation, it is vital to ascertain the combination of financial technology and institutions that would enlarge the research contribution of universi- ties to business without detracting from their teaching functions. With many countries worrying about the apparent shortage of skills, what is the merit, if any, of the human resources planning practiced by Singapore? If East Asia needs a different mix of skills--and needs it soon--how can this mix be achieved? And if it is to be achieved through market processes, could these be accelerated? REFERENCES Amsden, Alice H., and Wan-wen Chu. 2003. Beyond Late Development. Cambridge, Mass.: MIT Press. Baldwin, Richard, and Paul Krugman. 2000. "Agglomeration, Integration, and Tax Harmonization." Discussion Paper 2630 (November). Centre for Economic Policy Research, London. Baldwin, Robert E. 2003. "Openness and Growth: What's the Empirical Relationship?" NBER Working Paper 9578. National Bureau of Economic Research, Cambridge, Mass. Basu, Kaushik. 2003. "Globalization and the Politics of International Finance: The Stiglitz Verdict." Journal of Economic Literature 41(3):885­99. Besley, Timothy, and Robin Burgess. 2002. "The Political Economy of Government Responsiveness: Theory and Evidence from India." Quarterly Journal of Economics 117(4):1415­50. Bordo, Michael D., Barry Eichengreen, Daniela Klingebiel, and Maria Soledad Martinez- Peria. 2001. "Financial Crises: Lessons from the Last 120 Years." Economic Policy (16):53­82. Dyck,Alexander,andLuigiZingales.2002."TheCorporateGovernanceRoleoftheMedia." NBER Working Paper 9309. National Bureau of Economic Research, Cambridge, Mass. "East Asia: ASEAN 3." 2004. Oxford Analytica, January 8. Eichengreen, Barry, and Michael D. Bordo. 2002. "Crises Now and Then: What Lessons from the Last Era of Financial Globalization?" NBER Working Paper 8716. National Bureau of Economic Research, Cambridge, Mass. WHAT GLOBALIZATION MEANS FOR EAST ASIA 23 Frankel, Jeffrey A. 1997. Regional Trading Blocs. Washington, D.C.: Institute for International Economics. Fukase, Emiko, and L. Alan Winters. 2003. "Possible Dynamic Effects of AFTA for the New Member Countries." World Economy 26(6):829­51. Gal, Michal. 2003. Competition Policy for Small Market Economies. Cambridge, Mass.: Harvard University Press. Hanson, Gordon J., Raymond J. Mataloni Jr., and Matthew J. Slaughter. 2001. "Expansion Strategies of U.S. Multinational Firms." U.S. Bureau of Economic Analysis, Washington, D.C. Processed. Hatch, Walter, and Kozo Yamamura. 1996. Asia in Japan's Embrace: Building a Regional Production Alliance. Ithaca, N.Y.: Cornell University Press. Hermes, Niels, and Robert Lensink. 2003. "Foreign Direct Investment, Financial Development, and Economic Growth." Journal of Development Studies 40(1): 142­63. Hsiao, Cheng, and Yan Shen. 2003. "Foreign Direct Investment and Economic Growth: The Importance of Institutions and Urbanization." Economic Development and Cultural Change 51(4):883­96. Huang, Yasheng. 2003. Selling China: Foreign Direct Investment during the Reform Era. New York: Cambridge University Press. Keller, William W., and Louis W. Pauly. 2003. "Crisis and Adaptation in Taiwan and South Korea." In William W. Keller and Richard J. Samuels, eds., Crisis and Innovation in Asian Technology. Cambridge, U.K.: Cambridge University Press. Lardy, Nicholas R. 2002. Integrating China into the Global Economy. Washington, D.C.: Brookings Institution Press. Lawrence, Robert Z., and David E. Weinstein. 2001. "Trade and Growth: Import-Led or Export-Led Evidence from Japan and Korea." In Joseph E. Stiglitz and Shahid Yusuf, eds., Rethinking the East Asian Miracle. New York: Oxford University Press. Lee, Ha Yan, Lucca Antonio Ricci, and Roberto Rigobon. Forthcoming. "Once Again, Is Openness Good for Growth?" Journal of Development Economies. Leipziger, Danny M. 1997. Lesson from East Asia. Ann Arbor: University of Michigan Press. Mathews, John A., and Dong-Sung Cho. 2000. Tiger Technology. Cambridge, U.K.: Cambridge University Press. Miller, Stephen, and Mukti P. Upadhyay. 2000. "The Effects of Openness, Trade Orienta- tion, and Human Capital on Total Factor Productivity." Journal of Development Economics 63:399­423. Nabeshima, Kaoru. 2004. "The Technology Transfer in East Asia: A Survey." In Shahid Yusuf, M. Anjum Altaf, and Kaoru Nabeshima, eds., Global Production Networking and Technological Change in East Asia. New York: Oxford University Press. "Regional Trade Agreements." 2002. Oxford Analytica, July 23. Rodríguez, Francisco, and Dani Rodrik. 2000. "Trade Policy and Economic Growth: A Skeptic's Guide to the Cross-National Evidence." In Ben Bernanke and Kenneth Rogoff, eds., NBER Macroeconomics Annual 2000. Cambridge, Mass.: MIT Press. Rodrik, Dani. 1997. Has Globalization Gone Too Far? Washington, D.C.: Institute for International Economics. 24 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES Srinivasan, T. N., and Jagdish Bhagwati. 1999. "Outward-Orientation and Development: Are Revisionists Right?" Discussion Paper 806 (September). Economic Growth Center, New Haven, Conn. Urata, Shujiro, and Kozo Kiyota. 2003. "The Impacts of an East Asia FTA on Foreign Trade in East Asia." NBER Working Paper 10173. National Bureau of Economic Research, Cambridge, Mass. Wacziarg, Romain, and Karen Horn Welch. 2003. "Trade Liberalization and Growth: New Evidence." NBER Working Paper 10152. National Bureau of Economic Research, Cambridge, Mass. World Bank. 1998. East Asia: Road to Recovery. Washington, D.C.: World Bank. ------. 2000a. East Asia: Recovery and Beyond. Washington, D.C.: World Bank. ------. 2000b. World Development Report: Entering the 21st Century. New York: Oxford University Press. Yusuf, Shahid, and Simon J. Evenett. 2002. Can East Asia Compete? Innovation for Global Markets. New York: Oxford University Press. Yusuf, Shahid, M. Anjum Altaf, and Kaoru Nabeshima, eds. 2004. Global Production Net- working and Technological Change in East Asia. New York: Oxford University Press. Yusuf, Shahid, with M. Anjum Altaf, Barry Eichengreen, Sudarshan Gooptu, Kaoru Nabeshima, Charles Kenny, Dwight H. Perkins, and Marc Shotten. 2003. Innovative East Asia: The Future of Growth. New York: Oxford University Press. CHAPTER 2 HANGING TOGETHER? ON MONETARY AND FINANCIAL COOPERATION Barry Eichengreen I n Asia, the idea of wider monetary cooperation has been in the air since the crisis of 1997­98. The spread of financial instability after the deval- uation of the Thai baht highlighted the extent to which one country's monetary problems could have destabilizing repercussions for other countries. The perception was that the currency problems of 1997­98 had been precipitated by the large positions of highly leveraged institutions in New York and compounded by the less-than-generous assistance of mul- tilateral financial institutions in Washington, D.C. More than a few ob- servers concluded that Asian governments should take steps to create a zone of monetary stability that would be better insulated from these factors beyond their control. The response has been schemes of varying scope and ambition. Least ambitious are plans to build on already extant arrangements like the Asia- Pacific Economic Cooperation (APEC) Finance Ministers' Process (a venue for sharing information and pursuing cooperative programs), the Executives Meeting of East Asia and Pacific Central Banks (which is de- signed to encourage regional surveillance), and the Six Markets Group or G-4 2 (a venue for the exchange of views on monetary and financial is- sues among the vice ministers of finance and deputy central bank gover- nors of the regional financial centers).1 The hope is that elaborating these The author would like to thank Shahid Yusuf, Randall Henning, John Williamson, and Yeongseop Rhee for helpful comments and Calvin Ho for research assistance. In addition to the World Bank, the author is grateful to the Ford Foundation, the Hong Kong Institute for Mone- tary Research, and the Institute for European Studies of the University of California, Berkeley, for support for this project. 1. The United States has also been invited to attend recent meetings of the Six Markets Group. 26 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES arrangements will allow Asian countries to achieve more collectively than they could achieve individually. A second set of proposals recommends the creation of a common basket peg for exchange rates, perhaps as a way station on the road to the creation of a single Asian currency (Dieter 2000). Several motivations are apparent here. First is the role of currency pegs in the Asian miracle. Their histori- cal role as an anchor for wage and price expectations and as a facilitator of export growth creates understandable skepticism about the compatibility of floating rates with the Asian development model. Second is the role of yen­U.S. dollar fluctuations in setting the stage for the crisis. And third is the tendency, evident in 1997­98, for currency depreciation in one Asian country to spread instability to its neighbors. Observations like these pro- vide the motivation for proposals for a system of collective currency pegs to the yen (Kwan 2001), the U.S. dollar (McKinnon 2001), or a basket of major currencies (Williamson 1999). These proposals have been given prominence by a discussion paper prepared by French and Japanese offi- cials for the Third Asia-Europe Finance Ministers' Meeting in Kobe, Japan, in January 2001 (see Japan 2001). Similarly, there continues to be discussion of an Asian Monetary Fund to provide crisis countries with financial assistance subject to more appro- priate conditions. This idea was first floated by the Japanese government at a meeting in Bangkok in September 1997. It was then torpedoed by op- position from the U.S. government and the International Monetary Fund (IMF), which feared that a regional fund would undermine the effective- ness of IMF conditionality, and by the less-than-enthusiastic reaction of China, which worried that the arrangement would unduly enhance Japan- ese influence in the region.2 The next major initiative emanated from the Association of Southeast Asian Nations (ASEAN) or, more precisely, from ASEAN 3 (ASEAN plus China, Japan, and the Republic of Korea).3 This agreement is the 2. See Bergsten (2000c). This experience prompted the formation of the Manila Framework Group by APEC finance ministers at a meeting in November 1997. Because the Manila Frame- work Group (a 14-country subset of APEC members) includes not only the crisis countries and Japan but also Australia, New Zealand, and the United States, its makeup can be seen as an at- tempt to strengthen surveillance on a regional basis but in a manner consistent with existing IMF­World Bank arrangements. In any event, the discussions of the Manila Framework Group produced few concrete results. 3. The members of ASEAN are Brunei Darussalam, Cambodia, Indonesia, the Lao People's Democratic Republic, Malaysia, Myanmar, the Philippines, Singapore, Thailand, and Vietnam. HANGING TOGETHER? ON MONETARY AND FINANCIAL COOPERATION 27 Chiang Mai Initiative (CMI) of central bank swap arrangements.4 Draw- ings through this arrangement, other than small swaps for limited periods, can be used only to supplement existing IMF arrangements and are sub- ject to the latter's conditionality. The CMI is thus embedded in the IMF system. This new willingness of Asian policymakers to link their regional initiative to global financial arrangements has helped mollify opposition in Beijing and Washington, D.C. What these initiatives bode for the future is unclear. Is it realistic to at- tempt to build self-standing institutions of Asian monetary cooperation? Or is this effort infeasible in today's world of seamless globalization? Must regional initiatives instead be embedded in the global system of multilat- eral institutions and arrangements, much as Asia's economy and financial markets are embedded in the global economy and global financial system? Is it possible for Asia to square this circle as Europe has done, by creating regional economic and monetary institutions that are both autonomous and linked to their global counterparts? This chapter addresses these issues and their implications. The first section, "Postcrisis Trends," summarizes the development of currency- and financial-market conditions since the crisis. It documents the tensions in foreign exchange markets--on the one hand, the de jure transition to- ward greater exchange rate flexibility and, on the other hand, the de facto tendency to manage exchange rates and limit their fluctuation--and the sharp differences in the response across countries. It also documents a pronounced decline in cross-border bank lending and persistent obstacles to securities-market development. These observations underscore the de- sirability of a cooperative response to the region's monetary and financial problems. The second section, "Currency Options," considers possibilities for a cooperative monetary response, reaching generally negative conclusions. It argues that although pegged exchange rates played an important role in the development model pursued by East Asian countries in the second half 4. The Chiang Mai Initiative is a descendant of the Asian Swap Arrangement, the facility estab- lished in 1977 by the five original ASEAN members and extended to the five other ASEAN members at the Brunei Darussalam ASEAN Finance Ministers' Meeting in March 2000. That arrangement was then transformed, in May 2000, into the Chiang Mai Initiative, encompassing not only the 10 ASEAN countries but also Japan, China, and the Republic of Korea. After the agreement was publicly announced at the ASEAN meeting in Chiang Mai, Thailand, it was finalized in December 2000. Dedicated support lines under the Chiang Mai Initiative are US$1 billion. The previous members are to contribute US$150 million each, while the new ASEAN members will each contribute US$50 million. Countries will be eligible to borrow up to twice their maximum contribution. Swaps can be drawn for up to 6 months, with one 6-month extension possible (Henning 2002). 28 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES of the twentieth century, they will be less essential to the development model of the twenty-first. Moreover, Asian policymakers have no solution for the fragility of currency pegs in a world of high capital mobility and democratic politics.5 I conclude that not even a vastly expanded system of swap arrangements growing out of the Chiang Mai Initiative will enable Asian countries to sustain a system of collective pegs. At worst, the attempt to establish one could be a costly mistake. At best, it will constitute a diversion from the key task at hand. That task is to strengthen financial institutions and to promote the de- velopment of financial markets. Creating a zone of financial stability means (a) cooperatively pursuing initiatives to upgrade prudential super- vision and regulation and (b) fostering transparency and creditor rights. The third section of this chapter, "Financial Options," evaluates possibili- ties for enhancing financial cooperation in this light. I argue that Asian policymakers should establish an Asian Financial Institute (AFI) with the power to set standards for financial market regulation, to identify policies for promoting financial market development, to coordinate national ini- tiatives along these lines, to monitor the compliance of countries with its recommendations, and to apply the appropriate diplomatic and, perhaps, pecuniary sanctions to violators. ASEAN 3 is the logical entity to pursue this initiative. The concluding section poses several additional questions about the feasibility of this form of Asian monetary and financial cooperation. POSTCRISIS TRENDS External developments have contributed little to the development of financial markets and the stabilization of financial conditions since the outbreak of the crisis. Capital flows to emerging markets and to Asia in particular have declined markedly since 1997.6 The change in the net cross-border loans of Bank for International Settlements (BIS) member reporting banks to Asia-Pacific developing countries moved into negative territory in the third quarter of 1997 and then fell to significant negative levels, on the order of negative US$30 billion of net new commitments 5. In this context, I devote special attention to the experience of Singapore, which is frequently mentioned as a country that has succeeded in pegging its exchange rate while at the same time maintaining open capital markets. I show that its success in doing so reflects special circum- stances not present in other Asian countries. 6. This and the next paragraph draw on annual reports of the Bank for International Settlements (BIS 2001, 2002). HANGING TOGETHER? ON MONETARY AND FINANCIAL COOPERATION 29 per quarter. The total net claims of BIS reporting banks on Asia-Pacific developing countries fell by more than 25 percent from their peak in calendar year 1997.7 Net cross-border bank lending to the region turned positive late in 2001 for the first time since mid-1997 but still remained at relatively low levels compared with the peak years of the 1990s. This decline in cross-border bank lending has not been offset by the growth of securities markets. Hedge funds and proprietary trading desks curtailed their involvement in developing-country debt and equities after the crisis, thereby diminishing the liquidity of these markets. Emerging market equity issuance fell off sharply from an earlier average of US$16 billion per year (over the 4 years preceding the crisis) to only US$8 billion in 1998 and showed little tendency to recover subsequently (reflecting un- certain economic prospects and the collapse of technology equity prices) apart from a spurt in 1999 (reflecting large privatization transactions). Equity-related flows recovered in the early months of 2002, but whether this momentum will be sustained is yet to be seen. Net issuance by developing countries of international debt securities (a category that includes international money market instruments, bonds, and notes), which had been running at US$20 billion a quarter (roughly one-third of which had been attributable to Asia and Pacific issuers), fell almost as sharply as bank credits. By the fourth quarter of 1997, net is- suance of debt securities had declined to very low levels. Since then, it has remained at those low levels (with the exception of abortive recoveries in the second quarter of 1998 and the fourth quarter of 1999).8 Asian bor- rowers have come to the market to refinance maturing international bonds, but they have secured little new financing.9 Much of that refinanc- ing has been at maturities shorter than maturing obligations, reflecting the limited liquidity of primary markets. Paralleling developments in eq- uity markets, the liquidity of debt markets has declined, reflecting finan- cial sector consolidation and the withdrawal of risk capital used in market- making activities. Associated with these changes in quantities have been changes in prices. Spreads on emerging market debt securities have become increasingly decoupled from spreads on issues of comparably rated borrowers in the 7. Meanwhile, total net claims stagnated, neither rising nor falling significantly, in the case of emerging Europe and Latin America. 8. Negligible in this context means less than US$1 billion. In many of the subsequent quarters, net issuance was negative. 9. The vast majority of the new financing extended to emerging market borrowers in this period went to only four countries, all outside the Asia-Pacific region--Argentina, Brazil, Mexico, and Turkey. 30 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES industrial countries.10 A gap has been growing between spreads on invest- ment grade credits (Hungary, Korea, Malaysia, Mexico, and Poland, for example) and subinvestment grade credits (most other emerging markets). Launch spreads have risen significantly compared with launch spreads in the precrisis period. Exchange rate volatility rose sharply after the crisis. Most of the coun- tries of the region--aside from China, Hong Kong (China), and Malaysia--moved from fixed or tightly managed exchange rates to freer floating rates, according to the official IMF categorization. Some authors (for example, Kawai and Akiyama 2001; McKinnon 2001) argue that, offi- cial labels notwithstanding, rates remain tightly managed and are as stable now as before the crisis. Tables 2.1­2.4 shed some light on this issue.11 Table 2.1 shows that the exchange rates of six of the Asian countries con- sidered (Indonesia, Korea, Malaysia, the Philippines, Singapore, and Thailand) were unusually stable before the crisis, whether measured by the range of average monthly percentage exchange rate changes or by their standard deviations. Since the crisis, exchange rate variability against the U.S. dollar has increased sharply in many of these countries, the principal exceptions being Hong Kong (China), Malaysia, and Taiwan (China). (In constructing this and subsequent tables, I have omitted the crisis period it- self, defined as the second half of 1997 and calendar year 1998.) The pic- ture, in other words, may be more complex than suggested by McKinnon. Table 2.2 measures whether intervention in foreign exchange markets has risen or declined, displaying the mean absolute monthly percentage change in international reserves and the standard deviation of monthly re- serve percentage changes. The relatively high precrisis figures for the Asian countries, compared with those of the United States and Japan, con- firm that their exchange rates were tightly managed. After the crisis, re- serve volatility, as measured by the standard deviation, fell in Korea, the Philippines, Taiwan (China), and Thailand, while rising in Malaysia and Singapore.12 Clearly, Malaysia has continued to intervene heavily to peg its currency while Singapore has intervened to maintain its band. These data paint a more mixed picture of intervention in the other countries. Countries can also resist market pressures by adjusting interest rates. Table2.3,therefore,reportstherange,meanabsolutechange,andstandard 10. This decoupling resulted as much from the crisis of August 1998 in the Russian Federation as from the Asian crisis that preceded it. Both events reduced the correlation between the two sets of spreads, although the Russian crisis arguably had a greater effect. In any case, the earlier correlation has shown little tendency to reassert itself. 11. Here, I extend work by Hernandez and Montiel (2001). 12. By this measure, reserve volatility has remained unchanged in Indonesia while falling slightly in Hong Kong, China. HANGING TOGETHER? ON MONETARY AND FINANCIAL COOPERATION 31 Table 2.1 Monthly Nominal Exchange Rate Volatility Currency or Range of Mean Standard Country Period Absolute Change Deviation US$/deutschemark Precrisis 0.093 0.025 Postcrisis 0.122 0.027 US$/yen Precrisis 0.136 0.029 Postcrisis 0.098 0.025 Chile Precrisis 0.048 0.011 Postcrisis 0.169 0.029 Mexico Precrisis 0.166 0.034 Postcrisis 0.069 0.018 Indonesia Precrisis 0.019 0.003 Postcrisis 0.300 0.066 Korea, Rep. of Precrisis 0.043 0.011 Postcrisis 0.113 0.023 Malaysia Precrisis 0.049 0.009 Postcrisis 0.000 0.000 Philippines Precrisis 0.016 0.003 Postcrisis 0.104 0.020 Thailand Precrisis 0.015 0.004 Postcrisis 0.073 0.017 Australia Precrisis 0.066 0.017 Postcrisis 0.135 0.028 Hong Kong, China Precrisis 0.003 0.001 Postcrisis 0.001 0.000 New Zealand Precrisis 0.045 0.012 Postcrisis 0.141 0.030 Singapore Precrisis 0.021 0.006 Postcrisis 0.067 0.012 Taiwan, China Precrisis 0.056 0.011 Postcrisis 0.059 0.013 Note: Precrisis period is July 1995 to June 1997. Postcrisis period is January 1999 to November 2001, except in Germany (where it ends July 2001) and Mexico (where it ends October 2001). All exchange rates except the first two are against the U.S. dollar. Source: Author's calculations. deviation of monthly interest rates (money market rates where possible). Consistent with the results for reserves, monthly interest rate volatility has fallen in Korea and Thailand. This decline indicates a commitment to greater exchange rate flexibility. Monthly interest rate volatility has risen in Hong Kong, China, reflecting the Hong Kong Monetary Authority's commitment to its peg. Not surprisingly, interest rate volatility has also risen in Indonesia, again pointing to continued and generally unsuccessful 32 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES Table 2.2 Monthly Reserve Volatility Mean Absolute Standard Country Period Change Deviation Germany Precrisis 0.011 0.013 Postcrisis 0.032 0.045 Japan Precrisis 0.015 0.024 Postcrisis 0.019 0.027 Chile Precrisis 0.022 0.029 Postcrisis 0.018 0.027 Mexico Precrisis 0.066 0.098 Postcrisis 0.024 0.034 Indonesia Precrisis 0.021 0.028 Postcrisis 0.021 0.029 Korea, Rep. of Precrisis 0.033 0.041 Postcrisis 0.022 0.019 Malaysia Precrisis 0.021 0.027 Postcrisis 0.030 0.038 Philippines Precrisis 0.043 0.050 Postcrisis 0.024 0.039 Thailand Precrisis 0.018 0.029 Postcrisis 0.014 0.020 Australia Precrisis 0.052 0.085 Postcrisis 0.055 0.085 Hong Kong, China Precrisis 0.006 0.028 Postcrisis 0.011 0.014 New Zealand Precrisis 0.059 0.083 Postcrisis 0.051 0.064 Singapore Precrisis 0.010 0.008 Postcrisis 0.014 0.017 Taiwan, China Precrisis 0.011 0.019 Postcrisis 0.014 0.015 Note: Precrisis period is July 1995 to June 1997. Postcrisis period is January 1999 to November 2001, except for Germany, Hong Kong (China), Malaysia, Mexico, New Zealand, the Philippines, and Singapore (where it ends October 2001). All exchange rates are against the U.S. dollar. Source: Author's calculations. efforts to limit exchange rate fluctuations in a more volatile environment. It has fallen in Malaysia, presumably reflecting the insulation provided by capital controls.13 13. Malaysia is a different case; there, interest rate volatility fell noticeably after the crisis, re- flecting the imposition of capital controls. HANGING TOGETHER? ON MONETARY AND FINANCIAL COOPERATION 33 Table 2.3 Monthly Interest Rate Volatility Mean Absolute Standard Country Period Range Change Deviation Germany Precrisis 0.135 0.021 0.031 Postcrisis 0.289 0.044 0.060 Japan Precrisis 0.420 0.058 0.099 Postcrisis 8.000 0.403 1.246 Chile Precrisis 0.223 0.033 0.047 Postcrisis 1.350 0.099 0.197 Mexico Precrisis 0.520 0.116 0.135 Postcrisis 0.353 0.074 0.086 Indonesia Precrisis 0.400 0.070 0.098 Postcrisis 1.351 0.115 0.211 Korea, Rep. of Precrisis 0.341 0.068 0.089 Postcrisis 0.158 0.023 0.036 Malaysia Precrisis 0.680 0.067 0.115 Postcrisis 0.390 0.036 0.068 Philippines Precrisis 0.291 0.046 0.068 Postcrisis 0.818 0.056 0.127 Thailand Precrisis 0.845 0.214 0.243 Postcrisis 0.616 0.150 0.181 Australia Precrisis 0.072 0.013 0.022 Postcrisis 0.185 0.020 0.034 Hong Kong, China Precrisis 0.325 0.065 0.084 Postcrisis 0.895 0.119 0.176 New Zealand Precrisis 0.171 0.038 0.047 Postcrisis 0.289 0.030 0.052 Singapore Precrisis 0.527 0.101 0.130 Postcrisis 1.153 0.129 0.197 Taiwan, China Precrisis 0.157 0.026 0.036 Postcrisis 0.217 0.040 0.053 Note: Precrisis period is July 1995 to June 1997. Postcrisis period is January 1999 to November 2001, except for Australia, Indonesia, and Singapore (where it ends October 2001); Chile (where it ends July 2001); and Japan, Korea, and Malaysia (where it ends September 2001). Note that Japan's postcrisis range is 8 because the interest rate in July 2000 is 0.02 and in August 2000 is 0.16. (There is a 700 per- cent change.) Source: Author's calculations. Table 2.4 summarizes the preceding information, presenting the ratio of exchange rate volatility to interest rate volatility and the ratio of exchange rate volatility to reserve volatility. Rising ratios indicate freer floating--a sign that shocks to currency markets are being absorbed to a greater extent by the exchange rate and to a lesser extent by monetary policy adjustments 34 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES Table 2.4 Volatility Ratios Exchange Rate Exchage Rate Changes Relative to Changes Relative to Country Period Interest Rate Changes Reserve Changes Germany Precrisis 0.820 1.938 Postcrisis 0.453 0.600 Japan Precrisis 0.297 1.216 Postcrisis 0.020 0.943 Chile Precrisis 0.230 0.374 Postcrisis 0.148 1.096 Mexico Precrisis 0.248 0.341 Postcrisis 0.206 0.522 Indonesia Precrisis 0.118 0.118 Postcrisis 2.265 2.265 Korea, Rep. of Precrisis 0.122 0.266 Postcrisis 0.633 1.176 Malaysia Precrisis 0.081 0.339 Postcrisis 0.000 0.000 Philippines Precrisis 0.049 0.066 Postcrisis 0.158 0.512 Thailand Precrisis 0.016 0.132 Postcrisis 0.096 0.866 Australia Precrisis 0.728 0.198 Postcrisis 0.842 0.335 Hong Kong, China Precrisis 0.009 0.027 Postcrisis 0.003 0.035 New Zealand Precrisis 0.260 0.146 Postcrisis 0.574 0.463 Singapore Precrisis 0.050 0.851 Postcrisis 0.063 0.717 Taiwan, China Precrisis 0.317 0.587 Postcrisis 0.242 0.851 Note: Precrisis period is July 1995 to June 1997. Postcrisis period is January 1999 to July 2001, except in a few cases, where the period ends earlier because of limited data availability (for details, see preceding tables). Source: Author's calculations. and intervention.14 They confirm the existence in Hong Kong (China) and Malaysia of a continued commitment to pegging in the face of an 14. These measures, thus, at least partly address the concern that changes in the components, presented in tables 2.1­2.3, reflect shocks rather than policies. HANGING TOGETHER? ON MONETARY AND FINANCIAL COOPERATION 35 increasinglyvolatilemacroeconomicandfinancialenvironment.Singapore and Taiwan (China) present a mixed picture; in each case, one indicator but not the other suggests freer floating since the crisis. But for Indonesia, Korea, the Philippines, and Thailand, the evidence indicates that govern- ments and central banks have moved to a regime where exchange rates are allowed to move more freely in response to shocks. This finding does not mean that their governments have adopted a policy of benign neglect of the exchange rate; in particular, the countries continue to resist pressure for their exchange rates to appreciate for fear of what this appreciation will do to the competitiveness of their exports. This kind of resistance is clearly evident in the massive accumulation of foreign exchange reserves by the countries of the region. But notwithstanding these tendencies, the data considered here still clearly suggest that the exchange rates of these coun- tries are now noticeably more flexible than before the crisis. CURRENCY OPTIONS Various observers have argued that Asia should explore collective solu- tions to its monetary problems. In this section, I present their arguments and critique their proposals. The Problem The openness of Asian economies, not only to trade but also to capital flows, creates a presumption that exchange rate volatility and risk may be even more disruptive to growth there than in other times and places. The implication is that Asia may suffer more damaging consequences from ex- change rate instability than other less trade- and investment-oriented parts of the world. Recent empirical work has lent support to the argument that stable exchange rates encourage trade.15 Asian history is also invoked in this connection. Thus, McKinnon has argued that Japan's policy of peg- ging the yen to the U.S. dollar from the late 1940s until the early 1970s contributed to the country's emergence as an export powerhouse.16 Sachs (1985) has ascribed the East Asian economic miracle (in part) to the com- mitment of Asian governments to peg their exchange rates at competitive 15. See, for example, Eichengreen and Irwin (1995). The work of Frankel and Rose (2002) is fre- quently cited in this connection, but their evidence is based mainly on the trade-promoting effects of a common currency, not of stable exchange rates. 16. See, for example, McKinnon, Ohno, and Shirono (1997). 36 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES levels, thereby providing a nominal anchor for wages, the stability of which, in turn, ensured the profitability of exports and stimulated the early growth of low-wage manufacturing. More recently, similar arguments have been made about the importance of China's U.S. dollar peg for the rapid growth of that country's exports, which have been so critical for its economic success. The implication is that exchange rate stability was and is integral to the East Asian miracle. Without it, export-led growth would have been more difficult. The rapid expansion of labor-intensive manu- facturing would not have occurred. No Asian country, it is sometimes said, has successfully developed on the basis of a floating rate. Without necessarily disputing this interpretation of Asia's post­World War II economic history, one must point out that it is still not clear that these arguments will have the same force in the future as in the past. Abun- dant cheap labor is no longer essential to industrial development in middle- and high-income Asian countries; the key, rather, is rising pro- ductivity.17 And labor productivity, as opposed to the level of nominal wages, is not something on which monetary and exchange rate policies operate directly. Moreover, the high levels of investment that were en- couraged historically by stable real exchange rates and a high profits share in national income have lost their luster in the wake of the Asian crisis. To be sure, there are other reasons why competitive real exchange rates and stable nominal exchange rates are conducive to growth. Realistic real rates are important for commercially open Asian economies that continue to rely on export markets. Stable nominal rates encourage inward foreign investment and outsourcing from Japan, which, in turn, foster technology transfer and productivity growth.18 The argument has been made that the instability against the yen of Asian currencies, which were effectively pegged to the U.S. dollar until recently, damaged the growth prospects of the East Asian economies in the mid-1990s and set the stage for the sub- sequent crisis. At the same time, systematic analyses suggest that the exchange rate regime has come to play a less important role over time. Moreno (2001) 17. However, in China and in other late developers, abundant cheap labor clearly continues to play a role. 18. More generally, whether fixed or flexible exchange rates are more conducive to direct foreign investment is ambiguous, both theoretically and empirically. In industries where firms produce the same products in a variety of markets, exchange rate flexibility presumably makes foreign in- vestment more attractive because exchange rate variations are one more source of risk against which producers can hedge by diversifying production internationally. But when foreign firms and subsidiaries produce components rather than final products, currency fluctuations can ag- gravate cost fluctuations rather than provide insulation from them. This second case--the out- sourcing variant--is presumably the one that is more applicable to Asia. HANGING TOGETHER? ON MONETARY AND FINANCIAL COOPERATION 37 shows that although growth may appear to be faster (even recently) in Asian countries that peg their exchange rates, this pattern is an artifact of survivor bias.19 The growth effects of stable rates, properly measured, are actually smaller in East Asia than elsewhere. Crosby and Otto (2001) sim- ilarly conclude that the connection between growth and real exchange rates is more complex and contingent now than in the past. Related to this discussion is the argument that the newly industrializing economies of East Asia (not including Japan) must be concerned with the stability of exchange rates vis-à-vis one another and not just with respect to the G-3 currencies (the U.S. dollar, the yen, and the euro). These concerns were pointed out by the Asian crisis, when currency instability in Thailand and Indonesia quickly infected the entire region. Why intraregional currency fluctuations had such devastating effects is unclear, however, making for uncertainty about whether similar fluctua- tions in the future would necessarily have similar effects. Although frequent reference is made to the competitive devaluation channel (through which the initial devaluations undermined the actual and prospective export competitiveness of other countries in the region), the fact is that trade among the crisis countries was not large.20 More important were two other effects. First, because the countries of the region all exported into the same North American, Japanese, and European markets, depreciation by one could erode the market shares of the others. Although some sign of this effect is apparent, most of the evidence (for example, Harrigan 2000) suggests that it was small because exports from the crisis countries stagnated in the short run as financial distress led to declining output (rather than their exports rising sharply as this market-share-erosion argument requires). More important, surely, was what Goldstein (1998) refers to as the wake-up call: that the outbreak of financial instability--signaled by the collapse of the exchange rate--in a country where market participants naively believed that no such thing was possible awakened investors to the possibility of similar problems elsewhere. Once the devaluation of the baht revealed that something was rotten in the Kingdom of Thailand, investors suddenly became aware that all was not well in the neighboring East Asian countries. Currency instability thus served as the starting gun for capital flight by panicked investors. 19. It can also be interpreted in terms of reverse causation; that is, countries that grow quickly for independent reasons find it less costly to subordinate their macroeconomic policies to the imperatives of maintaining a stable rate. 20. Admittedly, trade is growing over time (Kwan 2001), which may give this argument more force in the future than it had in the past. 38 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES The conviction that currency devaluation was the principal channel for the contagious spread of the 1997­98 crisis and that exchange rate fluctu- ations, if allowed to persist, could again have equally devastating effects has prompted calls for the reestablishment of fixed parities, for agreement on the nature and composition of these pegs, and for an expanded system of currency swaps and even an international lender of last resort to provide emergency financing to countries that might otherwise be forced to aban- don their pegs. Rose (1998) was perhaps the first to invoke the evidence that contagion spreads primarily within regions in his support of the idea of an Asian Monetary Fund to pool the reserves of the participating coun- tries and to support those whose pegs were threatened by market pressures. Bergsten (2000c) has similarly argued that one rationale for monetary cooperation in Asia is that contagion is heavily regional.21 The Solution These arguments have led various observers to propose that Asian economies should resurrect their currency pegs and that governments should agree on the currencies to which to peg to limit intraregional fluc- tuations. Ito, Ogawa, and Sasaki (1998), as well as Williamson (1999) and a team of French and Japanese officials (Japan 2001), have advanced vari- ants of the argument that East Asian governments should agree on a sys- tem of collective basket pegs with weights on the U.S. dollar, the yen, and the euro. Pegging to a basket will avoid disruptions to export competitive- ness because of G-3 exchange rate fluctuations, and agreement on the weights will limit intraregional currency swings. Asia's recent history, these authors insist, demonstrates that floating rates are volatile and damaging to the real economy. A policy of benign neglect of the exchange rate, they observe, is not feasible for countries with fragile financial systems, high levels of liability dollarization, and heavy trade dependence. Thus, a num- ber of emerging markets that are officially classified by the IMF as having moved to independent floating (and, more generally, as having adopted 21. Actually, this rationale is an argument for regional surveillance and peer pressure to prevent the development of policy inconsistencies, not for an Asian fund to provide support for curren- cies jeopardized by inconsistent policies. To be sure, the observation that contagion has a re- gional component points to the possibility that a number of Asian countries could come under pressure from the currency markets simultaneously. But if they did, reserve pooling would be of little help because the countries in question would need to draw on their reserves at the same time. Indeed, having the relatively strong ones lend their reserves to their weaker neighbors might actually weaken confidence in the countries with stronger currencies. In fact, these are precisely the concerns that have been raised by Standard & Poor's, among others, in the context of the Chiang Mai Initiative. HANGING TOGETHER? ON MONETARY AND FINANCIAL COOPERATION 39 policies of greater exchange rate flexibility) continue to strictly limit the fluctuation of their currencies; they evince "fear of floating," in the wide- ly adopted terminology of Calvo and Reinhart (2000). They display high ratios of international reserve variability and interest rate volatility to ex- change rate variability, as if they habitually intervene in domestic and in- ternational money markets to limit currency movements.22 As we saw above, some--but by no means all--Asian countries fall into this camp. But purporting to float while really continuing to peg (or even strictly limiting the currency's fluctuation) does not enhance credibility when the authorities have no stated commitment to the regime. To the extent that an inconsistency between the de jure and de facto regimes is evident, cred- ibility will be damaged rather than enhanced.23 The alternatives are (a) an operating strategy for monetary policy that articulates an explicit role for intervention in foreign exchange markets but not a target for the exchange rate--inflation targeting being one such strat- egy (see below)--and (b) a hard peg (under which the de jure and de facto regimes are the same). A hard peg is likely to be most attractive to very small, very open economies, of which the region has several. The experi- ence of Hong Kong, China, demonstrates that this kind of arrangement can be compatible with openness, financial and otherwise. But a hard peg like the dollar-based currency board of Hong Kong, China, also has costs insofar as it will subject the economies of the region, with geographically diversified trade, to the vagaries of dollar-yen fluctuations.24 Moreover, maintaining confidence in a currency board requires strict fiscal discipline and a high degree of wage and price flexibility because adjusting the ex- change rate is no longer a way to achieve changes in relative prices. The success of the currency board requires an unquestionable commitment to the imperative of currency stability and an absence of political pressure on the authorities to use their policy instruments to pursue other goals. 22. Hausmann, Panizza, and Stein (2000) show that, of countries officially classified as having floating exchange rate systems or very wide bands, those with high levels of liability dollarization have the greatest tendency to limit exchange rate variability (in other words, they have the highest ratios of reserve volatility and interest rate volatility to exchange rate volatility). In addition, weaker evidence shows that countries with the highest rate of pass-through from exchange rates to domestic prices resist exchange rate movements. 23. If the authorities make a point of denying that they are ready to intervene whenever the rate moves by a certain amount, then they will create less bias in the band (in other words, stabilizing speculation by market participants when the edge of the range of permissible fluctuations is reached). 24. An Argentine-style currency board with weights on more than one anchor currency is a pos- sibility, although Argentina's early experience with the arrangement is not exactly a sterling advertisement of its merits. 40 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES Of course, these prerequisites for currency stability are ones that Argentina, another currency board country of the 1990s, lacked. Its crisis demonstrated in the most graphic way that a currency board is neither a foolproof bulwark against speculative pressure nor a guarantee of ex- change rate stability.25 Hong Kong, China, is different: it trades heavily with the United States and with China, another country that pegs to the U.S. dollar, so fluctuations in the rates between the reserve currency and the currencies of other major trading partners are less of a problem.26 Hong Kong, China, is endowed with unusually elastic supplies of labor from the mainland and relatively flexible wages and prices. Its unique po- litical system gives the authorities unusual insulation from political pres- sure to subordinate currency stability to other goals. But in virtually all of these respects, Hong Kong, China, is atypical. The implication is that what works there is less likely to work in other economies in the region. The shortcomings of a currency board are what attract some observers to the alternative of a common currency band. Williamson (1998) de- scribes the most fully developed of these proposals. Williamson would have countries each declare a fluctuation band with a width of not less than plus-or-minus 5 percent or more than plus-or-minus 15 percent. Although exchange rates would be allowed to float within the band, the authorities would intervene to keep them from straying further. The knowledge that they stand ready to do so would create bias in the band (stabilizing specula- tion, also known as the honeymoon effect). But to avoid having to defend in- defensible positions, Williamson advises governments to adjust the band whenever a significant change in the equilibrium rate takes place. These realignments should occur before speculative pressure builds up in antici- pation of them. So that speculative attacks and costly reserve losses are avoided, jump changes in the exchange rate should be avoided; the new and old bands should overlap, allowing the current rate to be contained in the interior of both. One presumption is that the authorities will intervene to prevent the rate from straying beyond the band; however, if they decide that market pressures are overwhelming, then they can allow the rate to go outside the band. This strategy should avoid forcing the authorities to commit their scarce reserves to a battle with international markets that they cannot win. If those market pressures are not justified by fundamen- tals, then the rate will, in any case, move back into the band once the spec- ulative flurry has passed. 25. One can now find many reviews of the Argentine tragedy. See, for example, Eichengreen (2002, chapter 4). 26. If and when China moves to a more flexible exchange rate against the U.S. dollar, the dilemma of Hong Kong, China, will become more difficult. HANGING TOGETHER? ON MONETARY AND FINANCIAL COOPERATION 41 This scheme has attractions. The commitment to intervene should en- courage stabilizing market behavior, while the soft margins and allowance for them to realign relieve the authorities of the need to engage in a futile battle with the markets. The common weights in the national currency baskets will limit intraregional currency fluctuations. And the knowledge that governments have negotiated an international agreement obliging each of them to behave in this way should enhance the credibility of their commitment to do so and, therefore, the extent of stabilizing speculation. But Williamson's blueprint also has problems, which are indicative of the limitations of all of the associated proposals. First, he suggests that the weights on the U.S. dollar, the yen, and the euro should be proportional to Asia's trade with the United States, Japan, and Europe.27 This approach privileges the destination of merchandise exports relative to the currency denomination of those exports, which is not obviously warranted on eco- nomic grounds.28 It privileges trade relative to financial flows, which is not obviously warranted, given that the Asian economies are buffeted as much by financial flows as by trade flows.29 A second problem is the reluctance of governments and central banks to adjust the exchange rate when its equilibrium level has changed. To in- duce stabilizing market behavior, they must reassure the markets that they attach priority to the preservation of the peg. This reassurance, in turn, means that their credibility is tarnished when they renege on that promise and change the rate, which deters them from adjusting the latter 27. Actually, Williamson refers to Asian countries' effective exchange rate, but I interpret his meaning in this way. 28. McKinnon (2001) emphasizes this observation. Even if one ignores the preceding point, the fact remains that the appropriate trade weights differ across countries because of differences in the destination of their exports. This dynamic means that either governments will have to com- promise on the appropriate country-specific weights, or they will have to sacrifice the objective of eliminating intraregional currency fluctuations. McKinnon (2001) suggests that this problem can be solved if East Asian countries--including Japan--peg to the U.S. dollar instead of a bas- ket. But for many observers, the idea that the yen-dollar rate could be repegged and that Japan would effectively turn over monetary policymaking authority to the U.S. Federal Reserve is highly improbable. The alternative of having other Asian countries peg to the yen solves neither of the problems raised here unless one assumes, after Kwan (2001), that other Asian countries will rapidly reorient their trade and financing so that the vast majority of trade and financing is conducted with Japan. More precisely, Kwan proposes that Asian countries first peg their cur- rencies to a basket. The weight assigned to the yen would then be increased gradually as Japan took steps to deregulate, to upgrade the Tokyo market as an international financial center to make it attractive to nonresidents, and to open its markets to Asian products, thereby deepening the interdependence between Japan and these countries. 29. Although, in principle, agreement is widespread that optimal currency pegs should reflect the sources of financing and the direction of trade, in practice, no agreement has been reached on the model or the weights. 42 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES before significant market pressures build up. Moreover, if the authorities reassure the markets that they are prepared to effectively minimize the extent of exchange risk, they will encourage capital to flow in beyond the point where its social return equals its social cost and, thus, set the stage for serious financial difficulties when the peg collapses (Dooley 1997; McKinnon and Pill 1999; Wilson 2000). The authors of collective band proposals assume that these problems can be solved (a) if governments somehow recognize the merits of early exchange rate adjustments (which would solve the "exit problem") and (b) if they commit to restoring depre- ciated rates to their previous level after each episode of financial pressures (which would limit the financial distress because of unexpected deprecia- tions). This reasoning, however, simply assumes convenient answers to difficult political questions. A third problem with Williamson's blueprint is that it creates a tradeoff between the credibility and flexibility of the band. If the authorities regu- larly shift the band before the rate reaches the margins to prevent the buildup of speculative pressure, then the monitoring-band regime will, in practice, differ little from floating. In particular, if, on the one hand, the authorities regularly adjust the margins before they are reached, then there will be no reason for bias in the band. If, on the other hand, they attempt to keep the rate from violating the edges of the band when the latter are approached, then they will have to butt heads with currency speculators. This confrontation will provide a harsh reminder that their foreign re- serves are limited, as is their capacity to put the economy through the wringer of high interest rates. This scenario limits the likelihood that they will emerge victorious from this contest with the markets. A network of credit lines and swaps that pools the reserves of the par- ticipating countries is an obvious response to this problem. The European Monetary System (EMS) provides a precedent, and the recently negotiated Chiang Mai Initiative provides the requisite mechanism. Currency specu- lators attempting to force an unwarranted devaluation would then have to contend with the reserves not only of the targeted country but also of its partners in the regional currency stabilization agreement.30 The problems with this solution are well known. Above all is the question of whether strong-currency countries would really be willing to 30. Although the collective reserves of the countries participating in the Chiang Mai Initiative are very large, they have committed only a share of these reserves under the swap lines of the ini- tiative. In addition, the lines available to the individual participating countries are only a fraction of the collective swap lines, and in some cases, these lines amount to less than a few billion U.S. dollars, a drop in the bucket relative to the liquidity of international financial markets. See also the section on "Financial Options." HANGING TOGETHER? ON MONETARY AND FINANCIAL COOPERATION 43 commit a significant fraction of their reserves to supporting weak partner currencies. In Europe, the commitment to collective currency pegs was strong and credible because intra-European trade is so extensive. Intra- Asian trade remains less important by comparison, as Williamson (1999) acknowledges. Moreover, even in Europe, the strong-currency country Germany obtained an opt-out from the provision of the EMS Articles of Agreement that obliged it to intervene without limit in support of its EMS partners, reflecting fears of the costs of unlimited interventions and what unlimited support might imply for its creditworthiness. A noteworthy point in this context is that participants in the Asian Swap Arrangement, the precursor of the Chiang Mai Initiative, can also opt out of that arrangement.31 Asia's situation is, if anything, even more difficult than Europe's. Throughout its existence, the EMS was supported either by capital controls (before 1992) or by a fixed timetable for completing the transition to monetary union (after 1992). Capital controls limited speculative pressures and, thus, the need for intervention, whereas the commitment to complete the transition to monetary union by 1999, there- by anchoring exchange rate expectations, induced stabilizing speculation more powerful than that which can be provided by a simple commitment to pegged rates. Above all, the EMS was buttressed by the set of interlocking political, economic, and financial commitments that make up what we now call the European Union. Europe had already established a customs union when the EMS was established. The European project was undergirded by a commitment to political integration, which was driven by the continent's two largest economies, France and Germany. Against this background, one had good reason to believe that member states would be prepared to support the currencies of their EMS partners. Clearly, the same preconditions are not present in Asia. ASEAN is still struggling to establish a free trade area.32 Its capital markets are already rel- atively open. Little appetite for political integration is apparent. There is 31. Opting out under "exceptional financial circumstances" was permitted from the inception of the Asian Swap Arrangement, and in 1992, the right to opt out became effectively unlimited (Henning 2002). 32. Some members remain reluctant to subordinate their industrial policies to the goal of re- gional free trade. In part, this reluctance to put free trade above other goals is indicative of the fact that the benefits of regional free trade are less than compelling as long as the free trade area does not encompass the three large economies of China, Japan, and Korea, not to mention Australia and New Zealand. Reflecting this realization, in November 2000, the leaders of the 10 ASEAN nations commissioned a study of the feasibility of linking their economies with those of China, Japan, and Korea. 44 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES no Beijing-Tokyo axis analogous to the axis between Paris and Bonn to push the process forward. As a result, Asia lacks the nexus of contracts that makes for credible currency commitments. If, as Xie and Yam (1999) sug- gest, Japan were to eventually move away from basing its security arrange- ments on the United States and create an Asian security system, then this problem would be solved, but at best, this possibility is a long-term prospect. These considerations suggest that a system of collective currency pegs would be fragile. Those with a preference for more graphic metaphors (and clichés) might call it an "engine of crisis" (or a "recipe for disaster"). But doesn't Asia's history suggest otherwise? In particular, hasn't Singapore succeeded in operating a currency band that successfully limits the fluctuation of its currency despite a commitment to open capital mar- kets (Rajan and Siregar 2000)?33 It has operated an undisclosed ("quiet") band system since 1975. It has limited the fluctuation of the Singapore dol- lar against a basket of currencies to within a narrow band.34 One potential explanation for this success is that Singapore has come closest to adopting Williamson's recommendations for how to run an intermediate regime. It operates a "basket, band, and crawl" regime, creating a presumption that the authorities will normally intervene to keep the exchange rate from straying far from the band. At the same time, however, the authorities keep open the option of letting the rate take the strain by going outside the band if they decide that market pressures are overwhelming. The band is wide, which allows the rate to fluctuate in response to cyclical conditions. Singa- pore has avoided the mistake of targeting a single currency; in 2000­01, for example, it did not have to follow the U.S. dollar up against the euro and the yen. It has adjusted its band periodically in response to changing do- mestic and international conditions. The implication is that other coun- tries can match this success if they adopt the same formula. Others would put the emphasis not on the design of the currency band but on other characteristics of the economy. Singapore has been able to credibly commit to adjusting its monetary policy instruments to limit ex- change rate fluctuations because it has had an impeccably strong banking and financial system. It has not had a large stock of nonperforming, short- term debts in the corporate sector. It has run fiscal and current account surpluses every year since 1989. It holds large reserves, equivalent to 33. Other counterexamples to the hypothesis such as China and Malaysia could be cited. But both countries have been aided in their efforts to peg their currencies by limits on capital inflows and outflows,somethingthatisunlikelytoberegardedasfeasibleanddesirableelsewhereintheregion. 34. On this history, see Monetary Authority of Singapore (2000). Patterson, Chong, and Eschweiler (2001) estimate that the width of the band is about 2 percent. The U.S. dollar, they estimate, has a weight in the basket of 52 percent, although the weight attached to other Asian currencies has been rising with time. HANGING TOGETHER? ON MONETARY AND FINANCIAL COOPERATION 45 6­9 months of its imports. Because of its combination of strong growth and flexible labor markets (achieved through a system of variable bonus- es), monetary policy adjustments designed to stabilize the exchange rate have not put undue strain on the economy. Because of Singapore's politi- cal stability, the commitment to hit those exchange rate targets has politi- cal support and, therefore, credibility. How many other countries can satisfy these prerequisites for the credi- bility and viability of a monitoring band? Few countries have equally strong banking and financial systems. Few have equally able bank supervi- sors. Few have equally flexible economies. Few have comparable records of political stability. This review suggests that the answer to the preceding question is "not many."35 Then what alternatives remain? Monetary union, which would elimi- nate intra-Asian exchange rate instability by eliminating intra-Asian ex- change rates, remains in the realm of social science fiction.36 Although capital controls would greatly simplify the defense of a regional system of currency pegs, the region has little appetite for the reimposition of con- trols, China and Malaysia to the contrary notwithstanding.37 Rather, gov- ernments see the liberalization of financial markets and the international- ization of banking systems as the best ways to solve their financial problems. These reasons all support the thinking that controls may be- come more difficult to operate in the future.38 35. This answer points to the question of whether Singapore itself can realistically expect to sat- isfy the demanding prerequisites for operating this regime in the future. The country may face an even more volatile economic environment in the future than in the past. Its politics may grow more contested. Authors such as Patterson, Chong, and Eschweiler (2001) have already sug- gested that these trends may force Singapore to move to a more flexible rate. 36. Of note, the Chinese appear reluctant to move to deep integration. As the Chinese Minister of Finance Xiang Huaicheng (Xiang 2001) recently put it, "Given diversified background in his- tory, culture, and level of economic development, the East Asian countries must pursue regional cooperation in a gradual and orderly manner, taking into account their unique characteristics." 37. In particular, assessments of the effects of Malaysia's controls conflict. Kaplan and Rodrik (2001) and Edison and Reinhart (2001) conclude that the controls were effective in insulating the economy from the Asian financial crisis. Others (for example, Spencer 2001) are more critical on the grounds that the controls allowed the authorities to ease regulations on lending to "nonpro- ductive" sectors, to weaken the definition of nonperforming loans, and to reduce capital require- ments, which hardly encouraged them to put their financial problems behind them. Moreover, the controls prevented capital inflows that were needed to recapitalize the banking system. 38. Not only financial liberalization but also changes in financial technology (computerized trading, the proliferation of derivative financial instruments) will make capital controls more difficult to operate in the future. To be effective, these kinds of controls will have to be encom- passing and draconian. And such measures are not something that residents, jealous of their financial freedom and increasingly able to make that preference known through the medium of democratic politics, are likely to tolerate. 46 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES Having ruled out all other options ad seriatum, the conclusion is that mostAsiancountrieswillmovetowardfreerfloatingcurrencies.39 Butfloat- ing is not an operating strategy for monetary policy; rather, as one econo- mist has put it, it is the absence of an operating strategy. What, then, should be put in its place? Although there are many possible alternatives to an ex- change rate­based monetary policy operating strategy, the obvious one is inflation targeting. Inflation targeting is an operating strategy with four el- ements: (a) an institutionalized commitment to price stability as the pri- mary goal of monetary policy; (b) mechanisms rendering the central bank accountable for attaining its monetary policy goals; (c) the public announcementoftargetsforinflation;and(d)apolicyofcommunicatingto the public and the markets the rationale for the decisions made by the cen- tral bank. Institutionalizing the commitment to price stability lends credi- bility to that objective and gives the central bank the independence needed to pursue it. Mechanisms for accountability make this pursuit politically ac- ceptable, and they impose costs on central banks that are incompetent or opportunistic. Announcing a target for inflation and articulating the basis for the central bank's decisions allow these mechanisms to operate.40 What is the role of the exchange rate in inflation targeting? Exchange rate movements convey information about future inflation and unemploy- ment. Thus, a central bank concerned about minimizing deviations in in- flation and unemployment from their targets will respond by adjusting policy when the exchange rate moves. But it will not follow a rigid rule for altering policy when the exchange rate moves to the edge of a prean- nounced band. How it will respond to exchange rate movements will de- pend on why the exchange rate moved and what that movement implies for future output and inflation. Briefly, an inflation-targeting central bank will respond differently to exchange rate fluctuations depending on the source and nature of the shock that causes the exchange rate to move. Thus, inflation targeting does not involve benign neglect of the exchange rate, although it involves no longer organizing the country's entire operat- ing strategy for monetary policy around a target level or range for the rate. 39. This view is similarly the argument of Corden (2002) and Goldstein (2002), who provide their own lists of particulars for how regimes such as these should be run. 40. The regime I am describing is flexible inflation targeting, not strict inflation targeting. Strict inflation targeting is when only inflation enters the central bank's objective function; flexible in- flation targeting is when there is also a positive weight on other variables, for example, output. Under flexible inflation targeting, the central bank does not attempt to immediately return the actual inflation rate to its target under all circumstances, because doing so would create undue volatility in interest rates and output. Rather, it eliminates discrepancies between actual and tar- get inflation gradually over time because it is adverse to sharp fluctuations in output. HANGING TOGETHER? ON MONETARY AND FINANCIAL COOPERATION 47 What is the role of international cooperation in the operation of this regime? Agreeing on a common inflation target would be a small step in the direction of a common monetary standard (although it is no guarantee of exchange rate stability).41 The availability of foreign credits and swaps could enhance the credibility of open-economy inflation targeting. When inflation rises temporarily but output falls, the central bank may be reluc- tant to raise interest rates to defend its inflation target at the cost of aggravating the recession. The availability of foreign credits may resolve this dilemma by financing foreign exchange market intervention that strengthens the exchange rate, thus supporting pursuit of the inflation tar- get without requiring higher interest rates that are counterproductive from the point of view of the full employment target. In reality, the effec- tiveness of sterilized foreign exchange market intervention is limited in most emerging markets, where the bond markets in which intervention takes place are underdeveloped. This last observation points to the main respect in which international cooperation can advance the operation of this monetary regime. Asian countries can cooperate in the development of the relevant financial mar- kets. This cooperation not only will facilitate sterilized intervention but also will limit the disruptions caused by the active use of interest rates and the greater flexibility of exchange rates implied by inflation targeting. If countries develop long-term bond markets, the maturity mismatches and short-term exposures that cause financial distress when the interest rate changes will no longer be such a problem. If countries strengthen the management and supervision of domestic banks, the currency mismatches that cause exchange rate changes to provoke widespread bank failures will be less disruptive. In other words, financial stability and development are needed for the successful operation of any monetary regime. Hence, I turn to the implications of this observation. FINANCIAL OPTIONS Asian prospects would be enhanced if governments eschewed these efforts to stabilize exchange rates per se and, instead, concentrated on steps to promote financial stability and financial development in the region. 41. It is not a guarantee (a) because exchange rates, being asset prices, are more volatile than commodity prices; (b) because different economies will experience different shocks, leading the authorities to accept different amounts of inflation and, hence, different exchange rate move- ments; and (c) because different central banks will attach different weights to the various argu- ments in their objective functions. 48 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES The Problem The 1997­98 crisis underscored the importance of buttressing financial stability and promoting financial development. Arguably, problems in the finance company sector were what rendered the Thai crisis so disruptive, and the run on Indonesia's banks was what transformed the depreciation of the rupiah into a full-blown financial panic. Had banks been better su- pervised and had financial markets been better regulated, the fallout from these currency adjustments would have been less. The output losses from involuntary exchange rate adjustments are smaller when depreciation is not accompanied by major financial sector problems.42 In the presence of stronger banks and better-regulated financial markets, it follows that the effects of currency adjustments that eliminate misalignments are more likely to be positive. Similarly, the underdevelopment of the bond markets that are the clos- est substitutes for bank-generated credit can be blamed for the exaggerated importance of bank financing that turned out to be the gap in the region's financial armor (Goldstein 1998). Securities markets are less conducive than banks to connected lending (securities exchanges being more anony- mous) and to the use of finance as an instrument of industrial policy (secu- rities markets being more decentralized and, therefore, difficult to guide). Thus, the development of decentralized, competitive, anonymous financial markets--especially the bond markets that are the most direct substitutes for bank financing--will strengthen market discipline and discourage gov- ernments from using financing to further nonfinancial ends, a practice that is incompatible with financial opening and liberalization. In addition, banks tend to be too big and well connected to be allowed to fail, thus creating a moral hazard of which investors are acutely aware. In the first half of the 1990s, this awareness encouraged indiscriminate bank-to-bank lending that financed the accumulation in banking systems of dubious real estate loans (as in the case of Thailand) and industrial com- mitments (as in the case of Korea). Much of this foreign financing was short term, reflecting the absence of liquid markets in long-term debt in- struments and the artificial incentives of the Basle Capital Accord for short-term, bank-to-bank lending.43 Consequently, when a shock to 42. See, for example, Gupta, Mishra, and Sahay (2000) and Bordo and others (2001). Output losses are two to three times as large when currency crises are allowed to become twin crises (Kaminsky and Reinhart 1999). 43. The latter reflected the assumption of the framers of the accord, which proved erroneous, that short-term loans were less risky because they were more liquid, hence justifying the appli- cation of lower capital charges. HANGING TOGETHER? ON MONETARY AND FINANCIAL COOPERATION 49 confidence caused this capital flow to reverse direction, the stability of entire national banking systems was placed at risk. Had this money instead been mediated by the bond market, the result would have been different. In response to the shock to confidence, the prices of these assets and liabilities, and not merely their quantities, could have adjusted. Modest adjustments on several margins are easier to ac- commodate than major adjustments on one. Although the fall in bond and equity prices would not have been painless, it might not have produced as profound a threat to the stability of banking systems and financial markets generally as did the liquidation of bank-to-bank loans. To contain these threats to stability, prosperity, and growth, Asian coun- tries must secure financial stability and must promote the development of securities markets. A large literature points to the measures needed to achieve these ends.44 Buttressing financial stability involves applying mar- ket discipline to financial institutions and strengthening prudential super- vision. Intensifying market discipline, in turn, means removing implicit guarantees and opening banking to foreign competition. Moreover, up- gradingprudentialsupervisionmeansestablishingindependentsupervisory and regulatory agencies; giving them dedicated budgets; ensuring that their employees are adequately trained and compensated; and empower- ing them to intervene when problems are detected, including, if necessary, giving them the power to reorganize or liquidate distressed intermedi- aries. Little controversy arises about the ingredients of this recipe, although the best way of blending those ingredients remains a matter of some controversy. Similarly, how to effectively promote the development of deep and liq- uid financial markets is well understood in principle. Doing so presuppos- es the creation of a framework that fosters transparency and strengthens creditor rights. Mandating the prompt and effective dissemination of fi- nancial information by those issuing debt securities--something that can be done by adopting securities-market regulations requiring disclosure-- will attenuate information asymmetries. In turn, this approach will limit the adverse selection and moral hazard that might otherwise stunt the growth of markets in these assets. But information in the absence of con- tract enforcement is not enough. In addition, effective creditor rights (in the form of restrictions on going into reorganization, laws mandating that secured creditors be paid first in the event of reorganization, and rules for whether management can stay in place after a reorganization) are needed to contain principal-agent problems that would otherwise discourage the 44. For a recent synthesis, see Caprio and Honohan (2001). 50 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES developmentofdeepandliquidbondandequitymarkets(LaPortaandoth- ers 1998). Again, although controversy arises about how to best implement these measures, little disagreement is expressed about their desirability. In the present context, two questions follow. First, does international cooperation have a role to play in advancing these policies? And, second, is there a role for cooperation at the regional level, particularly in Asia? The arguments for international cooperation are familiar (see, for ex- ample, Wyplosz 1999). To the extent that financial crises spill across bor- ders, financial stability has the character of an international public good. Governments will underinvest in providing this stability in the absence of international cooperation. Regulators will be reluctant to hold their banks to expensive capital and liquidity requirements in the absence of interna- tional cooperation, because those banks would then lose market share to more laxly regulated foreign competitors able to provide the same services for less. Regulators will be reluctant to require strict disclosure of financial information as a prerequisite for listing an issuer's securities on the local exchange, because the latter will then stand to lose business to exchanges with less stringent requirements. The Basle Capital Accord can be seen as an international response to the first of these problems, and the international standards of the International Organization of Securities Commissions, promulgated in cooperation with the IMF and the Finan- cial Stability Forum, can be seen as an international response to the second. Because the spread of financial instability and competition for market share do not respect regional borders, it is not obvious that such coopera- tion should be organized at the regional as opposed to the global level. If the externality is global, the response should be global. Additional ratio- nales are thus needed to justify cooperation at the regional level. Two sug- gest themselves. First, the transactions costs that must be surmounted to arrange a cooperative response may be lower at the regional level because the number of participating governments is smaller and the countries involved are more cohesive (reflecting similar historical experiences, long- standing diplomatic relationships, or preexisting nonfinancial agree- ments). Thus, Fratianni and Pattison (2000) attribute the success of the BIS to the fact that, historically, it has been made up of a small number of members at similar stages of development. Second, regional governments may share common problems, which encourages agreement. Asian countries all share, to one extent or another, problems of security-market underdevelopment, inadequate financial transparency, and bank-dominated financial markets, in turn reflecting the close historical connections between government and finance and the tendency for governments to use financial markets as an instrument of HANGING TOGETHER? ON MONETARY AND FINANCIAL COOPERATION 51 industrial policy.45 To the extent that Asian governments are aware of these common problems, a regional arrangement is the obvious basis for organ- izing training programs and technical assistance as well as for promulgat- ing internationally agreed standards for supervision and regulation. The Solution Recent initiatives suggest that Asian governments have come to recognize the urgency of addressing these issues. In 2002, three APEC teams began studying issues in capital market development. One of these groups is explicitly charged with framing recommendations for securitization and credit enhancement to improve the risk quality of Asian bonds. ASEAN 3 has formed six working groups to study various aspects of regional financial markets, including securitization, regional credit-rating agencies, regional clearing and settlement systems, and regional credit guarantee agencies. In an effort to jumpstart regional bond markets, the Executives' Meeting of East Asia­Pacific Central Banks (EMEAP) has set up an Asian Bond Fund, with contributions from the foreign reserves of each member bank, to invest US$1 billion in dollar-denominated bonds issued by qualified Asian issuers.46 To further stimulate regional debt mar- kets, the Korean government has tabled a securitization and guarantee scheme designed to stimulate a supply of high-grade credits to better match existing demand, and officials have given active consideration to proposals for the issuance of debt securities denominated in a basket of Asian currencies.47 In a companion paper (Eichengreen 2003), I suggest that these initia- tives could be usefully complemented by the creation of an Asian Finan- cial Institute, or AFI.48 The preceding initiatives identify, in particular, in- adequate scale and the inadequate supply of investment grade credits as the main obstacles to bond market development, and they seek to address these problems and encourage the creation of a pan-Asian bond market by focusing on currency and credit risk. In contrast, the AFI as I conceive it 45. Given the profound differences between the structure of the economies of either China and Korea or Singapore and Vietnam, this argument clearly should not be pushed too far. 46. Presumably, investments in the local-currency-denominated bonds of qualified Asian issuers will follow at some stage. At the time of writing, a second fund of up to US$1.5 billion for investment in Asian currency risk is under discussion. 47. On the Korean proposal for securitization and credit guarantee, see Oh and Park (2003), and on the Asian currency basket bond idea, see Ito (2003) and Olarn, Supapol, and Sangsubhan (2003). 48. More details on the proposal can be found in Eichengreen (2003). 52 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES would promote cooperation in addressing the problems of weak market infrastructure that have stymied financial market development at the na- tional level. It would provide technical assistance to national agencies seeking to strengthen prudential supervision and regulation. It would run training programs for bank inspectors, securities and exchange commis- sioners, and accountants, enlisting students from all of its members, exploiting economies of scale and scope, and encouraging the efficient pooling of knowledge and expertise. It could be a venue for the negotia- tion (a) of common agreements on capital and liquidity requirements and regulatory processes intended to promote the stability of banking systems and (b) of standards for information disclosure, securities listing, and cor- porate governance designed to promote the development of regional financial markets. If one believes, with the present author, that the main obstacle to financial market development in Asia is not inadequate scale or an inadequate supply of investment grade credits but, rather, the underde- velopment of the relevant market and regulatory infrastructure, then a regional institute that applies peer pressure and lends expertise for the development of that infrastructure has a role to play. To be sure, efforts to apply peer pressure and to provide expertise for the development of stronger financial infrastructure are also under way at the global level. For example, a host of relevant standards and codes are already being promulgated by, among others, the Basle Committee of Banking Supervisors (in the case of capital adequacy for international banks); the Financial Stability Forum (in the case of prudential supervision and regulation); the IMF (in the case of data dissemination, transparency, and codes of conduct for monetary and fiscal policies); and the Organisa- tion for Economic Co-operation and Development (in the case of corpo- rate governance). But having the AFI organize negotiations on the design of a distinct set of regional financial standards appropriate to Asia's circumstances would address concerns that global standard-setting initia- tives are not sensitive to the special features of the Asian model. What might this distinct set of Asian financial standards, sensitive to the economic structure, history, and traditions of the region, look like? How might Asian financial standards differ from the analogous global standards? For example, Asian standards might have fewer and looser re- strictions on portfolio concentrations. In many Asian countries, industrial development involves a prominent role for large conglomerates and in- dustrial groups, which draw their external financing from a small number of closely allied banks. This development model implies that portfolio concentrations that are relatively large by international standards may be a necessary corollary of economic development. But allowing claims on individual borrowers to constitute a larger share of individual bank HANGING TOGETHER? ON MONETARY AND FINANCIAL COOPERATION 53 portfolios in turn implies greater financial risk and the need for capital re- quirements higher than those required by the Basle Committee. I have chosen this example to illustrate that a distinctive Asian approach to prudential supervision and regulation need not be more lax than that mandated by global financial standards. Looser restrictions in one area, portfolio concentrations, could be offset by tighter restrictions in anoth- er, capital requirements. With the appropriate combination of measures, there is no reason why the Asian approach would necessarily be incom- patible with the relevant global standards. Clearly, a regional approach to coordinating prudential supervision and regulation would serve no pur- pose if it amounts simply to setting looser standards than those promul- gated globally. The argument for a distinctive Asian approach is not that Asia can afford worse financial regulation than the rest of the world, but that it may wish to attain the same standards of safety, stability, and effi- ciency in different ways. Thus, a regional approach to financial standard setting must be consistent with its global analog while still possibly differ- ing in its particulars in ways that speak to Asia's special needs. How would the AFI advance this Asian approach? First, it would take input from the national regulators and other authorities of the participat- ing countries. Those same national authorities would be responsible in the first instance for implementing and monitoring compliance with those standards. In addition, however, the AFI would monitor the compliance of its members and would discipline violators with public announcements and perhaps, ultimately, financial penalties. In addition, the AFI could provide central banking services. It could serve as a mechanism for coordinating monetary, fiscal, financial, and regulatory policies to promote the development of financial markets in the region while discouraging governments from pursuing strategies that promised to grow their financial markets at the expense of the markets of their neighbors. And under exceptional circumstances, it might provide emergency assistance, in the form of credits and swaps, to countries with financial difficulties that threaten to undermine financial stability and de- velopment in the affected country and its neighbors.49 In fact, this recommendation is not the first time that such an entity has been proposed. In 1995, Bernie Fraser, then the governor of the Reserve Bank of Australia, suggested establishing an Asian version of the BIS to carry out some of these functions.50 The institution Fraser envisaged would have been responsible for exchanging information with respect to 49. However, one could also imagine establishing an AFI that did not possess a lending capacity. 50. His initiative can be understood as a response to the instability that followed the Mexico cri- sis of December 1994. It lost steam when the BIS responded preemptively by expanding into Asia. 54 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES international financial and monetary policies and for developing contin- gency plans for dealing with financial crises. It was also expected to offer a venue for sharing information and experience with respect to supervision and surveillance of financial systems and to provide central banking serv- ices to member central banks. Still, Fraser's vision was more modest than that described here. In particular, the promulgation and enforcement of standards, regulations, and policies for promoting financial stability and development, which would be among the key functions of the AFI, were not among the responsibilities of the Asian BIS enumerated by Fraser. More recently, Bergsten (2000a, 2000b) proposed creating an APEC Financial Institute. He advocated the creation of an institution to provide trainingtobankers,auditorsandaccountants,lawyersandcreditraters,and supervisors and regulators throughout the region.51 But although Bergsten'smotivationissimilar,theresponsibilitiesoftheinstitutionheen- visages would again be more limited than those of the AFI proposed here. Bergsten's institute would provide training, not lending. It would not coor- dinate regulatory functions. It would not promulgate and monitor compli- ance with standards. The contrast is not surprising: APEC's heterogeneous membership (including Australia, Canada, New Zealand, and the United States, among others) is not obviously compatible with standard-setting, monitoring, and lending functions expressly tailored to Asia's needs. ASEAN 3 is a logical organizational basis for the AFI envisaged here. ASEAN 3 is an organization of Asian countries. It already is in the busi- ness of providing technical assistance: at the Fourth ASEAN Finance Min- isters' Meeting (in March 2000), ASEAN 3 finance ministry and central bank deputies agreed to establish a network of research and training insti- tutions. Since 1998, the association has conducted regional surveillance exercises in the context of the ASEAN Surveillance Process, the purpose of which is to further cooperation in the formulation of monetary, fiscal, and financial policies through information exchange, peer review, and rec- ommendations for action at the regional and national levels. That surveil- lance process is informed by all members providing the ASEAN Surveil- lance Coordinating Unit (SCU), which is based in the ASEAN Secretariat in Jakarta, with the same data provided to the IMF in conjunction with its article IV consultations and program negotiations. Although financial assistance (under the provisions of the Chiang Mai Initiative) may be pro- vided in response to the conclusions of this regional surveillance exercise, 51. These are realistic ambitions, Bergsten argues, because the new Asian regionalism is pro- ceeding more rapidly on finance than on trade, which is the opposite of the European model. This sequencing is logical, it can be argued, because the Asian crisis was a financial crisis. HANGING TOGETHER? ON MONETARY AND FINANCIAL COOPERATION 55 this assistance is contingent, as noted elsewhere in this chapter, on the recipient government meeting the conditions set down by the IMF. Thus, folding the Chiang Mai Initiative and the ASEAN Surveillance Process into the AFI would help ensure that the activities of the new AFI were co- ordinated and compatible with those of the Bretton Woods institutions. Creating an AFI on the platform of ASEAN 3 and housing within it the subscriptions and swap lines of the Chiang Mai Initiative would have the corollary benefit of removing ambiguity about the purposes of the initiative. Those purposes would be clearly defined as furthering the goals of the AFI (namely, fostering financial stability and development, not stabilizing exchange rates). Whether fixed or flexible exchange rates were more conducive to financial stability and development would then be recognized as a separate question. Might not some other regional grouping provide a better basis for this initiative? The APEC Finance Ministers' Process is not suitable because it involves a larger and even more heterogeneous group of countries, and its concrete achievements have been limited so far to the creation of training programs and seminars on topics such as financial regulation, risk man- agement, and credit analysis. The same is true of the Manila Framework Group, which does not even possess a permanent secretariat, a permanent staff, or dedicated funding. Although EMEAP has among its objectives regional surveillance, the exchange of information, and the promotion of financial market development, its meeting schedule is irregular, and those meetings have lacked coherence and continuity.52 Firm surveillance, peer pressure, and constructive criticism feature no more prominently in its discussions than in those of ASEAN. The SEANZA (Southeast Asia, New Zealand, and Australia) Group of central banks has many of the same limitations from this point of view.53 52. EMEAP was organized in the early 1990s with leadership from Japan and Australia. Its members are the Southeast Asian and Australasian members of SEANZA: Australia, China, Hong Kong (China), Indonesia, Japan, Korea, Malaysia, New Zealand, the Philippines, Singapore, and Thailand. There are annual meetings of EMEAP central bank governors, semi- annual meetings of the deputy governors, and working groups concerned with banking supervi- sion, financial markets, and payments and settlement systems. 53. SEANZA grew out of a 1956 meeting of central bank governors from the Asia-Pacific region. The governors agreed that the central banks of the region should pool their resources to provide training courses for promising central bank staff members (the first of which was held in 1957). An offshoot, SEACEN (South East Asian Central Banks), was then established in the 1980s as a train- ing and research organization. The SEANZA Forum of Banking Supervisors was established in 1984 as an additional subsidiary of the main SEANZA Group. The forum was intended to allow for the exchange of information on issues and problems of common interest. More recently, spe- cial-purpose regulatory agencies have joined the central banks in this forum. However, the inclusionofanumberofsmallerAsia-Pacificcountriesmakesitunwieldyforregionalcooperation. 56 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES An alternative to building an AFI on the foundation of the ASEAN Surveillance Process and the Chiang Mai Initiative is to expand the re- sponsibilities of the Asian Development Bank (ADB). The ADB is already in the business of providing advice on, among other issues, policies for promoting financial development. It already provides technical assistance to governments participating in the ASEAN Surveillance Process and publishes an Asian Development Outlook that resembles the World Economic Outlook and is integral to the IMF surveillance process. In the same man- ner that the IMF and the World Bank have organized financial stability reviews, might it not be logical for Asian countries to encourage the ADB to carry out similar functions? The ADB has not demonstrated the capacity to efficiently carry out an expanded set of functions. In addition, the United States, the larger European countries, a number of Central Asian republics, and some of the micro states of the Pacific are members of the ADB, which would compli- cate using it as a platform for Asian coordination.54 The ADB's charter explicitly states that it shall give preference to the smaller countries of the region, a mandate that is not obviously consistent with these other functions. Alternatively, might not the AFI be established by an entirely new grouping of Asian countries, separate from ASEAN, APEC, SEANZA, EMEAP, and the others? This group could be made up of countries com- mitted to financial openness (leaving out any that prefer to opt for capital controls) and to market-based banking systems (leaving out those that are reluctant to privatize state banks) as well as those at comparable levels of financial development (leaving out the poorest countries with the least de- veloped financial systems). Asian countries that were initially left out could opt in once they met these preconditions. The greater homogeneity of economic structures would allow the development of more detailed stan- dards for prudential supervision and more effective policies for financial development. But limiting initial participation in this way would do less to apply effective peer pressure to those countries that were furthest from best practice to upgrade their arrangements. It would do less to address the special needs of the poorest countries and to create a zone of financial stability encompassing all of Asia. Moreover, creating yet another regional grouping would only com- pound the alphabet soup problem--the proliferation of overlapping arrangements that robs regional initiatives in Asia of their coherence. 54. The United States is not only a member but also the largest shareholder, along with Japan. HANGING TOGETHER? ON MONETARY AND FINANCIAL COOPERATION 57 Although folding the AFI into an existing institution does not solve this problem, resisting the temptation to create yet another self-standing grouping can at least prevent making it worse. It will prevent adding an- other regional surveillance round, for example, to existing ASEAN and APEC surveillance exercises. In addition, there are reasons to think that folding the AFI into an existing regional organization such as ASEAN would enhance the effectiveness of the new institution because the com- mitments made by AFI members would then become intertwined with the other commitments of ASEAN members. Alternatively, might these duties not be better discharged by a global institution like the Bank for International Settlements, which has exten- sive experience relevant to cooperative agreements on the supervision of financial institutions and the regulation of financial markets? The BIS has recently taken on some new Asian members, thus indicating that it recog- nizes the existence of this market niche. But many Asian policymakers will regard this response as inadequate for the same reasons that they see the IMF as failing to fully meet regional needs. The BIS is dominated by the large Western economies. Its decisions are unlikely to be tailored to the imperatives of the Asian model. Because it is a club of high-income countries, its standards and services are not well suited to the needs of the Lao People's Democratic Republic, Myanmar, the Philippines, or Vietnam. It is in the business of coordinating the supervision of well- developed banking systems and the regulation of well-developed financial markets, not of designing policies to advance the development of those markets where they do not exist. CONCLUSIONS This chapter has considered the case for more extensive economic policy cooperation in Asia. It has attempted to push the debate forward by draw- ing a distinction between monetary cooperation and financial cooperation and by arguing that the case for financial cooperation to strengthen the su- pervision of banking systems and the development of financial markets is stronger than the case for monetary cooperation to stabilize intra-Asian exchange rates. Exchange rate fluctuations in and of themselves are not the principal threat to financial stability. A clearer and more pressing danger is the inadequate supervision of banking systems and the chronic underde- velopment of equity and, especially, bond markets. On the one hand, coop- eration to stabilize exchange rates would be a diversion at best and a costly mistake at worst. On the other hand, cooperation in strengthening banking 58 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES systems and in promoting the development of bond markets would go a long way toward creating a zone of economic and financial stability. This perspective has led me to propose the creation of an Asian Finan- cial Institute on the platform of ASEAN 3. The AFI would develop guidelines for the prudential supervision of banking systems and for policies of financial development--guidelines and policies that would be consonant with the Asian model. Its regional surveillance would monitor the compliance of members with those standards and policy guidelines. It would pressure governments that failed to meet its standards and comply with its guidelines. It would provide technical assistance for countries that found it difficult to meet these standards on their own. And in the event of financial difficulties that threatened to derail financial development in a country and destabilize its neighbors, it could provide emergency swaps and credits through the Chiang Mai Initiative. The case for an AFI on the platform of ASEAN 3 presupposes posi- tive answers to a series of difficult questions. First is the question of what would permit cooperation in developing and monitoring a distinct set of Asian financial standards from leading to overly permissive supervision and regulation. One could imagine a result in which the AFI simply gave aid and comfort to those working to defer rather than to force adjust- ment.55 It would be particularly important to address this danger were the Chiang Mai Initiative's swap lines folded into the AFI and used to assist countries experiencing temporary financial difficulties. In part, this prob- lem can be contained by making clear that the development of a separate set of regional guidelines for prudential supervision and regulation does not relieve the participating countries from their obligations to global standards but only helps them meet those obligations in different ways that are better attuned to their particular circumstances. In other words, the Asian financial standards promulgated by the AFI would be counter- productive if they were simply looser than the analogous global standards. But they could serve a useful role if they gave member countries guidance on how to most efficiently meet those standards in ways consistent with their economic and financial structures. In addition, the fact that the vast majority of the credits available to participating countries under the initia- tive can be drawn only when a country has an agreement with the IMF provides some reassurance that this financing would not be used simply to avoid adjustment.56 55. This issue is obviously related to the question, raised in the preceding discussion, of whether ASEAN's relatively ineffectual surveillance process can be strengthened. 56. This point suggests further the desirability of not changing this arrangement, as has been suggested by some of the participating governments (see below). HANGING TOGETHER? ON MONETARY AND FINANCIAL COOPERATION 59 This brings us to the question of whether and how the AFI could fit into the global framework. The mandate of the AFI must make clear that any financial standards it promulgates and financial development strate- gies it promotes should not conflict with those promulgated and promot- ed at the global level. The AFI would have to be seen by its members as helping them meet those standards in a fashion consistent with their own special circumstances, not as helping members evade those standards. Co- ordination is needed not only on targets but also on assessments of com- pliance. Unlike the Manila Framework Group, where the presence of the IMF as technical secretariat encourages the compatibility of regional surveillance activities with those of the IMF, the ASEAN Surveillance Process includes no comparable arrangement. ASEAN possesses its own Surveillance Coordinating Unit, as noted above. But the understanding that members will provide the SCU with the same information they pro- vide the IMF in conjunction with article IV surveillance and program ne- gotiations is no guarantee that the IMF and the SCU will draw the same conclusions. The two institutions might offer inconsistent, incompatible assessments of performance and recommendations for action, undermin- ing the credibility of one another's advice. This possibility suggests a need to build bridges between the SCU and the IMF and to involve the latter in the AFI's surveillance exercises.57 A final question--raised in the earlier discussion but worth repeating-- is whether separate regional standards and strategies for prudential super- vision and financial development would have significant value added. Is there really a case for distinct Asian financial standards and development strategies, or would efforts such as these at the regional level simply duplicate initiatives and strategies already under development globally? In this chapter, I have suggested some respects in which prudential regulation and financial development strategies might be tailored to Asia's tastes and needs. But are these and other differences between the "Asian way" and ongoing global efforts in these areas substantial enough to justify a major investment in building new institutions of Asian financial cooperation? This question is the one to which advocates of broader Asian financial co- operation must provide a detailed and convincing answer before the ambi- tious efforts at regional cooperation that they envisage deserve to go ahead. 57. 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"Crawling Bands or Monitoring Bands: How to Manage Exchange Rates in a World of Capital Mobility." International Finance 1:59­80. ------. 1999. "The Case for a Common Basket Peg for East Asian Currencies." In Stefan Collignon, Jean Pisani-Ferry, and Yung Chul Park, eds., Exchange Rate Policies in Emerging Asian Countries. London: Routledge. Wilson, Dominic. 2000. "Managing Capital Flows in East Asia." In Peter Drysdale, ed., Reform and Recovery in East Asia. London: Routledge. Wyplosz, Charles. 1999. "International Financial Instability." In Inge Kaul, Isabelle Grunberg, and Marc A. Stern, eds., Global Public Goods. New York: Oxford University Press. Xiang, Huaicheng. 2001. "Speech on Regional Cooperation." Paper presented at the ASEM Finance Ministers' Meeting, Kobe, Japan, January 14. Available on-line at http://www.mof.go.jp/english/asem/aseme03i3.htm. Xie, Andy, and Denise Yam. 1999. "East Asia: Is Asian Monetary Union Possible?" Global Economic Forum (Morgan Stanley Dean Witter), February 11. Available on-line at http://www.ms.com. CHAPTER 3 TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM Eisuke Sakakibara and Sharon Yamakawa T he case for preferring financial cooperation to monetary cooper- ation in East Asia has been argued in chapter 2. Other dimensions of regional cooperation, especially related to trade, have also been instrumental in the development of economies worldwide. Al- though cooperation in many of these dimensions has not occurred as rap- idly or as deeply in East Asia as in other regions, the cooperation that has occurred has nonetheless played a significant role in the political stability and economic growth of the region. At different times in history, there have been a variety of motivating fac- tors for cooperation in East Asia. The first of these factors was political, culminating in the formation of the Association of Southeast Asian Nations (ASEAN) in the 1960s. Progress in European and North American inte- gration in the early 1990s acted as a catalyst for ASEAN's formation of the ASEAN Free Trade Area (AFTA). The financial crisis of 1997­98 provided the impetus for the financial cooperation that led to the implementation of the Chiang Mai Initiative. Japan's decade-long economic stagnation has also been a factor, in that it has affected the patterns of trade, investment, and official development assistance (ODA) in the region. A new motivating factor is now emerging, and that is China. Most countries in the region see cooperation with China as preferable to com- petition with the growing economic giant, and this view could lead to even higher levels of cooperation in all areas--political, economic, and financial and monetary. We would like to acknowledge the support of others in the preparation of this paper. In partic- ular, we would like to thank Shuichi Shimakura and Eri Moriai for data support and Catherine Sasanuma and Shunichi Sueyoshi for their contributions to the research on regional institutions. 64 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES Many East Asians desire a regional identity, and this desire is motivating both the drive for a zone of stability referred to by Eichengreen in chap- ter 2 and the drive for a stronger voice in dealings with the industrial coun- tries of the West as globalization marches inexorably forward. Many in the region prefer to be less dependent on the West, particularly on the United States, and see regionalism as a way to achieve more self-reliance. In addi- tion, East Asia recognizes the benefits in trade, foreign direct investment (FDI), and financing that the European Union (EU) has derived from its deep integration. Although the process of integration would undoubtedly differ in East Asia, the region naturally desires a similar outcome. Trade and FDI have played major roles in the development of the region. The phenomenal growth of the 1980s and the early 1990s has been attributed to East Asia's liberalization in trade and FDI. These two areas interact in a mutually promoting way. The importance of this link has grown with the increased integration of international production networks. Together, the trade-FDI link and integration of production net- works create a synergy that facilitates the efficient functioning of the entire system. Furthermore, the potential for growth is enhanced when there is coordination in the formulation of trade and FDI policies. In this chapter, we will examine trade and FDI in East Asia from the per- spective of regionalism. The goal is to determine what role, if any, regional cooperation can play in the promotion of trade and FDI as contributors to regional prosperity. We will see that there are both global and intraregional elements in East Asia's trade and FDI, and that both of these elements are important to the continued development of the region. Given that situa- tion and the trend in the region to seek regional solutions to common issues, we will suggest two regionally focused approaches to the promotion of trade and FDI: regional agreements and regional production networks. The organization of this chapter is as follows. First, we present a brief review of trade and FDI links and their effect on growth and development. Then we assess the degree of openness in East Asia's trade and FDI at present. Next we review the trade and FDI patterns of the region, focus- ing on their intraregional and global aspects. Finally, we examine roles for regionalism in the promotion of trade and FDI in East Asia and make some concluding remarks. TRADE AND FOREIGN DIRECT INVESTMENT LINKS In recent years, the link between trade and FDI has generated intense in- terest in the international community. The link has been discussed at length in major reports produced by international organizations such as TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 65 the United Nations Conference on Trade and Development (UNCTAD), the World Trade Organization (WTO), and the Organisation for Eco- nomic Co-operation and Development (OECD), as well as in other studies.1 The common debate on this issue centers on whether trade leads to FDI or vice versa and whether trade and FDI are substitutes or com- plements. In fact, the interrelationship between the two is quite complex, varying by product, by economic sector, and across countries. In other words, the interrelationship depends on the type of FDI and the location and developmental level of the countries concerned. For example, in the case of natural resources (resource-seeking FDI), trade often leads to FDI, which in turn supports (or creates) trade. If this type of FDI exploits the same competitive advantages as the firms in the host economy do, it will most likely reinforce the existing export patterns of that economy. If this type of FDI exploits different resources than firms in the host economy do, it can change export patterns. In manufacturing (export-oriented manufacturing FDI), existing advantages can be rein- forced (for example, when low-cost labor is used to make clothing for export) or changed (for example, through the introduction of new tech- nologies, skills, brand names, and networks).2 Thus, it appears that trade leads to FDI (eventually), and then FDI leads to more trade (UNCTAD 1996, chapter 3; 1999, section II; 2001, p. 58). However, the evolution of international production networks suggests that this conclusion is no longer accurate. The issue is no longer one of whether trade leads to FDI or FDI leads to trade, or whether FDI substi- tutes for or complements trade or the other way around. According to UNCTAD, Rather, it is: how do firms access resources--wherever they are located--in the interest of organizing production as profitably as possible for the national, regional or global markets they wish to serve? In other words, the 1. See UNCTAD's World Investment Report series and other reports; the WTO Working Group on the Relationship between Trade and Investment Web site at ; and OECD (2002). Also, see Brainard (1997), Feenstra and Hanson (1996), Fukasaku and Kimura (2002), Goldberg and Klein (1997), Hanson (2001), Kleinert (2000), Markusen and Venables (1998), and Urata (2001), among others. Some of these are reviewed in OECD (2002). 2. Japan represents a good case of how outward FDI can change the structure of both exports and imports of both host and home countries through international production. Over the course of about 10 years (through 1999), "reverse imports" (imports from Japanese parent firms' affili- ates abroad) as a share of total imports have risen from 4 to 15 percent, and these imports are increasing faster than the exports of the parent firms. Also, the composition of Japan's imports is changing: the share of machinery and equipment imports--mostly electrical and electronics machinery--has risen from 17 to 31 percent over the same 10 years (UNCTAD 2002c, p. 46). 66 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES issue becomes: where do firms locate their value-added activities? In these circumstances, the decision where to locate is a decision where to invest and from where to trade. And it becomes an FDI decision, if a foreign location is chosen. It follows that, increasingly, what matters are the factors that make particular locations advantageous for particular activities, for both domestic and foreign investors. (UNCTAD 1996, p. xxiv) Trade and FDI are becoming more tightly linked in today's international production system, and they function together as the machinery that enables the system to operate. And, increasingly, multinational corpora- tions (MNCs) are the facilitators of this process. The growth in size and operation of MNCs has been phenomenal. According to UNCTAD (2003b, pp. 3, 222­23), in 2002 the 866,119 foreign affiliates of the 63,834 MNCs worldwide accounted for one-tenth of world gross domestic prod- uct (GDP) and one-third of world exports, and they employed more than 53 million people, more than double the number in 1990.3 The coverage of MNCs has broadened to include the whole range of manufactured exports, from low- to high-technology goods as well as services. Because MNCs have integrated international and regional production strategies, they can locate production largely wherever they choose. Different activities can be located in different countries and regions in order to take advantage of lower costs, better resources, faster transportation, and bigger markets.4 The connection between trade and FDI is thus intensified and, for coun- tries in which production is located, opportunities for trade based on com- parative advantage can increase. Both trade and FDI are well recognized today as facilitators of growth and development. They affect development separately and directly as well as indirectly through their interrelationship. Capital, technology, manage- ment expertise, training for the local work force, and access to wider mar- kets are some of the benefits that FDI can bring to host countries. These benefits can complement the resources and capabilities of the host coun- try, thereby increasing its export competitiveness (UNCTAD 2002c, chapter 6). Export competitiveness is a key element in the promotion of economic development, in that it can result in (a) increased foreign ex- change earnings, which can be used to import the products, services, and technologies necessary for increasing productivity and living standards; (b) diversification away from primary commodity exports toward higher 3. Generally, data are as of 2002, although the date differs for some countries and data are unavailable for others. 4. This situation is also referred to as fragmentation. See Arndt and Kierzkowski (2001) for a discussion of this topic. TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 67 technology exports; (c) better realization of economies of scale through larger and more diverse markets; (d) exposure to higher standards; and (e) easier access to information (UNCTAD 1999, p. 18; 2002c, pp. xx­xxi). There are, of course, situations in which these potential benefits are not realized in the host country. MNCs may concentrate solely on a host country's static comparative advantages and never develop the dynamic ones. They may fail to build links to the domestic business community. They may not bring high-level technologies or training to the local labor force. They may depart suddenly if conditions in the host country are per- ceived to have changed so that they no longer meet the MNC's criteria for operating there.5 Still, the relationship between global FDI flows and the growth of world GDP can be characterized as a stable and positive one.6 The overall conclusion of recent studies is that FDI contributes positively to both income growth and factor productivity in host countries, although the precise magnitude of the contribution is difficult to determine.7 Growth is affected by an increase in total factor productivity or an increase in effi- ciency in the use of resources in the host country.8 These increases occur through "the linkages between FDI and foreign trade flows, the spillovers and other externalities vis-à-vis the host country's business sector, and the direct impact on structural factors in the host economy" (OECD 2002, p. 68). Some of these studies found that FDI "crowds out" domestic in- vestment, but others found the opposite to be true. Some even found that "crowding out" could have an overall beneficial effect if scarce domestic funds are released as a result.9 5. See UNCTAD (2002c, pp. 152­53) for a further discussion of these and other possible nega- tive consequences of FDI. 6. During 1971­2000, the correlation between the FDI and GDP growth rates was 0.3. Similar- ly, a simple regression of FDI inflows against GDP during the same period is as follows: FDI inflows 190.9 0.0251 (GDP). R2 0.75, adjusted R2 0.55, and the t-value of GDP coefficients 6.0 (UNCTAD 2002c, p. 22). 7. "Recent studies" refers to 16 recent empirical studies that examined the effect of FDI on growth of income and productivity and that are reviewed and discussed in OECD (2002, chap- ter 3). This literature review focuses primarily on four questions: "1) Does FDI significantly affect the rate of growth of income or productivity? 2) Does FDI `crowd out' or `crowd in' domestic investment? 3) Do technology and knowledge spillovers take place in the domestic economy?, and 4) Are there any necessary preconditions (e.g., human capital, technological, or financial market development) for these positive effects to materialise?" (OECD 2002, p. 66). The studies covered, the specific questions addressed, the estimation techniques, and the major findings are presented in table III.1 on pages 70­74 of the OECD's report. 8. See Urata (2001) for more on this point. 9. For more on "crowding out," see UNCTAD (2003b, p. 105). 68 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES Attracting and reaping the benefits of FDI requires a certain level of development in education, technology, infrastructure, and financial markets. More specifically, macroeconomic stability, institutional predictability, fiscal discipline, efficient and equitable tax systems, prudent public sector debt management, strong domestic financial systems, devel- oped capital markets, transparency, openness to foreign trade, and an educated work force are desirable for this purpose. Creating this enabling environment, in many cases, requires policy changes on the part of national governments (OECD 2002, pp. 27­32). The links between trade and FDI and their combined effect on growth and development make it necessary for policies in these two areas to sup- port each other in terms of objectives and efficient implementation. Ignoring this need for mutually supportive policies can lead to weakening of the developmental contribution of each area, whereas acting on it can lead to synergies that can further promote growth and development (UNCTAD 1996, p. 73). The importance of this coordination increases as the international production system becomes more integrated. Many policies for the promotion of trade and, particularly, for the pro- motion of FDI are developed and implemented at the national level.10 For some countries, particularly less industrialized countries, a national approach can be difficult because of the lack of knowledge and skills in making policy related to foreign investment and in negotiating and imple- menting treaties and agreements (OECD 2002, p. 35). In such cases, a regional or multilateral approach can often work better. Before suggesting a regional approach for the promotion of trade and FDI in East Asia, in the next two sections we assess the region's regional and multilateral profile in these two areas. Examining certain indicators will help determine the region's degree of openness to, and integration with, the global economy. OPENNESS IN TRADE AND FDI Both trade and FDI have been significantly liberalized in what the World Bank refers to as the "third wave of integration (or globalization)" (World Bank 2002, p. 326). This "third wave" began in the 1980s and 10. Export-processing zones (EPZs) constitute one example of consistent trade and FDI policies at the national level. EPZs include "free-trade zones, duty-free zones, free-investment zones, [and] offshore zones." Activities performed in EPZs include "bonded warehousing, export processing, assembling, border or port trade, and financial services. However, despite these variations, export- oriented manufacturing has been the main focus of most zones" (UNCTAD 2002c, p. 214). TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 69 Table 3.1 Openness and Global Integration Indicators Trade Capital flows Trade in Simple mean Gross private goodsa tariffb capital flowsd Gross FDIe % of GDP All products (%) % of GDP % of GDP Country or region 1990 2001 1988c 2001c 1990 2001 1990 2001 Cambodia 22.4 91.7 n.a. n.a. 3.2 6.2 1.7 3.3 Indonesia 41.5 60.1 22.0 8.4 4.1 6.5 1.0 3.2 Lao PDR 30.5 50.4 n.a. 9.4 3.7 1.4 0.7 1.4 Malaysia 133.4 184.0 17.0 9.2 10.3 6.6 5.3 5.7 Philippines 47.7 88.9 28.0 7.0 4.4 42.0 1.2 2.7 Singapore 309.5 277.6 0.5 0.0 54.6 60.2 20.7 22.0 Thailand 65.7 110.9 38.5 17.0 13.5 9.1 3.0 3.5 Vietnam 79.7 93.6 12.7 15.0 n.a. 7.6 n.a. 4.0 China 32.5 44.0 41.2 15.3 2.5 10.4 1.2 4.9 Hong Kong, China 223.5 242.8 0.0 0.0 n.a. 97.0 n.a. 28.8 Japan 17.1 18.2 6.0 5.1 5.4 12.3 1.7 1.1 Korea 53.4 69.1 18.8 8.7 5.6 11.4 0.7 1.5 Canada 43.7 70.1 8.6 4.5 8.1 21.5 2.7 9.6 Mexico 32.1 54.2 13.4 16.2 9.2 7.9 1.0 4.6 United States 15.8 19.0 5.6 4.0 5.7 11.7 2.8 3.1 East Asia and Pacific 47.0 61.0 n.a. n.a 5.0 11.1 1.7 4.6 Europe (EMU or EU)f 44.9 56.3 3.7 3.9 14.1 49.3 2.9 14.8 n.a. Not applicable. Note: EMU European Monetary Union; EU European Union. a. Sum of merchandise exports and imports divided by the value of GDP, all in current U.S. dollars. b. Simple mean tariff is the unweighted average of the effectively applied rates for all products subject to tariffs. c. Actual year varies by country between 1988 and 1994 for year 1988 and between 1997 and 2001 for year 2001. d. Sum of absolute values of direct, portfolio, and other investment inflows and outflows recorded in the balance of payments financial account, excluding changes in assets and liabilities of monetary au- thorities and general government. e. Sum of absolute values of inflows and outflows of FDI recorded in the balance of payments financial account. This indicator differs from the standard measure of FDI, which captures only inward investment. f. Source provides the data in this table only for the EMU (not the EU), except for tariff data, which is for the EU. Source: World Bank (2003, table 6.1, pp. 310­12, and table 6.6, pp. 326­28). has progressed since then by virtue of transportation and communica- tions technology, declining tariffs, and lower barriers to FDI. East Asia has ridden the crest of this wave, as shown by the indicators in table 3.1. Trade expansion is an indication of the level of openness of an econo- my, as measured by the ratio of total trade (imports and exports) to GDP. 70 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES As a region, East Asia and the Pacific has a considerably higher trade-to- GDP ratio (61 percent in 2001) than do the European Monetary Union (EMU) and the North American Free Trade Agreement (NAFTA).11 There is a significant difference in the level of this ratio among the devel- oping East Asian economies, with Singapore and Hong Kong, China, at the high end, reflecting their roles as entrepôts, and China at the low end, reflecting the slower opening of its economy. Another indicator of openness in trade is import tariffs, which have been reduced significantly over the past decade, largely because of regional and global trade arrangements.12 In the early 1990s, the import tariffs of East Asian economies--with the notable exceptions of Hong Kong (China), Japan, and Singapore--were much higher than those of the European Union and those applicable under NAFTA. The higher tariffs reflect the region's developing-country status, as well as the earlier trade liberalization of the European Union and the NAFTA countries.13 By 2001, however, average tariffs in East Asia had declined sharply, particu- larly in the ASEAN-4 countries (Indonesia, Malaysia, the Philippines, and Thailand), partly because of progress under AFTA and the Bogor Declaration of the Asia-Pacific Economic Cooperation (APEC).14 As a result of China's preparations for WTO accession, its average tariff dropped from 41.2 percent in 1992 to 15.3 percent in 2001 for all prod- ucts (primary and manufactured). The level of private capital flows into a country indicates the strength of its investment climate and reflects the degree of liberalization of its 11. The World Bank (2003) provides this ratio for the EMU, rather than the European Union. Note that in table 3.1, ratios are shown separately for Canada, Mexico, and the United States. 12. Import tariffs may be imposed to obtain fiscal revenues as well as to protect certain domes- tic industries from foreign competition. Nontariff barriers, such as quotas, prohibitions, and licensing schemes, are also used for protection, but they are not included here because of the difficulty of combining them into an aggregate indicator. 13. Although tariffs were reduced significantly after the completion of the Uruguay round in 1993, average import-weighted tariffs fell to about 2.6 percent for high-income countries but only to 13.3 percent for developing countries (World Bank 2001, p. 316). In table 3.1, Mexico's tariff appears to have risen over the past decade, but, in fact, this rise occurred fairly recently. Mexico raised most of its most-favored-nation import tariffs by 3 to 10 percentage points in 1999 to generate additional revenue for the government, and these sur- charges were retained for 2000. These increases, however, did not apply to countries that had signed free trade agreements with Mexico (USTR 2000, p. 284). Although NAFTA was not signed until 1994 and the European Union was not officially established until 1995, the participating countries had been making efforts toward liberalizing trade long before then (particularly in the case of the European Union). 14. AFTA allows the newer ASEAN members a longer period of time than older members to reduce their tariffs. TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 71 financial markets. Table 3.1 shows that in 2001 the ratio of private capital flows to GDP for East Asia and the Pacific was 11.1 percent, which is nearly the same as that of the United States but well below that of the EMU (49.3 percent). The ratio is skewed by the very high ratios of Hong Kong (China) and Singapore, which have well-developed financial mar- kets. The ratios for most other countries in the region, however, are very low, reflecting their less developed financial markets and the prolonged effect of the 1997­98 financial crisis. The most important capital flows for developing countries, including East Asia, are FDI flows. As financial openness has led to a doubling of FDI relative to GDP globally over the past two decades, the East Asia and Pacific region has been the beneficiary of the largest growth, with its FDI:GDP ratio more than doubling between 1990 and 2001 (World Bank 2003, p. 309). In 2001 and 2002, the Asia-Pacific region led all regions in the number of policy changes designed to create a more favorable invest- ment climate for FDI, making it one of the fastest-liberalizing host regions in the world (UNCTAD 2002c, p. 7; 2003b, p. 40). East Asia's liberalized trade and FDI were instrumental in the region's growth in the 1980s and early 1990s. During that time, East Asia had opened up to other types of private capital flows (non-FDI), which even- tually led to the 1997­98 crisis, because countries in the region were ill prepared to cope with the volatility of these types of flows. The crisis brought to an abrupt end the earlier burst of super growth, discouraged foreign investment, and caused countries in the region to become wary of such investment. Yet these countries still recognize the importance to eco- nomic growth of remaining open to trade and FDI. PATTERNS OF TRADE AND FDI: GLOBAL AND INTRAREGIONAL East Asia has a history of openness and integration that continue today.15 However, the data and discussion in the preceding section do not reveal the intraregional and global mix of trade and FDI in the region. This mix can be determined through an examination of trade and investment patterns over the past decade or so. Trading Patterns East Asia has experienced tremendous growth in trade over the past two decades, with imports increasing more than fivefold and exports more 15. For a review of this historical legacy, see chapter 1 in Sakakibara and Yamakawa (2003a). 72 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES than sixfold between 1980 and 2001, reaching US$1.393 billion and US$1.527 billion, respectively. Since 1990, both imports and exports have more than doubled. The growth in imports and exports for both ASEAN and ASEAN 3 (the ASEAN countries plus China, the Republic of Korea, and Japan) mirrors that of the region in both periods.16 We will use two measures to analyze East Asia's trade. The first meas- ure is trade share, which indicates the magnitude of trade of one country with another, is easy to calculate, and is commonly used in general discus- sions of trading affiliations but has a number of shortcomings (discussed later). The second measure is the trade intensity index (TII), which is a more complex measure in terms of its calculation as well as the informa- tion it provides. It gives a clearer, more accurate picture of the trading patterns of countries and regions than does the trade share measure. Using these two measures, we will look at current trading patterns and how they have evolved over the past two decades. Trade Shares The snapshot of East Asia's trade shares in table 3.2 reveals both the global and the intraregional nature of the region's trade. Reflecting their global aspect, all ASEAN countries reported more than 10 percent of their trade (imports, exports, or both) to be with the European Union and the United States in 2001. Even the smallest nations conduct a significant amount of trade with these two extraregional partners; for example, 64 percent of Cambodia's exports were to the United States and 25 percent were to the European Union. Nearly all East Asian countries also have significant trade with one or more regional partners, with Japan being a major part- ner for most, followed by Singapore, China, and a few other larger regional countries. The regional and global trading patterns of East Asian countries have shifted over time, as revealed in table 3.3, which displays the trade shares of selected economies in 1980, 1990, and 2001. Japan was ASEAN's primary trading partner in both imports and ex- ports in the 1980s. However, this trade relationship weakened between 1990 and 2001, with the share of imports from Japan dropping by 6 per- centage points between 1990 and 2001 and the share of exports dropping by 16 percentage points between 1980 and 2001. ASEAN's imports were, of course, negatively affected by the East Asian crisis; however, the post- crisis rate of decline in the dollar value of imports from Japan was greater than the rate of decline in ASEAN's total imports. Although the dollar 16. The data source is the International Monetary Fund's Direction of Trade Statistics. The data include the ASEAN 3 countries plus Hong Kong (China) and Taiwan (China). EXP 2.6 6.8 1.8 2.8 0.0 0.7 1.8 0.6 2.1 17.4 -- 1.9 5.7 2.2 -- 8.2 7.6 15.1 41.9 62.8 26.8 VNM 3.6 0.0 0.2 2.2 0.7 3.1 IMP 11.8 11.5 12.0 11.4 -- 0.4 5.3 14.0 -- 2.7 3.1 totals 25.9 61.1 82.5 10.5 ea; Brunei; ietnam.V EXP 1.9 4.4 5.1 2.9 0.1 0.7 2.1 0.6 4.2 0.5 1.8 8.1 15.3 -- 1.2 2.4 Kor Brunei' 19.3 40.9 71.9 16.1 20.3 of THA IMP 3.4 6.0 1.3 4.2 0.6 0.0 2.2 0.1 5.0 1.3 1.8 4.6 -- 0.5 2.6 BRU 22.4 16.2 48.0 67.8 12.2 11.6 KOR VNM centage EXP 2.7 3.9 10.4 21.9 -- 0.0 0.1 1.2 0.0 2.5 0.1 1.7 3.3 1.7 1.4 1.3 12.2 29.1 77.1 14.7 22.5 Japan; Japan; States; per TWN and a IMP 6.3 5.5 1.7 as 24.1 -- 0.0 0.0 2.4 0.0 3.9 0.0 3.0 3.1 2.0 0.4 3.2 14.9 50.8 75.0 11.7 17.0 ea, JPN United EXP 7.5 3.7 4.3 8.6 5.0 0.3 0.3 2.7 0.0 0.3 2.5 -- Kor 4.2 1.7 2.9 16.9 29.0 44.5 76.5 13.0 15.0 Japan of U.S. SGP IMP 3.1 5.8 2.2 4.0 0.1 0.0 6.3 0.0 0.1 2.1 -- 4.2 0.7 2.1 Indonesia; omfr 13.0 16.2 29.7 51.6 76.2 11.1 15.5 Republic China; EXP 3.2 2.5 4.9 6.6 0.0 0.0 0.4 0.0 3.5 0.0 15.7 -- 7.2 4.2 0.2 0.8 15.5 37.0 78.7 19.3 28.0 the IDN imports PHL iwan,aT and IMP 6.6 3.2 4.3 5.4 0.0 0.0 2.6 0.0 3.1 0.0 data.s 20.6 -- 6.1 3.0 0.9 9.3 3.0 15.8 46.2 77.9 16.9 China, China; to EXP 3.3 1.7 4.4 0.9 0.9 0.0 -- 0.8 -- 2.6 -- 0.1 3.7 -- -- 0.4 33.7 43.1 63.2 14.4 16.4 plus TWN Kong, MYN exportss Indonesia' IMP 7.6 9.5 2.6 7.0 0.0 20.4 -- 2.6 -- 8.1 -- 0.3 17.4 -- -- 3.0 1.1 0.5 43.2 80.7 92.0 Hong countries Thailand; using EXP 3.4 4.3 4.6 3.7 0.3 0.1 1.8 0.0 13.3 -- 0.2 1.5 3.8 0.5 2.7 Brunei' 16.9 25.1 46.1 78.6 13.6 20.2 HK MYS left, IMP 4.0 5.2 2.6 5.7 0.0 0.0 3.0 0.0 -- 0.1 2.5 4.0 0.4 2.6 ASEAN THA 19.2 12.6 22.6 51.0 78.6 12.9 16.0 Union; e; top estimated is 3 EXP 1.4 0.0 1.7 0.0 0.9 -- -- 0.2 -- 0.0 -- -- 0.0 0.2 0.9 19.2 25.1 44.5 47.6 50.2 25.6 LAO opean Singapor starting IMP 1.8 1.0 8.3 1.4 0.4 -- -- 0.1 -- 0.3 -- -- 4.0 4.3 1.2 0.6 62.2 11.8 78.5 89.5 93.5 ASEAN Eur Indonesia e.g., EXP -- 6.3 3.9 0.0 0.1 2.2 0.0 1.8 0.2 1.7 2.7 1.2 1.2 1.6 EU SGP with 11.0 12.1 11.0 34.1 70.6 13.1 20.9 KOR Nations; column; IMP 18.9 -- 9.4 0.9 3.0 0.3 0.0 3.2 0.0 2.9 0.0 1.3 2.1 1.1 0.3 4.4 China; 11.3 39.6 67.3 10.6 15.9 trades'e Asian Philippines; EXP -- 6.3 7.7 5.8 6.0 0.0 0.0 1.6 0.0 2.7 0.0 2.0 3.6 2.9 0.4 2.2 13.5 27.4 74.7 16.0 30.4 CHN left-hand JPN PHL the Singapor IMP -- 4.9 0.4 4.1 0.5 0.0 4.3 0.0 3.7 0.0 1.8 1.5 3.0 0.7 4.7 16.6 15.6 37.1 69.3 12.8 18.3 Southeast in e, of efor 6.3 5.4 2.1 3.5 0.0 0.0 EXP 20.9 -- 0.0 3.1 0.1 1.1 1.9 0.6 3.2 countries; 10.9 17.8 50.4 76.4 13.8 15.3 Malaysia; IDN country ther IMP 9.3 8.0 2.4 4.2 0.0 0.0 18.2 -- 0.0 4.4 0.1 0.4 9.7 3.9 0.8 5.4 7.1 19.3 54.8 75.0 11.5 eement IMF; Association MYS EXP 5.9 1.8 36.9 -- 2.4 0.0 0.1 0.4 0.0 0.9 0.0 1.0 2.0 1.0 0.3 5.8 1.3 agr partner the 50.4 78.8 14.5 22.3 a to HK . 2001 IMP 4.5 trade 11.3 43.4 -- with 6.9 0.0 0.0 0.7 0.0 2.5 0.0 1.0 4.6 1.7 0.1 9.7 1.0 6.7 10.8 70.0 85.5 ASEAN Myanmar; wor (2002) es, EXP 4.7 -- Indonesia 16.9 17.5 1.9 0.0 0.1 1.1 0.0 1.2 0.2 0.6 2.2 0.9 0.7 6.9 1.5 28.5 72.8 15.4 20.4 Relations top IMF CHN MYN Shar with IMP 9.6 -- 17.6 3.9 the 11.2 0.1 0.0 1.6 0.0 2.5 0.1 0.8 2.1 1.9 0.4 9.5 2.5 36.7 71.0 14.7 10.8 omfr in Cooperation; trade data EXP 1.0 0.1 1.3 0.4 0.4 -- -- 0.1 -- 0.8 -- 0.3 2.2 0.6 1.9 5.9 8.3 0.1 Economic 74.2 24.8 64.2 Republic; its Export CAM country a using IMP 1.4 3.4 6.0 8.0 5.4 -- -- 0.7 -- 1.3 -- 0.2 7.6 1.9 0.1 1.2 27.4 34.6 71.8 82.6 97.5 Economic Closer of eportr and e not 4.1 0.0 0.0 EXP 46.5 12.4 -- -- 0.8 -- 0.2 0.0 0.0 5.0 0.0 1.5 6.9 10.6 16.5 79.4 98.1 11.6 CER Democratics shar BRU does . calculations Import 4.6 1.4 1.4 4.2 1.0 -- -- 2.0 -- 0.0 0.3 3.1 0.2 2.0 8.6 Asia-Pacific e IMP 22.7 34.1 62.4 69.8 85.8 12.6 trade People' as 3.2 or e 3 Kong available Cambodia; Authors' cent) APEC Lao eadsr Singapor PDR ce: ableT oup ea Not (per Country egionalr gr Japan Kor China Hong aiwanT Brunei Cambodia Indonesia Lao Malaysia Myanmar Philippines Singapor Thailand ietnamV ASEAN ASEAN APEC EU CER U.S. -- Note: CAM LAO ableT trade. Sour 73 74 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES Table 3.3 Trade Shares, Selected Economies and Selected Years (percent) ASEAN Trade Imports Exports partner 1980 1990 2001 1980 1990 2001 Japan 21.1 23.0 17.0 29.2 18.9 13.2 Korea 1.6 3.1 4.8 1.5 3.3 3.6 China 2.6 2.9 6.1 1.0 1.8 4.4 ASEAN 17.8 16.3 23.8 18.2 19.6 23.2 ASEAN 3 43.1 45.3 51.7 49.9 43.7 44.5 APEC 63.4 71.2 75.8 72.7 73.6 75.8 CER 3.5 3.1 2.7 2.8 2.1 2.8 EU 13.8 15.4 11.4 12.6 15.7 14.9 U.S. 14.5 14.4 13.3 16.1 19.4 18.0 Japan Japan -- -- -- -- -- -- Korea 2.2 5.0 4.9 4.1 6.1 6.3 China 3.1 5.1 16.6 3.9 2.1 7.7 ASEAN 17.5 12.7 15.6 10.4 11.6 13.5 ASEAN 3 22.7 22.9 37.1 18.4 19.8 27.4 APEC 51.1 61.3 69.3 53.0 67.6 74.7 CER 5.6 6.0 4.7 3.1 2.8 2.2 EU 6.5 16.1 12.8 15.2 20.4 16.0 U.S. 17.4 22.5 18.3 24.5 31.7 30.4 China Japan 26.5 14.1 17.6 22.2 14.3 16.9 Korea -- 0.4 9.6 -- 0.7 4.7 China -- -- -- -- -- -- ASEAN 3.4 5.8 9.5 6.6 6.4 6.9 ASEAN 3 29.9 20.2 36.7 28.8 21.4 28.5 APEC 64.4 64.8 71.0 60.7 73.1 72.8 CER 6.3 2.7 2.5 1.4 0.8 1.5 EU 15.8 16.7 14.7 13.7 9.6 15.4 U.S. 19.6 12.1 10.8 5.4 8.2 20.4 Korea Japan 26.3 26.6 18.9 19.2 19.4 11.0 Korea -- -- -- -- -- -- China 0.1 -- 9.4 0.0 -- 12.1 ASEAN 6.7 7.3 11.3 6.6 7.8 11.0 ASEAN 3 33.0 33.9 39.6 25.7 27.3 34.1 APEC 61.5 66.8 67.3 60.9 70.3 70.6 CER 3.4 4.4 4.4 1.5 1.7 1.6 EU 7.6 13.0 10.6 16.7 15.4 13.1 U.S. 21.9 22.1 15.9 26.4 29.9 20.9 Note: See table 3.2 note for description of acronyms. Table reads as trade share of a country/region in the top row with a partner in the left-hand column. Source: Authors' calculation using IMF Direction of Trade Statistics Yearbook (various years). TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 75 value of exports to Japan more than doubled over the past two decades, this increase did not keep pace with the growth rate of ASEAN's total exports, which rose nearly sixfold over that time. By contrast, intra- ASEAN trade shares appreciated quite considerably between 1980 and 2001 and ASEAN's trade shares with China and the Republic of Korea also showed marked improvement.17 The proportion of Japan's trade with the United States and the European Union, although still prominent, has declined since 1990, while the proportion of its trade with ASEAN and China has risen. The United States remains Japan's primary trading partner, with imports from that country making up 18 percent of Japan's total imports, and exports from the United States making up 30 percent of Japan's total exports. More remarkable, however, is that the dollar value of Japan's imports from China has risen nearly fivefold since 1990--to US$58 billion in 2001--and now makes up 16.6 percent of Japan's total imports, surpassing the share of imports from the European Union (12.8 percent) and from ASEAN (15.6 percent). Japan's exports to China are only 7.7 percent of its total exports, but this share continues to increase. As for China's imports, Japan supplies the largest share (17.6 percent in 2001), among ASEAN, Korea, the European Union, and the United States. Since 1990, Japan, Korea, and ASEAN shares of China's imports have increased but EU and U.S. shares have decreased. In exports from China, the U.S. share has risen dramatically since 1980 to reach 20 per- cent in 2001, surpassing the shares of Japan and the European Union. This outcome is a complete reversal of the share pattern in 1980, when exports from China to the United States made up the smallest share (5 per- cent), and exports to Japan made up the largest share (22 percent). This situation reflects improved relations between the United States and China over the past 20 years, as well as the fact that U.S. and EU MNCs are moving production to China and exporting from there. Korea's trade shares have also shifted markedly over the past 20 years, and although Japan retains the position of largest import share partner, the proportion of imports from that country has declined significantly. The shares of imports from the European Union and the United States have also declined since 1990, while those from China and ASEAN have risen significantly. A similar pattern is evident for Korea's export shares; 17. The higher share of intra-ASEAN trade relative to the shares of trade with nongroup part- ners does not necessarily mean that ASEAN is trading more intraregionally than externally. Given the shortcomings of the trade share measure, we will reserve judgment on this until we look at the trade intensity index. 76 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES that is, the shares of exports to Japan, the European Union, and the United States have become smaller, and the shares of exports to China and ASEAN have become much larger, so that the shares for each of these five partners approached parity in 2001, except for the U.S. share, which is still somewhat larger. Intraregional Trade Shares In table 3.3 we saw a marked increase in intra-ASEAN trade share over the past decade. This consequence of a significant rise in intraregional trade is supported by the two measures shown in table 3.4, which cover a broader spectrum of East Asian countries over a longer period of time. The ab- solute measure places a group's intraexports in the context of total world exports, reflecting the degree of importance of its intraregional trade in Table 3.4 Intraregional Trade: Merchandise Exports within Regional Group Absolute measurea (% of world exports) Regional group 1980 1990 1996 1998 2000 2001 APEC 19.1 27.1 33.2 32.1 35.4 33.8 ASEAN 0.7 0.9 1.6 1.3 1.6 1.5 ASEAN 3 3.7 4.6 7.2 5.5 7.0 6.7 All East Asiac 4.6 7.8 12.7 10.5 12.6 11.8 EU 24.3 29.5 24.1 22.7 22.2 22.9 NAFTA 5.4 6.8 8.3 9.7 10.6 10.4 Relative measureb (% of group's total exports) APEC 57.9 68.3 71.9 69.7 73.1 72.6 ASEAN 18.2 19.6 25.1 21.5 23.6 23.2 ASEAN 3 29.3 27.0 36.7 28.7 33.8 34.0 All East Asiac 33.7 40.3 50.2 42.9 47.7 47.7 EU 60.8 65.9 61.4 57.0 62.1 61.3 NAFTA 33.6 41.4 47.6 51.7 55.7 55.5 Note: NAFTA North American Free Trade Agreement. See table 3.2 note for description of other acronyms. Service exports are excluded. Although data have been calculated back to 1980 on the basis of current group membership, most of the groups came into existence in later years and their membership may have changed over time. Intratrade in earlier years may not have been affected by the same preferences (as set forth in preferential arrangements) as in recent years. a. Absolute measure is the sum of exports by members of a group to other members of the group as percent of world exports. b. Relative measure is the sum of exports by members of a group to other members of the group as percent of total exports by the group. c. All East Asia includes ASEAN plus Japan, Korea, China, Hong Kong (China), and Taiwan (China). Taiwan is not included in 1980 and 1990 data. Source: For APEC, EU, and NAFTA, World Bank (2003); for all others, authors' calculations using data from IMF (2002) for the years 2000 and 2001 and earlier Direction of Trade Statistics Yearbooks for prior years. TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 77 total world trade. The relative measure places a group's intraexports in the context of the group's own total exports, reflecting the degree of impor- tance of its intraregional trade relative to its extraregional trade.18 The patterns (both among regions and for each region over time) are similar for both measures. First, since the middle of the past decade, APEC has had the largest intraexport share of both world exports and its own total exports, followed in order by the European Union, all East Asia or the NAFTA signatories, ASEAN 3, and ASEAN.19 Second, the fluctuations in the importance of each group's intraregional trade in both world trade and its own trade have generally followed the same pattern over the past two decades. Intraregional trade for East Asian groups and for NAFTA generally increased in importance relative to both world trade and each group's own trade over the past 10 to 20 years. The European Union, however, is exceptional in that it experienced a decline in intraregional trade after 1990, although that trade has remained fairly stable for the past few years. This situation is noteworthy, considering that the European Union is the region that has become the most integrated during that time.20 These results, however, do not indicate that a group's trade is biased in favor of group members. Trade share as a measure of trade has certain shortcomings--primarily that the share size of a trading group is a direct reflection of the number of countries in the group and of the trading volume of those countries; that is, shares are larger for large groups of high-volume-trade countries and smaller for small groups of low-volume- trade countries.21 Furthermore, the larger the group is, the larger a country's share in that group.22 Thus, in order to assess the level of 18. Petri (1993) refers to these as measures of regional interdependence. Frankel (1997, chapter 2) also discusses these measures. 19. For the absolute measure, all East Asia's share is the third largest and the NAFTA signato- ries' share is the fourth; for the relative measure, the opposite is true, except in 1996. 20. Because data back to 1980 have been calculated on the basis of current group membership, these increases do not reflect the actual addition of members. 21. This situation is reflected clearly in table 3.4. The table shows that APEC, with its 21 mem- bers and its large-volume traders--such as Hong Kong (China), Japan, Singapore, and the United States--has a larger share in both world trade and its own trade than do the NAFTA countries, which are only three, or ASEAN, with its mostly small-volume traders. 22. For example, in table 3.2, exports from Hong Kong, China, to ASEAN are only 6 percent of total trade, but exports from Hong Kong, China, to APEC are 79 percent of total trade. This sit- uation does not necessarily mean that Hong Kong, China, trades more intensively with the countries of APEC than with the countries of ASEAN, but rather that there are more and larger trading countries in the APEC group than there are in ASEAN. See Frankel (1997) for a further discussion of this topic. 78 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES East Asia's intraregional trade accurately, we need to know not only the magnitude of intraregional trade of the countries in the region but also whether members of the region trade more intensively with one another than they do with those outside the region. A measure that has been developed to adjust for the shortcomings of trade shares and that comes closer to revealing the true nature of intraregional trade is the TII.23 Trade Intensity Index The TII is used to determine the actual intensity of one member's trade with another member of the same group or, in other words, the bias with- in a group of members to trade with one another.24 Table 3.5 shows TIIs for merchandise for East Asian countries in 2001. Most of the countries shown in table 3.5 have indices above 1.0 with 10 or more regional partners, indicating that their trade with these partners is above the normal level of trade, based on their trade with the rest of the world. Only the smaller countries, such as Cambodia, Lao People's Democratic Republic, and Myanmar, have intense relationships with just a few partners. Singapore has an intense trading relationship with the largest number of countries in the region, followed closely by Malaysia, Thailand, and Korea. Compared with previous years, some economies, including China, Taiwan (China), and Vietnam, have a greater number of regional partners with whom the indices are above 1.0.25 Our earlier trade share analysis led us to conclude that the trade of East Asian countries with the United States and the European Union is quite significant. This conclusion was supported by the TII in the case of the 23. See Drysdale and Garnaut (1993) for more in-depth analysis of trade using other indices, in- cluding the complementarity and bias indices. 24. This measurement is made by adjusting the trade shares of a country or group through some measure of that country's or group's importance in world trade. More specifically, it is the "ratio of the share of a country's exports with another country to the share of that other country in world imports. A number greater than one indicates that a country exports to another country at a greater level than the other is importing from the rest of the world, and a more `intense' bilat- eral trading relationship" (de Brouwer 2002, pp. 290, 292). A number of variations of this index include the "double-relative" measure of Petri (1993) and the "corrected concentration ratio" of Frankel (1997). The ratio used here is that presented in Anderson and Norheim (1993), de Brouwer (2002), and Drysdale and Garnaut (1993). Oth- ers have used similar versions of the index--for example, Goto and Hamada (1994); Goto and Kawai (2001); and Yamazawa, Hirata, and Yokota (1991). Rajan and Sen (2002) also calculate this ratio for imports. 25. See Sakakibara and Yamakawa (2003b, p. 13) for this index for 1995­97 and 1998­2000. The equation used to calculate the index for the earlier periods is the same as that used in this chap- ter, but there may be slight differences in raw data used in the calculations among the three periods. The results, however, are largely comparable. [Error correction: In table 4.5 in Sakak- ibara and Yamakawa (2003b), the indices for Thailand and Taiwan (China) with each other should be reversed.] USA 0.6 3.5 1.1 1.2 0.8 1.6 1.1 0.1 1.1 0.9 1.5 0.8 1.1 1.2 0.4 eportr CER 5.5 0.1 1.2 1.0 2.6 1.7 1.3 0.2 2.1 0.3 0.6 2.2 1.9 1.0 6.5 not A does 0.5 2.6 0.9 0.9 0.7 1.2 0.9 0.1 0.8 0.7 1.2 0.6 0.9 1.0 0.3 e NAFT oup gr EU 0.0 0.7 0.4 0.4 0.4 0.4 0.4 0.7 0.4 0.4 0.5 0.4 0.5 0.4 0.8 2.0 1.5 1.6 1.7 1.6 1.6 1.5 1.0 1.6 1.3 1.6 1.6 1.5 1.6 1.3 Singapor.wor endnotes. APEC top Regional see the in 4.7 0.5 2.1 2.9 3.1 2.3 2.3 2.8 2.9 2.6 2.2 2.9 2.5 1.7 2.5 index, try of ASEAN+3 coun a lation 3.1 1.1 1.2 1.0 3.7 2.4 2.0 8.3 5.9 6.3 3.2 8.3 4.4 2.2 3.0 with ASEAN calcu For 0.0 7.5 2.5 1.1 2.3 1.6 4.4 2.1 -- 0.7 6.4 4.7 5.3 -- VNM 97.1 column data.s 0.0 0.2 1.1 1.4 2.1 3.4 2.3 0.6 2.2 0.6 3.9 2.9 1.7 -- 1.7 TWN left-hand the 0.6 0.9 1.0 2.0 2.9 1.2 3.9 -- 4.3 4.3 -- 1.8 2.3 Indonesia' THA 11.0 19.8 in using SGP 2.6 1.1 1.1 1.0 5.6 1.8 1.4 0.0 8.7 1.9 3.7 -- 4.2 1.7 2.9 country a PHL 0.0 0.7 1.3 2.1 2.3 4.2 3.6 -- 3.1 0.2 -- 5.2 3.8 3.7 4.1 of estimated is 0.0 -- 4.3 0.8 2.6 1.0 3.6 -- 5.3 -- 0.4 7.9 3.3 0.0 MYN 12.9 intensity 0.1 0.7 1.0 0.7 2.7 2.2 1.5 0.0 -- 2.2 3.0 3.6 2.1 1.8 trade Indonesia MYS 14.4 as with -- -- 1.7 0.4 0.0 0.2 0.3 -- 0.2 -- 0.0 1.8 0.1 Country LAO 55.2 50.6 eadsr . 5.6 0.0 2.1 0.8 2.8 2.7 -- 0.0 1.5 0.8 1.5 1.7 0.8 1.2 1.2 KOR ableT tradese' (2002) JPN 8.5 0.2 3.0 1.1 3.8 -- 2.0 0.3 2.4 0.6 2.9 1.3 2.8 1.9 3.2 onyms. Singapor IMF acr e, 2001 IDN 1.3 0.1 1.7 0.7 -- 2.5 3.5 0.4 2.9 1.3 0.7 4.4 3.4 1.9 3.0 of efor omfr HK 0.0 0.1 5.4 -- 0.7 1.7 2.0 0.0 1.5 0.3 1.6 2.7 1.6 6.9 0.6 ther data Index, IMF; 1.1 0.3 -- 9.4 1.4 1.9 3.1 0.4 1.1 1.2 0.6 1.1 1.1 1.0 1.8 description using CHN the for to Intensity -- -- 3.3 5.8 0.6 0.5 2.9 -- 3.0 -- 0.5 6.3 note CAM 12.8 31.3 32.4 3.2 calculations radeT BRU -- -- 0.3 1.3 2.1 0.6 0.5 -- 0.0 0.6 2.7 0.4 0.7 Indonesia 14.9 15.6 table with 3.5 available. Authors' See ce: Not trade ableT Country BRU CAM CHN HK IDN JPN KOR LAO MYS MYN PHL SGP THA TWN VNM -- Note: its Sour 79 80 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES Table 3.6 Top Five Trading Partners for East Asian Economies Based on the Trade Intensity Index Country 1995­97 2001 Brunei Darussalam -- Thailand--11.0 Japan--8.5 Rep. of Korea--5.6 CER countries--5.5 Cambodia Thailand--17.1 Vietnam--7.5 Singapore--5.5 United States--3.5 Malaysia--2.7 Singapore--1.1 China--2.0 China Hong Kong--5.9 Hong Kong --5.4 Japan--2.8 Myanmar--4.3 Vietnam--2.8 Cambodia--3.3 Lao PDR--2.5 Japan--3.0 Hong Kong, China China--10.5 China--9.4 Philippines--1.9 Cambodia--5.8 Singapore--1.8 Philippines--2.1 Taiwan (China), Vietnam, and the Taiwan, China--1.4 United States--1.6 Indonesia Cambodia --6.1 Singapore--5.6 Japan--3.9 Japan--3.8 Singapore--3.7 Rep. of Korea--2.8 Vietnam--3.7 Malaysia--2.7 Japan Thailand--3.2 Philippines--4.2 Taiwan, China--3.1 Taiwan, China--3.4 Philippines--2.8 Thailand--2.9 Indonesia--2.7 Rep. of Korea--2.7 Korea, Rep. of Vietnam--6.2 Vietnam--4.4 China--3.3 Myanmar--3.6 Indonesia--3.1 Philippines--3.6 Philippines--2.4 Indonesia--3.5 Lao PDR Thailand--14.2 Vietnam--97.1 Taiwan, China--1.9 Thailand--19.8 Japan--1.6 China and European Union--1.1 Malaysia Singapore--8.1 Brunei Darussalam--14.9 Cambodia--4.2 Singapore--8.7 Thailand--3.1 Myanmar--5.3 Vietnam--2.1 Thailand--3.9 Myanmar -- Malaysia--2.2 Singapore--1.9 Indonesia--1.3 China--1.2 TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 81 Table 3.6 continued 1995­97 2001 Philippines Thailand--2.8 Thailand--4.3 Japan--2.7 Taiwan, China--3.9 Singapore--2.4 Singapore--3.7 United States--2.3 Malaysia--3.0 Singapore Cambodia--16.7 Brunei Darussalam--15.6 Malaysia--12.1 Malaysia--14.4 Vietnam--7.2 Cambodia--12.8 Thailand--4.2 Myanmar--7.9 Taiwan, China Hong Kong, China--4.9 Hong Kong, China--6.9 Vietnam--3.1 Cambodia--6.3 Philippines--2.4 Vietnam--5.3 Thailand--2.0 Philippines--3.7 Thailand Lao PDR--53.8 Lao PDR--55.2 Cambodia--16.3 Cambodia--31.3 Singapore--5.1 Myanmar--12.9 Vietnam--3.1 Vietnam--4.7 Vietnam Japan--4.1 Lao PDR--50.6 Australia--3.8 Cambodia--32.4 Philippines--3.4 CER countries--6.5 Indonesia--2.7 Philippines--4.1 -- Not available. Note: CER Closer Economic Relations trade agreement between Australia and New Zealand. Only trade partners with an index above 1.0 are shown. Source: Compiled from authors' trade intensity index tables. United States, but not in the case of the European Union. In fact, 9 of the 15 countries listed in the table (for 2001) have an intensity index above 1.0 with the United States, the same countries as in 1998­2000. The intensity indices with the European Union are all well below 1.0. Table 3.6 indicates the top four trading partners (those with a TII above 1.0) for each East Asian country for 1995­97 and 2001. In 2001, Japan was among the top four trading partners for only three East Asian countries: Brunei Darussalam, China, and Indonesia. The intensity indices of several of these countries with Japan in 2001 are nearly the same as, or even high- er than, they were in 1995­97, but Japan's ranking among each country's partners has dropped, indicating a weakening of each country's trade rela- tionship with Japan relative to its other trading partners.26 This finding is 26. For example, China's TII with Japan in 1995­97 was 2.8 and in 2001 increased to 3.0; where- as Japan ranked second in trade intensity as a partner for China in the earlier period, it ranked fourth in 2001. 82 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES Figure 3.1 Trade Intensity Index: Intraregional, 1980­2001 6.0 5.70 5.0 4.54 4.58 4.63 4.68 4.48 4.0 3.90 3.33 3.12 3.00 3.12 2.99 3.04 3.0 2.73 2.41 2.53 2.43 2.30 2.29 2.32 2.06 2.15 2.12 2.14 2.23 2.10 2.15 2.0 1.90 1.72 1.69 1.77 1.79 1.88 1.83 1.60 1.0 0 1980 1990 1996 1998 1999 2000 2001 ASEAN ASEAN 3 All East Asia EU NAFTA countries Sources: Calculated from World Bank World Development Indicators (various years) and IMF Direction of Trade Statistics Yearbook (various years). consistent with the findings in our previous trade share analysis.27 Never- theless, the indices of East Asian countries with Japan as a partner are, for the most part, above 1.0, except for those of some of the smaller ASEAN members. For some ASEAN countries, their TII with China as a partner declined between the 1998­2000 period and 2001 (see Sakakibara and Yamakawa 2003b, p. 13, and table 3.5 above). But more significant is that the number of regional countries with an above-normal trading relationship with China (that is, a TII above 1.0) rose from 7 in the earlier period to 10 in 2001. Furthermore, from China's perspective, its TII with its East Asian partners rose in 11 out of 14 cases between these two periods. As China opens up and develops, it broadens its trading sphere to include more regional partners. This pattern will undoubtedly continue with the final- ization of the China-ASEAN free trade agreement (FTA). Figure 3.1 compares TIIs of selected regional groups in Asia, Europe, and North America. Most notable in this figure is that ASEAN has had a 27. That analysis (see table 3.3) showed that, between 1990 and 2001, ASEAN's imports from Japan as a share of ASEAN's total imports had declined from 23 percent to 17 percent. For ex- ports, the decline was from 29 percent in 1980 to 19 percent in 1990 to 13 percent in 2001. TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 83 much higher intensity index than any of the other groups for all the years shown. Its index of 3.9 to 5.7 was well above that of the European Union (1.7 to 1.9) and of the NAFTA countries (about 3.0), indicating that ASEAN has had a higher degree of intraregional trade than the European Union or the NAFTA countries in 1980 and the 1990s. This finding is the opposite of the findings from our earlier trade share analysis (see table 3.4). The intensity is much lower for ASEAN 3 (slightly above 2 in most years). This finding could be attributed to China's above-normal external (that is, to the group) trade with Hong Kong, China (with which it has a TII of 5.4), and to Japan's trade with Taiwan, China (with which it has a TII of 3.4). The intensity for all East Asia is higher, which could be be- cause of the inclusion in that group of Hong Kong, China, which trades heavily with China. Both of these groups (ASEAN 3 and all East Asia) have indices greater than that of the European Union, but less than that of the NAFTA group. ASEAN's TII, however, declined significantly between 1980 and 1996, but in 1998 it returned to its 1990 level. Since 1998, the TIIs of the East Asian groups have remained fairly stable, and in 2001, all three groups recorded the highest TIIs since the mid-1990s. The trade intensity indices of the NAFTA countries and the European Union moved in the opposite direction. That of the NAFTA group rose between 1980 and 1996 but dropped off by 1998, with a further decline in 2000 and no change through 2001. The European Union's index fluctuated somewhat but generally rose between 1980 and 2000, when it reached its highest level of 1.88, dropping off slightly in 2001.28 Few clear regional trends emerge in the foregoing discussion, although the discussion does reinforce the argument that East Asia's trade continues to be open and global, with a strong intraregional component. Although the results based on the two different measures--trade share and trade intensity--are not always consistent, some general observations can be made. Despite some decline, the United States remains a major trading partner for most East Asian countries, including Japan. East Asia still con- ducts a significant (although declining, except for the share of exports from China) share of its trade with the European Union, although the TII reveals no bias.29 It does not appear from the analysis that East Asia's trade 28. Other studies, some covering different timeframes, generally confirm these findings. For ex- ample, see Frankel (1997, p. 29) and Goto and Kawai (2001, p. 7). Urata (2002) concurs based on his analysis of the "absolute," "relative," and "double-relative" (calculated differently than the intensity index used in this chapter but still comparable) measures. Schiff and Winters (2003, pp. 32­39) find a similar result for AFTA's trade intensity index in their analysis of 1 year before and 5 years after its implementation. 29. TII is less than 1.0. 84 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES is necessarily becoming more intraregional; in fact, there is some indica- tion of the opposite based on trade intensity since 1980. However, there has been a slight rise since 1999. Within the region itself, there are shifts; for example, ASEAN's trade with Japan is weakening, while its trade with China and Korea is rising. Japan is trading slightly less with extraregional partners and more intraregionally, particularly in its imports from China. China is exporting much more to the United States and the European Union but is importing more from within the region. Trade within the region will almost assuredly continue to change significantly over the next decade, and developing trends will be affected in no small way by further progress in China's economic reforms and lib- eralization, by developments in Japan's economy as well as in the global economy, and by the direction and extent of regional integration efforts within East Asia. The region has the power to steer these changes in a direction that will be advantageous to its growth and development, but it will take some concerted effort and a well-developed cooperative strategy, not to mention strong commitment on the part of national governments in the region. Patterns of FDI Flows FDI plays a critical role in the economic expansion of East Asian economies. The importance of FDI is evidenced by the share of FDI flows in the region's gross fixed capital formation. Over the past decade, this share has been between 7.3 and 14.8 percent for inward FDI and between 3.9 and 9.1 percent for outward FDI.30 These shares (for inward and out- ward flows) are comparable to those for the United States and are greater than those for Japan. Since the late 1990s, only the European Union has had larger shares, between 20 and 50 percent.31 The rise in FDI inflows to East Asia in the last decade has been re- markable.32 The value of inflows in the period 1991­96 (an annual average of US$55 billion) increased 2.6 times, to US$144 billion in 2000. Although since then inflows have declined by 35 percent to US$93 billion in 2002, this figure still represents a 69 percent increase since the begin- ning of the 1990s.33 30. Includes South, East, and Southeast Asia. 31. The source for data in this section on FDI is UNCTAD (2003b), unless otherwise indicated. 32. East Asia in this context includes the ASEAN 3 countries, Hong Kong (China), and Taiwan (China). 33. These figures refer to inflows in a given year (or average annual for 1991­96) and do not represent accumulated FDI stocks. TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 85 Among regional subgroups, ASEAN's inflows declined year on year for the same period (except in 1999), and in 2002 inflows were 31 percent lower than in the 1991­96 period. Inflows to ASEAN 3 were 63 percent higher in 2002 than in the 1991­96 period. The difference in results for these two groups reflects a combination of events, including a sharp increase in flows to China and postcrisis disinvestment in Indonesia, which continued through 2002. The growth in FDI, as in trade, was spurred by significant liberalization in the region during the 1980s and early 1990s, although this growth was reversed for a time by the East Asian financial crisis of 1997­98. Globally, there was a boom in FDI in 1999­2000, but this growth turned into a general downturn starting in 2001 and continuing through 2002. As mentioned, the East Asian region in general also experienced a decline in flows during the latter 2 years, but it still managed to increase its share of global FDI from about 10 percent in 1999­2000 to more than 14 percent in 2002.34 The region continues to hold the largest share of FDI inflows among developing regions. In 2002, China attracted the largest share of inflows in the region, as well as in the developing world, when the value of its inflows reached a high of US$53 billion.35 Since the early 1990s, when China reported inflows of US$25.5 billion (annual average for 1991­96), its flows have remained above US$40 billion. The country broke a new barrier of US$50 billion in 2002, and there is little reason to believe that the trend will not continue. China has the advantage of a huge domestic market, sustained rapid growth, improved export competitiveness, and its recent accession to the WTO. Also contributing to its flows is the large overseas network of Chinese workers (UNCTAD 2003b, p. 42). Sources of FDI A look at the sources of these FDI flows will allow us to assess the flow pat- terns for East Asia. Figure 3.2 shows the countries and regions that are the primary investors in ASEAN and how their investment levels have 34. There were some notable exceptions among individual countries (for example, Brunei Darussalam, China, Lao PDR, Malaysia, and the Philippines). 35. UNCTAD estimates that China's inflows would fall to about US$40 billion in 2002 if round- tripping were taken into account. Round-tripping is the investment that comes from locations abroad but is made by investors from China, and it is believed to cause FDI flows to China to be overreported. However, the World Bank estimates that China's round-tripping will decrease in the future as it eliminates preferential treatment for foreign investors over domestic investors (UNCTAD 2003b, pp. 43, 45). 86 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES Figure 3.2 Foreign Direct Investment in ASEAN by Source, 1995­2001 Percentage share of total investment 100 20 18 24 25 21 25 33 9 80 1 1 1 12 8 13 9 15 4 8 7 14 60 8 11 40 9 24 19 24 32 40 30 24 18 12 16 9 30 20 22 28 18 19 23 19 9 0 6 2 1 4 4 3 4 20 1995 1996 1997 1998 1999 2000 2001 Japan USA EU Asian newly ASEAN Australasia Others industrialized economies Note: Asian newly industrialized economies are Hong Kong (China), the Republic of Korea, and Taiwan (China). Australasia is Australia and New Zealand. Others include Bermuda, Canada, the Cayman Islands, India, and Pakistan, as well as various Central and South American countries and a few others. Source: Compiled from ASEAN (2002, tables 3.1.2­3.1.9). changed from the mid-1990s to 2001. During that time, except in 1997, the largest foreign direct investor in ASEAN was the European Union, which accounted for 19­40 percent of investment.36 This finding may be at least partly due to the efforts of the Asia-Europe Meeting (ASEM) under its Investment Promotion Action Plan (IPAP).37 The next largest investor is the United States, with a share of 20­30 percent in the past few years. Although the value of direct investment from the European Union and the United States was down significantly in 2001 from that in 1999 36. Not including the category of "Others," which comprises fairly large investments from un- specified countries and unclassified sources, the latter covering the banking sector. Although not specified, this source appears to relate to investment in the banking sector of Thailand in the postcrisis period. 37. ASEM is an informal process of dialogue and cooperation bringing together the 15 EU member states and the European Commission with 10 Asian countries (Brunei Darussalam, China, Indonesia, Japan, Korea, Malaysia, the Philippines, Singapore, Thailand, and Vietnam). IPAP's aim is to contribute to an enhancement of two-way investment flows between Asia and Europe by sharing experience and best practices on investment promotion and policy issues. TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 87 (by 41 percent and 37 percent, respectively), disinvestment (primarily in Indonesia and Malaysia) by Australia, Hong Kong (China), Korea, and other unspecified countries in 2001 pushed up the share for the European Union and the United States. Although all source countries and regions had a net withdrawal of in- vestment from Indonesia in 2000 and 2001, the largest withdrawal was from Japan (US$1.7 billion in 2000 and US$1.1 billion in 2001).38 Japan was also the individual source having the largest disinvestment in Malaysia in 2001 (US$1.2 billion).39 Thus, the share of ASEAN's FDI that comes from Japan dropped significantly over this time period--from 23 percent in 1997 to only 9 percent in 2001. Table 3.7 indicates the major sources of FDI for individual countries in East Asia, but it covers different time periods and types of flows and is drawn from different sources for each country, so comparisons across countries cannot be made. For most of the countries in this table, inward FDI comes from only a few sources--typically about 60­70 percent from only three source countries. The lack of diversification in FDI sources, as well as in destination sectors, which lean heavily toward electrical and electronic products, is a risk factor for East Asian economies. EastAsiancountriesthatappearamongthetopthreesourcesinthistable areJapanandHongKong,China,whichmaynotbesurprising,butthetable also shows that some of the newly industrializing economies (NIEs)-- specifically Singapore and Taiwan, China--are among the top three in- vestorsinsomecountries(seeUrata2001,pp.430­31).Fromoutsidethere- gion,themajorsourceofinvestment,unsurprisingly,istheUnitedStates.In figure3.2,theEuropeanUnionwasshowntobethetopinvestorinASEAN. The breakdown in table 3.7 shows that this investment comes primarily from only a few European countries--France (in Singapore), the Nether- lands (in Malaysia), and the United Kingdom (in Indonesia and Vietnam).40 38. There were also disinvestments in Indonesia in previous years, beginning in 1997 (during the crisis), when the United States was the only major investor to withdraw. Other source countries withdrew investment beginning in 1998, except the European Union, which began withdrawals in 1999. The United States invested again in 1999, but it disinvested in 2000. All major sources disinvested in 2001. 39. Disinvestment by the group of "other countries not specified" was US$3 billion. 40. The inclusion of the British Virgin Islands and Bermuda among the top three originating countries for China and Hong Kong, China, in table 3.7 is related to the practice of round- tripping and tax haven routing, whereby capital inflows and outflows in the form of FDI move through tax haven economies into and out of Hong Kong, China. The tax haven economies account for large levels of inflows and outflows of FDI related to Hong Kong, China. Although more than half of outward FDI from Hong Kong, China, goes to offshore financial centers (for example, the British Virgin Islands and the Cayman Islands), these funds actually are destined eventually to go elsewhere, including to China. 88 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES Table 3.7 Distribution of FDI in Selected Developing Countries Country and Top three sectors Top three originating data year (percent of total) countries (percent of total) China Manufacturing (46) Hong Kong, China (41) (1998­2000 Real estate management (16) United States (10) accumulated flows) Utilities (6) British Virgin Islands (9) Hong Kong, China Investment holding and British Virgin Islands (32) (2000 year-end stock) real estate (60) China (31) Wholesale and retail (11) Bermuda (10) Banking (9) Indonesia Chemical and Japan (16) (cumulative 1967 to pharmaceutical (30) United Kingdom (9) mid-2000) Paper (11) Singapore (8) Electronics and trading and other services (10) Malaysia Electrical and electronics (51) United States (28) (flows 2000­01) Paper, printing, and Japan (16) publishing (9) Netherlands (11) Nonmetallic mineral products (8) Philippines Manufacturing (46) United States (36) (flows 2000) Energy (32) Japan (27) Service export (13) Hong Kong, China (11) Singapore Electronic products and United States (40) (2000 inflows) components (48) Japan (16) Chemicals and chemical France (4) products (30) Transportation equipment (5) Taiwan Electrical and electronics (24) United States (24) (total approved flows Banking and insurance (15) Japan (21) 1952­2000) Services (11) Hong Kong (8) Thailand Trade (25) (total net inflows Machinery and Japan (27) 1995­99) transportation (11) United States (17) Electrical appliances (10) Singapore (13) Vietnam Oil and gas (59) United Kingdom (30) (flows 2000) Light industry (18) India (25) Heavy industry (9) Taiwan, China (15) Note: Concentrations are not comparable across countries as they are defined differently by national governments. Source: Compiled from OECD, (2002, p. 56) with additional information from UNCTAD (2001, pp. 24­25). TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 89 In table 3.7, Japan ranks first or second as a source of FDI for ASEAN-5 (Indonesia, Malaysia, the Philippines, Singapore, and Thailand) countries, but according to figure 3.2, Japan's share of investment in ASEAN has de- clined in recent years. Does this mean that Japan is investing less in ASEAN and more in other countries? Although Japan is not included as one of the top three investors in China in table 3.7, Japan's investment in China has been increasing since 1999. Before that, Japan invested far more in ASEAN-4 (Indonesia, Malaysia, the Philippines, and Thailand) than in China, but that investment began to decline sharply in 1997 (UNCTAD 2002c, box III.2., p. 44). By 2002, the share of Japan's outward FDI to China was 8.1 percent, whereas that to ASEAN-4 was lower, at 6.8 per- cent. The share of outward FDI to the Asian NIEs in that year was the highest of the three destinations, at 9.3 percent.41 Although FDI outflows from Japan to East Asia rose by 2.8 percent in 2002, this finding reflects primarily increased flows to the Asian NIEs (by 20.3 percent) and to China (by 20.8 percent). Outflows to ASEAN-4 declined by 25.3 percent in 2002. Still, Japan's outward stocks in China (US$12.5 billion) remained below those in ASEAN-4 (US$18.8 billion) and the Asian NIEs (US$24.9 bil- lion) (JETRO 2003, p. 16). Japanese transnationals began to increase their investment in China in the 1990s. A recent survey conducted by Japan Bank for International Cooperation (JBIC 2003) revealed that the number of Japanese companies having manufacturing bases in China rose from a little over 100 in fiscal year 1993 to about 1,105 in fiscal year 2003.42 Although the survey showed the number of companies with bases in ASEAN-4 to be even higher (1,157 in fiscal year 2003), it is almost certain that the number in China will surpass the number in ASEAN-4 in another year or so. China has been at the top of the list of promising destinations for manufacturing FDI by Japanese companies over the medium term, as reported in these annual surveys since fiscal year 1996, and in the fiscal year 2003 survey, the loca- tion in which the highest proportion of companies (73.9 percent) said they would "strengthen and expand the[ir] overseas business operations" was China (JBIC 2003, p. 4). The specific industries targeted by Japanese in- vestment in China have changed over time. In the mid-1980s, it was the food industry; in the early 1990s, it was the textiles industry; and since the 41. Asian NIEs in this case include Singapore in addition to Hong Kong (China), Korea, and Taiwan (China). 42. The survey was conducted in July­September 2003 and covered 932 manufacturing compa- nies that had three or more foreign affiliates, including at least one manufacturing base, as of November 2002. There were 571 valid responses, for an effective response rate of 61.3 percent. 90 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES Figure 3.3 Shares of East Asian Foreign Direct Investment Flows to ASEAN, Asian Newly Industrialized Economies, and China Percent 60 57 53 50 49 46 47 45 40 37 35 35 32 32 30 28 25 23 22 20 16 17 18 15 15 13 10 0 1991­96 1997 1998 1999 2000 2001 2002 ASEAN Asian newly industrialized economies China Note: Asian newly industrialized economies are Hong Kong (China), the Republic of Korea, and Taiwan (China). Source: Compiled from UNCTAD (2003b, annex B.1, pp. 249­52). end of the 1990s, it has been the chemical, electrical machinery, and trans- port machinery industries (JETRO 2003, p. 17). Figure 3.3, which shows the shares of East Asian FDI inflows to ASEAN, the Asian NIEs, and China, gives a fairly clear indication that China is taking shares of FDI from ASEAN. ASEAN countries were able to attract FDI easily in the 1980s because of their relatively high degree of openness in a market comprising fewer recipients than there are today. In the 1990s, competition for FDI increased markedly (ASEAN 2000, p. 6). Figure 3.3 shows that China has received a larger share of East Asian FDI than ASEAN has since the early 1990s, but that the difference between the two was smaller in the early part of that decade. The crisis of 1997­98 had a severe impact on flows to the ASEAN economies but not on flows to China. After China lost share to Hong Kong, China, in 1999 and 2000, its share has increased rapidly, reaching a remarkable 57 percent in 2002. China's potential to attract large amounts of FDI has caused consider- able concern among the ASEAN countries. Its accession to the WTO has made it more attractive to MNCs worldwide, and its lower costs have TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 91 become a major reason for MNCs in industrial countries to move produc- tion there.43 Malaysia is one country that has lost electronics-related in- flows to China.44 In 2001, Malaysia's inflows dropped to only US$554 mil- lion after 2 years of inflows of nearly US$4 billion. This decline has been attributed in part to a loss of flows to China, particularly in electronics production, which in the past has played an important role in Malaysia's economy.45 In 2002, however, Malaysia was able to make a comeback de- spite the global downturn in FDI. It received inflows of US$3.2 billion, al- though this increase came primarily from reinvested earnings while equi- ty continued to decline (UNCTAD 2003b, annex table A.II.1, p. 225). Although further divergence could occur, it is also possible that China will increase its own outward investment in ASEAN. This possibility is ex- plored later in the discussion of intraregional production networks. Intraregional FDI Compared with those of the European Union, Asia's intraregional flows make up a smaller share of total flows. Intra-EU investment increased from 51 percent in 1997 to more than 60 percent in 1999 (UNCTAD 2001, p. 18). In 2001 only 49 percent of the European Union's FDI out- flows stayed within the European Union, but that share rose to 66 percent in 2002 (UNCTAD 2003b, p. 70). By comparison, intra-ASEAN flows are small, at only 7 percent in 1999 and 2000 but rising to 15 percent in 2001 (table 3.8) and to 17 percent in 2002 (UNCTAD 2003b, p. 46).46 The broader group comprising ASEAN, China, and Hong Kong (China) as host economies and ASEAN, China, Hong Kong (China), Korea, and Taiwan (China) as source economies has a much larger intraregional share, which increased from 37 percent in 43. In the JBIC fiscal year 2003 survey, Japanese MNCs were questioned about the anticipated effects of China's WTO entry. Only 10.1 percent responded that China was "progressing" in the protection of intellectual property rights, and only 9 percent saw progress being made on the abolishment of local content and other business requirements. Also, tariff reduction was not seen as proceeding as expected. However, these views do not appear to have dampened their enthusiasm for investing in China (JBIC 2003, p. 18). 44. See Yusuf with others (2003, p. 294) for a list of leading electronics companies that have relocated from Malaysia to China. 45. Malaysia exported 200 billion ringgit (US$52.6 billion) in electronic goods in 2001, almost three-quarters of its total manufacturing exports (B. Low 2002). Another major cause of the decline in Malaysia's inflows was the repayment of intracompany loans, which has been occurring in most of the countries affected by the 1997­98 crisis since 1999. See UNCTAD (2003b, pp. 43­46) for details. 46. The shares of intra-ASEAN flows in table 3.8 differ somewhat from those in figure 3.2. Data in the former are from UNCTAD's FDI/TNC (transnational) database, and data in the latter are from the ASEAN Secretariat's FDI database. 92 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES Table 3.8 Intraregional Foreign Direct Investment Flows in Developing Asia, 1999­2001 (millions of US$) Source economy Subtotal of Total in reporting reporting host host Host Hong economy economy economy ASEAN China Kong Korea Taiwan (A) (B) 1999 ASEAN 1,685 78 886 510 347 3,506 25,029 Chinaa 3,275 -- 16,363 1,275 2,599 23,512 40,318 Hong Kong 759 4,981 -- 231 171 6,142 24,581 Total above 5,719 5,059 17,249 2,016 3,117 33,160 89,928 Percentage of A/B 37% 2000 ASEAN 1,259 58 1,045 153 580 3,095 18,625 Chinaa 2,838 -- 15,500 1,490 2,296 22,124 40,715 Hong Kong 7,703 14,211 -- 69 535 22,518 61,940 Total above 11,800 14,269 16,545 1,712 3,411 47,737 121,280 Percentage of A/B 39% 2001 ASEAN 2,334 151 365 304 113 1,929 15,211 Chinaa 2,970 -- 16,717 2,152 2,980 24,819 46,878 Hong Kong 1,930 4,934 -- 100 518 7,482 23,776 Total above 7,234 5,085 16,352 1,948 3,611 34,230 85,865 Percentage of A/B 40% -- Not available. a. For China, source economy of ASEAN includes only Indonesia, Malaysia, the Philippines, Singapore, and Thailand. Source: UNCTAD (2003b, table II.1, p. 46). 1999 to 40 percent in 2001. The Asian region has been at the forefront of a movement that began in the 1980s, when MNCs located in developing countries began to increase their outward investment, mostly in other developing countries. South, East, and Southeast Asian firms have accounted for the major portion of these outflows--between 51 and 81 percent of developing-country outflows since 1997 (UNCTAD 2003b, pp. 253­56). This position can be attributed to the export-oriented growth in these countries, which led to the growth of their MNCs; the MNCs then invested intraregionally as well as in industrial countries (UNCTAD 1999, p. 14). Intraregional flows in the NAFTA area are harder to discern. In the first 7 years of NAFTA (1994­2000), average FDI inflows to Canada were TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 93 US$21.4 billion and to Mexico were US$11.7 billion. These amounts were four times and three times, respectively, the average annual amounts the countries received in the 7 years before NAFTA (USTR 2002). It is unclear, however, whether this increase can be attributed to the effects of NAFTA. Mexico has indeed received substantial inflows from the United States since NAFTA, and the country has been integrated into its neigh- bor's production system, particularly in the automotive industry, which was already deeply integrated in Canada and the United States. However, Canada's share of outward FDI stock from the United States dropped from 17 percent in 1989 to 10 percent in 2000 (Rugman and Brain 2003, p. 3), and since NAFTA, MNCs have closed plants in Canada and have instead exported from the United States to Canada (UNCTAD 2003b, p. 58). Of the total U.S. direct investment outflows in 2001, 25 percent went to Canada and Mexico, with financial services in the latter being a major recipient because of the acquisition of Banamex by Citigroup (UNCTAD 2002c, pp. 40, 82). Although FDI inflows to East Asia have risen markedly over the past decade, there has been a noticeable shift in flows away from the ASEAN countries to China. The decline in investment in ASEAN is partly due to the effect of the Asian crisis, from which some countries have yet to re- cover. Recently, however, it has been caused more by the increase in China's attractiveness as a host country--an attractiveness generated largely by its lower wage costs and its highly skilled labor, as well as its increasingly liberalized trade and FDI environment. The region is still highly dependent on investment from the United States and a few European countries, because these countries are home to the largest num- ber of internationally integrated MNCs. Focusing on the intraregional-extraregional investment scenario should not deflect attention from the internal investment dynamics of the region, particularly where China is concerned. Not only Japan, but also other major regional investors, including Hong Kong (China), Korea, and Taiwan (China), are focusing on China. Table 3.8 shows that between 1999 and 2001 Taiwan, China, reduced its investment in ASEAN by 67 percent while increasing its investment in China by 15 percent. Korea disinvested in ASEAN in 2001 and raised its investment in China by a remarkable 69 percent. And China raised its investment in ASEAN by 94 percent. Trade and FDI in East Asia: Some Conclusions Given the strong link between trade and FDI, it might be expected that changes in their patterns would follow a similar trajectory over time. It is 94 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES true that the factors affecting one often also affect the other (for example, the 1997­98 financial crisis, the prolonged stagnation of Japan's economy, the opening up of China, the downturn in the global--particularly the U.S.--economy beginning in 2000, and changes in the international pro- duction system). Although the trade and FDI patterns are broadly consis- tent, precise similarities are not always evident; however, some general observations can be made concerning both trade and FDI patterns in the region: · East Asia still does a great deal of trade with, and receives a large amount of direct investment from, the United States and the European Union, albeit from some EU countries more than others. · Although the United States and certain European countries are still Japan's primary trade and investment partners, there are signs of a shift in both Japan's trade and its FDI from outside to inside the region, and there are shifts within the region as well, such that Japan's shares of trade with and investment in China are beginning to surpass those with ASEAN. · Although most countries have recovered well from the crisis in terms of trade and FDI, some have not--particularly Indonesia, which is still experiencing disinvestment. · ASEAN's trade with Japan is declining, while its trade with China and Korea is rising, and ASEAN is receiving less investment from Japan as well. · The rise of China is having a major effect on the region's trade and FDI patterns as MNCs both inside and outside the region shift operations to that country, often from other countries within the region. From these observations, we can discern the continuation of the highly liberalized nature of East Asia's trade and direct investment and the im- portance of maintaining its extraregional relationships. At the same time, intraregional relationships are strengthening as individual countries strug- gle to find a way to prosper and grow in the shadow of a rising China. In the next section, we will consider a role for regionalism in this dynamic environment. A ROLE FOR REGIONALISM IN PROMOTING TRADE AND FOREIGN DIRECT INVESTMENT We have made three observations so far: (a) East Asia's trade and FDI pat- terns are global and intraregional, (b) the current trend in East Asia is to seek regional solutions for shared issues, and (c) it is welfare enhancing to TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 95 coordinate trade and FDI policies. Consequently, it is worthwhile to ex- plore possible regional approaches to the promotion of trade and FDI in East Asia. Presented in this section are two such approaches: regional agreements and regional production networks. Regional Agreements There are many types of cooperative arrangements designed to promote trade and FDI. These arrangements can be narrow agreements, including only two countries and covering either trade or FDI, or they can be very broad agreements, including more than two countries and covering a wide range of activities. There are also many instances in which investment issues are being included in free trade agreements and regional integration frameworks. The European Union and NAFTA are the primary examples of the latter. Today's FTAs differ from earlier bilateral and regional agree- ments in that they often include investment provisions. In fact, compre- hensive regional agreements that contain both trade and investment provisions are occurring rapidly enough to warrant being called a trend (UNCTAD 2003b, pp. 48, 91).47 Both trade and investment agreements have the common goal of liber- alizing trade and investment activities and providing nondiscriminatory treatment of participants in the agreement. Investment agreements vary in their provisions as related to performance requirements, breadth of investment promotional measures, inclusion of protection standards, and range of investment issues covered, such as competition, technology trans- fer, employment, environmental protection, incentives, illicit payments, and conflicting requirements (UNCTAD 2002a, p. 9). Trade agreements focus chiefly on the elimination of tariffs on goods. However, it has been suggested that more recent regional trade agreements may be notable more for their promotion of FDI than for their promotion of trade and, in some cases, promotion of FDI could be the motivation for their formula- tion (Ethier 1998; Scollay and Gilbert 2001, p. 19). Table 3.9 lists the primary regional instruments dealing with FDI (adopted between 1980 and 2003) and involving East Asian countries. The number of agreements for East Asia is only 16 out of 160 worldwide that have been formed, but not necessarily adopted, between 1948 and 2003.48 47. For a thorough discussion of the inclusion of investment provisions in integration agree- ments, see UNCTAD (2003b) and Schiff and Winters (2003, pp. 101­122). 48. See UNCTAD (2003b, annex table A.I.13) for a complete list of these instruments. 96 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES Table 3.9 Main Instruments Involving East Asian Countries and Dealing with Foreign Direct Investment, 1948­2003 Year Title Setting Level 1980 Cooperation Agreement between the European ASEAN­ Interregional Community and Indonesia, Malaysia, European the Philippines, Singapore, and Thailand Community 1987 Revised Basic Agreement on ASEAN Industrial ASEAN Regional Joint Ventures 1987 An Agreement among the Governments of Brunei ASEAN Regional Darussalam, the Republic of Indonesia, Malaysia, the Republic of the Philippines, the Republic of Singapore, and the Kingdom of Thailand for the Promotion and Protection of Investments 1994 APEC Non-Binding Investment Principles APEC Regional 1995 ASEAN Framework Agreement on Services ASEAN Regional 1995 Osaka Action Agenda on Implementation of the APEC Regional Bogor Declaration 1996 Protocol to Amend the 1987 Agreement among ASEAN Regional ASEAN Member Countries for the Promotion and Protection of Investments 1998 Framework Agreement on the ASEAN ASEAN Regional Investment Area 1999 Agreement between the Government of the United Japan­US Bilateral States of America and the Government of Japan Concerning Cooperation on Anticompetitive Activities 1999 Short-Term Measures to Enhance ASEAN ASEAN Regional Investment Climate 2000 Agreement between New Zealand and Singapore New Zealand­ Bilateral on Closer Economic Partnership Singapore 2001 Protocol to Amend the Framework Agreement on the ASEAN Regional ASEAN Investment Area 2002 Agreement between Japan and the Republic of Japan- Bilateral Singapore for a New-Age Economic Partnership Singapore 2002 ASEAN-China Framework Agreement on ASEAN- Bilateral Comprehensive Economic Cooperation China 2003 Free Trade Agreement between the Government Chile- Bilateral of the Republic of Chile and the Government Korea of the Republic of Korea 2003 Singapore­Australia Free Trade Agreement Singapore- Bilateral Australia Instruments currently under consultation or negotiation (all bilateral except as noted) ASEAN-India Japan-Malaysia ASEAN-Japan Japan-Mexico Canada-Singapore Japan-Thailand Chile-Japan Japan-Philippines China-Japan Jordan-Singapore India-Singapore Mexico-Singapore Japan-Republic of Korea Singapore-ASEAN-China (plurilateral) Note: All agreements are adopted and binding, except those of APEC, which are nonbinding. Source: UNCTAD (2003b, annex table A.I.13) and other sources. TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 97 The relatively small number for East Asia indicates that the region is a newcomer to such arrangements. Particularly noteworthy are the agreements between New Zealand and Singapore and between Japan and Singapore because of their recognition of the complementarity of trade and FDI. For example, the Japan- Singapore New-Age Economic Partnership Agreement (JSEPA) includes trade-related elements, such as the elimination of tariffs on goods and of nontariff measures inconsistent with WTO measures. It also addresses trade-relatedissuesincludingrulesoforigin,customsprocedures,paperless trading, and mutual recognition of tests and certifications. However, im- portantlyforpromotinginvestment,italsocoverstheliberalizationoftrade in services, the facilitation of investments through promotion and protec- tion, and the movement of people between the two countries.49 In addition, JSEPA covers issues related to intellectual property, government procure- ment, and competition, and it enhances economic cooperation in financial services, information and communications technology (ICT), science and technology, human resource development, and other areas. Finally, it includes provisions for the settlement of disputes (Rajan and Sen 2002). The major drawback to JSEPA is its exclusion of agriculture. Agricul- ture is excluded partly because Singapore has virtually no agriculture, but also because agriculture is a particularly sensitive area for Japan. The agreement may thus be limited in its versatility as a prototype for other Asian countries where agriculture is of considerable importance. Aside from this exclusion, JSEPA is laudable in its broad coverage of elements important to the promotion of both trade and FDI. Listed at the bottom of table 3.9 are 14 instruments currently under consultation or in negotiation. Eight of these instruments include Japan as one of the bilateral partners, but ASEAN is also moving ahead rapidly in the formation of comprehensive FTAs with Asian partners. Among its efforts is the prominent ASEAN-China Free Trade Agreement (ACFTA), for which a framework agreement (listed as the ASEAN-China Frame- work Agreement on Comprehensive Economic Cooperation in table 3.9) was signed in Phnom Penh, Cambodia, in November 2002, designating 2010 as the completion date for the FTA, with an extension to 2015 for the newer ASEAN members. The goal of ACFTA is to promote compre- hensive economic cooperation through the elimination of tariff and nontariff barriers on goods, the liberalization of services trade, and the establishment of an open, competitive investment regime. Cooperation 49. Services--for example, transportation and communications--are increasingly important to- day because they link the various segments of production networks worldwide. See Jones and Kierzkowski (2001) for a discussion of this topic. 98 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES would be strengthened in the areas of agriculture, ICT, human resource development, investment, and the Mekong River basin development. Co- operation would be extended to include the areas of banking and finance, transportation, telecommunications, industrial cooperation, forestry and fisheries, and energy, among others. Provision for the establishment of a dispute-settlement mechanism is included. Although some ASEAN members remain wary of China's motives and doubtful of benefits accruing to ASEAN from ACFTA, most in the region see this approach as preferable to adopting a defensive, protectionist stance against the challenge of China. And although China may wish to assume leadership of the region eventually, it can benefit from coopera- tion with its neighbors, because it needs both a large market for its vast array of goods and resources for its industrial production. ACFTA is indicative of the region's recognition of the importance of cooperation and openness in a broad-based approach to the promotion of trade and investment in the region. In November 2002, Japan and ASEAN signed a joint declaration to draw up a framework for an FTA to be established within 10 years. The ultimate package is envisioned as broad in coverage, including measures to promote and facilitate trade and investment in financial services, ICT, human resource development, transportation, and other areas. At this time, however, Japan appears to be more actively pursuing bilateral agree- ments with individual ASEAN countries, including most recently Malaysia, the Philippines, and Thailand.50 APEC has contributed to the reduction of tariffs in the region through its Bogor Declaration and promotes free and open investment by encour- aging its members to eliminate restrictions through the framework of the WTO Agreement and the APEC Non-Binding Investment Principles. Taking NAFTA as a model, APEC has agreed on a very extensive set of investment principles, but because they are nonbinding and offer no con- crete protections, they are viewed as having little effect in promoting intra-APEC investment flows (Schiff and Winters 2003, p. 106). The ASEAN Free Trade Area has succeeded as a regional tariff reduction program and has taken steps to remove nontariff barriers through harmo- nization of product standards, simplification of customs clearance proce- dures, and harmonization of sanitary standards.51 Although known for its 50. Formal agreement to enter government-level negotiations on these bilateral FTAs was reached in December 2003. Other countries with which talks are in progress are Chile, China, Korea, and Mexico. 51. See the ASEAN Secretariat Web site, http://www.aseansec.org/4920.htm. TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 99 trade measures, AFTA also includes the promotion of FDI among its objectives. The ASEAN Investment Area (AIA) commits its members to grant national treatment to ASEAN investors; to open up their industries; and to promote, protect, and reduce impediments to investment in the region.52 There are a number of ways in which trade and investment agreements can be mutually promoting. The reduction in import tariffs has implica- tions for the location of FDI in that it lowers input costs for foreign affili- ates, making the host country more attractive for investment. Trade agreements also lead to wider market access. Those agreements that cover a broader range of issues--for example, incentives--can also lower pro- duction costs and risks, which would induce more, probably export- oriented, FDI.53 The literature on regional trade agreements and their economic effects is extensive, although it does not encompass the implications of invest- ment and services trade because of a lack of data and the limitations of current modeling methodology (Drysdale 2001; Frankel 1997; L. Low 2001; Mistry 2000; Panagariya 1999; Scollay and Gilbert 2001).54 The general consensus of this literature is that multilateral arrangements (or even better, free trade), are preferable to smaller regional or subregional arrangements. The most extensive recent study on this topic (Scollay and Gilbert 2001 and chapter 4 in this book) concludes that regional trade agreements (both bilateral and plurilaterel) create a "spaghetti bowl" effect and thus reduce the efficiency of regional trade. To avoid the negative effects of this phenomenon, the authors recommend arrangements of larger groupings, on the order of APEC. Schiff and Winters (2003) examine the effect of regional integration agreements on intrabloc and extrabloc trade for nine blocs, including ASEAN, the European Union, and the NAFTA group, between 1980 and 1996.55 They conclude that regional integration agreements had a smaller 52. The achievements of AIA have included global missions to promote the region, establish- ment of a database of part and component manufacturers, provision of access to investment and business information on the region, convening of regular forums with business organizations, capacity building through training workshops, and establishment of a working group to develop an FDI dataset (ASEAN 2000, 2001). 53. The degree to which incentives affect investment decisions is uncertain; however, they have been important in the investment strategies of some developing countries, particularly in attracting export-oriented FDI (see UNCTAD 2002c, pp. 204­8). 54. Scollay and Gilbert (2001, pp. 19­20) and Schiff and Winters (2003, p. 102) more recently confirm that a lack of data has limited the number of empirical studies covering the effect of regional integration agreements on investment. 55. Their analysis is based on an earlier study by Soloaga and Winters (2001). 100 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES effect on developing countries' trade flows than did the external liberaliza- tion that those countries had undertaken at the time (Schiff and Winters 2003, pp. 40­46). Most studies that cover the mutually promoting benefits of the com- bined trade-FDI agreements focus on regional integration agreements between industrial countries, such as the members of NAFTA and the European Union. Few focus on agreements between developing coun- tries, such as the members of the Southern Cone Common Market or Mercado Común del Sur (MERCOSUR), AFTA, and AIA. However, a study by Blomström and Kokko (1997) examined industrial and developing-country agreements and found that, theoretically, the capabil- ity of a regional integration agreement to attract FDI both internally and externally depends on a number of characteristics, including whether the agreement is between industrial countries, developing countries, or a combination; whether the countries are competitive or complementary; and the degree to which the group is integrated at the outset.56 Further- more, there may be a different effect on participating investors than on outside investors depending on how discriminatory the agreement is to outside investors. The authors' analysis of the South-South arrangement of MERCOSUR, which is similar to ASEAN, suggests that the agreement does increase investment inflows but that they are not likely to be distrib- uted equally among the various members. Also, macroeconomic stability may have been a more important determinant than regional integration. However, in the case of NAFTA (a North-South arrangement like ASEAN 3), although Blomström and Kokko focus primarily on NAFTA's beneficial effect on inflows to Mexico, they found also a positive effect on inflows to the United States and Canada. Although the increase in FDI inflows to Mexico began with the pre-NAFTA liberalization of Mexico's FDI regulations (from the mid-1980s), the process was enhanced by the implementation of NAFTA. Furthermore, Mexico enjoys a locational advantage in its geographical proximity to its northern neighbors with which trade barriers have been reduced by NAFTA. This advantage, in combination with Mexico's increased market orientation and cheap labor, has attracted investors, particularly from outside the region, not only to the Mexican market but also to the U.S. and Canadian markets. Blomström 56. In addition to providing a theoretical discussion of the effects of regional integration agree- ments on FDI decisions, the study examines three specific cases of North-North integration be- tween developed countries (Canada-U.S. Free Trade Agreement), North-South integration between countries at different levels of development (Mexico within NAFTA), and South-South integration between developing countries (MERCOSUR) integration. TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 101 and Kokko point out that "the potential for improved policy credibility and gains from guaranteed access to large northern markets" experienced by Mexico through its membership in NAFTA are general characteristics of North-South agreements (Blomström and Kokko 1997, p. 41). An example of a South-South bilateral trade agreement (with no in- vestment provision) that has benefited the partners both in trade and in investment is the India­Sri Lanka Free Trade Agreement, which the two countries signed in December 1998. This FTA gave duty-free access to India and Sri Lanka for 4,000 products on a preferential basis. It not only substantially increased the exports of each partner to the other but also stimulated new FDI in a number of product areas, for a total of 37 projects with US$145 million in total investment (UNCTAD 2003b, p. 49). The automotive industry offers another example of how preferential tariffs under regional trade agreements among developing countries, such as AFTA, have led to an expansion of intra-industry trade and increases in FDI in the member countries (UNCTAD 2002b, p. 65). This result is explained in the next section, in the discussion of regional production networks. Although not based on an empirical study, UNCTAD's assessment of the possible effects on FDI of selected regional agreements (including AFTA, the AIA agreement, and ACFTA) indicates that these agreements could lead to an increase in all three types of FDI (that is, market-seeking, efficiency-seeking, and resource-seeking investments). In addition, ACFTA could facilitate regional production networks and the division of labor (UNCTAD 2003b, pp. 227­28). The increase in the number of agreements combining provisions for both trade and FDI indicates broad recognition of the importance of link- ing trade and FDI in formulating agreements from which economic ben- efits are expected.57 It also indicates that policymakers in many countries (both industrial and developing) recognize that MNCs are moving away from the traditional linear internationalization sequence, which begins with exporting before progressing to FDI, to a more integrated approach to establishing an international production network.58 Furthermore, policies that liberalize trade and investment often precede or accompany 57. The coordination of policymaking for trade and FDI is not new. In fact, it has probably occurred more among developing countries than among industrial ones (see UNCTAD 1996, pp. 116­18). 58. An example is Honda's network of operations in motorcycles. Rather than starting its entry into Europe with exports, which was its conventional method, Honda used FDI very early on and integrated its EU operations by taking advantage of the increasingly liberalized framework there (UNCTAD 1996, p. 101). 102 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES regional integration arrangements. These policies can lead to increased FDI flows (Balasubramanyam 2002, p. 191). Although there is no template for regional agreements that guarantee an increase in trade and FDI, it is evident that the selection of partners to the agreement, as well as the structure of the agreement itself, is important in determining whether an agreement will be successful in achieving this outcome. Although larger groupings might be more welfare enhancing, a bilateral approach can be an initial step to a broader multilateral arrange- ment. In any event, including both industrial and developing countries in the agreement seems advisable, although not absolutely necessary to gen- erate benefits for members. Above all, the more comprehensive the agree- ment, the better the chance it will lead to the coordination of trade and FDI policies. Finally, forming preferential agreements should be seen as a temporary measure leading eventually to a more multilateral approach. Regional Production Networks Establishing regional production networks is another way in which re- gionalism can play a role in promoting trade and FDI through their links. Regional production networks are broader in concept than regional trade and investment agreements and could be viewed as an extension of those agreements. One of the economic determinants of efficiency-seeking FDI in a host country is "membership of a regional integration agreement con- ducive to the establishment of regional corporate networks" (UNCTAD 2003b, p. 85).59 Accepting that the formation of regional agreements is a temporary approach to the promotion of trade and FDI, regional produc- tion networks could be the next, or even concurrent, phase for East Asia in its evolution toward the ultimate goal of becoming a fully functioning member of international production networks. This observation is not meant to imply that a regional network should operate outside the inter- national network. Rather, it should operate within and as a part of the in- ternational network. Given the multilateral aspect of East Asia's trade and FDI and the changes taking place in international production networking, this operational structure would be essential for the region's continued growth and development.60 The European Union and the NAFTA countries play a major role in international production, and they are major providers and recipients of 59. Other determinants of this type of FDI are the cost of resources, assets, and other inputs, such as transportation and communications. 60. See Yusuf with others (2003, pp. 271­324) for a thorough discussion of changes occurring in international production networks and their potential effect on East Asian firms. TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 103 global FDI. These regions comprise mostly industrial countries, and most large MNCs, which dominate international production networks, are found in industrial countries. In East Asia, there is only one industrial country, plus four NIEs and 10 developing economies. This fact raises the question of the region's firm-level capabilities in the development of pro- duction networks. We will later examine some trade and FDI indicators that will help answer this question. The concept of production networking is not new to East Asia. For decades, Japan played a leading role in the establishment of networks through its "flying geese" model.61 Japan's lead was followed by the Asian NIEs--Hong Kong (China), Korea, Singapore, and Taiwan (China). Then the ASEAN-4 (Indonesia, Malaysia, the Philippines, and Thailand); China; and, most recently, Vietnam followed suit. All are at different stages of industrial development, and the "flying geese" model is viewed by many to be no longer the predominant growth model for Asia.62 However, the model helped establish the beginnings of a regional production network through the cross-border activities of MNCs, including trade, FDI, li- censing, and subcontracting, and it had the effect of increasing integration in the region.63 Japan has the largest share of global outward FDI in East Asia (about 5 percent for both outflows and outward stock in 2001 and 2002). Among developing countries worldwide, South, East, and Southeast Asian firms have accounted for the major portion of FDI outflows (78­81 percent in 2000­02), and these firms invest both in developing countries within the region and in industrial countries around the world. Of this group, the largest share of outward investment is from the NIEs, with Hong Kong, China, having US$18 billion or 52 percent in 2002, followed by Taiwan, China, with US$5 billion or 14 percent and Singapore with US$4 billion or 12 percent. ASEAN-4, however, has only a small share, with Malaysia having the largest portion at US$1.2 billion or 4 percent in 2002. China's share was a remarkable 19 percent in 2001, but it dropped to 8 percent in 2002. Nevertheless, China's 8 percent share still represents a significant increase from its 1 percent share in 2000. Although these small amounts of FDI outflows would not have much effect if they were poured into an economy the size of the United States, the same amount invested in a 61. This model was originally conceptualized by Kaname Akamatsu in the 1930s. 62. Yusuf with others (2003, pp. 284­86) points out that although Japanese firms channeled substantial investment flows, technology, and training resources to East Asia, they had a tendency to rely on their own subsidiaries and Japanese suppliers to such an extent that this tendency lim- ited opportunities for local firms to upgrade their competencies. 63. See Ozawa (1999) for a detailed discussion of the "flying geese" paradigm. 104 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES country the size of Malaysia or Indonesia could have a significant effect on the local economy. Given that MNCs are the drivers of international production networks, a look at the number of East Asian MNCs and their share in total foreign assets will give an indication of the region's position in that respect. Also, UNCTAD has developed an index called the transnationality index (TNI), which represents the extent to which host countries and individual firms (with separately calculated indices for each) are involved in international production.64 Table 3.10 shows these indicators for the largest 50 nonfi- nancial MNCs from developing countries. It also provides the number of parent corporations based in each economy and the number of foreign af- filiates located in each country. South, East, and Southeast Asia had the greatest number of companies on the top 50 list and the largest share of total foreign assets for at least 1999, 2000, and 2001; the 2001 list shows 33 entries and a 76.4 percent share in total foreign assets. Since 1998, Hong Kong, China, has main- tained the same number of firms (11), but the number for Singapore has declined (from 9 to 6). Korea also appears to have lost some firms between 1999 and 2000 (from 9 to 5).65 Furthermore, of the 11 newcomers to the top 50 list in 2000, 7 were from East Asia. Three of these were from China, but in 2001 only China National Chemicals remained on the list. Nevertheless, the foreign expansion of Chinese firms has progressed rapidly. China's top 12 MNCs in 2001, which are mostly state-owned enterprises, controlled more than US$30 billion in foreign assets, had more than 20,000 foreign employees, and reported foreign sales of US$33 billion. Enterprises that are not state owned, although they are mostly small and medium-size MNCs, are fol- lowing the same path and have investments in more than 40 countries around the world, including in Asia (UNCTAD 2002c, pp. 61­62). These data indicate the prominence of East Asia's MNCs among those of developing countries. However, it is possible to see the potential for East Asian firms to become global players by looking at the list of the top 64. UNCTAD's TNI for a host country is based on two FDI variables (FDI inflows as a per- centage of gross fixed capital formation and FDI inward stock as a percentage of GDP) and two variables related to foreign firms' operations in a host country (value added by foreign affiliates as a percentage of GDP and employment by foreign affiliates as a percentage of total employ- ment). The index for individual firms is calculated as the average of three ratios: foreign assets to total assets, foreign sales to total sales, and foreign employment to total employment. See UNCTAD (2002c) for further details. 65. According to UNCTAD (2002c, p. 102), four Korean companies were dropped from the list in 2000 because of a lack of data. Those companies remained off the list for 2001. in b 6 16 eign -- 598 669 2,241 a 9,132 2,841 2,721 1,544 2,352 1,106 3,359 filiates 12,909 15,567 14,802 14,052 15,712 65,460 eign For af 445,272 363,885 866,119 located economy (number) for and countries b in ent ---- ---- 9,934 -- -- 350 948 ---- 313 7,460 -- -- -- -- -- 606 -- -- 682 217 3,235 3,760 selected Par 63,834 34,291 based in economy (number) corporations corporations Economies ent filiates Par af Latest year ariousV 2002 1997 2002 2001 1995 2002 1997 1999 2002 1995 2002 2001 1998 1996 ariousV comparison: 2001 1998 2000 ariousV 2002 available For Developing om ---- 01 4 63 -- 11 1 9 5 1 7 2 50 -- -- -- fr 1999 . entries of 1 21 4 33 11 5 5 1 6 2 50 23 49 16 2000 economy Corporations Number 21 5 33 ------ ------ 13 11 ---- ------ 5 ------ 4 ------ 1 6 5 that ------ ------ 50 ------ ------ 2001 by ---- 5.9 0.7 7.0 1.1 2.4 1999 22.0 72.0 -- -- -- 26.4 -- 23.2 -- -- 11.2 -- -- -- -- ---- ---- ---- defined eign 100.0 as 23).­ Multinational for top 222 of (%) 0.5 total 1.82 4.4 -- -- 3.9 -- 73.3 38.9 13.4 -- 7.2 1.1 7.4 1.4 -- -- -- -- 27.2 53.0 10.7 shown, and 50 2000 100.0 in 88­ e assets 187 Nonfinancial Shar 5.1 18.5 6.47 -- -- 1.5 7.03 ---- -- 2.31 -- 5.8 ---- 0.8 5.41 3.6 -- -- -- -- 7.3 economy 29.1 54.9 2001 100.0 50 the pp. in opT m- ---- -- -- -- 9.6 -- -- -- -- -- -- -- -- -- 2003b, the fir 1999 48.3 46.0 39.1 45.4 -- 27.8 24.1 25.0 58.9 43.9 34.5 TNI filiates af of country 109;­ eported.r verage level eign 108 per A 2000 19.3 28.2 41.4 32.4 -- -- 28.5 42.0 -- -- 23.9 -- 38.1 -- 28.1 3.24 23.1 -- -- 31.3 -- -- 43.0 67.1 35.9 not or pp. Regions and companies/for available ounding.r (2002c, to AD Asia ent not otalT par e due ar UNCT Countries comparison: of sum orld for data omfr Southeast not /W c Home List number and e means may otal 100 Union Kong Compiled 3.10 East, States available. esents cent) Asia America ea PDR opT entry ableT est Brunei Cambodia China Hong India Indonesia Kor Lao Malaysia Myanmar Philippines Singapor iwanaT Zealand Thailand ietnamV ces: opean verage/T om Not Repr No Numbers (per Region/country W Latin Africa South, A Fr Australia New United Eur Japan -- a. b. c. Sour 105 106 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES 100 MNCs worldwide, which includes firms from both industrial and developing countries. In 2000, among a record five firms from developing countries, three East Asian firms made it to this list: Hong Kong's Hutchison Whampoa, Korea's LG Electronics, and Malaysia's Petronas. The latter two appeared for the first time. In 2001, the first two remained on the list, but Petronas was replaced by Singapore's Singtel. The ranking of the top 100 firms is generally related to the degree of their participation in cross-border mergers and acquisitions, because that is the primary mode of entry for firms investing in industrial countries.66 The mode of entry for developing countries is primarily greenfield invest- ment--two-thirds of FDI flows to developing countries are greenfield investments--and the share of developing countries in the value of merg- ers and acquisitions was only 10 percent in early 2000. This situation is gradually changing. In Asia, for example, the share of FDI (inflows) in the form of mergers and acquisitions increased from 8 percent in 1987­89 to 20 percent in 1998­2000 (OECD 2002, p. 50). Furthermore, outward FDI from developing Asia has shifted over the past two years from greenfield investments to mergers and acquisitions (UNCTAD 2002c, pp. 60­61). Table 3.10 shows a total of 9,934 parent corporations based in South, East, and Southeast Asian countries. (The years vary by country as shown in the table.) These corporations represent 15.6 percent of the total num- ber of parent corporations in the world.67 Korea alone claims the major portion of these corporations: three-quarters or 7,460, which is more than the number for Japan and the United States combined. Few other coun- tries reported having such enterprises; in addition to the NIEs, only Indonesia did so. It should be noted, however, that data for Singapore and Malaysia were not available for inclusion in this table. Although incom- plete, these figures do give some indication of the presence of East Asian parent companies in the world. More remarkable, however, is the number of foreign affiliates in the region: 445,272, which is more than 50 percent of the world total. Even more remarkable is the fact that 82 percent of those affiliates are located in China. This finding further indicates China's 66. "The largest 20 companies most actively involved in cross-border mergers and acquisitions accounted for one-fifth of the total value of cross-border merger and acquisition deals during the past 15 years: 1987­2001" (UNCTAD 2002c, p. 89). 67. UNCTAD defines a parent corporation as "an enterprise that controls assets of other entities in countries other than its home country, usually by owning a certain equity capital stake," which it states is usually 10 percent. However, it should be noted that each country in table 3.10 reports the numberofitsparentcorporationsandforeignaffiliatesbasedonitsowndefinitionofthoseentities. TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 107 growing dominance in regional FDI and the international production network. The TNI for host economies in 2000 (at the economy level rather than at the firm level--not included in table 3.10) points to Hong Kong, China, as the most transnational economy in the world, with Singapore sixth and Malaysia tenth. This ranking is based on "the production potential created through inward FDI and the results of this investment" (UNCTAD 2002c, pp. 20­21; 2003b, p. 6). As for firm-level TNI (table 3.10), developing Asia's average of 32.4 (in 2000) is higher than Latin America's TNI of 28.2 and compares favorably with Japan's TNI of 35.9. Even more remarkable are Singapore's TNI of 43.2 and Hong Kong's TNI of 42, which are equal to that of the United States. Even for Malaysian firms, the average TNI is high at 38.1. In fact, Hong Kong (China) and Singapore have traditionally had the most "transnationalized" companies among developing economies (UNCTAD 2002c, p. 102). As would be expected, though, the transnationality of firms in develop- ing Asia is below that of firms in industrial countries. The average TNI for the top 100 firms in the world (all but 5 from industrial countries) is 55.7, as compared with 32.4 for firms in developing Asia. Firms in developing economies are smaller and do not have the extensive geographical reach of MNCs in industrial countries, so it is difficult for them to explore markets in industrial countries (UNCTAD 2002c, pp. 109­10). However, it is eas- ier for them to explore markets in their own region, markets to which they are closer geographically and with which they have more familiarity. Structural shifts in production caused by a number of factors, including changes in technologies, demand patterns, and production organization, are reflected in changing trade patterns (UNCTAD 2002c, p. 143). Table 3.11 shows the trade structure for developing countries and gives an indication of how the East and Southeast Asia region has progressed in export competitiveness over the past 15 years (to 2000).In fact, the region has made the greatest progress among developing regions in the evolution from exporting primary commodities to exporting manufactured goods and services. A country or region that experiences an increase in market shares over time reveals its dynamic competitiveness and its ability "to keep up with changing technologies and trade patterns" (UNCTAD 2002c, p. 149). UNCTAD's list of economies that have raised their world market shares by at least 0.1 percent (so-called export winners) between 1985 and 2000 reveals that China is at the top of the list of developing countries in all 2000 4.3 1.3 0.2 0.4 0.3 0.1 1.9 1.0 Africa elativer Sub-Saharan 1985 5.4 1.7 0.4 0.5 0.3 0.3 4.1 1.9 the & 3.9 1.1 2.7 0.8 0.3 0.9 .04 East 2000 20.9 overstates Africa also Middle North 4.9 0.8 1.6 0.5 0.3 0.9 6.3 This 1985 21.4 a). which (Chin ntries. Of 6.5 4.6 5.3 5.0 3.6 4.8 6.0 2000 13.2 cou America iwanaT of Caribbean and Latin & 7.0 2.6 3.2 2.5 2.1 4.2 5.8 1985 12.5 ea, number a Kor in 2000 9.5 8.6 b 2000 11.7 22.6 33.4 11.7 29.1 18.7 South lacking and Southeast e Asia & and ar 8.4 4.7 5.3 1985 1985 10.4 10.8 22.9 10.9 10.1 East 2000).­ data North a (1999 Region, 2000 56.0 26.6 30.8 46.6 18.8 35.4 40.4 33.6 because 2000 Mongolia, by for 1985 Developing countries for 1985 61.2 29.8 17.5 32.4 10.4 16.6 28.6 30.3 (China), . average Categories Macau a 2000 3.6 5.2 2.4 3.6 2.6 1.3 1.2 2.9 2-year category understated a is oduct CEE c (China), Pr and 0.8 1.4 0.6 1.2 0.5 0.2 0.2 0.8 export 1985 Kong exports Major 1986)­ each in for in a Hong ope) 2000 40.4 68.2 66.8 49.7 78.6 63.4 58.4 63.5 (1984 cent Eur radeT n 148). 1985 per China, time. p. Developed countries for orld 1985 38.0 68.7 81.9 66.4 89.2 83.2 71.2 100 over 68.9 plus Easter to es VI.1, W and up of shar table e on average add countries based ces (Central based ces 3-year not a markets' (2002c, Structur egionsr ASEAN CEE oducts es es esourr technology on AD ee the of oup pr esourr technology transactions e gr 3.11 technology thr Based shar the UNCT cent) natural in ce: oduct ableT (per Pr Primary Manufactur natural Manufactur on Low Medium High Other otalT These Includes The Note: a. b. c. gain Sour 108 TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 109 categories of exports, except resource-based manufactures, in which it is third. Hong Kong, China, is on the list in only resource-based manufac- tures, and Korea, Singapore, and Taiwan, China, are in the top 10 in several categories. Malaysia, the Philippines, and Thailand are also promi- nent in the list for all sectors (UNCTAD 2002c, pp. 149­50). Three industrial sectors that have in recent years figured largely in in- ternational production networks involving developing countries are cloth- ing, electronics, and automobiles.68 In the clothing industry, production relocation has taken place largely through subcontracting. In East Asia, the NIEs were the first to be involved in this process. They began with the simple assembly of imported inputs and, after a short time, came to con- centrate on skill-intensive activities at home while outsourcing the labor- intensive activities of production to developing East Asian countries with lower wages. End products were then exported back to the home country or to third countries. In essence, there was a movement from "bilateral in- terregional trade flows to a more fully developed intraregional division of labour incorporating all phases of production and marketing" (UNCTAD 2002b, p. 100). There is reason to believe that this type of regional net- work will continue in the future, except that the players may change somewhat as competition increases from other East Asian countries and as they strive to upgrade from assembly to full-package manufacturing. The electronics industry is more globalized than the clothing industry and is driven by MNCs. Japan and the United States have played major roles as investors, whereas East Asian economies have been major host countries because of their low wages, highly skilled labor, good physical infrastructure, and fewer restrictions on exports relative to Japan. Before the early 1990s, Japanese MNCs tended to import components from Japan rather than obtaining them from local suppliers.69 Finished products would then be exported back to Japan or, in many cases, directly to third markets. This traditional pattern is beginning to change for higher-level electronics, specifically computer products, not only because of tougher competition and the increasing importance of speed in getting products to market, but also because of improvements in production capability in local economies (UNCTAD 2002b, pp. 103­4). Although this change bodes well for the future of regional production networks, it does not diminish the importance of the global element. In 68. A brief summary of these three industries, taken from UNCTAD (2002b, annex 3 to chap- ter 3, pp. 99­111), is presented here. See original for further details. 69. This tendency was in part because of the centralized management structure of the Japanese MNCs, the long time required to establish local supplier relationships, and the MNCs' prefer- ence for in-house component design. 110 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES fact, this industry has come to be characterized by the emergence of a new pattern of regional production sharing that has given rise to overlapping and competing international production networks. This situation has both positive and negative implications for East Asian economies in that it allows them to act as suppliers in a wide range of production networks, but it also gives buyers a wider selection of suppliers to choose from (UNCTAD 2002b, p. 105). The automotive sector in East Asia is one in which trade (through re- gional trade agreements) and FDI links, as well as the global and regional elements, are particularly evident. Investment in this industry from Japan, the European Union, and the United States has been drawn to ASEAN countries by AFTA's lowering of intraregional trade barriers and raising of import tariffs for nonmembers. Indonesia and Malaysia have benefited in particular. In fact, intraregional trade in motor vehicles and their parts has risen significantly in the AFTA countries. Table 3.12 shows the growth rate in imports from member countries to be very high in 1990­99 (18.6 percent for motor vehicles and 20.8 percent for parts). The negative growth for imports from nonmembers is primarily due to the Asian crisis, but it is also caused by efforts by some countries to develop national industries (UNCTAD 2002b, p. 108). After the mid-1980s, rapid economic growth in the region, plus the yen's appreciation and the formulation of regional trade agreements, helped the automobile industry develop rapidly. Japanese automakers convinced their Japanese suppliers, which they wanted to use for their pro- ductionnetworks,toestablishplantsinASEANcountries.Inthesecountries there were preferential tariffs for companies that had a minimum level of national equity. This shift benefited the automakers and strengthened the Table 3.12 Intraregional Imports of the Automobile Industry Share in total Growth rate Growth rate in $ million imports (percent) extraregional imports Region 1999 1990 1995 1999 1980­89 1990­99 1980­89 1990­99 AFTA Motor vehicles 175 1.1 1.0 5.4 9.4 18.6 1.5 0.7 Parts of motor 195 1.1 2.9 9.5 17.3 20.8 14.2 5.6 vehicles World Motor vehicles 365,672 10.7 6.6 Parts of motor 138,406 10.2 6.4 vehicles Note: Data in this table relate to SITC 781, 782, and 783 (motor vehicles), and to SITC 784 (parts of motor vehicles). Source: Compiled from UNCTAD (2002b, table 3.A5, p. 108). TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 111 competitiveness of the auto industry; it also improved the efficiency of the regional division of labor (Romijn, van Assouw, and Mortimore 2000, p. 139). Thus, a regional production network in automobiles can allow, and has already allowed, this industry to develop in the region, whereas on a national level, the industry's development is constrained by the lack of necessary economies of scale. Nevertheless, the region suffers from intraregional fragmentation of markets and excess capacity in the automo- bile industry. Furthermore, major restructuring and rationalization are needed, as is an increased supply of engineering talent to enable Southeast Asian parts makers to upgrade to being first-tier suppliers.70 From the foregoing discussion, we see the potential for East Asian countries to build further and even improve on the regional production network that was initiated by Japan in the post­World War II period and that has evolved through the development of the region's clothing, elec- tronics, and automotive industries. A description of how recent integra- tion efforts are furthering the development of regional production networks in East Asian automotive and electronics industries can be found in UNCTAD (2003b, p. 51). MNCs in East Asia, although not as numerous or as large as those in industrial countries, demonstrate an increasing level of transnationality and are prominent among MNCs in all developing countries. Chinese enterprises, especially, have great potential to become major investors in the region. Since the mid-1980s, China has significantly expanded its FDI outward stock from only US$131 million in 1985 to US$28 billion in 2001 (UNCTAD 2002c, annex table B.4, pp. 316­17). In 2001, Prime Minister Zhu Rongji proposed that China implement a "going outside" strategy. Although Chinese firms have been attracted to Latin America, North America, and Europe, they have evinced increasing interest in investing within Asia (Lawrence 2002). If ACFTA is successfully imple- mented, China's share of investment in ASEAN could increase signifi- cantly. In fact, a 2003 survey conducted by UNCTAD revealed that 21 percent (6 out of 28) of respondents in the Asia and Pacific region ex- pect China to be among their top three investors in 2003­05, double the number in the 2001­02 survey (UNCTAD 2003b, pp. 51­52).71 Further regional integration that includes China could bring FDI and trade- related benefits to both China and the countries of ASEAN. 70. For further details on the current and prospective environment for the automobile industry in East Asia, see Yusuf with others (2003, pp. 314­24). 71. UNCTAD's worldwide survey of investment promotion agencies on "prospects for global and regional FDI flows" (UNCTAD 2003a). 112 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES It is not necessary for a firm to be a large MNC to participate in a regional production network. The segmentation of the production process allows many smaller firms to concentrate on a single component, or a few related components, that may be used by larger firms in a final product, such as the computer chips that are components of a wide variety of prod- ucts. Regional production sharing can bring benefits over producing the whole product at the national level, as is common in East Asia now (Arndt 2001, p. 26). However, in the interest of the growth and development of firms and national economies, the goal should be for firms to upgrade from parts supply to the next stage of process innovation and design improve- ment and then on to original brand manufacturing. The path is fraught with difficulties in the form of high costs associated with upgrading to this stage, designing for final markets in distant countries where customer demands are unfamiliar, and becoming a competitive threat to existing clients as upgrading progresses. Therefore, only a few firms have thus far been successful in making this transition (Yusuf with others 2003, pp. 272, 286­91). Trying to establish regional production networks presents other prob- lems. Large MNCs are able to locate the various stages of production any- where in the world to take advantage of differences in factor prices and technologies. There is naturally a broader range of choices globally than regionally. Just as it is impossible for one country to have absolute advan- tage in all products, it is improbable that one region would either. How- ever, East Asia is highly diversified in its level of development, in the capability of its work force, and in its resources. It is possible through regional cooperation to take advantage of that diversification by bringing together the comparative advantages of individual countries so as to max- imize the comparative advantage of the entire region. MNCs will always operate in their own self-interest and choose loca- tions from that perspective. Although it is impossible to control all factors that might impinge on that decision and equally impossible to force enterprises to choose intraregionally as opposed to extraregionally, it is possible through coordinated policymaking, technology sharing, and capacity building to cultivate an environment that appeals to MNCs. This effort would take some sophistication and considerable cooperation, par- ticularly in the area of policymaking, but there are resources within the region, as well as within the international community, that could be drawn on for this purpose. Certain policies may need to be eliminated or changed so as not to obstruct cross-border production. Standardization of products and customs regulations would be needed to reduce costs and facilitate the TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 113 flow of goods. As Arndt (2001, p. 32) points out, "This task is clearly more complex than the traditional focus on the removal of trade barriers. The objective is not simply to free up the flow of goods, but to create an inte- grated regional production arena." Sometimes there must be dramatic structural changes in the economy of the countries involved. Such changes can mean a decline in the importance of manufacturing in a country's GDP or employment (Cheng, Qiu, and Tan 2001, pp. 182­85). Ideally, a well-developed regional production network would not only promote trade and investment intraregionally but also make the region more attractive to partners from outside the region, as has been the case with the European Union and the NAFTA group. A difficulty in East Asia is that individual countries, although cognizant of the value of regional cooperation, still tend to protect their own sover- eignty and carry out policymaking, particularly for FDI, at the national level. A regional approach can be a stage between a national approach and a global one. Arndt (2001, p. 26) states, "The basic idea is to think of the region rather than the nation as the production base and to spread com- ponent production around the region in accordance with comparative advantage." This observation does not imply that competition will disap- pear within the region as production networks develop. In fact, it will increase--not only between firms within a country but also between coun- tries as firms strive to upgrade their positions in the network. One exam- ple is the competition engendered by China's growth of FDI inflows at the expense of other regional economies and by the potential of its firms to become leaders in the regional production network.72 Networks, however, are not static, and the position of firms and countries within them will change over time. The appeal of regional production networks for East Asia is that they satisfy the desire to deal with issues through regional cooperation and yet are not entirely self-contained, in that there is still latitude for countries outside the region to invest in and trade with countries of the region, and vice versa. The goal is not to keep out extraregional investment or to limit regional countries that are investing externally, nor should such a network be restricted only to imports from and exports to regional economies. A regional production network is rather a way to optimize the comparative 72. Competition for markets will also increase. Examples include Japanese automobiles, which are at a competitive advantage in ASEAN but at a disadvantage against European cars in China. Japanese consumer goods are expected to face increased competition in the region from cheap Chinese consumer electronics and from European, North American, and Korean higher-end products (JETRO 2003, p. 29). 114 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES advantages of the region as a means of promoting complementarity in production and trade as opposed to all countries focusing on the same goods and services. This process should be dynamic rather than static. It should be flexible regarding shifts of production within the region, as well as between regions, remaining always open to being a part of the global production network. To act otherwise would show a failure to acknowledge the current reality of globalization and could be self-destructive. CONCLUDING REMARKS The recognition of trade and FDI links has become more important in today's global environment, which is characterized by an increasingly integrated international production network. MNCs, which are at the heart of this network, decide where to invest and from where to trade in pursuit of the most efficient organization of their production activities. Technology has facilitated this process through improved transportation and communication at a reduced cost. As a result, MNCs can locate their production activities anywhere in the world. Contributing to the economic growth and development in East Asia over the past two decades has been a phenomenal rise in trade and FDI activity, which has been attributed in large part to the region's liberaliza- tion of these two areas. Our analysis has revealed the continued multilat- eral nature of the region's trade and FDI and the importance of its extraregional relationships. Thus, a willingness to remain open is essential to the region's continued development and its achievement of prosperity. At the same time, we see a very high level of intraregional trade and FDI, with some shifts in trading and investment patterns both from out- side to inside the region and within the region itself. East Asia is witness- ing a shift in investment away from Southeast Asia (ASEAN) to the north in search of lower costs, and there is a foreboding that China will eventu- ally become the primary production center of the region with an absolute advantage in many types of products. Because of the recognized need to forestall such an eventuality, as well as the desire for a strong regional identity and a lessening of dependency on the West, regional cooperation efforts are gathering momentum in East Asia. One outcome of this cooperation is the heightened interest in forming regional trade agreements. Policies dealing with trade and particularly with FDI traditionally have been formulated at the national level in East Asia--generally with little TRADE AND FOREIGN DIRECT INVESTMENT: A ROLE FOR REGIONALISM 115 coordination. It is increasingly important that the development and implementation of these policies be coordinated and mutually supporting. In light of East Asia's rising interest in pursuing regional solutions and the importance of policy coordination in the promotion of trade and FDI, we have suggested two approaches that combine these two elements: (a) the formation of regional agreements and (b) the creation of regional produc- tion networks. The formation of regional agreements should specifically encompass aspects of both trade and FDI, with an appreciation of their interactive characteristics. Because this type of broad trade-FDI agreement is rela- tively new, there are few empirical studies of its welfare-enhancing capa- bilities. Existing studies indicate that the inclusion of both industrial and developing countries in the agreement can lead to potential advantages from improved policy credibility and guaranteed access to larger markets. In fact, a larger grouping of countries is deemed preferable. But many re- gional economies are embarking on a path leading to the formation of many bilateral agreements with partners both within the region and out- side it. ASEAN and China have taken this concept a step further and adopted a comprehensive agreement. There are those who believe that the proliferation of bilateral and re- gional FTAs will only complicate the multilateral negotiations of the WTO. Most of these agreements, however, are still under negotiation or consultation. So although it appears that a "spaghetti bowl" is indeed in the making in East Asia, it is conceivable that over the next 10 years or so these disparate negotiations could coalesce into a broader regional agree- ment if some standardization and consistency are maintained. Working out agreements in smaller groups, or even bilaterally, could be easier and less daunting for the smaller developing countries of East Asia. There are, of course, certain difficulties that would need to be ironed out, not least of which is the agriculture issue, but it is possible that the resolution of a troubling issue by one group can serve as an incentive for resolution to others. At least, the process of negotiating regional agreements should lead to more interaction and cooperation within the region. A step beyond, and possible extension of, regional agreements is our proposal for a regional production network. 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CHAPTER 4 NEW REGIONAL TRADING DEVELOPMENTS IN THE ASIA-PACIFIC REGION John Gilbert, Robert Scollay, and Bijit Bora S ince 1999, there has been a strong trend within the Asia-Pacific re- gion toward the promotion of regional economic integration through various kinds of preferential trading agreements (PTAs).1 This situation contrasts with that in the mid-1990s, when the Asia- Pacific Economic Cooperation (APEC), with its nondiscriminatory approach to regional trade liberalization, held center stage as the intended vehicle for economic integration in the region. The arrangements now be- ing proposed range from bilateral agreements among smaller economies of the region to the development of large trading blocs that embrace all or most economies on each side of the Pacific--an East Asian or perhaps Western Pacific trade bloc on the western side of the Pacific and a free trade area of the Americas (FTAA) on the other side.2 The willingness of the large Northeast Asian economies to consider entering into PTAs is a major point of departure from the past. These developments raise questions as to whether Asia-Pacific econom- ic integration will continue to be pursued on an Asia-Pacific-wide basis, embracing both sides of the Pacific, or whether the lead role will be taken by separate economic integration processes in East Asia and the Americas. This chapter seeks to address the implications of these new trends in Asia-Pacific regionalism for the economies of East Asia and for the role that 1. In this chapter the term regional trading agreement (RTA) has a broader meaning than prefer- ential trading agreement (PTA). It includes PTAs such as free trade areas and customs unions, as well as other regional arrangements, such as the Asia-Pacific Economic Cooperation, which are not preferential. 2. East Asia is here taken to comprise the Northeast Asian economies--China, Hong Kong (China), Japan, the Republic of Korea, and Taiwan (China)--and the Southeast Asian economies--members of the Association of Southeast Asian Nations. The Western Pacific takes in these economies, together with Australia and New Zealand. 122 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES regionalism may play in their future development. The chapter is organized asfollows.Thenextsectionbrieflyreviewstheevidenceontradeintegration in East Asia during the 1990s and summarizes the main developments in Asia-Pacific regionalism during that period. This section is followed by one in which computable general equilibrium (CGE) simulations are used to as- sess the welfare effects of a selection of the proposed new regional trading agreements (RTAs), including both bilateral agreements and a set of more extensivearrangementsthatcouldbedescribedasstepstowardanEastAsian tradingbloc.Theresultsallowustoidentifytheproposedarrangementsthat are likely to have the greatest effect and yield the largest welfare gains in the East Asian economies, so that these arrangements can then be analyzed in greater detail. This section also includes discussions on the implications of excluding sensitive sectors, such as agriculture, from such arrangements. The following section identifies and discusses the changes in produc- tion patterns indicated by CGE analysis of the steps toward an East Asian trading bloc, shown in the preceding section to be the RTA developments likely to have the greatest effect on the East Asian economies. These re- sults are reported to highlight both the individual sectors that are likely to face the largest adjustments and the adjustments that will have the most serious implications for the economy as a whole. The final section considers whether these potential trading agreements are likely to be building blocks or stumbling blocks in moves to achieve free trade in the Asia-Pacific region and a more open international econo- my. The question is whether these arrangements can be regarded as natu- ral trading blocs, with the favorable properties conventionally associated with such blocs. A gravity model is used to assess how far the arrangements under consideration may be considered natural trading blocs. The results are then compared with the results of the CGE simulations to determine the extent to which support can be found for the proposition that natural trading blocs are more likely to function as building blocks. This section shows that although some of the proposed arrangements may be regarded as natural trading blocs, this perception does not ensure favorable out- comes, in particular the absence or minimization of negative welfare effects on nonmembers. REGIONAL TRADING ENVIRONMENT Increasing trade integration has continued to be a feature of Asia-Pacific economic relations through the 1990s and into the current century. Policy reforms in individual economies and the stimulus of APEC have been NEW REGIONAL TRADING DEVELOPMENTS IN THE ASIA-PACIFIC REGION 123 contributing factors, as were a small number of significant RTAs that op- erated in the region through most of this period. However, despite the liberalization that has occurred, significant trade barriers remain, sug- gesting the potential for additional gains from further liberalization. The new round of World Trade Organization (WTO) trade negotiations launched at Doha in November 2001 provides one avenue for further liberalization. Another avenue that many East Asian economies have ac- tively explored over recent years is the establishment of new bilateral and plurilateral PTAs. Developing Trade Patterns in the Asia-Pacific Region Table 4.1 summarizes changes in broad trade patterns of the East Asian economies during the 1990s. By the turn of the century, the East Asian economies had achieved an impressive level of intraregional trade. The share of intraregional exports in the total exports of East Asian economies (excluding Brunei Darussalam) ranged from 37 to 56 per- cent, with the corresponding import shares ranging from 39 to 75 percent. The Southeast Asian economies exhibited particularly high levels of in- traregional trade, with the share of the imports and exports accounted for by other East Asian economies typically exceeding 50 percent and falling below that level only in the case of the exports of Thailand (48 percent), Vietnam (47 percent), and the Philippines (43 percent). Trends in these shares during the 1990s exhibit a degree of variation. In a number of cas- es, rising shares are observed in the first half of the decade, but these shares declined by the last 3 years of the decade, when the effects of the East Asian economic crisis were being felt. This pattern is observed in both the exports and imports of Brunei Darussalam, Singapore, and Vietnam, as well as in the exports of Thailand, although, except for the exports of Brunei Darussalam, the East Asian share was higher in the last 3 years of the decade than in the first 3. However, there was a steady fall in the East Asian share in the exports of Indonesia and, to a lesser extent, Malaysia, as well as in the imports of Thailand. A steady rise occurred in the East Asian share of both the exports and imports of the Philippines and in the imports of Malaysia. The share of Southeast Asia itself in the trade of Southeast Asian economies generally grew strongly over the decade, except in the cases of imports and exports of Vietnam and of the exports of Brunei Darussalam and Malaysia. By the last 3 years of the decade, this share ranged from 13 percent for Philippine imports to 26 percent for Malaysian exports. The share of Northeast Asia in the trade of Southeast Asian economies 99 0.0 0.0 2.0 1.4 0.6 1.4 1.8 0.9 2.4 1.6 2.0 2.6 1997­ South America 29 0.1 0.0 1.9 0.5 0.6 0.8 1.8 0.1 2.9 1.2 2.2 1.5 1990­ 99 1997­ 76.7 96.1 75.0 74.5 85.2 76.6 70.6 74.9 64.8 72.4 68.4 67.6 APEC 29 1990­ 73.5 93.7 75.1 78.8 84.9 81.6 69.2 80.1 63.6 67.7 70.2 69.8 A 99 6.3 8.2 1997­ 13.0 13.3 21.6 24.9 12.3 16.1 24.0 32.6 23.1 20.4 NAFT 29 1.8 8.1 1990­ 17.8 14.5 10.0 25.4 15.0 13.6 26.7 32.9 25.8 29.7 99 6.3 7.5 1997­ 11.9 11.8 20.1 23.0 10.7 14.8 21.0 30.0 21.1 18.1 United States 29 1.8 9.1 7.6 1990­ 17.7 11.8 23.2 13.1 12.7 22.6 29.7 23.3 26.3 99 1997­ 63.8 89.8 58.5 52.0 76.7 51.3 57.7 58.9 38.8 39.4 43.3 46.1 est W Pacific 29 1990­ 55.7 91.8 58.3 68.0 76.7 56.0 53.8 66.5 35.5 34.4 43.7 39.7 99 2.8 1.4 2.4 1.4 1.2 1.5 5.9 3.2 4.6 2.3 4.8 2.0 1997­ CER Economies 29 2.0 2.1 2.6 0.9 1.1 1.6 5.8 2.2 6.1 2.5 4.4 1.6 1990­ Asian 99 Asia 1997­ 61.0 88.5 56.1 50.5 75.5 49.8 51.8 55.7 34.2 37.1 38.5 44.1 East 29 1990­ 53.7 89.7 55.7 67.1 75.5 54.4 48.0 64.3 29.4 31.9 39.3 38.1 Northeast of 99 8.9 6.4 6.1 9.5 1997­ 45.3 20.0 10.2 16.0 17.0 13.6 13.9 13.0 Asia Southeast Exports 29 5.8 6.0 7.9 6.8 9.4 7.9 1990­ 39.1 20.6 11.8 13.5 12.0 10.1 and 99 1997­ 15.6 68.4 47.2 44.1 65.3 43.7 35.8 38.7 20.5 23.1 29.0 31.1 Asia Northeast Imports 29 1990­ 14.7 69.1 50.0 61.1 67.6 47.6 38.6 52.5 16.0 19.9 31.4 28.0 of 99 8.1 5.6 1997­ 49.8 20.3 16.7 12.7 18.9 21.6 19.3 10.4 Japan 29 5.4 1990­ 10.9 56.6 15.7 14.1 16.7 23.7 36.5 25.5 17.1 Distribution 4.1 Kong, of ea, ableT Country Brunei Darussalam Imports Exports China Imports Exports Hong China Imports Exports Indonesia Imports Exports Japan Imports Exports Kor Rep. Imports Exports 124 1.0 0.7 0.8 0.2 0.4 0.5 1.5 1.2 1.3 0.6 0.3 0.4 1.3 0.4 2.1 0.2 0.8 0.5 2.1 0.8 1.6 0.3 0.2 0.3 80.4 76.3 76.9 77.7 74.4 75.5 78.7 76.8 69.8 70.8 75.3 57.4 78.9 77.2 72.3 77.1 73.0 71.4 78.4 76.3 70.6 66.4 59.7 61.2 3.2 6.4 17.9 21.1 21.1 34.0 16.9 19.0 19.8 29.2 13.9 21.8 0.3 0.1 16.8 18.7 20.6 39.3 16.2 21.1 24.2 33.3 12.2 23.8 eement. Agr 2.9 5.1 17.1 20.1 20.3 32.9 16.1 18.2 18.8 26.1 12.9 20.3 radeT ee Fr 0.0 0.0 16.0 17.6 19.2 37.6 15.6 20.1 22.7 30.5 11.0 22.1 American 61.9 55.4 55.4 43.6 57.4 56.6 58.1 47.5 55.6 50.0 72.0 53.4 North 62.0 58.6 50.8 37.6 56.8 50.5 53.5 42.7 58.4 42.8 49.0 58.9 A NAFT 2.9 2.3 3.1 0.8 1.4 2.8 3.0 1.7 2.3 2.0 1.9 6.1 eement; 3.7 2.0 3.7 1.3 2.0 2.8 3.2 2.1 2.2 1.7 0.5 0.4 agr trade 59.0 53.1 52.4 42.9 56.0 53.9 55.0 45.8 53.2 48.0 70.0 47.3 Relations 58.3 56.5 47.1 36.3 54.8 47.8 50.3 40.6 56.2 41.1 48.5 58.4 Economic 21.4 26.2 13.1 13.5 25.9 28.4 14.7 11.4 14.1 19.6 25.3 16.7 Closer 6.6 8.5 20.0 29.6 10.0 21.8 25.1 11.0 13.0 14.5 27.6 19.0 CER 37.6 26.9 39.3 29.3 30.1 25.5 40.3 34.4 39.1 28.5 44.8 30.6 Cooperation; 38.2 26.9 37.1 29.7 33.0 22.6 41.7 29.6 43.2 26.7 20.9 39.4 7.1 8.9 21.9 12.1 20.5 15.1 16.3 27.0 25.8 15.0 10.7 20.3 Economic years). 8.1 6.8 25.5 14.7 19.8 19.1 20.1 31.3 11.3 29.5 17.5 24.8 Asia-Pacific (various e IMF APEC ce: Malaysia Imports Exports Philippines Imports Exports Singapor Imports Exports aiwan,T China Imports Exports Thailand Imports Exports ietnamV Imports Exports Note: Sour 125 126 GLOBAL CHANGE AND EAST ASIAN POLICY INITIATIVES remained considerably higher, but the trend was less clear cut, with increases over the decade for some Southeast Asian economies being out- weighed by falls for others. The picture for intraregional trade links of Northeast Asian economies was a little more mixed. East Asia accounted for about 50 percent of both imports and exports of China and Taiwan, China, and also of Hong Kong, China (where the figure for imports was 75 percent). However, it ac- counted for closer to 40 percent of trade in the Republic of Korea (38 per- cent of imports and 44 percent of exports) and 35 percent of trade in Japan (34 percent of imports and 37 percent of exports). The pattern of rising shares in the first part of the decade followed by falling shares toward the end of the