Asian Economic Cooperation In The New Millennium: China's Economic Presence (Advanced Research in Asian Economic Studies) (v. 1)

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Advanced Research in Asian Economic Studies - Vol. 1

Asian Economic Cooperation in the New Millennium: China's Economic Presence

Advanced Research in Asian Economic Studies Series Editor: Manoranjan DUTTA (Rutgers, The State University of New Jersey, USA)

Published Vol. 1 Asian Economic Cooperation in the New Millennium: China’s Economic Presence Editors: Calla WIEMER (East Asian Institute, National University of Singapore) Heping CAO (Peking University, China) Forthcoming Vol. 2

Economic Dynamism of Asia in the New Millennium Editors: Hiromitsu ISHI (Hitotsubashi University, Japan) Yoshinori SHIMIZU (Hitotsubashi University, Japan)

Advanced Research in Asian Economic Studies – Vol. 1

Asian Economic Cooperation in the New Millennium: China's Economic Presence

edited by

Calla Wiemer Heping Cao

World Scientific NEW JERSEY • LONDON • SINGAPORE • BEIJING • SHANGAI • HONG KONG • TAIPEI • CHENNAI

Published by World Scientific Publishing Co. Pte. Ltd. 5 Toh Tuck Link, Singapore 596224 USA office: 27 Warren Street, Suite 401-402, Hackensack, NJ 07601 UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE

Library of Congress Cataloging-in-Publication Data Asian economic cooperation in the new millennium: China’s economic presence / edited by Calla Wiemer, Heping Cao. p. cm. -- (Advanced research in Asian economic studies; v. 1) Revised papers from a conference held at Peking University in May 2002, sponsored by the American Committee on Asian Economic Studies, Peking University School of Economics, and the China Reform Forum. Includes bibliographical references and index. ISBN 981-238-762-5 1. Asia--Economic integration. 2. Asia--Economic policy. 3. China--Foreign economic relations. 4. China--Economic policy. I. Wiemer, Calla. II. Cao, Heping, 1957– III. American Committee on Asian Economic Studies. IV. Beijing da xue. Jing ji xue yuan. V. China Reform Forum. HC412.A744 2004

2004061094

British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library.

Copyright © 2004 by World Scientific Publishing Co. Pte. Ltd. All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without written permission from the Publisher.

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Foreword

It is my great honor and privilege to present Asian Economic Cooperation in the New Millennium: China’s Economic Presence to our readers. This is the first volume in the series, Advanced Research in Asian Economic Studies. I am thankful to Dr. Calla Wiemer of the National University of Singapore East Asian Institute and to Dr. Heping Cao of the Peking University School of Economics for serving as the editors of this volume. The volumes in this series shall draw upon research papers presented at international conferences sponsored by the American Committee on Asian Economic Studies (ACAES). ACAES is an inter-university not-for-profit educational organization governed by economists from an array of universities and research institutions in the US. It was founded in 1982 following the first successful conference which was held at the New Brunswick campus of Rutgers, The State University of New Jersey in April 1981. Founding members included Professor Lawrence R. Klein, the 1980 Nobel Laureate in Economics, who continues to serve on the ACAES Board and has participated in many ACAES conferences. Between 1981 and 2002, the organization has sponsored 24 international conferences — 14 jointly with universities and research academies in various Asian countries and ten with universities and other institutions in the US. This volume is the outgrowth of the 24th ACAES conference cosponsored by the Peking University School of Economics and the China Reform Forum, held in Beijing during May 27–29, 2002. Six of the 24 ACAES conferences have been held in China. Of these, four were cosponsored jointly by the Shanghai Academy of Social Sciences and the Chinese Academy of Social Sciences, three in Shanghai (the 18th in 1994, the 11th in 1990, and the 8th in 1988) and one in Beijing (the 14th in 1992), and one was co-sponsored by the Huazhong University of Science and Technology and held in Wuhan (the 7th in 1987). Two conferences were held v

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in Bangkok with co-sponsorship of Chulalongkorn University (the 22nd in 1998 and the 15th in 1992). Other venues included Tokyo with Tokai University (the 12th in 1991); Seoul with Seoul National University, the Korea Institute for International Economic Policy, and the APEC Studies Association of Korea (the 23rd in 1999); New Delhi with Jawaharlal Nehru University (the 19th in 1996); Hong Kong with the Chinese University of Hong Kong (the 6th in 1997); Bali with the University of Indonesia and Ikatan Sarjana Ekonomi Indonesia (the 17th in 1994); and Kuala Lumpur with the Malaysian Economic Association and the University of Malaya (the 20th in 1996). The remaining ten of the 24 ACAES conferences were held in the US. Co-sponsors have been Rutgers University (the 1st in 1981); theAsia Society of New York and the Port Authority of New York and New Jersey (the 5th in 1985); the Columbia University Pacific Basin Study Program (the 9th in 1989); the Brandeis University Lemberg Asia-Pacific Center (the 16th in 1994); the Federal Reserve Bank of San Francisco (the 21st in 1997, the 10th in 1990, and the 3rd in 1984); the Federal Reserve Bank of New York (the 4th in 1985); the Federal Reserve Bank of Atlanta (the 13th in 1992); and a group of commercial banks in New York City (the 20th in 1983). In 1981, The New York Times published a multi-column headline: “For the First Time in the History of the United States, the Trans-Pacific Share of its Trade Became Larger than the Trans-Atlantic One”. Prospects for industrialization of Asian economies beyond Japan ceased to be a question. Asia’s newly industrialized and industrializing economies brought an economic dimension to Asia which warranted serious academic study. Economic policy-makers and private businesspeople became interested in understanding Asian economic developments. Since the 1970s, a number of East Asian economies have followed Japan in showing remarkable economic progress and becoming substantive economic partners of the US and other mature industrialized economies. As Asian economies broke with their import substitution regimes to adopt open economic postures, investment from the affluent, savings/income rich economies flowed in seeking a low wage advantage. Export of newly manufactured products provided the basis for profit repatriation for foreign investors. The study of Asian economies warrants sustained attention. The interaction of Asia with the US through shifting patterns of economic performance constitutes one reference point. Japan is a post-war economic power and her belonging to the map of Asia is a geographic fact. South Korea, Taiwan, and

Foreword

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Hong Kong in Northeast Asia, and Singapore, Malaysia, Thailand, and others in Southeast Asia have become strong economic partners of the US. The transformation of these economies constitutes another reference point. In South Asia, India with her high-tech information industry has also become a reference point, independent of the other India where per-capita income remains persistently low. China with her accelerated rate of industrialization and rapid economic growth must be taken as yet another reference point notwithstanding the challenges this country continues to face. Asian economic studies in the United States for many years remained constrained. The US failed to normalize relations with China until the 1970s. It treated India and other countries in South Asia as a disjoint unit of the Asian continental map. A simplistic solution was made for Japan and then Korea by making them members of a European economic group. ACAES as an institutional forum with its publications has helped to fill a gap. My special thanks are due to all my fellow economists from Asia, Europe, and the American hemisphere who attended the 24 ACAES conferences over the years and presented their research findings. To the extent that ACAES has been able to promote scholarly study of Asian economies by way of bringing together the international community of economists at its forums, it has been a worthy endeavor. My very personal thanks are due to Usha Kaul and Ashok Kaul, and also to Rayne Peerenboom.

M. Dutta Professor of Economics, Rutgers University Member, Rutgers University Senate Fulbright Senior Specialist, 2002–2007 Series Editor, Advanced Research in Asian Economic Studies April 23, 2004

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Contents

Foreword

v

List of Abbreviations

xiii

Introduction: China’s Economic Presence Calla Wiemer

1

REGIONAL ECONOMIC INTEGRATION Inaugural Address Myoung-Ho Shin

21

Globalization: What It Is and Who Benefits D. Gale Johnson

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Prospects for an Asian Currency Area Robert Mundell

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The European Central Bank and the International Role of the Euro Juergen Schroeder

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Asian Economic Community: Intra-Community Macro- and Micro-Economic Parameters Manoranjan Dutta East Asian Economic Cooperation: The “10 + 1” Mechanism for Moving Forward Jingyi Ye

ix

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Contents

Pax Americana-Led Catch-Up, Flying-Geese Style: Regionalized Endogenous Growth in East Asia Terutomo Ozawa Asian Economic Integration: A Perspective on South Asia Saleem M. Khan and Zahira S. Khan

153 175

ASIAN POLICY & PERFORMANCE Can East Asia Rise Again? Tzong-Shian Yu

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Identifying Terms of Trade Effects in Real Exchange Rate Movements: Evidence from Asia Mardi Dungey

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Industrial and Commercial Firms’ Response to the Asian Crisis: A Logistic Approach Stephen Reynolds, Somchai Ratanakomut and James Gander

235

Moral Hazard and Legal Regulation in the Financial Market: Japan’s Mega-Bank Mergers Yoshinori Shimizu

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FOCUS ON CHINA Bank Regulation in China: Property Rights, Incentives, and Accountability Yan Guo

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Foreign Direct Investment in China: An Analysis of Source Country and Sector of Utilization Wenhui Wei and Manoranjan Dutta

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Agglomeration Economies and FDI Spatial Distribution: Evidence from Joint Ventures in China Chyau Tuan and Linda F. Y. Ng

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Korea–China Technological Cooperation Yang-Taek Lim

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Contents

ASEAN–China Free Trade Area: Background, Implications and Future Development Suthiphand Chirathivat

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Preferential Trade Agreements and China’s Trade Ramon Clarete, Christopher M. Edmonds and Jessica Seddon Wallack

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Index

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ADB AFTA Andean Pact APEC

ARF ASEAN

ASEAN-4 ASEAN-5 ASEAN-6 ASEAN + 3 AU CAREC

Caricom CAFTA CER

Asian Development Bank ASEAN Free Trade Area: Brunei Darussalam; Indonesia; Malaysia; Philippines; Singapore; Thailand; Vietnam Bolivia; Colombia; Ecuador; Peru; Venezuela Asia Pacific Economic Cooperation: Australia; Brunei Darussalam; Canada; Chile; People’s Republic of China; Hong Kong, China; Indonesia; Japan; Republic of Korea; Malaysia; Mexico; New Zealand; Papua New Guinea; Peru; Philippines; Russia; Singapore; Chinese Taipei; Thailand; United States; Vietnam ASEAN Regional Forum Association of Southeast Asian Nations: Brunei Darussalam; Cambodia; Indonesia; Laos; Malaysia; Myanmar; Philippines; Singapore; Thailand; Vietnam Indonesia, Malaysia, Philippines, Thailand ASEAN-4 plus Singapore ASEAN-5 plus Vietnam or APT: ASEAN plus People’s Republic of China; Japan; Republic of Korea African Union: 53 members Central Asia Regional Economic Cooperation; ADB program encompassing: Xinjiang, PRC; Kazakhstan; Kyrgyz Republic; Tajikistan; Uzbekistan Caribbean Community: 15 members China–ASEAN Free Trade Area Closer Economic Relations Trade Agreement: Australia; New Zealand xiii

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CMLV ECO

EFTA EU-15

EU-25 FTA FTAA Mercosur MSG NAFTA NIEs PTA RIA RTA SAARC

SAPTA SAFTA SPARTECA

WTO

Cambodia; Myanmar; Laos; Vietnam Economic Cooperation Organization: Afghanistan; Azerbaijan; Iran; Kazakhstan; Kyrgyz Republic; Pakistan; Tajikistan; Turkey; Turkmenistan; Uzbekistan European Free Trade Association: Iceland; Liechstenstein; Norway; Switzerland European Union: Austria; Belgium; Denmark; Finland; France; Germany; Greece; Ireland; Italy; Luxembourg; Portugal; Spain; Sweden; the Netherlands; United Kingdom EU-15 plus Cyprus; Czech Republic; Estonia; Hungary; Latvia; Lithuania; Malta; Poland; Slovakia; Slovenia Free Trade Area (or Aggreement) Free Trade Area of the Americas: 34 members Southern Common Market: Argentina; Brazil; Paraguay; Uruguay Melanesian Spearhead Group: Fiji; Papua New Guinea; Solomon Islands; Vanuatu North American Free Trade Agreement: Canada; Mexico; United States Newly industrialized economies: Hong Kong, China; Singapore; South Korea; Taiwan Preferential Trading Arrangement (or Agreement or Area) Regional Integration Agreement (or Arrangement) Regional Trade Agreement (or Arrangement) South Asian Association for Regional Cooperation: Bangladesh; Bhutan; India; Maldives; Nepal; Pakistan; Sri Lanka South Asian Preferential Trading Agreement (outgrowth of SAARC) South Asian Free Trade Area (outgrowth of SAPTA) South Pacific Regional Trade and Economic Cooperation Agreement: Australia; New Zealand; Cook Islands; Fiji; Kiribati; Marshall Islands; Micronesia; Nauru; Niue; Papua New Guinea; Solomon Islands; Tonga; Tuvalu; Vanuatu; Western Samoa World Trade Organization: 146 members

Introduction: China’s Economic Presence Calla Wiemer Visiting Senior Research Fellow East Asian Institute, National University of Singapore [email protected]

By virtue of its size and dynamism, China wields a powerful presence inAsia and globally as the new millennium opens. China’s rapid economic growth over the last quarter century has been accompanied by expanding shares in global and regional trade. Within Asia, this mounting presence strikes mixed reactions. The country’s abundant cheap labor gives it a cost advantage in manufacturing that pushes its Asian neighbors to find other comparative advantage niches. And global investment capital drawn to China is to some extent diverted from elsewhere in the region. But while China has caused concern within Asia as a competitive force, it has at the same time gained respect for its growing leadership role. Following the Asian financial crisis of 1997–1998, China aided regional recovery by holding the value of its currency firm relative to the US dollar, resisting pressure to devalue as other currencies in the region depreciated. And in multilateral economic forums such as WTO and APEC, China has increasingly found a voice representing the interests of developing countries. Against this backdrop, a conference was convened in May 2002 at Peking University under the banner “Asian Economic Cooperation in the New Millenium: China’s Economic Presence.” Co-sponsors of the conference were the American Committee on Asian Economic Studies, the Peking University School of Economics, and the China Reform Forum. A revised set of papers from the conference is contained in this volume. Authors come from throughout Asia as well as from the US, Europe, and Australia. This introduction draws from the conference papers to address three themes related to Asian economic cooperation and China’s presence: (1) gains from economic exchange; (2) financial stability, crisis response, 1

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and exchange rates; and (3) institution building and clout of the region globally. Conclusions regarding China’s economic role in Asia and the world follow. 1. Gains from Economic Exchange In his inaugural address, Asian Development Bank Vice-President MyongHo Shin set the tone for the conference stating that “trade growth has enabled Asian economies to increase per capita income and reduce the incidence and severity of poverty”. Gale Johnson developed this theme, conveying vividly that globalization is the key to the profound transformation in living standards that has taken place over a span of the last century or so. Encompassing far more than just trade and investment, globalization is most importantly about the spread of knowledge and ideas. Particularly powerful examples of how the spread of knowledge has boosted living standards are to be found in the areas of agricultural technology and public health. Advances in these areas have in turn permitted the release of labor from farming and the growth of cities, which “made it possible for people to specialize in the production of knowledge” thus accelerating the process of human advance. That globalization in this form has improved the lot of even the world’s poorest is clear from such indicators as life expectancy and caloric intake. The spread of knowledge and ideas has taken root, Johnson expounds, not only in science and technology but in institutions favorable to economic development such as private property, the rule of law, enforcement of contracts, democracy, markets, and effective public finance. To critics of globalization who would blame it for rising inequality, Johnson responds that “inequality has increased because globalization has not spread far enough, fast enough”. Globalization is manifest in the worldwide dominance of the market, whereas it is restrictions on markets that aggravate income inequality. As evidence, Johnson points to China. He attributes the disparity between urban and rural per capita consumption there to a combination of restrictions on migration to the cities and urban bias in investment and education. Johnson grants that globalization involves dislocations, but he argues these would occur with domestic growth anyway. Because a country’s growth is faster when it is integrated with the global economy, the need for change and adjustment is that much more compressed in time.

Introduction

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Terutomo Ozawa elaborates on the transmission of economic influences with reference to the “flying geese” paradigm. He details five stages of industrial development which countries pass through, each characterized by a leading sector on a value added hierarchy: (1) natural resource intensive (e.g., cotton textiles); (2) scale-driven capital intensive (steel); (3) differentiated assembly based (autos); (4) R&D driven (computers); and (5) IT based (the Internet). Britain led the world through the first two stages with the US taking over through the latter three. East Asia’s flying geese have followed the US during the post-war era with Japan first, followed by the NIEs, then the ASEAN-4, and finally China as the latest addition with the prospect of India tagging on next. The US has played the leadership role as a provider of knowledge — both technological and institutional — and markets, while Japan has been pivotal in segmenting production processes into transferable elements and shedding these to follower countries as bundles of capital and technology. The NIEs are now following Japan in taking on this function. Like Johnson, Ozawa emphasizes the importance for follower countries not just of absorbing technology but of adopting the institutions of openmarket capitalism. East Asia got the fundamentals right in this way: strong export orientation; high savings rates; emphasis on education; openness to FDI; flexible labor markets; and benefits broadly dispersed within society. Governments played an actively pro-business role in achieving this. Foreign direct investment has become ever more key in the development of follower countries as multinationals have come to perform the function of dispersing technology, now frequently even transfering R&D activities overseas. Japan was virtually closed to FDI; Korea and Taiwan went through a gradual process of opening; and China has absorbed FDI voraciously. Tzong-Shian Yu picks up on Ozawa’s theme of countries sequentially climbing the value-added ladder to address the question of his title: “Can East Asia Rise Again?” Success hinges on the continued upgrading of industrial structure from labor-intensive to technology-intensive or knowledgebased production. The NIEs have led the way with the ASEAN-4 following suit. Where Japan has long played the lead role in the flying geese profile, China’s emergence as an economic power is now changing the dynamic. China’s role as a motive force, however, takes a very different form as rather than passing technology and investment to developing countries in the region, it provides a market for raw material inputs and a low-cost base of production for investment in labor-intensive manufacturing.

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Further to East Asia rising again,Yu points to the importance of regional economic cooperation and the need for formal organizational structures to sustain it. China must play a key part in the development of these cooperative associations. Whether or not regional trade associations on balance expand trade or merely divert trade from non-members to members is a subject of debate and the focus of an empirical contribution by Ramon Clarete, Christopher Edmonds, and Jessica Seddon Wallack. The authors apply a gravity model to estimate the effects of 11 preferential trade associations (PTAs) on trade among members versus trade with the rest of the world and on trade specifically between members and China. The model takes as its unit of observation the exports of each nation to every other pairwise, and assesses whether membership in a PTA for either the exporting country, the importing country, or the combination has an effect on trade. This effect is judged relative to the level predicted by the basic gravity model, where this model holds that trade is inversely related to the distance between countries and directly related to their economic mass, controlling for various other factors. Regressions incorporate cross-sectional data at five year intervals for the period 1980 to 2000 with 3000 to 5000 observations per year. The effect of PTAs on exports is captured through an assortment of dummy variables for each PTA. Among the 11 PTAs included in the analysis, six are in the Asia Pacific region: AFTA, APEC, CER, ECO, SAPTA, and SPARTECA.1 Of these, AFTA, ECO, and SPARTECA were found to be generally trade diverting in that trade between members is greater than and that between members and non-members less than would be predicted by the gravity model in the absence of the PTA. APEC and SAPTA were found to be generally trade creating in that trade of members both with other members and with nonmembers is greater than would be predicted. For CER, there was found to be no effect on trade. Thus in some cases PTAs appear to have had the effect of liberalizing members’ trade orientation generally and increasing regional integration with the world; in other cases, they may have achieved a more limited form of opening directed at neighbors. In the case of APEC in particular, an avowed commitment to the principle of “open regionalism” is revealed to have been very effective.

1A

list of PTA abbreviations and member countries is provided at the beginning of this volume.

Introduction

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China was a member only of APEC among the study PTAs, and the positive effect of APEC on China’s trade was found to be substantial, true toAPEC’s generally trade enhancing character. For other PTAs in the region, the effect on China’s trade has not been so sanguine, although for ECO the bias against trade with China seems to have reversed in more recent years. For AFTA, SPARTECA, and SAPTA, however, the impact on China remains stubbornly negative. In light of the indication thatAFTA negatively affectsASEAN trade with China, China’s free trade agreement with this regional association portends real benefits. Suthiphand Chirathivat applies a general equilibrium framework to examine the impact of eliminating trade barriers between ASEAN and China. His simulation model involves 50 sectors and 45 countries. As expected given a baseline situation in which China’s barriers to exports from ASEAN are much higher than the reverse, the predicted increase in ASEAN’s exports to China at 53 percent exceeds that of China’s exports to ASEAN at 23 percent. On the ASEAN side, however, exports to China are in part diverted from third country markets rather than being newly generated. By contrast, on the Chinese side, an increase in imported inputs from ASEAN results in a cost advantage in production that yields newly created growth in exports to third country markets. Longer term, improved prospects for exporting raw materials and intermediate inputs to China could draw foreign investment to ASEAN, countering the diversion to China caused by that country’s magnetic effect on manufacturing investment. The composition of FDI flows into China is the subject of the paper by Wenhui Wei and Manoranjan Dutta. In 2002, China received more FDI than any other country in the world. Until 1992, loans were the primary source of capital inflow to China, but since the mid-1990s FDI has far overshadowed loans. The authors provide breakdowns of FDI with regard to source country and sector of utilization. The source country analysis shows the dominant share attributable to Hong Kong and Macao giving way through the 1990s to greater diversity of sources, with the US and the EU in particular making more substantial contributions over time. The sectoral analysis shows China following a pattern exhibited by other industrializing economies of Asia with shares going to manufacturing declining in favor of rising shares aimed at services. Unlike its Asian predecessors at their early stages of development however, China has never benefited from much foreign investment in agriculture.

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With regard to ASEAN concerns about China drawing away FDI, Wei and Dutta point out that global FDI flows have doubled since 1997 and that investment in the service sector amounts to a growing share of this expanding total. ASEAN has seen the services share of inward FDI rise, a transition that occurred with the NIEs at an earlier time and in China following afterward. Comparative advantage among the region’s economies is changing over time, and policies to encourage investment inflows must change in support of this evolutionary process. Chyau Tuan and Linda Ng also look at FDI inflows to China focusing their attention on the region that has received the greatest concentration of such inflows, the Pearl River Delta area of Guangdong Province adjacent to Hong Kong. They note that long after liberalization policies have spread nationwide and local costs of doing business have risen well above levels elsewhere in China, the region continues to dominate FDI inflows. To explain this, they appeal to agglomeration economies in a core-periphery system with Hong Kong at the core. Initially, as China began its opening more than 20 years ago, Hong Kong firms spun off their own manufacturing operations to the Pearl River Delta area. With the passage of time, Hong Kong came to specialize increasingly in the provision of sophisticated financial, legal, and trade services. As of 2000, re-exports topped exports for Hong Kong by a factor of 8, and the export to GDP ratio reached 128 percent. The authors examine patterns of declining density with distance from the core using firm concentration data for the population of 38,000 foreign joint ventures by county for Guangdong’s 104 counties. They find that the Hong Kong gravity effect is more pronounced for smaller than for larger firms and for manufacturing than for service firms, but that there is no difference by source of investment, Hong Kong versus elsewhere. Thus the appeal of proximity to Hong Kong transcends the power of being close to home for local investors. Because Hong Kong has such a strong tradition of small-scale manufacturing, the core-periphery pattern of dispersion in this region stands out with particular clarity. FDI is an important means by which developing countries receive transfers of technology, and China has benefited a great deal in this regard from its large FDI inflows. With Korea in particular though, efforts to develop technology exchange have gone well beyond FDI inflows asYang-Taek Lim documents. Korea and China have catered to mutual advantage in their technology relations. Korea is in a position to offer capital investment but needs

Introduction

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China’s sheer numbers in high-tech staff and size of market. Further, Korea has a technological edge in assembly and labor-intensive manufacturing whereas China is stronger in basic science. Thus, for instance, Korea is a world leader in memory semi-conductor technology but draws from China in the underlying science of materials fabrication. To promote technological exchange, formal agreements have been signed, research institutions have been established, regular visits by scientists and technicians have been carried out, joint research has been supported, and cooperative production ventures have been launched. All this has yielded the important side benefit of ameliorating political tensions fostered on the Korean side by fears that China poses a competitive threat in developed country markets and on the Chinese side by sensitivity over the large bilateral trade deficit held with Korea — the largest in fact between China and any trading partner other than Taiwan and Hong Kong. The Chinese sensitivity over trade imbalances has erupted in the country’s targeting 14 anti-dumping cases against Korea of a total 18 since a mechanism for bringing charges was defined in 1997. As close neighbors who did not even establish diplomatic relations until 1992, Korea and China must cultivate the positive, and technology cooperation is a prime venue for this. 2. Financial Stability, Crisis Recovery, and Exchange Rates The Asian financial crisis of 1997–1998 brought attention to the interdepence of the region’s economies. Tzong-shian Yu chronicles the ripple effect of the financial crisis as it spread through Asia and the further impact of the “New Economy slump”. The trigger for the financial crisis was Thailand’s depegging of its currency on July 2, 1997. The resulting loss of investor confidence reverberated through the region, causing real estate and stock markets to plummet. Beyond Thailand, other economies hard hit were Indonesia, Korea, Malaysia, Hong Kong, and the Philippines. Then just as recovery began to take hold in 2000, the US stock market collapsed and its technology sector went into a downturn. Asian countries that relied on the US market for technology exports — most notably Taiwan and Singapore — felt the greatest impact, but again the rest of the region suffered declining stock market and currency values too. China came through both these maelstroms relatively unscathed, and indeed helped to brace the entire region. As its neighbors’ currencies were dropping in value all around, China committed to maintaining its peg thereby

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yielding a competitive advantage in export markets to those countries in crisis. Moreover, China’s expansionary macroeconomic policies fueled its growth domestically, generating rising demand for inputs to production that could be sourced from the region. Robert Mundell maintains it was the instability of the yen-dollar exchange rate that brought about the financial crisis. Appreciation of the dollar caused Asian currencies tied to it to become overvalued, making them “sitting ducks for speculators”. More generally, the enormous instability in exchange rates between the major currencies — the dollar, the euro, and the yen — has made it difficult for third countries to manage their macroeconomic and financial policies. Mundell advocates that Asia adopt a common currency for international transactions, although for domestic purposes national currencies could be maintained. The common currency would need an internal or external anchor. Candidates for an internal anchor are the yen and the renminbi, but a choice between these two would be politically problematic. Besides, the renminbi is not convertible and China’s financial system is not well developed while Japan has its own macroeconomic and banking system problems. So an external anchor is called for, and for this the US dollar presents itself. The renminbi and the Hong Kong dollar are already pegged to the US dollar. The major problem is the instability in the yen-dollar rate. It would be of great benefit to Japan and the region, in Mundell’s view, for Japan to stabilize the value of the yen with respect to the dollar. Barring this, a currency area could be defined on ASEAN plus China and Korea, excluding Japan. China would have to take the lead. A first step could be to dollarize Hong Kong which has ample dollar reserves to retire its domestic currency. This would then become “the platform on which anAsian currency area could be built”. The euro provides a model of how currency union can succeed. Mundell tells us the process of unification went smoothly “because the locking of exchange rates was completely credible, and because the mechanism for adjusting the balance of payments was well understood and was allowed to work”. That is, domestic monetary policies were strictly subordinated to maintaining the system of exchange rates. Under such a regime, Mundell claims, speculative capital movements do not pose a threat. Juergen Schroeder elaborates on the European monetary system and evaluates its performance. The system rests on an independent central bank which is charged with maintaining price stability. For the euro

Introduction

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to become accepted as an international currency, it is critical that its value be maintained. Unexpectedly, in its first years of existence from 1999 to 2002, the euro fell in value relative to the dollar. Reasons for this include: (1) real factors such as faster growth in GDP and productivity in the US than in Europe; (2) capital market factors, specifically larger government deficits and more bond financing in the US than in Europe; and (3) expectations factors related to EU unemployment and labor markets, the tax system, the macroeconomic impact of adding new members, and uncertainty about the political commitment to price stability. Even so, there is evidence that the euro is gaining in acceptance internationally, as witnessed by its rising shares in international bonds issued by non-residents and in bank assets held by nonresidents. Against Mundell’s proposal to fix exchange rates in Asia and the European example, Mardi Dungey examines sources of volatility in Asian real exchange rates (the nominal exchange rate with respect to the US dollar times the ratio of the domestic price index to the dollar price index). Stability in the real exchange rate is good for a country’s business climate. However, shocks that affect a country’s terms of trade (prices on world markets for its exports relative to its imports) must be absorbed somehow. Dungey develops a model to empirically discern the sources of real exchange rate volatility, distinguishing between domestic factors and international factors under a latent variables specification that hinges on variance decomposition. She adds to this model an explicit variable for terms of trade variability and allows for interaction between the latent factors and the terms of trade. To the extent that domestic factors dominate in explaining real exchange rate volatility, there may be scope for domestic policy to moderate this variability. However, to the extent that international factors, including terms of trade shocks, impinge, domestic policies may have little scope for stabilizing real exchange rates. Stabilizing the nominal exchange rate would merely channel volatility to the domestic price level. Dungey applies the model to a sample of six Asian countries — Indonesia, Malaysia, Thailand, the Philippines, Pakistan, and Sri Lanka — for the period 1967 to 1998. In Dungey’s sample, greater exchange rate variability is generally associated with a stronger contribution to variability from domestic factors, although variability in the terms of trade can also be a critical force. The country with the greatest terms of trade volatility — Pakistan — had the greatest exchange rate volatility but also had the second

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largest share of volatility traceable to domestic factors. Similarly Sri Lanka showed very high levels of exchange rate variability, with both a high domestic factor share in explaining variability and strong terms of trade variability. The four countries of Southeast Asia in general showed less real exchange rate variability due to domestic factors and more, commensurately, due to factors common among the sample countries. Among this group of four though, the Philippines showed both the lowest real exchange rate volatility and the lowest share in volatility due to domestic factors despite quite high terms of trade volatility. It stands to reason that the four Southeast Asian countries would show more common factor variability relative to variability from domestic sources, given the greater degree of regional integration among these economies vis à vis the other two included in the sample. Regional integration can have the beneficial consequence of bringing collective pressure to bear on individual countries to maintain stable macroeconomic policies, precisely because it exposes each country to the economic perturbations of the others. Within East Asia, one of the greatest threats to regional macroeconomic stability lies in the troubled banking systems of the major economic powers. This volume contains papers examining each of the Japanese and the Chinese banking systems. In his study of the crisis in Japan’s banking system, Yoshinori Shimizu traces the root of the problem to the moral hazard common among countries undergoing rapid change in their financial systems. The problem in Japan has resulted in fiscal costs — estimated by Shimizu at 139 trillion yen — that far and away outstrip those of any other country in absolute terms. Relative to GDP though, a number of countries have experienced worse, in Asia these including Indonesia, Thailand, and Korea in connection with the Asian financial crisis. Japan is home to the world’s largest bank groups based on asset value. Shimizu argues that the incentive for mega-bank mergers has not been to achieve economies of scale but rather to gain such size as to escape the capacity of regulators to discipline — “too big to discipline adequately” or TBTDA. He tests this hypothesis by analyzing the effect of merger announcements on bank share prices for 11 mergers, regressing share price change relative to the Nikkei index on asset value of the counterpart banks in the merger. The coefficient estimate on the asset variable is significantly positive indicating that share prices tend to increase with the asset value of merger partners, while the intercept estimate is negative implying that

Introduction

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prices decline if the absorbed bank is sufficiently small. The interpretation is that the small bank in a lopsided merger gains by crossing the TBTDA threshold whereas the large bank, having already crossed that threshold, suffers loss of efficiency in becoming yet larger. In the long run, as the postmerger mega-bank falls victim to the poor lending practices that result from the moral hazard of TBTDA, its share price would be expected to decline, as indeed is observed to be the case. Shimizu maintains that the key to overcoming the moral hazard that leads to banking crises lies in establishing a regulatory and supervisory system that is roundly expected to follow through on enforcement. This has not happened in Japan. Historically, government protection prevented new entry into the industry, and under this cover bank operations were subject to all sorts of discretionary government controls; thus market discipline was kept at bay. The financial crisis has forced the country to move toward establishing an effective supervisory and regulatory framework and to commit to enforcing the rules firmly and uniformly. Yan Guo raises very similar issues in his examination of the Chinese banking system. The system is rife with moral hazard, and Guo doubts whether this can be overcome by the recent establishment of an independent bank regulatory commission. China’s banking system is dominated by four large state-owned commercial banks that oversee a vast network of local branches administered in parallel with the ranks of local government. The fundamental problem in regulating the banking system lies in the influence that local governments at various levels exert over counterpart local bank branches, a problem inherent in the hierarchical structure of the stateowned banking system. Professional advancement of not only bank officers but bank regulators as well rests on their pleasing superiors in the local government hierarchy. Constant government interference in bank business not only undermines managerial responsibility but provides a convenient excuse for poor performance. This is the crux of the moral hazard problem. Efforts to fix China’s banking system have not addressed this fundamental problem. The banking system is burdened with a huge overhang of non-performing loans, some of which have been spun off into asset management companies to be bundled and sold. Because these loans were made under government direction, it is appropriate that government bear the losses. However, the government’s capital injections to banks have been insufficient to clean up the problem, hence future injections are taken for granted and the moral hazard problem is perpetuated. To encourage a greater

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sense of local responsibility, branch banks have been allowed a degree of autonomy in lending since 1998. They have nevertheless operated within their lending quotas for fear of incurring penalties attached to new bad loans where any compensating rewards on the upside are slight. The result is that funds go unused for lending even as promising upstarts in the private sector fail to get financing. Finally, the government has moved aggressively to close and merge small unprofitable branches. However, this has been approached in an arbitrary manner without attention to market forces. In one notable respect though, the central government has taken visible action against the moral hazard problem. In some very high profile cases, it has moved to shut down insolvent financial institutions, forcing creditors to bear the losses. A few of these cases have even involved foreign investors, for example the Guangdong International Trust and Investment Corporation. This particular case served as a landmark in warning creditors of their responsibility for monitoring the behavior of financial institutions. In Guo’s judgment however, none of the measures taken thus far, in particular the establishment of the bank regulatory commission, will achieve the goal of creating an efficient well-functioning banking system. For that, it is necessary to change the fundamental incentive structure on which banks operate and to eject government from bank decision making. Building sound banking systems can help avert crises. Stephen Reynolds, Somchai Ratanakomut, and James Gander look at the microeconomic foundations for recovery from crisis. Their question is whether firms that are in good health when the crisis breaks recover more quickly than those that are not, where good health is judged by key financial ratios. They address this question using firm-level data for eight countries, with sample sizes by year for the three recovery years 1997–1999 on the order of 650 to 1300 firms. In alternative model formulations, they regress either the presence of positive sales growth or the rate of sales growth on lagged values of the ratios of short-term to total debt, long-term debt to shareholder equity, and after-tax profits to short-term debt. Lower values of the first two ratios and higher values of the third are expected to contribute positively to firm recovery. The results confirm that good firm-level financial health contributed to both better performance during the crisis and faster recovery from negative growth subsequent to the crisis. In those countries which suffered most during the crisis (Thailand, Indonesia, and Korea), firms showed faster growth in the years after the crisis than in the benchmark economy, Singapore, which suffered little, indicating that re-emergence can be very quick if preconditions are good.

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3. Institution Building and Clout of the Region Globally The financial crisis heightened the sense of economic interdependency in Asia and impressed upon leaders the need to approach their nations’ interconnectedness constructively. Further, the trend toward formal continent based organizational structures in the Americas and Europe has left Asia feeling the need to play catch up. Recent years have seen a great deal of activity in Asia aimed at institutionalizing economic cooperation. Shin notes that the number of trade associations in the region leapt from only two in 1995 to 16 in 2000. Most of these involve lesser forms of cooperation but hold visions of becoming full-blown free trade areas over time. Two of the most important free trade areas — AFTA and SAFTA — are outgrowths of regional cooperation bodies — ASEAN and SAARC, respectively — that initially focused on areas of cooperation other than trade and continue to emphasize broad based engagement in cultural, health, and environmental affairs. The largest association in the region at 21 members is APEC. Other Asia-Pacific regional associations that receive attention in this volume are CAREC, CER, ECO, MSG, and SPARTECA. It is an issue of debate whether regional associations further the cause of global integration or undermine it. Dutta points to Europe as “the learning model for an integration of regionalism and globalism”. He notes that the EU has a higher ratio of external trade to GDP than does either the US or Japan, indicating that regional economic integration there is associated with greater openness between the region and the rest of the world relative to a single large-country standard. In their empirical study, Clarete, Edmonds, and Wallack demonstrate that the major PTAs of Asia — APEC, AFTA, and SAFTA — have low and declining trade concentration ratios, revealing that member countries trade with each other at about the same rate they trade with the rest of the world. On the other hand, they note, these PTAs have not made particularly great strides in achieving economic integration. Overall, the work of these authors demonstrates the diversity in the effect of PTAs, some being trade creating and others trade diverting. APEC stands out for its express goal of open regionalism, the intent being not just to stimulate trade among members but to prod them to open their markets wider to the world. ADB Vice President Shin takes the position that regional economic cooperation has the important benefit of increasing trust and mutual understanding, which can only be a positive force globally. ADB’s approach is “to emphasize membership in the global multilateral trading arrangement

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while continuing to pursue limited RTAs that prioritize broader aspects of regional cooperation”. Many of the authors in this volume see the development of regional cooperation in Asia as a healthy countervailing force to the American and European blocs. Dutta argues that integration within Asia, by putting the region on a more competitive plane with the EU and the US, actually advances the forces of globalism.Asian countries taken individually account for small shares in world GDP and trade flows, but as a block become a presence to be reckoned with. To achieve real economic mass though, the region’s largest economies must be brought into the fold. The ASEAN-5 had a share in world GDP in 1997 of only four percent versus 20 percent for the EU and 21 percent for the US and a share in world exports of just five percent versus 39 percent for the EU and 14 percent for the US. Add China, Hong Kong, Taiwan, and Korea to the ASEAN-5 and the shares reach 21 percent for GDP and 18 percent for exports. Dutta expands on the role of regional integration in furthering globalism in the context of the current international milieu. The multilateral organizations established in the aftermath of World War II for a time provided a global institutional infrastructure of inclusion which was supportive of economic development. But with the collapse of the fixed exchange rate system and WTO paralysis in bridging the world’s rich and poor nations, the global infrastructure is no longer up to the task at hand. When smaller countries feel marginalized, they are more inclined to challenge the order of globalization. Through regional association with more economically advanced neighbors however, poorer nations can be aided in the transition toward regional and thence global integration. Jingyi Ye also views stronger Asian regionalism as bringing advantages on the global stage. She sees the EU’s emergence as a competitor to the US as instrumental in pushing the US to shift away from a purely global orientation and take up regional cooperation in North America. Asia must now become the third major regional bloc in order to bring about a tripartite balance, but cannot do so without China or Japan as part of the process. As Ye sees it, by becoming more unified, Asia can follow Europe’s model in furthering globalization by guarding against the dislocations that ultimately fuel protectionism and retreat. By using its weight in international negotiations, the EU has been able to effectively protect its agricultural sector while at the same time helping European manufacturers break into the US market. And with its achievement of monetary union, Europe has been

Introduction

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able to insulate itself from the impact of dollar fluctuations with respect to diverse national currencies. The process of building an Asian community is moving forward piecemeal on many fronts simultaneously. Chirathivat tells us Singapore is negotiating with Japan, the US, Australia, New Zealand, and Korea; Thailand is engaged in discussion with China, Australia, and New Zealand; Japan and Korea are considering a free trade agreement. Yu finds increasing support for a Greater China Economic Community, noting that China already has an FTA planned with Hong Kong and Macao and that incorporation of Taiwan would round out this bloc. Despite political difficulties, the cross-straits economic relationship is steadily building on the strength of tremendous flows of FDI and managerial talent from Taiwan to the mainland. But the real foundational building blocks for continent-based union are AFTA and SAFTA. Saleem M. Khan and Zahira S. Khan tell us that progress toward economic integration in South Asia under SAFTA has been slow due to political tensions and mistrust among member countries. Leaders have been preoccupied with territorial disputes and political conflicts that stretch back for decades. Poor governance and corruption have also taken a toll. A heavy handed role of government in allocating resources toward capital intensive industrial projects and inputs to defense in defiance of the region’s comparative advantage has contrasted negatively with the successful outward orientation of Southeast Asia. South Asia has thus lagged behind much of the rest of Asia in its economic development and export performance. The Khans review the statistical data to show that in the 1960s, the level of development in India and Pakistan was on par with that in Korea, Malaysia, and China. The gap that has emerged over the subsequent decades they describe as “shocking as an indicator of missed potential”. SAFTA is the outgrowth of SAARC which was formed in 1985 by seven nations of the sub-continent. The organization has a constructive role to play in pushing members to liberalize their economies and open up to trade in concert with global trends. Also in keeping with global trends, the Khans believe the association may find opportunities to expand inclusion by looking north to Central Asia, or west to Iran and Afghanistan, or east to Myanmar and Laos. AFTA is the more dynamic building block in the movement toward continent-based integration. The original ASEAN-6 signatories have substantially eliminated tariff barriers among themselves, and the CMLV

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members are following a planned phasing out of barriers over time. With dramatic implications for the region, China and ASEAN have agreed to establish a free trade area by 2010 and have begun a program of “early harvest” tariff reductions aimed at that goal. Japan and Korea are also in discussion with ASEAN to form bilateral FTAs. Ye brings insight to the approach of using AFTA as a jumping off point for broad based Asian economic cooperation. She describes the process as the “10 + 1 Mechanism” where the +1 is taken three times to bring in China, Japan, and Korea each on its own terms through separate negotiations. She finds merit for this strategy, which rests on multi-faceted ASEAN-bilateral dealings, to overcome obstacles that would impede progress in any pan-East Asia approach to seeking economic union. These obstacles are political and cultural in nature, not economic, Ye explains. One such obstacle is the “sovereignty constraint” which refers to the sensitivity in relinquishing sovereignty of countries that have lived under colonial domination within living memory. As Ye puts it, the humiliating experience of being colonized has “left the hearts of Asian peoples deeply scarred”. She sees a reflection of this in the weak institutional structures of ASEAN which result from an unwillingness to cede authority. Thus ASEAN has “no arbitration mechanism for resolving disputes, no organ or system for censuring behavior of member countries, and no entity vested with management powers”. Rather, its institutional existence rests on ongoing meetings among heads of state and their ministers and on the proclamations these meetings generate. A second obstacle presented by Ye to achieving pan-East Asian economic unity lies in the great diversity of the region with respect to race, religion, language, and political system. According to Ye, “this makes it difficult to develop any sense of unity in values and goals”. A third obstacle is created by whatYe refers to as the region’s “leadership dynamics”. On the one hand, the US is a strong hegemonic force; on the other, none of the region’s local powers is granted leadership legitimacy by the rest of the pack. US influence results in part from the country being in many cases the single largest but in all cases one of the largest trading partners of the economies in the region and in part from the military and political reliance many of the region’s countries have on it. Ye sees US exercise of its influence in Asia through the vehicle of APEC as detracting from local efforts to achieve autonomous regional cooperation. However, in the absence of US hegemonism, neither Japan nor China is in a position to

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assume a leadership role. Although Japan has long possessed the strongest economy in East Asia and has led many countries of the region in their development under the “flying geese” paradigm, its World War II history leaves residual feelings of resentment and distrust. Moreover, the flying geese formation is itself in flux due to Japan’s protracted economic slump and the NIEs’emergence to compete with the longstanding leader directly in many areas. As for China’s leadership candidacy, the country’s phenomenal economic growth and rising influence on the world stage result in its being regarded as a threat in some quarters. Given the dearth of acceptable candidates for a leadership role, ASEAN can become a fulcrum for advancing regional economic cooperation. Its achievements in building cooperation internally create a foundation. By structuring further alliances on bilateral terms with each of China, Japan, and Korea, direct competition among the region’s major powers is avoided. In this way, Ye sees the mechanism of 10 + 1 taken three times as a roundabout approach for achieving 10 + 3 where the direct approach would prove intractable.

4. China’s Presence Ye captures compellingly the sense of process that must guide China’s assertion of its presence in Asia. The country has become an economic powerhouse of global rank, and it has done so by engaging internationally. As Shin puts it, “China already has an open economy”. Its trade-to-GDP ratio is 40 percent as opposed to roughly 20 percent for Japan, the US, and India. Its FDI inflows in recent years have amounted to 17–18 percent of GDP versus six percent for the US. Increasingly, China is using its economic might to take a leadership position in international forums. Shin holds that China’s membership in WTO “will likely lead to better balance in multilateral trading arrangements”. Developing countries find common interest in reducing non-tariff barriers to trade, fighting anti-dumping rules, and eliminating agricultural protection in developed countries. China’s voice in these matters carries weight. China has come very far very fast since the inception of economic reform and opening 25 years ago. But in some respects, its economic progress may be precariously perched. The insolvency of its banking system

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and scale of non-performing loans pose a potentially serious threat to stability, and even absent a crisis the financial system does a poor job of allocating capital resources causing a drain on continued growth. Rural poverty remains widespread even as urban incomes are rising, and productive absorption of rural migrants to the cities remains a formidable challenge. The political process is non-transparent and non-institutionalized and the information system severely crippled in its development. The more tied to China other economies in the region become, the greater the danger of repurcussions should China’s economy falter. Granting that China’s leadership role is growing through the opportunities its dynamic economy creates for regional trade and investment and that its voice carries increasing weight in international forums on issues of importance to the developing world, China is nevertheless not regarded as a leader by its neighbors in terms of being a model. China is to be commended as the lone former command economy to have found a stable path, thus far, through the transition process. But its economic system, and more broadly the social system of which the economic system is a part, do not invite regional emulation. The institutions that Asia will put in place as its cooperative model develops must derive from elsewhere.

Regional Economic Integration


Inaugural Address∗ Myoung-Ho Shin Vice President, Asian Development Bank Manila, Philippines

Ladies and gentlemen, good morning. I wish to thank our hosts, the Peking University School of Economics, the American Committee on Asian Economic Studies, and the China Reform Forum, for inviting me to speak. It is an honor to address such a distinguished gathering. Today, I will address three main topics: first, how best to pursue the goal of regional cooperation; second, ADB’s activities in the PRC and in promoting regional economic cooperation; and third, the possible implications of PRC membership in the WTO. This conference is indeed timely in light of recent trade developments and new proposals under consideration. We need to understand their implications. We need to undertake the economic analysis that underpins good policy formulation. We need to assess the effects of alternative arrangements for trade integration on regional and global trade patterns. We need to assist policymakers to identify winners and losers. And we need to improve our understanding of the implications of trade integration on growth patterns across sectors. Economists use many analytical tools and techniques. This conference will undoubtedly provide an excellent opportunity to consider recent research applying these approaches, and I hope it will help share recent methodological advances. More importantly, the conference can help form some consensus on the important trade policy issues of the day, such as: How will continued PRC integration into the world economy affect trade flows? What domestic policy frameworks best enable developing countries ∗

Reprinted from Journal of Asian Economics, Vol. 13, No. 4, Myoung-Ho Shin, Asian economic cooperation in the new millennium, Pages 441–446, 2002, with permission from Elsevier. 21

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to benefit from regional cooperation? What are the pros and cons of regional initiatives for economic cooperation and global or multilateral initiatives? The conference will have been a success if it helps shed light on these questions, and if it indicates useful avenues for further research on trade and regional economic integration. A key policy question is how to achieve greater benefits from increased openness to trade. Although there is debate about the extent of the short-term adjustment costs of openness, there is widespread agreement that increased openness has a significant long-term positive impact. Accordingly, developments in regional trading agreements, or RTAs, and in the broader multilateral trading system carry important implications for both growth and poverty reduction. We can be, I think, optimistic about increasing global trade and increasing integration, including expansion of RTAs in the region. Globally, trade growth has enabled Asian economies to increase per capita income and reduce the incidence and severity of poverty. As trade has grown so has the number of RTAs. The WTO has received notification of 30 multilateral RTAs and 58 bilateral arrangements established in the past three decades. In the Asia and Pacific region, the number of RTAs has grown from two in 1995 to 16 in 2000. Others are under consideration. Virtually all global trade involves countries that are members of at least one RTA, and ADB estimates that about 97 percent of global trade involves countries that are members of RTAs. This compares to 72 percent in 1990. RTAs may be economically beneficial or harmful. While many refer to them generically as good or bad, I think we must look more carefully before making judgments. In general, the Asia and Pacific RTAs are less institutionalized than those in Europe, Latin America, or North America. There are no customs unions in our region. Dispute settlement tends to be handled bilaterally, with few formal mechanisms for resolution of disagreements. And much of the implementation of RTA agreements, such as application of rules of origin, takes place subnationally. Three typical Asian RTAs that extend reciprocal preferential treatment are the ASEAN Free Trade Area (AFTA), the Melanesian Spearhead Group (MSG), and the South Asia Preferential Trading Area (SAPTA). AFTA and SAPTA are outgrowths of regional cooperation bodies (ASEAN and the South Asian Association for Regional Cooperation or SAARC, respectively). They encompass a wide range of cross-national interactions in cultural, health, environmental, and other areas, in addition to trade. The

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general characteristics of Asian and Pacific RTAs make them less likely to increase trade between member countries by diverting trade away from non-member countries, and more likely to augment trade. In advancing the goal of trade liberalization, these RTAs have achieved only modest tangible success. AFTA has perhaps been the most active in drawing up a timetable whereby tariffs are to be reduced with the intention of eventually evolving into a true free trade area. MSG involves Pacific Island countries. Trade volume among member countries is low and these economies remain oriented toward the larger Australian and New Zealand markets. With its adherence to the principal of open regionalism, APEC merits special mention as a non-preferential trading arrangement that appears to advance regional and global free trade. Despite the rapid growth of RTAs over the past few decades, the debate over the role of RTAs in increasing trade openness is far from resolved. Disagreement remains over whether RTAs are building blocks or impediments to the realization of global free trade and whether RTAs can coexist with the international trading framework. The conclusion of a recent ADB study was that the region should continue its historical efforts that emphasize membership in the global multilateral trading arrangement while continuing to pursue limited RTAs that prioritize broader aspects of regional cooperation. Turning now to ADB, since the early 1990s it has actively supported regional and subregional cooperation, particularly in the Central Asian, South Asian and Southeast Asian areas. The events of September 11 and its aftermath have made regional cooperation even more vital, particularly in the South and Central Asia region where economic cooperation between neighbors can help increase trust and mutual understanding and foster regional stability. ADB actively supports the Central Asia Regional Economic Cooperation initiative, the Greater Mekong Subregion program, the South Asia Subregional Economic Cooperation program, the Indonesia-MalaysiaThailand Growth Triangle, and the Brunei Darussalam-Indonesia-MalaysiaPhilippines East ASEAN Growth Area. Let me look a little more at the Central Asia Regional Economic Cooperation program. The CAREC program’s operational strategy is to finance infrastructure projects and foster policy reform to promote cross-border activities in the areas of energy, trade, and transportation. The People’s Republic of China (in particular the Xinjiang Uygur Autonomous Region), Kazakhstan, Kyrgyz Republic, Tajikistan, and Uzbekistan take part in the

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program, and Azerbaijan and Turkmenistan are expected to become active. The Central Asia region’s isolation and its small domestic markets make the potential benefits of cooperation large. Efficient, rational use of Central Asia’s natural resources can be fostered by cross-border cooperation. This year ADB has stepped up its assistance in support of regional cooperation in Central Asia. There are new projects aimed at rehabilitating key sections of the regional transport networks, assisting in the reconstruction of post-war Afghanistan, and rationalizing the use of regional energy networks, and new initiatives in energy/water sector including one aimed at harnessing hydropower potential in Afghanistan. Dialogue seeks to build support for trade liberalization in the region — especially reduction of nontariff trade barriers — that would complement ADB support in cross border infrastructure development and other initiatives. ADB and our partners in Central Asia have recently established a framework committing ADB and its partners to an Annual Ministerial Forum to build trust and understanding, set priorities, and mobilize and coordinate the use of resources. The first Ministerial Forum was held in March, 2002. Let me turn now to my second major topic. ADB takes great pride in its partnership with the PRC and congratulates the country on its many recent achievements — sustaining the growth of its economy despite the global economic slowdown, and beginning its membership in the WTO. I might even mention here its qualification for this year’s World Cup, where, who knows, it may yet face my own country, Korea! Since the PRC became a member of ADB in 1986, we have supported the country’s transition to a market-based economy. ADB’s loans, technical assistance grants, and policy consultations have covered many areas. Cooperative efforts have ranged from loans for physical infrastructure and environment projects, to promoting human development by supporting education and social protection in the country, to providing policy support for implementing policy and institutional reforms, and to improving the capacity of government agencies. During the 1990s, ADB’s lending to the PRC averaged roughly $1 billion a year. By the end of 2001, total lending was more than $11 billion. In addition to loans, ADB has provided the PRC with technical assistance valued at more than $200 million. During the next three years, ADB’s lending to the PRC is expected to total about $3.5 billion. Consistent with an increased emphasis on poverty reduction, the PRC government and ADB have agreed that promoting development in the interior provinces will be the focus of future efforts. A goal of 70 percent of total lending to the PRC is targeted for this region.

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Membership in the WTO seems certain to increase the PRC’s participation in the global economy and its voice on trade issues. WTO membership will of course force adjustments in the Chinese economy as trade and investment barriers are lowered, tariffs and quotas reduced, and restrictions on the provision of a broad range of services phased out. The adjustments will raise the need for policies to mitigate any adverse affects on the poor. Even before the PRC joined WTO, the economy was being opened to international trade and investment. In terms of trade-to-GDP-ratio, China already has an open economy. The ratio is about 40 percent compared to 20 percent in Japan, the United States, and India. Likewise, in recent years, foreign direct investment in the PRC economy has equaled 17–18 percent of total investment compared to six percent in the US. China would probably have lowered its import barriers whether it joined the WTO or not, but membership will likely compel faster liberalization. Membership will likely provide greater momentum to trade reform and provide policymakers a clear mandate to see reforms through in the face of inevitable resistance from entrenched domestic interests. It will also make the PRC a more predictable trading partner. Foreign enterprises will gain better market access. Already strong foreign direct investment should now increase further, and foreign companies will be able to enter China’s less developed service markets. While WTO accession will change the PRC, China’s membership will also change the WTO and the global economy. It will likely lead to better balance in multilateral trading arrangements. As the largest exporter among developing economies, the PRC may find itself representing the interests of the developing economies of Asia and elsewhere. However, there is a danger that greater membership of developing countries and rule changes may erode WTO unity and the will to pursue trade liberalization. In a worsecase scenario, this could lead some developed countries to abandon the WTO in favor of more limited multilateral arrangements. The WTO has succeeded in bringing down tariff barriers to trade in many economic sectors, but agriculture and services in particular have been addressed to a much lesser extent. Yet it is in these neglected sectors that export prospects for developing economies, including China, may be brightest. Also, the WTO has made little progress in reducing non-tariff barriers to trade, yet it is these barriers that can really injure developing countries. Anti-dumping rules and subsidies for agriculture are used in many developed countries, and make it difficult for developing countries to compete. Another important point for the PRC and elsewhere in Asia is that a domestic policy environment that provides incentives for efficient

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investment and resources deployment is essential if countries are to benefit fully from greater economic integration and cooperation. In this regard, much remains to be done throughout the region. Setting a policy environment conducive to private sector development is key to growth and development. It is the private sector that generates most new jobs. Encouraging small and medium-sized enterprises is particularly important, because such enterprises tend to be both labor-intensive and dynamic. But growth of the private sector requires a sturdy legal and institutional framework, proper investment incentives, fair competition, and efficient factor and product markets. Creating such conditions is a tall order. Sustainable economic growth and development also requires more social protection and education, better environment protection, appropriate restructuring of state owned enterprises, and stronger banking and finance sectors. Succeed in these areas, and the PRC and others will be certain to reap the benefits of trade integration and regional cooperation. As a regional development institution, ADB has a responsibility to assist developing countries in the region to spur growth in pursuit of attainment of the Millennium Development Goals. ADB is optimistic about the longterm growth prospects for the region, but not complacent. Globalization, trade liberalization, technological advances — especially in information and telecommunications — make regional cooperation easier and more essential than ever. Globalization is both welcome and inevitable. But it brings turbulence and uncertainty and the successful countries will be those that handle variability best.

Globalization: What It Is and Who Benefits∗ D. Gale Johnson Professor, Department of Economics University of Chicago Chicago, Illinois, USA

Globalization is now a center of attention for various groups — those who oppose trade liberalization, those who are opposed to capitalism, those who believe the world is becoming homogenized by trade, by international investment, by communication — movies, radio and TV — and by McDonald’s. Globalization is also blamed for the rising inequality of income that has come about over the past two or three centuries. An opposite viewpoint is that inequality has increased because globalization has not spread far enough, fast enough. At one time not so long ago, there was relatively little inequality in the world. Maddison’s estimates for 1000 indicate that the per capita income of Asia was ten percent greater than in Western Europe (Maddison 2001). Today the difference in income from the highest to the lowest region is enormously greater — approximately 19 times (Maddison 2001). When the world had little inequality, it was poor. Virtually every one was poor, very poor. This was true in Western Europe as well as in Asia and the other continents. The World Bank estimates that in 1820, 75 percent of the world’s population lived on less than $1 per day (1985 prices) (World Bank 2000/2001, 45). This is the standard that the World Bank uses to define poverty — severe poverty. Today, 20 percent of the world’s population lives on less than $1 per day. Not a single country now has as high a percent of their population living on less than $1 per day as existed in the world in 1820. ∗

Reprinted from Journal of Asian Economics,Vol. 13, No. 4, D. Gale Johnson, Globalization: what it is and who benefits, pages 427–439, 2002, with permission from Elsevier. 27

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Globalization has consisted of far more than the international movement of goods and investment. These aspects of globalization have been the more obvious but perhaps less important. It has been the flow of ideas and knowledge that has had the greatest impact on people in the developing world. 1. What Made Globalization Possible and Effective? Globalization is a recent phenomenon in human history. There was little movement among the continents of either goods or ideas prior to the 16th century. Five developments have had a major role in making globalization both possible and effective in improving the well-being of the majority of the people of the world. 1. Knowledge. There has been an enormous increase in knowledge since 1750. Nearly all scientific knowledge related to living things — people, animals, and plants — has come in the last two and a half centuries, most since the mid-19th century. 2. Faster and cheaper transportation. The improvements in transportation that came with the steamship, the railroad, the auto, and the airplane have been enormous and have forever changed the relationships among the continents. With the improvement in transportation, goods, services, and ideas could flow much more easily from one place to another. 3. Faster and cheaper communication. Imagine how long it took for a letter to go from London to Tokyo 200 years ago. Imagine the impact of the telegraph that became available in the last years of the 19th century, plus the addition of the telephone and then the radio and satellite television. The flow of ideas has increased enormously within the last 150 years. 4. The growth of income that permitted the expansion of trade. An important component of globalization has been trade in goods. Higher income combined with the lower cost of transportation and communication increased the flow of trade in the 20th century. 5. Reduction of barriers to trade, especially following World War II. In 1950 world export was 5.5 percent of world gross domestic product; in 1998, it was 17.2 percent (Maddison 2001). 2. Why the World is Different Now: Knowledge It was not so long ago that life expectancy at birth was 25 to 35 years (Bogue 1969), 75 percent of the people consumed less than $1 per day, very few

Globalization: What It Is and Who Benefits

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were literate, and 80 to 90 percent of the world’s labor force was used to produce food. The world today has no more natural resources nor more sunlight nor more rain than it had 200 or 2000 years ago. Nor are the laws of nature different today. Yet the world produces vastly more in total and per capita terms than ever before — in 1990 the world’s output of goods and services was 40 times what it was in 1820 and per capita output was about seven times as great (Maddison 1993). What makes the world so different now is knowledge: we have a far better understanding of the laws of nature — of how to use our resources — human and natural — more effectively than ever before. The growth of knowledge was made possible by the improvement in agricultural productivity, which permitted releasing labor from food production to other activities and for cities to grow. In Western Europe from 1400 to 1800 there was no significant increase in the percentage of the population that was urban (from ten percent to 12 percent), but there was a large increase in the 19th century — in 1900, 38 percent of the population was urban (Johnson 2000). With the reduction in the percentage of labor force required to produce farm products and the significant increase in real per capita income in Western Europe and North America in the 19th century, institutions were created that made it possible for people to specialize in the production of knowledge. Research institutes, graduate universities, and agricultural experiment stations were inventions of the 19th century. Germany was the center of graduate education in the world in the 19th century; yet, as of 1900, all German universities and colleges had only 38,000 students and 1,830 faculty. In 1869–1870 there was only one Ph.D. awarded in the United States. In that year there were 52,000 students and 5,553 faculty in all colleges and universities in the United States. In the mid-1990s, there were 14.3 million students, 915,000 faculty, and 43,000 doctorates awarded (Johnson 2000). 3. Sources of Benefits of Globalization Globalization is generally associated with the flow of goods. And this is very important. In recent years several developing countries have gained enormously — South Korea, Taiwan, Hong Kong, Singapore, Japan, Chile — and all who opened their economies to trade have gained significantly. China, as a latecomer, has also gained a great deal — its real value

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of trade trebled in the 1990s. The advantage of trade to small countries can be enormous. In Europe small countries in the post-war period have grown at the same or higher rate than the large countries and this would not have been possible without relatively free trade. But no country is large enough or diverse enough to not gain from trade. But there is far more to globalization than trade and investment. Four aspects merit emphasis. First, in my opinion, is the flow of ideas. With rapid communication, an important new idea originating anywhere in the world can be known everywhere very quickly. But even in the days before communication was so cheap and rapid, some very important ideas were distributed throughout the world. One of the most important was the discovery of the germ theory by Pasteur in 1873. It was this theory that led to the discovery of the role of clean water and safe disposal of human excreta that contributed so much to the health of nearly all the people of the world during the 20th century. Until 1900 cities were not self sustaining — they were cesspools — deaths exceeded births and cities could grow only through migration. Second, the flow of capabilities — ideas must be transformed into either a product or a process, or both. An important source of reduction in child mortality in the last half century has been the availability of vaccinations against childhood diseases — the vaccines and the process are now available throughout the world. Third, the spread of literacy and education has been a major consequence of globalization. Literacy and education have moved from high to middle to low income countries. The increase in people’s capabilities due to literacy has been enormous. Illiteracy was dominant in the world, even in Europe and North America, two centuries ago and less than a century ago where most of the people of the world now live. Fourth, the flow of institutions and policies required for sustained economic growth. While there was a high degree of equality in the world 200 years ago, this is no longer the case. As will be shown later, the increase in inequality has not been because the poor have gotten poorer but because the rich have gotten far richer. The high income countries have adopted institutions and policies that resulted in long-term growth — protection of private property, the rule of law, enforcement of contracts, protection of individual rights, democracy, support of the market, and a fair and non-corrupt system of public finance. Where most of these institutions and policies have been largely accepted, there has been economic growth. Where they have


31

not been, the accomplishments have been modest. Unfortunately for the majority of the world’s population, the institutions and policies that have been associated with significant economic growth have not been adopted throughout the world. Discussions of increased inequality in the past two centuries seldom bother to ask why some countries have prospered while the majority have had slow rates of growth. It is clearly not because the Western Europeans, the North Americans, the Japanese, the South Koreans, and the Chinese of Taiwan, Hong Kong, and Singapore are more intelligent than the citizens of the rest of the world. These countries have done a few things right where others have failed. It is time that more effort is given to understanding why a few have prospered while many have lagged so far behind. Inequality has increased not because the poor became worse off but because the rich became so much richer.

4. Have the Poor Benefited? Let us now turn to the distribution of some of the major benefits of globalization. This examination will neglect the usual measure of economic growth and progress — changes in per capita income. In fact, for one large segment of the world’s population — the sub-Saharan Africa — it is estimated that real per capita GDP declined at an annual rate of −0.2 percent from 1965 to 1999 (World Bank 2001, 26); though for all low income countries, including sub-Saharan Africa, the growth rate was 1.8 percent (for the world, 1.6 percent). While 1.8 percent may seem small, it represents a doubling time of 39 years and more than a quadrupling in a century. Recent income growth rates for developing countries as a group are high by historical standards.

5. Life Expectancy Few people realize that as recently as three centuries ago life expectancy at birth did not exceed 35 years (Bogue 1969). For the world now it is almost double that, at 67 years (UNDP 2001, 144). But has globalization been effective in increasing life expectancy among the poorer nations of the world? Let us look at the data. Note that for the least developed countries life expectancy increased by almost 23 years from 1960 to 1997. In India in 1900 life expectancy

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D. G. Johnson Table 1. Life Expectancy at Birth, 1960, 1970, 1997 1960

1970

1997

46 39 40

54.5 43.4 44.1 62.0 49.0 60.1 71.4 59.1

64.4 51.7 48.9 70.0 63.0 69.5 77.7 66.7

All developing countries Least developed countries Sub-Saharan Africa East Asia South Asia Latin America and Caribbean Industrial countries World

69 53

Source: UNDP, Human Development Report, 1990 and 1999.

Table 2. Child Mortality, 1960, 1970, 1997 (Deaths per Thousand Children)

All developing countries Least developed countries Sub-Saharan Africa East Asia South Asia Latin America and Caribbean Industrial countries World

1960

1970

1997

2430 288 284

170 241 225 118 207 124 26 149

94 162 169 46 106 41 7 85

218

Source: UNDP, Human Development Report, 1990 and 1999.

was 23 years (Bogue 1969, 572); its life expectancy is now 63 years. The increase in life expectancy in the developing countries in less than 40 years equalled India’s life expectancy in 1900. What has been the primary source of the increase in life expectancy? It has been the decline in infant and child mortality. Child mortality is the rate of death for children under five years, and changes for developing countries over the past 40 years are given in Table 2. Between 1960 and 1997 child mortality in the developing countries fell by a remarkable 61 percent.


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In sub-Saharan Africa where real per capita incomes have stagnated for the past three decades, child mortality declined by 40 percent. Infant mortality rates for 30 low income countries, including China and India, fell from 157 per thousand births in 1960 to 62 in 1996 (Johnson 2000). In the United States in 1900 the infant mortality rate was 160 and in New York City it was 264. There can be no doubt that the benefits of globalization have become available to the poorer countries. The increase in life expectancy in the developing countries has been due primarily to the increased availability of clean water, improved sanitation, the availability of vaccination for childhood diseases, and increased food supplies. Improved methods of handling diarrhea through oral rehydration have also been effective in reducing child mortality and reducing stunting and wasting. Hardly any of these benefits would have been available to the poorer people of the world without globalization — the spread of ideas and capabilities. While data on the availability of clean water or safe water supplies are subject to a degree of uncertainty, the World Health Organization estimates that in 2000, 76 percent of the population of low income countries has access to “an improved water source” — formerly called access to clean or safe water (World Bank 2001). Access to a safe water supply has been an important factor in the reduction of infant and child mortality. 6. Increased Agricultural Productivity In the late 1930s grain yields were low and the same in developed and developing countries. And there had been no increase in grain yields for the previous century, either in the developed or developing countries. Data are presented for grain yields in the United States because annual data are available since 1866. Figure 1 gives corn yields in the United States for 1866 to 1997. The yield in 1800 was the same as in the 1860s (Cooper 1947, 3). Thus there was no increase in corn yields from 1800 to the 1930s — a period of a century and a third. But after the 1930s yields virtually exploded and are now almost five times what they were. Figure 2 shows wheat yields, which were the same in 1800 and the 1860s and are now approximately three times their level prior to 1940. It was not for lack of trying that grain yields stagnated during the first third or so of the 20th century. Substantial research efforts were underway for all grains but the first to succeed was the hybridization of corn, and

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D. G. Johnson 160

bushels per acre

140 120 100 80 60 40 20 1970

1978

1986

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1970

1978

1986

1994

1962

1954

1946

1938

1930

1922

1914

1906

1898

1890

1882

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1866

0

Source of data: USDA, Agricultural Statistics, various years.

Figure 1. Corn Yield in the US, 1886–1999

bushels per acre

50 40 30 20 10 1962

1954

1946

1938

1930

1922

1914

1906

1898

1890

1882

1874

1866

0

Source of data: USDA, Agricultural Statistics, various years.

Figure 2. Wheat Yield in the US, 1886–1999

nearly two decades later there followed improvements in wheat and rice. In all cases the new varieties were responsive to chemical fertilizers, much more so than the varieties they replaced. But to return to globalization and Table 3, the increase in grain yields occurred first in the developed countries. In 1970–1972, as the Green Revolution varieties were being adopted, yields in developed countries exceeded those in the developing countries by 65 percent. By 1994–1996


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Table 3. Grain Yields, 1935–1939 to 1994–1996 (Kilograms per Hectare)

1935–1939 1960–1962 1970–1972 1979–1981 1988–1990 1994–1996

Developed Countries

Developing Countries

World

1,150 1,729 2,351 2,624 3,042 3,178

1,150 1,205 1,423 1,863 2,376 2,588

1,150 1,428 1,802 2,188 2,642 2,808

Source: FAO, Production Yearbook, various years.

the margin was reduced to 20 percent.1 The higher yields in the developing countries are largely the consequence of globalization. Hybrid corn was created in the United States, the new varieties of rice in the Phillippines, and the new varieties of wheat in Mexico with the latter two being initiated largely by American foundations, especially the Rockefeller Foundation. Research in China made substantial progress in developing new varieties of rice in the 1960s, but lagged somewhat behind the International Rice Research Institute. It was primarily through globalization that the new varieties and methods of production spread throughout the world. A major factor in higher yields has been the availability of low cost nitrogen fertilizer. The process for making nitrogen fertilizer was transferred from the developed to the developing world. Were the higher yields reflected in improved caloric intakes for the poorer people of the world? The answer is in Table 4 and the answer is a definite yes for most of the developing countries of the world — the only exception for the period 1970 to 1996 is sub-Saharan Africa. From 1962 to 1996 average daily caloric intake increased by 700 calories and 35 percent. But before arriving at conclusions concerning the information in Table 4, it is well to consider what my colleague Robert Fogel found to be the daily caloric intakes in France and England. At the beginning of the 1After

1996 FAO stopped summarizing its grain data by developing and developed countries. The world average grain yield in 1997–1999 was 2,972 kilograms, 5.8 percent higher than in 1994–1996. For four large developing countries — China, India, Pakistan, and the Phillippines — the increases in grain yields for 1997–1999 compared to 1989–1991 ranged from 16 to 21 percent (FAO 1999). So the increases in productivity have continued in the developing world.

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D. G. Johnson Table 4. Daily Per Capita Supply of Calories, 1962, 1970, 1996

All developing countries Least developed countries Sub-Saharan Africa East Asia South Asia Latin America and Caribbean World

1962

1970

1996

1,940

2,129 2,090 2,226 2,033 2,094 2,491 2,336

2,628 2,095 2,205 2,862 2,402 2,182 2,751

2,296

Source: FAO, Production Yearbook, various years.

18th century — just 300 years ago — the average daily caloric intake was 1,657 in France and 2,095 in England (Fogel 1996). Over the next century caloric intake increased to 1,846 in France and to 2,237 in England — increases of approximately ten percent — and life expectancy increased from 32 to 36 years in England and from 26 to 32 years in France. Note that these life expectancies two and three centuries ago in two of the richest countries in the world are about one half the life expectancy now prevailing in all developing countries. Note also that not a single region in 1997 had a lower calory intake than France or England at the beginning of the 18th century or France a century later. A significant percentage of the people of the poorer developing countries are stunted and wasted but so was nearly everyone who lived in Europe 200 years ago. Robert Fogel says that the soldiers who stormed the bastille were 153 centimeters tall and weighed 42 kilograms or less. The graphs of corn and wheat prices are for the United States, but the prices mirror what occurred in world markets. Since the early 1960s wheat and corn prices have declined 40 percent or more; the decline in rice prices was similar. The supply of grain per capita increased and prices fell, not by a little but by a lot. The gain to poor people due to the enormous increase in productivity and the decline in real prices was very great, indeed. 7. Immunization A further positive benefit of globalization is the large percentage of children in developing countries who receive immunization shots. We have data

dollar per bushel


37

9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 1866 1876 1886 1896 1906 1916 1926 1936 1946 1956 1966 1976 1986 1996

Note: Data deflated by US wholesale price index. Sources of data: US Bureau of the Census (1960), Series E-1 for 1866–1890 and Series E-13 for 1891–1951; US Department of Agriculture (1962) and subsequent issues; Economic Research Service, USDA, Agricultural Outlook, various issues for recent data.

Figure 3. Real Corn Prices, 1866–1998 (1982 = 100) 12.00

dollar per bushel

10.00 8.00 6.00 4.00 2.00

18 66 18 76 18 86 18 96 19 06 19 16 19 26 19 36 19 46 19 56 19 66 19 76 19 86 19 96

0.00

Note: Data deflated by US wholesale price index Sources of data: US Bureau of the Census (1960), Series E-1 for 1866–1890 and Series E-13 for 1891–1951; US Department of Agriculture (1962) and subsequent issues; Economic Research Service, USDA, Agricultural Outlook, various issues for recent data.

Figure 4. Real Wheat Prices, 1866–1998 (1982 = 100)

on two — tuberculosis and measles for 1995–1997 (UNDP 1999, 175). For all developing countries 88 percent of the children were immunized against TB and 79 percent against measles. Sub-Saharan Africa lagged, but even there 67 percent of the children were immunized against TB and 53 percent against measles. In South Asia, including India, the percentages

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were 95 and 80, respectively. In China 96 percent of the children are immunized against the two diseases. These and other immunizations have been important in reducing child mortality. Without globalization very few of these children would now be protected against major childhood diseases. 8. Knowledge Globalization has made it possible for knowledge created in one part of the world to become available everywhere due to the low cost and speed of communication and the spread of literacy and education. Much of the knowledge, though not all, has been discovered in the industrial world. Knowledge generally requires transformation into products and services before the knowledge impacts our lives. Knowing how to produce hybrid corn does not increase yields; it was the actual creation of hybrid varieties that resulted in higher yields. Understanding the role of germs was an amazing discovery but it had to be translated into knowing that clean water was essential and knowing what was required to have clean water; similarly with respect to understanding the role of sanitation in preventing diseases — you had to know how to create a sanitary environment by creating a sewage system and a safe disposal place. Before Paris had clean water and sewers, child mortality was 450 per thousand — hardly more than one child out of two survived to five years of age. 9. Where Markets Have Not Been Permitted to Function One of the complaints about globalization is that it has resulted in an increase in the inequality of income. And it has — the rich have gotten richer but the poor have not gotten poorer. Figure 5 shows the ratio of urban to rural per capita consumption in China since 1952 and it shows clearly that when markets and the effects of globalization are restricted, the increase in inequality can be enormous. The ratio of per capita urban to rural consumption was 3.5 in China in 1999 (NBS 2001, 66). Why is there such a high ratio? Three reasons, two of which involve restrictions on markets. First, for more than four decades China has restricted migration from rural to urban areas. Second, investment in China has been biased in favor of urban areas — at least 70 percent of investment has gone to urban areas with little more than 30 percent of the population. Investment in fixed assets in township and village enterprises

39

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

1966

1964

1962

1960

1958

1956

1954

4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00 1952

Rural = 1.00


Source of data: China National Bureau of Statistics, China Statistical Yearbook, various years.

Figure 5. Urban-rural Consumption Ratio in China, 1952–1998

(TVEs) in 2000 was only 23 percent of the investment in state owned enterprises (SOEs), even though the TVEs employed 128 million workers and SOEs 81 million (NBS 2001, 107, 157). The third reason involves discrimination in the provision of education. Rural people get less and poorer quality education than urban people. On average, in 1990 the rural workforce had four fewer years of schooling than the urban workforce. If globalization is exemplified by the dominance of the market, China’s experience indicates that restraints on the market increase inequality rather than reduce it. Markets are the major avenue for reducing regional and urbanrural disparities in the returns to labor. If the market had been permitted to function in the allocation of labor and investment and if the same education had been available to all, the urban-rural per capita consumption difference would now be far less than it is. 10. Concluding Comments I should not leave the impression that all of the effects of globalization are positive for all people all the time. Whenever new knowledge is created, some people will be adversely affected — skills that were valuable before may lose much of their value, for example. But this would be true in any economy in which there is growth, even if countries did not trade. The dislocations are primarily the result of growth not globalization, except that the greater the degree of integration of an economy into the world economy, the greater will be the rate of growth and the greater the need for change and adjustment. Economic growth requires change; perhaps the most striking is the adjustment of labor employed in agriculture. When the United States won its independence from England, 80 percent of the nation’s labor was engaged in farming. Today little more than two percent are so employed.

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In China just half a century ago, 85 percent of workers were in primary industry; today it is probably less than 45 percent and in just three decades I estimate that farm employment will be about ten percent of the total. I hope it is clear that globalization involves far more than trade and investment. As important as these are in the improvement of the conditions of life, the spread of ideas throughout the world has been at least as important in affecting the lives of ordinary people. Ideas have had an enormous impact on the lives of everyone — understanding the role of germs, clean water and sanitation, plant breeding, inoculation against disease, literacy. The enormous advances in communication that have occurred over the last century and a half have greatly facilitated the spread of ideas and increased their positive impact upon the poorest of the poor. The benefits of globalization have been widely distributed; while much remains to be accomplished, much of what has been accomplished as a result of globalization has been enormous and largely unrecognized.

11. Acknowledgment The William ImMasche Foundation Endowment provided financial support for the preparation of this paper. The Endowment is in no way responsible for the content of the paper; I bear that responsibility.

12. References Bogue, Donald J., 1969. Principles of Demography (New York: Wiley). Cooper, Martin H., Glen T. Barton, and Albert P. Brodell, 1947. Progress of Farm Mechanization (Washington, DC: US Department of Agriculture), Miscellaneous Publication No. 639. Fogel, Robert W., 1996. “The Escape from Hunger and Premature Death 1700–2100: Europe, America and the Third World,” Ellen McArthur Lecture, Cambridge University. Food and Agricultural Organization (FAO), various years. Production Yearbook (Rome: FAO). Johnson, D. Gale, 2000. “Population, Food and Knowledge,” American Economic Review, 90(l): 1–14.


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Maddison, Angus, 1995. Monitoring the World Economy (Paris: Organization of Economic Cooperation and Development). ——, 2001. The World Economy: A Millennial Perspective (Paris: Organization of Economic Cooperation and Development). National Bureau of Statistics, 1988, 1999, 2001. China Statistical Yearbook (Beijing: China Statistics Press). United Nations Development Programme (UNDP), 1990, 1999, 2001. Human Development Report (New York: Oxford University Press). United States Department of Agriculture, various years. Agricultural Statistics (Washington, DC: US Department of Agriculture). World Bank, 1998, 2000/2001. World Development Report (New York: Oxford University Press). ——, 2001. World Development Indicators (Washington, DC: World Bank).


Prospects for an Asian Currency Area∗ Robert Mundell 1999 Nobel Laureate in Economics and University Professor of Economics Columbia University, New York, New York, USA [email protected]

Let me say how delighted I am to be able to take part in this 24th ACAES conference in Beijing. In my remarks today I want to focus on some features of the world economy that have a special impact on the Asian economy and are relevant for the making of macroeconomic policy in China.

1. The Advent of the Euro and the New Triad I will focus first on the change in the international monetary situation arising from the advent of the euro, the prospects for a new system of currency areas including one in Asia, and the possibility of reducing the distortions in international monetary arrangements arising from the proliferation of currencies and unstable exchange rates. The introduction of the euro has been one of the most significant developments in international monetary relations in decades. Upon its initiation as a banking currency in 1999 and its imminent completion at the end of the transition process on June 30, 2002 as the sole currency of the EMU, the euro, measured by monetary mass, became the second most important currency in the world. With enlargement of the European Union and attachment to the euro zone of other countries it will vie with the dollar as an international unit of account and means of payment and provide an alternative to it in case the dollar loses its luster or becomes unstable. ∗

Reprinted from Journal of Asian Economics, Vol. 14, No. 1, Robert Mundell, Prospects for an Asian currency area, Pages 1–10, 2003, with permission from Elsevier. 43

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With the advent of the euro, the international monetary core is now dominated by the three-currency triad formed by the dollar, euro and yen currency areas. Monetary power is proportionate to monetary mass which in turn is more or less proportionate to GDP. US GDP is close to $11 trillion, Euroland’s is about $7 trillion, and Japan’s is about $4.5 trillion.1 According to this criterion, the relative importance of the dollar, euro, and yen currency areas is 11:7:4.5. Further down the list comes the pound sterling area at $1.5 trillion, and the RMB area (which, however, is with the dollar area) of $1.2 trillion. The importance of currencies is, however, augmented by currencies anchored to them, forming currency areas. A currency area is a zone of fixed exchange rates and includes, of course, any zone with a common currency. The dollar area includes not just the United States but China, Hong Kong, Malaysia, a few states in Latin America and the Caribbean, and most Gulf States and others, whose currencies are tied to the dollar. Similarly, the euro area is augmented by the currency area of 14 African countries, the CFA franc, which, along with a few other states, is tied to euro.2 Like political alliances, currency areas are not static but evolve with the growth of economies and changes in political relationships. The euro area proper began with 11 and now, with the addition of Greece, contains 12 countries. With the euro now successfully launched as a paper currency, it is likely that Britain, Sweden, and Denmark will join the EMU area in the near future. With enlargement there could be ten “accession countries” in the euro area in a very few years. Counting the outer euro area in Africa, as many as 40 countries could be part of the euro area in ten years, with a total population of more than 400 million and a GDP potential as big as or larger than that of the United States. This is not to say that the euro zone will be larger than the dollar area. The dollar area itself will expand over the next few years. It is, however, probable is that the euro zone will vie with the dollar in importance as a unit of account and contract in major pricing decisions and for use in international reserves. The dollar-euro rate will be the most important (and the dollar-yen rate the second most important) exchange rate in the world economy. The advent of the euro will therefore change the power configuration of the international 1 Panama has long (since 1904) used the dollar as its sole paper currency (its national currency, the balboa, is a coin equal in value to one US dollar), and some other countries, including recently Ecuador, have replaced their national currencies with dollars, i.e., “dollarized”. 2 The euro is fixed in the 14 African countries at 655.957 CFAF.

Prospects for an Asian Currency Area

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monetary system by reducing the monopolistic role the dollar has enjoyed for three quarters of a century. 2. Exchange Rate Gyrations A major threat to the system arises from gyrations of the major exchange rates. The instability of exchange rates between the large currency areas has been enormous. A look at the dollar-euro rates over the past two years provides a sample; at its low point the euro was 30 percent below its value when it came into being on January 1, 1999. It has since recovered but there is no doubt that the high degree of instability has made it more difficult for Britain and other countries to join the euro area. The history of the DM/dollar rate over the past 25 years confirms the instability of major exchange rates. In 1975 the dollar was DM3.5; by 1980 it had fallen by half, to DM 1.7; by 1985 it had doubled, to DM 3.4; by 1992, in the pit of the ERM (Exchange Rate Mechanism) crisis, it was DM 1.34; and today it is around DM 2.2. These wild swings have created instability in real tax burdens, in burdens of indebtedness, in financial markets, and in trade balances, and made financial operations difficult for third countries. The experience of the yen-dollar rates is not any better. In the summer of 1985 the dollar was 250 yen and on the eve of the Plaza Accord in September of that year it was 239. Ten years later, in the spring of 1995, it had fallen to 78 yen, a tripling of the value of the yen that devastated the Japanese economy and saddled its banking system with non-performing loans that will occupy the attention of the authorities for years to come. The next phase of the yen-dollar gyrations hurt the rest of Asia. The dollar appreciated from 78 yen in April 1995 to 148 yen in June 1998. The low yen shut off Japanese foreign direct investment in Southeast Asia and closed down its engine of growth. At the same time the rising dollar appreciated pari passu the currencies of South East Asia to overvalued positions that made them sitting ducks for speculators. Thailand, Malaysia, Indonesia, and South Korea were all caught up in the same boat. It was the instability of the dollar-yen exchange rates that brought about the crisis. A major problem for Asia in the future is the volatility of the yen-dollar rates. It would be in the interest of Asia, and rest of the world, if the dollaryen rates could be fixed again, as it was between 1948 and the 1970s. There are some who contend that central banks cannot fix exchange rates now because capital movements have become too large and dominate

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exchange rates. The vast sums involved in cross-border transactions are all based on exchange rate uncertainty. Trillions of dollars are committed in hedge fund operations, swamping ordinary transactions. With transactions running over 1.5 to 2 trillion dollar in daily turnover, what kind of central bank’s intervention can compete? The lesson — so the argument goes — is that you cannot fix exchange rates now because whatever funds are committed will be swamped by these huge derivative transactions, the hedge funds and waves of speculation. In my opinion, this view is incorrect. It makes capital movements the culprit. But there is nothing wrong with capital movements any more than there is anything wrong with trade. My view takes a leaf from Napoleon’s comment to the effect that there are no bad soldiers, there are only bad officers. There are no bad capital movements, only bad monetary and exchange rate systems. You do not see bad capital movements between New York and California or any other state within the United States because exchange rates are securely locked. There were bad capital movements in the euro area before the middle of 1998 because exchange rates were uncertain. But after the middle of 1998, even before the euro had been introduced, when bilateral exchange rates were securely locked, speculative capital movements against the lira, mark, franc, and peseta and the other currencies of the euro area — contrary to widespread predictions — became a thing of the past. Hedge funds cannot make a dime in the euro area. Some observers had predicted before the middle of 1998 that fixing exchange rates would create such speculation of one currency against the others that the euro area would break down even before the euro was launched. Yet none of it happened. The euro came into being with very little intervention because the locking of exchange rates was completely credible, and because the mechanism for adjusting the balance of payments was well understood and was allowed to work. Everybody understood that the national central banks would now follow a passive monetary policy appropriate for a fixed exchange rate system and that monetary aggregates would be under the control of a central authority, the European System of Central Banks and its executive arm, the European Central Bank. 3. Currency Areas and Power Centers Any realistic discussion of currency areas has to take into account existing and prospective power centers. The power configuration is relevant because


47

it determines whether a currency arrangement is likely to be hegemonic or not. An Asian currency area with China alone would have a dominant policy center in China, and an Asian currency area with Japan alone would have a dominant policy center in Japan. An Asian currency area with both powers would have to evolve as a cooperative arrangement like the two foci of an ellipse. Similarly, a North American currency area would have a dominant policy center in the United States and a Mercosur currency area would have one in Brazil. Does Asia need a common currency? My answer is, yes. But it cannot have in the near future, a single Asian currency, which would involve more political integration than is now possible between China and Japan. Here the European example is worth interpreting carefully. Europe took a big gamble when it adopted the Delors report of 1989 as its plan for a single currency in Europe. This plan involved the abolition of national currencies. The Delors Committee could have proposed, instead of a single currency, a common currency that each country could have used for international transactions. National currencies would not have to be scrapped. The committee did not adopt this course because they believed — rightly — that a single currency was a larger, more irrevocable step. With national currencies abolished the cost of undoing the monetary union would be much greater. The actual decision to propose a single currency was a big gamble in 1989 because it was far ahead of European general opinion on the subject. Most European countries were not prepared to give so far as to give up their national currencies. Nevertheless, a year later, the gamble seemed to be a stroke of genius. The end of the Cold War brought in its wake the reunification of Germany and with it the age-old problem of Germany’s tendency to dominate. German unification created a sense of urgency for monetary unification as a prelude to deeper political integration. Europe took the leap to complete monetary union much earlier than it would have in the absence of German unification. Political motives constitute an important ingredient in monetary unions. The construction of a new currency for Asia out of the blue would be extremely difficult. Most successful new currencies have been started off on the back of an existing currency, establishing confidence in its convertibility, thus linking the old with the new and the familiar with the unfamiliar. It is easy to show links from the past between the Persian, Greek, and Macedonian staters, the drachma of Greece, the denarius of Rome, the dinar of Arabia, and the denier, denny, and penny of Western Europe. The

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pound sterling originated as the silver price of a Roman gold libra or pound. The dollar was built on the back of the Spanish dollar. The SDR, the IMF reserve asset that came into being in 1970, started off as a gold dollar equal to 1/35 of an ounce of gold.3 A currency area in Asia would probably have to start off anchored to an existing currency or group of currencies. 4. Does an Asian Currency Need an Anchor? Would an Asian currency area need an anchor? It is difficult to imagine it coming about without one. In theory a group of Asian countries could make a basket of their currencies and designate that as the unit of account and reference point to measure the Asian currency. Europe took this path. But three observations suggest that Europe is not a good model to follow. The first is that monetary union in Europe would have been much easier had an external currency anchor been chosen. In the late 1960s, when the project for a European currency was first introduced, convergence would have been comparatively easy since the currencies of the countries in question were all fixed to the US dollar, resulting in similar inflation rates and interest rates. European Monetary Union (EMU) took three decades longer because Europe took the indirect route through fluctuating exchange rates. The second is that monetary union in Europe would have been easier even if an internal anchor had been chosen. When European countries decided to cut their currencies loose from the dollar in August 1971, they could have organized a joint float against the dollar had they been willing to use one of the major currencies as the anchor for the joint float. The pound sterling had been the most important European currency until the late 1960s but the DM had overtaken it. A joint float could have been organized around the DM, but neither Britain nor France was willing to give the mark the prestige of pivot for Europe. Only in the 1980s did the DM become acknowledged by France (the second most important player in the Exchange Rate Mechanism) as the anchor for the ERM of the European Monetary System. As a consequence, the joint float could not be organized, generalized flexible exchange rates came into being, and EMU was delayed by nearly two decades. 3 The

ECU, based on a basket of European currencies, was an exception, but of course it never became a currency. The euro, however, was based on the ECU and it is therefore an exception to the rule. It would nevertheless be a hard act for Asia to follow!


49

The third observation is that the institutional, economic, and political groundwork had already been laid in Europe, whereas very little exists at the present time in Asia. The Common Market and later the Economic Community had been in service for decades and this provided a readymade institutional and political structure for monetary integration. Instead of following Europe in these tracks, however, Asia could leap-frog to a currency area if the potential members were willing to use an internal or external anchor. On the basis of these observations, I conclude that an Asian currency would be best linked to a currency anchor. But that immediately raises a follow-up question. Should the currency anchor be an Asian currency or an external currency? 5. An Inside Currency Anchor for Asia? Would an external or an internal currency anchor be better for Asia? The choice of an internal anchor might be a source of Asian pride. Equally, it could be a source of distrust between rivals. The European example of the early 1970s is worth keeping in mind, when a joint float was made difficult if not impossible because neither Britain nor France were willing to accord the mark the status of pivot for the Exchange Rate Mechanism. What Asian currencies could be used as a parallel currency in Asia? Only the large countries qualify. Large currency areas are more stable because adjustment is in inverse proportion to monetary mass. This limits the choice of internal anchor to the Chinese yuan (or renminbi) or the Japanese yen. China is the most populous country on earth, and is destined to become a superpower. Its growth over the past quarter century has been remarkable, and its exports have risen from less than one percent to over four percent of exports. Measured at purchasing-power-parity exchange rates, China’s GDP approaches that of Japan. It has benefited from and exploited the possibilities of globalization more than the other developing countries, and it has become a member of WTO. With Japanese direct investment pouring into China at an unprecedented rate, China’s development as the major manufacturing center of the world is inevitable. Its currency will become increasingly important in Asia. A major problem at the present time, however, is that China’s currency is not convertible on capital account, and its financial system is not well

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R. Mundell

developed. For the time being, therefore, China’s currency would not be suitable as the anchor for an Asian currency. What about the yen? Japan is a very rich economy, with a standard of living among the highest in the world. At current exchange rates Japan’s GDP is four times that of China. Japan is by far the world’s largest creditor nation, a position it has built up with a high savings rate coupled with huge current account surpluses. Japan also has been more successful than any other country in recent decades in keeping inflation under control. Since the currency reform of 1948, when one new yen replaced ten old yen, the yen has been one of the strongest currencies in the world. The shift of Japan’s major investment focus from Southeast Asia to China increases the importance of a stable exchange rate between China and Japan. Against these advantages, however, the choice of the yen as anchor would have to take into account severe problems with the Japanese economy. Japan has not put its macroeconomic house in order. Its banking system is in grave trouble, a casualty of the excessive appreciation of the yen between 1985 and 1995 when the dollar sunk from 250 yen to a low of 78 yen. The tripling of the value of the yen against the dollar between 1985 and 1995 weakened corporate balance sheets and saddled the Japanese banking system with hundreds of trillions of non-performing loans. A second problem has been with the policy mix in Japan, which has emphasized fiscal expansion combined with monetary tightness. Fiscal expansion coupled with a high degree of capital mobility and a flexible exchange rate has kept the yen overvalued, reduced the current account surplus, and built up the largest public debt level in the history of any country. As the Mundell–Fleming model suggests, fiscal policy combined with monetary tightness does not work to stimulate employment and output; the multiplier is zero. A third problem concerns the secular tendency of the yen to appreciate, reflected in long-term interest rates that are now below two percent. The expectation of appreciation has been built up as a consequence of past history: the dollar was at 360 yen for the first quarter century after the 1948 currency reform, but since the early 1970s its path has been sharply downward, reaching a low of 78 yen in 1995, and then rising to current levels. No country would want to hitch its currency to a yen that was so unstable relative to the dollar. No doubt Japan will correct its problems in the near future and it is still a technological leader. But until Japan’s


51

macroeconomic problems are corrected, the yen could not be used as the anchor for a currency area.4 If neither the Chinese yuan nor Japanese yen were suitable anchors at the present time, would an external anchor prove to be possible? There is the possibility of using a major currency like the dollar or euro, or a basket of currencies. 6. The Dollar as Anchor? US GDP is, at current exchange rates, about two and a half times that of Japan and ten times that of China. The dollar has been widely used in Asia and is the principal currency against which the others are measured. China and Hong Kong (with its currency board system) already uses the dollar as its anchor as does Malaysia. Other Asian countries could shift to using the dollar. But the major problem is the instability of the yen-dollar rate. The catastrophe of the late 1990s is well remembered. It is bad news for the Asian countries whenever the yen-dollar rate changes significantly. As already noted, as long as the yen is unstable against the dollar, it would have to be ruled out as an anchor for an Asian currency. On the other hand, imagine the transformation in Asia if the yen were again fixed to the dollar! Stabilizing the yen-dollar rate would serve Japanese policy interests and at the same time be a great benefit for Asia and the global economy. Remember that the glorious period of Japan’s “sudden economic rise” between 1955 and 1970 — which included fifteen years of 12 percent growth. This occurred when Japan had a policy mix that involved a fixed exchange rate monetary rule coupled with periodic tax cuts. By stabilizing the yen to the dollar again, Japan would not only help get its economy back to equilibrium but become a central focus in the financial structure of Asia. Stabilization of the yen-dollar rate would mean a fixed exchange rate zone in Asia that would include the dollar, the yen, the RMB, the Hong Kong dollar, and the Malaysian ringgit as well as countries outside Asia already linked to the dollar. With a stable yen-dollar rate there would be no need for fluctuating currencies in the rest of Asia, and the combined area 4 Other

difficulties with the use of the yen are associated with the geographical isolation of Tokyo, unfamiliarity with the Japanese language, and emotional issues associated with acknowledgement of Japan’s culpability in World War II.

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could expand to include the currencies of Korea, Taiwan, Australia, and New Zealand as well as those countries of the new ASEAN group that were in a position to accept monetary stability. The “APT” or ASEAN-Plus-Three group has been considered as a basis for consideration of Asian monetary arrangements. This includes the five initial ASEAN members and its five new members, plus Japan, South Korea, and China. But an APT currency area could never be viable as long as the yen-dollar rate is unstable. If Japan excluded forever the prospect of ever stabilizing the yen-dollar rate (or as an alternative the yen-SDR rate), China itself would have to take the lead as its RMB gradually becomes convertible and form its own currency area with its neighbors to the south and east. 7. Reform of the International Financial System The instability of the yen-dollar and dollar-euro rates pose a major problem for the dollar, euro, and yen areas and at least as great a problem for the rest of the world. Elsewhere (Wall Street Journal, March 30, 2000) I have argued that a G-3 monetary union, based on fixed rates between the dollar, euro, and yen could be used as a platform on which to build a much-needed world currency. The model would be the EMU as it now exists, before national currencies have been replaced. The G-3 monetary union would retain the existing currencies but lock them as the European currencies are now locked. It is important to realize that the currencies in the euro area with fixed exchange rates have not been subject to speculative capital movements. Five steps are required to form such a monetary union: (1) agreement on a common inflation rate; (2) agreement on a common index for measuring inflation (e.g., HICP, Eurostat’s Harmonized Index of Consumer Prices); (3) locking of exchange rates, with the dollar the focus; (4) a common monetary policy; and (5) an arrangement for dividing up seigniorage. Once that three-currency monetary union is brought into being, the Board of Governors of the IMF could establish an international currency — call it the “intor” — equivalent to a unit of the three-currency union. Initially it would probably be best to make the intor equivalent to the dollar because the dollar is the most widely-used international unit of account. The next step would be to designate the three central banks (for a given period) as the agent of the IMF Board of Governors with the responsibility of preserving stability in the area. The intor would thus achieve a stability


53

equivalent to the common platform of the dollar-euro-yen union. The next step would be for the Board of Governors to establish a World Central Bank with subscriptions from each country in proportion to their economic size, measured by GDP. I believe that this is a feasible route to fundamental reform of the IMF and that it could be accomplished in the coming decade. The process could begin by putting limits around the dollar-euro rate at 90 cents and 110 cents, and limits around the yen-dollar rate of 110 yen and 130 yen. Gradually, the need for the institutions and practices outlined above would become evident. As Paul Volcker has said, a global economy needs a global currency. 8. Dollarizing Hong Kong Proposals for an improvement in the global monetary situation may of course fall upon deaf ears. Does Asia or APEC have an alternative? With the creation of the euro, Europe took defensive steps to restore currency stability in its own sphere. Does Asia or APEC also need a common currency or currency area? The answer is surely, yes, in the absence of a global currency. Let us put aside for a moment the APEC group and concentrate on Asia. Could Asia draw on Europe’s experience? The answer is again, yes, but only to some extent. Europe has opted for a single currency which implies a high degree of political integration, much higher than is possible in Asia at the present time. Asia’s solution might lie rather in a parallel currency that is used for trading purposes in international trade in Asia. In theory it might be defined as a basket of the dollar, euro and yen currencies produced by an Asian Monetary Fund and backed by reserves of those currencies. But that solution may not be practical if the yen-dollar and dollar-euro rate continue to be unstable. Another question concerns the locus of the initiative for an Asian monetary area. An Asian Monetary Fund would realistically have to include the two superpowers of East Asia, Japan and China, and the organization that would be most appropriate to sponsor the Fund would be the ASEAN + Three countries, i.e., the ten ASEAN countries plus Japan, South Korea, and China. Japan should be a major sponsor of the Asian Monetary Fund and one could imagine regional headquarters in Tokyo, Beijing, and Hong Kong, the latter region being the most convenient meeting place.

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In the short run at least a potential Asian currency should be based on the dollar. At the present time both China and the autonomous region of Hong Kong are tied to the dollar. The best approach to getting convergence of other Asian currencies is for them to be also anchored to the dollar. A case can be made for dollarizing Hong Kong with the US dollar. I hasten to say in general I am not an enthusiastic advocate of dollarization, even in the Western Hemisphere. But I do believe that of all the economies in the world, the case of dollarizing Hong Kong is head and shoulders above the others. The Hong Kong currency supply is about 100 billion HK dollars, worth about US$12 billion, so HK dollars could be retired at the cost of US$12 billion in reserves. This would reduce Hong Kong’s foreign exchange reserves to about US$88 billion, surely ample as insurance for a lender-of-last resort function. Hong Kong residents would clearly gain much more than they would lose in giving up interest on US$12 billion, interest rates would come down to New York levels, and mistakes in Hong Kong’s monetary policy due to speculation would be eliminated. However, the gain I would envisage is for all of Asia, and particularly China and her near neighbors. A rock-solid dollar currency in an Asian economy would form the platform on which an Asian currency area could be built. With Japan’s participation in an Asian Monetary Fund, defensive arrangements would be in place to establish an Asian input into the problem of coping with the world-wide slowdown that is under way. 9. APEC Monetary Reform Could the Asian currency idea be expanded to include the non-Asian Pacific countries? If monetary stability based (initially) on the dollar is the goal, the answer is, yes. The entire Pacific Basin could participate in the currency area if each country were willing to commit to the degree of monetary stability that would result. What if the dollar became destabilized in the long run? That seems a distant prospect, but it cannot be ruled out. Once the monetary area as a whole is firmly established, arrangements should be made for an APEC currency that would start off as the dollar but which could achieve a wider base as appeared desirable. The use of the SDR might even prove a useful anchor.


55

An APEC currency area would be a significant step in the direction of a true common market in goods and services and financial instruments for over half the world economy, and it would also be a catalyst for discussing common problems associated with growth of the world economy. In the absence of leadership, however, nothing will happen.


The European Central Bank and the International Role of the Euro∗ Juergen Schroeder Professor, Department of Economics University of Mannheim, Mannheim, Germany [email protected]

1. Institutional Design and Objectives of the European Central Bank (ECB) Basically, two very different models for the institutional design and the objectives of a central bank have evolved after World War II: the AngloFrench model and the German model (De Grauwe 2000, 150–153). In the Anglo-French model, the central bank is politically dependent on the government, usually on the minister of finance, and normally focuses on a number of different economic objectives like price stability, high employment, stabilization of the business cycle, etc. In the German model, the guiding principle is political independence of the central bank. The central bank conducts monetary policy without interference from the politicians. The primary objective in this model is price stability. The central bank can also pursue other objectives, however, this is always conditional on not endangering “price stability”. When the European countries negotiated the Maastricht Treaty a clear decision was made for the German model. For the objectives of the ECB, Article 105 of the EU Treaty says: “The primary objective of the ECB is to maintain price stability. Without prejudice to the objective of price stability, the ECB shall support the general economic policy in the EU.” Price stability is the overriding objective in the treaty. When supporting general economic ∗

Reprinted from Journal of Asian Economics, Vol. 14, No. 2, Juergen Schroeder, The European Central Bank and the international role of the euro, Pages 209–218, 2003, with permission from Elsevier. 57

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policy the ECB is not allowed to endanger the objective “price stability”. According to the ECB definition, the objective “price stability” is met when the inflation rate of the Harmonized Index of Consumer Prices (HICP) for the Euro area is on average below 2 percent per annum over the medium run. Since the ECB was established the inflation rate of the HICP was 1.1 percent in 1999, 2.3 percent in 2000, 2.5 percent in 2001, and 2.1 percent in the first three quarters of 2002. So, for a new central bank the performance of the ECB was not bad at all. Of course, this good performance was necessary in order to build up reputation and credibility. Concerning the political independence of the ECB, Article 108 of the EU treaty says: “When exercising the powers and carrying out the tasks and duties conferred upon them by this Treaty . . . neither the ECB nor a national central bank, nor any member of their decision making bodies shall seek or take instructions from community institutions or bodies, from any government of a Member State or from any other body.” Furthermore, the ECB is not allowed to finance government budget deficits in the EU. Article 101 of the EU Treaty says: “Overdraft facilities or any other type of credit facility with the ECB or with the national central banks of the Member States in favor of Community institutions or bodies, central governments, regional or local authorities, public authorities . . . shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.” This political independence of the ECB is extremely important in order to avoid the misuse of the central bank by politicians. Why did the EU decide for the German model instead of the AngloFrench model? This question is interesting in that in almost all EU countries the Anglo-French model prevailed when the Maastricht Treaty and the ECB treaty were negotiated. Basically there were two reasons why the EU decided for the German model: (1) the monetarist counter-revolution; and (2) the strategic position of Germany in the European monetary integration process. To (1): Since Milton Friedman’s (1968) presidential address to the American Economic Association and Phelps’ (1967) pioneering work on the expectations augmented Phillips Curve, it is well known that, contrary to the Keynesian theory, inflation can reduce unemployment only temporarily if at all. In the long run monetary policy has no impact on employment. As inflation produces a lot of negative economic effects, it makes sense to use monetary policy exclusively to achieve price stability. This is the monetarism view. However, in reality, politicians are tempted to misuse the central bank’s money printing power because of inflation tax revenues and the possible positive short run impact on employment. In order to avoid

The European Central Bank and the International Role of the Euro

59

this politically induced bias to inflation monetarists demand that the central banks have political independence. Empirical studies show that the monetarist view is right: there is a negative correlation between inflation and central bank independence in industrial countries. In the 1980s and 1990s the monetarist view had become the prevailing one among university economists and especially among central bankers. So it is no surprise that the German model was chosen. To (2): The Germans had experienced two severe inflations: the hyperinflation of 1922–1923 and the inflation before the currency reform in 1948. These events had a strong impact on Germans’ attitude towards inflation. Due to this bad experience with inflation, from its establishment in 1955 onwards the German central bank had price stability as the overriding objective and it used to be the world’s most politically independent. With the foundation of the European Monetary System, EMS, in 1979 the monetary integration process in Europe began. Although the EMS was designed to work symmetrically it soon became an asymmetric system because Germany’s preference for price stability was far stronger than other EMScountries’ preference. The German central bank became the “leader” and the other European central banks became the “followers” with regard to monetary policy. The other European central banks only had the choice of either following the price stability oriented German monetary policy or devaluing their currency against the DM. Because this price stability orientation was so strong it is not surprising that the Germans were only willing to give up the DM, and with it the German monetary policy, and to introduce the euro and with it a European monetary policy, if the ECB treaty was at least as clear on central bank independence and on price stability as overriding objective as the German central bank agreement was. Further, in the negotiations of the Maastricht Treaty all EMS countries agreed on five convergence criteria which each country had to fulfil in order to qualify to become a member of the euro area. One criterion was that the inflation rate must not be more than 1.5 percent higher than the average of the three lowest inflation rates in the EMS countries. So, in order not to miss the boat to the Euro area the EMS countries had no choice but carry out the leader’s sound monetary policy. 2. The External Value of the Euro Many people in academia and in the business world expected that once the euro was introduced it would become strong, even stronger than

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the DM. Basically, there were two arguments behind these expectations. First, there is a larger and less open economy behind the euro than behind the EM. Second, the ECB is formally more independent than the German Central Bank used to be and the objective “price stability” is written down much more clearly than in the German Central Bank Law. However, reality turned out to be very different. Since its introduction on January 1, 1999 the euro has depreciated against all important currencies. The euro has depreciated about 20 percent against the US dollar. Figure 1 shows the development of the dollar exchange rate quoted in DM from 1979 to 2002 and the euro exchange rate quoted in dollars from 1999 to 2002. A great deal of empirical research has been done in order to find out why the euro is weak. Vaubel (2002) carries a very careful empirical study which addresses this question. His findings can be nicely summarized by using the conventional definition of the real euro exchange rate, R: E·p , p∗

R=

(1)

DM/$ 4.00 3.44

3.50

EMU 3.00 2.84 2.56

2.50

2.43 2.26

2.12 2.18

2.17

1.94

2.00

1.88

1.82 1.50 1.72

1.80

1.66

1.65

1.76 1.61

1.99

1.74 1.76 1.62

1.66

1.50

1.56 1.39

1.18

1.01

1.00 0.92

0.90 0.98

0.50

19 79 19 81 19 82 19 83 19 84 19 85 19 86 19 88 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 99 (J 199 an 7 )E M U 19 199 99 8 (D ec ) 20 00 20 200 02 1 (S ep )

0.00

Source: ECB.

Figure 1. Development of the Dollar Exchange Rate and the Euro Exchange Rate


61

where E is the nominal exchange rate, i.e., dollars per euro and p(p∗ ) is euro (US) area GDP price level. Solving (1) for E yields: E=

R · p∗ . p

(2)

Equation (2) tells us there are two reasons for the euro to depreciate, real reasons, i.e., when R falls, and monetary reasons, i.e., when the ECB conducts a more inflationary policy than the Fed and therefore p increases more than p ∗ . Vaubel investigated both reasons. For the monetary reasons he used the monetary approach as well as the asset market approach to exchange rate determination. Using the monetary approach, he found no clear indications that the ECB was too expansionary compared to the Fed. The weak euro was therefore not caused by a too loose monetary policy of the ECB. Using the asset market approach, he found that the relative increase in bonds in the Euro area exceeded the relative increase in bonds in the US, which, according to this theory, causes a depreciation of the Euro. For the real factors, Vaubel compared economic growth and productivity as well as government expenditure in the euro area and the US. According to his investigation, both growth and productivity rose less in the euro area than in the US and this caused the fall in R. For government expenditure, Vaubel found a relatively smaller increase in government expenditure and relatively smaller government deficits in the euro area than in the US, which again caused R to decrease. So, on average, Vaubel found good monetary and real reasons for the weak euro. It is well known since the pioneering work by Meese and Rogoff (1983) that the exchange rate is a forward looking variable, i.e., expected real and monetary developments determine the present exchange rate: E = F (E e ),

where E e =

R e · p ∗e , pe

(3)

and e denotes an expected value. According to this theory there are good reasons for the weak euro. There are many unsolved economic problems associated with the expected real economic variables in the euro area. The euro area has an unemployment rate of about ten percent, very rigid labor markets, and no structural reforms or if so then much too sluggish. There is an anti-incentive tax structure in many of the euro area countries and no sign of convincing tax reforms like the “flat tax rate” in the US under Reagan. The planned EU expansion

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will allow ten low income Eastern European countries to enter the EU and possibly the euro area. This will cause tremendous structural change. Given the low labor mobility and high wage rigidity, there will be tensions and temporary economic problems. All these negative expected real factors in the euro area relative to the US contribute to a weak euro. For the expected monetary variables, there are good reasons to doubt that the euro will show the same internal stability within the next 40 or so years as the DM has shown the last 40 years. The overriding ECB objectives of independence and price stability are necessary, but by a long way not sufficient conditions, for price stability. In a democracy the preferences of voters determine the degree of price stability in the long run. The remarkable price stability in Germany since World War II was not due to the German central bank independence. The reason was much more deeply rooted in German society. The very bad experiences with two serious inflations were, and are, the reasons for the German preference for price stability. No wonder that the other euro area countries had much less price stability since World War II; they had not had such bad experiences with inflation. There are currently 18 members in the Governing Council of the ECB which conducts monetary policy in the euro area — the national central bank presidents of the 12 countries and the six members of the Executive Board of the ECB. Each member has one vote. At best, Germany gets two out of 18 votes — the German central bank president and one German representative on the Executive Board. Majority voting in the Governing Council puts the German representatives in a minority position. As all the other members on average care less about price stability than the Germans do, unless they change their preferences, the average future inflation rate in the euro area should exceed the past inflation rate in Germany. Discounting these expectations adds to the weak euro.

3. The Euro as International Currency National money cannot become an international currency by law, and such a process does not take place overnight. It took the pound sterling about a century to replace the Amsterdam bank guilder as the international currency, and it took the US dollar about half a century to replace the pound sterling in international markets. The euro is three years old. Euro coins and euro notes are less than one year old. The most important conditions for national


63

Table 1. Size and International Linkages of the Euro Area, US, and Japan, 2000 Indicator Population GDP world share in PPP terms∗ Exports of goods & services share of domestic GDP share of world exports Imports of goods & services share of domestic GDP share of world imports

Unit

Euro area

US

millions EUR billion % EUR billion % % EUR billion % %

294 6,422 15.8 1,266 19.7 15.1 1,247 19.4 14.9

275 10,640 21.9 1,194 11.2 14.3 1,588 14.9 19.0

Japan 127 5,145 7.6 563 10.8 6.7 488 9.4 5.8

∗

1999 Note: Greece did not yet belong to the Euro area in 2000. Source: Hartmann and Issing (2002), citing: IMF/IFS (population, share of GDP, US and Japan trade data); WTO (aggregate world trade data); ECB (trade data Euro area).

money to take over money functions on international markets and to be accepted as international currency are the three following: (i) Stability of the currency. The currency has to be stable and, more important, there has to be confidence that the currency will be stable in the future. Up to now, this condition has not been met with the euro. (ii) Size, strength, and international linkage of the domestic economy. The country must be of a certain size in order to supply the international markets with its money as international currency without causing negative impacts on the domestic economy. Further, the country should not be too open economically so that it is buffered against world market instabilities. Table 1 compares the euro area, the US, and Japan in this respect.1 It can be seen that the euro area is closer to the US than Japan is. Its share in world GDP is 15.8 percent whereas the US share is 21.9 percent. The share in world exports with 15.1 percent and 14.3 percent is about the same. Table 1 does not say anything about the strength of the economies. Here the US is superior regardless of 1 Tables

1 and 2 and Figures 2, 3 and 4 are taken from Hartmann, P. and O. Issing, 2002. “The International Role of the Euro,” Journal of Policy Modeling, 24: 315–345.

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whether the strength is measured by unemployment rate, labor force participation rate, or per capita income. (iii) Depth, width and openness of domestic financial markets. The deeper, wider, and more open domestic financial markets are, the larger the economies of scale when a national money is used as international currency, i.e., the more attractive the money is as international medium of exchange, unit of account, store of value, and international deferred payment. Table 2 compares the euro area, US, and Japan in this respect. Again the euro area is second to the US and Japan is third. However, the US financial market is much deeper and wider. Stock market capitalization in the US is three times larger than in the euro area, and debt securities outstanding are twice as large. Only outstanding bank loans in the euro area are higher than in the US, EUR6.9 trillion compared to EUR4.2 trillion. These figures show the different ways households accumulate wealth. In the US, they buy stocks whereas in Europe they accumulate bank assets like saving accounts, etc. Therefore, the US financial system is mainly based on security market financing whereas the euroarea financial system is more based on bank loan financing. This may be a limit on the expansion of the euro as international currency.

4. Performance of the Euro as International Currency in First Three Years First, it is clear that the performance in the first three years does not say much about whether the euro will challenge the dollar as the international currency in the long run. Second, up to now there is only little data available concerning the international performance of the euro. However, the little data available show that the euro did not do too badly. Figure 2 shows the share of euro and dollar in the issuance of international bonds by non-residents. Since its introduction, the euro share has increased from roughly 20 percent to about 30 percent. This can be regarded as substantial. In the issuance of short term (money market) international bonds by non residents the euro also did very well. As Figure 3 shows, its share increased

Table 2. Size and Structure of Capital Markets in the Euro Area, US, and Japan, 2000 (In EUR Billion) Debt securities outstandinga Public

Euro area countries Austria 32.2 Belgium 196.1 Finland 315.5 France 1,554.4 Germany 1,364.9 Greece 115.5 Ireland 88.0 Italy 925.6 Luxembourg 36.5 Netherlands 688.2 Portugal 65.2 Spain 541.8 Euro area (total) 5,823.9 United States 16,259.3 Japan 3,431.9

133.5 264.2 75.3 712.9 810.7 117.9 28.5 1,122.2 0.1 175.2 56.3 332.1 3,829.0 9,140.4 4,904.2

Private

129.4 170.8 42.3 819.7 1,963.8 5.3 43.2 472.8 17.4 504.6 49.6 187.5 4,406.5 8,299.5 1,935.1

Bank loans outstandingb

Bonds, equities, and bank loans outstandingc

213.4 203.9 67.3 1,083.0 2,336.2 61.9 124.5 913.8 77.9 750.1d 148.6 571.4 6,964.3 4,201.8 5,253.8

508.4 835.1 500.4 4,170.0 6,475.6 300.5 284.2 3,434.4 131.9 2,118.1 319.7 1,632.8 2,123.7 37,901.0 15,525.0

Total

262.8 435.1 117.6 1,532.6 2,774.5 123.1 71.7 1,595.0 17.5 679.8 105.9 519.6 8,235.5 17,439.9 6,839.3

Bonds, equities, and bank loans % of GDPc

248.2 336.6 380.1 296.8 319.7 245.9 274.6 294.7 630.1 528.1 277.4 268.2 320.8 386.4 301.8

65

Source: Hartmann and Issing (2002), citing: ECB, BIS, FIBV. a Domestic and international debt securities shown by the nationality of the issuer. b Domestically licensed banks for Japan, and commercial banks plus savings banks plus credit unions plus money market mutual funds for the US. c Sum of the stock market capitalization, debt securities, and bank assets. d Excluding government loans.


Stock market capitalization

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J. Schroeder

EUR

USD

JPY

Other

60 50

% share

40 introduction of the euro

30 20 10 0 1994Q1

1995Q1

1996Q1

1997Q1

1998Q1

1999Q1

2000Q1

2001Q1

Figure 2. Currency Shares in International Bond and Note Issuance, Announced Issues at Current Exchange Rates, Excluding Home Currency Issuance

EUR

USD

JPY

Other

90 80 70

% share

60

introduction of the euro

50 40 30 20 10 0 1994Q1

1995Q1

1996Q1

1997Q1

1998Q1

1999Q1

2000Q1

2001Q1

Figure 3. Currency Shares in the Issuance of International Money Market Instruments, Announced Issues at Current Exchange Rates, Excluding Home Currency Issuance

The European Central Bank and the International Role of the Euro EUR

USD

JPY

67

Other

70 60

% share

50 40

introduction of the euro

30 20 10 0 1994Q1

1995Q1

1996Q1

1997Q1

1998Q1

1999Q1

2000Q1

2001Q1

Sources: BIS, ECB staff calculations, Hartmann and Issing (2002).

Figure 4. Currency Shares in International Bank Assets at Constant End of 1994Q1 Exchange Rates

from about ten percent to about 20 percent since the euro was introduced. In both markets, the share of the dollar fell as the figures show. So, on the financing side of the international capital market, the euro performed better than the aggregate of its predecessor currencies and better than the dollar. On the asset side of the international capital market up to now the only available data are for bank assets held in foreign currency. Figure 4 shows that euro asset holdings by non-euro area resident banks have increased continuously since the introduction of the euro whereas the share of the dollar stayed more or less constant. Finally, the IMF official data in Table 3 show that the euro share in the official foreign exchange holdings is roughly 13 percent, the same as the DM share used to be. To sum up, especially on the financing side of the international capital market the euro has been accepted as an international currency. However, whether this will continue depends mainly on the future stability of the euro, and this stability will be determined by monetary policy and the real economic developments in the euro area relative to the monetary policy and the real economic developments in the US.

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Table 3. Share of National Currencies in Foreign Exchange Holdings, Year Enda (In Percent) 1993

1994

1995

1996

1997

1998

1999

2000

2001

All countries US dollar Japanese yen Pound sterling Swiss franc Euro Deutshe mark French franc Dutch guilder ECUsc unspecifiedd

55.3 7.6 3.1 1.0 — 13.3 2.7 0.7 9.7 6.5

56.7 7.7 3.0 1.1 — 13.7 2.3 0.7 8.2 6.6

56.6 7.9 3.3 0.9 — 14.2 2.4 0.5 7.7 6.4

57.0 6.8 3.2 0.8 — 13.7 2.3 0.4 6.8 8.9

60.3 6.0 3.4 0.8 — 13.1 1.9 0.3 5.9 8.3

62.4 5.2 3.7 0.7 — 12.9 1.4 0.4 5.0 8.4

65.9 5.4 3.9 0.7 — 12.2 1.4 0.4 0.8 9.3

68.4 5.5 4.0 0.7 12.7b — — — — 8.8

68.1 5.2 3.9 0.7 13.0b — — — — 9.1

68.3 4.9 4.0 0.7 13.0b — — — — 9.0

Industrial Countries US dollar Japanese yen Pound sterling Swiss franc Euro Deutshe mark French franc Dutch guilder ECUsc unspecifiedd

48.8 7.6 2.4 0.4 — 15.1 2.9 0.4 16.7 5.7

50.2 7.8 2.2 0.3 — 16.4 2.6 0.4 15.2 4.8

50.8 8.2 2.3 0.2 — 16.3 2.4 0.3 14.6 5.0

51.8 6.6 2.1 0.1 — 16.4 2.3 0.2 13.4 7.0

56.1 5.6 2.0 0.1 — 15.6 1.7 0.2 12.0 6.7

57.9 5.8 1.9 0.1 — 15.9 0.9 0.2 10.9 6.4

66.7 6.6 2.2 0.2 — 13.4 1.3 0.2 1.9 7.4

73.5 6.5 2.3 0.1 10.7b — — — — 6.9

73.3 6.3 2.0 0.2 10.4b — — — — 7.6

74.5 5.5 1.8 0.4 9.7b — — — — 8.1

J. Schroeder

1992

Table 3. (continued) 1993

1994

1995

1996

1997

1998

1999

2000

2001

64.5 7.7 4.0 1.9 — 10.8 2.3 1.0 — 7.7

64.3 7.5 4.0 2.0 — 10.5 2.0 1.0 — 8.7

63.1 7.6 4.4 1.7 — 11.9 2.4 0.8 — 8.0

62.4 7.0 4.3 1.5 — 11.0 2.3 0.6 — 10.9

64.3 6.5 4.8 1.4 — 10.6 2.0 0.5 — 9.9

66.2 4.7 5.1 1.1 — 10.3 1.8 0.6 — 10.2

65.3 4.5 5.2 1.1 — 11.3 1.5 0.5 — 10.8

64.6 4.7 5.3 1.1 14.2 — — — — 10.2

64.2 4.4 5.2 1.0 15.0 — — — — 10.1

64.1 4.5 5.5 0.9 15.3 — — — — 9.6

Source: IMF Annual Report 2002.

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Note: Components may not be sum to total because of rounding. a Only IMF member countries that report their official holdings of foreign exchange are included in this table. b Not comparable with the combined share of euro legacy currencies in previous years because it excludes the euros received by euro area members when their previous holdings of other euro area members’ legacy currencies were converted into euros on January 1, 1999. c In the calculation of currency shares, the ECU is treated as a separate currency. ECU reserves held by the monetary authorities existed in the form of claims on both the private sector and European Monetary Institute (EMI), which issued official ECUs to European Union central banks through revolving swaps against the contribution of 20 percent of their gross gold holdings and US dollar reserves. On December 31, 1998, the official ECUs were unwound into gold and US dollars; hence, the share of ECUs at the end of 1998 was sharply lower than a year earlier. The remaining ECU holdings reported for 1998 consisted of ECUs issued by the private sector, usually in the form of ECU deposits and bonds. On January 1, 1999, these holdings were automatically converted into euros. d The residual is equal to the difference between total foreign exchange reserves of IMF member countries and the sum of the reserves held in the currencies listed in the table. e The calculations here rely to a greater extent on IMF staff estimates than do those provided for the group of industrial countries.


Developing Countries US dollar Japanese yen Pound sterling Swiss franc Euro Deutshe mark French franc Dutch guilder ECUsc unspecifiede

1992

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5. References De Grauwe, P., 2000. Economics of Monetary Union, Fourth Edition (Oxford: Oxford University Press). Friedman, M., 1968. “The Role of Monetary Policy,” American Economic Review 58: 1–17. Hartmann, P. and O. Issing, 2002. “The International Role of the Euro,” Journal of Policy Modeling 24: 315–345. Meese, R. and K. Rogoff, 1983. “Empirical Exchange Rate Models of the 1970’s: Do They Fit Out of Sample?” Journal of International Economics 14: 3–24. Phelps, E., 1967. “Phillips-Curve, Expectations of Inflation and Optimal Unemployment Over Time,” Economica 34: 288–296. Vaubel, R., 2002. “Die Ursachen der Euro-Schwäche 1999–2001,” in Renate Ohr (ed.), 10 Jahre Vertrag von Maastricht (Berlin: Duncker and Humblot) 47–56.

Asian Economic Community: Intra-Community Macro- and Micro-Economic Parameters∗ Manoranjan Dutta Professor, Economics Department Rutgers, The State University of New Jersey New Brunswick, New Jersey, USA [email protected]

1. Globalism and Regionalism The success of globalism with some 200 sovereign nation state economies of very diverse dimensions remains to be attained (190 members of the United Nations (UN) with Switzerland electing to be a member in 2002; 183 members of the International Monetary Fund (IMF) and The World Bank (WB); 144 members of the World Trade Organization (WTO), following admission of People’s Republic of China (PRC) and Taipei to its membership in 2001). Only with regionalism, based on economic grouping of a set of sovereign nation state economies belonging to a region, as observed on the map of the world, globalism can be operationally successful. Each regional economic group can be competitive actors in the global market and thus contribute to the maximization of economic gains for all the micro-economic actors — households as well as business units — of the world. Scholar-politician Saburo Okita (1989) spoke eloquently for the inter-dependence of globalism and regionalism. In what follows let us review the two factors which have contributed to this new economic paradigm.

∗

Reprinted from Journal of Asian Economics, Vol. 13, No. 4, M. Dutta, Asian economic community: Intra-community macro- and micro-economic parameters, Pages 447–496, 2002, with permission from Elsevier. 71

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1.1. The post-WWII infrastructure of globalization and the new world The post-WWII efforts to globalization, supported by the institutional infrastructures, such as, the United Nations (UN), the International Monetary Fund (IMF), The World Bank (WB), The World Trade Organization (WTO), the International Labor Organization (ILO) and a whole host of others, have failed to produce optimum results. True, the nonparticipation of the then communist economies created a problem. Even, participation by the non-aligned group of countries became a point of concern. The rich and the poor economies of the world failed to make the market economy work successfully. The delinking of the fixed gold value of the US dollar on August 15, 1971 added a new chapter to the situation. The G-5, then G-7 and now the G-8 elected to take their exchange rate management problem to themselves, effectively out of the IMF system. The donor countries of the WB became an inclusive economic club. The WTO faces a paralysis, as it has not been quite able to manage the trade issues facing the rich and the poor nations of the world, persistence of trade conflicts amongst the rich trading nations of the world apart. If investment did not go to economies of relative labor abundance and consequent low-wage cost per unit of product, labor moved to investment in labor-scarce economies with relative full employment and high wage rate, a la necessary modification of immigration and naturalization laws. The ILO watched the process and could hardly be an actor for freedom of labor movement. The phenomenon of illegal immigration continues to be widespread, much to the agony of millions of distressed people whose labor is in demand in the countries complaining against illegal immigration. No wonder, the Presidents of Mexico and the US recently shared their concern in this regard. The Asian Financial Crisis in 1997–1998 opened the debate and produced an endless flow of literature on the crisis after the crisis. A student of economics misses reading a pre-crisis research paper. One must ask the question if the post-WWII global economic system has become dysfunctional. 1.2. The European Economic Union The second factor we must consider is the successful experimentation of the new paradigm of economic regionalization in Europe in the post-WWII decades. Beginning with the European Coal and Steel Community (ECSC), effective July, 1952 with Germany, France, Italy, and 3-Benelux countries,

Asian Economic Community

73

and, the Customs Union of six ECSC countries in 1953, the European Union (EU) progressed through the Treaty of Rome (1958), One Europe Treaty (1986), the Maastricht Treaty (1992) to an economic union of 15 sovereign nation economies of Europe. On January 1, 1999, 12 of the 15 EU member economies “voluntarily surrendered” their monetary sovereignty and adopted one currency, euro, under the management of one intra-regional central bank, the European Central Bank (ECB) with its headquarters in Frankfurt, Germany, which has unanimously adopted English as its official language. The UK, Sweden, and Denmark are the three-out members of EU who have not yet joined the Euro-regime. In 2004, 10 more sovereign nation state economies of Europe — the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, Slovenia, plus Malta and Cyprus — are designated to become members of the EU. To summarize the core issues of the EU, the Economic Union has acted affirmatively on core economic issues — both micro and macro. Free intraregional flow of trade and investment and movement of labor for the 15 EU member economies must be the centerpieces of micro-economic integration. The EU is one member of the WTO and as such, the Union is represented by one member in the WTO with one vote for all 15 member economies. Adoption of one common currency with some necessary institutional provisions for fiscal policy cooperation complete the macro-economic integration for them. The three-out EU members will have to join the Euroregime to complete the process of integration. The intelligent guess is that the issue for the three is not if to join the Euro-regime, but when to join the club. Prime Minister Blair’s speech on November 23, 2001 is seen by many as an endorsement of the euro for the UK. The issue that ONE money, euro, will lead to one Europe must remain open for years ahead (Issing 1996). I have ventured to suggest that incompatibility of EU membership without membership of the Euro-regime will soon be too pronounced. Two points of clarification may be helpful. Firstly, one common currency for the Euro-regime must not be confused with the concept of a common currency area and its optimality (Mundell 1961, 1970, 1999). Secondly, the concept of sovereignty and its divisibility between monetary and political contents — warrants careful appreciation (see Dutta 1995, 2000a, 2000b). Be it noted that the EU is not “a fortress” union of its membership. The EU is an economic unit open to the global economy wherein inter-regional global competition amongst the regional unions of free market economies will contribute to the maximization of economic gains for each region as well as for

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the world as a whole. One can argue that the EU will be the learning model for an integration of regionalism and globalism. I have argued that the core of the emerging new economic regionalization paradigm must relate to: (1) a map-of-the-world view of the region; and (2) an intra-regional, multilateral, cooperative effort to map an economic region on to a geographic region (Dutta 1999).

2. Asia-Pacific Economic Cooperation (APEC) Combined with the pull-factor of successful industrialization at an accelerated rate for the select group of East Asian economies beyond Japan since the 1970s, plus normalization of the economic relationship with the People’s Republic of China (PRC) in 1970s, and the push factor of European economic regionalization in the post-WWII decades, several sovereign nation state economies on the two shores of the Pacific Ocean and in the South Pacific elected to constitute the APEC in 1989 (see Dutta 1999), and as of this date APEC membership has grown to 21 economies inclusive of Russia. They all belonged to a map-of-the-world view of a region if and only if the concept of the Lake Pacific were true. One must note that the divide of the Atlantic Ocean became a geographical fact to find the Americas not on the map of Europe. The Pacific Ocean, larger than the Atlantic Ocean, must be no less, if not more of, a geographic divide to provide an effective geographic sense of belonging together between the economies on the two shores of the Pacific. APEC has little to its credit in terms of accomplishment even for the effective promotion of an intra-APEC free trade regime. They have voted for the future-oriented 10/20 paradigm and substantively shelved the issue. Students of economics who share the paradigm of globalism and regionalism note with much care that American Hemispheric Economic Union is a subject of more intensive study. The Organization for African States recently is reported to have discussed the feasibility to “reinvent” itself as the African Economic Union following the model of the EU (The New York Times 2001). Recently, the case for Australian–New Zealand economic integration with one common currency, possibly managed by one intraregional common central bank, has been investigated (Grimes, Holmes and Bowden 2000).


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3. Lessons to Learn from the EU Model See Dutta (1992, 1999, 2000a, 2000b, 2001); Issing (1996, 2001); Kiyoshi (2000); Letiche (1997); Mazzucelli (1997); Monnet (1978); Schroeder (2000).

3.1. The pan-European culture and civilization Exclusivity of culture, religion, language, race, color have long been considered as the base for the identity of so many traditional sovereign nation states and their economic exclusiveness. The fact is that a modern sovereign nation state economy is colorfully touched by the multiplicity of culture, religion, language, race, color, performing arts and life-styles. Technology and knowledge defy all borders. The EU illustrates this fact of multiplicity and points to a pan-European experience, a new European life-style. Any suggestion to imply that these factors are irrelevant must be ignored. They continue to be significant in defining the European civilization by the pan-European experience — a unity in diversity.

3.2. Progression to an intra-EU micro- and macro-economic agenda The simple commodity based, be it coal and/or steel, economic union is untenable. The Customs Union, the Free Trade Area by specific agreements amongst a set of neighboring countries remains exposed to challenges. A more comprehensive economic regionalization involving a set of sovereign nation state economies belonging to the map of Europe became the order. The economic union adopted a well-formulated micro-economic agenda for intra-regional free flow of trade, investment and free movement of labor. This contributed to the emergence of an intra-regional European free market. However, this EU intra-regional free market could not be functionally effective in the absence of an intra-regional macro-economic agenda with well-specified and transparent monetary and fiscal guidelines. In 1992, the EU member countries did this by signing the Maastricht Treaty. The EU in 1998 covered 15 sovereign nation state economies of 374.3 million people with Gross Domestic Product (GDP) at US$7.8 trillion (PPP), when the US had a population base of 272.7 million people with a GDP base of $8.5 trillion (PPP).

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3.3. Membership of the EU anchored to the principle of inclusion, not exclusion Member economies belonging to the map of Europe were welcome if and only if candidate country was willing and able to accept the responsibility. In 1957 six members signed to join the EU, effective January 1, 1958. In five successive stages, EU membership rose to 15 in 1995 (Table 1). 3.4. EU’s competitively larger economic base warrants immediate attention EU with a GDP base of US$7.8 trillion (PPP) and a population base of 374 million has emerged as a competitive actor in the world market vis-à-vis the US with a GDP base of US$8.5 trillion and a population base of 273 million. Japan with a GDP base at US$3.0 trillion and a population base of 126 million is now a distant third. In the pre-EU regime, the four larger economies — Germany, France, UK, and Italy with GDP at US$1.8 trillion, US$1.3 trillion, US$1.3 trillion and US$1.2 trillion, respectively, Japan was the second largest economy of the world, next to the US, of course a distant second to the US. But, Japan was quite far ahead of each of the big four Table 1. EU Membership 1957 1957 1957 1957 1957 1957 1973 1973 1973 1981 1986 1987 1995 1995 1995

Belgium France Germany Italy Luxembourg The Netherlands Denmark Ireland UK Greece Portugal Spain Austria Finland Sweden

Source: From various official publications.


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Table 2. EU — GDP and Population in 1998

Belgium France Germany Italy Luxembourg The Netherlands Denmark Ireland UK Greece Portugal Spain Austria Finland Sweden Total US Japan

GDP (PPP) US$ (billion)

Percentage (%)

236 1320 1813 1181 14 349 124 67 1252 143 145 646 185 104 175 7754 8511 2903

3.04 17.02 23.38 15.23 0.18 4.5 1.6 0.86 16.15 1.84 1.87 8.33 2.39 1.34 2.26 100

Population (millions) 10.2 59 82.1 56.7 0.4 15.8 5.4 3.6 59.1 10.7 9.9 39.2 8.1 5.2 8.9 374.3 272.7 126.2

Percentage (%) 2.73 15.76 21.93 15.15 0.11 4.22 1.44 0.96 15.79 2.86 2.64 10.47 2.16 1.39 2.38 100

Source: World Factbook, 1999, see also Schroeder (2000). Note: PPP, purchasing power parity.

of EU. The global economic spectrum has thus undergone a major change (Table 2). In 2004, with the new membership of the ten members, EU will add to its GDP base at the 1998 GDP estimates: (PPP) in US billion dollars a total of US$0.6 trillion — and a population of 75 million (Table 3). Table 4 shows that the comparative standing of the euro — regime with 12 in-members exclusive of the three-out members of EU, based on GDP and population, vis-à-vis the US and Japan, is retained. 3.5. Shares of world trade for member economies of EU and the Euro-regime If there were an alpha-beta-gamma economy with US$10 trillion GDP base, trading with no other economies in the world, the rest of the world would

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M. Dutta Table 3. EU Plus 10 in 2004 — GDP (PPP) and Population

Cyprus Czech Republic Estonia Hungary Poland Slovenia Latvia Lithuania Malta Slovakia Total

GDP (PPP) US$ (billion)

Population (millions)

10 117 8 75 263 20 10 18 5 45 571

0.8 10.3 1.4 10.2 38.6 2.0 2.4 3.6 0.4 5.4 75.1

Source: World Factbook, 1999, see also Schroeder (2000).

have little concern for that economy and let it remain in splendid isolation. An individual economy’s economic interaction with the rest of the world can be measured by its trade with others. We consider that an individual economy’s share of world exports will be a quantifiable measure of its economic relationship with other economies (see Dutta 2000a, 2000b, 77– 83, see also Issing 2001). In my papers (Dutta 2000a, 2000b) I have presented data on annual export share of each member economy of EU for 1970 through 1997. Over the three decades, the individual export shares for the four larger economies of Germany, France, UK and Italy vary within the range of five and nine percent of world exports. For the 11 other EU members individual export shares vary within the range of 1–3 percent, their respective shares of world export being rather marginal. Germany has much more fluctuations. EU is one trading unit with one membership of the WTO, as referred to earlier. The 15-member EU share of world exports for the same period fluctuate around 40 percent of world exports. For the Euro-regime the share varies around 35 percent of world exports. No correction for intra-EU trade flows have been made. All trade are in 1995 US dollar. Table 5 presents the figures presented by Professor Issing. One concludes from Table 5 that the Euro-regime of 12 in-members of EU has a competitively large share of world trade as well as a larger share of exports and imports of goods and services as a percent of GDP vis-à-vis


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Table 4. The 12-Member Euro-Regime — GDP and Population in 1998 GDP (PPP) US$ (billion) Belgium France Germany Italy Luxembourg The Netherlands Ireland Greece Portugal Spain Austria Finland Total US Japan

Population (millions)

236 1320 1813 1181 14 349 67 143 145 646 185 104 6203 8511 2903

10.2 59 82.1 56.7 0.4 15.8 3.6 10.7 9.9 39.2 8.1 5.2 300.9 272.7 126.2

Source: World Factbook, 1999, see also Schroeder (2000). Note: PPP, purchasing power parity.

Table 5. Shares of World Exports in 1999

Shares of world exports Exports of goods and services (% of GDP) Imports of goods and services (% of GDP)

Euro-regime

US

Japan

18.9 16.9 15.9

15.2 10.3 13.2

9.1 10.7 9.1

Source: Issing (2001, 3). Note: World exports is net of intra-Euro-regime trade flows.

the US and Japan. In Table 6 we present the shares of world GDP in 1999 and of population in 2000. It shows that the Euro-regime commands competitive shares of world GDP (PPP) with a substantively larger population base. Obviously the competition in the world market must be related to the leading actors at present in the market. The importance of competitive open market has been the primary lessons in economics. To the extent the world competition will be more effectively operational by the EU and the

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M. Dutta Table 6. GDP Shares (PPP) in 1999 and Population in 2000 Euro-regime Shares of world GDP (%) (1999) Population (2000) (million)

16.2 302

US

Japan

21.9 272

7.6 127

Source: Issing (2001, 3).

Euro-regime, it will help the process of optimization of economic gains for all micro-economic actors — households and business units — belonging to all the economies of the world. I have argued that the two simple parameters based on an individual economy’s shares of world output and exports may determine its competitive position in the world market, denoting the two as GDPi /GDPw and Xi /Xw . The EU presents a novel paradigm. European experiment points to the fact that these industrialized economies could hardly be able to command competitive shares of world output and exports. The new regime of information technology is much more capital intensive. Thus, the model of regional economic union is pragmatic and preferred. Assuming other things equal, two of the world’s most populous economies — China and India — with relatively large endowments of natural resources — may independently do the miracle in the future. But other things are seldom equal, hence, the argument for learning from the European model must prevail (Dutta 1999, 2000a, 2000b). This will also make the globalization model effective. Or, a select set of affluent economies or economic groups with commands of larger shares of world output and trade will face an overwhelmingly large number of sovereign nation state economies each with marginal shares of world output and trade and their challenge to the order of globalization will be played on the streets of Seattle, Ontario, Washington DC, Rome, Paris, London, and Geneva. Will there be many more “secluded” places to convene conferences on globalization? Taking the WTO, now with 144 sovereign nation state member economies, three of them — the Euro-regime of EU, US and Japan with 700 million people in 2000, command about one-half of world output and trade (Table 7). One way to make globalization real is to welcome the EU/euro model and promote regional economic unions with competitive shares of world output and trade, which will provide effective support to the paradigm of globalism.


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Table 7. Shares of GDP (PPP) and World Exports (%)

Euro US Japan Total Rest of the world

GDP (1999)

World exports (1999)

Population (2000) (million)

16.2 21.9 7.6 45.7 54.3

18.9 15.2 9.1 43.2 56.8

302 272 127 701

Table is constructed for the paper. Data from official sources.

Table 8. GDP (PPP) Per Capita (%)

Germany Portugal Spain Ireland

1987

1998

100 20 42 47

100 66 75 84

Source: Schroeder (2000, 28).

3.6. Richer and poorer member economies in EU compact Eleven of the fifteen member economies of EU are relatively more advanced in terms of industrialization and affluence, while four — Greece, Spain, Portugal, and Ireland lag behind. All four of them are members of the Euroregime. EU set up the European Fund to undertake projects for intra-EU structural reforms so that all member economies would be able to compete in the EU free market. Indeed, drawing upon OECD findings, Schroeder (2000, 26) presents an instructive progress report showing that Ireland, Spain, and Portugal have made substantial progress toward closing their income gap with Germany in terms of per capita income (see Table 8). Here is a successful catching up process contributing to EU scores. 3.7. Freedom of labor movement Intra-regional free movement of labor in EU came in two stages — work permit and totally free movement. Any and all warnings of chaos proved to be

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untrue. Millions of workers from poorer member economies did not move to richer and more industrialized, hence relatively labor-scarce EU economies. It is equally true that all corporations from the richer and relatively laborscarce, high wage economies did not move their manufacturing units to the labor-abundant, relatively low-wage rate EU member economies, creating employment havoc in their respective home economies. Rather, a harmonized movement of investment from the relatively savings-surplus member economies to create employment where labor was relatively abundant and unemployed along with some movement of labor from the highunemployment economies to low-unemployment economies contributed to a market-induced balance in the labor market. 3.8. Fluctuations of exchange rate: euro vis-à-vis US dollar Much has been written about the euro–dollar exchange rate fluctuations. It is too soon to make a definitive judgment in this regard given the fact that euro has been a legal tender just over 24 months, when euro has not been a medium of exchange, but has functioned as a store of value and unit of account. The issue of euro–dollar exchange rate fluctuations has, of course, been subject to much speculation. The concept of equilibrium exchange rate is subject to much debate. Researchers have reported the euro–dollar exchange rate fluctuations both in terms of nominal rate and effective rate (Coppel, Durand and Visco 2000). Comparative productivity in the real economies of the two currency regimes in late 1990s also warrants much attention. True, the value of euro against dollar has fallen 24 percent over the past 24 months. A study on the fluctuations on dollar over the past 24 years may shed some more light. Further careful research on this problem will shed light on these fluctuations. The fact that euro has been successfully introduced as a medium of exchange as of January 1, 2002 will also be an important factor. 4. Asian Economic Community (AEC) Let us review the lessons from the EU and Euro-regime. 4.1. The map of Asia is as real as the map of Europe The pan-Asian culture and civilization is as real as the concept of panEuropean culture and civilization — the message is unity in diversity. The


83

grim history of intra-regional hostilities and wars in Europe and Asia cannot be allowed to stand in the way of the continental economic unity. 4.2. Any effort toward AEC must be based on a comprehensive intra-regional micro- and macro-economic agenda Much has been talked about the potentials of a free trade area, which cannot be functionally operational without free flow of investment and some form of free movement of labor. This intra-Asian micro-economic structure must be supported by the intra-Asian macro-economic framework. A replication of the EU model is not a necessary condition, but the EU model as it evolved over a period of time almost one-half of one century presents a comprehensive economic agenda for Asia and for other continental economic regionalization. 4.3. Membership of the AEC must be anchored to the principle of inclusion In Europe the initiative in 1958 came from the six European States, mostly in Western and Central Europe. Over time its membership grew to 15 sovereign nation economies, and in 2004, it is projected to be 25. In Asia, three East Asian economies — Japan, Korea, China — plus the original five members of Association of South East Asian Nations (ASEAN) — Singapore, Malaysia, Thailand, Indonesia and Philippines — appear to have under study a 3 + 5 intra-regional economic integration model. Will Taiwan be invited to join AEC? Will the five other ASEAN members be invited to join AEC? Will AEC over time reach out to South Asia and South Pacific? These are issues, which must remain to be addressed in the future. That is the lesson from EU. 4.4. Uniformity of the level of industrialization of prospective member economies of AEC, even if the group of 3 + 5 has been an issue of concern Beyond Japan, most of these economies have been traditional, agriculturedominant economies and may not be ready for an intra-regional economic integration. Uniformity, relative uniformity, of the level of industrialization of EU’s member economies has not been subject of research. Let us explore this issue. Based on sectoral shares of GDP (PPP) in 1999, Issing (2001) presents a comparative profile of the Euro-regime, US and Japan

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M. Dutta Table 9. Sectoral Shares of GDP (PPP) 1999 Euro-regime

US

Japan

2.8 28.5 68.7 100.0

1.6 27.3 71.1 100.0

1.8 36.4 61.9 100.0

Agriculture Industry Services Total Source: Issing (2001).

Table 10. Sectoral Shares of GDP (2000)

Japan Korea China Taiwan Thailand Singapore Malaysia Indonesia Philippines

Agriculture

Industry

Service

Total

1.8 14.2 11.9 2.4 9.9 0.1 8.7 16.7 19.9

36.4 37.8 64.0 34.6 44.5 33.2 46.8 43.5 34.4

61.9 48.1 24.1 63.0 45.7 66.6 44.6 39.8 45.7

100 100 100 100 100 100 100 100 100

Source: Asian Development Bank (2001). Note: Figures for Korea 1980.

(see Table 9). In Table 10 we present the profile of industrialization for the select economies of Northeast and Southeast Asia. Table 11 presents comparative GDP shares of the three sectors of the economies of Northeast and Southeast Asia selected for this study and of 15 EU economies for 1988 and 1997 and the trend of industrialization is evident. A comparison of the 1970 figures of the above countries will point to the fact that these Asian economies have progressed to a higher level of industrialization at an accelerated rate since 1970s. They are no longer agriculture-dominant, traditional economies and they have proved much to the surprise of many that industrialization in Asia can progress beyond Japan.

Table 11. Sectoral Shares of GDP (1998 and 1997) Country name

ASEAN ASEAN ASEAN ASEAN ASEAN NORTHEAST ASIA NORTHEAST ASIA NORTHEAST ASIA NORTHEAST ASIA NORTHEAST ASIA EU EU EU EU EU EU

Agricultural sector

Industrial sector

Service sector

1988

1997

1988

1997

1988

1997

22.48 19.32 22.96 0.39 16.18 25.66 0.32 2.67 5.04 10.10 6.53 3.24 4.35 3.92 1.88 1.93

16.09 11.15 18.69 0.15 9.73 19.09 0.12 1.74 2.55 5.35 n.a. n.a. n.a. n.a. 1.13 0.80

37.27 35.51 35.16 38.07 34.58 44.13 27.64 40.73 44.84 43.13 37.10 34.79 27.96 28.65 30.27 n.a.

44.33 44.64 32.21 34.53 41.30 49.99 14.71 37.18 35.32 43.08 n.a. n.a. n.a. n.a. 27.62 n.a.

40.25 45.17 41.88 61.53 49.24 30.21 72.04 56.61 50.13 46.78 56.37 61.98 67.68 67.43 67.85 98.69

39.58 44.21 49.10 65.32 48.97 30.93 85.17 61.07 62.14 51.57 61.69 n.a. n.a. n.a. 71.54 104.00


Indonesia Malaysia Philippines Singapore Thailand China Hong Kong, China Japan Taipei, China Korea Finland Sweden Denmark The Netherlands Belgium Luxembourg

Region

85

86 M. Dutta

Table 11. (Continued) Country name

France Germany Italy Spain Portugal Greece Ireland Austria United Kingdom

Region

EU EU EU EU EU EU EU EU EU

Agricultural sector

Industrial sector

Service sector

1988

1997

1988

1997

1988

1997

3.34 1.09 3.61 5.30 5.85 13.06 9.76 3.13 1.78

2.25 n.a. 2.63 n.a. n.a. n.a. n.a. n.a. n.a.

29.80 n.a. 34.02 35.07 38.69 22.56 n.a. 32.52 37.03

26.21 n.a. 30.50 n.a. n.a. n.a. n.a. n.a. n.a.

66.87 n.a. 62.38 59.63 55.47 64.38 60.66 64.35 61.19

71.53 44.19 66.37 25.06 n.a. n.a. n.a. 68.07 66.67


87

This point, as it has often been the issue of debate, merits further investigation. In Table 11, we present the profile of industrialization of Northeast and ASEAN-5 and EU based on two time points, 1988 and 1997. We present the profile based on annual date of sectoral shares of GDP for the same set of economies for some two decades since 1980 (see Figures 17–25). A close review will point to the fact that GDP shares from agricultural sector of all these economies are declining and shares of industrial and service sectors are moving upward. The second important point is to take note of that there are variations in the historical progression of the profile of industrialization for member economies in each group, inclusive of EU. For example in 1980, Greece a member of EU started with a 14 percent share of GDP from the agricultural sector and in 1995 this share came down to 12 percent — a very modest decline. Greece’s share of GDP from its industrial sector did not move upward while its share of GDP from its service sector moved up from some ten points over the same period. In Northeast Asia, China’s profile substantially differs from that of other economies in the group, albeit Hong Kong in this group has a very special economic structure. In Southeast Asia, apart from Singapore which has its special economic structure, Thailand presents a profile noticeably different from that of other four member economies. In addition, a third point remains to be noted. In Northeast Asia, several member economies have their respective shares of GDP from their respective service sectors moved upward, demonstrating their profiles of post-industrialized economic structure and their progressive advancement to the matured stage of industrialization. Japan of course is the leader.

4.5. AEC’s economic base in terms of its shares of world output and trade AEC’s economic base in terms of its shares of world output and trade will merit much discussion. Several issues, intra-AEC structural economic reform, free movement of labor, fluctuations of Asian money vis-à-vis euro and US dollar can be addressed independently. In Tables 12–17, we present GDP (PPP) in billion and export–import figures in 1995 constant billion US$. Our presentations cover data for 1987 and 1997, so that we have a pen-picture of the time profile of change over the decade. In response to the comments of a reader, our trade analysis in these tables includes both exports and imports, even though we have argued individual economy’s share of world export will be a sufficient parameter, since the global trade

88

Table 12. GDP and Trade of Euro Countries in 1987 and 1997

Austria Belgium Finland France Germany Ireland Italy Luxembourg The Netherlands Portugal

EXPORT/% of world export

IMPORT/% of world import

1987

1997

1987

1997

1987

1997

122.93 0.52 165.16 0.70 75.04 0.32 855.32 3.64 n.a. n.a. 34.20 0.15 847.05 3.61 5.75 0.02 218.97 0.93 90.19 0.38

189.38 0.49 245.65 0.63 107.87 0.28 1260.55 3.25 1858.89 4.79 78.15 0.20 1234.40 3.18 15.33 0.04 350.71 0.90 149.85 0.39

56.65 1.45 126.66 3.23 30.69 0.78 215.74 5.50 n.a. n.a. 21.30 0.54 170.77 4.36 12.42 0.32 155.86 3.98 19.56 0.50

104.61 1.40 209.20 2.79 57.81 0.77 404.39 5.40 701.48 9.37 66.95 0.89 317.79 4.25 22.28 0.30 271.58 3.63 37.64 0.50

57.17 1.42 118.56 2.94 29.28 0.73 224.18 5.56 n.a. n.a. 21.56 0.53 168.89 4.19 12.22 0.30 149.98 3.72 20.25 0.50

105.99 1.44 194.74 2.65 44.58 0.61 356.38 4.85 652.80 8.89 56.72 0.77 276.69 3.77 19.32 0.26 242.99 3.31 45.24 0.62

M. Dutta

GDP/% of world GDP

Table 12. (Continued) GDP/% of world GDP

Spain Total

World total

1987

1997

1987

1997

1987

410.98 1.75 4071.31 17.33 5006.72 21.31 23,492.08

653.25 1.68 6160.93 15.88 8149.82 21.00 38,800.99

73.26 1.87 1327.20 33.86 400.50 10.22 3919.67

167.73 2.24 2362.63 31.56 1064.95 14.23 7485.47

67.40 1.67 1286.14 31.89 572.73 14.20 4032.52

1997 162.31 2.21 2169.05 29.53 1200.38 16.34 7346.28

Source: World Bank 2001 Yearbook. Note: (1) GDP is PPP-adjusted international billion $; (2) export and import are in 1995 constant billion US$ at market price; (3) export is not adjusted for intra-EU trade.


US

EXPORT/% of world export IMPORT/% of world import

89

90

Table 13. GDP and Trade of EU Countries in 1987 and 1997

Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxembourg



1987

1997

1987

1997

1987

1997

122.93 0.52 165.16 0.70 n.a. n.a. 75.04 0.32 855.32 3.64 n.a. n.a. 99.73 0.42 34.20 0.15 847.05 3.61 5.75 0.02

189.38 0.49 245.65 0.63 132.01 0.34 107.87 0.28 1260.55 3.25 1858.89 4.79 149.76 0.39 78.15 0.20 1234.40 3.18 15.33 0.04

56.65 1.45 126.66 3.23 45.47 1.16 30.69 0.78 215.74 5.50 n.a. n.a. 15.27 0.39 21.30 0.54 170.77 4.36 12.42 0.32

104.61 1.40 209.20 2.79 69.26 0.93 57.81 0.77 404.39 5.40 701.48 9.37 23.14 0.31 66.95 0.89 317.79 4.25 22.28 0.30

57.17 1.42 118.56 2.94 41.08 1.02 29.28 0.73 224.18 5.56 n.a. n.a. 18.18 0.45 21.56 0.53 168.89 4.19 12.22 0.30

105.99 1.44 194.74 2.65 63.13 0.86 44.58 0.61 356.38 4.85 652.80 8.89 34.34 0.47 56.72 0.77 276.69 3.77 19.32 0.26

M. Dutta

GDP/% of world GDP

Table 13. (Continued) GDP/% of world GDP

The Netherlands Portugal Spain Sweden

Total US World total

1987

1997

1987

1997

1987

218.97 0.93 90.19 0.38 410.98 1.75 135.99 0.58 832.98 3.55 5502.77 23.42 5006.72 21.31 23,492.08

350.71 0.90 149.85 0.39 653.25 1.68 187.75 0.48 1239.96 3.20 7853.50 20.24 8149.82 21.00 38,800.99

155.86 3.98 19.56 0.50 73.26 1.87 66.31 1.69 223.39 5.70 1824.19 46.54 400.50 10.22 3919.47

271.58 3.63 37.64 0.50 167.73 2.24 113.83 1.52 372.88 4.98 2940.57 39.28 1064.95 14.23 7485.47

149.98 3.72 20.25 0.50 67.40 1.67 62.86 1.56 228.58 5.67 1778.64 44.11 572.73 14.20 4032.52

1997 242.99 3.31 45.24 0.62 162.31 2.21 93.05 1.27 386.06 5.26 2734.35 37.22 1200.38 16.34 7346.28



United Kingdom


91

China Hong Kong, China Taipei, China Korea Republic Japan Total Euro EU US World total


1987

1997

1987

1997

1987

1997

1247.26 5.31 77.79 0.33 148.40 0.63 280.49 1.19 1971.91 8.39 3725.85 15.86 4071.31 17.33 5502.77 23.42 5006.72 21.31 23,492.08

3880.21 10.00 153.22 0.39 291.40 0.75 703.96 1.81 3199.26 8.25 8228.04 21.21 6160.93 15.88 7853.50 20.24 8149.82 21.00 38,800.99

46.53 1.19 76.43 1.95 71.41 1.82 67.36 1.72 316.41 8.07 578.14 14.75 1327.20 33.86 1824.19 46.54 400.50 10.22 3919.67

190.82 2.55 230.66 3.08 141.26 1.89 203.76 2.72 572.10 7.64 1338.61 17.88 2362.63 31.56 2940.57 39.28 1064.95 14.23 7485.47

49.06 1.22 69.23 1.72 50.54 1.25 52.31 1.30 220.38 5.47 441.52 10.95 1286.14 31.89 1778.64 44.11 572.73 14.20 4032.52

160.65 2.19 238.86 3.25 136.81 1.86 183.54 2.50 457.62 6.23 1177.48 16.03 2169.05 29.53 2734.35 37.22 1200.38 16.34 7346.28


M. Dutta

GDP/% of world GDP

92

Table 14. GDP and Trade of East Asia Countries in 1987 and 1997

Table 15. GDP and Trade of ASEAN Countries in 1987 and 1997 GDP/% of world GDP

Indonesia Malaysia Philippines Singapore Thailand

Euro EU US World total


1987

1997

1987

1997

1987

1997

270.64 1.15 63.39 0.27 165.92 0.71 28.14 0.12 143.09 0.61 671.19 2.86 4071.31 17.33 5502.77 23.42 5006.72 21.31 23,492.08

644.82 1.66 185.76 0.48 276.50 0.71 77.95 0.20 390.37 1.01 1575.41 4.06 6160.93 15.88 7853.50 20.24 8149.82 21.00 38,800.99

28.29 0.72 26.40 0.67 13.39 0.34 38.18 0.97 20.55 0.52 126.81 3.24 1327.20 33.86 1824.19 46.54 400.50 10.22 3919.67

62.06 0.83 94.11 1.26 36.57 0.49 122.66 1.64 73.50 0.98 388.92 5.20 2362.63 31.56 2940.57 39.28 1064.95 14.23 7485.47

28.79 0.71 19.09 0.47 13.58 0.34 43.34 1.07 20.25 0.50 125.05 3.10 1286.14 31.89 1778.64 44.11 572.73 14.20 4032.52

75.16 1.02 95.62 1.30 43.75 0.60 129.93 1.77 72.02 0.98 416.48 5.67 2169.05 29.53 2734.35 37.22 1200.38 16.34 7346.28

93



Total


Table 16. GDP and Trade of South Asia Countries in 1987 and 1997 94

GDP/% of world GDP

India Nepal Pakistan Sri Lanka Total Euro EU US World total


1987

1997

1987

1997

1987

94.67 0.40 904.62 3.85 13.34 0.06 114.35 0.49 28.67 0.12 1155.65 4.92 4071.31 17.33 5502.77 23.42 5006.72 21.31 23,492.08

170.82 0.44 1962.31 5.06 27.27 0.07 229.05 0.59 56.31 0.15 2445.76 6.30 6160.93 15.88 7853.50 20.24 8149.82 21.00 38,800.99

1.38 0.04 15.70 0.40 0.34 0.01 5.76 0.15 2.49 0.06 25.68 0.66 1327.20 33.86 1824.19 46.54 400.50 10.22 3919.67

5.21 0.07 45.10 0.60 1.28 0.02 9.30 0.12 5.29 0.07 66.18 0.88 2362.63 31.56 2940.57 39.28 1064.95 14.23 7485.47

2.62 0.06 27.40 0.68 0.60 0.01 9.91 0.25 3.70 0.09 44.23 1.10 1286.14 31.89 1778.64 44.11 572.73 14.20 4032.52

1997 7.26 0.10 63.04 0.86 1.83 0.02 14.12 0.19 6.70 0.09 92.96 1.27 2169.05 29.53 2734.35 37.22 1200.38 16.34 7346.28


M. Dutta

Bangladesh


Table 17. GDP and Trade of ANZ Countries in 1987 and 1997 GDP/% of world GDP

Australia New Zealand Total Euro

US World total


1987

1997

1987

1997

1987

251.35 1.07 45.65 0.19 297.01 1.26 4071.31 17.33 5502.77 23.42 5006.72 21.31 23,492.08

425.30 1.10 68.69 0.18 493.98 1.27 6160.93 15.88 7853.50 20.24 8149.82 21.00 38,800.99

41.72 1.06 12.68 0.32 54.40 1.39 1327.20 33.86 1824.19 46.54 400.50 10.22 3919.67

83.92 1.12 19.19 0.26 103.11 1.38 2362.63 31.56 2940.57 39.28 1064.95 14.23 7485.47

39.49 0.98 11.15 0.28 50.64 1.26 1286.14 31.89 1778.64 44.11 572.73 14.20 4032.52

1997 93.00 1.27 19.24 0.26 112.24 1.53 2169.05 29.53 2734.35 37.22 1200.38 16.34 7346.28



EU


95

96

M. Dutta

inclusive of exports of all trading economies will cover imports by all trading member economies. Relative shares of an individual economy and of an individual region, as designated in the study, have not varied very much. It is noted that AEC beginning with the 3 + 5 model will have a competitive share of world output and trade (see Tables 14 and 15). Table 12 presents figures on GDP and trade of the 12 Euro countries and of the US. Table 13 relates to same data sets relative to all 15 EU member economies. It is instructive to note that GDP figures (PPP) of ten of the 15 EU countries — Austria, Belgium, Denmark, Finland, Greece, Ireland, Luxembourg, the Netherlands, Portugal, and Sweden as late as in 1997 remain less than one percent of world GDP. While the United States maintains a share of 21 percent. Following economic integration EU and Euro shares come to be 16 percent and 20 percent, respectively, in the same year. The net result is the economic units across the Atlantic — EU and US — become competitive actors in the world market. This competition will contribute to the maximization of the economic gains for micro-actors — households as well as businesses in all economies in the world. Trade shares of EU and of Euro-regime, as the two tables show, are much larger than that of the US, but the respective shares are large enough to ensure effective competition. Table 14 deals with relevant data for East Asian economies, China, Hong Kong, Taipei, Korea, and Japan — and offers a quick comparison with those of the Euro-regime, EU an US. Table 15 covers ASEAN-5 and also adds figures for the same three economic units, EU, Euro-regime and US. Table 16 presents the related data sets for South Asian economies and for the Euro-regime, EU and US. Finally, Table 17 presents Australian/ New Zealand plus the Euro-regime, EU and US. It is evident that in 1997, the shares of world GDP and world export and imports for the select group of Northeast Asia and Southeast Asia (Tables 14 and 15) add up to (21.21 + 4.06) 25.27 percent of world GDP, (17.88 + 5.20) 23.08 percent of world export, and (16.03 + 5.67) 21.70 percent of world imports. It follows that the AEC will thus be able to add to the level of effective competition in the world market. The process will further contribute to the maximization of world economic gains. The principle of inclusion will progressively lead to the admission of economies of South Asia and South Pacific to the AEC. The learning model will be the EU as it moves on to Europeanization of Europe with European economies in one continental unit.


97

We follow the above analyses by graphic presentations which show the annual data for the 1975–1999 time period for the economies of Asia, individual economy and each subregional total — Northeast Asia exclusive of Japan, Northeast Asia inclusive of Japan, Southeast Asia-5, Northeast and Southeast Asia-5, South Asia-5, Northeast exclusive of Japan, Southeast-5 and South Asia-5, Northeast, Southeast, Euro and US, Northeast, exclusive of Japan, Southeast-5, South Asia-5, Euro, US, without specific graphic presentations for the EU. We move from the decade based analyses presented in Tables 12–17 to an extended analysis based on annual data over a quarter of a century and our objective is to capture any substantive variation in relative shares of world output and trade for the individual sovereign nation economies, the sub-groups they belong to, the sum of the sub-groups, and its relevance for the Euro-regime and the US. The graphic presentations refer to the two parameters, shares of world output and world export, as we have argued at the outset. Figure 1 relates to shares of world GDP for Northeast Asia — China, Hong Kong (China), Korea, Taipei (China), and of the group. Figure 2 relates to the shares of world exports for the above economies and of the group. Figure 3 covers shares of world GDP of the above group inclusive of Japan. Figure 4 refers to shares of world export of the above group inclusive of Japan. Figure 5 deals with shares of world GDP of ASEAN-5 (Indonesia, Malaysia, Philippines, Singapore, and Thailand and the group total). Figure 6 covers shares of world export for the above group of economies. Figure 7 covers shares of world GDP of Northeast inclusive of Japan and Southeast-5. Figure 8 records shares of world export for the economies in Figure 7. Figure 9 describes shares of world GDP for South Asia-5 — Bangladesh, India, Nepal, Pakistan, Sri Lanka and the group. Figure 10 presents shares of world export for the economies in Figure 9 and its total. Figure 11 presents shares of world GDP for the three sub-regional groups, NE, SE and South Asia. Figure 12 does the shares of world export for the groups in Figure 11. Figure 13 presents shares of world GDP for the groups — non-exclusive of Japan, SE, Euro, and US. Figure 14 presents the shares of world export for the groups in Figure 13. Figure 15 presents of shares of world GDP of the groups in Figure 13 plus South Asian total. Figure 16 records shares of world export for groups in Figure 14 adding South Asian total.

98

14%

M. Dutta

12%

8%

China Hong Kong, China

6%

Korea, Rep. Tapei, China Northeast Asia Total (exclude Japan)

4%

2%

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

0% 1975

Percent

10%

Year Note: GDP is PPP-adjusted international billion $.

Figure 1. Share of World Total GDP: Northeast Asia Countries (Exclude Japan)

12%

10%

6%

4%

2%

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

0%

Year Note: Export and import are in 1995 constant billion US$ at market price. Source: World Bank 2001 Yearbook .

99

Figure 2. Share of World Total Export: Northeast Asia Countries (Exclude Japan)


China Hong Kong, China Korea, Rep. Tapei, China Northeast Asia Total (exclude Japan)

1975

Percent

8%

100

25%

M. Dutta

20%

China

15% Percent

Hong Kong, China Japan Korea, Rep. 10%

Tapei, China Northeast Asia Total (include Japan)

5%

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

0%


Figure 3. Share of World Total GDP: Northeast Asia Countries (Include Japan)

20% 18% 16% 14% China Hong Kong, China Japan

10%

Korea, Rep. Tapei, China

6%

Northeast Asia Total (include Japan)

4% 2%

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

0%

Year Note: Export and import are in 1995 constant billion US$ at market price. Source: World Bank 2001 Yearbook.

101

Figure 4. Share of World Total Export: Northeast Asia Countries (Include Japan)


8%

1975

Percent

12%

102

5%

M. Dutta

4% 4%

Indonesia Malaysia

3%

Philippines Singapore Thailand Southeast Asia Total

2% 2% 1% 1%

Year Note: GDP is PPP- adjusted international billion $.

Figure 5. Share of World Total GDP: ASEAN-5 Countries

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

0% 1975

Percent

3%

6%

5%

4%

Philippines Singapore Thailand Southeast Asia Total

3%

2%


103

Figure 6. Share of World Total Export: ASEAN-5 Countries

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

0%


1%

1975

Percent

Indonesia Malaysia

104

25%

M. Dutta

20%

Northeast Asia Total (exclude Japan) Southeast Asia Total Japan Northeast Asia Total (include Japan)

Percent

15%

10%

5%


Figure 7. Share of World Total GDP: Northeast Asia and ASEAN

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

0%

20% 18% 16% 14% Northeast Asia Total (exclude Japan) Southeast Asia Total Japan Northeast Asia Total (include Japan)

10% 8% 6%

2%

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

0%


105

Figure 8. Share of World Total Export: Northeast and South Asia


4%

1975

Percent

12%

106 M. Dutta

8% 7%

5%

Bangladesh India

4%

Nepal Pakistan Sri Lanka South Asia Total

3% 2%


Figure 9. Share of World Total GDP: South Asia Countries

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

0%

1976

1%

1975

Percent

6%

1.0% 0.9% 0.8% 0.7% Bangladesh India

Percent

0.6%

Nepal Pakistan Sri Lanka South Asia Total

0.5% 0.4% 0.3%


Figure 10. Share of World Total Export: South Asia Countries

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

0.0%

1975

0.1%


0.2%

107

108 M. Dutta

25%

20%

15% Percent

Northeast Asia Total (exclude Japan) Southeast Asia Total South Asia Total

10%

Northeast Asia Total (include Japan) 5%


Figure 11. Share of World Total GDP: Three Asian Regions

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

0%

20% 18% 16% 14% Northeast Asia Total (exclude Japan) Southeast Asia Total South Asia Total Northeast Asia Total (include Japan)

Percent

12% 10% 8% 6%

2%

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

0%


109

Figure 12. Share of World Total Export: Three Asian Regions


4%

110 M. Dutta

25%

20%

Northeast Asia Total (exclude Japan) Southeast Asia Total Euro United States Northeast Asia Total (include Japan)

Percent

15%

10%

5%


Figure 13. Share of World Total GDP: Four Groups

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

0%

40% 35% 30%

Percent

25%

Northeast Asia Total (exclude Japan) Southeast Asia Total Euro United States Northeast Asia Total (include Japan)

20% 15%

5%


Figure 14. Share of World Total Export: Four Groups

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

0%


10%

111

112 M. Dutta

25%

20% Northeast Asia Total (exclude Japan)

Percent

15%

Southeast Asia Total South Asia Total EURO United States

10%


5%


Figure 15. Share of World Total GDP: Five Groups

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1987

1988

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

0%

40% 35% 30% Northeast Asia Total (exclude Japan)

Percent

25%

Southeast Asia Total South Asia Total EURO United States

20% 15%


5%


Figure 16. Share of World Total Export: Five Groups

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

0%


10%

113

114

14%

Finland Sweden Denmark

12%

Netherlands Belgium

Percent

10%

Luxembourg France

8%

Germany Italy Spain

6%

Portugal Greece 4%

Ireland Austria

2%

United Kingdom

0% 1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

Year

Source: World Development Indicator 2001, Asian Development Bank Key Indicator 2001.

Figure 17. EU: Share of Agricultural Sector of GDP

1995

1996

1997

M. Dutta

16%

45%

40% Finland Sweden

35%

Denmark Netherlands

30%

Belgium

Percent

Luxembourg 25%

France Germany Italy

20%

Spain Portugal Greece Ireland 10%

Austria United Kingdom

5%

0% 1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

Year

Source: World Development Indicator 2001, Asian Development Bank Key Indicator 2001.

1996

1997

115

Figure 18. EU: Share of Industrial Sector of GDP

1995


15%

116

120%

Sweden Denmark Netherlands

80%

Belgium

Percent

Luxembourg France 60%

Germany Italy Spain Portugal

40%

Greece Ireland Austria 20%

United Kingdom

0% 1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

Year

Source: World Development Indicator 2001, Asian Development Bank Key Indicator 2001. Note: In some years Luxembourg's share of service sector of GDP were more than 100 percent. Further data check follows.

Figure 19. EU: Share of Service Sector of GDP

1996

1997

M. Dutta

Finland

100%

35% 30%

Percent

25% China Hong Kong, China Japan Taipei, China Korea

20% 15% 10%

0% 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Year Note: Taipei, China's industrial sector includes mining, manufacturing, electricity, gas and water, and construction. Its service sector includes trade, transport and communications, finance, public administration and other.

Figure 20. Northeast Asia: Share of Agricultural Sector of GDP


5%

117

118 M. Dutta

60%

50%

Percent

40%

China Hong Kong, China Japan Taipei, China Korea

30%

20%

10%

0% 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Year Note: Taipei, China's industrial sector includes mining, manufacturing, electricity, gas and water, and construction. Its service sector includes trade, transport and communications, finance, public administration and others.

Figure 21. Northeast Asia: Share of Industrial Sector of GDP

90% 80% 70%

Percent

60%

China Hong Kong, China

50%

Japan Taipei, China

40%

Korea 30%

10% 0% 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

Year Note: Taipei, China's industrial sector includes mining, manufacturing, electricity, gas and water, and construction. Its service sector includes trade, transport and communications, finance, public administration and others.

Figure 22. Northeast Asia: Share of Service Sector of GDP


20%

119

120 M. Dutta

30%

25%

Percent

20%

Indonesia Malaysia Philippines Singapore

15%

Thailand 10%

5%

0% 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Year Source: World Development Indicator 2001, Asian Development Bank Key Indicator 2001.

Figure 23. ASEAN: Share of Agricultural Sector of GDP

50% 45% 40%

Percent

35% 30%

Indonesia Malaysia

25%

Philippines Singapore

20%

Thailand

10% 5% 0% 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Year Source: World Development Indicator 2001.

Figure 24. ASEAN: Share of Industrial Sector of GDP


15%

121

122 M. Dutta

70%

60%

Percent

50% Indonesia Malaysia

40%

Philippines Singapore

30%

Thailand

20%

10%

0% 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Year Source: World Development Indicator 2001, Asian Development Bank Key Indicator 2001.

Figure 25. ASEAN: Share of Service Sector of GDP


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The annual data based graphic presentation covering the time period 1975–1999 show a pattern for the regional shares of world output and export in support of the case we argue for regional economic integration. In Section 4.4, we have discussed the issue of divergent levels of industrialization of Asia’s newly industrialized/industrializing economies and its relevance for the integration of Asian economic community. In Table 10 we have presented the level of industrialization of the selected economies of Northeast and Southeast Asia in 2000. Table 11 presents related data at two discrete time points, 1988 and 1997 for ASEAN-5, Northeast Asia-5 and EU-15. In Figures 17–25, we make graphic presentations of levels of industrialization. Figures 17–19 present EU-15 economies’ shares of GDP from agricultural, industrial and service sectors, respectively. Figures 20–22 relate to the comparable sets of data for Northeast Asian economies. Finally, Figures 23–25 describe the profile of the select group of Southeast Asian economies. In the graphic presentations, based on annual data for 1980–1998, efforts have been made to capture changes in the profiles of industrialization of these economies, which could have been missed in our review of related data at one time point (Table 10) or at two discrete time points (Table 11). Needless to add what has been done here is much less than what remains to be done. 5. Conclusion The conclusion for economic integration in Asia can be supported by the empirical evidence, based on the two parameters, its share of world output and trade vis-à-vis the respective shares of EU and the US. Indeed, each individual Asian economy, inclusive of China and India, the two billion-plus population economies of the world, has marginal shares of world GDP and of world exports. Historically, for years, Japan enjoyed the second largest ranking, next to the US, in terms of shares of world output and trade. After euro and EU, Japan has become a distant third. An Asian regional economic integration will be a plus for the paradigm of globalism. The 3 + 5 model may be the promising first step (see also, Kojima 2000; Letiche 2000). 6. Acknowledgments My sincerest thanks are due to Lawrence R. Klein, who taught me economics, econometrics and the linkages of the world economies, to Robert

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J. Alexander, who has persistently encouraged me to pursue my studies in economic regionalization in Europe and Asia, a field of study for which I have made a commitment, and to Daniel Tantum, Kiseok Lee and Amiya Sharma for their generous cooperation lent to me at successive stages of my study on this subject. My very special thanks to Wenhui Wei for his helpful research assistance for this paper. An earlier version was presented at the joint session, sponsored by American Economic Association (AEA) and American Committee on Asian Economic Studies (ACAES) at the annual meetings of AEA in Atlanta, GA, January 6, 2002. I must acknowledge my sincerest gratitude to John M. Letiche, Kiyoshi Kojima, Shinichi Ichimura, Terutomo Ozawa, James T.H. Tsao, Tzong-shianYu, Mei-chu Hsiao, Frank S.T. Hsiao, and Richard Hooley who very kindly read and made extensive comments on the earlier version and helped my work for the revision. For views expressed here and for all errors persisting, I remain responsible. This paper is the revised version of my presentation at the conference on Asian Economic Cooperation In The New Millennium: China’s Economic Presence, sponsored jointly by American Committee on Asian Economic Studies, Beida School of Economics — Peking University and China Reform Forum, in Beijing, People’s Republic of China, May 27–29, 2002.

7. References Asian Development Bank. Asian Development Outlook 213. Coppel, J., M. Durand and I. Visco, 2000. “The European Monetary Union, the Euro, and the European Policy Mix,” Journal of Asian Economics 11(1): 31–63. Dutta, M., 1992. “Economic Regionalism in Western Europe: Asia-Pacific Economies — Macro-Economic Core and Micro-Economic Optimization,” American Economic Review, Papers & Proceedings 82(2): 67–73. Dutta, M., 1995. “Macro-Economics — Supra-National Macro-Economic Core,” in M. Dutta (ed.), Economics, Econometrics and the LINK, Essays in Honor of Lawrence R. Klein (Amsterdam: Elsevier) 59–73. Dutta, M., 1999. Economic Regionalization in the Asia-Pacific: Challenges to Economic Cooperation (Cheltanham, U.K.: Edward Elgar Publishing) 318. Dutta, M., 2000a. “The Euro Revolution and the European Union: Monetary and Economic Cooperation in the Asia-Pacific Region,” Journal of Asian Economics 11(1): 65–88.


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Dutta, M., 2000b, September. “European Union and the Euro Revolution (mimeo),” Seminar given at George Washington University, Washington, DC. Dutta, M., 2001, October 18. “EU and the Euro Revolution: Revisiting the Theory of Optimum Currency,” Seminar given at University of Colorado at Boulder (mimeo). Grimes, A., F. Holmes and R. Bowden, 2000. An ANZAC Dollar? (Wellington, NZ: Institute of Policy Studies, Victoria University of Wellington) 133. Issing, O., 1996. “Europe: Political Union Through Common Money,” (London, U.K.: Institute of Economic Affairs) Occasional Paper # 98. Issing, O., 2001. “The Euro — The Experience of the Past 2 Years,” Journal of Asian Economics 12(1): 1–20. Kiyoshi, K., 2000. “The ‘Flying Geese’ Model of Asian Economic Development: Origin, Theoretical Extensions, and Regional Policy Implications,” Journal of Asian Economics 11(4): 375–401. Letiche, J. M., 1997. “Maastricht: Prospect and Retrospect,” Journal of Asian Economics 4(1): 191–206. Letiche, J. M., 2000. “Lessons from the Euro Zone for the East Asian Economies,” Journal of Asian Economics 11(3): 275–300. Mazzucelli, C., 1997. France and Germany at Maastricht: Politics and Negotiations to Create the European Union (New York: Garland Publishing). Monnet, J., 1978. Memoirs (English translation). Mundell, R. A., 1961. “A Theory of Optimum Currency Area,” American Economic Review 51(4): 657–665. Mundell, R. A., 1970. “Uncommon arguments for common currencies,” in H. G. Johnson and A. K. Swoboda (eds.), The Economics of Common Currencies (London: Allen & Unwin) 114–132. Mundell, R. A., 1999. “Updating the Agenda for Monetary Union,” in Blejer et al. (eds.), Optimum Currency Areas: New Analytical and Policy Development (Washington, IMF). Okita, S., 1989. “Policy Approaches to the Problem,” in L. Emmerij (ed.), One World or Several? (Paris: OECD Development Center) 41–50. Schroeder, J., 2000. “European Monetary and Economic Integration: Present State and Future Expectations,” Journal of Asian Economics 11(1): 23–29.


East Asian Economic Cooperation: The “10 + 1” Mechanism for Moving Forward Jingyi Ye Professor and Chair, Department of Economics School of Economics Peking University, Beijing, China [email protected]

1. Introduction Globalization has been argued to have two macro effects on the development of national economies (Cooper and Massell 1965): (1) The internationalization of production extends economic linkages among nations and deepens interdependence. Division of labor in production across national borders and expanded global trade increase export revenues to all countries. Trade creation brings economic dividends by generating scale economies and driving technological advance. As the traditional pattern of industrial sectors and division of labor is transformed within nations, the political boundaries between nations are broken down. (2) However, the industrial transformation and competition associated with globalization pose certain risks. Comparative advantage guides industrial development and drives growth in output value, but on a national basis some sectors take off while others decline. This process brings about a redistribution of welfare within nations and among them. If the imbalances and disruptions that accompany economic transformation exceed tolerable levels, unhealthy competition and trade protectionism rear up. Over the last half century, a system of regional cooperation has unleashed the benefits of trade creation while at the same time seeking to guard against the risks. The European Union (EU) and the North American Free Trade Agreement (NAFTA) are the pillars of this system. Asian economic cooperation is still in an earlier stage of formalization. This observation motivates the inquiry of this paper into how best to move East Asia 127

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beyond current impediments to economic cooperation. The paper has three parts: (1) a discussion of the present early stage of progress in East Asian economic cooperation; (2) an examination of factors that constrain progress; and (3) a view on leadership dynamics and how best to move forward.

2. Current Early Stage of Progress in East Asian Economic Cooperation 2.1. Successful examples of regional economic cooperation: EU and NAFTA The EU is history’s longest standing organization for economic cooperation. After 50 years of development, the EU today is positioned to compete with the US as no other entity in the world. Six original members have grown to the present 15. The EU in 2001 had a population of 370 million, GDP of US$7.86 trillion for a quarter of the world’s total, and imports and exports respectively of 40 percent and 37 percent of world totals. By 2004, the EU is slated to expand to 25 members with a population numbering 440 million to become an even more powerful economic force. The organization developed from the simplest form of free trade area and customs union to an increasingly unified market to today’s full economic and currency union. The EU takes a unified position in international negotiations, has succeeded in protecting the development of its agricultural sector, and has helped European manufacturers break into the American market (World Bank 2000). The gradual elevation in the position of the euro since its launching has not only promoted internal integration and brought benefits with respect to investment and productivity, but has also reduced the impact of fluctuations in the value of the US dollar on EU countries. The EU has achieved great economic and financial clout on the world stage (see Table 1). The US has reacted to the end of the Cold War with a notable adjustment its development strategy. To counter the effects of European economic integration, the US in the late 1980s gave up its longstanding policy of engaging strictly in multilateral trade negotiations to the exclusion of regional cooperation, and began to implement a line of “walking on two legs”. It first established an FTA with Canada, then went on to include Mexico in formation of NAFTA. This FTA has a population of more than 400 million and a GDP in 2001 of US$11.47 trillion for 37 percent of the world total.

Table 1. Economic Indicators for Major Trade Blocs, 2001 Merchandise trade Population

Area

million per km2 million km2

∗

Imports

billion % US$ billion % billion % US$ of world per capita US$ of world US$ of world

120 117

3.13 3.83

7,855 8,216

25 26

20,812 18,282

2,290 2,422

37 39

2,546 2,706

40 43

19 21

21.41 39.56

11,466 12,734

37 41

27,670 15,456

916 1,095

15 18

1,585 1,772

25 28

121

4.36

556

2

1,058

363

6

447

7

257 140 47

13.71 14.17 130.48

1,878 6,545 31,283

6 21 100

1,041 3,307 5,101

819 1,375 6,163

13 22 100

893 1,384 6,354

14 22 100

Excludes Cambodia, Laos, Vietnam, and Myanmar. Includes Hong Kong. Source of data: World Bank (2003).

∗∗

Exports

East Asian Economic Cooperation

Europe EU-15 377 EU-25 449 America NAFTA 414 FTAA 824 East Asia 526 ASEAN 6∗ ASEAN 6∗ + China∗∗ 1,804 ASEAN 6∗ + 3∗∗ 1,979 World 6,133

GDP

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The region’s imports and exports amount to 25 percent and 15 percent of world totals respectively. The US relies on the strength of NAFTA to give it a competitive economic posture with the EU. The US has continued to aggressively push for creation of the Free Trade Area of the Americas (FTAA) which after its establishment in 2005 will include all countries of the North and South American continents except Cuba. FTAA will have a population of 823 million and much increased world GDP and trade shares (see Table 1).

2.2. East Asia’s early stage economic cooperation Compared with the EU and NAFTA, Asia has made less progress in regional economic integration. Up until the 1990s, East Asia had only one economic cooperation organization — ASEAN, which included Indonesia, Malaysia, the Philippines, Singapore, Thailand, and Brunei. Asia’s largest economies — Japan, China, and Korea — had not joined any regional economic organization. In the 1960s, ASEAN was formed to achieve cooperation in the noneconomic sphere, the main objective being to protect against the incursion of communism. By the late 1980s and early 1990s, the break-up of the Soviet Union and the change in political system of East Europe ended 40 years of cold war history and caused a realignment of world economic and political forces with significant repurcussions for East Asia. Peace was restored to the Indo-China Peninsula and domestic turmoil in various ASEAN countries was put to rest. The importance of political and security issues diminished, and so did the political significance of bloc formation. World economic challenges rose to supercede political ones. Europe was becoming more integrated and North America was also catching on. Responding to the demands of this historic shift, ASEAN undertook a transition from political to economic cooperation. In January 1992, at the fourth ASEAN Summit in Singapore, the heads of state formally proposed to establish the “ASEAN Free Trade Area” and signed the “Framework Agreement on Enhancing ASEAN Economic Cooperation.” After ten years of effort, on January 1, 2002, the ASEAN six completed a tax reduction plan ahead of schedule and declared creation of the ASEAN Free Trade Area (AFTA). The four members that joined subsequent to the 1990s are also pushing forward with economic reform and trade liberalization, and will lower tax rates gradually as they marketize their economies and merge into AFTA. Achievement of


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the ten nation AFTA serves as a foundation and pushes all of East Asia to strive for greater economic cooperation. The 1997–1998 Asian financial crisis was a catalyst for the deepening and widening of regional economic cooperation. The crisis brought home to the region a sense of the negative aspects of globalization. It also brought a realization that the defense against global financial assault could not be borne by individual countries independently, nor left to international financial organizations, nor to bilateral relations with the US. The crisis caused East Asian nations to recognize the importance and urgency of joining together to establish a mechanism for protecting against potential future crises. The countries of East Asia in general became more willing to make concessions and tolerate differences in treatment among themselves. At the first East Asian summit held in Kuala Lumpur in 1997, a plan was formulated for holding annual summit and ministerial meetings among ASEAN, China, Japan, and Korea, a grouping known as the “10 + 3”. In 1999, through the “Joint Statement on East Asia Cooperation,” the 13 countries announced their intentions to carry out full cooperation. On May 6, 2000, the finance ministers of the 13 countries at a meeting in Chiangmai, Thailand reached unanimous agreement to establish among themselves a currency exchange system, known as the “Chiangmai Initiative” or CMI system. The objective of the CMI system was to establish a fund to mobilize foreign exchange support when member countries encountered short-term international payments problems, thus preventing a country from going into crisis and halting the spread to other countries around the region. In the last two years, under the CMI, bilateral negotiations on currency exchange have taken place and participation in bilateral exchanges has begun; a program of regular meetings of the 13 countries’ monetary and financial authorities has been put in place; and a system for disseminating information and evaluating policies has been initiated. In parallel with progress in monetary cooperation, construction of the East Asian FTA is also moving forward. But rather than following the “10 + 3” structure adopted for monetary cooperation, the FTA is being pursued in three separate versions of “10 + 1”. First, the Chinese government in late 2000 put forward a proposal to establish an FTA with the ASEAN 10 and was granted an enthusiastic response. In November 2001, leaders of the two sides formally signed the “Framework Agreement on Comprehensive Economic Co-Operation between ASEAN and the People’s Republic of China,” and all contracting parties agreed to quickly enter negotiations to form the China-ASEAN FTA by 2010. In the future, when this FTA

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comes into existence, it will have a market of 1.7 billion consumers, a GDP reaching US$2 trillion, and internal trade worth US$1.23 trillion. Second, the Japan–ASEAN 10 Free Trade Area is also developing vigorously. Japan and the ASEAN 10, in November 2002, signed the “Joint Declaration of the Leaders of ASEAN and Japan on the Comprehensive Economic Partnership.” This declaration expressed an intent to develop the partnership between Japan and ASEAN by pursuing all types of cooperation, including formation of an FTA, as quickly as possible within ten years. However, Japan and ASEAN have not as yet signed a formal free trade agreement. Third, Korea is also actively building relations with ASEAN and considering the possibility of establishing an FTA. Although movement is underway simultaneously in currency cooperation and FTA development, the process of bringing all of East Asia into the fold will be protracted. The scale of AFTA based on the ASEAN 10 is not large — a population of 525 million, GDP of US$556 billion or about two percent of the world total, and imports and exports respectively of seven percent and six percent of world totals. With the addition of China, based on 2001 figures, the numbers reach six percent of the world total for GDP and 14 percent and 13 percent respectively for imports and exports. Thus compared to Europe and America, East Asia’s weight as a trade bloc is still relatively slight. Organizationally, East Asia is also weaker in stature. Europe has the European Council, the European Court, and the European Parliament, all of which are supranational organs with overarching authority. ASEAN, by contrast, has an organizational structure based on meetings among heads of state and ministers, with a Secretariat to coordinate these meetings. There is no supranational authoritative body, but rather an on-going consultation process aimed at achieving consensus. There is no arbitration mechanism for resolving disputes, no organ or system for censuring behavior of member countries, and no entity vested with management powers. This difference in organizational structures has the potential to undermine ASEAN’s competitive strength with the European and North American economic blocs, and does not allow it to hold up its end of a tripartite balance. 3. Constraints on East Asian Regional Economic Cooperation In order to maintain internal peace, prosperity, and development, East Asia must take measures to overcome impediments to regional economic


133

cooperation. Systematic efforts have been made in achieving currency cooperation and FTA development, but a variety of factors constrain progress. Prospects with regard to FTA development are better than for financial and currency cooperation. A truly pan-East Asia FTA cannot be established directly in a single step but may be achievable through a roundabout approach that involves three “ASEAN 10 + 1” FTAs developing separately. An examination of the nature of the constraints will clarify why such an approach is advisable.

3.1. Economic constraints The theory of optimum currency areas holds that the cost of establishing a common currency peg or currency union, assessed in terms of foregone macroeconomic policy independence, is related to a variety of factors, among them the volume of trade within the bloc. Whether normalized with respect to the region’s total trade globally or with respect to GDP, intraregional trade is relatively high for Asia.1 Table 2 shows that intra-regional exports for Western Europe, Asia, and North American are respectively US$1,677 billion, US$722 billion, and US$391 billion. As a share of regional exports these values amount to 67.5 percent, 48.2 percent, and 39.5 percent respectively, and as a share of the world’s total exports 28.0 percent, 25.0 percent, and 6.5 percent. Thus Asia ranks in between Europe and North America in its concentration of total trade within the region. A similar ranking holds for regional trade relative to GDP as shown in Table 3. In 2001, world economic output reached about US$31 trillion and the share of international merchandise trade in world output was about 19 percent. The exports of Western Europe, Asia, and North America amounted to 83 percent of the total. Intra-regional export shares in GDP for Western Europe, Asia, and North America stood at 21.3 percent, 10.1 percent, and 3.4 percent respectively. Relative to world GDP, intra-regional export shares for the three regions were 7.9 percent, 4.8 percent, and 3.2 percent respectively.

1 This

observation is in keeping with Eichengreen and Bayoumi (1996) whose inquiry into the prospects for an East Asian currency union indicated that the level of regional economic integration among East Asian countries in the 1990s was similar to that among Western European countries in the late 1980s.

134 J. Ye

Table 2. Intra- and Inter-Regional Merchandise Trade, 2001 Trade value (billion US$)

Share of regional exports (%)

Share of world exports (%)

@ Destination @ Origin@ @

North America

Western Europe

Asia

World

North America

Western Europe

Asia

North America

Western Europe

Asia

World

North America Western Europe Asia World

391 255 376 1,308

188 1,677 252 2,429

207 195 722 1,298

991 2,485 1,497 5,984

39.5 10.3 25.1 21.9

19.0 67.5 16.8 40.6

20.9 7.8 48.2 21.7

6.5 4.3 6.3 21.9

3.1 28.0 4.2 40.6

3.5 3.3 12.1 21.7

16.6 41.5 25.0 100.0

Source: World Trade Organization, http://www.wto.org/english/res_e/statis_e/its2002_e/section3_e/iii03.xls (viewed November 2, 2003).

Table 3. Trade Shares in GDP, 2001 Exports/regional GDP (%)

Exports/world GDP (%)

GDP (billion US$)

North America

Western Europe

Asia

North America

Western Europe

Asia

World

North America Western Europe Asia World

3.4 3.2 5.3 4.2

1.6 21.3 3.5 7.8

1.8 2.5 10.1 4.1

1.2 0.8 1.2 4.2

0.6 5.4 0.8 7.8

0.7 0.6 2.3 4.1

3.2 7.9 4.8 19.1

11,466 7,855 7,143 31,284

Source: World Trade Organization, http://www.wto.org/english/res_e/statis_e/its2002_e/its02_byregion_e.htm (viewed November 2, 2003).


@ Destination @ Origin@ @

135

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J. Ye

North America, despite much lower intra-regional trade relative to either total exports or to GDP, has advanced further than Asia in achieving economic integration. Weak intra-regional trade orientation therefore should not be the factor restraining progress. If the three countries of North America at their relatively low level of intra-regional trade engagement could establish an FTA, then Asian economic cooperation, especially East Asian economic cooperation, should be at least as well motivated. Stronger motivation for integration also arises for Asia relative to Europe or North America due to the potential gains from trade that result from spanning northern and southern hemispheres. Lal (1998) points out that the 20th century was a century of trade within a single latitude — 80 percent of the world’s trade took place within the northern hemisphere while trade between north and south was very limited. Lal argues the reason for this is that 20th century economic development rested on large-scale factory-based manufacturing, the needs of which, in terms of energy and raw materials as well as supporting transportation, communication, and information infrastructure, were favored by northern hemisphere resource endowments and patterns of accumulation. For the same reasons, the north has made greater achievements in economic cooperation. If we conceive of national economic development as a complex random process, and of technological progress, business cycles, natural disasters, and the like as positive and negative random shocks, then the East Asian region with its feature of straddling northern and southern latitudes is exposed to greater internal variation in such shocks. In the south the season for plant diseases and pests is nonsynchronous with the season for crop disasters in the north. And in the south, the path taken by production technology has been different from that taken in the north. But now after more than a century of rapid development in the north, the scope for continued internal gains there has diminished while untapped opportunities await for trade expansion between north and south. This potential applies to trade between ASEAN and the other countries of East Asia. In conclusion, the constraint on developing regional cooperation in East Asia is not insufficient opportunity for economic gain. On the contrary, the potential for gain is enormous and arguably exceeds that to be had in regions of the world where cooperation has proceeded more successfully. Non-economic constraints thus call for examination.


137

3.2. The sovereignty constraint On the part of politicians, intellectuals, and the public across the board, the capacity to conceive and implement compromise and concession is poor in East Asia. Europe has a longstanding tradition of federalist thinking which Asia historically lacks. Moreover, most East Asian countries have been colonies or territories of the developed countries of Europe or of the US or Japan. They lost sovereignty and went through the humiliating experience of depending on other nations in politics, economics, and culture. This left the hearts of Asian peoples deeply scarred. Having cast off colonial domination within living memory, East Asians are not yet prepared to resurrender their national sovereignty in any shape or form. This high sensitivity surrounding national sovereignty manifests itself within regional cooperation efforts as difficulty forming supranational management organs and supervising mechanisms. Even with establishment of AFTA, the basic approach to governance has not significantly changed. The “10 + 3” mechanism has the character of a government “club”. Every year the 13 countries’ summit and ministerial meetings provide leaders with a platform for discussing East Asian and world affairs, opening up dialog, exchanging views, and promoting common understanding on the issues of interest. The joint declarations that emanate from these meetings typically merely state common views and intentions, leaving each country still free to take action, or not take action, or just muddle along, at its own choosing. There is no legal significance to the declarations and no system to reward or penalize behavior.

3.3. Political and cultural constraints The racial, religious, linguistic, and political characteristics of the countries of East Asia are highly varied (see Table 4). This makes it difficult to develop any sense of unity in values and goals. Deep cultural and social differences manifest themselves in regional cooperation as overly vague and flexible precepts and standards. The political resolve is lacking to coalesce and push forward with regional economic unification. Robust growth in intra-regional trade and investment, and with that great strides in economic development, have been achieved in recent decades. This process in itself has brought about increased economic integration, but as the result

Population (million)

Language

Principal religions

Government form

Cambodia

181

Brunei Indonesia

11.0

Khmer

Buddhism

constitutional monarchy

270

5.76

0.34

Malay

Islam

12,245

1,919

212

Bahasa Indonesian

Laos

237

5.3

Lao

Islam, Christianity, Catholicism, Buddhism, Hinduism Buddhism

constitutional monarchy republic

330

Malaysia

330

23.3

Malay, English, Chinese, Tamil

Islam, Buddhism Taoism, Hinduism, Christianity

democratic republic constitutional monarchy

Myanmar

677

49.0

Myanmar

Buddhism, Christianity, Islam

national peaceful development commission

GDP per capita (US$)

691

3,696

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J. Ye

Area (1000 km2 )

138

Table 4. Socioeconomic Indicators for East Asian Countries∗

300

78.4

Filipino, English, Spanish

Singapore

648

4.0

English, Malay, Mandarin, Tamil

Thailand

513

62.3

Thai

Vietnam

332

77.5

Vietnamese

China

9,600

1,300

Mandarin

Japan

378

127

Japanese

Korea

99

47.3

Korean

democracy

Buddhism, Christianity Buddhism, Daoism, Catholicism, Christianity Shintoism, Buddhism Christianity, Buddhism, Confucianism, Daoism

democracy

416

people’s democracy

890

Data for most recent years, 1999–2001. Sources: ASEAN, http://www.ASEANsec.org (viewed November 3, 2003); World Bank (2003).

914

parliamentary democracy

20,659

constitutional monarchy

1,831

constitutional monarchy parliamentary democracy

35,610 9,460

139

∗

Buddhism, Christianity, Islam Buddhism, Christianity, Islam Buddhism, Islam


Philippines

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of market forces and the economic choices of firms and households in a less than fully supportive environment. Given the deep-rooted nature of the political and cultural constraints to regional cooperation, absent a powerful external shock the situation is unlikely to change much. The constraints to regional cooperation based in sovereignty concerns and political and cultural factors constitute serious obstacles to progress, especially in moving beyond the “Chiangmai Initiative” toward currency union. To protect against financial crisis and support a stable regional exchange rate mechanism, East Asia must not only increase bilateral currency exchange reserves to create a sustainable intervention fund, but must also coordinate macroeconomic policy among nations. To ensure the success of such measures requires firm government commitment and stringent restraints on economic policy. East Asia currently lacks the foundations for this kind of cooperation. Compared to financial and currency cooperation, an FTA is easier to achieve because it allows for greater preservation of national sovereignty. An FTA is a loose but stable formation requiring only that member countries impose minimal barriers to trade. Moreover, this form of cooperation can be achieved through government negotiation to reach a settled state without need of on-going policy coordination that may run contrary to national economic interest. For the present and relatively long term future then, the FTA is the form of regional cooperation that will be most acceptable to East Asian policymakers and general public. 4. Leadership Dynamics 4.1. US hegemonism An external inhibiting factor on East Asian regional cooperation lies in the role of fellow Pacific nation the United States. For a long time, East Asian countries and the US have had strong trade relations. The US is the biggest trade partner for many countries in East Asia. ASEAN. Since 1986, the US has replaced Japan to become ASEAN’s largest export market, absorbing 20 percent of ASEAN exports. The US is also the second biggest source of imports for ASEAN behind Japan. Since the 1970s, the US has supplied about 15 percent of ASEAN’s imports (see Figures 1 and 2). China. China’s exports to the US have shown steady growth since the 1990s. As of 1997, the US has replaced Hong Kong to become China’s


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biggest export market. In 2000, China’s exports to the US amounted to 20.9 percent of its total exports. The US is also an important source of imports for China, becoming the second largest after Japan through the latter 1990s. In 2000, however, there was a drop to below the ranks of Japan and Korea with the US share at 9.9 percent (see Figures 3 and 4). Japan. Japan has the closest trade relations with the US of any East Asian country. The US has always been Japan’s biggest export market, far ahead of second place holder ASEAN. In 2000, Japan’s exports to the US represented 30.1 percent of its total exports while those to ASEAN amounted to only 14.3 percent. On the import side the US has similarly held the number one spot. From the mid-1980s, imports from the US claimed more than 20 percent of the total, at least until 2000 when the share slipped to 19.2 percent but remained in top place (see Figures 5 and 6). Korea. The US has consistently been the largest importer of Korean goods throughout the period examined. In the mid-1980s, Korea’s exports to the US reached as high as 40 percent of total exports, and by 2000 stood at 20 percent. On the import side, the US and Japan have alternated between first and second positions. In 1999, Korea’s imports from Japan and the


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Figure 6. Japan’s Import Shares by Pacific Region Trading Partner, 1977–2000

US were respectively 20.2 percent and 20.8 percent of total imports, and in 2000, 19.8 percent and 18.2 percent (see Figures 7 and 8). Many Asian countries rely on the US not only economically but also militarily and politically to varying degrees. Under such circumstances, these countries cannot help but consider US interests and wishes in their regional dealings. From the US standpoint, “Southeast Asia is a component part of US global strategy. US security and economic interests in Southeast Asia determine that it cannot tolerate any major Asian power taking a leadership role in Southeast Asia and cannot accept an East Asian economic region that excludes it”, (Lu 2000). The US pushes for East Asian regional economic cooperation to be subsumed under APEC so that it can better seek its own interests in East Asia and can rely on East Asian strength as a counterpoint to the EU. This is one major reason why since the 1990s East Asian nations have failed or given up in numerous attempts to formalize economic cooperation. The advantage of the “ASEAN 10 + 1” approach to regional cooperation is that it does not pose a direct affront to US strategy because the “10 + 1” model, whether it’s ASEAN + China or ASEAN + Japan or ASEAN + Korea, does not result in a large Asian country leading East Asian economic cooperation. Thus the “10 + 1” model of cooperation can


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Figure 8. Korea’s Import Shares by Pacific Region Trading Partner, 1977–2000

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circumvent the resistance caused by an outside hegemon attempting to protect its own interests.

4.2. The leadership void within East Asia Within EastAsia, there is contention for the role of “lead country” in regional economic cooperation. At present, no country has emerged that can take on the function of guiding and coordinating other East Asian nations. As contenders for the position, both Japan and China face problems. For the past 100 years, Japan has had the strongest economy in East Asia. East Asia has in turn afforded Japan the lead role in technology and investment in a “flying geese” model of vertical integration. Other countries of the region have hitched their economic development to Japan, and have consequently become highly dependent on the Japanese economy. The flying geese model involves a three tier international division of labor with Japan as leader, the East Asian newly industrialized economies in the second tier, and the other ASEAN countries in the third tier. Each tier takes on production for different stages of industrialization, and economic growth is driven by exports. Japan would like to use the flying geese formation to position itself as the leader in East Asian economic cooperation, but has encountered much resistance. The foremost reason for this resistance is that East Asian countries that suffered under Japan’s “Greater East Asia Coprosperity Sphere”, while welcoming Japanese technology and investment and the benefits of equal economic relations, are not willing to subject themselves to any arrangement implying Japanese control. The Japanese government has steadfastly refused to recognize mistakes and offenses committed under the “Greater East Asia Coprosperity Sphere” which it forced upon the countries of East Asia. This history makes it impossible for Japan to gain the political trust of East Asia. Second, the economies that were formerly in the second tier of the flying geese formation are taking off, coming into their own at the top of the East Asian industrial hierarchy and entering into economic competition with Japan. Third, for more than ten years the Japanese economy has been in decline undermining Japan’s leadership status in technology and investment. Japanese investment flows into Southeast Asia have dropped precipitously in recent years. In 1997, Japan’s direct investment in ASEAN countries exceeded US$6 billion accounting for 22.1 percent of all foreign direct investment in ASEAN. By 1999, the magnitude had fallen to US$769


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Figure 10. Japanese Share in Foreign Direct Investment in ASEAN, 1995–2000

million for 4.7 percent of the total, and in 2000 there was a net outflow of US$55 million (see Figures 9 and 10). Generating competition for Japan’s economic leadership position in East Asia, China’s economy is booming. In the long river of the last

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3000 years of history, China for a great stretch held the position of leadership politically, economically, and culturally in the East Asian region. Chinese culture and Confucian values to the present hold considerable place in East Asia. China, after several hundred years of economic landslide, has now entered a trajectory of revival. Especially with the last 20 years of rapid economic growth, China has become an important participant in the world economy. In 2002, China’s exports were US$325.6 billion ranking it fifth in the world after the US, Germany, Japan, and France. Its imports were US$295.2 billion for a sixth place ranking behind the US, Germany, England, Japan, and France. Foreign exchange reserves reached US$286.4 billion. Moreover, China’s influence does not rest strictly on its own economic growth, but on the integration of the Mainland, Hong Kong, and Taiwan, raising the position and influence of all as “Greater China”. China’s reintegration and soaring economy have touched off worries in other East Asian countries about China’s leadership in regional economic cooperation. This is especially so for Japan which sees China as a direct threat to its own economic position in the East Asia region even though China lacks the actual economic strength to dominate the region. Southeast Asian countries not only are unwilling to accept Japan’s leadership intentions in East Asian regional economic cooperation, but are also concerned that a strengthening China poses a threat. Hence they prefer that they themselves form the core of power in East Asian economic cooperation. The insight reflected in a speech by Singapore Minister of Trade and Industry, George Yeo, illustrates the sentiment: “Individually, Southeast Asian countries were too small to deal with the major powers on any basis of equality. Combined together in ASEAN, we had more negotiating leverage vis-a-vis the US, Japan, China, India and Europe.”2 The ASEAN nations have made concerted efforts to build their collective strength and influence. Establishment of AFTA and other aspects of regional cooperation are the result of their commitment. Regrettably though, there is still a gap between the desires of ASEAN and its actual economic power. The leadership conundrum leaves East Asia facing two horns of a dilemma with regard to its economic cooperation ambitions: without the active involvement of Japan and China, East Asia cannot achieve real

2Yeo, George.

“Building an ASEAN economic community”, ASEAN Free Trade Area Seminar, January 31, 2002, Jakarta; http://www.aseansec.org/12482.htm (viewed November 17, 2003).


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regional economic unity and global influence; however, if Japan and China actively engage, not only might there be competition between them for leadership, but the small countries could lose their cooperative spirit as they react to struggle between the two large countries and seek to bolster their own position as the core. The upshot is that an East Asian FTA can only be a fairly long-term development objective. An indirect path, such as the “ASEAN 10 + 1” mechanism entails, may work better than a direct one. Under the “10 + 1” model, the ASEAN 10 countries speak with a single voice, take a unified stand on issues, and as “one country united” negotiate with each of Japan, China, and Korea separately. This structure eliminates the intimidation when a large country faces off with a small one and relieves the worries of small East Asian countries about being “led” by a big country. It also avoids competition for “lead country” status that would create an obstacle to cooperation. Establishment of parallel “ASEAN 10+1” FTAs will provide a learning ground on which to build fully pan-East Asian cooperation. In the process, trade barriers will come down, the internal market of cooperating nations will expand, trans-national investment will be fostered, and every country in the region will benefit from productivity gains and economic growth. Beyond these economic benefits, cooperation will help to increase trust and reduce historical grudges and political differences, paving the way for a fully encompassing East Asian FTA. 5. Conclusion East Asian regional economic cooperation is subject to internal and external impediments that call for creativity in forging a path forward. The model will be different from that followed by Europe or North America. Unlike Europe and North America, East Asia lacks a federalist intellectual tradition. Rather, a consultative approach to problem solving is deeply ingrained in East Asian culture. And the pain and humiliation of a hundred years of colonial history, still fresh in memory, leave a legacy of great resistance to relinquishing national sovereignty. East Asia also differs from Europe and North America in its leadership dynamics. European economic unification depended critically on the leadership roles of Germany and France. In forming NAFTA, the US relied on its advanced economic development and broad international power to grasp leadership authority. In East Asia, by contrast, no country is in a position to

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exert a dominant role. Moreover, the US imposes its influence as an outside hegemon, economically with respect to trade and currency ties as well as politically and militarily, to degrees that vary among countries of the region. The “ASEAN 10 + 1” mechanism, pursued simultaneously on three fronts, offers a means to cope with the constraints East Asia faces. By taking this roundabout course and allowing a long transition period, the ultimate goal of pan-East Asia unification may become reachable where it would not be so if pursued more directly.

6. Acknowledgment The author is grateful to Mr. Shi Junfeng for research assistance.

7. References Cooper, C. A. and B. F. Massell, 1965. “Toward a General Theory of Customs Unions for Developing Countries,” Journal of Political Economy 73(5): 461–476. Feng, Zhaokui, 2003. “‘10 + 1’: Zou xiang Dongya Ziyou Maoyi Qu zhi Lu [‘10+1’: The Road to an East Asian Free Trade Area],” Shijie Jingji yu Zhengzhi [World Economy and Politics] 3: 21–26. Li, Xiangyang, 2002. “Quanqiuhua Shidai de Quyu Jingji Hezuo [Regional Economic Cooperation in the Era of Globalization],” Shijie Jingji [World Economy] 5: 3–9. Lu, Jianren, 2000. “Yatai Da Guo zai Dongnanya Diqu de Liyi [Benefits for Asia’s Large Countries in the SoutheastAsia Region],” Shijie Jingji yu Zhengzhi [World Economy and Politics] 2: 41–45. Kahler, Miles, 1997. “Cong Bijiao de Jiaodu Kan Yatai de Quyuzhuyi [Pacific Regionalism Viewed from a Comparative Perspective],” Shijie Jingji yu Zhengzhi [World Economy and Politics] 6: 15–19. Wu, Yikang and Youwen Zhang, 2001. Sanzudingwei? Quanqiu Jingzheng Tixi Zhong de Ou Mei Yatai Jingji Qu [A Tripod? European, American, and Pacific Economies in Global Competition] (Beijing: Higher Education Press). Zhao, Chunming and Zhenlin Liu, 2002. “Lun ‘Zhongguo — Dongmeng Ziyou Maoyi Qu’ de Qianjing yu Tiaozhan [China — ASEAN Free Trade Area: Future


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and Challenges],” Shijie Jingji yu Zhengzhi [World Economy and Politics] 11: 32–37. World Bank Policy Research Report, 2000. Trade Block (New York: Oxford University Press). World Bank, 2002. World Development Report 2003 (Washington D.C.: World Bank).


Pax Americana-Led Catch-Up, Flying-Geese Style: Regionalized Endogenous Growth in East Asia Terutomo Ozawa Professor of Economics, Department of Economics, Colorado State University Fort Collins, Colorado, USA and Research Associate, Center on Japanese Economy and Business Columbia Business School, Columbia University New York, New York, USA [email protected]

[individuals] know that where little wealth circulates, there is little to be got, but that where a great deal is in motion, some share of it may fall to them. The same maxim . . . should make a whole nation regard the riches of its neighbors as a probable cause and occasion for itself to acquire riches. Adam Smith, 1776 1. Introduction: Regionalized Endogenous Growth Despite the financial crises of 1997–1998, East Asia as a whole has experienced unprecedented rapid growth continually since the end of World War II (WWII). During the post-WWII golden age of capitalism (1950–1971), Japan’s per capita income multiplied sixfold, “growing at 8 percent a year compared with 4 percent in Western Europe. Labor productivity grew by 7.7 percent a year, compared with 4.8 percent in Western Europe, total factor productivity at 5.1 percent a year compared with 2.9 percent” (Maddison 2001, 139). Japan was thus the greatest beneficiary of the postwar golden age of capitalism, with fast increases in per capita income, labor productivity, and production efficiency (up until the bursting of the 1987–1990 asset bubble). The “neoliberal order” (1971–present) then ensued. In the wake of the first oil crisis of 1973, while growth in Japan and Western Europe slowed 153

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by more than a half, “Resurgent Asia” (15 countries) actually grew faster than in the golden age. Notable were the rapid growth rates experienced by the Asian NIEs (Hong Kong, Singapore, South Korea, and Taiwan). Shortly afterward, China began its rapid ascent once it opened up to the noncommunist world in 1978. Since the end of WWII there have thus occurred two economic miracles in East Asia, the Japanese miracle and the Asian NIEs miracle. And we are presently witnessing a third one, the Chinese miracle, in the making.1 And the Chinese miracle, though still in its inchoate phase, will be no doubt the most spectacular of them all in terms of speed (time compression) of growth and structural upgrading and the most dramatic in terms of its impact on the rest of the world — but especially on neighboring countries on the Pacific Rim — because of its huge domestic market and its expected swift integration into the global economy through the WTO accession. Why is it that three such economic miracles have occurred in overlapping sequence since WWII — and all of them in the East Asia region in particular? Why not in other regions? Are they simply disparate phenomena or do they exhibit some commonalities and interconnectedness in their growth characteristics, some common causes for such clustered regional growth? In short, why have East Asian economies grown so fast in sequential waves — and continued to grow vigorously even in the post-crisis period? The themes of my paper are: (1) following the path of the Pax Britannica, the Pax Americana has been generating powerful growth-clustering forces by way of providing a climbable ladder of industrialization and propagating growth stimuli to the world; (2) a model of structural upgrading (inspired by the so-called “flying-geese” paradigm of economic development) is useful to explain the forces of hegemon-led macro-clustering; (3) Japan fully exploited such forces to its own advantage and quickly caught up to the West; (4) this rapid industrial upgrading of postwar Japan in turn has generated an augmentative growth force for the rest of East Asia as it served as a structural intermediary and capacity augmenter; and (5) the public policies pursued by other East Asian economies have proved effective for the very reason that a favorable global environment was created by the unique roles of the US (as the first lead economy from the both demand and supply sides) and Japan (as the second lead economy mainly from the supply side) in disseminating complementary stimuli through trade and investment. 1Actually,

India may also experience an economic miracle, since it too started to open up its economy, if more slowly and gradually than China.

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2. Hegemon-Led Macro-Clustering One commonality of the three miracles is that the dramatic catch-up growth has taken place under the aegis of the Pax Americana, which came into existence after WWII. These Asian miracles are inconceivable without the role of the US as the hegemon of market capitalism. The US has created, and continues to maintain, a favorable global environment for trade, investment, and structural upgrading for those countries that are willing to follow its leadership by adopting a regime of market democracy. Indeed, the Pax Americana constitutes an economic system of what may be called “hegemon-led macro-clustering” (a hegemon-driven process of tandem growth), which is actually an extended outcome of Pax Britannicaled macro-clustering (Ozawa 2003). Macro-clustering is a phenomenon in which a hegemon economy propagates growth stimuli to its closely aligned cohort of countries (which are at lower stages of development and structural upgrading). The growth stimuli include the dissemination of technology, knowledge, skills, market information, and demand (via access to the hegemon’s home markets) — and above all, growth-inducing institutional arrangements of open market capitalism. This all contributes to higher levels of labor productivity and economic efficiency. The low-echelon countries can “free ride” and thrive on these stimuli. In other words, there are what may be called “economies of hierarchical concatenation” that the follower countries can reap from the forces of hegemon-led macro-clustering. There is basically a region-wide type of economic agglomeration (or regionalized endogenous growth), in which cross-border trade and investment are fundamentally market-driven (profit-motivated and -guided), though individual countries, especially those lower-echelon ones, are usually involved in market-enhancing dirigiste catch-up strategies. Put simply, a hierarchy of countries following a lead country matters — and matters a lot for regional economic growth in general and for individual countries’ economic development in particular. 3. A Reformulated “Flying-Geese (FG)” Paradigm As introduced elsewhere (Ozawa 1992, 2001a, 2001b), a model of industrial upgrading can shed light on the evolutionary process of hegemon-led industrial development. This model is a reformulated version of the so-called

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“flying-geese (FG)” theory, which originated in Akamatsu (1935, 1962) and expanded in Kojima (1958, 2000) and Kojima and Ozawa (1994 and 1995).2 The reformulated model is basically a “leading growth sector” stages model a la Schumpeter (1934), in which industrial upgrading occurs periodically by stages, in each of which a certain industrial sector can be identified as the main engine of structural transformation into a higher value-added level. As shown in Figure 1, the world economy has so far seen five tiers of industry emerge ever since the Industrial Revolution in England — five tiers conceptualized in the extended FG paradigm. The first dominant industry that appeared was what may be called “Heckscher–Ohlin” endowmentsdriven (natural resources and/or “raw” labor-intensive) industries (best represented by cotton textiles). It was soon followed by the “nondifferentiated Smithian” scale-driven (physical-capital intensive, natural resource processing, heavy and chemical industries, such as steel and basic chemicals). The golden age of capitalism, Mark I (1870–1913) stemmed from the growth of these first two phases of industrial development under the Pax Britannica. Its need — and its search — for natural resources (e.g., iron ore) and markets (for textiles and capital goods) led to colonialism overseas, and scale-driven heavy and chemical industrialization was once pursued under imperialism (as part and parcel of the arms race among imperialist powers). The rise of the Pax Americana originated from “Yankee ingenuity” in the innovation of interchangeable parts and assembly-line operations, which eventually culminated in the techniques of mass production — and the pattern of mass consumption (especially after WWII). The “differentiated Smithian” assembly-based industries (notably automobiles) emerged as the leading growth sector in the United States, following the introduction of Ford’s assembly-lines and Frederick Taylor’s scientific management. Mass production (Fordism-cum-Taylorism) emerged as the dominant manufacturing paradigm. Then, in the post-WWII period, R&D-driven industries as a new growth sector came to fulfil the “Schumpeterian” process (e.g., microchips, computers, telecommunications, and biotechnology). In the 1950s and 1960s, many large companies in science-based industries began to set up corporate R&D centers. Notable were I.B.M.’s Watson Labs

2 When

this FG model is interpreted as a model of “catch-up by learning,” it is built on the Smithian “wealth spillover” effect which is explicit in the quote cited from Adam Smith’s Wealth of Nations (1776) at the start of this paper.

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Figure 1. Structural Upgrading under Pax Britannica-Led and Pax Americana-Led Macro-Clustering

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and AT&T’s Bell Labs. The “age of corporate laboratories” (Best 2001) was thus ushered into the US economy, leading to America’s industrial leadership in many high-tech goods such as computers and electronics. And most recently, emanating from the Schumpeterian industries, the Internet and other forms of information technology (IT) came to revolutionalize the telecommunications industry. Consequently, the Pax Americana has given birth to the “McLuhan” Internet-enabled industries (named after Marshall McLuhan, the guru of mass communication) (Ozawa 2001b), a new phase of economic growth so far most extensively introduced in the US as a consequence of the IT revolution, particularly during the latter half of the 1990s. The so-called “New Economy” was thus born.3 It comprises both Schumpeterian and McLuhan industries, the former providing hardware (such as super-chips, computers, and telecommunication gear) and the latter software, the Internet, and its content). Indeed, the pace of globalization, which is basically the forces of Pax-Americana-led macro-clustering, has been accelerating with the IT revolution (notably, the introduction of World Wide Web). In short, what the Pax Britannica introduced were labor-intensive industries, as typified by textiles, and “bricks and mortar” industries, based mostly on natural resources (“natural capital” and “physical capital”), as epitomized by steel, basic chemicals, and heavy machinery. In contrast, the Pax Americana created highly component-intensive, assembly-based, genuinely consumer-oriented, and R&D-intensive manufactures such as cars and electronics — and most recently, the net-enabled goods and services. In particular, McLuhan IT-derived industries are built on “intellectual and entrepreneurial capital” and strongly geared to the needs of final consumers. The New Economy is the latest creation of Pax Americana-led consumer capitalism. The differentiated-Smithian, Schumpeterian, and McLuhan industries, the three tiers fostered under the Pax Americana, thus all require economic freedom as sine quo non. As William Baumol argues in his latest book, The Free-Market Innovation Machine: Analyzing the Growth Miracle of Capitalism (2002), the free market is the most efficient innovation machine to satisfy consumer needs and demand. Open market capitalism is therefore the 3 The IT revolution is fundamentally based on personal computers (PCs). And the PC revolu-

tion itself originated in the Western half (“younger regions”) of the US where entrepreneurs created leading companies such as HP, Apple, Microsoft, Sun-Microsystem, and Cisco (Norton 2001).


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necessary institution for Pax Americana-nurtured industries. In contrast, the Old Economy industries (especially the “smoke-stack” industries) are the legacies of the Pax Brittanica and were once developed and able to thrive as the leading sectors in the advanced economies in the pre-WWII period — even under a variety of economic systems: unfettered bourgeois capitalism and colonialism (early on in Britain and other early capitalist powers), welfare socialism (in Scandinavia), communism (in the Soviet Union and China), and fascism (in Germany, Italy, and Japan). Here it is worth noting that the collapse of the Soviet Union was in part caused by the rise of consumerism under democratic capitalism. Rostow (1960, 11) foresightedly prognosticated the self-destructive course of Soviet communism: In the 1950s Western Europe and Japan appear to have fully entered [the stage of high mass-consumption], accounting substantially for a momentum in their economies quite unexpected in the immediate postwar years. The Soviet Union is technically ready for this stage, and by every sign, its citizens hunger for it: but communist leaders face difficult political and social problems of adjustment if this stage is launched. Communism proved to be fatally incompatible with the age of consumerism. The former Soviet Union — for that matter, China before its open door policy — was stuck with the nondifferentiated Smithin industries (materialintensive and pollution-prone) and could not successfully climb up to the Pax Americana-led stages of high mass consumption. The institutions of market capitalism had to be introduced. 4. Demanufacturization and Tertiarization in the US As observed by Clark (1935), economic development is typically characterized by the relative decline of the primary sector, the rise of the secondary sector (manufacturing and construction), and the growth of the tertiary (services) sector — all in contiguous sequence over time. In this respect, the US has experienced a rapid pace of tertiarization in recent decades, causing fears of deindustrialization or “hollowing out”. In fact, “the deindustrialization wave” (Bluestone and Harrison 1982) began to erode the soil of

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industrial America, starting noticeably in the 1970s. In many instances, domestic factories were closed and American firms moved their manufacturing facilities outside the country. This trend continued unabatedly into the 1980s — so much so that in a special report, Business Week (1986) warned a transformation of US manufacturing companies into the “hollow corporation”. It observed: “A new kind of company is evolving in the US — manufacturing companies that do little manufacturing. Instead, they import components or products from low-wage countries, slap their own names on them, and sell them in America.” Moreover, America’s tertiarization, culminating in the emergence of the New Economy and the recent equity bubble (during the latter half of the 1990s), has been accompanied — and facilitated — by rising trade (and current-account) deficits. One important cause of this trade balance deterioration is a stepped-up transfer of manufacturing activities overseas, while American firms increasingly concentrate on knowledge creation (via R&D), entrepreneurial risk-taking, and financial services in the postindustrial economy.4 This structural change was captured in the product-cycle (PC) theory of trade and investment (Vernon 1966). It describes (1) why new high-income products and labor-saving processes are first innovated in, and exported from, the US ahead of other countries; but (2) why such US exports are soon replaced by overseas production once the technology involved is perfected and standardized, making it easy for the follower firms in other countries to imitate. Furthermore, in the end the US is actually to wind up importing these products, the very products it has initially innovated and exported. Thus, the PC theory can be reinterpreted as a theory of “demanufacturization” (if not precisely deindustrialization, since the most critical upstream operations, R&D activities and product/market development, are still retained at home), because it describes an ineluctable market-driven process of industrial migration from home and propagation abroad. In addition to this PC theory-Type 1, Vernon introduced the PC theoryType II (1979), in which R&D activities are, in turn, widely dispersed throughout the world via networks of multinationals’FDI — instead of being centered only in the US. The PC theory-Type II thus can be reinterpreted as a 4 Most recently Business Week (February 3, 2003) issued another special report on job migra-

tion from the US observing: “Is your job next? A new round of globalization is sending upscale jobs offshore. They include chip design, engineering, basic research — even financial anaylsis.”


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theory of R&D capability dispersion overseas.A full range of R&D activities (from basic research to commercialization, involving product/process engineering, designing, and development) are still controlled and managed by US multinationals, but they are now carried out across borders. This dispersion facilitates immediate local production overseas — without the prolonged sequence of innovations at home→exports→technology transfers and production transplantation→imports as depicted in the PC theory-Type I. In this connection, another version of PC theory (i.e., the PC theoryType III) should be proposed to describe how in the early stages of R&D activities American firms have often been induced to sell basic/seed technologies abroad through licensing agreements or other non-equity transactions — instead of fully developing and commercializing such technologies first at home or via networks of their multinational operations. In other words, D (development) drops out of R&D. The PC theory-Type III is, for example, quite relevant to Japan’s postwar strategy to acquire the latest Western technologies in “crude/unapplied” form under licensing and commercialize them into successful products. As rapidly catching-up economies (such as the NIEs and China) develop R&D capabilities of their own, the Japanese experience is most likely to be replicated. In sum, all the three types of the PC model illustrate the high propensity of the United States, the hegemon economy, to propagate newly introduced products and R&D capacities, as well as seed knowledge itself, abroad. And America’s New Economy has been — and still is — driven by what may be characterized as “financialization” (a phenomenon of tertiarization), a phase of capitalism in which the engine of growth shifts from manufacturing to financial activities such as securities investment, M&As, IPOs, and creation/trading of derivatives.5 Many new financial products and transactions have been innovated first in the United States. And these new financial products and services have begun to similarly go through the product-cycle process of spreading to other countries. Expectedly, the innovative US financial markets have attracted huge inflows of capital from overseas (estimated to be about $2 billion a day at one time prior to the sudden tanking of the US stock market in July 2002), leading to a large capital account surplus, which in turn caused

5As

Mandel (2000) succinctly put it, “If technology is the engine for the New Economy, then finance is the fuel.”

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a highly overvalued dollar and an equally large current account deficit. Consequently, the McLuhan phase of the US economy has again been transmitting growth stimuli abroad, especially to East Asia, currently the main supplier of IT hardware and services (programming and data-processing), as the US absorbs large amounts of imports from East Asia and elsewhere. 5. Japan’s Role as the Second Goose At the end of WWII, the US dominated the world in every tier of industry, ranging from the most technologically sophisticated down to the most standardized low-productivity industries, simply because the rest of the industrialized world lay in ruins. The US stood on top of the world, enjoying an absolute advantage in every single manufacturing industry, as well as in agriculture, forestry, and mining (including oil). Yet it could not remain a secluded colossus. Despite the absolute advantages in all industries, what mattered as a basis for trade was the logic of comparative advantage. And this principle was fully activated by the US as an effective tool of assisting other countries, but especially East Asia in the context of the US Cold War diplomacy — because of the region’s strategic importance. Japan in particular benefited enormously from this American trade policy and came to play two important roles for the rest of East Asia’s subsequent catch-up industrialization, (1) as an industrial upgrading intermediary; and (2) as a capacity augmenter. 5.1. Industrial upgrading intermediation and production fragmentation Perhaps nowhere else has there been observed as rapid a process of structural upgrading as in Japan since WWII. What Japan accomplished is a quick scaling of the ladder of industry, stage by stage; first from laborintensive Heckscher–Ohlin industries (as exemplified by textiles, from 1950 to the mid-1960s)6 and scale-driven non-differentiated Smithian industries (steel, from the late 1950s to the early 1970s) to assembly-based differentiated Smithian industries (automobiles, from the late 1960s onward), to R&D-driven Shumpeterian industries (computers, from the mid-1980s 6 Japan

actually reached the “nondifferentiated Smithian” stage of growth already in prewar days but modernized war-torn heavy and chemical industries in the postwar period.


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to the present), and finally to IT-based McLuhan industries (the Internet, mid-1990s onward) — all along the path of industrial upgrading trod by the West under the Pax Britannica and the Pax Americana.7 This swift industrial upgrading involved a move toward a higher value-added level of activity. And Japan was able to accomplish this feat by means of dynamic infant-industry protection and the absorption of advanced industrial knowledge from the West largely through licensing agreements in the post-WWII period. Structural upgrading has been a major source of Japan’s productivity growth. Although Japan eagerly borrowed foreign technologies, its absorptive effort was not mere imitation. In the process of adopting and adapting state-of-the-art technologies, Japanese industry has introduced numerous improvements, notably in techniques of commercialization. New ways of arranging production (process and plant-layout technologies) have been innovated even in such a traditional industry as steel. For example, a speedier adoption of oxygen converter in Japan than anywhere else (Lynn 1982) and the introduction of continuous casting and forging, along with the development of new light gauge steel, seamless electrical pipe, high tensile strength steel, etc. (Kosai 1986). A variety of consumer electronics products (such as miniaturized transistor radios and TV sets, calculators, digital watches, video-recorders, and CD players) have been innovated one after another out of basic technologies (e.g., transistors). During its catch-up phase of building up an efficient automobile industry in a relatively small domestic market, Japan technologically overhauled American-style assembly-based production by innovating so-called “flexible or lean production” (also known as the Toyota production system) (Ohno 1978; Womack, Jones, and Roos 1990). “Just-in-time” parts delivery replaced “just-in-case” inventory. This flexible production relies heavily on a cooperative group of suppliers of parts, components, and accessories (PCAs) down the stream of a sequential production process. PCAs are extensively outsourced instead of being produced in-house. In other words, the vertical integrated stages of production are “fragmented” between final 7 Japan

had already gone through the first two stages in the pre-WWII period. In fact, Akamatsu originally found FG patterns (import→local production→export) in the development of Japan’s labor-intensive manufacturing (such as woolen goods and cotton yarn and cloth) and light-machinery industry (spinning and weaving machines and machine tools) before WWII. Heavy and chemical industries were also set up in order to support Japan’s militarism.

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assemblers and their suppliers, as well as among different layers of suppliers themselves.8 Furthermore, because of the “dual” (or actually multi-layered) industrial structure of Japanese industry (where large, medium, and small firms coexist in close affiliation), process fragmentation (vertical specialization) has become all the more fine-tuned to make use of different labor costs and technological capabilities of suppliers at divergent levels of Japan’s industrial hierarchy. Fragmentation is thus even more pronounced in Japan’s assembly-based industries than anywhere else because of the introduction of lean production. Yet, Japan could not retain the whole segments of the fragmented production process at home. Rapid increases in labor costs in Japan, combined with the outward move of major assemblers overseas, have been compelling suppliers, especially those which produce relatively labor-intensive PCAs, to shift production to low-wage locations in neighboring countries. Thus, fragmentation itself compels such segmented-process transplantation. Process fragmentation has not been limited to the Smithian assemblybased industries alone, although they have been most amenable to it because of the intensive use of PCAs. As Japan moved up the ladder of structural upgrading, each tier of industry became vertically differentiated in technological sophistication, value-added, product quality, and factor intensity. For example, in scale-driven heavy and chemical industries a hierarchy of products developed in terms of differentiation along the lines of, say, crude steel vs. stainless or high-tension steel, and basic chemicals vs. refined chemicals. In the assembly-based automobile industry, cars are differentiated by high-end vs. low-end models — and parts, components, and accessories by high value-added key components vs. low value-added peripherals. R&D activities are differentiated in terms of basic vs. applied/adaptive research. Even the latest leading sector, the IT industry, covers a wide range of activities running from relatively low value-added (e.g., data-processing) to highly sophisticated software development. Each higher tier of industry thus offers to developing countries opportunities to participate in some low-end segments of production and service

8 The

notion of production fragmentation has recently been formally theorized. A survey of the literature is provided in Jones (2000). A systematic effort to theorize this phenomenon is also made by noted trade theorists in Arndt and Kierzkowski (2001).


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which are commensurate with their levels of technological sophistication and wages. In other words, developing countries with advantages in labor-intensive standardized goods can now join not only in lowest-tier (Heckscher–Ohlin) light industries but also in the low-end of each of highertier industry. Thus, an intra-industry vertical division of labor occurs across borders, along with an inter-industry horizontal division of labor. As a consequence, Japan’s step-by-step industrial upgrading has had an enormous impact on the industrialization pattern of other East Asian countries. As Japan lost comparative advantage in low-productivity tiers (or low-end goods at each tier), it transplanted via FDI those disadvantaged industrial activities to other Asian economies (first to the NIEs, then to the ASEAN-4, and most recently to China) where they could still produce competitively. In fact, this form of industrial shedding and comparative advantage recycling (Ozawa 1993) has been serving as an industrial structural facilitator for the region as a whole. It is worth noting that when a country loses a comparative/competitive advantage in a particular productive activity, two types of assets/resources are released from the contracting sector: (1) those readily transferable to the expanding sector (namely, homogeneous, nonsector-specific resources, such as land and labor); and (2) those specific to the contracting sector and, therefore, nontransferable to the expanding sector (for example, industry/firm- specific technology, knowledge, and experiences). Most resources of the first type, however, are nontransferable to other countries because of institutional or physical constraints. On the other hand, the second type of resources released will be wasted at home unless they are transferred to and employed in other countries where such industry/ firm-specific resources are needed to develop comparatively advantaged production. Through this mechanism, the resources released from the contracting sector at home are reused (instead of being discarded) and transformed into dividends from FDI operations. The end result is a rise in output and income for both home and host countries, thereby contributing to regionally clustered growth.

5.2. Capacity augmenter In climbing up the ladder of industrial upgrading, notably the differentiated Smithian rung of components-intensive, assembly-based industries, all the Asian follower countries’ export-led growth has become dependent

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on imported PCAs from the advanced countries, especially from Japan. Park and Park (1991, 93) makes a pertinent observation: [The NIEs] have relied on Japan as their main supplier of capital and intermediate goods . . . Almost 80 percent of [their] imports from Japan in the 1980s included capitaland technology-intensive manufactures. This dependence on Japan for capital and technology has increased in recent years. In 1987, [the NIEs] obtained from Japan almost 50 percent of their total imports of technology-intensive manufactures (up from about 41 percent in 1980) as compared to 26 percent form the United States. Similarly, Thurow (1996, 207) argues: On the Pacific Rim, countries run big trade deficits with Japan, which they finance out of their trade surplus with the United States . . . China’s 1995 trade surplus with Japan is . . . misleading since it sells Japanese components that are installed on products that are exported to Europe and America. In fact, Shinohara (1987) much earlier argued that Japan interacts with the rest of East Asia more strongly from the supply side (i.e., as a capacity augmenter) than from the demand side (i.e., as a market provider). In an econometric study, Nakamura and Matsuzaki (1997) similarly demonstrated Japan’s role of capacity augmenter by way of an international input-output analysis and concluded that Japan developed more of a supply-side relationship with the rest of East Asia. Thus, given this role of Japan, it is expected that the more successful other Asian countries are in developing export-driven manufacturing, the greater their dependence on input supplies from Japan — hence the more unfavorable their trade balance vis-à-vis Japan. But these developing countries also have recently started to rely on local production of PCAs by multinationals, especially from Japan. The same role of a capacity augmenter is now being played increasingly by the NIEs (notably South Korea and Taiwan which are more manufacturing-focused than Hong Kong and Singapore) in supplying PCAs to ASEAN-4 and China. This development is deepening an intra-Asian division of labor in manufacturing and trade.


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Looked at in the above light, East Asian economies are not simply export-driven but at the same time strongly import-driven; imports of industrial knowledge, capital goods, and supplies, especially through foreign multinationals’ operations, are critical for the success of export-driven local industries. Hence, an “import- and export-led growth” paradigm (Klein 1990; Dutta 1999, 2000) is most appropriate for East Asia’s growth — excepting Japan which built up a rather self-sufficient industrial structure under infant-industry protection and without much reliance on imported capital goods. The paradigm of import- and export-led growth is both trade- and FDI-augmenting, since foreign investments in labor-abundant economies “were to be paid for by sharing revenues from export earnings which generated a pool of hard currency. The profit repatriation home by foreign investors thus became a way of operation, which in turn induced additional inflow of foreign investment” (Dutta 2000, 71).

6. Export Competitiveness and Currency Appreciation It is well known that developing countries’ currencies tend to remain undervalued relative to advanced countries’ currencies (Kravis and Lipsey 1983; Bhagwati 1984). In fact, their governments like to keep their currencies undervalued to gain export competitiveness and protect domestic industries. An undervalued home currency is usually a plus factor in export-led growth. Yet, the very success of such a development strategy inevitably and eventually leads to home currency appreciation in the foreign exchange market as its trade balance improves. (If the exchange rate is nominally fixed, the currency becomes even more undervalued — i.e., the real exchange rate depreciates. This may strain trade relationships with other countries and cause excessively high domestic prices of imported capital goods and industrial materials. In other words, the benefits of undervalued currency begin to be outweighed by the costs.) In the wake of Japan’s rapid catch-up with its current account surplus rising, the Japanese yen became grossly undervalued and soared in market value once the fixed exchange rate was abandoned in 1973. The yen gained more than fourfold in value at one time in 1995 over the previously fixed rate which once prevailed under the original IMF system (i.e., from ¥360/$ in 1970 to ¥80/$ in April, 1995). Actually, the yen became grossly overvalued, compelling Japanese firms to transplant production to neighboring

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countries, especially ASEAN-4 and China, whose currencies were more or less tied to the US dollar and hence undervalued. In fact, the overvalued yen led to surging waves of outward FDI over the 1986–1996 period. Many Japanese firms moved out of Japan not so much because they lost real competitive/comparative advantage, but rather because the abnormally high yen made it more costly to produce at home than abroad (Ozawa 2001a). Although less pronounced, a similar exchange-rate effect has been observable in the NIEs’ overseas investments in ASEAN-4 and China. In 1985, the NIEs’ currencies also began to exhibit a secular trend of appreciation, though more moderately than the yen. In contrast, the currencies of ASEAN-4 and China exhibited a dramatic depreciation (undervaluation), since they are still in the relatively early stages of catch-up. These contrasting trends in exchange rates no doubt played a key role in the rapid transmigration of labor-intensive industries, first from Japan to neighboring countries and then from the NIEs to ASEAN-4 and China. In short, the staggered trends of changes in currency values among the East Asian economies at different stages of economic growth are another factor for comparative advantage recycling through FDI in East Asia — in addition to increasing wage differentials that develop during the course of rapid growth. 7. Public Policies of Catch-Up Economies We have so far examined the roles of the lead goose (the US) and the second goose (Japan) in transmitting growth stimuli by way of transferring technology, knowledge, and information through international business activities, notably FDI. But what has made the East Asian miracle possible is that the follower geese themselves have been capable of capturing and exploiting such favorable external conditions. In other words, for regionally clustered growth to occur, the emulator countries must possess what Abramovitz (1986) calls “social capability” for learning and catch-up. But what exactly is this social capability? According to the World Bank (1993), the high-performing Asian Economies (HPAEs)9 got the fundamentals right by way of (1) carefully limited and “market-friendly” government activism, (2) strong export orientation, (3) high levels of domestic savings, (4) accumulation of human and physical capital, (5) good macroeconomic management, (6) acquisition 9 The

HPAEs in the World Bank study consist of Japan, Hong Kong, Korea, Singapore, Taiwan, Indonesia, Malaysia, and Thailand.


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of technology through openness to direct foreign investment and licensing, (7) flexible labor markets; and (8) shared growth (spreading the benefits of growth to all groups). It should be noted that all these features are directly or indirectly related to pro-business activism. Indeed, the government mattered — and mattered a lot — in building market-compatible (if not totally market-dictated) economies. This is in sharp contrast to the neoclassical stance to place full trust in the market mechanism. In this regard, it should be noted that the World Bank, a proselytizer of market capitalism, initially resisted a proposal to study East Asian growth and that only after Japan agreed to pay for it did a team of researchers finally proceed. As explained by Stiglitz (2002, 91) who led that research, The reason was obvious: The countries had been successful not only in spite of the fact that they had not followed most of the dictates of the Washington Consensus, but because they had not. Though the experts’ findings were toned down in the final published report, the World Bank’s Asian Miracle study laid out the important roles that the government had played. These were far from the minimalist roles beloved of the Washington Consensus. There is an abundance of literature on the role of the government in East Asian growth (inter alia, Amsden 1989, 2001; Wade 1990; Aoki, Kim, and Okuno-Fujiwara 1997), hence there is no need here to detail it. It suffices to say that East Asian economies’ social capabilities are neither innate nor manna from heaven but have been envisioned and realized by the governments. The World Bank study focused mostly on the individual economies’ internal policies and institutions, and did not delve into the question of how growth externalities (stimuli and incentives) were generated and propagated to the HPEAs. The effectiveness of growth-promoting policies and practices at the individual country’s level was dependent on how each economy responded to and exploited the external environment and opportunities by means of public policies. This point appears to be supported by a recent statistical study; using data for 11 economies in East Asia and Latin America, Zhang (2002, 175) found that “although FDI is expected to boost host economic growth, it is shown that the extent to which FDI is growth-enhancing appears to depend on country-specific characteristics” (such as liberalized trade regimes, improved education and human capital conditions, exportoriented FDI, and macroeconomic stability).

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8. Conclusions East Asia has seen rapid growth in sequence — first in Japan, then in the NIEs, later in ASEAN-4, and most recently in China. These countries have been the beneficiaries of Pax Americana-led macro-clustering. Japan’s successful catch-up and joining the ranks of the advanced economies had mostly been completed by the end of the post-WWII golden age of capitalism (1950–1971) during which exchange-rate stability was maintained and capital controls were tolerated to shield the national financial markets. The Japanese government was heavily involved in “infant industry” protection strategies by restricting trade and inward FDI so as to build up national (not foreign-owned) domestic industries. Among the NIEs, South Korea and Taiwan initially followed many features of the Japanese model of catch-up but soon became increasingly more open to, hence more dependent on, inward FDI, thereby departing from the Japanese model. Hong Kong and Singapore, which are less manufacturing-focused and more service-based, both have long been totally open to inward FDI. ASEAN-4’s export competitiveness in manufactures (notably electronics) derives from foreign multinationals’ operations. Ever since the adoption of its open-door policy in 1978, China has been benefiting from stepped-up integration with the outside world through active trade and inward FDI. In sum, East Asia has been blessed, first of all, by the presence of the US, the hegemon of the post-WWII global economic system, which is the major provider of industrial knowledge and markets — and second, by the roles of Japan as a structural intermediary and as a capacity augmenter, roles which the NIEs themselves in turn have recently begun to play. The existence of these strong secondary geese is what makes regionalized endogenous growth possible in, and endemic to, East Asia. No doubt, East Asian growth has been the most successful outcome of Pax Americana-led macro-clustering. 9. References Abramovitz, Moses, 1986. “Catching Up, Forging Ahead, and Falling Behind,” Journal of Economic History XLVI(2): 385–406. Akamatsu, Kaname, 1935. “Wagakuni yomo kogyohin no susei [Trend of Japan’s wooden product industry],” Shogyo Keizai Ronso 13: 129–212.


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Akamatsu, Kaname, 1962. “A Historical Pattern of Economic Growth in Developing Countries,” Developing Economies 1: 1–23. Amsden, Alice H., 1989. Asia’s Next Giant: South Korea and Late Industrialization (New York: Oxford University Press). Amsden, Alice H., 2002. The Rise of “the Rest”: Challenges to the West from Late-Industrializing Economies (New York: Oxford University Press). Aoki, Masahiko, Hyung-Ki Kim and Masahiro Okuno-Fujiwara (eds.), 1995. The Role of Government in East Asian Economic Development: Comparative Institutional Analysis (Oxford: Clarendon Press). Armdt, Sven W. and Henryk Kierzkowski (eds.), 2001. Fragmentation: New Production Patterns in the World Economy (Oxford: Oxford University Press). Baumol, William, 2002. The Free-Market Innovation Machine. Analyzing the Growth Miracle of Capitalism (Princeton: Princeton University Press). Best, Michael H., 2001. The New Competitive Advantage: The Renewal of American Industry (Oxford: Oxford University Press). Bhagwati, Jagnish, 1984. “Why Are Services Cheaper in the Poor Countries?” Economic Journal 94(June): 279–280. Bluestone, Barry and Bennett Harison, 1982. The Deindustrialization of America: Plant Closings, Community Abandonment, and the Dismantling of Basic Industry (New York: Basic Books). Clark, Colin, 1935. The Conditions of Economic Progress (London: Macmillan). Dutta, M., 1999. Economic Regionalization in the Asia-Pacific (Cheltenham: Edward Elgar). Dutta, M., 2000. “The Euro Revolution and the European Union: Monetary and Economic Cooperation in the Asia-Pacific Region,” Journal of Asian Economics 11: 65–88. Jones, Ronald W., 2000. Globalization and the Theory of Input Trade (Cambridge, MA: MIT Press). Klein, Lawrence R., 1990. “Can Export-Led Growth Continue Indefinitely? An Asian-Pacific Perspective,” Journal of Asian Economics 1(1): 1–12. Kojima, Kiyoshi, 1958. “Nihon Keizai no Gankokeitaiteki Hatten to Boeki no Yakuwari [Flying-Geese-Style Growth of the Japanese Ecoomy and the Role of Trade],” reproduced in Kiyoshi Kojima (ed.), Nihon Boeki no Kozo to Hatten [The Structure and Growth of Japan’s Trade] (Tokyo: Shiseido). Kojima, Kiyoshi, 2000. “The ‘Flying-Geese’ Model of Asian Economic Development: Origin, Theoretical Extensions, and Regional Policy Implications,” Journal of Asian Economics 11: 375–401.

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Kojima, Kiyoshi and Terutomo Ozawa, 1984. “Micro- and Macro-Economic Models of Direct Investment: Toward a Synthesis,” Hitotsubashi Journal of Economics 25(1): 1–20. Kojima, Kiyoshi and Terutomo Ozawa, 1985. “Toward a Theory of Industrial Restructuring and Dynamic Comparative Advantage,” Hitotsubashi Journal of Economics 26(2): 135–145. Kosai,Yutaka, 1986. The Era of High Speed Growth: Notes on the Postwar Japanese Economy (English translation) (Tokyo: University of Tokyo Press). Kravis, Irvin B. and Robert E. Lipsey, 1983. Toward an Exploration of National Price Levels (Princeton: Princeton University, Department of Economics, International Finance Section, Studies in International Finance 52). Lynn, Leonard H., 1982. How Japan Innovates: A Comparison with the U.S. in the Area of Oxygen Steelmaking (Boulder, CL.: Westview Press). Maddison, Angus, 2001. The World Economy: A Millennial Perspective. (Paris: Development Centre Studies, OECD). Mandel, Michael, 2000. The Coming Internet Depression (NewYork: Basic Books). Nakamura,Yoichi and Izumi Matsuzaki, 1997. “Economic Interdependence: Japan, Asia, and the World,” Journal of Asian Economics 8(2): 199–224. Norton, R. D., 2001. Creating the New Economy: The Entrepreneur and the U.S. Resurgence (Cheltenham, UK, and Northampton, MA.: Edward Elgar). Ohno, Tai’ichi, 1978. Toyota Seisan Hoshiki: Datsu-kibo no Keiei o Mezashite [Toyota Production Formula: Toward Non-Scale-Based Management] (Tokyo: Daiyamondo). Ozawa, Terutomo, 1992. “Foreign Direct Investment and Economic Development,” Transnational Corporations 1(1): 27–54. Ozawa, Terutomo, 2001a. “The ‘Hidden’ Side of the ‘Flying-Geese’ Catch-Up Model: Japan’s Dirigiste Institutional Setup and a Deepening Financial Morass,” Journal of Asian Economics 12: 471–491. Ozawa, Terutomo, 2001b. “The Internet Revolution, Networking, and the ‘FlyingGeese’ Paradigm of Structural Upgrading,” Global Economy Quarterly 11: 1–18. Ozawa, Terutomo, 2003. “Toward a Theory of Hegemon-Led Macro-Clustering,” in Peter Gray (ed.), Extending the Eclectic Paradigm in International Business (Cheltenham: Edward Elgar) 201–225. Park, Yung Chul and Won-Am Park, 1991. “Changing Japanese Trade Patterns and the East Asian NICs,” in Paul Krugman (ed.), Trade with Japan: Has the Door Opened Wider? (Chicago: University of Chicago Press) 85–115.


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Rostow, W. W., 1960. The Stages of Economic Growth: A Non-Communist Manifesto (Cambridge: Cambridge University Press). Schumpeter, Joseph A., 1934. The Theory of Economic Development (New York: Oxford University Press). Shinohara, Miyohei, 1987. “Patterns and Backgrounds of Dynamics in the AsiaPacific Economies,” in M. Dutta (ed.), Asia-Pacific Economies: Promises and Challenges (Greenwich, CT: JAI Press) 23–48. Smith, Adam, 1776. An Inquiry into the Nature and Causes of the Wealth of Nations (London: Routledge). Reproduced by New York: E.P. Dutton, 1908. Stiglitz, Joseph E., 2002. Globalization and Its Discontents (New York: W.W. Norton). Thurow, Lester C., 1996. The Future of Capitalism: How Today’s Economic Forces Shape Tomorrow’s World (New York: William Morrow). Vernon, Raymond, 1966. “International Investment and International Trade in the Product Cycle,” Quarterly Journal of Economics 80(2): 190–207. Vernon, Raymond, 1979. “The Product Cycle Hypothesis in the New International Environment,” Oxford Bulletin of Economics and Statistics 41(4). Wade, Robert, 1990. Governing the Market: Economic Theory and the Role of Government in East Asian Industrialization (Princeton: Princeton University Press). Womack, James P., Daniel T. Jones and Daniel Roos, 1990. The Machine that Changed the World (New York: Macmillan). World Bank, 1993. The East Asian Miracle: Economic Growth and Public Policy (New York: Oxford University Press). Zhang, Kevin H., 2001. “Does Foreign Direct Investment Promote Economic Growth? Evidence from EastAsia and LatinAmerica,” Contemporary Economic Policy 19(2): 175–185.


Asian Economic Integration: A Perspective on South Asia Saleem M. Khan1 & Zahira S. Khan2 1

Professor, Department of Economics Bloomsburg University, Bloomsburg, Pennsylvania, USA [email protected] 2 Professor, Department of Mathematics, Computer Science and Statistics Bloomsburg University, Bloomsburg, Pennsylvania, USA [email protected]

1. Introduction Global trends in open regionalism indicate a gradual movement toward continent-based integration. Growing interest in open regionalism in recent years has promoted outward-oriented development and the harmonization of domestic economic policies with the forces of economic globalism along lines of liberalization, privatization, and deregulation. Many sub-regional trading blocs are currently adopting strategies of open regionalism and entering into continent-based integration. The deepening and widening of regional associations is focused on building a sound structure and guiding the merger of regional blocs into continent-based trading bodies. This trend is manifested in the enlargement of the European Union (EU), the building of ties between the Association of South East Asian Nations (ASEAN) and Asian Pacific Economic Cooperation (APEC), the establishment and potential enlargement of the South Asian Association for Regional Cooperation (SAARC), the launching of the Free Trade Area of the Americas (FTAA), the proposed establishment of the African Union (AU), and the widening and deepening of other regional arrangements around the world. The framework of continent-based integration, when operational, will invigorate propensities to trade, invest, and transfer technology, and will thus reinforce outward-oriented development among member countries. Significant positive side-effects of economic regionalism are already evident in 175

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Europe in particular, where economic growth, competition, and income convergence are being advanced. Open regionalism today is widely regarded as a dynamic tool of outward-oriented development. The emphasis on open regionalism is a matter of interest and priority in Asia, and its appeal is evident from the enlarging memberships in APEC and ASEAN. The future enlargement of SAARC, which now includes Bangladesh, Bhutan, India, the Maldives, Nepal, Pakistan, and Sri Lanka, is also a possibility. Prospective members might include Central Asian nations to the north, Myanmar and Laos to the east, and Iran and Afghanistan to the west. In the current environment of economic globalism, continent-based integration in Asia is both desirable and inevitable. In formulating the future strategies of regionalism, the leadership of various sub-regional groups in Asia should examine the desirability of enhanced cooperation aiming at a continent-based integration. Once Asian economic integration becomes a continent-based reality, it would be open by virtue of regional integration agreements (RIAs) to most sub-regions in Asia, including South Asia. Indeed, the scope ofAsian integration is of special significance for South Asia. There is a decades-old impasse on economic cooperation in South Asia, despite the twin problems of poverty and underdeveloped and underutilized regional potential. South Asian participation in Asian integration will become instrumental in expanding and exploiting existing economic potential and in reducing poverty. However, regionalism cannot succeed unless accompanied by key institutional changes. It is, therefore, essential for South Asian political leaders to seize global opportunities in a timely manner. A quick and concerted action on open regionalism and institutional change can create an economic breakthrough in South Asia, leading it to become an active partner in Asian economic integration and the global economy. This paper focuses on South Asia and advocates its participation in the evolving process of Asian integration. It emphasizes much needed institutional changes. The paper is organized in six sections. The first section introduces the theme of the paper. The second section describes trends in economic regionalism in Asia, particularly South Asia. The third section discusses the progress underway in economic regionalism around the world. The fourth section provides a commentary on the South Asian dilemma over priorities. The fifth section outlines selective institutional changes as part of a proposed strategy for South Asia. The paper concludes with policy recommendations.

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2. Regional Integration Agreements in Asia Why should South Asian countries move aggressively to re-examine strategies of open regionalism and redefine their economic links with other sub-regional groups in Asia? Exploiting the region’s huge economic potential and claiming its share in global prosperity are powerful arguments. APEC, ASEAN, and SAARC are existing expressions of economic regionalism in Asia. Over the long run, emerging relationships between these sub-regional groups have the potential for evolving into a continent-based integration. Already, an Indian Ocean group consisting of 47 sovereign countries is at an exploratory stage. The relative success achieved so far in their economic objectives by the Asian trading blocs is central to enlarging RIAs and eventually creating a single market by merging sub-groups inAsia. Given the trends, Asian integration’s future members will probably comprise Pacific countries as well as Central, East, and South Asian countries. The Asian Economic Union (AEU), or simply AU, as it most likely would be named eventually, could bring into its fold more than 30 countries with a combined GDP of over $9.5 trillion and more than half of the world’s population — 3½ billion people. South Asian economies have found the expression of their regional aims in SAARC which was established in 1985. The SAARC charter shows it to be a product of great vision, with the aim “to promote the welfare of the people of South Asia and to improve their quality of life; to accelerate mutual trust, understanding and appreciation of one another’s problems; and to promote active collaboration and mutual assistance in economic, social, cultural, technical and scientific fields” (SAARC 1988). SAARC continues to make progress toward the broader goals of economic liberalization and outward-oriented development (Khan 1999). A chronology of events showing progress toward economic integration in South Asia is outlined in Table 1. Table 1. SAARC Chronology of Events 1983 1985 1987 1995 2001

Declaration on South Asia Regional Cooperation (SARC) adopted South Asian Association for Regional Cooperation (SAARC) established SAARC Secretariat formed SAARC Preferential Trading Agreement (SAPTA) became operational Treaty regime on South Asian Free Trade Area (SAFTA) established

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However, progress on a South Asian Preferential Trading Agreement has been marred by bilateral disputes. Consequently, the realization of a treaty regime for a South Asian Free Trade Area has been slow to evolve. The consensus among all member countries is that the SAFTA aims, if realized, will promote a liberal trading environment, especially for intraregional trade and investment activity. Clearly the road to accelerated outward-oriented development in South Asia is through the SAARC’s economic agenda in general and continuous progress on SAFTA in particular. The SAARC action plan is a multifaceted program of regional cooperation, with SAFTA in particular a vehicle for stimulating intra-regional trade and investment. These are indeed positive developments and show that SAARC has a workable framework of economic integration. Additionally, since the late 1980s, several South Asian countries, in order to promote the twin objectives of development and integration, have undertaken concrete programs of economic reform and trade and investment liberalization. For example, Sri Lanka is continuing the reform process that began in 1985 by reducing dispersion in effective rates of protection. In 1987, Pakistan began shifting from a positive list of permissible imports to an exclusionary list of impermissables. Both India and Pakistan, in 1993, removed numerous restrictions on imports of capital and intermediate goods. Prior to tariff reform, the average nominal tariff rate in the region was above 80 percent, but the rate had dropped to 53 percent by 1993. By 1997, the region’s average tariff rate was down to 34 percent, and the number of tariff lines was also reduced. Policy negotiations to reduce the average rate to 18 percent are currently underway (Khan 2001). These reforms reinforce development efforts and the process of economic integration in South Asia. Progress on the SAARC economic agenda has been disappointingly slow so far and often comes to a halt due to cross-country tensions which have been rather frequent in the region. For example, there have been three major wars between India and Pakistan, cross border insurgency between India and Sri Lanka, water disputes between India and Bangladesh, and frequent political tensions between India and Nepal (Khan 2001). Intraregional trade, in volume and value, is still low, accounting for only three percent of all international trade for countries in the region. The prevailing attitudes and inherent contradictions in South Asian countries must be overcome and economic impasse must end. Unless South Asian leaders implement the SAARC action plan, they will not be able to either enhance


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or utilize the region’s economic potential and will continue to lag behind in their development efforts. Denying the region an active participation in the global economy also deprives its people of their fair share of global prosperity. Therefore, in an integrated development strategy for South Asia, to achieve a measure of progress on open regionalism is the first step. 3. World Trends in Regional Integration Agreements Economic globalism and its challenges are the major forces behind the expansion of economic regionalism around the world. Among the key factors promoting broader integration are increased internationalization of markets and countries’ desire to lock-in economic and political reforms (Hoekman and Kostecki 2001). In today’s world, economic integration encompasses most of the industrialized nations, transition economies, and the developing world. Regional integration is commonly viewed as a protective umbrella against the onslaught of economic globalism on the one hand and as an effective tool for outward-oriented development on the other. It is considered a mechanism for strengthening individual economies as well as their regional competitive positions in the global marketplace. At a time when the division of the world into major trading blocs is emerging as the trend of the future, there is convincing evidence that open regionalism is evolving into a continent-based framework. The orientation of EU, the most successful regime of economic integration, from the very outset has been toward continent grouping. The guidelines for widening, agreed upon at its summit in Nice in December 2000, confirm the continuation of this trend. All thirteen candidate-countries for EU membership are from central and east Europe. The economic integration of the European continent will eventually stretch from Ireland across to the Baltic States and to Bulgaria in the Southeast. At the same time, the evolution of this body from a free trade area in the 1960s to the present state is a remarkable example of deepening economic integration. The proposed Free Trade Area of the Americas (FTAA), to be completed by January 2005, will create a continent grouping including all countries of both North and South America. The Americas’ single market will stretch from the Bering Strait to Cape Horn, encompassing 34 countries with a total population of 800 million and a combined GDP of almost $12.5 trillion (Business Week, April 23, 2001). This is a big leap towards widening integration.

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Recently, the African leadership endorsed a plan to launch a continent-based African Economic Union similar to the EU. Economic integration among Africa’s 53 countries, with a population of about 850 million and an estimated GDP of $800 billion, is aimed at substantially reducing import tariffs and dismantling non-tariff barriers to trade and investment. There is also a plan to create a central bank and common currency for the entire African continent (Financial Times, July 10, 2002). The announcement indicates a commitment to deepening and widening integration. Some smaller regions are also initiating economic integration agreements. The Caribbean community (Caricom) announced on July 12, 2001, that it would establish an economic union integrating its 14 member countries with a market of 13 million people. The Caribbean Union’s goals are to promote trade in services, free movement of capital, dismantle barriers to trade, and impose a regime of common tariffs on imports from non-member countries. Future plans also envision establishing a regional court to adjudicate trade disputes and creating a common currency administered by a regional monetary authority (Financial Times, July 13, 2001). A chronology of other economic integration events worldwide indicates substantial progress towards both deepening and widening. The establishment of a monetary union in Europe, the ongoing negotiations for an Asian Free Trade Area (AFTA), and in July 1994, creation of the ASEAN Regional Forum (ARF) — a multilateral security group with regional economic aims that includes China, Russia, the United States and 15 other members — all point toward widening and deepening regionalism around the world. Most of these trading blocs are being promoted in the spirit of open regionalism to strengthen their respective competitive positions in global markets (Khan 1996). Parallel developments in the success of the Uruguay Round of the GATT and the initiatives of WTO are proving to be balancing instruments to any threats of inward-looking regionalism, trade retaliation, or indirect protection. How well these institutions will succeed in liberalizing trade, services, and investment flows, given the restrictive trade practices of major industrialized nations, particularly the US and the European nations, is not yet certain. However, these international institutions serve to link continentbased integration. The institutions discussed in Sections 2 and 3 will have a profound impact on shaping the 21st century world economic order. They will also prove to be the key to guiding countries into the 21st century and to exploiting enormous economic potential.


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4. South Asian Dilemma and Potential I have never been free of an intense awareness of the momentous human drama of the desperate striving for national consolidation and economic development in the south Asian countries. Gunnar Myrdal, Asian Drama, 1968 Gunnar Mydral’s observations sum up the peoples’ hopes in South Asia for accelerated development and common prosperity. However, the political leadership in most of the South Asian countries is embroiled in dispute and distrust. Consequently, efforts to resolve the many problems in the region have stalled. The current situation represents a tension between two contrasting world-views — prosperity through economic cooperation versus poverty through confrontation — and poses a dilemma as to which way to move. The South Asian dilemma has created an impasse over determining priorities pertaining to economic cooperation and territorial disputes. So far preoccupation with territory has taken precedence over economics. It appears preoccupation with territorial disputes and bilateral conflicts has blurred the leaders’ vision and hardened their attitudes. Despite peoples’ hopes and the region’s huge resources and enormous potential, this dilemma continues to hamper efforts toward reconstruction, development, and poverty reduction. Notwithstanding over five decades of development efforts in the SouthAsian region, negative effects of the impasse are obvious: low economic and social indicators and seriously underdeveloped and underutilized economic potential. 4.1. Economic indicators Key economic indicators for South Asia show a mixed picture, as reported in Table 2. South Asian countries achieved respectable growth rates in GDP with an increase since the 1970s. From the 1970s to 2000, annual GDP growth for India rose from 3.4 to 6 percent and for Bangladesh from 2.4 to 4.8 percent. These growth rates, however, lag far behind the rates achieved in China, at 10.3 percent, Malaysia, at 7.0 percent, and South Korea, at 5.7 percent. The rates of growth in South Asian countries are comparable to those observed in Latin America and other developing regions but remain

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Table 2. Growth Rates of Population, GDP, and GNP per Capita (% per Annum) GDP

GNP per Capita

1995–1999

1999–2015

1970–1980

1980–1990

1990-2000

1980–1991

1999–2000

South Asia Bangladesh India Nepal Pakistan Sri Lanka

2.4 2.0 2.2 2.8 1.4

1.9 1.3 2.2 2.5 0.8

2.3 3.4 — 4.9 4.1

4.3 5.8 4.6 6.3 4.0

4.8 6.0 4.8 3.7 5.3

−1.6 3.2 2.1 3.2 2.5

3.8 3.9 3.1 3.4 4.2

East Asia/China China Indonesia Malaysia Philippines South Korea

1.3 1.8 2.4 2.4 1.1

0.7 1.1 1.5 1.6 0.5

— 7.2 7.9 6.1 9.6

10.2 6.1 5.3 1.0 9.4

10.3 4.2 7.0 3.3 5.7

7.8 3.9 2.9 −1.2 8.7

7.3 3.1 6.0 2.1 7.8

Latin America Argentina Brazil Mexico Peru

1.4 1.8 2.0 2.1

1.1 1.1 1.3 1.5

2.5 8.1 6.3 3.5

−0.4 2.7 0.7 −0.3

4.3 2.9 3.1 4.7

−1.5 0.5 −0.5 2.4

−1.7 3.2 5.4 1.9

Sources: World Bank (1993, 1995, 1997–1999); UNDP (1995, 1997, 1999).


Population


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Table 3. Trade to GDP Ratios (%) Region South Asia East Asia & Pacific Sub-Saharan Africa Latin America & Caribbean

1970

1980

1990

1998

12 13 41 22

18 36 52 27

20 49 50 28

28 66 56 35

Source: World Bank SIMA database.

disappointingly low by Asian standards. One reason for this poor performance could be the higher population growth rates in South Asian countries than in China and other East Asian countries. However, disputes and distrust have also played a significant role in slowing down development. Since 1970, trade to GDP ratios have expanded for most developing countries as a result of economic liberalization. But as shown in Table 3, expansion in South Asia has been lackluster, probably due to the slow pace and half-hearted efforts in adopting economic reform and liberalization policies. Another revealing indicator is the factor intensity of exports, which changed significantly during the 1990s. Table 4 indicates that South Asia, which had produced mainly natural resource intensive commodities during the 1970s and 1980s, began to employ more of its abundant unskilled labor by the 1990s. But no progress seems to have taken place in the use of technology and human capital as contrasted to East Asia and Latin America. Limited use of technology and human capital in exports is related to meager inflows of FDI and high rates of illiteracy for South Asia, particularly in India, Bangladesh, Nepal, and Pakistan. 4.2. Social indicators Social indicators for the last three decades, presented in Table 5, show that in the countries of South Asia, life expectancy rose, infant mortality dropped, and adult illiteracy declined. However, compared with China and other East Asian countries, these improvements are not impressive. In South Asian countries, life expectancy is lower, infant mortality is higher, and adult illiteracy is much higher than in East Asia and Latin America. The share

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Table 4. Factor Intensity of Exports (Percentage Share of Resource Inputs) Natural resource 1988 Industrial Countries Developing Countries East Asia South Asia Latin America Sub-Saharan Africa E. Europe & C. Asia

Unskilled labor

Technology

Human capital

1998

1988

1998

1988

1998

1988

1998

22.51 17.9

9.8

9.7

39.4

45.2

28.3

27.1

27.2 50.2 67.0 78.3

16.8 15.9 42.4 79.0

30.5 35.9 5.8 6.0

24.0 81.2 9.3 5.9

23.8 7.9 13.4 6.6

42.6 2.2 25.4 7.7

18.5 6.1 13.8 9.1

16.6 0.6 22.9 7.4

38.0

37.6

23.9

18.4

20.2

21.3

17.8

22.7

Source: UN Comtrade and World Bank.

of population below the poverty line in South Asian countries is significantly higher than in East Asia and Latin America. Despite the SAARC agenda and the adoption of outward looking policies, all major economic and social indicators in South Asia are low both in absolute and relative terms. Fortunately, there is a bright side to this picture: enormous economic potential. 4.3. Economic potential This brings us to a discussion of the impact of South Asia’s dilemma on the region’s underdeveloped and underutilized economic potential. The cost in terms of foregone GDP and depressed living standards has been substantial. Table 6 shows that in the mid-1960s Korea, Malaysia, and China were at a par with India and Pakistan in per capita income. But by 2000 per capita incomes in Korea, Malaysia, and China were respectively 19, 7, and 2 times higher than in India and Pakistan. This gap is further widening with the higher growth rates found in the East Asian countries. The gap is shocking as an indicator of missed potential.

Table 5. Social Indicators Country

Life expectancy (years at birth)

Infant mortality (per 1000 live births)

Adult illiteracy rates (%)

Population below poverty line (%)

1991

1999

1980

1991

1999

1970

1991

1999

1983–1999

1984–1999

South Asia Bangladesh India Nepal Pakistan Sri Lanka

44 49 42 49 65

51 60 53 59 71

61 66 58 63 73

132 116 190 124 34

111 90 102 101 25

81 71 75 95 17

76 64 87 79 23

65 52 74 65 12

61 47 62 59 9

29 44 38 31 7

36 35 42 34 25

East Asia/China China Indonesia Malaysia Philippines South Korea

62 48 61 57 60

69 60 71 65 70

70 66 72 69 48

42 90 30 52 26

42 68 15 42 22

38 45 10 32 6

— 46 40 17 12

27 18 22 10 4

14 15 14 5 3

18 8 0 — 2

5 27 15 37 —

Latin America Argentina Brazil Mexico Peru

66 59 61 54

71 66 70 64

74 67 72 69

35 70 51 81

30 59 37 80

21 37 29 44

7 34 26 29

5 19 — 15

4 16 10 12

— 9 12 15

— 22 10 49

185

Sources: World Bank (1993, 1995, 1997–1999); UNDP (1995, 1997, 1999).


1970

186

S. M. Khan & Z. S. Khan Table 6. GNP per Capita Levels and Growth Rates

Country

South Asia Bangladesh India Nepal Pakistan Sri Lanka East Asia China Indonesia Korea Malaysia Thailand

GNP per capita

Growth rate (% per year)

GNP per capita

Growth rate (% per year)

1980

1960–1980

2000

1999–2000

80 240 140 300 270

−0.1 1.4 0.2 2.8 2.4

380 460 220 470 870

3.8 3.9 3.1 3.4 4.2

290 430 1520 620 670

4.8 4.0 7.0 4.3 4.7

840 570 8910 3380 1960

7.3 3.1 7.8 6.0 3.5

Sources: World Bank (1982, 1984, 2000–2002).

Without breaking the long-standing impasses, tackling economic problems through open regionalism will remain ineffective. In this regard there are lessons for South Asian leaders to learn. They should seriously examine the existing economic relationships between China and Taiwan, China and Japan, Russia and Japan, and Russia and the US. Presently and even during the Cold War period, despite differences on territorial and security matters, these nations have pursued pragmatic economic strategies. Their disputes have not been allowed to supercede economic relationships or stand in the way of economic progress. For achieving the objectives of economic development and common prosperity, the South Asian leadership should break the impasse and adopt similar pragmatic approaches so that the economic program is not left in limbo. This means no more dilemmas blocking a decision in favor of economic cooperation and dynamic open regionalism. Otherwise, the risk of falling behind becomes greater. How to better exploit the enormous economic potential of the region, how to take advantage of the existing opportunities in the international economy, and how to make open regionalism more effective are objectives that require a concrete approach which is outlined in Section 5.


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5. Proposed South Asian Strategy The principles of good government, the inducements to individual performance, the role of popular enlightenment, the foundations of thrift, the effect of competition and of monopoly, the relation between social classes, the reasons why some people, notably the English, worked hard and others, notably the Irish, were idle, were all grist for their highly diversified mill. Anything that was deemed to have a bearing on economic advance came into the discussion. The only test was broad relevance to the questions: What made for economic progress? Or, on the other hand, what led to stagnation — to the much discussed stationary state? John Kenneth Galbraith, Economic Development, 1964 The classicists had “concerned themselves with the aggregate requirement of progress.” From this vantage point, Galbraith sees “some serious shortcomings in the modern discussion” of the underdeveloped countries, and states: “We have given too little attention to inquiring whether the things that contribute to economic development are being employed in a context that is favorable to development.” Gunnar Myrdal, Asian Drama, 1968 Galbraith and Myrdal argue in favor of an institutional approach, a notion driven by the classical school’s intellectual foundations. We also advocate institutional change along with open regionalism for SAARC to accelerate outward-oriented development and harmonize trade policies in South Asia with the forces of economic globalism. To address the development challenges in South Asia, our suggestions are: • • • • • •

Create a development-friendly environment Shift from a geo-political to a geo-economic approach Institute good governance Allocate resources based on marginal productivity considerations Invest in human capital Adopt efficient economic management

Adopting political and economic reforms in South Asia can create a development-friendly environment. Democratic systems, human rights

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issues, political stability, macroeconomic stability, outward-looking strategies, market-oriented business practices, and a comprehensive legal framework are essential. Currently not a single country in the region can claim to have come even close to achieving the benchmarks set in these areas by leading European, North American, and East Asian economies. Democracy is important not just for political stability and moral reasons but also for more fair and effective economic development (UNDP 2002). Additionally, the “rules of the game” require truly entrepreneurial activity and competitiveness in the market. Business leadership for its part should respect and practice principles of risk taking, innovation, and competition. Developing and enforcing a legal framework with respect to such matters as contracts and bankruptcy is fundamental to creating a business friendly environment. Finally, achieving and maintaining macroeconomic stability by implementing sound fiscal and monetary policies is conducive to investment. A geo-economic approach will serve to promote open regionalism and strengthen SAARC’s economic agenda. For this to happen, a shift from a security-oriented, geo-political framework to a development-oriented, geoeconomic strategy is essential (Dutta 1999). De-emphasizing geo-political considerations automatically frees scarce resources (e.g., the peace dividend in the post-Cold War period) from defense and security spending. These resources can be channeled according to geo-economic considerations into civilian sectors, particularly investment in priority development projects. The geo-economic approach has great potential for accelerating outwardoriented development, increasing common prosperity in the region, and establishing strong economic links with the more productive sectors of the global economy. In the past, the aggressive pursuit of geo-political interests consumed valuable political assets and scarce resources and has had a negative economic impact. Major South Asian countries like India and Pakistan belonging to opposite camps (India’s close association with the Soviet bloc and Pakistan firmly in the Western camp) had rendered unproductive the economic landscape of the South Asian region. This divide had far reaching effects impeding agreement on regional disputes. Geo-political rivalries resulted in a hardening of attitudes on both sides. The disputes that might have been resolved through bilateral exchanges or international negotiations took on a life of their own evolving into a never-ending contest. In other words, the Cold War geo-political climate in the sub-continent has perpetuated territorial disputes justifying huge defense budgets. This expenditure has substantially detracted from economic development and prosperity.


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Good governance would be development-friendly for SouthAsian countries. Instead, poor governance is a formidable impediment to development. There is little evidence that under poor governance economic endeavors can succeed in these countries. The problem is enormous and complicated. Public institutions that foster good governance in South Asian countries are grossly lacking. Legal, political, and economic institutions are generally weak and corrupt. This weakness has limited the scope of business opportunities and promoted monopolies. Corruption is a major factor in undermining the efficient functioning of markets in South Asian countries in many ways: it taxes economic activity; it blocks entry to markets; it subverts the legitimacy of the state; and it concentrates wealth in fewer hands. The corruption tax has distorted economic choices, and bribes have increased the cost of investment. By protecting monopoly practices, corruption has often restricted the entry of firms. “License Raj” is a form of firms paying huge bribes to gain entry into markets. Small and capital-short firms have often been blocked out of markets. Corruption has stigmatized government, especially in Bangladesh, India, and Pakistan. A lack of democracy and absence of its traditions of accountability has only worsened the problems of governance. A glimpse of how democracy is practised in South Asia is afforded by the following: “What is democracy anyway?” reads a headline in the New York Times of May 3, 2003. “If there was a form of government that produced autocrats who sponsored terrorism, stole millions of dollars while impoverishing their citizens, shredded public education and health, permitted child bondage, tortured dissidents and tolerated pogroms against minorities then we would all condemn it. Except that in South Asia such a system is called democracy.” Nicholas Kristof Without better governance, extremism is likely to flourish, as is the case in Pakistan. This situation undermines national and international endeavors in achieving effective development. According to a basic principle of economic efficiency, resources should be allocated to their highest marginal productivity uses. Contrary to this principle, resource use in the South Asian countries is biased in favor of big capital-intensive projects and defense which are low return sectors.

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As shown in Table 7, India and Pakistan spent respectively 2.4–2.9 percent and 4.4–5.7 percent of GDP on defense during the 1990s. Human capital investment — in education, knowledge, skills, and healthcare — generates high rates of return in South Asia, yet in the past five decades it has received only meager allocations of public funds. Such investment is critical for both raising labor productivity and reducing poverty. If South Asian countries are to achieve faster economic growth, they must increase substantially their investment in human capital. Education in poor countries like India and Pakistan yields high returns as knowledge and skills contribute to productivity in the workplace. As shown Table 8, investments in primary education offer the highest yield. According to a study by Mingat and Winter (2002), investment in primary education yields higher returns than investment in physical capital by 11 to more than 30 percentage points. Investment in the education of girls can yield even higher returns. Countries in South Asia must pay special attention to investment in human capital. Efficient economic management and pragmatic approaches to solving problems are essential for a successful outcome of development endeavors. The remarkable successes achieved by China and the Asian Tigers of Hong Kong, Singapore, South Korea, and Taiwan strongly support this point. These countries have saved and invested, taken advantage of their resource endowments particularly abundant labor, and focused on education to increase the productivity of labor. Their governments have been stable and efficient and have adopted outward-oriented development policies. They have been business friendly and encouraged companies to compete, export, and succeed in world markets. Through a strategy of efficient economic management they have become model developing economies. These are good examples for South Asian countries to emulate. The tide in development thinking has shifted since Myrdal wrote in 1968, “too little attention has been paid to inquiring whether the things that contribute to economic development are being employed in a context that is favorable for development.” Institutions are now the focus as we start the 21st century. In order to achieve a successful outcome of continent-based integration in Asia, the “Asianization of South Asia” is critical due to its demographic might — almost one-fourth of humankind — and its huge economic potential. The combined strategies of open regionalism and institutional change offer the best hope for South Asia to develop economically and become an active sub-group in Asian integration.

Table 7. Public Sector Expenditure Allocation Countries

115 127 87

Defense expenditure

Social welfare expenditure Education∗ (% of GNP)

(% of GDP)

(% of spending on education + health)

Health (% of GNP)

1990

1999

1960

1990–1991

1960

1990

1985

1990–1995

2.9 5.7 2.7

2.4 4.4 2.1

68 393 — 102 67 159 76

65 125 23 63 38 84 66

0.5 0.3 1.3 1.0 1.2 0.9 0.6

1.3 1.8 2.1 2.0 2.1 2.1 1.5

3.2 3.1 2.3 4.1 4.1 4.2 3.2

3.2 2.7 2.3 3.8 4.1 3.6 —

Source: UNDP 1998. ∗ For India, Pakistan and China, public expenditure on education is for 1985–1987 and 1995–1997. ∗∗ Human Development Index (HDI) is a composite index based on: a long and healthy life, knowledge, and a decent standard of living.


India Pakistan China All Developing Countries High HDI Countries Medium HDI Countries Low HDI Countries

HDI∗∗

191

192

S. M. Khan & Z. S. Khan Table 8. Education Yield in Low-Income Countries (%) Schooling level Primary Secondary Tertiary

Private return

Social return

26.4 18.5 22.4

20.6 14.1 11.3

Source: Psacharopoulos (1994).

6. Conclusions Emphasis on open regionalism has gained momentum in recent years, and market-driven economic globalism will remain a pervasive force in the world economy for quite some time. Within this context, development approaches should be attentive to geo-economic considerations. Nationstates are building trading blocs oriented toward continents by deepening and widening regional trading blocs. Moreover, the evolution of open regionalism into continent-based phenomena will help regional blocs achieve countervailing power globally. These factors promote the growth of open regionalism into continental integration. Already big and economically strong regional groups — the EU, NAFTA, APEC — are enlarging their scope of trade relations and membership. Scholars, researchers, and policy makers are helpful in designing more innovative theoretical and practical models to enhance the economic propensities and potential of regional trading groups. The future direction indeed points to continent-based integration not only in Asia but around the world. The EU is already a continent-based economic union. NAFTA is aiming to create a single market of the Americas (FTAA) by 2005. Asia is developing momentum for continent-based integration. And recently African leaders have committed to establishing an economic union embracing their entire continent. South Asian countries must play their part and develop SAARC in the true image of open regionalism. An effective process of deepening and widening is critical. Not only should the region strive for comprehensive trading agreements within, it should also build ties with ASEAN and APEC. The economic future of South Asia is anchored in an open regionalism of Asian scope. The foundation for this lies in establishing appropriate institutions to ensure dynamic outward-oriented development.


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The creation of a more development-friendly environment, emphasis on geo-economic approaches, improvement in governance, the allocation of sufficient resources to civilian sectors and especially social services, and acceleration of human capital development will lead to a very prosperous 21st century for the South Asian people. 7. References Asian Development Bank, 2002. Poverty in Pakistan: Issues, Causes and Institutional Responses (Manila: Asian Development Bank). Business Week, April 23, 2001. “Betting on Free Trade” (NewYork: McGraw-Hill). Dutta, M., 1999. Economic Regionalization in the Asia-Pacific (Cheltenham, UK: Edward Edgar). Financial Times, July 10, 2002. “African Union” (New York). Financial Times, July 13, 2000. “Single Market for Caribbean” (New York). Galbraith, J. K., 1964. Economic Development (Cambridge, MA: Harvard University Press). Hoekman, B. M. and M. M. Kostecki, 2001. The Political Economy of the World Trading System (New York: Oxford University Press). Khan, S. M., 2001. South Asia: A New Regionalism, Research in Asian Economic Studies, Volume 9-B (Amsterdam, The Netherlands: JAI Press) 545–561. Khan S. M., 1999. “South Asian Association for Regional Cooperation,” Journal of Asian Economics 10(3): 489–495. Khan S. M., 1996. South Asia and APEC: Potential for Growth Enhancement, Research in Asian Economic Studies, Volume 7 (Greenwich, Connecticut: JAI Press). Mingat, A. and C. Winter, 2002. “Education for All by 2015,” Finance and Development 39(1): 32–35. Myrdal, G., 1968. Asian Drama, Volume 1 (New York: Pantheon). Psacharopoulos, G., 1994. “Returns to Investment in Education: A Global Update,” World Report 22(9): 1325–1343. SAARC, 1988–1995. SAARC Documents: 1988–1991 (Volume III); 1991–1993 (Volume IV), 1993–1995 (Volume V) (Katmundu, Nepal: SAARC Secretariat). UNDP, various years. Human Development Report (New York: Oxford University Press). World Bank, various years. World Development Report (New York: Oxford University Press).


Asian Policy & Performance


Can East Asia Rise Again? Tzong-Shian Yu Director, Chinese Institute of Economics and Business Taipei, Taiwan, ROC [email protected]

1. Introduction In 2000 when we edited the book From Crisis to Recovery (Yu and Xu 2001), we used “East Asia Rising Again?” as the sub-title because a great many people were not optimistic about sustained recovery in the aftermath of the financial crisis despite the robustness of the economies of East Asia at the time. In July 2001, I came across a note in the Economist titled, “East Asia Falling (Again),” which inspired me to consider whether East Asia could actually rise again having been plunged into a second slump, this time along with the global economy. A short time ago, many people were lauding the great achievement of the US economy — high growth with low unemployment and no inflation. Both policymakers and economists began to believe that in the era of the New Economy, there would no longer be business cycles! Unfortunately, the New Economy has shown itself unable to avoid the bursting of a bubble, and economists have realized that business cycles will remain with us. In this paper, I will attempt to identify those factors affecting the prospects for East Asia rising again to emerge from the recent economic slump which stems from excessive investment in the electronics and information industries. In order to examine this issue, it is first necessary to provide an overview of the East Asian economy with particular reference to the antecedents of the current slump in the East Asian financial crisis and the nascent recovery from it. After exploring the causes of the successive downturns and reviewing measures taken to counter them, I will offer a proposal for the formation of an East Asian Economic Community. 197

198

T.-S. Yu

2. Overview of the Recent Economic Situation in East Asia The economies most seriously affected by the East Asian financial crisis were Indonesia, Korea, Thailand, Malaysia, Hong Kong, and the Philippines, all of which saw both GDP and export growth rates drop sharply in 1998, as shown in Tables 1 and 2 respectively. Although Japan was less seriously affected, its GDP and export growth rates were nevertheless also negative. Of all the East Asian economies, only mainland China and Taiwan were able to avoid the contagion of the financial crisis: mainland China achieving healthy growth in both GDP and exports, with Taiwan at least able to maintain moderate growth in GDP. 2.1. Economic growth Fortunately, by late 1999, the economies of East Asia were gradually recovering from the financial crisis, and indeed resumed a rapid pace of growth in 2000. Hong Kong, Singapore, Korea, Malaysia, and mainland China realized GDP growth rates in excess of eight percent, and all 12 of the East Asian economies, with the exception of the Philippines, had export growth rates of over 14 percent. Based on growth in 1999 and 2000, many felt confident that the subsequent year would be a prosperous one and that East Asia would continue to share in the fruits of the New Economy. Table 1. East Asian GDP Growth Rates, 1996–2003 (% per Annum)

Taiwan Hong Kong Singapore Korea Thailand Malaysia Indonesia Philippines China Japan

1996

1997

1998

6.1 4.5 7.5 6.8 5.9 8.2 7.8 5.8 9.5 3.5

6.7 5.0 8.4 5.0 −1.5 7.7 4.7 5.2 8.8 1.8

4.6 −5.3 −0.9 −6.7 −10.8 −7.4 −13.0 −0.6 7.8 −1.2

1999 2000 5.4 3.0 6.4 9.5 4.5 6.1 0.8 3.4 7.2 0.2

5.9 10.1 9.4 8.5 4.8 8.6 4.9 6.0 8.9 2.8

2001

2002

2003(e)

−2.2 0.5 −2.4 3.8 2.1 0.3 3.5 3.0 7.3 0.4

3.6 2.3 2.2 7.0 5.4 4.1 3.7 4.4 6.7 −0.4

3.2 3.3 1.1 3.1 6.7 5.2 4.2 4.5 9.1 2.7

Note: (e) indicates “estimate”. Source: Chung-Hua Institution for Economic Research, Weekly Report on International Economic Situation CIER (2004).

Can East Asia Rise Again?

199

Table 2. East Asian Export Growth Rates, 1996–2003 (% per Annum) 1996

1997

1998

1999

2000

2001

2002 2003(e)

Taiwan 3.8 Hong Kong 4.0 Singapore 4.2 Korea 3.7 Thailand −0.8 Malaysia 6.2 Indonesia 9.7 Philippines 17.7 China 12.1 Japan −7.2

5.3 4.2 0.0 5.0 3.3 0.5 7.2 22.8 21.1 2.4

−9.4 −7.4 −12.1 −2.8 −5.1 −6.9 −8.5 16.9 14.0 −7.9

10.0 −0.1 4.4 8.6 7.4 15.6 −0.4 18.8 15.1 7.9

22.0 16.1 20.2 19.9 19.5 16.2 27.7 8.7 27.8 14.8

−17.2 6.3 −5.9 5.4 −11.7 2.8 −12.7 8.0 −6.9 5.8 −10.5 5.9 −9.3 1.5 −15.6 9.5 6.8 22.3 −15.9 3.1

10.4 11.8 16.1 19.3 17.2 8.0 6.8 1.2 34.6 12.3

Note: (e) indicates “estimate”. Source: As Table 1.

It was therefore unexpected when the New Economy bubble suddenly burst and growth in the US stalled in 2001. With the exception of mainland China, the economies of East Asia saw GDP growth rates turn downward precipitated by a fall in exports. Particularly noteworthy is that in the slump of 2001, among the most seriously affected economies were Taiwan and Singapore in a complete reversal of the 1998 recession when these economies were the least affected. In exports, no economy of the region, apart from mainland China, saw positive growth rates. At −17.2 percent, Taiwan had the deepest negative growth in exports, while Japan, the Philippines, Korea, and Singapore had negative export growth rates ranging from −11.7 percent to −15.7 percent. Obviously, the main source of the slump was the US where, as shown in Table 3, GDP growth started to falter from the third quarter of 2000 and import growth followed suit thereafter. From the second to the third quarters of 2001, growth in GDP became negative and from the second quarter of 2001 to the first quarter of 2002, growth in imports was negative for the US. Japan, too, is a major market for East Asian exports, and its GDP and import growth rates also turned negative from the third quarter of 2001 until the second quarter of 2002. However, from 2003 on, all the East Asian countries have eliminated the shadow of economic slump and resumed their remarkable growth not only in their exports but also in their GDP.

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T.-S. Yu Table 3. US and Japan GDP and Import Growth Rates, 1999–2001 Quarterly (% per Annum) US

1999 2000 1Q 2Q 3Q 4Q 2001 1Q 2Q 3Q 4Q 2002 Q1 Q2 Q3 Q4

Japan

GDP

Imports

4.1 4.1 2.3 5.7 1.3 1.9 0.3 1.5 −0.1 −0.4 0.1 2.4 1.4 2.2 3.3 2.9

12.3 18.9 22.6 21.1 18.5 14.1 −6.0 5.1 −3.0 −11.1 −14.9 −1.7 −12.2 0.3 7.4 13.2

GDP 0.8 2.4 8.2 3.1 −2.9 1.1 −0.6 1.2 −0.1 −0.6 −2.4 −0.6 −3.0 −0.2 1.8 2.6

Imports 10.7 21.9 23.2 29.0 22.0 15.4 −7.1 6.5 −4.2 −11.8 −18.9 −3.5 −18.2 −7.9 4.4 10.3

Note: Annualized growth rates by quarter determined as the average of the three monthly growth rates. Source: CEPD, International Economic Conditions Weekly, No. 1441 (June 2002).

2.2. The financial markets The stock and foreign exchange markets are highly sensitive to external economic forces and interact closely with each other. With the financial crisis, East Asian stock markets became sluggish while the foreign exchange markets went through erratic fluctuations. 2.2.1. Stock markets Declining stock prices can lead to loss of investor confidence that in turn fuels further stock declines with a snowballing effect. At the peak of the boom in technology stocks in September 2000, the NASDAQ index climbed


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Table 4. Stock and Foreign Exchange Markets of East Asia Stock markets Base (Index value) 6/28/00 Taiwan Hong Kong Singapore Korea Thailand Malaysia Indonesia Philippines China Japan

8,365.6 16,438.4 2,061.2 818.7 334.5 841.5 510.1 1,531.0 2,068.4 17,370.0

Foreign exchange markets

Change from base (%)

Base (Units/US$1)

Change from base (%)

6/27/01

6/26/02

6/28/00

6/27/01

6/26/02

−42.4 −20.9 −17.4 −28.6 −3.4 −29.9 −14.6 −7.6 −12.1 −26.2

−38.7 −37.0 −25.7 −14.3 −14.0 −16.2 −12.9 −23.0 −13.5 −38.4

30.70 7.80 1.74 1.116 39.10 3.80 8.685 43.10 8.28 155.40

−11.1 0.0 −4.4 −14.1 −13.5 0.0 −23.8 −17.6 0.0 12.7

−14.7 0.0 −2.8 −8.5 −7.1 0.0 −0.7 −14.1 0.0 −14.7

Sources: The Economist (2001, 2002).

above 5000 points. It then plummeted to around 1500 points by June 2001, a loss of 70 percent. From a baseline taken as June 28, 2000, stock prices in East Asian markets fell substantially in the year ending June 27, 2001, as shown in Table 4. Among the four little dragons (Taiwan, Hong Kong, Singapore, and Korea), the greatest drop was in Taiwan where losses amounted to 42.4 percent while the smallest was in Singapore where the market shed 17.4 percent of its value. Upon partial recovery in the second half of 2001, the greatest decline since the baseline as of January 2, 2002 was still in Taiwan at 38.4 percent while the smallest was in Korea at 14.3 percent. The four little tigers (Thailand, Malaysia, Indonesia, and the Philippines) also experienced a decline in their stock markets. Among them, for the period June 28, 2000 to January 2, 2002, Indonesia experienced the smallest decline while the Philippins and Malaysia suffered the most. Over the same period, stock prices in mainland China fell by 17.3 percent while in Japan the drop was 39.4 percent. Clearly, all the stock markets in East Asia were severely affected by the US slump, and as of January 2002, none of them had yet recovered.

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2.2.2. Foreign exchange markets There is a connection between exchange rates and stock prices. When stock prices rise, local currencies tend to appreciate against the US dollar since foreign investors need more local currency to undertake their stock market purchases. Conversely, if foreign investors withdraw capital from the stock market and repatriate funds, both stock prices and the currency value will tend to fall. East Asian financial markets have exhibited this type of correlation. In Taiwan for example, the New Taiwan dollar depreciated by 11.1 percent from the June 28, 2000 baseline to June 27, 2001, and by 14.7 percent from the baseline to June 26, 2002. For the currencies that are pegged to the US dollar, there is of course no exchange rate movement which is the case de jure in Hong Kong and Malaysia and de facto in mainland China where the central bank intervenes to maintain stability.1 In the remaining economies, exchange rates moved in the same direction as stock prices with the exception of Japan. During the period June 28, 2000 to June 26, 2002, the Japanese currency appreciated by 14.7 percent against a drop in the stock index of 38.4 percent. Japan’s large trade surplus with the US probably helped to sustain the value of its currency. 3. Comparing the East Asian Financial Crisis and the New Economy Slump Within just five years, from 1997 to 2001, the economies of East Asia have confronted two major economic recessions, the first caused by the East Asian financial crisis, the second by the slump in the New Economy. The two recessions were very different in nature. 3.1. Different sources of economic recession Both the financial crisis and the New Economy slump have been something of a nightmare for the East Asian economies. The outbreak of the East Asian financial crisis began in Thailand on July 2, 1997 when the country gave 1 There

are many reasons why the Chinese government controlled its currency value. Economic conditions in China remained strong, and the Chinese government wanted to ease the stress on the rest of East Asia by maintaining the value of the Renminbi. All of the troubled economies would have suffered more severely if mainland China had devalued its currency against the US dollar.


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up its fixed exchange rate system for a floating rate. The New Economy slump originated in the US at the end of 2000. Thailand is a small newly industrializing country with a shakey financial sector and low productivity, whereas the US is the world’s biggest and most developed economy with a very sound financial system and high productivity. 3.2. Different causes of the two recessions The East Asian financial crisis stemmed mainly from the marriage between excess external savings and excess internal investment (Yu and Xu 2001, 18–21). Before the outbreak of the East Asian financial crisis, a great deal of foreign investment had flowed into real assets within the region, and many local enterprises had enthusiastically poured money into housing and the stock markets drawing upon short-term loans. Once the bubble burst in real assets and the stock markets, the growth rates of these economies were suddenly plunged into negative ranges. Thus the contagion of the financial crisis was spread not through the channel of foreign trade, but through the loss of confidence within the financial sectors of the Asian economies. By 2000, all the East Asian economies were once again enjoying high economic growth rates, and were thus expecting that the subsequent year would also be a prosperous one. Unfortunately, in the wake of the sharp drop in the NASDAQ index during the winter of 2000, there was an immediate slowdown in the US economy which had a ripple effect around the globe that was particularly hard felt in East Asia. This effect was transmitted mainly through the channel of foreign trade. The main cause of the slump within the US economy was excessive investment in the electronics and information industries, and any country whose overall industry was dominated by the hi-tech sector, and which was also trade-oriented, inevitably suffered more severely. 3.3. Scope of the two recessions The financial crisis of 1997–1998 was focused on the economies of East Asia. All the developed nations managed to maintain moderate growth. Within East Asia, Indonesia, Korea, Thailand, Malaysia, and Hong Kong suffered more seriously than Taiwan, Singapore, and mainland China. In order to rescue the economies of Indonesia, Thailand, and Korea from deep recession, the IMF extended massive conditional loans. The economic slump that originated in the US actually began in late 2000, but became much more serious in 2001, and as of 2003, a firm recovery

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has yet to materialize. Although the slump in US growth and foreign trade has significantly influenced the entire global economy, East Asia has been affected more severely than the rest of the world. 3.4. Impact on the economies of East Asia The severity of the two recessions has varied among the economies of East Asia. As noted, the financial crisis hit Indonesia, Korea, Thailand, Malaysia, and Hong Kong most severely. The subsequent slump has had the greatest impact on Taiwan and Singapore which saw both foreign trade and GDP growth turn negative in 2001. For Indonesia, Korea, Thailand, and the Philippines, although trade declined in 2001, positive GDP growth was nevertheless sustained. The puzzling thing is why Taiwan and Singapore suffered more during the economic slump than the remaining economies of East Asia. Taiwan and Singapore were the first countries to develop their high-tech industries, and targeted the US as the main market for their exports. Once this market faltered, Taiwan and Singapore were the first to feel the backlash. As for the remaining economies of the region, most of their exports to the US were traditional or labor-intensive products. With the slowdown in the US economy, consumer spending on low-end, low-price commodities did not suffer as much as did that on high-tech goods. 4. Policy Measures to Combat the Slump In response to the economic slump, the troubled economies have adopted stimulatory macroeconomic policies involving reduction of interest rates, increased government spending, and tax cuts. By late March 2002, indications were that product orders were recovering, and indeed the global economy seemed back on track for recovery. Here, the policies of four countries are considered. 4.1. The United States The US Federal Reserve Bank cut its federal funds target rate (the rate banks charge on overnight lending) eleven times during 2001, from 6.5 percent to 1.75 percent. Although a reduction in interest rates is favorable for investment, sluggish consumer demand had an offsetting pull on aggregate


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demand. In July 2001, the US government adopted a measure to rebate individual income taxes in the amount of about US$600 per person, a large part of which it felt might be transformed into consumption.And, in the wake of the September 11 attacks on the US, the government decided to increase federal spending and to extend unemployment benefits from 26 to 39 weeks in addition to providing added healthcare support for the unemployed. 4.2. Japan Since the bursting of the bubble economy in Japan in 1990, the Japanese government has spent in excess of 120 trillion yen on more than twelve different programs aimed at promoting economic activity. Still, the problem of non-performing bank loans remains severe. In an effort to solve this problem while at the same time liberalizing equity markets so as to provide better support for emerging industries, the Koizumi regime proposed “Fundamental Measures for Economic and Fiscal Operation”. In addition, the government has attempted to restrain issuance of public bonds, allowed the currency to depreciate, and reduced interest rates to zero. Yet all this has failed to achieve the desired effect on the Japanese economy which remains mired in a “liquidity trap”. The economic downturn, both in the US and on a global scale, has had a particularly deleterious effect on the Japanese economy. The economic problems in Japanese prompted the US government to become concerned that financial crisis in Japan might lead to global economic depression. The US argued that Japanese reform programs were undermining global aggregate demand, which in turn would actually increase the bad debt problem. Consequently, it charged, many Japanese firms that should have survived have gone bankrupt, and many others have moved out of Japan in order to reduce production costs which has resulted in the “hollowing-out” of the economy. 4.3. Taiwan Taiwan has suffered more seriously than its East Asian neighbors from the economic slump of 2001. The government has reduced interest rates eleven times in its efforts to stimulate investment, and has allowed delay in settlement of non-performing loans by lending banks. This has resulted, in turn, in reducing the availability of new loans and depressing private investment. The situation has become even more dire as many hi-tech enterprises have moved out of Taiwan to look for business opportunities elsewhere.

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The government has advocated expanding public investment to stimulate an increase in private investment, but the political environment has not been conducive to progress in this area. Ultimately, the government has not come up with effective measures to lower unemployment, and interest rates have already been reduced to their lowest level in history. Consumers have shown an intractable preference for lower consumption that poses a fundamental obstacle to stimulating domestic demand. Even with interest rates at extraordinarily low levels, there has been no obvious stimulating effect on private revetment, but rather consumers have been driven to spend less. 4.4. Mainland China The economy of mainland China has not felt notable impact from the global slump. Nevertheless, the Chinese government has had serious problems to address such as bankruptcies among state-owned enterprises and the high ratio of non-performing loans of the big state banks. The central government has initiated ambitious programs aimed at the development of the western part of greater China. And it has benefited from a great deal of foreign investment, the industrialized world seeming to regard China as a huge factory endowed with abundant cheap labor and a market with great potential. This is why mainland China has maintained its high growth in contrast to other economies in the region. 4.5. Other countries All the East Asian countries have adopted stimulatory macroeconomic policies involving rapid money supply growth in support of rising public expenditure. But despite deep cuts in interest rates, the effects seem to have been very limited.2 Many of the trade-oriented economies are waiting for the recovery in the US because they feel that an increase in their exports to the US will be the greatest catalyst for a return to prosperity in the region. 5. Can East Asia Rise Again? So the question emerges as to whether East Asia can rise again from the current economic slump. Several factors bear positively on the region’s future prospects. 2 Japan

has reduced its interest rate to zero, so that there is no further scope for cuts.


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First, many of the economies of East Asia are endeavoring to upgrade their industrial structures from labor-intensive to technology-intensive or knowledge-based production. Taiwan, Singapore, Hong Kong, and Korea have made progress in establishing the foundations of a knowledge-based economy. Thailand, Malaysia, Indonesia, and the Philippines are also becoming oriented in this direction. Over the last two decades, these countries have generally been successful in pursuing economic development provided the political situation was stable, and the resulting performance in terms of export-led growth has been impressive. Second, East Asian cultures place great emphasis on education. If young people show promise in their studies, families will make great sacrifices to send them abroad for university or post-graduate degrees. After graduating, many gain work experience before returning to their native lands. This foreign education and experience can make a substantial contribution to the progress of their home economies. Returning graduates from overseas institutions have been of great help to Taiwan in its transformation from a labor-intensive to a technology-intensive industrial structure. In India, returning graduates were key to the success of the software industry in the 1990s. Even in mainland China, many who have studied abroad are now returning, and are being encouraged to contribute to R&D efforts in technology parks that the government has established. In The Myth of Asia’s Miracle, Krugman (1994, 70) writes that: Asian growth, like that of the Soviet Union during its high growth era, seems to be driven by extraordinary growth in inputs like labor and capital rather than by gains in efficiency. Whether his argument as applied to the past is valid or not, the economies of Asia have now begun to tackle the transformation to a knowledge-based economy, and what is emphasized in this process is gains in efficiency that rest on educational attainment and enhanced R&D capability. Third, the East Asian region is possessed of abundant natural resources and rich reserves of motivated manpower. East Asia can make the most of its comparative advantage by effectively tapping these natural resources and educating this workforce to gain a competitive edge on world markets. Two countries will play a leadership role for sustaining economic growth in the region — Japan and mainland China. With the world’s second largest economy, Japan was the East Asian leader under the “flying

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geese paradigm”.3 Having been first to complete its own industrialization, it then became the source of investment capital, technology, and semi-manufactured inputs to other economies in the region. Following the Japanese example, the four little dragons (Taiwan, Korea, Singapore, and Hong Kong) became newly industrialized economies, to be followed in turn by the four little tigers (Malaysia, Thailand, Indonesia, and the Philippines). However, since the bursting of the bubble in the 1990s, Japan has languished in long-term recession. Now mainland China has the potential to substitute for Japan in a different kind of leadership role for the region. In the twentyfirst century, mainland China stands to provide the largest market for other Asian economies and to offer low-cost labor and land for regional investors producing products for the world. Finally, the East Asian countries have the courage and confidence to confront any difficulty facing them. The four dragons and the four tigers all have great determination in pursuing economic growth. They have successfully overcome two recessions in the late 1990’s and given their best effort to reestablishing growth along trend paths. Based on the above, we can argue that the economies of East Asia will rise again from the current economic slump and go on to achieve sustained development in the future.

6. Prospects for Formation of an East Asian Community The formation of NAFTA and the EU puts pressure on the rest of the world to form countervailing trade alliances. Although there are several regional organizations in the Asia-Pacific, such as ASEAN which originally comprised five countries and is now up to ten, these organizations have not yet achieved real economic integration. APEC, which comprises many countries across the Asia-Pacific region, is also still a very loose economic organization which has not scored achievements in trade opening. Since the late 1980s, economists have advocated formation of a Greater China Economic Community, but no government leader on either side of the Taiwan Straits has shown any positive inclination toward this idea. Scholars have a useful role to play in generating ideas, but it is up to governments to implement them (Jing 2002). The framework favored by government 3 See

Ozawa, this volume.


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leaders is “ASEAN plus three”, where the “three” refers to mainland China, Korea and Japan, or alternatively “ASEAN plus one” where the “one” is mainland China. 6.1. ASEAN plus three In view of the powerful trend towards trade liberalization and globalization, ASEAN members appreciate the importance of free trade areas and in particular the value of strengthening their economic relationships with mainland China, Japan and Korea. On November 25, 2000 at the ASEAN Fourth Summit Meeting in Singapore, agreement was reached in principle on introducing mainland China, Japan, and Korea into the organization with the aim of eventually creating an ASEAN Free Trade Area encompassing these members. 6.2. ASEAN plus one ASEAN and mainland China have laid foundations for the China-ASEAN Free Trade Area, or CAFTA, specifying five priority areas of cooperation, namely, agriculture, information industry, human resources, mutual investment, and development of the Mekong River area. Progress toward establishing CAFTA will be furthered by, on the one hand, China’s market opening under WTO and on the other, steps being taken by the current members of ASEAN to set up their free trade area. To buffer the impact of more open competition with China, ASEAN members should begin now to adjust their economic structures. The payoff will come in the form of greater access to the mainland China market. This, combined with China’s access to the markets and resources of ASEAN, will spur development of the entire region. 6.3. ASEAN and Japan The Japanese government is very interested in the construction of an East Asian Common Market, and is proceeding stepwise with bilateral trade negotiations. On January 13, 2002, Prime Minister Koizumi signed a bilateral free trade agreement with Singapore, and is scheduled to undertake further bilateral trade talks with Korea, Mexico, Chile, and Canada. The regional common market ultimately envisioned would include Japan, Korea, China, Australia, New Zealand, and ASEAN.

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6.4. The Greater China Economic Community The mainland Chinese government has taken an initial step toward building a Greater China Economic Community in the planning of a free trade zone with Hong Kong and Macao. Incorporation of Taiwan would round out the community membership. If the current cross-strait relationship can be gradually improved, the four economies could conceivably come together to form a community in the future. Despite the political difficulties surrounding “one country — two systems” which have yet to be resolved, the economic relationship between mainland China and Taiwan is steadily strengthening. Taiwan’s economy is becoming ever more dependent on the mainland as evidenced by strong growth in bilateral trade and an increasing flow of capital and skilled manpower from Taiwan to the mainland. In fact, Taiwan does not have a more advantageous path to take.4 Ten years ago it was only Chinese economists who talked about a Greater China Economic Community or Greater China Economic Coordination, and no government official on either side of the Taiwan Straits showed any positive response. Now, government authorities in East Asia broadly are becoming increasingly interested in setting up a free trade area. And the Greater China dream no longer seems unrealizable, even if there is still a long, long way to go. 7. Concluding Remarks For the reasons outlined herein, we may feel confident that the East Asian economy can rise again from the global slump to get its economic growth back on track. Although it may be difficult to sustain growth rates at levels achieved in the past, moderate growth is still within reach over the long term. Under pressure from NAFTA and the EU, some kind of free trade zone will likely be established to be gradually developed into a more integrated economic community covering the whole of the East Asia region. 4 In

order to balance the development of foreign trade and overseas investment, the government in Taipei has adopted the “Toward the South Policy” to substitute for “Toward the West Action”. During the East Asian financial crisis, most Taiwanese enterprises that invested directly in Southeast Asia suffered not only from the recession but also from the political fallout and the riots in these countries. Consequently, many Taiwanese companies have avoided making further investment in Southeast Asia, and have become much more enthusiastic about investing in mainland China instead.


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There are many obstacles to greater economic integration that will need to be overcome. The financial systems and management approaches in many East Asian economies are still rather backward and thus unable to cope with the new era of economic liberalization and globalization. Furthermore, there are continuing political tensions within and between countries and territories that need to be managed. But the economic interest of the region will be served if the economies of East Asia move as expeditiously as possible toward freer trade and greater integration. 8. References Delhaise, P. F., 1998. Asia in Crisis (John Wiley & Sons). Henderson, C., 1998. Asia Falling? Making Sense of the Asian Currency Crisis and its Aftermath (McGraw-Hill). Jing, S.-T., 2002. “The Prospect for the ASEAN Plus Three,” The International Economic Conditions Weekly 1422: 5–12 (Taipei, Taiwan: Chung-Hua Institution for Economic Research and the Council for Economic Planning and Development). Klein, L. R., 1998. “What has Happened to the Economies of Southeast Asia?” East Asian Economic Perspectives 9(March): 4–8. Krugman, P., 1994. “The Myth of Asia’s Miracle,” Foreign Affairs 73(6): 62–78. Krugman, P., 1999. “The Return of Depression Economics,” Foreign Affairs 78(1): 56–74. Micklethwait, J. and A. Wooldridge, 2000. A Future Perfect (New York: Crown Business). Yu, T.-S. and D. Xu (eds.), 2001. From Crisis to Recovery: East Asia Rising Again? (Singapore: World Scientific).


Identifying Terms of Trade Effects in Real Exchange Rate Movements: Evidence From Asia Mardi Dungey Fellow, Research School of Pacific and Asian Studies Australian National University, Canberra, Australia [email protected]

1. Introduction There are a number of important sources of relative price changes within economies. For open economies, two important sources are the real exchange rate and the terms of trade. The real exchange rate represents the relative purchasing power of the domestic currency in foreign currency, controlling for the rise in general price levels in those countries; that is it is the nominal exchange rate deflated by the relative price levels within countries. In this paper this is given by the bilateral exchange rate deflated by consumer price inflation. The terms of trade represents the price of a country’s exports deflated by the price of its imports in the data used here.1 There are many theoretical linkages between these two prices, although the direction of the relationship is not theoretically established in all models. The motivation for this paper is the often observed strong empirical regularity between changes in the terms of trade and changes in the real exchange rate for many small open economies. However, the empirical literature produces very mixed results on the relationship between the two variables, ranging from little empirical relationship to strong and significant correlations; see Devereux and Connolly (1996) and Broda (2002) for example. For particular countries, such as Australia and Canada, the relationship is generally observed to be very strong; for example Karfakis and bilateral real exchange rate is given as E = eP ∗ /P where E is the real exchange rate, e is the nominal exchange rate, P is the domestic price level and P ∗ is the foreign price level. The terms of trade is given as TOT = Pexports /Pimports . 1 The

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Phipps (1999) and the literature reviewed in Aruman and Dungey (2003) for Australia, and Amando and van-Norden (1995) for Canada. Wider evidence of significant relationships between these variables is found in Habermeier and Mesquita (1999), Mendoza (1995) and Borda (2002) who examine the relationship in developing countries. The results are not always consistent. Habermeir and Mesquita (1999) using a panel of 51 countries, including 26 developing countries, find that developing countries have smaller exchange rate effects from the terms of trade than developed markets, however, Mendoza (1995) using 30 countries, of which 23 are developing, finds that the terms of trade effects are slightly larger in developing economies than in developed markets. Further, Borda (2002) splits a panel of 75 developing economies into fixed and flexible exchange rate regimes and finds that terms of trade contributions to real exchange rate volatility are larger in developing countries with a more flexible exchange rate regime. The relative size of the contribution of terms of trade volatility to real exchange rate volatility in developing countries varies enormously. Mendoza (1995) finds up to 49 percent of total real exchange rate volatility due to terms of trade volatility; Borda (2002) reports an average of 13 percent contribution for fixed exchange rate countries, and up to 43 percent in floating regimes. Devereux and Connolloy (1996) report a range of between zero and 67 percent for Latin American economies.2 While some of these studies examine directly only the bivariate link between the terms of trade and the real exchange rate, for example Karfakis and Phipps and Amando and van-Norden, most studies use the terms of trade as one control variable in explaining real exchange rate movements. There are good reasons to expect other factors to affect the real exchange rate; see Lane and Milessi-Ferretti (2000). The question addressed in this paper is what proportion of real exchange rate volatility can be attributed to volatility in the terms of terms of trade. The area of interest is the terms of trade effects themselves, however, it is desirable to control for all other aspects that may produce real exchange rate volatility. In a similar problem Borda (2002) identifies a Vector Autoregression (VAR) approach with macroeconomic control variables such as the degree of openness, financial development and fiscal policy. This choice of 2 These contributions are for an internal terms of trade measure, rather than the standard export price over import price definition used in the remainder of the literature reported here. With the standard definition Devereux and Connolly (1996) find negligible impact of the terms of trade on the real exchange rate.

Identifying Terms of Trade Effects in Real Exchange Rate Movements

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control variables is somewhat ad hoc, and in order to avoid it here a latent factor model approach is adopted. Latent factor models are characterized by the use of the properties of the data to identify the model components; in the current application for example, movements in real exchange rates are characterized as related to either terms of trade movements or to other potentially observable variables, but no attempt is made to determine what the observed variables may be. The advantage of this approach is that identification is based on the characteristics of the data, for example orthogonality of the factors, rather than on ad hoc choice of explanatory variables. Latent factor models of exchange rate movements have been proposed by Diebold and Nerlove (1989) and Mahieu and Schotman (1994), for example. Dungey (1999) shows how the model of Mahieu and Schotman (1994) can be estimated in a three factor version by the recognition of arbitrage conditions. The role of the current paper is to build on that framework to incorporate the role of an observed factor, here the terms of trade, into the latent factor model. The usual means of incorporating terms of trade effects in a real exchange rate equation is to adopt a small open economy assumption and assume that the terms of trade are exogenously determined. In this paper the observed variables are allowed to covary with the unobserved factors. In particular, this allows us to recognize that the terms of trade for a particular country varies both in response to international economic conditions and events, and also to some extent in response to country-specific events. Despite the sample of countries being small open economies, we recognize that in these countries not all other macroeconomic conditions are completely independent of changes in the terms of trade for that country (for example production may vary with terms of trade in export oriented economies such as East Asia). In this paper the covariation between the terms of trade and the unobserved factors is controlled using calibrations based on the statistical properties of the relationships between the terms of trade and real exchange rates over the sample data. Some experiments illustrate the degree of sensitivity to the calibration assumptions. The remainder of this paper is laid out as follows. The data are described in Section 2. Section 3 builds the latent factor model of real exchange rate changes, and explicitly develops the method for including the terms of trade as an observed variable potentially correlated with the unobserved factors. The empirical application of the model to a panel of five Asian economies is reported in Section 4. In particular, the results demonstrate

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that the independent contribution of the terms of trade varies quite widely over the sample, up to 24 percent, but that this is often offset by the effect of the correlation between the terms of trade and the latent factors. When the assumption of terms of trade exogeneity is maintained, such as in Borda (2002) and Mendoza (1995) the results generally understate the contribution of country-specific events — the extent of the understatement depends on the true level of correlation between the terms of trade and the countryspecific latent factor. Concluding remarks follow in Section 5.

2. Data The data consist of annual observations on real exchange rates, constructed using the nominal exchange rate and CPI for each country, and the terms of trade, constructed from import and export price indices, for six Asian economies over the period 1967 to 1998; data sources are given in Appendix A. There are 30 observations on the changes in the exchange rate and terms of trade for each country, a total of 180 observations in total. The countries included are Indonesia, Malaysia, Thailand, the Philippines, Pakistan and Sri Lanka, with the exchange rates expressed against the US dollar in each case. The features of the data are given in Tables 1–3. Table 1 details the variances of the changes in log levels of exchange rates and terms of trade data. Tables 2 and 3 give the covariance matrices for the standardized series of the changes in the log exchange rate and changes in the log terms of trade respectively.3 The non-standardized data can be retrieved by combining Tables 2 and 3 with the information in Table 1. A plot of the standardized data for each country is shown in Figures 1–6. The covariances between the standardized data for exchange rate and terms of trade changes themselves across countries is recorded in Table 4. These numbers are, as expected, quite low. Also as expected, the largest observations are recorded for the covariance between the terms of trade and the real exchange rate changes for the same country, the bold numbers in Table 4. This information is used with the covariance structures

3 Standardizing the data refers to the practice of subtracting the sample mean from the series, and dividing by the sample variance. This produces a series with mean 0 and variance of 1. This standardization has no effect on the results of the variance decomposition presented in the results, but vastly improves the efficiency of the computation process.


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Table 1. Variance of Changes in Log Exchange Rate and Log Terms of Trade Data Country

Percentage change Exchange rate

Terms of trade

131.23 37.93 101.32 35.33 145.47 126.29

210.52 66.63 49.45 80.66 242.20 178.69

Indonesia Malaysia Thailand Philippines Pakistan Sri Lanka

Table 2. Covariance Matrix, Standardized Changes in the Log Exchange Rate Country Indonesia Malaysia Thailand Philippines Pakistan Sri Lanka

Indonesia Malaysia Thailand Philippines Pakistan Sri Lanka 1 0.33 0.41 0.46 0.26 −0.13

1 0.36 0.66 −0.08 0.02

1 0.39 0.12 −0.02

1 0.19 0.07

1 −0.11

1

Table 3. Covariance Matrix, Standardized Changes in the Log Terms of Trade Country Indonesia Malaysia Thailand Philippines Pakistan Sri Lanka

Indonesia Malaysia Thailand Philippines Pakistan Sri Lanka 1 0.09 0.02 −0.30 0.36 −0.07

1 0.24 0.41 0.35 0.34

1 0.23 0.30 −0.20

1 0.13 0.29

1 0.42

1

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% 4

Erate

% 3

ToT

3

2

2

1

1

0

0

–1

–1

–2

–2

–3

Erate

ToT

–4

–3 69 71 73 75 77

79 81 83 85 87 89

69 71 73 75 77

91 93 95 97

79 81 83 85 87 89

Figure 1a: Indonesia %

Erate

91 93 95 97

Figure 1b: Malaysia

%

ToT

4

4

3

3

2

2

1

1

0

Erate

ToT

0

–1

–1

–2

–2

–3 69 71 73 75 77

79 81 83 85 87 89 Figure 1c: Thailand

91 93 95 97

–3 69 71 73 75

77 79 81 83 85 87 89 91 93 95 97

Figure 1d: Philippines % 6

% 5

4

4 3

Erate

ToT

Erate

ToT

2 1 0 –1

2 0 –2

–2 –3

–4 69 71 73 75 77

79 81 83 85 87 89 Figure 1e: Pakistan

91 93 95 97

69 71 73 75 77

79 81 83 85 87 89 Figure 1f: Sri Lanka

91 93 95 97

Figure 1. Exchange Rate Changes and Terms of Trade Changes (Scales in 100s of Percentage Points)

Table 4. Covariance Matrix, Standardized Changes in the Log Exchange Rates and Log Terms of Trade Exchange rates

Terms of trade Indonesia Malaysia Thailand Philippines Pakistan Sri Lanka


−0.25 −0.17 −0.22 −0.16 −0.09 0.02

−0.12 −0.28 −0.24 −0.24 −0.24 0.00

0.09 −0.15 −0.20 0.12 −0.06 0.03

0.07 −0.42 0.06 −0.30 0.23 −0.08

0.04 −0.27 −0.20 −0.10 0.09 0.06

0.04 −0.10 0.38 −0.06 −0.03 0.12


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of the exchange rate and terms of trade data in Tables 2 and 3 to identify the parameters in the model of Section 3. 3. Model Framework Consider a simple three factor model of the exchange rate, si,t = φi fi,t + φ0 f0,t + λi Wt ,

(1)

where si,t is the change in the bilateral exchange rate between currency i and a numeraire currency, 0. The latent factors are Wt , fi,t and f0,t . Wt represents the common shocks which impact on all exchange rates in the sample; each exchange rate has an individual response to this common shock, given by the parameter λi . fi,t and f0,t represent effects which are not common to all exchange rates but rather are associated with the two countries involved in the bilateral exchange rate. Each exchange rate involves the price of the currency of country i in terms of a common numeraire currency 0. Thus each exchange rate has a country-specific effect represented by fi,t with loading φi . The currency 0 effect given by f0,t affects each exchange rate, and with the same parameter φ0 , and hence is referred to as the fixed effect — it is fixed in that it does not change between exchange rates. The fixed effects result from a no arbitrage assumption which helps identify the model. Dungey (1999) shows that this reduces the parameterization of the problem and hence generalizes the problem of Mahieu and Schotman (1994). Under the assumption that all the factors are independent, and a normalization of factor variances, this model can be simply estimated from second moment conditions using Generalized Method of Moments (GMM). For GMM to be appropriate the exchange rate movements should be approximately normally distributed. This is not generally the case for high frequency financial data, but in this case annual observations are used and the evidence for volatility clustering is very limited. In the case of the Malaysian and Thai exchange rates univariate GARCH(1,1) tests produce significant GARCH parameters, although this should be viewed with suspicion for a sample of only 30 observations. Significant volatility clustering throws doubt on standard maximum likelihood based estimation techniques (Gourerioux and Monfort 1994) and alternative non-parametric methods are more appropriate (see Dungey, Martin and Pagan 2000). Here we remain with the usual methods and leave extensions to non-parametric methods to future work. The normalization assumption means that the estimated factor loadings are not particularly interesting. However, a simple variance decomposition

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remains unaffected. Hence we examine the contribution of each of the latent factors to total volatility in the exchange rates, as measured by the variance in the exchange rate changes. Equation (2) is the form of the variance equation, making use of the normalization assumption: var(si ) = φi2 + φ02 + λ2i .

(2)

The variance decomposition has the following components: • contribution to volatility in si from φi2 country-specific factor = ; var(si ) • contribution to volatility in si from φ02 fixed factor = ; var(si ) • contribution to volatility in si from λ2i . common world factor = var(si ) To incorporate the role of changes in the terms of trade as an observed explanatory variable Equation (1) is augmented as follows: si,t = φi fi,t + φ0 f0,t + λi Wt + δi toti,t ,

(3)

where tot i,t represents the changes in the log terms of trade for country i at time t. In a model of this form it is self-evident that it is no longer appropriate to assume that each of the variables on the right hand side is perfectly uncorrelated. In particular there are covariances between the terms of trade and the unobserved factors. For a panel of n exchange rates, I maintain the assumption that the unobserved factors are independent, and that changes in the terms of trade of country i impact on the terms of trade in country j through the covariances between toti and totj (denoted σT i,Tj ) rather than through the interactions of the terms of trade in country i with the country-specific factor of country j . That is, assume that σfj,T i = 0. However, the terms of trade in a particular country are assumed to correlate with the unobserved factor for that country and the common factor, that is σf i,T i = 0 and σw,T i = 0.


221

A system of n exchange rates is written as follows, where the t subscript is dropped for notational convenience:   f0  f1        f2      s1 φ0 φ1 0 0 .. 0 λ1 δ1 0 0 0 0  f3   s2  φ0 0 φ2 0 .. 0 λ2 0 δ2 0 .. 0   ..        ..  = φ0 0 0 φ3 .. 0 λ3 0 0 δ3 .. 0   fn , (4)       ..   .. .. .. .. .. .. λ4 .. .. .. .. ..   W     φ0 0 0 0 .. φn0 λ5 0 0 0 .. δn  tot sn 1   tot2     ..  tot n or simply S = BF.

(5)

Clearly what separates φi , the parameter on the country-specific factor, from λi , the parameter on the country-specific terms of trade, is the observed variance of the terms of trade. The second moment conditions of this system are given by: var(S) = B var(F )B .

(6)

The matrix of interest here is var(F ). Under the normalization of the variance of the independent latent factors this matrix has the form: F1,1 F1,2 var(F ) = , (7) F2,1 F2,2 where F1,1 = I(n+2)×(n+2) represents the variance-covariance matrix of the latent factors. As the factors are independent by assumption and normalized on the variances this is an identity matrix. The (n + 2) × n matrix of covariances between the latent factors and the terms of trade for each country is given by F1,2 = F2,1 , where F1,2 is:   σf 0,T 1 σf 0,T 2 .. σf 0,T n σf 1,T 1 σf 1,T 2 .. ..  . F1,2 =   .. .. .. ..  σW,T 1 σW,T 2 .. σW,T n

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The assumption that σfj,T i = 0 means this can be simplified to:   0 0 .. 0 σf 1,T 1 0 .. ..  . F1,2 =   .. .. .. ..  σW,T 1 σW,T 2 .. σW,T n The matrix F2,2 is the (n × n) variance-covariance matrix of the observed terms of trade data:  2  σT 1,T 2 .. σT 1,T n σT 1 σT 1,T 2 σT2 2 .. σT 2,T n  , F2,2 =   .. .. .. ..  σT n,T 2 σT n,T 2 .. σT2 n so that the full system looks as follows:  1 0 0 .. 0 0 0 1 0 .. 0 0  0 0 1 .. 0 0   .. .. .. .. .. ..  0 0 0 .. 1 0 var(F ) =  0 0 0 .. 0 1  0 σ 0 .. 0 σw,T 1  f 1,T 1  0 0 σf 2,T 2 .. 0 σw,T 2  .. .. .. .. .. .. 0 0 0 .. σf n,T n σw,T n

0 σf 1,T 1 0 .. 0 σw,T 1 σT2 1 σT 2,T 1 .. σT n,T 1

0 0 σf 2,T 2 .. 0 σw,T 2 σT 1,T 2 σT2 2 .. σT n,T 2

.. .. .. .. .. .. .. .. .. ..

0 0 0 ..



       σf n,T n  . σw,T n   σT 1,T n    σT 2,T n   .. 

σT2 n (8) The general expressions for the variance and covariance equations are given in Equations (9) and (10), taking into account the assumptions already made (see Appendix B for a fuller derivation of (10)): var(si ) = φ02 + φi2 + λ2i + φi2 σT2 i + 2φ0 δi σf 0,T i + 2φi δi σf i,T i + 2δi λi σW,T i , cov(si , sj ) =

φ02

+ λi λj + δi δj σT i,Tj + λi δj σW,Tj + λj δi σW,T i .

(9) (10)

Additional information on the characteristics of the relationship between the real exchange rate and the terms of trade also exists from the covariances between real exchange rates changes and changes in the terms of trade in


223

the data set, given in Table 4. The corresponding analytical equivalents from the model of Equation (3) are given as: cov(si , Tj ) = φ0 σf 0,Tj + φ0 σf i,Tj + λi σw,Tj + δi σT i,Tj ,

(11)

which, given the assumption that σfj,T i = 0 simplifies to: cov(si , Tj ) = λi σw,Tj + δi σT i,Tj

(12)

and in the case of i = j , cov(si , Ti ) = λi σw,T i + δi σT2 i .

(13)

Under these assumptions, the parameter set, θ = {φ0 , φi , λi , δi i = 1 . . . 6}, can be estimated from Equations (9), (10) and (12) using GMM. There are a total of 3n + 1 parameters to be identified, with n2 moment conditions so that the necessary identification condition is achieved with a minimum of 2 exchange rates against a common numeraire (that is data for 2 countries). The final results reported in the next section are given in the form of a volatility decomposition derived from Equation (9). That is the volatility of the real exchange rate si is divided into seven components as follows: Contributions to volatility in si from: φi2 ; • country-specific factor = var(si ) • fixed factor

=

φ02 ; var(si )

• common world factor

=

λ2i ; var(si )

• terms of trade

=

δi2 ; var(si )

=

2φ0 δi σf 0,T i ; var(si )

=

2φi δi σf i,T i ; var(si )

=

2λi δi σW,T i . var(si )

• interaction between terms of trade and fixed factor • interaction between terms of trade and country-specific factor • interaction between terms of trade and common world factor

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M. Dungey Table 5. Simple Factor Model Variance Decomposition Country

Fixed

Idiosyncratic

Common


2.87 9.92 3.71 10.65 2.59 2.98

35.10 75.33 72.87 57.21 90.70 93.55

62.04 14.75 23.42 32.14 6.71 3.47

4. Empirical Results Initially, consider the application of the model without the role of the terms of trade, as per Equation (1). The resulting decomposition is given in Table 5.4 The results indicate that the idiosyncratic (or country-specific) terms are dominant in the variance decomposition for all countries except Indonesia. The fixed factor accounts for very little of the decomposition in any country, the largest being 11 percent in the Philippines. The relatively large contribution of the idiosyncratic factors is not unusual but it is not a necessary result; Dungey (1999) examined a panel of five Pacific Rim developed country exchange rates against the US dollar and found idiosyncratic contributions of between 40 and 98 percent, in contrast Dungey (1997) examined six OECD currencies against the US dollar and found idiosyncratic contributions of between 4 and 90 percent. The next step is to include the effects of the terms of trade in the estimation. To do this requires data on the covariance between the terms of trade in each country and the idiosyncratic country factors, the common factor and the fixed factor respectively. This is undertaken in a number of calibration experiments in what follows. Because each of the unobserved factors is assumed to have unit variance it is easy to convert this experiment to calibration on the correlation coefficients, which makes for more ready

4 The

process converged to a global optimum, which was checked by grid searching over a range of starting values in increments of 0.01.


225

interpretation. To be clear, the correlation coefficient ρf i,T i is given by: σf i,T i ρf i,T i = 2 2 and σf2i = 1. σf i σT i The similar form for σW,T i is given by: σW,T i ρW,T i = 2 2 , where σW2 = 1, σW σT i so that the correlation coefficient is a direct reflection of the assumed covariance between the common and individual country factors. The first assumption is that the correlation between the fixed factor and the individual country factors is zero. This is not an unreasonable assumption, as the fixed factor represents the numeraire currency, here the US dollar. This would not be expected to vary with Asian terms of trade data. The second assumption is that the correlation between the common factor and the terms of trade data is also low, here it is set to 0.2. The evidence for this low value comes from work documenting the relatively low common components of movements in commodity prices, such as Cashin, McDermott and Scott (1999). The common component here represents common exchange rate changes for the group of six countries examined. Relating this to the terms of trade is conceptually similar to the search for a common cointegrating relationship between the terms of trade changes in each of these countries. The evidence, via Johansen–Julieus tests, suggests that the cointegrating vector for the terms of trade changes series is of full rank, that is, there are no common factors. In contrast, there is evidence of three cointegrating vectors for the real exchange rate changes. The final problem concerns the selection of the degree of correlation between the terms of trade and the individual country factors. The country factors represent influences specific to the countries in particular. The countries in the sample cannot be construed as influencing the prices of their imports, these are determined exogenously. Hence we allow the degree of correlation between the country specific effects and individual terms of trade to vary over a relatively low range, from 0.1 to 0.3.5 Estimation is carried out using standardized data as this vastly improves the time to convergence, while making no difference to the decomposition 5A

better way to calibrate the model is likely to be to extract the latent factors themselves from the simple factor model in Equation (1), and assess the degree of correlation between these factors and the terms of trade. This is the next step.

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results. It also has the advantage of making the use of the correlation coefficients more transparent — in standardized data the correlation coefficients are a one for one translation of the covariances between the factors. Hence, the assumption of σf i,T i = 0.3 means that the covariance between the terms of trade and the unobserved country factor for Pakistan is also 0.3, and similarly for all other countries. This makes it easier to assess the experiments, without altering the final decomposition results. For information purposes the translation of these correlation assumptions to covariances in the raw data is given in Table 6. Details of the individual experiments and the results are given in what follows. The results bear out some generalizations about the effects of terms of trade changes in this group of countries. The results were obtained using the OPTIMUM procedure in Gauss v3.5 with a convergence tolerance set at 0.0001. The value of the objective function is given in each case. Consider the case where σf i,T i = 0.1 and σf i,W = 0.2. The variance decomposition of the factors associated with volatility in the real exchange rate are given in Table 7, and graphically in Figure 2. The results for the case of σf i,T i = 0.3 and σf i,W = 0.2 are given in Table 8 and Figure 3. Tables 7 and 8 have a number of common results. First, the role of the fixed factor, associated with the numeraire currency of the US dollar makes no contribution to the volatility of the individual country exchange rates — this result is as anticipated, it means that exchange rate volatility for these countries is determined by factors which affect all currencies, and idiosyncratic factors. In fact, the tables show for Pakistan and Sri Lanka over 90 percent of real exchange rate volatility is associated with idiosyncratic factors, the common factor accounts for very little. This makes sense in the light of the other countries examined. Although I have loosely grouped all of Table 6. Correlation Coefficients and Covariances Country


Value of σf i,T i implied by σf i,T i = 0.1

σf i,T i = 0.3

21.05 6.63 4.94 8.66 24.22 17.87

63.16 19.89 14.82 25.98 72.66 53.61


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Table 7. Decomposition with σf i,T i = 0.1 and σf i,w = 0.2 (Objective Function = 0.51693) Country

Fixed Idiosyncratic Common TOT Cov(TOTi , fi ) Cov(TOTi , W )


0.00 0.00 0.00 0.00 0.00 0.00

∗

48.15 51.96 68.60 9.25 94.51 97.59

53.11 47.29 34.00 87.74 3.72 0.11

15.27 18.46 9.45 23.98 0.30 0.74

−5.33 −6.09 −5.01 −2.93 1.05 1.67

−11.20 −11.62 −7.05 −18.04 0.42 −0.11

Cov(T i, f i) = 0 by definition in the starting values.

Figure 2. Asian Volatility Decomposition with σf i,T i = 0.3 and σf i,w = 0.2

these countries under the “Asian” heading, there are in fact two quite distinct groups, comprising Indonesia, Malaysia, Thailand and the Philippines from East Asia and Pakistan and Sri Lanka from South Asia. This grouping is very apparent in the common factor results. The four East Asian countries have a larger component due to the common factor than do Pakistan and Sri Lanka. This factor accounts for between 34 and 88 percent of total volatility for the East Asian countries. The contribution of the terms of trade to real exchange rate volatility ranges from almost nothing in Pakistan and Sri Lanka to 24 percent in the

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M. Dungey

Table 8. Decomposition with σf i,T i = 0.3 and σf i,w = 0.2 (Objective Function = 0.51693) Country Fixed Idiosyncratic Common TOT Cov(TOTi , fi ) Cov(TOTi , W ) Indonesia Malaysia Thailand Philippines Pakistan Sri Lanka ∗

0.00 0.00 0.00 0.00 0.00 0.00

60.79 66.55 79.80 18.87 92.45 94.33

53.11 47.29 34.00 87.74 3.72 0.11

15.27 18.46 9.45 23.98 0.30 0.74

−17.98 −20.68 −16.20 −12.55 3.11 4.93

−11.20 −11.62 −7.05 −18.04 0.42 −0.11

Cov(T i, f i) = 0 by definition in the starting values.

Figure 3. Asian Volatility Decomposition with σf i,T i = 0.1 and σf i,w = 0.2

Philippines. In the existing literature on developing markets the contribution of the terms of trade is reported as 49 percent in Mendoza (1995) and in Borda (2002) at around 13 percent of real exchange rate volatility in pegged exchange rate regimes, and between 31 and 43 percent for floating regimes (in Borda’s classification system Thailand and Malaysia are classified as pegged regimes and Indonesia, Pakistan, Philippines and Sri Lanka as flexible regimes (Borda 2002, Table 5)). The contributions of the terms of trade are invariant to the correlation coefficients chosen in the experiments. Instead, what changes is the


229

contributions of the covariances between the individual country and terms of trade factors, and the idiosyncratic factors themselves. As the covariance between the individual factors and the terms of trade are increased the idiosyncratic factor has a larger effect on exchange rate volatility. The effect of the covariance between the terms of trade and the country specific factor on total volatility is negative for the East Asian economies, and positive for Pakistan and Sri Lanka. With an increase in the correlation coefficient the absolute value of each of these contributions increases — that is, in East Asia the effect is more negative, offset by a larger positive idiosyncratic effect. The correlation between the terms of trade and the common world factor shows a negative contribution to volatility on the East Asian exchange rates. These negative contributions represent the dampening effect that correlations between either world events and the terms of trade changes or individual country events and the terms of trade changes make to volatility in the real exchange rate. In other words, terms of trade adjustments play a role in reducing the volatility of exchange rate fluctuations. This may at first seem a little odd, as we typically talk of terms of trade shocks causing exchange rate movements. However, this aspect has already been accounted for in the model, given in the column corresponding to the terms of trade factor. The covariance factors show the moderation which occurs to the original shock because there are interrelationships between the determining factors. This is akin to a system style of estimation problem. Hence, in analyzing the results in Table 7, for example, the Indonesian real exchange rate volatility would have 15 percent of total volatility attributed to terms of trade changes — however, this effect is offset by the combined interactions of the terms of trade with Indonesian specific factors and interactions of the terms of trade with common factors for the sample. In Table 8, the terms of trade effect is more than offset by these interaction factors. The results in this section make intuitive sense when considered in line with the information in Table 4 particularly. The countries which record the greatest impact of the terms of trade on the real exchange rate are those with the highest covariances between the observed terms of trade changes and the real exchange rate changes — the highlighted blocks in Table 4. The Philippines and Malaysia have the highest contributions from the terms of trade, at 24 and 18 percent respectively, and also the greatest covariances between their own terms of trade and real exchange rates at −0.30 and −0.28. The smallest covariances between own terms of trade changes and real exchange rate changes are observed for Pakistan and Sri Lanka, and they show the

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Table 9. Decomposition with σf i,T i Function = 0.114785) Country Indonesia Malaysia Thailand Philippines Pakistan Sri Lanka ∗

= 0.0 and σf i,w = 0.2 (Objective

Fixed

Idiosyncratic

Common

TOT

Cov(TOTi , fi )

Cov(TOTi , W )

0.00 0.00 0.00 0.00 0.00 0.00

42.82 45.87 63.60 6.32 95.56 99.26

53.11 47.29 34.00 87.74 3.72 0.11

15.27 18.46 9.45 23.98 0.30 0.74

0 0 0 0 0 0

−11.20 −11.62 −7.05 −18.04 −0.42 −0.11

Cov(T i, f i) = 0 by definition in the starting values.

smallest contributions from the terms of trade in Tables 7 and 8, at less than one percent of total volatility. Comparing these results to the simple latent factor model without the terms of trade decomposition given in Table 5 shows that the countries which experience the largest terms of trade effects are those which have the most pronounced change in the structure of the contributions of the remaining factors. For example, in Table 5, the Philippines and Malaysia both had relatively small common factor contributions — but when the control for terms of trade is added these countries have relatively large common factor contributions. This is consistent with the relatively large contributions of the independent terms of trade effect to the overall decompositions in Tables 7 and 8. In the existing literature a small open economy assumption is often maintained, equivalent in this framework to setting the correlation of the terms of trade with the country specific latent factor to zero, that is σf i,T i = 0. The results of doing this are presented in Table 9. As expected from the previous results the implication of this restriction is to alter the component attributed to the country-specific factor in the decomposition. This makes sense in that it implies that country based shocks makes less contribution to exchange rate volatility than would be the case if this interdependence were taken into account.

5. Conclusions Measuring the contribution of volatility in the terms of trade to volatility in real exchange rates is a relatively uncluttered area of the existing literature.


231

Previous estimates of this contribution in developing countries range widely, from almost negligible effects reported in Devereux and Connolly (1996) to the almost half of total volatility reported in Mendoza (1995). To attain these estimates, a small open economy assumption is usually justified with Granger causality tests to demonstrate the exogeneity of the terms of trade from domestic economy conditions. The contribution of this paper is to develop an alternative model which explicitly takes into account the potential for correlation between domestic and international conditions and the terms of trade index of a particular economy. Real exchange rate changes are modeled as a linear combination of three independent latent factors — a fixed (numeraire) factor, a country-specific factor and a common world factor. In addition terms of trade changes are identified as an effect, and these are allowed to vary with both the country-specific and common world factor (the variation with the numeraire factor is set to zero). Calibration experiments show that the effects of varying the correlation between the terms of trade changes and the country-specific factor is not in the contribution of the terms of trade to real exchange rate volatility, but in the contribution of the country-specific factor. In general for the sample here, if the correlation of the terms of trade and the country-specific latent factor is understated, then the contribution of domestic country conditions (the country-specific factor) will be understated. An advantage of this approach is that it incorporates information from an integrated system of exchange rates, but produces results on the contribution of terms of trade volatility for each individual country’s real exchange rate. The application of this model to the six Asian economies of Thailand, Indonesia, Malaysia, Philippines, Pakistan and Sri Lanka, with bilateral exchange rates expressed against the US dollar, produces contributions of terms of trade volatility to real exchange rate volatility ranging up to 24 percent. The contributions are higher in the East Asian economies, and almost negligible in Pakistan and Sri Lanka.

6. Acknowledgements Thanks for useful comments and discussions are due to Shakila Aruman, Renée Fry and Vance Martin.

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7. References Amano, R. A. and S. van-Norden, 1995. “Terms of Trade and Real Exchange Rates: Canadian Evidence,” Journal of International Money and Finance 14: 83–104. Aruman, S. and M. Dungey, 2003. “Modelling the Australian Dollar Exchange Rate,” Australian Economic Papers 42(1): 56–76. Broda, C., 2002. “Terms of Trade and Exchange Rate Regimes in Developing Countries,” Federal Reserve Bank of New York, Staff Paper No. 148. Cashin, P., J. McDermott and A. Scott, 1999. “The Myth of Comoving Commodity Prices,” IMF Working Paper, 99/169. Devereux, J. and M. Connolloy, 1996. “Commercial Policy, the Terms of Trade and the Real Exchange Rate Revisited,” Journal of Development Economics 50: 81–99. Diebold, F. X. and M. Nerlove, 1989. “The Dynamics of Exchange Rate Volatility: A Multivariate Latent-Factor ARCH Model,” Journal of Applied Econometrics 4: 1–22. Dungey, M., 1999. “Decomposing Exchange Rate Volatility Around the Pacific Rim,” Journal of Asian Economics 10: 625–635. Dungey, M., 1997. “A Multilateral Approach to Decomposing Volatility in Bilateral Exchange Rates,” Australian National University Working Paper in Economics and Econometrics, No. 320. Dungey, M., V. L. Martin and A. R. Pagan, 2000. “A Multivariate Latent Factor Decomposition of International Bond Yield Spreads,” Journal of Applied Econometrics 15(6): 697–715. Gourieroux, C. and A. Monfort, 1994. “Simulation Based Econometric Methods,” CORE Discussion Paper. Karfakis, C. and A. Phipps, 1999. “Modeling the Australian Dollar-US Dollar Exchange Rate Using Cointegration Techniques,” Review of International Economics 7: 265–279. Habermeier, K. and A. Mesquita, 1999. “Long-Run Exchange Rate Dynamics — A Panel Data Study,” IMF Working Paper, 99/50. Lane, P. and G. Milessi-Ferrettti, 2000. “The Transfer Problem Revisited: Net Foreign Assets and Real Exchange Rates,” IMF Working Paper, 00/123. Mendoza, E. G., 1995. “The Terms of Trade, the Real Exchange Rate, and Economic Fluctuations,” International Economic Review 36: 101–137. Mahieu, R. and P. Schotman, 1994. “Neglected Common Factors in Exchange Rate Volatility,” Journal of Empirical Finance 1: 279–311.


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Appendix A. Data Sources The data were extracted from the Asian Economic Database of CEIC (Hong Kong) Ltd on dX data in April 2002. The real exchange rate was constructed by deflating the nominal exchange rate by the ratio of domestic to US consumer prices. The terms of trade in each case were constructed from the import and export price indices provided in that database. The database codes are given as in Table A1. Table A1. Data Sources Country

Nominal exchange rate local currency/USD

Consumer price index 1995 = 100

Import price index 1995 = 100

Export price index 1995 = 100

Indonesia Malaysia Thailand Philippines Pakistan Sri Lanka US

IDN.ECF MYS.ECF THA.ECF PHL.ECF PAK.ECF LKA.ECF USA.ECF

IDN.PCPI95 MYS.PCPI95 THA.PCPI95 PHL.PCPI95 PAK.PCPI95 LKA.PCPI95 USA.PCPI95

IDN.PIM95 MYS.PIM95 THA.PIM95 PHL.PIM95 PAK.PIM95 LKA.PIM95 USA.PIM95

IDN.PEX95 MYS.PEX95 THA.PEX95 PHL.PEX95 PAK.PEX95 LKA.PEX95 USA.PEX95

Appendix B. Derivation of the Covariance Expression Covariance (Si , Sj ) Cov (Si , Sj ) = E[(φi fi,t + φ0 f0,t + λi Wt + δi toti,t ) × (φi fj,t + φ0 f0,t + λj Wt + δi tot j,t )] = (λi + λj )φ0 σf 0,W + λi λj σW2 + φ02 σf20 + δi δj σT i,Tj + φi φj σf i,fj + φi φ0 σf i,f 0 + φ0 φj σf 0,fj + φi λj σf i,W + φj λi σfj,W + φi δj σf i,Tj + φ0 δj σf 0,Tj + φj δi σfj,T i + φ0 δi σf 0,T i + λi δj σW,Tj + λj δi σW,T i By assumption, the factors W and fi are all independent of each other, and σf i,Tj = 0. The expression then simplifies to that given in Equation (11).


Industrial and Commercial Firms’ Response to the Asian Crisis: A Logistic Approach Stephen Reynolds1,∗ , Somchai Ratanakomut2 & James Gander1,† 1

Professor, Economics Department, University of Utah, Salt Lake City, USA ∗ [email protected] † [email protected] 2 Associate Professor Emeritus Faculty of Economics, Chulalongkorn University, Bangkok, Thailand [email protected]

1. Introduction The economic crisis of South East Asia in 1997 has been studied by both micro and macro economists. The micro studies have focused on firm performance and signaling by the firm’s capital structure, particularly the role of short-term borrowing (see, for example, Reynolds, Ratanakomut and Gander 1999, 2001). The macro studies have focused on international trade arguments, particularly signaling by such variables as foreign exchange rates, international reserves, imports, exports, and gross domestic product (see Kaminsky, Lizondo and Reinhart 1998; Berg and Pattillo 1999; Kim, Kose and Plummer 1999; Tubtimtong and Chaivichayachat 2000; Monetary and Exchange Affairs Department 2000; and Policy Development and Review Department 2000). At the micro level, before the crisis firms in many industries saw great potential for growth as part of the “Asian Miracle”. Many firms with these expectations invested heavily in their productive capacity. Their economic health in terms of productive capacity was in good shape. However, with financial liberalization in the early 1990s, many relatively large firms borrowed from foreign sources and the borrowing was often denominated in US dollars or other foreign currencies. At the beginning of the crisis, lender confidence was reversed and the inflow of capital stopped. Drastic exchange rate changes occurred and projects became unprofitable. As a result of the exchange rate depreciation, the volume of firm sales increased, but not 235

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necessarily profits. This scenario accounts for some of the positive firm responses after the crisis that we analyze. A key issue in the literature has been the contagion nature of the crisis. The macro approach to this issue examines the symptoms of economic health or lack there of and how an economic disease spreads. It is left for micro economics, however, to examine the underlying causes of economic diseases and the economic body’s ability to respond and recover. In this paper, we examine how industrial and commercial firms responded to the 1997 crisis. Our key motivational concept is the role of the firm’s economic health prior to the crisis in determining the firm’s response to the crisis. If the firm was basically healthy in economic terms, then its return to good health (or its ability to avoid the disease or crisis) should be quick and thus there is a speedy recovery. Essentially, we study the marginal performance of firms after the crisis and its health history determinants. Two approaches are used. In one approach, we are interested in the likelihood (probability) of a quick recovery (positive response) and the role of several key indicators of economic health in affecting that probability. In the other approach, we examine firms’ sales growth rates from 1997 to 1999, controlling for the historical economic health of the firms. We expect a positive relationship between growth and health. The health indicators we use are generally accepted financial ratios used to evaluate firm performance and financial condition — the short-term to total debt ratio, the long-term debt/equity ratio, and the output to capital ratio. Dummy variables are used for the country of incorporation and the industry classification. Firm financial data are used for eight East and South East Asian economies over the time period 1993–1999. The eight economies are: Thailand, Indonesia, Korea, Singapore, Malaysia, Hong Kong, Philippines, and Taiwan. The first three economies were most affected by the crisis. Japan and China are included only for comparison purposes. In the next section, we describe the methodology and model. The following section contains the statistical results, and the last section contains conclusions. 2. Methodology and Model The methodology used to study the marginal responses of industrial and commercial firms to the financial crisis of 1997 is based on a general human

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health principle. If the human body is healthy, when a disease (e.g., a cold) occurs, the response time to the recovery of health will be very short. If the body is not in a healthy condition, then the response time will be much longer. In a similar way, we argue that for the economically healthy firm, response to the crisis will be very quick, or more particularly, the probability of a positive response will be high. This quick response or recovery also has a macro economic benefit in that it reduces the spread of the disease or contagion. Using optimal control theory concepts (for example, see Gander 1986), the firm’s current profit function is given by: π = π(Q, H, S),

(1)

where Q is current output, S is current spending on activities to create economic health (e.g., organizational reforms, information systems, and coordination systems), and H is the current status (or stock) of economic health with its path over time given by the differential equation, dH /dt = F (H, S). An alternative form is the difference equation, [H (t) − H (t − 1)] = F (H (t − 1), H (t − 2), . . . , H (t − r)), where the history of health will be captured by lagged variables. Spending on current health formation reduces current profit, but it increases future profit (with interest, implicitly) by increasing H . Under optimal conditions, the instantaneous rate of growth of Q depends on the current value of H at that instant. We build on the control theory concepts to develop the operational model. The economic health of firms is indexed by several standard accounting ratios used to measure the financial condition of firms (see, Marris 1964; Damodaran 1997; Kallunki, Martikainen and Perttunen 1996). The ratios include the short-term to total-debt ratio or debt-structure ratio (STLTDBTyy), the long-term debt to shareholders equity ratio or leverage ratio (LTDEQUYyy), the net income (profit after taxes) to short-term debt ratio (RISKINDyy) as a risk or vulnerability index, and sales to fixed assets ratio or productivity index (SALEFIXDyy), where the yy stands for the particular lagged year. The value of the short-term debt ratio is between zero and one. The lower the ratio the better is the economic health of the firm. The long-term debt/equity ratio has some negative values due to negative equity, so these were selected out of the sample. The risk index also has some negative values, but these cases were retained to capture ill-health. The assumption is that the lower the short-term debt ratio and the long-term debt/equity ratio,

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and the higher the sales/fixed asset ratio and the risk index, the healthier the firm. In the first approach to estimating firm response to crisis, the marginal response (performance) of the firm is indexed by the pair-wise nominal growth rate of the firm’s sales from 1996 to 1997, from 1997 to 1998, and from 1998 to 1999. If the ratio of the current to the previous year is greater than one (1 + g, where the growth rate g is greater than zero) for a given year (1997, 1998, or 1999), the marginal response for that year is considered good. A dependent dummy variable for each of the three years (DV 97, DV 98, DV 99) was set equal to one for a good response and zero otherwise for the year in question. In effect, we are treating the period 1993–1996 as the base period or stock of economic health, represented by the lagged explanatory variables from 1996, backwards. Statistically the best lag was from 1996 to 1993, after the economic liberalization period. As indicated above, the basis for the response index classification is the ratio of current to previous year nominal sales (1 + g) with g being the nominal rate of growth. As a microeconomic performance indicator the question arises, should the growth be based on nominal or real sales growth adjusted for the rate of inflation? Theoretically, a positive rate of growth of sales can be obtained from a number of combinations of price changes and quantity changes. Since sales = price times quantity at time t, or S = P Q, a simple log derivative shows that g = i + r, where i is the rate of inflation and r is the real rate of growth. Since we use (1 + g) for our responses, (1+g) = (1+i)(1+r). So, (1+g)/(1+i) = (1+r) gives real proportional growth. The problem is we only have macro data on the inflation rate i by year and by economy. In other words, i only varies across time and across countries. The cross-country variation will be picked up by our country dummy variables. The variation over time is irrelevant since we treat each after-crisis year separately. Also, the micro firm’s price behavior may be quite different from the macro price behavior. In fact, it has been argued by some economists (see Baumol 1967) that firms focus more on nominal sales and sales growth than on profits. If this is correct then (1 + g) is the appropriate basis for the response index. Differential rates of inflation by industry are an integral part of the macroeconomic adjustment process following currency depreciation (Caves, Frankel and Jones 2002, 416–418). Efforts to assess the micro level responses of firms in different industries must consider different


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rates of inflation in different economies and distinguish between industries supplying primarily tradeable goods from industries supplying nontradeable goods. The distinction is clearer conceptually than it is empirically. We approximate the distinction by separating industrial firms (tradeables) from commercial firms (non-tradeables) with the use of a dummy variable (DVCOMALL). The operational model is set in logistic form as Pr(Y = 1) = E(Y ) = Pr(I ∗ ≤I ) = F (I ), where Y is any one of our three dummy variables (DV 97, DV 98, DV 99), I ∗ is the unobservable threshold index, I = a+bX is the unobservable actual index as a function of the X’s and F (I ) is the logistic cumulative distribution function (CDF), 1/(1 + exp(a + bX)).1 The statistical results give the probability of a healthy response dependent on the predictor variables. In other words, if the firm is economically healthy (as indicated by its historical financial structure), then the probability of a healthy response (Y = 1) is expected to be high. The equation for I is given by: I = a + b1(STLTDBT 96) + b2(STLTDBT 95) + b3(STLTDBT 94) + b4(STLTDBT 93) + b5(LTDEQUY 96) + b6(LTDEQUY 95) + b7(LTDEQUY 94) + b8(LTDEQUY 93) + b9(SALEFIXD96) + b10(SALEFIXD95) + b11(SALEFIXD94) + b12(SALEFIXD93) + b13(RISKIND96) + b14(RISKIND95) + b15(RISKIND94) + b16(RISKIND93) + b17(DVCOMALL) + b18(DVTHA) + · · · + b24(DVHKG) + e, (2) where the seven-economy dummy variables go from DVTHA (Thailand) to DVHKG (Hong Kong) with Singapore (SGP) as the reference, DVCOMALL is an industry dummy variable equal to 1 for all commercial firms with an SIC 4000 or higher (the non-tradeables), the lagged variables are as defined before, and e is the error term. The second approach to estimating firm response to crisis uses the natural log of actual sales growth L(1+g)yy as the dependent variable regressed on the firm’s historical health (the lagged variables), where yy is the growth 1 Theoretically,

F (I ) can be any mathematical form that defines Y between zero and one. The Probit is one of these forms where F (I ) is the normal cumulative distribution function. It, however, did not converge, so its results are not reported.

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period (97/96, 98/97, and 99/98). The model is given by L(1 + g)yy = a + b1(STLTDBT 96) + b2(STLTDBT 95) + b3(STLTDBT 94) + b4(STLTDBT 93) + b5(LTDEQUY 96) + b6(LTDEQUY 95) + b7(LTDEQUY 94) + b8(LTDEQUY 93) + b9(SALEFIXD96) + b10(SALEFIXD95) + b11(SALEFIXD94) + b12(SALEFIXD93) + b13(RISKIND96) + b14(RISKIND95) + b15(RISKIND94) + b16(RISKIND93) + b17(DVCOMALL) + b18(DVTHA) + · · · + b24(DVHKG) + e,

(3)

where yy is either 1997, 1998, or 1999. If the firm is historically healthy, then its sales growth in yy (each taken separately) should be related to the lagged variables, with the appropriate signs, given earlier. We also pool the growth rates (in logs) and include a dummy explanatory variable (DVTM), coded 1 for the 1998 and 1999 observations and 0 for the 1997 observations. The pooling will allow us to compare variation in firmlevel growth rates across time (base versus later year periods). 3. Statistical Results The data are from Standard & Poor’s Compustat, Global Vantage file (2000) for publicly held industrial and commercial corporations, covering the period 1993–1999. For the eight economies studied, there were some 8,445 observations for the period. The response period (1997–1999) has 3,272 observations for the eight countries. The sample sizes vary depending on the year being considered (DV 97 has 1,340 observations, DV 98 has 1,278 and DV 99 has 654). After eliminating missing values for the variables used in the model, these sample sizes are further reduced during the regression process where actual sample sizes utilized are reported in the statistical results tables.2 2All

the independent variables are ratios, so problems of different currencies and different rates of inflation are avoided. Other researchers (for example, the Monetary and Exchange Affairs Department 2000) have used percentiles for absolute variables to avoid the currency


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Tables 1 and 2 contain the statistical results for the logistical model for the eight East and South East Asian economies and Japan and China, respectively. Japan and China were not set back by the 1997 crisis, but are included in the analysis for comparison purposes. The classification rate (Table 1) goes from 60 to 74 percent of the responses being correctly classified. So, the fits are good and significant. But, for DV 97, of the 16 coefficients only two are statistically significant at the five percent level for a two-tailed test (this is the standard used throughout the paper) and two are marginally significant between five and ten percent. Recall the expectation is that the lower the short-term debt ratio (STLTDB) and the long-term debt/equity ratio (LTDEQU), and the higher the sales/fixed asset ratio (SALEFIX) and the risk index (RISKIND), the healthier the firm. The negative sign for STLTDBT 96 is consistent with our expectations. The positive sign for STLTDBT 95 is not consistent, although their combined effect is negative as expected. The negative sign for SALEFIXD95 is not consistent with our expectations. The positive sign on the RISKIND93 is as expected. The mixed results for 1997 are not surprising, in view of the fact that 1997 was for its latter half the start of the crisis and there was much economic instability. The industry dummy (DVCOMALL) coefficient is not significant, so the distinction between tradeable and non-tradeable goods was not apparent. For economy differences, in particular, for Malaysia, Taiwan, Korea, and Indonesia (the last two economies were most affected by the crisis) the dummy variable coefficients were significant and positive, indicating a higher probability of response compared to Singapore which is captured by the intercept. The coefficient for Thailand is not significantly different from that for Singapore. These results are interesting for it means that during the economic turmoil at the onset of the crisis, the firms in the three economies most affected by the crisis had a probability of response at least as good or better than the economy least affected by the crisis. The results for DV 98, a year after the crisis, are overall much stronger than for DV 97. Five of the 16 lagged variables exhibit significant coefficients. The classification index is higher at 70 percent. The signs on the lagged variables STLTDBT 94 and SALEFIXD93 are consistent with our expectations regarding the effect of economic health on the probability of a conversion problem. Also, the lagged variables across years and between variables have very small correlations with only five out of a possible 170 correlations greater than 50 percent. Most (70 percent) are below ten percent.

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Table 1. Estimates for Logistic Regression, Eight Economies (Wald Chi-Square in Parentheses) Explanatory variable

Dependent variable DV 97

Sample size Classification (%) Constant§ STLTDBT 96 STLTDBT 95 STLTDBT 94 STLTDBT 93 LTDEQUY 96 LTDEQUY 95 LTDEQUY 94 LTDEQUY 93 SALEFIXD96 SALEFIXD95 SALEFIXD94 SALEFIXD93 RISKIND96 RISKIND95 RISKIND94

1,161 59.5 − 0.31 (1.57) − 0.59 (7.91)∗ 0.47 (3.65)∗∗ 0.08 (0.08) 0.05 (0.04) − 0.05 (2.36) 0.03 (1.33) − 0.04 (1.61) 0.004 (0.56) 0.002 (0.13) − 0.04 (3.68)∗∗ − 0.01 (0.24) − 0.001 (0.004) 0.001 (0.32) 0.000+ (0.35) 0.000+ (0.134)

DV 98 1,113 70.4 − 1.10 (15.99)∗ 0.57 (5.80)∗ − 0.13 (0.23) − 0.62 (4.14)∗ 0.71 (6.86)∗ 0.02 (1.07) 0.03 (2.58) −0.04 (0.94) − 0.01 (0.13) 0.004 (0.91) 0.01 (0.34) − 0.03 (2.06) 0.04 (4.04)∗ − 0.002 (3.28)∗∗ 0.000+ (0.01) 0.000+ (0.004)

DV 99 573 69.1 − 2.62 (30.60)∗ 0.20 (0.36) 0.42 (1.08) − 0.31 (0.44) − 0.18 (0.21) − 0.07 (0.97) 0.02 (0.60) − 0.11 (1.45) −0.02 (0.57) − 0.06 (2.79)∗∗ 0.03 (0.17) − 0.05 (0.85) 0.12 (8.27)∗ 0.000+ (0.02) 0.000+ (0.36) − 0.001 (0.774)

SUM9798 1,113 74.0 − 1.82 (32.47)∗ − 0.05 (0.04) 0.63 (4.71)∗ − 0.66 (4.23)∗ 0.10 (0.13) − 0.03 (0.78) 0.03 (2.47) − 0.11 (2.81)∗∗ − 0.001 (0.07) 0.003 (0.48) − 0.01 (0.14) − 0.04 (2.16) 0.03 (1.99) 0.001 (0.25) 0.000+ (0.09) 0.000+ (0.069)


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Table 1. (Continued) Explanatory variable


RISKIND93 DVCOMALL DVTHA DVIDN DVKOR DVMYS DVPHL DVTWN DVHKG

0.002 (6.73)∗ 0.04 (0.10) − 0.06 (0.09) 1.19 (21.26)∗ 1.25 (16.27)∗ 0.43 (4.90)∗ 0.30 (1.06) 0.71 (7.11)∗ 0.15 (0.37)

DV 98 0.001 (1.16) − 0.07 (0.22) −0.10 (0.19) − 0.76 (5.71)∗ 0.13 (0.18) − 0.22 (1.07) 0.02 (0.003) 1.20 (18.90)∗ − 0.22 (0.65)

DV 99 0.004 (4.74)∗ 0.34 (2.52) 2.54 (44.66)∗ 0.56 (0.62) − 3.48 (0.02) 2.16 (33.50)∗ 1.44 (3.72)∗ 3.92 (6.43)∗ − 2.62 (35.72)∗

SUM9798 0.001 (0.97) 0.07 (0.20) 1.03 (14.36)∗ 2.32 (57.57)∗ 1.65 (25.28)∗ 0.47 (3.13)∗∗ 1.00 (8.31)∗ 1.51 (23.52)∗ 0.73 (5.35)∗

∗

Significance at 5 percent. Significance between 5 and 10 percent. §Singapore is captured by the intercept.

∗∗

good response. The debt structure signs for 1996 and 1993 are positive and, so, inconsistent with our expectations. They indicate that as the short-run debt increases relative to the total debt, the probability of a positive growth response also increases. The sign on RISKIND96 is also contrary to expectations. Taiwan does better and Thailand and Korea do as well as Singapore, but Indonesia with a negative sign does worse than Singapore. The latter result is to be expected. For DV 99, only RISKIND93 (with the expected sign) and the productivity index (SALEFIXDyy) for 1996 and 1993 are significant, but 1996 has the wrong sign. Thailand, Malaysia, Taiwan, and the Philippines do better than Singapore; Hong Kong performs less well. DVCOMALL’s coefficient is only significant at the 11 percent level, but its positive sign is consistent

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Table 2. Estimates for Stepwise Logistic Regression, Japan and China (Wald Chi-Square in Parentheses) Explanatory variable


Sample size Classification (%) Constant§ STLTDBT 96 STLTDBT 94 LTDEQUY 96 SALEFIXD96 RISKIND96 DVCOMALL DVJPN

2,066 73.4 − 2.18 (12.92)∗ − 0.76 (17.29)∗ − 0.43 (5.92)∗ — — — — — — − 0.63 (27.22)∗ 2.03 (11.66)∗

DV 98 2,183 73.0 0.20 (4.20)∗ — — — — −0.17 (11.73)∗ − 0.03 (7.37)∗ 0.000+ (3.60)∗∗ − 0.99 (91.02)∗ − 0.78 (8.99)∗

DV99 330 53.6 1.39 (3.08)∗∗ — — — — — — — — — — — — − 1.50 (3.52)∗∗

SUM9798 2,164 72.8 − 0.54 (4.46)∗ — — — — — — — — — — 0.91 (80.42)∗ − 0.79 (9.30)∗

∗

Significance at 5 percent. Significance at 10 percent. § China is captured by the intercept. ∗∗

with the effects of currency depreciation common in the region in 1997 and 1998, leading first to a rise in the prices of tradeables (industrial firms) and later to a rise in the prices of nontradeables (commercial firms) as well as the currency re-appreciation in 1998 and 1999. The overall weak results for 1999 may be due partly to the relatively small sample size due to missing values and to the failure of the crisis effects to be neatly associated with calendar years. When 1997 and 1998 are combined, so we can run one dummy dependent variable (SUM9798), where 1 is for (1 + g) being greater than 1 (so g is positive) over the two-year period 1997–1998 and 0 is for (1 + g) being equal to or less than 1 (so g is zero or negative), the significant results are


245

more numerous, although a positive sign on STLTDBT 95 is contrary to our expectations, in contrast to the expected negative signs on STLTDBT 94 and LTDEQUY 94. But, more surprising are the positive and significant results for Thailand, Indonesia, and Korea. The firms in these crisis economies have on the average a higher probability of a good response than Singapore, a non-crisis economy. Also, as before, the tradeable/non-tradeable distinction is not significant. This evidence suggests that our sample firms, taken as a whole, did not particularly experience any reduced chance of positive growth during the crisis period (1997–1998). In Table 2, the results for Japan and China are reported for comparison purposes. A stepwise logistic regression was used so only the significant results are reported. For DV 97, the debt structure has the expected negative sign. Also, the industry distinction is significant. The negative sign implies that commercial firms (essentially, the non-tradeables) have a lower chance of growth than the industrial firms. This seems reasonable for 1997 in view of the fact that Japan and China are heavily export oriented and the rest of the world had not yet moved into a recession or growth slowdown. Also important for 1997 is the fact that firms in Japan had a higher chance of a positive growth response than firms in China. This result may be due to the fact that of the 2,066 observations for both economies, Japan has 97 percent of them. For DV 98, the significant coefficients for LTDEQUY 96, RISKIND96, and DVCOMALL have the expected signs, but that for SALEFIXD96 does not. Also note the reduced performance for Japanese firms given by the dummy variable for Japan. The results for DV 99 and SUM9798 have no significant coefficients for the lagged variables, so the history of economic health does not seem to matter. Interestingly, the positive sign on the industry dummy variable is significant. Now, the non-tradeables result in a higher chance of firm growth and depend more on the domestic economy. Also, the firms in Japan have a smaller chance of growth than those in China. In Table 3, we present the results of the regression of the log of sales growth rates on the explanatory variables to analyze firm growth performance during and after the crisis. The log of the growth of firm sales for 1997 (using stepwise regression) has significant coefficients for STLTDBT 95, LTDEQUY 96, and SALEFIXD95, but only the negative sign for LTDEQUY 96 is expected, although, the positive sign for STLTDBT 95 makes

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S. Reynolds, S. Ratanakomut & J. Gander Table 3. Estimates for Log of Sales Growth Rate Stepwise Regressions, Eight Economies (t-Values in the Parentheses) Variable Sample size R2 Constant§ STLTDBT 96 STLTDBT 95 STLTDBT 93 LTDEQUY 96 SALEFIXD95 DVTHA DVIDN DVTM DVKOR DVTWN

L(1 + g)97

L(1 + g)98

LGROGROUP

1,161 0.14 − 0.96 (−6.22)∗ — — 0.52 (2.44)∗ — — − 0.15 (−5.06)∗ − 0.007 (−2.68)∗ 0.67 (3.67)∗ 1.95 (8.49)∗ — — 2.80 (9.93)∗ 0.90 (3.61)∗

1,113 0.02 − 0.29 (−4.89)∗ 0.14 (2.06)∗ — — 0.14 (2.00)∗ — — — — — — — — — — — — 0.22 (2.88)∗

2,847 0.05 − 0.62 (−7.95)∗ — — 0.26 (2.72)∗ — — − 0.04 (−3.55)∗ − 0.004 (−2.64)∗ 0.31 (4.00)∗ 0.64 (5.77)∗ 0.13 (2.11)∗ 1.32 (9.64)∗ 0.52 (4.24)∗

∗

Significance at 5 percent. Significance at 10 percent. § Singapore is captured by the intercept. ∗∗

sense historically when firms relied heavily on short-term debt for financing growth. The coefficients for Thailand, Indonesia, and Korea are significant and positive, indicating that firms in these crisis economies had a higher growth rate on average than firms in Singapore. These results indicate that positive growth performance was still present during the crisis year of 1997.


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The 1998 growth-rate run produced similar results. The short-term debt ratios for two of the lagged years were significant with positive signs. However, only Taiwan had significant growth performance better than Singapore. The 1999 growth-rate run produced no significant results, so we excluded it from the table. So, at least for 1997 and 1998, economic health as indexed by some of the lagged variables does seem to matter. Grouping the growth rates for the three years 1997, 1998, and 1999 proved worthwhile. The year 1997 was taken as the base year (the crisis began mid-1997) and a dummy variable (DVTM) set equal to zero for 1997, one for later years was defined. The natural log of the growth rates (LGROGROUP) was run using stepwise regression to obtain the best results. Three lagged variables (STLTDBT 95, LTDEQUY 96, and SALEFIXD95) had significant coefficients. The signs, however, are opposite what was expected for the productivity index and the debt structure ratio. In any case, the coefficient for DVTM was significant and indicates that growth rates were generally higher during the 1998–1999 recovery period than during the base 1997 crisis year. This itself implies that firms were recovering from the crisis very quickly. Growth rates for firms in Thailand, Indonesia, and Korea were also significantly higher on average than those for firms in Singapore, a non-crisis economy. 4. Conclusions Healthy industrial and commercial firms, as indicated by certain financial ratios, appear to have robust or speedy responses to the crisis when analyzed by the logistical model. The best health indicators were the short-term to total-debt ratio (the debt structure) and the risk or vulnerability index (net income to short-term debt). The higher the debt ratio, the lower the probability of a positive response. The higher the net income index, the lower the risk or vulnerability, and the higher was the probability of a positive response. These results were not always consistent across years, but grouping did prove to be effective. In general, (1) the logistic regression results provided more support for the theory than the step-wise least-squares results; and (2) the evidence of the effects of past economic health on the firms’ post-crisis performance is stronger the closer is the proximity in time of the lagged data. The speedy recovery or response was not limited to the economies not strongly impacted by the financial crisis. In fact, at the micro level,

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Thailand, Korea, and Indonesia along with all the other economies appear quite healthy with a robust marginal growth response after the crisis from the larger, publicly listed firms taken as a whole. This we find to be not consistent with the conventional macro wisdom. The lagged operational model is theoretically closest to representing the concept of economic health and determining the marginal response of firms. Although the lagged variables varied in significance for the various runs, many were significant, particularly the short-term debt ratio and the productivity index. These were important economic health indicators. So, is there a message here for industrial restructuring? If our evidence is valid, it appears that the firms (at least in our sample) in the crisis economies rebounded as well or better than the firms in the non-crisis economies. There is no evidence of any universal catastrophic firm failure to recover from the crisis. What is needed is more disclosure of financial records. This would reduce the number of missing values in the primary data set. Other forms of restructuring have to do with the degree of competition and regulation within and across industrial sectors. It would be interesting to see if the concentrated industries were more or less responsive after the crisis compared to the less concentrated industries. We leave this topic for future research.

5. References Baumol, William J., 1967. Business Behavior, Value and Growth (New York: Harcourt, Brace, and World, Inc.) 45–52, 86–104. Berg, Andrew and Catherine Pattillo, 1999. “Predicting Currency Crises: The Indicators Approach and an Alternative,” Journal of International Money and Finance 18(4): 561–586. Caves, Richard E., Jeffrey Frankel and Ronald W. Jones, 2002. World Trade and Payments: An Introduction (Boston: Addison Wesley). Damodaran, Aswath, 1997. Corporate Finance: Theory and Practice (New York: John Wiley & Sons). Gander, James P. A., 1986. “The Economics of University/Industry Research Linkages,” Technological Forecasting and Social Change 29(1): 33–49. Kallunki, Juha-Pekka, Teppo Martikainen and Jukka Perttunen, 1996. “The Proportionality of Financial Ratios: Implications for Ratio Classifications,” Applied Financial Economics 6(6): 535–541.


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Kaminsky, Graciela, Saul Lizondo and Carmen M. Reinhart, 1998. “Leading Indicators of Currency Crisis,” International Monetary Fund Staff Papers 45(1): 1–48. Kim, Sunghyan Henry, M. Ayhan Kose and Michael G. Plummer, 1999. “Understanding the Asian Contagion: An International Business Cycle Perspective,” Paper presented at the 23rd International ACAES Conference, Seoul, Korea. Marris, Robin, 1964. The Economic Theory of ‘Managerial’Capitalism (NewYork: The Free Press of Glencoe). Monetary and Exchange Affairs Department, International Monetary Fund (IMF), 2000. “Macroprudential Indicators of Financial System Soundness,” IMF Occasional Paper No. 192. Policy Development and Review Department, IMF, 2000. “Debt- and Reserve-Related Indicators of External Vulnerability,” IMF.org/external/np/pdr/ debtres/index/html, 1–54. Reynolds, Stephen, Somchai Ratanakomut and James Gander, 2001. “Microeconomic Foundations of Macroeconomic Crisis: Risk Analysis of Asian NonFinancial Firms with Comparisons to Latin America,” Restructuring Asian Economics for the Millennium, Volume 9B (Elsevier Science) 395–408. Reynolds, Stephen E., Somchai Ratanakomut and James P. Gander, 1999. “The Private Sector in Financial Crisis: The Short-Term and Long-Term Capital Structure of Firms in Southeast and East Asia,” Journal of Asian Business 15(1): 1–14. Standard and Poor’s Compustat, Global Vantage file, 2000. Tubtimtong, Bangorn and Bundit Chaivichayachat, 2000. “Thailand Fundamental Response Patterns after the Financial Crisis,” Paper presented at the colloquium on the Asian Financial Crisis, Economics Department, University of Utah, Salt Lake City, Utah, USA. Turner, Jerry L., 1997. “The Impact of Materiality Decisions on Financial Ratios,” Journal of Accounting, Auditing and Finance NS12(Spring): 125–147.


Moral Hazard and Legal Regulation in the Financial Market: Japan’s Mega-Bank Mergers Yoshinori Shimizu Executive Vice President Hitotsubashi University, Kunitachi, Tokyo, Japan [email protected]

1. Introduction Enormous claims on fiscal resources have been imposed by financial crises since the 1980s in connection with financial deregulation and the transition to market economies. Ultimately, the fiscal expenditures have gone to compensate for bad loans made to borrowers, thus some elements of society have benefited from the turmoil. Especially in the transitional economies, select groups were able to exploit the shift in economic paradigm to their own advantage. Moral hazard on a gigantic scale underlay this squander. Japan has suffered the largest fiscal losses due to financial crisis of any country. Why have such big losses occurred in Japan? What went wrong? Why has Japan proved unable to fix the problem more quickly as other nations have? What measures should be taken? These questions are the focus of this paper. Beyond Japan, financial crises have been common among transitional economies, such as China and the countries of East Europe. To understand the scope of the problem, we first make a cross-country comparison of fiscal outlays made to settle financial crises. Then, we examine the Japanese case more closely with attention to the bank mega-mergers that have occurred there and their contribution to moral hazard in creating entities “toobig-to-discipline-adequately”. We stress the importance of market discipline, transparency, and enforceable rules with meaningful punishment to take control of the situation. 251

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2. Fiscal Costs of Financial Crises Worldwide What have been the fiscal costs of financial crises worldwide over the last two decades? Lindgren, Garcia and Saal (1996) report that 133 out of 181 IMF member countries experienced serious problems in their banking sectors between 1980 and 1996. Caprio and Klingebiel (1999) note 112 banking crises in 93 countries and 51 near-crisis problems in 46 countries since the latter half of the 1970s. For 40 countries experiencing serious financial crises, Honohan and Klingebiel (2000) find the average fiscal outlay to address the problem amounted to 12.8 percent of GDP. Figure 1 shows the fiscal costs for these 40 countries as a percentage of GDP. For Argentina, the magnitude reached 55 percent of GDP and for Indonesia 50 percent. For Thailand, Korea, and Malaysia, the amounts are expected to reach 20 to 55 percent after the Asian crisis. Total fiscal costs for developing countries taken together have amounted to one trillion dollars. The country that has had the largest loss in absolute terms is Japan which has spent ¥100 trillion, or 20 percent of its GDP, so far. Let us take a closer look at the cost of the Japanese financial crisis. The direct injection of public funds for bank recapitalization was ¥10.24 trillion, and the Deposit Insurance Corporation paid out ¥21.89 trillion for 117 cases by the end of fiscal year 2000 (as of February 6, 2002). These expenditures alone amounted to 6.4 percent of 2000 GDP. The accumulated write off of bad loans by all banks from 1992 through fiscal year 2000 (March 2001) was ¥71.82 trillion. The remaining outstanding balance of “high-risk loans” based on the broader definition of the Japanese Financial Supervisory Authority (FSA) was ¥32.52 trillion. Thus total bad loans broadly defined had mounted to ¥104.33 trillion, or 20.8 percent of 2000 GDP. For all deposit-taking financial institutions, the balance of the outstanding high-risk loans was ¥43.45 trillion. If we suppose that the accumulated write off for all deposit-taking financial institutions was proportional to that of all banks, it would be ¥95 trillion. Then, the total amount of the accumulated bad loans would amount to ¥139 trillion (27.8 percent of GDP). Japan surely has experienced the largest financial crisis in the world. 3. Legal Enforcement in the Transitional Economy Factors recognized as contributing to an accumulation of bad loans building to the point of financial crisis include: (1) unlimited deposit guarantee;

Moral Hazard and Legal Regulation in the Financial Market

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Argentina 1980-1982 Indonesia 1997 Chile 1981-1983 Thailand 1997 Uruguay 1981-1984 South Korea 1997 Cote d'Ivoire1988-1991 Venezuela 1994-1997 Japan 1992 Mexico 1994 Malaysia 1997 Slovenia 1992-1994 Philippines 1983-1987 Brazil 1994-1996 Republic Ecuador 1996 Bulgaria 1996-1997 Czech 1989-1991 Finland 1991-1994 Hungary 1991-1995 Senegal 1988-1991 Norway 1987-1993 Spain 1977-1985 Paraguay 1995 Sri Lanka 1989-1993 Colombia 1982-1987 Malaysia 1985-1988 Sweden 1991-1994 Indonesia 1992-1994 Poland 1992-1995 United States 1981-1991 Ghana 1982-1989 Turkey 1982-1985 Thailand 1983-1987 Australia 1989-1992 Turkey 1994 New Zealand 1987-1990 France 1994-1995 Philippines 1998 Egypt 1991-1995 Argentina 1995 0.0

10.0

20.0

30.0

40.0

% of GDP

Source: Prepared base on the data in Honohan and Klingebiel (2000).

Figure 1. Fiscal Costs of Banking Crises

50.0

60.0

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(2) open-ended liquidity support; (3) repeated re-capitalization; (4) debtor bail-out; and (5) regulatory forbearance. Moral hazard in bank lending behavior is the result. Honohan and Klingebiel (2000) estimate that had bank failures been adequately handled absent these five elements that lead to moral hazard, losses due to financial crisis globally would have been one tenth their actual level which was one percent of world GDP. On the other hand, were the situation to run its worst conceivable course, losses could amount to 60 percent of world GDP. For a proper handling of bank failures, many conditions need to be met. Legal, social, and historical factors are involved. Strong political leadership is required to prevent moral hazard from becoming institutionalized. It is a challenge for transitional economies to manage the task of creating efficient financial markets. When the institutional environment changes drastically and rapidly, such as in the East European transitional economies, financial turmoil is likely to occur. But in developed countries as well, huge fiscal costs have been incurred to resolve problems resulting from moral hazard in the financial markets when private liabilities (deposits) are guaranteed by government. In order to prevent this, a regulatory and supervisory system that has clearly understood legal enforcement power is indispensable. The key is the social conditioning formed through historical behavior of the government regarding the enforcement of established laws and regulations. People react only to enforceable laws. In countries where serious financial crises have occurred, including Japan and most other Asian countries, there had been no experience in dealing with bank failures and there was no legal framework designed for it. Banks were treated as special and heavily protected since they were so “important and sensitive” for society. Anyway, bank managers convinced politicians this was the case. And there are indeed legitimate reasons to use public support to avert “financial crisis”. In Japan, the banking sector had performed well for half a century with not a single case of bank failure. Because government protection prevented new entry into the industry and thus secured excess profits for banks, all kinds of bank activities were under the control of government. Under these circumstances, supervisory regulations were used as guidelines, and nobody including regulators believed that supervisory regulations had to be obeyed 100 percent of the time.Application of the laws was subject to discretion, and


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punishment for violations was mild. With respect to the regulation on large loans, punishment was a nominal fine of at most ¥3 million (US$20,000). A truly effective punishment should have been set in proportion to the losses incurred. On grounds of principle, there is disagreement as to whether bank managers should be forced to take legal responsibility for violations of the rules of good conduct. One view — “the non-limit theory” — asserts that as far as laws exist, all laws must be strictly applied; another view — “the limit theory” — says that the scope of behavior for which there is legally enforceable responsibility is quite limited. Under “the limit theory”, bank managers are to be held responsible only for cases where losses were clearly predictable as a consequence of their conduct. Disagreement extends further to the question of whether bank managers should bear a greater responsibility than managers of other types of business due to the public responsibility of accepting deposits. When the market environment suddenly changed in Japan after the burst of the bubble in the early 1990s and huge losses occurred unexpectedly, there was an outcry against “the limit theory” approach. In the United States, “the non-limit theory” is popular probably because bank failures had been rather common and experience had been accumulated in managing the problem. In Japan, by contrast, supervisory regulations on banks had not been understood as laws that have to be literally applied and there was no system for enforcement. Rules and regulations were not transparent. More than a few laws existed that were applied only in extreme cases of illegal activities. Since bank supervision had become discretionary rather than rule-based, even regulatory authorities were not clear as to which regulations had to be fully obeyed. Bank managers were therefore understandably confused by ambiguities in the regulatory system. At the same time, however, the ambiguity was used as an excuse by bank managers when problems arose. In Japan, there is a concept of “laws outside the legal system”. This refers to implicit social criteria that must be strictly observed, and violation of which leads to severe social censure even without any legal procedures. The conceptual basis for law and thus the role of law in governing behavior differ from country to country. The history of Japan’s financial crisis and response to this crisis over the last decade can be seen as moving the country towards establishing a supervisory and regulatory framework that are meant to be literally enforced without exceptions. This has been a process

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of adjusting not only regulations but also public perceptions toward more globally accepted norms. The Japanese banking system had been heavily protected and thus controlled by the government as a kind of “sacred territory” for several decades. In this sense, it was the industry which was most socialistic within the Japanese economy. This is the reason why Japan experienced a large-scale banking crisis more typical of transitional economies such as East Europe and China. 4. Mega-Bank Mergers and Too-Big-To-Discipline-Adequately (TBTDA) Bank mega-mergers became a growing world-wide phenomenon during the 1990s. In the developed industrial countries between 1990 and 2001, 246 cases were recorded in which the assets of merged banks reached over a billion dollars. The trend was accelerating as the number of cases during 1996–2001 was 153, and for 1990–1996, 93. Among 7,634 mergers and acquisitions among financial institutions during the 1990s, the average transaction value was US$158 million in the first half of the decade, and jumped to US$491 million in the second half. In the US, as a result, the number of banks and bank holding companies fell respectively from 14,000 and 11,000 in 1985 to 8,300 and 7,000 in 2000. Correspondingly, the asset share of the top 100 largest banks rose from 50 percent to 70 percent. Japan was caught up in this trend. Japan’s largest banks were recently re-organized into four mega-bank groups giving Japan the world’s largest bank groups based on asset size. The incentives for mega-bank mergers are various and involve regulatory regime change, progress in information technology, competitive pressures and pursuit of market domination, and economies of scale. On the other hand, however, in the US, the rate of growth and the profit rate of small banks have been consistently higher than those of large banks in the last fifteen years. In recent years, the hottest area of new bank establishment is the “de novo bank” asset size of which is not more than US$50 million. In addition, there has been no empirical evidence for an increase in optimal bank size or for the presence of economies of scope in the banking industry. Consequently, it is not at all clear that the world-wide tendency for increased size of the largest banks has contributed to the efficiency of the banking industry.


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From a supervisory standpoint, it is important to know whether the increase in bank size is a means to raise efficiency in response to technical progress and changes in economic environment, or a sign of moral hazard related to the idea of “too-big-to-discipline-adequately” (TBTDA) and/or “too-big-to-fail” (TBTF). In the next section, we will briefly survey the empirical results obtained in the US and, then in the section that follows, show the results of our research for Japan. A TBTF attitude on the part of the government could provide an implicit guarantee that reduces bank funding costs and thus leads to higher profits. Even though a TBTF policy will not be explicitly announced, a bank’s stock price should increase at the time of a merger announcement if investors suspect such a policy. That very increase of the stock price itself could be a possible purpose of mega-bank mergers. In this context, the purpose of mega-bank mergers is not strictly TBTF, but the escape from regulatory discipline, or TBTDA, or in other words, making bank supervision more complicated and difficult by making the size gigantic, at least for a period of time. If this is the nature of the motivation, the world-wide tendency for mega-bank mergers is manifestation of a kind of moral hazard that could potentially result in huge costs to taxpayers. 5. Merger Announcement and Stock Prices Empirical research in the US has yielded a sense of the effects of merger announcements on stock prices (Cirbett and Teharanian 1992; Houston and Ryngaert 1994; Siems 1996; Houston, James, and Ryngaeret 2001). Kane (2000) reported that, in the case of smaller banks, the stock price of the absorbed bank tends to rise markedly, while that of the absorbing bank tends to fall slightly at the time of the merger announcement. Different results were observed, however, for mega-bank mergers; the larger the merged bank, the greater the tendency for stock prices of both absorbing and absorbed banks to rise. The rates of increase in the stock prices were even larger when both banks were located within the same state. Two explanations have been given for this finding. The first is that the merged bank’s cost of funds could be expected to fall due to the difficulty on the part of the regulatory agency to execute proper and adequate supervision over large-scale and complicated organizations. The reduced cost of funds could come from the political power of gigantic banks to enforce an effective public guarantee on debts not formally covered by deposit insurance.

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The second is that mega-banks are expected to exert their monopoly power and to increase prices for their services in the future which should lead to higher profits. In fact, there is a view that the increased tendency for mega-mergers in the US in the 1990s was a market reaction to the legislation of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) which intended to prevent regulatory forbearance. But when a bank’s size becomes huge and its organization very complicated, an exception to the FDICIA might be expected when it confronts a failing bank. Since the failure of mega-banks does seriously affect the domestic economy, and even the world economy, there exists an incentive for the regulatory authority to forebear. Another finding of empirical research in the US is that the cost curve of the banking business has a very flat U shape with its most efficient minimum point located anywhere between US$100 million and US$10 billion dollars (Berger, Demsetz and Strahan 1999; Berger and Humpherey 1994). If this is the case, the average asset size of banks that Kane (2000) studied was located beyond the bounds of achieving economies of scale at an average US$52.6 billion for absorbing banks and US$25.9 billion for absorbed banks. Thus excess returns from mega-bank mergers must be attributable to TBTDA. 6. Empirical Research on Mega-Bank Mergers We have undertaken an empirical study of Japanese mega-bank mergers along the lines of Kane (2000). Table 1 shows the total asset size of each bank and the rise in its stock price relative to the Nikkei index, measured from three days before to one day after the merger announcement.1 The pattern found by Kane is discernible in Japan as well. In cases of merger among large city banks (money center banks), a positive premium in the stock price was observed for all involved banks, with one exception. This exception was the Daiwa–Asahi merger where the resulting troubled Reasona Bank was finally declared insolvent and nationalized by an injection of ¥1.96 trillion in public funds in June 2003. In cases where a large bank absorbed a smaller bank, the premiums were notably higher for the absorbed banks and negative for the absorbing banks. 1 The

reason for taking a benchmark at three days before the announcement is that in several cases stock prices started rising one or two days prior to the news due possibly to information leaks. These cases suggest the possibility of insider transactions which would provide an interesting research topic but is not our concern here.


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Table 1. Share Price Change Following Merger Announcement (From 3 Days Before to 1 Day After) Announce date (mo/da/yr)

Total assets (trillion yen)

Change in share price (%)

Change in Nikkei Index (%)

Premium over Nikkei (% points)

Mitsubishi Bank Nippon Trust Bank Mitsubishi Bank Tokyo Bank

10/12/94

48.8 1.3

2.000 8.333

2.511

−0.511 5.822

3/28/95

48.8 23.9

5.840 12.403

4.110

1.730 8.293

Mitsui Trust Chuo Trust

1/19/99

3.7 1.5

11.650 −6.931

4.659

6.992 −11.590

Fuji Bank Yasuda Trust

1/28/99

51.0 8.1

2.200 23.913

2.044

−4.244 21.869

Fuji Bank Dai-Ichi Kangyo Bank Industrial Bank of Japan Sumitomo Bank Sakura Bank

8/20/99

51.0 52.5

46.927 46.191

2.091

44.836 44.100

42.0

43.785

10/14/99

51.5 47.2

13.078 5.293

−2.550

15.628 7.844

Sanwa Bank Tokai Bank Asahi Bank

3/14/00

45.1 29.2 28.1

−2.851 5.833 7.774

−2.969

0.118 8.802 10.743

Sanwa Bank Tokai Bank Asahi Bank (exit)

6/15/00

−3.462 −0.385 −12.076

−3.900

0.439 3.515 −8.176

TokyoMitsubishi Bank Mitsubishi Trust

4/19/00

66.6

−4.353

−7.220

2.866

16.3

−2.065

Sanwa Bank Tokai Bank Toyo Trust Bank

7/5/00

45.1 29.2

0.000 1.147 7.821

−0.739

0.739 1.886 8.560

Daiwa Bank Asahi Bank

9/21/01

15.3 28.1

−5.556 1.538

0.146

−5.701 1.393

41.694

5.155

One unusual case is Mizuho Holdings which is a merger of three banks of roughly the same size (Fuji Bank, Dai-Ichi Kangyo Bank, and Industrial Bank of Japan). Asset size of the merged bank was especially large, and the rate of excess return is far greater than in other cases. For mergers involving

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trust banks, one exception (Chuo–Mitsui Trust) can easily be explained by the larger bank’s well-known high ratio of bad loans. The impact of bank size on share price has been captured via regression analysis where the dependent variable is the change in share price relative to the Nikkei and the regressor is the asset value of the counterpart bank or banks in the merger. Also included as a regressor is a dummy variable for mergers involving both a commercial bank and a trust bank in order to capture possible economies of scope. The sample comprises the 23 merging banks reported in Table 1. Coefficient estimates are reported in Equation 1 with standard errors given in parentheses. The R2 of the regression is 0.563. % Rel Share Price = −9.493 + 0.398 Assets + 2.002 Trust Dummy. (6.390) (0.099) (6.280) (1) Asset size is significant at the one percent level, while the trust variable is not significant. The asset coefficient estimate indicates that for each ¥1 trillion increase at the margin in the asset value of the counterpart bank or banks in a merger, a bank’s own share price goes up 0.398 percentage points relative to the Nikkei index. The negative intercept, however, indicates that when the counterpart bank is small, a bank’s own share price is expected to fall with the merger announcement. The break-even point derived from the coefficient estimates is ¥23 trillion, although this estimate is subject to a wide margin of error given the high variability of the intercept estimate. Based on these empirical results, the cause of the inflated share prices — whether economies of scale or TBTDA — cannot be identified. Nevertheless, since the correlation coefficient between asset size and profitability of Japan’s 20 largest banks became negative after 1990 (see Figure 2), economies of scale would not appear to have been persistent into the 1990s (Ohashi, Hamada and Sumida 2001). If TBTDA is an incentive for mergers and the difficulty of supervision and regulation arises from the gigantic size of the resulting mega-banks, the difficulty will become apparent in a declining stock price as time passes. The movement of the stock price relative to the Nikkei for four mega-banks before and after merger is shown in Figures 3a–3d. From this retrospective point of view, the decline in stock prices is a sign that the mega-banks failed to raise their efficiency by taking advantage of scale economies.


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1 0.8

Correlation Coefficient

0.6 0.4 0.2 0 –0.2 –0.4 –0.6 –0.8 –1

84

85

86

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89

90

91

92

93

94

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96

97

98

Fiscal Year

Figure 2. Correlation Between Asset Size and Profitability of Japan’s 20 Largest Banks, 1984–1996

Consequently, then, the rise in their stock prices at the time of the merger announcement is suspected as having been motivated by TBTDA. The asset sizes of Japanese mega-banks are by far the largest in the world. Some factors specific to Japan may create incentives for the formation of such large banks. For example, one factor may be the difficulty in reducing risk through geographical diversification of loans due to a high regional correlation of business conditions. Another may be the lack of economies of scope between banking and trust business, as indicated in the regression. Even if identification of the incentives for merger were not possible at the time of the merger announcement, it is important work for bank regulators and supervisors to judge the incentives retrospectively based on bank performance. In the future, we need to avoid bank mergers motivated by TBTDA because of the resulting burden on taxpayers. The bank regulatory and supervisory system plays an indispensable role in preventing moral hazard and protecting the public.

1994/1/5 1994/7/18

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Announcement: Merged: 1995.03.28 1996.04.01

120%

Y. Shimizu

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262

140%

100%

80% Mitsubishi Tokyo

60%

40%

20%

0%

Figure 3a. Stock Price Relative to Nikkei: Mitsubishi Tokyo Financial Group (Tokyo Mitsubishi Bank)

Announcement: 1999.08.20 Merged: 2000.09.29

120%

100%

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60% IBJ DKB Fuji

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0%


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140%

Figure 3b. Stock Price Relative to Nikkei: Mizuho Holdings (Fuji Bank; Dai-Ichi Kangyo Bank; Industrial Bank of Japan) 263

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120% Merged: 2001.04.01

Y. Shimizu

1994/4/11

264

140%

100%

80%

60% Sakura Sumitomo

40%

20%

0%

Figure 3c. Stock Price Relative to Nikkei: Sumitomo Mitsui Financial Group (Sakura Bank)

Merged: 2001.04.02

120%

100%

80%

60% Sanwa Tokai

40%

20%

0%


Figure 3d. Stock Price Relative to Nikkei: UFJ Holdings (Sanwa Bank; Tokai Bank) 2002/10/29 2003/2/5

2002/7/26

2002/4/24

2001/10/15 2002/1/22

2001/7/12

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Announcement: 2000.03.14

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1995/4/20

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1994/4/7

1994/1/5

140%

265

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7. Conclusion There are common problems of moral hazard underlying the financial crises and associated fiscal costs that have plagued transition economies. Mitigating moral hazard in the financial market would help to reduce the fiscal toll of financial crises. Attention to this problem will be even more important in the future under more deregulated and globalized financial markets. The legal and regulatory system must be designed in a way that limits the moral hazard problem. Key elements are full disclosure to achieve transparency and the enforcement of market discipline. Strong political leadership is needed to make a successful transition to more efficient financial markets without allowing banking problems to develop into financial crises. 8. References Berger,A. N., R. Demsetz and P. Strahan, 1999. “The Consolidation of the Financial Services Industry: Causes, Consequences, and Implications for the Future,” Journal of Banking and Finance 23: 135–194. Cornett, M. M. and H. Teharanian, 1992. “Changes in Corporate Performance Associated with Bank Acquisitions,” Journal of Financial Economics 31(2): 211–234. Gaprio, G. and D. Klingebiel, 1996. “Bank Insolvency: Bad Luck, Bad Policy or Bad Banking,” in Michael Bruno and Boris Pleskovic (eds.), Annual World Bank Conference on Development Economics (Washington D.C.: World Bank) 79–104. Honohan, P. and D. Klingebiel, 2000. “Controlling Fiscal Costs of Banking Crisis,” in The Changing Financial Industry Structure and Regulations: Bridging States, Countries and Industries, Federal Reserve Bank of Chicago, Working Paper 2441. Houston, J. F. and M. Ryngaert, 1994. “The Overall Gains from Large Bank Mergers,” Journal of Banking and Finance 18: 1155–1176. Houston, J. F., C. M. James and M. D. Ryngaert, 2001. “Where Do Merger Gains Come From? Bank Mergers from the Perspective of Insiders and Outsiders,” Journal of Financial Economics 60: 235–331. Kane, E. J., 2000. “Incentive for Banking Megamergers: What Might Regulators Infer from Event Study Evidence?” Journal of Money, Credit and Banking 32(2): 671–705.


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Lindgren, C. J., G. Garcia and M. I. Saal, 1996. “Bank Soundness and Macroeconomic Policy,” IMF Working Paper. Ohashi, K., H. Hamada and K. Sumida, 2001. “Effects of Consolidation on Financial Risk,” The Bank of Japan, Bureau of Credit System, Working Paper Series 01-1. Siems, T. F., 1996. “Bank Mergers and Shareholder Wealth: Evidence from 1995’s Megamerger Deals,” Financial Industry Studies (Dallas: Federal Reserve Bank of Dallas) 1–12.


Focus on China


Bank Regulation in China: Property Rights, Incentives, and Accountability Yan Guo Associate Professor, Economics Department School of Economics, Peking University Beijing, China [email protected]

1. Evolution of China’s Financial System and Regulatory Structure The foundations of China’s current financial law were laid in 1995. The Central Bank Law was announced in March granting the People’s Bank of China (PBC), China’s central bank, power to regulate and supervise financial institutions of all types under the leadership of the State Council. Later in the year, the People’s Congress passed the Commercial Bank Law and the Insurance Law which stipulated, for banks and insurance companies respectively, rules of entry, institutional organization, and closure. These laws provided the legal basis for financial operation and financial stability. At the same time, the People’s Congress also announced the Decision Regarding Punishment of Financial Crimes and revised the Criminal Law to define illegal behavior and set punishment. In 1998, regulatory authority over securities firms and insurance companies was transferred from the PBC to the China Securities Regulatory Commission (CSRC) and the China Insurance Regulatory Commission (CIRC) respectively. China’s financial regulatory structure thus comprised the PBC, the CSRC, and the CIRC, as depicted in Figure 1. Within the PBC, four departments have held regulatory and supervisory roles. Bank Department I has regulated state-owned commercial banks, policy banks, and foreign banks, and Bank Department II other commercial banks, such as joint stock banks and cooperative banks. The Non-Bank Financial Institution Department has regulated all non-bank financial institutions except securities firms and insurance companies. The Credit Cooperative 271

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Policy banks Banks Commercial banks

Credit cooperatives

UCCs RCCs

PBC

Non-bank financial institutions

TICs Financial companies

Overseas Chinese financial institutions

Leasing companies Foreign banks

Foreign financial institutions

State Council

Representative office

Securities companies CSRC

Securities exchanges Brokers Insurance companies Insurance brokers

CIRC Insurance agencies Insurance evaluating companies

Figure 1. China’s Financial Regulatory Structure Before April 2003

Department has regulated Urban and Rural Credit Cooperatives (UCCs and RCCs). In addition, there has been an Internal Audit Department responsible for auditing and examining the PBC’s own operations. In April 2003, the China Bank Regulatory Commission (CBRC) was carved out of the PBC bank regulatory departments divorcing regulation from the central banking role of the PBC.

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Arguments in favor of this separation of responsibilities have focused on the need to improve regulatory efficiency.1 The main arguments given in favor are as follows (Xue 2001; Wei 2001): (1) Conflicting goals between regulatory policy and monetary policy may influence the independence of monetary policy. Achievement of monetary policy targets may be compromised for the sake of regulatory goals. (2) With WTO entry, China’s separate commercial and investment banking systems should be transformed into a universal banking system in order to compete with foreign financial institutions. Therefore multiple regulators should be integrated into a single regulator to lower coordination barriers across different regulatory domains. CBRC is a transitional institution, which will strengthen bank regulation and prepare for future regulatory integration. Arguments have also been made against the separation of bank regulation from central banking. They are as follows (Xie 2002): (1) A universal banking system does not necessarily imply a single regulator, nor is it clear that a universal banking system is the best choice for China. China’s financial system is dominated by commercial banks and indirect financing. During the transition from central planning to markets, this banking system is vulnerable to external shocks. Eliminating the boundary between commercial banking and investment banking and separating regulation from central banking will undermine the stability of the financial system. (2) The regulatory capacity of the PBC is bolstered by its access to currency reserves, its political independence, and its strong human and information resources. Any separate regulatory organ would have to cooperate with the PBC, especially in the event of a banking crisis. Bank regulation and monetary policy are complementary, particularly in sharing information and handling crises. The costs of information transfer may 1 Debate on the separation of bank regulation from central banking began in earnest in 2000 when the chairman of one of the district People’s Banks wrote to Premier Zhu Rongji advocating it. The Premier sought further input from the PBC and from the State Council where research projects on financial regulation were undertaken by the Office for Restructuring the Economic System and by the Development Research Center.

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be higher than the benefits of regulatory autonomy at this early stage of China’s regulatory development. (3) A sound legal framework and good law enforcement are more important than the specific form of regulatory institutions. The ineffectiveness of China’s financial regulation is the result of poorly defined legal principles and ambiguous regulatory goals. These differing views on how to reform the financial regulatory system arise from differences of opinion as to how best to deal with problems that have existed under PBC administration of bank regulation. What follows is an examination of problems in China’s banking system and the efforts that have been made to address these problems with a view to understanding the limitations of a regulatory agency under existing circumstances. This should help to better inform thinking on how to improve the effectiveness of financial regulation in China. 2. Reform of State-Owned Banks China’s banking system is dominated by state-owned commercial banks. A heavy burden of non-performing loans (NPLs) and low capitalization ratios undermine system performance. In recent years, the PBC has implemented a series of measures to reduce NPLs and control commercial bank risk, as outlined in this section. 2.1. Elimination of credit quotas Commercial bank lending volume used to be controlled by quotas based on the credit plan made by the PBC. Beginning January 1, 1998, the PBC replaced compulsory credit quotas with indicative credit goals allowing commercial banks to make independent lending decisions and to bear the risks of those decisions. Under the new system, total lending must comply with asset/debt ratio standards and PBC monetary targets. The abolition of credit quotas meant the central bank could no longer control the money supply directly to implement monetary policy. Concerns had been raised that inflation would result from this removal of credit controls. However, it turned out that commercial banks had become more cautious about lending after 1995 because they would be held accountable for any new addition of bad loans after this point. In 1997, only 80 percent of credit quotas were


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lent, yet in 1998, the PBC lending target was increased by 25 percent over 1997 (Mao 1999, 78). On the one hand then, there is a large volume of unused funds reserved for lending by the PBC, while on the other, many small and medium sized private enterprises cannot get financing. Use of bad loans as a performance indicator makes bank managers overly cautious in their lending decisions given the lack of countervailing incentives to seek rewards from risk. This prevents the effective allocation of limited financial resources and points up the lack of competition for deposits in China’s financial market. 2.2. Recapitalization of state-owned commercial banks In order to increase state-owned banks’ capital/asset ratio to eight percent as prescribed in the Basel Accord,2 the PBC in 1998 reduced the reserve ratio from 13 to 8 percent and the Ministry of Finance issued RMB270 billion in special bonds to strengthen the capital position of the four state-owned commercial banks. Funds released for lending due to the reduction in the reserve ratio amounted to RMB377 billion (Mao 1999, 73). To offset the inflationary impact of this, the PBC called back RMB270 billion in loans to commercial banks. As a general rule, capital injection by central banks should be very cautious and sufficient to solve bank problems since moral hazard will be fostered if bankers expect another round of injection. A second injection would cause further harm still to central bank credibility not to give more injections. The injection of RMB270 billion by the PBC, however, raised commercial banks’ capital/asset ratio to only about six percent.3 Estimates of the sum needed to recapitalize the banking system in the face of accumulated bad loans vary with different approaches to calculation, and lack of data compromises the estimation exercise. It is widely believed though that more than RMB2 trillion will be needed to resolve the problem. 2.3. Transfer of NPLs to asset management companies (AMCs) The Chinese government set up four asset management companies corresponding to the four main state-owned commercial banks to absorb NPLs on lending done before 1995. In 2000, the total value of NPLs transferred to the 2 http://www.bis.org/bcbs/bcbscp2.htm 3 This

figure is computed using assets not weighted by risk (Mao 1999).

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AMCs was RMB1.4 trillion. Then, President of the PBC, Mr. Dai Xianglong, announced that the NPL share in the loans of state-owned banks amounted to about 25 percent by the Basel four-category standard and 30 percent by the five-category standard.4 According to the government’s schedule, stateowned banks are to reduce their NPL balances to 15 percent in five years. The huge NPL burden was generated under government lending dictates, so it is appropriate for government to provide support in resolving the problem. The sum of money that will be involved is a sensitive topic. According to Standard & Poor’s, the cost for China to reorganize its commercial banks will be about RMB4.5 trillion (US$540 billion), or 50 percent of 2000 GDP. This figure rests on an NPL estimate of about half of the total RMB11.3 trillion in loans outstanding.5 Considering the record of other Asian banks and China’s similarly high ratio of non-mortgage loans and lack of legal protections for creditors, the proportion of NPL debt that can be expected to be repaid may be only about 20 percent of the total with the remaining 80 percent to be backed by the Chinese government.6 Though this estimate is not universally agreed upon by Chinese experts, NPLs are by all reckonings a big headache for the Chinese government. The burden of NPLs has been removed from state-owned banks by the AMCs, and elimination of the credit quota has provided banks with independence and room to make decisions based on market principles. However, removing NPLs only resolves the historical problem, whereas how to better manage new lending through proper internal incentives and external regulation is the essential issue.

2.4. Classifying loans based on risk Before 1997, commercial banks classified loans by time overdue according to “one overdue debt and two bad debts” which refers to loans overdue for less than three months, between three months and 24 months, and over 24 months. China’s commercial banks used to have no independent authority to allocate reserves against bad loans, and write-offs had to be approved by the Ministry of Finance. In 1993, the Ministry stipulated that commercial banks should allocate 0.6 percent of total net loan value as reserves, with 4 http://www.bis.org/publ/bcbsc001.htm 5 The

Standard & Poor’s estimate includes NPLs of non-bank depositary institutions.

6 http://business.sohu.com/20011011/file/0000,022,100087.html


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this amount to be increased by 0.1 percentage points per year to reach one percent. This ratio of one percent is substantially lower than international standards and far too low to cover the assets at risk. In 1998, China introduced a new risk-related system for classifying bank loans by repayment probability and undertook a trial of the system in Guangdong Province. Under this system, bank loans are grouped into four categories based on international criteria — attention, inferior, doubtful, and loss, and into five categories based on the PBC’s own criteria — standard, attention, inferior, doubtful, and loss. Commercial banks were then, in principle, to independently allocate reserves at different ratios for each of these loan categories. The three month trial in Guangdong, however, revealed that the new classification system increased the NPL ratio by more than 10 percentage points (China Business Accounting System and Financial Regulation Research Group 2001). Due to concerns about political image and social stability, the scheme had to be shelved temporarily and the PBC directed commercial banks to continue the old approach to classification. Finally, in July 2001, the five category classification system was implemented, with provisions for commercial banks to more independently allocate loan loss reserves and write-off bad debt. Write-offs can be decided by commercial banks and approved by the commission office at the Ministry of Finance. The implementation of this new approach, which eliminates direct government intervention on reserve allocation decisions, will give bankers more independence to manage bank assets and regulators more reign to effectively supervise bank behavior.

2.5. Dispensation of unprofitable bank branches China’s state-owned banks have traditionally taken pride in their wide network of branches throughout the country. Almost every county had branches of the four state banks, but over 95 percent of profitable branches were located in the main coastal cities. The extensive branches in northwest China routinely suffered losses. To improve efficiency, the PBC in 1997 began calling on banks to merge and close unprofitable branches. In June 1998, the PBC, with State Council approval, outlined detailed guidelines for closing and merging redundant and unprofitable institutions. Closure was prescribed for all branches with deposits of less than RMB500 thousand and some with deposits of between RMB500 thousand and RMB1 million, and merger for branches with deposits between RMB1

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and RMB1.5 million. Three of the four state-owned banks were required to reduce their county level branches by specified proportions: 20 percent for the Industrial and Commercial Bank of China (ICBC); 10 percent for the Bank of China (BOC); and 30 percent for the People’s Construction Bank of China (PCBC). This process was to be completed by the end of 2000. Since 1999, the four state-owned banks have closed or merged over 30 thousand branches, mostly in economically less-developed regions thereby concentrating their business in big cities and developed regions. This government mandated process has left a void of financial services in some regions. It has also resulted in layoffs that have created a burden for local governments. Forcing closures according to rigidly defined central dictates prevented banks from exercising judgment and considering market factors in maintaining their branches. Unlike NPLs that resulted from government intervention in bank decision-making, branch development had not been dictated by government but rather was the outcome of commercial bank internal growth processes. In principle then, there is no reason why government should force commercial banks to close branches based on arbitrary size criteria. Imposing standards for closing and merging branches limits the management function of state-owned banks and simplifies the supervisory role of regulators. As with NPLs, government has lifted the burden of responsibility from commercial banks. But how to control creation of unprofitable branches in the future is the key issue for bankers and regulators. Government involvement cannot be a long-term solution. Frequent recourse to government intervention may give bankers an excuse for inefficiency and even malpractice.

2.6. Reorganization of the PBC The PBC reformed its organizational structure in 1998 to try to eliminate local government interference in bank regulation. Thirty-one provincial and municipal branches were merged into nine PBC district banks. The president of each district bank is appointed directly by the central bank rather than by the local government. The PBC reorganization was meant to address problems inherent when commercial banks, rather than being independent business entities, fall under local government administration. Under such a system, local governments treat banks as agents of economic policy, or less magnanimously


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as vehicles for rent seeking. This makes it very difficult for regulators to supervise bank behavior. Problems with bank oversight remained following the PBC reorganization due to conflicts within the administrative hierarchy. Specifically, the provincial commercial banks used to be supervised and regulated by PBC offices at the corresponding province level. Following the PBC reorganization, the district PBC has in principle become the primary regulator of provincial commercial banks, but in practice the district PBC can only regulate provincial banks located in the district’s capital city. For provinces that do not have a district PBC, the provincial branches of the PBC and the newly established Offices of Regulation take on the regulatory function. Because the outlying provincial commercial banks are of a higher administrative rank than their de facto regulators, they can easily circumvent supervision. Both regulator and banker behave as bureaucrats according to their administrative levels, conspiring to mutual advantage. The salary and promotion incentives of both agents depend not on achieving regulatory goals, but rather on complicated relationships among government officials. The general aim of all the measures outlined in this section is to create a healthy external environment for state-owned commercial banks to operate as independent enterprises and for the central bank to function as an independent regulator. However, the long history of the relationship between government and central bank and government and state-owned commercial banks cannot be overcome immediately. Without effective incentives for banker and regulator to control risk, the link with government cannot be cut and we therefore cannot expect a sound banking system to take shape. 3. Dealing with Problematic Institutions In January 2002, three overseas branches of the Bank of China (BOC) in the US were fined US$10 million by the US Office of the Comptroller of the Currency. Meanwhile, the National Auditing Bureau found illegalities with respect to lending, letters of credit, bank acceptances, and so forth, totaling 22 cases and involving RMB2.7 billion. The former president of the BOC and then-president of the PCBC, Wang Xuebing, was fired because of his “direct or indirect responsibility”. The BOC is one of China’s best run stateowned commercial banks and the only one to disclose information regularly, and Wang had a reputation for being one of the most outstanding bankers in China. This event prompted people to think about the Chinese banking

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industry and regulatory system and about the importance of appropriate incentive structures apart from particular leaders. Measures at the disposal of the PBC to deal with problematic institutions include closure, reorganization, merger and acquisition, and buyout. In this section, particular cases will be examined to see how these measures have been implemented. Since 1997, China has closed a number of prominent financial institutions including one commercial bank (Hainan Development Bank) and four trust and investment corporations (China Agricultural Trust and Investment Corporation, China Venturetech Investment Corporation, Guangdong International Trust and Investment Corporation, and most recently Guangda International Trust and Investment Corporation). In addition, 23 urban credit cooperatives and eight rural credit cooperatives have also been closed. The total asset value of these shuttered institutions is RMB108.9 billion (Liu 1999, 253).7 3.1. Closure of Hainan Development Bank (HDB) Hainan Development Bank was the first commercial bank closed in China. HDB was created at the initiative of the Hainan provincial government by merging five problematic trust and investment corporations. In August 1995, the PBC approved its establishment as a joint stock bank with total registered capital of RMB1.677 billion, of which RMB631 million originated with the five trust and investment corporations and another RMB1.046 billion was injected by new shareholders. From that point, HDB expanded rapidly by setting up branches and increasing assets. But a serious insolvency problem emerged in November 1997 (Wang 2002). Also at that time in late 1997, most of the 34 urban credit cooperatives in Hainan had liquidity problems which seriously influenced social stability in the province. With approval by the State Council, the PBC merged 33 of the urban credit cooperatives into HDB and injected new funds to address the insolvency problem. The emergency package temporarily saved HDB and the UCCs from a payments crisis. However, not long afterward, a crisis point was reached again. Finally the PBC closed HDB on June 21, 1998 and authorized the ICBC to take it over. 7 This

figure excludes Guangda International Trust and Investment Corporation because it was still in the process of liquidation.


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A PBC investigation found the following risk factors that disposed HDB to failure: • Total capital was less than stated because HDB provided its shareholders with funds as capital and did not write off the assets when balances were withdrawn. • Long term assets were financed by short term borrowing from the money market. • Asset risk was high because HDB invested heavily in real estate during a bubble. • HDB deceived regulators by reporting a balance sheet that included interest receivable on bad loans but excluded interest payable on debts. Why did these problems occur? To some extent, HDB was the victim of broader economic circumstances. When it was set up, the total GNP of Hainan province was only RMB600 million but commercial banks, including branches of the four state banks, numbered over 1000, in addition to which there were 21 trust and investment corporations and 34 urban credit cooperatives. To survive, many institutions incurred high costs to attract deposits and got involved in illegal activities. Economic policy was relaxed after the end of 1992 when Deng Xiaoping took his “Southern Tour”, real estate started booming, and investment funds poured into Hainan. When policy then tightened after 1994, the real estate bubble burst and investment collapsed. Many institutions met with crisis, and HDB was caught up in this larger milieu. However, there were also problems specific to HDB. Initial assets were evaluated based simply on the balance sheets provided by the five trust and investment corporations without independent audit. During the eight month consolidation period, managers of the original corporations exploited the opportunity to pursue personal gain, later investigation revealing huge drawdowns of assets over this interim. Compounding the problem, the merged entities were not integrated into a single functioning unit for a long time leaving internal gaps in management. The PBC repeated these errors when it merged in the 33 UCCs in 1997. This further merger was undertaken out of concern for broader economic stability and is emblematic of the larger problem of government intervention in bank management and regulation. Risk-taking was out of control not only in subordinate units, but at HDB headquarters as well. Even though HDB was formed as a joint stock

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commercial bank with oversight ostensibly by a board of directors, neither this nor external supervision were effective in reining in risky investment in such areas as foreign exchange transactions in Hongkong and establishment of overseas branches. In June 1998, the PBC closed HDB in accordance with the Commercial Bank Law, the PRC Corporate Law, and the PRC Rules of Financial Institution Management. The PBC appointed ICBC to take over all HDB assets and debts, and foreign creditors and domestic depositors were 100 percent guaranteed by the Chinese government. The case of HDB yielded a number of lessons regarding bank regulation: (1) The PBC did not effectively guard the new institution against the interests of local government. Local officials prefer to avoid closure of any financial institutions in their regions, and local PBC officials are complicit in accommodating this desire because their professional advancement depends on personal relationships within the government. (2) Because auditors are not held legally responsible for their performance, fair and independent audit of bank financial statements did not take place. (3) Both regulators and bank managers could benefit from the merger, with losses passed on to society as a whole. Merger and reorganization hid real problems and even worsened these problems. Bad loans from the original banks were taken over by a new institution aggravating moral hazard for both old and new managers. Unfortunately, failure in the first round merger did not prevent a repeat in the second round merger and even the ultimate folding of the failed institution into a state-owned bank. Mounting problems were covered up with ever bigger institutions, ultimately coming to rest with the state. At each stage of the HDB debacle, no one took responsibility for the loss of assets and everyone took advantage of opportunities to seek rents. The situation was rife with moral hazard, a problem compounded by poor information disclosure and weak accounting and auditing systems. Bank managers maximized their own payoffs to the detriment of bank profitability. Regulators hid problems, saving their own reputations and pleasing senior government officials. Neither bank managers nor regulators would ultimately bear the consequences because blame could be laid on government intervention.


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3.2. Clean up of trust and investment corporations (TICs) China’s trust and investment corporations were created in the early 1980s by local governments and state-owned commercial banks (Zhu 1999). TICs have helped state-owned banks escape credit controls and PBC regulation. Local governments could make use of TICs to develop their local economies. TICs shared the resources of their parent banks but pursued their business under looser regulatory control. Managers of TICs took advantage of their situation by investing in highly risky assets. While nevertheless contributing to the local economy and especially to the development of small and medium sized non-state enterprises, society as a whole was exposed to the downside risk from the investments. As early as April 1982, the State Council announced the Notice to Clean up TICs. All TICs owned by local government were to cease operation. Only those owned by state-owned commercial banks were allowed to carry on, and these were brought under central credit planning. In 1984, China’s economy was overheating. Credit and money supply growth were out of control. In 1985, the PBC wanted to reign in TICs and temporarily suspended their activities. But not until 1986 was there a formal legal basis for regulating TICs with the PBC announcement of the Temporary Rules for TIC Management. After 1986, TICs had another round of boom with their numbers eventually peaking at over 1000. From 1988 to 1991, under circumstances of high inflation and general market disorder, TICs sprang up under local government support. Most of them provided unauthorized services that diverted funds from the banking system to beyond the PBC regulatory reach. The State Council and the PBC therefore decided to separate TICs from commercial banks. In this process of separation, the PBC closed about 150 TICs. The PBC barred commercial banks from lending to TICs and further, in the Central Bank Law, blocked the financing channel between TICs and the central bank. Even so, from 1991 to 1993, TICs experienced further rapid growth engaging heavily in real estate investment. In 1999, securities investment was declared off-limits to TICs, and their investment banking arms were spun off into new companies or merged with existing ones. To further control risk and achieve economies of scale, the PBC closed, merged, or reorganized large numbers of TICs. Finally, in

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October 2001, the Trust and Investment Law was issued with the result that the number of TICs was further reduced to a projected 100 or so. Successive rounds of TIC clean up focused on merger, regulation, separation from commercial banking, and limiting the scope of business activity. Each round was influenced by current economic policy indicating that China’s financial regulation is driven by short term considerations rather than broader long-term principles. Rapid economic growth is associated with loose regulation and chaotic expansion of the financial industry. Subduing an overheated economy is associated with regulatory tightening. The overall pattern of financial regulation is thus inconsistent, and more reactive than proactive. The PBC often ignores troubled individual institutions only to find that the problems become systemic and beyond its control. An old Chinese saying is called to mind: “law fails when there are too many criminals” (fa bu ze zhong). All law breakers are then able to escape punishment. Three particular cases of TIC clean up merit detailed examination, these being Zhongyin Trust and Investment Corporation, Guangdong International Trust and Investment Corporation, and Guangda Trust and Investment Corporation. • Zhongyin Trust and Investment Corporation (ZYTIC) The PBC discovered that Zhongyin Trust and Investment Corporation was insolvent during an audit of its foreign exchange transactions. It then took over the institution in October 1995 for a one year period during which an independent accounting firm was retained to evaluate all assets and liabilities. At the end of the year, the PBC arranged for Guangdong Development Bank to take over. The audit revealed ZYTIC had been involved in extensive illegal dealings. ZYTIC paid interest rates above the PBC cap, putting its monthly financing costs at 1.68 percent. Its reserve account at the PBC was in deficit to the tune of almost RMB53 million. Loans to shareholders plus capital withdrawn by shareholders combined to reach 66 percent of total capital. Overdue loans stood at 82 percent of loans outstanding. Much of the asset portfolio was tied up in real estate investment. The manager had hidden mounting problems by fabricating financial statements. That problems had reached this extreme reflects seriously on the PBC’s oversight capability. The ZYTIC story again shows China’s financial regulation to be ex post and too late to avert major losses. ZYTIC was set up in 1988 and became insolvent in 1993, but the insolvency was not discovered by the


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PBC until 1995. The state of ZYTIC’s affairs by this point, complete with branches operating unlicensed, exposes a serious lack of market discipline permitted by a belief on the part of depositors that government will insure all losses. As for internal control, because shareholders took advantage of getting loans from ZYTIC, the board of directors exercised no control over managers at all. What is more, most shareholders were state-owned enterprises so that directors represented state property and felt little sense of real responsibility. • Guangdong International Trust and Investment Corporation (GITIC) Because foreign creditors are involved in international TICs, the PBC had been especially cautious in dealing with them for political reasons. Although some insolvent institutions had been liquidated, domestic household depositors and foreign creditors were generally guaranteed fully by the central government.8 Against this backdrop, the case of Guangdong International Trust and Investment Corporation shocked the international financial community. In closing GITIC in October 1998, the Chinese government announced that all creditors would be treated equally and government would not compensate their losses (Zhu 1999). GITIC had 135 foreign creditors out of a total 240, and liabilities to foreigners amounted to about half the total. Some of the foreign debts were not registered with the State Authority of Foreign Exchange which made them illegal, and these the Chinese government refused any responsibility for. Some foreign creditors tried to persuade the government to reorganize GITIC. However, according to China’s Bankruptcy Law,9 reorganization can be applied only when creditors force an enterprise to liquidate, and GITIC had applied for bankruptcy voluntarily. GITIC’s liquidation was a landmark for the Chinese government in demonstrating that it would no longer provide full guarantee of financial institutions. In the aftermath, there were runs on some financial institutions, and Standard & Poor’s immediately lowered its rating of China’s sovereign debt. This, however, was the price of reducing moral

8 When the PBC closed the ChinaAgricultural Trust and Investment Company, discrimination

between domestic and foreign investors led to a strong reaction by domestic creditors which made liquidation more difficult. 9 The Bankruptcy Law was passed in 1986. There is no special bankruptcy law for financial institutions.

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hazard in the longer term and ultimately achieving greater discipline in the financial system. • Guangda International Trust and Investment Corporation (GDITIC) On January 25, 2002, the PBC announced it was closing the Guangda International Trust and Investment Corporation.10 GDITIC was founded in 1991. Five years later, it reported to the State Council that it was insolvent and in crisis with RMB2.52 billion in losses. In October 1996, the State Council authorized the PBC to take the following measures to address the crisis: (1) extending US$500 million in emergency loans and renewing loans of RMB1.086 billion; (2) swapping RMB4.23 billion in debt for equity;11 (3) permitting GDITIC to stop interest payments to other financial institutions for three years in the amount of RMB4.62 billion; and (4) authorizing Guangda Group to issue RMB2.1 billion in bonds. In addition, GDITIC was to receive about RMB1.018 billion in tax refunds for the period 1996–1999. But although GDITIC got RMB12 billion in debt relief from the emergency package, it still had huge debts to be paid. In August 1996, GDITIC was ordered to stop efforts to collect its overdue loans. Most of its assets were in real estate investment, loans to unprofitable state enterprises, and low returning equities. These assets were plagued with unclear property rights, 37 real estate projects of 76, for example, not being properly documented legally. These problems greatly hindered debt collection. Closure of GDITIC had negative repurcussions for the stock prices of other companies held by Guangda Group, which is one of the biggest financial holding companies in China.12 This occurred despite Guangda Group immediately announcing that GDITIC was an independent firm, assets of which amounted to only 1.6 percent of the Guangda Group total, and that its closure would not influence other companies’ operations. The PBC put up about RMB12 billion over the course of five years, along with an enormous input of human resources, trying to salvage 10 http://www.ynetc.gov.cn/qygg/228.htm 11 Subsequently, GDITIC signed a contract with its creditors promising that those equities can be swapped back to debt in three years. 12 Guangda Group had total assets of RMB230 billion, with interests in securities companies and insurance, and six listed companies in HK and Singapore.


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GDITIC. In the end, however, GDITIC could not avoid a fate of bankruptcy, and regulatory forbearance had far reaching social costs. Of specific note, as part of the emergency package Sinopec swapped its debt for equity in GDITIC and also suffered major losses. PBC handling of the GDITIC case did ultimately reflect a change in approach in that the government finally decided to back away from guaranteeing financial institutions and their depositors. This constituted a step in the right direction toward reducing the moral hazard pervasive among both bankers and their creditors. TICs, as non-bank financial institutions, have played a positive role in strengthening competition in the financial market and channeling investment funds into the private sector. Under a more mature regulatory environment, managers of TICs would ideally have incentives to build more diversified asset portfolios than their peers at state-owned banks. 3.3. Urban credit cooperatives (UCCs) China’s urban commercial banks were formed by merging and reorganizing problematic urban credit cooperatives. Existing assets and liabilities were taken over by new institutions, with bad loans carried on the books at face value. New institutions were thus born with unrealistic financial assessments that had them heading toward crisis from the outset. Most urban commercial bank crises occurred within one year of bank establishment.13 UCCs were originally established with the aim of supporting local economic development, so local governments intervened heavily in their activities. Many UCCs became the financing channel not only for local governments but for their shareholders as well. Hence loans to government projects and shareholders form the bulk of the assets of problematic UCCs. When servicing of these loans foundered, UCCs resorted to unsound methods of attracting deposits, even offering loans for deposits. Regulation at the local level was so loose that some UCCs never got operating licenses from the PBC. But because they had local government support, they could still register as required of all businesses with the local Industrial and Commercial Bureaus. At the grassroots level, pleasing senior government officials is the first priority for bank regulators as their interests depend largely on 13 In

a total of nine cases, crisis occurred between six and 18 months after the bank was established (Liu 1999).

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their relationships with these officials. So regulatory independence cannot be achieved. In clear violation of the law, regulator and bank manager were in some cases one in the same person, with PBC employees themselves becoming UCC shareholders. In one case, an urban commercial bank was established by merging 48 UCCs, which then became the branches of the new bank. Less than two years later, the bank’s capital ratio was only 0.74 percent, its ratio of deposits to assets was 103 percent, and its non-performing loan rate was 87 percent. One UCC manager had lent to his own 11 companies in the amount of RMB217 million, which represented 92 percent of the UCC’s assets. Another manager had lent RMB289 million to his son’s company for 88 percent of the UCC’s assets. Many UCCs became financing agents for the entities that held them. Among the 48 UCCs, 27 belonged to government organs, two to educational institutions, 13 to other financial institutions including two that belonged to the local PBC, four to companies, and two to other types of institutions. The UCCs not only generated investment funds for their holding institutions, they contributed to the support of the employees of these institutions and even provided employment opportunities for their children. In order to preserve their liquidity, some UCCs attracted deposits by promising high interest rates. When the PBC finally intervened to clean up the situation, nine of the bank’s 43 branches were being run by depositors. Local governments intervene not only in the operation of UCCs and their successor commercial banks, but also in PBC supervision of these institutions. Even when UCCs are insolvent and should be closed, local governments often prevent the PBC from acting. Sometimes in order to try to save an insolvent institution, local governments go so far as to order competing institutions not to take new deposits so as to channel deposits to the troubled institution. UCC reorganization into urban commercial banks has become a way to hide problems. The result is that the problems are compounded as bankers take ever more risk knowing that responsibility can be shifted to government as the institutions become “too big to fail”.

3.4. Rural credit cooperatives (RCC) Rural credit cooperatives got their start under local governments during the Great Leap Forward in 1958. Following the Cultural Revolution in the late 1970s, they were merged into the Agricultural Bank of China (ABC).


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RCCs were thus positioned as both rural cooperative institutions and local units of the state bank. But RCCs lost their independence under control of the ABC and suffered the same problems as state-owned banks generally. In addition to the usual negative impact of government intervention, the low quality of personnel and competition from illegal financial institutions compounded RCC problems (Shang 2000). At an RCC in Hainan province, for example, only six of 70 employees had finished high school. The managers in seven of nine troubled RCCs examined in one study had been implicated in illegal business activity. One of them was sent to prison and, bizarrely, another had been selected as “an excellent role model” repeated times. Though there are no hard data, it is widely thought that the ratio of NPLs in RCCs is higher than in state-owned banks. Because of the cooperative origins of these institutions and the nature of their assets, the same remedies do not apply as with state-owned banks. In late 1996, RCCs were separated from the ABC and restructured by the PBC. The county level PBC now supervises and regulates RCCs. Although managers of RCCs are elected by shareholders, the caliber of management is still far from ideal. Based on experience, RCC managers and depositors have come to expect government guarantees so that the incentives for depositors to elect qualified managers and for managers to control risk are weak. Under the burden of high NPL ratios and heavy government intervention, managers can escape responsibility for their actions and are inclined to take excessive risk. The experiences examined in this section point to common problems from the smallest RCCs to one of the biggest commercial banks in China. Regardless of size or managerial talent, without effective incentives, regulators neglect ex ante supervision and hide problems while bankers pursue their own self-interest. Depositors, expecting to be fully insured by the government, do not exercise market discipline over banks. Government intervention provides a convenient excuse for both bank regulator and manager to escape responsibility. Though the trappings of a modern corporate governance structure and legal framework have been put in place, without changes in the incentive system, the regulatory structure alone will not ensure an efficient and well-managed financial system. 4. Clean Up of Illegal Bank Funds in the Stock Market Since China’s first stock market was established in Shenzhen in 1990, the issue of how to manage the flow of bank funds into stock investing has been

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the subject of debate.Although the PBC used to impose stringent restrictions on the use of bank funds for stock purchase, more recently controls have been relaxed. Prior to the promulgation of the People’s Bank of China Law in 1995, there was no clear official position on the use of bank funds for stock investing. The first few years of stock market take-off attracted huge sums of money, including bank funds. At that time, most banks had their own securities departments that had full access to bank capital with no administrative firewall to delineate risk behavior between commercial banking and capital market activities. As many securities companies had no capital of their own, bank funds were key in supporting the stock market. Besides the direct channel of investment through bank securities departments, indirect channels existed including the inter-bank loan market, repurchase agreements, diversion of bank loans to enterprises, and bank discounted loans on letters of credit. China’s Commercial Bank Law of 1995 formalized and reined in the commercial banking system, prohibiting commercial banks from engaging in trust and investment banking activities. Further, the PBC, the Ministry of Finance, and the CSRC jointly announced the Notice on Regulating Security Repurchase Agreements requiring that institutions engaged in repurchase must have 100 percent bonds and financial securities of their own and must trustee their holdings to a special security registration trustee company. The Notice helped stop the money flow from banks to non-bank financial institutions. Two years later in 1997, the PBC announced three more rules to prevent bank funds from leaking into the stock market, specifically, the Notice Banning Bank Fund Investment in the Stock Market, the Notice Prohibiting Commercial Banks from Engaging in Securities Trading and Repurchase Agreements, and the Notice Forbidding State-Owned Enterprises and Listed Companies from Trading Securities, which greatly restrained bank funds from being diverted into the stock market. However, these three notices were so stringent as to almost cut the connection between the money market and the capital market. Code 133 in the Securities Law of 1999 identified two illegal ways for bank funds to flow into the stock market, specifically, when commercial banks and their affiliates trade stocks and when financial institutions and enterprises borrow money from banks to trade stocks. However, this legislation did not specify any legal way for bank funds to enter the stock market.


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So in August 1999, the PBC announced another two rules to provide a legal basis for securities companies and mutual funds to borrow money through the inter-bank market. Thus for the first time, bank funds found an official legal channel into the stock market. Though legislation has put limits on legal avenues for bank funds to enter the stock market, lax enforcement means illegal channels are still used to divert bank funds. For example, commercial banks allow overdraft when doing settlement for financial institutions, some securities companies too allow overdraft for their customers, and securities companies delay client deposits with commercial banks and divert the money to investment. By year end 2000, it was estimated that bank funds in China’s stock market stood at RMB450–600 billion, representing about 28–37 percent of market capitalization and 4.5–6.0 percent of bank loans, with about 2/3 of this being illegal (Wu, Song and Ying 2001). In recent years, money supply growth has been much higher than nominal GDP growth, which is consistent with bank funds leaking into capital markets and suggests asset prices have been inflated by the diversion of bank funds. In one noteworthy case, four banks in Liaoning Province were found in July 2001 to have discounted commercial paper fraudulently issued by enterprises to shift RMB510 million into the stock market. The PBC censured the presidents of the four banks. After this, it was expected that the PBC would clamp down on the illegal flow of bank funds, and such expectations drove stock values down. There are two sides to consider in assessing the use of bank funds for stock investing. On the one hand, such investment can help to diversify bank asset portfolios and facilitate joint development of the money and stock markets. On the other hand however, without effective regulation, especially when the stock market is driven by speculation and the banking system is not sound, it will greatly increase risk in both markets. In China’s present circumstances, loose internal control and inefficient law enforcement are the overriding problems. To summarize, the Chinese government and the PBC have made much progress in reforming the banking system and developing a regulatory infrastructure. However, behavioral incentives for both bankers and regulators remain problematic and as a consequence, risk is not properly managed and society’s interests are harmed. The ready recourse to government intervention as an excuse for bank mismanagement compounds moral hazard problems.

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Laws on the books are inconsistently enforced which implies either that the laws are intrinsically flawed or that law enforcement mechanisms are poorly developed. As an illustration of the ineffectuality of the legal system, one manager of a UCC was fined a mere RMB10,000 for illegal lending.14 Nevertheless, he kept his job and went on to run the UCC to insolvency. Although systematic data are lacking, we must suspect that political pressure is a big factor in law enforcement, or the lack of it. Normally, information disclosure can help mitigate moral hazard problems, but because government at both local and central levels is accustomed to concealing problems, reform of the accounting system has lagged. The approach of the PBC is to investigate and clean up only when problems become too serious to be ignored. Only when the danger threatens the whole system do the government and the PBC face up to it and take action. 5. Potential Problems Associated with WTO Entry With WTO entry, China’s financial system will come under pressure from competition with foreign banks. Chinese banks will be at a disadvantage with respect to market orientation and provision of services. This raises challenges not only for commercial banks, but also for financial regulators. There are already instances of companies paying off debts to Chinese banks and turning their business instead to foreign banks operating in China.15 Most foreign banks can provide a diversified array of financial products involving loans and deposits, securities, and insurance, along with innovative services that bridge these traditional product categories. Chinese financial institutions, by contrast, are confined to narrow niches by the regulatory structure and have little latitude to cooperate and innovate in recognition of trends in global financial development, the PBC has begun exploring possibilities for banks to cooperate with insurance and securities companies. Nowadays banks can provide some intermediate services and can farm out other business to insurance and securities companies. This is blurring the boundaries between different types of financial businesses. China’s regulatory agencies — the PBC, CSRC, and CIRC — have realized the importance of cooperation and are engaging in regular consultation among themselves. 14Author’s

personal interview. example is Eric Co. moving its business to Citibank, http://news.sohu.com/92/09/ news206220992.shtml. 15An


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Prior to WTO entry, domestic and foreign bank business activities were strictly separated. With WTO, the separation is being dismantled and correspondingly the regulatory system must be redesigned. Under initial conditions, foreign banks have the advantage on interest rates, taxes, and scope of services. In such service areas as consulting and accounts management, foreign banks have autonomy even to the extent of charging different fees to different clients for the same service whereas domestic banks have limited flexibility is setting fees. The PBC has announced in Rules on Intermediate Business that commercial banks can decide their own service prices based on market conditions except where the pricing authority of the State Development Planning Commission prevails. Ultimately then, granting flexibility to banks on interest rates and service commissions depends on cooperation between the PBC and the State Development Planning Commission. In the area of taxation, foreign banks and domestic banks are subject to different treatment as well. The income tax rate on Chinese banks is 33 percent while on foreign banks it is only 15 percent. Moreover, foreign banks are given a full tax exemption in their first year of profitability and a partial exemption in their second and third years. Though both foreign and Chinese banks pay the sales tax at eight percent, the tax basis is different. Chinese banks pay sales tax on all interest income, while foreign banks pay only on net interest income. Discrimination between Chinese and foreign banks causes many problems. There was actually a case where a depositor sued Citibank because Citibank charged a service fee on his account.16 In fact, the customary charging of service fees by foreign banks is in violation of China’s Commercial Bank Law which stipulates that depositors have the right to receive interest on their accounts. The Citibank charge of $6 a month on accounts with less than $5000 is higher than the interest due. Thus the plaintiff’s lawyer argued that the law was violated. Though the court’s ruling is not yet in, the case makes it clear that the PBC must rethink its discriminatory regulation. Charging a service fee on deposit accounts may not be suitable for Chinese banks since household savings are their main resource. But whether to charge a service fee or not should arguably be a market decision for an individual bank to make based on its own strategy of attracting customers. The key issue is that the PBC has to adapt its regulatory approach following

16 http://news.sohu.com/92/09/news206220992.shtml

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WTO entry with the goal of providing a uniform and transparent regulatory environment for all commercial banks in China. Competition for human resources poses another threat to Chinese banks in the post-WTO environment. Because foreign banks pay higher salaries, some of China’s best bankers and financial experts have jumped from domestic to foreign banks. The most serious problem is the loss of employees from the PBC. The PBC has to regulate 43 thousand financial institutions and finds itself quite short of qualified employees. Current staff at the PBC are unable to carry out the institution’s functions. And because of the government personnel system in China, promotion is not a function just of performance, but of many other factors as well. Low salaries and uncertainty surrounding promotion tempt capable young PBC employees to take advantage of their positions to receive overseas training and experience, then sell their skills to commercial banks with foreign banks the employers of choice. This again shows the need for reform of incentive mechanisms, and particularly so in the personnel and compensation system of the PBC.

6. Conclusion China has made concerted efforts to reform its banking system and to support bank commercialization through appropriate legislation. But government managed bank restructuring, injections of capital, clean up of illegal and failed institutions, and the removal of non-performing loans from bank portfolios have all brought only superficial relief. Capital injections have been insufficient to clear up accumulated NPLs with the result that further injections are expected and a climate of moral hazard is perpetuated. Mergers and acquisitions have left unhealthy balance sheets intact which only serves to hide solvency problems and allow them to fester under cover of larger institutional umbrellas. PBC supervision has failed to prevent problems, rather responding to crises years in the making. Mismanagement and even criminal behavior on the part of bank managers have gone unchecked. With the dominance of state-ownership in China’s commercial banks, government officials become the principal representatives of property. From the smallest to the largest financial institutions, the personal interest of officials becomes the main factor in bank decision making. Neither bankers nor regulators have the authority to perform their jobs independently, and indeed find all too ready a scapegoat in government for bank failure. Under these conditions, government has no choice but to insure all risk to stabilize the financial system. This stimulates moral hazard behavior which is further


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aggravated by lax information disclosure requirements and a weak auditing system. The effort to improve regulatory efficiency by distancing the regulatory function from the central bank will not in itself achieve the desired outcome of a healthy banking system. What is needed are more penetrating reforms that address property rights, incentives, and accountability. For bank regulation to perform its role effectively, bank behavior must be guided by internal discipline in bank management and external discipline by the market. To achieve this, the following reforms are key: (1) clearly define property rights and responsibilities and create workable corporate governance structures; (2) regularize information disclosure and professionalize the external auditing function; (3) systematically enforce laws to punish criminal behavior; and (4) rationalize the PBC personnel and salary systems to improve incentives and retention. 7. References Ding, Yougang and Bing Liang, 2001. “Studies on Implementing Loan Loss Reserves and Writing Off Bad Loans in Chinese Commercial Banks,” Journal of Financial Research 8: 32–40. Liu, Shiyu, 1999. “China’s Practice of Dealing with Small and Medium Problematic Financial Institutions,” in Strengthen China’s Financial System: Problems and Experiences, BIS Policy Report 7(Oct): 252–257. Mao, Yigao, 1999. “Review of China’s Recent Bank Reform,” in Strengthen China’s Financial System: Problems and Experiences, BIS Policy Report 7(Oct): 70–87. Shang, Ming, 2000. Fifty Years of China’s Finance (Beijing: China Finance and Economy Publishing House). Wang, Xiaobing, 2002. “Hainan Development Bank Repays Debts,” Cai Jing 59. Wei, Jianing, 2001. “Cooperation of Three Regulatory Institutions,” State Council Development Research Center. Wu, Xiaoqiu, Qinghua Song and Zhanyu Ying, 2002. “Studies on Bank Funds Moving into the Stock Market,” Management World 4: 85–96. Xie, Min, 2002. “Experts’ Ideas: Cautiously Slow Down Divorcing Regulation from Central Bank,” Zhongguo Jingying Bao, Jan. 28. Xue, Xiaohe, 2001. “Qian, Xiaoan: China Needs Universal Financial Regulation,” China Economy Daily, Aug. 16. Zhu, Jun, 1999. “Closing Financial Institutions: China’s Practice,” in Strengthen China’s Financial System: Problems and Experiences, BIS Policy Report 7(Oct): 258–271.


Foreign Direct Investment in China: An Analysis of Source Country and Sector of Utilization Wenhui Wei∗ & Manoranjan Dutta† ∗

Research Associate Institute for Health, Health Care Policy and Aging Research Rutgers, The State University of New Jersey, New Brunswick, New Jersy, USA [email protected] † Professor Economics Department, Rutgers, The State University of New Jersy New Brunswick, New Jersy, USA [email protected]

1. Introduction Twenty years have passed since China decided to open its market to the world. Rapid growth has followed in both aggregate output and international trade (see Table 1). From 1979 to 2000, China’s GDP increased at an average annual rate of 9.5 percent.1 Exports and imports have increased even more quickly at more than 11 percent per year. However, China is still at a disadvantage when it comes to per capita income in absolute terms. By 2000, China’s per capita GDP was only US$768, which, although higher than the average for the UN’s low-income country grouping (US$460), was far below the world average (US$5439), and even below the average for lower-middle-income countries (US$1210).2 China’s goal is to become a competitive actor in the world market. To achieve this goal, two immediate objectives must be fulfilled: (1) The growth rate in GDP must remain higher than those of the mature industrialized countries. 1 This

GDP growth rate is calculated in constant US dollars. GDP grew at 13.1 percent per year using a purchasing power parity measure. 2All are in 1995 constant US dollars. 297

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W. Wei & M. Dutta Table 1. Key Economic Indicators for China, 1980–1999

Year

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

GDP GDP per GDP GDP in GDP per capita, Exports Imports (1995 capita growth PPP terms in PPP terms (1995 (1995 billion (1995 rate (%) (billion US$) (US$) billion billion US$) US$) US$) US$) 165 174 191 211 243 274 298 331 366 381 396 433 494 562 634 700 767 835 900 964

168 175 189 206 235 261 279 305 332 341 349 376 424 476 532 581 630 679 725 769

6.0 5.7 9.6 10.9 15.2 12.6 8.5 11.2 10.7 4.1 4.0 9.2 14.3 13.5 12.8 10.5 9.6 8.8 7.8 7.1

456 508 562 623 747 882 1032 1247 1465 1522 1590 1771 2107 2443 2798 3231 3580 3880 4151 4535

465 511 558 609 721 839 967 1151 1330 1360 1400 1539 1808 2073 2348 2681 2940 3154 3342 3618

31.5 38.0 45.6 51.0 59.5 50.0 48.7 55.6 61.9 68.0 76.5 91.9 105.2 115.0 148.6 168.0 179.5 228.3 232.9 252.1

32.6 36.5 37.6 46.3 59.8 70.7 60.5 55.7 66.9 72.1 62.5 76.1 96.9 125.2 137.6 151.9 161.1 181.1 183.7 219.0

Source: World Bank (2001).

(2) The rate of growth in trade must be accelerated. In light of this agenda of accelerated industrialization and GDP growth, Dutta (1999) argued that the case for rational exuberance favors economic engagement between the labor-abundant, agriculture-dominant, traditional economies of Asia with or without reserves of natural resources yet to be exploited and capital-rich, plant, equipment, and technology abundant mature industrialized economies. An import-export led growth model follows as the developing Asian economies import capital (plant and equipment) from the mature industrialized countries and pay for their imports by exporting some of the newly manufactured products to the world market thus earning export revenues in convertible currencies. The industrializing economy will seek to import capital goods and pay for them by exporting

Foreign Direct Investment in China

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some of its newly manufactured product, competing in cost and quality on the international market. The revenues earned on exports will be in hard currency and will provide a base for payment for the imported capital goods. There are different approaches to importing foreign capital: (1) Borrow from abroad, which includes: (a) loans from banks and financial institutions; (b) portfolio investment through financial markets — floating stocks and bonds. (2) Attract FDI (foreign direct investment), which may come in the form of: (a) wholly-foreign-owned investment; (b) joint ventures. Among these approaches, foreign borrowing incurs interest and principle repayment obligations irrespective of the success or failure of the project. For stocks and bonds, investors must accept the volatility of the market although they have the freedom to move in and out as they weigh factors one way or another. Buyers and sellers meeting in stock markets are exposed to the fluctuations of the market. Speculation is a part of the game. Hard lessons have been learned by East Asian countries during the Asian financial crisis of 1997–1998. FDI is an advantageous approach to importing capital goods — plant, equipment, and technology. Foreign investors directly share the risk of investment. They stand to share profits or suffer losses. FDI therefore merits careful analysis for an economic plan for accelerated industrialization and thus accelerated growth of GDP. Specific arguments for FDI made by Dutta (1990, 1991, 1999) are as follows: (1) FDI with its firm commitment to profit maximization must seek optimal input combinations. Foreign investors will make a thorough search for talent in the economy of their investment. The foreign principles can hardly plan to import one hundred percent of the local firm’s managers. These investors come from labor-scarce economies with relatively high wage rates. Relative labor-abundance and consequent low wage rates are the point of attraction for their investment in Asian economies. Indeed, recruitment of indigenous human resources will help the foreign investor in terms of market creation and penetration. This has been confirmed by a survey reported in Beijing Review (March 1, 2001) which

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(2)

(3)

(4)

(5)

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showed that in hi-tech industries, locally-recruited employees constitute a significant proportion of middle and upper level management and R&D specialists in foreign-invested firms. FDI will bring with it optimal technology embodied in plant and equipment. An ownership stake encourages the foreign investor to be competitive and maximize the returns on his investment. FDI must compete with indigenous investment, and the foreign technological advantage will help. A wild cry for technology transfer has gone up from many newly industrializing countries. It is difficult to get technology transfer not embodied in plant and equipment, but much easier when it is embodied and foreign owners maintain a stake in the use of the technology. The survey in Beijing Review previously cited indicated that among 86 high-tech foreign-invested firms, almost all made use of advanced technologies from their parent firms. Of the sample firms, 63 percent used technologies absent in the domestic market. FDI promotes export of newly manufactured products to the world market. The revenue earned in hard currency on exports creates the base for profit repatriation. This revenue will also contribute to the importation of additional plant and equipment for the firm’s expansion. Thus it becomes a win-win situation. Foreign investors through their access to the world market bring gain to the local market. They can raise manufacturing standards and volume and provide the global merchandizing to reach world markets. By 2001, foreign-invested firms accounted for over half of China’s total exports and imports. In the electronics industry, the output of foreign-invested firms had reached 1/3 of total production. In the mobile communications market specifically, Motorola of the US had taken an 11 percent share (MOFTEC 2002). As FDI helps augment the local economy’s exports, its current account balance improves thus helping to attract further FDI inflows fueling a cumulative progression of industrialization and economic expansion. By 2001, China’s foreign reserves had reached US$212.2 billion. FDI stimulates competition and promotes productivity of indigenous resources. From 1990 to 1999, the share of industrial output produced by foreign-invested firms increased from 2.3 to 27.8 percent. Foreigninvested firms have become the driving force in China’s industrial growth. Through the 1990s, the growth rate of industrial output from foreign-invested firms consistently topped the aggregate growth rate (see Table 2).


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Table 2. Industrial Output from FDI Firms, 1990–1999 (Unit: billion RMB) Year

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Total industrial output

Industrial output from FDI firms

% of total

1,970 2,314 2,915 4,051 7,687 9,196 9,960 5,615 5,820 6,378

45 122 207 370 865 1,315 1,508 1,043 1,416 1,770

2.28 5.29 7.09 9.15 11.26 14.31 15.14 18.57 24.00 27.75

Growth in industrial output (%)

17 26 39 90 20 08 −44 4 10

Growth in industrial output from FDI firms (%)

172 69 79 133 52 15 −31 36 25

Source: Ministry of Foreign Trade and Economic Cooperation.

(6) FDI, as it adds to the GDP growth rate, broadens the tax base of the economy and helps in balancing the government budget. This in turn reduces the threat of inflation and encourages further growth. China has made impressive progress in absorbing FDI. By 2000, it had utilized US$384 billion in FDI (MOFTEC 2001). In this paper, we examine the composition of FDI in China from two aspects: source country and industrial sector. Our analysis shows that the source country composition of FDI in China was at first polarized but has become more diversified in recent years. As for industrial sector, FDI in manufacturing is dominant, but the tertiary sector has shown rapid gains in recent years. China has not been successful in attracting FDI into its agricultural sector. Comparison with other Asian countries indicates that China is similar to the ASEAN countries which are all trying to follow the NIEs (Newly Industrialized Economies) whose FDI is now focused in services. We argue that China should concentrate on manufacturing FDI, while adjusting to the changing pattern of global FDI. The structure of the paper is as follows. Section 2 reviews China’s experience in foreign direct investment. Section 3 examines the source country

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composition of FDI in China and Section 4 its sectoral composition in comparison with nine other Asian economies. Section 5 concludes. 2. China’s Absorption of Foreign Investment, 1979–2000 Prior to 1979, there was virtually no foreign investment in China. In 1980, the first joint venture was set up by Schindler Holding AG. Twenty years later, China has become “the world’s strongest magnet for overseas investment”, ranked first among all developing countries. In 2002, China received US$52.7 billion in FDI-making it the world’s largest recipient (OECD 2003). During the years since its opening, China has absorbed foreign investment mainly in three ways: (1) Foreign loans, which include: (a) loans from foreign governments; (b) loans from international financial organizations; (c) export credits; (d) loans from foreign financial institutions; (e) bonds issued abroad. (2) Foreign direct investment, which includes: (a) equity joint ventures; (b) contractual joint ventures; (c) wholly-foreign-funded enterprises; (d) share-holding enterprises; (e) cooperating development. (3) Other investment, which includes: (a) stocks issued abroad; (b) international leasing; (c) compensation trade; (d) processing and assembling. In China’s statistics, two notions of FDI are used: the amount contracted (or approved) and the amount utilized (or realized). The amount contracted is the amount investors plan to invest over a period of time when applying for investment authorization. The realized value is not bound by the amount contracted and has in fact been consistently lower than that amount. Since


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Table 3. Contracted and Utilized FDI in China, 1983–2001 (Unit: billion US$) Year

Contracted

Utilized

Ratio (%)

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

1.92 2.88 6.33 3.33 3.71 5.30 5.60 6.60 11.98 58.12 111.44 82.68 91.28 73.28 51.00 52.10 41.22 62.38 69.19

0.92 1.42 1.96 2.24 2.31 3.19 3.39 3.49 4.37 11.01 27.52 33.77 37.52 41.73 45.26 45.46 40.32 40.71 46.85

47.8 49.4 30.9 67.4 62.4 60.3 60.6 52.9 36.4 18.9 24.7 40.8 41.1 56.9 88.7 87.3 97.8 65.3 67.7


in China local officials used to take credit for attracting FDI, they tended to encourage foreign investors to overstate the amount contracted. Differences were sometimes pronounced. For example, in 1992, the amount of FDI contracted was US$58.1 billion, but the amount actually realized was US$11.0 billion, only 19 percent of that contracted. For the period 1983 to 1996, the ratio ranged between 19 and 67 percent. Although from 1997 onward we see a closer match, the ratio dropped to 65 percent in 2000 (see Table 3). Given that approved FDI is not a very meaningful indicator, in our analysis we shall focus on realized FDI and only when this measure is unavailable shall we switch to approved FDI. Table 4 shows the total amount of foreign capital utilized in China from 1979 to 2000 by form. Total foreign investment in China increased dramatically during the 1980s and 1990s. Before 1992, China depended on loans

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W. Wei & M. Dutta Table 4. Foreign Capital Inflows into China by Form, 1979–2000 (Unit: billion US$) Year

Total

Loans

1979–1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

14.62 2.70 4.45 7.26 8.45 10.23 10.06 10.29 11.55 19.20 38.96 43.21 48.13 54.80 64.41 58.56 52.66 59.36

n.a. 1.29 2.51 5.01 5.80 6.49 6.29 6.53 6.89 7.91 11.19 9.27 10.33 12.67 12.02 11.00 10.21 10.00

FDI 2.69 1.42 1.96 2.24 2.31 3.19 3.39 3.49 4.37 11.01 27.52 33.77 37.52 41.73 45.26 45.46 40.32 40.71


as the primary source of foreign investment. After that, the share of FDI increased sharply and overtook loans. In 1998, FDI constituted 78 percent of total foreign investment in China. After 1998, FDI in China dropped. This was due mainly to the change in global investment patterns. Trans-national acquisition became the primary method of FDI, and most of this investment turned to developed rather than developing countries. The amount of global FDI in 1999 was twice that in 1997, and 90 percent of it flowed into developed countries. In addition, the Asian financial crisis caused investment in Asian countries to fall steeply. Despite this, in 2000 China was still ranked first among developing countries in absorbing FDI. In Table 5, foreign capital inflows into China are further disaggregated. Relative amounts of various forms of foreign loans (from foreign governments, from international financial institutions, etc.) and foreign investment (stock issued abroad, international leasing, etc.) did not change much over

Table 5. Realized Foreign Investment in China by Form, 1992–2000 (Unit: billion US$) 1993

1994

1995

1996

1997

1998

1999

2000

19.20

38.96

43.21

48.13

54.80

63.95

58.92

52.66

59.36

7.91 2.57 1.31 0.99 1.78 1.27

11.19 3.04 2.27 1.22 3.27 1.39

9.27 2.40 1.47 2.19 1.86 1.35

10.33 2.77 2.71 2.67 1.40 0.78

12.67 3.45 3.00 1.33 1.49 3.40

12.02 3.62 1.63 1.29 3.07 2.41

11.00 2.90 3.00 1.84 2.26 1.00

10.21 3.32 2.61 1.03 2.47 0.80

10.00 n.a. n.a. n.a. n.a. n.a.

FDI equity joint ventures contractual joint ventures foreign-funded enterprises share-holding enterprises cooperating development

11.01 6.11 2.12 2.52

27.51 15.35 5.24 6.51

33.77 17.93 7.12 8.04

37.52 19.08 7.54 10.32

41.73 20.75 8.11 12.61

0.25

0.42

0.68

0.59

0.26

45.28 19.58 8.92 16.15 0.29 0.34

45.58 18.84 9.34 16.52 0.60 0.29

40.32 15.84 8.22 15.54 0.29 0.38

40.71 14.34 6.60 19.26 0.13 0.38

Other foreign investment stock issue abroad international leasing compensation trade processing and assembling

0.28

0.26

0.18

0.29

0.41

0.04 0.17 0.07

0.05 0.09 0.12

0.02 0.09 0.07

0.03 0.21 0.04

0.09 0.16 0.16

6.66 5.14 0.32 0.09 1.11

2.33 0.62 0.38 0.09 1.24

2.13 0.61 0.19 0.01 1.32

8.64 6.93 0.03 0.01 1.27

Total Foreign loan from foreign governments from international financial organizations export credits from foreign commercial banks bond issues abroad

305

Sources: Ministry of Foreign Trade and Economic Cooperation and National Bureau of Statistics (2001).


1992

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the years. FDI initially took the form of joint ventures, either equity or contractual. Contractual joint ventures, and later joint ventures without a profit contract, remained limited to Hong Kong, Macao, and Taiwan and did not appeal to investors from mature industrialized capitalist countries. They preferred not to be involved in joint ventures with China’s state-owned enterprises with or without profit contracts. Approval of wholly-foreign-owned investment opened the Chinese market to investors from these countries. The share of wholly-foreign-owned firms increased from 24 percent in 1994 to 47 percent in 2000 while the share of joint ventures declined (see Table 6). For the first 9 months of 2002, 69 percent of approved FDI was for wholly-foreign-owned firms. (MOFTEC 2002) The increasing popularity of wholly-foreign-owned enterprises reflects both their attractiveness over joint ventures for foreign investors and China’s greater openness in foreign investment policies. Joint ventures may be less attractive because foreign investors must share control as board members, and their views may not be readily acceptable to local board members. Foreign investors are not satisfied to be limited to ownership shares of less than 50 percent, and thus wholly-foreign-owned firms are preferred.

Table 6. FDI by Organizational Form in China, 1992–2000 (Unit: billion US$)

1992 1993 1994 1995 1996 1997 1998 1999 2000

Equity joint venture

Contractual joint venture

Wholly-foreign-owned enterprises

Amount

%

Amount

%

Amount

%

6.11 15.35 17.93 19.08 20.75 19.58 18.84 15.84 14.34

55.6 55.8 53.1 50.8 49.7 43.2 41.3 39.2 35.8

2.12 5.24 7.12 7.54 8.11 8.92 9.34 8.22 6.60

19.4 19.0 21.1 20.1 19.4 19.7 20.5 20.3 15.9

2.52 6.51 8.04 10.32 12.61 16.15 16.52 15.54 19.26

22.9 23.6 23.8 27.5 30.2 35.7 36.2 38.6 46.9



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Competition is intensified with the entry of wholly-foreign-owned firms, which maximizes economic gains for consumers at home and abroad.

3. Source-Country Composition of FDI 3.1. Source-country composition of FDI in China FDI in China has been unusual in its composition by source country/region. Globally, most FDI originates in developed countries. For China, however, Hong Kong and Macao have been the dominant sources of investment capital since the early 1980s (see Table 7). Hong Kong and Macao accounted for 50 to 70 percent of total FDI flowing into China every year until the early 1990s. After l995 however, the share of FDI coming from Hong Kong and Macao dropped quickly. By 2000, these regions claimed only a 39 percent share. The decreased share of Hong Kong and Macao was not reflective of a decrease in absolute volume; rather the absolute magnitude rose from US$17 billion in 1994 to US$21 billion in 1996, although it began to decrease after 1996. Japan and the US are the second and third largest sources of FDI flows into China (the ranking differing depending on the year). Although Japan’s share in FDI inflow into China has been decreasing as of the 1990s, that of the US has steadily increased. In 2000, the US provided US$44 billion in FDI to China for almost 11 percent of the total that year. Another important investment source is Taiwan.3 As we can see from Table 7, Taiwan’s share of FDI in mainland China grew steadily in the 1980s and early 1990s, peaked in 1993 at 11.4 percent, and then steadily decreased. In 2000, its share was 5.6 percent and lagged behind the other major investors examined (Hong Kong, US, Japan, EU, and ASEAN). FDI from EU and ASEAN countries has risen very rapidly. In 1999, EU and ASEAN registered shares of 11.1 percent and 8 percent respectively, topping both Japan and Taiwan, and EU’s share was even higher than that of the US. Despite the effect of the Asian Financial Crisis, EU and ASEAN will surely play more important roles in the future given the on-going process of integration internal to these economic blocs.

3 Officially, Taiwan is claimed as a part of China and named Taipei, China, though investment

inflows from Taiwan are still reported.

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Hong Kong & Macao Year

Amount

%

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

1,329 1,598 2,095 2,077 1,913 2,487 7,709 17,861 20,175 20,500 21,258 21,027 18,930 16,672

59.2 69.1 65.6 61.2 54.9 57.0 70.0 65.0 60.0 54.6 51.0 46.5 41.6 41.4

Taiwan Amount

155 222 466 1,050 3,139 3,391 3,162 3,475 3,290 2,915 2,599

US

Japan

EU

ASEAN

%

Amount

%

Amount

%

Amount

%

4.6 6.4 10.7 9.5 11.4 10.0 8.4 8.3 7.3 6.4 6.4

326 263 236 284 456 323 511 2,063 2,491 3,083 3,443 3,239 3,898 4,216

14.5 11.4 7.4 8.4 13.1 7.4 4.6 7.5 7.4 8.2 8.2 7.2 8.6 10.5

263 220 515 356 503 532 710 1,324 2,075 3,108 3,679 4,326 3,400 2,973

11.7 9.5 16.1 10.5 14.4 12.2 6.4 4.8 6.2 8.3 8.8 9.6 7.5 7.4

179 53 157 188 147 246 243 671 1,538 2,131 2,737 4,171 3,979 4,479

7.9 2.3 4.9 5.5 4.2 5.6 2.2 2.4 4.6 5.7 6.6 9.2 8.8 11.1


Amount

60 88 266 1,003 1,872 2,616 3,176 3,426 4,194 3,275

Total %

1.7 2.0 2.4 3.6 5.5 7.0 7.6 7.6 9.2 8.1

Amount 2,244 2,314 3,194 3,393 3,487 4,366 11,008 27,515 33,766 37,521 41,726 45,257 45,463 40,319

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Table 7. FDI Inflow into China by Source Country/Region, 1986–1999 (Unit: million US$)


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The source country composition of FDI in China has become less polarized since the early 1990s, which is a good sign because it will reduce China’s exposure to regional economic fluctuations. The Asian financial crisis of 1997–1998 seriously reduced FDI from all Asian countries/regions, as shown in Table 7. However, after the crisis, a high level of FDI from within the region was sustained at over US$40 billion a year, and in 2001 an historically high US$46.8 billion was registered. 3.2. Comparison with other Asian countries Nowadays, many Asian countries, both NIEs like Hong Kong, Korea, Singapore, and Taiwan, and developing countries, like China,ASEAN countries, and India, are actively soliciting foreign investment by offering tax incentives and other economic inducements, often in search of spillover benefits of technology from foreign investors. FDI from developed countries tends to come with more advanced technology than that from developing countries. Therefore, how to attract FDI from developed countries is a subject of interest to Asia’s industrializing countries. W. Wei (2003) examined the inflow of FDI to Asian countries from developed source countries to determine the factors of importance in investment decisions. The Asian countries included in the study are China, the NIEs (Taiwan, Korea, Singapore and Hong Kong), selected ASEAN countries (Philippines, Malaysia, and Thailand), and India. The main finding is that firms from the US, Japan, and EU show different behavior in their approaches to FDI. US firms are strongly averse to corruption and prefer lower tax destinations, while Japan and EU seek out low-cost-labor destinations. China has been successful at attracting FDI from EU, but could achieve more with respect to the US and Japan. This result is in partial accord with S. Wei (2000) who also found that China was an under-achiever in absorbing FDI from the US.

4. Sectoral Composition of FDI 4.1. Sectoral composition of FDI in China Technology transfer is affected by the sectoral allocation of FDI. FDI in the primary sector (farming, hunting, forestry, etc) does not necessarily come with high technology and advanced management, but it helps China increase the income of farmers who constitute 70 percent of China’s population.

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While technology spillover effects of FDI are most apparent in the secondary or manufacturing sector, FDI in the tertiary sector (construction, real estate, financial services, etc.) brings advanced management practices to China. Therefore, it would be interesting and informative to examine the dynamic change of the sectoral composition of FDI in China. Unfortunately, industry-level data for FDI in China are not readily available in the desired detail. The data on industry-level realized FDI inflows date back only to 1997 (see Table 8) and no data on realized FDI stock are available. However, the Ministry of Foreign Trade and Economic Cooperation reports data on approved FDI flows into China back to 1987 which enable us to track FDI stock for some, but not all industries, back to that time (see Tables 9 and 10). We must be cautious interpreting the information obtained from these three tables.Annual FDI inflows are relatively volatile, and thus a stock measure provides a more stable picture. Also, approved FDI is just the amount promised by foreign firms when contracts are signed and, as discussed (see Table 3), the gap between approved and utilized FDI can be quite wide as it was in the early 1990s. As Table 10 shows, manufacturing’s share in approved FDI stock dropped substantially from 80.7 percent in 1991 to 67.8 percent in 1992 and further to 56.8 percent in 1993. However, we cannot necessarily say that actual FDI in the manufacturing sector dropped as well because the ratios of approved FDI to realized FDI in these years were only 36.4 percent, 18.9 percent, and 25.0 percent, respectively. In 1992, the new economic reform initiative launched by Deng Xiaoping caused foreign investment fever, especially in Hong Kong which accounted for 70 percent of realized FDI in that year (see Table 6). Most of the approved FDI, however, went to “bubble” projects in real estate and financial services , and many investments were not realized as the fever faded. Despite these problems, we can still glean insights as we look at the period from 1987 to 2000: (1) FDI in the primary sector was very low. From 1997 to 2000, the number of projects in the primary sector ranged from 900 to 1000 per year, only about four percent of annual FDI totals. Realized FDI inflows were only about US$1.2 billion, or three percent of the totals. This is easy to understand because land in China is state-owned which discourages foreign firms from investing in agriculture. However, given the fact that China has such a huge rural population with such a low income level, it would be beneficial for the government to adopt new policy

Table 8. FDI Inflow into China by Sector, 1997–2000 Number of projects

Amount approved (million US$)

Amount realized (million US$)

1998

1999

2000

1997

1998

1999

2000

1997

1998

1999

2000

968 814

1,044 876

892 762

983 821

1,782 1,065

2,056 1,204

1,794 1,472

1,990 1,483

1,568 628

1,202 624

1,267 710

1,259 676

154

168

130

162

717

852

322

506

940

578

557

583

14,716

13,477

12,042

15,988

27,065 30,827 25,332 44,254 28,120 25,582 22,603 25,844

Tertiary sector 5,317 Power/Gas/Water Production/ 156 Supply Construction 455 Transport/Storage/Post/ 279 Telecommunications Wholesale/Retail Trade 1,198 and Catering Real Estate 862 Social Services 1,400 Health Care, Sports and 38 Social Welfare Education/Culture/Arts/ 34 Radio/Film/Television Other 895

5,278 142

3,984 116

5,376 107

22,157 19,218 14,098 16,136 15,570 18,679 16,448 13,611 3,656 1,968 1,635 1,227 2,072 3,103 3,703 2,242

318 274

247 205

233 306

3,120 2,622

1,750 2,301

1,096 1,114

831 1,417

1,438 1,655

2,064 1,645

917 1,551

905 1,012

1,184

825

852

1,839

1,314

1,204

1,435

1,402

1,181

965

858

834 1,634 40

669 1,474 28

684 2,679 31

6,222 2,669 143

6,648 3,012 142

4,178 3,017 67

5,232 4,255 154

5,169 1,988 195

6,410 2,963 97

5,588 2,551 148

4,658 2,185 106

14

29

19

70

22

61

83

74

68

61

54

838

391

465

1,817

2,062

1,725

1,502

1,576

1,146

965

1,591

19,799

16,918

22,347

Primary sector Agriculture/Hunting/ Forestry/Fishing Mining and Quarrying Secondary sector

Total

21,001

311

Sources: National Bureau of Statistics (1999, 2000, 2001).

51,004 52,102 41,223 62,380 45,257 45,463 40,319 40,715


1997

312

Table 9. Approved FDI Flows into China by Sector, 1987–2000 (Unit: million US$)

Primary sector Agriculture/Hunting/ Forestry/Fishery Mining/Quarrying/ Petroleum Secondary sector

1992

1993

1994

1995

1996

1997

1998

1999

2000

125

211

121

123

220

681

1,272

1,026

1,747

1,152

1,782

2,056

1,794

1,990

125

209

121

122

220

678

1,192

972

1,736

1,139

1,065

1,204

1,472

1,483

0

3

80

54

12

13

717

852

322

506

1,776 4,021 4,664 5,569

9,623 32,667

51,174 43,899 61,648 50,486 27,065 30,827 25,332 44,254

2,046 23,467

55,341 35,504 26,392 19,498 22,157 19,218 14,097 16,136 3,656 1,968 1,635 1,227

2

Tertiary sector 1,597 Electricity/Water Distribution Construction 55 Wholesale Trade 29 Post/Telecommunication 16 Finance Real Estate 1,471 Business Services 1 Health/Social Services 11 Other Services 14 Total

1991

872

757

852

119 64 91 12 530 7 5 44

67 67 52

181 107 36

134 174 95

524 4 36 7

452 32 38 5

1,504 19 64 56

1,839 1,444 1,534 8 18,080 62 395 97

3,878 2,394 1,918 2,001 4,606 3,922 3,427 2,347 1,490 2,030 1,679 1,599 78 436 54 43,771 23,862 17,835 12,851 588 274 278 175 478 1,979 837 354 452 608 345 171

3,120 1,839 n.a. n.a. 6,222 n.a. n.a. 1,817

1,750 1,314 n.a. n.a. 6,648 n.a. n.a. 2,062

1,096 1,204 n.a. n.a. 4,178 n.a. n.a. 1,725

831 1,435 n.a. n.a. 5,232 n.a. n.a. 1,502

3,709 5,296 5,600 6,596 11,977 58,124 111,436 82,680 91,282 73,276 51,004 52,102 41,223 62,380

Sources: Data from 1987 to 1996 are from Ministry of Foreign Trade and Economic Cooperation, Almanac of China’s Foreign Economic Relations and Trade, various issues and Statistics on FDI in China, 1998. Data from 1997 to 2000 are from China Statistical Yearbook, 1999, 2000 and 2001 issues. n.a. = not available.

W. Wei & M. Dutta

1987 1988 1989 1990


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Table 10. Approved Inward FDI Stock in Selected Industries for China, 1987–2000 (Unit: million US$) Agriculture, Manufacturing Construction Wholesale trade Total husbandry, forestry and fishery

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Amount

%

Amount

%

697 906 1,027 1,149 1,369 2,047 3,238 4,211 5,947 7,086 8,151 9,355 10,827 12,310

3.0 3.2 3.0 2.8 2.6 1.8 1.5 1.4 1.5 1.5 1.6 1.6 1.8 1.8

18,574 22,595 27,259 32,828 42,451 75,117 126,291 170,190 231,837 282,323 309,388 340,215 365,547 409,801

80.3 79.5 80.1 80.8 80.7 67.8 56.8 55.8 58.5 60.2 59.4 59.4 59.6 60.6

Amount % Amount

%

Amount

363 482 549 730 864 2,703 6,581 8,975 10,893 12,894 16,014 17,764 18,860 19,691

6.2 5.3 4.6 4.1 3.5 3.0 3.6 3.9 3.8 3.8 3.7 3.6 3.6 3.5

23,123 28,419 34,019 40,615 52,592 110,715 222,151 304,831 396,112 469,388 520,392 572,494 613,717 676,097

1.6 1.7 1.6 1.8 1.6 2.4 3.0 2.9 2.8 2.8 3.1 3.1 3.1 2.9

1,446 1,510 1,577 1,683 1,857 3,301 7,908 11,830 15,256 17,603 19,442 20,756 21,960 23,395

Source: Approved FDI inflow data up to 1997 are from Ministry of Foreign Trade and Economic Cooperation, Almanac of China’s Foreign Economic Relations and Trade, various issues and Statistics on FDI in China, Beijing 1998. Approved FDI inflow data from 1998 to 2000 are from China Statistical Yearbook, 1999, 2000 and 2001 issues. 1999 approved FDI stock data are from the website: http://www.moftec.gov.cn/moftec− cn/tjsj/wztj/ wztj− menu.html Notes: (1) Approved FDI stock data from 1987 to 1998 are estimated by sequentially subtracting annual approved FDI inflow from 1999 approved FDI stock. Approved FDI stock in 2000 is estimated by adding 2000 approved FDI inflow to 1999 approved FDI stock. (2) Due to changes in sectoral reporting categories, many industries could not be included here. The data reported above are rough estimates and subject to future modification.

incentives to attract FDI in this sector. China is now exploring new policies in the western region, such as offering tax incentives. Since western China is predominantly rural, a policy addressing the conflict between land ownership and fully-foreign-owned firms will help attract FDI into this area and make an important contribution to the policy initiative to “develop the West”.

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(2) FDI in the secondary or manufacturing sector remains dominant in absolute terms although its share has shrunk from 80 percent in the 1980s to 60 percent in the 1990s (see Table 9). This happened mainly due to the quick increase in FDI in the tertiary sector and to the growing competition from domestic firms within the manufacturing sector. (3) FDI in the tertiary sector has been quickly catching up with FDI in the manufacturing sector. Before 1990, approved FDI inflows to the tertiary sector were only about 20 percent of those in manufacturing. After 1990, the ratio rose to at least 36 percent, and service FDI even surpassed manufacturing FDI in 1993 although that was due to the “bubble projects” in the tertiary sector at that time. From Tables 8 and 9, we see that real estate is the dominant component of FDI in the tertiary sector, and as noted in connection with agricultural FDI, ownership is essential to the investment decisions of foreign firms. For FDI stock, we have data only on the construction and wholesale trades in Table 10, and these constitute only a small part of the tertiary sector but tell a similar story to that told in Table 9. (4) Sectoral FDI trends were interrupted after 1997 when theAsian financial crisis occurred. The share of FDI in manufacturing rebounded while that in services dropped. We believe this reversal to be temporary, though, considering that globally FDI is ever more concentrated in services. In sum, manufacturing still dominates FDI inflows into China, though the service sector is catching up quickly. Nowadays, global FDI flows are concentrated in services, particularly finance and commerce, so there is much potential for China to draw greater FDI in these areas. 4.2. Comparison with other Asian countries Faced with the fast growth of FDI in China, many other Asian countries began to regard China as a competitor in attracting FDI. However, as we stated before, global FDI has doubled since 1997, though increases in other parts ofAsia have not matched this pace. Much can be done in these countries to adjust to changing trends in global FDI. Besides, what distinguishes China from most of the other developing countries of Asia is its huge rural population. Adopting polices wisely and cooperating with each other, China and other Asian countries cannot only avoid costly competition but can also strengthen their collective position in the global market for FDI. In this section, we examine the sectoral composition of FDI among 10 Asian economies: China, the NIEs (Hong Kong, Korea, Singapore, and


315

Taiwan), ASEAN (Indonesia, Malaysia, Philippines, and Thailand), and India. Data were extracted from the United Nations (1996 and 2000) World Investment Directory. We wish to see, on the sectoral level, how these countries differ in absorbing FDI. We used share of FDI in each sector as the indicator to be compared across countries. To reduce volatility over time and even out differences among countries, we treated the NIEs and the ASEAN countries as groups and computed 2-year FDI averages. In this way, we are able to illuminate more clearly differences in FDI absorption patterns among China, India, the NIEs, and ASEAN.4 Figures 1–3 illustrate primary, secondary, and tertiary shares of FDI inflows and Figures 4 to 6 the same sectoral shares for inward FDI stocks. 60%

50%

China India

40%

ASEAN (Indonesia; Philippines; Thailand)

30%

NIEs (Korea; Taiwan) 20%

10%

0% 1985-86

1987-88

1989-90

1991-92

1993-94

1995-96

1997-98

Sources: United Nations (1996 and 2000).

Figure 1. Share of FDI Inflow in Primary Sector by Region, 1985–1998 4 Here

again we run into the problem of data availability and comparability. We did not find enough industry-level data for meaningful comparison. Sectoral data are available in most countries, although different countries had different methods of measuring FDI, and we even found discrepancies between sources within a country. We believe the share of FDI by sector is more robust to differing methods of measurement than absolute value.

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90% 80% 70% 60% 50% 40% 30% China India ASEAN (Indonesia, Philippines; Thailand)

20% 10%

NIEs (Korea; Taiwan) 0% 1985-86

1987-88

1989-90

1991-92

1993-94

1995-96

1997-98


Figure 2. Share of FDI Inflow in Secondary Sector by Region, 1985–1998

We analyzed both flows and stocks because the combination gives us a more complete picture. Due to data limitations, not all countries are included in all figures. Drawing upon the six figures, our findings are reported below. (1) The NIEs (Hong Kong, Korea, Singapore, and Taiwan). As industrialized countries, none of the NIEs have significant inward FDI in the primary sector. All have seen a steady increase in the share of FDI (both flows and stocks) in the tertiary sector, dominating that of the manufacturing sector from the early 1990s. Although it follows the same trend, Taiwan’s shift lags somewhat behind the other NIEs in that its inward FDI stock in manufacturing was still 60 percent of the total as of 1999. FDI in Hong Kong, on the other hand, has always been highly concentrated in the tertiary sector. (2) ASEAN countries (Indonesia, Malaysia, Philippines, and Thailand). The primary sector share of FDI for these countries was high during the


317

70% China India 60%

50%

ASEAN (Indonesia; Philippines; Thailand) NIEs (Korea; Taiwan)

40%

30%

20%

10%

0% 1985-86

1987-88

1989-90

1991-92

1993-94

1995-96

1997-98


Figure 3. Share of FDI Inflow in Tertiary Sector by Region, 1985–1998

late 1970s and early 1980s but dropped quickly afterwards. In 1999, it constituted 5 to 15 percent of FDI stock, still high compared with the NIEs. The share of FDI in manufacturing increased steadily through the 1980s, peaked in the early 1990s, and then began to decrease. Correspondingly, the share of FDI in services climbed quickly in the late 1990s, although in terms of stocks, the services share does not exceed that of manufacturing except in Thailand. All this indicates that the ASEAN countries are taking the same path as the NIEs in absorbing FDI. (3) China. Detailed discussion has been given in the previous section. From the figures we see that FDI in China’s primary sector has always been low and that the share of FDI in manufacturing dominated through the 1980s and 1990s but has decreased as FDI in services has developed. (4) India. From 1985 to 1994, the sectoral distribution of FDI flows into India was quite stable. Shares in the primary and secondary sectors

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30% India ASEAN (Thailand; Philippines; Malaysia)

25%

NIEs (Korea; Singapore; Taiwan) 20%

15%

10%

5%

0%

1975-76 1977-78 1979-80 1981-82 1983-84 1985-86 1987-88 1989-90 1991-92 1993-94 1995-96 1997-98


Figure 4. Share of FDI Stock in Primary Sector by Region, 1975–1998 100% 90% 80% 70% 60% 50% 40% 30%

China India

20%

ASEAN (Malaysia; Philippines; Thailand)

10%

NIEs (Hong Kong; Korea; Singapore; Taiwan)

0% 1975-76 1977-78 1979-80 1981-82 1983-84 1985-86 1987-88 1989-90 1991-92 1993-94 1995-96 1997-98


Figure 5. Share of FDI Stock in Secondary Sector by Region, 1975–1998


319

70%

60%

50%

India ASEAN (Malaysia; Philippines; Thailand) NIEs (Hong Kong; Korea; Singapore; Taiwan)

40%

30%

20%

10%

0% 1975-76 1977-78 1979-80 1981-82 1983-84 1985-86 1987-88 1989-90 1991-92 1993-94 1995-96 1997-98


Figure 6. Share of FDI Stock in Tertiary Sector by Region, 1975–1998

were roughly the same, and only 2 to 3 percent of annual FDI inflows were allocated to the tertiary sector which was way below that in other Asian countries. The stock of inward FDI in the secondary sector dominated from 1975 with the share in the primary sector dropping quickly in the late 1970s, becoming stable by the early 1980s. We have data only up to 1995 for India. Given the fact that incentive policies have been adopted in India since 1995 and its tertiary sector has developed quickly, we expect the share of FDI in services to have increased since 1995. We can see that there are significant differences in the sectoral composition of FDI inflows among Asian countries. In the NIEs, FDI in services has dominated the other sectors. ASEAN and China are following the same path the NIEs have travelled. India still lags behind other Asian countries in absorbing FDI into its services sector. To achieve the objective of accelerated growth in industry and GDP, FDI in manufacturing should be encouraged. At the same time, FDI in services should be given attention as well because that’s where global FDI resources are concentrated.

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5. Concluding Remarks We have herein examined the composition of FDI in China with respect to source country and industrial sector and have drawn comparisons with the NIEs, ASEAN, and India. China has been known for its unusual composition of source countries in that most of its FDI has derived from Hong Kong and Macao. This has been changing in recent years, however, with FDI from the US and Japan becoming more important and that from EU and ASEAN also growing fast. In that sense, the structure of FDI in China is becoming more stable. As to the sectoral composition of FDI, China has not been effectively attracting investment into agriculture. Given China’s huge rural population and the widening income gap between rural and urban residents, more effort should be made in this area. Greater FDI in the agricultural sector will surely help raise rural incomes. FDI in manufacturing dominates in China but is decreasing as a share of the total while FDI in services is growing rapidly in both absolute and share terms. This pattern of a rising services share in FDI has also been exhibited in ASEAN countries, which are in turn following the NIEs. Much remains to be done in studying the quality of FDI in China. More thorough examination of source country and industrial sector would be useful in this regard.Another topic of interest is the geographical distribution of FDI within China. Using data up to 1995, Cheng and Kwan (2000) argued that regional income and establishment of Special Economic Zones has had a positive effect on FDI inflows, but they failed to find any significant effect on labor quality. It would be informative to re-examine their findings using later-year data.

6. References Beijing Review, March 1, 2003. “High-Tech Industry in China and Utilization of FDI,” http://www.beijingreview.com.cn/China/China2001-3-1.htm (in Chinese), accessed Octobor 16, 2003. Cheng, Leonard K. and Yum K. Kwan, 2000. “The Location of Foreign Direct Investment in Chinese Regions: Further Analysis of Labor Quality,” in Takatoshi Ito and Anne O. Krueger (eds.), The Role of Foreign Direct Investment in East Asian Economic Development (Chicago: University of Chicago Press) 213–238.


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Dutta, M., 1991. “United States–China Joint Ventures — A Revisit,” in M. Dutta and Zhongli Zhang (eds.), China’s Economic Reform, 1978–1988 (Greenwich, CT: JAI Press) 3–20. Dutta, M. and M. Merva, 1990. “US–China Joint Ventures: An Economic Appraisal,” in M. Dutta, Pei-Kang Chang and Shao-Kung Lin (eds.), China’s Modernization and Open Economic Policy (Greenwich, CT: JAI Press) 171–196. Dutta, M. and Zhongli Zhang, 1991. “Laws of the PRC on Joint Ventures,” China’s Economic Reform, 1978–1988 (Greenwich, CT: JAI Press) 21–64. Dutta, M., 1999. Economic Regionalization in the Asia-Pacific: Challenges to Economic Cooperation (London: Edward Elgar). MOFTEC (Ministry of Foreign Trade and Economic Cooperationa), 2001. “Statistics on China’s Utilization of Foreign Investment in 2000 (Jan–Dec),” http://www.mofcom.gov.cn/table/wztj/2000− 1− 12.html, accessed October 16, 2003. MOFTEC, 2002. “Statistics on Utilization of Foreign Investment in 2002 (Jan–Sept),” http://www.mofcom.gov.cn/table/wztj/2002− 9.html, accessed October 16, 2003. National Bureau of Statistics, 1999, 2000, 2001. China Statistical Yearbook (Beijing: China Statistical Information & Consultancy Service Centre). OECD (Organization of Economic Cooperation and Development), 2003. “Trends and Recent Developments in Foreign Direct Investment,” http://www.oecd.org/ dataoecd/52/11/2958722.pdf, accessed October 16, 2003 United Nations, 1996 and 2000. World Investment Directory (New York: United Nations). World Bank, 2001. World Development Indicators (Washington, D.C.: World Bank). Wei, Shang-Jin, 2000. “Why does China Attract So Little FDI?” in Takatoshi Ito and Anne O. Krueger (eds.), The Role of Foreign Direct Investment in East Asian Economic Development (Chicago: University of Chicago Press) 239–265. Wei, Wenhui, 2004. “Foreign Direct Investment in China,” Ph.D. Dissertation, New Brunswick, NJ, Rutgers University.


Agglomeration Economies and FDI Spatial Distribution: Evidence from Joint Ventures in China Chyau Tuan∗ & Linda F. Y. Ng† Professors, Department of Decision Sciences and Managerial Economics Faculty of Business Administration The Chinese University of Hong Kong, Hong Kong, China ∗ [email protected] † [email protected]

1. Introduction Fueled by the huge influx of immigrants, technology, and capital from China after World War II, Hong Kong attained remarkable export-led development. Real GDP growth averaged 10.1 percent during the 1960s and 9.8 percent during the 1970s. Since the 1970s, Hong Kong has continued its transformation away from manufacturing dominance to develop a service sector particularly strong in banking and finance. Industry progress was mitigated, however, by Hong Kong’s “passive” industrial policy and the resulting sluggish technological upgrading of a manufacturing sector dominated by small private labor-intensive firms (Tuan and Ng 1995c). The situation became critical in the late 1970s as Hong Kong’s competitive edge eroded vis à vis the other Newly Industrialized Economies (NIEs) of Asia whose governments were pursuing proactive policies to push development of high tech electronics, information, and communications industries (Tuan and Ng 1995a). The economic opening of China at about the same time provided Hong Kong with an alternative approach to sustaining economic growth. China established four Special Economic Zones (SEZs), two of which were located in the Pearl River Delta (PRD) of Hong Kong’s neighboring Guangdong province (Ng and Tuan 2001), and conferred on them special privileges with regard to FDI inflows. Hong Kong FDI into Guangdong started in 323

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the form of sub-contracting and subsequently took other forms, including full plant relocations, all aimed at continually reducing production costs to maintain Hong Kong’s competitive edge in the world market (Tuan and Ng 1994). This farming out of processing activities powered economic growth in Hong Kong until the late 1990s when the contagion effect of the Asian financial crisis hit (Tuan and Ng 1998). Real GDP growth from 1981 until 1997 averaged 5.8 percent a year. Across the border, Guangdong was busy achieving success with export-led growth driven by FDI inflows (Vogel 1989). The draw of investment from Hong Kong to Guangdong during the 1980s can readily be explained by Guangdong’s low input costs and early economic opening. But this explanation no longer holds in the 1990s, for strong FDI inflows continued despite the spread of more favorable policies throughout China and an increase in input costs in the PRD relative to other regions. Against vigorous competition from other parts of China, Guangdong remained the country’s largest recipient of inward FDI and maintained an economic growth performance unmatched elsewhere. Hong Kong’s share in Guangdong’s inward FDI slipped from 95 percent in 1986 to around 60 percent in 1999 while Guangdong remained the top ranked destination within China for Hong Kong’s outward FDI. By the end of 1998, 53 percent of all outward FDI from Hong Kong went to China and of this 65 percent was hosted by Guangdong (Hong Kong Government Department 1999). Why has Guangdong, and especially the Pearl River Delta, been able to continuously attract the major share of China’s FDI inflows from Hong Kong and other sources? Relatedly, what underlies Hong Kong’s successful economic growth experience over the last two decades? More overarchingly, what forces have been at work in the fast-growing region that encompasses Hong Kong and the PRD? This paper expands on conventional approaches to FDI analysis to examine the impact of agglomeration economies in a core-periphery (CP) system defined by Hong Kong and the PRD. The objectives of this paper are: (1) to confirm via gravity model analysis a CP relationship for the region; (2) to investigate patterns of FDI agglomeration within the CP-system; and (3) to explore the effects of industry type, FDI origin, and firm scale on FDI distribution.

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2. FDI Facilitation in a Core-Periphery System: Theories and Evidence 2.1. Significance of the core-periphery system and agglomeration economies The notion of a core-periphery relationship for Hong Kong and the PRD was first supported by Tuan and Ng (1995b) using gravity analysis based on prefecture data for the period 1988–1992. A subsequent study (Tuan, Ng and Wong 1998) used firm-level data to examine investment behavior with regard to stepwise plant relocation. The firm-level study demonstrated a spatial diffusion pattern of Hong Kong outward FDI with flows first concentrated in the SEZs, then extending gradually over time to ever further reaches of the PRD. The outward movement of processing activities and growing diffusion within a city-suburban context are well-known economic dimensions of evolving land use patterns (Alonso 1964). Investment is transmitted outward via plant relocation from the center or core, in this case Hong Kong, to the suburban areas or periphery, in this case the PRD. Seminal research on the topic of manufacturing firm relocation in New York City by the American Regional Plan Association contributed significantly to later studies of urban agglomeration economies and diseconomies (e.g., Henderson 1988; Krugman 1991; Richardson 1995). The process of manufacturing relocation from city core to periphery to form a CP system is the subject of Krugman’s (1991) spatial development theory. Krugman suggested that regional economic activities would tend to exhibit greater spatial concentration in relation to increasing scale economies in production. This “new economic geography” has emphasized the significance of agglomeration externalities to explain spatial investment flows (Krugman 1998). Within the CP region, transportation costs are a dominant factor in firm location decisions so that the nodes of highway networks become ideal sites for investment (Louveaux and Bequin 1982). Evidence of agglomeration economies in economic growth patterns of metropolitan areas was further elaborated by Quigley (1998) who discussed the implications of agglomeration for city size diversity. Factors noted by Quigley as underlying agglomeration were scale economies, savings in transaction costs, input sharing, and quality of life improvements due to concentration in both production and consumption activities. Quigley’s framework was used by Tuan and Ng (2001a) to analyze the

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Hong Kong-PRD CP system with respect to dispersion of economic activities and city size.

2.2. Hong Kong as a service-city core since 1990s Hong Kong’s export-led economic growth of the 1980s was realized mainly through the transfer of manufacturing to Guangdong. In the 1990s, opening of China’s service sector to FDI brought new momentum to regional growth. The formation of a CP system with a service core in Hong Kong and a manufacturing periphery in Guangdong was supported by development of a transportation network comprising road, river, ocean, rail, and air modes plus associated communications facilities all linked to a Hong Kong hub. As the network developed, more FDI was stimulated, and this in turn promoted further strides in infrastructure development to form a positive feedback loop. The process drove Hong Kong’s industrial restructuring from manufacturing to services, the associated shift in production and employment being analyzed in Ng (1995) and that in output in Tuan and Ng (1995d). An empirical study of Hong Kong’s restructuring was undertaken by Ng and Tuan (1996) using a survey that documented relocation of whole production plants and management operations to Guangdong and in particular the PRD region. Further evidence followed from a study of 2,441 foreign invested electronics firms that showed networked clusters of firms were formed by exploiting economies of agglomeration in the PRD region. A regional division of labor was formed between Hong Kong and the PRD within which Hong Kong performs mainly service functions while manufacturing operations are located in the PRD (Tuan and Ng 2001b). The changing nature of Hong Kong trade over the last two decades is captured in Table 1 which shows trade shares in GDP. The share of re-exports to GDP grew at an annual rate of 24 percent during 1980–1987 to surpass the share of domestic exports which grew at a 10.4 percent rate over the same period. The gap has widened dramatically since then, re-exports exceeding domestic exports by a factor of three in 1992 and a factor of almost eight in 2000 by which time total exports reached 128 percent of GDP. The majority of re-exports through Hong Kong are produced in Guangdong, and the PRD in particular. Hong Kong’s service exports have also increased over the last two decades due to China’s opening to FDI in trade services and transportation.


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Table 1. Commodity and Service Trade Shares in GDP, 1981–2000 (In Percent) Year

Commodity trade Domestic exports

1981 1987 1992 1997 1999 2000

47.1 50.8 30.0 16.0 13.9 14.2

Re-exports

24.4 47.5 88.6 94.0 95.7 104.4

Service trade Imports

81.5 98.8 123.0 122.3 113.3 130.6

Exports

Imports

20.7 24.0 24.3 22.5 23.8 26.3

12.8 13.6 14.7 13.6 14.7 14.6

Source: Compiled by the authors from HKSAR Department of Census and Statistics (2001).

Table 1 shows an increase in the share of service exports to GDP from 20.7 percent in 1981 to 26.3 percent in 2000. For the most part, Hong Kong’s service exports are “trade derivatives” in that they support merchandise trade by providing transport, logistics, and other trade services (Tuan and Ng 1998). As an export-led, small open economy, Hong Kong is moving along a service-oriented path. A further sense of Hong Kong’s role as a service-trade “derivatives” center can be gained by examining sectoral shares in GDP and employment, shown in Table 2. Between 1981 and 1999, manufacturing contracted steeply in relative terms, its share in GDP declining from 22.8 percent to 5.8 percent and in employment from 36.2 percent to 7.9 percent. Over the same period, trade and transport services saw its share in GDP rise from 15.9 percent to 24.3 percent and in employment from 7.7 percent to 20.8 percent. Other trade “derivatives” such as business services, financial services, and communications, have all demonstrated similarly notable growth. 3. Research Methodology This study undertakes to empirically examine flow patterns of FDI within the Hong Kong–PRD core-periphery system. Data utilized for the purpose are at firm level and exhibit detail on industrial sector, source of investment, and scale of operation as well as county location. Such detail offers the possibility for more thorough-going statistical analysis of the CP system than has heretofore existed.

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Table 2. Sectoral Shares in GDP and Employment, 1981, 1999 (In Percent) Sector

Manufacturing Trade/transport Business services Financial services Communication

1981

1999

GDP

Employment

GDP

Employment

22.8 15.9 2.6 7.8 1.4

36.2 7.7 1.9 2.7 0.7

5.8 24.3 4.1 11.7 1.9

7.9 20.8 5.2 5.0 1.2

Sources: Compiled by the authors, for employment from Hong Kong Monthly Digest of Statistics, various issues, Department of Census and Statistics, HKSAR, and for GDP from 2000 Estimates of Gross Domestic Product, Department of Census and Statistics, HKSAR, 2001.

3.1. The data The dataset comprises 37,742 joint venture (JV) firms operating in Guangdong province in 1998. The data were compiled by the Guangdong provincial government and released in the 1998 Database of Guangdong Joint Ventures. Corresponding data by county-level jurisdiction were obtained for major economic variables from official government publications. Major features of the JVs in the Guangdong database are as follows: (1) Small and medium-sized enterprise dominance: 55 percent of the sample JVs have registered capital of US$1 million or less and over 70 percent employ fewer than 100 persons. (2) Manufacturing dominance: 82 percent of the sample JVs are in manufacturing while only 2.5 percent are in primary production and 15.5 percent in services. Manufacturing is concentrated in low technology, labor-intensive activities. (3) Hong Kong source investment dominance: 83.3 percent of sample JVs have investment from Hong Kong, 3.5 percent from Macau, and 5.5 percent from Taiwan with these three sources thus claiming 92.3 percent of the sample. Firms with investment from Hong Kong did not differ significantly in key aspects from those with investment from other sources: average scale of investment was US$4.15 million for Hong Kong source firms, US$4.20 million for others; average employment


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was 160 versus 156 persons; and average length of operation was 15.1 versus 15.5 years. (4) Spatial concentration: a significant portion of sample JVs are located in the proximate area of Hong Kong — 68.7 percent in the PRD region (comprising 22 counties and six cities of county level jurisdiction) and 50 percent in Shenzhen, Zhuhai, Guangzhou, and Dongguan specifically. The Special Economic Zones of Shenzhen and Zhuhai are located, respectively, 35 kilometers by highway and 75 kilometers by sea from Hong Kong. Both Guangzhou (the provincial capital) and Dongguan are less than 200 kilometers from Hong Kong and connected with Kowloon (Hong Kong) by the Kowloon–Canton Railway. 3.2. Spatial distribution: GIS mapping With the aid of Geographical Information System (GIS) software, the distribution of foreign-invested joint ventures among Guangdong’s 104 county-level jurisdiction has been mapped in Figures 1 and 2. Figure 1

Figure 1. County Distribution of Manufacturing FDI in Guangdong by Firm Number (1998)

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Figure 2. County Distribution of Services FDI in Guangdong by Firm Number (1998)

captures the 30,178 manufacturing JVs and Figure 2 the 5,438 service JVs of the dataset. A core-periphery pattern of diffusion emanating from Hong Kong outward through Guangdong province shows up clearly in these figures.1 FDI has been transmitted from the core in Hong Kong to its proximate peripheral area in the PRD and then on to more outlying counties with ever declining density. 3.3. The model The model treats the county as the unit of observation and captures the relationship between the amount of FDI in a county and its distance from the core (Dist) controlling for three other factors in agglomeration, namely, land area (Area), population density (Pop/Area), and GDP per capita (GDP/Pop). Distance from the core — the frictional factor — is taken as road distance 1 Similar

of firms.

diffusion patterns were confirmed for FDI measured by value rather than number


331

from Hong Kong in kilometers as measured on the map. The explanatory variables interact multiplicatively so that the estimated parameters reflect elasticities. The estimating model is: β

β

β

β

FDIC = β0 (Area)C1 (Pop/Area)C2 (GDP/Pop)C3 (Dist)C4 εC

(1)

where C = 1, 2, 3, . . . , 104, indicates county, βs are the parameters to be estimated, and is the disturbance. County FDI is measured in two ways: (1) number of firms (FDI− N ); and (2) investment volume in US dollars (FDI− $). FDI is expected to vary inversely with Dist and directly with Area, Pop/Area, and GDP/Pop. Expected signs for the parameter estimates are thus β1 > 0, β2 > 0, β3 > 0, and β4 < 0. It is further expected that FDI for different firm types will respond differently to factors that affect agglomeration. The distinctions in firm type to be studied here are: (1) manufacturing versus services; (2) firm size where small and large are distinguished by a threshold of 200 employees for manufacturing firms and 100 for services firms; and (3) FDI source where investment from the Hong Kong core is distinguished from non-core sources. The model is estimated separately for different characterizations of the dependent variable. For example, in one regression the dependent variable is defined as the number of small manufacturing firms with core source investment. By selecting different firm features to define the dependent variable, a total of 16 regressions has been generated. Only counties that have positive values for a given definition of the dependent variable are included in a regression sample. Regression is performed using OLS in log-linear form. 4. Statistical Results Results are presented in Tables 3 and 4 for, respectively, comparison of manufacturing and service firms and comparison of firms with Hong Kong source and non-Hong Kong source investment. 4.1. FDI flow patterns by industrial sector and firm size Table 3 presents results from eight regressions distinguishing first between FDI measured by number of firms and FDI measured by investment value, then between manufacturing and services, and finally between small and large size.

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FDI by number of firms Manufacturing Sample size Elasticity coefficient constant Area Pop/Area GDP/Pop Distance Adjusted R 2

FDI by investment value

Services

Manufacturing

Services

Small 101

Large 100

Small 96

Large 73

Small 101

Large 100

Small 96

Large 73

−2.589 (2.081) 0.865∗∗ (0.114) 0.651∗∗ (0.157) 0.864∗∗ (0.209) −0.607∗∗ (0.250)

−2.918 (1.784) 0.736∗∗ (0.101) 0.734∗∗ (0.140) 1.062∗∗ (0.176) − 0.582∗∗ (0.214)

−6.503∗∗ (1.975) 0.972∗∗ (0.108) 0.650∗∗ (0.153) 0.969∗∗ (0.200) −0.336 (0.237)

−7.433∗∗ (1.428) 0.728∗∗ (0.080) 0.899∗∗ (0.121) 0.940∗∗ (0.142) −0.366∗∗ (0.161)

−0.320 (2.281) 1.076∗∗ (0.125) 0.831∗∗ (0.172) 1.130∗∗ (0.229) −0.596∗∗ (0.274)

2.016 (2.280) 0.893∗∗ (0.129) 0.530∗∗ (0.179) 1.594∗∗ (0.225) −0.405 (0.273)

−2.905 (3.047) 1.356∗∗ (0.167) 0.910∗∗ (0.236) 1.300∗∗ (0.308) −0.695∗ (0.366)

−6.092∗∗ (2.635) 1.014∗∗ (0.148) 1.138∗∗ (0.223) 1.767∗∗ (0.262) −0.165 (0.295)

0.611

0.709

0.630

0.788

0.633

0.673

0.598

0.701

Note: Standard errors given in parentheses; ∗ and ∗∗ indicate statistical significance at p < 0.10, and p < 0.01, respectively.


Table 3. Regression Results by Industrial Sector and Firm Size for FDI Measured by Firm Number and Investment Value

Table 4. Regression Results by Industrial Sector, FDI Source, and Firm Size for FDI Measured by Firm Number

Core source Sample size Elasticity coefficient constant Area Pop/Area GDP/Pop Distance Adjusted R 2

Services

Non-core source

Core source

Non-core source

Small 101

Large 100

Small 91

Large 77

Small 95

Large 79

Small 66

−2.914 (2.051) 0.880∗∗ (0.112) 0.680∗∗ (0.154) 0.797∗∗ (0.206) −0.628∗∗ (0.247)

−3.596 (1.780) 0.742∗∗ (0.101) 0.768∗∗ (0.140) 1.048∗∗ (0.176) −0.546∗∗ (0.213)

−2.005 (2.085) 0.510∗∗ (0.117) 0.745∗∗ (0.167) 0.907∗∗ (0.215) −0.638∗∗ (0.252)

−0.118 (1.917) 0.341∗∗ (0.121) 0.816∗∗ (0.161) 0.730∗∗ (0.208) −0.974∗∗ (0.241)

−5.993∗∗ (1.972) 0.931∗∗ (0.108) 0.617∗∗ (0.153) 0.895∗∗ (0.206) −0.388 (0.239)

−7.158∗∗ (0.378) 0.755∗∗ (0.078) 0.885∗∗ (0.113) 0.858∗∗ (0.136) −0.368∗ (0.156)

−6.573∗∗ (2.153) 0.611∗∗ (0.117) 0.463∗∗ (0.199) 0.965∗∗ (0.213) 0.074 (0.258)

−2.282 (2.226) 0.419∗∗ (0.131) 0.256 (0.192) 0.819∗∗ (0.239) −0.336 (0.257)

0.613

0.707

0.626

0.709

0.614

0.783

0.495

0.596

Note: Standard errors given in parentheses; ∗ and ∗∗ indicate statistical significance at p < 0.10, and p < 0.01, respectively.

Large 38


Manufacturing

333

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All coefficient estimates for all eight regressions are of the expected sign. Moreover, all estimates for the control variables — land area, population density, and per capita GDP — are significant at the one percent level. The numbers suggest generally higher elasticities for FDI measured by value than for FDI measured by firm numbers, particularly with respect to per capita GDP. The gravity (or distance) effect seems to be greatest for small manufacturing firms whether with respect to number of firms or investment value. That FDI location would be more influenced by distance from the core for small manufacturing firms stands to reason as the transportation cost savings would presumably be more critical for such firms. By contrast, services would tend to concentrate more highly in more urbanized and wealthier areas, and the more so for larger scale services, with less concern for distance from Hong Kong. 4.2. Behavior of FDI by investment source and firm size Table 4 presents results focused on assessing the impact of core source versus non-core source on investment flows, where again distinctions are drawn between manufacturing and services and between small and large scale. Investment flows are examined by firm number only. Again, all coefficient estimates are of the expected sign and estimates for the control variables are in general statistically significant. Investment by core source and non-core source does not show appreciable differences in responsiveness to these factors. The gravity effect has its most pronounced influence on manufacturing firms in contrast to the statistically negligible influence on services. This is explained by service activities usually being located close to the market Table 5. Firm Concentration Correlations by Industrial Sector and Firm Size Services

All sizes Small Large

Manufacturing All sizes

Small

Large

0.831 0.813 0.883

0.879 0.866 0.904

0.693 0.669 0.787

Note: Sample size = 104 counties; all coefficients significant at p < 0.01.


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and by transportation costs for moving commodities to and from the Hong Kong entrepot being of relatively little concern. The statistical results reveal no clear distinction for Hong Kong invested firms to locate closer to the core than other firms. On the contrary, for large manufacturing firms there appears to be a stronger tendency for noncore source investors to locate closer to Hong Kong. Thus the appeal of proximity to Hong Kong transcends the power of being close to home for local investors. 4.3. Agglomeration patterns by sector, size, and source: Correlation analysis Apart from the core-periphery pattern of agglomeration focused on Hong Kong, firms may be locating in more dispersed cluster patterns within Guangdong Province. Correlation coefficients for the number of foreigninvested JVs per county have been computed to test for this phenomenon. Table 5 details correlations by industrial sector and firm size and Table 6 by FDI source for manufacturing and for services. Table 5 shows that concentration of service firms tends to be highly correlated with concentration of small-scale manufacturing firms though less so with large-scale manufacturing firms, perhaps because large-scale firms are able to meet more of their own service needs in-house. This suggests the inter- and intra-industry linkages for small-scale manufacturing firms may be particularly high. Table 6 shows that for both manufacturing and services, Hong Kong and Taiwan invested firms have a very strong tendency to locate in the same counties. The tendency of firms with FDI from other sources to locate in the same counties as Hong Kong invested firms is somewhat less pronounced. Table 6. Firm Concentration Correlations by FDI Source and Industrial Sector Core source

Taiwan Others

Manufacturing

Services

0.938 0.779

0.918 0.852

Note: Sample size = 104 counties; all coefficients significant at p < 0.01.

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Taiwan and Hong Kong invested firms have shown success in sharing production resources and expertise. Both economies have strong traditions of small business entrepreneurship. Both also have been at the forefront of the drive to invest in Guangdong. 5. Conclusion The huge influx of FDI into Guangdong is difficult to explain with conventional FDI theories especially in the 1990s given the keen competition of the Shanghai–Jiangsu region with its strong industrial base and abundant input supplies. Appeal to Krugman’s (1991) core-periphery theory brings insight into the contribution of Hong Kong as a center of gravity. Agglomeration economies generated by the Hong Kong–PRD region have clearly contributed significantly to the attraction of FDI. In the Hong Kong–PRD system, core and periphery have made complementary contributions to the region’s dynamism. The Hong Kong economy rests on traditions of half a century of entrepreneurial small business which is the defining mode of operation for Guangdong. During the past two decades of boom in outward processing activities in the PRD, production techniques and scale of operation have remained unchanged. Hong Kong meanwhile has become the seat of regional headquarters for multinationals and a base for sophisticated financial, legal, and trade services. Emanating outward from the Hong Kong core is a developing web of superior infrastructure and tertiary industry that serve to reduce transaction costs and facilitate agglomeration. The agglomeration economies of this CP-system remain continuingly favorable particularly to small business entrepreneurs. China’s WTO accession should enhance the role of the Hong Kong– PRD region. To promote sustained FDI inflows, it is important to continue to improve the investment environment through efforts to raise the caliber of government administration, reduce bureaucracy and restrictions on business operations, build infrastructure, and maintain favorable macroeconomic policies. 6. References Alonso, W., 1964. Location and Land Use (Cambridge: Harvard University Press). Hong Kong Government Department, 1999. Hong Kong Government Survey of FDI (Hong Kong: Hong Kong Government SAR).


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Henderson, J. V., 1988. Urban Development: Theory, Fact, and Illusion (NewYork: Oxford University Press). Krugman, P., 1991. “Increasing Returns and Economic Geography,” Journal of Political Economy 99(3): 483–499. ——, 1998. “Space: The Final Frontier,” Journal of Economic Perspectives 12(2): 161–174. Louveaux, F., J. F. Thisse and H. Bequin, 1982. “Location Theory and Transportation Costs,” Regional Science and Urban Economics 12(Nov): 529–545. Ng, L. F. Y., 1995. “Changing Industrial Structure and Competitive Patterns of Manufacturing and Non-Manufacturing in a Small Open Economy: An Entropy Measurement,” Managerial and Decisions Economics 16: 547–563. Ng, L. F. Y. and C. Tuan, 1996. “The Industrial Economic Foundation of the Growth Triangle: Empirical Evidence from the Integration Process of Hong Kong and South China,” in J. S. Li (ed.), The Emergence of the South China Growth Triangle (Taiwan: Chunghua Institutions for Economic Research) 115–152. Ng, L. F. Y. and C. Tuan, 2001. “FDI Promotion Policy in China: Governance and Effectiveness,” The World Economy 24(8): 1051–1074. Ng, L. F. Y. and C. Tuan, 2002. “Building a Favorable Investment Environment: Evidence for Facilitation of FDI in China,” The World Economy 25(8): 1095–1114. Quigley, J. M., 1998. “Urban Diversity and Economic Growth,” Journal of Economic Perspectives 12(2): 127–138. Richardson, H. W., 1995. “Economies and Diseconomies of Agglomeration,” in H. Giersch (ed.), Urban Agglomeration and Economic Growth (Berlin: Springer-Verlag). Tuan, C., 1987. “Industrial Development and Scientific Manpower Training: The Case of Consumer Electronics in Hong Kong and Taiwan,” Taiwan Economic Study 10(4): 99–112 (in Chinese). Tuan, C. and L. F. Y. Ng, 1994. “Economic Liberalization in China and Structural Adjustment of Hong Kong Manufacturing,” Seoul Journal of Economics 7(2): 124–144. Tuan, C. and L. F. Y. Ng, 1995a. “Evolution of Hong Kong’s Electronics Industry under Passive Industry Policy,” Managerial and Decision Economics 16(4): 509–523. Tuan, C. and L. F. Y. Ng, 1995b. “Hong Kong’s Outward Investment and Regional Economic Integration with Guangdong: Process and Implications,” Journal of Asian Economics 6(3): 385–405.

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Tuan, C. and L. F.Y. Ng, 1995c. “Manufacturing Evolution under Passive Industrial Policy and Cross-Border Operations in China: The Case of Hong Kong,” Journal of Asian Economics 6(1): 71–88. Tuan, C. and L. F. Y. Ng, 1995d. “The Turning Point of the Hong Kong Manufacturing Sector: Impact of Outward Investment to the Pearl River Delta,” Journal of International Trade and Development 4(2): 153–170. Tuan, C. and L. F. Y. Ng, 1998. “Export Trade, Trade Derivatives, and Economic Growth of Hong Kong: A New Scenario,” Journal of International Trade and Economic Development 7(1): 111–137. Tuan, C. and L. F. Y. Ng, 2001a. “The Post-Industrialized Economic Growth of Hong Kong: Perspectives from a Mega-City Formation,” in J. Behrman, M. Dutta, S. L. Husted, P. Sumalee, C. Suthiphand and P. Wiboonchutikula (eds.), Restructuring Asian Economies for the New Millennium (North Holland: Elsevier Science) 513–532. Tuan, C. and L. F. Y. Ng, 2001b. “Regional Division of Labor from an Agglomeration Economies’Perspective: Some Evidence,” Journal of Asian Economics 12(1): 65–85. Tuan, C. and L. F. Y. Ng, 2002. “From Manufacturing Cross-Border Operations to Regional Economic Integration: Evolution of Hong Kong’s Economy and the Guangdong Factor,” in A. Yeh, Y. F. Lee, T. Lee and N. D. Sze (eds.), Building a Competitive Pearl River Delta Region: Cooperation, Coordination, and Planning (Hong Kong: Center of Urban Planning and Environment Management, The University of Hong Kong) 81–97. Tuan, C., L. F. Y. Ng and C. S. Wong, 1998. “Mega City Formation and Regional Development,” China Industrial Economy 7: 52–58 (in Chinese). Tuan, C. and C. S. Wong, 1994. “Evolution of FDI Patterns and Management of Transnational Corporations in Hong Kong,” Regional Development Dialogue 4(4): 125–145. Tuan, C., D. Wong and C. S.Ye, 1986. Chinese Entrepreneurship under Capitalism and Socialism — Hong Kong and Guangzhou Cases, Monograph No. 68 (Hong Kong: Center of Asian Studies, University of Hong Kong) (in Chinese). Vogel, E. F., 1989. One Step Ahead in China: Guangdong Under Reform (Cambridge: Harvard University Press).

Korea–China Technological Cooperation Yang-Taek Lim Professor, Department of Economics and Finance Hanyang University, Seoul, Korea [email protected]

1. Korea–China Economic Relations Since Korea and China established diplomatic relations on August 24, 1992, trade and investment between the two countries have grown rapidly, making each the other’s third ranked trading partner after the US and Japan.1 Based on this performance, Korea and China agreed to upgrade their relations from “cooperative companion” to “full cooperation” when Chinese Premier Zhu Rongji visited Korea in October 2000. Consequently, although Korea–China economic cooperation has been implemented primarily for economic reasons, as their economic relations have developed, political and security relations between Beijing and Seoul have also improved. Between 1992 and 2001, Korea’s exports to China grew at an average annual rate of 24 percent, about three times faster than Korea’s total exports which grew at 7.8 percent. Korea’s imports from China grew at a rate of 15 percent while the country’s total import grew at 6.2 percent. This led China’s share in Korea’s trade to increase, on the export side from 3.5 percent in 1992 to 12.1 percent in 2001, and on the import side from 4.6 percent to 9.4 percent. Korea’s trade with China recorded a surplus of US$1.22 billion in 1993, reached a peak at US$5.66 billion in 2000, and declined to US$4.89 billion in 2001. From 1993 through the first half of 2002, the cumulative surplus in Korea’s trade with China stood at US$33.31 billion. This number looms 1 Hong

Kong and Taiwan are excluded from the ranking for China. 339

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large relative to the US$8.80 billion surplus Korea recorded with the US and the US$10.10 billion deficit with Japan for the same period. China’s trade statistics show even larger surpluses in Korea’s favor, the figure for 2001 reaching US$10.9 billion, because Chinese numbers incorporate indirect trade via Hong Kong which is also in surplus. By China’s reckoning, its deficit with Korea is second only to that with Taiwan.2 The trade imbalance has generated friction between Korea and China. When Zhu Rongji visited Korea in 2000, he demanded that the Korean government correct the imbalance and open the country’s agricultural markets to Chinese products. The main reason for the explosive growth in Korea’s exports to China was the rapid increase in import demand resulting from the high-speed growth of China’s economy. China sustained GDP growth of about ten percent a year in the 1990s, with the rate declining somewhat thereafter to 8.0 percent in 2000 and 7.3 percent in 2001. Growth in the manufacturing sector at 8–10 percent a year stimulated import demand for materials, parts, and machinery. Because Korea is geographically close by and possesses both the technology and the production capacity to meet China’s needs, it has taken advantage of the opportunity presented by China’s rapid growth. The principal products exported by Korea to China are parts and raw materials including electric and electronic parts, semiconductors, and chemical raw materials (Korea Ministry of Foreign Affairs and Trade). Because of China’s fast economic growth, geographic proximity, and industrial complementarity, Korea–China trade is expected to continue to record steady gains. The Korean Ministry of Commerce, Industry and Energy (KMOCIE) predicts that Korea–China trade will triple to US$102.5 billion by 2008 when Beijing hosts the Olympic Games. Korea’s exports to China will be boosted as China’s WTO entry results in lower tariffs for core industries like automobiles, chemicals, and electronics and in the elimination of non-tariff barriers. As with trade, Korea’s investment in China has risen rapidly since diplomatic relations were established in 1992. Up to 1991, Korea’s cumulative contracted investment in China amounted to just 112 contracts worth 2 Korea’s

statistics for 2001 showed exports to China of US$18.19 billion while the corresponding import figure issued by the Chinese side was US$23.39 billion implying US$5.20 billion in Korean exports through Hong Kong. For imports from China, Korea showed US$13.30 billion which include indirect imports through Hong Kong while China’s corresponding export figure for direct exports only was US$12.52 billion.

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US$85 million. By year end 2001, the numbers jumped to 7,441 contracts worth US$8.72 billion. This accounted for 42.3 percent of all Korea’s foreign direct investment contracts and 17.0 percent of the total dollar amount (Korea Export-Import Bank 2000). China is second only to the US as a destination for Korean foreign direct investment for the period since 1994. China’s statistics capture an even larger investment flow from Korea at a cumulative US$12.48 billion through 2001 for a 3.1 percent share and seventh place in China’s total inward foreign direct investment.3 Whether China’s high economic growth on balance poses more threat or opportunity to the Korean economy in the future has become a controversial issue. Some analysts predict that Korea’s overall trade balance may deteriorate since the competitiveness of Chinese products on world markets has been improving (Song and Jung 2001). The share of Chinese products in the US and Japanese markets has soared while the shares of Korean products have held constant at roughly three percent and five percent for the two countries respectively. As China sees a steady transformation in its industrial structure, competitiveness in its capital- and technology-intensive industries is expected to pose a greater threat to Korea in the world market. Continued increase in Korea’s trade surplus with China will tend to bring about trade conflicts between the two countries.4 It is more likely that China will bring anti-dumping cases against Korean-made industrial goods and increase its pressure on Korea to open its agricultural market. Since introducing anti-dumping procedures in 1997, China, as of May 20, 2002, has brought 18 anti-dumping cases against foreign products, fourteen of which have been against Korean products. Since joining WTO in 2001, China has increasingly appealed to special import restrictions and antidumping measures. Five anti-dumping cases brought by China since WTO accession (copperplate paper, catechol, phthalic anhydride, cold-rolled sheet, PVC, and toluene) have been against Korean firms (Suh 2002). The number of anti-dumping cases against Korea is high because Korea has the largest trade deficit with China (excluding Taiwan), and also because steel and petrochemical products which are Korea’s primary exports to China pose a threat to Chinese domestic industries. 3 China’s measure is larger because it includes investment of small amounts not reported to Korean authorities, indirect investment via third countries, investment using local financing, etc. 4 For details, see Lim (2003).

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Given the sensitivity of its trade surplus with China, Korea should take care to implement judicious trade policies so that individual trade issues, such as the Korea–China garlic conflict in June 2000, do not erupt into full trade conflict. In the short term, trade conflict between the two countries should be resolved under WTO rules,5 and in the longer term, should be averted through expanded and more balanced trade between the two partners. Meanwhile, China’s industrial structure stands at a turning point. China needs to introduce advanced technologies in order to transform traditional industries and develop high-tech industries. In contrast, Korea possesses advanced technology in a number of high-tech industries. Korea is more advanced than China in the capital intensity and mechanization of its industry, but needs China’s sheer numbers in high-tech staff and size of market. Recognizing this mutual complementarity, Korea and China signed the Agreement on the Establishment of a Korea–China Industrial Cooperation Committee in Beijing in June 1994. Since then, subcommittee sessions have been held several times concerning TDX (Time Division Exchange), automobiles, airplanes, and HD (High Definition) TV technologies to discuss avenues for cooperation. High-tech industries generally have high growth potential. Moreover, development of high-tech industries tends to generate spin-offs that raise technology in other industries so that technological progress diffuses broadly. The introduction of high-tech to traditional industries yields higher value-added products through automation. But the spread of technology is impeded, with the gap between developed and developing nations thus becoming wider, as developed countries have increased their strategic alliance in high-tech industries. The returns to technology development have been reduced due to heavy R&D expenditure, rapid changes in technological innovation, and shortened product life cycles. Moreover, developing nations have ever greater difficulty entering high-tech industries because multinational firms from developed countries such as the US, EU, and Japan show an increased tendency to enjoy technological and 5 Each

member country of WTO is allowed to apply the criterion of “non-market country” to Chinese-made products for 12 years after China’s accession, opening the way for issuing arbitrary safeguards against Chinese products. Moreover, despite subsection 2.2, “Uniform application regardless of origin” of the Safeguard Agreement of the Uruguay Round, the “selective safeguard” provision may be invoked against Chinese products. For details, see Lim (2003).


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market dominance. As globalization has contributed to lowering barriers to the entry of multinational firms into developing nations, developed countries’technology hegemonism and protectionism against developing nations tends to become stronger. In addition, protection of intellectual property rights, emphasized in the Uruguay Round (UR), forces developing nations to bear higher costs for introducing, digesting, and expanding technologies (Lim 1997). Since Korea and China are inferior to developed countries in high-tech areas, they need to develop a new alternative to deal with the technological hegemonism and protectionism of developed countries (Lim 1999). The two countries must not only recognize the importance of science and technology (S&T) cooperation, they must also develop an efficient strategy for overcoming differences in their economic systems and socioeconomic environments.

2. Technology Policy and Cooperation Efforts 2.1. Korea’s technology policy and development The Korean government takes action in many ways to promote technological advance, as shown in Table 1. It directly undertakes R&D investment and conducts basic science research, and it promotes techno-park construction and the establishment of regional Technology Innovation Centers and Technology Business Centers. KMOCIE in particular promotes projects linking R&D with commercialization. For instance, under its industrial technology development initiative, the Korean government grants subsidies for projects involving common core technologies for domestic industry and for technologies to improve international competitiveness. Further efforts support expansion of industrial technology infrastructure including upgrading of technical staff, development of information systems, and promotion of joint research among industry, universities, and research institutes. In general, Korea’s technology is relatively advanced in assembly and labor-intensive manufacturing, whereas it is less developed in high technology, basic technology, and core technologies pertaining to design, materials, software, testing, and measurement (KMOCIE 1992). For example, in the semiconductor industry, Korea has risen to become the world’s second largest exporter. As Samsung Electronics succeeded in developing 256 MB DRAM (dynamic random access memory) six months to a year

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Y.-T. Lim Table 1. R&D Efforts Led by the Korean Government

Type of project

Highlights

Government-led priority R&D

Development of core technologies supporting national S&T innovation under the Five Year Plan for S&T Innovation.

Governmentdesignated R&D

R&D for addressing immediate national objectives and supporting development of basic technologies not adequately covered by the private sector.

Civilian-military technology development

Development of technologies for joint civil and military use.

Leading-technology R&D aimed at acquiring world-best technology in specified development products and fields by 2001. Creative research promotion

Identifying and germinating new technologies through basic science to overcome limitations of conventional technology.

Research base establishment

Intended to build a base for improving research productivity and competitiveness, covering construction of facilities for joint research among industry, universities, and research institutes.

S&T globalization

For cooperating with foreign researchers to overcome limitations of domestic R&D, and for supporting globalization of S&T and S&T based diplomacy.

Research-planning evaluation

Preliminary surveying, planning, management evaluation and support both for specific R&D projects and for R&D systems and policies in affecting R&D projects.

Sources: Korean Ministry of Science and Technology (1999 and 2000).

earlier than US and Japanese semi-conductor manufacturers, Korea took the world’s top position in memory semi-conductor technology. However, Korean technology is still in the early stages when it comes to non-memory aspects of semi-conductor production such as materials fabrication. In shipbuilding technology, as the world’s second largest shipbuilder Korea has been a global leader along with Japan. In 1993, Korea’s exports of ships surpassed those of Japan, although Korean productivity is only half that of Japan. Korea’s localization ratio of equipment and machinery


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in shipbuilding is about 85 percent whereas that of Japan is 67 percent (Korea ShipbuildingAssociation and Japan ShipbuildingAssociation 1998), although for high value-added LNG (liquefied natural gas) and LPG (liquefied petroleum gas) vessels Korea’s localization ratio is only about half that of Japan’s. In the information and communication field, Korea’s electronic exchange technology shows a three year gap relative to advance countries, but VAX (virtual address extension) and ISDN (integrated services digital network) technologies show a seven or eight year gap. Korea is weak in technologies related to ASIC (application specific integrated circuit) semiconductors, signal processing parts, CCDs (charged coupled devices), etc. In the automobile field, Korea is dependent on imported technologies for new car models and core parts such as engines, transmissions, and chassis. Electrical equipment technology lags four years behind the US, and technologies in new materials and lightweight auto bodies are in the early stages of development and application. 2.2. China’s technology policy and development Chinese S&T policies are carried out under long-term national development plans: the 15-year S&T Policy (1985–2000); the 10-year Plan for Development of the National Economy and Society (1991–2000); and the 9th Five Year Plan (1996–2000). Within this framework, the Top Six National S&T Programs have been articulated as follows: (1) the Key Technical Problem Tackling Program; (2) the Spark Program; (3) the S&T Achievement Promotion Program which mobilizes 60–70 percent of all scientists and technicians in traditional industry; (4) the High-Technology R&D Program (otherwise known as the 863 Program); (5) the Torch Program which targets the world scene; and (6) the Basic Research Program for expanding the base of S&T.6 Within this policy framework, the Chinese government concentrates limited resources to maximize S&T achievements. Examples of this approach include the transfer of defense technology to civilian industry and the promotion of cooperation among industry, universities, and research institutes through the Technology Development Center, the Open 6 Liu

and White (2001) analyzed China’s national innovation system under central planning and since reforms, revealing the evolving structure and dynamics of this system and current inconsistencies and perverse incentives.

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Laboratory in the China Science Institute, and the Technology Development Corporation. China succeeded in manufacturing airplanes in 1954, in developing jet planes and testing the atomic bomb in 1964, and in launching the “East is Red I” satellite in 1970. China has Nobel prize winners and world-famous scholars in the basic sciences. China has superior technology in aerospace, in defense, and in the basic sciences, but lags in manufacturing technology. Chinese technology in rockets, satellites, and nuclear science is on par with that of advanced countries. In particular, the Long March No. 4 rocket is top tier. Also, applications like DTP (desktop publishing), voice recognition and voice synthesis, and materials engineering in metals show advanced development. However, technology in computers and electrical machinery is still backward. Fertilizer and agricultural chemical technologies are also underdeveloped. And, the level of IC (integrated circuit) technology is low (The Korea–China Science & Technology Cooperation Seminar 1993).

2.3. Korea–China government cooperation in S&T Since establishing diplomatic relations in 1992, Korea and China have concluded two key agreements: the Agreement to Establish the Korea–China Industrial and Technological Cooperation Committee and the Agreement on Korea–China S&T Cooperation. 2.3.1. Korea–China Industrial Cooperation Committee In June 1994, Korea and China signed the Agreement to Establish the Korea–China Industrial and Technological Cooperation Committee in order to stimulate industrial cooperation between the two countries, especially joint development, production and sales of high-tech products. Since its first meeting in June 1994, attended by the Korean Minister of Commerce, Industry and Energy and the Chief of China’s State Economic and Trade Commission, the Committee has generally held annual meetings alternating location between Seoul and Beijing. The first meeting set automobile parts, HDTV, TDX, and mid-sized airplanes as priority areas of cooperation. Korea and China agreed to start with joint production of automobile parts. The two countries further agreed to promote joint technology development, joint production, and joint sales for mid-sized airplanes. Joint production of small electronic switches and


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joint development of next generation switches were agreed upon for TDX. Finally, the two countries agreed that industrial cooperation in HDTV would focus on specifications and joint development of core parts. Korea and China maintained good cooperation in the above four fields through the third meeting of the Committee in Seoul, August 1995. In 1996, the two countries had disagreements on mid-sized airplanes, and consequently postponed the fourth meeting of the Committee for one year. While joint investment in automobile parts yielded significant visible achievements, e.g., the establishment of a Daewoo joint venture to produce auto parts in Shandong, cooperation in HDTV, TDX, and mid-sized airplanes suffered disagreements and progress stopped or went at a snail’s pace. A breakthrough resulted, however, when former Korean President Kim Dae-Jung visited China. At the fourth meeting of the Committee held in Beijing in November 1998, Beijing and Seoul agreed to re-establish subcommittees for developing industrial cooperation into the 21st century. To the existing four areas of cooperation was added petrochemicals, and the subcommittee structure was reorganized into the Subcommittee on S&T Industrialization, the Subcommittee on Energy, Resources and Environment, and the Subcommittee on Industrial Policy. The Subcommittee on S&T Industrialization, at the fifth meeting of the Korea–China Industrial Cooperation Committee held in April 2000 agreed to construct the Korea–China industrial and technological cooperation network and to pursue joint technology development in mid- and small-sized airplanes, petrochemicals, automobile parts, and ATMs. In petrochemicals, both countries agreed to increase industrial and technological cooperation, to expand exchanges of personnel and information, and to strengthen nongovernmental links in furtherance of trade and investment. Agreement was also reached to expand cooperation from HDTV to new electronic industries in light of market conditions. 2.3.2. Agreement on Korea–China S&T Cooperation TheAgreement on Korea–China S&T Cooperation was signed in September 1992. The principal objectives of the agreement were: to pursue common national interests in combining achievements in basic science to develop commercial technologies; and to promote localization of R&D, exchange of scientists and technicians, joint research, and the acceleration of technology transfer in fields showing Chinese superiority and attracting common interest.

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Under the Consent to Exchange Technology Survey Groups between Korea and China, both countries dispatch delegations of 20 members four times a year to gain understanding of the state of technology held by the other side with an eye to discovering potential S&T cooperation projects. Between 1993 and 1998, Korea sent 150 individuals in 28 delegations, and China 126 individuals in 24 delegations. Pursuant to the 1994 signing of the Memorandum on Exchange of Post-Doctoral Researchers between Korea and China, the two countries have pushed forward with one-year training stints for post-doc researchers in universities, business firms, and research organizations. Between 1994 and 1998, 81 Chinese researchers visited Korea and 45 Korean researchers visited China. The Project for Medium- and Long-Term Attraction and Dispatch of Scientists and Technicians has been established for increasing mutual understanding and stimulating technological exchange. A total of 200 scientists and technicians have participated in this program. In 1998, 26 Chinese scientists visited Korea and ten Korean scientists visited China. Between 1993 and 1997, 12 joint research projects selected by the Korea–China Joint S&T Committee were completed under budgetary support from the governments of the two countries. In 1998, Research on the Reaction andAdjustment of Carbohydrate Transferase was selected as a new research topic and 15 on-going research topics were reconfirmed. Thus, a total of 16 research projects were underway as of the end of 1998. Loworbiting small satellites, fuselage design, and medical laser equipment were selected as primary joint research topics. Of final note, the two countries have established five joint research institutes: • International S&T Cooperation Center, established in the New Technology and Industrial Development District in Zhongguancun in Beijing in November 1993; • Korea–China Atmospheric Science Research Center, established jointly at Korea National University of Education and Beijing University in 1993 for promoting exchange of personnel and information in atmospheric science; • Korea–China Joint Ocean Science Research Center, established at the First National Ocean Research Institute in Qingdao, Shandong


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Province, China in 1995, the Center having performed joint research in marine science and technology and pursued joint development of marine natural resources; • Korea–China Advanced Materials Cooperation Center, established jointly at the Korean Institute of Science and Technology and Beijing Non-Ferrous Metal Research Institute in 1997 to foster information exchange and joint research and to seek to improve industrial competitiveness and achieve penetration of world markets in the field of new materials synthesis; • Korea–China Bioscience and Biotechnology Cooperation Center, established jointly in the Korea Research Institute of Bioscience and Biotechnology in 1997 and the Shanghai Research Center for Life Sciences in 1998 to engage in joint research, exchange of scholars and information, construction of a database, and industrial application of biotechnology. In the cooperative environment fostered by these government initiatives, universities and research institutes have undertaken a variety of S&T cooperation projects. These are summarized in Table 2. 3. Commercial Technology Transfer Korea’s first commercial technology export to China was water-jet weaving technology from Korea Synthetic Fiber in 1980. Since the normalization of relations in 1992, Korean technologies exported to China include: batterytype stabilizer (Korea’s Woomyoung Sound Wave Electronics and China’s Jilin Electricity, Science and Technology Development Limited), car air conditioner (Korea’s Doowon Climate Control and China’s Changchun Radiator Limited), vessel dismantling technology, automation facility technology such as PLC (power line communication), industrial heat treatment facility technology, flour-milling technology, etc. In contrast, Korea’s technology imports from China have had a more modest beginning. Korea has made acquisitions from China in the fields of military technology, materials technology, chemical engineering technology, and power generation technology. In addition, many Korean enterprises, Samsung Group for example, have sent technicians to China in pursuit of commercial prospects connected with technologies in aviation, medical science, biotechnology, and automobiles.

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Y.-T. Lim Table 2. S&T Cooperation by Universities and Research Institutes

Korean partners

Chinese partners

Project

System Engineering Research Institute, Doping Center, Korea Meteorological Administration

Beijing Asian Games Organizing Committee

Supported computing, doping and meteorological technology development for the 1990 Asian Games in Beijing

Pohang University of Science and Technology

Institute of High Energy Physics

China transferred technology and equipment of 60MeV linear accelerator (Feb 1989–Feb 1992) China transferred technology on design accelerator tube for 2000MeV accelerator (Oct 1991–Jun 1994)

Inha University

Ocean Research Institute

Drew ocean map by analyzing data for the Yellow Sea and simulating the underlying forms (1990–1994)

Korea Atomic Energy Research Institute

China National Nuclear Corporation

Korea advised on non-destructive inspection of reactors #1 and #2 of China’s Daya Bay (Mar 1991–Oct 1993) and on accident prevention technology for large cooler of nuclear power plant in Jinshan

Korea Atomic Energy Research Institute

National Petrochemical Industrialization Company

Signed agreement of technical support for Chinese reactor safety

Korea Science and Engineering Foundation

State Science and Technology Commission, Chinese Science Administration

Signed memorandum of understanding (Aug 1991)


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Table 2. (Continued) Korean partners

Chinese partners

Project

The Korean Federation of Science and Technology Societies

Chinese Korean Scientist Association

Held international academic conference

Natural Products Research Institute in Seoul National University

Chinese Medical Science Research Institute, Chinese Medicine Research Institute, etc.

Established Korea-China Center for Cooperation in Medicine Launched Korean New Chinese Medicine Development Planning Group (as a part of G-7 Project)

Korea Ocean Research & Development Institute

API

Held the International Conference on Ocean Science for Northeast Asia in Seoul (Oct 1992)

Korea Electrotechnology Research Institute

Xian High Voltage Electricity Research Institute

Signed technology cooperation convention (personnel exchange, joint research, joint use of research equipment, etc.)

Korea Electric Power Corporation, Korea Ocean Research & Development Institute

State Science and Technology Commission

Conducted feasibility study of tidal power generation in the Karolim Bay in Chungnam

Source: KIST (Korea Institute of Science and Technology) 1993.

3.1. Korea’s technology exports to China Korea’s technology exports to China take the form of provision of information, supply of services, patent licensing, trademark licensing, and other grants of industrial property rights. Compensation is received in the form of fixed royalties, initial payments, and running royalties, with a single project

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Y.-T. Lim Table 3. Korean Technology Exports, 1991–1998 Exports to all countries Cases

1991 1992 1993 1994 1995 1996 1997 1998 Cumulative total

License fee (US$ mil)

Exports to China

China share

Cases License fee Cases License fee (US$ mil) (%) (%)

39 80 105 129 123 85 71 41

35.2 32.5 45.1 110.9 112.4 108.5 163.0 140.9

6 36 51 55 49 36 22 6

0.3 3.2 10.3 12.8 17.9 9.2 44.5 31.2

15.4 45.0 48.6 42.6 39.8 42.4 31.0 14.6

0.9 9.9 22.8 11.6 16.0 8.5 27.3 22.2

673

748.5

261

129.4

38.8

17.3

Sources: Korean Industrial Technology Association (1998 and 1999).

typically generating more than one form of payment. Running royalties are generally set at about three percent of sales revenue. Licensing periods are usually three to ten years, but can be as long as 30 years or even permanent. Between 1991 and 1998, the number of cases of Korean technology exports to China was 261, and the corresponding license fees were worth US$129.4 million, as shown in Table 3. China’s share in all Korean technology exports was 38.8 percent by number of cases, but only 17.3 percent by value of license fees. The low value intensity of Korea’s technology exports to China may be explained by the concentration of technology transfers in industries where technology is in relatively mature stages. In 1998, technology exports of Korean firms were hurt by the Asian financial crisis, but Korea’s technology exports to China suffered relatively little due to China’s economic resilience through the crisis and its relatively large technology gap with Korea. For China, Korea ranks below a number of other countries as a source of technology transfer. According to Chinese statistics, the number of cases of technology imports increased dramatically from 359 in 1991 to 6,254 in 1998, while the value of license fees rose from US$3,459 million to


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Table 4. China’s Technology Imports by Source Country (Unit: Case, US$ million) 1991

1995

1997

1998

Cases License Cases License Cases License Cases License fee fee fee fee US Germany Japan Russia Sweden France Hong Kong UK Finland Italy Austria Canada Korea Total

54 54 63 9 6 35 28 21 — 28 10 7 — 359

135 265 269 1,374 18 194 20 344 — 353 25 67 — 3,459

798 2,272 398 1,892 533 2,249 285 759 72 211 78 1,706 674 586 82 718 22 101 153 977 45 303 62 204 38 103 3,629 13,033

1,432 1,816 832 1,584 972 3,391 136 1,078 94 653 168 667 724 532 206 314 47 94 314 601 84 341 118 2,805 131 866 5,984 15,923

1,094 3,000 610 2,351 1,386 2,088 143 1,921 105 927 232 762 1,115 746 188 621 59 452 189 370 92 305 123 278 212 272 6,254 16,375

Source: Same as Table 3.

US$16,375 million, as shown in Table 4. Countries serving as the principle sources of technology transfer for China showed change over time, with rank order for 1991 given as Russia, Italy, UK, Japan, and Germany, and in 1998 as the US, Germany, Japan, Russia, and Sweden. Korea ranked sixth as a source of China’s technology imports by number of cases, fourteenth by license fee value in 1998. Korea’s share in China’s technology imports by license fee value was a mere 1.7 percent in this year. Underlying these aggregates, the average value of technology imports per case for all countries was US$2.62 million in 1998 while for Korea it was a much lower US$1.28 million. Korea’s technology exports to China are dominated by electric/ electronic equipment, machinery, ceramics/cement, and oil refining/ chemicals (see Table 5). The share held by Korea in China’s imports in the transport and energy sectors is very low (see Table 6). Since these two sectors are characterized by large projects, such as power generation facilities

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Table 5. Korea’s Technology Exports to China by Industry (Unit: Case, US$ million) 1996

1997

1998

Cases License Cases License Cases License fee fee fee Food Pulp/paper Textiles Ceramics/cement Oil refining/chemicals Pharmaceuticals Metals Electric/electronic equip. Machinery Shipbuilding Construction Other Total

0 0 1 2 12 1 0 3 15 0 2 0 36

0.0 0.0 0.0 0.0 1.8 0.1 0.0 4.6 2.6 0.0 0.0 0.0 9.2

4 1 0 2 1 0 1 3 5 0 0 5 22

0.3 0.0 0.0 0.0 8.6 0.1 2.1 22.3 9.1 0.0 0.1 1.9 44.5

0 0 0 1 1 0 0 1 3 0 0 0 6

0.1 0.0 0.1 2.6 1.4 0.0 0.0 20.5 8.8 0.0 0.0 0.0 31.2

Sources: Korean Industrial Technology Association, various years.

and construction of railroads and harbors, Korean firms have limited ability to penetrate. China showed a continuous deficit in its global technology trade in the 1990s, as shown in Table 7. China’s unease about this imbalance may hinder Korea’s future expansion of higher valued technology exports to China. 3.2. Korea’s technology imports from China Korea’s technology imports from China do not figure significantly for either side relative to their respective worldwide levels of activity. Royalty payments made to China from the Korean side are shown in Table 8. Magnitudes are erratic from year to year due to the influence a few large projects can have on modest aggregates. The bottom line is that a magnitude like US$0.51 million for 1998 is minute relative to Korea’s global royalty payments for the year of US$2,386 million. Chinese statistics capture a much broader measure of technology exports to Korea showing a value for 1998 of US$80.89 million (Chinese


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Table 6. China’s Technology Imports from Korea by Industry (Unit : Case, US$ million) 1996

Energy Machinery/electronics Petroleum/chemicals Metals Transportation Agriculture/forestry Light industry/textiles Construction/materials Space/aviation Other Total

1997

1998

Cases

License fee

Cases

License fee

Cases

License fee

282 1,533 805 241 — — 750 98 — — 6,074

1,361 2,331 3,068 1,356 — — 1,022 438 — — 15,257

861 1,560 780 260 856 110 762 387 216 192 5,984

4,045 2,994 2,200 2,063 1,811 1,074 601 593 379 163 15,923

403 2,371 540 151 869 — 278 263 297 — 6,254

2,873 3,499 848 511 4,149 — 1,018 252 160 — 16,375


Table 7. China’s Technology Trade Balance with Korea (Unit: US$ million)

1991 1995 1997 1998 1991–1998 Total

Exports

Imports

Exports–Imports

1,277 2,530 5,521 6,687 25,991

3,459 13,033 15,923 16,375 80,852

−2,182 −10,503 −10,402 −9,688 −54,861

Note: Based on contracted amount. Source: Same as Table 4.

Ministry of Foreign Trade and Economic Cooperation 1999, 139). In relative terms though, China’s technology exports to Korea are still tiny at a mere 1.2 percent of the country’s global total. The main explanation for why Korea’s technology imports from China have been low is that China’s level of industrial technology is not highly advanced. Korea’s technology imports have been mainly from the US,

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Y.-T. Lim Table 8. Korean Royalty Payments on Technology Imports from China by Industry (Unit: US$1000)

Food Chemical fiber Oil refining/chemicals Pharmaceuticals Electric/electronic equip. Machinery Construction Other Total

1996

1997

5.0

29.7 34.1

482.3 57.8 20.0 223.2 479.0 1, 507.3

1998 11.6 92.5

30.0 55.7 15.6 237.4 402.5

172.2 81.4 47.1 106.4 511.2


Japan, and Europe. A second reason for the low level is that China’s procedures for technology export are very complex. These two factors have limited Korea’s imports from China. Looking to the future however, prospects exist for Korea to import technologies embodied in oil refining, chemicals, machinery, and electronics with a projected shift from vertical inter-industry trade to horizontal intra-industry trade. 4. Conclusion Korea and China have different industrial structures that are mutually complementary. Korea’s capital and manufacturing technology combine effectively with China’s natural resources and scientific research capabilities. Korea’s high-tech industry has shown steady growth for the last twenty years, and its well-developed manufacturing and peripheral technologies provide a good foundation for further high-tech development. On the other hand, China is known for world-class scientific research and has abundant manpower and vast market potential. Korea and China have cooperated successfully both in industrial technology applications and in S&T development. Cooperation in industrial technology has been led by KMOCIE (Korean Ministry of Commerce, Industry and Energy) and CSETC (China State Economic and Trade Commission). Cooperation in S&T development has been led by KMOST


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(Korean Ministry of Science and Technology) and CSSTC (China State Science and Technology Commission). Industrial technology cooperation between the two countries is aimed at expanding bilateral trade and investment and improving industrial competitiveness globally. S&T cooperation is promoted for the purpose of developing the foundation for technological advance through basic scientific research.7 To further Korea–China industrial and technological cooperation, the two countries should define appropriate roles of government, research institutes, universities, and business enterprises. Both governments should formulate strategy, carry out speedy collection, analysis, and dissemination of relevant information, and provide institutional support. Research institutes and universities should enhance S&T cooperation from the foundations of technological innovation through the stages of joint research and exchange of human resources to the ultimate transfer of research results to commercial application. Business enterprises, too, should establish long-term strategies for technology application. Korea has accumulated more than 40 years’ experience in industrialization and capitalistic economic development since the first Five-Year Economic Plan was implemented beginning in 1962, and can draw on this experience to take the initiative in S&T collaboration with China as China goes through its economic transition. To this end, Korea needs to cope actively with changes in Chinese policies on industry and technology. The basic elements of China’s recent S&T policies are summarized as follows: • First, Chinese S&T policy emphasizes the link between S&T and the economy and commercialization of research results. China’s R&D strategies include the 863 Plan, the National Priority Labs Plan, the Natural Science Fund Plan, and the Pandeng Plan. China’s industrialization strategies involve the independent technology development strategy (National Priority Industry Department Test Plan, Xinghuo Plan, Huoju Plan, Military-to-Civilian S&T Plan, etc.), the introduction of foreign technologies, and the construction of industrialization bases. • Second, the Chinese government provides increasing support for new technology development. Among the priority areas for government support are: biotechnology (seed improvement/new 7 For

discussion of the functional relationship between basic scientific research and S&T, see Lim and Song (1996 and 2003).

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medication); information technology (artificial intelligence/optical electronics/optical communication); automated artificial satellite monitoring system technology; and new materials (optical communication materials). • Third, China has introduced competition into the S&T system. Lifetime job security, position guaranty, and wage guaranty have been abolished and emphasis is now given to incentives and rewards. • Fourth, energetic attempts are being made to redirect national defense technologies to civilian uses. After Deng Xiaoping proclaimed in 1984 that national defense technologies should contribute to economic development, transfer of military technology to civilian applications has been rapid. Space technology and aviation in particular have shown active response to civilian demand. This paper emphasizes that Korea–China S&T cooperation has not served merely to satisfy business goals such as market entry, investment return, and technology application, but also as an effective device for the two countries to deepen and extend their trade and investment activities. In particular, China can learn from Korea’s process technology to reduce its import dependency on machinery, parts, and materials from the technologically advanced countries (e.g., Japan) through the assimilation and absorption of advanced product technologies.8 The learning-by-doing process can help China to alleviate its chronic trade deficits with Korea and Japan to transform its trade from inter-industry to intra-industry patterns. Finally, industrial and technological collaboration between China and Korea can aid in creating a new international order in Northeast Asia and improving political and security relations on the Korean peninsula (Lim 1999 and 2003). 5. References China State Science and Technology Commission, various years(a). National Statistical Yearbook of Science and Technology (Beijing: China State Science and Technology Commission).

8 The

rationale can be found in Jensen and Thursby (1987), Grossman and Helpman (1991), Roessner, Poter and Xu (1992), Keller (1996), Coe, Helpman and Hoffmaister (1997), Klein and Lim (1997), Kwark and Shyn (2001), Lim and Song (1996 and 2003).


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China State Science and Technology Commission, various years(b). Guidelines for Chinese Science and Technology Policy (Beijing: China State Science and Technology Commission). China State Science and Technology Commission, various years(c). Primary Science and Technology Research and Development Plan (Beijing: China State Science and Technology Commission). Chinese Ministry of Foreign Trade and Economic Cooperation, 1999. White Paper on Foreign Trade and Economy of China in 1999 (Beijing: Chinese Ministry of Foreign Trade and Economic Cooperation). Coe, D., E. Helpman and A. Hoffmaister, 1997. “North-South R&D Spillovers,” Economic Journal 107: 134–149. Grossman, G. and E. Helpman, 1991. “Quality Ladders and Product Cycles,” Quarterly Journal of Economics 106: 557–586. Grossman, G. and E. Helpman, 1991. Innovation and Growth in the Global Economy (Cambridge, Massachusetts and London: MIT Press). Grupp, H., 1991. “Innovation Dynamics in OECD Countries,” in Technology and Productivity: The Challenge for Economic Policy (Paris: OECD). Hong, Sung-Bum, 1992. “Changing Trends of Chinese Science and Technology Policies,” Science and Technology Policy Review 2(25): 24–38. Jensen, Richard and Marie Thursby, 1987. “A Decision Theoretic Model of Innovation, Technology Transfer, and Trade,” Review of Economic Studies LIV: 631–647. Kim, Byung-Roo, Sung-Bum Hong and In-Hwa Jung, 1993. A Study on the Schemes of Korea–China Science and Technology Cooperation (Seoul: Korean Institute of Science and Technology, Research Institute of Science and Technology Policy Management). Kim, Ki-Young and Sung-Jae Yoo, 1987. A Study on the Strategy of International Cooperation of Advanced Technologies (Seoul: Korean Institute of Science and Technology). Klein, John J. and Yang-Taek Lim, 1997. “Econometric Study on the Technology Gap between Korea and Japan: The General Machinery and Electric & Electronics Industries,” Technological Forecasting and Social Change 55(3): 265–279. Korea Center for Research and Evaluation of Science and Technology Policy, 1980. Chinese Science and Technology Policy (Seoul: KCRESTP Publishing Department). Korea Center for Research and Evaluation of Science and Technology Policy, 1987. A Study on the Strategy of International Cooperation of Advanced Technologies (Seoul: KCRESTP Publishing Department).

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Korea Export-Import Bank, 2000. Foreign Investment Information (Seoul: KEXIM Publishing Department). Korea Trade Information Service, 2000. Comparative Analysis of Export Competitiveness of Korea and China in OECD Market (Seoul: KOTIS Publishing Department). Korean Industrial Technology Association, various years. Information on the Import and Export of Technology (Seoul: KITA Publishing Department). Korean Institute of Science and Technology, 1993. Korea–China Science & Technology Cooperation Center, Korea–China Science & Technology Cooperation Seminar: Chinese Advanced Technologies and Strategy of Their Development (Seoul: KIST Publishing Department). Korean Ministry of Commerce, Industry and Energy, 1992. Competitiveness of Each Primary Industry and Tasks (Seoul: KMOCIE Publishing Department). Korean Ministry of Science and Technology, 1999 and 2000. Yearbook of Science and Technology (Seoul: KMOST Publishing Department). Kwark, Noh-Sun and Yong-Sang Shyn, 2001. “International R&D Spillovers: Domestic Absorptive Capacity for Foreign Technology,” Annual Conference of Korean International Economics, December 7, 5–50. Kwon, Oh-Kwan, 1993. “Present Situation and Outlook of Korea–China Science and Technology Cooperation,” Technology Management 32: 17–25. Lee, Jae-Yoon, 1993. “Chinese Technology Transfer Policies and Our Response to Them,” China Study (Seoul: Continental Research Institute). Lim, Yang-Taek and Choong-Han Song, 1996. “An International Comparative Study of Basic Scientific Research Capacity: With Reference to OECD Countries, Taiwan and Korea,” Technological Forecasting and Social Change 52(1): 75–94. Lim, Yang-Taek, 1997. Schemes of Growing Capital Goods Industry in the Era of WTO (Seoul: Korea Chamber of Commerce & Industry). Lim, Yang-Taek, 1999. Prospects and Challenges of Asian Economy in the 21st Century (Beijing: Chinese Social Science Press). Lim, Yang-Taek, 2000. Korea in the 21st Century (New York: NOVA Science Publishers). Lim, Yang-Taek, 2003. A Study on China’s Trade Policy After Its Joining WTO (Seoul: Korea Foreign Trade Association). Lim, Yang-Taek, 2003. “The Comparison of Basic Science Research Capacity of OECD Countries,” Journal of Technology Innovation 11(1). Liu, Xielin and Steven White, 2001. “Comparing Innovation Systems: A Framework and Application to China’s Transitional Context,” Research Policy 30: 1091–1114.


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Ma, Jung-Ga, 1993. “Present Situation of Chinese Science & Technology Cooperation,” Korea–China Science & Technology Cooperation Seminar (Seoul: KIST, Korea Science & Technology Cooperation Center). Roessner, J. David, Alan L. Porter and Huaidong Xu, 1992. “National Capacities to Absorb and Institutionalize External Science and Technology,” Technology Analysis & Strategic Management 4(2): 99–113. Song, Yu-Chol and In-Gyo Jung, 2001. Effects of Chinese Accession to WTO on Korea and Ways of Coping with It (Seoul: Korea Institute of Foreign Affairs and National Security and Korea Institute of International Economic Policy). Suh, Bong-Gyo, 2002. “Chinese Anti-dumping Cases Concentrated on Korea,” LG Economic Weekly, June 12.


ASEAN–China Free Trade Area: Background, Implications and Future Development Suthiphand Chirathivat Associate Professor and Dean, Faculty of Economics Chulalongkorn University, Bangkok, Thailand [email protected]

1. Introduction The Asian crisis has not deterred most of the affected countries of the region from their commitment to remain open and globally integrated. It has, however, caused them to consider that integration with the global economy requires not just openness in trade and finance, but also sound policies and institutions in a range of areas. The fact is that integration has accelerated development in all aspects but requires prudence regarding vulnerability to external shocks. Most of the ASEAN countries have, by now, emerged from the crisis and are pondering anew the process of integration within the regional and global context. China, having recently been admitted to the WTO, is growing strongly and developing a deeper integration with the Asian region and the world economy. While the ASEAN economies have been weakened by the crisis, China poses a growing challenge in trade and investment for the world. Against China’s dominance, the ASEAN countries, like countries elsewhere in the world, need to reassess their position and relative strength (UNCTAD 2001a). What lies ahead for the ASEAN–China economic partnership is now closely related to the newly concluded agreement on the ASEAN–China Free Trade Area (or ASEAN–China FTA). At the ASEAN Summit in November 2000, the leaders of ASEAN and China agreed to study the implications of China’s accession to the WTO and seek to improve economic cooperation and integration between the two sides. Creation of the 363

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ASEAN–China FTA was proposed as a key initiative to exploit areas of complementarity while building on existing strengths. Economic links between ASEAN and China are the subject of on-going examination (Chirathivat 2001; Chirathivat 2002). Will the ASEAN–China FTA help improve further the relationship between the two? What would be the future of ASEAN with China in a borderless Asia? ASEAN and China must each improve its competitiveness in order to gain fully the benefits of the ASEAN–China FTA. Meanwhile, one could ask why China needs a stronger economic relationship with its neighboring countries in Southeast Asia. For both sides, this represents the first FTA concluded with another country or grouping. For China, this is the first FTA concluded since its accession to the WTO. For ASEAN, it has been a long time from the creation of AFTA to the formation of its first bilateral FTA with another country.

2. Background At first glance, one would think that an ASEAN–China FTA is a natural response to the growing popularity of FTAs (Panagariya 2000). An FTA is attractive because it provides preferential access to both sides, and may draw attention from outsiders to become more involved with the group.1 Looking closer, one would find that ASEAN is losing its economic attractiveness due to the crisis while China is viewed as an appealing global economic partner. The reality is that China diverts foreign direct investment from the region as it competes with ASEAN for exports to third markets (Chirathivat 2001, 2002; Panitchpakdi and Clifford 2002). Linking the two sides together in an FTA could reinforce the position of each within the regional and global context. Trade liberalization has been gradual in ASEAN and China. For ASEAN, progress varies among countries with Singapore the most advanced, the ASEAN-5 well on their way to liberalization, and the CMLV (Cambodia, Myanmar, Laos, and Vietnam) not yet even in the WTO, but with all now involved in AFTA. China, on the other hand, has committed to a

1 For

example, Japan seems to watch very closely this new development. One may refer to the Koizumi speech of January 14, 2002 in Singapore about the new cooperative partnership with ASEAN.

ASEAN–China Free Trade Area

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comprehensive package of market liberalizing measures in its negotiations to enter. China’s accession to the WTO will require a lot of changes, and this will not be quickly or easily understood throughout China. The result of the liberalization process has been a large increase in foreign trade for both ASEAN and China. The reduction in tariff and non-tariff barriers has been motivated on different fronts. Multilateral institutions like the WTO encourage member countries to liberalize multilaterally and unilaterally. Since the 1990s, the regional approach to liberalization has also gained momentum (Bhagwati, Krishna and Panagariya 1999). Different countries in various regions have taken initiatives to liberalize among themselves as with AFTA. In fact, apart from the CMLV, the rest of the ASEAN countries are close to establishing their free trade area. The ASEAN–China FTA builds on historical and cultural linkages. Within this context ASEAN–China economic relations have grown rapidly in recent years as detailed in a report by the ASEAN Secretariat (2001): ASEAN–China trade totalled US$39.5 billion in the year 2000. ASEAN’s share in China’s foreign merchandise trade has been continuously on the rise, increasing from 5.8 percent in 1991 to 8.3 percent in 2000. ASEAN is now China’s fifth biggest trading partner. Meanwhile, the share of China in ASEAN’s trade has grown from 2.1 percent in 1994 to 3.9 percent in 2000. China is now the sixth largest trade partner of ASEAN. There is strong potential for further trade and investment between ASEAN and China despite both claiming their major export markets in the developed countries and both being major destinations among LDCs for foreign direct investment. Both ASEAN and China have identified existing measures that hamper their trade and investment (ASEAN Secretariat 2001). In the view of both sides, market opportunities would be increased if appropriate measures were taken, and trade and investment potential would then be realized. Thus a framework for ASEAN–China economic relations should be comprehensive and forward-looking building upon the momentum of China’s accession to the WTO. ASEAN and China are working to adopt a framework of economic cooperation containing six major elements, some of which could be implemented sooner than others. These elements are as follows (ASEAN Secretariat

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2001, 29): • Trade and investment facilitation measures which cover a wide range of issues like the removal of non-tariff barriers, mutual acceptance of standards and conformity assessment procedures to promote trade in services. • Provision of technical assistance and capacity building particularly to new members of ASEAN to expand their trade with China. • Trade promotion measures, consistent with WTO rules, to be given to the non-WTO members of ASEAN. • Expansion of cooperation in various areas such as finance, tourism, agriculture, human resource development, industrial cooperation, intellectual property rights, environment, energy, etc. • Establishment of an ASEAN–China FTA within ten years, with special and differential treatment given to ASEAN’s new members. • Establishment of appropriate institutions between ASEAN and China to carry out the framework of cooperation. 3. Implications With the ASEAN–China FTA to become an integral part of the future course of ASEAN–China economic relations, one could ask what would be the economic benefits of such an initiative. Certainly, there are strategic interests for both sides to consider. How would ASEAN deal with China’s dominance in an economic area with a population of 1.7 billion, GDP of about US$2 trillion and total trade estimated at US$1.23 trillion?2 It will be the largest FTA in the world in terms of population and one made up of developing countries at different levels of development. For the ASEAN-6 (Indonesia, Malaysia, the Philippines, Singapore, Thailand, and Vietnam), average tariff rates on Chinese products are already low compared to Chinese tariff rates on ASEAN products which are still quite high even with China’s accession to the WTO, as shown in Table 1. Non-tariff barriers imposed by China againstASEAN are also in general much higher than the reciprocal non-tariff barriers, as shown in Table 2. 2 By

comparison, the EU and NAFTA each have GDP of over 9 trillion US dollars (ASEAN Secretariat 2001, 30).


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Table 1. Bilateral Tariff Rates for ASEAN and China (%) ASEAN applied to China Fruits/vegetables Coal Food products Electrical goods Drinks/tobacco Machinery Average

China applied to ASEAN 5.0 9.4 5.0 4.8 6.2 3.4 2.3

Fruits/vegetables 27.4 Oil seeds 21.4 Petroleum products 8.4 Rice 112.8 Chemical/rubber/plastic products 19.2 Electrical Goods 16.6 Average 9.4

Source: Chulalongkorn and Monash General Equilibrium Model (CAMGEM), Chulalongkorn University.

Table 2. Tariff Equivalents of Non-Tariff Barriers (%) ASEAN applied to China Other commodities Milk products Drinks/tobacco Textiles Mineral products Average

China applied to ASEAN 13.6 17.0 51.2 7.3 9.6 9.2

Other commodities Rice Metal products Leather products Forestry products Average

76.6 100.0 83.7 76.8 96.8 69.1

Source: CAMGEM.

In an FTA, abolishment of trade barriers will allow trade expansion between ASEAN and China which could be realized through trade creation or through trade diversion. The removal of trade barriers will lower costs, expand intra-regional trade, and increase economic efficiency. This will help to boost real income in both regions as resources flow to sectors where they can be more efficiently and productively utilized. In addition to the increased trade within the FTA, non-members might come to engage in greater trade and investment with the FTA members as their economies become more outward oriented. By enlarging the market, establishment of the ASEAN–China FTA will intensify competition, increase investment, and bring about economies of scale which will have spill-over effects in research and development and lead to technological

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improvement in the long-run. It remains to be seen what would be the “dynamic” time-path of such a creation (Bhagwati 1993). There are, however, also potential concerns associated with an ASEAN– China FTA. Even after the FTA is fully implemented, varying degrees of discrimination across products and countries will remain due to differences in the rules of origin. The rules of origin create significant costs for administrative surveillance and implementation. This could cause complications if different countries in ASEAN and perhaps China get involved in an increasing number of separate but overlapping FTAs.3 That is why in preference to an FTA, some economists advocate a customs union which is characterized by a common external tariff (CET) equivalent to the lowest tariff prevailing in any of the member countries (Krueger 1997).4 Apart from the issue of rules of origin, having a large number of members in an FTA might confuse investors as to which rules, obligations, and incentives correspond to which partner. Also, the time and effort required to negotiate and implement the FTA are unknown, and the process may distract attention from the bigger WTO agenda. At this point, ASEAN and China have yet to start the long process of negotiation for trade liberalization under an FTA.

4. Simulation Results The effects of an ASEAN–China FTA have been simulated for this paper using the model of the Global Trade Analysis Project (GTAP) as adapted in the Chulalongkorn and Monash General Equilibrium Model (CAMGEM) of Chulalongkorn University, Thailand. The model contains 45 countries and 50 production sectors. The structure of the model is outlined in Appendix 1. In the modeling exercise, it is assumed that rates of trade protection are reduced to zero through elimination of all tariff and non-tariff barriers. Results are reported first for simulation of tariff elimination, then for elimination of non-tariff barriers. As shown in Table 3, ASEAN responds 3A

Singapore–Japan FTA has been formalized while Singapore continues to negotiate with the US, Australia and New Zealand. Thailand has also entered into negotiations for an FTA with Australia and New Zealand, and perhaps Japan and even China as well. 4 However, a major disadvantage of a customs union is that it requires a greater degree of policy coordination and collective decision-making as well as budgetary mechanisms to distribute the tariff revenue among members (Rajan and Sen 2002).


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Table 3. Impact of Tariff Liberalization on Trade Flows (%) Exports

ASEAN China Japan US EU Total

Imports ASEAN

China

Japan

US

EU

Total

−0.8 23.1 0.2 0.5 0.4

53.3 0.0 −1.4 −2.6 −1.7

−1.4 0.4 0.0 0.0 −0.1

−0.8 0.4 0.1 0.0 −0.0

−1.0 0.4 0.1 −0.0 −0.0

0.8 1.9 −0.1 −0.1 −0.0

1.0

1.5

−0.1

−0.1

−0.0

0.1

with a higher rate of expansion in exports to China as a result of the tariff liberalization at 53.3 percent than does China to ASEAN at 23.1 percent. There is a low degree of trade diversion for both ASEAN and China because the expansion in bilateral trade is so small relative to total trade for each side. In the ASEAN case, exports to third markets are reduced by the FTA while in China’s case, due to the cost advantage of input imports from ASEAN, exports to third markets increase. As a consequence of the tariff liberalization, ASEAN gains an increase in real GDP of 0.38 percent while China gains 0.36 percent, shown in Table 4. However, in terms of welfare, ASEAN has a greater net gain than China as effects on output prices, land rents, and wage rates are taken into account. Highlights of the sectoral impact of China’s tariff liberalization on ASEAN are captured in Table 5 and of the impact of ASEAN’s tariff liberalization on China in Table 6. ASEAN gains better market access for both agricultural and industrial products. Table 6 indicates that the effects of ASEAN tariff liberalization on China are particularly noteworthy for motor vehicles and parts, electrical appliances, metal products, and textiles. On the other hand, a negative impact for China results from increased imports of rice, edible oils, sugar, wood products, and “other commodities”. Simulating the impact of non-tariff liberalization is not an easy exercise since it involves various measures which are not easily captured. Notwithstanding this caveat, the study found that the impact of non-tariff liberalization on macroeconomic performance could be substantial for both ASEAN

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Table 4. Impact of Tariff Liberalization on Macroeconomic Performance Indicator

ASEAN

China

Overall Internal External Overall Internal Real GDP (%) 0.4 0.1 Land rents (%) 3.6 0.1 Wage rate (%) 1.0 0.1 GDP deflator (%) 0.6 −0.2 Terms of trade (%) 0.3 −0.1 Real investment (%) 0.8 0.3 Export (%) 1.0 0.5 Imports (%) 1.3 0.4 Trade balance (mil $) −178 −320 Welfare (mil $) 2986 190

External

0.3 0.4 0.3 0.1 3.5 0.2 −0.6 0.8 0.9 0.6 0.2 0.4 0.8 −0.2 −0.5 0.3 0.4 −0.1 −0.4 0.3 0.5 0.7 0.5 0.2 0.5 2.4 2.0 0.4 0.9 3.4 2.7 0.7 142 −980 −1238 258 2796 1787 588 1200

Note: Internal impact derives from a country’s own tariff liberalization, external impact from trading partner’s tariff liberalization. Overall impact is the sum of the two.

Table 5. Impact of China’s Tariff Liberalization on Sectoral Performance of ASEAN-6 Export (+)/ Trade import (−) balance change (%) (mil $) Export increase Rice Sugar Textile Vegetable oil Chem/plastic prods Cars/components Clothing Import increase Fruits/vegetables Other commodities Leather products

24.7 23.1 9.6 13.1 3.8 8.1 0.9

469 329 389 835 285 −78 22

−5.1 −1.9 −3.5

−72.9 −8.4 −52.2

Output growth (%)

3.5 5.9 3.3 6.7 1.7 0.8 0.4

                

 −0.4  −1.0  −0.2

Price Remarks increase (%)

2.1 1.3 0. 0.8 0.4 0.1 −0.1 1.7 1.3 0.1

More exports to China

More imports from China; production relocation to China


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Table 6. Impact of ASEAN Tariff Liberalization on Sectoral Performance of China Export (+)/ Trade import (−) balance change (%) (mil $) Export increase Fruits/vegetables Metal products Motor vehicle/parts Textiles Alcohol/tobacco Other food products Electrical appliances Import increase Other commodities Meat products Edible oil Rice Sugar Wood products

Output Price growth increase (%) (%)

2.7 3.5 58.7

5 76 214

0.3 0.8 1.4

5.5 39.7 4.2 4.1

107 91 −19 226

1.2 1.0 0.2 2.1

26.4 45.4 25.3 251.3 22.6 10.2

−180 −61 −549 −516 −275 −189

−1.2 −0.5 −7.5 −3.3 −6.3 −0.8

0.4 0.1 0.

    −0.0 −0.3  −0.2   −0.3   0     0.2   −0.6  −0.3       −0.1 −0.3

Remarks

More exports to ASEAN Cost reduction and more exports to ASEAN

More imports from ASEAN

Table 7. Impact of Non-Tariff Liberalization on Trade Flows (%) Exports

Imports ASEAN

ASEAN China Japan US EU Total

China

Japan

US

EU

Total

−2.2 33.5 2.1 2.5 2.1

187.0 0.0 −4.7 −7.1 −4.2

−5.6 4.7 0.0 −0.0 −0.3

−4.5 5.2 0.0 0.0 −0.2

−4.5 4.7 0.0 −0.1 −0.1

2.1 6.6 −0.0 −0.1 −0.1

3.1

4.7

−0.1

−0.1

−0.1

0.2

and China, as shown in Table 7. China would benefit greatly from expanded exports to third country markets whileASEAN could focus more on entering the China market to some extent diverting trade from other major ASEAN markets such as the US, the EU, and Japan.

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Table 8. Impact of Non-Tariff Liberalization on Macroeconomic Performance Indicator

ASEAN

China

Overall Internal External Overall Internal External Real GDP (%) Land rent (%) Wage rate (%) GDP deflator (%) Terms of trade (%) Real investment (%) Exports (%) Imports (%)

1.4 9.4 3.1 2.0 1.3 2.6 2.1 3.3

−0.0 −0.3 −0.0 −0.3 −0.1 0.1 0.5 0.5

1.4 9.7 3.1 2.3 1.4 2.5 1.6 2.8

2.3 0.4 2.5 −1.0 −1.3 3.3 8.0 9.9

2.1 −1.2 2.0 −1.6 −1.6 3.1 7.5 9.2

0.2 1.6 0.5 0.6 0.3 0.2 0.5 0.6

Trade balance (mil $)

−251

−290

59

−2276

−2095

613

Welfare (mil $)

11,640

−436

12,088

11,858

10,275

1,435

Note: Internal impact derives from a country’s own tariff liberalization, external impact from trading partner’s tariff liberalization. Overall impact is the sum of the two.

In macroeconomic terms, China gains more than ASEAN with a greater increase in real GDP although the effect on China’s trade balance is substantially more negative than the effect on ASEAN’s. The overall result given by the simulation is that there are trade gains for both ASEAN and China from forming an FTA. Trade creation will more than offset trade diversion for ASEAN while for China there is no obvious trade diversion. It remains to be seen how ASEAN and China will use these opportunities to strengthen their economic relationships. The simulation shows that China would look increasingly at ASEAN as an alternative source of inputs for natural resource-based or intermediate products. China still needs sources of imported inputs to satisfy the needs of its manufacturing industries which domestic suppliers may not be able to meet. With continuing strong growth in China, ASEAN could come to play a crucial role in supplying China’s demand for such products. 5. Framework Agreement At the suggestion of Chinese Premier Zhu Rongji at the ASEAN Summit in Singapore in 2000, the ASEAN–China Expert Group was formed to


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prepare a report on “Forging Closer ASEAN–China Economic Relations in the Twenty-First Century”.5 This report was presented at the following ASEAN Summit held in Brunei, November 2001. At the Brunei summit, ASEAN and Chinese leaders endorsed the proposal creating a framework on bilateral economic cooperation aimed at establishing an ASEAN–China FTA within ten years with flexibility to be accorded newer ASEAN members. The leaders also agreed that the framework should provide for an “early harvest” in which the lists of products and services would be determined by mutual consultation.6 According to the ASEAN Secretary General, the proposed FTA would allow each side to respond to the challenges and seize the opportunities. ASEAN member governments are adopting important policy measures, perhaps the most important since the creation of AFTA. It is then up to the business community to seize the opportunities and respond to these challenges.7 The governments of both sides have agreed to work out details of the proposed agreement. They could submit guidelines and principles for establishing the FTA to the leaders by the end of 2002 when the ASEAN– China Summit is to be held in Cambodia. In principle, this framework agreement must be more progressive than the WTO commitment, which means that both sides would have to work closely to further relax their trade barriers against each other. In order to move ahead with the framework agreement, both ASEAN and China have agreed to set a tentative timetable for eliminating tariffs according to three product categories as summarized in Table 9: • The first set of products involves the “early harvest” proposal focused on the top ten trading products from each country for which tariffs would be phrased out fastest. • The second set of products includes those normal items for which governments could phase out all tariff rates at the end the framework agreement period.

5 Report submitted October 2002, see http://www.aseansec.org/newdata/asean_china_ bc.htgm. 6 Press Statement by the Chairman of the 7th ASEAN Summit and the Three ASEAN +1 Summits, ASEAN Secretariat, 2001 (unpublished). 7 H.E. Rodolfo C. Severino, Secretary General of ASEAN, remarks at the First Meeting of ASEAN–China Business Council and Trade and Investment Facilitation Workshop, ASEAN Secretariat, Jakarta, November 8, 2001 (unpublished).

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Table 9. Tentative Timetable for Elimination of Tariffs between ASEAN and China Product categories

Top 10 trading products (early harvest)

First year China A minimum of 60% of the total tariff lines to have tariffs of 0–5% ASEAN

Third year

Last year

China China 100% of items in Same as the third the Inclusion List year to have tariffs of 0% ASEAN

ASEAN

A minimum of 40% of the total tariff lines to have tariffs of 0–5%

100% of items in 100% of items in the the Inclusion List Inclusion List to to have tariffs of have tariffs of 0% 0–5%

Normal products

Each side to have an Inclusion List with tariffs of 0–15%

Each side to have Each side to have an Inclusion List tariffs 0% with tariffs of 0–5%

Sensitive products

Sides to agree on Sides to agree on Each sides to have the tariff range the tariff range tariffs of 0–5%

Source: Author’s interviews.

• The last set of products, which is to be kept to a minimum, covers sensitive items for which more adjustment time is needed, and for these inclusion in the FTA would be step by step. According to these principles, the two parties should gradually lower tariff rates on globally competitive products at a faster pace than on sensitive products. Also, for the newer ASEAN members, China would offer the right to implement tariff reductions a few years later. In fact, FTA provisions would go beyond reduction of tariffs to cover also reduction and elimination of non-tariff barriers, liberalization in services trade, and liberalization in investment. However, it will take time to negotiate all these issues in the process of establishing the FTA. It remains to be seen how both sides will identify and continue to work on the issues.


375

6. Upcoming Challenges ASEAN linking up with China in an FTA is expected to boost the region’s attractiveness for investment. Such integration among the two sides seems to be necessary given increasing competition in the global economy following the Asian crisis and China’s entry into the WTO. China’s WTO entry together with the strong flow of foreign direct investment into the country serves as a wake-up call to all Asian countries to improve their competitiveness. For its part, China looks to ASEAN to improve ties and strengthen economic relationships in support of its growth. The ASEAN–China FTA could also attract outsiders like Japan, the US, the EU, and others to take a closer look at their partnerships in the region.8 On the other hand, some ASEAN members are still reluctant to open their markets to China fearing a flood of Chinese goods. The increased competition in ASEAN’s domestic markets as a result of liberalizing trade with China could negate any potential benefits from having better access to the Chinese market and to the FDI now flowing into China. ASEAN still needs to be careful in such an FTA not to sacrifice its own interests. The CMLV countries would benefit by waiting till a later stage to liberalize tariffs while Indonesia, the Philippines, Thailand, and Vietnam are more prepared to open up their markets. Thus, most ASEAN countries, at the moment, are busy working to reevaluate individually their own positions with China. There are costs and benefits with any liberalization exercise. Proper sequencing is still essential because domestic industries might need time to adjust. Overall, countries must seek to sustain benefits that outweigh the costs. Skeptics argue thatASEAN needs to exercise caution and work to ensure a win-win result. Much of the FDI flowing into China might not have been diverted from ASEAN as these capital flows are directed toward different objectives and are not competing with similar flows to the ASEAN region. Moving into an ASEAN–China FTA might not address ASEAN’s needs to strengthen its own internal position. 8 Japan’s manufacturers are also under threat from China’s cheap labor and cheap goods. Unemployment has been rising across the country, and it’s vital to adopt new technology and find new ways to complete. Japan’s industries are now struggling with the shifting of industries within the region as a way to survive. Far Eastern Economic Review, April 25, 2002.

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Whatever the arguments given, the proposal to establish an ASEAN– China FTA has given breath to the debate about forming an FTA for all Asia. This would mean that Japan and Korea, for example, could join the FTA agreement as well. This also contributes to a new round of debate about the timing for East Asia to form a trade group in the wake of the much stronger economic blocs in Europe and the Americas. It is in this sense that an ASEAN–China deal might be useful politically to keep the momentum going and pressure other countries to get with the free trade program for fear of losing benefits. Furthermore, with bilateral freetrade pacts proliferating within the region, the firming up of an East Asian FTA is moving closer. Singapore is negotiating simultaneously with Japan, the US, Australia, New Zealand, and South Korea. Thailand is engaged in a similar exercise with China, Australia, and New Zealand. A Japan– Korea free-trade agreement is being considered by both sides. This trend creates a strong impetus for an Asia-wide FTA. While new deals may boost trade, however, there must be avoidance of a confusing “spaghetti bowl” of conflicting and overlapping rules (Bhagwati 1997). The ASEAN–China FTA has contributed to new thinking about East Asia, not just as a geographic concept, but as an institutional arrangement. This regional approach may take time to realize, but still ought to be seen as the most desirable option. It is still the case that ASEAN and China are considered developing countries with strong dependency on outside markets rather than a self-contained group. However, by creating an ASEAN–China FTA, and developing appropriate institutions to carry out cooperation, both regions could gain in the long run.

7. Conclusion Although ASEAN and China are not yet considered major trading partners of each other, trade between them is expanding in some products suggesting growing future importance of intra-regional trade and perhaps investment brought about by rising income, product differentiation, and economies of scale. For many ASEAN member countries, the Asian crisis caused economic weakening, yet they must face the challenge of a new type of economic landscape in an integrating Asia where China is now a strong presence. Linking ASEAN and China together with a focus on regional and sub-regional, or even very localized, potential spots for high growth and


377

investment could help them to grow further in a regional context and also in a global economy. A new tentative framework of economic cooperation looks useful at this stage for ASEAN and China. This framework aims broadly to bring the two sides together, while addressing specific targets as well such as an ASEAN–China FTA. Politically, China proposed such a scheme to ASEAN. They agreed to a time frame for establishing the FTA of ten years. There would be trade gains for both sides. Trade creation will offset trade diversion overall with some ASEAN imports diverted from current trade partners to China. However, with China’s strong growth, imports from ASEAN could be absorbed to expand exports without causing significant trade diversion. China could look to ASEAN as an additional source of inputs for natural resource based and intermediate products. ASEAN and China, as newly industrializing regions, would still rely on outside sources for education, technology, and infrastructure development, requiring them to link to wider global production centers through the activities of multinational companies. These firms from Japan, the US, and the EU, for example, will turn to an ASEAN–China FTA for labor-intensive and other skill-appropriate products. Intra-industry specialization would result from the new arrangement between ASEAN and China, allowing for an efficient division of labor as well as generating interesting cooperation between the two. Creation of an ASEAN–China FTA would be an exercise that could contribute to the concept of an “Asian Economic Community” (Dutta 2002). In other words, East Asia is being transformed from a mere geographic concept into a regional institutional arrangement. With the prospect that an ASEAN–China FTA could contribute to an Asian institutional identity and lead to an escape from the “spaghetti bowl” effect, the new framework would also be a step toward globalization and away from the economic crisis that ripped through the region in 1997 and 1998.

8. Acknowledgments The author would like to thank Dr. Sothitorn Mallikamas for providing information and useful discussion used in Section 3 and Dr. Chayodom Sabhasri for giving an inside view of the policy debate in Section 4. Preparation of this paper was possible with the assistance of Ms. Bulanchai Udomariyasap and Ms. Duangkamol Sunthonkhan.

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9. References ASEAN Secretariat, 2001. “Forging Closer ASEAN–China Economic Relations in the Twenty-First Century,” Report submitted by the ASEAN–China Expert Group on Economic Cooperation, October, 1. Bhagwati, J., 1993. Regionalism and Multilateralism: An Overview,” in M. Jaime de and A. Panagariya (eds.), New Dimensions in Regional Integration (Cambridge: Cambridge University Press). Bhagwati, J., P. Krisna and A. Panagariya, 1999. Trading Blocs: Alternative Approaches to Analyzing Preferential Trade Agreements (Cambridge: MIT Press). Chirathivat, S., 2001. “Interdependence between China and Southeast Asian Economies on the Eve of the Accession of China into the WTO,” in Yamazawa I. and K. Imai (eds.), China Enters WTO: Pursuing the Symbiosis with the Global Economy (Tokyo: The Institute of Developing Economies). Chirathivat, S., 2002. “ASEAN–China Economic Partnership in an Integrating World Economy,” Chulalongkorn Review 14: 98–114. Dutta, M., 2002. “Asia Economic Community: Intra-Community Macro- and Micro-Economic Parameters,” Paper Presented at the Annual Meeting of AEA in Atlanta, GA (mimeograph). Gomory, R. E. and W. J. Baumol, 2000. Global Trade and Conflicting National Interests (Cambridge, Massachusetts: The MIT Press). Krueger, A., 1997. “Problems in Overlapping Free Trade Areas,” in T. Ito and A. Krueger (eds.), Regionalism and Multilateral Trade Arrangements (Chicago: The University of Chicago Press). Lloyd, P. J. and D. Maclaren, 2000. “Openness and Growth in East Asia after the Asian Crisis,” Journal of Asian Economics 11: 89–105. Neary, P., 2001. Of Hype and Heperbolas: Introducting the New Economic Geography,” Journal of Economic Literature XXXIX: 536–561. Panagariya, A., 2000, “Preferential Trade Liberalization: The Traditional Theory and New Developments,” Journal of Economic Literature XXXVIII(June): 287–331. Panagariya, A., 2001. “Preferential Trade Liberalization: The Traditional Theory and New Developments,” Journal of Economic Literature XXXVIII: 287–331. Panitchpakdi, S. and M. Clifford, 2002. China and the WTO (Singapore: John Wiley & Sons (Asia) Pte Ltd).


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Rajan, R. and R. Sen, 2002. “Singapore’s New Commercial Trade Strategy: The Pros and Cons of Bilateralism,” Centre for International Economic Studies, Adelaide University (mimeograph). Sunthonkhan, D., 2002. “China’s Accession to the WTO and its Impacts on Thailand: The GTAP Model Approach,” Master Thesis (in Thai), Faculty of Economics, Chulalongkorn University (mimeograph). World Bank, 2002. Globalization, Growth and Poverty: Building an Inclusive World Economy (Washington D.C.: World Bank and Oxford University Press). World Bank, 1997. China Engaged: Integration with the Global Economy (Washington D.C.: World Bank and Oxford University Press). UNCTAD, 2001a. “FDI to Asia booms, fuelled by Hong Kong,” Press Release, TAD/IMF/PR25, September 18, 6. UNCTAD, 2001b. World Investment Report (Geneva: United Nations). Wang, Z., 1999. “The Impact of China’s WTO Entry on the World Labor-Intensive Export Market: A Recursive Dynamic ECG Analysis,” The World Economy 22(3): 379–405. Yang, Y. and C. Zhong, 1998. “China’s Textile and Clothing Exports in a Changing World Economy,” The Developing Economies 36(1): 3–23. Zhao, H., 1997. “Foreign Trade in the People’s Republic of China: Past Performance and Future Challenges,” Asian Development Bank Review 15(1): 88–110.

Appendix 1: Summary of the Global Trade Analysis Project (GTAP) Model This paper makes use of the Global Trade Analysis Project (GTAP) model developed at Purdue University9 as adapted in the Chulalongkorn and Monash General Equilibrium (CAMGEM) Project of Culanlongkorn University, Thailand. The GTAP model in its latest version contains 45 countries and 50 production sectors. The model is structured on the following elements: (1) a prototypical regional household whose Cobb–Douglas preferences are defined over composite private expenditures, composite public expenditures, and savings; (2) private expenditures governed by a constant difference of elasticity 9 For

more information, see http://www.gtap.agecon.purdue.edu/products/models/default.asp.

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S. Chirathivat

(CDE) function; (3) production described by a multi-level Leonlief-type production function defined over value added and intermediate inputs generated from the Social Accounting Matrix (SAM) constructed for each region with value added produced through a constant elasticity of substitution (CES) function; and (4) macro closure of a CGE model with balances in each region defined on government deficit or surplus, aggregate saving and investment, and balance of trade. Finally, equilibrium in the model is achieved by the set of prices and quantities for goods and factors in all regions such that (1) demand equals supply for all goods and factors; (2) each industry earns zero profit; and (3) gross investment equals aggregate savings. The model is neoclassical in nature as prices in each region’s product and factor markets are assumed to be flexible and arable land for agriculture in each region is assumed to be fixed.

Appendix 2 Table A1. Change in Exports from Complete Tariff Liberalization Between ASEAN and China by Exporting and Importing Regions (%) Sector

China to Thailand

China to ASEAN

Thailand to World

China to World

ASEAN to World

−21.21 n.a. −1.44 138.40 104.89 −14.79 67.69 45.56 n.a. 135.91 n.a. 15.80

−1.62 −0.81 −2.03 94.20 52.71 −14.67 31.77 44.02 46.59 116.72 n.a. 16.71

n.a. n.a. 1.12 287.80 170.09 n.a. 3.20 149.56 91.89 6.94 n.a. 31.33

n.a. 1.63 3.75 19.81 24.22 1.62 1.79 16.01 91.89 11.25 n.a. 11.37

75.70 −1.67 4.79 1.52 −1.64 28.66 14.53 −0.51 −12.15 −5.18 0.00 −6.39

16.20 47.66 128.38 11.84 12.20 11.47 28.07 11.60 2.42 2.41 0.00 11.31

50.46 −1.45 17.39 9.34 1.25 31.04 26.15 3.19 −8.68 0.24 0.00 5.23

17.76 140.93 n.a. 22.19 −8.64 −0.32 146.21 85.61

10.74 135.63 3.68 10.09 −0.42 2.97 100.92 89.25

224.50 405.24 1.89 n.a. 2.40 41.92 n.a. 297.38

52.14 75.31 19.31 9.47 75.97 20.95 13.19 9.61

9.10 −3.49 −5.92 −2.69 −5.10 −1.22 58.08 44.38

−0.90 5.34 2.56 4.28 6.61 3.13 16.32 34.83

0.38 0.69 0.50 2.10 −0.26 −0.16 24.32 26.34

381

13 14 15 16 17 18 19 20

Paddy Wheat Cereal grain Veg, fruit, nuts Oil seeds Sugar cane/beet Plant-based fibers Crops Livestock Animal products Raw milk Wool, silk-worm cocoon Forestry Fishing Coal Oil Gas Minerals Meat products Poultry, seafood

ASEAN to China


1 2 3 4 5 6 7 8 9 10 11 12

Thailand to China

382

Table A1. (Continued)

21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37

Veg oil and fats Dairy products Processed rice Sugar Food products Beverages, tobacco products Textiles Wearing apparel Leather products Wood products Paper products, publishing Petroleum, coal products Chem, rubber, plastic products Mineral products Ferrous metals Metals Metal products

Thailand to China

ASEAN to China

China to Thailand

China to ASEAN

Thailand to World

China to World

ASEAN to World

30.18 143.75 395.04 103.12 165.86 352.19

146.08 53.25 234.43 103.15 160.06 688.91

34.52 128.57 n.a. 80.90 211.88 844.48

11.05 106.30 6.04 11.56 57.94 101.99

8.56 23.36 30.83 57.19 6.59 69.30

4.24 20.27 14.90 51.54 13.29 62.45

30.19 13.69 23.68 56.01 6.74 55.85

127.32 1065.35 107.25 15.30 50.56

133.22 1045.78 124.82 22.45 45.20

106.77 363.23 100.58 52.55 36.95

55.86 107.45 71.76 39.75 24.35

27.12 13.55 11.86 1.01 10.20

19.38 10.28 10.09 4.54 9.89

20.86 15.19 11.79 3.57 7.45

34.42

34.34

58.17

42.01

10.07

14.09

3.89

103.37

77.60

54.63

31.46

16.88

12.96

9.01

185.77 87.05 33.19 85.60

161.43 75.11 42.72 103.06

139.97 19.87 49.60 76.04

53.60 20.93 18.47 42.89

12.89 9.77 6.05 7.69

13.19 7.85 4.97 10.77

10.95 9.19 9.25 9.02

S. Chirathivat

Sector

Table A1. (Continued) Sector

38 39 40 41

45 46 47 48

49 50

ASEAN to China

China to Thailand

China to ASEAN

Thailand to World

China to World

ASEAN to World

785.90

473.49

577.47

491.87

21.95

65.49

5.46

−3.35

56.18

39.37

22.80

12.24

10.97

7.00

130.16

125.67

152.35

34.83

3.13

9.19

3.31

68.52

71.79

49.20

19.36

3.58

7.24

3.63

61.56 n.a. n.a.

133.17 n.a. n.a.

89.26 n.a. n.a.

27.85 n.a. n.a.

2.20 −1.91 0.00

6.60 −0.52 0.00

4.84 −1.45 0.00

n.a. 0.01 −0.62 −0.06

n.a. 0.68 −0.55 −0.08

n.a. 0.37 0.88 0.54

n.a. 0.22 0.72 0.55

0.00 0.10 0.23 0.00

0.00 0.15 1.14 0.36

0.00 0.58 0.19 0.21

−1.34

−0.44

0.84

0.69

−1.58

−0.40

−0.71

n.a.

n.a.

n.a.

n.a.

0.00

0.00

0.00


42 43 44

Motor vehicles and parts Transport equipment Electronic equipment Machinery equipment Manufactures Electricity Gas manufacture, distribution Water Construction Trade, transport Finance, business, recreation PubAd, defence, educ, health Dwellings

Thailand to China

383


Preferential Trade Agreements and China’s Trade Ramon Clarete1 , Christopher M. Edmonds2 & Jessica Seddon Wallack3 1

Professor, School of Economics, University of the Philippines Diliman, Quezon City, Philippines [email protected] 2 Visiting Assistant Professor, Economics Department University of Hawaii at Manoa (on leave from the Asian Development Bank) and Fellow, East-West Center, Honolulu, Hawaii, USA [email protected] 3

Ph.D. Candidate Graduate School of Business, Stanford University Stanford, California, USA [email protected]

1. Introduction In 2001, an estimated 97 percent of total global trade involved countries that were members of at least one preferential trade agreement (PTA). This compares to a 72 percent share in 1990. There have been 30 multilateral PTAs and 58 bilateral arrangements registered with the WTO over the past three decades, but only PTAs involving WTO member countries are obligated to report to the WTO so the actual number of PTAs is even larger. Most of these PTAs are among neighboring countries, and involve lesser forms of trade and economic integration. Most fall short of being free-trade agreements (FTAs) or customs unions (CUs), although most aspire to become FTAs in the future. Table 1 identifies some of the most important PTAs reported to the WTO, and gives their member countries, dates of formation, and other characteristics. The expansion of PTAs in the 1990s (see Figure 1) brings paramount importance to the question of how these preferential arrangements affect trade among members and non-members. Although trade flows among member countries tend to increase with the signing of a PTA, critics argue that this increased trade comes at the expense of trade with non-members 385

Full name of PTA

Member countries

Date entered into force

Type of agreement

Provision beyond tariff reduction

AFTA

ASEAN Free Trade Agreement

Brunei, Darussalam, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, Vietnam

28-Jan-92

Free trade agreement

Trade facilitation, investment, industrial cooperation, services trade. FTA is part of larger regional cooperation plans under ASEAN

ANDEAN

Andean Community

Bolivia, Colombia, Ecuador, Peru, Venezuela

25-May-88

Customs union

Services, migration, investment, some foreign policy, trade facilitation

APEC

Asia-Pacific Economic Cooperation

Australia, Brunei Darussalam, Canada, Chile, People’s Republic of China, Hong Kong (China), Indonesia, Japan, Republic of Korea, Malaysia, Mexico, New Zealand, Peru, Philippines, Papua New Guinea, Russia, Singapore, Chinese Taipei, Thailand, United States, Vietnam

6–7 Nov-89

Free trade agreement, non-binding commitments

Investment liberalization, business facilitation, technical cooperation

R. Clarete, C. M. Edmonds & J. S. Wallack

Acronym

386

Table 1. Characteristics of Selected Regional Trade Agreements∗

Table 1. (Continued) Acronym

CER

Closer Economic Relations Economic Cooperation Organization

Member countries

Australia, New Zealand

Afghanistan, Azerbaijan, Iran, Kazakhstan, Kyrgyz Republic, Pakistan, Tajikistan, Turkey, Turkmenistan, Uzbekistan


Type of agreement


1-Jan-83


Trade facilitation, services, investment

22-Jul-92∗∗

General cooperation

Investment, trade facilitation, coordination of market-oriented reforms

European Free Trade Association

Iceland, Liechtenstein, Norway, Switzerland

3-May-60


Trade facilitation, migration, investment

EU

European Union

Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Portugal, Spain, Sweden, The Netherlands, United Kingdom

1-Jan-58

Common market and currency union

Trade facilitation, services, investment, migration, common market, common currency

MERCOSUR

Southern Common Market

Argentina, Brazil, Paraguay, Uruguay

29-Nov-91

Customs union

Trade facilitation, investment, peace treaty, maintenance of democracy

387

EFTA

Preferential Trade Agreements and China’s Trade

ECO

Full name of PTA

388

Acronym

Full name of PTA

Member countries


Type of agreement


NAFTA

North American Free Trade Agreement

Canada, Mexico, United States

1-Jan-94


Trade facilitation, investment, labor, environment

SAPTA

South Asian Preferential Trade Arrangement

Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan, Sri Lanka

7-Dec-95

Preferential trade agreement

FTA is part of larger cooperation plans of SAARC

SPARTECA

South Pacific Regional Trade and Economic Cooperation Agreement

Australia, New Zealand, Cook Islands, Fiji, Kiribati, Marshall Islands, Micronesia, Nauru, Niue, Papua New Guinea, Solomon Islands, Tonga, Tuvalu, Vanuatu, Western Samoa

1-Jan-81

Non-reciprocal trade preferences

∗

As of January 31, 2002. Date of WTO notification.

∗∗


Table 1. (Continued)

160

250 147

140

133 200

80 62

100

60

50

20

24

40

29

20

12 0 1950

1955

1

2

1960

1965

1970

1975

1980

1985

1990

1995

2000

Year Sources of Data: GDP and export: WTO International Trade Statistics 2001; number of PTAs: WTO website.

Number of PTAs

World Exports

Gross Domestic Product

Figure 1. World Merchandise Exports, Gross Domestic Product and Number of PTAs: 1950 to 2000

0

Number of PTAs

Index (1990 = 100)

100

150


120

389

390


who might have a comparative advantage in some goods traded within the PTA. Supporters answer that in domestic policy environments hostile to trade reform, PTAs offer a politically feasible way of encouraging some economic integration. PTA proponents highlight the importance of PTA efforts at “deep integration” such as harmonization of customs or product standards and cross-border infrastructure projects, as well as reductions in tariffs and non-tariff trade barriers. Detractors, on the other hand, argue that “regionalization” impedes the advance of broader multilateral free trade. In this context, China’s dual track of trade liberalization — joining the WTO while also entering into several regional PTAs — warrants particular attention. To what extent have existing PTAs of which China is not a member influenced that country’s imports and exports? Will trade flows under PTAs provide the same benefits that broader based trade flows would have provided? And finally, will liberalization via PTA create a stepping stone for China to integrate more fully with the world economy or will it detract from efforts to integrate via the WTO? Answers to these questions must rely on theoretical modeling, with the results generally inconclusive and dependent on modeling assumptions. As with much of the debate over the advantages and disadvantages of PTAs, the consequences of PTAs for China’s trade and the effects of China’s dual track approach toward trade integration cannot be empirically adjudicated for lack of empirical counterfactuals. The question at the heart of the debate — are PTAs a stepping stone or stumbling block to worldwide free trade — requires speculation as to the future consequences of the recent proliferation of PTAs for the multilateral trading system. We can, however, take the first step in evaluating PTA effects on trade flows, particularly trade flows with China, by examining available data on past trade flows combined with information about PTA formation and expansion. In particular, this paper joins a growing literature addressing these concerns by estimating an augmented gravity model, drawing on a dummy variable technique developed by Aitken (1973), Braga, Safadi, and Yeats (1994), Eichengreen (1995), Frankel (1997), and Soloaga and Winters (2001). In a recent work, Clarete, Edmonds and Wallack (2003) add two variables that enable focus on the trade effects of PTAs for a particular trading country or region. We use this approach to estimate the effects of PTAs on trade flows, in particular trade flows to and from China.1 The analysis 1 Those

responsible for developing the theory of the gravity model include Deardof (1984, 1988), Helpman and Krugman (1985), and Helpman (1987). Frankel (1997, 61) cites Helpman and Krugman as the originators of the standard gravity model.


391

separately identifies PTA effects on members’ intra-bloc trade, extra-bloc exports, extra-bloc imports, and imports (exports) from (to) China. The following section describes the general debate over the effects of PTAs on world trade with particular reference to these issues in the case of China and its trading partners. We discuss the analytical structure of our model in Section 3 and present the results of the analysis in Section 4. Section 5 concludes the paper. 2. Trade Diversion and Trade Creation: PTAs and China China stands on the edge of economic integration with the world. Accession to the WTO in 2001, after nearly 15 years of negotiations that included signing bilateral agreements with 37 countries, signaled a shift toward multilateral integration and away from the prior system of overlapping shorterterm bilateral relationships. Still, China remains part of several PTAs and recently has again shown some preference toward PTAs by granting preferential market access to some of its Asian neighbors through the Bangkok Agreement. A key question to be answered is how these two forms of trade liberalization will affect trade flows between China and its partners. The lowering of trade barriers among PTA members may expose member economies to greater competitive pressures and open up larger markets for producers. Like other forms of trade liberalization, PTAs can increase competition in domestic industries which can then spur productive efficiency gains and improve the quality/quantity of inputs and products available in the economy (Dollar 1992; Sachs and Warner 1995; Edwards 1998; Wacziarg 2001). Producers can also benefit from the greater market size created through the PTA, which can expand opportunities for exporting products and lead to enterprise and employment growth. PTAs’ smaller size can also ease trade-facilitating “deep integration”, for example, in the form of harmonizing product standards or regulatory codes. For China, such positive effects could benefit the country’s economy by making available cheaper or better quality imports, even though China is not a party to these PTAs. The main fear, however, is that PTAs may augment intra-bloc trade by diverting trade away from non-member economies (de Melo, Panagariya, and Rodrik 1992; Bhagwati and Panagariya 1996; Schiff 1997). Such diverted trade flows may lead to sub-optimal patterns of specialization if the distribution of resources across members is not representative of the distribution of resources in the world. A country that is the relatively capital-rich

392


member of a PTA might be relatively labor-rich in relation to the rest of the world, for example. Specialization induced by such a PTA would be inferior to global free trade (Panagariya 1994; Venables 2000). Complex and overlapping international and regional trading arrangements can create a spaghetti bowl of complex and overlapping regulations and commitments that are difficult to disentangle and confound broader trade liberalization (Bhagwati and Panagariya 1996; Krueger 1997; Wonnacott 1997). As a nonmember of PTAs in Asia and other of its export markets, China could stand to lose from PTAs to the extent that they divert trade toward members and away from non-members. In general, the greater the contrast in factor endowments of a PTA’s member economies and the closer the agreement approaches open trade, the greater the economic benefits of the agreement. However, in a world where trade interventions and market imperfections are commonplace, the effects of PTAs on trade flows are generally ambiguous analytically. This makes empirical examination of the effects of PTAs on trade flows essential to understanding these effects.

2.1. Trade within PTAs One available measure to capture a growing preference for trade within a bloc is the intra-bloc trade share, i.e., the share of trade among members to total global trade of the bloc. Other things being equal, higher intra-bloc trade shares suggest a possible preference of members of a bloc to trade with each other. Figure 2 shows the intra-bloc shares of exports for eleven trade blocs over the period 1980 to 2000. Intra-bloc export shares exhibited a moderate rising trend during the 1990s, particularly for NAFTA, APEC, and AFTA. However, some of the growth of the intra-bloc export shares of these PTAs can be attributed to changes in the composition of the blocs rather than to a growing preference of PTA members to trade among themselves. Mexico joined Canada and the US in NAFTA in 1994. Chile, Mexico, and Papua New Guinea joined APEC in 1993, and Peru, Russia, and Vietnam became members in 1998. Vietnam, Laos, Cambodia, and Myanmar joined ASEAN between 1995 and 1998. In some instances intra-bloc trade shares have fallen in recent years (e.g., ECO, Andean Pact, and Mercosur between 1998 and 2000). Such decline appears to be the result of external shocks or institutional changes that occurred within the PTAs. Political instability and economic restructuring

80.00 70.00 60.00

EU

50.00 40.00

NAFTA

30.00 20.00

MERCOSUR

AFTA EFTA SPARTECA

10.00

CER ECO

1980 EU

SAPTA

ANDEAN

0.00

EFTA

1982

1984

NAFTA

AFTA

1986 SAPTA

1988

1990 Year SPARTECA

1992 ECO

1994 APEC

Sources of Data: APEC Direction of Trade Statistics 2001; DAB computation.

Figure 2. Intra-Bloc Export Share, Selected PTAs: 1980 to 2000

1996 CER

1998 MERC

2000 ANDEAN


Percent of Total PTA Export

APEC

393

394


in Central Asia combined with the lack of integration of ECO countries into the world economy explain the fall in the ECO intra-bloc trade share. External shocks associated with the Asian financial crisis likely contributed to a decline in Asian PTA intra-bloc shares in the late 1990s. With the exception of APEC, PTAs based in Asia (e.g., AFTA, SAPTA) tend to have larger shares of their respective trade with non-members — particularly in comparison to EU and NAFTA. This tendency may be a result of the nature of these PTAs in that NAFTA or EU constitute natural blocs and preferential policies have intensified the existing attraction among members to trade with one another. This explanation can hardly be applied, however, to the case of APEC, a matter we will return to shortly when we take up the apparent limitation of intra-bloc trade shares for measuring the impact of PTAs. Low intra-bloc trade shares are observed for ASEAN, SAPTA, Mercosur, and Andean. One possible reason for this is that these PTAs involve mainly developing economies. Trade of economies at lower levels of development tends to be oriented toward more wealthy countries even when borders are shared with other countries at similar stages of development. The importance of the US and EU as trading partners to countries in Latin American PTAs — Mercosur and the Andean Pact — is reflected in the relatively low intra-bloc trade shares of these PTAs. The high intra-bloc shares for APEC, EU, and NAFTA do not necessarily indicate the members of these PTAs prefer trade with other bloc members to trade with non-members, but may instead be a reflection of the size of the economies in these PTAs. The index tends to be higher for PTAs that include more and/or larger trading economies. Frankel (1997) cites the case of EEC (EU’s predecessor) expanding from six members in the 1960s to 12 in the 1990s resulting in an increase in EEC’s intra-regional trade share from 49 percent in 1962 to 60 percent in 1990. Some weaknesses of the intra-regional trade share as a measure of PTA trade orientation can be addressed by using the trade concentration ratio, or trade intensity indicator (Frankel 1997; Petri 1993). The trade concentration ratio is calculated by dividing the intra-regional trade share by the share of the region in total world trade. A value for the trade intensity indicator of one suggests the PTA does not have any trade diverting effect as PTA members are trading among themselves at the same intensity as with non-members. If the level of trade within the PTA is higher than the regional share of global trade, this suggests that trade in the region


395

goes beyond the normal pattern that would be expected in the absence of the PTA. Trade intensity indices for our 11 PTAs from 1980 to 2000 are displayed in Figure 3. In this figure, all the estimates are greater than one and show a pattern of results similar to that obtained in Frankel (1997).2 Larger PTAs such as APEC, EU, and NAFTA, tend to have indices close to one, while smaller ones tend to have bigger ratios, when PTA size is defined as the share of total world trade. It is interesting to note that the Mercosur and the Andean Pact trade blocs have the highest trade intensities, an observation also reported by Frankel. The Asian PTAs show lower index values. The trade intensity index for ECO indicates Central Asian countries of the bloc traded more among themselves in the first half of the 1990s but that the intra-bloc trade orientation decreased in the second half of the decade. A similar observation may be made for AFTA as the intensity index for the Southeast Asian bloc fell in the 1990s. SAPTA was formed in the middle of the 1990s, and as shown in the figure the trade intensity index for SAPTA rose until 1997 but fell subsequently. We computed the five-year averages of the intensity indices since 1980 in order to reveal more clearly the trend in trade concentration. APEC and EU consistently show the two lowest trade intensities among the 11 PTAs considered. NAFTA and EFTA held the bottom third and fourth places, although the index increased for NAFTA during the 1990s. The other PTAs in Asia exhibit a trend toward increasing outward orientation over time. Mercosur and the Andean Pact are found to have been the most trade diverting PTAs during the 1990s. The Andean Pact went from having the fifth highest to the highest trade intensity ratio from the early 1980s to the second half of the 1990s. This surge in intra-bloc trade follows our earlier observation that Mercosur and the Andean Pact intra-bloc exports increased dramatically from 1995 to 1998, but fell from 1999 to 2000. By deflating the intra-regional shares with regional shares of total world trade, we observe that Mercosur and the Andean Pact continued to show the highest intra-bloc trade intensity. This indicates that the trade shares of member countries of these PTAs in world trade declined by a rate greater

2 See Table 2.3 of Frankel (1997). There are differences between our estimates and Frankel’s

due to the difference in membership in the periods that the two studies focus on. Frankel’s period of analysis was from 1962 to 1994, while our analysis extends to 2000.

396 R. Clarete, C. M. Edmonds & J. S. Wallack

18.00 16.00 ANDEAN

Trade Intensity Index

14.00

MERCOSUR

12.00 10.00

SPARTECA

8.00

CER ECO

6.00 4.00 SAPTA

AFTA

EFTA NAFTA

2.00

EU APEC

0.00 1980 EU

1982 EFTA

1984 NAFTA

1986 SAPTA

1988 AFTA

1990 Year SPARTECA

1992 ECO

1994 APEC

Source of Data: Authors' Computation based on IMF Direction of Trade Statistics 2001.

Figure 3. Trade Intensities in Selected PTAs: 1980 to 2000

1996 CER

MERC

1998

2000

ANDEAN


397

than the decrease in intra-bloc trade. This highlights the importance of tracking global economic performance in assessing intra-regional trade activity and, as will be explained shortly, leads to an analysis of trade flows using gravity models. 2.2. How have PTAs affected China’s access to markets? On the one hand, China has gained at least conditional access to most major markets via PTAs. Bilateral agreements, often mixed with diplomatic considerations, dominated its past trade relations. The United States’ granting of most-favored-nation status, for example, had to be renewed every year and concessions in areas as diverse as human rights treatment of investment, and environmental standards, were often demanded. Then Director-General Ruggiero of the WTO emphasized the disadvantages of this situation in his April 21, 1997 speech at Peking University: China’s economic relations with the world are simply too large and too pervasive to manage effectively through a maze of arbitrary, shifting and unstable bilateral deals. China’s best guarantee of coherent and consistent international trade policies is to be found inside the rules-based multilateral system.3 On the other hand, many economically significant PTAs have excluded China. NAFTA, Mercosur, and the Andean Pact in the Americas have cemented trading relationships among members, to the possible exclusion of imports and exports from China. The European Free Trade Agreement has similarly created differential access to markets. The evolution of trade patterns suggests that these kinds of trade agreements can affect products in which China may have a comparative advantage. The share of exports in telecommunications and office equipment, items subject to low duties, nearly doubled from 8.81 percent of total merchandise trade in 1990 to 15.19 percent in 2000. Exports of garments and textiles, a category of goods that is more heavily regulated in international trade agreements, grew more slowly. Textiles, in particular, grew at a rate lower than that of total merchandise exports. While garment exports continued to be an above average performer, the increase in their share was 3Available

at http://www.wto.org/english/news_e/sprr_e/china_e.html.

398


less than one percentage point. The respective shares of textile and garment exports were 2.55 percent and 3.22 percent in 2000 compared to 3.08 percent and 3.19 percent in 1990. One set of questions that our analysis can address is how much trade has been diverted from China due to PTAs and, conversely, how much “extra” trade China has gained through its membership in one such organizations, APEC. 2.3. How will PTA membership affect access to China’s markets? One of the rest of the world’s main concerns with China’s membership in PTAs is that selective bilateral agreements will not create as much predictable access to China’s markets as rules-based multilateral negotiations will. The record suggests these fears are valid: liberalization via PTA tends to be fairly selective, and enforcement of provisions tends to be less strict than in the WTO. The degree of internal free trade varies greatly across PTAs, as does the breadth of the agreements beyond tariff reductions in terms of the sectors and goods covered and the extent of tariff reduction achieved. Agriculture is commonly excluded from the list of sectors where trade is liberalized. Most PTAs explicitly recognize the need for trade facilitation, harmonization of quality and other regulatory issues, infrastructure development, and streamlining customs procedures, but the extent of tangible activity in these areas tends to be limited for all but a few PTAs. Liberalization of trade in services is comparatively rare, although liberalization of within bloc investment policies is more common. The PTAs geographically closest to China tend to have modest — at best — achievements in liberalizing trade among members.4 Asia and Pacific Region PTAs have generally made few tangible achievements in lowering tariffs, and tariff reductions cover only a fraction of the goods traded among members. ASEAN, for example, the region’s PTA that has expressed the clearest intention of becoming a true Free Trade Area, achieved only modest liberalization until recent years.5 One positive note, however, is that PTAs in the Asian region have not tended to create such large differentials between members and non-members as PTAs in other regions have. The PTAs in the Asia and Pacific region tend 4 For

more background on these arrangements, see Asian Development Bank (2002).

5 “As recently as 1989, the fraction of goods eligible for regional preferences in ASEAN was

only on the order of three percent.” (Frankel and Wei 1998).


399

to be fairly outward looking and a large percentage of members’ trade goes to non-member countries. This reflects the region’s strong ties to the US, Europe, and some Latin American markets. Of all the PTAs reviewed, and APEC have the strongest links to the international economy, as reflected in the ratio of exports to GDP. CER, SAPTA, and SPARTECA, on the other hand, have relatively low ratios of exports to GDP. Given concerns about China’s implementation of its commitments, it is also worth noting that PTAs’ dispute settlement mechanisms tend to be relatively ineffective. While PTAs frequently specify some sort of bilateral negotiation in case of disputes, only a few agreements set up a supranational court to arbitrate disagreements between members and oversee implementation of agreements. Many of the agreements in the Asian region are more ambitious in aspiration than in implementation. This informality contrasts with PTAs in other regions that establish stricter rules and more formal institutional arrangements for advancing trade liberalization and for resolving disputes between members.

3. Analyzing Trade Effects of PTAs Using a Gravity Model In this section, we describe the technique used in Clarete, Edmonds, and Wallack (2003) to assess the trade effects of preferential trade agreements on China and discuss the data used in estimating the model. Before this, we go through the analytical structure of the gravity model of trade flows due to Frankel (1997) and Soloaga and Winters (2001). 3.1. Basic determinants In the gravity model, trade is viewed as positively affected by the economic mass of trading partners and negatively affected by the distance between them. Additional variables, such as physical area, population, indicators of cultural affinity, and sharing contiguous borders, are usually added to empirical gravity models to elaborate on the “economic mass” and distance variables. Under the model, the total merchandise exported by country i to country j (Xij ) is defined as follows: Xij = AYiαE YjαM Hi E Hj M Ni E Nj M Dij D¯ iδ εij , β

β

γ

γ

φ

(1)

400


where Yi , Yj Hi , Hj Ni , Nj Dij D¯ i εij A

are the gross domestic products of countries i and j ; are the geographic sizes of countries i and j ; are the populations of countries i and j ; is the distance between country i and country j ; is the average distance between country i and its trading partners; is the error term; is a constant;

and the following signs are hypothesized for the parameters: αE , αM > 0; βE , βM , γE , γM , φ, δ < 0. In logarithmic form, we have: log Xij = log A + αE log Yi + αM log Yj + βE log Hi + βM log Hj + γE log Ni + γM log Nj + φ log Dij + δ log D¯ i + aADJij + cIi + dIj + log εij ,

(2)

where the dummy variables ADJ ij , Ii , and Ij are added to capture additional features of the country pair such as whether the trading partners have adjacent borders (ADJ) or either partner is an island economy (I ). Per capita GDP is considered a key variable in the model, and larger economies are expected to engage in greater trade. However, a number of other factors act against the “gravity like” forces of economy size. Country geographic size and population are factors expected to reduce trade orientation by increasing the size of the domestic market and making economic activity more inwardly oriented. Japan and China, for example, both have large economies of roughly similar size, but trade little. This may be explained by the fact that China has a lower per capita GDP, which weakens China’s capacity to attract trade with Japan. China’s large population gives Chinese producers plenty of consumers domestically and tends to dampen rather than augment exports. Building upon insights from endogenous growth models, Frankel (1997) explains that countries with large populations tend to be more inwardly oriented than smaller countries because they are better able to exploit scale economies in their large domestic markets. This may explain why bilateral trade flows tend to have an inverse relationship to population size. Like population, physical area is expected to reduce trade flows to the extent


401

that countries with relatively limited natural resource endowments tend to be smaller and thus depend more on trade to obtain natural resources not available in country. Krugman (1991) considers the distance between two countries to be an important determinant of geographical patterns of trade. Trade is attractive to the extent that the gains exceed the transactions costs. Distance tends to increase the cost of transacting international exchange of goods and services. Beyond some distance, costs of consummating an international exchange become prohibitive and accordingly no trade occurs. The farther apart two potential trading partners are, the more costly their bilateral trade, which erodes possible gains from trade. Linnemann (1966) categorizes the costs of international trade transactions into three types: (1) shipping cost, including freight and insurance; (2) time cost; and (3) “psychic distance” or “cultural cost”. Distance is not the only determinant for shipping cost. In examining data on freight, insurance, and shipping charges, Frankel (1997) notes that shipping costs vary widely across countries in Central Africa, where two relatively remote trading partners may nevertheless have low aggregate shipping costs because only commodities that have low per unit shipping cost are traded. Accordingly, information on commodity composition of trade is needed in order to understand the relationship between distance and shipping cost. Evidence suggests the effect of distance on trade flows has changed through time. Estimates from a gravity model analysis carried out by Boisso and Ferrantino (1997) using data covering the years 1965–1985 suggest that distance had a deterrent effect on trade until the mid-1970s, but that since then this effect has declined. They claim that the average distance between trading partners increased in the post-war period because shipping costs have fallen steadily. Trading partners located far apart from each other need more time for goods transport which discourages trade. Transport cost includes foregone use value of goods not delivered on time. The “psychic distance” or “cultural cost” refers to the lack of familiarity by the citizens of a country with their trading partners.6 Cultural or linguistic affinity and shared borders are factors that would tend to reduce cultural distance. Countries sharing a common language or having citizens belonging to the same ethnic group are more likely to transact business with each other. 6 Drysdale

and Garnaut (1982).

402


In the specification of the basic gravity model used in this paper, following Soloaga and Winters (2001) we include two variables to capture different aspects of the influence of distance on trade flows. One measures the distance between the capital cities for each pair of trading countries (Dij ), the other a country’s remoteness as captured by the average distance away of its top trading partners (D¯ i ). In examining the effect of PTAs on the direction and volume of trade, it is important to control for the effect of distance on trade flows.

3.2. Preferential trade agreements in the gravity model In adopting the basic gravity model framework to study the effect of PTA membership on trade flows, Aitken (1973), and Braga, Safadi and Yeats (1994) introduce a variable into the model that takes a value of one if the two trading countries are both members of the PTA and zero otherwise. They interpreted the estimated coefficient of this dummy variable to be the sum of the trade-creation and trade-diversion effects of the PTAs. A positive coefficient for the variable indicates that the PTA tends to generate more trade to its members. One shortcoming of this initial approach is that a single variable cannot separate the effects of the PTA on trade creation and trade diversion, so does not inform judgments regarding the relative magnitude of the creation and diversion effects. Bayomi and Eichengreen (1995) and Frankel (1997) add a second variable to enable trade creating and diverting effects of PTAs to be separated in the estimates. The variable takes the value of one if the importing country is a member of the PTA and the exporting country is a non-member and zero otherwise. The coefficient of the “extra-bloc” variable represents the trade of non-members diverted to the members of the PTA. A positive value suggests PTA members increase imports to the bloc from non-members. Soloaga and Winters (2001) introduce two additional PTA-related variables in order to capture the effects of PTAs on trade in general. One variable purportedly captures the impact of non-discriminatory import liberalization enacted through the PTA, and takes a value of one if the importer is a member of a bloc and zero otherwise. This variable is different from the extra-bloc PTA variable of Bayoumi and Eichengreen and of Frankel because that variable captures only the extra imports of members from non-members. Soloaga and Winters’ specification considers the extra imports of members of the PTA from all trading partners regardless of their membership status.


403

A final dummy variable introduced by Soloaga and Winters seeks to capture the extra exports of PTA members to all their trading partners, and takes a value of one if the exporter is a member and zero otherwise. Equation (3) permits the decomposition of the trade effects of PTAs that Soloaga and Winters introduce: log Xij = log A + αE log Yi + αM log Yj + βE log Hi + βM log Hj + γE log Ni + γM log Nj + φ log Dij + δ log D¯ i + aADJij + cIi + dIj +

K (bk Pki Pkj + mk Pki + nk Pkj ) + log εij , (3) k=1

where Pki is a dummy variable that takes the value of one if exporting country i belongs to PTA k and zero otherwise, and Pkj is a similarly defined dummy variable for importing country j belonging to PTA k. The coefficient bk on the interaction of Pkj and Pki represents the additional exports from i to j that occur when both countries are members of the PTA k. The coefficient on Pkj , nk , represents the additional exports from country i, that may or may not be a member of PTA k, to a country j in PTA k. In other words, this coefficient represents the additional imports that country j in PTA k receives from the world. The coefficient mk on Pki represents the additional exports from country i, which is a member of PTA k, to the world. Soloaga and Winters’ extension of earlier models that examine the trade effects of PTAs seeks to measure the impact of PTAs on the trade of members generally, not just on intra bloc trade as in the traditional approach of Aitken and Braga, Safadi, and Yeats. The trade liberalization effects of PTAs are highlighted. The impact of the PTA on the trade of members is measured by the sum of the coefficients of the intra-bloc variable and the extra-import and extra-export variables. The total effect of the PTA on the trade of bloc members is thus bk + mk + nk , or the sum of trade diversion (bk ) and general trade liberalization effects on imports (nk ) and exports (mk ). The separate dummy variables allow us to assess the relative contribution of the PTA to narrow intra-bloc trade as well as general trade with the world. In the most extreme trade-diverting case, the coefficient bk would be positive (indicating increased exports when both countries are members of PTA k) and mk + nk would be negative (indicating that being in PTA k depresses a country’s imports from the rest of the world more than that it increases its exports to the rest of the world or vice versa so that the net effect on trade

404


flows between PTA members and the world is negative). In a case where the PTA expanded intra-bloc trade but trade with the rest of the world increased as well, bk and mk + nk would both be positive. 3.3. Modeling the effect of PTAs on China’s trade We introduce dummy variables into the gravity model in order to capture the effect of PTAs on China’s trade, following the approach in Clarete, Edmonds and Wallack (2003). The “China extra import” effect of PTA k is denoted by the coefficient of the interaction between the dummy variable Chinaj , which takes the value of one if importer j is China, and the dummy variable Pki , which is one if the exporting country i is a member of PTA k. The coefficient mC k measures the extra imports that China obtains from PTA k, regardless of whether China is a member of PTA k or not. The ‘China extra export’ effect is defined similarly. The coefficient nC k measures the added exports China provides to member countries of PTA k. It is the coefficient on the interaction between Pkj , the dummy variable denoting membership of importer j to PTA k, and the dummy Chinai , which takes the value of one if the exporting country is China and zero otherwise. The estimating equation is thus: log Xij = log A + αE log Yi + αM log Yj + βE log Hi + βM log Hj + γE log Ni + γM log Nj + φ log Dij + δ log D¯ i + a ADJ ij + cI i + dI j +

K

bk Pki Pkj + mk Pki + nk Pkj

k=1

C + mC k Pki Chinaj + nk Pkj Chinai + log εij .

(4)

As noted above, Soloaga and Winters separate the effects of a PTA into two components: first, the effect on trade diversion, or augmentation within the bloc relative to that predicted by the basic gravity model, and second, general liberalization effects bearing on members’ trade with all countries. The overall effect of the PTA k on its members’ trade is the sum of trade diversion and overall trade effects or (bk + mk + nk ). Under our specification, the effects of a PTA on China’s trade depend on the PTA membership status of both China and the trading partner. When China is not a member of PTA k, the effect of the PTA on members’ trade with China is to increase it above the level that would occur in the absence of the PTA by nk + nC k for exports from China (imports to the PTA) and


405

by mk + mC k for imports to China (exports from the PTA). China is a member of only one PTA of our 11, that being APEC. In the case of APEC, the incremental effect on China’s exports to other members is given by bk + mk + nk + nC k and to non-members by mk , while the incremental effect on China’s imports from other members is given by bk + mk + nk + mC k and to non-members by nk . 3.4. Data and estimation issues The data used in estimating the gravity model come from the 2001 IMF Direction of Trade Statistics (DOTS). Eighty-three countries are included in the analysis, and bilateral exports for every pair of these countries are extracted from the DOTS database at five year intervals over the period 1980 to 2000.7 The number of observations per year varies, and because the model was estimated in logarithms, instances of zero trade between two countries were dropped from the dataset. Dropping these cases from our estimation implies that our results should be interpreted as capturing the effect of PTAs on trade flows among trading countries conditional upon the decision to trade having been made. With this adjustment, we used a dataset comprising 6,806 pairs of trading partners which was further reduced in any given year due to zero values for the year such that sample sizes by year were: 3,317 in 1980; 3,567 in 1985; 3,948 in 1990; 4,644 in 1995; and 5,146 in 2000.8 Export values are expressed in real terms, deflated by a merchandise price index (base year 1990) obtained from the WTO (2001) International Trade Statistics 2001, then transformed into logarithms for the estimations. Estimation is carried out using single-year cross section data. Population and GDP data were obtained from the World Bank’s (2001) World Development Indicators. The distances between capital cities were obtained from John 7 These

83 countries accounted for 73 to 85 percent of total global exports during the period 1980 to 2000. 8Across the 83 countries included in our dataset, instances of no trade between pairs of countries accounted for between 16 and 20 percent of included country pairs in any given year. It seems reasonable to assume that the source of truncation — the decision to not export at all to a particular country — is at most only slightly correlated with membership in PTAs and geographic variables so that bias in the coefficients is minimal. This is clearly a second-best solution that affects the efficiency of the OLS estimates, but the alternative of explicitly modeling the decision to trade would, we feel, involve imposing too many assumptions on what are essentially highly idiosyncratic economic and political decisions.

406


Haveman’s (2002) international trade data website, while the data on land area were obtained from the CIA (2001). 4. Empirical Results In Tables 2a–2c, we report our gravity model estimation results. Estimations were carried out using cross sectional data for selected years (1980, 1985, 1990, 1995, and 2000). We discuss these results next, starting with Table 2a Table 2a. Basic Parameter Estimates, 1980–2000 (Selected Years) Coefficients Intercept

1980

1985

−1.0588∗∗∗ −0.7833∗∗∗

1990

1995

2000

3.3404∗∗∗

2.4168∗∗∗

2.3334∗∗∗

Log GDP: Exporter

1.4122∗∗∗

1.3088∗∗∗

1.2556∗∗∗

1.0857∗∗∗

1.0411∗∗∗

Log GDP: Importer

0.9579∗∗∗

0.9782∗∗∗

0.9571∗∗∗

0.9106∗∗∗

0.8509∗∗∗

Log −0.2430∗∗∗ −0.1976∗∗∗ −0.1983∗∗∗ Population: Exporter Log −0.0366 Population: Importer Log Avg. Distance: Exporter

0.3537∗∗∗

−0.0395

0.0236

−0.0659∗∗

−0.1787

0.0176

−0.0132

0.0004

0.0486

−0.2720∗∗∗

0.0315

Log Distance between Partners

−0.0001∗∗∗ −0.0001∗∗∗ −0.0001∗∗∗ −0.0001∗∗∗ −0.0001∗∗∗

Log Area: Exporter

−0.3064∗∗∗ −0.2771∗∗∗ −0.2512∗∗∗ −0.1419∗∗∗ −0.1433∗∗∗

LogArea: Importer

−0.1895∗∗∗ −0.2066∗∗∗ −0.1612∗∗∗ −0.1230∗∗∗ −0.1587∗∗∗


407

Table 2a. (Continued ) Coefficients

1980

1985

1990

1995

Dummy: Exporter an Island

0.0634

Dummy: Importer an Island

0.0450

0.0916∗∗

0.1790∗∗∗

0.0042

0.1495∗∗∗

0.0647

0.0987∗∗

0.0917∗∗

0.0716∗

Dummy: Common Land Border

0.2752∗∗∗

0.4019∗∗∗

0.4868∗∗∗

0.4668∗∗∗

0.3863∗∗∗

Adjusted R Square

0.674

0.679

0.726

0.715

0.701

Number of Observations

3,317

3,567

3,948

4,644

2000

5,146

∗

Significant at 90% confidence level. Significant at 95% confidence level. ∗∗∗ Significant at 99% confidence level. ∗∗

which summarizes the estimated coefficients for the basic variables of the model. Tables 2b and 2c present the estimated effects for each of the 11 PTAs, Table 2b for those PTAs found to be trade diverting and Table 2c for those found to be non-trade diverting. For the five single year regressions, between 67 and 73 percent of the variation in trade flows (adjusted for degrees of freedom) was explained by the variables of the model.

4.1. Basic determinants of trade flows We report in Table 2a that, as expected, the distance between capitals has a negative impact on trade, as does country land area, while higher GDP and sharing a common border or being an island affect trade positively. A country’s remoteness, represented by the average distance between it and its major trading partners, does not register a consistent effect across regressions.

408

Table 2b. PTA Parameter Estimates for Trade Diverting PTAs, 1980–2000 (Selected Years) 1985

1990

1995

2000

AFTA Intra-Bloc Exports (bk ) Overall Bloc Exports (mk ) Overall Bloc Imports (nk ) Bloc Exports to China (mCk ) Bloc Imports from China (nCk )

0.2299 −0.1212∗ −0.0434 −0.7190∗ −0.2760

−0.2343∗ −0.2922∗∗∗ −0.1151∗ −0.7295∗ 0.0844

0.1296 −0.2446∗∗∗ −0.1494∗∗∗ −0.4408 0.0459

0.1835 −0.2417∗∗∗ −0.0401 −0.2853 0.2598

0.0209 −0.2716 −0.0278 −0.2759 0.0768

ANDEAN Intra-Bloc Exports (bk ) Overall Bloc Exports (mk ) Overall Bloc Imports (nk ) Bloc Exports to China (mCk ) Bloc Imports from China (nCk )

0.6061∗∗∗ −0.0923 −0.0458 0.4507 −0.0966

0.1576 −0.1503∗∗ −0.1028 −0.2871 −0.6637∗

0.6967∗∗∗ −0.1881∗∗∗ 0.0819 −1.0039∗∗ −0.0146

1.1151∗∗∗ −0.1392∗∗ −0.0771 0.1314 0.3783

1.1315∗∗∗ −0.2763∗∗∗ −0.0803 0.7433∗ 0.4218

ECO Intra-Bloc Exports (bk ) Overall Bloc Exports (mk ) Overall Bloc Imports (nk ) Bloc Exports to China (mCk ) Bloc Exports from China (nCk )

0.4174 −0.0594 −0.2754∗∗∗ −0.1870 −0.0393

0.5589∗ 0.1211 −0.0606 −0.1951 −0.2582

0.7352∗∗ 0.3433∗∗∗ 0.2690∗∗∗ −0.0618 −0.3172

1.5337∗∗∗ −0.3290∗∗∗ 0.1046∗∗ 0.1769 0.4119

1.4975∗∗∗ −0.2433∗∗∗ −0.0047 0.5032∗ 0.1871


1980

Table 2b. (Continued) 1985

1990

1995

EFTA Intra-Bloc Exports (bk ) Overall Bloc Exports (mk ) Overall Bloc Imports (nk ) Bloc Exports to China (mCk ) Bloc Imports from China (nCk )

0.1172 −0.3552∗∗∗ −0.0456 0.2540 −0.2001

0.1102 −0.3160∗∗∗ −0.0204 −0.5716 −0.3438

0.0634 −0.3319∗∗∗ −0.0464 −0.2462 −0.2419

0.2857∗ −0.2458∗∗∗ 0.0990∗ 0.0366 −0.0799

0.3373∗∗ −0.2510∗∗∗ 0.0752 0.2790 0.0092

SPARTECA Intra-Bloc Exports (bk ) Overall Bloc Exports (mk ) Overall Bloc Imports (nk ) Bloc Exports to China (mCk ) Bloc Imports from China (nCk )

1.2049∗∗∗ −0.0575 −0.0348 0.7759 n.t.

1.2261∗∗∗ 0.0634 0.0871 0.1154 −0.2243

1.1579∗∗∗ −0.0415 0.1257 −0.5010 0.0152

1.5007∗∗∗ −0.1971∗∗ 0.1263 0.1292 −0.0203

1.3142∗∗∗ −0.3058∗∗∗ −0.0717 0.1768 −0.0283

∗

Significant at 90% confidence level. Significant at 95% confidence level. ∗∗∗ Significant at 99% confidence level. n.t. — No trade. ∗∗

2000 Preferential Trade Agreements and China’s Trade

1980

409

410

Table 2c. PTA Parameter Estimates for Non-Trade Diverting PTAs, 1980–2000 (Selected Years) 1985

1990

1995

2000

APEC Intra-Bloc Exports (bk ) Overall Bloc Exports (mk ) Overall Bloc Imports (nk ) Bloc Exports to China (mCk ) Bloc Imports from China (nCk )

0.6645∗∗∗ 0.0976 0.2534∗∗∗ 0.1606 −0.0284

0.8683∗∗∗ 0.1777∗∗∗ 0.4255∗∗∗ 0.6339∗ − 0.1657

1.2430∗∗∗ 0.4008∗∗∗ 0.5883∗∗∗ 0.1692 −0.3734

1.0787∗∗∗ 0.2894∗∗∗ 0.5076∗∗∗ 0.1609 −0.0523

1.1589∗∗∗ 0.2532∗∗∗ 0.6029∗∗∗ 0.3353 −0.0625

CER Intra-Bloc Exports (bk ) Overall Bloc Exports (mk ) Overall Bloc Imports (nk ) Bloc Exports to China (mCk ) Bloc Imports from China (nCk )

−0.7158 0.1544 0.0606 −0.5568 −0.4495

−0.5170 0.1329 0.1552 −0.6453 −0.3082

−0.7971 −0.1869∗ −0.0343 0.1169 0.0631

−0.7934 −0.0830 0.0146 −0.2227 0.2969

−0.6529 0.2912∗∗∗ 0.0990 −0.3337 0.1057

EU Intra-Bloc Exports (bk ) Overall Bloc Exports (mk ) Overall Bloc Imports (nk ) Bloc Exports to China (mCk ) Bloc Imports from China (nCk )

0.0894 0.1419∗∗∗ 0.0352 −0.4026∗ −0.6815∗∗∗

0.3629∗∗∗ 0.2231∗∗∗ 0.2027∗∗∗ 0.0174 −0.7820∗∗∗

0.2631∗∗∗ 0.1956∗∗∗ 0.0458 −0.3221 −0.4558∗

0.4151∗∗∗ 0.1177∗∗∗ 0.1725∗∗∗ −0.2706 −0.0903

0.7104∗∗∗ 0.2843∗∗∗ 0.3042∗∗∗ −0.1205 −0.1846


1980

Table 2c. (Continued) 1980 1.2059∗∗∗ 0.1174∗ 0.2771∗∗∗ 0.2468 0.4297

1990

1995

2000

1.3146∗∗∗ −0.0653 0.6191∗∗∗ 1.1533∗∗ −0.1015

1.3858∗∗∗ 0.0932 0.5896∗∗∗ 0.3577 0.2206

1.3507∗∗∗ 0.1172∗ 0.4850∗∗∗ 0.6909 0.7676∗

1.4367∗∗∗ 0.1442∗∗ 0.3376∗∗∗ 0.7016 0.7540∗

NAFTA Intra-Bloc Exports (bk ) Overall Bloc Exports (mk ) Overall Bloc Imports (nk ) Bloc Exports to China (mCk ) Bloc Imports from China (nCk )

−0.3108 0.0553 −0.2060∗∗ 0.0905 −0.7409

−0.3948 −0.0458 −0.2978∗∗∗ −0.5183 −0.4989

−0.6848∗∗ −0.1909∗∗ −0.4319∗∗∗ −0.1720 0.1068

−0.2524 −0.1790∗∗ −0.3395∗∗∗ −0.3559 0.1210

−0.2207 0.1246 −0.4878∗∗∗ −0.2816 −0.0671

SAPTA Intra-Bloc Exports (bk ) Overall Bloc Exports (mk ) Overall Bloc Imports (nk ) Bloc Exports to China (mCk ) Bloc Imports to China (nCk )

0.7405∗∗∗ −0.1036 0.1523∗∗ 0.4119 0.3263

0.5501∗∗∗ −0.0539 0.1006 −0.2996 −0.4111

0.5729∗∗∗ −0.0595 0.1783∗∗∗ −0.6758∗ −0.1090

0.5955∗∗∗ 0.0174 0.1250∗∗ −1.0631∗∗∗ −0.0045

0.5356∗∗∗ −0.1136∗∗ 0.1006∗ −0.9212∗∗ −0.0945

∗

Significant at 90% confidence level. Significant at 95% confidence level. ∗∗∗ Significant at 99% confidence level.


MERCOSUR Intra-Bloc Exports (bk ) Overall Bloc Exports (mk ) Overall Bloc Imports (nk ) Bloc Exports to China (mCk ) Bloc Imports from China (nCk )

1985

∗∗

411

412


4.2. Effects of PTAs In Tables 2b and 2c, we show the estimated effects of 11 PTAs on trade. Effects are captured at three levels: the effect on trade flows between members; the overall effects on trade of members with all trading partners regardless of whether they are members of the PTA; and the additional effects on China’s trade regardless of whether China is a member of the PTA. Coefficient estimates for the Soloaga and Winters’ dummy variables are given in the first three rows for each PTA. These capture the intra-bloc, overall export, and overall import effects of the PTA. We have grouped PTAs based on whether they are on balance trade diverting or non-trade diverting according to our estimates and report results in separate tables for each type. A PTA is regarded as diverting trade to the bloc if the estimates for mk and/or nk are generally negative and the estimate of the intra-bloc coefficient, bk is positive. Within the group of trade diverting PTAs shown in Table 2b, two (ECO and SPARTECA) are nevertheless in 1985 and 1990 on balance trade creating in that estimates of the coefficients for the intrabloc, overall exports, and overall imports dummy variables are generally positive. In one case (AFTA in 1985), the net effect is to diminish trade as the sum of intra-bloc and general trade effects is negative, and accordingly this PTA is not strictly trade diverting. For the remaining PTAs shown in Table 2c (APEC, CER, EU, MERCOSUR, NAFTA, and SAPTA), the general trade effects are for the most part positive suggesting membership in the bloc contributes to broad based trade liberalization on the part of member countries. Interestingly, the estimated coefficients for CER and NAFTA are generally negative including those for intra-bloc trade, indicating a lack of support for the hypothesis that these PTAs increase intra-bloc trade at the expense of non-members. This is particularly true with CER. The overall trade effects of CER are generally positive while its intra bloc trade effect is mostly negative. The estimated coefficients for SAPTA generally indicate that this PTA is not diverting trade, except in 2000.

4.3. PTAs diverting trade The trade diverting PTAs of Table 2b generally exhibit negative effects on trade with the world (mk and nk ), which, however, are more than offset by large positive intra-bloc effects (bk ). This suggests membership in these


413

PTAs led constituent economies to divert trade toward other members at the expense of trade with the rest of the world. AFTA’s estimated coefficients disclose a pattern of trade diversion, although the intra-bloc trade effects are generally not statistically significant. This result differs from those obtained in earlier research. Frankel (1997), for example, found membership in AFTA was associated with significantly more intra-bloc trade than would otherwise have been expected while Soloaga and Winters (2001) found that AFTA had a negative and statistically significant effect on intra-bloc trade. A possible explanation for why the results of this study differ from earlier research is that our analysis includes new members of ASEAN, namely Cambodia, Lao PDR, Myanmar, and Vietnam not captured in previous studies. These countries are less developed and less integrated into the global economy than the original five members of ASEAN so their inclusion tends to dilute the observed effect of ASEAN on trade within and outside the PTA. Andean Pact countries have since the 1980s been expanding intra-bloc trade at the expense of trade with the rest of the world. The estimates of the intra-bloc trade coefficient for this PTA are positive and generally statistically significant. The magnitude of the intra-bloc trade diversion effect obtained in our study is about a third lower than the corresponding estimates of Soloaga and Winters (2001). Our estimates also show membership in the Andean Pact was generally associated with significantly lower overall export levels although the negative effect on overall imports is not statistically significant. Our results contrast with those of Frankel (1997) who found that the intra-bloc trade estimate for the Andean Pact had a statistically negative coefficient. Membership in ECO was in 1980 associated with no significant effects on intra-bloc trade or on overall exports, although imports of the bloc were affected negatively. However, as ECO members carried out structural adjustment and opened up their economies to global trade after 1985, the PTA appears to have had a growing effect on intra-bloc trade. In 1990, this is accompanied by expansion of both exports and imports with the rest of the world. However, in 1995 and 2000, greater intra-bloc trade came at the expense of trade with the rest of the world. Particular caution is warranted in interpreting results for ECO, however, since the transition economies of Central Asia that make up ECO were undergoing dramatic changes during the years of our study. These changes in economic structure may have had more profound implications for trade flows to and from these countries than

414


changes in tariffs or other trade policies carried out under the aegis of ECO. Accordingly, one can expect that much of the change in trade flows captured in our estimates may be due to the broader transformation underway rather than to PTA membership. For EFTA, the estimated coefficients suggest the positive incremental effect of membership on intra-bloc trade was accompanied by reduced overall exports of the bloc and a lack of significant increases in overall imports except in 1995. EFTA underwent major changes in membership as a result of the expansion of the EU. Towards the second half of the 1990s, the trade diverting effect of the PTA is observed, while in the earlier years exports to the world declined without any significant increase in trade among members. Hence EFTA was trade reducing in the 1980s and 1990 but became trade diverting from the second half of the1990s. A final PTA that our estimates indicate fostered greater intra-bloc trade was SPARTECA, which involves Australia, New Zealand, and several Pacific island countries. The regression results indicating a strong intra-bloc effect are expected. Trade tended to flow more intensely among the smaller Pacific island economies that are members of SPARTECA and between Australia and New Zealand than between the Pacific island economies and their larger neighbors relative to the latter’s level of trade with the rest of the world. The potential for more trade between Pacific island economies and Australia and New Zealand is limited due to the small domestic markets of the Pacific Island economies. The estimated coefficient for total imports went from being not significantly different from zero in the 1980s to being negative and statistically significant in the 1990s. Thus expansion of intrabloc trade over time appeared to occur at the expense of member economies’ exports to the rest of the world.

4.4. Non-trade diverting PTAs Membership in APEC, EU, Mercosur, and SAPTA was found to expand trade between PTA members significantly while at the same time stimulating trade between members and the rest of the world. For CER, the estimated effects on trade were for the most part negligible. While NAFTA’s overall trade effects are negative, its intra-bloc effects indicate reduced trade. Results for this group of PTAs are summarized in Table 2c. The coefficients capturing the effect of APEC on intra-bloc and total trade are all, subsequent to 1980, positive and statistically significant.


415

This suggests thatAPEC is achieving its goals of open regionalism and broad trade augmentation. Our results are consistent with those of Frankel (1997). While some researchers have argued that Frankel’s estimate for the intrabloc trade effect of APEC was too high (Polak 1996), Frankel attributed the strong effect to the large share of total world trade accounted for by APEC member economies. He also noted the large coefficient estimate was not due to the effect of entrepôt economies as his analysis excluded Singapore and Hong Kong. Frankel concludes that the “APEC effect is genuine” and quoting Garnaut (1994), he maintains that the trade augmenting impact identified for APEC is consistent with the type of integration “where the initiative has remained primarily with enterprises acting separately from state decisions, and where official encouragement of regional integration does not include major elements of trade discrimination”. The estimated effect of EU membership on intra-bloc trade shifted over time from being statistically insignificant in 1980 to being significant and increasingly positive from 1985 onward. Estimates of the effect of EU membership on total imports and total exports are also positive and generally statistically significant. Our results differ from those of Soloaga and Winters (2001), which suggested that the EU had fostered neither overall trade nor intra-bloc trade. Soloaga and Winters offer the explanation that deeper economic integration between member economies has reduced EU’s imports from non-members. The difference in our results might be due to the fact that Soloaga and Winters used data on imports while our data were on exports.9 Bayoumi and Eichengreen (1997) observed that the strong intra-bloc effect of EEC in the 1980s appeared to have dissipated by the early 1990s. The coefficient estimates for intra-bloc trade and overall imports for Mercosur are all statistically significant and positive. These results are consistent with those obtained by Soloaga and Winters (2001) and Frankel (1997). Our estimated coefficients for overall exports show a tendency to rise and become more significant since 1985. Preusse (2001) looks at the impact over time of Mercosur and finds its effects on intra-bloc trade weakening whereas we find no evidence of this through our most recent year of analysis, 2000. Preusse argues there have been two phases in Mercosur’s implementation. In the first phase, intra-Mercosur investments contributed

9 It

is unclear how use of export versus import data affects results, although Havrylyshyn and Pritchett (1991) noted some of their gravity model estimates changed depending upon which type of data were used.

416


to greater regional integration that was trade enhancing. But he maintains the attempt at formation of a full-fledged customs union in 1995, aborted in the wake of the Asian crisis, reduced the intra-bloc trading bias of the PTA. Our estimate of the intra-bloc coefficient in 2000 indicates otherwise. Moreover, our estimates show Mercosur’s overall exports expanded while overall imports decreased in 2000 relative to 1995.Yeats’(1998) research suggests a tendency for elevated intra-bloc trade consistent with our results. He notes that Mercosur’s intra-bloc trade increased substantially at the expense of trade with non-member countries in the first half of the 1990s due to the groups’ “discriminatory tariffs against nonmembers, which are four to six times higher” than those of the EU or NAFTA. He further observes that intra-regional trade growth among members was concentrated in products that Mercosur producers were not competitive in selling outside the region. Our finding of continued robust growth of intra-bloc trade and relatively higher growth of the bloc’s overall imports compared to exports may well reflect the impact of accumulated inefficiencies induced by relatively high discriminatory protection maintained earlier. For SAPTA, the estimated coefficients for intra-bloc trade are statistically significant and positive across all years. These findings differ from that of Frankel and Wei (1998) who found SAPTA membership was associated with lower levels of trade between members than would normally be expected. Estimates for the impact of SAPTA membership on overall imports are significantly positive in most years although the impact on exports is not significant other than in the year 2000, when the overall net export effect is negative. Our estimates indicate that CER has had no statistically significant incremental trade effects within the bloc, and beyond the bloc only for overall exports in 1990 and 2000. Frankel (1997), by contrast, found the intra-bloc trade effects of this PTA were positive and statistically significant. Frankel used total trade data (i.e., sum of exports and imports) while we use export data, which may account for the differing results. Differences in the model specification (e.g., inclusion of language dummy variables in Frankel but a more simplified PTA dummy structure) may also be involved. Our estimation results do not suggest a statistically positive effect for NAFTA on intra-bloc trade. Earlier studies (Frankel 1997; Soloaga and Winters 2001) have yielded similar results, so consensus that NAFTA has not affected the trade orientation of its members is building. Our results suggest NAFTA members’ overall exports and overall imports are lower


417

than would be expected, and that the negative effect grows stronger over time. Soloaga and Winters obtained a similar finding, specifically that the coefficient for overall imports of NAFTA members was negative and statistically significant after 1986. Their study further found that the coefficients on overall exports went from being positive in the early 1980s to being negative after 1984. Our study concurs with that of Soloaga and Winters in finding NAFTA members may be reducing their overall trade with the rest of the world. 4.5. Effect of PTAs on China’s trade Our model includes two additional dummy variables to capture the effect of PTAs on China’s trade. The estimated coefficients for these variables are reported in Tables 2b and 2c. The effect of PTA k on China’s exports to members when China itself is not a member is given by nk +nC k , the effect on its imports from members when China itself is not a member by mk + mC k. China is a member only in the case of APEC for which the effect on exports to other members is given by bk + mk + nk + nC k and on imports from other . To express the effect on China’s exports members by bk + mk + nk + mC k or imports in terms of proportional change, a base of 10 must be raised to the power of the relevant parameter sum, then reduced by one.10 The results of this proportional change calculation for the 11 PTAs are shown in Table 3. To the extent that standard PTAs typically act to divert trade toward members and away from non-members, growth in the number and membership size of PTAs that exclude China would be expected to adversely affect China’s exports. Our estimation results indicate that while China’s exports to most of the 11 trade blocs were indeed negatively affected in the 1980s, the effect turned positive in the 1990s. This transition occurred in 10 Taking

the anti-log of Equation (4), exports of country i to country j can be expressed as baseline exports, Xij0 , times the incremental effect of PTAk :

Xij = Xij0 10 k

C (bk Pki Pkj +mk Pki +nk Pkj +mC k Pki China j +nk Pkj China i )

The proportionate effect of PTAk is then (Xij − Xij0 )/Xij0 , or

10 k

C (bk Pki Pkj +mk Pki +nk Pkj +mC k Pki China j +nk Pkj China i )

− 1.

418

Exports 1980

1985

1990

Trade Diverting PTAs ANDEAN AFTA ECO EFTA SPARTECA

−0.28 −0.52 −0.52 −0.43 −0.08

−0.83 −0.07 −0.52 −0.57 −0.27

0.17 −0.21 −0.11 −0.49 0.38

Non-Trade Diverting PTAs APEC CER EU MERCOSUR NAFTA SAPTA

8.71 −0.59 −0.77 4.09 −0.89 2.01

19.22 −0.30 −0.74 2.29 −0.84 −0.51

71.22 0.07 −0.61 5.46 −0.53 0.17

Imports 1995

2000

1980

1985

1990

1995

2000

1.00 0.66 2.28 0.04 0.28

1.20 0.12 0.52 0.21 −0.21

1.28 −0.86 −0.43 −0.21 4.23

−0.63 −0.90 −0.16 −0.87 0.51

−0.94 −0.79 0.91 −0.74 −0.71

−0.02 −0.70 −0.30 −0.38 −0.14

1.93 −0.72 0.82 0.07 −0.26

65.59 1.05 0.21 16.89 −0.40 0.32

88.65 0.60 0.32 11.35 −0.72 0.01

14.00 −0.60 −0.45 1.31 0.40 1.03

126.46 −0.69 0.74 11.25 −0.73 −0.56

250.98 −0.15 −0.25 1.82 −0.57 −0.82

107.79 −0.51 −0.30 5.43 −0.71 −0.91

223.04 −0.09 0.46 6.01 −0.30 −0.91


Table 3. Effect of PTAs on China’s Exports and Imports (In Proportionate Changes)


419

conjunction with China’s transformation from virtual autarky to avid participation in world trade, and suggests that the transformation was generally aided by interaction with PTAs. The notable exception is AFTA for which the effect on China’s imports remained doggedly negative and the effect on its exports by 2000 had turned only modestly positive. Current efforts to more closely integrate China with AFTA may thus help to reap yet untapped potential. In 2000, China’s incremental exports to all the trade-diverting PTAs except Sparteca are shown to be positive. China’s incremental imports from the trade-diverting PTAs showed a general tendency to decline from 1980 through the following decade, but to rise again thereafter. For AFTA in particular however, the effect on China’s imports remained consistently negative over time without evidence of any real improvement. No general pattern in the effects of the six non-trade diverting PTAs on China’s exports and imports is discernible. With some blocs, such as APEC and Mercosur, China has seen trade consistently above the level that would be expected in the absence of the PTA. Conversely, with CER, NAFTA, and SAPTA, China’s exports have generally been below the level that would be expected as have its imports from NAFTA. In between these extremes, China’s trade with EU has generally risen over time relative to the expected level as have its imports from CER and SAPTA.

5. Conclusions In this study, we estimated the effects of 11 PTAs on China’s trade using a gravity model of exports. Annual data at five year intervals from 1980 to 2000 for 83 countries constituted our sample. Control variables, including GDP, population, geographical area, and the distance between trade partners, were used to explain baseline trade flows against which the incremental effect of PTAs could be assessed. Our results indicate PTAs differ markedly in their impact on trade flows. The 11 trade blocs are classified into two groups based on whether they appear to divert trade toward bloc members or not. Five of the 11 PTAs were found to be trade diverting, namely the Andean Pact, AFTA, ECO, EFTA, and SPARTECA. While other authors have found AFTA to be trade creating, our result to the contrary may be due to the inclusion of new members of the bloc. Earlier studies involved only the original AFTA contracting

420


parties which are more integrated with the world economy than the newer members. For the remaining PTAs (APEC, CER, EU, MERCOSUR, NAFTA, and SAPTA), the general trade effects are for the most part positive suggesting membership in the bloc contributes to broad based trade liberalization on the part of member countries. APEC and CER are particular examples of PTAs that adhere to the principal of open regionalism. It is somewhat surprising that EU appears in this group as this PTA is generally considered to be one of the most trade diverting PTAs. Building on the model of Soloaga and Winters (2001), we introduced two new dummy variables to capture the impact of PTAs on China’s imports and exports. The PTAs included in this study are generally found to have contributed significantly to China’s trade expansion even though China is a member in only one case (APEC). These results suggest to us that PTAs offer a next-best path towards expanding world trade if negotiations for multilateral trade liberalization are slow in achieving results. It will be important to follow macro-level cross-country research of the sort pursued in this paper with more focused studies on the dynamics of PTA members’ trade policies. One matter that could be investigated, for example, is whether progress made by developing countries within the framework of PTAs paves the way for more general trade liberalization (Michalopoulos 1999). Policymakers need to be aware that PTAs vary in their trade promoting propensities. On the down side, PTAs have been known to divert trade toward members, run up high administrative costs, and create opportunities for unproductive rent seeking. The challenge to policymakers is to continue to innovate in the design of regional trade arrangements. Promising areas for negotiation lie in addressing negative externality problems and facilitating capital movements to, from, and within PTAs. Consequent reductions in the cost of doing business and increases in investment will result in economic growth for PTA members. 6. Acknowledgments The authors gratefully acknowledge useful consultations with Kym Anderson in the early phases of this research and the excellent research assistance of Catherine Lawas. This research was carried out with the financial support of the Asian Development Bank.


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Index

ADB. See Asian Development Bank Afghanistan, 24, 176 Africa, 31, 180 performance indicators, 183, 184 AFTA. See ASEAN Free Trade Area agglomeration economies, 6, 325 agriculture productivity, 33–36 shares, 114, 117, 120 Andean Pact, xi, 386 intra-bloc trade, 392–394, 396 trade effect, 408, 413 anti-dumping, 7, 341 APEC. See Asia Pacific Economic Cooperation APT. See ASEAN Plus Three ARF. See ASEAN Regional Forum Argentina, xii financial crisis, 252 performance indicators, 182, 185 ASEAN. See Associations of Southeast Asian Nations ASEAN China Free Trade Area. See China ASEAN Free Trade Area ASEAN Free Trade Area (AFTA), xi, 13, 22, 23, 130, 386, 399 China and, 5, 419 intra-bloc trade, 392–394, 396 regional organizing and, 16 trade effect, 4, 408, 412, 413 ASEAN Regional Forum (ARF), xi, 180

ASEAN Plus Three (APT), xi, 16, 17, 131, 209 as currency area, 52, 53 economic indicators, 129 Asia Pacific Economic Cooperation (APEC), xi, 13, 386, 399 as currency area, 54, 55 China and, 1, 5 intra-bloc trade, 392–394, 396 regional concept, 74 trade effect, 4, 410–415 US and, 16 Asian Development Bank (ADB), xi, 2, 13, 23 China and, 24 Asian Economic Community, 82, 83 Asian miracle, 168, 169 Association of Southeast Asian Nations (ASEAN), xi ASEAN-4, xi ASEAN-5, xi ASEAN-6, xi China and (see also China ASEAN Free Trade Area), 5, 381 economic indicators, 129 FDI receipt, 315–319 FDI source, 307, 308 history, 130 intra-bloc trade, 394 Japan and, 132, 209 Korea and, 132 organizational structure, 132 425

426

Index

sovereignty and, 16 trade, 140, 141 trade barriers, 366 Australia, xi, xii exchange rate, 213 trade agreements, 376 Azerbaijan, xii, 24 Bangkok Agreement, 391 Bangladesh, xii, 178 performance indicators, 181, 182, 185, 186 Bank of China, 279, 280 banking China, 11, 12, 271–295 crises, 252–254 Japan, 10, 11 mega-mergers, 256 Brazil, xii performance indicators, 182, 185 Brunei (Darussalam), xi socioeconomic indicators, 138, 139 Cambodia, xi, xii socioeconomic indicators, 138, 139 Canada, xi, xii, 392 exchange rate, 213 capital movements, 46 capitalism, 156 –159 CAREC. See Central Asia Regional Economic Cooperation Caribbean Community (Caricom), xi, 180 Caricom. See Caribbean Community Central Asia, 176 ADB initiative, 23 Central Asia Regional Economic Cooperation (CAREC), xi, 23, 24 CER. See Closer Economic Relations trade agreement Chiangmai Initiative, 131, 140 Chile, xi, 392 China, xi, 147–148 ASEAN and, 17, 381 bank recapitalization, 275

Bank Regulatory Commission, 272–274 banking, 11, 12, 271–295 exports, 199 FDI receipt, 3, 5, 6, 303, 324 financial crisis and, 7, 8 foreign capital inflows, 304, 305 foreign exchange market, 201 foreign invested enterprises, 301 growth rates, 198 inequality, 2 Korea and, 6, 7, 339–343 non-performing loans, 275, 276 performance indicators, 182, 185, 186, 191, 298 regional development and, 3 regional influence, 18, 208 regional leader, 147, 148 rural credit cooperatives, 288, 289 socioeconomic indicators, 139 state-owned banks, 274 stock market, 201, 289–292 technology policy, 345, 346 trade, 140–143 trade associations and, 5 trade barriers, 366, 367 trade effect of PTAs, 419 trade integration, 390, 391 trade openness, 25 trust and investment corporations, 283–287 urban bias, 38, 39 urban credit cooperatives, 287, 288 WTO and, 25, 292–294 China ASEAN Free Trade Area (CAFTA), xi, 16, 131, 209, 363–366 framework agreement, 373, 374 Chinese Taipei. See Taiwan Closer Economic Relations (CER) trade agreement, xi, 387, 399 intra-bloc trade, 393, 396 trade effect, 4, 410, 412, 414, 416 common currency, 8 communism, 159 consumerism, 159

Index core-periphery system, 6, 325 crisis. See financial crisis culture, 137–140 currency anchor, 48–52 area, 44, 47, 48, 133 international shares, 65–69 undervaluation, 167 world, 52, 53 deindustrialization, 159 democracy, 188, 189 division of labor, 165, 166 dollar (US), 44 as anchor, 51, 54 as international currency, 62–64 in international finance, 65–69 peg to, 8, 202 East Asia performance indicators, 183, 184 ECO. See Economic Cooperation Organization Economic Cooperation Organization (ECO), xii, 387 China and, 5 intra-bloc trade, 392, 393, 396 trade effect, 4, 408, 412, 413 education, 190, 207 EFTA. See European Free Trade Association EU. See European Union euro, 43, 44, 46–49 as international currency, 62–64 currency union, 8, 9 depreciation, 60–62 in international finance, 64–68 European Free Trade Association (EFTA), xii, 387 intra-bloc trade, 393, 394, 396 trade effect, 409, 414 European Union (EU), xii, 13, 387 as balancing force, 14 as model, 75–82 central bank, 57–59

427

economic indicators, 129 economic size, 76–80 FDI source, 307–309 GDP shares, 88–95 history, 72, 128 intra-bloc trade, 393–396 monetary system, 8, 9, 48 trade, 78 trade effect, 410–415 trade shares, 88–95 WTO and, 73 exchange rate real, 213 volatility, 9, 45, 46, 214 export shares by region, 99, 101, 103, 105, 107, 109, 111, 113 FDI. See foreign direct investment financial crisis, 7, 8, 202–204, 235, 236 fiscal cost, 252, 253 recovery from, 12 regional cooperation and, 13, 131 RMB and, 1 financial ratios, 236 flying geese, 3, 146, 154–159 foreign direct investment (FDI), 3, 170 arguments for, 299–301 China receipt, 5, 6, 303 foreign exchange markets, 202 Free Trade Area of the Americas (FTAA), xii, 130, 179 economic indicators, 129 FTAA. See Free Trade Area of the Americas general equilibrium model, 5, 368 Germany central bank model, 58, 59, 62 Global Trade Analysis Project (GTAP), 379, 380 globalization (globalism) growth and, 2 inequality and, 27 institutional infrastructure, 72 institutions and, 2, 30

428

Index

knowledge and, 2, 28–31, 38 markets and, 38, 39 regionalism and, 13, 14, 71, 127, 179 governance, 189 gravity model, 4, 390, 399–405 Greater China Economic Community, 208–210 gross domestic product shares by region, 88, 98, 100, 102, 104, 106, 108, 110, 112 Guangdong International Trust and Investment Corporation (GITIC), 285 Hainan Development Bank, 280–282 Hong Kong, xi, xii crisis response, 243 currency, 8 development, 323 dollarization, 53, 54 exports, 199 FDI source, 5, 6, 307, 308, 324 growth rates, 198 sectoral shares, 327, 328 stock and forex markets, 201 immunization, 36–38 India, xii, 31 FDI receipt, 315–319 performance indicators, 181, 182, 185, 186, 190, 191 trade liberalization, 178 Indonesia, xi crisis response, 241–245 exchange rate, 9, 10, 216–218, 227–230 exports, 199 financial crisis, 252 growth rates, 198 performance indicators, 182, 185, 186 socioeconomic indicators, 138, 139 stock and forex markets, 201 industrialization, 123 industry shares, 115, 118, 121 inequality, 2

infant industry, 163 institutions, 3 Iran, xii, 176 Japan, xi, 146, 200 ASEAN and, 17, 132 banking, 10, 11, 254 common currency and, 47, 50 economic policy, 205 economic problems, 50 exports, 199 FDI source, 307–309 financial crisis, 251, 252 fiscal cost of crisis, 252, 253 flying geese, 162–167 growth rates, 198 industrial development, 163–165 Korea and, 142 performance indicators, 200 post-war growth, 153 regional leader, 146, 147 socioeconomic indicators, 139 stock and forex markets, 201 trade, 142–144 trade agreements, 376 trade balance, 166 Kazakhstan, xi, xii, 23 knowledge-based economy, 207 Korea, xi, xii as FDI source, 6, 7 ASEAN and, 132 China relations, 339–343 crisis response, 241–245 exports, 199 financial crisis, 252 fiscal cost of crisis, 253 growth rates, 198 performance indicators, 181, 182, 185, 186 socioeconomic indicators, 139 stock and forex markets, 201 technology cooperation with China, 346–356

Index technology policy, 343–345 trade, 142–145 trade agreements, 376 Kyrgyz Republic, xi, xii, 23 Laos, xi, xii, 176 socioeconomic indicators, 138, 139 latent factor model, 215, 219 Latin America performance indicators, 183, 184 life expectancy, 31–33 Macao FDI source, 5, 307, 308 Malaysia, xi crisis response, 241–245 exchange rate, 9, 10, 216–218, 227–230 exports, 199 financial crisis, 252 growth rates, 198 performance indicators, 181, 182, 185, 186 socioeconomic indicators, 138, 139 stock and forex markets, 201 McLuhan industries, 158 Melanesian Spearhead Group (MSG), xii, 22, 23 Mercosur. See Southern Common Market Mexico, xi, xii, 392 performance indicators, 182, 185 miracle, 154 monetarism, 58, 59 moral hazard, 251, 254 MSG. See Melanesian Spearhead Group Myanmar, xi, xii, 176 socioeconomic indicators, 138, 139 NAFTA. See North American Free Trade Agreement Nepal, xii, 178 performance indicators, 182, 185, 186 New Economy, 158 slump, 7, 203, 204

429

New Zealand, xi, xii trade agreements, 376 newly industrialized economies (NIEs), xii, 166 currency valuation, 168 FDI receipt, 315–319 policy, 168, 169 North American Free Trade Agreement (NAFTA), xii, 128, 388 economic indicators, 129 intra-bloc trade, 392–394, 396 trade effect, 411, 412, 414, 416 open market capitalism, 158, 159 open regionalism, 4, 415 Pakistan, xii exchange rate, 9, 10, 216–218, 227–230 performance indicators, 182, 185, 186, 190, 191 trade liberalization, 178 Papua New Guinea, xi, xii, 392 Pearl River Delta, 6, 324, 325 People’s Bank of China, 278, 279 Peru, xi, 392 performance indicators, 182, 185 Philippines, xi crisis response, 243 exchange rate, 9, 10, 216–218, 227–230 exports, 199 growth rates, 198 performance indicators, 182, 185 socioeconomic indicators, 139 stock and forex markets, 201 pound sterling, 44, 62 poverty globalization and, 27 trade and, 2, 22 preferential trade associations (PTA). See also free trade area arguments for, 390 institutionalization in Asia, 22 members and provisions, 386–388 prevalence, 385

430

Index

regional trading associations, 22, 23 trade effect, 4, 13, 389–391, 398, 399 product-cycle theory, 160 PTA. See preferential trade associations regional trade associations. See preferential trade associations regionalism continent based, 175–177, 179, 192 globalism and, 13, 14, 71 renminbi (RMB), 8, 49, 50 Republic of China. See Taiwan Republic of Korea. See Korea research and development, 161 Russia, xi, 392 SAARC. See South Asian Association for Regional Cooperation SAFTA. See South Asian Free Trade Area SAPTA. See South Asian Preferential Trading Agreement Schumpeterian growth, 156–158 sectoral shares, 84–87 services shares, 116, 119, 122 Singapore, xi, xii crisis response, 241–245 exports, 199 growth rates, 198 New Economy slump, 204 socioeconomic indicators, 139 stock and forex markets, 201 trade agreements, 376 US market and, 7 Smithian growth, 156–158 social indicators, 185 South Asia performance indicators, 183, 184 South Asian Association for Regional Cooperation (SAARC), xii, 15, 176 history, 177 South Asian Free Trade Area (SAFTA), xii, 13, 178 regional organizing and, 15

South Asian Preferential Trading Agreement (SAPTA), xii, 22, 23, 178, 388, 399 China and, 5 intra-bloc trade, 393, 394, 396 trade effect, 4, 411, 412, 414, 416 South Korea. See Korea South Pacific Regional Trade and Economic Cooperation Agreement (SPARTECA), xii, 388, 399 China and, 5 intra-bloc trade, 393, 396 trade effect, 4, 409, 412, 414 Southern Common Market (Mercosur), xii, 47, 387 intra-bloc trade, 392–394, 396 trade effect, 396, 411, 412, 414–416 sovereignty, 137 SPARTECA. See South Pacific Regional Trade and Economic Cooperation Agreement Special Drawing Rights (SDRs), 54 Sri Lanka, xii exchange rate, 9, 10, 216–218, 227–230 performance indicators, 182, 185, 186 trade liberalization, 178 stages of development, 156 stock markets, 200, 201 Taiwan, xi, xii crisis response, 241–245 economic policy, 205, 206 exports, 199 FDI source, 307, 308 Greater China and, 210 growth rates, 198 New Economy slump, 204 stock and forex markets, 201 US market and, 7 Tajikistan, xi, xii, 23 tariff and non-tariff liberalization, 369–372 technology transfer, 6

Index terms of trade, 9, 213 tertiarization, 160 Thailand, xi crisis response, 241–245 exchange rate, 9, 10, 216–218, 227–230 exports, 199 financial crisis and, 7, 202, 252 fiscal cost of crisis, 253 growth rates, 198 performance indicators, 186 socioeconomic indicators, 139 stock and forex markets, 201 trade agreements, 376 trade concentration ratio, 394–396 determinants, 407 North-South, 136 regional concentration, 133–135 shares, 88 Turkmenistan, xii, 24 United States (US), xi, xii APEC and, 144 ASEAN and, 16 banking, 258 China trade, 397 economic policy, 204, 205

431

economic relations with Asia, vi, vii FDI source, 307–309 financial markets, 64, 161 global strategy, 128 hegemonism, 140, 155–159, 161 innovation, 158 New Economy slump, 203, 204 performance indicators, 200 trade, 140 trade agreements, 376 Uzbekistan, xi, xii, 23 Vietnam, xi, 392 socioeconomic indicators, 139 World Trade Organization (WTO), xii, 14 China and, 1, 17, 25, 397 performance, 72 Xinjiang, xi, 23 yen, 44, 45 as anchor, 50 as international currency, 63 dollar rate, 51, 52 financial crisis and, 8 in international finance, 65–69 valuation, 167, 168

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Asian Economic Papers. Volume 7, Issue 1, Winter 2008

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Asian Economic Cooperation In The New Millennium: China's Economic Presence (Advanced Research in Asian Economic Studies) (v. 1)

China's Industrial Revolution And Economic Presence (Advanced Research in Asian Economic Studies) (Advanced Research in Asian Economic Studies)

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Economic Dynamism of Asia in the New Millenium: From the Asian Crisis to a New Stage of Growth (Advanced Research in Asian Economic Studies) (Advanced Research in Asian Economic Studies)

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