ISSN O075-6407& BUSINESS

38th

REPORT
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RESEARCH INSTITUTE FOR ECONOMICSAND BUSINESS ADMINISTRATIONKOBE UNIVERSITY
1993

KOBE

ECONOMIC & BUSINESSREVIEW

38th

ANNUAL REPORT

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RESEARCH INSTITUTE FOR ECONOMICSAND BUSINESS ADMINISTRATIONKOBE UNIVERSITY

1993

CONTENTS

Page
Generalized Lower-of-Cost-or-Market Rule for Inventory
Valuation for Quasi-rational Managers•••••••••••••••••••••••••••••• Isao NAKANO 1

Effects of Financial Deregulation on Australian Financial
System ••••••••••••••t'"''''''''''••••••••••''"''''''•••••••••••••''''''''''' Kenichi ISIGAKI 19

NAFTA and Asis-Pacific Economic Relations '''''••••••••'•••••••••••••••• Seiji NAyA 47

The Asian Development Experience and lts Relavance to .
African Development Problems '''••''"''"''''''•••••••••''''••••••••••••• Seiji NAyA 71

Robert K. McCLEERY
A Qualitative Assessment of the Effects of NAFTA on Japan'sForeign Investment and Trade with East Asia and Mexico:
Opportunity or Diversion? '''"''''••''`"''''""''''''"''''''' William E. JAMEs 135

Dynamic Effects of Tax Policies in A q
Model of Investment '''''••••••••••••••''"''""'''"'''"''''''''''" Takao OHKAwA 163

Kazuo SHIMOMURA
Corporate Governance in Germany, Japan, and theUnited States: A Comparative Study '''•'•••••••••••••'''''""''' Kenji KoJIMA 171

Economic Issues in International Debt: A Survey "'''''""''''''' Hideki IzAwA 245'
A Note on the Estimation of Scale Economies and their

Use in Modeling Free Trade Agreements ''"'"''''"" Robert K McCLEERy 261

GENERALIZED LOWER-OF-COST-OR-MARKETRULE
FOR INVENTORY VALUATION FORQUASI-RATIONAL MANAGERS

Isao NAKANO

1. Introduction
Conservatism in the sense of recording events or transactions in
the way of giving the least favorable effect on assents, income andowners' equity [Cooper and Ijiri, p.113] is an important accounting
practice. In this paper I attempt to logically deduce a couple ofconservative valuation rules from a set of assumptions on rational
managerial behaviors. Although I use the term `rational', no value

judgment or endorsement for conservatism is intended. I wish topropose a purely descriptive statement. This exercise is based on theassumption that even in the pragmatic field of accounting a rigorous
deduction of an accounting phenomenon has a scientific value of its

own.

Conservative practices considered are: (1) the normality
requirement for acquisition cost; (2) the lower of cost or market rule;and (3) the realization principle for revenue recognition. Only inventory
assets will be taken up. Fixed assets have complicated `depreciation'
problems which would have to be treated separately.

2. Basic assumptions on 'rational' managerial
behaviors and 'rational' cost concept

In order to logically reproduce major conservative financial
accounting rules, we will start by making several fundamental
assumptions about ideally `rational' managerial behaviors. We willdefine the cost incurred by such rational behaviors as `rational' cost.
This rational manager is, in trying to reach a minimum cost as well asa maximum revenue, assumed to make a continuous search(prediction) along the `time' continuum. Further, we will define a

2

ISAO NAKANO`quasi-rational' manager whose search is simplified to sample priees at
a discrete number of points-in-time for determination of optimal prices.

The aquisition cost of a good by such a `quasi-rational' manager will
be called a `quasi-rational' cost concept. And we will demonstrate thatmajor conservative financial accounting rules can be logically derived
from a speeific kind of `quasi-rational' cost concept,
A `rational' cost or `rational' carrying value on the balance sheetof a good is defined to be equal to that amount of expenditure which
would have been incurred by the following set CA) of assumptions of`rational' managerial behaviors.
(A) Assumptions on `rational' (vis-a-vis `actual') managerial behaviors.

(1) In purchasing a good, a `rational' manager minimizes the amountof expenditure required for its acquisition.

(2) In selling the good, a `rational' manager maximizes the amount ofrevenue from its sale.
(3) A `rational' manager can accurately predict future phenomena.
(4) A `rational' manager is assumed to decide buying a good only if
the selling revenue is predicted to exceed its acquisition expenditure (inaddition to covering the other related expenses).

(5) Suppose that the amount of predicted revenue (the higher of agood's current net realizable value and its future selling price) should

lie below its minimum available acquisition price. In this situation, arational manager tries to bargain the minimum acquisition price to theamount of its benefit valuel otherwise he/she is assumed not topurchase the good.
(B) A `quasi-rational' manager is assumed to share all behavioral
characteristics in <A). The only difference is assumed to lie in the scopeof price data utilized by the person. That is, he/she is posited to takea price sample from the time continuum and to determine a minimum
cost and a maximum selling price from that sample.
(C) A `quasi-rational' cost or `quasi-rational' carrying value on thebalance sheet is the expenditure incurred by a quasi-rational manager.
In the following section, we will have a `quasi-rational' manager
trace and check the historical path of the `actual' manager's activities
about acquiring, holding and eventual selling of a good. The monetaryamount resulting from the manager's `rational' activities will be treatedas the standard carrying value on the conventional balance sheet; any
excess resulting from the manager's `actual' behavior will be treated as

GENERALIZED LOWER-OF-COST-OR-MARKET RULE FOR 3

INVENTORY VALUATION FOR QUASI-RATIONAL MANAGERS
a loss to be charged to current year income.

3. Symbols
Following symbols will be defined.

tb:the point in time when the inventory asset in question was
actually bought.
tp : current balance sheet date where we are now.
tf:the terminal point in time, i,e., the end point of our time horizon

for consideration.
ti :a `time' variable which indicates when the purchase of the good

would have been made by a (quasi-)rational manager. The`purchase period' is assumed to be tb S ti $ tp.
t2 : a `time' variable which shows when the selling will be made. This
`sale period' is assumed to be tp S t2 $ tf.
RV : net realizable value of the good if it is sold at current balance

sheet date.
FV (t2) : the amount of future sale revenue if the good is sold in its
normal course of disposal at time t2. (tp $ t2 S tf).

MER(t2) : a maximum expected revenue from selling the good if
comparison is made between RV and FV(t2), normal sale revenue
at tlme t2.
MER (t*) : the maximum possible value of MER(t2) where the future
sale is made at time t* when the selling price is maximized.
HC (ti) : acquisition price of the good if the purchase would havebeen made at time t!.
HC (t**) : the `rational', i.e., the Iowest acquisition price of the good

if the lowest was attained at time t**.
RC : replacement price of the good at current balance sheet date tp,
that is, HC (tp).
HC : Actual acquisition price of the good, that is, HC (tb).

4. Rational vs. quasi-rational behaviors of a manager

Let us concentrate on an inventory asset. For simplicity but
without any loss of generality, we assume an item of inventory asset
was bought on January 1, 1993 and is planned to be sold on December
31, 1994. This is the behavioral pattern of our `actual' manager. A

4 ISAO NAKANO`rational' manager with a complete predictive ability might

possibly act

in a different manner. See Figure 1.
Given the wholesale and resale price data in Figure

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rational manager would, according to Assumption (A) -(1), have paid
the minimum wholesale price of $1 at time t* to buy the asset andwill, according to Assumption (A) -(2), sell it at the highest resale priceof $4 at time t**, thus achieving a greatest possible sales margin of$3. But such a continuous search along the time continuum would be
too costly for actual implementation. So, we will model him to only
pick up the acquisition prices at the beginning and end of the purchaseperiod to approximate the minimum purchase price. That is, in Figure

GENERALIZED LOWER-OF-COST-OR-MARKET RULE FOR 5

INVENTORY VALUATION FOR QUASI-RATIONAL MANAGERS
1, $2 and $1.50 is assumed to be compared and the latter chosen.
This is a quasi-rational behavior and a quasi-rational cost according
to Assumptions <A) and (B). Hence, our quasi-rational manager wou}dhave postponed the purchase until December 31, 1993. Naturally, thispolicy and this purchase price $1.50 would be suboptimal, as comparedwith the true minimum of $1.00. We note here that a monotone pricetendency would have been required to justify the two point sampling as
optimal.

As to the estimation of the highest selling price, too, the same twopoint sarnpling is assumed to be made by a quasi-rational manager.
Considering two prices $3 and $3.50 at the two terminal dates of thesale period, the higher price $3,50 at the end date is determined to be

the maximum, which also will turn out to be suboptimal if comparedwith the true maximum of $4.00 at time t**.
In conclusion, two kinds of rationality need to be separated. `True

rationality' concerns a continuous search for a really minimum
acquisition price as well as for an actually maximum selling price. By
contrast, `quasi-rationality' could be defined as involving a comparisonof two price data as of the begin and end points of purchase period orsale period so as to choose the lower or higher one as the minimum or

maximum. In both concepts of rationality, a perfectly accurate
predictive capability is assumed to exist.

0ur hypothesis, then, is that a `quasi-rational' managerial
behaviors about buying and s611ing a product do underline major
conservative financial accounting measurement rules.

A quasi-rational manager is assumed to consider buying an
inventory asset at a minimum price possible, Le,, atmin (HC, RC) '''''''''•••••'••••-••••••••'' (1)so as to sell it at a maximum selling price of
MER - max (RV, FV(tf) ). •••••••••••••••••••••••••••••• (2)Accordingly, we will divide the possible situations into two cases.
Case 1 : MER >min (HC, RC) '''''''''''••••''''''''''•••'"'' (3)Case 2 : MER $ min (HC, RC) '''''''••••••••'''''••••••••'•••• (4)5. The case of maximum sale revenue exceeding
mlnLmum acqulsttlon cost
Our quasi-rational manager would, in this case, have bought theISAO NAKANO

6

good at the given minimum price according to our Assumption (A)-(4)above. Hence, if HC had been predicted to be smaller than RC, he/shewould have bought the product at time tb by paying HC. Otherwise, theperson would have postponed the purchase until the year-end, at whichtime the smaller cost RC would have been incurred. Hence, theacquisition cost incurred by the quasi-rational action would bemin (HC, RC),as stated above. By assumption (D), this amount is a quasi-rationalcost.

In actual situations, the `actual' manager have paid a greater
price HC, say $2, when the current year-end replacement price has
become lower, say $1.50. The difference $O.50 has resulted from his
irrational action, i.e., from his prediction error. That, therefore, does
not constitute part of the rational cost. It rather is a current year loss

under the quasi-rational cost measurement.

Oinr conclusion hence is that in case MER>min (HC, RC) the
quasi-rational manager would have acquired the good by paying theamount min (HC, RC), which qualifies as the quasi-rational cost andthe quasi-rational balance sheet value.

Considering the direction of the inequality sign in MER >min
(HC, RC),min (HC, RC) = min (MER, HC, RC). '•••••••••'''''''''""' (5)The right-hand side of (5) indicates that at least in this case wecan characterize the `quasi-rational' balance sheet value as the `lowest

of cost-marketror-benefiV valuation ''••••••• a logical extension of
conventional cost-or-market principle. This is a modified version of

the idea already proposed that the generalized `cost-or-market'
principle can explain a great part of conventional accounting practice[Ijiri and Nakano].

6. The case of maximum sale revenue being
smaller than minimum acquisition cost
The quasi-rational manager would have beat down the acquisition
price either at date tb or tp to the level of its expected benefit MER at

maximum before making the decision. Otherwise, he would not havebought one. Therefore, the quasi-rational acquisition price in this caseis equal to MER. This in turn is less than min (HC, RC) before theGENERALIZED LOWER-OF-COST-OR-MARKET RULE FOR 7

INVENTORY VALUATION FOR QUASI-RATIONAL MANAGERS
negotiatipn. So, in conclusion, the quasi-rational balance sheet value
will equal

MER = min (MER, min (HC, RC))- min (MER, HC, RC). •••••••••••••••••••••••••••••• (6)The last term in (6) demonstrates the quasi-rational cost is equal
to the `lowest of cost'market'or-benefit' value in this case, too.

By contrast, in this case, the `actual manager has bought the
product at a price HC, say, $2.00, which has turned out to be greaterthan the benefit value MER, say, $1.50. The difference $O.50 (HCMER) is a loss to be charged to current year which has arisen fromthe managers's suboptimal purchasing behavior as a result of his/her

prediction
error. .
Evidently, the value min (MER, HC, RC) as the quasi-rationalbalance sheet value can be interpreted as a `minimum purchase cost
available'. It is quite natural that a quasi-rational manager withaccurate predictive ability would have bought a good only at this leastacquisition price possible.

In the following, we will propose a financial accounting modelsuch that an inventory asset has been, and will also be, subjected to the`lowest of cost'market-or'benefit' valuation all the way through in thefirm, beginning at acquisition to the yearNend to the date of its sale in

the next year. By applying this accounting model, we will show it canapproximately reproduce three aspects of accounting practice, i.e., (1)normality requirement for acquisition cost ; (2) the lower of cost-ormarket valuation at a year-end ; (3) the realization principle forrevenue recognltlon.

7. Normality of acquisition cost
In retrospect, the requirement that the acquisition cost of an asset

be based on a normal, and not necessarily actual, cash outlay has notclearly been stated in authoritative US literature. Cost was defined asthe `bargained price' of the goods etc. and was said to be usually
measured by the amount of cash expended to acquire the good [Patonand Littleton], by cash outlay or by the fair market value of property

acquired [AAA 1936] [AAA 1941], or by the amount of cash or its
equivalent, the amount given up [AAA 1957]. The explicitly statedpurpose in such `price aggregate' or `cash expended' definition of cost

ISAO NAKANO

8

was said to lie in providing (1) available objective evidence in recording

the origin and disposition of the good for accountability purpose [AAA1948] or (2) the best available evidence of fair market value at the

moment of exchange [Paton and Littleton] or a satisfactory
quantification of future service expectations at the time of thetransaction [AAA 1957]. By defining cost as `economic sacrifice' inacquiring a good, the AICPA and FASB publications concurred in thosedual functions of cost: (i) cost as evidence of its acquisition and (M cost

as an attribute of it, that is, future benefits from the asset [FASB
1985]. If the latter function of benefit representation is to be stressed,

it is obvious that acquisition cost should depart'from cash outlay in' known. 'case the disparity is
Thus far, general accounting standards have been reviewed.
Normality of acquisition cost has only very indirectly been implied.
But investigating asset accounting rules and studies, we find explicit
reference to the requirement. On inventory valuation, it is stipulated

that the cost of a good acquired are usually defined as `that
expenditure which has been incurred in the normal course of businessin bringing the product or service to its present location and condition'[SSAP 9].

Such normality requirement may be said to be in effect for fixed
asset valuation, too. `If cost is in excess of market value this may be

the result of defects in judgment, major changes made during
construction of plant, excessive delays in completing a building or otheradverse factors. In such eases most authorities agree that recorded

cost should not exceed that which would have been incurred undernormal circumstances' [Davidson, Chaper 17, p.18]. This requirement

can be formulated asacquisition cost =: normal replacement cost RC (at thetime of acquisition) $historical cost HC. '•••'''''''' (7)How about the reverse case of HC$RC ? `[I]t is possible forassets to be acquired at a bargain price, perhaps in a distress sale. In
this event, authorities differ as to whether actual cost should be written

up to market value. Since accounting practices tend towards
conservatism in ambiguous cases, many (if not most) accountants
would not favor writing up in this situation, in conformity with theconcept of valuation at the lower-of-cost-or-market price' [Davidson,p.18]. This statement could be represented as

GENERALIZED LOWEROF-COST-OR-MARKET RULE FOR 9

INVENTORY VALUATION FOR QUASI-RATIONAL MANAGERS
acquisition cost = HC S RC. ''••••••••''''''''•••••••••••• (8)Thus, from (7) and (8), we may conclude that
acquisition cost == min (HC, RC) '''''"''''•••••••••••••''' (9)where both values are those at the acquisition date.
In addition it will be self-evident that since the aim of a business'enterprise is to earn profit as an excess of cash, `acquisition cost' isvalid only in so far as it lies below its maximum recoverable inflow ofcash MER = max (RV, PV). Hence, a comparison must still be madebetween the cost deterrnined by (9) and the recoverable inflow MER so
as to derive the lower of the two, which is the really valid acquisitioncost.

We have thus come to the conclusion that as a model of actual
asset valuation at its acquisitionacquisition cost =min (HC, RC, MER), -••••••••••••'''''''' (10)which agrees with our quasi-rational cost (5) if the purchase period
converges to O.

This model will be shown to explain the common practice ofeliminating abnormal spoilage and shrinkage from product cost
[Davidson, Chapter 38, p.21] [ARB No.43, par.5] as well as the rule ofvaluing a donated asset at its fair market value rather than at a zero
value [AICPA, APB Statement No.4, par.182].

If our manager is assumed to order his factory to reproduce a
product, normal spoilages and shrinkages must be expected to recur on
average, however rational he might be. In this sense, its replacement
cost at the acquisition date should naturally include normal amounts of
those losses. But the unexpected abnormal losses could be avoided ina careful production, so that they do not join its replacement cost.
Hence,RC (including only normal losses)$ HC (including both normal and abnormal losses). '•' (11)And if the product has been judged to be profitable by the quasirational manager,
HC<MER. •••••••••••-••••••••••••••••• (12)Our hypothesis is that conventional accounting is measuring`quasFrational' cost. Its appropriate measure in this case, considering(11) and (12), will bemin (HC, RC, MER) == RC (at the acquisition date),

which conforms to the conventional cost accounting practice ofISAO NAKANO

10including only normal losses,

As for a donated asset, how much can we presume would its
historical cost be? Historical cost, if logically generalized, may be
defined to be that amount which makes it possible to replace the good
if the price situation remains unchanged. So, its best estimate atacquisition date will be the then replacement cost, since its payment
will enable repurchase. That is,an estimate of HC = RC at acquisition date. ••••'•••••••••• (13)

If the donated good has been estimated to be a profitable one,
RC<MER. •••-••••••••••••••••••-•••••• (14Our `quasi+rational cost' measurement for a donated asset ismin ( HC, RC, MER ) = RC at acquisition date. ••••••''' (15)The fair market value is usually defined as `(an estimate of) value
determined by bona fide bargaining between well-informed buyers andsellers, usually over a period of time' [Cooper and Ijiri]. In this sense,

it may be said to be approximated by the normal replacement cost (15)of the donated asset in case of a profitable good. In consequence, theconsistency of this `fair market value' valuation with our `quasirational cost' has been demonstrated.

8. The lower of cost--or-market valuation

Vigorous criticism and weak, incomplete support have been
advanced towards the cost-or market rule, Criticism includes (1) lackin consistency: cost or the year-end market price is appliedinconsistently, selecting whichever is lower [Paton, 1922] [Mason][Paton and Paton, 1952] [Hendriksen]; (2) Violation of realization
rule: valuation loss is claimed to be unrealized; if after writing down
the book value the market price should rise (but not to the level oforiginal cost), then some unrealized valuation gain will be mixed in thenext year's income [Paton, 1922] [Paton and Paton, 1952]; (3)Unconservative profit showing in future periods: arbitrary changes will
be made in periodic assignment of income between periods, resulting in
disproportionate fluctuation of incomes with sales amounts, [Paton,

1922] [Paton and Paton, 1952] [Husband] [Hendriksen]; <4) Current

price fall may be recovered by future price rise; so, current
impairment does not necessarily imply permanent impairment in thebenefit of the asset [Paton, 1941] [Ijiri and Nakano]; (5) If the extent

GENERALIZED LOWER-OF-COST-OR-MARKET RULE FOR 11

INVENTORY VALUATION FOR QUASI-RATIONAL MANAGERS
of price down should be smaller than the sales margin in the product,
the original cost can be recovered in full from future revenue; in thiscase, no loss has been incurred [Paton, 1941] and <6) Understatementof service value of the total asset [Hendriksen].

It is impossible to overcome these critiques within the current
orthodox conceptual framework. But we will show that if our novel`quasi-rational cost' concept is accepted the cost-or-market rule canlogically be deduced.
Turning next to the defenders' side, the supportive arguments havebeen rather weak. (1) As to the amount of asset cost to be carriedforward, the American Accounting Association has expressed`recoverable cost' [AAA, 1936] or `residual cost' [AAA, 1948] concept.

This means that portion of cost which will be recoverable from future`estimated amount of sales proceeds less direct expense of completionand disposal' [AAA, 1948]. Writing down asset costs are admitted incase price changes etc. should make it necessary in reflecting `residual
cost'. An obvious difficulty with this concept is that of critique (4)above that a future price is hard to estimate. (British cost-ormarket rule also dictates using `current sales price' for market [SSAPNo.9]).

(2) The US costTor'market rule mandated by AICPA differs fromthe above in requiring current replacement cost, not selling price, forthe `market' so long as this stays within a price interval limited by the
net realizable value and this minus a normal profit margin. And if thereplacement cost is above or below the interval, then that upper orlower limit value should be adopted as the market [ARB No,43].

The ARB tries to justify the use of current replacement price byreferring to `utility'. No definition of utility is made in the document.

One interpretation is that the utility can be measured by the amount ofinvested cost recoverable with a normal profit. So, the lower limits `net
realizable value less normal profit margin' is said to be the base forthe rule, with the replacement cost determining an allowable profit
margin [Ijiri and Nakano].
It is obvious that this sort of utility measurement faces difficultyof estimating future, not current, realizable value. In addition,
replacement cost would seem rather superfluous in this interpretationof utility.

Consider our `quasimrational cost' concept. Note that our12 ISAO NAKANO
definition of the cost characterized as `the lowest of cost'market-

or-benefit' immediately dictates a sort of the lower of cost-ormarket valuation where the market may be said to mean the lower ofthe year-end replacement cost and net realizable value. (The present

value may be usually dropped because of a generally short stock
turn-over period).

An approximate quasi-rational cost of an inventory item== min (HC, RC, RV). '''''''"''"'''""''''''"'' (16)Interestingly enough, Parker [1966] has excavated this `lowest'
type of cost-or-market in the time-honored statement of Sanders,Hatfield and Moore [1938]. `The proper showing of current assets
requires that the values in general be the lowest of cost, replacement

market or realization'. According to Parker's another discovery[1966], Spicer and Pegler also suggested the same Iowest value basisfor `floating assets' [1925].

Next, we will consider possible relationships between this `lowest'

principle and the US mandated rule. A casual glance at the latter rulewould suggest that

the US cost-or-market value = min (HC, RV, max (RC, RV-NP))
where NP : normal profit margin ; RV : net realizable value.
It seems plausible to assume that the `net realizable value minus
normal profit margin' can be interpreted as a normal lower limit to thereplacement cost as this should scarcely become lower than that. So,

if we call this greater value max (RC, RV-NP) as a modified
replacement cost,

the US lower of cost-or-market value = min (HC, RV,
modified RC) '•••••••••'''''''''''''''"''' (ITWe have thus demonstrated by formula (IT that the US type
cost-or-market valuation is a sort of normalized `quasi-rational cost'measurement. It also proves consistency of the rule with normality
requirement for acquisition cost above, '9. The sales basis of revenue recognition
As a concrete application of the realization principle, the sales
basis has been defended on three grounds ; (1) its objectivity anddefiniteness ; (2) measurement of disposable income ; (3) its explicit
reporting of the critical event.

13
GENERALIZED LOWER-OF-COST-OR-MARKET RULE FOR
INVENTORY VALUATION FOR QUASI-RATIONAL MANAGERS(1) Objectivity and definiteness. Paton and Littleton [1940]
distinguished between the gradual earning of revenue and the valid

moment for its recognition. Only when the earning process iscompleted and the product transferred to the customer, the amount ofrevenue is said to be objectively determined. Their focal point issufficient reduction of uncertainty. Then, why is it sufficient at the saledate? `Sufficiently definite and objective to warrant recognition in theaccounts' [AAA, 1957] is an authoritative answer. Definiteness isequated by Windal to `permanence', i.e., that an item is unlikely to becancelled, revoked, or lost in the foreseeable future [Windal].
Objectivity is said to be equivalent to `measurability', i.e., that an item

must appear substantially the same to all accountants examining it[Windal]. Iji'ri and Jaedicke has appropriately defined it to mean the

degree of consensus among observers or measurers and formulated it
as (sample) variance of measures by multiple measurers with respect
to a single object [Ijiri and Jaedicke].

A difficulty in supporting realization principle by uncertainty
reduction is that other recognition bases may also be certain enough.
The 1964 Research Study Committee on realization concept has raised
the argument that receiving any liquid asset is not essential for revenue

recognition [1964 Committee], If some merchandise is accepted asconsideration and its objective valuation is possible, then revenue may
be deemed realized, it asserted. Another problem is whether the firm

involved must be a party to the sales transaction for revenue
recognition. The 1964 Committee did require that. But the 1973-74
Committee on external reporting did not, for the reason that a reliablemeasurement could be possible without the firm being one party to amarket transaction [1973-4 Committee].

In addition, we could also argue that the `cash basis' recognitionof revenue would be far more objective than the sales basis if
objectivity per se is the focal problem.

<2) Measurement of disposable income. The standard definition ofrealization is converting an item into money or into cash or its
equivalent (or service) [Cooper and Ijiri] [FASB, SFAC No.6, par.143].
This requirement for liquid asset in turn is frequently grounded on aclaim for disposable income. Bowers, in his article in 1941, has statedthat realization is an act or condition of placing a value increment into
disposable form [Bowers, 1941]. The University of Illinois Study Group14 ISAO NAKANO
has advanced the thesis that the realization test serves to hinder

erosion of the firm's capital through distribution of what has
mistakenly been considered profit [A Study Group].
Against the statement that the realization principle results in themeasurement of disposable income, it is argued that the liquid asset
which has flowed into the firm in the form of revenue will have been
invested into fixed assets and/or disappeared by payment, so thatcurrent realized income does not necessarily become equal to theamount of distributable fund at the year-end [Paton and Paton, 1955].
But clearly, were it not for current revenue, the disposable fund at theclosing date would be that smaller after those various distributions. In
this sense, realized net income may be said to be serving as an index
for the disposable income.
Our doubt is whether revenue on the cash basis would not give a
better measure for the available fund.
(3) Reporting of the critical event. If revenue and net income
could represent the most critical event in a transaction cycle, theinformation may potentially serve, say, evaluating managers'
achievements in terms of that important aspect. In proposing the`critical event' concept, Myers argued that revenue should be reported
at the moment when the `critical event' occurred [Myers, 1959]. The
entrepreneur's task lies in directing business, enduring the suffering ofrisk and receiving rewards from his/her bold decisions. Therefore,
income is said to have been earned at the moment the most important
decision has been made or when in a complete transaction cycle themost difficult task has been achieved. In most firms, sale is the criticalevent, at which point income should be recognized.
Horngren's characterization of realization as explicit reporting of

the event of exchange may be said to belong to this category[Horngren, 1965].

We have the following objection. Even if sales should be soimportant, the really `critical' event is not the delivery of themerchandise which is the exact event for revenue recognition in current

practice, but the consummation of the sales contract or the date oforder acquisition. Why not report profit on this date? (This view
would lead to adopting Ijiri's `commitment accounting', which proposes
to recognize the events at the time contracts are made [Ijiri, 1975],[Ijiri, 1980]).

15
GENERALIZED LOWER-OF-COST-OR-MARKET RULE FOR
INVENTORY VALUATION FOR QUASI-RATIONAL MANAGERS

We propose the realization principle or the sales basis can be
explained as a consistent measurement of `quasi-rational costs'. As

stated above, historical cost, replacement cost and the maximum
expected revenue (MER) are concerned here, so we must define theirmeasures of cash and accounts receivables. A logical extension ofhistorical cost is the amount of money required to replace the good at
the moment of its original acquisition (or assuming no price changes

have occurred). To reacquire (replace) some amount of money, $500
cash, we must give the same amount of money. Hence,An estimate of HC and RC of cash == the quantity ofmonetary units held. •••-•••••••-•••••••••••''••••• (18)

By almost the same reasoning,
An estimate of HC and RC of an account receivable = the netcollectible amount of money. ''••••••''''••••''''''''"'''' (19)

Net realizable value of cash is the quantity of monetary units

because giving the cash we will get the same amount of cash.
Obviously, the net realizable value of an account receivable is the netcollectible amount. The present value of future cash inflows frominvesting the given amount of cash or a receivable certainly will begreater than their current monetary amount. Hence, our conclusion isthat

MER of cash>its quantity of monetary units held ••••••-•• tzO)
MER of an account receivable > its net collectible amount..•••••••••••••••••••••••••-• eD

The quasi-rational cost is the least of HC, RC or MER. From(18) and eO) we see the quasi-rational cost of cash is measured by its
quantity of monetary units held, while that of an account receivable isits net collectible amount. Deduction of realization principle will follow.

Since in case of normal profitable good its selling price is greater thanHC or RC, its quasi-rational cost before sale is the smaller of HC and
RC, with the recognition of profit prohibited. Upon sale, cash or someaccount receivable flows in. Its quasi-rational cost is, as stated above,its quantity of monetary units or its net collectible amount. In
consequence, if we make a consistent measurement of quasi'rationalcost, revenue will appear at the date of sale and the net profit will
naturally have to be reported in the amount of aquired cash (or net
collectible money) - min (HC, RC).

16

ISAO NAKANO

10. Conclusion
The purpose of this paper has been to logically deduce a set ofmajor conservative financial accounting rules based on a couple ofbehavioral assumptions of a (quasi-)rational manager. Our conclusion
is that those various conservative measures on the balance sheet is the`lowest of cost'market-or benefit' attainable by a sort of rational
manager with a perfect predictive ability.

A practical implication of this analysis is the possibility ofextension of current conservative accounting system such that not only

the cost side but also the revenue side would be evaluated by thestandard of a (quasi-)rational manager. That is, we could imagine
that in a period when the good involved has been sold a maximum
amount of revenue as attainable by a quasi-rational manager will beshown on the income statement whereas its difference from the actuallyrealized revenue will be recorded on the debit side of the report as aloss after the fact resulting from, say, the predictive error of the`actual' manager. Returning to the example in Figure 1 above, theincome statement in 1994 would have to include the maximum possible

revenue $3.5 on the credit side, which would be matched with aprediction loss zero, because, if everything should have come out asplanned for 1994 in Figure 1, no errors would have occurred. If, on thecontrary, the selling price had been $5.0 on January 1, 1994, which
would have dropped to $3.5 at the year-end, when sale would be made,our proposed income statement for 1994 would have to show salerevenue of $5.00, then, contrasted with a loss from sale prediction
error of $1.5 on the debit side. This kind of income reporting would
approximately reveal the extent to which the `actual' manager has notbeen able to attain a maximum revenue because of partly responsible
and partly inavoidable price changes about the inventory asset, Since
not all of that loss could be attributable to the manager's defects, thatamount would have to be interpreted more as the extent of price risk
facing the firm. Such information would be potentially useful for theevaluation of the firm's economic value.

17
GENERALIZED LOWER-OF-COST-OR-MARKET RULE FOR
INVENTORY VALUATION FOR QUASI-RATIONAL MANAGERS

References
Cl)

American Accounting Association, "A Tentative Statement of Accounting
Principles Underlying Corporate Financial Statements", 1936, in : Accounting

and Reporting Standards for Corporate Financial Statements and Preceding(2)

Staternents and Supplements, (American Accounting Association).
, "Accounting Principles Underlying Corporate Financial Statements,"
1941, in : ibid.

[3)"Accounting Concepts and Standards Underlying Corporate Financial
Statements", 1948 Revision, in : ibid.

[4),"Accounting and Reporting Standards for Corporate Finaneial
Statements", 1957 Revision, in : ibid.

(5], "1964 Concepts and Standards Research Study Committee The
realization Concept", the Accounting RevieLv, (April, 1965).

(6),"Report of the 1973-74 Committee on Concepts and Standards[7)

External Reporting", in : the Supp]ement to Vol.XLIX (1974) of the Accounting
Review.
American Institute of Certified Public Accountants, APB Statement No.4, Basic

Concepts and Accounting Principles Underlying Financial Statements of(8)[9)

Business Enterprises.
Accounting Research Bulletin No.43, Chapter 4.

A Study Group at the University of Illinois, A Statement of Basic Accounting
Postulates and Principles, Center for International Education and Research in
Accounting, University of Illinois.

(11)

Bowers, R. Tests of Income Realization, Accounting Revieiv, (June, 1941).
Cooper, W.W., and Y.Ijiri, Kohler's Dictionary for Accountants, (Prentice'Hall,(12}Davidson, S., (ed.), Handbook of Modern Accounting, (McGrawhill, 1970).

(10)1983).
(13)

FASB, "Statements of Financial Accounting Concepts No.6", Elements of

C14)

Financial Statements, (Financial Accounting Standards Board, 1985).
Hendriksen, E.S., Accounting Theory, (Richard D. Irwin, 1970).

(15)

Horngren, C.T., "How Should We Interpret the Realization Coneept?", the
Accounting Review, (April, 1965).

[16]

Husband, G.R., "Another Look at Cost or Market Whichever Is Lower", the(17]

Accounting Review, (April, 1946).
Ijiri, Y., Theory of Accounting Measurement, (American Accounting Association,1975), Chapter 8.

(18)
(19)

, Recognition of Contractual Rights and Obligations, (FASB, 1980).

, and LNakano, "Generalization of CosVor-Market Valuation",
Accounting Hori2ons, (September, 1989).

(20)

Ijiri, Y., and R.K.Jaedicke, "Reiiability and Objectivity of Accounting(21)

Measurements", the Accounting Review, (July, 1966).
Mason, P.,"dissent to Chapter 4 of ARB No.43", ibid.

(22)

Myers, J.H., "The Critical Event and Recognition of Net Profit", Accounting
Review, (October, 1959).

(23)

Parker, RH. "Lower of Cost and Market in Britain and the United States 1 An
Historical Survey", Abacus (October, 1966).

{24)

Paton, W. A., "Valuation of Inventories", Journal of Accountancy, (December,1922).

ISAO NAKANO

18(25) , "The Cost Approach to Inventories", Journal of Accountancy, (October,1941).

(26) , and A.C.Littleton, An lntroduction to Corporate Accounting Standards,(American Accounting Association, 1940).

(27) , and W.A.Paton, Jr. Asset Accounting, (MacMillan, 1952).
(28) , and W.A.Paton, Jr. Corporation Aecounts and Staternents, (MacMillan,
1955), p.278.

(29) Sanders, T.H., H.R.Hatfield and U,Moore, A Staternent of Accounting Principles,(American Institute of Accountants, 1938).
C30) Spicer, E,E., and E.C.Pegler, Practical Auditing, (H.F.L., 1925).

(31) Statements of Standard Accounting Practice 9, Stocks and Work-in-progress,(The Institute of Chartered Accountants in England and Wales, 1980).
(32) Sterling, R.R., "Conservatism 1 The Fundamental Pripciple of Valuation in
Traditional Accounting", Abacus, (December, 1967).

(33] Windall, F.W., The Accounting Concept of Realization, (Michigan ,State
University, 1961).

PS. I appreciate valuable comments by Professors Yuji Ijiri and Shyam Sunder on
previous versions of this manuscript.

EFFECTS OF FINANCIAL DEREGULATIONON
AUSTRALIAN FINANCIAL SYSTEM

Kenichi ISHIGAKI

I.

lntroduction

In the 1980s, Australian financial system has changed very
drastically after establishment of the Campbell Committee in 1979.
Australia now has a virtually fully-deregulated financial system. The
deregulation not only changed the extent and nature of links between
borrowing and lending but also has been making wide and deep effects
on Australian economy as a whole.
The main purpose of this paper is to examine the effects of the
deregulation on Australian financial system, efficiencies of financial
market, and capital flow or foreign debt. The contents of this paper
are as follows: (1) to review the content of the deregulation in Australia(Part ll); (2) to make clear effects on Australian financial system of

the deregulation (Part M); (3) to examine how the deregulation
contributed to the increases of efficiencies of Australian financial
system, which are main purpose of the deregulation (Part rv-a); tomake clear how the deregulation has made effects on capital inflow andoutflow - the rises of net foreign debt, which is main economic problemof Australian economy in recent years (Part V-b); to make touch on
meaning of the deregulation on financial activities in the Asia-PacificRegion (Part V).
fi. Financial Deregulation in Australia
Australian monetary authorities had strictly controlled financial
institutions, especially banks up until the end of the 1970s'. On theother hand, regulatory authorities had not so severely restrictedactivities of non-bank financial institutions such as finance companies,

building societies, credit unions and so on. This assymetry of
icegulation on banks and non-bank financial institutions resulted not

20

KENICHI ISHIGAKI

only in the decrease of importance of the former as financial
intermediaries and increased the importance of the latter but also
decreased the efficiency of resource allocation because of restrietions

on competition among financial institutions. Government securities
market and the foreign exchange market also were regulated strictlyby the authorities. In addition, the circumstances surrounding theAustralian financial system had changed very drastically during thepreceeding three decades. The Australian economy had enjoyedprosperity during the 60s, however it suffered from high inflation andsevere unemployment during 70s. The high inflation rate induced highinterest rates. The effects of the development of international financial

markets and financial innovation were permeating into the Australianfinancial markets. Money supply control policy, which was adopted inreplacement of a Keynesian type monetary policy in 1976, was notconducted particularly well under the regulated financial system.

Against this background, the conservative government established
the Committee of Inquiry into the Australian Financial System (theCampbell Committee) in January 1979. Since then, both the Liberal andLabor government have advanced deregulation of the Australianfinancial system very rapidly. The deregulation is divided into threemain parts; banking sector, government securities market and foreignexchange market.
(1) Deregulation of Banking Activities

The main deregulations on banking activities which have been
implemented since 1979 are deregulation of interest rates, maturity ofdeposits, bank portfolios and entry to banking.
At the beginning of the 1980s, the Australian monetary authorities
decided to take steps to liberalise the financial system. The first big
step, in Dec.80, was to abolish the ceiling on interest rates on bankdeposits except checking accounts. The abolition of the ceiling resulted
in narrowing of the margin between market interest rates and interest

rates on bank deposit. In August 1984, the prohibition of bearing
interest on checking accounts was Iifted. Now both trading banks andsavings banks can freely set interest rates on all deposits.

The Reserve Bank of Autsralia had controlled interest rates of
Iending, especially overdrafts, as well as interest rates on deposits
although its controls on the former were not as strict as on the latter.

EFECTS OF FINANCIAL DERGULATION ON 21
AUSTRALIAN FINANCIAL SYSTEM

Traditionally, Australian banks provided finance to customers throughoverdraft, and the Reserve Bank imposed a ceiling on the interest rates.
The Reserve Bank gradually eased it on the interest rate of lending,and in April 1985, it advised banks that these remaining ceilings ontheir lending interest rate other than for housing loans had been
removed. Finally in 1986, the ceiling on housing loan were abolished.

For many years the Reserve Bank had controlled maturities of
fixed deposits between 3 months and 24 months. However, with thefinancial deregulation in the 80s, maturity controls on fixed deposits oftrading banks and saving banks were eased and finally abolished inAugust 1984. This deregulation made it possible for banks to raise
funds at the market interest rate in the short term money market andmanage their liabilities very flexibly and efficiently.

Monetary authorities had controlled bank portfolios in various

ways in order to implement monetary policy. Direct controls on
portfolios of trading banks and saving banks through the quantitative

guidance on lending of trading banks and SRD/LGS control very
severely restricted lending activities and portfolio management of bothbanks. However almost all these controls were eased during the firsthalf of the 1989s. Trading and savings banks have extended financial
activities and improved the management of assets and liabilities since
the deregulation of financial activities.

The Australian Government had prohibited foreign banks' entry
into the Australian banking sector except for the Bank of New Zealandand the National de Paris which had been permitted to enter intobanking business before World War ll. In addition, there was no bankentry from domestic interests until the 70s. At the end of 1970s, there

were only six major trading banks and six small banks. Furthermore,monetary authorities controlled the prices of their products andrestricted their activies. Therefore the Australian banking market wasa typical conservative oligopolistic market.

However the establishment of the Campbell Committee, together
with other factors, made it feasible for foreign banks and domestic
interests to enter into the banking market. The Australian Bank was
established in February 1981. The process and development of theinvestigation and discussion at the Committee revealed that theCommittee and the monetary authorities had a positive attitude towardforeign bank entry into the banking system. Taking account of

22 . KENICHI ISHIGAKI
possible invasion of powerful foreign banks, after complicatednegotiation, the two big mergers finally occurred in 1981. 0ne was themerger between the Bank of NSW and the Commercial Bank ofAustralia, and the other was the merger between the National Bank ofAustralia and the Commercial Banking Company of Sydeney. The
former is now named Westpac Banking Corporation, the latter the
National Australia Bank. ANZ Bank, who did not succeed in mergeringwith domestic bank, took over an English bank, the Grindly Bank in
1983 in order to strengthen its international banking business.

On the recommendation of the Campbell Report in 1982 and theMartin Report in 1984, the Treasurer issued a statement in February
1985 that following consideration of 42 applications, the Government
had selected 16 new banks including 3 Japanese banks which would be
invited to establish local banks rather than branches in Australia. The
Australian government had particular regard to the need to secure an
appropriate regional distribution takjng aceount of trade and othereconomic factors, foreign relations and reciprocity consideration. In

September 1985, the Chase Manhattan/AMP bank started its banking
business as the first new foreign bank entry and was followed by
Barclays Bank in the October, the Bank of Tokyo in November, andCity Bank in December 1985. Now 16 new foreign banks including thebank of China are doing banking business in Australia.

At the same time, the Australian government temporarily eased
regulations on foreign investment of merchant banks and authorized 65
new foreign merchant banking in Australia.
In addition to entries of foreign interests to the banking market,
new entries from domestic interests occurred. In February of 1985, the

NSW Building Society submitted a plan to become a savings bank
(Advance Bank Australian) and was authorized by the Treasurer. In
March of 1983, merchant banks, Hill Samuel Australia started its
trading banking business as the Macquarie Bank. New entries fromboth domestic and foreign interests, together with, other deregulationsof the financial market, contributed to the change from non-competitive
oligopolistic banking market to a competitive one.

(2) Deregulation of Foreign Exchange Market
The second major aspect of the deregulation of the Australianfinancial system is related to the government intervention into theEFECTS OF FINANCIAL DERGULATION ON 23
AUSTRALIAN FINANCIAL SYSTEM

foreign exchange rate and transaction in the foreign exchange market.

At the beginning of the 70s, major countries adopted a floatingexchange rate system in place of a fixed exchange rate system. The
Australian exchange rate system also changed during the 70s, but thesystem was not the same as a floating rate system because theexehange rate was not determined by the supply and demand forforeign exchange in the market but by the monetary authorities. Theyintervened in both spot and forward market in order to restrict the

speculative and disturbing movement of short-term capital flow.
Exchange controls on the spot market included 30 days rule, variable
deposit requirement, embargo on short-term borrowing, restriction on
foreign investment by Australian residents, control on interest bearing

investments in Australia by non-residents, and so on. Exchange
control on forward markets included 7 days rule, embargo on entry to
forward markets by non-residents, prohibition of risk cover withcapital transaction in official market.

In the 70s and the early part of the 1980s, however, the need forand effectiveness of exchange controls came to be widely questioned. In
addition, monetary authorities had recognized the conflict between themoney supply control policy and the foreign exchange policy.
The first big step toward liberalisation of the foreign exchange

market was in October 1983. The Reserve Bank phased itself out of
direct involvement in forward exchange. The next big step was theGovernment's decision to float the Australian dollar and to abol.ish amajor part of the existing exchange control in December 1983. The
third big step was in June of 1984. Forty companies were authorized
to deal in foreign exchange on the same term as bank dealers, Apartfrom the tax screening provision and foreign investment policy, only

controls retained in terms of the Banking (Foreign Exchange)
Regulations as at the end of June 1984 relate to investments toAustralia by foreign governments, their agencies and foreign banks
including central bank, and on the carrying or sending of Australiannotes and coins out of Australia.
These three steps toward the liberalisation of the foreign exchange
market made the Australian foreign exchange market wider, deeper andmore flexible and increased freedom of capital flow in and out ofAustralia.

KENICHI ISHIGAKI

24(3) Deregulation of Government Securities Market
The third major aspect of deregulation of Australian financial
system is related to the government securities market. The AustralianGovernment's intervention was based on its willingness to depress theinterest rate below the market rate which would prevail otherwise.

This system had some merit if the monetary authorities conductedmonetary policy based on interest rate targeting. However, theyabandoned the interest rate targeting policy and adopted monetary
targeting policy in 1976 because of high inflation and unemployment at
the time.

In December 1979, the Treasurer notified the change in the issuingsystem for Treasury notes from a tap system to a tender system. The

next step in April 1980 was the change in the issuing system ofTreasury bonds, that is medium and long term government bonds, froma periodical issues system to a tap system. It was followed by the

Loan Council's determination in June 1982 to manage the issuing
method of Treasury bonds from a tap system to a tender system. The
Loan Council approved that the Treasurer would detemine the timing of
the tenders and the quantity of the Treasury bonds sold. Prior to this,the Loan Council had determined aggregate annual borrowing
programmes of the authorities of the Commonwealth and State
Government as well as of those of governments themselves. It
prescribed maximum terms and conditions for various categories ofpublic sector borrowing, determined the allocation of programmes
between States, regulated the timing of public loans in Australia andapproved the term, conditions and timing of overseas borrowing.
However, after some easing of those regulations, in June 1983, the Loan

Council freed all the larger semi-government borrowers from its
control as to the term, conditions and timing of their borrowing.
Although the overall annual total would still be set, a former chairman
described the changes as `a de facto dissolution of the Loan Council'.

In addition to the deregulation of the issuing market ofgovernment securities, the Treasury liberalised their secondary
markets, especially the easing of compulsory or tax induced holding ofgovernment securities by financial institutions such as authorised

money market dealers, life insurance companies, savings bank.
Further, transaction arrangements between the Reserve Bank andfinancial institutions have changed. Until the end of 1984, the BankEFECTS OF FINANCIAL DERGULATION ON 25
AUSTRALIAN FINANCIAL SYSTEM

dealed in government securities with the authorized money market
dealer$ alone. In January 1985, the Bank started to deal in securities

beyond one year maturity through a variety of financial institutions

selected from amongst the trading banks, merchant banks, life
insurance companies and authorised dealers.
The deregulation of government securities transactions together
with the introduction of the new arrangement for transactions meansthat the interest rates of government securities are determined in themarket and it stimulates the width, depth and flexibility of thegovernment securities market.
M. Effects of Financial Deregulation on Australian Financial System

Financial deregulation in Australia have made wide and deep
effects in Australian financial system. The main effects on the systems
are as follows.
(1) Effects on Relative Shares among Financial lnstitutions.

As mentioned above, one of main part of the financial
deregulation in Australia is removal of controls on Banking business.

The regulation resulted that banks have been able to compete

more freely and equally among themselves and other non-bankfinancial institutions such as merchant banks, financial companies andbuilding societies. In addition, new entries to banking from bothforeign banks and domestic NBFI, especially building societies andmerchant banks, resulted in rise of share of banks and fall of share of

NBFI.
In the end of 1980, the share of banks in term of assets was 40.8
percent. It increased to 42.3 percent in the end of June of 1988. 0n theother hand, NBFI as a whole lost its share, while merchant banks andunit trusts have maintained on increased their share.
(2) New entries and Merger-Concentration.
The financial deregulation has promoted both establishment of

new banks and mergers between established banks. As mentioned
earlier, the monetary authority permitted new entry from foreign anddomestic interests as commercial banks and merchant banks. On theother hand, financial deregulation produced mergers between big

KENICHI ISHIGAKI

26

commercial banks. The establishment of Westpac Bank and Australian
National Bank in 1985 reflected the fact that big Australian banks
expected new entries of foreign banks and would defend themselves
against strong competitive foreign banks. As a result, the number ofbanks increased from 12 at the beginning of 1980 to 47 in August of
1990. Financial deregulation promoted mergers and concentration of
not only commercial banks but also other financial institutions such asbuilding societies and credit unions. There were 139 building societies
in 1980, however, in 1984, the number decreased to 75 and, in 1989, to 54.

There were 647 credit unions in 1980. The number also decreased to
530 in 1984, and to 396 in 1989. Financial deregulation generated
opposing forces such as new entry and exit of financial institutions,and through the deregulation and stronger severe competition, it would
expect to increase efficiencies of financial markets.

(3) Movement of Big Banks toward Universal Banking

Commercial banks and saving banks had been regulated very
strictly by banking law and monetary authorities before financial

deregulation during 1980's. Especially, commercial banks wereprohibited to engage merchant banking activities and broker businessof securities.

Merchant banks raised money in the short money market andinvested it freely, while commercial banks were regulated to issue time

deposits with shorter maturities than 3 months. Merchant banks wereable to expand their business in the short money market in the 1970s
and 1980s.

In addition, the limit on holding shares of merchant bank bycommercial banks had been 33.3%, which the regulation was eased to
60IO)6 in May of 1980. Further more, in August of 1984, the regulation

was abolished and commercial banks were able to hold 100% merchantbank subsidiaries.

A similar process had occured in the field of broking business of
securities. In Australia, security brokers and merchant banks could

manage issuing and accepting business of shares, while in thesecondary market, share brokers acted as an agent for buyers andsellers of shares. Share broker were generally not stock companies
but partnerships, however, since 1984, Australian stockbroker industry

has undergone substantial change. These have included the

EFECTS OF FINANCIAL DERGULATION ON 27
AUSTRALIAN FINANCIAL SYSTEM

incorporation of stockbroking firms and the introduction of commercial
banks and foreign ownership of firms.

Now Australian commercial banks, especially the big four banks

have saving banks, merchant banks, finance companies, andstockbroking firms as their subsidiaries.

In effect, the big four banks are able to do a kind of universalbanking.
(4) A Reduction of Demarcation between Financial lnstitutions

Financial deregulation reduced demarcation between financial
institutions. Two factors contributed to the reduction of demarcation''
The first is the entries from different financial institutions into otherfinancial sector such as commercial banks establishing new merchantbanks and stock broking firms. The second is that the regulation
promoted similarity in portfolio composition between different financial
mstltutlon.

Deposit thrift institutions such as commercial banks, saving banks,building societies and finance companies had speciaHzed in particularfinancial business, however financial deregulation stimulated financial
institutions to invade other finaneial sector, and it resulted in similarityof business.

Commercial banks had specialized in business finance, however

they have been increasing housing loans and consumer finance.
Finance companies have been expanding business finance beside
traditional consumer finance. Building societies had specialized in
housing loans, however they have been increasing consumer finance.
On liabilities side, these deposit taking institutions have beenissuing similar liabilities. They are issuing not only time deposits but
also demand deposit with checking facilities within a certain limitation.
Financial deregulation stimulated the reduction of the demarcation

between different financial institutions through the increase ofcompetition. At the same time, reduction of demarcation itself
intensifies competition between different institutions.

(5) Abolition of the Demarcation between Public Finance and Private

Finance
Australian monetary authorities had regulated the primary andsecondary market of government and semi government seurities market

KENICHI ISHIGAKI

28

in order to have funds raised at lower cost than the cost which Wouldbe determined in a free market and also in order to implemente lowinterest rate policy. As mentioned previously (section 1), thederegulation of government securities transaction together with theintroduction of new arrangement for transaction, means that interest
rate on government securities are determined in the market and it
stimulated the width, depth and flexibility of the government securities

market.

It has also meaned that the interest rates on government
securities and private securities are freely determined by market forces.
These rates reflect risk and profitability of these securities, therefore

artificial demarcation between publie finance and private financevanished.

Table 1 shows the development of average daily turnover ofgovernment bonds, bank bill, and equities from 1978 to 1988. Average
turnover of government securities increased from $70 million in 1978 tonearly 1.6 billion in 1988, increase of over twentyfold. In the same vein,average daily turnover in futures contracts for government securities
rose from nothing - the futures markets did not exist ten years ago to$1 billion in 1988. Both are spectacular increase. The turnover ofbank bill is larger than of bonds, and its growth was very fast too.
Equities turnover increase at a lesser.

These figures show a period of strong growth of Australian debt
and equity in 1980's. Of course, it reflects deregulation of interest rateof government bonds in term of bond tenders, but also deregulation ofinternational movement of capital in Australia and the rest of wor}d.
Non residents increased holding of Australian securities since abolitionof exchange controls and the floating of Australian dollar.

(6) Development of the Foreign Exchange Market
The deregulation of Australian financial system combined withmovement toward the internationalization of finance in advanced

western countries promoted the development of foreign exchange
market and capital flow in and out of Australia.

The Australian foreign exchange market developed very rapidly
since the deregulation of foreign exchange market in December 1983.
The average yearly turnover of foreign exchange was $100 million in
spot, $10 million forward, $110 million in total in November 1983. It

EFECTS OF FINANCIAL DERGULATION ON 29
AUSTRALIAN FINANCIAL SYSTEM

rose to $43.6 billion, $7 billion, $50.5 billion respectively. It is about

500 times in totaL

Table 2 shows the size of foreign exchange markets in the world.
The size of Australian market in term of gross and net turnover is 7thplace next to the Hongkong market. The size relative to the size of
GDP in Australia is very large. Fig.1 gives market share by currency

in Australian foreign exchange market. The main type of third
currency trading (i.e. not involving the Australian dollar) involve theDeutsche mark (18 percent of total turnover), yen (12 percent) andsterling (10 percent). On the other hand, less than 50 percent ofturnover is against local currencies'Australian dollar. This pattern is

consistent with Australia's role as a bridge Iinking the major theforeign exchange markets of New York, Tokyo and London. The
openness of Australia's financial markets, a favorable time zone
location and capital flow associated with the financing of a substantial

current account deficit have continued to underpin the Australian
foreign exchange market.
0n the other hand, the deregulation of the Australian financial
market and expansion of foreign exchange market resulted in severe
competition among foreign exchange dealers. Before the deregulation,
only 13 commercial banks were authorized to deal foreign exchange.
However, after that, not only, new foreign bank and domestic banks
but also authorized merchants banks were permitted to enter thedealing. As the result, there were 92 dealer doing business in February

1989. However strong competition pressures led to somerationalization. The total of authorized foreign dealers fell from apeak of 92 to 85; 31 are banks and 54 non-banks in 1990.
(7) lnternationalization of Banking Business

The deregulation of Australian financial market and thedevelopment of international financial market in the world havepromoted Australian banking business to .internationalize in the 1980s.
It has two aspects: foreign bank entry to Australian financial markets
and internationalization of Australian banking business.
As mentioned above, Australian monetary authorities permitted 16

foreign banks to establish their banks as subsidiaries. Generally
Speaking, new foreign-owned banks recognized the heavy infrastructure

cost of retail banking and have sought to sharpen their focus by

30 KENICHI ISHIGAKI
tageting niches in the corporate banking market. Table 3 shows themarket shares of the different groups of banks in recent years. The
share of the new foreign banks rose from 6.8 percent at the end of
September 1986 to 9.6 percent at the end of September 1987, due largely

to diversion from non-bank subsidiaries to banks. Since then it hasremained fairly steady, but it expanded rapidly in 1990. The expansionof market share of foreign bank as well as new Australian banks
resulted in a steady reduction in major banks' share. The new foreignbanks are mainly concentrated in commercial and other lending
categories, reflecting their extensive wholesale banking nature of theiroperatlon. .

In addition, the new foreign banks have a substantially higher
share of aggregate off-balance sheet business then on-balance sheet
asset in Australia. They are particularly active in the market-raterelated area, especially currency swap and interest rate swaps. In partat least, this is a reflection of their corporate banking focus. It seems

that new foreign banks have established their base in Australianbanking market. 'In the 80s, the overseas operations of Australian banks havecontinued to expand over recent years. Four major banks haveundertook and expanded major parts of overseas activities.
Several factors contributed to development in the international
operations of Australian banks. Firstly, the financing of international

trade was major factor in the earliest offshore operation. The
financing of international trade was a major motivation behind
Australian banks' earliest offshore operations. Australian companies
expanded their activities overseas, banks have followed their clients inorder to service their needs and to protect home based banking
relationship. Secondary, the deregulation and greater integration ofinternational financial market, facilitated in part by more flexible

exchange rate arrangements, have encouraged banks to conductbusiness across national border. Australian banks have also sought toestablish office in major financial centres (see Table 4). Thirdly, theentry of new foreign-owned banks into the Australian banking system

has given an additional impetus to Australian banks offshore
expansion. For example, the establishment of branches of four major
Australian banks Tokyo in 1985 and 86 was based on the reciprocity
that the Australian treasury authorized 16 foreign banks including 3

EFECTS OF FINANCIAL DERGULATION ON 31
AUSTRALIAN FINANCIAL SYSTEM

Japanese banks.
Table 4 shows a list of the overseas representations of Australianbanks. The form of representation and the type of businessundertaken in individual centres may be influenced by local
requirements and reciprocity requirement. The main locations ofoverseas network are world financial centres such as London, NewYork and Tokyo, and also in the Asia and Pacific area which are
Australian main trade partners.
The overseas assets of the major banks were abeut 31 percent of
their total assets at end June 1987, compared with about 24 percent inJune 1983. Fig.2 shows the detail of the country exposures ofAustralian banks. Main country exposures by regime are USA(18.8SO)6o), Japan (17.3906), UK (13.6%) and Asia (12.3%). This pattern issimilar to overseas network of major banks.
IV. Effects of Financial Deregulation on Efficiencies and Capital Flow

Since the Campbell Committee was established in 1979, financial

deregulation advanced very rapidly and it has had wide and deep
effects on performances of financial markets and the Australianeconomy as a whole. The committee's examination focused on existingareas of government intervention which bore significantly on theefficiency of the system. The Committee was confident that if official
barriers to entry and participation were removed, the financial system
would be strongly competitive and this would ensure that funds weregenerally allocated in an efficiently neutral fashion to all groups andsectors of the economy.
In addition, the Committee expected that deregulation would, if
implemented, have significant effects on not only the competitive
structure of financial intermediation but also the income distribution
between different groups of lenders and borrowers in the system. In
effects, however, the impact of deregulation is more than the Committee

expected. The deregulation has had deeper and wide effects on
Australian economy as a whole, especially on the foreign debt problem

which is one of the most important problems in the late 1980s.
Therefore, we examine in this part: (1) whether the deregulation
increased efficiencies of financial market; (2) what effects thederegulation made on inflow and outflow of capital in Australia, or the,32 , KENICHI ISHIGAKI
foreign debt accumulation problem.
(1) lmpact on Efficiencies in the Financial Market
Enhanced competition by financial deregulation would be expected
to increase efficiencies in the financial markets in the form of either:(a) a greater diversity of serviees for the same cost(b) reduced fee for existing services(c) a smaller differential between interest rates paid by banks on
deposits and those charged on loans
Table 5 shows a list of new financial products and services
developed by banks since 1980, when ceiling of interest rates on
deposits was removed. The list confirms us that a greater diversity ofservices has increased markedly during 10 years. Customers in theretail market can now enjoy new products and services such as variable

repayment mortgages, automatic sweep facilities, cash management
accounts, and electronic funds transfer at point-of-sale (EFTPOS). In

the wholesale area, customers can make use of the gamut of treasury

products such as swap, options and futures. While there are somearguments that consumers cannot take full advantage of the new
options because where are obstacles to excercising freedom of choice,
it is hard to see how anyone could claim to be worse off as a result of
the wider choice and diversity in bank products and services.
Financial deregulation had been expected to reduce financial costand, in result, fees for financial services. Fig.3 shows that for the
major Australian banks net interest income as a proportion of averageassets fell from around4per cent in 1982 to around 3.25 per cent in1990 and Fig.4 shows that the ratio of non-interest expense (excluding
bad debt provisions cost) to average assets fell from 4.6 per cent toaround 3.2 per cent. We also indicate by Fig.5 that fees of foreignexchange transaction in a retail market, the spread by buying andselling, i.e. fee of foreign exchange by Westpac Bank, had reduced since

the deregulation of foreign market in Dec. 1983. These figures suggest
the deregulation has contributed to increased efficiencies in financial
operations through severe competition between financed intermediaries.
In addition, we can confirm increase of efficiencies by Table 6, whichshows the components of banks profits. The fall in profits occurred
despite a substantial increase in the efficincies of banks as indicated by

the reduction in their operating costs. Part of the reduction inEFECTS OF FINANCIAL DERGULATION ON 33
AUSTRALIAN FINANCIAL SYSTEM

operating cost was absorbed by higher bad debt expenses, but more of

it was passed onto customers through Iower interest margin andfee-suggesting the operation of substantial competitive forces.

(2) Effects of Financial Deregulation on Australian lnflow and Outflow

of Capital and Foreign Debt Accumulation.

The removal of various controls•on international financialtransaction since the early 1980s, especially the floating of Australian

dollar in Dec. I983 allowed Australian entities much greater access to
the world capital markets and vastly expanded opportunities to acquire

foreign assets. As Table 7 shows, foreign borrowings have risen
sharply since early the 1980s, and so too has Australian investment
abroad, particularly equity investment. In June 1980, net foreign debt
was $7 billion:by Sept. 1989, it has grown to $112 billion. The ratio
of debt to GDP has risen from around 5 per cent in the late 197es toaround 32 per cent in the late 1980s.

Table 8 shows level of foreign investment in Australia by source
countries for give years ended June 1989. The United Kingdom and theUnited States are the traditional source countries and they are still
most important capital suppliers. However, Japan and other Asian

Pacific countries such as Hong Kong, Singapore, New Zealand are
becoming more important countries. On the other hand, Fig.6 shows
stock of Australian direct equity investment abroad in June 1988. UK
is still important direction (34 per cent), however, Asean Pacificcountribs, USA (20 per cent), and New Zealand (15 per cent) are also
important. The share invested in ASEAN countries is small (2 percent), however, it is expected to increase in near future because ASEAN

economy has been growing very fast and economic relation, especiallytrade interdependence between Australia and the region is very
lmportant.
These facts confirme us that deregulation of financial market has

increased the Australian inflow and outflow of capital andinterdependence between Asia Pacific region. However, it should berecognized that three movements has resulted in heavy accumuiation offoreign debt which let to Australian economy difficult in 1980s and1990s.

What is the reason for the rise in net debt ? How did thederegulation of financial market contribute to it ? The most34 KENICHI ISHIGAKI
fundamental reason is large and persistent deficits on her current
account. The average current account deficits in 1960s and 1970s was
2.25 per cent of GDP. It rised to more than 4 per cent in 1980s.
Changes in current account deficit are identical to changes in savinginvesting balance. In the first half of the 1980s, Australia experienced a

combination of expansionary fiscal policy and a rise in the current

account deficits. Many economist thought that fiscal deficits
contributed to the rise of current account deficits. In the second halfof 1980s, fiscal deficits decreased drastically, although it has remained

still large and net foreign debt increased very much. Public savings
has increased from the bottom and private saving been fairly stable
while personal saving ratio decreased considerably, however private
investment increase very much so that current account deficits remain
so high.

Has the deregulation been a factor in explaining the behavior of

the current account and the net foreign debt ? Firstly, thederegulation of exchange controls has increased the mobility of capitaland has given domestic residents greater access to foreign savings. As
a result, potential investors, who had been previously constrained byfunding shortage, were able to finance their investment. Secondly,

deregulation has altered the portfolio investment decision of
corporation and methods of financing of investments. Between June
1980 and Sep. 1989, Australian equity investment abroad rose by about$44 billion. Part of the large rise was financed by increased foreign

borrowing.

Fig.7 shows gross capital flow as a proportion of GDP. Bothoutflows and inflows of capital have increased relative to GDP in the
1980s. Capital inflows averaged 6.5 per cent of GDP in the 1980s more than double the average of the 1960s and 1970s. Capital outflows
grew steadily during the decade, averaging 2.5 per cent of GDP in the
1980s compared with less than one per cent in both 1960s and 1970s.

The rise of capital mobility induced by the removal of exehange
control had significant effects on the degree of a correlation between
saving and investment. Easy access of Australian entities to foreignsavings has increased and facilitated the widening in the current
accounts deficits and resulted in the net foreign debt of Australia.

EFECTS OF FINANCIAL DERGULATION ON 35
AUSTRALIAN FINANCIAL SYSTEM

V. Financial Deregulation in Australia and lts
Effects on the Asia-Pacific Region
In this paper we examined financial deregulation in Australia andits effects on financial activities and the Australian macro economy.
We can summarize our argument as followsl (1) Australian financial
deregulation in the 80s was divided into three main parts, dereguration
on Banking Activities, dereguration of foreign exchange market, anddereguration of government securities markets. <2) These dereguration
made wide and deep effects on the Australian financial system. The
effects included a change of relative shares among financial institutions,

new entries, mergers and concentration, a movement toward universalbanking, a reduction of demarcation between financial Institutions, ademarcation of public finance and private finance, development offoreign exchange markets, and the internationalization of banking
business. (3) However, these changes themselves are not important.
What important is whether these changes increased efficiencies in thefinancial system. We examined this point in terms of diversity ofservices, reduced fee for existing services and the smaller differential

between interest rates paid by bank on deposits and those charged onloans. We have some date suggest the dereguration have contributed

to increase efficiencies of financial operation through severe
competition between financial intermediations. (4) We also examined
what effects the dereguration makes on inflow and outflow of capital inAustralia, that is, one of the most economic problems in Australia lateof 1980s. We confirmed that the rise of capital mobility induced by theremoval of exchange controll had significant effects on the degree of acorrelaton between saving and investment. Easy access of Australian
entities to foreign saving has increased and facilitated the widening in
the current accounts deficits and resulted in net foreign debt.

What meaning do these changes to the Australian financial system
and its effects on financial activities and macro economy have for the
Asia and Pacific ? Firstly, since the floating of the Australian dollar in

December 1983, the Australian foreign exchange market has grownconsiderably in scale and sophistication and it now forms an important

link in the trading of foreign around the globe, especial Asia andPacific. One of main reason of its rapid gJrowth, besides removal ofcontrol on foreign exchange market, is time zones,

36

KENICHI ISHIGAKIThe Australian market enjoys an advantage over other markets in
the Asia-Pacific region as the early and late parts of the trading day
overlap with late New York and early European trading respectively.
At the same times, there is an increased volume of trading between
Australian market and Tokyo market where banks are opening earlier
to trade into the first hour or two in Australia. The deregulation andtime zone difference have contributed to increased convenience andbusiness chances in the Asia'Pacific region.

Secondly, the entry of foreign banks into the Australian banking
market and internationalization of Australian banking during the 1970s
would promoted increased economic linkages in the Asia-Pacific region.
Interdependence of trade in the Asia-Pacific region has increased very
rapidly in the 1960s and 1970s. These development promoted not only
increase of direct investments but also financial transaction in thisregion. Australian banks established new branches and agencies in
Asia-Pacific region. On the other hand, Japanese banks and otherAsia banks established new local banks in 1980s. These development
would promoted increase of trade, direct investment and financial
inflow and outflow of capital in this region.

Thirdly, the removal of various regulation promoted Australian
entries with much greater access into world capital markets and vastly
expanded opportunities to aquire foreign assets. The level of total
foreign investment in Australia grew from 70.9 billion in June 1983 to
245.9 billion. While U.K. is still the largest foreign investment countryin Australia, the share is declining. Asia-Pacfic countries such as
U.S.A., Japan, Hong Kong, Singapore, New Zealand have increased theirshare and absolute amounts. At the same time, the Australian lending
abroad and Australian equity investment abroad have increased very

rapidly. For example, the stock of Australian equity investment
abroad over the 1980s grew from 23.2 billion in June 1980 to 87.6 billion

in September 1989, which have been dominated by direct equity direct
investment. U.K. is the largest direction, and USA (20 percent) and
New Zealand (15 percent) are important. While the share invested in
ASEAN countries is still small, it would be expected that rapid growthof this region and increase of economic interdependence between
Australia and other countries in this region promote Australian entities
to increase direct investment to Asia and Pacific region.

The Australian economy and Australian financial markets have

EFECTS OF FINANCIAL DERGULATION ON 37

AUSTRALIAN FINANCIAL SYSTEM

been involved in the Asia Pacific economy and became a important linkof Asia Pacific economic relationships. However, it should be notedthat Australian excess dependence on foreign saving may become abinding constraint on Australia in the future.

TABLE1 : DAILY TURNOVER OF AUSTRALIAN DEBT AND EQUITY($ million)

CommonwealthBank

Government

Equities

Bills

Securities

Physical Futures

PhysicalPhysicalFutures(c)(a) (b)(d)

FuturesYear to June

1978
70
n.a.
10
1983 100 - 290 340 30

301988 1580 1050 3690 5210 270230(a) Turnover registered with Reserve Bank.
(b) Estimated turnover in the 10-year bond contract.
(c) Turnover by banks.
(d) National turnover on Australian stock exchanges.
Source : Reserve Bank of Australia, Bulletin, Fed. 1989, p.24.

TABLE2 : Foreign Exchange Market Activity-April 1989
(in billions of U.S. dollars per daor)

CountryGross
Turnover

Net

Turnover(a)Share of Net
Turnover Arranged
Through Brokers(%)
United Kingdom

241

187

38

United States

174

129

44

Japan

145

115

35

Switzerland

68

57

19(b)

Singapore

63

55

n.a.

Hong Kong

60

49

35

Australia

37

30

33(b)

France32

26

42

Canada18

15

40

Netherlands

16

13

41

Source :Reserve Bank of Australia, Bulletin, March, 1990,

p.15.

KENICHIISHIGAKI38

AUmx : MARKET SHARE-BY CURRENCY
JULY-DECEMBER 1989

NZi!l.2i.Y.SDoTHER

4.40/o
USDICHF
4.60/oGBPIUSD
lo.oo/e

AUDIUSD
48.70/o

USDIDEM
17.8e/e

USDIJPyp12.30/e

FIGURE 1
Source : Reserve Bank of Australia,

Bullentin,

March, 1990. p.15.

TABLE3: SHAREOF BANKS' AGGREGATE
AUSTRALIAN

BALANCE SHEET (%)

End September
1986

1987 1988 1989

1990

Major Banks

70.6

68.0

67.8

66.1

64.8

State Banks

17.0

16.0

16.6

17.2

16.8

Other Established Banks

3.0

2.7

2.4

2.3

2.2

New Australian Banks

2.6

3.7

4.1

5.0

5.5

New Foreign Banks

6.8

9.6

9.1

9.4

10.7

Source :Reserve of Australia,

Bulletin, Jan.

1990, p.9.

EFECTS OF FINANCIAL DERGULATION ON
AUSTRALIAN FINANCIAL SYSTEM

39

TABLE4 : OVERSEAS REPRESENTATIONS OF AUSTRALIANBANKSFORM OF REPRESENTATION
September 1987
Country

Full(incl.

Branchnetworks)

Bahrain
Bangladesh

Restricted

Branchb

Subsidiaryc

1

1

1

CanadaCayman Islands

1

7
1

4

China

3

ColumbiaFiji

1
2

France1

GreeceHong Kong

1

6(d)

4

India
Indonesia
Iran

1

3
1

Italy

Japan
Jordan

1

4

2
1

Kenya

1

Kiribati

1

Malaysia

2

Monaco

1

Nepal

1

Netherlands Antilles

New Zealand

1

2

1

Nigeria

1

Oman

1

Pakistan

1

Papua New Guinea

3

Qatar
Singapore1omon Islands
South Korea

2
2

Spain
Sri Lanka
Switzerland

1

Taiwan

1

4(e)

3

1

1
1

2
1

1

1

3
2

ThailandTonga

1Tuvalu1

Uganda1

United Arab Emirates

1

United Kingdom

8

United States(f)

11

10

6

VanuatuWest Germany

2

1

1

1

1

1
1
1
1

Zaire

ZambiaZimbabwe
Bank of Australia,

63Western Sarnoa

Source : Reserve

Office1

BrazilChannel Islands

Representative

Bulletin,

Dec. 1987, p.21.

KENICHI ISHIGAKI40

AUmx BANKSCOUNTRY EXPOSURES BY REGION-JUNE 1987

PER CENT OF TOTALJAPAN (17.3) ALL OTHER (8.8)
ASM (12.3)

LATIN

UNITED
KINGDOMAMERICA(3.8)(13.6)

UNI'IllD

OTHER

SIrATESINDUSIRIALISED(18.8)

COUNTRIES (25.4)

FIGURE2
Source :Reserve Bank of Australia, Bulletin, Dec. 1987.
: lndicative List of Major Product lnnovations
TABLE5by Banks since Deregujation(showing year of general availability)
1990
1989

Mortgage Offset AccountPayroll System

1988

Bankcard debit/credit card

1987

Enhanced retirement services
Life insurance
Fixed-rate mortgage lending

Business credit cards

1986

Home banking
Housing bonds
Equity mortgage loans

1985

EFTPOS

MasterCard ATM linkage
ATM netword links
Packaged statement accountSpecialised agri-business and rural
budgeting centres

Telephone banking

Cash management accounts
1984

Automatic sweep facilities
Daily interest cheque account1983

MasterCard
Compounding term deposits

1982

Variable-repayment home loans
Visa card for domestic and international use

Reduced tems and minimum balances
for term deposits
PIN for credit and debit card access
1981

1980

Monthly income term deposits
Card (rather than passbook) savings
accounts
Automatic teller machines
Source: Australian Bankers'Association (1990)

EFECTS OF FINANCIAL DERGULATION ON
AUSTRALIAN FINANCIAL SYSTEM
O/e

o/o

4.0

4.0

3.8

3.8

3.6

3.6

3.4

3.4

3.2

3.2

3.0

3.0

1982 1983 1984 1985 1986 1987 1988

1989

FIGURE3 : Major Banks' Net lnterest

MarginSource : Les Phelps, Competition: Profitability and1990

Margins, p.92.

o/o

o/o
5.0

5.0

4.6

4.6

4.2

4.2

3.8

3.8

3.4

3.4

3.0

3.0

2.6
81182 82183 83184 84185

FIGURE4 : Non-lnterst

Four
Sourse : Les Phelps, Competition

2.6

85186 86187 87188 88189 89190

Expenses/Average Total Assets
Major Banks: Profitability andMargins, p.93.

41

KENICHIISHIGAKI

42

TABLE6 : Componentsof Banks' Profits% of Average

Assets1986/90

1980/85

3.3

3.7

Net Interest
Non-Interest

l.8

1.7

Operating Expenses

3.9

3.2

Bad Debt Expense

O.2

O.5

Tax

O.6

O.6

ProfitO.8

O.7

Banking Industry,

Source: RBA Submission to the Inquiry into the AustralianJanuary 1991, page 17

120
110

-..-

100

-' r'r'

-" -s

.

.

N

N s N

.

--

.

90

A
-N
N
Å~
- -t .-.--

!

N

s

x xÅ~ N
.

.

s-

x x

l-

80

--

. ---N- -.
'N.
---..

-

--

"-

70

.x

NX ."
t"-'

h

A'.

N.

NN
N

t

.

60

..

,

,.

50

..

1
,

.
t

40

s-

30
1982

1983

1984 1985

1986 1987

1988

GERMAN-----• JAPAN •-- NEW ZEALAND-- U.K

FIGURE5 : Changes of Spreads in the Retail(1982=1OO)

1989 1990---

Foreign Exchange Market

U.S.A

EFECTS OF FINANCIAL DERGULATION ON
AUSTRALIAN FINANCIAL SYSTEM43

ASSETSTABLE7: AUSTRALIA'S FOREIGN LIABILITIES AND($ million)

Borrowing Equity Other(a) Total
24 3501982 June''
44 101,

1983 11
1984 tt

35 891

1985 tl1986 tl

67,47392 550,107 416'
122 802,145 370'
157 317'
166,052

1987 1!

l988

1!

1989 !11990 111991 t/26,38930,5984,356

32 221

5,551

4,446

,
37 562'41 153
,

6,583
6,884

55 095

7,803

5,275

3,442

16,52070 935

12 507

T,
16,265

6,478

3,533

22 51814 208

8,O18

4,480

26 706

11 687

5,808

17 O05

20,253

6,025

21 279'26,951
29,38430,62934 71233 875,39,77848,30251 967

6,853

52,6177,800',
81 873,111 618,140 587'
180 144,
199 492'

65,2907,438

69,175

7,515

84,8047,254

93 194

6,205

256,716100 398

5,973

272 423''

Source : Reserve Bank of Australia,lnvestment abroad
Other(a)Total

Gross Australian
Lending(b) Equity=tlzggÅ}!g!etglLlpygEUuegLgLAyE!!ajia-f estmentinAustralia

At end of

237,429

'

,

,

'

'

6,450
7,724
8,391

'
,
33,76043 283,62 O07,73 179'85 4il
,90,98795 129'Bulletin

IN AUSTRALIA BY
TABLE8: LEVEL OF FOREIGN
iNVESTMENT
1988-89 ($A BILLION)CUNTRY, 1984-85 to
1984-85

1985-86

1986-87

1987-88

1988-89

United Kingdom

26.1

29.3

37.3

45.7

47.2

United States

26.8

31.9

41.4

40.2

46.8

Japan

16.2

20.8

21.4

26.8

33.3

Germany(FR)

3.6

5.5

7.1

6,4

7.5

Switzerland

4.1

5.9

7.5

7.4

7.0

Hong Kong

3.4

3.0

3.0

4.9

6.8

Singapore

8.9

8.3

9.4

6.8

6.7

New Zealand

1.5

2.1

4.9

5.6

5.1

Netherlands

2.4

3.0

4.l

4.2

4.3

Canada

1.8

1.9

3.4

2.5

3.5

Bel-Lux

2.0

2.6

2.6

4.0

3.5

2.2

1.8

2.2

2.8

3.4

France

1.6

1.6

2.0

1.5

2.1

Other ASEAN

O.8

O.7

1.l

1.3

O.7

Sweden

O.3

O.3

O.4

O.3

O.5

Italy

O.2

O.3

O.3

O.3

O.3

Other

9.3

20.4

29.3

36.7

50.8

111.3

139.4

177.3

195.6

229.3

Country

Central America and Cari

TOTAL

bbean

Sources: ABS 5305.0 Foreign Investment, Australia, 1988-89
ABS 5352.0 Foreign Investment, Austra}ia, 1988-89:

Supplementary Country and Industry Studies
Note: Figures may not add due to rounding.
Source : Foreign Investment Review Board Report, 1989-1990.

KENICHI ISHIGAKI

44

DIRECT EQUrlY IwwENT ABROAD
COUNTRY COMPOSITION, JUNE 1988
U.K (34e/.)
U.S. (2oo/,)N.Z.(15e/e)

OTHER(210/.)OTHER

ASEAN (20/.)

OECD(80/,)

FIGURE 6
Source : Reserve Bank of Australia, Bulletin, March,

1990, p.22.

CURRENTACCOUNTDENCI[ISANDCAPITALFLOWS
o/o

9
8
7

6
5
4
3
2

PERCENTroGDPGROSSCAPrl/ALINFLOW

-1

9

8
CURRENr
ACCOUNT 7
DEFICrr
6
5
4
GROSSCAPrl/AL
3
OUTFLOW
2
1

1

o

o/o

AUSrRALIANEQUrTYINVESI'MENTABROADo-1791777817980!81821eegr18586!87gg189

FIGURE7
Source :Reserve Bank of Australia, Bulletin, March,

1990, p.22.

EFECTS OF FINANCIAL DERGULATION ON
AUSTRALIAN FINANCIAL SYSTEM

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[1]
[2]

[3]
[4]

Arndt, H.W. and Blackert, W.J., The Australian Trading Banh, 5th ed, Melbourne
Uni Press, 1977.
Arndt, H.W., "Australia's Current Account and Debt Problem: A Sceptical Viewof the Pitchford Thesis", Discussion Papers No.219, Centre for Economic Policy
Research, ANU, Dec. 1989.
Carew, E. First Money 2, Allen & Unwin, 1985.

CIAFS (Committee for Inquiry into the Australian Financial System),
Australian Ii'inancial System, AGPS, 1981.

[5]

Davis, K., "Australian Monetary Policy: A Decade of Change", Economic
Papers, Mar. 1988.

[6]

Davis, K and M. Lewis, "The New Australian Monetary Policy", Monetaror
Policy in Pacific Basin countries (ed. by H.S. Cheng), Kluwer Academic
Publisher, 1989.

[7]

Dixon, P.B. and D. McDonald, "Australian Foreign Debt 1975 to 1985",
Australian Econornic Papers, No.2, l986.

[8]Edey, M. and M. BrittenTJones, "Saving and Investment", in The Australian
Macro-Econornbl in the 1980s, Reserve Bank of Australia, 1990, pp.79'145.

[9]

Feldstein, M and C. Horioka, "Domestic Saving and International Capital
Flows", Economic Journal, 90, June, 1980, pp.314-329.

[10]

Forsyth, P.J., "Compertitiveness, Microeconomic Reform and Current AccountDeficit", Discussion Paper No.228, Centre for Economic Policy Research, ANU,

[11]

Harper, LR., "Monetary Policy in a Deregulated Financial System", The[12]

Australian Economic Review, 4th Quarter, 1988.
Harper, Ian, "Competitionl Choice and Diversity, Gainers and Losers", in The

Dec. 1989.

Deregulation of Financial Intermediaries, Reserve Bank of Australia, 1991,
pp.63u86.
[13]

Grenville, S.(ed), The Australian Macro-Economy in the 1980s, Research Bank ofAustralia, 1990.

[14]

Hogan, W. "Meeting the Debt Challenge", Econornic Papers, Vol.1, No.2, June,[15]

Macfarlane, Ian, The Deregulation of Financial Intermediaries, Reserve Bank of[16]

McCarthy, P., "Fiscal and the Budget Deficit", Economic Papers, Vo.l, No.2,

1988.

Australia, 1991.
June, 1988.
[17]

Phelps, Les, "Competition: Profitability and Margins", in The Deregulation of
Financial Intermediaries, Reserve Bank of Australia, 1991, pp.87mllO.

[18]

Pitchford, J.D., "A Sceptial View of Australia's Current Account and Debt
Problem", Australian Economic Review, 2nd Quarter, 1989, pp.5'14.

[19]

Pitchford, J.D., "Does Australia Really Have a Current Account Problem?",Economic Papers, Vol.8, No.4, Dec. 1989.

[20]

Pitchford, J.D., "Macroeconomic Policy and the Current Account in an Open
Economy with Partial Wage Indexation", The Econornic Record, Vol.66, No.193,

45

KENICHI ISHIGAKI

46

June, 1990, pp.157-170.
[21]
[22]
[23]
[24]

Reserve Bank of Australia, Report and Financial Staternent.
Reserve Bank of Australia, Bulletin, various issues.

Review Group, Australian Financial System, AGPS, 1984.
Shield, B., "The Current Account Deficit and the $A", Economic Papers, Vol.6,
No.3, Sep, 1987.

[25]

Smith, P., "Monetary Policy: The Last Two Years", Econornic Papers, Vol.7,

[26]

No.1,
Mar. 1988. • .
Tease, W,, "The Balance of Payment", in The Australian Macro-Econornbl in• the[27]

Treasury, Budget Paper, various years.

[28]

Valentine, Tom, "What the Campbeli Committee Expected", in The Deregulation

1980s, Reserve Bank of Australia, 1990, pp.159'209.

of Financial Interrnediaries, Reserve Bank of Australia, 1991, pp.36L60.

RELATIONSiNAFTAANDASIA-PACIFICECONOMIC

Seij i'NAyA2

I. Introduction

In the 1980s, many spoke about the dawn of the "Pacific Era," aphenomenon referring in great part to the rapid economic growth ofcountries in the Asia'Pacific region, fuelled by a remarkable growth intrade and investment. These countries have shared a common patternof economic growth based on a successful expansion of manufactured

exports. The U.S. has played a key role in the dynamism of thisregion; it has served as Asia's largest single export market and is stilla major investor in many countries. Japan, having caught up with theWest in the 1970s, not only serves as a modeL but has been thelocomotive for change through trade, investment, and aid throughout
the region.

But the emergence of the Asia-Pacific region is not due to Japanand the U.S. alone; i'n fact, its dynamism is now being propelled by the

rapid growth of the region's developing countries. The so-called newly

industrializing economies (NIEs: Hong Kong, Singapore, Taiwan, andSouth Korea) have been among the fastest'growing countries in theworld with average growth rates approaching or even surpassing 10
percent annually in the past three decades. Particularly, South Korea(henceforth Korea) was the star performer in the 1980s; it managed anaverage annual growth rate of more than 8 percent when mostdeveloping regions like Latin America had little or no growth (seeTable 1). The four resource-rich members of the Association ofSoutheast Asian Nations (ASEAN: Indonesia, Malaysia, the Philippines,
1 I would like to thank Robert McCleery for providing me with published andunpublished NAFTA research and for many helpful conversations and comments
on earlier drafts of the paper, and Clarita B. Baretto for her outstanding research
assistance. Many of these ideas were first presented in a speech given to the Asia
in the 21st Century Conference, KonmKuk University, Seoul, Korea, May 10r12, 1993.

2 Professor of Economics, University of Hawaii.

48

SEIJI NAYA

and Thailand) also had strong economic performances, closely
paralleling the NIEs in the 1980s and recording nearly the same averageannual growth in 1992 (except the Philippines). Malaysia and Thailand

are now considered the next tier of NIEs. As growth rates of NIEs
and ASEAN countries began to taper off in recent years, the economic
growth of China accelerated from 7.1 percent in 1991 to an incredible

12.8 percent in 1992. In fact, certain individual regions such as
Guangdong Province (next to Hong Kong) had an estimated growthrate of about 25 percent, an unheard of performance in the annals of
economic development.

' In the late 1980s an unprecedented globalization andregionalization of economic activity overshadowed the prospect of a

"Pacific Era." The global trading environment has been changing
significantly, with the integration of a Single Market in Europe on one

hand and the prospect of a North American Free Trade Agreement(NAFTA), on the other hand. Instead of the coming of the "Pacificera," there have been apprehensions that Asia would be left to its own
to fight an increasingly hostile and polarized world.

For example, economist Lester Thurow of the Massachusetts
Institute of Technology (MIT) contends that countries can no longer
prosper as in the past by finding niches in the world economy; rather,
the future will bring "head to head" competition which means that forevery winner there is a corresponding loser.3 He argues that a new"economic race" will replace the Cold War. In such a world, countries
will compete in strategic industries in which the winner will skillfully

exploit its position in order to stay ahead. He envisions a tripolarworld headed by the United States, Europe, and Japan. Similarly
another MIT economist, Paul Krugman, presents economic models
indicating that one global free trade bloc is "first best" although a"second best" option is for the world to be divided into three trading
blocs.` In this context, the desirability of broadly-defined preferential
trading arrangements (PTA) such as free trade areas (e.g., NAFTA),

customs unions (e.g., pre-1986 European Community), and economic
unions (e.g., European Single Market) must be carefully evaluated
3 Thurow, Lester, Head to Head; The Coming Eeonornic Battle Arnong Japan,
Europe and America, (New York, NY: Morrow, 1992).
4 Krugman, Paul, The Age ofDirninished Expectations: U.S. Economic Policy in the
1990s. (Cambridge, Massl MIT Press, 1990).

NAFTA AND ASIA-PACIFIC ECONOMIC RELATIONS

49

TABLE1AVERAGE ANNUAL RATES OF REAL GDP GROWTHa/

Developingb/c/

1960-69

1970-79

1980-90

1990

1991

1992

5.6
7.7
8.9
9.2

9.4
9.4
9.5
10.2

7.1

8.3
7.4
7.7

3.2
9.2
8.3
4.9

4.2
8.4
6.7
7.2

5.0
4.5
5.8
6.6

Indonesia
Malaysia ,

3.6

7.8

Pttsc.Pfi5".e,S

na

5.3
8.3

8.1
6.3

5.8
6.1
2.2

7.1
9.7
2.7

7.4

7.5

10.0

6.6
8.7
-O.7
8.2

5.9
8.0
o.o
7.5

6.6

7.9

10.1

3.9

7.5

12.8

3.3
9.2
4.7

2.7
7.9
2.2
5.8
4.5
6.5
5.2

-O.8
2.9

O.4
-4.4
2.1
4.2
3.4
4.4
4.4

O.9
6.0
2.3
3.5
3.7
5.4

Countries

Asia

Hong Kong
Korea
Singapore

TaiwanChina
Latin America
Arff,e.n,tilna

Chile

Colombia

El Salvadorna
5.8

Venezuela

7.2
5.6

Mexico

3.6
3.5
-O.7

1.9
O.7

na

na

-O.9
9.7
3.3
4.6
2.8

na

Notes:

na- Not Available.
* Real GNP for 1960-69, 1970-79, and 1980-90.
a/ 1962-69 for Argentina; 1961-69 for Singapore, Philippines, and Indonesia; 1967-69
for Hong Kong; 1964-69 for Brazil; and 1960-70 for China.
b/ 1971-79 for Malaysia.
Åë/ 1980-89 for Indonesia, Argentina, and Brazil; 1980-86 for Mexico.
Sources:

Asian Development Bank, Asian Development Outlook 1993.

Asian Development Bank, Key Indicators of Developing Asian and PacificCountries, various issues.

Hong Kong, Census and Statistics Department, Estimates of Gross Domestic
Product, 1966 to 1983;
Hong Kong Monthly Digest of Statistics, various issues.

International Monetary Fund, Interational Financial Statistics, Yearbooks
1990-1991.

Republic of China, Council for Economic Planning and Development, Taiwan
Statistical Data Book 1991;
Financial Statistics, Taiwan District, the Republic of China, 1991.
The Economist Intelligence Unit, Country Report 1993 Nol.

World Bank, World Development Report 1991.

against the relevant alternatives.

The potential effects of NAFTA on global trade and investment
patterns are profound and its implications far-reaching. On addressing
the po$sible impact of NAFTA, I will first discuss the changing trading
environment in section ll, which includes the rapidly liberalizing "new"Mexico and the issue of "what is NAFTA?" In section M, I will discuss

50 SEIJI NAYA
the implications of NAFTA on Asian developing countries, taking into

account not only economic aspects but also broader geopoliticalconsiderations. And lastly in section IV,I will discuss the various
options available to countries in the Asia-Pacific in the face of NAFTA
and the increasing focus towards regionalism and bilateralism in theworld today.

ll. The Changing Trading Environment
The move to extend the U.S.'Canada Free Trade Area to Mexico,
thereby creating NAFTA, would result in the world's largest regional
trading bloc, with a combined population of 368 million in a US$6
trillion market.5 It is a lopsided arrangement, with the U.S. as thedominant partner accounting for 87 percent of total GDP and 69
percent of total population. Although Mexico's GNP is less than 5
percent of the U.S. Ievel, its labor force is one'third the size of the U.S.

and growing at a rate 3 times as fast.

In terms of trade, the U.S. accounts for 79 percent of total tradein North America and Mexico only 6 percent in 1991. U.S.'Mexico
trade is a small fraction but has been growing very rapidly in recent
years. Particularly, there has been a rapid increase in intraindustry
trade, including textiles, electronics, and autos and auto parts, at atime when automobile imports from the world have been declining!
Mexico today is different from the Mexico of a decade ago, and is
evolving into a major trading partner of the U.S., taking advantage ofits complementary resource and factor endowments.

The "IVew" Mexico'A new NIC?
The formation of NAFTA has become possible because a "new"Mexico has evolved as a result of decisive restructuring and overall

reform. In the past, Mexico had a statist approach to economic
policymaking. This approach led to distorted incentives and, ultimately,
to an inefficient and inappropriate industrial structure.6
5 By comparison, the European Community has a total population of about 340
million and a GDP of roughly $5 trillion.
6 One of the strongest supporters of NAFTA, University of Texas Professor Sidney
Weintraub, dismissed the possibility of U.S.-Mexico free trade in a 1985 book.

NAFTA AND ASIA-PACIFIC ECONOMIC RELATIONS 51
Since the realization in 1985 that the debt crisis was structural,rather than a liquidity problem, Mexico has been liberalizing by
reducing tariffs and investment barriers. But unilateral liberalization

alone could not have had the same effects as NAFTA-in particular,
the sense of policy continuity as Mexico approaches a new presidential
election and a locking in of access to the U.S. market in the face ofgrowing protectionist rhetoric. NAFTA could provide a perception in
the international community that Mexico's shift to more open, liberal
economic policies is indeed a permanent one, rather than just the visionof one man (President Salinas de Gortari), his Yale economics degree,and his technocrat advisors.
The stable environment achieved has been attracting large inflows
of capital to Mexico and the return in large part of the "capital flight"that occurred in the early 1980s. Foreign investment inflows andcapital repatriation reached a record level in 1991, indicating a highdegree of confidence in Mexico's current economic management andfuture prospects. With these changes, Mexico hopes to be able tobolster income growth and increase external trade. Mexico could be aclear winner in NAFTA in terms of trade and investment as it could'

become the U.S.'s principal source for many labor-intensive

manufactured imports and a major recipient of U.S. and non-NAFTA
investment flows.

What is IVAFTA?
NAFTA is quite unique and unmatched in scope compared withother free trade areas. When the U.S.-Canada Free Trade Area wassigned in 1989, there was hardly any surprise; it was long expected andwas just the formalization of what had already taken place, in thesense that both countries had low average tariffs and special bilateraldeals eliminating trading barriers had already been signed for autos
and selected other sectors. But, with the proposed inclusion of Mexico

in a NAFTA, a great deal of attention and debate has arisen, as
NAFTA has potentially greater economic and geopolitical implications.
It signals that the U.S. is attempting to simultaneously pursue andbalanee bilateralism, regionalism and multilateralism Given the size
and relative proximity of Mexico, one can understand why the U.S. ispursuing this agreement. It is appealing politically (strengthening

52 SEIJI NAYA
democracy and stability in Mexico while discouraging emigration) andeconomically (promoting growth and investment in a country withstrong economic ties to the U.S.). Mexico is a natural trading partner,

in terms of geography and economic complementarities. There are also
distinct benefits to having a more developed Mexican neighbor, such asa growing market for U.S. exports of goods and services and a cheap

source of labor. And Mexico's petroleum reserves may lessen
dependence on the volatile Middle East.

NAFTA is significant because it is the first major integration
between developed and developing countries. It is not just a horizontal

integration as in the European Community (EC) but it is a vertical
integration. Unlike most members of the EC, which have similar levels
of income per capita and are at similar stages of development, NAFTA
consists of member countries with great disparities in income percapita, ranging from $2,870 for Mexico to $21,260 for Canada and$22,560 for the U.S. (see Table 2). Mexico's average industrial wage isjust one-eighth of the U.S. Ievel, although the real efficiency wage gap

is less for some occupations and skill levels. Consequently, thesedisparities will lead to specialization and a likely shifting of certain

production and assembly facilities from the U.S. and Canada to Mexico.

This is already taking place. Smith Corona announced its intention to
relocate its typewriter factories and Zenith (the only TV maker left in
the U.S.) is also moving its factories to Mexico, among others.

NAFTA aims at reducing and ultimately eliminating most, if notall, tariff and non'tariff barriers (NTBs) to trade and investment in
the U.S., Canada, and Mexico. But NAFTA is far more than a tradepact. It is a comprehensive agreement covering almost every aspect of
economic activities such as government procurement, investment laws,
transportation, energy, agriculture, banking and financial services, etc.

The agreement covers areas which are far beyond those proposed
under GATT.

Despite the controversies, ratification of NAFTA by thelegislatures of the three countries is likely, although perhaps not intime for the proposed January 1, 1994 starting date,7 The inclusion of

Mexico may be just the beginning as many more Latin American
7 NAFTA crossed its }ast and toughest hurdle when it passed in the U.S. House ofRepresentatives on November 18, 1993.

NAFTA AND ASIA-PACIFIC ECONOMIC RELATIONSTABLE 2

MACRO ECONOMIC INDICATORS

1991 1992

lyP'6`a(G .g)Pop(NtigsionP?gsC ga

$N

u.s.
CanadaMexicoTotal NAFTA
Japan

NIEs-4

S.Korea

ASEAN*
China

5,686

569
252
6,507
3,337

574
274
367
413

,i.G".itip?;,)igUktp,'oSSgs E(xgp',oS.lgs

532

253
27
88
368

22,56021 260'2,870

2.1
1.6

2.8

98
35

124
73
43
322

26,920
7,908
6,340
1,139

1,150

370

1,6
5,5
4.5
5.4
12.8

1/ 97
62
17
36
26

447
90
40

48
49
15
24

8

* ASEAN consists of the four largest member countries, namely Indonesia,
Malaysia, Philippines, and Thailand,
1/ Forecast.
Sources:International Monetary Fund, International Financial Statistics, Yearbook
1992.

World Bank, The World Bank Atlas 1992.
The Economist Intelligence Unit, Country Report 1993.
Financial Statistics, Taiwan District, Republic of China, July 1992.

Far Eastern Economic Review, Feburary 18, 1993.

countries wish to be included in the agreement. In fact, countries like

Chile and Argentina are closely watching Mexico. Latin Americancountries have renewed their interest in cooperation among themselvesin preparation for NAFTA becoming a hemisphere"wide free trade
agreement as espoused by the "Enterprise for the Americas Initiative,"

proposed by President Bush in 1991.8 They have embarked on
ambitious reforms of their own. Although the outcomes are notcertain, some Latin American countries are likely to emerge as
challengers to the countries in the Asia-Pacific in the 1990s, with orwithout hemispheric free trade. The highly literate and skilled labor
force in several of these countries should allow them to move rapidly
forward.

Most economists argue that NAFTA will expand trade, boost
economic growth, and lead to increased employment in all three
8 President Clinton has expressed his support for the initiative, but it is likely toproceed much more slowly under his presidency.

53

54 SEIJI NAYA
countries. But, the critical question is, by how much? As expected,
reflecting the relative size of the U.S, compared with Mexico, all studies

indicate that real GDP growth will be small for the U.S., amounting toless than half of 1 percent (with the exception of one study whichshowed a 2.07 percentage point increase).9 Mexico would gain the mostwith real GDP increase ranging from O.1 to as much as 6.8 percentage
points (Tables 3 and 4).'O These are static effects, however, comingfrom the reallocation of existing capital and labor between industries
and countries using existing technologies. When dynamic effects are

introduced, which refer to the expansion of markets and further

increases in economic growth and income through savings andinvestment and productivity responses, there could be greater gains.
As income and production levels grow in North America, demand forfinal and intermediate goods from all sources will rise. McCleery(1992) estimated that dynamic gains from NAFTA could increase real

GDP in Mexico by 11.39 percentage points over nine years, due toremoval of tariffs and NTBs, increased capital flows, and greater
technological innovation and diffusion, an increase of 1.2 percentage

points in annual growth (i.e., from 4 to 5.2 percent). The
corresponding impact for the U.S. is considerably less, of course,
ranging from a O.22 to O.51 percentage point change in year 2000 GDP(see Tables 3 and 4), showing gains that are similar in magnitude($20-30 billion per year) but dwarfed by the size of the U.S. economy.

These results show that increases in capital flows would have greater
importance for the Mexican economy than Iiberalization of tariffs andNTBs; on the other hand, increases in capital flows from the U.S. into

Mexico would not appreciably affect U.S. real GDP, given thesufficiently large U.S. capital market.t'
9 This study, by Roland-Holst, et.al. (1992), assumes that unrealized economies ofscale exist in the U.S. economy, which will be reaped with the expansion of themarket under NAFTA. It alone of the studies cited in Tables 3 and 4
simultaneously models CanadaTU.S. free trade (CAFTA) and NAFTA-the others
take CAFTA as given. And O.77 percentage points of the gain is from theassumption that price competition from Canadian and Mexican suppliers will
lower oligopolistically set prices in the U.S.

10 When capital is allowed to flow between countries, as will undoubtedly occur
under NAFTA, the gains for Mexico range from 3 to 8 percent.
11 The McCleery model also takes into account linkages in the world capital market;
if capital flows from the U.S. to Mexico began to create a capital shortage in the
U.S., rasing the rate of return to capital, then foreign investments from Japan,
Europe, and elsewhere would flow to the U.S.

ASIA-PACIFIC ECONOMIC RELATIONS 55
NAFTA ANDTABLE 3

FROM ECONOMY-WIDE MODELS OF A NAFTA:
AGGREGATE RESULTS
EFFECTS ON MEXICO(Percent Changes)

Authors of study Real Employ- Trade.............M...p..d..e.!(c.C[..?..p.Uc.y..S..c..e..n"a..r.ip.....................................................q..P..?............rp...e.p.Y.............B..a.la.p.c.e....

Static:Bachrach and Mizrahi:

FTA, no added capital in Mexico +O.32 +O.85 +1.18

FTA, additional capital in Mexico +4.64 +6.60 +59.12
Hinojoso and Robinson:

Tariff removal only +O.1 -O.1' NC

Tariffs and NTBs liberalized +O.3 +O.3 NC

Mexican growth(tariffs, NTBs, capital flows) +6.4 +O.1 NC

Mexican growth and migration +6.8 +1.4 NC

Robinson et al.:Trade liberalization +O.27 NA NC

Roland-Holst et al.:

CRTS, tariffs and NTBs +2.27 +1.49 NC
IRTS, tariffs and NTB$ +3.38 +2.40 NC
Dynamic:
Almon:

Tariff removal only, after lO years O.O -O.Ol -2.87
Tariffs and NTBs, after lO years -O.35 -O.90 -9.41

McCleery:Free Trade (Tariffs and NTBs) +O.Ol NC NA"+ increased investor confidence +3.09 NC NA"+"+ dynamic gains +11.39 NC NA

Notation:

NC - the variable is unchanged by assumption; NA - the figure is notavailable; FTA - Free Trade Area; NTBs - Non-tariff barriers; CRTS - constantreturns to scale; IRTS ' increasing returns to scale.
Source:"Economy-wide Modeling of the Economic Implications of a FTA with Mexico

and a NAFTA with Canada and Mexico," US International Trade Commission
Publication 2508, May 1992, Table 2b, pp.9-11.

Over time, NAFTA should spur industrial reorganization along
regional lines. U.S. suppliers of intermediate goods, capital goods andhigh-tech products will benefit by taking advantage of economies ofscale and as prime suppliers of the growing Mexican market. The key
elements of dynamic effects are the locking in of Mexican reforms(along with NAFTA) and their effects on factor flows, investment,
economic growth, and impact on international trade. Most importantly,
the real consequence of NAFTA is not the economic effects of the trade
agreement per se (i.e., trade and investment diversion) but the changing

U.S. geopolitical focus and increasing tendency towards regionalism
and bilateralism.

SEIJI56

NAYA

TABLE 4NAFTA:RESULTS FROM ECONOMY-WIDE MODELS
OF A
AGGREGATEEFFECTS ON THE UNITED STATES(Percent Changes)
Real

GDP

Employment

Trade
Balance

+O.02
+O.04

NC
NC

+O.03
+O.07

NC
NC

Authors of study..........H.M...p..d..e.J.1..P..p.lic.y...$..c..e..n..a.r.ip....

Static:Bachrach and Mizrahi:
FTA, no added capital in

MexicoMexicoFTA, additional capital in

Hinojoso and Robinson:
Tariff removal only

+O.1

+O.2

liberalized

o.o

-O.1

flows)

+O.1
+O.1

-O.3

NC
NC

Trade liberalization
Roland-Holst et al.:

+O.23

NA

NC

CRTS, tariffs and NTBs
IRTS, tariffs and NTBs
Dynamic:

+1.34
+2.07

+1.88
+2.47

NC
NC

10 years +O.11
+O.17

+O.03
+O.05

+12.3
+18.4

NC
NC
NC

NA
NA
NA

Tariffs and NTBs
Mexican growth(tariffs, NTBs, capital

Mexican growth and 'mlgratlon

o.oRobinson et al.:Almon:
Tariff removal only, after
Tariffs and NTBs, after 10

years

McCleery:Free Trade (Tariffs and" + increased investor

NTBs)
confidence" + " + dynamic gains

+O.22
+O.32
+O.51

Notation:

NC - the variable isunchanged by assumption;

available; FTA - Free Trade Area; NTBs - Non-tariff
returns to scale; IRTS u 'NA - the figure

increasing returns to scale.

is notCRTS - constantbarriers''

Source:"Economy-wide Modeling of the Economic Implications ofand Mexico," US International
and a NAFTA with Canadaa FTA with Mexico

Trade Commission

Publication 2508, May 1992,Table 2c, pp.12-13.

M. Impiications Of

NAFTA OnThe Asia-PacificRegionThe Asia-Pacific region cannot afford to have a waitrmand-see
attitude as NAFTA unfolds; it should prepare itself for the challenges

and opportunities that are presenting themselves. What does NAFTA
mean to the continued dynamism of the Asian countries? Will NAFTA
make the U.S. inwardly focused? These are the questions that will be
addressed in this section.

The bottom line question isl How will the AsiaTPacific countries

NAFTA AND ASIA-PACIFIC ECONOMIC RELATIONS 57

be affected by NAFTA? There are three primary avenues of impact on
the Asia-Pacific region-trade diversion, investment diversion, andgeopolitical considerations-and each is discussed in turn below.

Trade Diversion

NAFTA will give Mexico and Canada free access to the U.S.
market or free access than they had enjoyed before. By eliminatinginternal tariff and trade barriers among partner countries but keeping

external tariffs against the rest of the world the same, NAFTA
implicitly discriminates against non-NAFTA countries. This has theeffect of generating more intranNAFTA trade and less trade withcountries outside of the union, A negative impact of NAFTA is trade
diversion, which results if less efficient producers from NAFTA replace

more efficient producers from outside the union, leading to a loss inworld welfare.
' There are several factors that will neutralize some of the potential
trade diversion, however. First, tariff reductions under NAFTA will bemodest, as tariffs in all three countries are already relatively low. The
U.S. and Canada have average tariffs of about 4 percent and Mexico's

are now at 10 percent. In addition, if the Uruguay Round of GATT
negotiations succeeds, there will be further reduction of tariffs (in all

member countries) by about one-third. These existing tariffs may notpose too large barriers for non-partners, like Japan, in competing withproducts from member countries.
Second, the U.S. and Mexico already have close economic ties.
Mexico's exports to the U.S. account for about 70 percent of its totalexports while two-thirds of Mexican imports come from the U.S. Someapologists in the U.S. government have cited the high trade ratios of
Mexico and Canada as evidence that the potential for trade diversion isminimal. This is not true, however, as the U.S. produces a wide rangeof commodities that might capture increasing market shares, especiallyin rapidly growing economies. A change in Mexico's import mix
toward capital goods and middle-class consumption items, away fromluxury goods, could also affect the direction of trade. Sectors in whichmodest margins of preference might yield large increases in U.S.
exports to Mexico include some highly competitive capital goods andhomogeneous commodities, such as cereal grains. Yet the bulk of the

58 SEIJI NAYA
anticipated increases in trade will come from increases in the growth
rates and trade shares of GDP in the member countries,
In general, trade diversion would be greater in products where

NAFTA-members and Asian developing countries are in directcompetition and are substantial exporters to the country in question.
A rough proxy for the level of trade competition is the relative factor

endowments of the countries involved. By that measure, ASEAN
countries would be heavily impacted as they would be competing with

Canada in many resource-intensive products and with Mexico inlabor'intensive manufactures. In the short run, Korean exports to the
U.S. will not be hurt as much because Mexican industries are 5 to 10
years behind their Korean counterparts in terms of overall industrial
competitiveness. But if, as expected, U.S. capital and technology move
to Mexico and when Mexican industries catch up by improving theirproductivity, Korean exports to the U.S. will face greater competition.
Kreinin and Plummeri2 estimate that trade diversion from NAFTA on

Korea and ASEAN-4 countries would yield losses of 4-5 percent of
pre-agreement NAFTA exports. But inclusion of non-tariff barrier
effects could double or triple the estimates.i3 Korean exports to the

U.S. compete with other NAFTA countries in the following relatively
highly protected areas: organic chemicals, leather manufactures, textiles

and garments, iron and steel, metal manufactures, railway vehicles,

travel goods, furs, footwear, instruments, and fish (Kreinin andPlummer, 1992). Tariff-free access to the U.S. market by Mexico andCanada could reduce revenues of Korean exporters by some $800
million dollars. Trade diversion from Canada and Mexico could cost
Korean exporters $180 million and $15 million, respectively. Note thatmost of Korea's loss results from access to the U.S. market by Canada
and Mexico, but the effect of partner preference into the Canadian and
Mexican markets is likely to increase as Korea moves out of resource-and Iaboreintensive exports into subcontracting-dependent and
12 Kreinin, M. and M, Plummer, "Effects of Economic Integration in Industrial
Countries on ASEAN and the Asian NIEs," VVorld Developrnent, Vol.20, 1992.
13 On the other hand, the Kreinin-Plummer figures have been called overestimates of
the Iikely trade diversion, as they measure the difference between most favorednation (MFN) tariffs and no tariffs, while in actuality, U.S.-Mexico trade often
takes place at significantly lower than MFN rates (see the later section on themaquiladoras), and all tariffs will not be eliminated under NAFTA.
Is this "resource-and-labor-intensive" or "resource-and labor--intensive? nether. It
is a eontraption of "resource-indensive and labor-indensiveNAFTA AND ASIA-PACIFIC ECONOMIC RELATIONS 59

technology-based manufactures. As this restructuring continues, Korea
will compete less with Canadian and Mexican suppliers to the U.S. andmore with U.S. suppliers to Mexico and Canada.i`
The effects of tariff reduction on specific sectors may be affected

more due to content requirements and the phasing out of thernaquiladoras in NAFTA.'5 The following subsection explores theseissues in more detail.

1. Content Requjrements
Rules of origin and content requirement can discriminate against
goods produced from non-NAFTA counties or penalize firms controlled
by capital from non-NAFTA countries. U.S. producers, particularly intextiles, automobiles, and semiconductors, rely on rules of origin as away to increase domestic production and to gain an advantage against

Japan and other Asian competitors. The North American content
requirement will be set at 62.5 percent on passenger cars, light trucks,
engines, and transmissions, significantly higher than the present levels,

i.e., 50 percent in the U.S.-Canada Free Trade Area and 30 percent in

Mexico. With a higher content requirement percent, trade andinvestment diversions are likely to be larger, even with the inclusion of

Mexico. Obviously, the provision has been designed to protect regional

producers from foreign auto parts, such as those from Japan and
Korea.i6

Asian textile exporters will be negatively affected with the
adoption of stricter rules of origin that all textiles be produced withyarns (in some cases, such as cotton, all fibers) produced in North

America. Given the'new incentives under NAFTA there would be ashift in U.S. purchases of fabrics and apparel, as well as foreign
14 Ozawa, Terutomo, "The Dynamics of Pacific Rim Industrialization: How Mexico
Can Join the Asian Flock of Flying Geese," in Mexico's External Relations in the
1990s, Riordan Roett, ed. (Bou}der, Co.: Lynne Rienner, 1991), pp.129-47.

15 Maquiladoras are factories and assembly plants operating along the border justinside Mexico, primarily under American ownership. A special provision of U.S.
customs laws allows products produced in maquila plants in Mexico to enter the

U.S., paying tariffs only on the value added in Mexico and without being
subjected to quantitative restrictions,16 To give a simple numerical example, an auto assembler who had previously used
52 percent Canadian and American parts, 5 percent Mexican, and 43 percent Asian
would need to decrease imports from Asia. But a similar firm, using the same
pereentage of U.S. and Canadian parts, 30 percent Mexican, and 18 percent Asianmight reduce its usage of North American parts and increase imports from Asia

after the NAFTA agreement.

6e - SEIJI NAYA
investment in those industries, from Asia and the Caribbean to Mexico.
The three Chinas (Hong Kong, Taiw,an, and China) have reasons to beconcerned as their major exports (such as textiles and clothing,
footwear, consumer electronics, and chemicals) would be affected.
Although the Chinese economies are more competitive than Mexico in
products like toys, metal manufactures, leather products, and processed
food, there could also be trade diversion effects in these sectors.

2. The Phasing Out of Maquiladoras
The maquiladoras generate about 30 percent of Mexican trade.
They have been a back door to the U.S. market, bringing electronic
goods like television tubes produced by Asian countries through Mexico

into the U.S. Under NAFTA, the maquiladoras will be phased out.
This means that access to the U.S. market would be subjected to deuble
taxation. For example, a 15 percent duty on tubes would be required

coming into Mexico from non-NAFTA countries, and an additional 5
percent on television sets being shipped to the U.S. (in this example theU.S. tariff is relevant, as rules of origin are based on the place of
manufacture of the picture tube, regardless of other content). This
would result in less favorable market conditions for third countries andperhaps an erosion of Asian goods' competitiveness relative to U.S.
goods in the North American market.

Overall, trade diversion is not an insurmountable obstacle tocontinued export expansion into the North American market and it
should not be a cause of alarm for Asian developing countries,
assuming that NAFTA does not become inward-looking. The dynamic
effects of an increase in income can somewhat offset trade diversion.
At the same time, one should not forget the opportunities that will becreated by NAFTA. The aggregate employment and real wages are
expected to rise in North America. The more rapid the growth of
Mexico, the greater the trade opportunities for Asian countries,
particularly for the machinery and equipment exporters of East Asia.

In addition, Korea and other NIEs have a more than 20-year trackrecord of export diversification and growth, demonstrating theflexibility of their economies to adapt to changing world trading
conditions.i7
17 For Japan, and to some extent some NIEs, vulnerability to trade and investment

RELATIONSNAFTAANDASIA-PACIFICECONOMIC

Investrnent Diversion

The anxiety of Asian developing countries about NAFTA relates
more to the possibility of investment diversion in favor of the "new"Mexico, given its enhanced competitive position. The flow of foreign
direct investment (FDI) into a country tends to increase production forexports. Thus, an increase in U.S. FDI into Mexico could reduce FDI
in Asian developing countries and subsequently decreases their export
growth. These investment diversion and FDI-related export loss are
the key areas of concern. McCleery (1992) estimated that the increase
in investment flows to Mexico (from all sources) brought about by
NAFTA could be as high as $50 billion over 9 years. McCleery (1993)
simulates the effect on ASEAN countries if approximately $ 1 billion in

FDI is diverted away from their economies. The loss in foreignexchange and industrial capacity could reduce GDP growth rates byalmost one percent, on average.
Investment diversion is potentially the most important effect of

NAFTA especially because there is evidence that it is related totechnology transfer and productivity growth. Many estimates indicatethat investment diversion is likely to outweigh trade diversion.'8 FDI
has been a significant source of capital for manufacturing investment,

which is a major factor in the continuing dynamism of the ASEAN-4,
the NIEs, and China.i9 A decline in FDI is cause for concern because of

its potential negative effects on the future growth of trade,
diversion from NAFTA can be mitigated since it produces more specialized andtechnologically sophisticated, and thus less substitutable products. In fact, many
Japanese goods are necessary inputs for the U.S. manufacturing sectors and there

has been a rapid increase in American brand-name products imported fromJapan.
18 According to one econometric study which examines the effect of the U.S. andCanada shifting their combined investment of US$ 1 billion from ASEAN
countries to Mexico for eight years, GDP and trade balance of ASEAN countries

would decline annually by US$ 2 billion and US$ 437 million, respectively.
(MITI, White Paper on Trade, Overall Report, June 1992, p.280. The latter result is
at odds with McCleery 1993, which illustrates the more conventional argument; infour of the five ASEAN countries modeled, the reduction in capital inflows
necessitates a cut back in imports that is greater than the reduction in exports,
and the trade balance improves, at the expense of capital and intermediate goods

needed for growth.
19 See Naya S. and E. Ramstetter, 1992, "Foreign Direct Investment in Asia'sDeveloping Economies and Trade in the Asian and Pacific Region," Development
Papers No.10, ESCAP, United Nations, Bangkok.

61

62 SEIJI NAYA
productivity, and employment.20

Investment diversion refers to U.S., Canadian, Australian, andEC-based firms which may shift FDI flows to Mexico away from East
Asia and Indonesia. In addition, it can also refer to Japanese, Korean,

and Chinese investors in Hong Kong, Taipei, and Singapore who may,on the margin, reallocate investment from Southeast Asia or Mainland
China to Mexico. AIready, massive increases of foreign investment aregoing into Mexico, not only from the U.S., but also from Japan, Korea
and other Asian countries. Foreign capital inflows allowed Mexico torun a $12 billion balance of trade deficit in 1992 and preliminary
figures indicate an even larger deficit in 1993. Indeed, NAFTA has
made Mexico an attractive investment destination and manufacturingbase for products destined for Central and South America as well asNorth America.
Geopolitical Considerations

Many in Asia see NAFTA as a symptom of broader economic andgeopolitical initiatives in the U.S., namely a growing disenchantment

with the Europeans and Japanese in the GATT and a lessening ofinterest in Asia in the post Cold War world order.
Clearly, NAFTA marks a turning point. The U.S., the cornerstone

and driving force behind the GATT trade system which has been so
effective in reducing tariffs on manufactured goods, is now embracing
regionalism and bilateralism. In the 1960s, when it dominated the world

economy and accounted for fully half of the world's GNP, the U.S.
pushed for "open" markets and multilateralism in the world trading
system. Today, however, the U.S. position in the world economy has
dramatically changed as its relative economic strength has declined.
The combination of a weakening economic position and the collapse of
the Communist threat makes the U.S. Iess willing to make further
concessions for the benefit of the world trading system, particularly
those it views as having been "free riders" in the past.
Yet it is important that the U.S. maintain or increase its economic
20 See Ramstetter and W. James, 1992. Also The Economist (7-13) Nov.1992, p.85,
which asserts that because profit margins are higher and labor costs lower in

Asia than in Europe or North America, Japanese FDI wM increase more indeveloping Asia than elsewhere, once investment levels recover in the midL1990s.

RELATIONSNAFTAANDASIA-PACIFICECONOMIC

presence in the Asian region. Asia's dynamism is propelled by highinvestment rates, extensive trade and investment linkages, acommitment to research and development, the rapid spread oftechnology, a strong base of infrastructure and human resource
development, and public sector and private sector specialization andcooperation. It would be a mistake to think that the dynamism of Asia
can be re-created overnight in Latin America even if the same policy
prescriptions were fully adopted. The first priority in the American
agenda now is to restore U.S. domestic economic health; it is therefore
in the economic interest of the U.S. to be fully engaged in the Asia'
Pacific region, which accounts for one-third of world trade.

The effects of NAFTA on U.S. interests in Asia cannot be
determined with any degree of certainty, as many questions remain
concerning what NAFTA will be and how it will be perceived in Asia,
the U.S., and the rest of the Americas. How NAFTA affects the U.S.
economy will to some extent determine how tough the U.S. will be on
trading partner perceived as not playing on a level field. A positive

view of NAFTA is one that serves as a complement to GATT rather
than as a substitute. NAFTA should not be seen as a threat to the
GATT talks but rather as a challenge that could promote trade andinvestment, particularly with the dynamic Asian economies. Its
implication should be far beyond increased trade flows, as a step

toward private sector-led, market'based dynamism and global
lntegratlon.

IV. Options For Asia-Pacific Economic Cooperation

The future growth of the Asia-Pacific region depends on how
Asian countries respond to challenges and take advantage of emerging
opportunities in the face of NAFTA and other changes in the trading
environment. It is important to upgrade domestic supply conditions in

Asian countries for greater efficiency in response to increased
competition from "new" Mexico and other new NICs, such as Spain in
the EC. Speciali2ation within the region, fostered by openness to tradeand investment, is crucial to continued growth. And consultation andcornrnunication in fora like GATT and APEC can help to prevent
AIAFTA and the EC frorn becoming defensive trading blocs along
regional lines. These three points, competitiveness, specialization, and

63

64

SEIJI NAYA

preservation of the open world trading system, are discussed in turnbelow. A specific proposal for linking APEC and NAFTA is then given.

The growth pattern of the NICs shows that comparativeadvantage is a dynamic process. And the ability to pursue one's
comparative advantage as it evolves will depend on how open developed
country markets are. To stay competitive, countries will need to keep

on moving up the ladder of industrialization and allowing othercountries on the lower rungs to likewise move up. But this pattern ofdevelopment is not automatic. Countries will need to compete withothers in international markets and transform themselves despite
economic and political forces that resist change.

For Korea, as the country moves into the 1990s, widespread
restructuring should be undertaken. Production in the manufacturingsector has to shift further from labor'intensive processes toautomation and more sophisticated technologies. Only in this way canrapidly rising wages be matched by productivity growth, and thusinternational competitiveness be maintained. The agricultural sector
must adjust to meet greater international competition. The financial
sector needs to be deregulated; excessive credit rationing should be

reduced by enhancing the role of markets to efficiently allocate
resources. Special attention should be given to the problem of
increasing R&D in order to upgrade the industrial structures.

In the coming decade, Korea will need to make the nexttransformation, from NIE to OECD status.2' The challenge for Korea
is to be able to join the ranks of the industrialized countries; in GNP
per capita and other measures of development, it is still a little behindcountries like Spain and Italy.22 The task is not just to outcompete the

newly emerging NIEs or near NIEs, including the "new" Mexico, butmore importantly how to move up the ladder of industrialization and"catch up" with developed countries.

Secondly, the AsiaJPacific countries should push for greater
21 Naya, S. and Pearl Imada, "NIEs to OECD: Prospects for Korea and Taiwan,"
presented at Allied Social Sciences Association Meeting, January 5m7, 1993,
Anaheim, California. Based on statistical analysis, they conclude that Korea's
economic structure has it poised to leap into the rank of developed countries in thenext ten to twenty years.

22 According to the World Bank, World Development Report 1992, a high income
country has GNP per capita of more than US$9,OOO (in 1990 dollars). Korea's
GNP per capita was around $6.5eO.

ASIA-PACIFIC ECONOMIC
RELATIONSNAFTA AND

complementarity of economic structures within the region throughcooperation in trade and investment leading to de facto integration. In
the 1980s, direct foreign investment from Japan exceeded that of the
U.S. in the region. In the 1990s, the NIEs are increasing their direct

foreign investment in ASEAN and China at a rapid rate, even exceedingthat of Japan in several key markets. These new investments will befollowed by higher Ievels of trade flows. The Asia-Pacific region has

become truly interdependent, with the increasing reliance on theinternational marketplace occurring naturally as an outcome ofoutward-oriented policies and increasing regionalization of production.
Yet their reliance on the U.S. and Europe as markets for final products
still makes them vulnerable to the formation of trading blocs.
The opening-up process in China focused on so-called open cities
or special economic zones in coastal areas. Korean exports to China
amounted to $44 million during the first half of 1991, which sharply
increased by a factor of 11, reaching $493 million for the same period

in 1992. The extraordinary growth in Guangdong Province, alluded toearlier, has not only benefitted from Hong Kong capital andentrepreneurship, but has also resulted in a restructuring of the Hong

Kong economy (more than one-third of Hong Kong's industry has now
moved across the border into the Pearl River Delta). The province of
Fujian, across the straits from Taiwan, has seen a large infusion of
trade, industry, and capital, channeled indirectly through Hong Kong.
A similar pattern of development has occurred in Southeast Asia as

manifested by the growth triangle in Malaysia, Singapore, andIndonesia. Increased trade within the region coincided with this newpattern of investment, making Asia more self"sustaining as far as
economic growth is concerned. Some would argue that the region ispracticing de facto integration.

Third, the open world trading system can be preserved by using
the Asia-Pacific Economic Cooperation (APEC) process to work closelywith NAFTA countries, particularly the U.S. In view of rising economic
interdependence in trade, investment, and services, and also in responseto the trend towards regionalism in the rest of the world, there is aneed for an Asia'Pacific organization that can foster economic
cooperation, reduce bilateral disputes, and facilitate the exchange of

information. There is an East-Asian Economic Caucus which was
initially proposed as a sort of trade bloc to counter the blocs in North65

66 SEIJI NAYA
America and Europe, but the group has since been modified to be a
consultative body (within the GATT) due to lack of consensus support
for excluding the U.S. from the group.

It is difficult to see the development of an Asian trading bloc
without the participation of the U.S. It is true that the reliance of East

Asian exporters in the U.S. market has been declining and that
economic interdependence among Asian countries has been rising. But
still, exports of Japan and the NIEs to the U.S. comprised as much as
25 percent of their total exports while the NIEs' exports to Japan were
only about 10 percent in 1991. American reliance on East Asia hasrisen to 25 percent in 1991 from 20 percent in 1980-a five percentage
point increase over a decade, Also there is a question of leadership insuch an effort. Obviously, Asia needs the US,, and vice versa.
The major organization currently the best candidate to take onthese tasks is the Asia- Pacific Economic Cooperation (APEC). It is aprocess consisting of inter-governmental meetings. The 15 APEC
members are the U.S., Japan, Korea, Taiwan, Hong Kong, China,
ASEAN countries, Canada, Australia, and New Zealand. It has aconsiderable potential for linking Asia with NAFTA. Since Canada andU.S. are both members of APEC and NAFTA, APEC has the capacity
to influence the U.S. not to make NAFTA an inwardly-looking trading

bloc. Mexico has a strong interest in joining APEC, which would
further strengthen the link.23

Korea has been a central catalyst in APEC. It was a real coupfor Korea to succeed at the APEC meeting in Seoul in November 1991
in bringing the "Three Chinas" into the membership. The three Chinas'
membership in APEC represents an important political event since thisis only regional setting in which these countries can interact with eachother and with other countries in the region. Korea was also active
participant in the Fourth Conference held in Bangkok in September
1992, which upgraded APEC to an organization of economic cooperation
with a standing secretariat in Singapore. Korea should continue topush APEC forward to become an active, vital organization of
economic cooperation, at least on par with the OECD.
Just recently, President Clinton cited APEC as a vital regional
23 Mexico is now the 16th APEC member, as of November, 1993.
24 See Far Eastern Economic Review, "Group Therapy," April 15, 1993, pp.10-11.

RELATIONSNAFTAANDASIA-PACIFIC ECONOMIC

arrangement for the U.S. Also, Assistant Secretary of State for East
Asian and Pacific Affairs Winston Lord announced the administration's
support and intention to lead the APEC process to be more "relevant
and aetion-oriented".2` The announcement implies that the U.S. willremain engaged in Asia. The U.S. seems to be signalling that the newadministration's tactic for trade negotiations is no longer the "huband-spoke" approach as in the past-a series of bilateral arrangements
between the U.S. and APEC members. It is in the interest of the U.S.
to consider cooperative arrangements based on the concept of "openregionalism." The coming APEC ministerial eonference in Seattle inNovember 1993, with the U.S. as chair, holds a lot of promise.
APEC is an organization in search of a meaningful identity. It isa collaborative and consultative arrangement, but it does not aim tocreate a trading bloc. It is an open-ended process. APEC's raisond'etre is to promote an open and free multilateral trading system.
APEC would proceed in the spirit of "open regionalism" implying that
APEC agreements would not result in discriminatory measures in tradeand investment against non-member countries.
APEC's goal is broadly defined and the means will have to befound to mitigate conflicts and tensions in the region. What is needed

is a mechanism which can formalize "open regionalism." In thisconnection, APEC should be viewed as a "GATT-Plus" agreement basedon most favored nation (MFN) treatment that would promote andexpedite regionmwide liberalization, reducing trade and trade-related
issues and disputes.

APEC and AIAFTA should be linleed through a revised GATT Article

XXIV.
Promotion of APEC by itself does not resolve the potential of

NAFTA becoming inward-looking. NAFTA is GATT consistent, as
rules and their interpretation now stand.25 Article XXIV of the GATT
25 Perhaps it would be more correct to say that NAFTA is not inconsistent with therule of GATT. Of the more than 70 regional trade agreements that have been
notified to the GATT under article XXIV, none has been rejected, although few
were formally approved. Indeed, the U.S.-Canada pact, widely heralded as themost comprehensive FTA agreement ever notified to the GATT, was not formallyapproved, due to concerns about dispute settlement procedures and exclusions inagriculture. See Gary Hufbauer and Jeffrey Schott, "Regionalism in North67

68 SEIJI NAYA
allows for the creation of free trade areas, under conditions imposed toensure that the agreement will not lead to "fortress building,"
principally that the agreement cover "substantially all" trade, and thatexternal tariffs not be raised. Yet not only are these conditions very

weak, but they are often not met. For example, the content
requirement of NAFTA is a disguised from of protectionism. By
requiring higher regional content, regional producers receive protection

against imports. Interestingly, such a matter is rarely brought up in
GATT but it is normally assumed that is GATT consistent.

What is needed from the standpoint of APEC members is theguarantee that the spirit of Article XXIV is indeed adhered to by all.
If GATT is to permit regional free trade areas, it seems that the bestsolution is to revise Article XXIV such that there is an assurance tothe world that external protection will actually fall, rather thaneffectively rise through margins of preference to partners and disguised
protection through rules of origin.26 This is a clear way of linking

APEC and NAFTA, while making sure that regionalism will be open.
The remaining question is whether sufficient leadership can bemustered in GATT to formulate this amendment, which will takeconsiderable political will and diplomacy. If the U.S. abdicates its
leadership role, it is unlikely that reform will be forthcoming. Perhaps

a show of leadership in the GATT is one way President Clinton canleave his mark, clearly reconciling his beliefs in both multilateralism
and regionalism.

America," in Koichi Ohno, ed., Regional Integration and its Irnpact on DeveZoping
Countries, (Tokyo, Japan: Institute for Developing Economies, 1993) pp.281-302.

26 There have been suggestions in De Melo, Jaime and Arvind Pangariya, "The New
Regionalism in Trade Policy," World Bank, 1992, arguing that customs union
leads to positive welfare if all external tariffs come down to the lowest level
prevailing at the time of the union formation. This condition is stricter than the

proposed open regionalism amendment. Others have sought conditions on thevolume of trade with the rest of the world to ensure that it does not fall as aresult of regional free trade. The problem with this latter approach, of course, isagreeing on the relevant counterfactual-i.e., what the pattern of trade would havebeen if not for the FTA. See John McMillian, "Does Regional Integration Foster

Open Trade? Economic Theory and GATT's Article XXIV," University ofCalifornia at San Diego, Draft Manuscript, 1993, cited in Hufbauer and Schott,
1993, op.cit.

NAFTA AND ASIA-PACIFIC ECONOMIC RELATIONS

References[1]

De Melo, Jaime and Arvind Pangariya, The New Regionalism in Trade Policy,
World Bank, 1992.

[2]
[3]
[4]

Economist, (7-13) Nov. 1992, p.85.

Far Eastern Economic Review, "Group Therapy,", April 15, 1993, pp.10-11.

Hufbauer, Gary, and Jeffrey Schott, "Regionalism in North America," inKoichi Ohno, ed., Regional Integration and its Impact on Developing Countries,(Tokyo, Japan: Institute for Developing Economies, 1993) pp.281-302.

[5]
[6]
[7]

Kreinin, M. and M. Plummer, "Effects of Economic Integration in Industrial
Countries on ASEAN and the Asian NIEs," World Development, Vol.20, 1992.
Krugman, Paul, The Age of Diminished Expectations: U.S. Economic Poliay inthe 1990s. (Cambridge, Mass: MIT Press, 1990).
McCleery, Robert K., "An Intertemporal, Linked, Macroeconomic CGE Model of
the United States and Mexico Focussing on Demographic Changes and Factor
Flows," pp.371-441, and "A General Equilibrium Analysis of the Gains from

Trade for the Mexican Economy of a North American Free Trade AgreementComment," pp.655-658, in Economov-Wide Modeling of the Econornic Implicationsof a FTA with Mexico and a NAFTA with Canada and Mexico, (Washington,
DC: US International Trade Commission [Publication 2508], May 1992.
[8]

McCleery, Robert K., et al, "NAFTA and its Effect on other Regions," inKoichi Ohno, ed., Regional Intergration and its Irnpact on Developing Countries,(Tokyo, Japan: Institute for Developing Economies, 1993) pp.303-412.

[9]

MITI, White Paper on Trade, Overall Report, June 1992, p.280.

[10]

Ozawa, Terutomo, "The Dynamics of Pacific Rim Industrialization: How
Mexico Can Join the Asian Flock of Flying Geese," in Mexico's External
Relations in the 1990s, Riordan Roett, ed. (Boulder, Co.: Lynne Rienner, 1991),
pp.129-47.

[11]

[12]

Naya, S. and Pearl Imada, "NIEs to OECD: Prospects for Korea and Taiwan,"
presented at Allied Social Sciences Association Meeting, January 5-7, 1993,
Anaheim, California.
Naya, S. and E. Ramstetter, 1992, "Foreign Direct Investment in Asia'sDeveloping Economies and Trade in the Asian and Pacific Region,"[13]

Development Papers No.10, ESCAP, United Nations, Bangkok.
Roland-Holst, David, Kenneth Reinert and Clinton Shiells, "North American
Trade Liberalization and the Role of Non-Tariff Barriers," in Eeonomy-LVide
Modeling of the Econornic Implications of a FTA with Mexico and a IVAFTA
with Mexico and Canada and Mexico, (Washington, DC: US International Trade
Commission [Pub}ication 2508], May 1992).

[14]

[15]

Thurow, Lester, Head to Head: The Coming Econornic Battle Among Japan,
Europe and An2erica, (New York, NY: Morrow, 1992).
World Bank, World Development Report 1992.

69

THE ASIAN DEVELOPMENT EXPERIENCEAND ITS RELEVANCE TO AFRICAN
DEVELOPMENT PROBLEMS

Seiji NAyA and Robert K. McCLEERyi

I. Introduction to Asian Development: Myths and Realities

The enviable growth patterns of several Asian countries are wellknown. East Asia is the only region in the world which has been able

to maintain strong and consistent growth patterns over several
decades, led first by Japan and then by the newly industrializing
economies (NIEs) of Hong Kong, South Korea, Singapore, and Taiwan.
These economies have achieved not only two-digit growth rates andvast improvements in social indicators. but also very favorable income
distributions. In the NIEs, the lowest quintile of the population receives
more than five percent of total income and the highest quintile receives

less than thirty percent. From 1965 to 1990, incomes grew at 6 to 7
percent per capita in the NIEs, and 3 to 5percent per capita per annum

in the newly emerging growth pole of Southeast Asia (Indonesia,
Malaysia, Thailand). By contrast, the less developed countries (LDCs)

on average recorded 2.5percent per capita growth, and Africa only
grew by O.2percent per capita over the same period (Naya and Imada

1

Professor of Economics at the University of Hawaii and Associate Professor of
Economics, Kobe University, respectively. The senior author would like to thankthe Staff of the Research Institute for Economics and Business Administration,
Kobe University, for the support and intellectual stimulation provided during his

stay there in the Summer of 1992, when the background research for this paper

was carried out. The research assistance of Karen Eggleston is gratefully
acknowledged. Our thanks to the participants of the symposium"Promoting
Accelerated Growth in Africa! Perspectives from the Asian Experience" June 1992,
for contributing to our understanding of Africa's problems and challenges, and tothe chief project funder, the United Nations Department of Economic and Social

Development. A draft of this paper was presented to the Tokyo International
Conference on African Development, hosted by the United Nations Department of
economic and Social Development, October 1993. The views expressed herein andany errors are those of the authors alene, and shou}d not be attributed to any
other institution, organization, or individuals.

72 SEIJI NAYA•ROBERT K.MCCLEERY
1992; Roemer 1993). In the first years of this decade, economic growthin Africa did not keep up with population growth of over three percent

per annum, leading to a decline in per capita incomes of roughly one
percent per year (Yaker 1992).
This paper discusses some of the possible lessons to be learned
from the Asian development experiences and their relevance for African
development. We focus on Japan, the NIEs of East Asia, and Southeast
Asian countries; in the interests of brevity, we may refer to "Asian"experiences, Nevertheless, it should not be forgotten that there aremany poor countries in Asia: "Asia has more billionaires than any
other continent [but also] nearly twice as many people living inconditions of absolute poverty than the entire continent of Africa"(Swedish Foreign Ministry 1992, p.43). Moreover, several Asian
countries are transition economies, such as Mongolia, Vietnam, andNorth Korea.
There is no single Asian development model. This is even more
apparent now than it was for writers in the early to mid-1980s, as firstThailand and Malaysia, then Indonesia and China, established theircredentials as rapidly growing economies. Some of the success of the
NIEs may be attributable to initial conditions and other fortuitous
events, but the improved economic performance of the Association forSouth East Asian Nations (ASEAN) countries after adopting similar
policies "clearly attests to the importance of outward-looking policies"(Naya and Imada 1992, p.45). Eeonomic development has taken placein countries of widely varying cultural backgrounds, and under a wide
range of political regimes N from democratic to authoritarian. In the
People's Republic of China (PRC), for example, the southern provinceof Guangdong-which launched China's open policy in 1979 andcontinues to grow at an annual rate of 12-13percent - is led by suchleaders as communist party secretary Xie Fei, who opened the recent
provincial party congress with the maxim "poverty is not socialism"(Far Eastern Economic Review, 3 June 1993, p. 21).

The diversity among the countries of Asia is as great as thediversity in Africa, in terms of population size, climate, resource base,and culture (see Tables 1 and 2). Just as no single strategy was or
could have been used in all of Asia, no single strategy drawn from the
Asian experiences should be considered optimal for most or perhaps
any African country. At best we offer a number of recommendations

73
THE ASIAN DEVELOPMENT EXPERIENCE AND ITS RELEVANCE
TO AFRICAN DEVELOPMENT PROBLEMSTABLE 1
Basic lndicators

Population
Area StNPPCt Life
(Millions) (thousand Dollars GrowthRate Expectancy

mid-1990 square km.) 1990 1965-90 1990

Sub-Saharan Africa

Mozambique
Tanzania
Ethiopia

Somalia

Chad
MalawiBurundiZaire

UgandaMadagascar
Sierra Leone
Mali
Nigeria

15.7
24.5
51.2

7.8
5.7
8.5
5.4
37.3
16.3
11.7

4.1
8.5

802
945
1,222

638
1,284

118
28
2,345

236
587
72
1,240

115.5

924
1,267

Benin

7.7
7.1
9.0
4.7

Kenya
Ghana

24.2
14.9

Central African Rep.

3.0
3.6
8.1
5.7
2.0
1.8
2.6

Niger

RwandaBurkina Faso

Togo

ZambiaGuinea
Mauritania
LesothoLiberia

26
274
113
580
239
623
57
753
246
1,026

30
111

Sudan

25.1

2,506

Zimbabwe

9.8
7.4

Cameroon
Congo
Botswana

2.3
1.3

Mauritius

Ll

391
197
322
475
342
582
2

10.0

1,247

1.8
1.1

824
268

SenegalCote d'Ivoire

AngolaNamibia

Gabon

11.9
11.7

80
110
120
120
190
200
210
220
220
230
240
270
290
310
310
330
360
370
390
390
410
420
440
500
530
na
na
640
710
750
960

na

o.o
-O.2

TO.1
-1.1

O.9
3.4
-2.2
-2.4
-1.9
o.o
1.7
O.1
-2.4
1.0
1.3
-O.1

1.9
-1.4
-O.5
-O.1

-1.9

na

-O.6

4.9

na
na

O.7

-O.6

1,OIO
2,040
2,250

O.5
3.0
3.1
8.4
3.2

na
na

na
na

3,330

O.9

47
48
48
48
47
46
47
52
47
orl

42
48
52
45
48
48
50
59
55
49
54
50
43
47
56
54
50
61
47
55
57
53
67
70
46
57
53

for policies that might fit into an overall development strategy, a planthat must, to be effectively implemented, be embraced (if not designed)by national and local governments and bureaucracies.

The recommendations that follow are distilled from common
themes in the development policies of Asian countries over their mostsuccessful periods. They are not meant to be panaceas or magic
formulas. In fact, the adoption of any given policy without regard toSEIJI74

NAYA . ROBERT K.MCCLEERY''TABLE 1 -Continued
Basic lndicators
Population'(Millions)mid-1990

Area(thousandsquare km.)

tstNPPCt
Dollars GrowthRate
1990 1965-90

Life
Expectancy
1990

Other Africa

600
950

4.1
2.3

1,440
2,060
2,530

3.2
2.1
1.3

11,4905,400
11,160

6.2
7.1

6.5

74

7,510*

na

na

1,905

570

330
300
513

2,320
1,420

4.5
4.0
1.3
4.4

62
70
64
66

144
677

210

O.7

41.6

India

849.5

3,288

na

Nepal

18.9

350
170
380
470

na

1.9
O.5
2.5
2.9

52
61
59
52
56

52.1
25.1
8.1
25.1
35.9

2,382
1,221

5.8
42.8
3.0
20.2

1
99
1
36

Indonesia

178.2

Malaysia

17.9
61.5
55.8

Bangladesh

106.7

MyanmarEgypt, Arab

MoroccoTunisia
AlgeriaSouth Africa

Rep.

1,OOI

447
164

60
62
67
65
62

Asia
NIEs:

Hong Kong
Korea
Singapore

Taiwan78
71

ASEAN-4:

Philippines

Thailand

730

South Asia:

Pakistan

112.4

Sri Lanka

17.0

141
796
66

China

1133.7

9,561

370

5.8

70

Japan

123.5

378

25,430

4.1

79

71

* 1989Sources: World Development Report 1992 and Asian Development Outlook 1991.

the current policy environment may be as likely to hurt as to help

economic growth. There is no substitute for saving more out of
already meager incomes, working hard and productively for low pay,
exposing domestic firms to competition from efficient foreign firms andaccepting the fact that some will not survive, and taxing economic
activities fairly, while encouraging risk-taking and profit making.

When considering prospects for economic development, it isimportant to remember that there are no "basket cases." No matter
how grim prospects may seem for parts of Africa, one should takeheart from the fact that such currently dynamic economies as
Singapore, South Korea and Taiwan were viewed as hopeless afterAND ITS RELEVANCE75
THEASIANDEVELOPMENT EXPERIENCETO AFRICAN DEVELOPMENT
PROBLEMSTABLE 2Growth of Production
Avera e annualGDP

1965-80 1980-90

zzt lt1965-80 1980-90

rowth rate ( ercent).lt>!gl}}liaslS}ltu}g.fat

sutervlcesetc.

1965-80 1980-90

1965-80 1980-90

Sub-Saharan Africa

Mozambique

na

-O.7

3.9

2.8

Ethiopia

2.7

Somalia

3.5
O.1
5.5
7.1
1.9

1.8
2.4
5.9
2.9

Tanzania

Chad
MalawiBurundiZaire

UgandaMadagascar

Rwanda

O.6
1.6
2.7
4.2
6.0
O.3
4.9

Burkina Fasona

Sierra Leone

Mali
Nigeria
Niger

Benin

Zimbabwe
SenegalCote d'Ivoire

Cameroon
Congo
Botswana
Mauritius

AngolaNamibia
Gabon

4.0
1.4
-1.3
1.0

4.1
6.6

na
1.2

na
3.9
2.8
1.7
-3.4

na
na
na

3.3
2.7
2.0
3.1
2.5
2.5
2.4
2.6
2.3
3.3

na

-1.5

na

-3.2

-O.4

le.8

1.3

3.1

5.2

na

-1.7

-O. 6

7.9
3.6
5.5
2.3
5.2
1.2

O.2
6.7
5.2

-1.6

4.3
7.6
5.9
O.6

3.7
O.9
8.6
3.5
5.4
1.6
3.3
O.3
1.4
5.6
2.7

na

6.4
6.0

na
-3.7

na

O.7

L8

6.8

14.6
11.4

-1.0

na
na
na

1.0
2.6
5.8
4.9
4.0

na

na

na

-2.0

na

na

1.4

na

6.8

3.1

-O.7

na

na
na

na
na

na
na

2.9
3.0
O.5

na

2.4
3.1

na

3.3

O.3

4.2

1.0
1.6
3.6

10. 4

2.3
3.6

7.0
9. 9

10.2
6.8

11.3
6.0

9.7

-4.0
2.6
-O.5

13.5

5.3

na
na
na
na

10.8

2.8
4.3
2.0

Sudan

1.5

na

-O.3

-L4

5.6
5.1

2.2

Central African Rep.

Liberia

Ll

1.2

1.3
4.1
-O.1

O.8

2.1

6.8
1.3

Mauritania
Lesotho

2.8

1.6

3.3
3.6
3.3
1.0
2.7
5.4
3.7

Kenya
Ghana
Togo
ZambiaGuinea

3.9
1.8

na

2.1

3.8
5.0
2.3
6.8
5.1
6.2
13.9
5.2

na
na
9.5

4.3
2.8
4.2
3.0
1.5
l.6

na

O.4
2.3

5.0
1.6

2.1
1.9

2.9
1.4

3.1

na
na
na
na

O.7

na
na

1.0

na

10.5
2.5
5.3
6.8
5.3
2.2

3.j

4.5

na

na

1.1

na

na
na
na

na

3.9
4.9
1.8

3.0
O.7
3.5

2.9

4.9
5.7
o.o

41

-O.2

1.8

O.2

na

na

na

4.9
13.5

na
na

2.8
4.8

-4.6

1.4

na

7.2
1.1

6.5

na
na

4.9

O.8
5.6

na
na

na

3.4
2.9

11.8
4.8
4.7
11.5

-O.1

1.9

na
na
na
na

World Warll. In the 1960s, Singapore was regarded as "Asia's Cuba."
South Korea, devastatingly war torn and divided, with its agriculturalbase bereft of the mineral resources in the north, nevertheless emerged
within a generation of its civil war as a model of rapid and surprisingly

equitable economic development.

The outlook is indeed bleak for much of Africa. But economic
development is a long'term process. Societies cannot change overnight.

2.1

2.3
11.9
5.1

na

3.0

na

SEIJI76

NAYA. ROBERTK.MCCLEERYTABLE2 - Continued
Growth of Production
Avera e annualGDP

1965-80 1980-90

rowth rate

( ercent)zzt
lte
1965-80 1980-90 1965-80 1980-90 1965-80 1980-90-Stg:)dggfi.t-9!SZ;-e .rvlcesetC•.lttyZs}I}ugastg:ing.ft

Other Africa
7.3

5.0

2.7

2.5

6.9

5.7
6.5

4.0

2.4

6.4

6.1

3.6

5.5

2.3

9.9

na

3.1

na

na

3.7

1.3

3.0

4.3
2.6

8.6
9.9

7.1

Korea
Singapore

10.0

TaiwanASEAN-4:

9.7*

Indonesia

Malaysia

Egypt, Arab

MoroccoTunisia
AlgeriaSouth Africa

Rep.

5.6

4.3
3.8
6.0

13.7

6.7

7.1

4.1

6.4

3.0

na

-O.1

4.7

4.5
2.9
2.4

Asia
NIEs:

Hong Kong

na

na

na

-6.2

9.2
7.2

L5*

12.8*

8.2*

9.0*

9.7*

na

6.8
11.2

12.5
8.8
O.1
8.9

7.3

na

3.9
4.6

3.2
3.8
1.0
4.1

12D

na

5.0
7.4

6.7
4.2
2.6
7.8

O.6

2.6

2.8

2.8

3.6

5.8

na

na

na

na

na

1.1

4.8
4.3
2.3

5.7
3.2

7.7
6.3

8.9
7.8

L8*

7.0

5.5

4.3

7.4
5.7
7.3

5.2

Bangladesh

1.7

4.3

Myanmarna

na

Thailand

na

9.6
9.1

8.5*

O.9
7.6

na

12.7
6.6

6.4

Philippines

na

18.7
13.2

3.0
2.8

9.7

2.8

South Asia:

India

Nepal
Pakistan
Sri Lanka
China
Japan

3.6
1.9
5.2
4.0

5.3
4.6
6.3
4.0

6.8
6.4

9.5
4.1

2.5

3.3
2.7
2.8
-O.6

3.1

6.l

1.3

4.5

na

7.1

4.4

na

na

14.4

11.9
6.8

5.3

5.9

4.6

na

6.5

na

6.9
4.7
9.1

3.8

Notes: Figures in italics are for industry other than manufacturing.
'For Taiwan, figures are growth rates for valued added in the periods 1971-80 and
1981-90.

Sources: World Development Report 1992 and Asian Development Outlook 1991.

Economies take time to grow, adjust, and develop. With Africa's
abundant natural and human resources (though unevenly distributedand developed), it can certainly build a more prosperous future.
In the sections below, we will first contrast the post-war development

experiences of Asia and Africa with regards to the four main "gaps,"
or fundamental challenges of development: the agricultural (basic
needs) gap, human resource development, savings and investment, andforeign exchange. Closing or eliminating these gaps allows a country
to grow according to its underlying potential (which may still be quite
different in different societies).

THE ASIAN DEVELOPMENT EXPERIENCE AND ITS RELEVANCE 77
TO AFRICAN DEVELOPMENT PROBLEMS
The third section of the paper looks directly at differences in

economic policies in the two regions and how those differences
contributed to different outcomes. In particular, policies led to theclosing or effective management of the four gaps in many - albeit not
all - Asian countries, and the widening of the gaps in most - but not

all-African countries. The role governments seek to play in theirsocieties and what the populace expects from government will also be
discussed. In addition, the paper touches upon the role of culture ineconomic development and the impact of external factors on domestic
economic policies and performance.

ll. The Four Development Gaps
A. The Agricultural (Basic Needs) Gap

Without exception, the success stories in Asia have beencharacterized by the expansion of the provision of basic human needs -food and shelter - to the vast majority of the population. The properdevelopment of agriculture and meeting the society's basic needs form
the basis for filling the other development gaps, particularly the humanresource gap, which involves nutrition, health, education, and training.
Only a population with its basic needs met can be further cultivated asa resource. The burden on other resources of closing the
agriculture/basic needs gap is directly related to the growth rate of
the population (see Table 3).2

Despite the widely known fact that growth in manufacturingexports is the single most remarkable feature of the performance ofthe dynamic Asian economies, agriculture played an important role in
the growth of all but the city-states of Hong Kong and Singapore.
According to James (1990), "the empirical record of economic growth

2 For a thorough and balanced study of the impact of population growth on
economic development, see Johnson and Lee et. al. 1986. For example, they feelthat the reduction in fertility in China had a positive effect on per capita
agricultural income, but that the agricultural policy reforms begun in 1979 weremore important. While noting that some problems and inefficiencies in Africa
may be due to the sparseness of population, the authors state on page 89 that "Incontrast (to China), tropical Africa has a comparatively high land/population
ratio, but appears to be particularly vulnerable to problems induced by population

growth."SEIJI78

NAYA. ROBERTK.MCCLEERYTABLE3Population Growth and Projections

Population

Annual Growth of Population-(cent)1965-80(Millions)

1980-90

1989-2000

1990

2000

2025

3.0
3.1

16
25

21

51

71

42
64
156

Sub-Saharan Africa

Mozambique

2.5

2.6

Tanzania

2.9
2.7

3.1

2.9
2.0
2.9
1.9
3.1

3.1

2.5

Sierra Leone

3.0
2.5
2.0

Mali

2.1

Nigeria
Niger

2.5
2.6
3.3
2.1

Ethiopia

Somalia

Chad
MalawiBurundiZaire

UgandaMadagascar

RwandaBurkina Faso
Benin

Kenya

Ghana
Central African Rep.

Togo

2.7
3.6
2.2
1.8

3.1

2.4
3.4
2.8
3.2'
3.0
2.4
2.5
3.2
3.3
3.3
2.6
3.2
3.8
3.4
2.7

Sudan

3.0
3.0
1.5
2.4
2.3
3.0
3.0

Zimbabwe3.1

Senegal

2.9
4.1

2.7
3.4
2.9
3.8

2.7

3.0

2.8
3.6
1.6
2.8
2.4
3.6

3.4
3.3
1.0
2.6

ZambiaGuinea
Mauritania
LesothoLiberia

Cote d'Ivoire

Cameroon
Congo
Botswana
Mauritius

AngolaNamibia

Gabon

3.5
3.7
2.5
2.4
2.7
3.1

3.2
3.6

3.4
3.1
2.7
3.4
3.1

3.0
3.3
2.8
2.6
3.0
2.8
3.3
3.9
2.9
2.9
3.5
3.0
2.5
3.2
3.1
2.8
2.8
2.6
3.0
2.8
2.4
3.1

33

8
6
9
5

7

37
16

50
23

11

21

7

12

15

4
8

5

115

153

8
7
9
5

11

6

24
15

34
20

14
24
14
89
42
26
10
23
255
24
23
22
10
64
34

3
4
8
6
2
2
3

4
5

6
9

11

20
15

25
10

12

11

10
12

8
3
2
3

5
4
6
55
18
19
31
28

3.5
2.9

12
12

33
12
10
17
16

3.3

2
1
1

3
2
1

6
2
1

10

13

27

2
1

2
1

4
3

2.5
O.9
3.0
3.0
2.8

7

and development in Asia over the past three decades convincingly
demonstrates that countries neglecting agriculture tend to grow much
more slowly than those that pursued agricultural development earlyon."

One critically important aspect of the success of Asian
agricultural development has been land reform. In Japan, South Korea,

and Taiwan, the implementation of agrarian reforms laid the

79
THEASIANDEVELOPMENT EXPERIENCE AND ITS RELEVANCE
TO AFRICAN DEVELOPMENT PROBLEMSTABLE 3- Continued
Population Growth and Projections
Annual Growth of Population-( t)

Other Africa

Egypt, Arab

MoroccoTunisia
AlgeriaSouth Africa

Rep.

Population(Millions)

1965-80

1980-90

1989-2000

1990

2000

2025

2.1

2.4

2.5
2.1
3.1

2.6

1.8
2.4
1.9
2.8
2.2

52
25
8
25
36

62
32
10
33
45

86
47

43

2.4

2.3
3.0
2.4

14
52
65

Asia
NIEs:

Hong Kong

6

6

7

1.1

O.8
O.9

Singapore

2.0
2.0
1.6

2.2

1.2

Taiwan

na

20

4

1.9

3

na

na

na

2.4
2.5

1.8
2.6
2.4
1.8

1.6
2.3
1.8

178
18
61
56

209
22
74
64

275
32
101
84

2.3
2.1

1.8
2.0

128
51

176
70

2.1

L7

1,O06

1,348

2.6
3.1

2.5
2.7

1.4

1.1

107
42
850
19
112
17

24
147
19

37
240
24

Korea

1.4

47

3

54

ASEAN-4:
Indonesia

Malaysia
Philippines

Thailand

2.8
2.9

1.4

South Asia:

Bangladesh

Sri Lanka

2.6
2.3
2.3
2.4
3.1
1.8

China

2.2

1.4

l.3

1,134

1,294

1,597

Japan

1.2

O.6

O.3

124

128

128

Myanmar
India

Nepal
Pakistan

Sources: World Development Report 1992 and Asian Development Outlook 1991.

foundation for agricultural development and more equitable distributionof the fruits of economic growth. A vigorous smallholder promotion
scheme in Malaysia contributed to agricultural development. In contrast,

several attempts at land redistribution in the Philippines resulted in"spectacular failure" (Hill 1993, p.17). More successful Asian
economies invested in the infrastructure, institutions, and organizations

important for rural development, and adopted realistic taxation policies

so that "explicit or implicit taxation of agriculture was of limited

extent or duration" (Naya and Imada 1992, p.51). A sharp rise inagricultural productivity contributed to some or all of the following
benefits for the dynamic Asian economies: (1) the release of labor to80 SEIJI NAYA.ROBERT K.MCCLEERY
manufacturing activities in the cities; (2) the provision of foreignexchange (either directly through exports or through savings on foodimports); and (3) the lowering of urban food prices, inflation, and thuspressures for wage increases.
The green revolution and its technologies were crucial for Asia,
using the abundant water and labor intensively, along with fertilizer, togenerate high yields and thus economizing on scarce land. Yet Japanand Taiwan (and to a lesser extent, South Korea) were successful even

before the dissemination of the new technologies. Furthermore,
Malaysia in particular has gone beyond a simple adaptation of newtechnologies developed elsewhere for tropical agriculture to develop oneof the leading research programs and outreach efforts in developing ordeveloped countries (Roemer, Tomich, and Vincent 1993). Other foodproducts have been important since the mid-1970s, especially for

Malaysia and Thailand, where income growth has substantiallydecreased the fraction of rice in total caloric consumption andincreased demand for animal protein and feed (primarily maize).
"While the Green Revolution in rice has attracted the attention of those

who are hopeful of deriving lessons from the Southeast Asianexperience, it is important to note that edible oil, maize, and cassava

production also made important contributions both to increasing
domestic food consumption and to exports. ...It is clear, particularly

for Malaysia and Thailand, that food commodities other than riee are
driving production growth, maize and cassava in Thailand and edibleoil in Malaysia" (Goldman 1993). Thus, whereas any mention of Asianfood production must begin with the green revolution - which is not

generally transferable to Africa without massive investments in
irrigation, fertilizers, and at a tremendous cost in foreign exchange that is not the end of the story. Many of the policies used to increase
yields in maize, edible oils, and other food products had more modest

infrastructure requirements and may be more appropriate for Africa.

Table 4 lays out the contrasting agricultural performancestatistics of Asian and African countries. The three largest increases

in food production per capita among all low and middle income
developing countries from 1979m81 to 1987-89 were in Malaysia, China,
and Indonesia, where policies conducive to agricultural growth were
instituted or strengthened during the period. The cases of China andIndonesia in particular provide compelling evidence to refute the claim

AND ITS RELEVANCE81
THEASIANDEVELOPMENT EXPERIENCETO AFRICAN DEVELOPMENT
PROBLEMSTABLE 4Agriculture

Proportionof GDP (9e6o)
1965
1990

Growth Rate%

1965-80

Index of Food Output(1979-81-100)

1980-90

1988-90

Sub-Saharan Africa

Mozambique
Tanzania
Ethiopiana
46
58

Somalia71

Chad
Malawi42
seBurundina

Zaire

UgandaMadagascar
Sierra Leone

Mali
Nigeria

Niger

RwandaBurkina Faso
Benin

Kenya
Ghana
Central African Rep.

Togo
ZambiaGuinea
Mauritania
Lesotho

20
52
25
34
65
55
68
75
37
59
35
44
46
45
14

na

Mauritius

32
65
27
54
18
25
47
33
19
34
16

AngolaNamibiana
na

Liberia

Sudan
Zimbabwe
SenegalCote d'Ivoire

Cameroon
Congo
Botswana

Gabon

26

65
59
41
65
38
33
56
30
67
33
32
46
36
36
38
32
37
28
48
42
33
17
28
26
24

na
na
13
21

1.3

81

1.6

4.1

1.2

-O.1

na

3.3
2.7
2.0
3.1
2.5
2.5
2.4
2.6
2.3
3.3

88
84
94
85
83
92
97
95
88
89
97
106

na

-O.3
4.1

6.6

na
1.2

na
3.9

2.8
1.7
-3.4

na

na
na
na

-1.5

5.0
1.6
2.1
1.9
2.2

na
-2.0

na
na

2.9

na

47
27

1.4
3.3
4.2

13

3.3
3.6
3.3
1.0
2.7
5.4
3.7

na

O.7
-O.7

na
na

2.4
3.1
1.e

3.l

1.6
3.6

3

9.7

-4.0

12
13

na
na
na
na

11

9

2.6
-O.5
-O.1

na

71
77
114
112
I06
97
91

88
103
87
85
86
84
71
94
102
101
89
94
75
100
81
93
84

that macroeconomic reforms and openness only serve the benefit richindustrialists.

In China agricultural reforms begun in 1979 with the introductionof the "production responsibility system," which transformed
agriculture and greatly benefitted rural residents. By breaking up thecommune system, contracting production down to the household level,raising procurement prices, and allowing for market-based prices at

SEIJI82

NAYA . ROBERTK.MCCLEERYTABLE 4-Continued
Agriculture

Growth Rate

Proportionof GDP (SO}6)
1965
1990

fo}6
1965-80

1980-90

2.7

2.5

2.4

6.4

5.5

2.3

na

4.3
2.6

Index of Food Output(1979-81-100)
1988-90

Other Africa

Egypt, Arab

29
23
22

118
128
87
96
87

10

17
16
16
13
5

Hong Kong

2

o

Korea

38

3.0
2.8

2.8
-6.2

na

80
106
69

MoroccoTunisia
AlgeriaSouth Africa

Rep.

na

3.0

Asia
NIEs:

na

Singapore

3

9oTaiwan

17*

4

1.8*

L5*

na

Indonesia

51

22

4.3

Malaysia

28
26
32

na
22
12

3.9
4.6

na

3.2
3.8
1.0
4.1

123
147
84
106

Bangladesh

53

38

O.6

2.6

Myanmarna

na

ASEAN-4:

Philippines

ThailandSouth Asia:

31

2.5

3.1

60
26
26

1.1

Pakistan
Sri Lanka

44
65
40
28

3.3
2.7

4.8
4.3
2.3

96
93
119
115
101
87

China

38

27

2.8

6.1

133

Japan

10

3

-O.6

1.3

101

India

Nepal

na

na

*Figures for Taiwan are for 1970, 1990, 1971-80 and 1981-90, respectively.

Sources:World Development Report 1992 and Asian Development Outlook 1991.

the margin (after output quotas had been met), the PRC agricultural
sector was able to exceed a 7 percent annual average increase of grossvalue of agricultural output from 1978 to 1984 (more than twice therate achieved over the previous two decades). Farmers' incomes in 1983
were 2,3 times that of 1979 in nominal terms, outstripping the growth ofurban incomes, even though the urban/rural income ratio in realterms was still over 2:1 (World Bank, "China: Agriculture to the Year

2000," 1985, p.9, 13). Although some top Chinese officials seemdiscouraged by the seemingly stagnant performance of grain output
since 1984, overall agricultural output in China has continued to growat a high rate; anomalies in the agricultural data or overemphasis on

THE ASIAN DEVELOPMENT EXPERIENCE AND ITS RELEVANCE 83
TO AFRICAN DEVELOPMENT PROBLEMS"the grain problem" should not obscure the fact that the household
responsibility system has made and continues to make a remarkable
contribution to China's agricultural development (Johnson 1990, pp.
116-119).

Policies that have been tremendously successful in generating
manufacturing exports in Asiap countries have spurred food production
as well. The only caveat to this strong statement is that several other
Asian countries who did not substantially change policies (e.g., Laosand Myanmar) or began to shift only late in the period (e.g., India andVietnam) also recorded substantial, though smaller, gains.

The picture for African countries is almost completely reversed.
Only four sub-saharan African countries recorded any significant
increases: Burkina Faso, Benin, Ghana, and Senegal,3 and perhaps onlyin Ghana can the increase be directly tied to policy changes. Far more

serious is the situation in the rest of Africa, typified by theperformance in the world's four poorest countries: Mozambique,
Ethiopia, Tanzania, and Somalia. In these countries, per capita foodproduction dropped by 3 to 17 percent. While factors less subtle thaneconomic policies - such as war - affect the figures for individual
counties, the widespread decline throughout Africa is clear evidence ofa net policy bias against food production and food producers, generally
a numerous and already impoverished group. The consequences of thestagnation or decline in food production are increased human sufferingand increased reliance on commercial grain imports and/or aid.
It is, of course, not crucial for all countries in the region to be
self-sufficient in food production. If the stagnation in food production

were due to African countries specializing in other agricultural
products such as coffee, cocoa, cotton, etc. in which they hold acomparative advantage, then trading with countries such as the U.S.
(where 26 percent of the annual U.S. corn harvest is stored, with thepotential for expansion of output if export demand increased), thenthere would be no problem. Yet similar declines in export crops wererecorded in many of the same countries.
In sum, agricultural development in Asia provided the foundation
for industrial growth. Agriculture proved to be a source of savings

3 The tiny country of Comoros (with a population of half a million) actuallyregistered the highest increase.

84 SEIJI NAYA•ROBERT K.MCCLEERY
and foreign exchange for investment in other sectors, as well as

providing income to farmers with which they could purchase
manufactured goods. Taiwan's integration of agricultural development
and industrialization is perhaps the most successful in the world(Roemer in Winrock International 1991, p.51). African counties may beable to learn from Asian development experience. Not all countries
should strive for food self'sufficiency, but neither should agriculturaldevelopment be neglected.
'

B. Human Resource Development

Frequently one hears that social development and economic
growth are in conflict. By competing for resources, they vie forpriority among a country's long-term goals. Asian experiences showthat this need not be the case; some countries have achieved both. The

human development indicators of South Korea and Taiwan, forexample, rival developed countries in many areas.

There are four basic issues in human resource development(HRD): how much of the society's resources can be devoted to HRD,
how effectively those resources can be translated into services, howwell services can be targeted to specific segments of the population,and how consistent the pattern of HRD is with the pattern of economic

growth. To illustrate, let us consider the experience with HRD inseveral Asian countries.

Investment in people has been a focal point of East Asiandevelopment. One key has been the initial emphasis on labor-intensive
industries, which, through raising the demand for labor, raised incomesand spread the benefits of growth relatively equitably throughout thesociety. High rates of public sector spending on HRD were augmented
by considerable private spending, especially for education. In East

Asia, relatively homogeneous societies, good infrastructure, andwell-developed institutions enabled human resource services to bedelivered at a reasonable cost. No major segments of the population
were passed over for reasons of ethnicity, gender, caste, or geography.

Economic growth provided opportunities for newly developed health,education, and skills to be utilized in productive employment;
employment in turn provided higher incomes, a portion of which wasspent to further augment HRD, thus forming a virtuous cycle.

AND ITS RELEVANCE85
THEASIANDEVELOPMENT EXPERIENCETO AFRICAN DEVELOPMENT
PROBLEMS
In some Asian countries, parts of the cycle were either lacking or

weak. High levels of spending on public sector enterprises andexorbitant defense expenditures squeezed out HRD in South Asia, withthe exception of Sri Lanka and the neighboring Indian state of Kerala.
Poor roads, communications, and a harsh geography made provision ofbasic services extremely costly in parts of India, Nepal, Bhutan,

Indonesia, the Philippines, and parts of Indochina and the PRC.
Cultural attitudes toward women, the Caste system, tribal peoples withindigenous languages in Southeast Asia, "border peoples" in MyanmarN

Bangladesh, Myanmar-Thailand, Indonesia-Malaysia (Borneo),Indonesia-Papua New Guinea and elsewhere, all contribute to unequal
access to health services, education, and other aspects of HRD services.

Economic stagnation contributed to the inefficient use of humanresources in the Philippines and in all of South Asia, particularly Sri

Lanka. In the Philippines and Sri Lanka, discontent among the
educated unemployed contributed to social unrest. (For the Philippines,

emigration eased social problems and provided some return on theinvestment in higher education in the form of foreign exchange
remittances).

(1) Health
In Africa, the health situation is more grave than in virtually anyof the Asian countries (see Table 5). The infant mortality rate
provides a good picture of nutrition and health care in developing
c6untries. Every single low-income country in Africa is below averagefor the group of low'income countries, and many (13 of 24), including

but not limited to the poorest, have more than twice the infantmortality rates of the group. China and Sri Lanka stand out ascountries whose provision of health and welfare related services has far

outpaced their economic development. In China, for example, between
1970 and 1990, life expectancy increased from 61 to 70, and infantmortality rates declined while daily per capita calorie intake increased

significantly. UNICEF considers China an example of "how the health,education, and welfare of children can be dramatically improved evenat a low level of national income" (Swedish Foreign Ministry 1992,
p.210).` In contrast, no country in Africa is immune from the charge
4 One must add that studies of international purchasing power conclude that China's

SEIJI NAYA . ROBERTK.MCCLEERY86

TABLE 5
HealthPopulation
Per Physician(thousands)
1965

Infant mortality

Daily calorie

rate (per 1,OOO
live births)(per capita)

supply

1984

1965

1990

1965

1989

na

179
138
165
165
183
200
142
141
119
201
208
209
162
180
141
190
166
112
120
157
153
121
191
178
142
176
160
103
160
149
143
129
112

137
115
132
126
125
149
107
94
117
116
147
166
98
128
120
134
113
67

1,712
1,831
1,853
1,718
2,395
2,259
2,131
2,187
2,361
2,447
2,O14
1,938
2,185
1,996
1,856
1,882
2,O19
2,208
1,937
2,055
2,454
2,072
2,187
1,903
2,049
2,158
1,938
2,075
2,372
2,352
2,Oll
2,260
2,045
2,269
1,907
1,900
1,950

1,680
2,206
1,667
1,906
1,743
2,139
1,932
1,991
2,153
2,158
1,799
2,314
2,312
2,308
1,971
2,288
2,305
2,163
2,248
2,036
2,214
2,077
2,132
2,685
2,299
2,382
1,974
2,299
2,396
2,577
2,217
2,590
2,375
2,887
1,807
1,946
2,383

Sub-Saharan Africa

Mozambique
Tanzania
Ethiopia

Somalia

Chad
MalawiBurundiZaire

UgandaMadagascar
Sierra Leone

Mali
Nigeria
Niger

RwandaBurkina Faso
Benin

Kenya
Ghana
Central African Rep,

Togo
ZambiaGuinea
Mauritania
LesothoLiberia

Sudan
Zimbabwe

18.0
21.7
70.2
43.8
72.5
47.3
55.9
34.7
11.1
10.6
16.8
51.5
29.5
65.5
72.5
74.0
32.4
13.3
13.7
34.0
23.2
11.4
47.1
36.5
20.1
12.6
23.5

25.0
78.8
20.0
38.4
11.3
21.0
13.5

na

9.8
13.6
25.4
6.4
39.7
35.1
57.2
15.9
10.1

20.4

na

8.7
7.2

na

11.9
18.6

9.3
10.2

8.0

6.7

Cameroon
Congo
Botswana

19.5
20.6
26.7
14.2
27.5

na
na
na
na

Mauritius

3.9

6.9
1.9

AngolaNamibia

13.2

17.8

na
na

na

SenegalCote d'Ivoire

Gabon

2.8

65
192
145
153

85
101

88
82
138
121

93
136
102

49
81
95
88
116

38
20
130
100

97

exchange rate is extremely undervalued, thus standard comparisons of per capita
income in dollar terms understate China's level of development, perhaps by asmuch as a factor of four (Summers and Heston 1991). Yet a correction of income
measured for purchasing power parity does not alter the basic conclusions ofeither the cited report or this paper r that Asian countries devoted more public
and private resources to HRD relative to their incomes, while African countries
seem to devote less, with less effect, than their more successful Asian counterparts.

AND ITS RELEVANCE87
THEASIAN DEVELOPMENT EXPERIENCETO AFRICAN DEVELOPMENT
PROBLEMSTABLE5-Continued
HealthPopulation

Infant mortality

Daily ealorie(per capita)
1965

1989

66
67
44
67
66

2,399
2,112
2,217
1,701
2,759

3,336
3,020
3,121
2,866
3,122

7

2,853
2,852
3,198

1965

1984

rate (per 1,OOO
live births)
1990
1965

Per Physician(thousands)

supplyOther Africa

Egypt, Arab

Rep.

2.3

O.8

145

Morocco

12.1

4.7

145

Tunisia
AlgeriaSouth Africa

8.0
8.6
2.1

2.2
2.3

145
154
124

2.5
2.7

1.1

Korea
Singapore

1.9

1.4

27
62
26

7

2,486
2,178
2,285

Taiwan

na

na

na

na

na

na

Indonesia

31.7

Malaysia

6.2

9.4
1.9
6.6
6.3

128
55
72

88

61
16
41
27

1,791
2,353
1,875
2,138

2,750
2,774
2,375
2,316

144
122
150
171
149
63

105
64
92
121
103
19

1,970
1,897
2,021
1,889
1,773
2,171

2,021
2,440
2,229
2,077
2,219
2,277

na

Asia
NIEs:

Hong Kong

1.2

17

ASEAN-4:
Philippines

Thailandna

7.2

South Asia:

Bangladesh

Nepal

4.9
46.2

Pakistan
Sri Lanka

5.8

6.4
3.7
2.5
30.2
2.9
5.5

China

1.6

1.0

90

29

1,929

2,639

Japan

1.0

O.7

18

5

2,668

2,956

Myanmar
India

8.1
11.9

na

Source: World Bank, World Development Indicators, World Development Report 1992.

that neglect of this aspect of HRD has hampered development efforts.
Even at higher levels of income, African countries are often outliers,

with infant mortality rates two to three times higher than incomparable countries (Cote d'Ivoire, Congo, Cameroon, Namibia, andGabon) .

One specific health challenge is how to cope with the AIDS
epidemic sweeping across equatorial Africa. In Zambia, 43 percent ofsoldiers tested positive for the HIV virus, as did 36 percent of pregnant

woman. Thirty percent of supposedly healthy relatives of the AIDS
patients, when screened for blood donations, also tested positive for the

88 SEIJI NAYA.ROBERT K.MCCLEERY
virus. In Sub-Saharan Africa as a whole, one adult in 40 is HIV
infected, as are nearly one million children (Human Development
Report 1992, p. 14). The World Health Organization estimates that atleast 6.6 million adults in Africa are infected with the AIDS virus, andthat by 1994 the figure will have risen to 10 million (GCA 1992 Annual
Report, p. 13).

While the rise in the death rate to date represents only the tip of
the iceberg, deaths of people in the prime of life are already cutting

into the scarce supply of skilled labor. To cope with the risingmortality rates, private companies and government agencies alike must

train more employees and managers than they anticipate needing.
Corporate heads and policymakers are not immune, either. Individual
African countries and the world community as a whole must respondto this crisis. Although Asia by no means has all of the answers,
something in this area too can be learned from certain anti-AIDs
programs, specifically in Thailand.

(2) Education

In terms of an educational system, what is needed in LDCs is a

structure which starts by emphasizing primary, secondary, andvocational education. Over time, a country needs to increase the size ofthe pool of skilled labor and the ratio of skilled to unskilled workers.

Skills can and should be developed not only in the classroom, but also

on the job, through learning-by-doing. Japan, South Korea, Taiwan,
Singapore - all these economies have reaped the rewards of investment
in education, leading to highly skilled labor forces. In some countries,

the educational investments have still not been enough, leaving thehuman resource gap incompletely filled. Thailand's investment inprimary education, for example, has paved the way for development sofar, but future progress is clouded by the lack of adequate secondary
educational foundations.
Studies of the social value of education in developing counties
identify primary education as the level at which returns are highest.5
The percentage of the population completing at least a fourth grade
5 While this general conclusion holds across countries and regions, it is disturbingthat estimates for Afriea are much lower in abso}ute terms, indicating major

THE ASIAN DEVELOPMENT EXPERIENCE AND ITS RELEVANCE 89
TO AFRICAN DEVELOPMENT PROBLEMS
education is a guide to the capability of a country's labor force toperform simple industrial jobs requiring limited literacy and numeracy.
Furthermore, female education is particularly important. Information
about family planning, nutrition, and health - including information on
how to stop the spread of the AIDS virus - can only be effectivelytransmitted to households through female literacy.
In terms of these basic educational levels, the picture looks a bit
better for Africa than does the situation in health (see Table 6). A few

counties have an overwhelming majority of the latest cohort completingthe fourth grade, even among the low income countries (e.g., Tanzania,

Zambia, Ghana, Mauritania, Burkina Faso, and Niger); and others(Burundi, Rwanda, Cameroon, and Zimbabwe) are making rapid
progress toward achieving that leveL In contrast, several countries inAfrica are experiencing stagnation or even retrogression in theprovision of basic education to their populations. The pressure of
rapid population growth is only one of several factors. In fact, theentire basic educational system in some countries appears to be indisarray or decay. These countries include Benin, Zaire, Ethiopia,
Kenya, and Togo. Severe data problems limit the value of numericalcomparisons. The basic problems may be more or less severe in agiven country than the figures indicate, or just as severe in countries
for which data are not available or are not as startling.

Most countries are making improvements in extending basic
education to the female population. Yet there are still only about two
female pupils per three male pupils in primary schools, an one per twoor three in secondary schools throughout much of Africa. Zaire is afairly typical case for low'income Africa, with the ratio of female tomale students rising from O.48 to O.73 in primary and from e.15 to O.43
in secondary schools between 1965 and 1989. In no country is thegender inequality in education increasing (with the possible exceptionof secondary education in Mozambique); only in a few countries Chad, Benin, and Guinea - does female education seem to be stagnating
at a low level.

differences in the quality of basic education in the two regions (Glewwe 1991).
Improvements in the quality of education would raise the private rate of return toinvestments in schooling, thus eliciting better attendance and other,complementary private investments.

SEIJI90

NAYA . ROBERTK.MCCLEERYTABLE 6
Education
Percenta e of a e-t1965 1989

rou

enrolled-S dar1965 1989

in education

-tt

Adult

illiteracy

-( t)

1965

1989

o
o

o

67

o

na
na

1990

Sub-Saharan Africa

Mozambique
Tanzania
Ethiopia

Somalia
Chad

MalawiBurundiZaire

UgandaMadagascar
Sierra Leone

Mali
Nigeria
Niger

37
32
11
10

34
44
26
70
67
65
29
24
32
11

Rwanda53

Burkina Faso
Benin

12
34
54
69
56
55
53
53
13
94
41
29
110
40
60
94
114
65
101
39

Kenya
Ghana
Central African Rep.

Togo
ZambiaGuinea
Mauritania
LesothoLiberia

Sudan

Zimbabwe
SenegalCote d'Ivoire

Cameroon
Congo
Botswana
Mauritius

AngolaNamibia

Gabon

na

134

68
63

3

5

2

4
15

38

2

na

2

57
67
71

1

7

2

4

1

4

5

24
13
19
18

78
77
92
53
23
70
28
69
35
65
94
75
64
103
95
95

4
8
5
4
5

6

19

1

6

2

7

1

7

3

na

2

13

23
39

2

11

5

22
20
20
16
26

7
7

51

1

110

4

na
na

5

125
58

na

4
6
7

na

6

101

5

na

10
3

na
na

o
o

na

1

na
1

o
o
o
o

1

1

4

o
o
o

na
o
o
o
o
1

na

1

2
1
1

na
3

72

50
82
77
31
40
62
57
27
76
66

1

2
2
2
1

na
na
na

2
2

3

o

4

1

3
3
6
3

o

na

1

1

o
o

111
103

26

37
53

94

5

11

3
o

na
na

na
na

na
na

na
na

na

50
28
52
20
79
68
49

1

3

52
16
20
26

na

1

o

1

76
70

na
61

na

73
33
62
46
46
43
26

2

na

3
6
3

na
na
4

58

na
39

Finally, an important issue in African human resource
development is the brain drain from the continent. By 1987, nearly athird of Africa's skilled people had moved to Europe, impairing Africa's

capacity to govern and to train a new generation of professionals.
Estimates put the drain of middle-and high-level managers from Africa
at up to 60,OOO between 1985 and 1990. In Ghana, 'for example, 60
percent of doctors trained in the early 1980s are now abroad. In 1978

AND ITS RELEVANCE91
THEASIANDEVELOPMENT EXPERIENCETO AFRICAN DEVELOPMENT
PROBLEMSTABLE 6-Continued
Education
Percenta e of a e rou enrolled in

-Scod
-Prma
1965
1989
1965
1989

education Adult illiteracy

Mterta1965 1989-(1990t)

Other Africa

Egypt, Arab

MoroccoTunisia
AlgeriaSouth Africa

Rep.

75
57
92
68
90

97
68
115
94

26
11
16

81
36
44
61

7

20

1

11

2

8

1

11

51
35
43

na

15

na

4

na

na

29
35
45

73
86
69

5

6

na

na
na

10

na
na

na'

na

7

Asia
NIEs:

Hong Kong

103

Korea

101

Singapore

105

105
108
110

TaiwanASEAN-4:

na

na

na

na

Indonesia

72
90
113
78

118
96
111
86

12

28
41

47
59
73
28

Bangladesh

49

Myanmar

71

India

74
20
40

93

70
103
98
86
38
107

China

89

Japan

100

Malaysia
Philippines

Thailand

38

na

1

na

2

7

19

28

23
22
10

2

16

7

17

1

4

65

1

5

5

na

1

6

2

5

35

24
43
30
20
74

2

4

19
52
74
65
12

135

24

44

o

2

27

102

82

96

13

31

na

14

South Asia:

Nepal
Pakistan
Sri Lanka

13
15
27
5

12

Source: World Bank, World Develoopment Indicators,

World Development Report 1992.

alone, Sudan lost 17percent of doctors and dentists, 20percent of
university teaching staff, 30percent of engineers and 45percent ofsurveyors (Human Development Report 1992, p. 57). Although there areno easy answers, it would be worthwhile to consider the experience ofSouth Korea. It successfully overcame its brain drain problem by
actively recruiting back expatriate professionals. To do so, salaries
offered had to be reasonable and competitive.
With the exception of several }ow-income countries in South Asia,
it is clear that Africa is starting at a tremendous disadvantage relative

to Asia in the critical area of human resource development. The

92 SEIJI NAYA.ROBERT K.MCCLEERY
tt 'challenge facing both domestic policy makers and external aid
organizations is dauntingl to reallocate spending and mobilize new
resources for HRD; to make the provision of services more efficient

despite considerable geographical, social, institutional, andinfrastructural difficulties; to target overlooked groups based on
ethnicity, gender, geography, or religion; and to remove obstacles tolabor-intensive growth. As Asia has amply demonstrated, rapid
expansion of employment opportunities is the best way to combat
poverty and inequality. Employment generates private savings andinvestment (including investment in HRD), as well as tax revenues forcomplementary public investment programs.

C. The Savings/lnvestment Gap
The mobilization of domestic savings has played a critical role in

Asian development. Those scanning macroeconomic data on thedeveloping Asian economies are often most struck by the high rates ofsavings and investment in the region (see Table 7). This was notalways true, and as will be illustrated in the next section, thisachievement illustrates the importance of both macroeconomic stability

and appropriate policies. South Korea and Singapore increased theirsavings rates from five to ten percent in the early 1960s to 37 and 45
percent respectively in 1990. Indonesia's savings rate varied from O to

8 percent in the mid-1960s before rising to 37 percent in 1990.
Consistently high savings rates fueled and were further boosted by
rapid growth.
In Africa, savings rates have been low and widely fluctuating, as
illustrated in Table 7. There is a clear distinction between the havesand have-nots in terms of resources. Savings reflect resource
endowments, and vary widely with terms of trade shocks. The threerichest countries in terms of marketable resources - Botswana, Gabon,and Nigeria - all exhibit routine fluctuations of about 10 percentage
points in their in their savings rates, with peak fluctuations of 18 to 20

percent (IMF 1992). Such variance puts incredible stains on
development planning and fuels boom and bust cycles, exacerbating thehigh level of uncertainty and risk characteristic of developing
economles.

Conversely, the poorest countries in Africa save less than 10

THEASIANDEVELOPMENT EXPERIENCEAND ITS RELEVANCE93
TO AFRICAN DEVELOPMENT
PROBLEMSTABLE 7
Savings and lnvestment
Gross Domestic
Savings

Gross Domestic
Investment(SO)6 of GDP)(% of GDP)

1965

1990

1965

1990

na

-12

na

16
12

-6

15

6

13
11
12
14
6
17

37
25
13
16
10
19
19
11
12
17

Sub-Saharan Africa

Mozambique
Tanzania
Ethiopia

Somalia

Chad
MalawiBurundiZaire

UgandaMadagascar
Sierra Leone

Mali

8
6
o
4

22
-15
10

16
12

na
-1

11

o
8
5

8
5

12

11

18

26
15

1

10
29

Nigeria

10

Niger

na

Benin

3
5
4
3

Kenya
Ghana

15

18

8

11
-2
11

RwandaBurkina Faso

4
5
2

7

15
8
10
10
11

14
18
21
22
25

Central African Rep.

11

Togo
Zambia23
40

Guinea
Mauritania

na
27

3

Lesotho-41

11

Liberia

-26
27

Sudan

9

na
na

17
21

na
14

Zimbabwe23

Senegal

8

9

17
10
15
12

Cote d'Ivoire

29

Cameroon
Congo
Botswana

5

14
19
31

22
13
22

.13

Mauritius

13

AngolaNamibia

na
na

Gabon

12

37

21

na

6

21

17

na
na

na
na

37

31

9
12
20
12
24
15
11
22
14
20
15
71

na
na
21

13
10
17
16

na
30

na
na
19

percent of domestic production in a normal year, and in a bad year
consume all domestic production and much of whatever capital inflows
they can generate. No fewer than thirteen African countries consumed
more than 99 percent of their domestic product in at least one year
since 1980, leaving themselves totally dependent on foreigners to finance(and direct?) their development. Obviously, rain-fed agriculturalsocieties will be heavily dependent on weather; variability in rainfall is

SEIJI

94

NAYA . ROBERTK.MCCLEERYTABLE 7-Continued
Savings and investment

Gross Domestic

Savings(%o of GDP)

Gross Domestic
Investment(% of GDP)

1965

1990

1965

1990

14
l2
14
19
26

10
20
19
38
25

18
10
28
22
27

23
26
27
33
19

Singapore

29
8
10

36
15
22

Taiwan

na

33
37
45
28

28
37
39
22

Other Africa

Egypt, Arab Rep.

MoroccoTunisia
AlgeriaSouth Africa
Asia
NIEs:

Hong Kong
Korea

na

ASEAN-4:
Indonesia

8

Malaysia

24

Philippines

21

Thailand

19

37
33
16
34

8

20
21
20

36
34
22
37

South Asia:

Bangladesh

8

2

11

12

Myanmar

na

na

na

na

India

20
8
12
15

21
12

23
18
19
22

17

Pakistan
Sri Lanka

15
o
13
13

China

25

43

24

39

Japan

33

34

32

33

Nepal

6

Sources: World Development Report 1992 and AsianDevelopment Outlook 1991.

thus magnified in the savings rate, since savings is the residual oflncome mmus consumptlon.
The need to mobilize savings for growth is critical in thesecountries. Rather than a problem of managing fluctuations, it seems to
be more a question of creating something out of nothing. Yet even thepoor save, though usually in the form of livestock, land, or seed. Often

it is a question of how to develop institutions and institutional
mechanisms that are trusted by the people to intermediate savings
through a financial system. Where capital markets don't work, either

through inappropriate policies or due to problems inherent inTHE ASIAN DEVELOPMENT EXPERIENCE AND ITS RELEVANCE 95
TO AFRICAN DEVELOPMENT PROBLEMS'
developing countries (high information costs, etc.), the expansion of
economic activities for all but the largest private sector corporations

can be accomplished only through self'finance. An entire economy
attempting to finance growth through retained earnings cannot easily
restructure of transform itself from an agrarian to a manufacuturing-based economy.
(1) Formal and lnformal Financial lntermediation

Studies indicate that three factors underlay the successful
mobilization of domestic savings in dynamic Asian economies: (1)Positive real interest rates gave the populace incentives to save; (2)Sufficient availability and convenience of savings institutions, such as

the postal savings system in Japan, encouraged savings and pooled
resources; and (3) the profitability of investment opportunities
promoted domestic savings. That similar policies are important for
African economies is substantiated by Ikhide (1992) in his finding of apositive statistical relationship between real interest rates on the one

hand and financial deepening and efficiency of investment on the other,based on a sample of Sub-Saharan African countries. The governmentof a developing country has to provide incentives for financial
intermediation so that the economy can move away from self-financeto utilization of financial intermediary institutions. Development of afinancial system also depends heavily on the establishment of aneffective regulatory system, so that financial soundness is maintained.

Perhaps most importantly, financial reform and development requirepolitical commitment and macroeconomic stability.
In the formal financial sector, dynamic Asian economies haveoften implemented policies of financial regulation and credit allocation.
Indeed, credit allocation has been one major tool of industrial policy, atool which is still not obsolete. South Korea, for example, has beentalking seriously about the need'for financial reform for a long time,

but even the financial plan of the reform-minded Kim Young Sam
administration shows that administrators are loath to give up controlof credit levers: "Even if the Kim administration holds to the reform
timetable, it is unclear when banks will ever become totally independentof the government.... the situation could leave the government in firm
control of the financial system" (Paisley 1993).

96 SEIJI NAYA . ROBERT KMCCLEERY
In many areas of Africa, less than forty percent of the population
has access to a bank (Nzemen 1989). According to Nowak (1989), "percapita bank credit in the private sector amounts to $48 p.a. in
sub-Saharan Africa, but 90 percent of the economic operators have noaccess to it" (p.68). Development of the banking sector should be apriority for African LDCs.
Asian countries developed an effective substitute for working
formal capital markets. Several Asian countries, most notably South

Korea and Taiwan, developed Kerb (or curb) markets - the nameevoking a street corner setting as opposed to a bank building.
Working through the extended family, a local money lender could
economize on the gathering of information related to the credit
worthiness of a borrower by making the extended family responsible
for the repayment of loans. Limited personal mobility in East Asiansocieties and a broad scope for individually tailored terms andconditions helped to make the system work. In Southeast Asia, forexample, moneylenders, pawn shops, trade credits, and rotating credit
associations performed an essential function for small borrowers; insome cases, governments tried to extend and adapt the state banking
system to the requirement of these small borrowers (Hill 1993, p.37).
Throughout Asia, high interest rates in curb markets choked off
demand for consumption loans. Borrowers needed good prospects forlarge profits to make the risk of lending worthwhile; thus the system
contributed to allocative efficiency in investment.

African economies have also developed effective informal financial
systems, such as the tontines of Cameroon, Senegal, Cote d'Ivoire andCongo, also known as`esusu' in Nigeria, `likelemba' in Zaire, `susu'

in Liberia and `cilimba' in Zambia. Tontines form an informal
financial market whereby members invest their savings and can obtain
credit on a rotating basis. Tontines contribute to the monetarizationof the rural economy, channeling otherswise hoarded funds into
small-scale investments, which benefit from the collective monitoring by

tontine members (Nzemen 1989). As in Asia, the interest rates arehigh: 50-90percent for tontine members, 120-180percent for nonmembers, with "credit facilities for small traders and purveyors ofservices often [involving] interest of 10percent or 20percent per week

and sometimes per day" (Nowak 1989, p.69). Credit is difficult toobtain, but risks are also high. Africa's informal financial institutions

97
THE ASIAN DEVELOPMENT EXPERIENCE AND ITS RELEVANCE
TO AFRICAN DEVELOPMENT PROBLEMS

thus play a vital role in pooling funds and allocating them efficiently inunderdeveloped areas.

Of course, informal intermediaries have their limitations:"finaneial dua!ism aggravates economic dualism" (Nowak 1989, p.68).
There is no substitute for sound development of the formal financial
sector, using convinient, readily accessible, and trustworthy institutions.

Nevertheless, in view of the relative success of Asian economies' curb
markets, the role of such African informal financial institutions merits

further study and encouragement as a partial answer for themobilization and intermediation of savings in Africa.

(2) Foreign Aid and Djrect Foreign lnvestment
Foreign resource inflows allow countries to invest at a rate abovethat supportable by domestic savings alone. Of course, such inflows

require corresponding flows of equity or debt; even overseas

development assistance (ODA) may come with strings orconditionalities. Private capital flows follow investment opportunities,

so they may strengthen economic development once it begins to"take-off." Yet private capital flows can also magnify boom and bustcycles, boosting investment when it is already high and exhibiting a net
withdrawal of resources through debt service payments and withdrawalof equity when times are already tough. Concessional loans and aid
should be counter-cyclical, but in practice, hard times are strongly
correlated with recessions in the donor countries; thus, ODA tends tobe stretched more thinly at the very time that export revenues are
declining.

Whereas foreign aid can be important in assisting economies fill ingaps in savings and foreign exchange and can be channeled into
extremely useful areas such as human resource development, these are

only short-term solutions. In the long run, aid can only be
supplementary; a country cannot depend on aid in the long term. The
effectiveness of foreign aid in helping an economy launch its own
sustained development depends critically on how the aid is used, Aid
did play a role in Asian development, and that role was positive mostly
because aid was on the whole put to productive and efficient use. "Aidhas worked in East Asia where it has augmented an increase indomestic savings to support much higher levels of investment than

98

SEIJI NAYA . ROBERT K.MCCLEERY

could otherwise have been contemplated and not worked in instanceswhere it has substituted for a lack of growth in domestic savings(South Korea from 1953 to 1960 and the Philippines)" (Swedish Foreign
Ministry i992, p.156). Aid can also assist in structural adjustment
efforts. In the end, however, development must be internally generated.

Different countries and regions pursue different basic patterns offoreign resource utilization (see Tables 8 and 9). Rapidly growing

Asian countries generally drew in modest resources from abroad about 2-5 percent of GDP - during their periods of high growth.
"Crises" in this context are manageable, such as South Korea's 4,4
percent fall in its savings at the onset of the second oil shock in 1980.
Investment rates fell 4.3 percent in 198e and another 2.2 percent in l981,

even though consumption had stabilized (International Monetary Fund
1993). Thus the decline in foreign resource inflows was modest anddelayed; as a result, investment rates stabilized as a fraction of GDP
and rapid growth resumed.
The worst Asian crisis in recent years may have been that facedby the Philippines in the mid-1980s. Savings plummeted from 26 to 21
to 16 percent of GDP in 1983, 1984, and 1985. Investment fell even faster- from 30 to 22 to 16 percent - as net foreign resources declined fromfour percent to zero, and the Philippines GDP contracted by more than
15 percent in 1984-85. Nevertheless, the Philippines was able to restore
a measure of investor confidence, leading to a repatriation of capital, arise in investment level$ to 20 percent of GDP, and a return to modest(3-6 percent) growth despite a continuing drop in net foreign capital

inflows ('1 and -2 percent) in the next two years (International
Monetary Fund 1993).
Indonesia also has had problems with its external debt. After
defaulting in the mid-1960s, rapid economic growth and the oil boom
helped Indonesia keep debt levels low until another crisis emerged in
the mid-1980s, due to falling oil prices, maturing debt, and the rapidly

appreciating yen (in which some 40 percent of the debt wasdenominated). The debt-service ratio approached 40 percent in the late1980s. Indonesia avoided default by quick adoption of reform policies;
a flexible donor response was also crucial (Hill 1993, p. 55).

Thus the dynamic Asian economies have largely avoided onerous
debt burdens, the key being effective management of foreign capital
inflows and flexible responses, both by governments and donors.

AND ITS RELEVANCE99
THEASIANDEVELOPMENT EXPERIENCETO AFRICAN DEVELOPMENT
PROBLEMSTABLE 8
Official

Development AssistanceMillions
Of dollars
1988

1989

893
982
970
433
264
366
188
576
363
304
102
427
120
371
252
298
162
808
474
196
199
478
262
184
108
65
937
273
569
439
2en
89
151
59
159
22
106

772
920
752
427
241
412
196
634
403
321
100
454
346
296
232
272
263
967
552
192
183
392
346
242
127
59
772
265
650
403
458
91
160
58
148
59
133

Per Capita
1990(dollars)
1990

As
of

a%

GNP

1990

Sub-Saharan Africa

Mozambique
Tanzania
Ethiopia

Somalia

Chad
MalawiBurundiZaire

UgandaMadagascar
Sierra Leone
Mali
Nigeria
Niger

RwandaBurkina Faso
Benin

Kenya
Ghana
Central African Rep.

Togo
ZambiaGuinea
Mauritania
LesothoLiberia

Sudan
Zimbabwe
SenegalCote d'Ivoire

Cameroon
Congo
Botswana
Mauritius

AngolaNamibia

Gabon

946
1,155

888
428
315
479
265
823
557
382
70
474
234
358
287
315
261
1,OOO

465
232
210
438
292
211
138
115
792
343
739
689
os3
209
148
89
212
57
140

60.2
47.1
17.4
54.8
55.5
56.3
48.8
22.0
34.1
32.8
16.9
56.0

65.7
48.2
14.6
45.9
28.6
25.7
24.0
10.9
18.4
12.3

7.8
19.4

2.0

O.7

46.7
40.3
34.9
55.1
41.4
31.2
76.3
57.8
54.0
51.0
107.0
78.0
44.9
31.5
35.0
99.8
57.9
41.2
92.0
118.2
82.9
21.2
32.0
123.0

14.2
13.4

9.9

na

11.4

7.4
17.8
13.0
14.0
10.4
20.0
24.5

na

9.3
5.5

12.7
6.9

4.3
7.3
5.5
3.6

na
na

3.0

Africa lacks both. Africa's debt is now larger than the annual regional

GNP and almost two and a half times the value of exports. Whereas
developing countries in other regions have received substantial debt
relief, the debt crisis is still very real for Africa. Debt service
consumes almost 31percent of exports. There is need of a global
initiative to address Africa's debt problems (Yaker 1992).

Poor management of foreign capital inflows in Africa has

SEIJI100

NAYA. ROBERTK.MCCLEERYTABLE 8-Continued
Official Development Assistance
Per Capita

Millions
Of dollars(dollars)
1990

As a%
of

GNP

1990

1988

1989

1990

1,537

1,568

5,604

481
316
171

450
234
152

970
316
227

9.1

15.9
3.8
2.5
O.4

na

na

na

na

na

22
10
22

40
52
95

37
52
-3

6.4
1.2
-1.0

O.1
o.o
o.o

TaiwanASEAN-4:

na

na

na

na

na

Indonesia

1,632

1,839

1,724

9.7

1.6

Malaysia

104
854
563

140
844
739

469
1,277

805

26.3
208.0
14.4

2.9
1.0

Bangladesh

1,592

1,soe

2,103

19.7

Myanmar

451

184

170

India

2,097

1,895

1,586

4.1
1.9

9.2
O.8
O.6

Nepal

399

493

429

Pakistan
Sri Lanka

1,408

1,129

1,152

598

547

665

22.7
10.3
39.1

13.8
2.9
8.2

China

1,989

2,153

2,076

1.8

O.6

Japan

na

na

na

na

na

Other Africa

Egypt, Arab

MoroccoTunisia
AlgeriaSouth Africa

Rep.

107.6
38.6
39.2

Asia
NIEs:

Hong Kong
Korea
Singapore

Philippifies

Thailand

1.1

South Asia:

Source:World Bank, World Development Indicators,

World Development Report 1992.

magnified the boom and bust cycle observed in savings. Year-to-year
adjustments in investment levels of 14 percent in Botswana, 11 percent
in Tanzania and Zambia, and a remarkable 25 percent in both Gabon

and the Congo, are extreme but hardly atypical (International
Monetary Fund 1993). They evoke images of gold rushes to spendmoney on poorly planned and questionable projects, made more costly
as scarce resources (including planning capabilities) were stretched too

thinly or bid up in price, followed by half-completed buildings rusting

to the ground, half-finished roads and dams abandoned, and other lessvisible testaments to good intentions gone bad. Why would a country

AND ITS RELEVANCE101
THEASIAN DEVELOPMENT EXPERIENCETO AFRICAN DEVELOPMENT
PROBLEMSTABLE 9Total External Debt

Millions Debt/GNPof dollars Ratio
1990

1990

4,718
5,866
3,250
2,350

3.8
2.2
O.5
2.5
O.5
O.9
O.8
1.2
O.8
1.5
1.2

Debt Service/Export

Ratio
1990

Sub-Saharan Africa

Mozambique
Tanzania
Ethiopia

Somalia

Chad
Malawi492
1,544

Burundi

906

Zaire

10,115
2,726
3,938
1,189
2,433
36,068
1,829

UgandaMadagascar
Sierra Leone

Mali
Nigeria
Niger

RwandaBurkina Faso
Benin

Kenya
Ghana

741
834
1,427
6,840
3,498

Central African Rep.

901

Togo
ZambiaGuinea
Mauritania

1,296
7,223
2,497
2,227

Lesotho390

Liberia

1,870
15,383
3,199
3,745
17,956
6,023
5,118

Sudan

Zimbabwe
SenegalCote d'Ivoire

Cameroon
Congo
Botswana
Mauritius

AngolaNamibia
Gabon

516
939
7,710

na
3,647

1.1

Ll
O.8
O.3
O.3
O.8
O.8
O.6
O.8
O.9
2.1

na

O.3

O.6
O.1
o.o
O.2
O.5
O.1
O.4
O.5
o.o
O.1
O.2
O.2
O.1
O.2
O.1
O.5
O.3
O.1
O.2

na
na

1.0
2.2
O.4

O.1

na
na

o.o
O.1

O.5
O.7
2.0
O.5
2.2
O.2
O.4

na
na

1.0

na
na

O.3
O.5
O.4
O.2

na

O.1
O.1

na
na

attempt to invest 60 percent of its GDP in a single year, as

the Congo

did in 1982, given its level of economic development andcapacity? Why would it borrow 13 percent of its GDP, overa healthy 47 percent savings rate, to finance such a spree?
better answer is forthcoming than that it was available.
The poorest countries for the most part rely on aid andsustain double digit investment rates. An investment rate

absorptive

and above
Alas, nolending

toof, say,

12

SEIJI102

NAYA . ROBERT K.MCCLEERYTABLE 9-Continued
Total External Debt
Millions

Debt/GNP Debt Service/Exportof dollars

Ratio

1990

1990

39,88523,524
7,534
26,806

1.3
1.0

Ratio
1990

Other Africa

Egypt, Arab
MoroccoTunisia
AlgeriaSouth Africa

Rep.

na

O.6
O.5
na

1.0
O.4
O.4
O.5

na

Asia
NIEs:

Hong Kong
Korea
Singaporena

34,O14

na

na
O.1
na
na

na

O.1

na
na

TaiwanASEAN-4:

881

Indonesia

67,90819,5e230,45625,868

O.7
O.5

12,245
4,675
70,115
1,621
20,683
5,851

O.5
O.2
O.5
O.5
O.7

O.3
O.2
O.3
O.4
O.3
O.1

52,555

O.1

O.1

Malaysia
Philippines

Thailand

O.7
O.3

O.3
O.1
O.3
O.2

South Asia:

Bangladesh

Myanmar
India

Nepal
Pakistan

Sri Lanka

China '
Japan

na

na
na
Sources: World Development Report 1992 and Asian Development
Outlook 1991.

na

percent barely covers depreciation, with little left over to facilitate

capital broadening to accommodate a rapidly growing labor force,much less to deepen capital to allow for improvements in thetechnological level of production and to fuel labor productivity growth.

When one further considers that past policies have titled the structureof production in the economy away from labor-intensive export
activities and toward capital-intensive, state owned industry, the picture

is even more bleak.

Many Asian economies have been quite successful in attracting
and absorbing direct foreign investment (DFI). Here again, patterns

THE ASIAN DEVELOPMENT EXPERIENCE AND ITS RELEVANCE 103
TO AFRICAN DEVELOPMENT PROBLEMS
differ. Singapore welcomed DFI; South Korea preferred internationalborrowing. In light of the debt crises of many African countries andthe fact that few economies in the world could work their way out ofdebt as effectively as South Korea managed to, it makes sense for
Africa to follow the pattern of encouraging DFI. Indeed, several
African countries have already seen the wisdom of this approach. DFI
is an important channel for receiving and absorbing foreign knowledge,
including management skills and technology. Most critical in attracting
DFI is the overall political and economic stability of the host country.

Fiscal incentives, such as tax holidays and accelerated depreciation
allowances, although widely used, are less important than a predictablepolicy environment and good infrastructure. In the late 1980s, forexample, Indonesia did not offer incentives but attracted much more
foreign investment than the Philippines, which did (Hill 1993, p.41).
DFI is also linked to human resource development, both because low
human capital - in terms of health, education, and skills - lowers
returns to investments, and because a host economy's capacity toabsorb the beneficial transfers from DFI relies critically on its humanresource base.
Many African countries have begun to realize the importance of
attracting DFI. Unfortunately, political and economic instability,

sometimes corrupt and not impartial systems of justice, andoverregulated policy environments in Africa do not inspire confidence
among potential investors. In addition to addressing these fundamental

problems, we would recommend that countries interested in further
promoting DFI seriously consider establishing a "one"stop investment"
office. By cutting through the red tape that foreign investors have toface, a country can go a long way toward enhancing its attractivenessto potential investors. Of course there is no substitute for basic
political and macroeconomic stability, but policies to cut red tape anddelays can help.

D. The Foreign Exchange Gap
The previous section's discussion of foreign resource inflows indevelopment as a complement to domestic savings draws no distinction
between foreign and domestic currencies. In reality, however, mostdeveloping countries, particularly those whose currency is not freely

104 SEIJI NAYA.ROBERT K.MCCLEERY
convertible, ration foreign exchange. The government appropriates
what it needs for debt service, defense hardware, and other needs at apreferential exchange rate; then the remainder is sold at a premium ina secondary market or worse, allocated to licensed importers according

to capacity, history, politics, or rent seeking. Under such a system,
many inefficiencies develop. Imports of needed capital, intermediate

goods, and raw materials are rationed to the private sector,
introducing a further bias toward public sector production and against

exporting, as the proceeds from exporting are usually captured by thegovernment (purchased at the preferential rate). Thus, more important
than gross flows are the extent of regulation in the foreign exchange
market and the access of the private sector to foreign exchange.

The main feature which sets apart Asian countries is theiremphasis on trade. Trade has been the engine of growth in the region.

Country after country has promoted export-led growth strategies
because domestic markets were not large enough for efficient importsubstitution development. Small city-states like Singapore and Hong

Kong had no choice but to implement export-led growth; othercountries such as Japan - and later Taiwan and South Korea - had achoice, but also chose export-led development. Most recently, ASEAN
countries and coastal China, particularly the freewheeling southern
provinces, have adopted similar policies, with similarly remarkable
results (see Table 10).

Outward-looking policies impose discipline on the domestic
economy through international competition and market forces. The
exchange rate and factor and input prices must be realistic in order tomaintain export competitiveness. Openness therefore imposes an upperboundary on how much domestic prices can deviate from world market

prices (Naya and Imada 1992, p.48). The efficiency constraint ofoutward oriented policies has played an important role in Asian

economic dynamism. Successful export promoters have avoided
overvalued exchange rates, devaluing whenever inflation threatened theeconomy's international competitiveness. Dollar (1992) shows that suchpolicies have indeed made a difference in growth performance: "For theperiod 1976-1985, the most open quartile of countries had a per capita
growth rate of 2.9 percent; the next quartile, O.9 percent; the third

quartile, -O.2 percent; and the most closed quartile, -1.3 percent";
among his conclusions is the estimate that a shift to an Asian level ofAND ITS RELEVANCE105
THEASIANDEVELOPMENT EXPERIENCETO AFRICAN DEVELOPMENT
PROBLEMSTABLE 10Growth of Merchandise Trade
Merchandise trade(mi11ions of dollars),Ee2sRgz!ti ts
1990

1990

Sub-Saharan Africa

Mozambique
Tanzania
Ethiopia

Somalia

Chad
MalawiBurundiZaire

UgandaMadagascar
Sierra Leone
Mali
Nigeria
Niger

Rwanda

na

300
297
130
200
412
75
999

na

na

na

na

-4

-7

2

-1

1,081

-1

o

-1

4

4

-3

4

.4

na

na

na

na

10

10

5,688

11

-2

4
15

435

230
279
480
483

13

8
4

4
o

5

10

6

1

na

na

na

138

93

Kenya
Ghana

1,033

739
130

-5

T2

1
4

7

7
-15
-9
11

2

na

na

570

na

na

1,182
3,OOO

1,616
1,200

na

na
760

6
3

2

na

-1

-5

6
2

4
8
6

-5

na

5

113

na

97

106
100
106
110
139
145

na

75
109
114

107

na

111
100

na

106

80

6

1

-1
-3
-3

na

na

na

5

11

83

114

na
na

na
na

na
na

na
na

-1

3

10

na
na

na
na

9

na

na
na

na

3
6
5
10

98
106
95
167
126
116
108

93
70
163
88
102
80
97
100
77
98
100

na
na

na

1,620
2,100
1,300

na

na
na

-2
-8

1,851

na

104
133
111
143

9

na

na

108
84
111

na
na

na

na

4

na

101
117
107

103

-3
-1

4

-11

na

1990

114
106
107
118

4
o

-3

1985

2
o
6
1

2

Sudan

2,471

3
o

na
na

Zimbabwe'

na

o

6

450
600

2,600
1,200
1,130

-4

-5

na
na

500
400

Cote d'Ivoire

na

-3

-2
-2
-1

na
na
248
na

Liberia

783

-2

o

-11

468

Senegal

1

-2
-11

1
5

3

170
700

Mauritania
Lesotho

na

-3

4

4

300
na
na

5
3
5

2,124
1,199

Togo
ZambiaGuineaAngolaNamibia
Gabon(1987 -: 100)

1965-80 1980-90

347

335

Benin

Mauritius

Terms of trade

13,671

151

Burkina Faso

Cameroon
Congo
Botswana-( t) -It-:E2sR9:!lt
1965-80 1980-90

360
450
576
235
888
458
480
146
640

112
160

Central African Rep.

na

935

Average annual growth rate

1

10

-2

140

outward-orientation in Africa would lead to a gain of 2.1 percentage
points in per capita growth (p. 540). East Asian export promotion was
extremely aggressive and relatively accepted in an earlier era of theinternational trading regime; Southeast Asian export promotion has
been of a later vintage, and perhaps more relevant for Africa.
African countries in general are smaller in terms of population
than Asian developing countries; therefore, African countries face an

91

99

na

96

SEIJI NAYA e ROBERTK.MCCLEERY106

TABLE 1O-Continued
Growth of Merchandise Trade
Merchandise trade(mi11ions of dollars),EL2y2guE.gl}RguEtIorts

1990 1990

Average annual growth rate-(rcent)

Terms of trade

-It

-Erts
1965-80 1980-90 1965-80 1980-90(1987 == lee)

1985

1990

Other Africa

Egypt, Arab

MoroccoTunisia
AlgeriaSouth Africa

Rep.

2,985 10,340

o

-2

131

76

4

2
6

4

4,263 6,918
3,498 5,471

7

3

88

11

5

5

10
13

1

2

-5

8

2

o

-4

105
174
105

86
99
99
93

11
11

97
103

15,241 10,433
23,612 18,258

Asia
NIEs:
9

6

27

13

8
15

5

9

7

7

99

100
108
100

na

15*

na

18*

na

na

10

3

13

10

2

5

3

134
117
93

9

13

3
4

1
6
2

111

5

23,O02

21,83729,251
13,08033,129

10

91

94
93
99

Bangladesh

1,674

3,646

Myanmar

270

na

8

322

109
106

127

India

17,967

Nepal
Pakistan
Sri Lanka

162
5,590
1,984

7,377
2,689

China

62,091Japan

Hong Kong

29,O02
64,83752,627
66,24082,49569,58560,64752,700

Malaysia

25,55329,409

Philippines

8,681

Thailand

Korea
Singapore

TaiwanASEAN-4:
Indonesia

South Asia:

8

na

-2

-10

-4

-15

23,692

3

7

1

4

543

na

na

na

95

96

na

4
2

96
98
90
103

na

o

9
7

53,345

5

11

7

10

109

111

286,768 231,223

11

4

5

6

71

91

-2

o

-1

95
90

*1985-90. Sources: World Drvelopment Report 1992 and Asian Development Outlook

1991.

even greater constraint on industrialization if pursued through importsubstitution, relying on domestic markets. Export-Ied economic growthis thus even more critical for African developing countries. The relative

success of export promotion in Mauritius and Zimbabwe, despite
perhaps limited transferability, demonstrate that African economies ean

respond to similar policies. The record of former stars - such as
Kenya, Cote d'Ivoire, and Ghana - underscores the fact that countries

can go up or down. Among the countries that have shown acommitment to establishing export processing zones are Kenya, Liberia,

Senegal, Togo, Nigeria, and Tanzania. Fafchamps (1992) notes thatTHE ASIAN DEVELOPMENT EXPERIENCE AND ITS RELEVANCE 107
TO AFRICAN DEVELOPMENT PROBLEMS"Africa's rich artistic tradition can help [inspire the] design [of]products that are very appealing to western consumers and yet are
differentiated from Asian exports" (p.35). African countries would dowell to encourage such exports as part of an overall package ofoutward-oriented development.
Filling in the foreign exchange gap involves a number of policies

centered on flows of trade, investment, debt, and development
assistance. The exchange rate is one key, as it affects the relative
profitabilities of producing non-traded versus traded goods and sellingin the home market versus exporting. But exchange rate manipulation
does little good if private actors are insulated from the impact by
non-convertibility of the currency and/or strict licensing. Too often
well-meaning policies to regulate the use of scarce foreign exchange
result in a shrinking supply, as incentives to obtain foreign currency
are curtailed. Thus both policies designed to increase the net inflow offoreign exchange and those designed to allocate foreign exchange more
efficiently should be considered.

In this area, it is especially clear that different Asian countries
followed different policies, and different policies proved effective fordifferent countries. In South Korea, Taiwan, and even Japan, fullconvertibility was achieved quite late in the development process. The
allocation of foreign exchange was controlled by the government, notthrough formal licensing but by subtle incentives and controls.
Although this worked rather well in each case, the system depended onstrong ties between the business and public sectors and on thecompetence - even "moral authority" - of the bureaucracy. The
system does not seem to be transferable to many African countries;
such tight controls have failed dismally in India and in a number ofother developing countries. Indonesia and the Philippines each tried
convertibility relatively early; Indonesia has not faced recurrent boutsof capital flight, while the Philippines has.

Exports were not the only source of foreign exchange for dynamic
Asian economies. Direct foreign investment has provided additional
capital, as well as technology and managerial skills. Open policies

attracted DFI from Europe and the United States; more recently,
Japan and the NIEs have invested heavily in their Asian neighbors,
relocating "sunset industries" in labor-intensive manufacturing toSoutheast Asia and the PRC. This has been an important element of

108

SEIJI NAYA . ROBERT K.MCCLEERY

growth in the region (Naya and Imada 1992, p. 50). Local firms havelearned quickly how to bypass multinational channels and work directly
as international subcontractors, especially in the textile industry (Hill1993). The African private sector must try to do the same with its
incoming DFI. Labor-intensive industries from Asia have alreadybegun to seek out low wages in some African countries. Mauritius
hosts a good deal of recent investment from Hong Kong; and Taiwan
is the leading investor in Madagascar (Winrock Roundtable 1991, p. 19),

DFI can be an important supplement or even substitute for highlevels of debt. What is most important, however, is not so much theactual borrowing or investment, but how productively funds are
utilized. In Southeast Asia, there has been a trend away from public
debt toward private debt. Africa needs to try to start a similar trend.
Attraction of DFI requires a conducive environment, an issue to which
we turn below.

M Critical Determinants of Development Performance
A. Economic Policies(1) Macroeconomjc Stability

Asia's economic success is based on macroeconomic stability, afeature sorely lacking in Africa. Macroeconomic stability is criticallyimportant, since it affects each of the four development gaps, as well as

constituting a key component of structural adjustment policies. Most

fundamentally, economic development is a long-term process whichmust be founded on macroeconomic stability. Long-term planning is
too often held captive in Africa to crisis-mode operation; natural
disasters, wars, and political instability demand attention and divert
scarce human and physical resources, both domestic and foreign, awayfrom long-term development planning and implementation. But as theA$ian experience (particularly that of Thailand) demonstrates,
maintenance of macro stability even in the face of political andsocio'economic crises forms a basis for economic development.
Stabilization begins with controlling inflation. The detrimental
effects of inflation are numerous. Inflation inhibits the poor fromaccess to basic needs and increases the dependency burden non-THE ASIAN DEVELOPMENT EXPERIENCE AND ITS RELEVANCE 109
TO AFRICAN DEVELOPMENT PROBLEMS
working household members place on those who are employed. This inturn limits the ability of families to finance education out of savings oran individual to defer employment for education, despite the prospectsof higher pay in the future. Inflation deters savers who do not haveaccess to financial instruments which earn positive real rates ofinterest, especially those accustomed to holding currency. It
discourages financial intermediation by encouraging the purchase of
unproductive assets as inflation hedges. It discourages investment byintroducing additional uncertainty into an already risky environment.

This is especially true where some prices are controlled by thegovernment; a large element of investment becomes guessing whenadministered prices will be changed, and by how much. Rent seeking to
influence these decisions is common. An important administered pricein many countries is the exchange rate. Inflation erodes
competitiveness by altering the real exchange rate, reducing the
incentive to export. Unless the exchange rate is adjusted almost
constantly, the widening gap between the nominal exchange rate andpurchasing power generates expectations of a devaluation, which
encourage foreign eurrency speculation if not outright capital flight,

both of which widen the foreign exchange gap.
To control inflation, a country must manage money supply growth
and the budget deficit. Monetizing a large budget deficit is the primarycause of double-digit inflation in developing countries. Asian countries

were willing, when necessary, to sacrifice incomes in order to bringinflation under control. Only a few - the Philippines, South Korea, andThailand - borrowed excessively, and the later two soon corrected their
mistake. In fact, policy flexibility, in the face of policy-induced as well

as exogenous shocks, is an extremely important albeit underemphasizedfeature of Southeast Asian deve}opment (Hill 1993, p.38). Policy
makers must make hard decisions, both on how to allocate spending
among conflicting economic and political priorities and on how to raise
revenues to finance their spending plans. Both policy flexibility andallocating spending relate strongly to the role of the state, the topic of
the next sub-section.

The correlation between macroeconomic stability, as measured byaverage inflation, and economic performance is astounding in both
Africa and Asia (see Table 11). All Asian countries with inflation rates

above 10 percent for the decade of the 1980s had rates of per capita

SEIJI110

NAYA• ROBERTK.MCCLEERY

Table

11

Macroeconomic Stability
GNP Per capita
Growth rate
(percent)

Average annual
rate of inflation(percent)

1965-90

1965-80

1980-90

na

na

36.6
25.8

Sub-Saharan Africa

Mozambique
Tanzania-O.2

Ethiopia-O.2

Somalia-O.1

Chad
Malawi-1.1

BurundiZaire

UgandaMadagascar
Sierra Leone

Mali
Nigeria
Niger

O.9
3.4
-2.2
-2.4
-1.9
o.o
1.7
O.1
-2.4

9.6
3.4
10.2
6.2
7.4
5.0
24.7
21.4

17.7

Kenya
Ghana

-1.4

Central African Rep.

-O.5

Togo
Zambia-O.1-1.9

Guineana

na

Mauritania
LesothoO.6

Liberiana
na

Zimbabwe

O.7

Senegal-O.6

Cote d'Ivoire

O.5
3.0
3.1
8.4
3.2

7.6
6.7
6.3
11.5
5.8
6.3
9.4
9.0
6.8
8.4
11.8

na
na

na
na

Sudan '

Cameroon
Congo
Botswana
Mauritius

AngolaNamibia
Gabon

4.9

O.9

4.2

9.0
14.6

Benin

1.9

14.7

7.7
7.9

7.5
12.5
6.3
7.4
7.2
22.9
8.2
7.1
6.3

Burkina Faso

49.7

1.2
60.9
107.0
17.1
56.1

1.0
1.3
-O.1

Rwanda

2.1

12.8

3.0
2.9
3.8
4.5
1.9
9.2
42.5

5.4
4.8
42.2

na

9.0

12.7

na
na
10.8
6.7
2.3
5.6
O.5
12.0

8.8

na

13.4
-1.7

GNP growth below three percent over the same period. In thePhilippines, the highest inflation rate was coupled with the lowest
growth rate. In Africa, countries exhibiting double-digit inflation had
low or negative per capita income growth over the decade. But it isworth noting that only a few of the countries with single-digit inflation

managed positive growth. Once stabilization is achieved, it still may
take a push to get growth started.

THEASIANDEVELOPMENT EXPERIENCEAND ITS RELEVANCE111
TO AFRICAN DEVELOPMENT
PROBLEMS
Table 11-Continued
Macroeconomic Stability

GNP Per capita
Growth rate
(percent)

Average annual
rate of inflation(percent)

1965-90

1965-80

1980-9e

4.1

Other Africa

Egypt, Arab

Rep.

2.3

6.4
7.0

11.8

MoroccoTunisia
AlgeriaSouth Africa

3.2

6.7

2.1

10.9
10.3

7.4
6.6

14.4

8.1
18.4

5.1

1.3

7.2

Asia
NIEs:

Hong Kong

6.2

Korea

7.1

Singapore

6.5

5.1

1.7

Taiwan

9.1*

11.1*

3.1*

Indonesia

4.5

35.5

Malaysia

4.0

7.2

ASEAN-4:
Philippines

L3

4.9
11.4

Thailand

4.4

6.2

8.4
1.6
14.9
3.4

Bangladesh

O.7

15.9

9.6

Myanmar

na

India

1.9

na

na

Nepal

O.5

7.8

9.1

Pakistan
Sri Lanka

2.5
2.9

10.3
9.4

6.7
11.1

China

5.8

-O.3

5.8

Japan

4.1

7.7

1.5

South Asia:

7.5

7.9

*Figures for Taiwan are for 1971-90,1971-80 and 1981-90,
respectively.

Sources: World Development Report 1992 and AsianDevelopment Outlook 1991.

Is there a lesson from Asia on how to get this push? It takes
investment, and if private investors are reluctant, then a mix of public

policy and investment designed to create opportunities for profitable

investment in the economy is necessary. Policy makers must be
pragmatic at such a time, an suspend their opinions of what type ofinvestment they want (domestic or foreign, in Asia - Chinese or
Malaysian/Indonesia, in Africa - Indian or East African, etc.) and justget the ball rolling.

112

SEIJI NAYA . ROBERTK.MCCLEERY

To avoid monetizing budget deficits, revenues must be raised.
There are two points that often trip up policy makers in raising
revenues through a process of growth and structural change. The firstis the extension of taxation to the agricultural sector. There is atendency to spare the agricultural sector from taxation. Whether forreasons of politics, equity, or cost-effectiveness (the cost ofadministering an income tax on farmers may be seen as prohibitive,
relative to the costs per dollar of revenue of a trade tax), agriculture

may be exempted. This policy leads to a number of unfortunate
consequences, as it did in South Asia: (1) farmers perceived that subsidy

was their due, and other government programs such as credit to rural
areas yielded dismal repayment rates; (2) structural transformationfrom agriculture to industry and services was inhibited, as one would
be moving from outside to under the government's control; (3) in South
Asian countries where agriculture makes up about a third of GDP, thepolicy limits the tax base, but in African countries where nearly
two-thirds of GDP is agriculture the impact is unavoidably such aheavy tax on other sectors of economy and trade that private, formal
sector economic activity is minimal; (4) in the long run, the policy neverseems to help the very rural poor it targets; instead the effect seems to
be to keep them rural and poor; and (5) the policy is devilishly hard tochange once instituted. East Asia had success by combining land
reform with a taxation system that appeared to be fair to all,encouraging formal sector economic activity and not inhibiting thetransformation frorn agriculture to industry.
The second point is the transition from indirect to direct taxation.
The Asian experience indicates that there is scope to maintain revenue
tariffs, particularly on consumer goods, until well into the development

process. Thailand has average tariffs of over 20 percent, and Taiwan
and South Korea had many tariffs in the twenties until quite recently.
Japan has stil} not fully liberalized its trade in some areas. Tariffs, solong as they are rebated to exporters, perform a useful function in
encouraging production for export rather than the domestic market.

What must be avoided is a system of non-tariff barriers andprohibitive tariffs (with exceptions made for favorites), such as
characterized India until quite recently. The conversion of non-tariffbarriers to tariffs increases both government revenues and thetransparency of trade incentives. Many countries have learned that theTHE ASIAN DEVELOPMENT EXPERIENCE AND ITS RELEVANCE 113
TO AFRICAN DEVELOPMENT PROBLEMS
only thing worse than wasting foreign exchange on the purchase of
expensive foreign luxury goods is encouraging the inefficient productionof those luxury goods domestically.
As part of trade poliey, what is most critical is not necessarily thetariff rates per se-which may remain in the 30percent range asrevenue tariffs - but their dispersion. The dispersion of tariff rates
needs to be reduced, so that the rates are more even across the board.
Simultaneously, NTBs and red tape - such as collection invoices andrequired documentation - must be reduced and streamlined. What is
important is not tariff rates as such, but the cost of doing business,

and an argument can be made that reducing deadweight losses fromslow customs clearance, delays in loading and unloading, etc. are evenmore important than tariff reductions, after the transition fromprohibitive to revenue tariffs is made. Singapore's success as anentrepot for China and Southeast Asia may have initially relied on its

low tariffs, but it has maintained or enhanced its position even as
tariffs declined throughout the region by increasing its efficiency incustoms, cargo handling, and other areas.
Converting NTBs to tariffs and reducing tariffs from "prohibitive"(100 percent or more) to "revenue" (20 to 40 percent) can allow theprivate sector to get better established before burdening both it and afledgling bureaucracy with more complicated direct taxes. A corporate
income tax and a value added tax, along with a (normally nominal andself-reporting) personal income tax, are generally the best places tostart. These taxes do not greatly distort important incentives forexporting, saving, investing, and improving technological sophistication.

Value'added taxes were introduced in Indonesia in 1985 and in
Singapore in 1993; Kenya has led the way in Africa with theintroduction of a value'added tax in 1991 (Hill 1993; World Economic
Survey 1992).

At first, as reporting procedures and institutional arrangements
are being developed and refined, tax inspectors may do little more thansurvey places of business, decide how much business they should bedoing, and levy what is essentially a lump-sum tax (which is lessdistorting of incentives anyway). Of course, one must guard against
corruption. The Singapore system of meritocracy, relatively high pay(and status) for government service in order to attract good people,
and zero tolerance for abuse of rank or position may be relevant toSEIJI NAYA . ROBERT K.MCCLEERY114

Africa, although the system may take hold more or less easily in
different cultures.

(2) Structural Adjustment and Sequencing

Macroeconomic stability is the precondition for structuraladjustment. Often it is considered an integral step in the process.
Structural adjustment packages usually contain three elements: <1)stabilization measures, including good fiscal, monetary, and exchange
rate policies that keep both the government budget and inflation undercontrol; (2) corrections of distortions, including price, tax and financial

reforms, as well as liberalization, deregulation, and privatization; and(3) institutional factors, building capacity to accommodate the economic

reforms. Later policies include the establishment of bank branches inrural areas, the setting of a forward market in foreign exchange, andthe development of an effective bureaueratic capacity for economic

management.
In many respects it was not difficult for Asian economies to adopt
such structural adjustment policies, since they are very consistent withthe policies that were already in place. When policies advocated by theWorld Bank and other institutions conflicted with Asian prerogatives,
policies were tailored to fit domestic conditions. For example, many
economies have eschewed wholesale privatization of state enterprises.
In China and Thailand, the issue of privatization is extremely sensitive.

Policymakers have recognized the need to proceed slowly in suchsensitive areas of the political economy, thus structural adjustment

policies have been adopted to local conditions and constraints,
sometimes keeping intact the original intent of the external policy
initiative and sometimes finessing the ehanges entirely.

Structural adjustment policies may have been easier for Asia, butthey are essential for Africa. Macroeconomic stability and theusefulness of structural adjustment policies cannot be overemphasized.

When suitably tailored to host country circumstances and sustained

over a reasonable period of time, adjustment policies can havedramatically positive results. Although there is a common perceptionthat such poiicies increase poverty (at least in the short run), empiricalevidence from the Asian experience does not support this perception.
The removal of agricultural price controls boosted rural incomes, andTHE ASIAN DEVELOPMENT EXPERIENCE AND ITS RELEVANCE 115
TO AFRICAN DEVELOPMENT PROBLEMS
new labor-intensive export industries provided employment and incomesto low skill level workers. Structural adjustment need not exacerbate
poverty. As Hill (1993) notes, "the fact that this conclusion holds in acountry which reformed quickly and maintained growth momentum(Indonesia) and another where reform and growth were a good deal
slower (Philippines) suggests that the structural adjustment-poverty
nexus as postulated in much of the general literature is simplistic at
best and wrong at worst" (p.66).
The sequencing of reform policies is a complex and delicate issue.

Much debate surrounds the topic of proper sequencing. Taiwn'sdevelopment experience gives one example of a reasonable and effective
sequencing of reforms: after stabilization was achieved, the next steps

were interest and exchange rate reforms, including unification of
exchange rates and efforts to keep the exchange rate realistic. Taiwan

liberalized the commercial account prior to liberalizing the capital
account. Policies shifted from quantity controls to tariffs, maintaining

a significant level of domestic protection while building international

competitiveness in exporting industries and through export processing

zones; only later did Taiwan liberalize imports (Ranis in Winrock
Roundtable 1991, pp.30'31). This sequence of structural adjustment
policies was logical and obviously worked quite weil for Taiwan.
Different economies may consider variations in sequencing more
appropriate to their conditions and capacities.

The entire concept of sequencing implies a degree of control overpolitics and policies by technocrats or economic planners not always
found in developing or even developed countries. What is sometimes
called a lack of political will to institute or sustain reform andadjustment policies may be inherent in factional or decentralized
political systems. In some instances it may be best to grasp whatever
opportunities for reform one can, whenever they present themselves, as
opposed to seeking an ideal sequencing.

(3) The lnformal Sector

The macroeconomic statistics, social welfare indicators, andcontinuing policy failures paint a gloomy picture for Africa's future.

One ray of hope in the picture, however, as noted by many authors, isthe dynamism of the informal sector in many African economies. The

SEIJI NAYA . ROBERT K.MCCLEERY

116

expansion and vigor of this sector stand in sharp contrast to theperformance of large and/or state-owned enterprises. In 1985, thesector contributed as much as 34.6 percent of GDP in Liberia and 24.5
percent of GDP in Nigeria; it is estimated that in 1989, the informal
sector employed 59percent of the urban labor force (19percent of thetotal African labor force) and contributed substantially to ongoing
employment creation (Grey-Johnson 1992). The situation is reminiscentin many ways of that of China in the late 1970s, India in the mid-1980s,

and Vietnam today, Such similarity indicates that policy reforms
comparable to those instituted in the above mentioned countries could

impart dynamism to the economies as a whole.

The informal sector can flourish for a number of reasons.
Straightforward policy reforms cannot always spread this growththroughout the economy. Informal sector firms gain many advantages
that are not generalizable to the economy as a whole, such as tax
avoidance, ignoring regulations regarding health, safety, and theenvironment, and even engaging in activities prohibited under certain
civil and criminal laws. But it is safe to say that the health of theinformal sector in Africa is a clear indicator of overregulation by
governments, to the detriment of incentives for production, distribution,

and accumulation.

Motivations for regulation can seem innocuous. No one could
object to the guarantee of a minimum wage sufficient to meet basic

human needs, or to licensing requirements to allow urban andindustrial planning. Yet in practice, politicians tend to escalate
minimum wages far above the level justified by productivity, andimpose a maze of other regulations on hours, vacations, health,retirement, unemployment, and rights to unionization. Licenses areoften approved and revoked arbitrarily or by rent-seeking bureaucrats.
The consequences are too little entry of firms, too much market
concentration, too little employment creation, and lack of incentives towork hard once a worker is employed.

The situation in Africa has been characterized as follows(Fafchamps 1992): The problem - poor work motivation and initiative.

The cause - patronage and "defensive bureaucratization" in large
firms. The solution - self-employment in small, informal sector firms.
Family labor minimizes supervision costs, allows flexible hours, andshares risks and returns. The informal sector hires dropouts who areAND ITS RELEVANCE117
THE ASIANDEVELOPMENT EXPERIENCETO AFRICAN DEVELOPMENT
PROBLEMS

unemployable in the glutted formal labor market. They receive training

in exchange for long hours at low pay. When they have learned
enough, they often go into business for themselves, continuing the cyclewith their own family members and apprentices. Small businesses canthrive in areas like artisanship, micro retailing, and money lending,where informational advantages more than offset any scale economies.
These fir'ms are frequently the only outlet for small investors seeking
better returns than those available in the regulated banking system.
For example, civil servants might invest in the business activities of lesseducated family members.
Instead of encouraging such activities, African governments haveoften persecuted the informal sector. Avoidance of regulation,
arbitrage, and speculative activities draw the ire if not the fire of thelocal authorities. Efforts to control or restrain such trade haveincluded bulldozing of markets, setting up roadblocks, and executing
suspected black marketeers. One feature of the informal sector whichdraws such bureaucratic ire is its perceived tax evasion. As Oyowe(1993) points out, however, under the tax exemption thresholds for low

income levels, much of the informal sector would be exempt fromtaxation anyway, since even small business owner's incomes are
extremely low and unstable (p. 80).

A few recommendations for policy changes regarding the informal
sector are as follows: (1) Foster a change of attitude toward theinformal sector and acceptance of the sector as a resource to theeconomy. (2) Streamline and reform business registration and licensing
for health, safety, and environmental concerns. Currently, officials
have and exercise the authority to c}ose firms down, or threaten to doso, unless bribes and patronage are forthcoming. There are many
obstacles to a successful business-government partnership for economic
development, including historical animosity, ethnic and tribal divisions,and innumerable jealousies. Accommodation is necessary. Much canbe learned from the Asian experience of government-business relations,discussed further below. (3) Extend government credit, training, andother services to the informal sector, to help firms compete on a moreequal footing, while simultaneously deregulating the economy as awhole. (4) Help informal sector firms develop trader-producer linkages,

obtain subcontracting agreements, and gain access to informational
economies. The dynamism of the informal sector can thereby infuse

118 SEIJI NAYA.ROBERT K.MCCLEERY
export activities as well. Important in this regard is the role of private

traders linking small domestic producers to foreign suppliers andmarkets. Ideally, some processes will be standardized and mechanized;

but the role of small subcontractors will continue to expand. These
policies are along the line of a Taiwan model of export development.
As Fafchamps (1992, p.33) notes, "what Africa perhaps needs most isan active trading class well versed in international trade." Here again

the crucial significance of human resource development comes to thefore.

B. The Role of the Government
The private sector should serve as the engine of growth and theimplementer of the development vision. The importance of the private
sector, however, does not diminish the role of the government ineconomic development. Letting the private sector be the engine of
growth does not equate with the Western idea of laissez faire. The

governments of all of the dynamic Asian economies (except HongKong) played a much larger role than dictated by neoclassicaleconomics, i.e. the provision of public goods and the correction ofmarket failure. Asian governments played a crucial role in theireconomies by creating factors conducive to the working of the private
sector.

In contrast, African states have not done enough to foster
private-public sector cooperation. Dole Olowu (1993) notes that
African states "must not repress but encourage private sector
initiatives .... As the experience of the Asian countries shows, the statemust help to reduce uncertainty faced by private entrepreneurs... [aswell as] create a regulatory regime that fosters domestic andinternational assistance to small scale businesses in the informal sector[and] maintains law and order..." (p.5). Whereas Japan and South
Korea promoted large business congiomerates (known as zaibatsu andchaebol), Taiwan fostered development of small and medium-sizedbusinesses. Given African bureaucratic capacities, one important roleof African governments would be to follow the Taiwanese model interms of promoting small and medium-sized enterprises.
Asian economies have been the beneficiaries of relatively efficientand disciplined government bureaucracies. The "high degree ofTHE ASIAN DEVELOPMENT EXPERIENCE AND ITS RELEVANCE 119
TO AFRICAN DEVELOPMENT PROBLEMS
professionalism in the ranks of the civil service" in the NIEs (James,

Naya, and Meier 1989, p.211) has been critical in enabling close
government-business relationships to remain growth-stimulating
instead of corrupt and growth-inhibiting. The role of government inEast Asia also went beyond an autonomous bureaucracy to one ofclose partnership between government and business: "In the Asian formof capitalism, a positive relationship exists between the business
community and the government. Instead of the adversarial relationshipoften found in the West, there is a hierarchical relationship in East andSoutheast Asia where the government may directly influence theconduct of private enterprises for the benefit of the public good, and, inturn, government is expected to assist and protect the private
enterprises. Close collaboration helps to ensure that appropriate
policies are adopted and that a constituency supporting these policies
exists. A cozy relationship between government and business can invite

corruption, however, and thus care should be taken to maintainaccountability of public officials" (Naya and Imada 1992, p. 54). The
latter point is underscored by the myriad political corruption scandals

currently reverberating throughout the Japanese and South Koreanpolitical economies. One must also beware of government-business ties

leading to an abdication of the government's role in protecting
consumers from unsafe products and collusive pricing. Nevertheless,close government-business relationships can and have provided
important benefits for development: "Government support in thecontext of an outward-looking strategy helps to encourage risk taking
and innovation by business. The hierarchical relationship allows for
coordinated and timely responses to unforeseen contingencies" (James,
Naya, and Meier 1989, p.211).

What is important is the role the government plays, not its
absolute size (see Tables 12 and 13). Too much emphasis is placed on
the size of government. In Asia, the successful Thai government, theunsuccessful Philippine government, and the extremely successful South
Korean government are the smallest as a percent of GNP. At the otherend of the spectrum, the successful Malaysian government, unsuccessful

Papua New Guinean government, and the extremely successful
Singaporean government are the largest. Seven of the thirteen Africancountries for which data are available are in the 15 percent to 30
percent range defined by the aforementioned Asian countries. Of the

SEIJI120

NAYA . ROBERTK.MCCLEERY

TABLE

12

Government Current• Revenue

CentralPercenta e of total
Direct

Taxes
1972

1990

na

na
na
na
na
na

current

Domestic

revenue
International

Transactions

Transactions

Taxes

Taxes
1972

1990

na

na
na
na
na
na

1972

1990

na

na
na
na
na
na

Total current

Revenue as a

% of GNP
1972

1990

na

na
na
na
na
na

Sub-Saharan Africa

Mozambique
Tanzania

29.9

Ethiopia

23

Somalia

10.7
16.7
31.4
18.1
22.5
22.1
13.1
32.7

Chad
MalawiBurundiZaire

UgandaMadagascar
Sierra Leone

Mali

na

Nigeria
Niger

43

Rwanda17.9
16.8

Burkina Faso
Benin

na
na

Kenya
Ghana

35.6
18.4

Central African Rep.

na
na

Togo
ZambiaGuinea
Mauritania
Lesotho

49.7

na
na,

Sudan

14.3
40.4
11.8

Zimbabwena

Liberia

Senegal17.5

Cote d'Ivoirenana

Cameroon
Congo
Botswana
Mauritius

19.4
20.1
22.7

AngolaNamibia

na
na

Gabon

18.2

35

na

28.9
5.5

na

26.3
10.8

na
na
na
na
na

27.4
28.7
23.9

na

29.1
28.8
24.7
12.3
24.2
18.3
12.1
32.8
29.9
14.6

na

26.3

na

14.1

18

na

33.2

na

16.5
19.1

na
25.7
28.6

na
na
na
na
na

21.7
30.4
45.3
45.2
20
40.3
57.8
36.3
33.6
42.4

na
17.5

na

41.7
51.8

na

19.9
29.4

42.8
28.3

24.3
40.6

na
na

13.1

na
na

na

17.7

na

47.3
75.3

na

44.6
12

na
na
na
na
na

15.8
35.2
45.2

na

38.1

20.2

37

14.3

na

na
na

17.1

na
na

15.8
74.4
36.8
54.5
34.6

na

17.5

32.3
12.4
33.9

na

44.9

2

20.3
30.4

na

na
na

24.5

na

40.3
1.4
23.3

45.2
38.6
13.9

na

42.9

na

na
na

na
na

9.5

19.4
22.8
25.1

na

26.3

62.9
31.6
40.5

na
na

30.9

na

26.5
47.7
40.2

20.2

1.5
20.9

na

28.5

na

na
na

na
na

44.9

na

15.8
10.5
13.7
10.8
16
11.5
10.2
13.7
14.7
19.5

na

10.3

na

9.8
8.6

na

18

15.1

na
na

23.2

na
na

na
na
na
na
na

22.6
13.9
13.3

na

35.6

18.4
30.4
15.6

16.4

na

8.8
18.9

na

11.7
17
18

na
46.4

5.3

na
na

16.9

13.2

na

12

11.9
14.6
21.8
21.2
17.8

na
na

14

23.7

na
na

na
na

26.1

na

na
na

17.7

na

60.9
24.2

na

43.6

na

six that are not, three are "too high" and three are "too low." Much
more emphasis should be placed on what government does, how well it
does it, and how it finances its activities.

A government needs to set forth the long-term vision fordevelopment, and to establish a rule of law which is simple and astransparent as possible. Another critical role is establishing goodAND ITS RELEVANCE121
THEASIANDEVELOPMENT EXPERIENCETO AFRICAN DEVELOPMENT
PROBLEMSTABLE 12-Continued
Central Government Current

Revenue

Percenta e of total
Directcurrent revenue
International
Transactions
Transactions

Taxes

Taxes

Domestic

1972

1990

na

Total current

Revenue as a

Taxes

1972

1990

15.9

na

11.9

na.
12.9

45.7
31.6

na

1972

1990

na

14

SO}6 of GNP
1972

1990

na

35.9

Other Africa

Egypt, Arab

MoroccoTunisia
AlgeriaSouth Africa

Rep.

16.4
15.9

na

54.8

na

48.6

na

21.5

13.2

na

20.1

21.8

27.9

na

na

na

34.1

4.6

4.9

18.5
23.6

na

22.1

na

31.8

na

30.9

Asia
NIEs:

Hong Kong
Korea

na

na

na

na

na

na

na

13.1

na

Singapore

29
24.4

34
24.3

41.7
17.6

33.5
19.6

10.7
11.1

10.6
2.5

21.5

Taiwan

na

na

na

na

na

na

na

45.5
25.2
13.8
12.1

57.5
30.5
28.3
24.2

22.8
24.2
24.3
46.3

25.1
24.3
30.7
41.4

17.6
27.9
23
28.7

6
16.7
25.1
22.1

13.4
20.3
13.1
12.5

18.3
28.9
16.3
19.9

8.6

22.4
34.2
44.5
26.4
35.9
34.7

25.8
30.7
35.5
35.7
32.2
46.4

18.0
13.4
20.1
36.7
34.2
35.4

27.3
14.9
28.8
31
30.6
28.6

8.4

11.4

15.7
27.9
13.3

ASEAN-4:
Indonesia

Malaysia
Philippines

ThailandSouth Asia:

Bangladesh

Myanmar
India

Nepal
Pakistan
Sri Lanka

3.7
28.7
21.3
4.1
13.6
19.1

9

15.4
10.8
10
10.8

na

10.2
5.2

12.5
20.1

na

14.8
10
19
21.1

China

na

na

na

na

na

na

na

na

Japan

64.8

71.2

22.6

12

3.5

1.3

11.2

13.9

Sources: World Deveipoment Report 1992 and Asian Development Outlook 1991.

macroeconomic policies, and intervening to make the market work
rather than intervening to destroy market mechanisms. Several East
Asian countries have implemented industrial policies, utilizing tools offinancial control, tariffs and quotas, weak antitrust laws, favoritism ingovernment procurement, and administrative "guidance" by suchinstitutions as Japan's MITI and South Korea's EPB. More recently,

industrial policy has focussed more on promoting research anddevelopment for selected sectors, rather than direct intervention.

Successful industrial policy depends upon a strong, effective
bureaucracy, as well as a special government-business relationship; theSEIJI122

NAYA . ROBERTK.MCCLEERYTABLE 13
CentralGovernment Expenditure
as Surplus/deficit
a percentage as a percentage.ltS;s;gpSLagg-gÅí-!glLa!..g2sJ2gngULuzg-t .fttl dtreExpenditure

Defense
1972

1990

na

na
na
na
na
na

Education

Health
1972

1990

na

na
na
na
na
na

of GNP of GNP

1972

1990

1972

na

na
na
na
na
na

na

na

O.6

na
na
na

1990

Sub:Saharan Africa

Mozambique
Tanzania
Ethiopia

Somalia

Chad
MalawiBurundiZaire

UgandaMadagascar
Sierra Leone

Mali

11.9
14.3
23.3
24.6
3.1
10.3
11.1
23.1

5.4

na

6.7

na
na

3.6
3.6

5.3
8.0

na

Nigeria

40.2

Niger

na

24.5
20.1
12.7

19.2
21.3
29.4
17.5
20.6
13.3
20.8

na

8.1

16.2

na

2.1

na
na

14.0

111
na
na
na
na
na

19.7
13.7
13.5
14.9
22.1
19.9
14.1
21.8
16.7
23.9

na

9.1

Kenya
Ghana

6.0
7.9

na

na
na
na
na
na
7.8
3.2

29.8
26.4

25.2
34.7

21.0
19.5

Central African Rep.

na
na

na
na

na
na

na
na

na
na

RwandaBurkina Faso
Benin

Togo
ZambiaGuinea
Mauritania
LesothoLiberia

Sudan
Zimbabwe
SenegalCote d'Ivoire

Cameroon
Congo
Botswana
Mauritius

AngolaNamibia

Gabon

25.6
11.5

na

27.9
28.8

na

na

12.5

8.4

na

o.o

26.4

16.0

34.0

na
na

na
na

na
na

na
na

na
na

24.1

na

na
na
na
na
na

16.5

o.o

o.o
5.3

9.9

9.8

na
na

6.7

na

o.o
O.8

11.6

na
na
na

na

1.3
5.5

na

-5.0
-1.4

29.2

-2.7
-6.2

-1.9

na

na

o.o

13.0

-2.7

na
na

-8.1

11.1
28.9

na
na
na
na
na

31.4
14.0
26.1

na

21.9
24.9
33.5
25.1

-2.0
-4.4

na

-O.8

na

-2.7

O.3

na

-5.0

na
na

-4.2

-O.9

-4.2
-2.8

1.1

na

25.0
23.0

33.7
16.3

42.2
24.2

-23.8
-1.2

na
na
na

na

na
na

42.8

na

na
na

15.4

na

31.9

na

17.4

na
na
na

37.0

na
na

20.8

na

na

O.4

-13.8

16.0
23.8

na
na

40.5

na
na
na
na
na
na
na

31.0

na

-4.6

na
na

na
na
na
na
na

na
na

-1.4

-6.8

22.6
17.0

na

1.9

na
na

-3.9
-5.8

27.5
25.0
14.7

16.6
16.7
19.2

na

-O.8

na

-O.8

na
na
na

-11.9

transferability of this aspect of Asian development, therefore, may belimited. Southeast Asian countries have demonstrated that industrial

policies are not indispensable ingredients in outward-oriented
development success stories.

A more important feature of successful Asian development has
been the ability to recognize mistakes and to correct defective policies.

Singapore, for example, tried to raise wages excessively in the mid-

na
-7.9

na
na

-3.2

na

12.6
-O.5

na

7.0

na

AND ITS RELEVANCEl23
THEASIANDEVELOPMENT EXPERIENCETO AFRICAN DEVELOPMENT
PROBLEMSTABLE 13-Continued
Centrai Government Expenditure.Etlg:ggpSagg-gi-!gSt fttle dt ExpenditureasSurplus/deficit
Defense EdHU.C.aittihOn aP.efrcGel}liasge as a.fpetlgieptage
1972

1990

na

12.7

1972

1990

na

16.2

1972

1990

na

40.2

1972

1990

na

-6.9

-O.9

-4.5

Other Africa

Egypt, Arab Rep.

MoroccoTunisia
AlgeriaSouth Africa

12.3
4.9

na
na

na

6.5

24.0
37.9

22.4

na

22.8
23.1

na
na

na
na

na
na

22.7

na

na

37.2

na

34.6

-3.9

na
.4.4

na
na

-2.4

Asia
NIEs:

Hong Kong

na

na

na

na

Singapore

25.8
35.3

25.8
21.6

17,O
23.5

21.8
22.8

18.0
16.7

Taiwan

na

na

na

na

na

18.6

8.0

8.8

10.4

Korea

na

na

na

Ila

15.7
23.3
15.0

-3.9

-O.7

1.3

10.5

na

1.6

15.1
26.5
14.2
16.7

20.4
31.3
19.8
15.1

-2.5

-2.1

-9.4

-2.8

-2.1

-3.5

-4.2

4.9

9.2

15.0

.1.9

-O.4

ASEAN-4:
Indonesia

Malaysia
Philippines

Thailand

na

na

na

na

19.5
23.6

21.0
26.9

3.1

30.9
7.4

3,8
11,9
2,3
19,4

16.0
21.4
4.1
15.7
2.7
15.3

na

na

na

na

na

na

na

na

na

12.7

16.7

-1.9

.2.9

10.9
20.2

11.0
17.3

South Asia:

Bangladesh

5.1

10.1

19,8

Myanmar

31.6
26.2
7.2
39.9

24.7
17.0

21,1

India

Nepal
Pakistan
Sri Lanka
China

Japan

na

6.0

na

na

Sources: World Development Report 1992 and Asian

na

10.5
8.5
16.9
25.4

na

18.2
20,4
23.6
28.4

na

na

-3.2

-7.3

-1.2

r8.1

-6.9

-7.2

-5.3

-7.9

Development Outlook 1991.

1980s, but soon realized the folly of trying to hasten a market process.

South Korea, when it instituted policies speeding up the development ofchemical and heavy industries in the late 1970s and early 1980s, also

soon recognized that its policies were working at cross-purposes tomarket mechanisms and that they had to revert to earlier policies.
In attempting to define an appropriate role for the government, it
must be remembered how inexperienced Africa is self governance. The
bureaucracies are weak; there is limited indigenous capability forplanning, formulating, and implementing policies. Yet the private sector

is in many ways no more developed. And the relationship between the

124

SEIJI NAYA . ROBERT K.MCCLEERY

two sectors ranges from sheer hostility to close but inefficient

cooperation - for example, in capturing domestic markets inmonopolistic or oligopolistic ways (Winrock Roundtable 1991, p.140).
Attitudes need to change, and productive cooperation must be fostered.
In addition, an argument can be made that both the public sector andthe private sector should focus their attention and talents on an
extremely limited number of tasks.6 These tasks would quite rightly

differ from country to country. It may be that a blanket statement
such as "African governments should specialize in the provision oftransportation and irrigation infrastructure" may be as limiting as"African economies should specialize in the production of garments."

Rather than reserving sectors for government activity, policy
makers should be looking for effective cooperation in a number of
traditional and innovative new areas. Cooperation with the private

sectors has worked extremely well for some Asian countries.
Cooperation with multi-national corporations in the building of needed
infrastructure in a build-operate or build-operate-transfer mode could

hasten development while economizing on spending and foreignexchange. Even in the areas of health, nutrition, and basic education,scope exists to expand cooperation with NGOs and donors. Following
this line of thinking, African governments are not so much too big as
they are overcommitted. The ultimate goal of this strategy for both
African countries and donors must be to build capacity for effective
analysis and action in Africa.

In Asia, not only have individual governments tended to define
their appropriate role narrowly and to stick to that definition in theface of pressures to solve all of the country's ills, but regional
institutions have also contributed to economic growth by playing alimited and appropriate role. ASEAN has often been termed a failurefrom the perspective of economic integration. But economic integration
was never its intent. In many ways, its rhetoric on economic issues
was an excuse to forge political and security ties in the region. But
this in turn has yielded economic benefits to its member countries.

Defense spending as a percent of GDP dropped, particularly inIndonesia and Singapore, where it declined from 19 and 35 percent
6 For a more thorough treatment of this subject, see H. Bruton, "Barriers andOpportunities in African Development," mimeo, 1993.

THE ASIAN DEVELOPMENT EXPERIENCE AND ITS RELEVANCE 125
TO AFRICAN DEVELOPMENT PROBLEMS
respectively in 1972 to 8 and 22 percent in 1990 (see Table 13). Data for

Africa is much more sketchy, but casual evidence suggests that ratios

in excess of 20 percent are common, and no similar reduction in
defense spending is evident. According to official statistics (which
probably understate expenditure), "an estimated 4.8percent of GDP isused for defense in Sub-Saharan Africa, compared with 3.6percent inSouth Asia and 1.6percent in Latin America" (Global Coalition for
Africa 1992 Report, p.6). Regional institution building, aided by U.N.
initiatives, could help in this area, allowing a shift in expenditures
toward investments in human and physical capita.
In Asia, as countries have become interdependent, increasing
interaction has taken place not only between the government and theprivate sector, but also between all kinds of professionals. Because
neighboring countries have all adopted outward-oriented policies,
international meetings of scholars and policymakers within the region

have become more and more frequent. Often policymakers arethemselves scholars, and move back into academic circles after serving

as statesmen. With frequent meetings between professionals on policy
issues, much cross-fertilization takes place. Bad economic policies
become difficult to justify. This kind of interaction needs to befostered in Africa as well. One effective way to build capacity in
Africa, and at more than just the overall institutional level, would be tosupport such professional interactions on a broad scale. An importantside effect of such professional interactions is the demonstration effectof both good and bad policies. Initially, multilateral institutions suchas the World Bank and the United Nations can play an important rolein facilitating meetings of professionals and strengthening
bureaucracies.

C. Cultural Factors
In the 1980s, a number of debates broke out on the topic of therelative importance of cultural factors versus economic policies in thedetermination of economic growth rates. Those that argued for theimportance of cultural factors made a good point, that "Eastern
capitalism" is fundamentally different from "Western capitalism", andthus a Western-centered perspective is not adequate (Berger and Hsiao

1988). Rather than resting the argument on the formal Confucian

126 SEIJI NAYA.ROBERT K.MCCLEERY
traditions of Asia (that had earlier been held responsible for the slow

growth rates of China, Singapore, and Taiwan), they defined a more
pragmatic post-Confucianist culture, augmented by Buddhist, Shinto,and numerous folk religions.

Our position is that culture is indeed important, as eeonomic
incentives and motivations are certainly not the only determinants of

behavior. While not to ignore cultural factors, we have now seen
countries in Southeast Asia and even South Asia fundamentally change
the direction and nature of their economic policies, and, apparently asa result, jump from a low to a high growth path. "Some have argued
that Confucianism, which encourages hard work, saving, and education,
has been an instrumental factor [in Asian development], and indeed it
has. High rates of savings permitted domestic expansion without large
external debts. The emphasis on education created a large pool ofliterate and skilled workers able to meet the needs of an industrializing

economy. But these characteristics are not confined to those with theConfucian ethic" (Naya and Imada 1992, p.56). Cultural differences

between countries such as South Korea, Taiwan, Indonesia, and India(and even within countries such as Malaysia, Singapore, Indonesia, andIndia), and sharp ehanges in economic performance following policychanges within a country, invalidate the claim that the economic
success in Asia is dependent on a common, homogeneous culture. It isclear that what changed in the late 1980s in India, in the mid-1980s inIndonesia, in the late 1970s in China, and in the early to mid-1960s in

South Korea and Taiwan was not the culture (which can evolve andchange, but not rapidly), but economic policies.

We can now demonstrate fairly conclusively the importance ofeconomic policies in explaining why long term growth rates havediffered among countries with relatively similar endowments and in agiven country in different periods. Yet it may be true that cultural
factors determine how responsive an economy is to economic policychanges, or why eliminating the four gaps may produce(hypothetically) 10 percent long-term growth in China and 6 percent

growth in Indonesia. We hint at areas for future study by
hypothesizing that social and cultural factors affect the cost ofproviding a given amount of human resource development, influence theprospects for institution building and use of informal mechanisms inareas traditionally subject to market failures in developing countries

THE ASIAN DEVELOPMENT EXPERIENCE AND ITS RELEVANCE 127
TO AFRICAN DEVELOPMENT PROBLEMS(such as the kerb market for credit), and affect the response to policy
stimulus. These issues deserve careful study by scholars knowledgeable
in these areas.

D. External Factors
It is important to recognize that each Asian "success story" took
place in a specific global context. Even as the link between stimulus

and response in the physical sciences may be dependent on theenvironment (altitude, temperature, etc.), the Iink between economic
policies and results may also be dependent on the specific global

economic environment. Having stated this, one is struck by thevariance in the economic situation in which different waves of Asian
countries successfully pursued economic growth through policies thatwere hardly identical, but seem much more similar than the global
context in the 1960s, 70s, 80s, and early 90s. Rather than being able todismiss the Asian success stories as being a product of their specificenvironment and thus having little relevance for countries today, theremarkable fact is how consistently these countries recorded high rates
of growth in manufactured exports and GDP despite changes in theirenvironment. Through the high growth 1960s, the commodity priceboom, inflationary bouts, and low interest rates of the 1970s, and thehigh interest rates, exchange rate realignments, and slow growth in
output and world trade volumes in the 1980s, Asian countries havecontinued to grow. Expanding market shares have substituted for
rapid world trade growth; prudent policies have limited the impact ofinterest rate fluctuations; and the flexibility of policymakers and firms

alike have helped Asian economies to change with rapidly changing
clrcumstances.
The chief fear of the 1990s seems to be that the end of the cold

war will spawn a new protectionism in developed countries. Indeed, acursory look at recent trade policies and conflicts in the United Statesand Europe seems to support that view. Yet one must also consider
the recent success of China, India, Indonesia, and Pakistan in
expanding their manufactured exports at rates varying from 10 to over
30 percent per year in the early 1990s. For the determined exporters,
there are in fact more markets available now: "not only are there the

US and the EC, but also the NIEs themselves, a resurgent Latin

128

SEIJI NAYA . ROBERT K.MCCLEERY

America, and Eastern Europe" (Winrock Roundtable 1991, p. 19). While
it may well be more difficult to penetrate developed country markets inthe future, alternatives to a more outward-oriented and open economy

have failed to deliver either economic growth or substantial
improvements in the lot of the common people over the long run.
Rather than increasing vulnerability to external shocks, the policy mix
in Asia seems to promote adaptability to changing circumstances in the

global economy. Aside from the clear connections between high humanresource development, a competent bureaucracy, and openness to
information and technology from abroad (not just price signals), thislink is rather complex and worthy of further study.

We have described a number of "virtuous cycles" in thedevelopment process of a single country; for instance, increased
investment, increased income, increased savings, increased investment,

etc. and increased investment in HRD, increased complementary
investments in human and physical capital, increased economic activity,
increased tax collections (which can be used in part for further HRD
expenditure), etc. The following short section will attempt to quantify

how a "virtuous cycle" can develop for a region, building on what isoften termed the "demonstration effect," and how countries can be leftout (e.g., the Philippines),

Successful development in one country can lead to the emulationof those policies identified (by either the leader or follower country) as

instrumental to economic development. It is hypothesized that thestrength of the demonstration effect is directly proportional todistance, where "distance" may be defined beyond mere geography toinclude ethnic, religious, and other cultural factors. Yet two other lesswidely recognized factors rnay be just as important: the leader
economy's direct pull on regional trade and investment flows, and theflow of ideas and information through ministerial and sub-ministerial
meetings in regional fora (for Asia, ASEAN, APEC, PECC, PBEC, etc.).

Rapid economic growth in a country provides an opportunity forneighboring countries to be pulled along, through increased trade including tourism and other services - and investment flows. Fast
growth means increased demand for raw materials, components, andconsumer goods from all trading partners, but with a natural bias
toward neighboring countries (based on transportation cost and timeadvantages, greater information about products, cost, and quality,

THE ASIAN DEVELOPMENT EXPERIENCEAND ITS RELEVANCE129
TO AFRICAN DEVELOPMENTPROBLEMS
common tastes, and often well-developed regional supply relationships).

Rapid growth also involves restructuring the economy. In Asia, thismeant spinning off industries in which comparative advantage wasfalling to neighboring counties at the appropriate level of development.

For Japan, first textiles and then simple electronics, and finallycapital-and space-intensive manufacturing (such as some chemical andmetal processing) moved abroad as first labor then land became
relatively expensive. The extent to which this phenomenon actuallyoccurs depends on the strength of regional bias and of the leadcountry's reliance on external suppliers and markets, but primarily on
the degree of outward orientation in the follower countries, especially
their receptiveness to foreign investment and policies affecting exports.

The inducement for policy change is thus not merely the fact that aneighboring country is growing rapidly, but also the opportunity toride directly on its coat-tails to more rapid growth.

Similarly, a follower country is more likely to make policychanges in response to a successful development if (1) the context andimplementation of the policy is well-understood; (2) questions about the

impact of the potential policy shift on different groups can be asked
and answered in advance; and (3) if there is someone to consult with in
the event that problems develop during the planning or implementation

stages. What better way is there to develop the personal contacts
among mid-and upper-level bureaucrats and policy makers in theregion than through regional and sub-regional meetings? ASEAN, forinstance, was initially criticized for having too many meetings, with too

little tangible output. But very important intangible outputs have beendeveloped in the form of personal friendships, good working
relationships, and a growing policy consensus.

Once again, the implications for African development and the
U.N.'s role are not straightforward. Some observers have used the"demonstration effect" logic to argue for the concentration ofdevelopment resources in one or two especially promising countries, toengineer regional successes in Africa. But would this work? The
supporting conditions appear to be weak. Traditional trade links arewith European countries; transportation costs within the region arequite high (for instance, direct air freight routes between Africancountries are uncommon, requiring long layovers or transshipment
through Europe); and (at least initially) growth would not be outward-

SEIJI NAYA . ROBERT K.MCCLEERY

130

oriented. The exchange of information and personal networks present
in ASEAN also seem to be lacking, despite the best efforts of ECOWAS
and other regional fora. The U.N. can help to build these links.

IV. Conclusions and Recommendations
Economic development is a long-term process. Looking at the
dynamic Asian economies of today, it is hard to imagine that they wereonce considered "basket cases," but they were. The present African
crises of starvation, civil war, natural disasters, collapsing economies

and unacceptable human suffering do indeed make the future seem
bleak. But an old Chinese proverb reminds us that "it is often darkest
right before dawn." The potential for change and progress in Africa
is there.

Unlocking Africa's potential requires effective economic policies.
The Asian development experience points to several critical policy areas
for sustainable development: (1) macroeconomic stability; (2) agriculturaldevelopment; (3) human resource development; (4) mobilization ofsavings, development of financial intermediation, and incentives for
productive investment; (5) outward-orientation and attraction of DFI;
<6> effective management of foreign exchange resources and incentives
to producers of foreign exchange; (7) proper sequencing of structuraladjustment policies; (8) institutional capacity building and attention to

the problem of governance; (9) development of the informal sector; and(10) encouragement of a dynamic private sector working in cooperation
with government toward a society-wide vision of development.
Donors need to help Africa build capacity for effective economic
management. Although humanitarian aid and short-term assistance isnecessary, the focus needs to be put on building institutional capacity.

We have proposed that programs to foster networking between thepolicymakers and development scholars of Africa also be given priority.
One effort to monitor closely and perhaps build upon is the African
Capacity Building Foundation, a joint initiative of the United Nations

and concerned African institutions begun in 1991. Funded by aconsortium of donors and African governments, it will focus, at least

initially, on the key areas of poliey analysis and development
management.
In addition, there is no reason why the Asian experience ofTHE ASIAN DEVELOPMENT EXPERIENCE AND ITS RELEVANCE 131
TO AFRICAN DEVELOPMENT PROBLEMS
successful economic development and its relevance for Africa has to be

mediated by Western scholars. Programs should be established tofoster direct interactions between Africans and Asians. We propose
the development of scholarships and training programs to sponsor
visits by African policymakers to Japan, China, the NIEs, and other
Asian countries to learn firsthand of their development experiences.
Attention should be given not only to government policy, but also to

private sector dynamism and to how the two seetors worked inpartnership for development.
In the long-term process of economic development, multilateral
institutions, such as the United Nations and the World Bank, and thewestern partners in African development (in Europe, North America,and elsewhere) can and must play a supportive role. But ultimately
African development depends upon the African people. Just as Asians

have turned economies that were seemingly "basket cases" into
dynamic and even model developing countries, Africans face thechallenge of putting into practice their own vision of development. It

will inevitably take time and determination to make the economies
grow, adjust, and develop. But with Africa's abundant natural andhuman resources, a more prosperous future is not out of reach.

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A QUALITATIVE ASSESSMENT OF THE EFFECTS
OF NAFTA ON JAPAN'S FOREIGN INVESTMENT
AND TRADE WITH EAST ASIA AND
MEXICO: OPPORTUNITY OR DIVERSION?

William E. JAMES'

I. Introduction and Background
The Japan that can say "no", presumably to foreign (mainly U.S.)
pressures and demands, is by now a familiar concept.' Moreover, aJapan that can even say "yes" to launching its own international
initiatives is gaining attention (Anderson 1992).2 Indeed with thedecision to send troops to Cambodia as a part of the United Nations'peace-keeping forces, the visit of the emperor to China, and theassumption of the position of largest donor of Official Development
Assistance (ODA) on the globe, there are real signs that Japan is
beginning to play a role in world affairs that approaches its huge rolein the global economy and in its trade and investment in particular. In
fora such as the World Bank, some Japanese economists have even had

the temerity to question the premises of the Structural Adjustment
Lending (SAL) program and have held up the experiences of Japan andEast Asia as counter points to American-style free market reforms.3*

The author was a Visiting Professor, Research Institute for Economics and Business

Administration, Kobe University, Kobe, Japan and is a Senior Fellow, EastrWest
Center, Honolulu, Hawaii. The author is grateful to Kazuhiro Igawa, Shoji Nishijima,

Seiji Naya, Eric Ramstetter, Michael Plummer, Mitsuru Toida, Koichi Nakanishi,

Yumiko Okamoto, and Akira Kohsaka for helpful comments and information
pertinent to the study. The author is responsible for any errors and the views expressed
are the author's and not necessarily those of the institutions with which he is affiliated.

This paper was submitted in December 1992.
1

Ishihara, 1991.

2

Anderson argues that Japan has become an activist state in the conduct of foreign

policy and cites examples such as Prime Minister Miyazawa's willingness to
confront Russia on the issue of the four northern territories, as well as theexamples of sending troops to Cambodia, the emperor's China visit, and Japan's
3role as an ODA power.
Far Eastern Economic Review, 1 August 1991, p.56 and Far Eastern Economic
Review, 24 September 1992, p.108.

136

WILLIAM E. JAMESA Japan with a decisive and independent foreign policy may be
more inclined to respond to initiatives like the North American Free
Trade Agreement (NAFTA) and the forming of a single market in theEuropean Community (EC92) with initiatives of its own. Before
exploring the possible responses of Japan to the creation of NAFTA,
some caveats are in order.
First, to cast Japan in the role of a bold international player is tosome extent an exaggeration. In the crucial negotiations to complete a

GATT accord on agricultural subsidies, it is the U.S. and the EC(mainly France and Germany) that are the major actors. Japan has
been relegated to the sidelines. Rather than announcing that it will
begin to reform its rice import ban by adopting tariffication and othermeasures in order to help break the impasse, Japan has been perfectly
willing to sit on its hands in the politically safe position of doing
nothing (illustrating how the scandal-tainted LDP is beholden to thedomestic farm lobby). This timidity on the rice issue is not evennecessary. Voices of reason such as well known agricultural trade anddevelopment economist Yujiro Hayami have pointed out the shift to a
regime of tariffs and permissible imports will be a spur to accelerating

the type of structural changes within the rice and agricultural sector
that are essential to raise productivity to competitive levels.` The
inevitable need to expand and consolidate farms into larger units andto reduce labor use relative to other variable inputs will remain as theprincipal pressures for change in rural Japan. Adopting rice tariffs
initially of some 700 percent and opening the market so that 3 to 5

percent is captured by imports will hardly cause earthshaking
dislocations inside Japan. Thus far, Japan has been content to mouth

its hope for success of the GATT round without taking a lead in
making a successful conclusion more likely. Such a position isparticularly annoying as it is Japan that has benefitted most from theopen multilateral system that the GATT has safeguarded.
A second caveat results from the fact that Japanese government
initiatives in respect to international trade and investment will only beeffective if the private sector is in strong support. I can think ofseveral cases where private support for government initiatives has
failed to materialize. In recent years, for example, Japan has become
4 Hayami, 1988.

A QUALITATIVE ASSESSMENT OF THE EFFECTS OF NAFTA ON 137
JAPAN'S FOREIGN INVESTMENT AND TRADE WITH EAST ASIA
AND MEXICO:OPPORTUNITY OR DIVERSION?
the largest bilateral ODA donor to the South Asian countries (India,

Pakistan, Sri Lanka, Bangladesh, and Nepal), yet its private
investments and trade with these countries remain paltry even in theface of drastic reforms that are opening these formerly closed
economies (Abe and Igawa 1992). Government initiatives in evennearby countries like the Philippines have also generated a less than
enthusiastic response from Japan's private sector.5 Japan has sought

to play an increased role in sub-Saharan African and Eastern
European economic reconstruction, but has had at best limited effectbecause of unwillingness of investors to follow the government's lead.
The private sector can hardly be blamed for not wanting to throw goodmoney after bad or to venture into situations where the very securityof life and limb are at daily risk, Of course, there are also counterexamples that spring to mind. The cautious response of the Japanese
government to the Tiananmen slaughter and the continued emphasis on

economic relations with China has been well-received by Japanesebusinesses which have continued to venture into China in increasing
numbers. It is important to keep in mind the critical role of the private

business sector in any assessment of Japanese official initiatives,
particularly with respect to economic cooperation.
In short, there are still some good reasons to be skeptical about
Japan's willingness and ability to play a leading role in regional andglobal affairs, particularly if the initiative in question is likely to beviewed askance in Washington. Despite this skepticism, it remains agood probability that Japan will become more assertive, particularly in
Asian and Pacific affairs.

ll. The lmpact of NAFTA and Japan's Response on Asia.

The motivation for preparation of this paper stems from thesubstantial role international trade and investment have come to play
5 Japanese FDI remained quite low in the Philippines even after the overthrow of
Marcos in 1986 and the restoration of democracy. The government of Japan was
instrumental to the Multilateral Aid Initiative (MAI) to help pull the Philippines

out of a debt crisis and to rekindle economic growth. The MAI has seen some
improvement on the debt front, yet the economy remains weak, with growth rates
barely keeping pace with population increases. While Japanese investment flows
had been booming in neighboring countries, the Philippines attracted only atrickle (see Asian Development Bank, 1992 p.134 and Tecson 1992). Also see Far
Eastern Economic Review, 2 May 1991, pp.44=6.

138

WILLIAM E. JAMESin the economic advancement of the countries and territories of Eastand Southeast Asia. In the region encompassing Japan, China, thenewly industrialized economies (Hong Kong, Chinese Taipei, South

Korea, and Singapore) and the four largest members of the
Association of South East Asian Nations (Indonesia, Malaysia,
Philippines, and Thailand, henceforth the ASEAN-4), in 1990 the average

share of international trade in gross domestic product (GDP) was 53
percent (table one). It is Japan which stands at the apex of the East
Asian economic pinnacle. Undeniably, Japan plays a significant role inglobal and regional trade and Japanese multinationals and trading
cornpanies have had a major influence on the emergenee of East Asian

economies through trade and investment and other financialtransactions (Katano, Murakami and Ikemoto 1978; Ichimura 1988). In
the 1980s and into the early 1990s Japanese foreign direct investment(FDI) and related transfer of technology, restructuring of industry,
and creation of stronger marketing ties and management innovations
became especially noticeable in the region.6

The question I have been concerned with is what will be Japan's
response in future trade and investment decisions and, possibly in thearea of economic cooperation initiatives, to the NAFTA accord? Inturn, how will Japan's response affect trade and investment flows andpatterns in East and Southeast Asia and, consequently, the prospects

for continued rapid economic growth? These questions will assume
greater urgency should the current agreement on EC agricultural
subsidies and oilseeds fall apart. Agreement on agriculture is essential

to breaking the impasse in the GATT round. Failure would increase
greatly the prospects of a U.S.-EC trade war, though it stretches thelimits of any logic, that a single country (France) could convince theentire EC to abrogate the agreement with the U.S. after such arduous
negotiations and with the entire GATT accord at stake. If the GATT
round does unravel and the U,S. and EC remain at odds, and opt forprotectionist positions, will trade and investments be diverted from Asia

to the huge and protected markets of NAFTA and the EC? It is also

possible that discord within the EC may mount and reduce thelikelihood of a single market, protected or otherwise. The outcome, inthe context of a weak global economy and an unsettled trade system
6 See Omori and Takata, 1992 and Plummer and Ramstetter, 1991.

A QUALITATIVE ASSESSMENT OF THE EFFECTS OF NAFTA ON 139
JAPAN'S FOREIGN INVESTMENT AND TRADE WITH EAST ASIA
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would be that much more gloomy for recovery to robust growth.
There are those in Asia who have called for a more firm Asian
response to regionalism in Europe and the Americas. To date, theMahathir proposal for an East Asian Economic Grouping (EAEG) has
been the most forceful call to create an exclusive Asian cooperationgroup. However, the proposal has been scaled back to an East Asian
Economic Caucus (EAEC) and even this has been overshadowed by the
APEC and the move by ASEAN itself to create the ASEAN Free Trade

Area (AFTA) within the next 10-15 years. Asia-Pacific Economic
Cooperation (APEC) itself was first proposed by former Prime
Minister Hawke of Australia to exclude North America. This wasoverruled by other members and the U.S. was, with Canada, brought
into the fold. APEC, therefore, bridges East Asia and North America
and this is an important characteristic of the APEC process. Within
East Asia, open regionalism has received strong support from scholars
and policymakers (Elek 1992). A proposal for Regional Cooperation in
East Asia (RCEA) with the aim of strengthening the regional structureof production and trade without resorting to discriminatory tariffs, hasgained attractiveness as it is expected that intra-regional trade willcontinue to increase more rapidly than global trade (Furukawa 1992).
I will return to this point in considering what Japan might propose asa counter to NAFTA in the context of possible configurations of an
Asian-Pacific cooperation agreement.
There are new trends and patterns emerging in East Asian tradethat have permitted the region to continue its rapid economic growth
into the early 1990s despite the U.S. recession and stalled recovery,
slowdown in Japan and sluggishness in parts of Europe, and notably
Germany (Toida 1992). Despite the weakening global economy, theaverage rate of real economic growth in the NIEs and ASEAN-4
together was as high as 7.1 percent in 1990 (see table two), 6.8 percent

in 1991 and is projected to exceed 7 percent in 1992 and 1993 (Toida

1992 and ADB 1992). China has reported nearly double-digit real
economic growth for most of 1992 and shows few signs of slowing
down. The economic growth has been helped by the remarkable recent
expansion of intra-regional trade and investment (Toida 1992). From1986 to 1990, growth of intra-regional exports among the NIEs and
ASEANm4 have been expanding at a phenomenal rate of 23 percent per

annum, above the rates of expansion of exports to the world (19140 WILLIAM E. JAMES
percent), the U.S. (18 percent), the EC (21 percent), or Japan (15percent) and in 1990 the combined share of the NIES and ASEAN-4 in
ASEAN-4 exports exceeded the shares going to the U.S., Japan, or theEC (Toida 1992 and IMF 1991). It is also apparent that trade
expansion has been complemented by a rapid rise in flows of overseas
direct investment particularly involving Japan as an investor, the NIEs
as both investors and hosts, and ASEAN-4 and China mainly as hosts(Japan Committee for PEO 1992).7 •Recent research in the economics of regionalism has sought toevolve meaningful measures, in a quantitative sense, to determine
whether a proposed or existing grouping is "natural" so that it will
result in beneficial net trade creation. The criteria used by Krugman(1991) and Frankel (1992) among others, has focussed on the volume orvalue of intra-block trade as the key determinant of whether agrouping will tend to be tradeecreating on balance. If intra-blocktrade is already a large share of existing trade of block members as is
the case in NAFTA, then the effect can be expected to be positive or
trade'creating. However, Kreinin and Plummer (1992a and 1992b) haveproposed and estimated an alternative criterion that focusses on thepattern or composition of trade. They argue that if a block largely
preserves a pattern of trade that is closely correlated to a ranking of
revealed comparative advantage, then the block is likely to be a naturalgrouping. They have shown this to be the case for the NIEs (lessChinese Taipei) and the ASEAN taken together. The addition ofChinese Taipei (Taiwan) would be likely to strengthen rather thanweaken this result. I will come back to eonsider the inclusion of Japan
later in the paper.

A spectacular example of dynamic growth within the region canbe seen in the Hong Kong-Southeast China-Chinese Taipei triangle.
Economic growth in Guangdong has been reported to be in the vicinityof 20 percent per annum in real terms in recent years.8 Moreover
investments have been rising between the 3 Chinese economies sparking

even higher growth and trade expansion. However, this example is'
7 A surprising finding of the Pacific Economic Outlook (PEO) project on "Changing
Patterns of FDI in the Asia-Pacific Region" is that China's outward investment inHong Kong exceeds Hong Kong's FDI in China. See Tang 1992, pp.110-1,
8 Far Eastern Economic Review, 16 May 1991, pp.64m8.

A QUALITATIVE ASSESSMENT OF THE EFFECTS OF NAFTA ON 141
ASIA AND TRADE WITH EAST
JAPAN'S FOREIGN INVESTMENT
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telling about the prospects for Asia to try to go it alone as well as
indicative of how dependent growth in the region is on continued accessto global markets. In 1992, Hong Kong has reported a growth rate ofexports exceeding 20 percent.9 However, domestic exports of goods
and services produced in Hong Kong have been growing only at a 2
percent rate. In contrast re-exports of goods produced largely by
China are growing at a rate of over 30 percent and are now over 3
times as large as domestic exports. The U.S. is the largest market forthese re-exports and has a huge trade deficit with China whenre-exports are considered to originate in China.iO A U.S. decision towithdraw MFN (most favored nation) status would certainly bring a
sharp slowdown to growth in the Chinese triangle. No wonder there is
deep concern about U.S. trade frictions and political differences with

Beijing in both Taipei and Hong Kong. Japan has shown little ability
to absorb East Asian exports in volumes that would do anything toobviate the Ioss of the EC or North American markets. Table threeshows that U.S. imports have been a multiple of those of Japan. In
addition, Japan's imports of manufactured goods, though rising from24 percent of total imports in 1981 to about 50 percent in recent years,

are far less than what the U.S. imports.

It is clear that prosperity in the NIEs continues to depend asmuch or more on access to the North American market than it does on
intra-regional trade in East Asia. In 1990 the U.S. purchased nearly 28

percent of the NIEs exports compared to 11.5 percent for Japan,
Intra-regional markets in East Asia (including the NIEs, Japan, China

and ASEAN-4) by 1990 took around 40 percent of the NIEs exports,

compared to around 30 percent for North America. The NAFTA
markets combined are around three times as important as any
individual East Asian market is for the NIEs, except in the cases ofHong Kong vis-a-vis China, where the NAFTA is only slightly larger, in
Singapore visma-vis Malaysia where the NAFTA is about two times aslarge, and in South Korea vis-a-vis Japan where the NAFTA is about
1.5 times as large. The point is underscored by the fact that the
9 This was reported in the Asahi Evening News, October 20, 1991 p.4. Also see AsianDevelopment Bank, 1992, p.75 for data on domestic exports and re'exports in recent
years.

10 In 1992 it is estimated that the U.S. deficit with China will be $15 billion. See The
Daily Yomiuri, November 25, 1992, section A, p.5.

142 WILLIAM E. JAMES
composition of exports from the NIEs to the North American market ismore concentrated in sophisticated manufactured goods than is theexport trade with Japan. This is even more so in the case for the

ASEAN-4 exports where the U.S. has been a major purchaser ofmanufactures, whereas Japan has mainly imported primary goods andslightly processed raw materials.

The creation of NAFTA will result in elimination of trade
restrictions between the three countries involved: Canada, Mexico andthe United States. Therefore, all other countries including those in East

Asia would be discriminated against in the North American market
when competing with producers that are internal to NAFTA. One
empirical study (Kreinin and Plummer 1992c) has computed the static
effects of the NAFTA on the ASEAN (including Singapore and Brunei

with the ASEAN-4) and South Korea (hereafter Korea). The Kreinin
and Plummer study involved determining which industries in ASEAN

and Korea which currently export into North America would be
adversely affected by tariff discrimination after NAFTA takes effect.
The study involves matching of competing industries at the four digit
SITC level with a cutoff at exports of $250,OOO into North America in1987 or 1988. The same cutoff was used for competing industries in

Mexico and Canada, with a $500,OOO cutoff for the U.S.-based
competing exporters. Because of the difficulties involved in quantifying
non-tariff barriers (NTBs), the study focussed on the effects of tariffdiscrimination and so probably understates the degree of trade
diversion caused by NAFTA by what may be a factor of 2 or 3. The
results indicate that the integration of North America will divert $484
million or about 4 percent of ASEAN exports and $1,O15 million or 5
percent of Korean exports.

Among the sectors that will be hardest hit for ASEAN are
chemical compounds, veneer, textiles and clothing, and some machinery

items. Singapore appears to bear a disproportionate share of the
trade diversion within ASEAN, This is perhaps a result of the fact that

Singapore (like Korea) has been graduated from the U.S. General
System of Preferences (GSP) scheme. The ASEAN-4 continue to enjoy
GSP access for eligible exports to the U.S. For Korea the mostaffected sectors include organic chemicals, leather manufactures,textiles and clothing, iron and steel, metal manufactures, railway
vehicles, travel goods, footwear, furs, fish, and instruments (including

A QUALITATIVE ASSESSMENT OF THE EFFECTS OF NAFTA ON 143
JAPAN'S FOREIGN INVESTMENT AND TRADE WITH EAST ASIA
AND MEXICO:OPPORTUNITY OR DIVERSION?
watches and clocks). Most of the trade diversion is, of course,
accounted for by the U,S. market, which is huge compared to those of
Canada and Mexico. It is unsurprising that these sectors are thosewhere U.S. tariffs are rather high and that also have a strong incidenceof NTBs (e.g. textiles and clothing, iron and steel) as well. I have n6t

come across similar studies of the effect of NAFTA on Japan, or the

3 Chinese economies. NAFTA may have a strong effect on certain
sectors important to Japan, particularly automobiles, other transport

equipment and electrical equipment and machinery. Local content

regulations on autos may make it difficult for Japanese auto
assemblers to substitute vehicles produced within NAFTA for exports
from Japan or for such locally assembled models to have free access to
the NAFTA market as a whole. The three Chinese economies have evenmore reason to be concerned about NAFTA, as textiles and clothing,along with footwear, consumer electronics, and chemicals are all
significant in their exports. They are more competitive with Mexico inthese and other areas like toys, metal manufactures, leather products,
and processed food, hence effects are bound to be significant. Japan ismore complementary than competitive with Mexico and also enjoys
having on the ground major production and distribution networks
throughout North America, though less so in Mexico than in the U.S.
or Canada. ii

The trade diversion resulting from the creation of NAFTA is, in
effect, a once-and-for-all loss from the terms of trade effect of tariffdiscrimination in the North American market. A direct implication isthat if the GATT round succeeds and global tariff cuts (and reductionof NTBs) occur, the losses due to discrimination by regional groupings

such as NAFTA and EC will be that much lower. Hence, it is clearlyin the interest of the East Asian countries to pursue a successful closeof the GATT negotiations as quickly as is possible.

M. Evaluation of NAFTA From A Dynamic Perspective.
For a number of reasons, I am inclined to the view that the
dynamic consequences of the NAFTA accord are likely to far outweighthe static losses. The key elements in this are the far-reaching
11 See Omori and Takata, 1992, p.155, Also see Far Eastern Economic Review, 11
July 1991, pp.42-6.

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WILLIAME. JAMES

economic reforms undertaken in recent years by Mexico and the effects
these (along with NAFTA) wil} have on factor flows, investment andeconomic growth and, in turn, how these elements impact oninternational trade. As the dynamic effects occurring through changes

in investment (and labor migration) between the U.S., Canada, andMexico are likely to dominate static measures, it is important toconsider patterns of investment in varying scenarios.
In this context, it is noteworthy that Mexico has implemented an
unparalleled program of trade and investment liberalization along withachieving macroeconomic stabilization. Inflation has been brought
down from an average of over 70 percent per annum in the decade
1980-1990 to near a single digit rate, Economic growth averaged apaltry 1 percent annually in the 1980-1990 decade, but in recent years
has been in the 3-5 percent range. Mexico has been able to cut its debt
service ratio nearly in half from 50 percent in 1980 to 28 percent in 1990

and, as interest rates have fallen, it has cut the ratio of interest
payments to exports of goods and services to 16.7 percent in 1990, downfrom almost 30 percent in 1980. After major devaluations, the Mexican
peso has been freely floating and a competitive real exchapge rate has
been maintained. As exports have been growing (reaching nearly $30
billion in 1990, more than Malaysia or Indonesia), further progress indebt service reduction can be expected.
NAFTA is like an insurance policy for sustained economic reformin Mexico. In preparing for the implementation of the agreement,
Mexico has reduced its maximum external tariff from 100 percent to 20
percent, and has cut the overall average of its tariffs from 23 percent
to just 10 percent. The highly restrictive foreign investment law of 1973
was greatly liberalized in 1989 and, in anticipation of NAFTA, in 1992

further reforms to foreign investment regulations were announced.
These include a simplification of registration procedures, andclarification of the legal requirements for investment in real estate andMexican financial instruments. Not only has the climate for foreign
investors been improved, but also for all types of private investment.
Mexico is in the process of privatizing state enterprises as well.
Private investment, including a return of flight capital, could further

bolster income growth in Mexico and contribute to further expansionof Mexico's external trade, not only within NAFTA but also with otherregions including East Asia. If this income effect from higher private

A QUALITATIVE ASSESSMENT OF THE EFFECTS OF NAFTA ON 145
JAPAN'S FOREIGN INVESTMENT AND TRADE WITH EAST ASIA
AND MEXICO:OPPORTUNITY OR DIVERSION?
investment on imports is strong enough, it could more than offset thestatic losses from trade diversion.

The main issue of concern is that NAFTA may lead to investment
diversion that will mean that Japanese, Korean, and Chinese investors
in Hong Kong, Taipei, and Singapore may, on the margin, reallocate

investments from Southeast Asia or mainland China to Mexico.
Similarly, U.S., Canadian, Australian, and EC-based firms may also
shift FDI flows to Mexico and away from East Asia. While FDI flows
from multinational corporations based in the U.S., Japan and Europe

have not accounted for a very high proportion of total capitalformation in East Asian developing economies, FDI has been asignificant factor in manufacturing investment (Naya and Ramstetter

1992). And though the shares of output and employment ofmultinational affiliates in the NIEs and ASEAN-4 have been rather
small, they have been responsible for a very substantial share ofinternational trade, particularly in manufacturing. With the debt crisisand the slowdown of international commercial bank lending in the
1980s, other forms of private financial transactions including direct andportfolio investment have become more important sources of capital fordeveloping countries, especially in East Asia. In the latter half of the

1980s, FDI has been a major factor in the continuing economic
dynamism of the ASEAN-4, the NIEs and China. '2 Investment diversion
is more likely to occur in an industry or sector where there are bothstrong effects from trade diversion and a relatively large amount of

FDI. For ASEAN (including Singapore) the sectors that appear tomeet the above criteria are food, textiles and clothing, chemicals,
metals, and electronics.'3 For Korea the sectors facing investment

diversion are: chemicals, machinery, electronics, and transport
equipment.i` These are industries that are likely to be of strategic
importance in the future economic development of East Asia. A decline
in FDI is cause for concern because of the potential negative effects
12 Far Eastern Economic Review, 28 February 1991, p.72; Asian Wall Street Journal,
November 25, 1992, p.8; RH.Myers, 1992 and Plummer and Ramstetter, 1991. Myers
reports that two-way trade between Taiwan and China increased from $2.7 billion

in 1988 to $5.7 billion in 1991 and that 3,OOO companies from Taiwan haveinvestments in China topping $3 billion. In the past five years over 4 million
people from Taiwan have visited the mainland.
13 Kreinin and Plummer, 1992c.
14 Ibid.

146

WILLIAME. JAMES

this could have on future size and growth of trade and, secondarily,
employment.'5 In 1988, for example, export-sales ratios for majorityowned non'bank foreign affiliates of non-bank U.S. parents in the

ASEAN-4 averaged (over al} industries) more than 50 percent. In
Korea over 40 pereent of sales of U.S. multinational affiliates were
exports in 1988. Foreign affiliates of Japanese multinationals operatingin the NIEs and ASEAN had expoirt-sales ratios averaging over 40
percent in 1988.i6 U.S. and Japanese multinational affiliates share of

total merchandise exports of the NIEs and ASEAN-4 exceeded 20
percent in 1988 (Ramstetter and James 1992). The substantial role
multinationals play in the foreign trade of Asian NIEs, ASEAN-4, andChina implies that investment diversion could weaken the export growthof these economies in the future.

While shares of multinational affiliates in total employment
remain, for the most part, rather small (it is largest in Singapore,
where the employment share of U.S. and Japanese affiliates combined
was only 5.3 percent in 1988, elsewhere it rarely exceeded 1 percent of
total employment), in particular industries like electronics there could

be substantial effects. For example, foreign affiliate employment in
Korean electronics and electrical machinery was as high as 57 percent
in 1986." A substantial drop in FDI could therefore have a disruptive
effect on employment in a key industry.
Quantifying investment diversion is, at best, a heroic exercise witha substantial margin of error. Moreover, given the data problems with
FDI statistics, particularly in Japan and the East Asia, any statisticaleffort to estimate investment diversion would be highly unreliable.
Therefore, the approach I will take is to seek to assess qualitatively

how Japanese multinationals might respond to NAFTA. In Septemberof 1991 a survey of 563 Japanese affiliates was conducted by a
15 Ramstetter and James 1992; also see Far Eastern Economic Review, 11 July 1991,
pp.42-3. A recent article in The Economist (November 7-13, 1992, p.85) asserts that

because profit margins are higher and labor costs lower in Asia than in Europe

or North America, Japanese FDI will increase more in developing Asia thanelsewhere, once investment levels recover in the mid-1990s.

16 Ramstetter and James, 1002, pp.80-4. These ratios vary considerably between
countries and over the course of time and ultimately reflect the degree of opennessand export-orientation of the host country.

17 Kreinin and Plummer, 1992c; Plummer and Ramstetter, 1991 and Ramstetter andJames, 1992. The latter show that employment in Korean affiliates of U.S. parents
in electric and electronic equipment increased by over 40 percent between 1986 and1988.

A QUALITATIVE ASSESSMENT OF THE EFFECTS OF NAFTA ON 147
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Japanese economic journal, Nikkei Sangyo, with 269 responses. The
survey sought to determine prevailing attitudes among Japanesemanagers of affiliates already on the ground in the U.S. towards thecreation of NAFTA. Of those replying, 52.4 percent regarded NAFTA
as protectionist, 14.9 percent disagreed that NAFTA was protectionist,and 32.7 percent did not have an opinion either way at present. The
survey went on to ask how NAFTA would affect the U.S. economy in

the following specific areas U.S. competitiveness, employment,
agricultural prices, trade in services, and if NAFTA would squeeze out
Japanese firms in the U.S. market. 42 percent of respondents felt that
U.S. competitiveness would increase, 46.5 percent felt it would decrease

and 11.5 percent had no opinion. 58 percent believed NAFTA would
reduce employment in the U.S., 27.9 percent believed employment would
increase and 14.2 percent were unsure. 33.1 percent said NAFTA would
reduce U.S. farm prices, 42.8 percent said it wouldn't and 24.1 percent
didn't know. 63.2 percent said NAFTA would boost U.S. service trade,particularly export of communication equipment, 17.5 percent disagreed,and 20.3 percent had no view. Interestingly, only 17.5 percent of the
respondents felt NAFTA would squeeze Japanese firms out of the U.S.,
with 54.6 saying it wouldn't and 27.9 percent not sure either way.

Regarding the effects of NAFTA on Mexico, the survey asked if

NAFTA made Mexico more attractive to Japanese firms. An
overwhelming 62.1 percent agreed the NAFTA enhanced Mexico's
attraction to their firm. Another 34.6 percent felt NAFTA would haveno effect or didn't know. Only a paltry 3.3 percent believed NAFTA

reduced Mexico's attractiveness. The issue of local content
requirements of NAFTA has been asserted to be among the mostimportant influences on trade and investment within NAFTA. A recent

study (Fukasaku, Lee and Yamawaki, 1992) finds that local
procurement ratios of components and parts (to total procurement) ofJapanese affiliates in 1989 averaged 53 percent in Europe and 47
percent in North America. However, when taking into account value
added, (including, in other words, labor, depreciation, and otheroverhead costs in addition to parts and components) local content was
as high as 73 percent in North America and 70 percent in Europe.
Thus, the actual measurement procedure for local content makes anenormous difference. The survey tended to bear this out as 54.3
percent felt local content regulations would have a major impact on

148

WILLIAM E. JAMESJapanese firms operations, 41.3 felt the effect would not be large, while

only 4.1 percent felt there would be no effect. The survey included
some comments and observations from particular industries that arealso of interest. Automakers were among the most sensitive and someview NAFTA as a deliberate policy aimed at reducing Japan's market

share. Construction companies also expressed concern overprotectionism. Machinery producers and steel companies feel NAFTA
will induce companies to move production facilities to Mexico to takeadvantage of lower labor and other costs. Financial firms andbrokerages, in contrast, expressed skepticism over the reliability of
Mexico as an investment destination and even felt the longterm effectof NAFTA might be to weaken U.S. competitiveness in finance. Trading
companies pointed out the huge scale of Japanese FDI in the U.S. andasserted NAFTA was unlikely to have much impact on their operations.

Paper companies and producers of electronic goods took a morepositive attitude and expressed interest in expanding sales to Mexico
and improving the local content of their products.

The annual survey of Japanese FDI conducted for 1991 by the
Research Institute of Overseas Investment of the Export-Import Bankof Japan included a section on NAFTA (Tejima 1992). The survey wastargeted at 551 manufacturing firms with three or more foreigeregistered affiliates of which 298 or 54 percent replied.i8 The survey

asked the firms to indicate how regional integration in European andNorth American markets might affect their access and, accordingly,

what influence this will have on future FDI in those markets.
Interestingly, far more respondents (118 or 42.3 percent) thought thataccess to Europe would become more difficult than those that thought
this would be the case (73 or 26.6 percent) for North America. In fact

73.5 percent of respondents thought that access to North America
would be unaffected or remain easy compared to 57.6 percent for
Europe. The perception that European integration is more likely toresult in a protected market Ied a greater number of Japanese firms(98 or 35.2 percent) to state that they would increase the level of FDI

there. In the case of NAFTA only 49 respondents or 17.8 percent
expressed an intent to increase FDI as a means to ensure market
18 The firms answering the survey had a total of 4,617 overseas affiliates including
1,463 in the U.S., 1,047 in the EC, and 1.391 in the NIEs and ASEAN combined. For
details of the profile of responding firms see Tejima, 1992, p.27.

A QUALITATIVE ASSESSMENT OF THE EFFECTS OF NAFTA ON 149
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access. While 62 percent of firms indicated there would be no change
in their investment plans because of European integration, 80 percent
indicated the NAFTA would not effect their future FDI. An interestingnote to the survey is that the Japanese manufacturing multinationals inthe survey were about as keen to expand their FDI in Latin America asin the Asian NIEs, the U.S. or Canada. China and ASEAN continued tobe the favorite areas for expansion of future FDI. A preliminary
analysis of the 1992 survey shows that Japanese multinationals are
growing more concerned about the rise of regionalism in Europe andNorth America. Though they expressed increased anxiety overregionalism, the firm's surveyed were not planning to alter theirinvestment strategies substantially and were interested in the details of

how the NAFTA scheme would be implemented. One could surmisefrom this that Japanese firms are taking a wait-and-see attitude
towards NAFTA in formulating their future strategies.
Though of interest, survey results such as those above should not
be considered definitive of Japanese multinationals' attitudes towards

NAFTA. It is cause for some concern that the survey was conductedprior to the U.S. presidential elections, and with a new and unfamiliar

U.S. administration coming to power, Japanese views may havechanged.
IV. Japanese Officials' Views and the Private Sector's Reaction to

NAFTA.
Officialdom in Japan seems genuinely concerned over the direction

NAFTA might take (a) under Clinton instead of Bush and (b) with a
GATT agreement in place or without, Japanese officials have been
engaged in consultations with their largest Asian economic partners,
Korea, ASEAN, and China. Korea and Japan have agreed to carefully

monitor NAFTA and to work together against discriminatory orprotectionist actions by the U.S. Japan's Minister of International
Trade and Industry, Kozo Watanabe, openly criticized U.S. advocacy ofregionalism and the Bush proposal to negotiate free-trade agreements
along lines similar to NAFTA with other countries in the Pacific.
Watanabe specifically objected to the discriminatory local content
regulations of NAFTA and pointed out the Bush proposal contradicted
U.S. opposition to Malaysia's proposal to create a block in East

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WILLIAM E. JAMES

Asia. i9

Even as officials monitor the implementation process of NAFTA, it
appears Japanese companies are already moving to position themselves

to take advantage of NAFTA. For example, Nissan which has beenassembling light trucks and autos in Mexico since 1966 is making
efforts to boost the local content of its Mexican production runs.
Nissan recognizes that NAFTA will only give tariff breaks to Japanesesubsidiaries in North America if they increase the use of local
suppliers. Nissan Mexico recently begun placing orders with U.S. parts
suppliers, acting as if NAFTA was already in effect. One such supplieris Snider Mold of Wisconsin, which now exports molds to produce

components to Nissan in Mexico.20 Honda also appears to be
responding effectively to the U.S.-Canada FTA of 1988 as it hasestablished assembly operations in Canada and in the U.S. it has
invested in production of engine components. Recently Canadian and
U.S. negotiators came to terms in accepting Hondas assembled in
Canada as being Canadian rather than Japanese in origin, thereby
reversing a U.S. Custom's Service decision to charge import duties.2i

The decision came after three years of wrangling and is cited as aresult of the August 12 signing of NAFTA, which allows parts producedby American subsidiaries of Japanese companies to be considered
locally produced. The inclusion of Mexico in NAFTA will allow parts
sourced there to come within local content regulations of the agreement

and this may induce producers of autos and auto components to invest
there. In order for such investments to materialize Mexico will need to'demonstrate political stability and continued improvement in economic
conditions for private investors from abroad. As Japanese companies
have expressed some skepticism over the ability of Mexico's labor andproduction managers to meet the stringent productivity levels, quality
controls, and delivery schedules required, these appear to be areas
where Mexico will have to make visible strides.
Despite the wait-and-see attitude that appears to be dominant in
the Japanese private sector towards NAFTA, in official quarters vocal
criticisms against U.S. regionalism and protectionism are increasingly
heard. It is somewhat perplexing to the Japanese that the U.S. would
19 See the Asahi Evening News, October 19, 1992, p.1.
20 Asian Wall Street Journal, November 2, 1992, pp.1,6.
21 See the Asahi Evening News, October 19, 1992, p.7.

A QUALITATIVE ASSESSMENT OF THE EFFECTS OF NAFTA ON 151
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insist on moving ahead with FTAs in the Americas (and elsewhere suchas with Israel), yet vehemently oppose any Japanese initiatives orsupport for a regional grouping in East Asia. Japan does not appear

to favor an East Asian block, and would much rather continue toengage in trade, investment and other transactions on a multilateral,
non-discriminatory basis. Yet Japan has cautiously begun to consult
more closely with important economic partners in East Asia in how todeal with the perceived threat of fortress-like blocks in the EC and
NAFTA, It also has company in Korea and Chinese Taipei on the rice

issue, which puts these three economies in the odd position ofdesperately needing GATT to succeed, but not to the extent it threatens
their protectionist stand in rice and agriculture. There are other signsof change in patterns of trade and investment in the region that are
related to creation of NAFTA, in particular, investment flows from the
NIEs to Mexico, that are of concern to the ASEAN'4 and China.

V. The NIES, ASEAN, China and Japan: Coordinated Response or
lndividual Strategies?

For the economies of East Asia, international trade andinvestment are their life lines to sustained economic growth. A
successful conclusion to the Uruguay Round of the GATT is the closest
thing to a first'best solution to the problems posed by regionalism inEurope and North America. Yet a closure to the GATT negotiations isstill uncertain, even with the agricultural compromise between the EC
and U.S. there will remain many difficulties in hammering out final
agreements in agriculture, services, textiles, intellectual property rights,

and trade+related investment measures, particularly in arriving atagreement on implementation, dispute settlement mechanisms, andenforcement measures. The phasing out of the Multi-Fibre Agreement(MFA) is to take place over a ten year period with MFA quotas being
replaced with tariffs and textiles trade being brought under the GATT
umbrella. The U.S. has shown that, while its foremost interest is instrengthening the multilateral trading system, it is also ready to moveahead with bilateral negotiations and arrangements such as FTAs
where it feels these are in the national interest. The question for East

Asian economies is whether they should seek individual bilateralnegotiations with the U.S., including entering into FTAs with the U.S. as152 WILLIAM E. JAMES
has been suggested by some academics (see for example Schott 1989)
and, more recently by the out-going Bush administration, as well assome members of the U.S. Senate. Alternatives to this appear to be for
East Asian economies (1) to push more aggressively for a satisfactory

and timely GATT accord; (2) to strengthen economic cooperation
among themselves through existing institutions (e.g., ASEAN, APEC);or (3) to create new mechanisms for regional cooperation in East Asia

(e.g. EAEC or RCEA). These approaches are not conceptuallymutually exclusive, but given the limited resources available and the
difficulties of negotiating on more than one front without ending up at

cross purposes, it is important for East Asian economies to set
priorities. China and Chinese Taipei are both currently seeking
membership in GATT and have some additional work to do to conformwith GATT standards. For Chinese Taipei like Japan and Korea,
agriculture remains the achilles heel of their trading system coming
into conformity with the new GATT accord. Japan and Korea seem tobe spending an inordinate amount of effort and political capital in the
defensive posture of seeking to exempt themselves from tarifficationand market opening measures in agriculture. This may be smart orsafe from the standpoint of short term domestic political interest, but

it appears to be very unwise from an economic point of view. The
argument that agricultural protection is essentially a national security

issue is fallacious, as food stocking and storage is a far less costly
alternative (Tsiang 1989). Moreover, the benefits to these economies ofa successful GATT would far exceed the costs. An OECD study
projected the change in income that would accrue to various countries

or regions from successful implementation of GATT-sponsoredliberalization measures in the year 2002. East Asian economies
emerged as the biggest winners, with China gaining 2.5 percent of GDP,
the NIEs and ASEAN averaging a 2.6 percent gain, and Japan gaining
O.8 percent.22 Gains for the three NAFTA members, in contrast, were:
U.S. O.2 percent, Canada O.1 percent, and Mexico O.3 percent. Japan
should also take into account the fact that the global gain to all

developing economies from a successful GATT would be equal toaround $90 billion over the next decade, almost as much as Japan's
22 The results of the OECD study were reported in the International Herald Tribune,
November 21-22, 1992, p.1.

A QUALITATIVE ASSESSMENT OF THE EFFECTS OF NAFTA ON 153
JAPAN'S FOREIGN INVESTMENT AND TRADE WITH EAST ASIA
AND MEXICO:OPPORTUNITY OR DIVERSION?
entire ODA will be. Losers among the developing economies like some
African countries and, possibly some Asian countries could easily becompensated for their losses through additional ODA grants.
The option (2) mentioned above, can also be pursued profitably

and without jeopardizing the GATT process. The creation of AFTA
over the next 10-15 years is a case in point. Though it is still a longway off, the free trade agreement in ASEAN is being implemented
gradually through mutual trade liberalization. While AFTA, as in
NAFTA, will embody preferential (that is to say, discriminatory) tariff

treatment for members, it is being done in the context of overall
liberalization on a MFN basis. Indonesia is an excellent example ofthis process, and has not only reversed the trend towards higher
protection of the late 1970s and early 1980s, but it has substantiallyrationalized and reduced protection since then (GATT 1991). Japan,

China, and the NIEs can use the APEC forum to strengthen
cooperation and to engage the U.S. interest in the dynamic Asia-Pacificregion. APEC can be used to bring attention to outstanding issues orproblems that NAFTA might create and make the U.S. aware of theopportunities cooperation might entail. Clearly, the best interests ofEast Asia will be served by a successful implementation of the GATT

agreement and by strengthening regional economic cooperation on an
open and non-discriminatory basis. In this context, an East Asiangroup such a RCEA could be created as a means of broader
consultation within East Asia without threatening ASEAN or creating a
bloc on a discriminatory basis as a defense against the EC or NAFTA.
AFTA itself can be expected to eventually reduce external tariffs to thepoint where internal tariff preferences would become negligible. This isalready the case for Singapore and Brunei.
One of the concerns NAFTA has raised beyond its possible effects
on Japanese FDI, is that the capital surplus NIEs will also divert

investments to Mexico from the ASEAN-4 and China. There have beenreports of Korean and Chinese Taipei textile producers relocating to
Mexico and it is highly likely that textile trade will be among thesectors most strongly impacted by NAFTA. Korean auto producers
Hyundai and Kia Motors have already established production anddistribution facilities in North America, with Kia Motors announcing
the opening of an auto plant in Mexico in 1991. Furthermore, theKorean conglomerates, Samsung and Lucky Goldstar have announced

154 WILLIAM E. JAMES
their intention to locate a $150-200 million color television production

plant in Mexico. 23 With the slowdown of Japanese overseas investment
since 1991 projected to continue into 1993, there has to be concern in
China and ASEAN.2` Despite this situation China has reported record

levels of incoming FDI in 1992, and FDI realized has mounted from
$3.4 billion in 1990, to $4.2 billion in 1991 and $6.4 billion in the first

three quarters of 1992!25 In fact, it is more likely that China, and not

Mexico, will be the primary competitor for FDI inflows for the
ASEAN-4. Vietnam and India also loom as future competitors within

the region. .

The investment boom in China is seen as a result of several
favorable trends. The pronouncements by Deng that endorsed open
market reforms and high economic growth in South China, coupledwith an emphasis on deepening the reform process to expedite China's

membership in GATT and a successful compromise with U.S. tradenegotiators that led to continuing MFN treatment are the reasons for

invigorated investor confidence. China's proximity and inherent
attractiveness to overseas Chinese investors, particularly those in

cash-rich Taiwan, Hong Kong and Southeast Asia are also enabling
factors. The establishment of full diplomatic relations with South
Korea, despite objections from China's erstwhile ally in the north, has

no doubt boosted Korean ventures in China. Problems remain,
however. The recent discord between the Chinese authorities and thein-coming British Governor of Hong Kong threatens to undermine
economic relations. A new administration in Washington D.C. that has
characterized the policies of President Bush towards China as "failed"
is another worry, Should Clinton decide to withhold his veto powerover legislation to deny China MFN status, investor confidence andtrade would suffer a strong blow. Continuing to include China in aregional dialogue that encompasses the U.S., Japan, and ASEAN alongwith Hong Kong, Korea, and Chinese Taipei is an important reason forusing option 2 above. Japan's largest trade partner in East Asia in the
future is going to be China, replacing Korea. Japan has a very strong
interest in seeing China grow and prosper and would bear high costs
should China collapse into stagnation or chaos. Hence one can expect
23 Far Eastern Economic Review, 12 November 1992, p.65.
24 See Omori and Takata, 1992, pp.146-7.
25 Asian Wall Street Journal, November 25, 1992, p.8.

A QUALITATIVE ASSESSMENT OF THE EFFECTS OF NAFTA ON 155
ASIA AND TRADE WITH EAST
JAPAN'S FOREIGN INVESTMENT
AND MEXICO:OPPORTUNITY OR DIVERSION?
Japan to play a leading role in bridging China and North America as
well. For this reason, it would appear to be a superior strategy forJapan to seek to do its part to move GATT forward by agreeing toopen the rice market and accept tariffication and, at the same time, toseek a coordinated effort in East Asia to embrace open regional

cooperation. Japan has thus far resisted option 3 above wheninterpreted as a move to create a discriminatory bloc in East Asia, andit would do well to continue to eschew a strategy of building an
exclusive block in East Asia. An RCEA-type grouping, however, could
have advantages for Japan as it would provide a forum for East Asia
to engage in consultations and, at the same time, allow East Asians towork together for more open and liberal trade globally. Moreover, it
is probable that such a grouping would be natural. That is, it will not
distort the pattern of trade away from comparative advantage and,hence, would satisfy the criteria discussed earlier (Kreinin andPlummer, 1992a, 1992b). Despite this, a formal East Asian grouping is
not likely to be established in the near future. (Yamazawa, 1992).

Engaging in the creation of an organization or grouping that is
exclusively East Asian also carries with it some risk. It could easily beperceived as a first step towards a trade block. In addition, any likely

configuration of such a grouping would involve parties that havesubstantial political and security differences. Bilateral relationshipsthat are under strain include those between China and Hong Kong, Viet

Nam, and Chinese Taipei. While economic integration characterizes
East Asia, political problems such as reunification of the Korean
peninsula, holding peaceful elections in Cambodia, and deciding on how
to deal with the Burmese military dictatorship are less easy to resolve.

A final problem is that an East Asian group would leave out the
populous and impoverished nations of South Asia as well as the Asian
republics and territories of the former Soviet Union. It would be more

beneficial for East Asia and Japan if the South Asian nations,especially India, could join in the region's economic dynamism.
Conditions that would help the momentum of economic reform there
include a successful GATT and greater trade and investment links withJapan and East Asia. Japan could also choose to simply seek to cut
itself the best deal it can individually at GATT (gain an exception toagricultural reform in rice) and in a bilateral deal with the U.S. over
NAFTA and other frictions. The latter course would be consistent with

156

WILLIAME. JAMESJapan's traditional approach and would represent a failure of Japan tointernationalize its outlook and take up a global role commensuratewith its economie status.

VI. Conclusion
In the early 1990s the global economy has experienced a slowing ofgrowth and trade, including recession in the United States, Britain,
Canada, Australia, New Zealand, and Germany. Japan itself has beenplunged into recession by the collapse of the so-called bubble economy.
The broad nature of the economic slowdown has been attributed to theweak and halting U.S. recovery and to the fact that the U.S. alone is
not capable of serving as a locomotive. Indeed, the limited U.S, growthin 1992 is largely a result of export growth and such growth cannot besustained without improvement elsewhere. The only bright spots in theworld economy are in East Asian along with a few Latin American
developing countries. East Asian growth has been maintained in theface of a global slowdown mainly because of booming intra-regional
investment and trade. However, this has not been sufficient tostimulate growth elsewhere, particularly in Japan where financial
conditions associated with the bursting of the bubble economy may
preclude an early recovery. A successful end to the GATT round, while
not in itself a sufficient condition for recovery, is certainly a necessary

one. Japan, which finds itself with huge and mounting trade surpluses
resulting from declines in imports and sustained exports, risks enraging

its trade partners in both North America and Europe and providing
justification to protectionist interests therein. Japan's obstructing asettlement of GATT over the issue of rice is extremely unwise from an

economic perspective. Japan would be setting a bad precedent andwould be seen as lending support to protectionist interests elsewhere.
Japan's stand is clearly in favor of GATT in almost every area but
agriculture, and there is a strong self-interest motive for Japan tocompromise on rice in order to secure the benefits a stronger,
rejuvenated multilateral system of trade would bring. Though Japan
can find support for its stand on agriculture in Korea and, perhaps, inTaipei, it would be travelling on the low road to invoke such support inan effort to carve itself out an exception and leave the way open forothers to follow.

A QUALITATIVE ASSESSMENT OF THE EFFECTS OF NAFTA ON 157
JAPAN'S FOREIGN INVESTMENT AND TRADE WITH EAST ASIA
AND MEXICO:OPPORTUNITY OR DIVERSION?
In responding to NAFTA, it appears the Japanese government iswell aware of the dangers of a proliferation of bilateral discriminatory

pacts between the largest single market economy on the globe andothers. Japanese multinationals seem to be adopting a cautious
wait-and-see attitude, while being reasonably confident of their ability

to retain access to the NAFTA market through the investments they
have already made. It is well within reason for Japan to seek tostrengthen existing regional fora for economic cooperation as a meansof pressuring the U.S. to keep NAFTA open and to avoid the path ofbilateralism in its economic relations and dealings in the Asia-Pacific. 26

To quote a former Deputy Director-General of GATT, GardnerPatterson: "For a believer in the virtues--and the feasibility if pursued

vigorously by the United States--of an updated, broadened, andstrengthened GATT-type nondiscriminatory, multilateral trading
system, th'e implications of a spread of U.S.-fostered FTAs are
downright ominous. 27 Now that the GATT round has been brought tothe brink of success, it is incumbent upon beneficiaries of the system tostep forward and ensure success.
East Asia continues to lead the world in economic growth and inno small measure this is because of the region's closer integration
through trade and investment brought about largely by market forces.
The open regionalism practiced in the Asia-Pacific region is being

challenged by alternative models in Europe and North America.
Success in GATT could help to lead to convergence of the alternative

approaches that are now based on formal and discriminatory
arrangements (particularly the EC), with the more open style ofregionalism found in the Pacific, Globalization of economic activity
also means that a nation's (or a region's) self'interest must depend on
the well-being in other parts of the world. For Japan and East Asia,
it is clear that they have a basis for closer economic cooperation, but

not along discriminatory lines. They will benefit most from astrengthened GATT system and continued openness as individual
economies and as a region. Hence, Japan would do well to adopt allnecessary measures to see that this is the outcome.
26 At a recent ASEAN-related conference it was asserted that NAFTA would cost

ASEAN members at least $2 billion in annual exports, The Daily Yomiuri,
November 25, 1992, p.11.
27 Patterson, 1989, p.364.

WILLIAM E. JAMES

158

TABLE 1lnternational Trade and Asia (1990)(1) (2) (3) (4)GDP EXPORTS IMPORTS TRADE/GNP(US $mil) (US $mil) (US$mil) (%)
NIES

Hong Kong

69,99882,144

82,482

118

Korea

239,772

60,45768,45327

Singapore

34,59052,753

60,954164

Chinese Taipei

156,993

67,21454,71939

Indonesia

93,96925,67521,931

25

Malaysia

42,506

29,40929,251

69

Philippines

43,861

8,171

12,99324

Thailand

80,17222,80533,74135

ASEAN-4Othe Asia

Note:

China

363,788

69,47858,63218

Japan

2 961 047

287,678

235,307

9v}

Simple Average a

53

Weighted Average b

15

a The sum of column 4 divided by 10, the ratios in (4) arecalculated

by averaging exports and imports and dividing by GDP.
b The sum of columns 2 and 3 divided by 2, divided by thesum ofcolumn 1.
Sources:IMF International Financial Statistics Yearbook 1991.
'
IMF Direction of Trade Statistics Yearbook 1991.
Republic of China, Ministry of Finance, Department of Statistics,
Monthly Statistics of Exports and Imports Taiwan Area, Republic ofChina, No.257, (January 1991).

Republic of China, Finance Statistics, Taiwan District, September
1991.

159 ONA QUALITATIVE ASSESSMENT OF THE EFFECTS OF NAFTA
JAPAN'S FOREIGN INVESTMENT
ASIA AND TRADE WITH EAST
AND MEXICO:OPPORTUNITY OR DIVERSION?

TABLE 2
Economic Growth and Asia

1985 1986

1987

1988

1989

1990

1991 1992*

NIEs

4.9

11.7

12.3

9.6

6.3

6.8

7.3

7.1

7.1

ASEAN

4.0

O.6

4.5

6.0

8.1

8.7

7.6

6.0

6.7

32

9.0

10.0

9.1

7.1

7.1

6.8

n.a.

n.a.

Group

NIEs +

1993*

ASEAN 4
Note:

'proJection

Sources: Toida(1992)

ADB(1992)

TABLE 3lmports of

Manufactured Goods in Japan and the United States,1988

(1)

(2)

($Mil.)($Mil.)(3)

Total Imports Manufactures Ratio of (2)to(1)(percent)Japan

187,354

90,48848.3

United States

460,260

374,549

81.3

Note:

Manufactures are broadly defined to include industries
in SITC single-digit categories 5 through 8.

Source:United Nations,

New York.

Yearbook of International

Trade Statistics, 1991,WILLIAM E. JAMES

160

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EFFECTS OF TAX POLICIES IN
DYNAMICAQ

MODEL OF INVESTMENT'

Takao OHKAWA"
Kazuo SHIMOMURA

1. Introduction

The purpose of this paper is to demonstrate a theoreticalpossibility that tax policies designed to stimulate domestic investment
are ineffective if domestic firms compete with foreign firms which face

the tax policies of foreign governments. Abel (1982) provided theframework for a version of q theory of investment which makes
possible a rigorous dynamic analysis of tax policies. He proved thatan unanticipated permanent tax cuti stimulates current investment.
While his framework is sufficiently general to cover both perfectlycompetitive and monopolistic firms, it does not deal with any strategic
relationship between firms, i.e., oligopolistic interdependence is beyond

its scope. Fershtman and Muller (l984) developed a dynamic
framework of a duopolistic market, formulated a differential gamebetween firms which accumulate capital and rigorously proved theexistence, uniqueness and global asymptotic stability of the open-loop

Nash solution of the game, Mino (1987) constructed a dynamic gamewith a mathernatical structure virtually the same as that of Fershtman

and Muller, and proved an interesting comparative static analysis of
the stable steady state. In this paper we provide a sensitivity analysisof the effects of changes in tax policies on current investment intended

by firrns in a duopolistic market and show that a tax cut in Abel's
sense') can reduce current investment of one of the firms if the size of* We are indebted to Professor M.C. Kemp for valuable comments and suggestions.
Comments from Professors H. Adachi and K. Shinjou were helpful. We also thankthe participants of Kanernatsu Serninar, K. Itoh, S. Katayama, K. Kojima and H.
Suehiro among others, for their stimulative discussions.
** Lecture,r of Economics at Seinan-gakuin University.
1) Abel showed that one or some combination of <i) an increase in the investment tax
credit (rc), <ilan increase in the present value of depreciation deduction (z) bymeans of introduction of accelerated depreciation and cm a decrease in the

TAKAO OHKAWA & KAZUO SHIMOMURA

164

the tax cut is sufficiently different between firms.

2. The Model

The model in this paper is an amalgam of Abel (1982) andFershtman and Muller (1984). There is a duopolistic market in which
each firm seeks to maximize the present value of its net cash flow. Letni(K', K2),i== 1, 2, be the instantaneous operating profit of the firm
when capital stock of ith firm is Ki,i=1, 2. Let Ii and Ci(Ii) be therate of real gross investment of the i th firm and the cost ofpurchasing and installing Ii. The functions z`(K', K2) and Ci(Ii)satisfy Assumptions 1-5 in Fershtman and Muller (1984). Ki
accumulates according to the Nerlove-Arrow capital accumulation
equatlon,ki == I,-6,Ki, i= 1, 2,
where 6iis the physical depreciation rate. In what follows, we shallassume that 6i=6.
Now, let us superimpose Abel's assumptions concerning thecorporate income tax, depreciation deductions and the investment tax
credit (ITC) on the above duopoly modeL One may easily verify that
this can be done without causing any substantial change in the duopoly

model and that the fundamental system of differential equations
describing the Pontryagin trajectories can be described as

ki =Ii (q`)-6Ki, (1)q'i= (r+ 6) qi-Tizl (K', K2) (2)where r is the after-tax discount rate, qi the ratio of the shadow priceof installed K` to the net marginal cost of uninstalled capital, Ti the tax

parameter2) concerning the ith firm, which is supposed to be timeinvariant, and zl• (K', K2) ! 0zi (K', K2)/0Kj, {i, J} == {1, 2}.3'
corporate income tax rate (u) under z+ rc <1 stimulate current investment. In what
follows, we shall use the term "tax cut" in this sense.
2) Using the notation of footnote 1, thetax parameter of the ith firm is Ti= (1-ui)/(1-rcith ui2i). See Abel (1982, p,538).

DYNAMIC EFFECTS OF TAX POLICIES IN 165
A Q MODEL OF INVESTMENT

The system (1>, (2>, is virtually the same as eq. (19) in Fershtman

and Muller (1984). Thus, we can directly make use of their
propositiops and theorem concerning the open-loop Nash equilibrium.
First, the stationary state of the system of equations (1> and <2)
uniquely exists. (Propositions 5.1 and 5.2 of Fershtman and Muller(1984)) Let it be denoted by qi'(r, 6, Ti, T2) and Ki'(r, 6, Ti, T2).
Second, above the entire positive (Ki, K2) plane there exists a unique
two-dimensional time-invariant and stable manifold qi == qi(K', K2; r,6, Ti, T2) such that for any initial condition (K'(O), K2(O))>O, thesolution to (1), (2), (qi(t), Ki(t)) asymptotically converges to (qi'(r, 6,

Ti, T2), Ki'(r, 6, Ti, T2)) if qi(O) is taken to be equal qi(K'(O), K2(O);r, 6, Ti, T2). (Theorem 3 in Fershtman and Muller (1984)) Thissolution to (1), (2), describes the open-loop Nash equilibrium for given
initial condition (Ki(O), K2(O)).

3, The Propositions
Using the functions qi(.), the current investment function of theith firm can be expressed asIi (O) == gi (K'(O), K2(O); r, 6, Ti, T2)

EIi (qi(Ki(O), K2(O); r, 6, Ti, T2)). (3)Now let us state the main proposition of this paper.

PROPOSITION 1 Suppose z,i, (K', K2)! 02zt (K', K2)/0KtoKJ,i, j= 1, 2, is negative when i\j. If Ki(O) =Ki'(r, 6, Ti, T2), thenOgi /0 Tj > (< ) O, according as i =- (#) j, i, 1' - 1, 2. (4)Proof : Consider the variational equations of the system(1), (2), withregard to Tj, J'=1 or 2. Initially evaluating Tj as unity, we have3) (1) and (2) are derived as the first order conditions for the following optimal

problem:
INI: x• f [(1-u)z i(K'(t), K2 (t))-(1- rc i-ui2D Ci (Ii (t))] e"'t dt

subject. to Ki(t)=Ii(t)'6Ki(t) and Ki(O)=Kio for i=1, 2.

TAKAO OHKAWA & KAZUO SHIMOMURA

166

ke, -- Ii qbl- 6K;i,, i- 1,2 (s)4t[ v= (r+ 6) qbl- z,i,K'.,-z,i,K2., 'eij rrI, i= 1, 2 (6)where Ki .i i OKi/0 Tj qt.j =- Oqi/O Tj ande,,-(g; 1.ltl.I-i'

Since it is assumed that K`(O) =Ki'(r, 6, Ti, T2), all coefficients ofKSj, and q$j, in (5) and (6) are time-invariant, which implies that (5),(6) is a system of linear differential equations. Resorting to the usual

method of solving linear differential equations, we obtain the generalsolution,

4 -,K- =,;,Åëi(Zh) eXP (Z ht) Ahj+Kej (7)q}j 4=,;., di i(Z h) eXP (Z ht) Ahj+ abl, (8)where (Kt.,•,4inj),i= 1,2, ]'=1or 2, is the stationary state of (5),(6), Zh, h == 1, ''', 4, the eigenvalues of the coefficient matrix of (5), <6),

Ahj,h=1, "', 4, 1'=1 or 2, constants to be determined from theinitial condition of (5), (6) andÅë,(Z) i 1- (-1)
Åë2(Z)=I,,nl,[Ii'nli+a(Z)] (9)- (-1)<Pi(A)I,, (Z+6) (10)
- (-1)(Z + 6)
gb2(Z)=
I,, I,,nl, [Ii'zli+a(Z)] (IDwhere a(1) E (Z +6) [Z -(r+6)]. As was shown by Fershtman andMuller (See their Proposition 5,3), the coefficient matrix of the system(7) and (8), has two positive and two negative real eigenvalues under

their Assumptions 1-5. Let Ri, R2 be negative. Then,DYNAMIC EFFECTS OF TAX POLICIES IN 167
A Q MODEL OF INVESTMENT

considering Kbl. Rej and qijj. -qijj as t- oo, we have from (7), (8),K;.'.(O) =- SAhj Åëi(2 h) +,i2rb' .,'i =- 1,2 am

J h==1 J

qej .2(O) =,E,Ahj ipi(A h) +ai,',, i= 1, 2. a3)'
Solving (12) with regard to Ahi, substituting it in (13) and considering (9)(ID, we have`)

7z'l6(r+6) [Ii' n'li-ZiZ
2- 6 (r+ 6)]q}i(O) - (A,+2,-r)I,' I,' A

nl{I2' 7v ;2 [AiZ2+ 6 (r+ 6)] -Ii' I2' [zlizg2-nl2 zii]}+ (Zi+Z2-r) Ii' I2'A

q'T,(O)-thtZnz'-(z,+22-r)Ii' I2' A

where A- [6(r+6)(1/Ii')-zli] [6(r+6)(1/Ii)-z32]-nl2n3i, whichis positive, because zhz;2-zl2ngi>O (Fershtman and Muller'sAssumption 5). Since ziL'•, Ai and Z2 are all negative, it follows thatq'.,(O)>O and q'.,(O)<O if zb<O. q2.,(O)<O and q2.,(O)>O can besimilarly verified. Those results obviously imply (4).

Q.E.D.

REMARK Our assumption implies the "strategic substitute"discussed in Bulow, Geanakoplos and Klemperer (1985). As is easily
shown, O g,/O Tj beco mes positive for both j -- 1 and 2 when thestrategic complement is satisfied.

Suppose that the governments of countries 1 and 2 both make tax

cuts but of different sizes dTi=e,dE>O, ei\e2. The above
proposition implies that if the difference between ei and 02 is very
great, ei>>e2, then the second firm reduces its current investment eventhough the government of country 2 cuts the tax on the second firm.
However a tax cut by domestic government does not necessarily
discourages the investment of a foreign firm. In other words, under
4) The derivation of q'

Ti(O). and q' fy(O) is available from the authors on request.

1os TAKAO OHKAWA & KAZUO SHIMOMURA
some certain conditions, a tax cut by domestic government could
increase the level of investment not only for a domestic firm but also
for a foreign firtn.

Let T-Ti, i=1, 2. Similarly to (5), (6), we have the variational
equations with respect to T,

rtij-I', qe-6Ke (5)''tt

at.' - (r+ 6) q'iziiK'. -zi2K4-zl•, i= 1,2 (6)''Suppose that both firms are completely symmetric, i.e. Ii' = I2' - J',

zli=zg2izii, ni2=n;iinij. By a similar argument to that which isused in PROPOSITION 1, we seeq}(O) = ii, [6 - f` (z i+ 6)] [-il,T - (z ,, -z ,, )], i \j'
We can prove Zi+6<O5'. Therefore, considering that Zi<O,

zii<O,A>O and Fershtman and Muller's Assumption 5, qb(O) is
positive if nii is negative6). We can derive the following proposition
from the above considerations.

'
PROPOSITION 2 Suppose both firms are completely symmetric,
and nij, i, J' -- 1, 2, i\j, is negative. If Kt(O) =Ki"(r, 6, Ti, T2) thenog, /o T> o, i == 1, 2.

Let us restrict ei to the nonnegative simplex {(ei, e2)(ei+ e2 =1, ei)O}. Propositions1and2 suggest that the graphs of 0gj/0Ti, i\j,,can be depicted like Figure 1, if the firms are sufficiently

alike. Here, within the intervel of (e, a), a tax cut by domestic
government could raise the level of investment for the firms in both.
countrles.
•'
5) From the characteristic equation of the system (5), (6), we see thata(Zi) - (2i+6)[Zi-(r+6)] must be positive for any eigenvalue of the coefficientmatrix of (5), (6). Since Zi-(r+6) and 22-(r+6) are obviously negative, it follows

that Ai+6 is negative.
6) When zli=z;2 E zth zl2=nii E nij((i, i)=(1, 2), ilj) are satisfied, Fershtman andMuller's Assumption 5 leads tonlrzg2- nl2n:i = (nii)2-(n ij)2=(zii+ zij)(nii- zij) > O.

EFFECTS OF TAX POLICIES IN
DYNAMIC169

AQ MODEL OF INVESTMENT

agj

6Ti

ag2
6Ti

o

6gi

aT2

b

FIGURE 1.

1

ei (= 1 - e2)e

The graphs of oOgt,' (=

)
ei
-e
0E
1

0gj

4. A Concluding Remark
In this paper we have only dealt with the dynamic game within theprivate sector. It may be a possible way of developing the present
research to consider whether our results, particularly the discouraging
spillover effect (Proposition 1), can be carried over to an extended
version of the game in which the government in either country takes
part as the Stachelberg leader.

TAKAO OHKAWA & KAZUO SHIMOMURA

170

References[1]

A.B. Abel, "Dynamic Effects of Permanent and Temporary Tax Policies in a q[2]

J.I. Bulow, J.D. Geanakoplos and P.D. Klemperer, "Multimarket Oligopoly:
Strategie Substitutes and Complements," Journal of Pollitical Economy 93[3]

C. Fershtman and E. Muller, "Capital Accumulation Games of Finite Duration,"
Journal of Economic Theory 33 (1984), 322-339.
K. Mino, "A Model of Investment with External Costs," The Economics Studies

Model of Investment," Journal of Monetary Econornics 93 (1982), 357-373.

(1985), 488-511.

[4]

Quarterly 38 (1987), 76-85.

CORPORATE GOVERNANCE IN GERMANY, JAPAN, AND
THE UNITED STATES: A COMPARATIVE STUDY'

Kenji KOJIMA

Abstract
Various systems of corporate governance have evolved in different
countries. This paper examines the corporate governance in Germany,
Japan, and the United States. It demonstrates the U.S. companies havetended to address hazards of self'interested behaviors among
stakeholder by delineating the responsibilities of one to another, makethe board of directors ensure the interests of shareholders, and resort

to market for corporate control to correct failure of the board of

directors. The effects of business relationships on German andJapanese corporate governance can help explain inactive market forcorporate control in those countries. Japanese companies haveestablished corporate governance with relationship-based control
mechanisms to promote building and maintaining long-term business
relationship. The board of directors in Germany provides effective
safeguards against self'interested behaviors to consider interests ofstakeholder to achieve the long'term corporate goals. Although there

is some evidence that corporate governance in each country isconverging, the significant differences may sustain.

1 lntroduction'
Modern corporations in capitalist economies are frequently
described as a nexus of contracts among stakeholder of many types '* Financial support from Ministry of Education and Nomura Foundation for Social
Science in Japan is gratefully acknowledged. This paper was written while theauthor was a visiting scholar at Department of Economics, Harvard University
and Center for Operations Research and Econometrics, Universite Catholique deLouvain. He is deeply indebted to Michael L. Gerlach and W. Carl Kester on thesubject of this paper. He would like to thank Theodor Baums for his helpfulcomments and suggestions.

KENJI KOJIMA

172

shareholders, creditors, managers, workers, suppliers, and so forth.While these diverse groups have a strong incentive to cooperate inorder to furthet their individual interests, they are also frequently
tempted to exploit the corporation's resources to foster their own
individual interests at the expense of others. Various systems ofcorporate governance have evolved in different countries to attenuatethese hazards of self-interested behaviors. The different legal
arrangements prevailing capitalist economies are evidence of the wide

breadth of responses to problems of governance of which sucheconomies are capable. The diversity within even a single country canbe staggering, making it problematic to identify any particular systemof governance as a prototype of an entire country. Nevertheless, broaddifferences do appear to separate the systems most commonly foundamong large corporations in different countries such as Germany,
Japan, and the United states.

Whatever parallels one may draw across corporations in three
countries, there is no inevitability about convergence of three different

corporate governance. The reason convergence cannot be foreseen
stems from a fundamental premise: companies in those three economies
have historically evolved significantly different systems of corporate

governance. As capital and product markets have become moreglobally integrated, national differences in corporate governance havebeen drawn into sharp relief. One of the major differences amongcorporate governance in different countries is the relationships between

capital and labor markets and industrial corporations. Specifically, it

is commonly observed that large financial intermediaries in Germany
and Japan tend to have closer, long-term relationships with theirindustrial clients than do their counterparts in the United States.

While legal and historical considerations help to explain why
industrial organizations in each country have followed distinctive
trajectories, we need to explain the difference of patterns across thecountries as well as the similarity among firms within each countries
and their sustainability with providing economic rationale. The key toresponding to that problem is comprehensive understanding of thecorporate governance system with comparative study. This paper
examines the corporate governance in three industrialized countries,
Germany, Japan, and the United States, three of whose manufacturingsectors are highly competitive each other. The primary purpose of theCORPORATE GOVERNANCE IN GERMANY, JAPAN, 173
AND
THE UNITED STATES : A COMPARATIVE STUDY

paper is threefold: to present institutional characteristics of corporate

governance of the three countries in comparative perspectives, toidentify impQrtant differences in the corporate governance systems ofthese countries, and to provide economic rationale for these differences
across the countries and similarity among firms within eaeh country.

The interpretation of the descriptions of institutional
characteristics in corporate governance takes place within the context

of agency theory. The agency theory focuses on problems associatedwith the separation of ownership and management in the modern
corporations. For reasons of unobserved actions of management,
agents hired to do a job cannot always be counted on to act in the bestinterests of the principals that engaged them. Within the context ofmodern public corporations, considerable value may be dissipated bymanagers whose interests are not able to be perfectly aligned withthose of investors. Rational investors will recognize this possibility inadvance and reflect expectations of self'interested and unobserved
actions by managers in the prices paid for the corporation's securities.

The more interesting problem, however, is to create internal control
mechanism with monitoring, voice, and compensation systems that will
reduce the losses associated with the separation of ownership frommanagement. When prevailing internal control mechanism proves
deficient, the existence of external control mechanism with stock prices,

takeovers, and relationship-based control may be used to realignmanager's interest with investors'.

Since stockholders are the ultimate holders of the rights tocorporate control and also the bearers of residual risk, the purpose of

corporate governance is to ensure that the actions of corporation's
managers accurately reflect the interests of its stockholders. This
purpose, however, is not necessarily valid outside the United States. The

purpose of corporate governance may be to control and coordinate thebehaviors of various stakeholder of corporation so that they achieve
the goals defined by their country's culture, and legal and politicalsystems. The term "corporate governance" is, therefore, meant here to
imply the entire set of mechanisms used to control and coordinate thebehaviors of various self-interested stakeholder interacting in corporate

management in order to achieve corporate goals efficiently.

This study demonstrates that U.S. companies have tended toaddress hazards of self'interested behaviors among stakeholder by

KENJI KOJIMA

174

delineating the responsibilities of one to another in formal contracts
enforced by courts; relying heavily on competitive market transactions
with a large nuniber of lenders, suppliers, customers, managers, and soforth; and relying upon the incentives and discipline of the market toensure mutually beneficial behavior. Traditionally, groups ofstakeholder are distinctly separate in the typical U.S. corporations, andthere are reasonably clear boundaries separating a company from thefactor and product markets in which it transacts. The primary
responsibility of the U.S, board of directors is to safeguard theinterests often particular stakeholder, the shareholders, and to ensurethat managers seek to maximize the value of the shareholder's stake inthe corporation. Consistent with the U.S. propensity to rely uponcompetitive markets to induce satisfactory behavior among contacting
parties, an active market for corporate control is relied upon to correct
failures of the board of directors to act as a safeguard of shareholders
mterests.

The effect of stable and flexible business relationships on theGerman and Japanese corporate governance can help explain inactive
market for corporate control in those countries. Japanese companies
have established corporate governance which resorts to relationshipbased control mechanisms against the hazards of self-interested
behaviors to promote building and maintaining long'term business
relationships. Major eharacteristic among these can be identified that
financial institutions that are major shareholders as well as lenders areable to exert considerable influence through board representation anddirect intervention into operations of lending companies. This is asignificant institutional difference with the governance in the UnitedStates.

German corporate governance bears many similarities to theJapanese system, particularly regarding the maintenance of long-term
lender-borrower relationships and bank ownership of equity. In atleast one important respect - the composition of corporate boards of

directors - German governance provides more effective safeguards
against self-interested behaviors than does the Japanese system.
Japanese boards tend to be dominated by inside managing directors.
German supervisory boards, in contrast, are at least half-composed ofrepresentatives of the corporation's major institutional shareholders

and elected worker representatives. All major constituencies thus

CORPORATE GOVERNANCE IN GERMANY,ANDJAPAN, 175
THE UNITED STATES : A COMPARATIVE STUDY

influence corporate goals and the responsibility of achieving thepromotion of the company's best interest, according to German law.

While they are concerned with investors and nonowners, German
boards are expected to consider these interests in the context of how
they will influence the company's long'term well-being. Differences
between Germany and Japan are more matters of degree than of kind,
however, especially in comparison to common practice in the UnitedStates.

2 The Nature of Corporation
2.1 Public Corporation
Among the notable innovations within the capitalist economy, thejoint-stock corporation and the stock exchange are significant. The
corporate form, by establishing a division of labor between holders ofcapital and management and limiting the liability of the first,
simultaneously opens up new sources of capital, allows for the
specialization of the management function, and diffuses risk across a
broader set of investors. Development of the corporation have alsoestablished arrangements whereby ownership interests would be
represented, including the board of directors and the proxy voting.
Emerging in conjunction with joint stock corporations, the stock market

provides a highly ordered mechanism for the trading of shares that
corporations issue. Access to the actual trading process being limited

to a specific group of exchange members, these traders in turn maketheir services available to a general investing public, who are granted
protection through liability limits which restrict investor risk to theamount of their investment. The market for corporate control links
these two institutions, the public corporation and the stock market(Gerlach 1992).

The genius of public corporation is rooted in its capacity to
spread risk over the diversified portfolios of millions of individuals andinstitution and to allow investors to customize risk to their unique

circumstances and propensity. By diversifying risks that would
otherwise be borne by owner-entrepreneurs and by facilitating thecreation of a liquid market for exchanging risk, the public corporation

reduces the cost of capital. The public corporation makes norestrictions on who can own their residual claims and this makes it

176

KENJI KOJIMA

possible for customers, managers, labor, and suppliers to avoid bearing

any of the corporate residual risks. Because shareholders guarantee
the contracts of'

all constituents, they bear the corporation's residual

risk. The absence of restrictions on who can own corporate residual
claims allows specialization in risk bearing by those investors who aremost adept at the function. As a result, the corporation realizes great
efficiency in risk bearing that reduce costs substantially and allow it tomeet market demand more efficiently than other organizations. These
tradable claims on corporate ownership also allows risk to be borne byinvestors best able to bear it, without requiring them to manage thecorporations they own. From the beginning, through, these riskbearing benefits came at a cost. Tradable ownership claims create
fundamental conflicts of interest between those who bear risk andthose who manage risk ( Jensen 1984; 1989).
In discussions of the relationship between the corporate form andthe stock exchange, Berle and Means (1932) argued that the rise of thelarge, diffusely held, professionally managed corporation fundamentally

altered the nature of the relationship between ownership andmanagement over the firm. They worried that in separating these twofunctions, corporate management machinery were created to be largely
unaccountable to equity holders and to pursue their own interests atshareholders' expenses. The major concern of Berle and Means was
the increasing dispersion of ownership in public corporations and theconsequent loss of shareholder control, with the result that large

corporations were run by professional managers rather than bycompany's owners. But this trend has also has an economic rationale.
To the extent that large, bureaucratic organizations are capable ofachieving the objectives of reducing coordination costs for complex andcapital-intensive economic tasks, it makes sense to establish a divisionof labor in expertise. Professional managers are to specialize inrunning corporations while investors specialize in the capital provisionand risk-bearing function. Benefits from efficient management can beachieved by delegating management functions to professional managers
at all level of the company who have specific knowledge, rather thanallocating all management and control to the company's owners. Thisdivision of labor and the corresponding managerial revolution has

appeared in advanced capitalist economies (Fama and Jensen 1983;
Gerlach 1992).

CORPORATE GOVERNANCE IN GERMANY, JAPAN, AND 177
THE UNITED STATES : A COMPARATIVE STUDY

The major problem is associated with the separation of ownershipand management in the modern corporation. Managers hired to run a
corporation cannot always be counted on to act in the best of theshareholders that engage them. This fundamental reality induces
shareholders to expend resources in the development of incentives andmonitoring mechanisms designed to reduce self-interestedly
opportunistic behavior by managers. The cost of designing andrunning these mechanisms, and the value lost due to the remaining
self-interested opportunism by managers, are the agency costs thatrational investors must take into account when pricing the company's
securities. From this perspective, the primary purpose of corporate
governance is to develop efficient monitoring and incentive mechanismsthat will reduce the amount of foregone value associated with theseparation of ownership from management (Kester 1992).

2.2 Corporate Governance
The modern public corporations have developed primarily internaland external control mechanisms for corporate governance. Theinternal control mechanisms in which incentives and monitoring devices
are established facilitates professional managers to act in accord withthe shareholders' interest. Internal control in the public corporation isdelegated by shareholders to a board of directors. Shareholders
generally retain approval right by vote on such matters as board
membership, auditors choice, merger, and new stock issues. The board
then delegates most management and control functions to managers.
When internal control mechanisms work well, the board of directors
replace top management whose capability is no longer the best ones

available for the job. When these mechanisms break down,
however,shareholders receive some protection from external control
mechanism. The transferability of stocks of public corporations gives
rises to an external monitoring device - a stock market that specializes

in pricing common stocks and transferring them at low cost. Stockprices are visible signals that summarize the outcomes of management
for current and future cash flows. This external monitoring in thestock market exerts pressure to direct a corporation's management
toward the interests of shareholders. External control from market
for corporate control is also unique to public corporations and its
attributable to the unrestricted nature of its residual claims. The

178

KENJI KOJIMA

market for corporate control facilitates alternative management teams
to compete for the rights to manage the corporation's assets. This

competition can'take the form of mergers, tender offers, or proxyfights. Takeover enables new owners to change the company's assets,alter inefficient trade relationships, and change management. Other
organization forms such a$ nonprofit, partnership, or mutual insurancecompanies and saving banks do not benefit from the same kind of
external control mechanism (Fama and Jensen 1983; Jensen 1984).
Berle and Means (1932) had entangled in a debate over whether

they had ignored the importance of stakeholder other thanshareholders. Perhaps it is not shareholders alone, this argument
went, but firm's collective stakeholder that are important. Jensen(1984) argues that shareholders are commonly portrayed as one of thegroups in corporate constituencies, or stakeholder. It is asserted thatshareholders are not equal with these other groups because they are

the ultimate holders of the rights to corporate control. Public

corporations are unique organizations because they make norestrictions on who can own their residual claims and this makes it
possible for customers, managers, labor, and suppliers to avoid bearing
any of the corporate residual risks. Beeause shareholders guarantee
the contracts of all constituents, they bear the corporation's residual
risk. The absence of restrictions on who can own corporate residual
claims allows specialization in risk bearing by those investors who aremost adept at the function. As a result, the corporation realizes great
efficiency in risk bearing that reduce costs substantially and allow it tomeet market demand more efficiently than other organization.
Shareholders as the bearers of residual risk hold the right to control of

the corporation, although they delegate much of this control to a boardof directors. Williamson (1985) argues that the unsecured position ofshareholders' investments give them priority for corporate governance,with management granted a secondary position. Constituencies otherthan these two are better off, Williamson asserts, protecting theirbusiness interests by direct contractual guarantees rather than throughboard representation.
Based upon the ideal of shareholder democracy and the perceived
need to prevent abuse of corporate power, the corporate governancesystem in the U.S. is the product of constantly evolving American
jurisprudence. It seeks to promote allocative efficiency throughCORPORATE GOVERNANCE IN GERMANY, JAPAN, AND 179
THE UNITED STATES : A COMPARATIVE STUDY

antitrust laws that separate the interests of numerous stakeholder andthat keep them in competition with one another, and seeks to maintainthe accountability of corporate managers to corporate owners throughthe board of directors and the proxy-voting mechanism (Lightfoot1991). The corporate goal of the U.S, companies is established tomaximize the shareholders' wealth . From that point of view, it hasoften been argued that managers have been consistently unwilling toreturn surplus cash, so called free cash flow (Jensen 1989), to theirshareholders, preferring to hold on to it for a number of reasons:excess cash provides managers with autonomy vis'a'vis the capital
markets, reducing their need to undergo the scrutiny of potential
creditors or shareholders. Jensen (1989) argues that free cash flow

must be distributed to shareholders rather than retained for acompany to operate efficiently and maximize shareholders' value . But
this happens infrequently; managers have few incentives to distributethe funds, and there exists few mechanisms to compel
distribution.Managers have incentive to retain cash in part because
cash reserver increase their autonomy vis-a-vis the capital markets.
Large cash balances and independence from the capital markets canserve a competitive purpose, but they often lead to waste andinefficiency. Consider that companies distribute excess cash toshareholders and then must convene the efficient capital markets to
supply funds as sound economic projects arise. Shareholders are at agreat advantage in this world, where management's plans are subject
to enhanced monitoring by the capital markets.
Managers also resist distributing cash to shareholders because
retaining cash increases the size of the companies they run; managers

have many incentives to expand company size beyond that which
maximizes shareholder wealth. Compensation is one of the mostimportant incentives. The tendency of companies to reward middle
managers through promotions rather than annual performance bonuses
also creates an inclination toward growth. Organization must grow inorder to generate new positions to feed their promotion-based reward

systems. Furthermore, corporate growth enhances the social
prominence, public prestige, and political power of senior executives(Jensen 1989).

Modern industrial corporation faces vastly more complex
problems of coordination and controL The larger scale of operations

180

KENJI KOJIMA

today has in and of itself heightened the complexity of problems. In
addition, large corporate customers and suppliers, and new providersof factors of production such as equity owners, large institutional
lenders, professional managers, full-time employees, and so forth, haveemerged as groups of stakeholder whose economic welfare depends
upon the activities of the corporation in question, but whose priorities

with respect to the proper focus of those activities can differ sharply

one from another. Thus, controlling and coordinating the behaviors ofthese corporate stakeholder, each of which is fundamentally selfinterested and able to undertake some behaviors or to exploit some
information hidden from the view of other stakeholder, generates oneof the major problems facing modern capitalist economies (Kester
1991b).

Shareholder welfare is enhanced when cash is deployed in those
activities promising at least as much value in terms of discounted
future cash flows as the amount expended in the present. Employees
would presumably prefer richer compensation and greater job security.
Suppliers might want to have expanded volume of orders. Needless tosay, such diverse interests need not be mutually exclusive. Investments

might simultaneously expand capabity, provide jobs, and lower
production costs, as well as create value for shareholders. Such usesof cash might naturally entail little or no conflict among stakeholder.
When internally generated cash is scare relative to available uses,
conflicts on the use of eash are more likely to be resolved in favor ofshareholders and other suppliers of capital to the firm. Generally, newcapital will be forthcoming only if investors are confident that theirinterests will be protected and their welfare advanced. Even if
managers do not seek external capital, thus avoiding capital markets
tests of the perceived efficiency of planned investments, product market

tests may apply. Rivalry among competitions in the company's
product markets will exert a disciplinary force driving managers toseek sustainable competitive advantage, which is the very foundation ofvalue creation for shareholders. The company's internal control
mechanism in which compensation schemes are tied to equity interests
may further constrain the scope of managerial discretion in the use of
cash when capital is scared.
Stakeholder conflict about the use of cash tends to be greatest
when internally generated cash is abundant relative to investment

CORPORATE GOVERNANCE IN GERMANY, JAPAN, 181
AND
THE UNITED STATES:A COMPARATIVE STUDY
requirements. Under these conditions, managers enjoy greater latitudein its deployment. A surplus of cash relative to value-creating
investments allows managers to minimize capital oversight. The
imperatives of product market competition can be satisfied without
precluding the ability to pursue other stakeholder priorities. Internalmonitoring and control may also be less strictly executed when cash isliberally available. Management's incentive alignment with equity may
be too weak to overcome desires to act in its own interests or that ofother stakeholder demanding a greater share of the firm's economic
rents. The results often is the investment of excess cash at rates ofreturn below the cost of capital. If such investment becomes chronic,

conflict among shareholders, managers and other corporate
stakeholder will eventually emerge (Jensen 1989; Kester 1991a).

Since shareholders are the ultimate holders of the rights tocorporate control and also the bearers of residual risk, the purpose of

corporate governance is to ensure that the actions of corporation's
managers accurately reflect the interests of its shareholders. This
purpose, however, is not necessarily vaHd outside the United States. The

purpose of corporate governance may be to control and coordinate thebehaviors of various stakeholder of corporations so that they canachieve the goals defined by their country's culture, legal and politicalsystems.
Japanese corporations have a distinctively different approach tocorporate governance. The interests of external stakeholder get
represented in Japan. But boards of directors are not the primarymechanisms for ensuring this. Rather, these stakeholder take equity
positions in other firms in which they have business interests, creating

economic stakes in those companies that serve as Iegitimate bases ofinfluence. In this way, key external stakeholder like banks, suppliers,
customers, and so on get represented by becoming legally empowered
constituency of the firm. The interests of internal stakeholder are
represented in two ways. Managers dominate the boards of their own
companies, ensuring a substantial influence on internal decision making.

Since corporate shareholding is often reciprocal, at least among large

firms, managers are also able to exercise influence over the external

shareholding companies that constrain them. Mutual shareholdings
attempt at control in one direction are balanced against reciprocal
holdings in the opposite direction. In the United States, these investors

182 KENJI KOJIMA
have become largely separated from the activities of the firm
themselves ' that is, from their employees, lenders, and trading
partners. Therefore, a large constituency of institutional investors
have common interests but little ongoing interest in the firms in which
they hold shares. For corporate involvement in equity shareholding isso pervasive in Japan, Gerlach (1992) characterizes that Japanese stock
markets have been transformed largely into instruments of corporate
rather than purely financial interests.

The goals of U.S. corporations center on earning high returns on
investment and maximize current stock prices. Managers exercises thedominant influence on corporate goals, interpreting signals about

desired behavior from the external capital market, influenced bycompensation based on current accounting profits or unrestricted stock

options that heighten stock price sensitivity. U.S. executive's
preoccupation with shareholders wealth contrasts sharply with thegoals that guide German and Japanese managers: adequate returns,
secure employment, and enhanced international competitiveness. Banks,
the German manufacturer's principal shareholders, have reinforced thisemphasis on economic growth because they want greater lending
activity and more stable dividends. Moreover, because lender,
shareholder, and employee representatives all sit on the supervisoryboards, each group can ensure that the company's goals at least inpart reflect its interest.

The goals of the Japanese companies will be growth and longevity,with less emphasis on maximizing current returns on investment andstock prices. In fact, independent shareholders will rank fairly low on
the list of constituencies whose interests management is to represent.i

The typical large Japanese corporation does not have clear lines
distinguishing stakeholder from one another with carefully delineated

1 Some supporting evidence comes from comparative data provided in aquestionnaire survey of Japanese and the U.S. managers (Kagono, et al. 1985).

When asked to rank the relative importance they placed on nine preselected
corporate goals, the two sets of managers showed striking differences. Ranking
far most important in senior executives' corporate goals in the United States was
return on investment, followed by capital gains for stockholders. In Japan, in
contrast, the primary goals was increasing market share, followed by return on

investment and company's new product ratio (which was only seventh on theAmerican list). Capital gains for shareholders ranked at the bottom of the list
and were cited by almost none of the Japanese managers as an important goals
for their companies.

CORPORATE GOVERNANCE IN GERMANY, JAPAN, AND 183
THE UNITED STATES:A COMPARATIVE STUDY

rights and responsibilities between them. Rather, it is a coalition of

stakeholder - suppliers, lenders, customers, shareholders - holding acomplex blend of senior and junior, short-term and long-term, implicit
and explicit claims against the company. Because of the hazards of
expropriation to which equity claims are exposed when ownership isseparated from management, corporations are typically governed byboards of directors elected by shareholders to act in their bestinterests. Shareholder value maximization is the presumed goal of theboard and the managers it oversees. However, when a majority ofshares are distributed among a variety of stakeholder, each holding
different senior claims and able to extract returns by various meansother than dividends and capital gains on stock, strict shareholders

value maximization can be problematic as the dominant corporate
objective. Different stakeholder groups owning voting shares may be
pursuing their own goals. Some opportunities to add to shareholder
value, such as prematurely repaying a high fixed'rate bank term loan,
for example, may cost one of the shareholders more than it stands togain from a pickup in the value of the stock it owns (Kester 1991a).

Unbundling the debt, equity, and other claims is one way of
restoring the dominance of the shareholders' objective. But to theextent these complex bundles of claims evolved, this may not be
impossible. Under these conditions, corporate growth tends to emerge
as the common denominator among the stakeholder groups ' the one
objective that nearly everyone can agree on as having a potential
benefit. When the shareholders are also valuable long-term creditors,
supplier, and customers, focusing management's attention on growth
may better serve the goal of ex ante value maximization than would
explicit profit maximization. Growth also attenuate disputes among
stakeholder by relieving pressure to compare one group's gains to thegains of another with tradeoff. Given corporate stakeholder hold thebundling interests, their interests will be served in a variety of ways

apart from direct returns on their investments. Many of theseinterests will lead them to encourage company growth or other goals
at the expense of shareholders' value, In the case of banks, theseinterests include not only higher debt'equity ratios but also new fee
businesses from the client, increased loans to related companies, an
expanded employee base for bank deposits, increased compensatingbalances, and an improvement in their own equity capital positions

184

KENJI KOJIMA

through reciprocal shareholding positions which help to improve theirown equity bases (Kester 1991a; Gerlach 1992).

In contrasti to the United States, German shareholders andmanagers contrast the goal of corporation in the United States to theirown country. German managers believe that they think differently
about the goal of their companies in their society than do their U.S.
counterparts and believe these differences impact on their own and U.S.
corporate governance. Communitarian values, limited involvement inequity investing, and the belief that the corporate priority is to serve

customers and provide employment instead •of just creating
shareholders wealth is part of "cooperative capitalism" (Lorsch andMaclver 1991).

The term "corporate governance" is, therefore, meant here to
imply the entire set of mechanisms used to control and coordinate thebehaviors of various self-interested stakeholder involved in thecorporation in order to achieve corporate goals efficiently.

3 Corporate Environment
3.1 Characteristics of Capital Market
3.1.1 lnstitutional lnvestors in the United States
Approximately half of all shares in the United States are held byindividuals, and the other half by institutions. Institutional shareownership has been rising since 1950, when institutions with assets of$107 billion owned 8SO>6o of all outstanding equity. By 1980, institutions

with assets of $2 trillion owned 33906 of outstanding equity, and by
1990, with assets of $6 trillion, institutions controlled about 20% of all

financial assets and 45% of all outstanding equities. In 1989, pension

funds controlled about two-thirds of stock held by institutions, andinvestment companies and endowments each controlled about onesixth.2 Because individual shareholders tend to be more stable
investors than institutions and tend to hold diversified stock portfolios,

their incentive and ability to participate actively in corporate
2 The critical change is the concentration of shareholdings in the hands of fewer andfewer large institutions, namely, pension funds that provide retirement income andhealth care benefits to state and local public employees. Pension funds control$2.5 trillion worth of assets-more than 40% of all assets under institutional
control'and own shares worth $1 trillion, more than 25rdO of all publicly held
equity in U.S. companies. The 20 largest pension funds control assets worth morethan $620 billion-26% of all pension fund assets (Taylor 1990).

CORPORATE GOVERNANCE IN GERMANY, JAPAN, AND 185
THE UNITED STATES:A COMPARATIVE STUDY

governance are attenuated. Although individual own about half of allshares, they do only about 20%o of the trading whereas institutions doabout 80SO}6o. Heavy institutional trading is not surprising, however,when one considers the types of institutions that hold major equity
positions in the U.S. companies: pension funds, investment companies,
and endowments. Indeed, most equity-owning institutions are financial
in nature. Institutional investors hold highly diversified portfolios withsmall stakes in many of companies. For example, in 1990 the
California Public Retirement System (CalPERS) reportedly held stocklargest holding was O.71SO)6 of a company's equity. This fragmented
pattern of share ownership is due in part to legal constraints on

concentrated ownership, fiduciary requirements that encourage
extensive diversification, and investors' strong desire for liquidity. The

goal of institutional investors in the U.S. are purely financial and arefocused on quarterly or annual appreciation of their investment

portfolio compared with stock indices. Because managers aremeasured on their short-term performance, their investment goals
understandably focus on the near-term appreciation of shares. Mutual
funds and actively managed pension funds hold their shares, on
average, for only 1.9 years (Porter 1992).

Because of their fragmented stake in so many companies, short
holding periods, and lack of access to proprietary information throughdisclosure of board membership, institutional investors tend to basetheir investment choices on limited information that is oriented towardpredicting near-term stock price movements. The system drives them
to focus on easily measurable company attributes, such as current
earnings or patent approvals, as proxies of a company's value on
which to base market timing choices. Institutional agents do not sit on

corporate boards, despite their large aggregate holding. As aconsequence, they have virtually no direct influence on management
behavior. Indeed, with small stake in the company and an average
holding periods of two years or less, institutional agents are not viewed

by management as having a legitimate right to serious attention(Porter 1992).

3.1.2 Legal Restrictions in the U.S. Capital Market
Often preferring to take a passive role in corporate governance,large shareholders - especially mutual funds and pension funds - are186 KENJI KOJIMA
apparently absent from corporate boards. Legal restrictions in the
U.S. capital market explains why large institutional shareholders are

not represented in many instances, and why they are loathe toparticipate actively in governance. Banks, the largest of all U.S.
financial institutions are prohibited by law from owning controlling
blocks of stock in industrial companies. Bank themselves, as opposedto their trust funds, cannot directly own any stock in an industrial
company. Nor can they own stock indirectly through affiliation withinvestment banks. The Glass"Steagall Act of 1933 effectively blocked

these means. Bank holding companies, which can be owned andcontrolled by Banks, are similarly restricted. The Bank Holding
Company Act of 1956, later reinforced by the "One-Bank Holding
Campany" legislation in the 1970's restricts a holding company's
activities to those "closely related" to banking. In addition, a bankholding company cannot own more than 5% of the voting stock of a
non-banking company and cannot otherwise control an industrial
company. It is this limitation on control, rather than ownership, which
distinguishes the financial structure in Japan from that in the U.S.3

Although banks can own stock in a fiduciary capacity in theirtrust funds, no more than 10S06o of a bank's trust fund can be invested

in the stock of any corporation. In addition, other trustee laws
encourage trustees to pursue a strategy of high diversification toprotect themselves, further diminishing the potential ownership role oftrust funds. Thus, many of the indirect ways to control a company
which are commonly employed by banks in Germany and Japan as a
substitute for large stock ownership are precluded to U.S. banks(Edwards and Eisenbeis 1991). Furthermore, banks that exert actualor effective control over a company could be subjedt to "equitable
subordination" of their loans in the event of a bankruptcy proceeding,and might ever be subject to other liability, including penalties under

the Racketeer Influence and Corrupt Organizations Law, or RICO
(Lightfoot 1991).`

Pension funds are currently the Iargest institutional holders of
3 Geographic, product, and activity restrictions, as well as extensive deposit
insurance, account for American banks, small size, weak boardroom power, andthin equity base. American public opinion, which mistrusted private large
accumulations of power, and interest group politics explains these characteristicsof the U.S. banks (Roe 1993).

4 The U.S. has long-lived democracy, founded on a premise of checks and balances.

IN GERMANY, JAPAN,
CORPORATE GOVERNANCEAND
THE UNITED STATES:ACOMPARATIVE STUDY

187

common stock that control two-thirds of institutionally owned equities.
They own more than 25906 of all public-held equity in U.S. companies.
The largest 20 pension funds, together with the 10 largest U.S. money

managers, hold more than 16% of the shares of the largest 10 U.S.
corporations. Although pension funds own substantial amount ofequities, they have virtually no representation on corporate boards.
Individually, no pension fund may hold more than 109 of the stock ofany company if it wishes to receive favorable tax treatment as adiversified fund. As a result, no individual fund has that much voting

power. Pension funds might obtain considerable power if they voted asa block. Any attempt to sway shareholder opinion, however, could
collapse on legal obstacles: if a participant in a proxy fight tries toinfluence more than ten stockholders, he must obtain prior Securities

and Exchange Commission (SEC) approval.5 Thus, a number ofpolitical, institutional, and legal constraints combine to limit the rolethat pension funds can play as influential owners. While a relaxationof these constraints could enhance the ability of pension funds todividing power among the branches of government. This fragmentation of
governmental power helped produce fragmenting financial regulation that yielded
corporate governance by centralization of power in managers. Politics influences
the structure of the large public firm. Firms in nations that tolerate large poolsof private economic power evolve differently than firms do in nations that5

repeatedly fragment financial institutions, their portfolios and their ability to
network blocks of stock (Roe 1993).
First, pension funds embrace many different firms and political entities, which

generally do not encourage them to behave as influential owners. Pension plan
sponsors control the investment managers of pension funds, and the managers ofprivate firms are unlikely to encourage their pension fund managers to exert

control over the managers of other firms. This may be on reason that plan
sponsors typically divide pension assets among many different money managers,
thereby diluting the potential for any one fund manager to exercise control.
Government sponsors also have been reluctant to encourage their pension fundmanagers to exert control. For example, many government sponsors sought toptohibit their fund managers from financing hostile takeovers.

Second, ERISA (The Employee Retirement Income Se.curity Act of 1974)
requires that a pension fund should be diversified, unless it is clearly prudent not
to be diversified. To interpret this restriction, the ceurts define what is "prudent"
largely by Iooking at what has been the customary, generally'accepted, fiduciary

behavior. Fiduciaries commonly hold hundreds of different stocks, and look tovarious broad market indexes as performance benchmark. To deviate from thispractice fund managers would risk enhanced liability. Thus, the ERISA
diversification requirement, as presently interpreted, is an obstacle to pension
funds holding requirement, as presently interpreted, is an obstacle to pension funds
holding controlling blocks of stock in large public corporations.

Third, various fidueiary rules discourage pension fund managers fromexercising a controlling role. In particular, if pension fund managers were to takeseats on the boards of portfolio companies they might be subject to a

KENJI KOJIMA

188

exercise a controlling influence in the future, these changes are unlikely

to occur (Edwards and Eisenbeis 1991; Lightfoot 1991).
Like pensiori funds, rnutual funds tend to refrain from exercisinglarge shareholder rights in order to receive favorable tax treatment.
From their beginning mutual funds were viewed as passive investment
vehicles. Investors could pool their assets with other investors toachieve a more diversified portfolio and to obtain professional
management. Mutual funds, however, are not to be in the business ofmonitoring and controlling managements of their portfolio companies.
To prevent mutual funds from seeking control right, the Investment
Company Act of 1940 and the Internal Revenue Code subject them to anumber of restrictions.6

The law regulating insurance companies is state law. To sell in ahigher standard of care. As passive mvestors, ERISA holds fund managers to a

"prudent expert" standard: they must know something about the business ofinvesting. If they assume positions on the boards of portfolio companies, however,the prudent expert standard might well mean that they wi11 be held to a standardof expertise in the "business of the company." This standard of care would behigher than the usual corporate law's "business judgement" standard that is now
applied to board members, thereby subjecting fund managers to enhance liability
6

vis-a-vis their beneficiaries (Edwards and Eisenbeis 1991).
First, unless a mutual fund qualifies as a diversified mutual fund, it is taxed in ahighly unfavorable way. If the fund is not diversified, its income is taxed at theordinary corporate tax rate, and is taxed again when distributed to the fund's

shareholders. Thus, an undiversified mutual fund loses the pass-through tax
advantages of a diversified fund.

Second, both the tax and the Investment Company Act of 1940 define adiversified mutual fund as one that must have at least half of its investments incompanies that constitute no more than 50/o of its portfolio and constitute no morethan 10% of the portfolio coinpany's outstanding stock; and, with respect to theother half of the fund portfolio, no more than 25% of the fund's assets can beinvested in a single company.
Finally, to further inhibit mutual funds from seeking controlling interests, theInvestment Company Act of 1940 restricts a fund from advertising itself as"diversified" if the regulated part of its portfolio has more than 10% of the stockof any company, even if such stock holding constitutes a trivial portion of themutual fund's portfolio. Not surprisingly, almost all mutual funds want to beconsidered as "diversified." The result, therefore, is that mutual funds are excluded

from performing the monitoring and controlling functions of large investor. This
results is reinforced by other legal restrictions. For example, if the mutual fundowned 5% of a portfolio company's stock, or simply sat on its board, the portfolio
cempany would become a statutory affiliate of the mutual fund and of the mutual
fund's principal underwriter. Or if the mutual fund wished to assert control

jointly with another affiliate - defined as any company also owning 5% of aportfolio company - it would need prior SEC approval. This role clearly
discourages the kind of financial networks that are used in Japan to exert control(Edwards and Eisenbeis 1991).

CORPORATE GOVERNANCE IN GERMANY, JAPAN, AND 189
THE UNITED STATES : A COMPARATIVE STUDY

state, insurance companies must adhere to the laws of that state. Since

most large companies wish to sell insurance nationally, they aregoverned by laws of the most restrictive states. New York permits
20906 of a life insurer's assets, or one-half of its surplus, to be invested

in stock, but insurance companies cannot put more than 2% of theirassets into the stock of a single,company. Property and casualty
insurers also cannot own more than 5% of a company's voting stock.
Similarly, California, Illinois, and Texas prohibits life insurers frominvesting more than 10% of the insurer's capital and surplus in a single

company. Thus, with few exceptions state law prevents insurancecompanies from acquiring controlling blocks of stock, virtuallyeliminating them as effective owners (Edwards and Eisenbeis 1991).

The numerous legal and institutional constraints on financial
institutions in the United States have effectively prohibited them frombecoming controlling stockholders. While they clearly have thefinancial resources to exercising large shareholder rights, financial
institutions are inhibited from playing this role. This is in sharp
contrast to the roles played by financial institutions in Germany andJapan. Therefore, institutional investors in the United States simply
sell the stock of underperforming companies as quickly as they can.

There are no feasible options. Since they cannot work with the
managements of poorly-performing companies to improve performance,
their best strategy is to remove these companies from their portfolios.

The problem is that these large institutions, whether corporate or

public pension funds, mutual funds, or endowments, cannot act asowners in the sense that they could take a long-term view of ongoingcompany prosperity, understand the company's business and thecircumstances in which it operates, and participate in the selection andelection of directors. The obvious reason is that their primaryfiduciary responsibility is to their investors and beneficiaries, which canlead to a conflict of interest with their acting as owners. Current
practice suggests that a large institutional fund can be managed on theway of which leads to broadly diversified portfolios. The fund canindex its portfolio, investing it in hundreds of companies. For example,

CalPERS, with $62 billion in assets, holds equity in 1,3eO U.S.
corporations plus 300 international ones. In such a situation, thelimited budget available for an internal staff makes it absolutely
impossible to develop the detailed knowledge and to provide theKENJI KOJIMA

190

oversight.7 Alternatively, a large fund can distribute its assets toseveral external investment managers and urge them "to beat the
average." It is iihpractical that money managers could be expected toserve as the informed owners, because they are short-term investors,
not owners. In addition, they also have a clear conflict of interest
because these firms constantly solicit clients among the U.S. Iarge

corporations. Their own self-interests make them loathe to become
actively involved in corporate governance because they do not wish to

offend present or potential clients. Furthermore, current SEC
regulations restrict the shareholders' ability to communicate with eachother about governance matters, thus inhibiting institutions fromcollectively selecting directors or exerting oversight in other ways
(Lorsch 1991; Taylor 1990).

3.1.3 lntercorporate Shareholding in Japan
Corporate shareholding in the United States generally takes theforms of a capital market transaction, the primary purpose of which is

to earn high returns on investment and to maximize current shareprices. The buying of corporate shares by investors is seen as basedon a welfare-maximizing reckoning, sensitive to price signals reflectedin changing share prices among anonymous traders in dairy, ongoing
market. To the extent that investors have generally symmetrical access
7

The hardheaded economies of institutional ownership make exit an increasingly
unattractive option. As they account for a large percentage of outstanding shares,
pension funds find it harder to beat the market regularly. The very act of buying

or selling large blocks of share - funds as big as giant pension funds in New
York trade, in large blocks - cannot help but affect prices in the wrong direction.

When pension funds exit, they take everyone with them and administer selfinflicted damage on their own valuation. These facts have persuaded big pinsion
funds to adopt buy-and-hold strategies through stock indexing. The essence ofindexing is to create a class of permanent shareholders with a long'term
perspective on corporate performance, that is, selling shares is not chosen.

Publie pension funds, the institutions with the greatest freedom to use theirresources to exercise voice, are the least equipped to do so effectively. The
institutions best equipped to exercise voice have the least discretion or inclinationto act. For decades, pension fund fiduciaries hired full-time staff members who inturn hired portfolio advisers, consultants, and money managers, These
professignals were experts on identifying undervalued shares and designingcomputer-based trading strategies that took advantage of arbitrage opportunities,
in short, in an ownership option based on exit. But in a world of indexing, wherebuy-and-sell decisions are essentially eliminated, decision making returns to thefiduciaries. CalPER can afford to hire the best financial advisers in the world,

But most of them are experts in when to buy and sell stbcks, bonds, andoptionsmnot in how to restructure a big corporation (Taylor 1990).

CORPORATE GOVERNANCE IN GERMANY, JAPAN, 191
AND
THE UNITED STATES : A COMPARATIVE STUDY

to information, the stock market conforms closely to its original
purpose of raising and allocating capital by corporate stock issues.
This is not the only significance of the stock market's operation,

however. Where investors are other corporations, as it is the
predominant pattern in Japan, ownership becomes a means for building
relationships among those corporations in ways that set markets forcapital and control in the context of other business interests. This
does not imply that the stock market no longer allocate capital or

responds to conditions of supply and demand in Japan. Rather,
corporate ownership takes on the added feature of being one of themain means by which corporation's strategic interests are secured andpromoted. This difference is reflected in the concrete pattern ofrelationships among shareholders. The importance of Japaneseintercorporate relationships is nowhere more evident than in the caseof intercorporate ownership networks. Since Japanese intercorporateshareholding primarily reflects concrete strategic interests rather thanthose of portfolio diversification, major shareholders should take more
substantial positions in other firms. Corporate ownership is far moreconcentrated in Japan than in the United states. Major intercorporate
ownership dyad are not only more prevalent in Japan, they represent
stronger relationships than in the United States.8

There is good reason to believe that the relationship between
shareholders and a company in Japan will be a highly durable one
where shareholders take on the role of a reliable constituency ofwell'known trading partners. Independent estimates of holding bystable shareholders typically fall somewhere around 60% of
outstanding shares held on the Tokyo Stock Exchange. In comparison,
U.S. institutional shareholders are seen as extremely active traders incorporate securities and, by implication, unstable shareholders. It is
this ability to exit the relationship that gives institutional investors in

the United States their power over corporations (Gerlach 1992).
Substantial numbers of shares are typically owned by corporations andfinancial institutions with important business relationships witheompanies within a group, even if they are not themselves part of that
8 Intercorporate shareholding in Japan are rather recent phenomena. In the 1960s,
Japanese firms feared the U.S. firms would takeover tyhe Japanese with owning theJapanese firm's stock. Japanese firms chose to deter the U.S. domination bycross'shareholdings.

192 KENJI KOJIMA
group. Individual ownership of public corporations in Japan accounts
for small proportion and is declining. Table 1 provides aggregate
percentage holdings by investor category for all firms listed on any ofeight stock exchanges in Japan. Banks, insurance companies, andbusiness corporation owned 64S06o of listed share and individuals owned

23% in 1990. 'share ownership of JapanTeasbeieFiirms by Type of investors,

All Listed Companies (%)

1980 1985 ' 1990

Government O.2 O.8 O.6
Banks 17.3 19.5 21.7
Investment Trusts L5 L3 ' 3.6

Financial lnstitutions 40.5 44.4 46.9

Annuity Trusts O.4 O.7 O.9

Securities 'Companies 1.7 2.0 1.7

Life lnsurance 12.5 13.5 13.2
Other lnsurance 4.9 4.5 4.i
Other lnstitutions 2.2 2.6 1.8

Business Corporations 26.0 24.1 25.2

Individual&Others 29.2 25.2 23.1

Foreigners 4.0 5.7 4.2

Source: Tohyo Stoch Exchange I7actbook

3.1.4 Small Securities Market in Germany
The stock market is only used by a few companies for financing

purposes in Germany. There were about 2 million companies inGermany in 1987. 220 thousands companies were private companies
with limited liability and less than 2,800 were stock corporations. Only

649 companies are quoted on a stock exchange and less than 100 are
widely held and traded (Baums 1992). The German stock markets havethe small size. In fact, the market capitalization of all German
exchanges at the end of 1990 were only 561 billion D.M. compared to 3

trillion dollars on the New York Stock Exchange. The volume ofshares traded on all exchanges in Germany in 1988 was 848,OOO shares,of which 671,OOO were of German companies. Compared to the 41.7

CORPORATE GOVERNANCE IN GERMANY, JAPAN, AND 193
THE UNITED STATES:A COMPARATIVE STUDY

million shares traded on the NYSE in 1989, even allowing fordifferences in population and size of economies, the difference ininvestment philosophy between the United States and Germany isobvious. Large German companies engage in fairly extensive crossshareholdings. While some of the$e are no doubt reciprocal and may
parallel important business relationships, as in Japan, the extent ofreciprocity of ownership is not clearly documented. Companies cantake cross-shareholdings subject to a limitation of 25906o of the voting

rights associated with those shareholdings irrespective of their size.
Financial institutions are especially Iarge holders of equity in German

companies, second only to other business corporations as owners ofGerman companies. Individual ownership of German corporations issmallest in the three countries (Lorsch and Maclver 1991).

The immediate and accurate market valuation of stocks is notestablished well in Germany stock market. Companies' descriptions of
their development in their annual financial statements and quarterly

reports are unregulated. This is due to the various accounting
methods available to firms in regard to financial statements, divisional

structure, and valuation, among other items. The legislature has only
recently decided to limit the available accounting options, which bytheir very diversity limited the information value of accounting data.
Accordingly, information on companies listed on the stock exchange isoffered by a few observers of these companies. The market forcorporate information is poorly developed with the exception of the big

banks having easy access to information. Due to the many available
options in accounting methods and to the limited legal obstacles inplace against insider transactions, there is Iittle incentive to undertake

costly analysis of publicly-available company information. Thisdiminishes the reliability of valuations and the attractiveness of thestock market for investors who have access to internal•sources of
information, and thus impairs the price-making functions of market(Kallfass 1988).9
9 There is no legal prohibition of insider trading in Germany. Rather, there areinsider trading guidelines. These guidelines have been formulated by interested
association in order to reduce the demand for restrictions. They do not require
public documentation of insider transactions, provide for no official auditing,contain hardly any incentive for investors to take action against suspected insidertransaction and establish no strict system sanctions. These guidelines can thus
only prevent extreme abuse (Kallfass 1988).

194

KENJI KOJIMAThe pensions of the employees of a German company are carriedon the liability side of its balance sheet as "accrued pensions," ordeferred pension liability. These liabilities are insured by a "Pension

Guarantee Association," set up by German industry, to which eachparticipating company pays a premium. It means that there are nolarge pension funds trading or even owning shares. Direct pension

commitments accompanied by the formation of internal pension
reserves have provided much greater tax benefits to corporations thanretirement plans operated by legally autonomous pension funds.
Therefore, internal company financing by means of pension reserves
predominates. Such financing is not subject to market conditions andfunds remain in the companies of their origin. These funds are subject

to the decision of company management concerning their use, andsubstitute for bank loans and equity capital, diminishing dependence on

the credit and equity markets (Kallfass 1988; Lorsch and Maclver
1991).

3.2 Ownership Structure of Public Corporation
3.2.1 Uninvolved lnstitutional lnvestors in the U.S.

Among the 40 largest German public corporations, 29, or 72.5906o,

have shareholders who hold 5% or more of the equity. Among the 50
largest U.S. companies, there are only 8, or 16%, with as muchconcentration of ownership. In Germany, these large owners areentitled by custom to a seat on the supervisory board, and they do act

as owners. In the U.S., however, there are few instances where suchclear ownership exists. Even where it does exist, there is no guaranteeof a seat on the board. Therefore, large institutional funds simply
cannot act as owners, and it is very difficult to create an environment
in which there is true ownership. Active investors hold large equity or
positions, sit on boards of directors, monitor and sometimes dismiss
management, are involved with the long-term strategic direction of thecompanies they invest in, and sometimes manage the companies
themselves. The high cost of being an active investors has left financial

institutions and money management firms, which control more than
45% of all corporate equity in the United States, almost completely
uninvolved in the major decisions and long-term strategies of thecompanies their clients own. They are almost never represented on
corporate boards. They use the proxy mechanism rarely and usually

CORPORATE GOVERNANCE IN GERMANY, JAPAN, AND 195
THE UNITED STATES : A COMPARATIVE STUDY

ineffectively, notwithstanding recent efforts by the Council of
Institutional Investors and other shareholder activists to gain a larger

voice in corporate affairs. Institutional investors are remarkably

powerless; they have options to express dissatisfaction withmanagement other than to sell their shares and vote with their feet.
This would require a fundamental shift in the investment philosophy
and practices of major institutional investors and major reform in thelaws and regulations that affect their participation in the corporate
governance process. None of these change is likely to oecur anytime
soon (Jensen 1989; Lorsch 1991).
3.2.2 Stable Shareholding in Japan
Since corporate shareholding in the United States generally takes

the forms of a capital market transaction, the primary purpose ofshareholding is earning high return of investment. The shareholding inGermany and Japan is markedly defferent. The purpose ofshareholding can be characterized to strengthen business relationships.

The dominant owners hold significant stakes and seek long-term
appreciation of their shares, which they hold in perpetuity. Unlike theU.S., in which the goals are driven solely by the financial transaction,

the goals in German and Japan are driven by business relationships.
Suppliers and customers own stakes in each other, not to profit fromthe share ownership itself but to bond their business relationship.

The pattern of ownership and the goals of owners directly affectmonitoring and valuation approaches. Since owners hold significant
shares for long periods of time, they have both the incentive and thecapability to engage in extensive and ongoing information gathering
about the companies they own. And unlike the American investors,
principal Japanese and German owners are driven not by the need tomake decisions on buying or selling stock for profit-taking but by thedesire to assess the ongoing prospects of the company. They,
therefore, command the respect of management, have access to
information concerning the company through business relationships,
and can exert an influence on management.
While the majority of Japanese owners hold their company sharesfor long periods of time, the short-term owners in the country areprone to turning their shares over more frequently than owners do in
the United States, and basing their investment decisions on even less

196

KENJI KOJIMA

information. While roughly 60% of Japanese stock is held for the
long-term, the remaining is traded at such a rapid frequency that the
average rate of t'rading in Japan is similar to the rate of trading in the

U.S.. Yet, share prices and pressure from short'term owners andinvestors have virtually no direct or indirect influence on management
decisions (Porter 1992).

The importance of Japanese intercorporate relationships can be

identified in the case of intercorporate ownership networks.
Intercorporate shareholding in Japan is also more likely to bereciprocated than in the United States as a resuLt of the system ofkabushiki mochi-ai, cross-shareholding, The term mochi-ai, construed
narrowly, means "to hold mutually." But it also carries an additional
connotation form its other uses of helping one another, of sharedinterdependence, and of stability. One of the most significant outeomesof strategic interests on ownership patterns is the extent to which ties

in equity networks are overlap with ties in other networks.
Shareholdings positions in Japan are more likely to become embedded

in other ongoing relationships between the firms, as the role ofshareholder becomes merged with that of business partner. The linkingof equity and loan positions indicated a transformation in the nature ofeach in relationships among banks and their client firms. Credit, in theform of bank loans, has come to resemble equity in allowing creditors
flexibility in repayment by deferring interest and principal payments
and reducing the compensation balances that corporate borrowers needto leave in bank during times of financial distress. Loans are rolled

over as a matter of practice. Furthermore, banks intervene in the
management of their client firms, particularly when the company is introuble (Gerlach 1992).

Accompanying many of cross-shareholding by the financial andcorporate sectors are implicit but widely understood and rigorously

observed agreements not to sell shares held in conneetion with
on- going business relationships. The effects of these substantial stableshareholding are to create a potentially formidable barrier to takeover

and, thus, to entrench managers. Japanese executives continuallyassert that such shareholding may be effective to secure business
relationships among companies and serve as an indicator of mutual
long-term commitments. A decision to sell equity held under thesearrangement would be seen as equivalent to a permanent repudiation of

CORPORATE GOVERNANCE IN GERMANY, JAPAN, AND 197
THE UNITED STATES : A COMPARATIVE STUDY

the relationships (Kester 1991b).

3.2.3 Share Depository System in Germany .
In Germany, roughly three-fourth of top largest public
corporations have shareholders who hold 5%o or more of the equity.
These large owners are entitled by custom to a seat on the supervisoryboard, and they do act as owners. Since the average German owns
less equity directly or indirectly through institutional investing, thepattern of ownership of German companies is different from thepattern in the United States. There is a greater concentration ofownership in Germany, with banks, founding families, foundations,other companies, and even state entities owning significant blocks ofshares in many major companies. In 29 of the 40 largest German
companies there are shareholders who own 5% or more of the shares.
Importantly, ownership of even 10% is traditionally understood byGerman business leaders to entitle that shareholder to a seat on theowner's side of the supervisory board. This concentrated ownershiphas its roots in Germany's past, when many of prominent firms today
were founded by families. Some of the families retain their shares, andmany of them looked to Germany's banks for funds (Lorsch andMaclver 1991).
In addition to direct share ownership, German banks also act as
depositories for stock owned by other classes of shareholders. At theend of 1988, approximately 40% of the total market value ofoutstanding domestic shares, were deposited in German banks. When
added to their own share ownership, nearly 50% of listed German
corporate shares are directly or indirectly under their stewardship.
This role as a share depository has been quite important to German

corporate governance because of what is known as theVollmachtstimmrecht - the ability of banks to vote shares held in
deposit on behalf of the depositor. For many years this right of proxy

was virtually automatic, indefinite in duration, and did not require
instructions from the true shareholder. It was a condition of thedeposit itself known as the Depotstirnrnrecht. Today it is restricted
insofar as the right of proxy must be renewed every 15 months andbanks must solicit voting instructions from shareholders. Nevertheless,as a practical matter, banks continue to obtain wide latitude in thevoting of shares held on deposit, giving them considerable effective

198

KENJI KOJIMA

voting power (Baums 1992).!O As with Japanese company-bankrelationships, share held by banks are seldom traded infrequently. In

most cases, a ' primary equity'owning bank of a large industrial
corporation will be a Hausbank which has a long history of banking
business. A Hausbank would be a primary lender to a company andwould often enjoy representation on the supervisory board (Kester
1991b).

4 lnternal Control Mechanism''
4.1 Monitoring
4.1.1 Board of Directors in the U.S.
The U.S. corporate governance relies on the board of directors as

its main mechanism. Elected by shareholders, the board secureshareholders interests by overseeing management and board selection,
reviewing financial performance and allocation of funds, stipulating
eompensation of top management, and ensuring that the corporationacts in a legally and socially responsible manner. Generally,membership on U.S. boards does not reflect a company's closebusiness or financial relationships, as it often does in Germany andJapan. Rather, board composition in the United States tends to reflect
an American affinity for outside directors, or those with n.o direct
affiliations to management. No doubt, that U.S. firms are less likely toenter into close, long-term supplying and banking relationships thantheir German or Japanese counterparts explains part of the difference
in board composition. Most significant, however, is the emphasis on

accountability of managers to directors, and of directors toshareholders in the U.S. as shown in Figure 1. Companies have
responded to growing liability litigation, which has shifted the burdenof legal responsibility to directors, by choosing outside directors whoare considered indispensable for maintaining a neutral board capable
10 The recently available study shows the concentrated ownership in Germany.
Banks collectively represented more than 80% of all votes which were present in
the meetings of 32 largest public companies in 1984. As a consequence, banks were' able to elect the members of the supervisory board who were appointed byshareholders. Changes of the corporate charters could not be effected against theirvotes. The voting rights are highly concentrated in the three larggst banks such as

Deutsche Bank, Dresdner Bank, and Commerzbank. These three banks held about
450/o of all votes on average in those largest companies (Baums 1992).

CORPORATE GOVERNANCE IN GERMANY, JAPAN,AND
THE UNITED STATES : A COMPARATIVE STUDY

of objective oversight.

Shareholders

Board of Directors

Managers

Workers
Figure 1

Board of Directors in theu.s.

Boards, which have come to be dominated by outside directors
with no other links to the company, exert only limited influence on
corporate goals. An estimated 749 of the directors of the largest U.S.
corporations are now outsiders, and 80% are CEOs of other companies.

The move to outside directors arouse out calls for greater board
objectivity. But the cost of objectivity has been directors who lack ties

to the company and whose own companies are in unrelated business.
As a consequence, they often lack the time or ability to absorb the vast

amounts of information required to understand a company's internal
operations. Moreover, most directors have limited stakes in thecompanies they oversee. While the median aggregate holdings of theboard account for an estimated 3.6906 of equity, many directors have noshares at all or only nominal holdings (Porter 1992).

The Information on which directors make their judgements is a
crucial element. The way information is obtained by most corporateboards is one of their weakness. Directors lack independent
information and analysis regarding a company's performance. Virtually199

200 KENJI KOJIMA
all information comes to the board from management. Its content anduse is a potent means with the CEOs can influence events. Some CEOs
use information to engage the board in sound decision making; others,

however, control information. There is no independent source of
information and analysis. The outside directors, however, who usually

meet together only five to nine times per year, must rely on
information solely from management. The problems associated withinformation asymmetry are compounded by the shortage of time mostdirectors can devote to their board positions (Lightfoot 1991; Porter

Several aspects of the board system may promote the selection of

directors sympathetic to incumbent managers, thereby diluting
management's accountability to the board. The existence of the joint
CEO-chair of the board blurs the separation between management andoversight functions in many companies.ii In fact, CEOs also chair theboard in 80SO)6o of all U.S. corporations, and although CEOs can neither

hire nor fire directors, they often choose the nominating committee forthe directors, or even indirectly nominate the directors themselves.
Voting procedures for the election of directors may also diminish
management's strict accountability to the board: most shareholders
who vote for or against a slate of management'nominated directors
vote by proxy. Although write-in candidates are allowed, the effort
required to coordinate enough shareholders to install an alternative
board is formidable in most situations. The composition of corporateboards reveals a propensity to choose members inclined to support

management: 63% of all board members are CEOs of their own
11 Multiple board memberships have become common today. In 1969, 49% of theinside board members in these companies sat on one or more boards besides theirown. By 1985, the total had risen to 74%o, and insiders who served on three ormore boards more than doubled. If directors are spending much time on boards
generally not spending enough time on any one board, it is not possible fordirectors who are responsible for running their own eompanies or for those retired

executives who serve on more than two boards to be able to understand eaehbusiness well,

It is directors with a sizable stake in a company who are most likely toquestion- and challenge management's proposals. Experienced directors readily
concede that when they see strong and independent leadership on a board, it

usually comes from someone who owns a big block of stock or represents
someone else's large investment. Board members who own only a few shares are
not likely to influence the management, particularly if their annual compensation
for serving on the board is more than they earn from the stock (Patton and Baker
1987).

IN GERMANY, JAPAN,
CORPORATE GOVERNANCEAND
THE UNITED STATES:ACOMPARATIVE STUDY
corporations. (Lightfoot 1991)i2

In general, clear ownership can provide stronger incentives for

managers and directors to improve company performance. But
assuming that strong ownership in the U.S. corporation remains elusive,

to whom and for what should directors be accountable? The
assumption that directors should be accountable solely for the owner's

welfare is too simplistic and fails to take into account several
important new realities. For example, in 25 states there are now lawsthat permit directors to consider the welfare of constituents other thanshareholders ' employees, customers, suppliers communities. Even in
Delaware, where the majority of these companies are domiciled where
there is no such Iaw, the courts have begun interpreting directors'
accountability more broadly. These rapidly changing laws compoundedambiguity and confusion about corporate goals. These new law on
director accountability, stimulated by legislators' desire to protect local

companies from hostile takeovers, permit directors to consider otherstakeholder beyond shareholders. There is confusion in the board
room about how to think about shareholder's interest and what otherinterests directors should represent (Lorsch and Maclver 1991).

Both the German and Japanese corporations are significantly
different from the U.S.. For both, the predominant goal is to secure
the position of the corporation and ensure the company's continuity. In
Germany, the supervisory board consists of representatives of banks
and other significant owners, and in large companies, 50906o of the board

comprises representatives of employees. All major constituencies thus
12 CEOs select and groom their directors with great care, and often, by increasing thenumber of directors, they decrease their individual influence. Significant stock

ownership is not required for board membership, and those who question the
CEO's judgment or policies are excluded from the inner circles 7 the nominating
and compensation committees. As boards of directors grew larger, meeting tends
to become mere formalities, often degenerating into slide shows or theatricals
carefully scripted by the chairman. There is little or no time for give and take on
the issues. The chairman often becomes the sole mediators between the board andmanagement. Most boards develop close social ties that tends to restrain theirmonitoring function. The outgoing chairman often continues to serve on the board

after retirement. Outside directors seldom meet alone to discuss management
issues. Given the way boards operated, even a CEO who understands the need forreform is up against almost formidable odds, especially if he is a career insider.
It is virtually impossible for directors to change organizations and repudiate his
predecessor, the man who has given him his job. That predecessor still sits on theboard and has selected many of the other members (Johnson 1990).

201

202

KENJI KOJIMA

influence corporate goals and the responsibility of achieving thepromotion of the company's best interest, according to German law.
While they are'concerned with investors and non-owners, German
boards are expected to consider these interests in the context of how
they will influence the company's longmterm well'being. In Japan, theperpetuation of the corporation is the fundamental goal. This goal isreinforeed by the fact that most directors are inside members ofmanagement; moreover, lifetime employment is the norm in significantsized companies (Porter 1992).

4.1.2 The Two-tiers Board Structure ln Germany
One of the most unique features of German corporate governanceis the structure of its board of directors. Where as the U.S. board of
directors is intended to provide objective and shareholder-oriented
oversight of a company's management, its German counterpart, theAufsichtsrat, or supervisory board, is not chosen for its strict
commitment to shareholder interest. Its membership frequently reflects
the company's financial and business relationships and provides otherstakeholder with a voice in the company. Indeed, the two'tiers control

mechanism was created in the 1870s to give bankers an organ ofcontrol with which to oversee their investments.i3 Today, all public

corporations with more than 500 employees must have a two-tiers
board structure, with both a supervisory board and a management
board shown in Figure 2 (Baums 1992; Lightfoot 1991). The influenceof large German shareholders is exercised largely through the
Aufsichtsrat. This is one of the most important safeguards embodied

in the German system of corporate governance, and one unique toGermany. German Commercial Code provides for two forms of limited
liability stock companies: the Gesellschaft mit beschrdnhter Haftung, toGmbH; and the Ahtiengesellschaft, or AG. The former is privately
13 The supervisory board-management board dichotomy was introduced by theGeneral Commercial Code adopted by the German states in 1861, not having beenprevalent in the individualized articles of association of prior corporations. It was

not made compulsory until 1870, when the elimination of the requirements ofspecific state assent to incorporation and of governmental representatives incorporate management seemed to call for some substitute supervisory organ. The
present system, embodied in the 1937 act and modified in the 1965 version, is
designed to perfect the supervisory board's performance of its role as a watchdog(Vagts 1966).

CORPORATE GOVERNANCE IN GERMANY, JAPAN, AND203
THE UNITED STATES:A COMPARATIVE STUDY
owned and unlisted; the latter, publicly owned and listed on a

Germanstock exchange.

Shareholders

Supervisory Board

Management Boardi

ManagersiWorkers

Figure 2
The Two-tiers Board Structure in Germany

By law, AGs have two-tiers boards. The Vorstand, management
board, had day-to-day executive authority over the company and is thereal decision-making body on most matters. Typically, it has between
five and fifteen members who are full-time salaried executives of thecompany, each of which is responsible for strategy formulation andimplementation, and operations. Members of the Vorstand areappointed by the Aufsichtsrat for fixed terms usually lasting three tofive years, and can be dismissed in the intervening period only if there

has been a clear breach of duty. The Vorstand must report to the
Aufsichtsrat and gain its consent for major financial and investment
decisions. The Aufsichtsrat, in contrast, is a true supervisory board,
not an executive one. It is composed of nine to twenty-two members.
Subsequent to the Co-determination Act of 1976, half of these are madeup of elected worker representative.i4 The other half of the board is204

KENJI KOJIMA

elected by shareholders and consists entirely of members who are notfull-time employees of the company. Members of the supervisoryboard can only be replaced with a 75% vote of shareholders.i5 It is
not uncommon, however, to have retired company executives elected to
the Aufsichtsrat. In fact, the chairman of the Aufsichtsrat is quite
often the most recently retired chairman of the Vorstand.
In effect, the shareholder-elected half of the German Aufsichtsrat
is equivalent to the "outside" directors of an U.S. corporation. An
important difference, however, is that these German outside directors

are more commonly drawn from the executive ranks of other major
corporations or financial institutions that have a major stake of some

sort in the company in question. That stake may be a substantial
equity investment, a long'standing lending relationship, purchasing or

supplying arrangement, or, as in Japan, some combination of thesevarious types of claims. These directors tend to consider thecompany's most important investors and business relationships. They
also can and will exercise considerable influence in the shaping ofcorporate strategy through the composition of the Vorstand (Kester
1991b).

Although legally responsible for representing shareholder interests

at large, German Aufsichtsrat members are also able to act as de facto
representatives of, and monitors for, other stakeholder interests. Bank
executives on the boards of industrial corporations are especially well
positioned to represent other stakeholder interests. To the extent theirbanks lend to the corporation in question, the interests of creditors aswell as shareholders are directly represented. By virtue of banks'

extensive lending business and large equity stakes in German
14 The roots of employee co-determination reach back to the end of World War I
and the November Revolution of 1918. The Works Council Act of 1920 brought thefirst comprehensive treatment of the plant constitution. At the same time, and forthe first time, it ordered two places in the supervisory board of large enterprises
to be occupied by representatives of employees. After World War ll, the British

Labor Government encouraged the coal, iron, and steel industry to adopt
agreements between unions and boards of directors concerning the filling of thesupervisory board with an equal number of representatives of shareholders andemp!oyees. The Cordetermination Act of 1976 mandated the equal division of thesupervisory boards between shareholder and employee representatives for all large
enterprises with more than 2,OOO employees(Raiser 1988).
15 In France, management can be dismissed by a 50% majority of voting rights. In

the U.K., members of the board can be replaced by the chief executives or bycontrolling shareholders, possibly after payment of compensation (Franks andMayer 1990).

CORPORATE GOVERNANCE IN GERMANY, JAPAN, AND 205
THE UNITED STATES:A COMPARATIVE STUDY

Mittlestand, bank executives may also indirectly reflect the interests ofsmaller suppliers, customers, and so forth, who serve the needs of thelarger industrial corporations. German banks have large network ofinterlocks among directors sitting on supervisory boards of German

large corporations.i6 German board linkages represent anincorporation of major interests from both the financial and nonfinancial sectors. Banks act more like integrator of cross'connecting
economic sectors and other fractional interests (Kester 1991b).

While the management board meets frequently, as it operates thecompany, the supervisory board meets only three or four times a year.
By law, the members of the supervisory board meets only three or fourtimes a year and have as their primary responsibility the promotion of
the company's best interest. Such a statement does not give primary

importance to any one stakeholder. Beyond granting contracts tomembers of the management board, the supervisory board's duties
include approval of plant closing, strategic and financial decisions,reviewing company performance with the management board, approving
the annual report, and selecting auditors. Closing down facilities

depends on the workers' consent. An unanimous decision on the
supervisory board is required. To accomplish its duties, the board has

a right to collect comprehensive information and the management has

to provide information periodically on all important questions.
Members of board are required to treat information confidentially. In
addition to these two boards, there is an annual general shareholder
meeting, at which performance is reviewed and shareholders vote on

relevant proposals. The general meeting can resolve whenever the
management board requests its vote. In certain cases the general
meeting may vote in order to resolve disputes between the management
and supervisory boards. This is, for example, the case when the
supervisory board does not approve certain business decisions which
the management board wished to make and the management requests
16 Members of the managing or supervisory board of a bank can be members of thesupervisory board of a company. A single person must ltot be a mernber of mere

than ten boards at the same time. However, this rule does not restrain theinstitution which he represents. There is no rule in German Iaw which prohibitsa membership on boards of competing firms. In 1988, managers of nine banks
held 94 seats on the supervisory boards of 96 of the largest 100 companies. That

equals 5.4% of all board seats in those companies. The members of the
management boards of the Deutsche Bank alone held 35 of the respective seats(Baums 1992).

206

KENJI KOJIMA

a vote on these issues by the general meeting (Schmalenbach 1990). It
should be noted that it is the co-determined supervisory board and not
the general shareholders' meeting that grants management contracts. A
key but subtle difference between the United States and Germany is in
the procedure for voting shares held by trustees. In the United States,
shareholders must vote their proxies themselves, while in Germany theinstitutions that are custodians for individuals' shares, usually banks,
actually vote the proxies. This is an important source of power forGerman banks (Lorsch and Maclver 1991).i7

The ability to learn about how well a ,company is really
performing and what potential problems it faces is easier in Germany
than the U.S. because Germany is a relatively small country and there
are close ties among those who serve on the supervisory boards. Thereis a network among those who serve on supervisory boards. The top
executives know each other very well and exchange information witheach other. They meet regularly at supervisory boards. The banks
and insurance companies, whose managers are involved in so many
boards, also provide a setting for their executives to exchange data andideas. The informal information network among German executives,banks and owners provides an early warning system. The compactnessof the German economy and the smaller size of its businessestablishment seem to allow a better flow of information. Among
German managers and directors there is a widely shared expectationthat the chairman of the supervisory board will act if problems areserious. The responsibility of the chairman of the supervisory board is

not encoded in the co-determination law. In fact, it was constantly
emphasized that the chairman's role on the supervisory board is one ofbuilding consensus. As the role of the worker's representatives in
event of failing performance or other management difficulty concerns,
17 As to banks, there may be incentives to get involved in corporate governance.
First, they could try to protect their own equity investment. The right to vote theirclients' stock gives banks a leverage to protect or strengthen their own investment

without own capital infusion. Second, banks could trY to protect their credit in
the firm. Mostly, a shareholder will not get earlier or broader information thana bapk as a creditor. Even if banks are represented on the company's board, thiswill normally not provide the banks with better or earlier information than they
already have as creditors. Even if banks are not able•to get better information,
they can improve their positions as creditors in certain aspects being equity
owners or votes stock of the firm for its clients at the same time. A credltor
holding majority of the votes in the shareholders' meeting of the company canchoose who manages the company to secure the interest (Baums 1992).

CORPORATE GOVERNANCE IN GERMANY, JAPAN, AND 207
THE UNITED STATES : A COMPARATIVE STUDY

it follows a process which is not intended in the co-determination laws.

Co-determination fits with financial structure of German companies.
German pensions are funded on the liability side of a balance sheet in
employed companies, turning employees into long-term capital suppliersto the company. These liabilities are insured by a "Pension Guarantee
Association," set up by German industry, to which each participatingcompany pays a premium. The fact that pensions are in effect invested

in the employing company can imply that German employees have
incentive to get involved in the long term success of their companies.

Since workers make a long-term commitment to employed companies,
employee directors are concerned with long-term success. They also
have more frequent contract with management, in the ordinary courseof events, than owner's representatives, since they often work in thesame locations. This means they know a great deal about thecompany (Lorsch and Maclver 1991).i8
The supervisory board might be able to review the performance ofthe management by its results at the end of certain periods. According

to German law, management is required to set up and publish thefirm's balance sheet and profit and loss statement only annually. Bothare checked by independent public accountants who are supposed tosupport the supervisory board and report to it. The supervisory board
can be provided with information about the situation of the company

and then compare the results of the company with those of its
competitors to measure the performance of the management. A memberof the management board can be dismissed only for causes, forexample in cases of criminal offence, before the expiration date of his

term (Baums 1992).
Furthermore, the workers of every company with five or more
employees have the right to elect representatives to a works council by

German law. The works councils have broad access to information
about the financial condition of the company. They must be consulted
18 There are marked differences in the degree to which French, German and British
laws confer rights on employees and their representatives. In France, employees,
trade unions and workers' councils have the rights to be consulted about a rangeof corporate activities but do not possess a right of veto. In the U.K., companies
are free to consult and involve employees in corporate activities as they see fit but

not required to do so. Therefore, employee rights are considerably greater inGermany than in France, which in turn are greater than those in Britain (Franks

and Mayer 1990).

208

KENJI KOJIMA

by management about organizational changes such as jobclassifications and flexibility in shift assignments.i9 They even haveveto rights over 'company personnel decisions such as hiring and firing,transfer, layoffs, and overtime. Usually, union activists are elected tothe councils, which, in turn, rely on the research and expertise ofnational unions to gauge the implications of proposed management
policies (Summers 1980; Wever and Allen 1992).20

4.1.3 lnside Managing Directors in JapanThe goals of Japanese companies are growth. and longevity, with

Iess emphasis on maximization of shareholders' value. In fact,independent shareholders are in a rank Iow on the list of constituencies

whose interests management is to represent. The board of directors is

composed entirely of senior managers who do not hold substantial
equity in the company. Large Japanese companies are controlled byboards consisting of about 20 to 25 directors. All of Japanese
directors are virtually inside managing directors chosen from the ranksof top management itself. Although they are formally elected byshareholders votes at annual meetings, the slate is nominated bymanagement itself. Retired executives of important equity-owning
stakeholder join these directors as representatives of their former
employers.
Since the boards of directors of large Japanese companies almost
entirely comprise full-time managers in the company they direct, their
meetings have the flavor of a top level executive meeting. The jomu-hai(meeting of top executives) has replaced the torishimarlyahu-hai(board meetings) as the de facto locus of control. As one indication ofthis, we can look at the function of the kansayaku (company's
auditors), who is in charge of supervising the management traek
record set by the directors as shown in Figure 3. The shareholders of
19 In the United States there is no worker participation at this level. The unions reject

any such role, for they view their function as one of confrontation of management

through collective bargaining, and participation in management would beinconsistent with that function. Work participation in the decisions of thecompany is solely through collective bargaining (Summers 1980).

20 Thelen (1991) argues that works councils, supervisory boards, and management

boards make up a remarkable machine for producing consensus, which helps
German companies adapt change. By allowing the German corporate governanceto define external challenges in terms acceptable to all the stakeholder, s'uch
mechanism make it easier for stakeholder to agree on strategies for change.

CORPORATE GOVERNANCE IN GERMANY, JAPAN, 209
AND
THE UNITED STATES : A COMPARATIVE STUDY

the company are granted the legal authority to appoint this position.

However, these positions are almost pervasively filled by career
employees rather than by outsiders, and the job is often insignificant.

Although the legal trappings of the joint stock corporation are
maintained, two traditional institutions of shareholders control ' thegeneral shareholders' meeting and the board of directors have beentransformed into pro forma rituals intended primarily to satisfy therequirements of procedural legitimacy by largely devoid of real
substance. The general shareholders' meeting is, among the board of
directors, the primary institution within which owners can, in principle,

pass on the performance of the management they have hired. The
Japanese Commercial Code establishes an agenda for the meeting: theelection of directors, approval of the balance sheet and income

Shareholders

Board of Directors - AuditorsiManagerslWorkers

Figure 3
Inside Managing Directors in Japan

statement, as well as determination of dividends. The reality, however,is that it is a legal formality - a ceremony, the significance of whichlies not in what gets communicated between shareholders andmanagers but in what it indicate about control over the form and in
the ways it satisfies demands for legitimacy in the larger business
community. Large, stable shareholders do not typically bother to show

210

KENJI KOJIMA

up. In nearly 80 percent of the companies, those attending meetings
account for less than 20 percent of the company's shares (Gerlach1992).

This is not to say that the Japanese companies are undisciplined
by its external stakeholder, however, for the shacho'hai (president
council), main bank relationships, and other external controllingarrangements are capable of constrain firm management. The
shacho-kai serves as a forum for the representation of a complex
nexus of interests among a coalition of affiliated financial lenders andtrading partners. In some ways, it serves as a substitute for the
corporate board in a system where outside directors representing

nonmanagerial interests are lacking. However, the shacho-kai
represents these interests in a way that is different for the board of
directors in a respect. The shacho-kai is an informal institution inwhich the monitoring function is diffused. There is no defined orlegally binding governance relationship between the council and its
companies, and as a result, influence is negotiated between relatively
equally sized companies based on internal group relations rather thanon formal authority vested in law. Associated with this is the fact thatgovernance within the shacho-kai occurs within a known andcontrollable set of actors. Membership in the group is carefully
defined, and controlling inside takes place among mutually positioned
companies in a kind of community-based form of governance (Gerlach1992). •Externally, the shaeho-kai serves as a signal to the larger
business community that a relationship exists. This confers on themember company a degree of status resulting from being associatedwith the name of Mitsubishi, Sumitomo, and so on. Council
membership also sends signals that get picked up by managers inpurchasing and finance departments of their respective companies,
tilting decisions in favor of other group companies when there are nocompelling reasons to go elsewhere. Membership is closely associatedwith pattern of banking, trade, and other business relationships
involving group companies (Gerlach 1992).

Japanese companies have a number of interesting and different
features that shed light on the nature of corporate control overcompany's management and the way in which it is embedded inintercorporate networks. Gerlach (1992) summarizes these features as

CORPORATE GOVERNANCE IN GERMANY, JAPAN, AND 211
THE UNITED STATES : A COMPARATIVE STUDY

follows: first, directorships in Japan are associated with a broader
system of inter-company personnel flows or employee transfer. Insteadof serving as part-time directors, executives moving from one company
to another typically take up full'time positions in the recipientcompany. The pattern of movement of personnel between companies
indicates that the dispatching process serves to reinforce specificrelationships between companies rather than the more general interests
the company might have in monitoring its environment. Second, thedispatching of directors most often expresses a vertical relationship,with the flow of directors moving unidirectionally from one company toanother. Third, as a result of the first two features, outside
directorship is limited largely within a particular group of firms, but

the overall intragroup network is sparse in comparison to what wemight expect from the dense patterns of equity crossholding.

The predominance of full-time managers as directors is alsosignificant because not all of them began their careers in the same

company. A large portion have moved from one company to anotherby mutual agreement. Most involved younger employees and were only
temporary transfers. These typically Iasts for two years, during which

the dispatching company guarantees the employee's salary. But asmaller fraction of the total were employees in their early fifties who
were unlikely to be promoted to the director level in their own company
before retirement. When upper-level executives are dispatched to othercompanies, it is usually on a permanent basis with the employee taking

on an executive position in his new company. Where these employees

become directors of the recipient company, they are dispatcheddirectors. As a result of transfer, about one+third of the directors ofJapan's major corporations now come in from the outside, comparedto the United States where outside directors eonstitute over two-thirdsof the total. Such transfers provide extensive networks of enduringpersonal relationships between individual managers in relatedcompanies, networks that may facilitate future businesses between thecompanies by enhancing trust between the company's managers.
Reinforcing monitoring and communication at the managerial level areties at the level of the board of directors.

The distinctive feature of this form of directorship is that, incontrast to the U.S. model in which the director is truly "outside" that is, the directorship is a part-time position and connections to

KENJI KOJIMA

212

another organization are maintained - the dispatched director in Japan
becomes a full-time employee in the receiving company. These generally
represent long'standing intercorporate linkages and serve the interestsof management in two companies at once as part of an ongoing
relationship between the companies (Gerlach 1992).

4.2 Voice
4.2,1 Voting
Dissident shareholders resort to voting rather than the takeovermarkets or the courts to protect their ownership rights against
management entrenchment, to express their opposition to management
strategies, and even to field slates of directors to run against
management's nominees. Dissident investors in the U.S. would simply
sell the stock and move to a better prospect. But this selling option isdifficult for large institutional investors who have indexed much of
their portfolios. As an alternative, the best way is to encourage andimprove long-term management performance with adopting proxyvoting for boards of directors. When management of a given company
is significantly underperforming due to its own shortcomings, thestrategy with regard to proxy voting can be taken to cast its proxyballot so as to withhold its vote on the entire management slate of
directors, thus effectively voting "no." To emphasize its seriousness,some institutional investor will seek a meeting with targetedmanagement prior to the vote.
In the U.S., institutional investors have attempted to use the proxycontest as a way to influence management for the last few years.
During 1990 institutional investors proposed more than 120 proxy
resolutions, achieving some notable successes. However, the proxysystem is not well-suited as a vehicle for influencing long-run
corporate performance. Proxy contests have been used primarily as away to keep managers from adopting provisions that further protect

and entrench management, rather than improving a company's
competltlve posltlon.

There also are significant regulatory impediments to the use of

the proxy system. The Securities and Exchange Commission (SEC)
must review and approve all information and analyses distributed byparticipants in a proxy campaign. In its review the SEC encourages
simple and understandable analyses that can be readily understood by

CORPORATE GOVERNANCEIN GERMANY JAPAN AND 213
t!
THE UNITED STATES:A COMPARATIVE STUDY

small, unsophisticated, investors. Such communications, therefore, do
not provide the kind of sophisticated analYsis necessary to obtain athorough understanding of a company's long-run policies. SEC rules

discourage collective action among stockholders as well. If ashareholder in a proxy campaign tries to influence the votes of morethan 10 other shareholders, or to hold a meeting with them, allcommunications among these shareholders must be reviewed by the
SEC. This reviewing process significantly deters institutional investors

from acting together. While the SEC is currently reviewing its proxyrules with a view towards making them less of an obstacle to effective
eorporate governance, it is unlikely that proxy contests can ever be a
substitute for Iarge ownership right. It simply does not provide thekind of format conducive to a frank exchange of information between
management and shareholders, which is a necessary concomitant of arigorous and informative analysis of corporate strategy (Edwards andEisenbeis 1991; Taylor 1990).2'

Conducting a successful proxy fight to change managerial policies

would seem all but impossible in Japan. From the start, Japanese

regulations governing the proxy device have been rather weak.
Moreover, in contrast to the trend in the United States, Japan has had
a history of gradually relaxing proxy regulations in favor of incumbent

management. Among other steps, amendments over time haveabolished advance review of proxy materials by the Ministry of Finance
21 The proxy reforms recently approved by the SEC will make it easier for investors
to understand corporate incentive systems as well as to debate policies and to e}eet

independent candidate to the board, These reforms are designed to give theowners of dysfunctional corporations the options of internal reform rather thansimply selling their shares. By strengthening the system of independent directors

and reinforcing their accountability, the reforms will encourage boards of
directors to step in earlier to address persistent problems of corporate efficiency.
In traditional dissident proxy contests, the dissident investor chooses directors

who are usually viewed as his surrogates. In the institution-dominated market,

dissidents genuinely committed to soliciting independent board members canconvene a committee of major stockholders to choose the best possible candidates.
The dissident can then pledge to support a slate of candidates assembled by thisnominating committee. In situations where there is a clear and simple alternative
to management's present policies, campaigns in which dissident investors press a

specific alternative corporate agenda could become prevalent. These lobbying

campaigns disseminate expert reports detailing corporate performance andarguing for specific new strategies. Dissidents canvass shareholders usingsophisticated polling techniques to determine which issues are of broad concern toa large portion of the ownership base. These issues are then incorporated in thedissident agenda (Pound 1992a).

214 KENJI KOJIMA
even when a contest for control is at stake, and have deleted provisions
that the designated proxy agent should follow the voting instructions of
the shareholder Solicited (Kester 1991a).

Blank proxies, for example, were quite common in Japan andgenerally recognized valid in support of management's position.
Vagueness in the regulations on requiring disclosure of potential
conflicts of interest affecting a candidate for director have allowed
corporations to state routinely that there is no conflict. Shareholders

have no right to make proposals and have them included inmanagement proxy statements. Instead, they must own at least 3% of
the stock and convene a shareholders' meeting at their own expense.22
Although penalties for the violation of proxy regulations do exist, nosanctions have ever been imposed. In any event, it appears that
violation of proxy rules would not affect the validity of an action taken

at the shareholders' meeting because the regulations extend only to thesolicitation of proxies and not to corporate action itself (Thiazide 1983;
Kester 1991a).

Certain classes of shareholders can enjoy privileged voting rights,

others have no voting rights at all in Germany. AGs can issue
non-voting shares up to an amount equal to that of all voting sharesissued, and limit the voting power of an individual shareholders
irrespective of the number of share held. The restrictions have beenused in Germany to reduce the threat of takeovers (Franks and Mayer

1990).23 By purchasing common stock in a German corporation,
shareholders acquire voting rights. In the case of preferred stock,voting rights do not exist as long as the preferred dividend is paid.
Voting rights are exercised at the shareholders' general meeting. For

the individual shareholder, the information and attendance costs
outweigh the benefit of exercising voting rights at the general meetingof a public corporation. Thus, individual investors seldom exercise
22 A shareholder with 1% of the stock may propose specific items of agenda for the

meeting as elections of new directors. The agenda and resolutions proposed
should be, if requested by him, included in the notice of the meeting to be sent by
the company to all shareholders (Ishiguro 1990).
23 Frenqh companies are able to place serious restrictions on the transfer of sharesand voting rights of shareholders. Certain classed of shareholders can enjoy
privileged voting rights, others have no voting rights at all. Shareholders thathave held shares for a specified period may be entitled to double votes. Up to 25%
of capital can, under certain circumstances, be issued as non-voting preferred
equity. Up to 25foO of capital may be issued as investment certificates that can
only be transferred to holders of other investment certificates (Franks and Mayer
1990).

CORPORATE GOVERNANCE IN GERMANY, JAPAN, AND 215
THE UNITED STATES : A COMPARATIVE STUDY

their voting rights, excepts if they are major shareholders. Under
stock corporation law, shareholders can transfer their voting rights
with relative ease to the banks managing stock portfolios (Kallfass
1989).

In Germany, management does not control the proxy machinery.
German managers must filter proxy solicitation through their bankers.

It is doubtful that German managers can lawfully make a proxysolicitation as U.S. managers do. The German banks vote directly-heldstock as they think fit and recommend to brokerage customers how tovote. The typical procedure is that the bank asks its brokeragecustomers for a revocable proxy to vote the stock, for a maximum

period of 15 months. The bank then can vote, but informs thecustomer of how the bank intends to vote, giving the customer theopportunity to instruct the bank differently. Rational apathy should
lead most shareholders to ignore the solicitation, and in fact customers

rarely disapprove of their bank's recommendation. Through the
combination of concentrated stock deposits and a proxy system thatgives the banks the first-mover advantage, banks can elect a good partof the stockholding side of the supervisory board. Thus, banks andtheir nominees have a large voice on the supervisory board (Baums

1992; Roe 1993). '4.2.2 Direct and Ongoing Communication with Management
The essence of collective action is ongoing, private dialogue
between shareholders and managers rather than open confrontation
over points of disagreement in the U.S.. The Council of Institutional
Investors, which was created in 1985, includes more than 60 labor andpublic pension funds with assets of more than $300 billion. The
existence of one organization representing such vast assets suggests
the possibility of creating a monitoring body that would coordinate
pension fund activities with respect to individual corporations. Pension

funds are also pushing hard to create formal mechanisms for direct,

ongoing communication with management. For example, CalPERS
introduced resolutions to create shareholder advisory committees at

Avon Products, Occidental Petroleum, and TRW. Though collective
action shows promise in addressing the weaknesses of public elections,
it does have one grave flaw. The goal of collective action is directcommunication between large shareholders and corporate managers.

216

KENJI KOJIMA

Yet it is doubtful that this interaction will have much influence on
corporate performance.
In GermanY and Japan the banks play a leading role in exerting
influence because historically they are the ;main source of funds, often

supplying a wide range of services: they have shareholding and a seaton the supervisory board. In Japan associated companies, customers
and suppliers who may be shareholders may exert influence. All of thisis done quietly without pubiic confrontation except in the extremes.
Japanese ownership is built around reciprocal shareholding between
companies and their banks, suppliers and customers. Such reciprocal
ownership is small on a bilateral basis but powerful in the aggregate.

Main bank receives detailed performance data in the course of its
ongoing monitoring activities. This information flow is supplemented
by a network of bank alumni who have retired from financial careersand have been placed in second careers with affiliated companies.

Management transfer provides extensive networks of personal
relationships in related companies, that facilitate effective
communication at the various levels of management.
Since large owners have other business relationships with groupcompanies, they have opportunities for creative problem solving during

periods of trouble. It may be more accurate to describe Japaneseownership as flexible capital than as patient capital, Shareholders cansacrifice some value of their equity stake in return for other financial

benefits that grow out of their group relationship. This expertise andflexibility is what gives ownership voice in Japan such power. And it
is precisely what most big shareholders in the United States, especiallythe public pension funds, lack (Taylor 1990).

The increasingly concentrated ownership structure at major U.S.
corporation has created the incentives for the development of an
informal negotiation and voting'based approach by both active andinstitutional investors in the U.S.. The most significant aspects of the

new approach to corporate governance is the rise of informal politicalmechanisms to supplant and even replace the mechanical and extreme

measure of the formal voting challenge. The cause is increased

institutional ownership concentration, which creates a moresophisticated and smaller audience of investors, and hence makepossible a widely variety of less formal approaches to organizing a
critical mass of shareholders support. At a corporation with a few

CORPORATE GOVERNANCE IN GERMANY, JAPAN, AND 217
THE UNITED STATES : A COMPARATIVE STUDY

large institutions rather than thousands of relatively uninformed
individuals, management and the board may be influenced through suchmeans as circulating alternative policy proposals to major investors; or

soliciting votes for a shareholder proposal suggesting specific reformsof corporate policy or the structure of the board (Pound 1992b).

4.3 Compensations
The pressure to achieve short-term earning that U.S. managers
feel can only be understood if we also recognize the strong devotionthat many have to enhancing shareholder value. They believe theirprimary priority must be to provide a return to their shareholders.
Attending to other stakeholder, such as customers, employees, andsuppliers is viewed by most managers as a means toward this end.
Declines in short-term earnings and stock prices also hit the manager's
incomes, because so much of their incentive compensation, which is
two-thirds of their total pay, is affected by short-term earning.
Furthermore, executive compensations are not based solely on short'term results. Short-term is defined as any incentive awards that weremade based on one year's performance regardless of whether or not
the reward is paid in full currently, in installments, or deferred tofuture years. About one'third of total compensation is based onlong-term performance. The long-term incentives in most U.S.
companies are either paid in stock grants or stock options, whichfurther rivets top managers' attention to fluctuation in stock prices.

Given these rewards and manager's preoccupation with shareholder
value, it is not surprising that U.S. managers watch their shares prices

daily. In this situation, even incentives intended to be long-term canhave a definitive short-term spin. In spite of the compensationemphasis on short-term results and the importance of short-term
performance to the capital market, many top managers would prefer tofocus on longer-term results (Ellsworth 1985). •Current compensation committees usually occupy themselves withhow much top management should be paid, the proportion represented
by salary, and the formulas used to govern short-term and long-term
incentives like stock options. Most compensation committees also focus
primarily on peer-group comparisons to ensure that they pay of top
executives is at least on a par with competitors. However, using

peer-group comparisons often means staying in line with the218

KENJI KOJIMA

proportion of salary and short-term and long-term incentives paid by
the competition. In effect, this focus abandons compensation as ameans of placing more weight on a company's long-term performance
than on competition (Salmon 1993).
The Security and Exchange Commission recently responded to theclamor with new rules governing compensation disclosure in proxystatements. In the past, the SEC has required companies to disclose
the amount of money paid to executives. The new SEC regulations go
far beyond that requirement, mandating disclosure of the process bywhich executive pay determinations are made. It signals a significant
change in the role the SEC has traditionally played in the corporate
governance arena and, if directors have accountability to shareholders
for "process," may portend a major shift in corporate decision making.
Under the new regulations, the compensation committee must include"the factors and criteria upon which the CEO's compensation was
based" in the proxy statement. The new SEC rules require specificdiscussion of the relationship between compensation for the chief
executive and the company's performance, along with a description ofeach measure affecting that compensation - for example, profitability,

sale growth, return on equity, and market share. The rules also
mandate a discussion of the committee's general policies regarding
executive compensation. And they require a detailed explanation of
any adjustments that were made to reprice outstanding options held by
the CEO or any of the other four most highly compensated executives.

The SEC's intent is to bring shareholders into the compensationcommittee or boardmmeeting room and permit them to see andunderstand the specific decision made through the eyes of the directors(Hinsey 1993).

U.S. executives' preoccupation with shareholder wealth contrasts

sharply with the goals that guide Japanese managers: adequate

returns, secure employment, and increased international
competitiveness. Within the context of the Japanese stakeholder
coalition, management is measured not so much by it ability tomaximize the welfare of any one isolated stakeholder as by its ability

to maximize the total welfare and maintain the stability of thecoalition. Certainly the training, promotion, and reward systems forJapanese managers are aligned with these objectives. Other corporate

stakeholder' preferences do indeed become part of a Japanese

CORPORATE GOVERNANCE IN GERMANY, JAPAN, AND 219
THE UNITED STATES : A COMPARATIVE STUDY

manager's preferences. By the time a Japanese manager has becomea senior managing director, he tends to make decisions that will
generate primarily efficiency gain from which all stakeholder stand tobenefit rather than primarily redistribute gains in which one or a few
stakeholder gain at the expense of others.
The typical Japanese reward system reinforces this predisposition
by not aligning management's interest with those of any one corporate

stakeholder. Instead, management's interest is aligned with thepreservation of the entire coalition of stakeholder by a systern that
fosters risk aversion and rewards people for achieving size, stability,
and corporate longevity. Given a reward system consisting of steadypromotions, seniority-based compensation, regular semiannual cash
bonus, lump-sum severance indemnities, and placement in "second

careers" with affiliated companies at the time of retirement,
management's well"being depends on the company's longevity, growth,and the preservation of its relationships with other firms. These
achievements will ensure an ever-expanding set of opportunities forpromotion coupled with salary advancement and a source of income on
retirement. Executive compensation system in Japan also foster anemphasis on growth. We find little profit-based incentive compensation
at the division general manager level or below. Japanese executives
rarely receive stock options. Japanese presidents own little of theircompany's common stock, and executive salaries, which are modest by
American standards, are not closely tied to profits (Ellsworth 1985;
Kester 1991a).

5 External Control Mechanism
5.1 Market-based Controi
5.1.1 Takeovers
Takeovers can be carried out through mergers, tenders offers, andproxy fights, or sometimes through elements of all three. A tender
offers made directly to the stockholders to buy some or all of theirshares for a specified price during a specified time period does not
require the approval of the target company's management or board of

directors. A merger is negotiated with the company's management
and, when approved by its board of directors, is submitted to theshareholders for approval. In a proxy contest the votes of theKENJI KOJIMA

220

stockholders are solicited, generally for the election of a new slate of
directors. The takeover process penalizes incompetent or self'serving

managers whose actions have lowered the market price of theircorporation's stock. Takeovers enables new owners to change thecompany's patterns of investment, cease other deficient policies, altermaladjusted contracts, and perhaps change management itself.

The threat of hostile takeover should ensure that assets arecontrolled by those best able to manage them, and in the United States,with its well-developed market for corporate control, hostile takeover isthe ultimate check on management. When shareholders fail to take aninterest in the governance of a company, or when their governanceproves ineffective, low'quality managers are able to remain in positionor management's allegiance to the shareholder may falter. In either ofthese cases, a company's share price should drift lower so as to form
a gap between the stock's actual price and its potential value. If thegap between a company's market value and its perceived potential value
were to grow large enough, takeover would ensure that control overthe company's assets eventually would go to those who could earn ahigher return on those assets. The interests of managers andshareholders tend to be in conflict on many issues. The divergenceintensifies if the company becomes the target of an unfriendly takeover.

Target shareholders benefit when the bidders offer substantial
premiums over current market value. During a takeover top managers
of target companies can lose both their jobs and the value of theirtalents, knowledge, and income that are particular to the company.
Threatened with these looses, such managers may try to reduce thepreboiled of a successful unfriendly takeover and benefits themselves atthe expense of shareholders. The existence of employee stock
ownership plans, poison pill defenses, staggered boards, and supermajority provisions diminjshes the threat of takeover in many instances(Jensen 1984; Lightfoot 1991).24

The desirability of takeover activity in the United States has been
24 Corporate charters speeify governance rules and establish conditions for mergers,

such as the percentage of stockholders who must approve a takeover. Since
constraints on permissible charter rules differ from state to state, change the stateof incorporation will affect the contractual arrangement among shareholders andthe probability that a eompany will be a takeover target. It is alleged that somestates desiring to increase their corporate charter revenues make their statutes

appealing to corporate management. Allegedly, in doing so they provide

CORPORATE GOVERNANCE IN GERMANY, JAPAN, 221
AND
THE UNITED STATES : A COMPARATIVE STUDY

the subject of much debate. Proponents point to evidence of greater
operating efficiencies and the creation of tremendous shareholders
value to support arguments that an active market for corporate control
is both necessary and beneficial (e.g. Jensen 1984). On the other sideof this debate, many professional managers view takeovers, particularly

hostile ones, as restraining the vitality of American business by

diverting management's time and needlessly foreshortening theexecution of good long-run strategies. Kester (1991b) stands in a
middle ground between these two poles of the debate - an active
market for corporate control may be both necessary and desirable
within the context of the American style of corporate governance.

Both Germany and Japan have has remarkabley inactive markets
for corporate control, at least as far as large-scale takeovers areconcerned. Hostile takeovers are virtually unheard of in bothcountries. These facts contrasts sharply with the U.S. and U.K.
experiences.25 Germany and Japan have not have active markets forcorporate control largely because they have not needed them, notbecause they did not want them or could not tolerate them. They havenot needed active takeover markets because their corporate governancemanagement with great freedom from stockholder protection. Delaware, forexample, has few constraints in its rules on corporate charters and hence provides
much contractual freedom for shareholders.
Without switching their state of incorporation, companies can amend corporate
charters to toughen the conditions for the approva} by shareholders of mergers.

Such anti-takeover amendments may require a "supermajority" for approval orfor the staggered election of board members and can thus lower the probability
that the company will be taken over and thereby reduce shareholder wealth. On
the other hand, the amendments can also benefit shareholders by inereasing theplurality required for takeover approval and thus enable management to better
represent their common interests in the merger negotiations (Jensen 1984).
25 There is a higher level of control}ing ownership changes with takeovers in the U.K.

than in France or Germany. Takeover activity in the U.K. is distinguished by thepresence of acquisitions that are opposed by the incumbent management. The
significance of these is that they give rise to more executive changes than friendly

acquisitions. The U.K. imposes few impediments to the free transfer of bothownership and control. A basic premise of the U.K. capital market is thatinvestors should have the right to determine how their property is ernployed andcontrolled. The Stock Exchange has discouraged the use of discriminatory voting
rights as a means of limiting transfers of control. The Takeover Code discourages
the accumulation of cross-shareholdings as a method of preventing transfers ofownership. The rationale behind these rules and regulations is the promotion of
securities markets. Equal access to information and protection of small investors

from exploitation by dominant shareholders are regarded as central to thatprocess (Franks and Mayer 1990).

222

KENJI KOJIMA

have dealt with the agency problems of large organizations. The
threat of hostile takeover is not a significant element of German
corporate governance. Indeed, friendly mergers are uncommon, andhostile takeovers virtually unheard of. The special position of banks,
government antitrust policy, and the structure of the corporation all

discourage unfriendly takeovers. A takeover would be virtually
impossible without the support of the major banks because of theirextensive stock holdings, their control over shares held on deposit, andthe fact that they write the rules on takeovers.26 In fact, there are no

guidelines require the bidder to inform appropriate stock exchange of
an offer, refrain from insider trading before publication of the offer,publish the terms of the offer, and give those who may have accepted
a lower bid for their shares the higher price in the event that a second
offer is made (Lightfoot 1991).

The government Cartel Office in Germany must clear any bid if
the new concern would have more than DM2 billion in sale annually.
Also, the Cartel Office has the authority to review the merger andrequire divestment ex post. Several other structural aspects of German
corporations and corporate law impede takeovers. Major changes tothe corporation require 75% approval by shareholders, law prohibits
golden parachutes, and strict conflict-of-interest rules impede mostwould'be management buyout. Because companies with more than
2,OOO workers have equal employee and shareholder representation on
the Aufsichtsrat, employee support is virtually a prerequisite for a
successful takeover (Lightfoot 1991).

German shareholders rarely seem to encounter the temptation ofquick profits as a result of takeover attempts. The long-term
investment patten is given as one reason there are few takeovers.
Another reason is the long-term management contracts. Even if a
26 Sometimes under the Articles of Association of a company the transfer ofownership or title to some of the shares in the company is dependent on theconsent of the company, usually given by the management board. Such shares are
known as vinhuZierte Namensahtien, and are often issued by insurance companies

when the shares issued are partly paid. Such a right of refusal allows theinsurance company to decide upon whether it thinks a potential shareholder could
or would pay the unpaid amounts on the shares. It may also be used as a meansof preventing an unwelcome takeover. Furthermore, preference shares may be
issued with or without voting rights. Preferred shares without voting rights canbe issued up to the total nominal amount of all other classes of shares. Since
preference shares provide for the benefit of a public listing without any takeoverrisk, the issuing of them has become popular (Schmalenbach 1990).

CORPORATE GOVERNANCE IN GERMANY, JAPAN, AND 223
THE UNITED STATES:A COMPARATIVE STUDY

raider could gain ownership control of a German company, thesecontracts would prevent a quick change in management. Finally, thefact that the law provides German employees with seats on the
supervisory board discourages takeover attempts. A successful raider
would still have to deal with workers' representatives on the board,
who could well resist effort of change (Lorsch and Maclver 1991).27
Use of takeovers as a device for replacing a disloyal board of
directors and disciplining self-serving management is also blunted by
the Japanese corporate governance system. Historically, the tightmonitoring of client companies by share-owning banks and theircontrol over external funding left relatively little room for abusive

self-interested opportunism by management. When such abuse didarise, they were apt to be fewer, less severe, and less costly to correct

by selective intervention of the part of main banks rather than byexpensive battle for majority control. Strengthening the incentives tokeep management in place are cross-shareholding arrangements inJapan. The extensive ownership of a corporation's equity by othercompanies with which it does business provides a formidable defense
against a hostile takeover. These shareholders, of course, might one
day discover that they could obtain a premium by tendering theirshares in a hostile bid. But they would be unlikely to do so if a change
in ownership threatened to disrupt a beneficial business relationship orotherwise lower the value of explicit and implicit non-equity elaims
against the target company. Furthermore, reciprocal shareholding
arrangements mitigate temptation to tender shares owned in a target
company. Any visible cooperation with a hostile bidder would reveal
the selling company to be an untrustworthy shareholders. This would
almost certainly lead other corporations to dispose of their shares of

the unt.rustworthy firm, and widespread defection from business
relationships with it would follow. The selling company might
27 French companies are able to place serious restrictions on the transfer of shares.
Listed companies may Iimit transferability of shares by contract or articles ofincorporation. Transferability may also be limited by establishing privatecompanies that hold a group of shareholders' equity. Some of the restrictions ontransfers of control in France come from involvement of the government. The
French government has traditionally been a substantial shareholders in French
corporations. While several firms have been privatized, the hardcore shareholding
has been limited the external control that investors have been able to exert in thesefirms. It has delayed and impeded takeovers that have been deemed to be against
the national interests (Franks and Mayer 1990).

KENJI KOJIMA

224

ultimately find itself a deviant in the Japanese business community(Kester 1991a).

5.1.2 Market for Corporate Control in Japan

In the United States, a chronic transfer of value fromshareholders to other corporate stakeholder at the hands of incumbent
management, coupled with the high costs of disciplining management
through existing corporate governance mechanisms, has given rise toan active market for corporate control. It is, moreover, one often
stressed by successful unfriendly takeovers of even large corporations.

In such a market, the equity interests can be given a renewed preeminence by taking ownership out of the hands of a widely diffusedshareholder group so that management can be more effectively
monitored and controlled in accord with shareholders' interest. Usually

this entails changes in the board of directors, management, or both,and some recontracting with other key stakeholder such as labor,
suppliers, or major custorners. The threat of takeover has been
considered an important means of disciplining management, even inproblematic situations where ownership and management are
separated. The fundamental idea is that discipline is achieved throughcompetition among management teams within the area of the stock
market, and incumbent management is thereby driven to operate thefirm efficiently. However, hostile takeovers of the kind prevalent in the

United States are virtually absent in Japan, and this fact reveals asclearly as any the degree to which the market for corporate control
takes place not among firms that maintain longstanding relationships
with each other (Kester 1991a).

There are relatively few formal, explicit legal and regulatory
barriers to merger and acquisition activity in Japan. Fo,r purely
domestic combinations, the established legal and regulatory apparatus
is essentially neutral with respect to the fostering of businesscombinations. The least-used means of acquiring a target company's
stock is by a tender offer. Japanese has no regulations governingtender offer prior to an amendment to the Securities Exchange Law in1971. The 1971 legislation regulating tender offers purports to be
neutral with respect to favoring either bidders or targets. However,like proxy regulations, the tender offer rules work more to theadvantage of the target company's incumbent management than to theCORPORATE GOVERNANCE IN GERMANY, JAPAN, AND 225
THE UNITED STATESiA COMPARATIVE STUDY

bidder's. Whereas proxy regulations allow for concurrent filing andgeneral distribution of proxy materials with no provision for advance
review by the Ministry of Finance, tender offer regulations do requirebidders to receive Ministry of Finance approval and to give the target
advance notice of the bid. The need to complete a takeover within 30
days may also restrict the ability of bidders to change tactics andrenew efforts if insufficient shares are tendered during the original
offering period (Ishiguro 1990).

Two other aspects of securities law work to the advantage ofincumbent management in potential targets and against that of thebidders, at least as far as large companies are concerned ' therequirement of depositing sufficient cash prior to the announcement of
the offer and the present regulatory preclusion of using so-called junkbonds to finance takeovers. Indirectly, the Japanese prohibition
against repurchasing one's own shares may also inhibit the activity ofbidders ' repayment of any debt of the bidding company used forfinance a successful acquisition with funds subsequently borrowed by

the acquired corporation may be construed to be an indirect
repurchase of share by the target corporation itself. Similarly, bymaking the purchase and sale of companies more cumbersome, theprohibition against forming or effectively functioning as a holding
company also retard the activity of potential bidders (Kester 1991a).
Among the striking features of the merger and acquisition market
on Japan is the great emphasis placed on gaining the approval of key
stakeholder. The most important and most difficult stakeholder toappease is the company's employees, and particularly its enterprise

union. A number of important mergers have been postponed orcanceled because this approval could not be obtained. Why would top
management bother to consider the opinions of employees and trading
partners if they had decided a merger makes economic sense? In largepart, this is because core employees of large firms come packaged withthe companies involved. This is the case in the sense that firm andemployees make strong commitments in their internal labor markets
with informal employment guarantees. A large part of business activity
in Japan is carried out through relationships among people based onsocial frameworks developed over long periods of interaction, rather
than through formal definitions of roles and responsibilities in acontract (Gerlach 1992).

226 KENJI KOJIMACurrent Japanese activity in the market for corporate control
reflects the contracting cjrcumstances in which Japanese companies
operate. Kester' (1991a) points out that a well-established corporate
governance system allows Japanese companies to combine in large
industrial groups that can at once realize many of the adaptive
advantages of an administrative hierarchy without sacrificing most of
the advantage derived from utilizing the high-powered incentives of themarket. Consequently, direct ownership and control over specificassets are less imperative, and combinations involving large companies

are less frequent. When they do occur, they .are likely to havegovernment promotions or be at the insistence of a few major
institutional shareholders like main banks, the players in the Japanesemarket for corporate control are few and highly circumscribed in their
behavior.

Can such the U.S. market for corporate control take root andflourish in Japan? Clearly it has not to date, and many knowledgeable

observers doubt it ever will. Some point to technical, legal, andregulatory barriers that might inhibit such an evolution. Most appeal

to various extralegal barriers to merger and acquisitions. These
include membership in industrial groups, extensive cross-shareholdings,
the potentially high costs of recontracting with other stakeholder, anda sheer cultural bias against such activity. Thus Japan's market forcorporate control in the future is likely to display a controlled,
symbiotic relationship between traditional stable shareholders andmaverick corporate raiders. It will be more of a system in which acomparatively small number of important institutional shareholders
exercise discipline over managers who fail to perform according to
expectations than a true market with free competition (Kester 1991b).

52 Relationship-based Control
5.2.1 Long-term Business Relationships
One of the most salient and enduring characteristics of theJapanese corporations is their tendency to engage in close, long-termbusiness relationships with other companies. This particularly
characterizes their banking relationships, but also their dealing with

suppliers, subcontractors, and large corporate customers. Many ofthese in turn have long-standing relationships with one another,resu}ting in an intricate network of companies connected by formal andCORPORATE GOVERNANCE IN GERMANY, JAPAN, AND 227
THE UNITED STATES : A COMPARATIVE STUDY

informal commercial and financial commitments. This corporate
network is expressed in the Japanese keiretsu - a collection ofcompanies federated around a major bank, trading company, or large
industrial firm. It maintains stable, close relationships with a networkof suppliers, distributors, and creditors. Japanese keiretsu tends to be

characterized by a great deal of stability in group affiliation andloyalty as far as the favored status group memberships given eachother in their business dealing. Sustaining a complex network ofbusiness relationships within the group may also require a narrowingof the scope for independent action and the occasional subordination ofindividual corporate interests to that of the group at large.

Substantial though they may be, the economic incentives tomaintain long-term trading relationships in Japan are not perfect.
Because one party to an agreement can undertake hidden action to its
own benefit and to the detriment of the other, or make private use of
hidden information, the risk of self-interested opportunism corrupting
the relationship exists. That is why reciprocal equity ownership isrequired to sustain long-run business relationships. An exchange ofequity between two trading parties connects their economic interests,
which help mitigate incentives to act opportunistically. The more
equity the trading partner owns in the firm, the less sense it makes totry to exploit other shareholders' interests. Reciprocal equity
ownership between any two Japanese companies is typically smallgenerally in the range of 1'3906o of outstanding shares. By itself, sucha bilateral exchange of share constitutes a safeguard against abuse of

the relationship. But embed two transacting companies in a larger
cluster of interacting firms and multiply the percentage of bilaterally

cross-held share by a factor of 20 or 30, and the safeguard become
potent.

Another feature that helps Japanese industrial groups forestall

disputes or other problems that might destroy valuable trading
relationships is extensive information sharing. The core companies
such as a main bank, a major industrial corporation and a large
general trading company, the bank in particular, form the hub of avast information-sharing network. Because at most 5906 of eachcompany's outstanding shares are owned by the bank, much financial
information about their performance will be funneled to the bank in thenatural course of its monitoring activities. Furthermore, management

228

KENJI KOJIMA

transfers develop effective communication that ongoing relationships

require. Mid-c4reer managers or engineers may be temporarilytransferred to related companies to help solve specific problems or towork on joint projects. Such transfers provide extensive networks of

personal relationships between individual managers in relatedcompanies by enhancing trust between the company's managers.
Reinforcing monitoring and communication at various levels ofmanagers are ties at the level of the board of directors (Kester 1991a).

The quality of information that trade partners have at theirdisposal is clearly different from that available to outside investors.
Affiliate-shareholders have learned about each other through ongoing
trading relationships and through various collaborative projects andother forms of interaction that provide information not available infinancial statements. If, for example, product equality begins to
decline, the group trading firm and other trading partners are likely tobe among the first to know this through their purchasing connections.
The kind of in-depth information that the firm's main bank acquires inorder to extend loans is utilized as Well in its decision as shareholder.
How information is understood also differs. Affiliate'shareholders aremanagers with concrete knowledge about and experience in runningcompanies. They may be better able to evaluate the performance ofother managers across a range of criteria than are professional
investors whose skills come in other forms.

Within a keiretsu, a typical corporate stakeholder is likely topossess a rather complex blend of claims against other groupcompanies in which it has invested ' a combination of equity, credit,
and trading contracts. This is clearest in the case of lender-borrower
relationships, for a Japanese company's major lenders usually alsorank among its major shareholders. The holding of multiple claims

against a company may be even more pronounced in the case of
relationships between non-financial corporations. Many enduring
company-based and vendor-supplier relationships throughout theJapanese industry exhibit such multiple-claim ownership. A benefit
derived from this tendency to hold a blend of different financial andother claims gainst a company is an attenuation of frictions that might

normally arise among various stakehoider groups that each owns aseparate and distinct claim. The incentives to breach contracts with

suppliers and customers in interests of transferring value toCORPORATE GOVERNANCE IN GERMANY, JAPAN, AND 229
THE UNITED STATES:A COMPARATIVE STUDY

shareholders, or to borrow money and then take extraordinary risks
that might benefit shareholders at the expense of lenders, are reduced

when the impaired stakeholder are the company's principal
shareholders. Helping troubled companies work out temporary
financial problems will also be easier when the principal providers ofcapital hold roughly comparable bundles of senior and junior, shart-

term and long-term claims against the company (Kester 1991a).
Therefore, conflict of interests among the stakeholder can be mitigatedby relationship-based control mechanism shown in Figure 4.

Shareholders

Suppliers

Managers

Creditors

Workers

Major Customers

Figure 4

Relationship-based Control Mechanism in JapanFor most Japanese corporations, the long'term trading
reiationships with companies in which they invest constitute the chiefvalue of their overall dealings with those companies. Value comesfrom the transaction efficiencies generated by creating and maintaining

a longnvterm dealing, mutually beneficial trust relationships between
managers can be nourished and eooperation fostered. Contracting cantake place on a much less formal, more implicit basis, often an
advantage when it becomes necessary to adjust rapidly to a changing
environment. Adjustments in implicit agreements can be made much
faster and in more highly nuanced way by managers dealing at thetrading interface than they can by lawyers wrestling over formal

230 KENJI KOJIMA
written contracts. If the business relationship lasts long enough andbecomes close enough, the trading firms can become virtual extensionsof one another ih a vertical production and distribution system, though

without some of the management control problems that plague large
operations integrated under a single corporate hierarchy. Since therelationship is arm's-length and equity ownership is restricted tominority positions, market incentives are preserved and bureaucratic
disabilities held to a minimum. The common assertion by Japanesemanagers that shareholder interests rank comparatively low on theirlist of priorities can be explained, at least in part, by the fact that asubstantial number of a large company's shareholders typically are its

major creditors, customers and suppliers. For most of theseshareholders, their commercial trading relationship with the company is

as important, if not more so, as their equity investment per se. Not
surprisingly, therefore, Japanese managers will tend to view theirprimary tasks as being the preservation and enhancement of thesecomplex relationships rather than an immediate, direct pursuit of any
one stakeholder's interests such as that of exclusive equity owners(Kester 1991b).

The information and governance advantages to long-run business
relationships may have the results of lowering de facto capital costs
for Japanese firms even if direct costs, when measured by adjusted
interest rates, are not significant lower. Trade partners-shareholders
may also be willing to accept lower returns from their investments foran entirely different reason " promotion of their long-term businessinterests. The argument in brief is that intercorporate relationships
have brought together investment and managerial decisions within an
ongoing cooperative relationship between firms. Capital has been
moved closer to the point of investment decision, resulting in a general

pattern of rapid entry into new industries by existing firms with theearly and continued support of companies in the group. In case where
social benefits for investment outweigh private benefits, therefore, it

makes sense for trade partners-shareholders to permit "overinvestment" in certain projects if they are able to capture a sufficientportion of the benefits themselves. With the merging of shareholding
positions into ongoing trading relationships, the long-term viability of

the firm as a reliable supplier and customer becomes important. The
continual improvement in the quality and features of firms' product

CORPORATE GOVERNANCE'IN GERMANY, JAPAN, AND 231
THE UNITED STATES:A COMPARATIVE STUDY

lines takes on significance in and of itself - even where these
improvements are not captured in improved equity returns - because
investors receive benefits in other forms. Financial institutions, forexample, are among the top shareholders in large Japanese firms, yettheir equity positions are typically only a fraction of the loan andother business they carry on with the same firms. Not surprisingly,
these institutions are interested in ensuring that their borporate
borrowers are around over the long term to service their financial
obligations (Gerlaeh 1992).

Among the most prominent features of the keiretsu is a layered
set of personnel connections that serve as conduit for information
between companies and, occasionally, as a source of external discipline.

Employees transfers are common among business partners, particularly
among bank and their client firms and large manufacturers and theirsubcontractor. In addition, firms in keiretsu are linked through avariety of intercorporate executive councils that serve as a forum for
managers from different levels of the companies involved. While groupinteraction takes place at many levels, undoubtedly the mest prominentof these meetings are the presidents' councils that bring together thechief executive officers from the group's nucleus companies. The
shacho-kai is a kind of informal community council, with membership
limited to a set of core members. It appears that the shacho-kai inpractice is less a command center to determine the policies andpractices of individual companies than a forum for the discussion ofmatters of mutual concern. It simultaneously (1) establishes an identity

for the group and its participants, signifying relationships amongfirms, and instilling a sense of coherence; (2) creates a setting in whichissues of group-wide concern may be negotiated, including protection

and promoting the group name and, less often, arranging forassistance for companies in trouble, resolving conflicts among
members, or disciplining deviant group companies; and <3) enhances thegroup's position in the larger businesses community by presenting theimage of a powerful and historically prestigious collective. More often

than not, the executive remarked, nothing of particular note is
discussed and the meeting is merely an opportunity to exchange views
with other chief executives and to socialize. Nevertheless, the shachokai is considerable more than a old'fashioned business customs, for it

serves both to signify membership in the group and to provide a

232

KENJI- KOJIMA

common arena for the expression of the strategic interests group firms
have in one another. As such, it is significant both for its symbolism

and for what it reveals about the dynamics of keiretsu relationship(Gerlach 1992).
5.2.2 Outsider's lntervention

Each country's manufacturing companies relate to the financial
community. In Germany and Japan, these relationships are especiallyclose, and this has important implications: banks are more likely toprovide supports when their borrowers get in financial difficulty, sincehelping them remain competitive reduces the riskiness of their loans
and sustain their long-term growth to ensure their own; banks havesufficient influence on management to ensure their goals compatible
with their own. Together with the small portion of equity in corporate
capital structures, these close relationships curtail the importance ofshareholder wealth maximization as a corporate goal.
By setting specific debt-equity as corporate goals and by refusing
to issue equity for fear of diluting earning per share, management in
U.S. arbitrarily limits its available capital. Consequently, the capitalpotentially available becomes and irrelevant, unused asset. In Germany,

big commercial banks and central savings banks, or Landesbanhen,
practice "universal bankjng," which includes direct investment inequities and bonds.28 As a result, German bankers held directorships
on the supervisory board of the companies. German commercial banks,
facilitated by law and tax policy, own sizable portions of many large

industrial companies. Ownership gives it the power to block any
change in the company's statues. This has resulted in a concentrationof ownership among major banks. The larger banks also reinforce
their influence through the proxies they hold. These close relationships

lead to a commitment of the bank which can be detrimental for it
particularly in a financial distress of the company. Then, the bank isrequired to rescue its equity stake. If the company goes bankrupt, notonly the equity stake of the bank but also the credit extended to thecompany by the bank will be subordinated to other debt, even if its
28 Most of 4,500 German banks are universal banks, which may be active in thebanking business as well as the securities. In addition, those banks may
participate in the investment business, trade in real estates, rescue operations forfinancialiy distressed firms, get involved in rrLerger and acquisition (Baums 1992).

CORPORATE GOVERNANCE IN GERMANY,ANDJAPAN, 233
THE UNITED STATES : A COMPARATIVE STUDY

loan was secured by collateral. Thus, this may encourage banks tomonitor and influence management of the company (Baums 1992).
Ties between banks and industry are strong in Japan. Japanesekeiretsu makes extensive use of leverage and intercorporate holdings ofdebt and equity. Banks still play a central role in financing industries

through keiretsu. Bankers often serve on manufacturing companies'
boards and, particularly in periods of financial distress, become heavily

involved in management. While current Iaw requires Japanese banks to

reduce their equity positions to 5% of the outstanding equity inaffiliated borrowing companies, they still hold substantial equity intheir client companies. In contrast, individual shareholders exercise
little influence over management. Personnel in banks move frequently
between banks and companies as part of an ongoing relationship thatinvolve training, consulting, and monitoring. Japanese banks allow

companies to enter formal bankruptcy only when liquidation makes
economic sense-that is, when a company is worth more dead than alive(Ellsworth 1985).

The most powerful safeguard in the Japanese corporate
governance system is the ability of one or more equity-owning
stakeholder to intervene from time to time directly and explicitly in theaffairs of another company when necessary to correct a problem.
Typically, such intervention is undertaken by a company's main bank,usually to remedy nonperformance in the face of impending financial
distress. This responsibility generally falls to the troubled company's
main bank because it usually is the largest single supplier of capitaland has quicker access to more information than most other equityowning stakeholder. It also typically holds both debt and equity claims
against companies for which it acts as main bank. Whereas fear of
triggering so-called "equitable subordination" of their loans keeps
most American lenders on the sidelines until a loan agreement isformally breached, and even then restrains their degree of intervention,

Japanese main banks effectively assume such subordination from theoutset and take far-reaching, early steps to limit the damage. A mainbank for a financially distressed company voluntarily repays all of thecompany's debt to other Iending banks. A main bank assumes sole
responsibility for recovering loans form a company. Main bankintervention may also occur for reasons other than financial distress.

Dispute resolution and sheer dealmaking by banks among client234 KENJI KOJIMA
companies are also observed (Kester 1991b).29
'

' '

' '

' '

'

'
5.2.3 Deficiencies
in Japanese Corporate Governance 'Deficiencies in Japanese corporate governance may eventually giverise to sufficiently large abuses of non-controlling shareholders
interests. Economic incentives are beginning to change, in large
measure because of emerging weaknesses in the traditional Japanese
corporate governance system. Ironically, part of the cause of that
weakness is the very fruit of competitive success: an abundance of cash.

The combined effects of sluggish economic growth and considerable
success in product markets around the world have been the buildup of
substantial free cash flow, With this have come profound changes in
the financing patterns of large corporations. Net new investment by

Japanese corporations has been growing less quickly and isincreasingly being raised from capital markets, not from banks. Thishas meant a shift in the balance of power among corporate
stakeholders away from financial intermediaries, the traditional
primary suppliers of capital, and into the hands of corporate
managers. It is now commonplace to observe Japanese companies
repaying their loans completely and even refusing to accept formerbank officers as nominees for director.

Financial independence has furthered the deployment of cash inways that are of dubious value. Cash has been expended in unrelated
diversification such as life science, electronic communication, advanced

materials, and computer hardware and software that mature
manufacturers in Japan are trying to enter. The rationale for doing
so was to escape the limitations and intensifying rivalry of mature corebusinesses and, in particular, to keep personnel continuously employed,
29 There are a number of cases in which the main bank helps company work out offinancial distress. The best-known case is Sumitomo Bank's restructuring of
Mazda, the automobile manufacturer. Mazda got involved in considerable financial
difficulty after the 1973 oil shock caused dramatically to reduce the demand for
fuel-inefficient rotary'engine cars. In responding to these troubles, Sumitomo
Bank sent a number of their executives to•serve as directors in Mazda and others

to manage key divisions of the company. Sumitomo Bank lent Mazda money atfavorable rates and encouraged the company to sell its share in the banks.
Sumitomo Corporation, the large trading company of the group, took charge ofdealer networks and the newly appointed managers worked to improve efficiency
in production. The bank also promoted Mazda sales among their eustomers firms
and employees and leaned on suppliers to sell to the firm at favorable prices(Pascale and Rohlen 1983).
.
'

CORPORATE GOVERNANCE IN GERMANY, JAPAN, 235
AND
THE UNITED STATES : A COMPARATIVE STUDY

thereby honoring implicit promises of lifetime employment. However
well-intentioned these efforts may be, there is little reason to be

optimistic about their prospects for success. Many of the new
businesses being pursued have loose connections with companies'
present capabilities. To the extent that these capabilities are exceeded,
underperformance will result and capital will have been wasted, at leastfrom the point of view of capital suppliers.

No longer vitally dependent on bank credit to fund investment

programs, Japanese corporations make more perfunctory, lesssubstantive disclosures of information about past performance andfuture plans to their main banks. For their part, Japanese banks,
lately under pressure to meet BIS (Bank for International Settlements)

capital requirements, are becoming more sensitive to performance on
their equity investments. In general, the slowing of economic activity inJapan has destabilized a number of traditional relationships andresulted in sales of a fraction of shares previously held under cross-shareholding relationships. Yet, many sales of stably-held shares arelittle more than efforts to book current period gains that can be used

to boost sagging profits, and are followed by near immediate
repurchases. Other sales represent only a fraction of stably heldstock, not the entire amount; still others are sales to some other stableowner of the stock in question, thereby causing little substantive
ehange in the cross-shareholding relationships (Kester 1992),

The foremost objective of the Japanese companies is to sustain

growth. For many of these companies, growth is a useful proxyobjective for the maximization of the value of the firm. Given thewartime destruction of much of Japan's industrial capital andsubstantial economies of scale in many basic industries, there was astrong fundamental profit incentive underlying strategy oriented
toward high rate of investment and high market shares. However, thebias of Japanese corporation toward growth has extended well beyond
the period of reconstruction. This suggests a wider role for growththan as a proxy for value maximization. It may be a means by which
management might entrench itself. Managers might proactively seek tosecure their positions in the firm by investing heavily in those assetsthat they have a special expertise in managing, even to the point ofexpanding beyond the point justified by profit maximizationconsiderations. Alternatively, by pursuing unrelated diversification

236 KENJI KOJIMA
strategies, some managers may create highly complex organizations
that perhaps only they understand well enough to manage effectively. It

may be also be argued that growth and managerial entrenchment aredesired because they support the continuity of valuable long-term
relationships. Growth in particular may forestall potentially costly
stakeholder disputes while maladjusted contracts are realigned tochanged economic circumstances. The managerial discretion affordedby excess cash has given rise to the expression of latent self-intereststhat were successfully contained during Japan's high-growth period.
Today, some Japanese stakeholder appear to be gaining at the expenseof other without any immediate prospects of recontracting. With theirdiminished control over the supply of capital, and being !argely ownedby their industrial clients, the ability of lending-shareholding financial

institutions to undertake corrective action is greatly reduced (Jensen
1989; Kester 1991a).
Since the first oil shock of the 1970s, many Japanese industrial
corporations have been attempting to sustain competitive advantage intheir mature core businesses while searching for new avenues ofgrowth and profitability to replace the cores eventually. At the sametime, they have tried to avoid placing the burden of adjustment on any
one corporate stakeholder. The dramatic appreciation of the yen in
the 1980s has further threatened the profitability of industries such as

steel, textiles, shipbuilding, and consumer products that were theprincipal engines of Japanese economic growth in earlier decades. The
factor distinguishing the adjustment problems faced by the Japanesebusinesses in the late 1980s in the depth of the excess personnel andcapacity problems. For all the progress that has been made inshrinking capacity in some of Japanese mature or declining industries,

dealing with redundant workers and managers remains a serious
problem at many large companies. Previously taken programs such as
worker transfers to suppliers, subcontractors, and even industrial
customers, early outplacement of aging employees at all ranks, andsimple reliance on natural attrition to curtail the work force in linewith true needs have succeeded primarily in deferring final adjustmentof personnel requirements to the 1990s. The stage is being set in Japanfor overt conflicts among corporate stakeholder and the emergence ofstruggles for corporate control. Managers in declining industries arepushing to restructure corporate strategies, particularly in the direction

CORPORATE GOVERNANCE IN GERMANY,ANDJAPAN, 237
THE UNITED STATES:A COMPARATIVE STUDY
of greater diversification. Upholding implicit promises of lifetime

employment and maintaining the growth of their enterprises areprominent motives. This restructuring is being undertaken with lessbank oversight than ever before and in the face of ever-mounting
demands from these important sharehoiders for better financial returns(Kester 1991a).

Lending banks and other financial institutions, the traditional
monitors of manufacturing companies find that their ability to exercise
control over the uses of cash are severely impaired in this periods ofabundant liquidity. Other means of asserting one's voice as ashareholder have always been and continue to be quite ineffective.
Conducting a successful proxy fight to change managerial policies
about the deployment of corporate cash would seem all but impossible

in Japan. Profound change in the Japanese market for corporate
control has been made inevitable by the stresses that abundant cash
and waning bank authority over corporate clients have placed on the
traditional Japanese corporate governance system. Whether or notthat change will lead to the U.S. type of market hinges on how theJapanese corporate governance system adapts to these stresses (Kester
1991a).

6 Conclusions
In general, U.S. companies have tended to deal with hazards ofself-interested behaviors among stakeholder by delineating the
responsibilities of one to another, as much as possible, in formal,
explicitly written contracts enforced by courts; and relying heavily oncompetitive market transactions with a number of lenders, suppliers,
customers, managers, and so forth relying upon the incentives anddiscipline of the market to ensure mutually beneficial behavior.

Stakeholder groups are distinctly separated in the U.S. public
corporations, and there are reasonably clear boundaries dividing a firmfrom the factor and product markets in which it transacts. The
primary responsibility of the U.S. board of directors is to secure theinterests of the equity holders, and to ensure that management seeks tomaximize the value of the shareholders' stake in the corporation.
Consistent with the U.S. propensity to rely upon competitive markets to

induce appropriate behaviors among contacting parties, an active

238

KENJI KOJIMA

market for corporate control is relied upon to correct deficiency of theboard of directo.rs to act as a safeguard of shareholders interests.

By tying •themselves to one another in groups through equity
participation and various personal and institutionalized information'

sharing networks, yet avoiding outright majority ownership andmanagement, Japanese corporations have been able to exploit powerfulmarket incentives that derive from independent equity ownership.
Concurrently, the close involvements of major stakeholder in a company

enable them to adapt their relationship with the company to theprevailing environment. In lieu of arm's-length transactions among
many autonomous market participants, or extensive integration ofequity ownership under hierarchies, Japanese corporations engage inclose business relationships, formed by implicit contracts, personal

trust among managers, and extensive information sharing. The
existence of large minority equity claims among major stakeholder
helps mitigate the abuse of such business relationships.

German corporate governance bears many similarities to theJapanese system, particularly regarding the maintenance of long-term
lender-borrower relationships and bank ownership of equity. In atleast one important respect - the composition of corporate boards of
directors - German governance provides stronger safeguards against

self-interested behavior than does the Japanese system. Japaneseboards tend to be dominated by inside managing directors. Retired
executives of important equity'owning stakeholder sometimes join these

directors as representatives of their former employers. German
supervisory boards, in contrast, are at least half-composed of
executives of the corporation's major institutional shareholders andrepresentatives of iabors. AII major stakeholder thus influence
corporate goals and bear the responsibility of achieving the promotionof the company's best interest, according to German Iaw. While they

are concerned with shareholders and workers, German boards are
expected to consider these interests in the context of how they will

influence the company's long-term well-being. Because of theircommitment to the coalition of stakeholder, German managers haveviewed their tasks as being preservation and enhancement of coalitional

interests rather than an immediate, direct pursuit of any one
stakeholder's interests and increasing the overall welfare while allcating

gains among stakeholder in sueh a way as to mitigate conflict among

CORPORATE GOVERNANCE IN GERMANY,ANDJAPAN, 239
THE UNITED STATES : A COMPARATIVE STUDYthem.
In many other respects, however, German contractual governanceprovides somewhat weaker safeguards for the preservation of longterm relationships. Although supervisory board representation isconcentrated among a relatively small number of executives who sit on
many boards, the sort of temporary personnel transfers at lower levelsof management that are so common in Japan are rare in Germany.
Information sharing is less institutionalized in Germany than in Japan,

where intercorporate management and supplier organization arecommonplace. Differences between Germany and Japan are morematters of degree than of kind, however, especially in comparison tocommon practice in the United States.
The nature of equity ownership among the three countries further
reflects the differences in their approaches to governance. In the
United States, a higher degree of specialization in risk bearing has
resulted in delineating one stakeholder group from another, and making
equity investors a distinct class of claimants against the firm. The
advantage of such specialization is that it tends to enhance capital
availability and lower capital costs by providing investors with a richer
set of risk-return alternatives across which they can diversify. It also

yield a clear-cut residual claimant with unambiguous incentives tomonitor corporate management, for it is the residual claimant who will

benefit most from efficient production and the reduction of agency
costs. Thus, for the contemporary U.S. corporation with its largely
specialized stakeholder and its distinctly separate residual claimants,

the problems associated with the separation of ownership frommanagement become central to the governance issue, more so than thegoverning of intercorporate business relationships. The outside
directors, the use of the proxy voting and the development ofshareholder advisory committees are emerged as preferred means forsolving many of these problems. And when these governancemechanism fail, the market for corporate control has been depended
upon to concentrate ownership in the hand of new shareholders who
may then change underperforming patterns of investment, repeal otherpolicies having a detrimental effect on shareholder value, andconceivably change management itself.
In Germany and Japan, residual claimants are not, for the mostpart, separate and distinct from other stakeholder. Rather, a majority

240

KENJI KOJIMAof stock is often owned by a few shareholders who quite often possessother claims against the corporation. The financial institutions areneither pure debt nor pure equity holders. The role of equity inGerman and Japan is less to vest ownership rights in residual
claimants with strong incentives to monitor management than it is tobind otherwise diverse stakeholder to one another helping parties holdtogether in long-term trading relationships. It does so by reducing
conflict that normally arise among various stakeholder when they eachhold separate and distinct claims. The incentives to breach contracts
with suppliers and customers in the interests of transferring value ofshareholders, or to borrow money and then take extraordinary risks
that might benefit shareholders at the expense of lenders, are lessened

when the impaired stakeholder are also the company's principal
shareholders. Thus, the conflicts of interests among the stakeholder
can be mitigated by relationship-based control mechanisms.

The agency problem is addressed in Germany and Japan byplacing representatives of significant equity-owning stakeholder on theboard, and by relying on main banks and Hausbanks as delegatedmonitors for other major lender-owners. Importantly, the production
process, itself, also serves as a kind of monitoring system for equityowning stakeholder in Japan. Such monitoring by large shareholders
do not completely resolve agency problems of the separation between
ownership and management. Indeed, from the perspective of Japaneseindividual or non-group institutional shareholders without a voice on
the board, this sort of problem may actually be worse in Japan thanin the United States. Overinvestment in declining core industries,
excess employments, excess diversifications, and speculative uses ofexcess cash, among other problems, appear to be at least as
problematic in Japan as in the U.S.

While possibly recognizing deficiencies in the value maximizing
behavior of the corporations in which they invest, non-controlling
German and Japanese shareholders may, nevertheless, acquiesce tosuch behavior so long as they perceive the advantages of sustaining
long-term business relationships that support their investment to be
worth more than the foregone incremental value. In other words, they
may tolerate agency costs associated with the separation of ownershipfrom management as high or even higher than those present in the U.S.

corporations if the offsetting gain from bearing such cost is

CORPORATE GOVERNANCE IN GERMANY, JAPAN, AND 241
THE UNITED STATES : A COMPARATIVE STUDY

substantially reduced transaction costs, and greater efficiency inproduction (Kester 1992).

There is some evidence that these systems of corporate
governance are converging - that Japanese and Germany are moving
toward a more American-like system. Japanese banks may be forced
to liquidate some of their equity holdings to maintain adequate cash
balances; in Germany, there are proposals to limit bank ownership ofequity. Yet these changes are modest m if Japanese or German owners
are forced to sell their nonpermanent shares that are actively tradedand have little influence on corporate behavior. Changes are also
occurring in the United States, as institutional investors havediscussions with management and some boards take a more active rolein corporations. As in Japan and Germany, these changes appear
isolated and infrequent.30 All three countries have evolved unique andeffective systems of corporate governance. None of them, however, arestationary. As the world's capital and product markets integrate, andas companies domiciled in different countries engage in investments andtransactions across the border, these systems are increasingly coming
into direct contact and, sometimes, conflict with one another. As they

do so, the advantages and limitations of each become more clearly
revealed.

30 Breeden (1993), the chairman of the U.S. Securities and Exchange Commission,

contends that the German and Japanese corporate governance models, whilewell"suited for those countries, are not appropriate to U.S. traditions. The closed

nature of governance under those systems contradicts U.S. values of openness,
mobility, and accountability in running publicly owned corporations in the U.S.

Limiting information about corporate successes and failures to a handful ofpeople behind closed doors would not likely improve either the economy or thecompetitive position in the U.S.. Strengthening broad-based participation incorporate governance in a reasonable manner will help ensure both a strong andopen investment market and prompt and meaningful managerial accountability forconsistent profitability and growth.

KENJI KOJIMA

242

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CORPORATE GOVERNANCEAND
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243

ECONOMIC ISSUES IN INTERNATIONAL DEBT: A SURVEY

Hideki IzAWA

I lntroduction
Since the debt crisis occurred in Mexico in 1982, the debt problem
in the developing countries has received more attention. In 1989 Brady,
the U.S. Treasury Secretary, announced a plan for debt forgiveness andthen applied it to Mexico and other countries. Recently the creditorbanks to Brazil and Argentina have agreed to choose in exchange forbank loans either new bonds to forgive 35 % of the principal or to
reduce debt service (interest). This is called securitization.

We make use of the "principal-agent model" to analyze the debt
problem under asymmetric information. The principal (or uninformed
player) is the creditor, international banks, while the agent (orinformed player) is the debtor country. Rasmusen (1989) classified thefive types of principal-agent problems.

(1) Moral Hazard with Hidden Actions
The creditor (principal) and the debtor country (agent) begin withsymmetric information and agree to a debt contract, but then the
debtor takes an action (effort) unobserved by the creditor. The

creditor cannot observe whether the debtor country consumes orinvests the borrowed funds. For example, a policy-holder may neglect
health precaution and an insurance company cannot observe it.
(2) Moral Hazard with Hidden Information
It is the same as (1), except that Nature takes a move observed by
the debtor country but not the creditor. As the interest rate rises, thedebt country undertakes higher risk and higher return projects, andincreases default risk, lowering the bank's profit. The other example isthat member banks of Federal Deposit Insurance Corporation do notcare about safety of their loans.
The author is grateful to the Sawamura Fellowship for financial support. He is thankful
to Koji Shimomura and Kenya Fujiwara for helpful comments, but he is solely responsible
for any remaining errors.

HIDEKI IZAWA

246(3) Adverse Selection

Nature begins the game by choosing the debtor country's type(her payoff and strategies), unobserved by the creditor. Then thecreditor and the debtor country agree to a debt contract. It is difficult

to identify the type of the debtor country. As the interest rate rises,
the borrowers with high probability of repayment decrease the demand

for loans, while the borrowers with }ow probability of repayment
mcrease lt.

(4) Signalling and (5) Screening

Nature begins the game by choosing the debtor country's type,unobserved by the creditor. To communicate her type, the debtor
country takes actions that the creditor can observe. If the debtor
country takes the action before they agree to a contract, we say the
debtor country is signalling. For example, the debtor country may
accept IMF conditionality as a signal to communicate with lenders. On

the other hand, if she takes the action afterwards, she is being
screened. The creditor needs to monitor the debtor's actions.

In the section ll, we begin with international borrowing andlending under certainty in a prisoner's dilemma situation. Then we
discuss rescheduling and new lending under uncertainty. In section M
we present the debt repudiation model under asymmetric information
between borrowers and lenders. In section rv we examine some debt
reduetion schemes; unilateral debt forgiveness, and market-based debt

reduction schemes (debt buy-backs, debt swaps, and debtequity
swaps). Lastly, we conclude and mention future research issues.

ll Debt Problems under Certainty and Uncertainty'
We discuss first of all international lending and borrowing without

uncertainty and possibility of repudiation in a prisoner's dilemma.

Then we consider rescheduling and new lending in an uncertain-sltuatlon.
'
lnternationaHending and borrowing without uncertainty
First, we explain how international lending or borrowing increase
welfare. In Figure 1, the horizontal axis is the current goods and thevertical axis is the future goods in a country. The production
possibility curve and the indifference curves are drawn. The

247
ECONOMIC ISSUES IN INTERNATIONAL DEBT: A SURVEY

P
P2,-.--..
..
I

:

,
:

..L.-.--.. .

lc

IA
IL
;lIl1;IIl:
O Pi Ai Ci
A2
C2

D

1,

I Ue

U-

U.
(1+it)(1+i) iFigure 1
combination of production and consumption in the absence of capital

movement is shown at point A. Now suppose that a country canborrow or lend. In Figure 1 if the international interest rate (i') is
lower than the domestic interest rate (i), the new production is point P

and the new consumption is point C. The current consumption is OCi
and the current production is OPi. The future consumption is OC2 andthe future production is OP2. The country borrows PiCi from abroadin the current period and repays P2C2 in the future period.
Intertemporal welfare increases from Uo to U*. On the other hand, if
the international interest rate is higher than the domestic interest rate,

the country lends to a foreign country in the current period andreceives in the future period. Thus each country's welfare increases.
International borrowing and lending, that is, capital movements play arole to exchange internationally consumption goods between thecurrent period and the future period.
However, the debt country has an incentive to repudiate the debt
repayment in period 2 once the debt country borrowed in period 1, even
if she can be solvent. The debt country selects the point D in period 2

in Figure 1. The initial plan C is time'inconsistent. We show thisproblem as an example of a prisoner's dilemma.
Prisoner's dilemma

If a debt contract between the creditor and debtor cannot be
enforced, the debtor can violate some or all contractual stipulations,248 HIDEKI IZAWA
thereby inflicting losses on the creditor. Table 1 shows the strategic
situation which two players face in an unenforceable contract. The
creditor (lender) chooses rows either `lend' or `do not lend', and thedebtor (borrower) chooses columns either `repay' or `do not repay'.
The payoffs are defined as the gains. The first entry is the payoff tothe creditor and the second entry is the payoff to the debtor.

Table 1
debtorrepay do not repay
lend
creditor

do not lend

1,1

o,o

-1,2
o,o

The Nash equilibrium is a strategy (do not lend, do not repay) if

a contact fails to prevent the debtor from cheating, although undercooperation the Pareto-optimal payoff (1,1) could be reached.
Although the debtor prefers cooperation to not receiving the loan, her
ex- post incentive makes her cheat once the loan is made.

The situation described above is a variant of the one-shotprisoner's dilemma game, Debtors, however, are often interested in along-term credit relationship, In an infinitely repeated prisoner's
dilemma supergame, threats of retaliation such as a credit embargo

may deter a debtor from cheating and may support cooperativeequilibria for non-cooperative repeated games. However, if the game isrepeated only finitely, cheating and thus not lending is optimal in thelast round of the game since it is a single-stage prisoner's dilemma
game. By backward induction it is also optimal not to cooperate in thelast but one stage, and so on down to the first round of the game.
Next we take into account uncertainty on repayment capacity ofthe debt country.

Rescheduling and New Lending
In Figure 2 consider a two-period model of a country that has
inherited a debt D which comes due in period 1. The resource transfer

in period 1, Xt is known. If D exeeeds Xt, the debt country mustreschedule the debt or borrow new lending equal to D-Xi and repay(1+ i')(D -Xi) in period 2 where i' is an interest rate. However, thepotential resource transfer in period 2, X2 is a random variable and249
ECONOMIC ISSUES IN INTERNATIONAL DEBT: A SURVEY

debtor

D$X, D-X,>O
full repayment creditor periodl
do not lend lend D"Xidebtor default

nature period 2

1-p p(1 +i*) (D -X,) > X,B X,G 2 (1 +i*) (D-X,)
Figure 2
takes either X2G (good state of nature) or X2B (bad state of nature).

We assume that the good state in which a country can repay in fullhas a probability of p and the bad state has a probability of(1 -p). Then the expected receipt of creditor is p•X2G+(1 -p)•X2B.
If it exceeds (1+i')(D-Xi), the creditor may agree to reschedule orlend a new loan. In this case there is only a `liquidity problem' andnot a debt crisis. The creditor is still better off than default in period

1. However, if the debt is accumulated and is not permanently repaid,
the debt crisis happens.

If a lender (competitive banks) raises his interest rate, theborrower's behavior changes because adverse selection and moral
hazard raise default rates. Borrowers who expect to default are lessconcerned about the high interest rate, so the default risk rises. The

lenders would not lend to a risky borrower who offers to pay morethan the interest rate which maximizes the expected return to thelenders. As a result, credit is rationed in a loan market (see Stiglitz
and Weiss [1981]). In fact the private international banks have reduced
new lending to LDCs since the debt crisis.

M Debt Repudiation Model

We present the debt repudiation model under asymmetric
information between the lenders and the borrowers, based on Jaffee
and Russell (1976).

HIDEKI IZAWA

250

debt
country (borrower) .
The debt country solves a utility maximization problem of a
two-period model as follows. The utility consists of consumptions inperiods 1 and 2. The equation (2) shows the budget constraint inperiod 1 to the debtor country. The equation (3) shows the budget
constraint in period 2 and if the principal and interest payments of theborrowing is less than the repudiation cost (Z), a penalty such as
embargo, seizure of overseas assets, or exclusion from international
capital markets, the debtor country will pay the debt. However, if theyexceed the repudiation cost, the debt country does not have intention to

pay the debt even if it is solvent. The maximization problem to thedebtor country is as follows.

maxU[Ci, C2] (1){C,,C,,L}S'`' Zi, Zy;l: .(i+r) 'L' li [',l".l !2;Z ((Z]where Y is production (given), C is consumption, L is borrowing, r is
the interest rate, Z is repudiation cost.

If (1+r) L is equal or lower than Z, the debt country will not
repudiate the debt. Then the first-order condition is0U'

oL=Ui-(1+r) U2 -O (4)where Ui is the partial derivative of U with respect to the ith
argument. The demand for borrowing (foreign debt) is drawn as adown-sloping curve, DD' in Figure 3.

And whenever the repudiation cost Z is less than the debt
repayment, the debt country chooses L=oo and repudiate therepayment even if it can be solvent. The conditon for debt repayment,(1+r) .L s{: Z, is shown as an area below the hyperbola ZZ in Figure

3. Thus the demand curve for debt is shown as DA and oo in Figure
3. The indifference curves have zero slope where they intersect thedemand curve and become vertical above ZZ'. The borrower's utility
increases in the direction of the arrow.

251
ECONOMIC ISSUES IN INTERNATIONAL DEBT: A SURVEY

1+r

OL
Figure 3
lenders (competitive banks)

We assume that there exists asymmetric information about Z

between borrowers (debt country) and lenders (banks). Eachborrower knows his Z while the lenders cannot identify the good
debtors and bad debtors. Thus we assume that to the lenders Z is arandom variable which has lower and upper limits, Zf{g ZSZ, andf(M is the probability density function.

The risk-neutral banks are assumed to maximize their expected
profits. In competitive loan market, a zero profit condition must hold.

E[(1+")'LIL S: 1+Z,]+E[ZlL>1+Z.]' (1+i)'L (5)The expected revenue is equal to the cost to banks where i is theconstant (deposit) interest rate.

Now we examine the three cases as follows.

Case (i) Lzsg

1+r
No debt country will repudiate the debt. Then we obtain r=i.

HIDEKI IZAWA

252

line at 1+r='1+i

The supply of bank loan is shown as a horizontal

up to L=z.

Iii' M Figure 4.

z-

1+r

z

D3

D2
E4

7

s

(1+i)
E(Z)

Di

E2

T

v

1+i

D3'

E3

El

D2'

z"'

Dlt

g'
o

g
1+i

E (Z)

1+i

L

Fjgure 4

iiZ:r <L Sg ilr

Case (ii)

Somedebtors will repay and the others will not. From (5)(1+r)L
Since,f(IZ..,.f(z) dz +S,-(i'r'L zf(z) dz -= (1+i) L(6)d(d/+Lr) - !/-Å}-l i:eÅí!Å}I2+ Åí1+ )>o where p=f,l.,,.f(b dZ•

which is the probability of repayment, the supply curve of bank loan

shown as TS in Figure 4. As L increases, the interest rate increases
order to cover repudiation risk.

Case (iii)z"

1+r <LISm

ECONOMIC ISSUES IN INTERNATIONAL DEBT: A SURVEY 253

All debtors will repudiate their debts. The banks refuse to lend
the loan more than the ceiling, E(Z)/(1+i). Then the supply scheduleis shown a vertical line at S.

equilibrium(i) If a demand curve, DiDl in Figure 4 intersects between V and T,
the equilibrium is shown at point Ei where every debt country will not
repudiate and always repay the debt.
(ii) If a demand curve is D3D5 , the equilibrium is the point E4.

(iii) If a demand curve, D2Di intersects between T and S, the pooling

equilibrium is shown at point E2. There exists no credit rationing
where r• exceeds i by exactly amount necessary to compensate for the
repudiation risk. The good borrowers with high Z, who do not intend

to repudiate, have to pay a risk premium above i to support
indistinguishable bad borrowers. On the contrary, the separating
equilibrium is shown at point S to bad borrowers who always intend toborrow as much as possible regardless of the interest rate andrepudiate, and at E3 to good borrowers where an indifference curve istangent to the supply curve TS. When the banks offer various loan
contracts, the good borrowers choose E3 and the bad borrowers choose
S and reveal themselves. This mechanism is called self-selection. Thenthe banks can perfectly screen the types of debt countries. The banks

lend to only debt countries who choose E3 and do not lend to those
who choose S. Therefore the separating equilibrium does not hold. So

the bad borrowers mimic the good borrowers and choose E3. Thus
every borrower chooses E3 and the pooling equilibrium holds. However,E3 is below a demand curve and credit rationing occurs.

IV Debt Forgiveness and Market-based Debt Reduction
Debt ForgivenessNow consider that the creditors reduce the debt. The debt
forgiveness reduces payments in the good state, leaving payments inthe bad state unaffected. If the probability of the good state isunaffected by the debt reduction, it may not be in the creditors'
interests. Since there is a free-rider problem, it is difficult to arrange

HIDEKI IZAWA

254

unilateral debt forgiveness of syndicated loans for risk-sharing by thecreditors. Therefore unilateral debt forgiveness must be a concerted
action, which is ihvoluntary to the creditors.

When the debt country has to pay all foreign exchange to thecreditor whatever the state of nature realizes, the debt country has

zero residual. However, a reduction of debt leaves some residual
benefit to the debt country in a good state of nature. At very highlevels of debt obligations, the incentive effect may be so strong that a

reduction in debt will increase the debtor's expected payment. In
Figure 5, the horizontal axis is the present value of a debt country's

Value

Debt

o
Figure 5

debt obligation and the vertical axis is the expected present value of its

future debt service. If the country owes a low level of debt, it would be
expected to repay the debt in full and thus the expected value would lie
along the 45-degree line. At higher levels of debt, however, there would

be an increasing probability of default and thus the expected payments
would lie along a curve like CD, falling increasingly below the 45'degreeline. Krugman calls it the "debt Laffer curve" in analogy to the Laffer

ECONOMIC ISSUES IN INTERNATIONAL DEBT: A SURVEY 255

curve in tax. A reduction in the debt will actually increase its expected
payments if it is on the wrong side of the debt Laffer curve. Thus it
is in the collective interest of creditors to offer unilateral debt
forgiveness. However, we do not know where the countries really areon the curve.

We present the model of debt forgiveness by Sachs (1989).
Suppose that the heavily indebted country is excluded from theinternational capital markets and cannot make new borrowing. Thenthe debtor country's problem is as follows.

max U(Ci, C2){C,,C2,Ii}

s.t. C, == Q, - I,

C, = Q, (J,) -S

Q2 == Qi+(1+g) 'Ii g>O
S= min (R, Q2)

where .

C: consumption, Q: production, I: investment, S: actual debt
service in the second period, R: the amount of debt afterdebt-forgivenessOn the other hand, the creditor country chooses R such that it
maximizes S, subject to RsgD, where D is the debt (principal andinterest) due in the second period.

Consider the debtor country's problem, taking R as a parameter.
For low values of R, the debtor will be able to fully repay R since R
will be less than Q2 (Ii). Thus with S==R, the interior solution sets(1+g) equal to the marginal rate of substitution between the first andthe second period consumptions. The investment A is an increasing
function of R in this range. The debtor country makes adjustments bysaving today and investing more in order to raise the second period
production.
For large values of R, however, the debtor will not be able to fully

repay R since R>Q2 (Ii). In this case of debt overhang, the optimal
decision is zero investment since C2 = O. And the actual debt service isequal to Qi. The entire increase in output due to higher investment
would accrue to the existing creditors rather than to the debtor
country. There is no incentive to invest.

In Figure 6, the horizontal axis measures production andconsumption in the first period and the vertical axis measures those inHIDEKI IZAWA

256

the second period. When debt D = O, the consumption frontier is givenby the line CC which has slope-(1+g). The point Q == (Qi, Qi) is theconsumption point when Ii == O. The equilibrium is point A where CC

is tangent to the indifference curve U. When D>O, the CC shifts
vertically downward by the amount D(s:Qi) in Figure 6 (a). The
equilibrium is point B. The existence of a small amount of debt spurs
investment which is the horizontal distance between Ct and Qi.
For large level of debt (D> Qi), the CC" is kinked because of theconstraint C220 in Figure6 (b). The optimal policy is to set Ii =O,

and consume at the corner solution E, with Ci = Qi and C2 = O. Since
D is so large that it will not be fully repaid, an increase in Ii raises thesecond period output without raising the second period consumption.

With zero investment, Q2=Qi,and the actual repayment S is Q2.
Instead of D, the creditor can demand a smaller amount R throughdebt forgiveness. The result is a new equilibrium at point F. The debt
forgjveness raises the actual repayment from S to R, leaving the debtor
country's utility unchanged. It is obvious that a higher level of debt

forgiveness could make both the debtor country and the creditor
country better off than at point E.

cc

C,,Q2

C2,Q2

CC

U

U'

CC' D

A

D R

B

C2

Qi=C,

1

- (1+g

:

,D
I

l
l

l
1

U"

l

'

1

1
1

1

l

: Ii

Q

Q
1

CC"

s

F

1
l

t

E

'

o

Ci

Qi

Ci,Qi

o

NsN

Å~
Figure 6 (a)Low Debt

Figure 6 (b)C1=Q1High Debt

Ci,Qi

ECONOMIC ISSUES IN INTERNATIONAL DEBT: A SURVEY 257

Market-based Debt Reduction

We examine market-based debt reduction approaches throughvoluntary action rather than concerted debt forgiveness. If there is asecondary market in the debt, the market price is equal to the expected

repayment of the debtor country. The discount is (1-market pricedivided by the face value of the debt).

(i) Debt Buy'backs
Debtors may repurchase their own debt at a discount, However,debt buy-backs is prohibited, There are two reasons. One is the issueof seniority. Existing creditors are entitled to first claim on whatever

repayment the debtor can make. The other is a moral hazard problem.
Allowing debtors to buy back their debt at a discount rewards thecreditor who has the lowest secondary price. The effect of a buybacks lowers the price of debt in the secondary market and reduces the
expected total payment to the creditors. When the debt obligations
after buy-backs with foreign exchange still exceed the revenue in thegood state of nature, there is no incentive for the debt country to buyback the debt with foreign exchange.
(ii) Debt Swaps (Securitization)

In a debt swap a debt country issues a new bond and exchanges
it for the existing debt. The debt country needs no foreign exchange.
However, the new bond must be senior to old debt in the sense that it
has a prior claim on the country's payments. Then the effect of debt
swaps on the expected receipts to the creditor and the debtor is theoaaM
ne isaSp;nohtlbeiteddebftrobmUYI.sbsauCiknSgslennigarCtb'otnhdes.debtorwhichowesabankIS'(iii) Debt-Equity Swaps
The creditors sell debt at a discount in return for equity. Suchdebt-equity swaps simply exchange one kind of external liability for

another so that the total debt does not change. The equity is notnecessarily senior than bond. In addition, if the creditor sells equity
and the capital flows out of the debt country, the debt-equity swap isthe same as debt buy-backs by foreign exchange. The problem iswhether or not debt-equity swaps generate additional equity
lnvestment.

HIDEKI IZAWA

258

Such market-based debt reduction schemes will be beneficl'al toboth debtor and creditor only when the debtor is on the wrong side ofthe `debt Laffer curve'. It implies that there is no magic in marketbased debt reduction, as opposed to the orthodox strategy of concerted
iending and debt forgiveness.

V Concluding Remarks
We treat the debt problem as a principalpagent problem underasymmetic information between the debtor country and the creditor
country and examine the possibility of moral hazard and adverse
selection. And we present the debt repudiation model and examine
pooling and separating equilibria. Furthermore, we present the modelof debt forgiveness to derive the debt Laffer curve and then compare
debt forgiveness and market-based debt reduction schemes. We findthat they are beneficial to both debtors and creditors only when the
debtor is on the wrong side of Kruglnan's `debt Laffer curve'.

The World Bank reports in World Debt Tables 1992"93 that the
total debt outstanding by the developing countries including Russia is
1,703 billion dollars at the end of 1992. We need to reconsider the roleof international organizations such as the IMF and World Bank as wellas ODA to the LDCs, to advise structural adjustment and support
economic development.

'
References[1] Akerlof, G., "The Market for Lemons: Qualitative Uncertainty and the Market
Mechanism," Quarterly Journal of EconoTnics, vol.84, no.3 (August, 1970)
pp.488-500.
[2] Bulow J., and K. Rogoff, "Sovereign Debt: Is to Forgive is Forget?," American
Economic Review, vol.79, no.1 (March, 1989) pp.43-50.
[3] Cohen D., Private Lending •to Sovereign States, MIT Press, 1991.
[4] Dooley M., et al., Debt Reduction and Economic Activitov, IMF Occasional Paper
no.68, 1990.

[5] Eatpn J., and M. Gersovitz, "Debt with Potential Repudiation," RevieuJ of
Eeonomic Studies, vol.48, no.152 (April, 1981) pp.289-309.

[6]- Frenkel J., M. Dooley, and P. Wickham, eds., Analytical Issues in Debt,
International Monetary Fund, 1989.
[7] Jaffee D., and T. Russell, "Imperfect Information, Uncertainty, and Credit
Rationing," Quarterly Journal of Economics, vol.90, no.4 (November, 1976)

259
ECONOMIC ISSUES IN INTERNATIONAL DEBT: A SURVEY

pp.651-666.

[8]
[9]

Krugman P., Currencies and Crises, chs. 7, 8, and 9, The MIT Press, 1992.

[10]
[11]

Rasmusen E., Games and Information, Basil Blackwell, 1989.
Rothschild, M., and J. Stiglitz, "Equilibrium in Competitive Insurance Markets:[12]

Econornics, vol.90, no.4 (November, 1976) pp.629rr649.
Sachs J., "Conditionality, Debt Relief, and the Developing Country Debt Crisis,"

Mohr E., Econornic Theory and Sovereign International Debt, Academic Press,
1991.

An Essay on the Economics of Imperfect Information," QuarterLy Journal of

in Sachs J., ed., Developing Country Debt and Econornic Performance, vol.1, The
University of Chicago Press (1989) pp.255-295.
[13]

Stiglitz J., and A. Weiss, "Credit Rationing in Markets with Imperfect
Information," Arnerican Economie Review, vol.71, no.3 (June, 1981) pp.393-410.

A NOTE ON THE ESTIMATION OF SCALE ECONOMIES AND
THEIR USE IN MODELING FREE TRADE AGREEMENTSi

Robert K. MCCLEERY

Economists are fascinated by the concept of increasing returns toscale (IRS) or economies of scale, perhaps due to the universal allureof getting more (output) than you pay for (in inputs).2 However, there

is some theoretical confusion as to what economies of scale are, andeven more uncertainty in how to measure them. The result is that
economic models purporting to incorporate "economies of scale" maybe measuring something else entirely, yielding conclusions and policy

recommendations diametrically opposite to those both of more
standard models and of empirical observation.
The existence of economies of scale is readily apparent, especiallyin modern manufacturing operations. All sorts of fixed costs, such as
research and development, marketing, structures, etc., must be coveredin the price of output, and increasing production volume should
decrease average costs, thus raising profits and/or lowering prices
and increasing the quantity demanded.3 Questions remain on how best
to model economies of scale, including such basic questions as: Are theeconomies of scale internal to the firm, domestic industry, orinternational industry (Ethier 1979)?

The theory, as applied to modeling international trade and free
trade areas, has been known for more than 25 years (Balassa 1967,

Corden 1972, Krugman 1979 and 1980, Helpman 1981), but the
1 I would like to thank Professors Shigeyuki Abe, Kazuhird Igawa, Shoji Nishijima,
and Koji Shimomura for helpful comments on an earlier draft.
2 Although many economists use the two terms interchangeably, IRS is technicallydefined as alpha>epsilon, where alpha is the percentage increase in output
resulting from an epsilon percent increase in the quantities of all inputs to
production. Economies of scale, the focus of this note, are defined as declining
average costs of production as output increases in some relevant range.
3 At some high level of output, the firm structure and organization may become sounwieldy that the cost advantage to greater output is lost. Another way oflooking at the problem is to say that fixed factors are only "fixed" for output
varlatlons m a glven range.

262 ROBERT K.MCCLEERY
application to empirical models is relatively recent, with pathbreaking
studies by Harris (1984) and Cox and Harris (1985). A spate of studies

have emerged recently, aimed at estimating the impact of NAFTA,
particularly on Canada and Mexico, using the same (Cox and Harris
1992 and Sobrazo 1992, in USITC 1992) or a slightly modified (RolandHolst et. al. 1992) modeling framework. Before similar models appear
extolling the gains from the next EC enlargement, an ASEAN FTA, andthe Enterprize for the Americas Initiative (also called Western
Hemisphere FTA or WHFTA), it is worth reevaluating the basic model,
with an eye toward its applicability to developing countries and to
economies in a process of adjustment, as it is now being used.
A brief review of the Harris and Cox framework is given below insection I. Section II discusses some key assumptions of the model indetail, and questions their applicability to developing countries
undergoing structural change. The final section offers two alternatives
to modelers of trade liberalization in developing countries and someconclusions.

I. Overview of the Cox-Harris Model
Many standard assumptions are made: two factors of production,
capital and labor, with capital being perfectly mobile across the 29
productive sectors and two regions at the exogenous interest rate andlabor being perfectly mobile across industries but immobile acrossregions. Of the 29 sectors, 20 were designated a priori as "non-competitive increasing returns sectors," all of which are tradeable
manufactures. The 9 CRS sectors include, agriculture, forests, fisheries,

and mining (sectors in which Canada has a traditional comparativeadvantage) and all non-traded sectors. The economy is assumed to bea price taker in imports, but foreign and domestic output are imperfect
substitutes, as in Armington (1969). Correspondingly, firms are pricemakers in export markets. In cbmpetitive sectors, price equals
marginal cost, while pricing rules assumed in monopolisticallycompetitive or oligopolistic sectors are discussed in more detail below.

Factor markets are perfectly competitive. Firms enter and exit freely,with fixed costs being the only barrier to entry. In a particularly richversion of the model, found in Harris (1984), firms also endogenously

determine the number of product lines produced, trading off the lower

263
A NOTE ON THE ESTIMATION OF SCALE ECONOMIES AND
THEIR USE IN MODELING FREE TRADE AGREEMENTS

cost of longer production runs with the demand of consumers forvariety (see footnote 11 below). External balance requires that a trade

surplus be balanced by rental payments on foreign capital (note thatassumptions yield a one-way flow of FDI to Canada from the rest of
the world, and thus a trade surplus must be maintained).
The large welfare gains this modeling framework predicts comefrom two basic sources: the reduction in average costs (the economies
of scale effect) and the reduction in the price-cost spread (thepro-cornpetitive effect). The second effect is actually the principal
component of the size and variability of the estimated gains, with thesource of the variability being the (assumed) extent of oligopolistic
pricing behavior in a given industry, incorporated in a weighting
parameter in a linear combination of monopolistically competitive andfocal point (on the price of imports) price setting.` But this point, aswith other points that have been raised about the suitability of theArmington assumption, Cobb-Douglas welfare, and the choice of supply
and demand elasticities used, is not the focus of my comment.5 They

are not likely to yield policy recommendations at odds with the
Stolper-Samuelson theory and empirical observations, and their

weaknesses have been widely discussed and in some areas
acknowledged by the authors.6
The economies of scale effect is itself quite large. To quote Harris4

Cox and Harris (1985), Roland-Holst et. aL (1992), and Sobrazo (1992) present
sensitivity analysis on the pricing rule parameter. In Cox and Harris, raising theweight of the Eastman-Stykolt rule from O.2 to O.7 (assuming that markets are lesscompetitive and more oligopolistic) raises the estimated welfare gains for Canada
from unilateral liberalization to the world from 1.9 percent to 7.8 percent of GDP,a factor of four. Roland Holst et. al. present output effects for 26 industrial

sectors in the U.S. under Cournot pricing and contestable markets, and theestimate for contestable markets is generally 60 percent or more larger. Sobrazo
varies the Eastman'Stykolt weight as in Cox and Harris, but from O to 1, yielding

estimates of Mexican output and welfare gains from NAFTA that vary by factorsof fourteen and five, respectively.
5

Further, the somewhat questionable Armington assumptidn can be compounded by
the choice of elasticities. Sobrazo 1992 chooses an elasticity of substitution indemand of. O.375 between domestic autos and imports, despite the faet that theoverwhelming mojority of auto production in Mexico is done by multinationals 'Ford, GM, Volleswagen - in many instances, the same makes and models are
6

imported.
Whalley (1984) delivers the following criticism: "The weakness, however, is thatfrom a theoretical point of view the model relies on an ad hoc assumption ofcollusive behaviour. Collusive behaviour, (sic) is assumed rather than derived

from profit maximizing behaviour of firms. A further weakeness is that in
Canada there is collusion, abroad there is not."

264

ROBERT K.MCCLEERY(1984), "Notice the large increases in average production runs - in theorder of 50 pQrcent under both UFT and MFT (unilateral andmultilateral free trade). Indeed the domestic tariff alone seems
responsible for much of the increased scale economies at the industry
leveL" These factors result in 40 to 50 percent of the welfare gains
reported for Canada in Cox and Harris (1985) (extrapolating from thesensitivity analysis in table 4 and 5, pp. 136'37, comparing the result
using the mean of all parameter values and the extrapolated result forminimal efficient scale of operation [MES] approaching O).
Two parameters combine to generate the economies of scale effect:an estimate of the MES, defined as the point where the difference
between average and marginal costs falls below one percent, and thecost disadvantage ratio (CDR), which is one minus the ratio of average
cost at an output level one half of MES to average cost at MES.' The

values used are the mid-point between economic estimates andengineering estimates (which tend to be substantially higher).

ll. The Appiicability of the Cox-Harris Model to Developing
Countries, Particularly Mexico
The appeal of this approach is apparent, espeeially as traditionalmodels of the resource allocation effects of FTAs yield minusculewelfare gains, generally less than one half of one percent of GDP.S
7

Total costs in the Harris and Cox framework are TCi = Fi (r,w)+V`(P)'yi, where F
is fixed costs (units of capital and labor needed to begin production, multiplied by
the corresponding rental and wage rates) and Vi is a variable unit cost function of

input and factor prices assumed to be independent of the level of output. Thus,
raising the level of output reduces average cost, which asymptotically approaches
marginal cost as output rises.
8

Five of the studies reviewed by the U.S. Congressional Budget Office (1993) present

estimates of the impact on GDP of the U.S. and Mexico solely from resource
allocation effects. These estimates range from O.O to O.23 percent for the U.S. and-O.04 to O.32 percent for Mexico. Three broad classes of studies attempt to lookbeyond domestic resource allocation issues of NAFTA. Studies that model factor
movements across borders (investment, migration, technology transfer, or somecombination) include Adams, Alanis, and del Rio (1992), Bachrach and Mizrahi(1991), Brown, Deardorff and Stern (1992), Hinojosa-Ojeda and Robinson (1991),
McCleery (1992), and Young and Romero (1992). Studies that foeus on a single
industry and its international structure, including non'tariff barriers to trade,include Hunter, Markusen and Rutherford (1992) and Trela and Whalley (1992).
Studies that model economies of scale include Brown, Deardorff and Stern (1992),
Cox and Harris (1991, 1992), Hunter, Markusen and Rutherford (1992), RolandJ
Holst, Reinert and Sheills (1992), and Sobrazo (1992).

A NOTE ON THE ESTIMATION OF SCALE ECONOMIES AND 265
THEIR USE IN MODELING FREE TRADE AGREEMENTS
Some attempt to to go beyond the traditional competitive markets
paradigm to consider how a trade agreement would impact countries
involved in an FTA given the oligopolistic structure and pricing
patterns as well as economies of scale in certain key industries is called

for, especially in the case of a U.S.-Mexico FTA or NAFTA.
But three of the assumptions of the Cox-Harris mode! must bequestioned, especially in attempts to extend the model to developing
countries like Mexico. First, there is an implicit assumption of identicaltechnologies. This standard assumption allows one to bypass thedifficult task of estimating the extent of potential scale economies ineach sector and use U.S. scale levels as indicators of the MES(although note that Harris and Cox do not do this). Secondly, theassumption that average costs are diminishing at all output levels may

grossly overstate both potential output expansion and welfare gains
from trade liberalization. Thirdly, the assumption that a difference

between marginal and average cost always reflects unexploited
economies of scale is questionable. Several different reasons for a

spread between marginal and average cost exist, and a country
undergoing structural change due to changes in trade or other key
economic policies (such as Mexico, Indonesia, Spain, indeed, mostdeveloping countries today) may not be observed in equilibrium in thebase year chosen for model calibration. These points will beelaborated below, and two alternatives will be presented: either attempt

to improve the measurement of economies of scale in this type of modelor focus on the dynamics of adjustment and how trade agreements
affect growth rates.

A fundamental point of concern is the way economies of scale are

introduced and measured. The treatment of economies of scale issomewhat questionable in original U.S.-Canada context and may beentirely insupportable in the U.S.-Mexico situation or other developing

country context. The various authors appear to contend that
economies of scale are present in all industries in which marginal costs

are lower than average costs, and that point estimates of the ratio of

marginal to average costs provide parameters for scale economies that
hold for production increases in the range of 15 to 38 percent for

Mexico (Sobrazo 1992) and 41 to 67 percent for Canada (Cox andHarris 1985), in some sectors and scenarios.

There are two distinct alternative possibilities. First, the cost

266 ROBERT K.MCCLEERY
eurves may be U-shaped rather than declining forever, and the large
production increases predicted here could actually move firms up theother side of the U.9 Secondly, if costs are decreasing throughout, thenthe industry is what is known as a natural monopoly, and the body ofanalysis relevant to the behavior and regulation of those raresituations (generally utilities) applies here. The burden of proof inthat case would be on the authors to show why, in the integrated
North American market, any production at all takes place in Mexico.

The modeling answer is, of course, the Armington assumption,
combined with Cobb-Douglas utility, prevent any-domestic industries
from severe contraction. I suggest that the first interpretation is more

likely, and furthermore the author may well be measuring excess
capacity from some optimal factor mix (and, given different technology

in Mexico, MES may be lower and the minimum point on the average
cost curve may be much higher than in the U.S.) in the recessionary
base year of 1985, and that marginal costs would be rising as output

approaches capacity. Excess capacity would be observed in the
Cox-Harris estimations as high fixed costs, and thus a high CDR.iO
Excess capacity in a time of trade liberalization can mean one ofseveral things. First, it,can be an indication of extreme shortages ofimported intermediate goods. If foreign exchange is rationed,
producers may have to scale baek production despite the fact that anincrease in production would be profitable at the prevailing vectors of
input, factor, and output prices. Secondly, it can be an indication of
9 As mentioned in an earlier footnote, organization diseconomies may eventually
outweigh scale economies at the plant level, and fixed costs may not be fixed forincreases in output of 25 to 50 percent or more.
10 Three definitions of "excess eapacity" will be introduced here, two static and one
dynamic, each dependent on some factor market imperfection. In the static sense,on can imagine a firm that finds itself with too much capital relative to labor to
produce a given levei of output efficiently after trade liberalization has decreased

the wage/rental rate. In a putty-clay capital model, no secondary market will
exist for in-place capital goods, which can only be adjusted at the rate ofdepreciation. Alternatively, one can picture a Leontief production relationshipwith one or more imported intermediate goods (televisions picture tubes,
computers and chips, etc.) that could constrain production to a level inconsistent
with the level of fixed costs when imports are restricted. In a dynamic sense, theprofit maximizing level of output may be O, until a transition can be made to
production based on state-of-the-art technology. Rather than electing to shut
down, a firm with a trained labor force, distribution system, and other assets may
elect to stay in business at some level of output that employs its core labor force
in hopes of negotiating a merger or buy-out, even if it cannot cover its marginal
costs in the short run.

267
A NOTE ON THE ESTIMATION OF SCALE ECONOMIES AND
THEIR USE IN MODELING FREE TRADE AGREEMENTS

poor or constrained management - an unwillingness or inability to cut
back on expenses, particularly labor, in bad times. Thirdly, it could bea result of import penetration, indicating that the domestic firms are

inefficient technologically and unable to compete with imports with
their present organization, capital stock, and management structure.
Only in the first instance is it likely that industries with a large spread

between marginal and average cost would be the biggest gainers fromtrade liberalization.

In fact, it can be said that Sobrazo's results for Mexico, evenmore so than the original Cox-Harris results for Canada, are almost
the exact opposite of what would have been projected from so-called
revealed comparative advantage calculations or from a HeckscherOhlin-Samuelson (H-O-S) model based on factor endowments. In oneof their original articles, Harris and Cox state "The model has much incommon with the traditional Heckscher-Ohlin trade model, in which
comparative advantage plays the key role. The comparative advantage
effects are present in the model, but in addition there is scope for
intraindustry rationalization."ii But no such balance is evident in either

the original model or subsequent works. On page 126-127 of the same

paper, Cox and Harris continue "In terms of employment, themanufacturing sector gains at the expense of the rest of the economy.

This result is contrary to what one would expect on the basis of
traditional comparative advantage, which would argue, in the case of
Canada, that trade liberalization would lead to an expansion of the
primary sector at the expense of manufacturing." In Harris (1984), theperfect competition model is contrasted with the IO model witheconomies of scale, with the conclusion "The two models implemented
on the same data base and elasticity estimate yield dramaticallydifferent conclusions. The simple correlation coefficients between
relative output changes for both policy experiments is less than O.Ol.
The hypothesis of no correlation in levels or ranks is accepted at the 99

percent level of significance.... the two models give opposite signs on
expansion vs. contraction of industry in 10 of the 29 cases" (pp.102930). Is the cost of being freed from "the tyranny of the triangles"
breaking the "iron law of factor price equalization?"

The Sobrazo paper shows the same counterintuitive pattern of
11 Cox and Harris (1985), p.122.

268 ROBERT K.MCCLEERY
results. In some of the more labor-intensive sectors (agriculture, food,beverages, tobacco, textiles, apparel, and leather), gross output
increases are quite modest, in the range of 3.3 to 5.5 percent (table 8,

p.628). By contrast, capital-jntensive sectors (non-metallic minerals,

iron and steel, non-ferrous metals, metallic products, non-electricalmachinery, electrical machinery, transportation equipment, and othermanufacturing) enjoy double digit growth from 11 percent to over 30
percent. In perhaps the two most unlikely sectors - Iron and Steel,

where no developing country since Korea has been successful, andnon-electrie machinery, i.e, the production of capital goods, where theUnited States holds an indisputable comparative advantage and wide
technological edge - the projected production increases for Mexican
industry are just over 30 percent.i2

Some rather distressing policy implications come out of this work,

as well, especially for developing countries with significant public
enterprize sectors. In general there seems to•be a prescription for a
return to the bias toward heavy indgstry and capital intensive growththat characterized the late 1970s, however this time under a liberal
trade environment and in the guise of pursuing economies of scaleinstead of self'reliance through import substitution. If those gains
prove to be more modest than predicted, it could be a recipe for urban
unemployment, balance of payments crisis, and, in general, a return tothe "lost decade" of the 1980s for Mexico.
The inherent symmetry among all tradeable goods sectors in mostmodeling frameworks may be to blame. In fact, significant differences
may exist between export and import-competing sectors, especially indeveloping countries, that are not easily captured in models. "Whendomestic firms enjoy market power, extra competition from foreign
producers can force producers to expand or exit.... Trade reforms may
therefore reduce the rate of catch-up to international productivity

levels in import-competing sectors and accelerate it among
exportables."i3
12 Part of the problem may be attributable to the decision to hold employment
constant in this version, despite the inflow of capital into a labor-surplus
economy. The structure of the production functions would therefore require an
outflow of labor from Iabor-intensive sectors in order to equilibrate at the higher
level of eapital, contributing to the slow growth in labor-intensive sectors. With
only one type of labor specified, peasant farmers can readily and costlessly moveinto the capital-goods producing sectors.
13 Tybout, (1992), pp.190-191.

A NOTE ON THE ESTIMATION OF SCALE ECONOMIES AND 269
THEIR USE IN MODELING FREE TRADE AGREEMENTS
Naturally, the fact that the Cox and Harris predictions are atodds with traditional wisdom is not an indictment in itself. But
numerous instances of trade liberalization in developing countries haveemerged recently, and it is worth checking to see what type ofindustries seem to have expanded due to unilateral trade liberalizationin the "real world." It should also be pointed out that in a number ofother instances, with perhaps the case of Indonesian trade liberalizationin 1983-87 being the most relevant comparison, tariff reductions indeveloping countries have led to changes in the pattern of production,
employment and trade entirely consistent with the H-O-S approach.
Indonesia's tremendous spurt of manufacturing exports came in the
traditional areas of garments, textiles, and consumer electronics. Early
indications from Mexico's experience do not contradict this pattern, nordoes the product mix in Mexico's "free trade areas" along the border,
the maquiladoras.
Policy makers might also be unduly reassured by the Cox-Harrismodel's predictions. We would all agree that a drop in price and anincrease from the profit maximizing monopoly or oligopoly sales levelshould be noted in some formerly concentrated sectors. But thereassurance that a moderate reduction in the number of domestic firms
in many industries is both normal and desirable on efficiency grounds
ignores the conclusions of another branch of the growing trade andindustrial organization literature. In Krugman (1979), an expanding
market (through either labor force growth or trade liberalization)

increases the number of monopolistically competitive firms andproducts, increasing the welfare of consumers who value productdiversity and selection. It seems far more likely that a sharp
contraction in the number of firms as a result of trade liberalization inindustries which are already highly concentrated should be taken as
evidence of weakness rather than of potential strength.'`I have no disagreement with the portrayal of many sectors of
14 Subsequent to making this point in my comments on the Sobrazo (1992) paper ata workshop, I discovered that Cox and Harris were aware of this impact from the

beginning. Harris (1984) compares the IO model with and without productdifferentiation (PD) and shows that welfare gains are reduced by about 28 to 34
percent, "The reason is that the rationalization effects of free trade lowers (sic) the

number of domestic firms and hence the number of domestic and foreign products;
this has an adverse effect on welfare given the PD assumption" (p.1028). Cox andHarris (1985) and subsequent papers present only estimates without productdifferentiation.

270 ROBERT K.MCCLEERY
industry as being organized oligopolistically in developing countries.
But the model is predicated on the ability of these oligopolies toeffectively collude in restricting output and raising product prices. One
element not studied which might affect the ability of firms in a sector
to collude in price setting is ownership differences. In other words,

domestic firms or foreign firms based in a single country could moreeasily collude than a heterogeneous mix of firms. Yet anotherpossibility is that free trade might lead to a "rationalization" in which

a heterogeneous batch of producers, say, multinational from several
different countries and representative of one or two Mexican "Grupos"
is reduced to a smaller, more homogeneous group. This very reduction
in size and diversity could lead to oligopolistic pricing behavior in thefree trade scenario when such an agreement could not be maintained
before. Equilibrium price could even rise (given the extremely low
elasticities between imports and domestic production mentioned above)in some instances, moving the economy farther away from thecompetitive equilibrium. In the Cox-Harris terminology, the pricing
behavior may actually be endogenously related to the number of firms,
with a reduction in the number leading to more collusive behavior.

M. Conclusions and Alternatives
In conclusion, I would offer several cautions to those considering

the Harris and Cox framework for modeling the impaet of tradeliberalization or FTA formation on developing economies, and twosuggestions for how to cautiously proceed in this important area of
research. First, it must be understood that the chief source of gains
from liberalization in this framework is not the economies of scale
themselves, but the breaking down of oligopolistic pricing structures,and the estimates are quite sensitive to this assumed parameter.
Secondly, assuming developed country technology in developing
countries results in a tendency to overstate realizable economies ofscale, and the non-linearity of the effect of this assumption on the
results argues for caution in this regard. Even more important is theempirical difficulty of separating instances of unrealized economies ofscale from excess capacity, perhaps even excess capacity caused byimport competition in a previous round of liberalization. One should
not automatically assume that developing countries are observed inA NOTE ON THE ESTIMATION OF SCALE ECONOMIES AND 271
THEIR USE IN MODELING FREE TRADE AGREEMENTS
long run equilibrium in an arbitrary base year. Also the oligopolistic

pricing assumptions and economies of scale may interact, with the
reduction in the number of producers (which coincides with the longer
production runs as part of the rationalization of production associatedwith liberalization) actually increasing the potential for collusion in
price setting in the industry, as well as joint action to erect or raise

non-tariff barriers to trade. Increased collusion may partially orcompletely offset the benefits of tariff reduction.

The difficulty in identifying excess capacity from unrealized
economies of scale is but one manifestation of a widely understood
problem. "An important assumption that underlies most cost function
applications is that all inputs are in static equilibrium. In many
instances, however, the assumption of full static equilibrium is suspect,and hence, so are the empirical results."i5 Chao and Takayama (1992)
offer a possible solution in a recent paper. "... the crucial distinction

here is that E, L, and M [energy, labor, and machinery, the threefactors of production in their model] are, respectively, replaced by E',

L', and M' in our formulation [the estimated long run equilibrium
values]..."i6 This yields a long run total cost curve C', which can bedifferentiated to give e ==(dC'/dY)/(C'/Y), the ratio of LR
marginal cost to LR average cost, when the quantities of fixed andvariable factors have been adjusted to minimize costs. They go on toestimate economies of scale for U.S. manufacturing, circa 1947'71, of amodest 13 percent.i? This sort of estimation is more difficult, but
crucial in avoiding overstated results.

A further difficulty goes back to an early article by Friedman(1955) on the problems of estimating cost curves in the presence ofstochastic disturbances to output levels. In the words of Whalley(1984), "Attempts to estimate scale economies taking this regression
fallacy into account frequently fail to find significant scale economies.

In one such recent study for Canada, Rao and Piceston (t983), whose
results were not available to Harris, find slightly diminishing or

constant returns to scale for both durable and non'durable
manufacturing (Harris's increasing returns industries) and slightly
increasing returns to scale for non-manufacturing industries (Harris's
15 Brown and Christensen, (1981). p.209.

16 Chao and Takayama, (1992) p 333.
17 op. cit.

K.MCCLEERYROBERT

272

constant returns industries)." Such a gross reversal of a crucial

parameter indicates the dangers in making sectoral policy
recommendations based on such estimates.

And finally, this line of research leads one away from a
consideration of the dynamics of adjustment (including savings andinvestment behavior, labor supply responses, etc.), international factor

flows (capital, labor, and technology), and evaluation of the impact oftrade liberalization on specific groups (labor types, owners of mobile
and immobile capital, etc.) and thus on the political economy of trade
agreements.'8 These issues have received relatively less attention, but

may prove more important to our understanding of the motivations forand impacts of trade agreements than economies of scale. The view ofmainstream trade theory toward these dynamic effects is illustrated ina quote by Robson in a book on the economics of international
integration: "The whole issue of these `dynamic' effects is fraught withdifficulty and it is proposed to disregard them from this point in thischapter on the ground that, whatever its importance, and it may bevery great, economic analysis has not so far shown itself capable ofthrowing much light on them." Thus economists are looking foranswers where the "light" is best (where familiar analytical tools canbe used), knowing full well that their analysis is therefore incomplete
at best.

The criticisms levied here should certainly not be taken as an
excuse to return to the comfortable static, competitive models of thepast, but rather to better integrate the "no longer quite so newinternational trade theory" with both the traditional H-O-S theory ofcomparative advantage and with new developments in dynamic
modeling, including endogenous growth theory. It is entirely
appropriate for a pathbreaking work like the original Harris andCox-Harris papers to focus attention on a formerly overlooked aspectof trade liberalization, but not for others to generalize their model
beyond its intended scope and use it for,studies aimed at effecting
policy formation in developing countries.

18 See McCleery in USITC 1992, and Hinojosa Ojeda and McCleery inal. 1992.

Bustamante et.

273
A NOTE ON THE ESTIMATION OF SCALE ECONOMIES AND
THEIR USE IN MODELING FREE TRADE AGREEMENTS

References[1]

Adams, F. Gerard, Mario Alanis, and Abel Beltran del Rio, "The Mexico-UnitedStates Free Trade and Investment Area Proposal: A Macroeconometric
Evaluation of Impacts on Mexico," Journal of Policy Modeling, February 1992,
14, pp.99Tl19.

[2]

Armington, Paul, "A Theory of Demand for Products Distinguished by Place of[3]

Production," JnternationaZ Monetary Fund Staff Papers, March 1969, 16, pp.159'78.
Balassa, Bela, Trade Liberali2ation arnong Industrial Countries: Objectives andAtternatives, New York: McGrawfiHill, 1967.

[4]

Brown, Drusilla, Alan Deardorff and Robert Stern, "A U.S.-Mexico-Canada Free

Trade Agreement: Sectoral Employment Effects and Regional/Occupational
Employment Realignments in the United States," in National Cornmission for
Employment Policy, The Emploblment Effects of NAFTA: Recommendations and[5]

Bachground Studies, Special Report No.33, October 1992.
Brown, R.S. and L.R. Christensen, "Estimating Elasticities of Substitution in a

Model of Partial Static Equilibrium," in E.R. Bernt and B.C. Fields, eds.,
Modeling and Measuring Natural Resource StLbstitations, Cambridge, Mass: MIT
Press, 1981.

[6]

Chao, C.C. and A. Takayama, "LongNRun Output Elasticities of Factor Demands,

Non-homotheticity, and Scale Economies in U.S. Manufacturing," Journal of
Institutional and Theoretical Economics, June 1992, 148, pp.332T46.

[7]

Congressional Budget Office, Estirnating the Effects of NAFTA: An Assessmentof the Econornic Models and Other Ernpirical Studies, Washington D.C.: CBO,
1993.

[8]

Corden, W.M., "Economies of Scale and Customs Union Theory," Journal of
Political Economy, May/June 1972, 80, pp.465T75.

[9]

Cox, David and Richard Harris, "Trade Liberalization and Industrial
Organization: Some Estimates for Canada," Journat of PotiticaZ Econorny,
February 1985, 93, pp.115-45.

[10]Ethier, Wilfred, "Internationally Decreasing Costs and World Trade," tJournal ofInternational Economics, August 1979, 9, pp. 1fi24.

[11]

Friedman, Milton, "Comment on Statistical Cost Curves," in Business
Concentration and Price Policy, A Conference, Princeton, NJ: Princeton
University Press for the NBER, 1955.

[12]

[13]

Harris, Richard, "Applied General Equilibrium Analysis of Small Open
Economies with Scale Economies and Imperfect Competition," Arnerican
Econornic Review, December 1984, 74. pp.1016732.
Helpman, Elhanan, "International Trade in Presence of Product Differentiation,

Economies of Scale and Monopolistic Competition: A Chamberlain"HeckscherOhlin Approach," Journal of International Econornics, August 1981, 11,
pp.994-1008.
[14]

Hinojosa'Ojeda, Raul and Robert McCleery, "U.S.LMexico Interdependence,
Social Pacts, and Policy Perspectivesl A Computable General Equilibrium
Approach," in Jorge Bustamante, et. al., eds., Labor Marhet Interdependenee,
Stanford, CA.: Stanford University Press, 1992, pp.113-154.

[15]

Krugman, Paul,'"Increasing Returns, Monopolistic Competition, andInternational Trade," Journal of International Economics, November 1979, 9,
pp.469-79.

ROBERT K.MCCLEERY

274

[16]

, "Scale Economies, Monopolistic Competition, and the Pattern of Trade,"
Arrterican Econornic Review, September 1980, 70, pp.950-59.

[17]

Lancaster, Kelvin, " Intra-Industry Trade Under Perfect Monopolistic[18]

Robson, Peter, The Economics of International Integration, Londonl George[19]

Allen & Unwin, !984.
Trela, Irene and John Whalley, "Trade Liberalization in Quota Restricted Items:
U.S. and Mexico in Steel and Textiles," The VVorld Economor, January 1992, 15,Competition," Journal of International Economics, April 1980, 10, pp.151'75.

pp.45-63.
[20]
[21]

Tybout, J.R. "Linking Trade and Productivity: New Research Directions," VVorld
Banh Econornic Review, May 1992, 6, pp.189'211.
United States International Trade Commission, Econorrtbl-wide Modeling of the

Econornic Implications of a FTA with Mexico and a IVAFTA with Canada and
Mexico, Washington D.C.: U.S. International Trade Commission, 1992.
[22]

Whalley, John, `Trade, Industrial Policy, and Canadian Manufacturing' byRichard G. Harris (with the assistance of David Cox): A Review Article,"
Canadian Journal of Economics, May 1984, 17, pp.1-13.

BUSINESS
KOBE ECONOMIC&REVIEW

CONTENTS
NO. 31 (1985)
Toward the Negative Picture Theory of Commercial
Double-entry Bookkeeping and Financial Accounting '''''"''''"'''''''''''Isao Nahano
Stability of the Demand for Money: Australian Experiences''••'''''''''''Kenichi Ishigaki"Empirical Study of Changes in Accounting Policy" in the Case ofJapanese Enterprises ''"'"'''"'''''-""'"''''"'"""""''"''''"'-'••'"'''''•Hidetoshi Yamoji

An Empirical Study on International Short-Term Capital
Movements in Japan'''''''''''"'''"'"'''"'''''''''"'"'"'''''''"'''''''"'-'''''"'''''Hidehi Izawa

NO. 32 (1986)
Import Demand Structural Change in the PacificBasin Countries ''''''''"''''"'"''''-''"''''"''-'•"'''-••''''"'••''''''••"'''"'•Seitchi Katayarna

Kenichi Ishigahi
A Synthetic Analysis of Structuralist and Monetarist
Theory of Latin American Inflation '"''•••""'•••"'''••••'•••••-•'''•••••-"•Shoji Nishijima
StagflationmCauses and Policies- •'""''-''"''''•'''"''••"""••''""••`"'"'••'''''Nobuo Okishio

A Computabie General Equilibrium Model of theJapanese Economy'•""'''"'"'''''''''-'"'''-''""''''"''"''''•'"''"•'''""'•'''""Mitsuo Ezaki

NO. 33 (1988)
Agency Problems and Accounting Communication'''''''''''"'''"'''''""''"""'Isao IVahano
Strategic Corporate Innovation andJapanese Management ""'"'''''''''-''"'''''''"'-'''"'''"'''''"''''"''''"''Hideki Yoshihara

Financial Deregulationi and Financial
Relationships Between Japan and Australia ''-'""""••"""••"""'••"Kenichi Ishigaki
Keynes' User Cost and the Theory ofInternational Trade "''''''''''''''"''''''''''''''''''''"''''''''''"''-'"''''"''Kazuo Shirnomura

A Note on International Transmission ofDisturbances and Policy Interdependence
under Flexible Exchange Rates ''"'"'''''""''''"''''"'-'''''''-"''''''"'''''"''Hidehi IzaLva

Monetary Policy and Foreign Disturbances

in a Small Open Economy under Flexible
Exchange Rates and Rational Expectations''"''''"'''''''"'''"""''-"''''''Hidehi leawa
A Sketch of the Theory of Trade Cycle '''"''-"'''''-"''"'""''"'''-"'"-'•'''''IVobuo Okishio

NO. 34 (1989)
Recent Inflation of Land Prices in Metropolitan

Areas of Japan-A Case Study of Regional Accounting- "'''''''''"""'''"''''''''"'''''''Nobuko IVosse

Little Basics and Emloyeeism

Japanese Management inInternationa1 Perspetive"''''''"'`"""'-'''''''-'''''''''•'''"''"'''"''''"'''''Hiedhi Yoshihara

Bank's Loans to Developing Countries:
A Normative Approach''''''""'"'''-''"''''''''''''''"''''"''''"''''"''''"'"''Ka2uhiro Igawa

Japan's Trade Diplomacy:
Yesterday, Today, Tomorrow ''""''"'''''''"''''''''''"'''''''"''''''''''"''"'Peter Drysdale

A Labour Union in Every Country-A Game-Theoretic Approach-""'""""'""''"''''"''''"'''''-''''''"Kazuo Shirnomura
The Costs and Benefits for Firms of
Accounting Information Disclosure''`''''`''''''"'"-'''''''''"''''"''''''''Hidetoshi YamaJ'i

Increasing Returns to Scale and Optimal
Investment Policy of the Regulated Firm'''''''''''"''''''J"''''"''''"''Seiichi Katayama

Fumio Abe
Problems and Method of Economics'''"'''"'"'"'''"'''''"'''''''"''''"'''''''"''Nobuo Ohishio

Industrial Organization and International Trade-Textile Industries in theWestern Pacific Region- ••"'''"•"""'"'"'''''-'""''"'''''""'"'"'"''"""Katuhiho Ikeda

NO. 35 (1990)
Some Implications of the Present-Value-

Based Depreciation Within the
Historical Cost Framework '''''""''"'''-'"'--'''"''L''''"''''"'"''''"'"''''"''Isao Nakano

Foreign Subsidiaries as Contributors

to Parent Companies-A New Paradigm of Multinational
Enterprises- '••••"'"•••''"'''""""""'''''''''''''''"''''''"''""''""'''''"''Hidehi Yoshihara

The Gains from Free Trade for a Monetary
Economy''"'"'''••''••''••••••"'••-""••-'''"-'"'''''''''"''"'''''''"'"'''''''''''Murray C. Kernp

On the Optimal Timing of Foreign Aid '"'"""'"'''''"'''"'"'"'"'"'"'"''Murray C Kernp

Ngo Van Long
Kazuo Shimomura
A simple Union-Ridden General
Equilibrium Model-"'''''"''''"''''""''''"'"'''-"'"''''''"'''••''"'''•"'''Kazuo Shimornura

Industrial Policy under International
Oligopoly ''"'"'"'"'-'''''"'''"''''''"-'H'"''''"o''""''"H''''''''--"''"-''''"''Kenji Kojirna

Realtime Distributed Control of World Link Models
in the International Computer Networks''"'"'"'''''''"'""''"-""''"''''"'-KTo Miyazaki

NO. 36 (1990)
Outward Direct Foreign lnvestment 'and Structural Adjustment in a
Small Open Economy""'"'"''''"-''"''"'""''••'"'`''•''"'''';"`"H••''`"'••"'Chung H. Lee

An Approach to Transaetion
Contracts with Asymmetric
Information'''""'"''-''"''"'"'''''""'"''"'"''''''''''''''''"'"'"'''''''"'''''`''Kazuhiro Igawa

A Mathematieal Note on the
Impossibility of Global Absolute Advantage '''•"''"''-"''"'•'-''''Kazuo Shimomura
On Reform of the International
Monetary System: A Survey''H''"''"'•'''"'"••"'''''••''"''•'"'''''•''"'''••'"''Hidehi Izawa

NO. 37 (1992)
Corporate Behaviors on Disclosure of Social Responsibility

Information and Distrust Dissolution Accounting-A Survey of Researches Not Based on Rigorous Models ''"''''"'"''Isao Nahano
Local Entrepreneuership and Reverse

Technology Transfer-Messages
from Foreign Companies in Japan-••••"''••••••'''•••••'"•••'"-"•"'""Hidehi Yoshihara

The Forms of Enterprises and Transactionsin General Equilibrium: A Note on
Analytical Framework ''"'''""''-"'''''•••'''''•••••-'''••+•''''•••••''''••••''''-•'Ka2uhiro Igawa

A Note on the Flatness of theTransformation Surface ''''""'''••''"''•••'''''-•••+•••'•-•••••'••••''"'•••"''Ka2uo Shimornura

The Long-Term Relationship in theJapanese Distribution System:
Game-Theoretic Viewpoints'''''•••'---''••••''"•••••••"-•••••'"-•'''"''''"''''''''''KenJ"i Koiima

Recent Developments in the Theoryof Trade with ImperfectCompetition "•••'•-''••••••••••••••-••••••••••••••---••'••••••+''•••'-"'••-"'"'••'"''Winston W. Chang

Long-term Expectations and Ecnomic

Seiichi Katayama

GrowthmA Post Keynesian Theoryof Long-term Growth- '•+•••'-"••••••••••••••••'•-•••••''••••••'-•••••''''•-••••"-'Hideyuhi AdachiKOBE UNIVERSITY ECONOMIC REVIEW 39, 1993
Edited by Faculty of Economics,
Kobe University, Kobe, JapanCONTENTSWAKON YOSAI, the ldeology of .
Japanese Economic Development '•••'"'••••-''•••••••'"''''•'''''''''''"''Tadahiro Uematsu
A Model of Stagflation'-''''"'''''''''''''''"-•'''''••••''"'•••"`''''••"'''''•'"''''•Takeshi Nahatani

Key Currency System and Asymmetry
in the International Monetary System '''''''''''"''''"'''-"''''"-'''"''-'''''Seiichi FuJ'ita

Hospital Purchase Records Containing 'Grain Price Information in FifteenthCentury Ghent ''""""'"'"'""''"'''''''""''''-''''''"'''''''"'''''''•'"''''''Takashi Ohunishi

Analyses on the International Accounting Matrix''''""'''"''''"''''"''Kunikazu Tanaha\NNNNNNNNAr/NNNN;ArrN)\NNNNNNNNNNNNNNNNNNNNNNNN
The ANNALS OF THE SCHOOL OF BUSINESS ADMINISTRATIONKOBE UNIVERSITY No.38, 1993
Edited by the School of Business Administration,
Kobe University, Kobe, JapanCONTENTS
Sharing Naive Causal Models in an R and D Setting:

What Is Good for a Company May or •May Not Be Good for Individuals ''"''''''''''''''''''''''"'''''''''''''''"'''Tadao Kagono

Toshihiro Kanai
Organization Design Under New Technologies:
Towards Humanization of Work '"''''''""'''-"''''"'''''''"''''"'''"Norio Kambayashi
On the Fusion of International Transport Markets''"'"''''''''''"''''''''Kunio Miyashita

Buyers in Big Retailers;
Their Source and Content of Information "''"'''''"''''''''""''''''''"'Susurnu Ogawa
Toward a Theory of Hierarchical Decentralization '"'''''''''''''''''''"''''''Hideo Suehiro

KOBE UNIVERSITY LAW REVIEW 27, 1993
International Edition No. 27, 1993
Edited by Faculty of Law Kobe University, Kobe, JapanCONTENTS
Toward a New Framework of Administrative Law'''''''•-'''''''''''"''''''"Yasutaka Abe

Verbraucherschutz und neue Aufgaben desVertragsrechts in Japan ''"'"''•'"''''"'''''''•'''''"••''''''•+'''"''''"'''''Tamotsu Isornura

Candidate Evaluation and Voting Choice under theJapanese Electoral System''"''•'"''"••''"'•••"''''•+•''"''"'''''''''"'''''''''''Ichiro Miyahe

ECONOMICS ANDRESEARCH INSTITUTE FOR
KOBE UNIBERSITY
BUSINESS ADMINISTRATION,k,ggg,i.

Z,:.L-lj, S.l,ii, :ll' 'I{Ig-/r...

asie'

ny
'
•tw$•,'HISTORICAL SKETCH
In 1919, a research organization named the Institute for Commerce
was founded in Kobe Higher Commercial School, one of the chief
predecessors of Kobe University, with a gift made by F. Kanematsu &Company, a leading mercantile firm in Kobe. The orgamzation was
designed to carry on and facilitate integrated research on business andcommerce and to formulate and publish the results of these studies andinvestigations in such form as to make them available to the business

communlty.
With the founding of Kobe University of Commerce, successor of
Kobe Higher Commercial School, in 1929, the Institute extended its
research activities by adding several divisions. One was the famous
Latin-American Library, which soon became the center of research inthis field in Japan. A room for statistics equipped with various
computing machines was established and began publication of Ju'

Keizai T6kei and Sekai B6eki T6kei annually. A filing room was
prepared to deposit press clipping files systematically arranged by
topics and dates. Another room was designed to become the center ofall possible original records and data having to do with the beginningand progress of Japanese business.

yoOn the campus of Kobe University of Commerce, anotherorganization named the Institute for Business Mechanization was
founded in 1941 utilizing business machines donated by the IBM
Corporation and others. With Professor Yasutaro Hirai as its head abroad and forward-looking plan for business mechanization in Japanwas developed.

In 1944, Kobe University of Commerce changed its name to Kobe
University of Economics. After the War, however, the University was
consolidated with three other colleges in Hyogo Prefecture to become
Kobe University. With this development, the two Institutes were also
amalgamated into the Research Institute for Economics and Business
Administration, Kobe University. At present, the Institute, with its
twenty-three full-time professional staff members, carries on studies

and investigations in international economics, international
environment, international comparative economics, international
business, management information systems and international
cooperatlon.

ORGANIZATIONThe Institute consists of six sections. Each section and its researchsubjects are as follows:

1. International Economic Studies
International Economics, International Monetary Economics,

Maritime Economics, International Labor Relations
2. International Environmental Studies
Resource Development, International Organizations,International Industrial Adjustment
3. International Comparative Economie Studies
Pacific Basin I (Oceanian Economy),
Pacific Basin ll (Latin American Economy),

Pacific Basin M (North American Economy)
4. International Business Studies
Comparative Business, Multinational Enterprise,International Business Finance5. Management Information Systems
Business and Accounting Information, Information Processing
System, International Comparative Statistics
6. International Cooperation
In addition to the ordinary work of each section, several

research committees, whose members are not limited to theInstitute staffs, are regularly held to carry on joint studies.

At present, there are ten standing research committees, as
follows: Committee of International Economics, Committee of
Maritime Economics, Committee of Labor Market, Committee
of International Studies on Economic and Industrial StructUre,
Committee of World Link Model, Committee of International

Comparative Economics, Committee of International
Comparative Monetary Systems, Committee of International
Business Finance, Committee of Management and Accounting

Information Systems, and Committee of International
Comparative Statlstlcs.
For convenience and greater efficiency in carrying out its
research activities, the Institute has a general office which is

responsible for 1) the collection and preservation of acomprehensive collection of books, periodicals, pamphlets, andoriginal records and data of finance, trade, commerce,industry and business generally; 2) the classification,
cataloguing, indexing, arranging, annotation and compilationof these research materials; and 3) the formulation andpublication of the results of the investigations and studies

accomplished by the professional staff members of theInstitute.

As an affiliated institute the Documentation Center for'

Business Analysis has been established in 1964. It is the firstsystematic information facilities in the field of businessadministration in Japan that has been recognized andauthorized by the Ministry of Education. The purpose is tocollect and to make intensive control of all kinds of materials

on business administration and to make them available toscholars, universities, governments, and business world withthe aid of modern documentation techniques.

RRESEARCH INSTITUTE FORECONOMICS & BUSINESS ADMINISTRATIONKOBE UNIVERSITY
Director: Hideki YOSHmARA
Secretary: Syozo SAITOINTERNATIONAL ECONOMIC STUDIESInternational Economics Prof. Kazuhiro lGAwA
Assoc. Prof. Robert Kenneth MCCLEERYInternational Monetary Economics Assoc. Prof. Hideki IzAwA

Maritime Economics Assoc. Prof. Masahiro ToMITA

International Labor Relations Prof. Hiromasa YAMAMoTo
Assoc, Prof. Kazuo SHIMOMURA
Prof. Kouji SHINJo

INTERNATIONAL ENVIRONMENTAL STUDIES

Resource Development Prof. Shigeyuki ABE

Research Assoc. Akihiro NAKAHARAInternational Organizations Assoc. Prof. Junichi GoTo
International Industrial Adjustment Prof. Hiroshi SADAMIcm

Research Assoc, Ko MIYAZAKI
Prof. Makoto lOKIBE

INTERNATIONAL COMPARATIVE ECONOMIC STUDIES

Pacific Basin l Prof. Kenichi lSIGAKI(Oceanian Eeonomy) Research Assoc. Ryuzo MIyAO
Pacific Basin ll . Assoc. Prof. Shoji NISHIJIMA(Latin American Economy)

Pacific BasinM Prof, Seiichi KATAyAMA(North American Economy)

INTERNATIONAL BUSINESS
Coniparative Business Assoc. Prof. Kenji KoJIMA
Multinational Enterprise Prof, Hideki YoSHI}IARA
Assob. Prof. Mohammad Sikander KHANInternational Business Finance Assoc. Prof. Hidetoshi YAMAJI

MANAGEMENT INFORMATION SYSTEMSBusiness and Accounting Information Prof. Isao NAKANo

Information Processing Systems Prof, Komayuki lTow
International Comparative Statistics Prof. Yasuo KONISHI

Prof. Takeyuki TANIINTERNATIONAL COOPERATION Prof. Keizo NAGATANIDOCUMENTATION CENTER FOR BUSINESS ANALYSIS
Assoc. Prof. Norio OBATA
Office: The Kanematsu Memorial Hall

KOBE UNIVERSITYROKKO, KOBE, JAPAN