ISSN oo75-6407

ECONOMICBUSINESS&REVIEW
45th

ANNUAL VOLUME
tggre1Ie2e

RESEARCH INSTITUTE FOR ECONOMICSAND BUSINESS ADMINISTRATIONKOBE UNIVERSITY
2000

Discretionary Accrual Models and the Accounting Process'
Correctionsa) Lines 1-2 in page 107 should be changed as follows

Dep :arnount ofdepreciationb) Footnote 2 in page 107 should be deleted

Conclusions remain unaltered with or without the corrections.
Results are available from the authors on request.

KOBE ECONOMIC & BUSINESS REVIEW
Editor in Chief

Kazuo Shimomura
Co-Editors
Junichi Goto; Kenji Kojima; Takashi Kamihigashi

ISSN O075-6407

KOBE
ECONOMICBUSINESS&REVIEW
45th

ANNUAL VOLUME,teh"S

IIilliiOe"s.a.

Dstr1!SYRESEARCH INSTITUTE FOR ECONOMICSAND BUSINESS ADMINISTRATIONKOBE UNIVERSITY
2000

CONTENTS

Page
Imperfect Substitutes and Strategic Trade Policies under Cournot Duopoly:

MathematicalNote """""""""""""'SeiichiKATAYAMA/HiroshiOHATA 1

Shifts in the Japanese Corporate Governance-•-•••••••••---•••-t-••-•••--•-•-•---••••••••••--""-•'KenjiKOJIMA 15

FSC Certification in Japan: An Uncertain Future-••••••••-•-•••••---••••-••-•-••--•--•""'"-•••-••-"AkiraKAJIWARA 39

The Long-Run Impact of APEC Trade Liberalization on Real GDP

and Sectoral Adjustments•"'"HiroLEE/DavidROLAND-HOLST/DominiqueVANDERMENSBRUGGHE 57

Monetary Cooperation in East Asian Countries:

A Possibility from Macro Economic Indexes and Intra-Regional Trade Dependency•••••••••••••••••••••••••••••••••••••••••••••••••••Bong Gil KIM /Kazuhiro IGAWA 85

Discretionary Accrual Models and the Accounting Process .
••••""•Xavier GARZA-GOMEZ / Masashi OKUMURA / Michio KUNIMURA 103

KOBE ECONOMIC & BUSI2VE]SS REVIEW, 45(2000), l-13

IMPERFECT SUBSTITUTES AND STRATEGICTRADE POLICIES UNDER COURNOT DUOPOLY :MATHEMATICAL NOTE (")

SEIICHI KATAYAMA Kobe University
HIROSHI OHTA Kobe University

Abstract
This is a mathematical note for our paper "Imperfect substitutes and strategic trade

policies under Cournot duopoly". The main proposition of the paper is that undercertain conditions an export subsidy improves the world welfare. The whole
propositions are rigorously proved including the uniqueness for Cournot duopolyequi}ibrium solution.

JEL claasification: F12, F13
Keywords: strategic trade policy; differentiated gQpds

1. Introduetion

Despite many criticisms of its general validity strategic trade policy

arguments shed light on some aspects of modern world trade (see forexample, Krugman (1993), and Feeney and Hillman (2000)). In our recent
paper a general reciprocal market model is built to investigate welfare
consequence of trade policies in a formal model (Uekawa, Katayama andCorresponding Address:
Seiichi Kat•ayama
Research Institute for Economics and Business Administration (RIEB), Kobe University,
2-1 Rokkodai-cho, Nada-ku, K•obe 657-8501, Japan

E-mail: Katayama@rieb.kobe-u.ac.jp
Phone/Fax: 81-78-803-7000
Hiroshi Ohta
Graduate School of International Cooperation Studies, Kobe University,
2-1 Rokkodai-cho, Nada-ku, Kobe 657-8501, Japan
E-mail: ohta@rose.rokkodai.kobe-u.ac.jp
Phonetsax: 81-78-803-7109* Acknowledgement
The research is partly funded by the Grant-in-Aid for Scientific Research of Ministry of
Education (12630009-OO). The authors are grateful for it.

KOBE ECOIVOMIC & BUSINESS REVIEVV, 45(2000), 1-13

2

Ohta (2000)). It is shown that under certain conditions an export subsidy
improves the world welfare.

The model and propositions are expanded but the rigorous proofs forthese results are not given in the paper due to its space limitation. Though

they are somehow technical, the proofs themselves have their own value tothe interested readers and should be kept somewhere. Thus, this note is themathematical appendix to the paper.
All the symbols and the number of equations are the same as in the maintext. And note that the propositions in Uekawa, et.al. (2000) are stated withthe proofs.

2. The model
Consider a two-country trade model as follows. There are three goods (Z,X andY). Good Z is competitively produced in the two countries underconstant returns to scale and is taken as the numeraire in both countries.

Good X is produced by one imperfectly competitive domestic firm and good

Y by another imperfectly competitive firm in the foreign country. They
behave in a Cournot fashion,

Cost functions of good X and Y, clenoted by c (X) and c*(Y) , arecharacterized by'c' (X) >O, c" (X) <O and c*' (Y) >O, c*" (X) <O(1)

where X=x+x* is the total output of good X, and x and x* are domestic
and foreign sales, respectively, by the domestic firm. Throughout, a starredvariable denotes the entity in the foreign market. Similarly, Y =y +y* is
the total output of good Y produced by the foreign firm, and or and y* areits sales to the home and foreign markets, respectively. Note that we
presume in condition (1) increasing returns to scale in production for somereason, for example, sufficiently large fixed costs for both firms.

The social utility functions for the two countries are assumed to take thequasi-linear formU(x, y, 2) == u (x, y) +z

and

(2)

U(x*, y*, z') == u'(x', or') + z',

KATA YAMA & OHTA:IMPERFECT SUesTITUTES AND STRATEGIC TRADE POLICIas UATDER COURNOT3DL]OPOL Y

where x, y and z are consumption levels of goods X, Y and Z in thedomestic country and those with stars correspond to the foreign entities.
Assume that the sub-utilities in (2),namely, u(x, y) and u"(sc', y') are
increasing and strictly concave such that for i, i=1, 2,

u,>O,u:•>O and u,<u,i<O,u:-<u;•<O, (3)where u, is the partial derivative of u(x, y) with respective to its ith
argument, i=1,2: for example, u,==0u/0x and u,,==02u/OyOx. Since good

Z is taken as the num6raire in both countries, PZ == PZ"i 1,whereP
Z(respectively, PZ*) is the price of good Z in the home (foreign) country.

We see from the above assumptions on the social utility functions that theinverse demand functions of goods X and Y are obtained as
PX (x, y) = u,lPY (X, Y) = U,
pX" (x *, bl *) =u: ; PY* (x *, y*) =u; .

'Consider domestic import tariffs and export subsidies as the trade policy

instruments. For simplicity we assume that the foreign country imposes
neither import tariffs nor export subsidies under any circumstances. In
other words, the foreign country is passive in its trade policies. Let thedomestic import tariff be denoted by t and the domestic export subsidy by s.
Thus, the profit of domestic and foreign firms are expressed, respectively,by

V (x,x*,y*, y) =xPX +x*PX'-c (x+x*) + sx*
V*' (x ,x *, y*, y) =y *PY" + yPX- c*(1y+ y*) - ty,
3. The Propositions and the Proofs
Proposition 1. The Jacobian rnatrisc A of the equation system (7) is an N-P
niatrix. Therefore the solution, if any, to the system (7) is unique. (See,
Nikaido 1968, p. 371.)

Proof (Appendix 1 to the main text): The system of equation (7) is:4

KOBE ECONOMIC & BUSIAIIi SS REVIEVV, 45(2000), 1-13

V, =I)X +xPi -c' =O
V,= PX* +x*P,X *• - ct +s =o

V3" == PY' +y*P2Y* -c*' =O(7)

V,* = PY + yP,Y -c*' -t =O.
We shall show that the Jacobian matrix A is an N-P matrix. Let us defineA(r) for O< r<1 as follows
A(,) .. [q"ICi',ipti ,:, .-,crlC,I+l. p{.*,s,-,7.0v,?.D...l -r,ol':, 1 (Ai)

L rVt, O -7c*" q22-c*"+P2Yj
Since we know from (9) thatlq,,-c" +pt, 1-l-rc" L -1 rVi4 l=-{qii- (1 + r) c" +PXi- rVi4}>O
jq:, -c" +Pi,r1-1- rc"I-1 rV,,I=-{q:,- (1 + 7) c" +Pl,` rV,,}>O
lqS, -c *" +PiCime1' rc *"1-1rV321=-{q2"2- (1 + 7) c*" +PV2'- 7V32 }>O

1q,,-c *" +P,'l-I-rc *"i-1rV;,I=-{q,,- (1 + 7) c*" +P2Y- rV,*, }>O,

the transposed matrix A( r)' for O < r <1 has dominant diagonals andtherefore is non-singular. Since IA( r) i is a continuous function of r forO< 7<1 , we see thatsign IA(O)l = sign iA(1)1 == sign IA 1.
Thus, since 1A(O)l== V,,'V,,'V,', 'V,', >O, we see that IA 1>O. Furthermore,

all principal submatrices of A have dominant diagonals and therefore all
principal minors of order 3 are negative, those of order 2 positive and all
diagonal elements negative. Hence, A is an N-P matrix and the solution to
the system of equations (7) is unique.
Assumption l pt," < V,, and PV2' < VS2
Proposition 2 Suppose that either c" or c*" is negative and Assumption 1

KATA YAMA & OHTA:IMPERFECT SUnsTITUTES AND STRATEGIC TRADE POLICIas U,VDER COL]RroT DUOPOL
Y
5

is satisfied. Then a rise in the domestic import tariff increases theconsumption of good X in both countries and its output by the domestic
firm, and reduces the eonsumption of good Y in both countries and its
output by the foreign firm. Also, the tariff increase raises the sales
revenue of the domestie firm and reduces that of the foreign firm.
The proof is given with Assumption 1 in Uekawa, et. al. (2000).

Assumption 2 Pi < V,, and P2Y < Vr4
Proposition 3 Suppose that either c" or c*" is negative and Assumption 2
is satisfied. Then an increase in the dornestic export subsidy increases theconsumption of good X in both countries and its output by the domestic
firm, and reduces the consumption of good Y in both countries and its
output of the foreign firm, Also, the increase in the subsidy raises the total

sales revenue of the domestic firm and decreases that of the foreign firm.

Proof (Appendix 2): From the system (IDwe obtain the following.
Xs (t,S) = -A,, /IA 1(A2)=- [c" (V,', V',, -c*"2)+c*" V,, V,, ]/IA1>owith equality only if c" == c*" =O,
x,' (t,s) == -A,, /IA i(qn - C"){V'33 (q22 -c*" +P,V) -c*"2 }+ Pi,r V,', (q,, ww c*")-c*"2 }+ V,', (Pl,( P,V-V,, V,",)>o,since qii -2c" <O, q22 "c*" <O, V,, and V',, <O from (9-1)and (9-2).
Also we have thatYs' (t,S) =-A,, /IA 1(A4)= [V',, (V,, VI, - V,, V',, )+ c" c*" Vt, ]/lA i<o.

Ys (t,S) =A,, /1A 1(A5)== [C*" V,, V',, +c" V,, Vl, ]/ A1<o,6 KOBE ECOAIOMIC&BUSINESS REVIEW, 45(2000), 1-13

with quality only if c" =c*" ==O holds.
Therefore, it is immediately known that

0X/0s =' X, =x,+x,' >O and 6Y/6s =- Y,=y, +y; <O. (A6)
Furthermore, if the initial rate of export subsidy is less than the marginal

cost of the domestic firm and the tariff rate is nonnegative, it is shown
from (7) that
5 [PXX(sc, y)x + PX'(x', y')x' ]/ == c' x, + xpt, y.

+(c' -s)sc ,'+ x'P'f,'y,' (A7)>oandO [p'(x, y)x + PY(x", y')y' ]/0s == (c *' + t)y, + yPl xs+c*' y,' +y'P,' x,' (A8)<oProposition 4 In the case where the cost functions are tinear in the globat
sense, a full optimum calls for positive tO and sO.

Proof (Appendix 3): Using (4), (7) and (19) we obtain

OW/0t E W, = (PX- e' )x,+ y{1- (P,Yx,+ P,Y yt)}+x*P{iy:+ ty,- sxr +xr (x *pMr +px'-c' +s) (Ag)=- M + tyt- sxt'.
Here from the first order condition sc *pt,'+ PX'- c' + s = V, == O is used,andM i (PY - c' )x, + or {1- (Pi x, + P,Y yt)}+x*P'F,'yt' . (AIO)
Putting W, =O , we have that tyt - sxt' = -M.
Differentiating W by s, we have
0W/0S i W, = (pt - C' )X,- Y(pt, X, + pt2 Ys) +X*pt2'Ys'+ tbl. -sx,* +x,'(nc 'Pt,C +.PX" nt c' +s) (All)KA TA YAMA & OHTA :IMPERFECT SUesTITUTES AN-D STRATEGIC TRADE POLICiES UNDER COURNOT7 DUOPOL Y=' N + tys un sscs'

Here from the first order condition x*P,*+ PX' - c' + s..

V2 =O is used,andN i (PX - c' )x. +y{1- (Pl nc, + P,'y.)}+x*pt,'y.: .

(A12)

Putting W, := O, we have that ty, - snc,' =- N.

For the full optimality, Wt = VV, =O. Therefore,
W,(t, s) =M + tort - ssct' :== O,(A13)

W,(t, s) =N + ty, - sx,* =O.

(A14)

Let B !f- Yt X:1 and express (A13) and (A14) as

L-ys x,"].[g]..[y](A15)The sign of 1Bl is indeterminate, therefore the uniqueness and the sign ofthe solution (tO, sO) to the system in (A15) are in general indeterminate.
Hence in the following we consider the special case where c"(X) =:: c*" (Y)=: O, i.e., linear cost functions in both countries. Then we have x: ==y: =x,== y, == O, and 1B i == -y,x,' >O. The solution (tO, se) to the system (A15) isdetermined by[gZ],..i.i-i[XSIIX,][llU]1==i.i-i[gS'rm8,][[U]1 (Ai6)

Namely,tO == lB 1"ix,'M and sO = m lB I- iytN .

As we show in Appendix 4 below, it is revealed that M>O and N>O. Thus,
we havetO == x,'M/ 1B I>O and sO = - y,IV/ IB l>O .

KOBE ECO.NOMIC & BUSINESS REVIEW, 45(2000), 1-13

8

Derivation of M>O and N>O. (Appendix 4):
Using the fact that the (4, 4) th element of AATi is 1,
1= V4', xt - e *"yt' + V'4 4yt = Vti xt ` c *"y: + (q,2 + PY, - c *" )bl, .

Therefore,

1- (Pi x, + P,' y,)=hP,Y xt + Vt, xt "c*" yt' + (q,, -c*")= (- P; + Vt,)x, + ([y, - cv,')c*" + (P,, - 2c *")y,,
Since rPi' + V;, >O, and yt -yt' <O as seen below,
1- <Pl' x, + PSr' y,))O,
Note on y, r yt' <O :Yt rm st = Vn(PI' V3'3 - V3'2 V23) - V3'3(Vll(q;1 mC") -C"2) mC*"(VllV22 rm C"2) -C"V3'2 V14= Pi P{' (q,', r 2c *") + P]I,' (q,, rm c")(q,', rm c*")+(V3'3 wu c""){(q,, - c")(qr, -c")-c*" }+ {V3'3 l'l," (qr, - C") - C" V:, V,,}+ V,, (PXr PY,' - V,*, V,3)<o.
M = (PY - c') +y{1- (PI x, + P,V y,)}+x*pt,' or: >O,

since xt >O, P'f,' <O,y: <O and PX -c' ==: -xPl,C >O.
On the other hand,N - (PX - c' )x, - y(P,Y x. + P,' y,) +x*pt2* Y; •The first term is nonnegative since PX - c'>O and x,<O (=O iff c" =c*" =O).

And the third term is positive since sc *>O, P'f,' <O and y,* <O. And thesecond term is nonnegative since P," x, + P,Y y, <O (= O iff c" == c*" == O) .

Therefore, N> O .
The following is a note on P,X x, +P,r y, <O (== O iff c" =c*" =: O).
Since the (4,2)th element of AA-' is O,- Vt, X, -C*"Y,' + VI, Y, =:O,
- (Pr + yP,Y,)x, -c*" y." + Vi, y, =O

KA TA YAMA & OHTA:1,l4PERFECT SUesTITUTES AND STRATEGIC TRADE POLICIas LLVDER COURNOT DLT•OPOL Y 9

P,Y x, + P,Y y, = - (Vl, - P,Y )x, lt c*" y,' - (q,, r c *" )y,•'• PI x, +P,Yy, <O, and ==Oiffc" =c*" ==O.
Proposition 5. Assurne that the export subsidy rate is zero. An increase in

the home country's import tariff raises its welfare if initially t issufficiently snzall. Thus the optimal tariff rate is positive.

The proof is obvious from Appendix 4 above.
The effect of tariff on the foreign welfare. (Appendix 5)

If the home country levies tariff at the free trade, the welfare of theforeign country deceases.
W,"(t, O) = y(P,V x,-1) + y, *(PV" -c*' ) - nc *(I)){,* x,* + 1)JF,' y, *). (24)Since P,V <O and x, >O, the first term is negative. PY'-c*' = -orPY,' andyt'<O , therefore the second term is non-positive.

Proposition 6. Assume that the export subsidy rate is 2ero. The irnpact
effect of an increase in the home country's import tariff on the foreign
welfare is generally indeterminate. If the cost functions are linear in bothcountries, the effect tvorhs to reduce the foreign welfare,

Proof: See Appendix 5 above.
Proposition 7. Assume that the import tariff is zero, An increase in thehorne country's export subsidy raises its welfare if initially s is sufficiently

srnall. Thus the optimal subsidy rate is positive.

Proposition 8. Assume that the irnport tariff is zero. The effect of anincrease in the horne country's export subsidy on the foreign welfare is in
general indeterminate.

Proof (Appendix 6): From (19) and (20) again, we have

L'V(O, s) =u(x, y) -yP' +x*PX' -c(x +x*) (A17)KOBE ECONOMIC & BUSINEss REVIEVV, 45(2000), 1-13

10

W'(O, s) = u'(x *, y*) -x"PX' + yPY - c(y*+N). (A18)
Differentiating W(O, s) with respect to s yields,
W,(O, s)=[(PX - c")x,-y(Pi x, . P,' y,) -x*Pl,I"y l- sx; -- IV - sx; . (A19)

As we show in Appendix 4, AI>O. In addition, x,' >O from (A3). Thus the
optimal export subsidy sOO is

sOO =N/x,* >o. (A20)
In the perfect substitute case, a sufficient condition to obtain the same
proposition as this one is given (see Proposition 7 in Uekawa (1994)). The
condition is on the relative magnitudes of the second derivatives of homeand foreign cost functions. Here without such condition, we can assert thata home country's export subsidy increases its welfare.
Next we consider the effect of an export subsidy on the foreign welfare.
Differenciating W*(O, s) with respect to s yields
W,*(O, s) == (PY" c*' )or,' + yP,Y x, 'x*(P'F,' x,*+ P'F,' y,'). (A21)
The sign of W,"(O, s) is dependent on the term (P'F,' x,' + P'F,' y,') which is thechange in export price of the domestic firm induced by the subsidy policy.
Unfortunately, the sign of this term is indeterminate in general, and so is
the sign of W,"(O, s) in turn.

Proof of the fact that if c*"<c"<O and ur, <uS, <O, then Xt + Yt <O(Appendix 7):

Vll V12 O
Xt + Yt =- "C *" V23 + V14( V22 V3'3 -V23W32)- V21 V22 V23 / 1A l

O V3'2 V33*
= [(Plir - Vi4)(V22V3'3 - V23V3'2) + V,', {(q,, -c")(q',, -c")-c"2 }+ (qii- C")(pti' PY2' h V3'2 V23) +{ (qii'C")(q2'2-C"" )P'gi"M C"C *" V23 }YiA i

<o.
sc,*

+yt' = [-c*" V,,V,, -c" V,,V,', +c*"(V,,V,, -V,,V,,) +c" V,', V,, ]AA 1

KATA}'AMA & OHTA:li14PERFECTSUmsTITUTESAND STRATEGICTRADE POLICIEg UNDER COVRNOTDUOPOLY 11= [ { - c" V14(q *22 - c *") +c *"pelc(ql*1 - c" ) }+{ -C" V,,(PY,* - Vg,) +C *"pti P'(i' - V23) }+c *"(q,, rm c")(PE* n V,,) +c*"{(q,, -c")(q,', -c") -c"2 }]/ 1A 1.

Now, if c*"= c"=O, xr +y: <O and therefore x, +y, +x: +y: <O .
Suppose that c*" fi{ c"<O. Then, from Pl,C<V,,<O , the first { } is negativef{{lqS, -c*"<O and in turn if q;, SqS, . Recall that q,,==pt,'+x*PZ

if q,,-c"and q'i,=P;+y*P',',. The second terms in these equations include thethird partial derivatives of u* with respect to the first and the second
arguments, respectively. Normally, their signs are not known. Therefore,

escaping from the ambiguity and assuming that the effects of thesederivatives are small, we see the first { } negative if ur, :i{l u,', <O . Similarly,

the second { } is also negative if the same condition on the second partial
derivatives of u* holds. Since the third and forth terms in [ ] are readily
seen as negative, we have Xt + Yt <O.

Proof of the fact that when c' 221c*' 20 and c" 2c*" , c' 2c*' >c,(Appendix 8):
If c*" <c" <O then Xt + Yt <O. By definition,Ce ==Xt c'+ Y` c*'.

X,+Y,

X,+Y,

Therefore, if c' = c*' then c' = c*' == co ,if instead c'>c*', then co< x, {l'y, c*'+ x)II y, c*' ==c*' '.'. ct >c*t >Co•
If c'<c*', then c,>c*', and therefore it may not be the case that PY'>c,and P' >c, .
Proof of the faet that if IZ5X <PY, then P >c, (Appendix 9):
By definition, iZiS == x, ililty, ]i5x + x, +Y`y, Ii5y, where xt+yt <o.

-- N- N

Since Xt >O and Yt <O, if PX <PY, then P>PY and in turn P>c,.
Proposition 9. If c' 2c*' ;}ilO, c" l}}lc*", ur, S{uS, and PX <PY, a rise in the

KOBE ECONOMJC & BUSIIVLE SS REVIEVV, 45(2000), 1-13

12

domestic irnport tariff, starting from free trade, reduces the world welfare.

Proof: See the above Appendices.
Proof of the fact that if c' <c*', c"<O and c*" ::: O then c*'>c'> eO.
(Appendix 10):x,+nc,* + y, + y; =[-c"(VS, V,*, -c*"2) -c*" V,4, V,,'Vi,VS, Vt, +Vg, V,,V;, +c*"2+ Vg2 (]ViiV4'4 ' Vi4V4'i )+C" C"" V4'i+c*"VnV3"2 +c"V3'3 V4'i ]/IAi=[c" VS, (V;, -Vl, )+(Vg, - Vg, )(V,,V,', -V,,V,', )+C* "{ C"(C* "+ Vt,) + c* " V,,+ Vg, (V,,TV,,) }]AA l>O if c"<O and c*"; O.
Thus, with the similar argument as Appendix 8, we have the following
results.
If c*' = c' then cO== c*' = c' .

If c'>c*' , then cO >c*' , and therefore PX >cO and PY' >cO may not ho}d.
Proof of the fact that U,W(O,s) =: (P-cO)(X, + Y,)>O if c' Sllc", c" SO,c*" ::O and PX >PY (Appendix 11):
By definition, li5 == x, isy. ]ilix + x, +l\ls}, p"', where x. >o, y, <o andXs + Ys <O•
Thus, PX>,p"Y implies that P>,i;X and in turn that .)5>cO .

This appendix 11 is nothing but a proof ofA, A:: O and PX>PY, then an increase
Proposition 10 If c'<c*', c" <O,c*"in the domestic export subsidy, startins from free. trade, increases theworld tvelfare.

KATA YAMA & OHTA :IMPERIilECT SbTesTITVTas AND STRATEGIC TRADE POLICIas U,NTDER COURN•OT DL'OPOLY
13

References
Feeney, JoAnne and Arye L, Hillman (2ooO), "Privatization and the political economy
of strategic trade policy", forthcoming in International Economic Review.

Krugman, Paul (1993), "The narrow and broad arguments for free trade", ATnerican
Econornic Review, vol.83 No.2. pp.362-366,
Uekawa, Yasuo (1994), "Imperfect competition, intra-industry trade and trade policy",
The Econornic Studies Quarterly, 45, pp.1-13.

Uekawa Yasuo, Seiichi Katayama and Hiroshi Ohta (2oo1), "Imperfect substitutes andstrategic trade policies under Cournot duopoly", forthcoming in Alan Woodlanded. Economic theory and international trade: Essays in Hour of Murray C.
Kerrtp, Edgar Elgar.

KOBE ECONOMIC & BUSINESS REVIEW, 45(2000), 15-38

SHIFTS IN THE JAPANESE CORPORATE GOVERNANCE *KENJI KOJIMA Kobe University

Abstract
This paper examines the effects of structural changes in financial system on
corporate governance and finance in Japan, and discusses the future directions. Major
shifts in the Japanese corporate governance are under way. As equity financing replacebank financing as the primary source of capital in Japanese major firms, the power ofmain banks and the government to direct corporate behavior through funds control arewaning. As the economy continues to be sluggish, the effective role of relationshipbased governance system is under serious consideration.

JEL Ctassifieation: G21; G32; G33.

Keywords: Corporate governance; financial deregulation; financial relationships;
Japanese firms.

1. Introduction

Japan has been managing to avoid the worst of the pain from the collapseof its bubble economy earlier this decade. In the late 1980s Japanese firms
raised cheap equity-linked debt to investment in the expectation that theeconomy would continue to grow at a fair rate. Two decades of heavy
spending have left Japanese firms laden with debt. While Japan's fairly
healthy manufacturing sector is abundant in cash, the rest of the economy,
Corresponding Address:
Kenji Kojima
Research Institute for Economics and Business Administration (RIEB), Kobe University,
2-1 Rokkodai-cho, Nada-ku, Kobe, 657-8501, Japan,
E-mail: kojima@rieb.kobe-u.ac.jp
Fax: (81>78-861-6434* This paper was presented at the International Conference on Corporate Governance andRestructuring, Seoul, Korea, June 16 1998. The author is grateful for participants at theconference, particularly Sangsoo Park for useful comments and suggestions. Financial
supports from Ministry of Educaion in Japan are gratefully acknowledged.

16

KOBE ECONOMIC & BUSINESS REVIEVV, 45(2000), 15-38

particularly construction and property companies, is heavily indebted.
Firms have been able to meet the interest charges on this debt mainly
because the Bank of Japan has, for the past two-and-a-half years, kept
short-term interest rates at the bottom levels.

Japanese government has continued to protect even the weakest banks
into the mid-1990s. Until recent failure, no Japanese bank had gone burst

since the Second World War. Lending has been collateralized by realestates, the price of which always seemed to go up until the burst of the

bubble. What Japanese banks were for was to lend money to firms thatneeded the cash. Profitability of firms was not seriously considered. Credit

risk was not a problem: fast economic growth would in due course takecare of it. If a firm ran into trouble, its main bank would rescue it. But suchan implicit guarantee created moral hazard of managers in banks andfirms.

Major shifts in Japanese corporate governance are under way. The
government bureaucrats' ability to manage the Japanese economy throughtraditional methods has been severely eroded by the financial deregulation.
Large Japanese firms ean no longer be pressured to do whatever banks andgovernment may ask. The financial liberalization in Japanese capital
market led to a period of excessive investments by many Japanese firms.
Lacking proper oversight, many investment projects are now in great
trouble. These misguided investments were partially created by thegovernment itself, but many of the changes made are now beyond
government control. [I]he significant changes in the Japanese financial

system are now under consideration: new standards of accounting andfinancial disclosure, heightened capital adequacy requirements for banks,
and reforms in the financial system.
The Japanese corporate system has worked well in the most of the postwar period. But the balance of power in the Japanese corporate system ischanging. As equity financing replaces bank financing as the primarysource of capital in Japanese major firms, the power of main banks and thegovernment to direct corporate behavior through funds control are waning.
As the economy continues to be sluggish, the effective role of relationshipbased governance system is under serious consideration. As a result, thepotential power of stock market is likely to be rising.
This paper examines the effects of structural changes in financial systemon corporate governance and finance in Japan, and discusses the future
directions. The primary purpose of this study is twofold: to identify
important features of changes in financial system in Japan and their effects

17
KOJIMA:SHIFTS IN THE JAPANESE CORPORATE GOVERNANCE

on corporate finance and governance; to develop insights concerning
corporate governance and capital market under institutional andregulatory environments. ,This paper is organized as follows. The next section presents the major
characteristics of chronic problems in the Japanese corporate finance.
Section 3 describes major problems and changes in the Japanese financial
system. In particular, it describes serious bad loan problems and major
financial reforms in Japan. And it also discusses structural changes inmain bank system, which is one of the most distinctive features in theJapanese corporate finance. Some aspects of Japanese corporate financehave changed dramatically over the last decade. Most of these changes are
the result of changes in the structure of Japanese financial markets, which
in turn can be traced to regulatory changes, Section 4 discusses recent

shifts in the Japanese corporate governance under the financial
deregulation and its direction in future. Finally, section 5 presents
concluding remarks.
2. Chronic Problems in the Japanese Corporate Finance

Most of the restructuring undertaken by Japanese firms in the 1990s
failed to improve corporate profitability. Much of the improvement infirms' financial performance in the last decade was a reflection of
inexpensive capital rather than improved efficiency. Japanese firms madeexcessive use of capital in the late 1980s, failing to take into serious
consideration the long-run return for their investments. Japanese firms
were making low-return, long-term capital investment based on short andmedium-term costs of capital. Hence, many of those investments are nolonger profitable at current costs of capital.

In the bubble economy of the late 1980s, Japanese executives could lookforward to an immediate impact on sales and asset growth of large-scale
investment projects, ignoring the long-term risk to corporate profitability
and to shareholder wealth. Now most of Japanese firms need to focus moreon corporate value maximization. As well as cost reducing efforts, moves torestructure business units and project developments are intensifying.
Moreover, adding capacity and diversification are being reviewed where

they are considered to have been pursued to be infeasible, and thenintensive efforts in restructuring their businesses are prevailing.

Japan's economic slowdown in the 1990s is not cyclical phenomenon, but
one of Japan's worst and potentially long-lasting recessions in the post-

18

KOBE ECONOMIC & BUSINESS REVIEVV, 45(2000), 15-38

war era. Japanese major firms are experiencing a substantial downward
trend in profitability that has pushed returns on investment to their lowest

levels in the postwar era. One cause of decline in profitability can bepointed out that Japanese managers failed to adapt to structural changes
of Japanese economy since 1980s. Over the past decade, major firms havesignificantly reduced their dependence on bank financing by improving their
cash flows. Table 1 shows that major manufacturing firms in Japan have
improved debt-equity ratio substantially since 1980. As a consequence,

major mechanism of corporate governance has gradually been eroding
including the main bank system and the burden of debt. The core strategy

of major corporations has been simply to increase recurring profits
without giving proper consideration to the interests of shareholders. Thus,
Japanese firms have continued to make investments that earn low returns,
creating a situation in which extra assets with low return can easily build
up under the strategy for long-term growth.

Table 1
Debt-Equity Ratio of Manufacturing Firms in Germany, Japan, and the U.S.A,

Five-Years Average(Percentage)
1960-64 1965-69 1970-74 1975-79 1980-84 1985-89 1990-94 1995

Germany 139.48 152.2 196.94 226.08 238.41 248.25 259.79 n.a.
Japan 236.36 309.91 409.74 460.37 310.72 204.70 164,37 152.07

U.S.A. 55.76 73.45 88.24 90.56 105.13 133.62 161.90 159.74
Sources: The Bank of Japan (1974, 1978, 1986, 1994, 1996, 1997), Cornparative
Econornic and Financial Statistics: Japan and Other Countries.

Source Note:Statistiches Bundesamt, Unternehmen und Arbeitsstatten, The Bank ofJapan, Syuyohigyo Keieibunsehi (Business Analysis on Main Enterprises in Japan), The

U.S. Department of Commerce, Quarterlrv Financial Report for Manufacturing,
Mining, and Trade Corporations

Growths in market share and continued employment clearly have been
two of the dominant corporate goals in Japanese firms for most of the
post-war period. A more difficult item to assess is what performancemeasures are typically used by Japanese firms. Annual profitability is
considered an important financial goal, whether it is attaining an increasein annual profits or achieving certain level of profits to satisfy therequirement of main banks. Generating adequate cash flow to cover debt

19
KOJIMA:SHIFTS IN THE JAPANESE CORPORATE GOVERNANCE

interests is also a high priority for Japanese managers. But Japanesemanagers do not appear to consider consistently their earning stream, cash
flow, return on investment, or cost of capital with a viewpoint of corporate
value maximization.

The retention of much of their cash flow and fewer growing investment
opportunities in major businesses has produeed considerable financial slack

for Japanese firms. Coupled with freer access to international capital
markets, this has led to distancing of Japanese non-financial firms fromtheir banks, widening of managerial discretion over the allocation of
resources, and a drive to diversification, Freedom from product and capital

market discipline is prompting Japanese managers to deploy cash in ways
more likely to benefit themselves and other employees of the firm by
maintaining jobs than to benefit shareholders. The problematic use ofexcess cash to speeulate in capital markets and plunge into strategies of
unrelated diversification is two major deployments ending in failure.

In this regard, the remarkable success of Japanese corporations in the
post-war period has revealed its weakness. The managerial entrenchment
afforded by excess cash has given rise to the expression of latent selfinterests that were contained during high-growth period. With theirdiminishing control over non-financial firms, the ability of banks tomonitor a'nd undertake corrective action is greatly reduced. It is weakeningof vital control mechanism in the Japanese corporate governance systemthat can substitute for market for corporate control. 'Since Japanese major firms are no longer subject to substantial control

from main banks, the lack of an effective control mechanism would be
detrimental to corporate value maximization in the long run. The stablecross-shareholding isolates firm's executives from the control of stock
market, depriving managers of an effective mechanism for checking against
the accumulation of extra assets. Stable cross-shareholding insulates
managers from short-term oriented investors, thereby enabling managers
to carry out long-term investments. Cross-shareholding, however, leads toa lack of close monitoring on management, leaving it up to managers todiscipline themselves. Japanese managers could be entrenched to run firms
as they want.
Japan has been managing to avoid the worst of the pain from the collapseof its bubble economy earlier this decade. Japan has two chronic problems.
The first is excess capacity. In the 1980s Japanese firms raised cheap
equity-linked debt to investment in the expectation that the economy would
continue to grow at a fair rate. But rather than reduce capacity since then,

20

KOBE ECONOMIC & BUSINESS REVIEVV, 45(2000), 15-38

firms borrowed to add more, encouraged by interest rates that were close
to zero. It is indicated that, although the ratio of corporate investment to
GDP has fallen from its peak of 20 per cent, it still 16%q compared with
10.59(o( in the U.S. Overseas markets soaked up some of the resulting output,
thank to a falling yen. But demand from Asia, which takes more than 40906oof exports from Japan, is decreasing. Japan would try to export more to
the U.S. and Europe, but would require a further sharp and politicallyunacceptable fall in the yen. It can be estimated that corporate capitalspending will fall by around 2%o of GDP in 1998 and again the year after(The Economist, 1997).
TwTo decades of heavy spending have left Japanese firms laden with debt.
Although business sales have doubled sinee 1980, corporate debts are morethan triple their ievel in that year. While healthy manufacturing sector isabundant in cash, particularly construction and property companies arehugely indebted in Japan. Firms have been able to meet the interest charges
on this debt mainly because the Bank of Japan has kept short-term interest
rates at the bottom levels since 1994. As a result, by fiscal year 1996 thetotal amount paid in interest charges had dropped to 19 trillion yen from 38
trillion yen in 1991.

But cheap borrowing is rapidly becoming a thing of the past. Banks havebeen tightening up their lax lending practices. So have domestic bondinvestors, to whom borrowers have turned in increasing numbers. Until
lately, lenders assumed that large firms would not be allowed to fail, sothey paid little attention to creditworthiness. This has changed
dramatically. In November 1997, credit spreads; that is, the extra rateriskier borrowers must pay to sell their paper, shot up when Yamaichi
Securities, the Japan's fourth largest security firm, and Hokkaido
Takushoku, a large city bank, went bankru'
pt, These bankruptcies had two
important implications: that even large firms ,can fail, and that a mainbank's implicit promise to rescue its major client firms is doubtful. Table 2

shows that number of bankruptcies and average amount of debt default
have been growing since 1995.
The Japanese corporate finance is now in trouble: excess capacity, risinginterest costs, declining profits. More bankruptcies seem inevitable, as

small-medium size firms become unable to serve their debts. Without
growth, the only way to improve the profitability of Japanese is drastic
restructuring to remove excess capacity and unrelated businesses. Whilesome firms are moving in the right direction, they are few.

21
KOJIMA:SHIFTS IN THE JAPANLESE CORPORATE GOVERNANCE

Table 2Bankruptcy of Japanese Firms
Five-Year AverageAmount of Liabilitie Average Amount of Liabilities

Number of Cases(100 million en) (100 million en)
1970-74

9,199

8,588

O,934

1975-79

15,72523,6501.540

1980-84

18,522

28,072

1.515

1985-89

13,26026,8452,025

1990-94

11,97760,446

5.047

1995

14,834

81,228

5,475

1996

16,464140,447

8.530

Sources: The Bank of Japan (1974, 1978, 1986, 1995,), Economic Statistics Annual, The

Bank of Japan (1997, 1998), Economic Statistics Monthly

Source Note: Tokyo Shoko Research Ltd.

3. Problems and Changes in the Japanese Financial System

3.1. Bad Loan Problem
In the late 1980s, deregulation of interest rates, which raised the cost offunds to banks, caused the change of bank portfolio. Coping with decreasing

operating margin, Japanese banks introduced various measures to reduce
operating costs and started to compete for deposits and loans more eagerly

than ever. Many banks loosed loan examination cutting the staff in thedepartment to reduce costs and accelerate the loan making. Then the bankincreased easy collateralized loans to investment in real estates. Prices ofassets have been stagnating since the early 1990s in Japan.

This stagnation of asset prices caused the large amount of nonperforming loans to investments in real estates. Non-performing loans
include four kinds of loans: loans to bankruptcy; loans overdue in six
months; loans with reduced interest rates; and other loans used for rescue.
According to the report of Ministry of Finance in April 1995, the amount of

non-performing loans was 23.8 trillion yen in major banks. Large amountof non-performing loans has deteriorated banks' equity and major banks

unable to meet BIS (Bank for International Settlements) capitalrequirement. Japanese banks issued the subordinated debts to recover theircapital-assets ratio. Non-performing loans to real estates caused the22

KOBE ECONOMIC & BUSIIVESS REVIEVV, 45(2000), 15-38

serious problems with banks' own balance sheets.
The size of the bad-loan problem has been growing since then. Japanese

economy has stalled and bankruptcies, already at record levels, areincreasing. Furthermore, there are substantial amounts of loans by
Japanese banks to companies in Asian countries. The latest official figure
for the banks' bad loans, 77 trillion yen (600 billion dollar), may still be anunderestimate, and the gap in life-insurance companies' accounts may be 60'
trillion-yen more. The government announced
it was ready to spend 30
trillion yen to restore the banking system to be healthy. The government

intended to obtain funds mainly by borrowing from the government-run
postal saving system, and to use them in two different ways. About \17
trillion would go to pay off depositors in failed banks. The rest, about \13

trillion, would buy preferred stock and subordinated debt in individual
banks. This injection of capital would bolster the banks so that they canlend again to reduce the purported credit crunch on which many Japanese
blame a sluggish economy.
While paying off depositors is unavoidable, the Japanese government haslong promised its citizens that all of their bank deposits are insured. It
would not force the banks to write off and seH assets that have lost value.
This would leave investors, depositors and foreign banks with only the mostambiguous view of any institution's true financial conditions, Recapitalization

will also interfere with the long-overdue shrinkage of the financial sy.gtem,

Japan lags well behind the U.S. in restructuring its banking sector. From1987 through 1996, while the U.S. Iargest banks earned an average 8.4906o
return on equity, the Japanese earned an average of 1.8%o (The Economist,1998). Only handful of banks have merged or gone out of business. The
survival of so many banks has made it hard for the more efficient ones toearn a decent return. The onset of financial deregulation will only add tothese competitive pressures. The government needs to allow weak
institutions to fail rather than helping them survive.

Although the finance ministry assured that they have nearly solved their
bad Ioan problems, many of Japanese banks are still in trouble with badloans. By the end of the financial year 1997, banks had written off, reserved
against some \25.4 trillion of bad loans, with about \15 trillion still to go
and at a time when interest rates are at a record low. Japanese government
had continued to protect even the weakest banks well into the 1990s. Until
recent failure, no Japanese bank had gone burst since the Second World

War. None of the top 20 banks had actually gone bust. Although thegovernment claimed that none would be allowed to at least one, Hokkaido-

23
KOJIMA:SHIFTS IN THE JAPANLEI SE CORPORATE GOVERIVANCE

Takushoku bank has been shut down.
Japan is in the grip of a credit crunch. Strapped for capita}, mostJapanese banks are loath to lend to any firms with the slightest trace ofrisk, which means mainly small domestically oriented ones. The government

has rushed forward with solutions in credit crunch. The government's
source of funds will allow the public institutions, which it finances to lend

an extra 12 trillion-yen to small firms. The government is also proposing tostrengthen banks to buying preference stocks and subordinated debt andby approving some new accounting method, such as not deducting
unrealized losses on equities form banks' capital. In addition, the prompt

corrective action program, which would automatically penalize banks,
which capital falls below a certain level has been deferred for a year.

The average spread between the rate at which banks borrow and the rate
at which they lend has fallen, suggesting that banks are not deliberately
deterring borrowers by raising the price of credit. That does not mean thatfunds are easy to come by. Banks are favoring larger, creditworthierborrowers, and becoming more careful about lending to the rest. This
reflects a great awareness of credit risk, Historically, credit risk has neverbeen much a serious concern; Japanese banks have tended to lend toanyone who wanted money. This was possible because loans were backed
by collateral and because a borrower's main bank could be counted on tobail it out before it defaulted. Now that the economy has slowed, the valueof collateral is dubious and main banks no longer have the funds enough tobail out their clients, credit risk matters. Banks are anxious about lending
to firms that are unlikely to repay'.

3.2. Reforms in the Japanese Financial System

The Japanese financial system would have its own "Big Bang" to free itfrom heavy regulation and segmentation. The reforms in the Japanesefinancial system are intended to shrink the banking system and its ability
to lend recklessly. This should increase competition and thus welfare forsavers. The most compelling reason for deregulation is a fundamental flaw
in the Japanese financial system: its inefficiency at allocating money.

Despite recent deregulation, the system remains hugely biased againstsavers and in favor of borrowers and intermediaries such as banks. Since
1 Kang and Stulz (1997) show that bank-dependence affects firms adversely during the 1990

and 1993 period in Japan when bank balance sheets were weak. It suggests that a firm
can be constrained from investing in valuable projects when banks do not have soundassets enough to support a firm.

24

KOBE ECONOMIC & BUSINESS REVIEW, 45(2000), 15-38

savers have little choice over where to invest their money, most of them put

it on deposit at the bank or the post office. Deposit-takers, on the other

hand, until recently had little reason to worry about the credit risk
seriously, Lending has been backed by collateral and if that was notenough, a firm's main bank would bail it out. UItimately the government
guaranteed the banks. And cross-shareholdings among firms with common
interests made it hard for outsider shareholders to apply pressure onbanks to lend more profitably. While the system worked reasonably wellwhile the economy was growing and money was scarce, but now that theeconomy has got mature and money more plentiful, the system has becomecounterproductive.
The most urgent need is for great flexibility in the Japanese financial

system. Certain financial products and services were offered only by
specific institutions allowed by the government. Banks cannot underwrite
or deal in shares, but only they can offer foreign-exchange services;
securities firms cannot offer banking services, but only they can directlysell investment trusts. Neither is allowed to sell or underwrite insurance.
Commissions on all but the largest equity trades are still fixed. The main
obstacle in the way of more flexibility has been the Japanese financeministry. The ministry's strong control on new product also makes forsome odd inconsistencies. Japan's Big Bang is supposed to change all this.
In response to the ministry's mishandling of the banking crisis, a decision
has already been made to move supervision of banks and securities firms to
a new independent body, which will start to work in July 1998. The reforms
in the Japanese financial system will have profound consequences for theway firms are run. Although the Japanese corporate finance reflects theinadequate rewards that capital has attracted, firms will now have to start
counting the true cost of capital. Deprived of cheap funds from the banks,
many of the weaker ones would be forced out of business.
As shown in Table 3, the rapid growth of assets and low profitability ofJapanese banks has led to concern about their capital adequacy. Japanesebanks need to Watch their financial performance carefully. In contrast to
the low-margin, volume-oriented banking practices, Japanese banks are
now restraining growth and carefully tracking the profitability of theirrelationships with clients. Increasingly, banks according to the profitabilityof the relationship with them are ranking clients. Just as industrial clientsare now short listing the banks with which they do business, banks are now
beginning to identify and terminate relationships with clients that do notprovide them with sufficiently attractive rates of return.

25
KOJIMA:SHIFTS IN THE JAPANE SE CORPORATE GOVERNANCE

Table 3
Profit Performances of Commercial Banks in Germany, Japan, and the U.S.A

Five-Years Average(Percentage)

Gross Profit Margin
1980-84
1985-89
1990-94
1995

Germany

Japan

U.SA

2.24

1.75

1.99

2.21

1.35

3,47

2.10

1.23

3.35

1.95

1.51

3.42

O.54

O.53

O.90

O.70

O.58

O,78

O.54

O.26

1.10

O.73

-O.16

1.80

14.06

14.43

15.34

12.11

16.41

11.13

10.49

6.11

16.04

9.59

-3.35

22.49

5.89

3.69

6.19

6.84

3.64

6.50

8.15

4.41

7.20

7.66

4.91

8.01

Pre-tax Return on Assets

1980-84
1985-89
1990-94
1995
Return on Equity
1980-84
1985-89
1990-94
1995
Equity to Assets

1980-84
1985-89
1990-94
1995

Sources: The Bank of Japan (1974, 1978, 1986, 1994, 1996, 1997), Cornparative
Eeonomic and Financial Statistics: Japan and •Other Countries.

Source Note: Statistiches BUndesamt, Unternehmen und Arbeitsstdtten, The Bank ofJapan, SNayohigyo Keieibunsehi (Business Analysis on Main Enterprises in Japan), The

U.S. Department of Commerce, Quarterly Financial Report for Manufacturing,
Mining, and Trade Corporations

26

KOBE ECONOMIC & BUSINESS REVIEW, 45(2000), 15-38

The shifting patterns of Japanese corporate finance and the competitive
pressures on Japanese financial institutions to inerease their return on
assets is collectively resulting in a gradual separating of claims held

against non-financial firms. Rather than being key shareholders, lead

lenders, and primary vendors of financial services in long-term
relationships with clients, Japanese banks are now being reduced to theposition of minority shareholders that must compete fiercely for a client's
business on a transaction-by-transaction basis. For their part, Japanesebanks, lately under pressure to meet BIS capital requirements, arebecoming more sensitive to performance on their equity investments.2
Japanese banks are now forced to liquidate some of their equity holdings
to maintain adequate cash balances.
More generally, the effects of financial deregulation over the last decades
have been enormous. The process of change will continue, both because ofcontinuing deregulation and because some financial patterns change
sluggishly. Financial deregulation tends to undermine the main banksystem because major non-financial firms have greater access to market
debt as well as borrowing from foreign financial institutions. This makes it

potentially much more difficult for the main bank to monitor and control

those firms' behaviors. In consequence, the main bank system could
continue to be viable and advantageous for- small-and-medium-sized firms,
which need strong bank supports3. As Table 4 shows, there is significant
differences in capital structure and external financing between large andsmall-and-medium size firms in Japan. Small and medium firms depend
heavily on borrowing from banks. As firms reduce their dependence onbank financing, they might iose some of the benefits of relationship-based

borrowing. They may have a less ready source of financing, and creditors
may be less willing to help during the time of financial difficulty,

In general, the slowing of economic activity in Japan has destabilized a2 Horiuchi (1995)points out that bank regulation in Japan provided banks with a considerable

amount of rent that could be utilized when regulatory authority had a chance to rescue
troubled banks. Furthermore, competition-restricting regulations kept the franchise value
in the banking at a high level, giving banks incentives not to engage in activities associatewith moral hazard that are likely to prevail under extensive nets.
3 Petersen and Rajan (1994)find that borrowing from a single lender increases the availabilityof credit for small firms. For smaller firms wi,thout publicly traded common stock, thebenefit of bank monitoring are likely to be large relative to the potential adverse incentive

effects of information monopoly by a single'bank.

27
KOJIMA:SHIFTS IN THE JAPANESE CORPORATE GOVERNANCE

number of traditional relationships and resulted in sales of a fraction ofshares previously held under cross-shareholding relationships. Yet, many

sales of cross-held shares are little more than efforts to book current
period gains that can be used to boost sagging profits, and are followed bynear immediate repurchases. Other sales represent only a fraction of crossheld stock, not the entire amount; still others are sales to some other stableowner of the stocks in question, thereby causing little substantive change inthe cross-shareholding relationships. The bad loan problem in the early
1990s has resulted in weakening the Japanese banking system. Although theeffectiveness of main bank relationships is now under test, the financial
system in Japan seems unlikely to shift the arm's length financial system in

the U.S. Not well-developed infrastructure of Japanese capital market
restrains to replace relationship banking.

Table 4
Capital Structure by Size of Manufacturing Firms in Japan(Percentage)
1970

1975

1980

1985

1990

1995

1997

20.4

20.4

23.1

21.5

17.1

14.4

15.2

Bank Loans
Bonds

35.1

37.1

31.9

26.2

15.3

17.5

15.7

3.6

2.8

3.5

4.8

11.2

10.3

9.2

Stockholder's Equity

22.8

18.4

20.8

28.2

36.7

40.2

41.5

Debt-Equity Ratio

338.6

443.5

380.8

254.6

167.0

148.8

141.0

32.9

30.3

34.2

28.7

24.4

19.2

19.1

29.7

31.7

28.9

35.9

36.9

40.4

40.2

O.1

o.o

o.o

o.o

o.o

O.2

O.3

Stockholder's Equity

20.4

21.0

20.5

20.2

24.0

25.4

25.9

Debt-Equity Ratio

390.2

376.2

387.8

395.0

316.7

293.7

286.1

Large Firms
Accounts Payable

Small and Medium Firms
Accounts Payable
Bank Loans
Bonds

Source: Ministry of Finance (1970, 1975, 1980, 1985, 1990, 1995, 1997), HoojinhigNou

Toukei Nenpou (Annual Statistics of Corporations).
Note: Size of firms is based on their stocks. Large firms have more than lbillion yen
value of stocks, and small and medium firms have between 10 and 49 million yen valueof stocks

28

KOBE ECONOMIC & BUSINIi SS REVIEVV, 45(2000), 15-38

3,3. Struetural Changes in the Main Bank System
Japanese financial institutions may hold equity and debt at the same time.

Besides strengthening the long-term relationship between the financial
institutions and the firm, the simultaneous holding of debt and equityc}early reduces the scope for conflict between shareholders and debtholders
over the choice of policies, particularly in situations of financial distress.

The significance of the main bank system is the close information-sharing
relationship that exists between the bank and the firm. It is possible to viewthe main bank system as functioning as a substitute for the kind ofscreening and monitoring institutions that are prevalent in other eapital
markets such as bond and credit-rating institutions and security analysis
agencies. The close association that the main bank has with the firm meansthat the bank is able to obtain inside access to the firm and its
management, which is not readily available to the external capital market.

The main bank system can be also characterized in terms of banks
themselves delegating the monitoring of a particular firm to one particularbank: the main bank. The bank delegated to be monitoring is not only thebank with the largest loan share but also holds a significant stake in thefirm as a shareholder. Having a sufficient large loan share may be the way

in which the bank ensures that it obtains an adequate return on its
monitoring outlays. In this regard, it is worth noting the free-rider problem

may be mitigated somewhat by virtue of the fact that non-monitoringbanks will not be able to imitate the loan portfolio of the main bank in size.

It can be arued that this function of the main bank provides an important
substitute mechanism for what in effect is inactive market for corporate
cQntrol in Japan.

Main bank intervention can take a number of forms, ranging on the one
hand from caSes where the main bank stipulates certain measures that
requires the firm to take in exchange for the bank's support during aperiod of financial difficulty to cases where the bank sends officers to takeover the management and carry out the reorganization of a firm that is on
the verge of bankruptcy on the other. As a. consequencg, one can suggestthat the relationship-based corporate governance substitutes for the moremarket-based in Japanese firms.
Much of corporate finance in Japan has evolved around the main bankrelationship. This has been changing for large firms. Finaneial deregulationin Japan has created difficulties for the main bank system. Nevertheless,

29
KOJIMA:SHIFTS IN THE JAPANESE CORPORATE GOVERNANCE

that system seems likely to adapt and continue to provide supports forsmall and medium firms. The process of change will continue because ofcontinuing deregulation in capital market. Increasing financial sophisticationand capability to exploit opportunities arising from regulatory changes will
also continue to alter corporate financial practices. Financial deregulation

tends to undermine the main bank system because major non-financial
firms have greater access to arm's length debt as well as borrowing fromforeign financial institutions. This makes it potentially much more difficult

for the main bank to monitor and control those firms. Consequently, themain bank system could continue to be viable and advantageous for firms
which is limited to access to alternative debt sources and need strong banksupport. The financing practice of large Japanese firms is beginning toresemble the more arms-length financing patterns observed in the U.S. The
shift to the arms-length financing system may emerge, although it willcertainly take time. The infrastructure in financial market including rating

agencies, disclosure rules, regulation and enforcement of insider trading

are now being developed in Japan. Even though the deregulation made it
possible for major firms to arm's length financing, some firms still
maintain main bank relationships. The firms seeking the benefits of mainbank relationships will continue to have close ties with banks.

4. Shifts in the Japanese Corporate Governance

Deficiencies in the 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 governancesystem. Ironically, part of the cause of that weakness is due to anabundance of cash. The combined effects of sluggish economic growth andconsiderable success in product markets around the world have been thebuildup of free cash flow. With this have come profound changes in thefinancing patterns of large corporations. New investment by Japanese
corporations has been growing less quickly and the funds have being raised

from securities markets, not from banks. This has meant a shift in thebalance of power among corporate stakeholders away from financial
intermediaries, the traditional primary suppliers of capital, and into thehands of corporate managers. It is now commonplace to observe Japanesefirms repaying their loans and even refusing to accept former bank officers

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KOBE ECONOMIC & BUSINEss REVIEW, 45(2000), 15-38

as nominees for directors.
Financial independence has further the deployment of cash in ways thatare disputable. Cash was expended in diversification of unrelated
businesses. The rationale for doing so was to escape the limitations andintensifying rivalry of mature core businesses and, in particular, to keep

personnel continuously employed, thereby honoring implicit promises oflifetime employment. However well intentioned these efforts might be, there
was little reason to be optimistic about their prospects for success, Manyof the new businesses being pursued had loose connections with firms'
present capabilities. To the extent that these capabilities were exceeded,

under-performance resulted and capital has been wasted. No longer mainly

dependent on bank credit to fund investment programs, Japanese firms
make less substantive disclosures of information about past performanceand future plans to their main banks.
The foremost objective of Japanese firms has been to sustain growth. For

many of these firms, growth is a useful proxy objective for the
maximization of the value of the firm. Given the wartime destruction ofmuch of Japan's industrial capital and substantial economies of scale inmany basic industries, there was a strong fundamental profit incentive
underlying strategy oriented toward high rate of investment and highmarket shares. However, the bias of Japanese firms toward growth
extended well beyond the period of reconstruction. This suggests a wider

role for growth than as a proxy for value maximization, It might be ameans by which management might entrench itself. Managers mightproactively seek to secure their positions in the firm by investing heavily inthose assets that they have a special expertise in managing, even to thepoint of expanding beyond the point justified by corporate value
maximization considerations. It can be also argued that growth andmanagerial entrenchment are desired because they support the continuityof valuable long-term relationships. Growth in particular may forestallpotentially costly stakeholder disputes while maladjusted contracts are
realigned to changed economic circumstances. The managerial discretion
afforded by excess cash has given rise to the expression ol latent self-interests that were successfully contained during Japan's high-growth
period. Today, Japanese stakeholders appear to be gaining at the expenseof others without any immediate prospects of re-contracting. With theirdiminished control over the supply of capital, and being largely owned bytheir industrial clients, the ability of lending-shareholding financial

31
KOJIMA:SHIFTS IN THE JAPANESE CORPORATE GOVERNANCE

institutions to undertake corrective action has been greatly reduced.

Return on investments (hereafter, ROI) of Japanese firms are
considerably lower than those of the U.S. firms. As shown in Table 5
returns on assets have been consistently higher in the United States than inJapan since 1960.4 It suggests that Japanese firms are much less profitable

than their U.S. counterparts. The relatively Iow returns of Japanese firms
have been attributed to differences in accounting practices, corporate tax
rates, and exchange rates, capital structure, and cost of capital. Even after
adjusting for differences in tax rates, accounting practices, and debt levels

between the two countries, Japanese firms in most industries haveconsistently lower operating margin and return on assets than equivalent
U.S. firms. The operating margin provides the most fundamental measureof profitability since taxes, interest earnings and expenses, andextraordinary gains and losses do not affect it. Japanese firms appear to
be consistently less profitable than their U.S. counterparts (Blaine, 1993).

The capital structure policies and retum objectives of Japanese firms
usually enhance their long-term corporate growth by allowing the savings
from lower capital costs and return standards to be reinvested in cost
reduction, capacity expansion, and product development. U.S. firms arecaught between the need to compete against Japanese firms that are willingto invest capital at lower returns, and the need to provide returns toshareholders that ineet the required level of return in the capital market.

The U.S. managers impose higher return standards on their investment
decisions than the Japanese counterparts, Furthermore, executives of the
U.S: firms finance with much less debt, which produces a serious cost ofcapital disadvantage, reduces the growth rate that can be financiallysustained, and creates capital structure that reinforces the disparity incorporate goals and ROI objectives between U.S. firms and their foreign
rivals.

4 Brown, Soybel, and Stinckney (1994) compare the operating performance of Japanese andU,S. firms using financial statement date restated to a similar rporting basis dttring theperiod of 1985-88. The result show that neither country appears to generate systematicallyhigher profit margin, but that U.S. firms has higher turnover assets and therefore higher

rates of return on assets. Although financial statement ratios of Japanese and U.S. firms
are not directly comparable because of the use of different accounting principles, theirresults suggest that alternative accounting principles do not seriously distort thecomparability of financial statement data in both countries. Return on assets of U.S,
firms are significantly higher than those of the Japanese for the year 1985 to 1988 do,primariiy because turnover rates of assets are higher for U.S. firms.

32

KOBE ECONOMJC & BUSJNESS; REVIEW, 45(2000), 15-38

Table 5
Profitability of Manufacturing Firms in Germany, Japan, and the United States

Five-Year Average(Percentage)

Germany

US.A,

1960-64

3.00

Japan
319

1965-69

3.07

3.31

6.94

1970-74

1.87

2.60

5.92

1975-79

1.80

1.39

7.21

1980-84

O.97

2.16

5.68

1985-89

3.87

2.37

5.24

1990-94

2.66

1.65

3.24

1995

n.a,

1.73

6.08

GermanyJapan

U.S.A.

-1970-74

1.49

2.94

4.53

1975-79

1.29

1.37

5.20

1980-84

O.65

1.92

4.34

1985-89

2.54

2.24

4.66

1990-94

2.23

1.70

3.09

1995

n.a,

1.89

5.72

Return on Assets

Return on Sales

6.28

Sources: The Bank of Japan (1974, 1978, 1986, 1994, 1996, 1997), Comparative
Economic and Financial Statistics: Japan and Other Countries.

Source Note: Statistiches Bundesamt, Unternehrnen und Arbeitsstdtten, The Bank ofJapan, Syuyoleigyo Keieibunseki (Business Analysis on Main Enterprises in Japan), The

U.S. Department of Commerce, Quarterly Financial Report for Manufacturing,
Mining, and Trade Corporations
Note: Book values of assets in Japanese firms differ greatly from currentvalues.

U.S. firms rely heavily on cost-of-capital calculations to guide investment
decisions, and those firms that do not earn a sufficient return on capital tosatisfy the investors will fail. But for Japanese firms, investment decisions

are not made on a discounted cash flow basis. Japanese managers usuallyview the cost of equity as the firm's expense to serve this source of capital,
that is, dividends. With this view of cost-of-capital, it is easy to see why the

33
KOJIMA:SHIFTS IN THE JAPANESE CORPORATE GOVERNANCE

market price of their stock has little impact on investment decisions ofJapanese firms. Rather, barring market-imposed capital constraints,
Japanese managers' investment decisions are guided by what they believe
the cost of capital by what is quite different from prevalent financial
theories in the U.S. Japanese managers care about borrowing costs andthey push their banks and securities firms to get the best terms. The mostimportant criterion of Japanese firms is long-term goal of maintaining andenhancing their positions in the Japanese industry. Serious considerationsof ROI and capital costs thus play only a minor role in investment decisionsof Japanese firms. If an investment is necessary to keep up with acompetitor or offers an opportunity to grow, then the investment may bemade. While an U.S. manager might first determine the cost of capital andproceed to look for investments that offer returns more than that cost, theJapanese managers may first make the investment decision and then worry
about how to finance it.

But changes are under way. Investors taking a new interest in
performance have started rewarding firms with higher ROI. Not many
executives of Japanese firms care about their firm's share price. But firms,

which have started to set their goal in increasing their ROE, have been
gradually prevailing. After a change in the law in 1994, and a change intheir tax treatment the following year that made it easier for firms to buyback their own shares, 14 firms have said that they will take advantage ofthe new rules. Toyota repurchased \100 billion-worth of shares last year
and will do the same again in 1998.
But at least it has made a start, taking its cue from signs that Japanese

investors are beginning to care more about corporate governance.
Traditionally, the system has been that main banks made sure managenientof client firms with monitoring closely. In return for providing funds, anda rescue policy against financial trouble, main banks wielded a great dealof influence over a firm's management. That system worked fairly wellwhile corporate funds was scarce, and the banks were correspondingly
enough resources. But as money became easier, the system started to break
down, The bubble and its aftermath accelerated its demise. Firms flush withcash no longer needed the insurance that banks used to provide. Those.2 the banks could provide it. The
without money no longer believed thatbanks, mired in bad loans, lacked the money to rescue ailing firms,
Moreover, their moral high ground has been undermined by the dismal
state of their own business. Then, who are supposed to replace their places,

34

KOBE ECONOMIC & BUSINESS REVIEVV, 45(2000), 15-38

if the banks are no longer capable of ensuring that managers can act inshareholders' interests? While the stock market provides a mechanism forcorporate control in the U.S., it has not been in a position to play the samerole in Japan. Since most of firms' shares are typically held in closely
related firms, hostile takeovers have been almost impossible.
But two recent changes have given shareholders more of a voice. The firstwas zi revision to Japan's Commercial Code in 1993, making it easier andcheaper to sue a firm. Previously, the legal cost to the plaintiff was inproportion to the amount claimed, making most suits prohibitively
expensive. Now the flat-rate fee to the plaintiff is a mere 8,300 yen. The
effect had been to remove the barrier to shareholder suits. As a result such'suits have often been brought against executives. The second change is thatgiving stock option to employees has become much easier. An option to buy
their firm's shares at a fixed price gives directors an incentive to push up

the share price, bringing the interests of management and shareholders
more closely into line. Awarding stock options was possible only in aroundabout way because firms were not allowed to hold their own shares
directly. A few firms, such as Sony, got round this restriction through atechnical fix, but now the law has been changed there is no longer any needfor that. Toyota and other firms have already announced that they will
grant stock options to employees, although there are still questions overtheir tax treatment.

Japanese corporate governance has been an arrangement that arguably
reduces the agency costs associated with outside equity and debt financing.

The differences may help explain how, from the perspective of the U.S.,

Japanese firms can run in an environment in which corporate control
mechanisms appear very weak. Viewed together, these patterns seems tosuggest that Japanese managers can operate virtually independent of theinterests of their shareholders. The agency problem is addressed in Japanby placing representatives of significant share-owning stakeholders on theboard, and by relying on main banks as delegated monitors for other major
lender-owners. Importantly, the business relationship, itself, also serves asa kind of monitoring system for share-owning stakeholders in Japan. Suchmonitoring by large shareholders do not completely resolve agency
problems of the separation between ownership and management, Indeed,from the perspective of Japanese individual or non-group-affiliatedinstitutional shareholders without a representative on the board, agency
problems may actually be worse in Japan than in the United States.

35
KOJIMA:SHIFTS IN THE JAPANESE CORPORATE GOVERNANCE

Excess capacity in mature businesses, excess employment, excess
diversification, and speculative uses of excess cash, among other problems;

appear to be more problematic in Japan than in the U.S. While possibly

recognizing deficiencies in the value maximizing behavior of thecorporations in which they invest, non-controlling Japanese shareholders
may, nevertheless, acquiesce to such behavior so long as they perceive theadvantages 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 separationof ownership from management if the offsetting gain from bearing suchcost is substantially reduced transaetion costs.

U.S. executives' preoccupation with shareholder wealth contrasts sharply
with the goals that guide Japanese managers: adequate returns; secure
employment; increased corporate capabilities. Within the context of theJapanese stakeholders, good management is measured not so much by itability to maximize the welfare of any one isolated stakeholder as by its
ability to maximize the aggregate size of the welfare. Certainly the training,

promotion, and reward systems for Japanese•managers are aligned withthese objectives. Other corporate stakeholders' preferences do indeed
become part of Japanese managers' preferences.5
Although the significant differences in corporate governance between
Japan and the U.S., poor stock performance and an inability to generate
positive income increase the likelihood of top management turnover in bothcounties. It strongly suggests that an efficient governance system can not

approve managers of firms with poor stock performance and withparticular poor cash flows. Current earnings and current stock returns areimportant determinants of management turnover in Japan. This suggests
5 By the time Japaese managers have become senior managing directors, they tend to makedecisions that will generate primarily efficiency gain from which all stakeholders standto benefit rather than primarily redistribute gains in which one or a few stakeholders gainat the expense of others. The typical Japanese reward system reinforces thispredisposition by not aligning management's interest with those of any gne corporate
stakeholder. Instead, management's interest is aligned with the preservation of the entire

coalition of stakeholders by a system that facilitates to achieve corporate growth,stability, and longevity. Given a reward system consisting of steady promotions,seniority-based compensation, regular semiannual cash bonus, lump-sum severance
indemnities, and placement with affiliated firms at the time of retirement, management's

well-being depends on the firm's longevity, growth, and the preservation of its
relationships with other firms. These achievements will ensure an ever-expanding set ofopportunities for promotion coupled with salary advancement and a source of income on
retirement (Kojima, 1997) .

36

KOBE ECONOMIC & BUSINE SS REVIEVV, 45(2000), 15-38

that a firm's current stock price and cash flows provide good measures offirm's current and future prospects. The relation of management turnoverto stock returns and to negative income does not indicate that the Japanesesystem favors employees and managers at the expense of shareholders in
any obvious way.
Japanese corporate system has worked well in the most.of the post-war
period. But the balance of power in Japanese corporate system is changing.
As equity financing replace bank financing as the primary source of capitalin Japanese major firms, the power of main banks and the government todirect corporate behavior through funds control are waning. As the
economy continues to be sluggish, the effective role of the relationship-based governance system is under serious consideration. As a result, thepotential power of stock market is likely to be rising.

5. Conclusion

Japan has been managing to avoid the worst of the pain from the collapseof its bubble economy earlier this decade. In the late 1980s Japanese firms
raised cheap equity-linked debt to investment in the expectation that theeconomy would continue to grow at a fair rate. Until recent failure, noJapanese bank had gone burst since the Second World War. Major shifts in

the Japanese corporate governance are under way. The government
bureaucrats' ability to manage the Japanese economy through traditional
methods has been severely eroded by the financial deregulation. Large

Japanese firms can no Ionger be pressured to do whatever banks andgovernment may ask. The financial liberalization in the Japanese capital
market led to a period of excessive investments by many Japanese firms.
The significant changes in the Japanese financial systems are now in

consideration: new standards of accounting and financial disclosureheightened capital adequacy requirements for banks, and reforms infinahcial system.

The Japanese corporate system has worked well in the most of the postwar period. But the balance of power in the Japanese corporate system isichanging. As equity financing replacesbank financing as the primarysource of capital in Japanese major firms, the power of main banks and thegovernment to direct corporate behavior through funds control are waning.

As the economy continues to be sluggish, the effective role of therelationship-based governance system is under serious consideration. As a

37
KOJIMA:SHIFTS IN THIE JAPAIVESE CORPORATE GOVERNANCE

consequence, the market-based governance can be likely more effective.

Corporate financial patterns and practices in Japan appear quite
different, particularly in comparison with those in the United States. In

1.arge part, these differences are due to differing institutional andregulatory environments. There is some eviden'ce that these systems ofcorporate governance are converging: Japanese corporate governance ismoving toward the U.S. Yet these changes are slow. As in Japan, thesechanges do not appear significant so much. It is contended that theJapanese corporate governance system cannot be appropriate to the U.S.
corporate climate. The closed nature of governance under the system
contradicts U.S. values of openness, mobility, and accountability in runningpublicly owned corporations in the U.S. Strengthening broad participationin corporate governance and extensive disclosure of corporate management
will help ensure both a strong and open investment market and prompt andmeaningful managerial accountability for consistent profitability andgrowth. As the capital and product markets are getting more integrated in

the world, and as firms domiciled in different countries engage ininvestments and transactions across the border more extensively, different

systems of corporate governance are increasingly getting into directcontact and conflict with one another. As they do so, the advantages andlimitations of each become more clearly revealed.

References
Bank of Japan (1974, 1978, 1986, 1994, 1996, 1997), Comparative Economic andFinancictl Statistics: Japan and Other Countries.
Bank of Japan (1974, 1978, 1986, 1995), Econoniic Statistics Annual.

Bank of Japan (1997, 1998), Economic Statistics Monthly.
Blaine, M. (1993), "Profitability and Competitiveness: Lessons from Japanese andAmerican Firms in the 1980s," California Management Review, 36, (fall), 48-74.
Brown, P. R., V. E. Soybel, and C.P. Stickney (1994), "Achieving Comparability ofU,S. and Japanese Financial Statement Data," Japan and the World Economy,
6, 51-72.
The Economist (March 14, 1997)
The Economist (January 24, 1998)
Horiuchi, A. (1995), "Liberalization and Stability in the Japanese Financial System:

An Overview," discussion paper, University of Tokyo.
Kang, J-K. and R. M. Stulz (1997), "Is Bank-Centered Corporated Governance Worth38 KOBE ECONOMIC&BUSINESS REVIEW, 45(2000), 15-38

It? A Cross-Sectional Analysis of the Performance of Japanese Firms during

the Asset Price Deflation," working paper, NBER.
Kojima, K. (1997), Japanese Corporate Governance: An International Perspective,

RIEB, Kobe University.
Ministry of Finance (1970, 1975, 1980, 1985, 1990, 1995, 1997), Howfinkigyou

Touhei Nenpou (Annual Statistics of Corporations).
Petersen, M. A. and R. G. Rajan (1994), "The Benefits of Lender Relationship:
Evidence from Small Business Data," Journal of Finanee, 49, 3-37.

KOBE ECONOMIC & BUSINESS REVIEW, 45(2000), 39-55

FSC CERTIFICATION IN JAPAN: AN UNCERTAIN FUTUREAKIRA KAJIWARA Kobe University

AbstraetThis article presents an assessment of the adoption of Forest Stewardship Council(FSC) certification in Japan based on insights from concepts and theories provided
from the disciplines of sociology, social psychology, economics, and organizational
behavior. It provides a brief history of relevant developments in the forest sector inJapan, as well as a brief discussion of certain characteristics of the collective natureof Japanese society as they concern the current paradigm shift in Japan. Certification
is discussed with specific information about FSC Certification as a possible substitutefor assurance being lost due to the changes in business relationships resulting fromJapan's shift to a more open market. The article suggests that the adoption of awestern social instrument such as certification will have possible outcomes which
differ from those expected in countries where certification originated.

JEL classification: Q2, Zl
Kaytvords: FSC, certification, assurance, social change, trust, business relationship,
coJlectivist, decision making

Introduction

A visitor to a commercial Japanese forest might notice carvings on thetrunks of the trees. These carvings are the signatures of the person who
cared for the trees during their growth, and those signatures carry withthem the reputations of the caretakers. These "brands" assure buyers thatthe forest product meets the standards of quality associated with theCorresponding Address:

Akira Kajiwara
Research Institute for Economics and Business Administration (RIEB)
Kobe University, 2-1 Rokkodai-cho, Nada-ku, Kobe 657-8501, Japan
E-mail: kajiwara@rieb.kobe-u.ac.jp
PhoneFax: 81-78-803-7039

40

KOBE ECONOMIC & BUSINE SS REVIEVV, 45(2000), 39-55

reputation of a specific caretaker. This interpersonal connection between

producer and buyer forms a closed system of procurement and functioned
successfully over many years to reduce transaction costs by reducing risks

for the buyer. Through repeated transactions across generations,
reputations were established and these signatures carved into the trunks oftrees during their growth provided assurance in the market of forest
products.
Today these signatures can still be seen in some of Japan's forests, but
after harvesting of these areas, the forests that replace them do not havetrees with signatures. These new forests are not forests of "branded" trees

because over the }ast 20 years the market price has moved further andfurther away from covering this kind of intensive silviculture. Buyers haveturned to cheaper imports and with only a small market for domestic trees,
there is less incentive for this assurance system to eontinue to function. The

loss of these signatures is an indicator of the depth to which changes inJapan's socio-economic structures are being felt in the forest sector.

Over the last decade Japan's industries have experienced difficult
economic times. This situation has forced Japan's business community toreevaluate its traditional systems of business organization. Business
relationships are moving away from the traditional long-term interpersonal

system of transactions to the more flexible short-term market-basedtransactions which have been dominate in the West for several decades.
This paradigm shift is not an easy one, especially for the more traditionaland conservative actors in supply, manufacturing, and trading sectors, but

the change is happening and most of Japan's industries and businesses
seem to be recovering. Japan's forest industry has not been one of these.
There have been no signs of recovery, and most observers are saying thatthe forest industry cannot survive in today's economy if it holds to the
traditional systems. Those persons associated with the forest industry are

not optimistic about recovery, and no solutions have been forth coming torevitalize this once important contributor to many locai economies.
In 1996, coincident with the continued downturn in the forestry sector andthe paradigm shift mentioned above, WWF Japan introduced FSC
certification to a few key actors in the forest sector. It seemed strange tomany observers because there is no obvious logical rationale for theJapanese forest industry to be interested in adopting forest productcertification comparable to the rationale for certification in othercountries. Also, the concept of certification is historically unfamiliar inKAJIVVARA :FSC CER TIFICA TION IN JAPANJapanese society. In spite of these conditions, these actors joined together

informally to promote FSC certification in Japan and have attracted others

to join them from a variety of associated professions. These persons areactively promoting FSC certification in Japan and are meeting with somesuccess. It is unclear at this time what the outcomes of this initiative willbe, and even though there is apparent cooperation between the actors, their

expectations for this alien social instrument may be found to beincompatible with actual implementation of FSC certification as it proceeds.

E tSt J
Japanese society experienced two major social transitions prior to thecurrent paradigm shift. In 1868 at the beginning of the Meiji Restoration,
Japan adopted western style social institutions such as the parliamentary

monarchy system of England and the legal systems of France andGermany. German forestry systems and technologies were imposed onnational forest lands. These national forest lands were created from thevery large estate lands of the aristocratic clans, han. The Meiji government

seized these lands and brought them under the eontrol of a national
governmental agency. Lands which were privately owned and not part of
the feudal clan system were not confiscated, but ownership was clearly
established for taxation purposes. Therefore, in the forest sector,
structure of private ownership did not change and associated traditions
remained the same. Privately owned forest lands stayed as they had been
for centuries.

The second major social change was at the end of the Second World War.

During the occupation of Japan by the allied powers, the USA forces
attempted to change Japan to be a more democratic society. Three ofthese democratic changes were the creation of labor unions, the dissolutionof the 2aibatsu, large company groups owned exclusively by one family,

and the redistribution of farmland ownerships. These changes weresuccessful in many sectors of Japanese society, but the forest sector
managed to avoid almost all effects of these changes.

The two society-wide major social changes mentioned above hadtremendous impact on Japanese society, but the forest sector was able to
avoid them and kept traditional methods of operations in tact. The forest

sector can be described as old fashioned and traditional in almost all
aspects of their operations. The forest sector avoided sweeping changes in

41

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KOBE ECONOMIC & BUSINESS REVIEW, 45(2000), 39-55

Japanese society at two significant times, but it appears that it cannot
avoid the results of the financial crisis of the late 1990s. This upheaval
revealed the serious malfunction of Japanese society, and one of the mosttypical examples is the forest sector which is suffering very serious trouble.

The serious financial problems of this last decade have caused theorganizations and people in the forest sector to be apathetic because there

seem to be no solutions. One of the most demoralizing factors is thechronic financial loss in the domestic forest business. Since Japanese laborand transportation costs are some of the highest in the world, and sinceforest business is a heavily labor intensive industry, it is very hard tomaintain a profitable forest business in Japan. Furthermore, due to strong

Japanese currency, yen, tremendous numbers of cheap timber products
have been imported to Japan over the last twenty years. This economic
structure has made an already bad situation even worse for timbercompames.
Another serious problem is the failures in forest policy which created an
accumulated deficit in national forest account. Japanese forest authority
in government, Rin-Ya-Cho, Forest Agency, made a series of unfortunate

management decisions in response to changing government policies andshifts in market demands. During the economic expansion of the 1950s and1960s the agency grew rapidly because there was high demand for timber
products and domestic timber production was protected by the Japanese

government ban on imported timber products. The agency expanded
rapidly over these years and by the 1960s it had financial responsibility fora huge number of permanent/life-time employees as well as extensive
subsidy programs for influencing private timber production. During thesetimes of expansion, agency management did not expect the changes in trade
policies that were to come.

In 1964, the Japanese government completely opened the Japanese market
to imported timber. This was devastating to the forest industry in Japanand to the Forest Agency. In addition, in 1971 the government of the USA
eliminated the gold standard as backing for the USA currency. This change
in the conversion system caused major market fluctuations resulting in thevalue of the Japanese yen being raised significantly in relation to the USA
dollar. The forest agency was not prepared to respond to these drasticchanges which seriously impacted the economic situation surrounding theforest industry. A series of management decisions such as acceptance ofhigh interest loans from commercial banks rather than asking forKAJI VVARA:FSC CER TIFICA TION IAT JAPANassistance from other branches of government produced a US$ 30 billion
accumulated deficit in the national forest account as of 1998. The agencysought commercial loans because it wanted to avoid political and financial
influence and interference from the Ministry of Finance. Due to this deficit,

in March of 2000, the Diet redirected two-thirds of this deficit to thenational general account. The remaining one-third was left as the
responsibility of the Forest Agency over a term of 50 years (Forest Agency,

1999). As a condition of this arrangement, the Forest Agency agreed tochange their organizational structure loosing much of its autonomy andauthority.

These problems mentioned above have caused some serious side effects.
Due to the financial problem in national forest account, the Forest Agency

has reduced intensive forest management on the national forest lands
replacing it with the concept of "natural forest management approach".
(Arinaga and Kasahara, 1988; Kasahara, 1996) The adoption of thisnatural management approach has in effect created a situation in which
previously highly managed plantation production forests are now sufferingfrom reduction in management and silvicultural treatment. This lack ofmanagement policy has reduced the quality of stumpage in Japanesenational forests and there have been no initiatives to actively encourage thedevelopment of balanced natural ecosystems (Kawakita Shimposha, 1989).
Also, the Forest Agency and other public and private landowners have soldtheir forest lands to private enterprises to create golf and ski resprts. Thissituation has made local forest dependent communities decline economicallybecause the recession which Japan is now experiencing has undercut thepotential of this change in economic dependency from timber to tourism(Suzuki, 1999).

As can be seen from these problems, the forest sector in Japan is severely
depressed. The Forest Agency has lost its power to subsidize the industry

and the market price for timber products has made harvesting domestic
timber a liability. The traditional operating procedures are not functioning

and there have been no promising solutions to these serious financial
problems. Therefore, even in the very conservative and traditional forest
sector, the paradigm shift which is being observed in Japan's social andorganizational behavior is being felt intensively. In this dire situation,

forest industry actors are desperate to survive and this desperation may
have opened them to consideration of any possible initiatives which mightoffer hope to improve their situation. The adoption of FSC certification

43

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KOBE ECONOMIC & BUSINE SS REVIEVV, 45(2000), 39-55

may be driven by the hope that it can help revitalize the forest industry inJapan.
Certification

Certification of forest lands is based on third party conformance
evaluation of management practices. This certification process begins witha forest landowner or manager voluntarily rdquesting that a third party
certification body examine their forest operations. Certification is granted

if their management practices are in compliance with sustainable resource
standards. Specifically, f'or FSC certif'ication this means compliance with

the Forest Stewardship Council Certification Principles and Criteria for
Forest Management, which requires certain levels of environmental, social,economic, and technical qualification. Successful completion of a thoroughassessment permits the party seeking certification to associate wood
product from their land with the FSC logo. This logo is intended tocommunicate to the consumer that the product they are purchasing
originated from "certified well-managed lands."

Certification was originally intended as an economic incentive which
would generate higher profits for those timber producers, suppliers, andretailers who participate in certification programs. In addition to thisincentive, it was believed that companies producing 'and consuming wood
products could utilize certification as a quality control mechanism, Buying
certified products could be a way of avoiding low-performance suppliers. It
was also postulated that some companies producing wood products could
find a market place advantage in this situation and be encouraged topursue certification. Since Japanese companies place considerable
emphasis on the quality of supplied raw materials as well as quality of
their products, it could be expected that these original intentions would

make certification a useful instrument for Japanese timber related
manufactures. However, because most of the original intentions have notactually been realized by the implementation of certificdtion in othercountries, it could be unreasonable to expect them to be realized in Japan
as well.

Furthermore, if we look at the countries where certification evolved andfound application, we see that there are critical differences which makeJapan unique as a participant in FSC certification. Markets in Europe andthe USA have been established for certified wood products. These markets

KAJI VVARA :FSC CER TIFICA TION IN JAPANencourage land owners in timber exporting countries to participate incertification. Japan does not export timber and almost no FSC certified
wood products are traded in Japan. Therefore, because Japan is unique asa participant and because the original intentions cannot be expected tobenefit timber manufacturers, there is currently no apparent economic
incentive for FSC certification in Japan and no apparent rationale for the

implementation of FSC certification scheme in Japan. However, in Februaryof 2000, a private Japanese timber company obtained Japan's first Forest

Stewardship Council's certificate for their forest management. This
company pursued FSC certification even though the initial assessment costto certify one thousand hectares was over US$ 40,OOO (US$ 40/ha).
Compared to the fact that certifying large tracts of timberland can cost
anywhere from 7cents/ha to 21cents/ha for the initial certification in USA(Environmental Building News 2000), the cost in Japan is very expensive. At
the same time, two timber mills affiliated with this company also acquired
certificates for their CoC process. In June of 2000, a second certification
was initiated by a timber partnership on its lands in Kochi prefecture. Thiscertification project was supported by the local government of thiseconomically declining rural timber community. These certifications arebeing implemented even though there seems -to be no economic rational tojustify the cost.

There seem to be no immediately observable incentives for thesecompanies to participate in FSC certification not only because thesecompanies do not export wood products to countries where FSC
certification is recognized but also because there is no consumer market for

FSC certified products in Japan. However, these certification efforts arebeing supported by several other organizations and this movement toimplement FSC certification into Japanese forest sector is gaining

momentum.
Or anizations and Peo le
The first and originally most active promoter for forest certification
schemes in Japan was WWF Japan. It is similar to its parent and affiliatedorganizations in European and North American countries where forest
certification is more widely adopted. WWF Japan started to develop forest
certification initiatives in Japan in 1996, in line with Target 2 of the WWF

global "Forests for Life Campaign." They believed that their most

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KOBE ECONOMIC & BUSINE SS REVIEVV, 45(2000), 39-55

important role was to provide information and facilitate communication
since there are very few documents related to certification written in
Japanese (Maesawa 1999). Since early 1996, WWF Japan has translated
and published a few relevant documents including "The WWF Guide toForest Certification 1996" and an FSC leaflet and offered several
conferences and workshops all over the Japan. From April 1997, WWF
Japan has started selling FSC endorsed products in its mail ordercatalogue to introduce examples of certified products to consumers. Also,

WWF Japan has been trying to establish buyers groups and trying to findforest owners and/or managers who are interested in being certified under

FSC scheme. Due to the continuous efforts of WWF Japan through Mr.
Maesawa, the nation's first FSC certification was granted to the Hayami
Forest, a 1,070 hectare site located in the community of Miyama in Kii
Peninsula along the coast of the Japanese island of Honsyu.

It is important to point out that development and acceptance ofcertification programs has not been led by final consumers in countries

where forest certification is widely adopted. Rather, environmentalorganizations, companies, and individuals having specific reasons forsupporting certification have been the driving forces (Hansen and Juslin,1999). Specific reasons in other countries include economic incentives,
ecosystem health and preservation, and sustainable timber production.
Specific reasons for supporting forest certification such as these are notyet recognized in Japan.

In most countries such as those in North America and Europe wherecertification has been successful, many large companies, often retailers like

B&Q and Home Depot, have joined buyers' groups and created demand for
FSC certified products. This has not happened so far in Japan. However,
the National Federation of Timber Co-operative Associations which isaffiliated with the Forestry Agency, and Sanwa Research Institute (SRI)
which is one of the biggest consulting firms in Japan affiliated with a largecommercial bank, Sanwa Bank, have joined with WWF Japan as thecurrently most active promoters of FSC certification in Japan. SRI is now

managing the Forest Certification Research Working Group'

focusing on
implementation of FSC certification in Japan. This working group hasbrought together most of the main actors in the arena of forest products
certification.

Organizational factors in Japan discussed above compared to Europe andAmerica show us that the influence of ENGOs could be a critical element inKAJI VVARA :FSC CER TIFICA TION IN JA PA IV

adoption of certification in Japan. Those influences are very strong inEurope and North America and only beginning to be felt in Japanesesociety. Government regulations which are strong in Europe and North
America have given support to environmental initiatives such as forest

certification. In Japan, government has not strongly supported
environmental initiatiVes, but this kind of activity is beginning to be seen.

Furthermore, Japan is more and more feeling the pressure of compliance tointernational expectation resulting from its participation in theinternational markets and is moving towards decision making that is moresimilar to countries whose markets are more internationally open such as

those of Europe and North America. These changes are influencing thecurrent paradigm shift in Japan.
[t!:!!g-{l;g!!g!}!iygJSI}!yu}-g!-E!gpgl!gsg-Sggig!heColleetiveNatureofJapaneseSociet

Japan is an example of what sociologists term a collective society(Nakane, 1972). This concept of collectivism is often misunderstood. Many
people believe that in a collective society the members of that society will

sacrifice their personal well being for the good of the society. These
societies are often viewed as societies in which individual gain is lessimportant than the well being of the society as a whole. This view issimplistic, incorrect, and misleading for anyone interested in studying the
dynamics of collectivist society behavior. Collectivist societies are ones inwhich long-term closed relationships between individuals and groups
dominate the. social functioning within the larger society (Miller andKanazawa, 2000). Closed in this context means that groups form within thesociety which exclude others from participation. Keiretsu is the term used

for these closed groups in Japan. These keiretsu groups provide assurance

for the members of the group through long-term association and the
expectations which evolve over many years of interaction (Yamaji,
Kajiwara et al. 1994). By exclusion of others and commitment to themembers of the groups, all in the group are assured that their individualinterests will be met by the other members of the group as long as eachmember adheres to the group's expectations, This loyalty to one's group
creates in-group and out-group bias, and functioning successfully in acollective society without being a member of one of these groups is almost
impossible (Yamagishi, et al., 1998; Miller and Kanazawa, 2000).

Japan's collectivist society functioned very well in the past to reduce

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KOBE ECONOMIC (S} BUSINESS REVIEW, 45(2000), 39-55

uncertainty in social encounters, and allowed Japan to create a stable,highly productive and efficient society. Low transaction costs and stableequilibrium were enjoyed because of the in-group favoritism created bytransactions based on long-term relationships which were closed tooutsiders. Being closed to outsiders is an opportunity cost because newopportunities offered by non-in-group members cannot be enjoyed. Until
recently savings in transaction costs exceeded opportunity costs inJapanese society. However, the losses from not taking advantage of outside
opportunities have grown and the shift is being felt in all parts of Japanesesociety. Thus the mutually committed long-term relationships such as
keiretsu and permanent emp}oyment and the equilibrium establishedthrough them is being challenged. In-group favoritism is becoming aliability rather than an asset, and the paradigm shift from the long-termclosed relationships as the base for transactions to a more open system isbeing felt throughout Japan.

Paradi m Shift and Certification
The paradigm shift currently being experienced in Japan is explained by

Yamagishi's theories concerning collectivism and in-group favoritism(Yamagishi, Miller et al. 1998). His findings that in-group favoritism ispragmatically based on sanctioning, monitoring, and reciprocity as
opposed to psychological mechanisms and phenomenon provide insights
into the demise of the successful functioning of the long-term relationshipbasis for transactions traditionally favored by Japanese business people.
Yamagishi predicts that changes are going to come quickly to Japan. He
warns that as the "collectivist strategies" for maintaining equilibrium andreducing uncertainty fade away, Japan will go through a period ofsearching for new systems to replace the traditional ones. These new
systems will have to be ones that are compatible with the more open social
environment that is now evolving because of the irresistible opportunities

offered outside of the closed in-group arrangements, .If we accept
Yamagishi's warning that Japan's collectivist strategies for maintaining
equilibrium are being eliminated by the necessity to open to outside
opportunities, certification is coming to Japan at the time of paradigm
shift.

KA JI VVARA .- FSC CER TIFICA TION IAr JA PAN

Stgs}lg!-As!gp!Lg!lg!!iAdtt

As Japanese society searches for replacements for the sanctioning andmonitoring of the collectivist long-term relationship system, there will be aperiod of adaptive trial and error. North states that there is little in depth

understanding of all the aspects of adaptive efficiency in times ofenvironmental change, but observations suggest that overall institutionalframework is an important influence on how much a society encourages thetrials, experiments, and innovations that produce adaptive efficiency(North, 1990). Incentives built into the institutional framework direct
decision making processes, and decisions change and modify the existing
systems. If incentives exist and encourage problem solving experimentation,

the adaptive efforts have more opportunities for maximization. In
traditional Japanese society, social institutions and human preferences forfinding solutions have not encouraged the trials, experimentation, andinnovations which North deems important for adaptive efficiency. Japanese
problem solving has not been oriented to encourage adaptive efficieney
because until now there has been little pressure to adapt due to the relative

unimportance of outside environments. This has been especially true in theJapanese forest sector.
As witnessed by the advent of FSC certification in Japan, some Japaneseare attempting trials, experiments, and innovations even in the forest
sector. North's observation that adaptations are often initiated at margins

of organizations provides insights into the roles of the actors in FSC
certification in the initial stages of promotion in Japan. Margins are thenodes of organizations which are directly connected with the environment.
Because of their location close to the environment, agents or actors locatedin the margins are often those who initiate changes in response to changes
in the environment.
. . . the immediate instruments of institutional change are politicaland economic entrepreneurs who attempt to maximize at themargins that appear to offer the most profitable (short-run)alternatives. (North, 1990, 100)

One of the important characteristics of actors located at the margins isthey are often less constrained by organizational rules and conventions

than their superiors in the organizational structure. Since Japan's

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KOBE ECOIVOMIC & BUSINEss REVIEW, 45(2000), 39-55

organizations are highly centralized and hierarchical and usually have notencouraged individuals to experiment and innovate, adaptive problem
solving and decision making has been limited. The forest sector exemplifies
this phenomena, but if we look at the initial promoters of FSC certificationin Japan we see that many of them are located in the margins of theirprofessions and organizations. It appears that their location at the margins

has provided them with freedom from traditional constraints.

The location of these actors at the margins of their organizations has
implications for the adoption of FSC certification in Japan. One of the main

implications for FSC certification is that we cannot expect it to have thesame outcomes in Japan that it has had in the countries where it
originated. North points out that margins are especially sensitive to
cultural influence. Because margins are in direct contact with environments,

the margin actors are heavily influenced by those environments. These
environments are the interface of all the cultural norms of a society and theneeds created by interaction with the outside world. North states that thecultural specific norms of each society create a society's informal
constraints and are prevalent and persistent. Therefore, needs at themargins are culturally specific. Each environment in each society has
unique social institutions and constraints which dictate the choice processes

made by actors at the margins. One of these culturally specificcharacteristics is the bargaining power of individuals and groups at themargins. Since bargaining power will be different from society to society,we can expect marginal adjustments to have different outcomes.
Furthermore, since societies have different histories which limit how change

can be experienced, and since feedback on outcomes of adoption of social
instruments from another society is necessarily incomplete, we see thatmarginal adjustments can not be expected to have the same outcome indifferent societies. We can expect widely divergent outcomes when social
instruments are borrowed from another society. FSC certification can be

expected to have different outcomes in Japan than it has had in the
countries where it originated.

The insights gained from North's work give us cause for concern about
the implementation of FSC certification in Japan. We see a situation inwhich the actors promoting FSC certification in Japan are doing so withexpectations based on insufficient information. If the paradigm shift ishappening in the forest sector and if the other factors mentioned in thispaper are causing the financial difficulties observed in the forest sector,

KAJIVVARA :FSC CER TIFICA TION IN JAPAN

there are problems which need to be addressed by innovation
experimentation, but at present no rational solutions are available.

Garba e Can Model of Decision Makin
Concurrent with this situation, certification has been introduced to Japanas a social instrument valuable in countries Japan has looked to forinnovation in the past. Certification is not well understood in Japan, butinstead of being scrutinized and analyzed for its value in application in
Japan, it has been promoted as an exotic valuable tool for social innovation
for the forest sector in Japan. It appears that certification may have beenchosen mainly because of its availability at a time when problems exist thatneed solutions, people recognize the need for social change, and pressurefor immediate change has intensified. March and Olson describe this kindof decision making in their Garbage Can Model of Decision Making.
According to their model, it is common organizational behavior for
decisions to be made dependent on availability, timing and mix ofparticipants (March and Olson, 1979),

March and Olsen's theory provides insights to understand organizational
behavior in the adoption of certification in Japan. They state that when thethree features of problematic preferences, unclear technology, and fluid

participation are present, decision making can be subject to-processes
described in their Garbage Can Model of Organizational Choice. Of thethree, unclear technology seems to be evident since forest certification is
new to Japan, and information about forest certiitication is not readily

available. There is not enough information in Japanese because there has
been very little original work in the area of forest certification done inJapan, and information from outside Japan is not easily understood and
not widely available. Fluid participation can be observed in the variationand lack of consistency in who attends certification meetings. There has
been relatively little formal structure for the organization of this coalition.

The informal network which has evolved does not provide consistency withregards to the input from participants in decision making. The thirdfeature, problematic preferences is not yet readily observable, but I believe
closer inspection will reveal that differences in motivations and reasons forpromoting FSC certification are already influencing the actors' choices
concerning who they align themselves with, which meetings they attend, andwhich ideas they support. The implementation of FSC certification in Japan

51

and

KOBE ECONOMIC & BUSINE SS REVIEVV, 45(2000), 39-55

52

has all the hallmarks to be a classic candidate for Garbage Can Decision

Making analysis. If this model accurately describes the process of FSC
certification adoption in Japan, we have further cause for coneern about
whether or not FSC certification as a social instrument can provide
outcomes compatible with the expectations of the promoters.
Substitute for Assurance
As Yamagishi points out, Western societies are trust-based as opposed tothe assurance-based system of a collective society like Japan. In trustbased societies certain kinds of social instruments have evolved to reduce'risk and uncertainty which did not evolve in collectivist societies. Examplesof these social instruments are seals of approval, accreditations, credit
ratings, better business bureaus, and certifications. These social instrumentsfunction to provide predictability and reduce risk in the societies of the west

where exchanges are more impersonal than in the collectivist type ofsociety in which long-term relationships are fundamental to exchanges.

North points out that large amounts of time and energy have been
dedicated over centuries to the development of codes of conduct for theexchanges within all societies. Many of these norms find their way into theformal rules and laws of government while many others become
institutionalized in the informal constraints and customs of a society. In thewest, the social instruments mentioned above evolved to supplement theformal rules or laws of a trust-based society. These social instruments canbe installed by private sector groups without society wide approval and do
not require the legislation of governments. They can be installed within asector by the actors of that sector to establish credibility for theorganizations and individuals in the sector. The effectiveness of these social

instruments depends on the trustworthiness of the body responsible foradministering the social instrument and its reputation with the generalpublic. In the trust-based societies of the west, these social instruments

serve the purpose of providing risk reduction and predictability
intermediate between formal laws and informal constraints. Most of thesesocial instruments rely on some kind of third party authority as a meansof eliminating self-serving bias and thereby establish credibility.

FSC certification relies on third party participation for its effectiveness.

A third party as certification authority, usually through an accredited
auditor, evaluates the product or service of the first party by a set of

KA JI VVARA :FSC CER TIFICA TION IN JA PAN

standards. If the first party, such as a manufacturer, satisfies the auditor

with proof of ability to perform by those standards, the third party
certifies for the second party, such as general consumers, that the firstparty can achieve those standards. Certification is not a third party
guarantee that each and every product or service meets the standards, It isa statement of professional opinion that says that a first party has theability to meet certain standards and operates with those standards
consistently. Furthermore, North says that "cheating, shirking, andopportunism" are natura! to transactions and third party enforcement isnecessary to provide legitimacy and equilibrium. With certification, if there

is periodical renewal, then that renewal functions as enforcement. If
evidence shows that a first party has lowered its performance below that
expected for certification, certification can be taken away. Thus, with theaddition of renewal as an enforcer, certification reduces risks for second
parties and may make it seem attractive to FSC certification promoters as
a substitute for assurance.
Yamagishi says that assurance system equilibrium is being lost due to theparadigm shift in Japan, and there is nothing to replace it. It can be argued

that certification renewal as a kind of enforcement can replace thesanctioning and monitoring of the assurance system, and the formality ofcertification as a social instrument to reduce risk and uncertainty could
replace long-term relationships. Characteristics associated with certificationsuch as these may be increasing its attractiveness as a social instrument
for forest sector actors in Japan. Therefore, even th.ough Japan is not atrust-based society, it is possible that certification could function as areplacement for the assurance of long-term relationships which is being
lost in Japanese society. Therefore, regardless of the expectation of thepromoters, certification may function as a substitute for long-term
relationships. It may function for the forest sector in Japan very differently

from the way it functions in the societies where it originated.

Ritual or Rationale ?

According to Meyer and Scott, modern organizations which aredecentralized can respond to complex external changes and influences andabsorb conflicts better than centralized organizations. Furthermore, theystate that most organizations begin as rational, but in the face of conflict,they become more institutionalized and rely on ritual rather than technical

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KOBE ECONOMIC & BUSINE SS REVIEVV, 45(2000), 39-55

activity for their legitimacy. Institutionalized rituals consistent withprevailing myths and compatible with the socio-cultural environment
generate confidence in the organization and legitimize it. Legitimacy isnecessary for stability, and in order to perpetuate itself, maintaining
stability is the actual purpose of an organization. To understand anorganization it is important to identify where decision making actuallytakes place. It is also important to identify the number of sovereigns towhich an organization must answer. The number of sovereigns influences
the structure of an organization, and multiple sovereigns can destabilize it(Meyer and Scott, 1992),

These theories related to organizational behavior are applicable to theinvestigation and understanding of the behavior of the organizations which
are promoting FSC certification in Japan and of the organizations which
are growing out of their efforts. Because certification is a new kind ofsocial instrument in Japan and because coalitions proactive with ecologicalissues are new to this society, gaining legitimacy is critical for survival.

From the perspectives of Meyer and Scott, viewing certification as a ritual
can offer insights into the apparent non-rational application of certificationin Japan at this time. Also, most of the activities of the actors are notfollowing the traditional Japanese centralized organizational structure.

Decision making seems to be happening outside of the normal top/downJapanese structure, but there are multiple sovereigns waiting to see what
will evolve out of this initiative. Meyer and Scott's theories provide a

valuable framework with which to question the function of ritual andrationality in the organizational behavior of the actors involved incertification.

Japan has just begun the process of adopting the western concept ofcertification. As I have attempted to show in this paper, the adoption of
FSC certification scheme in the forest sector is a complex initiative. In
analyzing this process, it is important to look at not only the expectations
normally associated with certification and those voiced by th.e promoters,

but also the more subtle dynamics which may be operating to encourage
adoption of FSC certification due to the current paradigm shift in Japan.
FSC certification as a social instrument may provide important outcomes
which serve the Japanese forest sector in positive ways so far unnamed.
The loss of "brands" in Japanese forests as assurance could be replaced bylogos signifying assurance through certification.

KAJIVVARA:FSC CER TIFICA TION IAT JAPAN 55

Referenees
Arinaga, A. and Y. Kasahara (1990). Sengo nihon ringyo no tenhai hatei (Historicaldevelopment of Japanese foresty after WW2). Tokyo: Tsukuba Shobo.
Environmental Building News (20oo). Wood products certification: a progress report.

http://www.buildinggreen.com/features/cert/certification.html
Forest Agency ed. (1999). Rin-gyo hahusho (Forestry white paper). Tokyo: Nihon

Ringyo Kyokai.
Hansen, E. and H. Juslin (1999). The status of forest certification in the ECE region.

Geneva: UN: 42.
'

Kasahara, Y. ed. (1996). Yomigaere kohuyu-rin (Reforming national forest). Tokyo:' Liberta Shuppan.
Kawakita-shimpo-sha henshu-kyoku (1989). Rin-do (Forest road). Akita, Japan:

Mumyo-sha.
Maesawa, E. (1999). personal contact, WWF Japan.
March, J. G. and J. P. Olsen (1979). Ambiguity and choice in organizations. Bergen:
Universitetsforlaget.
Miller A. and S. Kanazawa (20oo). Order by accident : the origins and consequences ofconformity in Japan. Boulder; Westview Press.
Meyer, J. W. and W. R. Scott (1992). Organizational environments: ritual andrationality. Newbury Park: Sage Publications.
Nakane, C. (1972). blapanese society. Berkeley: University of California Press.

North, D. C. (1990). Institutions, institutional change, and economic performance.

New York: Cambridge University Press.
Suzuki, T. (1999). personal contact, Forest Policy Research Institute, Tokyo.
Yamagishi, T., A. S. Miller, et al. (1998). In-group bias and culture of collectivism.

Asian Journal of Social Psychology 1(3): 315-328.
Yamaji H., A. Kajiwara, et al. (1994). Nihontehi Kigyouhaihei no Keiseihatei(Developing process of Japanese corporate accounting) . Tokyo; Chuo-Keizai

KOBE ECONOMIC & BUSINEss REVIEW, 45(2000), 57-83

THE LONG-RUN IMPACT OF APEC TRADE LIBERALIZATIONON REAL GDP AND SECTORAL ADJUSTMENTSt

HIRO LEE Kobe University

DAVID ROLAND-HOLST Mills College

DOMINIQUE VAN DER MENSBRUGGHE The World Bank

Abstract
On the threshold of a new century, most of the APEC countries are embarking on an
ambitious plan for open multilateralism. Using an 18-region, 16-sector dynamic computable general equilibrium (CGE) model of the global economy, we appraise the ef-

fects of APEC trade liberalization on member-country real GDP, sectoral output,
exports and imports by the year 2020. 0ur results suggest that developing-country
APEC members could realize significantly greater gains in real GDP than developed

members. Although implied structural adjustments may be challenging for somegroups, they are necessary if each member economy and the region as a whole are to
realize the full economic potential of expanded regional trade.

ulEL Classification: F13, F14

Kervwords: APEC; trade liberalization; CGE model

Corresponding address:
Hiro Lee
Research Institute for Economics and Business Administration (RIEB),
2-1 Rokkodai-cho, Nada-ku, Kobe 657-8501, Japan
E-mail: hlee(@hieb.kobe-u.ac.jp
Tel/Fax: 81-78-803-7009

Kobe University

David Roland-Holst
Department of Economics, Mills College
5000 MacArthur Blvd,, Oakland, CA 94613, USA
E-mail: dwrh@mills.edu
Dominique van der Mensbrugghe

The World Bank, DECPG
1818 H Street, NW, Washington, DC 20433, USA

E-mail: dvandermensbrugg@worldbank.org
t Hiro Lee gratefully acknowledges financial support from the Japan

Promotion of Science (No. 11630041). 'Society for the58

KOBE ECONOMIC & BUSINIISS REVIEVV, 45(2000), 57-83

1 Introduction
The impetus of trade and investment liberalization by the Asia-Pacific
Economic Cooperation (APEC) countries appears to have slowed since the
Asian financial crisis of 1997-78. Before the crisis, the APEC countries wereon a steady course of greater commitments to open multilateralism. At the

1994 summit, APEC leaders delivered the Bogor Declaration to remove
trade and investment barriers (by 2010 for developed members and 2020 for

developing members). In Osaka in 1995, they agreed on the Action Agenda
for implementing the objectives. In 1996, APEC leaders adopted the Manila
Action Plan for APEC (MAPA), including individual and collective actionplans to liberalize trade and investment in the region, starting in 1997.

At the APEC summits of the past three years, a number of members(Japan and the United States in particular), have advanced no substantial

reductions in their individual action plans, beyond concurrent WTO
commitments. APEC currently has no consensual mechanisms for dealing
with countries that are slow-movers, nor does it possess agreed means toadvance trade liberalization in more protected sectors such as agriculture(Lloyd, 1999). For example, Japan and Korea are very reluctant to remove
trade barriers in the agricultural sector because this producer lobby is a

vocal opponent of trade liberalization in these countries. Moreover, forsome of the developing members, liberalization threatens to undermine
state-sponsored efforts to develop industries deemed strategic to thenational interest.

Despite APEC's preference for voluntary trade liberalization over formal
binding agreements, we argue that liberalization on a nondiscriminatory

basis can reinforce economic recovery and long-run growth of the region.
Attaining a vision of open multilateral trade will require reorganization of

economic activity around the Pacific to more fully exploit the diverse
resources, technologies, and tastes of this vast region. At the national level,such a transition may imply dramatic adjustments in specific economic
activities and policies, and resistance to such change will pose a challenge

to reformers. There is, however, conclusive evidence that all APEC members

will ultimately benefit from this process, and empirical economists canfacilitate reform by elucidating the detailed benefits and costs of APEC
trade reform.
This paper contributes to the policy dialogue by evaluating the effects of
APEC trade liberalization on member-country real GDP, sectoral output,

59TION
LEE, ROLAIVD-HOLST AND VAN DER MENSBRUGGHE: APEC LIBERALIZA

exports and imports using an 18-region, 16-sector dynamic computable
general equilibrium (CGE) model of the global economy. The next section
provides a brief description of the APEC model used for quantitative
assessments. In section 3, we present the aggregate and sectoral results of
the APEC trade liberalization experiment, and the final section summarizes

our main research and policy conclusions.

2 The Model and Data
2.1 Brief Description of the APEC ModelA CGE model is an empirical tool that is well suited to evaluating of new

trading arrangements for several reasons. First, it captures extensive
indirect effects, such as interindustry linkages between sectors and trade
linkages between countries and regions. Second, it can evaluate the effect ofremoving trade barriers on resource allocation and structural adjustment
in each country. Third, it can detail the impacts on both member andnonmember countries and thereby better elucidate implications for thenegotiating envlronment.
The APEC model used in this study is a dynamic CGE model of the global

economy, which is to a large extent based upon OECD's LINKAGE model(OECD, 1997). It contains 15 APEC countries/regions - Australasia (ANZ:

Australia and New Zealand), Japan (JPN), China including Hong Kong
(CHN), Korea (KOR), Taiwan (TWN), Singapore (SGP), Malaysia (MYS),
Thailand (THA), Indonesia (IDN), the Philippines (PHL), Vietnam (VNM),
Canada (CAN), the United States (USA), Mexico (MEX), and Chile (CHL) and 3 non-APEC regions -the rest of Latin America (LAT), Europe (EUR),
and the rest of the world (ROW).'One of the key features of the model is that goods are differentiated byregion of origin and are modeled as imperfect substitutes. On the importside, this is reflected by the implementation of the so-called Armington
assumption where a constant elasticity of substitution (CES) specification

is used to incorporate imperfect substitution of imported goods withrespect to domestically produced goods. A symmetric specification is used
1 The model is calibrated to social accounting matrices tsAMs) of the 18 regions, which areconstructed from the Global Trade Analysis Project (GTAP) database, version 4. See
Gehlhar et al. a997) and McDougall et al. a998)for detailed descriptions of the GTAP
database. Due to the data limitations, Brunei, Papua New Guinea, and Peru are aggregatedinto ROW. Russia, which is newly admitted to APEC in 1998, is also aggregated into ROW.

6D

KOBE ECONOMIC & BUSJNLE SS REVIEW, 45(2000), 57-83

to model export supply, the latter being implemented with constantelasticity of transformation (CET) functions.2

Three different production archetypes are defined in the model: crops,
livestock, and all other goods and services. The CES nests for the threearchetypes are depicted in Figures 1-3. In each production archetype,
sectors will be differentiated by different input combinations andsubstitution elasticities.

The key feature of the crop production structure is the substitution
between intensive cropping versus extensive cropping, i.e., between fertilizer

and land [see Figure 1 ]. Livestock production captures the important role
played by feed versus land, i.e., between ranch- versus range-fed production[see Figure 2 ]. Production in the other sectors more closely matches the
traditional role of capital-labor substitution, with energy introduced as anadditional factor of production [see Figure 3 ].

All sectors are assumed to be perfectly competitive and operate underconstant returns to scale. Production technology is modeled mainly by anesting of CES functions. The model has three kinds of factors of
production: labor, capital, and sector-specific fixed factors (e.g., land in
agricultural sectors). Labor supply is assumed to be fixed in all regions andfor all time periods, and the wage rate adjusts to insure equilibrium in thedomestic iabor market. While we assume no international migration, labor
is free to move across all sectors of the economy. Thus, there is a single
equilibrium wage rate.
Within each period, capital is classified as being either old or new. New

capital is generated by the previous period's investment. This vintage
structure of capital allows for differentiating the substitution possibilities

across inputs by the age of capital. Similar to labor, new capital is assumed

to be perfectly mobile across sectors and there is a single economywide
rate of return on capital.

All ineome generated by economic activity is assumed to be distributed toconsumers. A single representative consumer allocates optimally his/her
disposable income among the consumer goods and saving. The consumption/saving decision is static: saving is treated as a good and iLs amount isdetermined simultaneously with the demands for the other goods. The price2 Note that the CET export specification was not implemented in the LINKAGE model.
Hence, differences in model results can partially be attributed to this change in model
specification. Further, the trade elasticities used in this analysis were somewhat reduced
from those used in the previous study.

61
LEE, ROLAND-HOLST AND VAN DER MENSBRUGGHE: APEC LIBERALIZATION

Production Structure in the Crop Sectorsa

Figure 1:

xe
o?

ND

VA

o=O

o
KTEF

L

Mp

or

tw

XMp

./Ncr

ien

KTE

XDp

Aog
-------.

6

Regions

XEp
(sA,

dii

"
T

K

---------

XEp:
KT:

Output (by vintage)
Capital, labor, energy, land, and fertilizer composite good
Capital, energy, Iand, and fertilizer composite good
Capital, energy, and land composite good
Aggregate fertilizer bundle
The aggregate energy bundle
Capital and land bundle

K, L, and T:

Respectively capital, labor, and, land

XAp:

Armington demand for intermediate goods (other than

XDp:

The domestic component of intermediate demand
The imported component of intermediate demand

XP:
VA:
KTEF.•

KTE:
fert:

XMp:

fertilizer and energy)

Note: The following production elasticities
vintage, theothers are vintage independent:

are differentiatede, aV, ak and ae.

a In the current

version of the bundle, there is a single fertilizer input,

ciated with thechemicals sector in GTAP.

by capitalwhich isasso-KOBE ECONOMIC & BUSINE SS REVIEW, 45(2000), 57-83

62

Production Structure in the Livestock Sectors

Figure 2:

xe
or

VA

ND

o=O

u=o
or

XMp

U

or

XDp

Aor

TFD

KTEL

XAp

T

KTE

L

cr

Regions

XEp

feed

Acr
------t

Kv..

------

XP:
VA:
TFD.•

KTEL,•
feed:

KTE:
Kv
XEp.'

K L, and T:
XAp:

Output (by vintage)
Capital, labor, energy, land, and feed composite good
Land, and feed composite good
Capital, energy, and labor composite good
Aggregate feed bundle
Capital and energy bundle
Capital demand (by vintage)
The aggregate energy bundle
Respectively capital, labor, and land

Armington demand for intermediate goods. (other thanfertilizer and energy)

XDp:

XMp:

The domestic component of intermediate demand
The imported component of intermediate demand

Note: The following production elasticities

are differentiated by capital

vintage, thee, oV and ae.

others are vintage independent:

63
LEE, ROLAND-HOLST AND VAN DER MENSBRUGGHE: APEC LIBERALIZATION

Figure 3:

Production Structure in the Manufacturing and Services Sectorsa

xe
6?

ND

VA

6=O

UV

KTE

L

X4p
6"

Oe

XDp

X7lfp

//Nuw

KT

XEp
oEp

u=o

Regions

FF

Kv----------

XP:
VA:

Output (by vintage)
Capital, labor, energy, and sector-specific factor compos-

KTE;

Capital, energy, and sector-specific factor composite good
Capital and sector-specific factor composite good
Capital demand (by vintage)

ite good

KT:

Kv
XEp:
K, L,

The aggregate energy bundle

and FF: Respectively capital, labor, and sector-specific factor

XAp:
XDp:

XMp:

Armington demand for intermediate goods (other than en-ergy)
The domestic component of intermediate demand
The imported component of intermediate demand

Note: The following production elasticities
vintage, the others are vintage independent:
a The sector-specific factor includes thegas, and mining sectors.

are differentiated bye, a' and ae.

resource base in thecoal,

crude oil,capitalnatural

64

KOBE ECONOMIC & BUSINESS REVIEVV, 45(2000), 57-83

of saving is set arbitrarily equal to the average price of consumer goods.
The model spans the period 1995-2020. It solves every year from 1995-2010

and every five years from 2010-2020. While the model relies on sequential
static computation of equilibria, intertemporal trends are specified forfactor growth (labor) and accumulation (capital), as well as changes in
productivity. Land is assumed to be price-responsive, however, with no timetrend on the supply curve.

The model is calibrated on exogenous growth rates of reai GDP,
population, labor productivity, and an autonomous energy efficieney
improvement in energy use.3 In the baseline scenario, the dynamics arecalibrated in each country/region by imposing the assumption of abalanced growth path. This implies that the ratio between labor and thecapital/fixed-factor bundle (in efficiency units) is held constant over time.`

When the APEC trade liberaiization scenario is simulated, the growth ofcapital is endogenously determined by the saving-investment relation.

2.2 Import Protection and Export Tax/Subsidy Rates
Sectoral rates of nominal import protection and export tax/subsidy
rates for the 15 APEC countries/regions are summarized in Tables 1 and
2, respectively. The import protection rates are the sum of sectoral tariff

rates and ad valorem equivalents of quantitative restrictions (QRs) on

imports, which are computed from the GTAP database. The average
protection rates in 1995 [the last row of Table 1] range from 1.4 percent
in Singapore to 19.3 percent in the Philippines, and sectoral protection rates

differ significantly across APEC. The most notable sector is rice and wheat,

where the rates range from zero or negative in a number of countries to 535
percent in Japan.5 In other agriculture they are very high in Japan, Korea,

Taiwan, and Malaysia, whereas in processed food they are quite high in

3 Real GDP and population growth rates are based on the World Bank's latest projections.
4 This involves computing in each period a measure of Harrod-neutral technical progress inthe capital/fixed-factor bundle as a residual, given that the growth of the labor force(in efficiency units) is pre-determined. This is a standard calibratibn procedure in

dynamic CGE modeling.
5 In version 4 of the GTAP database, the observed domestic-world price gap is appliedat the commodity ievel to estirnate import protection and export tax/subsidy rates.
Thus a negative protection rate might result (e.g., rice and wheat in China, Mexico,
and Chile) when the domestic price is iower than the world price.

ts
trtr,ik

Table 1?.

lmpert Protection Rates in Major APEC Countries, 1995 (percent)g,

Products
1

Rice and wiieata

2 Other agricultuie
3

Coa1, oil, and gas

4 Otherminings

Processed fOod

6

Textiles and clothingb

7 Wood and paper
8 CheniicalsC
9 Metals and paod.

10 MaChinery and equip.
11

Transrport equip.

12
13
14
15
16

Other manufac.
Construction
Electricity

Tradeandtransp.

ANZ JPN CHNKORTWNSGP MYSTHA DN pmVNMCAN USAMEX cm
O.3 535.0
2.4
65.9
O.1

O.5
4.0
14.6
6.5
6.4
7.7
7.4
11.2

O.7
o.o
30.9

6.8

07

2.2
O.9
O.4
1.6
102 1.3

-14.5

7.6
3.0
1.4
11.4
30.9
13.6
14.6
12.4
12.7
38.4
24.8

66.0
45.0
4.2

68.0
49.2

45.4

59.2
25.7

2.8

2.8

o.o

1.7

1.6

34.2
l7.4
9.4
8.0
9.4
6.4
14.5
11.5

53.1
24.1
10.9
16.4
11.5
9.9
37.8

25.2

1.8

5.7
O.9

26.0

28.9

20.3

6.9

8.6
4,O
5.6
5.8
6.4
18.2

1.4

5.2
7.5
5.9

8.0
4.8
7.5

7.'8

852

34.9
17.6
2.7

O.4
1.3

o.o
o.o
2.8
O.1

o.o
6.4
3.4
3.7

92

70.8

5.2

18.0

85

1.1

21.6

4.8
4S.2

1.7

4.5

23.0
21.7
26.0
20.4
25.0

68.3
28.1
13.1
4.8
5.8
4.5

27.2

19.4

10.4

27.8

14.0
6.0
8.0
7.1

o.o
O.6
6.0
o.o
6.4
11.2
O.5
1.5
1.6

1.2

-17.5

-23.3

4.4
O.6

O.9
O.7
3.2

5.9
8.8
8.4

O.1

9.9
9.9
O.5
2.9
2.0

255

O.8

1.9
1.4

18.4

1.3

3.0

1.0

-2.0

10.1

3.4

10.4

1.1

9.8.

2.6
3.0

9.9

3.1

3.4
7.0

10.0
10.5
10.5
10.2

8
k
Åí7<

g.
ccN

ta?

gg

g
s
piri

blj

Other services

O.1

Weighted average

6.1

3.3
2.9
9.1

o.o
1.8
14.5

blo'

O.2
8.1

ts

o.o
o.o
8.3

o.o
o.o
1.4

o.o
o.o
9.0

o.o
.o.o

13.1

o.o
o.o
6.7

o.o
o.o
19.3

o.o
o.o
17.2

o.o
o.o
1.6

o.o
o.o
2.4

o.o
o.o
2.3

o.o
o.o

rQV

8.1

l!

Q
ee

[II

These rates include ad valercm equivalents o'fquantitative restrictions ori imparts.
a lnclude processed rice.
b includes 1eather and footwear.

st
N>s
FLgi

C include plastics and rubber producbs.

El)

Source: GTAP database. Version 4.

?H

[IR

&

Table 2
Export Tax and Subsidy Rates in )viajor APEC Counnies, 1995 (percent)g
Products

ANZ JMg CHNKORTWNSGP MYS 'IHA

1 Rice and wiieata-O.1

2 Other aghulture

-2.7
1.7

3

Coal, oil, and gas

4 Othermining
5 Hocessed fdod
6 Textiles and c!othingb

7 Wood and paper
89Chernicalsc

Mctals and psod.

10 Machinery and e(Iuip.
11

Transport eqptp.

12
13
14
15
16

Other manufac.
Construction

o.o
-3.0
o.o
O.3
O.2
o.o
1.0

02
1.5

-83.5
-12.5

o.o
o.o
4.4
o.o
o.o
o.o
o.o

32.7

2.4
19.6

O.9
2.2
-1.2
-5.5

-10.8
-7.3

-51.6

-56.8

O.3
o.o
o.o
O.3
o.o
o.o
o.o
o.o
O.4
o.o

O.7
o.o
o.o
O.7
O.5
o.o
o.o
o.o
o.o
o.o
o.o
o.o
o.o
o.o

-1.6

O.1
Q.1

-5.0

o.o

30.3

o.o o.oo.o o.o
O.8 o.o

O.9

o.o
o.o
o.o
o.o
o.o
O.2
o.o
o.o
o.o
o.o
O.1

o.o

DN PHL VNMCAN USAMEXCHL

-52.2
13.3
13.7
13.6

-55.7

-O.6

44.1

-1.0

o.o

-5.7

e.3
o.o
o.o
O.9

15.5
13.7
13.7
13.7
13.7
13.0
13.7

1.3
o.o
o.o
o.o
o.o
o.o
o.o

o.o
o.o
o.o
o.o
O.6
o.o
o.o
o.o
o.o
o.o
o.o

21.4

o.o
o.o

o.o
o.o

-3.2

O.1

o.o
o.o

215
o.o
1.3
o.o
2.0
o.o
.1.1

4.4
13.5

O.3
O.6

-1.5

'O.7

o.o

6.1

3.9
o.o
O.3

3.1

02

4.7
2.6
5.7

-3.0
o.o
O.1

1.9

O.4

o.o
o.o

1.9

O.1

1.9

4.0

o.o
O.4

3.2

O.2

26.3
4.4

O.1

29.5

O.6

3.8
o.o
o.o

1.0
1.5

O.7
O.8
O.5
O.5

1.9

o.o
o.o
o.o
o.o
o.o
O.1

o.o

13.7
o.o
1.3

o.o
o.o
o.o
o.o
o.o
o.o

O.1

Other services

O.1

o.o
o.o

Weighted average

O.5

O.1

o.o
o.o
o.o

13.7
13.2

o.o
o.o
2.4

g

R
R.

R
g.

E

sN

02

gg

O.8
o.o

g-

f

Elecuicity

Tradeandtransp.

gg

O.1

10.0
4.9
2.2

o.o
o.o
O.2

o.o
8.9
O.5

g•

.9

R
Positive number indicates export taxes and negative numbers indicate export subsidies.
qb•C see Table 1.

Source: GTAP database, Version 4.

ee67LEE, ROLAND-HOLST AND VAN DER MENSBRUGGHE: APEC LIBERALIZATION

Vietnam, Thailand, and the Philippines,6Developing-country members have substantially lowered trade barriers
on a variety of manufactured products, yet some of them still maintainrelatively high tariff rates. A number of manufacturing sectors, forexample, are still highly protected in the Philippines, Thailand, and China.

In simple manufactures (e.g., textiles, clothing, and footwear), developed

countries tend to impose trade barriers to protect unskilled workers.
Nevertheless, the import protection rates on textiles and clothing are higher

in developing members than in developed members.

On the export side, Malaysia imposes export taxes on all goods andservices with the exception of rice and wheat and processed food [Table 2 ] .

Its average export tax rate is 13.2 percent. Several APEC countries' export

subsidy rates on rice and wheat are very high, but these reflect large
domestic-world price differentials on the highly protected sector.' It is also

worth noting that, although many members rely on heavy export tax andsubsidy instruments in the grain sectors, this does not represent asignificant macro trade distortion for any country. Trade distortions onother agriculture, manufactures, and services are the main determinants ofeconomywide export bias.

3 Empirical Assessments
In this section, we exarnine both aggregate and sectoral effects of APEC

trade liberalization. To assess the implications of regional tradeliberalization, we first establish a baseline scenario that assumes no tradeliberalization during the 2000-2020 period. We then run a simulation on
nondiscriminatory APEC trade liberalization; i.e., developed members

remove import and export distortions by 2010 and developing members
remove them by 2020 on a Most-Favored Nation (MFN) basis.S
In contrast to a free trade area where each member country removes
bilateral trade barriers on imports from other members, trade liberalization
6 These are largely caused by the imposition of import quotas on a number of agricultural
products in these countries.
7 Japan's export subsidy rate of 83.5 percent on rice and wheat is significantly smaller thanits import protection rate of 535 percent. This is because heavily protected paddy rice andwheat have negligible amount of exports compared to processed rice. In GTAP database,
Japan's export subsidy rate on processed rice is set to zero whereas its import protection
rates on processed rice is the same as that on paddy rice.
8 Only positive tariffs and negative export distortions (i.e., subsidies) are phased out.

68

KOBE ECONOMIC & BUSINIi SS REVIEVV, 45(2000), 57-83

by APEC members is nondiscriminatory toward the rest of the world. Eachmember submits individual action plans (IAPs) every year, which provide a

blueprint for implementing liberalization and facilitation in APEC
(Yamazawa, 1997). The general perception among the APEC leaders is that
regional integration should be nondiscriminatory toward the rest of theworld, which is consistent with the process of multilateral tradeliberalization as envisioned under the World Trade Organization (WTO).9

Three caveats should be mentioned with regard to the APEC scenario.
First, it is assumed that APEC countries' liberalization coincides with the

Uruguay Round (UR) commitments during 1995-2000. However, a number ofcountries (e.g., Chile, China, Indonesia, and the Philippines) have committed

to tariff reductions that are significantly larger than the UR commitments(Yamazawa, 1997). Second, the baseline scenario does not incorporate
conceivable reductions in trade distortions beyond the year 2000 under the

new WTO Round. The first caveat would underestimate the impact of APEC
trade liberalization while the second would overestimate it. Third, theassumption that all members remove trade barriers on agricultural
products by 2010 /2020 might be too optimistic. For example, Japan, Korea,

and the Philippines have excluded liberalization of rice and some otheragricultural products from their IAPs. In particular, it is highly unlikelythat Japan would liberalize its rice market by 2010. Thus, these caveats
must be borne in mind when interpreting the simulation results.

3.1 lrnpact of APEC Trade Liberalization on Real GDP
Table 3 summarizes the impact of APEC trade liberalization, on an MFN
basis, on real GDP. It indicates percentage changes in real GDP relative tothe baseline in 2005, 2010, 2015, and 2020, as well as absolute changes (inbillions of 1995 U.S. $) in 2020. By the year 2020, real GDP of developed anddeveloping APEC members would increase by $42 billion and $83 billion,
respectively (the last column of the table). In addition, since there would be

no trade diversion under nondiscriminatory liberalization, the non-APEC
regions would also be able to capture nontrivial gains in real GDP ($16billion). The gains in real GDP are distributed very unevenly, however. In
2020, the Philippines would realizeLa 3.8 percent increase in real GDP overthe baseline projection, followed by Thailand (1.6 percent), Vietnam (1.4
percent), Singapore (1.3 percent), and Taiwan (1.1 percent). In percentage
9 See, e.g., Lloyd (1996), Oxley (1996), Tan (1998), and Yamazawa (1996).

69
VAN DER MENSBRUGGHE: APEC LIBERALIZA TION
LEE, ROLAND-HOLST AND

Table 3
Changes in Real GDP relative to the Baseline Values

Absolutechanges

Percentage changes

CountryRegionin 202oa

2005

201O

2015

2020

Australasia

O.1

02

13.0
38.8

Korea
Taiwan

O.1

O.5
O.2
O.7
O.4
O.8

5.8

O.1

O.2
O.2
O.4
O.3
O.5
O.6
O.6
O.7

O.7

Japan
China (incl. Hong Kong)

1.2

1.6

o.!

O.4
3.8

O.2
O.2
O.2
O.3
O.3
o.o
O.4
O.3
o.o
o.o
o.o
o.o
o.o
o.o
o.o

Singaporervfalaysia

Thailandlndonesia
Philippines

VietnamCanadaUnited States

MexicoChile
Other Latin Arnerica

EuropeRest of World

11.8

1.0

1.3

O.8

O.9

1.2

O.3
2.4

O.7
o.o

1.1

1.4

o.o

O.1

O.1

O.1

02

o.o
O.2
o.o
o.o
o.e

o.o
O.3
o.o
o.o
o.o

o.o
o.s
O.1
O.1

O.2
O.5
o.o

O.2
O.7

42.2
83.0

O.1

15.9

o.o

O.1

O.1

Non-APEC Countries

o.o

O.3
o.o

dollars.

6,6

1.1

3.4
3,2
6.9
2,1
8.2
O.7
O.6
22.8
O.2
1,2
2,4
9.2
4.2

Developed APEC
Developing APECa Billions of 1995 U.S.

O.9
O.5

O.1

70

KOBE ECONOMIC & BUSINESS REVIEVV, 45(2000), 57-83

terms, an increase in real GDP is very small in Japan, Canada, the UnitedStates, and Mexico.'O
The real GDP gains reported in this paper are significantly smaller thanthose obtained in our earlier study (Lee et al., 1999) for two major reasons.

First, the model used here is calibrated to the 1995 database, whereas we
used the 1992 database in the previous study. During the three-year period,

some APEC countries reduced trade barriers significantly, resulting inmuch Iower trade distortions in the base year. For example, Thailand
lowered its average tariff rate from 31.6 to 13.1 percent, and Indonesia from

12.3 to 6.7 percent during 1992-95. Second, some modifications in the
structure of t•he APEC model would affect simulation results. Most
importantly, the newly incorporated assumption of imperfect substitutability between domestically produced goods and exported goods, which
are represented by CET functions, would reduce the impact of the removalof trade distortions.

While countries with higher initial protection rates generally achieve
greater efficiency gains from trade reform, the extent of welfare gains
depends upon several other factors. Singapore has the lowest average rateof protection (with the exception of Hong Kong which is aggregated into
China), but its real GDP gains are relatively large. This is because its
export to GDP ratio and intra-APEC trade share are both extremely high,and an APEC-wide trade liberalization would enable it to capture a
relatively large gain through export expansion.

Canada and Mexico gain very little from APEC trade liberalization. Thisis because about three-quarters of Canadian and Mexican exports weredestined to the United States in 1995, and the U.S. tariff rates on Canadianand Mexican products were already quite low.ii Thus, the benefits for
10 Studies evaluating the effects of alternative trade liberalization scenarios among AsiaPacific countries include Brown et al. (1996), Lee and Woodall (1998), Lee et al. (1999),
Lewis et al. (1995), Yang et al. (1998), and Young and Chye (1997). These studies generallyfind that, in percentage terms, both discriminatory and nondiscriminatoty liberalization

by East Asian or APEC countries would lead to welfare gains to developing countries(e.g., China and ASEAN) that are significantly greater than those to developed countries.

Recent studies assessing the impact of the Uruguay Round (e.g., Francois et al., 1996,
1997; Goldin et al., 1993; Harrison et al., 1996; Hertel et al., 1996; Yang et al., 1997) also

show substantial variations in the distribution of world welfare gains across regions.

11 While we only summarize APEC countries' average protection rates by commodity in

Table 2, the GTAP database provide protection rates by trading partner and bycommodity.

LEE, ROLAND-HOLST AND VAN DER MEIVSBR UGGHE: APEC LIBERALIZA71TION

Canada and Mexico are expected to be very small because of their low
trade shares with non-U.S. APEC members.
A major reason why the U.S. gains (in percentage terms) are small might

be because ad valorem equivalents of nontariff measures (NTMs) inservices are not estimated in the base year. The frequency of NTMs invarious categories of services in APEC countries suggests that themagnitude of barriers to trade in services may be extremely large (APECand PECC, 1995). However, there is no proper method to convert frequency
ratios into ad valorem equivalents, and no attempt has been made in thepresent study. Service exports accounted for approximately one-quarter ofU.S. exports in 1995, and its share in total exports would have been muchgreater in the absence of regulations in its trading partners. Since the U.S.

has comparative advantage in services, service trade liberalization is
expected to bring substantial benefits.

Another limitation of this study is that we have only considered tradeliberalization. Liberalization on foreign direct investment (FDI) is expected

to bring additional gains. Lee and Roland-Holst (1998) show that, in thecontext of U.S-Japan trade, capital mobility increases the welfare gains toboth countries that accrue from bilateral trade liberalization. Petri (1997)

conducts APEC trade and FDI liberalization experiments and finds that an

exclusion of FDI liberalization would diminish global welfare gains
resulting from APEC'liberalization by $60 billion, or 23 percent of full
Iiberalization.'2 These results confirm our a priori expectation that theremoval of investment barriers would lead to additional real output andincome gains, which could be substantial for developing members.
3.2 Sectoral Results
Although the real GDP results of the liberalization scenarios indicate theoverall gains in the standard of living resulting from the removal of tradedistortions, economywide efficiency gains are rare}y distributed uniformly
across sectors. Trade liberalization might lead to a sharp contraction of
output and employment in highly protected activities, and the adversely
affected sectors are likely to strongly oppose trade reform.

In many of the previous studies assessing the impact of APEC trade
12 Other relevant work in this area includes Walmsley (1999), who modifies the standard
GTAP model and incorporates the existence of foreign ownership of capital and land.
She finds that the foreign ownership of assets has a significant effect on the results oftrade liberalization in the Asia-Pacific region.

72

KOBE ECONOA4IC & BUSINEss REVIEVV, 45(2000), 57-83

liberalization (e.g., APEC, 1997; McKibbin, 1998; Yang et al., 1998), sectoral

effects are not evaluated. However, aggregate results reveal only part ofthe story and can give misleading signals about the political feasibility oftrade accords. Since trade policy is often formulated from the bottom up,a modern view of national interest, such as that based on trade reciprocity

and open multilateralism, might encounter conflicts with establisheddomestic interests.

Table 4 provides absolute and percentage changes in sectoral output,
exports, and imports resulting from APEC liberalization compared with the
projected baseline values in 2020, Since rice and wheat are the mostprotected products in many East Asian members, the removal of tradedistortions in these products can lead to extreme adjustments. In
particular, Japan's output of rice and wheat is estimated to contract by 56

percent while its imports would rise by almost 700 percent compared withthe baseline values in 2020. By contrast, countries that export relatively
large shares of rice and wheat would experience sharp increases in output.
Driven by a surge in exports, the output of rice and wheat in Australasia,
Canada, and the United States is expected to rise by 108, 69, and 49 percent,respectively.

The agricultural exporters would generally experience reductions in
manufacturing output because labor and capital are drawn into theagricultural sectors.'3 For example, the United States would experience
reductions in growth rates of manufactures with the exception of processed

food, wood and paper, and chemicals. However, increases in output ofagricultural sectors and service-oriented sectors (sectors 13-16) would morethan offset the reductions in manufacturing output.

In China, Asian NIEs (Korea, Taiwan, and Singapore), and the ASEAN-4
countries (Malaysia, Thailand, Indonesia, and the Philippines), exports andimports increase in all manufacturing sectors. Not only would they expand
production of labor-intensive manufactures (e.g., textiles and clothing), but

most of the Asian developing countries also increase output of the great
majority of capital-intensive manufactures.

Korea and Taiwan's results are somewhat similar to' Japan's as
agricultural sectors contract (relative to the baseline case) and all
13 This result crucially depends upon the assumption that labor is homogeneous andperfectly mobile across sectors. Had we disaggregated labor by type and skill, labormobility would have been limited and many of the manufacturing sectors might nothave contracted.

gTable 4tDts

Changes in Sectoral Outpug Exports, and imports relative to the Baseline, 2020

foMions of 1995 U.S. dollars, percent)

Itrl}

:
Australasia

OutputExports

China (incl. Hong Kong)Japan
lmports

outputExports

lmports

outpntExports;ilmportsg($bn) (O/e) ($lm) (O/e) ($bn) (O/o) ($bn) (O/o) ($trn) (e/e) ($bn) ("/o) ($tm) (O/o) ($lm) (e/o) ($bo) (O/e)
5.2 182.4

o.o

6.5 61.8-55.7

O.1 O.7
O.1 O,4

O.3
O.3

11.6 -28.2-11.1

O.1 -89.0 74.4
-9.3 36.1
O.1

3 Caal, oil., and gas

6.2 108.4
2.3
3,8
O.5 1,O

19

02

4 onermining

O.5

-2.5

e.4 -3.2

1.8

5 Processed fbod

7.0
-1.4

g.s

5.4 22.S

o.o
O.4

-7.0

O.2 4.1

o.o
O.4
2.9

3.1 1.4
1.1 O.6

O.9
e.7

O.1 -2.1

O.9

8 Chernicals

O.5
e.4

O.1 O.4

1.8

1 Rice and wiieat

2 Otheragrialture

6 Textiles, clotlimg

7 Wood and paper
9 Metalsandptod.

-1.1

-1.6

O.2 O.9

O.8

10 Machinay

-1.6

-3.6

3.5

2.7
1.4

11 Transportequip.

-1.5

4.4

-O.3 -2.1-O.1 -2.0

12 Othermanufac

O.7

-3.7

O.O -1.5

13 Construction
14 Elecnicity

3.8

3.2
1.6
O.3
O.3

15 Tradeandtransp.
16 Otherservices

O.3
1.3

1.7

O.O D.1

02 -1.1

-1.6

O.7

-9.0

-1.2

8.6 -1.2

n.7

2.7
2.5

2.7

i:

D.8

4.0 O.1

O.4

13.0
4.3

1,O

17.4
2.5
11.9
8.7

-1.0

-5.8

14.1 19.9
21.0 11.3

23.2

-12

D.3

4.2

155

l.7

5.4

11.0

34.4

4.0

1.5

O.4

50.0
2.7

15.2

O.7
e.6

5.6

ilO.4

-1.1

2.2

2.0

38.0
2.2
9.7

o.o
O.5

-17.1

O.2

O.7

O.7

-3.7

7.1 -8.7-1.3

17.7 O.9
8.4 3.6

O.3

3.1

O.6

O.5

7.2 7.5

72 O.4O.8

5.1

7.2 n.4

8.1 16.9
6.3 40.4!O.7 22.0

2.1

7.8 -O.1

O.1

n.1

o.o

4.0

3.6

3.6

2.2
4.7

4.2
27.0

6.9
4.6

O.3

29.7

7.1

13.1

3.8

1.0

13.8
-23.7
12.8

O.8

13.9 3.6

5.8 O.5
11. 4.8
6.5 1.5

21.1
17.5

8.7
1.6

3.2 8.5
02 •1.7 O.7
1.2

691.9
57.2

17.8

2.4

-2.1

3.2

5.3
3.7

O.4
O.7
O.3

3.4

o.o

O.5

4.1 4.7
l.7 O.6

1.7
O.9

;tre

6.4

-7.0

1.2

5.I

13.2

1.9

18.3

14.0

7.0

21.7

g
x
cc
e
ctutj

g
g
F.

k

g
l•

O.6
1.0

28.5

12

23.9

7.8

-2.6

-3.1

8.4

O.6

4.3

6.6

-l.5

4.0

:6

Ntc

N"

Table 4 (condnued)g
gg

Taiwan

Korea
Exports

outputlmPCnts

output($lm) (e/o) ($hn) (O/e) ($tm) (O/e) ($hn) (O/o)
1 kice and wiieat
2 Otheragriculture

-3.4

4.5

o.o

-5.2

-5.5

o.o

63.1
O.1
3.1
2.3

2.0
8.5

101.5
36.4

2.5
1.6

-7.1

n.2

-71.4

O.6

6.9

e.1

5.1

1.0

3.0
2.6
7.5

o.o
o.o

4.5
O.4
3.9

1.6

1.5

O.3

1.6

o.o

5 Processed fbod

O.3
O.5

O.3

O.4

10.4

2.3

18.6

6 Textiles, clothing

22.8

15.1

23.0

2.0

O.4

O.4

8 Cheniicals

8.8

3.6

4.2

9 Metalsandptod.
10 Machinery

4.8
6.7

1.7

2.3

9.2
3.4
5.1
4.8

30.8

7 Wood and paper

14.3
O.5 '

1.6

9.1

11 Transportequip.

5.!

4.2

4.6

10.6

o.o

4.1
O.3

12 Othermanufac

1.5

1.5

1.6

7.8

O.8

7.7

13 ConstruCtion

1.5

14 Electricity

O.2
3.8

outpntExports

lmports(O/o) ($lm) (O/o) ($tm) (O/o) ($tm) (O/o) ($bn) (O/e)-3.0

3 Coal, oil, and gas

1.3

($bn)

imports-1.4

4 cuerrnming

O.1

Expcrrts

Singapore

1.4

116.6
44.5
1l.4

O.1

4.5

o.o

88.1

D.4

4.8

O.7
o.o

1.4

1.4

o.o
o.o
O.4
o.o

R

67.6 O.O

O.4

O.7 O.5

8.3

1.4 1.5
O.3 O.1
19.5 1.0
9.1 O.9
2.4 O.3
4.2 1.4
5.1 O.9
3.4 7.2
3.8 O.5
3.3 !.O

62
3.5

ILI

23.4

1.8

10.6

l.9

21.3

34.7
31.7

2.1

2.7

20.1

O.8

7.3

O.7

O.5

25.5
O.7

O.8

4.5

O.9

69

O.4

1.7

O.2

16.1

7.9

7.5

12.6

3.9

2.2

3.6

O.7

O.3

2.1

2.4

1.4

5.0

2.0
O.8

1.4

O.4

4.6

52
22

8.2

9.4
7.1
5.7

8.3

3.3

7.9

-1.5

-2.0

O.6

3.4

3.5

14.7

O.4

2.8

3.5

5.3

3.3

12.6

1.0

10.2

O.7

3.l

O.4
O.6

O.4

3.9

3.0

1.6

S.2

O.2

O.6

1.3

3.4

O.2

4.3

15 Tradeandtransp.

-3.4

4.3

O.6

O.2

O.2 O.6

7.9

-2.0

-3.4

-13
O.5

1.3

-5.9

O.9
D.8

O.8

16 Other services

1.7

1.2

e.1

n.6 o.7

2.3

1.4

O.3

6.7
9.7
6.9
5.4

2.3
1.4

O.5
2.1

2.2
5.5

O.3
e.6

2.4

O.6
e.3

-2.4

O.9

-2.2

O.5

4.9
1.7

g
Q
g
g
g.

E

gm

7.6

g

5.0

g-

3.8

.g

3.7
3.4

2.8
4.3

,.

g
.9
g.
tc

g.
tsi

Table 4 (continued)

Experts

lmpcnts

outputExp(rrts:

lndonesia

Thailand

Malaysia

outpute.

iii

lmpons

Chitpnt

Expcntslmperts

2tr:.

($tn) (o/o) ($tn) (o/o) ($tm) (o/Q) ($tm) (e/o) ($lm) (o/o) ($lm) (o/o) ($lm) (e/o) ($lm) (o/o) ($tm) (olo)
g.

-9.4

O.3 2.7
4.5 O.1

95.5
36.g
2.6

q.o

1.0

2.4

1.1

O.3

-1.6

O.1

2.1

O.3

16.9
12.7

1.3

2.0

-3.8 O.O
11.4 1.0
18.8 1.0

5,3

5.0

1.7

9.1 O.1

2.5

o.o

10.1

2.5

17.7 O.4

1.9

O.5

O.4
9.0

O.5

4.7 1.0
9.5 3.7
6.2 O.S7.7 O.6

4.8
2.5

O.1

7.0

4.9
2.7
8.4
o.o
1.7
O.8
6.7

3.6

4.5

6.0

O.4

1 ruce and wheat
2 Otlieraghculture

-1.g

-10.2

o.o

-35.6 1.9

-1.8
-2.3

4.7
q.3

o.o

3 Coal, oil, and gas-1.1

4 omermining

e.3

-3.9

O.1

5 Processedf6od

O.9

2.5

1.8

6 Textiles, clothing

22 115

7 Wood and papc r
8 Chernicals

1.7

3.2

n.1

9 Metalsandpsod.
10 mbchinery

13.6

11 Transportequip.

-1.0

-3.3

13.3
O.6

12 Othermanufac

1.1

3.5

1.4

13 Construction

-1.S

-2.4

14 Electricity

O.1

1.1

15 Trade and transp.
I6 Other services

-1.7

-1.5

O.4

-2.1

o.o

-1.8

5.1
-1 .8 ,

-1.1

O.O 3.0
O.2 2.2
1.3 3.8
O.1 1.1
O.1 2.0

O.4 -12.3
o.o
O.4
O.2 2.0o.o
2.4
O.3 9.3

9.6

3.3 13.3

1.4

18.2

1.3

2.8

4.1

1.2

O.1

O.7
O.3

3.6

O.6

Ll

O.4

5.8
3.7
O.9

4.6

21.6

-1.6

-11.8

1.1

16.5

o.o

O.1

1.1 5.0
O.5 5.6
O.3 4.6O.6 5.2
O.O O.9
O.2 3.5

O.2

O.3

1.7

12

o.o

O.1
O.4
O.5

62.8

O.1

12.8

11.4

4.7
n.2

4.0

o.o
1.7

O.3

6.8
7.5

-5.4

02

2.3
4.5

13.2
17.3

2.1

32.7

e.6

1.3

20.1

3.9

O.4

7.2

O.2

3.9

12

10.1

1.2

O.4

O.8

6.5

9.0
9.8

4.8
2.9

2.8

-10.6

O.2

6.1

1.1

8.7

O.2
2.5

1.3
2.7
1.5
1.7

O.2

02

1.5

1.4 O.1
O.6 D.4

63.6

O.3
O.6

-5.1

3.6
O.3

8.6
5.3

-1.6

O.6

-7.9
-5.0

O.7
O.7

e.2
o.o
2.6
O.9

O.5
1.7

15.5

O.4

10.2

O.3 2.6

O.1

O.9

O.1 12

o.o

-1.7

E
tag

g
k
k•

."'

g

g
E-

Ntri

Nos

Table 4 (continued)r<gVietnamPhilippines

outpntExperts

imports

outputExportsIl:

Canadalmports

outpatExpc)rts

impo!ts8gccF.4($hn) (O/o) (Slm) (Olo) ($tm) (O/o) ($bo) (elo)(Sbo) (o/o) ($tn) (o/o)

1 rdce and wheat
2 oneragricutture

-2.1

-11.8

o.o

45.7

1.0

55.8

1.1

22.1

O.1

O.2

O.4

23.1

o.o

1.2

e.s

-5.2

14.0
22.4

O.4
O.6

27.5
25.2

D.4

-5.6

1.5

19.7

1.3

o.o

O.9

o.o

-1.9

o.o

3 Coal, oil, and gas

1.7

4 omermming

1.4

O.8
o.o

59.2
O.4
21.9
4.3

o.o

14.1

o.o
O.6
o.o

4.5

($tm)

(O/o) ($hn) (O/e) ($tM) (O/e)

4.5
o.o

68.9
o.o

4.3
O.2

R

79.0

o.o

-18.1

g.

22

O.2
o.g
o.o
O.6

2.6
6.7
O.3
5.9

gm

2.9
O.2
O.8

14.1

g

O.8
2.0

-:

20.1

O.1

O.1

O.I

O.4

4.6

o.o

o.o

D.1

O.1

O.8
-3.3

5 Hocessed fbod

-1.7

-3A

Ll

21.1

1.0

15.3

-1.3

-16.5

O.1

-2.3

1.9

O.6

6 Textilea clothing

6.4

42.1

4.4

54.S ,

1.3

19.0

2.1

24.2

1.7

30.4

O.9

51.4
23.9

O.2
e.g

-1.5

6.1

7 Wood and paper

O.9

O.5

5.1

O.1

-1.5

o.o

5.5

O.1

7.5

O.7

O.5

O.8

O.8

6.7

O.2

6.6

O.1

16.1

O.1

1.5

O.7

O.8

O.2

O.7

9 Metalsandpeod.
10 Machinery

2.5

O.9

1.5

18.7

o.o

-1.9

o.o

5.1

o.o

-1.6

18.9

o.o

O.5

4.9

o.o

O,6

D.4

O.7

e.6

O.4

41.7

O.4

5.8

4.1

O.3

8.3

O.4

O.3

O.5

O.5

12 Othermmufac..
13 Construodon

1.1

1.0

32.6

O.3

10.1

O.2 -15.0
o.o
O.7

o.o
o.o

e.2
O.7

1.1

6.7

O.5
e.s

O.3

33.1

e.4
O.8

o.o

9.2

11 Ttansportequip.

26.5
32.6
27.9
22,6

25.7
20.7
28.9

O.1

8 Cheniicals

9,1
4,1

O.2
O.3

o.o

8.1

O.1

10.9

o.o

O.7

O.4
O.5

O.6
O.6
3.0

14 Electricity

O.1

15 Tradeandtransp.
16 Otherservices

2,2

9.7

1.4
1.6

9.7
1,6
1,6
2.2

O.5

3.3

19.8

-!.9

2.8

14.0

O.4

-17.0
-13.2

O.5

e.3

-1.6

O.2

12

O.4

O.2

o.o

e.1

O.2

O.2

O.2
O.8

O.5

5.0

o.o

-O.7

O.3

1.0

O.3

-2.6

o.o

O.7

o.o

-2.6

O.4
n.g

O.1

O.4

e.2

o.o

O.1

o.o

E

E
g•

.9
g•

O.8
o.o

tc

g
tsi

Table 4 (continued)Egi

MexicoUnited States

outpatExports

lmports

outputExports

Chile

outputlmports

Exports:.

imports($hn) (O/o) ($bn) (O/o) ($bn) (O/o) ($lm) (O/e) ($bn) (O/o) ($bn) ("/o) ($hn) (O/e) ($bn) (O/e) ($bn) (e/o)
48.g

10.3 80.7 n.1 -11.2 O.O

-2.4

7.6

23.1 40.9 1.9 5.7 O.1

O.2

3 Coal, oil, and gas

12.8
34.2
2.8

4 Otherrriming

D.1

e.1

5 Processed fbod

4.0
-15.1

O.5

1 Rice and wiieat
2 Otheragriculture

6 Textiles, clothing

7 Wood andpaper
8 Chemicals
9 Metalsandpsod.

10 Machnay

O.6

4.1

1.6
1.1

O.2

-3.5

n.4

-19.8

-1.2

O.1

11 Transportequip.

-O.2

o.o

12 Othermanufac

-3.7

-1.4

13 Construction

13.5

O.6

14 Electricity

O.8

O.3

15 Trade and transp.

6.4

02

16 Otherservices

16.1

O.2

O.2 12 15 1.0 1.3

O.O D.3 O,O O.O O.1
3.1 6.8 4.8 10.9 O.1-O.4 -12 31.9 15.9 08

O.1 O.1 1.2 1.3 O.2
1.7 1.1 5.0 3.4 O.3
O.1 O.2 2.7 2,3 O.7-3.1 O.6 26,7 4.2 1.3

O.3 O.2 8.4 3.5 1.1
O.1 O.4 8.3 7.0 O.3

O.I
o.o
1.7 O.9 5.1 3.0 -O.7

O.4 02 O.3 O.2 -1.0

O.O 2.9 O.O 92
O.2 3.3 O.O O.7

1.2

O.7 3.0 O.O -O.1

O.7

O.O 1.8 O.O 1.5
O.2 4.9 02 -S.3
O.2 -2.1 O.3 3.8
O.1 2,O O.O O.2
O.4 2.5 O.2 O.9
O.4 2.7 O.2 1,4
1.4 1.9 O.7 1.0
1.0 2.8 O.3 1.6
O.O O.5 O.5 8.3

O.1
-1.3

O.4
O.3
1.1

1.3
1,7

o.o

O.5

O.2

O.7

O.1

1.4

1.1

5.7

D.1

O.4

O.2
-22

O.7

2.8

o.o

O.1

2.2

6.4

O.1

-2.1

kf

O.O 7.1
O.2 4.4
O.O 9.1
O.7 6.7

o.o
o.o

2.1

O.1

3.4

o.o

02 3.3

O.1

4.8
4.0

O.4

9.3

O.1

3.6

1.5

--

O.1

3.8

as

O.4

3.3

O.3

2.8

O.2

8.1

-2.0

O.2

O.5

1.3

D.1

o.o

O.4

o,o

o.o

O.5 5.6

-O.1

-2.9

O.8

4.7

O,1 3DO,1-3,1

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78

KOBE ECONOMIC & BUSINESS REVIEW, 45(2000), 57-83

manufacturing sectors expand except transport equipment in Taiwan. One
notable difference is that the reductions in agricultural output in these twocountries' are significantly smaller than in Japan mainly because of theirmuch lower initial protection rates on agricultural products.

In China, removing the trade distortions would result in a fall inagricultural output, posing a potential problem on food supply in the longrun. Real output of a number of manufacturing and service-oriented
sectors would increase over the baseline level, where Hong Kong's
comparative advantage in manufactures and services might be contributing
significantly to these results.

Large structural adjustment•s occur in ASEAN eount.ries, particularly in
the Philippines. Textile and clothing output would increase in all six ASEAN
countries reported in Table 4, ranging from 7.3 percent in Singapore to 42.1

percent in the Philippines. Machinery is another sector that expands in all

the ASEAN countries. In the Philippines APEC trade liberalization would
lead to output increases in all manufacturing sectors in excess of 20 percent
over the baseline values in 2020.

Relatively small structural adjustments are predicted to occur in Mexico
and Chile. In Mexico, output growth is higher in fossil fuels, metals andproducts, machinery, and transport equipment over baseline projections,whereas it is lower in rice and wheat, textiles and clothing, and othermanufactures. The sectoral results for Chile are consistent with our apriori expectations on output adjustments for a resource-abundant
country. Real output growth is faster under the liberalization scenario inother agriculture, fossil fuels, other mining, wood and paper, andnonferrous metals (aggregated into metals and products), largely driven by

new export demand. Real output growth becomes slower in textiles andclothing, machinery, and other manufactures.
Although not reported in this paper, we also conducted a discriminatory
liberalization experiment. Standard deviations of changes in real output

relative to the baseline are not significantly different .between thediscriminatory and nondiscriminatory scenarios in most of the APEC
countries/regions. For products with comparative disadvantage, such as

agriculture and processed food in Japan and clothing in developed
members, the shares of intra-APEC imports are extremely high. Thus, eventhough these products suffer greater output losses under nondiscriminatory liberalization, additional contractions are relatively small.

79
LEE, ROLAND-HOLST AND VAN DER MEArSBRUGGHE: APEC LIBERALIZATION

4 Conelusions
At the turn of this century, most of the nations bordering the Pacific haveembarked upon an ambitious plan for open multilateralism. Although theaggregate benefits from more efficient regional specialization are readily
apparent, more detailed adjustment costs en route to Pan-Pacific free trade

are more difficult to ascertain but unlikely to be negligible in domestic

policy agendas. For this reason, implementation of this trade reform
agenda ean be facilitated by a deeper understanding of these adjustment
patterns, including the magnitude and incidence of their economic costs.
In that spirit, this paper has provided general equilibrium estimates of the

impact of APEC trade liberalization on real GDP, sectoral output, exports

and imports. Compared with the baseline scenario where no tradeliberalization is assumed during 2000-2020, real GDP of developed anddeveloping APEC members is predicted to increase by $42 billion and $83
billion, respectively, by the year 2020 while that of non-APEC members
would increase by $16 billion. The estimates based on our dynamic CGE
model are not forecasts, however. They depend upon the model structure,parameter values, and policy scenarios, The present model does notincorporate such features as scale economies or human capital in the

production function. The inclusion of these factors with dynamic
specification is likely to result in a substantially larger impact ofliberalization.'4 In addition, we have only considered liberalization ofmerchandise trade and did not include liberalization of service trade orinvestment in this study. Thus our results may be considered a lower end of
the full impact of APEC liberalization.

APEC members submit individual action plans (IAPs) each year,
providing their own liberalization and facilitation plans for the short-,
medium- and long-term horizons and unilaterally reduces its trade barriers

accordingly. However, the implementation of IAPs is non-binding andseveral member governments are thus reluctant to remove trade barrierson politically sensitive sectors, particular when the domestic economy isexperiencing a recession or crisis. Nonetheless, if each government
implements an adjustment program, including the training of workers in
14 Francois et al. (1997) show that the welfare gains resulting from the Uruguay Roundagreement under increasing returns to scale and monopolistic competition could bealmost three times as large as those when constant returns and perfect competition are

assumed.

KOBE ECONOMJC & BUSINESS REVIEW, 45(2000), 57-83

80

depressed sectors, the social costs of economic transition could be
mitigated. Overall, APEC trade liberalization would produce trade
expansion in most product categories, especially inexpensive imports at theexpense of high-priced domestic products.

AIthough the assessments of APEC liberalization would be enhanced byextension of our model, as well as by more careful evaluation of IAPs, ourresults provide some important poljcy implications. First, despite large
disparities in per capita income, nondiscriminatory liberalization promises

substantial benefits to the APEC member countries and people in the
Pacific Basin. These benefits appear to outweigh the adjustment costs ofattaining a higher and more sustainable growth trajectory. Second, while
the adjustments may be difficult for some groups, they are necessary ifeach of the member economies and the region as a whole is to realize its
full economic potential. A dynamic economy cannot avoid experiencing
structural adjustments, inasmuch as technological innovation and growthinduced changes in consumption and production patterns would require
such adjustments. Finally, while APEC liberalization is a good long-termprescription for regional growth, speeding up the process would also be
good First Aid for a country such as Indonesia that is still experiencing
economic crisis. Economies dealing with both recession and the prospect of

globalization should focus their resources on the recovery of exportoriented activities to secure a more sustainable basis for economic recovery

and future growth.

References
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Francois, J.F., B. McDonald, and H. Nordstrom (1996), "The Uruguay Round: A
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81
LEE, ROLAND-HOLST AND VAN DER MENSBRUGGHE: APEC LIBERALIZATIONFrancois, J.F., B. McDonald, and H. Nerdstrom (1997), "The Uruguay Round: A
GIobal General Equilibrium Assessment," in D. Robertson, ed., East Asian
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Global Econornic Irnplications, Paris and Washington, DC: OECD and WorldBank.
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Round," in W. Martin and L.A, Winters, eds., The Uruguay Round and theDeveloping Countries, Cambridge: Cambridge University Press.

Hertel, T.W., ed. (1997), Global Trade Analysis: Modeling and Applications, New
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Hertel, T.W., W. Martin, K. Yanagishima, and B. Dimaranan (1996), "Liberalizing

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Lewis, J.D., S. Robinson, and Z. Wang (1995), "Beyond the Uruguay Round: The
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Lloyd, P.J. (1999), "EVSL and Sector-based Negotiations," paper presented at the

APEC Study Centre Consortium Conference, Auckland, May 30-June 2.

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82

McDougall, R., A. Elbehri, and T.P Truong, eds. (1998), Global Trade, Assistance, andProtection: The GTAP 4 Data Base, West Lafayette: Center for Global Trade
Analysis, Purdue University.
McKibbin, W.J. (1998), "Regional and Multilateral Trade Liberalisation: The Effeets
on Trade, Investment and Welfare," in P. Drysdale and D. Vines, eds., Europe,

East Asia and APEC: A Shared Global Agenda9 Cambridge: Cambridge
University Press.

OECD (1997), "The LINKAGE Model," mimeo, OECD Development Centre, Paris.
Oxley, A. (1996), "Political Hurdles to the Realisation of the Bogor Declaration: The

Need to Revisit 'Open Regionalism'," paper presented at the Conference on
International Consortium of APEC Study Centers, Manila, May 9-10.
Panagariya, A. (1998), "Should East Asia Go Regional?" in H. Lee and D.W. Roland-

Holst, eds., Econornic Development and Cooperation in the Pacific Basin.'
Trade, Investment, and Environrnental Issues, New York: Cambridge University

Press.
Petri, P.A. (1997), "Foreign Direct Investment in a Computable General Equilibrium

Framework," paper presented at the Brandeis-Keio Conference on "Making
APEC Work: Economic Challenges and Policy Alternatives," Keio University,
Tokyo, March 13-14.
Tan, Kong Yam (1998), "Regionalism in the Pacific Basin: Strategic Interest of' ASEAN in APEC," in H. Lee and D.W. Roland-Holst, eds., Econornie
Developrnent and Cooperation in the Pacific Basin: Trade, Investrnent, andEnvironmental Issues, New York: Cambridge University Press.
Walmsley, T.L. (1999), "Incorporating International Capital Ownership into the GTAP

Model: Results for Asia-Pacific Trade Liberalisation," Preliminary Working

Paper No. IP-72, Centre of Policy Studies and the Impact Project, Monash

University. •Yamazawa, I. (1996), "APEC's New Development and Its Implications for Nonmember
Developing Countries, Developing Economies, 34: 113-137.

Yamazawa, I. (1997), "APEC's Progress toward the Bogor Target: A Quantitative
Assessment of Individual Action Plans," Report, Japan National Committee

for Pacific Economic Cooperation and APEC Study Center, Hitotsubashi
University, September.
Yang, Y., R. Duncan, and T. Lawson (1998), "Trade Liberalisation in the European

Union and'APEC; What If the Approaches Were ExchangLed?" in P. Drysdale
and D. Vines, eds., Europe, East Asia and APEC.' A Shared Global Agenda9
Cambridge: Cambridge University Press.

Yang, Y., W. Martin, and K. Yanagishima (1997), "Evaluating the Benefits of83
LEE, ROLAND-HOLST AND VAN DER MENSBRUGGHE: APEC LIBERALIZATION

Abolishing the MFA in the Uruguay Round Package," in T.W. Hertel, ed.,Global Trade Analysis: Modeling and Applications, New York: Cambridge
University Press.
Young, L.M. and K.M. Chye (1997), "Free Trade in the Pacific Rim: On What Basis?"in T.W. Hertel, ed., Global Trode Analorsis: Modeling and Applications, New

York: Cambridge University Press.

KOBE ECONOMIC & BUSINLESS REVIEW, 45(2000), 85-101

MONETARY COOPERATION IN EAST ASIAN COUNTRIES:A POSSIBILITY FROM MACRO ECONOMIC INDEXESAND INTRA-REGIONAL TRADE DEPENDENCY

Bong Gil KIM Kobe University
Kazuhiro IGAWA Kobe University

Abstract
This paper analy2es the possibilitpt of currenay area in Asia depending on
rnacro-economic indexes and on intra-regional trade dependency, and possiblbl
depending on financial dependency. These will be corrtpared with those in EU.
The next issue tvill be the process to converge into the currenay area in Asia, APEC

experience might give us much information about these issues. Not persuasive but
voluntary participation of rnernber eountries in rnonetary cooperation and startingfrom weah cooperation to tighter cooperation will be the style in Asia. However it is

not solved yet that gradual set-up of currency area is better or easier than rapid
introduction of one common currency.
All our arguinents depend on our speculative perspective that one global currency
systenz is the best final stage of international monetary systein and this stage will not
be in far future. ;iVe will discuss the perspective to a global currency area, tahing into

account of relations with Dollar and Euro and the Asian currency.
elEL classifieation: F31; F33; 023

Key words: Monetary Cooperation; International Monetary System, ACU, EURO
Corresponding Address:

Bong gil Kim
Research Institute for Economics and Business Administration (RIEB)
Kobe University, 2-1 Rokkodai-cho, Nada-ku, Kobe 657-8501, Japan

E-mail: bgkim@rieb.kobe-u.ac.jp
Phone/Fax: 81-78-803-7005

Kazuhiro Igawa
Research Institute for Economics and Business Administration (RIEB)
Kobe University, 2-1 Rokkod•ai-cho, Nada-ku, Kobe 657-8501, Japan
E-mail: igawa@rieb.kobe-u.ac.jp
Phone/Fax: 81-78-803-7001

86

KOBE ECONOMIC & BUSINE gS REVIEW, 45(2000), 85-1Ol

1. Introduetion

Depending on developments of technology, especially of transportations
and telecommunications and more recently of the information technology,
a world economy with many countries has rapidly integrated into a global
one. International trade of goods is growing faster than GDP growth rates,with trade liberalizations under GATT and WTO. International service
trade is also growing, on average, faster than GDP growth rates with
deregulation of service trades and of DFI in service sectors.

More impressive globalization has been accomplished by international
activities by business firms. DFI among developed countries has integrated

segmented markets into one world market. Multinational enterprises form
their organizations taking into account of global strategies. DFI intodeveloping countries has facilitated economic development of receiving
countries and has pushed internationalization of their domestic markets.
The technology developments have made optimum size of markets and of
business organizations larger and larger. The economy of scale and theeconomy of scope have become dominant factors to determine sizes of
economic activities. International M&A between large enterprises iscommon at the end of 20th century (see Table 16 in Appendix).

International capital movements are far more global than goods andservice movements. As often pointed out, the capital accounts in the balanceof payments are net capital movements flows and values of grolss capital
flows are much larger than the net values, some times more than hundreds
times. An accumulation of financial assets has increased a stock value ofinternational funds and this has been invested in global market.
International portfolio selection of the funds is an important businessactivity in many financial organizations and business enterprises.
Liberalization of capital movements and deregulation of financial sector,

these are on going trends in the recent world, which have pressures of
forming a global market mechanism. An efficient use of funds is beneficial

for both funds holders and funds users, and a global capital market isthought to be more efficient than locally segmented markets. This is true ina stable situatioB of a global capital market, without market failures.
However, it is well known that capital markets are not only always stable
but also are not effective in the sense of including market failure. Massive

free short-term capital movements are often criticized to be unstable.
Actually, speculative short-term capital movements have triggered many

KiM AND iGA VVA : MONETARY CO OPERA TiON JN EAST ASIAN CO UNTRIES 87. crlses.
currency
Under these global economic activities and these developments of global
markets, it becomes an important issue to design financial architecture,especially a new international monetary system. In this paper, we will
discuss a possibility of Asian monetary cooperation as a first step todesign a system of one global monetary unit, world money. In the following
section, we will discuss formal evaluation of a fixed exchange rate system
and a flexible exchange rate system, and will speculate to the better systemof the one global money.
In section 3, we will discuss possibilities of Asian, especially East Asian,monetary cooperation, depending on macroeconomic indicators. Final
section will be used for making bridge from a system with East Asianmonetary cooperation to a system of global money.
2. Fixed rates vs. flexible rates

If a foreign exchange rate is stable in both senses of smaller volatility andof market stability, a risk cover for exchange rate uncertainties will not bedifficult or costly. The adjustable peg IMF system after the world war 2nd
worked well for two decades to facilitate international transactions where'

US$ was convertible to monetary gold and the other countries tried to fix
their exchange rates to US$. International capital movements are rather
regulated to protect fixed exchange rates.

After the stop of convertibility of US$ to the monetary gold, foreignexchange rates have fluctuated to find appropriate rates. Depreciations of
US$ might called for jump up of oil prices in 1970s. International portfolio

managements become important under flexible rates. Oil money flows
caused debt problems to developing countries. Financial deregulation andliberalization of international capital flows have been promoted. It is notclear whether foreign exchange risk under flexible rates deteriorated
international transactions or not, but short-term capital movements,
speculating for foreign exchange rates, triggered currency crises. With debt
crises and currency crises, people understand that it is necessary to design

a stable new international monetary system.

Debate about foreign exchange rate systems, especially between fixed
rates and flexible rates, has been continued. Under fixed rates, long-run
inflation rates cannot be different among fixing member countries, andeven in a short-run, interest rates cannot be different with free capital

88

KOBE ECONOMIC & BUSINESS REVIEVV, 45(2000), 85-101

mobility. Monetary authority in most member countries must follows
obligation to maintain its exchange rate, and thus loses its independence ofmonetary policy. To maintain fixed exchange rates of N member countries,

N-1 effective instruments of N-1 countries are used and remained Nthcountry is free from an exchange rate policy. The burden of themaintaining exchange rates could be shared with N countries and themember countries can collectively use remained part of their policy forcollective targets, such as inflation rates or interest rates. Howevermonetary policy coordination might be difficult with many currencies ofmember countries.
Aiihough a monetary independence is abandoned in fixed rates, utility or
usefulness of each currency will be increased. A stability of value is a mostimportant factor for money to be accepted. With currencies of stableexchange rates, international transactions will be facilitated. Especiallyinternational transactions of financial assets in different currencies will bedirected to more productive ways than mere reshuffling for capital gains.

Fixed rate system is effective and is efficient when the rates areappropriate levels and are accepted with confidence by many countries.
When gold or real goods sustain the value of currency, it become important

to stabilize the gold price or the commodity prices. When government
authority maintains its currency value without gold or goods, there is noclear foundation for the value, Fixing exchange rates without somefoundation is very difficult and monetary cooperation becomes a play onknife-edges. Now we are in the situation that a currency has no backup likegold or some common foundation. A foreign reserve like US$ is not stablein value and it is difficult to accumulate enough amount of reserves against
speculative currency attacks.

A flexible exchange rate system is accepted as better system than theadjustable peg system of IMF in 1973.It is expected that exchange rateadjustments work to remove current accounts imbalances and speculations
are two ways and are stabilizing. However, it becomes clear that a flexible

rate system is not ideal and was selected in the difficult stage before
making better system. Without consensus about global systerh of exchange
rates, a flexible rate system is the only way for which major countries,
pursuing monetary independence, will accept. Of course, it is possible forsome countries to select fixed rates or some mixture system of fixed andflexible rates. In these cases the countries abandon their independenee ofmonetary policy, at least partially.

KIMANDIGAVVA:MONETARYCOOPERATIONINEASTASIANCOUNTRIIIS 8

Flexible rates have exchange risks and an exchange rate overshooting has
become one of common feature in currency markets. Speculations are often

to be one way and overshooting or bandwagon effects produce unstablesituations. Massive short-term capital movements easily produce currency
crises. Some times the currency crises accompany financial crises. In spiteof these defects, it is considered that a f!exible rate system is a better system. This is a only consistent system with a monetary independence, whichis thought to be one the most important matter for national sovereignty.
Now the question is whether the monetary independence has large merit
or not. Our argument is the merit is not large enough to overcome costs of
exchange risks and speculative risks. The merit is rather defensive against
bad effects of foreign monetary policies. If a large foreign country takes
more inflationary policies or high interest rate policies, an exchange rate
fixing country to the foreign currency should accept its policies and must
follow the similar domestic policies. To avoid the effects of high inflationsor the high interest rates, the latter country should take flexible rates. The

point is whether independent inflation rates are important matters or not.
One answer for this is, no merit in the long run if quantity theory of money

holds. Another answer is that long run economic growth rates will change

depending on inflation rates, and an optimum inflation rate might bechosen in each country. In this case, monetary independence has somemerit but the next question is whether the optimum inflation rates are very

different among countries or not. We need more investigations about thisquestion but we expect that the optimum inflation rates among advanced
countries are not much different. Some inflation rate could be acceptedamong those countries to enjoy advantages of fixed rates.
A monetary independence might be necessary for short run stabilization
policies. Interest rates can be different among countries with offsetting
capital gains or losses, taking into account of risk factors. The foreignexchange rate movements adjust the capital gains and losses and these areimportant mechanisms of flexible rates. If an exchange rate is fixed, pricemovements of financial assets will adjust to produce the same interest rates

among exchange rate fixing countries. International profit rates offinancial assets should be equalized either through exchange rateadjustments or through asset price adjustments. In the global market offunds there will be no merit of adjustments through foreign exchange rates,
which increase exchange risks.
We are now in the position to change the way of thinking to the direction

90

KOBE ECONOMIC & BUSINLESS REVIEVV, 45(2000), 85-1Olof constructing new financial architecture of an international monetarysystem. If both fixed and flexible rate systems are not good andintermediaries of the two are by and large not better, the new systemshould be the one with global money. An optimum currency area argument,
which was originally proposed by R. A. Mundell, is the central issue at thispomt.
3. Asian monetary cooperation
The experiences of EMU and experiments of Euro have given a confidence
to monetary authorities in the world that a monetary cooperation among
member countries is not costly burden relative to the merits of usefulnessof money. Of course the way to Euro was not straight and the historicalexperiment has just started. This experiment may confront difficulties, but
it should not be fail.

Euro in EU is introduced to compete with Dollar, and there are twocurrency areas with three economic areas. Asia, one of the economic areas,
has no regional common currencies to facilitate regional transactions. The

Asian currency & financial crisis has indicated that the crisis might bemuch smaller if Asia has some regional common currency. Asia depends on
Dollar and US did not extend sufficient supports to Asian countries indifficulty. IMF supports had enlarged the size of crisis, which pushmonetary authorities in those countries to follow international, American

in reality, financial standard. Each country wants to defend its own
financial system. However, a financial globalization has made it difficult to

defend from speculative currency attack by small one country. Without
global defense systems, it might be necessary to make regional defense
systems. Organizing an Asia currency area and using an Asian common
currency will be necessary to defend Asian financial system, we think. At
least it will be necessary to investigate the possibilities of the Asian

common currency.
To make a currency area, member countries should cooperate to keep asimilar inflation rates and similar interest rates. They should coordinate

their money supplies to economic growth rates and should keep macro
economic indicators to be acceptable among member cbuntries. Anotherimportant factor to form currency area is levels of intra-regionaltransaction or of interdependencies among regional members.

We are now in the position to investigate data of Asian countries

KIMANDIGAVVA:MONETARYCOOPERATIONINEASTASIANCOUNTRIIES 9

referencing to European data. Macro economic indicators in both regions
are as follows.

Table 1 Asia: average annual growth rate in 1980s(1980-89) (%)

Japan Korea China

Indonesia

Malaysia

Philippines

Singapore

Thailand

GDP

3.8

8.0

9.9

5.8

5.7

1.9

7.2

7.1

CPI

2.5

8.1

7.1

9.6

3.6

14.4

2.7

5.7

Ml

5.0

16.4

20.6

20.5

10.1

16.5

9.3

11.0

Ml-GDP

1.2

8.4

10.7

14.7

4.4

14.6

2.1

3.9

Note : China exclude Hong Kong
Source :IMF, International Financial Statistics, Yearbooho(%)

Table 2 Asia; average annual growth rate in 1990s(1990-96)

Japan Korea China

Indonesia

Malaysia

Philippines

Singapore

Thailand

GDP

1.4

7.7

11.6

7.2

8.8

2.8

8.3

8.6

CPI

1.4

6.4

9.5

8.6

3.7

10.7

2.5

5.1

Ml

7.4

16.0

25.8

14.3

19.3

16.3

10.3

13.5

Ml-GDP

6.0

8.3

14.2

7.1

10.5

13.5

2.0

4.9

Note : China exclude Hong Kong
Source :IMF, International Financial Statistics, Yearbooho
Table 3 EU: average annual growth rate in 1980s(1980-89)

Austria(%o)

Belgium Denmark France Germany Ireland

Italy

GDP

2.09

3.37

1.82

2.28

1.79

3.46

2.38

CPI

3.83

4.72

6.90

7.38

2.91

9.35

11.2

Ml

6.60

6.41

12.38

8,06

6.36

7.79

11,15

Ml-GDP

4.51

3.04

10.55

5.78

4.57

4.33

8.77

(continued)

Netherlands

Portugal

Spain

Sweden

U.K.

GDP

1.91

2.73

2.77

2.10

2.43

CPI

2.87.

17.67

10.26

8.08

7.32

Ml

6.82

19.02

15.90

7.55

5.07

Ml-GDP

4.91

16.29

13.13

5.45

2.64

Source : IMF, International Financial Statistics, Yearbooho

KOBE ECONOMIC & BUSINLasS REVIEW, 45(2000), 85-101

92

Table 4(%)

EU: average annual growth rate in 1990s(1990-97)

Austria

Belgium Denmark France Germany Ireland

Italy

GDP

2.33

1.69

2.34

1.49

3.52

6.59

1.25

CPI

2.83

2.41

2.10

2.22

2.62

2.38

4.70

Ml

7.79

2.81

5.48

2.30

9.84

10.32

5.25

Ml-GDP

5.46

1.12

3.14

O.81

6.32

3.73

4.00

(continued)

Netherlands

Portugal

Spain

Sweden

GDP

2,62

2.74

2.02

O.80

UK
1.58

CPI

2.54

6,85

4.76

4.00

4.02

Ml

7,38

11.56

7.18

4.79

4.88

MleGDP

4.76

8.82

5.16

4.00

3.31

Source :IMF, International Financial Statistics, Yearbooho
Inflation rates in 1990s are more different among Asian countries in table
2, from 1.410)6 in Japan and 2.5%o in Singapore to 10.7%o in Philippines and9.59(o( in China, relatively to EU member countries in 1990s. In EU, lowest is
2,1%o in Belgium and highest in 6.85%o in Portugal. This shows that it is morenecessary to unify inflation rates in Asian members. However, if inflation

rates of Asia in 1990s are compared to EU data in 1980s, the divergenceamong Asian members is not much different from the one in EU members.
It might be possible to say that Asia is ready to form currency area in near

future. The comparison of Table 1 and Table 2 shows that inflation rates in

Asian members are stabilizing and moving toward unification, with rapid
economic development in this area.
We can find similar results for the indicator "Ml growth rate minus GDP
growth rate", and this implies that money supply policies in Asian members
are not more divergent relative to those in EU members. Monetary policy
coordination among Asian member counties is not unrealistic from ourdata.

Comparison of lending rates will be possible, using Table 12 and Table 13

in Appendix. In 1994, lending rates in Asia are low in, Japan 4.13% andSingapore 5.88%o and are high in Indonesia 17.76%o and Philippines 15.06% In

EU, low rates are UK 5.96%o and Ireland 6.13%o and high rates are 27.44 in
Greece and 15.01S)(of in Portugal. We cannot say that interest rates are muchdifferent among Asian countries, compared with those among EU members.

KIMANDIGAVVA:MONETARYCOOPERATIONINEASTASIANCOUNTRIES 9

Table 14 and Table 15 show that general government balance (deficit)
indicators are rather better in Asian members relative to those in EU
members. This will imply the less restrictions for fiscal policies and smaller

costs of lose monetary independences in Asian members are than those in

EU members.
Let us turn to the data about intra-regional trade interdependences.

Table5 Asia members: weight of imports (906)
Japan

Japan

Korea

China

ASEAN

1980
1985
1990
1996
1980
1985
1990
1996
1980
1985
1990
1996
1980
1985
1990
1996

Korea

China

2.15

3.48
5.60
6.05
12.8

3.18
4.99
4.57
26,55
24.33
26.6

O.44
1.44
O.88

ASEAN
15.1

14.12
11.92
14.05
6.17

20.88
24.61

3.81

7.79
6.90
7.54
7.13

30.49
15.28

3.64

4.71

2.81

6.85

16.63

6.51

21.84

1.67

4.41

17.21

20.83

2.07

18.73

19.53
22.04

3.19

6.90
5.24

4.37

5.30

6.43

9.18

15.45
18.41

Total
20.74
22.90

22.96
30.92
33.71
33.74
34.38
34.85
35.55
38.85
24.95
32.32
45.13
48.53
43.41
50.13

Comment :China include Hong Kong. ASEAN: Indonesia, Malaysia,
Philippines, Singapore, Thailand
Source :IMF, Direction of Trade Statistics, Yearbooko

KOBE ECONOMIC & BUSINE SS REVIEVV, 45(2000), 85-101

94

Table 6

Korea

China

ASEAN

1980
1985
1990
1996
1980
1985
1990
1996
1980
1985
1990
1996
1980
1985
1990
1996

ASEAN

Korea

China

4.13

7.58

10.04

4.03

10.77

6.08

6.69

7.15

17,43
15.01

11.48
4.72
5.17

6.33
11.47
17.50

19.44

5.81

7.78

12.34

17.48

14.33

4.67
5.33
6.42
9.13

8.96
8.23
11.85
6.17
16.71
19.02
18.14
22.27

Japan

Japan

(%)

Asian members: weight of exports

13.05

O.60

14.05
22,61

O.95

16.45

3.15

26.80
25.53
18.43

1.65

3.25

14.16

3.57

2.85

3.20

Total
21.76
21.14
24.25
36.13
28.65
25.19
33.04
44.15

6.51

5.02

22.61

23.23
37.30
25,77
49.82
53.09
46.25
49,12

Comment :China include Hong Kong. ASEAN: Indonesia, Malaysia,
Philippines, Singapore, Thailand
Source :IMF, Direction of Trade Statistics, Yearbooko
Table 7 EURO : weight of intra regional exports (Billions of US$)

Totalexports

Weight(%)

1980

298.6

590.6

50.55

1985

262.2

557.6

47.02

1990

652.2

1,207.2

54.03

1995

840.4

1996

841.0

1997

822.3

Intra-regionalexports

1638.3'1673.6'

1,680.1

51.29
50.25
48.94

Comment :EURO 11 members :Austria, Belgium, Denmark, Finland,
France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal
Source :IMF, Direction of Trade Statistics, Yearbooho

Table 5 and Table 6 show that the trade dependency among Asia members
has tremendously increased from 1980 to 1996 and it is now more than 30906oof exports and imports is intra members trade. Compared with Table 7,
which shows intra regional exports of EURO members is about 500/o , Asian
members trade interdependency level is not relatively high. However, theKIMANDIGAWA:MOIVETARYCOOPERATIONIIVEASTASIANCOUNTRJES

figure in Asia of more than 30906o is not small, if we take into accounts that

the Asian members form export-oriented area to large markets in EU and
US, If the market size of Asia becomes large, with rapid developments inmember countries, especially in China and ASEAN, intra regional trade will
increase further. The recent movements to make free trade areas in Asia

will be good news for this. EURO members' figure of 509(ol could be
discounted if we take into accounts the regional geography of compoundarea consisting with many small members, In the case of the Asian region,

geographical diversities and geographical distances might be anotherfactors to reduce the figure, but these factors will be reduced quickly bytechnology innovations. The figures oÅí ASEAN about 50 %o suggest this. We
can find similar relations of indicators in Table 9, Table 10 and Table 11, inAppendix. The coefficient of interdependence in Asia is not high but iscatching up gradually to the one of EURO members.
In case of the Asian region, DFI dependences are also important. The
trend of DFI was from Japan to Asia NIEs, and this changed to ASEAN
and is now to China. In the mean time, Asia NIEs have graduated andstarted to make DFI to ASEAN and to China. Now ASEAN is not only
trying to invite DFI in high-tech industry but also is planning to graduate

and to make DFI to China and also to neighbors of ASEAN(See Table8).
These DFI network will increase the interdependency among regional
members, in trade and in finance. To protect these intra regional relations,
it is necessary to have regional financial systems like Asian currency area,(Millions

Table 8 Asian Shares of FDI Inflow in Asian Countries

Asian(Japan)

Korea
China
Thailand

Malaysia
Indonesia
Philippinesof US$, %)Shares(Japan)

1990

257(236)

Total
803

1996

1,202(255)3,203

37.5(7.6)

1990

4,440(457)6,59667.3(6.9)

1996

44,111(5,131)

73,27660.2(7.0)

1990

4,827(2,757)

8,182

59.0(33.7)

1996

9,122(6,156)

13,05069.9(47.2)

1990

973(657)2,303

42.3(28.5)

1996

4,O06(1,831)

6,780

59.1(27,O)

1990

4,221(2,241)

8,750

48.2(25,6)

1996

16,147(7,655)

29,93153.9(25.6)

1990

494(271)851

58.1(31.8)

1996

384(58)967

39.7(6.0)

Note:1) Asian members include Japan,

32.0(29.4)

Korea, China, Hong Kong,

KOBE ECONOMIC & BUSINESS REVIEW, 45(2000), 85-101

96

Indonesia, Malaysia, Philippines, Singapore, Thailand

2)

Contract Base
Source : JETRO, VVhite Paper on Foreign Direct Investrnent,

1999,

4. For one world money
It is convenient to use domestic currency for international trades andinvestments. It is US who takes advantages of this and EU is planning totake this advantage at least within Euro members. There is no such country
in Asia and Japanese Yen is partially used in trades and in investments in.Asia. Transactions of Asian countries mostly depend on US $ and currency
crisis and following financial crisis had accompanied Dollar shortages incountries of crisis. If Asian regional money (let us say ACU: Asian
Currency Unit) is used in international transactions, effects of currency
crisis will be mitigated and will be resolved by cooperative managements of

ACU member countries.
A starting point of producing regional currency ACU will be fixing
exchange rates of currencies in member countries to ACU and holding ACU

reserves. Monetary policy coordination and also government fiscal
constraints among member countries should be well planed. We alreadyhave the experiences of Euro in EU. The question is whether the Euro
procedure is applicable or is the best way for the case of ACU. Here we do

not intend to show a scenario to ACU, but we would like to discuss somepreliminary conditions for ACU.

In the case of EU and Euro, agreements and contracts among members
come first and then efforts for attaining agreed aims are followed. In thecase of Asia, agreements and contracts are not strict and members rather
want to enjoy contingent flexibilities. The Asian members, chosen here,
have different histories and are in different development stages. Therefore
strict and persuasive agreements and contracts might not be accepted and

APEC type more flexible methods might be preferable. Hgwever weakmonetary cooperation will call for speculative attacks and thus mitght put
the ACU design into null. To construct a currency area, strict cooperation

among members should be maintained, we think.

The size of ACU members should be large enough to protect ACU
monetary system without non-member supports. This implies that at least
Japan, Korea, and China should be included into the members. All three
countries have strong government to control domestic financial sectors andKIMANDIGAVVA:MONETARYCOOPERATIONINEASTASIANCOUNTRIES

are expected to be leaders of East Asia. Any one of the three could not bea dominant leader, and the three must be core members of ACU system.
ASEAN will join to ACU system to get merits of usefulness of theircurrencies. The roles of Korea and ASEAN as mediators to form ACU will
be very important to reduce conflicts for seeking an inside hegemony
between China and Japan.
To maintain the system of fixed rates, confidence of local currency values

is important. Managements to sustain the system call for strong
coordination among monetary authorities of member countries and also
call for skilled managers and workers for the system. It might be
speculative to jump to the argument for one common currency immediately.
However, this is not unreasonable if we agree that costs for sustaining thesystem of fixed rates with confidence and costs for sustaining the systemof one common currency might not be much different. The latter costs will
be smaller once the system is established. Anyway, usefulness of money will
increase and confidence for system will become strong as experiences of thecommon currecy system are accumulated.
When ACU is used for intra-Asia transaction, exchange rates between
ACU, US$, and Euro might be flexible. However coordination of the threecurrency regions will mitigate exchange rate fluctuations. Final stage is the

one global currency system. Political discussions of struggles for global
hegemony might be possible but economic discussions are also.necessary
for the process to the one global currency system. Without ACU in Asia,
Asian countries should take flexible rates (or some variation of flexible
rates) or fixed rates to US$ (or Euro). Exchange rate risks and unstablespeculations could not be eliminated for Asian local currencies. Situationsof good bargains of Asian firms by EU firms and/or US firms might
appear, as the situations after the last Asian currency crises. Approaching
to the final stage of global money, Asia will have small power without ACU.

EU plus US system will become a global standard of an international monetary system at expenses of Asian benefits.

KOBE ECONOMIC & BUSINESS REVIEVV, 45(2000), 85-101

98

Appendix
Table 9

Japan

Korea

China

ASEAN

(%)

Asia: coefficient of interdependence

ASEAN

Korea

China

1980

O.75

1.06

2.51

1985
1990
1996
1980
1985
1990
1996
1980
1985
1990
1996
1980
1985
1990
1996

O.81

1.58

1.78

O.93

O.97

1.78

O.89

1.61

2.24

O.27

O.95

O.49

1.19

O.85

1.66

2.28

2.60

ttttt

1.19
1.15
2.21
3.1

6.4

5.89
7.81

10.75

Comment : 1) China include Hong Kong.
2) ASEAN include Indonesia, Malaysia, Philippines,

Singapore, Thailand
Source :IMF, Direction of Trade Statistics, Yearbooko International
FinancialStatistics, Yearbooho
Table 10ASIA :

coefficient of interdepend

(%o)

ence

1980

1985

1990

1992

1994

1996

4.99

5.43

5.74

6.14

6.74

7.87

Comment :Asian members include Japan, Korea, China, Hong Kong,
Indonesia, Malaysia, Philippines, Singapore, Thailand
Source :IMF, Direction of Trade Statistics, Yearbooho Jnternational

FinancialStatistics, Yearbooho
Table 11 EURO members: coefficient of interdependence (%)

EUROmembers EUmembers
1980

11.52

12.58

1985

12.76

14.32

1990

12.60

13.91

1996

12.1

13.71

1997

12.95

14.51

KIMANDJGAVVA:MrOIVETARYCOOPERATIONINEASTASIANCOUNTRIES 9'
Comment :EURO 11 members: Austria, Belgium, Denmark, Finland,
France, Germany, Ireland, Italy, Luxembourg,
Netherlands, Portugal
EU members: EURO members, Greece, Spain, Sweden,
United Kingdom
Source :IMF,Direction of Trade Statistics, Yearbooho International. Financial Statistics, Yearbooko •'' (ERd of Period) (906)Table 12 Asia:Lending Rate
1980

Japan
Korea

1985

1990

1992

1994

1996

8.35

6,6

6.95

6.15

4.13

2.66

18.0

10.0

9.36

10.0

8.5

8.84

China
Indonesia
Malaysia

5.04

7.92

9.36

8.64

10.98

10.8

21.49

20.83

24.03

17.76

19.22

7.75

11.54

7.17

9.31

7.61

8.89

Philippines

14.0

28.61

24.12

19.48

15.06

14.84

Singapore
Thailand

11.72

7,93

7.36

5.95

5.88

6.26

16.15

16.08

14.42

12.17

10.9

13.4

-

Source l IMF, International Financial Statistics, Yearbooho
Table 13 EU: Lending Rate (End of Period)

1980

1985

1990

Belgium

12.54

13Luxembour
Demark

8.75

8.23

14.7

Finland

(o/o)

1992

1994

1996

13

9.42

7.17

7.06

8.75

6.58

5.5

5.5

14.1

11.8

10

8.7

7.7

10.41

11.62

12.14

7.91

6.16

5.29

France

11.13

10.49

10

7.89

6.77

6.34

Germany

9.53

11.59

13.59

11.48

10.02

9.13

Ireland

12.44

11.29

12.66

6.13

5.85

6.57

Italy

18.06

14.09

15.76

11.22

12.06

9.75

9.25

11.75

12.75

8.29

5.9

6.13

27.29

21.78

20.43

15.01

11.73

9.15

20.05

27.62

28.71

27.44

20.95

18.92

13.52

16.01

14.23

8.95

8.5

6.08

Sweden

16.89

16.69

152

1O.64

7.38

7.01

UK

12.33

14.75

9.42

5.48

5.96

6.58

Netherlands
Portugal
GreeceSpain

Source : IMF, International Financial Statistics,

Yearbooho

KOBE ECONOMIC & BUSINLE SS REVIEVV, 45(2000), 85-101

100

Table 14 Asia: General Government Balance (as % of GDP)
1980

1985

1990

1994

1996

Japan
Korea

-7.0

-4,9

-1.6

-3.1

-4.3

-2.2

-1.1

O.4

O.6

O.45

China

-1.5

o.o

-O.8

-1.2

-O,8

HongKong

2.7

1.0

O,7

1.1

1.3

Indonesia

-.2.4

-1.0

O.4

1.0

1.2

Malaysia

F13.3

-7A

-4.8

2.4

O.7

Philippines

-1.4

-2.0

-3.5

1.1

O.3

2.1

2.1

2.7

8.4

6.7

-6.4

-5.2

4.7

1.8

2.2

Singapore
ThailandSource : EPA(Japan): Asian Econorny (Ajia Keizai),
Table 15Austria

EU: General Government Balance

1998o

(as %

Belgium Denmark France Germany Irelandof GDP)
Italy

1990

-2.4

-5.5

-1.5

-1.6

-2.1

-2.3

1995

-5.1

-4.0

-2.4

-4.9

-3.3

-2.1

-7.7

1996

-3.7

-3.1

-p

O.9

-4.1

-3.4

-O.3

-6.6

1997

-1.9

-1.9

O.4

-3.0

-2.7

1.1

-2.7

•-

11.0

(eontinued)

Netherlands

Portugal

GreeceSpain

Sweden

U.K.

1990

-5.1

-5.1

-16.1

-4.1

4.2

-O.9

1995

-4.0

-5.7

-10.9

-7.1

•-

7.0

-5.7

1996

-2.0

-3.3

-7.5

-4.5

t3.5

-4.4

1997

-O.9

-2.5

-3.9

-2.6

-O.7

-1.9

Source : European Commission, European Econorny, No, 65,
1999.

1998. No.4,

KIM AND IGA WA : MONETARY COOPERATION IN EAST ASIAN COUIVTRIES 1Ol

Table 16

BuybaseSellbase(Millions of US$,%)

Cross border M&A
1990

1995

1996

1997(GrowthRate)World

159,959

237,184

274,611

341,653(24.4)

EU90,967

98,725

114,316

127,787(11.8)

AmericaJapan

21,691

65,58065,34681,442(24.6)

25,133

16,963

12,573

11,710(-69)

EastAsia

4,792

19,17521,71327,732(27.7)

World

159,959

237,184

274,611

341,653(24,4)

EU

60,32074,812

76,772

133,621(74.0)

AmericaJapan54,29762,90370,921

65,151(-8.1)

102

1,573

4,780

1,053(-78.0)

EastAsia

8,846

25,47535,15931,787(-9.6)

Source : UNCTAD,
World Investment Report ,2000.

References
Kazuhiro IGAWA(1991), `The Possibility of ASEAN Monetary Cooperation" ,Kobe Economic & Business Research Series, No.40.

Moon, W.S., Rhee, Y.S., Yoon, D.R. (1999), "Asian Monetary Cooperation" ,presented at Conference of The Japan Society of International Economics.

R.A. Mundell(1968), lnternational Economics, Macmillan London.

KOBE ECONOMIC & BUSINESS REVIEVV, 45(2000), 103-135

DISCRETIONARY ACCRUAL MODELSAND THE ACCOUNTING PROCESSXAVIER GARZA-GOMEZ Nagoya City Uniyersity
MASASHI OKUMURA Nagoya City University
MICHIO KUNIMURA Nagoya City University

Abstract
This paper introduces a discretionary accrual model based on the aecounting processdeveloped by Dechow, Kothari and Watts (1998). Our model tries to prevent a big
proportion of nondiscretionary accruals from being judged as discretionary, Using

data from the Japanese stock market, we find that our model fits accruals muchbetter than versions based on Jones (1991). Evidence in this paper shows that ourmodel may modify the findings of previous research in two areas: 1) studies that use
the versions of Jones model to detect earnings management and 2) studies that analyze

the relation between discretionary accruals and future performance or the relation
between discretionary accruals and stock returns.

JEL classification: M40
Keywords: Cash flows; Accounting process; Discretionary accruals; Earnings

management; Managerial discretion.
Corresponding Address:

Xavier Garza G6mez

Faculty of Economics
Nagoya City University,
1 Yamanohata, Mizuho-cho, Mizuho-ku,Nagoya 467-8501, Japan

ail:xavier. garza@emai
l.com
E-m
Masashi Okumura
Faculty of Economics

Nagoya City University,
1 Yamanohata, Mizuho-cho, Mizuho-ku,Nagoya 467-8501, Japan

E-mail:okumura@econ.nagoya-cu.aÅë.jp

Michio Kunimura

Faculty of Economics
Nagoya City University,
1 Yamanohata, Mizuho-cho, Mizuho-ku,Nagoya 467-8501, Japan
E-mail:kunimura@econ.nagoya-cu.ac.jp* Pr.evioqs versions of this paper have received the Kanematsu Fellowship Award at Kobe
P,psxe.2ss`.yia.n,g.kh.e,iXfiEyoA",k{I}il:,:ie.',mi2",.?gsg,Pge;jl•.",yv{ee'g,a,`.t.h,e}ftZA,fiR,n,1•P,a.filfg'c.F?,n,2.8a,Mo.l"sJa..rk.aa,`n,K.ibT,eg,U,/tt/";uZmiE'611K.ojk.Ou.'n.g.ag.ia".aa,bn,'8.g.w',S8."aS.nS.Sln."y/fi.g.:eg;i.ae,fLe,ari,ek,s,"?.oWE',e,.hd.egtMJ.,2v",a`,,Su,aa,E.r.e.d,."ogm,k?

support from the Paiko Foundation of Nagoya. This research is supported by the Science
Research Foundation of the Ministry of Education.

104

KOBE ECONOMIC & BUSINEss REVIEVV, 45(2000), 103-135

1.Introduction

Several studies indicate that earnings contain more information thanrather primitive constructs like operating cash flows. That is, thecorrelation between earnings and contemporaneous or future stock returns
and the correlation between earnings and future performance are higher

than the correlation between cash flows from operations and thesevariables. Such improvement in information content is obtained by the useof accruals. The explanation behind this is that accruals reduce theproblems of timing in measuring cash flows over short intervals (Dechow1994). In this sense, accruals contain the accounting adjustments necessary
to cancel variations related to the operating cash cycle. Nevertheless, since

GAAP allows certain discretion in reporting accounting numbers, there isa possibility that accruals contain management's expectations about future
cash flows and/or management's intention to manipulate information.

There have been several attempts to separate the nondiscretionary anddiscretionary part of accruals. Among them, we find the early works of
DeAngelo (1986), Healy (1985) and Jones (1991). However, these models
ignore the relation between cash flows and accruals reported in Dechow(1994), so some nondiscretionary accruals are misclassified as
discretionary causing a misspecification of these models.'

This paper introduces a discretionary accrual model based on theaccounting process. To do this, we model the short-term (working capital)
part and the long-term part of accruals. Our starting point for the working
capital accruals is in the work of Dechow, Kothari and Watts (1998), in
which they present a model that explains the serial and cross-correlationsof accruals, cash flows, and earnings. The latter part is assumed to follow

a random walk. By combining them, we get a model that resembles theaccounting process much better than the Jones model and modifications of
the Jones model including cash flows. Statistical tests indicate that ourmodel outperforms the two models, and that the Jones model is missspecified because it assigns most of the information content of total
accruals to the discretionary part. This occurs despite the fact that cash
flows can explain most of accruals' behavior.
As Bernard and Skinner (1996) point out, this miss-classification causes
1 Recent papers, such as Subramanyam (1996), Chaney, Jeter and Lewis (1998)and Jeter andShivakumar (1999) add a cash flow term to the Jones model in an initial attempt toconsider such relationship, and thus reduce this misspecification.

GARZA-GOMEZ, OKUMURA AND KUNIMURA : DISCRETIONARY ACCRUAL MODELS AND THE ACCOUNTING PROCESS 105

problems for empirical tests. In tests of earnings management, it can cause
the researcher to find manipulation when it does not exist (or not to findmanipulation when it exists); while in tests of the information content of
discretionary accruals, it affects conclusions we can draw because the roleof discretionary accruals could appear to be larger than the role ofnondiscretionary accruals. When we explore these possibilities and use
tests similar to Dechow, Sloan and Sweeney (1995), we find that our model

has more power to detect earnings management than the other models andthat the variable used to measure performance has a strong effect in testsof earnings management. To examine the information content of
discretionary accruals once the relation between accruals and cash flows is

considered, we replicate part of the tests presented in Chaney, Jeter andLewis (1998) and Subramanyam (1996). These studies report a strong roleof discretionary accruals, yet we measure the degree to which the reported

results originate from the inaccuracy of the Jones model. In general, we
find that the importance of discretionary accruals is reduced for our modeland other model using cash flows compared to results obtained with theJones model. We report, however, that despite the stronger role ofnondiscretionary accruals, discretionary accruals remain statisticallysignificant in our tests. In fact, results suggest that management might becommunicating to the stock market part of its private knowledge about the
firm's future performance by the use of discretion in accruals accounting.

Nonetheless, even though our model does a good job to capture theaccounting process, it does not consider some structural changes identified
in Hansen (1999). Therefore, the possibility that some nondiscretionary
accruals are incorrectly classified as managerial discretion still remains.

This paper contributes to current research in several ways: 1) It
introduces a discretionary accrual model which captures the relation
between cash flows and accruals better than previous models. 2) It provides

evidence that the Jones' (1991) model miss-classifies nondiscretionary
accruals as discretionary, and shows the problems this misspecification
causes. 3) It provides international evidence of the relevance of accruals

accounting in an important market such as the Japanese stock market,
allowing comparison to previous reports in the U.S.
The paper is organized as follows. Section 2 describes the data used in
our tests and the variable definitions. Section 3 introduces a discretionary
accrual model that tries to mimic the accounting process. Section 4 shows
the statistical properties of discretionary and nondiscretionary accruals

106

KOBE ECONOMIC & BUSIiVLE SS REVIEI?V, 45(2000), 103-135

obtained under the different models. Section 5 analyzes the models' ability

to detect earnings management. Section 6 uses the models to analyze
income smoothing, and Section 7 concludes.

2.Research design

This paper uses data from the Japanese stock market to analyze
discretionary accrual models. In this section, we establish the definition of

accruals based on the Japanese accounting system, and we describe thedata used in this study.

2.1 Accruats in Japan
This paper considers the accounting differences between U.S and Japan;
therefore, our definition for accruals differs from the definition commonlyused in the U.S. The main difference arises from the existence of special
reserve accounts. That is, the Japanese tax code allows firms to set aside

funds each year against future contingencies. These include reserves
against product returns, repairs, payments on guarantees, losses due to
doubtful accounts, and payment of retirement benefits (see French andPoterba (1991)). Japanese firms can use these reserve accounts as anadditional way to smooth income. The earnings components are defined asfollows. The item numbers oÅí the Japanese Development Bank (Kaigin)database are in parentheses.
Net income (NI) (293)

Earnings before extraordinary items (EBEI)= NI - gain from EI (245) + loss from EI (257)
Total accruals (TA)= Short-term (working capital) accruals + Long-term accruals
Short-term (working capital) accruals (STA)= (ACA - AC ash) - (ACL - AFI)
Long-term accruals (LTA) == - Dep - AAIIow
where

ACA == change in current assets (1)ACash == change in cash and cash equivalents (2)ACL = change in current liabilities (77)
AFI == change in financing items (82,83,84,85,86)

GARZA-GOMEZ, OKUMURA AND KUNIMURA : DISCRET'IONARY ACCRUAL MODELS AND THE ACCOUNTING PROCESS 107

Dep =amount of depreciation not considered in inventory2(402-342 *(12 +13 +14)/349)

AAIIow = change in allowances (122,123,124,125,126)and cash flow from operations (CFO) == EBEI - TA.
We scale all our variables by lagged total assets. We report that inpreliminary tests that measure the predictability of EBEI or CFO, the useof lagged total assets as a deflator yields more stable variables than theuse of lagged stock prices or lagged book equity. Thus, we choose lagged
assets as the deflator in this study.

2.2 Sample
Our sample consists of all non-financial firms listed in the first section of

the Tokyo Stock Exchange (TSE) for which all required data are available.

For stock returns, we use the Japanese Securities Research Institutedatabase. All accounting information is taken from the Japanese
Development Bank (Kaigin) database. We have a maximum of 1,214 firms in1995 and a minimum of 343 in 1962. 0riginal accounting database consistsof 33,193 firm-years, out of which 26,365 returns data are available.
2.3 Descriptive statistics

Table 1 reports descriptive information about the variables. Earnings
before extraordinary items (EBEI) are positive in 90 percent of the sample,

while cash flow from operations (CFO) are positive 81 percent of the time.
2 This definition subtracts the depreciation cost allocated to the inventory assets
remaining at the end of the period from the total amount of depreciation (402). Since
STA includes the increment in the inventory assets manufactured in the current year andthese assets have a part of the depreeiation cost of the manufacturing plants, a double

counting problem arises. We thank Isao Nakano for bringing to our attention thisproblem. To estimate the fraction of depreciation that is double counted, we first assume
that the first-in first-out method is followed, then we calculate a ratio of inventory assets(12+13+14) over the totalmanufacturing cost (349) (called V) and finally, we multiply itby the depreciation amount used in the production cost (342), We report that across al}
the firm-years, the average (median) value of W is O.17 (O.13). For those firm-years with
U above 1, we limit this value to 1. Nevertheless, we report that considering the double
counting problem does not affect our overall conclusions. We find that when we neglect

the problem (assuming W is equal to zero) or when we assume that U is equal to 1,
results are very similar to those shown in this paper. Results are available from theauthors on request.

KOBE ECONOMIC & BUSINIi SS REVIEW, 45(2000), 103-135

108

The average autocorrelation of EBEI is O.59, much higher than the
autocorrelations of cash flows (CFO) (O.09). Long-term accruals (LTA) are
positive only 1 percent of the time and have an autocorrelation of O.53. 0n

the contrary, short-term (working capital) (STA) accruals are positive
about 60 percent of the time but their autocorrelation is -O.05. Yearly
returns are positive 60 percent of the time and have a high variability. For
the estimation of accrual models, which is done with data from 1962 to 1995,

we limit our sample to those firms having a minimum of five years offinancial data and to those industries having at least six or morecompanies.S To reduce the effect of extreme observations, we remove allobservations having total accruals or cash flows (lagged by total assets)with an absolute value above 1, and those with stock returns that are morethan 4 standard deviations away from their mean. These restrictions andthe estimation of models cause a decrease of usable observations and thus

our sample is reduced to 32,304 company-years. We use these data tocompare discretionary accrual models in the next sections.

Table 1
Descriptive statistics
Variable

Mean Median Stdev

Max

MIn .%positive Autocorrelation

EBEI

O.029

1.63

-O.52

se

O.59

CFO
TA
LTA
STA
Return

O.024

O.038

O.053

O.051

O.082

1,47

-2.97

81

O.09

-O.024-O.025

O.073

2.98

-1.08

31

o.oo

-O.036-O.030

O.030

O.31

-O.86

1

O.53

O.Oll

O.oo7

O.066

3.oo

-1.05

58

-O.05

O.135

O.062

O.424

9.04

-O.90

60

Our sample corresponds to all non-financial firms listed in the Tokyo Stock
Exchange during the period 1962-1995 for which five (or more) consecutive years ofdata are available. Original accounting database consists of 33,193 firm-years, outof 'which 26,365 returns data sre available. All accounting variables are scaled bylagged total assets. Returns refer to cumulative annual stock returns measured
from July of year t to June of year t+1.

3 We use the 33-industry classification established by the TSE.

GARZA-GOMEZ, OKUMURA AND KUNIMURA : DISCRETIONARY ACCRUAL MODELS AND THE ACCOUNTIIVG PROCESS 109

3.The accounting process and discretionary accrual models
3.1 The origin of the explanatory power of accruals
In a recent paper, Dechow (1994) elaborates on the information containedin accounting accruals. She shows that cash flows have timing andmatching problems that cause them to be a 'noisy' measure of firm
performance." Since accounting accruals are designed to diminish suchproblems, they will improve earnings' ability to reflect firm performance. In

her paper, she reports evidence that earnings are more associated withstock returns than realized cash flows.

When we test this assertion using Japanese data, we also find that
accruals increase the explanatory power of cash flows. In a regression ofnext year cash flows, adding the accruals variable to a univariate
regression on cash flows increases the average R2 from O.107 to O.145 (seeTable 2). For future earnings, the increase in R2 is O.428, from O.158 to O.586.

When we test the explanatory power of accruals on stock returns, average
R2 goes from O.024 to O.048 for contemporaneous returns and from O.O06 to

O.029 for future returns. This evidence is consistent with the highinformation content of accounting accruals.

Table 2
Information content of total accruals
Avg, R2 for different specifications

Explanatory variables

CFO,

Next year cash flows
Next year earning

O.107
O.158

CFO,, TA,
O.145
O.586

Contemporaneous returns

O.024
O.O06

O.048
O.029

Dependent variable

Future returns

We report the average R2 of 34 yearly cross-sectional regressions using univariate
regressions of CFO (cash flows from operations) and multivariate regressions with
4 Timing refers to the revenue recognition principle, requiring firms to recognize revenues

when a firm has performed all, or a substantial portion of services to be provided andcash receipt is reasonably certain. Matching refers to the principle requiring cash

outflows associated with revenues to be expensed in the period in which the firm
recognizes the revenue.

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KOBE ECONOMIC & BUSINLE SS REVIEW, 45(2000), 103-135

CFO and total accruals (TA). Four different dependent variables are used:
Contemporaneous stock returns, next year cash flows and earnings and future
stock returns. The sample includes all non-financial firms listed in the first sectionof the Tokyo Stock Exchange with at Ieast 5 consecutive years of data. All extreme

data for cash flows and total accruals were excluded from the sample and theresulting number of firm-years is 32,304 for regressions using accounting variables.

The number of firm-years samples in regressions using stock returns is 26,117. The

period starts in 1962 and ends in 1995. Contemporaneous returns are compoundedfor 12 months starting three months after the fiscal year end of year t-1. Future

returns are compounded for 12 months starting three months after the fiscal year
end of year t. Returns are measured in excess of an equally weight,ed index of all
firms in the first section of TSE.

Yet, the origin of this high explanatory power cannot be clearly
determined. One source of the high information content of accruals is,without a doubt, the accounting process itself. However, since GAAP allows
certain discretion to report accounting accruals, there is a possibility that

accruals contain management's expectations about future cash flows or
management's intention to manipulate information. Several discretionary
accrual models have appeared with the purpose of separating these twosources of explanatory power. Among them, we find the works of DeAngelo(1986), Healy (1985) and Jones (1991).5 DeAngelo defines thenondiscretionary part of accruals as last year's value of total accruals,
Healy uses the average of past total accruals, and Jones models them as afunction of changes in sales and the level of equipment. Even though theJones model and the modified version pr6posed by Dechow, Sloan and
Sweeney (DSS (1995)) are recognized as the best alternatives, it has beenreported that even those models have problems to separate thediscretionary and nondiscretionary parts of accruals (see DSS (1995) and
Guay, Kothari and Watts (GKW 1996)).6
5 Most of the early models are developed with the intention to determine whether
management manipulated earnings in a specific point in time. Such studies assume
certain behavior of nondiscretionary accruals, estimate the discretionary part of accruals

as the error obtained by their model, and test for earnings management in a sample offirms where management is supposed to have an incentive to manipulate accounting
reports.
6 In addition to the models of Healy (1985), DeAngelo (1986) and Jones (1991), GKW study
the industry model proposed by Dechow and Sloan (1991), and the modified version of theJones model. A comparison of discretionary accrual models applied to the UK is foundin Young (1999).

GARZA.GOMEZ, OKUMURA AND KUNIMURA:DISCRETIONARYACCRUAL MODELS AND THE ACCOUNTING PROCESS 11

Nevertheless, if the discretionary accrual model is misspecified andincorrectly classifies nondiscretionary accruals as discretionary, then thismisclassification will cause problems in empirical tests. In tests of earnings

management, it will cause the researcher to find manipulation when it does
not exist (and vice versa), while in tests of the role of discretionary

accruals, it will affect the conclusions we can draw because the relative
information content of discretionary accruals (managerial discretion)

appears to be larger than the relative information content of thenondiscretionary accruals (accounting process) (see Bernard and Skinner(1996)).' We consider that the weaknesses of the current discretionary

accrual models are important enough to be examined, and that theircorrection may lead to more trustworthy conclusions in earnings
management studies and to more reliable inferences for studies analyzing
managerial discretion. The next subsections present our approach to model
nondiscretionary accruals.

3.2 Accounting process and discretionary accrual models

If the main objective of accruals is to mitigate timing and matchingproblems in cash flows, then it is natural to find a relation between cash

flows and accruals. Dechow (1994) reports that the correlation betweenchanges in cash flows and changes in total accruals is strong, -O.55 forannual intervals and K).88 for quarterly intervals. Using Japanese data, we
also find a strong relation of ffO.96 between changes in cash flows and total

accruals for annual intervals. This empirical evidence suggests a close
relation between accruals and cash flows. Yet a logical explanation for thisrelation was not available until DKW ,(1998) presented a model of theaccounting process and explained how operating cash flow forecasts areincorporated in earnings. Dechow, Kothari and Watts (1998) model the
relation between earnings, cash flows and working capital accruals andreport that the properties of accruals make earnings a better predictor of

future performance (measured by cash flows) than current cash flows.
They explain why there is a negative serial correlation in changes in cash

flow from operations and show how the accounting process offsets thenegative correlation to, produce smoother earnings series. This part of their
7 In a similar line, Hansen (1999) argues that structural changes (such as acquisitions orcapital changes, etc.) constitute normal business practices, yet discretionary accrualmodels tend to attribute such changes to managerial discretion.

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KOBE ECONOMIC & BUSIAIESS REVIEVV, 45(2000), 103-135

work indicates that one part of accruals can be explained by the behaviorof cash flows. In fact, when DSS (1995) and GKW (1996) analyzed
discretionary accrual models, both studies state that the problems of theevaluated models may derive from ignoring the time series properties andeorrelation structure of accruals and cash flows. Other studies, based on
DSS (1995) and the evidence shown by Dechow (1994), have already tried toconsider the relation between accruals and cash flows. Subzamanyam(1996), and Chaney, Jeter and Lewis (1998) report using an extension of theJones model where cash flow terms (or dummies controlling for the cash
flow level) are added to the original equation.S These modifications
represent a first attempt to incorporate cash flows to the modeling' ofnondiscretionary accruals. However, we consider this intuitive approach is
insufficient to capture the accounting process described in DKW (1998),

because DKW's model is based on the internal process taken by a firm toabsorb a shock in sales, such as changes in the credit terms of sales,
inventory adjustments, or modifications of the credit terms on purchases,
and cannot be explained adding only the level of current cash flows to theJones model.
3.3 The nzodel

To introduce our discretionary accrual model, we start from the basic
decomposition of accruals: short-term (working capital) accruals (STA)
and long-term accruals (LTA). Since managers can exercise discretion on
both components, we model the nondiscretionary part of each of them, andadd it to get our estimate of total accruals (TA):E [TA,,] -=E [STA,,]+E [LTA,,]. (1)To derive our estimate of short-term accruals, we consider the model
presented in DKW (1998), which represents the accounting process by whichcash flow forecasts are incorporated into earnings. Assuming that the only

accruals are accounts receivable and payable and inventory, DKW wereable to establish the contemporaneous correlation, between accrual
8 The reason for introducing this model in their reports is to check the robustness of theirresults against the possibility that the Jones model does not capture the relation between
cash flows and accruals. Nevertheless, they do not evaluate the model's ability to separate

the nondiscretionary and discretionary part of accruals. On the contrary, Jeter andShivakumar (1999) report that their model, based on a cash flow specification, has agreater power in detecting earnings management than the Jones model.

GARZA.GOMEZ OKUMURA AIVD KUrVIMURA : DISCRETIONARYACCRUAL MODELS AND THE ACCOUNTING PROCESS 113'

changes, AA,, and cash flow changes ACF, as:p AA, A CF, =(n-26)/[2( 7z2-26z +26a)]'5. (2)Eq. (2) (which corresponds to equation 18 in DKW (1998))9 indicates thatthe correlation coefficient p, is a function of the profit margin n and the
expected operating cash cycle 6 (expressed as a fraction of a year).

Considering that DKW's definition of aecruals inc}udes only short-term
accruals, and assuming a linear relation for Eq. (2), we can get:

ASTAi, == q+ Ki ACFi,+ui,, (3)where the expected value for K equals the right hand side of Eq. (2)multiplied by the ratio of the standard deviation of short-term accrualso(ASTAit) over the standard deviation of cash flows a(ACE,).iO By
separating the change (first difference) of accruals into levels we get:

STAi,=- q+STAi,. +KACFi, +ui,, (4)which shows that short-term accruals at time t depend on the parameter
K, on the change of cash flows, on the value of accruals at time t-1, and on

a constant term.
To empirically estimate aceruals based on Eq. (4), we assume that theparameter K is similar among firms in the same industry for a particular
year. However, since estimation of Eq. (4) is repeated for diverse industries,

we allow the coefficient of lagged accruals to differ from 1 and use thefollowing expression as our model to estimate STA:

STAi,=: Åëb,+ Åëi, STAi,-i + q52, ACFi,+ ei,. (5)To model long-term accruals, we assume they follow a random walk:

LTA,,= LTA,,-,+ta,. (6)We obtain our nondiscretionary accruals model by combining equations(5) and (6) to get
TAi,/Ai,-, =- Åëb [1/Ai,-i] + ÅëL, [STA`,-i/A`,-t]+ gbti [LTAi,-!/Ai,-,]+ Åëz [(CF;t-CFit-i)/Ait-i]+ Eit. (7)9 This expression is taken from equation 18 in DKW (1988), but it corrects for the misprintin p. 142.
10 This property follows from the definition of correlation coefficient and the definition ofslope.

114

KOBE ECONOMIC & BUSINIiSS REVIEVV, 45(2000), 103-135

We call Eq. (7) the accounting process (AP) model because it is designed
to reflect the cross-correlations between earnings, accruals and cash flows

as well as their serial properties, which arise naturally from applying
GAAP. For simplicity, we assume that the covariance between tu, and eit iszero. Similar to Jones (1991), we divide all the terms in the equation bylagged total assets to control for heteroscedasticity.

This model is flexible because it can be simplified or extended dependingon the assumptions made by the researcher. For example, Eq. (6) can be
reduced to a constant if long-term accruals contain only depreciation.ii The

AP model represents our first attempt to consider the serial and crosscorrelations of accruals and cash flows with the purpose of estimating
nondiscretionary accruals. We recognize, however, that our model does notconsider structural changes that do not modify current cash flows fromoperations, which leaves the possibility that some nondiscretionary
accruals will be incorrectly labeled as discretionary (see Hansen (1999)).
3.4 Estirnation of the corrtpeting models

Given that the AP model differs from previous discretionary accrualmodels, we must provide a basis of comparison for evaluating our model.
To do it, we choose the modification of the Jones (1991) model done by DSS(1995). Actually, most of the current studies on income smoothing andearnings management use either the Jones model or this modification.i2
Since the results obtained with the Jones and modified Jones models are
qualitatively similar in nature, in the remaining of the paper we only reportresults for the modified Jones model.i3 The'empirical specification for this
11 We report that variations of Eq. (7) in which the change of cash flows is separated intocurrent and lagged cash flows, or in which the coefficient of lagged accruals is forced tobe equal to 1, yield results very similar to those obtained with Eq. (7) and that ourconclusions remain the same. Results are available from the authors on request.
12 A small list includes Subramanyam (1996), DeFond and Park (1997), Hunt, Moyer and
Shevlin (1997), Chaney, Jeter and Lewis (1998) who analyze income smoothing using large

sarnples of firms and DeFond and Subramanyam (1998) who study the tendency of
income smoothing in specific samples. In the Japanese market, earnings management
research is also based on the Jones or the modified Jones models. Some examples
include Kunimura, Kato and Yoshida (1998), who study earnings management in thebanking industry, Okumura (1997) who studies the electric utilities, and Nakajo (1998)

who studies distressed companies.
13 Our choice to report DSS version instead of the original Jones model is based on the
better fit obtained in the estimation of nondiscretionary accruals.

GARZA.GOMEZ, OKUMURA AIVD KUNIMURA : DISCRETIONARY ACCRUAL MODErs AND THE ACCOUNTING PROCESS 115

model is:TA`t/At-i = a, [1/At-i] + b, [AREVit/Ait-i-• ARECiorAi,-i] + c, [PPE,/A`,-]+E,,. (8)where REV is revenue, REC refers to net reeeivables and PPE indicatesgross property plant and equipment.
As an alternative model, we also study a version of the Jones' model usedby Subramanyam (1996) and by Chaney, Jeter, and Lewis (1998) that adds
CFO as explanatory variable:
TAilA,-i = a, [1/Ai,-i] + bt [A[REVi!Ait-i] + ct [PPEit/Ait-i]+d, [CFO/A,,., ]+ E,,. (9)This model represents an initial attempt to consider the relation between
accruals and cash flows, so it is a natural rival to our AP model. For theremaining of the paper we refer to Eq. (9) as the Jones-CF model.

In earlier studies, discretionary accrual models are estimated firm byfirm using time series data until time t-1 and predicting values of accruals

for time t (following Jones (1991)). However, this estimation method
requires assuming stability of coefficients. DeFond and Jiambalvo (1994)
propose a cross•-sectional estimation method that avoids this assumption
and reduces the likelihood of the model being misspecified due to nonstationarity. With this method, the models are estimated separately foreach combination of industry classification and calendar year.'` Similar to
Subramanyam (1996), who estimates four combinations of the Jones modeland reports several advantages for the cross-sectional estimation method
including a larger sample and more precise estimates, we also compare thecross-sectional version against the time series versions of the models using

Japanese data. Our results are similar to Subramanyam (1996)i5 and14 Estimation of the AP model with the cross-sectional version implicitly assumes that the
profit margin, and the operating cash flow cycle do not vary among firms with the same
industry classification.
15 Preliminary tests, not shown, indicate that the cross-sectional versions of the models are
better specified than the time series versions. They have less variability in the estimatedcoefficients and their.estimates are superior to explain contemporaneous returns than thetime-series versions. Additionally, the cross-sectionai versions of the models yield better

results when used to explain future performanee and future stock returns. Other
advantage is that the use of cross-sectional versions increases the number of observations
available for estimation. This suggests that the superiority of the cross-sectional tnethod
is not particular to a data set.

116

KOBE ECONOMIC & BUSINESS REVIEVV, 45(2000), 103-135

therefore, we choose the cross-sectional over the time-series estimation
method. All the results reported in the next sections correspond to results

obtained with the cross-sectional method. Nondiscretionary accruals(NDA) are defined as the fitted values of the model and discretionary
accruals (DA) correspond to the residuals. The combination of cash f!ows

and nondiscretionary accruals is known as nondiscretionary income(NDNI) and is used as a benchmark between cash flows (CFO) and earnings
before extraordinary items (EBEI).

4.Properties of diseretionary and nondiscretionary aecruals under thedifferent models

This section presents a comparison of the statistical properties of
nondiscretionary income, nondiscretionary and discretionary accruals
obtained under the three competing models. The assessment is based on
several criteria, which include the distribution of discretionary andnondiscretionary accruals, the correlation structure and autocorrelation
patterns of earnings components, and the predictability of future
performance.
4.1 Basicproperties

Panel A of Table 3 shows the mean, the standard deviation, and theaverage of the absolute values of discretionary and nondiscretionary
accruals calculated for the three competing models, When we compare thestandard deviation of DA and NDA, we see that the modified Jones model
does not capture the variability of total accruals and leaves most of it to
the discretionary part, (the standard deviation of DA obtained with themodified Jones model is O.053). On the contrary, the Jones CF and AP
models do a better job at capturing the variability of accruals withstandard deviations fdr DA of O.020 and O.O16 respectively. The superior fitof the AP model can also be seen by comparing the averages of theabsolute values of DA and NDA estimated by the comp,eting models. The
average of absolute value of NDA estimated with the modified Jones model
is smaller than that estimated with the other two models. Similarly, theaverage of absolute values of DA estimated with the modified Jones model
is more than double the value obtained by the models containing cash flows,

: DISCRETIOIVARY ACCRUAL MODELS AND THE ACCOUNTING PROCESSGARZA-GOMEZ, OKUMURA AND KUNIMURA
117

Table 3Comparison of discretionary aecrual models
Panel A: Distribution of DA

and NDA

Average of DA
Standard deviation of DA
Average of absolute value of DA

Average of NDA
Standard deviation of NDA
Average of absolute value of NDA
Panel B: Cross-sectional auerage

CFO
EBEI

M Jones
Jones-CF

O.35

TA
NDNI

NDA

M Jones
Jones-CF

Jones-CF

O.oo3
O.020
O.O18

o.ooo
O.O16
O.O12

-O.026-O.025-O.023

O.029
O.034

O,053
O.050

O.055
O.051

of firm-speeific contemporaneous correlation

TA NDNI NDA DA
O.02

AP
CFO

AP

M Jones
O.oo3
O.053
o.ooo

-O.90

O.10

O.32

-O.13

O.62

-O.16

O.43

O.71

-O.10

O.38

O.87

-O.41

-O.73

O.59

-O.93

-O.23

AP

O.44

-O.92

-O.10

M Jones
Jones-CF

-O.77

O.40

O,84

-O.37

O.93

O.46

AP

-O.18

O.95

O.28

O.03

-O.88

M Jones
Jones-CF

-O.30

-O.35

AP

-O.10

-O.30

M Jones
Jones-CF

-O.09

AP

o.oo

O.13

Three discretionary aÅëcrual models are estimated using the cross-sectional
estimation method, and the resulting properties are compared. All firms in anindustry are regressed year by year. Industries with less than six firms are

discarded. The models ana}yzed include modified Jones, Jones-CF, and the APmodel.

Panel A shows statistical properties of discretionary accruals (DA) andnondiscretionary accruals (NDA). Panel B shows the cross-sectional average of thecontemporaneous correlation between earnings before extraordinary items (EBEI),

cash flow from operations (CFO), nondiscretionary income (NDNI), DA, NDA andtotal accruals (TA) for 1,214 firms.

118

KOBE ECONOMIC & BUSINLESS REVIEVV, 45(2000), 103-135

Panel A shows a big difference between the accruals estimated with themodified Jones model and the accruals obtained with models containing
cash flows. We explore this difference with the use of Panel B. In this panel

we show the average contemporaneous correlations between earnings, cash

flows, nondiscretionary income (NDNI), total accruals (TA),nondiscretionary accruals (NDNI) and discretionary accruals (DA)obtained under the competing models. We estimate contemporaneous
correlations using the time series of data for each firm and report themean for the cross-section of firms. The differences between the modified
Jones model and models containing cash flows are considerable. First,
consist•ent• with t•he evidence in panel A, we observe a very high correlation

between TA and DA, and a low correlation between TA and NDA for themodified Jones model, while for the AP and Jones-CF models, thecorrelation between TA and NDA is higher than the correlation between TA
and DA. Second, when we analyze the negative correlation between CFO
and TA we see that the discretionary accrual models capture this relationdifferently. Though the negative relation between TA and CFO is absorbed
by NDA in the AP and Jones-CF models, the relation between TA and CFO
is left for the discretionary part in the modified Jones model.

4.2 lncome smoothing
This section analyzes the time series properties of earnings components
to examine earnipgs smoothing. DKW suggest that the accounting process

works to smooth cash flow variations, yet results reported in
Subramanyam (1996) suggest that managerial discretion is the source ofsmooth earnings. Table 4 shows evidence of income smoothing andcompares the effect of nondiscretionary accruals for the three competingmodels. 'Panel A of Table 4 presents the cross-sectional mean and median valuesof firm-specific means and standard deviation for several performancevariables. We report this characteristic for earnings, cash flows and the 3

estimates of nondiscretionary earnings obtained from the competingmodels. The mean (median) standard deviation for cash flows is O,064(O,056). For earnings, this value is O.025 (O.021). When we analyze the timeseries of nondiscretionary income, we see the values of standard deviationdiffer greatly among models. The standard deviation ebtained for the NDNI

estimated with the modified Jones model is slightly lower than theOKLrMURA AIVD KUNIMURA : DISCRETIOIVARY ACCRUAL MODELS A,N'D THE ACCOUNTIA]G PROCESS 119
GARZA-GOMEZ,

variability of CFO with a mean (median) of O.057 (O.051). On the contrary,

NDNI estimated using the AP or the Jones-CF models has smaller
variability than earnings with a mean of O.023 for the two models, The factthat these two models generate estimates of nondiscretionary incomesmoother than earnings suggests that the negative relation between NDA
and CFO is the main cause of smooth earnings. Furthermore, because theaddition of DA to NDNI increases the variability of income, discretionary
accruals can be considered noise to the accounting process. This possibility
is further analyzed in the next sections.

Table 4
Income smoothing and models of discretionary aceruals
Panel A: Cross-sectional rnean and ntedian of time series mean and standard deviation

Mean

Stdev

Mean

Mean

MedianMedian

EBEI

O.031

O.027

O.025

O.021

CFO
NDNI
NDNI
NDNI

O.053

O.050

O.064

O.056

M. Jones
Jones-CF

O.027

O.024

O.057

O.051

O.028

O.027

O.023

O.020

AP

O.029

O.027

O.023

O.O19

Panel B: Autocorrelations of first differences

Delta EBEI

Delta CFO

Mean Median

Mean Median
Lag 1
Lag 2
Lag 3

-O.10

-O.11

-O.44

-O.46

-O.18

-O.19

rO.05

-O.05

-O.06

-O.07

O.02

O.Ol

Delta NDNIAPJones-CF

M. Jones

Mean Median Mean Median Mean
Lag 1
Lag 2
Lag 3

Median

-O.45

-O.47

O.34

-O.36

-O.19

-O.19

-O.04

-O.03

-O.10

-O.11

-O.13

-O.16

O.Ol

o.oo

-O.Ol

o.oo

-O.04

-O.05

All discretionary accrual models are estimated with the cross-sectionalverslon.

The sample includes all nonfinancial firms listed in the first section of

the Tokyo

Stock Exchange with at least 5 consecutive years of data. The table

reports the

cross-sectional mean and median for 1,214 firms.

120

KOBE ECONOMIC & BUSINESS REVIEW, 45(2000), I03-135

In Panel B of Table 4, we report the autocorrelation structure of the first-

differences in EBEI, CFO and NDNI estimated by the three discretionary
accrual models. All variables are negatively correlated up to three years,
yet the trend in time is different for the 5 variables. For EBEI, it presentsa small increase (in absolute value) followed by a decrease. For CFO, it

presents a large negative value in the first year, followed by a sharp
decrease in the second year and a value close to zero in the third year. The

pattern obtained by NDNI estimated with the modified Jones model follows
the trend of cash flows. Similar to Subramanyam (1996) it has a sharp

decrease in the second year and approaches zero in the next year. Amongthe discretionary accrual models using cash flows as expianatory variables,
we find that the estimates of NDNI made with the Jones-CF model, haveautocorrelation patterns similar to cash flows and to the estimates of

NDNI obtained with the modified Jones model but with lower absolutevalues. Estimates of NDNI obtained with the AP model are smoother andhave a pattern very similar to that of EBEI. These findings suggest that thesmoothing factor present in total accruals is assigned to the discretionary

part by the modified Jones model but is assigned to the nondiscretionary
part in the AP and Jones;CF model.
4.3 Predictabilityof future performance

Table 5 presents the mean and median correlation between current andfuture performance. We show results for EBEI, CFO and the 3 estimates of
NDNI. First, we can see that EBEI predicts future levels of cash flow better

than CFO. For example, in the case of CFOt+i, EBEIt has a mean correlationof O.12 while CFOt has O.09. This is consistent with DKW (1998), who assertthat earnings predict future cash flows better than current cash flows. Thisphenomenon can be attributed to the forecasting power contained in
accruals. We also measure the ability of NDNI to predict performance.
From the reported results, we see that NDNI obtained with the modified
Jones model has the lowest explanatory power, the Jones-CF model issecond and the AP model generates the highest correlatioris with future
performance. For example, the correlation between EBEIt+i, and NDNIt
estimated with the modified Jones, the Jones-CF and the AP models are
O.26, O.44 and O.47 respectively. When we measure the ability of NDNI topredict itself, we see that it is quite limited for the Jones model. The
average correlations for one, two, and three years ahead are O.07, O.03 andGARZA.GOMEZ, OKUMURA AND KUNfMURA : DtSCRerIOIVARrACCRUAL MODELS ArVD THE ACCOUIVTIIVG PROCESg 121

O.02. 0n the contrary, NDNI obtained with the AP model presents averagecorrelations of O.52, O.27, and O.17,

Table 5
Correlations between current and future net income,
cash flow from operations and nondiscretionary income

Explanatory

One year ahead Two years ahead Three years ahead
EBEI,+i CFO,+i NDNI,+i EBEI,+2 CFO,+, NDNI,+, EBEI,+3 CFO,+s NDNI,+evariable

Earnings before extraordinary items (EBEIt)

Mean O.59 O,12Median O.64 O.12

O.32
O.35

O.07 O.20 0.08
O.06 O.20 0.08

Cash flow from operations(CFOt)

Mean O.31

O.09
O.10

Median O.33'
Nondiscretionary ineome

O.19
O.21

(NDNIt) estimated with

O.05 O.14 0.07
O.04 O.14 0,07
modified Jones model

Mean O.26 O.07 O.07 O.16 O.04 O.03 O.10
Median O.28 O.07 O.08 O.17 O.ou O.03 O.11

O.04

O.02

O.04

O.02

Nondiscretionary income (NDNIt) estimated with Jones-CF model

Mean O.44 O.07 O.33 O.24 O.05 O.16
Median O.47 O.07 O.35 O.25 .0.oo O.15

O.16

O.06

O.10

O.16

O.05

O.10

Nondiscretionary income (NDNIt) estimated with AP model

Mean

O.47

O.08

O.52

O.26

o.os

O.27

O.16

. O.05

O.17

Median

O.50

O.09

O.56

O.28

O.07

O.29

O.17

O.06

O.18

The sample includes all nonfinancial firms listed in the first section of the Tokyo

Stock Exchange with at least 5 consecutive years of data.

The time series data for each firm in the sample is used to calculate
autocorrelations and cross-correlations one, two, and three years ahead, The table

reports the cross-sectional mean and median for 1,214 firms.

These findings corroborate the evidence presented in this section whichindicates that the use of the modified Jones model tends to assign all theforecasting power contained in total accruals to discretionary accruals,
while the use of models containing cash flows suggests that the explanatory

power of total accruals is shared by the accounting process and by
managerial discretion.

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KOBE ECONOMIC & BUSIIVIISS REVIEW, 45(2000), 103-135

5.Tests for detecting earnings management
In this section, we follow the work of Dechow, Sloan and Sweeney (1995)

and present tests for earnings management for the three competing
diseretionary accrual models. First, we compare the patterns of earnings
management found by the models in random samples and in samples basedon financial performance. We then measure the degree of manipulationsuggested by the models and finally, we present implications obtained fromthe comparison of our model against the commonly used modified Jonesmodel.
5.1 Testing the hypothesis of no earnings management
DSS (1995) evaluate the performance of 5 discretionary accrual models.
As part or their tests, they examine the frequency with which the competingmodels generate type I errors. This error occurs when the null-hypothesisof no earnings management is rejected even if the null is true. They foundthat the models work well when the firms suspected of having manipulated
earnings are randomly se!ected. However, they report high standard error
in their estimates, indicating low power to detect' earnings management.
When the suspects for manipulation are selected from firms with extreme
performance, the models seem to be misspecified. The models analyzed by
DSS find income decreasing practices for firms in the lowest decile ofearnings performance. For the low CFO firms, the models tend to findincome increasing (decreasing) practices more (less) often than the levelspecified for the test. Similarly, for firms with high CFO, the models findincome increasing (decreasing) practices less (more) often than expected.

DSS claim that the high rejection rates arise because the models do not
capture the negative relation between accruals and cash flows and attributea big part of accruals to discretionary accruals.

Table 6 presents the rejection frequencies for tests of earnings
management performed on 7 random samples taken from Japanese data.
The first sample contains 10oo firm-years randomly selected from the 32,304

firm-years in our data. The next samples are selected to have extreme
performance. For every measure (standardized by lagged total assets),firm-years are assigned in equal numbers to decile portfolios (3,230 firm-

years) and samples of 1ooO firm-years are randomly selected from theseportfolios.

GARZA.GOMEZ, OKUMURA AIVD KUNIMURA : DISCRETIONARY ACCRUAL MODEI,S AND THE ACCOUNTING PROCEgS 123

Since the rejection rates are unknown, instead of comparing the observed
frequency with a rejection rate, we present the frequencies obtained under
different models. This allows to compare what kinds of firms are reported
as having manipulated earnings by the competing models.

Table 6Comparison of the proportion of earnings management found byalternative diseretionary accrual models.
Earnings management < = O
Earnings management > = O
Null hypothesis

5%

Test level

1906o

50/o

1%

L Random sample of 1000 firms

M. Jones 4.2
Jones-CF 4.9

AP 4.1

2.

Randorn sample of 1000 firrns from

M. Jones 3.0
Jones-CF O.4

AP 4.03.

M. Jones 8.7

AP 15.5

Randorn sample of 1000 firms from

M. Jones 34.2

Jones-CF 8.0

AP 7.6

5.

Randorn sarnple of 1000 firms from

M. Jones O.8
Jones-CF 9.2

AP 6.06.

Rando,n sarnple of 1000 firms from

M. Jones 38.4
Jones-CF 10.2

AP 18.97.

the lowest decile of earnings perforrnance

2.3 20.9 11.7

Random sample of 1000 firms from the highest decile of earnings performance

Jones-CF 33.2
4.

1.5
3.8
1.0
1.7
3.4
1.9 3.2 1,3
1.4
1.2 6.3 2.4
O.3 22.5 10.5

Randonz sarrtple of iOOO firms from

M. Jones O.2
Jones-CF 8.0

3.7 6.8
3.0
15.6
2.0
O.7
8.9 3.2 1.1
16.4 O.3 O.1
2.8 7.2
7.5 4,2
3.9
3.3

the lowest decile of cash flow performancethe highest decile of cash flow performance

O.3 24.2 10.0

5.0 7.9 3.1
2.9 7.2 2.8
16.9
O.1
O.O
4.3 8.4 3.1
11.5
7.8 2.8

the lowest decile of NDNI perforrnancethe highest deeile of NDIVI performance

O.O 30.4 12.0

4.7 10.0 4.0

AP 6.83.8 9.9 4.5
percentage of randomly

Table reportsthehypothesis ofno earnings management is rejected (one-tailed test).

selected firm-years for which the

null

124

KOBE ECONOMIC & BUSINLE SS REVIEVV, 45(2000), 103-135

The first block in Table 6 corresponds to random sample of 1000 firmyears. The pattern of rejection is quite similar among the three models. The

next 2 blocks correspond to tests done using random samples of firms withextreme earnings performance. The AP and Jones-CF models tend to findincome increasing (decreasing) manipulation for firms with high (low)income more frequently than the modified Jones model. For example, for
low EBEI and the test level of 5 percent, the modified Jones model finds 6.3

percent of firms with income decreasing behavior while the AP and theJones-CF models report frequencies above 20 percent. For high EBEI firms,
the AP model finds 15.5 percent of rejection, the Jones-CF finds 33.2 percent
and the modified Jones model finds only 8.7 percent. This evidence may
suggest that the AP and the Jones-CF models may be overestimating the
proportion of firms performing earnings management and the modified
Jones model is appropriate. However, as explained below, this pattern of
behavior in firms with extreme earnings should be expected.
The next 2 blocks contain results for samples taken from the bottom andtop deciles of cash flow performance. Results for the modified Jones model
are consistent with those reported in Table 4 of DSS (1995). This modeltends to find income increasing (decreasing) manipulation for firms withlow (high) cash flow very often. Similarly, the modified Jones finds income
increasing (decreasing) for firms with high (low) cash flow in fewer

occasions than the AP and Jones-CF models. We attribute this to theinability of the Jones model to control for the negative correlation between

accrual changes and cash flow changes. However, the AP and Jones-CF
models seem to correct this deficiency.

DSS present results obtained using earnings and cash flows as measuresof performance of the firms. However, if we compare these two variables,
we can say that cash flows are free from manipulation, while earnings
contain managerial discretion, This difference is important when the tests
are performed for firms with extreme performance. For example, using our
32,304 firm-years, we find that from the initial 10 percent of firms in the top(bottom) deciles of cash flow performance, only 4.0 (2.6) percent finish in

the top (bottom) decile of earnings performance. This suggests two
implications. First, a total of 13.4 percent (6.0 + 7.4) of firms in the middie

80 percent of cash flow performance end up in the top and bottom decilesof earnings perperformance due to a combination of discretionary andnondiscretionary accruals. This suggests that firms in the top (bottom)
deciles of earnings performance consist mainly of firms with high (low)GARZA-GOMEZ, OKUMURA AND KUNIMURA : DISCRETIOIVARY ACCRUAL MODELS AND THE ACCOUNTING PROCESS 125

total accruals, so we can expect to find income increasing in high-income

firms and income decreasing manipulation in low-income firms. Second, acombination of discretionary and nondiscretionary accruals make theperformance of 6.0 (7.4) percent of the firm-years in the top (bottom)
deciles of cash flow performance move to the middle 80 percent of earnings

performance. This suggests that being an extreme cash flow performer
does not imply being an extreme earnings performer. In fact, managers
cannot confront the alternative to exercise discretion based only on cash
flows, since there are still some accounting accruals (nondiscretionary partof accruals) that can modify performance in the direction needed bymanagement.
Because of the problems suggested above, we perform additional tests
using nondiscretionary income (NDNI) in addition to earnings and cash

flows to define random samples of extreme performance. This variable
provides a good measure to discriminate performance, particularly when
we try to detect earnings management, because in theory, it includes
accruals obtained from the accounting process, but excludes discretionary

accruals. Assuming that the model correctly separates the discretionary
and nondiscretionary part of accruals, then NDNI represents the realsituation confronted by managers considering the possibility to manipulateearnings. The last two samples present results for the bottom and top
deciles of NDNI calculated with the competing models.'6 The rejection
patterns are similar to those corresponding to cash flows. The modified
Jones model tends to find income increasing (decreasing) manipulation forfirms with low (high) NDNI more often than the other models but cannot
detect income decreasing (increasing) for firms with low (high) NDNI. Thissuggests one more time that the modified Jones model leaves all theinformation of total accruals into the discretionary part.

5.2 Degree of manipulation found by the models
Results in the previous subsection suggest that the use of different models

leads to different conclusions. The modified Jones model tends to findearnings management on firms with extreme CFO more often that othermodels while the AP and Jones-CF models tend to find earnings
management on firms with extreme EBEI more often than the Jones-CF
16 Given that NDNI is different for the three models, the 1000 firms selected to perform tests

do not coincide among them.

KOBE ECONOMIC & BUSINLE SS REVIEVV, 45(2000), 103-135

126

model. To assess the models' ability to detect earnings
estimate the regression ofmanagement, we

DA;, =a +b PARTi, + ei,(10)where PART is the partitioning variable that identifies the sub sample inwhich earnings management is suspected. We perform this analysis for thesame definitions of PART used in Table 6: random samples, and random
sub samples of firms with high and low performance in terms of cash flows
and nondiscretionary income. We exclude earnings from this part of ouranalysis because under the null hypothesis of no earnings management, if
the sample is random., or if the sample is constructed so that PART is notitself a causal determinant of earnings management, we can expect that theestimated coefficient on PART to be zero, but for the case of earnings,
which include manipulation, we cannot hypothesize the coefficient on PARTto be zero."

Table 7 presents results for pooled regressions of discretionary accruals

on the dummy variable PART.i8 For the random sample obtained from all
firms, we observe that the estimated manipulation is very close to zero andstatistically insignificant for the three models. However, we remark that thestandard error (see Table 3) differs drastically among models. The value
obtained by the modified Jones model is O.053, quite higher than the values
obtained by the Jones-CF or AP models (O.020 and O.O16 respectively). These
values suggest that the AP model has the highest sensitivity (highest
power) to detect earnings manipulation.

17 We performed tests using earnings, and the coefficients are statistically lower (higher)
than zero for the bottom (top) earnings decile. The coefficients and t-values for PARTobtained for the modified Jones model are lower than for the AP and Jones-CF models.
'18 Our estimation procedure differs from that used in DSS (1995). The reason is that while
they estimate nondiscretionary accruals using the time series version of the Jones model,

we use the cross-sectional versions. Accordingly, DSS estimate equation 10 for all thefirms in the sample using time series data, while we report results using pooled
regression. Nevertheless, we can report that we performed year-by-year cross-sectional
regressions and firm-by-firTn time series regressions and results are qualitatively thesame and the ranking of models is maintained.

GARZA.GOMEZ, OKUMURA AND KUNIMURA:DISCRETIONARYACCRUAL MODELS AND THE ACCOUNTING PROCESg 12

Table 7
Estimated degree of manipulation under discretionary aecrualmodels (as pereent of total assets)

Random sample taken fromAll firms

Bottom CFO decile
Top CFO decile

Bottom NDNI decile
Top NDNI decile

M Jones Jones-CF

AP

coef

O.CK)OO

o.ooooO.oo06t-stat

o.oo

-O.05

O.92

coef

O.0835

O.oo26

O.oo22t-stat

46.95

3.15

3.72

coef

-O.0658-O.oo25-O.oo18

t-stat-36.48

-3.08

-3.01

coef

O.0908O.oo56

O.oo93t-stat

51.40

6.90

15.47

coef

-O.08os-O.O060-O.oo28

t-stat-45.19

-7.42

-4.65

The table reports the estimated slope in the equation DAit= a+ b PARTit+ eitDAit
represents discretionary accruals of firm i at time t and PART is the variable that

identifies candidates for earnings management. PART is defined for random
samples of all firms and also taken from top and bottom deciles of CFO andNDNI.

When we apply the regression to samples based on performance we findthat when CFO is used to discriminate firms, the coefficients obtained by
the modified Jones model are strongly significant with t-statistics above 20.

The amount of manipulation found by this model is 8.4 (-6.6) percent of
total assets for low (high) cash flow firms. For the models containing cash
flows, the degree of manipulation is below O.3 percent.

When NDNI is used to separate firms, all models find manipulation in thesamples used. For the sample taken from the bottom NDNI deciles, themodified Jones model finds a manipulation of 9.1 percent while the JonesCF finds O.6 percent and the AP model finds O.9 percent. Similarly, for the
sample corresponding to the top NDNI deciles, the modified Jones finds -8.1

percent against -O.6 percent and 'mO.3 percent for the Jones-CF and AP
models respectively. We attribute this big difference in the estimated degreeof manipulation to the fact that the Jones model assigns most of theinformation in total accruals to the discretionary part.

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KOBE ECONOMIC & BUSINLESS REVIEVV, 45(2000), 103-135

5.3 Implications for studies of earnings management

As we have seen throughout this section, when different discretionary
accrual models are used, results change considerably. In fact, finding
manipulation with one model does not necessarily imply manipulation whena different model is used.i9 Consequently, the identification of the best
discretionary accrual model is important in studies related to earnings

management.
In relation to the variable used to measure performance, we know that
because EBEI contains managerial discretion, we may expect to find income
manipulation in firms with extreme income more often than in firms withextreme NDNI or extreme CFO. Yet, empirical results show that firms

identified by the modified Jones model as having decreased income
intentionally have high CFO and high NDNI. In the same way, those foundas having increased income, have low CFO and low NDNI. On the other
hand, the firms identified by the AP and Jones-CF models as having
decreased (increased) income, have low (high) earnings.

In conclusion, our results indicate that the modified Jones model suffersfrom a misspecification, which is corrected by considering the relation

between cash flows changes and accruals changes. Our evidence alsosuggests that models containing cash flows are better alternatives than themodified Jones model to test for earnings management. Furthermore, we
emphasize that the selection of the variable used to measure performanceis critical for this type of studies.20 As stated above, nondiscretionary
income seems to be the best alternative because it resembles the situation

confronted by the manager considering the possibility to manipulate.
earnmgs.

19 When we analyzed how many firms identified as having manipulated earnings under one
model coincided with firms identified by the other models, we found that the degree of
cohcurrence between the AP and Jones-CF models is 31 percent, between the Jones-CF
and modified Jones models is 18 percent, and between the modified Jones and AP models
is 13 percent. These numbers contrast drastically with the 87 percent obtained between themodified Jones model and the original Jones model. ,20 DeFond and Park (1997) describe a similar experience. They report that when theyclassify firms into good and bad based on cash flows or based on premanaged earnings(nondiscretionary income), their predictions about earnings manipulation are supported,
but when income is used, their predictions are rejected.

GARZA.GOMEZ, OKUMURA AND KU?VIMURA:DISCRETIONARYACCRUAL MODELS AND THEACCOUNrl,VG PROCESS 1

6.Tests of managerial diseretion

Evidence presented in previous sections suggests that the modified Jonesmodel will affect conclusions related to managerial discretion. That is, thebad fit of this model Ieaves too much explanatory power in thediscretionary part of accruals. In this section, in the spirit of Bernard andSkinner (1996), we reproduce some of the tests performed by Chaney, Jeterand Lewis (1998) and Subramanyam (1996) using the three discretionary
accrual models analyzed in this paper. We evaluate the amount of influencethat the misspecification of the Jones model has on the conclusions
obtained by such studies on the importance of managerial discretion.

6.1 Intensity of income smoothing

Chaney, Jeter and Lewis (1998), using the Jones model to estimate
nondiscretionary accruals, find that managers consistently involve inearnings smoothing. They form predictions about the direction of
discretionary accruals in a given year by comparing nondiscretionary
income (NDNI,) to the previous year's reported earnings (EBEI,-i). When
NDNIt is lower (higher) than EBEIt-i, discretionary accruals should bepositive (negative). They report that 85 percent of the firms report

discretionary accruals in the direction needed to smooth income in any
given year. They find that the average discretionary accruals of the 47 (53)percent of the firms that increase (decrease) earnings is 9.7 (-6.8) percent ofassets. Their findings, however, depend crucially on the appropriateness of

the Jones model. If the model leaves too much information on thediscretionary part of accruals due to a misspecification, then CJL's results

may be inflated by the use of a misspecified model.

130

KOBE ECONOMIC & BUSINIiSS REVIEVV, 45(2000), 103-135

Table 8
Effect of discretionary accrual model selection to get inferences

about discretionary accruals.
Panel A: Tests for arnount of manipulation

M. Jones Jones-CF

AP

Firms with NDNIt >EBEIt-i

Average DA-O.0387-O.O164 -O.OI06

O.0403

O.O172 O.O095
O.0336 O.0201

Firms with NDNIt <EBEIt-

Average DA
Difference in means
Panel B: Ave.R2 obtained by a model using CFO

O.0791and NDA as explanatory variables

M.Jones Jones-CF AP
Next rvear cash flows
Next year earnings
Contemporaneous returns
Future returns
Panel C: Increase of R2 obtained by ineluding DA

O.113

O,113

O.132

O.185

O,304

O.460

O.031

O.041

O.ou4

O.O18

O.024

O.026

bayond NDA and CFO

M.Jones Jones-CF AP
Next year cash flows
Next year earnings
Contemporaneous returns
Future returns

O.042

O.034

O.O13

O.398

O.280

O.126

O.021

O.O12

O.022

O.020

O.O08

O.oo6

In Panel A, firms are identified as eandidates for income decreasing and firms
identified as candidates for income increasing based on tests made in Chaney, Jeterand Lewis (1998). The reported numbers show the amount of manipulation
estimated for each of the discretionary accrual models.
Panels B and C report the average R2 of 34 yearly cross-sectional regressions using

different combinations of earnings components as explanatory variables. Panel B

shows the results for models including CFO and NDA estimated using threedifferent models. Panel C corresponds to the incremental explanatory powerbrought by DA once NDA and CFO are included in the regression. The dependent
variables are the same used in Table 2.

Even if the majority of managers exercises discretion in the direction
predicted by CJL, we think that the amount of manipulation found in theirstudy is very high. We believe that the accounting process is a natural andvery important source of income smoothing and the attribution of all the

GARZA-GOMEZ, OKUMURA AIVD KUIVIMURA : DISCRETIONARY ACCRUAL MODELS AND THE ACCOUNTING PROCESS 131

smoothing to managers lessens the importance of accrual accounting.
Therefore, we replicate this part of CJL's tests to evaluate the degree of
dependence that their conclusions abouL the use of managerial discretion
have on their choice of discretionary accrual model. We use a big sample offirm-year observations from the Japanese stock market, and use CJL's
criteria to separate the two samples for which the predicted discretionary
accruals will be negative (NDNIt >EBEI,-i) and positive (NDNIt <EBEIt-i).
Panel A of Table 8 reports the results using the three discretionary accrualmodels presented in this paper. Using the modified Jones model the average

discretionary accruals are -3.9 and 4.0 percent for income decreasing andincome increasing samples, which results in a difference of 7.9 percent.
Incorporating cash flow into the discretionary accrual model reduces thedifference in discretionary accrual averages to 3.4 percent for the Jones-CF

model, and to 2.0 percent for the AP model. Despite the lower spread
between samples obtained under the AP model, the statistically significancefor the reported difference is very strong. This constitutes evidence that the

low fiL obtained by the Jones model causes an over-estimation of theamount of managers' manipulation.
6.2 Discretionary accruals andfutureperforrnance
Subramanyam (1996) finds that discretionary accruals have information
content to explain stock returns. He supports his result showing .evidence
that managers use discretionary accruals to send signals concerning future

performance. His results, however, depend on the appropriateness of theJones model. If the model is misspecified, some of his results may be overstated. Therefore, we replicate some of his tests and assess his conclusions

about the use of managerial discretion to signal future performance withthe use of alternative discretionary accrual models.

Accruals are known to have high information content and strong
explanatory power for stock returns or future performance (see Table 2).
This important contribution of total accruals is to be separated into thepart attributable to managers and the part explained by the discretionary
acerual model. This is why the goodness of the model becomes critical if wetry to evaluate the role of managerial discretion. Since discretionary
accruals are defined as the difference between the fitted and the originalvalues, a misspecified model will leave information unexplained, and therole of discretionary accruals will be overstated. Panel B of Table 8 shows

132

KOBE ECONOMIC & BUSINESS REVIEVV, 45(2000), 103-135

the predictive ability of a model that uses CFO and the estimates of NDA

obtained with the three definitions of nondiscretionary accruals as
explanatory variables. As we can see, the modified Jones model obtains thelowest information content of NDA and the AP model obtains the highest
information. Panel C shows that the highest increase of information
brought by discretionary accruals is for the modified Jones model and the
Iowest is for the AP model.2' This provides evidence that the low fit of themodified Jones model causes the explanatory power of DA to appear larger
relative to models with a better fit. Since Subramanyam (1996) uses theJones model, his conclusions regarding discretionary accruals may havearisen f'rom using misspecif'ied discretionary accrual models. Therefore, theselection of an adequate discretionary accrual model becomes important.
From the two models that incorporate cash flows, the AP model provides
the best alternative to the Jones model to test the role of managerial
discretion because the overestimation of discretionary accruals is reduced
for this model. If DA is found to contain information, even in models thatassign a big role to accounting accruals, then the conclusions regarding
managerial discretion will become stronger.

Table 9Explanatory power of discretionary accruals for future performanee
Dependent variable

Int

CFO,

NDA,

DA,

CFO,+,

O.029

O.644

O.430

O.420

EBEI,+,

EBEI,.
EBEIL-eNDNI,`,
NDNI,.,
NDNI,.,

coef
t-stat

14.48

19.05

10.50

10.09

coef

O.O05

O.762

O.737

O.668

t-stat

4.84

46.57

40.86

23.74

coef

O.oo8

O.626

O.610

O.438

t-stat

5.35

36.05

31.29

12.15

coef

O.O09

O.545

O.532

O.360

t-stat

5.57

29.70

25.57

12.84

coef

O.oo3

O.805

O.773

O.732

t-stat

4.50

52.75

49.13

36.79

coef

O.oo7

O.625

O.601

O.501

t-stat

5.74

36,07

33.23

18.60

coef

O.O09

O.531

O.512

O.343

t-stat

5.87

29.93

26.15

11.94

Adj.R2 Incr R2 Significance
O.145

O.O13

9/33

O.587

O.126

32/33

O.384

O,OM

27/32

O.292

O.042

23/31

O.756

O.174

33/33

O.453

O.087

31/32

O.321

O.044

23/31

21 The case of contemporaneous returns is special. The increase on R' istotal R2 is higher for the AP model than for the M-Jones model

similar but the

GARZA-GOMEZ, OKUMURA AND KUNIMURA : DISCRETIONARY ACCRUAL MODELS AIVD THE ACCOU2VTING PROCEss 133

Nondiscretionary accruals (NDA) and discretionary accruals (DA) are estimatedusing the AP model. Incr. R2 indicates the gain in explanatory power obtained with
the inclusjon of DA to a regression including cash flow from operations (CFO) and

NDA. Significance of the increment in R2 is reported as the number of years forwhich a Vuong's test for null incremental information is rejected at the 5 percent
sjgnificance level.

We use all non-financial firms Iisted in the first section of the Tokyo Stock
Exchange from 1962 to 1995. The full sample includes 30,673 company years forregressions using accounting variables for next year.

To test this assessment, Table 9 presents tests of the predictive ability

embedded in the discretionary accruals estimates obtained with the APmodel. CFO,, NDA,, and DAt are used to explain future performance asmeasured by CFO, NDNI, and EBEI. When we try to predict CFO,+i, theincrease in R2 brought by the inclusion of DAt is low, and significant onlyin 9 of the 33 years. When we predict EBEIt+! and NDNIt+i, the increases in
R2 obtained by adding DAt to the equation are in average O.126 and O.174

and significant in every year (only one year the increase in R2 is not
significant for the EBEI,+i case).22 When we use longer prediction horizons,

we find that the diseretionary accruals and their incremental explanatory

power above NDA remain significant up to 3 years into the future.
Nevertheless, the power of DA decreases as the prediction horizon
increases. Consistent with the idea of a relevant accounting proeess, theaverage coefficient for NDA is always larger than the coefficient obtained

by DA. This difference grows as the horizon involved in the prediction
mcreases.
7.Conclusions

This study develops a discretionary accrual model based on theaecounting process and the relationship between cash flows and accrualspresented by Dechow, Kothari and Watts (1998). We show that thecommonly used Jones (1991) model and the modification proposed by
Dechow, Sloan and Sweeney (1995) leave most of the information content of
22 We report that the predictability of NDNI obtained under the AP model is higher than
EBEI's, but lower for NDNI obtained with other models. This is consistent with evidence
in previous sections suggesting that DAs estimated with variations of the Jones model
have a predictable part.

KOBE ECONOMIC & BUSINESS REVIEVV, 45(2000),
103-135

134

total accruals into the discretionary part. We show how thismisclassification brings two problems for empirical tests. First, in tests forearnings management, it leads to incorrect inferences. Second, the relation

between discretionary accruals and future performance and the relation
between stock returns and discretionary accruals is inflated.

Throughout this paper, we have suggested and presented evidence that theaccounting process plays an important role in income smoothing. Since
managerial discretion is the other source of smooth income, we may expect

a diminished role of managerial discretion. However, when we analyze theinformation content of discretionary accruals, we find evidence thatmd( nagers do exercise discretion to signal futu're perforrria'nce'. In fact,using a discretionary accrual models designed to follow the nature of theaccounting process, we still find that discretionary accruals containpredictive power for future performance. We recognize, however, that ourmodel is a mere approximation to the real process generating accruals.
Therefore the possibility that some discretionary accruals are incorrectly
labeled as discretionary still exists.

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KOBE ECONOMIC & BUSINESS REVIEWCONTENTS
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A Note on Possibilities about Japan-Korea Free Trade Area:

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JapaneseSupplierRelations: AComparativePerspective ""'"""""'"""""'KenjiKoJ'irna
Development of the Forest Stewardship Council Certification Program••-•'••""""••••"•-•"""-"""""'Akira Kojiwara /Todd Malinich

No. 43 (1998)
What South Asia Can Learn from East/Southeast Asia:

International Trade and Foreign Direct Investment """""""""""""""Kazuhiro Igawa
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A Comparative Analysis of Pulp, Paper, and Packaging Companies
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Non-performing Assets of Banks and Financial Intermediation:

Experiences of Japan in the Inter-war Period """`;"'""""'""''•""""'Munehisa Kasuya

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A Simple Model of Technology Transfers in the North and South Economies:

Technology as Intermediary Goods '"""""""""""""""""""""''""'"'' Kazuhiso Igawa
Trade and Investment Relations of Japan and ASEAN

in a Changing Global Economic Environment "'""""""""""""""'""""''Shigeyuki Abe
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Organizational Coordination forProject Interdependency """"""'""""Kentaro Nobeoha
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Communication Industries ''"''"""'"'•""""•""""'"'H""""'"'"'"'"'""m'Jeffrey L. Funk
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