metadata: authors: 0: author: Sakakibara, Eisuke
1: author: Yamakawa, Sharon
count: East Asia and Pacific,Japan,Korea, Republic of,Thailand,China
docna: 0: docna: Regional integration in East Asia :
            challenges and opportunities - Part II : Trade, finance and integration
docty: Policy Research Working Paper
subtopic: Private Sector Economics,Urban Solid Waste Management,Trade Policy,Private Sector Development Law,International Trade and Trade Rules,Marketing,Trade and Multilateral Issues
teratopic: International Economics and Trade
abstracts: cdata!: The authors analyze the patterns of East
            Asia's trade and foreign direct investment (FDI) from a
            global and intraregional perspective, taking into account
            the importance of trade and FDI interlinkages. They propose
            two regionally-focused approaches to promoting trade and FDI
            in East Asia-regional agreements and regional production
            networks. The East Asia crisis strengthened appeals for
            regional cooperation in the financial area. As a result, a
            number of financial arrangements and initiatives have
            emerged since the crisis, the most prominent of these, the
            Chiang Mai Initiative. (The Association of Southeast Asian
            Nations plus China, the Republic of Korea, and Japan decided
            at their meeting in Chiang Mai, Thailand, in May 2000, to
            establish a regional network of swap arrangements.) While
            opening of the capital account is considered desirable in
            the long run, it is associated with considerable risk,
            particularly if macroeconomic policies are not sound and
            financial supervision and regulation is weak. Because of the
            potential volatility associated with floating regimes and
            the desire to avoid another crisis in the region, the
            authors discuss a number of options.
geo_reg_key: 517198,119225,517191
repnme: repnme: Regional integration in East Asia :
            challenges and opportunities - Part II : Trade, finance and integration
display_title: Regional integration in East Asia :
            challenges and opportunities - Part II : Trade, finance and integration
listing_relative_url: /research/2003/06/2390976/regional-integration-east-asia-challenges-opportunities-part-ii-trade-finance-integration
topicv3: Private Sector Development m1326060 1921,Intraregional Trade m1326248 1175,Trade m1326924 698,Trade and FDI m1504264 2556,Regional Integration m1504278 2576
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: International Economics and Trade
origu: PREM Sector Department (EASPR)
no_of_pages: 160
model_extractions: I POLICY RESEARCH WORKING PAPER 3079

# Abstract

Sakakibara and Yamakawa analyze the patterns of East Asia's trade and foreign direct investment (FDI) from a global and intraregional perspective, taking into account the importance of trade and FDI interlinkages. They propose two regionally-focused approaches to promoting trade and FDI in East Asia-regional agreements and regional production networks.

The East Asia crisis strengthened appeals for regional cooperation in the financial area. As a result, a number of financial arrangements and initiatives have emerged since the crisis, the most prominent of these, the Chiang Mai Initiative. (The Association of Southeast Asian Nations plus China, the Republic of Korea, and Japan decided at their meeting in Chiang Mai, Thailand, in May 2000, to establish a regional network of swap arrangements.) While opening of the capital account is considered desirable in the long run, it is associated with considerable risk, particularly if macroeconomic policies are not sound and financial supervision and regulation is weak. Because of the potential volatility associated with floating regimes and the desire to avoid another crisis in the region, the authors discuss a number of options.

This paper-a product of the Poverty Reduction and Economic Management Sector Unit, East Asia and Pacific Regionis part of a larger effort in the region to analyze integration through trade. Policy Research Working Paper 3078 on History and Institutions is part I of this paper. Copies of this paper are available free from' the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact ShahidYusuf, room MC2-509, telephone 202-458-2339, fax 202-522-1150, email address syusuf@worldbank.org. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. Sharon Yamakawa may be contacted at yamakawa@gsec.keio.ac.jp. June 2003. (149 pages)

> _The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent._

Produced bv Partnershios. Caoacitv Buildine. and Outreach
### **WORLD BANK EAST ASIA PROJECT**

## **REGIONAL INTEGRATION IN EAST** ASIA: CHALLENGES AND OPPORTUNITIES

**Eisuke Sakakibara and Sharon Yamakawa**

### **Global Security Research Center, Keio University**

# Part Two: Trade, Finance and Integration

Chapter IV - Trade and FDI: A Role for Regionalism Chapter V - Financial and Monetary Integration Chapter VI - Conclusion: Observations on Integration Chapter VII - Looking Ahead _Note: part one of this report is presented as_ _a separate working paper._
# **Acknowledgements**

We would like to acknowledge the support of others in the preparation of this paper. In particular, we would like to thank Shuichi Shimakura and Eri Moriai for data support and Catherine Sasanuma and Shunichi Sueyoshi for their contributions to the research on regional institutions.
# **Introduction to Part Two**

As stated in the "Overview" presented in Part One,<sup>the purpose of this study is to</sup> evaluate the pattern and gauge the progress of<sup>regionalintegrationin East Asia froma</sup> political-economic viewpoint. The focus<sup>is on the trade,investment,and</sup> financial/monetary aspects of regional cooperation<sup>in projecting a viableframeworkfor</sup> integration in the coming decade and assessing<sup>the prospectsfor its successin bringing</sup> prosperity to East Asia. The study examines<sup>the causalfactors of regionalisminEast</sup> Asia and the underlying dynamics of the movement.<sup>In this process,differencesbetween</sup> Asia's type of regionalism and that of other<sup>regionsof the world, in particular Europeand</sup> North America, will become apparent.

Part One set the stage for a discussion of regional<sup>integration in EastAsia (1) by</sup> reviewing Asia's historical trade and economic<sup>presencein the world,(2) by assessing its</sup> current degree of openness to, and integration<sup>with, the globaleconomy,and (3) by</sup> evaluating the status and performance of regional<sup>institutionsin theregion in the post-</sup> World War II era. The review of Asian economic<sup>history in Chapter I revealedtwo</sup> aspects of trade in the region (i.e., intraregional<sup>and global)that overlappedand</sup> interacted in such a way as to have effectively<sup>functionedas one system.This,in</sup> addition to the evidence of Asia's prominent role<sup>inthe globaleconomy at that time,</sup> supports the argument that Asian trade has been<sup>open and globalfor centuries.</sup> A look at East Asia's social, economic and political<sup>structuresin Chapter II</sup> revealed a region of enormous diversity, particularly<sup>when compared with other regions</sup> of the world. The characteristics of various<sup>regional groupings(e.g.,ASEANand APEC)</sup> were examined in an effort to determine if one<sup>or anotherof theseinstitutions brings</sup> greater benefit to the region and the economies<sup>therein.Whileagroup comprising</sup> developmentally similar economies could be<sup>amore workablearrangementin which</sup> smaller members would have more influence,<sup>there is a slightly more compelling</sup> argument in favor of agreements between industrial<sup>anddeveloping economiesin that</sup> they can bring significant benefits to the developing<sup>partners.</sup> Chapter III pointed out that the development of<sup>regionalinstitutionswas not an</sup> initial goal of East Asian integration; however,<sup>most EastAsianswould now like to seea</sup> strong regional institution in place to lead the region<sup>toward closer cooperationand</sup> deeper integration. Regional cooperation has<sup>reached the stage in East Asia where more</sup> structure and leadership is needed. However,<sup>most find the current condition of regional</sup> institutions in East Asia to be discouraging.<sup>The ASEAN-Plus-Threegrouping,although</sup> currently operating on the sidelines of ASEAN<sup>and having no secretariatof its own,is</sup> perceived by many to be the most workable<sup>and potentially beneficial groupingfor the</sup> region.

Part Two of the study, "Trade, Finance and Integration,"<sup>includes ChaptersIV</sup> through VII. Chapter IV analyzes the patterns<sup>of East Asia'strade andforeign direct</sup> investment (FDI) from a global/intraregional<sup>perspective, takinginto considerationthe</sup> importance of trade and FDI interlinkages. In this<sup>context, we proposetwo regionally</sup> focused approaches to the promotion of trade<sup>and FDI in EastAsia:regional agreements</sup> and regional production networks.

Taking the East Asian crisis as the point of departure,<sup>Chapter Vlooks at</sup> monetary and financial cooperation in the<sup>region.Prior to the crisis,economic</sup> iii
cooperation efforts in East Asia were focused on trade and investment. The occurrence of the crisis strengthened appeals for regional cooperation in the financial area. As a result, a number of financial arrangements and initiatives have emerged since the crisis. These are discussed in some detail with special attention paid to the most prominent of these, the Chiang Mai Initiative.

This chapter then reviews financial development in the region. In conjunction with this, financial structure (bank-based versus capital market-based systems) is examined in an effort to determine its effect, if any, on financial development.

Chapter V also addresses the issue of capital account liberalization and its advisability for emerging markets. While opening of the capital account is considered desirable in the long run, it is associated with considerable risk, particularly if macroeconomic policies are not sound and financial supervision and regulation is weak. Many factors related to an individual country's stage of development and current level of involvement in global capital markets need to be considered in setting realistic goals and objectives in this area.

Also, arising out of the Asian crisis and related to the issue of financial system reform is an ongoing debate on the appropriate currency regime for East Asian economies, extending to the suitability of a regional monetary arrangement for the region. Prior to the crisis, currencies of the crisis-affected countries were "effectively" pegged to the U.S. dollar. During the crisis, many of these countries switched to a floating rate regime. Because of the potential volatility associated with floating regimes and the desire to avoid another crisis in the region, a number of options are being discussed. This chapter discusses the pros and cons of these options.

Chapter VI summarizes the whole study (Parts One and Two) and concludes by providing some perspective on the current state of cooperation and integration in the region.

Chapter VII looks at regional integration from a future perspective. This chapter endorses the establishment of a genuine regional institution in East Asia. In addition, it takes a look (both short- and long-term) at what type of currency arrangements might be suitable for the region.

iv
# - **Chapter IV Trade and**<sup>**FDI: A Role for Regionalism**</sup>

Trade and foreign direct investment<sup>(FDI) have played a role, indeed a major role,</sup> in the development of East Asia.<sup>The phenomenal growthof the1 980sandearly 1 990s</sup> has been attributed to East Asia's<sup>liberalizationin these two areas.Tradeand FDI</sup> interact in such a way as to be<sup>mutuallypromoting. The importanceof this linkage has</sup> grown along with the increased<sup>integrationof the internationalproduction network.</sup> Together, they facilitate the efficient<sup>functioning of this system.Furthermore,the</sup> potential for growth is enhanced<sup>when thereis coordinationin the formulationof trade</sup> and FDI policies.

In this chapter we will look at<sup>regionalismin EastAsiafrom the perspectiveof</sup> trade and FDI, the objective being<sup>to determineif regional cooperation has a role to play</sup> in their promotion. In this process<sup>we will show that East Asia's trade and FDI have both</sup> global and intraregional elements<sup>that are essentialto the continued development of the</sup> region. Given that and the trend<sup>in theregion to seek regionalsolutions to common</sup> issues, we will suggest two regionally<sup>focused approachesto the promotion of trade and</sup> FDI in East Asia: regional agreements<sup>and regional productionnetworks.</sup>

# **Trade and FDI Linkages**

In recent years, the topic of<sup>trade andFDI linkage hasgeneratedintenseinterest in</sup> the international community and<sup>has been discussed at length in major reports produced</sup> by international organizations such<sup>as UNCTAD, the WTO,and the OECD,as wellas</sup> being addressed in smaller studies.'<sup>The common debate on this issuecentersmainly on</sup> whether trade leads to FDI or<sup>vice versaand whether they aresubstitutesor</sup> complements. In fact, the interrelationship<sup>between them is quite complex.It may vary</sup> by product, economic sector, and<sup>across countries.In other words,it dependsupon the</sup> type of FDI and the location and<sup>developmentallevel of the countries concerned.</sup> For example, in the case of natural<sup>resources (resource-seeking FDI), trade often</sup> leads to FDI, which in turn supports<sup>(and/or creates) trade.If this type of FDI exploits</sup> the same competitive advantages<sup>as firmsin the host economy it will most likely</sup> reinforce existing export patterns<sup>of that economy, but if it exploitsdifferentresources,it</sup> can change export patterns.<sup>In manufacturing (export-oriented manufacturing FDI),</sup> existing advantages can be<sup>reinforced(e.g.,low-costlabor used to make clothingfor</sup> export) or changed through<sup>theintroductionof technologies, skills, brand namesand</sup> networks that do not exist in<sup>thehost country.2In the finalanalysis, it appearsthat first,</sup> trade leads to FDI, and then, FDI<sup>leads to moretrade.3</sup> However, the accuracy of this<sup>assessmentseems to bein doubt becauseof the</sup> evolution of the international<sup>production network.It is now lessan issueof whether trade</sup> leads to FDI or FDI to trade,<sup>or whether FDI substitutesfor,or complements,trade or the</sup> other way around. "Rather,<sup>it is:howdo firmsaccessresources-wherever they are</sup> located - in the interest of organizing<sup>production as profitablyas possible for the</sup> national, regional or global<sup>marketsthey wishtoserve?In other words, theissue</sup> becomes: where do firms locate<sup>their value-added activities? In these circumstances,the</sup> decision where to locate is<sup>adecision where to investand from whereto trade.And it</sup> becomes a FDI decision, if<sup>a foreign locationis chosen.It follows that, increasingly,</sup>
what matters are the factors that make particular locations advantageous for particular activities, for both, domestic and foreign investors."<sup>4</sup> Trade and FDI are becoming more tightly linked in today's international production system and they function together as the machinery that enables the system to operate. And, increasingly, TNCs are the facilitators of this process. Their growth in size and function has been phenomenal. The estimated 850,000 foreign affiliates of 65,000 TNCs worldwide today account for one-tenth of world GDP and one-third of world exports.<sup>5</sup> Their coverage has also broadened to include the whole range of manufactured exports from low- to high-technology goods, as well as services. TNCs in their integrated international and regional production strategies can locate production largely wherever they choose. Different activities of the production process can be located in different countries or regions in order to take advantage of lower costs, better resources, transport facilities and markets.<sup>6</sup> Thus the connection between trade and FDI is intensified and for countries where this production is located, opportunities for trade based on comparative advantage can increase. Of course, countries must first be a part of the TNC's organizational structure in order to have the opportunity to benefit from these closer trade-FDI linkages.<sup>7</sup> Both trade and FDI are well recognized today as facilitators of growth and development. They impact development separately and directly, as well as indirectly through their linkages. Capital, technology, management expertise, training for the local workforce and access to wider markets are some of the benefits that FDI can bring to host countries. These can complement the resources and capabilities of the host country and, thus, increase its export competitiveness.<sup>8</sup> Export competitiveness is a key element in the promotion of economic development as it can result in (1) increased foreign exchange earnings, which can be used for the import of products, services and technologies necessary for increasing productivity and living standards; (2) diversification away from primary commodity exports to higher technology exports; (3) better realization of economies of scale through larger and more diverse markets; (4) exposure to higher standards; and (5) easier access to information.<sup>9</sup>

> There are, of course, situations where these potential benefits are not realized in

> the host country because TNCs: (1) may concentrate solely on a host country's static comparative advantages and never develop the dynamic ones, (2) may fail to build linkages to the domestic business community, (3) may fail to bring high level technologies or training to local labor, and (4) may suddenly depart if conditions in the host country are perceived to have changed so they no longer meet the TNC's criteria for

> operating there.'

> Still, the relationship between global FDI flows and the growth of world GDP can be characterized as a "stable and positive relationship."' The overall conclusion of recent studies12 is that FDI in general does contribute positively to both income growth

> and factor productivity in host countries although the precise magnitude of the impact is difficult to determine. Growth is affected by an increase in total factor productivity or an increase in efficiency in the usage of resources in the host country.'<sup>3</sup> This occurs through "the linkages between FDI and foreign trade flows; the spillovers and other externalities

> vis-a-vis the host country's business sector; and the direct impact on structural factors in the host economy."'<sup>4</sup> Although some of these studies found that FDI "crowds out"

> domestic investment, others found the opposite to be true. Some even found that

2
"crowding out" can have an overall<sup>beneficialeffectif scarcedomesticfunds are</sup> released.

In order to attract and reap the benefits<sup>of FDI, a certainlevelof development in</sup> education, technology and infrastructure,<sup>aswell as financialmarkets,is necessary.More</sup> specifically, macroeconomic stability,<sup>institutionalpredictability,fiscaldiscipline,</sup> efficient and equitable tax systems,<sup>prudent public-sectordebt management, strong</sup> domestic financial systems, developed<sup>capitalmarkets,transparency,opennesstoforeign</sup> trade, and an educated workforce are important<sup>in thisregard.Creating this enabling</sup> environment, in many cases, requires<sup>policy changeson the part of national</sup> governments. _15_ The interlinkages between trade and<sup>FDI and their combined effect on growth and</sup> development make it necessary for<sup>policiesin these two areasto supportone another in</sup> terms of objectives and efficient<sup>implementation,becauseignoring them canlead to</sup> weakening of the developmental contribution<sup>of each, whereasacting on them can lead to</sup> synergies that can promote growth<sup>and development further than if they were dealt with</sup> autonomously.'<sup>6</sup> The importance of<sup>thiscoordinationincreasesas the intemational</sup> production system becomes more integrated,<sup>as isnow taking place.</sup> Many policies for the promotion of trade<sup>and, particularly,FDI arecurrently</sup> developed and implemented at the<sup>nationallevel. 7However,for some countries,</sup> particularly lesser developed countries,<sup>a nationalapproachcan be difficultbecauseof</sup> the lack of knowledge and skills in<sup>foreign investment relatedpolicymakingand in the</sup> of<sup>treatiesand agreements.' 8In such cases,a regionalor</sup> negotiation and implementation multilateral approach may work better.

# **Patterns of Trade and FDI: Global**<sup>**andIntraregional**</sup>

As revealed in Part One of this study,<sup>East Asia has a historicallegacy of</sup> openness and global integration that<sup>continues today.However,the data and discussion</sup> presented in Part One do not tell us<sup>anything aboutthe current intraregionallglobalmix of</sup> trade and FDI in the region. In this<sup>section, we will make that assessmentby examining</sup> trading and investment patterns<sup>in East Asia over thelast decadeorso.</sup>

## **Trading Patterns**

East Asia has experienced tremendous<sup>growth in trade over the last two decades</sup> with imports increasing fivefold and<sup>exportssixfoldbetween1980and 2000 reachinga</sup> level of $1,349 billion and $1,589 billion,<sup>respectively,in the latter year.Between1990</sup> and 2000, growth was slower but still<sup>both importsand exports roughly doubledover</sup> those 10 years. The growth rate<sup>in importsand exportsfor both ASEAN and ASEAN-</sup> Plus-Three mirrors the regionwide<sup>ratefor both time periods.</sup><sup>**19**</sup> Trade can be measured in several ways.<sup>In our analysis we will usetwo</sup> measures: (1) trade share is a simple<sup>measurethat indicatesthe magnitudeof trade of one</sup> country with another. It is easy to calculate<sup>andcommonly used in general discussions of</sup> trading affiliations but has a number<sup>of shortcomingsthat will be discussed later.(2) The</sup> trade intensity index is a more complex<sup>measure in termsof its calculationaswell asthe</sup> 3
information it provides. It gives a clearer, more accurate picture of the trading patterns of countries and, especially of regions, than does the trade share measure. Using these two indices, we will take a look at current trading patterns and how they have evolved over the last two decades with the focus on regional/multilateral patterns and shifts.

# **Trade Measured in Shares**

> A snapshot of East Asia's average trade shares for 1998-2000 (Table 4.1), reflects both the global and intraregional nature of East Asia's trade. (See Table S.6 in appendix for separate import and export shares.) All but the smallest nations conduct a

> significant amount of trade with the EU and the U.S. (between 10 and 30 percent share of their total trade). But intraregionally, the trade shares of individual countries are even

> larger with ASEAN; in this case, it is the smaller countries that have the larger share. If

> the expanded ASEAN-Plus-Three (APT)<sup>2</sup> 1 is considered, the shares rise significantly for

> all countries, primarily because of the high level of trade with Japan (representing 10 to

> 28 percent for most countries), except for Hong Kong in which case it is trade with China that pushes up the share with APT.

4
Table 4.1

||<br>|<br>|<br>||Total<br>|Trad<br>199<br> <br>|e'S<br>8-200<br> <br>|hares<br>0<br>A<br>|(%)<br>LS<br>|YN<br>|PHL<br>|GPI|WN<br>|THA<br>|NM|
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
||BRU<br>|CAM<br>|CHN<br>|HKG|**ION**I <br>|PN<br>|OR<br> <br>|O<br> <br>|<br> <br>|<br> <br>|<br> <br>|<br>|<br> <br>|<br><br>||
|Japan|27.6|**3.2**|16.8|8.8|19.9<br>|_<br>|15.0|20.9<br>|12.1<br>|7.9<br>|18.2<br>|11.91<br>|18.2<br>|19.3<br>|15.2<br>|
|**Korea**|**7.6**|2.9|6.3|3.2|6.9<br>|5.2<br>|-<br>|0.8<br>|3.9<br>|5.7<br>|5.6<br>|3.2<br>|4.1<br>|2.5<br>|7.6<br>|
|China|0.7|4.1|-|38.5|5.2<br>|9.2<br>|8.6<br>|2.7<br>|3.0<br>|15.6<br>|2.5<br>|4.3<br>|0.0<br>|3.8<br>|6.1<br>|
|HongKong|1.2|8.3|16.3|-|2.6<br>|3.5<br>|4.1<br>|0.9<br>|3.6<br>|2.9<br>|4.8<br>|5.4<br>|12.0|4.2<br>|3.0<br>|
|Taiwan|0.7|5.5|5.5|6.1|4.1|5.9|3.6|0.8|4.7|3.5<br>|7.2<br>|4.1<br>|-<br>|4.2<br>|7.6<br>|
|Brunei|-|0.0|0.0|0.0|0.1|0.2|0.1|0.0<br>|0.2<br>|0.0<br>|0.0<br>|0.3<br>|0.0<br>|0.3<br>|0.0<br>|
|Cambodia|0.0|-|0.0|0.0<br>|0.1|0.0<br>|0.0<br>|0.0<br>|0.0<br>|0.0<br>|0.0<br>|0.2<br>|0.0<br>|0.3<br>|1.3<br>|
|Indonesia|.2.4|1.7|12|0.7||2.5<br>|2.4<br>|0.2|2.0<br>|5.4<br>|1.3<br>|3.8<br>|1.6<br>|2.0<br>|3.3<br>|
|Laos|0.0|0.0|00|00|0.0|0.0|0.0<br>|-<br>|0.0|0.0<br>|0.0<br>|0.0<br>|0.01<br>|_OA_<br>|0.4<br>|
|Malaysia|7.5|2.3|1.3|1.6|3.3|3.1<br>|2.5<br>|0.1<br>|-<br>|9.0|3.8<br>|16.3<br>|2.9<br>|4.5<br>|2.7<br>|
|Myanmar|0.0|0.0<br>|0.1<br>|0.0<br>|0.2<br>|0.0<br>|0.1<br>|0.0<br>|0.2<br>|-<br>|0.0|0.2<br>|0.0<br>|0.0<br>|0.0<br>|
|Philippines|0.1|0.1|0.6|0.9|1.0|1.9|1.6<br>|0.0<br>|1.9<br>|0.2<br>||2.4|2.1<br>|1.6<br>|1.2<br>|
|Singapore|16.2|12.3_|<br>2.3|3.4<br>|10.2<br>|3.1<br>|2.8<br>|3.1<br>`|16.9<br>|15.3<br>|6.9<br>|-<br>|3.2<br>|8.5|9.7<br>|
|Thailand|7.3i<br>|1021<br>|1.1<br>|1.3<br>|2.5.<br>|2.8<br>|1.0<br>|41.8<br>|3.5<br>|0.0<br>|2.6<br>|4.4.<br>|1.9<br>||4.1|
|Vietnam|0.0|10.9|0.4|0.2|0.9|0.5|0.6|2.7<br>|0.4<br>|O.0<br>|0.5<br>|1.0<br>|0.7<br>|0.9<br>|-<br>|
|ASEAN|33.5|33.9|7.0|81|18.1<br>|14.0<br>|11.2<br>|48.0<br>|25.2<br>|29.8<br>|15.2<br>|28.7<br>|12.4<br>|18.2<br>|22.2<br>|
|ASEAN+3|69.4|44.0|30.1|58.6|50.1|28.5|34.9|72.4<br>|44.1<br>|59.0<br>|41.5<br>|48.2<br>|34.6<br>|43.9<br>|51.0<br>|
|APEC|85.6|76.0|75.1|82.5|75.6|71.7<br>|69.7<br>|76.6<br>|75.9<br>|74.1<br>|84.5<br>|78.4<br>|76.3<br>|73.4<br>|71.2<br>|
|CER|2.9|0.4|1.9|13|4.0|3.3|3.1|0.2|2.6<br>|0.3<br>|1.8<br>|2.3<br>|2.2<br>|2.4<br>|4.9<br>|
|EU|12.9,|9.7|14.4|12.5|14.9|15.7<br>|12.4<br>|11.7<br>|13.3<br>|9.2<br>|14.6<br>|13.6<br>|14.6<br>|14.4<br>|17.5<br>|
|U.S.|11.3|17.4|17.8|14.9<br>|13.<br>|26.6<br>|20.4<br>|1.7<br>|19.7<br>|7.8<br>|27.4<br>|17.7<br>|21.7<br>|17.6<br>|4.0<br>|
|NAFTA|11.3|17.6|19.|16|14.5|29.5|22.8|2.0|20.7|8.5|28.7|18.61|23.4|18.9|4.6|
|TotalTrade=|sumofi|mportsa|ndexpor|ts||||||||||||

Table reads as total trade share of<sup>a country in the top row with a partner country in the left-hand column; e.g. starting top left -.</sup> Bunei's exports to and imports from Japan<sup>as percentage of Brunel'stotal trade.</sup> Some data for the year 2000 was esUmated,<sup>Including all countries' trade with Taiwan and some countries' trade with Vietnam.</sup> Singapore does not report its trade<sup>with Indonesia to the IMF;therefore, Singapore's trade with Indonesiais esUmatedusing data</sup> from Indonesia.

Source: Author's calculations based<sup>on data from IMF,Direction of Trade Stastcs</sup> The trading patterns of East Asian<sup>countries, however,have shifted over time.A</sup> review of these shifts can reveal regional/global<sup>trendsin the tradeof these countries.</sup> The following three figures (six graphs)<sup>reveal how the trade sharesof selected</sup> economies (i.e., ASEAN, Japan and<sup>China)22with some of their major trading partners</sup> have changed between 1980 and 2000.

**ASEAN -** The graphs in Figure 4.1<sup>revealchanges in theshares of ASEAN's trade with</sup> its major partners between 1980 and<sup>2000. (See TableS.7in appendixfor data table for</sup> this figure.)

5
Figure 4.1 <!-- Start of picture text --> ASEAN Import Shares<br>30<br>-- s--EU<br>F A~~~~~~~~~~~~~~~~~~~~.' U.S.<br>2155hia<br>-e- Korea<br>10 - _ I Intra-SEANI<br>5<br>1980 1990 2000<br>ASEAN Export Shares<br>35 -<br>30<br>25 - _ Japan<br>B'20 -- EU<br>-. *-- U.S.<br>-- China<br>Co __ e Korea<br>10 Intra-ASEAN<br>1980 1990 2000<br><!-- End of picture text -->

> Source: Authors' calculations using IMF, Direction of Trade Statistics

> Japan was ASEAN's primary trading partner in both imports and exports in the

> 1980s. However, this relationship had declined significantly by 2000 with the share of

> imports from Japan dropping from 23 to 16 percent between 1990 and 2000 and export

> share declining from 30 to 13 percent between 1980 and 2000. ASEAN's imnports were, of course, negatively impacted by the East Asian crisis; however, the post-crisis decline

> in the level of imports from Japan (37 percent between 1996 and 1998) was greater than

> the decline in ASEAN's total imports (26 percent for the same period). The dollar value of exports to Japan increased between 1980 and 2000 (to above pre-crisis levels), but this

6
did not keep pace with the growth rate of ASEAN's<sup>total exports,which increased sixfold</sup> over the 20 years to reach $432 billion<sup>in 2000.</sup> By 2000, this decline in share of exports dropped<sup>Japan'sposition below that of</sup> the U.S. and the EU, for which the share has<sup>remainedvirtuallyunchangedsince1990.</sup> Shares of imports from the U.S. and EU, like that<sup>fromJapan,havefallen off somewhat.</sup> While the importance of Japan, the U.S. and<sup>the EU in ASEAN'strade</sup> deteriorated, that of China and South<sup>Korea appreciated.The shares of both imports from</sup> and exports to these two countries increased<sup>fairlysteadily between1980and 2000.</sup> Figure 4.1 also shows that intra-ASEAN<sup>trade has appreciated quiteconsiderably.</sup> There was an increase in the share of intra-ASEAN<sup>imports of ten percentage points</sup> between 1990 and 2000, from 16.4 percent<sup>to 26.5percent placingit well above that of</sup> Japan (16 percent), the U.S. (14 percent)<sup>and the EU (11percent).Theshareof intra-</sup> ASEAN exports rose a bit more slowly,<sup>by three percentagepointsto 23percent in 2000,</sup> but still ended up being a larger proportion than<sup>that of the U.S.(20 percent), the EU (15</sup> percent) and Japan (13 percent).<sup>2 3</sup> JAPAN - Japan's pattern of trade shares has<sup>shifted noticeably (andsimilarly for both</sup> imports and exports) over the last 20<sup>years.(See Figure 4.2.)</sup> 7
Figure 4.2 <!-- Start of picture text --> Japan's Import Shares<br>25-<br>-4China<br>15 -<br>F ~ ~ ~ ~ ~ ~ ~ ~~~~~~~--Korea<br>i E<br>m ~~~~~~~~~~~~~~~~~~~~~~U.S.<br>-*ASEAN<br>0<br>1980 1990 2000<br>Japan's Export Shares<br>35 -_<br>30-<br>25 -<br>'U20- G =KEU<br>15 -- U.S.<br><#> 15- =~~~~~~~~~~ASEAN<br>10<br>5_<br>1980 1990 2000<br><!-- End of picture text -->

> Source: Authors' calculations using IMF, Direction of Trade Statistics

> The proportion of trade with the U.S. and the EU, although still prominent, is on a downward trend while that with ASEAN and China is sloping upward. The U.S. remains Japan's most prominent trading partner with imports from that country making up 19

> percent of Japan's total imports, 30 percent in the case of exports. More remarkable, however, is that since 1990, Japan's imports from China have more than tripled in value

8
to $54 billion in 2000 and now make up 14 percent of Japan's total imports, surpassing the share of imports from the EU (12 percent) and coming close to that of ASEAN (16 percent). On the other hand, Japan's exports to China, although having increased somewhat since 1990, are still only 6 percent of total exports, the same as that of South Korea.

**CHINA** -Between 1996 and 2000, China's imports grew 70 percent to $236 billion<sup>and</sup> exports doubled to $311 billion. Although still supplying the largest share of China's imports, the share from Japan has dropped from 27 percent in 1980 to 14 percent in 1990 but rose 2 percentage points by 2000. (See Figure 4.3.) The shares of imports from the EU and U.S. also declined between 1980 and 2000 to 12 and 8 percent, respectively.<sup>The</sup> shares of imports from ASEAN and South Korea have risen over the last 10 to 20<sup>years</sup> to reach the same level as that of the U.S. in 2000.

9
Figure 4.3 <!-- Start of picture text --> China Import Shares<br>30<br>25<br>15 -S1⁄2 * '4., EU<br>1980 1990 2000 ~~j* Ct -- m- Korea<br><!-- End of picture text -->

**China's Export Shares**

<!-- Start of picture text --> 10 ;'<br>25 _-d<br>020 s t - tS - . .,, 1<br>:15. =EU_<br>1980~~~~~~-- 1990200<br><!-- End of picture text --> Source: Authors' calculations using IMF, Direction _of_ Trade Statistics 10
In exports, the U.S. share has risen dramatically since 1980 to reach<sup>27 percent in</sup> 2000, far surpassing that of Japan and the EU (14 percent for both). This<sup>is a complete</sup> reversal of the share pattern in 1980 when exports to the U.S. made up the<sup>smallest share</sup> (5 percent) and the share for Japan was the largest (22 percent). This<sup>reflectsimproved</sup> relations between the U.S. and China over the last 20 years, as well as<sup>the fact that U.S.</sup> and EU TNCs are moving production to China and exporting from there.

# **Intrareglonal Trade Shares**

Figure 4.1 revealed that during the 1 990s the gap between the share of<sup>intra-</sup> ASEAN trade and the share of ASEAN's trade with its major non-Asian<sup>partners,the</sup> U.S. and the EU, had progressively widened. Does this mean that East<sup>Asia's trade is</sup> becoming more intraregional as opposed to global? Examining the intraregional<sup>trade of</sup> the entire region (not just ASEAN) in comparison with that of other regions<sup>over a longer</sup> period of time and in relation to (1) world trade as a whole and (2) East<sup>Asia's total trade</sup> (intraregional and extraregional) will help to answer that question.

The tables below present two measures based on trade shares for major<sup>Asian and</sup> non-Asian groups.

Table 4.2 <!-- Start of picture text --> Intraregional Trade<br>Merchandise Exports Within Regional Group (as share of world exports)<br>Absolute Measure<br>(% ofwad1d aests) 1970 1980 1990 1996 1998 1999 2000<br>APEC 20.9 19.1 27.1 33.2 32.2 33.5 35.6<br>ASEAN 0.5 0.7 0.9 1.6 1.3 1.4 1.6<br>ASEAN Plus Three n.a. 3.7 4.6 7.2 5.5 6.2 7.0<br>All EastAsia n.a. 4.6 7.8 12.7 10.5 11.2 12.7<br>European Union 27.3 1 24.4 29.5 24.1 22.7 24.8 22.3<br>NAFTA 7.91 5.5 6.8 8.3 9.71 10.3 10.7<br>NOTE: Table shows sum of exports by members of a group to other members of the group as a percent f woild eports.<br>Service spofts are excluded. AJthough data has been calculated back to 1970 or 1980 on the basis of current group membership, mcet of the groups<br>came Into existence In later years and their membership may have changed over lime. Intratrade In earlier years may not have been affected by the<br>same preferences (as set forth In preferential arrangements) as In rerent years.<br>I All East Asia includes ASEAN plus Japan, Korea, China. Hong Kong, and Taiwan. Tawan not Included In 1980 and 1990 data.<br>Source: For APEC, EU, and NAFTA: calculted using World Bank, World Deveiopment Indicators 2002; for all others: calculated using<br>IMF, Directin of Trade Statistics<br><!-- End of picture text -->
# Table 4.3

|**Mer**|**chandiseExport**|**Intr**<br>**sWithinRegi**<br>**Re**|**aregional Tra**<br>**onalGroup(a**<br>**lativeMeasur**|**de**<br>**sshareofgro**<br>**e**|**up'stotalex**|**ports)**||
|---|---|---|---|---|---|---|---|
|(%<br>**of**<br>totalexports)|1970|**1980**|1990|1996|1998|1999<br>||2000|
|**APEC**|57.8|57.9|68.3|72.1|69.7|71.9|73.2|
|ASEAN|22.9|18.6|19.9|25.4|21.7|22.2|23.1|
|ASEANPFusThree|**na.**|29.5|27.1|36.8|28.8|31.4|32.0|
|All EastAsia|n.a|33.8|40.4|50.4|43.0|44.8|46.3|
|European Union|59.5|60.8|65.9|61.4|57.0|63.3|62.1|
|NAFTA|36.0|33.6|41.4|47.6|51.7|54.6|55.7|

NOTE: Table shows sum of exports by members of a group to other members<sup>**_of_**thegroup as apercentage ofthe groupstotal exports.</sup> Service exports are excluded. Although data has **been caicuiated** back **to** 1970 or 1980 on the **basis** of current group membership, most of the groups came Into eaxistence in later years and their membership may have changed<sup>overtime.Intratradein eartier yearsmay not have been affected by the</sup> same preferences as in recent years.

I **All** East Asia indudes ASEAN plus Japan, Korea, China, Hong Kong, and<sup>Taiwan.Taiwannotincluded in1980 and1990</sup><sup>**data.**</sup> Source. For APEC, EU, and NAFTA used World Bank. World Development Indicators<sup>2002; for all others:authors' calculation usingIMF. DOTS</sup> The first measure (Table 4.2) places a group's intraexports in the context of total world exports reflecting the degree of importance of its intraregional trade in total<sup>world</sup> trade. The second measure (Table 4.3) places a group's intraexports in the context of its own total exports reflecting the degree of importance of its intraregional trade relative to its extraregional trade.<sup>24</sup> The patterns (both between regions and for each region over time) in Table 4.3 are similar to those in Table 4.2. First, since 1990, APEC has had the largest intraexport share of world exports and of its own total exports, followed by the EU, NAFTA, "All East Asia", ASEAN-Plus-Three and, finally, ASEAN.<sup>25</sup> Second, the fluctuation patterns in each group's intraexport share over time, or in other words, the increases and decreases in the importance of each group's intratrade in world trade and in its own trade, have generally followed the same pattern over the last two decades.

The increases in these measures for most regional groups, except the EU which experienced a decline that is noteworthy considering it is the region that has become the most integrated during that time, reflect members' intraexport growth relative to the growth of world exports and of their own total exports.<sup>26</sup> In other words, intratrade for East Asian groups generally increased in importance relative to both world trade and their own trade over the last 10 to 20 years. However, this does not indicate that a group's trade is more biased in favor of group members.

Trade share as a measure of trade has certain shortcomings, primarily that the share size of a trading group is a direct reflection of the number of countries in the group and of the trading volume of those countries; i.e., shares are larger for large groups<sup>that</sup> include high-volume-trade countries and smaller for small groups of low-volume-trade countries. 7 Furthermore, the larger the group, the larger is a country's share in that group.28 Thus, in order to accurately assess the level of East Asia's intraregional trade, we need to know not only the magnitude of intratrade of the countries within the' region (as shown above) but also whether members of the region trade more intensely with one another than they do with those outside the region. A measure that has been developed<sup>to</sup> adjust for the shortcomings of trade shares, and that comes closer to revealing the true nature of intraregional trade, is the "trade intensity index".<sup>29</sup> 12
# **Trade Intensity Index**

The trade intensity index is used to determine the actual intensity of<sup>one group'</sup> member's trade with another group member or, in other words, the bias<sup>within agroupof</sup> members to trade with one another.<sup>3</sup> Tables _5 (1995-97)_ and 6 (1998-2000) show merchandise trade intensities for East Asian countries.<sup>3</sup> ' Table 4.4 <!-- Start of picture text --> Trade Intenslty, East Asia, 1995.97- - - - -<br>AsiaI AUS CAM CHN I HK IDN JPN KOR LAO MYSI NZL PHL SCGP THA TWN VNM USA EU<br>AUS 3.21 0.7 1.51 0.9 4.0 2.9 2.1 0.6 1.61 22.3 2.4 1.1 1.5 2.3 1.2 0.3 0.3<br>CAM 2.61 0.2 - 2.01 1.4 0.8 0.4 0.1 - 2.7 0.0 0.0 5.5 17.1 0.8 - 0.7 1.3<br>CHN 1.71 0.9 1.7 - 15.9 1.2 2.8 1.8 25 06 0.5 1.1 0.9 0.7 1.0 2.8 1.1 0.4<br>H4K 1.71 0.9 1.5 10.51 0.8 0.8 0.4 0.4 0.8 0.5 1.9 1.8 0.9 1.6 1.6 1.6 0.4,<br>IDN 12.31 2.1 6.1 1.51 0.9 - 13.91 2.4 0.31 1.6 0.8 2.2, 3.7, 1.3 1.8, 3.7 0.9 0.4<br>JPN 1 1.91 1.5 0.6 1.81 1.5 2.71 - 12.4 0.9 2.3 1.3 2.8 1.9 3.2 3.1 1.3 1.6 0.4<br>KOR 12.01 1.2 0.6 3.31 2.0 3.1 1.91 - 0.5 1.8 0.6 2.4 1.6 1.5 1.5 6.2 1.1 0.3<br>LAO 1 1.71 0.1 1.11 0.1 0.2 1.6 0.2 - 0.0 0.0 0.0 0.9 14.2 1.9 - 0.4 1.1<br>MYS 12.21 1.4 4.2 0.91 1.4 .1.8 1.9 1.1 0.3 - 1.0 1.9 8.1 3.1 2.0 2.1. 1.2 0.4<br>NZL 12.41 16.4 0.4 1.0 0.8 2.0 2.4 1.9 0.1 1.6 - 2.0 0.6 1.1 1.5 1.4 0.6 0.4<br>PHL 1.31 0.7 0.3 0.5 1.2 0.8 2.7 0.9 0.1, 1.9, 0.4 - I2.4, 2.8 2.0, 1.81 2.3 0.5,<br>SGP 4.41 1.9 16.7 1.0 2.3 -I 1.2 1.1 3.91 12.1 1.1 2.9 - 4.2 2.1 7.2 1.1 0.4<br>THIA 6.91 1.3 16.3 1.2 1.4 2.3 2.6 0.7 53.8 2.7 0.7 1.6 5.1 - 1.4 3.1 1.2 0.4<br>TWN 1.81 1.3 1.0 1.8 4.9 1.8 1.7 0.8 0.3 1.8 0.9 2.4 1.6 2.0 - 3.1 1.5 0.4<br>VNM2 0 3.8 - 1.7, 0.8 2.7 4.1 1.1 - 1.4 0.7 3.4 2.6 0.9 1.4 - 0.3 1.0<br>UA 0.6 1.41 0.11 0.71 0.5 -0.7 1.4 1.3 0.1 0.9 0.9 1.4 0.9 0.8 1.3 0.3 - ,0.5<br>EU 0.3 0.51 0.21 0.31 0.3 0.5 0.3 0.3 0.2 0.3 0.3 04 03 03 31 0.3 0.41 -<br>NOTE: Table reads as trade intensity of a country in the left-hand column with a country in the top row.<br>The Asia trade intertsity is the unweighted average of trade intensities vith the rest of East Asia.<br>iSource: DeBrouwer 2002, Table 12.2, p. 291<br><!-- End of picture text --> Table _4.5_ <!-- Start of picture text --> _________ ~~~~~~~~~~~~Trade_ntenslty_Index. 1998.2000- -- -<br>13___ RUI CAM CHiNI HK IOIN JPN KOR LAO MYS MYN PHL SGP THKA TWN VNM ASEAN APT APEC EU NAFTA CER U.S.<br>BR-U - 0.21 0.01 3.685.0 5.9 2.4 0.0 0.2 3.8 11.9 0.3 0.1 4.2 4.91 2.0 0.1 0.5 2.6 0.7<br>CAM - 0.5 0.61 0.1 0.3 0.0 . 0.5 . 0.2 5.0 3.0 0.9 68.5 4.4 1.71 1.3 0.3 1.4 0.1 1.8<br>CNN HK _ 0.1 o.e 1.9 3.1 11.1 - - 6.21 10.8 1.5 __2.8 1.0 0.7 1.7 0.8 0.5 0.7 0.7 5.0 0.9 1.1 1.8 1.1 1.2 0.7 1.0 0.8 i.e 2.0 i.i i.e 1.1 1.9 2.9 i.e 1.7 0.4 0.4 1.0 1.0 1.2 1.1 1.31.2<br>ION 2.7 4.0 1.6 0.91 -___ 3.8 3.0 0.0 2.5 7.4 2.4 5.7 2.0 2.0 2.9 3.7 3.2 1.8 0.4 0.7 2.4 0.8.<br>JPN 0.4 0.4 1.8 1.6 2.31 - 2.5 0.6. 2.2. 1.1 3.6. 2.0, 3.0 3.5. 1.7 2.3 2.2 1.7. 0.4 1.3, 1.6 1.6<br>KOR 0.4 2.0 3.2 1.9 3.21 1.9 - 0.5 2.1 3.1 3.9 1.5 1.3 2.3 4.3 2.1 2.3 1.51 0.4 0.9 1.5 1.1<br>LAO .I 0.5 0.0 0.0 7.9 0.1 - 0.0 - 0.5 9.6 0.5 0.0 1.7 3.4 1.2 0.5 0.2 0.0 0.2<br>MYS 9.3 1.8 0.9 1.4 2.9 2.1 1.4 0.2 - . 7.6 2.9 8.9 3.7 2.3 2.0 5.9 2.8 1.7 0.4 1.0 2.0 1.2<br>MYN 1.6 2.0 0. 11 __ 12 0.5 3.2 0.4 3.5 - 0.9 - 2.1 1.6 1.1 0.4 0.9 0.2 1.0<br>PHL1 0.5 0.2 0.5 1.5 0.7 _ 2.6 -1.3 01.0 3.5 04 3.6 2.8 4.0 1.0 2.9 2.1 1.7 0.5 1.4 0.6. 1.8<br>SGP 15.1 12.1 1.2 1.8, 4.3 1.3 1.5, 2.2_ 14.0 9.1 4.4 . 4.8. 2.1 5.9 8.1, 3.0 1.6 0.4~ 0.8 2.21 1.0<br>THA 2.5 23.7 1.2 16 3.7 2.7, 0.81 61.51 3.2 0.0. 2.9 4.6 1.9 . ,4.9 4.1 ~ 2.6, 1.6 0.5 1.0. 1.91 1.2<br>TWN - 16.61 2.0. 1.81 1.01 . 1.91 . 3.6 1.71 - 2.01 4.7, 2.11 1.51 1.7, 0.41 1.11 1.21 1.4<br>vNm 0.2. 30.8 1.01 0.61 7.21 3.31 1.01 32.81 1.91 3.8 2.51 2.81 1.8 I 3.11 2.51 1.31 0.81 0.31 6.31 0.3<br>NOTE: Table reeds as trade Intensity of a country in the left-hand column vith a country in the top raw.<br>Somne 2000 Import and export data was estimfated, including ali countries' trade with Taiwan and some countries' trade vAith Vietnam. Singapore does not report Its tradea<br>with Indonesia to the IMF: therefore. Singapore's trade with Indonesia is estimated using Indonesia's data.<br>For calcutation of inidex see endnotes.<br><!-- End of picture text --> Souirce: Authore catcutations based on data from IMF, Direction of Trade<sup>Statistics</sup> 1 3
The above two tables reveal that most of the indices are above "one", indicating that these countries trade with each other above the "normal" level of trade based on their trade with the rest of the world. Singapore and Thailand have an intense trading relationship with the largest number of countries in the region and some of these are at a very high level, particularly with the newer ASEAN members.

Table 4.6 summarizes the data in the previous two tables indicating the top five trading partners (with an index of 1 or above) for each East Asian country.

Table 4.6

|||Top|FiveT<br>(<br>|rading<br>Based<br>|Partn<br> on Tr<br>|ersforEast<br>adeIntensity|Asian Ec<br> Index)|onom|ies<br>|||
|---|---|---|---|---|---|---|---|---|---|---|---|
||||_19_|_95-19_|_97_||||1998-|2000||
|Brunei|N.A.||||||THA|JPN|KOR|SGP<br>3||
||||||||-<br>11.9|8..|59|38<br>36||
|Cambodia|THA|SGP|MYS|ICHN|HK||VNM|SGP|THA|USA||
||17.11|<br>**5.5**|2.7|<br>2.0|14||68.5|5.0|30|18||
|China|HK|JPN|VNM|LAO|KOR||HK|MYN|JPN|VNM<br>**CAM**||
||**5.9**|**2.8**|**2.8**|<br>**2.5**|1.8||6.2|5.0|28|20<br>1||
|Hong|CHN|PHL|SGP|TWN|VNM||CHN|CAM|PHL|USA<br>SGP||
|Indonesia|CAM|JPN||SGP|VNM|KOR||MYN|SGP|CAM|JPN<br>KOR||
||61|39|37|<br>3|2.4||74|57|40|388<br>30||
|Japan|THA|TWN|PHL|IDN|**KOR**||PHL|TWN|THA|KOR<br>**ION_**||
||32|<br>3.1|28|<br>27|2.41||36|35|301|<br>25<br>23||
|South|VNM|CHN|IDN|I|**HK**||VPHL|<br>**HL**|CHN|IDN<br>MYN||
||62|331|<br>31|24|<br>|||9|<br>32|3<br>31||
|Korea|.|.|<br>||<br>2||||<br>.|<br>||
|LaoPDR|THA|TWN|JPN|CHN|EU||THA|**JPN**||||
||142|19|1.6|11|11||96|79||||
|Malaysia|**SGP**|CAM|THA|VNM|TWN||BRU|SGP|MYN|THA<br>PHL|IDN|
||81|42~,|314|<br>211|2C0||93|89|76|37<br>291|291|
|Myarnar|N.A.||||||SGP|MYS|**CHN**|BRU<br>JPN||
||||||||35|32|20|1.6<br>1.2||
|Philippines|THA|JPN|SGP|USA|TWN||TWN|SGP|MYS|THA<br>JPN||
||1<br>2.8|2.7|2.4|2.3|201||4.0|36|3.5|2.8<br>2.||
|Singapore|CAM|MYS|VNM|THA|LAO||BRU|MYS|**CAM**|MYN<br>VNM||
||1<br>16.7|12.1|7.2|4.2|3.9||15.1|14.0|12.1|9.1<br>5.9||
|Taiwan|**HK**<br>4.91|VNMI<br>3.11|PHL<br>2.4|THA<br>2.0|CHN<br>1|IDN<br>MYS<br>1|HK<br>6.6|VNMI<br>4.71|PHL<br>3.6|IDN<br>THA<br>2.0<br>2.||

14
|||TopF|iveTr<br>(B|ading<br>ased|Partnersfor <br>onTradeInte|East A<br>nsity I|sian<sup>Ec</sup><br>ndex)|<sup>onomi</sup>|<sup>es</sup>|||
|---|---|---|---|---|---|---|---|---|---|---|---|
|Thailand|**LAO**<br>|**CAM**|**SGP**|**VNM**|**MYS**||**LAO**<br>|**CAM**<br>|**VNM**|**SGP**|**IDN**|
||153.8|16.3|5.1|3.1|**2.7**||**61**<br>|**.**|**4.5**|**4.6**|**3.7**|
|Vietnam|**JPN**|**AUS**|**PHL**|**IDN**|**SGP**|X||**AM**|**IDN**|**PHL**|**JPN**|
||**4.1**|**3.8**|3.4|2.7|**2.6**|_|32.E|30.E|**7.2**|**3.8**|**3.3**|

Note: Only trading relationships with an index of<sup>1.0or aboveare includedin table.</sup> 1Source: Compiled by authors based on data<sup>in</sup> Tables<sup>S and 6.</sup> The above analysis using trade share revealed that<sup>the trade of East Asian</sup> countries with the U.S. and EU is quite significant.<sup>This conclusionis supportedby the</sup> intensity index in the case of the U.S., but not<sup>the EU.Althoughthe U.S.appears among</sup> the top five trading partners in 1998-2000<sup>foronly Cambodia and HongKong,there are</sup> in fact 11 East Asian countries that have an<sup>intensity indexof 1 or abovewith the U.S.</sup> (see Table 4.5). On the other hand, the intensity<sup>indices withthe EUare all well below 1</sup> (in fact, most are below 0.5). Thus, the intensity<sup>index confirmsan above-normal trading</sup> relationship with the U.S., but not with the<sup>EU.</sup> During 1998-2000, Japan was among the top five<sup>trading partnersfor seven East</sup> Asian countries, including China, Indonesia,<sup>the Philippines,and most of thenewer</sup> ASEAN countries. It is interesting to note that<sup>the intensity indicesof severalof these</sup> countries with Japan are nearly the same in 1998-2000<sup>as in1995-97,but Japan's</sup> position among their top five partners has<sup>droppedindicatinga relativeweakening of</sup> Japan's trade relationship with these countries<sup>relativeto their other trading partners. 32</sup> This indicates that Japan has declined slightly<sup>as a trading partnerfor someEast Asian</sup> countries, which is consistent with the findings<sup>inour earlier trade shareanalysis.3</sup> Nevertheless, the indices of East Asian countries<sup>with Japanas a partnerare allI or</sup> above (except for Cambodia) and many are<sup>2 or higher indicating a still strong trading</sup> relationship.

The newer ASEAN countries, in 1998-2000,<sup>aremore often among thetop five</sup> trading partners of the East Asian countries<sup>than they were in1995-97.</sup> This could be attributed to the effect on their trade of membership<sup>in ASEAN during the latter half of</sup> the 1990s.

Figure 4.4 below compares trade intensity<sup>indices of selected regionalgroupsin</sup> Asia, Europe and North America.

15
Figure 4.4 <!-- Start of picture text --> Trade Intensity Index - Selected Regions<br><!-- End of picture text --> <!-- Start of picture text --> 6.00-i _<br>5.00- __<br>3400- I ii1 iig -<br>1980 1990 199s 1998 1999 2000<br>ElASEAN *ASEAN +3 DAJI East Asia 3 EU NAFTA|<br><!-- End of picture text -->

See Endnotes for calculation of index.

**All** East Asia Includes ASEAN plus Japan, China, South Korea, Hong Kong and Taiwan. No Taiwan data for 1980 and 1990. Source: IMF DOTS Yearbooks 1985, 1992, 2000 **&** 2001; IMF DOTS Quarterly Updates; and World Bank, World Development Indicators 2002.

Prominent in this figure is that ASEAN, in all years shown, had a higher intensity index than any of the other groups. (See Table S.8 in appendix for intensity index data table.) Its index of 4 to 6 between 1980 and 2000 was well above that of the EU, for which the index was only between 1.7 and 1.9. Although NAFTA's index was higher (about 3.0 in all years), this was still below that of ASEAN. This tells us that ASEAN has had a higher degree of intraregional trade than the EU or NAFTA in 1980 and the 1 990s. This is the opposite of the findings based on the trade share analysis presented earlier. (See Tables 3 and 4.) If the ASEAN group is widened to include China, Japan, and South Korea (ASEAN-Plus-Three), the intensity drops considerably; i.e., to about 2 or slightly above. The reason for this could be the low level of trade between ASEAN and China relative to China's large share of exports to the U.S. and EU. Whereas if the "All East Asia" group is considered, the intensity goes up somewhat, probably because of the inclusion of Hong Kong which trades heavily with China. Both of these groups (ASEAN-Plus-Three and "All East Asia") have indices greater than that of the EU, but less than that of NAFTA.

Although these indices have not changed dramatically, there was an overall decline in intensity with some fluctuation over the 20-year period for the East Asian groups. However, for ASEAN most of the decline occurred between 1980 and 1990.

16
The trade intensity indices of NAFTA<sup>and the EU moved in the opposite</sup> direction. That of NAFTA rose between<sup>1980 and1996 but droppedoff by1998and,</sup> thereafter, remained virtually unchanged.<sup>The EU's indexfluctuated a bit but generally</sup> rose steadily between 1980 and 2000.<sup>5</sup> There are few clear regional trends<sup>that emergein the foregoingdiscussion</sup> although it does reinforce the argument<sup>thatEast Asia'stradecontinues to be openand</sup> global but with a strong intraregional<sup>component. While the resultsbased on two</sup> different measures - trade share and<sup>trade intensity-are not always consistent,some</sup> general observations can be made. Despite<sup>some decline, the U.S. remains a major</sup> trading partner of most East Asian countries,<sup>including Japan.There isstill a significant</sup> share (although declining) of East Asia's<sup>tradethat isconducted with the EU,although</sup> the trade intensity index reveals no<sup>bias.36It does not appear from the analysisthat East</sup> Asia's trade is necessarily becoming<sup>moreintraregional,infact, thereissome indication</sup> of the opposite based on trade intensity.<sup>However,within the region itself there are</sup> shifts; for example, ASEAN's trade<sup>with Japanis decliningwhilethat with Chinaand</sup> South Korea is rising. Japan, on the<sup>other hand, is tradingslightly less with extraregional</sup> partners and more intraregionally. China<sup>is exporting much moreto the U.S. and slightly</sup> more to the EU but importing more<sup>from within the region.</sup> Trade within the region will almost<sup>assuredly continue to change significantly</sup> over the next decade and developing<sup>trendswill beaffectedin no small way by further</sup> progress in China's reforms, by developments<sup>in Japan'seconomy,as well as in the</sup> global economy, and by the direction<sup>andextent of regionalintegrationefforts within</sup> East Asia. The region has the power<sup>tosteer these changesin a direction that will be</sup> advantageous to its growth and development<sup>but this will take someconcerted effort and</sup> a well-developed cooperative strategy.<sup>Somerelevantsuggestionsin this area will be</sup> made later in this paper.

# **Patterns of FDI Flows**

Although there is some variability country<sup>to country,overall,FDI plays a critical</sup> role in economic expansion for East<sup>Asian economies,as evidenced by the FDI shareof</sup> gross fixed capital formation shown<sup>in Table 4.7.</sup> 17
## Table 4.7

|**InwardandOutw**|**ardFDIFlows **<br>|**as Percentage**<br>**(Percentage)**|**ofGrossFix**<br>|**edCapitalFo**|**rmation**|l|
|---|---|---|---|---|---|---|
||1990-1995<br>(Annual||||||
|Region/Economy|average)|1996|1997|1998|1999|2000|
|Japan:|||||||
|inward|0.1|-|0.3|0.3|1.1|**0.7**|
|outward|2.2|1.8|2.1|2.3|1.9|**26**|
|EuropeanUnion:|||||||
|inward|5.5|6.5|8.1|15.7|28.5|50.1|
|outward|7.7|10.8|14.0|24.8|41.8|60.0|
|U.S.:|||||||
|**inward**|**4.3**|**7.0**|**7.8**|**11.9**|**18.0**|**17.5**|
|**outward**|**6.1**|**7.0**|**7.2**|**8.9**|**11.1**|**9.6**|
|**South,East**and South-EastAsia:|||I||||
|inward|**6.7**|**9.1**|**10.0**|10.5|11.5|14.0|
|**outward**|**3.8**|**5.3**|**5.4**|**3.9**|**4.4**|**9.0**|
|**Source:UNCTAD,WorldInvestmen**|**tReport2002,A **|**nnextableB.5**|||||

The rise in FDI inflows to East Asia in the last decade has been remarkable. (See Table S.9 in appendix.) The value of inflows has tripled from $45 billion in 1990-95 (annual average) to $136 billion in 2000. This level declined somewhat (by 29 percent to $96.4 billion) in 2001 but still represents a doubling of inflows since the beginning of the 1990s. Among regional subgroups, inflows to ASEAN declined over that period while those to ASEAN-Plus-Three rose by 80 percent, reflecting a sharp increase in flows to China along with post-crisis disinvestment in Indonesia and a significant decline in flows to Malaysia. The growth in FDI, as in trade, was spurred by significant liberalization in these areas during the 1980s and early 1990s, although this growth was reversed by the East Asian crisis of 1997-98.

In 2001, China attracted the largest share of inflows in the region, as well as in the developing world, when the value of its inflows reached a high of $46.8 billion. After doubling from $19 billion to $40 billion between 1990-95 (annual average) and 1996, its flows remained close to that level until 2001 when they increased further. During the first half of 2002, inflows rose by 19 percent over the same period in 2001, and this trend is expected to continue.37

# **Sources of FDI**

A look at the sources of these FDI flows will help in the assessment of FDI flow patterns for East Asia. We will first look at ASEAN as a group (Figure 4.5) and then at individual East Asian countries (Table 4.8).

18
Figure 4.5 <!-- Start of picture text --> FDI In ASEAN by Country of Origin<br>100%<br>* _ 80@ro- 1|11 t l_ j | j 4 1--- |L<br>80%<br>0 60% 8<br>40 2% 8<br>20%<br>.,<br>40 ____<br>0%<br>IL<br>-20% 4*<br>1995 1996 1997 1998 1999 2000<br>El Japan *USA DEU 3ANIEs *ASEAN Australasia *Others<br>FDI In ASEAN by Country of Origin - Excluding Indonesia<br>100% -<br>90% /1<br>80% i L<br>1 70% G<br>60% 30% ' 201G ~ ~ j . I -o 1- l l---l* __<br>20% J<br>10% LLJ; !<br>0% - _ _ _ __<br>1995 1996 1997 1998 1999 2000<br>*Japan EUSA DEU DANIEs gASEAN MAustratasia mOthers<br><!-- End of picture text -->

Source: Compiled from<sup>Statistics of Foreign Direct Investmentin ASEAN:Enhanced Data Set,2001 Edition, Tables</sup> 3.1.2. - 3.1.7., pp<sup>24</sup> -<sup>35</sup> .

Figure 4.5 reveals which<sup>countries/regionsare the primary investorsin ASEAN</sup> and how these relationships<sup>have changed over the last half decade.The bottom chart in</sup> this figure, excluding<sup>Indonesia,is presentedbecauseof the distortion effect of</sup> Indonesia's recent disinvestment<sup>on ASEANas a whole.</sup> The investor with the<sup>largestshareof FDI in ASEANis the EU whichaccounts</sup> for 20 to 30 percent of<sup>investment between1998 and 2000, compared to only 17-18</sup> percent in 1995.38 This considerable<sup>rise inshare may have been helped by theeffortsof</sup> 19
the transregional trade arrangement, ASEM (Asia-Europe Meeting), under its Investment Promotion Action Plan (IPAP).<sup>3 9</sup> The next largest investor is the U.S. with a share of 14 to 23 percent in 1998-2000. The intra-ASEAN share dropped precipitously after 1997, which is understandable given the deterioration in the major ASEAN economies during the crisis.

While all source countries/regions had a net withdrawal of investment from Indonesia in 2000,40 the largest was that of Japan (i.e., US$1.7 billion, or 38 percent of Indonesia's $4.5 billion of lost investment). But even without the effect of its disinvestment in Indonesia, the share of ASEAN's FDI that comes from Japan dropped significantly over this time period - from 19 percent in 1997 to only 10-11 percent in 1999-2000.

Table 4.8 gives an idea of the major sources of FDI for individual countries in East Asia, but it covers different time periods, types of flows and is drawn from different sources for each country. It is thus not comparable across countries. Table 4.8

|**Dist**|**ributionofFDIin**Selected**DevelopingCountri**|**es**|
|---|---|---|
|**Countryand DataYear**|**TopThreeSectors**<br>**(%oftotal)**<br>.___________<br>_________**__** **_________**_____<br>(%|**TopThreeOriginating**<br>**Countries**<br>___<br>**of total)**|
|China<br>(1998-2000accumulated<br>flows)|Manufacturing(46%)<br>Realestatemanagement(16%)<br>Utilities(6%)|HongKong(4**1%/)**<br>UnitedStates(10%)<br>VirginIslands(9%)|
|Hong Kong<br>(2000year-end stock)|Investmentholding/realestate (60%)<br>Wholesale/retail (11%)<br>Banking(9%)|VirginIslands(32%)<br>Mainland China(31%)<br>Bermuda(10%)|
|Indonesia<br>(cumulative1967-mid2000)|Chemicalsandpharmacy(30%)<br>Paper(11%)<br>Electronics,tradingandother services (10%)|Japan(16%)<br>UnitedKingdom(9%)<br>Singapore(8%)|
|Malaysia<br>(flows2000-01)|Electrical andelectronics(51%)<br>Paper, printing,publishing(9%)<br>Non-metallicmineral products(8%)|UnitedStates(28%)<br>Japan(16%)<br>Netherlands(11%)|
|Philippines<br>(flows2000)|Manufacturing(46%)<br>Energy-related(32%)<br>Serviceexport(13%)|UnitedStates(36%)<br>Japan(27%)<br>HongKong(11%)|
|Singapore<br>(2000inflows)|Electronicproductsandcomponents(48%)<br>Chemicalsandchemicalproducts(30%)<br>Transportequipment (5%)|United States(40%)<br>Japan(16%)<br>France(4%)|
|Taiwan<br>(totalapprovedflows1952-<br>2000)|Electronicsandelectrical(24%)<br>Bankingand insurance (15%)<br>Services (11%)|UnitedStates(24%)<br>Japan(21%)<br>HongKong(8%)|
|Thailand|Trade(25%)|Japan(27%)|
|(totalnetinflows1995-99)|Machineryandtransport(11%)<br>Electrical appliances(10%)|UnitedStates(17%)<br>Singapore(13%)|
|Vietnam<br>(flows2000)|Oilandgas (59%)<br>Lightindustry(18%)<br>_Heavy industry(9%)<br>.|UnitedKingdom(30%)<br>India(25%)<br>Taiwan_(15%)_|

NOTE: Concentrations are not comparable across countries as they are defined differently by national govemments. Source: Compiled from OECD, Foreign Direct Investment for Development, 2002, 56.

> For most of the countries in this table inward FDI comes from only a few sources i.e., around 60 to 70 percent from only three source countries. The lack of diversification

20
in FDI sources, as well as in destination<sup>sectors,which lean heavily toward electricaland</sup> electronic products is a risk factor<sup>for East Asianeconomies.</sup> Source countries within East<sup>Asia that appear among the top three in this tableare</sup> Japan and Hong Kong, which may<sup>not be surprising,but the tablealso showsthat some</sup> of the NIEs (specifically Singapore<sup>andTaiwan)are among the top three investorsin</sup> some countries.<sup>4</sup> 1 From outside<sup>the region,themajor sourceof irnvestment,</sup> unsurprisingly, is the U.S. In<sup>Figure4.5, the EU was shown to be thetopinvestor in</sup> ASEAN. Table 4.8 shows this<sup>investmentcomes primarilyfrom only a few European</sup> countries - the Netherlands (in<sup>Malaysia), France(in Singapore),and the U.K.(in</sup> Indonesia and Vietnam).<sup>42</sup> Although Japan appears as the<sup>number oneor twoinvestor in the ASEAN-543</sup> countries in Table 4.8, according<sup>to Figure4.5,itsshare of investmentin ASEAN has</sup> declined in recent years. Does<sup>this mean that Japan is investing less in ASEANand more</sup> in other countries? In fact, one-fifth<sup>of total JapaneseFDI in 2001went to East and</sup> Southeast Asia, some of which<sup>was redirected from the U.S.44;however,30 percentof</sup> this amount went to China while<sup>ASEAN receivedless.Although Japan is not included</sup> as a top-three investor in China<sup>in Table 4.8,the Japaneseinvestnentgap betweenChina</sup> and the four ASEAN countries of<sup>Indonesia, Malaysia,the Philippinesand Thailand has</sup> become almost nil since 1999.<sup>Prior to that, Japaninvested morein the ASEAN-445but</sup> this began to decline sharply in<sup>1997.46</sup> Japanese transnationals began to<sup>increase theirinvestmentin China in the1 990s.</sup> A recent survey conducted by<sup>JapanBank for International Cooperation (JBIC)47</sup> revealed that Japanese companies<sup>with overseasmanufacturingbases in Chinarose</sup> rapidly from about 100 in<sup>1993 to nearly 700 in 2001.Although the survey also revealed</sup> the number of companies with<sup>bases in ASEAN-4was higher than that (over1,000in</sup> 2001), it is possible the number<sup>in China will surpass that in the nextfew years.China</sup> has been at the top of the list<sup>of promisingdestinations for manufacturingFDI by</sup> Japanese companies over the<sup>mediumterm as reportedin these annual surveyssince</sup> 1996. Other ASEAN countries<sup>ranked below China but Thailand,Indonesia,Malaysia</sup> and Vietnam were among the top<sup>ten in all years.48Nicholas Lardy4 9points to the</sup> relocation of Japanese electronics<sup>manufacturingto China as"emblematic"of the trend</sup> of MNCs to redirect FDI from<sup>SoutheastAsia to China.50</sup> Figure 4.6 presents the shares of<sup>East Asia'sFDI inflowsfor China and ASEAN</sup> and gives a fairly clear indication<sup>that Chinaistaking shares of FDI from ASEAN.</sup> 21
> **Figure** 4.6

<!-- Start of picture text --> Shares of FDI Flows to East Asia for ASEAN and China<br>'o-<br>40-<br>30-<br>AC ~ ~~ ~ ~~~~~~2r~ ~<br>1,'1<br>1'0<br>10H<br>1990.95 1996 1997 1998 1999 2000 2001<br>COASEAN CICNnD<br><!-- End of picture text --> Source Compilted from UNCTAD, World Investment Renort 2002. Annex B 1 303-306 Over the course of this period, ASEAN's share of inflows to East Asia steadily declined from 38 percent (annual average for 1990-95) to a low of 8 percent m 2000 Thls recovered slightly in 2001 to 14 percent On the other hand, China's share of East Asian inflows rose from an average of 44 percent for 1990-95 to over half by 1998 Thereafter, it declined for two years, havmg lost share to Hong Kong (particularly m 2000), but rose to reach 49 percent mn 2001, close to its earlier peak ASEAN countries were able to easily attract FDI in the 1980s because of their relatively high degree of openness in a market comprismg fewer recipients than there are today In the 1 990s, competition for EDI increased markedly **5I** Furthernore, the cnsis of 1997-98 had a severe impact on flows to the ASEAN economies, but not on flows to China. Some countnes have been slow to recover from that shock The Philippines is the only ASEAN country in which 2001 mflows reached the peak levels of the 1990s.

> China's potential to attract large amounts of FDI has caused considerable concem among the ASEAN countries Its accession to the WTO has made it more attractive to TNCs worldwide and lower costs there have become a major reason for TNCs in industnal countnes to move production to China Malaysia is one country that has ,reportedly lost electronics-related inflows to China 52 In 2001, Malaysia's tnflows 'dropped to only $554 million after two years of inflows of nearly $4 billion (See Table S 10 **in** appendix ) This has been attributed to a loss of flows that have gone to China

> instead, particularly in electronics production, which m the past has played an important

> role in Malaysia's economy 53 Capital mvestment applications for electronmcs projects to be located **in** Malaysia dropped from 18 6 billion rmggit in 2000 to 7 3 billion nnggtt in

> 2001.'54 For China, foreign affiliates' share of exports in technology-intensive industnes

22
increased 22 percentage points between<sup>1996 and 2000(from 59 percent to 81percent).</sup> One example is the export of electronic<sup>circuits of whichforeignaffiliates'sharegrew</sup> from 78 percent of total exports in<sup>1996to 93percent in 2000with Intel and Samnsung</sup> being two major exporters. **5** On the positive side, there is also the<sup>potential for China to increase its own</sup> outward investment in ASEAN. The<sup>possibilities for this areexplored later in the</sup> discussion of intraregional production<sup>networks.</sup>

# **Intraregional FDI**

Compared to the EU and NAFTA, intra-ASEAN<sup>flows make up a smallershare of</sup> total flows. Figure 4.7 below shows<sup>intra-EU investmentincreasedfrom51percentin</sup> 1997 to over 60 percent in 1999. In<sup>2001,thelargest shareof the EU'sFDI flows went</sup> to other EU members.<sup>56</sup> Figure 4.7

**Intra- and Extra-EU FDI Flows**

<!-- Start of picture text --> 70<br>60<br>50<br>40 - 11 5 A EI.<br>* =nflows frm =ts.U<br>OTotal tntra-EU flows<br>IL 30 L l<br>10<br>1995 1996 1997 1998 1999<br>Note: Intra-EU figures represent the average of inward and outward flows as declared by Member States.<br><!-- End of picture text --> Source: UNCTAD, World Investment<sup>Report2001,Figure1.8.p.18.</sup> In the first seven years of NAFTA<sup>(1994-2000), averageFDI inflowsto Canada</sup> were US$21.4 billion and to Mexico<sup>were$11.7billion, which were four times and three</sup> times, respectively, the average annual<sup>amounts receivedin the seven years prior to</sup> NAFTA. In order to take advantage of the enlarged<sup>market that Mexico'smembership</sup> in NAFTA provides, a number of TNCs<sup>haveestablishedor upgraded productionin that</sup> 23
> country."8 Of the total U.S. direct investment outflows in 2001, 25 percent went to

> Canada and Mexico. Mexico benefited as the host country of the third largest crossborder M&A deal in the world in that year valued at US$12.5 billion and involving

> Citigroup of the U.S."<sup>9</sup>

Intra-ASEAN flows are small having declined from around 20 percent of ASEAN's inflows in 1997 to less than 10 percent in 1999 and 2000. (see Figure 4.5) On an individual country basis, only the smaller ASEAN countries, e.g., Brunei Darussalam and Lao PDR and Myanmar, rely heavily on investment from ASEAN and this has actually declined for each of them, as well as for other countries in the region, between 1996 and 2000. (See Figure 4.8 and Table S. 11 in appendix.) 24
# Figure 4 8

<!-- Start of picture text --> GeograDhical Olcfbution of FDI in ASEAN<br>100%-<br>90% -F<br>80%-<br>70%-,<br>S; - r a ;ura<br>8na IndonecLAuaoillauia<br>mASEAN<br>40%: 1 3r AN[c<br>80%-<br>Geographical Didibutlan of FDI In MSEAN<br>70%<br>30% - -_ _ -A<br>Darussatam~ ~ ~~~~~~~~~~DLurisl<br>-50% 19B|2000 1b96 2000 199 | 20w 9O 200 U9 2u000 EAEA<br>Myanar PtInzpne3 inapLo PD l}wiand ietsu<br>20%-<br><!-- End of picture text -->

Source Compiled from Statsticsof<sup>ForeignDrectInvestmentiASEAN.Enhancd Dat</sup> Set 2001 Edinon LikQe the trade intensity index, the FDI intensity index<sup>60</sup> can<sup>be used to show the</sup> bias witin a group for members to invest in one another.<sup>In thiscase,the results are</sup> _25_
-broadly consistent with those of the above FDI share<sup>analysis.Theindex isshown in the</sup> three graphs in Figure 4.9 for the regions of North America,<sup>the EU and Asia6'and their</sup> respective partner regions in the years 1990 and<sup>1999.</sup>

26
Figure 4.9 FDI Intensity Index, 1990 and 1999 <!-- Start of picture text --> North America - FDI Intensity<br>2 5<br>2 0 .99 U<br>115<br>10<br>0 5<br>0 0<br>NrIh Am EU AfMca Lin Am W Asia SE Asia Central &<br>Eastem<br>E uraps<br>European Union - FDI Intensity<br>18 0-199<br>182146 -...-. -- -- -- ----- - - -_ . .. _ * 19-9-9<br>)124 _ .___ , ,_ __ _. _ ,,_<br>L U __<br>0 6siE --- .-----<br>c 00.1 4- s@-EI 1<br>Nrih Am EU Africa Ltn Am W Asia SE Asia Central &<br>Eastem<br>Eurmpe<br>Asia - FDI Intensity<br>25<br>0990<br>31t999<br>2 0 -<br>-uo<br>0 5 * .__.__ _ .. . .<br>10 K<br>0a<br>NWIh Am EU AMCta Lln Am W Asia SE Asia Central &<br>Eastem<br>Europe<br><!-- End of picture text --> Source LJNCTAD, World Investment Report _2001,_ **_Figure 11lO,_** p 57 27
NAFTA (North America) has the greatest FDI intensity among the three regions shown; however, it is not intra-NAFTA but rather with Latin America, which is not surprising given the current planning for a Free Trade Agreement of the Americas (FTAA)<sup>6</sup> which is to be implemented in 2005. For the EU, the greatest intensity is intraregional, as well as increasingly with Central and Eastern Europe, which indicates expanded investment there by EU countries in anticipation of EU expansion. The high index with North America reflects the importance of the EU's investment relationship with the U.S.

Asia's intraregional intensity index (1.5) actually exceeded that of the EU (1.3) in 1999. (See above Figure 4.9.) Asia's highest FDI intensities are intraregional, as well as with North America, although the former increased in the 1 990s as the latter declined. This is consistent with the findings presented in Table 4.8 (top 3 source countries), which show the U.S., Japan, Singapore and Taiwan as top investors in ASEAN and other East Asian countries. Additionally, it is not inconsistent with Figure 4.5, which indicates a decline in intra-ASEAN investment as TNCs in Singapore, which were very active in 1999 and 2000, have focused their investments in Northeast Asia.64 This trend has apparently continued in 2001 when Singapore doubled its outward investment, surpassing Hong Kong as the largest outward investor in the region, primarily through two major M&A deals, one in Hong Kong and the other in Australia.

The Asian region has been at the forefront of a movement that began in the 1 980s when TNCs located in developing countries began to increase their outward investment, mostly to other developing countries. South, East and Southeast Asian firms have accounted for the major portion of these outflows; i.e., 66 percent of developing country outflows in 1997 and 84 percent in 2001. (See Table S.12 in appendix.) This can be attributed to the export-oriented growth in these countries, which led to the growth of their TNCs which then invested intraregionally as well as in developed countries.f<sup>5</sup> In summary, while FDI inflows to East Asia have risen markedly over the last decade, there has been a noticeable shift in flows away from the ASEAN countries to China. While the decline in investment in ASEAN is partly due to the effect of the Asian crisis, from which some have yet to recover, recently it is caused more by the increase in China's attractiveness as a host country, largely because of its highly skilled but lowercost labor, as well as its increasingly liberalized trade and FDI environment. Despite the increase over the decade in the bias toward intraregional investment (FDI intensity index), the region is still highly dependent on investment from the U.S. and a few European countries, as these countries are home to the largest number of internationally integrated TNCs. Focusing on the intraregional/extraregional investment scenario should not deflect attention from the internal investment dynamics of the region, particularly where China is concerned. Not only Japan, but also other major regional investors, including Hong Kong, Singapore and Taiwan, are focusing on Northeast Asia as well.

# - **Trade and FDI in East Asia Some Conclusions**

Given the strong linkage between trade and FDI, it might be expected that changes in their patterns would follow a similar trajectory over time. It is true that the factors affecting one often also affect the other; e.g., the 1997-98 financial crisis, the prolonged stagnation of Japan's economy, the opening up of China, the downturn in the global (particularly the U.S.) economy beginning in 2000, and changes in the 28
international production system. However, although broadly consistent,<sup>precise</sup> similarities are not always evident. For example, while the bias, or intensity,<sup>in</sup> intraregional trade has been at a fairly high level but declining over the last two<sup>decades,</sup> intraregional FDI began at a fairly low level but has risen in recent years.

Some general observations, however, can be made concerning both trade<sup>and FDI</sup> patterns in the region:

- East Asia still does a great deal of trade with, and receives<sup>alarge amount of</sup> direct investment from, the U.S. and some European countries.

- Although the U.S. and certain European countries are still Japan's primary trade and investment partners, there are signs of a shift<sup>in both trade and FDI</sup> from outside to inside the region (involving China particularly).

- While most countries have recovered well from the crisis in terms of<sup>tradeand</sup> FDI, some have not, particularly Indonesia, which is still experiencing disinvestment.

- ASEAN's trade with Japan is declining while that with China and<sup>South</sup> Korea is rising and ASEAN is receiving less investment<sup>fromJapan aswell.</sup>

- The rise of China is having a major impact on the region's<sup>tradeand FDI</sup> patterns as TNCs both inside and outside the region shift<sup>operationstothat</sup> country, often from other countries within the region.

From these observations we can discern the continuation of the highly liberalized nature of East Asia's trade and direct investment and the importance of maintaining<sup>its</sup> extraregional relationships. At the same time, intraregional relationships<sup>are</sup> strengthening as individual countries struggle to find a<sup>way to prosper and grow in the</sup> shadow of a rising China. In the next section we will<sup>considerarolefor regionalismin</sup> this dynamic environment.

# **A Role for Regionalism in Promoting Trade & FDI**

We have so far made three observations: (1) East Asia's trade<sup>and FDI patterns</sup> are global and, at the same time, intraregional, (2) the current trend in East Asia<sup>is to seek</sup> regional solutions for shared issues, and (3) it is welfare-enhancing to coordinate<sup>the</sup> formulation of trade and FDI policies. Consequently,<sup>it is worthwhiletoexplore possible</sup> regional approaches to the promotion of trade and FDI in East Asia. Presented<sup>in this</sup> section are two such approaches: regional agreements and regional production<sup>networks.</sup>

## **Regional Agreements**

There are several types of cooperative arrangements designed<sup>to promotetrade</sup> and/or FDI. These can be narrow agreements, including<sup>only twocountries and covering</sup> either trade or FDI, or they can be very broad agreements, including more than<sup>two</sup> countries and covering a wide range of activities. There are many<sup>cases</sup> where investment issues are being included under free trade agreements or under<sup>regional</sup> integration frameworks, such as NAFTA. In fact, these are the fastest growing<sup>in number</sup> of all regional agreements that address investment issues.<sup>66</sup> Both trade agreements and investment agreements have the common<sup>goalof</sup> liberalization of trade/investment activities and non-discriminatory<sup>treatment of</sup> participants in the agreement. Investment agreements vary in their provisions<sup>asrelated</sup> 29
to performance requirements, breadth of investment promotional measures, inclusion of protection standards, and range of investment issues covered, such as competition, technology transfer, employment, environmental protection, incentives, illicit payments and conflicting requirements. 67 Trade agreements focus chiefly on the elimination of tariffs on goods. However, it has been suggested that more recent regional trade agreements may be notable more for their promotion of FDI than of trade and, for some, this could be the motivation for their formulation.<sup>68</sup> Table G.4 in the appendix includes a list of primary regional instruments dealing with FDI (adopted between 1957 and 2002) and involving East Asian countries. The number of agreements for East Asia is only 1 1, out of a total of 105 worldwide, indicating the region as a newcomer to such arrangements.<sup>69</sup> Furthermore, the number of these that are also trade agreements (see Table G.3 in appendix), meaning they encompass both trade and investment issues in one agreement, are only two: the agreement between New Zealand and Singapore and that between Japan and Singapore [aside from AFTA, which covers trade, while investment is covered under a separate agreement, i.e., ASEAN Investment Area (AIA), and APEC which has its separate APEC Non-Binding Investment Principles).<sup>70</sup> As trade agreements in general are concerned, these two are noteworthy in their recognition of the complementarity of trade and FDI. For example, the Japan-Singapore New-Age Economic Partnership Agreement (JSEPA) includes trade-related elements, such as the elimination of tariffs on goods and of non-tariff measures inconsistent with WTO, and addresses trade-related issues including rules of origin, customs procedures, paperless trading, and mutual recognition of tests and certifications. Important for promoting investment, it covers the liberalization-of trade in services,<sup>7 1</sup> the<sup>facilitationof</sup> investments through promotion and protection, and the movement of natural persons between the two countries. Additionally it covers issues related to intellectual property, government procurement and competition, and enhances economic cooperation in financial services, information and commnunications technology, science and technology, human resource developinent, and others. Finally, it includes provisions for the settlement of disputes.

The major drawback to JSEPA is its avoidance of the agriculture issue, partly because Singapore has virtually no agriculture but also because agriculture is a particularly sensitive area for-Japan. This is why the agreerment may be limited'in **its** versatility as a prototype for other Asian countries where agriculture is of considerable importance. Aside from this, it is laudable in its broad coverage of elements<sup>importantto</sup> the promotion of both trade and FDI.

A number of other FTAs are currently being negotiated in East Asia. These include a Japan-Korea FTA (in the study phase since 1998), which is expected to be quite broad in its coverage. It 'would not aim merely at removing the tariffs and nontariff measures that still exist between the two countries; it would aim at a comprehensive framework encompassing an array of market-integration measures, such as investment promotion, trade facilitation, and harmonized trade and investment rules and standards."7 Japan and Korea both place a high priority on finalization of this FTA. Korea would like to implement FTAs also with Singapore and Mexico in the short term.<sup>74</sup> The FTA that has taken center stage in the region recently, however, is the ASEAN-China FTA (ACFTA), for which a framework agreement was signed in 30
Cambodia in November 2002, designating 2010<sup>as the completiondate for the FTA with</sup> an extension to 2015 for the newer ASEAN<sup>members. The goal of this agreement is to</sup> promote comprehensive economic cooperation<sup>through the eliminationof tariff and non-</sup> tariff barriers on goods, the liberalization of<sup>servicestrade, andthe establishmentof an</sup> open, competitive investment regime. Cooperation<sup>would be strengthenedin the areas of</sup> agriculture, ICT, human resource development,<sup>investmentand the MekongRi&er basin</sup> development and extended to include the areas<sup>of bankingandfinance,transportation,</sup> telecommunications, industrial cooperation,<sup>forestry and fisheries, energy,and others.</sup> This framework agreement was accompanied<sup>bya so-called"early harvest"program</sup> which reduces the tariffs on certain agricultural<sup>items(e.g.,live animals, meat,fish,dairy</sup> products, live trees, vegetables, fruits and nuts)<sup>within three yearsin an effort to</sup> accelerate trade liberalization of these items.<sup>Provision for the establishmentof a</sup> dispute-settlement mechanism is included.

While some ASEAN members remain wary of<sup>China's motivesand doubtful of</sup> benefits accruing to ASEAN from the ACFTA,<sup>most in the region see this approachas</sup> preferable to adopting a defensive, protectionist<sup>stanceagainst the challengeof China.</sup> From China's perspective, while it may have<sup>somedesirefor leadershipin the region,it</sup> can also benefit more from cooperation with,<sup>than alienationof,its neighborsas it needs</sup> a large market for its vast array of goods<sup>andresourcesfor its industrialproduction.This</sup> FTA is indicative of the region's recognition<sup>of the importanceof cooperation and</sup> openness in a broad-based approach to<sup>the promotion of trade and investment.</sup> Also in November 2002, Japan and ASEAN<sup>signeda joint declarationto draw up</sup> a framework for an FTA to be established within<sup>ten years; however,in this case,Japan</sup> may proceed by forming bilateral agreements<sup>with individual ASEANcountriesfirst,</sup> followed by an FTA with ASEAN<sup>as a group.The ultimatepackageis envisagedas</sup> broad in coverage, including measures to promote<sup>andfacilitatetradeand investmentin</sup> the areas of financial services, information<sup>and communications technology,human</sup> resource development, transportation, and others.<sup>At thesame time, China, South Korea</sup> and Japan reached agreement to initiate next<sup>year(2003)a joint study on thesubject of</sup> the economic effects of an FTA among<sup>those threenations.</sup> As previously mentioned, ASEAN and<sup>APEC haveseparate trade andFDI</sup> agreements. APEC has contributed to the<sup>reduction of tariffsin the region throughits</sup> Bogor Declaration and promotes free and<sup>open investment by encouragingits members to</sup> eliminate restrictions through the framework<sup>of the WTOAgreement and the APECNon-</sup> Binding Investment Principles. AFTA has<sup>succeededas a regionaltariff reduction</sup> program but has done little beyond that, especially<sup>in the area of non-tariff barriers.</sup> APEC and AIA's achievements in the area of<sup>investment promotionconsist mainly of</sup> studies, training, dialogue, and the provision<sup>of information.75</sup> There are a number of ways that trade and<sup>investment agreementscan be mutually</sup> promoting. The reduction in import tariffs<sup>hasimplications for the locationof FDI inthat</sup> it lowers input costs for foreign affiliates making<sup>thehost country more attractivefor</sup> investment. Trade agreements also lead<sup>to wider marketaccess.Those agreements</sup> covering a broader range of issues, for example<sup>incentives,can alsolower production</sup> costs and risks which would induce more,<sup>probably export-oriented,FDI.7</sup> The literature on the issue of regional trade<sup>agreements(RTAs)77and their</sup> economic effects is extensive,<sup>7 8</sup> although<sup>these do not encompassthe implicationsof</sup> 31
investment (nor of services trade) because of a lack of data and the limitations of current modeling methodology.<sup>7 9</sup> The general debate has been whether trade blocs are "stumbling blocks" or "building blocks" to free trade.<sup>80</sup> The consensus of this literature overall is that multilateral arrangements, or free trade, as opposed to smaller regional or subregional arrangements, are preferable. The most extensive recent study on this topic (Scollay and Gilbert, 2001) concludes that RTAs (both bilateral and plurilateral) create a "spaghetti bowl" effect and, thus, reduce the efficiency of regional trade.<sup>8</sup> ' As a means of avoiding the negative effects of this phenomenon, the authors recommend arrangements of larger groupings, e.g., APEC. Most economists, including many who have specifically addressed the issue of RTA proliferation, believe that free trade (through its primary advocate, the WTO) is the best alternative for promoting international trade. 2 However, in the "first comprehensive empirical study of the effect of the postwar multilateral agreements on trade," Rose (2002)83 finds that "membership in the GATT/WTO is not associated with enhanced trade, once standard factors (such as the effect of income on trade) have been taken into account."<sup>84</sup> On the other hand, he did find that trade is nearly doubled by the Generalized System of Preferences (GSP), which is a type of developedcountry to developing-country preferential arrangement.<sup>5</sup> Other studies also attach some importance to the developed/developing country relationship, as discussed below.

Most studies that cover the mutually promoting benefits of the combined trade/FDI agreements focus on developed country regional integration agreements, such as NAFTA and the EU, while few focus on agreements among developing countries, such as MERCOSUR and AFTA/AIA. However, a study by Blomstrom and Kokko (1997) examined developed and developing country agreements<sup>86</sup> and found that, theoretically, the capability of a regional integration agreement for attracting FDI both internally and externally depends on a number of characteristics, including whether the agreements are between developed countries, developing countries or a combination of both, whether the countries are competitive or complementary, and the level of group integration at the outset. Furtherrnore, there may be a different impact on participating investors versus outside investors. For example, the implications of the findings in the South-South arrangement of MERCOSUR, which is similar to ASEAN, are that it does increase investment inflows but these are not likely to be equally distributed among the various members. Also, macroeconomic stability of the countries involved may have been a more important determinant than regional integration.

However, in the case of NAFTA (a North-South arrangement like ASEAN-PlusThree), they found a profound effect on inflows to Mexico due to NAFTA's enhancement of domestic reforms, thus contributing to significant, positive, and even permanent change in Mexico's investment environment. Also, given Mexico's locational advantages in labor-intensive industries relative to the U.S. and Canada, regional integration brought more commercial opportunities and increased investment to all three NAFTA members, particularly from outside the region. There are some general characteristics in NAFTA that could apply to other North-South agreements, particularly relative to "the potential for improved policy creditability and gains from guaranteed access to large northern markets."<sup>87</sup> The automotive industry is an example of how preferential tariffs under regional trade agreements among developing countries, such as AFTA, have led to an expansion of intra-industry trade and increases in FDI in the member countries.<sup>88</sup> This example 32
spans both the "regional agreement" approach and the<sup>"regionalproductionnetwork"</sup> approach that we are proposing in this chapter.<sup>It will therefore be explainedin the next</sup> section on regional production networks.

Admittedly, as many regional agreements are still in<sup>the early stagesof</sup> formulation, it is impossible to determine at this<sup>point whether thecomprehensivenature</sup> (encompassing both trade and FDI) of their initial<sup>frameworkswill in fact be realized in</sup> their _final_ implementation. Nevertheless, the fact<sup>that thisconceptis incorporatedin the</sup> early stages, and that such frameworks are increasing<sup>in number, indicatesa recognition</sup> of the importance of linking trade and FDI in formulating<sup>agreementsfromwhich</sup> economic benefits are expected. **89** It also indicates that policymakers in many<sup>countries</sup> (both developed and developing) recognize that<sup>TNCs aremovingaway from the</sup> traditional linear internationalization sequence,<sup>which beginswith exportingbefore</sup> progressing to FDI, to a more integrated approach<sup>to establishingan international</sup> production network.<sup>90</sup> Furthermore, policies liberalizing<sup>tradeand investmentoften</sup> precede or accompany regional integration arrangements.<sup>These can lead to increased</sup> FDI flows.<sup>9</sup> ' While there is no template for regional agreements<sup>that guarantees an increasein</sup> trade and FDI, it is evident that the selection of partners<sup>to the agreement,as wellasthe</sup> structure of the agreement itself, are important in<sup>whether or not it issuccessfulin</sup> achieving this outcome. While larger groupings might<sup>be morewelfare enhancing,a</sup> bilateral approach could be an initial step to a broader<sup>multilateralarrangement.In any</sup> event, the inclusion of both developed and developing<sup>countriesin the agreementseems</sup> advisable. Above all, the more comprehensive the<sup>agreement,the better thechancethat it</sup> will lead to the coordination of trade and FDI policies.<sup>Finally,the formationof</sup> preferential agreements should be seen as a temporary<sup>measure leadingeventually toa</sup> multilateral approach.

# **Regional Production Networks**

The establishment of regional production networks (RPNs)<sup>is another way in</sup> which regionalism can play a role in promoting trade<sup>and FDI through their linkages.</sup> The establishment of RPNs is broader in concept than<sup>regionaltrade and investment</sup> agreements, and could be viewed as an extension of<sup>these.One of the hostcountry</sup> economic determinants of efficiency-seeking FDI<sup>indicated by UNCTADis"membership</sup> in a regional integration agreement conducive<sup>to theestablishmentof regionalcorporate</sup> networks."<sup>92</sup> Accepting that the formulation of regional<sup>agreementsis a temporary</sup> approach for the promotion of trade and FDI, regional<sup>production networkscould be the</sup> next step, or even a concurrent step, for East Asia<sup>asit moves towardthe ultimategoal of</sup> becoming a fully functioning member of the _global_ production<sup>network.This is not to</sup> imply that a regional network should operate outside<sup>the internationalnetwork.Rather,it</sup> should operate within it and as a part of it. Given that<sup>there isa multilateral aspect to</sup> East Asia's trade and FDI, this could be considered<sup>essentialfor theregion's continued</sup> growth and development.

The EU and NAFTA play a major role in international<sup>production and are major</sup> providers and recipients of global FDI. These regions<sup>comprisemostly developed</sup> countries, and most large TNCs, which are central<sup>to theglobal production network,are</sup> found in developed countries. In East Asia, on the<sup>other hand, there isonly one</sup> 33
developed country, plus four NIEs and ten developing economies. This raises the question of whether or not the region has a sufficient number of TNCs capable of contributing in a major way to production networks in the region. We will later examine some trade and FDI indicators that will help answer this question.

> The beginnings of a regional production network, in fact, already exist in East Asia. Japan played the lead role in establishing this network through its "flying geese" model.<sup>93</sup> Japan's lead was followed by the Asian NIEs (Singapore, Hong Kong, Taiwan and South Korea) and then by the ASEAN-4 (Malaysia, the Philippines, Indonesia and Thailand), by China, and now Vietnam. All are currently at different stages of industrial development, and the "flying geese" model is viewed by many to be no longer the predominant growth model for Asia; however, it helped establish the beginnings of a

> regional production network through the cross-border activities of TNCs, including trade, FDI, licensing and sub-contracting, and it had the effect of increasing integration in the region.

Currently, Japan is included in the "Triad" (along with the EU and the U.S.), which accounts for the largest share of global inward and outward FDI.<sup>95</sup> In addition, among developing countries, South, East and Southeast Asian firms have accounted for the major portion of FDI outflows (i.e., 84 percent in 2001) and these firms invest both in developing countries within the region, as well as in developed countries around the world. Figure 4.10 shows which East Asian countries are the major providers of outward FDI.

34
Figure 4.10 Share of Asian FOI Outflows - 2001 <!-- Start of picture text --> Ilsa,iluiid Q:Isur C11<br>1% 3% 6<br>18%<br>HF.ioj Kosiqc<br>2.9%<br>33% p I.sppillwics 3%<br>1 *7<br><!-- End of picture text --> _Note In_ this figure _Asia_ Includes South, Easg _and Southeast Asia._ Source Compiled from UNCTAD, World Investment Report 2002 Annex table B 2, 307-309 Unsurpnsingly, the largest share of the region's outward investment **is** from the NIEs. Contranly, the ASEAN4 countries provide very little of these outflows. However, China's share is significant - 6 percent, up from a share of only 1 percent **in** 2000.

On a global level, the region's (excluding Japan) share of FDI outflows was nearly 5 percent **in** 2001 with that of Singapore, Hong Kong and Taiwan (around 1.0 to _1 5_ percent each) being the largest among individual countnes (See Table S. 12 **in** appendix.) Wiule this may not appear to be much compared to the EU's 59 percent, it is very close indeed to Japan's 6 percent. Furthennore, while a small amount of FDI poured into an economy the size of the U.S. would not have much effect, if the same amount is invested in a country the size of Malaysia or Indonesia, it could have a significant impact on the local economy Given that TNCs play such an important role in the intemational production network, a look at the number of East Asian TNCs and their share in _total_ foreign assets will give some indication of the region's firm-level capacity for contributing to regional production networks. In addition, UNCTAD has developed an index called the "transnationality index" (TNI),<sup>96</sup> which gives some idea of the extent to which host countries and TNCs (separately calculated indices for each) are involved **in** international production. Table 4 9 shows these indicators for the largest 50 non-financial developingcountry TNCs, based on their foreign assets 35
Table 4.9

|**HomeCoun**|**es/Regionso **<br>**Average**<br>**Network**<br>**Spread**<br>**Index**|**ftheTopS0**<br>**Average**|**Non-finan**<br> **TNI**|**cialTNCsf**<br>**ShareInt **<br>**of**|**rom Devel**<br>**otalforeig**<br> **top50(%**|**opingE **<br>**nassets**<br>**)**|**onomies**<br>**Num**|**berofent**|**ries**|
|---|---|---|---|---|---|---|---|---|---|
|**Reglon/Country**<br>|**2000**|**2000**|**1999**|**2000**|**1999**|**1998**|**2000**|**1999**|**1998**|
|**WestAsia**||19.3||0.5|||1||-|
|LatinAmerica|**.**|**28.2**|**48.3**|**21.8**|**22.0**|**28.3**|**12**|**10**|**9**|
|Africa|**.**|**41.4**|**46.0**|**4.4**|**5.9**|**6.3**|**4**|**4**|**3**|
|South, East and**Southeast**Asia||**32.4**|**39.1**|**73.3**|**72.0**|**65.7**|33|36|38|
|China|2.9|28.5|**.**|3.9|-|8.8|3||3|
|HongKong|1.4|42.0|45.4|38.9,|26.4|22.0|11|11|10|
|India||.|9.6|<br>-|0.7|0.8||1|<br>1|
|Korea|7.6|23.9|27.8|13.4|23.2|16.7|5|9|6|
|Malaysia|1.6|38.1|24.1|7.2|7.0|6.3|5|5|6|
|Philippines|5.0|28.1|25.0|1.1|1.1|1.5|**1**|1|1|
|Singapore|4.0|43.2|58.9|7.4|11.2|**7.2**|6|7|9|
|Taiwan|4.8|23.1|43.9|1.4|**2.4**|**2.4**|2|2|2|
|Average/total'||31.3|34.5|100.0|100.0|100.0|50|50|**50**|
|FromTop100List for Comparison:<br>||||||||||
|U.S.<br>|<br>1|43.01||1<br>27.21|-<br>I|<br>1|<br>**231**|||
|EU||67.1||53.0|||49|||
|Japan||35.9||10.7|||16|||

a Numbers may not add up exactly due to rounding. **Note:** List does not include countries **from Central and Eastern** Europe. Source: Compiled from UNCTAD. World Investment Report 2002, Table tv.i6., 108 and Fiure IV.8., 109.

> South, East and Southeast Asia have the greatest number of companies (33) on the top 50 list and the largest share of total foreign assets (73 percent), as of 2000. Among these countries, the positions of Hong Kong, South Korea and Singapore are significant.

> While Hong Kong has largely maintained the same number of firms on the list since 1998

> (11), the number for Singapore has declined since then (from 9 to 6). South Korea also lost some firms between 1999 and 2000, but this is reportedly due to a lack of data.

> Furthermore, among the 11 newcomers to the top 50 list, seven were from East

> Asia, three of which were from China. The foreign expansion of Chinese firms has progressed rapidly. China's top 12 TNCs, which are mostly State-owned enterprises, controlled over $30 billion in foreign assets, had over 20,000 foreign employees and reported foreign sales of $33 billion in 2001. Non-State-owned enterprises, although mostly small and medium-sized TNCs, are following the same path and have investments

> in over 40 countries around the world, including Asia.<sup>97</sup>

These data indicate the prominence of East Asia's TNCs among those of developing countries. However, it is possible to see the potential for East Asian firms to become "global players" by looking at the top 100 "worldwide" list, which includes firms from both developed and developing countries. In 2000, among a record five firms from developing countries, three East Asian firms made it to this list: Hutchison Whampoa (Hong Kong), LG Electronics (South Korea) and Petronas (Malaysia), the latter two for the first time.

36
The ranking of the top 100 firms<sup>is generally related to theirdegreeof</sup> participation in cross-border M&As<sup>98asthat is the primary modeof entryfor firms</sup> investing in developed countries.<sup>On the other hand, the mode of entry fordeveloping</sup> countries is primarily greenfield investment<sup>-two-thirdsof FDI flows todeveloping</sup> countries are greenfield investments<sup>and theshare of developingcountries in the valueof</sup> M&As was only 10 percent in early 2000.<sup>This,however,is gradually changing.In</sup> Asia, for example, the share of FDI<sup>(inflows)thatwas in theformof M&As increased</sup> from 8 percent in 1987-89 to 20 percent<sup>in1998-2000.99Furthermore,outward FDI from</sup> developing Asia has also shifted over<sup>the last two yearsfromgreenfield investmentsto</sup> M&As. ° The transnationality index (TNI) for<sup>host countries(country level,as opposed to</sup> firm-level; not included in the above table)<sup>indicates HongKong as themost</sup> transnational economy in the world,<sup>with Singapore being fourth and Malaysia,eighth.</sup> This is based on the production<sup>potentialand resultsof their inward FDI.10</sup> As for firm-level TNI (see Table 4.9<sup>above),developingAsia'saverageof 32.4</sup> (in 2000) is above Latin America's 28.2<sup>and comparesfavorably with Japan's 35.9.Even</sup> more notable is Singapore's43.2<sup>and Hong Kong's 42,which are virtually thesameas</sup> the United States' TNI of 43. Even<sup>for Malaysianfirms,the average TNIis highat 38.1.</sup> In fact, Hong Kong and Singapore<sup>havetraditionally had the most "transnationalized"</sup> companies among developing-countries.<sup>10 2</sup> The Network Spread Index (also in<sup>Table4.9 above)measuresthe numberof</sup> countries in which a firm has foreign<sup>affiliates,thusgiving an indication of the "degreeof</sup> transnationalization of a company."<sup>**103**South Koreanfirms have the highest indexon</sup> average among the top 50 developing-country<sup>firms -closeto8percent.Thefirmsof</sup> other countries have much lower<sup>indices on averagewith the next highestaverageindex</sup> being for firms of the Philippines<sup>and Taiwan-around 5 percentforeach.Thefirms of</sup> Singapore and Hong Kong have the<sup>lowestaverage index becausetheirforeign</sup> operations are only in a few locations,<sup>particularlyin China.</sup> As would be expected, though, the<sup>transnationalityof developingAsia's firmsis</sup> below that of developed country firms.<sup>The averageTNI for the top100 firmsin the</sup> world, of which all but five are developed<sup>countryfirms, is55.7versus32.4 for</sup> developing Asia's firms, and<sup>the average NetworkSpreadIndexof thetop100 TNCsis</sup> about 14 percent versus about<sup>3.5percent for thetop50 developingcountryfirmns.104</sup> Firms in developing economies are<sup>smaller anddo not haveas extensiveageographical</sup> reach as do developed country TNCs,<sup>soit isdifficultfor them to exploredeveloped</sup> country markets.<sup>**0**</sup> However, it would be easier for them<sup>toexplore marketsin their own</sup> region to which they are closer geographically<sup>and with which they have more</sup> familiarity.

Structural shifts in production caused by<sup>anumberof factors,including new</sup> technologies, new demand patterns,<sup>and new production organization,are reflectedin</sup> changing trade patterns.'<sup>06</sup> Table 4.10<sup>showsthe trade structurefor developingcountries</sup> and gives an indication of how the region<sup>of East and Southeast Asiahasprogressed in</sup> export competitiveness over the last<sup>15years (to2000).(SeeTableG.5inappendixfor</sup> description of product categories.)<sup>In fact,the region has madethe greatest progress</sup> (among developing regions) in the evolution<sup>from exportingprimarycommodities to</sup> exporting manufactured goods and services.

37
# Table 4.10

<!-- Start of picture text --> Structure of World Trade In Major Product Categories, By RegIon, 1985 and 2000<br>(Percentage)<br>r _ _ _ _ _ _ _ _ _ _ _ _ _ Of which _ _ _ _ _ _<br>Developed Developing East & Southeast Latin America & Middle East & Sub-Saharan<br>Countrle a CEEb Countries' Aab Caribbean North Atrica Ahica<br>Product' 1985 2000 1985 2000 1985 2000 1985 2000 1985 2000 1985 2000 1985 2000<br>Primary products 38.0 40.4 0.E 3.6 61.2 56.0 10.4 9.5 12.5 13.2 21.4 20.9 5.4 4.'<br>Manufactures based on<br>natural resouraes 68.7 68.2 1.4 5.2 29.8 26.6 8.4 11.7 7.0 6.5 4.9 3.9 1.7 1.3<br>Manufactures not based<br>on natural resources 81.9 66.8 0.6 2.4 17.5 30.8 10.8 226 2.6 4.6 0.8 1.1 0.4 0.2<br>Low-technology 66.4 49.7 1.2 3.6 32.4 46.6 22.9 334 3.2 5.3 1.6 2.7 0.5 0.4<br>Mecdium-technology 89.2 78.6 05, 2.6 10.4 18.8 4.7 11.7 2.5 5.0 0.5 0.8 0.3 0.3<br>High-technology 83.2 63.4 0.2 1.3 16.6 35.4 10.9 29.1 2.1 36 0.3 0 0.3 0.<br>Othertransartons 71.2 58.4 0.2 1.2 28.6 40.4 5.3 8.6 4.2 4.8 0.9 0.9 4.1 1.9<br>Totat 68.9 6853 0.8 2.9 30.3 33.6 10.1 18.7 5.8 6.0 8.3 4.0 1.9 1.0<br>Based on a 3-year average for 1985 (1984.1 986) and a 2-year average for 2000 (1999.2000).<br>These three regions add up to 100 percent for each export category.<br>IndILudes the ASEAN countries plus China. Hong Kong (China). Macau (China), Mongolia, North and South Korea, and Taiwan.<br>See Appendix for desalption of product categories.<br>The share of CEE (Central and Eastern Europe) in exports is understated for 1985 because data are laidrng in a number of countries. This aeio overstates the relatve gain<br>in Source: the group's UNCTAD, market World shares Investment over time. Report 2002. Table VI.I., p148.<br><!-- End of picture text --> A country/region that experiences an increase in market shares over time reveals its dynamic comrnetitiveness and its ability "to keep up with changing technologies and trade patterns."<sup>1</sup> 67 UNCTAD's list of economies that have raised their world market shares by at least 0.1 percent (so-called "export winners") between 1985 and 2000 reveals that China was at the top of the list (of developing countries) in all categories of exports, except resource-based manufactures in which it was third. Hong Kong is on the list in only resource-based manufactures while South Korea, Singapore and Taiwan are in the top 10 of several categories. Malaysia, Thailand and the Philippines are also prominent in the list for all sectors.'<sup>08</sup> Three industrial sectors that have in recent years figured largely in international production networks involving developing countries are clothing, electronics and automobiles.'<sup>09</sup> In the clothing industry, production relocation has taken place largely through subcontracting. In East Asia, the NIEs were the first to be involved in this process. They began with the simple assembly of imported inputs and, after a short time, came to concentrate on skill-intensive activities at home while outsourcing the laborintensive activities of production to lesser-developed East Asian countries having lower wages. End products would then be exported from there back to the home country or to third countries. In essence, there was a movement from "bilateral interregional trade flows to a more fully developed intraregional division of labour incorporating all phases of production and marketing." 1<sup>0</sup> There is reason to believe this type of regional networking will continue in the future, except that the players may change somewhat as competition increases from other East Asian countries, which will undoubtedly upgrade from assembly to full-package manufacturing.

The electronics industry is more globalized than the clothing industry and is driven by TNCs. Japan and the U.S. have played major roles as investors while East 38
Asian economies have been major host countries because<sup>of their low wages,highly</sup> skilled labor, good physical infrastructure and fewer<sup>restrictionson exports relativeto</sup> Japan. Prior to the early 1 990s, Japanese TNCs<sup>tended to import componentsfromJapan</sup> rather than obtaining them from local suppliers.'l I Finished<sup>productswould then be</sup> exported back to Japan or, in many cases, directly<sup>to third markets. This traditional</sup> pattern is beginning to change for higher level electronics,<sup>specificallycomputer</sup> products, as a result of not only tougher competition<sup>andthe increasing importanceof</sup> speed in getting products to market, but also because<sup>production capabilityis improving</sup> in local economies.' 2 While this bodes well for the future of regional production<sup>networks,it does not</sup> diminish the importance of the global element.<sup>In fact,this industry has come to be</sup> characterized by the emergence of a "new<sup>patternof regionalproductionsharing"that has</sup> given rise to "overlapping and competing international<sup>productionnetworks." This has</sup> both positive and negative implications for East Asian<sup>economiesin that it allows them to</sup> act as suppliers in a wide range of production networks,<sup>but it also gives buyersawider</sup> selection of suppliers to choose from.1<sup>13</sup> The automotive sector in East Asia is one where<sup>trade(through regionaltrade</sup> agreements) and FDI linkages, as well as the<sup>global/regional element, are particularly</sup> evident. Investment in this industry from Japan,<sup>the U.S. andthe EU has beendrawn to</sup> ASEAN countries by AFTA's lowering of intraregional<sup>trade barriersandraisingof</sup> import tariffs for non-members, which has benefited<sup>MalaysiaandIndonesiain</sup> particular. In fact, intraregional trade in motor<sup>vehiclesandtheir parts hasrisen</sup> significantly in the AFTA countries. Table<sup>4.11shows thegrowth ratein importsfrom</sup> member countries to be very high in the 1990-99<sup>period(18.6percentfor motor vehicles</sup> and 20.8 percent for parts). The negative growth<sup>for imports from non-members,is</sup> primarily because of the Asian crisis, but also<sup>becauseof efforts by some countriesto</sup> develop national industries.''<sup>4</sup> Table 4.1 1 <!-- Start of picture text --> Intrareglonal Imports of the Auto obile Industry<br>Growth rate in<br>Share In total Imports Growth rate extrareglonal Imports<br>$ million (Percent)<br>Region 1999 1990 1995 1999 1980-1989 | 1990-1999 1980-1989 1990-1999<br>AFTA Motor vehides 175 _ 1.1 1.a 5.4 9.4 18.6 1.5 -0.7<br>Parts of molor vehicles 195 1.1 2.9 9.5 17.3 20.8 14.2 -5.6<br>Motor vehides 365.672 1 10.7 6.6<br>Parts of motor vehicles 138.406 1 _ 10.2 6.41<br>Note: Data in this tab rebtes to SiTC 781,782. and 783 (motr vehicles), end to SITC 784 (parts f motr vehicles).<br>Source: Crnplled from UNCTAD, Tradeaand DeveloPment Report, 2002: Table 3A5, 108.<br><!-- End of picture text -->

After the mid-i 980s, rapid economic growth in the<sup>region, plus the yen's</sup> appreciation and the formulation of RTAs, helped<sup>the automobile industrytodevelop</sup> 39
rapidly. Japanese automakers convinced their Japanese suppliers, whom they wanted to use for their production networks, to establish plants in ASEAN countries. In these countries there were preferential tariffs for companies having a minimum level of national equity. This benefited the automakers and strengthened the competitiveness of the auto industry, as well as improved the efficiency of the regional division of labor. _11_<sup>_5_</sup> Thus, a regional production network in automobiles can allow, and has already allowed, this industry to develop in the region, whereas on a national level its development is constrained by the lack of necessary economies of scale.

From the foregoing discussion we see the potential for East Asian countries to build further on the regional production network that was started by Japan in the post-war period and that has evolved through the development of the region's clothing, electronics and automotive industries. TNCs in East Asia, although not as numerous or as large as developed-country TNCs, demonstrate an increasing level of transnationality and are prominent among developing-country TNCs.

Chinese enterprises, especially, have great potential to become major investors in the region. Since the mid-1980s, China has significantly expanded its FDI outward stock from only US$131 million in 1985 to US$28 billion in 2001.116 In that year (2001), Prime Minister Zhu Rongji proposed that China implement a "going outside" strategy. While Chinese firms have been attracted to Latin America, North America and Europe, there is increasing interest in investing within Asia."<sup>7</sup> If the ASEAN-China FTA is successfully implemented as planned, China's share of investment in ASEAN could increase significantly. Further regional integration that includes China could bring FDI and trade-related benefits to both China and the countries of ASEAN.

It is not necessary for every firm to be a large TNC in order to participate in a regional production network. The segmentation of the production process allows many smaller firms to concentrate on a single component, or a few related components, that may be used by larger firms in a final product, such as computer chips that are components of a wide variety of products. Regional production sharing can bring benefits over producing the whole product at the national level, as is common in East Asia now.<sup>118</sup> This type of production can take place in other industries as well, for example, the clothing industry, as described above. "<sup>9</sup> It allows specialization at the firm level and yet allows firms to participate in a wider regional network. This may be easier as a starting point than trying to compete from the outset in a global network.

There are, of course, potential problems in trying to establish regional production networks. Large TNCs are able to locate the various stages of production anywhere in the world in order to take advantage of differences in factor prices and technologies. There is naturally a broader range of choices globally than regionally: Just as it is unlikely that one country will have absolute advantage in all products, it is unlikely one region will either. However, East Asia is highly diversified in its level of development, the capability of its work force, and its resources. It is possible through regional cooperation to take advantage of that diversification by bringing together the comparative advantages of individual countries so as to maximize the comparative advantage of the entire region.

Nonetheless, TNCs will always operate in their own self-interest and choose locations from that perspective. Although it is impossible to control all factors that might 40
influence that decision and equally impossible to force<sup>enterprises to choose</sup> intraregionally as opposed to extraregionally, it is possible<sup>throughcoordinated</sup> policymaking, technology sharing and capacity building<sup>to cultivatean environment</sup> appealing to TNCs. This would take some sophistication<sup>and considerablecooperation,</sup> particularly in the area of policymaking, but there<sup>are resourceswithin the region,as well</sup> as in the international community, that could be drawn<sup>upon for this purpose.</sup> Certain policies may need to be eliminated or changed so as<sup>not to obstructcross-</sup> border production. Standardization of products and customs<sup>regulationscould be needed</sup> to reduce costs and facilitate the flow of goods. As stated<sup>in Arndt (2001), "Thistask is</sup> clearly more complex than the traditional focus on the removal of<sup>tradebarriers.The</sup> objective is not simply to free up the flow of goods, but to create<sup>an integrated regional</sup> production arena."<sup>1</sup> 12 Sometimes' there must be dramatic structural changes in<sup>the</sup> economy of the countries involved and it can mean a decline<sup>in the importance of</sup> manufacturing in a country's GDP or employment.'<sup>2'Ideally,a well developedregional</sup> production network would not orily promote trade and<sup>investmentintraregionallybut also</sup> would make the region more attractive to partners from outside<sup>the region,as has been</sup> the case with the EU and NAFTA.1<sup>22</sup> A difficulty in East Asia is that individual countries, although<sup>cognizantof the</sup> value of regional cooperation, still tend to protect their own<sup>sovereignty and carry out</sup> policymaking, particularly for FDI, at the national level. A _regional_<sup>approach can be a</sup> stage between a _national_ and a _global_ approach. "The<sup>basic idea isto think of the region</sup> rather than the nation as the production base and to<sup>spread componentproduction around</sup> the region in accordance with comparative advantage."'<sup>23</sup> The appeal of regional production networks for East Asia<sup>is that theysatisfy the</sup> desire for dealing with issues through regional cooperation<sup>and yet are not entirely self-</sup> contained in that there is still latitude for countries outside the<sup>region to investin, and</sup> trade with, countries of the region and vice versa. The<sup>goal isnot to "keep out"</sup> extraregional investment or limit regional countries<sup>investing externally,nor should it be</sup> restricted to only imports from and exports to regional economies.<sup>It is merely a way of</sup> optimizing the comparative advantages of the region<sup>as a means of promoting</sup> complementarity in production and trade, as opposed to all<sup>countriesfocusing on the</sup> same goods and services.

This process should be dynamic, rather than static. It should<sup>be flexible regarding</sup> shifts of production within the region, as well as with other regions,<sup>remainingalways</sup> open to being a part of the global production network. For to<sup>act otherwisewould be a</sup> failure to acknowledge the current reality vis-A-vis globalization<sup>and,thus, potentially</sup> self-destructive.

# **Concluding Remarks**

The recognition of trade and FDI linkages has become<sup>more importantin today's</sup> global environment characterized by an increasingly<sup>integratedinternational production</sup> network. TNCs, which are at the heart of this network,<sup>decidewhere to invest and from</sup> where to trade in pursuit of the most efficient organization<sup>of their production activities.</sup> Technology has facilitated this process through improved<sup>transportationand</sup> communication at a reduced cost. As a result, TNCs<sup>can locatetheir production activities</sup> anywhere in the world.

41
Contributing to the economic growth and development in East Asia over the<sup>last</sup> two decades has been a phenomenal rise in trade and FDI activity. This has been attributed in large part to the region's liberalization in these two areas. Our analysis<sup>has</sup> revealed the continued multilateral nature of the region's trade and FDI and the importance of its extraregional relationships. Thus, the willingness to remain open<sup>is</sup> essential for the region's continued development and the achievement of prosperity.

At the same time, we also see a very high level of intraregional trade and FDI with some shifts in trading and investment patterns both from outside<sup>to inside the region</sup> and within the region itself. East Asia is witnessing a shift in investment away<sup>from</sup> Southeast Asia (ASEAN) to the north in search of lower costs, and there is a foreboding of China eventually becoming the primary production center of the region with<sup>an</sup> absolute advantage in many types of products.

Because of the recognized need to forestall such an eventuality, as well as the desire for a strong regional identity and a lessening of dependency on the<sup>West, regional</sup> cooperation efforts are gathering momentum in East Asia. One outcome of this<sup>is the</sup> heightened interest in forming regional trade agreements (RTAs).

Trade and, particularly, FDI policies have traditionally been formulated at<sup>the</sup> national level in East Asia and generally with little coordination between the two. However, it is increasingly important that the development and implementation of<sup>these</sup> policies be coordinated and mutually supporting. In light of the East Asia's rising interest in pursuing regional solutions and the importance of policy coordination in<sup>the</sup> promotion of trade and FDI, we have suggested two approaches that combine these two elements: (1) the formulation of regional agreements and (2) the creation of regional production networks.

The first of these, the formation of regional agreements, should specifically encompass aspects of both trade and FDI with an appreciation of their interactive characteristics. As this type of broad trade/FDI agreement is relatively new,<sup>there arefew</sup> empirical studies of its welfare-enhancing capabilities. Studies that do exist<sup>indicatethat</sup> the inclusion of developed, along with developing, countries in the agreement<sup>could lead</sup> to potential advantages from improved policy credibility and guaranteed<sup>accessto larger</sup> markets. As with regional trade agreements (RTAs), it appears that a larger<sup>grouping of</sup> countries is preferable. But Singapore is proceeding along the path of bilateral agreements in anticipation that they will serve as a prototype for other economies in the region. ASEAN and China are moving ahead with their plans for an<sup>ASEAN-ChinaFTA</sup> in ten years, while Japan is pursuing bilateral agreements at the same time<sup>it isstudying a</sup> broader agreement with ASEAN as a bloc.

There are those who are alarmed at the proliferation of bilateral and regional FTAs and who believe they will only complicate the multilateral negotiations of<sup>the</sup> WTO. It should be kept in mind, though, that most of these agreements are still under negotiation and far from finalization. So while it appears that a "spaghetti bowl"<sup>is</sup> indeed in the making in East Asia, it is conceivable that over the next ten years or<sup>so</sup> these disparate dialogues and negotiations could come together and, if some standardization and consistency is maintained, coalesce into a broader<sup>regional agreement</sup> in the long term. Working out agreements in smaller groups, or even bilaterally,<sup>could be</sup> easier and less daunting for the smaller, less developed countries of East<sup>Asia.There are,</sup> of course, certain difficulties that would need to be ironed out, not least of which is<sup>the</sup> 42
agriculture issue, but it is possible that resolving a troubling issue by one group can serve as an incentive to others for resolution. For example, China's "early-harvest" offer<sup>to</sup> open its agriculture sector is seen by some analysts as motivated by a desire to appear more accommodating than Japan and South Korea.1<sup>24</sup> This could apply indirect pressure to the latter two countries to act likewise. At least, the process of negotiating regional agreements should lead to more interconnection and cooperation within the region.

A step beyond, and possible extension of, regional agreements is our proposal for a regional production network. While this has the appeal of being broader in context, it is a more complex approach which necessitates setting the stage for production networking by the elimination of restrictive policies and the creation of an enabling environment for cross-border transactions. The goal here is to maximize the comparative advantages of the region as a whole, which would require a shift in focus on the part of East Asian governments from the _national_ to the _regional._ This approach would require<sup>a longer</sup> timeframe than the implementation of regional agreements but could be an extension of them, resulting in a broader approach that could involve the entire region as opposed to only a few countries. It is possible through these two approaches for East Asia to reach the ultimate goal of being a full-fledged participant in the global production network.

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# - **Chapter V Financial and Monetary Integration**

Four areas of financial and monetary integration will be covered in this<sup>chapter.</sup> The first of these, the East Asian crisis, is of particular importance because of<sup>its</sup> detrimental.effect on the regional and global economies at the time,<sup>as well asits role as a</sup> catalyst for the beginning of financial integration in the region. The second area<sup>deals</sup> with financial development in East Asia, including a review of financial structure<sup>and the</sup> development of financial markets. The last two areas deal with two related<sup>issues at the</sup> forefront of post-crisis discussion: capital account liberalization.and a regional<sup>currency</sup> regime.

# **East Asian Crisis: Implications for Regional Cooperation**

The crisis of 1997-98 in East Asia was an event that captured worldwide attention not only because of the severity of its impact on the region's economy but<sup>also because of</sup> its far reaching effect on the global economy. Furthermore, the swiftness of<sup>its</sup> progression, taking the region from the status of "miracle" to that of "crisis"<sup>in less than</sup> a year, surprised all within the region, as well as those outside the region that<sup>were</sup> economically connected to it, including governments, investors, rating agencies,<sup>and</sup> international financial institutions.

While it is not the intent of this study to conduct an in-depth examination of<sup>the</sup> crisis itself, its relevance to the topic of regional integration cannot be overlooked.<sup>We</sup> will review the possible causes of this cataclysmic event in an effort to determine<sup>if, and</sup> how, it has hindered or furthered progression of cooperation in the region.<sup>In so doing,</sup> we will examine the causes of the crisis (and aggravating factors) as presented<sup>in the</sup> extensive literature on the topic. Out of the crisis there has arisen a<sup>callfor reformsto the</sup> financial systems of these countries in an effort to promote growth and reduce<sup>the riskof</sup> another crisis. We will look at how these reforms are being carried out with<sup>a viewto</sup> assessing the role of regionalism in the process.

The most notable aspect of the crisis was the sudden and swift<sup>reversalin1997 of</sup> private short-term capital flows that Asian countries had attracted in large volume<sup>during</sup> the prior three years. Table _5.1_ shows that net private capital flows into the<sup>fivecrisis</sup> countries (Indonesia, Korea, Malaysia, the Philippines, and Thailand) increased<sup>nearly</sup> two and a half times between 1993 and 1996 (from $30.8 billion to $74.3 billion).<sup>Then</sup> in 1997, the flow suddenly reversed and $5.6 billion flowed out of these countries,<sup>with</sup> additional outflows of $31.6 billion in 1998. In fact, these have continued with<sup>$13.9</sup> billion in 1999, $15.7 billion in 2000, and $16.2 billion in 2001.<sup>IMFprojections arethat</sup> outflows will continue through 2003 but gradually decline.

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Table 5.1 <!-- Start of picture text --> Nat Capital Flows'<br>(billions of US _)<br>- __________________________ 1993 1899 I995 1 t997 1998 19SS 2000 2001 2t 2003<br>Cials Counbcl_s_a' _ _ _<br>PrFs Cfif nl n e 308 353 5658 74 3 - a6 -31 5 .139 -157 -16 2 -a4 .39<br>Pt -et wImVn,nT. 67 7 5 t3 1 7 102 1l1. 146 14 3 8.3 103 ¶06<br>PulvipuWdlokrhh not 250 t3&3 18s 26 9 9 -9 0 118 70 3 2 51 Is<br>Ottar pfS ram nitS -08 15.6 279 35 24 7 1 -404 -36 9 -27 7 -219 -tO<br>OleW lund_ 32 07 88 -47 137 170 -221 6 oe ¶4 33<br>Chinswn' -200 4 171 _ .481 4061 -69 -381 -224 III -11A 7 -121<br>Cwrut ame - 2 -9S .531 .255 697 627 471 326 231 179<br>'NM od fiW l rnf _t a itS .dat in rt.rn ndSpnlkro 9unt fal oarhs ri sllarrn rS imn m ta hLung dtieW arid pftbcwroa<br>wa. seda btld9w Star St tectnunr may inbtds sn odw fn<br>A rdfla in Indiezb m hncta<br>The asnm o the uTwt aooni biae natS pttve cw Sflu ndlows 3sl a1 nd ellAa in resea quade wvit ih. WcpSII algn<br>tu awn Ith casil un nld arms aid ondwasbt<br>chdi MtinLdau KXmas UMfqa Uhn Ptppo ad Th,a__d<br>Bcs IMF WcuWd Ecwned Outo AM 2002, TatI 1 5 29<br><!-- End of picture text --> So devastating and extensive was this reversal that the crisis came to be identified as a "capital account **crisis"** This is **in** contrast to the more typical "current account cnsis" which **is** characterized by poor macroeconomic fundamentals such as high uiflation and large fiscal deficits The East Asian economies pnor to the cnsis did not suffer in general from unsound macroeconomic policies as they had for the most part high savings ratios, sound fiscal positions, low inflation and high growth It **is** widely agreed that poor macroeconomic policy was not a pnmary factor in the crisis Frankel (2000) pomts out that Thailand made some macro policy mistakes in 1997 and "excessive expansion led to excessive current account deficits and excessive indebtedness " But he goes on to say, "statistical evidence suggests that a large current account deficit or-a hugh level of debt is not a hlghly significant predictor of crises ,125 More important **is** the fact that capital inflows compnsed primarily short-term foreign currency loans, which led to the double mismatch of maturity and currency as banks were lending long term and in local currency for nontradables (primanly real estate) This in turn led to twin crises **in** currency (resulting in devaluations) and m baning (resulting m banks becoming overburdened with non-performing loans causing many to eventually fail) Lookmg again at Table 5 1 above, we see that of the three types of capital flows, e , direct investment, portfolio investment, and other flows (which mcludes borrowmg), the last of these had the largest inflows before the crisis and outflows afterwards Many regional and intemational observers have speculated at length on the cause (or causes) of the crisis with no true consensus having been reached Some of these causes/vulnerabilities are lIsted in Table 5 2 45
Table 5.2

|**Source**|**Causes/Vulnerabilities**|
|---|---|
|RadeletandSachs<br>(1999)|*WeaknessesintheAsian economies,especiallypoorfinancial,<br>industrial,andexchangeratepolicies.<br>*<br>Overinvestment indubiousactivities resultingfrom the moral hazard<br>ofimplicitguarantees,corruption,andanticipatedbailouts.<br>*<br>Financial panic- whatbeganasmoderatelysizedcapitalwithdrawals<br>cascadedintoapanicbecauseofweaknessesinthestructureof<br>intemationalcapitalmarketsandearlymismanagementofthecrisis.<br>*<br>Exchange ratedevaluationsinmid-1 997inThailand(andlateinthe<br>yearinKorea)thatmay haveplungedthesecountries into panic.|
|Eichengreen(1999)|Three sourcesofvulnerability:<br>*<br>Modest macroeconomic imbalances- appreciationofreal exchange<br>ratesandcurrent-accountdeficits.<br>*<br>Seriousbanking sectorproblems.<br>*<br>Mismanagementofthematuritystructureofdebt.|
|Krugman(1998)|*<br>Crisis was onlyincidentallyaboutcurrencies.<br>*<br>Mainly aboutbadbankinganditsconsequences.<br>*<br>Someofthecrisisisassociatedwithunwiseinvestments(office<br>towers,autoplants)rather thanwithexcessive investmentperse.<br>*<br>"Herding"byinvestorsplayssomeexplanatory roleas<br>overinvestmentand overvaluationofassetswasnotonlythefaultof<br>domesticfinancialintermediariesbutalso private individualsand<br>foreigninstitutional investors whoboughtstocks and realestatein the<br>cnsiseconomies.|
|Kawai,Newfarmer<br>and Schmukler<br>(2001)|*<br>Burgeoning,globalflowofprivate capital,esp.shortterm.<br>*<br>Macroeconomicpoliciesthatallowedlarge inflowsofshort-term,<br>unhedgedcapitaltofuela domesticcreditboom.<br>* Newlyliberalizedbutinsufficientlyregulateddomestic financial<br>marketswithhighly leveragedcorporations.<br>*<br>Mounting politicaluncertaintyinThailand,Korea,andIndonesia.|

46
|Source|Causes/Vulnerabilitles|
|---|---|
|Lindgrenetal<br>(1999)|*Financial andcorporate sectorweaknesses combined<sup>with</sup><br>macroeconomic vulnerabilitiestosparkthecrisis.<br>*<br>Formalandinformalcurrencypegs,whichdiscouraged<sup>lendersand</sup><br>borrowers fromhedging.<br>*<br>Capitalinflowshadhelpedfuelrapid credit expansion,<sup>whichlowered</sup><br>thequalityofcreditandledtoasset<sup>priceinflation.</sup><br>*<br>Inflated assetpricesencouraged further capitalinflows<sup>andlending,</sup><br>oftenbyweakly supervisednonbankfinancialinstitutions.<br>*Highlyleveraged corporatesectors,especiallyinKorea<sup>andThailand,</sup><br>andlargeunhedgedshort-termdebtmadethe<sup>crisiscountries</sup><br>vulnerabletochangesinmarketsentimentingeneral,<sup>and to changes</sup><br>inexchange and interest ratesinparticular.<br>*Weaknessesinbankand,corporate governance<sup>andlackofmarket</sup><br>disciplineallowedexcessiverisktaking,asprudential<sup>regulations</sup><br>wereweak or poorlyenforced.<br>*<br>Close relationships betweengovernments,financial<sup>institutions,and</sup><br>borrowers worsenedtheproblems,particularly<sup>inIndonesiaand</sup><br>Korea.<br>*<br>Weakaccounting standards, especially forloan<sup>valuation,and</sup><br>disclosure practiceshelpedhidethegrowingweaknesses<sup>from</sup><br>policymakers,supervisors,market participants,<sup>andinternational</sup><br>financial institutions.<br>*Inadequaciesinassessingcountryrisk<sup>onthepartofthelenders.</sup>|
|ADBI<br>(Yoshitomi)'<sup>26</sup>|*<br>Massiveinflowsofshort-termcapitalaidedbyunsophisticated<br>financial systems,financedexcessiveinvestmentsinreal<sup>estateand</sup><br>somemanufacturingindustries.<br>*<br>Suddenreversalofcapitalflows coincided with<sup>cyclicaldownturn</sup><br>resultingintwincrises:currencycrisis(depreciation)<sup>andbanking</sup><br>crisis(creditcontraction).<br>* Twincrises ledtodeteriorationinbalance<sup>sheetsoffinancial</sup><br>institutionsand businessenterprises.|

47
It is readily apparent from the literature referenced in the above table that there is no universal agreement as to the cause (or causes) of the crisis, although there is consensus in certain areas. Furthermore, while some of these may not have actually caused the crisis, they probably at least contributed to its worsening. What is important, however, is that the East Asian crisis was multifaceted with roots deep in the fundamental financial and economic (and in some cases even political) structure of the affected countries. In fact, there is general consensus that the financial, economic, and legal systems in these countries require reform and restructuring in order to prevent another crisis of such magnitude.

These studies, as well as others not mentioned here, make specific recommendations for reform perceived as necessary to prevent another crisis. Mishkin (2001) presents 12 basic areas of financial reform (described below) that summarize many of these recommendations. (Some of these reforms, and their implications for regional cooperation, will be discussed in more detail later in the paper.)

# **Twelve Areas of Recommended Financial Reform:**

- **I.** **_Prudential supervision_** _-_ A banking crisis, arising out of the deterioration of banks' balance sheets, can increase the likelihood of a foreign exchange crisis and lead eventually to a full-blown financial crisis. This necessitates the need for governments to create and sustain a strong bank regulatory/supervisory system to reduce excessive risk-taking in their financial systems associated with moral hazard. These reforms take seven basic forms: prompt corrective action, risk management, limiting too-big-to-fail policies, adequate resources and statutory authority for prudential regulators/supervisors, independence of

- regulatory/supervisory agencies, accountability of supervisors, and restrictions on connected lending.

**_2. Accounting and_** _disclosure_ **_requirements_** _-_ These are often lacking for financial institutions in emerging market and transition countries and this makes it difficult for markets and supervisors to monitor institutions to deter excessive risk-taking.

_3. Legal_ **_and judicial_** _systems -_ These are needed to promote the efficient functioning of the financial system. Unclear or hard to enforce property rights can severely hamper the process of financial intermediation. An effective efficient bankruptcy process (often lacking or cumbersome in developing countries) can decrease asymmetric information in the marketplace.

_4._ **_Market-based_** _discipline -_ Market discipline can discourage excessive risk taking by financial institutions. Thus market discipline should be enhanced through (1) disclosure requirements to provide more information to the markets so as to help them monitor financial institutions, (2) the implementation of credit ratings for financial institutions, and (3) the issuance of subordinated debt1<sup>27</sup> (particularly with a ceiling on the spread between its interest rate and that of governrment securities), which a bank would be unable to sell if it has become overexposed to risk.

5. **_Entry offoreign_** _banks -_ Entry of foreign banks can lead to a banking and financial system that is less fragile and less prone to crisis because they help insulate the banking system of an emerging market economy, which is often more volatile than that of an industrialized country, from domestic shocks.

48
_6. Capital controls -_ Mishkin does not advocate the typical "exchange controls" that were adopted by Malaysia during the crisis since they may have the undesirable effect of blocking the entry of funds which would be used for productive investment opportunities. He suggests instead a type of "prudential control" that would, for example, restrict banks in how fast their borrowing could grow, which could substantially limit capital inflows. This would focus on improving bank regulation and supervision as a means of restricting capital inflows so they are less likely to produce a lending boom and excessive risk taking by banks. The issue of capital controls, however, is complex and has been the subject of many studies by economic and financial experts in the field particularly since the East Asian crisis. Therefore, the topic will be addressed in some depth later in this chapter.

7. _Reduction of the role ofstate-ownedfinancial institutions -_ This is proposed in the interest of promoting economic growth since in many emerging market countries the government intervenes through directed credit programs or stateowned banks resulting in moral hazard problems and lending to borrowers who do not have productive investment opportunities.

8. _Restrictions on foreign-denominated debt_ - Emerging market countries tend to have a debt structure with substantial foreign-denominated debt, which can make the financial system more fragile and prone to financial .crises triggered by currency crises and devaluations.

9. _Elimination of too-big-to-fail in the corporate sector_ - Corporations that are considered to be too-big-to-fail (or too politically influential) by the government can lead to increased risk taking by lenders.

10. _Sequencingfinancial liberalization -_ While deregulation and liberalization are not per se undesirable objectives, if not managed properly with a bank regulatory/supervisory structure, accounting and disclosure requirements, and well-functioning legal and judicial systems in place at the time liberalization is undertaken, there can be disastrous consequences.

11. _Monetary policy and price stability_ - Monetary policy can play an important role in promoting financial stability. Price stability can lead to the reduction of an economy's dependence on foreign-denominated debt, thus enhancing financial stability. Countries with a past history of high inflation tend to have debt contracts denominated in foreign currencies which makes the financial system more fragile due to the possibility of currency depreciation triggering a financial cnsis.

_12. Exchange rate regimes andforeign exchange reserves -_ The view here is that, in general, a fixed or pegged exchange rate regime, while being one way to control inflation, can be a dangerous strategy for an emerging market country with a large amount of foreign-denominated debt. Also, low levels of international reserves relative to short-term foreign liabilities can increase vulnerability to crises. Exchange rate regimes and their suitability for East Asia are examined in detail later in this chapter.

Given the complex and comprehensive nature of these recommended reforms, it is clear that the task of carrying them out is daunting, particularly for emerging economies, which often lack the needed expertise and economic resources necessary for such an _49_
undertaking. It is true that a number of the crisis-affected countries haye taken steps at the national level and achieved some success in their reform efforts, but much remains to be done, as can be seen in Table 5.3.

Table 5.3

|**Crisis-affectedCountry**|**Progressat theNationalLevel**in**FinancialSector**<br>Restructuring' <sup>2 8</sup>|
|---|---|
|Indonesia|*<br>IndonesianBankRestructuringAgency (IBRA)createdto<br>resolveproblembanks,provideguaranteesofcreditlinesand<br>manageanddisposeoffrozenbankassets.Asset<br>Management Unit(AMU)createdtofocusondebtrecovery.<br>64banksand2jointventurebanks closedbetween1997and<br>1999.16bankstakenoverbetween1998and1999.<br>*<br>Noforeignordomesticequitycapital markets.<br>*<br>Hasnotrecognizedfull extentofNPLsbutperformed<br>comprehensive system-wideportfolioreviews.<br>*<br>Newbankruptcylaw,butnoteffective.<br>*<br>IntheorycanforeclosenonviableNPLsbutthisisnotyet<br>enforcedin legalsystem.<br>*<br>Nosecondary market forbankNPLs(saletofinancial<br>investors).|
|Korea|*<br>KoreaAssetManagementCorporation(KAMCO)<br>reestablishedtomanageanddisposeofNPLs. Financial<br>Supervisory Commission(FSC)createdto overseefinancial<br>andcorporate restructuring.FinancialSupervisoryService<br>(FSS)establishedtosuperviseandregulatefinancial<br>institutions.<br>*<br>Liquidated16of30merchantbanks,10of25leasing<br>companies,28of231mutualsavingscompaniesand128of<br>1,666creditunions.Nocommercialbankliquidations.<br>*<br>W64trillionallocatedforrecapitalizationofviablebanksof<br>whichW60trillionalreadyused.Costcouldrise dueto<br>furthercorporate restructuring(Daewoo).<br>_*_<br>5banks successfulin1998indomestic equitycapitalmarket.|

_50_
|**Crisis-affected**Country|Progressat**the**National**Level**In**Financial'Sector**<br>Restructuring <sup>12 8</sup><br>|
|---|---|
||*PartiallyrecognizedextentofNPLs.<sup>Anew'forward-looking'</sup><br>systemofloanclassificationintroduced<sup>in1999.</sup><br>*KAMCO has used W20trillionto<sup>purchaseW56trillion(face</sup><br>value)ofNPLs(7%ofallbank<sup>loans).</sup>|
|Malaysia|*<br>Danamodalcreated torecapitalize<sup>banksandfincos.</sup><br>Danaharta createdtopurchase,<sup>manage,and disposeofNPLs.</sup><br>CorporateDebtRestructuringCommittee<sup>(CDRC) createdto</sup><br>oversee voluntarycorporatedebtrestructuring.<br>*Nobankliquidations.Malaysia<sup>optedinsteadforindustry</sup><br>consolidation throughmergers.<sup>58financialinstitutionsin</sup><br>processofbeingconsolidated<sup>into10corebanlinggroups.</sup><br>*<br>RM6.4billion alreadyinjected into<sup>10financial institutions.</sup><br>Recapitalizationcostinitiallyestimated<sup>to beRM16billion</sup><br>butinjectionseventually reduced<sup>toRM5.3billion.</sup><br>* Noforeignor domestic equitycapital<sup>markets;banks</sup><br>encouragedtouseDanarnodalif<sup>needcapital.</sup><br>*<br>Recognitionoffull extentofNPLsin<sup>progress.</sup><br>.<br>IncentivesforNPLrestructuring<sup>inplacein theformof</sup><br>capitalsupportandwaiverofstamp<sup>duties.</sup><br>*<br>Good frameworktofacilitate foreclosure<sup>ofnon-viable NPLs.</sup><br>DanahartaActspeeds foreclosures.<br>|
|Philippines|*<br>Central BankMonetary Board<sup>decidesonbankclosures.</sup><br>Philippine DepositInsurance Corp.,<sup>establishedin1963,</sup><br>responsiblefor receivership<sup>and liquidationofbanks.</sup><br>*<br>1commercial bank,7thriftsand44<sup>ruralbanksunder</sup><br>receivershipsince1997.<br>.<br>No viablebanksrecapitalized;incentives<sup>formergers.</sup><br>*<br>Nobanksobtained foreignordomestic<sup>equitycapitalbut</sup><br>several commercial banksseeking<sup>additionalcapital via</sup><br>private placementsandequity markets.<br>*<br>RecognizedfullextentofNPLsbut<sup>fortreatmentof</sup>|

51
|**Crisis-affectedCountry**|**ProgressattheNationalLevelinFinancialSector**<br>**Restructuring**<sup>**12 8**</sup>|
|---|---|
||restructuredloans.<br>*<br>Favorableloanloss provisioningtreatmentforrestructuring<br>NPLs.<br>*<br>Nosecondary marketforbank NPLs.|
|Thailand|*<br>Financial RestructuringAuthority (FRA)andAsset<br>Management Corporation (AMC)establishedin1997for<br>resolutionof56closedfmcosandsaleoftheirassets.<br>_*_<br>57outof91fmcos,1outof15banksliquidated.<br>*<br>TB300billiontorecapitalizeviablebanks.<br>*<br>Atleast8banks haveforeignequity;3banks have issued<br>Tier-Icapitalthroughadomesticinnovativecapital<br>instrument(aboutTB80billion).<br>*<br>RecognizedfullextentofNPLswithimplementationofnew<br>loan classification rulesin1998.<br>*<br>Market-based guidelinesandincentivesputinplacefor<br>restructuringofviableNPLs.<br>*<br>Newbankruptcyandforeclosurelawpassedin 1999.<br>Utilizationlow.<br>*<br>AuctionprocessforUS$20billionofshutdownfincosloans.<br>Nocentralizedmechanism forbanksNPLs(onlyprivate<br>sector-based).|

> Source: Compiled from Kawai (2000, Table A13.1)

> While it is necessary that certain reforms be carried out at the national level, it is often the case that when individual countries pursue strategies and formulate policy based on their own self-interest, the benefits derived are often less than optimal for the country concerned and may even be detrimental to its neighbors (so-called "beggar-thy-neighbor" policies). On the other hand, benefits can often accrue to most countries in a region when mutual interests are taken into account and policy is set on a cooperative basis.

It is also true that a country may have little difficulty carrying out reforms in one area, but often policy changes or reforms in related areas are necessary to achieve the desired overall effect or to prevent undesirable consequences. A case in point is Chile's capital controls in the 1990s. Eichengreen (1999) points out in his discussion of Chile's capital controls that taxes on capital inflows are effective only when supplemented by 52
other policies to encourage hedging<sup>by banks andcorporationsand tostrengthen the</sup> domestic financial system, which<sup>is atime-consuming,laboriousprocess'2.Cooperative</sup> efforts among countries in the establishment<sup>of standards andreform criteria can</sup> considerably alleviate the burden<sup>of this processon individual countries.</sup> Such cooperative efforts could occur<sup>on aglobalor regional basis.Itcould be</sup> argued that an international approach<sup>is warrantedbecause the causesof present-day</sup> crises have global ingredients and<sup>spillover effects.An exampleis theelemental capital</sup> inflows of the Asian crisis, which were<sup>largely fromoutside the region.Asian policies</sup> that reduced restrictions on borrowing<sup>abroadcoincided with structuraland</sup> macroeconomic changes elsewhere<sup>in the world (e.g.,lowerborrowingratesin the U.S.</sup> encouraged foreign investment in<sup>Asia).'30The Asian crisisalsoprovidesan example of</sup> spillover effects where repercussions<sup>of the crisis spread quicklytoother regionsof the</sup> world (i.e., to Russia, Latin America<sup>and eventually even to the U.S.via theLong-Term</sup> Capital Management (LTCM) hedge<sup>fund which ended up being bailed out by the U.S.</sup> Federal Reserve.) In the. years immediately following<sup>the Asian crisis, therewere innumerablecalls</sup> to reform the "international financial<sup>architecture"(i.e.,the internationalmonetaryand</sup> financial system). There were proposals<sup>by national governments,byinternational</sup> financial institutions (IFIs) and other<sup>internationalorganizations,and by the private</sup> sector. They included the creation of<sup>apermanentStandingCommitteeforGlobal</sup> Financial Regulation bringing together<sup>the IMF,the World Bank, the BasleCommittee,</sup> and other regulatory groups (Brown,<sup>1998),creationof a publiccorporationto insure</sup> investors against debt defaults (Soros,<sup>1997and1998),andenactmentof legislationby</sup> countries receiving IMF assistance<sup>toimposean automaticreductionof the principal of</sup> interbank deposits extended to banks<sup>in their countries (Litan et al, 1998). "'Somerecent</sup> initiatives for improving the intemational<sup>financialarchitectureareoutlinedin Table</sup> 5.4 132 Table 5.4

||**GlobalInitiativestoImprovetheInternational**<sup>**FinancialSystem**</sup><br>|
|---|---|
|*<br>|Informationandtransparency:The World<sup>Bank andIvIFamongothershavebeenworking on</sup><br>newstandardsfordisseminating data<sup>onreservesandextemal debtandonnewcodesofgood</sup><br>practicesinfiscal, monetary,and<sup>financialdisclosure.</sup><br>|
|*<br>|Banking andsupervision:Workis ongoing<sup>tostrengthenBaslecoreprinciples.TheWorld</sup><br>BankandIMFare conductingjoint<sup>assessmentsoffinancialsystemstoascertaincompliance</sup><br>withnewinternationalnormsand<sup>detectextantweaknesses.</sup><br>|
|*<br>|Securities markets:TheIntemational<sup>OrganizationofSecuritiesCommissionshasprepared</sup><br>principlesandstandardsfor disclosure.<br>|
|*<br>|Accountingandauditing:TheIntemational<sup>AccountingStandardsCommitteeisreviewing</sup><br>principles with theobjectiveofhaving<sup>uniformstandardsby2002.</sup><br>|
|*<br>|Bankruptcyand govemance:TheU.N.<sup>CommissiononIntemationalTradeLawhas</sup><br>disseminatedanewmodelawofcross-border<sup>insolvency,andtheOrganizationforEconomic</sup><br>CooperationandDevelopment Task<sup>Forceisworkingonintemationallyapplicable principles</sup><br>ofcorporategovernance.<br>|
|*|Private sector involvement: The<sup>IMFanditsBoard,amongothers, havebeenworking</sup><br>ongeneralprinciplestoelicit<sup>greater privateparticipationinfinancingpackages,in</sup><br>partbecauseIMFresourcesare<sup>limitedandinparttodiscouragethe"moral hazard"</sup>|

53
**Global Initiatives to Improve the International Financial System** that could be associated with bailouts.

Source: Kawai, Newfarner, and Schmukler (2001: Box 2, 48) While most of the literature has been focused on restructuring the financial architecture at the international level, some discussion and early-stage planning have occurred at the regional level. Even before the crisis, there were some financial arrangements in place although their accomplishments were few. (See Table 5.5.) Table 5.5

|**Forum**|Year<br>**Originated**|**Number**<br>**of**<br>**Members**|**Purpose/Objectives**|
|---|---|---|---|
|Inter-ASEAN<br>networkofcurrency<br>swaparrangements<br>andrepurchase<br>agreements|1977|Originally<br>5;now10<br>+3|Purpose was to provideimmediate<br>short-termswapfacilities tomembers<br>withtemporaryinternationalliquidity<br>problems.InitiallysetatUS$100mil.<br>for5memberswithamaximumof<br>$40mil.receivablepermember. Total<br>raisedtoUS$200mil.in1978witha<br>receivableof$80mil.permember.<br>Total raised toUS$1billion byChiang<br>MaiInitiativein May2000.|
|EMEAP(Executives'<br>MeetingofEastAsia<br>andPacificCentral<br>Banks)|1991|11|MembersaretheSoutheast Asianand<br>AustralasianmembersofSEANZA.<br>Objectivesincludeenhancedregional<br>surveillance, exchangeofviewsand<br>information,andfinancialmarket<br>development.|
|TheSix Markets<br>Group(alsocalledG-<br>6,orG-4plus2)|1994|Originally<br>4;now6|Initially thefourmajor Asianfinancial<br>centers(Australia,HongKongSAR,<br>Japan,Singapore).Recently,China<br>andthe U.S. invitedtoattend<br>meetings. Objectivesincludestability<br>oftheregion'sfinancialandforeign<br>exchange markets.Attendedbyvice<br>ministersoffinanceanddeputy<br>governorsofcentral banks.|
|APEC.Finance<br>Ministers Process|1994|21|Membersare APEC economies.<br>Providesaforumtoexchangeviews<br>andinformation amongmemberson<br>regional financialdevelopmentsand to<br>pursuecooperativeprogramsto<br>promotefinancialsector development<br>and liberalization.|

54
|**Forum**|**Year**<br>**Originated**<br>|**Number**<br>**of**<br>**Members**<br>|**Purpose/Objectives**<br>|
|---|---|---|---|
|SEACEN(SouthEast<br>AsianCentralBanks)|1980s|13|Initiallyatrainingandresearch<br>organization;nowsubstantive forum<br>fordiscussionofcentralbanking<br>issues.Includesmajor Southeast Asian<br>economies,aswellassomesmaller<br>Asia-Pacific Countries.<br>|
|SEANZA (SouthEast<br>Asia,NewZealand,<br>Australia)|1956|17|Largestoftheregionalpolicyforain<br>termsofmembership.Forumfor<br>exchangebetween centralbanksand<sup>a</sup><br>vehiclefortrainingincentralbanking.|
|Source:**IMF,**APEC andAS|EAN|||

# **ASEAN's Response to the Crisis**

Despite the fact that the ASEAN swap<sup>arrangementdescribedabovehad been in</sup> place for 20 years prior to the crisis for<sup>the purposeof providing liquidity in the event of</sup> just such a crisis, ASEAN was surprised<sup>by the events of the crisis and failed to provide</sup> any meaningful assistance. Soesastro<sup>(1998)providesa bleakassessmentof ASEAN's</sup> response to the crisis saying that the crisis-affected<sup>countrieshad to resortto theIMF or</sup> resolve the problem on their own (as did<sup>Malaysia) because ASEAN was "not in a</sup> position to do anything".<sup>33</sup> ' In fact, the ASEAN<sup>finance ministersmet for the first time in</sup> March 1997 and voiced their expectation<sup>that the positiveoutlook for Asia would</sup> continue. Even after the crisis was in full<sup>swing,ASEAN's response was weak. The</sup> existing ASEAN swap arrangement was<sup>woefullyinadequate(US$200million at the</sup> time) and was reportedly never used. The<sup>ASEANfinanceministers met again in</sup> December 1997 in Kuala Lumpur to discuss<sup>the crisis andpossible responsesbut</sup> reportedly did not make any kind of financing<sup>arrangementto help ASEANmembers.'3 4</sup> The official view of ASEAN's role in response<sup>to thecrisiswas summarizedin</sup> 1998 by Rodolfo Severino, ASEAN Secretar<sup>-General,whooutlinedfour levels of</sup> response by ASEAN members at that time:'3

- _National Level_ - Individual countries<sup>affected by the crisiswere undertaking</sup> reforms, with varying degrees of success,<sup>relatedto closer supervisionand tighter</sup> discipline of banks, greater transparency in<sup>financialtransactions,promotionof</sup> more competition, enactment of bankruptcy<sup>laws andstronger commercialcodes,</sup> and strengthening of the rule of law and<sup>the judiciary.(Some of theseare</sup> described in detail in Table 5.3, "Progress<sup>at the National Level in Financial</sup> Sector Restructuring".)

- _Bilateral Level -_ ASEAN's government<sup>leaders offeredoneanothermaterialand</sup> financial assistance and advice. For example,<sup>Thailandofferedriceand the</sup> Philippines offered medicine, Singapore<sup>guaranteed letters of credit issued by</sup> Indonesian banks, and Malaysia extended<sup>to Indonesiaa standby creditof</sup> US$250 million with Singapore offering<sup>asimilar facility.</sup>

55
- **_International_** _Level -_ ASEAN called upon the developed countries to maintain open markets to, and trade financing for, Southeast Asian countries, to honor letters of credit issued by Indonesian banks, and to be accommodating in renegotiating Indonesia's debt. It also encouraged China not to devalue the reninbi.

- _ASEAN_ **_Organization_** _Level -_ ASEAN reaffirmed its commitment to regional economic integration and open regionalism. In their ASEAN Vision 2020 statement, government leaders pledged to maintain regional macroeconomic and financial stability through closer cooperation, to promote liberalization of the financial services sector, and to keep the ASEAN Free Trade Area on track and on schedule.

In ASEAN's view, the origin of the crisis was global in nature. It therefore believed the best response would be to work with the IMF and other international forums in formulating a solution. Along this line, ASEAN called upon developing countries to work toward a resolution. ASEAN's response was initially in the form of advice, recommendations, and general pledges for further cooperation; however, more concrete steps are being taken now. (This is discussed further under "Post-Crisis Initiatives".)

# **APEC's Response to the Crisis**

APEC was no quicker or more effective in its response to the crisis than was ASEAN, although in the case of APEC this was more understandable since its membership was less cohesive than that of ASEAN. 1<sup>36</sup> Action taken by APEC in response to the crisis primarily occurred after, rather than during, the crisis. Initially this was in the form of somewhat vague resolutions by the economic leaders to work together to support a sustained recovery and to strengthen their markets through greater transparency, enhanced competition, and improved regulation. More recently, however, the APEC Finance Ministers Process has reportedly led APEC's response to the Asian financial crisis through the acceleration of its "collaborative initiatives to develop regional financial and capital markets and support freer and stable capital flows in AsiaPacific."1<sup>37</sup> These initiatives are of a more concrete nature as evidenced by the list below:

## **APEC Finance Ministers Process Collaborative Initiatives**

- Strengthening financial market supervision through training of banking supervisors and securities regulators;

- * Assessing banking supervisory regimes;

- Reform of pension systems;

- Improving credit rating agencies' ability to channel timely and accurate information to capital markets and strengthening financial disclosure

_56_
standards;

- Developing domestic bond markets;

- Strengthening corporate governance;

- Designing a Voluntary Action Plan for Supporting<sup>Freer andStable Capital</sup> Flows; and

- Endorsing the inaugural meeting of the APEC<sup>Privatization Forum,part of an</sup> initiative to support privatization efforts through<sup>institutional strengthening</sup> and investment promotion.

Source: APEC Secretariat, Finance Ministers Process,<sup>updatedDecember13,2001</sup> The fulfillment of these initiatives is being carried<sup>out through the use of seminars</sup> and training programs on such topics as pension<sup>fund reform,financial institution and</sup> product regulation, risk management, and credit<sup>analysis.Some seminarswere held in</sup> 2000 and 2001.

# **Post-Crisis Initiatives**

The occurrence of the crisis strengthened appeals<sup>for regionalcooperationin the</sup> financial area. As a result, a number of financial<sup>arrangementsand initiatives have</sup> emerged since the crisis. These are described below.

_Asian_ **_Monetary Fund_** _(AMF) -_ The idea for<sup>an Asian MonetaryFund (AMF)</sup> was proposed in September 1997 by Japan to bring<sup>stability to Asian currenciesand</sup> financial markets and work towards prevention of the<sup>recurrence of anothercrisis. In</sup> furtherance of this goal, it planned to raise US$50-60<sup>billion in contributionsfrom</sup> participating countries and another US$50 billion<sup>from the Japanesegovernment.' 38It</sup> was to be independent of the IMF and function as<sup>a substitute forIMFactivitiessuch as</sup> regional surveillance. The original membership<sup>was to be Japan, Korea,China, Taiwan</sup> and Hong Kong.

The plan was abandoned, however, a few months<sup>later due to the opposition of the</sup> IMF and the U.S. Some objections were that it enhanced<sup>the moral hazard problem,</sup> created a double standard (RIF and AMF), and challenged<sup>IMF leadership.Another</sup> factor was the general nonsupport of China for<sup>the idea.In its place the Manila</sup> Framework Group was established in 1997, followed<sup>in1998by the implementationof</sup> the New Miyazawa Initiative.

The AMF proposal is not dead, however, and resurfaces<sup>from time to time from</sup> different quarters. Malaysia is one of the most<sup>frequent champions of this idea but others</sup> are supportive of the idea, even some of those<sup>who wereoriginally opposed to it.The</sup> Chiang Mai Initiative (discussed below) is viewed<sup>by some as a precursor to an AMF.</sup>

**_Manila Framework Group_** _(MFG) -_ In November<sup>1997,financeand central</sup> bank deputies from the Asia-Pacific region'<sup>39</sup> and high-level<sup>representativesfrom the</sup> IMF, World Bank and ADB met in Manila to create<sup>a new frameworkfor regional</sup> cooperation to enhance the prospects for financial<sup>stability.The primary purposeof this</sup>

57
group was regional surveillance and it included the following initiatives: (1) a mechanism for regional surveillance to complement global surveillance by the IMF, (2) economic and technical cooperation to strengthen financial systems and regulatory capacities,<sup>(3)</sup> measures to strengthen the IMF's capacity to respond to financial crises, and (4) a cooperative financing arrangement that would supplement IMF resources.'<sup>40</sup> Noteworthy in this Framework, as evidenced by these initiatives, is the recognition that the IMF has the central role in the international monetary system.

Although this group is still meeting today, it does not appear to be strongly influential in the region. Its eighth meeting in Beijing in March 2001 was attended by representatives from the original 14 countries and IFIs, plus the Bank for Intemational Settlements (BIS). A summary of the discussions of that meeting reveal this group to be somewhat slow moving and functioning primarily as a forum for the exchange of views and experiences. Although the cooperative financing arrangement of the MFG was briefly mentioned, the focus was on improvements in financing facilities in the region through enhanced IMF facilities (e.g., Supplemental Reserve Facility (SRF), Contingency Credit Line (CCL), etc.). In the end they agreed to avoid duplication of activities of other regional groups. (The MFG reportedly met most recently in December 2001 to discuss money laundering and prevention of financial crises, but little other information is available about the meeting.) _New Miyazawa Initiative (NMI)_ - This arrangement, announced in October 1998, was implemented by Japan as a bilateral support mechanism "to assist Asian countries affected by the currency crisis in overcoming their economic difficulties and to contribute to the stability of international financial markets."'<sup>4</sup> 1 The support package consists of US$30 billion, of which US$15 billion is available for Asian countries' medium- to longterm financial needs for economic recovery provided either as official development assistance (ODA) or untied loans. '<sup>42</sup> The other US$15 billion is for countries' short-term capital needs during the process of implementing economic reforms. Commitments under this initiative, as of February 2000'43, totaled US$21 billion with US$13.5 billion of that amount being medium- to long-term support. (See Table 5.6).

58
# Table 5.6

|__|**(Financial**<br>_______|**NowMlyazawaInitiati**<br>**supportalready indicatedas**<br>~~~~~~~~(in<br>**millionsofUSS**|**vo**<br>**of February2000)**||____|
|---|---|---|---|---|---|
||**MedLium-toLong-term**<br>|**FitnancaiaSupport**<br>|**Short-tennFinancial**|**Support**|**Total**|
||**JBIC(OOF**<sup>**1 **</sup>**account)**<br>|JJBC**(0DA**<sup>**2 **</sup>**account)**<br>__|||.|
|**Indonesia**|**1.500**|**1,430**|||**2,930**|
|**Korea**|**3.350**|||**S,000**|**8,350**|
|**MWaiysia**|**900**|**950**||**2,500**|**4,350**|
|**Philippines**|**1,.104**<br>0|<br>**1,400**<br>||**__**|<br>**2.500**|
|**Thailand**|1.351|<br>**1,520**|||**_**<br>**2,870**|
|**Subtotal**|**8,200**|**5,300**|**_**|||
|**Total**||**13,500**||**7,500**|**21.000**|
|**'OOF**=**Other**|**OfficialFlows**|||||
|**ODA**=**OfficA**|**alDevelopment Assistance**|||||
|Soume<br>**Japa**|**nMinist**ofFinance(http**ll**|**wwwmof**go**jplenglishllf/alo**|**e42ahtm)**|||

According to the Japanese Mimstry of Fmance (MOF), these are not grants but mamly loans that wll be repaid. The objectives of the untiative are to support corporate debt restructunng, strengthen the social safety net, stimulate the economy and facilitate trade finance and assistance to small- and medium-sized enterpnses In the "Second Stage" of the NMI, Japan pledged its readiness to assist in the mobilization of up to 2 tnllion yen of domestic and foreign private-sector funds for Asia through assistance **in** fundraising in international financial and capital markets (via JBIC and ADB credit guarantees and interest subsidies), and through assistance in mvesting in Asian pnvate-sector enterpnses via equity funds Through this mitiative Japan hopes to utilize its abundant savings and promote active use of the Tokyo market.

Although the NMI was implemented shortly after Japan's unsuccessful attempt to form an Asian Monetary Fund (AMF) **in** 1997, **it** differs from the onginally conceived AMF, whlch was a multilateral scheme focused on the stabilization of currency as opposed to a bilateral imtiative for recovery assistance Also, the NMI is an arrangement separate from the Chiang Mal Iitiative (discussed below), but there are some similaiLties m **its** short-tern facility in that **it** consists of short-term swap arrangements. Two of these are currently m place (US$2 5 billion with Malaysia and US$5 billion with Korea). These are not tied to the IMF and are annually renewable _ASEAN Surveillance Process -_ At the ASEAN Finance Mminsters' Meeting (AFMM) m October 1998 **in** Washmgton, DC, the ASEAN Surveillance Process (ASP) was officially established based on the pnnciples of peer review for all member states and cormplementanty with the global surveillance undertaken by the IMP The objective of the process is to strengthen cooperation through an exchange of information, a peer review process, and recommendations for action at not only the regional, but also the national level. _It_ is the last of these **(i** e , recommendations by a regional body for action to be taken by an individual country) that Soesastro (2000b) views as a departure from 59
ASEAN's principle of non-intervention with the potential to transform the nature of ASEAN, if in fact it is actually carried out. 44 As part of the ASP function, all ASEAN member states are. to provide the ASEAN Surveillance Coordinating Unit with baseline data like that provided to the IMF under its Article IV consultation mission. Technical assistance and capacity building for this process are to come primarily from the Asian Development Bank (ADB).

As for ASEAN's peer reviews, little information beyond their mention in official meeting statements is available. In March 1999, at the Third AFMM in Hanoi, the ministers stated that they had conducted a "peer review of each other's economic situation"'<sup>45</sup> and listed as positive results the stabilization of their economies, including<sup>a</sup> return to stability in the foreign exchange markets, build-up of reserves, decline in interest rates, recovery in stock markets, and others. The implication is that these results were the outcome, at least in part, of ASEAN's Surveillance Process; however, this is difficult to confirm. The Surveillance Process was not mentioned in the official statement of the May 2000 AFMM, but was referred to in a general way in the official statement of the April 2001 AFMM where it was stated that discussions of ways to enhance the ASP would proceed with the plus-three countries of China, Japan and Korea. There was only an oblique reference to the ASP in the Sixth AFMM in April 2002 related to ADB's confirmation of continued support for the process.

The precise nature of the complementarity between ASEAN's Surveillance Process and that of the IMF is unclear. As Soesastro (2000b) points out, one advantage of a regional mechanism is that a country might be less reluctant to accept advice from neighbors who can also be impacted by the economic condition of that country. This close connection gives a country's neighbors a legitimate interest in its policies and performance. 146 Eichengreen (2001) argues the need for coordination between ASEAN's Surveillance Process and that of the IMF because of the potential for "inconsistent, incompatible assessments of performance and recommendations for action," which could undermine the credibility of each other's advice.'<sup>47</sup> This he sees as a distinct possibility given there is no guarantee that both bodies will arrive at the same conclusion even if they receive the same information.

_AGRI-_ In November 1998, the United States and Japan announced the Asian Growth and Recovery Initiative (AGRI) to stimulate economic recovery and growth. The participants in this initiative include the APEC economies, as well as officials from<sup>the</sup> ADB, IMF, and World Bank. The initiative has four key components: (1) accelerate bank and corporate restructuring, (2) facilitate the provision of trade and working<sup>capital</sup> finance, (3) mobilize the return of private sector capital, and (4) provide financial, legal, and accounting assistance for restructuring and market-based reforms.

_Chiang Mai Initiative (CMI) -_ The CMI was established by the ASEAN Plus Three (ASEAN plus China, Japan and Korea) Finance Ministers at Chiang Mai, Thailand in May 2000 as a regional financing arrangement supplementary to existing<sup>international</sup> facilities. It is probably the most concrete and currently active of the regional<sup>financial</sup> arrangements to come out of the Asian crisis. The CMI has two parts: _ASEAN Swap Arrangement (ASA) -_ This is the aforementioned swap arrangement originated by ASEAN in 1977 in an amount of US$200 60
- million In November 2000, it was enlarged to US$ 1 billion and expanded to include all ASEAN members

- _Bilateral Swap Arrangement (BSA) and Repurchase Agreement -_ The purpose of the _Bilateral Swap Arrangement Is_ to provide short-term financial assistance In the form of swaps to a country m need of balanceof-payment support or short-term liquidity support 148 Up to 10 percent of the maximum amount of drawing can be provided for a short-term penod without linkage to the IMF The BSA essentially links the intenational reserves of the 10-member ASEAN countries with those of China, Japan and South Korea allowing the ASEAN countries to effectively borrow U S dollars to bolster their own reserves Although not officially stated, the likely creditor nations are Japan, Korea and China There can also be bilateral swap arrangements between the "plus-three" countries, as currently exists between Japan and China and between Japan and Korea The timing of any disbursement would be tied to that of the imposition of IMF conditions

- The purpose of the _Repurchase Agreement_ is to provide temporary foreign exchange liquidity via the sale and buyback of appropriate secunties to a country that is in need of foreign exchange liquidity support

It would be nearly a year before any BSAs were put in place Japan took the lead **in** the negotiation of agreements with ASEAN countries but Chma and South Korea are now mcluded There are currently nine BSAs for a combined total of $18 5 billion that have been signed and several more are under negotiation BSAs signed as of November 2002 are shown in Table 5 7 Table 5 7

|BSAsu|ndertheChiangMalIniti|ative|
|---|---|---|
|Countries|Currencies|Amount<br>(USSbillions)|
|JaparnSKorea|Dollar/Won|_2.|
|Japan/Malaysia<br>|Dollar/Ringgit<br>|10<br>|
|Japan/Thailand|Dollar/Baht|3**0**|
|Japan/Philippines|Dollar/Peso|30|
|JapanlChina|Yen/Yuan|30|
|China/Thailand|Dollar/Baht|20|
|China/Malaysta|Dollar/Ringgit|15|
|**S**Korea/China|DollarMWon/Yuan|2**0**|
|SKorea/Thailand|Dollar/Baht|10|
|____Japan_MOF|**|**<br>Total|18.5|
|**SoureJapanMOF'chittp**|**_JYW._mf**go-p**ouhoulkokkinrg**|**p=lhtnw**and**others**|

_Initially_ Malaysia, disturbed by the IMF's handling of the Asian _crisis,_ objected to the linkage of the CMI with IMF conditionality and voiced a preference for monitonng 61
by an Asian agency more familiar with regional economies. Malaysia wanted<sup>to be able</sup> to draw on more than 10% of the line exclusive of IMF conditionality but was unable<sup>to</sup> gain support in this from other ASEAN countries and eventually agreed to enter into<sup>a</sup> BSA with Japan in the spring of 2001. The finance ministers' concession to Malaysia's objections relative to the IMF was to agree to review the CMI in three years.

As for Indonesia, it has been concemed more with domestic problems and working with the IMF since the crisis, but in May 2002, it began negotiations for a<sup>$3</sup> billion BSA with Japan. This was originally scheduled to be<sup>signed this past summer but</sup> has been delayed. The Philippines has been negotiating BSAs with China and South Korea but these are not yet ready to be signed. The plan of Asian policymakers<sup>as of this</sup> date is for all major BSAs to be signed by May 2003.149 Singapore has so<sup>far not signed</sup> any BSAs although it has been in negotiations with Japan this past<sup>year.For the time</sup> being, Brunei and the newer members of ASEAN are excluded, with<sup>the latter being</sup> more interested in ODA than in short-term swap arrangements.

While the CMI swap arrangements themselves are bilateral in nature, there<sup>isa</sup> multilateral aspect to the CMI in that the creditor nations will coordinate the<sup>provisionof</sup> funds when one or more of their partners are in need of short-term liquidity.<sup>This means,</sup> of course, that the more swaps that are in place, the more effective the arrangement<sup>will</sup> be. Major concerns relative to the CMI are its potential effectiveness<sup>and its risk. The</sup> concerns are focused in three areas: (1) its indications for moral hazard, (2) the level<sup>of</sup> risk for the countries involved, and (3) the amount of support available.

_1. Moral Hazard -_ As revealed earlier in the review of the literature<sup>on causes of the</sup> crisis, one concern often voiced was that of moral hazard. While most of the discussion of this issue focused on the moral hazard engendered by the implied guarantees of support by governments for domestic financial institutions<sup>(and for</sup> some corporates as well), there were also suggestions that the IMF<sup>contributedto</sup> .moral hazard by virtue of its emergency rescue packages.<sup>Thesame could be said</sup> of the CMI because of its commitment to support in the event of a liquidity crunch, the only difference being that in this case the support would<sup>be regional as</sup> opposed to national or international. The problem of moral hazard could<sup>be</sup> reduced by imposing conditionality and or by tying the financial support<sup>to some</sup> predetermined standards of macroeconomic and financial stability of member economies (Yoshitomi and Shirai, 2000).

2. _Credit Risk -_ The BSA agreements being put in place provide U.S. dollars<sup>for</sup> local currencies which means the hard-currency providers (probably<sup>Japan,China</sup> and Korea) are taking real credit risk relative to their partner in the swap.<sup>By</sup> linking the swap to IMF conditionality, the risk may be reduced to<sup>someextent,as</sup> the country in difficulty would supposedly be required to take steps to correct conditions that led to the emergency.<sup>150</sup> Of course, there is no guarantee<sup>that the</sup> conditions imposed by the LvIF would improve the situation. For example,<sup>it</sup> is widely contended that the IMF's requirements imposed on Thailand and<sup>other</sup> countries during the 1997 crisis may have worsened the crisis. There is also<sup>the</sup> concern that if IMF conditions need to be imposed, it may take some time<sup>to</sup> actually put them in place and that the disbursement of funds could<sup>be delayedas</sup> a result. This risk could be alleviated if predetermined standards are already<sup>in</sup> place and qualification for support is based on regular assessments<sup>from regional</sup> 62
surveillance (Yoshitomi and Shirai, 2000). Nonetheless, the potential creditor nations have mdicated their preference for IMF lmkage perhaps bellevmg that even uncertam protectton is better than none at all. The ratig agency, Standard & Poor's, indicated that if the CMI does not involve IMF conditionality, credit ratmgs **in** the region could be negatively impacted **151**

- 3 _Sufficiency of support_ - Given that the aggregate official foreign reserves of the ASEAN-Plus-Three countnes was around US$900 billion **in** 2001 with US$700 billion of that amount held by the Plus-Three countnes (Cluna, Japan and Korea) alone, the potential support amount seems enormous - over 10 times that of the U S (around US$70 billion in 2001) t52 However, swap lmes to individual countries are very small (US$1-3 billion), especially when compared to amounts traded **in** the global currency market where daily volume can be as much as $1 3 tnillion **153** Even more revealmg is to look at the amount of emergency assistance committed and disbursed to the cnsis-affected countries m response to the 199798 crisis (See Table 5 8)

Table 5 8

|Co|mmitmen|tsandDisburs<br>inRespon<br>**(in**billi<br>Commitm<br>.T|ementsof<br>setothe A<br>onsof**US **<br>ents<br> f<br>Bilateral|theInternat<br>sianCrisis<br> dollars)<br>otal|ionalCo<br>Dis<br>**~(as **|mmunity<br>bursement<br>**of**53h012**0**|s<br>**DI**|
|---|---|---|---|---|---|---|---|
|**Countiy**|**IMF**|Multilateral|**Bilateral**|**-Tota**|IMF|**COther**|**Total**|
|Indonesia|150|100|24.7|497|11**6**|10.3|**21.9**|
|Korea'|211|<br>142|231|58**4**|19**8**|**106 **|**30.4**|
|Thailand|4**_0_**|<br>2_7_|105|172|3**4**|**109 **|**14.3**|
|**Total**|**40.1**|26.91|_<br>58.3|**125.3**|**34.8**|**3L8**|**66.6**|
|'WorldBankand|**ADB**|||||||
|**2**Indudesaugme|ntataonssi|nceJuly1998||||||
|3Koreahasrepai|dUSS13b|ililonofthe financi|ngprovidedb|ytheIMF**as**|ofend-May|2000||
|'Combinedmulil|ateraland|bilateraldisburse|ments|||||
|Source**IMf**(20|00cTable|1)||||||

Tis table shows that a total of US$125.3 billion was committed by IFIs and individual countnes **in** support of the three countries most affected by the cnsis - Indonesia, Korea, and Thailand When compared to this amount, the CMI's current US$18 5 billion in BSAs, the US$1 billion under its ASA, and the $7 5 **billion** under the NMI seem small mdeed The amount committed in response to the cnsis was nearly five times this amount.

There are those who are of the opinion that the Chiang Mai Initiative is not what Asia needs at this tune because circumstances have changed in the region since the 1997 cnsis For one thmg, most of the region's currencies are no longer pegged so there **is** no target for central banks to defend and thus little mcentive for speculators to attack.<sup>154</sup> 63
However, the CMI's bilateral swap arrangements themselves could trigger this event if they involve a target exchange rate to be defended before swaps can be called upon. It could also be argued that the focus and energy of the ASEAN countries might be more effective in preventing another crisis if directed towards needed reforms in the financial and corporate sectors rather than on short-term fixes. As revealed earlier in Table 5.3, which shows progress in financial sector restructuring at the national level, progress has been made in this area, but much remains to be done. As mentioned, the ASEAN Surveillance Process and the initiatives of the APEC Finance Ministers Process are making some moves in this direction as well, but more concrete efforts are needed.

The significance of the Chiang Mai Initiative is not really in its size, but rather in its implications for regional cooperation. If the CMI attains its goal of forming a financial network connecting the economies of East Asia, its value will be enhanced as it becomes more than just a few bilateral arrangements for emergency purposes. In this respect it takes on considerable importance as a potential vehicle for future monetary cooperation. It can also be viewed as a statement intended to show the world that Asian countries can work together and be self-reliant.

The IMF's view on the issue of regional monetary cooperation has' changed over the last several years. Vehemently opposed 'to the possibility of an Asian Monetary Fund (AMF) when the idea was first floated in 1997, the Fund has become more open to possibilities in the area of monetary cooperation. In January 2001, Horst K6hler, Managing Director of the IMF, commented on the implementation of the CMI saying that he welcomed the initiative and encouraged the ASEAN+3 countries to make it operative. He added, however, that he understood it to be a complement to the IMF's financial assistance for members in the region.<sup>155</sup> The U.S. as well has expressed its general concurrence with the CMI and efforts towards monetary cooperation in general. More significant, however, is the response of China, which was originally opposed to the idea of an AMF, but has since become more accepting of the regional efforts towards monetary cooperation and has even signed two BSAs, one with Thailand and one with Japan.

Looking at the Chiang Mai Initiative as a step towards further integration rather than an end in itself would seem to be appropriate at this time. While at the present time it adds a degree of financial security to the region, its real significance lies in its implications for future monetary cooperation in the region. Some even see a natural progression from the Chiang Mai Initiative leading to the renewal of an old idea: an Asian Monetary Fund (AME). While establishment of an AMF could be some time in coming to fruition, the idea has not disappeared and suggestions for its implementation resurface not infrequently.

# **National, Regional or Global Approach: Which is Best?**

Opinions vary as to where the primary responsibility should lie for the prevention and cure of crises although most promote a sharing of responsibility between the global and regional with the actual reforms being carried out at the national level. Nellor (2000) argues that the primary surveillance function must be a global activity as stipulated by an integrated global economy. In support of this opinion, he refers to the many global economic interactions; for example, the fact that developments in Latin American 64
financial markets affect financing costs<sup>of capitalin Asian emerging markets.As for</sup> surveillance, he claims that the part of<sup>surveillancerelated to theassessment of policy</sup> interactions must be handled globally because<sup>of theintegrated natureof the global</sup> economy. However, the second aspect<sup>of surveillance(i.e.,encouraging countriesto</sup> adopt desirable policies) could involve<sup>regional groupsthat can strengthenthe process</sup> through building mutual support and<sup>'peer pressure.'Herefersto the effect of shared</sup> 'culture' in a region as a further<sup>strengtheningfactor.156</sup> Nobel and Ravenhill (2000) emphasize<sup>the globallyintegrated natureof the</sup> financial system as a potential hindrance<sup>to theeffectivenessof regional action.They</sup> raise the issue of the most appropriate<sup>geographicaldefinition of the region emphasizing</sup> the imprudence of excluding Australia and<sup>New Zealand,as wellas Taiwan,whichthey</sup> see as a potential contributor of funds<sup>but which could not beincludedin agrouping of</sup> which China is a member. On the<sup>issue of aregionalmonetaryfund, they question the</sup> enforceability of conditionality<sup>on a borrowerby itsneighborsbecauseof the potential</sup> for political embarrassment. Their<sup>conclusion is that themost feasibleregional</sup> collaboration on financial issues<sup>would bein the formof systematicmonitoringof</sup> conditions since neighbors are<sup>well placedto observeconditionsacrosstheir bordersand</sup> have the incentive to apply peer pressure<sup>toreducethe risk of contagion.'57</sup> Kawai, Newfarmer and Schmukler (2001)<sup>promotea sharing of responsibilityfor</sup> policy reforms at all three levels (international,<sup>regionaland national). One of their "nine</sup> lessons from the East Asian crisis<sup>andcontagion"isthatimprovementsundertakenat the</sup> regional level should be consistent<sup>with thoseinthe globalframework becauseeconomic</sup> contagion begins with a geographical<sup>focusbut spreadsglobally.Their frameworkfor</sup> regional financial coordination covers<sup>three areas: 158</sup>

1. Regional consultation and economic<sup>surveillance/monitoringfor</sup> crisis/contagion prevention - Exchanges of<sup>macroeconomic policiesand</sup> structural information such as fiscal positions,<sup>monetary and exchange rate</sup> policies, capital flows, external debts, financial<sup>system conditions,and</sup> corporate sector development. Peer pressure<sup>would provide theincentiveto</sup> pursue policies leading to stability of<sup>accountsand currencies.</sup>

2. A regional financing facility to augment<sup>internationalliquidityin timesof</sup> crisis - This should be consistent with,<sup>andcomplementaryto,a globalfacility</sup> to promote synergy, international<sup>coherenceand involve private creditors who</sup> are often financial institutions outside the region.

3. Programs to assist in the resolution<sup>of the systemic impact of thecrisisand</sup> accelerate recovery - Regionally concerted<sup>action to mobilizefiscal resources</sup> from core regional countries is needed<sup>torecapitalize weak banks,facilitate</sup> corporate debt restructuring and increase social<sup>safety net spending.</sup> Given the region's already fairly high degree<sup>of financial opennessbut, at the</sup> same time, its preference for noninterference<sup>in the domesticconcernsof neighbors,it</sup> could be argued that the most logical and<sup>workableapproachfor crisis preventionand</sup> resolution in East Asia would be<sup>onethat encompasses all three levels (national,regional</sup> and global). The CMI is an example<sup>of this in thefact that itis made up of regionalswap</sup> arrangements but still linked to IMF conditionality.<sup>Thisissuewill beaddressedagain</sup> later in this chapter.

65
# Summary

The Asian crisis of 1997-98 was a turning point for the region. It brought an end to the fantastic growth (particularly of the Asian Tigers) of the 1980s and early 1990s, which few believe will ever return. However, it also brought an awareness of the need for financial cooperation in the region. This is in part because of disappointment at what is perceived as failures on the part of international financial institutions (i.e., the IMF) and developed Westem countries (i.e., the U.S.) in resolving the crisis.

> The primary focus in the region since the crisis has naturally been on their

> prevention and resolution. As previously mentioned, this has led to a call for reform in a number of areas, including financial regulation and supervision, information disclosure, and legal system changes, as well as discussion of whether a national, regional or intemational approach is best. In the following sections, we will take a closer look at three areas that have in recent years become the focus of intense discussion because of their potential role in crisis prevention: financial development, capital account liberalization, and regional currency regimes.

66
# **Financial Development in East Asia**

Arising out of the Asian financial crisis is the consensus<sup>that restructuring and</sup> strengthening East Asia's financial sector is one<sup>essential elementof a program for</sup> preventing another crisis. Beyond this, achieving<sup>a sound and stablefinancialsector is an</sup> important step toward overall economic development.

In this section we will review the development of<sup>financial markets acrossthe</sup> region. In conjunction with this, financial structure<sup>will be examined in an effort to</sup> determine its effect, if any, on this development.<sup>The importanceto this processof the</sup> legal, regulatory and macroeconomic environments<sup>willalso be considered. Finally,we</sup> will evaluate the various approaches under consideration<sup>for achieving the level of</sup> financial development necessary to foster<sup>growth in the region.</sup> There is ample literature'<sup>59</sup> dating back to the late<sup>19thcentury that atteststo the</sup> importance of financial development for economic<sup>growth. Ross Levine (1997)in his</sup> review of this body of literature'<sup>6 0</sup> points out that<sup>it is characterizedby a wide variety of</sup> often-conflicting opinions on the topic. However,<sup>the conclusion to his own analysis,</sup> although "stated hesitantly and with ample qualifications,"<sup>is that the "preponderanceof</sup> theoretical reasoning and empirical evidence suggests<sup>a positive,first-order relationship</sup> between financial development and economic<sup>growth."'lDominic Wilsonin a more</sup> recent paper states, "The past few years have seen<sup>moreconcertedattempts to argue that</sup> these links [between financial development<sup>andgrowth]are both empirically valid andof</sup> practical importance, a task that has probably become<sup>easiersince the recentfinancial</sup> crises."<sup>162</sup> Recent research also shows that the<sup>poorer segmentsof society benefit directly</sup> from financial development, and income distribution<sup>is alsoimproved. 163</sup> The importance of financial market structure to financial<sup>development has also</sup> been debated but with more tentative conclusions.<sup>Financial structure is variously</sup> defined, but the most common definition is that<sup>the financialstructure of an economyis</sup> the degree to which it has a bank-based or market-based<sup>financialsystem.In bank-based</sup> systems, banks provide the major portion of credit<sup>to the economy,and in market-based</sup> systems, firms obtain financing primarily in capital<sup>markets(bond and equity markets).</sup> However, in most countries both sectors co-exist<sup>and have importantroles to play in</sup> financing within the economy. "There<sup>is no empirical supportfor policiesthat artificially</sup> constrain one in favor of the other. Indeed,<sup>thedevelopment of eachsector seemsto</sup> strengthen the performance of the other by<sup>maintaining the competitiveedge of</sup> individual financial firms."164 Ren6 Stulz (2001) defines financial structure more<sup>broadlythan just bank-based</sup> or market-based systems. In his words, it comprises<sup>"the institutions, financial</sup> technology, and rules of the game that specify how<sup>financial activity is organizedat a</sup> point in time."'<sup>6 5</sup> He acknowledges that bank-based<sup>economies and market-based</sup> economies have different financial structures; however,<sup>he believesthat other</sup> characteristics matter a great deal in how the financial<sup>systemperformsitsfunctions.</sup> Both the narrow and broad definitions of financial<sup>structure will berelevantto our</sup> discussion of financial development in East Asia.

67
# Financial Structure in East Asia

Before commencing a discussion of recent thiking on how best to promote financial development **in** East Asia, we will look at the region's current financial structure Developing economies are generally more dependent upon bank lending than on capital markets for financing This **is** largely true for the developing economies of East Asia as well Figure 5 1 below shows the breakdown of total extemal finance by source **(i** e, bank loans, equities and corporate bonds) for selected East Asian countries and the U S for 1990 to 1999 It is obvious that among the lesser-developed economies bank loans and equities are a much greater source of external financing than are corporate bonds. In the case of Thailand, Indonesia and China, bank loans are the largest source while Singapore, Malaysia and the Philippunes are more reliant on the equities markets In Korea, bank loans are the most important source although equities also play a sigmficant role However, when compared with the U S , for which bank loans make up only about 13 percent of extemal financing, the heavy reliance on bank lending by the other countnes shown (from around 30 percent for Singapore and Malaysia to over 80 percent for China) becomes obvious Flgure 5 1 <!-- Start of picture text --> Breakdown of External Financing 199O-1999 Average<br><!-- End of picture text --> <!-- Start of picture text --> 80<br>70<br>60<br>20 30 -- -|- - - - - -<br>US Singapore Koam Malayaa Thailand Indonea Philixprms China<br>Source Adapted from Shirai (2001b Chart 2c, 15)<br><!-- End of picture text -->

Table _5_ 9 presents a dtfferent perspective of financial structure (and includes some countnes not shown above), but the implications are the essentially same. Financing source as a percentage of GDP<sup>166</sup> (I998) for the developing countrnes similarly reveals a heavy reliance on bank loans Among these countries Indonesia, Korea, 68
Malaysia and Thailand have the highest<sup>levelof relianceon bank lending.In Malaysia's</sup> case, however, there is greater reliance<sup>on equities (137 percent of GDP, which is not</sup> much below the percentages for the U.S.<sup>and someEuropean countries.)</sup> Corporate bond markets, on the other hand, are<sup>very poorlydeveloped acrossthe</sup> region although Korea's market is considerably<sup>larger than that of the others (except for</sup> Japan's). Japan's financing source profile<sup>(in terms of loans,equities and corporate</sup> bonds) is more characteristic of other Asian<sup>countries and some European countries</sup> (especially Germany) than it is of the U.S.<sup>167In fact,thereisa well-recognized</sup> difference between the bank-centered<sup>model,of which Germanyand Japan 168are</sup> representative, and the Anglo-Saxon model, of<sup>whichthe GreatBritain and theUnited</sup> States are representative.'69 Table 5.9

||Finan<br>|cingSourcesfor<br>199<br>**(%of**|SpecifiedCou<br>8<br>**GDP)**|ntries||
|---|---|---|---|---|---|
||BankClaims<br>onPrivate|||||
|Country|<br>Sector<sup>1</sup>|TotalEquities|Total Bonds<sup>2</sup>|Govt.Bonds<br>|CorporateBonds<br>|
|Indonesia|68.9|24.0|1.8|0.0|1.1<br>|
|Korea|82.5|35.7|86.5<br>|55.6<br>|30.9<br>|
|Malaysia|104.1|136.9|52.5|27.4<br>|21.0<br>|
|Philippines|50.3|54.3|14.2|12.1|1.9<br>|
|Thailand|127.8|30.9|18.6|8.6<br>|3.1<br>|
|Japan|133.3|65.9|137.7|97.7|40.0<br>|
|France|77.1|68.1|83.2|50.3|32.9<br>|
|Germany|125.9|51.5|94.5|40.8|53.7<br>|
|Italy|62.4|48.0|133.2|102.5<br>|30.7<br>|
|The Netherlands|124.0|159.6|64.4|52.8<br>|11.7<br>|
|UK|120.8|169.7|61.0|33.2|27.8|
|USA|63.6|158.0|164.2|94.0|70.2|
|<br>Bankdaimsarethe<br>asequitysecurities.<br>**2**Bondfigures forthe<br>Bondfiguresfordeve|<br>closestavailablep<br>Claimsonthepriva<br> developingcountri<br>lopedcountriesare|<br>roxyforbank<sup>loans</sup><br>tesector,<sup>therefore,</sup><br>es<sup>includeonlydeb</sup><br> debt<sup>securitiesof </sup>|<sup>,althoughclaims</sup><br> <sup>shouldapproxima</sup><br><sup>t securities within</sup><br><sup>allmaturities,notj </sup>|<sup>couldalsoinclude</sup><br><sup>te to loans tothe</sup><br><sup>itialmaturitiesof</sup><br><sup>ustbonds.</sup>|<sup>otherclaims,such</sup><br><sup>privatesector.</sup><br><sup>atleastoneyear.</sup>|
|Source:Compiledfro|mEndo(2001:Tab|le<sup>5,245)</sup>||||

Financial structure in the region has changed<sup>over time as illustratedin the figures</sup> below, which show bank loans and corporate<sup>bonds, respectively,asa percentageof total</sup> external finance for eight selected countries<sup>for the years1990 to1999.Withthe decline</sup> in bank lending after the crisis came<sup>arise in corporatebondissuanceinthe crisis</sup> countries from $68 billion in 1997 to $130<sup>billion in 200017,mostly inKorea,but alsoto</sup> a lesser extent in Malaysia and Thailand.<sup>17'After the bankingsector problemsof the</sup> crisis, capital markets grew in importance<sup>formost of the crisis-affectedcountries.</sup> 69
Figure 5 2 <!-- Start of picture text --> Outstanding Bank Loans as Parcent of Total External Finance: 1990.1999 Time<br>Series<br>90 -<br>70 -- --<br>60 _<br>50 -<br>40-<br>30 -<br>20<br>1990 1991 1992 1993 1994 1995 1996 1997 1998 1999<br>--- #- Korea -- Malaysia Thailand , Indonesia -i Philippines<br>100<br>90 -<br>80 - _ _- -<br>70 -<br>60 -<br>50<br>20-<br>1990 1991 1992 1993 199.4 1995 1998 1997 1998 1999<br>1--Ctt a-. -Singapom U u_.<br><!-- End of picture text --> <!-- Start of picture text --> Note External finance is defined as the sum of outsmnding bank loans, outstanding corporate bonds issued<br>and equity market capitalization<br>Source Shirmi (2001 b Chart Id, 9)<br><!-- End of picture text --> 70
Figure 5.3

**Outstanding Corporate Bonds Issued**<sup>**(Percentof TotalExternalFinance):**1990-1999</sup> **Time Series**

<!-- Start of picture text --> 30.0<br>25.0 , .<br>20.0<br>tS O _ _ | I =~~~~~~~~~~~~~~~~~a Malays Ia<br>_ S | ik ~~~~~~~~~~~~~~~~~~~~~~~~~~Thtafnaengd<br>t5.0 __ * doneai<br>5.0<br>0.0<br>1990 1991 1992 1993 1994 1995 1996 1997 1998 1999<br>25D _0<br>30.0 ~~~~~~~~~~~~~~~~~~~~--llpla---<br>Slr9apore<br>1990 991 _ 992 gm3 994 9 99 6 _~~~17 997 98 W99<br><!-- End of picture text -->

Source: Shirai (2001b: Chart 2d, 16) The Asian Policy Forum (under the ADB Institute)<sup>labels thefinancialsystem in</sup> Asia an "intermnediate financial market structure,,"1<sup>7 2whichis betweena bankc-centered</sup> system and a full-fledged capital market; commercial<sup>banks not onlyprovide traditional</sup> banking services but also are active in the<sup>corporatebondmarket asmajor issuers,</sup> investors, underwriters, dealers/brokers<sup>andguarantors.' 7</sup> A somewhat different approach to the assessment<sup>of the fmnancialstructureand</sup> development of East Asian economies is presented<sup>in arecent study by DemirgidiyKunt</sup> and Levine (200 la)'<sup>7</sup> , where selected economies<sup>are classifiedaccording totheirstatus</sup> 71
as developed or underdeveloped and their structure as bank-based or market-based.<sup>(See</sup> Table 5.1 0.) Table 5. _1_ 0

|**C**<br>|**ountryClassification**<br>**(Based ondatacoll**<br>|**ofFinancialStructure**<br>**ected**in**the1990s)**<br>||
|---|---|---|---|
|**Financiallyunderdevelo**|**pedeconomies**|**Financiallydevelope**|**d economies**|
|**Countryname**|**StructureIndex**|**Countryname**|**StructureIndex**|
|<br>**_Bank-based economies:._**||**_Bank-basedeconomies:_**||
|**Indonesia**|**-0.50**|Austria|-0.73|
|Argentina|-0.25|Belgium|-0.66|
|India|**-0.14**|Italy|**-0.57**|
|Ireland|-0.06|Finland|-0.53|
||=|___<br>_<br>_Norway|-0.33|
|||NewZealand|-0.29|
|**_Market-based economie_**|**_s:_**|**Japan**|**-0.19**|
|Denmark|0.15|France|-0.17|
|Chile|0.25|Germany|-0.10|
|Philippines|0.71|||
|||**_Market-basedeconomie_**<br>|**_s:_**<br>|
|||Netherlands|0.11|
|||**Thailand**|**0.39**|
|||Canada|0.41|
|||**Australia**|**0.50**|
||=|____<br>**_Korea**|**0.89**|
|||Sweden|0.91|
||_**_**_|__<br>GreatBritain|0.92|
|||**Singapore**|**1.18**|
|||<br>UnitedStates<br>|1.96|
|||Switzerland|2.03|
||I__<br>__|<br>**Hong Kong**.|**2.10**|
||_ _<br>_|<br>___<br>**Malaysia**|**2.93**|
|Notes:||||

(1) A country is defined as having an underdeveloped financial system if both of the' following hold: (1) _Claims of deposit money banks on the private sector/GDP_<sup>is less than</sup> the sample mean and (2) _Total value traded as a share of GDP_ is<sup>less</sup> than<sup>the sample mean.</sup> (See Table S.16 in Statistical Appendix.) Thus, a country's financial system is classified as underdeveloped only if it has poorly developed banks and markets. (2) Countries are ranked along the spectrum from bank-based to market-based,<sup>wherehigher values of</sup> _Structure_ indicate higher levels of stock market development relative to banking-sector<sup>development.</sup> Countries that have above the mean values of _Structure_ are then classified as<sup>market-based.Countries</sup> that have below the mean values of _Structure_ are classified as bank-based. **_Source: Demirg() -Kunt and Levine (2001a: Table 3.12, 121)_** Demirgii9-Kunt and Levine developed a conglomerate index of financial structure that is based on measures of size, activity, and efficiency. These measures when combined into a "Structure Index" (see above table) identify a country's<sup>place on a</sup> market-based versus bank-based spectrum. Countries are also distinguished<sup>between</sup> 72
those that have underdeveloped financial systems and those that have<sup>developed</sup> systems.<sup>1</sup> 75 This is done to avoid classifying two countries in the same bank-based<sup>(or</sup> market-based) category if one has poorly developed banks (or capital markets)<sup>andthe</sup> other has highly developed banks (or capital markets) by international<sup>standards.(See</sup> "Notes" at bottom of Table 5.10 above for classification criteria.) According to this classification, there are more East Asian economies<sup>thatare</sup> market-based (i.e., the Philippines, Thailand, Australia, Korea, Singapore,<sup>HongKong,</sup> and Malaysia) than bank-based (i.e., Indonesia and Japan). In fact, Hong<sup>Kongand</sup> Malaysia have higher Structure Indices (2.10 and 2.93, respectively) than<sup>thatof the U.S.</sup> and Switzerland (1.96 and 2.03, respectively).<sup>176</sup> The Hong Kong<sup>and Malaysianstock</sup> markets are quite large and active; however, their high Structure Indices mean<sup>that their</sup> stock market development is high relative to their own banking-sector development,<sup>but</sup> not relative to the level of stock market development in other countries.<sup>In another</sup> example, the Philippines is classified as market-based because its banks<sup>are small and</sup> underdeveloped, not because its stock market is very well developed.

When viewed in this way, the classification for most countries (in Table 5. 10)<sup>is</sup> consistent with the information provided in the prior tables where<sup>it was revealed thata</sup> number of East Asian economies had a larger proportion of equity financing than<sup>bank</sup> financing (e.g., Singapore, Malaysia and the Philippines). On the other<sup>hand, Thailand</sup> and Korea are shown in the earlier figure to have a larger proportion of bank-sector financing whereas Demirgii'-Kunt and Levine classify them as<sup>market-based.The</sup> Demirgii9-Kunt and Levine classification, however, adds another<sup>dimensionthrough its</sup> representation of the relationship between stock market and bank sector development based on a number of ratios,1<sup>77</sup> as opposed to a simple proportionate<sup>breakdown of</sup> financing sources.

In the case of Korea, the authors point out that although it is usually viewed as large-bank dominated, it is classified in their study as having a market-based<sup>financial</sup> system. They explain that this is not only because Korea has a very<sup>active and efficient</sup> equity market (based on _Turnover_ and _Total value traded/GDP_ ratios<sup>-seeTable S. 13 in</sup> the Statistical Appendix) but also because nonbanks play a role as substantial as that of banks in Korea and this is reflected in the ratios.'<sup>7 8</sup> The Demirgiig-Kunt and Levine structure classifications incorporate data for banks and stock markets but not for bond markets.'<sup>79</sup> However, the<sup>chartsappearing</sup> earlier in this section reveal that the corporate bond markets in East Asian economies<sup>are</sup> not at all well developed.

# **Developing Financial Markets in East Asia**

Recommendations for the best course of action to reach the goal of "welldeveloped financial markets" in East Asia have generally focused on two approaches. One approach is to look at financial market structure and assess<sup>whethera bank-based</sup> financial system or a market-based system is more advantageous<sup>for emerging</sup> economies. Since the Asian crisis, discussion of this approach has intensified, particularly surrounding the issue of developing local-currency corporate bond markets as a means of lessening the chance of another crisis.

73
The second approach advocates a focus on improving<sup>the legaland regulatory</sup> environment in order to set the stage for the natural<sup>evolutionof financial structure,</sup> which is believed to change gradually through the process<sup>of economic development.</sup> According to this approach attempts to quickly change financial<sup>structuredirectly,</sup> without first having in place well-developed legal, information,<sup>andenforcement</sup> mechanisms, are rarely successful.

In fact, both these approaches have essentially the same ultimate goal<sup>(i.e.,sound</sup> and stable financial markets) and recommend some of<sup>the same stepsin the</sup> accomplishment of this goal. Even those who advocate<sup>the approach of changing the</sup> financial market structure do not suggest that this can<sup>be accomplishedas merely a</sup> technical infrastructure-building exercise with some regulations,<sup>an exchange,and a</sup> clearing system. **1**<sup>**80**</sup> In addition to an appropriate legal<sup>and regulatory system,there is the</sup> need for an environment that will attract participants, and<sup>thisenvironmentrequireslegal,</sup> information, and enforcement mechanisms. These two<sup>approaches to financialmarket</sup> development in East Asia are discussed further below.

# **Financial Market Development Via Change in Financial**<sup>**Structure**</sup>

With the banking sector having been the recipient of considerable<sup>blame for its</sup> role in the Asian crisis, attention has shifted to the development<sup>of capital markets (equity</sup> and bond markets) in Asia as an alternative to the heavy<sup>relianceon banks.Wilson</sup> (2002) believes that post-crisis models'<sup>81</sup> show that<sup>with accessto several sourcesof</sup> financing, firms can balance debt and equity to maintain<sup>a manageabledegree of leverage</sup> and reduce the impact of shocks specific to a particular<sup>form of financing.Kawai (2002),</sup> in his review of bank and corporate restructuring, places<sup>importanceon thedevelopment</sup> of local capital markets. He believes that an active corporate<sup>bond market can functionas</sup> a warning mechanism as well as an exit mechanism while<sup>equity financingcan provide a</sup> cushion against currency and interest rate shocks.

## **Corporate Bond Markets**

The primary focus of financial structure change has recently<sup>beenon improving</sup> corporate bond markets as an effective and feasible way<sup>to minimize the chancesof crisis</sup> like that of 1997-98. The reason for this is that local-currency<sup>bondslock in interest rates</sup> and local-currency funding which can have a dampening<sup>effecton crises caused by</sup> international capital flows.

Beyond crisis prevention, there are other reasons to encourage<sup>the developmentof</sup> local-currency corporate bond markets. Some of these<sup>are (1) improvementof resource</sup> allocation efficiency through market-determined interest<sup>rates,(2) provisionof financing</sup> for longer-term, larger-scale projects than banks are<sup>able to handle becauseof their focus</sup> on quality improvement, (3) enhancement of financial<sup>institutiontransparency through</sup> information disclosure, and (4) creation of competition<sup>with banksleading to lower</sup> interest rates. 182 The difficulty in achieving well-developed corporate<sup>bond markets, however,</sup> should not be underestimated. The process is complex<sup>and takesconsiderable timeto</sup> accomplish as evidenced by the list of requirements for<sup>a well-functioningcorporate bond</sup> 74
market that appears in Table G.6 in the General Appendix.'<sup>83</sup> It should also be realized that for some developing countries, success might prove to be impossible.

This process is further complicated by the involvement of "attitudes, cultures, and politics. Developing new attitudes and behavior is a main reason why developing markets take so long. People need to learn new ways of thinking about how and with whom they do business. New cultures need to be created - for taking and managing risk, disclosinf information, and maintaining quality operations and accounts, among other areas."'<sup>8</sup>

- The corporate bond markets in East Asian countries in general are not well

- developed 85 as is revealed by the following description of their main characteristics. 186 1. Government bond markets are underdeveloped because (a) the size of issues is small with diverse types of official bonds and the issuing time is irregular, (b) secondary markets are highly illiquid, and (c) the maturity is narrowly spread.

2. Corporate bond markets are largely underdeveloped for a number of reasons:

- a) Poorly developed government bond markets make it difficult to establish benchmark yield'curves that are necessary for the pricing of corporate bonds. Although some governments in Asia have been able to establish benchmark yield curves as a result of their post-crisis increase in bond issuance to finance expansionary policy, bank recapitalization and social safety nets, there is uncertainty as to the extent this will continue once fiscal deficits are no longer so large.

- b) Some governments have adopted low interest rates and transaction taxes that discourage investors from transacting bonds in the secondary market.

- c) The issuer base is narrow with few large, reputable non-financial firms and the size of issues is small with maturities concentrated on the short- to medium-term.

- d) The investor base is narrow and limited with individual investors preferring safe, liquid bank deposits. Corporations prefer stock markets and bank loans to bond markets as the former two financing sources are more convenient than bond issuance because of strict rules and regulations for listing and issuing, as well as high fees.

- e) Institutional investors are generally underdeveloped and concentrated.

- f) Secondary markets are largely illiquid.

- g) Corporate bonds are primarily guaranteed or privately placed (especially before the crisis).

- h) The market infrastructure in Asia is poor. Some countries still use paper-based bookkeeping and lack systems for electronic clearing and funds transfer while there is no regional clearinghouse for payment and settlement transactions.

- i) Some central banks in Asian countries are not in favor of developing domestic bond markets because of the fear it will weaken their power over monetary policy.

3. Commercial banks play a key role in the corporate bond market in that they are at the same time major investors, guarantors, underwriters and issuers of corporate bonds.

75
A particular problem in Asian bond markets is the limited institutional investor base. This is due to a number of factors, including low income per capita<sup>and poor</sup> wealth accumulation in regional economies. In addition, there is a lack of investor confidence because of inadequate information about issuing firms and poor<sup>legal and</sup> judicial infrastructure, which if improved could serve to assure debt<sup>repayment,penalize</sup> the dissemination of false information, and prohibit insider trading.'<sup>87</sup> In Indonesia, Korea, and Thailand, the major institutional investors are financial institutions. In Malaysia there is a single institutional investor (i.e., the<sup>Employees</sup> Provident Fund) that dominates the investor base with the second major investor<sup>being</sup> the banking sector. Financial institutions in some countries tend<sup>to hold their bonds until</sup> maturity because of reserve and liquidity requirements that are imposed on<sup>them.This</sup> buy-and-hold strategy not only reduces the liquidity of the secondary market but<sup>is also</sup> one reason why financial institutions dominate the investor base<sup>since littleis left overfor</sup> retail investors. An inactive and undiversified investor base leads to pricing inefficiencies. 188 In recent years, particularly since the crisis, individual countries<sup>have taken steps</sup> to develop their bond markets with varying degrees of success. Due<sup>to the constraintsof</sup> time and space, an in-depth assessment of the level of development of each<sup>country's</sup> market will not be undertaken here but Park Yoon-Shik (2001) reports that<sup>Korea,</sup> Malaysia and Thailand in particular have made progress in this area through<sup>the</sup> strengthening of market infrastructure, the establishment of benchmark yield curves<sup>and</sup> the opening of their markets to foreign participants. The result has been a<sup>gradual</sup> diversification away from excessive reliance on the banking sector to<sup>an expandeduse of</sup> bonds. He cautions, however, that more needs to be done particularly in<sup>the areasof</sup> corporate governance, bankruptcy and workout procedures, disclosure, and commercial laws. Also, secondary market liquidity remains a problem.<sup>189</sup> Finally, not everyone agrees that bond market development is the answer<sup>to the</sup> financial system problems in East Asia. In the words of Dr. Julia Turner,<sup>Managing</sup> Director of Moody's Asia Pacific, "[.. .] bond market reforms alone are inadequate<sup>to</sup> spur capital market development. [...] as long as borrowers have the<sup>option toborrowat</sup> uneconomic rates from their bankers, without disclosing the true state of their financial health, not even the most enlightened reform of capital market regulation<sup>will be</sup> sufficient to motivate them to borrow in the public debt markets."'<sup>9 0</sup> In view of<sup>the fact</sup> that the banking sector still plays an essential role in the financial markets,<sup>Moody's</sup> espouses the "Basel Committee's Proposal" for bank reform'<sup>9</sup> ' as a key contributor<sup>to</sup> capital market reform and development, provided it is "sensibly implemented."'<sup>9 2</sup> A regional forum that also believes the banking sector plays,<sup>and will continueto</sup> play, an essential role in the region is the Asian Policy Forum/ADB Institute.<sup>Its</sup> proposal for financial development targets both the banking sector and bond<sup>market in</sup> combination as described in the following section.

# **Bank Involvement in Bond Market Development**

In East Asia, the banking sector already plays a significant<sup>role in its</sup> underdeveloped bond markets.' l Table 5.1 1 reveals the scope of this involvement for four East Asian countries.

76
# Table 5.11

|**Roleof**|**theBanking Sector**|in**Asia**||
|---|---|---|---|
|**Banksas:**<br>**Thailand**|**Indonesia**|**Korea**|**Malaysia**|
|**Issuers**<br>**X**|**X**|**x**||
|**Underwriters**<br>**X**|||**x**|
|**Investors**<br>**X**|**X**|**X**|x|
|**Guarantors**|**X**|**X**|**X**|
|||(beforethecrisis)|(before the crisis)|
|Note:Listedintheleft-handcolumnareare|aswherethebankin|gsectorplaysacrucial<sup>r</sup>|<sup>ole.</sup>|
|Source:Shirai(200lb: Table3,19)||||

The Asian Policy Forum (APF)/ADB Institute'<sup>94</sup> views commercial<sup>bank</sup> involvement in the development of bond markets (its so-called _intermediate stage_<sup>of</sup> financial development) as logical and desirable as an interim step in the long-term evolution of financial market development in Asia. The rationale for this view is<sup>related</sup> to the particular difficulties that Asian countries face in their financial environment, including severe information asymmetry between issuing companies<sup>and publicinvestors,</sup> the lack of companies sufficiently large, mature and reputable for their information<sup>to be</sup> credible, and the necessity to establish the legal and regulatory framework needed<sup>for</sup> sound capital markets. These difficulties hamper the development of bond<sup>marketsin the</sup> region. This group also expects the bank-based system to continue its dominance<sup>in Asia</sup> and believes a sound capital market cannot be developed to replace it in a short<sup>periodof</sup> tinme.'19 The APF argues that banks already have certain advantages related to<sup>the nature</sup> of their existing business that would make them natural intermediaries<sup>in underdeveloped</sup> bond markets. They could serve as investors (relying on their previously<sup>collected</sup> household savings and information on issuing companies) and as issuers (relying<sup>on their</sup> large size and already established reputation). In addition, they can make<sup>use of</sup> information they already possess on borrowers to underwrite bonds, which would<sup>leadto</sup> lower costs relative to investment banks. In an _intermediate financial market structure,_ "commercial banks continue to provide traditional banking services while<sup>becoming</sup> major issuers, investors, underwriters, dealers/brokers, and guarantors in the<sup>corporate</sup> bond market. Thus, banks actively engage in securities and related business,<sup>such as</sup> derivatives."196 [See Table G.7 in the General Appendix and Shirai (2001a:<sup>34-46)fora</sup> detailed assessment of the advantages of this structure.] While the aforementioned concept may be logical, the risks inherent in<sup>bank</sup> involvement in the securities business should not be underestimated.<sup>Some of theseare</sup> indicated in Table G.7. In a financial system, banks are the most fragile part<sup>becauseof</sup> the "demandable" nature of their liabilities. Even a small triggering event can<sup>lead to a</sup> run on a bank.'<sup>97</sup> The APF does caution that certain disadvantages could arise in the _intennediate financial market structure._ These include a higher default ratio on bank loans<sup>as the</sup> more reputable firms would prefer lower cost bond issuance leaving<sup>less reputablefirms</sup> 77
to choose bank loans. Also, it could result in hindrances to the development of bond markets if particularly powerful banks tend to substitute bank loans for bond<sup>finance or if</sup> they emphasize cost-saving at the expense of product innovation.<sup>1 98</sup> The perceived complementarity between banks and bond markets leads the<sup>APF</sup> to propose that the development of bond markets can be fostered through<sup>strengthening</sup> the banking sector. To accomplish this, it makes nine proposals in two areas.'<sup>9</sup>

- A) Proposed steps for strengthening the banking sector:

- 1) Reducing government interference in banks' financing operations and eliminating the abuses of connected lending.

- 2) Strengthening prudential and supervisory regulations on banks in a manner suitable for local conditions. Not all countries have the same level of institutional infrastructure and arrangements for universal prudential regulations. Also, developed country soundness indicators are not always effective for emerging economies.

- 3) Determining the appropriate corporate structure for banking organizations so as to reduce the risks associated with banks engaging in securities activities. This can be either separate banking and securities subsidiaries under one holding company or different departments in one entity.

- B) Proposed steps for the development of corporate bond markets:

- 4) Planning, prioritizing and pacing the sequenced development of bond markets with governments assuming a primary role.

- _5)_ Regular issuance of government bonds with a well-spaced maturities mix<sup>(not</sup> disregarding fiscal prudence) and adoption of a comprehensive market-based pricing system.

- 6) Stimulating demand and supply of corporate bonds through the establishment of legal, regulatory, and information infrastructure for bond markets and the introduction of tax incentives in the early stage.

- 7) Establishing related financial markets, in particular, derivatives markets to improve risk management and enhance liquidity.

- 8) Improving clearing and settlement systems.

- 9) Preparing for establishing an Asian regional bond market.

The weaknesses in the structure of the financial and-corporate sectors of East Asian economies (particularly before the crisis) are by now well known. In his examination of the financial and corporate sector issues related to the crisis, Kawai (2002) describes them thus: "The list of fundamental structural deficiencies<sup>in East Asia's</sup> financial and corporate sectors is long. It includes a lack of prudent risk<sup>management on</sup> the part of commercial banks, ineffective banking regulation and supervision,<sup>poor</sup> accounting, auditing and disclosure practices, and weak governance of<sup>corporations.The</sup> close relationship between corporations and banks, coupled with their influence<sup>over</sup> governments and legislatures, undermined even the weak prudential safeguards<sup>that did</sup> exist. Ineffective legal and court systems contributed to inadequate protection<sup>of</sup> minority shareholders."<sup>200</sup> As is apparent, these issues have implications<sup>not only for the</sup> banking sector but also for the capital markets in these countries.

Since the crisis, efforts have been made to remedy many of these deficiencies with varying degrees of progress in countries throughout the region. Details of this 78
progress were provided earlier in this chapter and a very thorough<sup>review of bank and</sup> corporate restructuring can be found in Kawai (2002).2<sup>**I**</sup> Accomplishing the APF's proposals (strengthening the banking<sup>sector and</sup> developing corporate bond markets) would require strong political<sup>will and commitment</sup> as well as financially sophisticated human resources with<sup>particular expertisein the credit</sup> area. While prudential and supervisory regulations have<sup>beenin placein developed</sup> countries for a long time and would seemingly serve as examples<sup>for developing</sup> economies, they may not always be appropriate or feasible for emerging<sup>markets.</sup>

# **A Regional Bond Market**

In recent years, interest in the establishment of a regional<sup>bond market in Asia has</sup> surfaced. **202** A regional bond market is seen as having the economies of<sup>scaleto be more</sup> cost-effective than local bond markets in numerous small economies.<sup>It could also</sup> provide diversification for corporate financing and utilize abundant<sup>financial resources</sup> (i.e., large pool of savings), which would be able to flow freely across<sup>borders.</sup> The New Miyazawa Initiative (NMI)<sup>2 03</sup> , of which the<sup>secondstage places</sup> particular priority on the development of bond markets,<sup>is</sup> perceived<sup>as the precursor to</sup> the development of regional bond market activities in East Asia.<sup>The relevantmeasures</sup> are: **2**

- Acquisition of sovereign bonds issued by Asian countries<sup>by the JEXIM (now</sup> -

- Japan Bank for Intemational Cooperation JBIC).

- Supporting Asian countries in raising funds from international<sup>financial</sup> markets through the use of guarantee mechanisms and/or interest rate subsidies.

- Possible establishment of an international guarantee institution<sup>witha prime</sup> focus on Asian countries.

It is believed that Japan's decision to guarantee Asian<sup>sovereigndebt issues</sup> (under the NMI) has prompted improvement of bond markets<sup>in theregion.205However,</sup> progress toward development of a regional bond market has<sup>been slow toproceed from</sup> the momentum of the NMI. In fact, the major markets in the region<sup>(HongKong,</sup> Singapore, Sydney and Tokyo) have reportedly gained no<sup>significantmomentum from</sup> the Nmi.<sup>206</sup> In fact, the difficulties of developing an Asian bond market<sup>are not that different</sup> from those of developing local bond markets. Requirements<sup>include thefollowing:207</sup>

- A regional credit rating agency

- A regional clearing and settlement system

- Mechanism for cross-border borrowing and lending of<sup>securities</sup>

- Harmonization of tax treatment

- Regional trading mechanisms

- Fuller dissemination of information concerning creditworthy<sup>Asian companies</sup>

- Greater credit enhancement for potential bond issuers

- Increased communication between the public and private<sup>sectors</sup>

- A dominant Asian currency to serve as a key international<sup>currency</sup>

- A regional bond-trading center. The APF sees<sup>Tokyo as the most likely</sup> candidate for this because of its developed economy and business<sup>activity but</sup> perceives it to be hampered because of the insufficient internationalization<sup>of</sup>

79
the yen and its weak institutional infrastructure for JGBs (Japanese Government Bonds) and low presence of foreign institutions.

Individual countries would need to assess the costs<sup>and benefits to participationin</sup> an Asian regional bond market. The benefits would<sup>includepricing advantagesand</sup> accessibility to regional financial resources while costs<sup>would be potentialcurrency</sup> mismatches and "internationalization" of local currencies<sup>associatedwith using a</sup> "regional" currency.<sup>208</sup> There is also rivalry among certain<sup>financialcenters(e.g., Hong</sup> Kong, Singapore, Bangkok) that want to be regional<sup>hubs.This has resultedin only</sup> sporadic cooperation when it comes to any kind of<sup>link-up209of bond settlementsystems</sup> for cross-border transactions.<sup>2 10</sup>

# **Developing Equity Markets**

The development of equity markets is also being<sup>propoundedaspart of capital</sup> market development in the region. It is argued that developing<sup>equity markets can be less</sup> complicated than developing bond markets. Among other<sup>things, bond markets require</sup> supporting pricing infrastructure and bond issuers must be able<sup>to manage their cash flow</sup> so as to service and repay their bonds. Also, bond markets<sup>cannot grow as fast as equity</sup> markets.<sup>2 1</sup> ' In Southeast Asia, there are equity markets in Bangkok,-<sup>Jakarta,Kuala Lumpur,</sup> Manila and Singapore. The Northeast Asia equity<sup>marketsare in Taipei,Seoul, Tokyo</sup> and Hong Kong. The major markets in East Asia as a<sup>wholeare Hong Kong,Singapore</sup> and Tokyo.<sup>212</sup> As has been the case for corporate bond markets, equity<sup>markets in the region</sup> have also come under scrutiny since the Asian crisis.<sup>While thefive SoutheastAsian</sup> markets performed largely in line with the Dow Jones Composite,<sup>NYSE Compositeand</sup> S&P 500 indices during the first half of the 1990s, they<sup>fellsubstantiallybehind the U.S.</sup> markets in the period following the crisis.<sup>213</sup> Although bank loans<sup>werethe most affected</sup> by the sharp flow reversals during the crisis, portfolio investments<sup>werealsosubject to</sup> volatility and suffered outflows, albeit to a lesser degree.<sup>21 4</sup> (See Table 5.12.) 80
Table 5 12

||||NMC|4aaFlaw'||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|
|______________|_________**_**__<br>19S3|______<br>194|t<br>168|<br>91188|188i|1 6|low<br>1W||2201|2002<br>.||
|crulsCowaslrbr'<br>~|~|_||||||||||
|P____C_-______roe_|308|354|566|743|-58|-316|-139|157|-162|_|-39|
|P____<br>d<br>hb<br>,<br>_not<br>_7_a_|__<br>ei|es|103|117|102<br>|115|148|143|83|103|10e|
|P<br>MaW<br>dinsbwt<br>r|250|133|186|289|B9|-90|118|70|32|51|15|
|Qdwpi<br>cmpna_fbvarot_|-o0e|156|2790|357|-247|-341|-A04|369|-277|219|.180|
|OflaMAwnr|32|07|a8|-47|137|170|22|68|0o|14|33|
|Chwiinkltn|-200|-a5|175|-49|406|-489|-382|-.24|_.117|113|121|
|C'rrlnaccxr|-135|-232|-39|-531|-25|097|627|471|32e|231|179|
|_OUCf_AsianS!igng<br>a_t_|_m|||||||||||
|A<br>.lvS<br>_mm"nee_|2ZS|349|407|460|196|-154|15.2|02|354|159|95|
|Privaedmuthvunlnot|264|352|441|439|473|483|473|401|452|492|so5|
|PrtcampaWgdionwrsfwL notn|0 9|75|2.1|33|21i|-92|24|-2.8|-176|-4 3|-59|
|Olt_wprvsC*W_flows.nd|-47|-108|-54|-12|-256|-544|-348|373|78|291|-347|
|_ofa!flowsnot_|82|25|-33|-73|-4e|31_|<br>s|-21|-20|40|48|
|Chmin<br>rara|-166|-e14|254|-417|-468|-16e|-386|-26.2|807|-42a|-344|
|Ctrrwmoowt|72|183|845|147|514|410|32.7|35a|547|421|359|
|ovopingAsiaTotal<br>_||-|||||.|..._|...|=||
|PthCwiteflw<br>as|1<br>53-3|703|975|1203|_140_|_-470_|13|_-155_|iz2|Is|se|
|Pctflcdtiflyimtnd|331|447|544|55s|875|598|el|**5** 44|535|55|807|
|PrtvpXoiftbnat<br>not|259|208|20 7|302|68|-182|142|44|144|08|-44|
|OVwprh<br>eqtrctdflows<br>no|-65|46|225|345|503|-85|760|-742|-199|-5410|507|
|0dd<br>_fal_<br>__<br>_|<br>14|32|55|-120|71|207|18|45|_-14_|_54_|81|
|COwgin**_rsSiU_**|-368|-57<br>9|-429<br>S|45|42|-435|768|-48|-924|-541|-485|
|CLewntmauzt<br>.|-207|**_449_**|413|-X34|259|1107|954|029|873|652|546|
|Hong**Kong**||-.||||||||||
|P<br>n<br>sCq.f<br>nram||73|-72|.94|117|4-5|10|42|-5|-99||
|1Notcwdt<br>anpria<br>rnaantwhnssno<br>2Rn.<br>cdabntda,<br>5wiwirslmay<br>3**A**<br>n*sign_v%WeanonIncre._<br>**4**ThesmnoflancunwsefLd**baa..**notpul<br>g<br>tuxn<br>d towctmd**_mctmi_**sins**mid**<br>5<br>1<br>ndxAsKam<br>Sappo<br>aidTiwr<br>Pru*f|tw-f<br>ht<br>sesctlWra<br>akisu<br>ofCine|vIflmtnam<br>**_mm_**_dl_1d<br>n.etdflc|Sir<br>-n<br>W<br>i_flows_<br>tFlowsaid|<br> <br>nd**_SmIt_**<br> **chdg.**inr|**_tuM_**natrm<br>wwn<br>equ|tanlbIo<br>asiwhim|hCatu<br> qppos.lziL|d8C1S mid|p1$obM|mw||
|6I1diAnluirdwi<br>KCr<br>MatiwiVWFtip|HsmWdald|Tid||||||||||
|**_OSr-aM1F_**Wald**EwnncOafloaApl**2002|Tame152|9||||||||||

The abbve table shows that pnvate portfolio investment recovered quite significantly in 1999 after the cnsis but not to anything near pre-crisis levels In fact, Investment fell again in both 2000 and 2001 This could be attributed to the world economic slowdown following the bursting of the dot-com bubble in the U.S. and the September 11 th terrorst attack in the U S A small recovery is expected in 2002 as recovery of the U.S. economy appears to be gaimng momentum.

The capitalization and trading volume of these equity markets **is** extremely small compared to that of some major stock markets, particularly those in the U.S. (See Table 5 13 for some comparisons) 8I
Table 5.13 <!-- Start of picture text --> Stock Market Capitalizations<br>(US$ billion)<br>Market 1995 1996 1997 1998 1999 2000<br>New York (Dow Jones Industrial) 5,950 7,210 8,900 9,654 13,400 16,755<br>Tokyo (Nikkei) 3,440 3,150 2,285 2,375 3,560 3,795<br>London (FT100) 1,380 1,410 1,780 2,070 2,750 2,665<br>Hong Kong (Hang Seng) 301 428 384 353 509 515<br>Taipei (Weighted Price) 176 287 313 264 300 417<br>Seoul (Composite) 198 144 53 75 272 252<br>Singapore (STI Ind Index) 169 184 127 110 207 173<br>Kuala Lumpur (Composite) 214 302 97 92 140 159<br>Manila (Composite) 56 80 35 31 37 19<br>Bangkok (SET) 139 105 25 32 52 40<br>Jakarta (Composite) 66 93 36 17 29 41<br>Total Southeast Asia 644 764 320 282 465 432<br>SE Asia as percent of Dow Jones 10.8 10.6 3.6 2.9 3.5 2.6<br>SEAsia as percent of HKSE 214.0 178.5 83.3 79.9 91.4 83.9<br>Source: Freeman (2000: Table 1, 4)<br><!-- End of picture text --> The above table shows that as of June 2000, the aggregate capitalization of Southeast Asia's five stock markets was US$432 billion, which was only about 3 percent of the Dow Jones, 16 percent of the London Stock Exchange, and 3.6 percent larger than 216 the exchange in Taipei.

Table 5.14

|S|tockMarketC|apitalization||
|---|---|---|---|
||(percent <br>|ofGDP)<br>||
|||Jan.1990|Jan.1995|Jul.2000|
|Indonesia|n.a.|22.8|33.8|
|Malaysia|n.a.|248.8|165.0|
|Thailand|n.a.|85.6|40.3|
|Singapore|122.9|236.3|261.9|
|Korea|54.8|41.2|66.4|
|China|n.a.|n.a.|8.1|
|Taiwan|154.8|84.3|119.9|
|HongKong|110.1|218.1|336.7|
|Australia|45.9|61.8|35.6|
|U.S.|50.6|62.5|184.5|
|Source:Wilso|n(2002,Table|2.3,26)||

Table 5.14 puts the capitalization level into perspective (showing stock market capitalization as a percent of GDP) and also shows changes over time. The degree of capitalization has increased and Wilson (2002) attributes this to a greater degree of 82
'equitisation' of (i.e., entry of new firms<sup>into) the economyas opposedto the result of a</sup> rapid index growth.<sup>21 7</sup> He suggests that<sup>the latter would be the explanationfor thegrowth</sup> of capitalization in the U.S., which is related<sup>to thestock market boom of the latter half of</sup> the 1990s.

Table 5.15

|**StockMarketLiquidit**<br>|**y***<br>|
|---|---|
|**erae**|**vrae**|
|**g**<br>**(1990-95)**<br> <br>|**g**<br>**(1995-00)**<br>|
|Indonesia<br>3.7<br> <br>|3.7<br>|
|HongKong<br>4.1<br> <br>|5.2<br>|
|NYSE<br>4.1<br> <br>|5.8<br>|
|Malaysia<br>3.8<br> <br>|4.1<br>|
|Korea<br>0.6<br>|1.5<br>|
|China<br>n.a.<br> <br>|6.7<br>|
|Taiwan<br>25.1<br> <br>|23.8<br>|
|Thailand<br>8.4<br>|4.9<br>|
|Singapore<br>n.a.|3.1|
|<br>*monthlymarkettumoverasaper<br>stockrelativetomarketcapitalizati<br>Source:Wilson(2002:Table2.4,2|centage<sup>of</sup><br>on<br>6)|

Stock market liquidity (shown in Table<sup>5.15)has increasedin several countriesof</sup> the region in the latter half of the 1990s<sup>but in most casesremainslower than that in the</sup> U.S. Taiwan, which has a high level of<sup>tuxnover,2'8is anotable exception.</sup> Freeman and Bartels (2000) assert that stock<sup>markets are of primaryimportance to</sup> Southeast Asia's post-crisis recovery, which<sup>they viewas primarily,although not</sup> exclusively, involving corporate sector<sup>debt restructuring,particularlyfor Indonesiaand</sup> Thailand. With bank lending still constrained<sup>anddevelopment of a regional bond</sup> market a long-term possibility, they see<sup>theequity marketsof theregion as importantfor</sup> obtaining necessary capital, some of which<sup>must comefromabroad.</sup> In a review of the five Southeast Asian<sup>equity markets,Freeman(2000) identifies</sup> several weaknesses in the region's<sup>equity marketsincluding low capitalizationand</sup> trading volume, as well as sectoral bias.<sup>This bias refers to the overrepresentationin the</sup> equity markets of banks and finance<sup>companies(with their high levels of non-perfomiing</sup> loans) and property development companies<sup>(withtheir high leverageand vacant</sup> buildings). On the other hand, high<sup>tech companies (electronics,computer-related,</sup> telecommunications, media, etc.) are underrepresented<sup>-even though theseare of more</sup> interest to institutional investors.<sup>219</sup> Singapore<sup>is an exceptionwith only19.6 percent</sup> (April 2000) of total market capitalization<sup>in the financesectorcompared to 42 percent</sup> for Manila and 34 percent for Jakarta.<sup>220There arealso problems with the stocks</sup> underlying the markets as the well-documented<sup>needfor improved corporategovemance</sup> attests.

83
Yang and Siregar (2001) found, based on a review of the literature and their own empirical work, that the financial liberalization of Asian economies in the 1980s and early 1 990s enhanced interaction and integration among the stock markets in the AsiaPacific region. However, in the period following the crisis, there appeared to be no longrun relationship among the returns of these markets, but a strong short-run relationship was found, which suggests to the authors that the movement in these stock markets is unrelated to changes in fundamental economic conditions. This implies that "stock markets in the Asia-Pacific region do not satisfy the criteria for full information efficiency and this may be evidence that Asia-Pacific stock markets are subject to speculative bubbles."<sup>2</sup> Freeman (2000) acknowledges there are steps that could be taken on a national basis to improve the functioning of individual markets and these include:<sup>222</sup>

- Improving the regulatory environment that pertains to the equity markets

- Sk Ending the use of distinctions between foreign and local share, and/or ceilings on cumulative foreign holdings of stocks

- Making strides to improve levels of corporate disclosure by listed firms

- Liberalizing the listing requirements

- 'Spring cleaning' the indices of stocks that have been unable to recover from the impact of the Asian financial crisis.

However, he makes another, more comprehensive, proposal and that is the formation of a regional equity market through the consolidation or merger of existing major markets and involving interested ASEAN countries<sup>223</sup>

# **A Regional Equity Market**

Freeman (2000) views the proposal for a regional equity market as the "portfolio investment equivalent" of the ASEAN Investment Area (AIA), which is designed to attract FDI into the region. Although the combined capitalization level (see Table 5.13) would still be small by global standards, it would be enough, in his opinion, to keep these markets from being dismissed altogether by institutional investors. It would raise liquidity levels that could lessen the chances of capital flows actually driving market performance, which is now the case. It might also reduce the problem of sectoral imbalance although would probably not eliminate it altogether. The presence of Singapore's more balanced SGX in the aggregation could help to reduce sectoral skewing.

He identifies several problems of a political and logistical nature in this proposal. From a political perspective, there is the view that a country's equity market is a sign of modernity and a strategic asset that should not be strongly influenced by foreigners. There is also the issue that the larger markets (e.g., Singapore) might perceive a regional market as potentially diluting to their existing strength. From a logistical perspective, there would need to be consistency among the five markets in terms of trading systems, settlement and payment systems, membership structure, listing requirements, fee structure, et cetera.

In order to mitigate potential political issues, he suggests that the pan-regional entity might be newly created, rather than being derived from an already existing equity market. Although it would need to have a minimal physical presence somewhere in the region (Singapore being the most likely location, in his opinion), it could function on a virtual basis.

84
Solving logistical issues would be somewhat more<sup>involvedalthough his</sup> examination of one area (i.e., listing requirements)<sup>across the five marketsrevealed that</sup> despite many differences, there are broad consistencies<sup>for primary criteria.Furthermore,</sup> he suggests that needed logistical changes could<sup>be carriedout incrementallyin a manner</sup> similar to the process for AFTA and the AIA. He<sup>alsosees the possibilityof building a</sup> regional corporate bond market in conjunction<sup>with a regional equity market.</sup> Freeman sees the development of a regional equity<sup>market as part and parcelof</sup> the move toward regional cooperation, which<sup>sofar hasbeen concentratedon trade and</sup> FDI. In his view, it is essential to attract foreign<sup>institutional investors back to the</sup> region's markets through improved corporate disclosure<sup>andmore protectionof the rights</sup> of minority shareholders, among other things.<sup>He places the onus for accomplishing this</sup> on regional authorities.

There is, however, considerable ambivalence in the<sup>region towardforeign</sup> investors. Given the limited number of institutional<sup>investorsin the region andthe</sup> tendency of individual investors to prefer less<sup>riskyinvestments(e.g.,bank deposits),</sup> regional authorities can readily see the need<sup>to attract foreign investors.On the other</sup> hand, because of their perceived negative role<sup>in the crisis,there is still considerable</sup> distrust where foreign investors are concerned.<sup>224Rajan andSiregar (2002)expressthis</sup> dilemma as follows, "The challenge for<sup>regional policymakers is to facilitate the ongoing</sup> recovery in foreign capital inflows while ensuring<sup>that the economies' vulnerabilitiesto</sup> sudden reversals in capital flows do not increase<sup>in tandem."225</sup> This, of course, underlies much of the discussion on this<sup>issue.A definitive regionalsolution has not</sup> been found, although certain countries have<sup>had some successwith specificnational</sup> policies (e.g., Malaysia's capital controls).

Although well argued, it is uncertain whether<sup>formation of aregionalequity</sup> market would signal foreign investors that ASEAN<sup>is seriousabout creating a regional</sup> environment conducive to business and generate<sup>ahigher benchmarkof performance</sup> across Southeast Asia, as Freeman suggests.<sup>Whatcannot be disputed is that underlying</sup> the creation of a regional equity (or corporate<sup>bond)marketis the needfor improved</sup> corporate governance and financial market reform.<sup>Furthermore, there are those who</sup> argue that focusing on financial reform will<sup>leadnaturally to well-developedcapital</sup> markets and the appropriate financial structure will<sup>emergeat eachstageof development.</sup>

# **Focusing on Financial Development Rather**<sup>**Than Financial**</sup> **Structure**

A slightly different perspective on the relationship<sup>betweenfinancial</sup> development/financial structure and economic growth<sup>is presented ina recent volumeof</sup> work edited by Demirgiiu-Kunt and Levine. The<sup>studiesand analyses in thisvolume</sup> find, "Overall financial development matters<sup>for economicsuccess,but financialstructure</sup> per se does not seem to matter much.,,<sup>226The editorssuggestthat it wouldbe more</sup> beneficial if policymakers focused on legal,<sup>regulatoryand policy reforms in order to</sup> improve the functioning of both markets and banks<sup>ratherthan being concernedabout the</sup> extent to which their financial system is bank-based<sup>or market-based.</sup> Demirgiuc-Kunt and Levine (2001 a) found in their<sup>own analysis that at higher</sup> levels of income, financial sector development overall<sup>for bank-basedandmarket-based</sup> 85
institutions is greater. In other words, both banks and stock markets are larger, more active and more efficient in richer countries. Also, stock markets (relative to banks) become more active and efficient in higher-income countries. Finally, the authors examined financial structure relative to legal, regulatory, tax, and macroeconomic determinants and found that countries having a "Common Law tradition<sup>227</sup> , strong protection for shareholder rights, good accounting standards, low levels of corruption, and no explicit deposit insurance tend to be more market-based, even after controlling for income. On the other hand, countries with a French Civil Law tradition, poor protection of shareholder and creditor rights, poor contract enforcement, high levels of corruption, poor accounting standards, heavily restricted banking systems, and high inflation tend to have underdeveloped financial systems in general, even after controlling for income."<sup>228</sup> Some of these findings are presented in Table 5.16 below for selected countries.

Table 5.16

|Indicator|sofFinancialDevelo|ment,FinancialStruct|ureandthe**Le**|al**System**|acrossCoun|tries|
|---|---|---|---|---|---|---|
|Country|Finance-activity|Structure-actvity|**AntI-director**|Creditor|Ruleof**law**|**Legal**origin|
|India|-4.35|-1.61|**5**|<br>4|2.50|E|
|Japan|-0.43|-1.00|4|2|5.39|G|
|Malaysia|-1.08|-0.32|**4**|**4**|4.07|E|
|Philippines|-4.17|-1.47|**3**|**0**|1.64|F|
|Thailand|-1.98|-0.92|**2**|<br>3|3.75|E|
|Australia|-2.14|**-1.18**|4|**1**|6.00|E|
|NewZealand|-3.14|-1.64|4|**3**|6.00|E|
|Denmark|-3.63|**-1.87**|**2**|<br>**3**|**6.00**|S|
|France|-2.57|-2.28|**3**|<br>**0**|5.39|F|
|Germany|-1.76|-1.52|1|<br>**3**|5.54|G|
|**Italy**|-3.89|-2.52|**1**|<br>**2**|5.00|F|
|**Switzerland**|0.55|-0.39|**2**|1|6.00|G|
|United**Kingdom**|-1.33|-0.74|5|**4**|**5.14**|E|
|UnitedStates|-0.80|-0.64|**5**|**1**|**6.00**|E|
|NOTES:<br>Finance-actvity=Indica<br>Structure-aclvlty=Indic<br>Creditor=Indexofdegre<br>d acompany. Ranges|toroffinancialdevelopment;<br>atoroffinancialstructure;a<br>etowhichlegalcodesofa<br>from0to 4 with0beinglow|ameasureofoverallactivit<br> measureoftheactiMtyof s<br> countryprotectdalmsofse<br>est|yoffinancialIntem<br>tockmarketsrelativ<br>cured creditorsIn|iediariesand<br>etotheactiv<br> caseofreorga|markets.<br>tyofbanks.<br>nzationorriquida|Uon|

Ant-director = Index of degree to which legal codes of a country protect minority sharehdder rights. Ranges from.0 to 6 with 0 lowest. Rule of law = Assessment of law and order tradition of a country. Ranges from 10 (strong law & order tradlUon) to 1 (weak tradition) Legal origin: E = BitUsh, F = French, G = German, S = Scandinavlan _Source:_ **_Beck._** _Demirguc-Kunt, Levine,_ **_and_** _Maksimovlc (2001:_ **_Table_** _SAI, Appendr_ **_5.1,_** _234-230)_ In financial development<sup>22 9</sup> (represented by the indicator 'Finance-activity' in the above table), Switzerland has the highest value and India, the lowest. Although too few countries are included to make an overall assessment of the Asian region, the results are as might be expected in that Japan's financial development is highest among those listed while India and the Philippines are at the low end with Malaysia and Thailand in between.

'Structure-activity' gives an indication of a country's financial system being more market-based or bank-based relative to other countries in the sample.<sup>230</sup> The remaining 86
indicators provide information regarding legal and regulatory<sup>differenceswith three</sup> indicators ('Creditor', 'Anti-director', and 'Rule of law') reflecting<sup>the rightsof outside</sup> investors and the degree to which they areprotected<sup>while 'LegalOrigin'refersto the</sup> classification of a country's legal system.2 The protection of secured creditors ('Creditor') and minority shareholders ('Anti-director')<sup>arefairly strongin India and</sup> Malaysia but weaker in the Philippines and Thailand<sup>with Japanbeing weak in theformer</sup> but strong in the latter.<sup>232</sup> It is interesting to note that<sup>in terms of securedcreditor</sup> protection Japan is at about the same level as other countries<sup>witha Gernan-originated</sup> legal system (e.g., Germany and Switzerland).<sup>233However,Japan'sprotection of</sup> minority shareholders is considerably stronger than<sup>that of thesetwocountries.234</sup> The secondary importance of financial structure (bank-based<sup>or market-based)is</sup> further supported by the findings of Schmukler and<sup>Vesperoni(2001)in their analysisof</sup> cross-country microeconomic data. Their results<sup>suggestthat for emerging markets,</sup> whether they are bank-based or market-based is less<sup>important thanthe fact that they are</sup> emerging markets. They also found that<sup>integrationwith world capitalmarkets has</sup> similar effects on firns whether they operate<sup>in a bank-basedor market-basedsystem.</sup> They conclude, "[ ... ] the financial sector<sup>of emergingmarkets(either bank-basedor</sup> market-based) needs further development and can<sup>potentiallybenefitfromintegration</sup> with international markets."<sup>235</sup> The Demirgiiu-Kunt and Levine studies reveal that as a<sup>countryundergoes the</sup> development process its financial structure will tend<sup>to change"because banksand</sup> markets have different requirements concerning<sup>information and contract enforcementin</sup> order to function effectively."<sup>236</sup> Thus, based on this research,<sup>it appears advisablefor</sup> policymakers to focus on financial development<sup>through the reformation of the legal and</sup> regulatory environment allowing the financial structure<sup>to evolve naturallyfrom that.</sup> Again, we come back to financial market reform<sup>as thefocus recommendedfor</sup> policymakers.

# **Conclusion: How to Achieve the Goal**

The goal, as stated at the beginning of this section, is<sup>todevelop the region's</sup> financial sector to a level of soundness and stability<sup>that would not only reducethe</sup> chances of another crisis but also promote economic<sup>growth in the region.We have</sup> presented basically two approaches for the achievement<sup>of this goal:(1) focusingon</sup> changing financial structure so as to move away<sup>from the currently dominant bank-based</sup> system to a more market-based system and (2) focusing<sup>on reformingthe regulatory,</sup> legal and macroeconomic environment which will lead<sup>naturally toa moveaway froma</sup> bank-based to a market-based system. These<sup>approachesappear atfirst glanceto be</sup> opposites. However, upon closer examination it can<sup>be seen that the ultimate outcomeis</sup> the same - although approached from different<sup>directions.</sup> In the first approach, developing corporate bond markets<sup>is proposedas an</sup> altemative method of financing for firms that have traditionally<sup>relied on the banking</sup> sector. However, corporate bond markets in the region<sup>are nowsignificantly</sup> underdeveloped with a narrow issuer base and<sup>limited investors (particularly institutional</sup> investors), among other problems. While some progress<sup>in developing corporatebond</sup> markets has been made in individual countries,<sup>a</sup> great<sup>dealof work remainsto bedone.</sup> It will be. a costly and lengthy process requiring<sup>years, even decades,tocomplete.</sup> 87
Because of this, as well as a sense of urgency since the Asian crisis, an interim plan has been proposed whereby banks would play a major role in the development of bond markets. Although banks already figure prominently as investors and issuers in the region's bond markets and there are a number of advantages to pursuing this path, there are also well-recognized risks associated with banks' involvement in the securities business. Given the weaknesses that already exist in the region's banking sector, these risks cannot be dismissed lightly. Thus, an important part of this proposal is the strengthening of the banking sector. Preferably, this would be carried out prior to increasing or formalizing its bond market activities. In conjunction with this, the need for improving corporate governance cannot be overlooked.

Another path to bond market development has also been proposed. The creation of a regional bond market is seen as potentially more cost effective than developing individual country markets given the small size of the individual economies in the region. Although the creation of a regional bond market would not necessarily require the participation of every country in the region, there would need to be a high level of cooperation and compromise among those that do choose to participate. The process would be complex and also extremely time consuming to carry out. It would thus be a long-term endeavor rather than a possibility for the near future.

A regional equity market, although less often mentioned in the discussion of regional capital market development, has also been proposed. A number of individual equity markets already exist in the region with some of these being fairly well capitalized (e.g., Hong Kong, Singapore, Taipei and Tokyo). In addition, there is ample evidence that some countries utilize a high level of equity financing. While some efforts have been made to link exchanges in the region, the creation of a regional equity market (as for a bond market) would entail a high level of cooperation and the need to overcome a number of political and logistical problems.

Underlying the above-mentioned proposals is the necessity to restructure the banking and corporate sectors of the region. Even though the development of bond and equity markets is seen by many as an essential part of financial development in the region, there is recognition that this must be accomplished in conjunction with strengthening of these sectors. The second approach described in this section starts with financial restructuring and allows the development process to bring about changes in financial structure that are appropriate at each level of development.

Regardless which of the above approaches is chosen as the route to financial development in the region, it is apparent that the process will be complex and lengthy. This raises the question of how the process should be undertaken and at what level (or levels) - national, regional or intemational - it should be pursued. Should it be controlled, guided or overseen by regional institutions or through regional cooperation, or should it be led by national governments. What, if any, should be the role of international institutions?

Of course, a variety of opinions and recommendations abound. There are those who believe the process should be handled entirely at the national level, those who think that regional institutions can help, and those who believe that international institutions and developed countries, who have extensive experience in this area, should be involved. Most believe it cannot be accomplished without involvement of the private sector.

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Nam et al (2001) indicates that one obvious and desirable policy direction in the post-crisis period (for those wanting to take best advantage of liberalized capital markets) is to move away from the pre-crisis relationship-based system, accompanied by weak corporate governance and inadequate financial supervision, towards a market-based system with strengthened corporate govemance and supervisory institutions. In order to successfully carry out this endeavor the authors believe a third party is required to change the rules and to provide leadership in the move to this "new, better equilibrium". In<sup>their</sup> opinion a "natural candidate" for this role is the national government, albeit in cooperation with intemational organizations and other governments and with significant involvement of the private sector. They reason that involvement at the national<sup>and</sup> intemational levels is necessary because there is no incentive for any individual<sup>playerto</sup> take on the role unilaterally. 23 The aforementioned proposal of the Asian Policy Forum (APF) regarding the strengthening of banks in conjunction with the development of bond markets<sup>comprises</sup> both regional and national elements. Guidelines and suggestions are being<sup>madeat the</sup> regional level (through the APF, which includes participants from all over Asia) but this entity has no enforcement power so that compliance would be up to each individual country.

Eichengreen (2001) suggests that regional cooperation could be effective in the promotion of financial stability and development in the region. Costs could be lower at the regional level than at the international level and agreement could be facilitated<sup>by the</sup> sharing of common problems by regional govermments. Specifically he recommends establishment of a new forum, an "Asian Financial Institute" (AFI) based on the ASEAN+3 platform.

He foresees the responsibilities and activities of such an institution including the provision of technical assistance on prudential supervision and regulation to national agencies, the administration of training programs for inspectors, supervisors and accountants, the provision of central banking services (e.g., clearing and settlement) to member central banks, and the negotiation of distinct financial standards for the region, among others. He sees an AFI as accepting input from national regulators and authorities but having considerable power in monitoring compliance and imposing penalties. A major stipulation of this proposal (one that could very well mean its nonacceptance in the region) is the abandonment of "ASEAN's consensual approach to surveillance and presumption of nonintervention in national affairs for a more forceful approach." Without this, "a meaningful regional arrangement to promote financial stability and development [...] would not be possible."<sup>2</sup> 8 Eichengreen does not view an AFI working in isolation but rather in cooperation with intemational fora so as to ensure consistency in financial standards and financial development strategies.

At the international level, of course, standards for capital markets already exist and could conceivably be adopted by developing countries. However, despite<sup>the</sup> benefits that could be derived from their adoption, such as the reduction of information problems and the improvement of access for developing countries to the international financial system, these standards generally reflect conditions in developed countries so that they may not in all cases be appropriate for developing countries. The setting and implementation of international standards has to date been carried out primarily by industrialized countries. Developing countries naturally want to be a part of the standard 89
setting process if they are to adopt those standards into their national regulatory and supervisory regimes.

There is also some disagreement regarding implementation of intemational standards. Developed economies, represented by the G-7, are seeking rapid<sup>and complete</sup> compliance even suggesting that it become part of IMF conditionality<sup>whiledeveloping</sup> countries (represented by the G-24) prefer adoption to be voluntary and gradual.<sup>239</sup> Haruhiko Kuroda, Vice Minister for Intemational Affairs for Japan,<sup>in referringto the</sup> Basel Committee on Banking Supervision (BCBS) as the established intemational organization for supervising banks whose members are all from industrialized<sup>countries</sup> says, "If the IMF were to force emerging economies to abide by the rules<sup>decreedby the</sup> Basel Committee, such a move might be resisted."<sup>240</sup> Of course, developed countries and intemational institutions certainly<sup>have the</sup> experience and knowledge to provide adequate advice in this area; however, while cognizant of that, the current politico-economic mood in the region might limit the extensive involvement of these entities. Since the Asian crisis, and its perceived mishandling by the IMF and lack of assistance from the U.S., calls for<sup>regionalsolutions</sup> have increased. Also, recent events (i.e., the collapse of energy trader<sup>Enron2 4'in the</sup> U.S. and the heavy losses incurred by a forex trader at Allfirst, U.S. subsidiary<sup>of Allied</sup> Irish Bank<sup>242</sup> ) have cast serious doubts on the transparency and managerial<sup>competence</sup> of the financial services industry in the U.S. and Europe. The claims of<sup>superiority in the</sup> areas of corporate govemance by the developed countries might now be conceivably<sup>met</sup> with skepticism in Asia.

Even setting standards at the regional level could be difficult. Differences<sup>in the</sup> level of financial market development among the countries of the region<sup>imply different</sup> needs in terns of markets and financing sources. For example, a bank-based<sup>system can</sup> be advantageous in a country where legal and accounting systems are<sup>weakor contract</sup> enforcement is poor since strong banks can apply pressure to firms to obtain<sup>information</sup> and payment of debt.<sup>243</sup> The standard-setting process would be complex<sup>and requirea</sup> high level of cooperation, communication and preparedness. It<sup>is</sup> not<sup>clear that currently</sup> existing regional institutions in East Asia are at a stage where they could<sup>undertakesuch</sup> an endeavor, and to establish new institutions to undertake the project (as<sup>suggested by</sup> Eichengreen) seems redundant.

A look at the EU's experience puts into perspective how difficult<sup>it would be to</sup> develop regional markets and standards. The EU has achieved<sup>a</sup> currency<sup>union but is</sup> still in the early stages of creating a single market for financial<sup>services.244"At present,</sup> investors who want to trade in shares in more than one EU country have<sup>to contend with</sup> such a baffling array of regulations, red tape and languages that few bother<sup>trying.',245A</sup> recent study by the European Financial Services Round Table, which is<sup>a forunof banks</sup> and insurers, found that the creation of a Europewide market for financial products, which at present does not exist, would increase competition and wider<sup>choice,and thus</sup> save consumers and investors as much as El 5 billion a year.<sup>246</sup> Given the realities of the politico-economic situation in East Asia,<sup>it is most likely</sup> that the national authorities will have the primary role in directing the process. This observation is bome out by the recent comments of Rodolfo Severino,<sup>secretary-general</sup> of ASEAN, on the related topic of a common currency for the region. He said that ASEAN members desire to control their own economic destinies and are<sup>reluctantto give</sup> 90
up decisionnaking power where their own economies are concerned.<sup>247</sup> Nonetheless, it would be most likely that they would not operate in a vacuum but would be open to some involvement by regional and international players as well.

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# **Capital Account Liberalization**

It is widely acknowledged that the sudden withdrawal of capital from Asia played a primary role in the 1997-98 crisis. This followed a huge inflow of capital<sup>into the</sup> region in the years leading up to the crisis, resulting from a relatively<sup>significantdegree</sup> of capital account liberalization in the crisis-affected countries in the early 1990s. (See Table 5.1 earlier in this chapter.) It was widely believed that financial<sup>liberalization in</sup> general, and capital account liberalization in particular, were essential stepping<sup>stoneson</sup> the path to economic growth. It was thus recommended (some say by the Washington Consensus) that developing countries open their capital accounts,<sup>and thesecountries</sup> embraced the idea wholeheartedly. The East Asian crisis (and its aftermath)<sup>has altered</sup> that thinking to a great extent. Wyplosz (2001 b) even declares, "A silver lining of<sup>the</sup> recent crises is that the liberalization activism of the 1990s is _nowpass."_<sup>_248_</sup> Nonetheless, financial liberalization as an ultimate goal is not dead and the way to proceed towards its achievement has engendered considerable debate.

Academic studies over the last decade have found the relationship between<sup>capital</sup> account liberalization and growth to be generally positive, but not strong.<sup>Tenof these</sup> studies conducted between 1994 and 2001 were reviewed by IMF staff<sup>whofound the</sup> conclusions to be about evenly split between a finding of a "positive'<sup>relationshipand</sup> that of "no effect".<sup>249</sup> Those studies with a finding of "positive" were conducted<sup>more</sup> recently (2000-2001). One study was reported as having a "mixed" result.<sup>This study</sup> was conducted by Arteta, Eichengreen and Wyplosz (2001) who found "somewhat more evidence of a correlation between capital account liberalization and growth when<sup>we</sup> allow the effect to vary with other dimensions of openness."<sup>250</sup> The authors go on to explain that sequencing of reforms plays a role in the effect of capital account liberalization (although they found this to be more robust in the 1980s than in the 1970s or 1990s), but macroeconomic imbalances are potentially more harmful than<sup>the lack of</sup> trade openness under capital account liberalization.

The review of these studies (plus the results of the IMF's own study of 38 developing countries for the period 1980 to 1999) found that the channels<sup>throughwhich</sup> capital account liberalization can positively impact growth include the following:<sup>25'</sup>

- For developing countries, all forms of capital inflows can increase investment. In the case of domestic investment specifically, liberalization does have a positive effect in raising that as well.

- Capital account liberalization (particularly FDI) can bring technology spillovers but primarily in countries that have a highly educated workforce, which enables it to exploit such spillovers.

- Capital account liberalization can lead to a deepening of domestic<sup>financial</sup> markets (more so in the case of portfolio flows than FDI); however, it<sup>can</sup> also result in severe financial difficulties if the appropriate institutional framework is not in place.

While most regions of the world have been opening their capital accounts throughout the 1980s and 1990s, there are differences in degree of opening within developing countries across regions. The developing economies of Asia have been trending toward openness since the 1970s - in FDI as well as in portfolio<sup>and barnkflows,</sup> 92
which rose significantly in the early 1 990s. Among developing<sup>countries,Asian</sup> countries are the largest users of FDI flows (average for 1970-2000),<sup>whileLatin</sup> American countries constitute the largest users of portfolio flows.<sup>This can be attributed</sup> to a history of larger fiscal deficits in Latin America relative to<sup>Asia,whichled to more</sup> floating of government bonds and the earlier development of<sup>capitalmarketsin some</sup> Latin American countries.<sup>252</sup> The events associated with the East Asian and other crises<sup>haveclearly</sup> demonstrated that the road to financial liberalization is fraught with<sup>risk.Wyplosz</sup> (200 lb) studies the effect of domestic and external financial liberalization<sup>on both</sup> developing and developed countries. Among his findings are the<sup>following:(1)capital</sup> account liberalization is the "most sensitive step" of the<sup>financialliberalizationprocess,</sup> (2) the capital inflow problem associated with liberalization is<sup>greater for developing</sup> countries than for developed countries, (3) while liberalization reduces<sup>foreign exchange</sup> pressure in the long term, initially it causes instability that can last<sup>for several years,and</sup> (4) immediately after capital account liberalization, developing countries<sup>experience a</sup> boom (nearly 15 percent of GDP), but this is followed by<sup>asharp contraction.</sup> Capital controls have been used by some countries in response<sup>to the large</sup> inflows that follow capital account liberalization or the large outflows<sup>associated witha</sup> crisis. Controls on cross-border capital flows are generally of two types:<sup>(1)</sup> administrative (direct controls), which are prohibitions, that are<sup>either outrightor involve</sup> an approval procedure, on capital account transactions and (2) market-based<sup>(indirect</sup> controls), which discourage cross-border flows by making them<sup>morecostly, e.g.,</sup> through the use of taxes or other price-based measures.

Controls on inflows are more commonly used in the event of<sup>aspeculativebubble</sup> and are becoming increasingly accepted as a short-term<sup>prudential measurefor</sup> preventing the accumulation of short-term foreign liabilities, especially<sup>by lower-income</sup> economies while improving their financial supervisory systems.<sup>253Controlson outflows,</sup> however, are often implemented during a currency crisis associated<sup>withaspeculative</sup> attack and are less widely endorsed although acknowledged to have been<sup>successfulin</sup> some cases where they were used. Controls are generally imposed<sup>on short-termflows</sup> because of their potentially speculative nature and destabilizing effect.<sup>Short-term,rather</sup> than long-term, flows were the core of the problem during<sup>the EastAsian crisis.</sup> Controls on short-term capital inflows were used on several<sup>occasions during the</sup> 1990s, specifically by Brazil (1993-97), Chile (1991-98), Colombia<sup>(1993-98),Malaysia</sup> (1994), and Thailand (1995-97). In all five cases, the controls<sup>wereput in placebecause</sup> of concerns over the negative effects 'of large capital inflows into developing<sup>economies</sup> in the 1 990s. The principle motivation in all cases was to<sup>maintainan interestrate</sup> differential between domestic and foreign interest rates while at the<sup>same time reducing</sup> pressure on the exchange rate. While initially effective, they<sup>did not result in the</sup> achievement of both of these objectives. There is evidence<sup>thatthey were partlyeffective</sup> in Malaysia and Thailand in controlling the level and maturity of<sup>inflowsandallowing</sup> the reduction in the use of sterilization operations. In Colombia, and possibly<sup>in Chile,</sup> they were effective in maintaining a differential between domestic<sup>and foreigninterest</sup> rates. In the case of Brazil, the controls were largely ineffective.<sup>25 4</sup> Instances where controls on capital outflows have been used<sup>include Malaysia</sup> (1998-2001)"', Spain (1992), and Thailand (1997-98). In the<sup>caseof Malaysiaand</sup> 93
Thailand, controls were imposed in response to the East Asian crisis to stop the flow of capital out of the country and counteract downward pressure on their exchange rates. At the time, Thailand had a pegged exchange rate regime and Malaysia had a managed float but later fixed the ringgit to the U.S. dollar when it imposed its capital controls. The goal of each was to curtail speculation and stabilize their currencies by restricting access to domestic currencies by nonresidents.

The effectiveness of these controls was mixed. In Malaysia, capital outflows were largely contained by the elimination of the offshore ringgit market (through the restriction on access to the currency by nonresidents), by restrictions on the repatriation of portfolio capital by nonresidents, and on the outward investments of residents. The currency was stabilized and has remained so. In Thailand, the controls were initially effective and speculative attacks temporarily halted. However, the offshore market was still active and large return differentials and expectations that the baht would be depreciated undermined the effectiveness of the controls. Thailand eventually floated the baht.<sup>256</sup> At the time Malaysia imposed its capital controls (September 1998) the international prognosis was generally negative with predictions of loss of investor confidence and a decline in investment (FDI inflows), which were particularly important to Malaysia. This was despite the fact that Malaysian authorities took steps to exempt FDI and current account transactions from the controls. While there is now widespread agreement as to the success of Malaysia's controls (even by the IMF), there is less agreement as to the reason for this. The conventional view is that timing played a sigrnificant role and that Malaysia was about to recover from the crisis anyway particularly in light of the recovery of Korea and Thailand at the same time with no imposition of capital controls. Kaplan and Rodrik (2001) analyze the effectiveness of Malaysia's capital controls in its recovery relative to the recovery of Korea and Thailand, both of which utilized the IMF program. They conclude that the controls were effective in stabilizing the financial markets, which allowed authorities greater monetary and fiscal autonomy. They also conclude that the controls permitted a faster recovery than would have been possible under the IMF program.<sup>257</sup> In fact, the IMF has since indicated its agreement with the former of these findings; i.e., that the capital controls "appear to have provided some breathing space in which to implement more fundamental policy reforms [. .. ]." However, it tempers this acknowledgement by stating that this was "at the cost of weakening the confidence of international investors, thereby increasing the cost of funding from abroad, weakening FDI flows somewhat, and producing large administrative costs.",<sup>258</sup> On the other hand, Malaysia was not left with high debt levels to international lending institutions as were Korea and Thailand. In the IMF's view, the effectiveness of Malaysia's controls was enhanced by factors such as "macroeconomic and structural adjustments," as well as the "authorities' strong enforcement capacity and favorable exchange rate developments."<sup>25 9</sup> In fact, the effectiveness of Malaysia's capital controls, versus the long-term ineffectiveness of Thailand's controls, has been attributed in part to the fact that they were so comprehensive and succeeded in effectively eliminating the offshore ringgit market whereas leakages occurred in Thailand's case. IMF staff, however, have hypothesized that the capital controls implemented by Thailand earlier in the crisis (and which failed) may have worsened the situation in that country by delaying its implementation of the structural reform and stabilization package.

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The previous discussion has focused on the use of capital<sup>controls(on outflows)</sup> as a means to control international flows in a crisis situation.<sup>Capital controls, however,</sup> can also be effective in risk management associated with international<sup>capitalflows in</sup> non-crisis situations. High risks are associated with capital account<sup>liberalizationin the</sup> absence of well-developed financial supervisory and regulatory<sup>systems.Prudential</sup> policies applied to financial institutions can limit the vulnerability<sup>of the economyto the</sup> risk of excessive international capital flows by strengthening<sup>thefinancialsystem,thus</sup> enabling it to deal with market volatility and may even, in some<sup>cases,reduce the</sup> volatility of flows through financial institutions.'61 Prudential<sup>regulation and supervision</sup> could therefore be considered as an alternative to the<sup>imposition of capitalcontrols.26 2</sup> On the other hand, under circumstances where prudential<sup>policiesare not well</sup> developed (or where nonfinancial firms play a significant role),<sup>capitalcontrols can be</sup> useful in the management of some risks associated<sup>withinternational capital flows.It</sup> should be emphasized, however, that no single type of<sup>capital control is appropriatefor</sup> every country in all situations, and they can be complex,<sup>difficult to administer and</sup> generally require strong enforcement capability. Direct<sup>controlsaregenerally easierto</sup> administer than indirect controls but they can be distortionary in<sup>the preventionof sound,</sup> as well as risky, flows. Nonetheless, capital controls may<sup>be usefulparticularly in</sup> countries that lack well-functioning prudential policies; i.e., market<sup>discipline,</sup> transparency and internal controls in financial institutions.<sup>263</sup> Wyplosz (200 lb) recommends the following for minimizing the<sup>problems</sup> associated with capital account liberalization for<sup>developing countries.</sup>

- Wait until 'a proper economic, and possibly political, infrastructure<sup>can be</sup> built in order to reduce the possibility of pressure on exchange<sup>ratesand</sup> boom-bust cycles.

- Prepare in advance for liberalization by implementing<sup>adequatewelfare</sup> systems and build up public savings via fiscal policy so as to have<sup>financial</sup> reserves on hand in the event of a bust.

- While acknowledging that the debate on "fixed versus<sup>floating" and"extremes</sup> versus the soft middle" is ongoing, some form of exchange<sup>rateflexibility</sup> (i.e., floating or the ability and willingness to realign pegs) is essential<sup>during</sup> liberalization so that a temporary revaluation in the capital inflow<sup>stage and</sup> devaluation in the event of outflows could prevent a speculative<sup>attackand</sup> ensuing crisis.

- Sequence liberalization over several years starting with the domestic<sup>goods</sup> market, then trade, then the domestic financial market, and<sup>finally the capital</sup> account (long-term, then short-tern).

- Banking regulation and supervision should be developed and<sup>financial</sup> institutions should function properly. Goods markets should be free<sup>and open.</sup>

- Several of these recommendations are echoed by the IMF, including the

sequencing of policies relative to "country-specific circumstances."<sup>Emphasisis placed</sup> on sound and sustainable macroeconomic policies and financial<sup>sector reformas two of</sup> the most important for opening of the capital account. The<sup>formeris designatedas a</sup> precondition to financial and capital account liberalization<sup>asa means of defusingits</sup> linkage with instability. The latter is advised for implementation<sup>duringliberalization (if</sup> not preexisting). The IMF recommends early stage attention<sup>to domestic financial</sup> 95
liberalization through market-based monetary arrangements and central bank reforms with gradual phasing in of prudential regulation and supervision, and financial restructuring policies. Transparency and data disclosure are also deemed important. Social and regional considerations should be taken into account in determining the pace, timing and sequencing of liberalization.<sup>2</sup> " An alternative to "sequencing"<sup>265</sup> is presented in Fan (2002) who describes China's opening and reform process as "compatible opening." Although in this case it is applied particularly to China, the concept is theoretical and could be applied to market liberalization for emerging economies generally. In discussing the problems that China faces in further financial market opening, Fan says, "these problems do not mean further opening is not the right thing to do, but they do show that domestic reform should be the main priority and that liberalization is helpful only when compatible with domestic development."<sup>266</sup> In fact, he proposes, "reform and market opening should go hand in hand, progressing neither too fast nor too slow, so that they can promote and facilitate each other."<sup>26</sup> 7 He faults the prevailing "sequencing" theory as not being politically realistic because in reality, "policymakers just do what the situation allows."<sup>268</sup> Furthermore, developing countries are often pushed by those in favor of sequencing to liberalize as fast as possible.<sup>269</sup> Some may criticize the "compatible opening" theory as being a "half-way" solution, but Fan responds that domestic reform itself is only half completed. "One of the lessons of the East Asian crisis is not that closed markets create instability, but that the crisis was caused by 'complete opening' before 'complete reform'."<sup>270</sup> The downside to this approach is that it is government managed which could lead to unfair competition rent seeking. It could also be slower but does not necessarily need to be depending on the pace of domestic reform, with which liberalization should coincide.

Since the 1997-98 crisis, Asian countries have, to varying degrees, taken major steps towards restructuring their financial systems and strengthening their macroeconomic policies. (Some of these are outlined in Table 5.3 earlier in this chapter.) However, as is the case for China's domestic reform, East Asian countries still have considerable work to do in order to attain the level of financial and structural development that would minimize the risks associated with capital account liberalization. It is obvious that a task of this magnitude can not be accomplished in the short, or even medium, term and has been estimated to take decades.

In his assessment of globalization, Fan Gang points out that developing economies are hampered in their ability to compete globally in part because of their vulnerability to the risks associated with the international market. In order to prosper, these countries must have more than the foreign capital and technology brought by globalization or the cheap labor that is in plentiful supply at home. They further need "competitive economic structures, strong institutions, the experience to manage markets and basic education [... **y].X27** In his view, globalization does not bring these to developing countries, or at least not as completely or as quickly as it does capital and technology. He points out that their acquisition or development requires considerable time to complete - as much as 10, 20, or even 50 years, which is still not as long as it took industrialized countries to develop their market systems.

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# Summary

Capital account liberalization is desirable<sup>in the long run butis associatedwith</sup> considerable risk in the process, particularly<sup>if macroeconomicpolicies are not sound and</sup> financial supervision and regulation is weak.<sup>Whilesequencingof theopening of the</sup> capital account is often recommended, there<sup>is no single formula for this process, just as</sup> there is no simple rule for the use of capital<sup>controls."Compatible opening"where the</sup> progress of domestic reforms coincides<sup>with that of market liberalizationis alsoan</sup> altemative. Both "sequencing" and "compatible<sup>opening"can,if handled properly,be</sup> geared toward the specific circumstances<sup>of financial developmentin individual</sup> countries. Many factors related to an individual<sup>country'sstageof developmentand</sup> current level of involvement in global<sup>capitalmarkets need to be consideredin setting</sup> realistic goals and objectives in<sup>thisarea.</sup> 97
# **A Regional Currency Regime**

Arising out of the Asian crisis and related to the issue of financial system reforn,<sup>272</sup> is an ongoing debate on the appropriate currency regime for East Asian economies, extending as far as a discussion of the suitability of a regional monetary arrangement for East Asia.<sup>273</sup> Prior to the crisis, currencies of the crisis-affected countries were "effectively" pegged to the U.S. dollar.<sup>274</sup> (See Table 5.17 below for "official" pre-crisis exchange rate regimes for the crisis-affected countries.)<sup>2</sup> 75 Large capital inflows into these countries caused rapid appreciation of their exchange rates, especially after 1994. When the dollar appreciated against the yen beginning in 1995, the currencies became overvalued. The eventual reversal of capital flows in mid-1997 put downward pressure on these currencies, which were vigorously defended by their respective central banks. In the end, after their foreign exchange reserves were depleted (Thailand and Korea), the currencies could no longer be defended and were allowed to float and, thus, depreciate. This depreciation, combined with rising interest rates, negatively impacted banks. Their nonperforming loans increased as borrowers (particularly real estate developers)<sup>276</sup> went into bankruptcy, and they suffered direct balance sheet losses (to the extent they were net dollar borrowers). The only exception was Malaysia, which switched from a managed float to a conventional fixed peg and imposed capital controls.

Table 5.17

|**CrisisCountry**|**Pre-CrisisExchangeRate**<br>**Regime***<br>**(12/31/91)**|
|---|---|
|Indonesia|CrawlingPeg|
|Korea|Managedfloatwithnopre-<br>announcedexchange ratepath|
|Malaysia|Peggedrateinhorizontalband|
|Philippines|Managedfloatwithno pre-<br>announced exchangeratepath|
|Thailand|Other ConventionalFixedPeg|
|*SeeAppendixfordesc|riptionofexchangerateregimes.|
|Source: IMF AnnualRe|port 2000andFischer(2001:Tables2,3,and 4)|

Radelet and Sachs (1999) believe that if Thailand had switched to a float earlier in 1997 and moderately tightened monetary and fiscal policies, foreign exchange reserves 98
would not have been exhausted and the<sup>crisis "could have been largely avoided".278For</sup> the same reason, Corden (2000) also<sup>suggests thatThailandcould have resorted toan</sup> earlier float but believes there might still<sup>have beenasudden depreciationas lendersand</sup> the foreign exchange market realized<sup>that the boom was ending soon.</sup>

# **Bipolar or "Two-Corner Solution"**

Because of their perceived negative<sup>rolein the crisis,the pre-crisis"soft pegs" fell</sup> out of favor as a prescribed regime for<sup>emergingmarketcountries.As an alternativeto</sup> (and reaction against) this regime, many<sup>experts advocateda bipolar or two-corner</sup> solution for East Asia. This solution<sup>involvesachoiceof either absolutely fixed</sup> exchange rates (e.g., currency board,<sup>monetaryunion, dollarization), or freelyfloating</sup> rates.<sup>27</sup> 9 The theory associated with<sup>this solutionis that if countries have hard pegsor</sup> free floats, then speculative attacks will<sup>no longer be a threat and currencycriseswill</sup> cease to be a problem.<sup>280</sup> Advocates of the two-corner solution<sup>pointto the so-called "impossibletrinity" to</sup> support their view. The essence of this<sup>principle is that the following three goalscannot</sup> co-exist:

- Fixed exchange rate (i.e., exchange<sup>rate stability)</sup>

- Free flow of capital (i.e., financial<sup>marketintegration)</sup>

- Independence of monetary policy

Frankel, Fajnzylber, Schmukler and Serven<sup>(2000)suggest this does not mean</sup> that a country must give up one of the three<sup>entirely but could instead choosea halfway</sup> approach on two of the goals; e.g. half-stability<sup>andhalf-independence,suchas would be</sup> the case if a country adopted a "target<sup>zone of moderate width."They go on to explain</sup> that a government could pursue "a managed<sup>floatin which half of every fluctuationin</sup> demand for its currency is accommodated<sup>by interventionandhalf is allowed tobe</sup> reflected in the exchange rate."<sup>28</sup> ' McCauley<sup>(2001)pointsout a similar suggestion by</sup> Yi Gang and Tang Xian (2001), which<sup>is that"an independent monetary policy (1)might</sup> be combined with semi-fixity of the<sup>exchange rate(1/2) and a halfway open capital</sup> account (1/2)."282 In an attempt to offer a possible theoretical<sup>rationale for the favored two-corner</sup> proposition283 , Frankel, Fajnzylber, Schmukler<sup>andServen(2000) examineease of</sup> verifiability of exchange rate regimes.<sup>Theirreasoning is that verifiability (i.e.,the</sup> ability of the market to determine from<sup>available data that the officialexchangerate</sup> regime of a country is in fact in operation)<sup>contributesto "transparency,"which has</sup> become a major focus for post-crisis<sup>reform and figures prominently in discussions of the</sup> new international financial architecture.<sup>They focus on exchangerate bands284as one</sup> type of "intermediate" (non-corner)<sup>regimeand attemptto assessthe degreeto which it is</sup> verifiable from observed data. They conclude<sup>thaton the whole, a wider bandwidth,</sup> multiple instead of simple basket pegs,<sup>and frequent parity realignmentsall make it more</sup> difficult to statistically verify the announced<sup>regime.Credibilityis an essential element</sup> in maintaining foreign exchange stability<sup>and the ability to verifyan announced regime</sup> would understandably contribute to<sup>that credibility.They reason that if this is indeed the</sup> case, then a more easily verifiable corner<sup>regime might be preferable to investors.</sup> Credibility is a major goal of emerging<sup>market countriesand a primary reasonfor their</sup> pursuit of exchange rate stability.

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There are a number of reasons to question the suitability of the two-corner solution for East Asian countries. A floating rate would adjust as needed to maintain intemal and external balance but has drawbacks for the emerging economies of Asia. In this case, there are two problems in particular with a freely floating regime.<sup>285</sup>

- _1) Short-term volatility -_ The narrow and shallow capital markets of Asian economies make them vulnerable to the manipulations of a few large players in the international capital market, which can result in extreme volatility that can be magnified by the effects of "herding". This high volatility, and its attendant high risk, can lead to an increase in interest rates, which in turn can slow economic growth. The situation is worsened by the limited and costly hedging opportunities in Asia. Another problem is that exchange rate volatility causes fluctuation in the real value of domestic assets and this can prompt domestic investors to seek stable investments abroad.

- 2) _Medium-term exchange rate misalignment -_ Capital inflows will cause a currency to appreciate, attract more inflows and further appreciate until a persistent misalignment occurs in the medium term. This can result in the distortion of domestic resource allocation between tradables and nontradables.

At the other corner is a fixed exchange rate, such as a currency board. A currency board provides a high level of stability (and credibility, provided there is certainty the peg will not be abandoned), but a country must give up monetary policy independence, which few countries are willing to do. Also, the rate cannot be adjusted if the country wants to attain certain targets of internal and external balance. If a real devaluation is needed, it can only be brought about through declines in domestic prices and wages. In addition, the lack of a lender of last resort can be problematic in an environment of liberalized financial markets.

Larrain and Velasco (1999)286 have identified certain conditions they believe necessary for a country planning to adopt an exchange rate anchored to another currency:

- Small, as opposed to large, countries and countries that have symnmetric shocks with the anchor country are better candidates as there is less need for such countries to have an independent monetary policy and flexible exchange rate than if they had to deal with asymmetric shocks on their own.

- Most of an adopting country's trade should take place with the anchor country to minimize the negative effects of exchange rate fluctuations on trade competitiveness.

- An adopting country's inflation preferences must be broadly similar to those of the anchor country. This is generally easier to accomplish for countries that have a history of high inflation as they are often willing to endure considerable hardship to achieve price stability.

- The adopting country should have flexible labor markets so as to reduce the reliance on other policy measures, such as monetary policy, for dealing with economic shocks.

- A strong, well-capitalized and well-regulated banking sector is needed to reduce the need for a lender of last resort.

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- High-quality institutions and a rule of law should<sup>be in place as they make it</sup> easier to adhere to the strict rules concerning monetary<sup>policy that come with</sup> anchoring the currency.

Among Asian countries, only Hong Kong SAR<sup>has a currency board,which was</sup> adopted in 1983 and has been highly successful.<sup>Eichengreen (1999) attributesthis</sup> success to its internationalized banking system,<sup>opennessto trade,flexiblelabor markets</sup> and the monetary authority's insulation from political<sup>pressures.These characteristicsdo</sup> not come together in most other East Asian countries.

# **A Floating Regime or an Implicit Dollar Peg?**

As previously noted, most of the crisis-affected<sup>countriesswitched to a floating</sup> rate regime during the crisis. Current exchange<sup>rateregimes for East Asian countries</sup> (along with their monetary policy frameworks) are<sup>listed in Table5.18.287</sup> Table 5.18

|**Ex**<br>|**change**Rate**Arrangements and **<br>(AsofDecember <br>|**AnchorsofMonetary**<sup>**Policy**</sup><br>31,2000)<br> **iFk**|
|---|---|---|
|**Country**|ExchangeRateRegime|**MonetaryPolcyramewor**<br>|
|Australia|Independently floating|Inflationtargeting framework|
|BruneiDarussalam|Currencyboard|Exchangerateanchor|
|Cambodia|Managedfloating with no<br>preannouncedpathfor<br>exchangerate|Fund-supportedorother monetaryprogram|
|China|De factopegarrangement<br>underaformallyannounced<br>policyofmanaged or<br>independentfloating(against<br>dollar)|Two nominalanchors:<br>(1)Exchange rateanchor<br>(2)<br>Monetaryaggregatetarget|
|HongKongSAR|Currency board(dollar)<br>.|Exchangerateanchor|
|Indonesia|Independently floating|Fund-supportedorothermonetaryprogram|
|Japan|Independentlyfloating|Hasnoexplicitly statednominalanchor,but<br>rathermonitorsvarious indicatorsinconducting<br>monetary policy.|
|LaoPDR|Managedfloatingwithno<br>preannouncedpathfor<br>exchange rate|Hasno explicitlystatednominalanchor,but<br>rather monitors variousindicatorsinconducting<br>monetary policy.|
|Malaysia|Otherconventionalfixedpeg<br>arrangement(againstdollar)|Exchangerateanchor|

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||**ExchangeRate Arrangements and**<br>**(AsofDecember**|**AnchorsofMonetaryPoilcy**<br>**31,2000)**|
|---|---|---|
|**Country**|**ExchangeRateRegime**|**MonetaryPolicyFramework**|
|Myanmar|Otherconventionalfixedpeg<br>arrangement(againsta<br>composite)|Exchangerateanchor|
|New Zealand|Independently floating|Inflationtargetingframework|
|Philippines|Independently floating|Two nominalanchors:<br>(1) Monetaryaggregate target<br>(2)Fund-supported orothermonetary<br>program|
|Singapore|Managedfloating withno<br>preannouncedpathfor<br>exchangerate<br>(Singapore describesits<br>regimeas abasket,band,and<br>crawl(BBC)withundisclosed<br>parameters.)<sup>28 8</sup>|Other(not specified)|
|South Korea|Independentlyfloating|Other (notspecified)|
|Taiwan|Managedfloating"g|N.A.|
|Thailand|Independentlyfloating|Inflation targeting framework|
|Vietnam<br>NOTE:Taiwanisnoti|Peggedexchangeratewithin<br>horizontal band(0.1%daily<br>movement, one-sided)<br>(Defactoarrangement undera<br>formallyannounced policyof<br>managedorindependent<br>floating.)<br>ncluded intheIMFlisting.|Exchangerate anchor|

Source: [MF, Intemational Financial Statistics, July 2001 There is, however, some controversy about the true nature of these countries' announced regimes, which for most are indicated as independently floating. Several recent studies 90 are reviewed in Branson (2001). These studies examine variability in exchange rates, intemational reserves and interest rates of certain "floater" countries relative to the variability in these indicators for the U.S., Japan and Germany. They find that, for the most part, countries are neither adopting a hard fix nor are they actually freely floating but rather are managing their exchange rates against the dollar, yen or 102
DM/euro, or against a basket. (These studies<sup>cover a numberof "floater" countries</sup> including some, but not all, East Asian countries<sup>that float.)</sup> McKinnon (2001) is more specific in claiming<sup>that although having officially</sup> switched to a floating rate regime during the crisis,<sup>many East Asian countriesin fact</sup> returned to pegging against the dollar after the<sup>crisis.McCauley(2001), on the other</sup> hand, disputes this claim with his findings<sup>that in1999-2000(relative to1995-1996)</sup> "exchange rates have become more volatile<sup>not onlyabsolutely butalso inrelation to</sup> interest rates in Indonesia, Korea, the Philippines,<sup>Taiwanand Thailand.In addition,</sup> exchange-rate volatility has risen relative<sup>to interest-ratevolatilitymarginallyin</sup> Singapore and substantially in Taiwan."<sup>29</sup> 1<sup>He does,however,acknowledge that</sup> countries in East Asia have the capacity, in the<sup>form of internationalreserves,and the</sup> willingness to intervene in order to support their<sup>currencies.Healsofindsa willingness</sup> to limit exchange rate volatility by restricting<sup>financial transactions involvingnon-</sup> residents. (See Table G. 1 1 in General Appendix.) De Brouwer (2001) also questions the claims<sup>that East Asianfloatersare</sup> implicitly dollar pegging and goes further to say<sup>that evenif therewerestability against</sup> the dollar for these currencies in the past few years,<sup>it could have been the result of the</sup> efforts of the crisis-affected economies to build<sup>up their foreignexchange reserves.</sup> Currency movement against the dollar would<sup>have been limited asthese countriesbought</sup> dollars when cheap and refrained from buying<sup>when expensive,but heemphasizes this is</sup> not implicit dollar targeting. He also points<sup>out thatstability againstthe dollar couldin</sup> fact be stability against the yen since it<sup>isnot clearwhether theseeconomieswere</sup> targeting the dollar or the yen. The exchange rate<sup>between the two has been stablein</sup> recent years.<sup>292</sup> Calvo and Reinhart (2000) argue that emerging<sup>market countries havea tendency</sup> to stay away from a pure float because of<sup>a</sup> fear<sup>of largeexchangerateswings -what</sup> they call "fear of floating". The reasons the<sup>authorsgive for this fear (or conversely,why</sup> exchange rate stability is highly sought after)<sup>are as follows:</sup>

- Exchange rate volatility can be an indication<sup>of the monetaryauthority'slack</sup> of credibility,

- • Exchange rate volatility can cause debt<sup>servicingdifficulties and defaults</sup> since liabilities are often foreign-currency denominated,

- • Exchange rate volatility appears to be more<sup>damagingto trade inemerging</sup> markets which may be because trade<sup>is predominantlyinvoiced in U.S. dollars</sup> and hedging opportunities are more limited,<sup>and</sup>

- • The passthrough from exchange rate<sup>swingsto inflationis higher in emerging</sup> markets than in developed economies.

Fof these reasons, the authors believe<sup>that although emerging marketcountries</sup> might indicate an "intention" to float, they in<sup>fact do not allow their currenciestodo so.</sup> Branson (2001) concurs with the "fear of floating"<sup>theory and believesthatdeveloping</sup> countries' fear of unstable financial markets<sup>is justifiedsince thesemarketsarenot well</sup> integrated into the international system,<sup>unlike thoseof largedeveloped economieswhich</sup> can float without concern. He concludes<sup>that developingcountriesdo not,and should</sup> not, adopt either of the corner solutions.

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# **"Intermediate" or "Middle" Regime Alternatives**

If the two-corner solution is not the answer, what are the alternatives? There are a number of options between the two extremes of a hard peg and a free float, often referred to as "intermediate" or "middle" regimes. Kwan (2001) lists these in descending order of commitment to maintain a fixed rate: "monetary union, currency board, adjustable pe crawling peg, basket peg, target zone or band, managed floating, and free floating."'9P The third through sixth of these are identified as intermediate regimes and the two on each end as polar regimes. Some consider the intermediate regimes as reversions to the soft pegs of the pre-crisis era; however, Frankel (1 999b) is of the opinion that the recommendation to avoid middle regimes in favor of a hard fix or free float is not appropriate because their rejection is no more than "a rejection of where most countries have been, with no reasonable expectation that the sanctuaries of monetary union or freefloating will, in fact, be any better."<sup>294</sup> Kwan (2001) believes it is preferable "to improve the intermediate regimes with explicit exchange rate targets so as to make them less vulnerable to currency speculation."<sup>295</sup> The first question that must be asked is whether or not East Asia is ready for a common currency arrangement. Bayoumi, Eichengreen and Mauro (2000) assess the level of preparedness of Asia (ASEAN in particular) for monetary union by looking at trade patterns, economic shocks, factor mobility, and the monetary transmission mechanism. They determine that "in terms of the economic prerequisites for monetary integration, ASEAN is not in a significantly worse position than the EU was a few years prior to its signing the Maastricht Treaty."<sup>296</sup> They emphasize, however, that ASEAN lacks the political commitment to put economic integration ahead of loss of sovereignty, which was instrumental in the EMU's success. In their estimation this lack of commitment would make monetary integration very difficult for ASEAN to achieve in the foreseeable future.

In fact, most agree that monetary union is a long-term prospect for East Asia. However, there is an ongoing search for some type of common currency arrangement that would benefit the region in the short- to medium-term. The determination of a common currency regime for East Asia, however, is complicated by the heterogeneity of the region's economic and financial characteristics. (Many of these were discussed earlier in this study.) The extent and importance of this diversity as it relates to monetary integration becomes evident in light of the IMF's list of "Considerations in the Choice of Exchange Rate Regime" appearing in Table G. 12 in the General Appendix. This list indicates the desired degree of exchange rate flexibility for particular economic characteristics. Depending upon which countries are to be included in an optimal currency area in East Asia, there is diversity among countries in potentially every area included in this list.

A number of studies have been carried out in the 1990s to assess East Asia's status as an optimal currency area (OCA). Kawai and Takagi (2000) review the literature<sup>297</sup> on this topic and arrive at the conclusion that based on various economic criteria (such as those in Table G. 12), "East Asia is no less ready for a regional monetary arrangement than Europe was before EMU." They also acknowledge (due to the endogenous nature of OCA criteria), "the very act of forming a regional monetary arrangement will enhance the suitability of East Asia for such an arrangement."<sup>298</sup> 104
There have been many efforts since the Asian crisis to define a common currency arrangement that would be suitable for the region. The proposed arrangements have tended to be in the form of intermediate regimes with a "common basket peg" being a prominent feature. The recommendations have been that countries in the region peg their currencies to a basket comprising the yen, dollar and euro, as these are the most reflective of East Asia's trade and investment activities.<sup>299</sup> Some proponents recommend that the weights in the basket be based on the respective country's trade shares with Japan, the U.S. and the EU, while others believe they should be based on an average of trade shares with these three countries.

The common basket peg is recommended because it is viewed as one that will provide exchange rate stability, which is generally believed to be essential for the promotion of trade, FDI and economic growth in the region,<sup>300</sup> and at the same time allows for some flexibility against the three major currencies (yen, dollar, and euro).<sup>301</sup> Including the yen in the basket, however, could be problematical if a currency union is the eventual goal. It would in effect treat the yen asymmetrically whereas the yen, yuan and won should be treated symmetrically as the yen becomes a non-special currency in the region.

One often discussed type of common basket peg is the basket-band-crawl or BBC.<sup>302</sup> A band would be placed around a parity (center of the band) that would be periodically adjusted in small steps so as to track the underlying fundamental equilibrium exchange rate (FEER). The parity would be defined in terms of a basket of currencies and would comprise trade-weighted currencies of a country's principal trading partners. This is chosen over a single currency for countries with diversified trade (no dominant trading partner) in that a basket would stabilize the effective exchange rate<sup>303</sup> . The band would be publicly announced and would function as a guide to the equilibrium rate for the market. Its function would be to stabilize market expectations, thus reducing the risks of volatility and misalignment. The exchange rate would fluctuate within the band, but the central bank would intervene at the edges of the band to keep the rate from moving outside the band.<sup>3</sup> 0<sup>4</sup> The band is recommended to be wide in order to (1) eliminate the need to defend a disequilibrium exchange rate, (2) allow adjustment of the parity, in line with fundamentals, without causing expectations of discrete changes that would be destabilizing, (3) allow for some monetary policy independence when a country's cycle is out of sync with the world norm, and (4) to help cope with strong temporary capital inflows. The crawl is part of the formula to neutralize differential inflation; however, the goal is to do this in such a way as to maintain competitiveness.<sup>305</sup> Williamson (2001) believes it is rational to have an exchange rate policy rather than leaving rates to the market in order to prevent rates from moving too far from the rate that makes sense in terms of the fundamentals (i.e., the FEER). In his opinion, it is rational to seek continuous internal balance, but acceptable to secure external balance in the medium term. This is the exchange rate objective in the BBC regime. He suggests that the use of monetary policy, sterilized intervention, and capital controls are three options for preventing the exchange rate from becoming misaligned.

Williamson recommends weights of about one-third each on the dollar, the euro and the yen, which could be created as an Asian currency unit (ACU).<sup>306</sup> He foresees a imarket in the ACU being established and, once functioning, the ACU could be used as 105
the "common reference point" for all exchange rates in the region, whether<sup>they be</sup> pegged, managed or floating exchange rates. He notes several problems<sup>with this</sup> scheme. Some countries may consider an ACU peg too complicated<sup>to be credible,at</sup> least in comparison to a dollar peg. There could be resistance to disclosure<sup>of the</sup> contents of the basket and the parity, which he views as important. Also,<sup>agreement on</sup> reference rates for currencies that had been floating would require cooperation<sup>among</sup> partners, as these could not be unilateral decisions.

Kawai and Takagi (2000) consider a common currency basket as preferable<sup>to</sup> what they see as the "current de facto dollar peg policy" in that it would<sup>ensure exchange</sup> rate stability in the region. They agree that the common basket could<sup>serveas the</sup> reference anchor in conducting exchange rate policy but that each country<sup>couldchoose</sup> its own formal exchange rate arrangement. It would be a "pragmatic policy<sup>optionfor</sup> East Asia until greater political and institutional developments create<sup>an environment</sup> conducive to a more robust framework of monetary and exchange rate<sup>cooperation." 307</sup> In their opinion, more needs to be done to build institutions for surveillance and consultation, which could be comparable to the European Monetary Cooperative<sup>Fund</sup> (EMCF) and the European Monetary Institute (EMI), which were important<sup>in the</sup> monetary integration of Europe.

Despite the significant support for the common basket peg regime, it does have<sup>its</sup> detractors. De Brouwer (2002) does not dispute the importance of intraregional<sup>currency</sup> stability given that nearly half of East Asian countries' trade<sup>is intraregional.308Nor does</sup> he disagree that Japan, the U.S. and the EU are important trading partners<sup>for countries</sup> within the region, which implies that pegging to a single currency<sup>would not bring</sup> stability to the effective exchange rate. Nonetheless, he argues several<sup>points against the</sup> common basket peg as a common currency arrangement for East Asia.<sup>Some of his</sup> arguments are as follows:

- a) He suggests that it might be more appropriate to use a country's own trade weights rather than common trade weights because trade patterns vary significantly among countries within the region. He points to Cambodia, Lao PDR and Vietnam in particular as being "outliers" in that they trade more with other countries in the region than they do with the U.S., EU or Japan.<sup>309</sup> For this reason a basket based on common weights would be less stabilizing than one with each country's own weights. Some countries could become less competitive against others depending upon which currencies in the basket move, and how they move.

- b) Using an export similarity index, he determines that the region's export structure is increasingly similar to that of industrialized countries so<sup>that</sup> only the lesser developed countries in East Asia still have intraregional trade that is more similar than extraregional trade. In view of this finding, the common basket peg may not be appropriate for the region since it implies that stabilizing intraregional exchange rates is more important<sup>than</sup> stabilizing exchange rates with Japan, the U.S. and the EU.

- c) Switching to a common basket peg would mean, for most countries<sup>in the</sup> region, changing from a floating rate regime to which they have already become adapted.

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- d) A common basket peg presumes that exchange rate volatility adversely affects trade and economic performance but he finds a lack of evidence for this in East Asia.

- e) Pegging forces changes in the real exchange rate through the price level rather than the nominal exchange rate, which in a situation of persistent inflation, is inefficient.

Wyplosz (200 la) sees the merit of a common basket peg in that it would stabilize exchange rates within the region as well as with major trading partners outside the region. He points out the disadvantage, however, that decisionmaking would be carried out by individual countries without institutional support. He suggests that the Chiang Mai Initiative (CMI) in association with common basket bands might serve the purpose as an EMS-type arrangement. However, he identifies two problems with this: (1) whereas support of the bilateral pegs of the ERM (exchange rate mechanism) of the EMS (European Monetary System) was automatic and unlimited, the CMI amounts are limited relative to what the markets could mobilize and (2) the dollar and euro would be included in the basket but are not part of the CMI arrangement eliminating the possibility of concerted intervention, which made the EMS arrangement so successful. Therefore, in his opinion, this combination would not stand up to a speculative attack. He also suggests the alternative of stabilizing bilateral rates and managing the common rate against the dollar and euro but notes that an institution would be needed to provide a coordinating mechanism in this case.

As an alternative to the common basket peg, Williamson (2001) suggests (and later dismisses) a system of mutual pegging among currencies in the region similar to the European snake<sup>310</sup> and ERM. However, he points to what he sees as obstacles to this alternative. In his view there is no economic power dominant enough to anchor the system and dismisses Japan in that role because of what he refers to as the "vagaries of the yen." He also sees difficulties with Hong Kong switching from its currency board, and political issues for China and Taiwan relative to their bilateral exchange rate.

Wyplosz (2001 a) believes that while there are many types of soft pegs, the differences among them are less important than the implementation of procedures to enforce and verify the arrangements. He emphasizes the importance of the support provided by adequate institutions if the adoption of a peg is part of a regional agreement.<sup>31</sup> Kawai and Akiyama (2000) emphasize the importance of coordinated action by East Asian countries in any attempted move to a new exchange rate arrangement where the relative weights are shifted away from the dollar toward the yen and euro. In their opinion, such a move would be difficult for a country on a unilateral basis if neighboring countries do not make a similar shift.

# **Concluding Remarks**

During the crisis, most East Asian countries switched from their "effective" dollar pegs to a floating rate regime (with some notable exceptions including Malaysia and Hong Kong). Although it is still disputed as to whether or not these countries have since returned to implicit dollar pegging, there is evidence of more volatility in Asian exchange rates after the crisis than there was before. While the two-corner solution of a hard fix on the one hand or a pure float on the other is recommended by some as the most 107
appropriate exchange regime for East Asian economies, most<sup>in theregion favor some</sup> type of intermediate regime. A common basket peg has been<sup>widely discussed and has</sup> many supporters, particularly in Japan; however, there<sup>is</sup> sufficient<sup>disagreementwith</sup> this suggestion in the region to allow for the consideration of<sup>alternativesin the area of</sup> monetary cooperation. Most agree that a currency union<sup>isa long-term propositionfor</sup> East Asia, but there are possibilities short of this proposal<sup>that arefeasible for Asia in the</sup> short- or medium-term. This paper's recommendations in<sup>this area arepresented in</sup> Chapter VII.

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# - **Chapter VI Conclusion: Observations on Integration**

We began this study of East Asian regional integration<sup>with a review of the</sup> region's economic history extending back hundreds of years. During<sup>that time Asia was</sup> the source of a wide variety of both primary and manufactured<sup>goods that were highly</sup> desired throughout the world. This was made possible by the region's<sup>richnessin</sup> primary resources as well as its large and highly civilized population<sup>whose skills were</sup> technologically sophisticated for that time. As a result, Asia enjoyed<sup>a very high level of</sup> GDP and per capita income, which during some periods surpassed<sup>even that of Europe.</sup> Historically, Asia played a central role in not only intraregional<sup>trade, but also in</sup> global trade. Its complex pattern of trade covered a wide area encompassing<sup>East, West,</sup> South and Southeast Asia as well as Europe, Africa and the Americas,<sup>throughoutwhich</sup> a wide variety of goods were exchanged, facilitated by the use of<sup>precious metals as</sup> currency. The region weakened during the latter part of the millennium<sup>as the Industrial</sup> Revolution gained momentum in Europe and colonialism expanded in Asia.<sup>The</sup> negative effects of the latter event are still evident today as East<sup>Asia struggles to return</sup> to its past strength and prominence.

Two historical factors will have a significant impact on the way East Asia proceeds toward regional integration in the future. One is that Asia<sup>has been an open</sup> region fully involved in the world economic system and has<sup>playeda centralrolein</sup> worldwide trade and the global division of labor. The second<sup>is that intraregional trade</sup> has a long history in the region and was very well developed in<sup>the past.</sup> Another characteristic of equal importance in its effect on East Asia's<sup>progress</sup> toward integration is the diversity of its social, economic and political<sup>structures.East</sup> Asia is expansive in terms of territory and number of countries,<sup>extendingover15million</sup> square kilometers and including as many as 15 nations with wide<sup>differencesbetween the</sup> largest and the smallest. By comparison, the EU is compact<sup>(3</sup> million<sup>Km2and15</sup> countries) and NAFTA is long and narrow (21 million Km<sup>2</sup> but with only<sup>3 countries,of</sup> which two are of much larger size than the third.) In population<sup>(representingboth a</sup> market and source of labor), East Asia is enormous encompassing<sup>nearly2billion people</sup> (again with wide differences between the largest and smallest countries)<sup>comparedto</sup> about 400,000 each for the EU and NAFTA.

The countries of East Asia are much more heterogeneous than<sup>are thecountriesof</sup> the EU or NAFTA in terms of ethnicity, religion, culture, and<sup>politicalsystems, both</sup> within the individual countries themselves and between countries of<sup>the region.Thereis</sup> also considerable diversity among East Asian countries in<sup>economicandfinancial</sup> development with Japan at the high end as a developed country and<sup>the newerASEAN</sup> members at a lesser-developed stage. While the EU also has some<sup>economic diversity</sup> (e.g., Germany and Greece) and differences will undoubtedly increase<sup>as the EU</sup> enlarges, the gap is much narrower than that between, for example,<sup>JapanorSingapore</sup> and Vietnam.

Differences exist not only in GDP but also in industrial development<sup>as well.</sup> Japan, of course, is highly industrialized, and Singapore and Taiwan<sup>are leadersin high-</sup> tech industries, but Vietnam, Cambodia and Lao PDR export primarily<sup>low-tech</sup> products. Also, the financial markets of Singapore, Hong Kong<sup>and Japanare very</sup> 109
advanced whereas those of the newer ASEAN members are virtually undeveloped. These differences have significant implications for both trade and monetary<sup>integration.</sup> In view of this heterogeneity, we examined the characteristics of various regional groupings (e.g., ASEAN and APEC) in an effort to determine if one or another<sup>of these</sup> institutions brings greater benefit to the region and the economies therein. It can<sup>be</sup> argued that a group comprising developmentally similar economies would be<sup>a</sup> more workable arrangement in which smaller members would have more influence,<sup>but there is</sup> a slightly more compelling argument in favor of agreements between industrial and developing economies in that they can bring significant benefits to the developing partners.

Regional institutions have been slow to develop in East Asia in part because<sup>that</sup> was never a defined goal of regional cooperation in the region. This, however, is beginning to change. As cooperation among the nations of the region<sup>becomes a higher</sup> priority, attention is increasingly directed toward the formation of more dynamic, effective regional institutions having greater capability for the promotion of trade, investment, finance and security in the region. These efforts have been<sup>complicated by</sup> the region's diversity, historical political tensions between certain countries,<sup>the desireto</sup> protect national interests and specific industries, and the region's<sup>already established</sup> openness in trade and FDI including its long-standing relationships with<sup>the U.S.andthe</sup> EU. The result has been the formation of a variety of regional groups<sup>encompassinga</sup> wide range of member nations.

The most prominent among these are ASEAN (and its extension ASEAN-PlusThree) and APEC. The defining characteristic of ASEAN is its so-called "ASEAN Way," which emphasizes consensus, non-intervention and minimal institutionalization. As opposed to using treaties and binding obligations, ASEAN prefers non-binding<sup>plans</sup> and guidelines. Its secretariat has few powers and limited authority and is<sup>thus</sup> characterized as a "soft" secretariat. National interests, therefore, tend to take precedence. These characteristics make regional decisionmaking difficult<sup>andslow.The</sup> ASEAN way is often contrasted with the more formal and legalistic "Brussels way". "Institution building" has been identified as the second ingredient (after<sup>pragmatism)of</sup> Europe's successful integration progress.<sup>312</sup> Unlike the EU, however,<sup>ASEAN has been</sup> unwilling to move in the direction of establishing a supranational body<sup>and has instead</sup> maintained its commitment to preserving national sovereignty.<sup>3 13</sup> Whereas<sup>the EU is</sup> structured and treaty-based, ASEAN is flexible and ambiguous.

APEC is primarily recognized for its policy of "open regionalism" or "concerted voluntarism" of which the goal is the pursuit of free and open trade and<sup>investment and a</sup> commitment to nondiscrimination toward nonmembers. This is contrary<sup>to theconcept</sup> of preferential treatment and discrimination against nonmembers, which<sup>ischaracteristic</sup> of regionalism in the EU and NAFTA.<sup>314</sup> There is some question, however,<sup>whether</sup> "open regionalism" will continue to characterize regional cooperation in East<sup>Asia,</sup> particularly in light of the increasing number of FTAs now being proposed<sup>and</sup> formulated there.

Both ASEAN and APEC are viewed by many as weak and ineffective institutions and are often criticized for the vague and noncommittal outcomes of their frequent meetings. There is also the issue of membership. ASEAN is viewed<sup>as too small and not</sup> fully representative of the entire region as certain major players (Japan,<sup>China and Korea,</sup> 110
as well as Hong Kong and Taiwan) are not<sup>included.On the other hand,APECis not</sup> considered to be a "true" regional grouping<sup>because of the inclusion of countries on the</sup> other side of the Pacific.

A third group that seems to hold more promise<sup>is ASEAN-Plus-Three which is</sup> more representative of the region in<sup>terms of its membership,although it alsodoes not</sup> include Hong Kong and Taiwan. However,<sup>it is not an officialor fully functioning</sup> regional institution but operates on<sup>the sidelinesof ASEAN.Furthermore,its focus until</sup> recently has been primarily on the fmancial/monetary<sup>aspectsof cooperation,with its</sup> Chiang Mai Initiative, to the exclusion<sup>of trade and investment.The focusof this group,</sup> however, seems to be changing now<sup>with progress being madein theformulation of the</sup> ASEAN-China FTA and the interest<sup>this has sparked in the other two Plus-Three</sup> countries of South Korea and Japan.

The liberalization of trade and FDI in<sup>East Asia has contributedsignificantlyto</sup> the region's at times phenomenal economic<sup>growth and developmentover the last two</sup> decades. Our analysis reveals the<sup>continued multilateral natureof East Asia's tradeand</sup> FDI and the importance of its extraregional<sup>relationships.Atthe same time,there is a</sup> very significant intraregional component<sup>with some recent shifts in trading and</sup> investment patterns both from outside<sup>to inside the region and within the region itself.</sup> One example of this is the apparent<sup>shift ininvestment away from Southeast Asia</sup> (ASEAN) to the North (China) in search of<sup>lower costs,among otherthings.</sup> In light of East Asia's rising interest in<sup>pursuingregionalsolutionsto common</sup> problems and the importance of policy<sup>coordinationin the promotionof trade and FDI,</sup> we propose two approaches that combine<sup>these two elements:(1) theformulation of</sup> regional agreements and (2) the creation<sup>of regional productionnetworks.In the case of</sup> the former, agreements should encompass<sup>aspectsof both trade and FDI with an</sup> appreciation of their interactive characteristics.<sup>Additionally, including both developed</sup> and developing countries as partners in<sup>theagreement has been shown to bring greater</sup> benefits. While larger groupings<sup>may be more welfare enhancing,a bilateral approach</sup> could be an initial step to a broader multilateral<sup>arrangement.</sup> The second approach, the creation of regional<sup>productionnetworks,is a step</sup> beyond, and a possible extension of, regional<sup>agreements. EastAsia has the potential to</sup> build such networks on the foundation established<sup>by JapaneseTNCs in the post-war</sup> period. TNCs in East Asia, although not<sup>as numerous or as large as thoseof developed</sup> *countries, demonstrate an increasing<sup>level of transnationalityandhave risen to the top</sup> among developing country TNCs in this<sup>respect.TheTNCsof the Asian NIEs have</sup> already demonstrated their potential in<sup>thisrespect, andChina's enterprisesare likely to</sup> catch up quickly. Regional production<sup>networksareappealingin that theysatisfy the</sup> desire for regional solutions and yet are<sup>not entirely self-containedasthey are non-</sup> discriminatory, thus allowing countries<sup>outside the region to invest in, and trade with,</sup> countries of the region, and vice versa.<sup>Thisapproach would requirea longertimeframe</sup> to implement than would the regional-agreement<sup>approach,but it would be broader in</sup> context and could involve the entire region<sup>as opposedto only a few countries.Through</sup> these two approaches East Asia could<sup>attainthe ultimategoalof participatingfully in the</sup> global production network.

Prior to the 1997-98 crisis, regional<sup>integration efforts on theeconomicsidein</sup> East Asia tended to focus on trade and<sup>directinvestment.Thecrisisarousedan</sup> 111
awareness of the need for financial cooperation in<sup>the region to preventanother such</sup> occurrence. Although a number of proposals for such<sup>cooperation were made at the time,</sup> the Chiang Mai Initiative (CMI) of bilateral swap arrangements<sup>has made the most</sup> progress with six BSAs signed and eight under negotiation.<sup>Although many complain</sup> that the CMI amounts are too small to be effective<sup>in a major crisis, the processitself is</sup> important in its coordinating and cooperative effect<sup>on theeconomiesof the region.At</sup> the same time, it is not exclusively regional in that it<sup>includes a global elementthrough its</sup> link with IMF conditionality.

The crisis also brought calls for financial sector restructuring<sup>and reformbut</sup> efforts so far have been carried out primarily at the national<sup>level.Many observers,</sup> however, believe that a coordinated effort at the<sup>national,regional and internationallevels</sup> is necessary because of the regional and global nature of<sup>recent crises.</sup> Discussions have focused on the best way to develop<sup>the region'sfinancialsector</sup> to a level of soundness and stability that would not<sup>only reducethe chancesof another</sup> crisis but also promote economic growth in the region.<sup>Many believea move away from</sup> a bank-based system to a market-based system is desirable.<sup>We have presentedtwo</sup> approaches currently under discussion for the achievement<sup>of thisgoal.Onefocuseson</sup> changing financial structure so as to move away from<sup>the currently dominantbank-based</sup> system to a more market-based system, and the second<sup>focuses on reforming the</sup> regulatory, legal and macroeconomic environment,<sup>which should lead naturally to a move</sup> away from a bank-based to a market-based system.<sup>The ultimateoutcomesof these two</sup> approaches are the same (i.e., a market-based system), but<sup>they are reachedfromdifferent</sup> directions.

Still, there are those who are of the opinion<sup>that a bank-based system is</sup> appropriate for some economies under certain circumstances<sup>andotherswho believe that</sup> developing capital markets is not the answer for East<sup>Asia.Some alsoexpectthat bank-</sup> based systems will remain prominent in East Asia even<sup>with the eventual developmentof</sup> capital markets. In any event, strengthening the<sup>banking system is essential.It is not</sup> clear, however, whether this should be undertaken<sup>at the national,regionalor</sup> international level, or possibly at all three levels.

Another topic of debate that came out of the crisis<sup>is capitalaccount liberalization</sup> which, while desirable in the long run, is associated<sup>with considerable risk,particularlyif</sup> macroeconomic policies are not sound and financial<sup>supervisionandregulation is weak.</sup> While the issue of capital controls has been controversial,<sup>a"sequencing" or "compatible</sup> opening" approach may be desirable for most emerging<sup>economies.</sup> In the area of monetary integration, a currency<sup>union,although possibly desirable</sup> for East Asia, would not really be feasible in the region<sup>for decades.In theinterim, many</sup> favor an intermediate currency regime that could<sup>be sometype of adjustablepeg or band,</sup> with a basket peg (including the yen, euro and<sup>dollar) being the mostoften mentioned.</sup> Some believe this to be appropriate for the region<sup>becauseof its trade andinvestment</sup> patterns. Others, however, disagree, citing significant<sup>variation in trade patternsbetween</sup> some countries in the region that can disadvantage<sup>them relativeto other countries when</sup> the yen or euro fluctuates against the dollar. Other<sup>possibilitiesfor monetarycooperation</sup> exist, including the recommendation of this paper which<sup>is for some typeof foreign</sup> exchange policy coordination that would lead eventually<sup>to monetaryintegration. Thisis</sup> discussed in Chapter VII.

112
This study has raised a number of issues for<sup>the regional integration processin</sup> East Asia. In contrast to Europe and North America,<sup>EastAsian countrieshavea</sup> tendency to change politically and economically,<sup>sometimes quitedramatically.For</sup> example, China until recently had been closed<sup>but isnow opening up withthe potential</sup> for remarkable consequences, both negative<sup>and positive dependingupon howthis is</sup> dealt with in the region. Also, Japan's economy<sup>rose to a high level after World War II</sup> but in the last ten years has faltered and<sup>shows littlesign of near-termrecovery. This has</sup> jeopardized the country's position and<sup>influencein the region. TheASEAN-5countries</sup> experienced astronomical growth in the 1980s<sup>and early1990s, then suffered a nearly</sup> complete turnaround in 1997-98 as a result<sup>of the crisisand will probably never returnto</sup> those heights again. Also before the crisis,<sup>Indonesiaplayeda leadership role in regional</sup> integration, but since then has been struggling<sup>simply tosurviveand hasnot been able to</sup> resume this role.

These examples evidence the potential for<sup>great changein East Asiaand provide</sup> some understanding of the trial and error<sup>nature of regional integration in the region. In</sup> fact, it is often implied that the process<sup>of Europeanintegrationis a well-thought-out</sup> strategy; however, it is rather characterized,<sup>in the wordsof CharlesWyplosz,asa</sup> "process of muddling-through, two steps forward<sup>and onestep backward,withdeep and</sup> lingering divergences as to what the end objective<sup>is."315In this respect,Asia's own non-</sup> strategic, somewhat sporadic progression towards<sup>integrationis not dissimilarfromthat</sup> of the EU. However, the EU's well-developed<sup>institutionshaveassumed the roleof</sup> transforming projects into reality when opportunities<sup>are presented.316Thereis little</sup> evidence that East Asia's institutions are<sup>capable of doing the same.</sup> It could be said the motivation for regional cooperation<sup>was similar, yetdifferent,</sup> for ASEAN and the EU. Politics played the<sup>primary rolein both cases.In Europe's case,</sup> economic interdependence was thought to be<sup>the most effectiveforcefor promoting the</sup> political cooperation that was considered<sup>to behighly desirablein the regionin the post-</sup> war period. This was the case in the<sup>formationof the European CoalandSteel</sup> Community and the EEC. In ASEAN's<sup>case, politicalcooperationwasalsothe</sup> motivating factor with economic cooperation<sup>followingfrom there.Thus,politicsplayed</sup> the main role in both regions but the<sup>approach was from differentdirections.317</sup> In fact, there have been various motivators<sup>for East Asianintegration.As just</sup> mentioned, the initial motivation for ASEAN's<sup>formationinthe 1960s was political.</sup> Then in the early 1990s, progress in European<sup>andNorth Americanintegrationacted as a</sup> catalyst for Asia's emphasis on economic integration<sup>with the formationof AFTA and</sup> APEC's Bogor Declaration. The financial<sup>crisis of 1997-98 was the motivation in the</sup> latter half of the 1 990s, this time in the<sup>areaof financialcooperation.At thesame time,</sup> Japan's economic situation has been an<sup>indirect motivating factoras it hasaffected the</sup> country's patterns of trade, investment and<sup>ODA in the region.The uncertainty</sup> surrounding its economy makes it difficult to<sup>predict what will be Japan'sfuturerole in</sup> East Asia. There is now a new motivating<sup>factorfor cooperation emerging-and that is</sup> the opening up of China. As China seeks<sup>cooperationwith its neighborsin theregion,</sup> this will decrease suspicion and distrust and<sup>could lead toeven higher levelsof</sup> integration in all areas - political, economic<sup>and financial/monetary.</sup> East Asia's institutions are often criticized for<sup>being "talkshops". While</sup> institutional effectiveness is certainly desirable,<sup>theimportance of dialogueand</sup> 113
discussion should not be underestimated. This is particularly true given the social and cultural enviromnent in Asia where the emphasis is on consensus and noninterference. Furthermore, bringing China into the dialogue is essential.

The general consensus is that regional integration in East Asia will not (and in many respects, should not) proceed in the same way as has integration in Europe or North America. That is not to say East Asian countries will never achieve a high level of integration, but they will undoubtedly follow a different path to get there, and the end result will most likely be different as well. In the final chapter we look ahead to the future to see where this path might lead.

114
# - **Chapter VIl Looking Ahead**

There seems to be little doubt that Asia was<sup>the centerof the world economyin</sup> the pre-modern and early modem<sup>eras.UnlikeBritain after the Industrial Revolutionor</sup> the United States after World War II,<sup>Asiancountries,including India,China and some</sup> Islamic empires, had not been hegemonic<sup>but had been dominant both in sizeand</sup> influence. These Asian empires engaged<sup>in complex patternsof global trade involving</sup> many routes. Their activities, however,<sup>werelargely commercialand trade-centeredand</sup> did not involve much direct investment,<sup>aswas thecase for Britain.Global,as well as</sup> intraregional, trade had thrived for centuries<sup>until the period of colonizationby the West.</sup> As Asia regained independence and started<sup>to engageinglobal economic</sup> activities after World War II, the<sup>historical legacyof centuriesof global tradingwere</sup> quite important in that both hard and<sup>softinfrastructures,such as ports and a merchant</sup> class, were well developed. Indeed,<sup>Asia, particularly East Asia,had benefited</sup> significantly from a legacy of openness<sup>in trade. Itstradeand economic transactionsare</sup> broadly spread over all the regions<sup>of the world, much moresothan those of Europeand</sup> the U.S. Given the level of development,<sup>Asia, particularly East Asia,is alsoquite open</sup> in trade, FDI and finance. Its dynamism during<sup>most of the past decadeshas been the</sup> result of this openness and the global<sup>natureof the region.East Asiahasfunctionedas a</sup> major manufacturing base for the globalized<sup>world economy. Assuch, East Asian</sup> economies have had a very high export-GDP<sup>ratio, someof them even exceeding100</sup> percent.

Reflecting the open and global nature<sup>of trade and othereconomic transactions,</sup> regional economic cooperation has<sup>been relativelyweak in East Asia.ASEAN started as</sup> a political organization and still<sup>espouses the"ASEANway", emphasizingconsensus,</sup> non-intervention and minimal institutions.<sup>APEC's"open regionalism"is patternedafter</sup> ASEAN's "concerted voluntarism"<sup>and has served to supplement globalliberalization</sup> rounds by WTO-GATT very effectively.

It might be reasonable to say that Asian<sup>regional organizationshave not been</sup> regional in the true sense of the<sup>word but have been quitedifferentfromgenuine regional</sup> organizations like the European Union<sup>and NAFTA. Given the open and global natureof</sup> the Asian region and given the enormous<sup>diversitythat exists among the countriesof the</sup> region, this has been somewhat natural and<sup>hasserved theregion well. Asia has been the</sup> greatest beneficiary of global liberalization<sup>in trade and FDI,andan organizationlike</sup> APEC has served the region well by effectively<sup>supporting global liberalization.So far</sup> so good, and if we believe that global capitalism<sup>continuesto evolve smoothlyas in the</sup> past, one would support "open regionalism",<sup>or thelack of genuineregional</sup> organizations. Many economists<sup>trained in the neoclassicaltradition supportsuch</sup> propositions and conclude that APEC or<sup>the WTOis the organizationthat should be</sup> supported by Asian countries and that<sup>the formation of genuineregional organizations</sup> should be avoided. If their assumption of<sup>perfectcompetitionis satisfiedor if global</sup> institutions exist to rectify imperfections<sup>in the globalmarket, their positionis not</sup> unreasonable.

However, the reality of the globalized world<sup>is far from ideal.Thereis noglobal</sup> lender of last resort; neither do we have<sup>a</sup> global<sup>supervisory agency nor a global anti-</sup> 115
trust agency. Referring to the lack of a global lender of last resort, Mervyn King (1999) argued the two "purist" solutions to the problem; namely, the creation of a global lender of last resort and reinstatement of permanent capital controls are neither feasible nor desirable under the current intemational political regime. The middle way, or muddling through, is the only politically feasible solution and King refers to the creation of a "doit-yourself' lender of last resort including establishing a regional lender of last resort as one of the middle-way solutions.

The East Asian crisis of 1997-98 has given rise to the recognition of the imperfections, or lack of governance, of globalized markets. The Asian miracle, to a significant degree a result of the open and global nature of this region, suddenly turned into the Asian crisis. Not only global institutions like the IMF and the World Bank, but also regional institutions like ASEAN and APEC, were unable to perform any useful function to stop the contagion of the crisis. Also, initial prescriptions by the IMF may have aggravated the crisis rather than stopping it. It is not only the policy recommendations made during the crisis, but also those made before the crisis, that need to be reexamined. The strong pressure to deregulate, particularly in international finance, without comparable strengthening of financial supervision had exposed many countries in the region to a degree of risk unmanageable by national governments. International organizations could not substitute for national governments in managing these new market risks. What is necessary is not to substitute market for government but to redefine the role of government in view of the rapidly changing international environment. Joseph Stiglitz<sup>3 18</sup> correctly points out what needs to be done in the future as follows: "Just as before they were misled by the chimera of deregulation - they should have asked instead what is the _right_ regulatory structure for their current situation - so too in the future, they will have to resist accepting without question the current mantras of the global marketplace of ideas. There will have to be _strengthened_ regulation of securities markets and an improved overall legal environment, especially in areas such as corporate governance and bankruptcy. The legal structures will have to comport with international standards, yet be adapted to their own special situations; wholesale borrowing will not work." Policy efforts have to be largely national. However, the question here, in relation to regional cooperation, is whether genuine regional institutions like the EU would help national governments to accelerate their efforts in the right direction. Or should we leave these matters to intemational organizations such as the IMF and the WTO.

We endorse the establishment of a genuine regional institution in Asia, or at least in East Asia, on several grounds. First, existing global institutions are strongly biased toward market fundamentalism or the neoclassical paradigm, and their past records in international capital and finance are very poor. The establishment of a genuine regional institution could provide a countervailing force and would contribute to reforming international institutions. Indeed, global institutions are necessary, but healthy competition among global and regional institutions would help improve their performance.

Second, international institutions, politically dominated by Westem countries and staffed largely by Western economists, often lack sufficient knowledge of regional values, culture and history and tend to impose their own views or try to "Westemize" the 116
country in question. Indeed, international<sup>standardsneed to be adhered to but standards</sup> should reflect existing cultural and<sup>institutionaldiversity.Regionalorganizationscan</sup> supplement global ones effectively<sup>in suchareas.</sup> Third, as in the case of the EU, necessary<sup>structuralreformssuch as theones</sup> mentioned by Stiglitz, can be more<sup>smoothlyand willingly implementedif such reforms</sup> are deemed essential for regional integration.<sup>There has been increasingresistanceto</sup> externally imposed reforms. Regional<sup>cooperationor integration (even slow integration)</sup> is a more effective way to internalize<sup>these reforms.</sup> Fourth, the lack of global govemance, such<sup>as thelack of a globallender of last</sup> resort or global financial regulation,<sup>is expectedto continue for the foreseeablefuture.</sup> Rather than completely relying on<sup>national governance,thereseems to be some roomfor</sup> regional governance. In a region<sup>likeAsia wherethediversityis enormous,regional</sup> governance is more difficult than<sup>in Europe,for example.However, more flexibleand</sup> softer cooperation could be developed.

Fifth, regional integration has been proceeding<sup>quicklyin Europeand, toalesser</sup> degree, in the Americas although there<sup>are recentsignsof increasing acceleration there as</sup> well. Is it politically feasible or desirable<sup>for Asia tobe as open andglobal as in the past?</sup> Might not Asia be victimized by these<sup>two predatoryempiresin thefuture,asit wasin</sup> the 19 th and **20h** centuries? This is a rather<sup>defensive positionbut has been a major</sup> driving force for the recent moves toward<sup>moreregionalcooperation.</sup> If we are to establish a genuine regional<sup>organization,what kindof organization</sup> should it be and what kind of<sup>regionalcooperationshould be its focus?One obvious</sup> question that needs to be answered<sup>in thecontext of regionalcooperationis what new</sup> type of division of labor is possible<sup>with the rapidemergence of Chinaasa</sup> manufacturing giant in the region? The<sup>division of labor that has existedin East Asia,</sup> namely the "flying geese formation"<sup>led by Japanand the NIES,needsto adaptto this</sup> new environment. In fact, it is<sup>currently under rapid transformationandwill eventually</sup> evolve into one that includes China as<sup>the key player.The precise characteristicsof this</sup> new division of labor are not yet certain<sup>but one thingis clear -China cannot be</sup> dominant in every single manufacturing<sup>sector thatcurrently existsin the rest of Asia.</sup> Strategic concentration in key<sup>areasof technological or other areas of advantage for a</sup> country should allow it to coexist with<sup>China and the rest of Asia.Japan,for one, can</sup> climb higher on the technology ladder, developing<sup>its own technologicalskillbasewhile</sup> using China as its key manufacturing base.<sup>ASEAN countriescould specializein areasof</sup> manufacturing where they possess a skill<sup>advantage.</sup> In many countries industrial reorganization<sup>could become necessaryand involvea</sup> potentially large number of mergers<sup>and acquisitions.If an FTA between China and</sup> ASEAN, or among the members of<sup>ASEAN-Plus-Three (APT), were tobe concluded and</sup> monitored by a genuine regional institution,<sup>Asia-wide industrialreorganization would</sup> become a major policy initiative for<sup>the region.Although the processwould,and should,</sup> be essentially market driven, institutional<sup>involvement would be desirablesince policy</sup> coordination among the countries<sup>involvedwould be a keyelementof success.</sup> Regional trade agreements (RTAs) within<sup>APT,nevertheless,can proceed</sup> simultaneously with the Doha process.<sup>Positivefeedbackandsound competition between</sup> the two processes should accelerate<sup>liberalization,thus benefitingall countriesconcerned.</sup> By pursuing RTAs, Asian countries<sup>can gain a bargainingpositionvis-A-vis the U.S.and</sup> 117
Europe to channel WTO discussions in their favor. There has been criticism, particularly among developing countries, that the WTO process has benefited only developed countries, the U.S. above all. A two-track strategy (RTAs and WTO) would give leverage to Asian developing countries to counterbalance this bias.

China and the ASEAN countries have recently agreed to form an FTA by 2010, with some allowance for preferential treatment for less developed ASEAN countries. Korea and Japan could potentially join this arrangement to make it an APT FTA agreement. Given the diverse nature of the participating countries, the FTA should have initially some preferential treatment and exceptions for the less developed countries, but in general the FTA will accelerate integration, eventually eliminating preferences and exceptions. A pragmatic, rather than a purist, approach is required here. Parallel and reciprocal FDI agreements should proceed simultaneously with trade liberalization.

> In the area of international finance, various ideas concerning regional monetary and financial cooperation have emerged since the financial crisis of 1997-98. The crisis,

> it has been generally agreed, was capital-account driven, rather than current-account

> driven as were many crises in the past. Furthermore, a dual mismatch in currencies and

> maturities was one of the major causes of the crisis. Thus, it is only natural that discussions and suggestions for crisis prevention are focused on the areas of exchange

> rate regime and financial market regulation.

Reviewing these recent developments, Eichengreen (2001) argues, "Cooperation to stabilize exchange rates would be a diversion at best and a costly mistake at worst." He believes "cooperation in strengthening banking systems and promoting the development of bond markets, on the other hand, would go a long way toward creating a zone of economic and financial stability."<sup>319</sup> These are the grounds upon which he advocates the creation of an "Asian Financial Institute" on the platform of ASEAN-PlusThree.

> We think quite the opposite is the case for the following reasons. First, given the major differences in the stage of development of financial markets among APT countries,

> say between Japan and Laos, it is not at all realistic to come up with common guidelines

> for the prudential supervision of banking systems or capital markets. Second, as he himself admits, whether regional standards for prudential financial supervision apart from

> global standards are necessary or not is quite doubtful. Each country can have its own policy adhering to global prudential rule depending upon its stage of development or its politico-economic system. However, there is no "Asian" or cultural commonality in

> financial regulation around which to form regional standards as such. As has often been pointed out, Asia is very diverse culturally, racially or ethnically. While there is some common ground for the formation of a standard apart from the global standard, diversity

> should be respected over and above any monolithic adherence to a uniform standard.

In contrast to cooperation in prudential financial supervision, exchange rate cooperation or cooperation on forex/capital account policies can be effective among countries of different developmental states. Just as less advanced countries in Central and East Europe peg their rates to the Euro, late starters in ASEAN could fix their rates to the currencies of advanced countries possibly with some capital controls. Also, variations in the micro or structural aspects of financial systems can be maintained in exchange rate cooperation as long as some coordination in macro policies is possible. This distinction between macro and micro, or macro and structure, is very important if 118
diversity is to be respected.<sup>Countries could coordinateexchange rateor monetary</sup> policies while maintaining<sup>different politicaland economicsystems.</sup> The issue then is what kind<sup>of forex cooperationis possibleamong Asian</sup> countries? Eichengreen (2001)<sup>reviewsvarioustypesof foreign exchange regimes</sup> including an EMS-type snake,<sup>a currency-board-typepeg to the dollar,the yen or a</sup> dollar-yen-euro basket, and<sup>amonetary union. However, he concludesthat monetary</sup> cooperation is either infeasible<sup>or premature.True, its ultimatesuccessis a longshot as it</sup> is in the case of FTAs. Difficulties<sup>in creatinga currencyunion are atleast as greatas</sup> those in forming FTAs. It<sup>is alsotrue thereis a strong fear of floating among Asian</sup> countries, including Korea<sup>320, and theextent of currencymanagement hasnot been</sup> insignificant. Furthermore, Chinese-<sup>and Malaysian-typepartial capitalcontrols can be</sup> implemented in countries where<sup>the IMFdoesnot have a dominant role.</sup> Indeed, cooperation needs to<sup>be pursued in agradualand orderly manner but</sup> setting the target of currency<sup>union,alongwith FTAs,in the distantfuture,say ten years</sup> from now, is not inconsistent<sup>with gradualism. A commoncurrency peg asadvocated by</sup> Kawai and Takagi (2000) or<sup>Williamson (1999, 2000, 2001)may be a steptoward</sup> currency union but inclusion<sup>of the yen ina basket is a problemif an eventualmove to</sup> currency union is desired. The<sup>formaladoption of a common currency pegwith</sup> appropriate weights is difficult<sup>enough politically.The more ambitiouslong-termgoal of</sup> forming a currency union along<sup>with FTAswould seem morelikely to be successfulif it</sup> were combined with a pragmatic<sup>andfeasibleforexcoordinationpolicy in the short term.</sup> Given the widespread fear of<sup>floating in Asia,it seemsappropriate to coordinate</sup> the management of floating<sup>ratesamong authorities.In otherwords,interventionsin</sup> forex markets by authorities<sup>and theasset allocation of foreign reservescan be</sup> coordinated to avoid mutually<sup>inconsistentactions.Specific bandsneed not be agreed</sup> upon but authorities can consult<sup>with one anotherandcoordinatetheir policies,if</sup> necessary, to stabilize intraregional<sup>exchangerates.CountrieslikeKorea,China, Japan</sup> and the advanced ASEAN<sup>countries can regularly meetand constantlycommunicate with</sup> one another to exchange respective<sup>views on forexdevelopmentsand to try tostabilize</sup> their intraregional exchange<sup>rates by coordinatingmacro and interventionpolicies.There</sup> is no need to have fornal agreements<sup>butan APT version of G7,so tospeak,on macro</sup> and forex policies alone would<sup>contribute a lot to stabilization.</sup> Eventually, forex cooperation<sup>should developinto the formation of an Asian</sup> curTency unit (ACU) with<sup>a flexible snake around the central value,as in the case of the</sup> ECU and the snake. That<sup>is,the joint floating of Asian currenciesvis-a-vis the U.S.</sup> dollar and euro with a relatively<sup>wide band around the centralrate.Although the creation</sup> of a common currency a la the<sup>euro may not be feasible even in the long run,a soft and</sup> flexible form of currency union<sup>with an ACU could be a long-termnpossibility. It would</sup> enhance and accelerate integration<sup>through trade andFDI, and viceversa.</sup> Speculative attacks are realistic<sup>possibilities,but with a wideand flexibleband</sup> Asian countries should be able<sup>to fend off such speculation using their huge amountof</sup> combined foreign reserves if<sup>effective coordinationof macro policies accompanies joint</sup> foreign exchange interventions.<sup>The needto jointlydefend an ACU with a wide band</sup> logically leads to the idea of<sup>extending the Chiang Mai Initiativeto an Asian Monetary</sup> Fund (ATF), which would<sup>pool a portion of theforeign reservesof the participating</sup> countries and conduct macroeconomic<sup>surveillance.Participating countries could</sup> 119
conduct joint intervention and coordination of macro policies with the AMF as the secretariat. Articles of the AMF could provide the modality and modus operandi of coordination and intervention.

In conclusion, let us emphasize that the concrete proposal outlined here is just one example, and the process of formning a genuine regional organization should be gradual and pragmatic. As in the case of Chinese national policy, structural reform needs to proceed simultaneously with opening or liberalization. The moves also need to be gradual and simultaneous on all fronts.

> X In several UNCTAD reports, including the World Investment Report series; the WTO's Working Group

> on the Relationship between Trade and Investment, which can be found at

<http://www.wto.org/wto/english/tratop_e/invest_e/invest_e.htm>; and OECD (2002). Smaller studies include Urata (2001), Markusen and Venables (1998), Hanson (2001), Goldberg and Klein (1997), Brainard (1997), Feenstra and Hanson (1996), Kleinert (2000), and Fukasaku and Kimura (2002); among others. Some of these are reviewed in OECD (2002).

2Japan represents a good case of how outward FDI can change the structure of both exports and imports of both host and home countries through intemational production. Over the course of about ten years (through 1999), "reverse imports" (imports from Japan's affiliates abroad) as a share of total imports have risen from 4 percent to 15 percent and these are increasing faster than the exports of parent firms. Also, the composition of Japan's imports is changing such that the share of machinery and equipment imports, mostly electrical and electronics machinery, has risen from 17 percent to 31 percent over the same time period. (UNCTAD (2002c: 46.) UNCTAD (1996c: Chapter III), UNCTAD (2001: 58), and UNCTAD (1999a: Section II). 4UNCTAD (1996c: xxiv)

> 5 UNCTAD (2002c: xv)

6This is also referred to as fragmentation. See Arndt and Kierzkowski (2001) for discussion of this topic.

7 UNCTAD (1996c: Chapter IV) and UNCTAD (2002c: Chapter V) s UNCTAD (2002c: Chapter VI) 9 UNCTAD (2002c: xx-xxi) and UNCTAD (1999a: 18)

**'°** See UNCTAD (2002c: 152-153) for further discussion of these and other possible negative consequences of FDI.

UNCTAD J (2002c: 4) During 1971-2000, the correlation between the FDI and GDP growth rates was 0.3. Similarly, a simple regression of FDI inflows against GDP during the same period is as follows: FDI inflows = -190.9 + 0.0251 (GDP). R<sup>2</sup> = 0.75, adjusted R<sup>2</sup> = 0.55, t-value of GDP coefficients = 6.0. (UNCTAD (2002c: 22).

> 12 This refers to 16 recent empirical studies that examined the effect of FDI on growth of income and productivity and that are reviewed and discussed in OECD (2002: Chapter III). This literature review focuses primarily on four questions: . J. .11) Does FDI significantly affect the rate of growth of income or productivity? 2) Does FDI 'crowd out' or 'crowd in' domestic investment? 3) Do technology and

> knowledge spillovers take place in the domestic economy? and 4) Are there any necessary preconditions (e.g., human capital, technological or financial market development) for these positive effects to materialise?" (66) The studies covered, the specific questions addressed by each, their estimation techniques and major findings are presented in Table III. 1. on pages 70-74 of the OECD's report. 13 See Urata (2001) for more on this point.

> 14 OECD (2002: 68)

15 OECD (2002: 27-32) 16 UNCTAD (1996c: 73)

> 17 Export-processing zones (EPZs) constitute one example of consistent trade and FDI policies at the national level. [EPZs include "free-trade zones, duty-free zones, free-investment zones, [and] offshore

> zones [... .]." Activities performed in EPZs include "bonded warehousing, export processing, assembling, border or port trade and financial services. However, despite these variations, export-oriented manufacturing has been the main focus of most zones." UNCTAD (2002c: 214).

120
**18** OECD (2002: 35)

19 Data source is IMF's Direction of<sup>TradeStatistics.Taiwan notincluded.</sup> 20 Table numbers beginning with "S" are<sup>locatedin theStatistical Appendix;those beginningwith "G"are</sup> in the General Appendix.

21 Includes the ASEAN countries plus<sup>China,JapanandSouth Korea.</sup> 22 These three were selected because: (1)<sup>ASEANis themostprominent officialall-East-Asiangroup, (2)</sup> Japan is the only developed country<sup>in the regionand has playeda major rolein tradein the region for the</sup> last two decades, and (3) China has recently<sup>entered the WTOandhas experiencedthe most rapidgrowth</sup> in the region in recent years.

23 Some caution, however, is advised<sup>in interpretingthis data tomean that ASEAN is trading more</sup> intraregionally than extemally with the U.S.<sup>andthe EU.Giventhe shortcomingsof thetrade share</sup> measure, we will reserve judgment<sup>on thisuntilaftera lookat thetradeintensityindex.</sup> 24 Petri (1993) refers to these two measures<sup>as the "absolute"and "relative" measures,respectively,of</sup> regional interdependence. Frankel (1997:<sup>Chapter2) alsodiscussesthesemeasures.</sup>

**2S** The one exception (among the years<sup>includedin thetable) wasin1996 when"AllEastAsia's" share</sup> surpassed that of NAFTA, reflecting<sup>the rapid growth periodin the regionatthat time.</sup> 26 Since data has been calculated<sup>backto 1970 on the basis of currentgroup membership, these increases</sup> would not reflect the actual addition<sup>of members.</sup>

**27** This is clearly reflected in Tables 3<sup>and 4 whereAPEC with its 21membersand large-volume traders,</sup> such as Hong Kong, Singapore, Japan<sup>and theU.S.,has a larger sharein bothworld andits own trade than</sup> does NAFTA, which includes only<sup>threemembers of whichoneis the U.S.,or ASEANwith10relatively</sup> small traders.

28 For example, referring back to Table<sup>2,Hong Kong's tradewith ASEANisonly 8 percent of itstotal</sup> trade (average for 1998 to 2000) but<sup>itstrade with APEC isover82 percent,which does not necessarily</sup> mean that it trades more intensively<sup>withthe countriesof APEC than with the countries of ASEAN but</sup> rather that there are more and larger<sup>tradingcountriesin the APEC group than thereareinASEAN.[See</sup> Frankel (1997) for further discussion<sup>of this topic.]</sup> 29 See Drysdale and Gamaut (1993)<sup>foreven more in-depth analysisof tradeusing other indices including</sup> the complementarity and bias indices.

30 This is done by adjusting the trade<sup>sharesof acountry/groupthroughsome measureof that</sup> country's/group's importance in world<sup>trade.Morespecifically,it isthe "ratioof the shareof a country's</sup> exports with another country to the<sup>shareof thatother countryin worldimports.A numbergreater than</sup> one indicates that a country exports to<sup>anothercountry at a greaterlevel than theother is importing from the</sup> rest of the world, and a more 'intense'<sup>bilateraltrading relationship."(DeBrouwer2002: 290 and 292)</sup> There are a number of variations of<sup>this index including the"double-relative" measure of Petri (1993)and</sup> the "corrected concentration ratio" of<sup>Frankel (1997).The ratio usedhere is that presented in Drysdaleand</sup> Garnaut (1993), Anderson and Norheim<sup>(1993), and DeBrouwer (2002). Thereareotherswho have also</sup> used similar versions of the index; e.g.,<sup>Yamazawa,Hirata,andYokota (1991),Goto and Hamada(1994),</sup> and Goto and Kawai (2001). Rajan and<sup>Sen (2002)alsocalculatethisratiofor imports,in additionto</sup> exports.

31 The same formula was used to calculate<sup>the indexin bothtables buttheremay be slightdifferencesin</sup> raw data used in the calculations as<sup>they weredrawn fromsomewhat different sources.The results,</sup> however, are largely comparable.

32 For example, China's index with<sup>Japan in1995-97 was 2.8andthis remained unchangedin1998-2000;</sup> however, Japan was in second position<sup>as apartner for Chinain theearlier periodbut inthird positionin</sup> the latter period.

33 That analysis showed that from 1990<sup>(from at least1980in the case of exports) tothe end of the decade</sup> ASEAN's trade with Japan. as a share<sup>of ASEAN'stotal tradehad declined.(SeeFigure1.)</sup> 34 Excluding Myanmar and Brunei, which<sup>werenotincludedin the1995-97study.</sup> 35 These findings are generally confirmed<sup>by other studies,somecoveringdifferent timeframes.For</sup> example, see Frankel (1997: 29) and<sup>Goto and Kawai(2001:7).Urata (2002)concurs basedon his analysis</sup> of the "absolute", "relative", and "double-relative"<sup>(whichis calculateddifferently thantheintensity index</sup> used in this paper but is still comparable)<sup>measures.</sup> 121
36 Exports to the EU are actually less than might be expected based the EU's imports from the rest of the world (i.e., trade intensity index is less than 1.0).

37 UNCTAD (2002c: 55) 3S Not including the category of "Others" which comprises fairly large investments from unspecified countries and unclassified sources, the latter of which is the banking sector. Although not specified, it may be related to investment in the banking sector of Thailand in the post-crisis period.

> 39 ASEM is an informal process of dialogue and cooperation bringing together the 15 EU member states and the European Commission with ten Asian countries (Brunei Darussalam, China, Indonesia, Japan South Korea, Malaysia, the Philippines, Singapore, Thailand and Vietnam). IPAP's aim is to contribute to an enhancement of two-way investment flows between Asia and Europe by sharing experience and best practices on investment promotion and policy issues.

There were also disinvestments in Indonesia in previous years beginning in 1997 (during the crisis) when the U.S. was the only major investor to withdraw. Other source countries withdrew investment beginning in 1998, except the EU which began in 1999. The U.S. invested again in 1999, but disinvested in 2000. 41 See Urata (2001: 430-31) on this point.

42 The inclusion of the Virgin Islands and Bermuda among the top three originating countries for China and Hong Kong is related to their practice of "round tripping" and "tax haven routing" whereby capital inflows and outflows in the form of FDI move via tax haven economies into and out of Hong Kong. These economies account for large levels of inflows and outflows of Hong Kong-related FDI. Although more than half of Hong Kong's outward FDI goes to offshore financial centers (e.g., the Virgin Islands and the Cayman Islands), these funds actually are destined to eventually go elsewhere, including to mainland China.

43 Brunei Darussalam, Indonesia, Malaysia, the Philippines, and Thailand.

44 UNCTAD (2002c: 37) 45 Indonesia, Malaysia, the Philippines, and Thailand.

- 46 UNCTAD (2002c: Box III.2., 44)

47 JBIC (2002). The survey was conducted in July 2001 and covered 792 manufacturing companies that have three or more foreign affiliates, including at least one manufacturing base as of October 2000. There were 501 valid responses for an effective response rate of 63.3 percent. 48 UNCTAD 2002c: Box 111.2., 44)

- 49 Lardy (2002: 135-136)

50 The possibility for increased Japanese investment in China is further supported by a survey conducted by Japan Extemal Trade Organization (JETRO) in October 2001 which revealed that 21 percent of respondents (based on 645 responses among the 720 Japanese TNCs surveyed) indicated plans to relocate production sites to China with 67.5 percent of these likely to be moved from Japan, 9 percent from Hong Kong, 7.8 percent from ASEAN-5, 6.6 percent from Taiwan, and 1.2 percent from South Korea. In the same survey, respondents indicated that most aspects of the investment climate in Malaysia and Thailand were better than in China with concerns about China's investment climate centered on its establishment rules, transparency of investment rules and its tax system. However, respondents felt that market growth, production costs and labor supply were better in China. (UNCTAD (2002c: Box 111.2., 45).

'ASEAN (2000: 6) 52 See B. Low (2002) and Eckholm and Kahn (2002).

53 In 1992, 38 percent of Malayisa's total FDI stock was concentrated in the electrical and electronic equipment sector. The percentage of fixed assets in this industry that were foreign owned rose from 68 percent in 1970 to over 90 percent in 1990 with Japan being the single largest investor in this sector. [UNCTAD (2000: 54)] Malaysia exported 200 billion ringgit (US$52.6 billion) in electronic goods in 2001, almost three-quarters of its total manufacturing exports. [B. Low (2002)]

- 5 B. Low (2002)

- 55 UNCTAD (2002c: 162 and Table VI.7., 166)

- **56** UNCTAD (2002c: 40).

- 57 USTR (2002a).

- **58** UNCTAD (1999a: 12).

59 UNCTAD (2002c: 82 and 266).

60 FDI intensity is measured by the ratio of the share of partner "b" in FDI stock of region "a" to the share of the region "b" in world FDI stock. [See UNCTAD (2001: 57) for equation.] 122
|61Forthisindex,theregionof"Asia"includes<sup>China,Japan,Malaysia,Pakistan, RepublicofKorea,</sup><br>|
|---|
|Singapore,Taiwanand Thailand and"SEAsia"<sup>includesthedeveloping countriesofSouth, Eastand</sup>|
|SoutheastAsia(i.e.,excludes Japan).|

62 See Table S.3 in appendix for list of member<sup>countries.</sup> 63 Hong Kong is also included as a top investor<sup>in thattable but is not includedin the definitionof "Asia"</sup> for the intensity index calculation. 6UNCTAD (2001: 24). **65** UNCTAD (1999a: 14). 66 UNCTAD (2002a: 9). 67 UNCTAD (2002a: 9). 68 Scollay and Gilbert (2001: 19) and Ethier<sup>(1998).</sup> 69 A complete list of all such agreements worldwide<sup>can befound inthe sourcedocumentindicated at the</sup> bottom of this appendix table.

**70** Table A.6 shows only signed and adopted<sup>agreements and Table A.7shows only agreementssince1995.</sup>

71 Services, e.g., transportation and communications,<sup>are increasinglyimportanttoday as they link the</sup> various segments of production networks<sup>worldwide.[See Jonesand Kierzkowski (2001)for a discussion</sup> of this issue.] 72 "Agreement Between the Republic of<sup>SingaporeandJapanfor a New-AgeEconomic Partnership,"</sup> January 2002; Rajan and Sen (2002).

Yamazawa (2001: 20).

74 According to Senior Secretary to the President<sup>for EconomicAffairsHyun Jung-Taik,thesethree</sup> countries (Japan, Singapore and Mexico) cause<sup>theleast concernin terms of agriculturalissuesfor South</sup> Korea. [Speech at Seoul National University<sup>in November2002 (Kim, 2002).]</sup> 75 The achievements of AIA are mainly in<sup>thearea of globalmissions to promote theregion, establishment</sup> of a database of part and component manufacturers,<sup>provision of accesstoinvestment/businessinformation</sup> on the region, convening regular fora with business<sup>organizations, capacity building through training</sup> workshops, and others (ASEAN 2000a). Completed<sup>projectsunder APEC'sCollectiveActionPlanon</sup> Investment (for 1996-2000) include publication<sup>of aninvestment guidebook,compilation of a compendium</sup> of initiatives and strategies of FDI stakeholders,<sup>organizationof investment symposia,establishmentof</sup> policy dialogues to review various investment<sup>regimesandinvestment aspectsof FTAs, studiesof</sup> investment liberalization, and the conduct of<sup>severaltrainingprogramsand seminars(Austria2001).</sup> 76 The degree to which incentives affect investment<sup>decisionsis uncertain.;however,theyhave been</sup> important in the investment strategies of some<sup>developingcountries, particularlyinattracting export-</sup> oriented FDI. [See UNCTAD (2002c: 204-208).] 77 See Table G.2 in the General Appendix for a<sup>descriptionof various types of tradearrangementsand</sup> Table G.3 for a list of recent RTAs in the<sup>Asia-Pacificregion.</sup> 78 See Drysdale (2001), Frankel (1997), Scollay<sup>andGilbert (2001), Panagariya(1999),Low(2001),and</sup> Mistry (2000).

79Scollay and Gilbert (2001: 19-20) 0Phrasing that was first coined by Bhagwati<sup>(1991: 77)and popularizedby others.</sup>

**81** RTAs can overlap and adopt complex and inconsistent<sup>rules of origin that add cost and result in</sup> inefficiencies. This phenomenon was first<sup>described by Bhagwati, Greenaway, andPanagariya(1998).</sup> **82** See Panagariya (1999), Drysdale (2001)<sup>and Scollayand Gilbert (2001).</sup>

**83** Rose uses a standard "gravity" model of bilateral<sup>merchandisetrade anda largepanel data set covering</sup> over 50 years and 175 countries.

4Rose (2002: 1) 85 GSP (Generalized System of Preferences) is<sup>a systemusedby many developedcountriestohelp</sup> developing nations improve their financial or<sup>economiccondition throughexports. In effect,it providesfor</sup> the duty-free importation of a wide range of<sup>products thatwould otherwise be subject tocustoms duty if</sup> imported from non-GSP-status countries.<sup><http://www.customs.ustreas.gov/travel/gsp.htm#Whatis GSP></sup> 86 In addition to a theoretical discussion of the effects<sup>of RIAs on FDI decisions,thestudy examines three</sup> specific cases of North-North (Canada-U.S. Free<sup>TradeAgreement),North-South(Mexicowithin NAFTA)</sup> and South-South (MERCOSUR) integration.

87 Blomstr6m and Kokko (1997: 41)

**88** UNCTAD (2002b: 65)

123
**89** The coordination of policymaking for trade and<sup>FDIis not entirelynew.Infact,it hasprobablyoccurred</sup> more among developing countries, than among developed<sup>countries.See UNCTAD(1996c:116-118).</sup> **90** An example is Honda's network of operations in<sup>motorcycles.Ratherthan startingitsentry intoEurope</sup> with exports, which was its conventional method,<sup>it usedFDI very earlyonand integrateditsEU</sup> operations by taking advantage of the increasingly liberalized<sup>frameworkthere.(UNCTAD (1996c:101).</sup> **91** Balasubramanyam (2002: 191) 92 UNCTAD (2002c: 24) and (1998: 91)

93 Originally conceptualized by Kaname Akamatsu<sup>in the1930s.</sup> 94 See Ozawa (1999) for a detailed discussion of the<sup>"flying geese"paradigm andhow it ledto the</sup> development of East Asia.

95 "During 1998-2000, the Triad accounted<sup>for three-quartersof globalFDI inflowsand85percentof</sup> outflows, and for 59 per cent of inward and 78 per cent of<sup>outwardFDIstocks."[UNCTAD(2001:9)]</sup> 96 UNCTAD's "transnationality index" for a country is<sup>based ontwo FDI variables(i.e.,FDI inflowsas a</sup> percentage of gross fixed capital formation and FDI<sup>inwardstockasa percentageof GDP) andtwo</sup> variables related to foreign firms' operations in a host country<sup>(i.e.,value added byforeignaffiliatesasa</sup> percentage of GDP and employment by foreign<sup>affiliatesas a percentageof totalemployment.)The index</sup> is also applied to individual firms and in this<sup>caseis the averageof three ratios: foreignassets/totalassets,</sup> foreign sales/total sales and foreign employment/total<sup>employment.[SeeUNCTAD(2002c)for further</sup> details.] 97 UNCTAD (2002c: 61-62)

**98** "The largest 20 companies most actively involved<sup>in cross-border M&As accountedfor one-fifthof the</sup> total value of cross-border M&A deals during the past<sup>15 years:1987 -2001."UNCTAD (2002c:89).</sup> h OECD (2002: 50)

**'°** UNCTAD (2002c: 60-6 1)

**101** UNCTAD (2002c: 20-21)

**102** UNCTAD (2002c: 102)

**103** This index is "calculated as the ratio of the number of<sup>foreigncountries(N)in whichaTNCoperates</sup> wholly-owned affiliates to the number of foreign<sup>countries(N*)in which itcouldpotentiallyoperate. The</sup> latter number is calculated for the countries (excluding<sup>the homecountry)whichhada positive FDI stock</sup> in 2001, defining them as potential locations for FDI. All<sup>inall,this covered187countries."[UNCTAD</sup> (2002c: 109)]

04 See Table IV.2. on page 89 and Figure IV.9.<sup>on page110of UNCTAD (2002c).</sup> **105** UNCTAD (2002c: 109-10)

**106** UNCTAD (2002c: 143) **107** UNCTAD (2002c: 149) **108** UNCTAD (2002c: 149-150)

**109** A brief summary of these three industries, taken from<sup>UNCTAD (2002b: Annex3 toChapterIII,99-</sup> Ill), is presented here. See original publication for<sup>further details.</sup> **110** UNCTAD (2002b: 100)

1 This was in part because of their centralized management<sup>structure,the long timerequiredin</sup> establishing local supplier relationships and their<sup>preferencefor in-housecomponentdesign.</sup> **112** UNCTAD (2002b: 103-4) '3 UNCTAD (2002b: 105) **114** UNCTAD (2002b: 108)

**115** Romijn, Van Assouw and Mortimore (2000:<sup>139)</sup> 116 UNCTAD (2002c: Annex table B.4., p316-317) **117** Lawrence (2002) **118** See Arndt (2001: 26) **119** See also Jones and Kierzkowski (2001:<sup>32-33).</sup> **120** Amdt (2001: 32) **121** See Cheng, Qiu and Tan (2001: 182-185) 122 See section on Regional Agreements above. **'2** Arndt (2001: 26) **124** Wain (2002) **'2** Frankel (2000: 20)

124
|126ADB Institute(2000:2)|
|---|
|127Uninsureddebtthatisjuniortoinsured deposits<sup>butseniortoequity.</sup>|
|128Thistableincludessomecompleted,and<sup>yettobecompleted,reforms.Fora completeand detailed.</sup><br>|
|discussionofprogress byindividualcrisis-affected<sup>countriesinfinancialsectorandcorporatesector</sup><br>restructuringseeKawai (2000).|
|129Eichengreen(1999:52).|
|<br>130SeeEichengreen(1999:AppendixC) for<sup>furtherdiscussionofthe coincident natureofeventsin the</sup>|
|Asian crisis.|
|**13'**Eichengreen(1999:AppendixA.)|
|<br>**132**Proposalsanddevelopmentsinthesettingof<sup>financialstandardsarealsoreviewedinEichengreen</sup><br>(1999:Chapter3)andinNellor(2000:<sup>Table14.1).</sup>|
|<br>33SeeSoesastro(1998: 375)|
|<br>34Soesastro (1998)|
|<br>'"Severino(1998)|
|136Soesastro(1998)|
|137APECFinanceMinisters Process,<sup>updated May9,2001.</sup>|
|<http://www.apecsec.org.sg/fora/activity....nister_-process/finance_-process_upd.htm>.<br>138YoshitomiandShirai(2000:68).|
|139Most,althoughnotall,oftheAPECcountries<sup>wererepresented: Australia, BruneiDarussalam,Canada,</sup>|
|China,HongKongSAR,Indonesia,Japan,<sup>Korea,Malaysia,NewZealand,thePhilippines,Singapore,</sup>|
|<br>Thailandand theUnitedStates.|
|14 0 "ANew FrameworkforEnhancedAsian RegionalCooperationtoPromote FinancialStability,"Meeting|
|ofAsian FinanceandCentralBank Deputies,<sup>Agreed SummaryofDiscussions,Manila,Philippines,18-19</sup>|
|November1997.|
|**"41**Japan,MinistryofFinance(2002),<http://www.mof.gojp/English/qa/myO01.htm>|
|<br>**142**TheUS$15billionofmedium- and long-term<sup>supportundertheNewMiyazawaInitiativeishandled</sup>|
|throughtheJapanBankforInternational Cooperation<sup>(JBIC),which is themergedentityoftheformer</sup>|
|<br>Export-ImportBankofJapan (JEXIM)andthe<sup>OverseasEconomic CooperationFund(OECF).</sup>|
|<br>143Datawere obtained fromJapanMinistryof<sup>Finance,<http://www.mofgo.jp/English/if/eleO42.htm>and</sup><br>aredated February2000,butamountsremainunchanged<sup>today.</sup>|
|<br>144SeeSoesastro(2000b:141)|
|**145**ASEAN (1999)|
|<br>146Soesastro (2000b:140)|

147 Eichengreen (2001: 45) 148 The BSA is similar to a currency swap the<sup>U.S.Treasury extendedto Mexicoin themid-1990s when the</sup> peso was in danger of collapsing. Mexico swapped<sup>itspesos for dollarsto builditshard currency reserves,</sup> and later returned the dollars with interest.<sup>(Alan Yonan, Jr.,lain McDonald, andAlastairMclndoe,</sup> "Japan/Swaps Deal -2: To Insulate Asian<sup>Economies," Emerging Markets Report,10 May2001.</sup> <http://www.djinteractive.com>.

**149** Wheatley (2002)

**150** Not all of the swap arrangements will involve<sup>linkagetothe IMF(e.g.,the Japan/Chinaswap),butso far</sup> most are linked.

151 "S&P says Asia swap deals could threaten ratings,"<sup>ReutersEnglish NewsService,10 May 2001.</sup> <http://www.djinteractive.com>. **152** IMF (2002a) 153 Alan Yonan, Jr., lain McDonald, and Alastair Mclndoe,<sup>"Japan/SwapsDeal -2: To InsulateAsian</sup> Economies," Emerging Markets Report, 10 May<sup>2001,<http://www.djinteractive.com>.</sup> 154 Alan Yonan, Jr., lain McDonald, and Alastair<sup>Mclndoe, "Japan/SwapsDeal -2:To InsulateAsian</sup> Economies," Emerging Markets Report, 10 May<sup>2001,<http://www.djinteractive.com>.</sup>

**155** Horst K6hler, "New Challenges for Exchange<sup>RatePolicy,"Remarks made at theAsia-Europe (ASEM)</sup> Meeting of Finance Ministers, Kobe, 13 January<sup>2001.</sup>

**156** Nellor (2000: 341-342)

157 Noble and Ravenhill (2000: 30-32) 158 Kawai, Newfarmer and Schmukler (2001: 44-47) 125
159 Other studies supporting this view,<sup>inadditionto those mentionedin thisparagraph,include Demirguc-</sup> Kunt and Maksimovic (1998), Rajan<sup>and Zingales (1998),Wurgler (2000), Levine andZervos (1998),and</sup> Beck, Levine, and Loayza (2000).

160 Including Bagehot (1873), Hicks (1969),<sup>Schumpeter (1912),Robinson (1952),Lucas(1988),</sup> Chandavarkar (1992), Meir and Seers<sup>(1984),and Stern(1989).</sup> 161 Levine (1997: 688) 162 Wilson (2002: 17 .

**163** World Bank (2002b) and Li, Squire,<sup>and Zou (1997)</sup>

**164** World Bank (2001: 6-7)

**165** Stulz (2001: 146-147)

166 Percentages in this table are not<sup>directly comparable to those of othersources (e.g.,Shirai 2001b).They</sup> may vary for some countries, which<sup>might be due todatabeing obtained from differentsources.The</sup> results, however, are broadly consistent.

167 Japan's percent of GDP for equities<sup>was undoubtedlyhigher during thebubble era.</sup> 168 Japan has become less bank-centered<sup>in recent years.</sup> 169 Stulz (2001) refers to Thurow (1992)<sup>in comparing theAnglo-Saxonsystemof maximizingshareholder</sup> influence to the German/Japan system of<sup>minimizing shareholderinfluence.Dore (2000)examinesthis</sup> subject in detail in his book, Stock Market<sup>Capitalism: WelfareCapitalismwhichcovers the labor,</sup> productivity, financial, cultural and<sup>socialaspectsof these two systems.</sup> 70 IMF (2001b: 214)

**171** Including government bonds,<sup>the total outstandingamounts of localcurrency-denominated long-term</sup> bonds in these countries increased from<sup>$181billion at the end of 1997to$422 billionat the endof 2000.</sup> This was because of the large quantities<sup>of bondsissued by governments in domesticmarketsto fund the</sup> purchase of NPLs and to recapitalize local<sup>banks. (IMF,2001c:214)</sup>

72 Asian Policy Forum (2001) and Shirai<sup>(2001a)</sup>

**173** The APF recognizes three stages in<sup>the developmentof financialmarkets:Stage I -bankdominant,</sup> Stage ll - intermediate, and Stage III -<sup>full-fledgedcapital-marketbased.</sup>

**174** This study is based on recent cross-country<sup>datafrom almost150countries on banks, insurance</sup>

companies, pension and mutual funds,<sup>financecompanies, and stockand bond markets.Italsoincludes</sup> information on each country's political,<sup>economic,and social environment.</sup>

**175** The classifications are based on<sup>thelevel of "financialdevelopmenf'as definedby theauthors(seenote</sup> at the bottom of Table 5.10). This may<sup>differfrom a country'slevel of economic development.In other</sup> words, a country may be a "developing<sup>economy"but at the same time beclassifiedas "financially</sup> developed" in this study (e.g., Thailand<sup>and Malaysia).Or it may be a"developed economy"but classified</sup> in this study as "financially underdeveloped"<sup>(e.g.,Denmark).</sup>

176 The higher the Structure Index, the<sup>higher thelevelof stockmarketdevelopment relative to banking-</sup> sector development.

177 The authors point out that their study<sup>usesa database that "drawson awider arrayof sourcesand</sup> constructs indicators of the size, activity,<sup>and efficiency of a much broader set of financialinstitutions and</sup> markets" than have been used in previous<sup>studiesof thisnature.(Beck,Demirguic-Kunt,and Levine,2001:</sup> 17-18)

**178** Demirgiu-Kunt and Levine (2001<sup>a:120)</sup>

**179** Although their original database<sup>includesindicatorsfor bothequity and bond markets,itappearsthat the</sup> Structure Index shown here incorporates<sup>only equities (and not bonds)in the capital marketsindicators.</sup>

180 Some have tried to establish stock markets<sup>in this waybut were unsuccessful.Harwood(2000:5-6)</sup> 18' For example, Krugman (1999) 182 Harwood (2000) 183 This list presumes that infrastructure,<sup>includingregulationsand regulators,exchanges, and trading and</sup> clearing systems, is already in place.

184 Harwood (2000: 8) 185 However, it should be noted that there<sup>is somediversityin thelevelof developmentof bond markets</sup> among the various countries of the region.

**16** Asian Policy Forum (2001), Shirai<sup>(2001b),Park (2001),and World Bank(2002b).</sup>

**187** Shirai (2001b: 1)

188 IMF (2001b: 215) 126
**189** Park (2001: 66) **'9** Tumer (2001: 337) **19'** Although not specifically stated, presumably<sup>thisis areferenceto the BaselCommittee'smulti-track</sup> effort to revise the Basel Capital Accord,<sup>whichincluded a proposalforaninternal-ratingsbasedapproach</sup> ("IRB approach") to regulatory capital.<sup>See Web site at <http:Hlwww.bis.org/publ/bcbsca.htm>for recent</sup> uVdate. 2Turner (2001: 339) '9' As of 1998, China was the only country<sup>(out of 51industrialand emerging countriessurveyedby the</sup> Institute of International Bankers) that<sup>had a completely"pure"separatebankingsystem,rmeaningthat</sup> banks are not permitted to engage in<sup>anytypeof securitiesactivity.[ClaessensandKlingebiel(2001:26)]</sup> 194 Asian Policy Forum (2001), Yoshitomi<sup>and Shirai(2001), andShirai(2001a)</sup> **195** Yoshitomi and Shirai (2001: 69) 196 Shirai (2001 a: 34) 197 World Bank (2002b: 79) 198 See Shirai (2001 a: 46-55) for further<sup>details.</sup> 199 ADB Institute (2001) and Asian Policy<sup>Forum (2001)</sup> 200 Kawai (2002: 86-87) 201 A complete review of bank restructuring<sup>in Indonesiais presentedin Pangestu and Habir (2002).</sup> 202 See Kuroda (2001), Kobayashi (2001),<sup>Sakakibara(2001),and AsianPolicyForum(2001).</sup> 203 See Chapter V of this paper for<sup>descriptionof NMI.</sup> 204 Asian Policy Forum (2001: 23) and<sup><http://www.mof.gojp/EnglishIif/eleO42.htm>.</sup> **205** Park (2001: 58) 206 Asian Policy Forum (2001: 22) 207 Asian Policy Forum (2001: 23) and<sup>Kuroda (2001:77)</sup> 208 Asian Policy Forum (2001: 22-23) 209 Australia and Hong Kong already have<sup>a link-upin placefor their securities clearing systems.</sup> **210** Park (2001: 59) 211 Harwood (2000: 9)

212 Sydney would also be in this category if<sup>Australiais includedin the region.</sup> 213 Freeman and Bartels (2000: 1-2)

**214** Although the primary outflows were<sup>bank-lendingflows,therewereconsiderableportfolio(equity)</sup> outflows as well. A6cording to Rajan<sup>andSiregar (2002), theseoutflows "playedanimportant'supporting</sup> role' in the regional crisis" (62). **215** IMF (2002b: 17)

Freeman (2000: 10) 217 Wilson (2002: 25) cautions against<sup>becomingoverly distractedby downwardvaluationchangesrelated</sup> to financial crisis when assessing the<sup>long-termprogressin financialdevelopmentand market</sup> sophistication because prices do not provide<sup>sufficientinformationabout theunderlyingefficiencyof the</sup> market.

218 Wilson (2002: 25) 219 Freeman's analysis is based on<sup>data prior toJuly 2000.In view of thesubsequentdeclinein techstocks</sup> worldwide, this may have altered somewhat.<sup>However, Freeman laterimpliesthat thesectoral bias is fairly</sup> well entrenched in the region.

220 Freeman (2000: 6) 221 Yang and Siregar (2001: 24) _2m_ Freeman (2000: 8 and 22)

**223** Freeman acknowledges that he is not<sup>thefirstto makesuch a proposal.The Bankof ThailandGovemor</sup> Chatumongol Sonakul proposed<sup>a joint venturebetween the equity markets inBangkok, KualaLumpur and</sup> Singapore in May 2000.

224 Freeman claims that the role of foreign<sup>institutional investorsin thecrisiswas exaggeratedandthattheir</sup> guilt was less than that of foreign commercial<sup>banklenders.</sup> Rajan and Siregar (2002: 74)

**226** Demirguc-Kunt and Levine (200 lb:<sup>12)</sup>

**227** Legal systems having European origin<sup>include English CommonLaw and the French, German,and</sup> Scandinavian Civil Law. English<sup>Common Lawdiffers fromcivil lawin that laws wereformedprimarily</sup>

127
by judges trying to resolve particular cases.<sup>[See Beck,Demirgiuc-Kunt,Levine,and Maksimovic(2001:</sup> 204-205) for a detailed explanation of<sup>thesesystems.]</sup> 22 Demirguc,-Kunt and Levine (2001a: 132) 229 The authors define financial development as<sup>appliedin thisstudy as anassessment of the "efficiency</sup> with which financial intermediaries and markets<sup>(1) assessnew projectsand firms,(2) exertcorporate</sup> control, (3) ease risk management and (4) mobilize<sup>savings.[Beck,Demirguic-Kunt,Levine and</sup> Maksimovic (2001: 195)] 230 This is not an absolute measure.

231 Detailed descriptions of what the variables<sup>intheseindicatorsrepresentare presentedin TableG.8in the</sup> General Appendix.

232 Traditionally, creditors such as banks<sup>andinsurancecompanieswerekeyshareholdersof corporationsin</sup> Japan. However, the ownership structure of Japanese<sup>firmshasshiftedso that cross-shareholdingshave</sup> been reduced and foreign investors have increased.<sup>Furthermore, shareholdersareexercisingtheirrights</sup> actively. [Yasui (2001)] 233 Dore (2000) describes in detail the similarities<sup>betweenJapan'sandGermany'sformsof capitalism(i.e.,</sup> Rhenish capitalism) versus the Anglo-Saxon<sup>version thatisespoused by the USand UK.</sup> 234 Japan's Commercial Code, which provides<sup>protectionfor minority shareholders,was amendedin1993</sup> strengthening that protection.<sup>[Yasui (2001)]</sup> 235 Schmukler and Vesperoni (2001: 372) 236 World Bank (2002b: 78) 237 Nam et al (2001: 87-88) 238 Eichengreen (2001: 39) 239 Lamberte (2001: 137-139) 240 Kuroda (2001: 76) 241 Enron, an energy-trading company in Texas,<sup>declaredbankruptcy inDecember 2001.Surroundingthe</sup> bankruptcy are accusations of incompetence, conflict<sup>of interest and even corruption.This has led to calls</sup> for reforms to accounting standards, the auditing<sup>system, and corporategovernancein theU.S.</sup> 242 In January 2002, a foreign exchange trader at<sup>Allfirst wasaccused of being instrumentalin the lossof</sup> $750 million to the bank. This occurrence added<sup>tothecallsfor investigationsintoand reformof the</sup> financial services industry, particularly the accounting<sup>industry,inthe U.S.andEurope.</sup> 243 Demirguc-Kunt and Levine (2001b) 244 At the beginning of 2002, a compromise<sup>wasreachedon theimplementationof theLamfalussy</sup> proposals which are a series of reforms for the<sup>harmonizationof the regulationof Europeansecurities</sup> markets through "fast-track" legislation [Saltmarsh<sup>(2002:B4)].</sup> **245** Saltmarsh (2002: B4) 246 Saltmarsh (2002: B4) 247 Michael Richardson, "Asia Looks To Zones<sup>of Free Trade RegionUnlikelyto PushFor a Monetary</sup> Union," International Herald Tribune<sup>03 Jan.2002:9,08Jan.2002<http://www.djinteractive.com>.</sup> 248 Wyplosz (2001b: 21) 249 Some of the more recent studies included<sup>in thisreview are:Rodrik(1998),Klein and Olivei (2000),</sup> Chanda (2000), Arteta, Eichengreen, and Wyplosz<sup>(2001),Bekaert,Harvey, andLundblad(2001),and</sup> Edwards (2001).

**250** Arteta et al (2001: 26-27)

**231** IMF (2001d: 155-163)

> 2 52 IMF (2001d: 151)

**253** Kaplan and Rodrik (2001: 1)

254 Ariyoshi et al (2000) 255 Malaysia's controls were relaxed significantly<sup>in February1999.[AsianPolicy Forum(2000:3)]</sup> 256 Ariyoshi et al (2000)

**257** Kaplan and Rodrik (2001: 32)

**258** IMF (2001 d: 164)

> 2 59 IMF (2001d: 164)

260 Ariyoshi et al (2000: 28) 261 Ariyoshi et al (2000: 38) 128
|262However, thedistinction between prudential policiesandcapital controlsisnotalwaysclear[Ariyoshiet<br>|
|---|
|al(2000: 32)].<br>|
|263Ariyoshietal(2000: 39-40)|
|264IMF(2001d:167-169)|
|**265**Fan (2002:166)claims, "therehasnever beenareal caseofsequencing,exceptforsome technical<br>preparationsforacertainstepofmarket liberalisation."<br>Fan(2002:165)<br>267Fan(2002:165)<br>|
|**268**Fan(2002:166)|
|269Anotherproblemwithsequencingisthatitisdifficulttodetermineatwhatpointastephasbeen<br>completedsothatthenextstep canbetaken.Incompatible openingitisdifficulttoknowwhichpolicies<br>arecompatible,butit requiresno"check points,"onlythat small stepsbetakenin allareasfromwhich|
|achievementswillaccumulate.Itcouldthusbemorechaoticthansequencing.[Fan(2002:166)]<br>270Fan(2002:167)|
|271Fan(2002:158)|
|**272**While thisistheviewofmanyintheregion,therearethosewhodisagree.Eichengreen(2001)views<br>monetary cooperation(tostabilizeexchangerates)andfinancial cooperation(tostrengthenbanking<br>|
|systems)asseparateanddistinctwith thelatterbeingofahigherpriority thantheformer.|
|<br>23Descriptionsofcommoncurrencyregimes(asidentifiedbytheIMF)arepresentedintheGeneral|
|Appendix.|
|274Theywereactually"soft"pegstobaskets composedoftheU.S.dollar,Japaneseyen,German markand|
|other Europeancurrencies, buttheweightoftheU.S.dollarwasdominant(Yamazawa,1998).|
|**275**SeeTableG.9inappendixfordescriptionsofcommonexchangerateregimes.|
|<br>276Realestate developershad borrowedindollars(unhedged)fromdomesticbankstofinance realestate|
|projects.|
|277RadeletandSachs (2000:115)|
|<br>278Radelet andSachs (2000:137)|
|279Nocountryusesacompletelyfreefloatingexchangerate.Countriesthatareconsideredtobefree|
|floaters(suchasthe U.S.and Japan)willonoccasion intervenewithmodestsmoothingwhenabsolutely|
|necessary.|
|**280**Calvo andReinhart(2000:26)|
|<br>**281**Frankel, Fajnzylber,Schmukler,andServen(2000:8)<br>**282**McCauley(2001:9)|
|283Theauthorsarguethatatheoretical rationaleforthetwo-comerpropositionislackingandtheyreject|
|otherpossibleexplanations(i.e.,theimpossibletrinity,thedangersofunhedgedforeign liabilities,and|
|govemmentreluctancetoabandonshipintime)asnotconvincing.[SeeFrankel,Fajnzylber,Schmukler,<br>andServen (2000)foradetaileddiscussion.]|

2S4 A pegged exchange rate within a horizontal band - the value of the currency is maintained within margins of fluctuation around a formal or de facto fixed peg that are wider than plus or minus I percent around a central rate (parity). There is some limited degree of monetary policy discretion, with the degree of discretion depending on the bandwidth.

285 Asian Policy Forum (2000: 4) 286 Larrain and Velasco (1999: 11-12) and Glick (2002: 202-203) 287 See Table G. 9 and G. lOin the General Appendix for descriptions of exchange rate regimes and monetary policy frameworks, -respectively.

288 Williamson (2001: 97) 289 Williamson (2001: 97) 290 Calvo and Reinhart (2000), Frankel, Schmukler and Serv6n (2000), and Benassy-Quere and Cceur6 (2000) 291 McCauley (2001: 25). The author reconciles the findings of McKinnon (2000) with his own contrary findings in his Appendix A, page 46.

292 De Brouwer (2001: 58) 293 Kwan (2001: 75) with categories based on Eichengreen (1994) and Frankel (1999b). **294** Frankel (1999b: 6) 295 Kwan (2001: 77-78) 129
296 Bayoumi, Eichengreen and Mauro (2000: 147)

**297** Goto and Hamada (1994), Eichengreen and Bayoumi (1999), Benassy-Quere<sup>(1999), Kawaiand</sup> Akiyama (2000), and Bayoumi, Eichengreen and Mauro (2000). **298** Kawai and Takagi (2000: 25) **299** Some advocates of this regime are Dombusch and Park (1999), Murase (2000),<sup>Williamson (1999,</sup> 2000, 2001), Ogawa and Ito (2000), and Kawai and Takagi (2000). **300** De Brouwer (2002: 299) says that the evidence is mixed conceming the adverse<sup>effectof currency</sup> volatility on economic performance. **301** Kawai and Takagi (2000)

**302** Favored by Dombusch and Park (1999) and Williamson (1996, 2000, and<sup>2001), amongothers.</sup> **303** "The 'effective exchange rate' is the weighted-average exchange<sup>rate againstallcurrencies,wherethe</sup> weights are generally chosen to reflect the pattem of trade. (An alternative<sup>weighting system, basedon</sup> trade elasticities, recognizes that countries are also important competitors,<sup>rather than just tradepartners.) A</sup> 'real effective exchange rate' corrects for changes in relative inflation so<sup>that theindex doesnot change if</sup> prices increase as much at home as the weighted average of the country's<sup>trading partners." (Williamson,</sup> 2001: 97)

304 Kwan (2001) and Williamson (2001) **305** Williamson (2001: 98) **306** Ogawa and Ito (2000) suggest that publishing a "typical<sup>currencybasketunit" (or ACU)for the region</sup> could be helpful to each country in calculating its own basket. 307 Kawai and Takagi (2000: 25-26)

**308** De Brouwer (2002: 292). The author bases his analysis on trade data for 1995-97.<sup>Intermsof</sup> intraregional trade share for 1998-2000, as presented earlier in this study, the proportion<sup>has dropped</sup> slightly but is still close to half.

**309** Again, de Brouwer bases his analysis on trade data<sup>for 1995-97.Our datafor 1998-2000reflectssome</sup> changes in trade pattems for East Asian countries. Although<sup>itis stillthe casethatCambodia,LaoPDR and</sup> Vietnam trade more with other countries in the region than<sup>with theU.S.,Japan and EU,comparedto the</sup> earlier period Cambodia now exports more to the<sup>U.S.than the EUbut still littleto Japan,LaoPDR's share</sup> of exports to the EU has halved while that to Japan is<sup>nearlyfive times greater,and Vietnam'sshareof</sup> exports to Japan has dropped considerably while<sup>tradeshareswith theU.S.and EUare relatively</sup> unchanged.

**310** The EC signed the Baste Agreement in 1972 which reduced the<sup>bilateral fluctuationmarginsof its</sup> member nations' currencies to +/-2.25 percent (the snake) against the wider world of<sup>4.5percent(the</sup> tunnel). This became known as the 'snake in the tunnel' (or European Common<sup>MarginsAgreement).</sup> While the European currencies would continue to fluctuate against the dollar<sup>and other currencieswithin</sup> the wider band, intra-European fluctuations would be decreased. The tunnel<sup>disappeareda yearlater when</sup> the dollar was floated. This left the "snake" as a joint float. Aldcroft and Oliver<sup>(1998: 146-150)and</sup> Rehman (1997: 14-17)

**311** Wyplosz (2001a: 130)

**312** Wyplosz (2001a) identifies the European Commission and the<sup>ECB(European Central Bank)asthetwo</sup> main institutions today. He does not downplay the shortcomings of these institutions<sup>andthe many</sup> difficulties they face in carrying out their functions, but states<sup>thattheir existence hasbeen "crucial"and</sup> "they embody the principle of a common good and common aims which<sup>transcend national interestsand</sup> objectives." Wyplosz (2001 a: 140)

"' Tay (2000b: 159-60) and Soesastro (2000a: 192) **314** Urata (1998)

**315** Wyplosz (2001a: 140)

**316** Wyplosz (2001a: 140)

**317** Kartadjoemena (2001: 210-211) **318** Stiglitz (2001a: 523) **319** Eichengreen (2001: 43) **320** Park et al (2001)

130
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