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p. 53 of 54 BACK | NEXT I. Developing Asia and the World - Economic Developments and Prospects II. Economic Trends and Prospects in Developing Asia III. Asia's Globalization Challenge Introduction The Asian Growth Experience and Globalization Policies for Adapting to Globalization Institutional Options in a Globalizing Environment Conclusions - Toward a Framework for Globalization

Asian Development Outlook 2001 : III. Asia's Globalization Challenge

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Institutional Options in a Globalizing Environment

As Asian economies integrate further into the global economic system they face a number of challenges and opportunities. In many cases these can be addressed by the private sector. However, in some instances governments will have to be involved. Because of the nature of the globalization process, they will have to adopt new approaches and be willing to develop new institutions and policies to address the issues presented by continued globalization. Governments will no longer be able to rely solely on national initiatives, although these will still be important. They must go further in developing relationships and participate with other countries in institution building to deal with global issues at both the regional and global levels. In this section, the focus is on the macroeconomic landscape, eschewing more detailed microeconomic and sector policy issues. Particular attention is paid to the dynamics of institution building as it relates to globalization.

Establishing an Institutional Framework

Economists tend to assume the existence of appropriate institutions. Put another way, if a certain set of institutions were to be efficient, economists assume that they will develop in response to latent demand (Davis and North 1971). Thus, if new technologies generated by start-up firms are the motor for growth, and if supporting their development requires financial markets capable of providing venture capital, then a market-based financial system will spring up in response to the profit incentives perceived by aspiring venture capitalists. And if, to attract FDI, countries must adopt demanding corporate disclosure standards and legal systems affording strong protection for creditor rights, then they will do so in order to prevent FDI from being diverted to jurisdictions that are quicker to respond. It is important to understand why this may not occur in an orderly fashion.

Institutions can be understood as coordinating mechanisms— as coordinating the actions of different economic and social agents.²⁵ They do so by providing standards for socially constructive behavior. Because they function as standards, they are a source of network externalities.²⁶ And like any technology that throws off network externalities, once established they tend to become locked in. As David (1993) has put it, institutions, by virtue of their inertial character, become the “carriers of history.”

Because institutions have an inertial character, radical institutional change is the exception, not the rule. Wholesale change requires the political and economic system to be displaced from its equilibrium. It follows that radical change often occurs in response to major shocks—crises, for example. (A model of the linkage is provided by Drazen and Grilli 1993.) By definition, crises disrupt the operation of existing institutions. That disruption creates a vacuum in which new arrangements can develop. This is the story told in Olson (1982) of institutional change in the wake of war and crisis. More generally, the suboptimal performance of existing institutions that has been made clear by a crisis can foster the consensus needed for agreement on changes in prevailing arrangements. Thus, the political and economic crises of the 1940s and 1950s are commonly credited with creating a hothouse environment conducive to the growth of the institutions that served Asia so well in its period of rapid economic growth. Economies like Korea and Taipei,China emerged from the Second World War and the Asian conflicts that erupted in its wake in a parlous economic state. In Korea, for example, years of foreign occupation and civil war had left the population on the margin of subsistence. The political disputes and the fact that the NIEs and Southeast Asia were a principal battleground of the Cold War created a crisis of national survival in countries across the region. This crisis in turn cultivated the political support for the institutional changes needed to strengthen the state and the economy. Land reform was carried out in Korea and Taipei,China which allowed the benefits of rising agricultural productivity to be widely shared and created a rural middle class. Korea; Singapore; and Taipei,China developed effective tripartism. Powerful urban interests were induced to acquiesce to government programs that were designed to develop the rural infrastructure necessary for balanced growth. Regime leaders had the political autonomy to develop independent technocracies and performance-based civil service systems. These institutional ingredients of Asia’s “miracle” are by now well understood. The point here is that their development should be seen as a social response to this crisis of national survival.

In the wake of the Asian financial crisis of 1997/98, it is again clear that a crisis can catalyze reform.²⁷ This is particularly evident in the steps taken by DMCs to update and strengthen their financial institutions, with the aim of restoring investor confidence, and the long-run goal of equipping themselves with the institutional prerequisites for navigating a world of global finance. Prudential supervision and regulation have been strengthened, and new rules have been adopted to encourage arm’s-length dealing between financial institutions and their customers. Governments have encouraged the development of bond markets that were long suppressed in favor of bank-based intermediation. Foreign investment has been liberalized in nearly all countries in the region. Thailand replaced its Alien Business Law with new provisions allowing foreign firms to hold up to 100 percent equity in Thai banks, and 39 sectors have been opened to increased foreign participation. Korea, meanwhile, opened real estate, securities dealing, and other financing business to foreign investors and granted foreigners the right to purchase 100 percent of the equity of domestic firms. The NIEs and Southeast Asia have taken comprehensive action to facilitate mergers and acquisitions, both domestic and international. However, Indonesia and Malaysia appear to be exceptions: the Indonesian system does not favor mergers and acquisitions, while Malaysia appears to favor domestic but not international mergers and acquisitions.

Indonesia and Thailand have adopted significant legislative changes to their bankruptcy systems. In the second half of 1998, Indonesia created a specialized commercial court with jurisdiction over bankruptcy-related matters and adopted an automatic stay provision similar to that provided for under the US bankruptcy code. In Thailand, new bankruptcy legislation pushed through over political opposition had a positive impact on the equity valuation of financial and nonfinancial companies (Foley 1999). Such reforms can be seen as prerequisites for growth and stability in a financially globalized world. While financial reform has long been on Asia’s agenda, it is hard to imagine such rapid progress in the absence of the crisis. However, while crisis can breed reform, reform without crisis is to be preferred. The question is how this is best achieved.

Global Initiatives

The process of achieving reform without crisis can be organized at the global level. Thus IMF, the World Bank, and the Financial Stability Forum, with impetus from the governments of the Group of Seven leading industrial nations, have launched a multi-pronged effort to encourage industrial and developing countries to upgrade their financial practices and institutions. The focus of this effort is on institutional arrangements in areas like data dissemination; fiscal, monetary, and financial policy transparency; banking regulation and supervision; securities and insurance regulation; accounting, auditing, and bankruptcy; and corporate governance. The mechanism is the pro-mulgation of international standards for acceptable practice in these areas that all countries, including Asian countries, must meet, and efforts to encourage compliance through a combination of IMF surveillance, peer pressure, and market discipline.²⁸ In other areas such as product and process standards and classification mechanisms such as International Organization for Standardization classifications, the important role of global agencies is clear.

The case for these global initiatives is straightforward. If markets are global, so must be their regulation and the institutions through which that regulation takes place. In a world of systemic risk, economic and financial institutions take on the character of a global public good. Institutional arrangements affecting, among other things, prudential supervision and the conduct of monetary-cum-exchange-rate policies are of critical interest not just to the initiating country but also to the rest of the world. Global initiatives to influence national practices are justified as a way of internalizing these externalities.

The danger is that these global initiatives will subject countries to blueprint formulas, denying them the opportunity to design regulatory institutions responsive to their distinctive traditions. This is where standards come in. Standards, which define criteria that all countries should meet but allow them to meet them in different ways, offer a way of reconciling the common imperatives created by participation in international markets with the diversity of economic systems. The complaint that IMF’s structural interventions are arbitrary and capricious at least partly explains the backlash that they have provoked; with the promulgation of standards, objective criteria will exist to which IMF can refer when it demands structural reforms.

At the same time, such an approach raises compelling objections. The official donor community as a whole does not possess the resources to design and monitor compliance with detailed international standards in all the relevant areas. In its early country reports on the observance of standards and codes, IMF has been forced to rely on self-evaluations by the subject countries, a practice that threatens the objectivity of the process. For IMF to carry out this function in a satisfactory way would require a very significant increase in its staff and a radical change in expertise, both of which are unlikely for the foreseeable future (see IMF 1999b).

Moreover, reservations have been voiced about how much can be accomplished through the promulgation of international standards. The definition of acceptable standards causes disagreement—as seen in the dispute between the US and the European Union over accounting standards or the wide variation among advanced industrial countries in the provisions of bankruptcy and insolvency codes. The danger is that an international standard broad enough to encompass these variations will tend toward a lowest common denominator. Moreover, standards, by defining the minimum acceptable threshold, may weaken the incentive for countries to do better. What will prevent governments from taking steps to meet the letter of the requirement without in fact satisfying its spirit?

Such qualms are reinforced by experience with the most important experiment in standards setting to date, the International Convergence of Capital Measurement and Capital Standards, or the 1988 Basle Capital Accord (the Basle Accord). The Basle Accord established an 8 percent minimum (weighted) capital adequacy standard for international banks. It deserves some credit for steps taken subsequently, by countries represented on the Basle Committee on Banking Supervision and others, to bring capital adequacy up to this minimum. Reassuringly, the existence of the Basle Accord has not prevented countries like Argentina from doing better. But, at the same time, the Basle Accord has been subject to evasion. The gap between the reported and actual capital of countries with banking crises is a case in point. The Basle Accord did nothing to head off these crises or resolve them.

Banks have discovered ways of shifting assets subject to high capital charges off their balance sheets through securitization and the use of derivative securities without modifying the underlying risks. This should serve as a warning of the danger that the standards setters will always be one step behind the markets. Finally, experience with the Basle Accord demonstrates that poorly designed standards, or standards that lag behind circumstances, can create perverse incentives. One need only recall the incentive in the Basle Accord to engage in short-term lending to non-OECD countries. While lending to OECD banks was given a risk weight of 20 percent irrespective of the term of the loan, lending to non-OECD banks carried this reduced weight only for loans of less than a year, whereas loans of longer maturity carried the full 100 percent risk weight. This led to a shift toward short-term portfolio asset holdings that were easily liquidated during the Asian financial crisis.

In hindsight, the perverse incentives conferred by the Basle Accord on international banks are clear. But there is a more fundamental point. If institutional arrangements at the global level are to be appropriate for a wide variety of experiences, they must be carefully developed and drafted only after intensive policy discussions with all the relevant parties. Economists disagree among themselves over the design of an efficient bankruptcy law, over the stabilizing or destabilizing effects of additional data disclosure, and over the merits of fixed versus flexible exchange rates. In addition, the high-income countries themselves continue to show a diversity of institutional arrangements. Therefore, global initiatives to change national institutions and practices in a particular way must be considered very carefully to ensure that they will indeed reduce risk and increase financial stability.

The Regional Option

To some extent, the external shocks associated with the forces of globalization can be moderated by regional initiatives. The coordination of policies and institutions between countries can be addressed at the regional level, while the need for continued diversity of policies and institutions can be satisfied by differences in these practices between regions. Insofar as the cross-border externalities associated with national policies are felt mainly by countries within a region, this creates an argument for coordination at the regional level. In addition, arguments can be made for coordinating exchange rate and R&D policies at the regional rather than the global level. Some evidence suggests that the spread of currency crises was mainly a regional phenomenon (Glick and Rose 1999) and perhaps a better coordinated regional response, such as the Chiang Mai initiative to expand swap lines among Asian currencies, could have been less disruptive. Eaton et al. (1998) similarly show that R&D spillovers are primarily concentrated in the region in which R&D takes place and that their magnitude diminishes with physical distance.

Frameworks for addressing such problems at the regional level have developed in other parts of the world, providing precedents that DMCs could follow. The European Monetary System, the precursor to European Economic and Monetary Union, illustrates the scope for regional cooperation in the monetary-cum-exchange rate domain. The Consultative Group on International Agricultural Research, which encourages its participating centers to share the fruits of their agricultural research and which is primarily funded by multilateral institutions, is an example of similar arrangements for R&D.

While regional associations like ASEAN and the South Asian Association for Regional Cooperation (SAARC) already exist, they have mainly been concerned with trade issues (see also Box 3.4). There is a growing belief that Asia needs a broad-based regional free trade zone to interact more effectively with countries of the North American Free Trade Agreement and the European Union.

Interest in the regional option has attracted new attention in Asia in the wake of the 1997/98 financial crisis. This was a reflection of the perception that the advice and conditionality of the international financial institutions were inadequately tailored to the particulars of the crisis and that these institutions failed to capture the distinctive features of the Asian approach to growth and economic learning. This experience has given rise to discussions for the establishment of an Asian Monetary Fund. Similarly, the Chiang Mai initiative can be seen as a way of addressing regional financial pressures. Discussions of the case for a common basket peg for Asian countries (Williamson 1999) are seen as responding to the dilemma of having to choose between a hard peg and a floating exchange rate. Asian countries can avoid this difficult choice by agreeing to a collective peg and supporting one another in its maintenance. In Europe—where it has promoted cooperation—this style of institution building encouraged the harmonization of policies and institutions, created a zone of monetary and financial stability, and led to a measure of political integration. In Asia, however, the motivations for regional cooperation are different from Europe’s and are in their infancy. DMCs have less interest in a regional trade arrangement since much of their trade is with the US, and regional preferences could antagonize powerful political bodies and jeopardize extra-Asian market access.

Moreover, Asia has shown virtually no desire for political integration, given the various political tensions since the Second World War, often exacerbated by outside influences. Rather, the impetus for monetary cooperation reflects the desire to create a zone of financial stability. The fear created by the financial crisis is that small currencies and large financial markets are incompatible. Asian central banks, on their own, lack the resources to cope with global financial flows, even with the position-taking ability of a few highly leveraged institutions. Confronted with the vast liquidity of global capital markets, unilateral floats and unilateral pegs are subject, in this view, to speculative manipulation, and both are therefore equally uncomfortable for the government attempting to operate them. The solution is the pooling of reserves designed to marshal sufficient resources for the authorities to counter speculative pressures and, ideally, maintain the stability of intra-Asian rates. Whether desire for such financial cooperation proves strong enough to support wider regional cooperation will only be known in time.

Multilateral liberalization is another area where a regional focus may be an appropriate catalyzing force. DMCs need to concentrate on their own priorities during the next round of World Trade Organization (WTO) multilateral trade negotiations, the so-called Millennium Round. Coordination among DMCs could be effective in putting forward an agenda of proposals that would benefit the entire region. General tariff reduction, reduction of agricultural subsidies in industrial countries, elimination of preferential tariffs in regional arrangements, and antidumping safeguards are some of the areas where DMCs could develop a set of their own proposals.

National Initiatives

If one accepts the argument for diversity of national practices, a uniform mode of governance across countries cannot be optimal. Nonetheless, scholars seeking to go further distinguish three forms of governance: the strong state, the decentralized state, and the participatory state. The strong state model vests responsibility for designing and implementing institutional arrangements with an authoritarian government and its bureau-cratic arm. Korea and Singapore prior to the 1990s are representative of this model. The decentralized state encourages experimentalism and competition among local jurisdictions, on the same grounds that the national approach encourages experimentation and competition among countries. Thus, federal systems generally encourage competition among their states and this has led to some successes. Policies of devolution in the PRC, which led to the emergence of town and village enterprises, can be seen in a similar light.

The participatory approach, in a world of globalized markets, may have advantages, according to Rodrik (1999). He argues that democratic governance facilitates the development of institutions that produce greater short-term stability, ease adjustment to adverse shocks, and deliver superior distributional outcomes. The implication is that these characteristics will be particularly advantageous in a globalized world where volatility is pervasive, small states are susceptible to adverse shocks emanating from international markets, and income distribution is under strain.

Sah (1991) observes that democracies empower a wider range of decision makers and argues that this diversification implies less risk in an environment of imperfect information; hence, democracy should be positively associated with short-term stability. Rodrik (1997) provides cross-sectional evidence for the period 1960–1989 supportive of this hypothesis. He also reports evidence that democracies adjusted more successfully to external (terms-of-trade) disturbances over this period. A stronger point follows: more open democracies with less executive autonomy handle shocks better. Rodrik (1997) observes that the recent experience of the NIEs and Southeast Asia is consistent with these conclusions. Korea and Thailand, with their more open, participatory political regimes, handled the crisis better than Indonesia, by providing an alternative to riots, protests, and demonstrations and by facilitating the smooth transfer of power to new leaders.

Finally, there is evidence that participatory systems pay higher wages and are characterized by less income inequality, since participation leads to the development of more elaborate social insurance and transfer mechanisms.

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