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Economic Integration of East Asia: Trends, Challenges and Opportunities

Speech by
Shamshad Akhtar
Director General, Southeast Asia Department
Asian Development Bank

At the Symposium on “The Challenges and Opportunities of Economic Integration in East Asia”

The Royal Society, London
27 October 2004

Around the world, regionalization is gaining ground following the historic introduction of the Euro. Gripped by this wave of regionalism, the debate on East Asian economic integration has intensified. Some argue that this is a feasible option, while skeptics argue that the region does not have the required preconditions for integration. This debate has been enriched by the substantive and concrete experience of the EU. In the next half hour I will provide you with a grand tour of the status, opportunities and challenges to East Asia’s economic integration.

In many ways East Asia is a natural hub for integration.

This is better illustrated empirically – by the selected indicators

• East Asia has a huge domestic market of nearly 2 billion people – about three times EU market,
• East Asia is the fastest growing region in the world. Over the last two decades we have seen average annual growth rates of about 7% -- far outstripping the 5% growth in the rest of the world
• East Asia also has a high domestic savings rate of about 20-45% depending on the country. This compares well with the EU’s average of about 20%
• Finally, East Asia holds over half the world’s foreign exchange reserves.

It has to be acknowledged upfront that East Asia cannot fully replicate or emulate the EU model. The region is more diverse and heterogeneous than Europe. The political, demographic and economic conditions are also very different. Despite these differences, the pressure has been growing for the region to expand cooperation and integrate more fully. To make real progress on integration East Asia will need to develop political and social consensus and tackle issues of extreme poverty and terrorism. The region will also have to gear itself to face growing competition from globalization and the emergence of regional blocs, like the EU.

I would like to start with an assessment of the progress, East Asia has achieved on integration along three main tracks:

1. Trade and investment integration
2. Financial development and integration, and
3. Exchange rate, monetary coordination and common currency issues

Then I will turn to the emerging key challenges and opportunities for East Asia.

I will wrap with some perspectives on the way forward for financial cooperation in East Asia.

Let’s start with the trade and investment integration situation

The bottom line is that East Asia has made impressive progress in trade integration. This is once again better captured by evidence

• Overall East Asian exports have been the fastest growing in the world. Regional share in world exports has risen from 15% in 1980s to 25% in 2003.
• Intraregional exports as % of total regional exports has increased from over 33% in 1980 to over 50% in 2003. While this is lower than the share of intraregional exports in NAFTA or the EU, the real story is that they have increased more than eleven-fold over the past 23 years…. AND they are still growing.
• In addition, trade intensity for the region has grown significantly.

This exponential growth can be partly attributed to the internal dynamism and competitiveness of markets. Low labor costs and critical pockets of highly skilled labor have continued to attract large amounts of FDI to the region. This investment has facilitated the establishment of integrated cross-border production networks, which led to the creation of small, specialized industries within the manufacturing chain. These chains now form the basis of much of the intra-industry trade in East Asia.

Despite a reduction in worldwide flows, East Asia’s share in FDI has grown from around 7% in 1980 to over 17% in 2003. The share of intraregional FDI in total inflows to East Asia reached almost 40% in 2001. Declining inflows from Japan have been replaced partly by China and some of the newly industrialized economies. These economies are looking for relocation of businesses to reduce production costs as higher domestic prices have made some of their industries less competitive in global markets.

One important thing to note is that the growth in intra-regional trade and investment has been entirely market driven. This has implications that will be discussed later on.

The second part of the integration puzzle I would like to discuss is financial sector integration

For the most part, East Asian financial markets are relatively liberalized and large. We are talking about

• close to half of the world’s official reserves,
• a third of the world’s savings, and
• a fifth of the world capital flows.

However, the region has yet to effectively intermediate its financial resources. Regional financial markets are fragmented and differ substantially: large financial centers, like Japan, Hong Kong, and Singapore are diversified with substantive equity markets. They are global players and have developed strategic alliances around the world. Other markets are much smaller and exhibit a high dependence on banks catering primarily to local demand.

There are some noteworthy post crisis developments.

• The biggest news is that the banking sector has been transformed and consolidated; crisis affected banks show improvements as visible from trends of increased bank profitability, higher capital reserves, and lower non-performing loans.
• There are also impressive developments on the bond market side. Local currency bonds have more than doubled from 1997-2004 reaching almost $1.4 trillion dollars, or 48% of the region’s GDP. Almost 90% was in local currencies and about half were government bonds. At the same time, regional central banks have established Asian Bond Funds. The first bond fund was for 1 billion in dollar-denominated Asian sovereign bonds and the second bond fund will invest in local currency bonds of longer tenor. Bond issuances of mixed basket currencies are not far off. The idea is that these funds will generate more demand for longer tenor local currency issuance.
• There has also been progress in the regional equity markets. Almost all of them have recovered to pre-crisis levels.

Despite these developments there are some obstacles to financial integration. Many of these have been thoroughly discussed in many places so I will just touch on them briefly.

1. There can be inconsistent application of policy, legal and regulatory standards across the region,
2. Inadequate accounting standards and low skills in this area
3. Unclear tax rules and weak corporate governance standards.

Limited financial inter-linkages are emerging in the region as a result of:

• The growth of intraregional trade.
• Open capital accounts.
• Heightened activity of cross-border mergers and acquisitions in the financial and corporate sectors.
• A growing appetite within East Asia for regional sovereign bonds.

More East Asian economies are investing in regional debt issues. Although it’s still slow going. Alternative opportunities for investment are helping the region to intermediate their own funds and channel savings directly back into the region. Asia is issuing and owning a larger share of its own financial instruments. Over time, secondary trading in outstanding bonds will facilitate greater concentration of bond ownership in the region.

Let’s now turn to the exchange rate arrangements in East Asia

Prior to crisis the US dollar was used as an anchor for the regional currencies. They were implicitly pegged to the US dollar in managed float arrangements except for the Chinese yuan and Hong Kong dollar. These two currencies have always remained at a fixed rate to the US dollar.

The most notable movement in currencies of the region occurred when the Japanese Yen appreciated sharply against the US dollar following the 1985 Plaza Accord.¹ And when some of the regional currencies lost a significant amount of their value against the US dollar in 1997. The graph also shows that due to “fear of floating” most of the region’s currencies in the post crisis period continued to tightly manage their currencies to the US dollar. In fact, in 1998 Malaysia joined China and Hong Kong in fixing its currency to the US dollar. Despite this cautious exchange rate management in East Asia, the exchange rate arrangements remain fundamentally weak.

The first question is where do we go from here? What are the new post crises needs of the economies?

Advocates of a common currency argue that East Asia is now highly integrated. Trading relationships have grown, markets are more open, and as evident there is a growing synchronization of region’s business cycles. This synchronization reflects the impact of growing intra-trade and intra-industry linkages and the comparable external shocks. The region’s business cycles will facilitate movement towards greater coordination and ultimately toward a viable common currency.

We know that a common monetary standard among close trading partners is preferable to unrestricted exchange rate flexibility. This raises the issue of how to determine a credible anchor for the trading bloc. Much has been written on this topic but each regional bloc has its own economic fundamentals and conditions with unique and special challenges.

The second question is how to chart the optimal path to a fully integrated currency area in EA?

Ultimately, the decision on currency arrangements will necessarily be a political decision and given that this decision calls for strong consensus among a number of countries it has to be clear from the start that common currency is a long term goal – we are talking of decades and not years, for the real exchange rate adjustment process to be sufficiently aligned for a common currency. Progress will need to be backed by solid institutional arrangements including a suitable monetary coordination mechanism, regional surveillance activities, and a regional liquidity facility. ASEAN+3 activities are a step in the right direction. The bilateral swap arrangements are now close to $40 billion dollars and the ASEAN Secretariat is coordinating a regional surveillance mechanism.

The transitional arrangements must also be flexible enough for the advanced regional economies and the developing economies in particular the pegged regimes like China to make gradual adjustments over time. When these economies are considerably nearer to each other than at present, the possibility for full monetary union will be more realistic.

So to try and respond to the questions posed earlier of where do we go and how do we get there …………

We know that progress is underway to move towards greater financial cooperation. But the how and process associated with it has been fairly ad hoc. Let’s now address this question. There is no doubt that East Asian economies with their strong export orientation, solid base of human capital, and several decades of extraordinary growth behind them, can be expected to thrive in a politically and economically well-integrated environment. Especially, if this environment helps the region to align well to globalized markets and internationally accepted standards. Weak institutions in East Asia have held back the pace of progress, especially in financial integration. We can expect that East Asian economies will face several challenges and opportunities as the integration process further evolves and matures. There are five critical factors here.

The first one is the political dynamics. The political dynamics and rationale for integration differ substantially from Europe. After World War II European motivation for regional cooperation was driven by the desire to foster political and social cohesion. Building political and economic interdependence within the EU was seen as a way to address security conflicts in the region. In contrast, East Asia lacks a common vision and mandate for regional cooperation. Some countries are still struggling with political stability, retain historical grudges and sensitivities, and have serious poverty concerns.

East Asia has experienced a relatively long period of peace, which has provided some space for economic prosperity and higher level of motivation and drive for regional economic cooperation. A common focus on economic growth unites even the most diverse nations in the region and can provide a fertile ground for a common political vision.

The second factor is the regional role of the two economic heavyweights, China and Japan. Even though these countries have clout, they have not yet defined a common political and economic agenda. Historically, these countries have had divergent interests and position on economic matters. A preoccupation with pressing domestic concerns has further detracted them from wholeheartedly focusing on regional cooperation. Rapid development of economic links, and political changes in China, are helping to change historical dynamics in favor of fostering a common interest between the two nations in promoting stability and growth in the rest of Asia. We will see what the future brings but for sure these two nations will have to be at the center stage to orchestrate regional integration.

The third factor is lack of an institutional framework for regional integration. The only formal institutional mechanism at the regional level, ASEAN, is a subregional initiative that lacks members of key East Asian nations and has a voluntary approach to policy implementation. This has at times undermined its effectiveness as a regional institution. With the inclusion of the larger players, ASEAN+3 now operates as a loose alliance that is deliberating on all key issues of financial architecture and coordinating activities related to regional surveillance and exchange of key vulnerability data. Concrete outcomes of these working groups have included the Chang Mai Initiative that led to establishment of swap arrangement among a number of countries. These efforts under ASEAN+3 require coordination to develop a regional financial integration blue print.

The fourth key factor is to enhance and expand free trade and factor mobility. Currently, the only regional free trade and investment agreement, supported by ASEAN, has yielded limited results. While average tariffs may be lower in the region, there continues to be protection in selected sectors and unnecessary barriers to trade, capital and labor mobility. As a result of delays in the latest WTO negotiations, East Asia has now resorted to a multitude of bilateral trade and investment arrangements. For example, despite its strong preference for multilateral trade liberalization, Japan entered into a partnership agreement in 2002 with Singapore. In addition, China and Japan are working on a free trade agreement with ASEAN that will take them beyond WTO agreements and open up more sectors of the economy. These arrangements are a good start on the dialogue, but their consistency with WTO guidelines and consistency among themselves is critical for an eventual formation of an East Asia Community.

Lastly, we have to acknowledge the China factor. China’s emergence as an economic powerhouse has been a real eye opener for the region. The reality is that China has grown into a $1 trillion dollar global economic force, with a trade/GDP ratio that has risen from 10% in 1979 to 50% in 2003. Immediate outcomes of China’s success are already being felt in Asia. Most critical of these has been the competitive pressure from China. With its seemingly limitless supply of low wage labor and high levels of FDI it has dominated manufacturing in the region. There are concerns over the impact of China’s industrial and financial restructuring process and the impact of the yuan’s revaluation and convertibility. These policy changes need to be effectively managed to avoid destabilizing the regional and global economy.

China’s continuing growth will certainly increase the demand for certain goods such as agricultural products and raw materials. Regional economies will need to work hard and smart by exploiting market niches within manufacturing chains while steadily enhancing productivity. The bottom line is that China’s emergence as a regional economic powerhouse is simply too immense a development not to be addressed in a cooperative way. Strengthened regional linkages supported by a regional free trade and investment regime would assist the rest of East Asia in taking advantage of potential opportunities and rising to the competitive challenges posed by China. Perhaps recognizing this, China has stepped up its participation in support of formal mechanisms for regional cooperation.

I would like to now share some perspectives on financial cooperation and next steps to follow

Even those who think preconditions are not right for a common currency, agree that East Asia has made a good beginning towards regional financial cooperation. To move forward, it is crucial for the region to establish a strong institution for monetary and exchange rate coordination. This will set the stage for a currency area or the eventual adoption of a single currency. The following steps are a pre-requisite:

• First, to establish a more credible defense mechanism against excessive currency fluctuations. ASEAN+3 needs to enhance and multilateralize the existing bilateral swap arrangements. Under the current arrangements, the maximum liquidity support one country can draw is only $6-7 billion. Once we realize that Korea alone required $23 billion in foreign currency liquidity during the Asian crisis, we see how small the facility really is.
• Second, to establish a regional reserve pooling mechanism, or other regional borrowing arrangements as a precursor to a possible centralized monetary arrangement, such as an Asian Monetary Fund. China will only be able to participate after its financial sector restructuring has achieved its goals and capital account convertibility is in place.
• Next is to establish a credible regional surveillance mechanism that limits moral hazard and provides robust financial surveillance. For now it appears that relying on IMF reviews is the best option.
• The next step is to drill down to the national level to strengthen and harmonize the regional financial architecture by adopting consistent international regulatory and supervisory frameworks.
• Finally, start the move toward inflation targeting by all East Asian monetary authorities. This discipline is a critical part of streamlining monetary management and facilitating monetary coordination in the region.

As a starting point, one or more groups of countries within East Asia with some degree of real exchange rate comparability should shift from explicit or implicit dollar anchors to an agreed basket of currencies. Of course with the flexibility of a crawling band exchange rate regime.

This flexibility is needed to provide lead-time for currencies with hard pegs and fragile financial systems to effectively manage the shift to the new anchor. It would also allow real exchange rates to adjust over time as the region’s economies develop. Another goal during this transition period is for Japan to take a greater role in regional currency management.

To conclude - The largely market-driven trade and investment integration we have seen in East Asia has led to a dynamic regional economy, although the financial side of this process has lagged. New steps are being taken to move toward more formal institutional arrangements for financial cooperation. The key long-term goal of an Asian Monetary Union seems achievable but it will require a lot of effort. The crucial test of political commitment is much further down the road. Our European audience today will appreciate that integration is a process in which, however great your progress, the greatest challenges always lie ahead.

The Plaza Accord was a meeting of G-7 in NewYork, which led to devaluation of US dollar versus major currencies.