Asia-pacific Trade and Investment Review, 2008 (Economic and Social Commission for Asia and the Pacific)

ESCAP is the regional development arm of the United Nations and serves as the main economic and social development centre for the United Nations in Asia and the Pacific. Its mandate is to foster cooperation between its 53 members and 9 associate members. ESCAP provides the strategic link between global and country-level programmes and issues. It supports Governments of the region in consolidating regional positions and advocates regional approaches to meeting the region’s unique socio-economic challenges in a globalizing world. The ESCAP office is located in Bangkok, Thailand. Please visit our website at <www.unescap.org> for further information.

The shaded areas of the map are ESCAP members and associate members.

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ASIA-PACIFIC TRADE AND INVESTMENT REVIEW Vol. 4

United Nations

New York, 2008

ECONOMIC AND SOCIAL COMMISSION FOR ASIA AND THE PACIFIC

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ASIA-PACIFIC TRADE AND INVESTMENT REVIEW Vol. 4 United Nations publication Sales No. E.09.II.F.7 Copyright  United Nations 2009 All rights reserved Manufactured in Thailand ISBN: 978-92-1-120572-5 ISSN: 1815-8897 ST/ESCAP/2518

References to dollars ($) are to United States dollars, unless otherwise stated. A solidus (/) between dates (e.g. 1980/81) indicates a financial year, a crop year or an academic year. Use of a hyphen between dates (e.g. 1980-1985) indicates the full period involved, including the beginning and end years. The following symbols have been used in the tables throughout the journal: Two dots (..) indicate that data are not available or are not separately reported. An em-dash (—) indicates that the amount is nil or negligible. A hyphen (-) indicates that the item is not applicable. A point (.) is used to indicate decimals. A space is used to distinguish thousands and millions. Totals may not add precisely because of rounding. The designations employed and the presentation of the material in this publication do not imply the expression of any opinion whatsoever on the part of the Secretariat of the United Nations concerning the legal status of any country, territory, city or area, or of its authorities, or concerning the delimitation of its frontiers or boundaries. Where the designation “country or area” appears, it covers countries, territories, cities or areas. Bibliographical and other references have, wherever possible, been verified. The United Nations bears no responsibility for the availability or functioning of URLs. The views expressed in this publication are those of the authors and do not necessarily reflect the views of the United Nations. The opinions, figures and estimates set forth in this publication are the responsibility of the authors, and should not necessarily be considered as reflecting the views or carrying the endorsement of the United Nations. Any errors are the responsibility of the authors. Mention of firm names and commercial products does not imply the endorsement of the United Nations.

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AIMS AND SCOPE The Asia-Pacific Trade and Investment Review is an annual, peer-reviewed journal for the dissemination of timely information and research analysis on new, emerging issues of trade, investment and enterprise development in Asia and the Pacific. Primarily aimed at government policymakers, researchers and representatives of the private sector, the Review imparts information on the latest trends in trade and investment policy issues facing the region. The Review emphasizes implications for policy relevance and operational research rather than academic research on theoretical and methodological issues. Articles have been drawn from research work conducted by outside researchers and consultants as well as the staff of the Trade and Investment Division of ESCAP. Beginning in 2009, the Review will restrict its focus to analyses and surveys of trends and issues in trade and investment in the Asia-Pacific region, prepared largely in-house.

ADVISORY BOARD MEMBERS Mohamed Ariff Malaysian Institute of Economic Research Kuala Lumpur, Malaysia Razeen Sally London School of Economics London, United Kingdom of Great Britain and Northern Ireland Karl P. Sauvant Columbia Law School – Earth Institute Columbia University, New York, United States of America Rajah Rasiah Asia-Europe Institute University of Malaysia, Kuala Lumpur, Malaysia John S. Wilson World Bank Washington, D.C., United States of America Patrick Low World Trade Organization Geneva, Switzerland

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EDITORS Chief Editor Ravi Ratnayake Director, Trade and Investment Division

Managing Editors Marc Proksch Trade Policy Section Trade and Investment Division Yann Duval Trade Facilitation Section Trade and Investment Division Masato Abe Private Sector and Development Section Trade and Investment Division

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CONTENTS Page Special brief .................................................................................................................

1

Jagdish N. Bhagwati

Termites in the trade system ...........................

3

Research articles .........................................................................................................

9

Ramesh Gampat and Chatrini Weeratunge

The rise of China: What does it mean for the least developed countries in the Asia-Pacific? ........................................

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Who will be the main global IT services hub: India or China? ....................

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Kakali Mukhopadhyay and Paul J. Thomassin

Economic impact of East and South-East Asian free trade agreements .........

57

Tran Quoc Trung

Performance of export-oriented small and medium-sized manufacturing enterprises in Viet Nam ....................................................

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Policy options for establishing effective subnational innovation systems and technological capacity-building .....................

115

Staff papers .................................................................................................................

139

Seema Joshi

Deok Soon Yim and Byung-Sam Kang

Marc Proksch

Yang Zhendai

Asian-African trade and investment cooperation .....................................................

141

Issues in the long-term development of sovereign wealth funds ..............................

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CONTENTS (continued) Page Overviews of recent studies on trade and investment published by the ESCAP secretariat ....................................................................................................................

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Unveiling protectionism: regional responses to remaining barriers in the textile and clothing trade ...............................................................................

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Trade facilitation beyond the multilateral trade negotiations: regional practices, Customs valuation and other emerging issues—a study by the Asia-Pacific Research and Training Network on Trade ................................

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Towards coherent policy frameworks: understanding trade and investment linkages ..........................................................................................................

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Special Brief

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Termites in the trade system

Jagdish N. Bhagwati*

T

wo different questions must be distinguished in the current political debate on free trade for the United States of America (but they apply equally to any other open economy): Should we have free trade? If we agree that we should, how should we trade freely? Often, the press announces that the consensus on the desirability of free trade among economists has disappeared; but in each instance, they have been disproven. Today, the most potent argument is that free trade may increase income and wealth, but that it suppresses workers’ wages and even harms the middle class. Nearly all research shows that this claim is also mistaken. My own research demonstrates that trade may even have moderated the fall in wages that labour-saving technical change is producing. Many are mistaken, though, in thinking that freeing trade through free trade agreements (FTAs) is a good idea. FTAs are better described as preferential trade agreements (PTAs) since they free trade for members only, so they are freeing trade on a discriminatory basis. As I argue in my book, Termites in the Trading System (Bhagwati, 2008), FTAs have several crippling downsides that must be recognized. First, they will often divert trade from cheaper non-member sources to more expensive member sources, doing harm rather than good. Second, the enormous increase in such FTAs, now numbering more than 350 and still growing, has led to a systemic effect, creating what I have called a “spaghetti bowl” of preferences and chaos in the world trading system. *

Professor, Economics Department, Columbia University, New York, New York, United States of America. Much of this note was published under a similar title in The New York Sun on 2 July 2008 and ESCAP acknowledges the permission to reprint the text.

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Third, in one-on-one negotiations between powerful, hegemonic nations, such as the United States, and weaker, smaller FTA partners, several lobbies in the hegemon have imposed demands unrelated to trade on the weaker nations, increasing resentments abroad. In Seoul, there was a street demonstration against the proposed United States-Republic of Korea FTA. These powerful-country lobbies include labour unions seeking to raise labour standards with a view to raising the production costs of rival firms abroad, financiers seeking absence of capital controls and firms wanting ever-stronger patent protection. There are plenty of reasons to believe that these preferential trade agreements have slowed down our progress on the multilateral freeing of trade, as with the Doha Round of multilateral trade negotiations. The Doha Round’s success is essential to strengthening the multilateral trading system, which is beneficial to all. The American doctrine of inducing multilateral trade liberalization by signing FTAs has, however, proven to be a chimera. Much attention and lobbying has been diverted to inconsequential deals. We need to put a moratorium on FTAs, while treating those already ratified as water under the bridge. The free traders who are passionate supporters of these FTAs are undermining everything that we have worked for in seeking to produce and strengthen a nondiscriminatory trading system. There is no better example of folly wrought by good intentions. The following are excerpts from Termites in the Trading System: How Preferential Agreements Undermine Free Trade (Bhagwati, 2008).

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PROLIFERATING PREFERENTIAL TRADE AGREEMENTS

“Perhaps the most striking historical flirtation with preferences in trade came from John Maynard Keynes, arguably the 20th century’s most influential economist. At the end of World War II, the British were sceptical of non-discrimination as implied by the most favoured nation, or MFN, clause, which would automatically extend to every member country of the proposed trade institution the lowest tariff extended to any member. They also wished to hold on to their imperial preference, which extended British protection to its colonies and dominions. On the other hand, the Americans vigorously supported the MFN clause and favoured non-discrimination in the trading arrangements being contemplated after the conclusion of the war. They were led by Cordell Hull, the Secretary of State between 1933 and 1944 and a recipient of the Nobel Prize for Peace; he believed, not without substance, that free trade would also lead to peace, not just prosperity. Keynes sided with his own, and made the following characteristically flamboyant statement:

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“ ‘My strong reaction against the word “discrimination” is the result of my feeling so passionately that our hands must be free ... The word calls up and must call up ... all the old lumber, most-favoured-nation clause and all the rest which was a notorious failure and made such a hash of the old world. We know also that it won’t work. It is the clutch of the dead, or at least the moribund, hand.’ “Yet once they had thought more deeply about the issue, Keynes and other British economists who were engaged in the negotiations with the United States that led to the final agreement in Proposals for Expansion of World Trade and Employment had come to accept the Cordell Hull view that non-discrimination was a key principle that had to prevail in the proposed new regime for international trade. Keynes, who thought that intellectual inflexibility was a mark of inferior minds, then spoke in the House of Lords what are among his most eloquent words: “ ‘[The proposed policies] aim, above all, at the restoration of multilateral trade ... the basis of the policies before you is against bilateral barter and every kind of discriminatory practice. The separate blocs and all the friction and loss of friendship they must bring with them are expedients to which one may be driven in a hostile world where trade has ceased over wide areas to be cooperative and peaceful and where are forgotten the healthy rules of mutual advantage and equal treatment. But it is surely crazy to prefer that.’ “As it happens, Keynes was reverting to an anti-discrimination view that had begun to make increasing sense to economists during the 1930s. World trade had gradually been shifting to a multilateral non-discriminatory regime by growing acceptance of the MFN principle, under which any member of a trade treaty, later the GATT as well, would receive the same lowest tariff that any other signatory of the treaty would enjoy. But world trade would soon turn disastrously to bilateralism and attendant preferences in trade. “Read almost any of the splendid accounts of world trade in the 1930s and you will find fulsome and fulminating accounts of how the tit-for-tat protectionism and the competitive depreciations of currency, which were intended to divert limited world demand to one’s own goods to reinflate one’s economy, led to extensive use of quotas, which are necessarily discriminatory. They led also to explicit bilateral treaties aimed at balancing trade flows bilaterally wherever possible. “It was manifest that protectionism, each trading nation acting on its own, had damaged the world trading system: each nation followed what the Cambridge economist Joan Robinson famously called ‘beggar my neighbour policies’ and many were beggared in the end. By contrast, coordinated action, eschewing protection and agreeing to increase world aggregate demand (rather than seeking to divert to oneself a given, insufficient amount of world demand), would have produced a better result.” (Bhagwati, 2008, pp. 1-7)

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THE PANDEMIC OF PTAs

“There is yet another irony. The interwar proliferation of preferences was a result of an uncoordinated pursuit of protectionism, itself aided by the breakdown of financial stability and macroeconomic equilibrium in the world economy. But the current tide of preferences has been a result of politicians mistakenly, and in an uncoordinated fashion, pursuing free trade agreements because they think (erroneously) that they are pursuing a free trade agenda. “So today we have a cumulative total of over 350 PTAs reported to the WTO. Even if only active PTAs are counted, the estimated total is still large. By either count, the PTAs are evidently increasing continually.” (Bhagwati, 2008, p. 11) Economies of Asia and the Pacific joined this PTAs bandwagon relatively late during the 1990s, but are now leading the race of signing and negotiating new agreements. This led to a regional tangle of trade rules and regulations which was appropriately named “noodle bowl” (figure 1). Figure 1. “Noodle bowl” of trade agreements in Asia and the Pacific

Source: tid/aptiad. Note:

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Asia-Pacific Trade and Investment Agreements Database, ESCAP, available at www.unescap.org/ Not all PTAs are shown.

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“Among economists, I was the earliest to warn against PTAs, starting in 1990 when I sensed that we were facing a systemic threat to the principle of non-discrimination in world trade. I was then in a minority of one, even among economists, many of whom thought I was a ‘multilateralist freak’. Arrayed on the other side were truly eminent economists, among them Larry Summers, who became the United States Treasury Secretary, and the remarkable Paul Krugman, my former MIT student and now New York Times columnist. “But now that the proliferation and its many downsides have become evident, and ever more threatening, I daresay that the profession has moved like a herd into my corner. Pascal Lamy, currently the Director-General of the WTO, once remarked that half the economists in the world were now opposed to FTAs. I retorted mischievously that this was an English understatement by a distinguished Frenchman; in fact, nearly all were. “I discovered that the European Union, which started the pandemic while the United States had grossly aggravated it, applied its MFN tariff to only six countries [or areas]—Australia, New Zealand, Canada, Japan, Taiwan Province of China, and the United States—with all other nations enjoying more favourable tariffs. I asked Pascal Lamy, who was then the European Union Trade Commissioner, Why not call it the LFN (least favoured nation) tariff? “In short, we now have once again a world marred by discriminatory trade, much as we had in the 1930s.” (Bhagwati, 2008, pp. 11-14) And we know how that turned out. While it will be impossible to halt the formation of PTAs, we can still try to mitigate their adverse effects—going back to the table of multilateral negotiations and trying harder to close the deal, which is to reduce the overall trade barriers in a non-discriminatory fashion and make bilateral exchange of trade preferences less attractive.

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REFERENCES Bhagwati, J. (2008). Termites in the Trading System: How Preferential Agreements Undermine Free Trade (New York, Oxford University Press).

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Research Articles

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The rise of China: What does it mean for the least developed countries in the Asia-Pacific? Ramesh Gampat and Chatrini Weeratunge*

ABSTRACT

C

hina’s unprecedented economic growth and integration into the world economy have attracted global attention. Its boom in exports of processed goods and the emergence of regional production networks, and thus production complementarity, has spread high rates of growth across several Asian—especially East Asian—economies. The poorer economies, especially the region’s least developed countries (LDCs), derive the least benefit from the “China effect”, as they are not integrated into the regional production networks. Poorer economies in the region supply mostly raw materials and resource-based products to China. This paper examines the challenges and opportunities China presents to LDCs in the Asia-Pacific region. The main conclusions are: (a) there is a surging trade imbalance between LDCs and China; (b) there is an increasing concentration of LDC exports to and imports from China, by commodity and by country; (c) LDCs and China do not compete in any significant way in third-country markets; and (d) foreign direct investment (FDI) flows to China have a positive effect on FDI flows to LDCs. An important policy implication is the need for more equalizing growth in the region and, in particular, between the emerging economies—such as China—and LDCs, which can be achieved by addressing the challenges and constraints caused by supply-side issues and market access.

*

Ramesh Gampat and Chatrini Weeratunge, United Nations Development Programme (UNDP) Regional Centre, Colombo, Sri Lanka.

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INTRODUCTION

China has become the centre of global attention in recent years. Thirty years of rapid economic growth at 9 per cent annually led to an elevenfold increase in per capita gross domestic product (GDP) between 1975 and 20061 and structurally transformed the Chinese economy. If the average growth rates of the past two decades are projected, China’s GDP would reach $3,825 billion by 2015. Sustained rapid growth has lifted millions of people out of poverty: the number of people living on $1 a day fell by 288 million between 1990 and 2003 (Asian Development Bank, 2005). China’s export boom and the emergence of regional production networks have spread high rates of growth across several Asian economies. However, not all economies have benefited in equal measure. The more advanced ones (Hong Kong, China; Singapore; the Republic of Korea; Japan; and Taiwan Province of China) have benefited the most, followed by the Association of Southeast Asian Nations (ASEAN)-4 economies, consisting of Malaysia, Indonesia, Thailand and the Philippines. Particularly in the case of emerging Asia, the export boom is “built increasingly around rapid growth in intraregional trade that has China playing a central role”. (Gruenwald and Hori, 2008) The poorer economies, especially the region’s least developed countries (LDCs),2 derive the least benefit, as they are not integrated into the regional processing production networks; they mostly supply raw materials and resource-based products to China. While LDCs generally have very open economies and liberalized trade regimes, their integration into the global economy has not progressed smoothly. Effective integration is hindered by geographical constraints, limited market access, the small size of their domestic economies, inadequate infrastructure and weak industrial and institutional capacities, among other things. Thus, while China’s growth offers opportunities to LDCs, there is a fear that challenges may far outweigh potential gains. There has been extensive discussion on the impact that China, including its accession to the World Trade Organization (WTO), is having on the global economy and on other developing countries.3 Most of these studies are largely aggregative in that they examine the impact of China’s growth on broad regions of the world or for specific 1

2

3

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In constant 2000 United States dollars; World Development Indicators online (available by subscription at http://publications.worldbank.org/WDI), accessed from http://ddp-ext.worldbank.org/ext/DDPQQ/report.do? method=showReport on 17 March 2008. A country is categorized as a least developed country (LDC) based on three criteria: low income, weak human assets and economic vulnerability (United Nations Development Programme, 2008). There are 14 LDCs in the Asia-Pacific region: Afghanistan, Bangladesh, Bhutan, Cambodia, Kiribati, the Lao People’s Democratic Republic, Maldives, Myanmar, Nepal, Samoa, Solomon Islands, Timor-Leste, Tuvalu and Vanuatu. Unless otherwise specified, LDCs in this paper refer to the Asian and Pacific LDCs only. See, for example, Martin and Ianchovichina (2001), Shafaeddin (2002), Lall and Albaladejo (2004), Kaplinsky, McCormick and Morris (2007) and Jenkins and Peters (2007).

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products or sectors. To our knowledge, no study has focused specifically on the impact of China on the Asian and Pacific LDCs. This paper takes up this task and examines some challenges and opportunities that China’s robust growth presents to LDCs. Following Jenkins and Edwards (2004), three kinds of direct effects have been identified: O

Complementary trade effect: growth of exports from the Asian and Pacific LDCs to China

O

Competitive trade effect in third markets: increased competition of LDCs with China for exports to third markets

O

Competitive or complementary investment effect: the effect of the rise of China on FDI flows to the Asian and Pacific LDCs

The overall gain for any of the Asian and Pacific LDCs from the growth of China will depend on the sum of complementary and competitive effects. Of course, these effects may operate differently in the short and long term and, while this is an important issue, the focus of the paper is on structural issues. The rest of the paper is structured as follows: section 2 examines the evolution of the trade balance between China and LDCs. Trends in merchandise trade between China and LDCs are reviewed in sections 3 (exports) and 4 (imports). Competition between China and LDCs in third-country markets is discussed in section 5. Section 6 examines an unsettled issue: does the attractiveness of China as a destination for FDI divert such flows from LDCs? The final section summarizes the main findings of the paper and draws out the policy implications.

2.

CHINA AND THE LEAST DEVELOPED COUNTRIES: EVOLUTION OF THE TRADE BALANCE

While China’s economy has recorded sustained and robust growth, it is the ballooning trade surplus that has attracted more attention in recent times. Based on data reported by China to the United Nations Commodity Trade Statistics Database (Comtrade), the country’s trade balance was less than $9 billion dollars in 1990; three years later it slumped to negative $12 billion. The sustained recovery that began in 1994 led to a cumulative trade surplus of $551 billion against the rest of the world. What is remarkable, however, are the extremely high levels of surplus recorded in 2005 and 2006: $102 billion and $177 billion, respectively (see chart 1).4 This is a sixfold increase from 2004 and, for 4

Cui and Syed (2007) reported that China’s trade surplus was nearly $215 billion (balance of payments (BoP) basis) at the end of 2006, which was 8 per cent of that year’s GDP.

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Trade balance

Chart 1. China: evolution of the merchandise trade balance, 1990-2006 (Billions of United States dollars) 180 160 140 120 100 80 60 40 20 0 -20 990 991 992 993 994 995 996 997 998 999 000 001 002 003 004 005 006 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 Year

Source:

United Nations Comtrade database, available at http://comtrade.un.org/db.

the first time during the 17-year period from 1990-2006, the trade surplus surpassed 5 per cent of GDP in 2006.5 During the past three years, China’s trade surplus increased by close to $80 billion per year, but it is expected to stabilize this year (The Economist, 2008). How large is China’s trade surplus with the Asian and Pacific LDCs? The available data show that China amassed a cumulative merchandise trade surplus of $571 billion against the rest of the world during the period 1990-2006. Of this amount, $28 billion was built up against LDCs in the region.6 In other words, about 5 per cent of China’s trade surplus during the 17-year period was amassed against 10 LDCs in the region. What is noteworthy is not so much that the surplus against LDCs has grown at an accelerating rate over time, but that almost 60 per cent of it was amassed during the last five years. The surplus in 2006 was 24 times larger than that in 1990, rising from $207.1 million to $5 billion. While fluctuating, the trade balance grew at 23.8 per cent annually; growth began to accelerate in 2002 and reached 33.7 per cent in 2006. As share of GDP, the trade imbalance of LDCs with China moved from 0.6 per cent in 1990 to 4.6 per cent in 2006, growing steadily since 1999 when it stood at 1.9 per cent (see chart 2). The most rapid growth throughout the entire period was witnessed in 2007, with a jump of 0.9 per cent from the previous year.

5 6

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According to The Economist (2008), China’s current account surplus reached 10 per cent of GDP in 2007. Data have been obtained from the United Nations Comtrade database, with China as the reporter country. Timor-Leste, Tuvalu, Kiribati and Vanuatu are excluded from the analysis because of the dearth of data.

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Chart 2. LDCs: trade imbalance with China (Share of GDP) 2006

(4.6) (3.7) (3.5)

2004 (3.0)

2002

(2.7) (2.5) (2.3)

2000

(1.9) (2.0) (2.1) (2.0) (2.2)

1998 1996 1994

(1.4) (1.1) (1.0)

1992 1990 0.0

(0.8) (0.6)

-0.5

-1.0

-1.5

-2.0

-2.5

-3.0

-3.5

-4.0

-4.5

-5.0

Source: United Nations Comtrade database, available at http://comtrade.un.org/db and World Bank, World Development Indicators, accessed online.

Throughout the entire 17-year period, Bangladesh, Cambodia, the Lao People’s Democratic Republic, Myanmar, Nepal and Samoa incurred a persistent negative trade balance with China. Except for the first year of the period, this observation was also true for Afghanistan, Bhutan and Maldives. Solomon Islands, on the other hand, has run a positive and growing trade balance with China since 1998, which amounted to $345 million in 2006. Timor-Leste incurred a trade surplus with China in 2006 (see table 1). Table 1. Least developed countries: trade balance pattern with China Surplus

Accelerating deficit

Solomon Islands Timor-Leste (based on data for 2006)

Afghanistan Bhutan Bangladesh Maldives (although the pattern is Cambodia unclear) Lao People’s Democratic Republic Myanmar Nepal Samoa Vanuatu (based on available data)

Source:

Decelerating deficit

Authors’ calculation based on data from the United Nations Comtrade database.

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Bangladesh accounted for more than half of the cumulative trade imbalance of the Asian and Pacific LDCs with China: it amassed a $15.5 billion merchandise trade deficit with China during the 17-year period. The country’s deficit began to grow rapidly in 2003, when it reached $1.3 billion (up from $1 billion in the previous year); it posted a record of almost $3 billion in 2006. Bhutan ran a cumulative deficit of $8.6 billion, but its deficit began to decline rapidly after peaking at $2 billion in 2003, reaching $161.2 million by 2006. The other country with a major deficit is Myanmar. Its deficit amounts to $7.2 billion for the 17-year period; nearly $1 billion of it was built up in 2006. Two other countries accumulated deficits in excess of $1 billion during the period: Cambodia and, to a lesser degree, Nepal. If these patterns persist, it seems likely that several LDCs in the region will continue to incur relatively large trade deficits with China. This may affect their ability to reduce poverty and contain rising inequality and, more generally, achieve the Millennium Development Goals.

3.

ASIAN AND PACIFIC LEAST DEVELOPED COUNTRIES: EXPORTS TO CHINA

Total exports by LDCs7 to China represented a mere $134 million in 1990, but that figure rose to $235.8 million a decade later, representing an increase of 75 per cent. The pace picked up thereafter and, by 2006, LDC exports to China had reached $571.2 million, which was 2.4 times the value recorded at the beginning of the decade. However, absolute numbers can be deceiving: LDCs sent 4.7 per cent of their combined exports to China in 1990 compared with 2.6 per cent 17 years later. Either the Asian and Pacific LDCs do not produce commodities that the Chinese market demands, or they can do so, but not at sufficiently competitive prices, or exports are constrained by both tariff and non-tariff trade barriers, especially for agricultural products. Myanmar and Bangladesh supplied 90 per cent of total LDC exports to China in 1990, but this figure had contracted to slightly less than two thirds by the end of the period. Cambodia had become a major exporter to China by 2000, displacing Bangladesh as the second largest exporter. Yet the combined exports of these three countries—Myanmar, Cambodia and Bangladesh—accounted for only 86 per cent of LDC exports to China by 2000 and had slipped even further six years later to a little over two thirds. Myanmar remained the top exporter to China, even though its share of total LDC exports declined 7

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Most of the trade-related data were obtained from the United Nations Comtrade online database, with China as the reporting country, as trade data for most LDCs are generally not available or lack consistency. Therefore, China’s imports from LDCs were taken as exports by LDCs to China; similarly, China’s exports to LDCs were taken as LDC imports from China. Kiribati, Timor-Leste and Tuvalu were excluded from the analysis owing to a lack of data.

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from 77 per cent in 1990 to 44 per cent in 2006; that of Bangladesh, which recovered from a steep plunge in 2000, was 4 per cent higher at the end of the period than at the beginning; that of Cambodia, having risen dramatically from 1990 to 2000 (from less than 1 per cent to 25 per cent), had contracted sharply to 6 per cent by the end of the period; and that of Nepal fell steadily from 3.9 per cent in 1990 to 1.5 per cent in 2006. On the other hand, the Lao People’s Democratic Republic and Solomon Islands gained ground, with their exports to China as a share of total LDC exports growing steadily. The exports of the Lao People’s Democratic Republic increased from 4.6 per cent at the beginning of the period to 8.7 per cent at the end, while Solomon Islands became the second largest exporter to China among the Asian and Pacific LDCs, with 22 per cent of total LDC exports. How important was the Chinese market for LDCs? Only Myanmar, Nepal and the Lao People’s Democratic Republic shipped more than 2 per cent of their respective exports to China in 1990. At the end of the period, the exports of the Lao People’s Democratic Republic to China remained unchanged at about 8 per cent; Myanmar’s exports had plunged to 6.9 per cent from 31.7 per cent; and Nepal’s had fallen to 1 per cent from 2.5 per cent. Bangladesh sent about 1 per cent of its exports to China at the beginning of the period but only 0.8 per cent in 2006. Indeed, of the 11 LDCs for which data are available, only Cambodia, Solomon Islands and Vanuatu sent a larger share of their exports to China in 2006 than in 1990. For Solomon Islands, the rise was dramatic: from almost nothing in 1990 to 92.5 per cent in 2006, with most of the exports comprising cork and wood. These changes suggest that, apart from Solomon Islands, the Asian and Pacific LDCs have yet to establish a firm footing in the Chinese market. This is evident from the fact that the relative importance of the Chinese market for the exports of a given LDC changed, sometimes sharply, from 1990 to 2000 and again in 2006. Since the Chinese market is vast, the unsettled situation does not seem to be the result of competition but is more likely linked to supply constraints faced by LDCs. The major commodities exported by LDCs to China were concentrated in four categories (2, 6, 5 and 3) of the Standard International Trade Classification (SITC) Revision 2 (United Nations Statistics Division, 1986) and accounted for 80 per cent of exports in 1990 and an even higher share in 2006 (see table 2). The major change arose from the growing importance of crude matter, excluding food/fuel, in 2006, which dominated LDC exports to China, representing close to three quarters of all exports compared with less than 40 per cent in 1990. In terms of composition, three quarters of crude matter exports to China consisted of cork and wood, most of which were supplied by Solomon Islands.

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Table 2. Least developed countries: major export commodities to China (Millions of United States dollars) Commodity Classification (SITC Rev. 2) 2 – Crude matter, excluding food/fuel 6 – Manufactured goods 5 – Chemical products n.e.s. 3 – Mineral fuel/lubricants Subtotal Total LDC exports

Percentage of total exports

Value 1990

2006

1990

2006

51.45 35.23 11.43 9.39 107.50 134.01

418.95 49.81 19.60 19.91 507.56 571.20

38.4 26.3 8.5 7.0 80.2 100.00

73.4 8.7 3.4 3.3 88.7 100.00

Source: United Nations Comtrade database and authors’ calculation. Abbreviations: SITC Rev. 2 – Standard International Trade Classification, Revision 2 (published by the United Nations Statistics Division); n.e.s. – not elsewhere specified. Note: The numbers in the SITC Rev. 2 column preceding the commodities groups are the SITC commodity classification codes at the single digit level.

What is the relative importance of key commodities in the export structure of selected LDCs to China (see table 3)?8 Fertilizers comprised 70 per cent of Bangladesh’s exports to China in 1990; coffee, tea, cocoa and manufactures thereof, comprised another 21 per cent. The export basket was more diverse in 2006: leather and leather manufactures accounted for 35 per cent of exports to China; textile fibres, 33 per cent; artificial resins and plastic materials, 8 per cent; fish, crustaceans and molluscs, 7 per cent; and apparel and clothing, 7 per cent. More than a third of Cambodia’s exports to China in 2006 consisted of cork and wood, followed by crude rubber (25 per cent) and textile yarn and fabrics (20 per cent) (exports were insignificant in 1990). The supply of cork and wood from the Lao People’s Democratic Republic to China fell from two thirds of its total exports at the beginning of the period to about 47 per cent at the end. By this time, however, crude, synthetic and reconditioned rubber accounted for slightly over a third of the country’s exports to China. The export bundle of Myanmar to China had become narrower by 2006 and was marked by a heavy concentration of cork and wood products (60 per cent of total exports to China, rising from 13 per cent in 1990). Nepal’s exports to China had become more diversified by 2006: its main export in 1990—crude animal and vegetable matter—had dried up, while that of leather manufactures had contracted by half. On the other hand, new commodities had emerged in its export bundle: cork and wood (20 per cent), processed animal and vegetable oils and waxes (20 per cent), textile yarn and fabrics (14 per cent) and metal manufactures (14 per cent). Most of the exports leaving Solomon Islands in 2006 went to China, and practically all of them consisted of cork and wood (exports of this commodity to China were zero in 1990). 8

18

The criterion for selection was LDCs with exports of more than $5 million to China in either 1990 or 2006.

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Table 3. Selected least developed countries: major export commodities to China (Percentage of total exports) Country Bangladesh

SITC Rev. 2 07 — Coffee, tea, cocoa, spices and manufactures thereof 26 — Textile fibres 56 — Fertilizers 61 — Leather, leather manufactures and dressed fur skins

1990

2006

21.3

—

— 69.4 4.2

33.1 — 35.1

— — —

24.8 34.3 20.1

66.8 —

46.9 34.2

Cambodia

23 — Crude/synthetic/reconstituted rubber 24 — Cork and wood 65 — Textile yarn, fabrics, made-up articles n.e.s. and related products

Lao People’s Democratic Republic

24 — Cork and wood 23 — Crude/synthetic/reconstituted rubber

Myanmar

22 — Oil—seeds and fruits 24 — Cork and wood 23 — Crude/synthetic/reconstituted rubber 66 — Non-metallic mineral manufactures n.e.s. and related products

18.4 13.3 — 29.6

— 59.7 8.4 —

Nepal

24 — Cork and wood 29 — Crude animal and vegetable materials n.e.s. 43 — Animal and vegetable fats and oils, processed; waxes of animal or vegetable origin

— 23.7 —

19.5 — 21.0

Solomon Islands

24 — Cork and wood

—

99.9

Source: United Nations Comtrade database and calculations by authors. Abbreviation: n.e.s. – not elsewhere specified.

What are the broad categories of exports from LDCs to China? The ensuing discussion is based on data for 2000 and 2006 and employs the same categories as Shafaeddin (2008). Labour-intensive products. This group includes labour-intensive agricultural products, manufactures, and textiles and garments:9 their relative importance in LDC export baskets to China declined from 31.5 per cent in 2000 to 19.4 per cent in 2006. 9

The figures for labour-intensive products were obtained by adding the figures in the Standard International Trade Classification (SITC), Rev. 2 categories representing labour-intensive agricultural products (037, 042, 05, 06, 07, 232), labour-intensive manufactures (892, 893, 894, 895, 898, 899, 269, 61, 63, 665, 666, 821, 831, 851) and labour-intensive textiles and garments (65, 84).

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During this period, the share of labour-intensive exports from four of the poorest countries (Afghanistan, the Lao People’s Democratic Republic, Myanmar and Nepal) to China increased. Bangladesh and Cambodia, on the other hand, supplied a smaller share of labour-intensive products to China in 2006 than in 1990. Myanmar, the biggest LDC exporter to China, mostly supplied China with products that were not labour-intensive. Samoa and Maldives did not export labour-intensive products to China in 2000, but they did so six years later, with Samoa exporting less than 2 per cent of its total exports to China and Maldives, about two thirds. Other agricultural products and manufactures. These exports stagnated at 15 per cent between 2000 and 2006. In the case of Afghanistan, Samoa and Vanuatu, this category of products contracted by more than 20 per cent. On the other hand, Bangladesh almost doubled its share of these commodities, while Cambodia’s share, although still less than 10 per cent, has surged more than fourfold in absolute terms since 2000. Forestry. Cambodia, the Lao People’s Democratic Republic, Myanmar, Nepal and Solomon Islands supply the Chinese market with forestry products, primarily cork and wood. The value of such exports rose from 37 per cent of total LDC exports in 2000 to 51.8 per cent in 2006. Mineral and petroleum products. Exports of mineral and petroleum products from LDCs to China are relatively small, but they have increased from 4.1 per cent to 6.7 per cent of total LDC exports; oil in Cambodia has recently attracted investors, including Chinese investors. Consumption products. All LDCs supplied the Chinese market with consumption products 10 in 2006, which contrasts sharply with 2000, when only five LDCs did. Nevertheless, the relative importance of such exports seems to be declining, as they contracted from 12 per cent to 6.8 per cent of total LDC exports to China from 1990 to 2006. The major consumption commodities include three SITC categories: coffee, tea, cocoa, spices and manufactures thereof; apparel and clothing accessories; and vegetables and fruits.

4.

ASIAN AND PACIFIC LEAST DEVELOPED COUNTRIES: IMPORTS FROM CHINA

The value of LDC imports11 from China has grown very rapidly: in 2006, they represented 14.5 times their 1990 value; in absolute terms, they rose from $386.2 million to 10

11

20

The figures for consumption commodities were obtained by adding the figures in the following SITC Rev. 2 categories: 00, 01, 02, 03, 04, 05, 06, 07 09, 11, 12, 269 and 851. Comparable data for all LDCs, except Kiribati and Timor-Leste, are available from the United Nations Comtrade database.

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$5,587.5 million in that period. The value of LDC imports from China in 1990 was 2.9 times the value of its exports in that year, while that figure rose to almost 10 times in 2006. As with exports, LDC imports from China are heavily concentrated by country: 77 per cent of the demand came from Bangladesh and Myanmar in both 1990 and 2006. Bangladesh, the most populous and one of the poorest LDCs, saw its imports from China surge to $3,090.4 million in 2006 from $125.8 million in 1990. This represented a rise from 32.6 per cent of total LDC imports from China in 1990 to 55.3 per cent in 2006. At this level, China supplied 3.5 per cent of Bangladesh’s import demand in 1990 compared with 19.3 per cent in 2006. Myanmar ranked next, even though its share of LDC imports declined from 47.6 per cent to 21.6 per cent; nevertheless, China supplied 63 per cent of Myanmar’s imports at the end of the study period, 4 per cent less than at the beginning. The value of Cambodia’s imports from China in 2006 was more than four times that of 2000, rising from $164.1 million to $697.8 million (these imports were insignificant in 1990); this was equivalent to 12 per cent of total LDC imports in 2006. Imports to the Lao People’s Democratic Republic from China in 2006 were almost five times those of 2000, rising from $34.5 million to $168.7 million (they represented just $8 million in 1990). In relative terms, the country accounted for only 3 per cent of total LDC imports from China in 2006, compared with 2 per cent in 1990. On the other hand, both Afghanistan and Nepal, despite growth in absolute terms, accounted for a smaller share of total LDC imports in 2006 than they did in 1990. Imports from China to all LDCs except Bhutan increased in absolute terms, in some cases considerably. The increase was particularly robust for countries in the Pacific, which hardly imported anything from China in 1990. For example, Vanuatu’s imports from China in 2006 were 16.6 times those in 2000; Samoa’s, 6.5 times; and those of Solomon Islands, 5.0 times. For Tuvalu, 83.8 per cent of its 2006 imports ($10.9 million) came from China, rising from nothing six years earlier. No other LDC is as import-dependent on China as Vanuatu. These LDCs, however, were not important, relatively speaking, to the total pool of imports from China due to the dominance of Bangladesh and Myanmar. Since 1 per cent of total LDC imports from China in 2006 amounted to $56 million, Bhutan, Maldives, Samoa, Solomon Islands, Tuvalu and Vanuatu—all of which imported less than this amount— simply got lost in the numbers. LDC imports from China are less concentrated than their exports (i.e. they import a broader range of commodities than they export), even though there is a tendency for increasing import concentration over time. Two SITC categories (6 and 7) are of major importance (see table 4). Manufactured goods not only topped the list of imported commodities; they also increased in importance, rising from 28.7 per cent of total LDC imports from China in 1990 to 41.7 per cent 17 years later. Machinery and transport 21

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equipment, the second major category of commodities, accounted for 25.6 per cent of LDC imports from China in 1990 but declined to 17.5 per cent in 2006. Even so, these two SITC categories comprised the bulk of LDC imports from China: 54.3 per cent and 59.2 per cent in 1990 and 2006, respectively. A similar situation, albeit one of more rapid movement, was found for exports: the share of the top two commodity categories rose from 64.5 per cent to 82.1 per cent during the same period. Table 4. Imports of LDCs from China: major commodities (Millions of United States dollars) Commodity Classification (SITC Rev. 2) 7 – Machinery and transport equipment 6 – Manufactured goods 8 – Miscellaneous manufactured articles 5 – Chemical products n.e.s. 9 – Commodities n.e.s. 3 – Mineral fuel/lubricants 2 – Crude matter, except food/fuel Subtotal Total LDC imports

Percentage of total imports

Value 1990

2006

1990

2006

99.0 110.8 4.1 10.4 — — 7.0 231.4 386.2

980.3 2 332.3 140.3 0.7 140.7 112.8 3 707.1 5 587.5

25.6 28.7 1.1 2.7 — — 1.8 59.9 100.0

17.5 41.7 2.5 0.0 2.5 2.0 66.3 100.0

Source: United Nations Comtrade database and authors’ calculation. Abbreviation: n.e.s. – not elsewhere specified.

About 4.5 per cent of the imports from China to Bangladesh were deemed special transactions (unclassified commodities) in 2006; this was not the case in 1990. Myanmar was the only large LDC that imported petroleum and petroleum products from China in 2006. These products represented 9 per cent of its imports in that year; such imports were absent in 1990. What were the major commodities that LDCs imported from China between 1990 and 2006?12 First, there was a significant compositional shift in the import basket during that period, with both a broader range of commodities being imported in 2006 and noticeable changes occurring in the relative importance of the commodities imported (see table 5). For both years, however, imports from China were concentrated around manufactured goods and machinery/transport equipment. The former group dominated imports in 1990, while the latter group dominated in 2006. Of the four LDCs included in the analysis, imports of petroleum and petroleum products from China were important for Tuvalu and Vanuatu, representing 15 per cent and 13 per cent of their imports from China in 2006, respectively. 12

22

As with exports, only LDCs that imported more than $5 million from China in either 1990 or 2006 have been selected for the analysis.

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Table 5. Selected least developed countries: major import commodities from China (Percentage of total imports) Country Afghanistan

Bangladesh

Cambodia

Lao People’s Democratic Republic Maldives Myanmar

Nepal

Samoa

Tuvalu Vanuatu Source:

SITC Rev. 2 category

1990

2006

62 67 69 07 76 77 78 71 72 76 78 65 66 72 78 71 77 78 66 77 82 33 65 69 72 76 77 78 26 65 69 72 76 77 84 85 89 76 77 64 65 33 79 33 69

10.13 9.82 48.39 — — 5.40 17.66 21.24 — 8.75 — 40.00 27.78 8.98 — 8.88 8.75 – – – — 37.47 6.86 — 5.70 6.13 — 16.71 — 9.12 20.76 — 9.76 — — 6.54 — — 18.33 — — – — –

6.96 8.57 — — 32.75 7.74 8.67 — 6.01 8.20 — 62.17 — — — 8.47 6.34 23.09 6.58 9.48 7.81 9.01 16.34 — 5.37 — — 7.35 — 17.29 — — 11.46 — 26.12 8.68 6.50 26.77 26.77 — 9.38 15.05 80.37 13.17 47.21

United Nations Comtrade database and calculations by authors.

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5.

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CHINA AND LEAST DEVELOPED COUNTRIES: EXPORTS TO THIRD MARKETS

Based on available third-market export data for the top five commodities, LDCs and China have only two key product categories in common: SITC Rev. 2 categories 84 (articles of apparel and clothing accessories) and 89 (miscellaneous manufactured articles). As miscellaneous manufactured goods account for a small portion of LDC exports, the ensuing discussion will focus on SITC Rev. 2 category 84 (articles of apparel and clothing accessories) and textiles, which are important to both China and LDCs. Global trade in textiles and clothing, which amounted to $530 billion in 2006, has become increasingly competitive following the phasing out of the Agreement on Textiles and Clothing on 1 January 2005 (World Trade Organization, 2007). With a well-established textile and clothing industry, a vertically integrated production structure and competitive prices, China is the dominant player in the textile and clothing market. Its exports of textiles and clothing to the United States were 76.7 per cent higher in 2006 than in 2004, while its market share in the sector rose from 17.2 per cent to 27.5 per cent in the same period, equivalent to a growth of 60 per cent. China’s performance was less stellar in the European Union than in the United States, but it was still impressive, with 60.6 per cent growth and an increase in market share of 35.3 per cent (see tables 6 and 7). Note that China recorded this robust performance despite safeguard measures imposed by both the United States and the European Union in 2005. Table 6. United States market for textiles and clothing for six Asian countries (Value in thousands of United States dollars; market share and export growth as a percentage) 2004 Country

Value

World 86 703 575 China 14 948 476 Bangladesh 1 986 278 Cambodia 1 430 845 Nepal 132 563 Lao People’s 2 112 Democratic Republic Maldives 81 052

2005 Market share 100.0 17.2 2.3 1.7 0.2 0.0

0.1

Value

2006

Market share

92 595 009 100.0 22 445 458 24.2 2 380 338 2.6 1 716 164 1.9 98 422 0.1 2 836 0.0

4 720

0.0

Value

Market share

96 201 234 26 418 449 2 919 631 2 146 378 88 724 8 004

100.0 27.5 3.0 2.2 0.1 0.0

1

0.0

200420042006 2006 Market Export share growth growth 11.0 76.6 47.0 50.0 -33.1 279.0

0.0 59.9 30.4 29.4 -50.0 0.0

-100.0 -100.0

Source: Based on Yumiko Yamamoto and Ratnakar Adhikari, Textiles and Clothing Tracking Report, UNDP Regional Centre in Colombo (forthcoming).

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Table 7. European Union market for textiles and clothing for six Asian countries (Value in thousands of euros; market share and export growth as a percentage) 2004 Country

European Union-Extra Trade China Bangladesh Cambodia Lao People’s Democratic Republic Nepal Maldives

2005

2006 Market share

200520042006 2006 Market Export share growth growth

Value

Market share

Value

Market share

Value

67 349 936

100.0

71 678 693

100.0

79 710 794

100.0

18.4

0.0

14 661 418 3 895 402 519 712 118 195

21.8 5.8 0.8 0.2

20 836 111 3 710 534 477 098 119 352

29.1 5.2 0.7 0.2

23 541 345 4 807 093 552 464 122 449

29.5 6.0 0.7 0.2

60.6 23.4 6.3 3.6

35.3 3.4 -12.5 0.0

77 787 255

0.1 0.0

73 088 55

0.1 0.0

68 503 2.7

0.1 0.0

-11.9 -98.9

0.0 0.0

Source: Based on Yumiko Yamamoto and Ratnakar Adhikari, Textiles and Clothing Tracking Report, UNDP Regional Centre in Colombo (forthcoming).

Bangladesh is the largest LDC exporter of textiles and clothing, and export growth in the period 2005-2006 indicates that the country has benefited from the safeguards imposed on China by WTO. Textile and clothing exports from Bangladesh to the United States grew robustly, registering a cumulative growth of 47 per cent between 2004 and 2006. Despite a decline in exports to the European Union and a loss of market share in 2005, Bangladesh recovered with a strong performance in 2006. The net result is that exports to the European Union in 2006 were more than a fifth higher than in 2004, while market share expanded by 0.2 per cent. Bangladesh specializes in the production and export of low-cost, high-volume, ready-made garments. This is evident from its revealed comparative advantage (RCA)13 index (2005) of 27.31 for clothing compared with 3.60 for China. In the case of textiles, the opposite is true: with an RCA value of 2.69, China is more specialized than Bangladesh, which has an RCA value of 1.30 (James, 2008). A stronger specialization in clothing, duty-free access to the European Union market under the Everything But Arms (EBA) initiative and the safeguards imposed on China have all played a key role in helping Bangladesh to compete effectively with China (EmergingTextiles.com, 2007). Cambodia developed a niche as an ethical clothing producer through high compliance with international labour standards and has managed to sustain its position in 13

Revealed comparative advantage (RCA) is “a measure of relative competitive performance of a country’s exporters of a particular product or class of goods” (Institute for Trade and Commercial Diplomacy, 2004).

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the global textile and clothing trade after the Agreement on Textiles and Clothing was phased out. Its exports to the United States reached $2.1 billion in 2006, which represents a 50 per cent expansion from 2004 and a 0.5 per cent gain in market share. Performance in the European Union market was less strong, with exports rising to €552 million in 2006, a tepid 6.3 per cent over 2004 exports. As a result, Cambodia’s share of the European Union market contracted by 0.1 per cent. The Lao People’s Democratic Republic earned nearly $143.2 million from textile and clothing exports in 2005. The productivity of both labour and capital there is low, but labour costs are considered to be one of the lowest among LDCs, which confers a competitive advantage on the country. Exports, which are concentrated in the European Union market owing to the tariff- and quota-free access provided under the European Union EBA initiative, increased from €119 million in 2005 to €122 million in 2006, which was just sufficient for the Lao People’s Democratic Republic to maintain its 2004 European Union market share. The country is unable to fully utilize its duty-free access due to the stringent European Union rules of origin criterion: 42 per cent of the raw materials used in its clothing and textile sector are imported from countries that do not fall under the European Union rules of origin specifications. While the textile and clothing industry in Maldives was adversely affected after the removal of quotas, the decline was not mainly a result of increased competition. The Maldivian textile and clothing industry was established by foreign investment during the period in which the Agreement on Textiles and Clothing was in force to take advantage of underutilized quotas. Once quotas were removed, the profit motive dictated relocation, which led to the decline of the industry. Exports to both the United States and the European Union collapsed after 2004. The decline of Nepal’s textile and clothing industry cannot be attributed solely to the phase-out of quotas. Other factors also played a role, including the preferential access to the United States market accorded to the sub-Saharan African countries through the African Growth and Opportunity Act (AGOA), the Maoist insurgency, labour unrest (Adhikari and Weeratunge, 2007) and the 12 per cent appreciation of the Nepalese currency against the United States dollar between July 2006 and June 2007. Data on United States imports of the clothing items restricted by safeguards imposed on China give an indication of whether LDCs benefited from the measure. For example, between 2005 and 2006, exports of restricted categories by Bangladesh and Cambodia to the United States grew by 32.9 per cent and 42.2 per cent, respectively. The Lao People’s Democratic Republic did not export these restricted categories to the United States in 2004 and 2005, but it exported nearly $1.73 million worth in 2006. Nepal, which was unable to exploit the opportunity, experienced a 21.7 per cent reduction in exports of the restricted categories to the United States during the period 2005-2006.

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There are essentially two types of barriers to textile and clothing exports from LDCs: domestic supply-side constraints and market access restrictions imposed by importing countries. The former includes political, structural and institutional barriers that constrain competitiveness. The lack of a vertically integrated supply chain, poor trade facilitation, high transaction costs, inadequate infrastructure, low labour productivity and the high cost of compliance with Customs procedures hinder the growth of the textile and clothing industry in LDCs. They will continue to constrain the ability of LDCs to compete effectively when quota restrictions on China are removed in 2009. Even though the European Union provides duty-free access to the textile and clothing exports of LDCs, LDCs in Asia have low utilization rates because of a lack of production capacity for textiles and raw materials. The EBA rules of origin double transformation criterion specifies that the exporting country must undertake a minimum of two finishing operations. As this is not possible for many LDCs, they are unable to fully utilize the duty-free access provisions; they simply cannot meet the required rules of origin threshold. In 2004, the EBA utilization rate for clothing preferences was only 33.8 per cent for Bangladesh and 65.8 per cent for Nepal (World Trade Organization, 2005).

6.

THE RISE OF CHINA AND IMPLICATIONS FOR FOREIGN DIRECT INVESTMENT IN THE LEAST DEVELOPED COUNTRIES

China is a magnet for foreign direct investment (FDI). The country attracted $685.8 billion in FDI inflows during the period 1990-2006. The nine LDCs included in the analysis14 received $9.7 billion in FDI during the 17-year period under study, which was less than 10 per cent of what China received in 1992, the year when the country witnessed a surge in FDI inflows. Bangladesh was the most important LDC as a destination for FDI, accounting for 53 per cent of FDI to all LDCs during that period; Cambodia ranked second with over a quarter of total FDI inflows. These two countries were the only LDCs to receive a cumulative sum of over $1 billion each in FDI during the period and together they accounted for 82 per cent of total FDI to LDCs during 1990-2006. Bangladesh and Cambodia are the LDC giants in terms of domestic market, exports and imports, industrial supply capacity, strong textile sectors, labour market conditions and growth rates during 1995-2005.15

14

15

Kiribati, Solomon Islands, Timor-Leste, Myanmar and Tuvalu have been excluded from the discussion because of a lack of data. According to Shafaeddin (2008), Bangladesh and Cambodia have the highest industrial supply capacity among LDCs in the region (proxied by manufacturing value-added as a percentage of GDP—17.2 and 19.1, respectively), while their rates of growth were 5.13 and 7.10, respectively, during 1995-2005, two of the highest among LDCs in the region.

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Does the “FDI haven” offered by China divert investment that would otherwise have gone to LDCs in the Asia-Pacific region? At first sight, this might seem to be the case, as the regional production networks that FDI has helped build emerged largely to supply parts and components to China, which is also a low-wage economy. No LDCs participate in any regional production network,16 but it is crucial to note that inward FDI flows are a function of several factors. Standard determinants include market size variables (real GDP growth rates, growth rates of real per capita income and GDP), policy variables (the degree of openness, corporate tax rates, import duties and the quality of infrastructure), institutional characteristics (indices of corruption, the degree of Government stability and indices of the rule of law), labour market conditions (illiteracy rates and wage rates), standard gravity model variables (the size of the source country and destination countries and the distance between them) and the global supply of FDI. Several of these variables have been found to have a significant effect on inward FDI. Chantasasawat and others (2004), using two-stage least squares, estimated equations for FDI inflows to China and eight other Asian economies for the period 1985-2001.17 While questions can be raised about their methodology, they found that the level of FDI inflows to China and the other eight economies are positively, not negatively, correlated. They concluded that “a 10 per cent increase in the FDI inflows to China would raise the level of FDI inflows to the East and South-East Asian countries by about 5 to 6 per cent, depending on the specifications”. In a later study, Chantasasawat and others (2005), found that trade liberalization in the Asian countries is a strong force in attracting FDI. On the other hand, Mercereau (2005), using data for 14 countries for the period 1984-2002, concluded that inward FDI to China crowded out FDI to Singapore and Myanmar. Using a gravity model of bilateral flows to analyse FDI rather than trade, Eichengreen and Tong (2005, p. 23) found that China’s attractiveness as a destination for FDI had a positive effect in other Asian countries, “as would be the case if China and these other economies [we]re part of the same global production networks.” Correlation coefficients for absolute levels of FDI, as well as associated growth rates, offer a rough indication of whether or not such inflows to China affected FDI inflows to the nine LDCs included in the analysis (see table 8).18 Many macroeconomic time series are not stationary in their levels and can lead to spurious results. The level of such variables can become arbitrarily large or small with no tendency to revert to their mean level. Such variables are best represented by their first differences or growth rates.

16

17

18

28

Regional production networks are the supply chains that developed in East Asian countries to supply parts and components to the huge processing component of China’s export sector. The other eight economies are Hong Kong, China; Indonesia; Malaysia; the Philippines; the Republic of Korea; Singapore; Taiwan Province of China; and Thailand. Because of data gaps in country coverage, the correlation periods are not uniform. Data on FDI from China to LDCs, which would have added a more nuanced argument to this section, do not exist.

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In general, the absolute level of inward FDI to these LDCs (together and individually), and to the Asia-Pacific region as a whole, continued to rise even as China attracted a larger inflow of FDI (see table 8). The correlation results between China and LDCs show: (a) a strong positive association between FDI inflows to China and to countries with a correlation coefficient higher than 0.5, including Afghanistan, Bangladesh, Bhutan, Cambodia and Maldives; (b) a positive but weaker association between FDI inflows to China and to countries with a correlation coefficient of less than 0.3, including Nepal and Vanuatu; and (c) a negative association, albeit weak, only for Samoa. If the growth rate of FDI, instead of its level, is examined, then a slightly different picture emerges. A strong positive association exists only for Afghanistan and Bhutan. Weaker associations exist for Bangladesh, Cambodia, the Lao People’s Democratic Republic and Nepal; and a negative association is evident for Maldives, Vanuatu and Samoa. Even in the aggregate, the very strong absolute level association between FDI inflows to China and other Asia-Pacific economies, including LDCs, is degraded considerably when growth rates are used. Table 8. Foreign direct investment: correlation coefficient between China and LDCs, 1990-2006 Country or area China and Afghanistan China and Bangladesh China and Bhutan China and Cambodia China and the Lao People’s Democratic Republic China and Maldives China and Vanuatu China and Nepal China and Samoa China and all nine LDCs Memo items China and India China and the Asia-Pacific region Source:

Coefficient (level)

Coefficient (growth rate)

0.56 0.92 0.96 0.70 0.40 0.73 0.14 0.06 -0.17 0.85

0.61 0.35 0.74 0.22 0.23 -0.34 -0.15 0.08 -0.06 0.46

0.76 0.89

0.60 0.55

Authors’ calculation based on UNCTAD, Handbook of Statistics 2006-2007 (Geneva, 2007).

Why might these positive associations exist between FDI to China and FDI to LDCs? Two kinds of linkages are possible: production and resources. In manufacturing, especially in the region, firms tend to specialize in the context of a growing fragmentation of the production process. For example, an investor—a transnational corporation— establishes factories in both China and Bangladesh to take advantage of their respective 29

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competitiveness in distinct stages of production. Parts and components are then traded between China and Bangladesh (and possibly other economies as well). In this scenario, an increase in FDI to China is positively associated with an increase in FDI to LDCs. A complementary argument is that, as China grows, its market size and appetite for raw materials increase. As a result, some transnational corporations will set up production facilities in China to take advantage of a growing market, while others will invest in LDCs (and other parts of Asia) to extract minerals and resources to feed China’s rising demand for them. Once again, this argument predicts that FDI in China will lead to FDI in LDCs. The general conclusion from this exploratory correlation analysis is that the levels of FDI inflows to China have two effects: they enhance investment in Asian LDCs, possibly through complementary inflows of FDI, but they also divert FDI inflows away from these LDCs. On balance, however, the result is a positive one: the investment-enhancing effect of FDI inflows to China dominates, so they have an uplifting effect on such flows to LDCs.19

7.

CONCLUSIONS AND POLICY IMPLICATIONS

The 10 LDCs in Asia accounted for approximately 5 per cent of China’s trade surplus during the period 1990-2006. LDC exports to China were concentrated by country and product; crude matter, a large fraction of which comprised forestry products, dominated by 2006. Imports from China to LDCs were dominated by two countries: 80.2 per cent went to Myanmar and Bangladesh in 1990, slightly less than in 2006. The combined shares of the top two SITC commodity groups imported by LDCs from China rose from 55 per cent to 59 per cent by the end of the period. LDCs and China do not compete in any significant way in third-country markets. A correlation analysis suggests that FDI flows to China have a positive effect on flows to LDCs. An important policy implication is the need for more equalizing growth in the region and, in particular, between the emerging economies, such as China, and LDCs. Greater participation by LDCs in regional and global markets is hindered by supply-side constraints and limited market access for products for which they have a comparative advantage. Assistance could be provided in two ways: O

19

20

30

A regional fund could be established to find solutions to supply-side constraints.20 Foreign exchange reserves have grown robustly during the last several years; China’s foreign reserves alone surpassed $1.6 trillion in March 2008 (Chinability, 2008). A regional fund, as proposed by Gampat (2007), could be set up to invest excess reserves in LDCs, providing resources for

Chantasasawat and others (2005, p. 37), using panel regression, examined the shares of FDI to developing countries and found that “the China effect is negative for both the East and South-East Asian economies…” This could complement the Aid for Trade initiative.

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infrastructure projects—such as roads, port services, and information and communications technologies—to reduce the infrastructural bottlenecks and contributing investments in human capital—including technology transfers and skills development—to enable LDCs to diversify their products, move up the value chain and improve competitive capacity. O

21

Consistent with Target 1321 of Millennium Development Goal 8 and the decision taken at the Sixth WTO Ministerial Conference held in Hong Kong, China in 2005 that “developed country members shall, and developing country members in a position to do so should provide duty-free and quotafree market access to LDCs” (United Nations Development Programme, 2008), China and other newly industrialized countries in the region should provide greater market access for Asia-Pacific LDC exports. This could be done by: (a) providing duty- and quota-free treatment for all LDC exports; and (b) strengthening market access preferences through improved special and differential treatment provisions, liberal rules of origin and flexible product standards for goods originating from LDCs (United Nations Development Programme, 2008). Additionally, the Global System of Trade Preferences among Developing Countries (GSTP) should be used as a mechanism for enhancing South-South trade among countries in the region, led by China and India, for example.

Target 13: Address the special needs of LDCs. “Includes: tariff- and quota-free access for Least Developed Countries’ exports; enhanced programme of debt relief for heavily indebted poor countries and cancellation of official bilateral debt; and more generous official development assistance for countries committed to poverty reduction” (United Nations Development Programme, 2005, p. 3).

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REFERENCES Adhikari, Ratnakar and Chatrini Weeratunge (2007). “Textiles and clothing in South Asia: current status and future potential”, South Asia Economic Journal, vol. 8, No. 2. Asian Development Bank (2005). Asian Development Outlook 2005 Update (Manila). Chantasasawat, Busakorn, K.C. Fung, Hitomi Iizaka and Alan Siu (2004). “The giant sucking sound: is China diverting foreign direct investments from other Asian economies?”, paper presented at the 6th Asian Economic Panel Meeting, Seoul, 9-10 October 2003, available at http://econ.ucsc.edu/faculty/working_papers/ fung2.pdf. ______ (2005). “FDI flows to Latin America, East and Southeast Asia and China: substitutes or complements?”, available at http://econ.ucsc.edu/faculty/ working_papers/fung3. pdf. Chinability (2008). “China’s foreign exchange reserves, 1977-2008”, accessed from http:// www.chinability.com/Reserves.htm on 22 June 2008. Cui, Li and Murtaza Syed (2007). The Shifting Structure of China’s Trade and Production, IMF Working Paper No. WP/07/214 (Washington D.C., International Monetary Fund). The Economist (2008). “Economic Focus: From Mao to the mall”, 16 February, p. 86. Eichengreen, Barry and Hui Tong (2005). Is China’s FDI Coming at the Expense of Other Countries?, NBER Working Paper No. 11335 (Cambridge, Massachusetts, National Bureau of Economic Research). EmergingTextiles.com (2007). European Union Clothing Imports in 2006 (Statistical Report), accessed from www.emergingtextiles.com/?q=art&s=070326-apparel&r= eu-apparel-import&n=1 on 29 May 2007. Gampat, Ramesh (2007). “A regional fund for the least developed countries of Asia”, World Affairs, vol. 11, No. 4, pp. 44-50. Gruenwald, Paul and Masahiro Hori (2008). “Intra-regional Trade Key to Asia’s Export Boom”, IMF Survey Magazine, accessed from www.imf.org/external/pubs/ft/survey/ so/2008/CAR02608A.htm#top on 20 March 2008. Martin, W. and E. Ianchovichina (2001). “Implications of China’s accession to the World Trade Organisation for China and the WTO”, The World Economy, vol. 24, No. 9, pp. 1205-1219, September. Institute for Trade and Commercial Diplomacy (2004). Glossary: Economic and Commercial Concepts and Terms, accessed from www.itcdonline.com/introduction/ glossary2_q-z.html on 25 June 2008.

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James, William E. (2008). Asian Textile and Apparel Trade: Moving Forward with Regional Integration, ERD Working Paper No. 111 (Manila, Asian Development Bank). Jenkins, Rhys and Chris Edwards (2004). How Does China’s Growth Affect Poverty Reduction in Asia and Latin America? Final Report to DFID, Latin America/ Caribbean and Asia/Pacific Economics and Business Association (LAEBA) Working Paper No. 34 (Washington, D.C., Inter-American Development Bank and the authors), available at www.iadb.org/laeba/downloads/WP_34_2004.pdf. Jenkins, Rhys and Enrique D. Peters (2007). The Impact of China on Latin America and the Caribbean, IDS Working Paper No. 281 (Brighton, Institute of Development Studies at the University of Sussex). Kaplinsky, Raphael, Dorothy McCormick and Mike Morris (2007). The Impact of China on Sub-Saharan Africa, IDS Working Paper No. 291 (Brighton, Institute of Development Studies at the University of Sussex). Lall, Sanjaya and Manuel Albaladejo (2004). “China’s competitive performance: a threat to East Asian manufactured exports?”, World Development, vol. 32, No. 9, pp. 14411466. Mercereau, Benoit (2005). FDI Flows to Asia: Did the Dragon Crowd Out the Tigers?, (Washington, D.C., International Monetary Fund). Shafaeddin, Mehdi (2002). The Impact of China’s Acccession to WTO on the Exports of Developing Countries, UNCTAD Discussion Paper No. 160 (Geneva). _____ (2008). South-South Regionalism and Trade Cooperation in the Asia-Pacific Region, Discussion Paper (Colombo, United Nations Development Programme Regional Centre). United Nations Development Programme (UNDP) (2005). Voices of the Least Developed Countries of Asia and the Pacific: Achieving the Millennium Development Goals through a Global Partnership (ST/ESCAP/2370) (New Delhi, Elsevier). _____ (2008). Making Globalization Work for the Least Developed Countries (New York). United Nations Statistics Division (1986), Standard International Trade Classification, Revision 2 (New York), available at http://unstats.un.org/unsd/cr/registry/regct.asp? Lg=1. World Trade Organization (WTO) (2005). Sub-Committee on Least-Developed Countries— Options for Least-developed Countries to Improve their Competitiveness in the Textiles and Clothing Business—Note by the Secretariat, WT/COMTD/LDC/W/37, 28 June (Geneva). ______ (2007). International Trade Statistics 2007, accessed online from www.wto.org/ english/res_e/statis_e/its2007_e/its2007_e.pdf on 20 April 2008.

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Yamamoto, Yumiko and Ratnakar Adhikari (forthcoming). Textiles and Clothing Tracking Report (Colombo, United Nations Development Programme Regional Centre). Data sources United Nations Conference on Trade and Development (2007). Handbook of Statistics 2006-2007 (Geneva). United Nations Commodity Trade Statistics Database (Comtrade), available at http:// comtrade.un.org/. World Bank (various issues). World Development Indicators (WDI), (Washington, D.C.) accessed online at http://web.worldbank.org/WBSITE/EXTERNAL/ DATASTATISTICS/0,,contentMDK:20398986~isCURL:Y~pagePK:64133150~ piPK:64133175~theSitePK:239419,00.html on 5 March 2008.

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Who will be the main global IT services hub: India or China?

Seema Joshi*

ABSTRACT

I

ndia is considered to be a global information technology (IT) services hub, thanks to its commendable performance in information technology services (ITS) and information technology-enabled services (ITES). In general, services in India account for a larger share of GDP than in China but, in value terms, Chinese services exports surpass those of India. This is evident from the fact that, in terms of global exports of services, China ranks at number 9 and India at number 12. Besides, with the exception of computer, information, communications and other commercial services and insurance and financial services, China is selling more transport and travel services to the world than India. However, India still has a lead in ITS and ITES. Against this background, we raise and attempt to answer the following question in this paper: in the future, who will be the main global IT services hub: India or China? Keeping in mind the relatively better physical, social and information and communications technology infrastructure and more favourable business environment in China, the notion that India is the main IT services hub of the world might remain only an illusion unless India makes serious attempts to remove constraints to economic growth. In other words, unless serious reforms in the infrastructure sector and business environment are implemented in India through good governance, China might also become a global IT services hub, in addition to being a manufacturing hub, and it might even supersede India in this regard.

*

Sir Ratan Tata Senior Fellow at the Institute of Economic Growth, University of Delhi Enclave, North Campus, Delhi, India.

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1.

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INTRODUCTION

There are some similarities between China and India. Both countries have huge populations and are among the most dynamic and rapidly growing economies in the world. Together, the two countries account for 37.3 per cent of the world population, with China at 20.3 per cent and India at 17.0 per cent in 2005. These shares are higher than the shares of global GDP in these countries, with China contributing 5.0 per cent and India 1.8 per cent, for a combined contribution of 6.8 per cent to global gross domestic product (GDP) in 2005 (see World Bank, 2007a). China is growing faster than India. China’s GDP registered a growth rate of 10.3 per cent during the period 1980-1990 and 9.6 per cent during the period 1990-2003, while GDP in India grew by 5.7 per cent and 5.9 per cent, respectively, during these periods. Even during the year 2004/05, China’s GDP grew at a faster rate (10.2 per cent per annum) than that of India (9.2 per cent per annum). At the outset, it may be noted that the share of agriculture in GDP declined in both economies during the process of structural change (1965-2005). In China, however, it was followed by an expansion of the manufacturing sector, whereas in India it was the services sector which started to grow. As a result, China has emerged as the manufacturing powerhouse of the world and India as the IT services powerhouse.1 In terms of share of GDP, the services sector is larger in India, at 54 per cent of GDP in 2005, than in China, at 40 per cent. However, if we look at the average annual growth rate of the services sector in the two countries, we find that the output in the services sector grew at a faster rate in China than in India during the period 1990-2005. Even in terms of the value of services exports, China is ahead of India. Given this background, the following question appears in this paper: who will be the main global IT services hub: India or China? A modest attempt has been made to answer this question in the present paper. The paper is organized in four sections. Section 2 focuses on India as a global IT services hub. Section 3 tries to answer the question: who will be the main global IT services hub: India or China? The paper demonstrates that the quality of China’s physical, social and information and 1

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The share of manufactures in China’s merchandise exports was 92 per cent in 2005. China is the third largest merchandise exporter after Germany and the United States, out of 152 countries for which data are available (World Bank, 2007a). What is remarkable about China is its transition from an inefficient and high-cost State-owned enterprise model merely two decades ago to the fiercely competitive and cost-innovative private sector model which has spawned various Chinese transnational corporations. Some of them—such as Lenovo, Haier, TCL, Huawei and ZTE—are quite familiar, but there are dozens of others that are practically unheard of outside China. These include, for example: Galanz, which supplies more than half of all the microwave ovens sold globally; Wanxiang, the world’s largest producer of universal joints; BYD, the second largest manufacturer of rechargeable batteries worldwide; CIMC, commanding a 55 per cent share of shipping containers globally; ZPMC, which holds a 54 per cent share of the global market in harbour cranes; Vimicro, cornering 60 per cent of the market for multimedia processors; and Pearl River Piano, the world’s largest manufacturer of pianos, which has captured 40 per cent of the United States market in upright pianos and 15 per cent overall, in just five years (quoted from The Business India, 23 September 2007; see also Zeng and Williamson, 2007).

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communications technology (ICT) infrastructure is generally better than that of India, as is its overall business environment, and therefore argues that China could overtake India in exports of information technology services and information technology-enabled services in a decade or so if India does not take urgent action to improve its fundamentals to maintain its IT services lead. Section 4 provides concluding remarks.

2.

INDIA: A GLOBAL IT SERVICES HUB

India is called a global IT services hub. An examination of the sectoral composition of its GDP for the period 1950/51-2006/07 brings out the fact that “servicization” of the production structure has taken place in India. During the 1950s, the primary sector was the dominant sector of the economy and accounted for the largest share of GDP. However, the scenario changed subsequently, especially in the 1980s. The output of the services sector increased at a rate of 6.63 per cent per annum in the period 1980/811989/90 (i.e. during the pre-reform period) compared with 7.71 per cent per annum in the period 1990/91-1999/2000 (i.e. during the post-reform period). The tertiary sector emerged as the largest sector of the economy in terms of both growth rate and share of GDP in the 1990s. In 2006/07, 55.1 per cent of GDP was contributed by this sector (Joshi, 2004 and 2008). Turning now to India’s export basket of services, table 1 clearly shows that, among the services exports, the highest growth rate (35.9 per cent in 2006/07) was registered by the miscellaneous segment, comprising software and non-software services. The miscellaneous services category is the main category of exports, as it accounts for a 76.7 per cent share of total services exports in 2006/07, followed by travel (11.6 per cent), transport (9.9 per cent), insurance (1.5 per cent) and government not included elsewhere (0.3 per cent). Software services contributed 38.5 per cent of miscellaneous exports, while the non-software segment accounted for 38.2 per cent. The major contributors to non-software exports were business services (28.8 per cent), followed by financial services (4 per cent) and communication services (2.5 per cent) (Prasad, 2007, pp. 15-16). The recent surge in services growth during the last two decades has been attributed mainly to high productivity services such as IT services and ITES,2 including business process outsourcing (BPO), knowledge process outsourcing (KPO), medical business process outsourcing (MBPO), legal process outsourcing (LPO), research process 2

The IT-ITES industry has been divided into three segments: IT services and software, ITES-business process outsourcing (BPO) and hardware. ITES refers to those outsourcing services which are processed and delivered with the use of information technology. BPOs mainly provide low-end services such as medical transcription, document processing, data entry and processing. knowledge process outsourcing (KPO) is a new breed of high-end BPOs, according to NASSCOM (2006).

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Table 1. Indian services exports by major categories (Value in millions of United States dollars; growth rate and share as a percentage)

Services (total) 1. Travel 2. Transportation 3. Insurance 4. Government not included elsewhere 5. Miscellaneous A. Software B. Non-Software i. Communication services ii. Construction iii. Financial iv. News agency v. Royalties, copyrights and license fees vi. Business services vii. Personal, cultural, recreational viii. Others

Value in 2006/07 (Preliminary)

Growth rate in 2006/07

Share in total services

81 330 9 423 8 069 1 200 273 62 365 31 300 31 065 2 068 397 3 213 438 164 23 459 251 1 075

32.5 20.0 28.3 14.3 -11.7 35.9 32.6 39.3 -5.2 -56.7 88.6 29.2 27.1 82.4 96.1 -73.4

100.0 11.6 9.9 1.5 0.3 76.7 38.5 38.2 2.5 0.5 4.0 0.5 0.2 28.8 0.3 1.3

Source: Reproduced from H.A.C. Prasad, “Strategy for India’s services sector: broad contours”, Working Paper No. 1/2007-DEA (New Delhi, Ministry of Finance, Government of India, 2007), p. 15.

outsourcing (RPO), engineering process outsourcing (EPO) and human resource outsourcing (HRO).3 India has achieved unparalleled success in the export of information technology software and related services over the past decade. As shown in table 2, the total export revenues earned by this sector grew from $7.7 billion in 2001/02 to $23.6 billion in 2005/06, and they are forecast to reach $30.5 billion in 2006/07, whereas the total export revenue of this sector stood at just $1.8 billion in 1997/98. Currently, India is regarded as the premier destination for the global sourcing of IT and ITES (India, undated, p. 69). As of December 2006, over 440 Indian companies had acquired quality certifications that exceeded those of any other country in the world, with 90 companies certified at level 5 of the United States Department of Defense Software Engineering Institute Capability Maturity Model (SEI-CMM) (India, 2008c, p. 252).

3

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Abbreviations are from Joshi, 2007.

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Table 2. Performance of the Indian IT-ITES (exports) during the Eleventh Five Year Plan (Billions of United States dollars) 2001/ 2002/ 2003/ 2004/ 2005/ 2006/ 02 03 04 05 06 07F Software and related services exports

7.7

9.5

12.8

17.7

23.6

30.5

CAGR

Targets

Status

31.7%

50 by 2008/09 60 by 2009/10

On track On track

Source: India, Eleventh Five Year Plan 2007-2012: Information and Technology Sector, Department of Information Technology (New Delhi, Ministry of Communications and Information Technology, undated), available at http://planningcommission.nic.in/aboutus/committee/wrkgrp11/wg11_IT.pdf. Abbreviations: CAGR – compound annual growth rate; F – forecast.

It is important to point out here that “strong demand over the past few years has placed India amongst the fastest growing IT markets in the Asia-Pacific region. The Indian software and ITES industry has grown at a compound annual growth rate of 28 per cent during the last five years and the industry’s contribution to national GDP has risen from 1.2 per cent during the year 1999/2000 to a projected 4.8 per cent during 2005/06”. (India, undated, p. 92) That is why India has earned itself the “reputation of an IT superpower”.4 Being an IT services hub implies being a major centre for catering to the IT services needs of the world. According to the National Association of Software and Services Companies (NASSCOM) (2006), India has a dominant and growing share of the global IT-ITES pie: “Over [fiscal years] FY 2001-[20]05, India’s share in global sourcing has grown from 62 per cent to 65 per cent for IT and 39 per cent to 46 per cent for ITESBPO. India’s leadership is also reflected in the strong preference shown by customers for sourcing various services from the country. …India remains the most preferred offshore location for sourcing a broad range of business services.” Further, “India is well positioned to extend its leadership in the global IT-ITES industry by leveraging its fundamental advantages of a disproportionately large talent pool, developed depth of service offerings and demonstrated process excellence at a continued cost advantage.” Indian ITES-BPO companies are increasingly exploring new service lines. Key service lines are: research and development and engineering services, consulting services, system integration, application development and maintenance, traditional IT outsourcing and horizontal services (such as finance accounting and administration, customer interaction services, human resources administration and research). IT is being applied in core business rather than support services and there has been an emergence of verticals in 4

See the website of Software Technology Parks of India, Ministry of Communications and Information Technology, www.stpi.in.

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IT, such as banking, insurance, manufacturing, pharmaceuticals, travel and hospitality, animation, media and entertainment (India, undated, pp. 69-70). Keeping in view the performance of IT-ITES in India, the emergence of new service lines and verticals on the horizon, business transformation through the use of IT and the emergence of India as a top destination for IT and ITES, it would not be a misnomer to say that India is evolving into a global IT services hub. Coming now to the contribution of IT and ITES to employment, table 3 indicates that in both the IT and ITES sectors, the number of employed knowledge professionals has grown from 0.284 million in the year 1999/2000 to 0.830 million in 2003/04 and it is expected to reach 1.287 million by the end of 2005/06. Furthermore, this sector is expected to directly employ 1.6 million professionals in FY 2008 (see India, 2008c; NASSCOM, 2008; Joshi, 2009). Table 3. Indian IT-ITES sector: knowledge professionals employeda (Millions of professionals) Number

1999/2000 2000/01

2001/02

2002/03

2003/04

2004/05 b 2005/06 b

IT, engineering and research and development, software product exports

0.110

0.162

0.170

0.205

0.296

0.390

0.513

IT-enabled services exports

0.420

0.700

0.106

0.180

0.216

0.316

0.409

Domestic sector

0.132

0.198

0.246

0.285

0.318

0.352

0.365

Total

0.284

0.430

0.522

0.670

0.830

1.058

1.287

Source: India, Eleventh Five Year Plan 2007-12, Volume III (New Delhi, Planning Commission, 2008), p. 253. a Notes: Does not include employee numbers related to the hardware sector; b Estimated employment of knowledge professionals.

According to NASSCOM (2005), India’s offshore IT and BPO industries hold the potential to create over 8.8 million jobs by 2010—2.3 million direct jobs and 6.5 million indirect or induced jobs. There is a lot of scope for future expansion, as only 10 per cent of the potential global IT-ITES market has been developed. The remaining 90 per cent (worth $300 billion) remains to be tapped (India, 2006, p. 26). Services emerged as an important source of export revenue in India during the period 1990-2005. As shown in table 4, exports of commercial services registered increases from $4.6 billion in 1990 to $17.67 billion in 2000 and $56.1 billion in 2005, an increase of 40

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Table 4. India’s export performance in the services sector (Billions of United States dollars) Year 1990 2000 2005

India’s commercial services exports 4.60 (0.56%) 17.67 (1.23%) 56.09 (2.28%)

World services exports 815.8 1 453.8 2 459.9

Source: World Bank, World Development Indicators, various issues. Note: Commercial services exports comprise transport, travel and other commercial services. Other commercial services include such activities as insurance and financial services; international telecommunications; postal and courier services; computer data; news-related service transactions between residents and non-residents; construction services; royalties and license fees; miscellaneous business, professional and technical services; and personal, cultural and recreational services.

over 1,119.6 per cent during the past 15 years. Furthermore, India had become the twelfth largest exporter of commercial services by 2005, and it was twenty-sixth out of 152 countries for which data are available from the World Bank (2007a) in merchandise exports. India’s share of total world services exports increased over time from 0.56 per cent in 1990 to 1.23 per cent in 2000 and to 2.28 per cent in 2005. Further, in 2005, the revealed comparative advantage (RCA)5 for commercial services exports (CSE) was more than one (RCA>1), signifying a comparative advantage for India in CSE, whereas in merchandise exports, the RCA was 0.8 (i.e. RCA<1) (calculated from World Bank, various issues). RCA in other services segments was greater than one, indicating a huge export potential (see Joshi, 2009). All of these facts and figures show the growing importance of services exports in total exports from India. Services exports have been growing at 28 per cent annually, while goods exports have grown at 22 per cent annually for the last five to six years. Services exports are expected to amount to $311 billion by 2012 and are likely to overtake merchandise exports, which are expected to amount to $305 billion by 2012, according to a recent study by the Federation of Indian Chambers of Commerce and Industry (see The Times of India, 2007). The share of services in the country’s total exports is expected to rise to 50.4 per cent by 2012 from its current 37.1 per cent. Its share in global services exports is expected to increase to 6 per cent by 2012, nearly three times the current 2.3 per cent, as predicted by the same study.

5

Revealed comparative advantage (RCA) is the ratio of two different ratios. The numerator is the ratio of the exports of commercial services of the region or country to its total exports (merchandise+CSE). The denominator is the ratio of world exports of CSE to total world exports.

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Considering the structure of services exports, we can observe from table 5 that the share of travel and transport services exports in commercial services exports declined during the 1990-2005 period, whereas that of insurance and financial services and computer, information, communications and other commercial services increased to represent over 70 per cent of India’s services exports. Table 5. Structure of services exports, India (Percentage of commercial services exports)

Year

Transport

Travel

Insurance and financial services, and computer, information, communications, and other commercial services

1990 2000 2005

20.8 10.6 13.3

33.8 17.9 16.8

45.4 71.4 69.9

Source:

World Bank, World Development Indicators 2007 (Washington, D.C., 2007).

Table 6. Breakdown of IT industry earnings by sector, India (Billions of United States dollars) Earnings

FY 2004

FY 2005

FY 2006

FY 2007

ITS - Exports - Domestic

10.4 7.3 3.1

13.5 10.0 3.5

17.8 13.3 4.5

23.7 18.1 5.6

ITES-BPO - Exports - Domestic

3.4 3.1 0.3

5.2 4.6 0.6

7.2 6.3 0.9

9.5 8.3 1.2

Engineering services and research and development, software products - Exports - Domestic

2.9

3.9

5.3

6.5

2.5 0.4

3.1 0.8

4.0 1.3

4.9 1.6

16.7

22.6

30.3

39.7

12.9

17.7

23.6

31.3

5.0

5.9

7.0

8.2

21.6

28.4

37.4

47.8

Total software and services revenues - Exports Hardware Total IT industry (including hardware)

Source: NASSCOM, Strategic Review 2007 (New Delhi, 2007). Abbreviation: FY – fiscal year.

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It is important to point out here that earnings from the software and services segment (exports as well as domestic) are expected to be $39.7 billion in financial year 2007, of which exports earnings are expected to amount to $31.3 billion (see table 6). This figure is likely to reach the $60 billion mark by 2010, according to NASSCOM estimates. Having examined India’s current status as a global IT services hub, let us examine the central question: who will be the main global IT services hub in the future: India or China? In other words, can China become a global IT services hub by competing with India, and what are the sources of China’s strengths which could undo some of India’s advantages in the field of IT-ITES—the only services segment in which the exports of India surpass those of China.

3.

CHINA AND INDIA: SOME COMPARISONS

Having examined the current status of India as a global IT services hub, let us do a comparative analysis of services sector performance in China and India and the sources of strength of both countries in the services sector.

(a) A comparative analysis of services sector performance in China and India Having reviewed the performance of India’s services sector and noticed its huge potential, it appears appropriate to compare China’s position with that of India in services exports in order to attempt to answer the above-mentioned questions. In terms of the sectoral composition of output, the services sector dominates in India, while the industrial or manufacturing sector is the most prominent in China (see table 7). Table 7. Sectoral composition of output (Percentage of GDP) Year 1990 (A-I-S) 2000 (A-I-S) 2005 (A-I-S) Source:

China

India

27-42-31 16-51-33 13-48-40

31-28-41 25-27-48 18-27-54

World Bank, World Development Indicators 2007 (Washington, D.C.)

2007. Note: A-I-S stands for the respective percentage shares of the agricultural/ primary, industrial and services sectors in total GDP of the country.

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Table 7 reveals that, in both countries, the share of agriculture declined while that of services rose over the period 1990-2005. However, in 2005, the services sector accounted for 54 per cent of GDP in India versus 40 per cent in China. Nevertheless, if we look at the average annual growth rates of the services sector in the two countries, we can observe that services sector output grew at a faster rate in China than in India (see table 8). Table 8. Growth of sectoral output (Average annual percentage) Country or area China India World Source:

GDP

Agriculture

Industry

Services

19992000

20002005

19992000

20002005

19992000

20002005

19992000

20002005

10.6 6.0 2.9

9.6 7.0 2.8

4.1 3.0 2.0

3.9 2.5 2.2

13.7 6.3 2.4

10.9 7.5 2.0

10.2 8.0 3.1

10.0 8.5 2.7

World Bank, World Development Indicators 2007 (Washington, D.C., 2007), pp. 190-192.

Both China and India have implemented comprehensive reform measures, although in China reforms started as early as 1978, whereas India began its reforms 13 years later in July 1991. One of the purposes of reforms is to integrate the domestic economy into the world economy through the progressive dismantling of controls in various sectors. One indicator of an economy’s increasing global integration is the growing importance of that economy’s trade in the world economy and the increased size and importance of private capital flows to and from that economy as a result of the liberalization of its financial markets (World Bank, 2007a). It can be observed that, as a consequence of these reforms, both China and India are currently firmly integrated in the world economy, but the extent of integration differs. Table 9 shows that merchandise and services trade as a percentage of GDP almost doubled in both countries between 1990 and 2005. In China, merchandise trade stood at 63.6 per cent of GDP in 2005, while in India, it stood at 28.5 per cent. The services trade in China was 7.1 per cent of GDP versus 8.2 per cent in India. Foreign direct investment (FDI) inflows were 3.5 per cent of GDP in China and less than 1 per cent (0.8) in India. Similarly, the net inflow of gross private capital as a percentage of GDP was much higher in China than in India. So the performance of the four indicators clearly demonstrates that China’s integration into the world economy took place at a faster rate than that of India (with the exception of one indicator—services trade as a percentage of GDP).

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Table 9. Indicators of integration into the world economy (Percentage of GDP) Merchandise trade

Country China India Source:

Trade in services

FDI net inflows

Gross private capital flows

1990

2005

1990

2005

1990

2005

1990

2005

32.5 13.1

63.6 28.5

2.9 3.4

7.1 8.2

1.0 0.1

3.5 0.8

2.5 0.8

10.9 5.9

World Bank, World Development Indicators 2007 (Washington, D.C., 2007), pp. 316-317.

To examine the question of whether or not China will become a global IT services hub by competing with India, we will examine CSE in the two countries during the period 1990-2005. Table 10 shows that the value of CSE was $5.74 billion in 1990 and $73.90 billion in 2005 for China, while for India, these values were $4.61 billion and $56.09 billion, respectively. During the triennium 2003-2005, CSE was $60.78 billion for China and $40.25 billion for India. Table 10. Commercial services exports (Billions of United States dollars) Year

China

India

1990 2000 2005 Triennium 2003-2005

5.74 30.14 73.90 60.78

4 .61 17.67 56.09 40.25

Source: 2007).

World Bank, World Development Indicators 2007 (Washington, D.C.,

When we examine the structure of CSE for both countries, as shown in table 11, we find that, in 2005, 61.4 per cent of China’s CSE ($45.36 billion) came from the transport, travel and insurance and financial services sectors. In contrast, in India these three sectors accounted for just 33.6 per cent of CSE ($18.83 billion), indicating that China might become a global services hub, replacing India. In value terms, Chinese services exports have already overtaken those of India. The ITS-ITES sectors (included in the “computer, information, communications and other commercial services” column in table 11) are the only CSE sectors where India was ahead of China, as these sectors represented 66.4 per cent of CSE ($37.24 billion in absolute terms) in India, compared with 38.6 per cent ($28.52 billion in absolute terms) in China. Indeed, India also sold more insurance and financial services to the world ($1.96 billion) than China ($0.66 billion) in 2005. However, the share of India’s computer, information, communications and other commercial services exports out of total CSE are quite a bit higher in both percentage terms (66.4 per cent) and 45

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Table 11. Structure of commercial services exports

Country

China India

Commercial service exports (Billions of United States dollars)

Transport (Percentage of CSE)

1990

2005

1990

2005

1990

2005

1990

2005

1990

2005

5.74 4.61

73.90 56.09

47.1 20.8

20.9 13.3

30.2 33.8

39.6 16.8

4.0 2.7

0.9 3.5

18.7 42.7

38.6 66.4

Source:

Travel (Percentage of CSE)

Insurance and Computer, inforfinancial services mation, communi(Percentage of cations and other CSE) commercial services (Percentage of CSE)

World Bank, World Development Indicators 2007 (Washington, D.C., 2007), pp. 210-211.

absolute terms ($37.24 billion) than its shares of insurance and financial services out of total CSE (3.5 per cent of CSE; $1.96 billion). This observation also explains why India is called an IT services hub. It is important to mention here that “India’s sustained leadership in the ITS and ITES sectors is driven by strong fundamentals comprising a large and growing pool of qualified, English-speaking manpower, a keen focus on defining and adhering to global quality standards, a demonstrated emphasis on information security practices, an improving quality of telecommunications infrastructure with its costs approaching globally competitive levels, and a strong Government support focus on improving basic infrastructure and developing policies and an effective regulatory regime which favour the growth of the industry”. (Karnik, 2005) However, the sustainability of the impressive growth of the ITS and ITES sectors (as a result of which India is dominating China in exports of computer, information, communications and other services) has been questioned in the wake of challenges such as rising labour costs; the rapid growth in demand for talented manpower and quality staff— a shortage of 0.5 million professionals is expected by the end of the decade if the current trends are maintained (NASSCOM, 2005); and competition from countries such as the Philippines, China and Ireland in supplying low-cost labour and talent. High attrition rates (the average attrition rate in India is estimated at 55 per cent) and a backlash against outsourcing in some countries are other challenges (Joshi, 2006b).

(b) A comparison of the sources of strength of the services sectors in China and India The single most important obstacle which is holding back India’s growth is its inadequate and poor quality infrastructure. Therefore, whether India will be able to handle

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the above-mentioned challenges and sustain competitiveness in the services sector will be determined mainly by the quality of its infrastructure (both physical and social) and its business environment. Undeniably, without political will and commitment, all efforts to achieve rapid development will come to naught. Let us, therefore, examine the state of the infrastructure and business environment prevalent in the two countries concerned. (i)

Transport infrastructure

The infrastructure sector comprises a wide array of services, such as transport; power generation, transmission and distribution; and telecommunications. As far as transport infrastructure is concerned, China has a very strong transport network. The country is connected internally by 1,870,661 km of roadways, 74,408 km of railways and 123,964 km of waterways. Although the physical infrastructure may not be as crucial for software services as for hardware manufacturing, the growth of software services also requires the physical infrastructure for its employees. For example, those working in the ITS and ITES sectors make use of transport. Similarly, business delegations visiting the countries would make use of road, rail, air and water transport. Although India has one of the largest road networks in the world, with 3.34 million km of roadways (India, 2008b, p. 218), it is not adequate for speedy and efficient transport, as the quality of the roads is bad. According to the Economic Survey (India, 2007, p. 179), an investment into the infrastructure sector in India of about $320 billion would be required during the Eleventh Five Year Plan to exploit the growth potential of the economy. (ii) Power infrastructure The availability of a high-quality power infrastructure is critical for rapid development, yet power shortages are very common in India. The greatest weakness in the power sector is on the distribution side. Transmission and distribution losses were 26 per cent of energy output in India and 6 per cent in China in 2004. Prior to 2005, there were acute power shortages in China also, but China has been continuously expanding its power generation capacity. In 1987, China generated 0.1 million megawatts (MW), which grew to 0.2 million MW in March 1995, 0.3 million MW in April 2000, 0.4 million MW in May 2004 and 0.5 million MW in September 2005. In contrast, the Government of India is targeting capacity increases totalling 0.1 million MW over the next 10 years (Morrison, 2006; Rastogi, 2007). Half of the Indian population is without electricity today and, indeed, without a supply of any other form of commercial energy (India, undated). India faces acute power shortages at times of peak demand. The overall energy shortage6 was 9 per cent (of actual demand) for the year 2007/08 (up to January 2008), while peak capacity shortage7 was about 15 per cent (of peak demand) for the same time period. The power 6 7

Energy shortage implies the gap between energy requirements and availability. Peak capacity shortage implies the gap between energy demand and supply during peak hours.

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shortages in India point towards low and inadequate investment in the construction of generating capacity and transmission networks. The Government has a plan to wipe out this shortage by the end of the Eleventh Five Year Plan (2011/12) and to provide a 5 per cent spinning reserve8 and ensure uninterrupted quality power at an affordable cost. The national electricity policy aims to provide power to all by 2012. Accordingly, a capacity addition of 78,755 MW (0.078755 million MW) has been proposed for the Eleventh Five Year Plan (2007-2012) (India, 2008a). Whether this plan will actually be implemented will depend on the political will and commitment to implement power sector reforms. (iii) ICT diffusion infrastructure ICT diffusion cannot take place without physical infrastructure. India is far behind China with respect to the required physical infrastructure for spreading ICT and digital technologies. There has been an increase in ICT expenditures in both China and India in absolute and relative terms, but India, which is called the IT services powerhouse of the world, spends less on ICT than China, $19.66 billion versus $66.61 billion in 2001 and $45.97 billion versus $117.40 billion in 2005 (see table 12). It is also important to point out here that per capita ICT expenditures in China and India were $90 and $42, respectively, in 2005. Table 12. ICT expenditures in China and India (Billions of United States dollars) Country China India

Total ICT expenditures 1995

2001

2005a

20.40 7.25

66.61 19.66

117.40 45.97

Sources: United Nations Development Programme, Regional Human Development Report: Promoting ICT for Human Development in Asia (New York, 2004), p. 20; World Bank, World Development Indicators 2007 (Washington, D.C., 2007), pp. 40-41 and 304-305. a Note: Figures for 2005 have been computed by the author by multiplying per capita ICT expenditures by total population in the respective countries.

India’s telecommunications infrastructure is not adequate, either. Although both China and India have expanded their telecommunications infrastructure, the number of fixed telephone lines per 100 people was 27.51 in China and just 3.36 in India in 2007. The number of mobile cellular subscribers, Internet subscribers and broadband subscribers (per 100 inhabitants) also lags behind in India, as compared with China (see table 13). 8

48

Spinning reserves consist of any backup energy production capacity that can be made available to a transmitting system within 10 minutes and can operate continuously for two hours.

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Table 13. Growth of the telecommunications network, 2007 (Per 100 inhabitants)

1. Main (fixed telephone lines) 2. Mobile cellular subscribers 3. Internet subscribers 4. Broadband subscribers

China

India

27.51 41.19 11.31 5.00

3.36 19.98 1.15 0.27

Source: International Telecommunication Union, ICT Statistics Database (Geneva), www.itu.int/ITU-D/ICTEYE/Indicators/Indicators.aspx#.

It is somewhat ironic that a global IT services powerhouse not only suffers from power shortages but also from an inadequate telecommunications infrastructure. As far as tele-density is concerned, the number was 12.18 per 100 people for India in 2004, which increased to 16.28 per 100 people as of the end of November 2006. For China, it was 49.74 per 100 people in 2004. (iv) Social infrastructure Undeniably, a knowledge-intensive economy driven by IT requires educated and capable people with high productive capacities to exploit the vast opportunities being offered by the services revolution in the current era of globalization. Therefore, it would be difficult for India to maintain its advantageous position in IT and ITES exports unless it adequately expanded its social infrastructure (especially education and health services). Services growth offers opportunities, but people must have the knowledge, skills, capacities and capabilities to seize those opportunities. Herein lies the importance of building up and improving social infrastructure (Joshi, 2004 and 2006a). Let us examine the state of social infrastructure in China and India. China has a high literacy rate of 91 per cent. The Government of China spent 2.1 per cent of GDP on education in 2005 (KPMG and NASSCOM, 2007). In contrast, with a 61 per cent adult literacy rate, India spent just 3.7 per cent of GDP on education in 2005 (World Bank, 2007a). In China, adult and youth literacy rates were 91 per cent and 99 per cent, respectively, in 2003, while in India these rates were 61 per cent and 84 per cent, respectively. The combined gross enrolment ratio for primary, secondary and tertiary schools was 69 per cent in 2002/03 for China and 60 per cent for India (UNDP, 2006). The primary pupil-teacher ratio was 21 in China and 40 in India in 2007 (World Bank, 2007a). In China, there was a fivefold increase in the enrolment of students in higher education, from 2.9 million to 15.6 million, during the period 1995-2005 (KPMG and NASSCOM, 2007). The UNDP Human Development Report 2006 ranked India 126th out of 177 countries, with a Human Development Index (HDI) value of 0.611. At this level, India’s position was lower than that of China, which had a rank of 81. It is important to point out 49

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that India had 348 universities and 17,973 colleges in 2005, which turned out 2.5 million graduates (Bhattacharya, 2006). However, only one quarter of them were employable, as the remainder lacked the necessary skills. Consequently, there is a skills shortage despite large numbers of unemployed graduates. The Government of India spends just 0.37 per cent of the country’s GDP on higher education compared to 0.50 per cent in China (Aggarwal, 2006).9 This is not only a problem in India. The quality and employability of Chinese students, too, have been questioned, as there is a relatively poor knowledge of English in China and the education system is essentially theory-based. The official languages spoken in China are Mandarin and Cantonese. Mandarin is spoken by 800 million people, followed by about 90 million who speak Wu and 80 million who speak Cantonese. There is a dearth of English-speaking workers in China (KPMG and NASSCOM, 2007). However, the Government of China has taken steps to take advantage of the growing IT sector. For instance, it has made the study of English mandatory for all students over the age of five. India currently has a competitive edge over China because of its large pool of Englishspeaking people (India has the second largest English-speaking population in the world after the United States), but this advantage will probably be eroded in a decade or so. Even the state of health infrastructure is better in China than in India. In China, public expenditures on health were 1.8 per cent of GDP in 2004, as opposed to just 0.9 per cent of GDP in India. The number of physicians per 1,000 people is 1.5 in China and 0.6 in India. There were 2.5 hospital beds per 1,000 people in China and 0.9 per 1,000 people in India during the period 2000-2005. In view of the emerging shortage of skilled staff in the IT and ITES sectors and the consequent rising labour costs, along with the rising rate of lifestyle diseases,10 the level of public expenditure on education and health in India is too low. Although China is currently lagging behind India in ITES, it is posing stiff competition to India—along with countries such as the Philippines and Ireland—on the basis of low-cost labour and talent. Neither China nor India has a dearth of cheap available labour. However, India is surpassing China in the ITS-ITES sectors because of its relatively high quality and skilled English-speaking labour force and low operational costs.11 The day 9

10

11

50

In its Eleventh Five Year Plan 2007-12 (Volume II, p. 36) India pledged to raise public expenditure on education to 6 per cent of GDP, a figure initially suggested by the Kothari Commission in 1966 and again mentioned in the National Policy on Education (1986) and by the Ramamurthy Committee (1991) (see Joshi, 2006a, p. 362). Traditionally, a large number of deaths at a young age have been caused by infectious diseases, but the prevalence has changed from infectious to lifestyle diseases, such as cardiovascular diseases, stroke, heart attacks, backaches, spondylitis, obesity, eye problems, headache and pressure, often because of the extensive use of headsets and constant calls (Joshi, 2006b, pp. 331-332). “Based on data shared by some of the leading companies in India, sourcing services from India has helped client organizations reduce their cost base by up to 60 per cent” (NASSCOM, 2006).

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is not far off, though, when China will reach India’s current level or even overtake it. Thus, if India wants to maintain its lead over China in exports of IT and ITES, it will have to diversify its export basket by moving up the value chain and by easing constraints in infrastructure and the business environment. In particular, India will have to penetrate markets for high-end products such as IT consulting, system integration and package implementation. Further, to deal with the problem of skilled labour shortages, India will need to confront problems related to higher education, such as low public investment, outdated curriculums, low occupational focus and low quality. In order to meet the challenges of a modern knowledge economy, an increase in public expenditure on higher and technical education is a must. In addition, there is a need to introduce institutional and policy reforms, on the one hand, and to encourage creativity, innovation and the spirit of entrepreneurship in the education system, on the other hand. Undeniably, it is absolutely essential to promote investment in innovation in research and development (R&D). Contrary to current needs, however, R&D expenditure as a proportion of GDP was just 0.8 per cent in India during the period 2000-2004, compared with 1.44 per cent in China during the same period. Further, China publishes more articles in scientific and technical journals than India: 29,186 in 2003 in China versus 12,774 in India (World Bank, 2007a, pp. 308-309). In conclusion, it appears that China is in an advantageous position compared with India as far as the availability and quality of physical, social and ICT infrastructures is concerned. (v) Business environment Even if a country has an adequate level of physical and social infrastructure development, if it does not have a favourable business environment, growth will not be sustainable. The business environment in China and India can be evaluated from a number of business indicators, as shown in table 14. It is quite evident that starting a business in India is a costly affair, as it costs 74.6 per cent of per capita income in India compared with only 8.4 per cent in China. Registering property, enforcing contracts and closing a business also take longer in India and involve more procedures than in China. China also scores better than India on the employment and disclosure indices, as employment is less rigid and better protection is provided to investors in China than in India.

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Table 14. Business environment in China and India: indicators China

India

1. Starting a business Number of procedures Time required (days) Cost (percentage of per capita income)

13 35 8.4

13 33 74.6

2. Registering property Number of procedures Time required (days)

3 32

6 62

3. Enforcing contracts Number of procedures Time required (days)

35 406

46 1 420

4. Employing workers a Rigidity of employment index: 0 (least rigid) to 100 (most rigid)b

24

41

5. Protecting investors Disclosure index: 0 (least disclosure) to 10 (most disclosure)c

10

7

6. Closing a business Time to resolve insolvency (years)

1.7

10

Sources: World Bank, World Development Indicators 2007 (Washington, D.C., 2007); World Bank, Doing Business 2008 (Washington, D.C., 2007). a Notes: Figures for employing workers are for April 2006; b The rigidity of the employment index measures the regulation of employment, specifically the employment of workers and the rigidity of working hours. This index is an average of three sub-indices: a difficulty of hiring index, a rigidity of hours index and a difficulty of firing index; c The disclosure index measures the degree to which investors are protected through disclosure of ownership and financial information.

Therefore, in view of the above-mentioned sources of strength in China, it is absolutely essential for India to address the current challenges in the field of ITS and ITES by implementing urgent actions to improve the physical, educational, IT and social infrastructure. The apprehension that China is overtaking India in the services sector is supported by a discussion note prepared by KPMG and NASSCOM (2007), which pointed out that “if Indian ITS-ITES companies do not become ‘peripatetic enough’, catching up with the global giants in terms of worldwide presence and scale would be difficult”.12

12

52

The KPMG and NASSCOM discussion note reviewed the strategies and experiences of foreign and Indian IT-ITES companies in Central and Eastern Europe, Latin America and Asia and the Pacific. They find that Indian companies have a varying and thin presence. Although Indian companies score lead points in areas such as project management, customer relations management, transitioning and security, and risk management, the study suggests that Indian companies will have to focus on areas that offer the requisite language, transaction processing, high-end programming and knowledge processing skills.

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CONCLUSIONS

India is called the main global IT services hub because of its relatively large exports of services, especially ITS and ITES, but as far as the value of services exports is concerned—in particular the value of exports of transport and travel services—China is ahead of India. China is the ninth largest global exporter of services and India is the twelfth. Indeed, India has an edge over China in the export of computer information, communications and other commercial services because of the dominance of IT services and ITES exports. India is the world’s leading destination for the outsourcing of IT services, mainly because of its educated, English-speaking, technically savvy young people and low operational costs. However, given the sources of strength that China has at present in the form of its physical, social and ICT infrastructure and relatively more favourable business environment with less regulation and more openness, China might leave India far behind in competitiveness in services, even in the ITS and ITES sectors. It is quite possible that, in a decade or two, China might supersede India to become the main global IT services hub, in addition to a manufacturing hub. Therefore, unless reforms in these sectors become a reality in India, its status as an IT services powerhouse might remain only an illusion. An examination of China’s performance, compared with that of India, clearly suggests that there is no reason to be complacent about India’s current status as a global IT service hub.13 India still has a long way to go before it can catch up with China, be it in exports of transport, travel or insurance and financial services or in the building of infrastructure or the creation of a more favourable business environment. Herein lies the central role of good governance. The Government of India should promote principles of good governance in all its aspects, including implementing public programmes, ensuring the interaction of the Government with ordinary citizens, ensuring the rule of law, improving the efficiency and accountability of the public sector and tackling corruption. In so doing, the Government can help achieve and sustain rapid and inclusive development. However, to achieve this lofty ideal in totality seems to be quite difficult in practice. The apprehension expressed in this paper has been further corroborated by the helplessness and despair expressed by Prime Minister Manmohan Singh recently in his keynote address at the McKinsey Board Meeting on 23 October 2007: “I don’t think there is any lack of thinking on what needs to be done to sustain and further accelerate growth. … However, given the nature of competitive politics and the very fractured mandates given to Governments, it has become difficult sometimes for us to do what is manifestly obvious.”14

13

14

The recent appreciation of the rupee against the United States dollar has made exports of goods and software services from India more expensive. This development points towards the fact that cost competency alone (on which the whole concept of outsourcing is based) may not be able to sustain the export growth of the IT industry. India might lose some of its clients to low-cost service provider countries, which are evolving in South Asia and Latin America. See the excerpts of the keynote address delivered by Dr. Manmohan Singh at the McKinsey Board Meeting on 23 October 2007, which dwelt at length on the Indian economy in The Hindu Business Line, 25 October 2007.

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REFERENCES Aggarwal, Pawan (2006). “Public policy in the face of many contradictions of Indian higher education”, paper presented at the ASSOCHAM-ICRIER Joint Conference on Globalization and Higher Education in India, New Delhi, 1-2 November. Bhattacharya, B.B. (2006). “Globalization of higher education and the role of the government”, paper presented at the ASSOCHAM-ICRIER Joint Conference on Globalization and Higher Education in India, New Delhi, 1-2 November. The Business India (2007). “Learn, improve, disrupt”, 23 September, p. 138. The Hindu Business Line (2007). “The unfinished agenda of economic reforms”, 25 October. India (2006). Towards Faster and More Inclusive Growth: An Approach to the 11th Five Year Plan (2007-2012) (New Delhi, Planning Commission, 14 June), available at http://planningcommission.nic.in/plans/planrel/app11_16jan.pdf. _____ (2007). The Economic Survey 2006-07 (New Delhi, Economic Division, Ministry of Finance). _____ (2008a). Annual Report 2007-08—Power: The Building Block of the Economy (New Delhi, Ministry of Power), available at www.powermin.nic.in/indian_electricity_ scenario/pdf/Annual_Report_2007-08_English.pdf. _____ (2008b). The Economic Survey 2007-08 (New Delhi, Economic Division, Ministry of Finance). _____ (2008c). Eleventh Five Year Plan 2007-12, Volume III (New Delhi, Planning Commission), available at http://planningcommission.nic.in/plans/planrel/fiveyr/ welcome.html. _____ (2008d), website of the Software Technology Parks of India, Ministry of Communications and Information Technology, www.stpi.in. _____ (undated). Eleventh Five Year Plan 2007-2012: Information and Technology Sector (New Delhi, Department of Information Technology, Ministry of Communications and Information Technology), available at http://planningcommission.nic.in/aboutus/ committee/wrkgrp11/wg11_IT.pdf. International Telecommunication Union, ICT Statistics Database (Geneva), available at www.itu.int/ITU-D/ICTEYE/Indicators/Indicators.aspx#. Joshi, Seema (2004). “Tertiary sector-driven growth in India: impact on employment and poverty”, Economic and Political Weekly, vol. 39, No. 37, pp. 4,175-4,178. _____ (2006a). “Impact of economic reforms on social sector expenditure in India”, Economic and Political Weekly, vol. 41, No. 4, pp. 358-365. _____ (2006b). “From conventional to new services: broadened scope of tertiary sector”, Indian Journal of Labour Economics, vol. 49, No. 2, pp. 321-335. 54

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_____ (2007). “The main drivers of services growth in India in post globalisation period”, Conference Volume Part II, 90th Annual Conference of the Indian Economic Association (IEA), 25-27 October, University of Kashmir, Hazratbal, Srinagar, pp. 943-951. _____ (2008). Growth and Structure of Tertiary Sector in Developing Economies, (New Delhi, Academic Foundation). _____ (2009). “IT and ITES as an engine of growth: An exploration into the Indian experience”, Institute of Economic Growth, Working Paper Series No. E/294/2009 (New Delhi, University of Delhi Enclave). Karnik, Kiran (2005). “Indian ITES-BPO: Vision 2010”, Yojana (New Delhi), October. KPMG and the National Association of Software and Services Companies (NASSCOM) (2007). Emerging Destinations for Indian IT-ITES Industry, Discussion Note. Morrison, Kevin (2006). “Power market: industrialization fuels demand”, The Financial Times, 9 May. The National Association of Software and Services Companies (NASSCOM) (2005). NASSCOM-McKinsey Report 2005—Extending India’s Leadership of the Global IT and BPO Industries (New Delhi). _____ (2006). NASSCOM Strategic Review 2006—The IT Industry in India (New Delhi). _____ (2007). NASSCOM Strategic Review 2007 (New Delhi). _____ (2008). NASSCOM Strategic Review 2008 (New Delhi). Prasad, H.A.C. (2007). “Strategy for India’s services sector: broad contours”, Working Paper No. 1/2007-DEA (New Delhi, Ministry of Finance). Rastogi, Anupam (2007).“The infrastructure sector in India 2006”, India Infrastructure Report, p. 10. The Times of India (2007). “Services exports may touch $311b by 2012”, 6 April, p. 24. United Nations Development Programme (UNDP) (2004). Regional Human Development Report: Promoting ICT for Human Development in Asia (New York). _____ (2006). Human Development Report 2006—Beyond Scarcity: Power, Poverty and the Global Water Crisis (New York). World Bank (2007a). World Development Indicators 2007 (Washington, D.C.). _____ (2007b). Doing Business 2008 (Washington, D.C.). _____ (various issues). World Development Indicators (Washington, D.C.). Zeng, Ming and Peter J. Williamson (2007). Dragons at Your Door: How Chinese Cost Innovation is Disrupting Global Competition (Boston, Harvard Business School Press). 55

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Economic impact of East and South-East Asian free trade agreements Kakali Mukhopadhyay and Paul J. Thomassin*

ABSTRACT

T

he expansion of the economies of East and South-East Asia over the last 15-20 years has heralded one of the most dramatic periods of economic growth and development the world has experienced. Even without the support of formal regional trade agreements, countries in East and South-East Asia have lowered barriers to intraregional trade, increased trade both within the region and with world markets, diversified their production and trade, and increased foreign direct investment (FDI), which all contributed to growth. The current trend in the region is towards the conclusion of free trade agreements (FTAs) and economic partnership agreements. All countries in East Asia, including China and Japan, are accelerating their move towards concluding such agreements with other countries in the region. The potential of an East Asian free trade area may be realized by 2010 and an East Asian multilateral regional trading community is expected to be established by 2020, with the aim of creating a stable, prosperous and highly competitive region with the free movement of goods and services, freer movements of capital, equitable economic development and reduced poverty and socio-economic disparities. (continued on page 58)

*

Department of Agricultural Economics, McGill University, Montreal, Québec, Canada. The authors gratefully acknowledge the Ministry of Environment of Japan and the Institute for Global Environmental Strategies (IGES) in Japan for their assistance in funding the study. The authors would like to thank Professor Debesh Chakraborty, Department of Economics, Jadavpur University, Calcutta, India for his constructive comments and suggestions.

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(continued from page 57)

This study addresses regional economic integration within the Association of Southeast Asian Nations (ASEAN) plus China, Japan and the Republic of Korea (ASEAN+3) and assesses its possible economic impact in 2020 using the Global Trade Analysis Project (GTAP) model. The objective of the present study is to estimate the detailed economic impacts of trade liberalization in East and South-East Asian countries by the year 2020 under various possible scenarios. A recursive updating procedure has been used to forecast assessments based on the model for three time periods: 2000-2010, 2010-2015 and 2015-2020. The liberalization of trade through tariff reductions influenced the share and direction of trade in the countries included in the simulated agreements. The share of important export items rose for most of the countries included in the agreements and it shifted away from the rest of the world towards the ASEAN region. On the whole, the analysis of this result clearly shows that an ASEAN+3 agreement would be more beneficial than agreements for other regional clusters in terms of output growth and trade and, thus, in terms of the welfare of all of the participating countries in the year 2020.

1.

INTRODUCTION

Over the past decade, we have witnessed the worldwide proliferation of regional trade agreements (RTAs). Even after the launch of the World Trade Organization (WTO) multilateral trading system, RTAs have continued to spread, in particular in the Asia-Pacific region. However, there have been marked differences across regions and subregions1 in terms of the degree to which regional trade integration has been carried out. Although the East Asian region had traditionally been characterized by a dearth of RTAs, in recent years, the region’s focus has shifted from multilateral trade agreements to RTAs. Recent developments in individual economies, such as China’s miraculous export-driven growth performance and entry into WTO, Japan’s prolonged recession and desire to regain its leadership in the region, the Republic of Korea’s regime change towards a more liberalized economic system and Singapore’s active intention to become a hub of regionalism, are factors behind this change in East Asian commercial policy towards regionalism.

1

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Region here is specified as East and South-East Asia.

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The Asian movement towards regionalization2 —known as ASEAN 10+3, +4 or +6—is relatively new, but it may take on major importance, as it concerns China, Japan and the Republic of Korea. The move in the region is now towards the conclusion of free trade agreements (FTAs) and economic partnership agreements. All countries in East Asia, including China and Japan, are moving towards the conclusion of such agreements with other countries in the region. The potential of an East Asian free trade area may be realized by 2010. It is also expected that an East Asian multilateral regional trading community will be established by 2020 (Hew, 2006).3 This multilateral regional trading community is expected to decrease the current barriers to trade between individual countries, expand the movement of goods and services between countries, and boost the economic growth of individual countries. This article seeks to assess the possible economic impact of regional economic integration under ASEAN+3 by 2020 using the Global Trade Analysis Project (GTAP) model. In particular, the study estimates the detailed economic impacts that could result from trade liberalization in the ASEAN+3 region by the year 2020 for six countries (China, Indonesia, Japan, the Republic of Korea, Thailand and Viet Nam). The structure of the paper is as follows. A brief review of the literature is presented in section 2. Section 3 briefly explains the method of analysis. Details on databases, the aggregation scheme and scenario development are described in section 4. Section 5 deals with analysis of the results. Section 6 concludes the paper.

2.

LITERATURE SURVEY

Numerous studies have been conducted on the impacts of various trade liberalization mechanisms, including WTO agreements, and the economic effects of RTAs and their sectoral and regional implications for both the environment and poverty. In order to address all of those impacts, empirical research is usually based on two distinct methodologies. One relies on a simulation approach based on global general equilibrium models to analyse the economic effects of policy changes as a result of the formation of an RTA. The simulation approaches are useful in specifying the mechanism by which the formation of an RTA translates into improvements in the economy. There are a number of 2

3

ASEAN+3 comprises the 10 ASEAN members plus China, Japan and the Republic of Korea. ASEAN+4 includes ASEAN members plus China, Japan, the Republic of Korea and India. ASEAN+6 covers the East Asia Summit group, comprising ASEAN+3, Australia, New Zealand and India. At the Ninth ASEAN Summit in Bali in October 2003, ASEAN leaders agreed to establish an ASEAN Economic Community (AEC) by 2020. AEC is one of three pillars (the other two being the ASEAN Security Community and the ASEAN Socio-cultural Community) that make up the ASEAN Community, as declared by ASEAN leaders in the Bali Concord II (available at www.aseansec.org/15159.htm). In line with the ASEAN Vision 2020, it is envisaged that AEC will be a single market and production base with a free flow of goods, services, investment, capital and skilled labour.

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articles on the computable general equilibrium (CGE) and Global Trade Analysis Project frameworks. Some worth mentioning are JETRO (2003); Park (2006); Lee and Park (2005); Igawa and Kim (2005); Chawin (2006); Scollay and Gilbert (2001); McKibbin, Lee and Cheong (2004); Urata and Kiyota (2003); Ando and Urata (2006); McDonald, Robinson and Thierfelder (2007); and Strutt and Rae (2007). Lee and Park (2005) mentioned that the trade creation effect expected from the proposed East Asian FTAs would be significant enough to overwhelm the trade diversion effect. Ando and Urata (2006) found that the ASEAN+3 FTA was more desirable than the bilateral FTAs (ASEAN-China, ASEANJapan, ASEAN-Republic of Korea) for all member countries at the macrolevel. However, in these general equilibrium model-based studies, it was unclear whether the member economies ultimately realized the potentially beneficial effects. The other method applies econometric approaches to historical trade data and assesses the impacts of the formation of an RTA on bilateral trade flows. The most important contributions in this respect are from Aitken (1973); Frankel (1993); Braga, Safadi and Yeats (1994); and Dee and Gali (2003). Most studies found that RTAs tended to increase trade between members and the rest of the world, thereby fostering greater trade worldwide. However, some RTAs were estimated to have negative effects on extra-bloc trade. Furthermore, Dee and Gali (2003) argued that traditional gravity equation analyses had not been successful in quantifying the impact of “new age” provisions of RTAs on trade and investment. They indicated that 12 of 18 recent RTAs examined had diverted more trade from non-members than they had created among members. It is an open question whether RTAs create more trade than they divert. If an RTA has damaging economic effects on non-members, it could become a stumbling—rather than a building—block of global free trade. The simulation approaches from various pieces of literature showed the reallocation of global production and welfare gains across countries. Some studies found that RTAs expanded intra-bloc trade, while contracting trade and output in non-member countries. For instance, Burfisher, Robinson and Thierfelder (2004) carefully reviewed the empirical findings on the trade effect of RTAs based on both methodologies. They indicated that the empirical evidence resulting from CGE models showed a relatively stronger net trade creation effect and positive welfare effects of RTAs on member economies compared with evidence resulting from gravity models. While carefully considering caveats about CGE models, Lloyd and MacLaren (2004) suggested that RTAs had positive welfare and net trade creation effects for members, while the effects for non-members were negative and tended to increase with the size of the RTA.

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3.

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METHODOLOGY: GTAP MODEL4

The most widely recognized method used to undertake the analysis of impacts of trade liberalization is the CGE model for global trade. The CGE modelling framework that was chosen to undertake the analysis in this paper was produced by the Center for Global Trade Analysis at Purdue University, United States of America. The database and model are called the Global Trade Analysis Project (GTAP) (Hertel, 1997). The basic structure of the GTAP model includes industrial sectors, households, Governments and global sectors (transport and banking) across countries. Countries and regions in the world economy are linked together through trade. Prices and quantities are simultaneously determined in both factor markets and commodity markets. Three main factors of production are included in the model: labour, capital and land. Each industrial sector requires labour and capital, while the agricultural and forestry sectors require all three factors. Labour and land cannot be traded, while capital and intermediate inputs can be traded. It is assumed that the total available amount of labour and capital is fixed. In the model, firms minimize the cost of inputs given their level of output and fixed technology. The production functions used in the model are of a Leontief structure. This means that the relationship between fixed and intermediate inputs is fixed. Similarly, the relationship between the amount of intermediate inputs and outputs is also fixed. Firms can purchase intermediate inputs locally or import them from other countries. Household behaviour in the model is determined with an aggregate utility function. This utility function includes private consumption, Government consumption and savings. Current Government expenditures are covered by the regional household utility function as a proxy for Government provision of public goods and services. Domestic support and trade policy (tariff and non-tariff barriers) are modelled as ad valorem equivalents. These policies have a direct impact on the production and consumption sectors in the model. Changes in these policies have an impact on the production and consumption decisions of sectors in the model. There are two global sectors in the model: transport and banking. The transport sector takes into account the difference in the price of a commodity as a result of the transport of the good between countries. The global banking sector brings into equilibrium savings and investments in the model.

4

As the world economy becomes more integrated, there is an increasing demand for quantitative analyses of policy issues on a global basis. The Global Trade Analysis Project (GTAP) model was established in 1992, with the objective of facilitating multi-country, economy-wide analyses (Hertel, 1997). Since its inception, GTAP has rapidly become a common “language” for many of those conducting global economic analyses.

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In equilibrium, all firms have zero real profit, all household expenditures are within their budget, and global investments equal global savings. Changing the model’s parameters allows one to estimate the impact from a country’s or region’s original equilibrium position to a new equilibrium position. Closure plays a very important role in GTAP modelling. Closure is the classification of the variables in the model as either endogenous or exogenous variables. Endogenous variables are determined (solved for) by the model and exogenous variables are predetermined outside the model and can therefore be changed from the outside, or shocked. Closure can be used to capture policy regimes and structural rigidities. The closure elements of GTAP can include population growth; capital accumulation, including FDI; industrial capacity; technical change; and policy variables (taxes and subsidies). The number of endogenous variables has to equal the number of equations. This is a necessary but not sufficient condition for a solution. It may be general equilibrium (GE) or partial equilibrium (PE) depending on the choice of the exogenous variables. The standard GTAP closure has the following characteristics: all markets are in equilibrium, all firms earn zero profits and regional household expenditures are on budget constraint (i.e. there are no savings and no loans).

4.

MODEL AGGREGATION, SCENARIOS AND MACROVARIABLE ASSUMPTIONS

(a) Introduction Version 6 of the GTAP model and database was used to undertake the analysis.5 This version of the model includes 57 commodities (sectors) and 87 regions. The 57 industrial sectors in the model provided a broad disaggregation of the industrial sectors in each country and region. The 87 regions were aggregated into 14 regions, with an emphasis on the countries in East and South-East Asia. Given the regional emphasis of the study, the greatest level of disaggregation occurred for the countries in East and South-East Asia, while other countries not included in the economic integration process were aggregated into larger regional areas. This aggregation included nine individual countries in East Asia and five other regions. The nine individual countries were China, Indonesia, Japan, Malaysia, the Philippines, the Republic of Korea, Singapore, Thailand and Viet Nam, while the aggregated regions were: the remaining countries in South-East Asia (other ASEAN); the members of the North American Free Trade Agreement (NAFTA); the rest of 5

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GTAP 6 has 87 regions—more than six times the number in the original GTAP 1 database. All of these additions to the database have been provided by members of the GTAP network. The regional sectoral data (57 sectors) draw heavily on the source input-output tables from varying years. The GTAP 6 database was constructed by combining the I-O tables with 2001 macroeconomic data. Details are available in Dimaranan and McDougall (2006) and Hertel (2006).

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the Organisation for Economic Co-operation and Development (OECD) countries, meaning all OECD countries except Canada, Japan, the Republic of Korea and the United States; the Rest of the World (ROW)1, which included South Asian countries and Hong Kong, China; and the rest of the countries in the world (ROW2). Data for 57 industrial sectors were included for all 14 regions (9 individual countries and 5 aggregated regions) in the model that was used to address the study objective.

(b) Scenarios The following scenarios were used in this analysis: (i)

Business-as-usual

We took the 2000 model and used our macroeconomic shocks—changes in the values of the macroeconomic variables (GDP, skilled and unskilled labour, and capital)—to generate a new economy for the years 2010, 2015 and 2020. In this analysis, the tariff structure for all regions and countries remained unchanged from 2000. This business-asusual (BAU) scenario remained the same throughout the analysis and was the base to which the other scenarios were compared. (ii) Medium economic integration Medium economic integration (MEI) describes a scenario where the timing of the tariff reductions—both import tariffs and export subsidies—is delayed. This scenario was simulated for an FTA within ASEAN (W-ASEAN) and for bilateral agreements between ASEAN and China, ASEAN and Japan, and ASEAN and the Republic of Korea (ASEAN-CJK), analysed together. (iii) Deep economic integration Deep economic integration (DEI) describes a scenario where economic integration, (i.e. reductions in both import tariffs and export subsidies) occurs within a rapid time frame. This scenario was also simulated for both W-ASEAN and for ASEAN-CJK. The last simulation was part of the DEI scenario. In this simulation, tariff barriers were reduced further for ASEAN plus China, Japan and the Republic of Korea. This simulation differed from the others because, in this case, the tariff barriers between China, Japan and the Republic of Korea were reduced to defined levels. This was the simulation that treated ASEAN+3 as a fully integrated trading block where tariffs were reduced for all countries and between all countries. The ASEAN+3 integration was part of the DEI scenarios and materialized only in 2020. The above scenario description required a change in the development of the GTAP model to undertake the analysis. In this case, the updating of the model to 2020 required a number of discrete steps. These steps for the scenario analysis are described in table 1. 63

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Table 1. Descriptions of business-as-usual, medium and deep scenarios Regional scope

Commodity scope

By 2010

By 2015

By 2020

Current tariffs

Current tariffs

Current tariffs

Business-as-usual (BAU) ASEAN, whole study region (ASEAN+3), other regions

All commodities

Tariff reductions under medium economic integration (MEI) Within ASEAN, ASEAN with each of China, Japan and the Republic of Korea

Agricultural commodities

Whole study region (ASEAN+3)

Agricultural commodities

Non-agricultural commodities

Non-agricultural commodities

Current tariffs Current tariffs

40%

80%

50%

100%

Current tariffs Current tariffs

Current tariffs Current tariffs

Current tariffs Current tariffs

Tariff reductions under deep economic integration (DEI) Within ASEAN, ASEAN with each of China, Japan and the Republic of Korea

Agricultural commodities

40%

80%

Non-agricultural commodities

50%

100%

Whole study region (ASEAN+3)

Agricultural commodities

Current tariffs Current tariffs

Current tariffs Current tariffs

Non-agricultural commodities

Current tariffs Current tariffs 80% 100%

(c) Modifications of the GTAP model to 2020 There are two general approaches to updating the model: a recursive process and the use of dynamic GTAP. For the current study, we used the recursive updating process. The recursive process uses projections of macroeconomic variables into the future to simulate what the various economies would look like in the future. The recursive updating process is based on forecasting the economies of the countries and regions by exogenously shocking the baseline model with projections of selected macroeconomic variables. These projections of the macroeconomic variables were taken from various sources.

(d) Macroeconomic variable estimates and underlying assumptions The five primary factors of production used in the production system were land, natural resources, unskilled labour, skilled labour and physical capital. The first step in the process was to develop a BAU projection to 2010 from the benchmark 2000 GTAP 6 database. The projection of the global economy to 2010 was made with assumptions 64

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concerning economic and factor growth rates. Exogenous projections of each region’s GDP growth 6 were estimated, as were factor endowments such as population, skilled and unskilled labour, and capital stock (Walmsley, 2007; Dimaranan, Ianchovichina and Martin, 2007; United Nations, 2007). Total factor productivity was endogenously determined to accommodate the combination of these exogenous shocks. This approach allowed us to predict the level and growth of GDP as well as trade flows, input use, welfare and a wide range of other variables. Instead of considering capital accumulation, we added the extra change in investment in period t (It) resulting from trade liberalization shocks along with the baseline capital forecast for the next time period (t+1). The resulting forecast provided a projection of the global economy in 2010 that was in equilibrium. This forecasted economy in 2010 provided the starting point for a subsequent simulation exercise. A similar procedure was followed for the years 2015 and 2020. The GTAP model simulates the impact of trade liberalization (reductions in import tariffs and export subsidies) under several scenarios. It estimates how trade flows will change as import tariff restrictions and export subsidies are reduced. As the trade flow between countries changes as a result of trade liberalization, economic growth will be impacted, as will industrial sectoral output, trade and welfare.

5.

ANALYSIS OF THE RESULTS

The model was run to address trade liberalization by simulating a regional trade agreement that reduced import tariff restrictions and export subsidies between the six individual countries chosen for the study and other ASEAN countries. Particular attention was given to how the changes in import tariff and export subsidy reductions affected key variables such as trade patterns, terms of trade, industrial structure, factor returns and welfare levels for each phase of integration. Poverty implications were also considered.

(a) Effects on output Trade liberalization has two offsetting effects on output levels. On the one hand, reductions in the costs of intermediate inputs create beneficial forward linkages to domestic production and promote industrialization (Puga and Venables, 1998). On the other hand, more intense import competition has an adverse effect on the profitability of importcompeting firms. Results showed that the output growth rate was highest for China, followed by Viet Nam, Thailand and Indonesia, and was lowest for Japan in the BAU periods (see table 2). The output growth of ROW1 was also higher compared with the rest of OECD and NAFTA. The real output trend was maintained in almost all trade scenarios. 6

Projections are from World Bank (2007), adjusted to the 2000 base, and estimated and projected values developed by the Economic Research Service of the United States Department of Agriculture.

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The percentage changes in output growth under each scenario involving trade liberalization were compared with the BAU 2020 period. Table 2 focuses on the extent to which the growth of different countries and regions changed after each scenario. Let’s take a look at the projected world economic situation as a result of the ASEAN agreement scenarios. The results indicate that regions outside the agreements were net losers with negative output growth. The total output growth performance of most of the ASEAN member countries in the agreements was highest under the ASEAN+3 agreement at 2020. The output growth of the countries in the agreement fluctuated in each phase of subsequent trade liberalization. The highest output growth was achieved by Viet Nam, followed by Thailand, Singapore, Malaysia and Indonesia, under all scenarios. The performance was not too rosy for Japan or the Republic of Korea, though the ASEAN+3 agreement at 2020 was good for them in terms of growth of output. Besides that, Japan was a loser under the DEI 2020 scenario and the Republic of Korea was a loser in the case of MEI 2020. Though China’s output growth was not significant, it was at least positive under all scenarios. Table 2. Percentage change in the real value of output during 2000-2020 under various trade scenarios 2000-2010 2010-2015 China Japan Republic of Korea Indonesia Malaysia Philippines Singapore Thailand Viet Nam Other ASEAN Rest of OECD NAFTA ROW1 ROW2 Total

137.68 21.39 60.08 68.88 66.04 54.50 58.88 69.58 97.43 53.31 24.40 34.36 71.33 53.63 40.59

53.22 11.15 28.41 36.27 33.41 26.23 26.19 33.20 41.74 26.30 12.91 16.83 35.20 25.05 21.20

2015-2020 54.39 11.05 29.38 37.78 34.07 27.15 25.77 34.62 40.06 26.28 14.47 15.60 31.75 24.72 22.27

BAU 2020- BAU 2020- BAU 2020MEI 2020 DEI 2020 ASEAN+3 0.22 0.038 -0.21 1.30 2.06 2.004 3.056 5.31 6.52 0.042 -0.27 -0.26 -0.71 -0.16 -0.08

0.22 -0.05 0.15 1.97 2.34 2.70 3.29 7.81 8.42 0.25 -0.15 -0.27 -0.75 -0.23 -0.04

0.24 0.008 0.307 2.30 3.30 2.31 2.07 6.88 13.58 0.13 -0.60 -0.68 -0.76 -0.61 -0.29

As expected, countries and regions included in the regional trade agreements increased their industrial output, while regions not included in the regional trade agreements decreased their industrial output. The reason for this result is as follows. A reduction in import tariffs lowers the import price, and domestic users immediately substitute domestic 66

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products with competing imports, which increases the aggregate demand for imports. The cheaper imports serve to lower the price of intermediate goods, which causes excess profits. This, in turn, induces output to expand.

(b) Export and import shares The result of output growth under the different agreement scenarios during the period 2000-2020 can be further analysed by investigating the export and import share of each country both in the study region and outside the region. The share of China’s exports to and imports from other countries within the region included in the agreement scenarios declined, having the lowest share of all the participating countries throughout the study period (see figures 1 and 2). For China, shares of exports and imports within the region varied between 23 and 25 per cent in the DEI and MEI scenarios in 2020, but under the ASEAN+3 scenario in 2020, shares increased to approximately 28 per cent for both exports and imports, while the shares of Japan and the Republic of Korea increased gradually throughout the period (2000-2010, 2000-2015 and 2000-2020). The share increase was noted only in the ASEAN+3 agreement at 2020, where it increased by almost 10-12 per cent more. Figure 1. Export share of six countries in ASEAN+3a (Percentage) 90 80 70

BAU 2000 BAU 2020 MEI 2020 DEI 2020 ASEAN+3 2020

60 50 40 30 20 10 0 China

Japan

Republic of Korea

Indonesia

Thailand

Viet Nam

a ASEAN+3 includes Brunei Darussalam, Cambodia, China, Indonesia, Japan, the Lao People’s Democratic Republic, Malaysia, Myanmar, the Philippines, the Republic of Korea, Singapore, Thailand and Viet Nam.

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Figure 2. Import share of six countries in ASEAN+3a (Percentage) 90

BAU 2000 BAU 2020 MEI 2020 DEI 2020 ASEAN+3 2020

80 70 60 50 40 30 20 10 0

China

Japan

Republic of Korea

Indonesia

Thailand

Viet Nam

a ASEAN+3 includes Brunei Darussalam, Cambodia, China, Indonesia, Japan, the Lao People’s Democratic Republic, Malaysia, Myanmar, the Philippines, the Republic of Korea, Singapore, Thailand and Viet Nam.

The export and import shares increased for other countries in the region under all scenarios (MEI, DEI and ASEAN+3) at 2020. Overall, these shares show that the RTAs of ASEAN countries with China, Japan and the Republic of Korea enhanced the economic growth of each individual country taking part in the RTAs. The export and import shares in different tariff reduction scenarios showed considerable trade diversion. The simulation showed an increase in trade among countries in the ASEAN+3 region; basically it created more intra-bloc trade, but diverted trade with non-members. The highest trade diversion was observed in ASEAN+3 scenarios at 2020.

(c) Sectoral analysis (i)

Output

The sectoral rankings of output, export and import for the countries in each scenario can add more insight to the study. The rank of the top six sectors in output growth is presented in table 3. The rank remained almost constant in each BAU period (2000, 2010, 2015 and 2020), while fluctuations in rank were observed within the sectors for all six countries. In the case of China, vegetables, fruits and nuts and animal products were in the top 10 in 2000 and 2010, while from 2015 onwards, electronic equipment entered the top 10 list. For Indonesia and Thailand, the food products sector was major until 2015 and was taken over by manufacturing equipment and paper and paper products in 2020. 68

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Table 3. Rank of the top six sectors in output growth, BAU 2020 China

Japan

Republic of Korea

Machinery and equipment nec

Motor vehicles and parts

Machinery and equipment nec

Electronic equipment

Electronic equipment

Chemical, rubber, plastic products

Chemical, rubber, plastic products

Electronic equipment

Textiles

Machinery and Leather equipment nec products

Electronic equipment

Electronic equipment

Chemical, rubber, plastic products

Chemical, rubber, plastic products

Motor vehicles Paddy rice and parts

Textiles

Machinery and equipment nec

Ferrous metals

Paper products, publishing

Textiles

Mineral products nec

Ferrous metals

Motor vehicles and parts

Machinery and Chemical, equipment nec rubber, plastic products

Food products nec

Manufactures nec

Paper products, publishing

Petroleum, coal products

Motor vehicles Wearing and parts apparel

Machinery and equipment nec

Indonesia

Thailand

Viet Nam Mineral products nec

Oil

Abbreviation: nec – not elsewhere classified.

In the case of medium and deep integration, the same sectors were in the top six, across the countries. Fluctuations in rank within the sectors were observed for Indonesia, Thailand and Viet Nam only. It was observed that paddy rice was in third place for Viet Nam in BAU 2020, but the sectoral rank dropped down to sixth in the other scenarios. With widespread liberalization, agricultural processing in Viet Nam expanded but experienced competitive pressure from other rice-producing countries. As the profitability of agricultural processing fell in Viet Nam due to the increasing competition, Vietnamese labour and other resources moved to more profitable labour-intensive sectors such as clothing and light manufacturing, the expansion of which was stimulated by increased market access to the ASEAN countries. Output growth increased across the countries after 2015 for a few common sectors, such as electronic equipment; machinery and equipment; and chemical, rubber and plastic products. These sectors became more prominent under the medium and deep integration scenarios in 2020. Thus, both under the ASEAN+3 2020 scenario and under the other two integration scenarios, output in heavy manufacturing—rather than in primary and light manufacturing—increased for the countries participating in the agreements.

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(ii) Export share The export share rank for the top six sectors was almost the same as the output share rank for all six countries, with only a few changes (see table 3). For China, wearing apparel took the place of mineral products. For Japan, metals not elsewhere classified (nec) took the place of paper products and publishing, while for Indonesia, coal took the place of motor vehicles. Similarly, for the Republic of Korea, textiles replaced petroleum and coal products. Sugar replaced wearing apparel in Thailand. In Viet Nam, leather, oil, and machinery and equipment remained in the list of top six sectors, while the other three top sectors changed in the ASEAN+3 2020 scenario compared with the BAU 2020 output share. The rank of export share for the top six sectors remained constant in both the medium and deep integration scenarios, but the shares of a few sectors increased under each scenario. For example, the export share of electronic equipment from China and Thailand always ranked first, while its share increased from 17.64 per cent (BAU 2000) to 27.94 per cent (ASEAN+3 2020) in China and from 24.08 per cent to 36.18 per cent in Thailand. The most interesting result was observed for Japan. The following sectors reduced their export shares from BAU 2000 to ASEAN+3 2020: manufacturing equipment (from 26.06 per cent to 23.73 per cent), electronic equipment (from 20.86 per cent to 11.12 per cent) and motor vehicles (from 17.84 per cent to 15.82 per cent). On the other hand, ferrous alloys increased their share from 3.30 per cent to 8.46 per cent in the same period. A minor increase in the export share of textiles was observed for the Republic of Korea for the same period, while its export share of manufacturing equipment increased from 11.59 per cent to 15.46 per cent. For Viet Nam, the chemical, rubber and plastic products sector was a new addition to the export list, and under the ASEAN+3 2020 scenario, it had a large share, at 25.90 per cent. Paddy rice was an important sector under all trade scenarios in Viet Nam, though it did not appear in the list of the top six sectors. Further, two new additional sectors appeared on the list (chemical, rubber and plastic products and textiles), covering almost 32 per cent of the export share. In the case of Viet Nam, tradable commodities such as paddy rice responded marginally to most of the tariff reduction scenarios. Viet Nam is the third largest riceexporting country in the world and has recently pursued policies to expand its rice export market. The Vietnamese rice export regime involved an export tax until 1998 but, after that, the Government of Viet Nam removed the rice export quota (Nielsen, 2003). On the other hand, in Thailand, export shares of electronic equipment and manufacturing equipment have increased by a factor of 1.5. Thailand has had a comparative advantage in electrical and electronic equipment since the 1990s. The implications of tariff reductions on the electrical and electronic appliances are quite obvious in Thailand. The export-led industrial boom began in the mid-1980s in Thailand and electrical and electronic appliances captured market shares of 21.55 per cent in 1990 and 48.87 per cent in 2000 (Mukhopadhyay, 2006). 70

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From the above export share analysis, it is clear that the top six sectors were not too sensitive for Japan (except for ferrous metals), but they were sensitive for other countries, such as Indonesia, Thailand and Viet Nam. To explain further, we have presented the performance of the top six export sectors under different trade scenarios in table 4. Table 4. Share of export of the top six sectors in 2000 (BAU) and 2020 (ASEAN+3) (Percentage) BAU 2000 China 40 ele 41 ome 42 omf 28 wap 29 lea 33 crp

Japan 17.64 15.05 11.07 9.69 8.33 6.31

41 ome 40 ele 38 mvh 33 crp 39 otn 35 i_s

Indonesia 40 ele 30 lum 33 crp 28 wap 27 tex 41 ome

Republic of Korea 26.06 20.86 17.84 9.22 3.73 3.30

40 ele 41 ome 33 crp 38 mvh 27 tex 39 otn

Thailand 12.41 8.72 7.51 6.81 6.48 5.51

40 ele 41 ome 33 crp 25 ofd 42 omf 27 tex

28.26 11.59 10.24 8.83 7.69 5.48 Viet Nam

24.08 12.30 8.91 6.81 4.28 4.07

29 lea 16 oil 28 wap 25 ofd 41 ome 8 ocr

17.58 13.91 10.29 8.83 5.14 5.10

ASEAN+3 2020 China 40 ele 41 ome 42 omf 28 wap 33 crp 27 tex

Japan 27.95 19.26 12.06 6.85 6.82 5.51

41 ome 38 mvh 33 crp 40 ele 35 i_s 36 nfm

19.49 10.48 10.07 7.65 6.56 5.38

40 ele 41 ome 33 crp 24 sgr 38 mvh 27 tex

Indonesia 40 ele 27 tex 33 crp 41 ome 31 ppp 15 coal

Republic of Korea 23.73 15.82 12.64 11.12 8.46 4.63

40 ele 41 ome 33 crp 27 tex 38 mvh 35 i_s

36.18 19.11 13.20 5.07 3.52 3.33

33 crp 29 lea 16 oil 28 wap 27 tex 41 ome

Thailand

25.55 15.46 9.05 8.91 8.58 6.89 Viet Nam 25.90 18.87 14.97 8.82 6.71 6.56

Note: The two-digit codes and their three-letter counterparts represent sectoral classifications in the GTAP database.

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Table 4. (continued) Abbreviations: crp ele i_s lea lum mvh nfm ocr ofd

– – – – – – – – –

chemical, rubber, plastic products electronic equipment ferrous metals leather products wood products motor vehicles and parts metals not elsewhere classified crops not elsewhere classified food products not elsewhere classified

ome – machinery and equipment not elsewhere classified omf – manufactures not elsewhere classified otn – transport equipment not elsewhere classified ppp – paper products and publishing sgr – sugar tex – textiles wap – wearing apparel

It is interesting to note that ferrous metals were always among the top six for Japan in the entire DEI scenario, with metals not elsewhere classified entering the list when there were higher tariff reductions. Similarly, for Thailand, sugar was added to the top six lists as tariff reductions increased. (iii) Import share In the case of imports, the share of the top six sectors changed under the ASEAN+3 2020 scenario across the countries (see table 5). Some new sectors entered the list compared with BAU 2000. One interesting point is that the top six sectors were common for exports and imports in most cases. This happened due to intra-industry trade. The top exports and imports of most industrial countries are actually similar items. Such trade is more beneficial than inter-industry trade because it stimulates innovation and exploits economies of scale. Here we considered BAU 2000 as a representative of all other BAU periods (2010, 2015, and 2020). Though the percentage shares fluctuated within the BAU period, the sectors remained constant in terms of trade importance. For Japan, the import shares of the sectors declined (except for ferrous alloys and chemical, rubber and plastic products), while for China, the Republic of Korea and Indonesia, the import share of most of the top six sectors increased compared with BAU 2000. In the case of Thailand, electronic equipment and manufacturing equipment import shares increased by a factor of 2.5. For Viet Nam, three new additional sectors appeared in the list, which covered almost 44 per cent of total imports. The concepts of trade creation and trade diversion as a result of discriminatory trade liberalization can be mentioned here. Trade creation measures the gains from expanding trade in the products being liberalized. Trade diversion, by contrast, measures the reductions in the trade of products that are disadvantaged by preferential liberalization. In the case of Japan, the trade diversion effect dominated, while for Thailand and Viet Nam, there was a net trade creation effect.

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Table 5. Import share of the top six sectors in 2000 (BAU) and 2020 (ASEAN+3) (Percentage) BAU 2000 China 40 ele 41 ome 42 omf 28 wap 29 lea 27 tex

Japan 16.42 14.46 10.87 10.31 8.81 6.50

41 ome 40 ele 38 mvh 33 crp 39 otn 35 i_s

Indonesia 40 ele 30 lum 33 crp 28 wap 27 tex 41 ome

Republic of Korea 25.87 20.18 18.29 9.45 3.80 3.52

40 ele 41 ome 33 crp 38 mvh 27 tex 39 otn

Thailand 11.42 9.01 7.56 7.33 6.71 5.12

40 ele 41 ome 33 crp 25 ofd 28 wap 27 tex

26.82 11.55 10.67 9.05 8.42 5.57 Viet Nam

22.25 11.80 9.31 6.93 4.28 4.24

29 lea 16 oil 28 wap 25 ofd 8 ocr 41 ome

18.29 13.32 10.54 8.65 5.16 4.95

23.39 16.21 12.64 10.77 8.66 4.71

Republic of Korea 40 ele 24.60 41 ome 15.39 27 tex 9.42 33 crp 9.17 38 mvh 9.06 35 i_s 7.03

ASEAN+3 2020 China 40 ele 41 ome 42 omf 28 wap 33 crp 27 tex

Japan 26.92 19.16 12.42 7.51 7.01 5.81

41 ome 38 mvh 33 crp 40 ele 35 i_s 27 tex

Indonesia 40 ele 27 tex 33 crp 41 ome 31 ppp 30 lum

Thailand 18.38 10.59 9.99 7.34 6.60 5.35

40 ele 41 ome 33 crp 38 mvh 27 tex 32 p_c

Viet Nam 53.23 27.48 13.29 10.60 6.86 4.88

33 crp 29 lea 16 oil 23 pcr 28 wap 27 tex

28.12 17.35 12.35 10.28 7.91 5.93

Note: The two-digit codes and their three-letter counterparts represent sectoral classifications in the GTAP database. Abbreviations: omf – manufactures not elsewhere classified crp – chemical, rubber, plastic products otn – transport equipment not elsewhere ele – electronic equipment classified i_s – ferrous metals p_c – petroleum and coal products lea – leather products pcr – processed rice lum – wood products ppp – paper products, publishing mvh – motor vehicles and parts tex – textiles ocr – crops not elsewhere classified wap – wearing apparel ofd – food products not elsewhere classified ome – machinery and equipment not elsewhere classified

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Clearly, the gains from trade creation are larger the higher the rate of protection initially applied to these trade flows and the more price responsive total domestic demand is for these goods. Trade diversion costs are likely to be greater the higher the tariffs applied in the non-partner markets and the greater the reduction in the quantity of imports from these markets. On the other hand, import liberalization typically brings about an increase in exports by changing the real exchange rate. Lowering the domestic price of at least some imports causes consumers to substitute these goods for non-traded goods. The reduction in demand for the non-traded good lowers its price relative to the prices of traded goods— a relative price change that is frequently termed a real exchange rate depreciation (Salter, 1959). This reduction in the profitability of non-traded goods production makes production for export relatively more attractive and increases the supply of exports.

(d) The effects on factor returns Besides the effects on output, export and import, FTAs also have some impact on factor returns. As regional integration makes trade easier, it tends to raise the returns on at least some factors of production (Winters, 1996). A simple application of the HeckscherOhlin model to our scenarios might lead us to expect ASEAN returns on capital to fall since ASEAN and China are capital-scarce relative to their partners, Japan and the Republic of Korea. Since international trade tends to increase the returns on the abundant factor and reduce those on the scarce factor, increased trade might be expected to reduce the returns on capital in ASEAN members. However, there are a number of reasons to believe that the basic Heckscher-Ohlin model is too simple for our purposes and one might expect ASEAN to raise the rates of return on capital for both partners under trade liberalization regardless of capital abundance. First, the standard Heckscher-Ohlin model applies only to a so-called square model with equal numbers of factors of production and goods. The GTAP 6 database identifies five factors of production—land, unskilled labour, skilled labour, capital and natural resources—and 57 commodities. Second, the Heckscher-Ohlin model presumes homogeneous products, whereas experience suggests that many markets are better represented by differentiated products and intra-industry trade. The GTAP model makes the Armington assumption.7 In addition, the substitutability of domestic and foreign goods is also very important. Third, integration might affect the rate of return on capital through the price of intermediate and capital goods. A reduction in tariffs and trading costs on the

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The Armington assumption differentiates commodities by their country of origin. It takes the products of an industry which come from different countries to be imperfect substitutes for each other. This has become a standard assumption of international CGE models. These models generate smaller and more realistic responses of trade to price changes than implied by models of homogeneous products.

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imports of capital equipment reduces the prices which industry has to pay for investment goods (Fukase and Martin, 1999). (The model does not capture this effect directly because the total stock of capital in each country is fixed in these simulations.) Table 6 shows the results of the simulation for the changes in returns on the factors of production. The measure reflects the changes in factor prices relative to the price index for private consumption expenditure. It does not, however, take into account the effects of changes in the revenue position of the Government and its ability to redistribute tax revenues to individuals, either through transfers or through the provision of public goods. Table 6. Real returns on the factors of production (Percentage change) MEI 2020

China Japan Republic of Korea Indonesia Malaysia Philippines Singapore Thailand Viet Nam Other ASEAN Rest of OECD NAFTA ROW1 ROW2

ASEAN+3 2020

Unskilled labour

Skilled labour

Capital

Unskilled labour

Skilled labour

Capital

0.519 0.004 0.199 1.737 5.185 2.077 2.582 4.079 11.883 0.35 -0.136 -0.038 -0.195 -0.105

0.558 0.015 0.139 1.574 4.44 2.407 2.261 3.247 5.758 0.366 -0.112 -0.038 -0.179 -0.073

0.599 0.029 0.136 2.113 4.793 3.504 2.074 4.26 9.084 0.362 -0.068 -0.032 -0.213 -0.099

1.04 0.259 0.765 -0.277 2.022 0.802 1.16 0.271 10.067 -0.312 -0.132 -0.037 -0.447 -0.105

1.072 0.139 0.093 -0.419 1.898 0.837 0.904 -0.315 4.511 -0.203 -0.101 -0.032 -0.37 -0.083

1.026 0.176 0.448 -0.504 2.067 1.502 0.342 -1.896 8.195 -0.304 -0.072 -0.041 -0.42 -0.127

If we compare the scenarios, then MEI 2020 showed a favourable return in the countries participating in RTAs (except China, Japan and the Republic of Korea) for three factors: skilled labour, unskilled labour and capital. It seems that high tariff reductions were not beneficial to achieving good factor returns in the ASEAN region. In ASEAN, Viet Nam had good returns, followed by Malaysia, in MEI 2020, which reflected the wider scope of Viet Nam’s liberalization, which is likely to induce its industrialization. Further, the concept of comparative advantage is supported by the case of Viet Nam because unskilled labour returns were comparatively higher than capital returns. On the contrary, the comparative advantage theory is not supported in the case of Indonesia and Thailand. Though they are labour-intensive countries, the capital returns increased more under the MEI 2020 scenario. The welfare decomposition result provides further insight into the analysis. 75

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(e) Welfare implications The impact of trade liberalization on welfare differs between large and small countries. A large country can affect the international terms of trade by raising the world prices of its imports and lowering the world prices of its exports. In contrast, since a small country cannot influence the international terms of trade, it has to accept the world prices of its exports and imports. The present analysis included both small economies, such as Thailand and Viet Nam, and large economies, such as China and Indonesia. Welfare gains from a multilateral (i.e. regional) liberalization are fundamentally determined by two factors: (a) the change in efficiency with which any given economy utilizes its resources; and (b) changes in a country’s terms of trade, which permit us to calculate the regional equivalent variation—or the amount of money that could be taken away from consumers, at initial prices, while leaving them at the same level of post-simulation utility.8 If a particular country experiences an improvement in its terms of trade, i.e. export prices rise relative to import prices, then the equivalent variation9 gain will be larger than the efficiency gain.10 If the terms of trade deteriorate, then the opposite will happen. From table 7, we can observe that trade liberalization under the MEI, DEI and ASEAN+ 3 scenarios led to increased global welfare. However, the gains in welfare were mainly attributed to the countries belonging to the ASEAN+3 region involved in the trade liberalization, while the rest of the regions faced a loss in welfare, with the exception of ROW2 under the MEI 2020 scenario. However, not all of the welfare gains were distributed evenly among the 10 economies involved in the trade agreement. In the MEI 2020 scenario, China, Malaysia and Thailand were the countries that experienced the greatest welfare increases, while the Republic of Korea actually faced a decline in total welfare. When we applied the ASEAN+3 2020 scenario, China, the Republic of Korea and Thailand gained, while Japan actually experienced a welfare decline. From these two scenarios, China and Thailand appeared to gain the most welfare from trade liberalization in the region. If we further decompose these two results (see table 7), most countries involved in the various trade liberalization scenarios improved their allocative efficiency, resulting in an increase in global allocative efficiency. The exceptions were Singapore under the MEI 2020 scenario and Japan under the ASEAN+3 2020 scenario, which experienced a deterioration in allocative efficiency ($8,249.6 million). On the other hand, the various trade agreements appear to have caused a huge deterioration in the terms of trade for China in both scenarios. 8 9

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Post-simulation utility is the level of utility obtained after the trade scenario exercise is carried out. Equivalent variation is a measure of how much more money a consumer would pay before a price increase to avert the price increase. John Hicks is attributed with introducing the concept of equivalent variation. When a country participates in a free trade region, it may gain due to trade creation and may either gain or lose due to trade diversion. The former has a positive effect on welfare because the removal of tariffs within the region allows the country to allocate its resources more efficiently in production. The country can import the goods that it formerly produced inefficiently under tariff from member countries that are more efficient producers (Caves and Jones, 1981).

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Table 7. Welfare decomposition in different trade scenarios (Millions of United States dollars) MEI 2020 Allocative Terms of efficiency trade effect China Japan Republic of Korea Indonesia Malaysia Philippines Singapore Thailand Viet Nam Other ASEAN Rest of OECD NAFTA ROW1 ROW2 Total

10 072.4 2 253.5 477.8 1 059.4 2 909.8 996.6 -222.1 3 628.4 2 812.1 401.5 -847.8 -652 -1 431.7 -1 248.1 20 209.7

-5 991.6 -707.1 -726.1 1 793 3 183.7 374.3 3 108.6 3 088 360 -139.3 -3 613.7 -1 771.1 -2 200.6 3 241.8 0

ASEAN+3 2020 Total 4 373.1 1 627.9 -225.2 2 753.2 6 688.9 1 379.3 3 035.3 6 842.3 3 578.3 238.4 -3 976.6 -3 888.6 -3 743.3 1 526.9 20 209.7

Allocative Terms of efficiency trade effect 27 833.1 -8 249.6 1 849 634.9 2 092.5 477.9 81 2 217.3 1 692.4 541.1 -213.5 -580.8 -1 700.3 -1 750.1 24 924.9

-13 692.5 7 686.1 4 416.3 130.8 -272.4 -108.6 993.4 6 504.2 1 292.3 -78.6 -3 266.6 -1 512.4 -4 094 2 002.1 0

Total 15 894.8 -1 624.8 5 939.1 894.1 2 070.3 375.1 1 115.4 8 833.7 4 698 455.3 -3 028 -4 158.4 -6 033.8 -505.9 24 924.9

We have already noted that the terms of trade effect was negative for China, Japan and the Republic of Korea under MEI 2020, while a positive terms of trade effect was observed for Japan and the Republic of Korea under ASEAN+3 2020. From the analysis above, it can be observed that Japan was the loser under DEI 2020, but it was a winner under ASEAN+3 2020 and MEI 2020. It experienced negative output growth, followed by reductions in both export and import shares under DEI 2020 compared with BAU 2020. The Republic of Korea was a loser under MEI 2020. It had negative output growth, though its exports increased marginally, but imports also declined as compared with BAU 2020. While real output growth was insignificant under the various trade scenarios, China gained under all scenarios. Its export and import shares also increased marginally compared with BAU 2000. Other countries involved in the economic integration scenarios benefited from increased industrial output growth, with Viet Nam ranking first under the various scenarios, followed by Thailand. It was also observed that, when an economy moved to higher tariff reduction scenarios, output growth, exports and imports all increased for the participating countries in the agreement under the scenario (except China, Japan and the Republic of Korea), while non-agreement countries decreased industrial output growth and were losers in all scenario cases. Moreover, the direction of trade for the member countries under the agreement predicted a trade diversion movement 77

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(i.e. trade moving away from non-agreement countries). Further, if the ASEAN+3 2020 scenario materializes at all, the results of the study indicate that it will not improve the poverty situation in the region, even though all participating countries expect to benefit overall. Our current study supports Urata and Kiyota (2003), Scollay and Gilbert (2001), Lloyd and MacLaren (2004) and McDonald, Robinson and Thierfelder (2007) regarding the gains achieved by the countries participating in the various agreements and the fact that the countries or regions outside the agreements were losers. The study also supports Ando and Urata (2006) and Park (2006) since the highest growth was achieved in the case of ASEAN+3 integration.

6.

CONCLUSIONS

East and South-East Asian free trade agreements increased output growth for all participating countries. Other countries in the world had marginal negative growth. Among the countries in the agreements, Viet Nam achieved the highest growth, followed by Thailand. The lowest positive growth was attained by Japan and the Republic of Korea. Japan was a net loser under the DEI scenario, but a net gainer under the ASEAN+3 and MEI scenarios in 2020. The ASEAN+3 2020 scenario was favourable for all countries participating in the agreement. Though real output growth was insignificant, China was a net gainer in all trade liberalization scenarios. It was also observed that if an economy moved to a higher tariff reduction scenario, output, export and import growth all increased for the participating countries (except China, Japan and the Republic of Korea), while non-agreement countries decreased industrial output growth and were losers in all scenarios. Moreover, the direction of trade for member countries in each agreement under various scenarios was concentrated among the countries participating in the agreement, which predicts a trade diversion movement (i.e. trade is diverted away from non-agreement countries). The total export and import shares of the countries belonging to the ASEAN+3 region increased under different trade liberalization scenarios during the period 2000-2020, especially those of Indonesia, Thailand and Viet Nam. The sectoral responses to trade liberalization were high for electronic equipment in China, Thailand and Indonesia; chemical, rubber and plastic products in Viet Nam; manufacturing equipment in the Republic of Korea; and ferrous metals in Japan. However, with the adoption of trade liberalization among all countries under the ASEAN+3 2020 scenario, we can see that all countries tended to benefit. This may provide a further incentive to pursue greater trade liberalization among the countries in the study.

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REFERENCES Aitken, N.D. (1973). “The effects of the EEC and EFTA on European trade: a temporal cross-section analysis”, American Economic Review, vol. 63, No. 5, pp. 881-892. Ando, M. and S. Urata (2006). “The Impacts of East Asia FTA: A CGE Model Simulation Study”, Keio University Market Quality Research Project (KUMQRP) Discussion Paper No. 2005-021 (Tokyo, Keio University). Braga P., R. Safadi and A. Yeats (1994). “Regional integration in the Americas: déjà vu all over again?”, The World Economy, vol. 17, pp. 577-601. Burfisher, Mary E., Sherman Robinson and Karen Thierfelder (2004). “Regionalism: Old and New, Theory and Practice”, MTID Discussion Paper No. 65 (Washington, D.C., Markets, Trade and Institutions Division, International Food Policy Research Institute). Caves, Richard E. and Ronald W. Jones (1981). World Trade and Payments: An Introduction (Boston, Little, Brown Book Group). Chawin, L. (2006). “East Asia FTAs: ASEAN perspective”, paper presented at the International Conference on WTO, China and the Asian Economies: Economic Integration and Development, University of International Business and Economics, Beijing, 24-25 June. Dee, Philippa and V. Jyothi Gali (2003). “The Trade and Investment Effects of Preferential Trading Arrangements”, NBER Working Paper No. 10160 (Cambridge, Massachusetts, National Bureau of Economic Research). Dimaranan, B., Elena Ianchovichina and Will Martin (2007). “China, India and the future of the world economy: fierce competition or shared growth?”, paper presented at the Tenth Annual Conference on Global Economic Analysis: Assessing the Foundations of Global Economic Analysis, Center for Global Trade Analysis, Purdue University, West Lafayette, Indiana, 7-9 June. Dimaranan, B. and Robert McDougall (2006). “Chapter 5—Data base summary: sectoral data”, GTAP 7 Data Base Documentation, GTAP Resource No. 1926 (West Lafayette, Indiana, Center for Global Trade Analysis, Purdue University). Frankel, Jeffrey A. (1993). “Is Japan creating a yen bloc in East Asia and the Pacific?”, in Jeffrey A. Frankel and Miles Kahler, eds., Regionalism and Rivalry: Japan and the United States in Pacific Asia (Chicago, Chicago University Press). Fukase, Emiko and Will Martin (1999). “A Quantitative Evaluation of Vietnam’s Accession to the ASEAN Free Trade Area”, World Bank Policy Research Working Paper No. 2220, (Washington, D.C., World Bank).

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Hertel, Thomas W., ed. (1997). Global Trade Analysis: Modeling and Applications (Cambridge and New York, Cambridge University Press). _____ (2006). “Chapter 1—Introduction”, GTAP 6 Data Base Documentation, GTAP Resource No. 1797 (West Lafayette, Indiana, Center for Global Trade Analysis, Purdue University). Hew, Denis (2006). “Economic Integration in East Asia: An ASEAN Perspective”, UNISCI Discussion Paper No. 11 (Madrid, Research Unit on International Security and Cooperation, Complutense University of Madrid), May. Igawa, Kazuhiro and Bonggil Kim (2005). “East Asian free trade agreement: strategic aspects for Japan”, in Choong Yong Ahn and others, eds., East Asian Economic Regionalism: Feasibilities and Challenges (New York, Springer), pp. 21-36. Japan External Trade Organization (JETRO) (2003). Prospects for Free Trade Agreements in East Asia (Tokyo), available at www.jetro.go.jp/en/stats/survey/pdf/2003_01_ epa.pdf. Lee, Jong-Wha and Innwon Park (2005). “Free trade areas in East Asia: discriminatory or nondiscriminatory?”, The World Economy, vol. 28, No. 1, pp. 21-48. Lloyd, Peter J. and Donald MacLaren (2004). “Gains and losses from regional trading agreements: a survey”, Economic Record, vol. 80, No. 251, pp. 445-467. McDonald, Scott, Sherman Robinson and Karen Thierfelder (2007). “Asian growth and trade poles: India, China, and East and Southeast Asia”, paper presented at the Tenth Annual Conference on Global Economic Analysis: Assessing the Foundations of Global Economic Analysis, Center for Global Trade Analysis, Purdue University, West Lafayette, Indiana, 7-9 June. McKibbin, Warwick J., Jong-Wha Lee and Inkyo Cheong (2004). “A dynamic analysis of a Korea-Japan free trade area: simulations with the G-cubed Asia-Pacific model”, International Economic Journal, vol. 18, No. 1, pp. 3-32. Mukhopadhyay, Kakali (2006). “Impact on the environment of Thailand’s trade with OECD countries”, Asia-Pacific Trade and Investment Review, vol. 2, No. 1 (United Nations publication, Sales No. E.06.II.F.22, ST/ESCAP/2414) pp. 25-46. Nielsen, Chantal P. (2003). “Vietnam’s rice policy: recent reforms and future opportunities”, Asian Economic Journal, vol. 17, No. 1, pp. 1-26. Park, Innwon (2006). “East Asian regional trade agreements: do they promote global free trade?”, Pacific Economic Review, vol. 11, No. 4, pp. 547-568. Puga, Diego and Anthony J. Venables (1998). Agglomeration and Economic Development: Import Substitution versus Trade Liberalization, Centre for Economic Policy Research Discussion Paper No. 1782 (London).

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Salter, W.E.G. (1959). “Internal and external balance: the role of price and expenditure effects”, Economic Record, vol. 35, No. 71, pp. 226-238. Scollay, Robert and John P. Gilbert (2001). New Regional Trading Arrangements in the Asia-Pacific? (Washington, D.C., Peter G. Peterson Institute for International Economics). Strutt, Anna and Allan Rae (2007). “Interacting preferential trade agreements: illustrations from Asia-Pacific”, paper presented at the Tenth Annual Conference on Global Economic Analysis: Assessing the Foundations of Global Economic Analysis, Center for Global Trade Analysis, Purdue University, West Lafayette, Indiana, 7-9 June. Urata, Shujiro and Kozo Kiyota (2003). “The Impact of an East Asia FTA on Foreign Trade in East Asia”, NBER Working Paper No. 10173 (Cambridge, Massachusetts, National Bureau of Economic Research). United Nations (2007). World Population Prospects: The 2006 Revision, Population Database, Population Division, Department of Economic and Social Affairs of the United Nations Secretariat (New York), http://esa.un.org/unpp. Walmsley, Terrie (2007). Personal communication. (Dr. Terrie Walmsley, Director of GTAP modelling at Purdue University, United States). Winters, L. Alan (1996). “Foreign direct investment and the dynamic analysis of trade”, paper presented at the Lebanon and EURO-Mediterranean Partnership Conference, Beirut, 1-2 July, organized by the Lebanese Center for Policy Studies. World Bank (2007). World Development Indicators 2007, (Washington, D.C.).

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Performance of export-oriented small and medium-sized manufacturing enterprises in Viet Nam Tran Quoc Trung*

ABSTRACT

T

he liberalization of the business environment and increased international integration in Viet Nam have resulted in the rapid expansion of small and medium-sized enterprises (SMEs), in general, and export-oriented small and mediumsized manufacturing enterprises (SMMEs), in particular, especially since 2000. More than 95 per cent of formal enterprises belong to the SME category. About 17 per cent of SMMEs are involved in export activities. Export-oriented SMMEs account for 36 per cent of the workforce and 45 per cent of total assets, and contribute about 42 per cent of the industrial output of all SMMEs. Export-oriented SMMEs tend to be larger in size and mainly belong to the medium-sized category. They are unevenly distributed among regions and are mainly concentrated in the south-east of the country. They are owned both by domestic private companies and by foreign investment enterprises. Among SMMEs, the exportoriented firms are more likely to survive in business, expand their operations, generate (continued on page 84)

*

Economist, Ministry of Planning and Investment, Hanoi, Viet Nam. Any errors are the responsibility of the author; the views expressed are those of the author and do not necessarily reflect those of the Ministry of Planning and Investment, Asia-Pacific Research and Training Network on Trade (ARTNeT) members, partners or the United Nations. This study was conducted as part of the ARTNeT initiative and was carried out with the aid of a grant from the World Trade Organization. The technical support of ESCAP is gratefully acknowledged. The author would like to thank Yann Duval and Marc Proksch for extensive comments on the draft paper. Comments on this paper are most welcome.

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(continued from page 83)

jobs and become large enterprises. Although they perform well in terms of growth rate, especially foreign investment enterprises, the profitability of export-oriented SMMEs is relatively low. The promising findings are that, among export-oriented SMMEs, there is increasingly sustainable development and that this sector is becoming more efficient and productive. Those SMMEs that are in the medium-sized category and are owned by foreign investors operating export-oriented industries located in the south-east and the Red River delta have a higher probability of participating in the export market. SMMEs also gain benefits from international integration in the improvement of their performance, and the large manufacturing enterprises within the industry play an important role in increasing the participation of SMMEs in exports. In addition to the traditional factors determining the performance of exportoriented SMMEs (i.e. capital and labour), this study finds the form of ownership, company location and previous experience in the export market (but not in the type of industry in which the firm operates) to be significant determinants of export-oriented SMME performance. Analysis of the 2004-2005 data shows that export-oriented SMMEs are more likely to create jobs and to become large enterprises than those that are not. The study recommends the formulation of policies that support the development of business linkages and networking and that promote subcontracting arrangements between small and large enterprises or between domestic firms and foreign investment enterprises. It is also necessary to support and facilitate the involvement of SMMEs in exporting, either directly or indirectly through large manufacturing enterprises. Moreover, substantial investment in infrastructure and industrial support facilities and services in the underdeveloped regions is required, with priority being given to those areas with the greatest potential for development, i.e. the north central coast, the south central coast and the Mekong delta.

1.

INTRODUCTION

Since 1986, the liberalization of the business environment and increased integration into the world economy have been key themes in the open-door policy of Viet Nam. Most notably, the central Government has made great efforts to promote and facilitate the development of the private sector by promulgating and implementing a number of business and investment promotion laws since the early 1990s, and it has been

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especially successful with its introduction of the Enterprise Law1 in 2000. Furthermore, trade policy2 in Viet Nam has changed significantly from inward-oriented import substitution towards outward orientation (Oostendorp, Trung and Tung, 2006). Most recently, Viet Nam became an official World Trade Organization (WTO) member in January 2007. During this process, the small and medium-sized enterprise (SME)3 sector has developed at a remarkable pace in terms of the number and performance of enterprises. The highly dynamic SMEs created about 28 per cent of the total of 7.5 million newly created jobs during the period 2000-2005 (Viet Nam, 2006). However, there are several major concerns regarding the SME sector, namely: (a) although the number of private domestic firms registered under the Enterprise Law increased steadily each year, only half of the firms actually exist. Existing enterprises are very small, and there are very few mediumsized and large firms (Vietnam Development Information Center, 2004); (b) the emerging private sector is still, to a large extent, inward-oriented, and a very small proportion of private manufacturing SMEs are participating in the export sector; and (c) most SMEs do not realize the great impact that globalization and integration have on their businesses (Vietnam Development Information Center, 2004; Viet Nam, 2003 and 2005; Kokko and Sjöholm, 2004). These concerns would suggest that small domestic businesses face obstacles in operating, expanding and eventually making it to the top (Vietnam Development Information Center, 2004). The inward orientation and small scale of the SME sector are expected to pose a big challenge for the future contribution of SMEs to economic growth, export performance, job creation and poverty reduction targets, as pointed out in The Five-Year Socio-Economic Development Plan, 2006-2010 (Viet Nam, 2006). It is a fact that export-oriented manufacturing SMEs4 are viewed as a dynamic, flexible and innovative sector, contributing to exports and industrial development. In Viet Nam, these enterprises tend to be larger in size, perform better and enjoy more opportunities to become large enterprises than the majority of SMEs, in general, and manufacturing SMEs, in particular. They also have very different characteristics in terms of 1

2

3

4

The most important aspect of the Enterprise Law was the simplification of the business registration procedure for new private enterprises and the elimination of more than 160 business licences and permits as well as thousands of sub-licences and conditions issued at the ministerial and local levels as of 2000. Trade policy included a shift from a State monopoly on foreign trade towards a more competitive system, with increasing participation by the private sector, the abolition of non-tariff barriers, integration into the world economy via regional and multilateral trading agreements and the unification of the multiple exchange rate system. SMEs in Viet Nam are defined as businesses and production establishments that have a registered capital of less than 10 billion dong (about $625,000) or permanent employees numbering less than an annual average of 300, or both. In this paper, SMEs in Viet Nam are defined in terms of labour. Export-oriented manufacturing SMEs in Viet Nam are formally registered enterprises that have an annual average number of permanent employees of less than 300, are operating as manufacturers and are involved in direct export activities in the surveyed year.

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ownership, regional distribution and industry of operation than those of other SMEs, especially manufacturing SMEs (see annexes I and II). A better understanding of this type of enterprise, as well as how to support and promote them, will be the key to the success and further industrial development of Viet Nam in the future. The main objectives of this study are to reveal the factors behind export participation by manufacturing SMEs and the performance of export-oriented manufacturing SMEs, and to identify a set of measures that would enable SMEs to participate more easily and directly in global trade, especially in the context that has existed since Viet Nam joined WTO. The analysis in this paper is based on six surveys5 of enterprises that were in actual operation at the end of the year preceding each survey. The surveys were conducted annually from 2001 to 2006 by the General Statistics Office of Viet Nam. Section 2 provides an overview of the SME sector and a review of SME support policies that have significant effects on the development of the SME sector, in general, and an analysis of the development of export-oriented small and medium-sized manufacturing enterprises (SMMEs) since 2000, in particular. Section 3 quantitatively analyses the export participation of manufacturing SMEs and the performance of export-oriented SMMEs in Viet Nam over the past few years. Section 4 discusses the policy implications drawn from this study.

2.

DEVELOPMENT AND PERFORMANCE OF EXPORTORIENTED SMMEs

(a) Characteristics and development The development of the SME sector in Viet Nam can be divided into two phases, with the turning point in 2000 when the Law on Enterprises came into effect. Since then, the Government has adopted more reform policies and initiatives to accelerate the development of the private enterprise sector, namely: stipulating supporting measures for SME development in 2001; establishing the Credit Guarantee Fund for SMEs in 2001; developing an SME support institutional infrastructure6 at the central and local levels to 5

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In 2001 and 2006, 42,288 and 113,352 enterprises were surveyed, respectively. Manufacturing enterprises accounted for about 22 per cent of all the enterprises surveyed. Some 89 per cent of all manufacturing enterprises were within the small and medium-sized categories. The panel enterprise data can be constructed from these surveys. This infrastructure comprises the SME Development Promotion Council at the central Government level; the Agency for SME Development (ASMED) under the Ministry of Planning and Investment; three Technical Assistance Centers for SMEs under ASMED; the Department of Locality Industries under the Ministry of Industry and Trade and some supporting centres for SMEs under local authorities in Hanoi, Ho Chi Minh City, Binh Thuan and Ba Ria-Vung Tau; and some business associations.

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develop SME support policies and programmes and to support SMEs in human resources training, trade and investment promotion, technology transfers, etc. as of 2003; setting up State-funded programmes to support SMEs in providing staff training in 2004; and developing the SME Development Plan for the period 2006-2010 to promote the SME sector in a systematic and orderly manner in 2006. As a result, the SME sector has achieved significant development. The number of SMEs increased nearly threefold from 39,915 in 2000 to 109,738 in 2005. SMEs are the dominant type of enterprise in Viet Nam, accounting for more than 95 per cent of all enterprises. However, the gap between the number of actively operating enterprises and the number of registered enterprises is still large. By the end of 2005, there were 113,352 active enterprises compared with 205,095 registered enterprises. SMEs have been rapidly expanding and attracting a large proportion of the country’s labour force and capital. In 2005, SMEs created more than 2.5 million jobs for workers, which was more than two times higher than in 2000, and accounted for 40.5 per cent of all employees working in the formal enterprise sector. Total assets of SMEs also increased more than threefold from 2000 to 2005. In 2005, the total assets utilized by SMEs represented some $57 billion and accounted for 34 per cent of the total assets of the formal enterprise sector. SMEs in the service sector account for 63.4 per cent of all enterprises, followed by those in the manufacturing sector (20 per cent) and construction (13.3 per cent). Geographically, most SMEs are concentrated in the regions where big cities are located, such as the Red River delta area (27 per cent), the south-east (36 per cent) and the Mekong River delta area (13 per cent). Only a small proportion of SMEs are located in the remaining regions, such as the north-west and the Central Highlands, due to the underdevelopment of those regions. In terms of ownership, domestic non-State-owned enterprises comprise 95 per cent of total SMEs, while State-owned enterprises (SOEs) and foreign-owned enterprises account for only about 2.5 per cent. The size of most SMEs is very small, with nearly 95 per cent of them falling within the small enterprise category and having less than 100 employees each. The rapid expansion of the SME sector resulted in a rapid increase in the number of export-oriented SMMEs, at a compound annual growth rate of 16 per cent between 2000 and 2004. Table 1 shows that the number of export-oriented SMMEs increased rapidly from 1,551 enterprises in 2000 to 2,225 enterprises in 2004. Although only about 17 per cent of SMMEs were involved in export activities, they accounted for 36 per cent of all employees working in SMMEs and 45 per cent of the total assets utilized by all SMMEs. These shares have not changed much during the past few years.

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Table 1. Export-oriented SMMEs in Viet Nam

2000 Enterprises Number of export-oriented SMMEs Percentage of all SMMEs Employment Employment of export-oriented SMMEs (persons) Percentage of all employees of SMMEs Persons engaged per export-oriented SMME Assets Total assets of export-oriented SMMEs (billions of dong) Percentage of total assets utilized by all SMMEs Total assets utilized per export-oriented SMME (billions of dong)

2003

2004

CAGR 2000-2004 (Percentage)

1 551 17.3

2 225 16.0

2 810 17.2

16.0

163 057

222 242

282 851

14.8

36.9 105.1

33.0 99.9

35.9 100.7

35 032.7 55 030.4 76 903.4 45.6 22.6

42.2 24.7

44.7 27.4

Source: Viet Nam, General Statistics Office, Enterprise Surveys, 2000-2005. Note: Calculations are for only those years in which export data were collected. Abbreviation: CAGR – compound annual growth rate.

Nearly two thirds of export-oriented SMEs were manufacturing food products, textiles and garments, wood products and furniture, and rubber and plastic products, sectors in which Viet Nam has achieved a high growth rate in export volume during the past few years. It is important to note that the share of export-oriented SMMEs in these industries has been declining, while the share of export-oriented SMEs manufacturing footwear, chemicals and chemical products, non-metallic mineral and metal products, and machinery and equipment has been increasing in terms of the number of enterprises, labour and revenue but not in terms of assets during the same period. The role of foreign investment in the capital incentive industries also increased (see figure 1). This implies that exportoriented SMMEs are shifting from labour-intensive industries to capital-intensive industries. It is important to note that export-oriented SMMEs, both domestic non-Stateowned enterprises and those with foreign investment, accounted for the largest proportion of export-oriented SMMEs, while only 3.3 per cent of export-oriented SMMEs were State-owned. The foreign investment enterprises expanded faster than domestic enterprises, while SOEs underwent contraction. The number of foreign investment export-oriented SMMEs increased by more than two times during 2000-2004. The main reason for the 88

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Figure 1. Export-oriented SMMEs by industry 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2000 2004 Enterprises

2000 2004 Labour

2004 2000 Assets

2000 2004 Revenue

Other products. Footwear, chemicals and chemical products, non-metallic mineral and metal products, machinery and equipment. Food products, textiles and garments, wood products and furniture, rubber and plastic products.

reduction in the number of SOEs is that the Government has been promoting the implementation of the SOE reform programme through the equitization, transfer, sale, contracting and leasing of small SOEs since 1998 (Mekong Economics Ltd., 2002). More than two thirds of export-oriented SMMEs were located in south-eastern Viet Nam, the hub of industrial development which has better infrastructure and seaport and logistics facilities. The enterprises in all other regions (except the Red River delta) represented only a small number of export-oriented SMMEs. The share of export-oriented SMMEs in the south-east and the Mekong delta is increasing, but it is declining in all other regions. The enterprises undergoing expansion are mainly located in the south-east, the Mekong delta, the Red River delta, and the north central coast. Compared with SMEs, the company size, ownership and geographical distribution of export-oriented SMMEs are quite different. The company size, in terms of labour and capital, of export-oriented SMMEs tends to be larger than that of other SMMEs and of SMEs. The cumulative fraction of export-oriented and inward-oriented SMMEs, in terms of labour and capital, clearly indicates that the size of export-oriented SMMEs is much bigger than that of inward-oriented SMMEs (see figure 2). 89

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Figure 2. Cumulative fraction of export-oriented and inward-oriented SMMEs by labour and assets, 2004 1.0

1.0

0.8

0.8

0.6

0.6

0.4

0.4

0.2

0.2

0

0 0

100 200 Employees/firm

300 Outward firm

Source:

0

10 5 Log of total assets/firm

15

Inward firm

Viet Nam, General Statistics Office, Enterprise Survey, 2004.

Domestic non-State-owned SMEs and SMMEs dominate the market, while both domestic non-State-owned and foreign investment export-oriented SMMEs account for the largest proportion of enterprises. SMEs and SMMEs are distributed more evenly among the developed regions of the country and are expanding in all regions except the Mekong delta (see annex I), whereas export-oriented SMMEs are mainly concentrated in the south-east (see annex II). Among export-oriented SMMEs, the ownership and geographical distribution characteristics of long-established and new export-oriented SMMEs are similar. In terms of size, as measured by the total number of employees and the total capital utilized, the well-established export-oriented SMMEs tend to be larger than new companies. More importantly, the new export-oriented SMEs are expanding the fastest (see annex I). This implies that small manufacturing enterprises in Viet Nam also have strong potential for becoming exporters and for being able to catch up with the large enterprises. However, it will require a major effort to reduce the regional development gaps in terms of infrastructure and industrial support services.

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(b) Performance of export-oriented SMMEs Measured by the increase in revenue at a compound annual growth rate of 19.7 per cent and in profit at a compound annual growth rate of 59.6 per cent, the export-oriented SMMEs performed well between 2000 and 2004. Although only about 17 per cent of SMMEs were involved in export activities, these export-oriented enterprises accounted for about 42 per cent of the total revenue of all SMMEs, 46 per cent of the total profit of all SMMEs and nearly 40 per cent of the total tax contribution of all SMMEs (see tables 1 and 2). Because the export-oriented SMMEs grew relatively faster than other SMMEs, these share figures have shown a tendency to increase during the past few years. Table 2. Performance of export-oriented SMMEs in Viet Nam (Billions of Vietnamese dong at constant prices, unless otherwise specified)

Revenue Total revenue of export-oriented SMMEs Percentage of total revenue of all SMMEs Total revenue per export-oriented SMME Profit Total profit of export-oriented SMMEs Percentage of total profit of all SMMEs Total profit per export-oriented SMME

CAGR 2000-2004 (Percentage)

2000

2003

2004

32 104.5 42.6 20.7

50 572.3 38.0 22.7

65 835.7 41.7 23.4

19.7

295.1 39.0 0.2

1 873.9 50.0 0.8

1 915.0 46.1 0.7

59.6

3.1

37.6

Source: Viet Nam, General Statistics Office, Enterprise Surveys, 2000-2005. Note: Calculations are for only those years in which export data were collected. Abbreviation: CAGR – compound annual growth rate.

The transition matrix of company size during the period 2000-2005 shows that export-oriented SMMEs in Viet Nam are more likely to expand and become large manufacturing enterprises than inward-oriented SMMEs. During the period 2000-2003, about 8.4 per cent of export-oriented SMMEs became large manufacturing enterprises, while only 2.8 per cent of inward-oriented SMMEs achieved the same result. Similarly, 5.3 per cent of export-oriented SMMEs, but only 1.2 per cent of inward-oriented SMMEs, successfully expanded between 2003 and 2005 (see table 3).

91

Enterprises in 2003 Export-oriented firms Micro

Small

40.7 2.4 0.7 0.0 0.2 26

51.9 72.1 14.5 4.3 1.1 437

Enterprises in 2000

Panel A Micro Small Small to medium Medium Large Total number of firms

Small to Medium medium 3.7 17.8 45.5 18.3 1.7 274

0.0 5.5 20.5 38.2 5.4 197

Inward-oriented firms Large

Total number of firms

Micro

Small

3.7 2.2 18.8 39.3 91.7 751

27 505 303 186 664 1 685

71.7 12.6 0.6 0.0 0.0 1 110

28.1 77.6 16.2 3.8 0.9 2 122

0.2 8.0 59.1 12.0 0.9 402

27.3 85.7 22.5 5.3 1.2 5 357

0.2 4.5 60.1 26.3 3.9 778

Large

Total number of firms

0.0 1.1 13.8 43.7 5.1 153

0.1 0.8 10.3 40.5 93.2 336

1 154 2 236 340 158 235 4 123

0.1 0.6 11.9 46.6 10.8 328

0.1 0.3 4.8 21.0 84.0 731

2 128 5 355 716 281 739 9 219

Small to Medium medium

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Table 3. Enterprise size transition matrix, 2000-2005 (Percentage)

Panel B

Enterprises in 2003

Enterprises in 2005 40.4 3.7 1.2 1.0 0.0 66

55.8 80.1 19.8 4.1 0.9 920

0.0 13.6 53.6 20.0 1.9 474

1.9 1.7 16.8 43.5 6.2 284

1.9 0.9 8.6 31.4 91.1 982

52 964 500 290 920 2 726

72.4 8.9 0.8 0.7 0.0 2 025

Source: Viet Nam, General Statistics Office, Enterprise Surveys, 2000-2005. Note: Panel A is calculated based on the panel enterprise data between 2000 and 2003 and panel B is calculated based on the panel enterprise data between 2003 and 2005.

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Micro Small Small to medium Medium Large Total number of firms

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Table 4 shows that performance was better among export-oriented SMMEs than among inward-oriented SMMEs in terms of productivity as measured by the total revenue per employee per enterprise and the total profit per employee per enterprise, but not in terms of profitability as measured by the percentage of profitable firms. The average total revenue per employee per enterprise and total profit per employee per enterprise of exportoriented SMMEs were about 1.6 and 3.0 times higher than these of inward-oriented SMMEs, respectively, in 2004. In the same year, some 62 per cent of export-oriented SMMEs were profitable, while about 69 per cent of inward-oriented SMMEs were profitable. However, the difference in returns on capital between export-oriented and inward-oriented SMMEs was not statistically significant at the 10 per cent confidence level in 2003 and 2004. Table 4. Productivity and profitability of SMMEs in Viet Nam (Productivity in millions of Vietnamese dong at current prices; profitability as a percentage) 2000

Productivity Total revenue per employee per SMME Total profit per employee per SMME Profitability Percentage of profitable SMMEs Percentage of loss-making SMMEs Rate of return on capital Source: Note:

2003

2004

Exportoriented

Inwardoriented

Exportoriented

Inwardoriented

Exportoriented

Inwardoriented

270.4

198.1

295.6

192.8

340.9

215.8

-1.8

2.0

7.6

2.1

5.3

1.8

61.6

75.4

61.8

71.1

62.2

69.3

38.4

24.6

38.3

28.9

37.8

30.7

-1.6

7.7

-5.9

-2.5

0.5

-3.3

Viet Nam, General Statistics Office, Enterprise Surveys, 2000-2005. Rate of return on capital per enterprise = mean (total profit/total fixed assets*100).

It is important to note that the productivity and profitability of export-oriented SMMEs in Viet Nam were increasing while the productivity and profitability of inwardoriented SMMEs were declining. It can be seen, therefore, that inward-oriented SMMEs were more profitable than export-oriented SMMEs in relative terms but not statistically in absolute terms. However, the returns on capital of both export-oriented and inward-oriented SMMEs, on average, were very low, and they were much lower than the average market interest rate. This is a major concern.

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For the period 2000-2004, among export-oriented SMMEs, foreign investment enterprises tended to be more productive but less profitable than domestic enterprises. In addition, enterprises located in the developed regions (the Red River delta and the south-east) were more productive but less profitable than those located in other regions. Enterprises located in the mountainous and highland regions (the north-west and the Central Highlands) had the lowest productivity and profitability compared with enterprises located in all other regions (see annexes I and II). This implies that the regional gap in terms of the development and performance of export-oriented SMMEs is increasing. It is important to note that the performance of export-oriented SMMEs operating in industries in which Viet Nam has a comparative advantage in international markets appears to be no better than that of export-oriented SMMEs operating in other industries. Medium-sized, established enterprises perform better than small and new enterprises (see annexes I and II).

(c) Plant and job turnover rate of export-oriented SMMEs Both entry and exit are crucial elements of the market selection process that leads to the restructuring and evolution of industry. Therefore, the process of the entry and exit of firms has long been held to play an important role in the evolution of industry and its adaptation to change. Entry and exit are inherent parts of the dynamic competitive process that lead to some firms expanding and others declining. There is evidence that when an economy integrates deeply into the world economy, the exit and entry of SMEs are frequently seen. Those which are able take opportunities to increase their productivity or competitiveness are survivors, and the active entry by SMEs would be a source of dynamism in the manufacturing sector (Bellone, Musso, Nesta and Quéré, 2006; Hahn, 2000; Kawai and Urata, 2001). Tables 5 and 6 show that enterprise and job turnover rates in Viet Nam between 2001 and 2005 were extremely high compared with those in other developing and developed countries. However, it is important to note that the enterprise and job turnover rates of SMMEs declined rapidly during the period 2001-2005. In relative terms, the exit and job destruction rates of export-oriented SMMEs were lower than those of inwardoriented SMMEs (see tables 1 and 6). This reflects the low costs of entering and exiting the market which resulted from the removal of obstacles to doing business and especially to market entry in Viet Nam during the past decade. It also implies that SMME development is tending to become more stable, especially in the case of export-oriented SMMEs.

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Table 5. Plant and job turnover rates of manufacturing enterprises in developing and developed countries (Percentage) Country (Period covered) Chile (1979-1986) Colombia (1977-1989) Morocco (1984-1990) Republic of Korea (1983-1993) Taiwan Province of China (1981-1991) United States of America (1963-1982) Canada (1973-1992)

One year

Five years

One year

8.5 11.9 9.5 ..

.. .. .. 64.2

26.9 24.6 30.7 ..

.. .. .. ..

Minimum plant size covered 10 workers 10 workers 10 workers 5 workers

..

67.9

..

..

1 worker

..

26.9

18.9

58.4

5 workers

..

..

21.9

..

5 workers

Plants

Jobs Five years

Source: James R. Tybout, “Manufacturing firms in developing countries: How well do they do, and why”, Journal of Economic Literature, vol. XXXVIII, (2000) pp. 11-44.

Table 6. Entry and exit rates and job turnover rate of SMMEs in Viet Nam (Percentage)

Entry rate Exit rate Share of exit, export-oriented SMMEs Share of exit, inward-oriented SMMEs Enterprise turnover rate Job creation rate Job loss rate Share of jobs lost in export-oriented SMMEs Share of jobs lost in inward-oriented SMMEs Job turnover rate

2001

2002

2003

2004

2005

41.1 29.1 12.3 87.7 35.1 48.5 32.1 35.5 64.5 80.6

39.6 15.3 27.5 49.6 19.6 69.2

32.5 18.8 25.7 41.1 23.0 64.1

34.7 16.4 9.7 90.3 25.5 41.7 22.7 30.3 69.7 64.4

31.1 15.3 11.1 88.9 23.2 34.7 22.9 35.3 64.7 57.6

Source: Viet Nam, General Statistics Office, Enterprise Surveys, 2000-2005. Note: Let Nt be the number of enterprises observed in year t; Et the number of enterprises observed in year t but not in year t-1; and Xt the number of enterprises observed in year t-1 but not in year t. Then the entry rate is Et/Nt-1 and the exit rate is Xt/Nt-1. The enterprise turnover rate is the average of these two statistics. Similarly, the rate of gross job creation is the number of jobs at entering enterprises plus the number of new jobs at expanding enterprises, divided by the initial number of jobs, while the gross job loss rate is the number of jobs that disappear as enterprises contract or exit divided by the initial number of jobs. The sum of these two rates is the job turnover rate (Tybout, 2000). The export-oriented or inward-oriented enterprises are defined based on enterprises observed in year t-1.

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One interesting finding was that the labour productivity and profitability of terminated export-oriented SMMEs between 2004 and 2005 were the lowest (see table 7). Thus, performance is a very important indicator of the failure and success of enterprises. Table 7. Export-oriented SMMEs in Viet Nam by survival and termination, 2004 (Millions of Vietnamese Dong at the current rate, unless otherwise specified)

Total mean Survived between 2003 and 2005 Started up between 2003 and 2004 and survived to 2005 Terminated between 2004 and 2005 Source:

Share of Rate of profitreturn on making total assets firms (Percentage) (Percentage)

Revenue per employee

Profit per employee

340.9 386.6 170.9

5.3 10.7 -6.3

62.2 68.7 44.3

-0.4 1.1 -3.7

352.3

-9.8

51.6

-4.1

Viet Nam, General Statistics Office, Enterprises Surveys, 2000-2005.

The finding on the exit rate of SMMEs was relatively higher than the finding from a three-wave survey of SMEs in Viet Nam conducted by the Institute of Labour Science and Social Affairs, which found that the exit rate of SMEs was in excess of 15 per cent per year in the early 1990s, declining to less than 10 per cent in recent years (Vietnam Development Information Center, 2004). However, the SMEs in those surveys were only located in the major cities of Viet Nam and they were not representative of all SMEs. Therefore, in the cities, the exit rate may be lower. The high plant turnover rate in Viet Nam would be consistent with the finding by Goreski (1995) that, in a turbulent economic environment, company entry and exit rates are both high. Rapid growth provides many opportunities for new firms, while making existing companies obsolete more quickly.

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DETERMINANTS OF THE EXPORT PARTICIPATION OF SMMEs AND THE PERFORMANCE OF EXPORT-ORIENTED SMMEs

(a) Determinants of the export participation of SMMEs What factors determine why some SMMEs are involved in export activities and others are not? The descràptive analysis in section 2 shows that the share of export-oriented SMMEs has not changed much in relative terms during the past few years. The mediumsized manufacturing enterprises are more likely to be involved in export activities than are small enterprises. Export-oriented SMMEs mainly operate in industries in which Viet Nam has a comparative advantage in international markets. They are owned by both private domestic and foreign investors and are mainly located in the south-east and Red River delta regions, which have better infrastructure, port and logistics facilities, and easier access to labour, raw materials and other industrial support services. Although the descriptive analysis is useful, it suffers from the limitation of only being able to see the effects of one variable at a time. A more rigorous answer to the question, which would allow one to measure the effect of a variable while holding all other influences constant, calls for the estimation of a logistic model. Here, the dependent variable is set at one if an enterprise is involved in export activities in the year of the survey and to zero otherwise. A range of variables is believed to affect whether or not an SMME exports (see annex III). Those used in this model include: (a) Labour productivity; (b) Enterprise size (measured with dummy variables for micro, small, small to medium, and medium-sized enterprises); (c) Ownership (measured with dummy variables for SOE, domestic private and foreign investment enterprises); (d) Type of industry (measured with dummy variables for export-oriented, import-substituting and non-tradable industry);7 (e) Export participation in the previous year (dummy variable); (f) Availability of credit (financial leverage measured in terms of total assets divided by shareholder equity); (g) Business linkages (measured as the logarithm of the number of large enterprises or large export-oriented enterprises in the industry); 7

An industry has been defined as export-oriented if its exports are larger than its imports and exports are more than 10 per cent of industry gross output; import-substituting if its imports are larger than its exports and imports are more than 10 per cent of industry gross output; and non-tradable otherwise.

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(h) Year that dummies control for differences in macroeconomic environment over time; (i)

Regional dummy variable control for other regional determinants of performance, such as access to markets, the quality of local infrastructure or the availability of natural resources.

The logistic model was estimated by using pooled data from the 2000, 2003 and 2004 Enterprise Surveys of the General Statistics Office, during the preparation of which export information was collected. The estimation results are set out in table 8. The more productive and larger enterprises were found to have a higher probability of participating in export activities. These findings complement earlier studies on SMEs, which showed that a very small proportion of private SMMEs participated in exports and that exporters tended to be large in size (Vietnam Development Information Center, 2004; Kokko and Sjöholm, 2004). Foreign investment enterprises were found to have a higher chance of participating in export activities than their domestic private and SOE counterparts. Financial constraints did not appear to influence the determination of export participation by SMMEs.8 However, this finding should be interpreted with care because it is widely known that SOEs in Viet Nam still benefited from cheaper credit and better access to land and Government procurement policies (O’Connor, 1998; Tenev and others, 2003) prior to July 2006 (when the Law on Investment of 2005 became effective), while foreign investment enterprises were required to have legal capital of more than 30 per cent of their investment capital. Regressions (1), (2) and (4) in table 8 show that the number of large enterprises or export-oriented large enterprises in the industry was significant, which raised the likelihood of export participation by SMMEs. This implies that there were business linkages between large enterprises and SMEs within the industry. Regression (3) confirms the findings that enterprises were more likely to participate in exporting if they were operating in exportoriented industries in which Viet Nam had a comparative advantage in international markets. Regression (4) shows that being an exporter in the previous year significantly increased the probability of remaining an exporter in either 2003 or 2004 or both. The year dummies in table 8 suggest a rather pessimistic finding of a declining trend in export participation by SMMEs9 in relative terms. Enterprises located in the south-east region were more likely to engage in export activities, while enterprises located in the Northern Uplands and the Mekong delta regions were less likely to do so. 8

9

98

Annex I shows that, in 2004, only about 4 per cent of SMMEs were State-owned, while 86 per cent were domestic private enterprises and nearly 10 per cent were foreign investment enterprises. About 4.5 per cent of SMMEs became large manufacturing enterprises during the period 2000-2003 and some 2.1 per cent did so during the period 2003-2005.

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Table 8. Logistic model of export participation by a manufacturing SME, 2000, 2003 and 2004 (pooled data) Regression with robust standard errors and clusters (ISIC industry classifications at the two-digit level). Pooled data: 2000, 2003 and 2004. Number of observations 39 085 39 085 39 085 30 163 Wald chi2 (17) 10 282.18 6 401.57 7 625.45 9 974.25 Prob. > chi2 0.0000 0.0000 0.0000 0.0000 Pseudo R2 0.3022 0.3152 0.3112 0.3768 Log pseudo-likelihood -12 346.85 -12 116.80 -12 187.06 -8 463.24 Number of clusters (industry) 23 23 23 23 Regressions (1)

Ln (annual real revenue per employee) Small* Small to medium* Medium* Domestic non-SOE * Foreign investment enterprise* Financial leverage Ln (number of large enterprises in industry) Ln (number of large exportoriented enterprises in industry) Import industry * Small export-import industry Export in previous year* Year 2003* Year 2004* North-east* North-west* North central coast* South central coast* Central Highlands* South-east* Mekong delta* Intercept

(2)

(3)

(4)**

Coef.

Robust std. err.

Coef.

Robust std. err.

Coef.

Robust std. err.

Coef.

Robust std. err.

0.153b

0.036

0.169b

0.028

0.143b

0.026

0.082b

0.026

1.514b 2.820b 3.262b 0.965b 3.001b 0.00015 0.438b

0.185 0.213 0.197 0.208 0.224 0.000 0.158

1.536b 2.819b 3.247b 0.816b 2.896b 0.00013 -

0.183 0.217 0.192 0.155 0.168 0.000 -

1.552b 2.863b 3.315b 0.881b 2.921b 0.00014 -

0.173 0.198 0.173 0.188 0.189 0.000 -

1.341b 2.369b 2.751b 1.070b 2.954b 0.00018 0.404b

0.182 0.199 0.202 0.187 0.187 0.000 0.147

-

-

0.503b

0.113

-

-

-

-

-0.547b -0.483b -0.646b -0.480 -0.141 0.254 0.586 0.967b -0.900b -7.174b

0.119 0.126 0.210 0.252 0.234 0.296 0.370 0.144 0.331 0.796

-0.402b -0.509b -0.659b -0.487a -0.110 0.233 0.529 0.950b -0.980b -7.147b

0.104 0.116 0.198 0.218 0.249 0.287 0.374 0.143 0.327 0.545

-0.908 b -1.701 b -0.468 b -0.276 b -0.687 b -0.467 a -0.089 0.206 0.468 1.008 b -0.914 b -4.642 b

0.266 0.447 0.107 0.069 0.215 0.227 0.305 0.305 0.458 0.152 0.336 0.478

2.322b -0.161a -0.725b -1.173b -0.155 0.168 0.343 0.847b -0.672a -7.293b

0.181 0.070 0.251 0.400 0.299 0.272 0.407 0.149 0.267 0.751

Source: Viet Nam, General Statistics Office, Enterprise Surveys, 2000, 2003 and 2004. Notes: Coefficients in bold are significant at the 10 per cent level; a significant at the 5 per cent level; b significant at the 1 per cent level; * dummy variables. ** In model (4), the year 2000 has been dropped. Abbreviations: ISIC – International Standard Industrial Classification; Coef. – coefficient; std. err. – standard error.

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(b) Determinants of the performance of export-oriented SMMEs This section considers the performance of export-oriented SMMEs between 2000 and 2005. Performance is driven by the quantity and quality of the labour and capital used, as well as other variables used in the logistic model, i.e. enterprise characteristics, industry of operation, export experience (X), business linkages, regions and so forth (Z), but excluding enterprise size and the availability of credit because of multicollinearity10 (see annex III). It is impossible to know, a priori, which factors are the most important for the performance of export-oriented SMMEs and must be investigated. Let Y be an enterprise performance variable of interest (revenue or revenue growth 11 and labour growth of the enterprise). It is naturally related to various characteristics of the enterprise, denoted as X1, …, Xk or, in shorthand (vector) notation, as X. If the business climate and infrastructure variables matter, Y is also related to Z1 through Zk. Therefore, the model can be demonstrated with the following equation: Yi = F(Xi, Zi, uyi) where uyi is a random disturbance, capturing unmeasured determinants of, and stochastic influences on, enterprise revenue and its growth. The model is estimated by single-equation regression techniques. These techniques assume that explanatory variables are exogenous; in other words, they are not manipulated in response to enterprise revenue. Yet, according to Glewwe (1999), within the model, the simultaneously determined inputs (such as capital and labour) and industries of enterprises are likely to be endogenous. Therefore, the inclusion of these variables in the model can cause a simultaneity bias for ordinary least squares estimates. To remedy such a bias, these variables are excluded from the model, and two models are estimated: (a) without inputs and industries, referred to as the reduced form specification; and (b) with inputs and industries, referred to as the structural form specification. Enterprise revenue in year t is measured by annual revenue at current prices. To reduce the impact of outliers and deal with heteroscedasticity,12 this variable is specified in 10

11

12

Multicollinearity is caused by correlations among the explanatory variables, i.e. the correlation between enterprise size and labour, and the correlation between financial leverage and capital. This reduces the precision of the estimated impact of each one of them. Enterprise revenue growth between year t1 and year t0 is the difference in the natural logarithm of enterprise real revenue, which gives the proportional difference in real revenue or, in other words, the percentage change in real revenue between year t0 and year t1. The real annual revenue is adjusted by the annual producer’s price index of industrial products and expressed in 1995 prices. The revenue growth regression model has been estimated for the sample of export-oriented SMMEs. However, due to limited space, we do not report the estimated results of revenue growth of export-oriented SMMEs in this paper. To make sure of the presence of heteroscedasticity in the regressions, the White test and the Breusch-Pagan/ Cook-Weisberg test are applied for investigation.

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logarithmic fashion and the regressions are estimated with robust standard errors and cluster by industry at the two-digit International Standard Industrial Classification (ISIC) level. This means that slope estimates indicate the proportional impact of a one-unit change in Z on Y. The model is estimated by using cross-sectional data from the 2000, 2003 and 2004 Enterprise Surveys. The labour growth of an enterprise between year t1 and year t0 is the difference in the natural logarithm of total employees of the enterprise. The growth regression model is estimated based on the sample of surviving panel enterprises between year t0 and year t1. The independent variables refer to conditions in year t0, so the regression attempts to find determinants of future labour growth. The model is estimated by using panel data from Enterprise Surveys between 2000 and 2001, 2003 and 2004, and 2004 and 2005. The labour growth regression model is estimated for the sample of all SMMEs between year t0 and year t1 to examine whether or not export-oriented SMMEs are better at generating jobs than inward-oriented SMMEs. The average values of the proportional difference in the real revenue of exportoriented SMMEs between 2000 and 2001, 2003 and 2004, and 2004 and 2005 are 0.18, 0.21 and 0.18, respectively. This means that the annual average revenue growth rate of the surviving export-oriented SMMEs is almost the same as the average growth rate of the industrial exports volume of nearly 19.3 per cent per year during the period 2001-2005. The average values of the proportional difference in total employees of SMMEs between 2000 and 2001, 2003 and 2004, and 2004 and 2005 are 0.05, 0.20 and 0.21, respectively. The estimated results for the reduced form specification and the structural form specification are almost the same in terms of the significant effects of the explanatory variables on the performance of export-oriented SMMEs, except for the ownership dummy variable in the revenue models in 2000 and 2003 and the regional dummy variable in the revenue models in 2000, 2003 and 2004. The estimated results in table 9 show that both capital and labour are statistically associated with higher revenue for export-oriented SMMEs. Relative to SOEs (the omitted ownership dummy), the average revenue of domestic and foreign investment enterprises is significantly lower. Being an exporter in the previous year has statistically significant effects on the increase in revenue. The estimated results13 for the labour growth of SMMEs in table 10 show that, relative to inward-oriented SMMEs (the omitted dummy), the average labour growth of export-oriented SMMEs is significantly higher between 2004 and 2005 but not in earlier

13

The ordinary least squares estimates of the labour growth of all surviving enterprises in the panel data do not have much explanatory power; the R2-values are between 0.015 and 0.05. As might be expected, since the growth rate depends on two noisy measures (e.g. labour in year t0 and labour in year t1), the models explain only between 1.5 per cent and 5 per cent of the variation in the growth rates.

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Linear regression Ordinary least squares estimates in the presence of arbitrary heteroscedasticity and clusters (ISIC industry classifications at the two-digit level) Number of observations 1 532 1 532 2 214 2 214 2 798 R-squared 0.6150 0.1773 0.6411 0.1590 0.6498 Number of clusters (industry) 23 23 23 23 23 2000

2003

Regressions (1)

Dependent variable: Log (annual current revenue) Ln (labour) Ln (capital) Domestic non-SOEs* Foreign investment enterprises* Ln (number of large enterprises in industry) Exports in previous year* North-east* North-west* North central coast* South central coast* Central Highlands* South-east* Mekong delta* Intercept

Coef.

Robust std. err.

0.184a 0.813b 0.035 -0.479b 0.010

0.067 0.041 0.096 0.144 0.136

-0.230 -0.999b -0.408 0.352 -0.162 0.057 0.480a 0.885

0.216 0.304 0.213 0.217 0.176 0.138 0.181 0.637

2004

Regressions (2)

Coef.

-1.377b -0.129 -0.098

-0.339 -1.801a -0.591a 0.379 0.204 0.336b 0.603a 9.825b

(1)

Robust std. err.

2 798 0.1822 23

Regressions (2)

Coef.

Robust std. err.

0.165 0.137 0.199

0.302b 0.767b -0.347 -0.761a -0.068

0.055 0.050 0.309 0.336 0.114

-1.852b -1.026b -0.204

0.268 0.683 0.250 0.187 0.212 0.111 0.253 0.834

0.219b -0.107 -0.798 -0.122 0.202 -0.249a 0.200a 0.456a 1.304

0.055 0.216 0.528 0.113 0.125 0.103 0.075 0.186 0.685

0.745b -0.020 -1.477a -0.125 0.333b 0.043 0.391b 0.437 10.817b

Coef.

(1) Robust std. err.

(2)

Coef.

Robust std. err.

0.356 0.304 0.182

0.275b 0.781b -0.164a -0.583a -0.130

0.068 0.167 0.525 0.268 0.106 0.341 0.098 0.292 0.832

0.355a -0.555 -0.515b -0.039 0.341 -0.187 0.222b 0.350a 1.310a

Coef.

Robust std. err.

0.035 0.039 0.060 0.079 0.097

-1.937b -1.196b -0.303

0.178 0.151 0.176

0.051 0.277 0.142 0.057 0.181 0.118 0.055 0.153 0.571

0.742b -0.335 -1.931b 0.103 0.483b -0.014 0.390b 0.370 11.343b

0.066 0.293 0.247 0.136 0.140 0.277 0.121 0.288 0.882

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Source: Viet Nam, General Statistics Office, Enterprise Surveys, 2000-2005. Notes: Regression (1) is a structural form specification; regression (2) is a reduced-form specification; Coefficients in bold are significant at the 10 per cent level; a significant at the 5 per cent level; b significant at the 1 per cent level; * dummy variables. Abbreviations: ISIC – International Standard Industrial Classification; Coef. – coefficient; std. err. – standard error.

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Table 10. Determinants of the labour change of SMMEs Linear regression Ordinary least squares estimates in the presence of arbitrary heteroscedasticity and cluster (ISIC industry classifications at the two-digit level) Number of observations 6 297 11 567 13 829 R-squared 0.0508 0.0154 0.0313 Number of clusters (industry) 22 23 23 2001-2000

Dependent variable: “Log (total employees t1)” – “Log (total employees t 0)” Export-oriented* Small* Small to medium* Medium* Domestic non-SOEs* Foreign investment enterprises* Ln (number of large enterprises in industry) North-east* North-west * North central coast* South central coast* Central Highlands* South-east * Mekong delta * Intercept

Coef.

Robust Std. Err.

0.048 -0.260b -0.329b -0.347b -0.025 0.058 -0.029b -0.002 -0.080 -0.032 -0.082a -0.047 -0.024 -0.178b 0.455b

2004-2003

2005-2004

Coef.

Robust Std. Err.

Coef.

Robust Std. Err.

0.033 0.033 0.035 0.030 0.021 0.027 0.009

-0.041 -0.045 -0.065 -0.105 0.217b 0.454b -0.056a

0.028 0.073 0.083 0.088 0.038 0.046 0.021

0.049b -0.187b -0.267b -0.260b 0.053 0.159b -0.014b

0.016 0.025 0.034 0.042 0.039 0.042 0.004

0.043 0.039 0.026 0.033 0.054 0.022 0.023 0.068

0.030 0.141 0.084 0.039 0.002 -0.012 -0.092a 0.289b

0.058 0.172 0.080 0.036 0.059 0.034 0.040 0.096

-0.018 -0.048 -0.056 0.011 -0.057 -0.036 b -0.054 b 0.203 b

0.021 0.052 0.034 0.025 0.042 0.011 0.011 0.041

Source: Viet Nam, General Statistics Office, Enterprise Surveys, 2000-2005. Notes: Coefficients in bold are significant at the 10 per cent level; a significant at the 5 per cent level; b significant at the 1 per cent level; * dummy variables. Abbreviation: ISIC – International Standard Industrial Classification; Coef. – coefficient; std. err. – standard error.

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years. This means that export-oriented SMMEs may have become better than inwardoriented SMMEs at generating jobs. The average labour growth of micromanufacturing enterprises is significantly higher than that of other SMMEs. Relative to SOEs (the omitted ownership dummy), the average labour growth of foreign investment enterprises is significantly higher.14 Although the number of large manufacturing enterprises in the industry does not appear to have statistically significant effects on the performance of export-oriented SMMEs in all regressions between 2000 and 2005, there is evidence of increasingly fiercer competition in the market between large manufacturing enterprises and SMMEs in the same industry. We find that the performance of export-oriented SMMEs operating in tradable industries is no better, statistically, than that of enterprises operating in import-substituting industries or non-tradable industries, but we do not report the estimated results here. Relative to the Red River delta (the omitted regional dummy), the average enterprise revenue on the south central coast and in the south-east and the Mekong delta is significantly higher, while the average enterprise revenue in the Northern Uplands is significantly lower.

4.

CONCLUSION AND POLICY IMPLICATIONS

The liberalization of Viet Nam’s business environment, together with the increased integration of the country into the world economy, has resulted in the rapid expansion of the SME sector, especially since 2000. By the end of 2005, SMEs in Viet Nam accounted for more than 95 per cent of all enterprises, 40.5 per cent of the workforce in the formal enterprise sector and 34 per cent of the total assets utilized by all enterprises. SMEs dominate in the service sector. Most SMEs are owned by the domestic private sector, while domestic private and foreign investment enterprises together account for the largest proportion of export-oriented SMMEs. SMEs are more concentrated in the developed regions (the Red River delta, the south-east and the Mekong delta) and have opportunities to expand in the underdeveloped regions. However, export-oriented SMMEs are mainly concentrated and expanding in the south-east. Compared with SMEs, the size of export-oriented SMMEs tends to be larger, placing them in the medium-sized category, while the majority of SMEs belong to the small enterprise category. The rapid expansion of the SME sector, together with significant improvements in trade policies that moved away from inward-oriented import substitution towards outward orientation, resulted in a rapid increase in the number of export-oriented SMMEs, which had a compound annual growth rate of 16 per cent between 2000 and 2004. About 17 per 14

However, all results on labour growth performance should be interpreted cautiously and would warrant further investigation, given the low explanatory power of the overall model.

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cent of SMMEs are involved in export activities. The export-oriented SMMEs accounted for 36 per cent of the workforce of all SMMEs, 45 per cent of the total assets utilized by all SMMEs and about 42 per cent of the industrial output of all SMMEs. During the period 2001-2005, these enterprises performed well and achieved an annual average growth rate that equalled the average growth rate of industrial exports. However, the rate of return on the capital of SMMEs, on average, was very low and much less than the average market interest rate; nearly one third of all SMMEs were operating at a loss. Although the share of export-oriented SMMEs in the SMME sector showed a declining trend, performance and profitability increased during the last few years. The plant closure and job destruction rates of export-oriented SMMEs were lower than those of inward-oriented SMMEs and showed a declining trend. The analysis presented in this paper confirms that medium-sized manufacturing enterprises were more likely to become exporters. Those SMMEs operating in export-oriented industries that were owned by foreign investors, had previous experience as exporters and were located in the south-east and Red River delta regions15 had a higher probability of participating in the export market. More interestingly, the export-oriented SMMEs were more likely to expand their operations, generate more jobs and become large enterprises than were inward-oriented SMMEs. These findings strongly support the self-selection hypothesis, according to which firms need to be efficient to survive and thrive in the highly-competitive export markets, and the idea that production cost advantages may be gained through economies of scale. Increasingly sustainable development is occurring among the export-oriented SMMEs and the export-oriented SMME sector is becoming more efficient and highly productive. SMMEs benefit from integration and increased trade liberalization through improved performance, while the large export-oriented manufacturing enterprises play an important role in boosting direct export participation by SMMEs. Therefore, policies that address this externality by: (a) supporting the development of business linkages and networking; and (b) promoting subcontracting arrangements between small and large enterprises, or between domestic enterprises and foreign investment enterprises, will greatly assist SMMEs in improving performance and increasing the benefits of integration. It is also necessary to support and facilitate efforts by SMMEs to engage in exporting, either directly or indirectly through large manufacturing enterprises. In addition to the traditional factors determining the performance of exportoriented SMMEs (i.e. capital and labour), form of ownership, location and previous experience in exporting in other sectors are significant determinants of the performance of 15

These regions have better infrastructure, as well as port and logistics facilities and better access to international market information, capital and human resources, stronger business linkages, and networking between SMEs and large enterprises in the industry.

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export-oriented SMMEs. In addition, foreign investment enterprises tend to grow more rapidly than do domestic enterprises and SOEs. Earlier studies have explicitly indicated the financial constraints faced by SMEs, as well as the practice among banking and financial institutions to favour financing for SOEs and large enterprises. However, the findings detailed in this paper do not appear to support the hypothesis that financial constraints hinder export participation by SMMEs or the performance of export-oriented SMMEs. This may be interpreted as meaning that export-oriented SMMEs: (a) are among the most dynamic, efficient and productive SMMEs; (b) are usually large in size; and (c) have the potential to develop. Therefore, these enterprises can be expected to gain access to financial sources more easily than other SMEs. Viet Nam has made great efforts during the past decade to remove obstacles to doing business, especially to market entry. However, to enable SMMEs to continue operating smoothly and effectively, succeed in highly competitive export markets and reduce the regional differences in export participation, substantial investment in infrastructure and industrial support facilities and services (i.e. roads, ports, logistics, facilities and services, and market information) is required in the underdeveloped regions of the country. Such investment should be prioritized and implemented first in those regions with the highest development potential, i.e. the north central coast, the south central coast and the Mekong delta.

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REFERENCES Bellone, F., P. Musso, L. Nesta and M. Quéré (2006). “Productivity and Market Selection of French Manufacturing Firms in the Nineties”, OFCE Working Paper No. 4 (Paris, Observatoire Français des Conjonctures économiques), February. Glewwe, Paul W. (1999). The Economics of School Quality Investments in Developing Countries: An Empirical Study of Ghana (New York, St. Martin’s Press). Goreski, Paul A. (1995). “What do we know about entry?”, International Journal of Industrial Organization, vol. 13, No. 4, pp. 421-440. Hahn, Chin-Hee (2000). Entry, Exit, and Aggregate Productivity Growth: Micro Evidence on Korean Manufacturing, Economics Department Working Paper No. 272 (Paris, Organisation for Economic Co-operation and Development). Kawai, Hiroki and Shinjiro Urata (2001). Entry of Small and Medium Enterprises and Economic Dynamism in Japan (Washington, D.C., World Bank Institute). Kokko, Ari and Fredrik Sjöholm (2004). “The Internationalization of Vietnamese SMEs”, Working Paper No. 193 (Stockholm, Stockholm School of Economics). Mekong Economics Ltd. (2002). SOE Reform in Vietnam: Background Paper (Hanoi). O’Connor, David (1998). “Rural industrial development in Vietnam and China: A study in contrasts”, MOCT-MOST: Economic Policy in Transitional Economies, vol. 8, No. 4, pp. 7-43. Oostendorp, Remco H., Tran Quoc Trung and Nguyen Thanh Tung (2006). “The Changing Role of Non-farm Household Enterprises in Vietnam”, Working Paper (Hanoi, Vietnam Economic Research Network). Tenev, Stoyan, Amanda Carlier, Omar Chaundry and Quynh-Trang Nguyen (2003). Informality and the Playing Field in Vietnam’s Business Sector (Washington, D.C., International Finance Corporation). Tybout, James R. (2000). “Manufacturing firms in developing countries: How well do they do, and why”, Journal of Economic Literature, vol. XXXVIII, pp. 11-44. Viet Nam (2003). “WTO accession and Vietnamese manufacturing firms: Awareness, perception and possible responses”, National Centre for Social Sciences and Humanities, Institute of Economics, paper presented at WTO Accession Forum, Hanoi. _____ (2005). SME Development Plan 2006-2010 and Action Plan for its Implementation (Hanoi, Ministry of Planning and Investment). _____ (2006). The Five-Year Socio-Economic Development Plan, 2006-2010 (Hanoi, Ministry of Planning and Investment). 107

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_____ (various years), Enterprise Surveys, (Hanoi, General Statistics Office). Vietnam Development Information Center (2004). Vietnam Development Report 2005: Governance, Joint Donor Report to the Vietnam Consultative Group Meeting, Hanoi, 1-2 December.

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Annex I. SMEs, SMMEs and export-oriented SMMEs in Viet Nam, 2004 (Percentage, unless otherwise specified) SMEs Enterprises Number of enterprisesa Percentage of all enterprises Distribution of enterprises by:

Manufacturing SMEs

Export-oriented manufacturing SMEs

88 222 96.2 100.0

16 389 17.9 100.0

2 810 3.1 100.0

Ownership SOEs Domestic non-SOEs Foreign

3.4 93.9 2.8

3.7 86.5 9.8

3.3 57.8 38.9

Region Red River delta North-east North-west North central coast South central coast Central Highlands South-east Mekong delta Others

27.4 6.8 1.2 5.9 6.8 3.1 34.5 14.2 0.1

28.1 5.1 0.6 4.2 5.4 1.9 38.6 16.0 0.2

17.5 1.7 0.1 2.3 3.9 2.0 67.6 5.1 0.0

Size Micro Small Small to medium Medium

50.4 43.5 4.4 1.7

23.8 60.8 10.6 4.8

4.1 54.3 26.5 15.2

2 212 289 38.3

788 856 13.7

25.1

48.1

282 851 4.9 35.9 100.7

701 168.1

172 186.9

76 903.4

32.4

8.0

3.6

Employment Employment (persons) Percentage of all employeesb Percentage of manufacturing SMEs Number of persons engaged per enterprise Assets Total assets (billions of Vietnamese dong) Percentage of total assets utilized by all enterprisesc Percentage of total assets utilized by manufacturing SMEs Total assets utilized per enterprise (billions of Vietnamese dong)

44.7 8.0

10.5

27.4

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SMEs Performance Total revenue per employee per enterprise (millions of Vietnamese dong at the current price) Total profit per employee per enterprise (millions of Vietnamese dong at the current price)

Manufacturing SMEs

Export-oriented manufacturing SMEs

457.3

237.3

340.9

2.1

2.4

5.3

Source: Viet Nam, General Statistics Office, Enterprise Surveys, 2000-2005. a Notes: Includes formally registered enterprises but excludes household enterprises; b Equal to total employees of SMEs (total employees of SMEs and large enterprises); c Equal to total assets of SMEs (total assets of SMEs and large enterprises).

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Annex II. Export-oriented SMMEs, 2004 (Percentage, unless otherwise specified) Start-up and new exportoriented SMMEsc

Total

220 100.0

1 331 100.0

2 163 100.0

9.1 64.1 26.8

1.7 58.4 40.0

3.6 56.4 40.0

22.3 1.8 0.0 2.3 2.7 1.4 61.8 7.7

17.5 1.1 0.2 2.6 4.2 1.7 67.8 4.8

17.0 1.3 0.1 2.5 4.1 2.1 67.9 5.1

1.4 50.9 31.4 16.4

4.2 56.3 25.5 14.0

3.1 53.0 27.4 16.4

107.2

97.1

105.5

41.5

21.2

29.0

536.4

320.6

380.1

15.3

3.2

8.4

Old export- New exportoriented oriented SMMEsa SMMEsb Enterprises Number of enterprisesd 612 Distribution/category of enterprise by: 100.0 Ownership SOEs 5.9 Domestic non-SOEs 49.2 Foreign 44.9 Region Red River delta 13.9 North-east 1.3 North-west 0.0 North central coast 2.1 South central coast 4.4 Central Highlands 3.3 South-east 70.1 Mekong delta 4.9 Size Micro 1.5 Small 46.7 Small to medium 30.1 Medium 21.7 Employment Number of persons engaged 123.0 per enterprise Assets Total assets utilized per enterprise 41.6 (billions of Vietnamese dong) Performance Total revenue per employee per 453.2 enterprise (millions of Vietnamese dong) Total profit per employee per enterprise 17.2 (millions of Vietnamese dong)

Source: Viet Nam, General Statistics Office, Enterprise Surveys, 2000-2005. a Notes: Enterprises involved in export activities in 2000; b Enterprises which went from inward-oriented in 2000 to export-oriented in 2004; c Enterprises which were newly established between 2000 and 2004 and were involved in export activities in 2004; d Includes only enterprises in panel data between 2003 and 2004.

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Annex III. Definitions of variables Variable

Definition

Dependent variable in table 8

Outcome of being an enterprise involved in export activities or not in 2000, 2003 or 2004: exporter (1) and non-exporter (0)

Dependent variable in table 9

Logarithm of annual revenue at current prices in 2000, 2003 or 2004

Dependent variable in table 10

Difference in the natural logarithm of total employees between 2001 and 2000, 2004 and 2003, or 2005 and 2004

Ln (labour)

Natural logarithm of total labour of the enterprise

Ln (capital)

Natural logarithm of total assets of the enterprise

Ln (annual real revenue per employee)

Natural logarithm of annual real revenue per employee in 2000, 2003 or 2004 (in VND million at 1995 prices)

Export-oriented*

Dummy variable, = 1 if enterprise is involved in export activities

Small*

Dummy variable, = 1 if enterprise has an average number of annual permanent employees from 11 to 100

Small to medium*

Dummy variable, = 1 if enterprise has an average number of annual permanent employees from 101 to 200

Medium*

Dummy variable, = 1 if enterprise has an average number of annual permanent employees from 201 to 300

Domestic non-SOE*

Dummy variable, = 1 if enterprise is domestic private

Foreign investment enterprise*

Dummy variable, = 1 if enterprise is foreign investment

Financial leverage

Total assets divided by shareholder equity

Ln (number of large enterprises in industry)

Natural logarithm of number of large manufacturing enterprises in industry

Ln (number of large exportoriented enterprises in industry)

Natural logarithm of number of large export-oriented manufacturing enterprises in industry

Import industry*

Dummy variable, = 1 if enterprise operates in import substituting industry

Small export-import industry*

Dummy variable, = 1 if enterprise operates in small exportimport industry

Exports in previous year*

Dummy variable, = 1 if enterprise was involved in export activities in previous year (2000 or 2003)

Year 2003*

Dummy variable, = 1 if enterprise is in the Enterprise Survey in 2003

Year 2004*

Dummy variable, = 1 if enterprise is in the Enterprise Survey in 2004

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Variable

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Definition

North-east*

Dummy variable, = 1 if enterprise is located in north-east

North-west*

Dummy variable, = 1 if enterprise is located in north-west

North central coast*

Dummy variable, = 1 if enterprise is located on north central coast

South central coast*

Dummy variable, = 1 if enterprise is located on south central coast

Central Highlands*

Dummy variable, = 1 if enterprise is located in Central Highlands

South-east*

Dummy variable, = 1 if enterprise is located in south-east

Mekong delta*

Dummy variable, = 1 if enterprise is located in Mekong delta

Note:

* Dummy variables.

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Policy options for establishing effective subnational innovation systems and technological capacity-building Deok Soon Yim and Byung-Sam Kang*

ABSTRACT

A

subnational innovation system can be defined as an innovation system at the subnational level that is composed of the local government; local universities; local industries, especially small and medium-sized enterprises; financial institutes; and consulting companies within a certain public administrative district and that has formal and informal networks among the actors. Previous studies done by various scholars such as Saxenian (1994 and 1999) and Porter (1998) were reviewed to gain a clear understanding of subnational innovation systems. Those research results emphasize networks among firms, research institutes and universities, and an innovative culture, among other things. In subnational innovation systems, the innovation value can be created through value creation processes, which are scientific and technological knowledge creation, knowledge transfer, and knowledge utilization, with the sharing of knowledge, innovative culture and financial resources. Therefore, policies on subnational innovation systems emphasize local specificity, the networking of actors and competitiveness through innovation. As subnational innovation systems are closely (continued on page 116)

*

Deok Soon Yim, Research Fellow, Gyeonggi Research Institute, Republic of Korea; Byung-Sam Kang, former NRL Expert on Technology Innovation and Enterprise Development, Private Sector and Development Section, Trade and Investment Division, and currently NRL Expert on Space Technology for Disaster Risk Reduction, Information and Communications Technology and Disaster Risk Reduction Division, ESCAP, Bangkok.

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(continued from page 115)

linked to national innovation systems, it is also necessary to design policy in the context of national innovation systems. In addition, it is recommended that the policies on small and medium-sized enterprises, national innovation systems and subnational innovation systems be harmonized so that these policies can bring about a coherent synergy. In the last section, policy guidelines for planning, implementation and evaluation are presented. For the planning process, it is important to analyse the internal and external conditions for innovation and identify its target areas in industry or technology. Then, there have to be some future scenarios and some goals set, either in quantitative or qualitative terms. The harmony among policies on subnational innovation systems, industry, and trade or foreign direct investment should always be taken into consideration. In the implementation stage, concerted innovation efforts by relevant actors are most important. Even if the enterprise is the key actor, both national and local governments should provide various incentive schemes for those involved to work together and learn from each other. The World Trade Organization (WTO) regime and intellectual property rights norms should be respected. If an effective committee is composed, it could expedite policy implementation. In addition, policy on subnational innovation systems requires more social consensus because it aims to establish such systems in the long term. Finally, the process of building a subnational innovation system should be properly evaluated on the basis of appropriate assessment tools. The evaluation criteria (or measures) can be classified into three categories: input measure, throughput measure and output measure. The results of the evaluation should be fed back into the processes of setting goals and making implementation policies. If the results of the evaluation suggest that the original goals were set too high, they could also be modified.

1.

INTRODUCTION

Innovative small and medium-sized enterprises (SMEs) play a pivotal role in raising the growth potential of national economies. Having fewer internal resources than large firms, SMEs often face difficulties in accessing the technologies, knowledge and know-how needed to build their own innovative capabilities and reach their markets. Generally speaking, it is hard for SMEs to innovate and grow on their own internal resources. In this regard, the establishment and strengthening of an innovation system for SMEs is important. 116

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Many developing countries in the Asia-Pacific region have very fragmented innovation systems and, thus, their indigenous innovation capacity is very weak. The framework of a subnational innovation system can be effective in addressing this issue. It is important to note that policies based on subnational innovation systems focus on industrial development and enhancing the competitiveness of local enterprises through technology and innovation capacity-building. Against this background, ESCAP implemented the technical cooperation project entitled “Subnational Innovation Systems and Technology Capacity-building Policies to Enhance Competitiveness of SMEs” from June 2005 to July 2007. With this project, ESCAP aimed to provide policymakers with the capacity necessary for policymaking to promote local SME competitiveness based on an effective subnational innovation system. As a result of the project, ESCAP disseminated a comprehensive publication, Enhancing the Competitiveness of SMEs: Subnational Innovation Systems and Technological Capacity-building Policies, in 2007. Still, member countries need to understand the concept of subnational innovation systems more clearly and to receive substantial guidance in a condensed form which can be used easily in the field. This article combines the main overview of the concept of subnational innovation systems drawn from the above-mentioned publication with concise guidance for the policymakers of ESCAP member countries on how to build a subnational innovation system in a region or country. The definitions of innovation of several scholars and the concept of the subnational innovation system are introduced in sections 1-3. In the following section, Government policies on small and medium-sized enterprises (SMEs) that are based on subnational innovation systems are explained in the context of today’s business environment. The last section contains guidance and policy options which could be useful to have on hand when building subnational innovation systems from the planning through the implementation stages.

2.

RELATED CONCEPTS

In this section, related concepts are reviewed and definitions are presented. First, there are two important concepts: invention and innovation. Often, invention is confused with innovation, but there is clear difference between them. While the invention is focused on finding new things or concepts, the innovation is rather oriented towards using something new to create value, whether it is economic or not. It can be said that the innovation is not completed until someone successfully implements the invention and makes money on an idea. In this sense, we may consider the following definitions: “Innovation…is generally understood as the introduction of a new thing or method… Innovation is the 117

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embodiment, combination, or synthesis of knowledge in original, relevant, valued new products, processes, or services.” (Luecke and Katz, 2003) “Innovation is the lifeblood of any organization, without it, not only is there no growth, but, inevitably, a slow death.”1 Another important concept is the national innovation system. The basic idea of a national innovation system was based on the realization of the importance of the system in innovation activities. Modern science and technology policies have evolved over time since the military research and development efforts in the First and Second World Wars. In the old days, policymakers directed their attention to the development of technology by managing research and development projects. However, people started to realize that innovation comes out of very complex processes with many actors involved: not only researchers but also consumers, government and so on. Recent theories emphasize the systemic characteristics of innovation, rapid technological change and globalization. Freeman (1995) and Metcalfe (1995), respectively, also emphasized the importance of networks and systems and defined the national innovation system as follows: “the network of institutions in the public and private sectors whose activities and interactions initiate, import, modify and diffuse new technologies”; “that set of distinct institutions which jointly and individually contribute to the development and diffusion of new technologies and which provide the framework within which governments form and implement policies to influence the innovation process. As such it is a system of interconnected institutions to create, store and transfer the knowledge, skills and artefacts which define new technologies”.

SUBNATIONAL INNOVATION SYSTEM2

3.

In this section, the concept of the subnational innovation system will be explained by comparing it with the national innovation system. In addition, the success factors of subnational innovation systems will be introduced, with a brief review of other successful innovation clusters as examples.

(a) National versus subnational innovation system Nowadays, science and technology are understood in the context of the innovation system, which means that there are many related actors, while the development and utilization of science and technology take place through complex processes. The research 1

2

This citation appears on the website “Pearls of Wisdom from Inventor Don Sheelen” (www.donsheelen.com/ page1.aspx). Most of this section was adapted from Yim (2006).

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institutes produce science and technology results, which, to be utilized, need more actors, such as a technology transfer centre, a venture capital fund, a bank, a managerial consulting company or an entrepreneur. It is important to see that not only research and development institutes but also banks, governments, and markets are working together in the innovation process. It is also important to go beyond research and development and to see innovation as the final outcome or goal of the national innovation system. Innovation is a resultsoriented concept. It is not assumed that good science and technology automatically lead to good innovation. It is rather assumed that something more (such as marketing, commercialization or financing) is needed to turn good science and technology into real innovation. Among the various models and theories on innovation, the subnational innovation system has its background and roots in the national innovation system and the innovation cluster. From the 1990s onward, the national innovation system theory has attracted the attention of many policymakers. The national innovation system model started to focus more on relations and processes between various innovation actors. In addition, many people from various backgrounds started to study the concept of the innovation cluster. Not only researchers in science and technology policy, but also researchers in economic geography, urban planning and sociology adopted the perspective of the innovation cluster. For example, Saxenian (1994 and 1999) compared Silicon Valley with the Route 128 area around Boston, Massachusetts in the United States of America and concluded that the innovative culture and organizational network in Silicon Valley were the most important factors explaining its prosperity and successful development. In the national innovation system and/or innovation cluster model, the main elements of interaction are knowledge, money and people. The main activities are knowledge creation and the transfer and utilization of such knowledge in the market. For this purpose, all innovation actors interact with each other and exchange knowledge, financial and human resources. While the national innovation system model is a rather abstract concept, the innovation cluster model can provide practical guidelines for policy on subnational innovation systems. It is important to note that innovation takes place in a certain area as a result of the interaction between the market and innovation actors. In this sense, an innovation cluster can be said to be a reduced national innovation system. Innovation cluster theory includes multidisciplinary perspectives from sociology, economic geography, network theory and industrial organization theory. This systemic perspective implies that policymakers should emphasize not only the quantitative aspect of science and technology policy, such as science and technology investment and the number of research and development personnel, but also the management of science and technology resources.

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Figure 1. National innovation system

Glo

N

& T e n v i ro n m e bal S nt

on ati

T e n v i ro n m a l S& en

t

Government Research institutions

Universities Knowledge, money, people

Industries

Market

Financial institutions

Other actors

Source: Deok S. Yim, “Utilization of R&D output: perspective of S&T knowledge innovation system”, paper presented at the King Abdulaziz City for Science and Technology (KACST) International Seminar “Research Planning and Management Symposium”, Riyadh, Saudi Arabia, 1998. Abbreviation: S&T – science and technology.

In order to draw practical implications from theories on national innovation systems and innovation clusters, it is necessary to define innovation actors according to their generic roles in the system. In traditional science and technology policy, the university is regarded as the actor that only produces scientific knowledge. Now, that has changed and some universities do business with their research and development output. We can see that industries and government-supported research institutes are also extending their activities to basic and fundamental research. In addition, financial institutions and consulting companies have become very critical to the commercialization of research and development (see figure 2). In order to clearly understand the concept of the subnational innovation system, it is necessary to review other related concepts, such as the national innovation system, the global innovation system and the innovation cluster. Innovation activities can be conceptualized at various levels: global, national and subnational. The level of the innovation system is important because it determines the level of the policy target. Since SMEs are affected more by the subnational environment than the national one, it is necessary to lower the scale of the innovation system to the subnational (or regional) level. 120

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Figure 2. The extended roles of actors in the national innovation system Environment, supporting agency

Market, financial institutes, government and international S&T environment

Industry Major actors

Universities Government research institutes

S&T knowledge production

S&T knowledge transfer

S&T knowledge use

Source: Deok S. Yim, “Science and technology policies of Korea toward knowledge based economy”, paper presented at the Third Triple Helix International Conference, Rio de Janeiro, Brazil, 26-29 April 2000. Abbreviation: S&T – science and technology.

In general, a subnational innovation system has characteristics similar to those of the upper level innovation system, which is the country’s national innovation system. It can be said that the subnational innovation system is a kind of reduced national innovation system and that several subnational innovation systems constitute a national innovation system. These relationships among the various actors and between the national innovation system and the subnational innovation systems are shown in figure 3. In addition, a subnational innovation system has more local-specific characteristics due to its local geography, innovation culture, resources and so on. Thus, a subnational innovation system policy should consider not only the characteristics of the national innovation system, but local specificities, as well. Generally speaking, the competitiveness of the national innovation system is the sum of the competitiveness of the subnational innovation systems, which is also the sum of individual industrial and/or corporate competitiveness. Since the subnational innovation system is a system concept, it has its own actors, structure (networks) and activities. Similar to the national innovation system concept, the activities in a subnational innovation system are the research, transfer and utilization of knowledge, and production. In addition, there are secondary value activities, such as financing, information provision and human resource development and supply. Table 1 compares the subnational innovation system concept with other related theories and concepts. The subnational innovation system shares characteristics with other innovation systems. It has characteristics similar to those of a national innovation system and is similar in size to an innovation cluster. However, it also has many unique aspects. 121

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Figure 3. Subnational innovation system

e ev

s ral

ional

ubn

in n ovation sys

tem

a t i ona l innovation

Local government

sys

tem s

S

Na t

Universities

Knowledge, money, people

Local industries Market

Research institutions Financial institutions

Other actors

Source: Deok S. Yim, “Sub-national innovation system policy to enhance local SMEs competitiveness”, paper presented at the Regional Consultative Meeting on Sub-national Innovation Systems and Technology Capacity Building Policies to Enhance Competitiveness of SMEs, Seoul, 18-20 January 2006.

In the concept of the subnational innovation system, the network and the interaction among actors are more important than a single actor’s capability. Technological innovation occurs with the interaction of various actors. In this sense, a subnational innovation system is like an ecosystem, where all the players depend on and help each other for the benefit of technological development. The main or major player can be varied according to the specific conditions of the subnational innovation system. However, the university and local government are the driving forces for enhancing the competitiveness of local SMEs. Large companies are also important as the driving source leading to innovations in the national innovation system. However, SMEs receive special attention because of their local specificities in subnational innovation systems. The innovation cluster concept also focuses more on the local and regional (i.e. subnational) level innovation processes. An innovation cluster—such as Silicon Valley—may go beyond specific administrative borders and include several cities. However, the concept of a subnational innovation system is based on public administrative boundaries, and policies on such systems target innovation in specific administrative areas, such as cities and surrounding regions.

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Table 1. Concepts and policies related to the subnational innovation system

Category Focus

Global innovation system (GIS) O

O

Subnational National innovation innovation system system (NIS) (SIS)

Global innovation process Multinational corporations (MNCs)

O

National level innovation process

O

Innovation cluster

Subnational level innovation process

O O

Clustering Innovation in a specific area

Major actors

O

MNCs, national innovation systems

O

National/local government, universities, industry, public institutions

O

Local government, local universities, local industry (SMEs), public institutions

O

Industry, universities, public research institutions

Network/ structure

O

Global network

O

National level network Connected to GIS

O

Local network Connected to NIS and GIS

O

Global/local network

Policy objective

O

Integration of NIS into GIS

O

National competitiveness

O

Subnational (regional) competitiveness

O

Competitiveness of cluster

Policy direction

O

Utilization of global opportunities

O

Promotion of interaction Promotion of S&T culture R&D investment and management

O

Involvement of local government More local content in S&T policy

O

Cluster establishment, development

O

O

O

O

O

Source: Deok S. Yim, “Sub-national innovation system policy to enhance local SMEs competitiveness”, paper presented at the Regional Consultative Meeting on Sub-national Innovation Systems and Technology Capacity Building Policies to Enhance Competitiveness of SMEs, Seoul, 18-20 January 2006. Abbreviations: S&T – science and technology; R&D – research and development.

In conclusion, a subnational innovation system can be defined as an innovation system at the subnational level that is composed of local government; local universities; local industry, especially SMEs; financial institutes; and consulting companies within a certain public administrative district and that has formal and informal networks among the actors. In a subnational innovation system, the innovation value can be created through value-creation processes, which are science and technology knowledge creation, knowledge transfer, and knowledge utilization, with the sharing of knowledge, innovative culture and financial resources. Therefore, a policy based on subnational innovation systems puts emphasis on local specificity, the networking of actors and competitiveness through 123

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innovation. As a subnational innovation system is closely linked to the national innovation system, it is also necessary to design policy in the context of the national system.

(b) Success factors of a subnational innovation system In order to design and implement policies on subnational innovation systems, it is important to know the success factors of the systems, but the concept of the subnational innovation system is relatively new and not enough research has been done on it. As we can see from the comparison of related concepts in table 1, a subnational innovation system is a kind of small national innovation system and it has characteristics similar to the innovation cluster, which is based on a small subnational area. Therefore, it may be useful to briefly refer to the existing research related to the innovation cluster. The success factors of the innovation cluster can be used later to identify successful factors in the development of subnational innovation systems. There are many factors that affect the successful development of the innovation cluster. For instance, the initiatives of central and local governments and role division and cooperation among related actors are important. Of course, the location itself is often the most important factor determining the performance of an innovation cluster. Why are clusters generally built in a particular area and what are the principal factors influencing cluster construction? If we know the factors and conditions causing the cluster to be formed and developed, we can apply those conditions in building successful subnational innovation systems. Many scholars have tried to answer these questions from their respective scientific backgrounds. For instance, traditional economic theory points out the comparative advantage in production cost as the main reason for a production cluster to be built in a particular country or area. The industrial cluster is an example similar to the innovation cluster. An industrial cluster is a regional system which also requires technological innovation. Porter (1998) identifies the factors influencing the establishment of an industrial cluster as follows: (a) Historical circumstance. A cluster’s roots can often be traced to historical circumstances. In the state of Massachusetts in the United States, for example, several clusters had their beginnings in research done at the Massachusetts Institute of Technology (MIT) or at Harvard University. The Dutch transport cluster owes much to the central location of the Netherlands in Europe, an extensive network of waterways, the efficiency of the port of Rotterdam and the skills accumulated by the Dutch through the country’s long maritime history; (b) Local demand. Clusters may also arise from unusual, sophisticated or stringent local demand. Israel’s cluster in irrigation equipment and other advanced agricultural technologies reflects the country’s strong desire for self-sufficiency in food, together with a scarcity of water and hot, arid growing conditions; 124

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(c) The prior existence of supplier industries. The prior existence of supplier industries, related industries or even entire related clusters provides yet another seed for new clusters. The golf equipment cluster near San Diego, for example, has its roots in southern California’s aerospace cluster. That cluster created a pool of suppliers for castings and advanced materials, as well as engineers with the requisite experience in those technologies; (d) Innovative companies. New clusters may also arise from one or two innovative companies that stimulate the growth of many others. MCI and America Online have been hubs for growing new businesses in the telecommunications cluster in the Washington, D.C. metropolitan area. Saxenian (1999) emphasizes the following as the promoting factors of an innovation cluster: (a) the systematic network among firms, research institutes and universities; (b) a culture of accepting failures; and (c) a culture of exchanging information. She uses these factors to explain why Silicon Valley is more prosperous than Route 128 in the Boston area. A wide literature review on world innovation clusters was conducted to identify and compare the success factors of the innovation cluster. From this comparison and review, eight key success factors were identified (Yim and Kim, 2005). The first key factor is a high level of research capability. It is very obvious that the high level of the research capabilities of the universities in Silicon Valley have been the primary source of its success. The second factor is the abundance of highly qualified manpower. Silicon Valley (United States), Silicon Wadi (Israel) and Hsinchu (Taiwan Province of China) have all strengthened their research capabilities by utilizing foreign manpower. In Taiwan Province of China, policies to attract foreign human resources initiated by the Government in the 1980s decisively contributed to the transfer of technical knowledge and know-how from Silicon Valley to Hsinchu, and this facilitated the early acquirement of developed technology. In addition, a large number of Jewish scientists and engineers who lived in the Russian Federation moved to Israel after the collapse of the Union of Soviet Socialist Republics, which bolstered Israel’s science and technology human resources. Third, the creation of infrastructures also results in a pleasant business climate. Silicon Valley provides specialized professional business infrastructures, and the professional services of consultants, lawyers and accountants are available to those starting up new high technology enterprises. In Hsinchu science park, English courses are provided at the school to make it easier to attract English-speaking foreign researchers. The fourth factor is the retention of sufficient funds. In the case of the city of Oulu in Finland, the central Government concentrated 50 per cent of its research and 125

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development budget in the telecommunications sector. Therefore, the city grew into a huge, complex industrial town and has now become the driving force of the telecommunications industry in Finland. The Government of Israel decided to set up a national venture capital fund and then founded Yozma Venture Capital in 1992, while during the same period it established about 10 funds as Yozma’s affiliated companies, which enabled direct investment in high technology enterprises. Fifth, the diffusion of science and technology and an innovation culture are important within the context of a liberal business climate. Firms in Silicon Valley not only compete but also cooperate with each other. Through competition and cooperation, they are getting to know the rules of survival. In the case of the leading companies in Kista, Sweden, Ericsson and Nokia maintain a balance among professional service firms, which then creates a culture of respecting other firms. In particular, cooperation among research institutes, universities, large enterprises and related industries has led to active interrelationships in Oulu, Finland. The sixth factor is management and vision. China, under its Governmental reform and open policy starting in the beginning of the 1980s, has overcome the restrictions of the planned economy structure in such fields as industry, science and technology, and education. Through this policy, China has introduced new management and vision. Seventh, multinational corporations and their research institutes have played an important role in the development of many innovation clusters through the globalization process they have induced. The research institutes of worldwide wireless mobile communications and wireless Internet access companies, such as IBM, TeliaSonera, Hewlett-Packard, Motorola, Nokia, Cisco, Oracle, Compaq and Siemens, have already pushed into Kista (Sweden), Oulu (Finland) and Matam (Israel). In particular, Zhongguancun of China has changed from being a manufacturing-centred base to a research and development one, and it is now considered to be the most attractive place for research and development activities. Finally, the start-up of companies can be regarded as one of the success factors for an innovation cluster. In Silicon Wadi in Israel, a cooperative incubator industrial system is well formed among companies, universities, research institutes and private organizations so that new companies in this system share information and solve their problems in cooperation with universities and research institutes to make their business even more sophisticated. Therefore, these companies utilize universities and research institutes as consulting agencies for technology.

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SMALL AND MEDIUM-SIZED ENTERPRISES AND SUBNATIONAL INNOVATION SYSTEMS

In any innovation system, the role of industry cannot be overemphasized. Industry involves producing technologies as well as using them. SMEs are usually key players in subnational innovation systems because they are closely related to the local economy and development. The performance of SMEs is, to a great extent, affected by such local conditions as the availability of a good university, a public research institute, a leading company and so on. It is natural that SMEs are more related to subnational innovation systems than to national innovation systems and that they have more interaction with local actors. In this context, policies on SMEs have to consider the concept of subnational innovation systems more than that of national innovation systems. The following considerations could be borne in mind in this regard.

(a) Changes in environment It may be noted that today’s SMEs are facing a rapidly changing environment, first of all because of globalization. Traditionally, SMEs have operated mostly in local areas. Most of the input was secured from the local area, the market was local and SMEs were competing in the local market. Now, SMEs have to compete in the global market and monitor globalization trends and their effects. Second, technological capabilities have become a key competency factor, not only for large companies but for small companies, too. The competition based on low cost has become very tough due to new emerging countries such as China and India, which have very cheap labour. Many SMEs are not fully aware of this change and have lost their domestic markets. Third, it may become more difficult to find the right manpower because SMEs are losing people to multinational corporations, and qualified personnel can find jobs in other countries. Fourth, a local area—especially in developing countries—often does not provide the right resources for SMEs to enhance their technological competitiveness. Technological and managerial support are not widely available. SMEs without technological resources have a difficult time attaining global competitiveness. It seems that the changes are affecting SMEs negatively, but there are also many SMEs which use these environmental changes as opportunities. The SMEs which have prepared themselves for technology and the global market are the ones which would grow even faster in the rapidly changing environments.

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(b) Technological innovation by small and medium-sized enterprises SMEs have both advantages and disadvantages in technological innovation. They have difficulty mobilizing appropriate resources for research and development and new product development. However, this difficulty can be offset by the flexibility of SMEs. In fact, many successful SMEs can succeed in innovation and compete with large companies because they are able to concentrate on niche innovation areas, which large companies neglect. In addition, successful SMEs can make quick decisions on innovation because they are small and have less organizational hierarchy. In this regard, SMEs can have comparative advantages in technological innovation. However, the lack of human resources and capital is a traditional barrier for SMEs in commercializing their technologies. Therefore, it is always necessary to secure enough resources—both human and financial—to take advantage of the opportunities offered by technological innovation. Another important factor for technological innovation by SMEs is the right choice of technology based on their strategic goals. Which technologies do SMEs need for which purposes? It is often observed that new and advanced technologies are preferred in some developing countries but, in many cases, SMEs do not need such technologies and do not have adequate resources to utilize them effectively. Rather, there are many cases in which older and traditional technologies are more appropriate for SMEs. The managers or decision makers of SMEs do not seem to be well aware of the importance of technological innovation. Often, technologies and research and development are recognized as important issues and regarded as part of the long-term agenda in corporate decision-making but, as global competition becomes more stringent, technological competency has to be a primary issue for SMEs, as well.

(c) Value chain and networking and the role of multinational corporations The value chain process, as presented in figure 4, shows the primary and secondary (supporting) chains of value functions. The primary value chain refers to the primary value-creating activities of the company. The secondary value function refers to the activities that do not create value directly but support the primary value functions. There are various actors in each process of the value chain. The related elements are market, government, industry, university and society. It is easy to understand that many actors are interacting to create value in each value chain process. The main interaction activities concern money, human resources, information, technology and so on. As the actors interact, they create some sort of network. Networked actors bring synergetic effects to the competitiveness of SMEs. The network can be open or closed, as well as local or global. The network can be formed between users and producers. 128

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Figure 4. Value chain process in the innovation system

Primary value functions

R&D

Production

Marketing

R&D ability is the key function and driving force of an industry value chain

Secondary value functions

Human resources Information supply

Venture capital Consulting services

Source: Deok S. Yim, Wang D. Kim and Jung H. Yu, “The evaluation of Daedeok Science Town and its implication for the national innovation policy—in the perspective of innovation cluster,” presented at the Portland International Conference on Management of Engineering and Technology (PICMET) 2004 Symposium, Innovation Management in the Technology-driven World, Seoul, 31 July-4 August 2004. Abbreviation: R&D – research and development.

In the globalized economy, multinational corporations often lead such networks. They allocate their production or even research and development units to the most favourable locations and coordinate the global value chain process for their corporate objectives. Therefore, how to attract multinational corporations and make them the leading part of a subnational innovation system is very important.

(d) Integration of the subnational innovation system concept into SME policy Policy on the national innovation system encompasses policy on subnational innovation systems, as well as SME policy and technology policy. This relationship can be shown as in figure 5. SME policies based on a subnational innovation system need to be designed in relation to technology and to elements of the subnational innovation system. As we can see from figure 5, SME-related policy may be better designed in the context of the subnational innovation system and local development. Since technological capacity is one of the key elements for the competitiveness of SMEs and since their technological capacity-building could be promoted through a well-established subnational innovation system, there has to be a common core policy which integrates the subnational innovation system, technology and SME policies.

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Figure 5. Relationship among national and subnational innovation systems, technology and SME policies

N IS policy

SIS policy

Technology policy

SME policy

Source: Deok S. Yim, “Sub-national innovation system policy to enhance local SMEs competitiveness”, paper presented at the Regional Consultative Meeting on Sub-national Innovation Systems and Technology Capacity Building Policies to Enhance Competitiveness of SMEs, Seoul, 18-20 January 2006. Abbreviations: NIS – national innovation system; SIS – subnational innovation system; SME – small and medium-sized enterprise.

Traditional SME policies, however, are categorized according to the functions of marketing, financing, human resources and technology. These policies can also be categorized according to the life cycle of SMEs, as shown in table 2. Whereas traditional SME policies fall into one of the these categories (marked with an arrow), SME policies that are based on a subnational innovation system rather deal with the whole life cycle of SMEs together in the context of a subnational innovation system. SME policies that are based on a subnational innovation system do not ignore the usefulness of traditional SME policies and recognize that life cycle-specific SME policies are working. The perspective of the subnational innovation system, however, places more emphasis on the networking and co-evolution taking place among the concerned innovation actors. It is important to place more focus on the innovation-friendly ecosystem of SMEs. SME policies that are based on a subnational innovation system should have a longer-term time framework and system characteristics than traditional SME policies. For instance, these policies could help SMEs to start and grow by providing a creative culture and networking opportunities among the concerned actors. They have to focus on the interactions within the system itself rather than targeting any one single actor.

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Table 2. Conceptual framework for SME policies based on a subnational innovation system

Areas of traditional SME policies

Life cycle of SMEs Pre-start-up

Start-up

Growth period

Declining period

Marketing













Finance













Human resources













Technology













Perspectives of a subnational innovation system (important factors)

O

O O

Linkages among universities, industry, research institutes and financial institutes Creative and risk-taking culture Opening and globalization of the region

Source: Modified from Deok S. Yim, “Sub-national innovation system policy to enhance local SMEs competitiveness”, paper presented at the Regional Consultative Meeting on Sub-national Innovation Systems and Technology Capacity Building Policies to Enhance Competitiveness of SMEs, Seoul, 18-20 January 2006, p. 20. Abbreviation: SME – small and medium-sized enterprise.

5.

POLICY OPTIONS FOR BUILDING A SUBNATIONAL INNOVATION SYSTEM

To build an innovation system and reap economic gain from it in a country or at the subnational level, first of all, planning is important. Based on the plan, its implementation in harmony with other related policies and evaluation and feedback are highly desirable. Recommendations and policy options for these phases are outlined in the following three subsections.

(a) Planning Generally speaking, planning involves a series of processes aimed at outlining how to carry out a given mission under a certain vision, such as analysing the environment and resources, setting a goal, choosing a target, designing the methods to mobilize the needed resources, identifying the stakeholders and participants and their respective roles, and making an action plan. The goal is to build a subnational innovation system, possibly with characteristics that take into consideration the subregional environment, in order to gain tangible economic rewards from it. In the planning of Government policies on subnational innovation systems, the analysis of the innovation environment comes first. One should analyse the status of the 131

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main elements of the subnational innovation system: the quantity, quality and flows of knowledge, money, and people. Also, the main activities of interaction should be examined for knowledge creation, transfer and utilization. The availability of the required natural resources and the scale and level of institutions, universities, research power, skills, etc. should also be checked. To set the target of the economic impact that is expected to be induced by a subnational innovation system, both national and subnational competitiveness (which is the sum of the competitiveness of industries) should be carefully analysed. The level or status of competition of the selected industry or products in the global market should also be studied. Second, based on these analyses, a substantive goal and strategies should be set to reinforce the three main elements of the subnational innovation system and to stimulate its three activities (knowledge creation, transfer and utilization). In this process, the target areas that are most suitable for the country or region (at the subnational level) should be decided or selected. The goal should be measurable in numbers or in qualitative terms to enable policy effectiveness to be evaluated. Then, there have to be some scenarios for achieving the ultimate goal—economic gains—by building a subnational innovation system using the existing resources and within the existing circumstances. For instance, one scenario could be that a country (or region) that exports raw materials without any value added processes could change its industrial structure to one of high added value through the primary treatment of domestically sourced raw materials or by using them to manufacture intermediary goods. In another example, domestic enterprises, including SMEs, could be used to provide intermediary goods to a multinational corporation operating in the country. Third, strategies for mobilizing the resources required for the execution of the plan should be prepared. Human resources and capital could be included at this stage and infrastructure could be considered. Finally, the subnational innovation system policy should be harmonized with, or linked to, other relevant policies such as those on industry, SMEs, foreign direct investment, research and development, vocational training, trade and decentralization. As has been noted in the policy concept on subnational innovation systems, innovation policy, industry policy and SME policy should be in alignment. Currently, this is not always the case. For instance, there are often cases where the innovation policy promotes local technological capacity-building but industrial policy favours foreign technologies over those that are domestically developed. Foreign direct investment policy should also be aligned with innovation policy. For instance, when there is a chance to attract foreign direct investment, the impact on the 132

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existing domestic industry and companies should be considered. Its positive impacts should be maximized in all areas. This applies not only to employment and other economic variables, but also to the likelihood of goods being purchased from domestic companies and the transfer of technology. A set of measures aimed at maximizing these positive impacts could be used in the early stages of bargaining with foreign investors. Of course, such measures should be in conformity with WTO rules and they should not undermine the overall attractiveness of the investment climate. A country, or an area within a country, with limited resources cannot afford all kinds of scientific research or technological development. It is inevitable that there will be a focus on certain types of research and development and technology. Such focused research and development should support the targeted industry and innovation activities. Sometimes a country’s or area’s unique circumstances require unique, specific technologies different from those needed in other countries or areas. Vocational training is important to create an adequate workforce for the production of goods on a scale that is large enough to be profitable for an industry. Vocational training, whether at home or abroad, should be closely linked to the demands of industry and the requirements for innovation, in terms of training areas, number of trainees, quality of trainees, etc. Trade policy can help innovation by streamlining the flow of goods and services which are indispensable but could not be acquired in the domestic market. Appropriate tariff adjustments for those items could help to reinforce the three elements and stimulate the three activities. As an example, laboratory equipment and machinery, which are indispensable for the creation and utilization of knowledge, could be considered.

(b) Implementation First, concerted innovation efforts by individual actors are very important in building subnational innovation systems leading to a competitive economy. It is necessary to create and maintain a committee composed of representatives of the relevant central and local government bodies and of organizations and the private sector to secure the coherence, consistency and connectivity of their roles and activities. It can also help to quickly solve problems which arise from the process of building an innovation system. Among the actors, enterprise is the key player in innovation. Government and public institutions are supporters of innovators. Industry, or companies, should take full advantage of available national resources and pursue active cooperation with public institutions and universities. Cooperation among enterprises is also encouraged, e.g. assemblers or big enterprises supporting SME suppliers with technology development or quality control, the sharing of information on global market trends, resource mobilization, training, etc. 133

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Second, if an innovative actor adopts a new technology, new design or new production method, it should abide by WTO rules and not violate the intellectual property rights (IPR) of others. Conversely, if an innovator develops a new technology itself, it should be protected by IPR in domestic legislation, as well. When the technology is an outcome of cooperative research between a transnational industry and a domestic industry or, when technology transfer from outside is involved, the probability that the parties could violate one another’s IPR should be thoroughly examined and it should be prevented. Third, it is recommended that a scheme of incentive- and risk-sharing be designed to support the development of innovation activities. There are various kinds of costs and risks linked to different stages of innovation activities: creating knowledge (research), utilizing knowledge (applied technology development, the adoption of new technologies, quality control, mass production facility investment), human resource education and training, bargaining with customers and negotiating contracts, carrying out international trade transactions, etc. If innovation actors alone were to assume the whole burden of failure, this would seriously undermine their motivation to engage in innovation, especially in less developed countries. When government, institutions, universities, industry and capital providers share the burden of innovation, key innovation actors (industries or individual companies) are much more inclined to perform their innovation tasks. According to the character or the progress of innovation, various kinds of supporting measures can be adopted: tax incentives, research and development subsidies, investment and loans, service support, insurance for some kinds of risk, etc. At the same time, careful awareness is needed so as not to hurt and diminish the spirit of innovation of actors due to excessive aids and partial favouritism. On the other hand, when competitive pressure is great enough, they have no choice but to innovate to remain competitive. Fourth, appropriate regulation is necessary to enable innovation actors to work more freely and creatively. In the process of innovation, new technologies, new business models and new types of cooperative action between players would emerge, which would be likely to go beyond the scope of traditional government administrative regulations. Without appropriate regulation, which may involve deregulation, the benefits of innovation are difficult to realize. The existence of appropriate IPR laws is a case in point. Furthermore, it is desirable to have an open society to promote innovation, as it would increase personal responsibility and accountability for moral choices as government restrictions are reduced. Fifth, a network among relevant organizations is required. It is true that a simple invention or the efforts of a single organization without related supplementary action (knowledge transfer, utilization, capital involvement, etc.) can hardly lead to successful innovation. Closely connected activities result from cooperation among relevant organizations through knowledge sharing and transfer, and face-to-face contacts. An international network is also important to make the best use of experienced experts and

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other kinds of resources from other countries. Clusters are well placed to build close networks among relevant organizations. Sixth, social consensus on the need for innovation is necessary. If only a few people are involved in developing the innovation system, without being understood by a wider group of relevant people and society at large, chances for success are slim. A general understanding is needed among government, public institutions, people at large, industry, etc. that without innovation, a sustainable economy and competitive advantages cannot be obtained. The establishment of subnational innovation systems, especially in developing countries, requires a lot of investment and consistent support from government. There have been many cases in many areas where resources from the government budget were needed. Without strong support from the public and the government, the budget would not be available for a long time and it would be hard to complete the establishment of the subnational innovation system.

(c) Evaluation Finally, the process of building a subnational innovation system should be properly evaluated using appropriate assessment tools. Such an evaluation should lead to feedback to improve the process for the creation of a better innovation system. The nature of such an evaluation can vary according to the circumstances prevailing in a country or area. In principle, the objectives of the evaluation are preset goals and targets, which are defined in either quantitative or qualitative terms. In order to evaluate the policy results, an evaluation committee is needed. The first thing it should do is define more clearly and in detail the evaluation measures. Usually, the policy goal or target can be measured from several perspectives. For instance, the effectiveness of the subnational innovation system can be measured in its various aspects. The selection of measures is rather difficult because there are so many aspects and time is needed to reach a consensus among the related actors in the subnational innovation system, such as the government, industries and universities. In general, the measures can be classified into three categories: input measure, throughput measure and output measure. The input is about what and how much is invested (or flowed into) the subnational innovation system. The throughput is about how the input has been transferred or processed into output. The output is about the final result of the system. It is relatively easier to measure input than throughput or output. Output can be defined in terms of technology development, the ratio of technologically intensive products in the subnational innovation system and so on.

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It is necessary to give special attention to the throughput aspect, as well, since the subnational innovation system is based on its system characteristics. Many indices can be used to measure throughput. For instance, the number of joint projects or exchanges of knowledge or people are good examples. In addition, the degree of innovative and risk-taking or sharing behaviour in the culture should be evaluated and promoted for the development of the subnational innovation system. The status of the network and cooperation among universities, industries and public institutes are also important. Finally, the results of the evaluation should be used to set goals and make implementation policies. If the results of the evaluation suggest that the original goals were set too high, they could also be modified

6.

CONCLUSION

If developing countries want to build a viable economy and achieve sustainable growth, increasing their production capacity is essential. Such capacity should be based on competitive advantages, which could open global markets for industries via global value chains. SMEs could strengthen their competitive advantages and positions in a global value chain by adopting new knowledge (technologies), namely under the scheme of a subnational innovation system. A review of the characteristics and success factors of subnational innovation systems in developed countries shows that three elements (knowledge, money and people) and three activities (the creation, transfer and utilization of knowledge) of interaction are essential to build a subnational innovation system. For the convenience of policymakers who may wish to build a subnational innovation system, three steps (planning, implementation, and evaluation and feedback) are introduced, along with policy options and a few points and examples to be considered. In the planning stages, the three elements and the environment should be analysed and goals should be set jointly with the relevant stakeholders. Also, coherence and consistence among relevant national and subregional policies are important. At the implementation stage, measures and examples for the reinforcement of the three elements and for the stimulation of the three activities were recommended; they should be in conformity with the WTO regime. Lastly, evaluation is needed in three categories: input, throughput and output measures. Information from the evaluation should be fed back into the processes of setting goals and making implementation policies. With the concerted efforts of central and local governments, universities and public institutions, enterprises and financing institutes, a subnational innovation system could be built which could provide an environment conducive to the creation of new companies and the growth of already existing SMEs. The system can lead to national and subregional productive capacity-building and ultimately help to achieve the Millennium Development Goals. 136

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REFERENCES ESCAP (2007). Enhancing the Competitiveness of SMEs: Subnational Innovation Systems and Technological Capacity-building Policies (ST/ESCAP/2435). Freeman, Chris (1995). “The ‘national systems of innovation’ in historical perspective”, Cambridge Journal of Economics, vol. 19, No. 1, pp. 5-24. Luecke, Richard and Ralph Katz (2003). Managing Creativity and Innovation (Boston, Harvard Business School Press). Metcalfe, Stan (1995). “The economic foundations of technology policy: equilibrium and evolutionary perspectives”, in Paul Stoneman, ed., Handbook of the Economics of Innovation and Technological Change (Oxford, Blackwell Publishing). Porter, Michael E. (1998). “Clusters and the new economics of competition”, Harvard Business Review, November-December. Saxenian, Annalee (1994). Regional Advantage: Culture and Competition in Silicon Valley and Route 128 (Boston, Harvard University Press). _____ (1999). “Comment on Kenney and von Burg, technology, entrepreneurship and path dependence: industrial clustering in Silicon Valley and Route 128”, Industrial and Corporate Change, vol. 8, No. 1 (Oxford, Oxford University Press). Yim, Deok S. (1998). “Utilization of R&D output: perspective of S&T knowledge innovation system”, paper presented at the King Abdulaziz City for Science and Technology (KACST) International Seminar: Research Planning and Management Symposium, Riyadh, Saudi Arabia. _____ (2000). “Science and technology policies of Korea toward knowledge based economy”, paper presented at the Third Triple Helix International Conference, Rio de Janeiro, Brazil, 26-29 April. _____ (2006). “Sub-national innovation system policy to enhance local SMEs competitiveness”, paper presented at the Regional Consultative Meeting on Subnational Innovation Systems and Technology Capacity Building Policies to Enhance Competitiveness of SMEs, Seoul, 18-20 January. Yim, Deok S., Wang D. Kim and Jung H. Yu (2004). “The evaluation of Daedeok Science Town and its implication for the national innovation policy—in the perspective of innovation cluster,” presented at the Portland International Conference on Management of Engineering and Technology (PICMET) 2004 Symposium: Innovation Management in the Technology-driven World, Seoul, 31 July-4 August. Yim, Deok S. and Wang D. Kim (2005). “The evolutionary responses of Korean Government research institute in a changing national innovation system”, Science Technology and Society, vol. 10, No. 1, pp. 31-55. 137

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Asian-African trade and investment cooperation

Marc Proksch*

ABSTRACT

T

he commercial relationship between Africa and Asia has received increased attention in recent years, especially as selected emerging Asian countries are slowly replacing Western countries as leading donors and investors. China, in particular, has emerged as the leading investor in Africa, prompted by its need to tap Africa’s natural resources for its own booming economy. As a result, a somewhat asymmetrical commercial relationship has emerged in which China imports natural resources from Africa although its exports to Africa are relatively low. At the same time, while China is a leading investor in Africa, African outward foreign direct investment is still limited. Similar relationships are emerging between Africa and other Asian countries, including India and Japan. This paper examines the nature of the growing commercial relationship between Africa and Asia, with a focus on China and India, and identifies challenges and obstacles to effective commercial relationships as well as opportunities. For instance, the lack of good governance is a recurring theme in African development. On the other hand, the existence of trade complementarities presents an opportunity for expanded trade and investment between the two continents. The paper concludes by outlining modalities at the national level and for regional cooperation to foster this promising commercial relationship so that it benefits both Asia and Africa in a sustainable manner. In this regard, it highlights the role of the United Nations regional commissions, the Economic Commission for Africa and the Economic and Social Commission for Asia and the Pacific. *

Economic Affairs Officer, Trade Policy Section, Trade and Investment Division, ESCAP, Bangkok.

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INTRODUCTION

While Africa is known for civil wars, famine, AIDS and poverty and Asia is known for technology advancement, knowledge development, hard and disciplined labour, and foreign exchange reserve surpluses, the actual picture is obviously more complicated. Quite a few African countries actually have rapidly growing economies with booming trade and investment. However, intra-sub-Saharan African trade accounts for less than 10 per cent of the region’s total trade, while intra-Asian trade represents about 50 per cent of trade in the ESCAP region.1 Intra-African trade is hampered not only by the relatively high tariffs African countries maintain but also by non-tariff barriers, poor infrastructure, political tensions and the lack of proper trade facilitation (Njinkeu and Fosso, 2006). This is the situation despite the fact that regional integration is more advanced in Africa than in Asia, at least on paper. Most regional trade agreements among Asian countries are either preferential trade or “free” trade agreements, while Africa boasts the highest number of Customs unions of all regions in the world. (Asia, leaving aside the Commonwealth of Independent States, has none.) Furthermore, one could expect that these obstacles would logically affect all of the trade of African countries, and they are certainly not dissimilar to those encountered in Asia. It is therefore remarkable that, despite these obstacles, during the last 15 years, trade flows between Africa and Asia have rapidly increased. Removing these obstacles would trigger even greater interregional trade flows. A similar picture can be observed in the area of investment. Asian foreign direct investment (FDI) in Africa has risen rapidly in recent years. The rise in investment in Africa by Asia is directly related to the rise in exports from Africa to Asia. This brief paper seeks to summarize the recent findings and recommendations on the commercial relationship between Africa and Asia and to outline areas in which Africa and Asia, through agencies such as the United Nations regional commissions—the Economic Commission for Africa (ECA) and the Economic and Social Commission for Asia and the Pacific (ESCAP)—can work together to foster this relationship in support of inclusive and sustainable development. Section 2 provides an overview of African-Asian relationships in trade and investment; section 3 identifies challenges and opportunities for efficient trade and investment relationships between the two continents; and section 4 outlines modalities for enhancing these relationships at the national and regional levels, with particular attention paid to the roles of ECA and ESCAP.

1

The ESCAP region comprises all Asian and Pacific countries and economies, including Central Asia and the Caucasus, Turkey and the Islamic Republic of Iran but not including the Middle East.

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AN OVERVIEW OF AFRICAN-ASIAN COMMERCIAL RELATIONSHIPS

(a) Trade During the period 2003-2008, total exports from African countries to Asia grew by 20 per cent, and the annual growth rate during that period reached an all-time high of 30 per cent. Already in the early 1990s, exports from Africa to Asia were significant, growing by 15 per cent in the period 1990-1995. Imports from Asia to Africa were also high in the early 1990s but, since then, export growth has been higher than import growth. The import growth rate on an average annual basis was 13 per cent in the period 1990-1995 and 18 per cent in the period 2000-2005. According to a World Bank study, Asia now receives 27 per cent of Africa’s exports, triple the amount in 1990 and almost equalling Africa’s exports to the United States of America and the European Union. In fact, Asia’s imports from Africa have outpaced imports from other regions. Meanwhile, Asian exports to Africa are growing 18 per cent per year, faster than to any other region in the world. One third of total African imports come from Asia, second only to imports from the European Union. Asia was Africa’s third largest trading partner in 2005 (23 per cent), after the European Union (27 per cent) and the United States (25 per cent) (Broadman, 2007) (see figure 1). China is the leading Asian trading nation for Africa, followed by Japan. However, India has emerged as a leading trading nation, as well, and together with China, it accounts for the recent high growth rates in African-Asian trade. China’s relationship with Africa has clearly evolved from donor to investor and trader. Bilateral trade between China and Africa surged to nearly $55 billion in 2006 from $10 billion in 2000, when the Forum on ChinaAfrica Cooperation was established. This figure jumped 40 per cent from 2005 to 2006 alone. China is now Africa’s third largest trading partner after the United States and the European Union. Since the beginning of 2005, China has begun scrapping tariffs on 190 kinds of imported goods from 28 of the least developed African countries with which it has diplomatic relations. In addition, China is providing preferential trade credits and establishing a large fund to support Chinese FDI in Africa. India’s trade with Africa has soared from $967 million in 1991 to $30 billion in 2007/08. The most important products exported to Africa are pharmaceuticals, cotton, nuclear reactors, boilers, mechanical appliances, vehicles and railway wagons, and rolling stock. Indian-African trade links go back centuries and Indians are a significant minority in various East and South African countries. This link is demonstrated, for instance, by the growth in trade between South Africa and India at about 30 per cent per annum in the last few years.

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Figure 1. Average annual merchandise export growth rate, Africa to Asia, and Africa’s merchandise exports to Asia Average annual merchandise export growth rate, Africa to Asia 60% Africa’s merchandise exports to Asia, by destination, 2004

48%

50%

Percentage

40% Rest of Asia 51%

30% 20%

20% 14%

10%

14%

China 40%

13%

7%

India 9%

0% 1990- 19991994 2004

1990- 19991994 2004

1990- 19991994 2004

China

India

Rest of Asia

Total 2004 exports from Africa to Asia: $37 billion

Source: Harry G. Broadman, presentation given at ABCDE Tokyo, 29 May 2006; Data sources: IMF Direction of Trade, as of 9 April 2006. Notes: The 2004 export figures are based on the data for the first 10 months of exports, adjusting for November and December exports using the average monthly export of January to October 2005. Asia includes Afghanistan, Bangladesh, Brunei Darussalam, Cambodia, China (including Hong Kong, China and Macao, China), India, Indonesia, Japan, the Republic of Korea, the Lao People’s Democratic Republic, Malaysia, Maldives, Mongolia, Myanmar, Nepal, the Democratic People’s Republic of Korea, Pakistan, the Philippines, Singapore, Sri Lanka, Taiwan Province of China, Thailand and Viet Nam.

To boost India’s trade with the sub-Saharan African region, the Government of India launched the Focus Africa Programme under the Export-Import Policy 2002-2007.2 Individual states have also taken initiatives. For instance, the southern Indian state of Andhra Pradesh recently signed a preliminary deal with Kenya and Uganda to send 500 farmers to work as entrepreneurs and landowners to cultivate land in these nations.3 An India-Africa Partnership Summit was convened in India in April 2008. At the Summit, India announced a unilateral preferential market access scheme for exports from all 50 of the least developed countries (LDCs), of which 34 are in Africa. Products to be covered under the 2

3

The Ministry of Commerce and Industry of the Government of India announces the Export-Import Policy every five years. The policy, in general, aims to develop export potential, improve export performance, encourage foreign trade and create a favourable balance of payments position. The current policy covers the period 2004-2009. The Export-Import Policy is updated every year on 31 March and the modifications, improvements and new schemes become effective from 1 April of every year (see www.infodriveindia.com/ Exim/DGFT/Exim-Policy/2008/Default.aspx). “India—Boosting trade with Africa” in Africa Business Pages: business guide, Internet edition, available at www.africa-business.com/features/india_africa.html.

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new export regime included cotton, cocoa, aluminium and copper ores, ready-made garments and non-industrial diamonds. India has extended lines of credit worth $2.15 billion to African nations and trading groups over the last five years; they are expected to more than double to $5.4 billion over the next five years. India has been negotiating a free trade agreement with the Southern African Customs Union (SACU)—which groups Botswana, Lesotho, Namibia, South Africa and Swaziland—since 2002. A framework agreement was signed in 2004. India is also engaged in negotiating a triangular trade agreement with South Africa and Brazil. Ideally, it could link the South Asian Free Trade Area (SAFTA) with SACU and the South American Common Market (MERCOSUR). However, China remains a more important trading partner for Africa than India is. Africa’s exports to China grew by 48 per cent annually in the period 1999-2004, compared with 14 per cent for India; today, 10 per cent of sub-Saharan exports are now to China and some 3 per cent are to India (Broadman, 2007). Other Asian countries are also expanding their trade links with Africa. Japan is the leading importer of coffee from Africa, while Malaysia holds nearly 80 per cent of the market share in palm oil in Africa. Malaysian-African trade jumped by over 20 per cent to $3.3 billion in 2006. Other Association for Southeast Asian Nations (ASEAN) countries, such as Indonesia, the Philippines, Singapore and Thailand, are also experiencing growing trade and investment ties with Africa, mostly with South Africa but increasingly with other sub-Saharan countries, as well, as they look for raw materials to feed their manufacturing sector. Indonesia is the largest importer of African products among the ASEAN-5 nations (Indonesia, Malaysia, the Philippines, Singapore and Thailand). African exports to these countries expanded by 65 per cent from $2.3 billion in 2001 to $3.9 billion in 2005. Food products are increasingly important in these exports (Yoshino, 2008). Africa’s exports to Asia consist mainly of commodities and raw materials, including crude oil. Africa has $30 billion in untapped oil and gas resources but it needs major investment to get it out of the ground. Africa currently supplies a third of China’s crude oil. In 2006, oil and gas accounted for over 60 per cent of Africa’s exports to China, followed by non-petroleum minerals and metals at 13 per cent. Africa’s imports from China comprised mainly manufactured products and machinery and transport equipment, which together accounted for about three fourths of total imports. This pattern is similar to trade between Africa and other trading partners (Wang and Bio-Tchané, 2008). China’s commercial links with Africa have traditionally been dominated by the State sector but, in recent years, the Chinese private sector has been at the forefront of trade and investment in Africa, mostly in textiles and mining but also in services, agriculture, processing and manufacturing and, increasingly, in construction.

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There is an apparent asymmetry between Africa and Asia. While Asia accounts for one quarter of Africa’s global exports, this trade represents only about 1.6 per cent of the exports shipped to Asia from all sources worldwide.

(b) Investment Foreign direct investment relations between Asia and Africa are basically a one-way street, with the Asian investors targeting African countries mainly motivated by trade and demonstrating a strong trade-investment nexus. The main draw cards have been oil and other natural resources, helped by consistently high commodity prices. Hence, FDI in the oil-producing countries in Africa has been the highest. However, FDI in other sectors, such as agro-industry, textiles, other manufacturing sectors and services, has also experienced recent growth. Factors that have, to some extent, played a role in investment decisions in these sectors include: the Cotonou Agreement between the European Union and the African, Caribbean and Pacific Group of States (ACP); the European Union Everything But Arms (EBA) initiative; the phase-out of the Multifibre Arrangement; and the duty- and quota-free access to the United States market provided to some African countries under the Africa Growth and Opportunity Act (AGOA) (ECA, 2006; UNCTAD, 2007). According to a 2007 study by the United Nations Conference on Trade and Development (UNCTAD) and the United Nations Development Programme (UNDP) on FDI in Africa, FDI outflows from developing countries in Asia averaged $46 billion during the period 2002-2004, of which flows to Africa made up only $1.2 billion annually. This amount nonetheless made up the largest interregional FDI flow in the developing world. According to the UNCTAD World Investment Report 2007, the value of cross-border acquisitions of African enterprises reached a record level ($18 billion) in 2006, almost half of it in the form of mergers and acquisitions by Asian transnational corporations, particularly in oil, gas and mining activities. Despite the growing inflows of FDI from Asia, sub-Saharan Africa accounts for only 1.8 per cent of global FDI inflows. Traditionally, FDI flows from developing countries in Asia to Africa have been mainly from the newly industrializing Asian economies (Hong Kong, China; the Republic of Korea; Singapore; and Taiwan Province of China). Singapore, India and Malaysia are currently the top Asian originators of FDI in Africa, with cumulative investment stocks of $3.5 billion, $2 billion and $1.9 billion, respectively, in 2004, followed by China, the Republic of Korea and Taiwan Province of China. China and India have emerged as leading investors. The study also reveals that the annual FDI inflows to Africa from China, India and Malaysia have been higher than FDI from European countries or the United States (see table 1). In 2005 alone, Chinese FDI in Africa amounted to $400 million and, by the end of 2005, China had an accumulated total

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Table 1. Foreign direct investment flows to Africa from selected countries (Millions of United States dollars) Year

China

India

Malaysia

France

Germany

United Kingdom

United States

2000 2001 2002 2003 2004

85.0 24.5 30.1 60.8 320.0

243.3 184.8 883.4 338.4 22.1

77.7 49.4 340.1 411.0 175.6

1 300.9 1 796.0 855.4 1 095.9 1 028.1

651.4 -259.5 -328.4 -319.4 181.3

2 119.7 1 658.4 3 291.3 5 639.4 10 588.1

716.0 2 438.0 -578.0 2 697.0 1 325.0

Source: UNCTAD and UNDP, Asian Foreign Direct Investment in Africa: Towards a New Era of Cooperation among Developing Countries, UNCTAD Current Studies on FDI and Development No. 3, UNCTAD/ ITE/IIA/2007/1 (New York and Geneva, 2007).

of $1.6 billion in FDI stock in Africa (see table 2), despite the fact that Chinese companies regard African countries as among the least desirable investment destinations (Broadman, 2007). Chinese companies are present in 48 African countries, although Africa still accounts for only 3 per cent of China’s outward FDI. A few countries have attracted the bulk of China’s FDI in Africa: the Sudan is the largest recipient (and the ninth largest recipient of Chinese FDI worldwide), followed by Algeria (eighteenth) and Zambia (nineteenth). Chinese enterprises have entered sectors such as road and railway building, communication systems, irrigation works and energy generation. Chinese textile and clothing firms are also investing heavily in Africa at the moment as a way to get around the United States and European Union limits on Chinese exports in this sector. By the end of 2005, China had signed investment promotion and protection agreements with 28 different countries in Africa and had set up 98 enterprises on the continent. Table 2. FDI stock of China, India and Malaysia in Africa and the world (Millions of United States dollars) China

Regions Africa World Share of Africa (percentage)

India

Malaysia

1990

2005

1996

2004

1991

2004

49 1 029 4.76

1 595 57 200 2.79

297 3 139 9.46

1 969 11 039 17.83

1 3 043 0.03

1 880 41 508 4.53

Source: UNCTAD and UNDP, Asian Foreign Direct Investment in Africa: Towards a New Era of Cooperation among Developing Countries, UNCTAD Current Studies on FDI and Development No. 3, UNCTAD/ ITE/IIA/2007/1 (New York and Geneva, 2007).

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Indian investment is concentrated in East and South Africa. For instance, India is among the top five sources of FDI in Uganda. Tata Industries is a leading investor in South Africa. Unlike in the area of trade, Indian investors tend to be better integrated in Africa than Chinese investors. There are various platforms to promote Asian-African trade and investment, such as the Africa-Asia Business Forum (AABF) and the Tokyo International Conference on African Development (TICAD), which has implemented measures to boost Africa’s FDI inflows, including from Asian small and medium-sized enterprises.

3.

CHALLENGES AND OPPORTUNITIES FOR EFFICIENT AFRICAN-ASIAN TRADE AND INVESTMENT

(a) Challenges As investment links between Africa and Asia are very much dependent on trade links, it can be expected that obstacles to trade and to investment are interlinked, as well. For that reason, in the context of this paper, no distinction is made. The following obstacles and challenges for efficient African-Asian trade and investment can be identified: (a) An anti-private-sector bias, which led to the nationalization of private companies in many countries;4 (b) An uninformed, distorted form of nationalism, which is manifested in the form of unnecessary bureaucracies in the trade and investment process; (c) A lack of effective access to international markets (despite existing measures under the Generalized System of Preferences (GSP) and other schemes for developing and least developed countries); (d) Massive value loss from Africa to the outside world as a result of the export of raw materials and semi-processed goods, which makes Africans the unacknowledged donors of wealth to Europe, the United States and other parts of the world; (e) A small, fragmented African market, characterized by low purchasing power; (f) An absence of effective backward linkages between domestic small and medium-sized enterprises (SMEs) in Africa and transnational corporations from Asia; 4

For instance, in Uganda, former President Idi Amin expelled the Indian community which had made Uganda its home because he did not see the usefulness of the private sector in the economy. However, there are signs that, at least in some African countries, the tide is changing in favour of private sector development. (Speech by Yoweri Museveni, President of Uganda, at the India/Africa Partnership Summit Forum in New Delhi on 8 April 2008). Points (a) to (e) are also derived from his speech.

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(g) The crowding out of domestic investment by Chinese and Indian investment; (h) A lack of proper infrastructure and the related high transaction costs of trade and investment; (i)

Poorly developed labour and capital markets;

(j)

Relatively high levels of protectionism, both in Africa (with the exception of South Africa) and in Asian countries (including high levels of tariff escalation and non-tariff barriers), which hamper effective South-South trade and investment;5

(k) High levels of corruption and an overall absence of good governance in selected African and Asian countries, including the incidence of civil and international wars and conflicts (predominantly in Africa); (l)

A lack of effective trade and investment integration between Asia and Africa (i.e. a high number of regional trade agreements (RTAs) within Africa and Asia but not between them).6

These obstacles and challenges can be categorized in various ways. Obviously, most of them are rooted in the overall absence of a minimum level of development, especially in Africa, which is required to spur value-added trade and investment flows. They include the absence of well-developed legal, institutional and financial frameworks, policies and institutions; education and health infrastructure; private sector businesses and representative institutions; and other interrelated elements which make up a conducive investment and business climate and contribute to supply-side capacity. In addition, Africa and Asia are host to many of the world’s landlocked developing countries. Of the 12 landlocked countries in Asia, Azerbaijan, Armenia, Kazakhstan, Kyrgyzstan, Mongolia, Tajikistan, Turkmenistan and Uzbekistan are now economies in transition, while 5

6

Following the India/Africa Partnership Summit Forum, the Indian Institute of Foreign Trade (IIFT) conducted a study to ascertain the feasibility of entering into a Preferential Trade Agreement (PTA)/Free Trade Agreement (FTA) between India and South Africa (IIFT, “Feasibility Study on India-SACU Preferential Trade Agreement/Free Trade Agreement”, 2008). The study found that more than 50 per cent of India’s exports are subject to a tariff of less than 10 per cent in South Africa and only 33 per cent are facing a tariff rate of more than 20 per cent. On the other hand, 55 per cent of imports from South Africa face high tariffs of more than 20 per cent in India. Only 34 per cent of imports from South Africa are subject to low tariffs of 10 per cent and below. The weighted average tariffs in India and South Africa are 22.89 per cent and 16.35 per cent, respectively. The existence of the Indian Ocean Rim Association for Regional Cooperation (IOR-ARC) is noteworthy. It was formally launched in March 1997 and consists of 19 Asian and Pacific, Middle Eastern, and East and South African member countries. The Association disseminates information on trade and investment regimes in the respective member countries, with a view to helping the region’s business community to better understand the impediments to trade and investment within the region. These information exchanges have been intended to serve as a base to expand intraregional trade. However, no formal free trade agreement exists between the member countries.

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Afghanistan, Bhutan, the Lao People’s Democratic Republic and Nepal are classified as LDCs. There are 15 landlocked countries in Africa, most of which are LDCs. Many of them are plagued by civil strife and natural disasters, such as droughts, and other environmental problems, such as desertification and deforestation, and suffer from abject poverty and a high incidence of disease. Such constraints do not make for effective development and, hence, for the effective promotion of trade and investment, yet without the development of private-sector-led trade and investment, no wealth can be generated, and wealth is needed to address the overall development concerns. In this context, the rising flows of Asian investment capital in Africa and exports from Africa to Asia offer opportunities to escape the vicious cycle of underdevelopment. While it appears that challenges and obstacles to effective African-Asian trade and investment are basically an African problem, this would be misleading. Many of the identified obstacles are prevalent in both African and Asian countries but they tend to be generally more profound in Africa. In addition, it should be added that Asia has been recovering for a long time from the 1997 crisis and many Asian investors, in particular SMEs, are still inexperienced and reluctant to invest abroad, let alone in Africa, as compared with easier investment destinations in Asia itself. This is coupled with the traditional aversion to risk found in Asia.

(b) Opportunities Doing business in or with Africa is certainly challenging. Nevertheless, there are potential rewards which make it worth the risk. Below is a brief analysis of the main opportunities for African-Asian trade. First of all, there are clear complementarities and a shifting of comparative advantages between the two continents. Conventional theory dictates that developing countries produce primary products, as they are endowed with rich natural resources and low labour costs, while developed countries have high labour costs and focus on the high value added and technologically advanced industries and services. However, these advantages are slowly shifting. Labour costs in Asia have steadily risen, while emerging Asian countries have accumulated capital surpluses. Savings rates have also rocketed across Asia since the 1997 financial crisis, creating avenues for outward investment. Coupled with global pension fund reforms, these factors have enabled emerging Asian countries to become investors themselves through channels such as pensions and investment funds in the next generation of developing countries, both in Asia and Africa. These investments are, as yet, not very large but new opportunities are emerging as private sector investments and mergers and acquisitions take on more active roles. In trade, obviously, emerging Asian countries have progressed to higher stages of manufacturing, requiring vast raw materials and natural resources, which are abundantly available in Africa in return for Asian investments to explore and exploit such inputs. 150

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For instance, a country such as China is advanced in agricultural technology, seed cultivation and oil exploration and has relatively cheap and durable light industry products and machinery. These products could meet the needs of African countries at much lower costs than when sourced from developed countries. In addition, Asian countries tend to be more flexible on political issues and are familiar with working in a developing country environment. Second, while investing in Africa appears risky, an early presence may reap benefits. In a similar fashion as Japanese transnational corporations waited patiently for profits in countries such as China and Viet Nam, the early presence of Chinese and Indian transnational corporations in Africa is sure to reap rewards in due time. African countries have booming populations despite a relatively high mortality rate. The current population of Africa is estimated to be 900 million and it is expected to grow to 2 billion by 2025. As a result, these countries constitute potentially lucrative markets for relatively cheap products which are not provided by developed countries at prices offered by Asian countries. Though purchasing power is still relatively low, quite a few African countries have witnessed impressive economic growth rates. Over the past decade, Africa has recorded an average growth rate of 5.4 per cent, which is on a par with the rest of the world. An ECA report (2008) notes that African economies have continued to sustain the growth momentum of previous years, recording an overall real GDP growth rate of 5.8 per cent in 2007, with 30 countries recording higher economic growth rates in 2007 than in 2006. According to the World Bank Africa Development Indicators 2007 (World Bank, 2008), a group of 18 resource-poor countries—home to 35.6 per cent of the Africa’s population—have done as well as some oil-rich countries, if not better, sustaining growth of more than 4 per cent over the last decade. Today, the East African Community, for instance, has a combined population of 120 million people, with a combined GDP of about $50 billion.7 Africa’s growth performance has been driven mainly by robust global demand, including from Asian countries such as China and India, and high commodity prices. African exports include food and agricultural products, as non-essential foods such as coffee, cocoa, tea and nuts are experiencing stronger demand in Asia than in the already saturated markets of developed countries (World Bank, 2004). These trends clearly offer opportunities for Asian investors to set off a virtuous cycle of development in both Africa and Asia. Asian investment in Africa is progressing beyond natural resources and is increasingly targeting labour-intensive manufacturing, such as textiles and clothing, and 7

The East African Community is an intergovernmental organization comprising five East African countries: Kenya, Tanzania, Uganda, Burundi and Rwanda. A customs union in East Africa was signed in March 2004 and commenced on 1 January 2005. Under the terms of the treaty, Kenya, the region’s largest exporter, will continue to pay duties on its goods entering the other four countries until 2010, based on a declining scale. A common system of tariffs will apply to goods imported from third-party countries.

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light manufacturing. To some extent, this investment is motivated by the access of African countries to developed markets under GSP and other preferential market access schemes. Although some of these schemes, such as EBA, are also available to Asian developing or least developed countries, others, such as AGOA, are not. Moreover, as mentioned earlier, where developed countries have imposed restrictions on Chinese exports, Chinese companies find it convenient to invest in Africa and export their products without restriction from there to the developed countries. A successful Doha round and restrictive rules of origin may, however, undermine the effectiveness of preferential market access schemes. At the same time, African manufacturing sectors geared towards exports to developed countries are benefiting from relatively cheap imports from Asia, especially in the textile and clothing and automobile industries (World Bank, 2004).

4.

MODALITIES FOR ENHANCING EFFICIENT AND EFFECTIVE AFRICAN-ASIAN TRADE AND INVESTMENT FLOWS

(a) National level modalities Broadman (2007) identifies four areas for national level reform, both in Africa and Asia: (a) “At-the-border” reforms, such as the elimination of the escalating Chinese and Indian tariffs on Africa’s leading exports and the elimination of African tariffs on certain inputs that make its own exports uncompetitive. These reforms are aimed at trade liberalization. Apart from tariffs, a whole range of non-tariff measures in both Africa and Asia need to be dismantled. These reforms may be able to be implemented in the short run, depending on the extent to which African countries depend on tariffs for Government revenues. However, according to Broadman, they are less important than the reforms in the other areas; (b) “Behind-the-border” reforms in Africa to unleash competitive market forces, strengthen Africa’s basic market institutions and improve governance. These reforms cover the gamut of development and are focused on developing supply-side capacities. They include strengthening the overall business and investment climate through better and more effective legal, institutional and financial systems; better infrastructure; and a higher level of skills. They also include reforms aimed at developing capacity to achieve higher value addition at home. This is a long-term issue; (c) “Between-the-border” improvements in trade facilitation infrastructure and institutions to decrease transaction costs, such as improvements in Customs administration, logistics, and transport and communications and the adoption of standard compliance and certification facilities. African countries have a long way to go towards effective trade facilitation, as do their Asian counterparts, and this includes the adoption of international standards and the adoption of single window systems; 152

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(d) Reforms that leverage linkages between investment and trade to allow African businesses to participate in the modern global production-sharing networks generated by Asian investments in Africa and to facilitate the transfer of technologies.

(b) Regional cooperation modalities Improvements in African-Asian trade and investment flows require both African and Asian countries to implement reforms. Hence, there is an imperative for them to work together. This can be done through the organization of regular strategic dialogues within established platforms which already exist in the form of the India-Africa and China-Africa forums, TICAD and the Asia-Africa Trade and Investment Conference, but these forms of dialogue tend to be dominated by a particular country (e.g. India, China or Japan) rather than engaging dialogue between the two regions that includes all countries. Such a platform could be established under the auspices of ECA and ESCAP and/or the Asian Development Bank and the African Development Bank. Such platforms could provide broader dimensions of African-Asian cooperation, result in concrete schemes on trade and investment and business development (in particular for SMEs), provide opportunities for learning from best practices, and establish business contacts and useful intergovernmental contacts. Alongside such platforms, business and investment forums could be organized where African and Asian businesses would be brought together or where at least Asian entrepreneurs (in particular, SMEs) would be presented with business opportunities in Africa. Business-to-business exchanges are important and do not necessarily have to be government-driven. Chambers of commerce at the national and/or subregional level should also undertake initiatives in this regard. The Africa-Asia Business Forum could be strengthened for this purpose. The Forum is a series of intense face-to-face negotiations between selected African and Asian firms organized within the framework of TICAD. It aims to identify business partners to enter into various types of deals such as joint ventures, franchising, licensing and technology transfer. The fourth Africa-Asia Business Forum (AABF IV) took place in Dar es Salaam, Tanzania, from 12 to 14 February 2007, bringing together 212 participants from 17 African and 7 Asian countries; 118 memoranda of understanding, valued at $156 million, were concluded during the Forum.8 Second, Asian and African countries need to promote intraregional integration, which will facilitate economic cooperation between the two continents and more efficient flows of trade and investment within each region. While Africa has large subregional integration schemes, they are, in fact, rarely effectively implemented.

8

Website of the Africa-Asia Business Forum, accessed from www.ticadexchange.org/main2.asp?id=141& lan=en on 30 December 2008.

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Third, Africa and Asia should establish stronger trade and investment linkages through the formation of regional and/or (as a second best option) bilateral trade agreements. Bilateral trade agreements could be concluded between countries in Africa and ASEAN, India and China, while a regional trade agreement could be concluded within the framework of the Indian Ocean Rim Association for Regional Cooperation. The only initiative at the moment is the proposed India-SACU free trade agreement, but negotiations are stalling. In addition, selected emerging and richer Asian countries could grant African countries preferential market access. Worldwide, progress has already been made in the Global System of Trade Preferences among Developing Countries (GSTP) but the implementation of this system tends to be very slow. There is also a need for more financial cooperation between Asia and Africa to support trade and investment flows between the two regions. Deepening financial market reforms and ensuring higher quality services among financial institutions will enable the optimum mobilization of savings as well as securing the uses of capital. Such security will be beneficial to developing countries in avoiding, or at least reducing, financial risks.

(c) Role of ECA and ESCAP As the principal regional representatives of the United Nations in their respective regions, ECA and ESCAP can do a lot, together and by themselves, to promote interregional cooperation. By themselves, they should continue promoting and fostering intraregional integration by strengthening and consolidating regional trade agreements which are far-reaching in scope, broad in commitments and membership, and actually being implemented. Africa has various Customs unions, which are rather weak. RTAs have proliferated in Asia, but none of them are Customs unions; they are, rather, preferential trade agreements which are presented as free trade agreements. ESCAP has undertaken efforts to map and assess these agreements through its Asia-Pacific Trade and Investment Agreements Database,9 with the aim of streamlining, harmonizing or even consolidating them. It is also the secretariat to the Asia-Pacific Trade Agreement,10 the members of which—Bangladesh, China, India, Sri Lanka, the Republic of Korea and the Lao People’s Democratic Republic—have launched a fourth round of tariff negotiations as well as negotiations on framework agreements in the areas of trade in services, non-tariff barriers, investment and trade facilitation. Membership expansion initiatives are also being implemented. In addition, ESCAP is organizing regional and subregional networks to promote trade cooperation and efficient trade, with the purpose of promoting the adoption of internationally recognized principles and practices of trade facilitation and efficiency among its members. In the future, it is envisaged that ESCAP will promote subregional and regional cooperation in the area of finance, as well. It has already established mechanisms 9 10

Available at www.unescap.org/tid/aptiad. Available at www.unescap.org/tid/apta.asp.

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such as the Asian Clearing Union and the Asian Reinsurance Corporation. Through such modalities, ESCAP is promoting intraregional integration, which is essential for the promotion of effective interregional cooperation. As far as interregional cooperation is concerned, there are various options. Already, ESCAP and the Economic Commission for Europe (ECE) have circulated a project profile for submission under the seventh tranche of the United Nations Development Account. The project aims to establish networks, starting with the countries of Central Asia, with a broad mandate to discuss matters related to both trade policy, including RTAs and World Trade Organization (WTO) issues, and trade facilitation. Such platforms could be used for interregional dialogue. A similar initiative could be launched by ESCAP and ECA. ECA and ESCAP could also cooperate in establishing a knowledge database on African-Asian trade and investment patterns and relations to understand better how the markets work in both regions (World Bank, 2004). On the basis of this database, analytical studies, including studies at the sectoral level, could be undertaken to identify areas for cooperation in and the expansion of trade and investment and to identify bottlenecks. Together, the two commissions could forge a deeper integration of both African and Asian enterprises into regional, interregional and international supply chains. The focus of these efforts should be on SMEs. Already, FDI in Africa from Asian SMEs and business-tobusiness contacts between the two regions are increasing and both commissions should nurture and foster such developments through the organization of interregional business and investment forums. Joint training programmes with WTO on WTO/Doha issues could also be contemplated, as both commissions have excellent relations with WTO in the delivery of technical assistance aimed at promoting the multilateral trading system. Joint activities could also be organized to highlight best and good practices in the area of business development, including entrepreneurship development, technology transfer and development, and the overall improvement of the business and investment climate. In this respect, Africa could learn a great deal from Asian experiences. ESCAP and ECA should also address the issue of asymmetry. As yet, most interregional FDI flows are from Asia to Africa and most exports are from Africa to Asia. Africa needs to start investing in Asia, as well, to tap into interregional supply chains and directly access inputs for its own manufacturing. Africa also needs to focus more on adding value in its own industries to escape dependency on commodities only, particularly as current high prices may not persist and commodity prices are known for their wide fluctuations. These are some preliminary ideas. Any modality identified above in section 4 could, and should, be supported by the regional commissions in close cooperation with the regional development banks and global institutions such as UNCTAD, the United Nations Industrial Development Organization (UNIDO) and WTO, in particular with reference to

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the implementation of the One United Nations concept and within the wider framework of Aid for Trade initiatives. Such ideas and concrete interregional projects could be further discussed within the Executive Committee on Economic and Social Affairs (EC-ESA)11 trade cluster or the United Nations Chief Executives Board (CEB) Interagency Cluster on Trade and Productive Capacity, which was recently launched at UNCTAD XII.12

11 12

More information on EC-ESA is available at www.un.org/esa/ecesa. More information on UNCTAD XII is available at www.unctad.org/Templates/Meeting.asp?intItemID= 4287&lang=1.

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REFERENCES Broadman, Harry G. (2007). Africa’s Silk Road: China and India’s New Economic Frontier (Washington, D.C., World Bank). Economic Commission for Africa (ECA) (2006). Economic Report on Africa 2006: Capital Flows and Development Financing in Africa (Addis Ababa). _____ (2008). Economic Report on Africa 2008—Africa and the Monterrey Consensus: Tracking Performance and Progress (Addis Ababa). Wang, Jian-Ye and Abdoulaye Bio-Tchané (2008). “Africa’s burgeoning ties with China”, Finance and Development, vol. 45, No. 1. Njinkeu, Dominique and Bruno Powo Fosso (2006). “Intra-African Trade and Regional Integration”, paper prepared for the First Annual African Development Bank Group Economic Conference on Accelerating Africa’s Development Five Years into the Twenty-first Century, Tunis, 22-24 November. United Nations Conference on Trade and Development (UNCTAD) and United Nations Development Programme (UNDP) (2007). Asian Foreign Direct Investment in Africa: Towards a New Era of Cooperation among Developing Countries, UNCTAD Current Studies on FDI and Development No. 3, UNCTAD/ITE/IIA/2007/1 (New York and Geneva). UNCTAD (2007). World Investment Report 2007: Transnational Corporations, Extractive Industries and Development, UNCTAD/WIR/2007 (New York and Geneva). World Bank (2004). Patterns of Africa-Asia Trade and Investment: Potential for Ownership and Partnership, October, paper prepared for the Tokyo International Conference on African Development (TICAD) Asia-Africa Trade and Investment Conference, Tokyo, 1-2 November 2004. _____ (2008). Africa Development Indicators 2007: Spreading and Sustaining Growth in Africa (Washington, D.C.). Yoshino, Yutaka (2008). “Africa-Asia trade and investment: opportunities and challenges”, (Washington, D.C., World Bank), April.

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Issues in the long-term development of sovereign wealth funds

Yang Zhendai*

ABSTRACT

S

overeign wealth funds (SWFs) have been around for over half a century, largely unnoticed. In recent years, with the growth of their number, scale and investment activities, and the emergence of new players, SWFs have been, among other things, capturing increasing public attention and generating debate on geopolitical concerns, Government involvement in investment activities, and pro-protectionism versus pro-liberalization policy orientation. Among global SWFs, the fund managed by the China Investment Corporation (CIC), the sixth largest SWF in the world1 and the second largest in the Asia-Pacific region, is frequently talked about but the details of CIC are less well known. The lack of information leads to a lack of trust and confidence, which in turn could induce an unfavourable investment environment in the recipient country, and even a protectionist environment worldwide. In an attempt to make SWFs a positive force for a stable and healthy global financial market, this paper uses CIC as a case study to analyse a set of lessons learned and crucial issues to be addressed for the long-term development of SWFs, particularly those that are newly established or under preparation in developing countries. It is hoped that, with an enhanced understanding of SWFs and the improvement of their practices, public and private confidence in both home countries and recipient countries could be boosted. This would in turn create a pro-liberalization environment for SWF development and allow the global financial market to benefit from efficient and optimized resource allocation through free and fair competition in an open market. * 1

Associate Economic Affairs Officer, Trade Policy Section, Trade and Investment Division, ESCAP, Bangkok. The “Big Six” sovereign wealth funds worldwide are Abu Dhabi Investment Authority (United Arab Emirates), Government Pension Fund (Norway), Government Investment Corporation (Singapore), Saudi Arabian Monetary Agency Foreign Holdings (Saudi Arabia), Kuwait Investment Authority (Kuwait) and China Investment Corporation (China).

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INTRODUCTION

SWFs have gained worldwide attention in recent years. While applauded as a source of liquidity and stability amidst the current global financial market turmoil, SWFs have also raised “anxiety”. (Bhagwati, 2008) There are concerns that: (a) Governments may mismanage their international investments to their own economic and financial detriment as well as to that of the global economic and financial systems; (b) SWFs may be managed in the pursuit of non-commercial or “strategic” objectives, such as controlling the industries of national security interest in the recipient countries, obtaining vital industrial knowledge and expertise, and promoting State-owned or State-controlled national champions in the home country to be global champions; (c) the handling of large investments connected to the Government may induce large-scale corruption; (d) the limited transparency of SWFs makes it difficult to monitor their activities and assess their impact on global markets; and (e) SWFs may induce an outbreak of financial protectionism in the recipient countries and the world at large. As Professor Jagdish Bhagwati (2008) pointed out in his testimony before the United States Senate Committee on Foreign Relations, the “role reversal” from a world in which private investors from wealthy industrialized countries invest around the globe to one in which the Governments of emerging markets become major shareholders of companies in industrialized countries presents “a painful reality which makes many of our citizens uncomfortable”. Like it or not, the growing interdependence of sovereign countries in international financial markets is a matter of fact in the world today. In a sense, the lack of confidence and the resulting risk of protectionism to counter SWFs are due to the lack of proper information and understanding. In this regard, a comprehensive study of SWFs is of great significance. In particular, a study of the SWF of China, CIC,2 which is frequently talked about but the details of which are less well known, undoubtedly forms an essential part of this effort and could throw light on the development of other SWFs. This paper consists of five sections. After the introduction, section 2 provides an overview of SWFs, and section 3 provides a case study of CIC by reviewing its background, establishment, corporate structure and investment practices. Based on the case study, section 4 discusses lessons learned and crucial issues to be addressed for the long-term development of SWFs, and section 5 concludes by discussing the global implications of SWFs, measures to be taken by SWFs, and the role of international organizations in harnessing the force of SWFs for a sound global financial market.

2

As there is no formal name of the fund managed by the China Investment Corporation, the paper uses “CIC” to refer to either the fund or the corporation that manages the fund, depending on the context.

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AN OVERVIEW OF SOVEREIGN WEALTH FUNDS

Although the term “sovereign wealth fund” is new to the public, SWFs have been around for decades. The first SWF was set up by the Government of Kuwait in 1953, with the purpose of investing surplus oil revenues in order to reduce the country’s reliance on its finite oil resources. The second was set up in 1956 by the British colonial administration in the Gilbert Islands (since 1979 known as Kiribati) to hold royalties from phosphate mining (Kern, 2007). Since the 1950s, SWFs have experienced two major waves of inception. The first was in the 1970s, with Temasek Holdings (1974) and the Abu Dhabi Investment Authority (1976) as examples, and the second has been since the new millennium, with the establishment of over 20 SWFs during the period 2000-2007 (Linaburg and Maduelle, 2008). To date, there has been no single universally accepted definition of an SWF. As Truman (2008) summarized in his testimony before the United States House of Representatives, “the broadest definition of a sovereign wealth fund is a collection of Government-owned or Government-controlled assets. Narrower definitions may exclude Government financial or non-financial corporations, purely domestic assets, foreign exchange reserves, assets owned or controlled by subnational governmental units, or some or all Government pension funds.” An alternative way of defining an SWF is to look at its five key traits, which, as summarized by Jen (2007), a researcher at Morgan Stanley Research Global, are: (a) it is sovereign; (b) it has high foreign currency exposure; (c) it has no explicit liabilities (in contrast to a national State pension); (d) it has high risk tolerance; and (e) it has a long investment horizon. Although consensus on the definition of an SWF has yet to be reached, it is generally agreed that SWFs can be classified into two categories, based on the sources of funds. They are commodity-based funds (such as oil, gas and other natural resources-based funds) and non-commodity-based funds (such as foreign exchange reserves, general tax and other revenue-based funds). Based on the objectives of the funds, which vary from shielding the domestic economy from fluctuations in commodity prices and improving the return on foreign exchange reserves to accumulating wealth for future generations, the International Monetary Fund (IMF) work agenda on SWFs (IMF, 2008) classified SWFs into five types: (a) fiscal stabilization funds; (b) savings funds; (c) reserve investment corporations; (d) development funds; and (e) pension reserve funds (those without explicit pension liabilities). Due to the difference in definitions and the limited level of transparency of most SWFs, the number of SWFs worldwide, as well as the estimates of their size, varies among various sources. For example, the assets under management (AUM) of SWFs at the end of 2007 were estimated to be $2 trillion to $3 trillion depending on the source. According to the Sovereign Wealth Fund Institute, there were a total of 47 SWFs worldwide as of 30 June

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2008, with 62 per cent of them being oil- and gas-related funds and with total AUM valued at $3.9 billion. In terms of geographical distribution, SWFs in the Asia-Pacific region and in the Middle East are each managing 40 per cent of the AUM of global SWFs, while the remaining 20 per cent was distributed in Europe, Africa, North America and Latin America. Regarding the future growth of SWFs, the often-cited projections are $10 trillion by 2012 (Johnson, 2007) and $12 trillion by 2015 (Jen, 2007). It should be noted that $3.9 trillion is a “significant but not huge” (Johnson, 2007) or “large also small” figure (Bhagwati, 2008) in the context of the global gross domestic product (GDP) of $54 trillion and the total value of traded securities of $165 trillion in 2007 (Johnson, 2007). However, due to their political background, rapid growth, massive investments and limited transparency, SWFs have raised public concerns over financial stability, corporate governance, and political interference and protectionism (BlundellWignall and others, 2008), to name a few, and have attracted wide attention from policymakers, the private sector, academia and the general public.

3.

A CASE STUDY OF THE CHINA INVESTMENT CORPORATION

(a) Establishment As discussed in section 2, based on the source of funds, SWFs are generally classified into commodity-based and non-commodity-based types. With its funds originating from the soaring foreign exchange reserves of China, which increased from $149.2 billion in 1998 to $1.8 trillion by the end of June 2008 (State Administration of Foreign Exchange, 2008), CIC undoubtedly belongs to the latter. Foreign exchange reserves serve, inter alia, the purpose of supporting and maintaining confidence in monetary and exchange rate management, limiting external vulnerability by maintaining foreign currency liquidity, and assisting a Government in meeting its foreign exchange needs and external debt obligations. They are managed to ensure that: (a) adequate foreign exchange reserves are available to meet a defined range of objectives; (b) liquidity, market and credit risks are controlled in a prudent manner; and (c) subject to liquidity and other risk constraints, reasonable earnings are generated over the medium to long term on the funds invested (IMF, 2001). Though no consensus on the optimal reserve level exists, there are some well-known measures of reserve adequacy. These measures include the following: the rule of thumb that reserves should cover short-term external debt; the Greenspan-Guidotti rule that the reserve level should cover at least all external debt due within one year; the reserveto-M2 ratio, which has a critical value ranging from 5 per cent to 20 per cent; and the months of imports criterion, which suggests that a reserve level should be sufficient to cover about three to four months’ worth of imports (Park, 2007). In the case of China, its 162

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ratio of foreign exchange reserves to short-term external debt has been far above 1 since 1990, the reserve-to-M2 ratio was well above 5 per cent and even surpassed 20 per cent in 2006, and the reserves were adequate to cover imports of over one year in 2005 and 2006, far more than the standard of three to four months (Park, 2007). In sum, whatever criterion for adequate reserve level is applied, China comfortably passed the test. Or in other words, China’s foreign exchange reserves are well in excess of the country’s immediate needs. Against this background, while the soaring foreign exchange reserves figure represents secured liquidity, and the use of the reserves, largely in the form of United States Treasury bonds, secures safety, great public concerns have been raised about their profitability, or huge opportunity cost. Facing up to mounting appeals for improving the return on the foreign exchange reserves of China, and witnessing the success stories of SWFs such as Singapore’s Temasek Holdings and the Norwegian Government Pension Fund, the Government of China started looking into the proposal of creating an SWF of its own with the purpose of improving the return on its “excess” foreign exchange reserves. In January 2007, the National Financial Work Conference convened by the State Council endorsed the establishment of China’s first SWF. On 29 September 2007, six months after the announcement of this decision, the China Investment Corporation, Ltd. officially started operation. With a capital of $200 billion, CIC emerged as the sixth largest SWF in the world (see figure 1). Figure 1. The six largest sovereign wealth funds in the world (Billions of United States dollars) 1 000

875

800 600 397

400

330

300

264 200

200 0 Abu Dhabi Investment Authority (United Arab Emirates)

Government Pension Fund (Norway)

Government SAMA Foreign Holdings Investment Corporation (Saudi Arabia) (Singapore)

Kuwait Investment Authority (Kuwait)

China Investment Corporation (China)

Source: Author’s mapping based on Sovereign Wealth Fund Institute, 12 June 2008, available at www.swfinstitute.org/funds.php.

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To set a clear-cut line between the traditional foreign exchange reserves and the reserve-based SWF, the Standing Committee of the National People’s Congress approved the issuance of eight tranches of special Treasury bonds up to 1.55 trillion yuan by the Ministry of Finance of China to purchase $200 billion of foreign exchange reserves from the People’s Bank of China for CIC. The bonds issued were a mixture of 10- and 15-year bonds with annual coupon rates ranging from 4.3 per cent to 4.68 per cent. As arranged between the Ministry of Finance and CIC, since the special Treasury bonds were yuan-denominated, CIC is required to pay for the interest in the form of yuan every six months. In February 2008, CIC paid the half-year interest on the first tranche of bonds (600 billion yuan), amounting to 12.9 billion yuan. CIC Chairman Lou Jiwei calculated that CIC needs to earn at least 3 million yuan per working day to service its debt (Li and others, 2008). Given the fact that the major assets of CIC are in the form of United States dollars, along with the significant depreciation of the United States dollar against the yuan, the obligation of servicing its capital cost is significant, and will undoubtedly be a consideration in the investment decisions of CIC.

(b) Corporate governance Typical modern Chinese corporations have a corporate governance structure consisting of the general meeting of the shareholders, the board of directors, the board of supervisors and management. CIC generally follows this model by having a Board of Directors, a Board of Supervisors and a Management Committee. As a corporation operating a fund originating from the wealth of the sovereign State, the “shareholders” of CIC ideally should be the sovereign State representing the people, and its general meeting of shareholders should therefore ideally take place at the National People’s Congress level. However, in the case of CIC, it directly reports to the State Council, which unofficially turns CIC into an entity at the equivalent level of a ministry. The Board of Directors of CIC is composed of 11 members, including 3 executive directors, 5 non-executive directors, 2 independent directors and 1 staff representative, and its Management Committee is composed of 7 members. With the exception of the staff representative, whose name remains unknown to the public, all the other Board members come from either former or current top or senior positions of key Government agencies in charge of economic and financial issues (see annex I). Such a list not only demonstrates the visible Government background of CIC, but also reflects the desire of the Government of China to achieve an outstanding performance of its SWF through employing its most experienced senior officers, although their performance in the financial market has yet to be tested. While the corporate governance structure of CIC was disclosed immediately upon its establishment, its business structure is still being shaped. On 22 November 2007, CIC 164

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launched a global recruitment for 24 positions, including equity portfolio managers for emerging markets and for markets in Europe, the United States of America and Japan; fixed-income portfolio managers; senior researchers; market analysts; a compliance manager; a risk control manager; a programme manager; a public relations manager; an accountant; and an information technology manager. While building up its internal fund management capacity, CIC is also in the process of recruiting external fund managers (Caijing Magazine, 22 November 2007). The result of this recruitment has yet to unfold, but the recruitment announcement itself could give a hint about the management structure and future investment orientation of the Corporation.

(c) Investment activities Just like the overall reform and opening up of China itself, the investment activities of CIC also represent an exercise in learning through experience. When CIC was established, it acquired the Central Huijin Investment Corporation (CHIC) as a wholly-owned subsidiary company. Funded with foreign exchange reserves, CHIC was a State-owned investment corporation created in 2003, serving the strategic purpose of stabilizing and restructuring the financial sector of the country. During the period 2003-2006, CHIC made a series of significant investments in domestic banks and securities companies, notably the $22.5 billion investments in both the China Construction Bank and the Bank of China, the $15 billion investment in the Industrial and Commercial Bank of China, the 30 billion yuan investment in the China Everbright Bank, and the 10 billion yuan investment in China Galaxy Securities. CHIC played a critical role in the restructuring of those companies, and the investments have earned a good return. Therefore, CIC paid the People’s Bank of China $67 billion to acquire CHIC, which consumed about 33.5 per cent of the capital of CIC. In May 2007, CIC made its first investment,3 which was in the amount of $3 billion, in the initial public offering (IPO) of Blackstone Group, the largest private equity fund in the world. The high-profile deal was made at $29.605 per share (a 4.5 per cent discount off the IPO price) for 9.4 per cent of Blackstone Group’s stake in the form of non-voting shares for a lock-in period of four years (Caijing Magazine, 22 May 2007). Just when people were expecting an eye-catching return on this deal, unfortunately, with the continuous decline of United States stocks since the beginning of the subprime mortgage crisis, Blackstone Group’s stock prices also went into a downward spiral. The first anniversary of its IPO witnessed a 41 per cent drop in price from $31 to $18.25 per share (see figure 1), representing a $1.23 billion loss for CIC. Positioned as a passive investor 3

The deal was made by the Central Huijin Investment Corporation when the establishment of the China Investment Corporation was still under preparation, but it is generally regarded as the first investment of the China Investment Corporation.

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pursuing purely commercial interests, CIC relinquished the right of “voting with hands” by voicing its opinion at Board meetings. At the same time, the contracted four-year lock-in time left CIC with no right of “voting with feet” by selling the stocks on the market, even when faced with the huge loss. Not surprisingly, the first deal made by CIC received heavy criticism, including questions about whether the investment decision had gone through a due diligence investigation process and a proper decision-making process, whether it was wise to make the first investment in private equity, which stands at the high-risk end of the portfolio spectrum, and whether it was proper to make investments directly without engaging external fund managers when the internal investment capacity of CIC was still limited. What made the deal even more undesirable was that, shortly after receiving investment from CIC, in September 2007, Blackstone Group used $600 million to purchase a 20 per cent stake in the chemical business of the China National BlueStar (Group) Co., Ltd., a subsidiary of the country’s largest chemical company, ChemChina Group Corporation. This is an example of “round-tripping”, which goes against the wishes of CIC to diversify its holdings in overseas markets and to soak up domestic excess liquidity. The deal also incurred considerable currency conversion costs, as well as other transaction costs, because of the depreciation of the United States dollar against the yuan. In November 2007, CIC made a second investment, amounting to $100 million, in the IPO of the China Railway Group (CRG), the third-largest infrastructure construction company in the world, at the Hong Kong Stock Exchange. The lock-in period of the investment of CIC in CRG is one year (Caijing Magazine, 20 November 2007). With an IPO price of 6.80 Hong Kong dollars (HK$) per share on 7 November 2007, the share price of CRG closed at HK$ 5.99 as of 24 June 2008 (see figure 2), representing a 13.5 per cent drop during the half-year period. This deal was also questioned, including whether this investment was in line with the investment diversification objective of CIC (as the Hong Kong Stock Exchange is increasingly vibrating at the same wavelength as the mainland stock exchanges), and the possibility of the capital re-inflow of CRG into the mainland market, which is already afflicted with excess liquidity. Nevertheless, the second deal was, in general, more positively appraised than the first one. In December 2007, the third investment made by CIC was in Morgan Stanley through the purchase of $5 billion in equity units (a 9.9 per cent stake), which could be converted into common stock at no more than 1.2 times the reference price after a lock-in period of 31 months. These special equity units also granted CIC a passive investor’s position with “no special rights of ownership and no role in corporate management”. Morgan Stanley was contracted to pay for an annual coupon rate of 9 per cent on a quarterly basis during the lock-in time period (Caijing Magazine, 23 December 2007). The value of this deal lies in both interest revenue and stock value. Although the stock price of Morgan Stanley went down by 19 per cent, from $49.51 to $40.19 per share, since CIC became a shareholder (see figure 2), the deal was regarded as a win-win deal and won praise for CIC after its heavily criticized investment in Blackstone Group. On the one hand, the deal

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injected much-needed capital into the subprime mortgage loans-afflicted investment bank and demonstrated the positive role of CIC as a market-stabilizing force; on the other hand, it provided CIC with stable interest revenue during the lock-in period, which is important for enabling CIC to service its own debt. It was also expected that, when the 31-month non-convertible period ended, the current financial market turmoil would be over and CIC would stand a good chance to earn capital gains. In March 2008, CIC made its fourth investment in the IPO of Visa, amounting to $100 million (Caijing Magazine, 24 March 2008). Since IPO, the stock price of Visa has risen from $56.50 to $82.66 per share as of 24 June 2008 (see figure 2). Although there is no lock-in period for this deal, CIC has indicated its intention to be a long-term investor in Visa. Figure 2. Stock price trends of the investments of the China Investment Corporation Blackstone Group (June 2007 – June 2008)

China Railway Group (December 2007 – June 2008)

Morgan Stanley (June 2007 – June 2008)

Visa (March 2008 – June 2008)

Source: The Wall Street Journal, 26 June 2008, available at http://online.wsj.com/quotes. Note: For Blackstone Group, China Railway Group and Visa, the China Investment Corporation invested in their initial public offerings, while for Morgan Stanley, the China Investment Corporation invested on 19 December 2007.

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To sum up: as a new fund that aims to be a successful long-term global investor, it may be too early to assess the performance of CIC based on only half a year of operations; however, the four investments made so far reveal a gradual improvement in the investment performance of CIC by following a learning-through-experience track.

4.

KEY ISSUES TO BE ADDRESSED FOR THE LONG-TERM DEVELOPMENT OF SOVEREIGN WEALTH FUNDS

CIC is not alone in the pursuit of the survival and long-term development of SWFs. The problems encountered and the lessons learned during the past six months of operations are of value not only to CIC itself, but also to other newcomers in the SWF arena. Furthermore, the following recommendations for the governance, management and operation of commercial entities will not only help to improve the performance of SWFs, but also ease the “anxiety” about them and hence create a pro-liberalization environment for them.

(a) Set up detailed objectives and practical investment guidelines For SWFs to be successful, a clearly defined objective is a must. While it is easy to define the overall objective of an SWF as maximizing long-term returns within acceptable risk boundaries, such an overall objective cannot be achieved without a set of detailed and practical guidelines (for example, for the allotment of the fund to various types of investment instruments, the ceiling proportion for investment in a single industry and a single firm, and so forth). Take, for example, the Norwegian Government Pension Fund (NGPF). By adhering to the overall mission of safeguarding the petroleum wealth of Norway for future generations and judging the prevailing global financial situation, the Ministry of Finance created a set of guidelines for the Fund, including: an assets allocation ratio of 60:40 between fixed income instruments and equities (in July 2007, this ratio was amended to 40:60); a maximum ownership share of 5 per cent for any single company; a risk limit of 1.5 per cent expected tracking error;4 and no investment in Norwegian companies or in Norwegian currency (the krone). In contrast, such practical objectives and guidelines are still lacking for CIC, which, in a large sense, led to the “drifting” of its investment strategy in its early investments. To achieve successful and sustainable development, other SWFs must learn from this lesson to clarify their investment objectives and establish their operational guidelines on a priority basis.

4

Tracking error is a measure of how closely a portfolio follows the index to which it is benchmarked. It measures the standard deviation of the difference between the portfolio and index returns.

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(b) Establish a sound governance structure with sufficient operational autonomy By defining the rights and responsibilities within an organization and institutionalizing checks and balances, corporate governance is of great significance in ensuring that the organization is managed efficiently and in line with the stated objectives of its owners. In addition, while Governments need to hold SWFs accountable for their performance, SWFs should also be granted a sufficient degree of autonomy. In the case of CIC, for example, questions could be raised about: (a) whether a board and management made up purely of Government officials are capable of directing and managing the Fund; (b) whether the Corporation has sufficient autonomy to operate the Fund; (c) whether there is a clear and reasonable division of responsibilities between these bodies; and (d) whether there are clear decision-making rules and procedures. The Government of China has, on numerous occasions, stated its desire to follow the Singaporean Temasek Holdings model in operating its SWF. One key feature of the Temasek Holdings model is its high degree of operational autonomy and freedom from political interference in its day-to-day operations. Such autonomy is exemplified by the composition of its Board of Directors, which consists of private sector business leaders, with the exception of one representative from the Ministry of Finance. In addition, about 40 per cent of the senior managers of Temasek Holdings are non-Singaporeans, and over one quarter of its professional staff consists of non-Singaporeans. In contrast, the Board members of CIC, except one staff representative, all have a Government background. In an international seminar on pension funds held in China in February 2008, Knut N. Kjaer (2008), the former Chief Executive Officer of the Norges Bank Investment Management, which is another model example of an SWF, particularly stressed the importance of granting a high degree of autonomy to SWFs: “If corporate governance places the SWFs too close to the Government, and non-professional Government officials get anxious when the market turns bad, the above corporate governance will easily make the SWFs change their investment strategies, which is detrimental to the SWFs.” Therefore, SWF managers must take due note of such lessons in order to ensure the quality of their governance and management.

(c) Enhance transparency and communications with the general public As the IMF work agenda on SWFs (2008) indicates, “evidence suggests that SWFs are generally passive and long-term investors with no desire to impact company decisions by actively using their voting right”. In addition, “unlike private equity and hedge fund investors, SWFs do not usually rely on high leverage, do not face capital requirements, and are not likely to face pressures to rapidly liquidate positions based on withdrawals—all of which can make them more stable investors” (Butt and others, 2008). CIC and others actually provide supporting cases to these features. Their investments in the United States 169

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financial market since late 2007 provide an example of how SWFs could act as a marketstabilizing force in the subprime crisis. However, the emergence of SWFs from the Middle East and emerging Asian markets, such as the United Arab Emirates, Saudi Arabia, China and the Russian Federation, has generated not only applause, but also concerns, particularly regarding the possibility of using SWFs as a vehicle for political rather than commercial purposes. For example, there are concerns that “China may use the CIC to secure energy resources or purchase strategic assets for geopolitical purposes. There are also market apprehensions that the CIC could seek to increase its market share in important industries via targeted acquisitions or takeovers. Others are concerned that CIC might make investments in particular companies in order to obtain access to sensitive technology or information” (Martin, 2008). Such concerns have led to specific parliamentary hearings, numerous media discussions, a review of existing regulations and a surge in financial protectionist tendencies. One key reason behind such concerns is the lack of transparency of the Funds. Using the 10-score Linaburg-Maduell Transparency Index developed by the SWF Institute as a measurement, SWFs in developing countries generally have a score low (see annex II). In the case of CIC, so far, no official website has been established, and it scores only 2 on the Index, in sharp contrast to such high-scoring examples as NGPF and the New Zealand Superannuation Fund, which both score 10. Therefore, in order for SWFs to dispel suspicion and create a favourable business environment, one measure should be to increase transparency and proper communication with the general public. Though transparency is not a sufficient condition to win trust, it is a necessary condition, and SWFs in developing countries have a long way to go in this regard. It should also be pointed out that the issue of transparency is important not only at the international level, but also at the domestic level. As the funds managed represent the wealth of sovereign countries, that is, the public at large, SWFs should avail themselves of monitoring by the general public.

(d) Carry out a human resources development strategy suitable for its stage of development To score in the global financial market, an essential requirement for any fund is to build a highly experienced and professional team. At an early stage, when the internal investment capacity is still limited, the fund must leverage the capacity of experienced external fund managers. This was also the experience of NGPF in its early stages of development. In the case of CIC, the first investment was made directly in Blackstone Group without engaging any external fund manager. The hasty entry into the unfamiliar field of 170

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private equity incurred a huge loss to CIC (although still on the books), and resulted in the Corporation topping the list of the “Top 10 Worst Biz Deals in 2007” in Time magazine (2007). Aware of this problem, the top management of CIC decided on a three-step strategy: (a) making investments through external fund managers; (b) gradually increasing the proportion of investments made by in-house fund managers; and (c) establishing overseas branches (Xinhua News Net, 2007). Such a strategy is also of common value to other SWFs. As it is impossible to build such a team overnight, fund managers must start preparations as soon as possible. In addition, in an era characterized by ever-accelerating financial innovations, there are various types of products and tools under the umbrella of portfolio investment, and each of these requires specialized knowledge and experience. In this regard, human resources capacity-building should also be aligned with the investment orientations of the funds, which are undergoing development themselves. Furthermore, to attract the most competitive fund managers and stimulate a good investment performance, it is also essential for SWFs to set up performance-based compensation schemes.

(e) Determine risk management positions and improve risk management Lying at the heart of fund management is the issue of risk management, which needs to be singled out. Potentially high returns are always accompanied by high risks. That is why the mandates of SWFs are always expressed in terms of maximizing long-term, risk-adjusted returns or maximizing returns within acceptable risk boundaries. In a sense, it is the level of risk tolerance of each SWF that determines its investment allocation and, hence, its expected rate of return. The risk positions of some well-known SWFs are mapped in figure 3. Figure 3. Varying investment objectives and risk profiles of sovereign wealth funds Low

Stabilization

Investment objective

Examples:

Government bonds

Risk tolerance

High

Fixed Equity Real Hedge Private Leveraged estate funds equity buyouts income

Russian Stabilization Fund Norwegian Government Pension Fund Abu Dhabi Investment Authority Kuwait Investment Authority Temasek Holdings Qatar Investment Authority

Wealth accumulation

Source: Shams Butt and others, “Sovereign wealth funds: a growing global force in corporate finance”, Journal of Applied Corporate Finance, vol. 20, No. 1, 2008.

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It should be noted that only upon clarifying the overall tolerance level can fund managers decide on product line distribution, geographical distribution and individual investments. As risk levels vary from product to product, defining an overall risk tolerance level should be among the top priorities of the SWF decision makers.

(f) Ensure compliance with rules and regulations, and policy coordination To be responsible citizens in an increasingly linked world, SWFs should also attach importance to abiding by the rules and regulations and to policy coordination issues. As the IMF work agenda on SWFs (2008) points out, “…appropriate coordination between the SWF and the fiscal and monetary authorities is therefore critical to achieve overall policy objectives. At least four policy angles are relevant: fiscal policy, monetary policy, balance sheet implications, and external stability.” If they are properly integrated into a sound overall fiscal management framework, SWFs can be a useful policy tool to facilitate fiscal stabilization and to save resources for long-term purposes, such as preparing for an ageing population and the exhaustion of natural resources, and facilitating intergenerational transfers. SWFs can also serve as a stabilizing tool if they are properly coordinated with monetary policy. For example, the focus on the overseas investments of CIC not only serves the purpose of investment diversification but also plays a positive role in soaking up the current excess liquidity in domestic financial markets and in alleviating inflationary pressure. In addition, as entities in the global village, it is also important for SWFs to behave as responsible global citizens and abide by the emerging codes of conduct for SWFs. Here again, NGPF provides a good model. It follows a set of ethical guidelines developed by the Government of Norway and screens investments for not only commercial criteria but also corporate social responsibility criteria, as developed by the international community.

5.

GLOBAL IMPLICATIONS AND TASKS FOR INTERNATIONAL ORGANIZATIONS

As pointed out earlier, SWFs should not cause too much concern. By the end of 2007, the AUM of SWFs worldwide accounted for only 11.6 per cent, 12.1 per cent and 17.3 per cent of the AUMs of pension funds, mutual funds and insurance funds, respectively (see figure 4). Although the AUM of SWFs is larger than that of hedge funds, given the high-leverage feature of hedge funds, it is also misleading to conclude that SWFs are dominating hedge funds. As Mackie (2008) indicates, SWFs “make up only 2 per cent of the world’s $165 trillion-worth of traded securities” and “will probably still account for less than 3 per cent of global traded securities in 2015”.

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Figure 4. Assets under management, end of 2007 (Trillions of United States dollars) 28.5

Pension funds

27.3

Mutual funds 19.1

Insurance funds 3.3

Sovereign wealth funds 1.9

Hedge funds

0.8

Private equity 0

5

10

15

20

25

30

Source: International Financial Services London Research, Sovereign Wealth Funds 2008, April 2008, Chart 2, available at www.ifsl.org.uk/output/Reports.aspx.

Nevertheless, the potential implications of the practices of SWFs should not be underestimated, either, given the increasing degree of interdependence of global financial markets. A number of issues have been brought up by IMF in its work agenda on SWFs (2008). First, there are circumstances in which SWFs could cause market disturbance. For instance, actual or rumoured transactions may affect relative valuations in particular sectors and result in herding behaviour, adding to market volatility, especially in shallower markets. If SWFs begin to pursue riskier investment strategies, they may act to amplify rather than stabilize cycles. Second, the shift from traditional reserve assets to more diversified SWF assets could have implications for the absolute and relative price of assets and the flow of funds between countries, leading to global imbalances. Third, significant effects may also be felt on mature sovereign debt markets. For instance, the diversification of SWF-held portfolios away from low-risk, short-term instruments, such as United States Treasury bills, into longer-term equity stakes may affect interest rates and equity prices. If SWFs diversify away from dollar holdings and invest more in line with global equity indices, a decline in capital inflows into the United States may cause a further depreciation of the United States dollar. In addition to the economic impact, SWFs have also raised geopolitical and national security concerns. For example, the United States is in the process of adopting legislation to tighten the scrutiny of investments by foreign Government entities where they raise security concerns. The Committee on Foreign Investment in the United States can recommend that the President block foreign direct investments that are deemed to be a threat to national security. There have been calls for greater oversight and regulation of the activities of SWFs and special procedures or restrictions on proposed investments by 173

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SWFs, including financial reporting requirements, limits on SWF ownership of United States companies, and restrictions on the types of equity investments SWFs can make in United States companies. The European Commission is also investigating whether takeovers by publicly controlled foreign investment funds are a concern and need remedial action. Both France and Germany are considering setting up a system similar to that in the United States. On the other hand, people are aware that SWFs can also play a stabilizing role in global financial markets. As summarized by IMF (2008): first, as long-term investors with no imminent call on their assets, and with mainly unleveraged positions, SWFs are able to sit out market downturns for longer periods of time or even go against market trends; second, large SWFs may have an interest in pursuing portfolio reallocations gradually so as to limit the adverse price effects of their transactions; third, the investments of SWFs may enhance the depth and breadth of markets; and fourth, SWFs could, as long-term investors and by diversifying the global investor base, contribute to greater market efficiency and lower volatility. An example of a positive role played by SWFs is their injection of much-needed capital into financial institutions such as Morgan Stanley, Citigroup, Merrill Lynch and Credit Suisse when they faced liquidity shortages. Based on the scoreboarding of 46 SWFs worldwide, Truman (2008) found “they are no different from other investors except that their stakes may be measured in the billions rather than in the hundreds of millions of dollars” and warned that “the greatest risk to the United States economy is that we will erect unnecessary barriers to the free flow of capital into our economy and, in the process, contribute to the erection of similar barriers in other countries to the detriment of the health and continued prosperity of the United States and global economies.” He further argued that “we may not in all cases be comfortable with the consequences of the free flow of finance and investment either internally or across borders, but on balance it promotes competition and efficiency.” Truman’s testimony echoes Kern (2007), who states that “the benefits of liberalization and free market access are tremendous and well-documented”, “investors as well as investment targets can benefit greatly from a seamless flow of capital across countries”, and protectionism is “unacceptable”. Therefore, “we must recognize, and not compromise on, our openness” (Bhagwati, 2008). In conclusion, the task before us is not to close the door on SWF investment, but rather, to harness the force of SWFs for the benefit of a healthy global financial market. On the part of SWFs, drawing lessons from CIC and from good examples such as NGPF, efforts should be made in the following areas: first, to clearly define objectives and practical investment guidelines; second, to establish a sound governance structure with sufficient operational autonomy; third, to enhance transparency and communication with the public; fourth, to build up human resources and set up a performance-based incentive scheme; fifth, to determine the risk tolerance level and enhance risk management; and finally, to ensure compliance with rules and regulations, and policy coordination.

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As far as the role of international organizations is concerned, efforts should be made in at least the following areas: first, to improve statistics on SWFs and include them in the global financial surveillance system; second, to develop a set of internationally accepted codes of conduct for SWFs and promote their implementation; third, to build up the management and operational capacities of SWFs and facilitate the sharing of international best practices; and lastly, to conduct analytical studies to enhance the understanding of SWFs and their features, macroeconomic linkages and implications, and facilitate the formulation of proper policy responses. The Asia-Pacific region houses 40 per cent of SWFs worldwide in terms of both the number of SWFs and the assets under their management. Therefore, there exists an important potential role for ESCAP, the largest United Nations body in the region, which could include monitoring the regional SWF trend, developing international codes of conduct, sharing regional lessons and best practices, and building up regional capacities so as to harness the force of SWFs for a stable and healthy financial market.

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REFERENCES Blundell-Wignall, Adrian, Yu-Wei Hu and Juan Yermo (2008). “Sovereign wealth and pension fund issues”, Financial Market Trends, No. 94 (Paris, Organisation for Economic Co-operation and Development), pp. 117-132. Bhagwati, Jagdish (2008). “Sovereign wealth funds and implications for policy”, testimony before the United States Senate Committee on Foreign Relations, 11 June. Butt, Shams, Anil Shivdasami, Carsten Stendevad and Ann Wynan (2008). “Sovereign wealth funds: a growing global force in corporate finance”, Journal of Applied Corporate Finance, vol. 20, No. 1, pp. 73-83. Caijing Magazine (2007). News report on Huijin’s investment in Blackstone, 22 May (in Chinese), available at www.caijing.com.cn/2007-05-22/100020127.html. _____ (2007). News report on “The China Investment Corporation enters into business”, 29 September (in Chinese), available at www.caijing.com.cn/2007-09-29/ 100031997.html. _____ (2007). News report on CIC’s investment in China Railway Group, 20 November (in Chinese), available at www.caijing.com.cn/2007-11-20/100038600.html. _____ (2007). News report on CIC’s global recruitment, 22 November (in Chinese), available at www.caijing.com.cn/2007-11-22/100038873.html. _____ (2007). News report on CIC’s investment in Morgan Stanley, 23 December (in Chinese), available at www.caijing.com.cn/2007-12-23/100042675.html. _____ (2008). News report on CIC’s investment in Visa, 24 March (in Chinese), available at www.caijing.com.cn/2008-03-24/100053803.html. IMF (2001). Guidelines for Foreign Exchange Reserve Management (Washington, D.C.), September, available at http://imf.org/external/np/mae/ferm/eng/index.htm. ______ (2008). Sovereign Wealth Funds—a Work Agenda (Washington, D.C.), February. International Financial Services London (IFSL) Research (2008). Sovereign Wealth Funds 2008, available at www.ifsl.org.uk/output/Reports.aspx. Jen, S. (2007). “How big could sovereign wealth funds be by 2015?”, Morgan Stanley Perspectives, 4 May. Ji, Minhua and Haili Cao (2008). “A model sovereign wealth fund”, Caijing Magazine, No. 206, March (in Chinese), available at www.caijing.com.cn/2008-03-08/ 100051417.html. Johnson, Simon (2007). “The rise of sovereign wealth funds”, Finance and Development (Washington, D.C., International Monetary Fund), vol. 44, No. 3, pp. 56-57.

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Kern, Steffen (2007). “Sovereign wealth funds—state investments on the rise”, Current Issues (Frankfurt, Deutsche Bank Research) 10 September. Kjaer, Knut N. (2008). Speech at the 2008 Pension Fund International Seminar, Suzhou, China, 28 February, in Jin, Minhua and Cao, Haili, “A model sovereign wealth fund”, Caijing Magazine, No. 206, March 2008 (in Chinese), available at www.caijing.com.cn/2008-03-08/100051417.html. Li, Jing and others (2008). “A question of 200 billion dollars”, Caijing Magazine, No. 206, March (in Chinese). Linaburg, Carl and Michael Maduell (2008). Linaburg-Maduell Transparency Index (Roseville, C.A., Sovereign Wealth Fund Institute), available at www.swfinstitute. org/research/transparencyindex.php. Mackie, Daniel (2008). “Asset-backed insecurity”, The Economist, 17 January. Martin, Michael F. (2008). China’s Sovereign Wealth Fund, report to Congress No. RL34337 (Washington, D.C., Congressional Research Service), 22 January. Park, Donghyun (2007). Beyond Liquidity: New Uses for Developing Asia’s Foreign Exchange Reserves, Economic and Research Department Working Paper Series No. 109 (Manila, Asian Development Bank). State Administration of Foreign Exchange (2008). Data on Monthly Foreign Exchange Reserves, available at www.safe.gov.cn/model_safe_en/tjsj_en/tjsj_list_en.jsp?ID =30303000000000000&id=4. Time (2007). “Top 10 Worst Biz Deals in 2007”, available at www.time.com/time/specials/ 2007/top10. Truman, Edwin M. (2008). “The rise of sovereign wealth funds: impacts on US foreign policy and economic interests”, testimony before the Committee on Foreign Affairs, United States House of Representatives, 21 May. Xinhua News Net (2007). News report on CIC’s three-step investment strategy, 29 November, available at http://news.xinhuanet.com/fortune/2007-11/29/ content_7169395.htm.

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Annex I. Corporate governance structure of the China Investment Corporation State Council

Board of Directors

Executive Directors

LOU Jiwei

GAO Xiqing

Board of Supervisors

Non-Executive Directors

ZHANG Hongli

HU FU LIU ZHANG LI Xiaoqiang Yong Ziying Shiyu Xiaolian

Independent Directors

Staff Rep

WANG LIU Zhongli Chunzheng

Management Committee

Chairman LOU Jiwei

General Manager GAO Xiqiang

Vice GM ZHANG Hongli

Vice GM YANG Qingwei

Vice GM HU Huaibang

Vice GM XIE Ping

Vice GM WANG Jianxi

Source: Author’s mapping based on Caijing Magazine, “The China Investment Corporation enters into business”, 29 September 2007, available at www.caijing.com.cn/2007-09-29/100031997.html. Notes: LOU Jiwei, former Vice-Minister of Finance and Deputy Secretary-General of the State Council GAO Xiqing, former Vice-Chairman of the National Pension Fund and former Vice-Chairman of the China Securities Regulatory Commission ZHANG Hongli, Vice-Minister of Finance ZHANG Xiaoqiang, Vice-Chairman of the National Development and Reform Committee LI Yong, Vice-Minister of Finance FU Ziying, Assistant Minister of Commerce LIU Shiyu, Deputy Governor of the People’s Bank of China HU Xiaolian, Deputy Governor of the People’s Bank of China and Director-General of the State Administration of Foreign Exchange LIU Zhongli, former Minister of Finance WANG Chunzheng, former Vice-Chairman of the National Development and Reform Committee HU Huaibang, former Commissioner of the Discipline Inspection Committee of the China Banking Regulatory Commission YANG Qingwei, Director-General of the Investment Department of the National Development and Reform Committee XIE Ping, former Director-General of the Financial Stability Department of the People’s Bank of China, and General Manager of the China Huijin Investment Corporation, which has merged into the China Investment Corporation WANG Jianxi, former Assistant Chairman of the China Securities Regulatory Commission and Chairman of the China Huijin Investment Corporation

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Annex II. Linaburg-Maduell Transparency Index Norway-GPF New Zealand Australia Future Fund USA-Alaska South Korea-KIC USA-New Mexico Azerbaijan Canada-AHF USA-Wyoming Hong Kong-HKMA Singapore-Temasek Ireland-NPRF Malaysia Timor-Leste Singapore-GIC Kuwait-KIA UAE-Mubadala Bahrain Russia UAE-Dubai Trinidad & Tobago Saudi Arabia-SAMA Vietnam UAE-ADIA Kazakhstan Chile Botswana UAE-RAK China-SAFE China-CIC Iran Oman Venezuela-FIEM Qatar-QIA Libya-LIA Algeria UAE-Federal Brunei Nigeria Kiribati Mauritania Angola

Over $100 billion AUM Under $100 billion AUM 0

1

2

3

4

5

6

7

8

9

10

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Point Principles of the Linaburg-Maduell Transparency Index +1

Fund provides history, including reason for creation, origins of wealth and Government ownership structure

+1

Fund provides up-to-date independently audited annual reports

+1

Fund provides ownership percentage of company holdings and geographic locations of holdings

+1

Fund provides total portfolio market value, returns and management compensation

+1

Fund provides guidelines in reference to ethical standards, investment policies and enforcer of guidelines

+1

Fund provides clear strategies and objectives

+1

If applicable, fund clearly identifies subsidiaries and contact information

+1

If applicable, fund identifies external managers

+1

Fund manages its own website

+1

Fund provides main office location address and contact information, such as telephone and fax

Source: Carl Linaburg and Michael Maduell, Linaburg-Maduell Transparency Index (Roseville, California, United States, Sovereign Wealth Fund Institute, 2008), available at www.swfinstitute.org/research/ transparencyindex.php, accessed on 6 October 2008. Notes: The Linaburg-Maduell Transparency Index is calculated by accumulating the assessment of performance in the 10 aspects for each sovereign wealth fund. A higher score represents a higher level of transparency. The names indicated are the names of the funds and are not necessarily the names of the countries or areas involved.

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Overviews of Recent Studies on Trade and Investment Published by the ESCAP Secretariat

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Unveiling protectionism: regional responses to remaining barriers in the textile and clothing trade

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n 1 January 2005, international trade in textiles and clothing finally became part of the multilateral trading system, but producers and exporters are not breathing any easier. The trading environment for this sector has since been changing more rapidly than ever. Competitive pressures have intensified in the largest import markets, and exporters of textiles and clothing face heavy pressure to cut prices. For countries in which this sector generates employment and foreign exchange revenues, this has caused further difficulties for development prospects. These are typically least developed countries with a lack of financial, technological and other resources for absorbing a large, unskilled and predominantly female labour force employed by the textile and clothing sector. There are also clear signs that other forms of protectionism may be on the rise in some developed countries, which are the major import markets. Therefore, to sustain previous trends of production and exports of textiles and clothing from developing countries in the region, recourse should be found in alternative but complementary strategies through regional cooperation. The creation of regional supply chains through the integration of markets and gender-differentiated trade adjustment financing to compensate losers (most of whom would be women) should be pursued. This would enable key stakeholders to formulate appropriate policy responses, including gender-differentiated responses, and to more effectively participate in negotiations on future policy frameworks relevant to this sector. Given the relevance of the textile and clothing sector to ESCAP member countries, the secretariat undertook the implementation of a project under the theme, “Weaving the Fabric of Regional Cooperation for Competitive Garment Exports: A Post-Quota Trading Environment”, which was supported financially by the Government of China and the secretariat of the Colombo Plan for Cooperative Economic and Social Development in Asia and the Pacific. The overall project objective has been to improve the effectiveness of responses by participating ESCAP member country Governments to the changing trading environment in the textile and clothing sector by formulating policies for improved intraregional trade and investment flows.

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Phase 1 of the project brought together multi-stakeholders from the region, as well as from outside the region, for a workshop at the Guanghua Business School in Beijing in 2005 to discuss the early impact of the elimination of the Multifibre Arrangement and the changes in the patterns of supply, demand and trade. That dialogue led to a follow-up seminar with an emphasis on the development of vertical and horizontal sectoral integration within the region. Thus, the focus of Phase 2 of the project was on exploring deeper regional cooperation in trade, investment and production in the textile and clothing sector. Towards that end, two research studies were produced and included in chapters III and IV of the publication, and the Regional Dialogue on Restrictive Policies and Measures in the Textile and Clothing Trade was organized in 2007 at the China-Europe International Business School in Shanghai, China. Some of the papers and most of the country reports presented at that meeting have also been integrated into this volume. While China remains the focus of any analysis of the textile and clothing sector, it is important to note that, since 2006, China has been diversifying its export structure in order to reduce its dependence on textiles and clothing. As discussed in this publication, many developing countries in the region have recognized this as an opportunity to defend, if not increase, their own market share, particularly through intraregional cooperation in investment and production in this sector. However, some economies—as is evident from the country reports in Part Two of the publication—still consider China to be a tough competitor. Unveiling Protectionism: Regional Responses to Remaining Barriers in the Textiles and Clothing Trade (ST/ESCAP/2500) is available at www.unescap.org/tid/ publication/tipub2500.asp.

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Trade facilitation beyond the multilateral trade negotiations: regional practices, Customs valuation and other emerging issues—a study by the Asia-Pacific Research and Training Network on Trade

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his publication brings together the main research outputs produced by the Asia-Pacific Research and Training Network on Trade (ARTNeT) and its members and partners between April 2006 and January 2007.1 It includes 10 chapters. The first chapter, by Yann Duval, introduces the concept of trade facilitation beyond the ongoing multilateral trade negotiations. After highlighting key trade facilitation trends and issues faced by countries in Asia and the Pacific, the paper discusses the emergence of trade facilitation provisions in preferential trade agreements, ongoing Customs valuation issues and the link between trade facilitation and services. The paper, which serves both as an introduction and a synthesis of the studies presented in the remaining chapters, stresses the need for a broader approach to trade facilitation. Such an approach would involve identifying weak links and bottlenecks along the international supply chain and addressing “behind-the-border issues”, such as domestic business regulations and infrastructure. In chapter II, Patrick Wille and Jim Redden compare the treatment of trade facilitation in four selected regional trade initiatives—the Association of Southeast Asian Nations (ASEAN) free trade area (AFTA), the Asia-Pacific Economic Cooperation (APEC), the South Asian Free Trade Area (SAFTA) and the Pacific Agreement on Closer Economic Relations (PACER)—as well as in one bilateral free trade agreement, the AustraliaSingapore Free Trade Agreement (ASFTA). They propose model trade facilitation principles and measures that may be instructive for developing country negotiators and policymakers.

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ARTNeT is an open network of national-level research institutions in the region launched by ESCAP and the International Development Research Centre (IDRC), Canada in October 2004 and supported by the United Nations Development Programme (UNDP), the United Nations Conference on Trade and Development (UNCTAD) and the World Trade Organization (WTO) as core partners. The ESCAP Trade and Investment Division (TID) serves as the secretariat of the network. Please visit www.artnetontrade.org for more details.

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In chapter III, Sachin Chaturvedi analyses trade facilitation provisions in South Asian free trade areas and finds that coverage of trade facilitation issues is minimal in all but one of the five trade agreements (two regional and three bilateral) reviewed against the list of trade facilitation measures that are relevant to Articles V, VIII and X of the General Agreement on Tariffs and Trade (GATT) and those that are under negotiation at the World Trade Organization (WTO). He argues that transit facilitation measures, including the development of infrastructure at land Customs stations and border agency coordination, are of particular importance to the region and that these issues could be tackled in part through the inclusion of relevant provisions in trade agreements and cooperation frameworks. Chapter IV, by William E. James, is dedicated to rules of origin in preferential trade agreements. Their complexity and their lack of harmonization across a growing number of overlapping agreements in the Asia-Pacific region is seen as an increasingly significant impediment to trade. Chapter V, by Sachin Chaturvedi, and Chapter VI, by Pushpa Raj Rajkarnikar, focus on Customs valuation in India and Nepal, respectively, as the issues associated with Customs valuation remain a key concern for both traders and Governments, even if they are not part of the ongoing WTO negotiations on trade facilitation. These chapters are complemented by chapter VII, by Biman Chand Prasad, which provides a comparative analysis of the broader trade facilitation needs and priorities of Fiji and a selection of Asian developing countries, building on the earlier work of ARTNeT. Chapters VIII and IX provide a broader perspective on trade facilitation. In the first of these chapters, Dariel De Sousa and Christopher Findlay examine the linkages between trade facilitation and trade logistics services liberalization as an initial effort to understand the interplay and level of priority that should be accorded to border trade facilitation measures as opposed to measures that would facilitate the development of trade facilitation-related infrastructure and services. Chapter IX, by Prabir De, looks at trade facilitation in a trade (transaction) cost framework and evaluates the impact of transport costs and underdeveloped infrastructure on the bilateral trade flows of 10 Asian developing countries. Chapter X, by Florian Alburo, concludes the volume with recommendations on how to arrive at a meaningful multilateral agreement on trade facilitation. The complete study, published as an ESCAP publication (ST/ESCAP/2466) with the support of the UNDP Regional Centre in Colombo,2 is available online at www.unescap.org/tid/artnet/pub/tipub2466.asp.

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Financial support provided by UNDP for this study is gratefully acknowledged. The generous support of the International Development Research Centre (IDRC), Canada, without which ARTNeT would not exist, is also acknowledged.

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Toward coherent policy frameworks: understanding trade and investment linkages1

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s economic integration continues, the distinction between domestic and international issues becomes more tenuous. Enhancing coordination and coherence among international trade, investment and domestic policies is of increasing importance for developing countries of the Asia-Pacific region in order to compete effectively and reap the benefits of globalization. In this context, the publication brings together a number of papers that highlight the increasing significance of trade and investment linkages and their effect on the development of domestic industries and services. The first two chapters, by Nagesh Kumar and Pierre Sauve, respectively, focus on investment provisions and regulation through trade agreements. Kumar finds that the investment provisions included in Asian regional trade agreements have tended to be progressively liberal, given the varying levels of development existing in the region. They have included provisions on investment protection, promotion and facilitation and on most favoured nation status and dispute settlement. The provisions are consistent with the provisions on investment contained in the Agreement on Trade-related Investment Measures (TRIMs) and have sometimes adopted a more ambitious approach. The more comprehensive attempts by the Association of Southeast Asian Nations (ASEAN), in particular, to deepen regional economic integration, for example, through the adoption of the ASEAN Investment Area and industrial cooperation schemes, indicate its recognition of the potential of industrial restructuring. Sauve also recognizes that it is important to see investment provisions in trade agreements and bilateral investment treaties in the broader context of economic integration trends, pointing out that the empirical evidence currently available suggests that bilateral investment treaties do not, on the whole, appear to exert determinative impacts on the investment decisions of multinational firms.

1

Four of the chapters in this publication were prepared as part of an exploratory regional study on trade and investment policy linkages supported by the Asia-Pacific Research and Training Network on Trade (ARTNeT). The generous support of the International Development Research Centre, Canada to ARTNeT is gratefully acknowledged. Please visit www.artnetontrade.org for more details.

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The third chapter, by Rajan Sudesh Ratna, concentrates on the issue of rules of origin in those agreements and the need for more coherent and harmonized approaches to the design of those rules. The chapter specifically points to elements that could be harmonized within rules of origin and develops guidelines for harmonization which could be followed by negotiators. The fourth chapter, by Santi Chaisrisawatsuk and Wisit Chaisrisawatsuk, explores in some detail the interactions between foreign direct investment (FDI) flows and import and export flows using a gravity model approach. The strong two-way positive relationship between bilateral trade and FDI flows identified in the econometric analysis supports the need for a coordinated approach to trade and investment policy issues. Chapter V, by Tulus Tambunnan, and chapter VI, by Tham Siew Yean and Andrew Kam Jia Yi, are country case studies that examine the linkages between trade and investment liberalization and the development of small and medium-sized enterprises in Indonesia and education services in Malaysia, respectively. These sectoral analyses highlight the mixed effects of trade and investment liberalization at the micro level and the importance of inter-agency coordination, without which the needs of SMEs and other stakeholders may not be adequately addressed. The last chapter, by Rashmi Banga, examines the drivers of outward FDI from the developing economies in the region. While trade is found to be an important factor in the development of outward FDI from developing economies, inward FDI and domestic constraints, such as poor infrastructure and the high cost of labour, all contribute to the growing outward FDI trend. The complete study, entitled Towards Coherent Policy Frameworks: Understanding Trade and Investment Linkages, has been published as No. 62 in the Studies in Trade and Investment series (ST/ESCAP/2469). It is available online at www.unescap.org/tid/artnet/ pub/tipub2469.asp.

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