Economic Globalization and Asia: Essays on Finance, Trade and Taxation

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Economic Globalization and Asia <

*

Essays on Finance, Trade and Taxation

Ramkishen S. Rajan

iRS

Institute of Policy Studies Cctebiatma tC> VWS J988-20Q3

World Scientific

Economic Globalization and Asia Essays on Finance, Trade and Taxation

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Economic Globalization and Asia Essays on Finance, Trade and Taxation

Ramkishen S. Rajan University of Adelaide, Australia and Institute of Policy Studies, Singapore

iRS

Institute of Policy Studies CrMiming M Years 1988-2003

Y | p World Scientific NEW JERSEY • LONDON • SINGAPORE • SHANGHAI • HONG KONG • TAIPEI

Published by World Scientific Publishing Co. Pte. Ltd. 5 Toh Tuck Link, Singapore 596224 USA office: Suite 202, 1060 Main Street, River Edge, NJ 07661 UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE

British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library.

ECONOMIC GLOBALIZATION AND ASIA Essays on Finance, Trade and Taxation Copyright © 2003 by World Scientific Publishing Co. Pte. Ltd. All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without written permission from the Publisher.

For photocopying of material in this volume, please pay a copying fee through the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA. In this case permission to photocopy is not required from the publisher.

ISBN 981-238-389-1

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Printed in Singapore by World Scientific Printers (S) Pte Ltd

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VII

Preface

The term "economic globalization" has been discussed extensively in the popular press, by business executives and by policy makers all over the world. While academic economists have made some excellent contributions to specific, technical aspects of economic globalization, there appears to be a need for economists to discuss the broader aspects of the issue in a more accessible manner. Failing this, the general debate will be informed only by the writings of non-economists. This is the motivation for this volume which is a collection of essays on various aspects of economic globalization in general, but with specific reference to Asia. Apart from the Introductory Chapter, the other eight chapters in this volume explore various issues pertaining to finance, trade and taxation in Asia. While all the Chapters in this volume have been interlinked, each has been written — and therefore can be read — as a distinct self-contained piece. In fact all the Chapters are extensively revised and updated versions of separate papers written for various other outlets. A n extensive bibliography has intentionally been included at the end of each Chapter to assist readers who may be interested in pursuing specific topics in more detail. Certain Chapters in this volume were co-authored. In particular, Chapters 6 and 7 were co-authored with Rahul Sen (Institute of Southeast Asian Studies, Singapore), while Chapter 9 was co-authored with Mukul Asher (National University of Singapore). The other Chapters, while not explicitly co-authored, have been influenced in one way or the other by many other collaborators whom I have had the good fortune of working with. In particular, in addition to Mukul Asher and Rahul Sen, I would like to acknowledge the stimulating intellectual partnerships I have thus far had with Graham Bird (Surrey University, UK), Chang Li Lin (Institute of Policy Studies, Singapore), Sanjay Marwah (Ohio University) and Reza Siregar (University of Adelaide).

VIII

Preface

I would also like to express my gratitude to Senada Nukic who painstakingly read through an earlier draft and offered valuable editorial assistance. My appreciation also to Ms Kim Tan of World Scientific Publishing who ensured smooth and timely publication of this book. My colleagues at the Institute of Policy Studies have always been a source of cheer and encouragement. My most heartfelt thanks must go out to my wife, Harminder Chyle, who has always been fully supportive of my work but has also ensured I have remained grounded and kept everything in perspective. This book was completed while I was visiting Claremont McKenna College (CMC), California as a Freeman Foundation Asian Scholar. I am grateful for the financial and intellectual support offered by C M C and the Freeman Foundation, as I am for the facilities made available to me at the Lowe Institute for Political Economy at CMC. Needless to say all remaining errors are solely due to my own ignorance or oversight. Ramkishen S. Raj an University of Adelaide, Australia & Institute of Policy Studies, Singapore October 2003

IX

Contents

Preface I.

vii

Economic Globalization: Finance, Trade and Taxation Chapter 1. Economic Globalization and Small and Open Economies: Finance, Trade and Taxation 1. Introduction 2. Globalization of Finance and Capital Flows 3. Globalization of Production and Trade: Agglomeration versus Fragmentation 4. First versus Second Waves of Globalization 5. Globalization, Public Finances and Income Distribution 6. Concluding Remarks Bibliography

3 3 4 7 9 12 13 16

II. International Monetary and Financial Issues in East Asia Chapter 2. International Capital Flows and Regional Contagion: Boom and Bust in East Asia in the 1990s 1. Introduction 2. Dynamics of Capital Flows in East Asia in the Late 1990s 3. Contagion: Definitions and Transmission Channels 4. Concluding Remarks Bibliography Chapter 3 . Liquidity Enhancing Measures and Monetary Cooperation in East Asia: Rationale and Progress 1. Introduction 2. Liquidity, Enhancing Measures: Safeguarding against Capital Account Crises

27 27 28 33 40 41 53 53 55

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Contents

3. Regional Response to Regional Crisis: The Chiang-Mai Initiative 58 4- Beyond the Chiang-Mai Initiative 62 5. Concluding Remarks 70 Bibliography 71 Chapter 4. Choosing the Right Exchange Rate Regime for Small and Open Economies in East Asia 83 1. Introduction 83 2. The Problems with Super-Fixes 84 3. The Flexible Exchange Rate Option Reconsidered 90 4. Concluding Remarks: Intermediate Regimes Revisited 95 Bilbliography 99 III. International Trade Issues in Asia Chapter 5. The Nexus Between Trade Liberalization and Poverty in Asia 111 1. Introduction 111 2. Trade Liberalization and Income Growth 112 3. Trade Liberalization and Poverty 116 4. Rural Sector and Agriculture 121 5. Concluding Remarks 123 Bibliography 124 Chapter 6. India's Decade Long Trade Reforms: How Does it Compare with Its East Asian Neighbours? (with Rahul Sen) 134 1. Introduction 134 2. Evolution of India's Merchandise Trade in the 1990s 136 3. The Flying Geese Pattern: India versus East Asia 138 4- India's Emerging Comparative Advantage in Services Trade 144 5. Concluding Remarks 147 Bibliography 148 Chapter 7. Singapore's Drive to Form Cross-regional Trade Pacts: Rationale and Implications (with Rahul Sen) 166 1. Introduction 166 2. Country Composition of Singapore's Trade, 1995 and 2000/2001 168 3. Why has Singapore Embraced the Bilateral Route? 170 4. Concerns with Bilateralism 173

Contents 5. Concluding Remarks Bibliography Chapter 8. International Trade in Infrastructural Services in East Asia: Telecommunications and Finance 1. Introduction 2. Liberalizing Trade in Services: A Basic Review of Theory 3. The Liberalization of Infrastructural Services in the Asia-5 Economies 4- Liberalizing Trade in Services: The Empirical Evidence 5. Concluding Remarks Bibliography

XI

176 178 189 189 192 194 199 205 206

IV. International Tax Issues in Asia Chapter 9. Economic Globalization and Taxation: With Particular Reference to Southeast Asia (with Mukul Asher) 231 1. Introduction 231 2. International Factor Mobility and Burden of Taxation 231 3. Efficiency and International Taxation 234 4- Tax Competition and FDI 238 5. Globalization, E-commerce and Taxation of the Internet 241 6. Financial Globalization and the Tobin Tax 243 7. Concluding Remarks 245 Bibliography 246 Index

253

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3

Chapter I

Economic Globalization and Small and Open Economies: Finance, Trade and Taxation1

1. Introduction T h e term "economic globalization" has been the buzzword of the 1980s and more so the 1990s. Economic globalization, broadly defined as the shrinkage of economic distances (i.e. costs of doing business) between nations, is more accurately seen as a set of processes pertaining to (a) production and trade flows, and (b) finance and international capital flows2. Both aspects of globalization have been aided and abetted by three factors. First are the innovations and advances in transportation, information and communications technologies such as the Internet which have dramatically lowered the costs of doing business across borders (Baldwin and Martin, 1999, Masson, 2001 and World Bank, 2002b). Second is the push by the various international institutions towards global economic liberalization (i.e. reduced policy barriers to trade and investment) through the General Agreement on Tariffs and Trade (GATT), and its successor, the World Trade Organisation (WTO) in the case of world trade in goods and services, and to a lesser extent in the movement of natural persons; and the International Monetary Fund (IMF) in the case of global finance and international capital flows. Third is the shift in perceptions about the appropriate role of government and near global consensus on the need for extensive, albeit judicious, use of market incentives for economic success3. 1

This Chapter draws and extends upon Rajan (2001a) and Bird and Rajan (2001b).

2

There is, of course, another aspect of globalization — globalization of labour. This is discussed in Section 4. 3

Note that the use of markets does not, by any means, imply complete laissez faire. As Dani Rodrik (2000a) has noted: The idea of a mixed economy is possibly the most valuable heritage that the twentieth century bequeaths to the twenty-first in the realm of economic policy ... (W)e enter the twenty-first century with a better understanding of the complementarity between markets and the state — a greater appreciation of the virtues of the mixed economy. That is the good news. The bad

4

Economic Globalization and Asia

The remainder of this Chapter is organized as follows. The next two Sections discuss the two aspects of economic globalization, viz. that of finance and capital flows (Section 2) and production and trade (Section 3). Section 4 discusses whether contemporary economic globalization is a new phenomenon and how much further it can go. Section 5 explores the public finance implications of globalization. Section 6 offers a few concluding remarks on some oft-noted concerns about economic globalization ("globaphobia"). 2. Globalization of Finance and Capital Flows The 1990s have seen accelerated progress towards the liberalization and integration of global financial markets, a process that began in earnest in the 1980s. According to the World Bank data on capital flows, developing economies have enjoyed a surge in capital inflows, with institutional investors (i.e. pension funds, mutual funds, hedge funds and the like) contributing to an all-time high of US$300 billion in long term private inflows in 1997. This was almost seven times the figure in 1990 (Table 1). T h e spate of financial crises in emerging economies in the latter half of the 1990s, the generalized downturn in real economic activity in industrial countries, as well as the bursting of the technology bubble in the US and elsewhere, have worked in tandem to lead to a fall in capital flows to developing countries after peaking in 1997. The World Bank data referred to above excludes short-term flows (especially debt) or asset transactions (such as changes in foreign deposits held by developing country residents). In light of this, Table 2 provides IMF data on capital flows. While the FDI and portfolio data are broadly in line with those of the World Bank, of significance is the component termed "other investment". This category broadly includes short and long term credits (including use of IMF credit) as well as currency and deposits and other accounts receivable and payable. Not surprisingly, it is this component that has shown the greatest degree of variability (Bird and Raj an, 2001a) 4 . news is chat the operational implications of this for the design of development strategy are not that clear. There remains plenty of opportunity for renewed mischief on the policy front.. (T)he state and the market can be combined in different ways. There are many different models of a mixed economy. The major challenge facing developing nations in the first decades of the next century is to fashion their own particular brands of the mixed economy (pp.1 & 3). According to Rodrik, the five essential functions that public institutions must serve for adequate functioning of markets are: protection of property rights, market regulation, macroeconomic stabilization, conflict management, and social insurance. We revisit the issue of social insurance in Section 6. 4

This component turned sharply negative in 1994 and in 1997-1998, periods corresponding to the Mexican-Tequila crisis and the turmoil in East Asia, respectively (see Chapter 2).

Economic Globalization and Small and Open Economies

5

The increase in global foreign currency (forex) transactions has been even more dramatic. Daily global forex trades (i.e. traditional instruments of spots, swaps and forwards) increased from US$18.3 billion in 1977 to nearly US$1.4 trillion by 1998 before falling slightly to US$1.2 trillion in 2001 (BIS, 2002) 5 . To put this growth in perspective, one should note that the trade to forex volume (annualized) ratio has declined markedly from 23.9 percent in 1977 to 0.3 percent in 1998, rising marginally to 0.4 percent in 2001 due to the recent decline in foreign exchange (forex) turnover (Table 3) 6 . Meanwhile, the ratio of official reserves and daily foreign currency turnover declined from 16.2 days in 1977 to just 0.9 days in 1998, rising slightly to 1.4 days in 2001. This suggests that monetary authorities may have become less well equipped to defend currencies in the face of speculative attacks — a point we take up later. The potential benefits due to globalization of finance and capital flows, assuming that the necessary pre-conditions are met, include 7 : a) static resource allocation gains through international specialization in the production of financial services; b) static financial gains through appropriate portfolio diversification internationally; c) dynamic or x-efficiency gains through the introduction of competition in the financial sector; d) gains from intertemporal trade through access to global financial markets; e) absence of rent-seeking and other costs of capital restraints; and f) imposition of market discipline on policy makers by ensuring that profligate policies, such as unsustainable external or fiscal imbalances and debt accumulation, trigger capital outflows and balance of payments/currency crises. Despite the foregoing theoretical advantages, a careful examination of the available empirical literature on the subject suggests much less reason to be sanguine about the benefits of an open capital account (Arteta et al., 2001, 5

Three points ought to be noted. First, to obtain forex volumes, we need to multiply the daily turnover by 250 (trading days). Second, the growth would have been slower if measured in some other major currency (such as the Deutsche mark or Japanese yen), given the depreciation of the US$ between 1989 and 1995. Third, there are a number of other issues relating to inter-temporal comparisons of the survey which have been discussed elsewhere (BIS, 1996 and Felix, 1996). 6

Galati (2001) offers four reasons for the decline in forex turnover between 1998 and 2001. In order of importance they are (a) consolidation in the banking industry; (b) the introduction of the euro; (c) the growing share of electronic broking in the spot interbank market; and (d) consolidation in the corporate sector. 7

For elaborations of these benefits, see Mathieson and Rojas-Suarez (1993). Also see Bayoumi (1998) and Obstfeld (1998) for comprehensive surveys of financial globalization and international capital mobility.

6

Economic Globalization and Asia

Eichengreen, 2002 and Raj an, 2002). Indeed, financial openness has been associated with several episodes of severe financial turbulence in global currency markets. In fact, currency crises seem to have become the norm rather than the exception since 1992. Specifically, in 1992-93, Europe was faced with the very real possibility of a complete collapse of the European Exchange Rate Mechanism (ERM). T h e Italian lira and British pound withdrew from the ERM, three other currencies (viz. the Spanish peseta, Irish pound and Danish krona) were devalued, and there was a substantial widening of the bands within which the currencies could fluctuate. In 1994-95, there was the Mexican currency crisis which saw a steep devaluation of the peso and Mexico on the brink of default. There were also spillover effects on Argentina and Brazil (so-called "Tequila effect"). Between July 1997 and mid-1998, the world experienced the effects of the East Asian crisis, which started somewhat innocuously with a run on the Thai baht, but spread swiftly to a number of other regional currencies, most notably the Indonesian rupiah, Malaysian ringgit, Philippine peso and Korean won (so-called "Tom-Yam effect"). Other large emerging economies such as Russia and Brazil also experienced periods of significant market weakness and required the assistance of the IMF. The Russian ruble was devalued in August 1998 — during a period of exceptional financial market turbulence (BIS, 1999) — while the Brazilian real's peg was eventually broken in January 1999. A number of other smaller emerging economies such as Turkey and Ecuador also experienced currency crises in the 1990s, with Argentina and Venezuela being the most recent victims. While a currency crisis is inevitable if a country has weak fundamentals, the problem arises when an economy suffers from such crises even when the macroeconomic imbalances are not necessarily unsustainable. There is a class of models which allows for multiple equilibria and shows how currency runs may be "self-fulfilling" (Obstfeld, 1996 and Rajan, 2001b). The focus of these models is on the trade-off faced by policy-makers between the benefits of retaining a pegged exchange rate, on the one hand, and the costs of doing so, on the other. This set of models stresses that while speculative attacks are not inevitable (based on underlying bad fundamentals), neither are they arbitrary or random (i.e. unanchored by fundamentals). Rather, there must exist some weaknesses in the economic fundamentals of the country for an attack to occur, as the credibility of the fixed exchange rate regime is less than perfect. Thus, referring to the East Asian crisis of 1997-98, Rodrik (2000a) has noted: One lesson of the crisis was that international capital markets do a poor job of discriminating between good and bad risks. It is hard to believe that there was much collective rationality in investor behaviour during

Economic Globalization and Small and Open Economies

1

and prior to the crisis: financial markets got it badly wrong either in 1996 when they poured money into the region, or they got it badly wrong in 1997 when they pulled back en masse. The implication is that relying excessively on liquid, short-term capital.is a dangerous strategy (pp. 8-9). As the turmoil in international financial markets in East Asia has receded, it is appropriate that the research focus shifts from short-term crisis management to crisis prevention. Two of the more important policy issues under discussion with regard to the strengthening of the framework for crisis prevention are 8 : the choice of an appropriate exchange rate regime for small and open economies, and the role of and scope for regional financial and monetary cooperation. Section II of this book examines these issues.

3. Globalization of Production and Trade: Agglomeration versus Fragmentation A n important characteristic of the global economy has been the tendency for agglomeration, i.e. the geographical concentration of industries in particular countries and particular regions within a country (Anderson, 2003 and World Bank, 2002b). This phenomenon of "firm-congestion" or bunching together spatially helps explain why regions with similar underlying characteristics sometimes turn out to be very different, i.e. "history matters for economic geography". The new economic geographers and old school development economists have stressed the existence of scale economies (or market size effects and linkages), thick labour markets and pure external economies as reasons for this cumulative causation and specific spatial configurations of production (Hanson, 2000 offers a comprehensive recent literature review). However, these "centripetal forces" could just as easily be rationalized by the Knickerbocker Oligopolistic theory of multinational enterprises (MNEs) which argues that a MNE will tend to enter a market in which a rival has already done so ("follow-the-leader" strategy) or to pre-empt competitors' entry ("first-moveradvantage"). Alternatively, one may explain these "band-wagon" or "herding" effects by arguing that the existence of foreign investors may act as a signal to other potential investors about the extent of investment-conduciveness of the country's overall policy regime. This reduces uncertainty and therefore increases ex-ante (expected) returns. Regardless of this, all three bodies of the literature share a common thread in the sense of explicitly or implicitly assuming strategic complementarity as 8

See Rajan (1999) for a discussion of crisis management issues with reference to the East Asian crisis.

8

Economic Globalization and Asia

defined and discussed by Bulow et al. (1985), i.e. the output expansion of one firm raises anticipated profits of the other. These factors entrench investments in certain regions. The problem with the early literature on agglomeration was the near absence of considerations of factor costs and prices in the analyses. However, following Krugman and Venables (1995) and Krugman (1999), there has been a recognition that, in the presence of fixed or immobile factors (like land), and as long as there is imperfect substitutability between these factors and those which may have a perfectly elastic supply, agglomeration will eventually lead to a rise in production costs. These factor cost appreciations and other "congestion effects" may, at some stage, offset the "concentration effects", hence leading to a dispersion of economic activity to peripheral regions (Hanson, 2000). In other words, dispersion occurs when the centrifugal forces outweigh the centripetal ones. The new economic geography literature has, however, been largely silent on the specifics of dispersion of economic activity. If anything, the dynamics described previously — whereby there will come a time when the centrifugal forces offset centripetal forces — suggests that the longer-run shift of production from the core to the peripheries will be a zero-sum game, with the latter gaining at the expense of the former (Hanson, 2000). To quote Krugman and Venables (1995): (B)oth concerns about uneven development and worries about maintaining First World living standards in the face of Third World competition have some justification. In particular, they seem to correspond to different stages in the process of globalization ... an early stage of growing world inequality ... As transport costs continue to fall ... there eventually comes a second stage of convergence in real incomes, in which the peripheral nations definitely gain and the core may well lose (p. 859). Given this perception, in the face of possible "hollowing out" or de-industrialization due to escalating costs and concomitant diminishing attractiveness, might there not be a case for the core or developed countries to take remedial measures? In particular, a plausible case might exist for the erection/escalation of tariffs and other trade barriers so as to decelerate the centrifugal forces by diminishing the feasibility of moving to the outlying regions and servicing the core through trade. However, this policy conclusion runs contrary to conventional wisdom regarding the benefits of free trade and the general presumption that factor intensities of goods and factor endowments of countries play a significant role in international trade. The implicit assumption in the agglomeration literature is the inability to unbundle products into their parts, components and accessories (PCAs). With major strides over the decades in transportation, coordination and communication technologies, economic globalization provides vastly increased opportunities

Economic Globalization and Small and Open Economies

9

for the fragmentation of previously integrated goods and activities into their constituent PCAs. This in turn may be spread across countries on the basis of comparative advantage. The importance of such production fragmentation is that it suggests that globalization, by expanding opportunities for international specialization and trade, will benefit all parties involved (i.e. the ones in the "core" as well as those in the "periphery" 9 ). Thus, in the longer-term, globalization and free trade ought to be an unambiguously positive-sum game 10 . This globalization and regionalization of production has in turn been facilitated by MNEs. Indeed, a large part of trade in PCAs is of the intra-firm variety (i.e. involving international affiliates of the same company). The latter in turn constitutes some one third of global trade, while at least 80 percent of all international trade is said to be related to at least one MNE (Kleinert, 2001). Another important dynamic of international trade in the current epoch of globalization is the noteworthy role played by services. Despite the vague statistical description of services, it is noteworthy that international trade in services has outpaced that of merchandise trade over the last decade. Echoing the view of many informed observers, Primo Braga (1996) has declared that the "internationalization of services is viewed as being at the core of economic globalization" (p. 34); while the World Bank (2002a) has proclaimed that "(i)n virtually every country, the performance of the service sectors can make the difference between rapid and sluggish growth" (p. 69). Part III of this book examines various aspects of international trade and development in Asia.

4. First versus Second Waves of Globalization The world economy is no more, and, in some ways, is actually less integrated than it was back in 1913 when cross-border transactions costs had been significantly reduced by the advent of the railroad, steam ships and the telegraph in the 19th century and by the automobile and aeroplane in the early 20th century. However, while

9

The term "production sharing" is used by Yeats (1998), while the term "production fragmentation" is used by Jones and Kierzkowski (2000). Other terms sometimes used in the literature to describe this phenomenon include intra-product specialization" (Arndt, 1996, 1998), "super-specialization" (Arndt, 2001), "disintegration of production" (Feenstra, 1998), "HeckscherOhlin (HO)-plus-production fragmentation" (Knetter and Slaughter, 2000) and "slicing the value chain" (Krugman, 1995). 10

This statement presupposes that the necessary institutional structures are in place to allow a country to exploit the opportunities that are available in the global market place.

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Economic Globalization and Asia

technological progress continued unabated, the "triple whammy" of World War I (1914 to 1918), the Great Depression (1929 to mid 1930) and World War II (1939 to 1945) effectively halted the trend towards economic globalization. A n index of the intensity of globalization over the last century would reveal a U-shape, with a lengthy trough spanning the period between 1914 and 1950-60. This said, there are some important differences in the characteristics of historical and contemporary globalization — the "first" and "second" waves of globalization (Baldwin and Martin, 1999, Bordo et al., 1999 and World Bank, 2002b) 11 . In the case of the globalization of production and trade, the pre World War I wave largely involved extensive growth, a general increase in the tradability of goods and services. Contemporary globalization, on the other hand, reflects in large part intensive growth, i.e. intra-product specialization (at least in the case of manufactured goods) as well as increased trade in services. There has also been greater involvement of developing countries in world trade in the more recent wave of globalization. With regard to financial integration and international capital flows, while privately traded bonds (for infrastructural and transport projects such as railroads) predominated before World War I, capital flows in the 1990s and beyond have been dominated by equity investments (portfolio and debt), securitized funds and other short term capital flows (Obstfeld, 1998 and Taylor, 1998). Further, while present-day net flows may not have reached the peaks attained pre World War I, gross cross-border capital flows are far greater today than ever before. Just how far has the second wave of globalization in the contemporary era progressed? Intra-country trade between regions still far exceeds inter-country trade, even where much smaller physical distances exist between two countries than between two regions in the same country. A n oft-cited example is the fact that trade between states in the US is on average twenty times more than trade between a Canadian province and a US state (McCallum, 1995). Similarly, Wei (1996) finds that during the period 1982 to 1994 a typical OECD country was on average about two and a half times more likely to buy goods and services from itself than from a trading partner, after controlling for factors such as geographical distance and relative size. Although this "home bias" in trade is tending to decline gradually, with tests of absolute and relative price differentials across countries suggesting growing real sector integration (Knetter and Slaughter, 2000), the process has not yet reached full maturity; there is still a long way to go.

11

The World Bank (2002b) notes that there are three broad periods — "the first wave of globalization" (1870-1914), "the second wave" (1945-80) and the "third wave" or "new wave" (1981 to the present).

Economic Globalization and Small and Open Economies

11

Similarly, while the mobility of capital has increased greatly, the degree of financial market integration is far from complete. Although tests of capital mobility, such as direct comparisons of on and off shore nominal interest rate differentials of assets of the same type, seem to reveal significant integration, domestic savings and investment correlations remain extremely high (implying that domestic investment is constrained by available national savings). Portfolio choices by the US and other industrial resident investors continue to show a significant bias towards domestic assets as opposed to an internationally diversified portfolio 12 . While savings-investment correlations have been on a declining trend over the last 30 years, it is premature to argue that anything close to full financial integration has been attained. The one area of globalization that has lagged now compared to the 19th century is that of movement of people, especially unskilled ones, across national borders (World Bank, 2002b). While the first wave of globalization was a period of mass migration, these flows remain tightly controlled; social and political compulsions and biases prevent many industrial countries from taking a more laissez faire attitude towards such cross-border flows (Bauer and Zimmermann, 2000 and Simon and Lynch, 1999). Consequently, the global market for unskilled labour remains extremely fragmented. As Streeten (2001) concludes: (T)here is much less international migration than during 1870-1913. Barriers to immigration are higher now than they were then, when passports were unnecessary and people could move freely from one country to another to visit or work..The eighteenth-century French economist Francois Quesnay added to laissez-faire the concept of laissez'passer (unrestricted travel and migration), but this is forgotten today, perhaps because..it..would interfere with..social stability and cohesion, or security, in the countries receiving the migrants ... But., these objections also apply to the free movement of goods and services. In any case, there is an inconsistency. The strict limits on migration have, in turn, built-up migration pressures which have sometimes manifested themselves via illegal immigration (Hatton and Williamson, 2001 and World Bank, 2002b). There is, however, an intensified competition between countries for skilled personnel/"global talent"/"international competence". The economic implications of this "brain drain" — defined loosely as the out-migration of human capital from developing to developed countries — for developing countries are not altogether apparent. 12

In the international finance literature, the former (i.e. high domestic savings-investment correlation) is referred to as the Feldstein-Horioka puzzle. The latter (i.e. lack of international portfolio diversification) is called the "home bias" effect.

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Economic Globalization and Asia

On the one hand, the developing countries from which the emigrants originate stand to gain through (a) remittances (which in turn add to the country's Gross National Product); (b) the establishment of diasporic business and trade networks; (c) providing a positive signal to others to acquire more human capital and (d) various other externalities from return migrants (something that East Asia including China appears to have benefited from). On the other hand, the emigration of skilled workers could be malignant rather than benign to the poor source countries as they may not be able to recoup the costs of subsidizing higher education (particularly relevant for countries like India), as well as prevent them from attracting more knowledge-intensive industries and building high quality public institutions (Desai et al., 2001). A recent report by the International Labour Organization (ILO) suggests that, on a net basis, the losses to developing countries from the brain drain can be substantial (Lowell and Findlay, 2001 ) 1 3 .

5. Globalization, Public Finances and Income Distribution Economic globalization can be expected to have far-reaching budgetary implications for countries. Tanzi (2000) has used the term "fiscal termites" to depict how globalization and technological changes have been "gnawing away" at the foundations of national tax systems. He identifies eight fiscal termites: E-commerce and transactions; use of E-money; intra-company trade; off-shore financial centres and tax heavens; derivatives and hedge funds; inability to tax financial capital; growing foreign activities; and foreign shopping. Globalization may lead to preferential tax treatment for mobile factors relative to immobile ones — i.e. portfolio investment over physical investment, foreign and large domestic investment over small and medium sized domestic ones, and skilled over unskilled labour. To be sure, the relatively high supply elasticity of mobile factors implies that the burden of tax on these factors may fall primarily on the immobile ones. Indeed, at the extreme, complete factor mobility (i.e. perfect elasticity of supply) may imply that any taxes on mobile factors fall solely on the immobile ones, as mobile factors relocate overseas unless there is corresponding compensation (through subsidies, fall in other costs, etc.). Table 4, borrowed from Hufbauer (2000), succinctly summarizes the effects of globalization on the mobility of various tax base items. Hufbauer's elaboration of the Table is useful and quoted at length below. The technologies underlying greater mobility are familiar ... Wage and salary income will acquire greater mobility in the next thirty years because 13

Commander et al. (2002) reach a similar conclusion. It is in this context that many have suggested the imposition of a "brain drain tax".

Economic Globalization and Small and Open Economies

13

any work that can be performed on the computer will in time be capable of remote performance: an individual in Bombay can sell her engineering services in Berlin. Physical migration may well remain tightly controlled, perhaps limited to professionals, family reunification, and some guest workers, but mental migration will be practically unlimited. Electronic commerce (e-commerce) will greatly increase the mobility of goods consumption as shoppers search websites for bargains far away, and as goods are delivered by private shippers such as FedEx and UPS. E-commerce will also enhance the mobility of services consumption as households buy education, entertainment, insurance, legal, and accounting services from distant suppliers. Falling airfares will enable households to spend more of their tourist and health dollars in distant locations. Investment income will become highly mobile as pension funds and brokerage firms develop worldwide networks and households seek to diversify their portfolios. Likewise, corporate profits will become even more mobile as dense intra-firm networks of purchases and sales enable multinational enterprises to shift production and distribution to locations with the highest returns, and maintain their financial accounts with a view to minimizing their taxes. Among the top 100 multinational firms, it is commonplace for more than half of sales, assets, and employees to be located outside the home country ... The extent of international operations will only grow (p. 2). The implications of globalization for tax structures are discussed in Section IV of this book. To anticipate the main conclusion, globalization may lead to reduced progressivity (increased inequity) of tax structures. Thus, taxes levied directly on relatively immobile factors would be welfare-enhancing in the sense of having the same incidence as taxes on the mobile factors without necessarily leading to flight of the latter to evade or avoid the burden of the tax. Given the increased mobility of various sources of the tax base, this in turn implies intensified dependence on a narrow tax base consisting of immobile factors such as the less educated workforce and the rural sector. To the extent that these may be the groups most vulnerable to the effects of globalization, Vito Tanzi (1998), former director of the IMF's Fiscal Affairs Division, has noted that "(a)lthough the economics of this conclusion is right, the politics of it is surely worrisome."

6. Concluding Remarks As Alan Greenspan (2001) has correctly noted: the debate surrounding the increasing cross-border integration of markets inevitably ... elicits such strong reaction because it centers on the important question of how economies are organized and, specifically, how individuals deal with one another (p. 1).

14

Economic Globalization and Asia

Similarly, Roach (2001) has observed: Globalization is all about cross-border connectedness. It is also about the inevitable stresses and strains that come about with such connectivity (p. 3). Public protests during recent W T O , IMF, the World Bank and World Economic Forum (WEF) meetings and industrial country summits suggest that the road towards further globalization may be rocky. Indeed, the possibility of a backlash actually stalling the road toward an integrated world economy cannot be entirely discounted. What needs to be done to pre-empt this? Some of the so-called "globaphobia" — demonization of globalization — undoubtedly lacks intellectual basis and must be put down to irrational ideological biases or misinformation (Smadja, 2000) 14 . However, it would be a mistake to arbitrarily dismiss the recent anti-globalization protests and the legitimate social concerns that some protestors might have raised 15 . Arguably, among the most important concerns as an economy liberalizes and integrates with the world economy is the need for adequate social insurance to protect the most vulnerable in society. It is important for policy makers to ensure that the pace of liberalization is controlled and cautious so as to ensure an appropriate fit between marketoriented reforms and existing institutional capabilities (Rodrik, 2000b). While economic globalization provides innumerable opportunities for small and open economies, especially those which emphasize good economic governance, it can and does carry significant risks (Anderson, 2003). In particular, openness raises the sense if not level of vulnerability of small states which have limited domestic markets and are therefore especially susceptible to external shocks (also see Chapter 5). As Rodrik (1999) has observed: While the fear of drastic reduction in income associated with job loss and unemployment is an important component of economic insecurity, another is sheer volatility in the household income stream (p. 12). In view of this increased sense of economic insecurity, a number of informed observers have suggested that, as an economy liberalizes and integrates with the world economy, there may be a need for a more comprehensive social insurance program to protect the most vulnerable in society in the event of economic

14

We restrict ourselves to economic globalization — concerns about cultural dominance and the like are beyond the scope of this discussion. For a discussion of these non-economic issues, see Giddens (1999) andTomlinson (1999). 15

Lai (1999) highlights some of the fears and dangers associated with globalization.

Economic Globalization and Small and Open Economies

15

downswings. It is almost inevitable that as individuals face greater market risk — which are at least partly an outcome of increasing globalization of economic activities — there will be a yearning for economic security which the government will need to respond to. Rodrik (1997) has underscored the foregoing point better than most. (I)t is not whether you globalize..., it is how you globalize. The world market is a source of disruption and upheaval as much as it an opportunity for profit and economic growth ... It has now become commonplace to point out that market-oriented reforms require social safety nets to prevent people from falling through the cracks ... (T)he provision of social insurance is an important component of market reforms — it cushions the blow on those most severely affected ... and it avoids a backlash against the distributional and social consequences of globalization (pp. 11, 13 and 14). In addition to national policies, international and regional institutions will have key roles to play in coordinating solutions and policy responses to help countries integrating with the world economy manage the tensions and problems that globalization may create, while maximizing their gains. Apart from these legitimate concerns, policy makers also need to be sensitive to and address any possible disconnect between the actual and perceived costs of globalization. Fareed Zakaria (2000) articulates the issues at hand most unequivocally and bears being quoted in full: The advocates of globalization — and I am one of the loudest — have relied too much on economic necessity and too little on persuasion. Why bother patiently explaining the virtues of policies when you can instead threaten a country with the wrath of the markets? Often we simply cheered as countries were forced to abandon foolish policies under the pressure of global capitalism. As a result, we have not yet fashioned a political, cultural, and moral case for globalization, one that resonates with the average citizen. However, powerful it may be, the bond market cannot do this. It is a task for human leadership — for politicians, businessmen, writers, activists and anyone else who believes that globalization has been, on the whole, a force for human progress and liberty (p. 17). In short, constituencies in favor of globalization must continuously and consciously be built 16 . If those who perceive themselves as "losers" from the process continue to become better organized, more articulate and more powerful, gainers may find it increasingly difficult to make significant advances. 16

The Newsweek (December 2000-February 2001), the Economist (September 23, 2000) and the Business Week (November 6, 2000) carry special reports on the issue of economic globalization, anti-global sentiments and possible remedies.

16

Economic Globalization and Asia

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Commander, S., M. Kangasniemi and A. Winters (2002). "The Brain Drain: Curse or Boon? A Survey of the Literature", mimeo (May). Desai, M., D. Kapur and J. McHale (2001). "Sharing The Spoils: Taxing International Human Capital Flows", mimeo (September). Eichengreen, B. (2002). "Capital Account Liberalization: What do Cross-Country Studies Tell Us?", World Bank Economic Review, 15, pp. 341-365. Feenstra, R. (1998). "Integration of Trade and Disintegration of Production in the Global Economy", journal of Economic Perspectives, 12, pp. 31-50. Feldstein, M. (2000). "Aspects of Global Economic Integration: Outlook for the Future", Working Paper No. 7899, NBER. Felix, D. (1996). "Statistical Appendix", in M. ul Haq, I. Kaul and I. Grunberg (eds.), The Tobin Tax: Coping with Financial Viability, New York: Oxford University Press. Galati, G. (2001). "Why has Global FX Turnover Declined? Explaining the 2001 Triennial Survey", BIS Quarterly Review, December. Giddins, A. (1999). Runaway World: How Globalization is Reshaping Our Lives, London: Profile Books. Greenspan, A. (2001). "Globalization", speech at the Institute for International Economics' First Annual Stavros S. Niarchos Lecture (October 2001). Hanson, G. (2000). "Scale Economies and the Geographic Concentration of Industry", Working Paper No. 8013, NBER. Hatton, T. and J. Williamson (2001). "Demographic and Economic Pressure on Emigration Out of Africa", Working Paper No. 8124, NBER. Hufbauer, G. (2000). "Tax Policy in a Global Economy: Issues Facing Europe and the United States", mimeo, February. IMF (1998). International Capital Markets Developments, Prospects, and Key Policy Issues, Washington, DC: IMF. IMF (2000). World Economic Outlook, Washington, DC: IMF. IMF (2001). World Economic Outlook, Washington, DC: IMF. IMF (2002). World Economic Outlook, Washington, DC: IMF. Jones, R. and H. Kierzkowski (2000). "Globalization and the Consequences of International Fragmentation", in R. Dornbusch, G. Calvo and M. Obstfeld (eds.), Money, Factor Mobility and Trade: Essays in Honor of Robert A. Mundell, Cambridge, MA: MIT Press.

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Kleinert, J. (2001). "The Role of Multinational Enterprises in Globalization: A n Empirical Overview", Working Paper No. 1069, Kiel Institute of World Economics. Knetter, M. and M. Slaughter (2000). "Measuring Product-Market Integration", M. Blomstrom and L. Goldberg (eds.), Topics in Empirical International Economics: A Festschrift in Honor of Bob Lipsey, Chicago: University of Chicago Press. Krugman, P. (1995). "Growing World Trade: Causes and Consequences", Brookings Papers on Economic Activity, 1, pp. 327-362. Krugman, P. (1999). "The Role of Geography in Development", in J. Stiglitz and B. Pleskovic (eds.), Annual Bank Conference in Development Economics, Washington, DC: World Bank. Krugman, P. and A. Venables (1995). "The Globalization and the Inequality of Nations", Quarterly Journal of Economics, 60, pp. 857-881. Lai, D. (1999). "Globalization: W h a t Does it Mean for Developing and Developed Countries?", in H. Siebert (ed.), Globalization and Labour, Tubingen: Mohr Siebeck. Lowell, B.L. and A.M. Findlay (2001). "Migration of Highly Skilled Persons from Developing Countries Impact and Policy Responses: Draft Synthesis Report", report prepared for the International Labor Organization (June). Masson, P. (2001). "Globalization: Facts and Figures", Policy Discussion Paper No. 0114, IMF. Mathieson, D. and C. Rojas-Suarez (1993). "Liberalization of the Capital Account", Occasional Paper No. 10, IMF. McCallum, B. (1995). "National Borders Matter: Canada-U.S. Regional Trade Patterns", American Economic Review, 85, pp. 615-623. Obstfeld, M. (1996). "Comment (on Currency Crisis)", NBER Macroeconomic

Annual

1996, pp. 393-407. Obstfeld, M. (1998). "The Global Capital Market: Benefactor or Menace?", Journal of Economic Perspectives, 12, pp. 9-30. Primo Braga, C. (1996). "The Impact of the Internationalization of Service on Developing Countries", Finance and Development, March, pp. 34-37. Rajan, R. (1999). "Economic Collapse in Southeast Asia", Policy Study, T h e Lowe Institute of Political Economy, Claremont. Rajan, R. (2001a). "Economic Globalization and Asia: Trade, Finance and Taxation", ASEAN Economic Bulletin, 18, pp. 1-11.

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Rajan, R. (2001b). "(Ir)relevance of Currency-Crisis Theory to the Devaluation and Collapse of the Thai Baht", Princeton Studies in International Economics No. 88, International Economics Section, Princeton University. Rajan, R. (2002). "International Financial Liberalisation in Developing Countries: Lessons from Recent Experiences", Economic and Political Weekly, 37, July 20-26, pp. 3017-3021. Roach, S. (2001). "Globalization: An Ever Braver New World", Global Economic Forum, Morgan Stanley-Dean Witter, February 20. Rodrik, D. (1997). Has Globalization Gone Too Far?, Washington, DC: Institute for International Economics. Rodrik, D. (1999). "Why is there So Much Insecurity in Latin America/", mimeo (October). Rodrik, D. (2000a). "Can Integration into the World Economy Substitute for a Development Strategy?", mimeo (May). Rodrik, D. (2000b). "Institutions for High-Quality Growth: What They Are and How to Acquire Them", Working Paper No. 7540, NBER. Simon, R. and J. Lynch (1999). "A Comparative Assessment of Public Opinion Toward Immigrants and Immigration Policies", International Migration Review, 33, pp. 455-467. Smadja, C. (2000). "From Diatribe to Dialogue", Newsweek, Special Edition (December 2000-February2001). Streeten, P. (2001). "Integration, Interdependence, and Globalization", Finance and Development, 38, June. Tanzi, V. (1998). "The Impact of Economic Globalization on Taxation", International Bureau of Fiscal Documentation Bulletin, August/September, pp. 338-343. Tanzi, V. (2000). "Globalization, Technological Developments, and the Work of Fiscal Termites", Working Paper No. 00/181, IMF. Taylor, A. (1998). "Argentina and the World Capital Market: Saving, Investment, and International Capital Mobility in the Twentieth Century", journal of Development Economics, 57, pp. 147-184. Tomlinson, J. (1999). Globalization and Culture, Cambridge: Polity Press. Wei, S.J. (1996). "Intra-National versus International Trade: How Stubborn Are Nations in Global Integration?", Working Paper No. 5531, NBER.

20

Economic Globalization and Asia

World Bank (1999). Global Development Finance 1999, New York: Oxford University Press. World Bank (2001). Global Development Finance 2001, New York: Oxford University Press. World Bank (2002a). The World Development Report, New York: Oxford University Press. World Bank (2002b). Globalization, Growth and Poverty: Building an Inclusive World Economy, New York: Oxford University Press. Yeats, A. (1998). "Just How Big is Global Production Sharing?", PoIic;y Research Working Paper No. 1871, The World Bank. Zakaria, F. (2000). "No, Economics Isn't King", Newsweek, Special Edition (December 2000-February 2001), pp. 14-17.

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Table 3 Global Official Reserves, Foreign Currency Trading and Trade, 1977-2001 Year

1977 1980 1983 1986 1989 1992 1995 1998 2001

Daily Global Reserves to Reservesb Tradea (US$ billion) (US$ billion) Forex Volume Trade Ratio (US$ billion)c (%) 296.6 468.9 496.6 552.6 826.8 1022.5 1330.0 1278.3 1726.3

1094.7 1960.0 1752.6 2074.5 3003.2 3780.6 5053.0 5491.1 6194.1

18.3 82.5 119.0 270.0 570.0 750.0 990.0 1400.0 1210.0

Trade to Forex Ratio (%)

27.1 42.8 45.4 50.5 75.5 93.4 121.5 116.8 157.7

23.9 5.3 3.7 1.6 0.8 0.6 0.4 0.3 0.4

Reserves to Forex Ratio (days) 16.2 5.7 4.2 2.0 1.5 1.4 1.3 0.9 1.4

Notes:

a) Simple average of exports and imports b) Includes gold holdings c) Excludes derivatives Sources: BIS (1996, 2002) and IMF, International Financial Statistics Yearbook, various issues

Table 4 Effects of Globalization on the Mobility of Tax Base Items Tax Base Item Wages and Salary Income Consumption of goods Consumption of services Investment income Corporate profits Source: Hufbauer (2000)

Mobility in 1970

Mobility in 2000

Mobility in 2030

Low Low Low Low Low

Low Moderate Low Moderate Moderate

Moderate Moderate Moderate High High

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II. International Monetary and Financial Issues in East Asia

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27

Chapter 2

International Capital Flows and Regional Contagion: Boom and Bust in East Asia in the 1990s 1

1. Introduction There are by now some comprehensive discussions of the East Asian crisis of 1997—98, so there is no need to go over well-traveled terrain 2 . Suffice it to note that the regionwide contagion in East Asia may be broadly divided into four subperiods. The devaluation of the Thai baht was the first period (July 1997). The second period was when the contagion spread to the other Southeast Asian countries (Indonesia, Malaysia and the Philippines specifically) between July and mid October 1997. The third period was when the crisis engulfed the larger East Asian region (Hong Kong, Singapore, South Korea and Taiwan) following the pre-emptive devaluation of the New Taiwan dollar in October 1997. Once the South Korean won was devalued in November 1997, this then reverberated back to Southeast Asia and many other emerging economies in general. This was the fourth period (Berg, 1999). The crisis did intensify in mid 1998, but this was due to a pronounced liquidity crunch in emerging markets as a whole following the Russian debt moratorium (IMF, 1999a and World Bank, 1999). The remainder of the Chapter is organized as follows. The next Section provides an overview of trends and patterns in international capital flows to the five crisis-hit economies in East Asia (Indonesia, Malaysia, Philippines, Thailand and South Korea) during the boom period (1990-96), the bust period (1997-98), and the eventual recovery that followed. Section 3 is devoted to defining and detailing the various transmission channels via which currency and financial crises may spread contagiously, and drawing out policy implications thereof. The final Section concludes the Chapter.

^ h i s Chapter draws on Chang and Raj an (2001), Raj an (2000, 2003) and Raj an and Siregar (2002). 2

For detailed accounts of the East Asian crisis, see Berg (1999), Corsetti et al. (1999), Radelet and Sachs (1998a,b), Rajan (1999) and World Bank (1998).

28

Economic Globalization and Asia

2. Dynamics of Capital Flows in East Asia in the Late 1990s 2.1.

Capital inflow boom

The speculative attacks in emerging economies have almost always been preceded by very large private capital inflows (Dooley, 2000). More specifically, Radelet and Sachs (1998a) have observed that "at the core of the (East) Asian financial crisis were the massive capital inflows that were attracted into the region during the 1990s" (p. 8). A proper perspective of the East Asian crisis may therefore only be gained by considering the pre-crisis boom period. N e t private capital inflows to the Asia-5 economies were positive and exceeded the corresponding current account deficits, resulting in a sustained accumulation of international reserves. This accumulation was particularly high in Thailand which was among the ten largest emerging market recipients of net private capital flows (together with Malaysia and Indonesia) during the period under consideration (Lopez-Mejia, 1999 and World Bank, 1997). Cumulative inflows into Thailand and Malaysia constituted about one half of their respective GDPs between 1989 and 1995. Some salient features of the effects of the capital inflow boom enjoyed by the Southeast Asian countries are summarized in Table 1. The period of comparison for changes in key macroeconomic variables is the boom period relative to the immediately preceding period of equal length. The duration of the boom period was especially long-lasting in Thailand (between 1988 and 1995). During this period, Thailand and Malaysia each saw their GDP growth rates increase by about 4 percent on average over the corresponding pre-boom period, and by about 2 percent in the Philippines and Indonesia. Only Korea experienced a decline in the rate of increase in economic growth. Further, in contrast to Mexico during its boom period prior to the Tequila crisis (1989-94), where a capital inflow fuelled a consumption boom, average consumption (as a percent of GDP) actually fell in Thailand, Indonesia and Malaysia; while average investment increased (especially sharply in Thailand) 3 . This rise in "productive capacity" ensured that the growth was relatively non-inflationary — though, in hindsight, insufficient attention was obviously paid to the productive deployment of the resources (Rajan, 1999). Push versus Pull Factors: There is a large body of literature on the determinants of capital inflows which focuses in particular on the question of whether capital inflows were "pulled" or "pushed" into emerging economies. The former

3

The aggregate data must, however, be interpreted with some caution. Disaggregated savings data reveal household savings in Thailand to have collapsed during the boom period (Thanompongphan and Associates, 1999).

International Capital Flows and Regional Contagion

29

refers to improvements in an emerging economy's/region's investment attractiveness, consequently drawing capital into it. The latter refers to a reduction in attractiveness in investing in the home market (industrial economy) leading to a search of foreign investments in emerging economies in general. In other words, push factors are largely external to the emerging economies, while pull factors are country or region specific (due to more conducive policy regimes, for instance). Recent research suggests that the two phenomena are in fact complementary. Specifically, while push factors determine the timing and magnitude of new capital inflows to emerging economies in general, pull factors (country or region specific) are instrumental in determining the geographic distribution of these flows (Dasgupta and Ratha, 2000 and Montiel and Reinhart, 2000). The generally favourable international macroeconomic environment in the 1990s — in terms of sustained rapid growth in trade and GDP and wealth creation (in the U S in particular) and relatively low international interest rates — were among the cyclical push factors from industrialized economies (World Bank, 1997). Rapid improvements in telecommunications and information technologies and the proliferation of financial instruments, institutionalization of savings and internationalization of investment portfolios (mutual and pension funds) in search of opportunities for risk diversification have been among the structural or trend factors leading to intensified global capital flows (World Bank, 1997). It is also important to consider the type of external financing when thinking about the distribution of capital inflows. For instance, it is revealing that, on average, the "other net investment" component constituted a relatively high share of total capital inflows to the Asia-5 economies than to the other Asian ones (Table 2) — about 75 percent in the case of Thailand, the "trigger" country. This category of capital flows includes syndicated bank lending and trade financing, along with some other smaller items. It therefore captures movements in bank financing and has been consistently found to be the most volatile component of capital flows in the balance of payments account 4 . There was a particularly rapid increase in international bank lending to Asia-5 in the 1990s, principally between 1995 and 1996. The incentive for this lending boom to Thailand in particular is apparent from Table 3 which reveals the significant and sustained interest rate premium offered by the country over the

4

At the other end of the spectrum, direct investment has been the most resilient form of external financing (Bird and Rajan, 2001a, World Bank, 1999 and Osei et al, 2002). As such, economies most prone to currency crashes tend to have a relatively smaller share of FDI in total capital inflows and a relatively higher share of short-term external debt (Frankel and Rose, 1996 and World Bank, 1999). Conversely, short-term indebtedness has been found to be a robust predictor of financial crises (Rodrik and Velasco, 1999 and World Bank, 2000).

30

Economic Globalization and Asia

LIBOR rate despite an extremely stable exchange rate relative to the US dollar 5 . Indeed, it is revealing that the interest rate differential in Malaysia over LIBOR was fairly low, and Malaysia was the only crisis-hit economies where direct investment constituted some 70 percent of total capital flows on average (Table 2). In light of the significance of bank lending in the East Asian crisis, it is useful to consider BIS data on the stock of bank exposures (i.e. rather than flows). It is important to keep in mind the important caveat that such data excludes nonbank institutions, which played a significant role in the intermediation of capital flows in the region, and only covers transactions by BIS-reporting banks. Table 4 reports the nationality of banks that have extended loans to the region. Japanese banks clearly had relatively higher exposures to the crisis-hit economies, being responsible for over one-third of total bank credit to Asia-5 as of mid 1997. Interestingly, Western European banks as a group (almost one-third) had large exposures to the regional economies (Korea in particular), while US banks had relatively low and stable exposures (less than ten percent). O n the issue of direct investment, the East Asian economies as a group attracted fairly high levels of FDI inflows due primarily to plant relocation from Japan, particularly for Indonesia, Malaysia and Thailand. This in turn was due to a combination of general considerations of long-term profitability, as well as the fact that multinational enterprises (MNEs) looked upon the region as an integrated production hub (World Bank, 1999). Therefore, while the attractive growth prospects, sound domestic macroeconomic policies (actual or perceived) and progressive financial and capital account deregulation in the Asia-5 economies were among the forces pulling capital flows into the region in general, other pull factors were probably more specific to the type of capital inflow (Dasgupta and Ratha, 2000).

2 . 2 . The bust, stabilization and recovery The collapses of the baht and the regional currencies were principally due to reversals of capital flows from the banking sector rather than portfolio equity investments. Indeed, balance of payments data from the International Institute of Finance (IIF) reveal that the Asian-5 economies most affected by the regional crisis saw a sharp reversal in net private capital flows of US$155 billion between 1996 and 1998 (an inflow of US$118.5 billion in 1996 but an outflow of 5

Bird and Rajan (2001b, 2002b) develop simple frameworks to explain this persistent interest premium.

International Capital Flows and Regional Contagion

31

US$37.3 in 1998) (Table 5). This reversal was primarily due to net (short-term) lending by foreign commercial banks, which totalled over US$130 billion in inflows between 1995 and 1996, but turned into a net outflow of US$66 billion over the following two years as international banks became unwilling to roll over existing short-term debts to the region. Interestingly, the data in Table 4 also reveal that while Japanese and US banks reduced their exposures in Asia-5 between June and December 1997, the European banks were still expanding their lending to the region in these few months. This was probably due to the fact that the Japanese had particularly large exposures in Thailand, the first country to be affected by the regional crisis, while European (and US) banks were most exposed to Korea, which was impacted only in the latter part of the year. This sudden reversal in bank lending is often portrayed as strong evidence of a bank panic (Chang and Velasco, 1998, 1999 and Radelet and Sachs, 1998a,b) 6 . A much less noticed aspect of the sharp contraction of private market financing is the decline in portfolio flows in 1997-98 following the initial bank panic, as investors too tried to scale down their regional financial exposures ("flight to quality"). In contrast, FDI flows remained remarkably durable during the period under consideration and increased significantly in Korea 7 . Indonesia was the sole exception, FDI having collapsed due to ongoing socio-political uncertainties (World Bank, 1999). Having peaked in late 1997, the East Asian crisis seemed to be abating by early 1998 in all the regional economies except for Indonesia (where the rupiah remained extremely weak in light of economic policy slippages and civil unrest). As an example, Korea, which was the most rapidly improving regional economy, was upgraded by two major ratings agencies in February 1998. However, market turbulence re-emerged and intensified with the devaluation and unilateral domestic debt default by Russia in mid August, followed by the near-collapse of

6

Of course, these ex-post swings in bank flows are only necessary and not sufficient evidence in support of a bank panic model. Accordingly, at least in the case of Thailand, Raj an (2001) has provided data on the foreign asset and liability positions in order to determine its ex-ante vulnerability to an external shock (such as a devaluation), and then discusses the movements in capital withdrawals from the country following the shock. Since the devaluation followed by collapse scenario is closely intertwined with the important issue of the illiquidity versus the insolvency of domestic financial institutions, this issue is also examined, as are the consequences of the systemic liquidity crisis post devaluation. The evidence presented in its entirety strongly supports a bank panic view. Such a systematic exploration of the data remains to be done for the other crisis-hit economies. 7

Latin America also shared this experience of stable FDI flows during a boom and bust period (Fernandez-Arias, 2000).

32

Economic Globalization and Asia

the US hedge fund, the Long-term Capital Management (LTCM). Depreciation of the Japanese yen vis-a-vis the US dollar — which in turn caused concerns about the recovery prospects of the other Asian economies and uncertainties following the imposition of capital controls by Malaysia on September 1st of that year — exacerbated the bearish sentiments in East Asia during that period (BIS, 1999, IMF, 1999a and World Bank, 1999) 8 . Marked as this downturn was, it proved to be temporary. The easing of official interest rates in the US and other industrial countries, as well as an agreement on an IMF rescue package for Brazil, worked in tandem to generate a broad-based recovery in emerging markets in general by the fourth quarter of 1998. While the devaluation of the Brazilian real in early 1999 threatened to derail the recovery in East Asia yet again, in actuality it did not. There was limited negative fallout from the Brazilian crisis9. Korea, Malaysia and Thailand were all upgraded by ratings agencies in the first half of 1999 (ADB-ARIC, 2001, 2002). While capital flows have varied significantly across the Asia-5 economies, aggregate net private capital outflows, which totalled over US$40 billion in 1997 and 1998, turned into aggregate net inflows of US$25 billion in 2000 and 2001. The growth performances of the regional economies broadly mirrored the dynamics of capital flows. Having contracted markedly in 1998 due mainly to drops in capital investment and private consumption, the regional economies bounced back in 1999 and consolidated their respective positions in 2000. The economic revival essentially began in early 1999 as monetary and fiscal policies remained highly accommodative (Boorman et al., 2000 and ADB-ARIC, 2001, 2002). Bank Flows: Closer examination of IMF data on recent capital flows to the Asia-5 economies reveals some important points. First, bank-related outflows have continued unabated (i.e. the "other net investment" component). The sustained bank outflows from the region occurred despite a renewed willingness of lenders to maintain, if not slightly increase, exposures to the region because of repayments of external liabilities to commercial banks. These repayments were largely concentrated in Thailand and Indonesia. It is important to note that a central difference between the outflows in 1997-98 and 2000 was that the former was largely unanticipated and thus highly disruptive. In the latter, the loan repayments had been anticipated and scheduled. According to the IIF (2001), net

8

For an overview of the Malaysian capital controls, see Bird and Rajan (2002a) and references cited within. 9

The other significant negative shock during this period was the collapse of one of China's largest investment and trust corporations (ITICs), the Guangdong ITIC (GITIC) in October 1998.

International Capital Flows and Resional Contasion

33

repayments by all Asian economies to banks totalled almost US$100 billion in 1998 and 1999. Additional insight might be obtained from the BIS data on the nationality of creditor banks (Rajan and Siregar, 2002). While all major creditor banks between December 1997 and June 1998 reduced their stocks of outstanding loans to the region, this trend continued between June 1998 and June 1999 only in the cases of Japanese and UK banks, as most of the repayments by Asian borrowers were focused on these two creditors. In contrast, outstanding loans by US, French and German banks stabilized. Equity Flows: What about equity investments? Portfolio equity investment flows appeared to have stabilized and turned positive, averaging US$10 billion between 1999 and 2001. FDI flows remained positive mainly due to sharply depreciated asset values and exchange rates and relaxation of foreign ownership rules which spurred merger and acquisition (M&A) activities in Korea. However, the Asia-5 economies' share of FDI to the whole of the developing East Asian region has been on a declining trend, particularly so in the case of the four Southeast Asian economies (Indonesia, Malaysia, the Philippines and Thailand). The decline appears to be a reflection of growing concerns by international investors about the commitment by some of the economies to structural reforms, along with heightened political uncertainties in a number of these countries (ADB-ARIC, 2001, 2002). While it is certainly revealing that FDI has not been stimulated in the regional economies despite large currency depreciations and reductions in domestic asset values, Indonesia was the only country where the actual stock of FDI continued to be depleted (with net outflows since 1998).

3. Contagion: Definitions and Transmission Channels 3 . 1 . More regional than gobal A n important characteristic of the East Asian crisis has been the rapid pace at which it spread from Thailand to many other East Asian economies — so-called "contagion". This term broadly refers to the simultaneous occurrence of currency crises in two or more economies. It may be more formally defined as a situation where a currency crisis in one economy leads to a jump to a "bad" equilibrium in a neighbouring economy (Masson, 1998) 10 . While there is a need to be very precise

Some have referred to contagion as an increase in asset price volatility across countries. Forbes and Rigobon (1999) define contagion — or "shift contagion" — as entailing a significant increase in cross-market linkages after a shock.

34

Economic Globalization and Asia

in defining the term "currency crisis" in empirical analyses, we take it here to broadly involve an actual break of an exchange rate peg and concomitant currency depreciation, or speculative pressure which may not lead to an exchange rate depreciation, but does lead to an international reserve depletion or an interest rate hike. The currency crises of the 1990s stress the importance of contagion or negative spillover effects that are largely regional in scope (consequently they are also referred to as "neighbourhood effects"). While the East Asian crisis did threaten to turn global, it did not. Similarly, while the currencies of Thailand, Hong Kong and the Philippines underwent brief periods of speculative attacks during the Tequila crisis, the crisis predominantly affected Mexico's neighbouring economies (such as Argentina). In a study using a sample of 20 countries covering the periods of the 1982 Mexican debt crisis, the 1994-95 Tequila crisis and the 1997-98 Asian crisis, De Gregario and Valdes (2001) found contagion to be directly dependent on geographical horizon. Using a panel of annual data for 19 developing economies for the period 1977-93, Krueger et al. (2000) concluded that a currency crisis in a regional economy raises the probability of a speculative attack on the domestic currency by about 8.5 percentage points 11 . 3.2.

Transmission

channels

What are the channels which cause the contagious spread of crises? A distinction needs to be made between transmission channels that are related to investor sentiment or psychology (termed "pure contagion"), and linkages between countries that are measurable/observable ex-ante (referred to as "spillovers" or "linkages") 12 . Spillovers in turn take the form of trade (real) or financial linkages between countries 13 . 11 Other empirical studies confirming this regional dimension of currency crises include Calvo and Reinhart (1996), Frankel and Schmukler (1996), Click and Rose (1999) and Kaminsky and Reinhart (2000a). 12 A third category, "common external shocks" or "monsoonal effects", refers to all those factors that impact all regional economies (Masson, 1998). A number of external shocks have been suggested in the case of the East Asian crisis (Whitt, 1999). In a study using a comprehensive data set of financial statistics, product information, geographic data, and stock returns involving 14,000 companies in 46 economies, Forbes (2000) found all the above transmission mechanisms were important in the case of the East Asian crisis, particularly the product competitiveness channel. A priori, it is surprising that the common creditor/credit crunch effect (through banks) was not found to be as important. This might be explained by the fact that Forbes focused on international rather than regional propagation and did not explicitly test for the herding channel. Kaminsky and Reinhart (2000b) and Van Rijckeghem and Weder (1999) have concluded that the bank lender channel was particularly important in the East Asian crisis, though the inclusion of a trade competition variable tends to dilute the significance, due possibly to the high correlation between competition for funds and trade. 13

Calvo and Reinhart (1996) call this type of crisis propagation "fundamentals-based contagion".

International Capital Flows and Regional Contagion

35

a) Trade spillovers Glick and Rose (1999) have noted: trade is an important channel for contagion, above and beyond macroeconomic influences. Countries who trade and compete with the target of speculative attacks are themselves likely to be attacked ... This linkage is intuitive, statistically robust, and important in understanding the regional nature of speculative attacks (pp. 604-5 ) 1 4 . Trade spillovers in turn could either be due to "complementarity" or "competition" in export product structures between regional economies. With regard to the former ("direct channel"), there may, on the one hand, exist extensive intraregional trade and investment linkages which could lead to contagion due to trade complementarities. For instance, on the one hand, currency devaluation in an emerging or developing economy is often accompanied by a sharp economic downturn (Rajan and Shen, 2001), thereby compressing imports. This in turn reduces the exports of its trading partners, consequently leading to "demand-driven" trade spillovers. O n the other hand, there may be extensive and growing trade, investment and other intraregional interdependencies, leading to contagion due to trade complementarities that are "supply-driven", i.e. "indirect channel". For instance, it is commonly noted that Japanese FDI has developed an intricate division of labour based on both horizontal and vertical differentiation in East Asia (Kawai and Urata, 1998). This in turn has stimulated intraregional trade which has constituted roughly two-fifths of the regions' total trade, with parts, components and accessories (PCAs) playing a particularly important role in such transactions (World Bank, 2000). Accordingly, any disruption in one economy could interrupt the entire "production network", leading to a withdrawal of investors from all other trade partners. In contrast to the complementary-induced channels, even economies that do not have strong trade and investment linkages with the crisis-hit economies may yet be indirectly impacted if their exports to third markets overlap significantly. In other words, currency devaluation in one economy may provoke devaluation in a trade competitor (i.e. another economy with similar export structures/ comparative advantage) that suddenly finds itself in a competitive disadvantage (Gerlach and Smets, 1995 and Huh and Kasa, 1997). Corsetti et al. (1999) have shown that a game of competitive devaluation could generate currency overshooting if market participants, anticipating that a series of competitive devaluations 14

Also see Van Rijckeghem and Weder (1999). In a pioneering study, Eichengreen et al. (1996) emphasized this channel for industrial countries.

36

Economic Globalization and Asia

will take place once there is a successful speculative attack in one country, flee from the trade competitors 15 . b) Financial sector spillovers and pure contagion While trade spillovers appear to be relatively straightforward, in practise it can be difficult to clearly distinguish between trade and financial linkages, as most countries with strong trade linkages are also likely to be connected via finance channels (Kaminsky and Reinhart, 2000a,b). As Dornbusch et al. (2000) note: A channel similar to trade links can be financial links. The process of economic integration of an individual country into the world market will typically involve both trade and financial links. In a world or region that is heavily economically integrated — covering trade, investment, and financing links — a financial crisis in one country can then lead to direct financial effects, including reductions in trade credit, FDI and other capital flows to other countries (p. 6). While acknowledging this fact (also see Berger and Wagner, 2002), it is much harder to distinguish between financial spillovers, on the one hand, and pure contagion, on the other, as both largely pertain to investors' decisions. The one substantive distinction between spillovers and pure contagion is that there must exist ex-ante linkages between the crisis-hit economies, while in the latter, the linkages only appear ex-post. Masson (1998) shows how it is conceptually possible for "pure contagion" to make an economy relatively more susceptible to a currency crisis. To be sure, he notes: pure contagion is only possible if changes in expectations are self-fulfilling, and this requires that financial markets be subject to multiple equilibra. (and) ... (e)ven if each country separately is not subject to multiple equilibra, together they may be, since the fear of crisis in one will increase the devaluation probability in the other, making a crisis more likely in both (pp. 5-6). Shifts in market sentiments could lead to jumps between one equilibra and the other, consequently introducing sharp volatility in financial markets.

15

Rajan et al. (2001) explore the various trade spillover channels noted above as they try to explain the spread of the crisis from Indonesia, Malaysia, Philippines, South Korea and Thailand to the city states of Hong Kong and Singapore.

International Capital Flows and Re$ional Contasion

37

Theoretically, anything could act as the coordinating device leading to a jump from a "good" to "bad" equilibra. To illustrate the practical difficulties in distinguishing between financial sector linkages versus pure financial contagion, consider the case of bank withdrawals. O n the one hand, there could exist substantive linkages by way of the Asia-5 economies and Hong Kong/Singapore sharing a common creditor (e.g. Japanese banks). It is also possible that the two economies might be impacted as their own financial institutions have large exposures to the Asia-5 economies and experience sharp capital losses. These are instances of actual pre-crisis linkages and qualify as financial spillovers. However, losses in one economy may lead banks (or open-end mutual funds, for that matter) to rationally unwind positions in other regional economies in which they have exposures. This so-called "forced portfolio adjustment" behaviour or "liquidity constrained" effect, which is a perfectly rational behavior, may occur for a number of reasons. These include, an anticipation of higher-frequency redemptions, the need to cover capital losses in other crisis-hit markets ("cash-in" effects), and in order to reduce portfolio risks and improve the liquidity position ("flight to safety" effects)16. In addition to the direct linkages and liquidity constraints, there is the possibility of "panic herding" or "bandwagon" effects, as international creditors and investors choose to reduce exposures to all emerging economies (particularly those in the region) if they are spooked by the crisis in one or more of the regional economies, leading to an international bank panic (Diamond and Dybvig, 1983). One can never be sure as to what causes these investor panics/sudden shifts in market expectations and an indiscriminate withdrawal from many markets. This is what makes multiple equilibria-based explanations difficult to pin down, as a jump between a good (i.e. non-attack) and bad (i.e. attack) equilibrium is driven by market psychology or changes in the interpretation of existing information. A weakness or attack on one currency could lead to a reassessment of the region's "fundamentals" and the probability of a similar fate befalling regional economies with broadly similar macroeconomic stances (whether actual or perceived). This is popularly termed the "wake-up call" effect (Ahluwalia, 2000). This phenomenon could also refer to the sudden realization of how little market participants

See Calvo (1999) for a model involving two sets of agents (informed and uninformed), in which margin calls necessitate asset sales in one economy following price declines in another. FolkertsLandau and Garber (1998) stress risk control systems as a possible reason for regionwide asset selloffs and resultant contagion; while Van Rijckeghem and Weder (1999) emphasize the value at risk (VAR) technique in particular. However, Schinasi and Todd Smith (1999) show such financial contagion could result from normal/textbook portfolio diversification rules.

38

Economic Globalization and Asia

truly understood about the regional economies, leading to a regionwide downgrading/sell-off (Radelet and Sachs, 1998b). In related literature, Drazen (1999) has developed a contagion model which is based on economies being in an implicit or explicit currency/monetary union. Thus, devaluation by one economy acts as a wake up call to investors in the sense that it leads them to question the commitment of other regional economies to maintain "club membership" by not devaluing. Dooley (2000) suggests that the "bunching together" of crises may be due to revisions in the effective size of official lines of credit available to the regional governments to defend the currency (either from international agencies or ad hoc bilateral or multilateral agreements). Such sudden capital withdrawals are, of course, neither limited to bank flows nor need arise solely in the context where financial markets are subject to multiple equilbra or self-validating expectations. For instance, focusing on portfolio flows, and assuming that there exist some fixed costs of informational gathering and processing country-specific information, Calvo and Mendoza (1996, 2000) show how just a rumor of such vulnerabilities may generate large-scale reallocation of funds away from one destination to another, making small open economies susceptible to large swings in capital flows and costly boom-bust cycles (Rajan, 2001). Suffice it to note here that the Calvo-Mendoza model is most appropriately seen as an open economy extension of the information-based herding and cascades genre of models that have been recently developed to explain herding behavior in domestic financial markets a la Banerjee (1992), Scharfstein and Stein (1990) and others 17 . The literature has thus far not been able to come up with a consistent definition of financial sector spillovers. Following the definition of trade spillovers, which include both direct and indirect channels, we define both direct financial sector spillovers as well as indirect or cross-market interconnection via liquidity constraints. This leaves only capital outflows triggered in international financial markets due solely to sudden shifts of sentiment of financial agents (i.e. "animal spirits or herding") following a crisis in another economy as qualifying as "pure contagion". This appears closest to the definition by Masson (1998). As Van Rijckeghem, and Weder (1999) note: Pure contagion refers to those crises triggered by a crisis elsewhere but which cannot be explained by changes in fundamentals or by any sort of the rather ":mechanical" spillovers ... but are possibly caused by shifts in market sentiments (increased risk aversion) or changes in interpretation

17

Bikhchandani and Sharma (2000) provide a succinct discussion of the various types of recent herding models in financial markets.

International Capital Flows and Regional Contagion

39

given to existing information (an increased perception of risk or a "wakeup call (pp. 5-6). In turn, these shifts in market sentiments could be due to the "irrationality" of financial agents or complete rationality but informational asymmetries and fixed costs in information-gathering and processing a la Calvo-Mendoza or financial markets that are subject to multiple equilibra (Pritsker, 1999). Figure 1 summarizes the foregoing discussion.

3.3.

Pure contagion versus fundamentals

in East Asia

Against the analytical background described previously, it is revealing to note that, in almost all crises experiences, the economies initially and worst affected by the crises were also the ones with the worst fundamentals to begin with. This said, even the strongest regional economies can be and have been affected by weaknesses in neighbouring economies because of trade and financial interdependencies (Berger and Wagner, 2002). Thus, the term contagion is quite apt; like a spreading virus, agents with the weakest immune system to begin with are the ones most severely impacted. This point is nicely illustrated in the case of Asia using Table 6, which is borrowed from Goldstein and Hawkins (1998). It is fairy clear that, by most counts, Thailand had the worst "fundamentals" (Raj an, 2001). It was followed by Indonesia, which was the most severely impacted by the crisis. Hong Kong and Singapore, which seem to have had the best fundamentals, were the least affected (Rajan et al., 2001). Malaysia and the Philippines were somewhere "in between". The fact that stronger, though much more open and regionally integrated economies were much less affected, underscores the need for the primary focus to be placed squarely on the domestic policy arena. In the Asian context, this broadly involves strengthening financial systems and corporate and industrial structures (Balino et a l , 1999). However, given the fact that regional spillovers or interdependencies are fairly high and growing in Asia, even relatively strong regional economies can be and have been affected by crises in the weaker neighbouring economies. 18 These policy externalities suggest the need for some form of regional cooperation in the financial and macroeconomic spheres. T h e emphasis on sound domestic

18 Similarly, in the case of the Tequila crisis, Chile, which was acknowledged to be by far the strongest regional economy in Latin America, was relatively unaffected.

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Economic Globalization and Asia

economic policies and a regional approach to crisis prevention is fully consistent with the spirit of "subsidiarity" which is being increasingly emphasized by the IMF. Some might argue that pure contagion will be far less important in the future, as investors seem to have differentiated between the regional economies following the crisis (Van Rijckeghem and Weder, 1999). This view is debatable. In any case, indications are that countries in the region will be more susceptible to the fundamentals of the neighbouring ones, as the stronger economies like Singapore have sharply escalated their investments in the crisis-hit economies such as Thailand, where asset prices remain depreciated 19 . In other words, regional interdependencies can be expected to rise significantly in the future, suggesting the need for a regional monetary facility more than ever. Conversely, regional or international cooperation will not be of much use if a country's "fundamentals" are poor. Indeed, due to the above-noted regional contagion effects, enhanced regional measures may actually prove to be detrimental to the other countries (negative externalities). Therefore, it is of no surprise that some East Asian countries with stronger fundamentals have gone out of their way to emphasize that their economic situations are not comparable to (i.e. are much stronger than) those of the crisis-hit economies (Lee, 2002).

4. Concluding Remarks While the term "contagion" has gained prominence, notoriety in fact, following recent currency crises, it should be recalled that it was used in a positive sense pre-crisis to describe the spread of trade and investment liberalization and economic prosperity in East Asia. Specifically, a positive externality of being associated with dynamic open economies involves the transformation of the conventional prisoner's dilemma — which suggests that protectionist policies are the "dominant strategy" for each country acting in isolation — to one of prisoner's delight, whereby trade liberalization is the dominant strategy for a country in a region in which some other countries are already reaping the benefits of a liberal trade regime (Garnaut, 1994) 20 . A n important policy conclusion drawn during

19

Thus, figures from the Thai central bank show Singapore's direct investment in Thailand to have jumped to 31.7 billion baht in 1998, up from 9.9 billion baht in 1997, making Singapore the third largest investor in the country after the US and Japan (Far Eastern Economic Review, October 21, 1999, p. 68). 20 Of course, an infinitely played prisoner's dilemma game predicts that a cooperative strategy could be supported if agents have sufficiently low discount rates (so called "Folk Theorem").

International Capital Flows and Regional Contagion

41

that time was the need for a formalization and institutionalization of these marketdriven linkages, i.e. creation of regional economic alliances. In a similar vein, the contagious transmission of currency crises, which often tend to be regional, has provided the basis for regional financial and monetary cooperation. To be sure, if the knock-on effects from financial crises are primarily a regional phenomenon, does it not follow that the liquidity provided in an attempt to forestall the contagion effects of crises should be provided regionally? This is the focus of Chapter 3.

Bibliography Ahluwalia, P. (2000). "Discriminating Contagion — An Alternative Explanation of Contagious Currency Crises in Emerging Markets", Working Paper No. 00/14, IMF. Asian Development Bank-Asia Recovery Information Centre (ADB-ARIC) (2001). Asia Recovery Report 2001 (March), Manila: ADB. Asian Development Bank-Asia Recovery Information Centre (ADB-ARIC) (2002). Asia Recovery Report 2002 (October), Manila: ADB. Balino, T. and Associates (1999). Financial Sector Crisis and Restructuring: Lessons from Asia, Washington, DC: IMF. Bank of International Settlements (BIS) (1998). 68th Annual Report, Basle: BIS. Bank of International Settlements (BIS) (1999). 69th Annual Report, Basle: BIS. Bank of International Settlements (BIS) (2000). 70th Annual Report, Basle: BIS. Banerjee, A. (1992). "A Simple Model of Herd Behavior", Quarterly Journal of Economics, 107, pp. 796-817. Berg, A. (1999). "The Asia Crisis: Causes, Policy Responses, and Outcomes", Working Paper No. 99/138, IMF. Berger, W. and H. Wagner (2002). "Spreading Currency Crises: The Role of Economic Interdependence", Working Paper No. 02/144, IMF. Bikhchandani, S. and S. Sharma (2000). "Herd Behavior in Financial Markets — A Review", Working Paper No. 00/48, IMF. Bird, G. and R. Rajan (2001a). "International Currency Taxation and Currency Stabilisation in Developing Countries", Journal of Development Studies, 37, pp. 21-38. Bird, G. and R. Rajan (2001b). "Banks, Financial Liberalisation and Financial Crises in Emerging Markets", The World Economy, 24, pp. 889-910.

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Bird, G. and R. Rajan (2002a). "Does FDI Guarantee the Stability of International Capital Flows? Evidence from Malaysia", Development Policy Review, 20, pp. 191-202 Bird, G. and R. Rajan (2002b). "Resolving the Interest Rate Premium Puzzle: Capital Inflows and Bank Intermediation in Emerging Economies with Reference to East Asia", mimeo (January). Boorman, ]., T. Lane, M. Schultze-Ghattas, A. Bulir, A. Ghosh, J. Hamann, A. Mourmouras and S. Phillips (2000). "Managing Financial Crises: The Experience in East Asia", Working Paper No. 00/107, IMF. Calvo, G. (1999). "Contagion in Emerging Markets: When Wall Street is a Carrier", mimeo (May). Calvo, G. and E. Mendoza (1996). "Mexico's Balance-of-Payments Crisis: A Chronicle of a Death Foretold", Journal of International Economics, 41, pp. 235-264. Calvo G. and E. Mendoza (2000). "Rational Contagion and the Globalization of Securities Markets", Journal of International Economics, 51, pp. 79-113. Calvo, S. and C. Reinhart (1996). "Is there Evidence of Contagion Effect", in G. Calvo, M. Goldstein and E. Hochreiter (eds.), Private Capital Flows to Emerging Economies After the Mexican Crisis, Washington, DC: Institute for International Economics. Chang, L.L. and R. Rajan (2001). "The Economics and Politics of Monetary Regionalism in Asia", ASEAN Economic Bulletin, 18, pp. 103-118. Chang, R. and A. Velasco (1998). "The Asian Liquidity Crisis", Working Paper No. 6796, NBER. Chang, R. and A. Velasco (1999). "Liquidity Crises in Emerging Markets: Theory and Policy", in B. Bernanke and J. Rotemberg (eds.), NBER Macroeconomics Annual 1999, Cambridge, MA: MIT Press. Corsetti, G., P. Pesenti and N. Roubini (1999). "What Caused the Asian Currency and Financial Crisis? Part I: Macroeconomic Overview", Japan and The World Economy, 11, pp. 305-373. Dasgupta, D. and D. Ratha (2000). "What Factors Appear to Drive Private Capital Flows to Developing Countries? And How Does Official Lending Respond?", Policy Research Working Papers No. 2392, The World Bank. Diamond, P. and P. Dybvig (1983). "Bank Runs, Deposit Insurance, and Liquidity", Journal of Political Economy, 91, pp. 401-419. De Gregario, ]. and R. Valdes (2001). "Crisis Transmission: Evidence from the Debt, Tequila, and Asian Flu Crises", in S. Claessens and K. Forbes (eds.), International Financial Contagion, Boston, MA: Kluwer Academic Publishers.

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Dooley, M. (2000). "A Model of Crises in Emerging Markets", Economic Journal, 110, pp. 256-272. Dornbusch, R., C.P. Yung and S. Claessens (2000). "Contagion: Understanding How It Spreads", The World Bank Research Observer, 15, pp. 177-197. Drazen, A. (1999). "Political Contagion in Currency Crises", in P. Krugman (ed.), Currency Crises, Chicago: University of Chicago Press. Eichengreen, B., A. Rose and C. Wyplosz (1996). "Contagious Currency Crisis", Scandinavian Economic Review, 98, pp. 463-484Fernandez-Arias, E. (2000). "The New Wave of Capital Inflows: Sea Change or Tide?", Working Paper No. 415, Inter-American Development Bank. Folkerts-Landau, D. and P. Garber (1998). "Capital Flows from Emerging Markets in a Closing Environment", Global Emerging Markets, 1, Deutsche Bank (London). Forbes, K. (2000). "The Asian Flu and Russian Virus: Firm-level Evidence on How Crises are Transmitted Internationally", Working Paper No. 7807, NBER. Forbes, K. and R. Rigobon (1999). "Measuring Contagion: Conceptual and Empirical Issues", mimeo (undated). Frankel, J. and S. Schmukler (1996). "Crisis, Contagion, and Country Funds: Effects on East Asia and Latin America", Working Paper No. 96-04, Center for Pacific Basin Monetary and Economics Studies, Federal Reserve of San Francisco. Frankel, J. and A. Rose (1996). "Currency Crisis in Emerging Markets: Empirical Indicators", Journal of International Economics, 41, pp. 351-368. Garnaut, R. (1994). "Open Regionalism: Its Analytic Basis and Relevance to the International System", Journal of Asian Economics, 5, pp. 273-290. Gerlach, S. and F. Smets (1995). "Contagious Speculative Attacks", European Journal of Political Economy, 11, pp. 5-63. Glick, R. and A. Rose (1999). "Contagion and Trade: Why are Currency Crises Regional?", Journal of International Money and Finance, 18, pp. 603-617. Goldstein, M. and J. Hawkins (1998). "The Role of Contagion in the Asian Financial Crisis", mimeo, Reserve Bank of Australia. Huh, C. and K. Kasa (1997). "A Dynamic Model of Export Competition, Policy Coordination, and Simultaneous Currency Collapse", Working Paper PB No. 97-08, Center for Pacific Basin Monetary and Economics Studies, Federal Reserve of San Francisco. Institute of International Finance (IIF) (2001). "Capital Flows to Emerging Market Economies" (January).

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Economic Globalization and Asia

IMF (1999a). International Capital Markets: Developments, Prospects, and Key Policy Issues, Washington, DC: IMF. IMF (1999b). World Economic Outlook, Washington, DC: IMF. Kaminsky, G. and C. Reinhart (2000a). "On Crises, Contagion, and Confusion", Journal of International Economics, 51, pp. 145-168. Kaminsky, G. and C. Reinhart (2000b). "Bank Lending and Contagion: Evidence from the Asian Crisis", T. Ito and A. Krueger (eds.), Regional and Global Capital Flows: Macroeconomic Causes and Consequences, Chicago: University of Chicago Press. Kawai, M. and S. Urata (1998). "Are Trade and Direct Investment Substitutes or Complements?: A n Empirical Analysis of Japanese Manufacturing Industries", in H. Lee and D. Roland-Hoist (eds.), Economic Development and Cooperation in the Pacific Basin, New York: Cambridge University Press. Krueger, M., P. Osakwe and J. Page (2000). "Fundamentals, Contagion and Currency Crises: A n Empirical Analysis", Development Policy Review, 18, pp. 257—274Lee, H.L. (2002). "Remaking Singapore for a Different World", speech at the Institute for International Economics (Washington, DC, November 13). Lopez-Mejia, A. (1999). "Large Capital Flows: A Survey of the Causes, Consequences, and Policy Responses", Working Paper No. 99/17, IMF. Masson, P. (1998). "Contagion: Monsoonal Effects, Spillovers, and Jumps between Multiple Equilibria", Working Paper No. 98/142, IMF. Montiel, P. and C. Reinhart (2000). "The Dynamics of Capital Movements to Emerging Economies During the 1990s", in S. Griffith-Jones and M. Montes (eds.), Short-term Capital Movements and Balance of Payments Crises, Oxford: Oxford University Press. Osei, R., O. Morrissey and R. Lensink (2002). "The Volatility of Capital Inflows: Measures and Trends for Developing Countries", Working Paper No. 02/20, Centre for Research in Economic Development and International Trade, University of Nottingham. Pritsker, M. (1999). "The Channels for Financial Contagion", mimeo (October). Radelet, S.and J. Sachs (1998a). "The Onset of the East Asian Financial Crisis", Working Paper No. 6680, NBER. Radelet, S. and J. Sachs (1998b). "The East Asian Financial Crisis: Diagnosis, Remedies, Prospects", in W. Brainard and G. Perry (eds.), Brookings Papers on Economic Activity, 1, pp. 1-74.

International Capital Flows and Regional Contagion

45

Rajan, R. (1999). "Economic Collapse in Southeast Asia", Policy Study, The Lowe Institute of Political Economy, Claremont: California. Rajan, R. (2000). "Financial and Macroeconomic Cooperation in ASEAN: Issues and Policy Initiatives", in M. Than (ed.), ASEAN Beyond the Regional Crisis: Challenges and Initiatives, Singapore: Institute of Southeast Asian Studies. Rajan, R. (2001). "(Ir)relevance of Currency Crises Theory to the Devaluation and Collapse of the Thai Baht", Princeton Studies in International Economics No. 88, International Economics Section, Princeton University. Rajan, R. (2003). "Safeguarding Against Capital Account Crises: Unilateral, Regional and Multilateral Options for East Asia", in G. de Brouwer (ed.), Financial Governance in East Asia, London: Routledge, forthcoming. Rajan, R., R. Sen and R. Siregar (2001). "The Tale of Two Cities Revisited in Light of the East Asian Crisis: Hong Kong, Singapore and Trade Spillovers", mimeo (July). Rajan, R. and C.H. Shen (2001). "Are Crisis-Induced Devaluations Contractionary?", Discussion Paper No. 0135, Centre for International Economic Studies, University of Adelaide. Rajan, R. and R. Siregar (2002). "Private Capital Flows in East Asia: Boom, Bust and Beyond", in G. de Brouwer (ed.), Financial Markets and Policies in East Asia, London: Routledge. Rodrik, D. and A. Velasco (1999). "Short-Term Capital Flows", Working Paper No. 7364, NBER. Scharfstein, D. and J. Stein (1990). "Herd Behavior and Investment", American Economic Review, 80, pp. 465-479. Schinasi, G. and R. Todd Smith (1999). "Portfolio Diversification, Leverage, and Financial Contagion", Working Paper No. 99/136, IMF. Thanompongphan, B. et al. (1999). "Recent Development in Household Savings Behaviour", Quarterly Bulletin, 39, pp. 27-33, Bank of Thailand. Van Rijckeghem, C. and B. Weder (1999). "Sources of Contagion: Finance or Trade?", Working Paper No. 99/146, IMF. Whitt, J. (1999). "The Role of External Shocks in the Asian Financial Crisis", Economic Review, Federal Reserve Bank of Atlanta, Second Quarter, pp. 18-31. World Bank (1997). Private Capital Flows to Developing Countries: The Road to Financial Integration, New York: Oxford University Press.

46

Economic Globalization and Asia

World Bank (1998). Global Development Finance 1998, New York: Oxford University Press. World Bank (1999). Global Development Finance 1999, New York: Oxford University Press. World Bank (2000). Global Development Finance 2000, New York: Oxford University Press.

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48

International Capital Flows and Regional Contagion Table 2 Net Capital Flows, 1989-1996 (percent of GDP)

Indonesia: Private Capital Flows Direct investment Portfolio Investment Other Investment Official Flows Change in Reserves3

1991

1992

4.6 1.2 0.0 3.5 1.1 -2.4

2.5 1.2 0.0

1993

Simple Average (1989-96)

1994

1995

1996

3.1 1.2 1.1 0.7 0.9 -1.3

3.9 1.4 0.6 1.9 0.1 0.4

6.2 2.3 0.7 3.1 -0.2 -0.7

6.3 2.8 0.8 2.7 -0.7 -2.3

5.1 1.7 0.5 3.0 0.7 -1.7

15.1 17.4 7.8 8.9 0.0 0.0 6.2 9.7 -0.6 -0.1 -11.3 -17.7

1.5 5.7 0.0 -4.2 0.2 4.3

8.8 4.8 0.0 4.1 -0.1 2.0

9.6 5.1 0.0 4.5 -0.1 -2.5

10.2 7.2 0.0 2.9 0.0 -5.1

5.0 2.0

4.6 1.8 0.3

9.8 1.6 -0.2 8.5 0.2 -4.8

4.1 1.8 0.2 2.1 2.0 -1.8

9.3 0.9 0.6 7.7 0.7 -1.2

11.5 1.6

1.4 1.1 -3.0

Malaysia:

Private Capital Flows Direct investment Portfolio Investment Other Investment Official Flows Change in Reserves3

11.2 8.3 0.0 2.9 0.4 -2.6

Philippines:

Private Capital Flows Direct investment Portfolio Investment Other Investment Official Flows Change in Reserves3

1.6 2.0 0.3 0.2 3.3 -2.3

2.0 1.3 0.1 0.6 1.9 -1.5

2.6 1.6 -0.1 1.1 2.3 -1.1

10.7 1.5 0.0 9.2 1.1 -4.3

8.7 1.4 0.5 6.8 0.1 -2.8

8.4 1.1 3.2

0.4 2.5 0.8 -1.9

2.4 1.4 -0.9

Thailand:

Private Capital Flows Direct investment Portfolio Investment Other Investment Official Flows Change in Reserves3

4.1 0.2 -3.2

Note: a) Minus sign denotes a rise and vice versa Source: IMF (1999a,b)

8.6 0.7 0.9 7.0 0.1 -3.0

12.7 0.7 1.9 10.00 0.7 -4.4

1.4 8.5 0.1 -4.3

International Capital Flows and Regional Contagion

49

Table 3 Macroeconomic Conditions Leading to Unhedged External Borrowing in East Asia, January 1991-June 1997 (in percent) Country

Indonesia South Korea Malaysia Philippines Thailand

Interest Rate Spread3 (%)

Annual Average Appreciation v/s US dollarb

Exchange Rate Variability0

11.5 4.1 1.6 6.5 4.0

-3.8 -3.2 1.2 0.9 -0.3

0.7 3.4 2.6 3.8 1.2

Notes: a) Local deposit rate less LIBOR (US$) for East Asian economies b)+ implies an appreciation; — implies a depreciation c) Standard deviation of percentage deviation of exchange rate from regression time trend Source: World Bank (1998)

50

Economic Globalization and Asia

Table 4 Nationality of BIS Reporting Banks Providing Loans, 1997-1999 (US dollar millions) End June 1997 Japan

France

Indonesia

23153

4787

5610

4332

4591

58273

Malaysia

10489

2934

5716

2818

2400

28820

Philippines Thailand

Germany

UK

USA

Total

2109

1678

1991

1076

2816

14115

37749

5089

6028

2361

4008

69382

Korea

23732

10070

10794

6064

9964

103432

Asia-5

97232

24558

30139

16651

23779

274022

End December 1997 Japan

France

UK

USA

Total

Indonesia

22018

4773

Germany 6174

4492

4893

58211

Malaysia

8551

2883

7197

2014

1787

27333

Philippines

2624

2165

2999

1607

3225

19715

Thailand

33180

4718

6028

2361

2533

58534

Korea

20278

11135

9616

6924

9531

93364

Asia-5

86651

25674

32014

17398

21969

257157

UK

USA

Total

End June 1998 Germany

Japan

France

Indonesia

19030

4009

7542

3967

3226

50268

Malaysia

7905

2391

5160

1613

1149

23024

Philippines

2308

1780

2161

1775

3025

17803

26120

3943

5286

2088

1757

46801

Thailand Korea

18934

7913

8400

5634

7409

72444

Asia-5

74297

20036

28549

15077

16566

210340

End June 1999 Japan

France

UK

USA

Total

Indonesia

14043

3967

7542

3428

3724

43764

Malaysia

6056

2225

2837

2837

1074

18623

Germany

2263

1996

2689

1760

2912

16521

Thailand

18278

2922

4632

1476

1232

34694

Korea

15018

8752

7605

4685

6420

63482

Asia-5

55658

19862

25305

14186

15362

177084

Philippines

Source: BIS, Consolidated International Banking Statistics, various issues

Table 5 Aggregate Net Capital Flows to the Asia-5 Economies3, 1995-2002 (US dollar billions) Type of Capital Flow

1995

1996

1997

1998

1999

2000

2001b

2002b

Private Flows Equity Investment Direct Portfolio Private Creditors Commercial Banks Others0

93.4 16.1 4.1 12.0 77.2 63.7 13.5

118.5 20.0 4.8 15.2 98.6 69.2 29.4

4.4 6.2 6.8 -0.7 -1.8 -17.6 15.8

-37.3 16.6 13.3 3.3 -53.9

-1.5 35.0 16.1 18.9 -36.5 -32.3 -4.2

16.9 25.4 13.8 11.6

9.3 21.0 9.9 11.1 -11.7 -5.7 -6.0

10.2 11.0 7.5 3.6 -0.8 -2.0 1.1

-48.4 -5.5

-8.4 -12.8 4.4

Notes:

a) Asia-5 economies denote Indonesia, Malaysia, Philippines, Korea and Thailand b) Estimate c) Includes resident net lending, monetary gold and errors and omissions Source: IIF (2001) Table 6 Summary of Economic Fundamentals of Selected Asian Economies Country Rank ngsa

Fundamentals 1

2

3

4

5

6

7

External International Reserves" Current Account/GDPc Debt/GDPd Export Slowdowne Real Exchange Rate: deviation from PPPf

P T T T S

I K P S K

M M I M H

T P M K M

K I S H T

H H H P I

s

Banking Strength Capital Adequacy8 Nonperforming Loans'1 Bank Ratings'

K M I

T T K

I K T

M I P

P P H

H S M

H

Liquidity Mismatches Excess Credit Growth' Short-term external debt/Reserves'1 Broad Money/Reserves1

P T T

M I I

T P P

I K K

S M M

K S S

H H H

Overall Average111

T

I

K

P

M

S

H

Overall based on Thailand Weights"

T

I

K

P

M

s

H

Notes:

a) I—Indonesia, H — Hong Kong, K — South Korea, M — Malaysia, P — Philippines, S — Singapore, T — Thailand. Ordinal ranking in descending order of "bad" fundamentals b) In SDRs, June 1997 c) 1996 d)1997 e) Change (%) In 1996 less the average change (%) previous three years f) June 1997 g) Unclear from source, but probably average of 1996 and 1997 h) 1997 estimates i) May 1996 j) Growth of credit to private sector relative to nominal GDP, 1996 k) June 1997 1) June 1997 m) Equal weights to all fundamentals (including two others included in original sources) n) Greater weights given to fundamentals in which Thailand is weakest Source: Goldstein and Hawkins (1998)

S

s I p

s s

52

Economic Globalization and Asia

T—1

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ca

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CJ) M U5

E o H

53

Chapter 3

Liquidity Enhancing Measures and Monetary Cooperation in East Asia: Rationale and Progress1

1. Introduction Referring to the East Asian crisis of 1997-98, the International Monetary Fund (IMF) has recently drawn attention to a "new breed of economic crisis" in a "globalized financial market". These new generation models focus on the "capital account" in contrast to the first two model generations that focus on the "current account". In a meeting in 2000 in Tokyo, the Group of Seven (G-7) countries concurred with this analysis. In their declaration entitled "Strengthening the International Financial Architecture", they reportedly noted the need for the IMF to reform itself and its facilities so that "(i)n future the IMF would be better able to cope with capital account crises, such as the Asian crisis which broke just over three years ago" 2 . Dornbusch (2001) describes a capital account or "new-style" crisis as follows: A new-style crisis involves doubt about credit worthiness of the balance sheet of a significant part of the economy — private or public — and the exchange rate ... when there is a question about one, the implied capital flight makes it immediately a question about both ... the central part of the new-style crisis is the focus on balance sheets and capital flight ... Because new-style crises involve the national balance sheet they involve a far more dramatic impact on economic activity than mere current account disturbances..(p. 2). It has become commonplace to interpret the new genre of currency crisis models as being "bank-centered". While this is far too narrow a perspective and does not do adequate justice to the large milieu of new crisis models which emphasize various types of capital flows and dynamics (Rajan, 2001), it is not

1

This Chapter draws on Bird and Rajan (2002), Chang and Rajan (2001) and Rajan (2000, 2002).

2

Quoted in an AFP report "G7 Calls for Major Overhaul of World's Finances" (July 8, 2000).

54

Economic Globalization and Asia

altogether surprising. After all, the strong and positive correlation between banking and currency crises (so-called "twin crises") since the late 1980s and 1990s is a well documented fact, with the causation most often running from banking to currency crises (Kaminsky and Reinhart, 1999). What is more, these twin crises are far more pervasive in developing countries than in developed ones (Glick and Hutchison, 1999 and IMF, 1998). The probability of banking crises themselves occurring seems more likely following financial liberalization, with sharp increases in domestic (bank) lending acting as significant predictors of currency crises. The IMF (1998) has suggested that the greater frequency of banking crises worldwide since the 1980s is "possibly related to the financial sector liberalization that occurred in many countries during this period" (p. 115). Much ink has been spilt over the question of whether the East Asian crisis was due to insolvency or illiquidity. The importance of tackling this question cannot be underestimated, as the consequences for economic policy will vary greatly depending on what the problem is perceived as being. O n the one hand, in the case of a liquidity crisis, some form of coordination (via lender of last resort functionary, moratorium or standstill on debt, etc) will be able to avert sharp real losses. O n the other hand, in cases where banks are insolvent, allowing them to continue operating without restructuring will magnify market distortions and the concomitant fiscal costs of bailout and rehabilitation. Whatever the reasons for the crisis and devaluation, the extent of the postdevaluation economic contraction experienced by many emerging economies is exacerbated by the nominal appreciation of external liabilities which are often foreign currency based and uncovered, slashing the net worth of individuals, corporations and the domestic financial systems at large (World Bank, 2000). This so-called "balance sheet" effect leads to massive collateral damage and outright bankruptcies, which in turn aggravates domestic economic conditions and intensifies capital outflows (Raj an and Shen, 2001). This was certainly the case in East Asia. While managing a conventional current account crisis involves a judicious combination of adjustment and financing, dealing with a capital account crisis principally demands the restoration of "market confidence" and is a much more imprecise and complex undertaking. Accordingly, the emphasis is best placed on crisis prevention as opposed to management or resolution. In this regard, it is crucial that emerging economies augment sound economic policies with appropriate financial safeguards to shield themselves from external shocks and adverse shifts in market confidence. Among the more important means of guarding against capital account shocks are those aimed at international liquidity enhancement. This Chapter examines potential ways of enhancing the availability of liquidity in crisis conditions so as to minimize losses in the event of future crises.

Liquidity Enhancing Measures and Monetary Cooperation in East Asia

55

Liquidity enhancement measures are often seen in terms of unilateral and multilateral actions, the latter invariably involving an expanded role for the IMF. These are discussed in Section 2. As noted in Chapter 2, "contagion" often tends to have a regional as opposed to global dimension. This regional dimension of contagion provides rationale for exploring regional approaches to tackling illiquidity concerns. Section 3 examines and assesses the regional initiatives that are currently underway in Asia, including the Chiang-Mai Initiative (CMI). Section 4 discusses ways of building on the CMI and fortifying steps towards regional monetary cooperation. The final Section offers a summary and a few concluding remarks.

2. Liquidity-Enhancing Measures: Safeguarding against Capital Account Crises 2.1.

Reserve

buildup

Stockpiling of reserves by the East Asian economies in the early 1990s helped somewhat cushion the exchange rate depreciations in 1997—98. Also of importance is the fact that the regional economies began re-accumulating international reserves following the sharp declines in 1997 (so-called "floating with a life-jacket"), implying that the current account surpluses exceeded total capital outflows3. To emphasize the extent to which a policy of reserve accumulation has been embraced by East Asia, note that the region now houses the world's largest holdings of foreign reserves in aggregate. To be sure, global international reserves stood at US$ 2,223 billion in May 2002, a near doubling in nominal terms since early 1994. Developing countries account for around two-thirds of the world's international reserves, with East Asia alone holding 38 percent of the global share in May 2002, up from about 30 percent in 1994 (Aizenman and Marion, 2002). Korea and China stand out as having accumulated reserves particularly aggressively between 1992 and 2001. The preceding highlights a seeming paradox. The regional economies (save Hong Kong and Malaysia) have generally allowed for a relatively greater, albeit modest, degree of variability of their currencies according to market conditions (see Chapter 4). Yet the central banks in developing countries have appeared keen on bolstering reserves to historically high levels 4 .

Another reason for the accumulation of reserves is the "fear of floating" that seems to characterize developing countries (see Chapter 4). 4

Of course, the impact of exchange rate variability on reserve holdings runs both ways. On the one hand, with flexible regimes, the exchange rate acts as a safety valve in response to balance of

56

Economic Globalization and Asia

N o doubt, the replenishment and accumulation of international reserves, on the one hand, and the curbing of imports as well as the lengthening of the average maturity profile of external indebtedness of the regional economies, on the other, have worked in tandem to significantly improve the external positions of the regional economies (Tables 1 and 2). The higher import and external short term debt coverage of reserves has substantially eased the extent of the region's vulnerability to the destabilizing effects of volatile and easily reversible capital flows. However, an important drawback of such a policy of reserve hoarding is that it involves high fiscal costs as the country effectively swaps high yielding domestic assets for lower yielding foreign ones (Bird and Raj an, 2003 and Raj an, Siregar and Bird, 2003) 5 . Since international reserve holdings have been found to be a theoretically and statistically significant determinant of creditworthiness (Bussiere and Mulder, 1999, Haque et al., 1996 and Disyatat, 2001), depleting them as a way of cushioning the effects of capital outflows on the exchange rate may make matters worse by inducing further capital outflows. If capital outflows reflect a perception within private capital markets that a country is illiquid, reducing international reserves and therefore curbing liquidity further is hardly likely to be an effective strategy. In other words, the reversibility that makes reserve depletion credible in the context of trade deficits is often absent in the context of capital outflows.

2.2.

Foreign bank entry and contingent credit lines

In light of the above, it has been suggested that the internationalization of the domestic banking systems in developing countries could be an important additional means of overcoming illiquidity during crises periods. The argument is that a banking system with an internationally diversified asset base is more likely to be stable and less prone to bank runs and outright crises since the domestic payments disequilibria. On the other hand, past exchange rate changes may be an indication of the extent of variability of and susceptibility to external shocks. Insofar as central banks need to hold reserves to counter these external shocks, this suggests the need to hold larger quantities of reserves. 5

There is the additional question of what the appropriate size of reserve holdings is, i.e., against what yardstick should reserve adequacy be measured? The generally accepted rule of thumb that a country needs to hold reserves equivalent to short term debt cover (i.e. debt that actually falls due over the year) is true only in the case where a country is running a current account balance and there are no other liabilities that are easily reversible. The optimal level of reserves depends on a number of factors such as degree of export diversification, size and variability of the current account imbalance, type of exchange rate regime, etc. (Bussiere and Mulder, 1999). A related issue pertains to the appropriate currency composition of reserves (Eichengreen and Mathieson, 2000).

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branches of foreign banks are able to obtain financing from the foreign head office, which could act as a private lender of last resort. In addition, since portfolios of foreign banks are much less concentrated in any single country, particularly in the developing and emerging host ones, they ought to be less susceptible to country-specific crises. Thus, it is often noted that foreign banks in Argentina and Mexico were able to maintain access to offshore financing during the Tequila crisis of 1994 and 1995, while domestic banks were faced with credit squeezes. There are other potential advantages of allowing foreign bank entry — such as lowering overall financial costs structures — which may make it a desirable policy in and of itself6. Regardless of foreign bank entry, countries may find it useful to establish contingent lines of credit with foreign banks and private financial institutions as a means of providing additional international liquidity to deal with sudden capital flow reversals. Indonesia, Argentina, Mexico and South Africa are some examples of countries that have recently arranged such private lines of credit with international banks. More generally, there are a number of problems and limitations of obtaining such credit lines unilaterally and on a private basis rather than regionally or multilaterally via official channels. First, there may be high opportunity costs involved insofar as the individual countries have to commit certain assets/revenue streams as collateral. Second, calling on these lines of credit when needed could lead to a hike in the country's international risk premium. Third, while negotiating lines of credit with a country, the financial institutions could undermine the effectiveness of these commitments and their effective exposures to that country through other channels (through various corporate risk management techniques). Foreign banks themselves could be sources of contagious transmission of crises. For instance, in response to a crisis in one country, multinational banks might attempt to liquidate positions in other regional economies to which they have exposures, i.e. the "credit crunch" or "liquidity" channel discussed in Chapter 2. Fourth, and related to this, if the credit lines are called upon by one country, the international financial institutions may be forced to reduce their exposures in other emerging economies, either to cover losses or in order to reduce portfolio risks and improve the liquidity position ("flight to safety" effects).

6

See Bird and Raj an (2001) and Claessens et al. (1999) for discussions about the potential benefits of foreign bank entry. Of course, as with financial liberalization in general, to foreign bank entry must be undertaken in a careful (gradual?) manner so as to avoid any major disruptions to the domestic financial system by enticing domestic banks to opt for increasingly risky investments. Montreevat and Rajan (2001) discuss Thailand's experience with bank restructuring and foreign bank entry.

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In view of this, Fischer (2001a) has stressed the need for a multilateral response in the form of IMF lending to complement unilateral measures that countries may take towards liquidity enhancement. 23.

Multilateral

Safeguards: Liquidity, Crisis and the IMF

The problem facing the IMF, which has constituted one component of the debate about a new international financial architecture, has been how to provide adequate liquidity to help forestall a crisis in a distressed economy and prevent its spread to other countries where there is reluctance to make concessions in terms of conditionality and reluctance to substantially increase the IMF's lending capacity. The IMF's response has been to create the Contingent Credit Line (CCL). The idea here was to establish a precautionary line of credit for countries with "sound" policies that might be affected by contagion from a crisis and to finance this from outside the IMF's quota-based resources by New Arrangements to Borrow (NAB). The negotiation of conditionality with potential users of the CCL would therefore take place before the country needed to draw on the IMF. But member countries have hitherto been reluctant to negotiate a CCL with the IMF. Consequently the facility has had to be re-evaluated (Rajan, 2003). Its weaknesses have been widely recognized and acknowledged and has undergone some modifications, including a reduction in the relatively high costs of borrowing via this facility and a review of the conditionality involved as part of obtaining the funding (Fischer, 2001a). However, this sort of "tinkering" fails to recognize a more fundamental drawback of such a scheme. Why should countries sacrifice sovereignty over national policy and subject themselves to strict conditionality when all they receive in return is an option on a drawing? Since, in many instances, countries fail to implement conditionality for one reason or another, a situation could arise where a country complies with a significant proportion of conditionality and yet is ineligible to draw in the event of experiencing contagion from a crisis. Of most concern, however, has been the possibility that by negotiating a CCL a country sends out a negative signal to private capital markets that it is vulnerable to a crisis. This may have an adverse effect on capital flows to the country and may contribute to causing the very crisis that the CCL is intended to help avoid. Moreover, there must remain some doubt about whether the facility would be adequately financed. 3. Regional Response to Regional Crisis: The Chiang-Mai Initiative The regional dimension of the 1997-98 East Asian crisis, as well as the perceived inadequacies of the IMF's response to it, has motivated a sub-group of East Asian

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economies to take some small but important steps towards enhancing regional financial stability and protect themselves against externally induced shocks and liquidity crises. Ito (2002) has suggested there are four reasons for Japan's interest in regional financial cooperation. These reasons appear just as relevant to other countries in the region and warrant highlighting. First, the experience of the Asian currency crisis that was highly contagious has shown that.Asia and Japan have been "on the same boat." Their strong trade and financial linkages mean that one country's financial difficulties affects others quite easily. Preventing a financial crisis in one country, if possible, is of others' interest ... Second, the less-than-perfect performance of (the) IMF in managing various stages of the Asian currency crisis has given an interest in building a regional framework that is substitutable or complement(ary) to (the) IMF ... Third, success in economic and currency integration in Europe shows that it is indeed possible for a region to unify the currency. Of course, there are many steps before monetary union. But, Europe clearly shows a model for a group of advanced and middle-income emerging market economies to integrate real economies and financial markets ... Fourth, there is a fear factor. Asia may be left behind in a rush toward(s) regionalism. The EU is poised to expand to the east and the N A F T A may be expanded to the Free Trade Area of the Americas (FTAA). Fragmented Asia may suffer in any trade negotiations or trade wars as each of the Asian economies may be dwarfed by the expanded Euro Area or the "dollarized" Americas (p. 1). Table 3 summarizes the various regional initiatives in East Asia. While these initiatives towards enhanced regional surveillance are important in their own right — and have been extensively discussed elsewhere (Chang and Rajan, 2001, Manzano, 2001 and Rajan, 2000) — they do not in and of themselves reduce a country's susceptibility to a capital account or new-style crisis which requires access to international credit lines as discussed previously.

3.1.

The Chiang-Mai Initiative

(CMI) is born

Against this background it is important to note that selected East Asian economies have recently agreed to create a network of bilateral currency swaps and repurchase agreements as a "firewall" against future financial crises. This has since come to be termed the Chiang-Mai Initiative (CMI) following an agreement in Chiang Mai, Thailand on May 6, 2000.

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At a broad level, the CMI is aimed at providing countries facing the possibility of a liquidity shortage with additional short term hard currencies. The CMI extends and expands upon the little known ASEAN Swap Arrangement (ASA) and encompasses all ASEAN countries as well as China, Japan and Korea (i.e. ASEAN Plus Three or APT). The ASA was established in the 1970s to provide short term swap facilities to members facing temporary liquidity or balance of payments problems. In 1977, there were only five ASEAN signatories — Indonesia, Malaysia, Philippines, Singapore and Thailand — each contributing about US$40 million. This facility was increased to US$200 million in 1978. At the Fourth ASEAN Finance Ministers Meeting in Brunei Darussalam (March 24-45, 2000), the Ministers agreed to expand the A S A to include the remaining ASEAN members, Brunei Darussalam, Cambodia, Laos, Myanmar and Vietnam. In keeping with this expansion, the A S A was enlarged to US$1 billion with effect from November 17, 2000. There are also a series of repurchase agreements (repos) that allow ASEAN members with collateral such as US Treasury bills to swap them for hard currency (usually US dollars) and then repurchase them at a later date. The expanded A S A is to be made available for two years and is renewable upon mutual agreement of the members. Each member is allowed to draw a maximum of twice its commitment from the facility for a period of up to six months with the possibility of a further extension of not more than six months. This expansion of the ASA is the first step in putting into effect the CMI which envisages that hard currency lines of credit will be made available to members. In addition to the expansion of the A S A among Southeast Asian countries, the three ASEAN Dialogue partners (China, Japan and Korea) have simultaneously been in discussions aimed at establishing a Bilateral Swap Arrangement (BSA) amongst themselves. Japan has recently signed BSAs totaling US$6 billion with Malaysia, Thailand and Korea, and is planning to add ones with China and the Philippines. BSAs among other members of the APT are expected in the near future. While the maximum amount of withdrawal under each of the BSAs will be determined by negotiations between the two countries concerned, in the spirit of "regional partnership" there is to be full coordination and consultation among all members when deciding on disbursements.

3.2.

The economics of the CMI

While the basic idea behind the CMI is clear, many details still need to be clarified. Journalistic accounts suggest that 10 percent of the funds will be available automatically while the rest will be subject to IMF conditionality.

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First, the resources need to be capable of being disbursed quickly. Speed is of the essence in a crisis. Second, the credit lines need to be "sufficiently large" to generate confidence in private capital markets and to repel speculative attacks, as well as involve sufficient countries to avoid potential problems of co-variance and to allow the pooling of risks. Third, the rate of interest needs to be "sufficiently high" so as to guard against moral hazard 7 . Countries need to be discouraged from using such credit lines as a matter of course. Fourth, access to such liquidity needs to be separated from the detailed negotiation of conditionality which would prejudice quick dispersal; links to IMF conditionality are therefore a cause of some concern. However, given the part played in the East Asian crisis by weak domestic financial structures and inadequate prudential standards and supervision, there is a strong argument for making access to the credit lines associated with the CMI conditional upon compliance with some minimum set of financial standards. This would encourage countries to push ahead with reforms to their domestic financial systems (see Bird and Rajan, 2002 for a brief progress report on financial restructuring efforts in the region). A credible system of regional swaps based on these principles would have two key attractions. It would enable participants to avoid the severe output losses that are associated with extreme shortages of liquidity (Rajan and Shen, 2001). Based on this, by creating confidence that such extreme shortages will not occur, the incidence of crises could be reduced. Of course, confidence would be undermined if the swap arrangements were used to try and defend disequilibrium real exchange rates. Therefore, the CMI should not be a mechanism for inappropriate currency pegging in the region. The history of bilateral swaps in the context of the Bretton Woods system demonstrates that they are an ineffective means of defending seriously misaligned currencies. A n important next step would therefore be to reinforce and augment the existing bilateral currency swap arrangements under the CMI if it is to be made a credible and effective financing mechanism. The size of currency swap, though large in comparison to some countries' quotas in the IMF (Henning, 2002), remains small in absolute terms. To be sure, currently, the total amount of BSAs covering all 13 East Asian countries is estimated at around US$20 billion, with the maximum amount of money that any individual country can draw varying

7

The need to charge "prohibitively high" interest rates is, of course, the classic rule for a lender of last resort proposed by Walter Bagehot. Park (2001) also discusses the issue of appropriate interest rate for a regional financial facility. Willett (2001) suggests that ex-ante lending facilities should follow a policy of "time escalating interest rates". Admittedly, this does not solve the moral hazard problem at the creditor or investor level. The way to limit such investor moral hazard would be for the private sector to share in the burden of bailouts, i.e. "take a haircut".

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significantly. Nonetheless, the US$20 billion that is available in aggregate is comparable to the US$17.2 billion that was granted to Thailand itself as part of the IMF program of 1997-98. If the aim of liquidity arrangements is to ensure the availability of large-scale liquidity in crisis periods, the current size and manner in which the CMI is structured precludes it from playing the role satisfactorily.8

4. Beyond the Chiang-Mai Initiative The CMI is noteworthy as the financial commitments involved exceed anything that has taken place before in East Asia. Going forward, if the CMI is to be built upon as a way of providing short term liquidity at the regional level, it would be natural to think about extending the facility to establish a full-fledged regional reserve pooling mechanism or liquidity support program (Henning, 2002). Indeed, if the hitherto decentralized and bilateral swap arrangements are activated collectively, the CMI will go a long way to being a de facto regional pooling arrangement. More to the point, a regional standing reserve pool essentially involves participating central banks being able to access a portion of their regional partners' foreign reserves during times of distress. Many Asian governments have hitherto been unwilling to consider restructuring the CMI to create a more formalized regional structure. This should not come as a surprise. Regional reserve pooling has by no means been an easy issue in practise. For instance, in the case of Europe, despite having established a single regional central bank, the federal structure of the union and very different levels of reserves held by individual countries (central banks) implied that pooling of reserves was done only partially. The fact that the Asian economies maintain the bulk of the world's foreign exchange reserves suggests that (a) there is a definite case of resource misallocation with huge opportunity costs as highlighted previously; and (b) the region has sufficient aggregate reserves to develop a large and credible common reserve pool arrangement. More importantly, the reserves are well distributed between many "strong currency" countries, including Japan, China, Korea and Singapore. This is important, because if a region on balance had relatively more "weak currency" countries than strong ones, sustainability, if not creation of a common reserve pool would certainly come into question. It would be highly unlikely that the few strong currency countries would be willing to allow their reserves to be constantly

8 Henning (2002), Park (2001) and Wang (2003) offer comprehensive descriptions of the CMI and make useful suggestions on how it may be built upon while still maintaining its credit line character.

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compromised by the weaker currency countries. Conversely, if reserves are well spread out among a number of "strong currency" countries, these countries will be able to work together to require the weak currency ones to implement necessary macroeconomic and structural reforms if they are eligible to draw upon the com' mon pool when needed. (The issue of conditionality and other pre-requisites are discussed in Section 4.2).

4>1- Reserve pooling versus exchange rate The European experience

coordination:

If the CMI does evolve into a regional liquidity facility, it would be natural to ask whether effective financial cooperation can be pursued in the absence of regional exchange rate coordination. Certainly, any explicit form of exchange rate coordination necessitates that a reserve pooling arrangement be in place to jointly manage the regional currency arrangement. But such a strong form of coordination requires much more. Uppermost on the list is the need for close coordination of regional macroeconomic policies, which in turn almost inevitably requires some sort of constraining arrangement to ensure compliance. However, it would be fair to say that the regional countries in Asia do not currently have the consensus or political will necessary to consider establishing a coordinated exchange rate regime in the near future (Eichengreen and Bayoumi, 1999). Indeed, small but strong currency countries like Singapore are unlikely to be willing to forsake the discretion they have over their own macro policy and subordinate themselves to a regional monetary alliance that is untested and where their voice may not be significant. On the other hand, a reserve pooling arrangement requires no such binding constraint on their decision-making until and unless they need to draw on the common pool. A reserve pooling arrangement also offers benefits on its own. Therefore, it can be pursued regardless of any decision pertaining to explicit regional exchange rate coordination' This being said, if a greater degree of exchange rate coordination — in the form of common regional basket pegs or even a collective exchange rate regime or an Asian Monetary system (equivalent to the European Monetary System or EMS) — becomes more practicable over time, it will be necessary to further strengthen the centralized monetary pool (Kusukawa, 1999). Indeed, as envisaged by Williamson (1999), there may be a need to put in place an equivalent to the European Very Short Term Financing Facility (VSTFF) to sustain the regional currency arrangement in the event of speculative attacks. To be sure, under the VSTFF, central banks granted loans to one another at unlimited amounts for 45 days to 3 months. Interest would be paid at prevailing

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market rates and up to 50 percent could be repaid in the European Currency Unit (ECU) (Henning, 2002). This facility was under the control of the former European Monetary Cooperation Fund (EMCF) which was financed by US dollar deposits of each member states' reserves and the EMCF issued ECU in return 9 . The EMCF's board was composed of governors of participating national central banks and was established to scrutinize European monetary policies, administer the operation of credit facilities, and authorize exchange rate realignments. Apart from the VSTFF, the other financial facilities under the purview of the EMCF were the Short Term Monetary Support (STMS) which was meant for temporary balance of payments problems (loans of about 3 to 9 months) and the Medium Term Financial Assistance (MTFA) which was financed through assigned lending quotas for individual central banks with loans for 2-5 years subject to remedial macroeconomic conditionality. A n important element of the EMS was the creation of the European Currency Unit (ECU) which was to function as the region's unit of account. Official ECUs were issued to member central banks through the EMCF in exchange for 20 percent of their US dollar and gold reserves. The EMCF was dissolved following the formation of the European Monetary Institute (EMI) in January 1994 10 . The EMI took over the tasks of the EFMC while additionally being tasked with strengthening central bank cooperation and monetary policy co-ordination as well as assisting with the preparations needed to establish the European System of Central Banks. The EMI itself went into liquidation with the establishment of the European Central Bank (ECB) in June 1998. Following the dissolution of the ECU with the creation of the euro in 1998, the reserves held by the ECB were transferred back to the regional central banks. More generally, as with the EMS, there needs to be an explicit agreement that regional financing arrangements and interventions will need to be rapidly disbursed, automatic and unlimited. A plausible argument could be made that if speculators are intent on attacking a currency arrangement, no level of reserves will be sufficient to counter this. However, in the presence of strong fundamentals, the availability of a large standing pool of reserves ought to bolster confidence and reduce the probability of an attack in the first instance. Indeed, as

9

The EMS, set up in 1979, consisted of four main components, the ECU, the Exchange Rate Mechanism (ERM), the Financial Support Mechanism (FSM) and the European Monetary Cooperation Fund (EMCF). The EMCF itself was established in 1973 following the Werner Report and after the creation of the "snake in the tunnel". 10 All said, the EMCF possessed little authority in practise, as the regional central bank authorities were unwilling to forsake their macroeconomic autonomy, and its role was largely subordinant to the Council of Ministers of Economics and Finance (ECOFIN).

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noted previously, it is instructive that international reserves (appropriately scaled) consistently shows up as a leading indicator of currency crises11. Insofar as greater exchange rate coordination facilitates intra-regional over extra-regional trade, the optimal size of reserve holdings of the region may decline as there is a substitution of external trade by domestic trade 12 . In addition to this reduced transactions demand for reserves, the absence of the need to stabilize intra-regional exchange rates with exchange rate coordination also suggests a lower precautionary need for reserves 13 . There is a more subtle issue to note when it comes to the precautionary demand for reserves. Countries hold reserves as a war chest against adverse geopolitical developments and other "non-market considerations" (Reddy, 2002). To the extent that closer monetary integration enhances intraregional security and reduces some of these intraregional geopolitical considerations, the region's aggregate demand for reserves can be expected to decline.

4.2.

Surveillance and policy

conditionality

In the absence of exchange rate coordination, there is the perennial concern that the incentives for participating countries may be blunted. Specifically, some member countries may be less concerned about maintaining unsustainable currency regimes as there may be the expectation of the availability of large-scale regional financial assistance in the event of a speculative attack. Thus, even if there is no explicit exchange rate coordination, it is important to have in place an effective monitoring and surveillance mechanism such that all participating countries can exercise some degree of influence on one another's policies, as well as to highlight or rein in profligate policies. In other words, for a centralized reserve pooling mechanism to operate effectively, it is imperative that an appropriate mechanism be in place to monitor participating countries' policies and

1

' This said, during the days of the EMS, many Western European countries imposed restrictions on capital flows. This may have facilitated the sustainability of the regime, particularly as international capital flows were much less intense since the mid 1990s. 12

Frankel and Rose (2002), Click and Rose (2001) and Rose (2000) estimate gravity models using both cross-sectional and time series data and conclude that a common currency is especially trade stimulating intraregionally. 13

Offsetting these effects, with a full-fledged currency union, there will be an automatic decline in "international reserves" with the re-definition of regional currencies. However, this is of less relevance for Asia (compared to Europe, for instance) as the US dollar is the most important reserve asset in Asia.

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compliance, with automatic pre-agreed sanctions in place to deal with noncompliance (i.e. conditionality) 14 . The need to ensure "due diligence" in all likelihood requires the establishment of a small, permanent but technically capable secretariat or a monitoring and surveillance institution to coordinate activities/actions and monitor regional and global economic developments and promote regional policy dialogue 15 . The IMF would be expected to be involved in such regional surveillance (most likely with observer-status). However, such regional surveillance is expected to be conducted independently of the surveillance undertaken by the IMF, not unlike the OECD-based surveillance. Dieter (2000) observes: The provision of a public regional liquidity fund ought to be accompanied by two monitoring bodies, a regional monetary committee and a regional banking supervision system. Committing foreign reserves of a country's central bank, even if it is limited to a certain percentage, is not a simple bookkeeper's exercise, but a genuine expression of confidence. In order to further build this mutual trust, the regional monetary committee is of vital importance. Central bankers could meet frequently, e.g. monthly, to discuss developments in the financial sector and in foreign exchange markets ... The establishment of a regional monetary committee would also contribute to the creation of "intra-regional policy networks", which enable policy-makers to deepen their knowledge of their partners in the region. Absent the possibility of policy conditionality being imposed on borrowing countries by such an independent surveillance unit, it is unlikely and inadvisable to institute a reserve pooling arrangement as this could give rise to all sorts of moral hazard problems on the part of the borrower which may promote permissive

14

The tradeoff between automaticity of liquidity availability, on the one hand, and that of ensuring the conditionality is met, on the other, is an issue in need of much more in-depth discussion. 15 In this regard, a natural starting point may be to extend the ASEAN Surveillance Process (ASP) to encompass the North Asian countries. This has already been done with the inclusion of China, Japan and South Korea. A major limitation of the ASP as it is currently structured is that there are no fact-finding missions as with the IMF. Participating governments (finance ministry and central bank officials) offer information to the ASP directly. Thus, to a large extent, the effectiveness of regional surveillance is still highly limited. If the regional pooling arrangement is put in place and operates with a little more independence from the IMF, there may be a need to substantially strengthen regional surveillance. Whether member countries are willing and able to move beyond the current peer review process to more formally engage each other and confront/be ready to be confronted in the event of profligate policies is unclear. Henning (2002) offers a useful discussion on how surveillance among the APT countries might be strengthened.

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behavior. Indeed, at the extreme, any arrangement that has weak conditionality and enforcement will not be seen as credible by the markets and is not sustainable. In other words, the regional facility may go bankrupt or significantly weaken financially as the strong currency countries may choose to opt out. In the case of an Asian liquidity facility, it would be premature to discuss here the exact type of conditionality or surveillance system that ought to be involved or the enforcement mechanisms and operating procedures that needs to be put in place. Nonetheless, given that the issue of conditionality is of significant importance, we briefly note here the experience of the Latin American Reserve Fund (Fondo Latinoamericano de Reservas or FLAR for short). The FLAR, which is a financial and monetary institution of the Member Countries, evolved from the Andean Reserve Fund (which operated between 1978 and 1991) with a current membership comprising Bolivia, Colombia, Costa Rica, Ecuador, Peru, and Venezuela. The FLAR also offers participating member central banks an opportunity to invest their non-committed international reserves with the regional institution so as to benefit from its investment expertise. The FLAR has provided short and medium term financial assistance to crisishit member countries. In particular, members can avail themselves of a number of different types of loans: loans and guarantees to support balance of payments; Liquidity loans; and Emergency loans 1 6 . The FLAR has maintained its own conditionality which is by and large weaker than that of the IMF (each type of loan comes with slightly different conditionality). Nonetheless, despite its limited size with relatively "weak currency" countries, the FLAR has never experienced any difficulty in recovering its loans. Thus, as long as policy discipline in lending is in place, it is unlikely that the regional Asian facility will go bankrupt.

4.3.

Nexus between monetary regionalism and the IMF

So would a new Asian financial architecture based perhaps on a regional liquidity facility threaten or facilitate international financial stability? Would regional reform be a stepping-stone or a stumbling bloc to international monetary reform? It could be a stumbling bloc if loans from the regional facility carried conditionality that was inconsistent with that coming from the IMF. Moreover, the attitude amongst advanced economies that Asia is looking after its own problems could reduce the urgency with which reform at the international level is pursued. It is therefore important to identify the comparative advantages of regional and 16 In addition, the FLAR offers members loans to support public external debt restructuring and also has an export finance facility.

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international financial institutions and the division of labour between them (Bird and Rajan, 2002). Boughton (1997) has reminded us: although the intention was that the availability of the Fund's resources should prevent countries from experiencing financial crisis, in practice, the institution has often found itself helping its members cope with crises after they occur (p. 3). Monetary and financial regionalism, as discussed in this Chapter, could help the IMF fulfill its stated aim; it is consistent with the principle of "subsidiarity". Why choose to deal with a problem at the global level when it can be handled adequately and perhaps more effectively at the regional level? Just as multilateral trade liberalization and multilateral trade institutions have been joined by an increasing array of regional trading arrangements, regional financial crises may be better handled by regional arrangements. To the extent that regional arrangements may help reinvigorate interests in strengthening the international financial architecture, they could act as "stepping stones" towards multilateral reforms rather than "stumbling blocs". Regional arrangements ought to promote greater commitment to and national ownership of programs and conditionality, a point that is universally recognized as being of significant importance. Things could be organized along the following lines. O n the basis of work done by the Basel Committee, a regional liquidity facility could stipulate financial standards appropriate in an Asian context. Asian countries could commit themselves to achieve these standards over a specified time frame. Being on course in terms of meeting them could then be a necessary precondition for financial support from the regional facility in the event of contagion from a regional crisis. Beyond the need for the crisis-country to pursue "non-profligate" macroeconomic policies, loans from the regional facility would carry nothing equivalent to IMF structural conditionality and would be available only on a short-term basis, and at a high interest rate to help deal with potential moral hazard problems 17 . The very existence of additional short term liquidity could reduce the incidence of speculation and crisis. Countries with fundamental and longerterm economic problems would still have to turn to the IMF, where they would be exposed to IMF conditionality (discussed further below). By providing an extra incentive for members to reform their domestic financial systems, a process, that may yet not have gone far enough (Bird and Rajan, 2002), the regional monetary facility ("Asian Monetary Fund") could help to prevent

17

This recommendation is in sharp contrast to the manner in which the CMI is currently structured, where 90 percent of the potential drawings under the CMI are contingent on the debtor country having an ongoing IMF program (Henning, 2002). Of course, the assumption here is that an effective regional surveillance mechanism is in place.

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future crises. By providing an additional source of short-term liquidity it could take financial pressure off the IMF during crisis periods. The IMF would continue to stand ready to assist economies where regional arrangements failed to resolve problems, but, in this event, it might be more reasonable to assume that these problems were not exclusively to do with shortages of liquidity, and this would raise the credibility of IMF conditionality. Elaborating on the issue, Park (2001) notes: There is also the argument that regional financial management could be structured and managed to be complementary to the role of the IMF. For example, an East Asian regional fund could provide additional resources to the IMF while joining forces to work on matters related to the prevention and management of financial crises. A n East Asian monetary fund could also support the work of the IMF by monitoring economic developments in the region and taking part in the IMF's global surveillance activities. The East Asian monetary fund could also be designed initially as a regional lender of the last resort while the IMF assumes the role of prescribing macroeconomic policies to the member countries of the East Asian monetary fund (p. 6). Beyond cooperation in surveillance, the regional facility could work closely with the IMF to develop mechanisms appropriate for Asia to involve the privatesector involvement in crisis resolution and promote "constructive engagement" and constant dialogue among creditors and debtors. In this way a regional facility could contribute to enhanced international financial stability 18 . For all the foregoing reasons, an efficient, regionally based cooperative arrangement for providing liquidity would be consistent with the central elements of the new international financial architecture. It is still possible to think globally and to act regionally19. The IMF would continue to stand ready to assist economies where regional arrangements failed to resolve problems, but in this case, it might be more reasonable to assume that these problems were not exclusively to do with shortages of liquidity, and this would raise the credibility of IMF conditionality 20 .

18

Herming (2002) has suggested a particular division of labour, whereby the A P T countries provide intraregional financing, while the IMF supports the region's surveillance and provides conditionality. 19

Needless to say that in addition to these regional and multilateral liquidity pools, countries are expected to maintain sound debt and reserve management policies to minimize the chances and costs of disorderly exits. 20

As Fischer (2001b) has noted, there are two primary objectives of Fund conditionality viz.: to ensure that IMF resources are used to promote economic reform and adjustment, rather than to postpone it; and to ensure that the borrower is able to repay the loan on the agreed terms, making the resources available to other members who may need them.

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Economic Globalization and Asia

In other words, the first two "ports of call" in the event of a crisis would be own reserves as well as pooled reserves from the regional monetary facility. IMF funds would be additional to these, but ought to be available on a "stand-by" basis so that markets are clear as to the large size of aggregate reserves available to the countries. In such a case, the obvious question that follows is how would the IMF conditionality relate to regional conditionality? While far greater attention needs to be given to this complex issue than can be offered here, it seems important to sub-divide IMF lending into those pertaining to liquidity based assistance (a la CCLs), on the one hand, and structural adjustment measures, on the other. In the first instance, IMF assistance ought to be available via the CCL-type liquidity facility, in which case, macro and financial conditionality presumably ought to be broadly similar to/consistent with those devised by the regional facility21. In cases where liquidity assistance (both regional and multilateral based) is found to be insufficient, and the problems faced by the country are considered far "graver", the "conventional" IMF structural conditionality would be appropriate — though in this case there is an ongoing and unresolved debate as to what exactly constitutes "appropriate" Fund conditionality (IMF-IEO, 2002).

5. Concluding Remarks With memories of crisis still reasonably fresh, it is perhaps unsurprising that the East Asian countries have exhibited a desire to stock-pile reserves to finance international transactions, meet unexpected difficulties in the balance of payments, and most importantly, as an insurance or a "war chest" against future crises (Bird and Raj an, 2003). However, an important limitation of such a reserve-hoarding policy is that it carries large implicit fiscal costs as the country effectively swaps high yielding domestic assets for lower yielding foreign ones. In view of these high costs, some prominent economists have gone so far as to suggest that developing countries rethink the policy of openness to international capital flows (other than those related to foreign direct investment) (Rodrik, 2000). Assuming though that countries do want to optimize subject to a relatively open capital account, is there any way in which the liquidity yield from holding reserves may be generated without the need for individual countries to continue to accumulate them? Indeed, if capital outflows reflect a perception within private capital markets that a country is illiquid, reducing international reserves and thus curbing liquidity further is hardly likely to be an effective strategy.

21

This is unlike the current situation where IMF liquidity-based conditionality is determined almost unilaterally by the Bretton Woods institution.

Liquidity Enhancing Measures and Monetary Cooperation in East Asia

71

Therefore, countries will do well to look beyond domestic reserve management to buttress their international liquidity positions if they are to effectively protect themselves from the vagaries of international capital markets. This is where a reserve pooling arrangement comes into question. The potential upside gains of an arrangement of this type can be significant in some instances 22 . What is more, the benefit of reserve pooling is likely to rise substantially when the pool arrangement is undertaken as part of a larger process of monetary and trade integration. All said and done, a significant degree of effort and political will by regional countries is needed in order to create the conditions necessary to ensure that such a facility will function effectively.

Bibliography Aizenman, J. and N. Marion (2002). "The High Demand for International Reserves in the Far East: What's Going On?", Working Paper No. 9266, NBER. Bird, R. and R. Rajan (2001). "Banks, Financial Liberalisation and Financial Crises in Emerging Markets", The World Economy, 24, pp. 889-910. Bird, G. and R. Rajan (2002). "The Evolving Asian Financial Architecture", Princeton Essays in International Economics No. 226, International Economics Section, Princeton University. Bird, G. and R. Rajan (2003). "Too Good to be True?: The Adequacy of International Reserve Holdings in an Era of Capital Account Crises", The World Economy, 26, pp. 873-91. Boughton, J. (1997). "From Suez to Tequila: The Fund as Crisis Manager", Working Paper No. 97190, IMF. Bussiere, M. and C. Mulder (1999). "External Vulnerability in Emerging Market Economies: How High Liquidity Can Offset Weak Fundamentals and the Effects of Contagion", Working Paper No. 99/88, IMF. Chang, L.L. and R. Rajan (2001). "The Economics and Politics of Monetary Regionalism in Asia", ASEAN Economic Bulletin, 18, pp. 103-118. Claessens, S., A. Demirguc-Kunt and H. Huizinga (1999). "How does Foreign Entry Affect the Domestic Banking Market?", Working Paper No. 1918, The World Bank.

22

Other benefits of an effective regional liquidity facility, such as having a regional voice on international monetary affairs, are certainly important but not discussed here. See Henning (2002), Bird and Rajan (2002) and Chang and Rajan (2001).

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Dieter, H. (2000). "Monetary Regionalism: Regional Integration without Financial Crises", Working Paper No. 52/00, Centre for the Study of Globalisation and Regionalisation (CSGR), University of Warwick. Disyatat, P. (2001). "Currency Crises and Foreign Reserves-A Simple Model", Working Paper No. 01/18, IMF. Dornbusch, R. (2001). "A Primer on Emerging Market Crisis", mimeo (January). Eichengreen, B. (2002). "Wither Monetary and Financial Cooperation in Asia?", paper presented at PECC Finance Forum Cooperation (Honolulu, August). Eichengreen, B. and T. Bayoumi (1999). "Is Asia an Optimum Currency Area?, Can it Become One? Regional, Global and Historical Perspectives on Asian Monetary Relations", in S. Collignon and J. Pisani-Ferri (eds.), Exchange Rate Policies in Asian Emerging Countries, London: Routledge Press. Eichengreen, B. and D. Mathieson (2000). "The Currency Composition of Foreign Exchange Reserves: Retrospect and Prospect", mimeo (January). Eichengreen, B. and A. Rose (2001). "To Defend or N o t to Defend? T h a t is the Question", mimeo (February). Fischer, S. (2001a). "Reducing Vulnerabilities: The Role of the Contingent Credit Line", paper presented at the Inter-American Development Bank (Washington, DC, April 25). Fischer, S. (2001b). "Priorities for the IMF", remarks to the Bretton Woods Committee (Washington, DC, April 27). Frankel, J. and A. Rose (2002). "An Estimate of the Effect of Common Currencies on Trade and Income", Quarterly Journal of Economics, 117, pp. 437-466. Glick, R. and M. Hutchison (1999). "Banking and Currency Crises: How Common Are Twins?", Working Paper No. PB99-07, Center for Pacific Basin Monetary and Economic Studies, Federal Reserve Bank of San Francisco. Glick, R. and A. Rose (2002). "Does a Currency Union Affect Trade?: The Time Series Evidence", European Economic Review, 46, pp. 1125-1151. Haque, N., M. Kumar, M. Nelson and D. Mathieson (1996). "The Economic Content of Indicators of Developing Country Creditworthiness", Working Paper No. 96/9, IMF. Henning, R. (2002). East Asian Financial Cooperation after the Chiang Mai Washington DC: Institute for International Economics. IMF (1998). World Economic Outlook 1998, Washington, DC: IMF. IMF (2000). World Economic Outlook 2000, Washington, DC: IMF.

Initiative,

Liquidity Enhancing Measures and Monetary Cooperation in East Asia

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IMF (2001). World Economic Outlook 2001, Washington, DC: IMF. IMF-IEO (2002). "The Role of the IMF in Recent Capital Account Crises", Issues Paper for an Evaluation by the Independent Evaluation Office (IEO) (June 18). Ito, T. (2002). "Japan's Perspectives on Regional Financial Cooperation", paper presented at the PECC Finance Forum Conference (Honolulu, August 11-13). Kaminsky, G. and C. Reinhart (1999). "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems", American Economic Review, 89, pp. 473-500. Kusukawa, T. (1999). Asian Currency Reform: The Options of a Common Basket Peg, Tokyo: Fuj i Research Institute Corporation. Manzano, G. (2001). "Is there Any Value-added in the ASEAN Surveillance Process?", ASEAN Economic Bulletin, 18, pp. 94-102. Montreevat, S. and R. Raj an (2001). "Banking Crisis, Restructuring and Liberalization in Emerging Economies: A Case Study of Thailand", mimeo (July). Park, Y.C. (2001). "Beyond the Chiang Mai Initiative: Rationale and Need for a Regional Monetary Arrangement in East Asia", mimeo (June). Rajan, R. (2000). "Financial and Macroeconomic Cooperation in ASEAN: Issues and Policy Initiatives", in M. Than (ed.), ASEAN Beyond the Regional Crisis: Challenges and Initiatives, Singapore: Institute of Southeast Asian Studies. Rajan, R. (2001). "(Ir)relevance of Currency Crises Theory to the Devaluation and Collapse of the Thai Baht", Princeton Studies in International Economics No. 88, International Economics Section, Princeton University. Rajan, R. (2003). "Safeguarding Against Capital Account Crises: Unilateral, Regional and Multilateral Options for East Asia", in G. de Brouwer (ed.), Financial Governance in East Asia, London: Routledge, forthcoming. Rajan, R., G. Bird and R. Siregar (2003). "Examining the Case for Reserve Pooling in East Asia", mimeo (January). Rajan, R. and C.H. Shen (2001). "Are Crisis-Induced Devaluations Contractionary?", Discussion Paper No. 0135, Centre for International Economic Studies, University of Adelaide. Reddy, Y.V. (2002). "India's Foreign Exchange Reserves: Policy, Status and Issues", lecture at the National Council of Applied Economic Research (New Delhi, May 10). Rodrik, D. (2000). "Exchange Rate Regimes and Institutional Arrangements in the Shadow of Capital Flows", mimeo (September).

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Rose, A. (2000). "One Money, One Market: Estimating the Effect of Common Currencies on Trade", Economic Policy, 15, pp. 7-46. Wang, Y. (2003). "Instruments and Techniques for Financial Cooperation", in G. de Brouwer (ed.), Financial Governance in East Asia, London: Routledge, forthcoming. Williamson, J. (1999). "The Case for a Common Basket Peg for East Asian Currencies", in S. Collignon and J. Pisani-Ferri (eds.), Exchange Rate Policies in Asian Emerging Countries, London: Routledge Press. Willett, T. (2001). "Restructuring IMF Facilities to Separate Lender of Last Resort and Conditionality Programs: The Meltzer Commission Recommendations as Complements rather than Substitutes", Working Papers in Economics No. 28, Claremont Colleges, California. World Bank (2000). Global Economic Prospects and the Developing Countries, New York: Oxford University Press.

Liquidity Enhancing Measures and Monetary Cooperation in East Asia Table 1 Reserves as a Proportion of Imports (months), GDP (in percent) and Average Amount (US dollar millions), 1992-2001 1992

1995

1998

2001

Indonesia Imports3 GDP Average13

3.0 8 10376.7

2.7 7 13022.5

5.1 19 19020.8

11.0 21.1 27863.5

Malaysia Imports3 GDP Averageb

4.2 30 15082.8

3 27 25063.0

5.1 34 21441.8

4.6 35 28071.3

Philippines Imports3 GDP Average13

2.8 8 3941.9

2.1 9 6199.4

2.6 13 8771.2

5.3 19 12771.5

Singapore Imports3 GDP Average13

5.7 82 38028.3

5.7 82 65798.9

7.3 90 73170.9

7.8 91 75687.8

Thailand Imports3 GDP Average13

4.9 18 19574.5

4.9 22 33455.7

6.2 23 27020.1

6.4 28 31734.4

3.0 35 N/A

3.1 40 53283.5

4.8 55 92826.8

6.8 66 113307

China Imports3 GDP Average11

3.1 4.6 33875.2

5.9 10.7 67595.4

9.5 15.5 145535.8

9.0 15.9 194410.2

Korea Imports3 GDP Average*3

2.2 5.0 15365.3

2.5 4.0 29679.9

5.1 5.0 42351.3

8.2 4.0 97834.1

Japan Imports3 GDP Average11

2.1 2.0 71408.6

3.9 4.0 166451.2

5.0 5.0 213459.8

N/A 8.5 374028.8

Country

Hong Kong Imports3 GDP Average13

Notes: a) Ratio to average monthly imports of merchandise goods b) Average of total foreign exchange reserves minus gold Source: IFS-CD ROM and ADB Database

75

76

Economic Globalization and Asia Table 2 External Debt of the Asia-5 Economies, 1995-2000 (percent of GDP)

Country

1995

1996

1997

1998

1999

2000

Indonesia" Malaysia Philippines Thailand Korea

56.3 37.6 54.9 49.1 26.0

53.4 38.4 55.0 49.8 31.6

63.9 43.8 61.6 62.0 33.4

149.4 58.8 81.7 76.9 46.9

95.5 53.4 75.7 61.4 33.4

93.8 49.3 78.9 51.7 26.5

5.9 7.6 11.3 11.4 9.3

5.7 6.4 7.5 6.8 7.7

of which: Short Term Debt Indonesia" Malaysia Philippines Thailand Korea

8.7 7.2 8.3 24.5 14.6

7.5 9.9 12 20.7 17.9

27.5 11.1 14 13.3 23.1

Notes: a) Data for Indonesia exclude trade credits Source: IMF (2000)

76.4 11.7 15.6 21.0 9.7

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APEC (Asia-Pacific Economic Cooperation). Established in 1989

Led by Heads of Governments, Finance Ministers (initially Foreign Affairs and Trade Ministers) of 21 countries (Australia, Brunei, Canada, Chile, China, Hong Kong, Indonesia, Japan, Korea, Malaysia, Mexico, New Zealand, Papua New Guinea, Peru, the Philippines, Russia, Singapore, Taiwan, Thailand, the US, and Vietnam).

Macroeconomic and exchange rate issues, freer and stable flows of capital, private sector participation in infrastructure development, and the development of financial and capital markets.

Leaders' Declaration in Vancouver in November 1997: .. .strongly endorse the framework agreed to in Manila as a constructive step to enhance cooperation to promote financial stability: enhanced regional surveillance; intensified economic and technical cooperation to improve domestic financial systems and regulatory capacities ... Memorandum to APEC Leaders in September 1999: .. .Ministers reaffirmed the value of peer surveillance within APEC economies and the benefits to be derived from greater cooperative efforts at the micro level, particularly in financial and capital markets.

ASEAN (Association of South East Asian Nations). Established in 1967

The association of 10 member countries (Indonesia, Malaysia, the Philippines, Singapore, Thailand, Brunei, Vietnam, Laos, Myanmar, Cambodia).

The objectives range from free trade to environmental protection, social, cultural and scientific development.

Economic Globalization and Asia

Structure

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ASEAN Surveillance Process. Established in 1998

Structure The institutional bodies consist of ASEAN Finance Ministers Meeting (AFMM), ASEAN Select Committee and ASEAN Central Bank Forum.

Focus Monitoring and analyzing the macroeconomic situation and developments and any other specific areas, including structural and sectoral issues. Enhancing surveillance work, relevant sector and international organizations within and outside ASEAN may be consulted.

Mandate Terms of Understanding in 1998: (a) exchanging information and discussing economic and financial development ... (b) providing an early warning system (EWS) and peer review process to enhance macroeconomic stability and financial system ... (c) highlighting possible policy options and encouraging early unilateral or collective actions to prevent a crisis ... (d) monitoring and discussing global economic and financial developments ...

Liquidity Enhancing Measures and Monetary Cooperation in East Asia

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SEACEN (South East Asian Central Banks). Established in 1982

Structure A cooperative organization of central banks and monetary authorities of 11 economies: Australia, China, Hong Kong, Indonesia, Japan, Korea, Malaysia, New Zealand, the Philippines, Singapore, and Thailand.

A organization of central banks of 11 economies: Indonesia, Korea, Malaysia, Myanmar, Mongolia, Nepal, the Philippines, Singapore, Sri Lanka, Thailand, Taiwan.

Focus Exchanging of information in the areas of banking supervision and monetary policy, foreign exchange policy and operational issues. Reporting on the Regional Foreign Exchange Markets Monitoring and Exchange Rate Regimes.

Facilitating cooperation in research studies and training programs relating to the policy and operational aspects of central banking.

Mandate Governors' unanimously agreed at the meeting in July 1997 that closer cooperation and coordination among EMEAP members is necessary and important to enhance financial stability and market development in the Asia Pacific region.

The objectives of the SEACEN Research and Training Centre established as a legal entity to promote a better understanding of financial, monetary, banking and economic development matters.

Liquidity Enhancing Measures and Monetary Cooperation in East Asia

Grouping

81

82

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Focus

A regional policy forum of central bank governors from British Commonwealth countries in the Asia Pacific region.

Providing training courses for central bank staffs and forum for banking supervisors in order to exchange information on issues and problems of common interest.

BIS Asian Consultative Council. Established 2001

The council within BIS, comprising the Governors of the BIS member Central Banks in the Asia/Pacific region (The BIS Representative Office for Asia and the Pacific in Hong Kong provides the secretariat).

Providing a vehicle for communication between the Asian and Pacific members of the BIS and the Board and Management on matters of interest and concern to the Asian central banking community.

IOSCO Asia Pacific Regional Committee (IOSCO-APRC) (IOSCO: International Organization of Securities Commissions). Established 1976

One of the four regional committees of IOSCO (a worldwide forum for securities regulators) consisting of Australia, Bangladesh, China, Hong Kong, India, Indonesia, Japan, Korea, Kyrgyz Republic, New Zealand, Pakistan, Papua New Guinea, the Philippines, Singapore, Sri Lanka, Taiwan, Thailand, Vietnam and Malaysia.

Regional cooperation in the regulation of the capital markets, particularly focusing on the enhancement of cooperation, mutual assistance and information sharing in the enforcement of illegal securities activities. Formulating a regional approach in combating these illegal operations, which have affected investors in the region.

The objective of the SEANZA Forum of Banking Supervisors established as an offshoot to provide a means for banking supervisors from the region to establish contact with each other.

APRC will consider its regional multilateral Memorandum of Understanding (MOU), aimed at enhancing information sharing as well as cross-border cooperation and multiple jurisdiction surveillance and enforcement functions.

Economic Globalization and Asia

SEANZA (South East Asia, New Zealand, Australia). Established in 1956

Mandate

83

Chapter 4

Choosing the Right Exchange Rate Regime for Small and Open Economies in East Asia1

1. Introduction Prior to the East Asian crisis of 1997-98, Thailand and the other Southeast Asian countries were, in principle, supposed to have adopted "currency basket regimes". Thus, the US dollar, Japanese yen and other currencies were to have received weights consistent with their respective significance in economic linkages with the Southeast Asian countries. However, in reality, the US dollar had the overwhelming weight de facto (Tables 1 and 2), leading McKinnon (1999, 2000) and Ohno (1999) to refer to East Asia's "dollar standard" and "soft dollar zone", respectively. Significantly, the Japanese yen had a weight of less than 0.1 in the average Southeast Asian currency basket. This was despite the fact that Japan was the region's largest export market along with the US and the region's dominant import source2. Japan was also the region's largest creditor, and a substantial share of bank lending (debt flow) and external debt (stock) to the region was denominated in yen (Rajan, 2002a). In other words, the Southeast Asian countries made the mistake of rigidly pegging to the US dollar rather than in pegging more flexibly to a basket of currencies3. An immediate lesson that many observers appear to have drawn from recent financial crises in emerging market economies in the 1990s is that the only viable exchange rate option boils down to one between flexibility, on the one hand, and "credible pegging", on the other. According to this view, emerging economies

1

This Chapter draws on Bird and Rajan (2002a), Rajan (2002a) and Rajan (2003).

2

The dominance of Japan in external trade relations with Southeast Asia coincided with largescale inflows of Japanese foreign direct investment (FDI) into the region (i.e. FDI has been largely trade creating). 3

To be sure, Thailand and Malaysia had very rigid US dollar pegs, Indonesia pursued a crawling band arrangement (to compensate for inflation rate differentials between Indonesia and the US), while the Philippines was somewhere in between (Rajan, 1999 and Fischer, 2001).

84

Economic Globalization and Asia

have to gravitate to these two extremes (Table 3 and Figure 1). Any currency arrangements that lie in between these polar extremes or corners (i.e. those in the "middle") are viewed as being inherently unstable and crisis-prone. The following observation by Eichengreen (2001a) typifies the mainstream view: high capital mobility has made it exceedingly difficult... to operate pegged-but-adjustable exchange rates ... Intermediate regimes are fragile. Operating them is tantamount to painting a bull's eye on the forehead of the central bank governor and telling speculators "shoot here" (p. 267). In line with these recommendations, the IMF data on exchange rate arrangements in developing countries reveals a de jure trend away from soft peg arrangements. For instance, the share of countries officially classified as having a pegged exchange rate regime dropped from 97 percent in 1970 to just 11 percent by 1999 (Table 4). This phenomenon has been colourfully described in various places as the "corners hypothesis", the "hypothesis of the vanishing intermediate regime", the "missing middle", the "hollowing of the middle", or the "law of the excluded middle". But does this corners hypothesis really stand up to careful scrutiny? This is the question we explore in this Chapter. A number of observers have strongly favoured the corner solution of an irrevocably fixed regime. Such a hard peg or "straitjacket" is supposed to signal greater commitment to rule out arbitrary exchange rate adjustments (i.e. "escape clauses" cannot be invoked), and the authorities' willingness to subordinate domestic policy objectives such as output and employment growth to the maintenance of the pegged exchange rate. However, there are strong reasons as to why many countries seem unwilling to go down this route. We examine some of them in Section 2. This appears to leave a flexible regime as the only viable policy option. Section 3 deliberates on the case for and against a flexible regime. To anticipate the main conclusion of the Section — while favouring relatively more flexible regimes, emerging economies in Asia and elsewhere have continued to heavily manage their currencies despite being officially described as "floaters". In other words, there appears to be a definite "fear of floating" among emerging economies; soft pegs have retained their widespread appeal. In view of this, the final Section revisits the corners hypothesis and offers an alternative policy perspective.

2. The Problems with Super-Fixes A n underlying weakness with adjustable peg regimes is in a sense exactly that the peg is adjustable. A problem occurs when foreign exchange (forex) markets see

The Right Exchange Rate Regime for Small and Open Economies

the adjustment coming. Speculators face the infamous one-way option and act accordingly. There will be a period of time when government commitments to maintaining the peg lack credibility. But how can an exchange rate peg be made credible? Only by making it almost unshiftable, i.e. a "hard peg" or "super fix". This might be done by maintaining one's national currency but creating a rigid commitment to permanently fixed or "hard" rates through institutional arrangements such as a Currency Board Arrangement (CBA), or by effectively abandoning the domestic currency altogether by using domestically the currency of another country (dollarization, yenization or eurorization). However, as will be discussed briefly below, each of these superfixes has its own problems which may make them unattractive or unviable policy alternatives.

2 . 1 . Currency Board Arrangements

(CBAs)

A CBA involves issuing a domestic currency whose value is fixed in terms of a currency issued by another country ("reserve currency") and is fully backed by foreign currency assets. A CBA is often compared to a vending machine that automatically exchanges reserve currency for local currency upon demand. It is generally recognized that a CBA requires the satisfaction of a number of preconditions, including a strong and durable domestic financial system that is able to withstand possible interest rate hikes on a sustained basis at times when the domestic currency is under selling pressure (Frankel, 1999). Failing this, currency crisis vulnerability might merely be transformed to financial sector vulnerability. To the extent that the banking systems in many emerging economies remain weak, the CBA alternative appears to be infeasible over the near and medium-terms. This is especially so since the lender of last resort function of a central bank is eliminated by the introduction of a CBA, in turn implying the need for a strong, well-capitalized and well-supervised domestic financial system to be in place 4 . There is also the question of whether such economies have the degree of labour market and internal flexibility to make such a super fix viable. Failing this, a CBA makes adjustments to large economic shocks extremely costly. In such circumstances, forsaking the exchange rate as a policy tool is not an appealing option.

4

The point is sometimes made that the preconditions are not necessary for the implementation of a CBA or dollarization (which overlap considerably). There is no doubt such hard fixes can be implemented prior to reforms. But the key question is, what are the implications of doing so? In particular, are hard fixes sustainable absent such reforms? Eichengreen (2001a) provides a useful discussion of this issue.

85

86

Economic Globalization and Asia

Argentina: Proponents of CBAs often held up Argentina in the 1990s as a poster child of the virtues of such an arrangement. Argentina's hard US dollar peg Argentina, which had been the linchpin of Domingo Cavallo's "Convertibility Plan" in 1991, was certainly pivotal in helping the country realize acutely needed financial and monetary stability. Nonetheless, the large devaluations in emerging market economies (Mexico in 1994-95, East Asia 1997-98 and especially Brazil in January 1999, a principal trading partner), on the one hand, and the strength of the U S dollar in recent years against other major currencies, on the other, required real exchange rate adjustments in Argentina that were not forthcoming. JP Morgan's real effective exchange rate (REER) indices make clear the sharp appreciation of the Argentine peso in recent years (Figure 2). Notice the marked contrast in REER movements between Brazil and Argentina since 1999. While it is always a tough ask to empirically determine the extent to which an exchange rate is over or undervalued in real terms, the consensus has been that the Argentine peso was overvalued by some 30 to 40 percent in recent times. This loss of price competitiveness in international markets along with unsustainable budgetary problems meant that the CBA had become a severe liability to the Argentine economy 5 . While the country's current account deficit remained "under control" (3 to 4 percent of GDP), this was mainly due to a check in imports, an inevitable outcome of the stagnant domestic economic conditions. Indeed, Argentina was mired in a deep recession which persisted for more than half a decade. High and rising unemployment inevitably followed (IMF, 2001). It is against this background that the Argentine CBA was finally forsaked in early 2002. It is useful to note that the Argentine crisis did not lead to contagious fallout to other emerging economies in the region, let alone the globe. This, of course, stands in sharp contrast to the East Asian crisis which began in Thailand and rapidly spread to Indonesia and other regional economies like Korea and some extra-regional ones too (see Chapter 2). There are three obvious reasons for this difference in crisis dynamics. One, Argentina's problems were long foreseen; it was a slow-burning crisis and was widely discounted in the markets, unlike that in East Asia which caught most observers and financial market participants by surprise6. Two, Argentina's 5

An empirical study by Catao and Falcetti (1999) has confirmed that Argentine manufactured exports are highly sensitive to both economic activity in Mercusor as a whole as well as the Argentine-Brazil bilateral real exchange rate. 6

Admittedly, the potential for a crisis in Thailand was foreseen by many but largely ignored by the Thai authorities (Rajan, 2001).

The Right Exchange Rate Regime for Small and Open Economies

external financing primarily involved bond markets rather than banks, as had been the case in East Asia. Bondholders appear to have been more discerning than banks in differentiating between indebted countries. Finally, emerging markets never really regained their luster following the East Asian crisis, with the result that capital inflows to emerging economies in general were fairly subdued post 1998. Consequently, there was little scope for a generalized, large-scale flight of capital following the Argentine debacle. Notwithstanding the different spread effects, an important parallel between the Argentine and East Asian episodes was the pivotal role played by the US dollar pegs in instigating the vulnerabilities which eventually led to the countries succumbing to crisis. 2.2.

Dollarization

In view of the limitations of the extremes of flexible and CBAs, some observers have jumped to the conclusion that a single currency zone may be the most attractive option for small and open economies. This entails an entire region adopting another country's currency (like the US dollar) as its own, or establishing an entirely new one. Prominent economists have urged emerging economies in Latin America to abandon their respective national currencies in favour of the US dollar (Hausmann, 1999). Some like Ecuador, El Salvador, Guatemala and Panama have already done so, while many others are advocating this policy for the larger economies in the region like Mexico, Canada, Brazil and possibly even the entire American continent. Salvatore (2002) correctly notes: Good candidates for dollarization are small open economies for which the United States is the dominant economic partner and which have a history of poor monetary performance and hence very little economic policy credibility (p. 19). Thus, a policy of unilateral dollarization may have merit in some small countries in the Americas as well as some Caribbean nations (though skeptics abound even in this case). However, the relatively low levels of de facto dollarization in other regions like Asia makes dollarization an unfeasible option. The same argument holds against policies of euroization or yenization 7 . In any case,

7

The relative merits of dollarization over a CBA are not discussed here (see Frankel, 1999). Suffice it to note that the major advantage of dollarization is a reduction in currency (and possibly even country) risk premium, therefore offering lower domestic interest rates, as well as eliminating concerns about the sustainability of the domestic currency peg (i.e. no "escape clause"). The most important disadvantages of moving from a CBA to dollarization is the loss of seigniorage, constraints on liquidity management, as well as the transition costs.

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regardless of the economic arguments, very few countries appear willing to unilaterally abandon the domestic currency for that of another country as it could be viewed as giving up some degree of political independence and sovereignty. Among the choice of superfixes, the political unpalatability of dollarization, along with the above-noted policy constrictions of a currency board, seems to leave only a common regional currency as a practicable alternative. But is it? Eichengreen (1994, pp. 4-7) appears to think so. He has predicted that, in the future, capital mobility will leave countries with one of two choices, viz. a super fix involving monetary union, or the other extreme of floating. Von Furstenberg (2000) argues more specifically that monetary unions are "inevitable..the wave of the future" (pp. 199-200).

23.

Monetary Union

Having experienced the turbulence of the regional crisis against the backdrop of the successful introduction of a single European currency, leaders of the Association of Southeast Asian Nations (ASEAN) agreed to study the feasibility of a common ASEAN currency system8. There has been much popular discussion in the region about the economic and political possibility and desirability of forming a larger monetary alliance or Asian Monetary Union (AMU) akin to the European Monetary Union (EMU) 9 . From an economic standpoint, Eichengreen and Bayoumi (1999a,b) have concluded that East Asia may be as close to — or as far away from — being an Optimum Currency Area (OCA) as Western Europe 10 . This conclusion is based on an O C A index that takes into account the costs associated with asymmetric regionwide shocks as well as the benefits from stabilizing exchange rates with trading partners 11 . More informally, but in similar vein, the IMF's Managing Director, Horst Kohler (2001), has noted: trading patterns and geography do make it reasonable to think of the creation of an internal market in Asia as a possible, future stage in regional cooperation. And why should this not be a basis for greater monetary integration ... 1 (p. 4)

8

Announced as part of the latest ASEAN summit meeting in Hanoi and included in the "Hanoi Plan of Action" (Business Times, Singapore, 15 December, 1998).

9

For instance, see The Straits Times, Singapore (11 January, 1999 and 4 October, 1998).

10

Similarly, Rockoff (2000) has emphasized that the US could be said to have been an OCA only around the 1930s. See Kenen (2000) for a recent discussion of the OCA theory. 11

In any case, it is possible that OCA criteria may be at least partly endogenous, suggesting that some unions may be more justifiable ex-post than ex-ante (Frankel and Rose, 1998).

The Right Exchange Rate Regime for Small and Open Economies

Apart from the fact that East Asia's external trade and investment linkages with the rest of the world are relatively higher than that of Europe (in which intra-European links dominate), there are at least two important differences between ASEAN/East Asia and Europe. First, any form of regional monetary union requires that there be compensating fiscal transfers from the richer to less well off states in the absence of sufficiently frictionless intraregional labour mobility. In the case of Europe, the extent of such transfers is quite significant in per capita terms of the poorer states, but fairly low in absolute terms, as the richer states in Europe are much larger than the poorer ones (Eichengreen and Bayoumi, 1999a,b) 12 . This contrasts with ASEAN where the poorer regional members also happen to be the largest ones (Indonesia versus Singapore, for instance). Second, the European experience has emphasized the need for strong political will and consensus towards such a policy goal. Indeed, some like Goodhart (1995) dispute the relevance of economic criteria altogether, claiming that political considerations dominate formation of monetary areas. Such a political consensus, while possibly emerging in Southeast and the larger East Asian regions, is still far off from being universal. To be sure, "vision statements" by regional leaders for a monetary union, while having become more common since the crisis, have hitherto not been backed up by any serious discussion on the type of institutional structures or formal mechanisms and decision-making bodies needed for such regional economic integration of monetary and exchange rate policies to be a success. These include an independent regionwide central bank, a system of inter-regional fiscal transfers, and measures to ensure European-type macroeconomic convergence. Eichengreen and Bayoumi (1999b) have noted: there is little sign, comparable to the evidence which has existed in Europe for nearly 50 years, of a willingness to subordinate national prerogatives to some larger regional entity, There is no wider web of interlocking arrangements, as in the EU, which would be put at risk by a failure to follow through on promises of monetary and financial cooperation (p. II) 1 3 .

12 The issue of division of fiscal transfers is a growing source of some tension in the Eurozone area with the expansion of the EMU to poorer Eastern European states. 13

In addition, substantial asymmetries in the sizes, levels and stages of economic development of the countries in East Asia, on the one hand, and the de facto policy of strict non-intervention in one another's affairs (economic and particularly political), on the other, makes it extremely difficult to envisage the successful introduction of "tie-in" clauses to create punishment mechanisms to ensure conformity of economic policies as done in Europe.

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Thus, Kenen's (2000) general conclusion that solving the problems of governance and accountability needed to form a monetary union may be far too herculean a task for most other groups of countries outside Europe, appears especially pertinent to East Asia in the foreseeable future (see Chapter 3). More generally, on examining the prospects on monetary unions in East Asia and elsewhere, Cohen (2002) reaches the following conclusion: While there is reason to believe that some groups of countries will move modestly to pool a degree of their monetary sovereignty, predictions of many full new monetary unions around the globe, on the model of Europe's EMU, appear premature at best. The difficulty of defending uncompetitive national currencies may be growing, but for most governments the disadvantages of monetary union continue to look more formidable still. Few countries share enough group loyalty to make the requisite sacrifice of monetary sovereignty seem acceptable; and even for those that might be prepared to make the commitment, willing partners are hard to find. The world's monetary map will include a growing number of limited alliances but few, if any, new joint currencies like the euro. The wave of the future will turn out to be little more than a ripple (p. 19).

3. The Flexible Exchange Rate Option Reconsidered 3.1.

Reasons to favour flexibility

A priori, there are a number of reasons that underlie a preference for a greater degree of exchange rate flexibility. First, the more flexible the exchange rate regime, the keener the incentives for agents to undertake appropriate foreign exchange (forex) risk management techniques in response to the higher element of exchange rate risk, while simultaneously reducing the extent of moral hazard which could lead to "excessive" unhedged external borrowing (referred to as a "fixed exchange rate bubble"). The introduction of these transaction costs and exchange rate risks may also help moderate the extent of capital inflows, consequently dampening the intensity of boom and bust cycles (this is essentially a moral hazard argument). Second, small and open economies are far more susceptible to large external shocks, such as changes in foreign interest rates, terms of trade, and regional contagion effects. Received theory tells us that a greater degree of exchange rate flexibility is called for in the presence of external or domestic real shocks. By acting as a safety valve, flexible exchange regimes provide a less costly adjustment mechanism by which relative prices can be altered in response to such shocks as

The Right Exchange Rate Regime for Small and Open Economies

opposed to fixed rate regimes. The latter relies on gradual reductions in relative costs through deflation and productivity increases vis-a-vis trade partners to restore internal balance. This can prove to be prolonged and costly, as the Argentine example illustrates 14 . Hong Kong, the other notable example of an operating CBA, has been faced with similar deflationary pressures since 1998 with ever more frequent calls for it to forsake its US dollar peg (Liu, 2002 and Rajan and Siregar, 2002) 15 . Third, many small economies have diversified trade structures (dependent on the US, Japan, Europe and intra-Asian trade). O C A criteria suggest that such economies are good candidates to maintain more flexible regimes. Thus, in the case of East Asia, institutionalization of the pre-crisis dollar pegs (via a CBA or dollarization) would not have helped domestic economic performance in 1996—97 (just prior to the crisis) to the extent that the problem was, at least partly, one of loss of competitiveness due to fluctuations in the US dollar and yen cross-rate (as noted in Section 1). Consistent with this, a study of exports by about 100 emerging economies to the US, Japan and Europe over the period 1983-92 concludes that the more flexible the exchange rate regime the better the export performance (Nilsson and Nilsson, 2000). However, countries pegging to a composite group of currencies do not appear to have experienced weaker economic performance than ones with independently floating regimes 16 . Fourth, it is often suggested that a rigid basket peg may operate as a nominal anchor for monetary policy and be a way of introducing some degree of financial discipline domestically and breaking inflationary inertia. Thus, a study of 136 countries over the period 1960-89 conducted by Ghosh et al. (1995) found that inflation rates generally tend to be greater and more volatile under more flexible regimes, though economic growth is less volatile. A n IMF (1997) study of 123 emerging economies covering the period 1975-96 arrives at a broadly similar conclusion, viz. the median inflation rate of "peggers" has been consistently

14 Three points should be noted here. One, empirical evidence suggests that pass through of devaluation is partial; indeed, inflationary predictions were dire in many economies following the financial crises in the 1990s but did not materialize. Two, devaluation can have real effects in the short term during non-crisis periods. Devaluation during crisis periods appears to be contractionary rather than expansionary (Hausmann et al., 2000 and Rajan and Shen, 2001). Three, repeated devaluations will only have price effects without any real effects as they come to be anticipated by the private sector. 15 T h e Deputy Chief Executive of the Hong Kong Monetary Authority, Tony Latter (2002), offers a stout defense of the Hong Kong-US dollar peg. 16 Their data is based on official IMF classification of exchange rate arrangements, i.e. they use de jure rather than de facto exchange rate regime.

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lower and less volatile than those with more flexible arrangements, though the inflation rate differential between the two sets of countries has decreased through the 1990s. While these studies are instructive, they are by no means conclusive, as they do not account for the possibility of endogeneity of the choice of exchange rate regimes. Specifically, we cannot be sure as to whether a fixed exchange rate actually leads to lower inflation or whether countries which experience low inflation rates adopt such a regime. Glick et al. (1999) have argued that policies of pegging exchange rates in East Asia were of little benefit in terms of acting as a counter-inflationary device, this goal having been attained primarily due to other factors such as relative autonomy of the monetary authorities. In their view, the use of exchange rates as nominal anchors may have actually acted as a liability as it prevented the necessary nominal currency adjustments in response to external shocks from taking place. In addition, both theory and lessons of experience with nominal anchors have shown that such pegging loses credibility over time and induces booms followed by inevitable busts and crises episodes. Pegging the exchange rate also constrains monetary independence; if unrestrained monetary policy has been a facet of the country's past, imposing exchange rate fixity may be an advantage as it constrains the active use of monetary policy. If, however, monetary and fiscal policies have proved effective in the past, governments may be reluctant to constrain their ability to use them in the future by targeting a particular exchange rate 17 . Fifth, there is a widespread belief that a pegged regime induces increased policy discipline as fiscal profligacy will lead to a reserve depletion or burgeoning debt and an eventual currency collapse. However, the effects of unsound macro policies become evident immediately under flexible rates through currency and price level movements (i.e. depreciation-inflation spiral). Thus, flexible rates ought to instill greater fiscal restraint, as the costs of macroeconomic policy transgressions have to be paid upfront. In other words, the key distinction between fixed and floating rates is in the intertemporal distribution of costs and benefits (Tornell and Velasco, 2000). Gavin and Perotti (1997) have provided some empirical validity of this argument. After controlling for a host of other factors, they find that Latin American fiscal policies were more prudent under flexible rates than under floating ones.

17

However, recent empirical evidence casts doubt on the extent to which floating regimes in emerging economies provide insulation from foreign interest rate shocks (see Frankel et al, 2000 and Hausmann et al., 2000).

The Right Exchange Rate Regime for Small and Open Economies

3.2.

Reasons for a "fear of floating"

In view of the anticipated benefits of flexible regimes, the IMF has advocated this type of regime for a number of emerging economies. Despite the preceding reasons favouring a flexible exchange rate regime, countries with flexible regimes have experienced "excessive" volatility over the last few decades 18 . It is admittedly difficult to define what exactly is meant by the term "excessive". However, a reading of the relevant empirical literature reveals that evidence of excessive exchange rate variability comes in a number of forms (Bird and Rajan, 2001). For instance, a number of surveys of forex market participants clearly indicate that short term/high frequency exchange rate movements are caused by "speculative" or "trend-following" elements rather than underlying macroeconomic fundamentals. The problem of destabilizing speculation (as opposed to the Friedmanite speculators) — and consequent excessive or selfaggravating exchange rate volatility — and dominance of fads and bubbles appears to have been aggravated in emerging economies, making a flexible regime especially unviable/unsuitable to them. This is particularly so since thin markets — which usually exist in emerging economies — imply that a few transactions can lead to extreme currency fluctuations. Even if it were accepted that flexible exchange rates often appear to exhibit greater volatility in high frequency data than would be warranted by the underlying fundamentals, why might such excessive volatility be of concern? Recent studies have provided evidence of a negative impact of exchange rate volatility/uncertainty on investment (Corbo and Cox, 1995 and Huizinga, 1994). To the extent that investment has a significant positive impact on economic growth, declining investment will have an enduring negative impact on the quantity of real resources. Even in the absence of a negative effect on the level of investment, exchange rate variability may have an adverse impact on the composition of investment since decisions could be based on disequilibrium prices. In an important study, Benassy-Quere (1999) shows that exchange rate volatility could have a detrimental impact on FDI, comparable to the distortions created by currency misalignments. It has often been argued that firms and other agents involved in international transactions can buy cover to hedge themselves against exchange rate movements. However, in addition to the costs involved with such operations, perfect hedges may be very difficult to create technically (given acute revenue-cost uncertainties) 18

Of course, almost no country has maintained a completely free (or pure) float, the authorities intervening intermittently to smooth market fluctuations. In other words, "dirty floats" — i.e. forex market interventions without commitment to defend any specific parity — have been the norm.

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(Adler, 1994). Indeed, even if effective hedges could be created, they would entail non-negligible transaction costs, thus diverting scarce resources from "real" economic activity. This is especially true in the case of emerging economies where rudimentary capital markets have necessitated using cross-hedging techniques (rather than direct hedging), which invariably are far costlier. Wei (1999) provides some important empirical evidence which suggests that exchange rate volatility has had a detrimental effect on trade between pairs of countries to a much larger extent than suggested by previous studies. More generally, in a comprehensive survey of the literature on the impact of exchange rate volatility on trade flows, McKenzie (1999) concludes that the recent empirical studies have had "greater success in deriving a statistically significant relationship between volatility and trade" (p. 100). Calvo and Reinhart (2000a) review a more limited set of such studies and reach a similar conclusion. Another recent set of empirics by Andrew Rose based on gravity models using both cross-sectional and time series data suggests institutionally fixed exchange regimes (i.e. common currency, currency boards or dollarization) stimulates trade, which in turn boosts income (see Frankel and Rose, 2002, Glick and Rose, 2002 and Rose, 2000). As is common knowledge, proponents of the European Monetary Union (EMU) have used such an argument extensively in support of a single regional currency 19 . Notwithstanding the recent weakness of the Australian dollar, its successful experience with a floating arrangement, particularly in terms of withstanding the East Asian crisis, has often been cited as evidence of the "superiority" of such a regime, and has been prescribed as a panacea for other emerging economies. However, such an advocacy does not pay due consideration to the fact that there are important structural differences between industrial countries such as Australia, on the one hand, and emerging economies, on the other. For instance, industrial countries have well-developed and diversified financial systems that are able to minimize real sector disruptions due to transitory exchange rate variations (abstracting from the resource allocation costs of misalignments noted previously). Most importantly, industrial countries are able to borrow overseas in their domestic currencies. Many emerging economies are 19

Conversely, as regional countries become increasingly integrated through trade and investment, arbitrary shifts in comparative advantage and demand due to alterations in exchange rates may provoke political backlash and disrupt real intraregional linkages. In addition, a regional currency eliminates transaction and information costs (i.e. enhances transparency) and reduces the likelihood that producers can arbitrarily price discriminate across countries in the region. This problem becomes especially acute when regional countries have agreed on a trade pact — why bother negotiating detailed tariff and rules of origin requirements when sudden currency depreciation by a member alters relative prices and competitiveness, offsetting the effects of the regional trade rules that were agreed upon (Bird and Rajan, 2002b and Rajan, 2002c)?

The Risht Exchange Rate Regime for Small and Open Economies

unable to do so, leading to an accumulation of foreign currency debt liabilities that are primarily dollar denominated and unhedged (i.e. "liability dollarization") 2 0 - In such countries, sharp depreciations in their currencies alter the domestic currency value of their external debt and therefore the net worth of the economies, with calamitous real sector effects (so-called "balance sheet" effects). This in turn may be an explanation for the continued priority given to a high degree of exchange rate stability in emerging economies. In other words, many emerging economies are plagued by an acute "fear of floating" (Calvo and Reinhart, 2000b). 4. Concluding Remarks: Intermediate Regimes Revisited T h e so-termed "hollowing out hypothesis" or "law of the excluded middle" appeared to draw analytical support from the "Impossible Trilogy or Trinity". Simply put, this states that a country cannot simultaneously conduct independent monetary policy and pursue a fixed exchange regime if it wants to remain completely open to international capital flows (Figure 1 again). From an analytical perspective, Frankel (1999) has provided us with the timely reminder that the Impossible Trinity or Trilogy does not on its own imply that in an increasingly globalized world economy an intermediate regime is unviable or that countries will be compelled to abandon the middle ground. In fact, there is a growing body of opinion that recognizes the potential usefulness of restraints on financial flows as a financial safeguards; there is no longer an ideological belief in the benefits of a completely open capital account 21 . Once this is accepted, the analytical basis in support of the corners hypothesis weakens substantially; neither corner appears to work all that well for emerging economies. The preceding leads to the rather unsatisfying conclusion that when it comes to the choice of appropriate exchange rate regime, all that can really be said is that there exists a broad spectrum of choices. It is not a black-or-white issue; shades of gray abound. The choice of exchange rate regime cannot be done in isolation. It must be seen as part of a coherent macroeconomic strategy. N o exchange rate regime will deliver stability if domestic macroeconomic policy is unsound, with large fiscal deficits, rapid monetary growth and inflation. Pegged exchange rates will become overvalued and reserves will fall, while flexible exchange rates will depreciate and may result in crises just as much as pegged 20

This is commonly referred to as the "original sin" hypothesis, a term attributed to Hausmann (1999) and Hausmann et al. (2000).

21

While empirical evidence regarding the benefits from capital account liberalization is unclear, risks of premature of ill-timed liberalization are unequivocal (Arteta et al., 2001 and Rajan, 2002b).

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regimes. Exchange rate policy in emerging economies may need to have a more limited objective. Rather than focusing on disciplining domestic macroeconomic policy and labour markets, perhaps the exchange rate regime should be designed in the first instance to minimize exposure to the third currency phenomenon, where the problem for emerging economies arises from fluctuations in the values of the currencies of their major trading partners against one another. In the absence of strong capital controls, currency intervention ought not be framed as a specific target for the exchange rate. Such targets inevitably tempt speculators by offering them the infamous one-way option. Thus, exchange rate and monetary policy strategies must involve a "fairly high" element of flexibility rather than a single-minded defense of a particular rate. This might best be achieved by a variant on sliding parities and wider bands around an appropriately weighted currency basket, the extent of which varying across the countries depending on individual circumstances and policy preferences (a so-termed band-basket-or-crawl or BBC) 22 or a flexible inflation target. The latter involves gradual adjustment to an inflation target along with a positive weight on the exchange rate (in addition to inflation and output) 2 3 . While the topic of inflation targeting has been extensively discussed elsewhere (for instance, see Eichengreen, 2001b and Cavoli and Raj an, 2002), a few words on the currency basket arrangement may be in order 24 . There have been a number of recent studies attempting to measure optimal currency baskets in Southeast Asia. As discussed previously, there is good reason to believe that the Japanese yen was significantly underweight in the baskets of the crisis-hit Southeast Asian countries. This is confirmed by Table 5 which summarizes the estimates derived by the various studies of the yen's weight in optimal baskets for the regional currencies. To be sure, a simple average of the various studies reveals the optimal weight of the Japanese yen to be in the range of 0.3 and 0.4, the remainder being divided between the U S dollar, euro and/or

22

The crawl is meant to compensate for inflation differentials. Williamson (1999b, 2002) discusses the BBC policy in some detail. 23

In principal, Korea, Thailand and Indonesia, all of which have been under IMF-supported programs, are supposed to have adopted more flexible exchange rate regimes in conjunction with inflation targeting. However, as Eichengreen (2001b) has noted, none of them have put in place the other elements of inflation targeting and cannot be classified as genuine inflation targeters. In addition, given the high import content of consumption baskets in developing countries, targeting inflation (consumer prices) is, to some extent, akin to targeting the nominal exchange rate. 24

Of course, if the major currencies (US dollar, Japanese yen and euro) are managed within certain target zones as sometimes suggested, there would be little difference between a single currency and multicurrency or basket currency arrangement.

The Right Exchange Rate Regime for Small and Open Economies

regional currencies (depending on the type of study). This is far higher than the de facto pre-crisis weights of less than 0.1. In view of the need for a degree of flexibility, the suggestion by Dornbusch and Park (1999) and Williamson (1999a,b, 2002) for the maintenance of wide bands and, if need be, a crawl or slide to account for inflation differentials, seems to have strong rational, i.e. a BBC rule. Such a system may be a way of trading off the disciplinary and credibility benefits of a pegged regime with the flexibility of a floating one. Admittedly, the distinction between a peg and a band is somewhat arbitrary. However, a peg is generally considered to be a band in which the maximum movements permissible on either side of the central parity are no more than 2.25 percent (Frankel, 1999 and Mussa et al., 2000). There remain other outstanding questions of significant importance. These include the appropriate size of the bandwidth; whether the bands should be "soft margins" or "soft buffers" such that the government may or may not intervene if the currency threatens to fall outside the pre'determined band (i.e. no absolute commitment); and whether the government should make explicit the values of the bands or this should be left more ambiguous as in the case of Singapore. The Monetary Authority of Singapore (MAS) describes its exchange rate policy as follows: (The) MAS manages the Singapore dollar against a basket of currencies of Singapore's main trading partners and competitors. The basket is composed of the currencies of those countries that are the main sources of imported inflation and competition in export markets ... T h e tradeweighted Singapore dollar is allowed to float within an undisclosed target band. The level and width of the band are reviewed periodically to ensure that they are consistent with economics fundamentals and market conditions. T h e M A S intervenes in the foreign exchange market from time to time to ensure that movements of the..(Singapore dollar) exchange rate are orderly and consistent with the exchange rate policy 25 . The MAS seems to have adopted a "monitoring band" as opposed to a "crawling band" in which there is an obligation to defend the edges of the band. Williamson (1999a) discusses this point at some length: The obligation..(of a monitoring band)..is instead to avoid intervening within the band (except in a tactical way, to prevent unwarranted volatility). There is a presumption that the authorities will normally

Obtained from the MAS website: www.mas.gov.sg.

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intervene to discourage the rate straying far from the band, but they have a whole extra degree of flexibility in deciding the tactics that they will employ to achieve this. In particular, if they decide that market pressures are overwhelming, they can choose to allow the rate to take the strain even if this involves the rate going outside the band (p. 5). Admittedly, this sort of monitoring band may be interpreted by some as being no different from a dirty or partial floating regime. However, in contrast to a floating regime, with a monitoring band, the threat of possible intervention by the MAS may suffice to reduce speculative attacks. Quoting Williamson (1999a) once again: If the authorities choose not to defend the band, is that not floating? Actually, having a monitoring band may make a difference even if the authorities choose not to intervene, so long as the market knows that they can employ policy weapons which they might wield at some future date in seeking to push the rate back within the band, and they know where the band is. This knowledge should make the market fearful of pushing the rate so far as to set up the conditions for a bear squeeze (or a "bull squeeze"). Another possible reason is that the market may believe that the authorities have chosen a correct estimate of the long run equilibrium rate in their positioning of the band, and this again may discourage the market from pushing the rate as far as it would otherwise go (p. 5) 26 . To be sure, there is no suggestion that such a band is a panacea against each and every speculative attack. Certainly it is not. The point of a monitoring band, or a crawling band with soft margins, is that it is a means of having some impact on the exchange rate without a specific exchange rate target which takes precedence over all other objectives 27 . Such a currency basket may also justify an expansion of the Chiang-Mai initiative (CMI) by East Asian central banks to include — at least partial — pooling of reserves to create a regional credit facility and make transparent the hitherto implicit exchange rate policy coordination through unilateral perusal of de facto U S dollar pegs (see Chapter 3 and Rajan,

16

The argument for broader and more flexible bands is that they allow the authorities the time and space to demonstrate their commitment to the band boundaries with remedial measures before the boundaries are reached and speculators are offered a one-way bet (Hallett and Ma, 1995). Williamson (1999a) makes a similar point is some detail. 27

Of course, one could argue instead that developing countries should pursue fully flexible regimes accompanied by some sort of nominal anchor or monetary policy operating strategy, usually taken to be an inflation target (Eichengreen, 2001b and Cavoli and Rajan, 2002).

The Ri3ht Exchange Rate Regime for Small and Open Economies

99

Siregar and Bird, 2003 ) 28 . Alternatively, if such a regionwide basket regime is not politically tenable, each of the countries may want to initially formulate distinct currency baskets and gradually work towards a more uniform or common regional currency basket. Bilbliography Adler, M. (1994). "Exchange Rate Planning for International Trading Firm", in Y. Amihud and R. Levich (eds.), Exchange Rates and Corporate Performance, New York: Irwin Professional Publishing. Arteta, C , B. Eichengreen and C. Wyplosz (2001). "When Does Capital Account Liberalization Help More than it Hurts?", Working Paper No. 8414, NBER. Benassy-Quere, A. (1999). "Optimal Pegs for East Asian Currencies", journal of the Japanese and International Countries, 13, pp. 44-60. Bird, G. and R. Rajan (2001). "International Currency Taxation and Currency Stabilisation in Developing Countries", Journal of Development Studies, 37, pp. 21-38. Bird, G. and R. Rajan (2002a). "Optimal Currency Baskets and the Third Currency Phenomenon: Exchange Rate Policy in Southeast Asia", Journal of International Development, 14, pp. 1053-1073. Bird, G. and R. Rajan (2002b). "The Political Economy of a Trade First Approach to Regional Integration", Discussion Paper, Centre for International Economic Studies, University of Adelaide. Calvo, G. and C. Reinhart (2000a). "Fixing for Your Life", in S. Collins and R. Rodrik (eds.), Brookings Trade Forum 2000: Policy Challenges in the Next Millennium, Washington, DC: Brookings Institution. Calvo, G. and C. Reinhart (2000b). "Fear of Floating", Working Paper No. 7993, NBER. Catao, L. and E. Falcetti (1999). "Determinants of Argentina's External Trade", Working Paper No. 99/121, IMF Cavoli, T. and R. Rajan (2002). "Designing Appropriate Exchange Rate Regimes for East Aisa: Inflation Targeting and Monetory Policy Rules", mimeo (December). Cohen, B. (2002). "Are Monetary Unions Inevitable?", mimeo (Undated).

28

Kusukawa (1999) recommends the establishment of a regional body to support the common basket system, possibly some kind of Asian Monetary Fund (AMF). See Chapter 3 for a detailed discussion of monetary regionalism in East Asia.

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Corbo, V. and V. Cox (1995). "Exchange Rate Volatility, Investment and Growth: Some New Evidence", in W. Gruben, D. Gould and C. Zarazaga (eds.), Exchange Rates, Capital Flows, and Monetary Policy in a Changing World Economy, Boston: Kluwer Academic Press. Dornbusch, R. and Y.C. Park (1999). "Flexibility or Nominal Anchors?", in S. Collignon and J. Pisani-Ferri (eds.), Exchange Rate Policies in Asian Emerging Countries, London: Routledge Press. Eichengreen B. (1994). International Monetary Arrangement for the 21st Century, Washington, DC: Brookings Institution. Eichengreen, B. (2001a). "What Problems Can Dollarization Solve?", Journal of Policy Modeling, 23, pp. 267-277. Eichengreen, B. (2001b). "Can Emerging Markets Float? Should they Inflation Target?", mimeo (April). Eichengreen, B. and T. Bayoumi (1999a). "Is Asia an Optimum Currency Area?, Can it Become One? Regional, Global and Historical Perspectives on Asian Monetary Relations", in S. Collignon and ]. Pisani-Ferri (eds.), Exchange Rate Policies in Asian Emerging Countries, London: Routledge Press. Eichengreen, B. and T. Bayoumi (1999b). "On Regional Monetary Arrangements for ASEAN", paper presented at an International Conference on Exchange Rate Regimes in Emerging Market Economies (December 17-18, Tokyo). Eiji, Y. (1999). "Tricurrency Basket-based Fixed Exchange Rate Regime", Osaka City University Review, 35, pp. 53-69. Fischer, S. (2001). "Exchange Rate Regimes: Is the Bipolar View Correct?", journal of Economic Perspectives, 15, pp. 3-24. Frankel, J. (1999). "No Single Currency Regime is Right for All Countries or at All Times", Essays in International Economics No. 215, International Economics Section, Princeton University. Frankel, J. and A. Rose (1998). "The Endongeneity of the Optimum Currency Area Criteria", Economic Journal, 108, pp. 1009-1025. Frankel, J. and A. Rose (2002). "An Estimate of the Effect of Common Currencies on Trade and Income", Quarterly Journal of Economics, 117, pp. 437-466. Frankel, ]., S. Schmukler and L. Serven (2000). "Global Transmission of Interest Rates: Monetary Independence and Currency Regime", mimeo (August). Frankel, J. and S. Wei (1994). "Yen Bloc or Dollar Bloc?: Exchange Rate Policies of the East Asian Countries", in T. Ito and A. Krueger (eds.), Macroeconomic Linkage: Savings, Exchange Rates, and Capital Flows, Chicago: University of Chicago Press.

The Right Exchange Rate Regime for Small and Open Economies

Gavin, M. and R. Perotti (1997). "Fiscal Policy in Latin America", Macroeconomics Annual, 12, pp. 11-71.

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Ghosh, A., A. Guide, J. Ostry and H. Wolf (1995). "Does the Nominal Exchange Rate Regime Matter?", Working Paper No. 951121, IMF. Glick, R., M. Hutchison and R. Moreno (1999). "Is Pegging the Exchange Rate a Cure for Inflation?", in T. Willett (ed.), Exchange'Rate Policies for Emerging Market Economies, Boulder: Westview Press. Glick, R. and A. Rose (2001). "Does a Currency Union Affect Trade?: The Time Series Evidence", European Economic Review, 46, pp. 1125-1151. Goodhart, C. (1995). "The Political Economy of Monetary Union", in P. Kenen (ed.), Understanding Interdependence: The Macroeconomics of the Open Economy, Princeton, NJ: Princeton University Press. Hallett, A. and Y. Ma (1995). "Economic Cooperation Within Europe: Lessons from the Monetary Arrangements in the 1990s", Working Paper No. 1190, CEPR. Hausmann, R. (1999). "Currencies: Should there be Five or One Hundred and Five", Foreign Policy, 116, pp. 65-79. Hausmann, R., U. Panizza and E. Stein (2000). "Why do Countries Float the Way They Float?", Working Paper No. 418, Inter-American Development Bank. Huizinga, J. (1994). "Exchange Rate Volatility, Uncertainty, and Investment: A n Empirical Investigation", in C. Leiderman and A. Razin (eds.), Capital Mobility: The Impact on Consumption, Investment and Growth, New York: Cambridge University Press. International Monetary Fund (1997). World Economic Outlook, IMF. International Monetary Fund (2001). IMF Press Release No. 01/37 (September 7). Ito, T., E. Ogawa and Y. Sasaki (1998). "How Did the Dollar Peg Fail in Asia?", Journal of the Japanese and International Economies, 12, pp. 256-304. Kenen, P. (2000). "Currency Areas, Policy Domains, and the Institutionalization of Fixed Exchange Rates", mimeo (April). Kohler, H. (2001). "New Challenges for Exchange Rate Policy", paper presented at the Asia-Europe Meeting of Finance Ministers (January 12, Kobe, Japan). Kusukawa, T. (1999). Asian Currency Reform: The Options of a Common Basket Peg, Tokyo: Fuji Research Institute Corporation. Kwan, C. (1995). Enken no Keizaigaku (The Economics of the Yen Bloc), Tokyo: N i h o n Keiza Shinbunsha (in Japanese).

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Latter, T. (2002). "Why Blame the Peg?", speech by Deputy Chief Executive of the Hong Kong Monetary Authority (Hong Kong, March 12). Liu, H.C.K. (2002). "Hong Kong Pegged to a Failed Policy", Asia Times, October 16. McKenzie, M. (1999). "The Impact of Exchange Rate Volatility on International Trade Flows", journal of Economic Surveys, 13, pp. 71-103. McKinnon, R. (1999). "The East Asian Dollar Standard, Life After Death", mimeo (July). McKinnon, R. (2000). "After the Crisis, The East Asian Dollar Standard Resurrected: A n Interpretation of High-Frequency Exchange-Rate Pegging", mimeo (August). Mussa, M., P. Masson, A. Swoboda, E. Jadresic, P. Mauro and A. Berg (2000). "Exchange Rate Regimes in an Increasingly Integrated World Economy", Occasional Paper No. 193, IMF. Nilsson, K. and L. Nilsson (2000). "Exchange Rate Regimes and Export Performance of Developing Countries", The World Economy, 23, pp. 331-349. Ohno, K. (1999). "Exchange Rate Management in Developing Asia: Reassessment of the Pre-crisis Soft Dollar Zone", Working Paper No.l, Asian Development Bank Institute. Rajan, R. (1999). "Economic Collapse in Southeast Asia", Policy Study, Claremont, CA: T h e Lowe Institute of Political Economy, Claremont McKenna College. Rajan, R. (2001). "(Ir)relevance of Currency Crises Theory to the Devaluation and Collapse of the Thai Baht", Princeton Studies in International Economics No.88, International Economics Section, Princeton University. Rajan (2002a). "Exchange Rate Policy Options for Post-Crisis Southeast Asia: Is There a Case for Currency Baskets?", The World Economy, 25, pp. 137-163. Rajan, R. (2002b). "International Financial Liberalisation in Developing Countries: Lessons from Recent Experiences", Economic and Political Weekly, 37, July 20-26, pp. 3017-3021. Rajan, R. (2002c). "Examining the Links Between Trade and Monetary Regionalism", Economic and Political Weekly, 37, November 2-9, pp. 4493-4494. Rajan, R. (2003). "Choosing an Appropriate Exchange Rate Regime for Small and Open Emerging Economies", BriefingNotes in Economics, forthcoming. Rajan, R. and C.H. Shen (2001). "Are Crisis-Induced Devaluations Contractionary?", Discussion Paper No. 0135, Centre for International Economic Studies, University of Adelaide.

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Rajan, R. and R. Siregar (2002). "The Choice of Exchange Rate Regime: Currency Board (Hong Kong) or Monitoring Band (Singapore)?", Australian Economic Papers, 41, pp. 538-556. Rajan, R., R. Siregar and G. Bird (2003). "Examining the Case for Reserve Pooling in East Asia", mimeo (January). Rockoff, H. (2000). "How Long Did it Take the United States to Become an Optimal Currency Area?", Working Paper No. H0124, NBER. Rose, A. (2000). "One Money, One Market: Estimating the Effect of Common Currencies on Trade", Economic Policy, 15, pp. 7—46. Salvatore, D. (2002). "Euro and Dollarization: Forms of Monetary Union in Integrating Regions", mimeo (undated). Tornell, A. and A. Velasco (2000). "Fixed Versus Flexible Rates: Which Provides More Fiscal Discipline?", Journal of Monetary Economics, 45, pp. 399-436. Von Furstenberg, G.M. (2000). "Can Small Countries Keep their Own Money and Floating Exchange Rates?", in K. Kaiser, J. J. Kirton and J.D. Daniels (eds.), Shaping a New International Financial System, Aldershot: Ashgate. Wei, S.J. (1999). "Currency Hedging and Goods Trade", European Economic Review, 43, pp. 1371-1394. Williamson, J. (1999a). "Crawling Band or Monitoring Bands: How to Manage Exchange Rates in a World of Capital Mobility", Policy Brief No. 99-3, Washington, DC: Institute for International Economics. Williamson, J. (1999b). "The Case for a Common Basket Peg for East Asian Currencies", in S. Collignon and J. Pisani-Ferri (eds.), Exchange Rate Policies in Asian Emerging Countries, London: Routledge Press. Williamson, J. (2002). "Future Exchange Rate Regimes for Developing and Developing East Asia: Exploring the Policy Options", in Tan K.Y. (ed.), Asian Economic Recovery: Policy Options for Growth and Stability, Singapore: Singapore University Press.

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Economic Globalization and Asia Table 1 Currency Weights of Southeast Asian Countries, 1979-1995 Kwan(1995) b

FrankelandWei(1994) a

Currency

US dollar Indonesian rupiah Malaysian ringgit Philippine peso Singapore dollar Thai baht Simple Average

0.95 0.78 1.07 0.75 0.91 0.89

Japanese yen

US dollar

0.16 0.07 -0.01 0.13 0.05 0.08

Japanese yen

0.99 0.84 1.15 0.64 0.82 0.88

0.00 0.04 -0.24 0.11 0.11 0.00

Notes: a) Based on weekly movements for the period January 1979 to May 1992 b) Based on weekly movements for the period January 1991 to May 1995 Source: Rajan (2002a)

Table 2 Southeast Asian Exchange Rates Statistics, 1990-1996 Domestic Currency per US$ Rate in 1990

Indonesia Malaysia Philippines Thailand

Domestic Currency per US$ Rate in 1996

Exchange Rate Variability (1990-96)a

End of Period

Period Average

End of Period

Period Average

End of Period

Period Average

1901.0 2.7105 28.000 25.520

1842.8 2.7049 24.311 25.114

2383.0 2.5290 26.288 25.610

2342.3 2.5159 26.216 25.487

18.94 0.00 0.13 0.00

18.78 0.00 0.13 0.00

Notes: a) Coefficient of variation for the entire period 1990-96 Source: Calculated by author from IMF, International Financial Statistics, various years

The Right Exchange Rate Regime for Small and Open Economies

105

Table 3 Exchange Rate Regimes Ranged along the Continuum from Most Flexible to the Strongest Fixed-Rate Commitment Definition

Type

• •

Flexible Corner Free Floating Managed/Dirty Float

• • •

Intermediate Regimes Target Zone Crawling peg Adjustable peg

•

Basket peg

•

Fixed Corner Fixed peg

•

Currency Board

•

Monetary Union

The absence of regular/systematic intervention in the forex market. The absence of a specific target for the exchange rate.

A margin offluctuationaround some central rate. A pre-announced policy of devaluing or revaluing "a bit" each week. Fixing the exchange rate, but without any open-ended commitment to resist devaluation or revaluation in the presence of a large balance of payments deficit or surplus. Fixing not to a single foreign currency but to a weighted average of other currencies.

Commitment to undertake whatever forex market intervention is needed to maintain prevailing rate, but not necessarily any institutional commitment to back the regime. Three defining characteristics: fixing not just by policy, but by law; backing increases in the monetary base one-for-one with forex reserves; and allowing balance of payments deficits to tighten monetary policy, consequently adjusting spending automatically. The adoption of a foreign currency as legal tender. Includes the special case of official dollarization.

Source: Adopted from Frankel (1999)

106

Economic Globalization and Asia Table 4 IMF Exchange Rate Classification, 1970-1999 Percent oi countries in the sample which were classified by the IMF as having11:

Year

Peg

Limited Flexibility

Managed

Flexible

1970 1975 1980 1985 1990 1995 1999

97.2 63.9 38.9 33.3 19.4 13.9 11.1

0.0 11.1 5.6 5.6 13.9 8.3 11.1

0.0 13.9 47.2 36.1 30.6 38.9 33.3

2.8 11.1 8.3 25.0 36.1 38.9 44.5

Note: a) Sample based 154 exchange rate arrangements Source: Calvo and Reinhart (2000b)

Table 5 Comparing Optimal Weights of the Japanese yen in Southeast Asian Currency Baskets

Benassy-Quere (1999) Itoetal. (1998)a Eiji (1999) Bird and Rajan (2002a)a Kusukawa(1999)a Kusukawa(1999)a'b Williamson (1999b)b Simple Average

Indonesian rupiah

Malaysian ringitt

Philippine peso

Thai baht

0.30 0.56 0.45 0.59 0.39 0.32 0.33 0.42

0.21 n.a 0.40 0.46 0.36 0.32 0.33 0.35

0.23 0.72 0.40 0.35 0.31 0.32 0.33 0.38

0.29 0.50 0.40 0.59 0.40 0.32 0.33 0.41

Notes: a) Based on the simple average of stated ranges b) Based on a common basket which include the four Southeast Asian countries plus Singapore, Korea, Singapore, P.R.C. China, Hong Kong and Taiwan Source: Compiled by author

The Right Exchange Rate Regime for Small and Open Economies

Closed Capital Account

Pure Float

Superfix

Fully open capital account

Source: Modified from Frankel (1999) Figure 1 T h e Impossible Trinity

Latin American REERs, 1994-2001 160

of* <& ^ S* •

^

-^VVVV&/VV * -# ^ #

•$>

•$>'

•$>'

v>#' ^

^

Note: Decline in index implies real deprecation and vice versa Source: JP Morgan Figure 2

^

pN

•$>' S

^

107

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111

Chapter 5

The Nexus between Trade Liberalization and Poverty in Asia1

1. Introduction Among the most important concerns as an economy liberalizes and integrates with the world economy is the need to protect the most vulnerable in society and ensure that their well-being improves over time. But what is the link between economic globalization and poverty? 2 The issue is far from straightforward. A t the risk of generalizing, there is limited evidence to suggest that globalization of finance and capital flows (other than foreign direct investment) has had a discernible positive impact on growth, let alone poverty reduction (Cobham, 2001). Indeed, all that can be said with certainty is that if international financial liberalization does not take place in a well-sequenced and timed manner it could lead to episodes of severe financial instability and distress (see Chapter 1 and Bird and Rajan, 2001 ) 3 . Baldacci et al. (2002) confirm that financial crises negatively impact income distribution and poverty, and the adverse effects are stronger in countries that have a relatively more skewed income distribution (also see Winters, 2001 and World Bank, 2000). One aspect of globalization that would undoubtedly reduce poverty worldwide would be by allowing greater mobility across national borders of unskilled labour. However, social and political compulsions and biases prevent many industrial countries from taking a more laissez faire attitude towards such crossborder flows. While there is an ongoing contest between countries for skilled labour or "global talent", the economic implications of this "brain drain" for developing countries appear ambiguous in theory and negative in practice (see Chapter 1 for an elaboration).

1

This Chapter extends upon Rajan (2002b) and Rajan and Bird (2002).

2

No attempt is made here to define "poverty" or to discuss how it is measured. See Kanbur and Squire (1999) for a detailed discussion on this. Also see Bhalla (2002). 3

See Rajan (2002a) for a recent discussion of international financial liberalization and its various definitions.

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Economic Globalization and Asia

This leaves the third aspect of globalization, viz. trade and production. Watkins (2002) makes the following pertinent observation: Openness — along with associated free market reforms — holds the key to making globalization work for the poor ... International trade has the potential to act as a powerful catalyst for poverty reduction, as the experience of East Asia demonstrates. It can provide poor countries and people with access to the markets, technologies, and ideas needed to sustain higher and more equitable patterns of growth ... But if globaphobia is unjustified, so too is "globaphilia" — an affliction, widespread ... in Washington, that holds that increased integration through trade and openness is an almost automatic passport to more rapid growth and poverty reduction (p. 1). What is the nexus between trade liberalization and poverty? This is the key question of this Chapter with particular reference to Asia. The remainder of this Chapter is organized around three main sections. Recognizing that growth is a necessary condition for a sustained reduction in poverty, the next section discusses the analytical and empirical links between trade and growth. Growth is by no means a sufficient condition for poverty reduction. Therefore, Section 3 focuses on the issue of trade, income distribution and poverty. What needs to be done to ensure that growth will not bypass the poor in developing countries? Section 4 briefly delves into the complementary policies that need to be undertaken if significant inroads are to be made in reducing poverty. These two sections by and large concentrate on merchandise, and — to a lesser extent — agricultural trade. The final section concludes the Chapter. A n Annex on the effects of trade protection follows the main text.

2. Trade Liberalization and Income Growth 2 . 1 . What does the literature

conclude?

Trade liberalization ought to provide the usual Harberger Triangle welfare gains by reducing, if not entirely eliminating, the wedge between domestic and foreign prices. Assuming demand elasticity = s and tariff rate or tariff equivalent = t, the size of the welfare loss, in a partial equilibrium analysis (i.e. the Harberger Triangle), is simply te 2 /2. So, if the tariff equivalent is ten percent and the elasticity of demand is one, the welfare loss is just half of one percent (of consumer expenditure). Most empirical studies measuring these welfare losses find them to be about this level (Baldwin, 1992). Does this imply that trade protectionism is not "significantly" harmful? The answer is no for at least three reasons.

The Nexus between Trade Liberalization and Poverty in Asia

113

One, Tullock (1967) has noted that even in a static setting, the welfare costs of protectionism may actually be much larger once the costs of rent-seeking activities and other pre-existing distortions are taken into account (Annex 1). Thus, removal of such distortions could significantly boost income. Two, once again in a static sense, Romer (1994) has argued strongly that the non-rivalry of many goods (characterized by large fixed costs and constant marginal costs) which enter as inputs (like blueprints) implies that if such goods are impeded, there could be potentially large losses to the economy (as much as 10-12 percent of GDP). Three, there could be a host of other dynamic gains to be had from trade and the introduction of competition in terms of scale economies, technological innovations, learning-by-doing effects, etc., which in turn lead to sustained rates of growth (not just one-off increases in income levels) (Grossman and Helpman, 1991 and Srinivasan, 2001). However, there are also endogenous growth models that suggest that trade might be growth-stunting (Grossman and Helpman, 1991 and Srinivasan, 2001). This may occur if the forces of dynamic comparative advantage push an economy away from the direction of activities that stimulate long run growth. Thus, as Rodriguez and Rodrik (2000) note: there should be no theoretical presumption in favour of finding [an] unambiguous negative relationship between trade barriers and growth rates in the types of cross-national data typically analyzed. Accordingly, as with most things, the nexus between trade and growth can only be settled empirically. It is fair to say that the bulk of the empirical literature using cross-country data has found international trade in goods to be growth inducing 4 . There are, however, two important problems with most existing studies. First, while the studies may have unearthed a positive association between trade and growth, most are unable to conclude anything about causality per se. Does openness lead to growth; does growth lead to openness (for instance, the richer a country gets, the more likely it is to dismantle trade barriers); or are both caused by a third factor (i.e. are trade and income growth both endogenous)? Rodrik (2000b) for one holds the view that both are caused by the quality of institutions. Harrison (1996) concludes that the results of previous studies on the direction of causality between openness and growth are "mixed", with causality being bi-directional.

4

Recent studies that have found a positive association between openness and trade include Coe et al. (1997), Dollar (1992), Edwards (1993, 1998), Roemer and Gugerty (1997) and Sachs and Warner (1995), and most recently, Bhalla (2002), Dollar and Kraay (2001b) and Morrissey et al. (2002).

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Economic Globalization and Asia

In an important study, Frankel and Romer (1999) attempt to decipher the causation between trade and growth. The authors undertake a cross-sectional study involving 100 countries during the period since 1960. They deal with the potential endogeneity problem of the trade variable by instrumenting it with a set of variables usually used in the estimation of the gravity model for trade flows. While results vary on the basis of the specific data set and equations used, they generally suggest that openness does have a statistically and economically significant effect on growth 5 . Second, even if the causality from trade to growth is accepted, the FrankelRomer study, like all others, is subject to an important criticism in that it links growth with trade outcome measures (export, imports) rather than trade policy measures (like tariffs and nontariff barriers). This point was first clearly made by Moon (1997), but more recently and forcefully by Dani Rodrik (for instance, see Rodriguez and Rodrik, 2000 and Rodrik, 2000b). As Rodrik (2000b) notes: Saying that participation in world trade is good for a country is as meaningful as saying that upgrading technological capabilities is good for growth ... The tools at the disposal of governments are tariff and non-tariff barriers, not imports or exports ... (T)ariff measures are a reasonable proxy for trade restrictions ... (T)he relevant question for policy-makers is not whether trade per se is good or bad ... but what the correct sequencing of policies is and how much priority deep trade liberalization should receive early in the reform process..(pp. 1-3). In other words, while there does exist a link between de facto trade openness and growth, one cannot say for sure that there is a nexus between trade liberalization per se and growth, as a host of macroeconomic and external factors have not been properly controlled for. It is also extremely difficult to sort out the effects of trade liberalization from other domestic policy options, particularly as countries that undergo trade reforms do so as part of an overall growth-enhancing policy package. Increased openness may be the result of trade liberalization per se, or because of other nontrade policy actions or some combination of the two 6 . Indeed, the recent World Bank (2002) report entitled Globalization, Growth and Poverty, which attempts to offer evidence of the benefits of being a "globalizer", implicitly recognizes that there may not be a direct link between trade policy

5

Dollar and Kraay (2001b) also make an attempt to control for reverse causation from income growth to changes in trade shares. 6

Rodriguez and Rodrik (2000) go on to assert "the search for such a relationship is futile".

The Nexus between Trade Liberalization and Poverty in Asia

115

measures and outcomes. As the report states: We label the top third "more globalized"..(countries) ... without... (in) ... any sense implying that they adopted pro-trade policies. The rise in trade may have been due to other policies or even to pure chance ... (In fact) ... (w)hether there is a casual connection from opening up trade to faster growth is not the issue (pp. 34-6).

2.2.

Implications for policy: Focus on growth1

W h a t does all of this imply for policy? T h e link between growth and trade openness per se as opposed to growth and trade liberalization suggests (a) that governments should aim to enhance their effective degree of trade integration with the rest of the world, and (b) trade liberalization per se may not be sufficient to achieve this. "Opening doors" (in a well-sequenced manner) and "getting the prices right" are clearly necessary but insufficient to ensure an outward oriented policy is successful in terms of promoting export-led growth. At the least, for trade liberalization to translate into de facto openness and growth it is imperative that appropriate macroeconomic and exchange rate policies also be in place. In other words, to be successful, trade reforms must be part of a logically consistent package of sound macroeconomic policies and structural reforms. Sharer (2001) makes a broadly similar point in his review of Africa's prospects in the global trading system: The causes of Africa's weak trade performance are complex ... A country's ability to improve its trade performance in the short run is determined mainly by its macroeconomic and structural policies. Trade and growth prospects are enhanced by a macroeconomic framework that emphasizes appropriate fiscal and monetary policies conducive to price stability, saving and investment, and a sustainable external current account position. These factors are critical in maintaining a stable economic environment and, thus, in encouraging productive activities. FDI and Export Platforms: Beyond disciplined macro policies, most developing countries that have been successful global exporters have also found it necessary to encourage the inflow of export-oriented FDI which is able to exploit the country's comparative advantage and plug into export markets (McMillan et al., 1999). FDI, particularly when it involves multinational enterprises (MNEs), brings in capital, technical know-how, organizational, managerial and marketing Section 3 discusses the issue of income distribution and poverty more specifically.

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Economic Globalization and Asia

practices and global production networks, helping accelerate the process of economic development in host countries.

3. Trade Liberalization and Poverty Even if trade openness (as opposed to just liberalization) is linked to more rapid growth, this does not necessarily imply it is an effective instrument in reducing poverty. For instance, if a growth strategy based on trade openness leads to a significant worsening of income inequality of households at the bottom of the income strata, it may not make any discernible in-roads in alleviating poverty. In such circumstances it would be necessary for outward orientation to promote growth at a "sufficiently rapid" pace for the poor to have any chance of benefiting via "trickle down" effects. However, the political sustainability of such inequitable growth is doubtful; the distributional character of economic growth matters as much as the rate of growth. But does outward orientation lead to "equitable" growth? 3 . 1 . Trade 3.1.1.

theories

Stolper-Samuelson (SS) model

What does theory tell us about the functional distribution of outward-oriented growth? Starting with the workhouse 2 x 2 x 2 (two-factor, two-goods and twocountries) Stolper-Samuelson (SS) model, theory suggests that international trade will lead to a rise in the relative returns of the abundant factor; unskilled labour in the case of developing countries (assuming no market distortions). Thus, according to conventional theory, the poor (unskilled labour) will be the largest beneficiaries of trade liberalization, i.e. openness in developing countries ought to be "pro-poor" in addition to being "pro-growth". Similarly, in the ageold Arthur Lewis (1954) dualistic paradigm with surplus labour reserves (elastic labor supply), trade and growth ought to be employment-intensive, thus benefiting the poor. Findlay (1995) has combined the insights from the conventional SS model with the Lewis framework to show how trade in a labour surplus economy can lead to a virtuous cycle of employment, capital accumulation and growth. This seems consistent with the East Asian experiences in the 1970s to mid 1990s. 3.1.2.

Specific factors model

A n important assumption of the SS model is that all factors are freely mobile between sectors within a country. This is, however, a heroic assumption in anything but the long run.

The Nexus between Trade Liberalization and Poverty in Asia

117

Consider the simplest case of two factors (Labour and Capital) and two industries ("Export industry" and "Import industry"). Assume the country in question is relatively labour abundant and the Export Industry is labour intensive. In the short run, assume all factors are immobile. Free trade leads to a rise (fall) in the price of the labour intensive Export (Import) industry. Thus, the real returns to labour and capital in the Export industry rise, while they fall in the case of the Import industry. In the medium run, assume labour is mobile across sectors but capital remains immobile. Labour moves from the Import to the Export industry such that wages are equalized across sectors. Whether labour ends up benefiting in real terms depends on its consumption basket. Returns to capital in the Export industry unambiguously improve, and those to the Import industry unambiguously worsen. In the long run, all factors are mobile and real wages in both sectors rise, while real returns to capital decline a la Stolper-Samuelson (see Table 1).

3.13.

Summing up

What does the preceding discussion imply? One, there is every possibility that unskilled labour in some sectors may experience a worsening of income distribution in the immediate to short run. Two, even in the long run, when all factors are fully mobile, the simple SS model does not offer definitive conclusions if one of more assumptions are relaxed (see Table 2 and Davis, 1996). This is especially so if there are significant labour market distortions leading to an ex-ante bias towards the capital and skill-intensive sectors (discussed in Section 3.2). Similarly, in the case of the Lewis model, if the reserve army of labour is delinked from the growth enclaves (e.g. rural versus urban segmentation, for instance), growth might bypass one segment of the poor 8 . Three, the growth effects of trade openness are not instantaneous; they take time to eventuate. For instance, controlling for other factors, Greenaway et al. (2002) find a "J-curve" association between per capita income and various measures of trade liberalization. In other words, while trade liberalization may be growth-stimulating in the medium and long runs, it may initially be growthretarding. This is so as the import competing industries contract in the short run, while it may take time for the exportables sector to react to the positive stimulus.

8

More specifically, with such segmented labour markets, adjustment will be reflected in increases in real wages and not employment. One can identify four sectors of the labour market in developing countries: formal urban, formal rural, informal urban, and informal rural.

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Economic Globalization and Asia

All these suggest that while trade openness (as opposed to just trade liberalization) is important in raising "all boats" over time, the link between trade openness and poverty is much less clear in the short run. What do the data tell us? Empirical studies have by and large found that growth has not given rise to more unequal income distribution (Dollar and Kraay, 2001a, Morrissey et a l , 2002, Roemer and Gugerty, 1997 and World Bank, 2000). Thus, as Dollar and Kraay (2002) note, "(t)he combination of increases in growth and little systematic change in inequality in the globalizes has considerably boosted efforts to reduce poverty". In other words, the Kuznets Curve hypothesis (which purports the existence of a U-shaped nexus between income and inequality) does not appear to be empirically valid. Measures of income distribution have generally been stable over time within countries 9 ; there appears to be as much tendency for income inequality to worsen slightly as there is for it to improve (Fields, 1989) 10 . Ghura et al. (2002) have recently estimated the elasticity of income on the poor with respect to average income and find that economic growth raises the incomes of the poor but by less than one-to-one. This said, the evidence is far from unequivocal (for instance, see Bhalla, 2002 and Timmer, 1997), especially once country-specific circumstances are considered.

3.2.

Labour market rigidities: Particular reference to India

Table 3 offers an indication of patterns of income inequality changes in 73 countries between the 1960s and 1990s based on the World Income Inequality Database (Cornia and Court, 2001 ) n . While outward oriented growth in a number of countries in Asia such as Malaysia and the Philippines appear to have been matched by decreasing inequality (though both remain relatively inequitable societies), others like China, Korea and Thailand have experienced a worsening of inequities over time.

9

While the conventional Kuznets hypothesis linked inequality with income levels, there has more recently been an attempt to relate inequality with income growth. Neither the level nor the growth versions of Kuznets hypothesis seem to be empirically valid in general. Even if there were a link, the issue of causation would be relevant, as high levels of inequality could well depress growth (Alesina and Perotti, 1996 and Morrissey et al., 2002). 10

It is, of course, plausible that poverty may worsen even if some measures of income inequality do not change — e.g. lower and upper middle income households improve significantly while the poorest households see a worsening of income. 11

The World Income Inequality Database (WIID) may be accessed from the UNU-WIDER website: http://www.wider.unu.edu/wiid/wiid.htm.

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While Table 3 suggests that inequality in India has remained unchanged between 1960s and 1990s, more recent evidence indicates that inequalities in the country have been rising since the initiation of the economic liberalization since mid 1991 (Ahluwalia, 2000, Deaton and Dreze, 2002 and Jha, 2002). While liberalization has been important in promoting mid-skill level software exports, the reforms in India do not appear to have generated significant employment in the export-oriented, labour intensive manufacturing industries. This compares unfavourably to the experiences of the East Asian economies in the 1980s and 1990s which have emerged as important global players in labour-intensive manufacturing (Chapter 6). Apparently they have not been able to "pull up" the poor from poverty (Jha, 2002). Thus, Deaton and Dreze (2002) conclude: Most indicators have continued to improve in the nineties, but social progress has followed very diverse patterns, ranging from accelerated progress in some fields to slowdown and even regression in others. We find no support for sweeping claims that the nineties have been a period of "unprecedented improvement" or "widespread impoverishment" (p. 3729). Contrary to Datt (1995) and a number of other critics, the reforms in India per se are not ex-ante biased towards the capital and skill-intensive sectors and thus "anti-poor". Rather, they have become so ex-post mainly because of draconian labour laws and resulting labour market distortions and rigidities. From a policy angle, it is imperative that distortions that bias domestic relative factor prices against unskilled and semi-skilled labour inputs are eliminated. More flexible functioning of the labour market and greater emphasis on cordial tripartite relations between labour-management-government are needed if a country is to be competitive as a location for labour-intensive investments and the reforms are to be "friendly" to unskilled labour and thus "pro-poor" over time. Given the acute difficulties that governments often face in curbing labour union "militancy" and labour market distortions at a national level, institutional innovations such as export platforms that are generally free from such competitivenesshindering constraints and high tariffs, gain greater relevance (Kundra, 2001 and Naik, 2002). Radelet (1999) stresses the importance of export platforms (such as export processing zones or EPZs, bonded warehouses, duty exemption systems, duty drawback systems, duty rebate systems, and other kinds of facilities) as being instrumental in promoting manufactured exports in developing countries in the early stages of liberalization. The key aspect of such export platforms is that they allow exporters to import capital and intermediate goods on duty-free terms. These platforms are meant to shield exporters from the distortions in the rest of the economy like high tariffs and unwieldy and corrupt bureaucracies and other factors that might

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adversely impact international competitiveness. In addition, becoming a successful exporter of parts, components and accessories (PCAs) trade requires that the country be able to freely import intermediate goods 12 . EPZs (or export platforms more generally) are by no means fool-proof methods for promoting investment, exports and growth. While some Southeast Asian economies, China and Mauritius are often held up as examples in which FDI and EPZs have transformed the economy, they have been dismal failures in many other countries. Radelet (1999) discusses the characteristics of successful export platforms and concludes that such platforms are most effective when they are well managed with minimal red tape including streamlined and predictable customs procedures. Competition between various export platforms may be helpful, and they should be built in appropriate locations and provide reliable infrastructure and utilities if the necessary investment and export responses are to eventuate. Subramaniam and Roy (2001) emphasize the importance of strong institutions and governance structures as being prerequisites for successful export platforms. — These are probably pre-requisites for successful development in general. — Strong political push and administrative support are also important considerations that determine the success of such platforms (Kundra, 2001). It is important to stress that export platforms are meant to be temporary solutions to overcome distortions that afflict the rest of the economy. A n oftnoted criticism of such export platforms is that they could lead to uneven or enclave type development. However, persistent enclave development is really a reflection of the heavy distortions in and unattractiveness of the rest of the domestic economy, as opposed to a drawback of export platforms per se. If anything, such export platforms ought to have important learning effects for the rest of the economy.

4. Rural Sector and Agriculture The foregoing discussion is admittedly more relevant to trade in manufactures (and services) than to agricultural goods and other primary commodities. However, as Martin (2001) has documented, many developing countries —including relatively

12 Radelet (1999) and Rodrik (1995) in fact note that the greatest benefits of an outward oriented strategy is the ability to import important intermediate capital goods needed to facilitate an investment boom which in turn stimulates exports. While many observers have assumed that export booms stimulated the East Asian growth in the 1980s and 1990s, Rodrik argues that the causation has run from imports to investment (which incorporate new technologies) and then exports.

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poor ones in Southern Africa — have seen a significant increase in their respective shares of manufacture exports. As he notes: This change has profound implications. Not only does it greatly diminish concerns about potential declines in the terms of trade, but it also puts much greater pressure on domestic policy-makers to maintain a relatively open regime that will allow imports of intermediate and capital goods, and support production of manufactured goods for exports (p. 27). The preceding notwithstanding, a large proportion of the populace in developing countries is still closely tied to the rural sector and in agriculture, and this is where the bulk of the poverty is concentrated. Accordingly, this sector cannot be ignored if significant inroads are to be made in reducing poverty and raising living standards in developing countries 1 3 . Ravallion and Datt (1996) have found that direct targeting of rural poverty in India will generate benefits to the urban poor, though not vice versa (this could be because of the capital intensive bias of the urban sector noted in Section 3.2, thus its expansion in the presence of existing distortions provides little benefit by way of low-skilled employment growth). T h e authors further suggest that growth in the rural sector has an equalizing income effect in the urban sector, while expansion of the urban sector actually exacerbates overall income inequalities (also see Datt and Ravallion, 2002). In view of this, steps are needed to improve the productivity of the rural sector. Specific actions are needed to ameliorate basic infrastructural services such as roads, irrigation, power and basic public health measures (sanitation and sewerage, supply of clean drinking water, etc). Virmani (2002) makes a particularly strong case for such rural infrastructure to be classified as "public goods" and ought therefore to be provided by the government 14 . In addition, various regulations which hinder productivity improvements, such as price controls, licensing requirements and trade restrictions need to be revoked. Innovative methods of providing rural credit finance (micro finance) are also of importance. It is instructive to note that the pro-poor effects of East Asian growth pre-1997 were due to an astute combination of outward orientation along with complementary policies in agriculture (including land reforms) and

13 14

This agriculture versus industry debate is, of course, an age-old one.

However, in reality many public goods in developing countries tend to be fairly "costly" to the end user (i.e. rural poor), either because the poor are not able to access the services easily (due to lack of geographical proximity), or because middle-men/service providers attempt to extract informal payments to provide the service.

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widespread basic education (Birdsall et al., 1995) 15 . Indeed, Cornia and Court (2001) refer to land concentration, urban bias and inequality in education as "traditional causes" of inequality. There is a complex nexus between illiteracy, openness and agriculture 16 . Specifically, while the simple two factor SS model non-agricultural commodities may well benefit low skill urban labour, it may do little to benefit the "completely" unskilled labour and thus the most poor in society in the rural areas. While this further suggests the need to improve basic literacy rates in the rural areas and to facilitate the extent of inter-regional labour mobility (Sachs et al., 2002) 17 , the importance of working towards liberalizing trade in agriculture is critical. In relation to this, industrial country protectionism and market access impediments in the agriculture sector are extremely detrimental to developing countries. The World Bank President, James Wolfensohn, is exactly correct when he notes the following of industrial countries and leaders: If we care about the poorest developing countries, a special focus is needed on agricultural trade liberalization. They depend far more heavily than the better-off developing countries on agriculture for their GDP and exports ... It makes no sense to exhort poor countries to compete and pay their way in the world while we simultaneously deny them the means to do so, by restricting their market access in areas such as agriculture where they have a comparative advantage..We must work flexibly and creatively towards a world trading system that really makes a difference for developing countries..In order to have a balanced and inclusive world trade system, we need to pay special attention to developing countries' current problems with the design and implementation of the rules of the game in international trade (Wolfensohn, 2000).

15

While stressing the importance of land reforms, Cornia and Court (2001) note: Many land reform efforts in the past have been badly planned and implemented without paying much attention to the incentives of all actors involved and to the functioning of the input and credit markets (p. 27).

Banerjee (1999) offers a timely reminder that such redistribution policies cost money and expend valuable administrative and political capital. 16

An "adequate" level of education of the populace and "reasonable" infrastructure are also required if a country is to fully benefit from FDI (Borenzstein et al, 1998). 17 Steps to improve rural infrastructure and the overall productivity of rural workers will not only facilitate agriculture production, but could also make the rural areas more appealing for low-skill intensive manufacturing and related services.

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5. Concluding Remarks James Wolfensohn has summarized the facts and figures on what he refers to as "the crisis of poverty" facing the world in the 21st century. As he notes: With respect to income poverty, we can see two trends over the past decade. In percentage terms, the picture looks positive. The proportion of the population of developing and transition economies living on less than $1 a day fell from 28% in 1987 to 24% in 1998. Excluding China, the reduction is rather less — from 29% to 26% in those same years. But a growing world population has delivered a stark challenge. The actual number of people living in dire poverty has remained roughly constant, at about 1.2 billion. Excluding China, the number has actually risen, from just under 880 million to over 980 million. In addition, the total number of people living on under $2 a day is now estimated at nearly 3 billion, approaching half the world's population (Wolfensohn, 2000). It goes without saying that the permanent eradication of poverty ought to be a country's and, indeed, the international community's overarching objective. The issue of poverty is multidimensional and exceedingly complex. To understand its causes, it is essential to study the underlying economic and social circumstances and processes (World Bank, 2000) 1 8 . This Chapter has made no attempt to provide a detailed discussion of the causes and consequences of poverty. Rather, the aim here has been much more modest, viz. to discuss some of the links between trade and poverty at a rather broad level, as well as to suggest ways of ensuring that trade liberalization benefits the poor. Trade and openness remain engines of growth and important instruments of development. Inward looking, statist development strategies are not sensible policy options. It is a fact that countries that have experienced rapid growth and have managed to make significant inroads into alleviating poverty have been those that have integrated with the global economy in a market-consistent manner. However, the weight of evidence suggests that it would be simple-minded to think that trade liberalization per se is able to generate trade and income growth on a sustained basis, let alone alleviate poverty. Trade liberalization must be accompanied by a milieu of other policies to ensure that a country is successful in integrating more intensively with the world in a manner that is favourable to growth and poverty reduction. These include — but by no means are limited to — sound macroeconomic policies, strong institutions, and a favourable investment

18

Cassen (2002) notes that income — or lack of it — is just one aspect of poverty. He examines a broad range of indicators to obtain a clearer understanding of how the "well-being" of the poor in India has changed in the 1990s.

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climate including removing regulations that restrict the degree of flexibility of domestic labour market operation (which may in turn prevent the realization of gains from comparative advantage). More open economies are invariably more susceptible to external shocks and disturbances. Indeed, Ghura et al. (2002) find that the poor are particularly vulnerable to adverse movements in the price of tradables. Thus, while openness and complementary policies could reduce absolute poverty, they may increase the probability of a household falling into poverty in the event of a sharp adverse shock (also see Stiglitz, 1998). In order to counter this possibility, at least two sets of government policies need to be in place. First, in a dynamic environment, policies must be focused on continued basic re-training and re-tooling of individuals so that they are be able to adapt to shifting comparative advantage. Policies in the short and medium terms should also focus on facilitating inter-sectoral mobility of labour and capital so as to ensure that resources can be shifted frictionlessly in response to changing demand conditions. Second, there is a need to establish adequate social safety nets to protect the least well off and mechanisms to compensate "losers" (Ravallion, 1999, 2002). Needless to say, while the need for well-designed social safety nets to mitigate the possible harmful effects — at least in the "short term" — on the poor is particularly relevant, it is important to try and ensure that these social policies do not hinder or delay the process of reforms. These safety nets are meant to supplement and not supplant growth-oriented structural reforms. It is also important that the budgetary costs of these programs be quantified and well targeted, as there is always the danger that the programs may be captured by vested interests.

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Deaton, A. and J. Dreze (2002). "Poverty and Inequality in the 1990s", Economic and Political Weekly, September 7, pp. 3729-3748. Dollar, D. (1992). "Outward-Oriented Developing Economies Really Do Grow More Rapidly: Evidence from 95 LDCs, 1976-85", Economic Development and Cultural Change, 40, pp. 523-544. Dollar, D. and A. Kraay (2001a). "Growth Is Good for the Poor", Policy Research Working Paper No. 2587, The World Bank. Dollar, D. and A. Kraay (2001b). "Trade, Growth, and Poverty", Policy Research Working Paper No. 2615, The World Bank. Dollar, D. and A. Kraay (2002). "Trade, Growth, and Poverty", Finance and Development, 38, September. Edwards, S. (1993). "Openness, Trade Liberalisation, and Growth in Developing Countries", journal of Economic Literature, 31, pp. 1358-1393. Edwards, S. (1998). "Openness, Productivity and Growth: What Do We Really Know?", Economic Journal, 108, pp. 383-398. Fields, G. (1989). "Changes in Poverty and Inequality in Developing Countries", World Bank Economic Review, 4, pp. 16-86. Findlay, R. (1995). "Recent Advances in Trade and Growth Theory", in M.G. Quibria (ed.), Critical Issues in Asian Development: Theories, Experiences and Policies, Hong Kong and New York: Oxford University Press. Frankel, J. and D. Romer (1999). "Does Trade Cause Growth?", American Economic Review, 89, pp. 379-399. Ghura, D., C. Leite and C. Tsangarides (2002). "Is Growth Enough? Macroeconomic Policy and Poverty Reduction", Working Paper No. 021118, IMF. Greenaway, D., W. Morgan and P. Wright (2002). "Trade Liberalization and Growth in Developing Countries", Journal of Development Economics, 67, pp. 229-244Grossman, G. and E. Helpman (1991). Innovation and Growth in the Global Economy, Cambridge, MA: MIT Press. Harrison, A. (1996). "Openness and Growth: A Time-Series, Cross-Country Analysis for Developing Countries", Journal of Development Economics, 48, pp. 419-447. IMF (2002). "The Role of Capacity-Building in Poverty Reduction", Issues Brief No. 02/02, IMF (March). Jha, R. (2002). "Reducing Poverty and Inequality in India: Has Liberalization Helped?", Working Papers in Trade and Development No. 2002/04, Research School of Pacific and Asian Studies, Australia National University.

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Kanbur, R. and L. Squire (1999). "The Evolution of Thinking about Poverty: Exploring the Interactions", mimeo (September). Kundra (2001). "SEZs: How Well Will They Perform?", The Hindu, August 16. Lewis, A.W. (1954). "Economic Development with Unlimited Supplies of Labour", The Manchester School, 22, pp. 139-191. Martin, W. (2001). "Trade Policies, Developing Countries, and Globalization", mimeo (October). McMillan, M., S. Pandolfi and B. Salinger (1999). "Promoting Foreign Direct Investment in Labor-intensive, Manufacturing Exports in Developing Countries", Discussion Paper No. 42, Consulting Assistance on Economic Reform (CAER), Harvard University. Moon, B. (1997). "Exports, Outward-oriented Development, and Economic Growth", mimeo (September). Morrissey, O., J. Mbabazi and C. Milner (2002). "Inequality, Trade Liberalisation and Growth", Working Paper No. 102/02, Centre for the Study of Globalisation and Regionalisation (CGSR), University of Warwick. Naik, S.D. (2002). "Welcome Initiatives But No Big Leap", Business Line, Chennai, April 18. Radelet, S. (1999). "Manufactured Exports, Export Platforms, and Economic Growth", Discussion Paper No. 43, Consulting Assistance on Economic Reform (CAER), Harvard University. Rajan, R. (2002a). "International Financial Liberalisation in Developing Countries: Lessons from Recent Experiences", Economic and Political Weekly, 37, July 20-26, pp. 3017-3021. Rajan, R. (2002b). "Trade Liberalization and Poverty: Revisiting the Age-Old Debate", Economic and Political Weekly, 37, December 7-13, pp. 4941^1944. Rajan, R. and G. Bird (2002). "Trade Liberalization and Poverty: Where Do We Stand?", mimeo (November). Ravallion, M. (1999). "Protecting the Poor in Crisis", PREM Note No. 12, The World Bank. Ravallion, M. (2002). "An Automatic Safety Net?", Finance and Development, 39, June. Ravallion, M. and G. Datt (1996). "How Important to India's Poor is the Sectoral Composition of Growth", World Bank Economic Review, 10, pp. 1-25. Ravallion, M. and G. Datt (2002). "Why has Economic Growth Been More Pro-Poor in Some States of India Than Others?", Journal of Development Economics, 68, pp. 381-400.

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Rodrik, D. (1995). "Trade Strategy, Investment and Exports: Another Look at East Asia", Working Paper No. 5339, NBER. Rodrik, D. (2000a). "Can Integration into the World Economy Substitute for a Development Strategy?", mimeo (May). Rodrik, D. (2000b). "Comments on 'Trade, Growth, and Poverty' by D. Dollar and A. Kraay", mimeo (October). Rodriguez, F. and D. Rodrik (2000). "Trade Policy and Economic Growth: A Skeptic's Guide to the Cross-National Evidence", in B. Bernanke and K. Rogoff (eds.), NBER Macro Annual 2000, Cambridge, MA: NBER. Roemer, M. and M.K. Gugerty (1997). "Does Economic Growth Reduce Poverty", Discussion Paper No. 4, Consulting Assistance on Economic Reform II, Harvard Institute of International Development. Romer, P. (1994). "New Goods, Old Theory, and the Welfare Costs of Trade Restrictions", Journal of Development Economics, 43, pp. 5-38. Sachs, J. and A Warner (1995). "Economic Reform and the Process of Global Integration", Brookings Papers on Economic Activity, 1, pp. 1-118. Sachs, J., N . Bajpai and A. Ramiah (2002). "Understanding Regional Economic Growth in India", Working Paper No. 88, Center for International Development, Harvard University. Sharer, R. (2001). "An Agenda for Trade, Investment, and Regional Integration", Finance and Development, 38, December. Srinivasan, T.N. (2001). "Trade, Development and Growth", Princeton Essays in International Economics No. 225, International Economics Department, Princeton University. Stiglitz, J. (1998). "Towards a New Paradigm for Development: Strategies, Policies, and Processes", Prebisch Lecture at U N C T A D (Geneva, October 19). Subramaniam, A. and D. Roy (2001). "Who Can Explain the Mauritian Miracle: Meade, Romer, Sachs, or Rodrik", Working Paper No. 01/116, The World Bank. Timmer, P. (1997). "How Well do the Poor Connect to the Growth Process?", Discussion Paper No. 17, Consulting Assistance on Economic Reform (CAER), Harvard University. Tullock, G. (1967). "Welfare Costs of Tariffs, Monopolies and Theft", Western Economic journal, 5, pp. 224-232. Virmani, A. (2002). "A New Development Paradigm: Employment, Entitlement and Empowerment", Economic and Political Weekly, June 1, pp. 2145-2154.

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Watkins, K. (2002). "Making Globalization Work for the Poor", Finance and Development, 39, March. Winters, A. (2001). "Trade and Poverty: Is There a Connection?", in Trade, Income Disparity and Poverty, Lausanne: WTO. World Bank (1999). Poverty Trends and Voices of the Poor, Washington, DC: World Bank. World Bank (2000). World Development Report: Attacking Poverty, New York: Oxford University Press. World Bank (2002). Globalization, Growth and Poverty: Building an Inclusive World Economy, New York: Oxford University Press. Wolfensohn, J. (2000). "Remarks at the Tenth Ministerial Meeting of UNCTAD Rethinking Development — Challenges and Opportunities", remarks at the Tenth Ministerial Meeting of UNCTAD (Bangkok, February 16).

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Annex 1 Costs of Protectionism This Annex is a simple partial equilibrium illustration of the welfare costs of protectionism (or conversely, the welfare benefits from liberalization). Assume that a country is small, i.e. a price taker in world markets. Referring to Figure 1 below, in autarky, the country produces qa at a price p a . Assume that the foreign price level is p w < p a . Assume that the country imposes a per unit tariff on imports (t). Let p t = pw (1 + t) < p a , i-e. the tariffs are not prohibitive. The result of this trade policy is as follows: At price p t , domestic production is qj' and consumption is at q,}. The excess of consumption over domestic production (q c t ~qa t ) is made up by imports. What is the welfare impact of this tariff relative to free trade? Consumers clearly lose, with the loss given by the area DACE. Producers gain by the amount DXZE while the government gains tariff revenues of XABY. The difference between the consumer loss and the producer/ government gains is given by the two triangles XYZ and ABC or areas (i) and (iii). These are referred to as the Harberger triangles. In a classic piece, Tullock (1967) argued that some part of the government revenue (area (ii)) would be used on unproductive activities such as salaries of customs officials. Similarly, producers may engage in unproductive lobbying activity and expend resources to capture part of the producer surplus given by the quadrilateral (iv). Thus, while it is conventionally argued that the welfare costs of protectionism are the triangles (i) and (iii), with areas (ii) and (iv) being mere redistributive transfers from consumers to the government and producers, so respectively, in actual fact these are not just transfers as resources are expended for unproductive activities (i.e. they are "social losses"). Price ($)

quantity (q)

The Nexus between Trade Liberalization and Poverty in Asia

Table 1 Functional Income Distribution of Trade Liberalization Over Time Short run (Immobile Factors) Export Industry

Import Industry

Workers

Gain

Lose

Capitalist-owners

Gain

Lose

Medium run (only Capital Immobile) Export Industry

Import Industry

Workers

?

?

Capitalist-owners

Gain

Lose

Long run (all Factors Mobile) Export Industry

Import Industry

Workers

Gain

Gain

Capitalist-owners

Lose

Lose

131

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Table 2 Why the Stolper-Samuelson (SS) Theorem may be Limited Help for Analyzing Poverty The functional distribution of income is not the same as the personal distribution of income: T h e income of a given household is only indirectly linked to the returns to various factors of production. It depends on their ownership of the various factors, which is usually very difficult to ascertain empirically. Dimensionality: T h e very powerful SS result holds only in a model with 2 factors and 2 goods. Once we move beyond this, the results are much weaker. In an n x n model each factor has an "enemy" — a good whose price increases definitely hurt the factor — but not necessarily a "friend". In non-square (i.e. m x n) models, with different numbers of factors and goods, unambiguous results are even scarcer. Diversified equilibrium: T o be sure of SS effects, the country must be producing all goods, both before and after the price change in question. If we distinguish many different goods at different levels of sophistication, this is unlikely. If countries do n o t produce all goods, the basic mechanism can break down, and perverse results are possible. Differentiated goods: SS is based on a model in which goods are homogeneous across foreign and domestic suppliers. Many argue that goods are better thought of as differentiated, in which case the critical issue is how closely domestic varieties are substitutable for the foreign varieties whose prices have changed. If the answer is "rather little", the prices of domestic varieties will be only slightly affected by trade shocks but there will be little quantity response to the price increase for the imported variety, so the terms of trade losses from the price increase will be correspondingly unmitigated. Constant returns to scale (CRS) and smooth substitution between factors: If industries are subject to economies of scale, their responses to price shocks will tend to be larger than a CRS approach suggests. Also, under such circumstances it is possible for all factors to gain or lose together, which weakens t h e inter-factor rivalry aspect of SS. Similarly, if technology is endogenous, or if labour can be substituted for other factors only in discreet steps, there may be discontinuities in the way factor prices respond to shocks. Perfectly competitive goods and factor markets: These are required for the direct and simple transmission of goods price shocks into factor price effects. Once there are economic rents in the system, transmission becomes more complex and difficult to predict. Non-traded goods: If some goods are non-traded, their prices are no longer determined by world prices plus tariffs, but by the need to clear the domestic market. They will accommodate shocks through both price and quantity responses, rather than just the latter as for traded goods in a small country. This will tend to attenuate the rate at which tradable goods price shocks are translated into changes in the relative demands for different factors. Reference set of relative factor abundance: Davis (1996) shows that countries that may be labour-abundant in a global sense may yet experience a worsening of income if it is capitalabundant in a regional or local sense.

Source: Adoption and extension of Winters (2001)

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Table 3 Income Inequality Changes in 73 Countries from the 1960s to 1990s Inequality Rising

Developing Countries

Transitional Countries

Total

12: Australia, Canada, 15: Argentina, Chile, China, Columbia, Denmark, Finland, Costa Rica, Guatemala, Italy, Japan, Netherlands, New Hong Kong, Mexico, Pakistan, Panama, Zealand, Spain, South Africa, Sweden, UK, USA Sri Lanka, Taiwan, Thailand, Venezuela

21: Armenia, Azerbaijan, Bulgaria, Croatia, Czech Rep. Estonia, Georgia Hungary, Kazakhstan, Kyrgyztan, Latvia, Lithuania, Macedonia, Moldova, Poland, Romania, Russia, Slovakia, Slovenia, Ukraine, Yugoslavia

48

Developed Countries

Constant

3: Austria, Belgium, Germany

12: Bangladesh Brazil, Cote d'lvoire Dominican Rep, El Salvador, India, Indonesia, Puerto Rico, Senegal Singapore, Tanzania, Turkey

1. Belarus

16

Declining

2: France, Norway

7: Bahamas, Honduras, Jamaica, South Korea, Malaysia, Philippines, Tunisia

0

9

All

17

34

22

73

Source: Cornia and Court (2001)

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Chapter 6

India's Decade Long Trade Reforms: How Does It Compare with Its East Asian Neighbours? 1

1. Introduction The strategic objective of Indian policy-makers at the outset of independence was the creation of a self-reliant economy and the reduction of the high levels of poverty that existed, all within a democratic political framework. In order to achieve these objectives, the authorities steadfastly pursued a Socialist strategy of state-directed, heavy industry based industrialization complemented by an acrossthe-board import substitution policy, financial repression and complex industrial requirements. Notwithstanding some notable successes, the highly statist and interventionist development policies adhered to during this period of insulation led to a severely distorted production structure (Raj an and Marwah, 1998). While growth did pick up in the latter half of the 1970s, the Indian economy was generally mired in a vicious circle of low productivity/product obsolescence and slow growth. Not only was the performance of the Indian economy well below the targets set by the planning authorities, the country was left lagging in terms of economic growth and development relative to its East Asian neighbours such as China and South Korea which had broadly similar levels of per capita income at the time of India's independence (Kelkar, 2001). Jagdish Bhagwati (1992) rationalizes India's development failure as follows: I would divide them into three major groups: extensive bureaucratic controls over production, investment and trade; inward-looking trade and foreign investment policies; and conventional confines of public utilities and infrastructure. The former two adversely affected the private sector's efficiency. T h e last, with the inefficient functioning of public sector enterprises, impaired additionally the public sector enterprises' contribution to the economy. Together, the three sets of policy decisions broadly set strict limits to what India could get out of its investment (p. 13). 'This Chapter was co-authored with Rahul Sen and is an update and revision of Rajan and Sen (2002).

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Although some tentative steps were taken in 1985 to liberalize and unshackle the economy by delicensing a few industries, these partial and rather ad hoc measures contributed to the creation of severe and unsustainable macroeconomic imbalances in the Indian economy, particularly with regard to escalating fiscal deficits (Joshi and Little, 1996). The imbalances corresponded to a period of severe political instability and uncertainty following three successive minority governments during 1989-91. While the fragilities in the Indian economy were largely homemade, the shock of the 1990 Gulf war was the single factor which "broke the camel's back", as India was brought to the brink of an international default, something that had never occurred in its post-independence history. Faced with a severe balance of payments crisis — foreign exchange reserves plummeted to US$1 billion in late June 1991 — barely sufficient to cover a fortnight worth of imports, India entered into an IMF structural adjustment program (Cerra and Saxena, 2000). In addition to the conventional expenditure switching and reducing policies, as part of the IMF agreement, a range of far-reaching economic policy reforms was launched in July 1991 in the external, industrial, financial and public sectors (Desai, 1999 and Srinivasan, 1996). With regard to the trade reforms specifically, while India continues to have one of the world's most restrictive external sectors, significant progress has been made in recent years towards a compression and simplification of tariff structures. India's tariff structure has become more uniform across goods, as observed by a decline in the dispersion of tariff rates over 1990-98 (Table 1). India aims to have in place a tariff structure similar to the middle-income Developing East Asian (DEA) economies in the next 5-11 years. Noteworthy steps have also been taken to reduce nontariff barriers (NTBs) and eliminate quantitative restrictions (quotas and import licensing requirements), particularly on intermediate and capital goods (IMF, 1998, 2002). These reforms have coincided with positive developments at the macroeconomic level. The Indian economy recovered smartly from the crisis, real GDP growing at an annual average rate of 6.4 percent between 1992 and 1998 (Table 2) 2 . Not only was this a marked improvement from India's own past, it was the second highest rate of growth in the world behind China. Of equal importance is the quality of growth. As Desai (2000) has noted, "the Indian economy appears to be ... sound ... Something has changed; we are no longer in the boom-and-bust mode of the 1960s, 1970s or 1980s" (p. 4). This in turn may be partly attributable to the fact that post-1991 growth was driven principally by an expansion of private

2

The IMF (1998) and Kalirajan (2001) have detailed India's trade and investment policy reforms over the last decade.

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investments while national savings simultaneously rose, thus ensuring that there was no significant pressure on the balance of payments position (compared to the consumption-led growth of the mid to late 1980s). This Chapter concentrates on the impact of India's trade reforms in the 1990s on its international trade linkages with the rest of the world. The next Section documents the extent to which India's engagement with the global trading system has increased. Section 3 goes on to analyze shifts in India's export patterns over the past two decades and compares it to that of East Asia which has long been characterized as having followed a "flying geese pattern" (FGP) of production and trade. The FGP, due to Japanese economist Akamatsu Kaname, has been used to describe the shifting pattern or spatial reorganization of international production and comparative advantage across East Asian countries (see Kojima, 2000). Data limitations invariably limit focus of the empirical analysis in Sections 2 and 3 to merchandise trade. However, as part of India's newfound global orientation, trade in services has taken on a key role, constituting over a quarter of India's total exports in 1999/2000 (IMF, 2002 and Raipuria, 2001). Within the services sector, the Information and Communications Technologies (ICT) sector is of particular relevance. This sector is seen as a means of "leapfrogging" the stages of trade and development that is characteristic of the FGP pattern, and is the focus of Section 4. The final Section concludes the Chapter.

2. Evolution of India's Merchandise Trade in the 1990s 2 . 1 . Trade reforms to date It is instructive to note that India's trade liberalization efforts can be broadly divided into two periods. The first half of the 1990s (from 1991 to 1996) was a period of intense liberalization as tariffs fell dramatically. The second half of the 1990s can at best be characterized as a period of consolidation of but definite deceleration in the pace of tariff compression in general; the average tariff level remained largely unchanged. In fact, while the simple average tariffs remained more or less constant, there was a slight increase in the trade-weighted tariffs from a low of 25 percent in 1996 to 30 percent by 2000. The Indian rupee was allowed to float in March 1992, and currency convertibility on the current account was introduced in August 1994 3 . One needs to be cognizant of the fact that the reform efforts in India are fairly recent and an ongoing process; the full effects will therefore take time to come 3

It is by no means suggested that such nominal tariffs are a complete measure of the degree of a country's openness (see Panagariya, 1999 and Pritchett, 1996).

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into fruition. Nonetheless, it is fair to ask if and to what extent the decade long reforms have been successful in integrating India with the global market economy. Table 3 summarizes the key indicators of India's external sector, while Table 4 compares India's indicators to the major DEA economies for the period 1980-98. Figure 1 charts movements in India's share of global trade. The following general observations may be delineated on the basis of available data 4 . First, India has been able to gradually increase its share in global merchandise trade and exports from 0.58 percent and 0.44 percent in 1980 to 0.74 percent and 0.69 percent, respectively in 1999. While this increase may not appear particularly striking at first, it is, considering that India's share in world merchandise trade was more or less on a declining trend during the early 1990s. Between 1990 and 1999, India's merchandise trade and exports grew at an annual compound average of 8.2 percent and 9.0 percent, respectively. Since this growth was matched by an expansion of the overall economy, India's level of de facto openness, as proxied by the trade to GDP ratio, has remained more or less constant over the past few years at 0.25 (though this was almost 70 percent higher than that in 1980). These improvements notwithstanding, India has continued to lag behind the DEA economies 5 . For instance, India's exports to GDP ratio was the lowest among all the countries considered here between 1980 and 1989, and this remained so during the post-reform period. India's share of manufactured exports in total exports during the 1980-89 period was higher than all the DEA economies except Korea, but by 1990-98, all of them except Indonesia and the Philippines surpassed India in diversifying their export baskets towards manufactured goods (World Bank, 2000). Second, an analysis of India's composition of exports over 1988-90 to 1998-2000 (Table 5) reveals that while India's export dependence on primary products, as indicated by its average share in India's total merchandise exports, declined over the period (from 24 percent in 1988-90 to about 20 percent in 1998-2000), that on manufactured products increased slightly (from 71 percent in 1988-90 to 77 percent by 1998-2000). W i t h regard to the manufactured exports during the 1998-2000 period, the largest share of exports consisted of Handicrafts, primarily Gems and Jewellery (18.0 percent), Engineering goods (14.0 percent), Readymade Garments (12.3 percent), Textile Yarn Fabrics

4

The IMF (1998) and Kalirajan (2001) have detailed India's trade and investment policy reforms over the last decade, while Forbes (2001) provides a useful discussion of the practical implications of these reforms for businesses operating in or planning to operate in India. 5

Except for China, the other East Asian countries were significantly affected by the financial crisis of 1997-98.

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(11.6 percent) and Chemicals and Allied products (8.8 percent). This product composition remained almost unchanged over the past decade or more 6 . 3. The Flying Geese Pattern: India versus East Asia While there has been an increase, albeit modest, in the degree of India's global economic integration since the initiation of the reforms, it is important to understand the reasons behind this. Accordingly, we examine shifts in India's comparative advantage in merchandise trade. As before, it is insightful to have a yardstick of comparison. We therefore place India's export experience in an East Asian context. The shifting composition of trade, and the catching up of the East Asian countries, has often been described as following the flying geese pattern (FGP) (see Feenstra and Rose, 2000 for a recent empirical confirmation of this phenomenon). According to the FGP, economies are arranged in a descending order of their stages of industrialization so that countries participate in the international division of labour at different stages in the product cycle in accordance with their comparative advantage. In other words, the traditional Heckscher-Ohlin approach is extended and given a dynamic nature. Specifically, it has become legion to think of international production and trade in East Asia in terms of Japan as the most advanced economy producing and exporting new and higher value added goods before others in the region. Japan in turn has been tailed closely by the four economies, Hong Kong, Korea, Singapore and Taiwan, collectively referred to as the "Four Tigers". Then come the other crisis-hit economies (Malaysia, Thailand and Indonesia or MIT economies), and behind them, China and other emerging regional Southeast Asian countries such as Cambodia, Lao and Vietnam. 3.1.

Methodology

In order to proceed with the empirical analysis, we make use of the conventional concept of Revealed Comparative Advantage (RCA) introduced by Balassa (1965) and extended upon by Balassa and Noland (1989). According to Balassa, since £>re-trade relative prices are unobservable, analysis of trade patterns often needs to depend on post-trade data; the pattern of international trade broadly

6

It is interesting to note here that among these top products in India's manufacturing export basket, almost all have involved some amount of foreign investment, except for Gems and Jewellery. Incidentally, Engineering goods and Chemicals and Allied industries were opened to foreign investment since 1970s, while ready-made garments and textiles was opened to foreign investment during the early 1990s (Sharma, 2000).

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reflects relative costs and differences in non-price factors. The most commonly used ex-post trade index is the export index of R C A (XRCA). The XRCA index is simply the ratio of the share of country i in world exports of commodity k to its share of total commodity exports. This index is represented as XRCA = (Xj7X£,)/(Xi/XJ, where X^ = exports by country i of commodity k; Xjj, = world exports of commodity Jc; X; = total exports of country i; and Xw = total world exports. The weighted average of XRCAs of all commodities equals one. A n individual XRCA index value greater than one indicates an ex-post or a revealed comparative advantage in the good, and if less than one, it indicates a comparative disadvantage. A major limitation of this index is that at any point in time it takes into account only one side of the trade flows, i.e. exports or imports. Nonetheless, this index has been widely used to explain the export performance and similarity of trade patterns among the East Asian countries (for instance, see Chow, 1990 and Rana, 1990). We analyze the shifting pattern of trade between India and its East Asian neighbours using a slightly modified version of XRCA. Following Laursen (1998), we rely on the Export Revealed Symmetric Comparative Advantage (XRSCA) index, wherein the conventional XRCA index is modified to make it symmetric. The modified XRCA takes on values between 1 (highest comparative advantage and degree of specialization) and — 1 (no specialization) 7 . T h e XRSCA is defined as follows: XRSCA = ( X R C A - 1 ) / ( X R C A + 1 ) . A positive value of XRSCA indicates the presence of specialization in that particular product category and therefore a high degree of de facto comparative advantage in this area. We examine shifts in comparative advantage in selected product groups of manufactured exports according to the factor intensities classification developed by Garnaut and Anderson (1980) 8 . The authors classify product groups of trade in manufactured goods into four main categories depending on whether labour or capital (either physical or human capital) is used more intensively in production of those commodities 9 . As noted, the XRSCAs are estimated for India and the selected DEA economies to enable a cross-country comparison of shifting comparative advantage

7

Unlike the conventional XRCA, the XRSCA index can also be used in econometric analysis to understand the pattern of change in specialization of exports in a particular commodity category as the error terms of XRCAs are normally distributed. 8 9

See Annex 1 for details on the classification.

T h i s classification covers the SITC categories 5 to 8 at the 3-digit level. This classification is still fairly aggregated since it does not differentiate between unskilled labour intensive and capital/technology intensive activities at further disaggregated (SITC 5 digit) commodity levels, i.e. parts and components and accessories (PCAs) of manufactured products.

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in manufactured goods. The shifting pattern of product specialization is then investigated using the XRSCA series for these countries in order to relate the observed changes to those predicted by the FGP of international production and trade. The indices are worked out for the years 1982, 1987, 1992, 1996, 1997 and 1998. The data source for all countries is the UN International Trade Statistics Yearbook. 3.2.

Results

Tables 6 and 7 respectively present the estimated XRSCAs for each commodity group, along with their shares in each country's total exports as well as in world exports. The results reveal that India continues to specialize heavily in unskilled labour intensive (ULI) manufacturing goods, especially in textiles and textile yarns and in clothing and accessories, as observed by the increase of XRSCA indices in this category from 0.34 to 0.56 between 1982 and 1996. The share of ULI goods in India's total exports nearly doubled during this period from 17.5 percent in 1982 to 33 percent in 1997, while the indices relating to the total world exports of ULI goods also showed a marginal increase from 1.1 percent in 1982 to 1.5 percent by 1997. However, India's level of specialization in this category has actually declined since 1996. Among other categories, India's XRCA indices in Physical Capital Intensive (PCI) goods have shown some degree of improvement over the same period, while more differentiated and sophisticated Technology Intensive (TI) and Human Capital Intensive (HCI) goods have not experienced any discernible improvement (their XRSCA values actually declined in 1996). The share of TI goods in India's exports nearly doubled over this period, though its share in world exports saw a negligible increase from 0.14 percent to 0.17 percent. Therefore, although in relative terms there has been a positive shift in the composition of its exports towards TI goods during the reform period, India has not been able to attain international competitiveness in this category despite a decade of liberalization. In contrast, the majority of the DEA economies focused their export thrust towards technology intensive goods over time with rising per capita incomes, consistent with the prediction of the FGP hypothesis. More evidence of this is given by the increases in East Asia's XRSCAs in TI goods and changes in signs from negative to positive over 1982-98. Malaysia, the Philippines and Korea attained comparative advantage in TI goods by the beginning of the 1990s, while China attained this status in 1998. Other than China and Indonesia, the shares of TI goods in total exports of all other East Asian developing countries were more than half of their respective exports by 1998. The shares increased four to

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five fold for most of these countries over the 1982-98 period. A notable aspect of East Asia's export dynamism is that the share of all these countries' exports in world exports increased significantly (by more than double or triple) over this period. Telecommunication equipment, Electrical Machinery and parts, and more recently, Electronic products, viz. Data Processing Machines, have been the major items of export among TI goods. All the DEA economies other than Malaysia were specialized in unskilled labour intensive (ULI) goods during this period. The Philippines and Korea have been distinctly moving away from this area of export specialization, as observed by a decline in the absolute values of their XRSCAs from 1997. Their shares in world exports of ULI goods and in their total exports have also declined during this period. Only China and Indonesia still remain heavily specialized in ULI goods. Among other categories, Physical Capital Intensive (PCI) goods have also managed to increase their shares in East Asia's exports over time, though Korea is the only country that attained an outright comparative advantage in this area. Human Capital Intensive (HCI) goods declined in their comparative advantage for most of these countries, with the exceptions of Korea and Indonesia which attained comparative advantage in this category by 1998. Comparing shifts in India's export patterns to those of East Asia, it is clear that India's XRSCA value in this category is comparable to that of Indonesia and Korea in 1998. China had a higher level of export specialization in this category than did India, with 56 percent of its exports taking the form of ULI goods. A t the same time, while the East Asian developing countries including China deveL oped a significant comparative advantage in TI goods in the 1990s, India has been unable to do so. The DEA economies have, almost without exception, also improved on their ex-post comparative advantage in HCI goods, indicating a con' stant shift in the composition of these countries' exports over time. Thus, while Korea was at a higher level of specialization in ULI goods in 1982 compared to that of India during the same period, it managed to halve it by 1998; in contrast, India experienced a slight increase. A further interesting observation is that in 1982 India was at the same level of specialization in TI goods as the Philippines and China were in 1987. However, while the Philippines attained comparative advantage in this category of exports by the mid-1990s and China did so in 1998, India has failed to experience even a marginal improvement in the existing level of specialization in TI goods. Even Indonesia, which was negligibly specialized in this category in 1982 and had lower XRCAs and XRSCAs compared to India, increased it significantly by 1996. To complement the foregoing analysis, we have computed the rank correk' tion of XRSCAs of India (products being ranked in each country in descending order of XRSCA values) as well as the selected DEA economies over five different

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sub-periods between 1982 and 1997. The results are presented in Table 8 10 . The rank correlation of XRSCAs among the different periods in a country indicates the degree of export specialization/de-specialization (i.e. extent of export product dynamism) over time. A positive rank correlation value of unity indicates no change in specialization. Values close to zero indicate a discernible change in the rankings of the XRSCA index values, denoting the presence of export dynamism. The results indicate that over the decade of 1987-97, changes in the degree of export specialization experienced by India were lower than each of its East Asian neighbours, and there was no discernable change in this trend in the post reform period. Thus, over a fifteen-year period of 1982-97, the rank correlation of India's XRSCAs exceeded those of the DEA economies, indicating that India's export structure was relatively much less dynamic. Table 9 shows the results of pair-wise correlation of export structures of the four-product groups (for which XRSCAs are computed) between India and the individual DEA economies for 1987 (five years before reforms) and 1997 (five years after reforms). In 1987, India's export structure for these products was similar to that of China (a correlation of 0.96), followed by Indonesia (0.82) and Korea (0.79). However, the degree of correlation declined substantially by 1997, with India's export structures in these four product categories of manufacturing goods being closest to that of Indonesia (0.76) followed by China (0.68). 3.3.

Summary and Caveats

The preceding empirical results, while expectedly mixed at times, do by and large indicate that reforms initiated in 1991 have shown some positive signs in terms of more rapid growth in India's merchandise trade and rising share in world exports, as well as in infusing greater dynamism into the country's overall export structure 11 . Notwithstanding an improvement in the country's overall export performance since the reforms, India continues to lag far behind most of its East Asian neighbours. The latter have been successful in diversifying and upgrading their exports towards high growth-oriented, technology intensive and knowledge-based products in the manufacturing sector. The fact that India had a head start in the industrialization process over most of the DEA economies in the 1950s puts in perspective the extent to which the heavily protectionist regime has held India

10 11

Specifically, Table 8 summarizes the rank correlations and not the product rankings.

Empirical analysis suggests that a real depreciation of the Indian rupee as well as a general boom in world trade are important explanatory factors of India's post-reform export spurt (Brahmbhatt et al., 1996 and Sharma, 2000).

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back. India's insular policy precluded it from harvesting the benefits that were reaped by other DEA economies from actively engaging in the international division of labour 12 . Despite the recent reforms, India's level of overall integration in the global trading system in merchandise trade remains rather low. The foregoing results, while revealing, must be interpreted with some degree of caution. As indicated, the XRSCAs have been computed at the 3-digit product level which does not adequately differentiate between the final good and its parts, components and accessories (PCAs) 1 3 . Accordingly, the distinction between technology intensity and labour intensity becomes blurred at times. For instance, Electronic goods exports are considered to be technology or capital intensive according to the Garnaut and Anderson (1980) classification, whereas within this product group, production and exports of its PCAs may vary in factor intensities, with some being relatively labour intensive. This is likely to be particularly relevant for XRSCAs computed for manufactured exports of DEA economies in the SITC 7 category (Machinery and Transport equipment) since PCAs in East Asia constitute about one-fifth of the region's manufacturing exports (Ng and Yeats, 2001) 14 . What explains this pattern of trade in East Asia, and why is India not observed to be following the FGP? As noted, Japan has been a major player in expanding East Asian trade and upgrading the region's industrial structures via the infusion of FDI. In other words, East Asian trade has been largely investment-driven (Athukorala and Hill, 1998 and Fung et al., 2002). Japanese FDI to East Asia really took off following the sharp appreciation of the yen after the Plaza Accord of September 1985. Inflows essentially took place in three sequential but overlapping stages. Investments were initially made in the newly industrialized economies (NIEs) like Korea, Hong Kong, Singapore and Taiwan during 1986-89. Labour-intensive Japanese investments then began to be diverted to Southeast Asian countries (Malaysia, Indonesia and Thailand or MIT specifically) from 1988 to the early 1990s, attracted by the low wage levels and rapid growth of the region. As the NIEs themselves moved to more capital

It is ironical that India was one of the 23 original signatories to the General Agreement on Tariffs and Trade ( G A T T ) in 1947. 13 Such differentiation may be better done at the SITC 4 and 5 categories. Ng and Yeats (2001) show that within the SITC 7 category, at least 60 individual product groups consisting solely of PCAs on manufactured equipment can be identified. Chapter 1 offers a number of references on the theory of trade in PCAs. 14

Ng and Yeats (2001, Table 2) observe that apart from exports, nearly three-fourths of East Asian imports of telecommunication equipment (SITC 76) and a half of Office machinery (SITC 75) were PCAs for further assembly.

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and skill intensive stages of production, NIE firms also began using the MIT countries as export platforms for labour intensive PCAs, as observed earlier. Since the early 1990s, investments in China from Japan and other NIEs have grown dramatically (Fung et al., 2002) 15 . In contrast, Japan has been an insignificant source of FDI to India. For instance, between 1998 and 2001, India accounted for a paltry 3 percent of Japan's total number of projects in Asia and less than 1 percent in value terms (data from the Ministry of Finance, Japan). India, being a latecomer to the international stage, clearly missed the boat in terms of being part of this regional division of labour in manufactured PCAs.

4. India's Emerging Comparative Advantage in Services Trade India has fared much better in the area of services trade, particularly new and dynamic sectors like information and communication technology (ICT). The services sector in India has outperformed merchandise trade, especially over the post-reform period. Thus, while merchandise and services trade expanded at almost the same rate between 1980 and 1989 (9 percent), the average annual growth of services trade over the 1990-98 period was about 15 percent (Raj an and Sen, 2002). India's services trade grew by nearly double that of merchandise trade during the 1992-98 sub-period itself. India's share in Asia's exports of commercial services (as defined by the W T O ) increased from 3.5 to 5.8 percent between 1990 and 2000 (WTO, 2001, Table 111.79). The ICT services sector comprises IT related and enabled services, viz. those involving trade in and use of computer software, hardware and the like, as well as services involving communications technology, viz. the Internet, E-commerce and the telecommunications sector. This category of services spans a wide range of activities and primarily involves the extensive use of knowledge and information as a vital input in the factor of production, combining the latest developments in electronic and communications technology. While ICT services were viewed as being nontradable just a few years ago, they have in fact been the main thrust of rapid expansion of services trade in India, accounting for nearly 58 percent of service exports and about 16 percent of total exports in 1998 (Table 10). Their share in India's services export was almost

15

In fact, the Southeast Asian policy-makers have expressed concerns about what they perceive as a diversion of investments from their countries to China (Wu et al., 2002). Their response has been to hasten the implementation of the ASEAN Free Trade Agreement (AFTA), as well as take early steps to create an ASEAN-China Free Trade Agreement.

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double that in 1995 16 . In comparison to the DEA economies in 1997, before the regional financial crisis of 1997-98 began, the share of ICT exports (to total services exports) in India was higher than that of China, Indonesia and Korea. During the crisis year of 1998, India had the second highest share in ICT service exports after the Philippines, and was the only country apart from Indonesia which experienced an increase in the share of ICT goods. The development of the ICT industry in India has been primarily attributable to the software and product services segments which posted an average revenue growth of about 50 to 60 percent annually during the 1990s; from a mere US$20 million 10 years ago to US$5.6 billion in 1999-2000. Growth of software development has been overwhelmingly market-driven, as opposed to being government-led; government intervention has been minimal ("hands off) and largely reactionary. Its expansion has been propelled by an increasing international demand for such skills, mainly from the US market, on the one hand, and India's nurturing of a pool of skilled IT professionals, on the other 17 . The Indian software industry employs some 160,000 professionals and contributes around 10 percent of India's total merchandise exports. However, despite this rapid growth, India's share of the total global software market is still a mere 1-2 percent 18 . The fact that India's share of the total global software market is currently miniscule, suggests there may be significant scope for future expansion. In view of this, the Indian government has identified the software industry as a major export and growth thrust area. A comparison of the major potential factors influencing the development of ICT-enabled services reveals that India ranks favourably in comparison to some leading DEA economies, with a clear advantage in terms of workforce availability and skills, and also in terms of a cosmopolitan work culture (NASSCOM, 2001). Some segments of ICT-enabling services (such as back-office operations, remote maintenance, medical transcription, call centers, content development and remote maintenance) have been important sources of employment generation in India.

16

Using the XRSCA index for services, Sen (2002, Table 8) estimated that India gained a significant comparative advantage in ICT-enabled services over 1990-99 as shown by a marked movement towards a positive XRSCA from 0.10 to 0.18. 17

India possesses the world's second largest pool of scientific manpower that is also English speaking (see Arora and Athreya, 2001, Bajpai, 2001, Miller, 2001 and Tschang, 2001). 18

See uiww.hyderabad.com/news/200W322/newsl8.htm. However, India's share in other submarkets is above 10 percent. For instance, India commands an 18 percent market share in the global customized software market.

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Despite the foregoing advantages, there can be no room for complacency. Over the years, the growth in the computer software sector has been much more rapid and steady than that of the hardware sector. The development of the hardware sector has been held back by severe and longstanding bottlenecks in infrastructure and supporting facilities (discussed in Brahmbhatt et al., 1996), and a rather unattractive tax regime. The DEA economies including China have outperformed India in this area 19 . Lai (2001) has suggested that "the hardware sector is thoroughly demoralized in India... India needs a positive agenda rather than merely adopting a laissez faire policy ... in IT manufacturing" (p. 116). In addition, the diffusion rates across the population have been much slower in India compared to its East Asian counterparts. Thus, while the use of mobile phones, facsimile machines, cable television sets and Internet services in India increased significantly during 1995-97 compared to earlier periods, their utilization rates still lagged far behind the DEA economies (Miller, 2001 and Table 11). In part, India has lagged because of a late recognition of the potential in this sector and a lack of proper policy and institutional framework to encourage the usage of ICT in India in the beginning of the 1990s 20 . To conclude, the development of India's ICT sector in general has brought substantive advantages to the country over and above direct employment creation and being an additional source of export earnings. As Miller (2001) has noted: The fact that India is demonstrably competitive internationally in the production of sophisticated software brings other advantages to the country. Indian technological sophistication, though still narrowly defined, has begun to alter international perception of the country. Instead of viewing India as a country burdened by decades of heavy-handed government regulation of the economy, foreigners now view the country somewhat more favourably... (p. 21) 21 .

19 This being said, this component of trade is reflected in merchandise trade statistics and has already been discussed in Section 2. 20

This is admittedly a double-edged sword because, as noted, absence of government regulations is what facilitated the development of this area in the first instance. The key is to ensure that government initiatives are constructive rather than onerous and stifling. Admittedly, as with many other developing countries, India's track record as far as this is concerned leaves a lot to be desired. Hitherto, government failures in India appear to have far outweighed market failures. 21

Former US Treasury Secretary, Paul O'Neil, noted on a recent visit to India — "It is the corner of technological progress and modernity. It is also a land still burdened by massive poverty" (O'Neil, 2002).

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5. Concluding Remarks India has made some important strides since the initiation of the reform program in 1991 and has been one of the fastest growing economies in the world in recent times. Given that the liberalization program in India has been evolutionary (with inevitable hiccups and backtracking in the interim) rather than revolutionary, a decade offers too few degrees of freedom to pass definitive judgment on the longer-term prospects of the Indian economy. Nonetheless, considering that India faced virtual bankruptcy in mid-1991, its economic performance since then has been laudable and rather under-appreciated. On the positive side, all indicators reveal that the reduction of the antiexport bias has allowed the Indian economy to attain an unprecedented degree of integration with the global economy in the 1990s. India has developed a significant comparative advantage in services trade, especially in ICT related and enabled services, which offer significant opportunities for the economy to leapfrog the development stages and "catch up" with the fast growing DEA economies. In reference to this, Bajpai (2001) has noted: Inspired by the success of Singapore, several developing countries consider IT as a unique opportunity to leapfrog whole stages of industrial development. Having missed the first two industrial revolutions, they are eager not to miss the third one — the making of the knowledge economy (p. 13). On the negative side, India remains highly inward looking in comparison to China and its other East Asian neighbours which engaged with the multilateral trading system and laid out the welcome mat for FDI much earlier (since the late 1970s and early 1980s) 22 . Accordingly, India has largely been left out of the global division of labour, particularly with regard to parts, components and accessories (PCAs) production. Poor quality public infrastructure, inflexible labour laws, barriers to entry and exit, and a milieu of other administrative and institutional burdens that contribute to a sluggish environment, have impeded investments in the manufactured sector, thus contributing to India's comparatively modest trade performance in this area. The policy framework related to attracting

22

The former Governor of India's central bank (Reserve Bank of India), Bimal Jalan, recently noted: Despite all the talk, we are nowhere even close to being globalized in terms of any commonly used indicator of globalization. In fact, we are still one of the least globalized among major countries — however, we look at it (Jalan, 2002).

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Economic Globalization and Asia

and implementing FDI proposals in India also needs to be more stable, consistent and supporting if the country is to fully realize its considerable latent investment and overall economic potential.

Bibliography Arora, A. and S. Athreya (2001). "The Software Industry and India's Economic Development", Discussion Paper No. 2001/20, United Nations University-WIDER. Athukorala, P. and H. Hill (1998). "Foreign Investment in East Asia: A Survey", AsianPacific Economic Literature, 12, pp. 23-50. Bajpai, N. (2001). "Sustaining High Rates of Economic Growth in India", Working Paper No. 65, Center for International Development, Harvard University. Balassa, B. (1965). "Trade Liberalisation and 'Revealed' Comparative Advantage", Manchester School of Economic and Social Studies, 33, pp. 99-123. Balassa, B. and M. Noland (1989). "Revealed Comparative Advantage in Japan and the United States", journal of International Economic Integration, 4, pp. 8-22. Bhagwati, J.N. (1992). India's Economy: The Shackled Giant, Oxford: Clarendon Press. Brahmbhatt, M., T.G. Srinivasan and K. Murrell (1996). "India in the Global Economy", Policy Research Working Paper No. 1681, World Bank. Cerra, V. and S. Saxena (2000). "What Caused the 1991 Currency Crisis in India?", Working Paper No. 00/157, IMF. Chow, P. (1990). "The Revealed Comparative Advantage of the East Asian NICs", The International Trade Journal, 5, pp. 235-262. Desai, A.V. (1999). "The Economics and Politics of Transition to an Open Market Economy: India", Technical Paper No. 155, Paris: OECD Development Centre. Desai, A.V. (2000). "India's Reforms: Achievements and Arrears", Working Paper No. 67, Center for Research on Economic Development and Policy Reforms, Stanford University. Feenstra, R. and A. Rose (2000). "Putting Things in Order: Patterns of Trade Dynamics and Growth", Review of Economics and Statistics, 82, pp. 369-382. Forbes, N. (2001). "Doing Business in India: What has Liberalization Changed", Working Paper No. 93, Center for Research on Economic Development and Policy Reforms, Stanford University.

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Fung, K.C., H. Iizaka and A. Siu (2002). "Japanese Foreign Direct Investment in China and Other Asian Countries", mimeo (October). Garnaut, R. and K. Anderson (1980). "ASEAN Export Specialization and the Evolution of Comparative Advantage in the Western Pacific Region", in R. Garnaut (ed.), ASEAN in a Changing Pacific and World Economy, Canberra: ANU Press. IMF (1998). "India: Recent Economic Developments", Staff Country Report No. 98/120, IMF. IMF (2002). World Economic Outlook, Washington, DC: IMF. IMF. International Financial Statistics, various issues. Jalan, B. (2002). "Address by the Reserve Bank Governor at the Thirty Six Convocation of the Indian Statistical Institute" (Kolkata, January 15). Joshi, V. and I.M.D. Little (1996). "Macroeconomic Management in Indian 1964-94", in V.N. Balasubramanyam and D. Greenaway (eds.), Trade and Development: Essays in Honor ofjagdish Bhagwati, London: MacMillan Press. Kalirajan, K. (2001). "The Impact of a Decade of India's Trade Reforms", paper presented at conference on a Decade of Reforms in India (Australia National University, Canberra, November 20-21). Kelkar, V.L. (2001). "India's Reform Agenda: Micro, Meso and Macro Economic Reforms", Fourth Annual Fellows Lecture 2001, Centre for the Advanced Study of India, University of Pennsylvania. Kojima, K. (2000). "The 'Flying Geese' Model of Asian Economic Development: Origin, Theoretical Extensions, and Regional Policy Implications", Journal of Asian Economics, 11, pp. 375-401. Lai, K. (2001). "Institutional Environment and the Development of Information and Communication Technology in India", The Information Society, 17, pp. 105-117. Laursen, K. (1998). "Revealed Comparative Advantage and the Alternatives as Measures of Specialization", Working Paper No. 98-30, Copenhagen Business School, Denmark (DRUID). Miller, R. (2001). "Leapfrogging? India's Information Technology Industry and the Internet", Discussion Paper No. 42, International Finance Corporation. National Association of Software and Services Companies (NASSCOM) (2001). Available at http://www.nasscom.org.

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Ng, F. and A. Yeats (2001). "Production Sharing in East Asia: Who Does What for Whom, and Why?", in L. Cheng and H. Kierzkowski (eds.), Global Production and Trade in East Asia, Dordrecht: Kluwer Academic Publishers. O'Neil, P.H. (2002). "Excerpts from US Treasury Secretary's Remarks to the Confederation of Indian Industry and American Chamber of Commerce in New Delhi on November 22", The Indian Express, November 25. Panagariya, A. (1999). "Trade Policy in South Asia: Recent Liberalisation and Future Agenda", The World Economy, 22, pp. 353-378. Pritchett, L. (1996). "Measuring Outward Orientation in LDCs: Can It be Done?", journal of Development Economics, 49, pp. 307-335. Raipuria, K. (2001). '"Knowledge Bowl' Yet to Yield Major Gains", Economic and Political Weekly, 35, pp. 3351-3352. Raj an, R. and S. Marwah (1998). "Confronting Contradictions in the Indian Economy: An Evaluation of the Past — Policies for Future Investment and Growth", in F. Columbus (ed.), Asian Economic and Political Issues, Commack, New York: Nova Science Publishers. Rajan, R. and R. Sen (2002). "Trade Reforms in India Ten Years On: How Has It Fared Compared to Its East Asian Neighbours?", Discussion Paper No. 0147, Centre for International Economic Studies, University of Adelaide. Rana, P. (1990). "Shifting Comparative Advantage among Asian and Pacific Countries", The International Trade Journal, 4, pp. 243-258. Reserve Bank of India. Handbook of Statistics on the Indian Economy, various issues. Sen, R. (2002). "Singapore in the Global Trading System: Strengthening Linkages Beyond the Southeast Asian Region", paper presented at the Institute of Policy Studies Symposium on Sustaining Competitiveness in the Singapore Economy (Singapore, July 26-27). Sharma, K. (2000). "Export Growth in India: Has FDI Played a Role?", Discussion Paper No. 816, Economic Growth Center, Yale University. Srinivasan, T.N. (1996). "Indian Economic Reforms: Background, Rationale, and Future Prospects", mimeo (September). Tschang, T. (2001). "The Basic Characteristics of Skills and Organizational Capabilities in the Indian Software Industry", Working Paper No. 13, Asian Development Bank Institute. United Nations (UN). International Trade Statistics Yearbook, various issues.

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151

World Bank (2000). World Development Indicators, New York: Oxford University Press. World Bank (2001). Global Economic Prospects, New York: Oxford University Press. World Trade Organization (WTO) (2001). International Trade Statistics 2001, Geneva: WTO. Wu, F., T.S. Pao, H.S. Yeo and K.K. Phua (2002). "Foreign Direct Investment to China and Southeast Asia: Has ASEAN Been Losing Put?", Economic Survey of Singapore Third Quarter 2002, Ministry of Trade and Industry.

152

Economic Globalization and Asia

Annex 1 Classification of Commodities of Manufactured Exports according to Relative Factor Intensities SITC Rev.2

Product description

SITC Rev.2

and category

category

category

65 651

Product description and category

Unskilled labour intensive

Technology intensive

(ULI) goods

(TI) goods

Textile yarn, n.e.s

54

Medicinal and pharmacy products

Textile yarn

56

Fertilisers, manufactures

652

Cotton fabrics, woven

57

Explosives and pyrotechnic

653

Fabrics, woven of manmade fibres

58

Artificial resins and plastic materials

654

Other textile fibres

59

Chemical material and products

657

Special textile fabrics

752

Automatic data processing machines

664

Glass

759

Parts, n.e.s of and Accessories

665

Glassware

76

Telecommunication equipment

666

Pottery

81

Sanitary, plumb fixtures

77-775

Electrical machinery and Parts thereof

87

Professional, scientific, and controlling instruments

82

Furniture and parts

83 84

Travel goods Apparel and clothing accessories

85

Footwear

51

Organic chemicals

Miscellaneous- jewellery, art antiques

52

Inorganic chemicals

Baby carriages, toy

67

Iron and Steel

68

N o n ferrous metals

71

Power generating machinery

89-896-897 894

Human capital intensive (HCI) goods

88-885

Photographic apparatus-watch clock Physical capital intensive (PCI) goods

55

Essential oils

72

Machinery specialized

62

Rubber manufactures

73

Metalworking machinery

64

Paper, paperboard

74

General industrial machinery and equipment, n.e.s

69

Metal manufactures n.e.s

775

Household electric and non-electric Equipment

78 79

Road vehicles Other transport equipment

885

Watches and clocks

896-897

Works of art + jewellery

Source: Garnant and Anderson (1980)

751

Office machines

India's Decade Ions Trade Reforms

153

Table 1 Dispersion of Average Tariff Rates of Selected DEA Economies, 1990-1998a

India Thailand Indonesia China Philippines

1990-94

1995-98

39.4 25.0 16.1 29.9 28.2

12.7 8.9 16.6 13.0 10.2

Note: a) Measured by the standard deviation Source: World Bank (2001, Table 2.1)

00 ON

1*

ON

O OO ON

Q

X r) 2

3 ^ o

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3 OJ &H 4-)

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rt T ^J £

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billi .G.R at fa<

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in

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m

< d Z < Z rn

r^- r-j r->

India's Decade Long Trade Reforms

ON

d d

NO

CO

r-- r-i

o m

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rn

NO

o rn NO r^ ni ni

p

r-Ni

in

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o (-N)

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r^ r-) r-i

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m

r~i d d r—

rj o O NO in d NO

rs m O l>- in m rn r-H d r-J ^1-

TI- OO u-i ^17 ^t1 rn

d

m

m NO ON

NO in

m 00 in in

d d

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r>S d d r-1

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->)oo

C/D

*-J

X

tj

est ent, net

Foreign d irec

US$) X

( % o f G DI)

ows (current

--P

^

lio

ows Foreign d ire t inv est ent, net

ows est ent, net

Foreign d ire

o

s

c

Reserves

-T3

"C 2

1E

O

Current a/c alam

c c O o

1J T1

ufaci

e (Rupe

hang Nominal

*

Trade/GDP atio

ports (%) Share in

US$ bil Merchan dis impi

iports) Import duties

(%) g in total Share in

Share of i

(US$ bil lions) Total trai

'—

Merchan dis export! US$ bil

1999 990

( % o f G DP)

o

< Z < Z o Q

U CO

p-T

S

jd T3

I 3

CQ

3 O CO

155

156

-d

o

S o

8

"* S JJ

_Dw w , .*< H "S ^ -a w Q

c

-a

-a c

05

t-l

ro

t^l

ro

O

r—

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r^

O

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ro

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—; ^ o

r-J

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ro

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d

d

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d

UO

i-

•n

ri

(/j

Tl

n

•s e-

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c

3

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CO

O

Q

Economic Globalization and Asia

(J

"-»-r

p.

har

f gooc X UJ

worl har

a --9

worl [an

DP)

157

India's Decade Long Trade Reforms Table 5 India's Average Exports of Selected Principal Commodity Categories over Pre and Post-Reform Period, 1988-2000 (US dollar billions)

No.

Category

1

Primary products

2 2.1

Manufactured products, of which Handicrafts, of which

2.1.1

Gems and Jewellery

2.2

Engineering goods

2.3

Readymade Garments

2.4

Textile Yarns, Fabric

2.5

Leather products

2.6

Chemicals and Allied products Petroleum products

3

1 + 2 +3 Total Exports Notes:

1988-90

1994-96

1998-2000

1994-96 over 1988-90

1998-2000 over 1988-90

3.4 (24.1) 10.1 (71.0) 3.2 (22.7) 2.7 (19.3) 1.6 (11.1) 1.6 (11.2) 1.1 (7.9) 1.1 (7.5) 0.9 (6.0) 0.7 (4.9)

5.8 (21.6) 20.2 (75.4) 5.4 (20.2) 4.6 (17.1) 3.6 (13.6) 3.2 (11.9) 2.9 (10.8) 1.6 (5.8) 1.9 (7.2) 0.8 (3.0)

7 (19.9) 27.3 (77.3) 7.4 (20.8) 6.3 (17.9) 4.9 (13.9) 4.3 (12.3) 4.1 (11.6) 1.6 (4.6) 3.1 (8.8) 1 (2.8)

2.4 (18.8) 10.1 (80.3) 2.2 (17.4) 1.8 (14.7) 2.1 (16.4) 1.6 (12.6) 1.8 (14.2) 0.5 (3.9) 1.1 (8.5) 0.1 (0.8)

3.6 (17.0) 17.2 (81.6) 4.1 (19.6) 3.6 (16.9) 3.3 (15.9) 2.7 (12.6) 3 (14.2) 0.6 (2.6) 2.2 (10.7) 0.3

14.2

26.8

35.3

12.6

21.1

(1.4)

a) Figures in parentheses constitute percentages of the total exports (1 + 2+3) b) Mid-point to Mid-point compound annual growth rates of total exports: 1988-90 to 1994-96: 11.12 percent per annum over 6 years. 1988-90 to 1998-2000: 9.51 percent per annum over 10 years. Source: Reserve Bank of India, Handbook of Statistics on Indian Economy 2000

158

Economic Globalization and Asia Table 6 A n Analysis of Export Revealed Symmetric Comparative Advantage (XRSCA) among India and the DEA Economies according to Gamaut-Anderson Classification of Products by Factor Intensities, 1982-98

Countries

XRSCA

1982

Unskilled Labour Intensive goods India XRSCA >0 0.34 XRSCA <0 China XRSCA >0 XRSCA <0 Inodnesia XRSCA >0 -0.82 XRSCA <0 Korea XRSCA >0 0.67 XRSCA <0 XRSCA >0 Malaysia -0.56 XRSCA <0 XRSCA >0 Philippines 0.24 XRSCA <0

1987

1992

0.45

0.39

0.56

0.43

0.37

0.43

0.57

0.56

0.61

0.62

1996

1997

1998

0.31

0.27

0.11

0.44

-0.27 0.57

0.49

0.38

0.19

0.34

-0.46 0.07

-0.13 0.15

-0.16 0.21

-0.19

-0.08

-0.13

-0.07

Physical Ca jtial Intensive goo ds India China Indonesia Korea Malaysia Philippines

XRSCA XRSCA XRSCA XRSCA XRSCA XRSCA XRSCA XRSCA XRSCA XRSCA XRSCA XRSCA

>0 <0 >0 <0 >0 <0 >0 <0 >0 <0 >0 <0

Technology Intensive goods XRSCA > 0 Inida XRSCA < 0 XRSCA >0 China XRSCA <0 XRSCA >0 Inodnesia XRSCA < 0 XRSCA > 0 Korea XRSCA <0

-0.62

-0.59

-0.33

-0.35

-0.24

-0.31

-0.56

-0.37

-0.24

-0.17

-0.15

-0.80

-0.66

-0.70

-0.61

-0.64

-0.25 0.17

-0.26

-0.31

-0.18

-0.19

-0.06

-0.36

-0.68

-0.48

-0.46

-0.30

-0.17

-0.69

-0.48

-0.71

-0.75

-0.87

-0.89

-0.59

-0.58

-0.58

-0.64

-0.54

-0.60 0.05

-0.59

-0.25

-0.1

-0.04

-0.91 0.07

-0.63 0.17

-0.39 0.21

-0.43 0.23

-0.90 0.03

-0.11 0.39

India's Decade Long Trade Reforms

159

Table 6 (continued) Countries Malaysia Philippines

XRSCA XRSCA XRSCA XRSCA XRSCA

>0 <0 >0 <0

Human Capital Intensive Goods India XRSCA > 0 XRSCA <0 China XRSCA >0 XRSCA <0 Inodnesia XRSCA >0 XRSCA <0 XRSCA >0 Korea XRSCA <0 XRSCA >0 Malayisa XRSCA <0 XRSCA >0 Philippines XRSCA <0

1992

1996

0.18

0.18

0.40

0.49

0.42

' 0.25

0.43

-0.34

-0.53

-0.37

-0.47

-0.42

-0.33

-0.26

-0.21

-0.16 0.03

-0.88

-0.69

-0.48 0.09

-0.53 0.15

0.32

-0.04

-0.06

-0.90

-0.83

-0.54

-0.51

-0.51

-0.42

-0.86

-0.83

-0.81

-0.72

-0.72

-0.85

1982

1987

-0.29

-0.21

-0.57

-0.66

-0.05

-0.31

-0.56

-0.95 0.17

1997

Source: Computed from the UN International Trade Statistics Yearbook, various issues

1998

160

Economic Globalization and Asia Table 7 Export Pattern of Commodities between India and the DEA Economies according to Garnaut-Anderson Classification of Products by Factor Intensities, 1982-1998

Countries

1982

Unskilled Labour Intensive goods India ow 1.10 17.48 Sct China o„ NA NA o ct Indonesia 0.12 i>w oct 0.82 Korea ow 6.62 48.31 oct 0.31 Malaysia ow 3.79 s« 1.62 Philippines ^>w 13.33 s Physical Capital Intensive j;oods 0.13 India ow 4.01 ^>Ct China NA Ow NA Set Indonesia ow 0.14 1.90 ^ct Korea 0.79 ow 11.80 ^ct 0.52 Malaysia ^w 12.91 ^ct 0.19 Philippines s 3.10 s Technology Intensive good s India Sw Set

China

Sw ^ct

Indonesia

ow bct

Korea

ow *ct

0.14 3.04 NA NA 0.07 0.63 1.41 12.22

1987

1992

1996

1997

1998

1.15 32.50 4.98 31.20 0.40 7.05 7.99 49.65 0.41 6.90 1.16

1.12 31.40 8.42 51.00 1.69 25.76 6.49 41.29 0.83 10.61 1.36 18.61

1.40 31.39 10.13 45.26 1.63 22.77 5.80 28.86 1.04 9.65 1.54 20.35

1.50 32.82 11.95 52.76 1.15 19.76 3.22 19.13 0.96 8.91 0.77 10.02

28.34 11.96 56.12 1.02 33.27 2.96 26.93 0.89 11.00 0.87 11.46

0.25 9.00 1.05 8.20 0.16 3.10 1.52 15.20 0.38 6.30 0.17 3.04

0.31 9.19 1.75 10.51 0.23 4.26 1.76 15.6

0.37 10.27 2.08 11.67 0.20 4.48 1.93 14.57 0.76 12.14 0.07 1.15

0.35 8.90 2.05 12.43 0.24 10.13 2.04 23.93 0.75 11.88 0.06 0.96

0.13 5.09

0.17 6.76

1.37 11.60 0.20 4.29 3.09 23.65

2.34 17.96

0.18 6.88 2.73

0.17 5.90 3.11 26.48 0.32 18.82 3.33 54.92

14.24

0.12 5.07 0.56 5.50 0.14 3.93 1.14 11.60 0.21 5.52 0.35 6.77

0.12 4.79 0.51 4.70 0.03 0.88 2.51 17.82

0.54 6.5 0.15 2.59

0.41 9.85 3.97 30.11

21.37 0.37 11.24 3.53 37.25

1.450

India's Decade ions Trade Reforms

161

Table 7 (continued) Countries Malaysia

ow Set

Philippines

sw sct

1982

1987

1992

1996

1997

1998

0.81 13.96

0.96 23.50 0.20 3.61

2.15 37.97 0.91 17.22

2.05 32.94 2.42 55.10

3.26 53.47 1.66 38.40

3.14 69.95 2.52

0.13 5.48 0.81 7.90

0.28

0.04 1.23 2.00 18.90

0.24 9.62 1.16 9.90 0.17 3.59 1.97 18.60

0.24 6.92 2.02 13.83 0.43 20.25 2.82 37.35

0.14 3.63 0.09 1.80

0.44 7.89 0.10 2.03

0.28 8.24 1.93 11.56 0.29 6.77 2.93 23.59 0.45 5.66 0.12 2.83

0.27 3.17

Human Capita Intensive goods 0.29 India t>w 8.23 ^ct NA China ow NA ^ct 0.03 Indonesia ow 0.37 Set Korea 1.89 ow 24.00 bct 0.08 ow Malaysia 1.80 *ct ow Philippines 0.07 1.16 bct

8.24 1.70 10.18 0.33 6.14 3.06 22.60 0.47 5.76 0.16 2.88

Source: Computed from the UN International Trade Statistics, various issues

59.74

0.44 7.85 0.05 1.57

162

Economic Globalization and Asia

Table 8 Changes in Degree of Export Specialization of India and the DEA Economies3, 1982-1997 Period

India

China

Korea

Malaysia

Indonesia

Philippines

1987-92 1992-97 1987-97 1982-97

0.84 0.94 0.82 0.75

0.87 0.95 0.78 NA

0.82 0.55 0.43 0.41

0.68

0.78 0.88 0.68 0.39

0.75

0.64 0.45 0.34

0.74 0.47 0.46

Note: a) Computed by Spearman's Rank Correlation measures (adjusted for common ranks) Source: Computed from the UN international Trade Statistics Yearbook, various issues

Table 9 Correlation of Export Structures in Manufactured Goods between India and the DEA Economies, 1987-1998

1987 1997 1998

China

Korea

Malaysia

Indonesia

Philippines

0.96 0.68 0.63

0.79 0.39 0.36

0.17 0.01 0.00

0.82 0.76 0.77

0.42 0.07 0.04

Source: Computed from the UN international Trade Statistics Yearbook, various issues

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Table 10 Indicators of Diffusion of ICT and Related Services in India and the DEA Economies (per 1000 persons), 1992-1997 1992

Cable TV subscribers Fax machines Internet hosts Mobile phones Personal computers Radios Telephone mainlines Television sets

0.0 0.0 0.0 0.0 0.5 96.5 7.7 39.6

Cable TV subscribers Fax machines Internet hosts Mobile phones Personal computers Radios Telephone mainlines Television sets

21.1 0.1 0.0 0.1 0.9 332.9 9.7 190.1

Cable TV subscribers Fax machines Internet hosts Mobile phones Personal computers Radios Telephone mainlines Television sets

0.0 6.8 0.0 6.2 56.8 1,005.2 354.2 208.6

Cable TV subscribers Fax machines Internet hosts Mobile phones Personal computers Radios Telephone mainlines Television sets

0.0 0.2 0.0 0.2 2.0 149.4 9.0 76.1

1995 India 17.2 0.1 0.0 0.1 1.3 119.7 12.9 61.4 China 28.4 0.2 0.0 2.9 2.3 331.1 33.0 243.5 Korea 156.4 8.9 6.5 36.4 107.7 1,020.0 412.4 321.9 Indonesia 0.0 0.4 0.1 1.1 5.0 151.5 16.9 113.0

1997

18.8 0.2 0.0 0.9 2.1

1992-95

1992-97

12.2

121.4 18.6 69.1

9.1 0.1 0.0 0.0 0.8 105.0 10.1 51.4

0.1 0.0 0.2 1.2 110.4 12.4 56.4

40.0 1.6 0.2 10.6 6.0 333.3 56.2 271.8

24.9 0.1 0.0 1.2 1.5 332.6 19.9 217.5

29.2 0.6 0.1 3.5 2.6 332.5 30.0 233.2

145.2 0.0 28.8 149.6 150.7 1,032.8 444.0 342.4

94.0 8.0 2.6 18.6 79.8 1,009.3 383.5 272.9

111.2 5.3 9.0 49.0 100.3 1,017.0 401.4 294.8

0.0 0.9 0.5 4.5 7.9 156.4 24.7 134.1

0.0 0.3 0.0 0.5

0.0 0.5 0.2 1.6 4.7 152.7 15.8 106.2

3.4 150.8 12.2 94.3

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Table 10 continued 1992

Cable TV subscribers Fax machines Internet hosts Mobile phones Personal computers Radios Telephone mainlines Television sets

0.0 2.5 0.0 10.7 21.9 426.4 111.5 149.3

Cable TV subscribers Fax machines Internet hosts Mobile phones Personal computers Radios Telephone mainlines Television sets

0.0 03 0.0 0.9 5.2 143.5

1995

10.4 78.4

1997

1992-95

1992-97

Malaysia 0.0 5.0 2.0 50.0 37.3 432.6 165.7 169.1

5.2 6.9 18.7 92.3 46.1 419.9 194.9 166.1

0.0 3.3 0.7 26.9 29.4 430.6 137.1 159.3

1.4 4.3 5.6 45.3 34.2 427.1 153.6 161.5

Philippines 5.8 0.7 0.3 7.2 9.6 145.7 20.5 104.9

6.9 0.0 0.6 18.0 13.4 158.8 28.7 107.7

3.7 0.5 0.1 3.1 7.3 144.5 15.2 96.9

4.7 0.3 0.2 7.3 9.0 149.0 19.1 100.4

Table 11 Communications, Computer, etc. [ICT] (percent of Service Exports, BoP) in India and the DEA Economies, 1980-1998

China Korea Indonesia Malaysia Philippines

1980

1989

1990

1995

1997

1998

NA 23.6 NA 29.8 63.6

22.8 27.7 10.3 24.5 77.6

20.2 34.2 10.7 25.3 77.6

27.2

38.0 39.6 4.2 55.1 82.0

35.7 33.5 5.0 NA 76.4

Source: World Bank (2000)

36.4 4.4 44.5 84.3

India's Decade Long Trade Reforms

165

0.80 0.750 70.

* / * ^ ^ *

0 65 % 0.600 55

*s

0.500 45 0.40.

^ys k.

A

/ ^ ^

^^^

^

• 1980

1989

1990

1992

1995

1997

1998

Year Share in World Exports

Share in World Trade

Note: Includes merchandise trade only Source: World Bank (2000) Figure 1 India'a Global Trade Linkages, 1980-1999

1999

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Chapter 7

Singapore's Drive to Form Cross-regional Trade Pacts: Rationale and Implications 1

1. Introduction The Singapore economy has experienced one of the highest rates of growth in the world over the past three decades, its Gross Domestic Product (GDP) appreciating at an annual average rate of about 8 percent during the period 1980-2000 (Table 1). The growth has in turn propelled Singapore's average real per capita income from US$3,365 in 1965 to over US$28,000, which is one of the highest in the world, surpassing most developed countries (Rajan, 2003). A key element of Singapore's hitherto successful growth strategy has undoubtedly been its outward orientation, particularly its openness to international trade and investment flows. Accordingly, Singapore has been a leading advocate of global trade liberalization and the free flow of goods and services across international borders. Indeed, despite its microscopic physical size, the World Trade Organisation ( W T O ) has ranked Singapore as the tenth largest merchandise trading nation in the world and among the top twenty in crossborder trade in commercial services (Tables 2 and 3). In nominal terms, Singapore's total merchandise trade (exports plus imports) has risen six fold from US$40 billion in 1980 to almost US$250 billion in 2000, an annual average growth of 9.6 percent (Figure 1). Over the entire period, Singapore's merchandise trade (exports plus imports) declined on a year-on-year basis in only three years, viz. the recession of 1985 and 1986 and then in 1998 during the global electronics downturn and the ensuing East Asian financial crisis. Although Singapore recovered smartly from the crisis, it has recently been the victim of the downturn in the global electronics cycle as well as the general deterioration in the external environment (particularly the sharp slowdown in the US and continued recession in Japan). Thus, Singapore's overall merchandise

'This Chapter is co-authored with Rahul Sen and draws on Rajan and Sen (2002) as well as on a longer monograph by the authors (Rajan, Sen and Siregar, 2001).

Singapore's Drive to Form Cross-Regional Trade Pacts

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trade declined by 3.8 percent in 2001 compared to the previous year (Department of Statistics Singapore, 2002). The dynamics of export growth largely parallel those of merchandise trade — robust growth between 1980 and 2000 (10.3 percent annual average), with year-on-year declines in the mid 1980s and late 1990s, and most markedly in 2001. Singapore's Deputy Prime Minister, Lee Hsien Loong, recently made the following observation about the Singapore economy and the external environment it currently faces: Singapore has reached a turning point. For more than two decades until the Asian Crisis in 1997, Singapore enjoyed sustained high growth. Southeast Asia was doing well, foreign investments grew year by year, and our exports expanded. We upgraded our economy, and transformed the lives of Singaporeans in less than a generation ... But the last five years have shown clearly that this phase is over. T h e Asian Crisis plunged Southeast Asia into political and economic uncertainties. The US recession marked the end of the long boom, and the start of a new period of slower growth. After September 11th last year..(2001).., the discovery of terrorist groups in Southeast Asia linked to Al Qaeda brought new worries that will stay with us for many years. Our world has changed profoundly, and we must change with it (Lee, 2002, p. 1). It is against this — rather bleak — external setting and the recent disappointing trade performance that Singapore has aggressively sourced preferential accords with a number of its trading partners in an effort to remain a global trade and investment hub. Singapore has already established bilateral trade pacts with New Zealand, Japan, and the European Free Trade Area (EFTA), which consists of Iceland, Liechtenstein, Norway, and Switzerland. It has also completed negotiations with Australia and the United States (US), and is also in the process of negotiating FTAs with Canada, India, Jordan, Mexico, South Korea and Sri Lanka. Talks on a tripartite trade arrangement involving New Zealand and Chile have also been launched. This Chapter examines the reasons for and against Singapore's attraction to the "new regionalism" in general and cross-regional bilateral FTAs (bilateralism

2

Three caveats should be noted here. One, the term "regionalism" is not meant to have any geographic connotation, referring to any trade initiatives that are not multilateral in nature. Rather than "new regionalism", some prefer to use the term "second regionalism" in contrast to the "first regionalism" of the 1950s and 1960s which involved mainly South-South economic integration, i.e. FTAs

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for short) in particular 2 . The remainder of this Chapter is organized as follows. By way of background, the next Section examines the country composition of Singapore's external trade. Data limitations restrict the analysis in this Section to merchandise trade. Section 3 highlights the motivations behind Singapore's urge to form a series of bilateral trade pacts in general, and with the two economic super-powers, the US and Japan, in particular. This is followed by a discussion of the drawbacks and potential concerns of such a bilateral/preferential trade strategy in Section 4. The final Section concludes the Chapter with a brief discussion of the nexus between new regionalism and multilateralism. Are the two antagonistic or are there inherent synergies between them?

2. Country Composition of Singapore's Trade, 1995 and 2000/2001 It would be useful to briefly examine the geographical distribution of Singapore's trade. Figures 2a and 2b offer a snapshot of Singapore's total exports to its major trading partners in 1995 and 2001. Neighbouring Malaysia is currently the single largest export destination, accounting for nearly a fifth of Singapore's total exports, followed closely by the US (15.4 percent) and the East Asian economies including Hong Kong (8.9 percent), Japan (7.7 percent) and Thailand (4.4 percent). Overall, in 2001, more than half of Singapore's total exports were destined for the ASEAN-plus-Three (or A P T ) economies (i.e. ASEAN plus Japan, China, and Korea) and the US. The shares of most of Singapore's major trading partners in their total exports declined in 2001 compared to 1995, with the notable exceptions of Australia, China, India and Korea (the first three were negligibly impacted by the 1997-98 East Asian crisis). Specifically, Singapore's exports to the large Asian economies of China and India grew at average rates of 19 and 12 percent, respectively during the period, which was significantly higher than the growth of the city-state's exports to its top five established trading partners. China increased its share in Singapore's exports from 2.3 percent to 4-4 percent during this period, the largest increase in export shares of the city-state's

among developing economies as part of import substitution development strategies (Lawrence, 1999 and Rajan, 1995). Two, Jagdish Bhagwati notes that the term "preferential trade arrangement" (PTA) is a more apt description for such trade pacts. As he declares of such trade arrangements (Bhagwati, 1995), they are: "two-faced: they embody both free trade and protection. Economists interested in the quality of public policy discourse should perhaps take a pledge henceforth to rename free trade areas as "preferential" trade areas" (p. 2). Three, we use the terms free or preferential trade "agreements", "arrangements", "pacts" and "accords" interchangeably in this paper.

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major trading partners. At a subregional level, apart from the Philippines, the share of major ASEAN countries in Singapore's exports declined between 1995 and 2001 for reasons noted in the Introductory Section. The preceding analysis does not distinguish the entrepot component of exports (re-exports) from the value-added component (domestic exports). Re-exports have, on average, constituted between 40 and 60 percent of Singapore's total exports with the exception of the North American countries (viz. US, Canada) and some East Asian ones (Japan, China and Hong Kong). Considering only domestic exports, we note that in 2001, the US remained Singapore's top export market (in value-added terms), accounting for nearly a fifth of Singapore's domestic exports, followed by the East Asian economies, Malaysia (12.9 percent), Japan (8.9 percent), Hong Kong (8.7 percent) and Thailand (3.5 percent). Overall, as in the case of total exports, more than half of Singapore's total domestic exports went to the APT economies and the US (Figures 3a and 3b). Figures 4a and 4b present Singapore's total imports from its major trading partners and regional groupings for the 1995 and 2000. Japan has been the single largest source of imports, accounting for 17.2 percent of Singapore's total imports in 2000 (though down from 21.2 percent in 1995). The city state's other important import sources are Malaysia (17.0 percent), the US (15.0 percent) and other East Asian economies, including China (5.3 percent) and Thailand (4.3 percent). Overall, about two-thirds of Singapore's total imports were sourced from the APT grouping plus the US. Singapore has been running persistent bilateral deficits with Japan which have been increasing both in magnitude as well in terms of Singapore's total trade with Japan, especially during the period 1985-94. The deficit was around US$ 6.7 billion in 2001, constituting about 26 percent of Singapore's bilateral trade with Japan. In contrast, Singapore has recorded a persistent and growing bilateral trade balance with the US since the mid 1980s, amounting to about US$0.3 billion in 2001, though these surpluses are a relatively low share of overall Singapore-US trade. Continual trade deficits with Japan might partly be a reflection of the inability of foreign (including Singapore) exporters to penetrate the Japanese market due to the maintenance of both official and (especially) unofficial non-tariff barriers (NTBs) (Lawrence, 1987). Indeed, these barriers have in turn often led to the accusation that Japan "imports too little" from its trading partners (Takeuchi, 1989), with a survey of Singapore exporters in the late 1980s revealing them to be "generally overawed by the Japanese closed market image (Lim, 1988, p. 100). In the context of a Singapore-Japan FTA, this factor could be of potential importance, as a bilateral FTA ought to provide Singapore open (and preferential) access to the Japanese market.

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Economic Globalization and Asia

3. Why Has Singapore Embraced the Bilateral Route? Singapore's choice of trading partners to form trade pacts can be broadly divided into three groups. The first group of countries, which includes the US and Japan, are major established trading partners. Proposed bilateral trade accords by Singapore with these two economies are best seen as a formalization of the de facto extensive and deep linkages that are already in existence. While the US has signed a series of bilateral FTAs with Canada, Israel, Mexico and Jordan, the Singapore-US FTA is the first such one that the US has signed with an Asian economy. It has also been suggested that Singapore's bilateral trade accords with the US and New Zealand, along with anticipated ones with Australia and Chile, may lead to a Pacific-5 or P-5 FTA, which itself could be a precursor to an APEC-wide FTA. As noted, Singapore is in the process of negotiating deals with Canada and Mexico, the two other members of the North American Free Trade Area (NAFTA). Could this be a first step in Singapore's eventual accession into that alliance? A possible Singapore-Japan FTA is interpreted by some as an important signal of Japan's weakening adherence to non-discriminatory multilateralism, not unlike the shift in the trade policy stance by the US in the 1980s which led to the global proliferation of regional blocs (Rajan and Sen, 2003). While Singapore's FTA with the US is seen as strengthening trans-pacific links, that with Japan is seen as bolstering ties between Northeast and Southeast Asia. While the focus of this Chapter is on Singapore's perspective, it is worth noting that the larger countries are willing to negotiate trade pacts with Singapore despite its already liberal trade policy for two main reasons. One, Singapore's services sector remains relatively more protectionist than its manufacturing sector. Thus, countries like the US are keen on using the bilateral trade pact to open up Singapore's service sector further. Two, given Singapore's small size and absence of an agricultural sector of any significance, countries like Japan are keen on using negotiations with the city-state as a "practice ground" before they initiate negotiations with other countries with whom there may be more complex and sensitive issues to deal with. The second group of countries includes Australia, Korea, New Zealand, the EFTA countries, and the like, who do not account for more than 5 percent of Singapore's total exports, domestic exports, or total imports. The aim here is to seek out new markets in view of the seeming loss of growth momentum in Singapore's immediate neighbours as well as to diversify the city-state's external economic linkages. The third group includes the emerging economic giants of China and India which offer significant medium and longer-term opportunities for Singapore

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businesses. The aim of trade agreements with these two countries is to develop "special relationships" and for Singapore businesses to gain first-mover advantage into these large markets (Sen, 2002). Effectively, the city-state is trying to expand its hinterland from the immediate Southeast Asian region to encompass the larger Asian region to include these two emerging giant countries. As Singapore's Deputy Prime Minister, Lee Hsien Loong, has noted: Given the prosperity of China and India, Singapore has been extending its hinterland beyond the traditional areas in Southeast Asia, to service a wider area defined by a radius of 7 hours' flying time from Singapore. This brings China, India and even Australia within Singapore's catchment. Jet travel and modern telecommunications makes this feasible. Many companies are already setting up headquarters in Singapore to do this (Lee, 2002, p. 3). With regard to Singapore's immediate neighbourhood, valid concerns have been expressed that Southeast Asia has lost the dynamism and drive towards trade and investment liberalization and integration (which entails much more than intraregional tariff elimination) that it had pre-crisis, and is seen by extra regional foreign investors as the "less attractive cousin" of Northeast Asia (Business Times, Singapore, December 11, 2000). It is important for Singapore that investors not perceive it as being in the same boat as the rest of the region, i.e. Singapore needs to remain on the radar screen of world investors even if Southeast Asia as a whole may not be (Lee, 2002). Conversely, it is plausible that Singapore could act as the "flag-bearer" for the region in that its trade initiatives could help maintain global interest and draw extra-regional investments into Singapore and the Southeast Asian region as a whole as the crisis-hit economies gradually rebuild their economic and financial structures. The surge of recent FTA initiatives by Singapore may also be a means of building political momentum for other ASEAN/APEC member economies to hasten the process of regional and unilateral liberalization. 3 More generally, FT As appear to be increasingly regarded by policy-makers as effective and expeditious instruments for achieving trade liberalization among "like minded" trading partners (Schiff et al., 2000). Formation of bilateral FTAs among such partners is also seen as a means of overcoming the so-called "convoy problem", whereby the "least willing member" ("foot-dragger") holds the pace of trade integration back. Alternatively, as is sometimes said, "those who can run faster should run faster and ought not to not be held back by those who choose 3

This is commonly referred to as "competitive liberalization", whereby modest liberalization induces broader liberalization.

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not to run or do so at a snail's pace". While the argument that regional trade pacts are easier to negotiate and can be concluded at a faster pace than global negotiations may not hold true as a general rule (Baldwin, 1997 and Bhagwati, 1995), it does seem to be relevant in the case of Singapore which sets strict deadlines for completion of discussions. (This, however, may come with its own problems; see Section 4). Another "first-mover advantage" in establishing FTAs with a host of different countries early on takes the shape of a "hub" of overlapping arrangements (Wonnacott and Lutz, 1989). Producers in the hub enjoy cost advantages vis-a-vis producers in the "spokes", being able to obtain more of their intermediate goods at lower prices. Further, since exports originating from Singapore are given preferential access to a number of other markets (with which Singapore has trade accords), this may encourage the transshipment of goods through Singapore ports, hence fortifying its already dominant role as an entrepot point. Of course, it is for this very reason that FTAs stipulate special provisions or Rules of Origin (ROOs) which are meant to prevent goods being re-exported from/circumvented through the lower tariff country to the higher tariff one (i.e. trade deflection). However, this in turn may lead to a shift of export platforms from other regional developing economies to Singapore in order to gain duty-free market access. Care must be taken though to ensure that ROOs are not manipulated in such a way that partners gain de facto protection for their goods in the Singapore market (see Section 4) 4 . Trade accords, particularly the recent ones Singapore is involved in, go well beyond just merchandise trade liberalization and also encompass liberalization of services trade and other trade facilitation measures which lead to "deep integration" among partners (Lawrence, 1999). These measures include investment protection and liberalization, harmonization and mutual recognition of standards and certification, protection of intellectual property rights, opening of government procurement markets, streamlining and harmonization of customs procedures, and development of dispute settlement procedures. These FTAs are therefore more appropriately referred to as Trade and Investment Facilitation Agreements (TIFAs). Such FTAs could act as a "testing ground or pilot project for exploring complex trade issues" and may help establish some sort of precedent or benchmark for trade negotiations involving a larger number of countries, including one at the multilateral level (Sager, 1997, p. 242). Simultaneously, to the extent that contracting parties to an FTA agree to move beyond their respective W T O 4

Even if ROOs are in place, there could be "indirect trade deflection", as low-tariff member could meet its requirements for a product from the non-members and export a corresponding amount of its own production to the members of the trade alliance (Robson, 1998).

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commitments, there may be a demonstration effect that motivates future rounds of broader multilateral negotiations under the auspices of the W T O 5 . Thus, one hears policy-makers in the region often refer to their proposed RTAs as being "state of the art", "trail-blazing", or "WTO-Plus". Singapore's drive towards FTAs is not solely economic by any means. FTAs could also serve as a vehicle by which Singapore draws attention to itself and enhances the city-state's political recognition and profile with the integrating partners and carves out a pivotal role for itself in regional and multilateral trade fora6.

4. Concerns with Bilateralism It is commonly noted that since Singapore has one of the most liberal trade and investment regimes in the world with near zero tariff rates on most goods (and limited non-tariff barriers), this implies that the scope for trade diversion — replacement of lower cost suppliers from non-member countries — from Singapore's vantage point is quite small 5 . Nonetheless, it would be wrong-headed to conclude that there are no ill-effects whatsoever. What are some potential concerns of Singapore's recent eagerness to form FTAs? The proliferation of a number of overlapping or intersecting FTAs raises many technical problems with respect to the implementation of ROOs. Even with a single FTA, a concern is that ROOs with a particular country, say the US, may be sufficiently prohibitive so as to induce Singapore exporters to source their inputs from the U S than some other developing country in Asia (such as Korea, for instance). In other words, the US exports its external tariffs to Singapore. This appears to have been the case with NAFTA, where the U S negotiated a R O O on Mexican assemblers of automobiles. ROOs also give rise to significant costs due to the need for administrative surveillance and implementation. In practice, ROOs are particularly complex — they are almost two hundred pages in the case of N A F T A and eighty pages of small print in the case of the EU's agreement with Poland — as they have to take into account tariffs on imported intermediate goods used in products produced within the FTA. The book-keeping and related costs escalate sharply as production gets more integrated internationally (so-called "spaghetti bowl" phenomenon) and countries get involved with an increasing number of separate but 5

This could be due to the fact that in spite of non-preferential liberalization in services providing larger welfare gains than the preferential route, more efficient bargaining among members and achieving greater regulatory cooperation is possible through plurilateral arrangements rather than the multilateral one (Mattoo and Fink, 2002). 6

Koh (2000) makes this point convincingly in the context of the Singapore-US FTA.

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overlapping FTAs. This is especially so as there may not be uniformity in the computation of regional content requirements. Accordingly, Krueger (1997) strongly favours a Customs Union or C U (where members have common external tariffs) over FTAs. Note that absent ROOs, an FTA is a de facto C U with a common external tariff (CET) equivalent to that of the lowest tariff prevailing in any of the member countries. If unconstrained, this reduces the effective tariff of every member to that of the lowest tariff rate plus the transportation cost involved in indirect importing (real resource cost). With prohibitive ROOs, an FTA becomes a C U where an external tariff is the highest that prevails among members. A major disadvantage of CUs is that they require greater degree of policy coordination and collective decision-making and budgetary mechanisms to distribute the tariff revenue between members 7 . Apart from the issue of ROOs, a large number of FTAs may leave investors confused as to which rules, obligations and incentives correspond to which partner. This is in contradiction to one of the main aims of RTAs, viz. to enhance transparency and reduce transactions costs so as to facilitate cross-border business activities. Worse still, there is the possibility that membership in multiple trade accords may create "obligations made in one that contradict those made by others" (Schiff et al., 2000). Bergsten (2000) highlights this point in the context of compatibility of sub regional arrangements with the APEC's goal of regionwide trade liberalization (i.e. the Bogor declaration of free and open trade by 2010/2020). As he notes of the blueprint on the Singapore-Japan proposed FTA: it states that Japan is unwilling to liberalize agricultural trade, even in a deal with Singapore where there is no agricultural trade. In other words, they do not accept the principle. They can argue, as this blueprint does, that it is perfectly compatible with the W T O . The W T O says you must substantially cover all trade. If there is no agricultural trade, you do not have to include it to meet the W T O test. But the APEC test, which was hammered out after much debate in both Bogor and Osaka, states that trade liberalisation must be comprehensive — no sectors can be excluded. APEC was consciously being W T O + and the Japan-Singapore agreement,

7

Schiff et al. (2000), who argue chat a "central issue for countries planning to integrate their trade is whether to choose and FTA or CU", discuss the issues in some detail. Wonnacott (1996) has suggested a hybrid scheme, i.e. an FTA but without ROOs in two sets of products: one where the members agree upon CETs, and the other where all members have low tariffs. Schiff et al. (2000) discuss these and other proposals. Panagariya (1999) notes that ROOs could either exacerbate or moderate welfare-reducing trade diversion.

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if that study result becomes the actual outcome, would violate its precepts ... Moreover, the report says nothing about completion by 2010. That deadline is a commitment for countries in the APEC context ... Japan and Singapore should be asked how their new agreement is compatible with APEC (p.5). Singapore appears to be willing and able to negotiate FTAs with unparalleled rapidity. However, this swiftness apparently hinges on the Republic's readiness to accept a number of conditions in the context of the bilateral accords set forth by the larger partners, such as labour and environmental standards, in the case of the FTA with the U S (said to be modelled after the US-Jordan agreement), or exclusion of agriculture in the case of the FTA proposals with Japan (as noted by Bergsten above). While acceptance of these conditions may not be problematic in the case of Singapore (given its high environmental standards and negligible agricultural sector and no farm lobby to speak of), if they are eventually included in the agreements, the city-state is not necessarily helping the cause of less well off developing countries in multilateral negotiations at large 8 . Further, if Singapore unilaterally signs on to such non-trade linkages, might that not preclude ASEAN from taking a common and credible stand on these and other issues given the fact that the regional alliance famously follows a policy of consensus? In addition, the presence of such linkages could imply that Singapore-based FTAs may be an inappropriate model for future trade arrangements and could make the Singapore-based FTAs de facto exclusionary to other ASEAN members. This is despite repeated "assurances" by Singapore policy-makers that the FTAs are no t exclusive and are open to accession by any country which agrees to the terms of the agreement 9 . Indeed, referring to the US-Singapore trade agreement, Singapore's Minister of Trade and Industry, George Yeo, reportedly remarked:

Bhagwati's (1995) discussion of the US FTA strategy during NAFTA negotiations is prescient: NAFTA's passage..was subject to Mexico's acceptance of supplemental agreements on environmental and labour standards ... (W)hy should such agreements be a precondition for freer trade?..(The) US was a superpower bargaining one-on-one with a vastly inferior power. In turn, those supplemental agreements have encouraged the environmental and labour lobbies to argue that because NAFTA required them, so must the WTO ... In short, NAFTA has made the WTO's business more complex, not less..(T)he United States can first force Mexico to buckle under to those demands and then tell Chile and others, "This is how NAFTA is, so you must accept these 'nontrade' terms and conditions if you wish to come on board." ... (T)hat 'Takethem-one-by-one' strategy works so much better than trying to impose extraneous, indeed harmful, conditions through multilateral trade negotiations where all countries facing such demands negotiate together and have more bargaining power (pp. 12-3).

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We have set high standards..I'm doubtful other countries can come up with these standards, because their economies are not as advanced as ours, but in any case, it should be something they should strive to achieve (quoted in Lien, 2002b). The issue of expansion or amalgamation of existing FTAs is an important outstanding issue that has not been paid sufficient attention to by enthusiasts of such preferential agreements.

5. Concluding Remarks While Singapore's new commercial trade strategy was initially greeted with much skepticism and even irritation by some of its Southeast Asian neighbours, their view has since softened significantly. Indeed, countries such as Thailand and the Philippines are now looking to emulate the Singapore strategy10. In addition, a case might be made that Singapore's go-it-alone approach helped push ASEAN to seriously explore the possibility of an ASEAN-China FTA and even those with Japan and India (Lee, 2002). In addition, the US President George W. Bush launched the Enterprise for ASEAN Initiative (EAI) during the APEC Summit in October 2002 to strengthen bilateral trade linkages with ASEAN. While details of the EAI remain unclear, the proposal essentially offers ASEAN countries the opportunity to sign bilateral trade pacts with the US as long as they are members of the W T O (implying that Cambodia, Laos and Vietnam may remain ineligible for the time being). While the EAI is viewed as a means of eventually networking Southeast Asia with the US seamlessly, the initiative appears to have less to do with economics than it does with symbolism regarding the commitment of the US to the Southeast Asian region at a time of global security and political tensions (Lien, 2002a). Academic and policy interest in bilateral and plurilateral trade arrangements has been preoccupied with the question as to whether they are "stumbling" or "building" blocs towards multilateral liberalization. The analytical literature is inconclusive (Winters, 1999), and the empirical literature far too unreliable to

9

Wonnacott (1996) cautions that while spokes are certainly worse off in a hub-and-spoke regime compared to a "full" or complete FTA, it is unclear as to whether hubs are better or worse off. This is so, because while the collective income of a hub-and-spoke arrangement tends to be smaller (given the inefficiencies caused by overlapping FTAs), the share of benefits accruing to the hub is larger than a full FTA. As is often said, hubs and spokes arrangements "combine regional integration with the hub and disintegration among spokes". 10

Other countries in the larger Asian region such as China, India, Japan and Korea have also embraced the bilateralism route.

Singapore's Drive to Form Cross-Regional Trade Pacts

177

make any definitive judgments. RTAs may be stumbling blocs if preferential access gained by some reduces the motivation or incentive to liberalize multilaterally 11 . Related to this, countries that are members of FTAs may take the view "(i)f we do not get what we want in the..multilateral..negotiating agenda, why should be worry? We have our own FTA. That is where the action is!" (Crawford and Laird, 2001, p.207). Such an attitude would undoubtedly weaken the multilateral trading system and may even pose an outright threat to multilateralism. It is clear that the Singapore policymakers are of the opinion that FTAs are building blocs and complementary to rules-based multilateralism. To their credit, Singapore leaders have made a concerted effort to reaffirm the primacy of the multilateral trading system. For instance, the Singapore Prime Minister Goh Chok Tong has reportedly noted: FTAs should not be pursued at the expense of the multilateral trading system. We must continue to invest efforts towards the launch of a New Round (of multilateral trade negotiations), to ensure that the gap between FTAs and the W T O does not grow so wide that it becomes irreconcilable (Business Times, Singapore, December 5, 2000) 12 Similarly, the city-state's Deputy Prime Minister recently observed: To secure our overseas markets, our basic approach has been multilateral — to rely on the framework of the World Trade Organisation ( W T O ) to ensure a level playing field and protect the interests of a very small player. Singapore will contribute actively to the Doha Development Agenda, because multilateral trade liberalisation will continue to be the cornerstone of our trade policy. However, the failure of the Seattle W T O meeting in 1999 highlighted clearly the limitations and risks of a purely multilateral approach. After Seattle, many countries, including Singapore, reassessed their positions, and decided that it would be wise to complement the multilateral approach with a strategy of bilateral Free Trade Agreements (FTAs) with key trading partners (Lee, 2002, p. 2). 11

After all, the WTO recently warned in its Annual Report (2001b) that the cumulative impacts of all the various FTAs that have proliferated worldwide "posed a systemic risk to the rules-based multilateral trading system". I2 Schiff et al. (2000) evaluate the practical implications of the Article and its provisions and make recommendations for altering the provisions to render them more effective. There exists an "Enabling Clause" introduced in 1979 (Decision on "Differential and More Favourable Treatment, Reciprocity and Fuller Participation of Developing Countries") that further relaxes the above provisions.

178

Economic Globalization and Asia

The recent failure of the Doha Round will no doubt further fuel belief in and support for the FTA strategy. O n e way to ensure that preferential arrangements are consistent with multilateralism is for them to be accompanied by a sunset clause which would require, over time, that signatories to the agreement offer bilateral or regional concessions to all non-members on the basis of Most Favoured Nation (MFN) status. In other words, concessions offered by one country to another member should be presented unconditionally to all other W T O members within a pre-specified timeframe. As Panagariya (1999) notes, this would be the "best dynamic time path to bring..(FTAs)..up to multilateral free trade" (also see Srinivasan, 1998). While the foregoing is ideally something that should be written into the W T O Articles of Agreement, Singapore could take the lead in this regard and insist its inclusion in trade accords to which it is a signatory. Singapore ought also to stand firm on requiring that its FTAs be comprehensive in coverage, not allowing omission of sectors even in areas that may not be of economic significance to the city-state (agriculture being a case in point). In this way, FTAs can truly be WTO-compatible. Conversely, exclusion of specific sectors in FTAs only perpetuates the problems that exist with multilateral trade liberalization.

Bibliography Asian Development Bank (ADB) (2002). Asian Development Outlook 2002, Manila: Oxford University Press. Baldwin, R. (1997). "The Causes of Regionalism", The World Economy, 20, pp. 865-888. Bergsten, F. (2000). "Back to the Future: APEC Looks at Subregional Trade Agreements to Achieve Free Trade Goals", speech given at the Pacific Basin Economic Council luncheon (Washington, DC, October 31). Bhagwati, J. (1995). "U.S. Trade Policy: The Infatuation with Free Trade Areas", in The Dangerous Drift to Preferential Trade Agreements, Washington, DC: The AEI Press. Crawford, J .A. and S. Laird (2001). "Regional Trade Agreements and the WTO", North American Journal of Economic and Finance, 12, pp. 193-211. Department of Statistics, Singapore (DOS) (2002). Yearbook of Statistics, Singapore: DOS. Ethier, W. (2001). "The New Regionalism in the Americas: A Theoretical Framework", North American Journal of Economics and Finance, 12, pp. 159-172.

Singapore's Drive to Form Cross-Regional Trade Pacts

179

IMF. Direction of Trade Statistics Yearbook, various issues. Koh, T. (2000). "US-S'pore FTA: It's Good for More Than Just the Two", The Straits Times, Singapore, December 7. Krueger, A. (1997). "Problems with Overlapping Free Trade Area", in T. Ito and A. Krueger (eds.), Regionalism versus Multilateral Trade Arrangements, Chicago: University of Chicago Press. Lai, D. (1993). "Trade Blocs and Multilateral Free Trade", Journal of Common Market Studies, 31, pp. 349-358. Lawrence, R. (1987). "Imports in Japan: Closed Markets or Minds?", Brookings Papers on Economic Activity, 2, pp. 517-558. Lawrence, R. (1999). "Regionalism, Multilateralism, and Deeper Integration: Changing Paradigms for Developing Countries", in M. Mendoza, P. Low and B. Kotschwar (eds.), Trade Rules in the Making: Challenges in Regional and Multilateral Negotiations, Washington, DC: Brookings Institution Press. Lee, H.L. (2002). "Remaking Singapore for a Different World", speech at the Institute for International Economics (Washington, DC, November 13). Lien, J. (2002a). "Bush Targets FTAs with More ASEAN Nations", Business Times, Singapore, October 28. Lien, J. (2002b). "Singapore Could Seal FTAs with Australia, US Next Month", Business Times, Singapore, October 29. Lim, H. (1988). "Singapore-Japan Trade Frictions", in ASEAN-Japan Relationship Towards the 21st Century, Japanese University Graduates Association of Singapore, pp. 91-121. Mattoo, A. and C. Fink (2002). "Regional Agreements and Trade in Services: Policy Issues", Policy Research Working Paper No. 2852, The World Bank. Panagariya, A. (1999). "The Regionalism Debate: An Overview", The World Economy, 22, pp. 477-512. Raj an, R. (1995). "Regional Economic Cooperation Involving Developing Countries in the Post-Cold War World: Lessons from the Asia Pacific", Development and International Cooperation, 10, pp. 383-404. Rajan, R. (2003). "Sustaining Competitiveness in the New Global Economy: Introduction and Overview", in R. Rajan (ed.), Sustaining Competitiveness in the New Global Economy: A Case Study of Singapore, Cheltenham: Edward Elgar.

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Rajan, R. and R. Sen (2002). "Singapore's New Commercial Trade Strategy: Examining the Pros and Cons of Bilateralism", in Chang L.L. (ed.), Singapore Perspectives 2002, Singapore: Times Academic Press. Rajan, R. and R. Sen (2003). "The Japan-Singapore 'New Age' Economic Partnership Agreement: Background, Motivation and Implications", in Trading Arrangements in the Pacific Rim, New York: Oceana Publications. Rajan, R., R. Sen and R. Siregar (2001). Singapore's Attraction to Free Trade Areas: Bilateral Trade Relations with japan and the US, Singapore: Institute of Southeast Asian Studies. Robson, P. (1998). The Economics of International Integration, London: Routledge. Sager, M. (1997). "Regional Trade Agreements: Their Role and the Economic Impact on Trade Flows", The World Economy, 20, pp. 239-252. Schiff et al. (2000). Trade Blocs, Washington, DC: The World Bank. Sen, R. (2002). "Singapore in the Global Trading System: Strengthening Linkages Beyond the Southeast Asian Region", paper presented at the Institute of Policy Studies Symposium on "Sustaining Competitiveness in the Singapore Economy" (Singapore, July 26-27). Singapore Trade Development Board (2001). Review of First-Half 2001 Trade Performance and Outlook for Second-Half 2001 (www.tdb.gov.sg/gss/sl-briefs/2001/review2001.pdf). Singapore Trade Development Board. Singapore Trade Statistics, various issues. Srinivasan, T.N. (1998). "Regionalism and the WTO: Is Nondiscrimination Passe?", in A. Krueger (ed.), The WTO as an International Organisation, Chicago: The University of Chicago Press. Takeuchi, K. (1989). "Does Japan Import Less than it Should?: A Review of the Econometric Literature", Asian Economic Journal, 3, pp. 138-170. Winters, A. (1999). "Regionalism Versus Multilateralism", in R. Baldwin, D. Cohen, A. Sapir and A. Venables (eds.), Market Integration, Regionalism and the Global Economy, Cambridge, UK: Centre for Economic Policy Research. Wonnacott, P. (1996). "Beyond NAFTA — The Design of a Free Trade Agreement of the Americas", The Economics of Preferential Trade Agreements, Washington, DC: AEI Press.

Slnsapore's Drive to Form Cross-Regional Trade Pacts

181

Wonnacott, R. and M. Lutz (1989). "Is there a Case for Free Trade Areas/", in J. Schott (ed.), Free Trade Areas and US Trade Policy, Washington, DC: Institute for International Economics. World Trade Organisation (WTO) (2001a). International Trade Statistics 2001, Geneva: WTO. World Trade Organisation (WTO) (2001b). Annual Report of the Director-General 2001, Geneva: WTO.

182

Economic Globalization and Asia Table 1 Growth Performance of Singapore and Selected East Asian Economies, 1981-2002 (GDP growth, percent per annum) Average

Average

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1991-95

1996

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7.3

8.7

7.5

8.0

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6.0

8.7

8.6

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7.9

8.4

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5.4

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5.9

9.9

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0.3

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5.5

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4.2

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7.8

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4.6

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4.8

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9.1

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5.5

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10.9

8.8

2.6

3.2

4.0

1.4

3.3

1.9

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0.7

2.2

-0.4

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Singapore's Drive to Form Cross-Resional Trade Pacts

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• — Domestic Exports — X — Imports

Source: IMF, Directions of Statistics Yearbook, various issues Figure 1 Growth of Singapore's Merchandise Trade (US dollar billions)

185

186

Economic Globalization and Asia

Philippines 1.6/c

China, PRC 2.3% "1 Au+alia orea - ^ 0 , - , 2.^/c

Thailand 5.8'

Canada Switzerland °-5% r 0.3% /NewZea|and |nd|. J16%| a3% Malaysia 19 2=;.

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Hong Kong 8.5% Others 13.7%

Europe 15.2%

Source: Computed from Singapore Trade Development Board, Singapore Trade Statistics, various issues Figure 2a Share of Singapore's Major Trading Partners in Singapore's Total Exports, 1995

Japan 7.7% Europe 14.8% Hong Kong 8.9%

Switzerland 0.5% New Zealand 0.3%

Malaysia 17.3%

Canada 0.3% 2.6%

China.PRC 4.4%

Philippines\_ T n a i l a n d 4.4% 2.5%

Source: Computed from Singapore Trade Development Board, Singapore Trade Statistics, various issues Figure 2b Share of Singapore's Major Trading Partners in Singapore's Total Exports, 2001

Singapore's Drive to Form Cross-Regional Trade Pacts

187

United States 24.6%

India J.1% New Zealand ° - 3 % China 2.4% Korea 2.4%

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New Zealand 0.4%

Source: Computed from Singapore Trade Development Board, Singapore Trade Statistics, various issues Figure 3b Share of Singapore's Major Trading Partners in Singapore's Domestic Exports, 2001

Economic Globalization and Asia

188

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Korea 3.6%

Source: Computed from Singapore Trade Development Board, Singapore Trade Statistics, various issues Figure 4b Share of Singapore's Major Trading Partners in Singapore's Total Imports, 2000

189

Chapter 8

International Trade in Infrastructural Services in East Asia: Telecommunications and Finance1

1. Introduction Rapid advancements in Information and Communications Technologies (ICTs) and regulatory reforms have worked in tandem to increase the scope and importance of service transactions in the global economy. Service activities have constituted a large and growing share of production, employment, investment and trade, which in turn has led to profound structural changes in many countries, especially in middle and upper income developing ones (World Bank, 2001, 2002) 2 . Tables 1 and 2 summarize the growth in service and merchandise exports over the last two decades (1980-2000), respectively. While merchandise exports of developing countries doubled in value during this period, their service exports ballooned four-fold. The overall average growth of service exports of the developing countries was almost 8 percent, outpacing that of merchandise exports which averaged 5 percent. By 1999, commercial services trade accounted for nearly a quarter of world trade and an estimated half of global FDI stocks to all regions except Sub-Saharan Africa (World Bank, 2001). Noticeably, the proportion of services in overall international trade appears to be smaller than its corresponding share in aggregate output and employment. O n the basis of this, services have conventionally been considered to be "less tradable" than manufactured or even agricultural products. However, this is no longer a valid conclusion for an increasing number of services. Part of the reason for the apparently low share of services in international trade may relate to definitional and data problems. In particular, trade in services often requires the simultaneous movement of factors of production (labour and 1 2

This Chapter draws on Raj an and Sen (2002) and Raj an and Bird (2002).

As classified by the World Bank according to income, these cover Newly Industrializing Economies (NIEs) in East Asia, Oil producing countries in the Gulf region and Israel.

190

Economic Globalization and Asia

capital in the form of FDI). In other words, a number of important modes of supply of services are not considered in the conventional trade statistics on a balance-of-payments basis 3 . In addition, some services, such as transportation, insurance and finance are vital in facilitating the production process and in bringing manufactured and agricultural goods to the market. Other types of services are directly embodied in goods but may not explicitly be taken into account (e.g. design, software, repair work and other technical expertise). Available statistics may, therefore, severely downplay the actual magnitude of international trade in services as many transactions go unrecorded 4 . In addition, figures for merchandise trade may be artificially inflated because of the high share of reexports, when is in fact entrepot trade is largely a service transaction. Following Bhagwati (1984) and Sampson and Snape (1985), trade in services may be classified on the basis of the location of the service providers according to the following four-fold typology5: (a) Mode 1: cross'border supply which are services supplied from one country to another (e.g. international telephony); (b) Mode 2: consumption abroad which refers to firms or consumers making use of a service across a national frontier (e.g. tourism and health services); (c) Mode 3: commercial presence which occurs when a foreign company establishes a subsidiary or branch abroad to provide services in another country (e.g. foreign banks or telecommunications firms setting up overseas operations); and (d) Mode 4: presence of natural persons which involves individuals traveling from their own country to supply services in another country (e.g. consultants, design or software engineers, or the temporary transfer abroad of employees of a multinational). In the first kind of transaction, production and consumption are "separated" or "splintered", while the other modes require the mobility of factors of production, consumers or both. Table 3 offers an indication of the global scale of each of the four modes of international service transactions. Mode 3 appears to be where the most multilateral negotiation activity has taken place thus far. In a recent study, Carzaniga

3

The World Bank (2002) has noted that "(t)he available evidence suggests that commercial presence has been the most dynamic mode of services supply in recent years" (p. 72). 4 In recent years, a number of the multilateral institutions have taken significant steps to try and improve the quality of cross-border services transactions. For instance, see the UN-ESCAP's website on this issue: http://esa.un.org/unsd/tradeserv/ as well as that of the World Bank: http://wwwl.worldbank.org/wbiep/trade/services_data.htm. 5

The General Agreement on Trade in Services (GATS) has since adopted this classification.

International Trade in Infrastructural Services in East Asia

191

(2002) notes: Recent estimates, based on limited empirical information, suggest that Mode 3, commercial presence, accounts for more than half of world trade in services and Mode 1, cross-border trade, for about a fourth, while Mode 2, consumption abroad contributes less than one-fifth. Mode 4 was found to be nearly insignificant, accounting for just over 1% of world services trade (p. 3). The relative insignificance of Mode 4 is not surprising as it appears to be "significantly more restrictive than conditions for other modes" (Carzaniga, 2002, p. 3; also see Hoekman, 2000, p. 45 ) 6 . Insofar as commercial presence is particularly susceptible to not being captured in balance of payments accounts (Dee et al., 2001), the Mode 3 channel of cross-border trade in services is in all likelihood severely under-estimated. Despite statistical imprecision, Primo Braga (1996) has declared that the "internationalization of services is viewed as being at the core of economic globalization" (p.34). It is in recognition of its rising importance that a multilateral framework for liberalizing trade and investment in the service sector was conceptualized in the form of the General Agreement on Trade in Services (GATS) initiated under the aegis of the W T O 7 . To what extent do emerging economies stand to gain from liberalizing trade in services? The purpose of this Chapter is to monitor the extent of trade liberalization in two key infrastructural services in five East Asian economies (viz. China, Indonesia, Malaysia, South Korea and Thailand — henceforth termed the Asia-5 economies), and to assess, on the basis of available evidence, the likely consequences of liberalization. Why do we focus on these two sectors? A clue is provided by Hoekman (2000) who notes: the various measures of openness suggest barriers to competition are higher in transportation, finance, and telecommunications. These are also basic "backbone" inputs that are crucial to the ability of enterprises to compete internationally.... This suggests negotiating attention should focus on financial services, telecoms and transport (p. 39). 6

Carzaniga (2002) summarizes the Mode 4 GATS commitments made by countries. To try and move the liberalization of this mode forward, Hoekman (2000) suggests: one could envisage a safeguard instrument that is limited to Mode 4 liberalization commitments, and is explicitly aimed at providing OECD country governments with an insurance mechanism that can be invoked if liberalization has unexpected detrimental impacts on their societies (p. 45). 7

See Hoekman (2000), Hoekman and Mattoo (2000) and Mattoo (2001) for recent discussions on the GATS.

192

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Insofar as the key transportation services like air and maritime have been discussed extensively elsewhere (for instance, see Fink et al., 2000 and World Bank, 2002, Chapter 4 and references cited within), we focus on telecommunications and financial services. The layout of the Chapter is as follows. Section 2 briefly examines the theoretical case for liberalizing trade in services. Section 3 records the state of play with respect to the liberalization of trade in telecommunications and financial services in the Asia-5 economies. Section 4 reviews the empirical evidence on the effects of liberalizing international trade in services, and attempts to provide some indication of its implications for Asia. Particular reference is made to Mode 3 supply of services via commercial presence. The final Section offers a few concluding remarks. Annex 1 summarizes the distinction between capital account deregulation and the internationalization of financial services.

2. Liberalizing Trade in Services: A Basic Review of Theory As noted, technical advancements have been a major reason for the growth and increased internationalization of service activities, as have regulatory reforms. The latter involves privatization and market deregulation through the breaking up of monopolies and reducing other "behind the border" measures such convergence in and mutual recognition of standards and certification, protection of intellectual property rights (IPR), opening of government procurement markets, streamlining of customs procedures, development of dispute settlement procedures, rights of establishment of and operation of a commercial presence by foreign firms, limitations on foreign ownership or requirements to enter joint ventures, and non-discriminatory access to distribution networks. There have been a handful of theoretical studies on the role of services in the production process and international trade (e.g. Markusen, 1989; also see survey by Sapir and Winter, 1994). At the risk of generalizing, notwithstanding some theoretical curiosities, the broad conclusion of these studies is that the positive static welfare effects of liberalizing trade in goods extends to services as well. A n appropriately timed and sequenced liberalization of the service sector ought to (a) provide the usual Harberger Triangle welfare gains by reducing, if not entirely eliminating, the wedge between domestic and foreign prices (see Chapter 5) and (b) permit the "rationalization of service activities along the lines of comparative advantage" (Deardorff, 2001). A number of developing countries have a comparative advantage and niche export opportunities in certain service activities, particularly professional and business ones (such as computer and office services), tourism, health, construction and transport. They thus have a substantial stake in an orderly liberalization of global service markets.

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Beyond the direct effects on output and employment, as noted, the service sector is a key input in merchandise and agricultural production and trade. According to the World Bank (2002): As countries reduce tariffs and other barriers to trade, effective rates of protection for manufacturing industries may become negative if they are higher than they would be if services markets were competitive (p. 76). In addition, a relatively new phenomenon in trade in manufactured goods is "intraproduct specialization", broadly defined as the fragmentation of the process of production of a good into its sub-component parts and processes which in turn are distributed across countries on the basis of comparative advantage (see Chapter 1). Such production fragmentation depends heavily on the reduction in transactions costs (i.e. insurance, transportation and ICT services), and is therefore facilitated by services liberalization (Deardorff, 2001). For instance, effective telecommunications liberalization is usually followed by a significant expansion of networks and a marked decline in prices. The liberalization of the financial services sector ought also to enhance the process of sectoral and intertemporal resource allocation, overall savings, investment and risk sharing. In addition to these direct static gains, as with trade in goods, there are potential dynamic productivity and growth gains via technology transfer (particularly in cases where services are embodied in FDI), as well as via the introduction of market competition (i.e. "X-efficiency"). Further welfare gains could accrue to consumers from the availability of broader product variety of specialized producer services as well as enhanced product quality (World Bank, 2002). A n important caveat should be noted. Unlike trade in merchandise and agricultural goods, it is especially important to ensure that the deregulation of services is handled with care, and, in particular, that the domestic regulatory environment is strengthened prior to and during the process of liberalization. The benefits from liberalization of services are far from automatic. If deregulation and internationalization takes place prematurely, i.e. in a weak or ineffective regulatory and supervisory environment, there may be severe calamitous consequences on the sector in question as well as disruptions to the overall macroeconomy. As is increasingly recognized, the issue is not one of whether to open up and integrate with the global economy in a market-consistent manner, but when and how to do so. Nowhere is this more pertinent than in the case of services. This said, what is meant by "effective regulation" will vary based on the sector under consideration 8 .

8

Admittedly, it might be difficult to distinguish between regulations that are necessary to minimize possible financial and economic disruptions, and those that may have a protectionist goal or effect (see Fink et al., 2001).

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For instance, effective regulation in the case of the telecommunications sector refers to pro-competitive regulation, while in the financial service sector it usually refers to prudential regulation (Mattoo et a l , 2001 ) 9 .

3. The Liberalization of Infrastructural Services in the Asia-5 Economies 3 . 1 . Importance of the service sector in the Asict'5 economies Table 4 captures important trends in the development of the service sector and trade in services in the Asia-5 economies over the last two decades. It is clear that the contribution of the service sector to the GDP in all these economies (except Thailand) has been increasing over the past two decades, with the highest increase registered in China. However, with the possible exception of Malaysia, all the other selected East Asian economies recorded a slower average growth in value-added in the service sector between 1991 and 1999 compared to the previous decade. N o doubt the growth in later years of the 1990s was negatively impacted by the regional financial turmoil of 1997-98. With the growth in valueadded of the service sector, there has been a rise in the proportion of the labour force employed in the service sectors by these economies. For instance, a quarter of Thailand's labour force was employed in the service sector in 1990-99, while Korea was at the extreme, with more than a half of the country's labour force employed in the service sector. There has also been a sharp growth in trade in services over the past two decades. Figure 1 highlights the trends in growth of service exports in these economies. The three Southeast Asian economies (Indonesia, Malaysia and Thailand) have experienced high growth rates in trade in services, particularly over the mid 1980 to 1990 period. How has the composition of trade in services altered over the past two decades? As can be seen from Table 4, apart from Indonesia, there has been an increase in the share of communication and computer related service exports and imports in total services trade of these economies in 1990-99 compared to 1980-90, particularly in the cases of Thailand and China. This dynamism is not apparent in the case of insurance and financial services whose share in total service trade has remained quite low across the two decades, possibly reflecting the

'There will inevitably be short term adjustment costs from liberalization which need to be appropriately managed. This in turn has implications for the timing of liberalization.

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continued restrictiveness of this sector to international trade. Other than for China and Indonesia, there has also been a decline in the share of travel services in total services trade in 1990-99 compared to the previous decade. This trend is also observable for all economies in the case of transport services which used to constitute the bulk of trade in services during the decade of the 1980s. How significant is FDI to the service sectors in these economies? It is clear from Table 4 again that, with the exception of Korea, the East Asian economies have increasingly utilized FDI in their economies over 1980-99, with the highest increase in the FDI-to-GDP ratio occurring in China in 1990-99 compared to a decade earlier. The FDI to Gross Capital formation (GCF) ratio has also risen sharply in all economies, particularly in China. All in all, it is fair to conclude that the service sectors in the relevant Asia-5 economies have grown rapidly and consistently, both in terms of domestic activity, as well as international trade. This growth has, at least partly, been fuelled by FDI inflows over the past two decades. One can expect that further liberalization in important service sectors such as finance and telecommunications, will, if well timed and sequenced, facilitate and accelerate the sector's growth.

3.2.

Extent and direct costs of services trade

restrictions

Restrictions on trade in services are measured using a trade restrictiveness index developed by Warren and Findlay (2000) and further elaborated by Findlay and McGuire (2001). Broadly, the index is a frequency measure that estimates the restrictiveness of an economy's trading regime for services based on the number and severity of restrictions. Restrictions are initially classified in two ways. First, according to whether they apply to actual establishment or right to entry (commercial presence), on the one hand, or to ongoing operations, i.e. continued day-to-day operations of a service supplier after it has entered the market, on the other 10 . Second, according to whether the restrictions are imposed on domestic and foreign service suppliers equally ("non-discrimination"), or whether they are done so "discriminatorily", i.e. restrictions imposed either only on foreign or only domestic service suppliers. Table 5 summarizes the restriction categories in each type of service sector.

10 The reason for distinguishing restrictions on establishment from ongoing operations is so that the former can be modelled as restrictions on the actual movement of capital, while the latter can be modelled as restrictions on output.

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A trade restrictiveness index score is computed for each economy based on a methodology of scores and weights. The more prohibitive the restriction, the higher is the score. Some degree of subjectivity needs to be used in assigning scores. The restriction categories are then weighted once again on the basis of a judgement about their relative economic costs. For instance, and for reasons that are not completely clear, restrictions on FD1 are given a higher weight than those on the temporary movement of people. The weights are ascribed in such a way that the total restrictiveness index score ranges from 0 ("least restrictive") to 1 ("most restrictive"). Separate index scores are computed for domestic and foreign service suppliers. The difference between the foreign and domestic index scores may be interpreted as an indicative measure of the extent of discrimination against foreigners. W i t h regard to telecommunications services, China, Thailand and Indonesia have been relatively restricted, with significant limitations on FDI in fixed network and mobile phone services (with restrictions on the latter generally being larger than on the former). Korea and Malaysia are moderately restricted in terms of having some limitations on FDI in telecommunications service providers (Table 6). Table 7 highlights the estimated price/cost effects of maintaining trade restrictions in the Asian economies. As can be seen, there is a direct relationship between the price/cost of services and the degree of protection of the particular sector. For instance, the price effect measures on foreign service suppliers in telecommunications in China and Indonesia are well over 100 percent. The price effect measures for Korea are the lowest, while those on Malaysia are "moderate". Therefore, the Table suggests that countries with the most restrictive regimes stand to reap the largest efficiency gains from liberalization. With regard to banking services, results of the trade restriction indices indicate that Malaysia and Indonesia are the most restricted markets in the AsiaPacific region, limiting new foreign bank entry, strictly restraining foreign equity participation, and disallowing banks from expanding their existing operations (Findlay and McGuire, 2001). Having recently relaxed a number of restrictions on foreign bank entry, the banking sectors in both Korea and Thailand are "moderately restricted", with at least one significant restriction that limits foreign access to their market (Tables 8 and 9). With this as background, the remainder of this Section offers an overview of recent developments in the telecommunications and financial sectors in the Asia-5 economies with particular emphasis on their respective schedules of liberalization vis-a-vis the G A T S . W i t h regard to financial services, the focus will be limited to the banking and insurance sectors.

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Telecommunications

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services

Despite a common move to greater telecommunications openness, policy choices have varied markedly among the Asia-5 economies (Fink et al., 2001). Table 10 summarizes the specific G A T S commitments by the Asian economies in telecommunications services. Korea is the only country to have committed to liberalize almost all telecommunications services. China has made commitments in all but two basic telecommunications services viz. telex and telegraphic services, though it remains to be seen whether it does in fact liberalize these services within the given timeframe. Malaysia too has made commitments in all but two value-added telecom services viz. Electronic Data Interchange (EDI) and On-line Information and/or data processing services. In comparison, Thailand has offered commitments in only two sectors of valueadded telecom services. Indonesia has also been rather cautious in liberalizing value-added telecom services compared to basic services. This is: partly due to the fact that the state-owned enterprises PT Telkom (sole local and long distance service carrier), PT Indosat and PT Satelindo (exclusive providers of international services) are among the few firms that remain financially viable amidst the floundering political and economic environment (Abrenica and Warren, 1999, p. 8). Many of the economies in Asia persist with wide-ranging restrictions on foreign equity ownership. Fink et al. (2001) conclude that: While the traditional public monopoly is becoming a rarity, most governments seem reluctant to forego discretionary policy-making and delegate choices completely to the market. One important battle seems to be largely won: in most cases, privatization has been accompanied by the introduction of some measure of competition. But governments have been reluctant to allow unrestricted entry, and in most cases there are restrictions on the extent of private and foreign ownership, at least in the main incumbent. There is a high degree of variability in the pattern of regulation both in terms of the degree of autonomy and the domain of the regulator. Many governments have also had difficulty in establishing credibility for their reform programs (p. 7). In short, there has been a clear preference for a policy of "managed competition" in many Asian countries. However, Fink et al. (2001) observe that there are relatively larger welfare gains to be had from an increase in competition than from a simple change of ownership. A case against increased competition is hard

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to make, but there may be technical limitations to competition (for instance, the scarcity of radio spectrum required for the provision of mobile telecommunications services is a case in point), or there may be significant economies of scale (due, for instance, to substantial fixed costs). Governments appear more willing to open up the mobile network segment of telecommunications as there is less political need to protect incumbent operators with state ownership.

3.4.

Financial services

Reviewing the financial service commitments made by a number of a developing and transition economies, Mattoo (1999) reaches the following conclusion, which is just as applicable to the Asia-5 economies under consideration here: In broad terms, governments have adopted three different approaches to the financial services negotiations, assuming that they participated at all. These are: (i) to bind the status quo, which may have been arrived at after liberalization, either unilateral or in the context of the negotiations; (ii) to make binding commitments that represent less than the status quo in policy terms; and (iii) to promise future liberalization, which may or may not have been planned prior to the negotiations. These categories are not necessarily mutually exclusive when the set of a country's commitments is taken as a whole, nor is it always easy to determine the precise category in which a policy position should fall. The distinctions are useful, however, in thinking about the relationship between W T O negotiations and domestic liberalization processes (p. 23). Table 11 summarizes the specific G A T S commitments by the Asian economies in financial services. As with a number of other countries, the Asia-5 economies have bound their obligations at less than the status quo. For instance, notwithstanding Korea's recent aggressive steps towards liberalization, its G A T S commitments with regard to foreign portfolio investments have been less than those it made to the OECD. For the other countries, the binding of commitments below status quo is a reflection of the governments' dual objectives of trying to encourage foreign investments into the financial sector, while simultaneously avoiding a repeat of the turmoil and instability following the premature and illsequenced liberalization prior to the regional crisis of 1997-98 (not to mention providing some degree of protection to the incumbent national suppliers from immediate competition). As further evidence of this reluctance to move forward aggressively in their liberalization programs, Table 12 summarizes the various grandfathering provisions (which guarantee the ownership and branching rights

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of incumbent firms) undertaken by the Asian economies. As Mattoo (1999) observes: It is evident that grandfathering was primarily an Asian phenomenon. T h e grandfathering provisions reflect the relative emphasis in these negotiations on guaranteeing the rights of incumbents. They provide the benefits of security to investors who are already present in the market rather than to new investors (p. 28). This being said, all the economies, especially Korea and Thailand, have continued to take important steps towards relaxing foreign equity limitations. There appears to be a clear policy preference for encouraging foreign equity investments (ownership/divestment) over the promotion of market competition. 4. Liberalizing Trade in Services: The Empirical Evidence While theory suggests a number of potential benefits from a well-timed and sequenced approach to liberalization of trade in services, what do empirical studies tell us about the magnitude of these gains? Notwithstanding the recent "revisionist view" of Rodriguez and Rodrik (2001), the bulk of the empirical literature using cross-country data has found that international trade in goods has been growth-inducing 11 . What about the case of services? In view of the acute data problems, it should not be surprising that there is a dearth of empirical studies on the impact of services liberalization on growth. For reasons discussed above, one might expect, a priori, the liberalization of trade in services to generally have a relatively larger effect on economic growth than merchandise trade. This is particularly so since services have hitherto remained relatively protected. 4.1.

The econometric

evidence

Mattoo, Rathindran and Subramaniam (henceforth M-R-S) (2001) have examined the impact of liberalization of the financial and telecommunications sectors on overall economic growth. Given the paucity of studies on this issue, as well as the influence that it has apparently had on the World Bank (see World Bank, 2002), it is worth summarizing the main elements of the study in some detail.

11 Rodriguez and Rodrik (2001) argue that "that there is a strong negative relationship in the data between trade barriers and economic growth, at least for levels of trade restrictions observed in practise". Srinivasan (2001) provides a strong critique of the revisionist view. Some of this literature between trade and growth is referred to in Chapter 5.

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M-R-S create an index based on a set of openness indicators for both sectors. In the case of telecommunications, the index is a lexicographic representation of three policy variables, viz. competition, foreign ownership and regulation, with the first element deemed as most important followed by the second. The first two variables indicate the degree of international competition. A proxy for regulation is included in recognition of the importance of effective regulation in "ensuring access for rival service suppliers to the networks of incumbents on reasonable terms" (p. 11). A country's telecommunications sector is thus considered to be "fully liberalized" if the index value is 9 (Table 13). As with the telecommunications sector, the liberalization index for the financial service sector consists of three components. The first two are similar, viz. competition and foreign ownership, but the third is an index for capital controls, which is included in recognition of the close nexus between financial sector openness and capital account deregulation (see Bird and Rajan, 2001 ) 12 . The reason for excluding regulation in this sector as a measure of openness is that it "does not have the same competition-promoting role that it does in the telecommunications sector" (p. 12) 13 . A country's financial sector is considered to be "fully liberalized" if the index value is 8 (Table 14). Having developed the indices for services liberalization, M-R-S run a series of cross-country regressions for a sample 60 countries (37 of which are developing ones) for the period 1990-99. They estimate the following regression specification: Gj = a + pXj + "YR,-

for] = 1, ... , N

where Gj is the average annual growth rate of per capita G N P (adjusted for purchasing power parity) between 1990 and 1999 in country j , a is a constant term, Xj is the vector of standard growth controls for country j 1 4 , R, is a vector of the openness to trade in services for country j , and N represents the number of countries in the sample.

12

Since no data are available on national policies on competition and foreign ownership, M-R-S infer them from the countries' commitments under the GATS. As some countries (like Brazil) have de facto liberal regimes, the authors make appropriate adjustments to the rankings to reflect this. 13

M-R-S go on to note that "the omission may nevertheless be serious because the quality of banking and prudential regulations is of paramount importance in addressing systemic risk" (p. 12). 14

The standard growth controls used by M-R-S include the natural log of per-capita GNP in 1990 (the convergence variable), investment rate (lagged value), schooling ratio (human capital), government consumption to GDP ratio (as a proxy for government size and magnitude of government induced distortions), the inflation rate (as a proxy for macroeconomic imbalances), proxy variables for political and institutional stability, geographical and regional dummies, and an index of tariff and non-tariff barriers.

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Considering indices for the telecommunications and financial sectors individually, M-R-S find that both indices entered with the right sign (i.e. positive), the latter being statistically significant at at least the 10 percent level. Results are consistent if the sample is limited to developing countries. Thus, evidence suggests that the greater the degree of telecommunications and especially financial sector openness, ceteris paribus, the greater will be average output growth. The evidence of the growth-inducing effects of financial sector openness (i.e. the Schumpeterian thesis of banking sector development facilitating economic growth through technological change and capital accumulation) has also been confirmed by a number of other studies (for instance, see Beck et al., 2000, King and Levine, 1993 and Levine et al., 2000). In the case of telecommunications, Roller and Waveman (2001) also find a positive linkage between a country's telecommunications infrastructure and its economic growth. Table 15 reproduces results for the case of "complete liberalization" in both sectors, i.e. interaction of liberalization dummies of both sectors, with the variable taking on a value 1 if both sectors are fully liberalized and zero otherwise. As can be seen, the coefficient is once again statistically significant with a value of 0.015. This suggests that countries that have fully liberalized both their telecommunications and financial service sectors have tended to grow by an average 1.5 percentage points faster than others in the 1990s. The magnitude is even higher when the sample is limited to developing countries. All in all, the M-R-S study provides strong evidence that financial and telecommunications liberalization is positively associated with growth. Both sectors are key determinants of growth in modern economies, not only in their own right (i.e. share of GDP), but also in terms of being important in the production and exchange of other goods and services.

4-2. The economy-wide effects of further

liberalization

While the preceding discussion alludes to the sector specific gains to be reaped from reducing trade restrictions, the determination of intersectoral and economywide impacts really requires a Computable General Equilibrium (CGE) framework (Hoekman and Primo Braga, 1997). Such a framework is especially important when analyzing the economic impact of the service sector because of its role as an input into the production of many goods. In this Section we consider the results from a particular multi-sector, multiregional CGE model of world trade and investment. The so-called FTAP model covers 19 regions (spanning Asia, North and South America and the EU) and 3 sectors (agriculture, manufacturing and services). The theoretical structure of

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the FTAP model encompasses both FDI and portfolio investment. It is closely based on the well-known Global Trade Analysis Project (GTAP) model (Hertel, 1997), with FDI and other modifications to the structure included to account for services liberalization 15 . Incorporating FDI allows us to examine the comprehensive removal of restrictions on all modes of service supply, including restrictions on services delivered via FDI (Mode 3). As noted previously, this delivery mode is, in all likelihood, severely underestimated in the balance of payments data. The theoretical literature on FDI and trade in services remains thin, Markusen, Rutherford and Tarr (2002) being a notable exception. Summarizing the Markusen-Rutherford-Tarr study, Hoekman (2000) notes: Their research finds that FDI is beneficial to host economies — not only because it is a source of new knowledge and competitive pressure, but also because FDI in services can increase the demand for skilled workers and help host countries to begin to produce and export advanced products. . . . This work suggests that the rationale for ownership restrictions may be weak if it has the effect of inhibiting entry. It is crucial to identify and consider the rationale for policies that limit competition in services (p. 34) Returning to the FTAP model, the price/cost effects of trade protectionism noted above are modeled as tax equivalents to capture the direct effects of current services trade restrictions. Restrictions on establishment are modeled as taxes on capital, while those on ongoing operations are modeled as taxes on the output of FDI firms and the exports of firms supplying through other modes of delivery. Using the FTAP model, Dee and Hanslow (2000) reach the following set of conclusions with regard to the projected gains in real income about a decade after complete liberalization has taken place (accounting for transitory adjustment effects). Note that the results are static in nature, showing only the direct impact of trade liberalization and not the ensuing impact on savings, investment and therefore growth. First, the world in general is projected to be better off by around US$260 billion annually as a result of eliminating all post-Uruguay Round trade restrictions 16 . Second, about half these gains are projected to come from liberalizing trade in services, US$80 billion from the liberalization of manufactures, and

15

The treatment of FDI in the FTAP model is in turn based on Petri (1997). Dee and Hanslow (2000) offer detailed discussion of the FTAP model. Descriptions and documentation related to the model are available on the website of the Productivity Commission of Australia's website: http://www.pc.gov.au. 16

China itself is expected to gain from services liberalization by around US$90 billion.

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the remainder from liberalizing agriculture. The much larger gains attributed to liberalization of trade in services are in line with the theoretical priors outlined earlier, as are the predictions that the largest gains go to the regions with the highest services trade barriers. The results found by Dee and Hanslow (2000) are in broad concurrence with those of other general equilibrium frameworks which tend not to be as sophisticated as the FTAP model (Findlay and McGuire, 2001). But all these general equilibrium results may understate the gains from liberalizing services, as not all the modes via which services are supplied are necessarily taken into account. Dee and Hanslow (2000) conclude that, with regard to partial liberalization of trade in services, the greatest global benefits would derive from the liberalization of non-discriminatory or market access restrictions. In addition, the removal of all restrictions on establishment would yield a larger total benefit than removing all restrictions on ongoing operations. Verikios and Zhang (2001) also use the FTAP model but focus specifically on the impact of liberalizing the financial and telecommunications service sectors. They make use of more recent estimates of trade barriers (i.e. post Uruguay Round) and project the total gain in world income from liberalizing these two sectors to be about US$48 billion. What about liberalization of specific sectors?

43.

Telecommunications

services

Table 16, taken from Verikios and Zhang (2001), shows the results of complete liberalization of the telecommunications sector for various countries and the world at a whole. The world is projected to gain by about US$24 billion (a 0.1 per cent rise in world real GNP). All regions in Asia are expected to gain, except Malaysia and Thailand. China and Indonesia are expected to experience the largest gains, with Korea and other higher income countries benefiting relatively less. While the results further indicate that countries with higher initial barriers should benefit the most through liberalization, the results for the middleincome countries like Malaysia and Thailand are certainly surprising and warrant closer examination. The FTAP model allows five sources of gains from liberalization to be distinguished: The first three effects are "income generating", with the other two being "income redistributing". As Verikios and Zhang (2001) note: For the world as a whole, only changes in allocative efficiency, net capital endowments and product variety contribute to the changes in real GNP. These three effects can be referred to as 'income generating' factors. The other effects do not change world total GNP, that is, what constitutes a

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gain for one region is a loss for other regions. They can therefore be referred to as 'income redistributing' factors. For the world as a whole, whether a policy change is beneficial or not depends on income generating factors rather than income redistribution factors. At the regional level, however, both types of contributing factors are important (pp. 11-12). The projected declines experienced by Malaysia and Thailand post-liberalization result from adverse movements in the terms of trade and declines in net FDI incomes outweighing the allocative efficiency gains. However, in the case of large, and relatively protectionist countries like China and Indonesia, the allocative efficiency gains dominate. Korea benefits marginally from a combination of allocative efficiency benefits as well as positive net FDI income. While the preceding discussion has been about the income of telecommunications liberalization on overall income (GNP), the outstanding question is how this increase in income is divided across the various sub sectors in the economy. Verikios and Zhang (2001) find that in all cases, and as expected, the telecommunications sector itself sees an expansion (save for Hong Kong), with the extent of expansion being larger the more protectionist the country in that sector pre-liberalization. Beyond that, few generalizations can be made. Nonetheless, it is noteworthy that China and Indonesia are expected to benefit virtually acrossthe-board (the exceptions being "other services" in the case of China and Indonesia, and primary industries in China).

4.4.

Financial services

Table 17 reproduces the results of the complete liberalization of the financial sector (which include banking, insurance and business services) for various countries, as well as the world as a whole. The world as a whole is projected to gain by about US$23 billion (a 0.09 percent rise in world real GNP). As before, complete liberalization of financial services tends to benefit developing regions more than developed ones. The sources of gains can be decomposed as in the case of the telecommunications sector. The largest gains are generated due to capital reallocation to the liberalizing countries as well as allocative efficiency gains. As before, there are significant gains due to the availability of greater product variety but fairly large losses due to the FDI income effect. The terms of trade effect is also negative. Overall, Thailand and Indonesia benefit the most from liberalizing the sector. Somewhat surprisingly, China appears to benefit only marginally, while Malaysia and Korea benefit moderately. The reason for China's rather moderate projected gain is due to a sharp adverse movement in the terms of trade effect which

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negates the allocative efficiency gains, while the gains due to changes in new capital stock are rather small. With regard to the sectoral distribution, as expected, the financial services sector itself is expected to gain. Recall that in the case of the liberalization of the telecommunications sector, obvious patterns of sectoral gains or losses do not emerge. Interestingly, in the case of liberalization of the financial service sector, virtually all other sectors are expected to be positively impacted for four of the five Asian countries (except China). The exceptions are the primary industries in Malaysia and Korea. Consistent with the modest gain by China, the positive benefits accruable to the financial, telecommunications and construction service sectors as well as the secondary industries in the country are matched by negative effects on the primary industries and other service sectors. 5. Concluding Remarks This Chapter has attempted to assess the state of services liberalization and policy environment of the financial and telecommunications sectors in the five Asian economies, viz. China, Indonesia, Korea, Malaysia and Thailand. The assembled evidence confirms the theoretical expectation of a beneficial impact of an appropriately timed and sequenced liberalization of the telecommunications and financial service sectors on overall growth and welfare. The Chapter then went on to analyze the state of deregulation of these two key infrastructural services in each of the five countries noted above in general, and with respect to their respective G A T S commitments in particular. While the country experiences indicate a general move towards greater deregulation and privatization, a close comparison of actual policies with the offers made by these countries under the G A T S schedule reveals that many of the multilateral offers made have been at status quo or below it (i.e. "water" in the liberalization commitments). It is generally recognized that such binding below the status quo legitimizes the possibility for regulatory backsliding in the future. This is hardly the signal most developing countries will want to send to foreign firms. Concerted attempts must be made in future multilateral trade rounds to reduce the wedge between applied regulations and bound liberalization commitments. The current trend of telecommunications sector liberalization in the Asian economies suggests that all five economies have moved more aggressively to deregulate their respective regional mobile networks, which, along with the introduction of digital cellular technologies, has facilitated its pointed growth vis-a-vis fixed lines. Liberalization efforts in the fixed line segment has lagged because most of the incumbent monopoly services providers in these countries have been in the

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fixed-line segment and would be more directly affected by competition in this area compared to the newer segments in value-added telecommunications networks. In the case of financial services liberalization, the five economies have generally bound their G A T S commitments at less than the status quo. Nonetheless, there has been a de facto move towards greater financial liberalization. There appears to be a clear policy preference for promoting foreign equity investments (ownership/divestment) over the promotion of market competition. Korea and Thailand have been front-runners in this regard, while Malaysia and Indonesia are the most restricted. If China does meet most of its outlined commitments, there is likely to be a significant increase in competition in the local banking and insurance sectors by 2007 as most of the ownership and geographic restrictions would be removed. In response to this increased competition for services-oriented FDI from China, as well as in order to enhance domestic efficiency, Malaysia and Indonesia will have to seriously contemplate hastening the pace of financial services liberalization in their countries. All the economies have begun deregulating their insurance service sectors, though there appears to be relatively greater willingness to undertake more liberal commitments in the banking sector compared to the insurance sector. However, as with the case of liberalization of trade in goods, liberalization of trade in services could involve fairly painful temporary/short term adjustment costs which need to be appreciated and appropriately managed. In addition, liberalization of services in particular requires that the institutional and regulatory environment be fortified prior to and during the process of liberalization. Deregulation in a weak or ineffective regulatory and supervisory environment could cause severe instability in that sector and the overall economy in view of the important linkages that services have with the rest of the economy. This was made plain by the East Asian crisis of 1997-98 which was partly due to premature, i.e. ill-timed and ill-sequenced, financial liberalization.

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Hoekman, B. and C. Primo Braga (1997). "Protection and Trade in Services: A Survey", Open Economies Review, 8, pp. 285-308. Karsenty, G. (2000). "Just How Big Are the Stakes?", in P. Sauve and R. Stern (eds.), GATS 2000: New Directions in Services Trade Liberalization, Washington DC: Brookings Institution. King, R. and R. Levine (1993). "Finance and Growth: Schumpeter Might be Right", Quarterly journal of Economics, 108, pp. 717-737. Kono, M., P. Low, M. Luanga, A. Mattoo and L. Schuknecht (1997). "Opening Markets in Financial Services and the Role of the GATS", Special Studies, WTO. Kono, M. and L. Schuknecht (1999). "Financial Services Trade, Capital Flows, and Financial Services", Staff Working Paper ERAD No. 98-12, WTO. Levine, R., N. Loayza and T. Beck (2000). "Financial Intermediation and Growth: Causality and Causes", Journal of Monetary Economics, 46, pp. 31-77. Markusen, J. (1989). "Trade in Producers Services and in Other Specialized Intermediate Inputs", American Economic Review, 79, pp. 85-95. Markusen, J., T. Rutherford and D. Tarr (2000). "Foreign Direct Investment in Services and the Domestic Market for Expertise", Policy Research Working Paper No. 2413, The World Bank. Mattoo, A. (1999). "Financial Services and the World Trade Organization: Liberalization Commitments of the Developing and Transition Economies", Policy Research Working Paper No. 2184, The World Bank. Mattoo, A. (2001). "Shaping Future GATS Rules for Trade in Services", Policy Research Working Paper No. 2596, The World Bank. Mattoo, A., R. Rathindran and A. Subramanian (2001). "Measuring Services Trade Liberalisation and its Impacts on Economic Growth: An Illustration", Policy Research Working Paper No. 2655, The World Bank. Petri, P. (1997). "Foreign Direct Investment in a Computable General Equilibrium Framework", paper presented at the conference Making APEC Work: Economic Challenges and Policy Alternatives (Tokyo, March 13-14). Primo Braga, C. (1996). "The Impact of the Internationalization of Service on Developing Countries", Finance and Development, March, pp. 34—37. Rajan, R. (2002). "International Financial Liberalisation in Developing Countries: Lessons from Recent Experiences", Economic and Political Weekly, 37, July 20-26, 2002, pp. 3017-3121. Rajan, R. and G. Bird (2002). "Will Asian Economies Gain from Liberalizing Trade in Services?", Journal of World Trade, 36, pp. 1061-1079.

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Raj an, R. and R. Sen (2002). "International Trade in Services in Selected ASEAN Countries: Telecommunications and Finance", Working Papers in Economics and Finance No. 3, Institute of Southeast Asian Studies, Singapore. Rodriguez, F. and D. Rodrik (2001). "Trade Policy and Economic Growth: A Skeptic's Guide to the Cross-National Evidence", mimeo (May). Roller, L and L. Waverman (2001). "Telecommunications Infrastructure and Economic Development: A Simulations Approach", American Economic Review, 91, pp. 878-909. Sampson, G. and R. Snape (1985). "Identifying Issues in Trade in Services", The World Economy, 8, pp. 171-182. Sapir, A. and C. Winter (1994). "Services Trade", in D. Greenaway and A. Winters (eds.), Surveys in International Trade, Oxford, UK: Basil Blackwell. Srinvasan, T.N. (2001). "Trade, Development and Growth", Princeton Essay in International Economics No. 225, International Economic Section, Princeton University. Verikios, George and X. Zhang (2001). "The Economic Effects of Removing Barriers to Trade in Telecommunications and Financial Services", paper presented at the Fourth Annual Conference on Global Economic Analysis (West Lafayette, June 27-29). Warren, T. and C. Findlay (2000). "Measuring Impediments to Trade in Services", in P. Sauve and R. Stern (eds.), GATS 2000: New Directions in Services Trade Liberalization, Washington DC: Brookings Institution Press. World Bank (2000). World Development Indicators, New York: Oxford University Press. World Bank (2001). Global Economic Prospects 2002, New York: Oxford University Press. World Bank (2002). The World Development Report, New York: Oxford University Press. World Trade Organisation (WTO) (1998a). "Financial Services", background note by the Secretariat, Council for Trade in Services, S/C/W/72, WTO: Geneva. World Trade Organisation (WTO) (1998b). "Telecommunication Services", background note by the Secretariat, Council for Trade in Services, S/CfW/74, WTO: Geneva.

210

Economic Globalization and Asia

Annex 1 Internationalization of the Banking System versus Capital Account Deregulation18 In a bank-based system, "International Financial Liberalization" (IFL) involves two related but conceptually distinct components, viz. capital account deregulation and internationalization of financial services. The relation between international capital flows and internationalization of financial services may be succinctly and effectively captured by the matrix below borrowed from Kono and Schuknecht (1999). Cell I on the uppermost left-hand corner refers to the case of financial autarky, i.e. neither financial services trade nor an open capital account. Cell IV on the bottom right-hand side denotes the case of "complete" IFL, i.e. liberal capital account and bank internationalization. The remaining two cells may be broadly classified as "partial IFL". Specifically, Cell II involves the case of bank internationalization with capital restrictions; Cell III is the case of capital account deregulation but with restrictions on trade in banking services maintained. In reality, the two elements of IFL are related and cannot be cleanly separated. Nonetheless, the assumption of total separability is useful conceptually, with Cells II and III best being seen as matters of degree of the two elements of IFL. As per the GATS, the WTO has emphasized that countries could maintain selective controls on the capital account while still moving towards internationalization of the banking sector, which broadly involves providing national treatment to foreign services and service suppliers (Claessens and Glaessner, 1998, Kono and Schuknecht, 1999 and Kono and Associates, 1997). Matrix on Domestic Versus International Capital Flows and Bank Internationalization Loan provided by domestic supplier Loan involves domestic capital only Loan involves international capital only

Loan provided by foreign supplier

Cell I: Neither financial Cell II: Financial services services trade nor trade only international capital flows Cell III: International Cell IV: Financial services capitalflowsonly trade and international capital flows

Source: Kono and Schuknecht (1999)

The issue summarized in this Annex is detailed in Bird and Raj an (2001) and Raj an (2002).

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Table 3 International Transactions in Services by Mode of Supply, 1997 GATS Mode of Supply Mode 1 Mode 2 Mode 3 Mode 4 Total

Category Commercial services (excl. travel) Travel Gross output of foreign affiliates Compensation of employees

—

Value (US$ billions)

Cumulative Share (percent)

890

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430 820

19.8 37.8

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Note: Modes 1, 2 and 4 are derived from balance-of-payments (BoP) data Source: Karsenty (2000)

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Economic Globalization and Asia Table 5 Classifying Barriers to Trade in Banking and Telecommunication Services

Barriers to establisment

Banking

Non-discriminatory barriers to market access Are there restrictions on the number of bank licenses?

Discriminatory deviations from national treatment Are there restrictions on the number of foreign bank licenses? Are there restrictions on foreign equity investments or requirements for foreigners to enter through a joint venture with a domestic bank? Are there restrictions on the permanent movement of people?

Telecommunications

One measure of restriction is actual number of competitors in fixed and mobile markets. Is there an enforced monopoly, partial competition or full competition in various fixed line markets and mobile market? W h a t percentage of the incumbent fixed or mobile operator is privatized?

W h a t percentage of foreign investment is allowed in competitive carriers?

Barriers to ongoing operation

Are there general restrictions on raising funds, lending, providing other lines of business, or expanding the number of banking outlets?

Are foreign banks restricted in raising funds, lending, providing other lines of business, or expanding the number of banking outlets? Are there restrictions on the proportion of foreigners on the board of directors? Are there restrictions on the temporary movement of people?

Telecommunications

Are there restrictions on leased lines or private networks? Are there restrictions on third party resale? Are there restrictions on connection of leased lines and private networks to the public switched telephone network?

Are there restrictions on callback services?

Source: Dee, Hanslow and Phamduc (2001)

Table 6 Restrictiveness Indices for Telecommunications Services'

Economy Argentina Australia

Establishment 0.12 0.04

Domestic ongoing operations

Total 3

0.17 0.00

0.29 0.04

Establishment

Foreign ongoing operations

Total 3

0.12 0.04

0.17 0.00

0.29 0.04

Austria

0.13

0.00

0.13

0.13

0.00

0.13

Belgium

0.03

0.07

0.10

0.13

0.07

0.20

Brazil

0.17

0.03

0.21

0.28

0.03

0.31 0.44

Canada

0.04

0.10

0.14

0.14

0.30

Chile

0.02

0.07

0.09

0.02

0.07

0.09

Colombia

0.10

0.10

0.20

0.16

0.30

0.46

Denmark

0.03

0.00

0.03

0.03

0.00

0.03

Finland

0.00

0.00

0.00

0.00

0.00

0.00

France

0.05

0.00

0.05

0.21

0.00

0.21

Germany

0.05

0.00

0.05

0.05

0.00

0.05

Greece

0.16

0.10

0.26

0.16

0.30

0.46

Hong Kong

0.11

0.10

0.21

0.11

0.10

0.21

India

0.19

0.20

0.39

0.29

0.40

0.69

Indonesia

0.14

0.20

0.34

0.27

0.40

0.67

Ireland

0.19

0.00

0.19

0.35

0.00

0.35

Italy

0.14

0.00

0.14

0.14

0.00

0.14

Japan

0.04

0.00

0.04

0.04

0.00

0.04

Korea

0.15

0.20

0.35

0.28

0.40

0.68

Luxembourg

0.17

0.00

0.17

0.17

0.00

0.17

Malaysia

0.04

0.20

0.24

0.18

0.40

0.58

Mexico

0.03

0.20

0.23

0.13

0.40

0.53

Netherlands

0.03

0.00

0.03

0.03

0.00

0.03

New Zealand

0.03

0.00

0.03

0.03

0.00

0.03

Philippines

0.00

0.13

0.13

0.12

0.33

0.45

Portugal

0.11

0.20

0.31

0.11

0.40

0.51

Singapore

0.21

0.13

0.34

0.31

0.13

0.44

South Africa

0.19

0.20

0.39

0.19

0.40

0.59

Spain

0.18

0.03

0.21

0.18

0.23

0.41

Sweden

0.10

0.00

0.10

0.10

0.00

0.10

Switzerland

0.20

0.00

0.20

0.20

0.00

0.20

Thailand

0.23

0.20

0.43

0.39

0.40

0.79

Turkey

0.27

0.20

0.47

0.40

0.40

0.80

United Kingdom

0.00

0.00

0.00

0.00

0.00

0.00

United States

0.00

0.03

0.03

0.00

0.03

0.03

Uruguay

0.22

0.13

0.35

0.22

0.33

0.55

Venezuela

0.16

0.20

0.36

0.16

0.40

0.56

Notes: a) Figures may not add up to total due to rounding off error b) The restrictiveness index scores range from 0 to 1. The higher the score, the greater are the restrictions for an economy Source: Findlay and McGuire (2001)

Table 7 Price Effect Measures for Telecommunications Services

Economy Argentina Australia Austria Belgium Brazil Canada Chile Colombia Denmark Finland France Germany Greece Hong Kong Indonesia Ireland Italy Japan Korea Luxembourg Malaysia Mexico Netherlands New Zealand Philippines Portugal Singapore South Africa Spain Sweden Switzerland Thailand Turkey United Kingdom United States Uruguay Venezuela

Establishment 1.60 0.31 0.85 0.22 3.19 0.30 0.40 5.28 0.20 0.00 0.34 0.32 1.58 0.65 29.66 1.46 1.00 0.26 1.83 0.65 1.23 0.81 0.20 0.27 0.00 1.35 1.28 6.65 1.71 0.65 1.23 15.88 11.20 0.00 0.00 4.74 4.21

Domestic ongoing operations 2.22 0.00 0.00 0.44 0.61 0.76 1.28 5.28 0.00 0.00 0.00 0.00 0.98 0.61 41.04 0.00 0.00 0.00 2.47 0.00 5.50 5.43 0.00 0.00 21.43 2.45 0.82 7.12 0.32 0.00 0.00 14.01 8.40 0.00 0.20 2.87 5.37

Total3

Foreign ongoing Establishment operations Total3

3.81 0.31 0.85 0.65 3.81 1.07 1.68 10.55 0.20 0.00 0.34 0.32 2.56 1.26 70.70 1.46 1.00 0.26 4.30 0.65 6.73 6.24 0.20 0.27 21.43 3.80 2.10 13.77 2.03 0.65 1.23 29.90 19.59 0.00 0.20 7.61 9.57

Note: a) Figures may not add up to one due to rounding off error Source: Findlay and McGuire (2001)

1.60 0.31 0.85 0.87 5.07 1.08 0.40 8.44 0.20 0.00 1.43 0.32 1.58 0.65 56.34 2.67 1.00 0.26 3.49 0.65 5.08 3.58 0.20 0.27 19.28 1.35 1.90 6.65 1.71 0.65 1.23 27.09 16.74 0.00 0.00 4.74 4.21

2.22 0.00 0.00 0.44 0.61 2.29 1.28 15.83 0.00 0.00 0.00 0.00 2.94 0.61 82.08 0.00 0.00 0.00 4.95 0.00 11.00 10.85 0.00 0.00 53.57 4.90 0.82 14.24 2.22 0.00 0.00 28.03 16.79 0.00 0.20 7.18 10.73

3.81 0.31 0.85 1.31 5.68 3.37 1.68 24.27 0.20 0.00 1.43 0.32 4.52 1.26 138.41 2.67 1.00 0.26 8.43 0.65 16.08 14.43 0.20 0.27 72.85 6.25 2.72 20.89 3.93 0.65 1.23 55.12 33.53 0.00 0.20 11.92 14.94

Table 8 Restrictiveness Indices for Financial Services

Economy Argentina Australia Austria Belgium Brazil Canada Chile Colombia Denmark Finland France Germany Greece Hong Kong India Indonesia Ireland Italy Japan Korea Luxembourg Malaysia Mexico Netherlands New Zealand Philippines Portugal Singapore South Africa Spain Sweden Switzerland Thailand Turkey United Kingdom United States Uruguay Venezuela

Establishment 0.00 0.00 0.00 0.00 0.00 0.00 0.19 0.05 0.00 0.00 0.00 0.00 0.00 0.00 0.05 0.00 0.00 0.00 0.00 0.00 0.00 0.19 0.00 0.00 0.00 0.10 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.05 0.00 0.00 0.14 0.00

Domestic ongoing operations

Total3

Establishment

0.00 0.00 0.00 0.00 0.01 0.00 0.10 0.00 0.00 0.00 0.00 0.00 0.00

0.00 0.00 0.00 0.00 0.01 0.00 0.29 0.05 0.00 0.00 0.00 0.00 0.00

0.04 0.00 0.07 0.00 0.00 0.13 0.19 0.00 0.08 0.00 0.00 0.00 0.05 0.00 0.11 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

0.04 0.05 0.07 0.00 0.00 0.13 0.19 0.00 0.27 0.00 0.00 0.00

0.03 0.09 0.03 0.03 0.39 0.03 0.27 0.08 0.03 0.03 0.03 0.03 0.03 0.03 0.31 0.37 0.03 0.03 0.03 0.21 0.03 0.38 0.13 0.03 0.03 0.37 0.03 0.13 0.03 0.03 0.03 0.03

0.14 0.00 0.11 0.00 0.00 0.00 0.00 0.00 0.05 0.00 0.00 0.14 0.00

0.24 0.27 0.03 0.03 0.18 0.07

Foreign ongoing operations Total3 0.04 0.03 0.04 0.04 0.12 0.04 0.13 0.15 0.04 0.04 0.04 0.04 0.04 0.07 0.29 0.18 0.04 0.04 0.17 0.22 0.04 0.26 0.04 0.04 0.03 0.16 0.04 0.25 0.16 0.04 0.04 0.05 0.15 0.10 0.04 0.04 0.29 0.10

0.07 0.12 0.07 0.07 0.51 0.07 0.40 0.23 0.07 0.07 0.07 0.07 0.07 0.09 0.60 0.55 0.07 0.07 0.19 0.43 0.07 0.65 0.17 0.07 0.06 0.53 0.07 0.37 0.19 0.07 0.07 0.08 0.39 0.37 0.07 0.06 0.46 0.17

Notes: a) Figures may not add up to total due to rounding off error b) The restrictiveness index scores range from 0 to 1. The higher the score, the greater are the restrictions for an economy Source: Findlay and McGuire (2001)

Table 9 Price Effect Measures for Banking Services

Economy Argentina Australia Austria Belgium Brazil Canada Chile Colombia Denmark Finland France Germany Greece Hong Kong India Indonesia Ireland Italy Japan Korea Luxembourg Malaysia Mexico Netherlands New Zealand Philippines Portugal Singapore South Africa Spain Sweden Switzerland Thailand Turkey United Kingdom United States Uruguay Venezuela

Establishment 0.00 0.00 0.00 0.00 0.00 0.00 15.47 3.54 0.00 0.00 0.00 0.00 0.00 0.00 3.54 0.00 0.00 0.00 0.00 0.00 0.00 15.38 0.00 0.00 0.00 7.32 0.00 0.00 0.00 0.00 0.00 0.00 0.00 3.54 0.00 0.00 11.00 0.00

Domestic ongoing operations 0.00 0.00 0.00 0.00 0.87 0.00 7.73 0.00 0.00 0.00 0.00 0.00 0.00 2.65 0.00 5.35 0.00 0.00 10.03 14.93 0.00 6.73 0.00 0.00 0.00 3.66 0.00 8.15 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Total3

Foreign ongoing Establishment operations Total3

0.00 0.00 0.00 0.00 0.87 0.00 23.20 3.54 0.00 0.00 0.00 0.00 0.00 2.65 3.54 5.35 0.00 0.00 10.03 14.93 0.00 22.11 0.00 0.00 0.00 10.99 0.00 8.15 0.00 0.00 0.00 0.00 0.00 3.54 0.00 0.00 11.00 0.00

Note: a) Figures may not add up to one due to rounding off error Source: Findlay and McGuire (2001)

2.53 7.08 2.52 2.52 35.06 2.53 22.74 6.47 2.52 2.52 2.52 2.52 2.52 1.97 28.58 32.91 2.52 2.52 2.05 18.15 2.52 35.92 10.48 2.52 2.52 33.28 2.52 10.69 2.64 2.52 2.52

2.81 2.22 2.80 2.80 10.50 2.81 11.26 11.88 2.80 2.80 2.80 2.80 2.80 4.94 26.50 16.42 2.80 2.80 13.22 18.58 2.80 24.69 2.92 2.80 2.18 14.08 2.80 20.76 12.27 2.80 2.80

2.24 20.56 23.12 2.52 1.95 15.35 5.35

3.71 12.50 8.43 2.80 2.80 24.99 8.09

5.34 9.31 5.32 5.32 45.56 5.34 34.00 18.35 5.32 5.32 5.32 5.32 5.32 6.91 55.08 49.33 5.32 5.32 15.26 36.73 5.32 60.61 13.40 5.32 4.69 47.36 5.32 31.45 14.90 5.32 5.32 5.95 33.06 31.54 5.32 4.75 40.34 13.44

International Trade In Infrastructural Services in East Asia

221

Table 10 Summary of Specific GATS Commitments in Telecommunications Services

X

i.

J-

k.

1.

m.

n.

01.

X

X X X

X X X

X

X

X

X

X

X

X

X X X

X X X

X X

X

X X X

X X

X

X

X X

X

X

X

X

X X

59

55

51 57

48 46

65

57

46

b.

c.

d.

e.

China X Indonesia X Korea X

X X X

X X X

X X

X X

X

X

Malaysia Thailand

X X

X

X

X X

X X

X X

Total

69 63

64 59

47

59

Key: a. Voice Telephone Services b. Packet-Switched Data Transmission Services c. Circuit-Switched Data Transmission Services d. Telex Services e. Telegraph Services f. Facsimile Services g. Private Leased Circuit Services h. Electronic Mail i. Voice Mail j . On-line Information and Data Base Retrieval k. Electronic Data Interchange (EDI) 1. Enhanced/Value-Added Facsimile Services m. Code and Protocol Conversion n. On-line Information and/or data processing 01. Terrestrial-based mobile 02. Satellite-based mobile 03. Other, other Source: WTO (1998b)

02. 03.

TO

f.

h.

a.

X 45 43

7—(

OJ

>

o

PH

C

C

« rl)

^H £ 4) S -o o H U C/1 H

<

a

u <£ o
o

fi i/)

M-

fT a E S

D l/J

Insurance

Countries

Securities

Banking

Asset management X X X X X

x

2

2

8

Financial information

x

£5

Underwriting X X X X X

£

$

X X X X X

go

Trading in derivatives

Trading in securities

x

X X X X X

p

g

X X X X

Total

Trading in Forex X X X X X

China Indonesia Korea Malaysia Thailand

X X X X X

Lending

g

Deposits

X X X X X

Intermediation

X X X X X

Reinsurance

x x x x x £>

3

Non-life

Others

International Trade in Infrastructural Services in East Asia

223

Table 12 Grandfather Provisions in GATS Schedules on Banking and Insurance Services in Selected Asian Economies Country Foreign equity-related Indonesia

Malaysia

Legal form-related Indonesia

Malaysia

Thailand

Source: Mattoo (2001)

Provision Banking and Insurance: Share ownership of foreign services suppliers is bound at the prevailing laws and regulations. The conditions of ownership and the percentage of share ownership is stipulated in the respective shareholder establishing the existing individual joint venture shall be respected. No transfer of ownership shall take place without the consent of all parties in the joint venture concerned. Banking: Entry is limited to equity participation by foreign banks in Malaysian-owned or controlled commercial and merchant banks with aggregate foreign shareholding not to exceed 30 percent, but the thirteen wholly-foreign owned commercial banks are permitted to remain wholly-owned by their existing shareholders. Banking: Existing branches of foreign banks are exempted from the requirement imposed on new entrants to be in the form of locally incorporated joint venture banks. Insurance: Branching is only permitted for direct insurance companies with aggregate foreign shareholding of less that 50 percent but companies are permitted to maintain their existing network of branches. (See also foreign equity-related provision above). Banking: While the establishment of new branches is subject to discretionary licensing, existing foreign banks which already had the first branch office in Thailand prior to July 1995 will each be permitted to open no more than two additional branches.

224

Economic Globalization and Asia

Table 13 Methodology for Constructing Telecommunications Index of Openness3 Rank

Market Structure

Ownership (FDI)

Independent Regulator

9 8

Competitive Competitive

FDI allowed FDI allowed

Yes No

7

Competitive

FDI not allowed

Yes

6

Competitive

FDI not allowed

No

5

Not Competitive

FDI allowed

Yes

4

Not Competitive

FDI allowed

No

3

Not Competitive

FDI not allowed (private)

Yes

2

Not Competitive

FDI not allowed (public)

Yes

1

Not Competitive

FDI not allowed

No

Note:

a) Rankings are assigned on a basis of a lexicographic scheme discussed in detail in source Source: Mattoo, Rathindran and Subramaniam (2001)

Table 14 Methodology for Constructing Financial Index of Opennessa Rank

Market Structure

8 7

Competitive Competitive

Foreign Equity Permitted

Capital Controls (Dailami Index)

> 50% > 50%

>1.6 <1.6

6

Competitive

< 50%

>1.6

5

Competitive

< 50%

<1.6

4

Not Competitive

> 50%

>1.6

3

Not Competitive

> 50%

<1.6

2

Not Competitive

< 50%

> 1.6

1

Not Competitive

< 50%

<1.6

Note: a) Rankings are assigned on a basis of a lexicographic scheme discussed in detail in source Source: Mattoo, Rathindran and Subramaniam (2001)

International Trade In Infrastructural Services in East Asia

225

Table 15 Impact of Full Liberalization of Telecommunications and Financial Services: Regression Estimates Dependent variable: Growth of per capita GNP, 1990-1999 Independent variable

Natural log of initial GNP (1990) Primary education enrollment (1990) Lag of investment to GDP ratio (1980-'89 average) Government consumption to GDP ratio (1990-'99 average) Average annual inflation rate (1990-99) Dummy variable for tropical countries

Whole sample

(1)

(2)

(3)

(4)

-0.019*** (-2.69)

-0.024*** (-3.49)

-0.018** (-2.28)

-0.022** (-2.49)

0.052** (2.1) 0.166*** (3.75)

0.042* (1.92)

0.038 (1.53)

0.205*** (3.36)

0.227*** (3) -0.261*** (-3.92) -0.0004 (-0.33)

0.035** (1.44) 0.306*** (3.11) -0.235*** (-3.37) 0.001 (-0.87)

-0.031*** (-3.93)

-0.037*** (-4.25)

0.012 (1.44) 0.002

-0.002

0.005 (0.41) 0.15 (1.4) -0.001

(0.8)

(0.31)

-0.003 (-0.39)

0.001 (0.13)

0.025** (2.14) -0.005*** (-3.07) 0.182*** (3.83)

0.028** (2.64) -0.004*** (-2.49)

0.76

0.78

37

37

-0.001 -0.73

-0.165*** (-3.04) -0.002 (-1.56)

-0.026*** (-4.04)

-0.030*** (-4.33)

-0.209*** (-3.46)

Dummy for Sub-Saharan Africa

-0.009 (-1.05)

Dummy for Latin America countries Quality of institutions

-0.0004 (-0.26)

Dummy variable for political stability

-0.003 (-0.45)

(0.84) 0.001 (0.08)

Dummy variable for full liberalization of both sectors

0.015* (2.18)

0.015** (2.21)

-0.004*** (-3.70)

-0.004*** (-3.32)

Constant

0.170*** (4.17)

0.190*** (4.33)

R-squared

0.67 59

0.71 59

IMF goods trade restrictiveness index

Number of observations

Only developing countries

0.185*** (3.32)

Note: *, **, *** indicate statistical significance at the 10%, 5% and 1% levels, respectively. The figures in brackets indicate t-statistics with Huber-White heteroskedasticity consistent standard errors Source: Fink, Mattoo and Rathindran (2001)

226

Economic Globalization and Asia Table 16 Sources of Change in Real G N P of Complete Liberalization in Telecommunications Services (US dollar millions)

Region Korea Indonesia Malaysia Thailand China World

Allocative efficiency

Terms of trade

Net capital endowment

Product variety

Net FDI income

Row sum

Real GNP

36 1152 17 37 5575 20600

-5 -434 -30 -562 -1301

-13 1303 60

1 401 -5 17 1037 2938

16 -1151 -3 -55 -343 -

35 1258 -22 -502 5321 24313

0.01 0.70 -0.03 -0.35 0.81 0.10

-34

354 833

Notes: T h e sum of the terms of trade effects on G N P do not sum exactly to zero due to numerical inaccuracy in solving the model Source: Verikios and Zhang (2001)

Table 17 Sources of Change in Real G N P of Complete Liberalization in Financial Services (US dollar millions)

Region Korea Indonesia Malaysia Thailand China World

Allocative efficiency

Terms of trade

Net capital endowment

Product variety

Net FDI income

Row sum

Real GNP

796 753 262 703 1221 6463

-578 -340 -112 -266 -1157 -16

1826 2245 150 2311 104 14164

663 549 70 453 322 2112

-1229 -1943 -144 -1797 -106 0

1468 1250 226 1396 384 22640

0.36 0.70 0.27 0.96 0.06 0.09

Notes: T h e sum of the terms of trade effects on G N P do not sum exactly to zero due to numerical inaccuracy in solving the model Source: Verikios and Zhang (2001)

International Trade in Infrastructural Services in East Asia

-•• Indonesia -•- Malaysia -A- Thailand -*- China -*- Korea Source: World Development Indicators, CD-ROM, The World Bank Figure 1 Service Exports Growth of East Asian Economies, 1980-1999

227

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IV. International Tax Issues in Asia

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231

Chapter 9

Economic Globalization and Taxation: With Particular Reference to Southeast Asia1

1. Introduction Present tax systems evolved when each country formulated its own tax policy and focused on the requirements of its domestic economy. When tax treaties, agreements and conventions among nations were negotiated, they were principally within the framework of national sovereignty in tax policy. The process of economic globalization has been changing this, particularly with respect to the level of taxation, mix of taxes, design of particular taxes, and the manner of their administration and compliance. Adaptation of the tax systems to globalization is expected to be slow and subtle rather than discontinuous. Indeed, Slemrod (1995) has noted: tax structures will adapt slowly and in subtle ways to the pressures of an integrating world economy. For this reason, everything we know about taxation is not yet wrong but is a little bit more wrong everyday (p. 146). This Chapter discusses the impact of the ongoing process of economic globalization on tax structures with particular reference to Southeast Asia. The remainder of this Chapter is organized as follows. The next Section discusses the distribution of tax burdens on mobile versus immobile factors in general. Some global efficiency principles of taxation in a borderless world are outlined in Section 3. Section 4 focuses on the effects of global tax competition on foreign direct investment (FDI) and multinational enterprises (MNEs). Section 5 touches on the tax implications of the Internet and E-commerce. Taxation of global capital flows (non-FDI) is discussed in Section 6. The final Section offers a few concluding remarks. 2. International Factor Mobility and Burden of Taxation By definition, the process of economic globalization implies higher supply elasticities by any one tax-jurisdiction for footloose factors such as capital and skilled 1

This Chapter is co-authored with Mukul Asher and draws on and updates Asher and Rajan (2001).

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Economic Globalization and Asia

labour, while increasing the (derived) demand elasticities for immobile factors such as land and unskilled labour (Rodrik, 1997 and Wood, 1995) 2 . To be sure, labour is typically less mobile than capital, though certain types of professional and technical human resources have not only become moderately mobile, but have also become more sensitive to cross-border differentials in tax burdens. Most types of financial capital flows are highly mobile and sensitive to tax-induced changes in net returns. FDI has increasingly become more "footloose" as globalization has led to the production-distribution chain being divided among many tax jurisdictions (see Chapter 1). Globalization has thus enhanced the relative power of capital and of net capital-exporting countries, while the relative power of labour and of capital importing countries has declined. This is of particular relevance to developing countries in general, and to Southeast Asia in particular. In Southeast Asia, only Singapore is a net lender abroad 3 . Factors or activities with low mobility include types of labour which have little demand internationally, natural resources and real estate, and domestic country-specific investments. What are the implications of differing degrees of international factor mobility for tax policy? The first implication concerns the overall level of taxation. Here the trend is towards a more uniform international treatment of foreign investment and skilled labour, given the limited substitutability between the two factors and importance of each in output growth. As MNEs expand their cross-border operations, they will increasingly require the freedom to move skilled workers around their worldwide operations to optimize resource utilization, given the existence of some nontraded service processes. The Economist (November 1, 1997, p. 92) has gone so far as to argue that the growth of MNEs "seems likely to spur the next big development in the history of migration". However, this pressure to ensure an alignment between corporate and personal taxes is not solely due to globalization trends. For instance, conventional wisdom a la Musgrave (1959) reminds us that corporate taxes cannot be too low compared to personal income taxes. If this were so, owners of family businesses could incorporate the firm and retain the profits rather than pay them out as wages and other factor remuneration and sell some of the shares, thus avoiding the higher income tax (assuming low capital gains tax). Table 1 provides data on individual and company income tax rates and their respective number of brackets in six Southeast Asian counties. The highest marginal company income tax rates in Southeast Asia range from a low of 22 percent 2 3

This conclusion is not without its critics. For instance, see Panagariya (2000).

Some developing countries such as India and Malaysia are net capital-importing countries, but they nevertheless have significant investments in selected sectors abroad.

Economic Globalization and Taxation

233

in Singapore to a high of 32 percent in the Philippines. In Vietnam, the standard rate is also 32 percent, though for some types of activities, the highest rate is 50 percent. Thus, the rates vary in a narrow range. These rates are also lower than the corresponding standard federal corporate income tax rate of 35 percent for the United States (US). Some states in the U S also levy corporate income taxes. The range for individual income tax rates among Southeast Asian countries is somewhat wider. Thus, Singapore's range of 4 to 22 percent is much lower than 10 to 60 percent for Vietnam, though the number of income tax brackets (six) is the same (Table 1). Except for Vietnam, the top marginal tax rate is lower in Southeast Asia than the 38.6 percent federal rate for 2002 in the U S (some states in the US also levy individual income taxes) 4 . Related to this, for many high net-worth individuals, the proportion of income earned or derived from foreign sources is high and increasing. As the foreign component is highly sensitive to tax regimes, erosion of the tax base and departure from the accepted global taxation principal — viz. that all income of the individual should be aggregated and taxed at the same rate (a la Simons, 1938) — is occurring. Individual income is increasingly being taxed at different rates according to the nature of income (i.e. whether it is in the form of wages, interest or dividends). Such a "discriminatory" or schedular approach to taxation is becoming increasingly common. For instance, Scandinavian countries have moved towards a "dual" income tax, with lower taxation on income from capital than from labour earnings. The problem with this approach is that if the tax differential is significant, it provides incentives for tax evasion and avoidance, with incomes from higher taxed sources being disclosed as having been derived from the lower taxed source 5 . Second, the inverse elasticity rule (so-called "Ramsey Rule") suggests that on efficiency grounds, the marginal tax rate should be inversely related to the elasticity of factor supply. Therefore, preferential tax treatment for mobile factors relative to 4

It is, however, important to keep in mind that effective tax burden (even if the economic incidence is not taken in to account) depends both on the tax rates and on how the tax base is defined. International variations in the definition of the tax base for corporate (or company) and personal income taxes remain quite considerable. In Singapore and Malaysia, income tax is partially integrated through the dividend-received-credit method. T h e other Southeast Asian countries employ classical method of corporate taxation under which dividend income is double taxed (DasGupta and Mookherjee, 1998 and Asher, 2001). These variations could lead to greater differences in effective rates than nominal rate comparisons alone may suggest. Nevertheless, a close bunching of nominal income tax rates is observable in the case of Southeast Asia, suggesting that these countries do take into account the tax rates in the neighbouring countries. 5

This comes into conflict with the trend towards harmonization of income tax on skilled labour and capital, thus suggesting that the burden may fall disproportionately on low-skilled (low wage) labour.

234

Economic Globalization and Asia

immobile ones is justified on efficiency grounds. As noted, relatively high supply elasticity of mobile factors implies that the burden of tax on these factors will fall primarily on the immobile factors6. Indeed, at the extreme, complete factor mobility (i.e. perfect elasticity of supply) will imply that any tax on the mobile factor will fall solely on the immobile ones, as the mobile factors will relocate overseas unless there is corresponding compensation (through subsidies, reduction in other costs, etc.). Third, loss of the income base of tax of mobile factors and the political economy consequences of income tax regressivity of taxing immobile factors suggests that there may be a move to replace taxes on income with those on selective and/or general consumption, and to extend and intensify the role of cost-recovery, user charges and prices charged by state enterprises. Thus, the European Union (EU) is considering requiring member states to levy V A T on state-run postal services which traditionally have not attracted any tax. The tendency towards a shift from income-based to consumption taxes is exemplified by the following observation by the Deputy Prime Minister of Singapore, Lee Hsien Loong (2002): What matters to businesses is after tax returns. We have to reduce the burden of direct taxes on businesses and individuals to the minimum possible, to encourage investment and wealth creation across the board. Hence, we are cutting the top rates of corporate and personal taxes from about 25% to 20% over 3 years, while raising indirect taxes to make up the revenues (p. 4). Fourth, even as the tax administrators confront challenges in administering current taxes, new types of taxes may become feasible with the rise of new technologies and activities (Tanzi, 2000). As an example, France has recently levied royalties tax on blank CDs, DCDs, and mini-disks. It is considering imposing such a tax on anything that can be used to record an original work, such as computers, DVD players, and Video Recorders, with the aim of compensating artists whose works may be copied (Business Times, Singapore, January 18, 2001).

3. Efficiency and International Taxation

International factor mobility has increased the need for efficient and equitable tax treatment of firms operating in multiple tax jurisdictions. Current procedures used by most countries to allocate the tax base between jurisdictions and to avoid double taxation through a network of more than 1500 bilateral double taxation 6

The assumption in this Section is that the residence principle of taxation is not applied. This issue is elaborated upon in the next Section.

Economic Globalization and Taxation

235

treaties (DTAs), most of which are modeled after the OECD conventions (Owens, 1998), is not only cumbersome, but will also come under increasing pressure as the scope and volume of cross-border activities expands sharply. This is because DTAs are based on the assumption of national sovereignty in tax policy which will have less relevance as the process of globalization progresses. Each subsidiary of the parent company located in different tax jurisdictions is currently taxed as a separate entity. This provides incentives for firms engaged in activities in multiple tax jurisdictions to lower their worldwide tax liabilities through transfer pricing, i.e. manipulation of costs of inputs imported from subsidiaries in different tax jurisdictions and through allocation of joint costs of the headquarters (HQs) (Gropp and Kostial, 2000). Currently, the recipient (or host) country in which investment or activity is based has the first right to tax the resulting income. The sending (or home) country then has the right to tax the income (which it need not exercise) according to whether it follows the residence or source principle. Under the residence principle, a country reserves the right to tax the income of its residents regardless of where in the world it is earned. The countries do, however, attempt to offset taxes paid abroad (i.e. to avoid double taxation) through tax credits or deductions to alleviate the tax burden on the mobile factor on the same income earned. In the case of tax credits, the capital exporting country deducts taxes paid in the host country. In the case of tax deductions, the income liability at home is net of the taxes paid abroad. The latter thus provides less of a tax relief than the former, and is consequently less attractive to investors (though this depends on whether each is partial or full). The tax credit method, if perfectly administered, and without the deferment of taxes on foreign income not brought back to the home country, implies that tax burden of an economic entity will be identical regardless of where in the world the activity occurs 7 . This is consistent with the notion of the global efficiency and Capital Export Neutrality (CEN). If a country uses the residence principle but permits foreign taxes to be deducted, it would meet the requirements of national efficiency but not global efficiency or CEN. National efficiency requires that capital exports be carried to the point where the return after foreign tax abroad equals the be/ore-tax return on domestic investment.

' Other complications could arise due to tax sparing schemes available between the host and home countries. In such agreements, the capital importing country (using the residence principle) allows for any tax savings (due to foreign country exemptions) from investing in a foreign country to be fully credited against taxes due at home, despite the tax not having been levied. There is evidence that such tax sparing agreements makes repatriated profits less sensitive to taxes in home countries ( C h e n e t a l . , 1997).

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Economic Globalization and Asia

Under the source (or territorial) principle, capital income is taxed as income under the personal income tax, and the tax liabilities are assessed on the basis of where the income originates, regardless of whether it is by residents or non-residents. Thus, residents are not liable for their income earned abroad but not brought into the territory. A source-based tax is in effect a tax on investment and does distort investment allocation (i.e. the marginal returns on capital pre-tax are not equalized). Consequently, the source-based tax does not fulfil the CEN criteria if applied at different rates. However, the source principle implies that all savers within a country face the same tax burden regardless of the country of residence. Under unfettered global capital flows, this will equalize the net returns to savers (inter-temporal marginal rate of substitution) across countries, hence ensuring that world savings are efficiently allocated. This notion of efficiency (of savings allocation) is referred to as the principle of Capital Import Neutrality (CIN). In contrast, the residence principle is not consistent with CIN. The principles of both CEN and CIN could also be theoretically attained if all countries choose a single tax principle (either one) and apply uniform proportional tax rates. In the absence of such harmonization/coordination, this outcome will not occur. The residence principle is seen as being preferable as a second-best alternative to tax harmonization as it will not induce unbridled tax competition between countries to attract mobile factors and will lead to maximization of global production. It seems, therefore, to satisfy the criteria for evaluating a country's tax policy set out by Slemrod (1990), viz. how well resources are allocated internationally, and how successfully a country is able to protect its revenue base against other countries 8 . However, a residence-based tax system has very high informational requirements. In particular, it requires that either the authorities in the factor-importing country provide the necessary information to tax authorities in the factor-exporting country, or that the mobile factors truthfully report their foreign incomes, both of which seem rather unlikely. This makes it relatively infeasible to impose such a system unilaterally by the home (capital-exporting) country 9 . In cases 8

The residence principle may be seen as the open economy version of the aggregate efficiency theorem in optimal tax theory a la Diamond and Mirrlees (1971). 9

Bacchetta and Espinosa (1995) have developed a game-theoretic model in which information transmission may be used as a strategic device by inter-jurisdictional authorities acting in a noncooperative manner. In particular, the motivation for such cross-border information sharing is that it allows both governments to set higher tax rates. This is so, as the capital-importing country will have information on the exact amount of investment, while the capital-exporting country is able to ensure tax evasion/avoidance is minimized. On the other hand, the cost of such information sharing by the capital-importing country is that it is less able to attract foreign investment attempting to minimize global tax burdens. These two effects may lead to partial sharing of information between countries.

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where such information is freely available (such as in the case of state taxes in the US), the residence principle may result in limited intra-state tax competition despite free inter-jurisdictional mobility of factors of production and no explicit attempt at tax harmonization (Tanzi, 1995, and Tanzi and Zee, 1998) 10 . In the US, national earnings of the corporations are allocated to different states on the basis of a weighted formula based on sales, expenses and property of a corporation in each state. So each firm is not considered as a separate entity in each state, though each state is free to set its own corporate income tax rate. Apart from the failure to meet the CIN efficiency criteria noted previously, two further problems arise from the residence principle. First, a perpetual deferment of profit or income repatriation from abroad will reduce the present value of the tax burden substantially, driving it to zero at the limit 11 . Second, the requirement of "country of domicile" may be abused in the sense that individuals and firms may claim tax havens as their "tax address" of residence. Direct taxation gets highly convoluted in an interdependent world as some countries adopt the residence principle, others the source principle, or as is most frequent, a combination of the two. For instance, France, Germany and The Netherlands use the source or territorial approach to taxation, while Japan, Canada, the US and UK use the residence approach. In Southeast Asia, all countries have adopted the source principle for income tax.

4. Tax Competition and FDI 4 . 1 . Fiscal

incentives

The recognition of the importance of FDI for overall economic growth has implied that countries have and will increasingly compete with each other to attract FDI by offering tax holidays and other concessionary measures. 10

According to Tanzi and Zee (1998), this is unlike the EU in which inter-union informational flows are far more limited, hence making the residence-based tax far less workable. According to the authors, the coefficient of variation of personal income taxes in 1994 in the EU was about one third that in the US, suggesting that there is greater tax competition among EU member countries. Part of the reason for restrained tax competition among US states may also be due to the limited role state taxes play relative to the federal tax system which collects over two thirds of total taxes. The European Court has recently taken an activist stance in striking down individual member country's corporate income tax provisions which are not compatible with fundamental freedoms of the EU treaty (Financial Times, London, February 5, 2003). This may adversely impact on revenue from this tax in the member states. Only full corporate tax harmonization is compatible with the EU treaty, but politically this is unachievable for the foreseeable future. 11 Most countries allow for deferment of active incomes while requiring that passive income (such as dividends) be taxed on an accrual basis.

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While the theoretical literature on fiscal incentives and FDI is burgeoning (see review by Devereux, 1990), the empirical literature is lagging. However, the available empirical evidence to date suggests that such fiscal incentives are important at the margin in influencing investment decisions (see Chen et al., 1997 for a succinct review of the empirical studies) 12 . Fiscal incentives are particularly useful when used essentially as signalling devices about the government's/ country's general (welcoming) attitude towards foreign investment and the overall business environment. Tanzi and Shome (1992) draw this conclusion in the case of East Asia. Conversely, tax incentives will be least effective when used as substitutes for necessary investment-conducive policies, such as overall macroeconomic policies and infrastructural and supporting facilities. Many East Asian countries have made extensive use of preferential tax treatments and other implicit and explicit subsidies to attract MNEs. Chen et al.'s (1997) econometric investigation provides some empirical confirmation of the potential tax competition between certain East Asian countries (viz. Hong Kong, Malaysia, Singapore and Taiwan) for FDI from the major industrialized countries (viz. Germany, Japan, UK and US) between 1972 and 1980. In fact, Chia and Whalley (1995) suggest the existence of a sort of Stackelberg competition among Southeast Asian countries, with the rest of the countries emulating or responding to the tax incentives provided by Singapore 13 . Moves to reduce standard rates of income tax lessen the impact of fiscal incentives provided in the form of income tax reduction, however. States with strong fiscal positions can use a combination of low tax rates and aggressive fiscal incentive policies as a competitive strategy to attract location of economic activity against fiscally weak states. Formal tax incentives form only a part of the overall picture. The negotiation of informal tax incentives with particular tax officials is not uncommon in some Southeast Asian countries, and the regional economic crisis of 1997-98 has not changed these practices. So, even though formal tax incentives may not be available, taxpayers may still enjoy significant monetary benefits. For instance, Singapore provides subsidies to investors that go well beyond traditional tax measures involving training, expenditure, pricing of land and utilities, and even taking 12

Apart from the more formal empirical studies, one of the most revealing anecdotal instances of this is the intense competition between Thailand and the Philippines to attract a new GM automotive plant to each country in 1997. The Philippines lobbied particularly aggressively, reportedly offering incentives such as the Subic Bay site and other fiscal inducements (Business Week, June 3, 1996, p. 56). 13 A similar pattern seems to prevail in Central Europe, with Hungary taking the lead and being most aggressive in providing investment incentives, and Poland and the Czech Republic responding in kind (Easson, 1998).

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rather large equity stakes in selected ventures. As with the formal incentives, the informal incentives are also likely to benefit large companies, both domestic and foreign, disproportionately. Transparency of the formal and informal fiscal incentives' regimes has been rather low in Southeast Asia. Except in Singapore, there has been a noticeable lack of post-incentive performance evaluation of firms granted formal fiscal incentives. Even Indonesia, which removed income tax-based incentives as a part of its 1983-tax reform, continued with provisions of non-income tax incentives. More recently, it has also reintroduced income tax-based incentives (Jakarta Post, May 15, 1999). O n reviewing the evidence in FDI incentives, Kokko (2002) reaches the following conclusion: it appears clear that FDI incentives are effective in the sense that they influence FDI flows. Yet, it is not obvious whether they are efficient, meaning that the benefits to the host country are at least as large as the costs for providing the incentives..(I)t is possible that the competition between potential investment locations, internationally or within countries, will raise the subsidy levels so much that most of the benefits are shifted from the host country to the foreign investors even when there are substantial spillovers..(pp. 3-5). Despite these concerns regarding the use of such incentives, unilateral withdrawal of incentives as policy instruments by any single country would be potentially costly to it, i.e. there is a Prisoner's Dilemma game in operation. The Southeast Asian countries have operated on the basis that, in a globalized world, those able to locate a particular activity or a plant in a jurisdiction will be in a better position to grow. Thus, it is the insecurities of globalization that have been driving formal tax incentives in these countries. It is for this reason that they have not been able to agree on the rules for competing for investments. The regional crisis of 1997-98 has made these countries more insecure. It is also likely to lead to even sharper demarcation between fiscally strong countries such as Singapore and Malaysia (though to a much lesser extent), on the one hand, and the remaining Southeast Asian countries, on the other. This leads one to conclude that prospects for cooperation in the fiscal incentives area have become even dimmer than before the crisis. Nevertheless, the Southeast Asian countries will need to ensure that their respective stances with regard to the use of fiscal incentives are consistent with emerging international practices and norms 14 . 14

However, such formal or informal tax competition — commonly referred to as "tax poaching" or "tax piracy" — may merely be replaced by non-tax forms such countries "cutting corners" by relaxing environmental and other standards in an effort to reduce non-tax costs for mobile factors (so-termed "race to the bottom"). This said, empirical studies (both econometric and surveys) have

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With growing specialization in production of components in locations in different countries, intra-firm transactions account for a growing share of world trade. For instance, in 1994, 36 percent of U S exports and 43 percent of U S imports were of the intra-firm nature (Clausing, 1998). There is evidence that the share of intra-firm trade in the US' trading partners are significantly higher, at least with regard to bilateral trade with the US (He, 1995). With the global dominance of MNEs in trade and related transactions, one of the major issues of tax policy and MNEs is the allocation of the tax base for these firms between countries. Accounting manipulations allow for a transfer of tax bases (paper profits) even if physical capital (real activity) remains intact, as MNEs attempt to exploit differences in marginal statutory tax rates across countries, either actual or de facto (if there exist different laxities with which tax administration is carried out). In most situations, this involves maintaining a judicious setting of the imputed values on the internal transfer of goods and services between operations in different countries. Such tax-shifting manipulations in which intra-firm sales are invoiced (i.e. "transfer pricing") are often arbitrary, since no formal sales occur, and firms can play strategic games in an effort to lower their tax liabilities. It has been found that, for the period 1982 to 1994, the US has had a less favourable intra-firm trade balance with low tax countries (Clausing, 1998). This would be expected a priori if we assume that US sales to affiliates based in low taxed countries are underpriced, while those with high taxed ones are overpriced, and the tax differential is not offset by import tariffs imposed by the low taxed countries. Similarly, evidence suggests that US MNEs reduce their tax burden between 3 and 22 percent by shifting reported incomes from high-tax countries to low-tax ones (Harris et a l , 1993). The fact that transfer pricing is pervasive in the US despite the country's tax authorities being among the most technically well-equipped in the world (and thus most effective in imposing penalties of flagrant tax violations), suggests that the existence of transfer pricing on a global scale is indeed widespread. National tax authorities need to establish clear rules and guidelines for the setting of such transfer prices using arms-length transactions as a yardstick. However, the problem in developing countries, as always, is a matter of implementation, given the strains and other constraints faced by tax administrations (Das-Gupta and Mookherjee, 1998).

failed to discern any relation between low environmental standards and the amount of investment inflows (Chang and Rajan, 2001 and Levinson, 1996). Evidence for the race-to-bottom thesis, interpreted to mean inability to maintain revenue levels, is also not strong in OECD countries, though the revenue to GDP ratios seem to have stopped growing (Messere, 2000 and Tanzi, 2000).

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5. Globalization, E'commerce and Taxation of the Internet New technologies are resulting in a growing importance of electronic commerce or "E-commerce" activities. According to the OECD (1997): E-commerce refers generally to commercial transactions, involving both organizations and individuals, that are based upon the processing and transmission of digitalized data, including text, sound and visual image and that are carried out over open networks (like the Internet) or closed networks ... that have a gateway onto an open network (p. 1). According to estimates, total E-commerce activities stood at over US$650 billion in 2000 (Meehan, 2000 and Orbeta Jr., 2000). The varieties of transactions conducted on the Internet include the provision of on-line information, payments and settlement of accounts, advertising, gambling and other entertainment (music, games, etc.), sale-lease of goods, banking, insurance and brokerage services, legal services, real estate services, travel services, and increasingly, health-care, education and government services, share trading, reservations and ticketing (OECD, 1997, Owens, 1997 and Soete and Ter Weel, 1998). While business-to-consumer (B2C) transactions are on the rise, the market is dominated by business-to-business (B2B) transactions (Table 2). E-commerce will require major adjustments in the traditional means of allocating revenue among jurisdictions and in the current systems of tax administration. Thus, it would be difficult to apply the source-based taxation method to businesses involved in E-commerce (Au, 1998). E-commerce transactions could result in: (a) the disappearance of traditional audit trails (through creation of electronic books); (b) greater accessibility of tax havens and offshore banking facilities (E-commerce uses its own payments system, referred to as "cyberpayments"); and (c) the weakening or elimination of convenient points of taxation in the production-distribution process due to disintermediation (OECD, 1997 and Owens, 1997). B2B E-commerce transactions could facilitate the use of transfer pricing by MNEs by making them increasingly difficult for governments to detect. As Owens (1997) aptly notes: The communications revolution presents no new problems, no fundamentally or categorically different dimensions, for transfer pricing. It just presents all the old problems more quickly (p. 1849). The inability (or unwillingness) to tax Internet-based transactions, on the one hand, and non-zero tariffs on physical cross-border trade, on the other, may hasten the pace of substitution of the mode of transactions to virtual commerce as it gets technically feasible to do so. This in turn will further erode the tax base on tradable goods, with some developing countries being especially vulnerable to

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this revenue loss unless international rules and agreements are modified. Global agreements and standards will be needed before E-commerce can be effectively taxed. Member countries of the World Trade Organisation ( W T O ) have agreed to keep E-commerce tax-free until 2003 (Teltscher, 2002). Nevertheless, the future of taxation of E-commerce and the Internet remains far from certain. Developing countries have, by and large, not had much influence on the policy debate, with the U S and other OECD countries dominating discussions. The communications revolution, which has led to the rapid growth of the Internet, could also offer some benefits to tax administration. These include possibilities of more accurate and efficient record-keeping, faster and easier compliance with tax requirements, including through electronic filing of returns and automated deductions of certain taxes such as payroll and social security taxes and provision of information to taxpayers (Tanzi, 1998, 2000). The communications revolution could also assist in improved exchange of information among the tax administrators of different countries. However, the advantages of the communications revolution for tax administrators, particularly those in developing countries, will definitely not be automatic. Tax administration systems would need to be revamped, requiring substantial investments in information technology hardware, development of specialized software, intensive high quality training for existing tax officials, and modifications in personnel policies to secure requisite manpower comfortable with new technologies. The governments need transparent, consistent, and realistic policies for taxing E-commerce. While countries such as Singapore are well positioned to harness the benefits of these new technologies (Das-Gupta and Mookherjee, 1998, Chapter 11), they will pose severe short and medium term challenges to most developing countries, particularly in terms of making it increasingly difficult for them to collect even existing taxes. Absent effective policy coordination and collective action on at least a regional if not on a global basis, the Internet and accompanying new communication technologies will pose grave challenges to governments in maintaining fiscal sustainability. The OECD (1997, p. 9) has succinctly summarized the key issues of E-commerce and the Internet for tax authorities as follows: a) to review existing taxation arrangements, including concepts of sources, residency, permanent establishment and place of supply, and to modify the existing arrangements or develop fair alternatives, if required; b) to ensure that E-commerce technologies, including electronic payment systems, are not used to undermine the ability of tax authorities to properly administer tax law;

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c) to provide a clear and equitable tax environment for businesses engaged in both physical and E'Commerce; and d) to examine how these new technologies can be exploited to provide better service to taxpayers. Developing countries must take the lead of the OECD in undertaking analyses on how E-commerce will impact the tax base and tax regulations, administration and compliance for specific taxes (such as the VAT) and plan a coordinated approach to tackle the challenges posed by the Internet.

6. Financial Globalization and the Tobin Tax Financial capital is probably the most mobile of factors, and is therefore extremely sensitive to inter-regional tax differentials. With the ever-escalating frequency and intensity of financial crises, they can no longer be dismissed as mere aberrations in an otherwise well-functioning global capital market (see Chapter 1). While emphasizing the need for measures to enhance the soundness of banking and financial systems (particularly prudential supervision), the ferocity of the East Asian crisis has belatedly but surely awakened policy-makers to consider the need to impose some frictions in the sand of the wheels of international finance. The theoretical rationale outlined for the possible imposition of some form of restraints on international capital flows may be summarized as follows (Bird and Rajan, 2000). The first best rationale for such levies (on a permanent basis) are based on the existence of capital market distortions, which include the prevalence of multiple equilibra in foreign exchange (forex) markets and the herd behaviour of financial market participants. The second best rationale (for temporary controls) includes the possible "over borrowing" syndrome due to incomplete or inappropriately sequenced financial sector reforms (including inadequate prudential regulations). A tax on international forex activities was originally proposed by James Tobin (1978). The so-called Tobin tax is essentially a permanent, uniform, advalorem transactions tax on international forex flows. The burden of a Tobin tax is claimed to be inversely proportional to the length of the transaction, i.e. the shorter the holding period, the heavier the burden of tax. For instance, a Tobin tax of 0.25 percent implies that a twice daily round trip carries an annualized rate of 365 percent; in contrast, a round trip made twice a year carries a rate of 1 percent. Accordingly, and considering that 80 percent of forex turnover in 1995 involves round trips of a week or less, the argument has been made that the

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Tobin tax ought to help reduce exchange rate volatility and consequently curtail the intensity of "boom-bust" cycles due to international capital flows. But what does available research tell us about the Tobin Tax? Based on available research on the topic, the following policy conclusions may be drawn (Bird and Rajan, 1999, 2001 and Haq et a l , eds., 1996). The Tobin tax cannot be applied unilaterally, as this will merely lead to a migration of forex transactions to untaxed countries (i.e. avoidance via migration). If the Tobin tax is limited to spot transactions (as per Tobin's original suggestion), this will lead to a tax-saving reallocation of financial transactions from traditional spot transactions to derivative instruments. As such, to prevent tax avoidance via asset substitution, it ought to be applied on all derivative products like forwards, futures, options and swaps. There is broad consensus that the tax must be levied at a rate designed to minimize the incentive to undertake synthetic transactions in order to evade the tax (i.e. geographical or asset substitution), or to alter the forex market structure from a decentralized, dealer-driven market to one that is centralized and customer-driven. Suggestions of the "most appropriate" tax rate have generally ranged between 0.1 and 0.25 percent. A Tobin tax will probably be far more successful in (and ought to be aimed at) moderating (short term) capital inflows (especially debt financing) rather than outflows. In other words, the aim should be to prevent excessive "booms" from occurring in the first instance, rather than attempting to mitigate the effects of (let alone, eliminate) the busts that invariably follow. Given the above (preventive) objective of a Tobin tax, it needs to be imposed in a counter-cyclical manner, i.e. the tax rate should be raised during a boom period and lowered (even eliminated altogether) at other times. This is consistent with the Chilean experience with and management of its interest-free deposit requirement, as well as the empirical literature on capital restraints, which seems to indicate that capital controls have been more effective at preventing "excessive" capital build-up than at stemming capital flight (Bird and Rajan, 2000). Estimating the revenue from currency taxation is a complicated methodological exercise since much depends on the rate and coverage of the tax, the level of transactions costs, the elasticity of capital movements with respect to the effective increase in transactions costs associated with the tax, as well as the extent to which it is avoided. Based on tax rates of between 0.1 and 0.25 percent, estimates of tax revenue range from a low of US$140 billion to a high of US$300 (Table 3). While all such estimates must be viewed with some skepticism (given the complex calculations of tax rates and elasticities), what is certainly true is that a Tobin tax can be expected to raise a lot of money if properly implemented.

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The political economy of currency taxation suggests it will receive greater support if it can be shown to make a significant contribution to offsetting the perceived inefficiencies of private international capital markets (Bird and Raj an, 2001).

7. Concluding Remarks Globalization and the consequent reduction of economic distances between nations pose some severe challenges to tax structures around the world. Nations will experience far-reaching changes in the level of tax revenue, tax mix and systems of tax administration and compliance. Countries are being forced to exhibit much greater awareness of and sensitivity to the tax changes being undertaken by their trading partners and competitors, effectively reducing tax policy autonomy. By making it more difficult to tax the full range of economic activities, the ongoing process of economic globalization is making it increasingly difficult for countries to attain "fiscal sustainability". The notion of fiscal sustainability loosely refers to trends and levels in budgetary revenue and expenditure that are consistent with the macroeconomic objectives of high employment, low inflation and the appropriate real exchange rate. Some have argued that one of the benefits of tax competition is exactly that it ought to lead to a reduction in tax bases and in public spending, which is "invariably unproductive and wasteful". Consequently, tax competition is argued to be net welfare-enhancing. However, political economy compulsions will almost inevitably mean that the burden of such adjustments invariably fall on the social sector and on public infrastructure expenditure at the time when the need for both is quite great. This said, the economic crisis in East Asia in 1997—98 has emphasized the need for social safety nets if social cohesion is to be maintained in times of adversity. More generally, Rodrik's (1998) empirical study, which reveals a positive correlation between openness and government consumption, may be interpreted as suggesting that government consumption plays a cushioning role in more open countries (which are) subject to external shocks 15 . Grunberg

15

Similarly, Quinn (1997) finds that openness to capital flows is associated with larger government size. Alesina and Wacziarg (1998) have argued that Rodrik's result may be capturing a spurious relation as smaller countries have a larger share of government consumption in GDP and more open trade. However, they confirm that Rodrik's result (and thus insight) holds if government expenditures are limited to transfer payments. Garrett (2000) also finds that neither Rodrik's nor Quinn's results hold in general if the focus is on the levels of globalization and government spending. However, if one focuses on changes rather than levels, there is evidence that increases in trade (and capital) openness has put downward pressure on government spending worldwide.

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(1998) has christened this increasing difficulty in mobilizing revenues (due to a shrinking tax base) and the simultaneous need for growing fiscal expenditure as the "fiscal squeeze" model due to globalization. If current trends persist, reconciling this fiscal squeeze with the social sector, particularly pension and health care needs, and with the greater necessity for growth-enhancing government expenditure, will be among the greatest economic challenges yet faced by governments around the world. Bibliography Alesina, A. and R. Wacziarg (1998). "Openness, Country Size and Government", journal of Public Economics, 69, pp. 305-321. Asher, M. (2001). "Globalization and Fiscal Policy: Rationale for Reform in Southeast Asia", in M. Asher, D. Newman and T. Snyder (eds.), Public Policy in Asia: Implications for Business and Government, Westport: Quorum Books. Asher, M. and R. Rajan (2001). "Globalization and Tax Systems: Implications for Developing Countries with Particular Reference to Southeast Asia", ASEAN Economic Bulletin, 18, pp. 119-139. Au, L. (1998). "Electronic Commerce: A Tax Perspective", Coopers & Lybrand Financial Update, Second Quarter, Singapore, pp. 6-7. Bacchetta, P. and M. Espinosa (1995). "Information Sharing and Tax Competition among Government", journal of International Economics, 39, pp. 103-121. Bird, G. and R. Rajan (1999). "Time to Reconsider the Tobin Tax Proposal?", New Economy, 6, pp. 229-233. Bird, G. and R. Rajan (2000). "Restraining International Capital Flows: What does it Mean?", Global Economic Quarterly, 1, pp. 57-80. Bird, G. and R. Rajan (2001). "Cashing In On and Coping with Capital Volatility", journal of International Development, 13, pp. 1-23. Chang, L.L. and R. Rajan (2001). "Regional Versus Multilateral Solutions to Transboundary Problems: Insights from the Southeast Asian Haze", The World Economy, 24, pp. 655-671. Chen, S., ]. Martinez-Vazquez and S. Wallace (1997). "Foreign Direct Investment and Tax Competition in Southeast Asia", mimeo. Chia, N. and J. Whalley (1995). "Patterns in Investment Tax Incentives among Developing Countries", in A. Shah (ed.), Fiscal Incentives for Investment and Innovation, Oxford: Oxford University Press.

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Clausing, K. (1998). "The Impact of Transfer Pricing on Intrafirm Trade", Working Paper No. 6688, NBER. Das-Gupta, A. and D. Mookherjee (1998). Incentives and Institutional Reform in Tax Enforcement: An Analysis of Developing Country Experience, Delhi: Oxford University Press. Deveruex, M. (1990). "Tax Competition and Impact on Capital Flows", in H. Siebert (ed.), Reforming Capital Income Taxation, Germany: J.C.B. Mohr (Paul Siebeck). Diamond, P. and J. Mirrlees (1971). "Optimal Taxation and Public Production I: Production Efficiency", American Economic Review, 61, pp. 8-27. D'Orville, H. and D. Najman (1995). Towards a New Multilateralism: Funding Global Priorities, New York: United Nations. Easson, A. (1998). "Tax Competition Heats Up in Central Europe", International Bureau of Fiscal Documentation Bulletin, May, pp. 192-197. Felix, D. and R. Sau (1996). "On the Revenue Potential and Phasing In of the Tobin Tax", in M. ul Haq, I. Kaul and I. Grunberg (eds.), The Tobin Tax: Coping with Financial Viability, New York: Oxford University Press. Frankel, J. (1996). "How Well do Markets Work: Might a Tobin Tax Help?", in M. ul Haq, I. Kaul and I. Grunberg (eds.), The Tobin Tax: Coping with Financial Viability, New York: Oxford University Press. Garrett, G. (2000). "Globalization and Government Spending Around the World", mimeo (October). Gropp, R. and K. Kostial (2000). "The Disappearing Tax Base: Is Foreign Direct Investment (FDI) Eroding Corporate Income Taxes?", Working Paper No. 00/173, IMF. Grunberg, I. (1998). "Double Jeopardy: Globalization, Liberalization and the Fiscal Squeeze", World Development, 26, pp. 591-605. Haq, M., I. Kaul and I. Grunberg (eds.) (1996). The Tobin Tax: Coping with Financial Volatility, New York: Oxford University Press. Harris, D., R. Morck, J. Slemrod and B. Yeung (1993). "Income Shifting in U.S. Multinational Corporations", in A. Giovannini, R. Hubbard and J. Slemrod (eds.), Studies in International Taxation, Chicago: University of Chicago Press. He, X. (1995). "What is New? A Close Look at Intra-Firm Cross-Border Trade", Business & The Contemporary World, 4, pp. 134-150. Kokko, A. (2002). "Globalization and FDI Incentives", paper presented at the Annual World Bank ABCDE-Europe Conference (Oslo, June 24).

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Lee, H. L. (2002). "Remaking Singapore for a Different World", speech at the Institute for International Economics (Washington, DC, November 13). Levinson, A. (1996). "Environmental Regulations and Industry Location: International and Domestic Evidence", in J. Bhagwati and R. Hudec (eds.), Fair Trade and Harmonization: Prerequisites for Free Trade?, Vol. 1, Cambridge, MA: MIT Press. Meehan, M. (2000). "Forrester: E-commerce to Explode in Asia, Europe, South America", Computerworld, April 21. Messere, K. (2000). "20th Century Taxes and Their Future", Bulletin for International Bureau of Fiscal Documentation, 54, pp. 2-29. Musgrave, R. (1959). The Theory of Public Finance, New York: McGraw Hill. Orbeta, A.C. Jr. (2000). "E-Commerce in Southeast Asia: A Review of Developments, Challenges and Issues", Discussion Paper No. 2000-38, Philippines Institute for Development Studies. Organisation of Economic Cooperation and Development (OECD) (1997). Electronic Commerce: The Challenges to Tax Authorities and Taxpayers, Paris: OECD. Owens, J. (1997). "The Tax Man Cometh to Cyberspace", Tax Notes International, June 2, pp. 1833-1852. Owens, J. (1998). "Taxation within a Context of Economic Globalization", International Bureau of Fiscal Documentation Bulletin, July, pp. 290-296. Panagariya, A. (2000). "Trade Openness: Consequences for Poverty and Income Distribution", mimeo (December). Paul, J. and K. Wahlberg (2002). "Global Taxes for Global Priorities", paper prepared in conjunction with a roundtable on "Global Taxes for Global Priorities", organized by Global Policy Forum, WEED, and the Heinrich Boll Foundation (New York, May 5 2001). Quinn, D. (1997). "The Correlates of Changes in International Financial Regulation", American Political Science Review, 91, pp. 531-551. Rodrik, D. (1997). Has Globalization Gone Too Far.7, Washington, DC: Institute for International Economics. Rodrik, D. (1998). "Why do More Open Countries have Bigger Governments?", Journal of Political Economy, 106, pp. 997-1032. Schulze, G. and H. Ursprung (1999). "Globalisation of the Economy and the Nation State", The World Economy, 22, pp. 295-351.

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Simons, H. (1938). Personal Income Taxation: The Definition of Income as a Problem of Fiscal Policy, Chicago: University of Chicago Press. Slemrod, J. (1990). "Tax Principles in an International Economy", in M. Boskin and C. McLure, Jr. (eds.), World Tax Reform, San Francisco: ICS Press. Slemrod, J. (1995). "Comments", in Taxation in an Integrating World, Washington, DC:

The Brookings Institution. Soete, L. and B. Ter Weel (1998). "Globalization, Tax Erosion and the Internet", mimeo (October). Tanzi, V. (1995). Taxation in an Integrating, Washington, DC: Brookings Institution. Tanzi, V. (1998). "The Impact of Economic Globalization on Taxation", International Bureau of Fiscal Documentation Bulletin, August/September, pp. 338-343. Tanzi, V. (2000). "Globalization, Technological Developments, and the Work of Fiscal Termites", Working Paper No. 00/181, IMF. Tanzi, V. and P. Shome (1992). "The Role of Taxation in the Development of East Asian Countries", in T. Ito and A. Krueger (eds.), The Political Economy of Tax Reform, Chicago: University of Chicago Press. Tanzi, V. and H. Zee (1998). "Consequences of the Economic and Monetary Union for the Coordination of Tax Systems in the European Union: Lessons from the U.S. Experience", Working Paper No. 98/115, IMF. Teltscher, S. (2002). "Electronic Commerce and Development: Fiscal Implications of Digitized Goods Trading", World Development, 30, pp. 1137-1158. Tobin, J. (1978). "Proposal for International Monetary Reform", Eastern Economic Journal, 4, pp. 153-159. Wood, A. (1995). "How Trade Hurt Unskilled Workers", journal of Economic Perspectives, 9 , pp. 57-80.

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Table 1 Individual and Company Income Tax Rates in Southeast Asia, in force early 2003 (percent) Country

Nominal Rate Structure Individual Income Tax

Company Income Tax

Indonesia

5-35 percent (5 brackets)

10-30 percent (3 brackets)

Malaysia 3

1-28 percent (9 brackets)

28 percent

Philippines

5-32 percent (7 brackets)

32 percent

Singapore

4-22 percent (6 brackets)

22 percent

Thailand

5-37 percent (5 brackets)

30 percent13

Vietnam

10-60 percent (6 brackets) (Foreigners residing in Vietnam are taxed 10-50 percent)

10-50 percent (Standard rate of 32, with numerous exceptions and room for interpretation); Special rates for foreign investment (Standard rate of 25 percent)

Notes:

a) Malaysia's 1999 Budget proposed that corporate and individual income tax for 1999 be waived. This is to bring tax payments to a current year basis from the year 2000 onwards. Since before this change, there was a one-year lag in the payment of income tax (e.g. Income tax payable in 1999 is based on the income earned in 1998), this change did not affect 1999 tax revenue flows materially b) From January 1, 2002 small and medium enterprises (SMEs) (defined as a juristic company or partnership with paid up capital not exceeding baht 5 million at the end of any accounting period) are charged 20% rate if net profits are less than baht 1 million and 25% rate if between baht 1 and 3 million. Normal 30% rate apply above baht 3 million Sources: Asher and Rajan (2001); PricewaterhouseCoopers Services Pte Ltd's taxation website: http://www.pwctax.com/

Seller/Buyer

Business

Consumer

Government B2G (Businesses offering to sell goods and services to government)

GM/Ford (with suppliers and dealers) National Transportation Exchange (Buyer and sellers of trucking space) Philippines: SVINet/Macro (Shopping mall and suppliers) PhilBX

Amazon (retail book selling) Dell (direct computer selling) Philippines: Estore-Exchange (retail, various items)

Singapore: GeBiz (One-stop, round-the-clock centre for government business dealings)

Consumer

C2B (Consumer offering to sell goods and services to business) Priceline (consumer bid for airline tickets) JobsDB (businesses posting job vacancies) Consultants' web pages

C2C (Consumers offering to buy and sell goods and services to other consumers) Ebay (consumer auctions)

C2G (Consumers offering to sell goods and services to government)

Government

G2B (Government offering to sell goods and services to businesses)

G2C (Government offering to sell goods and services to consumers)

G2G (Government offering to buy or sell goods and services to other government agencies)

Philippines: Customs (Importation) PhilJobNet(Employment facilitation)

US: Service Arizona (renew motor vehicle registrations, ordering personalized plates to replacing lost ID cards, etc.) Singapore: eCitizen Centre (integrated government service delivery)

251

B2C (Businesses offering to sell goods and services to consumers)

Economic Globalization and Taxation

B2B (Businesses offering to sell or buy goods and services to other businesses)

Business

Economic Globalization and Asia

252

Table 3 How Much Revenue Can the Tobin Tax Generate?

Study

Tax Rate Assumed (per cent)

Annual Tax Revenue Derived (billions of US dollars)

Felix and Sau (1996)

0.25

290

Felix and Sau (1996)

0.10

140-180

D'Orville and Najiman (1995)

0.25

140

Frankel (1996)

0.10

170

Paul and Wahlberg (2002)

0.20

300

Source: Compiled by authors

253

Index

APEC (Asia-Pacific Economic Cooperation), 174 ASA (ASEAN Swap Arrangement), 60 ASEAN (Association of Southeast Asian Nations), 4, 16, 18, 42, 45, 60, 66, 71, 73, 78-80, 88-89, 100, 144, 149, 151, 168-169, 171, 175-176, 179, 209, 246 band crawling, 83, 97, 98 monitoring, 65-66, 69, 79-80, 97, 98 bank flows origin, 30 BBC (band-basket-or-crawl), 96-97 bear squeeze, 99 behaviour forced portfolio adjustment, 37 BSA (Bilateral Swap Arrangement), 60 bull squeeze, 99 capital account, 53, 56 capital inflows geographic distribution, 29 push versus pull factors, 28 timing and magnitude, 29 CBA (Currency Board Arrangement), 85-87, 91 CCL (Contingent Credit Line), 58, 70 CEN (Capital Export Neutrality), 235-236 centrifugal forces, 8 centripetal forces, 7, 8 ceteris paribus, 201

CIN (Capital Import Neutrality), 236, 237 CMI (Chiang-Mai Initiative), 55, 58-63, 68, 98 complete IFL, 210 concentration effects, 8

254

Index

congestion effects, 8 contagion, 27-40, 55, 58, 68, 90 financial, 37 pure, 34 convoy problem, 171 current account, 53 currency crisis, 6, 33-34, 36, 53, 59, 85 regional economy, 34 cyberpayments, 242 direct channel, 35 dollarization, 87-88 ECB (European Central Bank), 64 E-commerce, 12, 13, 231, 241-243, 248 B2B transactions, 4, 3, 14, 241, 252 taxation of the internet, 241-243 economic globalization finance and capital flows, 4-7 production and trade, 7-9 first versus second waves, 9-12 public finances, 12-13 income distribution, 12-13 economic liberalization global, 3 effect(s) balance sheet, 53-54, 95 bandwagon, 37 flight to safety, 37 liquidity constrained, 37 panic herding, 37 wake-up call, 37 EMCF (European Monetary Cooperation Fund), 64 EMI (European Monetary Institute), 64 EPZ (Export Processing Zones), 120 equity flows, 33 ERM (Exchange Rate Mechanism), 6 FDI (Foreign Direct Investment) and export platforms, 115 fear of floating reasons, 93-95 firm-congestion, 7 fiscal incentives, 237-240 fiscal sustainability, 243, 245 fiscal squeeze, 246 fiscal termites, 12

Index

255

fixed exchange rate bubble, 90 flexible exchange rate, 90-95 flexible inflation target. See BBC flow(s), 3 capital, 4 finance, 3 international capital, 3 production and trade, 3 flying geese pattern, 138-144 follow-the-leader strategy, 7 four tigers, 138 FTAP model, 201

G-7, 53 G A T T (General Agreement on Tariffs and Trade), 3 globaphilia, 112 globaphobia, 4, 14, 112 growth extensive, 10 intensive, 10 Harberger triangles, 130 hollowing out hypothesis, 95 IIF (International Institute of Finance), 30 IMF (International Monetary Fund), 3, 4, 6, 13, 14, 17-19, 23, 27, 32, 40-42, 44-46, 48, 53-55, 58-62, 66-77, 84, 86, 88, 91, 93, 96, 99, 101, 102, 104, 106, 125-126, 135-137, 148-149, 157, 179, 182, 185, 248, 250 data on capital flows. See flow(s) impossible trilogy, 95 impossible trinity. See impossible trilogy India's trade reforms, 134-146 evolution, 136-138 indirect channel, 35 international trade infrastructural services, 189-199 communications services, 197-198, 203-204 financial services, 198-199, 204 international factor mobility, 231-234 intraproduct specialization, 193 inverse elasticity rule, 233 Knickerbocker oligopolistic theory, 7 laissez'faire, 11 laissez-passe, 11

256

Index

labour and capital factors short run, 117 medium run, 117 long run, 117 law of the excluded middle. See hollowing out hypothesis liability dollarization, 95 liquidity enhancing measures, 55-58 reserve buildup, 55-56 foreign bank entry, 56-58 contingent credit lines, 56-58 Mexican debt crisis, 34 monetary regionalism, 67-70 Monetary Union, 88-90 OCA (Optimum Currency Area), 88, 91 pegging, 61, 83, 91-92 Ramsey Rule. See inverse elasticity rule reserve buildup, 55 SEZ, 119 reserve pooling full, 62 partial, 62 Singapore's cross-regional trade pacts, 166-176 spaghetti bowl phenomenon, 173 spillovers trade spillovers, 35 demand-driven, 35 financial sector spillovers, 36 interdependencies, 39 strong currency countries, 62 super-fixes, 85 surveillance and policy conditionality, 65-67 taxation Southeast Asia, 231-245 Tequila crisis, 4, 28, 34, 39, 57 Tequila effect, 6 Trade and Investment Facilitation Agreements (TIFAs), 172 Tobin tax, 243-245 trade in services location of service providers cross-border supply, 190

Index

consumption abroad, 190 commercial presence, 190 presence of natural persons, 190 trade liberalization, 111-123 trade theories, 116-118 Stolper-Samuelson model, 116 Specific Factors model, 116 transfer pricing, 241 VSTFF (Very Short Term Financing Facility), 63, 64 WEF (World Economic Forum), 14 World Bank, 4, 9, 14 data on capital flows. See also flow(s) WTO (World Trade Organisation), 3, 14, 129, 144, 151, 166, 172-178, 180-181, 184-186, 191, 198, 207-210, 221, 223, 242

257

Economic \ 4* Globalization and Asia ,? J>^> !&i

*V*

Essays on Finance, Trade

and

Taxation

he term "economic globalization"^+ias been discussed extensively in the popular press, by business executives and by policymakers all over the world. While academic economists have made some excellent contributions to specific technical aspects of economic globalization, there appears to be a need for economists to discuss the broader aspects of the issue in a more accessible manner. Failing this, the general debate will be informed only by the writings of noneconomists. That is the motivation for this book, which is a collection of essays on various aspects of economic globalization in general, but with specific reference to Asia.

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www.ips.org.sg www.worldscientific.com 5289 he

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