- Time and Date: 9:20-16:30; Friday, March 28, 2008
- Venue: Department for Business, Enterprise and Regulatory Reform, London
- Language: English
- Hosts: Centre for Economic Policy Research (CEPR) / Research Institute of Economy, Trade and Industry (RIETI)
Summary of Proceedings
Background and overview
This workshop was part of an on-going collaboration between the Centre for Economic Policy Research (CEPR), based in London, and RIETI.
- Richard BALDWIN (Professor of International Economics, Graduate Institute of International Studies, Geneva / Policy Director, CEPR)
- Julian FRANKS (London Business School / CEPR)
- FUJITA Masahisa (President and CRO, RIETI / Professor, Konan University)
- Thierry MAYER (University of Paris 1, CEPII / CEPR)
- MIYAJIMA Hideaki (Faculty Fellow, RIETI / Professor, Waseda University)
- Gianmarco OTTAVIANO (University of Bologna / CEPR)
- WAKASUGI Ryuhei (Faculty Fellow and Research Counselor, RIETI / Professor, Institute of Economic Research, Kyoto University)
- YOSHINO Naoyuki (Professor, Keio University)
In a globalizing and dynamic world economy, regional integration attracts intense interest and debate among academics and policy-makers alike. The expansion of global markets and the deepening of economic interdependency create a range of new economic and political challenges. The processes of integration in Europe and East Asia, while having very different foundations and at different stages of development, feature prominently in the dialogue. Integration in Europe has effectively progressed from a customs union in 1957, to the creation of a single market in the 1980s, to currency union in 1999. East Asian integration, on the other hand, has been less politically influenced, more informal, and primarily led by multinational corporations, with integration policies such as free trade agreements (FTAs), for example, tending to follow the economic reality.
The workshop featured policy-oriented presentations from some of Europe's and Japan's leading economists on the process of economic integration in both regions. Presentations from RIETI included a consideration of trade, investment, offshoring, and financial integration, as well as an overview of regional integration in East Asia. Researchers from CEPR discussed equity markets and institutions, considering the changing characteristics of corporate ownership and control in Japan during the last 100 years (with comparisons to the UK and Germany); the "internationalization" of European firms, which focused on the characteristics of European firms involved in international activities through exports or foreign direct investment (FDI), which concluded that the international performance of European countries is essentially driven by a handful of high-performance firms; and the effect of the euro on trade and FDI which, using the latest data and empirical techniques, consolidates what we know about the euro's trade and investment effects and investigates the precise channels through which the "euro-trade" effect works.
The workshop included participants from government, the private sector, and academia. Presentations were policy-oriented and designed to stimulate discussion.
The Internationalization of European Firms
Thierry Mayer (University of Paris 1, CEPII / CEPR) and Gianmarco Ottaviano (University of Bologna / CEPR)
Summary of paper
The lack of statistical information at the firm level has so far prevented systematic inclusion of firm-level analysis in the policy-maker's standard toolbox. This report argues that the time is ripe to supplement the policy-making toolbox: firm-level datasets are now available and provide new information that one cannot afford to ignore.
The focus of this report is on the characteristics of European firms involved in international activities through exports or foreign direct investment (internationalized firms, hereafter IFs). The analysis of firm-level evidence reveals some new facts that are simply unobservable at the aggregate level:
- IFs are superstars. They are rare and their distribution is highly skewed, as a handful of firms account for most aggregate international activity.
- IFs belong to an exclusive club. They are different from other firms. They are bigger, generate higher value added, pay higher wages, employ more capital per worker and more skilled workers, and have higher productivity.
- The pattern of aggregate exports, imports, and foreign direct investment (FDI) is driven by the changes in two "margins." The "intensive margin" refers to average exports, imports, FDI per firm. The "extensive margin" refers to the number of firms actually involved in those international activities.
- The extensive margin is much more important, as the reaction of aggregate trade and FDI flows to country fundamentals takes place mostly through that margin. This is impossible to see without firm-level data and thus has not been seen so far.
In short, the international performance of European countries is essentially driven by a handful of high-performance firms. Moreover, the opening up of trade and FDI triggers a selection process whereby the most productive firms substitute the least productive ones within sectors. This is good for productivity, GDP, and wages.
Presentation and discussion
Traditional trade analysis is based on nations and industries. However, nations do not trade. It is firms that trade. Hence, firm-level analysis is essential to understand issues surrounding competitiveness and for effective policy-making in Europe.
Analysis of firm-level evidence reveals new facts on IFs (European firms involved in international activities through exports and FDI - also termed the "happy few" by the authors), and how it maps into aggregate export and FDI performance that is unobservable at the aggregate level.
These happy few export a large number of products to many locations, whereas a huge number of small firms are usually exporting a marginal part of their activity to very few countries.
IFs are generally bigger, generate higher value-added, pay higher wages, employ more capital per worker and more skilled workers and have higher productivity. Overall, a handful of these high-performing firms dominate the international performance of European countries.
Only a small fraction of European firms is taking advantage of the internal opportunities from the single market and the external opportunities from globalization.
Patterns of aggregate exports, imports, and FDI can be said to be dictated by changes in two margins:
Intensive margin - average exports, imports, FDI per firm
Extensive margin - the number of firms involved in these international activities
The reaction of the extensive margin of trade to gravitational forces is much greater than the intensive margin, as the reaction of aggregate trade and FDI flows to country fundamentals takes place mostly through that margin. For instance, the effect of the exporting country's size on trade comes from the number of its exporting firms.
Hence, internationalization of European countries is a matter of increasing the number of firms involved, as much as increasing the number of already active firms.
In order to increase the number of firms involved, policies fostering firm performance (though employment and productivity) are more important than policies fostering exports, imports, or FDI.
- Promote intra-industry competition - Liberalization in terms of opening up to trade and FDI leads to reallocation of firms within sectors, with the most productive ones substituting least productive ones; leading to productivity, GDP, and wage enhancements.
- Increase the number of exporters and multinationals - The most important factor for a country's trade and export performance is how many of its firms engage in these activities
- Focus on the superstar firms of the future, rather than the incumbents - to broaden the export base, countries should not focus on policies supporting the existing firms, but instead on lowering barriers to exports and FDI and by creating conditions for tomorrow's superstars to emerge.
- Fight against small trade costs, as these costs of internationalization reduce the number of exporters.
Offshoring and Trade in East Asia
Ryuhei Wakasugi (Faculty Fellow, RIETI / Kyoto University)
Summary of paper
Japanese shares of export and manufacturing value added in the global market have declined significantly, whereas those in China have risen sharply. The recent increase of global offshoring is noteworthy as a factor to cause changes in the structure of international trade and the production-depth. This paper examines how the recent increase of offshoring by Japanese firms relates to the changes in the composition of export and manufacturing value added among Japan, China, East Asian countries, the U.S., and European countries, on the basis of our original survey of Japanese firm's offshoring and the statistics of export and manufacturing production of these countries. It also discusses how the net cost saving of offshoring due to wage differentials and institutional factors will affect the sustainability of Japanese offshoring.
Presentation and discussion
Recent international trade (spurred by innovation in ICT and air shipping) has led to an increase in global locations for production of goods and services. Current international division of tasks is different from the previous trade models and is akin to technical innovation, as it enables offshoring firms to obtain rent by utilizing production factors at a lower cost and a high level of technology.
International trade statistics take into account the volume of sales instead of value added; as recent progress in division of tasks has promoted repeated transactions of parts, intermediate products, and services across national borders; leading to a large increase in the volume of international trade after the 1990s.
In the past 10 years, trade structure involving East Asia, the U.S., and European countries has undergone dramatic changes. Japan's relative share of exports has decreased, while that of China has increased sharply.
Distribution of manufacturing value added has also undergone a change. There has been no significant change in the share of manufacturing value added in European and East Asian countries, the Japanese share has declined and Chinese share has increased sharply.
Firm-level data shows that structural changes in trade and manufacturing value added are related to recent growth in Japanese offshoring to China. However, firm-level data on offshoring does not clarify what part of the changes in trade and production is explained by increase in offshoring.
Offshoring firms need to determine the viability of offshoring by weighing the benefits of cheap production costs (for instance lower wages) with the costs of coordination of unbundled tasks.
Apart from wage cost savings (which have been found to be the biggest influence on a firm's decision to offshore) and changes in exchange rates, improvements in institutional factors including legal systems, protection of intellectual property rights, and safety standards of products will also be determining factors in what type of tasks will be offshored and if offshoring will be sustainable in the future.
Equity Markets and Institutions: Perspectives from Japan, Germany, and the UK
Julian Franks (London Business School / CEPR) and Hideaki Miyajima (Faculty Fellow, RIETI / Waseda University)
Summary of paper
Corporate ownership and financing in Japan in the 20th century is striking. In the first half of the 20th century equity markets were active in raising more than 50% of the external financing of Japanese companies. Ownership was dispersed both by the standards of other developed economies at the time and even by those of the UK and U.S. today. In the second half of the 20th century, bank finance dominated external finance and interlocking shareholdings by banks and companies became widespread. The change from equity to bank finance and from an outsider system of public equity markets to an insider system of private equity in the middle of the 20th century coincided precisely with a marked increase in investor protection: in the first half of the 20th century investor protection was weak and in the second it was one of the strongest in the world. Informal institutional arrangements rather than formal investor protection explain the existence of equity in the first of the half of the century - business coordinators in the early 20th century and zaibatsu later. Insider private equity in the form of bank ownership and cross-shareholdings emerged in the second half of the century in response to financial distress and the absence of well-developed bankruptcy laws which encouraged Japanese banks to swap their corporate debt for equity.
Presentation and discussion
Corporate ownership and financing in Japan in the 20th century is striking. In the first half of the 20th century, equity markets were active in raising more than 50% of the external financing of Japanese companies. Ownership was dispersed both by the standards of other developed economies at the time and even by those of the UK and U.S. today. The prevalence of equity did not rely on either formal systems of investor protection or the dominance of large shareholders. Instead it depended on the emergence of certain informal institutional arrangements (business coordinators, zaibatsu ) that encouraged the participation of small investors.
In the second half of the 20th century, bank finance dominated external finance and interlocking shareholdings by banks and companies became widespread. The change from equity to bank finance and from an outsider system of public equity markets to an insider system of private equity in the middle of the 20th century coincided precisely with a marked increase in investor protection: in the first half of the 20th century investor protection was weak and in the second, it was one of the strongest in the world.
Weak investor protection in the first half of the 20th century coincided with active stock markets, a large amount of equity issuance, high dividend distributions and dispersed ownership. Strong investor protection in the second half of the 20th century was associated with bank finance, low levels of dividend distribution, and an insider system of ownership.
Insider private equity in the form of bank ownership and cross shareholdings emerged in the second half of the century in response to financial distress and the absence of well-developed bankruptcy laws which encouraged Japanese banks to swap their corporate debt for equity.
Steps toward the Development and Integration of the Asian Bond Market
Naoyuki Yoshino (Keio University)
Summary of paper
This paper describes the following issues. Firstly, with regard to the high savings ratio in the Asian region, the paper will suggest how to circulate the accumulation. The second topic is how to develop the bond market and other related financial markets in the Asian region in order to promote active financial investment in the Asian region. The third topic looks at the steps toward the integration of the Asian bond market. The fourth and final topic is the description of the revenue bond for infrastructure investment as one of the urgent needs for basic infrastructure investment in Asia.
The development of the government bond market is the key for all of the bond markets in each country of the region, since the government bond is regarded as a benchmark for all the bonds in each country.
Step one will be to issue bonds which match the need for investors. Short-term, medium-term, and long-term bonds should be issued so as to match the variety of investors in each country. Short-term bonds will fit with commercial banks that prefer 1-5 years of maturity. Medium-term bonds, such as 10-year maturity and 15-year maturity, will be preferred by commercial banks and insurance companies. Long-term bonds and super long-term bonds, such as 20-, 30-, 40-, and 50-year, will be preferred by pension funds.
The kinds of government bond which would be issued by each country should fit with the demand from the various financial institutions base on their maturity preference. Increasing liquidity to the government bond market is important in order to develop the bond market.
In addition to government bonds, corporate bonds, infrastructure revenue bonds, and small-and medium-sized enterprise (SME) financing bonds will be developed in the next step.
Infrastructure revenue bonds explained in this paper are one of the instruments in the development of Asian bond markets. Most Asian countries have high savings rates, and even given the high economic growth rates and investment rates in region, it would be possible to secure investment funding if savings were put to use within Asia. Unfortunately, most of the funds collected in Asia are invested in North America and Europe, because Asia only offers safe assets in the form of deposits or risk assets in the form of equity, with virtually no bonds or investment trusts, etc., to serve as intermediate financial instruments. In other words, the quality of the financial instruments traded in the region's financial markets is extremely fragile.
The Asian currency crisis of 1997 was caused by two mismatches in fundraising and investment: (i) a maturity mismatch and (ii) a currency mismatch. The first, the maturity mismatch, was the result of foreign investors investing short-term funds in the financial markets of Thailand, Indonesia, and other Asian countries, while financial institutions borrowing from them (both banks and finance companies) used the funding to make long-term loans on the domestic market. As a result, when speculative foreign investors rapidly began to pull out their short-term funds, financial institutions were unable to collect from their domestic investments and became strapped for repayment funding. The second factor, the currency mismatch, was the result of financial institutions borrowing abroad in dollars and making loans to domestic companies in baht (in the case of Thailand) so that large fluctuations in exchange rates created a mismatch that institutions were unable to cope with.
There are two steps that are required to prevent the recurrence of an Asian currency crisis: (1) investing Asia's high savings within the region, and (2) enhancing financial instruments within the region so that there is a flow of stable, long-term funding. It is for these reasons that policy-makers in the Asian region have advocated the development of Asian bond markets.
There are, of course, many different types of bonds: (i) public bonds issued by central and local governments, (ii) bonds issued by quasi-public institutions such as electric power bonds, (iii) corporate bonds, (iv) securitization products backed by mortgages, and (v) securitization products backed by obligations of SMEs, etc. However, at the present, there is just barely a secondary market for the government bonds issued in Asia.
Currently, Thailand, Sri Lanka, Mongolia, and India are studying the introduction of revenue bonds for infrastructure investment leaded by the United Nations Economic and Social Commission for Asia and the Pacific (UNESCAP) and the Japan Bank for International Cooperation (JBIC) for which the author is an active project member.
Presentation and discussion
Asian financial markets can be characterized by the following traits:
- Most East Asian countries show a very high national savings to GDP ratio.
- Much of these savings are deposited in the banking sector, making it very strong at the expense of the capital market.
- There is a bias toward domestic financial investment (home-country bias), due to asymmetric information about other Asian countries and lack of financial instruments.
Since most Asian countries have high savings rates, it would be possible to secure investment funding if savings were put to use within Asia. Unfortunately, most of the funds collected in Asia are invested in North America (37.1%) and Europe (30.7%), as the quality of financial instruments traded on the region's financial markets is very fragile. Asia does not offer any intermediate financial instruments - middle-risk, middle-return products - such as mutual funds, investment trusts, etc. and offers only bank deposits and stocks.
Europeans keep more than 65% of their investment within Europe, denoting large regional financial investments. This is a direction Asian investors need to turn to as well.
Development of the government bond market is key for all bond markets, since the government bond is regarded as benchmark for all bonds in each country. A liquid and transparent government bond market will enhance transactions of various financial institutions in the bond market.
The kind of government bonds which would be issued by each country should fit in with the demand from various financial institutions on their maturity preference.
Besides government bonds, corporate bonds, infrastructure revenue bonds, and SME financing bonds should be developed in the next step.
The Asian currency crisis was caused by a maturity mismatch and currency mismatch in fundraising and investment. There are two steps to prevent the recurrence of a similar crisis:
- 1. Investing Asia's high savings within the region
- 2. Enhancing financial instruments within the region to ensure a flow of stable, long-term funding
In order to enhance the portfolio capital flows in Asia, there should be a continuous information exchange between Asian countries and institutions, harmonization of various legal frameworks, development of financial markets and products, and a drive toward consumer education.
Regional Integration in East Asia: An Overview
Masahisa Fujita (President, RIETI / Konan University)
Presentation and discussion
Globalization of the world economy has not been progressing uniformly around the world. Over the past half-century, global economic activity in terms of size of GDP has been increasingly intensifying and converging within and around each of the 3 regions - East Asia, EU, and North America (more than 80% of the world GDP concentration), while strengthening the economic interdependency within each region. This is occurring despite common sense which indicates that lower transport costs would make geographical accessibility or distance less important leading to a more even distribution of economic activity in the world. This paradoxical phenomenon can be explained by Spatial Economics (Edward Elgar Publishing, 2005).
The observed spatial configuration of economic activities is considered to be the outcome of a process involving two opposing types of forces: agglomeration and dispersion.
Under the presence of a sufficient heterogeneity in goods1 , the three-way interaction among increasing returns2 , transport costs3 , and migration of workers4 creates a circular causation leading to the agglomeration of both consumers and suppliers of these goods and services.
The continual reduction in transport costs over the past half-century has been promoting simultaneously the globalization of the world economy and its regional integration at the sub-global level.
The impact of decreasing transport costs is non-monotonic. Only with a sufficient reduction in transport costs, will agglomeration economies start dominating the dispersion force of transport costs, leading to the formation of economic concentrations. However, with too much concentration of economic activities in core regions, wage rates and land costs increase, which tends to push away some of the activities with high labor intensity to peripheral regions. This is what happened in the "flying geese" process of economic growth in East Asia during the second half of the last century.
Unlike the EU and North America, East Asia has attained such a high level of economic integration mainly through market mechanisms, with little support from region-wide political institutions. Further, the concentration of world GDP in the three regions has been intensifying recently with East Asia growing the fastest.
The Euro's Trade and FDI effects
Richard Baldwin (Graduate Institute, Geneva / CEPR)
Summary of Presentation
The introduction of the euro was an immense political and symbolic step toward an integrated Europe. It was also the world's largest economic "experiment." This experiment opens the door to a major advance in our understanding of how a common currency affects economic activity ranging from trade and foreign direct investment to wage-setting behaviour and corporate business strategies.
A series of studies stretching back to the early years of the decade have begun to piece together a wide range of results. The resulting collage - for example, as presented in Richard Baldwin's book, In or Out : Does it Matter ? (CEPR, 2006) - is still not very coherent, and as such is not particularly useful for policy-makers. To a large extent, the fragmented nature of the literature stems from the newness of the experiment. Each year, studies using another year's worth of data have emerged, making systematic comparison difficult. And no one has yet put in the effort to do a thorough stocktaking that involves actually re-estimating all the findings using the latest data and best econometrics.
The goal of this project is to make a major advance in our understanding of the euro's impact on trade and FDI. There are two key elements to this effort. The first element consolidates what we know about the euro's trade and investment effects, using the latest data and empirical techniques. The second pushes out the frontiers of our knowledge by investigating the precise channels thorough which the euro is affecting trade and investment - the microeconomics of the euro-trade effect. The time is ripe for this endeavor. We now have enough data, both at the aggregate level and sector and firm level, to go well beyond generalities and conjecture; to really figure out what happened, why it happened, and what it all means for policy.
Presentation and discussion
Traditionally, it has been assumed that exchange rate volatility and multiple currencies depressed trade. This was based on empirical results derived from figures on growth of trade during the "classical gold standard" (1880-1914). It was asserted by Mundell that the principal microeconomic gains from nations forming currency unions would be through enhancements in trade (the optimal currency area theory).
However, economists had been unable to find robust empirical evidence for an exchange rate volatility link to trade flows. Rose (2000) produced a seminal paper with robust results showing that exchange rate stability and common currency were powerful stimulants to trade. The results showed that a currency union would increase trade by 200%.
Baldwin and Taglioni attempt to correct various econometric flaws in previous research - using nominal trade data and GDP, handling numeraire issues with time dummies, using time varying country dummies and time invariant pair dummies etc. They use new evidence that updates the Rose estimates using the latest data and best empirical techniques and argue that the aggregate trade effect of the euro (the Rose effect) is around 5%-15%.
- When goods are sufficiently differentiated from each other, their suppliers can locate close by without involving severe price competition.
- Scale economies make it profitable concentrate activities in the same location.
- The presence of transport costs leads to "home-market" effects for the supplier locating near a large market.
- Migration of workers is a prerequisite for the agglomeration of workers and firms together.
*This seminar is funded by the Great Britain Sasakawa Foundation.