Global Financial and Economic Crisis and Asia's Trade Potential

Biswa BHATTACHARYAY
I read an article by Klingebiet (2003) which said that from late 1970s up to 2003, there were 117 systemic crises and 51 cases of border line crisis (between systemic and non-systemic crisis). Past and present crises show that we have not learned enough on how to prevent them. What can be learned from this is that we may not be able to accurately predict crises, particularly their timing but some lessons have been learned on how to contain and limit the damage that follows from such crises. So it is important to be prepared for crises in order to minimize their impact, and that it is also important to manage crises when they occur. Today, Asia is witnessing an economic crisis following the sub-prime mortgage crisis in the United States. The sub-prime mortgage market crisis, which originated in U.S. in summer 2007, has had a devastating effect on the U.S. and EU's financial system through the bursting of housing bubble, bankruptcies and credit crisis.

The present crisis is an outbreak of gross financial irregularities, excessive risk taking, large global imbalance, and loose monetary policies in the U.S., among others. The excess savings in Asia was termed as one of the major causes to the ongoing crisis, because by putting Asia's excess savings into advanced economies at a lower interest rate, such economies have tendencies to overspend. The final crisis has led to a major global recession which has been coursed through three major channels, namely, export collapse, reversal of capital flows, and the weakening of market confidence. Experts are referring to this as the first global recession in the new era of globalization.

There are many consequences of the crisis. Asian economies, which are highly trade-dependant and globalized, have suffered immensely, with growth, exports and imports, and domestic demand declining. An anti-globalization sentiment has been rising whereas questions have been raised about the future of the export-led Asian growth model. Trade patterns and production structures in Asian countries built over decades in order to export to advanced economies have been affected by the crisis. Many studies have also been conducted by the WTO, World Bank, Asian Development Bank, and the IMF to identify the causes of the crisis and also the remedies.

The direct impact of the financial crisis on the Asian financial market has been limited because Japan, Korea, Taiwan, China, and Singapore have relatively less toxic assets in the U.S. financial market. However, indirect impacts have been significant, with large GDP contractions witnessed in Japan, Korea, Malaysia, Thailand, and Singapore, whereas countries such as India, Indonesia, and Vietnam are facing smaller GDP contractions. Job losses in Asia have been enormous. In China alone, 1.12 million people have lost their jobs as a result of this crisis. Apparently, the financial crisis has been most severe for international demand dependant countries, and less severe for domestic demand dependent countries.

World exports and imports have suffered severely due to heavy contractions in demand in advanced economies, which has subsequently affected the large developing economies like China, and India, as well as the Asian newly-industrialized economies (NIE), and most severely the major ASEAN economies. As a result, the GDP of major Asian economies has been impacted by this crisis, while some of them are in recession and others are experiencing contractions in growth.

By the third quarter of 2008, the crisis started to heavily impact on GDP growth in Asia. Japan, Korea, Singapore, and Thailand have experienced high contractions due to export dependence. The exports slowdown continued until May 2009 and there is still no sign of recovery. The export dependency of Asian economies has increased over time, with export to advanced economies being a major component of exports of emerging Asian economies. At this juncture, this brings the question of whether it is necessary to rebalance Asia's growth strategy in the medium to long run.

Major Asian economies have faced high negative export and import growth, as well as high contraction in output, with very few exceptions. According to the IMF, stabilization as of May 2009 is uneven and recovery therefore will be slow. With this background, there is a need to reinterpret future trade potential of Asian economies.

Prabir DE
Trade potential is an indication of an economy's optimal trade producing capacity. It is immensely important to estimate trade potential for countries which are severely affected by the crisis. It also allows policy makers to assess future trade-generating ability, and allows for thinking on trade facilitation, promotion, expansion and specialization. Here, the trade potential of Asian countries, especially those which are heavily dependant on advanced economies, has to be understood. In any kind of trade simulation, several models can be used. We use the gravity model, which can better predict trade potential. The gravity model has gained popularity because policy makers can utilize some variables that cannot be used in other models.

The Gravity model was used to estimate trade potential of the ASEAN+6 countries in pre- and post- crisis period. In general, a standard gravity model shows that total trade between two partners will depend on economic mass, represented by GDP, and the bilateral distance. Many exogenous variables can be applied, while augmenting the basic gravity model. The trade potential pre- and post- crisis period provides us an understanding as to whether the countries would be able to recover export losses, as well as any policy implications. Data of this study was collected for a time series period of 1991 to 2007 for 16 Asian countries. Data has been taken at bilateral pairs for 16 Asian countries and the estimated coefficients provide the elasticity since the augmented gravity model is taken in log-linear form.

In this study, pre-crisis and post-crisis scenarios have been compared for the 16 Asian countries, of which trade potentials of Thailand, Malaysia, China, and India have been examined specifically because of their high trade dependence ? both international and national.

In the pre-crisis era, Thailand's trade potential was exceeded for some countries like Argentina, Singapore, and the Philippines, while the country has large unrealized trade with many developed countries such as the U.S., UK, France, Germany, and Australia, and developing countries like China, India, and Brazil. In the post-crisis era (till 2014), this gravity model estimates suggest that Thailand may experience a slow down in trade with many of its partners, including trade contractions with countries those are the country's energy import sources. There is the possibility of trade contraction and/or no trade growth in the case of Thailand's trade with the U.S., UAE, Malaysia, and Myanmar in the post-crisis period. At the same time, there would be opportunities for Thailand to expand trade with a host of countries including China, India, Brazil, Japan, Australia, the UK, Korea, Vietnam, Indonesia, Italy, France, and Germany.

For Malaysia, the model indicates that the country's trade expansion with advanced economies has been largely unrealized. But in the post-crisis period, this potential is likely to be changed. The estimated model indicates that Malaysia's trade with developed countries will slow down heavily while that with developing countries will grow albeit at a slower rate.

India has large unrealized trade with neighboring countries like Pakistan and China, and developed countries such as the U.S., Japan, and France. In the post-crisis era, this potential will change dramatically, with a large contraction and/or no growth with about 53 countries. On the other hand, India shows trade expansion with neighboring and newly emerging countries in the post-crisis period, thereby showing new trade opportunities.

For China, trade potential in the pre-crisis period exceeded mostly for African countries, but with a smaller margin. In the post-crisis era, China will have trade expansion mostly with developing countries. China's trade with advanced economies will reduce heavily due to contraction in import demand in developed countries. Trade would also be reduced with African and small island nations as well. A smaller amount of trade expansion will occur with countries in Central and East Asia

What can be concluded from these findings is that there exists large unrealized trade in Asia, both pre- and post- crisis period, mainly due to the presence of high and complex trade frictions. Crisis has been slowing down the trade potential volume with varied margins. The gravity model estimates indicate while Asia's trade will decelerate with developed countries in the post-crisis era, trade with developing countries will expand. This also indirectly suggests that Asian countries will have more intraregional trade potential, with India, China, and ASEAN nations driving the regional demand. However, Asian countries have to undertake drastic policy reforms in order to attain the unrealized trade potential.

Biswa BHATTACHARYAY
The empirical findings of the gravity model show that the trade potential within Asia is relatively large. Less consumption in advanced economies has been affecting the manufacturing production networks in Asia. Asia's intraregional trade has increased over time, but it must be kept in mind that this was mainly for parts and components for the final goods for advanced economies. In addition, Asia's trade integration with advanced economies makes the region vulnerable to every adverse shock. The question then is how to manage the process of trade and economic integration to reduce and mitigate such external shocks.

It is quite natural that the pattern of import demand of advanced economies will be affected significantly in the short term and medium term. Asia therefore should make adjustments for this, as it is the world's production factory. It can continue to play this role for the advanced economies, but it can also begin to supply finished goods for Asian consumption, particularly for emerging market economies. In order to do this, a structural change and shift may be required. Regional demand has to be increased, and domestic private consumption should be increased in order to create demand for final goods for Asia. New engines of growth, such as large regional infrastructure projects, should be created, acting as a sort of national financial stimulus, allowing for more demand in Asia, and increasing intraregional trade. Increasing integration of large countries such as China, India, and Indonesia, while engaging in regional economic integration, through infrastructure connectivity, is another step that can be taken in this regard.

Governance in Asia is also a weak point. In order to connect Asia, large financing, technical capacity, technology, skills and knowledge are required. Asia is rather weak in these areas. In terms of financing, Asia has a large pool of savings, but there is no confidence in the market. Asian financial markets must be integrated in order for Asian savings to be used for their own productive investments, such as for infrastructure development. Simultaneously, social protection and social safety nets are required for enhancing consumption within Asia.

There is a need for short-, medium-, and long- term policies for Asia. In a continent that is so heterogeneous with the presence of land-locked, small and large countries, such policies must take into consideration the nature, development stage, capacity and size of the various Asian economies. In order to minimize risk for the crisis, product and sector diversifications are important. The service sector can act as the future growth engine because there is a huge potential and this is a sector that is more resilient than the manufacturing sector during crises.

Some short-term policy priorities which must be examined are the diversification of geographies versus countries, and the use of a pan-Asian free trade agreement (FTA) ? a consolidation of bilateral, plurilateral, and sub regional FTAs. Reducing non-tariff trade barriers, which will reduce trade costs thus enhancing and facilitating trade, and stronger support of trade finance and SMEs are points that must also be looked at. Restructuring industry and production networks in order to enhance skill and capacity development, reducing protectionism, and, strengthening the Doha Round are also imperative for revival of trade in the post-crisis era. The aforementioned priorities will require stronger regional cooperation in key areas, including infrastructure connectivity. To supplement the trade liberalization initiatives, successful implantation of hard and soft infrastructure projects are needed.

There are some medium- and long- term policy priorities as well, such as investing in infrastructure projects that will increase connectivity in the medium term. In the long term, productive capacity must be improved. This will encourage efficiency-seeking industrial restructuring. A seamless Asia, connecting the sub regions of Asia through infrastructure networks such as the Asian Highway; Trans-Asia Railway; the Japan-proposed Mekong-India Economic Corridor (MIEC); the GMS/CAREC corridors; and the Delhi-Mumbai Industrial Corridor (DMIC) should be the priority. The integration of financial markets utilizing Asian savings for productive investment serves as conduits for large scale infrastructure projects. A boosting factor and impetus for Asian integration would be the successful implementation of the ASEAN Economic Community by 2015. The creation of a pan-Asia FTA including services and a customs union by 2020 with the goal of a common market should be our renewed integration agenda. On an immediate level, planning for stronger national and regional institutions and good governance are immensely important.

Q: In your model, you have included language as a variable, can you explain this? And what does this mean where you mention that Japan and Korea recorded negative figures, while other countries recorded positive figures, including China? Secondly, you recommended Asian financial market integration. In this regard, will China continue to keep strict capital controls?

Prabir DE
If you do not speak a common language, less trade will occur. Japan and Korea are recording negative values, but statistically, this is insignificant even at the 10% level. Trade promotion is not helped by speaking different languages. For China, the model shows positive figures, and China perhaps through engaging in more trade, has been able to pick up an international language faster. This may be reflected in the model, but only because there are many conditions.

Biswa BHATTACHARYAY
While many believe that capital accounts need to be convertible, the IMF has stated recently that capital account convertibility is very risky for domestic financial markets that are not developed. Every country that opened up their capital markets suffered significantly during the crisis. Malaysia eventually reversed the capital account convertibility after the Asia financial crisis.

Without full capital account convertibility, there are many areas in which Asian financial markets can be integrated. Asian countries are highly dependent on international banks for cross-country financial transactions. Banking and financial services sectors have not been liberalized in most Asian countries. The capacity of Asian banks is weak in comparison to international banks, and there is a lack of reputed Asian rating agencies. Many things can be done as Asian one-market initiatives such as linking the stock and bond markets, having its own regional rating agencies, and building confidence and trust in Asian markets. Asian markets must be developed and well-integrated before opening up to the rest of the world. If integration and linkage can be achieved, Asia can begin to utilize its own savings for its own infrastructure and other productive investments.

Q: Is it possible to introduce the idea of adjustments with the exchange rates into your model? This is an important thing to do during this crisis period.

Prabir DE
That is a study in progress. The gravity model is being called the "powerhouse for trade researchers." The model is simple, as the countries' trade depends on economic size. Even though GDP and trade are causally linked, it is not easy to explain their causal relationship. But the model at present is simple and has the ability to find trade potential. One can include exchange rate and other variables also in the gravity model.

Q: You said that your model is simple, but do you have any conclusions for this model? You have given specific cases in which this model applies most effectively, but in a general manner. Please give us some specific cases in which your argument is applied effectively.

Prabir DE
The reasoning behind why we applied the gravity model instead of others is because it is a static model with a long time period. Policy makers wanted to know whether those important variables could be influenced by trade flows, which is another reason why the gravity model was used in this study. Many exogenous variables can be applied in any kind of regressions, which cannot be done with other models. Also, it is a simple model that has become very popular. This study focuses 16 Asian countries, but we concentrate on four countries, namely, Thailand, Malaysia, India, and China. When the pre-crisis and post-crisis periods are compared, it is clear that trade potential between the countries and their partners will experience contractions due to slow down in advanced economies. A further attempt can be made to liberalize trade by removing the various frictions, which we will be doing in the next phase of the study. The numbers are broad and absolute, and are not product-specific. Perhaps, in future we will have to look at sector-specific figures. Currently, many papers are being produced using the gravity model. Although it is a simple model, it gives policy direction and creates interest for further studies in the future.

Q: In regards to national infrastructure projects being coordinated in order to move intraregional integration forward, given domestic political concerns and thus far inefficacious attempts at Asian integration, even if better governance is realized, how do you rate the feasibility of Asian countries integrating infrastructure projects at a level that would lead to better overall integration?

Biswa BHATTACHARYAY
Critics always say that Asia is very diverse and heterogeneous, therefore making it difficult to integrate. However, if you look at the European Union, you can see that this can happen. The issue is to take note that political will and commitment are required for Asian integration through infrastructure connectivity.. This is not to say that this is not happening, as there are many subregional infrastructure programs in Asia. There is a GMS infrastructure program involving countries like Cambodia, Lao PDR, Vietnam, Thailand, Myanmar, and China, with different political systems, but were also progressing very well. The major challenge is not with hard infrastructure, but with soft infrastructure. Soft infrastructure such as efficiency of public management and systems, and the harmonization of rules, regulations and processes, border transit systems and procedure need to be enhanced to enhance capacity of participating countries and their implementing agencies.

In South Asia, Bhutan supplies hydroelectric power to India and this makes up about 40% of Bhutan's GDP. Central Asia has many bilateral gas pipelines as well. Asian trade and economic integration is mostly market driven, and geared toward advanced economies. This needs to be complemented with a top-down, European style approach.

Questions exist in terms of who will finance such projects. Our study "Infrastructure for a Seamless Asia" shows that required investment for infrastructure connectivity can generate a 13 trillion dollar net income gain for Asia during 2010-2020 and beyond, giving an immense reward which Asian countries cannot ignore. On the political side, leadership and commitment are required; and large and advanced economies must assist in making the projects viable or bankable to provide for win-win situations for all participating countries. The regional infrastructure projects must be designed with proper guarantees against major risks to encourage private sectors participation through PPP. The leading financing agencies such as the Asian Development Bank, the World Bank, and JBIC can help in this regard.

Q: In regards to pan-Asia FTA, how feasible is it, and how wide should it be?

Biswa BHATTACHARYAY
If all of these CGE models estimating benefits of regional FTAs are looked at, what can be concluded is that the more countries there are in a FTA, the greater the benefit. A Pan-Asia FTA will not happen in the short term, however. It is more difficult to negotiate with diverse parties, making it easier to deal with bilateral agreements. So bilateral FTAs are more popular. A study by ADB suggests that many bilateral FTAs are not used by most businesses, particularly SMEs. Multinationals and large companies mostly use FTAs as they trade with many countries whereas SMEs trade with few countries. However, if SMEs do not trade with more countries, they will never grow nor have the capacity to become large size companies. Despite such studies showing large benefits, policy makers are not convinced of a Pan-Asia FTA. There can be two tracks. Starting with the P4/P8 model followed by some Asian, Latin American and North American countries such as Singapore, Chile, Brunei, Peru and USA, where 4 to 8 countries are involved, these are small and large country combinations. If the benefits of these groupings are huge, other counties will naturally join in. This P4/P8 model is suitable for Asia. One or two large Asian economies must undertake this first, and then smaller countries will follow.

Q: What are your views about the Asian crisis? Your proposals do not mention a currency union. Does this mean that you do not think that currencies matter in fermenting trade?

Biswa BHATTACHARYAY
The Gulf countries for instance, which are geographically and culturally linked, have agreed for a currency union by 2010. These countries are homogeneous but small countries, and unless they have a union, their industries will not be cost-effective or feasible. However, the union may not happen in the foreseeable future. If a common market exists, that is, large and linked together; a currency union will naturally form. Many countries have currency restrictions without capital account convertibility, where foreign currency cannot readily be converted into other currencies without official permission. At the same time, their financial markets are not well developed and regulated. Therefore, a currency union is not feasible in near future.

Regional infrastructure development is doable, and a practical initiative. India and China can aid in starting the development of a regional infrastructure to encourage others to join and thereby encouraging regional demand. In view of the ongoing crisis, production networks will have to be reoriented to serve the large Asian middle class. It must be cautioned however, that financial markets must not be opened unless they are well developed and regulated. In previous cases where this has happened, huge capital flow, inflow and outflow, have created problems. However, an artificial currency basket can be created for financing regional infrastructure networks through bonds based on an Asian currency unit. If countries borrow money using this artificially created currency basket, risk will be diversified. Smaller and less wealthy countries, however, must be financed in local currency bonds, and not be exposed to the currency basket which still has foreign currency risk.

Q: What do you think about the probability of another type of P4/P8 forming?

Biswa BHATTACHARYAY
ASEAN is a good case for Asia since its structure is the most formal out of all of the other trade group formations in Asia. The P4/P8 model is a model for both large and small countries. However, the benefits for large countries joining such a group needs to be more convincing.