# Pitfall of Envisaged "East Asian Economic Integration" - Implications of Expanding Imbalances in the Global Economy

TANIKAWA Hiroya
Senior Fellow, RIETI

The envisioned integration of East Asian economies centering on the ASEAN+3 countries is being viewed with great expectation and interest by the nations concerned and their business communities alike. The Japanese government is no exception and has been exerting full-fledged efforts to pursue such regional integration. Specifically, the government is promoting negotiations for a free trade agreement (FTA). Meanwhile, on the monetary and financial front, it is enhancing cooperation with other East Asian countries to ensure foreign exchange stability and develop bond markets. There has been a particularly remarkable development on the monetary front where the idea of creating a common regional currency has been raised. Behind this strong momentum surely lies firm confidence in the future of the East Asian economy and strong expectations for new frontiers of further economic development which will be opened up by the elimination of economic boundaries.

## Self-sufficiency of East Asian economic integration

Would it become possible for East Asia to evolve into a self-sustaining economic zone, comparable to the European Union or North America, simply by eliminating intra-regional economic barriers? Ten years ago this autumn, Asia-Pacific countries including ASEAN+3 - the member states of the Association of Southeast Asian Nations (ASEAN) plus Japan, China and South Korea - endorsed the Bogor Declaration that calls for realizing free and open trade and investment in the region by 2020 at latest. The leaders of the member states of the Asia-Pacific Economic Cooperation (APEC) forum thus aspired for the creation of an APEC-wide economic community. The goal reflected their shared recognition that the Asia-Pacific region would be able to become self-contained by including North America, not only in a political and security context but also in an economic context. Has this recognition become a thing of the past or worse than useless?

I am very much aware of the efforts and hard work undertaken thus far by the governments concerned. I have no intention of denying the importance that East Asian countries promote intra-regional trade and investment liberalization, just as their European and North American counterparts had done in their respective regions from the 1970s through to the 1990s. I find it quite rational that the experience of the Asian crisis in 1997 and 1998 has led to the formation of a consensus among East Asian countries on the need to create a regional cooperation mechanism for monetary and exchange rate policies that is not dependent on the United States. Also, I acknowledge that the aforementioned APEC initiatives for trade and investment liberalization has lost impetus due to the innate limitations of the APEC framework, and that the stagnation of the new round negotiations of the World Trade Organization (WTO) has accelerated initiatives for liberalization under regional frameworks. Therefore, I do not believe that simply returning to the APEC/WTO frameworks can be an alternative to the current policy.

Nevertheless, why am I questioning the "self-sufficiency of East Asian economic cooperation," bringing up a rather classical issue? This is because a series of signs indicate that various imbalances contained within the basic growth mechanism of East Asia - which has brought prosperity to the region - have been approaching their critical thresholds in recent years, putting the sustainability of the current mechanism into question. In this regard, the existing ideas for economic integration, which are premised on the current basic mechanism for prosperity, are transitional in nature. We need to go beyond the elimination of institutional barriers and the creation of a currency cooperation framework. We must strive to design a sustainable and self-sufficient mechanism for East Asian economic development and draw up a sound prospect for the integrated East Asian economies. I believe these are the very policy stances that we need to adopt today.

## Basic mechanism for economic prosperity in East Asia/China and accumulating imbalances

As pointed out by many economic historians, Japan's restoration and prosperity in the postwar period were realized as a result of U.S. postwar policy. In the early stages of Japan's postwar recovery, the otherwise severe impact of economic adjustments for restoring stability was alleviated by reconstruction funds provided by the U.S. - the Government Appropriations for Relief in Occupied Areas (GARIOA) Fund and the Economic Rehabilitation in Occupied Areas (EROA) Fund - as well as by special procurement demand generated by the outbreak of the Korean War. This was followed by the expansion of industrial exports to the gigantic U.S. market, which gave Japan a foothold for the subsequent high economic growth. The Bretton Woods system - an international monetary system based on the "liberalization of trade" (current account transactions), "restrictions on capital transactions" and "fixed exchange rate system" - provided foundation for such an export-driven growth.

The Bretton Woods system functioned extremely well. The system paved the way for the early reconstruction of the war-devastated economy of Japan and West Germany, thereby fulfilling the U.S. goal of turning the two countries into powerful allies. At the same time, however, the U.S. policy of generous market opening and tolerance over foreign exchange rates favorable for non-U.S. exporters resulted in the chronic current account deficits of the U.S. Finally, in 1971, roughly a quarter century after its installation, the Bretton Woods system collapsed, replaced by the Smithsonian regime (effective devaluation of the U.S. dollar and shift to the floating exchange rate system).

Throughout these periods and up until today, Japan has been dependent on the U.S. market, though to differing degrees. In the mean time, in a V-shaped "flying geese" pattern of regional development, the newly industrialized economies (NIEs) and ASEAN countries have been absorbing technology and investment primarily from Japan (from Japan and the U.S. at a later stage). As an export destination, however, these economies have been overwhelmingly dependent on the U.S. market. In this sense, the East Asian economy from the 1980s through to the 1990s was far from being "self-sufficient." The East Asian region has only been able to deserve the definition of a self-sustainable economic zone when combined with North America. It is against this backdrop that trade and investment liberalization became the key policy agenda of the APEC.

Has this situation changed drastically since the mid 1990s? As mentioned above, the Asian crisis in 1997 and 1998 was a turning point but did not change the nature of the regional economy drastically. If there is anything that might have changed the reality of the regional economy, it would have been the "rise of China," a phenomenon that has suddenly become conspicuous since the mid 1990s.

The Chinese economy's remarkable development in recent years is symbolically reflected in changes in the global trade structure. China accounted for only 1.7% of global exports in 1990 but the percentage rose to 6% in 2002. Likewise, China's share in the global imports increased from 1.3% in 1990 to 4.1% in 2002. China's export and import performance surely stands out. During the same period of time, Japan's shares in global exports and imports declined, while NIEs' shares edged up only slightly. ASEAN countries increased their shares but not to the extent of doubling. In the past five years, the composition of Chinese exports has changed notably with high-tech products - electric and electronic machinery, in particular - showing a rapid increase in terms of shares of overall exports. Meanwhile, the development of the economy has been generating a sizable number of wealthy and middle-class Chinese, especially in the urban areas. Thus, China is now beginning to gain attention as an enormous consumption market. All these tendencies - along with stories about specific successful companies (mostly private-sector companies or township enterprises called "xiangzhen qiye") or other business establishments that boast high-level technology and high-grade human resources - have been generating a new image of East Asia as an economy that is self-sustaining and self-sufficient, while at the same time providing the foundation for a range of arguments viewing China as a threat.

Concerning China's remarkable development, the CEPII (Centre d'Etudes Prospectives et d'Informations Internationales), a French quasi-governmental research institute, has come up with a series of interesting research results in recent years. This has been made possible through extremely detailed analyses of intra-regional trade in Asia, specifically, by capturing the flows of commodities - both finished products and parts - into and out of China on the six-digit level of the Standard International Trade Classification (SITC). The findings by the CEPII effectively revealed the "real picture of leaping China" that could not be apprehended by reading ordinary trade statistics. For instance, China's exports have expanded rapidly over the past few years with the weight of high-tech exports showing a remarkable increase. According to the CEPII, however, most of these phenomena are attributable to China's integration into the East Asia-wide production and distribution networks - especially for electric and electronic machinery - formed through extensive foreign direct investments. Meanwhile China's contribution in terms of added value has been limited to its function in the assembly sector that is heavily dependant on the supply of abundant cheap labor. This is the situation observed as recently as 2002. In other words, all that China has been doing is importing expensive parts and intermediary goods from Japan and NIEs, and then, assembling them into finished products for export to the U.S. and Europe (ie triangular trade). In this sense, the aforementioned postwar structure of the East Asian economy characterized by its heavy reliance on the U.S. market has not changed at all.

Assuming that China's full-fledged economic development began in the mid 1980s, distortions caused by imbalances revolving around China - which have been accumulated within the quasi-Bretton Wood system in the past 20 years or so - must be enormous. In 2003, the current account deficit of the U.S. reached an amount equivalent to 5% of its gross domestic product (GDP), while its trade deficit with China - a major cause of the overall current account deficit of the U.S. - totaled $100 million, according to 2002 statistics by the International Monetary Fund (IMF). China's trade surplus with the rest of the world, however, stood at slightly more than$20 million, with the remaining surplus vis-a-vis the U.S. basically offset by China's huge deficit in (parts and components) trade with other Asian countries. In this context, it is fair to say that the massive U.S. trade deficit is held against East Asia, which as a whole has grown into a giant factory with countries interlinked through extensive, region-wide production and distribution networks. Unfortunately, this also means that once the U.S. current account deficit becomes unsustainable, whether because of certain extraordinary factors or as a natural outcome of economic mechanisms, any resulting impact would spread all across East Asia.

## Sustainability issues facing East Asia and China, and prospects for economic integration

As discussed above, the remarkable progress of the Chinese economy (and of the East Asian economy led by China) in recent years has been supported by the enormous U.S. trade deficit with China. How long the current situation can be maintained depends on the sustainability of the U.S. current account deficit. This is the first sustainability question confronting the East Asian economy today. Considering the history of current account deficit adjustments made by industrialized countries including the collapse of the Bretton Woods system, and given the scale of the U.S. deficit that hovers at a record high of 5% of GDP, it may appear likely that a major adjustment through the devaluation of the U.S. dollar will inevitably occur at some point in the not-so-distant future. In reality, however, things are not so simple. Unlike during the 1970s-80s, the "home bias" in investment portfolios - an idea pointed out by Feldstein and Horioka (1980) that nations' savings are, on net, generally invested domestically - is far less evident in today's financial capital market and it is quite possible to maintain capital flows at a level exceeding the amount of current account deficit. So long as this situation continues, the occurrence of adjustments such as drastic U.S. dollar devaluation is not necessarily inevitable. On the other hand, it is also a reality that East Asian governments - which have built up a substantial amount of foreign reserves as a result of massive market interventions for the sake of maintaining their dollar pegging system - have been actively purchasing the U.S. treasury bonds, a move based on a clear policy intention to circulate the dollars back to the market. Yet, a series of recent studies generally point to the difficulty of sustaining the massive U.S. current account deficit over a long period of time. There seems to be a consensus that some sort of adjustment would be inevitable though opinion differs as to the timing and specific process of such an adjustment.

The second sustainability issue regards the sustainability of the triangular trade itself or that of the Chinese economy as a component of such a trade mechanism. As discussed above, China has become a major exporter by accepting massive foreign direct investments in the assembly sector, thereby establishing its position within the East Asian production and distribution network. Underneath its remarkable development, however, lie serious distortions resulting from excessive incentives that the Chinese government has given in taxation and other areas to promote investments. The Chinese market, as it stands today, is far from being monolithic because regulations and customary practices differ from region to region. Also, there are substantial disparities in people's income levels, in particular between those living in the urban and those in rural areas. All these phenomena represent non-negligible disequilibrium. But the gravest concerns stems from the distorted composition of aggregate demand, in which consumption represents only 40% and investment accounts for just as much, while total export and import values are equal to 59% of GDP. Apparently, this situation is not sustainable. In the mid- to long-term perspective, it is indispensable for China to narrow various disparities through such means as intensive investment in the reinforcement of educational and social infrastructure in remote areas, and to steer its course toward a growth track led by domestic demand.

Apart from those discussed above, East Asia is facing a number of challenges that must be addressed in order to solve the existing imbalances. In-depth studies must be made, for instance, to explore how East Asian countries can best cope with currency adjustments and coordinate policies, and to find out what kind of foreign exchange regime would be desirable for the region. Needless to say, it is important to accelerate FTA negotiations and enhance cooperation in foreign exchange and finance. In the long term, however, it will become increasingly important to develop a "policy vision for a new paradigm" that goes beyond simply promoting regional economic integration because the existing paradigm - which has enabled East Asia to achieve a remarkable economic growth in the past 20 to 30 years - will not be sustainable in the long term.

June 8, 2004

June 8, 2004

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