Northeast Asian Economic Cooperation and Structural Reform
<RIETI Featured Fellow> FUKAGAWA Yukiko

We are enjoying our favorite season, as the sakura, or cherry blossoms, are in full bloom. In Japan, everything starts in April, the fiscal year, the new school year, and we have new faces in our office too. Bracing ourselves, Japan should carry forward the structural reforms that have been launched. And we may use gaiatsu or foreign pressure to help address these domestic issues. But how? RIETI Report interviewed faculty fellow Yukiko Fukagawa, who recently became a professor at the University of Tokyo, on free trade.

FUKAGAWA Yukiko
Professor Fukagawa has been a faculty fellow at RIETI since April 2001. She became a professor at Graduate School of Arts and Sciences, University of Tokyo in April 2003. After she received a B.A. in political science & economics from Waseda University, she became an analyst at Overseas Research Department, JETRO. She received a M.A. in international economics from Yale University and finished the Ph.D program in Business History at Waseda University. She was also a senior economist at Long-Term Credit Bank Research Institute, and an associate professor at Aoyama Gakuin University. Her expertise is East Asian development, and development and economic system.

<Northeast Asian Economic Cooperation and Structural Reform>

RIETI Report: Could you tell us about your research on free trade agreements (FTAs)?

Fukagawa: For the moment, there are three major themes, namely, (1) an FTA between Japan and South Korea, (2) an FTA among Japan, China and South Korea and (3) an FTA between Japan and the Association of Southeast Asian Nations (ASEAN). The Institute of Developing Economies (IDE) of Japan and the Korean Institute for International Economic Policy (KIEP) initiated a joint study in 1999 regarding a Japan-South Korea FTA. That study was later taken over by the Japan-Korea FTA Business Forum and then by a tri-sectoral study group comprising members of the Japanese and South Korean business communities, government officials and scholars. I have been conducting study on this theme as a member of the tri-sectoral study group. Regarding the Japan-China-South FTA, I am engaged in policy research as a member of a joint study group formed by Japan's National Institute for Research Advancement (NIRA), KIEP and the Development Research Center (DRC) of the State Council of China. The results of this study will be submitted to the respective leaders of those three countries. As for a Japan-ASEAN FTA, I am primarily working with two informal study groups, one under the Chief Cabinet Secretary and another under the Ministry of Foreign Affairs. In all of these three themes, my interests lie in what should be the contents of an agreement to deepen economic ties, what impact the agreement will have, and what framework should be established on what time schedule.

First of all, integration of Japan and South Korea's markets is important for both countries - where institutional systems have been developed on a similar and relatively sophisticated level - as a means to promote internal structural reform. That is, if either country begins to offer better conditions for investment, competitive companies will shift their operations in that direction thereby forcing the other to improve its investment environment. Also, if an FTA between the two countries results in the activation of mergers and acquisitions then cross-border industrial adjustments such as those seen between the United States and Europe may be realized. Furthermore, there has been a growing tendency for the Won to move in tandem with the Yen ever since South Korea opened its capital market. Should Yen-denominated settlements become widespread, South Korea will rarely be a trade partner and therefore a country with which Japan needs to take on little exchange risk. I am particularly interested in how the two countries' institutional systems will converge when they come under a common framework.

Secondly, I believe that another important mission for Japan and South Korea is to provide a model for possible FTAs with China and ASEAN. Being mature economies, both Japan and South Korea find it difficult to maintain high economic growth and take a market-driven, or reality-driven, approach, as has been the case in China. But Japan and South Korea are capable of making a different kind of contribution. By realizing a highly institutionalized FTA that covers a broad range of areas including direct investment, financial services, intellectual rights protection, settlement systems and competitive policy, they can present a model for other countries to follow.

Our study on an FTA among Japan, South Korea and China is now in its third year and we have begun summarizing after focusing on trade in the first year and on direct investment in the second year. In our study on trade aspects, we compared the direction of reform in each country and the meaning of integrating Northeast Asian markets. As for direct investment, we analyzed differences between Japan and South Korea in their patterns of investment activities in China. In the ongoing third year, we will revalidate the relationships between trade and foreign direct investment and then put forward a set of policy proposals to develop closer ties between the three countries.

With its structural reform having run its course, South Korea seems to be relatively comfortable with a growing China. Unlike in Japan, concerns over the "hollowing out of industries" are rarely heard in South Korea. This is because foreign direct investment and trade are not regarded as alternatives but as complementary activities and thus both investment and trade have been growing in South Korea. Another reason for the South Korea's different approach can be found in the structural change that is taking place in that country, with the information technology sector taking the lead. Taking a lesson from the relationship between China and South Korea, Japan should stop complaining about an undervalued Yuan. Instead, Japan should devote its energy to finding a way out of its ongoing stagnation while maximizing benefits derived from the expansion of the Chinese market.

With China being a newcomer to the World Trade Organization, the Japan-South Korea-China framework tends to be seen in a long-term perspective. There also are discrepancies between Japan and China regarding their assumed timetables. Japan wants to start negotiations urgently with either country that is ready to do so, but China seems reluctant. In our study, we are examining several different scenarios for realizing a trilateral FTA, including one in which Japan and South Korea go ahead to form an FTA with China joining them later, and another in which all the three countries sign on to an FTA at the same time.

It is generally assumed in Japan that, for an FTA with ASEAN, Japan should conclude an FTA with each of the four leading ASEAN countries, namely Thailand, Malaysia, Indonesia and the Philippines. In line with this approach, discussions are underway over how to maintain momentum on deepening liberalization and solidarity within the ASEAN region in the case that Japan forms a separate FTA with each ASEAN member. Because agricultural products represent a relatively high portion of its trade with ASEAN countries, Japan's interests tend to center on agricultural issues. However, given the reality of Japanese companies' operations in Southeast Asia, in which the "cooperation" aspect tends to be pushed to the fore irrespective of whether it improves the efficiency of intra-regional production networks or foster human resources, I am more interested in policies that expand private-sector cooperation as well as review the government's official development assistance (ODA) program.

RR: Could you tell us how free trade is related to structural reform?

Fukagawa: As globalization proceeds, structural reform can no longer be carried out by a country acting alone and it is necessary to utilize external market pressure as leverage. Trade liberalization will expose low-productivity sectors to external competition and force them to change, while consumers will have more options to choose from in terms of price, goods and services. Ironically, it may be difficult to see the merits of trade liberalization today in Japan, which is already in deflation. But Japan owes its postwar economic success and improvement in living standards to the blessings of the free trade system.

Both Japan and South Korea have the inertia of past economic systems that hampers the progress of deregulation. Such countries need the type of external pressure that is brought about by the dynamic cross-border movement of management resources such as people, goods and money under an economic cooperation agreement. Internal institutional systems of all countries reach equilibrium in the process of development. Therefore, when deregulation proceeds and opens up a country to the outside world, a new equilibrium needs to be established. Hit by an acute currency crisis, South Korea carried out drastic structural reforms and its institutional realignment has made substantial progress. Although complementary relationships between newly created institutions have yet to be established, and the inertia of past institutional systems still remains in certain areas, there will be no returning to the old equilibrium.

In Japan, too, things are beginning to change, as seen in the dissolution of cross-shareholding and reforms in the main banking system. But the changes are taking place only at a snail's pace and not in such a way as to embrace 'globalism'. Arguments arising out of a homogeneous society are inclined to become homogeneous. But if Japan is not ready to repeat the "lost decade," it needs to aggressively take in new players and new management resources from outside to reconstruct its economy. Although it is long over due, Japan seems to be finally ready to discuss productivity improvements in the agricultural sector in parallel with trade liberalization and to consider the possibility of accepting foreign labor in the context of its aging of society. Neighboring countries are pinning high hopes on the Japanese market. By coherently examining economic cooperation and the reform agenda, Japan will be able to demonstrate its commitment to FTAs.

RR: It appears that Japan is not very keen on free trade.

Fukagawa: In Asia, Japan is the only country that is obliged to eliminate duties and other restrictive regulations on "substantially all its trade" under the provisions of Article 24 of the WTO rules. In this regard, Japan cannot afford to make empty promises. In contrast, other countries are categorized as "developing countries" and, thus, it is considered acceptable for an FTA asserted by China or ASEAN to differ from one envisioned by Japan. This explains why Japan prefers to seek to conclude highly-institutionalized economic cooperation agreements only with "realistic partners."

If an FTA under the framework of ASEAN plus 3 (Japan, South Korea and China) is assumed to be the common final goal for Asia, Japan may find no shared values at this stage - probably with the sole exceptions of economic growth and excessive institutional differences between members countries. Japan tends to undervalue the benefits it could yield from the growth of other East Asian countries. However, I believe that there is much that Japan can share with other Asian countries if it choose to see the high growth potential and demand of the region as a means to break its ongoing stagnation, and takes a strategic approach towards regional integration.