%0' 31j POLICY RESEARCH WORKING PAPER 3 079 Public Disclosure Authorized Regional Integration in East Asia Challenges and Opportunities Public Disclosure Authorized Part II: Trade, Finance, and Integration Eisuke Sakakibara Sharon Yamakawa Public Disclosure Authorized The World Bank Public Disclosure Authorized East Asia and Pacific Region Poverty Reduction and Economic Management Sector Unit June 2003 IPOLICY RESEARCH WORKING PAPER 3079 Abstract Sakakibara and Yamakawa analyze the patterns of East Mai Initiative. (The Association of Southeast Asian Asia's trade and foreign direct investment (FDI) from a Nations plus China, the Republic of Korea, and Japan global and intraregional perspective, taking into account decided at their meeting in Chiang Mai, Thailand, in the importance of trade and FDI interlinkages. They May 2000, to establish a regional network of swap propose two regionally-focused approaches to promoting arrangements.) While opening of the capital account is trade and FDI in East Asia-regional agreements and considered desirable in the long run, it is associated with regional production networks. considerable risk, particularly if macroeconomic policies The East Asia crisis strengthened appeals for regional are not sound and financial supervision and regulation is cooperation in the financial area. As a result, a number weak. Because of the potential volatility associated with of financial arrangements and initiatives have emerged floating regimes and the desire to avoid another crisis in since the crisis, the most prominent of these, the Chiang the region, the authors discuss a number of options. This paper-a product of the Poverty Reduction and Economic Management Sector Unit, East Asia and Pacific Region- is part of a larger effort in the region to analyze integration through trade. Policy Research Working Paper 3078 on History and Institutions is part I of this paper. Copies of this paper are available free from' the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact ShahidYusuf, room MC2-509, telephone 202-458-2339, fax 202-522-1150, email address [email protected]. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. Sharon Yamakawa may be contacted at [email protected]. June 2003. (149 pages) The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentationsare less than fully polished.The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Produced bv Partnershios. Caoacitv Buildine. and Outreach WORLD BANK EAST ASIA PROJECT REGIONAL INTEGRATION IN EAST ASIA: CHALLENGES AND OPPORTUNITIES Eisuke Sakakibara and Sharon Yamakawa Global Security Research Center, Keio University Part Two: Trade, Finance and Integration Chapter IV - Trade and FDI: A Role for Regionalism Chapter V - Financial and Monetary Integration Chapter VI - Conclusion: Observations on Integration Chapter VII - Looking Ahead Note: part one of this report is presented as a separate working paper. Acknowledgements We would like to acknowledge the support of others in the preparation of this paper. In particular, we would like to thank Shuichi Shimakura and Eri Moriai for data support and Catherine Sasanuma and Shunichi Sueyoshi for their contributions to the research on regional institutions. Introduction to Part Two As stated in the "Overview" presented in Part One, the purpose of this study is to evaluate the pattern and gauge the progress of regional integration in East Asia from a political-economic viewpoint. The focus is on the trade, investment, and financial/monetary aspects of regional cooperation in projecting a viable framework for integration in the coming decade and assessing the prospects for its success in bringing prosperity to East Asia. The study examines the causal factors of regionalism in East Asia and the underlying dynamics of the movement. In this process, differences between Asia's type of regionalism and that of other regions of the world, in particular Europe and North America, will become apparent. Part One set the stage for a discussion of regional integration in East Asia (1) by reviewing Asia's historical trade and economic presence in the world, (2) by assessing its current degree of openness to, and integration with, the global economy, and (3) by evaluating the status and performance of regional institutions in the region in the post- World War II era. The review of Asian economic history in Chapter I revealed two aspects of trade in the region (i.e., intraregional and global) that overlapped and interacted in such a way as to have effectively functioned as one system. This, in addition to the evidence of Asia's prominent role in the global economy at that time, supports the argument that Asian trade has been open and global for centuries. A look at East Asia's social, economic and political structures in Chapter II revealed a region of enormous diversity, particularly when compared with other regions of the world. The characteristics of various regional groupings (e.g., ASEAN and APEC) were examined in an effort to determine if one or another of these institutions brings greater benefit to the region and the economies therein. While a group comprising developmentally similar economies could be a more workable arrangement in which smaller members would have more influence, there is a slightly more compelling argument in favor of agreements between industrial and developing economies in that they can bring significant benefits to the developing partners. Chapter III pointed out that the development of regional institutions was not an initial goal of East Asian integration; however, most East Asians would now like to see a strong regional institution in place to lead the region toward closer cooperation and deeper integration. Regional cooperation has reached the stage in East Asia where more structure and leadership is needed. However, most find the current condition of regional institutions in East Asia to be discouraging. The ASEAN-Plus-Three grouping, although currently operating on the sidelines of ASEAN and having no secretariat of its own, is perceived by many to be the most workable and potentially beneficial grouping for the region. Part Two of the study, "Trade, Finance and Integration," includes Chapters IV through VII. Chapter IV analyzes the patterns of East Asia's trade and foreign direct investment (FDI) from a global/intraregional perspective, taking into consideration the importance of trade and FDI interlinkages. In this context, we propose two regionally focused approaches to the promotion of trade and FDI in East Asia: regional agreements and regional production networks. Taking the East Asian crisis as the point of departure, Chapter V looks at monetary and financial cooperation in the region. Prior to the crisis, economic iii cooperation efforts in East Asia were focused on trade and investment. The occurrence of the crisis strengthened appeals for regional cooperation in the financial area. As a result, a number of financial arrangements and initiatives have emerged since the crisis. These are discussed in some detail with special attention paid to the most prominent of these, the Chiang Mai Initiative. This chapter then reviews financial development in the region. In conjunction with this, financial structure (bank-based versus capital market-based systems) is examined in an effort to determine its effect, if any, on financial development. Chapter V also addresses the issue of capital account liberalization and its advisability for emerging markets. While opening of the capital account is considered desirable in the long run, it is associated with considerable risk, particularly if macroeconomic policies are not sound and financial supervision and regulation is weak. Many factors related to an individual country's stage of development and current level of involvement in global capital markets need to be considered in setting realistic goals and objectives in this area. Also, arising out of the Asian crisis and related to the issue of financial system reform is an ongoing debate on the appropriate currency regime for East Asian economies, extending to the suitability of a regional monetary arrangement for the region. Prior to the crisis, currencies of the crisis-affected countries were "effectively" pegged to the U.S. dollar. During the crisis, many of these countries switched to a floating rate regime. Because of the potential volatility associated with floating regimes and the desire to avoid another crisis in the region, a number of options are being discussed. This chapter discusses the pros and cons of these options. Chapter VI summarizes the whole study (Parts One and Two) and concludes by providing some perspective on the current state of cooperation and integration in the region. Chapter VII looks at regional integration from a future perspective. This chapter endorses the establishment of a genuine regional institution in East Asia. In addition, it takes a look (both short- and long-term) at what type of currency arrangements might be suitable for the region. iv Chapter IV - Trade and FDI: A Role for Regionalism Trade and foreign direct investment (FDI) have played a role, indeed a major role, in the development of East Asia. The phenomenal growth of the 1980s and early 1990s has been attributed to East Asia's liberalization in these two areas. Trade and FDI interact in such a way as to be mutually promoting. The importance of this linkage has grown along with the increased integration of the international production network. Together, they facilitate the efficient functioning of this system. Furthermore, the potential for growth is enhanced when there is coordination in the formulation of trade and FDI policies.