Chapter 4 Issues and challenges for ’s external economic policy This chapter outlines the importance of Japan’s involvement in the issues of East Asia and the concrete orientation of Japan’s multi-tiered external economic policy from the perspective of promoting even closer economic relations between Japan and East Asia and utilizing East Asia’s dynamism for the revitalization of Japan’s economy.

Section 1 Measures for the issues of East Asia

1. Current status and issues surrounding energy in East Asia While international energy security has improved on the whole, with the growing diversification of supply sources on a global level, there is an increasing energy demand and dependence on external sources of energy in the East Asian region. This tendency will be exacerbated with future economic growth and there are concerns about the expansion of the impact in the case of risk emergence. In addition, due to the rapid economic growth in the East Asian region in recent years, there has been a tendency towards increased energy-related CO2 emissions in the region. In the future, it will be necessary to heighten energy security in East Asia at the same time as properly considering the issue of global warming. In order to control the increasing demand for energy in the East Asian region and also the increased dependence on external sources, and thus to reduce risk, it will first be necessary to ensure the effective use of resources such as natural gas and coal that exist within the region and to improve the efficacy in using energy. However, with economic growth comes an increased demand for petroleum and there is no escaping the fact that the major portion of this supply is dependent on the Middle East. Given such circumstances, in order to ensure energy security in the East Asian region, multilateral frameworks such as ASEAN+3 and bilateral frameworks should be utilized, and Japan will have to make further efforts in the future towards use of regional energy resources, improvement of energy use and efficiency, sharing of recognition concerning emergency response measures, and the implementation of cooperation projects.

2. Stabilization of the currency and financial systems The stability of currency and financial systems is important in the current environment in which trade and investment aspects in the East Asian region are advancing and accelerating closer together. In a situation in which the currency and financial system is unstable, there is a possibility that this could lead to a downturn in companies’ global activities due to increased foreign exchange risks and that this could hinder the dynamism of East Asia. With regard to this point the Asian currency and economic crises that broke out in 1997 are still fresh in the mind. In the countries that were embroiled in the Asian currency and economic crises, given that long-term domestic credit was financed by short-term foreign

- 275 - funds (a double mismatch), once a flight of short-term funds began rapidly due to the bursting of the bubble, this caused a serious credit crunch on the balance sheets of banks and companies. International efforts have been made based on the recognition of the factors that caused the Asian currency and economic crises, and determination that such an event would never occur again. Examples of such efforts are the Announcement of the New Initiative to Overcome the Asian Currency Crisis (New Miyazawa Initiative), and the Chiang Mai Initiative. However, many doubts remain concerning the status of the growth of the capital markets and the ability to provide long-term funds in the countries and regions of East Asia. Given this situation, in order to secure growth of capital markets in greater Asia and the provision of long-term funds, efforts are being promoted under the Asian Bond Market Initiative. This initiative incorporates several measures such as the promotion of market participation by multiple issuers, promotion of issuance of various bonds, including the basket currency bond, and the development of a market-nurturing environment.

1. Current status and issues surrounding energy in East Asia 1 (1) Situation surrounding the energy in East Asia (a) Rising demand and increasing dependence on the Middle East With the growing diversification of supply sources on a global level, the international energy security has improved on the whole, compared to the 1970s. Furthermore, since the mid-1980s, the international oil market has been gradually taking over the power to decide crude oil prices from the Organization of Petroleum Exporting Countries (OPEC). The development of the international oil market spread the awareness that, as long as it is functioning, it is possible to procure petroleum through the market by paying an appropriate price. Thus, the international market has had the effect of further improving the energy security on a global level. Against this backdrop, it should be noted that there is an increasing energy demand and dependence on external sources of energy in the East Asian region. It is likely that the energy demand in East Asia, which serves Japan as a route for transportation of petroleum and a source of natural gas, will increase faster than in other regions. The share of the entire Asian region in the global energy demand increased from 14 percent in 1973 to 28 percent in 2000 and is expected to become 32 percent in 20202, and it is possible that the dependence on external sources for petroleum and other fuels will also increase. Particularly in China, which accounts for one-third of the petroleum demand of the Asian region, there is a movement to suppress coal consumption because of environmental restrictions and the imports of crude oil are increasing rapidly. If such trends accelerate, the dependence on external sources of energy in the East Asian region may increase even further.

1 The entire subsection is based on data from the Ministry of International Trade and Industry (1999a). 2 International Energy Agency (IEA) (2002b). - 276 - (b) Energy security-related issues in East Asia Despite the increasing energy demand and dependence on external sources of energy, the East Asian region does not yet have a fully developed emergency response system, such as provision of an oil stockpile to meet the demand for petroleum in an event of a reduction of supply. The energy demand structure in East Asia and other Asian regions has become increasingly vulnerable, and there are concerns about the expansion of the impact in the case of risk emergence. Looking at the international political situation, various destabilizing factors, such as territorial disputes, political turmoil and weapons of mass destruction issues, have latently piled up and pose an ever-increasing threat to the smooth transportation of petroleum. Particularly close attention should be paid to the changes in the international political situation in the Middle East, a region on which East Asia’s dependence for energy sources—especially oil—is expected to increase even further. Various mid- to long-term destabilizing factors, such as increased unemployment due to the increasing number of young people, concerns over a setback in the Middle East Peace Process and the issue of weapons of mass destruction, have accumulated in the Middle East region, which plays a major role in the global supplies of petroleum. In this and other regions there still exists a possibility for risk emergence, such as reduction of supplies, though the forms of potential risk have changed since the oil crisis. A fresh example of such developments is the suspension of the supplies of natural gas to Japan that took place following the deterioration of the security situation in the Special Territory of Aceh in Indonesia. Another risk scenario, albeit not one that is likely to have a serious impact, is a disruption of transportation of petroleum in a choke point such as South-East Asia, which may lead to stringent demand of tankers and shortage of chartered ships. These are some of the factors that can destabilize the oil supply, and if they do emerge and a panic situation occurs against the backdrop of the insufficient oil stockpile system, it could impact Japan through disrupted oil supply and increase in prices. In most cases of envisioned emergence of risks, the matter of securing enough quantity can be addressed through building of an oil stockpile, but, in terms of prices, it is fully conceivable that the emergence of risks will have an impact on the global economy. That is why attention must be paid to the global expansion of a new risk in the form of increased volatility of crude oil prices3. Behind this increasing volatility of crude oil prices are structural changes such as the curtailment of surplus producing capacity of oil producing countries, as well as the decrease in the refining capacity and inventory days of European and American consuming countries, all of which work as buffers against variable supply and demand. Also, if a reduction of supply occurs in an oil producing country with a large crude oil surplus production capacity, it might have a strong impact not only in terms of prices, but also in terms of quantity.

(c) Economic growth and CO2 Global warming is an issue that must be tackled by all of humankind. More than 60 percent of the

3 The West Texas Intermediate (WTI) future crude oil prices rose four times between the end of 1998 and 2000, reaching a peak level of US$37.80 per barrel. - 277 - global greenhouse gas emissions are energy-related CO2 emissions4. This clearly indicates that the global warming issue and the energy issues are inseparable. Furthermore, as greenhouse gas emissions—mainly energy-related CO2 emissions—increase in line with economic development, the rapid economic growth in the Asian region and particularly in China, the Republic of Korea (ROK) and the countries of the Association of South-East Asian Nations (ASEAN) is aggravating the problems of global warming and energy. Due to the economic growth, energy-related CO2 emissions in the major developing countries are on the rise. High levels of emissions are particularly eminent in China and India. Looking at the final energy consumption by sector, it is increasing in every sector of all but a few major developing countries. Particularly outstanding is the increased demand in the manufacturing sector and the transportation sector, which typically involves cars. Also, as indicated on Figure 4.1.1, the share held by developing countries in the global energy-related CO2 emissions is likely to expand further.

Figure 4.1.1 Projected energy-related CO2 emissions

(Million tons) 45,000 Developing countries 40,000 Transitional economies 35,000 OECD 47% 30,000 43% 25,000 39% 20,000 34% 10% 10% 11% 15,000 11%

10,000 43% 55% 50% 47% 5,000

0 (Year) 2000 2010 2020 2030 Source: World Energy Outlook 2002 (IEA).

Figure 4.1.2 Changes in energy-related CO2 emissions in Asia (1990-2000) 1990=100 250

200

150

100 中国China インドIndia 50 韓国ROK タイThailand マレーシアMalaysia

0 1990 1992 1994 1996 1998 2000 (Year) Note: Sectoral Approach Data. Source: CO2 Emissions from Fuel Combustion (IEA).

4 IAE (2002a). - 278 - Figure 4.1.3 Comparison of per capita energy-related CO2 emissions for the world’s major powers

9.1 Japan 8.25 US 20.57 19.3 8.89 UK 9.73 10.14 Germany 12.15 6.18 France 6.08 10.34 Russia 11.6 2.37 China 1.99 2000 ROK 9.17 5.28 0.9 1990 India 0.7 NIEs 9.08 5.6 ASEAN 4 1.59 0.945 11.09 OECD 10.55 2.07 Non-OECD 2.16 3.89 World 3.96

0 5 10 15 20 25 (Tons per capita) Source: CO2 Emissions from Fuel Combustion (IEA).

Figure 4.1.4 Comparison of energy-related CO2 emissions for the world’s major powers relative to GDP

0.2 Japan 0.21 0.63 US 0.74 0.41 UK 0.54 0.31 Germany 0.43 0.21 France 0.24 4.21 Russia 4.17 2.88 China 5.69 0.7 ROK 0.66 2.01 India 2.13 0.59 2000 NIEs 0.58 1.02 1990 ASEAN 4 0.79 0.45 OECD 0.51 1.6 Non-OECD 1.93 0.69 World 0.78

0 1 2 3 4 5 6 (kg/million 95 US$) Source: CO2 Emissions from Fuel Combustion (IEA).

The impact of the Asian currency crisis of 1997 on Malaysia, Thailand and the ROK resulted in temporary reduction of CO2 emissions in those countries, but then the volume of emissions started to rise again (Fig. 4.1.2). Figures 4.1.3 and 4.1.4 indicate that energy-related CO2 emissions per capita as well as relative to gross domestic product (GDP) in both Newly Industrializing Economies (NIEs) and ASEAN 4 has continued on a rising trend throughout the 1990s. This suggests that the increase of CO2 emissions exceeded the population and GDP growth rates. In China, the rate of increase of CO2 emissions is lower than the GDP growth rate, but the emission levels are high and there are concerns that they might have a serious impact on the global warming. Together with Russia, China features very high levels of emissions relative to GDP. Looking at the country’s share in global GDP and in emissions (Fig. 4.1.5), despite the fact that China’s share in the global GDP is only 3.1 percent, its share in energy-related CO2 emissions is 12.8 percent. This is due to the energy demand structure with emphasis on coal, which abounds in China. The current degree of dependence on coal is around 70 percent and the degree of dependence on petroleum is 20 percent. If China’s economy continues its

- 279 - rapid growth, the country’s CO2 emission share is likely to expand further unless the demand structure is drastically changed.

Figure 4.1.5 Top four energy-related CO2 emitting countries and the EU (2000)

CO2 emissions (World: 23.42 billion tons) 100% US 5.67 billion tons 24.2% China Other Other US 3.1% 8.93 billion tons 24.0% 26.4% 38.2% Share of GDP (in US$) Russia (Average rate in 1995) 1.1% World 34.01 trillion US$ 100%

EU Japan China 28.8% 16.7% 3.00 billion tons 12.8%

Russia 1.51 billion tons EU 6.4% 3.16 billion tons Japan 13.5% 1.15 billion 4.9% Source: CO2 Emissions from Fuel Combustion (IEA).

A time-series analysis of the relationship between economic growth and energy consumption shows that this relationship is based on a three-stage process (Fig. 4.1.6). Stage 1: In countries with low per capita GDP, the energy efficiency improves parallel to the increase in incomes during the economic growth process. Stage 2: When the per capita GDP increases to a certain level, the energy efficiency deteriorates. Stage 3: As economic growth advances still further, the energy efficiency improves at a faster pace than the increase of income.

Figure 4.1.6 Per capita GDP and TPES/GDP (Developed countries: 1960-2000, Developing countries: 1971-2000)

(Tons [converted to oil]/US$1,000) 1,000 1971 Indonesia 2000

Malaysia US

Turkey Taiwan

ROK Singapore UK 1960 2000 100 Japan China 4,000

3,000

2,000

1,000 India - ※Both axes display logarithms. 0.0 0.5 1.0

10 0 1 10 100 (US$1,000/person)

Source: CO2 Emissions and Energy Supply-Demand Structure for Major Developing Countries (The 13th Global Environmental Subcommittee Meeting, Environmental Committee, Industrial Structure Council, METI). - 280 - It appears that many developing countries are currently at Stage 1 or Stage 2. Presuming that the developing countries will experience further economic growth, finding a way to prevent the deterioration of energy efficiency that occurs in Stage 2 is an important issue in terms of the energy security as well as the global environment. The level of energy-related CO2 emissions relative to GDP in Japan is the lowest among the world’s major powers (Fig. 4.1.5) and Japan is the country with the highest energy use efficiency ratios. A major issue that must be addressed in order to secure the effectiveness of various international initiatives against greenhouse gases is the creation of a global-scale framework with the wide participation of the United States (US) and the developing countries, including China.

(2) Energy situation surrounding Japan Considering the high degree of dependence of Japan on petroleum and on the Middle East for imports of petroleum, as well as the regional situation in East Asia, it is clear that the energy security situation in Japan is somewhat different from the energy security situation in Europe and North America (Fig. 4.1.7). As indicated on Figure 4.1.8, the degree of Japan’s dependence on the Middle East for imports of crude oil decreased after the first oil crisis, but since the mid-1980s it has been rising again. Against this backdrop, the Energy Security Working Group, a subcommittee of the Advisory Committee for Energy, attempted to quantitatively evaluate and analyze the risks related to the energy sources for Japan and studied various possible directions to respond to such risks. The results of the analysis suggest the following: 1) As a mid- to long-term solution, a shift from petroleum to nuclear power and coal, and an increase of the share of those energy sources will contribute to reducing the energy sources- relates risks. 2) Although environmental and other restrictions make a drastic shift to coal difficult, it is possible to reduce the risks through a shift to natural gas.

Figure 4.1.7 Energy situation of major OECD countries (2000) (%) Japan US UK Germany France Dependence on oil 51 39 36 39 34 Dependence on oil imports 100 59 -58 97 98 Dependence on crude oil from the Middle East 88 27 4 11 29 Energy self-sufficiency 20 73 117 40 51 Note: Figures under “Dependence on crude from the Middle East” are 2001 figures. Source: Energy Balances of OECD Countries (1999-2000) (IEA), Oil Gas Coal & Electricity Quarterly Statistics (2001 Fourth Quarter) (IEA), 2003 Handbook of Energy & Economic Statistics in Japan (EDMC).

- 281 - Figure 4.1.8 Trends in degree of Japan's dependence on the Middle East for imports of petroleum

Degree of dependence on Middle East (%) 95

90

85

80

75

70

65

60

55

50 (FY) 1965 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01

Source: 2003 EDMC Handbook of Energy and Economic Statistics in Japan (EDMC (Energy Data and Modeling Center)).

(3) Measures to be taken in consideration of the abovementioned situation (a) Domestic response The international energy-related and political situation is undergoing significant changes, and various new circumstances that have a strong impact on Japan’s energy security are emerging. In order to precisely grasp those circumstances and develop effective policies to deal with them, it is important to systematically analyze and evaluate the risks facing Japan. The Ministry of Economy, Trade and Industry needs to strengthen its capacities for information-gathering, analysis and evaluation of the various aspects of the international energy market structure, and the international political situation.

The strengthening of the relations with oil producing and gas producing countries is expected to produce the following effects: to contribute to the political and economic stability in the producing countries by providing indirect support to their economic reforms; to facilitate and expand opportunities for petroleum development companies to make direct investment in the upstream sectors in the producing countries; and to contribute to the creation of independent channels for dialogue and diplomatic activities through fostering and strengthening of mutual trust. Toward that end, it is important that the government develop a comprehensive resource strategy, including creation of a framework for promotion of specific cooperative efforts in the fields of environmental protection, infrastructure-building, development of oil-related technologies and fostering of human resources.

The best way to ensure energy security is to save energy, but it is also important to implement a shift to energy sources with lower supply risk. Coal is a good energy source as far as energy security is concerned, but from the perspective of various global environmental issues and economic concerns, it

- 282 - is important to promote the development and adoption of nuclear power, natural gas and new energy sources. Nuclear power may be regarded as an excellent energy source from an energy security point of view, as uranium, the material used in producing nuclear energy, offers great stability in terms of supply as well as prices, and two years’ worth of fuel is domestically stored in fuel processing plants. Nuclear power can be seen as a semi-domestic energy source, since plutonium and other usable materials can be extracted from the fuel that was once used in nuclear power plants and thus the fuel can be recycled. Therefore, by establishing a domestic nuclear fuel cycle, the shift to nuclear power is expected to further improve the long-term energy security. Furthermore, since no CO2 is emitted in the process of electrical power generation in nuclear power plants, nuclear power is the energy source of choice from the perspective of global environmental issues as well. As for natural gas, although Japan’s dependence on the Middle East is not as high for this resource as for oil imports, the dependence on a specific region is high—70 percent of the supplies of natural gas to Japan come from East Asia. However, since it is possible to secure to a certain extent the supply of natural gas from the regions close to Japan and to diversify the supply sources, natural gas seems to pose lower supply risks than petroleum, so it is important to expand the use of natural gas while paying attention to the ensuring of supply stability. An important issue that must be addressed in order to secure alternative sources of energy to meet the petroleum demand in the transportation sector in particular, is the development of gas-to-liquid (GTL) technologies and dimethyl ether (DME) technologies and eventual introduction of these new energy sources as fuel for fuel cell vehicles in the future.

(b) Regional response in the East Asian region In order to control the increasing demand for energy in the East Asian region and also the increased dependence on external sources, and thus to reduce risk, it will first be necessary to ensure the effective use of resources such as natural gas and coal that exist within the region and to improve the efficacy in using energy. However, with economic growth comes an increased demand for petroleum and there is no escaping the fact that the major portion of this supply is dependent on the Middle East. Given such circumstances, in order to ensure energy security in the East Asian region, multilateral frameworks such as ASEAN+3 (Japan, China and the ROK) and bilateral frameworks should be utilized, and Japan will have to make further efforts in the future toward use of regional energy resources, improvement of energy use and efficiency, sharing of recognition concerning emergency response measures and the implementation of cooperation projects. Cooperation and efforts in the East Asian region is important also from the viewpoint of its possible priming effect in strengthening the mutual trust between Japan and the East Asian countries and the region as whole. One such concrete effort is the Japan-China-Korea-ASEAN Energy Ministers’ Meeting held in Osaka in conjunction with the convening of the Eighth International Energy Forum in September 2002. At the meeting, the ministers confirmed the “Energy Cooperation among Japan, China, Korea and ASEAN (Hiranuma Initiative)” proposed by Japan, as a basic direction for measures that must be taken by each country separately as well as collectively, and decided to carry out a detailed study and

- 283 - implementation of the initiative on a working level. An outline of the content of the “Energy Cooperation among Japan, China, Korea and ASEAN” is as follows.

A network should be established among the energy ministries of Japan, China, the ROK and ASEAN to allow timely information-sharing in response to emergencies. Information-sharing through this network will open the way for a coordinated response, contributing to the stability of the regional energy market. Further, each country shall prepare a menu of measures to respond to emergencies, such as release of stockpile, reducing/raising level of stockpile, emergency production increase, consumption restraint and stabilization of domestic supply and demand.

Currently (as of April 2003), only Japan and the ROK (both International Energy Agency (IEA) members) among the East Asian countries have national oil stockpiles in addition to the legally required private-sector stockpiles. As Asia is expected to account for 45 percent of world oil demand growth in the future, developing Japan’s emergency response capacity will be critical, including development of private-sector stockpiles, creation of national stockpiles or some other means. With this view, Japan will further encourage stockpile build-up initiatives by China and the ASEAN members through the ASEAN+3 Oil Security Workshop, seminars jointly hosted with the IEA, bilateral dialogue and so on.

Studies should be conducted on appropriate commercial and/or policy responses to long-term issues faced by the Asian oil market, namely soaring oil demand in Asia and greater dependence on the Middle East. These studies could address, for example, the timely sharing of oil data (production, demand, stockpiles) to identify oil market trends (crude oil and oil products) in Asia, and oil price mechanisms in the Asian market (including addressing the so-called “Asian Premium” issue).

Japan should pursue greater use of Asia’s abundant natural gas reserves through infrastructure development (pipelines, etc.), technological development and commercialization (GTL, DME, etc.). Moreover, for the enlarged effective use of natural gas in the changing market environment, commercial players should be encouraged to reach flexible contract terms that will ensure stable supply and economy.

The clean and efficient utilization of energy is vitally essential not only for energy policy but also in terms of protecting the global environment. Japan will provide active support toward the further dissemination of energy conservation and new energy technology and measures in China and the ASEAN countries, with a view to promoting the effective use of the Clean Development Mechanism

- 284 - (CDM) and other mechanisms provided in the Kyoto Protocol.

Promotion of energy conservation in the fast-growing East Asian region is essential for the improvement of the energy supply and demand. Toward that end, it is necessary to implement various measures such as revision of energy prices by each country, preferential treatment to encourage energy conservation and introduction of new energies, and to establish management systems on national and corporate levels. However, implementation of these measures in the developing countries is often obstructed by lack of awareness regarding energy conservation, and lack of funding, technologies and human resources. In order to solve these problems, active cooperation and support by Japan will be effective, and it will be necessary to provide active and systematic assistance in all areas where cooperation is possible, while coordinating various projects, including initiatives to change the consciousness of the people, with the governments and relevant organizations in the partner countries. On the basis of this belief, the Ministry of Economy, Trade and Industry is currently carrying out the Green Aid Plan (GAP), a project for bilateral cooperation toward solving energy-related environmental issues, with seven Asian countries (Thailand, Malaysia, Indonesia, the Philippines, Vietnam, China and India). Specifically, the project involves initiatives providing assistance for creation of a system for energy conservation through initiatives to plant energy conservation consciousness in managers by implementation of plant diagnosis, support for small group activities and recommendations regarding energy conservation legislation, as well as initiatives for improving the energy conservation consciousness of the governmental and industrial circles.

Also, since ensuring stable energy supply fundamental for the economic development of the Asia- Pacific region, the Asia Pacific Economic Cooperation (APEC) forum is engaged in various energy security initiatives that should be implemented in non-emergency times in order to ensure the ability of APEC to react adequately and in an internationally synchronized manner should an emergency occur. Specifically, APEC is engaged in compilation of petroleum data on a monthly basis and real- time sharing of information in the event of an emergency, and is examining petroleum stockpiling as an emergency response measure in case of stringent supply.

(c) Global response In recent years, in an environment marked by diversification of energy-related issues, such as diversification of the players handling crude oil, liberalization of the internal energy markets in the consuming countries and growing concerns over the global environmental issues, there has been a rising instability in the petroleum markets and an increasing awareness of the challenges that must be addressed by both producers and consumers. Japan should actively call on all related countries concerned to advance partnerships and cooperation in order to address the global challenges. In this regard, in addition to the IEA, an organization for cooperation among the consuming countries that is in charge of solving various energy-related issues such as emergency response measures, the

- 285 - International Energy Forum (IEF), a framework for dialogue between energy-producing and - consuming countries, is gaining importance.

The shift from “confrontation” to “cooperation” in the relations between energy-producing and - consuming countries became definite during to the Eighth IEF (a platform for producer-consumer dialogue) held in Osaka in 2002 under the overarching theme of “Addressing Energy Issues Common to both Energy-Producing and Energy-Consuming Countries.” This meeting represents a significant milestone in the history of the IEF for being the first meeting to be held in the 21st century and also the first to be held in East Asia, and for the number of Asian countries, which participated for the first time. The specific results achieved at the forum are: (i) confirmation of collaboration between oil-producing and oil-consuming nations toward stabilizing the oil market (the “Osaka spirit” or the sense of being in the same boat); (ii) establishment of common understanding of the energy supply-demand situation in the Asian region; (iii) affirmation of the importance of natural gas, which is superior in terms of both environmental protection and energy security; and (iv) reinforcement of the momentum of the IEF (establishment of a permanent secretariat, perpetuation of an initiative to promote oil data transparency). Compilation and upgrading of statistical data toward improvement of market transparency is a specific activity that the participants in the forum need to implement in cooperation in order to achieve stability of the oil markets that is in the best interest of both producing and consuming countries. When carrying out efforts to this end, it will be important to take full advantage of the abundant knowledge resources the IEA has accumulated.

The concerns over a possible disruption of oil supplies on a global scale following the labor strike in Venezuela in December 2002 and the attack on Iraq launched in March 2003 happened to turn into an opportunity for the IEA member countries to test the effectiveness of the established emergency response measures and the structures for cooperation between producing and consuming countries. The IEA member countries announced to the oil markets that they have well-prepared and sufficient stockpiling to deal with any emergency situation that might occur. Furthermore, they directly contacted the oil-producing countries for their assurance to respect their commitment for stable oil supplies. As a result, disruption in oil supplies was avoided, and the oil prices that had previously soared took a downward turn on the eve of the attack on Iraq and the oil markets got on the track toward normalization. Thus, the global response based on the collaboration structure of the IEA member countries and the cooperation between producing and consuming countries has proved successful so far. In the future, it will be important for the IEA member countries to maintain obligatory stockpiles as the foundation of their emergency response policies while continuing to strive for close communication, and to further support and strengthen the momentum in the relations between producing and exporting

- 286 - countries that have entered a new stage of collaboration following the Eighth Producer-Consumer Dialogue.

2. Stabilization of the currency and financial systems (1) Experience from and reflection on the Asian currency crisis The stability of currency and financial systems is important in the current environment in which trade and investment aspects in the East Asian region are advancing and accelerating closer together. In a situation in which the currency and financial system is unstable, there is a possibility that this could lead to a downturn in companies’ global activities due to increased foreign exchange risks and that this could hinder the dynamism of East Asia. With regard to this point, the Asian currency and economic crises that broke out in 1997 triggered by the shift to a managed float system of the Thai baht are still fresh in the mind. The impact of the crises was not limited to the currency system, but had very serious consequences in the real economy as well. Creation of stable Asian currency and financial systems with significant growth potential while taking full advantage of the lessons learned from those currency and economic crises is one of the challenges facing East Asia. The Asian currency and economic crises escalated roughly in two stages. The first stage was the 1997 currency crisis and its spread, when the value of currencies of the neighboring countries (the Philippine peso, the Indonesian rupee and the Malaysian ringgit) as well as the Korean won dropped, and the share prices in those countries fell following of the outflow of short-term funds. The second stage started with the further drop of the baht, rupee and won in the beginning of 1998 and developed into a serious crisis of the real economy. For example, the real GDP growth rate of the ROK and ASEAN 4 turned negative from 1997 through 1998, and the increase of the manufacturing production index started decelerating from the second half of 1997 against the same period of the previous year, recording double-digit negative results in Thailand, Indonesia and the ROK in the second quarter of 1998 and in Malaysia and the Philippines in the third quarter of the same year. Furthermore, through contagion, the currency crisis achieved unprecedented global expansion, spreading out of the East Asian region and the countries within it to affect countries such as Russia and Brazil. The following paragraphs examine in retrospect the factors that triggered the Asian currency and economic crises by stages, namely “Outbreak of the currency crisis” and “Supervening outbreak of the financial crisis and its development into an economic crisis.”

(a) Outbreak of the currency crisis The traditional arguments on currency crisis claim that a drastic drop of currency value (= currency crisis) is a result of a shortfall of foreign finances in a country that finances its chronic current account deficit with foreign capital and occurs when the foreign currency reserves in that country decrease, and the monetary authorities find themselves unable to sustain the currency exchange rate. However, a comparative analysis of the currency crises that have occurred in the 1990s and the currency crises of the 1980s and before, shows that the impact of current account-related factors has faded, while the influence of several other foreign economy and finance-related indexes has increased anew.

- 287 - The first of such indexes is the short-term interest rates in the developed countries. At the time of the outbreak of the currency crisis, most of the ASEAN countries and the ROK had adopted a de facto dollar peg system and boasted attractive conditions for portfolio investment, such as opportunities for interest income free of foreign exchange risks due to the gap between the domestic and foreign interest rates. It is thought that the portfolio investments and bank loans that had entered the Asian countries capitalizing on the gap between the domestic and foreign interest rates reacted acutely to the rising interest rates in the developed countries and demonstrated an increasing trend to flow out, which pushed down the currency value5. The second such index is the short-term liabilities ratio. Even in the period immediately following the two oil shocks—the 1970s and the beginning of the 1980s—there was a time when oil money that could not be absorbed by the developed countries flowed into credit-worthy developing countries such as semideveloped countries and oil net exporters. Then, in the 1990s, the development of the financial technologies allowed the diversification and reduction of investment risks. This resulted in advancement of globally dispersed investments and thus short-term interests started flowing even into the rest of the developing countries. In such an environment, it became highly probable that foreign factors, such as the abovementioned increase in short-term interest rates in developed countries and domestic factors, such as increasing political uncertainties, might cause drastic outflow of capital or, in other words, might act as pressure to push down the currency value. The short-term liabilities ratio in the ASEAN 4 countries and the ROK on the eve of the crisis was very high, with more than 50 percent in the ROK and more than 40 percent in Thailand, and in such circumstances a shakeup of one kind or another could easily have triggered drastic outflow of capital. Thus, the factors characterizing the Asian currency crisis were the gap between domestic and foreign interest rates, and the short-term liabilities ratio.

(b) Supervening outbreak of the financial crisis and its development into an economic crisis The Asian currency crisis attracted significant attention from the Japanese economic circles because it developed into a far more serious-than-expected financial and economic crisis. Looking carefully at circumstances surrounding the financial crisis, it can be observed that a serious credit crunch occurred in the process of development of the Asian currency crisis into an economic crisis. As for the circumstances that triggered such a serious credit crunch, the International Monetary Fund (IMF), the World Bank, and other parties have so far provided various explanations that can be summarized as follows6. Domestic financial institutions were weak (in terms of financial foundation and ability to screen loan applications) in the first place when liberalization was implemented without proper control in place. At the same time, short-term foreign currency debts and long-term local currency domestic credit (the double mismatch of “currency” and “maturity”) expanded, and economic boom and inflation of assets (bubble economy) occurred. However, the bubble collapsed, a currency crisis broke

5 White Paper on International Trade (1999b). 6 White Paper on International Trade (1999b). - 288 - out and the short-term fund was pulled from the market, causing heavy damage to the balance sheets of financial institutions. This resulted in a severe credit crunch (including trade financing) and the economy decelerated significantly because of the downturn in the production activity and the increase in corporate bankruptcies. In the corporate sector, there was excessive dependence on inefficient indirect financing due to the undeveloped capital markets, which was accompanied by lack of corporate governance, making the situation prone to excessive increases of short-term foreign currency debts and domestic capital investments. It has also been pointed out that once the financial crisis led to the credit crunch, the weaknesses expanded significantly and triggered further downturn of the production activity and corporate bankruptcies. In short, the development of the Asian currency and economic crises can be summarized as follows. In the countries that were eventually struck by the crises, the currency exchange rates were practically based on the dollar peg system. Because the interest rates in those countries were higher than the rates in the US, they offered attractive and risk-free investment opportunities for foreign investors. Given that long-term domestic credit was financed by short-term foreign funds (double mismatch) from these investments, once a flight of short-term funds began rapidly due to the bursting of the bubble, a serious credit crunch on the balance sheets of banks and companies ensued. In addition, the weakness of the domestic financial institutions and their dependence on inefficient indirect financing only accelerated those trends.

(2) Efforts to prevent currency crisis International efforts have been made based on the recognition of the factors that caused the Asian currency and economic crises, and the determination that such an event would never occur again. Japan has played a proactive leading role in such efforts and has significantly contributed to the prevention of currency crises. Apart from measures to stabilize the East Asian economy through dispersing of investment and fund management risks for international investors and the central banks of each country, initiatives implemented by Japan with the objective of preventing currency crises also help stabilize the Japanese economy by reducing currency exchange-related risks in trade and capital transactions by Japanese companies.

(a) A New Initiative to Overcome the Asian Currency Crisis (New Miyazawa Initiative) The New Initiative to Overcome the Asian Currency Crisis (referred to as “New Miyazawa Initiative” hereinafter) was announced in November 1998, as an immediate relief package to assist Asian countries affected by the currency crisis in overcoming their economic difficulties and to contribute to the stability of international financial and capital markets. Through this package, Japan offered support measures totaling US$30 billion, of which US$15 billion were made available for Asian countries’ mid- to long-term financial needs for the recovery of their real economy, while the other US$15 billion were set aside for their possible short-term capital needs during the process of implementing economic reforms.

- 289 - Regarding the mid- to long-term financial support, the New Miyazawa Initiative aimed to assist the recovery of the Asian countries’ real economy by helping them implement the various policy measures described below. (i) Supporting corporate debt restructuring in the private sector and efforts to make financial systems sound and stable. (ii) Strengthening the social safety net. (iii) Stimulating the economy (implementation of public undertakings to increase employment). (iv) Addressing the credit crunch (facilitation of trade finance and assistance to small- and medium-sized enterprises). To achieve these objectives, Japan proposed financial assistance to those countries, making use of the various measures listed below. (i) Providing direct financial assistance using public funds in the form of Export-Import (JEXIM) loans to Asian countries, acquisition by JEXIM of sovereign bonds issued by Asian countries and extending official development assistance (ODA) yen loans to Asian countries. (ii) Supporting Asian countries in raising funds from international financial markets through JEXIM and utilization of the guarantee functions of trade insurance and provision of interest subsidies to Asian countries on funds lent by JEXIM or private banks in conjunction with the Asian Development Bank. (iii) Providing financial support in the form of co-financing with multilateral development banks, such as the World Bank and the Asian Development Bank. (iv) Providing necessary technical assistance for implementation of a comprehensive approach to address the issue of corporate debt restructuring and the stabilization of the financial system. The objective of the short-term financial support is facilitation of trade finance. Initially, the New Miyazawa Initiative targeted the ROK, Thailand, Malaysia, the Philippines and Indonesia. Vietnam was included in the initiative in May 1999 under a separate framework. The mid- to long-term assistance authorized by March 2000 includes US$3.35 billion in assistance to small and medium-sized enterprises in the ROK, US$2.87 billion to help financial reform in Thailand, US$2.5 billion to the Philippines, US$1.85 billion in assistance to Malaysia and US$2.93 billion to Indonesia. Twenty billion dollars were set as assistance to Vietnam under a separate framework7.

(b) Regional financial cooperation in Asia (Chiang Mai Initiative)

7 After the announcement of the New Miyazawa Initiative, as the financial situation in the Asian region and individual countries stabilized to a certain level, the international community and the governments of countries in this region began to focus their attention toward promoting the recovery of economic growth. Based on this development, a new initiative for growth and economic recovery of Asia was announced in November 1998. This initiative, which supplements policies for revitalization of demand and economic activity, and measures to reduce the negative social impacts of the crises, encompasses four major items: promotion of restructuring of financial institutions and private enterprises, financing of trade and working capital, promotion of restored capital inflow in the private sector and technical assistance. However, this initiative did not result in any concrete measures. - 290 - Apart from the initiative proposed by Japan, various discussions were held within the ASEAN+3 framework regarding the necessity of regional financial cooperation in East Asia. The necessity to strengthen self-help and assistance mechanisms in East Asia was mentioned during the ASEAN+3 Summit Meeting held in Manila, Philippines in November 1999. The matter was taken up during the ASEAN+3 Finance Ministers’ Meeting held in Chiang Mai, Thailand in May 2000, where the participating finance ministers endorsed a specific initiative. The objectives of the Chiang Mai Initiative were to establish intra-regional financial arrangements to complement the existing international facilities and to reinforce the self-help and assistance mechanisms in Asia. The ministers agreed to expand the existing swap arrangement among five of the ASEAN member countries (Indonesia, Malaysia, the Philippines, Singapore and Thailand) to cover all members of ASEAN, and to create a network of bilateral swap and repurchase trade agreements between the countries of ASEAN+3. Based on this agreement, in November 2000, the ASEAN Swap Arrangement extended its coverage to all members of ASEAN and increased the size of swap arrangements from US$200 million to US$1 billion. Regarding the bilateral currency swap arrangements, ASEAN+3 countries reached an agreement over the key principles of those arrangements, and work on the conclusion of the arrangements is currently under way. As of February 2003, Japan has concluded its bilateral currency swap arrangements with the ROK, Thailand, the Philippines, Malaysia, China and Indonesia, and has launched negotiations with Singapore. Bilateral currency swap arrangements have been concluded between China and Thailand, and progress is being made in the negotiations by China and the ROK with the ASEAN countries. This intra-regional framework of financial arrangements, by its very existence, works as a deterrent to excessive fluctuations in the capital flow and helps prevent outbreaks of currency crises. It is also expected to quantitatively supplement financing by the IMF, if a currency crisis does occur. Such development of financial cooperation is extremely meaningful for the stability of the regional currency and financial markets. Japan should continue its proactive efforts toward creation of a network of bilateral swap agreements between the countries of ASEAN+3.

(3) Towards sound development of the Asian financial markets – Asian Bond Markets Initiative (a) Current situation and challenges facing the Asian financial markets This section argues that at the time of the Asian currency and economic crises, banks and businesses faced difficulties in procuring funds as Asian currency values depreciated causing debts denominated in foreign currencies to balloon and they plunged into excess debt. This situation led to a credit crunch and the macro-economy suffered a major shock. This experience induced a strong awareness of the need for Asian countries to develop capital markets, especially domestic bond markets offering liquid, corporate bonds denominated in the local currency, as part of the overall diversification of fund procurement methods aimed at complementing bank loans. In fact, major Asian corporations that faced a credit crunch due to the Asian currency and economic crises obtained funds by issuing corporate bonds. However, various infrastructure-related problems, such as the immaturity

- 291 - of the regional bond-rating agencies, the inadequacy of the legislations regarding bankruptcy procedures and the inadequate bond-settlement mechanisms, make it appear that market mechanisms are not yet functioning adequately in Asian corporate bond markets compared to their counterparts in the US or other developed countries.

Efficient utilization of relatively ample domestic savings and avoidance of excessive dependence on foreign funding is desirable for the Asian countries. As a matter of fact, the ratio of domestic savings to GDP is high in Asia; in most countries, excluding the Philippines and a few other countries, it exceeds 30 percent. Also, the ratio of main financial assets to GDP is relatively high compared with developing countries in other regions. Despite the high savings ratio, though, many doubts remain concerning the ability of the Asian countries to provide long-term domestic funds. The income levels in the Asian countries rose sharply in the 1990s, and the amount of domestic funds provided domestically increased and the accumulation of domestic financial assets advanced. However, the ratio of long-term funds in the provision of domestic funds remained at relatively low levels. Some point out that the small amounts of long-term funds provided in the Asian countries may be harmful and have an adverse effect on the economy, noting that they might stand in the way of domestic investment, especially in plant and equipment. The reason behind these opinions is that long- term funds are essential for the implementation of plant and equipment investment and technology development investment, which require long gestation periods, and the insufficiency of such funds is likely to hinder these investments. Apart from this, it has been already mentioned that Asian countries’ increasing dependence on foreign funds because of their insufficient ability to provide long-term funds was one of the factors behind the Asian currency and economic crises. The inflow of foreign funds played a very useful role in promoting the economic growth of the Asian countries, but, on the other hand, it is also true that the lack of efforts to effectively utilize domestic savings while opting for easy dependence on the expanding inflow of funds caused the Asian currency and economic crises. According to such opinions, in order to avoid the recurrence of the currency and economic crises in the future while sustaining their economic development, the Asian countries must improve the financial intermediary functions of the domestic financial system, and its ability to provide long-term funds in particular. Fostering of domestic bond markets is considered as one of the ways for long-term corporate fund procurement. It is necessary to make efforts to achieve that and to explore measures to improve Asian countries’ ability to provide long-term funds.

(b) Securing growth of capital markets and the provision of long-term funds – Asian Bond Markets Initiative – In this environment, the proposal for fostering of bond markets, made by the ROK at the Informal ASEAN+3 Finance and Central Bank Deputies’ Meeting held in Tokyo in November 2002 as part of the ASEAN+3 Finance Ministers’ Process, launched a discussion on that issue. Japan proposed the “Asian Bond Markets Initiative” at the ASEAN+3 Informal Session held in December 2002 in Chiang

- 292 - Mai. The same initiative was presented again at the “ASEAN+3 Informal Session of Finance Minister Deputies and Central Bank Deputies and High Level Seminar on Fostering Bond Markets in Asia,” held in Tokyo from the end of February to the beginning of March 2003, where participants exchanged opinions in line with the main agenda contained in the initiative. The bond markets in Asia are immature and of a small scale and, as a result, their liquidity is low. Under the recognition that this is the major factor impeding market participation for both investors and issuers, this initiative encompasses a variety of items ranging from issues that must be addressed immediately, to mid- to long-term tasks, and the ASEAN+3 countries were expected to deal with them in a synchronized manner and in accordance with the specific situation in each country. Regarding these tasks, a proposal was made to establish task forces under the ASEAN+3 Finance Ministers’ Process for studying the issues at hand. An overview of the Asian Bond Market initiative is presented below.

The first requirement in fostering markets that will attract a wide variety of companies to issue bonds is increasing the depth of the market. In order to increase the depth of the market, it is necessary to promote bond issuance by the governments and the government agencies in each country, as well as in large enterprises and small and medium-sized enterprises. First, governments and government agencies in countries where the bond markets are underdeveloped are expected to proactively issue bonds on a regular basis and to complement the bond issuance by private enterprises in terms of amount of bonds issued and redemption period, and also to contribute to the creation of benchmarks in the market. Under the current conditions where private enterprises have no access to the bond markets, it is beneficial for governments and government agencies to procure funds on their behalf and then lend those funds to the private enterprises in fostering bond markets, and useful to the sound development of the private sector. The second point concerns the issuance of bonds by large corporations. Asia has witnessed a surge in intra-regional foreign direct investment, which is contributing to the increasing economic interdependence within the region. The future economic partnership agreements are expected to further promote intra-regional foreign direct investment and will lead to an increase in the number of companies involved in cross-border business operations. It will certainly help develop bond markets if those companies issue bonds in host countries to finance direct investment or to provide financial support to local suppliers. Third, measures to allow small and medium-sized enterprises to access bond markets must be explored. In addition to loans, an efficient method to achieve this is the formation of asset-backed securities (ABS) based on corporate bonds as collateral. The utilization of such structured bonds will ensure the volume of issued bonds necessary for the formation of the distribution markets. It is also expected to offer investors the advantage of dispersing risks in the same way as setting up portfolios.

An important step in boosting market liquidity is to promote the issuance of a variety of bonds.

- 293 - This means encouraging the issuance of bonds denominated in various regional currencies as well as basket currency bonds based on a collection of Asian currencies. From the viewpoint of promoting fund procurement without currency mismatches, it is important to foster bond markets denominated in local currencies. As a first step in this direction, international institutions, such as the Asian Development Bank and the World Bank/International Finance Corporation, and national government agencies country are expected to issue bonds denominated in local currency in the Asian countries where the bond markets are underdeveloped. Companies that operate across national borders and institutional investors that invest internationally can reduce foreign exchange risks by issuing and purchasing basket currency bonds based on a collection of regional currencies. Therefore, it will be meaningful to pursue the issuance of such bonds. For instance, it will be worthwhile to explore the possibility of repackaging some national government bonds denominated in local currency as basket currency bonds. The issuance of basket currency bonds could also pave the way for the establishment of an Asian Currency Unit (ACU).

In Asia, there is a critical gap between risks associated with bonds as perceived from the perspective of issuers and that of investors. It is often pointed out that this gap has hampered the expansion of bond markets in Asia. While this gap in perception can be expected to be mitigated as bond markets develop, the fact remains that it presents a major obstacle to bond issuance when a market is still underdeveloped. The following paragraphs explore the development of a market- nurturing environment required in order to fill the gap in risk perception between investors and bond issuers. First, provision of guarantees would prove effective as a transitory measure in the early stages of bond market development. From this perspective, it is desirable to use international institutions such as the Asian Development Bank that are operating credit guarantee facilities, extensively for this purpose. Furthermore, government agencies such as the Nippon Export and Investment Insurance (NEXI) and the Japan Bank for International Cooperation (JBIC) could contribute to fostering bond markets by providing guarantees to private corporate bonds and sovereign bonds issued in Asia. Also, in order to make effective use of such existing credit guarantee facilities, it is essential for international financial institutions and the government agencies of various countries to address in a synchronized manner the issuance of international bonds by private enterprises. Achieving tangible results to this end is the immediate task in the swift fostering of bond markets. While fostering of bond markets can certainly be propelled through guarantees provided by existing institutions, such facilities are subjected to several operational constraints. For instance, some institutions cannot provide stand-alone guarantees but are only able to offer guarantees with loan operations. Others might have only a limited capacity to provide guarantees. That is why an international organization that might be called “Asian Regional Guarantee Facility” would have a useful role to play. Once established, such an organization would play a particularly important role in helping corporations in the region issue international bonds. Furthermore, the facility could also offer currency swaps. This would facilitate fund procurement by private corporations without inviting the

- 294 - currency mismatches associated with the issuance of international bonds, and could help international investors avoid foreign exchange risks. In order for its guarantees to be effective, it would be essential that such a facility achieve a high credit rating. To this end, the facility should be established on the basis of an international treaty signed by the countries in the region and thereby given a solid legal foundation. Furthermore, the governments in the region and the ADB might subscribe to the shares of the facility to equip it with an adequate financial base to fulfill its operational functions. These conditions would help ensure that the facility will be able to fully perform its expected functions. Second, developing the necessary infrastructure constitutes a key requirement in fostering bond markets in Asia. Elements of such infrastructure include accounting standards, disclosure rules, settlement systems, rating agencies, and rules and regulations concerning transactions. For this purpose, it is very important for the countries of the region to mutually provide technical assistance under the ASEAN+3 framework. Third, it is necessary to create regional mechanisms for disseminating information. There are many companies in the Asian region with outstanding business performances and solid financial foundations. Unfortunately, such information is not widely known, even within the region. Hence, it is desirable to create an information network for disseminating corporate data and information concerning economic conditions in the Asian region throughout the world.

The Asian Bond Markets Initiative as described above combines issues that can be addressed with the objective of short-term realization, and issues that must be considered on a mid- to long-term basis. The introduction of currency baskets bonds and the establishment of an Asian Regional Guarantee Facility, for example, are among the latter. The introduction of currency baskets is regarded as feasible if appropriate guarantees are provided, and various proposals have been put forth regarding possible methods for creation of basket currencies. For instance, one idea that was presented at the High Level Seminar in Tokyo is the “Asian Basket Currency (ABC).” This proposal involves the establishment of some kind of organization, which is charged with the creation of the basket currency in accordance with the amount of regional currencies pooled in this organization. The composition of the basket currency will be determined by the amount of regional currencies pooled initially, and the ABC value will fluctuate in line with the exchange rate fluctuations of these currencies. There is another idea that allows continuous change to the ABC composition in line with the changing amount of currencies pooled in the organization (variable depending of the inflow and outflow of funds) but keeps the value of the ABC from being affected, in principle, by the exchange rate fluctuations of the individual currencies. A third idea suggests using major currencies (US dollar, euro and yen) rather than Asian currencies to create a basket (with a fixed composition ratio of 6:2:2, for instance). Yet another idea suggests creating a new artificial currency instead of a basket currency. In any case, the direction toward promotion of bond issuance in the Asian region using methods that minimize the influence of exchange rate fluctuations would be effective. That is why it is necessary for the parties concerned to explore various ideas and to strive to come up with even better

- 295 - ideas. Last but not least, it must be noted that various initiatives are being implemented within the Finance Ministers’ Meeting Process under APEC in order to respond to the necessity of infrastructure developments essential for the bond market development in the countries in the region. Such initiatives strive to understand the various factors that hamper the bond market development in terms of securitization and credit guarantees and to produce concrete proposals conducive to the solving of such problems.

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