Concept Note for a Proposed Report

THE EAST ASIA PROJECT: GROWTH, GRAVITY, AND FRICTION IN A DYNAMIC REGION

December 7, 2005

Project (noun). A planned undertaking: a large usually government-supported undertaking. Webster’s New Encyclopedic Dictionary.

I. Background and Motivation

The last decade was an eventful one in Asia. The emergence of China and—to a lesser extent—India as important players in global has changed how the developing world, and indeed development itself, is now perceived. This is especially true for the East Asia and Pacific (EAP) Region.1 The steady rise of China during the last two decades, the crisis of the nineties, and the growing concentration of and investment flows within Asia all reflect a vastly different reality than that at the beginning of the 1990s. The proposed report is a contribution to the debate on how development strategies should be adapted in response to these changes.

Much of what happened during the last decade was not anticipated in 1993, when a team examined the development experiences in an influential report—The East Asian Miracle: and Public Policy (henceforth “Miracle”). Miracle emphasized -led growth, rapid capital accumulation and skill-building, capable governments and contestable private sectors. The reality is that many — especially garments and electronics, the bread and butter of East Asian trade—are under threat, the crises of the 1990s has called into question the competence of governments, and even capital accumulation has faltered for a while. But most of the countries in the region have resumed their march towards industrialized country status.

What is going on? Our hypothesis is that East Asia is changing from a set of countries that rapidly integrated with the world to a region that is aggressively exploiting the sources of dynamism that lie within Asia. Just as the region was drawn earlier to the developed world by prospects of a mutually beneficial exchange of , capital, and

1 The East Asia and Pacific Region is defined as Southeast Asia (essentially Indonesia, Vietnam, , , Myanmar, Malaysia, Cambodia, Laos, and Singapore), Northeast Asia (essentially China, Hong Kong, Japan, South Korea, Mongolia, and Taiwan, China) and the Pacific Islands (Papua New Guinea, East Timor, and several smaller islands). For data availability reasons, this report will generally focus on a dozen countries: the ASEAN big seven—Indonesia, Vietnam, Philippines, Thailand, Malaysia, Cambodia, and Singapore—and the Northeast big five—China, Japan, South Korea, Hong Kong., and Taiwan, China. Together they account for much of the region’s population and GDP.

1 ideas, different parts of the region are now being pulled towards each other by the same motives and modes. The result is rapid regional integration in the exchange of goods, capital, and ideas. This economic integration—at least in terms of intraregional trade and investment flows—rivals those in the European Union and North America. What is different is that integration in the EU and North America was aided by formal agreements; East Asian integration has taken place without a formal region-wide agreement: • The share of intra-regional trade in East Asia has risen steadily from 36 percent in 1980 to 54 percent in 2003, and is now greater than the ratio for NAFTA and close to the ratio for the EU—see Figure 1. • The share of intra-regional foreign direct investment flows in East Asia doubled between 1985-87 and 1995-97 to 41 percent, despite falling during the financial crisis—see Figure 2. • The share of intra-regional travel in total passenger-miles flown—an unsatisfactory but available proxy for the exchange of ideas—rose to about 10 percent by 2002, the same as that in Europe—see Figure 3. The growing intra-regional flows of goods, capital, and ideas reflect growing centripetal forces, which we term ‘Gravity’.

This integration is the source of dynamism in the region, and has given it a second breath. But it is also a source of economic contagion. The East Asian crisis was the most visible example of this contagion. And was a reminder that the transition from middle-income to high income status is rarely linear. Based on the development experiences of richer countries in Latin America and Eastern Europe that have had periods of high growth, it is clear that developing countries inevitably will face pitfalls that have slowed down some countries, and have derailed most others.

Box 1. Does East Asia need a new development paradigm?

Jolted by the crisis of the 1990s, countries such as Thailand and Malaysia have proposed shifting the basis of growth from exports to domestic demand. A widely discussed attempt is that of Prime Minister , since 2001, to move Thailand away from an overemphasis on manufacturing for exports by adding a second track that boosts domestic demand.

“Thaksinomics”, as this approach has been nicknamed, is outlined in a 2004 Government of Thailand document entitled Facing the Challenge: and Strategy. It consists of several strands: revitalizing growth at the grassroots level (e.g., in villages and SMEs), jumpstarting some sectors (such as agriculture, tourism, automobiles, healthcare, and real estate), generally increasing long-term competitiveness, ensuring a stable macroeconomic environment (e.g., by raising taxes and paying off foreign debt), and boosting exports (e.g., through regional and global cooperation).

Based on ADB-sponsored analysis in five countries—China, India, South Korea, Philippines and Thailand—there does not appear to have been such a shift during the last decade. In Thailand, since the crisis, exports have been the main contributor to growth, not domestic demand. The general findings are:

2 (a) there is no evidence that export-led strategies contributed to the Asian financial crisis; on the contrary there is some evidence that the period just before the crisis was marked by an overexpansion of demand; (b) there is no evidence that East Asian countries are switching from foreign-demand-led to domestic-demand-driven growth; and (c) the highest growth episodes are when both domestic demand and exports grew, with countries such as South Korea demonstrating that this pattern can be sustained for long periods.

In fact it is inevitable that in the long term, the two have to generally move together, with the rate of growth of exports in effect setting a ‘speed limit’ on how much domestic demand can grow.

Source: Asian Development Outlook (2005)

What are the pitfalls that could trip up East Asia’s steady growers? In a high-performing region such as East Asia, it is easier perhaps to think of what is not a potential pitfall. Fiscal prudence is now almost a habit, and is likely to remain one. Competitive exchange rates are seen by countries in the region as an important building block of economic policies necessary to sustain growth, as is low . Financial sector pitfalls have been faced and, by and large, recognized and accounted for by most countries in East Asia. Labor flexibility was long recognized as necessary, and remains a policy priority. Low rates are still a long way away….. The list of the region’s strengths is long.

So what are the likely pitfalls? We can think of three. The region faces challenges associated with ensuring vibrant cities, social cohesion, and clean governments: • Cities have been an important—possibly the most important—driver of East Asia’s global and regional integration. The next section elaborates. Here we point out that countries in the region may already be seeing the limit of development strategies that rely on primate cities as their main engine—see Figure 4. With 500 million people projected to move to cities in the next decade in EAP, risks accompanying the pattern of urbanization could trip up some of the region’s fast growers. Most governments in the region face the daunting challenge of managing this urbanization.

Table 1: Primate cities can account for more than a third of national income in East Asia Agglomeration Current City Size Population % of GNP % of National Area, Country (Millions) National Total Total

Shanghai, China 12.8 1.2 12.5 Manila, Philippines 10.4 12.1 25.1 Bangkok, Thailand 6.5 10.9 37.4 Source: United Nations – The State of the World’s Cities 2004/2005.

• An unintended by-product of rapid global integration can be rapid “domestic disintegration”. The most noticeable indicator is the prevalence of lagging regions in many of the countries in the region. This aspect is also a central part of the conceptual approach outlined in the next section. There are other dimensions of this

3 ‘domestic disintegration’ such as rising inequality and social conflict. Just as regional integration has occurred at the same time as domestic disintegration, however, it is rising inequality at the country level does not rule out the region becoming a more equal place. There are some indications are that this has happened—see Figure 5. So while there are concerns about rising inequality among the Chinese and the Cambodians, the evidence points to falling inequality among East Asians. So while regional economic integration is clearly a force for the good, governments can maintain the momentum only by ensuring social cohesion. • Global or regional economic integration increases domestic pressures in another way—by reducing the benefits of country size, while largely leaving unaffected the costs of belonging to a large heterogeneous country, it can lead to citizens becoming more demanding of their governments, in particular, becoming less tolerant of overly centralized or corrupt governments.2 These changes can often mean that citizens expect better services, more efficiency, and more honesty. This would imply, for instance, that East Asians should be less permissive of corruption than other regions. This seems at least anecdotally to be true—see Figure 6. And indices of corruption permissiveness may even have declined in the region since the mid-1990s.3 Less anecdotally, it is clear that corruption is hardly an “Asian ”: levels of corruption differ greatly among East Asian countries—see Figure 7.

Congestion, conflict, and corruption reflect the domestic side-effects of growth driven by international integration, which we term ‘Friction’.

Developing East Asia’s per capita income is still just one seventh that of high income countries, so the region still has a long way to grow.4 For growth to continue, the private sector must find ways to harness the forces of gravity outlined above, and to exploit the momentum generated by intra-regional integration. And governments must reduce the friction that arises in this process, and play a critical supporting role. Tackling this tandem of tasks is necessary to keep the economies in East Asia growing rapidly enough over the next 25 years to attain its historical peak share of world GDP of 43 percent in 1820, from its current share of about 32 percent.

Together, these measures constitute a large government-supported undertaking which we term ‘The East Asia Project’.

2 Alesina, Spolaore and Wacziarg (2004) summarize the slew of papers that explore the relationships between economic integration, political disintegration, and country size. 3 Moreno (200?) provides an explanation of the World Values Survey numbers reported in Figure 6. 4 Based on adjusted per capita income numbers reported in the 2004 World Development Report.

4 Box 2. Once Every Four Years: World Bank Regional Studies in East Asia

Since the early 1990s, the World Bank has completed a major study of East Asian growth every four years—The East Asian Miracle (1993), Lessons from East Asia (1997), and Rethinking the East Asian Miracle (2001). The frequency befits the most dynamic region in the world. Each of these efforts has been different in nature, and the proposed report again differs in both focus and format from the three previous World Bank publications.

The differences between Miracle and the proposed report can be summed up in three points: • First, while the 1993 report analyzed growth in eight high-performing Asian economies (Japan, Korea, Hong Kong, Indonesia, Singapore, Malaysia, Thailand, and Taiwan, China), there was no explicit attempt to explain their experience in regional terms. While the report recognized that the countries learned from each other—and hence adopted a pragmatic blend of market fundamentals and government intervention—there was no economic analysis of ‘neighborhood effects’. The Miracle eight could have been anywhere, they just happened to be in East Asia. In contrast, regional or neighborhood factors are a central theme of this report. • Second, Miracle deliberately omitted the growth experience of China., since China was so different from the eight HPAEs. The implication of China’s rapid rise is a central matter for this report, precisely because China is so different from the other East Asian countries. • Third, the aim of the 1993 report was to help other regions learn the lessons of rapid growth in East Asia, and—by extracting general, transplantable lessons—inform the development debates current at the time. This report is also intended to inform debates on regional integration in East Asia that have become widespread in the region since the financial crisis of the late 1990s.

Lessons from East Asia (henceforth “Lessons”) consisted of country case studies, and attempted to examine how public policy lessons permeated borders between countries in the region, and explain the adoption of development approaches with common elements in countries as different as post-conflict Japan and Korea, small states such as Hong Kong and Singapore, and post- communist China and Vietnam. Lessons did not use an explicitly regional framework of analysis in understanding economic activity; this report will.

Rethinking the East Asian Miracle (henceforth “Rethinking”) aimed to address questions raised by several commentators who, prompted by the financial crisis of 1997-1998 were skeptical of the durability of the East Asian development approach. Rethinking consisted of essays on several issues central to this report—trade, FDI, and technology, industrialization, corporate governance, and regional trade and monetary arrangements. The proposed report will reexamine many of these issues, but using the lens provided by the conceptual framework outlined below.

5 II. Conceptual Foundations

The objective of the report is to analyze the tendencies of international integration and ‘domestic disintegration’ and the linkages between them. An understanding of these linkages will help in developing approaches that facilitate the coexistence of international and domestic integration. We propose utilizing the large but relatively recent literature on the “new ” developed by Krugman, Sachs, Venables, Henderson, Fujita, and others to discipline our inquiry.5 Besides helping to organize the report, this should also help us attain insights additional to what an informal approach to these questions might yield. In particular, the analytical framework should inform the following questions: • What is the relationship between international integration and scale economies in economic activity? That is, do international flows of goods, factors, and ideas foster increasing or do they help in exploiting existing scale economies? • What is the relationship between international integration and domestic of economic activity? That is, what effects do international flows have on patterns of urbanization, and what do these factors depend on? • How do these two relationships interact and is there a useful role for public policy in ensuring that these interactions are beneficial or benign? That is, what is the appropriate role of government in reducing transaction costs?

For our purposes, the most useful insights come from the segment of this literature which develops the links between growth, trade, and spatial distribution of economic activity. We are less interested in the literature that deals with questions such as where cities are located and why some cities have developed into metropolises and others have not. We are also not interested in the explanations offered by the new economic geography into questions of inequality between countries. Unfortunately, however, we end up appealing to the relatively less developed parts of the literature, viz., those that focus on the links between economic growth and economic geography, and the links between economic geography and international trade.6

5 Krugman (1991) utilizes the concepts of increasing returns and transport costs to explain the growth of cities. The essence of the argument is that due to increasing returns and imperfect firms have an incentive to concentrate production in one location. Driven by transport costs, firms will choose locations for these facilities that have close proximity to the consumers and or to other firms. Migration of workers to the cities attracted by higher may further increase the benefits of agglomeration due to market size. These models have also been used to analyze inequality between the cities and other regions, between different sectors and occupations (see, e.g., Venables 2000). If migration is restricted, rising inequality can be the result. If migration is not restricted, as workers migrate to the cities attracted by higher wages, disparities between sectors and regions may arise, especially if the levels of skills or education are different between city and rural jobs. As pointed out by Alonso-Villar (2001), there can also be a countervailing force due to congestion costs in these cities. 6 Fujita and Mori (2005) point out that the first generation models of the new economic geography are essentially static. Linkages with the new economic growth literature have not been developed, “because both agglomeration and growth are complex phenomena in themselves, one should expect any integrated analysis to face many conceptual and analytical hurdles.” But such efforts are already underway. Krugman (1998) and Venables (2003) indicate that the relationship between international trade and factor

6 Box 3. Increasing Returns and Four Waves of Economic Thought

An academic literature that has burgeoned since the publication of The East Asian Miracle identifies unexhausted as the central force driving both imperfect competition and geographic concentration of economic activity. Krugman (1998) writes that:

“The reason that geography has finally made it into the economic mainstream is … (that) imperfect competition is no longer regarded as impossible to model, and so stories that crucially involve unexhausted scale economies are no longer out of bounds. Indeed, the new economic geography may be regarded as the fourth (and final?) wave of the increasing returns/imperfect competition revolution that has swept through economics over the past two decades. First came the New , which created a toolbox of tractable if not entirely convincing models of imperfect competition; then the New Trade Theory, which used that toolbox to build models of international trade in the presence of increasing returns; then the New Growth Theory, which did much the same for economic growth. What happened after 1990 was the emergence of the New Economic Geography, ... a… style of economic analysis which tries to explain the spatial structure of the economy using certain technical tricks to produce models in which there are increasing returns and markets characterized by imperfect competition.”

Giving its timing, the analysis in The East Asian Miracle could make little or no use of these advances. In fact, the type of economy outlined in the New Economic Geography literature makes for a tempting target of government intervention: there is no presumption that the market will get it right; in some circumstances, small policy interventions can have large and lasting effects; and processes of concentration tend to produce winners and losers so there is an obvious incentive for governments to ensure that their countries emerge as winners.

But it remains difficult to draw general policy implications. The proposed report will acknowledge that the combination of new trade theory, new growth theory, and new economic geography implies a critical role for public policy. It will propose, however, that the most robust policy implications are those aimed not at promoting specific activities but rather at keeping transactions costs low so that all economic activities—but especially those subject to increasing returns to scale—expand.

Source: “The Role of Geography in Development”, Krugman (1998).

Nevertheless, we expect that despite being constructed from off-the-shelf components, our framework will provide useful insights into the dynamics of economic growth in East Asia, and the role of constructive public policy. The core of the framework is a two- sector, two-region, two-cost model: • Two technologies: increasing returns to scale in industry, constant returns to scale in agriculture. Due to economies of scale in industry—broadly defined to include manufacturing and business services—firms have an incentive to concentrate their

flows and spatial inequalities within countries is also hard to investigate. They cite Ades and Glaeser (1995) as a rare investigation into this question, which finds some evidence that more open economies have less concentrated economic activity. But Krugman (1998) points to difficulties in empirical testing, and Venables (2003) writes that all that exists are examples rather than general findings. The literature remains short of having findings that are robust enough to form a basis for policy advice.

7 production. Agriculture, on the other hand, operates under constant returns to scale and farm activity remains dispersed. • Two regions: large cities and other parts of the country. Due to agglomeration economies, large primate cities become the loci of industrial production. As trade barriers fall, cities also become the main facilitators of international integration. • Two costs: internal and international transaction costs. As economies develop, transportation costs fall, but at a different pace internally and internationally. Other components of transaction costs are congestion, crime and pollution.

In using this framework to understand the domestic effects of international integration, the aspects to note are the effects of international integration on economies of scale in industry and the “horse race” between internal and international transactions costs, with cities as the critical links. International flows of goods, factors and ideas help realize existing economies of scale in industry, and even increase these , thus widening the productivity wedge between industry and agriculture as economies grow.7 In an open economy, if international transportation costs (between primate cities) fall faster than domestic transport costs, international trade between primate cities will grow faster than the flow of goods between core and periphery within countries. This has domestic implications for spatial and social inequality.

In an open economy with falling trade barriers, increasing returns in manufacturing translate into specialization within manufacturing by primate cities in different countries. Again due to increasing returns, the access to markets in other countries leads to more growth opportunities for (more specialized) firms in each primate city. Assuming no international mobility of labor, brakes on this growth can occur because of congestion costs or (domestic) transportation costs. Congestion costs and labor due to high transportation costs can lead more capital-intensive technologies, which further exacerbate domestic earnings differentials. If left unaddressed, the combination of differential returns and differential transportation costs can leads to another drag on growth—social costs associated with high inequality.

Governments have to address these potential coordination failures, and help reduce transaction costs. 8 But the presence of increasing returns implies that governments can extract large rents from industry. So while governments can help growth by reducing congestion, social, and transportation costs, they can also reduce or even eliminate the rents due to increasing returns in industry. Uncorrupt governments will speed growth by reducing congestion costs and lower transportation costs (by providing social and physical infrastructure efficiently); corrupt governments can act as an additional brake on growth by appropriating returns in the increasing returns sector.

7 The framework can meaningfully distinguish between trade in intermediate goods and trade in final goods, a useful feature in studying East Asian growth. 8 Lanaspa and Sanz (2001) consider such a role for the government and point out that whether the economy is spatially concentrated or dispersed in such a version of the NEG model depends on initial conditions.

8 III. Report Outline

Table 2 proposes an outline for the report. The report consists of an overview and a concluding chapter which bookend three main sections: • Section 1 on Growth presents the stylized facts on the pace and pattern of economic growth in East Asia. The section also presents a simple conceptual framework, for analyzing economic growth, international integration, and their domestic effects. • Section 2 on Gravity assesses the prospects for exploiting the economies of scale implied by economic growth and greater international integration. It analyzes the state of the three channels of centripetal gravity , or the “connectors”—the international flow of goods, capital and ideas—and identifies the factors underlying the growth of intra-regional flows relative to those between East Asia and other regions. These flows are themselves inter-connected, but it is possible to discern differences in the importance of each for intra-regional flows. The three chapters analyze the state of development of intra-regional flows in East Asia, going from the robust flows of intermediate , to the growing capital flows, to the incipient intra-regional flows of ideas. • Section 3 on Friction analyzes the domestic prerequisites of sustained growth from the levels increasingly being attained by many East Asian countries—robust cities, cohesive societies and uncorrupt governments.

Outlines for chapters 4-6 and chapter 9 can be found at the end of this concept note.

9 Table 2: Proposed Outline of the Report Ch. Subject Contents Responsibility 1 Overview • The East Asia Project—reattaining historical peak Kharas and Gill share of world GDP (43 percent) over the next 25 years—implied growth rate of 6-7 percent. • Intra-regional integration—trade, capital, and knowledge flows—as ‘Gravity’ • ‘Domestic disintegration’—lagging regions, livelihoods, and governance—as Friction • Harnessing gravity—the role of firms • Reducing friction—the role of government Growth: Maintaining Pace and Patterns 2 Facts • Trends in East Asia; comparisons with other s Tatucu • Evidence of stronger economic gravity • Evidence of growing/falling friction • What East Asia needs to do—the project 3 Framework • International integration, domestic disintegration Gill and • Economies of scale, transactions costs Hariharan • New Economic Growth, Trade and Geography • Private sector and government actions Gravity: Exploiting Economies of Scale 4 Trade • Deep regional integration Haddad and • Production networks Urata • Policy implications? 5 Finance • Regionalization not driven by saving deficits Vostroknutova, • “Capital swaps” Pinto and • Policy implications? Aizenman 6 Ideas • Growing regional exchanges Brahmbhatt • Information flows • Policy implications? Friction: Reducing Transaction Costs 7 Cities • Instruments for global integration Bhattasali • Production transaction costs • What is needed-- 8 Cohesion • Prerequisite for economic stability Datt • Implied social transaction costs • What is needed—social services or social security? 9 Corruption • The corruption paradox in East Asia Mountfield • Fiscal and political decentralization • What is needed—from Renzhi to Fazhi

10 Prospects • Transitioning through middle income status Kharas and Gill • Main policy agenda: Behind the border • Secondary agenda: Regional cooperation

10 IV. Proposed Schedule

Table 3 lists the main milestones.

Table 3: Schedule Stage Milestone Month, Year

Concept Concept paper preparation October, 2005 Concept Concept paper distribution and discussion November, 2005

Production Issue contracts for background papers November, 2005 Production Detailed outline of chapters December, 2005 Production First draft of chapters 2-9 March, 2006 Production Revised draft of chapters 2-9 April, 2006 Production First draft of full report May, 2006

Discussion Discussion draft posted on external web June, 2006 Discussion Bankwide review June, 2006

Publication Revised draft to printer July, 2006 Publication Printed version ready August, 2006

Dissemination Launch at 2006 Annual Meetings September 17, 2006 Dissemination Country seminars, articles, etc Until December, 2006

11 Selected References

Ades, A. and E. Glaeser. 1995. “Trade and Circuses: Explaining Urban Giants.” Quarterly Journal of Economics 110: 195-227. Alesina, Alberto, Enrico Spolaore, and Romain Wacziarg. 2000. “Economic Integration and Political Disintegration.” American Economic Review, Vol. 90, No.5, pp 1276-1296. Alesina, Alberto, Enrico Spolaore, and Romain Wacziarg. 2004. “Trade, Growth, and the Size of Countries,” forthcoming in Handbook of Economic Growth. Alonso-Villar, O. 2001 “Large Metropolises in the Third World: An Explanation,” Urban Studies, 38(8) 1359-1371. Asian Development Bank. 2005. Outlook 2005: Promoting Competition for Long Term Development. Aviat, Antonin, and Nicolas Coeurdacier. 2005. “The Geography of Trade and Asset Holdings,” draft. Duranton, Gilles, and Diego Puga. 2003. “Micro-Foundations of Urban Agglomeration Economies,” paper prepared for the Handbook of Regional and , Volume 4, edited by J. Vernon Henderson and Jacques Thisse, North Holland. Fujita, Masahisa, and Tomoya Mori. 2005. “Frontiers of the New Economic Geography”, Discussion Paper No. 27, Institute of Developing Economies. Kanbur, Ravi, and Anthony Venables. 2005. “Spatial Inequality and Development: Overview of the UNU-WIDER Project.” Kawai, Masahiro. 2004. “Regional Economic Integration and Cooperation in East Asia”, paper prepared for OECD seminar on the “Impact and Coherence of OECD Country Policies on Asian Developing Economies, Paris, April 19-20, 2004. Krugman, Paul R. 1991, “Increasing Returns and Economic Geography,” Journal of , 49(1) 137-150. Krugman, Paul R. 1998. “The Role of Geography in Development,” paper prepared for the Annual World Bank Conference on Development Economics, Washington, DC., April 20-21, 1998. Leipziger, Danny (ed.). 1997. Lessons from East Asia, University of Michigan Press. Stiglitz, Joseph, and Shahid Yusuf (ed.). 2001. Rethinking the East Asia Miracle. Oxford University Press, World Bank. Venables, Anthony. 2000, “ Cities and Trade: External Trade and Internal Geography in Developing Economies,” Working paper, Center for Economic Policy Research, London School of Economics. Venables, Anthony. 2003. “Spatial Disparities in Developing Countries, Cities, Regions and International Trade,” paper produced for the UNU-WIDER project on Spatial Inequalities in Developing Countries. Woo, Jeffrey Sachs and Schwab (eds.) (2000): The Asian Financial Crisis. MIT Press. World Bank, 1993. The East Asian Miracle: Economic Growth and Public Policy, Policy Research Report, Oxford University Press for the World Bank. World Bank. 2005. East Asia Decentralizes. Office of the Chief , East Asia and Pacific Region. The World Bank, Washington DC. Wue, Chia Siow and Mari Pangestu (2003): “The Rise of East Asian Regionalism.” Draft.

12 Figure 1: Gravity—Intraregional share of trade has grown in East Asia

The Share of Intra-Regional Trade in Major Economic Areas (1980-2003)

70

60

50 European Union-15

40 East Asia NAFTA % 30 ASEAN-10 MERCOSUR 20

10

0 1980 1985 1990 1995 1999 2003

Source: Urata, Shujiro (2004), IMF Direction of Trade Statistics 2004.

Figure 2: Gravity—Intraregional share of FDI has grown in East Asia

The Share of Intra-Regional FDI

80

70

60

50 1985-1989 40 % 1990-1994 30 1995-1997

20

10

0 East Asia NIE's ASEAN 4 China

Source: Isogai and Shibanuma (2000).

13 Figure 3: Gravity—Intraregional share of international travel has grown in East Asia

Intra-Regional International Air Traffic Flows as a Share of Total International Air Traffic Flows (Passenger Kilometers Flown)

13 12 11 10 North America 9 South America 8 Central America 7 Africa % 6 Europe 5 Middle East Far East (East Asia) 4 Southwest Pacific 3 2 1 0 1982 1987 1992 1996 2000 2002 2003

Source: IATA World Air Transport Statistics (1982, 1987, 1993, 1997, 2001, 2003, 2004).

Figure 4: Friction—Urbanization has often been unbalanced in East Asia

Largest Urban Agglomeration as a Share of Total Urban Population (2004)

70

60

50

40 % 30

20

10

0 Laos China Korea Japan Brunei Vietnam Malaysia Thailand Mongolia Myanmar Indonesia Cambodia Philippines

Source: United Nations - World Statistics Pocketbook (2004); World Bank – World Development Indicators Database.

14

Figure 5: Friction—Inequality has declined among East Asians

Regional Measures of Income Inequality (Gini coefficients) 1960-2000

70

60

50

40 Gini 30 1960 1980 20 2000

10

0 East Asia South Asia Sub- Middle Latin Eastern Saharan East and Am erica Europe Africa North Africa

Source: Bhalla (2002).

Figure 6: Friction—East Asians are relatively intolerant of corruption

Level of Corruption Permissiveness

1.8

1.6

1.4

1.2

1

0.8

0.6

0.4

0.2 Less permissive --- More Permissive 0 Africa East Asia Latin America South Asia Western Formerly Democ rac ies Communist Countries

Source: World Values Survey (1995-2001), Moreno (2002)

15 Figure 7: Friction—Corruption levels differ vastly within East Asia

Transparency International Corruption Perception Index

10

9

8

7

6 1995 5 2000

4 2004 1 = worst, 10 = best = 10 worst, = 1 3

2

1

0 China Indonesia Japan Hong Kong Korea Malaysia Philippines Singapore Taiw an Thailand

Source: Transparency International – Corruption Perception Index Reports (1995, 2000, 2004)

16 Tentative Outline Chapter 4: Trade

Since the mid-1980s East Asian economies have experienced a rapid expansion of both foreign direct investment (FDI) and FDI-induced manufactured trade. The simultaneous expansion of trade and FDI has clearly contributed to further economic development and growth in the region. The emergence of an FDI-trade nexus was driven by regional production networks formed by multinational corporations, especially from Japan. These networks have promoted the specialization of production in East Asia by fragmenting the production process across different countries within the region based on their comparative advantage in a particular stage of the production sequence. This phenomenon has led to increased intra-regional trade and was market- led rather than forced by regional agreements. Component trade has played a much more important role in trade expansion in East Asia relative to the overall global experience and experiences of other major regions (Kawai, 2004).

The region continues to evolve. The emergence of China as a great economic and trade power is bringing far reaching changes in the region, as well as the world economy. China now holds large world market shares in traditional industries (e.g., footwear, clothing), but is also rapidly enlarging its shares in electrical and electronic exports, the world’s fastest growing segments of world trade. For East Asian countries, China has become a major trade partner—China is now the second export market for Japan and its first supplier; the first export market for Korea and its second supplier. In 2003 and 2004, the accelerated increase of China’s import demand has been the engine of economic growth throughout East Asia. The fear that the rise of China will crowd out trade opportunities for the rest of the region did not materialize.

The evolution of specialization patterns across East Asia, with China at its heart, confirms the “flying geese” model. But changes in the global economy, together with the development in technology and production techniques, meant that newcomers are not exactly following the trade and development patterns of old-timers. First, although newcomers may export similar products as the leaders did in earlier stages, their structures of production are quite different—Japan has developed a strong indigenous innovative base, but Taiwan and Korea have remained dependent on imported technology, components, and equipment; industrial structures in ASEAN countries remain highly dependent on foreign controlled firms, have a high import content of exports, and limited backward linkages with local component suppliers (Gaulier 2005). Second, the new East Asian production networks have given rise to a “triangular trade pattern”: Japan and the NIEs export capital goods and sophisticated intermediate goods (especially parts and components) to ASEAN and China, which process them for exports destined to the US and Europe. Finally, while the expansion of regional production networks has increased intra-regional trade, this did not come at the expense of extra-regional trade—that is, there is no evidence of rapid intra-regional trade integration in terms of final products. In fact, East Asia’s dependence on extra-regional trade in final goods has increased over the years (Athukorala and Yamashita, 2003).

Another evolution is the proliferation of FTAs. Intra-regional trade in East Asia has always been driven by market forces rather than institutional arrangements. In recent years, East Asia has seen the emergence of a number of new partnership agreements. These alliances promote free trade, foreign direct investment, and economic and technical cooperation. Various factors explain the rapid expansion of FTAs in East Asia (Urata, 2004). First, rapid expansion of FTAs in other parts of the world—driven by the difficulty in carrying out trade liberalization on a global scale—has prompted East Asian economies to form FTAs in order to maintain and expand market access for their exports. Countries have also come to realize that the WTO cannot adequately deal with newly emerging international economic activities, such as FDI, trade in services, and labor

17 mobility. Second, East Asian economies have become interested in using FTAs as way to promote deregulation and structural reforms in the domestic markets. Third, the need for regional cooperation through FTAs has increased following the East Asia crisis. Finally, political factors are always prime suspects behind FTAs—East Asia seems to be searching for a regional leader or hub, and the two candidates are China and Japan.

The proposed chapter will have four parts: • Profile and evolution of trade in East Asia. The first section will assess the changes in the profile of trade in East Asia, the nature and size of intra-regional vs extra-regional trade, which countries are moving up the technology ladder, the change in competitiveness indicators across countries… It will also assess the frictions that are emerging: what is the extent of pressure the trade expansion is putting on cities (most China’s exports are produced in coastal areas, Indonesia’s production is geographically concentrated, etc.); is there an upward pressure on wages, and is this affecting the countries’ competitiveness in low-wage products; is the expansion and upgrading of ports, customs, and trade facilitation more generally moving as fast as trade or is there congestion in and around ports? • East Asia and China. The second section will assess the impact of China. In which products is China competing against East Asian countries in third markets, how correlated is China’s export structure with that of other countries of the region, is China displacing East Asian exports and how are these countries adjusting (are they moving up to higher value products, or shifting to different products), how is China’s emergence affecting the competitiveness of its neighbors, are Chinese exports putting downward pressure on in the global markets, is FDI coming to China displacing or reinforcing FDI inflow to the rest of the region? • Production networks. The third section will evaluate the nature and scope of the production sharing networks by assessing to what extent fragmentation trade is expanding more rapidly than conventional final good trade. What is the degree of dependence on this new form of international specialization in East Asia compared to other regions, the reasons for the expansion in production networks in East Asia (including, the role of China, the relatively more favorable policy setting, agglomeration benefits arising from the early entry into this new form of specialization, inter-country wage and skill differential in the region, and lower transportation costs)? To what extent has international production fragmentation played a role in continuing the dynamism of East Asian countries and increasing intra-regional economic dependence, whether these production networks are moving towards higher value products, and what are the linkages between production sharing and FDI? • The “new” regional agreements The fourth section will assess the rising in a “new” regionalism in East Asia. Can East Asia benefit from such regional agreements—especially in terms of increased regional cooperation (including with lagging regions), pushing the domestic reform agenda, and tackling services liberalization and migration issues?

Available data to undertake this analysis includes disaggregated trade data from UNCOMTRADE; FDI data from World Development Indicators, UNCTAD, and World Investment Reports; firm-level data from investment climate surveys. Several trade and competitiveness indicators will be used using UNCOMTRADE data (including Revealed Comparative Advantage, Intra-Industry Trade index, Trade Intensity index, trade dependency indicators, Herfindhal’s index for geographic dispersion, Hirschmann export concentration index, trade complementarity index…); gravity models will also be used to assess the displacement impact of China (for trade and investment); partial equilibrium models will be also used to explain key relationships.

18 Tentative Outline Chapter 5: Finance

The chapter will serve as a link between the previous chapter on trade focused on production networks, and the next chapter on the flow of technology. The possible guiding questions are: • What have been the trends in capital flows during the last two decades, before and after the crisis? What has been the impact of FDI on growth in EAP? • What are the key factors accounting for strengthened gravity forces between EAP countries? Increasing returns etc. • While the “saving glut” is a benign outcome of the take-off (is it indeed?), what are the policy implications for the contemporary policy makers in Asia?

What have been the trends in capital flows to/from East Asia and within East Asia during the last decade? How have the volumes, structure, portfolios changed since the crisis? • Capital flows: bank loans, bonds, assets, equity, public finances, and remittances. • Huge increase in inflows to developing countries and EAP after crisis • FDI (and portfolio) flows have been increasing and are the largest share in the 1990s. What do these changes imply about the region’s integration and specific links with the rest of the world?

What are the key factors accounting for strengthened gravity forces between EAP countries? How does this relate to growth? The issues to cover include how the deeper regionalism reflects greater diversity, maturity and depth of regional markets • Greater gains of vertical FDI from maturing tigers [Japan, Taiwan (China) and Korea] to emerging one [China, Vietnam, etc]. • Greater scope for exporting final products from younger tigers to maturing domestic markets. • The growing size of regional markets implies greater scope for specialization, greater role for intermediaries [Hong Kong, Singapore], facilitating vertical FDI and greater utilization of economies of scale. • The risk of vertical fragmentation of production and “just in time” delivery can be mitigated by ‘natural hedge’ offered by relying on several supplier of intermediate products. • The size of some markets, like China, and the remaining trade costs, implies greater gains from horizontal FDI to these markets. • The growing size and income/capita of regional markets suggests that the maturing tigers enter the stage where they will attempt to exploit scale economics at the level of R&D and headquarter services, shifting production to the emerging one, leading to the observed patterns of FDI and trade in the region. The 1997-8 crises and the slowing down of Japan may encourage this trend.

Is the “saving glut” a benign outcome of a take-off and greater financial integration? How did the current “capital swap” come about? What are the policy implications and the role of the state in keeping the balance and improving the terms of the deal? Addressing this issue highlights the positive association between growth and self-financing in recent years for most countries. It puts China’s case in a broader context, where the present saving glut may be a by-

19 product of the successful take-off of China. The competing interpretations are the strategic one, versus the possibility that it’s a residual outcome of other forces. • Deficit of knowledge, not . The need to keep attracting this “loaded” capital (carrying knowledge, R&D, etc.) -- the need for the governments to improve the investment climate, i.e. infrastructure for FDI. • Under the current financial architecture, are the “capital swaps” more growth-inducing? • The growing size of China suggests that strategic issues, like the balance of terror argument of Larry Summers, and the possibility of protection and populist pressure from the US are emerging rapidly. This may further intensify regionalism, etc. • The bottlenecks of investment climate (infrastructure, corruption, property rights, etc) will challenge countries that approach a more maturing stage of development. This is the stage where the easier gains from trade [“the low hanging fruit”] are exhausted and further improvements may be needed to attract more diversified FDI. The good news is that maturity may induce a shift in the equilibrium -- it may be easier to generate the needed policy change. • Investigate the question of why given the high savings, the EAP countries do not invest in themselves (or under-invest in developing, and over-invest in developed countries). What can be done to (and should it be done?) to attract these countries to invest to their own (or regional) economies? For example, improve the investment climates so that the risks of investing in EAP countries are reduced, and the savings/investment balance is changed?

20 Tentative Outline Chapter 6: Ideas

The generation and application of new technology, knowledge or ideas is widely acknowledged to be a crucial driver of economic development. Romer (1993), for example, stresses the importance of overcoming ‘idea gaps’ relative to ‘object gaps’ in the process of development; i.e., of surmounting barriers to the productive absorption of available ideas versus overcoming gaps in objects such as factories or raw materials.9

New ideas can be absorbed from abroad or created at home. With about 90 percent of global research and development being done in the developed world, technology transfers from the rich countries remain the primary mode by which developing countries acquire new ideas. Analysts have conceived of ideas flowing between countries through a variety of channels. Among the more extensively studied are idea flows embodied in or associated with trade (in particular trade in capital equipment) and foreign direct investment flows.10 Other idea flows have been described as disembodied, in the sense that they are not embodied in physical goods or investment flows. These idea flows may however be embodied in or associated with the movement of people between countries, through migration or business travel. They may occur through trade in various kinds of consulting, business and educational services. They may occur through formal purchase or licensing of patented technology, or through the public disclosure of underlying templates required in patents, which may stimulate new discoveries. And finally disembodied idea flows occur via modern telecommunications and through the production and consumption of public or open source information in the increasingly vast universe of print and electronic media.

Although developing countries rely preponderantly on absorption of knowledge from advanced countries, one of the distinguishing features of successful development is the emergence of an indigenous ideas- or knowledge-producing sector. A capacity for low level or incremental innovation is a significant factor even in low or middle income economies, facilitating the local adaptation needed for successful implantation of foreign technologies. Local employees of multinational companies operating in economies like China and India are the originators of a growing volume of incremental innovations patented by those companies.11 Beyond this level of incremental or adaptive innovation, however, advanced economies are marked by high levels of R&D undertaken by business firms on a systematic long term basis. The development of a strong domestic idea producing sector generally implies further growth in rather than a decline in cross- border idea flows, as a result of growing specialization and potential gains from trade in technology or cross-border technology partnerships. Indigenous innovation should also facilitate innovation that is better directed towards complementing the relative factor specific to East Asian economies. Complementing the central role of business innovation are other elements of a well functioning national innovation system (NIS), including public sector and university R&D, and high levels of secondary and tertiary education, among other elements.

9 Romer, Paul, Idea Gaps and Object Gaps in Economic Development, Journal of , December 1993, 32(3), 543{573. 10 Saggi (2000) surveys research on trade and FDI as channels for technology transfer. Kamal Saggi: Trade, Foreign Direct Investment and International Technology Transfer. World Bank Policy Research Working Paper 2349. May 2000. 11 Puga, Diego and Daniel Trefler. Wake up and smell the ginseng: the rise of incremental innovation in low wage countries. NBER Working Paper 11571. August 2005.

21 The East Asia region is characterized by diversity in country levels of technological development, especially with respect to domestic creation of new ideas. Historically, they have also pursued disparate approaches to the acquisition of new ideas and knowledge. Economies such as Korea, Singapore and Taiwan (China) already devote 2 percent or more of GDP to R&D, essentially advanced economy levels. In these economies, indicators of innovation output such as patents per capita surged five to fourteen fold between 1990 and 2004, approaching or reaching advanced economy levels. On the other hand, while Korea’s per capita GDP (in PPP terms) is 2.5 times that of Thailand, its expenditure on R&D (as a percentage of GDP) exceeds Thailand’s by nearly 25 times. Patents per capita in Singapore are 30 times those in Malaysia (compared to a 2.8 ratio in per capita income). Scientific and technical articles per capita in Taiwan (China) are more than 40 times greater than in China.

How then can one characterize the state of idea flows and idea generation in East Asia? Rather than attempt an encyclopedic survey, the proposed chapter will look at a selected set of issues, drawing on relatively new sources of data for fresh insights.

First, idea flows. Are they characterized by the same forces of ‘gravity’ or regionalization as trade and capital flows? • Insofar as ideas are embodied in trade and FDI one could assert somewhat tautologically that the regionalization of trade and FDI also represents regionalization in ideas flows. One way to make some progress here may be to ask whether the product composition of intra-regional trade is changing in the direction of products that are more intensive in R&D and technology. This appears to be the case. Similarly, is it possible to analyze the sectoral distribution of intra-regional FDI and ask whether it is shifting towards more R&D intensive sectors. This analysis could be conducted in or in collaboration with the chapters on trade and FDI. • Disembodied idea flows are harder to measure. Wong (2001) studies the relative importance of embodied and disembodied idea flows in closing income gaps, proxying disembodied idea flows by bilateral international telephone traffic.12 He finds that telephone traffic has a quantitatively much larger impact on income per worker and TFP than does trade. Analysis of bilateral telephone traffic data may provide some indication of whether there is more regionalization in idea flows. • A more direct approach to idea flows may be provided by analysis of patent and scientific literature citations. As noted, patents granted to Korean, Taiwan (China), Singapore and Hong Kong inventors have increased rapidly in recent years. Patents per capita in China and Malaysia, which much lower in level, have also increased rapidly. What are the intellectual origins of these patents? Do they still mainly cite earlier patents from advanced economies like the US and Japan, or are they beginning to cite more national and intra-regional patents. The methodology for analysis of the geographical characteristics of knowledge flows using patent citations has been recently elaborated by Jaffe, Trajtenberg and their collaborators.13 It is also possible to conduct similar citation analysis of scientific and technical journal articles.

Second, idea generation in East Asia. Can one go beyond the familiar but broad brush statistics such as national R&D as a percent of GDP, numbers of scientists and engineers? In which industrial sectors are the Newly Industrialized Economies (and emerging economies like China

12 Wei-kang Wong. How good are embodied and disembodied idea flows in bridging income gaps and idea gaps? Berkeley. http://iber.berkeley.edu/wps/econ/wkwong_minigrant.pdf 13 Jaffe, Adam B. and Manuel Trajtenberg. Patents, Citations and Innovations. MIT Press. March 2005. See especially Section II: The Geography of Knowledge Spillovers.

22 and Malaysia) undertaking innovation? What does this imply for the evolving comparative advantage of East Asian economies? What is the relative importance of the institutional sources of innovation: private, public, universities etc? Is it possible to say whether globalization fosters or hinders the emergence of indigenous idea production capability? Are the East Asian economies converging or diverging in their capacity for indigenous idea production? What conclusions follow from the likely conclusion that they have in fact diverged? Can European experience throw any light on this question? Can one evaluate the technological capability and characteristics of firms in the middle income economies which do not yet undertake much independent research or innovation? Several approaches could be considered: • Economies such as Korea, Taiwan (China) and Singapore produce detailed innovation and R&D statistics comparable to those in other advanced economies. These should provide a convenient overview of trends in these leading economies. • Patent analysis can provide further insights into idea generation in the NIEs. For example Jaffe and Trajtenberg (2005) develop patent metrics that try and capture the ‘basicness’, scientific content and general importance of innovations. • The World Bank’s Investment Climate Surveys provide a rich source of micro level data on the technological capability and activity of firms in middle income economies of the region such as China, Indonesia, Malaysia, Philippines and Thailand. The Thailand ICA presented a useful analysis of technological capabilities in that country using a framework developed by Sanjaya Lall. This approach can be extended to a comparative evaluation of these middle- income economies.

Lastly, policy issues. If we assume that the NIEs are well launched on the path of independent innovation, the main question is how the middle and low income economies of the region can better avail themselves of international knowledge flows, including newly emerging intra- regional flows, as well as in some cases begin fostering the buildup of domestic innovative capabilities. While there is unlikely to be a unique set of policies appropriate for all, there are likely to be certain base conditions that are favorable in most cases. These include broad openness to trade and FDI (the bearers of embodied ideas), some effort to evolve an effective domestic competition policy, improvement in higher education and provision of basic infrastructure services, maintenance of a stable policy environment and protection of property rights. In short a broad agenda of strengthening the investment climate. Specific questions deserving further inquire are the appropriate framework for intellectual property rights in economies at this level of development, and the role if any for more active technology policy interventions.

23 Tentative Outline Chapter 8: Cohesion

The East Asia Region has experienced rapid growth over the last two decades and, by most accounts, this growth has been accompanied with large-scale reductions in poverty – both in the number and proportion of poor people in the region. The ability of many countries to take advantage of the forces of global economic integration through the flow of goods, capital and technology has been a major factor in this success story. Looking ahead, one may be tempted to take the view that these countries just need to do more of the same – although what that is may be a point of some debate – to continue their successful transition to a higher stage of development and the virtual elimination of poverty.

However, such a linear view of the East Asian growth experience is beset with difficulties. Two big questions relate to: (i) the sustainability of the growth process and (ii) how widely shared will be the benefits of this growth process. This chapter focuses on the second question from the perspective that lack of shared growth itself is a potential impediment to the sustainability of growth. Put simply, social cohesion depends on a wider sharing of the benefits of growth, and continued threats to social cohesion (increasing “friction”) could stall the growth process through economic and/or political channels.

The first part of this chapter will look at the current or emerging sources of “friction”. i) Uneven growth? There are concerns of lagging regions within all “successful” fast- growers. Inequality of income or consumption within countries has been growing within a number of countries. ii) Economic and social dislocation? Are structural changes associated with the growth process causing economic and social dislocation? For instance, there is a large movement of people within countries from rural areas to urban growth centers, unleashing major challenges for social policy. iii) delivery? With transition to market-based provision of many public services, there is an emerging issue of equitable and affordable access to public services especially in education and health. iv) Increasing vulnerability? While reducing aggregate poverty, there are concerns that the growth process is exposing segments of the population to newer risks to their wellbeing through changes in the operation of factor or product markets.

The second part of the chapter will go on to explore the role and challenges for social policy in this context. There are several important issues here. First is the issue of “jobs to people” or “people to jobs”. Should public policy focus on poor area development or facilitating labor mobility to high growth areas? Second is the issue of social assistance or social insurance. Is there a case for social protection policy to shift focus from social assistance to social insurance? And is this case differentiated across countries or across social groups? The third issue is how to meet the challenge of service delivery in the increasingly decentralized environment in many countries? The chapter will conclude with a discussion of implications for social policy in the region.

24 Tentative Outline Chapter 9: Corrruption

As East Asian economies integrate and grow, corruption may become a major source of friction. Most indicators suggest that East Asia remains one of the most corrupt regions of the world. The dynamics of rapid economic development may in some ways increase opportunities for corruption; in other ways, they may work to reduce such opportunities. The growth and integration dynamics may also create an environment in which there is less tolerance of corruption. How these countervailing forces play out will determine whether corruption in the region spreads and deepens further or is contained and reduced. It will also, this chapter will argue, be an important determinant of whether East Asia’s current growth dynamic continues apace or slows prematurely.

This chapter will discuss the somewhat paradoxical nature and impacts of corruption in East Asia today. As Campos (2001) argues, corruption in East Asia presents proponents of good governance with a difficult apparent paradox. China, Indonesia, Vietnam, South Korea, the Philippines and Thailand have all managed to trade successfully and to attract large inflows of private investment over several decades (although the Philippines and Vietnam were latecomers). Social outcomes associated with core public investment have often been much better than would be predicted by GDP per capita. Economic growth has been amongst the fastest in the world. Yet for much of this period these countries have figured prominently in global lists of most corrupt countries. Possible resolutions of this paradox will be explored and assessed.

The chapter will explore the possible impacts (positive and negative) of the regional growth and integration dynamics described in earlier chapters on opportunities for corruption. Bigger government may create greater opportunity for corruption in the public sector. Growth and integration will go hand in hand with urbanization—and major investment in urban infrastructure will be necessary to avoid congestion and ensure that cities are engines of growth rather than bottlenecks. At the same time, growth and integration may generate inequality and this may create a bigger role for Government spending to offset such inequalities. As societies become richer they will wish to spend a larger share of income on services including services such as health and education which may be provided by the public sector. In all OECD countries, both the public and private sectors were many times larger at the end of the 20th Century than at the start.

The greater presence of increasing returns may create additional economic rents and so new opportunities for corruption in both public and private sectors. Even assuming no deadweight losses associated with government spending and taxation, the presence of increasing returns implies that governments can extract rents from industry. So while governments can help growth by reducing congestion, social, and transportation costs, they can also reduce or even eliminate the gains arising due to increasing returns in industry. Uncorrupt governments will speed growth by reducing congestion costs and lower transportation costs (by providing social and physical infrastructure efficiently); corrupt government officials can act as an additional brake on growth by appropriating returns in the increasing returns sector.

At the same time, the dynamics of growth and integration may reduce the scope for corruption in certain ways. As East Asian countries grow and integrate, the structure of GDP and of trade will increasingly comprise services and products with higher knowledge content. Integrity and trust may become pre-requisites for success in business in a way that it was not hitherto. Corruption may be harder to broker across national and cultural boundaries as trade and foreign direct investment become more significant. There is some evidence suggesting that corruption deters foreign investment (e.g. Shang-Jin Wei, NBER Working Paper No. 6030). FDI may bring with it

25 international accounting and auditing standards which help deter corruption. Action to tackle corruption in customs administration and elsewhere may be necessary as part of regional and international trade liberalization treaties such as AFTA and WTO.

The chapter will explore the likely impacts of this growth and integration on demand for better governance. Greater intra-regional and international exchange of goods, capital and ideas (“Gravity”) may expose citizens to other governance models and to debates about governance less widely accessible domestically. More generally, Friedman (2005) argues that economic growth creates conditions conducive to uncorrupt and citizen-responsive governance and democracy. This argument tallies to some extent with evidence that East Asians are relatively intolerant of corruption. However, Friedman makes clear that the evidence of a correlation between economic growth and good governance holds only when the majority of the public (he suggests those in the 15th to 85th percentile) are benefiting from economic growth. As such, tackling the friction of corruption and the friction of growing inequality/conflict may go hand in hand.

The chapter will conclude with some tentative conclusions regarding corruption and the future of East Asia. The argument that East Asian countries have been able to “manage” corruption in such as way as to minimize its impact on growth and integration (e.g. Chang (2001); Campos (2001)) may have some validity historically. However, other evidence suggests it is more relevant to the past than the future. What was adequate will no longer be enough. As East Asia’s integration moves forward, almost all sectors become important for international competitiveness and the scope to contain corruption to the domestic economy is shrinking. Corruption will either be drastically curtailed, as has been the case in some of the region’s most dynamic economies, or it will infect tradable sectors and undermine integration dynamic.

26