Three Factors Driving a New Phase of Trade Integration in Asia

First, we are seeing now the start of a new phase of foreign direct investment (FDI) inflows within Asia. There are several factors behind this.

I start with Japan, which is still the largest Asian economy: at market exchange rates, which is what matters for international trade and investment, Japan has the largest GDP in Asia by far, twice as large as that of China. Japan has seen a recovery of corporate profitability and a recovery in the financial position of its banks. It is a healthier economy. And the fundamental transformation in Japan that took place in the 1990s, which was halted for some years, is now likely to pick up pace: the shift from manufacturing to research, and design-driven production, and to services. This will mean a decanting of manufacturing operations, particularly many forms of mass manufacturing that are still located within Japan, out of the country, with major implications for Asia. Take Japan today and compare it with the United States. Twenty-four percent of Japan's GDP is still in manufacturing, whereas for the United States, the proportion has fallen to 14 percent. Japan has 18 percent of employment in manufacturing, compared with 10 percent for the United States. In both countries, these shares have declined over time, with Japan typically about 15 years behind the United States. And I think Japan is going to continue to move in that direction. It may not reach U.S. levels, but it is going to continue to decant manufacturing offshore. The numbers that we are talking about are very large.

The Economist Intelligence Unit (EIU) estimates that the stock of Japanese FDI abroad will increase by 65 percent in the next five years. Historically, about one-third of Japanese investment abroad has gone to other countries in Asia. We can expect at least one-third of the increase in the stock of Japanese investment in the next five years and beyond going to the rest of Asia. But it will not be only a China story. Japanese firms have already significantly stocked up on their investments in China. They had been underinvested in China. Their subsequent investments in China have corrected for this, and they are now no longer under-invested in China. So, going forward, for fresh flows of Japanese FDI, we can expect to see a more diversified set of locations—not just China, but Southeast Asia and India as well, that is, a more diversified approach covering the whole of Asia. And with that will emerge new supply chains like what we have seen in the motor industry in Southeast Asia, but extending to a whole set of other industries.

Next, besides Japan, we are now seeing the start of a wave of outbound FDI from other Asian countries that we have not seen before: in particular, from China and India, which will be the major new players in the next 20 years. Chinese and Indian firms are substantial players that are now looking across Asia for new markets as well as new sites for production, much as the Western and Japanese multinationals did in an earlier era. And this, too—whether it is Tata Steel or Hua Wei, or a whole new set of firms coming out of these two large megaplayers—this too is going to lead to increased intraregional trade.

The second factor that is propitious to the growth of intraregional trade is the fact that the middle class is now coming into its own in Asia. It is already large, but it is now growing much faster than GDP. By some estimates, by 2010, we will have a middle class of about 650 million people in China, India, and Southeast Asia. That is about 75 percent growth in five years, which will mean a tremendous escalation of demand for things that you cannot obtain at home. They will want imported products, which differentiate themselves from the others. This is going to spur a whole new growth of imports, not just from within Asia. There will be an expansion of Asia's demand for the world's exports. The Asian supply chain will increasingly be oriented not just to the United States and Europe but also to Asian final demand as well. This is a new phase in intraregional trade.

The third factor is the broadening of free trade agreements (FTAs). The momentum of FTAs in Asia is growing. The Association of Southeast Asian Nations (ASEAN) was a leader, and ASEAN has now set itself a more ambitious target of achieving an ASEAN Economic Community by 2015—with a free flow of goods, services, investments, and skilled people within the Community. ASEAN is also negotiating with China and India to have FTAs with those two megaeconomies.

What started as bilateral deals have cascaded into regional FTAs and can eventually support multilateral trade liberalization. It is a cascading process which tends to be a little messy and some say carries the risk of having a “spaghetti bowl” or “noodle bowl” effect. But I would say, better a bowl full of noodles than an empty bowl. Better that we create the momentum and the political economy that favor reform in each of these economies through bilateral and regional FTAs. That can only be propitious to multilateral trade liberalization.

So this process of FTAs, starting with bilaterals, moving on to regionals and then cross-regional FTAs, is itself going to spur intraregional trade in Asia. This is another reason why I say we are very likely to get to at least 60 percent of Asian trade being intraregional within 10 years.

A resurgence of intraregional investment and the growing domestic demand spurred by a rapidly expanding middle class will lead to an expansion of intraregional trade, aided and abetted by FTAs that reduce barriers to trade within the region. It is essentially a bottom-up process, aided top-down. With or without monetary union, we are likely to get heightened intraregional trade.

Easing Capital Restrictions

It will also require an easing of capital controls and restrictions in Asia. We know that sequencing is important. We know that the pace at which you ease capital controls and lift them has to be shaped by prudential considerations and linked to financial stability, particularly of the banking system. But the direction has to be clear and we cannot afford to be too slow in this process.

Asian policymakers have to address the trade-off that we have always faced: the trade-off between wanting to avoid the volatility that comes with freer capital mobility, on the one hand, and wanting and needing greater liquidity in our markets, on the other. We will not have more liquid markets without a freer flow of capital, both from within the region and from global markets. And everyone wants liquidity—not just short-term investors or alternative fund managers but also long-term investors, who prefer more liquid markets so that they can exit without paying a high price. So what is in the interests of short-term investors is also by and large in the interests of long-term investors.

We have to pay careful attention to sequencing. But we cannot be too slow in lifting capital controls and restrictions in the region if we want to develop healthier and deeper financial markets.

We should aim for a seamless flow of trading, clearing, and settlement across the debt and equity markets in Asia. But the outcome of this will not, I think, be what you see happening in Europe, where you have an extremely heavy concentration of financial activity in one financial center, that is, London, with a number of smaller, satellite financial centers outside London. In Asia, I can see, for a long time to come, vibrancy in several centers: Tokyo, by virtue of the enormous hinterland around it provided by the Japanese economy; Shanghai too, increasingly servicing a large domestic hinterland; Mumbai coming up and eventually occupying the same place; the international financial centers, namely, Hong Kong and Singapore, each having distinct niches, competing with each other, but also complementing each other; and other domestic financial centers—Kuala Lumpur, Bangkok, Jakarta—some of which will also have international niches, like Kuala Lumpur in Islamic finance.

Therefore, I see competition and complementarity in this emerging set of financial centers across Asia—not the London effect.

Why the European Schema Is Not Appropriate for Asia

The fundamental issue for policymakers concerns the trade-off between the benefits of having a common currency, which arise principally from enhanced trade and financial integration, and the costs of losing autonomy over domestic monetary policy—that is, losing the ability to adjust either your exchange rate or domestic interest rates in response to your own economic cycle. This is the basic trade-off that Asian policymakers inevitably face when they ask themselves if a single currency, or any other form of monetary integration, will enhance economic growth and the welfare of their citizens.

Are Asian countries prepared to lose their ability to use the exchange rate as a shock absorber in certain circumstances? Are they willing to lose the ability to adjust interest rates to respond to economic cycles? And is nominal convergence a necessary prerequisite in Asia for real economic convergence—for achieving a greater commonality of economic cycles in countries across the region and achieving over time a convergence in real incomes?

Even in Europe, this question is still being played out. These are still early days in the experience of the euro zone, but the evidence so far is that nominal convergence has not led to a narrowing of real economic differences. Some argue that nominal convergence has accentuated real economic divergences because of the loss of flexibility on the part of national policymakers to use monetary policy as a buffer or mechanism for adjustment in response to economic shocks.

Asia will face a more challenging task than Europe in ensuring that the costs of monetary integration do not outweigh its benefits. First, because economic disparities in Asia are wider than in Europe—far wider. In Europe, disparities in per capita income across countries are something in the order of 3 or 4 to 1; meaning that the richest economy, in terms of per capita income, is about three to four times richer than the poorest within the group. In Asia, the ratio is about 50-100 to 1.

What this also means is that we are likely to see, for a very long time to come, a large difference in growth rates between Asian economies with low per capita GDPs that are catching up and transforming themselves, like China and some of the ASEAN economies, and the more mature, higher-income, slower-growing Asian economies. This will likely mean different paths for their real effective exchange rates as well.

Second, economic structures in Asia are very different. We have economies that are governed by advanced technology and services, economies that are largely agrarian, and economies where mass manufacturing is the driver of growth. So these are very different economic structures, even with a high overall degree of intraregional trade. The shocks that Asian economies face and their response to shocks will therefore often be asymmetric. This makes exchange rate coordination a tricky task, even under the favorable conditions.

Third, there is a lack of a suitable anchor player. In the 40 years of transition to a common currency in the euro zone, the first 15 years involved pegging to the U.S. dollar while the last 25 years really involved de facto pegging to the deutsche mark. How this became possible can only be explained by events and experiences specific to European history—a history that brought a Germany that had gone through hyperinflation to be totally committed to low and stable inflation, and whose post-war social compact gave the Bundesbank the independence to pursue monetary policy with that singular objective. Further, because Germany was by far the largest economy in the Europe of the last quarter century and the divergences between Germany's circumstances and the rest were not so wide, most European countries were willing to commit themselves to following the Bundesbank. That is how they made this transition to a single currency, over 25 years—and even then with considerable stresses and strains in the union along the way.

Asia does not have the equivalent of a Germany to anchor the transition. Japan, currently the largest economy, has the low inflation preferences required of an anchor country. But Japan is very different from the other economies for reasons I have mentioned—different growth profile, different economic structure, different shocks affecting it, different responses to shocks. And Asia lacks, very obviously, the political history that brought the leading European countries together to decide that as a matter of political imperative, a union was preferable to any other outcome. Asia lacks that.

Will China—which will eventually be the largest Asian economy—play the role of a Germany? This is hard to envisage. China, for the next 20 or 30 years, will be an economy going through major transformation. It is still a principally agrarian society. No one can predict exactly how China will unfold. But an economy going through major structural transformations cannot play the role of anchor. Further, it will take some time before China itself can have an efficient monetary policy transmission mechanism.

So we do not have the advantage that Europe had in making the difficult transition from having different national currencies to a common currency by following a de facto leader in the deutsche mark.

Asia's strength lies in its diversity. This diversity is what makes intraregional trade an attractive and compelling economic proposition. This diversity can also help in the diversification of financial portfolios across Asia. But, it is this same diversity that militates against monetary integration, because it raises its costs, including the risks of destabilization arising from monetary union.

Intermediate Proposals for Asian Monetary Integration

If a common currency or monetary union is therefore not viable, are there alternative intermediate proposals that are worth considering? Several proposals have been made. Broadly speaking, they fall into two sets.

The first is the idea of a currency basket—for Asian countries to manage their own currencies against a common basket through some form of a coordinated, managed float system. This common currency basket system would serve to constrain monetary policy and exchange rate policy independence among the member countries. Each of us would use the same currency basket as the benchmark, and adopt some form of a peg or managed float against this basket: possibly a band with a center point, with some flexibility in terms of the crawl of this band, but essentially de facto fixing against a common currency basket.

This is an appealing idea, but it would face great challenges of transition. With freer capital movements—which are essential if we want trade and financial integration—and our divergent economic circumstances in Asia, it would be especially challenging to sustain a system equivalent to the exchange rate mechanism (ERM) or the snake in Europe for a period of years. Even the ERM faced tremendous stresses along the way, requiring great political commitment to the eventual goal of achieving monetary union, to see them through. Asia does not have the same political imperative. So the strains and stresses arising from a coordinated system of pegs or managed floats against a common currency basket will not only risk destabilizing monetary integration but could also erode confidence in the larger game of Asian integration in trade and finance.

The second set of proposals involves establishing a parallel currency—an ACU or Asian Currency Unit, just like the former European Currency Unit (ECU). Some of the proponents of an ACU will make it very clear that this is not a transition to a common currency: the proposal is merely for the setting up of a parallel currency, that is, a unit of account that could be used in the settlement of cross-border trade, or by financial institutions as a currency of denomination for bonds and other financial instruments. It will be a market-driven process with no obligation on the part of the national monetary authorities to peg their currencies to the ACU. It is a parallel benchmark of sorts.

I think this is worth considering, particularly if it can promote the debt market in Asia and help develop the regional capital market. It is not in any sense a scheme for monetary integration: there would remain national currencies with national monetary policies. I see it as a scheme for financial integration. It would be useful to have a currency of denomination that is widely accepted across Asia for bonds and other instruments: this is something we can explore.

But most proponents, like Barry Eichengreen, also agree that it will be a very slow process for an ACU, or any parallel currency, to be accepted by the market. Even in Europe, before the advent of the euro, the ECU never really took off as a currency of denomination, whether for financial assets and instruments or for trade. It never really displaced national currencies before the euro actually came into being.

If that was the case in Europe, it is all the more likely to be true in Asia. I would say that we can explore this idea, particularly if we can use a parallel currency to spur the development of financial markets, but it is not a scheme that takes us in the direction of monetary integration as such. And, as some have pointed out, too, prudential supervisors will also want to make sure that financial institutions, particularly banks, when using an ACU as a currency of denomination for loans or other assets, will not face currency mismatches vis-à-vis their national currencies, which have typically been the currencies of denomination of banks' liabilities. So prudential supervision is also likely to hinder the advancement of an ACU.

So an ACU is not a bad idea, but it is not intrinsic to the larger argument of whether we need Asian monetary integration or some form of coordination of national currency movements.

Toward De Facto Monetary Policy Coordination

What, then, is the alternative? I think the alternative is what we are already seeing unfold before us. First, Asian exchange rates have now become a lot more flexible, compared with the period before the Asian crisis. To be sure, we are not all rushing toward freely floating exchange rates; in fact, apart from the yen, I do not think there is any other truly freely floating exchange rate in Asia today. But the majority of Asian currencies are now in some form of a managed float, with varying degrees of fixity or flexibility. We are all mostly operating a managed float system, that is, an intermediate solution. That is the first development.

Second, there has been increasing adherence to inflation targeting, or commitments to low and stable inflation as the objective of monetary policy. We see this across the region. Although the inflation thresholds may differ, the thresholds are all coming down. There is increasing clarity and conviction that the objective of monetary policy is to maintain low and stable inflation.

The combination of these two developments—the shift toward managed floats and the shift in the objective of monetary policy toward low and stable inflation—has brought about, de facto, a certain degree of coordination in monetary policy across Asia. Indeed, if you look at the correlation of Asian exchange rates over the past six years, that is, 2000-06, compared to the years before the crisis, 1990-96, the correlation for the recent period has been much higher despite the move toward greater currency flexibility.

I think this de facto monetary policy coordination—not top-down, but obtained because national authorities find it in their own interests to move in this direction—is not a bad way to go. It preserves flexibility when required. It allows secular trends in effective exchange rates to diverge over time to reflect the very different rates of productivity growth and the different transformations we are going to see among economies in Asia.

And it retains the agenda for change as a national agenda. Any top-down process, any process that is overly coordinated in Asia—by a committee or body outside of the national authorities—will not incentivize politicians to take ownership of change. The future of Asia is about change and reform in almost every sphere, requiring great political effort to convince populations, convince banks, convince firms, to move, to open up, to shake out the inertia. And unless national politicians and authorities feel that they own the agenda, change is going to be difficult.

This process that we are seeing—market-driven, national authorities responding to their own economic circumstances—leading, de facto, to increased monetary coordination is, I think, the best way to go.