Trade, Investment and Financial Integration in East Asia

Transcription

1 Trade, Investment and Financial Integration in East Asia Submitted to the ASEAN Secretariat May 2005 Daiwa Institute of Research

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3 Executive Summary Ⅰ. Facts Found in the Research Trade and Investment Integration Trade and investment integration in East Asia have proceeded since the 1980s. Accumulation of Foreign Direct Investment (FDI) inflows has been a force driving the intensification of intra-regional trade in East Asia, as well as multiple engines of the economic growth. Multinational firms, in particular based in Japan, have extended their activities throughout Asia by means of FDI, and have played an important role in development of intra-regional production and procurement networks and the vertical economic integration we see today. What we are experiencing is ongoing market-driven trade and investment integration. The shares of intra-regional trade in East Asia still remain at a significantly lower level, at around 40 percent, than those of the EU or NAFTA. As such, there may be scope for further expansion of intra-regional trade under a number of possible Free Trade Agreements (FTAs). Any plausible combinations of FTA in East Asia will bring about welfare gains to all the FTA members. However, the more national participation in FTAs, the greater the gains in total, as well as the gain accruing to each member. Financial Market Integration There exists a general consensus that financial market integration contributes to long-term economic growth. The degree of financial integration in East Asia has increased recently, but East Asia has shown greater financial integration with the global economy than with regional economies. Regionality is weak and there is no strong pulling, or anchor market that could match the U.S. market. Lack of success in policy coordination among East Asian countries, despite the efforts that have been made, seems to be a fact relevant to this. 6/20/2005The many controls and restrictions that remain in place at the domestic level in the East Asian countries have hampered the development of legal, accounting, supervisory, and regulatory mechanisms essential to regional financial stability. Without fundamental reforms at the domestic level, the success of any attempt at regional financial integration may be threatened. The direction and structure of capital movement in East Asia created a highly vulnerable i

4 and unstable financial environment in East Asia, and as these causal conditions still persist they raise the likelihood of a future crisis, one that would impede the development of the capital market of the region. Monetary Integration and A Basket Currency Regime A Basket Currency regime has several benefits as one of the intermediate and optimal options for East Asia; these benefits include stabilizing trade competitiveness, capital flows and GDP. However, even after the financial crisis, some of the Asian currencies were de facto pegged to the US dollar, resulting in several competitive devaluations. Because of a coordination failure problem, monetary authorities in East Asia have failed to introduce a common currency basket system, even though they may be aware of the merits of such a system. The five ASEAN countries and Korea will be candidates for a common currency area with a common Currency Basket as an anchor currency. A common Currency Basket is more appropriate as an anchor currency than the US Dollar for forming a common currency area in the region. Sequencing and Policy Prerequisites of Economic Integration It is reasonable to believe that economic integration begins with elimination of customs barriers and quotas. Trade integration increases economic interdependence of member countries in the region, and this interdependence will garner attention and stimulate interest in taking common action to prevent economic shocks. Regional trade arrangements will in turn stimulate intra-regional FDI. Trade openness is closely related to the degree of financial integration. Trade liberalization is a prerequisite of capital account liberalization. If domestic factor markets and foreign trade are still heavily distorted when the capital account is liberalized, capital could flow into sectors heavily affected by distortions, further increasing inefficiencies in domestic production. Trade openness is found to be closely related to the degree of financial integration. Even after the FTAs are established, economic agents will face currency exchange costs and exchange rate risks in international transactions. In such a situation, the movements toward bilateral and regional free trade agreements might gain momentum to form a common currency area in East Asia. Ⅱ. Policy Recommendations Establish Regional FTAs as Immediate Actions ii

5 Trade integration deserves to be a critical part of any broad regional coordination agenda. As an item for policy agendas, expansion of FTA membership will properly be the basic strategy. The goal for the region should be an ASEAN+10+3 FTA, and any subsets would be transition stages. In such an expansion process, the policy-makers should carefully design all FTAs they work on to be compatible with larger FTAs in the future. And an FTA should cover services as well as goods. In the EU, economic cooperation supplemented the integration. A remarkable example is the European Monetary System (EMS). Stability of the EMS became an essential base from which the EU could move forward, to monetary integration. As such, economic cooperation has been an instrument with which the EU governments can handle the issue of the diversity of the participating countries. Regional FTAs will provide the countries in East Asia with the opportunity to formalize such cooperation actions. Promote Financial Market Integration The countries of East Asia should promote financial market integration. Liberalizing and opening capital markets are basic measures. Important prerequisites are institutional strengthening of the domestic financial sectors, development of the required financial markets and establishment of prudential regulations. In light of experience during the currency crisis, a multi-speed approach to undertake domestic reforms, together with incentive measures such as the Asian Bond Fund, are recommendable. Regional financial infrastructures, including a regional settlement and clearing system and regional harmonization of credit rating standards, should be established for fostering regional cross-boarder bond markets in East Asia. Policy Cooperation and Coordination as Prerequisites for Monetary Cooperation Regional economic integration in terms of trade, FDI, and financial transactions would make private sectors recognize that foreign exchange transaction costs and foreign exchange risks are significant obstacles to trade, FDI, and financial transactions. The East Asia economy would move on monetary cooperation and, in turn, monetary integration. However, it is suggested that policy cooperation and coordination, especially regarding monetary policy, among East Asian countries are needed as prerequisites for monetary cooperation. Sovereign East Asian monetary authorities need to fully develop their own domestic monetary policy capability before engaging in policy cooperation of any sort. As East Asia deepens its economic integration, policymakers should fully develop weak-form macroeconomic policy cooperation before contemplating formal monetary coordination. Regional policy cooperation might take a flexible and multi-speed approach iii

6 that is endogenous to underlying fundamentals and institutions. Implement Regional Exchange Rate Coordination At the time of the initial step of currency coordination, the monetary authorities should have a common understanding about the interactions between their currencies. This understanding can be achieved by conducting policy dialogue and macroeconomic surveillances by and among the policymakers of the regional countries. Macroeconomic surveillance alone may not be so effective if it is conducted by policymakers acting as representatives of each of the regional countries. It may be desirable that a neutral intraregional institution, which is independent of the governments of regional countries, should prepare for the macroeconomic surveillance by helping the governments deepen their common understanding. It is also recommended to promote macroeconomic policy cooperation prior to formal coordination. Especially for coordinated exchange rate policies among East Asian countries, it is recommended to introduce deviation measurements of each East Asian currency from a weighted average of East Asian currencies, which we will call as Asian Currency Unit (ACU). Create Common Currency Basket as a Common Currency Unit While all the options have pros and cons, a recommendable option to implement stronger regional coordination is to have all the monetary authorities in the region agree on an arrangement to create a common currency unit that consists of a currency basket, named here as the Asian Currency Unit (ACU). The monetary authorities may use the ACU as a convergence criterion according to the European precedent. In addition, the monetary authorities could use their home currencies deviation from the ACU to measure convergence and consider their findings when discussing their exchange rate policies. In addition, the regional currency arrangement whereby regional currencies are all made related to and through the ACU will help avoid a coordination failure in deciding on exchange rate policies and, in turn, prevent a competitive devaluation in the region because the monetary authorities would have jointly committed to the arrangement. The monetary authorities in East Asian countries should first link their own home currencies to the ACU before they turn attention to achieving regional monetary integration. This implies that there is a choice for the monetary authorities to realign the exchange rates of the home currency vis-à-vis the ACU or to stop linking their home currencies to the ACU. The existence of this choice might induce speculative attacks on weaker currencies. Such a possibility makes it recommendable for the monetary authorities to make a strong commitment to link their home currency to the ACU. The strongest commitment is to proceed to monetary integration. Having made iv

7 such a commitment, the monetary authorities of the participating countries would have no option to abandon it. Such a commitment would contribute to the stability of the exchange rate system because private economic agents would build up their confidence in the coordinated exchange rate policy in East Asia. v

8 Table of Contents Executive Summary Tables/Figures/Abbreviations Introduction: Chapter 1. Global Trends of Regional Integration: Patterns, Stages and Sequencings of Economic Integration in the Case of the European Union: 3 (1) FTA and CU (2) Development of Economic Integration in the EU (3) Economic Integration and Cooperation (4) Sequencing of the Stages of Economic Integration (5) Enlargement and Diversity (6) Concluding Remarks 1.2 Another Mega-bloc: North America: (1) Two-track Approach by the United States (2) Effects of NAFTA and FTAA Chapter 2. The Patterns of Integration in Trade and Investment in the East Asia: The Market-led Integration in the East Asia: (1) Increasing Trade Relations in East Asia (2) Market-led Integration in the East Asia 2.2 Regional Trade Arrangement in the East Asia: (1) Why Push Integration Through Institutionalization? (2) Scope for Gains from an FTA (3) Policy Agenda Chapter 3. Financial Integration in the East Asia: Introduction: Literature Review on Financial Integration: Volume-based Approach: (1) Model Specification (2) Estimation Results 3.4 Asset Price Based Approach: (1) Real Interest Parity Test (2) I-CAPM Test 3.5 International Risk-sharing Approach: vi

9 (1) Theoretical Background (2) Decomposing the Ccross-sectional Variance of Shocks to GDP (3) Estimation Results 3.6 Conclusion: Chapter 4. Monetary and Currency integration in East Asia: Analysis of the Macroeconomic Integration: (1) Synchronization of Business Cycle 4.2 Analysis of the Optimal Exchange Rate Regime; Time Series Analysis and Exchange Rate Regimes: (1) A Currency Basket System in East Asia a. Enhanced Trade Competitiveness b. Capital Flow Effects c. GDP Effects (2) A Common Currency Basket System in East Asia a. Linkages of East Asian Currencies to the US Dollar b. Coordination Failure in Selecting Exchange Rate Regimes and a Common Currency Basket System (3) Possibility of a Common Currency Basket System a. Symmetry of Shocks b. Generalized Purchasing Power Parity c. From Trade Integration to Monetary Integration 4.3 Challenges of Regional Monetary and Currency Integration: (1) Surveillance Process for Coordinated Exchange Rate Policy (2) Toward Future Monetary Integration 4.4 Asian Currency Unit (ACU) for Monetary Policy Cooperation in East Asia: (1) Introduction (2) ECU in the European Community (3) Private Use of the ECU (4) The ECU Divergence Indicator (5) Asian Currency Unit: ACU (6) Asian Currency Unit at PPP standard: ACU* (7) ACU* as an Instrument for East Asian Macroeconomic Policy Coordination (8) Longer View vii

10 Conclusions and Policy Recommendations: Ⅰ. Conclusions: Ⅱ. Policy Recommendations: List of Authors: viii

11 Tables Development of the European Economic Integration (Deepening) Common Policies of the EC/EU History of Trade Agreements in North America Exports and Imports of the Region (Amount) Exports and Imports of the Region (Shares in the World) Trade Share and Intensity Indexes of Intra-regional Trade Foreign Direct Investment Intensity Indexes on FDI Outflows of Japan and Korea Gravity Model of Trade Welfare Gains from Various Combinations of FTA 3-1 Panel Estimation of Equation (3-2) 3-2 Real Interest differentials: Pre-crisis and Post-crisis Period 3-3 Stock Exchanges 3-4 Correlation of Stock Market Indices: Jan ~ Oct Correlation of Stock Market Indices: Jan ~ Mar Correlation of Stock Market Indices: Apr ~ Dec Correlation of Stock Market Indices: Jan ~ Oct Correlations of Real GDP per capita: 1991 ~ CAPM Results to Test Financial Market Integration 3-10 Estimated Risk Sharing (Sub-Periods) 3-11 Estimated Risk Sharing (Sub-Groups) Correlation Coefficients Among GDP Growth Rates Optimal Weight for a Currency Basket for East Asian Countries Means and Standard Errors of Estimated and Simulated Values Estimates of Weights on the US Dollar (Daily data) Intervention Correlation Between Japan and Other Selected Countries Symmetry of Aggregate Supply and Demand Shocks Summary of Empirical Analysis on a Common Currency Area Calculation of equivalents for 1 December 1978: Re-composition of the ECU Basket Weight of the currencies in the basket (1) Number of Units of Each Currency Weight of the nine currencies in the basket - PPP standard - ix

12 Figures 3-1 Trends of Foreign Assets and Liabilities/GDP in ASEAN Trends of Foreign Assets/GDP in ASEAN Trends of Foreign Liabilities/GDP in ASEAN Correlation of GDP Growth Rates Between ASEAN Countries 4-2 Correlation of GDP Growth Rates Between ASEAN Countries and China 4-3 Correlation of GDP Growth Rates Between ASEAN Countries and Japan 4-4 Correlation of GDP Growth Rates Between ASEAN Countries and Korea 4-5 Correlation of GDP Growth Rates Between CJKH. 4-6 Movements of ACU, ACU* and East Asian Currencies (1) 4-7 Movements of ACU, ACU* and East Asian Currencies (2) 4-8 Foreign Exchange Rates of East Asian Currencies (Group 1) 4-9 Foreign Exchange Rates of East Asian Currencies (Group 2) 4-10 Foreign Exchange Rates of East Asian Currencies (Group 3) x

13 Abbreviations ACU Asian Currency Unit G-PPP Generalized Purchasing Power Parity AFTA ASEAN Free Trade Agreement/ASEAN Free Trade GTAP Global Trade Analysis Project Area HK$ Hong Kong Dollar AMU Asian Monetary Unit IFS International Financial Statistics BF Belgian Franc IMF International Monetary Fund CAPM Capital Asset Pricing Model IP Irish Pound CET Common External Tariffs JSEPA Japan-Singapore Economic Partnership Agreement CNY Chinese Yuan JPY Japanese Yen CM Common Market KRW Korean Won CPI Consumer Price Index LIB Liberalization Index CU Customs Union LIT Italian lira CUSFTA Canada-US Free Trade Agreement M&A Merge and Acquisition DKR Danish Crown (Krone) MCAP Stock Market Capitalization DM German Mark MLR Malaysian Ringgit ECSC The Coal and Steel Community NAFTA North America Free Trade Agreement ecofins Economic and Finance Ministries NTBs Non-Tariff Barriers ECU European Currency Unit NTD Taiwan Dollar EEC European Economic Community NTM Non-Tariff Measures EEMU European Economic and Monetary Union ODA Official development assistance EFTA European Free Trade Association Open Trade openness EMS European Monetary System Per GDP Per capita GDP EMU Economic and Monetary Union PLP Philippine Pesos EPA Economic Partnership Agreement RIR-J Real Interest Differential to Japan ERM Exchange Rate Mechanism RIR-US Real Interest Differential to U.S. EU European Union SPD Singapore Dollar EV Equivalent Variation SMC Stock Market Capitalization FD Financial Depth TIC Treasury Inter-nation Capital System FD Financial Development TLB Thailand Baht FDI Foreign Direct Investment TW$ Taiwanese Dollar FF French Franc UKL British Pound FTA Free Trade Agreement WTO World Trade Organization FTAA Free Trade Area of the Americas GATT General Agreement on Tariffs and Trade xi

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15 Introduction This report examines the economic integration of East Asia. Economic integration implies various shapes of more intensified international economic relations. Typically, the European Union (EU) has taken more than half a century to deepen, enforce and extend its integration, both economically and institutionally. North America, after the establishment of North America Free Trade Agreement (NAFTA), emerged as another mega regional economic bloc. The economies in East Asia are clearly following a trend of increasingly intensified economic ties among them. However, the economic integration in East Asia has been mainly economy-driven, rather than supported by full-fledged institutional arrangements, which is reflected in the concurrent increase in intra-regional trade and foreign direct investment (FDI). On the other hand, the degree of financial integration within East Asia has increased or even somewhat surpassed that of trade integration. The focuses here are placed on the important linkages among trade, financial and monetary integration in East Asia. At a basic level, higher levels of trade tend to increase the demand for financial instruments and services related to trade, and thus provide a catalyst to more financial liberalization. Financial integration in turn facilitates trade and investment flows through easier access to necessary financing and risk management tools. Monetary integration, either in a loose form of exchange rate coordination or a monetary union, usually brings about price stability and lower risk related to intra-regional trade. As pointed out by the World Economic Outlook of the International Monetary Fund, trade integration is needed to take full advantage of international financial integration, as low trade penetration tends to increase an economy s vulnerability to external financial crisis. To the extent that trade integration can enhance welfare gains and synchronize business cycles, this will also create an incentive for countries to pursue greater intra-regional financial and monetary cooperation in order to take the whole advantage from increased trade. The first chapter of this report consists of historical reviews and literature surveys on the experiences of two prominent examples of economic integration in the world, i.e. the EU and NAFTA. It first examines the stages, phases and sequencing of economic integration, experienced by the EU, as the reference pattern. The experience of the EU is compared to the theoretical proposition of Balassa s five stages. An analysis of NAFTA, the world s largest Free Trade Agreement (FTA), follows in the same chapter. Diversity characterizes NAFTA, in that it comprises one giant country with the highest per capita income, and two other smaller members. A focal point here is how NAFTA has affected the smaller members, particularly Mexico whose economy is still in the economic convergence process. 1

16 The second chapter covers the real-side integration in East Asia, i.e., trade and investment integration. Intra-regional FDI, while representing financial transactions, has played an important role in promoting intra-regional trade through establishing production networks in East Asia. The analysis also focuses on comparison of the degree of trade and investment integration among East Asia, EU and NAFTA. Institutionalization to promote trade and FDI, by means of an FTA or an even wider Economic Partnership Agreement (EPA) will provide scope for further gains. Indeed, the recent political agenda in East Asia appears to be shifting to a higher plane, from economy-driven trade relationships to more institutionally-supported integration, as evidenced by the free trade negotiations between ASEAN andchina and the Framework for Comprehensive Economic Partnership between ASEAN and Japan. The third chapter empirically examines the degree of financial integration in East Asia, by means of three established analytical approaches. Regional financial integration within East Asia is compared to the region s financial integration with the global market as represented by the United States market. The statistical tests also cover the relation between trade openness and the degree of financial integration. This will provide important suggestions on the process and sequencing of economic integration, that may be multi-faceted, rather than single-tracked. The fourth chapter considers monetary and currency integration in East Asia. The first section analyzes the synchronization of business cycles that closely reflects the regional production networks in East Asia. Intensified real-side integration may result in macroeconomic integration. Then, as an optimal exchange rate system, a currency basket system will be reviewed regarding the benefits of stabilization on three aspects, namely, trade competitiveness, capital inflows, and aggregated demand. After these analyses, the conclusion and policy recommendations follow. Emphasis is placed on the empirical facts of the inter-relations among the three dimensions of the integration, i.e., real-side integration, financial integration and monetary (currency) integration. As implied, these three correlate with each other to a considerable extent. Real-side integration may proceed to others, while financial and macroeconomic integration may take place simultaneously with the formation of the production networks. Recommendations also include discussion on the pre-requisites for the implementation of institutional arrangements. 2

17 Chapter 1: Global Trends of Regional Integration 1.1 Patterns, Stages and Sequencings of Economic Integration in the Case of the European Union (1) Free Trade Agreement and Customs Union Economic Integration is, first of all, the gradual elimination or abolition of economic barriers which impede free movement of goods, services, capital and persons among a group of nation states. Today we can distinguish a variety of economic integrations in the world from viewpoints of degree, size and diversity. Concerning the size of Economic Integration, we can separate regional Economic Integration from Global Economic Integration like lowering tariffs in the framework of the rounds under the General Agreement on Tariffs and Trade (GATT) and World Trade Organization (WTO). There are more than 150 regional economic integrations in the world, in which the EU integration, the North America Free Trade Agreement (NAFTA) and the emerging East Asian Economic Integration are the three biggest regional integrations in their economic size. Concerning the degree, Balassa s definition (Balassa [1961]) is well known. According to him, there are five stages of degree of integration: (1) FTA, (2) CU (Customs Union), (3) CM (Common Market), (4) Economic Union, and (5) Total Economic Integration. More specifically: 1) A FTA abolishes intra-regional tariffs and quotas. 2) A Customs Union (CU) not only abolishes intra-regional tariffs and quotas, but also creates common external tariffs (CET). In a CET, the competence to change tariffs moves to a supranational institution like the European Economic Community (EEC) or common agreement of all the member countries. A member country of a CU cannot change tariff rates of the CET. In case of the EU, the European Commission, a supranational body of the Union, negotiates tariffs with member countries of the GATT or WTO. 3) A Common Market is, according to Balassa, a CU which also abolishes restrictions on factor movements. Factor movements include free movement of capital and persons. Though Balassa did not refer to free movement of services, a common market realizes free movement of services, namely free supply and demand of services across the frontiers inside the common market and freedom of establishment of firms supplying services. In order to accomplish free movement of services, they must abolish regulatory barriers; that is, they must harmonize laws related to services. As a definition, a common market is an economic area in which free movement of goods, services, capital and persons (the four freedoms ) is guaranteed. 4) An Economic Union is a CM with some degree of harmonization of national economic policies in order to remove discrimination due to disparities in these policies. 5) The total Economic Integration means, according to Balassa, unification of monetary, fiscal, 3

18 social and counter cyclical policies and setting up of a supranational authority where decisions are binding for the Member States. Concerning the diversity, economic integration between developed countries and developing countries can be diverse due to differences in development levels or other factors and participating countries must deal with the diversity by creating common policies or development funds etc. In the 1960s, there were two types of economic integration in Europe: EEC and EFTA (European Free Trade Association). The EFTA was an FTA and the EEC was a CU with Common Agricultural Policy. The EFTA is still an FTA 45 years after its birth, though the member countries have changed. But the EEC raised its degree of integration from a CU via a Common Market to an Economic and Monetary Union (EMU). This example suggests that choice of an FTA or a CU at an initial stage of Economic Integration is crucial. Tinbergen [1954] distinguished positive from negative integration. A negative integration is related only to elimination or abolition of economic barriers. A positive integration establishes supranational institutions or systems which are responsible for implementing common policies. An economic integration in a real CU is deep and positive. It is deep, because participating countries transfer their competence to manage their tariffs to a supranational institution, namely the CU. When a CU is accomplished, the CU has a common external tariff (CET) as mentioned above. The CET can be managed by the supranational body and the member states cede their sovereign rights to participate in negotiation on tariffs in the GATT/WTO. Only the CU can have power to negotiate with other participating countries belonging to GATT/WTO. The integration is positive, because, adding to elimination of economic barriers inside the CU, a supranational institution was created and common commercial policy was implemented by the CU. A real or standard CU is rare in the world. For example, MERCOSUR in South America names itself as a common market or a CU. But it has no supranational institution. Top politicians of the participating countries have decided how and when tariffs are eliminated or what products were exceptions in a tariff elimination program, and so on. MERCOSUR is similar to the AFTA (ASEAN Free Trade Agreement), rather than the CU in the EEC. Economic integration in an FTA is shallow and negative. It was called negative integration, because an FTA does not create a supranational body and only eliminates tariff barriers and quotas. It is shallow, because participating countries do not lose their sovereignty over external tariffs. An FTA has never developed into a CU in the past. Choosing an FTA or a CU depends on the political will of participating countries and what they want to realize by the integration. 4

19 (2) Development of Economic Integration in the EU The Economic Integration of the European Union did not necessarily follow the Balassa scheme of the five stages. The Economic Integration began with creation of the Coal and Steel Community (ECSC) on the basis of Paris Treaty in The ECSC was a supranational institution, hence it was a positive integration. But the Community embraced only the coal and steel sectors. In 1958, the ECSC developed into the EEC created by the Rome Treatyn signed in The EEC accomplished a CU and Common Agricultural Policy at the end of the 1960 s. This is the first half of the history of the European Economic Integration, where a member nation state kept total control over its national macro-economy. With a transition to the era of globalization, the EU made headway to the latter half history of its Economic Integration. What the EU wanted to do in the latter half was to create an EU-wide national economy which includes national economies of the member countries. What the EU has realized since 1985 in the common market and the European Economic and Monetary Union (EEMU) is the four freedoms and the Single Currency, both of which are major characteristics of a national economy. After the long stagnation of the economic integration process in the 1970 s and the first half of the 1980 s, the EU began to create a common market in face of the challenges of American and Japanese industries to the European economy. The new phase of the Economic Integration was led by the intelligent European president, Jacques Delors, led the EC to complete the internal market integration by The Single Market integration began in 1985 to abolish all non-tariff barriers to realize free movement of goods, services, capital and persons. This epoch-making integration succeeded and the single market started in The EU made further headway by the introduction of the Single Currency, the euro, in the late 1990s. There are three likely, basic, reasons for the integration to go further: completing a true single EU market, the German problem, and the threat of globalization. Different currencies fragmented the Single Market by diversified foreign exchange rates movements inside the Market. The slogan of the monetary integration, one market, one money, shows why the common market had to go further to the Single Currency regime. In order to integrate the unified Germany in the EU system, the EU countries wanted Germany to give up its own currency. Germany accepted the demand in order to create a stable European order around the EU after the demise of the cold war. In this sense, the monetary integration was political in nature. Countervailing against U.S.-led globalization is a continuation of the will of Europeans since 1980 s. The euro was introduced in 1999 in non-cash form and then the cash was introduced in Europeans call the Single Market plus the Single Currency regime the European Economic and Monetary Union (EEMU). In the EEMU, the European Central Bank issues the euro and implements monetary policy for the euro area. The euro became legal tender in March 2002 among the twelve countries of the EU. With the accomplishment of the monetary integration, the Economic 5

20 Integration of the EU was fundamentally completed. The monetary integration looked to be too challenging for several countries. Great Britain, Sweden and Denmark do not participate in the Single Currency regime, preferring to retain control of their own monetary policy. Table shows how the European Economic Integration deepened during the past half century. Table Development of the European Economic Integration (Deepening) Decade Institution Integration & common policy Remarks 1950s ECSC Coal and Steel Community Paris Treaty of s EEC EC CU Agricultural policy (CAP) Rome Treaty of 1957, CU accomplished in EC since Competition policy 1970s EC Commercial (Trade) policy Monetary Cooperation 1980s EC From CU to Common (Single) Market Single Market formation by Single European Act of s From EC to EU Strengthened common policies in Single Market. Monetary integration and Single Currency, EURO. Single Market started in EU started in 1993 based on Maastricht Treaty of EURO was introduced by 11 countries in s EU EURO became legal tender in Constitution Treaty of 2004 EURO circulated in 12 countries since Political integration to the fore (Source) Various documents Compared with Balassa s definition, there are several differences in the case of the EU s experience. The EU introduced a supranational institution at the beginning stage of the integration (accordant to Balassa s scheme, it is introduced at the end stage of integration). The EU started from the CU, not an FTA. Balassa s last stage is based on a vision of a unitary state, but the EU is far from such a centralist image. The EU did not unify fiscal, social and countercyclical policies, but unified only monetary policy. Nor has the EU become a federal state. It is a mixture of a confederation and federation and is very hard to imagine that the EU will be a federal state in the future. (3) Economic Integration and Cooperation In the EU, economic cooperation supplemented the integration. In order to promote 6

21 Economic Integration, the EU needed a treaty and the treaty had to be ratified by all of the member countries. If unanimous ratification is not likely to be reached, a group of countries, if they want to advance further, can have recourse to cooperation. A remarkable example is the EMS (European Monetary System). The EMS was a successor to the Currency Snake of the 1970 s, which failed because of several conflicts between Germany on the one side, and France, Italy and the UK on the other side, and it became at last a small German Mark zone. The EMS was created under Franco-German leadership. The US dollar fluctuated violently and thereby introduced economic confusion into the EC. Germany and France took the lead in creating a fixed exchange rate regime in the EC. The UK did not participate and there were objections to such an ambitious attempt in the other countries as well. In December 1978, the EMS could start by a mere resolution of EU governments to make the EC a zone of monetary stability, which meant a zone which could stabilize foreign exchange rates within the EMS. The central banks of the eight EC countries concluded the Basel Accord and the EMS started in March The Exchange Rate Mechanism (ERM) of the EMS was a block floating regime. Inside the ERM, the participating currencies pegged their exchange rates to the central rates. The central rates were decided by all participating countries considering the competitiveness of each currency (so-called parity grid system ). The fluctuation margin permitted to each of the currencies was plus or minus 2.25% around the central rates. The central banks intervened in the foreign exchange market when the two currencies reach the fluctuation margin. They sold the strong currency against the weak currency The participants could change their central rates in order to adjust their inflation differentials. When more than three currencies were included in the realignment, all of the finance ministers and central bank presidents had to meet to decide how the realignment should be done. Such a consultation mechanism worked as a de facto surveillance regime and the peer pressure pushed the countries to take stability-oriented monetary and fiscal policy. After the French socialist government decided to adopt a stability-oriented monetary policy of the German type in 1983, the EMS succeeded in bringing about monetary stability in the EU. From the start of the ERM to 1987 there central rate realignments in the EMS on 11 occasions. During this period, the French franc, for example, lost about 30% against the German mark. After February 1987, there was no central rate realignment among the core countries of the EMS. This shows that the EMS achieved success at the end of the 1980 s. The EMS was, however, attacked in 1992 and 1993 by hedge funds led by George Soros. The speculators sold heavily weak currencies vis-à-vis the mark. In September 1992, Italy and the UK, which participated in 1990, left the ERM. Though the central banks sold the mark, the speculators could buy the strong currency at the 2.25% margin as much as they wanted. This is the 7

22 so-called one-way-bet speculation. The high-powered money overflowed in the German money market so much that the authorities could not maintain the narrow fluctuation margin. In August 1993, the participating countries decided to widen the fluctuation band from plus or minus 2.25% to plus or minus 15% around the central rates. The wider margin made it impossible for speculators to get profits from one-way-bet speculations. The EMS recovered stability and the central banks could again steer their currencies in the narrow band of plus or minus 2.25% around the central rates after The stability of the EMS after 1996 became an essential base for the EU to move forward to the monetary integration. Economic cooperation is an instrument with which the EU governments can handle the diversity of the participating countries. Cooperation can be done by a group of countries that want to promote de facto Economic Integration. The experience of the EMS tells us that skillful cooperation is much better than bad integration. Economic cooperation will surely be able to play a crucial role in East Asia, because cooperation can proceed in some cases without any formal treaty or agreement. (4) Sequencing of the Stages of Economic Integration Balassa s five stages scheme suggests that economic integration begins with trade integration (FTA and CU), and then deepens gradually to abolition of Non-Tariff Barriers (NTBs) in the process of common market building. The integration moves further to common policy building, and other economic integrations in the macro-economic field. The monetary integration comes at the end of the process. It is reasonable to believe that economic integration begins with elimination of customs barriers and quotas, which enables the share of intra-regional trade in the total trade of each country to increase. The trade integration increases economic interdependence of member countries in the region, which will attract their attention and stimulate their interest in common actions towards economic shocks. In the case of the EU, the share of intra-regional trade increased from about 35% to about 50% during the EU s period of establishing its customs union, i.e., from 1958 to In the history of the EU, monetary integration is realized at the last stage in accordance with the Balassa s definition. However, we should not forget that the EU began monetary cooperation in the 1970 s, when the EC was faced with the instability of the dollar rate vis-à-vis West European currencies. In , the EC began to cooperate in the area of foreign exchange policy in order to solve the instability problem. The EC s six member countries launched the idea of Economic and Monetary Union based on the Werner Report of 1970, yet they failed in stepping into an Economic and Monetary Union in Hence, they began to cooperate in a foreign exchange rate accord (the so-called Snake ) which started in April Then new countries sought to become members, and were approved to participate in the EC in 1973 (the UK, Denmark and Ireland). 8

23 How to successfully defend the regional trade networks and related production networks is always a top priority for the member states participating in a regional integration regime, once the intra-regional trade share reaches a crucial level, such as 50% in the example of the EU. Therefore, it will be reasonable to predict that the regional integration partners in East Asia will be obliged to promote monetary cooperation in the near future. Regarding the ASEAN, it is still unlikely to realize an independent monetary cooperation framework, since the share of intra-regional trade is only about 20%. However, if we take up the ASEAN+Three, then the share is up to as much as 50%, which is equal to the level of the EC at the beginning of the 1970s. Since the ongoing FTA establishment in East Asia will increase the share of intraregional trade among the ASEAN+Three, this area will be further eligible to foreign exchange rate cooperation. An FTA or a CU creates an environment where the members promote monetary cooperation. When trade barriers are eliminated in a FTA or a CU, the foreign exchange rates of this region will affect the competitiveness of each member country. Hence, the foreign exchange rate stability inside the region becomes more important than before, and orderly adjustments of the foreign exchange rates will become essential. The previous analysis implies that economic interdependence and trade integration are the necessary conditions for regional monetary cooperation. (5) Enlargement and Diversity The number of member countries of the EU increased from 6 to 25 through the five enlargements that have taken place to date. Ireland became a member in 1973 and Greece in Spain and Portugal participated in The membership of these four developing countries caused the EU to encounter a diversity problem in the presence of both the core and the peripheral countries. Besides, there was another diversity problem, that of the highly industrialized countries and countries with high share of agriculture in terms of employment and the percentage over GDP. The EU has handled these diversity problems by adopting several measures. First of all, common policies were oriented towards the diversity problems. Table 2 shows the common policies of the EU according to three functions of public policy: allocation, redistribution and stabilization of a national economy. The second column, redistribution, is related to the diversity problems of the EU. Common Agricultural Policy (CAP) developed to integrate complicated agricultural regimes of each country into a common regime. One of its main objectives was to keep a fair living standard for farmers in comparison with urban workers. 9

24 Table Common Policies of the EC/EU Allocation Redistribution Stabilization 1960 s Competition policy Agricultural policy 1970 s Commercial policy Regional policy Monetary cooperation 1980 s Above policies strengthened R.P. strengthened EMS 1990 s Industrial policy Cohesion policy EMS to EEMU (Source) Summarized by Author Moreover, regional policy or structural policy was oriented so as to directly support the poor regions of the EU. In the poor regions, where per capita income is less than 75% of the EU average, the EU transfers funds of the EU budget to such poor regions or structural-decline regions. However, the member states and regional authorities need to develop structural programs to be eligible to get money from the EU. Cohesion policy is oriented to develop infrastructure and environmental facilities in the four developing countries: Ireland, Greece, Spain and Portugal. Therefore, in order to tackle diversity problems in East Asia, common policies or cooperation for the sake of redistribution should also be designed to include agriculture. The official development assistance (ODA) from the wealthier countries should be reorganized and distributed more efficiently for the sake of integration partners. The second measure to tackle diversity problems is to design integration methods to concede handicapped positions to peripheral countries. In the EU, in this connection, they refer to multi-speed Europe, variable geometry or flexibility. In the ASEAN, special treatments are allowed for the three new members in Indochina. Appropriate methods of economic integration should be developed. (6) Concluding remarks Liberalization or market forces are not enough to tackle diversity problems in an integrated region. They tend sometimes to worsen the diversity problems. If the benefits of the economic integration are absorbed by a country or a small group of countries, the economic integration cannot proceed smoothly because of the resistance of the others. To design an integration regime where every member country can share the benefits of the economic integration is crucial. The success of the EU Economic Integration suggests that the benefits are not necessarily distributed evenly to every member country. Common policies or other appropriate methods of integration must ensure that every country gets benefits of the integration equally. Some European experts on Economic Integration commented that it would be better to implement a FTA well than a CU badly. There are two comments that need to be made here about the current economic integration 10

25 in East Asia. Firstly, there are too many FTAs in East Asia. We need to consider how so many FTAs will be integrated into only one: the ASEAN + Three FTA. Secondly, the members are currently building not mere FTAs but a FTA+s (FTA pluses). An EPA (Economic Partnership Agreement) is a kind of FTA+, namely FTA plus the facilitation measures for customs duty, some movement of persons or the opening of government procurements etc. Moreover, in the near future, we will be able to include in these monetary cooperation, environmental policy cooperation, common development of oil resources in East Asian Sea, etc. Besides, people have started to discuss the construction of high-speed railway networks and making better use of the ODA funds for developing East Asian countries. How to devise the ways to add such a plus to an FTA will be an original contribution of the Economic Integration and cooperation in East Asia. If we consider seriously about the East Asian Community during the process of the Economic Integration, a plus will be even more important than a simple FTA in the future. References Balassa, Bela (1961), The Theory of Economic Integration, Irwin, Homewood, Illinois. Pelkmans, Jacques (2001), European Integration. Methods and Economic Analysis, 2 nd ed., Pearson Education. Tanaka, Soko (1991), The Completing the Internal Market and Reorganization of Europe, Toyo Keizai Shimposha (in Japanese). Tanaka, Soko (1996), The European Monetary System, Yuhikaku (in Japanese). Tinbergen, Jan (1954), International Economic Integration, North-Holland. Yoshitomi, Masaru (2003), Reality of Asian Economy, Toyo Keizai Shimposha (in Japanese). 11

26 1.2 Another Mega-bloc: North America (1) Two-track Approach by the United States Since the mid-1980s, regional integration agreements took place along with multilateral trade liberalization. 1 Regional integration agreements have proliferated because the United States shifted her trade agenda toward to a two-track approach, resorting to regional integration agreements as a way to achieve trade liberalization. Against this background, the North American Free Trade agreement (NAFTA) was made, superseding the Canada-U.S. Free Trade Agreement (CUSFTA) when Mexican entry was ratified by all three countries. This chapter provides a simple assessment of the effects of NAFTA, compared to EU, with special emphasis on trade patterns. The NAFTA came into effect on January 1, Its passage through the United States Congress was surprisingly contentious when it was finally brought forward for ratification in the fall of In fact, the United States has been the major trading partner of both Canada and Mexico for many decades and Canada and the United States have had free trade arrangements since the mid 1960s. The United States and Mexico began building a cooperative trading relationship in the mid 1980s (Table 1-2-1). Nonetheless, NAFTA was created from two bilateral relationships that exist between United States and Canada and between the United States and Mexico, respectively. The bilateral relationship Canada and Mexico is not as important quantitatively and qualitatively as the other two. This is primarily due to the fact that the U.S. economy dominates those of Canada and Mexico and therefore serves as the hub in a hub-and-spoke relationship based as much on economic realities as on geography. 1 The analysis in this part benefits from Li and Li (2002). 12