emerging financial ri sks in east asia · 2015. 1. 21. · edited by doo yong yang edited by doo...

Edited by Doo Yong Yang

Edited by Doo Yong YangEm

erging Financial Risks in East Asia

Korea Institute for International Economic PolicyPolicy Research Institute Ministry of Finances, Japan

KIEP�PRI

Price USD 7

300-4 Yomgok-dong, Seocho-gu, Seoul, 137-74, KoreaTel. (822) 3460-1114, Fax. (822) 3460-1122URL: http://www.kiep.go.kr

The Korea Institute for International Economic Policy (KIEP) was founded in1990 as a government-funded economic research institute. It is the world’s leadinginstitute on the international economy and its relationship with Korea. KIEP advisesthe government on all major international economic policy issues, and also serves as awarehouse of information on Korea’s international economic policies. Further, KIEPcarries out research for foreign institutes and governments on all areas of the Koreanand international economies.

KIEP has highly knowledgeable economic research staff in Korea. Now numberingover 100, our staff includes research fellows with Ph.D.s in economics frominternational graduate programs, supported by more than 40 researchers. Our staff’sefforts are augmented by our affiliates, the Korea Economic Institute of America (KEI)in Washington, D.C. and the KIEP Beijing office, which provide crucial and timelyinformation on the local economies. KIEP has been designated by the government asthe Northeast Asia Research and Information Center, the National APEC StudyCenter and the secretariat for the Korea National Committee for the Pacific EconomicCooperation Council (KOPEC). KIEP also maintains a wide network of prominentlocal and international economists and business people who contribute their expertiseon individual projects.

KIEP continually strives to increase its coverage and grasp of world economicevents. Expanding cooperative relations has been an important part of these efforts. Inaddition to many ongoing joint projects, KIEP is also aiming to be a part of a broad andclose network of the world’s leading research institutes. Considering the rapidlychanging economic landscape of Asia that is leading to a further integration of theworld’s economies, we are confident KIEP’s win-win proposal of greater cooperationand sharing of resources and facilities will increasingly become standard practice in thefield of economic research.

Kyung Tae LeePresident

300-4 Yomgok-Dong, Seocho-Gu, Seoul 137-747, KoreaTel: 02) 3460-1114 / FAX: 02) 3460-1122URL: http//www.kiep.go.kr

Price USD 7

KOREA INSTITUTE FOR

INTERNATIONAL ECONOMIC POLICY (KIEP)

300-4 Yomgok-Dong, Seocho-Gu, Seoul 137-747, Korea

Tel: (822) 3460-1178 Fax: (822) 3460-1144

URL: http://www.kiep.go.kr

Kyung Tae Lee, President

Conference Proceedings 06-04

Published December 29, 2006 in Korea by KIEP

ⓒ 2006 KIEP

Cover designed by Jae Yong Lee

List of Participants

Kyung Tae LeePresidentKorea Institute for International Economic Policy (KIEP)

Doo Yong YangDirector Korea Institute for International Economic Policy (KIEP)

Jonghwa ChoSenior Research FellowKorea Institute for International Economic Policy (KIEP)

Yonghyup OhAssociate Research Fellow Korea Institute for International Economic Policy (KIEP)

Deok Ryong YoonResearch Fellow Korea Institute for International Economic Policy (KIEP)

Jongwha LeeProfessor Korea University

Yung Chul ParkChairman & Professor Public Fund Oversight Committee & Seoul National University

Zhang BinVice Director IWEP

Masatake NishimuraExecutive Vice President Policy Research Institute (PRI)

Naoyuki YoshinoSpecial Research Fellow & Professor Policy Research Institute (PRI) & Keio University

Yuri Sasaki Associate Professor Meiji Gakuin University

Kentaro IwatsuboSpecial Research Fellow & Assistant ProfessorPolicy Research Institute (PRI) & Hitotsubashi University

Nobuhiro HayashiDeputy DirectorPolicy Research Institute (PRI)

Shunji KarikomiEconomistPolicy Research Institute (PRI)

Foreword

Unprecedented economic recovery in East Asia since the financial crisis reveals the great potential for economic development for the coming decades. Even though several economies in the region seriously suffered from the crisis, most countries in the region have shown robust economic growth, and cast no doubts on the prospect for future strong economic growth. Nevertheless East Asia is currently facing serious challenges for future prosperity. The issue of the global imbalance influences countries’ macroeconomic policies and structural reform in most East Asian countries. Many causes of the global imbalance have been suggested, but it seems like there is no clear consensus on the main cause of the global imbalance. As a consequence, there is no clear solution. However, the potential devastating effect of an imbalance adjustment in East Asia is so clear that the real and financial sector in the regions could suffer from the depreciation of the U.S dollar and a global scale liquidity drain.

Moreover, the exchange rate management in East Asia have also been scrutinized, and the appreciation of regional currencies has been suggested as a partial solution for the global imbalance. It has been alleged that East Asia’s prolonged, large-scale exchange rate intervention prevents East Asia’s currencies from appreciating against the US dollar. The undervalued currencies are said to underpin an export-led economic strategy that produces economic and employment growth. Exchange rate management in the region is under great debate, as it is seen as one way to solve exchange rate risk exposure and reduce global imbalances. China recently announced that it is adopting a basket of currencies as the peg for its exchange rate instead of the US dollar. This change raises questions of East Asian’s exchange rate management or regimes, and how to respond to this change. It is not clear whether this is an opportunity or threat in East Asia.

Related to the exchange rate movements, higher interest rates in the U.S. have also adversely affected East Asian economies. In general, upward movements in US interest rates triggered a number of emerging market crises in the 1980s and 1990s. Two risk factors are worthy of note

in this regard. First, higher capital gains on US assets attract capital, thus reversing international capital flows. Increasing uncertainty combined with declining international liquidity and weakening currency conditions increase the volatility of capital in emerging markets. It also increases risk premia and therefore increases the cost of capital. Second, higher interest rates globally may decrease global consumption spending, hence reducing external demand for East Asian exports. Since investment and consumption in East Asia have been sluggish, such risks may accelerate financial vulnerability in the region.

Against this background, this year’s joint project by the Korea Institute for International Economic Policy (KIEP) and the Policy Research Institute (PRI) tries to identify major financial risks in East Asia and provide comprehensive analyses and policy implications and recommendations. Identifying important policy issues and engaging in rigorous academic research have been the major goals of the KIEP and PRI project since 2003. Likewise, the KIEP and PRI project successfully conducted the previous projects such as “Financial Development and Integration in East Asia” and “Financial Interdependence and Exchange Rate Regimes in East Asia.”

We would like to acknowledge the efforts of KIEP to organize the conference of the project. The 3rd KIEP-PRI seminar was successfully held in Shilla Hotel of Jeju island in Korea on January 12, 2006. We are particularly grateful to Kwon Sik Kim, Jun Hui Lee, Phillip Lee, and Jungwoon Kim for their excellent assistance. We also thank the paper authors, discussants, and other participants who contributed to the conference.

Kyung Tae Lee Shigeki MorinobuPresident PresidentKorea Institute for Policy Research InsitituteInternational Economic Policy

Contents

List of Participants 3

Foreword 5

Introduction 13

Theme 1. Current Capital Flows and Related Risks in East Asia

1. Determinants of Korea’s Capital Outflows 232. Capital Inflow under the Fear of Sudden Stop

－ Which Currency Regime is Optimal for the Asian Countries?

46

Theme 2. China’s New Exchange Rates Regimes and its Implication to East Asia

3. Global Imbalances and East Asia’s Policy Adjustments 694. China’s Reform on Exchange Rate System and International

Trade between Japan and China 92

5. Consequences of Real Exchange Rate Misalignment: the Case

of China 111

Theme 3. Too Much or Too Less: How to Stimulate PrivateSectors in East Asia

6. Financial Crisis and Domestic Investment in East Asia137

7. The Small Business Financing and the Development of the

Bond Market in Asia 167

List of Tables

1. Determinants of Korea’s Capital OutflowsTable 1. Total investment made by Korean investment companies 26Table 2. Summary Statistics 34Table 2-1. Statistics based on the sample on FDI: 1990-2004 34Table 2-2. Statistics based on the sample on bank loans: 1990-2004 34Table 3. Gravity Equation for Trade 35Table 3-1. Panel data for 1990-2003. 35Table 3-2. Panel data for 2000-2004. 36Table 4. Gravity Equation for FDI 38Table 4-1. Basic Model 38Table 4-2. Including Trade as an Explanatory Variable 39Table 5. Gravity Equation for Bank Loans 41Table 5-1. Basic Model 41Table 5-2. Including Trade as an Explanatory Variable 42

3. Global Imbalances and East Asia’s Policy AdjustmentsTable 1. International Reserves of East Asia, 1999-2005 70Table 2. Reserve Build up, 2000-2005 71Table 3. Current Account Surpluses of Ten East Asian Economies

72Table 4. Bilateral trade balances of US with East Asian economies,

2000-2005 73Table 5. Selected Fiscal Indicators 83Table 6. Short-term real interest rates 84

4. China’s Reform on Exchange Rate System and International Trade between Japan and ChinaTable 1. Japan’s trade with China(by types of goods) 99Table 2. Production cost structure of digital camera A 102Table 3. Japan’s trade specialization coefficient with China by items

104Table 4. Japan’s import functions by industry (Trade from China to

Japan) 108Table 5. Japan’s export functions by industry (Trade from Japan to

China) 108

5. Consequences of Real Exchange Rate Misalignment: the Case of ChinaTable 1. Difference in Growth Rate (%) of Agriculture, Industry and

Service in China 115Table 2. Decomposition of Growth in Industry and Service 117

6. Financial Crisis and Domestic Investment in East AsiaTable 1. Global Effects of Increased Financial Risks on Investment

159Table 2. Global Effects of Increased Financial Risks on Real GDP

160Table 3. Actual V.S. Simulated Changes in Investment Rates 161Table 4. Real Interest rates in East Asian Economies 162Table 5. Selected Fiscal Indicators in East Asian Economies 164

7. The Small Business Financing and the Development of the Bond Market in AsiaTable 1. Value of Shipment in Manufacturing 167Table 2. Productivity Index (Whole Industry) 168Table 3. Corporate Bankruptcies 174Table 4. Change in start-up and closure rates [enterprise-based] 176

List of Figures

1. Determinants of Korea’s Capital OutflowsChart 1. Korea’s Total FDI Inflows and Outflows 28Chart 2. Korean FDI outflows by recipient countries 28Chart 3. Total amount of claims made by Korean banks 29Chart 4. Korean bank claims by major recipient regions 30

2. Capital Inflow Under the Fear of Sudden StopFigure 1. Exchange rates of Asian currencies against US dollars 51Figure 2 Change Rates of Ren Min Bi against US dollar and Japanese

Yen 51Figure 3. Change Rates of Korean Won against US dollar and

Japanese Yen 52Figure 4. Change Rates of Indonesian Rupia against US dollar and

Japanese Yen 52Figure 5. Change Rates of Singaporean Dollar against US dollar and

Japanese Yen 53Figure 6. Change Rates of Philippines Peso against US dollar and

Japanese Yen 53Figure 7. Change Rates of Thai Baht against US dollar and Japanese

Yen 54Figure 8. Change Rates of Malaysian Ringitt against US dollar and

Japanese Yen 54Figure 9. Capital Balance in Thailand 56Figure 10. Capital Balance in Hong Kong 56Figure 11. Capital Balance in China 57Figure 12. Capital Balance in Singapore 57Figure 13. Capital Balance in Korea 58Figure 14. Capital Balance in Philippines 58Figure 15. Capital Balance in Malaysia 59Figure 16. Capital Balance in Indonesia 59Figure 17. Components of Other Investments in Thailand 60

3. Global Imbalances and East Asia’s Policy AdjustmentsFigure 1-A. Real Effective Exchange Rate 78Figure 1-B . Real Effective Exchange Rate(ASEAN 4) 78Figure 2-A. CPI Inflation: China. Japan, Korea 86Figure 2-B . CPI Inflation: Hong Kong and Singapore 86Figure 2-C . CPI Inflation: Malaysia, Indonesia, Philippines and Thailand

87Figure 3-A. Nominal Exchange rate and NDF forward (6 months) in

China 87Figure 3-B. Nominal Exchange rate and NDF forward (6 months) in

Taiwan 88Figure 3-C. Nominal Exchange rate and NDF forward (6 months) in

Korea 88

4. China’s Reforms on Exchange Rate System and International Trade between Japan and ChinaFigure 1. Daily RMB/USD rate in 2005 94Figure 2. Monthly JPY/RMB rate 95Figure 3. Japan’s trade with China 97Figure 4. The share of trading partners of Japan 97Figure 5. Share by countries trading with China 98Figure 6. Japan's FDI to China 100Figure 7. Production process and division of function for digital camera

A 101Figure 8. Comparison of an export unit price and an import unit price

of the same item in trade with China 105

5. Consequences of Real Exchange Rate Misalignment: the Case of ChinaFigure 1. RMB Nominal Effective Exchange Rate, Real Effective Exchange

Rate and USD Nominal Effective Exchange Rate 112Figure 2. Tradables and Nontradables Sectors 127

6. Financial Crisis and Domestic Investment in East AsiaFigure 1. Growth Rate of GDP in East Asia, 1990-2005 139Figure 2. Investment Ratios in East Asia, 1990-2005 145Figure 3. Real Stock Price Index in East Asia, 1990-2005 151

7. The Small Business Financing and the Development of the Bond Market in AsiaFigure 1-1.New Product Development’s Effect on Employment Growth

(1998-2002) (Manufacturing) 169Figure 2. Loans by Domestically Licensed Banks 171Figure 2.1 Loans growth 171Diagram 1. Economic Cycle and SME loans. 172Figure 3. Corporate Bankruptcies 175Figure 4. Bankruptcies Debts 175Figure 5. Share of Loans 177Figure 6. Supplementary Role of Government financial Institutions 178Diagram 2. 178Diagram 3. 179Diagram 4. 179Diagram 5. JASME Securitisation of Loans 180Diagram 6. High Risk /Start-up 181Diagram 7. 182Diagram 8. 182Diagram 9. 183Diagram 10. 183Diagram 11. Securitization of SME Loans 188Diagram 12. Multi-surrency Revenue Bonds 189

Introduction

Doo Yong Yang

The economic consequences from the Asian crisis have been enormous. East Asia had experienced unprecedented economic slowdown, causing a sharp decline in living standards, rising unemployment, industrial breakdown, and social dislocation. After realizing the huge negative impacts from the system crisis in the region, there have been tremendous efforts on preventing future crisis since 1997, including structural reforms for each country and regional monetary and financial architecture in the regional level. Even though all these efforts contributed to economic recovery, no one is convinced that the current economic conditions are good enough to induce stable long-term growth. Since the Asian crisis, there has been a series of economic changes in the region. If we examine these changes, it seems that financial risks in East Asia still remain and have recently been increasing.

First, capital flows in East Asia have changed and do not seem to be healthy. There has been a significant structural change in capital flows in East Asia. East Asia is no longer an import region due to huge current account surpluses followed by rapid accumulation of foreign reserves. Since foreign reserves should be invested into more liquid and safer financial assets, most foreign reserves in East Asia go to the most developed capital markets. Such capital flow results in raising financial vulnerability in the region. Investment from advanced economies in the region is concentrated on risky assets, which can induce a sensitive response to even a slight increase of risk, regardless of huge foreign reserves in the region. It also creates a vicious cycle. To reduce this risk, East Asia is accumulating more foreign reserves and importing more risky capital flows. It is worthy to note that steady current account surpluses are critical for continuing growth of foreign reserves. However, it would further increase the overseas liabilities of the U.S. This in turn would lead to bigger risks to the international financial market when the U.S. attempts to manage the increasing risk of global imbalance from

14 Emerging Financial Risks in East Asia

increasing current account deficit by depreciating the US dollar or appreciating East Asian currencies.

Second, related to capital flows in the region, exchange rate management in East Asia face a great challenge. It has been alleged that East Asia’s prolonged, large-scale exchange rate intervention prevents East Asia’s currencies from appreciating against the US dollar. The undervalued currencies are said to underpin an export-led economic strategy that produces economic and employment growth. Exchange rate management in the region are in the midst of a great debate, since management is seen as one way to solve exchange rate risk exposure and reduce global imbalances. China recently announced that it is adopting a basket of currencies as the peg for its exchange rate instead of the US dollar. This change raises questions of East Asian’s exchange rate management or regimes, and how to respond to this change. It is not clear whether this is an opportunity or threat in East Asia.

Third, higher interest rates in the U.S. have also adversely affected East Asian economies. In general, upward movements in US interest rates triggered a number of emerging market crises in the 1980s and 1990s. Two risks factors are worthy of note in this regard. First, higher capital gains on US assets attract capital, thus reversing international capital flows. Increasing uncertainty combined with declining international liquidity and weakening currency conditions increase volatility of capital in emerging markets. It also increases risk premia and therefore increases the cost of capital. Second, higher interest rates in a global scale may decrease global consumption spending, hence reducing external demand for East Asian exports. Since investment and consumption in East Asia has been sluggish, such risks may accelerate financial vulnerability in the region.

Against this background, this year’s joint project by the Korea Institute for International Economic Policy (KIEP) and the Policy Research Institute (PRI) tries to identify major financial risks in East Asia and provide comprehensive analyses and policy implications and recommendations. Identifying important policy issues and carrying out rigorous academic research on these issues have been the major goals of the KIEP and PRI project since 2003. Likewise, the KIEP and PRI project successfully conducted previous projects such as “Financial Development and Integration in East Asia” and “Financial Interdependence and Exchange Rate Regimes in East Asia.”

This proceeding is the final outcome of the 3rd KIEP and PRI project.

Introduction 15

The issues are related to the financial risks in East Asia, recently discussed in policy and academic circles. There are 7 papers in this volume, which can be classified into three different themes as follows.

Theme 1. Current Capital Flows and Related Risks in East Asia

This theme describes current capital flows in East Asia and identifies and evaluates related risks from possible capital reversal. Since the Asian crisis most countries in the region have accelerated the further opening of capital markets. As a consequence, capital flows in the region have increased, and risks from volatile capital movements have also enlarged. Amidst such a circumstance it is quite important to identify potential risks and policy tools to handle potential capital reversals in the region.

In chapter 1, Yonghyop Oh and Kwanho shin investigate the economic determinants of Korea. They find that Korea has relatively intensive trade exchange with countries in East Asia. However, Korea’s preference for North American market as the destination of its capital outflows to a great extent surpassed the level of preference over East Asian countries. Moreover they find that the dependency of Korean economy on North American market has decreased relatively, while the dependency on East Asian market increased. Korea’s high dependency on North America in the financial transactions suggests the persisting vulnerability of Korea’s financial market towards external shocks. It seems that the current trade and capital flows of Korea and East Asia is the root cause of global imbalance. Most East Asian countries have experienced current account surplus with the U.S. and have invested the capital earned by trade in the U.S. As a result of this structure, exchange rate adjustment has been impeded.

Yuri Sasaki in chapter 2 examines the optimal currency regime under the volatile capital movements which can bring the risk of a sudden stop. The author reviews the recent studies on capital flows and exchange rate regime, and shows the recent movements of exchange rates and capital flows in selected East Asian countries. She also empirically estimates the capital flows in those countries based on the push and pull model. She finds relative flexibility of exchange rates in East Asian countries except for countries which adapt the fixed exchange rate regime. She also finds that the variance of the Japanese Yen is negatively correlated with the capital inflows in the region. This finding


is so important to determine the potential stability of capital flows in the region. If there is volatility in the Japanese Yen due to the adjustment of global imbalance in the future, we could suspect the volatile movements of capital in the region.

In chapter 3, Yung Chul Park succinctly analyzes the current economic environment in East Asia which is quite relative to the issue of global imbalance, and provides policy recommendations. He insists that the sterilization of surpluses originating in both the current and capital accounts has kept most East Asian currencies undervalued, and the cost of higher reserve holdings is increasing. In order to rebalance the global imbalance, he argues that East Asia as a whole needs to embrace a more domestic demand based growth strategy. In this regard, Japan should be prepared to absorb more goods and services not only from the U.S but also from other East Asian countries. In addition, he insists that there is a need for a collective exchange rate policy in East Asia, since there is generally little room for fiscal and monetary policies to boost domestic demand in the region, and that Japan and China should provide leadership for any collective policy actions and cooperation.

Theme 2. China’s New Exchange Rates Regime and its Implication to East Asia

China’s current adoption of the BBC regime is the most important change in exchange rate management in East Asia. The questions on this issue are whether it is more beneficial to East Asia if the Chinese renminbi will gradually increase its flexibility or undergo one big change in its value, and whether it would be advantageous to other East Asian countries if they were all to adopt a similar arrangement. In addition, it is worthy to note how current changes in China’s exchange rates regime affect East Asian economies. We have two papers on this issue.

First, Kentaro Iwatsubo and Shunji KariKomi, in Chapter 4, explores the impacts of exchange rate movements on trade between Japan and China, with special attention to differences of pricing structure of international trade across industries. They find that Japan and China become large trade partners for both and their trade pattern transformed from inter-industry trade to intra-industry trade. They empirically investigate the impacts of bilateral exchange rates between China and Japan on the trade volume between China and Japan in selected

Introduction 17

industries. They find that the mean of real exchange rates and volatility of the Chinese renminbi affect trade volume between China and Japan in a few industries, while Chinese income growth has a positive effect on Japan’s export to China. However, for electrical machinery industry, they find no significant effects of exchange rate changes on import and export. Moreover, they also find no significant effects of foreign demand on trade. Based on this finding, they conclude that to extent that Japanese firms are likely to influence the pricing structure of trade, trade cannot be affected by exchange fluctuation. This implies that the cost of China’s exchange rate reform can be mitigated by Japanese firm’s overseas production and pricing strategy.

In chapter 5, Zhang Bin and He Fan provide a theoretical model to investigate the effects of renminbi on the Chinese economy, and suggest policy implications. They insist that the combination of maintaining a constant relative price of tradables and nontradables, and the more rapid improvement of the total factor productivity of the tradable sector in respect of the nontradable sector not only brings forth economic growth, but also leads to structural distortions in the industry/service sector, expansion of trade balance, and declines in wage and an increase in the profit rate, which deteriorates the income distribution. They suggest two different approaches to solve the problem. First, revaluation of the nominal exchange rate of reminbi is examined, and they conjecture that the reminbi revaluation reflects the reasonable adjustment of the relative prices of tradables to nontradables, so as to optimize the economic structure, correcting the external imbalance, and spread the transferring of urban labor to the urban area. Of course, there exists short-term negative impacts from the exchange rate re-alignments, but the authors insist that it will play a positive role in improving employment and promoting the China’s economic structure. Second approach is to solve the current distortions by further boosting reform to the sectors lagged behind in the adoption of market principle in the service industry, and promote the TFP of the service sector. This approach shall shorten the gap between the two sectors, combining with improving the external position and adjust the distortions in the economy. They also suggest that appropriate government macroeconomic policies and functions are required to implement either approach.


Theme 3. Too much or two less: How to stimulate private sectors in East Asia

A hike in interest rates on a global scale could derail a strong and broad-based recovery in East Asia. Despite strong growth, investment recovery has been sluggish in East Asia, except in China, while a rebound in consumption remains vulnerable to a tightened monetary stance. In addition, diminishing external demand for East Asia’s exports will also interrupt economic expansion. Under these circumstances, it is a quite important to identify each countries macroeconomic policy stance and to analyze the consequences of these macroeconomic policy measures. The third theme of this volume emphasizes the importance of domestic macroeconomic policy to cope with external shocks. Two papers are discussed in this context.

Jong-wha Lee in chapter 6 investigates the causes of investment depression in East Asia since the Asian crisis. He shows that investment in East Asia has dropped and has remained below the pre-crisis level, mainly due to increased financial risk and a decreased rate of return on investment. He insists that East Asia needs to revive domestic investment in order to achieve robust economic growth for the next decades. A increase in public investment in the more efficient sectors such as public infrastructure, health, education, and R&D would help to raise the investment rate and the potential output growth rate. Moreover he suggests that macroeconomic adjustment policies need to go along with structural reform policies that can improve the efficiency of investment. He also mentions that the investment declines in East Asia have contributed to the recent surge of global imbalances.

Naoyuki Yoshino in chapter 7 stresses the role of government banks to support and fulfill the needs of small businesses. This issue is very important in increasing the domestic investment since the governmental financial institutions’ assistance enables the implementation of investment projects that would have been impossible. Although the government’s special credit guarantee program could alleviate the financial constraints of SMEs that are seriously affected by the credit crunch, it also poses a new problem of moral hazard. To deal with this problem, the credit guarantee system should be well balanced between the overall efficiency in SME financing and the cost incurred by the government. He also insists that to enhance portfolio capital flows in Asia, there should be a

Introduction 19

continuous information exchange between Asian countries and institutions, a harmonization of the legal frameworks, development of the financial market and its products and a drive towards consumer education. He concludes that a more fluid flow of capitals in East Asia would not only benefit the Japanese SME but will also increase the opportunity for SME in other countries in East Asia.

Theme 1

Current Capital Flows and Related Risks

in East Asia

Determinants of Korea’s Capital Outflows

Yonghyup Oh Korea Institute for International Economic Policy

Kwanho ShinKorea University

1. Introduction

Legal and institutional restraints limiting the free flow of international capital have been removed rapidly within the past decade. Accordingly, the flow of international capital increased in great amount compared to the past.1) Not being an exception to this trend, Korea made continuous effort to eliminate its domestic barriers against capital inflows and outflows since the mid 1990s. Even after having suffered a currency crisis amid this process, comprehensive international capital movement is now allowed in Korea.

The amazing expansion of international capital movements is rapidly merging into one big international capital market altogether. It’s expected that will not only affect in great extent. not only the national market but also the whole global economy Being this the case, many scholars are conducting researches on the economic effect of capital market integration. They have particular interest in the impact imparted by the exchange of international asset on interest rates, real exchange rates, change in business fluctuations, and risk allocations.2)

1) Lane and Milesi-Ferretti (2003) and Obstfeld and Taylor (2003) made a report of this recent fast movement of capitals in their empirical research papers.

2) The level of net foreign capital and its influence on the interest rate is a classical topic of research. For more information, refer to Frankel and Rose (1995). Recently, Lane and Milesi-Ferretti (2001) analyzed the influence of net foreign capitals on the exchange rate, and Sorenson and Yosha (1998) investigated net profit from foreign capitals and its influence on the international risk allocation. Imbs (2004) empirically tested the effect of the capital integration on business


However, the size of transnational capital movements varies among countries. Some countries are undergoing this integration process by closely interrelating among themselves, but among other countries such integration is taking more time. Legal and institutional constraints seem to play a big role in the integration, but other purely economic factors also make some impact. Therefore, considering the importance of the integration of international capital markets, the need for assessing economic determinants of international capital movement is even more stressed out.

The integration of International capitals presents similarities as well as differences when compared to the trade integration, well regarded as the integration of physical goods market. The determinants of trade integration have been successfully explained by the Gravity Model.3) According to the Gravity Model, the closer the trade partner is geographically and the bigger economic it has, the more trade integration will be possible. This model has only recently applied to the study of the transnational capital movements. Research conducted by Portes, Rey and Oh (2001) and Portes and Rey (2005) proved that overall, the gravity model can be successfully applied successfully in the assessment of capital movements. Not only they prove the applicability of important variables of the existing gravity model in the study of the international portfolio investment but they also revealed the importance of a newly added variable, information exchange size. In addition to this, the geographical proximity does not always imply accelerated capital integration. According to Kim, Lee and Shin (2005), integration of capital markets among the Asian countries is slow in progress, in spite of their geographical nearness. Asian countries’ capital markets seem to be more closely integrate to the global market such as American or UK market. This shows that the economic factor of the capital movement may present different characteristics compared to that of the trade integration.4)

fluctuations.

3) For justification for gravity model application in trade, see Anderson (1979), Deardorff (1998), Anderson, James E. and van Wincoop (2003).

4) To see how FDI are allocated among different countries refer to the work of Wei (2000) and Stein and Daude (2003). Wei (2000) studied the FDI from 14 countries towards 45 countries within the period of 1990-1991 and concluded that increase in tax and corruption against MNCs decreases the attraction of FDI. He also found out that the geographical proximity and the usage of same language

Determinants of Korea’s Capital Outflows 25

This research paper assesses the economic determinants of Korea’s capital outflow analyzing Korean Foreign Direct Investment (FDI) during the period of 1990 to 2004, and due to the claims by Korean banks in 2000-2004. Korean is a net exporter of capital due to the recent and continuous trade surplus. Korea’s foreign currency holdings in 2005 reached the amount of 200 billion dollars. However, based on the data provided by Korea Bank, the total investment in equity products based on foreign currency made by Korean investment companies such as equity investment, insurance companies or ITMCs didn’t exceed 33.4 billion dollars by March, 2005, even including their investment on Korean Paper. (Table 1) Although this research does not embrace every single data related to capital, we used the major 2 data to show how Korea’s capital outflow is performed and to highlight essential facts needed to help you understand the integration process of the Korean capital market in the global economy.

Focusing the discussion only in Korea, the academic background for this topic is abundant, such as the study on the amount of FDI inflow (Kim 2000) and outflow (Lee and Lee 2002), Kang and Lee (2004), as well as paper on the inflow of foreign capital in respect to net financial

increase FDI at a significant level. Stein and Daude (2003) based their research on the fact that the difference in longitudes cause difference in time line and this eventually may impede the exchange of information among countries for the analysis of FDI determinants. They revealed argued that geographical distance does not influence negatively on FDI, but it’s longitudinal distances that affect negatively on FDI, as difference in time line is accentuated due to the distances. For researches on factors determining claims by banks you can consult the works done by Buch (2002, 2003) and Kawai and Liu (2001). Buch (2002, 2003) figured out that the level of information and regulations are essential conditions in the decision making process for foreign claims. He also pointed out that the degree of their importance varies among countries. Kawai and Liu (2001) analyzed bank’s international lending made by developed countries in favor of the developing ones and claimed found that variables such as the economy size, income per capita, correlation of trade and FDI, economic aid, country risk rate play important role in the determination process. Lane and Milesi-Ferretti (2003) used the newly constructed survey-based database of international portfolio investment for analysis and revealed important determinants of investment decision process such as bilateral trade size, correlation of countries’ total production, correlation of profit rate in the stock market of both countries, and the usage of the same language.


Year 2001 2002 2003 2004 2005.3

(Tentative) (Tentative)

(A) (B) (B-A)

Equity1,048.6

(8.3)

1,451.1

(8.2)

1,281.3

(5.9)

3,066.9

(10.2)

4,467.7

(13.4)

1,400.8

<45.7>

Bonds4,150.7

(32.9)

6,580.5

(37.2)

9,960.6

(45.7)

14,351.7

(47.7)

15,416.0

(46.1)

1,064.3

(7.4)Korean

Paper

7,410.0

(58.8)

9,663.5

(54.6)

10,536.7

(48.4)

12,674.0

(42.1)

13,526.6

(40.5)

852.6

(6.7)

Total12,609.3

(100.0)

17,695.1

(100.0)

21,778.6

(100.0)

30,092.6

(100.0)

33,410.3

(100.0)

3,317.7

<11.0>

Notes: 1) % in ( ), 2) % increases in < >. Korean Paper is issued by residents

in foreign countries (CB, DR, BW, CD, and etc.). The data are from the

bank of Korea.

Table 1. Total investment made by Korean investment companies

(Thousand Dollars, %)

capitals (Lee 2003). But due to the short history of domestic financial capital investment destined to foreign countries, no research was published before. Besides, the originality of this research paper resides in the utilization of an extended gravity model summing up new variables such as the level of development of the financial market and of the legal institution, the amount of trade and the amount of information exchange.

The following are the structure of this research paper and order of new findings. First, in the Part 2, we draw a chart on Korea’s current status international investment to help your easy understanding. Accordingly, we could verify that the Korea’s foreign FDI is increasing, as well as the claims by Korean banks. The region which was the major beneficiary to this trend was China for FDI and Europe for claims.

In part 3 the explanation on the applied model and data source was given.

In part 4 we analyzed the determinants Korea’s capital outflow through the extended gravity model. At the same time, asymmetrical comparison and analysis of the determinants with those of trade size were presented. But there seems to be no single variable that can explain these 3 variables (trade size, FDI, banks’ claim) at a statistically significant


level. This result shows that the determinants of goods and capital flows are yet different and it also demonstrates the possible differences present between capital goods and financial capital. As for interregional trade, Korea shows high level of trade size with countries of East Asian region. However, the fact that Korea concentrates its investment much heavily in the American market rather than in East Asian is one meaningful finding. We also found that the FDI outflow is not correlated with trade size between countries, but claims by banks is.

The last part is the presents the conclusion of this paper.

2. Recent Status of Korea’s Capital Outflows

The objective of this paper is assessing the determinants of Korea’s capital outflows. We have particular interest in testing the effect of each variable on the amount of capital outflows. The variable included in the analysis are: level of the development of the financial market, size of information exchange, level of insider’s transaction, economic size, etc., These variables are considered as the fundamental causes of capital flow. The definition of financial capital in this study will be restricted to the official capital needed for claims and investment activity. Therefore, individual capital outflow or capital flight will be excluded in the analysis.

To be more specific, the capital outflow analyzed in this paper is limited to FDI outflows and claim by Korean banks. By nature, FDI can be regarded as both financial capital and real capital. This is due to the fact that financial investment on the capital market such as the purchase of stocks of certain company exceeding 40% of the total stocks is reported as FDI. However, not like FDI, claims by Korean banks are considered as pure investment on financial capital. Claim by banks generally bears low risk for profit rate change, differing from FDI in which risk is high. This study will also make a comparison among the different investment decision making methods performed by these two types of investment.

Chart 1 shows the fluctuations of Korea’s FDI inflows and outflows from 1991 to 2004. First of all, we can highlight the sudden increase of the FDI inflow before and after the financial crisis. This is partially due to the fire sale incurred by dramatic decline of value of capital assets


-

2,000,000

4,000,000

6,000,000

8,000,000

10,000,000

12,000,000

14,000,000

16,000,000

18,000,000

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

FDI InflowFDI Outflow-

2,000,000

4,000,000

6,000,000

8,000,000

10,000,000

12,000,000

14,000,000

16,000,000

18,000,000

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

FDI InflowFDI Outflow

Notes: FDI Outflows and inflows data are from Korea Eximbank and

Ministray of Commerce, Industry and Energy respectively.

Chart 1. Korea’s Total FDI Inflows and Outflows(Thousand Dollars)

-1,000,000

0

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

총FDI미국

유럽

중국-1,000,000

0

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

총FDI미국

유럽

중국

Notes: FDI Outflows are from Korea Eximbank.

Chart 2. Korean FDI outflows by recipient countries (Thousand Dollars)

after the crisis. But taking into account that FDI inflow took place in high level yet in 2004, it seems that Korea’s FDI inflow has been level-up after the crisis.

But FDI outflow doesn’t come go along with this trend, having only two important upward shifts in the mid 1990s and in early 2000. Since 2001, it shows a steady increasing tendency suggesting the possibility of continuous increment of FDI outflows.


Total bank loans

-

20,000,000

40,000,000

60,000,000

80,000,000

100,000,000

120,000,000

140,000,000

160,000,000

2000 2001 2002 2003 2004

Total bank loans

Total bank loans

-

20,000,000

40,000,000

60,000,000

80,000,000

100,000,000

120,000,000

140,000,000

160,000,000

2000 2001 2002 2003 2004

Total bank loans

Chart 3. Total amount of claims made by Korean banks

Chart 2 illustrates Korean FDI outflows sorted by recipient country. Specifying separately main partner countries like USA, Europe and China, we tried to show fluctuations of FDI outflow to recipient countries. According to the chart, we can notice that the increase of FDI outflows in the mid 1990s was mainly due to investment to USA, but the shift in investment in the early 2000 was because of China. Therefore, the fact whether FDI outflow will increase or not, may be dependant on the prospects of the development of the Chinese economy.

Chart 3 shows the total amount of claims made by Korean banks. The total amount of claims by Korean banks is steadily increasing. The only exception was the year 2001, when the amount of FDI outflow exceeded the size of FDI outflow over 10 times in the same period of time, in terms of absolute size. By this result, we can see the importance of claims by banks over FDI outflow in term of absolute size of money flow. However, as most of the claims are short-term claims and generally FDI outflows are on long-term basis, the importance of claims by banks is absolutely bigger in flow rather than in stock.

Chart 4 presents the claims by Korean banks in the same period of time sorted by by major recipient regions. Compared to the FDI outflow, where Japan’s contribution was not essential, Japan is one of the most important recipient of foreign claims by Korea. That’s why we added


-

2,000,000

4,000,000

6,000,000

8,000,000

10,000,000

12,000,000

14,000,000

2000 2001 2002 2003 2004

U.S.

Europe

China

Japan

-

2,000,000

4,000,000

6,000,000

8,000,000

10,000,000

12,000,000

14,000,000

2000 2001 2002 2003 2004

U.S.

Europe

China

Japan

Chart 4. Korean bank claims by major recipient regions

Japan as a separate category of the analysis, The findings we can point out from this chart is that claim destined to the US is the biggest in terms of absolute size, but it’s in a stationary state. But claims with destination to Europe are continuously in augment, almost reaching the total amount of claims towards US. Claims towards Japan are steadily decreasing and claims towards China increasing every year. But they account together only for half the size of claims towards US and Europe.

3. Research Methodology and data source

3.1 Research MethodologyThe basic assumption is that Korean capital outflow decision making

can be explained through the Gravity Model. We’ll also add more variables and prove the impact level of each variables first starting from the application of the basic Gravity Model. Therefore, factors that determine Capital outflows will be analyzed through the study of variables divided in 4 groups as follows: 1) variables of basic Gravity Model 2) Level of development of capital market and legal institution 3) trade size 4) size of information exchange. We are further analyzing the importance of variables in each category.


The basic gravity model is cited from Portes, Ray, and Oh (2001)’s basic equation for assessment of international financial movement size. To be more specific, the next extended gravity model will be applied in the study:

))ln(

)ln(

)ln()ln(ln

)ln()ln()ln(

11109

876

543

210

ijttKtj

ijtjtij

ijtjiij

jK

jKtjKKjt

YEARTradeUSAEast

InsiderLegalMcap

TeleAreaAreaDist

tPopPopGDPGDP

GDPGDPCap

εδβββ

βββ

βββ

βββ

+++++

+++

+++

++=

(3.1)

In equation 3.1, k represents Korea, j the recipient country, and t stands for time.

GDP: Gross Domestic ProductPop: PopulationDist: Distance between Korea and country jArea: Area of National territoryTele: Total amount of telephone calls between Korea and country jMcap: Size of the stock marketLegal: Index of legal institutional developmentEast: Dummy for East Asia. ‘1’ for countries located in East Asia,

and ‘0’ for the rest.USA: dummy variable for the USA. ‘1’ if a country ‘j’ is USA and

‘0’ if not.Trade ijt: Average of real trade size between country I and j at a

given time t.Year: dummy whether year is given time or not (1 or 0)

The applicability of basic Gravity Model in the analysis of the determination of international trade size was already repeatedly proven by numerous scholars. The model itself was named so because number of researches proved the negative ratio of trade and geographical distance, and positive ratio of trade and economic size. The equation 3.1


is an extended version of the gravity model used in trade analysis in order to apply to the analysis of transnational capital movements.

The real GDP, an indicator of the economic size, is an important basis for determining international investment of the financial capital, as the bigger the economy size of recipient/donor country is, the more attraction of foreign investment is expected. However, for developing countries that have big sized economy but with relatively low level of economic development, real GDP per capita was considered, as it reflects the level of economic development.

As financial capitals do not incur any significant transportation cost for its circulation, transportation cost is hardly relevant to the distance in financial capital investment. But taking into consideration on the fact that the geographical proximity helps the easy access to information, we could say that the distance and the amount of information exchange have negative relation. We also considered the amount of phone calls, an indicator of direct exchange of information. Through this variable, we tried to test whether the size of information exchange between countries served as a factor of attraction of the investment.

The theoretical foundation of the emphasis on the size of the financial market relies on the expected number of financial products in relation to the size of the market itself. In other words, as the market has more diversified financial products, higher is the probability that financial risk insurance product may exists in the market. Under the assumption that the countries with developed financial market may be much able to invest overseas and as countries with high degree of financial development is more likely to attract foreign investment, we included variables that reflect the size of the financial market, such as size of stock market, degree of insider’s transaction, and degree of development of related legal institution.

Furthermore, in order to test the regional orientation of the investment, we included the dummy variable of East Asia, and also the dummy of USA, as synonym of global market. Lastly, to prove the effect of trade increase on the financial capital mobilization, we included the variable of trade size, sum of total imports and exports.

3.2 DataThe source and explanation about different data used in this paper


are as follows. Basic currency used in this paper is the US dollar, except specified differently. Data on FDI is based on Net total investment of 1990-2004, analyzed from the data of Foreign Capital Outflow of the Korea Eximbank. Starting from 98 countries in 1990, the country list has been increased in length up to 156 countries in the year 2004. Claims by Korean banks destined to foreign countries are based on the data of the Bank of Korea. The destination of bank claims varies every year but it embraces almost the whole world, being reported claims toward nearly 200 countries in total.5)

GDP, exchange rate and population data are collected from the International Financial Statistics of the IMF, and International trade size from IMF’s Directions of Trade. Data on country area and transnational distance are from Rose (2004) and the size of financial market (total market price), which represents the degree of the development of the financial market, is from DataStream database. The index of insider’s transaction and index of the institutional development of the financial

market are from IMD’s Index of international competitiveness. For both data, higher number means higher institutional development. Lastly, the total amount of telephone calls between Korea and the partner country is measured by 1 million minutes per unit and uses the dataset of TeleGeography located in Washington.

Table 2 summaries the simple regression results of each variables of 2 datasets used in the analysis. Table 2-1 shows the mean and the standard deviation of each variables from the dataset of the Capital Outflow from 1990 to 2004. Table 2-2 is based on the data of claims by Korean banks, and presents the mean and standard deviation of the respective variables.

4. Estimated result of the Model

Before analyzing the movement of capital, we tried to verify the applicability of this model by testing it first on the determinants of trade size. Through this study we are going to identify the economic factors

5) Data are from a draft version of dataset to be reported to BIS. It was not made public yet.


Mean S.D.

Log FDI investment 206.07 1080.43

Log distance 8.57 0.53

Log GDP in pair 41.70 2.18

Log Per capita GDP in pair 7.93 1.49

Area in pair 23.53 2.42

Log of bilateral telephone calls 2.06 2.37

Los size of the stock market 6.31 2.13

Index of legal institutional development 6.59 1.43

The index of insider’s transaction 5.57 1.41

Log of bilateral trade 13.60 3.07

Note: The number of observations is at maximum 1801.

Table 2-1. Statistics based on the sample on FDI: 1990-2004

Mean S.D.

Log bank loans 294.19 1182.12

Log distance 8.58 0.50

Log GDP in pair 41.62 2.00

Log Per capita GDP in pair 7.81 1.48

Area in pair 23.34 2.31

Log of bilateral telephone calls 1.89 2.27

Los size of the stock market 6.44 2.21

Index of legal institutional development 6.62 1.43

The index of insider’s transaction 5.67 1.36

Log of bilateral trade 13.40 2.88

Note: The number of observations is at maximum 748.

Table 2-2. Statistics based on the sample on bank loans: 1990-2004

Table 2. Summary Statistics

that determine trade size and movement of financial capital, and see how similar or different they are. After applying the model to the determinants of trade size, we will do the same to the determinants of FDI outflow and claims by Korean banks.


(1)Random Effects

(2)Between Effects

(3)Random Effects

(4)Between Effects

(5)Random Effects

(6)Between Effects

Distance-0.541*[0.261]

-0.770**[0.278]

-0.551*[0.222]

0.144[0.281]

-0.07[0.276]

0.432[0.325]

GDP in pair0.948**[0.106]

0.943**[0.118]

0.318*[0.125]

0.271[0.207]

0.405**[0.117]

0.407[0.187]

Per capita GDP in pair

0.119[0.132]

0.262[0.142]

0.019[0.114]

0.056[0.208]

0.059[0.099]

-0.124[0.196]

Area in pair-0.096[0.085]

-0.112[0.091]

0.104[0.087]

-0.18[0.150]

0.119[0.075]

-0.134[0.130]

Bilateral telephone calls

0.274**[0.081]

0.777**[0.163]

0.178*[0.086]

0.623*[0.186]

Size of the stock market

0.015[0.054]

-0.141[0.087]

0.031[0.049]

-0.077[0.080]

Legal institutional development

0.04[0.057]

0.164[0.188]

0.023[0.056]

0.132[0.160]

Insider’s transaction

-0.063[0.061]

-0.167[0.233]

-0.005[0.063]

0.15[0.251]

East Asia1.268**[0.447]

1.223**[0.574]

U.S.0.538

[0.498]0.171

[0.618]

R-squared 0.56 0.78 0.85 0.96 0.89 0.98

Observations 1346 1346 96 96 96 96

Note: All the variables are bilateral ones between country i and country j. All variables except the dummy variables are taken logarithm. Robust standard errors of the estimated coefficients are reported in parentheses. Intercept and year dummy variables are included (not reported). ** and * indicate that the estimated coefficients are statistically significant at 1 % and 5 % levels respectively.

Table 3. Gravity Equation for Trade

Table 3-1. Panel data for 1990-2003.

4.1 Estimated Result of Gravity Model for Trade SizeMost of the variables of the equation (3.1) of the extended gravity

model are selected based on the theory on financial capital movement,


(1)

Random

Effects

(2)

Between

Effects

(3)

Random

Effects

(4)

Between

Effects

(5)

Random

Effects

(6)

Between

Effects

Distance-0.950**

[0.337]

-0.781*

[0.329]

-1.430**

[0.452]

-0.216

[0.783]

-1.058

[0.830]

-1.498

[5.781]

GDP in pair0.960**[0.146]

0.859**[0.149]

0.114[0.284]

0.109[0.783]

-0.11[0.367]

-0.363[2.568]

Per capita GDP in

pair

0.029

[0.160]

0.192

[0.165]

-0.036

[0.244]

0.263

[0.785]

0.057

[0.307]

0.738

[2.989]

Area in pair0.012

[0.112]

0.013

[0.108]

0.362

[0.203]

0.088

[0.512]

0.437

[0.249]

0.753

[2.283]


-0.02[0.071]

0.433[0.400]

-0.067[0.066]

-0.166[1.817]

Size of the stock

market

0.238**

[0.089]

0.01

[0.329]

0.326**

[0.091]

0.059

[0.457]

Legal institutional

development

-0.037

[0.045]

-0.136

[0.968]

-0.055

[0.042]

-0.329

[1.572]

Insider’s transaction0.024

[0.046]-0.192[0.708]

0.04[0.043]

-0.294[1.938]

East Asia1.609

[1.155]

0.597

[3.549]

U.S.1.798

[1.447]

2.919

[9.264]

R-squared 0.72 0.71 0.62 0.91 0.73 0.94

Observations 387 387 50 50 50 50

Note: see note for Table 3-1.

Table 3-2. Panel data for 2000-2004.

but we should first verify their effect on the trade size. As the fact that economic size and distance do in fact influence on the trade size is already well proven, we expect that the same factors will probably have important explanatory power as determinants of trade size.

Table 3 shows the regression results for trade size. Different data on capital outflow and bank claims were used, so estimation on trade size


was also made based on these non-identical data. Table 3-1 gives the result of the estimation of the Gravity Model using the data of Capital outflow. Row (1) and (2) display the result of the most basic gravity model, and present the estimation result of Random Effects and Group Effects. Row (3) and (4) are extensions of model (1) and (2) and include 4 additional explanatory variables (amount of phone call, size of stock market, legal institution, and index of insider transaction). Row (5) and (6) adds the dummy for East Asia and USA.

According to the result presented above, the gravity model seems to explain quite well the determinants of Korean trade. Particularly, the coefficient of geographical distance tend to be negative in general, and in the row 1,2 and 3 the results are statistically significant at 1 or 5%. Moreover the GDP square, indicator of the economy size, had a positive coefficient by the level of 1 or 5% significance as showed in the result Table row 1,2,3 and 5.

The number of phone calls also proved to be significant at 1% level in rows 3,4,5 and 6. These results suggest the important role played by information variable as a determinant of trade size. However, considering that the cause-effect relationship is difficult to be analyzed in this regression, the opposite interpretation is also possible. In other words, we could deduce that because trade size increases, the phone calls are more frequent. Nevertheless, since in reality increment in trade transaction do not bring growth in the usage of phone calls, perhaps the 1

st interpretation might be correct.

Besides variables mentioned above, other variables are not statistically significant. But the estimated coefficient for the dummy variable (East Asia) was always positive and had a significance level of 1% as seen in rows 5 and 6. The estimated coefficient of geographical proximity ia nor statistically significant anymore. In case of Korea, the suggestion of advantage in distance in trade gains explanatory power only for trade with East Asian countries.

Time series gravity model was used in <Table 3-2> because starting from the year 2000, data for claims by Korean banks was available. Generally, the estimated results show similar trend to the results of <Table 3-1>. All estimated coefficients regarding geographical distance were negative, being significant at 1 or 5% level in rows 1, 2, and 3. In case of GDP square, indicator of economic size, all coefficients were positive when they were statistically significant. The coefficients for


(1)Random Effects

(2)Between Effects

(3)Random Effects

(4)Between Effects

(5)Random Effects

(6)Between Effects

Distance-0.019[0.023]

-0.019[0.026]

-0.236[0.217]

-0.17[0.226]

-0.355[0.328]

-0.277[0.233]

GDP in pair0.022*[0.010]

0.023*[0.011]

0.083[0.144]

-0.103[0.166]

0.09[0.174]

-0.028[0.134]

Per capita GDP in pair

-0.004[0.012]

-0.004[0.013]

-0.074[0.154]

-0.201[0.168]

-0.099[0.158]

-0.323[0.141]

Area in pair0.005

[0.008]0.004

[0.008]0.06

[0.095]0.14

[0.121]0.084

[0.096]0.154

[0.093]


　　

　　

0.024[0.109]

0.122[0.131]

-0.098[0.146]

-0.116[0.133]

Size of the stock market

　　

　　

0.121*[0.060]

0.173*[0.070]

0.126*[0.064]

0.197*[0.057]

Legal institutional development

　　

　　

0.089[0.139]

-0.121[0.151]

0.063[0.141]

-0.142[0.115]

Insider’s transaction

　　

　　

-0.063[0.153]

0.186[0.187]

0.016[0.169]

0.428[0.180]

East Asia　　

　　

　　

　　

0.193[0.604]

0.524[0.412]

U.S.　　

　　

　　

　　

0.725[0.585]

1.018**[0.443]

R-squared 0.06　 0.19 0.28　 0.74 0.30　 0.89

Observations 1353 1353 96 96 96 96


Table 4. Gravity Equation for FDI

Table 4-1. Basic Model

phone calls were not statistically significant anymore, but rather the coefficients for capital market size, which showed to be positive and statistically significant. The coefficient of dummy (East Asia) was also positive but its statistical significance was lower.

4.2 Estimated Result of Gravity Model for FDI<Table 4> summaries results of the gravity model with foreign

investment as dependant variable. Each row’s characteristics are the


(1)Random

Effects

(2)Between

Effects

(3)Random

Effects

(4)Between

Effects

(5)Random

Effects

(6)Between

Effects

Bilateral trade0.004

[0.004]

-0.003

[0.009]

0.058

[0.215]

0.503

[0.256]

-0.033

[0.246]

0.459

[0.275]

Distance-0.017

[0.023]

-0.021

[0.027]

-0.227

[0.221]

-0.243

[0.194]

-0.35

[0.332]

-0.475

[0.233]

GDP in pair0.018

[0.010]

0.026

[0.014]

0.067

[0.157]

-0.239

[0.156]

0.105

[0.209]

-0.215

[0.161]

Per capita GDP in

pair

-0.005

[0.012]

-0.003

[0.013]

-0.078

[0.156]

-0.229

[0.142]

-0.1

[0.159]

-0.266

[0.126]

Area in pair0.005

[0.008]

0.004

[0.008]

0.06

[0.095]

0.231

[0.112]

0.086

[0.098]

0.215

[0.088]

Bilateral

telephone calls

-0.003

[0.149]

-0.269

[0.228]

-0.089

[0.163]

-0.402

[0.206]

Size of the stock

market

0.125*

[0.062]

0.244*

[0.069]

0.126

[0.065]

0.232*

[0.054]

Legal institutional

development

0.084

[0.141]

-0.204

[0.134]

0.066

[0.144]

-0.202

[0.105]

Insider’s

transaction

-0.056

[0.155]

0.27

[0.164]

0.018

[0.171]

0.359

[0.160]

East Asia0.234

[0.680]

-0.037

[0.488]

U.S.0.735

[0.593]

0.940**

[0.384]

R-squared 0.06 0.19 0.28 0.84 0.30 0.94

Observations 1346 1346 96 96 96 96


Table 4-2. Including Trade as an Explanatory Variable

same to the Table 3 above mentioned. In other words, rows 1 and 2 are results of simple gravity regression, and the changing results through adding more variables are presented in rows 3, 4, 5 and 6. We reported two different estimations, being Table <4-1> the result of the regression excluding without considering trade size, and <Table 4-2> the result


when trade size was included in the model. The explanations about the estimated results are as the following.

First, according to the results of the regression in <Table 4-2>, coefficients of the distance turned out negative and statistically not significant. Here we could see that the relative importance of geographical proximity in FDI flows is smaller than in trades. However, estimated coefficients of GDP square, the indicator of market size, were statistically significant as well as positive in sign in rows 1 and 2 of the table. These results suggest that market size is also important in capital investments.

The estimated of coefficient of Capital market size were all positive and statistically significant at 5% level. This implies that not only the overall market size but also the recipient country’s capital market size is important for the determination of Korea’s FDI outflow.

Another particularly interesting finding is that the variable of East Asian dummy was not statistically significant as expected at the beginning. This implies that that the destination of Korean capital outflow is not concentrated in the East Asian region. On the other side, the US dummy variable was statistically significant as shown in the estimated results of row 6, perhaps reflecting the importance of the global market (the US market) in the financial investment portfolio.

The result of the regression including the bilateral trade size is presented in the <Table 4-2>. In general, the results were similar to those of the <Table 4-1> and the coefficient of the trade size wasn’t statistically significant. This suggests that Korea’s FDI outflows are performed regardless of the increase in trade size.

4.3 Estimated Result of Gravity Model for Claims by Korean banksThe result of the regression setting the amount of claims by Korean

banks as dependent variable is summarized in the <Table 5>. The explanations about the table rows are identical to those of <Table 3>, and we analyzed in two different times differentiating the model with and without the variable of trade size. (In Table 5-1 we didn’t consider trade size as variable, while in Table 5-2 we did).

Coefficients of geographical distance were all negative and statistically significant at 1% in the row 1 and 2, which shows results of the basic gravity model. Contrary to FDI outflow, claims by Korean banks seem to show important correlation with geographical distance of the destination. By the other hand, coefficients GDP squares are all


(1)Random

Effects

(2)Between

Effects

(3)Random

Effects

(4)Between

Effects

(5)Random

Effects

(6)Between

Effects

Distance-0.381**

[0.120]

-0.390**

[0.122]

-0.365

[0.360]

0.613

[0.443]

-0.737

[0.522]

-0.565

[2.497]

GDP in pair0.295**

[0.053]

0.319**

[0.055]

0.710**

[0.213]

0.548

[0.443]

0.374

[0.245]

0.104

[1.109]

Per capita GDP

in pair

-0.071

[0.059]

-0.067

[0.061]

-0.018

[0.182]

-0.131

[0.444]

0.139

[0.156]

0.336

[1.291]

Area in pair-0.044

[0.040]

-0.046

[0.040]

0.135

[0.150]

-0.213

[0.290]

0.385**

[0.140]

0.362

[0.986]

Bilateral

telephone calls

-0.047

[0.120]

0.546

[0.226]

-0.358**

[0.115]

0.039

[0.785]

Size of the stock

market

-0.09

[0.088]

-0.113

[0.186]

-0.057

[0.079]

-0.078

[0.198]

Legal

institutional

development

-0.038[0.093]

0.009[0.547]

-0.107[0.076]

-0.168[0.679]

Insider’s

transaction

-0.043

[0.093]

-0.109

[0.401]

0.081

[0.079]

-0.257

[0.837]

East Asia1.203

[0.705]

0.29

[1.533]

U.S.3.292**

[0.987]

2.512

[4.001]

R-squared 0.51 0.51 0.75 0.97 0.92 0.99

Observations 387 387 50 50 50 50


Table 5. Gravity Equation for Bank Loans

Table 5-1. Basic Model

positive and statistically significant at 1% in 3 occasions. Although East Asian dummy was not statistically significant, the US dummy gained significance in the estimation of row 5. Therefore we can assume that for determining both FDIs and international claims the global market represented by the US dummy is important.


(1)Random

Effects

(2)Between

Effects

(3)Random

Effects

(4)Between

Effects

(5)Random

Effects

(6)Between

Effects

Bilateral trade0.042

[0.024]

0.088*

[0.034]

0.717**

[0.119]

0.545*

[0.107]

0.471**

[0.087]

0.432

[0.000]

Distance-0.343**

[0.120]

-0.321**

[0.122]

0.578**

[0.152]

0.730*

[0.146]

-0.01

[0.215]

0.082

[0.000]

GDP in pair0.253**

[0.057]

0.243**

[0.062]

0.428**

[0.089]

0.489

[0.145]

0.303**

[0.079]

0.261

[0.000]

Per capita GDP

in pair

-0.075

[0.058]

-0.084

[0.060]

-0.119

[0.090]

-0.274

[0.148]

-0.005

[0.079]

0.017

[0.000]

Area in pair-0.044

[0.039]

-0.047

[0.039]

-0.162**

[0.060]

-0.261

[0.095]

0.011

[0.066]

0.037

[0.000]

Bilateral

telephone calls

0.093

[0.078]

0.31

[0.087]

0.017

[0.074]

0.11

[0.000]

Size of the stock

market

-0.099*

[0.038]

-0.118

[0.061]

-0.130**

[0.027]

-0.104

[0.000]

Legal

institutional

development

0.014[0.080]

0.083[0.179]

0.031[0.063]

-0.026[0.000]

Insider’s

transaction

-0.089

[0.077]

-0.005

[0.132]

-0.099

[0.065]

-0.13

[0.000]

East Asia-0.017

[0.208]

0.032

[0.000]

U.S.1.481**

[0.413]

1.251**

[0.000]

R-squared 0.53 0.54 0.99 0.99 0.98 0.99

Observations 387 387 50 50 50 50


Table 5-2. Including Trade as an Explanatory Variable

Result of the regression including the variable of bilateral trade size is arranged in <Table 5-2>, showing overall similarity to the result of <Table 5-1>. But contrary to FDI outflows, coefficients of trade size were all positive and statistically very significant. So we can come to the


conclusion that claims by Korean banks are closely correlated to the increase in the bilateral trade size.

5. Conclusion

This research paper analyzed the economic determinants of Korea’s capital outflow throughout the extended Gravity Model. At the same time, we made analytic comparisons to the economic determinants of trade size. This extended gravity model proved to have high explanatory power for the correlation of trade size, FDI, and the total amount of claims by banks performed by Korea to the rest of the world. And other interesting finding was that some particular variables of the financial market, such as the total amount of phone calls, and the size of the capital market, proved to be meaningful in understanding the trade size and Korea’s FDI outflow. This result implies the close correlation of these variables with the determinants of trade size and FDI outflow, or perhaps these variables are by themselves important determinants of these economic activities.

The close correlation of variables of the financial market such as the degree of development of the financial market and exchange level with the variables of goods market is not an exceptional finding. For example, the flow of trade amount is somehow interconnected to the flow of capital, as well as the FDI outflows characterized with features of financial capital activity, such as in M&A.

However, a variable explaining all three variables altogether within a meaningful level of significance was not found in this analysis. This may due to the still different characteristics of determinants of goods and capital, as well as the difference between financial capital and capital goods.

Taking into consideration the regional characteristics, Korea seems to have relatively intensive trade exchange with countries in East Asia. But Korea’s preference over North American market as the destination of its capital outflows surpassed in a great extent the level of preference over East Asian countries, which is an important finding of this paper. In respect of trade, the dependency of Korean economy on North American market has decreased relatively, while the dependency ration on East Asian market increased. But Korea’s high dependency on North America in the financial arena suggests the persisting vulnerability of Korean


financial market towards external shocks. Other important finding of this research is the fact that trade size

doesn’t seem to make impact on the determination of FDI outflow, contrary to claims by banks. This difference reflects the actual process of claim which is related to the trade process. It suggests that claims by Korean banks, at least, may increase naturally with the increment in trade size. Study on the influence of this interrelation with trade in the process of deepening the financial market integration is another important subject of further studies.

References

Anderson, James E. 1979. “A Theoretical Foundation for the Gravity Equation.” American Economic Review 69, 106-116.

Anderson, James E. and van Wincoop, Eric. 2003. “Gravity with Gravitas: A Solution to the Border Puzzle.” American Economic Review, Vol. 93 (1), 170-192.

Buch, Claudia. 2002. “Are Banks Different? Evidence from International Data.” International Finance 5 (1), 97-114.

Buch, Claudia. 2003. “Information or Regulation: What Drives the International Activities of Commercial Banks?” Journal of Money, Credit and Banking 35 (6), 851-869.

Deardorff, Alan V. 1998. “The Determinants of Bilateral Trade: Does Gravity Work in a Neoclassical World?” In Jeffrey A. Frankel ed. The Regionalization of the World Economy. Chicago: University of Chicago.

Frankel, Jeffrey and Andrew K. Rose. 1994. “A Survey of Empirical Research on Nominal Exchange Rates.” In Handbook of International Economics. Vol. 3. Grossman and Rogoff eds. Amsterdam: North- Holand.

Imbs, Jean. 2004. “Trade, Finance, Specialization, and Synchronization.” The Review of Economics and Statistics 86 (3), 723-34.

Kawai, Masahiro and Li-Gang Liu, 2001, “Determinants of International Commercial Bank Loans to Developing Countries.” Mimeo. University of Tokyo and Asian Development Bank Institute.

Kang, Sung Jin, and Hongshik Lee. 2004. “Location Choice of Multinational Companies in China: Korean and Japanese Companies.” KIEP WP 04-13.

Kim, June-Dong. 2002. “Inward foreign direct investment into Korea: recent performance and future tasks.” Joint U.S.-Korea Academic Studies, Vol.

Capital Inflow under the Fear of Sudden Stop 45

13, 195-220. Kim, Soyoung, Jong-Wha Lee and Kwanho Shin. 2005, “Regional and

Global Financial Integration in East Asia.” Mimeo. Lane, Philip R., and Gian Maria Milesi-Ferretti, 2002, “External Wealth

the Trade Balance and the Real Exchange Rate.” European Economic Review 46, 1049-1071.

Lane, Philip R., and Gian Maria Milesi-Ferretti, 2003, “International Financial Integration.” IMF Staff Papers, Vol. 50 Special Issue: 82– 113 Washington: International Monetary Fund.

Lee, Byungyoon. 2003. “The determinants of foreign banks' entry in Korea and its effects on Korean domestic banks' performance.” Economic Papers of the Bank of Korea 6 (1), 42-65.

Lee, Chang-Soo, and Chong-Kyu Lee. 2002. “Korea's FDI into China: Determinants of the Provincial Distribution.” KIEP WP 02-16.

Obstfeld, M. and Alan M. Taylor. 2003. “Global Capital Markets: Integration, Crisis, and Growth.” Cambridge: Cambridge University Press.

Portes, R. and H. Rey. 2005. “The Determinants of Cross-border Capital Flows: The Geography of Information.” Journal of International Economics 65 (2), 269-296.

Portes, R., H. Rey, Y. Oh. 2001. “Information and Capital Flows: the Determinants of Transactions of Financial Assets.” European Economic Review 45 (4-6), 783-796.

Sorensen, Bent E. and Oved Yosha, 1998. “International Risk Sharing and European Monetary Unification.” Journal of International Economics 45, 211-238.

Stein, E., and C. Daude. 2003. “Institutions, Integration, and the Location of Foreign Direct Investment.” Washington, DC, United States: Inter-American Development Bank, Research Department. Mimeographed document.

Sung Jin Kang and Hongshik Lee. 2004. “Location Choice of Multinational Companies in China: Korean and Japanese Companies.” KIEP WP 04-13.

Wei, S. 2000. “How Taxing is Corruption to International Investors?” Review of Economics and Statistics 82 (1), 1-11.

Capital Inflow under the Fear of

Sudden Stop

― Which Currency Regime is Optimal for

the Asian Countries?

YURI SASAKIDepartment of Economics

Meiji Gakuin University

Introduction

Since 1992, there happened several currency crises in emerging countries. After the currency crises, many economists and academic researchers have started to argue the optimal currency regimes which prevent such crises. Those papers have discussed the optimal currency regimes which stabilize trade balance or those which enhance economic growth. That is because deterioration of macro economic fundamentals in Thailand before the crisis was thought a significant factor to cause the crisis in East Asian countries. But it is not examined that those optimal currency regimes also prevent risk of the capital flow.

Like other papers, the purpose of my previous papers was searching for the optimal currency regime which stabilizes the trade balance. The reason why we looked for the optimal regime in such a sense was that the instability of fundamentals in Thailand was the significant factor of causing the Asian currency crises. But, recently, some studies stress on damages from the sudden stop rather than damages of sharp currency devaluations. In this paper, I would like to examine the optimal currency we suggested before is also optimal for the capital flow under the risk of sudden stop.

Also, I would like to test the recent belief of the Asian currency regimes. After the crises, many economists argued “Two Corner


Solutions”. But after the discussions, some papers find the evidence that there’s fear of float in Asian countries and they present their currency regime is managed or independent float, but actually their currencies had strong linkages with the US dollar and the exchange rates were not floating so freely. It seems to be believed that Asian countries are going to back to Dollar Peg system.

The section 2 shows the surveys on recent papers on capital flow and currency regimes. The section 3 shows the exchange rates movements in Asian countries. The section 4 shows the capital flows in Asian countries. The section 5 explain the analysis of push and pull incidents and the section 6 states conclusion.

2. Surveys of Recent Studies

It is useful to review the recent papers on sudden stop and optimal currency regime. First I will review the papers on Sudden Stop and second I will show the review of the papers on optimal currency regime.

2.1. Papers on Sudden StopRecently, topic “Sudden Stop” attracts a great deal of academic

attention. More and more papers on sudden stop are published. It is said that the expression “Sudden Stops” was first used by Dornbusch, Goldfajn and Valdes (1995) and has since become increasingly popular. The first analytic approach to the problem of sudden stops is Calvo (1998). By Cavallo and Frankel (2004) paper, the “Sudden Stop” is defined as, “sudden stop -- and abrupt cut-off in capital inflows --entails a resource transfer to creditor countries, from the debtor country. Often it also entails a financial or currency crisis in the latter, accompanied by a sharp fall in output.” Since around 2000, there have been many papers hit by the term Sudden Stop.

Among them, Frankel and Cavallo (2004) find that openness indeed makes countries less vulnerable, both to severe sudden stops and currency crashes, and that the relationship is even stronger when correcting for the endogeneity of trade. Calvo, Izquierdo and Mejia (2004) are among the empirical papers that find that openness to trade is associated with fewer sudden stops. They focus on the effect of DLD(Domestic liability dollarization) and the effect of openness (the


effect of RER). Milesi-Ferretti and Razin (1998, 2000) find that openness helps trigger crises and/or sharp reversals of the current account.　Mendosa(2005) analyzed Mexico and found that tradable price fluctuate more than nontradable price. Caballero, Cowan and Kearns (2004) examines the cases of Chile and Australia using the factor of country trust and currency trust.

2.2. Papers on Currency RegimeCalvo and Reinhart (2000a) analyzed the exchange rates, foreign

reserves, monetary base and interest rates in Asian countries. They concluded that although some of the Asian counties announced that they were adopting a floating exchange rate regime, their currencies had strong linkages with the US dollar and the exchange rates were not floating so freely.

McKinnon (2000) analyzed how daily changes in the exchange rates of 9 East Asian currencies have a strong relationship with the US dollar. He showed that the movements of the East Asian currencies had high correlation with the movements of the dollar prior to 1997. These two papers suggest that most of Asian countries were not floaters and some of them adopted a de facto dollar peg regime, which are classified as an intermediate exchange rate regime.

Williamson (2000) explains this “revealed preference” of Asian countries as follows: “they see gains in an intermediate regime that they believe outweigh the costs in terms of greater vulnerability to crises and having less simple policy rules to follow.” Williamson (2000) regards that the primary benefit of intermediate exchange rate regimes is to allow policy to be directed to limiting misalignments of exchange rates. Overvaluation of home currencies would weaken competitiveness of tradable good industries while undervaluation would cause overheating and imported inflation. Thus, the benefit of a basket currency system would have bean significant for Asian countries that have been taking export-oriented strategies for their economic growth.

One corner of the two-corner solution is floating exchange rate regime. However, clean float is not quite possible or desirable. Not many countries practice clean float (no intervention). If one corner means a “lightly managed” float, then it would become difficult to draw a line between “highly managed” and “managed” floating regimes.

Currency board is the other corner which will automatically increase


and decrease the monetary supply according to the changed in foreign reserves. However, the aspect of the fixed exchange rate will put the currency board under the same criticism of fixed exchange rate regime of soft peg--namely, if a country pegs to a country that does not share common shocks, then competitiveness will vary as the key currency appreciates and depreciates. That would then translate in the fluctuations in foreign reserves, the interest rate, price levels, and the capital flows. Domestic sectors have to be really flexible to absorb such volatility. Williamson (2000) recommends BBC rule, where BBC stands for basket, band and crawl.

In the new wave of pass-through studies, Devereux and Engel (1998) directly examined how price setting affects the optimal choice of exchange rate regime. They show that, when prices are set in the consumers’ currency, the adoption of a floating exchange rate system would be better because a floating exchange rate insulates domestic consumption from foreign monetary shocks. Under floating exchange rates, the prices paid by home residents for imported goods are not affected by exchange rate fluctuations if producers set the price in the consumers’ currency. When prices are set in the producers’ currency, a fixed exchange rate regime is better than a floating exchange rate system if the negative effect of uncertainty of floating exchange rates on domestic consumption dominates the insulation effect of the floating exchange rate regime. This reveals that, when prices are set in the producers’ currency, there is a trade-off between floating and fixed exchange rates. Exchange rate adjustment under floating rates reduces the variance in consumption, but exchange rate volatility itself leads to a lower average level of consumption.

These local-currency pricing models assume that stickiness of the local currency price is the reason for consumer prices not responding greatly to exchange rates. Nevertheless, there are other possible explanations for the incomplete pass-through.

3. Recent Movements of Asian Exchange Rates

In this section, I will show some recent data in order to check the movement of exchange rates.


3.1. Currency Regime after the CrisesAfter the crises, East Asian countries officially announce that they

adopt the regimes reported in Table1. Table 1 is the classification quoted by World Economic Outlook 2004, published by IMF.

But after the crises, many believe that the two corner regimes are better than intermediate regime, and also there is “Fear of Float”, it seems that the Asian countries are going back to Dollar Peg regime.　

In addition, some papers show the empirical evidences on the fact that many Asian countries are going back to Dollar Peg system. McKinnon (2000) states East Asian currencies have a strong relationship with the US dollar. Ono and Fukuda’s (2003) shows that Malaysia’s going back to Dollar Peg system in 1998 and introduction of inflation targeting policy to some Asian countries since 2000 affects on the structural changes of exchange regimes in East Asian countries and they conclude that East Asian countries are going back to Dollar Peg regime.

3.2. The Recent Movement of Exchange RatesTo show the correlation between the Asian currency and the US

dollar, and the correlation between the Asian currency and Japanese Yen, Figure 1 show the exchange rates of Asian countries against US dollar. Chinese Yuan, Hong Kong Dollar and Malaysian Ringitt are almost vertical because they peg their currencies to US dollar. The other exchange rates seem to correlate the exchange rate of Japanese Yen (red line) in some periods. Change rates of the Asian exchange rates against US Dollar and change rates against Japanese Yen are plotted in Figure 2 to Figure 8. The shapes of these rates are almost the same among Chinese Yuan, Hong Kong Dollar and Malaysia Ringitt.

Figure 7 shows that Thai Baht change rates against the US dollar and that against Japanese Yen. The change rate against US dollar seems to narrower than the change rate against Japanese Yen, but in some points change rate against Japanese Yen is moving narrower than the change rate against US dollar, and in the other points, the differences between two lines are not so wide. The almost same things are observed in Korean case and Singapore care.

The findings from these data are that both of Yen and the Dollar have moved after the crises except for the cases of Ren Min Bi, Hong Kong Dollar and Malaysian Ringitt. Thus the Asian currencies except these three don’t seem to go back to Dollar Peg.


Figure 1. Exchange rates of Asian currencies against US dollars

Change rates of Ren Min Bi

- 0.2

- 0.15

- 0.1

- 0.05

0

0.05

0.1

0.15

0.2

1998

M1

1998

M5

1998

M9

1999

M1

1999

M5

1999

M9

2000

M1

2000

M5

2000

M9

2001

M1

2001

M5

2001

M9

2002

M1

2002

M5

2002

M9

2003

M1

2003

M5

2003

M9

2004

M1

2004

M5

2004

M9

2005

M1

2005

M5

2005

M9

USDJPY

Figure 2. Change Rates of Ren Min Bi against US dollar and Japanese Yen

Change rates of Ren Min Bi


Change Rates of Korean Won

- 0.2

- 0.15

- 0.1

- 0.05

0

0.05

0.1

0.15

0.2

1998

M1

1998

M5

1998

M9

1999

M1

1999

M5

1999

M9

2000

M1

2000

M5

2000

M9

2001

M1

2001

M5

2001

M9

2002

M1

2002

M5

2002

M9

2003

M1

2003

M5

2003

M9

2004

M1

2004

M5

2004

M9

2005

M1

2005

M5

2005

M9

USDJPY

Figure 3. Change Rates of Korean Won against US dollar and Japanese Yen

Change Rates of Korean Won

Change Rates of Indonesia Rupia

- 0.2

- 0.15

- 0.1

- 0.05

0

0.05

0.1

0.15

0.2

1998

M1

1998

M5

1998

M9

1999

M1

1999

M5

1999

M9

2000

M1

2000

M5

2000

M9

2001

M1

2001

M5

2001

M9

2002

M1

2002

M5

2002

M9

2003

M1

2003

M5

2003

M9

2004

M1

2004

M5

2004

M9

2005

M1

2005

M5

2005

M9

USDJPY

Figure 4. Change Rates of Indonesian Rupia against US dollar and Japanese Yen

Change Rates of Indonesia Rupia


Change Rates of Singapore Dollar

- 0.2

- 0.15

- 0.1

- 0.05

0

0.05

0.1

0.15

0.2

1998

M1

1998

M5

1998

M9

1999

M1

1999

M5

1999

M9

2000

M1

2000

M5

2000

M9

2001

M1

2001

M5

2001

M9

2002

M1

2002

M5

2002

M9

2003

M1

2003

M5

2003

M9

2004

M1

2004

M5

2004

M9

2005

M1

2005

M5

2005

M9

USDJPY

Figure 5. Change Rates of Singaporean Dollar against US dollar and Japanese Yen

Change Rates of Singapore Dollar

Change Rates of Philippines Peso

- 0.2

- 0.15

- 0.1

- 0.05

0

0.05

0.1

0.15

0.2

1998

M1

1998

M5

1998

M9

1999

M1

1999

M5

1999

M9

2000

M1

2000

M5

2000

M9

2001

M1

2001

M5

2001

M9

2002

M1

2002

M5

2002

M9

2003

M1

2003

M5

2003

M9

2004

M1

2004

M5

2004

M9

2005

M1

2005

M5

2005

M9

USDJPY

Figure 6. Change Rates of Philippines Peso against US dollar and Japanese Yen

Change Rates of Philippines Peso


Change Rates of Thai Baht

- 0.2

- 0.15

- 0.1

- 0.05

0

0.05

0.1

0.15

0.2

1998

M1

1998

M5

1998

M9

1999

M1

1999

M5

1999

M9

2000

M1

2000

M5

2000

M9

2001

M1

2001

M5

2001

M9

2002

M1

2002

M5

2002

M9

2003

M1

2003

M5

2003

M9

2004

M1

2004

M5

2004

M9

2005

M1

2005

M5

2005

M9

USDJPY

Figure 7. Change Rates of Thai Baht against US dollar and Japanese Yen



- 0.2

- 0.15

- 0.1

- 0.05

0

0.05

0.1

0.15

0.2

1998

M1

1998

M5

1998

M9

1999

M1

1999

M5

1999

M9

2000

M1

2000

M5

2000

M9

2001

M1

2001

M5

2001

M9

2002

M1

2002

M5

2002

M9

2003

M1

2003

M5

2003

M9

2004

M1

2004

M5

2004

M9

2005

M1

2005

M5

2005

M9

USDJPY

Figure 8. Change Rates of Malaysian Ringitt against US dollar and Japanese Yen



4. Recent Movement of Capital Flow in Asia

In this section, I will show some recent data in order to check the movement of capital. To show the capital flows in Asian countries, it is shown capital balance of Asian countries in Figure 9 to Figure 16. The black line is Financial Account quoted by IFS CD-ROM. This line started to fall sharply after the crisis and recently recovered.

This Financial Account is consists of Direct Investment, Portfolio Investment and Other investment. The brown bar is net direct investment and the blue bar is net portfolio investment and the orange bar is Other Investment. These three bars show that the main source of sharp decline of Financial Account is Other Investment.

Especially in Thailand, capital flowed in through banks, so the amounts of other investment were so huge, but the same movements can be observed in other countries’ figures, too. In Indonesia, Other investment started to fall after the crisis but the other two investments also started to fall. In Malaysia, Other investment started to fall after the crisis and PI also declined since 1999. Philippines Case is like Thailand’s case. Only other investment started to fall since 1998. Korean Case is like Thailand’s case in the sense that only other investment started to fall after the crisis. But Unlike Thailand’s case, the financial account recovered soon after the crisis. Singapore is the different case. It is unlike to other ASEAN countries. China Case is like Thailand’s case in the sense that other investment started to fall since 1998. But Unlike Thailand’s case, PI also started to fall since 1997 and the level of DI is much higher than the other two types of investments.

Figure 17 shows the components of Other Investment in Thailand. It shows that banks’ liability and other sectors, mainly private firms, liability are the major contents in other investment.

From the data, we find that the typical Thailand’s case is also observed in Indonesia, Malaysia, and Philippines. The typical pattern are (1) other investment started decreasing in crises year, (2) direct Investment started decreasing in crises year only in Indonesia, and (3)In addition, the investment level has been recovered gradually.


Thailand

-2.5

-2

-1.5

-1

-0.5

0

0.5

1

1.5

2

2.5

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Uni

t: 10

bill

ions

US

D DI(net)

PI(net)

OI(net)

FINANCIAL ACCOUNT,N.I.E.

Figure 9. Capital Balance in Thailand

Hong Kong

-6

-5

-4

-3

-2

-1

0

1

2

3

4

1990

1992

1994

1996

1998

2000

2002

2004

Uni

t: 10

bill

ions

USD

DI(net)PI(net)OI(net)FINANCIAL ACCOUNT, N.I.E.

Figure 10. Capital Balance in Hong Kong


China

-6

-4

-2

0

2

4

6

8

10

12

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Uni

t: 10

bill

ions

US

D DI(net)

PI(net)

OI(net)


Figure 11. Capital Balance in China

Singapore

-2.5

-2

-1.5

-1

-0.5

0

0.5

1

1.5

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Uni

t: 10

bill

ions

US

D DI(net)

PI(net)

OI(net)


Figure 12. Capital Balance in Singapore


Korea

-3

-2

-1

0

1

2

3

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Uni

t: 10

bill

ions

US

D DI(net)

PI(net)

OI(net)


Figure 13. Capital Balance in Korea

Philippines

-1.5

-1

-0.5

0

0.5

1

1.5

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Uni

t: 10

bill

ions

US

D DI(net)

PI(net)

OI(net)


Figure 14. Capital Balance in Philippines


Malaysia

-1

-0.5

0

0.5

1

1.5

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003Uni

t: 10

bill

ions

US

D

DI(net)

PI(net)

OI(net)


Figure 15. Capital Balance in Malaysia

Indonesia

-1.5

-1

-0.5

0

0.5

1

1.5

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Uni

t: 10

bill

ions

US

D DI(net)

PI(net)

OI(net)


Figure 16. Capital Balance in Indonesia


Thailand - Other Investment

OI BANKSASSETS

OI MON AUTHLIAB

OI BANKS LIAB

OI OTHERSECTORS LIAB

-15000

-10000

-5000

0

5000

10000

15000

20000

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

OI MON AUTH ASSETSOI GEN GOVT ASSETSOI BANKS ASSETSOI OTHER SECTORS ASSETSOI MON AUTH LIABOI GEN GOVT LIABOI BANKS LIABOI OTHER SECTORS LIAB

Figure 17. Components of Other Investments in Thailand

5. Analysis of Push and Pull Incidents

In this section, I will show the Push and Pull Model based on Fernández-Arias (1996). Suppose that capital flow is conducted as trade of s assets. The profit from home project “s” depends on the expected return Ds and creditworthiness of home country C which takes from zero to one. Assuming decreasing marginal propensity of product, Ds is negative function of net flow into all the projects. Cs is negative function of stock s (=S-1+F) at the end of the period. Thus, capital flow is determined as following.

Ds(d, F) Cs(c, S-1+F) = Ws(w, S-1+F)

Where Ws denotes opportunity cost of asset s in foreign country, depending on S, d denotes the home country’s health, and w is a factor which represents liberalization of financial market in foreign country. Suppose D, C and W as follows,

Ds = Ds(d, F), D1 > 0 and D2 < 0.


Cs = Cs(c, S-1+F), C1 > 0 and C2 < 0.Ws = Ws(w, S-1+F), W1 > 0 and W2 < 0.

From equation (1), F is written as this.

(5)F = F(d, c, w, S-1)

From (5), we estimate the following equation.

FA/GDP ＝ CONST＋DV＋YV＋LIUS＋LIJP＋LUSGDP+LJPGDP

Where FA is financial accounts, DV is variance of US Dollar, YV is variance of JP Yen, LIUS is long term interest rate spread against the US Dollar, LIJP is long term interest rate spread against the JP Dollar, LUSGDP is log(US GDP) and LJPGDP is log(JP GDP).

We pool the data of Hong Kong, Indonesia, Korea, Malaysia, Philippines, Singapore, Thailand and China from 1980 to 2004. The result is reported in Table 2. The coefficient of DV is 0.03 and not significant. The coefficient of JV is not significant but the significant level is 0.13. The coefficient is -0.14 and this means that the lower the variance of Japanese Yen, the more (net) capital inflows.

6. Conclusion

In this paper, we have reviewed the recent studies on capital flow and exchange regimes. We show the recent movement of exchange rates and capital flow. We estimate the capital flow based on the push and pull model.

We found that both of Yen and the Dollar have moved after the crises except for the cases of Ren Min Bi, Hong Kong Dollar and Malaysian Ringitt. Thus the Asian currencies except these three don’t seem to go back to Dollar Peg. From the capital flow data, we found that (1) other investment started decreasing in crises year, (2) direct Investment started decreasing in crises year only in Indonesia, and (3)In addition, the investment level has been recovered gradually.

In the regression analysis, it is shown that the coefficient of variance of Yen is negative and significant. This means that the lower the


variance of Japanese Yen, the more (net) capital inflows. In this paper, we couldn’t examine the sudden stop equations

directly. We will do this in the future work.

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Reviving the Intermediate Option.” Washington, D.C.: Institute for International Economics.

Theme 2

China’s New Exchange Rates Regimes

and its Implication to East Asia

Global Imbalances and East Asia’s Policy

Adjustments

Yung Chul ParkGraduate School of International Studies

Seoul National University

1. Reserve Holdings and Current Account Developments in East Asia: An Overview

At the end of September 2005, a total of reserves held by ten East Asian economies6) stood at $2,485 billion, up from a little over one trillion five years earlier (see Table 1). All of these economies have been running sizeable amounts of surplus on their current accounts. While accumulating surpluses, some of these economies- in particular China, South Korea, and Taiwan - have also piled up large capital inflows since 2003. The bulk of the current account surpluses and capital inflows have been sterilized and added to their reserves (see Table 3). About 46 percent of East Asia’s total trade surplus came from the region’s trade with US in 2004 and not surprisingly much of it converted into its holdings of short-term US treasury securities, which has been the source of transpacific imbalance (Table 4). The reserve accumulation in most East Asian economies with the possible exception of Japan has been the result of sterilized intervention for stabilizing either the nominal or real effective exchange rate with the objective of maintaining their export competitiveness.

In 2004, the ten economies added $506.5 billion to their combined reserves (Table 2). In contrast, however, there has been a substantial decrease in their reserve accumulation in 2005. As shown in Table 2, the amount of reserve buildup in East Asia comprising the ten economies as a whole is estimated to be around $240 billion, less than a half of the

6) They are: China, Japan, Korea, Taiwan, Hong Kong, Indonesia, Malaysia, Philippines, Singapore, and Thailand.


　 1999 2000 2001 2002 2003 2004 2005*

Japan287.0 354.9 395.2 461.3 663.3 833.9 843.6

(31.8)** (34.9) (35.1) (34.3) (37.2) (36.4) (33.9)

China157.8 168.3 215.7 291.2 408.2 614.5 769.0

(17.5) (16.6) (19.2) (21.6) (22.9) (26.9) (30.9)

Subtotal 444.8 523.2 610.9 752.5 1071.5 1448.41612.6

(64.8)

Hong Kong96.3 107.5 111.2 111.9 118.4 123.5 122.3

(10.7) (10.6) (9.9) (8.3) (6.6) (5.4) (4.9)

Korea, South74.0 96.1 102.8 121.4 155.3 199.0 206.7

(8.2) (9.5) (9.1) (9.0) (8.7) (8.7) (8.3)

Singapore76.9 80.1 75.4 82.1 95.7 112.2 115.6

(8.5) (7.9) (6.7) (6.1) (5.4) (4.9) (4.7)

Taiwan106.2 106.7 122.2 161.7 206.6 242.0 253.8

(11.8) (10.5) (10.9) (12.0) (11.6) (10.6) (10.2)

Subtotal 353.4 390.6 411.6 477.1 576.0 676.7 698.4 (28.1)

Indonesia26.5 28.5 27.3 31.0 35.0 35.0 30.2

(2.9) (2.8) (2.4) (2.3) (2.0) (1.5) (1.2)

Malaysia30.6 29.5 30.5 34.2 44.5 66.4 79.7

(3.4) (2.9) (2.7) (2.5) (2.5) (2.9) (3.2)

Philippines13.2 13.1 13.4 13.1 13.5 12.9 16.0

(1.5) (1.3) (1.2) (1.0) (0.8) (0.6) (0.6)

Thailand34.1 32.0 32.4 38.1 41.1 48.7 48.5

(3.8) (3.1) (2.9) (2.8) (2.3) (2.1) (2.0)

Subtotal 104.4 103.1 103.6 116.4 134.1 163.0174.4

(7)

Total 902.6 1,016.9 1,126.1 1,346.1 1,781.5 2,288.1 2485.4

Notes: * At the end of September

** Percentage of the total

Source: IMF, International Financial Statistics and The Economist (2005),

November 5-11 and 12-18.

Table 1. International Reserves of East Asia, 1999-2005

(US dollars, billions)

Global Imbalances and East Asia’s Policy Adjustments 71

　 2000 2001 2002 2003 2004 2005* Sum

Japan

　

67.5 40.3 66.1 202.0 170.6 9.7 556.2

(59.4)** (36.8) (30.1) (46.4) (33.7) (4.0) (34.2)

China

　

10.5 47.4 75.5 117 206.3 193.7 650.4

(9.2) (43.3) (34.3) (26.8) (40.7) (79.7) (39.9)

Korea &

Taiwan

22.6 22.2 58.1 78.8 79.1 21.0 281.8

(19.9) (20.3) (26.4) (18.1) (15.6) (8.6) (17.3)

Hong Kong &

Singapore

14.4 -1.0 7.4 20.1 21.6 2.7 65.2

(12.7) (-0.9) (3.4) (4.6) (4.3) (1.1) (4.0)

ASEAN 4***-1.3 0.5 12.8 17.7 28.9 16.0 74.6

(-1.2) (0.5) (5.8) (4.1) (5.7) (6.6) (4.6)

Total 113.7 109.4 219.9 435.6 506.5 243.1 1628.2

Notes: * Estimates based on country sources and Quarterly Review and

Outlook, 2005, Global Insight

** Percent of the total *** Indonesia, Malaysia, Philippines and Thailand

Source: IMF, International Financial Statistics and The Economist (2005),

November 5-11 and 12-18.

Table 2. Reserve Build up, 2000-2005

(US dollars, billions)

level of 2004. The direct cause of the decline was an overall drop in current account surpluses except for China and capital inflows into the region. In 2004, a total of current account surpluses of the ten economies amounted to $356.5 billion. Although many of these economies suffered from a sharp deterioration in the terms of trade caused by a large increase in oil prices and a slowdown in exports in the first half of the year, they registered collectively a surplus of almost $360 billion on their combined current account in 2005. Non-oil producing economies such as South Korea and Taiwan saw a sharp increase in their import bills, which cut into their surpluses.


　 2000 2001 2002 2003 20042005* (est)

2006 (Forecast)

Sum

Japan

119.7 87.8 112.4 136.2 172.1 153.0 　 781.2

(56.0)** (49.0) (47.4 (45.3) (48.3) (42.6) (47.4)

(2.5)*** (2.1) (2.8) (3.2) (3.7) (3.3) (3.1) 　

China

20.5 17.4 35.4 45.9 68.7 100.3 　 288.2

(9.6) (9.7) (14.9 (15.3) (19.3) (27.9) (17.5)

(1.9) (1.5) 2.8) (3.2) (4.2) (5.5) (3.8) 　

Korea &Taiwan

21.2 26.2 31.0 41.6 46.3 28.4 　 194.7

(9.9) (14.6) (13.1) (13.8) (13.0) (7.9) (11.8)

(2.6) (3.4) (3.7) (4.7) (4.7) (4.9) 　　

Hong Kong

&

Singapore

20.3 26.0 31.5 44.9 42.1 55.5 　 220.3

(9.5) (14.5) (13.3) (14.9) (11.8) (15.5) (13.4)

(7.9) (10.5) (12.7) (18.1) (15.6) (19.0) 　　

ASEAN 4

32.1 21.7 26.7 32.2 27.3 22.0 162.0

(15.0) (12.1) (11.3) (10.7) (7.7) (6.1) (9.8)

(7.1) (4.9) (5.4) (5.7) (4.4) (3.2) 　　

Total 213.8 179.1 237 300.8 356.5 359.2 　 1,646.40

Notes: * Estimates based on country sources and Quarterly Review and

Outlook 2005, Global Insight ** Percent of the total

*** Percent of GDP

Table 3. Current Account Surpluses of Ten East Asian Economies

(US dollar, Billions)


　 2000 2001 2002 2003 2004 2005* Sum

Japan -81,555.0 -69,021.6 -69,979.4 -66,032.4 -75,562.1 -68,603.5 -430,754.0

　 (35.5)** (33.5) (30.5) (27.0) (25.4) (23.9) (28.8)

China -83,833.0 -83,096.1 -103,064.9 -124,068.2 -161,938.0 -166,835.4 -722,835.6

　 (36.5) (40.3) (44.9) (50.8) (54.3) (58.2) (48.4)

Hong Kong 3,133.0 4,381.4 3,266.2 4,669.3 6,513.5 6,237.8 28,201.2

　 (-1.4) (-2.1) (-1.4) (-1.9) (-2.2) (-2.2) (-1.9)

Korea -12,477.7 -13,000.8 -12,996.0 -13,156.8 -19,755.5 -13,158.2 -84,545.0

　 (5.4) (6.3) (5.7) (5.4) (6.6) (4.6) (5.7)

Singapore -1,372.0 2,651.8 1,415.5 1,422.4 4,238.1 4,935.5 13,291.3

　 (0.6) (-1.3) (-0.6) (-0.6) (-1.4) (-1.7) (-0.9)

Taiwan -16,096.7 -15,252.6 -13,766.2 -14,151.5 -12,879.2 -10,308.7 -82,454.9

　 (7.0) (7.4) (6.0) (5.8) (4.3) (3.6) (5.5)

Indonesia -7,965.2 -7,583.0 -7,087.6 -6,998.7 -8,139.1 -7,517.0 -45,290.6

　 (3.5) (3.7) (3.1) (2.9) (2.7) (2.6) (3.0)

Malaysia -14,630.9 -12,982.6 -13,665.3 -14,526.1 -17,257.6 -19,077.8 -92,140.3

　 (6.4) (6.3) (6.0) (5.9) (5.8) (6.7) (6.2)

Philippines -5,135.5 -3,665.5 -3,703.7 -2,071.7 -2,049.7 -2,071.4 -18,697.5

　 (2.2) (1.8) (1.6) (0.8) (0.7) (0.7) (1.3)

Thailand -9,768.1 -8,737.6 -9,932.7 -9,343.2 -11,210.5 -10,361.2 -59,353.3

　 (4.3) (4.2) (4.3) (3.8) (3.8) (3.6) (4.0)

Total-229,701.1 -206,306.6 -229,514.1 -244,256.9 -298,067.1 -286,759.9 -1,494,605.7

(49.3)*** (45.9) (45.1) (42.0) (42.0) (47.9)

Notes: * Up to October

** Percentage of the total

*** Percentage of East Asia in total US trade balanceSoure: U.S. Census Bureau

Table 4. Bilateral trade balances of US with East Asian economies,

2000-2005

(US dollars, Millions)


The most striking development was the marked fall in Japan’s reserve accumulation in 2005, which amounted to less than $10 billion, compared to more than $170 billion a year earlier, although it chalked up a current account surplus of $159 billion. The decrease in the reserve buildup in Japan has therefore been the result of a large increase in capital outflows. A similar development has taken place in both Hong Kong and Singapore. Equally striking were the cutbacks in reserve addition of four NIEs of East Asia – South Korea, Taiwan, Hong Kong, and Singapore. The increase in their combined reserves in 2005 was about $24 billion, which was less than a quarter of the level of 2004.

Does this decline in reserve accumulation in East Asia, which a recent IMF report (2005) describes dramatic, is a promising sign that global imbalances are gradually resolving themselves into a manageable problem through market forces and no longer threaten global financial stability? This paper will show that such an optimistic prediction is premature; some of the underlying causes of the global imbalances remain unchanged as can be seen by the growing trade imbalances between East Asia and the US. The ten East Asian economies increased their combined share in the US trade deficit by six percentage points to 48 percent, although their total trade surplus as a proportion of GDP declined in 2005.

The sterilization of surpluses originating in both the current and capital accounts has kept most East Asian currencies undervalued7). The operation has incurred a relatively high cost.8) By any measure of adequacy, East Asia’s foreign exchange reserve has been excessive. In realizing the high cost of reserve holdings, some of the East Asian economies have loosened up the control over capital outflows whereas others such as Thailand have undertaken large public investment projects to stimulate domestic demand. However, further capital account liberalization may not help curtail East Asia’s current account imbalance to the extent that the deregulation is motivated to prevent appreciation

7) The reserve accumulation is a prima facie evidence of undervaluation.

8) The cost arising from the interest rate differential between the domestic and foreign interest rates has been a minor one compared to other more serious cost factors. The weaker dollar has inflicted substantial capital losses on their holdings of dollar assets. The undervalued currency along with the export-led growth strategy has discouraged investment in the non-tradable sector, causing misallocation of resources and unbalanced growth of the economy.


of their currencies. There is indeed a high probability that some of these economies return to tightening capital outflows when their current accounts deteriorate.

Although East Asia’s current account surpluses tapered off in 2005, recent forecasts suggest that they are not likely to go below three percent of GDP in the near future. If indeed the surge in crude oil prices are tempered and the US deficit continues to rise, East Asia may start accumulating again large current account surpluses in 2006.

If they are holding more reserves than they need for self-insurance and other purposes, one might ask why the East Asian economies would resist a currency appreciation or expansionary monetary and fiscal policy to scale down their current account surpluses and reserve accumulation. One answer is that neither appreciation nor expansionary monetary and fiscal policy may be effective in reducing their current account surpluses relative to global imbalances. According to the IMF report (2005), a further appreciation of East Asia’s currencies “will only have limited effect on current account positions” (p. 5). The report goes on to say that domestic demand expansion will need to be driven by structural reform because there is little room for activist macroeconomic policy.

It is true that East Asian countries including China have relapsed into the pre-crisis interventionist mode of policy management, thereby delaying the much needed reform and their integration into the global financial and trade system. However, little is known as to whether and how much the institutional reform will contribute to eliminating the imbalance over time. Even if it can significantly, the reform will be a long term process. The global economy can hardly wait for the completion of the reform. East Asia including Japan appears to be entering the expansionary phase of the business cycle, but given the region’s export-oriented bias and high saving propensity, the prospective boom may not necessarily dissipate the gravity of the transpacific imbalance.

Among the ten economies, the two large countries – Japan and China – hold 65 percent of the region’s total reserves. In 2005, they accounted for more than 70 percent of the region’s current account surplus. It is therefore clear that as long as Japan and China remain unable to bring down their surpluses, other smaller East Asian countries individually or collectively could do so much to halt a further increase in the transpacific imbalance by augmenting domestic demand, simply because the number of the economies which could reflate domestic


demand is small and their combined size is also small.

2. Recovery in Japan

There is little disagreement that East Asia as a whole will need to embrace a more domestic demand based growth strategy to deflect the tension caused by the growing transpacific imbalance. Unless Japan is prepared to absorb more goods and services not only from the U.S but also from other East Asian countries, the external pressure on the rest of East Asia to expand domestic demand will not be heeded. If Japan makes headway in reviving domestic economy, other East Asian counties will also fall in line to cooperate with Japan and the US to take appropriate policy actions desired for the resolution of the imbalance. In the absence of Japan’s recovery, one cannot have much hope for restoring balance between the two sides of the Pacific with only policy changes in the rest of East Asia.

Fortunately, there is every indication that Japan is recovering. Recent forecasts show that Japan is emerging from a decade-long deflation. Industrial production rose for a fourth month in November 2005. In the same month consumer prices excluding fresh food (core price index) rose 0.1 percent from a year earlier for the first time in ten years. The Tankan survey published on December 14 shows that an index of confidence among large manufactures climbed to the highest in 2005, indicating that the pace of investment of these producers would exceed earlier expectations.

Recovery was powered by exports riding on the back of China’s spectacular economic growth in 2004. After a setback in the first half of 2005, exports have been rising again at an unexpectedly strong pace, fueling corporate profits and investment. Exports appear to have bottomed out against the backdrop of recovering of imports of China. The Yen is weakening in real effective term more than expected. Unlike in previous periods of expansion, this time the export growth has led to the creation of a virtuous cycle linking it with investment with consumption demand. Domestic demand is therefore beginning to combine with exports to drive economic recovery. Assuming crude oil prices are setting down, Japan is likely to enter the uprising phase of the business cycle where a sustainable recovery would help core prices register stable gains. The optimistic outlook does not necessarily mean that Japan will


return to the soaring 1980’s anytime soon. Many forecasters estimate that the GDP growth rate in 2005 will be 2.4 percent, lower than that in 2004, and fall off again below two percent for the next five years. The excitement in Japan is that for the first time in ten years the motor of domestic demand will be humming.

Looking into the near future, despite the expected increase in consumption spending, national saving as a proportion of GDP will remain at around 25 percent. There will be a marginal increase in the share of investment in GDP. As a result, compared to the 2005 level, the current account surplus will decline by 0.2 percentage points to 3 percent of GDP in 2006. Japan will therefore continue to be the major source of East Asia’s current account surplus. Nevertheless, few would argue for an activist macroeconomic policy: a right macroeconomic policy mix does not dictate more spending for investment in infrastructure and other public projects. Japan is faced with a difficult task of managing a national debt which is approaching 150 percent of GDP, and fiscal policy has demonstratively been ineffective in turning around the economy from the decade long stagnation. Although the economy is on the road to recovery little change is expected in Japan’s fiscal policy.

The signs of deflation ending have opened a debate whether Japan’s central bank should move to end its super easy monetary policy known as quantitative easing, which has driven the real interest rate below zero. Given the moderate pace of recovery, however, there is the concern that any increase in the interest rate for restoring normalcy of monetary policy has the danger of stifling growth and plunging the economy back into recession.

The Yen has weakened considerably against the US dollar in recent periods. As a result of this weakness and the deflationary trend, over the three year period beginning in 2003, the Yen depreciated in a real effective term by almost 15 percent in contrast to a large appreciation of the Korean won and strengthening of the Reminbi (see Figure 1A). The Yen’s depreciation has complicated exchange rate policy in other East Asian economies. If a further appreciation of East Asian currencies should be part of the resolution of global imbalances, then the Yen’s depreciation, whatever the causes may be, will have to be reversed. Now that core prices are rising again, Japanese policymakers may find room for a stronger Yen, which is a precondition for collective appreciation of East Asian currencies.


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Figure 1-B. Real Effective Exchange Rate(ASEAN 4)

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3. Policy Adjustments in China

China’s remarkable growth and entry into the global trading system have led to the creation of a triangular trade relationship involving China, the U.S, and Japan plus East Asia’s emerging economies. In this relationship, Japan and East Asia’s emerging economies export capital goods and intermediate inputs to China. China in turn uses these capital and other intermediate goods to produce a wide variety of manufactured goods that are exported to the U.S, EU, and other regions. One implication of this vertical integration in production is that China holds the key to the exchange rate adjustment in East Asia.

China has revalued its currency- Renminbi-by 2 percent against the US dollar on July 21st in an effort to diffuse the growing external pressure, including the threat of protectionism, for reducing its burgeoning current account surplus from the US and other countries. Together with the initial revaluation China introduced a managed floating against a basket of major currencies and was expected to adjust the Renminbi – US dollar exchange rate with changes in the bilateral exchange rates of the currencies in the basket. After five months of the operation of the new system, little is known, however, as to the currencies included in the basket or the size of the band within which the currency is allowed to change.

The Chinese authorities have managed the new exchange regime to strengthen further the Renminbi relative to other major currencies so as to restrain further increases in the current and capital account surpluses, but the size of appreciation has been small. Although the external pressure for additional revaluation has not subsided, it appears highly unlikely that China will accept the demand of 20 to 30 percent revaluation relative to the dollar the US administration and a number of American economists including Bergsten and Roubuni are calling for. As shown in Figure 3A, the Reminbi - US dollar exchange rate has fluctuated within a very small band, indicating China continues to peg its currency to the U.S. dollar. Although the Reminbi has appreciated by six percent in a real effective term in 2005, the forward premium has been a measurable size (see Figure 3A).

In view of China’s growing current account surplus, should the country allow a greater flexibility of the Reminbi to let it appreciate vis-à-vis the US dollar and other currencies? Recent studies cast some


doubt as to whether China’s unilateral appreciation will have any significant impact on the aggregate current account position of the ten East Asian countries. The IMF report (2005) examines two scenarios of the Reminbi’s appreciation. In the first scenario where China revalues its currency by 10 percent against all other currencies, Asia’s current account balance, which includes India, declines by 0.1 percent of GDP in the first round and much less when multiplier effects are taken into account. The second scenario assumes that other Asian currencies also appreciate by 5 percent against non-Asian currencies. This scenario understandably produces a larger decline in Asia’s current account balance up to 1/3 percent of GDP.

This small effect is in a large measure caused by the supply of goods and services that appears to be highly price elastic as a result of the abundance of labor and a rapidly growing stock of capital. Furthermore, after a spurt in 2004, CPI inflation has decelerated, and there is growing concern that China may become susceptible to deflation (Figure 2A). China’s national saving rose to 51 percent of GDP and is expected to increase further. When this high propensity to save is combined with the export led development strategy, it is likely to lower price elasticities of trade and to produce a surplus on the current account.

While acknowledging the need to increase flexibility of the Renminbi – US dollar exchange rate, the Chinese policymakers have shown strong reservations about making an initial move at present with the fear that the small move could exacerbate capital inflows. A larger initial move may be necessary to restrain capital inflows, but such a policy change has not been seriously contemplated because its negative impact on employment and growth and on the banking sector saddled with large amounts of non-performing loans. It may be true that there is little persuasive evidence that the currency is substantially undervalued from a competitiveness point of view. However, if the Chinese authorities continue to delay the currency adjustment, then it will induce further capital inflows with the consequences more serious than the loss of employment and output.

As for monetary and fiscal policy management, looking at the size of government debt or fiscal balance as a percentage of GDP, China has ample room for expansionary fiscal policy (see Table 6), although it is an entirely different matter whether it has the administrative capacity


required to conduct an efficient tax and expenditure policy. On the front of monetary policy, China’s tightly managed exchange rate system allows scope for an independent domestic interest rate policy given porous but substantial and effective controls on international capital movements. Indeed, to prevent overheating of the economy and financial instability, the Chinese authorities have adopted both administrative measures and interest rate rises to rein in the rapid growth of credit and capital investment. These measures have achieved some success stabilizing the rate of inflation. Despite the tightening of credit growth, there is still excess liquidity in the system, which continues to fuel real estate speculation and asset price inflation. In view of these developments, a loosening of China’s credit policy to permit more rapid growth of investment in order to restrain the current account surplus would run the risk of overheating the economy and exacerbating the non- performing loans problems at the banks as excessive investments may result in a large increase in business failures.

4. Policy Adjustment in East Asia’s Emerging Economies

The current account balances of South Korea and Taiwan fell to 2 and 3.2 percent of GDP in 2004 respectively. And this trend is expected to continue into 2006. Domestic demand has been growing at a somewhat higher rate than before, but export earnings will continue to drive economic expansion in 2006 in the two economies, although the sharp appreciation of the Won in recent periods has dampened such a prospect in Korea. As a regional financial center with an open capital market, Hong Kong and Singapore have seldom been identified as sources of global imbalances. Although their current account balances as a proportion of GDP have been large and growing, they have mostly been balanced out by large capital outflows to add only $2.7 billion to their reserves in 2005.

Among ASEAN 4, Thailand recorded a deficit on its current account in 2005. Indonesia and the Philippines have been battling for subduing inflationary pressures (Figure 2-C). Given the small size of their current account surpluses, these countries do not figure importantly in the resolution of global imbalances. Malaysia is the only country that has continuously run sizeable amounts of surplus on its current account,


which has averaged more than 13 percent of GDP since 2003. It appears there will be no appreciable change in Malaysia’s current account imbalance for the next two years. Therefore, among the eight East Asia’s emerging economies, Malaysia, South Korea, and Taiwan may need to make policy adjustments as part of East Asia’s efforts to resolve global imbalances.

4.1.. Fiscal PolicyEast Asian countries have traditionally valued highly fiscal

prudence, and with the IMF on the watch many of them have not seriously considered fiscal expansion as a means of stimulating domestic demand regardless of its effectiveness since the 1997-98 crisis. Reflecting this fiscal conservatism, the government debt as a proportion of GDP has been low in East Asia except for Japan and the Philippines (Table 5). Many young democracies in East Asia suffer from the rigidity of and lag in fiscal policy as a result of a slow and complicated political process of determining the size and distribution of government expenditure between projects, sectors, and regions. Fiscal policy can be pro cyclical if the lag is long and persistent. East Asian policymakers are also aware of the possibility of replicating Japan’s experience with a pump-priming policy that has resulted mostly in a massive increase in national debt.

Among the ASEAN states, Indonesia and the Philippines are currently in no position to contemplate any further increase in government spending or cut taxes. The Indonesian government is committed to further fiscal consolidation to reduce vulnerability arising from the high level of public debt. Its objective is to achieve broad budgetary balance by 2006-2007 consistent with lowering public debt to below 50 percent of GDP. The Indonesian government has also been engaged in fiscal reform that envisages more efficient tax administration and improvement in budget preparation and execution. The size of the public debt in the Philippines has been close to 100 percent of GDP, which is high and unsustainable. The new administration has committed itself to balancing the budget by 2009 by tax increases and streamlining fiscal expenditure.

Thailand and Malaysia have been able to bring down budgetary deficits to a manageable level, and as such they do not have either budgetary deficit or national debt problems that could rule out an expansionary fiscal policy.

Thailand has a room for additional fiscal stimulus, and its authorities


1990-96 1999-2001 2002-20042005

(Jan.- April)

Hong Kong -3.59 8.26 1.99 1.43

Philippines 4.20 4.53 1.84 -1.39

China 5.04 1.26 0.69

Indonesia 4.27 2.71 1.18 -2.95

Malaysia 2.59 1.54 0.93 0.35

Taiwan 3.05 4.47 0.76 -0.83

Korea 7.35 2.53 0.59 0.15

Japan 2.38 0.80 0.45 0.21

Thailand 4.97 2.43 0.17 -0.66

Singapore 0.36 -0.15 1.39

Note: 1) The real interest rates have been calculated as the difference

between representativeshort-term market interest rates and the actual CPI inflation rate

over the past year.

Source: Genberg, McCauley, Park and Persaud (2005)

Table 6. Short-term real interest rates

have seen the need to run a budgetary deficit to boost domestic demand. South Korea, Singapore, and Taiwan could certainly take high doses of fiscal expansion. Of theses countries, South Korea has been most active in implementing an expenditure switching policy by combining an increase in government spending with an exchange rate appreciation. The two other countries have not been as active as export earnings have been large enough to sustain relatively high rates of growth.

4.2. Monetary PolicyMonetary policy in East Asia is accommodating as judged by the

level of real short-term interest rates. Since the financial crisis of 1997-98 real interest rates have declined in most economies and they are now close to zero and even negative in some cases. (Table 6) Would it be appropriate for monetary policy to be even more expansionary for the


purpose of contributing to the reduction of external imbalances? For several reasons, the answer is negative. First, easing monetary policy further would increase domestic demand but at the risk of fueling asset price inflation (real estate inflation in particular) which could lead to another boom-bust cycle as in the run-up to the crisis in 1997. No country in the region is willing to take this risk. Second, some central banks have adopted explicit or implicit domestic inflation objectives for the conduct of their monetary policy. This has limited the scope of further easing at this stage. At the first sign of CPI inflation in 2005, the central bank of Korea raised the interest rate and Taiwan’s central bank also hinted recently the possibility of raising the interest rates. Third, it is uncertain whether monetary expansion would succeed in reducing current account surpluses through expansion of domestic demand.

Four of East Asia’s emerging economies - Indonesia, the Philippines, South Korea, and Thailand - have adopted explicit inflation targeting as their monetary policy regime. Subject to maintaining price stability such a policy regime may at times permit the authorities to pursue domestic output objectives. At present, however, further easing of monetary policy would not stimulate consumption and investment demand until it accelerates further the ongoing asset inflation in the cases of South Korea and Thailand, and would contribute to general inflationary pressures in Indonesia and the Philippines.

If the responsiveness of corporate investment in Asia to short-term interest rates were very large, it might be reasonable to suppose that easier money would help narrow the gap between savings and investment and thereby reduce the current account surplus in the region. However, the corporate sector is producing a financial surplus in most countries in the region. This net corporate savings suggests that the cost of freshly raised bank loans or newly issued bonds might not have a strong effect on investment demand. Indeed, the persistent sluggishness of investment demand in East Asian countries (except China) in the presence of very low real interest rates suggests that traditional channels of monetary policy, in particular the cost of capital channel, may have weakened. For example, it is generally believed that this is the case in Japan, and it may also be true in Taiwan and South Korea.


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Figure 2-B. CPI Inflation: Hong Kong and Singapore

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Figure 2-C. CPI Inflation: Malaysia, Indonesia, Philippines and Thailand Year – on –Year Change


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Figure 3-A. Nominal Exchange rate and NDF forward (6 months) in China

Source: Bloomberg


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Figure 3-C. Nominal Exchange rate and NDF forward (6 months) in Korea

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5. Exchange Rate Policy Coordination in East Asia

There is little disagreement that an across the board appreciation of East Asian currencies constitutes an important component of the resolution of global imbalances. However, as noted earlier, if China insists on maintaining its limited flexibility, other East Asian countries are not likely to let their currencies strengthen vis-à-vis the Renminbi as China has emerged as their export competitor in regional as well as global markets.9)

Whatever China does, would it not be in the interest of other East Asian countries to allow their currencies strengthen relative to the dollar independently? Apparently to many East Asian countries, it is not. If the dollar falls as it has and China maintains its near fixed parity vis-à-vis the dollar, then other East Asian countries with an intermediate currency regime fear that they will be forced to absorb disproportionately more the pressure of appreciation of the East Asian currencies. That is, with the weakening of the dollar, their concern is that more of capital inflows into East Asia will flock to the countries that look vulnerable to appreciation, causing a larger appreciation of their currencies relative to the dollar than otherwise, if they do not intervene.

What is significant about China’s move to an intermediate regime is that it will broaden the scope of coordination of exchange rate policy among some of the ten East Asia economies and revive the discussion of establishing a new modality of cooperation for monetary integration in the region. As Kawai (2002) notes, South Korea and Thailand have shifted to a de facto currency basket arrangement similar to Singapore’s managed floating since the crisis. Malaysia has also adopted a basket arrangement. The behavior of real effective exchange rates of Indonesia and the Philippines (Figure 1-B) also indicate that the currencies of the two economies are also linked to a basket of major currencies. Excluding the Yen, which will remain an independently floating major currency, this means that practically all emerging economies in East Asia now have a similar framework of exchange rate policy.

Since the policy authorities of these economies are expected to adjust

9) A 2004 IMF report on Indonesia reflects this gridlock when it says that in 2003 Indonesia’s currency level was not seriously misaligned as it was broadly in line with other regional currencies from a competitiveness point of view.


their dollar exchange rates with changes in the bilateral exchange rates of the currencies in their baskets including the dollar, Euro, and Yen to keep their nominal or real effective exchange rates stable, ASEAN 4, China, Korea and Taiwan will keep a close watch over changes in the dollar exchange rates of other economies just to make sure that their export competitiveness does not slip. Before the regime shift in China, a depreciation of the dollar against the Yen or the Euro automatically increased the competitiveness of Chinese exports. With the introduction of a basket system, such a change in competitiveness will be minimized.

Among China, South Korea, Taiwan, and ASEAN 4, if any economy moves to weaken its currency vis-à-vis the dollar to let its nominal effective exchange rate depreciate, such an intervention will set off competitive devaluation in the region. To prevent such a disarray the competitive clash would be in the interest of the region. With a new regime in place, and its growing economic influence, China will be placed in a position to initiate the discussion of coordination of exchange rate policy including establishing a collective exchange rate arrangement for the ten economies or the eight if Hong Kong and Taiwan are excluded.

Clearly there is a need for a collective exchange rate policy for the entire region. And there is an institutional arrangement such as the ASEAN+3 meetings of finance ministers or their deputies, which could serve as fora for coordination of exchange rate policy among ASEAN 4, China, Korea and Singapore. However, if the past experience with policy coordination among ASEAN+3 is any guide, the seven countries will not be able to agree on any issue as complicated as the realignment of their currencies vis-à-vis the dollar. There are two structural problems causing this impasse.

One problem that has frustrated exchange rate policy coordination in East Asia is that Japan is a very important trade partner to, but cannot participate in any regional framework for exchange rate policy coordination among the seven countries. This is because the Yen is a free floating international currency, whereas other East Asian currencies are linked to baskets of regional and international currents. Even if Japan could be brought into the regional framework, Japan and China, the two major countries, which can and should provide leadership for any collective policy actions and cooperation, would be unlikely to see eye to eye on many regional issues, largely because of their rivalry for a greater


economic and political influence in East Asia. Even if the two were able to work together, they would not be able to persuade other emerging economies to agree on bilateral exchange rate adjustments, in particular if these countries had to revalue their currencies.

Another constrain on regional cooperation on collective exchange rate policy is related to the differences in bilateral trade imbalances among the East Asian countries. When the eight East Asian countries are divided into Japan, China, and the group of emerging economies – ASEAN 4, Korea and Singapore, Japan has been running surpluses in its trade with all these economies including China. The group of emerging economies on the other hand has been running a surplus in its trade with China, but a large deficit with Japan.

Because of these different profiles of the bilateral imbalances, the group of East Asian emerging economies may be able to accept a simultaneous appreciation of their currencies and the Reminbi against the dollar. However, if the yen is not expected to appreciate, China and other emerging economies will not move, for fear of deepening their persistent structural trade deficits with Japan. And the Yen will not necessarily appreciate vis-à-vis the U.S. dollar unless the Japanese authorities intervene. To economists, bilateral trade imbalances may not matter, but to politicians and policymakers, they matter and a lot, especially when coordination of exchange rate policy and the source of deficits in Japan.

References

Genberg, Hans, Robert McCauley, Yung Chul Park and Avinash Persaud. 2005. “Official Reserves and Currency Management in Asia: Myth, Reality and the Future.” Geneva Reports on the World Economy 7. International Center for Monetary and Banking Studies.

IMF. 2005. Asia-Pacific Regional Outlook- September 2005. Asia and Pacific Department.

Kawai, M. 2002. “Exchange Rate Arrangements in East Asia: Lessons from the 1997-98 Currency Crisis.” Monetary and Economic Studies 20, no s-1. Tokyo: Bank of Japan, Institute for Monetary and Economic Studies. (December)

China’s Reform on Exchange Rate System

and International Trade between Japan

and China

Kentaro IWATSUBOHitotsubashi University and Policy Research Institute, Ministry of

Finance, Japan

Shunji KARIKOMIPolicy Research Institute, Ministry of Finance, Japan

Abstract

This paper explores the impacts of exchange rate on trade between Japan and China, with special attention to differences of pricing structure of international trade across industries. Although the Chinese yuan was fixed against the U.S. dollar for several years, it has been fluctuating against the Japanese yen, which provides us with a natural experiment to test the exchange rate effect. We find that exchange rate changes and volatility have little influence on trade volume in most industries, while Chinese economic growth significantly affects Japan’s export to China. For electrical machinery industry, in which Japanese firms’ division of production process is prevailing, we find no evidence of exchange rate impact on trade. These results suggest that the recent reform on China’s exchange rate system does not seem to have a significant effect on the external sectors of the two countries and the cost of exchange rate fluctuation can be, to some extent, mitigated by Japanese firms’ overseas production and pricing structure.

China’s Reform on Exchange Rate System and International Trade between Japan and China 93

1. Introduction

The Chinese government revalued the yuan by 2.1% against the U.S. dollar on July 21, 2005.At the same time, it also announced that the Chinese currency would be allowed to fluctuate against the basket of currencies. The governor of the People’s Bank of China revealed that this currency basket is essentially comprised of the dollar, the euro, the yen and the Korean won, taking into account such factors as trade, capital transactions (external claims and debts) and direct investment. The authority has also adopted a narrow band of 0.3% on either side of the central rate within which the yuan can fluctuate against the dollar.

The shift of China’s exchange rate system from a traditional dollar peg to a currency basket system drew substantial attention, but press reports and many economists cast doubts on the effectiveness of the revaluation of the RMB because the rate of revaluation was too scant to satisfy their expectations.10) Figure 1 displays the daily movement of the RMB/USD rate. In addition to the revaluation on July 21 by 2.1%, the RMB has been steadily appreciating. Nevertheless, the overall rate of appreciation is about 3% as of March 19, 2006. The Chinese monetary authority did not appreciate their currency markedly although its flexibility was relatively increased.

How does revaluation/devaluation affect current account? This question has been extensively addressed in open macroeconomics. A traditional answer to this question is that it depends on Marshall-Lerner condition. In Mundell-Fleming model, devaluation (revaluation) can improve (deteriorate) the trade balance if the Marshall-Lerner condition is fulfilled. This represents an a-temporal condition that relates to the

10) Frankel (2005) summarizes several arguments supporting the view that de facto dollar peg may now have outlived its usefulness for China. (1) China’s economy is on the overheating side of internal balance, and appreciation would help easy inflationary pressure. (2) It is increasingly difficult to sterilize the inflow over time, exacerbating inflation. (3) Although external balance could be achieved by expenditure reduction, e.g., by raising interest rates, the existence of two policy goals (external and internal balance) in general requires the use of two independent policy instruments (e.g., the real exchange rate and the interest rate). (4) A large economy like China can achieve adjustment in the real exchange rate via flexibility in the nominal exchange rate more easily then via price flexibility.


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Figure 1. Daily RMB/USD rate in 2005

elasticity of substitution for home and foreign goods.For the last two decades, most of current account literature have

moved towards an inter-temporal choice theoretic approach stressing the importance of consumption smoothing and investment as an explanation of current account dynamics. Devereux (2000) extends a dynamic sticky-price open economy macroeconomics model a la Obstfeld and Rogoff (1995) to allow for the possibility that some firms in one or both countries might set prices in the currency of final sales. This type of pricing structure has been referred to as “pricing-to-market”.11) He argues that when prices are set in the producers’ currency, the effect of the devaluation hinges on the traditional Marshall-Lerner condition. On the other hand, when prices are set in consumers’ currency, the response of current account depends on the size of intertemporal elasticity of substitution of consumption across time periods. Pricing structure has a significant bearing on the effect of devaluation on the current account.

11) The justification for this type of pricing structure is that it is consistent with the recent findings of Engel (1993, 1999) and Engel and Rogers (1996), indicating substantial deviation from the law of one price in traded goods across countries, which are almost fully accounted for by movements in nominal exchange rates.


0

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1988 1990 1992 1994 1996 1998 2000 2002 2004 (year)

(JPY/RMB)

Source: IMF, "Internaiotnal Financial Statisitcs".

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1988 1990 1992 1994 1996 1998 2000 2002 2004 (year)

(JPY/RMB)

Source: IMF, "Internaiotnal Financial Statisitcs".

Figure 2. Monthly JPY/RMB rate

This paper explores the impacts of exchange rate changes and volatility on trade between Japan and China, with special attention to differences of pricing structure of international trade across industries. Along with the rapid increase in Japan-China trade in the last decades, Japan and China became large trade partners for both, and their trade pattern transformed from “inter-industry trade” to “intra-industry trade.” Formerly, Japan exported manufactured goods while importing food and natural resources. However, China has recently increased to export manufactured goods to Japan to the extent that their imports are greater than their exports to China.

The foreign direct investment of Japanese manufacturing firms in China has played a significant role in changing the trade pattern. They developed the division of production process between Japan and China, which led to increases in trade of differentiated goods within an industry and in trade between intermediate goods and final goods. The more the Japanese firms’ production in China is linked to the trade between Japan and China, the more Japanese firms are likely to influence the pricing

Source: IMF, Internatiotnal Financial Statisitcs.


structure of trade. This mitigates the exchange rate effects on trade volume.In this paper, we conduct a regression analysis to test this hypothesis.

Although the Chinese yuan was fixed against the U.S. dollar from 1997, the JPY/RMB rate has been fluctuating (Figure 2). This provides us with a natural experiment to test for the price impact on trade volume between Japan and China.

We find evidence from Japan’s import and export functions that real exchange rate changes and volatility of the RMB affect the trade volume between China and Japan in few industries, while Chinese income growth has a positive effect on Japan’s export to China. For electrical machinery industry, in which the Japanese firms’ division of production process is prevailing, we document no significant effects of exchange rate changes on import and export. Moreover, almost no significant effects of foreign demand on trade flows can be detected. These findings are consistent with our hypothesis that, to the extent that Japanese firms are likely to influence the pricing structure of trade, trade cannot be affected by exchange rate fluctuation. The cost of China’s reform on exchange rate system can be, to some extent, mitigated by firms’ overseas production and pricing strategy.

The remainder of the paper is organized as follows. Section 2 discusses the background on the recent change in trade pattern between Japan and China. Section 3 presents the estimation results and Section 4 concludes.

2. Background

2.1 Changes of Japan-China trade patternJapan-China trade has been continuously growing for the recent

years. “Trade Statistics” issued by the Ministry of Finance of Japan revealed that total trade value marked a highest record year after year for 6 consecutive years (Figure 3). In 2004, Japan’s export to China reached 8.0 trillion yen and its import from China amounted to 10.2 trillion yen. The trade deficit against China increased to 2.2 trillion yen.12)

12) According to Japanese statistics, Japan is marking deficit in Japan-China trade, but according to Chinese statistics, it is China who is in deficit. Such difference comes mainly from the different way of recording. In Japan, goods must display the country of origin, and when China exports to Japan via Hong Kong, such


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1988 1990 1992 1994 1996 1998 2000 2002 2004Year

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ImportTrade balance

Source : Ministry of Finance ,“Trade STatistics”

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1988 1990 1992 1994 1996 1998 2000 2002 2004Year

Trilion yenExport

ImportTrade balance

Source : Ministry of Finance ,“Trade STatistics”

Figure 3. Japan’s trade with China

Source:　Minist ry of Finance," Trade Stat ist ics"

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その他

EU

USA

Asia(exc.China,Hong kong)Hong Kong

China

＜Import＞＜Export＞

Figure 4. The share of trading partners of Japan

trade is recorded as “import from Mainland China”. For China, when the final destination is not known at the time of shipping, such deal is recorded as “export to Hong Kong”.

Source: Ministry of Finance, Trade Statistics.

Source: Ministry of Finance, Trade Statistics.


＜Export＞

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25

1995 96 97 98 99

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2004（Ｙｅａｒ）

（％）

Source: China Customs Statistics.

＜Import＞

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ASEAN

USA

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Figure 5. Share by countries trading with China

＜Export＞

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1995 96 97 98 99

20002001200220032004

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China is the second largest importing country to Japan, and dependency on China increased from 6.3% of year 2000 to 13.1% in year 2004 (Figure 4). Also, the share of China in Japan’s total import increased from 14.5% to 20.7% during the same period.13) As a result, the difference between China and USA, who is the largest trading partner to Japan, has become smaller, making the existence of China as a trading partner more significant than ever.

For China, Japan is the largest exporting country (Fourth importing country). However, China, who is achieving high economic growth of annual 9%, is an extremely promising market to all other countries. So, even though Japan’s total export value with China has increased, the share of Japan in China’s total import has shrunk, since other countries like Korea and ASEAN countries are increasing their export to China (Figure 5).

What are the items Japan is exporting to China, and what are the items it is importing from China? In the past, a major trade pattern between Japan and China was “inter-industry trade”, in which Japan exported manufactured products while importing food, fuel, and raw

13) If we include Hong Kong, export dependency on China as of 2004 jumped to 19.3% from 12.0% of 2000, and import dependency on China during the same period also rose from 15.0% to 21.1%.

Source: China Customs Statistics.


Table 1. Japan’s trade with China (by types of goods)

＜Export＞　　　　　　　　　　　　　　　　　　　　　　　　　　　 (%)

Year 1980 1990 1995 2000 2004

Food 0.0 0.4 0.4 0.5 0.4

Fuels & raw materials 0.5 1.8 2.4 3.2 3.1

Manufactured products 99.5 97.8 97.2 96.3 96.5

Textiles 8.0 9.9 10.8 9.8 4.8

Chemicals 10.7 12.3 9.3 13.2 12.4

Metals 33.2 19.5 14.2 10.7 9.7

Machineries 42.3 46.2 55.8 54.9 ·60.4

＜Import＞

Year 1980 1990 1995 2000 2004

Food 10.9 16.1 13.1 10.7 7.9

Fuels & raw materials 66.6 33.2 9.6 6.6 5.1

Manufactured products

22.5 50.7 77.3 82.7 87.0

Textiles n.a. 26.5 34.4 29.6 21.4

Chemicals n.a. 5.4 3.7 3.0 3.2

Metals n.a. 4.6 6.1 4.1 5.3

Machineries n.a. 4.3 14.4 26.1 39.4

Source: Ministry of Finance, Trade Statistics

materials. However, export of manufactured products from China to Japan increased and, as a result, the pattern has now shifted to “intra-industry trade”, in which both countries export their industrial products to each other (Table 1).

When we look at imported goods from China, we find that goods manufactured in labor-intensive industry, such as food, textiles, and footgear still take up large share. As for textiles, the share of Chinese textiles among Japan’s imported textiles is as high as 74.6%, due to wide distribution of low price commodities through mass sales store such as UNIQLO. The reasons behind this are; a) Quality of Chinese goods have improved very much from the days when Chinese goods were thought to be “cheap and nasty”. b) Japanese consumers’ inclination to buy low


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1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 (FY)

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Source: Ministry of Finance,"Outward and Inward Foreign Direct Investment"Note: On prior notice basis. The fiscal year begins in April, and ends in March of the following year.

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1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 (FY)

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Source: Ministry of Finance,"Outward and Inward Foreign Direct Investment"Note: On prior notice basis. The fiscal year begins in April, and ends in March of the following year.

Figure 6. Japan's FDI to China

price goods. Along with above tendency, the share of capital-intensive goods

such as machineries and electrical instruments is increasing. When we look at export of 2004, while textiles increased 13.1% from the previous year, machineries and equipment showed great increase of 32.6%, due to increase in office appliances, computer applications, and mobile phones.

2.2 Japanese firms’ division of production process in ChinaThe expansion of Japan-China product trade is largely promoted by

foreign direct investment of Japanese firms in China. Japan’s FDI in China after the Chinese government took the “reform

and opening-up policy” in the 80s, and the yen appreciation in mid 90s further urged Japanese firms to shift their production location(Figure 6). During this period, the number and total amount of contract increased dramatically and marked the peak in 1995. When prospect of China joining WTO became clearer, contract amount started to rise once again and real spending for 2001 exceeded that of 1998 and marked the highest

Note: On prior notice basis. The fiscal year begins in April, and ends in March of the following year.

Source: Ministry of Finance, Outwardand Inward Foreign Direct Investment


in history. It should also be noted that, after 2001, global trend of foreign direct investment turned toward decrease, but FDI to China kept increasing. The current situation may be called as the “Third China Investment Boom”.

Japanese firms operating in China established systems to carry out final assemblies in China, but procure parts necessary for the assembly do not always come from domestic market but from other countries such as East Asian countries. Especially, highly sophisticated parts and materials are mostly imported from Japan. According to the regular survey conducted by Ministry of Economy, Trade and Industry, “Overseas Business Activities of Japanese Companies”, Japanese firms engaging in production activities in China procured only one third (37.7%) of necessary materials from domestic market, and imported 33.7% from Japan.

Figure 7 shows production process of digital camera A, from one of the leading precision equipment manufacturer.14)

Marketing/ productplannig Product development Component

product ion Product assemnbly Sales

Japan Head quarters(Planning/ development)

Headquarters (Productdevelopment / design)

Aff iliated companiesin Japan

Sales headquarters(Reimport )

Overseasmarket

（China）

Aff iliated companiesin China

Af f iliatedcompanies in China

Aff iliated companiesin China dist ributuionin China

Third country Af f iliated companies inEurope and US

Worldwide (Europeand US, etc.)

Japanese,Taiwanesecomponentsmanufacturers inChinese localcompaniesOriginal designmanufacturingcompanies of Asianregions other thanChina

Source: METI,"White Paper on International Economy and Trade 2004"　

In- housedivision oflabor

　Other companies

Figure 7. Production process and division of function for digital camera A

14) The firm’s operation in China started in early 90’s when it built factories in Guangdong. At the initial stage of its operation in China, only assembly of final products was undertaken. However, the scope and scale of the works gradually expanded to lens parts, plastic molding, painting, and mounting. By late 1990’s, fully independent silver salt camera production line had been established. The firm started manufacturing digital cameras in early 2000. The following explanation is based on “White Paper on International Economy and Trade 2004” pp. 164-166.

Source: METI, White Paper on International Economy and Trade 2004.


Component group Location ofsupplier

Share ofproductioncosts(%)

Componentcosts Imaging operation function/exterior Japan 13

Total63 eg. TFT, Metal cladding, etc. China 1Japan49 Optical system unit Japan 13China 8 eg. Filters, Image pickup devices, Lenses, etc. China 6

Switzerland4 Thailand 2Thailamd2 Circuit board Japan 17

eg. Custom IC, Electrical components, etc. Switzerland 4Other components Japan 6

China 137

Total 100

Source: METI,"White Paper on International Economy and Trade 2004"

Labor costsOthers

Note: Japan in "Location of supplier" means that a component is supplied by Japanese company( excluding Japanese companies in China). It does not always mean that its production processeswere all oprated in Japan.

Component group Location ofsupplier

Share ofproductioncosts(%)

Componentcosts Imaging operation function/exterior Japan 13

Total63 eg. TFT, Metal cladding, etc. China 1Japan49 Optical system unit Japan 13China 8 eg. Filters, Image pickup devices, Lenses, etc. China 6

Switzerland4 Thailand 2Thailamd2 Circuit board Japan 17

eg. Custom IC, Electrical components, etc. Switzerland 4Other components Japan 6

China 137

Total 100

Source: METI,"White Paper on International Economy and Trade 2004"

Labor costsOthers

Note: Japan in "Location of supplier" means that a component is supplied by Japanese company( excluding Japanese companies in China). It does not always mean that its production processeswere all oprated in Japan.

Table 2. Production cost structure of digital camera A

Product planning and development of the digital camera are basically implemented in Japan　(Headquarter). Parts are procured from various countries, and the parts production is undertaken by many different countries according to the function of each part. For example, in the manufacturing of CCD (charge-coupled device for picking up images), the initial stage of manufacturing is undertaken in East Asian countries, and the final stage in Japan. As for lenses, 5 to 7 lenses are mounted in one camera, and each lens is manufactured in different countries according to its function. Furthermore, the metal cladding, which is part of the image operation function, is also procured from various manufacturers in Japan and other countries. They are procured according to the production skills of the manufacturer. Some manufacturers are good at producing tiny parts, some are good at processing delicately designed products, and some are good at processing flat parts. However, as mentioned later, high added value products are manufactured by Japanese firms. As for assembly, China is the sole location for assembly, and assembled final products are shipped to all sales points in the

Note: Japan in "Location of supplier" means that a component is supplied by Japanese company (excluding Japanese companies in China). It does not always mean that its production processes were all porated in Japan.

Source: METI, White Paper on International Economy and Trade 2004.


world. Table 2 shows parts of a digital camera, the country they come from,

the cost share, and share by countries. From this figure, we see that most of the important parts come from Japanese firms. The main reason could be that since a digital camera is a high-added value product, it needs high quality parts, and at present, there are no other firms but Japanese ones who can constantly provide high-quality precise parts.

The division of functions for China and Japan for this firm is apparent. In other words, the firm’s headquarter in Japan concentrates to “developing added values”, and “innovating technologies”, and China is regarded as “production sites of added value”.15) As for the future division of functions between Japan and China, the firm is trying to strengthen and expand the capacity of Chinese mass production plants and transfer some parts of unit design technology to local plants which do not include state of the art technology. By doing so, it is seeking ways to expand local procurement in China by improving the technological capabilities in China.

2.3 Two types of trade patternsWe next provide a trade specialization coefficient as a measure of

competitiveness or the division structure between Japan and China. The “trade specialization coefficient” referred here shows figures expressing difference in export and import of a certain industry, divided by their sum. The value of the coefficient varies from +1 to -1, and the closer the value to zero, the more balanced the trade between two countries in that industry is, in other words, horizontal division of work is going on between the two. In terms of Japan-China trade, the closer the coefficient is to +1, the more one-way export is going out from Japan, and closer to -1, the more one-way import from China to Japan.

Table 3 shows Japan’s trade specialization coefficients with China by

15) If Japan tries to keep only R&D section in Japan, manufacturing capability and knowledge may disappear. For this reason, domestic site recently engages not only in R&D but also test production, production of key components, and production of high technology few production products such as single-lens reflex cameras. Also, up until recently, the firms were concentrate assembly works to China only to establish robust production systems. However, the firms expressed their plan to seek production sites other than China, in the future, in order to reduce the risk of production site other than China.


1988 1990 1995 2000 2005

-0.97 -0.97 -0.96 -0.95 -0.92

-0.99 -0.95 -0.75 -0.82 -0.50

0.33 -0.10 -0.20 -0.30 -0.22

Iron and steels 0.93 0.51 0.34 0.55 0.51Clothing andaccessories -0.98 -0.99 -0.99 -0.99 -0.99

General machinery 0.97 0.87 0.73 0.22 -0.07Electoricalmachinery 0.91 0.57 0.19 -0.01 -0.01

Transport equipment 0.99 0.93 0.60 0.34 0.43

Source: Ministry of Finance,"Trade statistics"

Note: The trade specialization coefficient (TSC) is caluculated as follows : TSC=value of exports -Value of imports / Value of exports + Value of imports . Figures are always within the rangebetween -1 and 1. -1 indicates a specialization in imports and 1 in exports.

Year

Food and beverages

Mineral and fuels


1988 1990 1995 2000 2005

-0.97 -0.97 -0.96 -0.95 -0.92

-0.99 -0.95 -0.75 -0.82 -0.50

0.33 -0.10 -0.20 -0.30 -0.22

Iron and steels 0.93 0.51 0.34 0.55 0.51Clothing andaccessories -0.98 -0.99 -0.99 -0.99 -0.99

General machinery 0.97 0.87 0.73 0.22 -0.07Electoricalmachinery 0.91 0.57 0.19 -0.01 -0.01

Transport equipment 0.99 0.93 0.60 0.34 0.43

Source: Ministry of Finance,"Trade statistics"

Note: The trade specialization coefficient (TSC) is caluculated as follows : TSC=value of exports -Value of imports / Value of exports + Value of imports . Figures are always within the rangebetween -1 and 1. -1 indicates a specialization in imports and 1 in exports.

Year

Food and beverages

Mineral and fuels


Table 3. Japan’s trade specialization coefficient with China by items

items. For primary products such as food and beverages (vegetables and fruits) and mineral fuels, there are far more import from China to Japan than export vice versa, showing great competitiveness of China in this field. On the other hand, the coefficient of industrial products as a whole was 0.33 in 1988, but in 2005, the value has became -0.22, which implies the relationship between Japan and China may be described as horizontal division of work.

Nevertheless, when we look closer to each item, the situation differs very much by item. In some items, conventional situation has not changed. For example, in clothing, China has continuously been strong, and in transport machines, Japan has been strong.

On the contrary, coefficients for general machinery and electrical machinery used to be close to +1, but have drastically reduced. This may be described as a development that along with expansion of business activities of Japanese firms in China, household electrical appliances and

Note: The trade specialization coefficient (TSC) is caluculated as follows: TSC=value of exports - Value of imports / Value of exports + Value of imports. Figures are always within the range between-1 and 1. -1 indicates a specialization in imports and 1 in exports.

Source: Ministry of Finance, Trade statistics.


Export unit price Import unit price

A B (A)/ (B)Iron and steel products Thousand yen/1000kg 104.19 72.34 1.44

Non-metaric mineral ware Thousand yen/1000kg 617.9 346.4 1.78

Medical products Thousand yen/kg 10.3 1.0 9.92

Leather Thousand yen 6952.4 919.4 7.56

Computer and parts Thousand yen 23.4 14.39 1.63

Facimile Thousand yen 67.8 13.9 4.88

Audio disk players Thousand yen 6.9 5.2 1.35

Passenger automobiles Thousand yen 2524.2 350.2 7.21

Source Ministry of Finance,"Trade stistics "

Articles Unit

Note It was calculated based on the data of 2005 (the amount from January to October ).

Export unit price Import unit price

A B (A)/ (B)Iron and steel products Thousand yen/1000kg 104.19 72.34 1.44

Non-metaric mineral ware Thousand yen/1000kg 617.9 346.4 1.78

Medical products Thousand yen/kg 10.3 1.0 9.92

Leather Thousand yen 6952.4 919.4 7.56

Computer and parts Thousand yen 23.4 14.39 1.63

Facimile Thousand yen 67.8 13.9 4.88

Audio disk players Thousand yen 6.9 5.2 1.35

Passenger automobiles Thousand yen 2524.2 350.2 7.21

Source Ministry of Finance,"Trade stistics "

Articles Unit

Note It was calculated based on the data of 2005 (the amount from January to October ).

Figure 8. Comparison of an export unit price and an import unit price of the same item in trade with China

precision machines which used to be exported to China one-sidedly have gradually come to be manufactured in China, and then exported back to Japan. The movement we observe recently is Japan’s machine parts import from Japanese firms in China. These are machine parts using medium degree technology and not manufactured in Japan any more. These machine parts are assembled in Japan with capital intensive high quality production management process, to become high added value products, and exported to Europe and USA. As a result of these corporate activities, even though the items fall in the same category, thanks to the difference of added value, the volume of traded goods increases and horizontal division of works also increases. When we compare the price per unit of the items exported from Japan andimported to Japan, both in raw material and final products, export item unit price far exceed that of import items (Figure 8).

Based on those examinations, Japan-China trade pattern can be categorized into following patterns.

(1) Inter-industry tradeJapan exports capital-intensive goods (e.g., durables) to China, and

imports labor-intensive products (e.g., textile) and primary products.(2) Vertical intra-industry tradea) The trade between intermediate and final goods (division of

Note: It was calculated based on the data of 2005(the amount from January to October).Source: Ministry of Finance, Trade statistics.


production process between China and Japan). Japan exports parts/ intermediate goods and China assembles and exports final products.

b) The trade between low and high value-added goods of the same item.

3. Regression analysis

In this section, we undertake regression analysis on Japan’s import and export functions to test for the impacts of exchange rate changes and volatility on trade volume. We examine in what industries the changes and volatility of the JPY/RMB rate affect trade volume. Also, we investigate whether the exchange rate effect on trade volume is weaker for the industries in which the division of production process is prevailing.

We estimate a regression of the following form:

tttttt FDeTRTR εσµλγβα ++∆+∆+∆+=∆ − )ln( 21

where TR∆ is the quarterly rate of change in trade volume by industry, e∆ is the real effective exchange rate change, and FD∆ is the rate of change in foreign demand (e.g., Japanese real GDP growth rate

and Chinese real GDP growth rate). Lastly, )ln( 2tσ is the exchange rate

volatility, which is estimated by assuming that real effective exchange rate follows an EGARCH model.16)

)ln()ln(

),,0(~

21

1

12

2

−−

− ++=

+=∆

tt

tt

tt

tt

dba

N

ce

σσε

σ

σε

ε

We use quarterly trade volume by industry as a dependent variable. The Japan’s import function covers 31 industries (3 digit HS codes) and

16) EGARCH model assumes the non-negativity of conditional volatility.


11 sectors (7-digit PC codes) in electrical machinery industry. The export function covers 19 industries (3 digit HS codes) and 25 sectors (7-digit PC codes) in electrical machinery industry.17) The sample period is from the first quarter of 1988 to the third quarter of 2005.

The key parameters we focus are γ andµ . Since an increase in e implies real appreciation of the RMB against the Japanese yen, γ is expected negative for Japan’s import functions while positive for the export functions. An increase in exchange rate volatility will reduce trade if hedging is not possible or is expensive. Therefore, µ is expected negative for the export and import functions. λ is expected positive since income growth increases import from abroad.

Both Table 4 and 5 displays only regression results with significant coefficients because most regression coefficients are not significant. The former is the outcome of Japan’s import function and the latter is about the export function. Table 4 shows that the changes and volatility of the RMB rate have negative effects on China’s export to Japan in few industries (five out of 31 industries (3-digit codes) for exchange rate changes and three out of 31 for exchange rate volatility). Japanese income growth has a positive effect on import in four industries (3-digit codes) out of 31.

Table 5 presents the regression results from the export function. We find no significant effects of exchange rate changes on trade volume. In only two out of 19 industries, exchange rate volatility affects negatively the trade volume. On the other hand, Chinese income growth has a significantly positive effect on Japan’s export to China. This relationship can be detected in 9 out of 19 industries.

For electrical machinery industry (7-digit codes), in which Japanese firms actively engage in division of production process, we find no evidence of exchange rate effects on import or export (Table 4 and 5). Moreover, there are almost no significant effects of foreign demand on trade flows (one out of 11 sectors for import and 4 out of 25 sectors for export).

17) HS code refers to the Harmonized Commodity code subject to the international convention on the Harmonized Commodity Description and Coding System. PC code refers to principal commodity code that the Japanese customs create for 7 to 9-digit statistic codes. They are used in publication of the Trade Statistics.


The findings are summarized as follows: first, we find little evidence that China’s exchange rate fluctuations affect the international trade between Japan and China. For the trade from Japan to China, China’s income growth is more influential for trade than exchange rate changes and volatility. This finding is consistent with that of previous studies such as Fernald et al. (1999).

Our new finding is that trade volume is not affected by exchange rate fluctuation for the industry in which firms’ division of production process is prevailing. This suggests that the cost of exchange rate fluctuation can be, to some extent, mitigated by firms’ overseas production and pricing strategy.

4. Conclusion

Following the revaluation of Chinese yuan and its shift from a dollar peg to basket peg, their effects have attracted tremendous attentions. This paper explores the impacts of real exchange rate on trade between Japan and China. We find evidence from Japan’s import and export functions that real exchange rate changes and volatility of the RMB affect the trade volume between China and Japan in few industries, while Chinese income growth has a positive effect on Japan’s export to China.

For electrical machinery industry, in which the Japanese firms’ division of production process is prevailing, we document no significant effects of exchange rate changes on import and export. Moreover, we find almost no significant effects of foreign demand on trade. These findings are consistent with our hypothesis that, to the extent that Japanese firms are likely to influence the pricing structure of trade, trade cannot be affected by exchange rate fluctuation. The cost of China’s reform on exchange rate system can be, to some extent, mitigated by firms’ overseas production and pricing strategy.

Acknowledgements

We would like to thank Dr. Jonghwa Cho, Prof. Yuri Sasaki, Prof. Naoyuki Yoshino, Prof. Jongwha Lee, Dr. Deok Ryong Yoon and


participants of the PRI-KIEP Seminar. Any remaining errors are our own.

References

Arize, A. C, Osang, T., Slottje, D. J. 2000. "Exchange-Rate Volatility and Foreign Trade: Evidence from Thirteen LDC’s." Journal of Business and Economic Statistics, Vol. 18, No. 1, pp. 10-16.

Caporale, T., Doroodian, K. 1994. "Exchange Rate Variability and the Flow of International Trade." Economics Letters 46, pp. 49-54.

Doganlar, M. 2002. "Estimating the Impact of Exchange Rate Volatility on Exports: Evidence from Asian Countries." Applied Economic Letters, pp. 859-863. (September)

Eichengreen, B. 2004. "Chinese Currency Controversies." International Macroeconomics and International Trade Discussion Paper Series No. 4375.

Engel, C. 1993. "Real Exchange Rates and Relative Prices: an Empirical Investigation." Journal of Monetary Economics 104, pp. 205-228.

. 1999. "Accounting for U.S. Real Exchange Rates." Journal of Political Economy 107, pp. 507-538.

Engel, C., Rogers, J. H. 1996. "How Wide is the Boarder?" American Economic Review 79, pp. 637-654.

Fernald, J., Edison, H., Loungani, P. 1999. "Was China the First Domino? Assessing Links Between China and Other Asian Economies. Journal of International Money and Finance, pp. 515-535.

Frankel, J., 2005. "On the Renminbi: The Choice between Adjustment under a Fixed Exchange Rate and Adjustment under a Flexible Rate." NBER Working Paper No. 11274.

Kroner, F. K. 1993. "The Impact of Exchange Rate Volatility on International Trade: Reduced from Estimates Using the GARCH-in-mean Model." Journal of International Money and Finance, pp. 298-318.

Loungani, P. 2000. "Comrades or Competitors?: Trade Links Between China and Other East Asian Economies." Finance and East Asian Economies, Vol. 37, No. 2.

Ministry of Economy, Trade and Industry. 2004. White Paper on International Economy and Trade 2004.

. 2005. White Paper on International Economy and Trade 2005.

Consequences of Real Exchange Rate

Misalignment: the Case of China*

18)

Zhang BinInstitute of World Economics and Politics,

Chinese Academy of Social Sciences

He FanInstitute of World Economics and Politics,

Chinese Academy of Social Sciences

We develop a tradable-nontradable model in which real exchange rate is exogenous and tradable sector is experiencing faster TFP growth than that of nontradable sector. The model suggest that under the policy combination of fixed nominal exchange rate and low inflation target, the relative high growth of TFP in tradable sector bring about not only economic growth, but also (1) distorted economic structure; (2) enlarging trade surplus; (3) wage depression and slowdown of transferring labor force from rural area to urban area; (4) worsening of income distribution. Currency appreciation and faster TFP growth in nontradable sector is the key to solve above distortions.

Introduction

Within open economy, the real exchange rate affects not only the international competitiveness but also the interior competitiveness of the trade sectors over nontradable sectors. In a mature market economy system, economic fundamentals changes will have the real exchange rate adjusted correspondingly to direct more reasonable allocation of capital and labor force between different economic sectors and therefore play a

* Paper prepared for 3rd KIEP-PRI Seminar, January 12, 2006 Jeju Island.


70

80

90

100

110

120

95 96 97 98 99 00 01 02 03 04 05

� � �人人人人人人 �� 人人人人人 � �美美人人人人

Source: IFS

Figure 1. RMB Nominal Effective Exchange Rate, Real Effective Exchange Rate and USD Nominal Effective Exchange Rate

key role in maintaining the external and internal balance and ensuring the growth potential of the economy. But in China, determination of the (external) real effective exchange rate of RMB is largely dependent on variation of the nominal effective exchange rate of USD (see Figure 1) since consolidation of RMB exchange rates in 1994. There is no sufficient mechanism in forming the real exchange rate of RMB to reflect the economic fundamental changes. The reasonable allocation of resource between economic sectors through the change of real exchange rate is also restricted. Particularly since the depreciation trend of USD in 2002, the real exchange rate of RMB has declined correspondingly and triggered subsequently the RMB appreciation expectation and speculations in financial market. There has been intense arguing between the academic circles on whether RMB needs to be appreciated and how the mechanism to form RMB exchange rate is improved.

In the past few years, there have been a lot of studies arisen from the RMB exchange rate issue such as the studies in view of the internal and external macroeconomic balancing by Anderson (2003), Goldstein (2004), Frankel (2005), Blanchard and Giavazzi (2006), who suggest that the current RMB exchange rate needs to be adjusted; as well as the

� � �人人人人人人 �� 人人人人人 � �美美人人人人RMB Nominal Effective Exchange Rate Real Effective Exchange Rate USD Nominal Effective Exchange Rate

Consequences of Real Exchange Rate Misalignment: the Case of China 113

studies in view of equilibrium of exchange rate by Zhang Bin (2003), Shi Jianhuai and Yu Haifeng (2005), who point out that the real RMB exchange rate has been undervalued to a certain extent since 2003 and RMB needs to be reevaluated. There are more studies focusing on the impacts of adjustment of RMB exchange rate upon independency of monetary policies, export, employment and inflation, such as the studies about relationship between currency appreciation and employment by He Xinhua (2003), Wan Jieqiu and Xu Tao (2004); the study about impacts of RMB appreciation on investment, price, employment and so on using the Quarterly Macroeconomic Model by He Xinhua (2004); the study about impacts of currency appreciation on export, employment, economic growth, etc by Zhang Shuguang (2005) and the studies about relationship between RMB real exchange rate and foreign trade by Li Jianwei and Yu Ming (2003), Lu Xiangqian and Dai Guoqiang (2005). In addition, insightful discussions in regard to the effect of adjustment to RMB exchange rate on Chinese economy have been made by many scholars such as Yu Yongding (2003), McKinnon and Zou Zhizhuang (2005). In general, most of these studies think that the adjustment to current RMB exchange rate will make a negative impact on employment and foreign trade in a short term, but reform of current RMB exchange rate system will benefit to maintaining independency of monetary policies.

Although there have been a rich research outcomes on the issue of RMB exchange rate, the above studies still have insufficient policy reference to current exchange rate decision. Foreign scholars have come to a conclusion using typical macroeconomic analysis framework that RMB exchange rate needs to be adjusted for restoring internal and external balancing. However, Chinese macroeconomic policy makers think that Chinese macroeconomic administration authority still has sufficient countermeasures even facing growing external imbalance and threats to monetary independency. With help by means of capital regulation, administrative measures and sterilization operations, the macroeconomic administration authority is fully capable of maintaining the current or next RMB exchange rate that may not be accepted in market. If currency appreciation could affect Chinese economy, particularly making severe negative or uncertain effect on employment and economic growth, the macroeconomic administration is absolutely able to continue maintaining current exchange rate and abandon the goal for external


balance temporarily in consideration of domestic economic stability. The empirical studies about the effect of adjustment to RMB exchange

rate on independency of currency policies, exportation, employment, price, etc that domestic scholars are focusing on may have more valuable reference to making exchange rate policies. However, most of empirical studies failed to discuss how the adjustment to RMB exchange rate acts on the allocation of resources in a general equilibrium framework that reflects characteristic facts of Chinese economy and instead, they came to conclusion of empirical studies by directly using the traditional econometric model that associates the concerned variables and exchange rates as well as other relevant variables directly, or indirectly in a form of simultaneous equations. Although the empirical study has answered how the adjustment to exchange rate would take effect, the mechanism by which to have effect has not been well explained. The reference of empirical study conclusions to policy makers will be largely discounted in consideration of model setting deviation brought by imperfect theory and thinking about characteristic facts of Chinese economy, plus data and measure problems. The empirical studies on RMB equilibrium exchange rate answered directly to what extent the exchange rate needs to be adjusted. However, like other empirical studies they skipped over the mechanism by which the change of exchange rate acts on allocations of economic resources. Their persuasion on policy making is not sufficient.

To provide more sufficient reference basis for adjustment to exchange rate policies, it is urgent to clarify in theory how the adjustment to RMB exchange rate will bring changes on resource allocation, and what effects it will have on wage, employment, industrial structure, trade balance, etc. This will help to enlarge the view on exchange rate study, and particularly to associate the unbalanced economic structure, loss of employment opportunities and severe external unbalance that emerged in China in past several years with the exchange rate issue in a unified research framework. Extension of recognizing these problems will provide further reference to making exchange rate policies. It is just what this paper is made for. Analysis is carried out in the following four parts. The second part shows a few stylized facts in Chinese economic growth that relate to modeling. The third part establishes basic models. The fourth part extends models. The fifth part discusses the policy implications of the model.


Value added at unchanged price Average growth rate (5)

Productivity at unchanged price Average growth rate (%)

Agriculture Industry Service Agriculture Industry Service

1981 - 1993 5.7 11.6 11.9 3.7 6.2 4.2

1994 - 2004 3 11.1 8.6 3.6 9.8 3.8

Source: Output and labor force data are from respectively World Development

Indicator 2005 and Huatong Database. The growth rate is calculated by the author.

Table 1. Difference in Growth Rate (%) of Agriculture, Industry and Service in China

Stylized Facts in Chinese Economic Growth

1. Faster TFP growth in Industrial Sectors than in Service SectorsIn more than 20 years of implementing reform and opening policies,

distinctive growth difference between sectors has shown while Chinese economy is maintaining an overall rapid growth. It can be seen by comparing the average growth rate of value added in major economic sectors shown in Table 1, that the industry and service is the master engine to promote an overall economic growth and that the growth in agricultural sectors is relatively slow. It can be seen by comparing the average growth rate of labor productivity that the labor productivity in industrial sectors has greatly exceeded other sectors and become an engine to promote the increase of labor productivity in entire society. It is noticed by comparing the average growth rate in both stages between 1981 and 1993 and between 1994 and 2004, that the growth rate of labor productivity in industrial sectors at the latter stage increases largely while the growth rate of value added in industrial sectors at the latter stage keeps essentially even with that in the former stage, and that both the growth rate of value added and the growth rate of labor productivity in service sectors are obviously lower than those at the former stage.

There are two reasons that industrial sectors grow faster than service sectors. First, in term of production functions, the industrial sector has more advantages than that of service sectors. Within a well organized system, the industrial sectors at a low-level development stage faces


large rooms for technical advance, capital deepening and improvement of resource allocation. The total factor productivity (TFP) and the labor productivity are easy to grow quickly. This has been experienced by most economies that had been at rapid economic growth period. Second, the industrial sectors such as manufacture, textile experienced a systematic marketization reform. It is seen in detail that the marketization reform in industrial sectors covers several key respects:

Enterprise ownership: A lot of non-state owned enterprises came out and became the major force to promote the growth in industrial sectors. A large-scale rebuilding on withdrawal, reorganization and share-holding has been made for the state owned enterprises. By the end of 2004, 1,464 companies among 2,903 large state-owned and state-holding enterprises in the whole country have been reestablished as corporate enterprises with multiple share-holding. The proportion of reestablishment is over 50%.

Market building: A thorough price system reformation has been made in most industrial sub-sectors and the market entry limits were loosened. The reasonable market competition order has been formed in most industrial sectors.

External environment: Tariff and non-tariff walls reduced; policy incentives are given to attract the direct investment from foreign countries.

It is no doubt that the above market reformation measures successfully carried out has established a promise for technical advance and improvement of resource allocation efficiency in industrial sectors and helped to realize fast increase of the total factor productivity in industrial sectors.

Comparing with the rapid growth in industrial sectors, the growth in service sectors is relatively slow. There are also two reasons for that. First, in term of production function, comparing with industrial sector, there are relatively lower rooms for TFP growth, capital deepening and resource allocation improvement in service sector and that the progress of total factor productivity is limited. Second, the marketization reform in those sub-sectors with a considerably large proportion in service industry, such as education, medical, health, environment, finance, communication, is so slow that the improvement on technology and resource allocation efficiency in these sectors has been restricted. The principal operators in above sectors are state-owned enterprises and the private sectors face very high restrictions for market entry. As for market building, price control and


Industry Service

output growth

rate

Capital growth

rate

Labor growth

rate

output growth

rate

Capital growth

rate

Labor growth

rate

1981-1999 12.3 5.9 4.1 10.9 13.8 6.9

Source: The data of capital stock are from Estimation of Capital Stock in

Chinese sub-sectors by Sun Linlin and Ren Ruoen (2002). The data of output and labor force are from respectively World Development

Indicator 2005 and Huatong Database. The growth rate is calculated

by the author.

Table 2. Decomposition of Growth in Industry and Service

market entry control are very popular, the market competition is insufficient, and the monopolization in some industries representative of railway traffic and post service is very severe. In addition, the competition from international market is very limited comparing with industrial sectors, since it is difficult for most products of service sectors to be involved in international trade.

The empirical studies have proved the higher total factor productivity in industrial sectors than in service sectors. On the basis of new classical production function that total factor productivity = output growth rate – (capital growth rate * capital’s share)- (labor growth rate * labor’s share), it can be seen in Table 2 below that the output growth rate in industrial sectors is higher than in service industry, but the capital growth rate and the labor growth rate in industrial sectors are much lower than in service sector. It is not difficult to deduct from Table 2 that the total factor productivity in industrial sectors is much higher than the total factor productivity in service industry.

Since most tradables are in industrial sectors and most nontradables are in service sectors, the total factor productivity in industrial sectors relatively higher than in service sectors also reflects the total factor productivity in tradables sectors relatively higher than in non tradables sectors. This is an important assumption in the following model analysis.


Exogenous Nature of the Determination of Relative Price of Tradables to Nontradables

Although a considerably extensive price system reformation has been experienced in the past marketization reform for more than 20 years, the relative price of products in tradables sectors and nontradables sectors are still difficult to reflect the supply-demand relation between products in these two types of sectors and to optimize resource allocation between two sectors. The relative price of products in tradables sectors and non tradables sectors (that is the real exchange rate) in a mature market economy is dependent on the change of economic fundamentals behind these two sectors. As shown by Balassa- Samueslon Effect, if the tradable sectors experienced faster technical advance than in nontradable sectors, it would result in higher relative price of non tradable to tradable. Under the assumption that the country is a price taker in international market, there are two ways to realize the increase of relative price of nontradables to tradables:

(1) Currency appreciation: Given the international market price of tradables, currency appreciation in the country reduce the domestic price of tradables such as export, potential export, import, import substitution, etc, and the price of nontradables raises relatively to the price of tradables.

(2) Inflation: Since the nominal exchange rate is unchanged and the international market price of tradables is given, inflation will translate into the price increase of nontradables. The price of nontradables raises relatively to tradables.

Either of the above ways means appreciation of real exchange rate in accordance with definition of real exchange rate.

The above two ways to realize price increase of nontradables relative to tradables are not feasible under the current exchange rate forming mechanism and price administration target in China. China has maintained a stable USD peg from 1997 to July 2005. Although the appreciation of USD relative to other major currencies in the world during this period has helped China realize appreciation of RMB nominal effective exchange rate to a certain extent, RMB also follows USD to depreciate relatively to other major currencies in the world as USD depreciates. It is seen at least from the forming mechanism that there is no mechanism in determination of RMB nominal exchange rate that reflects the demand on real exchange


rate adjustment arisen from the change of essential economic aspects. In addition to maintaining stability of RMB/USD nominal exchange rate, Chinese macroeconomic administration authority watches the price target closely and maintains stability of domestic price by market and administrative means when facing various shocks. For macroeconomic administration, it is no doubt correct to keep the price stable. However, since the nominal exchange rate does not reflect real exchange rate adjustment, stability of domestic price also restricts the real exchange rate adjustment demanded by the change of economic fundamentals.

The experience proved exogenous nature of RMB real exchange rate. The fluctuation of RMB real exchange rate is largely dependent on the fluctuation of USD nominal weighted trade exchange rate. In the sample period from the second quarter in 1994 to the forth quarter in 2004, the correlation coefficient of RMB nominal effective exchange rate (that is nominal weighted trade exchange rate) to USD nominal weighted trade exchange rate is 0.96 while the correlation coefficient of RMB real effective exchange rate to nominal effective exchange rate is 0.91. These two high coefficients indicate that the fluctuation of RMB real effective exchange rate is largely dependent on RMB nominal effective exchange rate and that the fluctuation of RMB nominal effective exchange rate is largely dependent on USD nominal effective exchange rate.

It needs to be explained that the above RMB real effective exchange rate is an external real exchange rate adjusted with cost of living index, while the real exchange rate representing the relative price between nontradables and tradables is an internal real exchange rate. Although both are closely associated, they are not exactly consistent (for their differences, please refer to Hinkle and Nsengiyumva, 1999). Although the change of real effective exchange rate is not big comparing 1995 and 2004, the price of nontradables in many domestic fields has still raised obviously than the price of tradables. The possible reasons behind it may be as follows:

In the case that the given tradable price is unchanged, domestic overall price increase is presented by non-trade article price increase and results in domestic non-trade article price increase relative to tradables.

Due to large proportion and intense competition of Chinese merchandise in international market, both international price and domestic price of these commodities reduce and the price of domestic nontradables rises relatively to tradables.


Although in the case of external real exchange rate are determined exogenously, the room for internal real exchange rate adjustment is not completely loss, this room is still dependent on the domestic inflation target and the change of external real exchange rate. Particularly when the external real exchange rate depreciates (as RMB external real effective exchange rate has experienced after 2002) along with low domestic inflation target, the price raising of nontradables relative to tradables can not be realized even it is demanded by economic fundamentals changes. The price of nontradables even goes lower than of tradables.

Basic Model

In this sector, we put two stylized facts mentioned above into a tradables-nontradables model. And we are going to observe, on the condition that the relative prices of tradables and nontradables are exogenous, the mechanism of the resource allocation such as the labor and capital movement between two sectors. Due to the difference of the TFP (Total Factor Productivity) between the two sectors, and disclose, under this kind of supposition, the changes of the employment ratio, output ratio and trade balance to be emerged between the two sectors.

Economy is composed of tradable and nontradable sectors, and the two sectors meet the following form of Cobb-Douglas Production Function:

1( , ) a aT T T T T T TY A F K L A K L −= =

1( , ) b bT N N N N N NY A G K L A K L −= =

In which, subscript T stands for tradables sector, while subscript N stands for nontradables sector; , , ,Y A K L stands for output, TFP, capital and labor respectively; 0 1b a< < < , means the capital intensity of tradable sector is higher than that of nontradable sector.

The representative manufacturers of the two sectors are facing the following maximum problems:


, , , , , 11( ) [ ( , ) ]

1s t

T S T S T S S T S T Ss t

Max A F K L w L Kr

∞−

+=

− −+∑

, , , , , 11( ) [ ( , ) ]

1s t

S N S N S N S S N S N Ss t

Max q A F K L w L Kr

∞−

+=

− −+∑

In which , 1 , 1 , , ,i S i S i SK K K i T N+ += − = (no depreciation)；the price of the tradables is 1, and the price of nontradables in respect to tradables

is q . Assume /t t tk K L= ， /n n nk K L= , the marginal conditions of capital

and labor which meet the above problems of maximum are：

1aT Tr A ak −= (1)

1bN Nr qA bk −= (2)

(1 ) aT Tw A a k= − (3)

(1 ) bN Nw qA b k= − (4)

In the above system, , , ,t nr w k k are endogenous variables, standing for marginal rate of return on capital, wage, capital-labor ratio of tradables and capital-labor ratio of nontradables respectively, the endogenous r assumes implicatively the non-complete flow of international capital. According to our discussion in the last sector, the price q of nontradables to tradables is subject to the nominal effective exchange rate of USD, i.e. it maintains exogenous in the above system; besides, the

other , , ,t nA A a b are also the exogenous variables of the system.

(1 )(3) /(1) / taw r ka−

= = ;(1 )(4) /(2) / n

bw r kb−

= = ,

combine and get:


1 1( / )n ta bk ka b− −

= (5)

Combine(1),(2), and put into(5), we come easily to:

( , / , , )t t t nk k q A A a b= (6)

( , / , , )n n t nk k q A A a b= (7)

( , / , , )t nr r q A A a b= (8)

( , / , , )t nw w q A A a b= (9)

We can get from the above system:

/ ( ) 0;TT

N

AkA

∂ ∂ < / ( ) 0;TN

N

AkA

∂ ∂ < / ( ) 0;T

N

ArA

∂ ∂ > / ( ) 0;T

N

AwA

∂ ∂ <

Deduction 1: with exogenous relative price of tradable to nontradable and other conditions being equal, faster of the TFP growth in tradables sector than that of nontradable sector will bring about (a) the declining of the capital-labor ratio of the tradable sector; (b) the declining of the capital labor ratio of the nontradable sector; (c) the ascending of the marginal rate of return on capital; (d) the decreasing of wage level.

Why does faster improvement of TFP growth in tradables to nontradables bring forth the above effects? The key to the question lies in the following aspects: (1) provided the levels of the relative TFP of the tradable sector and the nontradables sector are improved, while the other conditions being equal, the relative higher TFP of tradable sector shall result in the improvement of the rate of return of capital of the tradable sector in respect of that of the nontradable sector. With the effect of the signal of the rate of return on capital difference, the capital market exports its capital towards the direction which is more propitious to the tradables sector, the marginal rate of return of capital remains on a higher level ( r ↑ )as against to the former marginal rate of return on capitals of nontradables sector. (2) Against to the higher marginal rate of


return on capital, there is the declining of the capital labor ratio of both

sectors ( ;t nk k↓ ↓ ). The key to achieving this lies in the flowing ratio between capital and labor. In consideration of that the capital intensive tradables sector has higher capital labor ratio, while the labor intensive nontradables sector has a lower ratio of that, provided the flowing out capital-labor ratio is in-between both ratios, the final result is the declining together of the capital-labor ratios of both the tradables sector and the nontradables sector. For example, the tradables sector has 100 capital and 10 labor, the capital-labor ratio is 10:1; the nontradables sector has 50 capital and 25 labor, the capital-labor ratio is 2:1; if the capital-labor ratio flowing out from the nontradable sectors to the tradables is in-between both capital labor ratios of both sectors, such as 20 capital and 5 labor, the final result shall be the capital-labor ratio of tradables sector is 8:1, while it is 1.5:1 for the nontradable sector, the ratios of both sectors are declining. (3) Corresponding to the declining of the capital-labor ratio, it is surely to be the decreasing of the wage level

(w↓ ).Assume the total amount of capital and labor of both sectors are

constant, and are utilized sufficiently, we can easily get:

,

'( ) /( ) ( ,...), 0ATNAN

TT T N

N

AK K L L k kA

− − = <

,

'/ ( ,...), 0ATTAN

TT T T

N

AK L k kA

= <

And can come to:

/ ( ,...)( (..))

(1 )

TT

NT T T

AK k uLAL L ku

−= =

−(10)

/ ( ,...)( (..))

1

Tt

Nn n t

AL K kAL L ku

−= =

−(11)


In which n

t

kuk

= ，from formula(5)we know it is a constant 1 1( / )a ba b− −

.

From formula (10)/(11) we get,

/ ( ,...)

/ ( ,...)

TT

t N

Tnt

N

AK k uLL A

AL L K kA

−=

−(12)

/ 0; / 0T Tt n

N N

A AL LA A

∂ ∂ > ∂ ∂ < ( / ) / 0Tt n

N

AL LA

∂ ∂ >

Deduction 2: with exogenous relative price of tradable to nontradable and other conditions being equal, faster of the TFP growth in tradables sector than that of nontradable sector will bring about the transferring of labor from the nontradables sector to the tradable sector, and the employment proportion of the tradables sector to the nontradables sector is increasing.

Using(10)、(11)and the production function of both sectors, we get

1( ,...) ( ,...)

( ,...)

b a b b b aT TT T

N N N N

TT TT

N

A ALu k Ku kY A A A

AY A K LkA

− + −−=

−(13)

The above equation can further be formulated as ( ( , ..), ..)N N TT

T T N

Y A AF kY A A

= ,

and with (..) 0

( )T

N

FAA

δ

δ<

；Further, we can easily get( / ) 0( / )

N T

T N

Y YA A

δδ

< .

Deduction 3: with exogenous relative price of tradable to


nontradable and other conditions being equal, faster of the TFP growth in tradables sector than that of nontradable sector will bring about the increasing of output of tradables sector as against to the nontradable sector.

By far, we have seen, from the supply sides of both sectors, under the condition that the relative prices of both sectors are exogenous, the effect of the change of relative TFP growth of both sectors to the re-allocation between the two sectors of capital and labor, which also results in the change between the overall rate of return on capital, wage, the relative employment level of both sectors and the relative output level of both sectors.

In order to discuss the effect of the above industry structure changes on the trade balance, it is necessary to induct the demand side. Assume the representative family face following maximization problem:

( )s tt s

s t

MaxU u Eβ∞

−

=

=∑

In which, expenditure level E includes the expenses of tradables TE and nontradables NE , which also meets the constant substitution elasticity function form of:

1 1 1 11( , ) [ (1 ) ]T N T NE E E m E m E

θ θ θθ θ θ θ θ

− −−= + −

s.t. T NE qE E+ =

In which, E stands for the overall expenditure level; θ stands for the

substitution elasticity of the tradables and the nontradables, 0θ > , m and

(1 )m− stand for the expenditure share of tradables and nontradables

respectively, 0 1m< < . Solve the above problem and we come to

(1 )N

T

mE qm E

θ−=− (14)

Formula (14) shows that the expenditure ratio of the tradable sector


and the nontradable sector are depending on the relative price of both sectors, the product substitution elasticity of both sectors and the output and expenditure shares m , but are not concerned with the total expenditure level of both sectors. The expenditure ratio of representative family to the products of both sectors remain exogenous provided the products relative prices of both sectors are exogenous. Formula (13) can

also be formulated as ( , , )T NE h q m Eθ= .

The trade balance can be formulated as:

T TTB Y E= −

TBStands for the trade balance, TY stands for the production of tradables, TE stands for the expenditure of tradables, the trade balance equals to the national produced tradables minus the national tradables expenditure. Divided by the tradable output on the two sides of the equation, and we come to:

/ 1 /t t tTB Y E Y= − (15)

In which, the proportion of the domestic tradables expenditure and domestic tradables output can be formulated as:

( , , ) (..) ( (..))/(..) ( (..))

n n nt t

t t t

h q m L A g kE YL A f kθ

= (16)

In which, ( , , ) (..) ( (..))T n n nE h q m L A g kθ= .

Easy to figure out, / 0

( / )t t

T N

E YA A∂

<∂

or ( / ) 0( / )

t

T N

TB YA A

∂>

∂.

Deduction 4: with exogenous relative price of tradable to nontradable and other conditions being equal, faster of the TFP growth in tradables sector than that of nontradable sector will bring about the


ET’ T’ T

Tradable

Non tradables

O

NT

NT

E

E’

Figure 2. Tradables and Nontradables Sectors

decreasing of the domestic tradables expenditure in the overall tradables output, and the increasing of the proportion of the trade balance to the tradables production.

We can explain this deduction more vividly by figure (2). On the original position, the production possibility margin is the inner curve in the figure; the straight line from the original point to the right upward position represents the expenditure proportion of tradables and nontradables, the curve remains stable when the relative prices of tradables and nontradables are exogenous; the economical tradables production = tradables expenditure = OT; nontradables production = nontradables expenditure =ONT; trade balance is 0. Due to the improvement of the TFP of tradables in respect of nontradables, the production possibility margin shifts to the outer curve, this results in the asymmetrical expansion in the tradables production. If keeping on constant of the relative prices of the tradables and the nontradables, the tradables production in the new production possibility margin shall be OT’, while that of the nontradables' is ONT’; as for the demand side, however, the domestic tradables expenditure does not expand in line with the expansion of the tradables production, on the contrary, due to that the expenditure ratio of tradables and nontradables remains


unchangeable under the condition that the relative price of both products are exogenous, the decreasing (caused by the decreasing of the nontradables production) of the expenditure of nontradables brings forward in the meantime the decreasing of the domestic expenditure of tradables. And finally, tradables production is larger than its expenditure, and results in the trade balance of ET’T.

Model Expansion: Introducing the Agricultural SectorDuring China’s rapid economic development of over 20 years, a

great number of abundant labor force in the countryside continuously turn to the manufacturing industry and service industry in the urban area, put this fact into the above model shall be closer to the fact of China's economic growth, and is helpful to observe, on the basis of that the relative prices of tradables and nontradables are exogenous, the influence of the improvement of the relative TFP level of the tradables sector and the nontradables sector on the labor flowing, industry structure change and trade balance between the countryside and the urban area.

Suppose the above tradable-nontradable model include the non- agricultural tradables sector and nontradables sectors, and meanwhile there is also a relatively independent agricultural sector. There is a uniform labor market among the agricultural sector, the non-agricultural sector and the nontradables sector, and meets the following relations:

_

( , ), 0, 0A w ctL L L w ct L L= + > < (17)

In which, _

, ,AL L L represents the overall labor supply, agriculture labor supply, and the labor supply of non-agricultural tradables sectors and nontradables sector. There exists entirely uniform labor market between the non-agricultural tradables sector and the nontradables sector, L is subject to the wage levelw , when w is going a upward tendency, more labor of the agricultural sector flow to the non- agricultural tradables sector and the nontradables sector; meanwhile, L is subject also to the switching cost of the transferring of agricultural labor to the urban area, the cost is various policy discrimination and restriction which the urban labor never encountered during their switching of jobs in different sectors, and as well the opportunity cost for the basic survival guarantee which bring forth by land (the urban


workers can not achieve that) to the agricultural labor.From Deduction (1), we can see that, on the basis of exogenous

relative price of tradables to nontradable are, the improvement of the relative TFP level of the tradables sector and the nontradables sector shall lead to the decreasing of the wage level. Put this deduction into formula (17), the decreasing of the employment of the non-agricultural tradable sector and nontradable sector in the urban area is concluded. This conclusion is obviously not in compliance with the phenomenon, which we have seen, of the transferring to the market of large quantity of countryside labor, the main reason is that we only considered the influence of the variation of relative TFP of the tradables and nontradables sectors to the wage and the flowing of labor, comparing to the factors as the overall labor supply change arising from demographic changes, and the change of the switching cost of the agricultural labor transferring to the urban area etc., the aforementioned influence may not be dominant. We found from the analysis of the transferring situation between the urban and agricultural labor that during 1978 to 1995, the proportion of the agricultural labor to the whole society labor declined 17%; during 1996 to 2004, the said proportion declined only 4%; in average, the transferring speed of countryside labor has slowed down half during the latter period. In 2004, there was also the situation of “Worker Shortage” in the southeast coastline areas in China. These facts indicate that, while the urban sector is undergoing the rapid improvement of the labor productivity, the wage level has not yet been improved accordingly; the transferring of agricultural labor to the urban area for employment has also been restricted.

Substitute ( ( ,..), )T

N

AL L w ctA

= for the constant L in formula (12), the

employment proportion of tradables and nontradables sectors can be formulated as:

/ ( ,...) ( ( ,...))

( ( ,...)) / ( ,...)

T TT

t N N

T Tnt

N N

A AK k uL wL A A

A AL L w K kA A

−=

− (18)

Compared to formula (12) (in which the entire labor supply of


non-agricultural sector and nontradables sector is constant), we can see

from formula (13) without effort, when the entire labor supply of the

non-agricultural sector and nontradables sector is an increasing function

of the wage, the improvement of the relative TFP level of the tradables

sector and nontradables sector shall result in the more notably improving

of the employment proportion t

n

LL of the two sectors. Put ( ( ,..), )T

N

AL L w ctA

=

into formula(13), we can get the more notable descending of the output

proportion N

T

YY of both sectors; put

formula(18)into formula(16), the proportion of tradables expenditure to

tradables production /t tE Y shall be declined notably too, or in other word, the proportion of trade balance to tradables production / tTB Y shall be notably increased.

Policy ImplicationsIt is easily to figure out from the above model that, under the

combination of maintaining constant relative price of tradables to nontradables, the more rapid improvement of the TFP of the tradable sector in respect of the nontradable sector not only brings forth the economic growth, but also leads to (1) the structural distortions of industry/service sector; (2) expanding of trade balance; (3) declining of wage level, which blocks the transferring of countryside labor to the urban area; (4) decreasing of wage and increasing of profit rate, which deteriorates the income distribution. After introducing the phenomenon of countryside labor transferring to the urban area, the above situation shall be more serious.

The approaches for solving the above problems implied in the model mainly consist of two sides. The first is to re-evaluate the nominal exchange rate of RMB, and by means of the appreciation of the real exchange rate realized from nominal exchange rate reevaluation, reflects the reasonable adjustment of the relative prices of tradables to nontradables, so as to optimize the economic structure, correcting the external imbalance, and spread the transferring of countryside labor to the urban area. From system (6)–(9) and formula (16), we can easily figure out that the appreciation of real exchange rate shall boost the capital labor ratio of both sectors, promote the wage level, decrease the profit rate level, meanwhile, decrease


the employment and output proportion of the tradables sector in respect of the nontradables sector, and reduce the trade surplus. What is to be specially explained is that when discussing, in a traditional view, the effect of the currency appreciation to the economy, it is mainly emphasized on some short term negative impact of the currency appreciation to the export and GDP growth rate, and on some structural unemployment issues, provided RMB chooses a large range of revaluation, those impacts shall unfold in certain individual extend in a short period in China. However, we need to know that the negative impacts are short-termed. In a medium and long term point of view, the currency appreciation shall play a positive role in improving the employment and promoting the China’s economic structure. Balancing the advantages and disadvantages, it is a reasonable choice of giving consideration both to short-term and long-term benefits to revaluate RMB exchange rate to a reasonable level, accompanying with fiscal or other policies to evade the short-term negative impacts due to the appreciation of the currency. If only consider the short-term benefits but neglect the long term benefits, the short-term benefits shall come to an end eventually by the continuous deterioration of the economic structure and the instability of the macro economy. In addition, during the process of revaluate RMB exchange rate to its reasonable value range, we can adopt the method of step by step or the way of one time revaluation19). Especially when USD is having the tendency of depreciation against other main currencies in the world, the step by step small range of appreciation of RMB against USD is most probably unable to reach the aim of the appreciation (or even depreciation) of its real effective exchange rate, the nominal exchange rate level of RMB can hardly be accepted by the market, which shall cause violent market speculation and the successively increased operation pressure of the currency authority. In this connection, not only can the positive function of the exchange rate price as a lever of allocating the economic resources hardly be reached, but also shall the instability of the short-term macro economy be increased.

The other important way to solve the distortions is to further boost reform to the sectors lagged behind in the adoption of market principle in the service industry, and promote the TFP of the service sector On the condition that the TFP of the tradables sector is fixed, further

19) Refer to Zhangbin, Hefan (2005) for the more specific discussions of in which way to realize the revaluation of the exchange rate of RMB.


improvement of the TFP of nontradables sector shall shorten the gap between the two sectors, combining with the model we can easily see that it shall play a positive role to optimize economic structure, improve the external position, and spread the transferring of countryside labor to the urban area. In connection with China’s previous successful experience in reform, it shall be the crucial point for the successful marketization reform to release the price restriction, ease the limitation of the business ownership qualification, ease market entry and encourage the fair market competition among the business entities under different ownerships. Meanwhile, as the marketization reform of the modern service industry sector of education, medical, hygiene, environment, finance and transportation etc. is relatively lagged behind, and as they shall always be involved with problems of the public products and public safety, it is inevitable to encounter the malfunctioning of the market when boosting the reform of these sectors, and this is in need of the government to define the government function precisely while boosting the reform, on one hand, the government should release the power positively, expand the function of private sectors in allocating resources; on the other hand, the government should concentrate the resources and actively make up the market disfigurements.

References

Anderson, Jonathan. 2003. “The Complete RMB Handbook.” Asian Economic Perspectives. UBS Investment Research. (October)

Blanchard, Olivier and Francesco Giavazzi. 2006. “Rebalancing growth in China: A three handed Approach.” Journal of World Economy. (March)

Frankel, Jeffrey. 2005. “On the RMB: The Choice Between Adjustment under A Fixed Exchange Rate and Adjustment under A Flexible Rate.” NBER Working Paper No. 11274

Goldstein, Morris, 2004, “Adjusting China’s Exchange Rate Policies.” High-Level Seminar, Dalian, China, May 26-27.

He, Xinhua. 2004. “Appreciation is better than increasing the interest rate.” International Trade, Vol. 11.

. 2005. “Impact of RMB Exchange Rate Adjustment on Employment.” International Economic Review. (March)

Li, Jianwei, Yu Ming. 2003. “The Fluctuations of RMB’s REER and Its


impacts on China’s Economic Growth.” Journal of World Economy. (Novermber)

Lu, Xiangqian, Dai Guoqiang. 2005. “The Impacts of RMB REER Fluctuations on Export and Import: 1994-2003.” Journal of Economic Research. (May)

McKinnon, R., Zhou Zhizhuang. 2005. “Comments on RMB Exchange Rate Appreciation: From International Scholars.” International Economic Review. (May)

Shi, Jianhuai, Yu Haifeng. 2005. “RMB’s Equilibrium Exchange Rate and Misalignment: 1991-2004.” Journal of Economic Research. (April)

Wan, Jieqiu, Xu Tao. 2004. “Impact of RMB Exchange Rate Adjustment on Employment. ”Journal of Economic Research. (February)

Yu, Yongding. 2003. “Cleaning up the Fears of RMB Appreciation and Moving towards Balanced Economic Growth.” International Economic Review. (September)

Zhang, Bin, He fan. 2005. “How to Adjust RMB Exchange Rate Policy: Targets, Schemes, and Timing.” International Economic Review. (March)

Zhang Bin. 2003. “RMB’s Equilibrium Exchange Rate: Estimation Based on a Single Equation Model.” Journal of World Economy. (Novermber)

Zhang Shuguang. 2005. “The Costs and Benefits of RMB appreciation.” Journal of Economic Research. (May)

Theme 3

Too Much or Too Less: How to Stimulate

Private Sectors in East Asia

Financial Crisis and Domestic Investment

in East Asia*

20)

Jong-Wha LeeKorea University

1. Introduction

The financial crisis of 1997~98 brought a recession of unprecedented magnitude to East Asia, especially to the five countries that were most directly affected by the crisis. The GDP growth rate plunged in 1998 from the pre-crisis average of 7.0 percent to the negative number, and the unemployment rate increased sharply. The initial sharp contraction of GDP in 1998 was largely caused by the collapse in investment. Four of the Asian-crisis countries―Indonesia, South Korea, Malaysia, and Thailand―showed dramatic declines of investment in 1998 by well over ten percentage points of GDP.

Since 1999, East Asian economies have recovered rather quickly from the crisis and have substantially improved their macroeconomic and structural conditions. However, while rates of economic growth rebounded quickly to pre-crisis levels in East Asia, many crisis-hit East Asian economies have not recovered their pre-crisis investment ratio. The failure of investment ratios to rebound significantly in the crisis-hit economies can be attributed to the crisis. But, it is intriguing that investment ratios became depressed permanently not just in the crisis-hit economies but also in the other non-crisis economies in East Asia except China.

The purpose of the paper is to investigate the causes of investment depressions in East Asia since the financial crisis. We assess what has caused the long-terms declines in investment rates in East Asian

* This is the revision of the draft that was presented at the KIEP and PRI Seminar, “Emerging Financial Risks in East Asia,” January 12-13, 2006. I am grateful to Doo Yong Yang and Naoyuki Yoshino for helpful comments, and Hyung Joo Kim and Jong Suk Han for data assistance.


economies. We use a simulation of a multi-country intertemporal general equilibrium or DCGE (Dynamic Computable General Equilibrium) model in order to investigate empirically the effects of an increase in financial risk (or a decrease in risk-adjusted rate of return) on investment rates in the East Asian economies. We find the substantial part of the changes in investment rates in East Asia over the period from 1997 and 2004 is explained by the adverse shock to private investment. We then discuss the prospects of investment and assess the adjustment polices that East Asia can adopt.

The remainder of this paper is organized as follows: Section II provides a brief review of the recent performance of East Asian economies in GDP growth, investment, and stock prices. Section III analyzes the causes of investment declines in East Asia after the financial crisis. Section IV introduces the dynamic simulation model and estimates the effects of a financial risk shock on investment rates in the East Asian economies. Section V discusses the prospects of East Asian investment and assesses the feasibility and desirability of various policies to adjust the investment depression. Section VI concludes the paper.

2. Post-Crisis Performance of GDP Growth and Investment in East Asia

2.1. Economic GrowthFigure 1 shows the annual growth rate of real GDP for each of the

East Asian economies from 1990 to 2005.21) The sharp economic contractions in 1998 for the five Asian-crisis countries are evident: real GDP fell by 13 percent in Indonesia, 11 percent in Thailand, 7 percent in South Korea, and 7 percent in Malaysia, but only 1 percent in the Philippines. The other East Asian economies were also affected but to a less degree: real GDP growth rate during 1998 was -5.0 percent in Hong Kong, -0.8 percent in Singapore, and -1.0 percent in Japan. The GDP growth rates were positive for China and Taiwan– 7.8 percent and 4.3 percent, respectively.

In 1999-2000, economic recoveries occurred, and the GDP growth rates were positive in all ten economies. The quick recoveries in the years following the crisis did not lead to growth patterns returning to previous

21) The underlying GDP data are from the International Monetary Fund, World Economic Outlook Data Base.

Financial Crisis and Domestic Investment in East Asia 139

Growth Rate of GDP in China

0

2

4

6

8

10

12

14

16

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Growth Rate of GDP in China

0

2

4

6

8

10

12

14

16

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Growth Rate of GDP in Hong Kong

-6

-4

-2

0

2

4

6

8

10

12

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Growth Rate of GDP in Hong Kong

-6

-4

-2

0

2

4

6

8

10

12

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Figure 1. Growth Rate of GDP in East Asia, 1990-2005


Growth Rate of GDP in Indonesia

-15

-10

-5

0

5

10

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Growth Rate of GDP in Indonesia

-15

-10

-5

0

5

10

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Growth Rate of GDP in Japan

-2

-1

0

1

2

3

4

5

6

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Growth Rate of GDP in Japan

-2

-1

0

1

2

3

4

5

6

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Figure 1. Continued


Growth Rate of GDP in Korea

-8

-6

-4

-2

0

2

4

6

8

10

12

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Growth Rate of GDP in Korea

-8

-6

-4

-2

0

2

4

6

8

10

12

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Growth Rate of GDP in Malaysia

-10

-8

-6

-4

-2

0

2

4

6

8

10

12

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Growth Rate of GDP in Malaysia

-10

-8

-6

-4

-2

0

2

4

6

8

10

12

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Figure 1. Continued


Growth Rate of GDP in Philippines

-1

0

1

2

3

4

5

6

7

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Growth Rate of GDP in Philippines

-1

0

1

2

3

4

5

6

7

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Growth Rate of GDP in Singapore

-4

-2

0

2

4

6

8

10

12

14

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Growth Rate of GDP in Singapore

-4

-2

0

2

4

6

8

10

12

14

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Figure 1. Continued


Growth Rate of GDP in Thailand

-15

-10

-5

0

5

10

15

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Growth Rate of GDP in Thailand

-15

-10

-5

0

5

10

15

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Growth Rate of GDP in Taiwan

-4

-2

0

2

4

6

8

10

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Growth Rate of GDP in Taiwan

-4

-2

0

2

4

6

8

10

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Figure 1. Continued


levels for the crisis-hit East Asian economies. In fact, the rebound of growth for 1999-2000 slowed down in the subsequent period. Thus, it looks likely that the financial crisis in 1997-98 had persisting negative effects on growth. However, the subsequent downturn over the period 2001-2002 may have come from the global recession. During the same period, the non-crisis East Asian economies also experienced a drastic fall in growth rates.

Since 2003 growth rates rebounded: the annualized per capita growth rates over the period of 2003-2005 were 6.0 percent in Malaysia, 5.9 percent in Hong Kong, 5.5 percent in Thailand, 5.3 percent in Indonesia, 5.1 percent in the Philippines, 4.1 percent in Taiwan, 3.8 percent in Korea, and 2.0 percent in Japan.

A central issue is whether the East Asian economies, particularly the crisis-hit ones, will be able to return to the pre-crisis trend rate of growth. Despite the rebound of growth for 2003-2005, the average growth rates are lower than the high growth rates of between 7 and 8 percent that they achieved in the decades before the crises. These economies are unlikely to return to pre-crisis high growth path. The East Asian economies have now become so much richer than they were a few decades ago that they now face a much smaller gap in physical and human capital in the long-run potential levels than it had in previous decades. Consequently, as the “catching-up” process through capital accumulation is expected to slow down over time, the economies will inevitably become adjusted to a lower growth path.

2.2.. Investment RatiosFigure 2 depicts the investment ratios for the East Asian economies

from 1990 to 2004. The ratios are for total capital formation (private plus public) relative to GDP.22)

Four of the Asian-crisis countries―Indonesia, South Korea, Malaysia, and Thailand―showed dramatic declines in 1998 by well over ten percentage points. For the Philippines, which historically had a low investment ratio, the reduction in 1998 was comparatively small, amounting to about 4 percentage points. For the five countries in which investment declined sharply, no substantial recoveries have occurred until 2004. The

22) The underlying data are from the International Monetary Fund, World Economic Outlook and the Asian Development Bank, Key Indicators of Developing Asian and Pacific Countries.


Investment Ratio in China

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

50.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Investment Ratio in China

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

50.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Figure 2. Investment Ratios in East Asia, 1990-2005

investment ratios in 2004 remained at 21.3 percent in Indonesia, 30.2 percent in South Korea, 22.5 percent in Malaysia, 17.1 percent in the Philippines, and 27.1 percent in Thailand.

The other five non-crisis East Asian economies except China also exhibited decreases in investment ratios after the crisis. Investment ratios declined by 7 percentage points in Singapore and 5 percentage points in Hong Kong in 1998, and then continued to decline afterwards. The investment ratios in Japan and Taiwan have also declined: in 2004, the investment ratios were 23.9 percent and 17.5 percent respectively, which dropped by 5 and 7 percentage points from their peak ratios in 1997. Investment ratios still remained high in China, increasing from 38.0 percent in 1997 to 45.8 percent in 2003. While both public and private investment declined in East Asia, the fall in private investment has been more dramatic.23)

23) According to the IMF, World Economic Outlook Data, the average of public investment-to-GDP rate declined from 9.6 percent in 1997 to 6.2 percent of GDP in 2002 for East Asia NIES. Data on public investment in individual countries are limited.


Investment Ratio in Hong Kong

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Investment Ratio in Hong Kong

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Investment Ratio in Indonesia

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Investment Ratio in Indonesia

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Figure 2. Continued


Investment Ratio in Japan

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Investment Ratio in Japan

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Investment Ratio in Korea

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Investment Ratio in Korea

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Figure 2. Continued


Investment Ratio in Malaysia

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

50.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Investment Ratio in Malaysia

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

50.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Investment Ratio in Philippines

0.00

5.00

10.00

15.00

20.00

25.00

30.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Investment Ratio in Philippines

0.00

5.00

10.00

15.00

20.00

25.00

30.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Figure 2. Continued


Investment Ratio in Singapore

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Investment Ratio in Singapore

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Investment Ratio in Thailand

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Investment Ratio in Thailand

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

45.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Figure 2. Continued


Investment Ratio in Taiwan

0.00

5.00

10.00

15.00

20.00

25.00

30.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Investment Ratio in Taiwan

0.00

5.00

10.00

15.00

20.00

25.00

30.00

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Figure 2. Continued

Investment demand in East Asia moderated in the latter half of 2004 and 2005. As GDP growth decelerated, private investment showed a declining trend in Asian NIES. In China, the policy tightening began to curb investment in a number of overheated sectors (IMF, 2005).

2.3. Stock-Market PricesFigure 3 examines patterns in real stock-market prices. The general

idea is that a change in an economy's stock market likely reflects the change in the market's perception of long-term growth prospects. In the figures, the real stock-market values are computed by converting local currency values of stock-market indexes to U.S. dollars and then dividing by a measure of the U.S. price level. The natural logs of these values were calculated, the values in January 1998 were normalized to zero, and all values were divided by the natural log of two (to obtain convenient units for the graph). The resulting numbers are plotted in Figure 3, with the values for January 1998 labeled as 1.

The five Asian-crisis countries saw sharp declines in real stock- market valuations from the start of the financial crisis in summer 1997 until the fall of 1998. Although the stock prices rebounded from the trough over 1999-2000, they again fell in 2001-2002. While stock prices


propotionatescale,Jan.1993=

10

8

4

2

1

1/2

1/490 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Stock Market Index in Thailand

Stock Market Index in China

propotionatescale,Jan.1993=

10

8

4

2

1

1/2

1/490 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Figure 3. Real Stock Price Index in East Asia, 1990-2005


propotionatescale,Jan.1993=10

8

4

2

1

1/2

1/490 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Stock Market Index in Hong Kong


8

4

2

1

1/2

1/490 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Stock Market Index in Japan

Figure 3. Continued



8

4

2

1

1/2

1/490 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Stock Market Index in Indonesia


8

4

2

1

1/2

1/490 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Stock Market Index in Korea

Figure 3. Continued



8

4

2

1

1/2

1/490 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Stock Market Index in Malaysia


8

4

2

1

1/2

1/490 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Stock Market Index in Philippines

Figure 3. Continued



8

4

2

1

1/2

1/490 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Stock Market Index in Singapore


8

4

2

1

1/2

1/490 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Stock Market Index in Taiwan

Figure 3. Continued


have increased continuously since 2002, the valuations in 2005 still fall short of those from early 1997 in these Asian-crisis countries except South Korea. The ratios of values for September 2005 to those for January 1997 are 0.67 for the Philippines, 0.29 for Indonesia, 0.40 for Malaysia, and 0.44 for Thailand. The ratio is 1.16 for South Korea in which stock prices rose rapidly in 2005.

For the five other non-crisis East Asian economies, stock prices dropped over 1997-2002 and then have recovered slowly, exhibiting the fluctuations similar to those of the crisis-hit economies. But, the declines in stock-market valuations are less dramatic. The ratios of values for September 2005 to those for January 1997 are 0.61 for Taiwan, 0.75 for Singapore, 0.86 for Japan, 0.90 for Hong Kong, and 1.85 for China. In contrast, China’s stock market valuation has continued to decline since 2002 through 2005.

From the perspective of the financial markets, the slow recovery in real stock market valuation since the 1997 financial crisis seems to reflect permanent negative effects of the adverse shocks on the economic outlook of East Asian economies. A fall in an economy's stock market valuations likely reflects the market's belief that long-term growth prospects have diminished. Perceptions of the long-term growth prospects for the East Asian economies must have changed since the financial crisis.

3. The Cause of Long-term Declines in East Asian Investment

What has caused the permanent declines of investment ratio in East Asia? First of all, the failure of investment ratios to rebound significantly in the crisis countries suggests that the crisis had a long-term adverse effect. Barro and Lee (2003) present evidence from a panel data set of 85 countries from 1975 to 2000 that currency and banking crises are associated with contemporaneously reduced values of economic growth and investment over the five-year period following a crisis. More importantly, the broader evidence indicates that while currency crises do not have a persisting adverse influence on economic growth, banking crises have a long-term adverse effect on investment over 10 years. The results from this exercise can be applied to the case of the Asian financial crisis, thereby explaining why the crisis-hit countries in East Asia have not recovered their pre-crisis investment ratio, whereas their


output growth rates have rebounded since 1999. In this regard, the stretched investment depression in East Asia can

be a result of the financial crisis. The Asian financial crises were not only currency crises but also involved severe distress for banking systems. The structural problems in the corporate and financial sectors would cause a crisis and subsequently a long-term decline in investment rate. The illiquidity of financial institutions, and the high leverage and excessive investment of corporate sector are noted as the structural problems that made the East Asian economies extremely vulnerable to financial panic and economic crisis. An increase in perceived risk by investors after the crisis must have affected the long-term decline in domestic investment.

While the investment falls in Indonesia, South Korea, Malaysia, and Thailand were specifically related to the Asian financial crisis, other occurrences had the effect of permanently depressing private investment demand in the other five non crisis-hit East Asian economies except China. Therefore, there must have been other factors that caused the permanent depression of investment in East Asian economies as a whole. We can consider that investors’ perceptions of the prospects for not only the crisis-hit economies but also the non-crisis East Asian economies have changed. The investors have observed that the structural problems in the corporate and financial sectors exist in most East Asian economies. An increase in perceived corporate and financial risk by investors after the crisis must have affected the long-term decline in domestic investment.

It may have happened that not just the crisis-hit economies but also the non-crisis economies were forced to reduce the excessive investment prior to the 1997-98 crisis. Many East Asian economies found themselves with large underutilized capacity in manufacturing and vacant commercial and residential buildings that were constructed before the crisis. The existing excess capacity, despite the sharp decline in real interest rates, has held back new investment in many East Asian countries.

There must be other structural factors that have contributed to investment declines in East Asia. In recent years, the capital intensity of Asian exports has declined as the region has shifted to exporting more IT industry products and services that are skill and knowledge intensive than before. This shift has also contributed to weaker investment demand (Lee, McKibbin, and Park 2005). In addition, productivity of


investment in East Asian economies has been declining. As the East Asian economies continue to grow, they approach long-run potential levels of capital stock. The “convergence” factor implies a diminishing rate of return to new investment.

4. Effects of Financial Risk on Domestic Investment24)

In this section, we explain the changes in investment ratios of the East Asian economies after the financial crisis based on a simulation of a multi-country intertemporal general equilibrium, which is called as the Asia Pacific G-Cubed model. The Asia Pacific G-Cubed model consists of 19 countries or regions each of which has 6 sectors (see McKibbin and Wilcoxen (1998)). This is a multi-country intertemporal general equilibrium or DCGE model which has detailed country coverage of the region and rich links between countries through goods and asset markets based on explicit intertemporal optimization by the agents (consumers and firms) in each economy and a short run nominal wage rigidity (by different degrees in different countries).

We focus on the increased financial risk (or decreased risk-adjusted rate of return to investment) in the East Asian economies after the financial crisis, and investigate empirically its effects on investment rates.

We consider that the adverse shocks are permanently given to East Asian economies. We assume an Asian investment shock as follows: a permanent rise of 0.5% in the equity risk premium in Japan, 2% in Indonesia, and 1% in other Asian economies ex China that are sufficient to reduce private investment rates by the extent observed after the 1997-98 crisis. By contrast, a decrease of 0.5% in the equity risk premium is assumed for China by reflecting the Chinese investment boom. The significantly lower stock market valuations after the crisis seem to indicate the risk premium for holding equities has increased. The increase in the equity risk premium can be a result of various factors. Barro (2005) shows that low-probability disasters such as financial crises

24) The simulation results reported here is a part of the simulation exercises that evaluate the effects of various policy shocks on global imbalances in Lee, McKibbin, and Park (2005). Please refer to the paper for details of the features of the simulation model and the estimation results.


year 1 year 5 year 10

USA 0.75 1.92 1.89

Europe 0.84 2.18 2.45

Japan -5.37 -12.97 -15.82

Korea -12.43 -22.91 -24.39

Hong Kong -2.07 -4.48 -5.61

Singapore -8.04 -31.56 -44.26

Taiwan -8.12 -24.72 -30.26

China 5.50 9.44 9.32

Indonesia -14.73 -50.21 -62.64

Malaysia -10.07 -23.03 -23.19

Philippines -12.49 -25.28 -18.05

Thailand -6.95 -28.44 -44.91

Source: Simulation results of the Asia Pacific G-Cubed model, cited from Lee,

McKibbin, and Park (2005).

Table 1. Global Effects of Increased Financial Risks on Investment(% deviation from baseline)

and natural disasters influences equity risk premium. We assume the rise in equity risk premium, instead of country risk premium. Evidence shows that in the crisis-hit East Asian countries, country risk premia increased sharply with the eruption of the crisis in 1997, but then have quickly returned to the pre-crisis level.

Results are presented for the percent change in private investment relative to baseline (Table 1) and the percent change in real GDP relative to baseline (Table 2). These tables contain results at year 1, 5 and 10 following the shocks indicated. The rise in equity risk premia acts to reduce private investment in East Asia. In the first year, private investment declines by between 2% and 14% relative to baseline, and the negative impacts on investment are magnified over time due to the permanent nature of the shocks. In the five years following the shocks, the investment declines range from 13% (Japan) to 50% (Indonesia). The reallocation of global capital tends to increase investment in economies


year 1 year 5 year 10

USA 0.09 0.31 0.43

Europe 0.13 0.40 0.64

Japan -0.57 -3.03 -4.72

Korea -2.47 -6.81 -10.77

Hong Kong -0.15 -1.44 -2.38

Singapore -1.06 -7.73 -14.93

Taiwan -0.40 -4.22 -7.70

China 1.61 2.57 3.15

Indonesia -3.76 -12.21 -21.54

Malaysia -1.64 -7.94 -13.11

Philippines -2.75 -7.77 -9.16

Thailand -0.77 -8.33 -20.75

Source: Simulation results of the Asia Pacific G-Cubed model, cited from Lee,

McKibbin, and Park (2005).

Table 2. Global Effects of Increased Financial Risks on Real GDP(% deviation from baseline)

receiving the capital that flows out of East Asia. As a result, in the US and Europe investment increases by about 0.8 % at year 1 and about 2.0% at year 5.

As expected the fall in real investment in Asian economies reduces GDP in the economies (Table 2) despite the rise in net exports that accompanies the real exchange rate depreciations in Asia. The opposite is true in the United States where the stronger real exchange rate lowers net exports but the fall in long term real interest rates driven by the capital inflow stimulates private investment by more than the fall in net exports, causing US real GDP to rise.

Table 3 summarizes the changes in investment ratio to GDP over the 5 years and 10 years obtained from the simulations with the shocks of Asian investment declines.25) The simulation results are compared to the actual changes in investment rates over the period from 1997 to 2004. We can see that for the East Asian economies except Hong Kong, the

25) We convert the estimated declines in the investment levels into the changes in investment rates by using the actual investment rates in 1997, as a base year, and then taking account of the estimated declines in GDP.


Actual Changes of Investment

Rates(% of GDP)

Simulated Changes

(% of GDP)

Country 1997 2004Change

1997-2004year 5 year 10

USA 19.8 19.6 -0.2 0.3 0.3

Europe 19.6 19.2 -0.4 0.3 0.4

Japan 28.7 23.9 -4.8 -3.5 -3.9

Korea 36.0 30.2 -5.8 -6.2 -5.5

Hong Kong 34.0 22.0 -12.0 -1.0 -1.1

Singapore 39.3 18.3 -21.0 -10.1 -13.5

Taiwan 24.1 18.9 -5.2 -5.2 -5.9

China 38.0 45.8 7.8 2.5 2.3

Indonesia 31.8 21.3 -10.5 -13.8 -16.7

Malaysia 43.0 22.5 -20.5 -7.0 -5.0

Philippines 24.8 17.1 -7.7 -4.7 -2.4

Thailand 33.7 27.1 -6.6 -7.4 -10.3

Source: Simulation results of the Asia Pacific G-Cubed model, reconstructed

from Lee, McKibbin, and Park (2005).

Table 3. Actual V.S. Simulated Changes in Investment Rates

depression of private investment after the 1997 financial crisis is well explained by the investment risk premium shock.

5. Prospects of Investment and Adjustment Polices in East Asia

A central task for the East Asian economies is whether they will be able to recover the pre-crisis investment rate and thereby the trend rate of growth. The large decline and the lingering depression of East Asian investment after the crisis seem to indicate that the investment rates have dropped below the optimal level. IMF (2005a) estimates that the current levels of investment in most East Asian economies are below


1996 1997 1998 1999 2000 2001 2002 2003 2004

China1

0.7 5.8 5.4 4.6 2.8 2.5 3.5 1.5 -0.6

Hong Kong -1.2 -1.3 2.6 9.8 10.8 4.3 4.5 2.7 0.5

Indonesia 7.1 21.6 4.8 2.9 6.5 3.5 1.7 1.0 -0.7

Japan 0.2 -1.2 -0.2 0.4 1.0 0.8 1.0 0.2 0.00

Korea 7.5 8.8 7.5 4.2 2.9 0.6 1.4 0.5 0.05

Malaysia 3.4 4.9 3.2 0.7 1.2 1.4 0.9 1.6 1.3

Philippines 4.9 10.3 4.2 3.7 6.5 3.0 4.1 3.5 1.0

Singapore 1.5 2.4 5.3 2 1.3 1.0 1.4 0.2 -0.7

Taiwan2

2.9 4.8 4.4 4.5 3.4 3.6 2.2 1.6 -0.4

Thailand 3.3 9.0 4.9 1.5 0.3 0.3 1.2 -0.5 -1.5

Notes: 1. Discount Rate which the central banks lend or discount eligible paper for deposit money banks is used instead of money market rate.

2. 6months interest rate.

Source: IMF, WEO and IFS database; and ADB key indicator 2005 for Taiwan data.

Money market rate is used as short-term nominal interest-rate and

real interest rate is based on contemporaneous inflation.

Table 4. Real Interest rates in East Asian Economies

their long-run steady-state levels. It can be argued that a major part of investment reduction after the

financial crisis is a necessary adjustment to reduce excessive investment prior to the financial crisis. Then, it follows that, when the adjustment is fulfilled, investment will rise to the optimal level. However, it is not clear that investment in East Asia will regain its optimal level. In fact, investment rates have recovered steadily in most of East Asian economies. However, it is not likely that investment rates and output growth rates in most of East Asian economies would increase substantially East in the immediate future. As discussed earlier, stock market valuations have not rebounded to their peaked levels in East Asia, indicating that the increase in financial risks and decline in rates of return to investment have a prevailing effect. Recent surges in stock market prices may forestall further recovery in


investment rates; however, it is too early to judge whether it is a permanent change.

One issue is whether East Asian governments need to adopt active adjustment polices in order to raise the investment rate. First of all, expansionary monetary policies, if East Asian central banks were able to maintain them, would help to revive private investment demand. But, with increasing inflation pressures due to the rise in commodity prices, capital inflows and real assets bubbles, and the upward movements in U.S. interest rates, many East Asian governments have little room to implement expansionary monetary policy and thereby stimulate private spending. Average nominal and real interest rates have already fallen and currently reached at substantially low levels (Table 4).

Unable to expand demand by monetary policy, East Asian governments can consider fiscal expansion as another means. Emerging East Asian economies need more public investment, especially infrastructure investment, in order to maintain long-term potential growth rates. The continuing decline of the ratio of public investment to GDP has raised some concerns. It is claimed that East Asia faces a very large infrastructure gap as investment in infrastructure has lagged in recent years (IMF, 2005a). The increase in high-quality infrastructure investment would help raise long-term growth. However, for most East Asian economies which have traditionally valued fiscal prudence highly, the lax fiscal policy is a reluctant choice for the policymakers. The public debt to GDP ratios have increased steadily since the financial crisis (Table 5). IMF (2005a) judges that not many Asian countries are currently in the position of contemplating fiscal expansion.

Moreover, the increased public resources are often allocated to inefficient sectors. Before raising public infrastructure investment, identifying and eliminating inefficiencies in fiscal expenditures such as wasteful investment projects, badly targeted transfer and subsidy programs, and extravagant civil service payrolls must be undertaken. Strengthening institutional capacity and transparency is necessary to ensure adequate economic and social rates of return to public investment.

In this regard, the macroeconomic adjustment, if implemented, should go along with structural reform polices that can help not just revive the level of investment but also improve the efficiency of investment. Structural reforms in corporate and financial sectors will


lower financial risks and increase rate of return to investment. The stimulus of investment by expansionary macroeconomic polices does not guarantee efficient allocation of investment funds. During the crisis and subsequent recovery process, East Asian economies have accomplished a great deal in improving the soundness and profitability of financial institutions and alleviating corporate distress. But, the significant parts of the structural problems still remain in these economies, impeding the recovery of investment as well as the efficient allocation of investment. Whether real practices in banking management and supervision of the financial sector have improved is still questionable. The unhealthy connections among large firms, financial institutions and the government that undermined the allocation of capital and weakened financial systems are not completely resolved. For many East Asian economies, financial institutions still remain under the heavy influence of the government. One way to improve efficiency of the banking institutions is to expedite introduction of foreign ownership and placement of foreign expertise at the highest management level. There is also need to encourage development of equity and bond markets to facilitate financing of long-term investment in the region.

Some advanced East Asian economies such as Hong Kong, Korea and Singapore need to focus on investment for technology development and human resource improvement rather than physical capital accumulation. The importance of physical capital investment tends to decrease as the economy shifts from accumulation-driven growth to technology-driven growth. Facing a diminished chance for a rapid “catching up” through high rates of factor accumulation, the greatest challenge for these East Asian economies is to expedite its productivity growth. Efforts to increase technology investment and to enhance the quality of human resources are crucial for productivity improvement. In this regard, fiscal expansion focusing on R&D and human capital investment will be more helpful to promote sustained growth.

6. Concluding Remarks

Since the 1997~98 financial crisis, domestic investment has been permanently depressed in many East Asian economies. This paper shows that investment has dropped and has remained below the pre-crisis


levels, mainly due to increased financial risk and decreased rate of return on investment. East Asia needs to revive domestic investment in order to achieve robust economic growth for the next decades. An increase in public investment in the more efficient sectors such as public infrastructures, health, education, and R&D would help to raise the investment rate and the potential output growth rate. Macroeconomic adjustment polices need to go along with structural reform polices that can improve the efficiency of investment.

One of the major consequences of the depressed investment in East Asia is the widening of regional saving-investment imbalances. The investment declines in East Asia outside of China, as combined with saving falls in the United States, have contributed to a recent surge of global imbalances (IMF, 2005b and Roubini, 2005). An interesting topic is to explore the effects of the investment decline in East Asia on the global imbalances, and see if the revival of investment in East Asia can help to diminish the global imbalances. We plan to investigate this issue in subsequent research.

References

Barro, Robert J. 2005. “Rare Disasters and Asset Markets in the Twentieth Century.” Mimeo. Harvard university.

Barro, Robert J. and Lee, J.W. 2003. “Growth and Investment in East Asia Before and After the Financial Crisis.” Seoul Journal of Economics, 16 (2), pp. 83-113.

International Monetary Fund, Asia and Pacific Department. 2005a. Regional Outlook. (September)

International Monetary Fund. 2005b. World Economic Outlook. (September) Lee, J. W., McKibbin W. and Y. C. Park. 2005. “Transpacific Trade

Imbalances: Causes and Cures.” Working Paper. Forthcoming. World Economy.

McKibbin, W. and P. Wilcoxen. 1998. “The Theoretical and Empirical Structure of the G-Cubed Model, Economic Modeling, 16, 1, pp. 123-148.

Roubini, N. 2005. “Global Imbalances” A Contemporary Rashomon Tale with Five Interpretations.” Unpublished manuscript.

Scale 1995 1996 1997 1998 1999 2000 2001 2002

SMEs157,139(51.3%)

159,523(51.0%)

164,025(50.8%)

157,940(51.6%)

150,550(51.7%)

153,624(51.1%)

146,818(51.2%)

137,776(51.1%)

Large Enterprises

148,890(48.7%)

153,546(49.0%)

159,047(49.2%)

147,929(48.4%)

140,900(48.3%)

146,854(48.9%)

139,849(48.8%)

131,586(48.9%)

Total 306,030 313,068 323,072 305,869 291,450 300,478 286,667 269,362

Note: SMEs are defined as establishments employing 4 to 299 employees and

Large Enterprises as those employing 300 or more.

Source: Ministry of Economy, Trade and Industry, Census of Manufactures

Table 1. Value of Shipment in Manufacturing

The Small Business Financing and the

Development of the Bond Market in Asia

Naoyuki YoshinoKeio University

Ahmad Sharifuddin ShamsuddinGraduate Research Student

Department of Economics, Keio University

1. Introduction

Small and medium enterprises (SME) are the driving force behind the growth of a developed economy. SME play a pivotal role in the economy not just by merely supporting the larger industries, but also could create employment opportunities and act as growth engine. The landscape of the Japanese economy has very much influenced by the small and medium sized businesses since postwar. Japan is famous for its large corporation such as Toyota, Sony, to name but a few; however


Scale 1995 1996 1997 1998 1999 2000 2001 2002

Value Added

(billion yen)

SMEs

Large

Enterprises

158,715

(57.2%)

118,558

(42.8%)

147,384

(54.6%)

122,336

(45.4%)

152,907

(55.5%)

122,754

(44.5%)

153,151

(56.6%)

117,262

(43.4%)

148,034

(55.3%)

119,697

(44.7%)

153,404

(55.5%)

123,225

(44.5%)

140,357

(54.6%)

116,534

(45.4%)

138,717

(53.8%)

119,152

(46.2%)

Productivity of

Value Added

(thousand yen)

SMEs

Large

Enterprises

4,993

10,032

4,840

10,287

4,894

10,265

4,837

9,696

4,602

9,831

4,573

10,425

4,483

10,109

4,558

10,228

Notes: 1. SMEs are defined as establishment capitalization at less than 100 million yen,

and Large Enterprises as those capitalized at 100 million yen or over.

2. Productivity of Value Added = Value Added / (no. of employees + no. of

directors)

Source: Ministry of Finance, Financial Statement Statistics of Corporations by Industry

Table 2. Productivity Index (Whole Industry)

it is a surprise for outsiders of Japan by the size of SME and the employment it created. SME consist of 99.7% of the overall number of enterprises in Japan, with a share of 70% in the number of employees. The value of shipment jumped 20 fold from 1960 to the year 2000 (METI, Census of manufacturing Industry, Ministry of Public Management, Home Affairs, Post and Telecommunication). Despite the changes including high economic growth, oil crisis, and steep appreciation of Yen, the position of SME especially in manufacturing remained stable for a long time. SME have thus contributed to Japan’s economic development.

There are two types of SMEs in general, one is to supply equipments and/or materials to larger corporations, and the other is producing finished products.

SME have performed better than the large enterprises in the area of limited production of diversified product and in areas where demand fluctuates uncontrollably. These areas grow more important for improvement of national income. While large enterprises have undertaken primarily mass production, SME have focused on limited production of diversified product. These businesses are servicing a niche market such as customised robots and machinery for large industry, and luxury audio amplifier systems. SME do not necessarily maintain the same size in the area of

The Small Business Financing and the Development of the Bond Market in Asia 169

Employment size

Employment Growth (%)

Source: Ministry of Economy, Trade and Industry, SME White Paper FY2003

Figure 1-1. New Product Development’s Effect on Employment Growth (1998-2002) (Manufacturing)

2.7

1.1

0.5 0.40.2

0

0.5

1

1.5

2

2.5

3

0-20 21-50 51-100 101-300 301-

limited production of diversified product, they grow through the development of new products. Naturally SME are more efficient than large enterprises in developing innovative products because of their ability to make and implement decisions more effectively. This is due to the fact that there are less bureaucracy involved in the decision making process at smaller firms. SME have provided lots of innovations to society through the development of new products during their growth. To illustrates, the karaoke machine invented by Daisuke Inoue in 1971, and the shredder devised by Meikoshokai company president Takagi in 1960, are evidence of innovations from SME that influenced and shaped today’s businesses, operationally or culturally. SME with such strengths have been and will be able to lead the rejuvenation of the Japanese economy through the creation of innovations. More importantly, SME have the capacity to create jobs. By engaging in the development of new product, more jobs will be created. Enterprise that engaged in the development of new product proved to increase employment faster.

Growing SME indicate that it is important to employ external employee, and recognized that shifting from family venture to non family enterprise is important in order to achieve growth. As a result of


this, employment is created by these growing SME and eventually leads to the revitalization of the economy.

2. SME Financing Scenario

The main obstacle for the development of this sector is mainly the inability to obtain sufficient funds for the business to grow. Access to capital is often cited as the major deterrent in the growth of SME. It is somewhat difficult to obtain debt and equity financing on appropriate terms for working capital, start-ups, and expansions, restructuring, venturing into international trade, and other critical needs. Among other, reasons of this phenomenon can be attributed to cost of lending will be higher for small and medium business due to scale of the transaction. Therefore interest rate will be higher compared to larger firms (Yokokura 1988). Banks prefer to maintain ongoing transactions especially for long term funds with larger firms when it comes to reduction of financial transaction risks. Finally, due to imperfections in the capital market largely because of institutional restrictions, and funds markets are imperfect due to economies of scale, it is difficult for small size firms to obtain long term funding (Yokokura 1988).

Funds are the heart and soul of any small business venture. While the importance of other areas of business such as operation management, marketing, or the other factors that could affect a business such as the overall business environment should not be neglected, funding remains the most vital part of a small and medium business ventures.

As illustrated by figure 2, SME depends heavily on loans, and the domestically licensed banks also very much depended on SME as the main source of investment. SME consists of more than 60% of the total loans given out by the domestically licensed bank.

However, this dependency proved to be more of a disadvantage towards the SMEs compared to the banks. As illustrated in figure 2.1, during recession and low growth period between 1985 and 1989, the percentage of loans given to SMEs dropped significantly. Banks are reluctant to disseminate loans due to the lack of confidence in the market because of the economic recession. Banks were concerned there would be a hike in the number of NPL, and therefore were very selective and too prudent in approving loans especially to SMEs in badly


Loans G row th

0100000020000003000000400000050000006000000

19801983

19861989

19921995

19982001

2004

year

amou

nt (1

00 m

illio

n Y

en)

Total Loans(100 m illion)loans to Sm e(100 m illion)

Loans G row th

0100000020000003000000400000050000006000000

19801983

19861989

19921995

19982001

2004

year

amou

nt (1

00 m

illio

n Y

en)

Total Loans(100 m illion)loans to Sm e(100 m illion)

Source: Bank of Japan Economics Statistics Annual

Figure 2. Loans by Domestically Licensed Banks

Loans G row th chart

-10-5

05

1015202530

19801982

19841986

19881990

19921994

19961998

20002002

2004

year

grow

th p

erce

ntag

e

Total loansSM E

Loans G row th chart

-10-5

05

1015202530

19801982

19841986

19881990

19921994

19961998

20002002

2004

year

grow

th p

erce

ntag

e

Total loansSM E


Figure 2.1 Loans growth

affected industry such as those who are involved in local tourism and leisure activities. Demand in these industries are highly correlated to the


Boom Period Boom period

Recession period

Boom Period Boom period

Recession period

Diagram 1. Economic Cycle and SME loans.

`perceived` or real disposable income of the target population. As the disposable income is reduced because many people resort to savings rather than spending on leisurely activities, mainly out of being prudent and feeling the insecurities resulted by the recession.

As a result, during the recession period a lot of NPLs were cut and businesses that deemed underperforming or unattractive will not get any funding. The shaded area in diagram 1 represents the period of which no or very small number of loans are granted to small businesses. On the perspective of the banks this is particularly the most practical and sensible thing to do in such time. The short run benefit for the bank is the declining number of NPLs and reducing the risk of the banks` investment. The downside is, in the long run, the banks will lose out in terms of long term customer retention. As there is no loyalty to the banks because to these businesses the banks are merely a place to get money, only interested in making money, and not perceived as a partner. However, it is important to note that a lot of these small businesses (such as those who are involved in the tourism and leisure activities), although will not be able to service their loans in the recession period are more than able to so in the boom period. The regional banks


in some area in Japan continue to finance these businesses even in recession time. This is due to the fact that these businesses are their good customers and are able to settle the debts when the economy is getting better. This according to the regional banks, are long term relationship banking. However, the difficult issue is until what extent is considered sensible for these regional banks to continue to support these businesses in hard economic times? What if the number of NPLs skyrocketed and resulting in the insolvency of the banks? More importantly, will tax payers' money be utilised to bail out these banks?

3. SME Financing Policy

Since there a lot of hindrances for small businesses to acquire financial assistance, a policy was developed to overcome problems related to these sectors, not only concerning financing but every aspect of the small and medium enterprises.

SME policy derived from the market imperfections. Small business policy serves to lessen the disadvantages to SMEs of imperfections in the market for human resource, goods, financing, and information.

In term of financing SMEs, low cost funds are provided through allocations in the general and the FILP budgets to the government small business financial institutions.

The primary role of financing is operating through market mechanism, rather than use of competition restriction and direct subsidies as policy instrument.

The underlying concept was to stop the use of small business policy as a `protective policy`, in contrast to agricultural policies which employ direct subsidies and import restriction. This is seen as a step to overcome the `subsidy mentality` that has been plaguing the agricultural industry and more importantly to nurture enterprising fortitude among the small businesses. Instead of giving direct subsidies, indirect subsidies are given in terms of the low interest rate loan. In order to disseminate these subsidies, Government financial institutions such as Japan Finance Corporation for Small and Medium enterprise (JASME) were set up.


　 No of Bankruptcies 　 Debts (100million yen)

　 Overall SME Percentage of Overall SME Percentage of

　　　 which SME 　　 which SME

1994 14061 13965 99.31726051 56294 40917 72.68447792

1995 15108 14970 99.08657665 92411 46561 50.38469446

1996 14834 14731 99.30564918 81299 49693 61.12375306

1997 16464 16293 98.96137026 140447 57494 40.93643866

1998 18988 18749 98.7413103 137484 68329 49.69960141

1999 15352 15135 98.58650339 136214 80640 59.20096319

2000 18769 18497 98.55080185 238850 65691 27.50303538

2001 19164 18819 98.19974953 165196 73151 44.28133853

2002 19087 18867 98.84738304 137824 77540 56.26015788

2003 16255 15877 97.67456167 115818 57651 49.7772367

2004 13679 13392 97.90189341 78177 53656 68.63399721

Source: Tokyo Shoko Research, Ltd., Bankruptcy White Paper.

White paper on SME in Japan, Japan Small Business Research Institute

Table 3. Corporate Bankruptcies

4. Government Financial Institutions for SME

4.1. SME Bankruptcies The number of bankruptcies among the small businesses makes it a

rather unattractive sector for private banks to extend its loans.

As shown in Table 3, and figure 3 and 4, bankruptcy ratios among SME are much larger than the large corporations. 99% of the bankrupt companies are SMEs. However it is interesting to note that SME still contributes to 99% of the overall number of corporations and 70% in the number of employees as mentioned in the earlier part of this paper. This indicates that SMEs are flexible enough to be set up even though they often face with structural change. This flexibility combined with the existence of government financial institutions assist the SMEs to ease the


Corporate Bankruptcies

0

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ies

96.59797.59898.59999.5

perc

enta

ge OverallSMEPercentage of which SME

Corporate Bankruptcies

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ies

96.59797.59898.59999.5

perc

enta

ge OverallSMEPercentage of which SME

Figure 3. Corporate Bankruptcies

Source: Tokyo Shoko Research, Ltd., Bankruptcy White Paper.White paper on SME in Japan, Japan Small Business Research

Institute

B ankrup tcies (D eb ts)

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Figure 4. Bankruptcies Debts

OverallSMEPercentage of which SME

OverallSMEPercentage of which SME

Source: Tokyo Shoko Research, Ltd., Bankruptcy White Paper.

White paper on SME in Japan, Japan Small Business Research Institute


　 ’75-‘78 ’78-‘81 ’81-‘86 ’86-‘91 ’91-‘96 ’96-‘99 ’99-‘01

Start-up

Rate5.90% 5.90% 4.30% 3.50% 2.70% 3.60% 3.10%

Closure

Rate3.80% 3.80% 4.00% 4.00% 3.20% 5.60% 4.50%

Source: METI website

Table 4. Change in start-up and closure rates [enterprise-based](Non-primary industries/annual average)

process of setting up new enterprises.

4.2. Role of Government Financial InstitutionsWithin the traditional framework of Japan’s credit and loan system,

financing for SMEs has been undertaken largely by private financial institutions, which include city and regional banks, often referred to as commercial or ordinary banks, credit associations and credit cooperatives. Financing by commercial banks characteristically focuses on relatively prominent SMEs, with allocations granted depending largely upon prevailing economic and financial conditions.

Credit associations and credit cooperatives, on the other hand, specialize in SME financing. However, these lenders are not able to meet all the needs of SMEs, due to the high level of demand for financing. Moreover, customers are often not satisfied with the terms and conditions of loans extended by these organizations. Under these circumstances, one of the functions of government financial institutions, such as NLFC and Japan Finance Corporation for Small and Medium Enterprise (JASME), is to provide supplementary loans to this very large segment of the economy. At the end of March 2005, government financial institutions had provided 10.1% of the total of financing to SMEs. Among others the objectives of the government financial institutions are; to fill gaps in the supply of financing, which is focusing on the underserved segment, and to supplement rather than to compete with the private financial institutions.

As illustrated by figure 3, the government financial institutions are merely supplementing the domestically licensed bank in satisfying the financing needs of the SMEs. However critics of the government financial institutions and the private banks themselves argued that the government financial institutions also focuses on the prominent SMEs


Private Financial Institutions¥227,463 (89.9%)

Domestically Licensed Banks

(City Banks, Regional Banks and Others) ¥177835 (70.3%)

Institutions for SMEs-Credit Associations ¥40,444(16%)-Credit Cooperatives ¥9183 (3.6%)

The Shoko Chukin Bank¥9,573(3.8%)

National Life Finance Corporation¥8,420(3.3%)

Japan Finance Corporation for SME¥7,472(3%)

Government Financial Institutions for

SMEs¥25,466(10.1%)

SmallMedium

Enterprises

¥252,930

Loans Outstanding to SMEs (as of March 31, 2005) in billion yen.Sources: Compiled from Bank of Japan, Financial and Economic Statistics

Monthly and other sources

Figure 5. Share of Loans

and therefore are interfering with the private banks. Furthermore, the government financial institutions customer retention (due to the subsidised low interest rate) meant that it defeat the original purpose of supplementing the private banks as customers do not seek other banks service and continue to borrow from just the government financial institutions.

To be fair to the government financial institutions and the policy makers, a more appropriate perspective should be taken into account.


0

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DLB (100 million)Govt Financial Institution (100 million)


Figure 6. Supplementary Role of Government financial Institutions

r S1 S2

L1L

L L=loan

D

Diagram 2

The imperative issue is whether the existences of the government financial institutions along with low interest rate had a positive effect on the investment spending and eventually generate economic growth.

Cargill and Yoshino (2003) suggested that there are three effects of the subsidised interest rate; the quantitative effect, low interest rate effect, and the `cow bell` effect.

4.2.1. The Quantitative Effect

Diagram 2 illustrates the quantitative effect of the government loans.


D

L L1 L2

D1 S S1S2

L

r

D

L L1 L2

D1 S S1S2

L

r

Diagram 4

rD1

S1

L1 L2 L

DS

rD1

S1

L1 L2 L

DS

Diagram 3

The government loans increase the supply of credits and thus shifting the supply curve from S1 to S2. This will increase the loans from I to I1. This clearly will lead to an increase in economic activity and thus, promoting growth.　　

4.2.2. Low interest rate effect

As illustrated by diagram 3, as a result of the interest rate subsidy, higher profit expectations also increases, therefore demand shifted to the right and further increase loan to I2.

4.2.3. `cow bell` effect

Government loans will increase the supply from S to S1 and


SME

JASME

Government

Superior

Investors

Mezzanine

Securitisation

Loans

Funds

Subsidised

SME

JASME

Government

Superior

Investors

Mezzanine

Securitisation

Loans

Funds

Subsidised

Diagram 5. JASME Securitisation of Loans

therefore would also increase loans from I to I1. More often than not the increase in credit supply is targeted to some particular sector or industry, which the government may want to promote in line with its broader industrial policy. When this took place it also serves as an indicator to the private institutions that particular sector/or sectors are being singled out from the government and may have more future potential growth compared to the rest. This will result in an increase in credit supply by the private institutions and further shifted the supply to S2 and hence loans supply will also increase to I2.

However it is important to note that, this increase in supply may not reach those small businesses that are not directly targeted by the industrial policy. Although the `cow bell` effect will increase the credit supply and further shift the supply function, its effect is not comprehensive.

4.3. Japan Finance Corporation for Small and Medium Enterprise (JASME) Securitisation of loans

Since July 1, 2004, JASME has been engaged in Securitisation Support Programs to support the securitisation efforts of private and other financial institutions to provide SMEs with a smooth supply of unsecured loans. The purpose of all these securitisation programs is to support the procurement of long-term, unsecured funding for SMEs and


Government

financial

Institutions

SME100% loan

Diagram 6. High Risk /Start-up

the diversification of funding channels.As illustrated by diagram 5, JASME securitises SME loans and

subsidies the underperforming loans (the mezzanine) and securitises the superior ones in order gain a favourable rating. The problem with this program is government funds are needed in order to subsidies for the mezzanine part. If the funds and subsides are not in place, the rating would be unattractive, hence the interest rate would have to be higher to attract potential investors and would result in a higher interest rate for the loans to the SMEs.

5. Some propositions

5.1. Co-financingIn order to further enhance the role of the government financial

institutions, and also to ensure that it will not `cannibalise` the product of the private financial institutions for the small business loan market, a win-win arrangement should be geared up. A system whereby both the private financial institutions and government financial institutions can at the same time extend loan to the same SME.

As illustrated by diagram 6, high risk SME or start-up only opportunity to obtain loan maybe from government institutions. However, after having successfully servicing the first term loan, the small business may need/want to obtain further financial assistance. More often than not they will go to the same government institutions. This will “deny” the private institutions of the opportunity to do business with good small businesses, as shown in diagram 7.

For SME with proven track record and/or those who are can be categorised as low risk, the second term financing should be co-financed. This will give a signal to the private institutions that these SME is in


Government financial

InstitutionsSME

Private financial Institutions

100% loan application

Diagram 7

Government financial

InstitutionsSME

Private financial Institutions

80%

20%

Diagram 8

good financial health and would trigger the cowbell effect discussed earlier in this paper. Consequently, the level of financing from the private institutions can be increased from 20% share shown in diagram 8 to 50-50, or even more.

5.2. Credit Guarantee-based on banks NPL performance to avoid `moral hazard`

In order to avoid moral hazard normally associated with credit guarantee, banks should be partly held responsible for the occurrence of the non performing loans resulted from the credit guarantee. Banks NPL ratio should be the indicator of how many guarantee percentage it should receive. The higher the NPL ratio the lower the credit guarantee given, and vice versa. This measure will enable banks to be more vigilant in extending loans to a really solid small businesses rather than


Bank ANPL 20%

Bank B

NPL 40%Credit

Guarantee

Bank C

NPL 5%

80% Guarantee

60% Guarantee

95% guarantee

Diagram 9

CreditGuarantee Corporation

NPLPrivate financial

institutionsSME

Loan

90%

10%

Diagram 10

giving out loans to any businesses that sometimes only exist on paper, as they do not fear the risk of NPL as all the loans are guaranteed 100%.

As suggested by diagram 9, bank C will receive higher credit guarantee percentage for its loans as the NPL ratio is smaller.

In a more micro level, credit guarantee will also engender “connection lending”, where loans are extended based on the connection the bank has with the business. In a close knit society like Japan, connection plays an important role in business deal. The banker or credit association may be a close relative to the person or business that lends for the bank or credit association.


As illustrated in diagram 10, whenever a NPL occurs, 90% of the NPL would be absorbed by the credit guarantee corporation, and the rest 10% will be shouldered by the lending banks. This way, banks will be more careful in its lending behaviour so as not to lend based on “connection” rather than on business merit.

5.3. Beyond National Boundaries; the Creation of Asian Bond Market.A broader view is perhaps necessary for the financing of SME to be

less independent from the domestic capital market. Although it is difficult for SME to obtain fund and generate capital through the capital market due to its imperfection as discussed earlier in this paper, it is not impossible to explore the opportunity that exists in the vastly untapped Asian financial market.

5.3.1. Three Principal Traits of East Asian EconomyAsia’s financial market is characterized by three principal traits: first

of all, it has a very high savings ratio in many of its countries (Thailand and China are but two examples); secondly, much of these savings are deposited in banks making the banking sector very strong and the capital market comparatively small; thirdly, there is a bias towards domestic investment, which is mainly due to a lack of information about other countries, so-called asymmetric information.

5.3.2. Two Types of Investors (Retail Investors and Individual Investors)In Japan there is currently discussion within the FSA about how to

protect investors and how to enhance the Japanese capital and banking market. Professor Yoshino’s idea is to separate the different types of investors into institutional, or retail investors and individual investors. Different rules should be applied to the two different groups because professional people require less regulation, whereas individuals prefer increased regulation as they lack a certain amount of knowledge and so should be protected more. However, within the proposed system, a wealthy investor can declare themselves as an institutional investor rather than an individual investor thus increasing the risk and decreasing the amount of protection, but increasing the potential gains.

5.3.3. Four Types of Portfolio InvestmentIn order to smoother Japan’s capital inflow and outflow, portfolio


allocation is required. There are four different types of portfolio allocation: (i) maturity diversification; (ii) regional diversification; (iii) country diversification and (iv) sector diversification.

Maturity diversification is the time span of the bond, i.e. whether it is a short medium or long term bond. Regional diversification relates to the continents, Asia, Europe and America etc., and country diversification is portfolio allocation with regard to different nation states (Malaysia, Thailand and Singapore for example). The fourth type of allocation, sector diversification relates to the industry sector the bonds belong to (manufacturing and services for example). In order to make these allocations go as smoothly as possible, there needs to be a free flow of information between the relevant parties.

5.3.4. Reduction of Asymmetric Information among East Asian CountriesSo as to integrate the capital market in Asia, an information network

is essential to reduce the asymmetric information, thus in turn reducing the home country bias effect that is to be currently witnessed. An independent organization should collect the data so that it is as neutral as possible and free from the potential bias it could accrue if it emanated from a private company. This means either setting up a new inter- governmental organization, or creating a new Financial Services Authority (FSA) or central bank. There should then be an internet site published by this new organization which distributes four different types of data: macro data (for example growth and interest rates); data relating to tax rates, the legal system and the accounting system; regional and sector information; and day to day information (including interest rates, exchange rate and productivity). Since the data will be available on the internet, the investor can easily access the relevant materials and compare different countries. This should improve the diversity of the portfolio of capital flows among various countries and reduce asymmetric information.

To make the information exchange as useful as possible, there should be a harmonization of financial markets within the Asian region including the areas of rules, regulations and taxes. If the markets are not coordinated, it will be very difficult to invest in other countries. The legal system should also be harmonized for the same reasons. Both these reforms require high-level talks involving Asian nations’ governing bodies. The Asian Committee of Financial Regulators will be created to fulfil the need of harmonization of the financial market and financial system.


5.3.5. Creation of New Independent Regulator: FSA (Financial Services Agency)

Recently there have been many discussions as to whether an FSA should be established. An FSA, as in the case of the UK, would create a system of integrated regulation. That is to say that all regulation would be done by the same body. Unlike the UK, France regulates its financial institutions (banks, securities and insurance), financial market and investors with separate regulatory bodies. In Japan’s case, an FSA is in operation, but other Asian nations prefer to have separate regulators. In order to integrate the financial markets, there should be a common regulatory framework. Once this is achieved, capital mobility will increase.

In terms of the specific Japanese case, the FSA was established in 2001, so it is relatively new. It falls within the jurisdiction of the Cabinet Office and so is separated from the work of the Ministry of Finance (MoF). General financial supervision is carried out by the FSA, whereas the MoF deals specifically with crisis management and so concentrates particularly on planning and bank failure contingencies. The Securities and Exchange Surveillance Commission (SESC) is run by the FSA and they in turn manage certified public accountants and the Auditing Oversight Board. This brings about a structure whereby the FSA is in charge of all the financial market and institutions and so in the Japanese case there is definite unification of the financial market.

As far as bank examination in Japan is concerned, there exists a dual system. The Central Bank of Japan’s target is price stability. However, a sound payment system and sound financial system is important so is examined both by the Central Bank of Japan and the FSA. On the other hand, insurance and securities are examined only by the FSA. The reason why the banks are monitored by two independent organizations is that banks deal with cash and the payment system. If the payment system collapses it will have a huge adverse effect on the economy.

The basic mission of the FSA is to maintain sound financial intermediation and a sound payment system since this form the basis of economic activity and have to be closely watched for anomalies. The FSA also aims to maintain a stable and active financial system with an efficient and just financial market to enhance public benefits and to develop the national economy. Furthermore, the FSA promotes and protects user benefits, which are the depositors, insurance contractors


and investors in the securities market. The FSA is also involved in maintaining a transparency and fairness over all financial activities. A further reason why the FSA was established was to create a body with special skills relating to financial supervision and foresight of future outcomes. Previously there was no such organization because the financial market was not complicated enough to warrant one. These days however the financial market has become increasingly complex as it is developing so rapidly and thus a specific body is needed to assimilate this knowledge. The FSA also coordinates with overseas’ inspecting agencies and promotes international harmonization of rules and regulations.

5.3.6. Several Steps to Create Capital Market in East AsiaThere are several steps to take in order to develop the capital

market. The market participants are the Central Bank, pension funds, insurance brokers, banks and recently, individuals. In many countries, the Central Bank accumulates reserves. In the past, this was often dollars because they were thought to be the safest as most countries exports to the US. Recently however, the Central Bank started to diversify these reserves, investing in the Yen, Euro, Pound and other Asian currencies. These are held in security assets and not currency though so countries hold various government bonds. The acquiring of various government bonds was the first step for the development of the capital market in Asia.

The second step for capital market development is the creation of Public Enterprise Bonds. In Thailand this type of bond has recently increased with power plants and government entities issuing securities which many people bought. Following that, large companies issued corporate bonds. However, the areas of small businesses and public infrastructure are not yet well implemented in Asia, so the promotion of these latter two areas is considered to further improve the capital market. Small businesses rely fully on banks to provide their financing. If the banking sector malfunctions, the small business sector is drastically affected. This phenomenon was witnessed during the financial crisis of 1997. Public infrastructure is currently financed by taxpayer’s money. Public infrastructure should also be financed by the capital market however so that inefficient construction of public infrastructure can be avoided. The various market participants have different investment


SMEs PrivateBanks

Credit Guarantee

INVESTERS

Loans

Securitization

Loan Guarantee

Diagram 11. Securitization of SME Loans

characteristics. The Central Bank, as mentioned previously, is concerned with accumulating reserves, pension funds mainly invest in long term investments of about twenty to thirty years, insurance brokers invest in medium to long term investments of fifteen to twenty years, banks in shorter investments of three to four years and individuals have started to invest in government and pubic enterprise bonds.

5.3.7. Small Medium Sized Business’ Financing (SME-Financing)Small and Medium sized businesses have in the past depended

almost exclusively on bank loans because SMEs are very difficult to monitor and investors can not scrutinize them sufficiently well, which is in stark contrast to large companies who have much disclosure and who are subject to many rating agencies. In Japan, securitization and credit guarantee has been initiated, along with a significant amount of data analysis, referred to as Credit Risk Data (CRD). Every year since 2000 about 10 000 companies’ data is collected. Although SMEs have in the past tended to massage the facts relating to their enterprise, if the data is assessed over a number of years, trends can be seen and so one can draw a general, if not specific, picture from these trends. This has made it much easier to securitize these low assets into the market. The more reliable the data becomes, the more able Japan will be to securitize the SME sector.


ProjectYen

Won

Project

Dollar US Dollar Market

Japanese Market

Korean Market

Diagram 12. Multi-surrency Revenue BondsPHP Business Review, Yoshino 2005-7-8

5.3.8. Public Infrastructure Financing Through Revenue BondPublic infrastructure is funded solely by tax payers’ money and the

only exceptions to this rule appear to be the Private Finance Initiatives (PFIs) in existence in Britain. When the same style of PFI system was implemented in Japan, it did not fare well because when the banks went bankrupt, the burden had to be carried by the public sector and so tax payers’ money was being eaten up whereas the private sector did not incur the same scale of losses. In answer to this, Professor Yoshino proposes a revenue bond. An example of such a revenue bond would be the construction and management of a toll road where 30% of the revenue comes from tax payers’ money and 70% from that of investors. The tax payers’ money can be justified because the toll road will have a certain number of external effects. The revenue collected from the toll road will be paid to the investors as a return on their investment. If 30% is paid by tax payers, 10/7 is the amount the investors can expect to get in their return. The return provides an incentive for the investors to scrutinize the management of the toll road because if it is not effective, they will not gain as much as they could do otherwise. Furthermore, if a loss is incurred, it will be borne by the investors and not that of the taxpayer.

There are many different currencies in Asia and so projects within Asia should also be funded to reflect these different currencies, the


returns issued in the relevant currency. The bond return should be calculated based on the share that each currency holds. That is the essential idea of a multi-currency bond.

5.3.9. Community FundThe final fund proposed is a community fund. This is actually a

much smaller fund than the previous two and has already been created in Japan with the instigation of windmill power plant funds. The wind energy plants have environmental benefits in that they are much cleaner than, for example, nuclear plants, so provide an ethical fund for investors. However, the wind plants only produce a small amount of energy for their comparative size so only one community might be benefited by a single plant, thus making it a small-scale project. The revenue is collected by electricity bills and also from private investment.

6. Conclusion

The role of government banks is important in supporting and fulfilling the needs of small businesses left by private institutions. Government financial institutions assistance enable the implementation of investment projects that would have been impossible without the easing of financial constraints resulted in the improvement of profitability. Although the government's special credit guarantee program did alleviate the financial constraints of SMEs then seriously affected by the credit crunch, it also poses a new problem of moral hazard. As far as improving the economic efficiency of SMEs is concern, the target of the public credit guarantee system should not be limited to high-risk low-profitability companies. The long run objective of the scheme should also be scrutinized, whether the benefit of the scheme would improve SME’s overall efficiency to balance out the cost incurred by the government in paying the defaulted loans using taxpayers’ money.

Furthermore, to enhance portfolio capital flows in Asia, there should be a continuous information exchange between Asian countries and institutions, a harmonization of the various legal frameworks, development of the financial market and its products and finally, a drive towards consumer education, particularly with regard to asset management and personal loans.


Creation of Regulators Network among East Asian Countries would enhance information exchange and promote common rules of various financial activities.

Certain Asian countries have suffered from taking consumer loans from non-bank finance companies who charge a high interest rate and so consumer education is necessary in order to minimize the unsound financial decisions Asia takes.

A more fluid flow of capitals in Asia would not only benefit the Japanese SME but will also increase the opportunity for SME in other countries in the Asian region to gain more access to capital and market for their products.

References

Cargill, Thomas.F. & Yoshino, Naoyuki. 2003. Postal Savings & Fiscal Investment in Japan. The PSS and The FILP, New York, Oxford University Press.

Komiya Ryurato et al. 1988. Industrial Policy of Japan. Tokyo: Academic Press.

Mark, Scher and Naoyuki Yoshino. 2004. Small Savings Mobilization and Asian Economic Development. M. E. Sharp.

Naoyuki Yoshino, Sahoko Kaji and Tamon Asonuma. 2005. “Optimal Exchange Rate System in East Asia and the Regional Bond Market.” Emerging East Asian Regionalism; Trend and Response, Edited by Zhang Yunling, World Affairs Press, September 2005.

Naoyuki, Yoshino. 2005 Enhancing Portfolio Capital Flows in Asia, Third East Asia Congress, December 9-11, 2005, Third Session, Kuala Lumpur, Malaysia Bank of Japan Economics Statistics Annual. Various Years.

Ministry of Economy, Trade and Industry, SME White Paper. Various Years.

Tokyo Shoko Research, Ltd., Bankruptcy White Paper. Various years.White paper on SME in Japan, Japan Small Business Research Institute.

Various years.

￭ Policy Analyses

￭ Monograph

A list of all KIEP publications is available at: http://www.kiep.go.kr.

List of KIEP Publications

01-01 Capital Account Liberalization and Macroeconomic

Performance: The Case of Korea / Soyoung Kim,

Sunghyun H. Kim, and Yunjong Wang

02-01 Currency Union in East Asia / Han Gwang Choo

and Yunjong Wang

02-02 East Asian Economic Integration: Recent

Development of FTAs and Policy Implications /

Inkyo Cheong

02-03 Understanding the Determinants of Capital Flows in

Korea: An Empirical Investigation /

Sammo Kang, Soyoung Kim, Sunghyun H. Kim, and

Yunjong Wang

02-04 Korea's Corporate Restructuring since the Financial

Crisis / Chan-Hyun Sohn

03-01 Monetary Cooperation in East Asia: Exchange Rate,

Monetary Policy, and Financial Market Issues /

Sung Yeung Kwack, Choong Yong Ahn, and

Young-Sun Lee

03-02 Analysis of the Trade Negotiation Options in the

East Asian Contex / Nakgyoon Choi, Soon-Chan

Park and Changsoo Lee

04-01 Saving, Investment and International Capital Mobility

in East Asia / Soyoung Kim, Sunghyun H. Kim, and

Yunjong Wang

05-01 Korea-Japan FTA: Toward a Model Case for East

Asian Economic Integration / Choong Yong AHN,

Inkyo CHEONG, Yukiko FUKAGAWA, and Takatoshi

ITO eds. /

05-02 Feasibility and Economic Effects of a Korea-U.S.

FTA / Junkyu Lee, and Hongshik Lee

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Inkoo Lee, Backhoon Song, and Soonchan Park

05-04 Rationale for a China·Japan·Korea FTA and Its

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et al.

06-01 From East Asian FTAs to an EAFTA: Typology of

East Asian FTAs and Implications for an EAFTA /

Chang Jae Lee, Hyung-Gon Jeong, Han sung Kim,

and Ho-Kyung Bang

06-02 Global Imbalance and its Implications on East Asian

Economies / Doo Yong Yang

▪China's Integration with the World Economy / Kyung Tae

Lee, Justin Yifu Lin, and Si Joong Kim eds.

▪Korean Crisis and Recovery / David T. Coe and Se-Jik

Kim eds.

▪North Korea Development Report 2002/03 / Choong Yong

Ahn ed.

▪Toward a Transparent and Globalized Economy / Choong

Yong Ahn ed.

▪North Korea Development Report 2003/04 / Choong Yong

Ahn ed.

▪Understanding Economy and Politics of Today's Russia /

Yeo-Cheon Jeng and Seok-Hwan Kim

▪Policy Directions for Strengthened Economic Relations

between Korea and Mexico / Won-Ho Kim ed.

▪KoreaᆞSingapore FTA: Its Essentials and Significance /

MOFATᆞKIEP (in Korean)

▪The 9th forum for Korea-Latin America and the

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▪An Introduction of Korea-EFTA FTA (in Korean)

▪Building a Strategic Partnership between Korea and

Mexico for the 21st Century: Vision and Agenda for

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01-01 Regional Financial Arrangements in East Asia:

Issues and Prospects / Yoon Hyung Kim and

Yunjong Wang eds.

01-02 Korea's Five Years in the OECD: Finding a New

Path / Hyungdo Ahn ed.

02-01 Korea's Road to a Sound and Advanced Economy

/ Co-authors

02-02 Market Opening of the Chinese Service Industry

and It's Implication for Foreign Enterprises

/ Wolla Park and Eui-Hyun Choi eds.

02-03 Economic Cooperation of South Korea, North Korea

and China: Possibility and Problems Investigation /

Myung Chul Cho ed.

03-01 Financial Market Opening in China and Korea /

Young-Rok Cheong, Doo Yong Yang, and Wang

Tongsan eds.

03-02 Financial Development and Integration in East Asia

/ Choong Yong Ahn, Takatoshi Ito, Masahiro Kawai,

and Yung Chul Park eds.

03-03 European Integration and the Asia-Pacific Region /

Heungchong Kim ed.

03-04 Structural Reforms and Economic Development

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Sohn ed.

03-05 Northeast Asian Economic Integration: Prospects

for a Northeast Asian FTA / Yangseon Kim and

Chang-Jae Lee eds.

03-06 China's Role in Asia and the World Economy:

Fostering Stability and Growth / Yunjong Wang ed.

04-01 Strengthening Economic Cooperation in Northeast

Asia / Yoon Hyung Kim and Chang Jae Lee

04-02 Enhancing Investment Cooperation in Northeast

Asia / Joon-Kyung Kim and Chang Jae Lee

04-03 Monetary and Exchange Rate Arrangement in East

Asia / Yonghyup Oh, Deok Ryong Yoon, and Thomas

D. Willett

05-01 Diversity in Development: Reconsidering the Washington

Consensus / Jan Joost Teunissen and Age Akkerman

05-02 Regionalism in Northeast Asia: Opportunities and

Challenges / Hyungdo Ahn and Yong Shik Choo

05-03 New Aspects of Globalization and its Challenge to

the World Economy / Heungchong Kim ed.

06-01 Road to Prosperity and Cooperation: Financial Hub

in Northeast Asia

06-02 Africa in the World Economy - The National,

Regional and International Challenges / Jan Joost

Teunissen and Age Akkerman

06-03 Global Imbalances and the US Debt Problem

- Should Developing Countries Support the US

Dollar? / Jan Joost Teunissen and Age Akkerman

06-04 Emerging Financial Risks in East Asia / Doo Yong

Yang

02-01 Culture and Trade in the APEC-Case of film

industry in Canada, Mexico and Korea / Byung-il

Choi

02-02 Diffusion Factors of Electronic Trade for Trade

Facilitation in the APEC Region: A Case of Korean

Small Business / Yongkyun Chung and Yongwhan

Park

02-03 Narrowing the Digital Gap in the APEC Region /

Yoo Soo Hong

02-04 Implementing the Bogor Goals of APEC / Hongyul

Han

03-01 Trade Structure and Complementarity among APEC

Member Economies / Sang-yirl Nam

04-01 Revisiting the Open Regionalism of APEC

- Assessment and New Challenges - / Seok-young

Choi

05-01 APEC After Busan: New Direction / Andrew Elek

05-02 A Renewed Vision for APEC: Meeting New Challenges

& Grasping New Opportunities / John McKay

06-01 Cooperation among APEC Member Economies: An

Interdisciplinary Approach of Economic and Cultural

Perspectives / Hwy-Chang Moon and Min-Young Kim

06-02 Evaluation of Investment Liberalization Efforts by

APEC Economies / Taeho Bark

99-01 A Review and Evaluation of the OECD Convention

on Combating Bribery of Foreign Public Officials in

￭ Discussion Papers

International Business Transactions and Subsequent

Implementation Measures / Keun-Ho Chang

99-02 OECD Principles of Corporate Governance and

Lessons for Korea / Seong-Bong LeeᆞHyong-Kun Lee

99-03 Consumer Protection Issues on Electronic Commerce in

OECD and its Implications for Korea / Sung-Jin Kang

99-04 Official Development Assistance: Trend and lssues

of DAC Members / Yul Kwon

99-05 OECD Issues on Trade and Competition Policy and

Implications for Korean / Mikyung YunㆍJong-Keun

KimᆞYongsook Na

99-06 OECD Regulatory Reform Reviews: The U.S., the

Netherlands, Japan, Mexico / Junsok Yangᆞ

Hongyoul Kim

00-01 OECD Regulatory Reform and Country Review of

Korea: Recommendations and Their Implementation

/ Junsok YangᆞHong-Youl Kim

00-02 The Assessment & Implication of OECD

Recommendations on Korean Agricultural Policy /

Yoocheul SongᆞJihyun Park

00-03 The Assessment & Implication of OECD

Recvommendations on Korea's Financial and Capital

Market / Sang In HwangᆞHyong-Kun Lee

00-04 The Assement and Implication of OECD

Recommendations on Korea's Environment /

Chang-In Yoon

01-01 OECD Regulatory Studies: Regulatory Compliance /

Junsok YangᆞHong-Youl Kim

01-02 Private Actions for Injunction or Damages under

Antitrust Law / Seung Wha CHAG

01-03 Comparison of Recent Tax Reforms in Germany

and Korea / Yu-Chan Kim

01-04 Professional Sports and Competition Law -

Evaluation on Competition Law Implementation

Experience in the OECD Countries and its

Implication - / Won Joon Kim

05-01 Korea's Currency Crisis and Regulations on

Merchant Banking Corporations / Doo-Yull Choi

01-01 Korea's FTA (Free Trade Agreement) Policy:

Current Status and Future Prospects / Chan-Hyun

Sohn and Jinna Yoon

01-02 An Appraisal of ASEM Economic Dialogues and

Future Prospects / Chong Wha Lee

02-01 Searching for a Better Regional Surveillance

Mechanism in East Asia / Yunjong Wang and Deok

Ryong Yoon

02-02 Korea's FTA Policy: Focusing on Bilateral FTAs with

Chile and Japan / Inkyo Cheong

02-03 Update on Korean Economic Reforms and Issues in

Korea's Future Economic Competitiveness

/ Junsok Yang

02-04 Prospects for Financial and Monetary

Cooperation in East Asia / Yunjong Wang

02-05 An Overview of Currency Union: Theory and

Practice / Sammo Kang and Yunjong Wang

02-06 Korea's Trade Policy Regime in the Development

Process / Nakgyoon Choi

02-07 Reform of the Financial Institutions in China: Issues

and Policies / Eui-Hyun Choi

02-08 Reverse Sequencing: Monetary Integration ahead of

Trade Integration in East Asia / Kwanho Shin and

Yunjong Wang

02-09 Can East Asia Emulate European Economic

Integration? / Yung Chul Park and Yunjong Wang

02-10 Debt Resolution, Cross-Border M&As, Governance

and Control in Korea's Post-Crisis Corporate

Restructuring / Chan-Hyun Sohn

02-11 Liberalization Measures in the Process of Korea's

Corporate Restructuring Trade, Investment and

Capital Account Market Openings / Chan Hyun

Sohn, Junsok Yang and Seung Beom Kim

03-01 Inward Foreign Direct Investment into Korea:

Recent Performance and Future Agenda /

June-Dong Kim

03-02 The Need for Intraregional Exchange Rate Stability

in Emerging East Asian Economies / Jonghwa Cho

03-03 Evolving Patterns of Corporate Financing in Korea /

Haesik Park and Yunjong Wang

03-04 Trade Facilitation in the WTO : Implications for

￭ Working Papers

Developing Countries and a Roadmap to Cancun

/ Chan-Hyun Sohn and Junsok Yang

03-05 Moving Forward on the Establishment of an

Effective Surveillance System and an Improved

Financial Architecture for East Asia / Yunjong

Wang and Wing Thye Woo

04-01 Monetary Union and Real Convergence Compared:

Europe and East Asia / Heungchong Kim, Woosik

Moon, and Deok Ryong Yoon

04-02 Critical Assessment of India's Banking Sector

Reform / Tae Hwan Yoo

04-03 The Structure of North Korea's Political Economy:

Changes and Effects / Young-Sun Lee and Deok

Ryong Yoon

05-01 A Brief Appraisal of India's Economic and Political

Relations with China, Japan, ASEAN, the EU and

the U.S. / Tae Hwan Yoo and V. Balaji Venkatachalam

01-01 Does the Gravity Model Fit Korea's Trade

Patterns? : Implications for Korea's FTA Policy and

North-South Korean Trade / Chan-Hyun Sohn and

Jinna Yoon

01-02 Impact of China's Accession to the WTO and Policy

Implications for Asia-Pacific Developing

Economies / Wook Chae and Hongyul Han

01-03 Is APEC Moving Towards the Bogor Goal?

/ Kyung Tae Lee and Inkyo Cheong

01-04 Impact of FDI on Competition: The Korean

Experience / Mikyung Yun and Sungmi Lee

01-05 Aggregate Shock, Capital Market Opening, and

Optimal Bailout / Se-Jik Kim and Ivailo Izvorski

02-01 Macroeconomic Effects of Capital Account

Liberalization: The Case of Korea / Soyoung Kim,

Sunghyun H. Kim, and Yunjong Wang

02-02 A Framework for Exchange Rate Policy in Korea /

Michael Dooley, Rudi Dornbusch and Yung Chul

Park

02-03 New Evidence on High Interest Rate Policy During

the Korean Crisis / Chae-Shick Chung and Se-Jik

Kim

02-04 Who Gains Benefits from Tax Incentives for Foreign

Direct Investment in Korea? / Seong-Bong Lee

02-05 Interdependent Specialization and International

Growth Effect of Geographical Agglomeration

/ Soon-Chan Park

02-06 Hanging Together: Exchange Rate Dynamics

between Japan and Korea / Sammo Kang, Yunjong

Wang, and Deok Ryong Yoon

02-07 Korea's FDI Outflows: Choice of Locations and

Effect on Trade / Chang-Soo Lee

02-08 Trade Integration and Business Cycle Co-

movements: the Case of Korea with Other Asian

Countries / Kwanho Shin and Yunjong Wang

02-09 A Dynamic Analysis of a Korea-Japan Free Trade

Area: Simulations with the G-Cubed Asia-Pacific

Model / Warwick J. McKibbin, Jong-Wha Lee, and

Inkyo Cheong

02-10 Bailout and Conglomeration / Se-Jik Kim

02-11 Exchange Rate Regimes and Monetary

Independence in East Asia / Chang-Jin Kim and

Jong-Wha Lee

02-12 Has Trade Intensity in ASEAN+3 Really

Increased? - Evidence from a Gravity Analysis

/ Heungchong Kim

02-13 An Examination of the Formation of Natural Trading

Blocs in East Asia / Chang-Soo Lee and Soon-Chan

Park

02-14 How FTAs Affect Income Levels of Member

Countries: Converge or Diverge? / Chan-Hyun Sohn

02-15 Measuring Tariff Equivalents in Cross-Border Trade

in Services / Soon-Chan Park

02-16 Korea's FDI into China: Determinants of the

Provincial Distribution / Chang-Soo Lee and

Chang-Kyu Lee

02-17 How Far Has Regional Integration Deepened?

- Evidence from Trade in Services

/ Soon-Chan Park

02-18 Changes in Industrial Interdependency between

Japan and Korea since 1985

- An Application of International Input-Output Analysis /

HongBae Lee

03-01 Trade Integration and Business Cycle

Synchronization in East Asia / Kwanho Shin and

Yunjong Wang

03-02 How to Mobilize the Asian Savings within the

Region: Securitization and Credit Enhancement for

the Development of East Asia's Bond Market /

Gyutaeg Oh, Daekeun Park, Jaeha Park, and Doo

Yong Yang

03-03 International Capital Flows and Business Cycles in

the Asia Pacific Region / Soyoung Kim, Sunghyun

H. Kim, and Yunjong Wang

03-04 Dynamics of Open Economy Business Cycle Models:

The Case of Korea / Hyungdo Ahn and Sunghyun

H. Kim

03-05 The Effects of Capital Outflows from Neighboring

Countries on a Home Country's Terms of Trade

and Real Exchange Rate: The Case of East Asia /

Sammo Kang

03-06 Fear of Inflation: Exchange Rate Pass-Through in

East Asia / Sammo Kang and Yunjong Wang

03-07 Macroeconomic Adjustments and the Real Economy

In Korea and Malaysia Since 1997 / Zainal-Abidin

Mahani, Kwanho Shin, and Yunjong Wang

03-08 Potential Impact of Changes in Consumer

Preferences on Trade in the Korean and World

Motor Vehicle Industry / Sang-yirl Nam and Junsok

Yang

03-09 The Effect of Labor Market Institutions on FDI

Inflows / Chang-Soo Lee

03-10 Finance and Economic Development in East Asia /

Yung Chul Park, Wonho Song, and Yunjong Wang

03-11 Exchange Rate Uncertainty and Free Trade

Agreement between Japan and Korea / Kwanho

Shin and Yunjong Wang

03-12 The Decision to Invest Abroad: The Case of

Korean Multinationals / Hongshik Lee

03-13 Financial Integration and Consumption Risk Sharing

in East Asia / Soyoung Kim, Sunghyun H. Kim, and

Yunjong Wang

03-14 Intra-industry Trade and Productivity Structure:

Application of a Cournot- Ricardian Model / E.

Young Song and Chan-Hyun Sohn

03-15 Corporate Restructuring in Korea: Empirical Evaluation

of Corporate Restructuring Programs / Choong

Yong Ahn and Doo Yong Yang

03-16 Specialization and Geographical Concentration in

East Asia: Trends and Industry Characteristics /

Soon-Chan Park

03-17 Trade Structure and Economic Growth - A New

Look at the Relationship between Trade and

Growth / Chan-Hyun Sohn and Hongshik Lee

04-01 The Macroeconomic Consequences of Terrorism /

S. Brock Blomberg, Gregory D. Hess, and Athanasios

Orphanides

04-02 Regional vs. Global Risk Sharing in East Asia

/Soyoung Kim, Sunghyun H. Kim, and Yunjong

Wang

04-03 Complementarity of Horizontal and Vertical Multinational

Activities / Sungil Bae and Tae Hwan Yoo

04-04 E-Finance Development in Korea / Choong Yong

Ahn and Doo Yong Yang

04-05 Expansion Strategies of South Korean Multinationals /

Hongshik Lee

04-06 Finance and Economic Development in Korea /

Yung Chul Park, Wonho Song, and Yunjong Wang

04-07 Impacts of Exchange Rates on Employment in

Three Asian Countries: Korea, Malaysia, and the

Philippines / Wanjoong Kim and Terrence Kinal

04-08 International Capital Market Imperfections: Evidence

from Geographical Features of International

Consumption Risk Sharing / Yonghyup Oh

04-09 North Korea's Economic Reform Under An

International Framework / Jong-Woon Lee

04-10 Exchange Rate Volatilities and Time-varying Risk

Premium in East Asia / Chae-Shick Chung and Doo

Yong Yang

04-11 Marginal Intra-industry Trade, Trade-induced

Adjustment Costs and the Choice of FTA Partners

/ Chan-Hyun Sohn and Hyun-Hoon Lee

04-12 Geographic Concentration and Industry Characteristics:

An Empirical Investigation of East Asia / Soon- Chan

Park, Hongshik Lee, and Mikyung Yun

04-13 Location Choice of Multinational Companies in China:

Korean and Japanese Companies / Sung Jin Kang

and Hongshik Lee

04-14 Income Distribution, Intra-industry Trade and Foreign

Direct Investment in East Asia / Chan-Hyun Sohn and

Zhaoyong Zhang

05-01 Natural Resources, Governance, and Economic

Growth in Africa / Bokyeong Park and Kang-Kook

Lee

05-02 Financial Market Integration in East Asia: Regional

or Global? / Jongkyou Jeon, Yonghyup Oh, and

Doo Yong Yang

05-03 Have Efficiency and Integration Progressed in Real

Capital Markets of Europe and North America

During 1988-1999? / Yonghyup Oh

05-04 A Roadmap for the Asian Exchange Rate Mechanism

/ Gongpil Choi and Deok Ryong Yoon

05-05 Exchange Rates, Shocks and Inter-dependency in

East Asia: Lessons from a Multinational Model /

Sophie Saglio, Yonghyup Oh, and Jacques Mazier

05-06 Exchange Rate System in India: Recent Reforms,

Central Bank Policies and Fundamental Determinants

of the Rupee-Dollar Rates / Vivek Jayakumar, Tae

Hwan Yoo, and Yoon Jung Choi

06-01 Investment Stagnation in East Asia and Policy

Implications for Sustainable Growth / Hak K. Pyo

06-02 Does FDI Mode of Entry Matter for Economic

Performance?: The Case of Korea / Seong-Bong

Lee and Mikyung Yun

06-03 Regional Currency Unit in Asia: Property and

Perspective / Woosik Moon, Yeongseop Rhee and

Deokryong Yoon

Edited by Doo Yong Yang

Edited by Doo Yong YangEm

erging Financial Risks in East Asia

Korea Institute for International Economic PolicyPolicy Research Institute Ministry of Finances, Japan

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