International Public Policy and Regionalism at the Turn of the Century (Series in International Business and Economics)

International Public Policy and Regionalism at the Turn of the Century

Series in International Business and Economics Series Editor: Khosrow Fatemi Titles include: BAKER Selected International Investment Portfolios BEANE The United States and GATT: A Relational Study CONTRACTOR Economic Transformation in Emerging Countries DUNNING Globalization, Trade and Foreign Direct Investment FATEMI International Trade in the 21st Century FATEMI The New World Order: Internationalism, Regionalism and the Multinational Corporations FATEMI & SALVATORE The North American Free Trade Agreement GHOSH New Advances in Financial Economics GRAY & RICHARD International Finance in the New World Order HAAR & DANDAPANI Banking in North America: NAFTA and Beyond KOSTECKI & FEHERVARY Services in the Transition Economies KREININ Contemporary Issues in Commercial Policy MONCARZ International Trade and the New Economic Order PRAKASH et al The Return Generating Models in Global Finance Related Elsevier Science Journals—Sample copy available on request International Business Review International Journal of Intercultural Relations Journal of International Management Journal of World Business World Development

International Public Policy and Regionalism at the Turn of the Century

Edited by

Khosrow Fatemi San Diego State University — Imperial Valley Campus

2001 PERGAMON An imprint of Elsevier Science Amsterdam - London - New York - Oxford - Paris - Shannon - Tokyo

ELSEVIER SCIENCE Ltd The Boulevard, Langford Lane Kidlington, Oxford OX5 1GB, UK © 2001 Elsevier Science Ltd. All rights reserved. This work is protected under copyright by Elsevier Science, and the following terms and conditions apply to its use: Photocopying Single photocopies of single chapters may be made for personal use as allowed by national copyright laws. Permission of the Publisher and payment of a fee is required for all other photocopying, including multiple or systematic copying, copying for advertising or promotional purposes, resale, and all forms of document delivery. Special rates are available for educational institutions that wish to make photocopies for non-profit educational classroom use. Permissions may be sought directly from Elsevier Science Rights & Permissions Department, PO Box 800, Oxford OX5 1DX, UK; phone: (+44) 1865 843830; fax: (+44) 1865 853333, e-mail: [email protected]. You may also contact Rights & Permissions directly through Elsevier's home page (http://www.elsevier.nl), selecting first 'Customer Support', then 'General Information', then 'Permissions Query Form'. In the USA, users may clear permissions and make payments through the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA; phone: (978) 7508400, fax: (978) 7504744, and in the UK through the Copyright Licensing Agency Rapid Clearance Service (CLARCS), 90 Tottenham Court Road, London W1P OLP, UK; phone: (+44) 171 631 5555; fax: (+44) 171 631 5500. Other countries may have a local reprographic rights agency for payments. Derivative Works Tables of contents may be reproduced for internal circulation, but permission of Elsevier Science is required for external resale or distribution of such material. Permission of the Publisher is required for all other derivative works, including compilations and translations. Electronic Storage or Usage Permission of the Publisher is required to store or use electronically any material contained in this work, including any chapter or part of a chapter. Except as outlined above, no part of this work may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the Publisher. Address permissions requests to: Elsevier Science Rights & Permissions Department, at the mail, fax and e-mail addresses noted above. Notice No responsibility is assumed by the Publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein. Because of rapid advances in the medical sciences, in particular, independent verification of diagnoses and drug dosages should be made. First edition 2001 Library of Congress Cataloging in Publication Data A catalog record from the Library of Congress has been applied for. British Library Cataloguing in Publication Data A catalogue record from the British Library has been applied for. ISBN 0-08-043885-7 Typeset by The Midlands Book Typesetting Company, United Kingdom. (^) The paper used in this publication meets the requirements of ANSI/NISO Z39.48-1992 (Permanence of Paper). Printed in The Netherlands.

To My Wife Marcella. For 31 years of inspiration and support, which have made everything possible.

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Contents

EDITOR

xi

CONTRIBUTORS

xiii

PREFACE

xix

ACKNOWLEDGMENTS

xxiii

PART I: INTRODUCTION 1.

Introduction KHOSROW FATEMI

3

PART II: INTERNATIONAL COMPETITIVENESS AND PUBLIC POLICY ISSUES 2.

3.

4. 5.

6.

The Relative International Competitiveness of the United States, Europe, Japan, and Asia DOMINICK SALVATORE

17

Environmental Standards and Multinational Competitiveness: A Public Policy Proposal SARIANNA M. LUNDAN

30

MNCs, Environmental Issues and Globalization R. WAYNE COLEMAN

45

An Analysis of the OECD Convention on Combating Bribery of Foreign Public Officials SIMON H. LANGER AND JOSEPH PELZMAN

60

Corporate Responsibility and Child Labor in Global Business FOAD DERAKHSHAN AND KAMAL FATEHI

78

vii

viii

Contents

PART III: ECONOMIC DEVELOPMENT AND INTERNATIONAL TRADE 7.

8.

9.

Borrowed Growth: Current-account Deficit-based Development Finance TERUTOMO OZAWA

95

Trade Liberalization and Structural Adjustment in Transition Economies: An Empirical Examination HUBERT GABRISCH AND MARIA-LUIGIA SEGNANA

114

A Cyclical Framework for Forecasting Trade Flows LORENE HlRIS AND DEBASHIS GUHA

132

PART IV: GLOBAL AND REGIONAL TRADING BLOCS 10. The Effects of Regional Trading Blocs on Globalization SARAH K. BRYANT AND KATE J. MASSEY

157

11. Some Measures of Regionalism and Globalization for Latin America RAUL MONCARZ

170

12. MERCOSUR: South America's Most Powerful Trading Group CHERYL HEIN

188

13. The Seattle Debacle: Beyond The Seattle WTO Ministerial Meeting MORDECHAI E. KREININ

202

PART V: FINANCIAL AND INVESTMENT ISSUES IN EUROPE 14. Capital Movements Between CEE Countries and the European Union JANINA WITKOWSKA

217

15. Financial Markets Integration: Real Interest Rate, Saving, and Consumption Paths in the EU IOANNIS N. KALLIANIOTIS

234

16. European Monetary System: Implications for the British Pound BIMAL PRODHAN AND RANKO JELIC

258

Contents

ix

PART VI: FINANCIAL CRISIS IN ASIA AND ITS GLOBAL IMPLICATIONS 17. Restoring Growth in Asia: A Reexamination of Trade and Investment M. RAQUIBUZ ZAMAN

279

18. Asian Miracle to Asian Nightmare BALASUNDRAM MANIAM

294

19. The Asian Financial Crisis and Performance of U.S.-based Asia Mutual Funds JOHN R. NORSWORTHY, WOLFGANG BESSLER, IRVIN MORGAN, RIFAT GORENER AND DING LI 312 PART VII: INTERNATIONAL MONETARY AND INVESTMENT ISSUES 20. The Inadequacy of the Current International Monetary System ROBERT C. SHELBURNE

337

21. Euroland Versus the U.S.: Analysis and Framework for Monetary Strategies ANDRE FOURCANS AND THIERRY WARIN

353

22. Global Accounting Harmonization: A Comparison of U.S. and German Views KURT

JESSWEIN

370

23. Global Equity Market Diversification for American Investors: The Case of Emerging Stock Exchanges Mo VAZIRI AND PARVIZ ASHEGHIAN

24. Endogenous Corruption Risk and FDI in the Developing Countries DAMIEN BESANCENOT AND RADU VRANCEANU

385

395

AUTHOR INDEX

413

SUBJECT INDEX

415

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Editor Khosrow Fatemi is currently Dean of the Imperial Valley Campus of San Diego State University. Previously, he was Dean of the College of Business Administration and the Graduate School of International Trade and Business Administration, and taught graduate courses at Texas A&M International University. He has taught international classes and has been a guest lecturer in different countries around the world including China, Costa Rica, Mexico, Taiwan, France, Germany, Italy, and Iran. Dr. Fatemi holds a Ph.D. and an M.B.A. from the University of Southern California, and a B.A. in Business Administration and Economics from the Abadan Institute of Technology. Dr. Fatemi has published several books including The New World Order: Internationalism, Regionalism and the Multinational Corporations; International Trade in the 21st Century; North American Free Trade Agreement: Opportunities and Challenges; The North American Free Trade Agreement (Co-edited with Dominick Salvatore); Foreign Exchange Issues, Capital Markets, and International Banking in the 1990s (Co-edited with Dominick Salvatore); Selected Readings in International Trade", The Maquiladora Industry: Economic Solution or Problem'?; International Trade: Existing Problems and Prospective Solutions; International Trade and Finance: A North American Perspective; and U.S.-Mexican Economic Relations: Prospects and Problems. His articles have been published in the International Journal of Finance, Journal of Borderland Studies, Issues in International Business, The Middle East Journal, International Management Development Journal, and The Wall Street Journal. Dr. Fatemi has presented over 100 papers at national and international conferences dealing with international trade, the North American Free Trade Agreement, U.S.-Mexico issues and international education. Dr. Fatemi is the Founder and Editor-in-Chief of the Global Economic Quarterly, and serves as the Editor-in-Chief of the Series in XI

xii

Editor

International Business and Economics for Elsevier Science, Ltd. He was the Founding Editor of The International Trade Journal which he edited for 12 years. Previously he edited two monthly publications, The NAFTA Digest and The Border Business Indicators. He is a Founding Member and serves as Executive Vice-President for the International Trade and Finance Association. He has been Chairman or Co-Chair of the Program Committee for six annual conferences on "Western Hemispheric Economies in the 21st Century," and over 15 International Trade and Finance Association annual and international conferences. Dr. Fatemi also serves on the editorial or review boards of Journal of Teaching in International Business, International Business Review, SAM Advanced Management Journal, International Journal of Finance, and Latin American Business Journal. He is active in professional organizations such as the Academy of International Business and the International Trade and Finance Association. In July 1999, the International Management Development Association (IMDA) named Dr. Fatemi as "International Business Dean of the Year."

Contributors Parviz Asheghian is a Professor of Economics at California State University - San Bernardino. He holds a Ph.D. from Georgia State University, an M.A. from the University of Florida, an M.B.A. from the University of Detroit and a B.A. from the Iran Institute of Advanced Accounting. Damien Besancenot is an Associate Professor of Economics (Maitre de Conferences) at the Paris 2 University in Paris, France. He holds a Ph.D. from the Paris 2 University. Wolfgang Bessler is a Professor at the Center for Financial Technology at the Justus-Liebig-University in Giessen, Germany. He previously taught at Rensselaer Polytechnic Institute in New York as well as at various Institutes in Europe and North America. Dr. Bessler holds a Ph.D. in Banking and Finance from the University of Hamburg (German) and an M.B.A. from McGill University in Montreal, Canada. Sarah K. Bryant is the Director of the Evening M.B.A. program at the City University of London (U.K.). Prior to the City University position, she worked in the risk management area for the U.S. Department of Treasury in Washington, DC, and taught at the University of Maryland, College Park, Johns Hopkins University and George Washington University. Dr. Bryant has also worked as a Senior Economist at Chase Econometrics (now WEFA Group), the American Bankers Association and the Federal Home Loan Bank Board. R. Wayne Coleman is an Associate Professor of Marketing at Texas ATM University - Kingsville. He received his D.B.A. from Louisiana Tech University. Foad Derakhshan is a Professor of Management at California State University - San Bernardino (California). He received his Ph.D. degree in Management from Louisiana State University. He has served as a visiting professor at the University of Queensland, XIII

xiv

Contributors

University of Western Australia, Fulda University, Manjin University, Assumption University and Mahidole University. Kamal Fatehi is Professor of Management and Chair of Management and Entrepreneurship Department, Kennesaw State University, Georgia. Dr. Fatehi graduated from Louisiana State University with a Ph.D. in Management. He has also taught in Louisiana and Illinois. In 1994, he was awarded and served as a Fulbright Senior Scholar with Western University in Baku, the Republic of Azerbaijan. Andre Four^ans is a Professor of Economics and Finance at ESSEC, Graduate School of Economics and Management, Cergy-Pontoise (Paris), France. He holds an Engineering degree from Paris, an M.B.A. from the University of Illinois, a Doctorate in Business Administration from Indiana University and a Ph.D. in Economics from the University of Paris. Dr. Fourcans has been a Member of the Economic, Monetary and Industrial Policy Committee of the European Parliament, a Special Advisor to a European Commissioner on Taxation, and is a Member of the Economic and Social Council of France (advisory body to the Government). Hubert Gabrisch is the leader of the Division on Central-Eastern Europe of the Institut fur Wirtschaftsforschung Halle in Germany. Rifat Gorener is a Doctoral student in Financial Technology at the Lally School of Management and Technology at Rensselaer Polytechnic Institute in New York. He received an M.B.A. in Finance from Fairleigh Dickinson University and M.S. and B.S. degrees from Gazi University, Ankara, Turkey. Debashis Guha is Director of Product Development and a Senior Research Scholar at the Economic Cycle Research Institute in New York. Dr. Guha obtained his Ph.D. in Management Science from Columbia University's Graduate School of Business. He also holds a Master's degree in Physics and a Bachelor's degree in Electrical Engineering. Cheryl Hein obtained her B.S. in Accounting and an M.S.-B.A. from Michigan Technological University in Hough ton, Michigan and her Ph.D. in Business from the University of Arkansas. Until recently she was a Professor of Accounting at Texas A&M University - Corpus Christi. Lorene Hiris is an Associate Professor of Finance at the C.W. Post Campus of Long Island University, and Senior Research Scholar at the Economic Cycle Research Institute in New York. Dr. Hiris

Contributors

xv

received her D.P.S. in International Business and Business Economics from Pace University. She also holds an M.B.A. degree in Finance from Long Island University. Ranko Jelic is a Senior Lecturer in Finance at the University of Birmingham (U.K.). Dr. Jelic holds a Master's degree in Accounting and Finance from the London School of Economics, a Master's degree in Monetary Economics and Banking from the University of Belgrade and a Ph.D. in Finance from the University of Hull. Kurt Jesswein received his Ph.D. in International Business from the University of South Carolina. He currently serves as an Assistant Professor of Finance at Murray State University in Murray, Kentucky. He has also taught in Texas, Frankfurt (Oder), Germany, and Hong Kong and has presented a series of international banking seminars in Athens, Greece. loannis N. Kallianiotis is an Associate Professor of Finance at the Arthur J. Kania School of Management at the University of Scranton (PA). He holds a B.A. in Business from the Aristotelian University of Thessaloniki, Greece; an M.A. in Business Economics from Queens College, CUNY; an M.Ph. in Economics from the Graduate Center, CUNY; and a Ph.D. in International Finance and Monetary Policy & Financial Institutions from the Graduate Center and Baruch College, City University of New York. Mordechai E. Kreinin is University Distinguished Professor of Economics at Michigan State University. Dr. Kreinin has been a consultant to numerous international and U.S. organizations in both the public and private sectors. Simon H. Langer is an Attorney at Global Trade and Development Group in Washington, DC, and Bethesda, Maryland. Dr. Simons received his A.B. from Berkeley, an M.A. from the University of Southern California, an L.L.M. from Columbia University and a J.D. from the California Western School of Law. Ding Li is a Doctoral student in Finance at the Lally School of Management and Technology at Rensselaer Polytechnic Institute in New York. He received his M.B.A. from Rensselaer Polytechnic Institute and a B.S. degree from Beijing University of Aeronautics and Astronautics. Sarianna M. Lundan obtained her Ph.D. in Management from Rutgers University. She is an Associate Professor of International Business Strategy at the University of Maastricht (The Netherlands) and previously taught at the University of Reading in England.

xvi

Contributors

Balasundram Maniam is an Assistant Professor of Finance at Sam Houston State University in Huntsville, Texas. He holds a Ph.D. in Finance from the University of Mississippi, and an M.B.A. in Business Administration and an undergraduate degree in Computer Science from Arkansas State University. Kate J. Massey is currently a Ph.D. student in Public Administration and Policy at Virginia Polytechnic Institute and State University. She received her M.S. in Business from Johns Hopkins University and a B.A. degree from the University of South Carolina. Ms. Massey serves as the Director of Grants and Contracts at the Urban Institute, a public policy think tank in Washington, DC. Raul Moncarz is Vice-Provost for Academic Affairs and Professor Finance at Florida International University in Miami. He holds a Ph.D. in Economics from Florida State University in Tallahassee. Dr. Moncarz served as a Fulbright Scholar in Central America, and has also worked for a number of private and public institutions including USAID. Irvin Morgan is Clinical Assistant Professor of Finance at the Lally School of Management and Technology at Rensselaer Polytechnic Institute. He is a Doctoral Student in Finance and Entrepreneurship from Rensselaer Polytechnic Institute. He received an M.B.A. in Finance from the University of Chicago and a B.S. in Mathematics from Tulane University. John R. Norsworthy is a Professor of Economics and Finance at the Lally School of Management and Technology at Rensselaer Polytechnic Institute in New York. He also serves as the Co-Director of the Center for Financial Technology, and as a member of the Faculty of Information Technology. He holds a B.A. and a Ph.D. in Economics from the University of Virginia. Terutomo Ozawa is a Professor Economics at Colorado State University. He received a Ph.D. in Economics and an M.B.A. in management from Columbia University. He has served as a consultant for international organizations such as UNITAR, UNCTC, UNCTAD, UNESCAP, World Bank, OECD, Asian Development Bank, and the Asian Productivity Organization. Joseph Pelzman is a Professor of Economics and International Affairs at George Washington University and a Professorial Lecturer at the George Washington University Law School. He received a B.S. and a Ph.D. in Economics from Boston College and a J.D. from George Washington University Law School. Dr. Pelzman has been the Lady Davis Visiting Professor of Economics at the Hebrew University in Jerusalem, a Visiting Professor at

Contributors

xvii

Boston College and a Visiting Scholar and Fellow at Harvard University. Bimal Prodhan holds a Master's degree in Finance from the London School of Economics, a Doctorate in the Faculty of Law of the University of Glasgow (Scotland), and is a Fellow of the Chartered Institute of Management Accountants, London. He is currently a Senior Lecturer in Finance at the University of Hull (U.K.). Dominick Salvatore is a Professor of Economics and Department Chairman at Fordham University in New York. He is a consultant at the United Nations and the Economic Policy Institute in Washington, DC. Maria-Luigia Segnana is an Associate Professor of Microeconomics at the University of Trento in Italy. Robert C. Shelburne is a Senior International Economist in the Division of Foreign Economic Research of the U.S. Department of Labor. He received his Ph.D. in Economics from the University of North Carolina at Chapel Hill and has taught at Ohio University and North Carolina State University. Mo Vaziri is the Chair of the Department of Accounting and Finance and a Professor of Finance at California State University San Bernardino. He is also the Director of the Center for Global Management and Coordinator of the Business Access and Opportunity program as well as the Arrowhead Laboratory for Security Analysis (ALSA). Dr. Vaziri received his Ph.D. in Finance from the University of Oklahoma. Radu Vranceanu received his Ph.D. in Economics from the Paris Pantheon-Assas University. He is an Associate professor at ESSEC, Graduate School of Economics and Management, Cergy-Pontoise (Paris), France. In January 2000, he was appointed Economic Affairs Officer with the UN Economic Commission for Europe in Geneva, Switzerland. Thierry Warin is a doctoral student in Economics at ESSEC, Graduate School of Economics and Management, Cergy-Pontoise (Paris), France. Janina Witkowska is a Professor of International Economics at the Institute of Economics, University of Lodz in Poland, and is an advisor to the President of the Polish Agency for Foreign Investment. She holds a Ph.D. in Economics from the University of Lodz M. Raquibuz Zaman is the Charles A. Dana Professor of Finance and International Business, and Chairman of the Department of Business Administration at Ithaca College, Ithaca, New York He obtained his Ph.D. from Cornell University.

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Preface Until recently, public policy has been the sole domain of nations and their sub-units. The growth and dominance of international organizations in recent years has created a new need for an internationalized public policy. Furthermore, the expanding role of extra-national entities has also created an enhanced need for an examination of globalized public policy. The first purpose of this volume is twofold: (1) to provide an examination of international public policy in its current form; and, (2) to provide a forum for publication of some of the research findings in ongoing studies of international public policy. With the demise of the cold-war era and the rise of power of extra-national entities—ranging from the United Nations to multinational enterprises and from the International Monetary Fund to the World Trade Organization—a new "system" was evolved for which few rules were in place. Consequently, it became a "learn-asyou- play" game. The situation was further exacerbated by the lack of sufficient academic research on the topic. Recent years have witnessed a rise in the number of such studies, but there are still far too few. Thus the second purpose of this book is to augment the work done in the area of examining the internationalizing process of public policy. It is hoped that it will also lead to an acceleration of the examination process. ORGANIZATION OF THE BOOK This volume consists of seven parts and twenty-four chapters. Its organization is intended to provide a balance perspective of an ongoing—albeit at a slow pace—research in a relatively new field of study. The book begins with an introductory chapter by the Editor, who also provides introductory remarks to each part. Part Two consists of five chapters examining international competitiveness and public policy issues. It begins with an XIX

xx

Preface

examination of "the relative international competitiveness of the United States, Europe, Japan, and Asia" by Professor Dominick Salvatore. This is followed by two chapters on environmental issues. Chapter Three is an examination of international public policy from an environmental perspective by Professor Sarianna Lundan while Chapter Four is on MNCs, environmental issues and globalization by Professor R. Wayne Coleman. Finally, Chapters 5-6 analyze specific aspects of international public policy. In Chapter Five, Professors Simon H. Langer and Joseph Pelzman discuss the OECD Convention on combating bribery of foreign officials, while in Chapter Six Professors Foad Derakhshan and Kamal Fatehi present an evaluation of child labor laws in international business. Part Three presents the findings of three studies on economic development and international trade. In Chapter Seven, Professor Terutomo Ozawa examines different aspects of economic development based on borrowing in foreign markets. Professors Hubert Gabrisch and Maria-Luigia Segnana present the findings of their study on trade liberalization and structural adjustment in transitional economies in Chapter Eight. Part Three concludes with Chapter Nine in which Professors Lorene Hiris and Debashis Guha discuss their work in developing a leading indicator for forecasting trade flows. Part Four deals with some of the more practical issues that both the policy-makers and practitioners in the field have to contend with on a regular basis, namely global and regional trading blocs. In Chapter Ten Professors Sarah K. Bryant and Kate J. Massey investigate the impact of regional trading blocs on globalization and market integration. Integration in Latin America is the topic of the next two chapters. Professor Raul Moncarz provides, in general terms, an analysis of regionalism efforts in Latin America in Chapter Eleven. This is followed by a more specific evaluation of MERCOSUR in Chapter Twelve by Professor Cheryl Hein. Chapter Thirteen is an examination of the World Trade Organization and the history of its development including the Seattle Ministerial meeting by Professor Mordechai E. Kreinin. Part Five consists of three chapters discussing different aspects of investment and financial issues in Europe. In Chapter Fourteen, Professor Janina Witkowska discusses capital movement between members of the European Union and three potential members, Poland, Hungary, and the Czech Republic. Professor loannis N. Kallianiotis evaluates the integration of the European Union and its impact on capital markets in Chapter Fifteen. Finally, Professors

Preface

xxi

Bimal Prodhan and Ranko Jelic study the fluctuations of the British Pound against the currencies of Britain's major trading partners in Chapter Sixteen. Part Six presents three different studies of the Asian financial crisis of the late 1990s and its global implications. In Chapter Seventeen Professor M. Raquibuz Zaman examines the role of foreign direct investment and private capital flows in East Asia's recovery. Professor Balasundram Maniam provides an overview of the crisis in Chapter Eighteen and finally Professors John Norsworthy, Wolfgang Bessler, Irvin Morgan, Rifat Gorener, and Ding Li investigate the impact of the crisis on the performance of U.S.-based Asian mutual stock funds. The book concludes with Part Seven in which international monetary and investment issues are examined. This part begins with an examination of the current monetary system by Professor Robert Shelburne in Chapter Twenty. The next two chapters cover two aspects of the financial relations between the United States and Europe. First, in Chapter Twenty-One, Professors Andre Fourcans and Thierry Warin present their findings on developing a theoretical framework for monetary strategies between the two trading partners. This is then followed by a discussion of accounting standards in relation to the United States and Germany by Professor Kurt Jesswein in Chapter Twenty-Two. The next chapter includes an examination of capital equity market diversification for American investors in emerging stock exchanges by Professors Mo Vaziri and Parviz Asheghian. Finally, the book concludes with Chapter TwentyFour, an analysis of endogenous corruption risk and foreign investment in the developing countries by Professors Damien Besancenot and Radu Vranceanu.

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Acknowledgments This volume contains, for the most part, revised and updated studies which were first presented at the international conference of the International Trade and Finance Association (IT&FA) held during May 26-29, 1999 in Casablanca, Morocco. My special thanks go to the IT&FA family for their support of the Association in general and our international conferences in particular. My very sincere thanks also go to the authors of the papers first presented at the Casablanca Conference and now published in this volume. The timely submission of their articles and their adherence to editorial observations made my work in putting together this volume much easier and much more pleasant. It was, indeed, a great pleasure working with such a group of professional colleagues. The Conference was held in cooperation with the School of Business Administration (CNCD) in Casablanca, Morocco. My very special thanks go to the CNCD community for their support and for their invaluable assistance in planning and implementing the Casablanca Conference. I am particularly indebted to Dr. M'hamed Seqat, the President of CNCD, for his leadership, unwavering support, and superb organization of the Conference. The time and effort that Ms. Sue Nichols, my able assistant at the Imperial Valley Campus of San Diego State University and the Assistant Editor of the Global Economy Quarterly, put into the preparation of this volume was far beyond the call of duty. The thoroughness of her work on this volume exemplifies her devotion and dedication to her career. It is a pleasure to have her as a colleague. Finally, a note of thanks to David Lamkin who, until recently, served as the editor for the Series in International Business and Economics at Elsevier Sciences, Ltd. The professionalism that he demonstrated in handling of this project and the Series in general was greatly appreciated. I look forward to working with his successor, Neil Boon. Calexico, California May 2000

Khosrow Fatemi

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Parti Introduction

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1 Introduction KHOSROW FATEMI

I. INTRODUCTION The state of the global economy at the dawn of the Third Millennium is—not surprisingly—a mixture: a mixture of successes and failures, of problems and potentials, and of opportunities and pitfalls. On the one hand, from the perspective of macro-economic indicators, the global economy has rarely been as prosperous as it is today. Measured by any common indicator of economic development, the world is better off at the turn of the century than any other time in history.1 The global economy is larger today than it has ever been (Table 1.1); it has been expanding more rapidly than ever before; and there are few long-term negative prospects on the horizon. On the other hand, distribution of income among—and within—many nations is more unbalanced than any other time in history; the developing countries spend about one-quarter of their exports on debt-service payments (Table 1.2) and, while many countries are greatly benefiting from the recent changes in the structure of the global economy, most are not. Unquestionably, one of the most controversial issues of global economy in the early years and decades of the 21st century is the globalization of many activities which previously have been the sole domain of national governments. It is the widespread prevalence of such activities which has brought to reality the need for internationalization of public policy. And nowhere is the need more pronounced than in international trade. Two, almost contradictory, developments in international trade in recent years have contributed greatly to this need. The two changes are (1) the rapid growth of multilateralism in international trade as best manifested by the replacement of the somewhat innocuous General Agreement on Tariffs and Trade (GATT) with the all-powerful World Trade Organization2 (WTO) and

4

Khosrow Fatemi TABLE 1.1 Gross National Product 1997

Low Income Countries Lower Middle Income Countries Upper Middle Income Countries High Income Countries WORLD TOTAL

Number of Countries 62' 602 363 244 182

Total GNP (Billion $) 721 2828 2584 23802 29925

Per Capita GNP ($) 350 1230 4520 25700 5130

1

Includes 39 countries and territories in Africa, 11 in Asia, eight in Europe, one in the Middle East, and three in the Americas. - Includes five countries and territories in Africa, 16 in Asia, 12 in Europe, nine in the Middle East and North Africa, and 18 in the Americas. * Includes six countries and territories in Africa, three in Asia, eight in Europe, six in the Middle East and North Africa, and 13 in the Americas. 4 Includes four countries in Asia, 18 in Europe, and two in North America. Source: The World Bank, World Development Report: 1998-99, Washington, DC: The World Bank, 1999, pp. 190-191, and 250-251. TABLE 1.2 Debt Service Payments1 by the Developing Countries as a Percentage of the Export of Goods and Services Year

Africa

Asia

1991

26.6 26.9

17.2 20.4 18.1 16.8 16.1 16.2 14.5 19.5 15.7 14.6

1992 1993 1994 1995 1996 1997 1998 19992 20002 1

2

26.5 26.7 27.6

22.6 22.6 24.2 28.3 26.8

Middle East and Europe 11.4 12.4 13.8 13.8 12.9 17.8 15.3 15.6 17.4 15.2

Western Hemisphere 39.3 41.9 44.4 43 42.7 45.1 50.1 50.9 54.9 47.9

Developing Countries 22.7 24.5 24.6 23.6 23 24.1 24.1 27 27 24.5

Debt-service payments refer to actual payments of interest on total debt plus actual amortization payments on long-term debt. The projections incorporate the impact of exceptional financing items. Projections.

(2) the rapid growth and success of regional free trade agreements and of regionalism in international trade in general. II. REGIONALISM AND INTERNATIONAL TRADE

One of the more controversial developments of the last few decades has been the unprecedented growth in the number—and arguably

Introduction

5

the success—of free trade agreements (FTAs), and other forms of regional integration. The idea of free trade agreements is nothing new, but the widespread use and the success of such efforts is.3 Much of this can be attributed to the success of the European Union (EU) in bringing not only economic expansion but also political stability to Europe. Even though the EU is no longer merely a free trade agreement, it still epitomizes the prosperity that an FTA can bring to a region. During the years since 1957, when the Treaty of Rome established "the European Communities" there have been dozens of FTAs negotiated, fewer signed, and even fewer implemented. Very few have actually been successful. FTAs are by definition exclusionary and they favor other members of the agreement over the non-members. How much of this favorable treatment is at the expense of other countries—in other words, trade diversion—and how much of it is through expansion of trade—trade creation—is the subject of an ongoing debate among scholars in the field. Nevertheless, the influence of geography seems inordinate in most FTAs. Unquestionably the benefits of membership in an FTA have helped many countries experience economic growth at rates which probably would not have been possible without such alliances. For example, it is doubtful that Portugal, Spain, and Greece would be where they are economically, without the benefits of membership in the European Union. It is even more doubtful that Mexico would have been able to recover from the currency problems of the early 1990s as fast and as effectively as it did without membership in the North American Free Trade Agreement (NAFTA). Similar, albeit not as strong, comments can be made about many other countries and their membership in regional groupings. The fate of the non-members, however, portrays a vastly different picture. And, most countries around the world fall in this category, at least as far as membership in an effectively functioning FTA is concerned. In many ways, these are the countries which need the economic assistance of an FTA the most. With few exceptions, the continent of Africa falls in this category, as do most of the Asian and Latin American countries. While several attempts are underway to form FTAs in these regions, it is doubtful that a group of countries exporting the same few raw-materials can benefit much by eliminating trade barriers among themselves,4 although they could create an international cartel and control the price of their exported commodities, a la OPEC (The Organization of Petroleum Exporting Countries). Even then, OPEC's record in recent years has

6

Khosrow Fatemi

been anything but a shining success story and, more importantly, how many commodities are as unique, as much in demand, and as limited in supply as oil is?5 III. MULTILATERALISM IN INTERNATIONAL TRADE

The idea of a multilateral and powerful trade organization dates back to the Bretton Woods negotiations of the 1940s. The "new" international economic system was to have three distinct components, each with its own coordinating and monitoring organization. One component was the International Monetary Fund (IMF) and its responsibilities included monitoring global financial and monetary issues. The IMF was to serve as the global central bank. Given that the Bretton Woods negotiations were held in the shadow of the depression of the 1930s, having a strong international financial system and a global organization to monitor it—more likely to control it—was not an idea that many nations could oppose. Consequently, despite some sporadic opposition, the International Monetary Fund was successfully created. The second component of the envisioned international economic system was the creation of an international agency to facilitate global development, and re-development in the case of Europe. The International Bank for Reconstruction and Development (The World Bank) was the second successful outcome of the negotiations. The third component, designed to be similar the International Monetary Fund, was the International Trade Organization (ITO). The goal was for the ITO to do for international trade what IMF had done for the international financial and monetary system. For a variety of political and economic reasons, the ITO was never ratified by the United States Senate and died from inaction. The compromise substitute for the ITO was the much less comprehensive GATT which, unlike the IMF and the World Bank, had little organizational structure and less power. IV. REGIONALISM AND MULTILATERALISM OF THE 1990s

Two, almost contradictory, developments have dominated the international trade arena in recent years. On the one hand, the World Trade Organization is the first bona fide functional global trade organization. By virtue of its bylaws, the WTO requires trade issues to be discussed at the global level, where all members would have an opportunity to participate in, and benefit from, any negotiations to

Introduction

7

reduce trade barriers. On the other hand, during the same period of time, numerous regional trading blocs have been created which, by definition, are regional and not global and, therefore, violate the spirit of the WTO, if not its charter.6 The combination of the WTO and an array of regional blocs has created an environment unparalleled in history in which national governments are voluntarily subjugating their economic policies to the decisions of international organizations. This situation has brought together a highly unusual alliance of opposition, from extreme right to extreme left, as well as many centrist groups. These groups may not have much in common except their opposition to a perceived "world government". Nevertheless, their success in Seattle and their effect on the IMF/World Bank meetings in Washington in April 2000 does point out a failure; at best, this is a public relations failure on the part of the three organizations—as the World Bank and IMF tried to portray after the Washington demonstrations. At worse it is a failure of mission and of raison d'etre—as the Seattle and Washington demonstrators tried to convey. Without giving credence to the paranoia of a few extremist—or as they would argue, puritan or nationalist—commentators, the fact remains that the rise of such multilateral organizations in recent years has created situations where national governments subjugate their sovereignty to the decisions of a multilateral entity. More to the point, this has accentuated the need for the globalization of public policy. Like many other parameters of the international economy, this is another phenomenon of the post cold-war era. And like the rest, there is little historical precedent to rely on. V. FUTURE PROSPECTS

It is highly likely that the World Bank and the International Monetary Fund will continue to play major roles in the global economy; if for no other fundamental reason, one could argue that bureaucracies do not wither away easily, and these are powerful bureaucracies. There are, however, fundamental reasons for the continued existence of each organization. Despite the many shortcomings of the International Monetary Fund, the global monetary system cannot function without a controlling organ. And, in that role, the IMF has been successful. It is highly likely that without an "IMF" to impose conditions and austerity measures on countries facing short-term currency and balance of payments problems in return for financial assistance, most would have become long-term crises. Austerity

8

Khosrow Fatemi

measures are never popular with the masses and the IMF is a good scapegoat for weak governments facing financially-induced political problems at home. Even though the World Bank does have a long-standing record of funding successful projects in the developing world, the argument in favor of its continued existence is not quite as pressing or as convincing, and it is much more complex. On the one hand, it could be argued that the single most important measure of the effectiveness of a development bank is the role it has played in reducing poverty and income disparity among nations. By that criterion, the World Bank has by and large been a colossal failure, as the gap between the poor and the rich has widened during its era. On the other hand, its supporters can point to the large number of successful projects that the Bank has funded and ask whether many of those would have been implemented without World Bank funding. Maybe more significantly, how can a world, in which as many nations are as poor as they are, function without a "development bank"? And if such a bank is needed, what are the reasons to argue in favor of a different "development bank"? The fate of the World Trade Organization is more doubtful than either of its financial or developmental counterparts. Philosophically, there is a long history of global development without a powerful organization controlling international trade. One could argue, in fact, that lack of such an entity to create barriers to trade facilitated, and not hampered, the expansion of global trade. In more practical terms, a bad precedent has been established in which non-trade issues have become part of trade negotiations. And, in the long run, this may well be what will render the WTO useless. The important question should not be whether environmental and labor laws in other countries are important or not; rather, whether they are—or should be—part of trade negotiations. This is particularly interesting in the case of compensation issues. The reality is that for many countries inexpensive labor is one of the few—if not the only—comparative advantage they have. Taking that away, these countries would be left with few or no products to export; which also means no foreign currencies to import. Future debacles such as Seattle and Washington notwithstanding, a functioning global economy needs control mechanisms. Despite their many shortcomings, the International Monetary Fund, the World Bank, and even the World Trade Organization may well be better alive than dead.

Introduction

9

NOTES

1.

2.

3. 4.

5.

6.

The World Bank classifies countries of the world into four categories: high income, upper middle income, lower middle income, and low income. The per capita income of the high income countries is 73 times that of the low income countries, the highest disparity ever. Organizationally, the World Trade Organization is a much more powerful entity than its predecessor, the General Agreement on Tariffs and Trade (GATT). For example, the WTO can sanction member countries and impose penalties on them for violating WTO rules. GATT's most powerful weapon was international public opinion, at best a questionable one. Counting all free trade agreements in the world, there are more members in such organizations than there are countries. In other words, a typical or average country belongs to more than one regional trading bloc. MERCOSUR is the most noticeable exception. Its member countries—Argentina, Brazil, Paraguay, and Uruguay—have been successful in reducing some trade barriers among themselves. Their success is, however, marred by frequent political bickering, partly caused by the fact that the union consists of two small members (Paraguay and Uruguay) and two large economies (Argentina and Brazil). The smaller two are very uneasy about the dominance of the alliance by the two larger members. OPEC was able to push up oil prices temporarily in 1999-2000 and the bench mark crude oil reached $30 per barrel in several years. It should, however, be noted that even at this rate, oil prices in real terms are about where they were in the early 1970s. The framers of the World Trade Organization incorporated an exemption clause into the charter of the organization, in effect, exempting regional trade organizations from certain provisions of the WTO charter. This may have provided a good cover for regional groupings, but its does not detract from the basic fact that these organizations are far from the ideals of global trade.

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Part II International Competitiveness and Public Policy Issues

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Part II: International Competitiveness and Public Policy Issues An important component of international public policy at the turn of the Century is the issue of competitiveness on a global scale. As the borders between countries disappear - or at least shrink in significance - and as more and more enterprises enter the global market arena, competitiveness, which used to be entirely in the domestic domain of the business sector, has evolved into an international phenomenon. Companies can no longer consider their domestic markets "safe" from international competitors. Like practically every other aspect of managing a firm, environmental constraints, including competitiveness, have also been globalized. Part Two consists of five chapters analyzing different aspects of international competitiveness and public policy issues. In Chapter Two, Professor Dominick Salvatore examines the relative international competitiveness of the United States, Europe, Japan, and Asia. Professor Salvatore studies competitiveness trends in hightechnology products, office equipment and telecommunications and manufactured goods since 1980 to detect any changes in the competitiveness of these industries. The results of his study "indicate that the United States lost international competitiveness in high technology products with respect to Europe and the rest of Asia in all three goods classifications from 1980 to 1997, and with respect to Japan from 1980 to 1990. Europe gained international competitiveness in all three goods categories with respect to the United States and Japan but experienced a reduction with respect to the rest of Asia. Japan lost international competitiveness with respect to the United States and Europe, especially since 1990, but gained it with respect to the rest of Asia, except in manufactured goods." In Chapter Three Professor Sarianna M. Lundan examines international public policy from an environmental perspective. Specifically, she uses the case of the paper industry to illustrate the changes which have taken place in the development and implementation of environmental standards and the role that both the multinationals 13

14

as well as other non-governmental organizations have played in the process. She argues that some recent changes in the world economy have made the old framework of public policy inappropriate and this requires new approaches to the development of such policies. Specifically, she cites two such changes. First, she points to "the importance of created (and mobile) assets for national economic growth and the growth of intra-firm trade in the world economy, which reinforces the notion that the issue of trade and environment is really an issue of multinationals and the environment." Second, [she argues that] "multinational environmental strategy has changed both the way in which MNEs respond to regulation as well as the way in which national governments approach the issue of regulation." Professor Lundan concludes that these changes "point toward two possible future scenarios: either a new policy domain where multinationals will gradually become full-fledged participants in the political process, or toward the maintenance of the status quo, where multinationals may be the de facto engines of change." In Chapter Four Professor R. Wayne Coleman addresses MNCs, environmental issues and globalization. He points out that because of "the growth of public concern about the environment and the business response to this concern, the 1990s were declared the decade of environmentalism." He argues that this trend will continue and "the number and diversity of issues confronting international business which fall under the banner of environmentalism will continue to grow ... However, the continuing growth of globalization will also provide a basis for dealing with such trade issues through converging standards and regulations brought about by international agreements such as GATT-WTO and also by international environmental certification programs and international environmental standards such as ISO 14000." Chapter Five provides an examination of one of the specific issues regarding international public policy. Professors Simon H. Langer and Joseph Pelzman discuss "The OECD Convention on Combating Bribery of Foreign Officials." They analyze "the provisions of the OECD Convention, the United States legislation that entitled the International Anti-Bribery Act of 1998 and how it amends the Foreign Corrupt Practices Act (FCPA) to comply with the OECD Convention; and factors to consider in implementing compliance and due diligence programs for government and multinational companies. In Chapter Six Professors Foad Derakhshan and Kamal Fatehi present an analysis of another aspect of international public policy,

15

namely the question of child labor and its implications for globalization of business activities. They maintain that "the use of child labor is neither a new problem nor restricted to the less-developed parts of the world." They view the problem as a major one with universal prevalence, even though the primary use of child labor is in the developing world. They cite statistics by the International Labor Organization which "puts the estimate of the number of working children between 100-200 million, with about 95% living in lessdeveloped and developing countries." Professors Derakhshan and Fatehi argue that "the existence of child labor does not seem to have a positive influence on an multinational company's decision to invest in a particular country. [In fact,] in the light of recent publicity over the issue, most companies prefer to avoid countries where child labor exists." They conclude by expressing the hope that "globalization [could be] a vehicle to reduce incidence of child labor through the economic development opportunities that it creates."

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2

The Relative International Competitiveness of the United States, Europe, Japan, and Asia DOMINICK SALVATORE

I.

INTRODUCTION

This chapter examines the relative international competitiveness of the United States, Europe, Japan, and the rest of Asia in high-technology products and in all manufactured goods, and how this changed over the past three decades. International competitiveness is a crucial aspect of all modern economies, but a great deal of disagreement exists on how to measure it (see Salvatore, 1992, 1993; McKibbin and Salvatore, 1995). This chapter uses the implicit or revealed comparative advantage of nations to measure their international competitiveness and how this changed over time. The 197098 period is split into two sub-periods (with some years' overlap): 1970-89 and 1980-97, with more data available for the latter than for the former sub-period. II. CHANGES IN RELATIVE COMPETITIVENESS OF THE U.S., EC, AND JAPAN IN THE 1970S AND 1980S

Table 2.1 shows the exports of high-technology goods of the U.S., the European Community (EC(9)—the nine members, excluding Greece, Portugal, and Spain), Japan, and the Newly Industrializing Economies (NIEs) of Hong Kong, Korea, Singapore, and Taiwan from 1970 to 1989. High-technology goods include chemicals and drugs, mechanical equipment, electronic goods, aircraft and parts, and scientific instruments. 77

18

Dom in ick Sa Iva tore

The top part of Table 2.1 shows that the percentage of world high-technology exports of the U.S. declined from an average of 29.5 in 1970-73 to 25.1 in 1979-82 and 20.6 in 1986-89, or by 30.2% between the earliest and the latest periods. The corresponding figures for EC (9) were 46.4, 44.1, and 37.4, for a decline of 19.4% between 1970 and 1973 and between 1986 and 1989. On the other hand, the percentage of world high-technology exports of Japan increased from an average of 7.1 in 1970-73 to 10.1 in 1979-82 and 16.1 in 1986-89, or by 126.8% between the earliest and the latest periods. The corresponding figures for the four East Asian NIEs were 1.3, 4.1, and 8.8, for an increase of 576.9% (but starting from a very low base) between 1970-73 and 1986-89. The lower part of Table 2.1 shows the comparative-advantage index in high-technology goods for the same nations and regions from 1970-73 to 1986-89. The (revealed) comparative-advantage index of a country or region is measured by the country's or region's world export-share in the product group as a percentage of that country's or region's share of total world exports of manufactures. Between 1970-73 and 1986-89, that index for all high-technology product groups together declined from 219 to 192, or by 12.3% for the U.S. and from 99 to 91, or by 8.1% for the EC. On the other hand, the comparative advantage index rose from 80 to 133 or by 66.3% for Japan and from 54 to 110 or by 103.7% for the East Asian NIEs. Among the subcategories of high-technology goods, only in chemicals did the U.S. comparative-advantage index rise. In electronic goods, it fell by 20.8%, in aircraft and parts, it fell by 5.5%, and in scientific instruments it fell by 4.1%. For the EC, the index rose by 5.7% in chemicals and drugs, 44.4% in aircraft and parts (as a result of the successful introduction of Airbus), and by 5.8% in scientific instruments, but it fell by 10.2% in chemicals and drugs and by 25.3% in electronic goods. For Japan, the index rose sharply for mechanical equipment and electronic goods, and moderately for aircraft and parts (where its revealed comparative advantage index was very small) and in scientific instruments, and it fell sharply in chemicals and drugs. For the East Asian NIEs, the index rose for all categories of high-technology goods, but especially for mechanical equipment, scientific instruments, and electronic goods—in that order. Overall, Japan and the NIEs gained in competitiveness over the U.S. and the EC in mechanical equipment, electronic goods, and scientific instruments but lost in chemicals and, with respect to the

Competitiveness of the United States, Europe, Japan, and Asia

19

TABLE 2.1 Exports of High-Technology Goods Performance Index Share of world High-technology exports: 1970-73 1979-82 1988-89 % change 1970-73 to 1986-89 Comparative-advantage index in hightechnology goods: All product groups: 1970-73 1986-89 % change 1970-73 to 1986-89 Chemical and drugs: 1970-73 1986-89 % change 1970-73 to 1986-89 Mechanical equipment: 1970-73 1986-89 % change 1970-73 to 1986-89 Electronic goods: 1970-73 1986-89 % change 1970-73 to 1986-89 Aircraft and parts: 1970-73 1986-89 % change 1970-73 to 1986-89 Scientific instruments: 1970-73 1986-89 % change 1970-73 to 1986-89

U.S.

EC(9)'

Japan

NIEs2

29.5 25.1 20.6 -30.2

46.4 44.1 37.4 -19.4

7.1 10.1 16.1 126.8

1.3 4.1 8.8 576.9

219 192 -12.3

99 91 -8.1

80 133 66.3

54 110 103.7

111 124 11.7

123 130 5.7

86 47 -45.3

45 46 2.2

156 145 -7.1

108 97 -10.2

93 144 54.8

21 68 223.8

212 168 -20.8

95 71 -25.3

110 200 81.8

132 190 43.9

440 416 -5.5

63 91 44.4

6 7 16.7

16 19 18.8

217 208 -4.1

103 109 5.8

86 100 16.3

15 43 186.7

'

Excludes Greece, Portugal, and Spain. Hong Kong, Korea, Singapore, and Taiwan. Source: Adapted from D'Andrea Tyson, L. (1992) Who's Bashing Whom? Trade Conflict in HighTechnology Industries, Washington, DC: Institute for International Economics, 23-24.

EC, also in aircraft and parts between 1970 and 1989. Comparing the international competitiveness of the U.S. and the EC, the table shows that the U.S. performed relatively better than the EC only in mechanical equipment and electronic goods. One important reason for the better EC performance vis-d-vis the U.S. may have been the successful strategic industrial policies of the EC. One reason for the poor U.S. performance, especially during the decade of the 1980s, was the large dollar overvaluation between 1981 and 1985.

20

Dominick Salvatore

III. CHANGES IN U.S. RELATIVE COMPETITIVENESS IN HIGHTECHNOLOGY PRODUCTS

The above table and discussion looked at the international competitiveness of the U.S., the European Union, Japan, and the rest of Asia from an overall point of view. Lack of more detailed data did not permit the measuring of the changes in international competitiveness between any pair of nations or regions. This is possible with the more detailed data published by the World Trade Organization or WTO (formerly the General Agreement on Tariffs and Trade or GATT) since 1980. This is shown in Table 2.2, which shows the change in the overall international competitiveness in high-technology products of the U.S. with respect to Western Europe, Japan, and the rest of Asia from 1980 and 1998. The rest of Asia refers here primarily to the Dynamic Asian Economies (DAEs), which include the four Newly Industrializing Economies or NIEs (Hong Kong, Korea, Taiwan, and Singapore), as well as Malaysia, Thailand, and China. High-technology products refer here to chemicals, machinery and transport equipment. Chemicals include pharmaceuticals. Machinery refers to power-generating machinery, electrical machinery and apparatus, non-electrical machinery, office equipment, and telecommunications equipment. Transport equipment includes automotive products and other transport equipment. Automotive products incorporate many new technologies and can increasingly be regarded as a high-technology product. Other transport equipment refers to aircraft and locomotives. Table 2.2 gives data on the hightechnology exports and imports, the net balance, and the net balance as a percentage of total manufactured exports of the U.S. with respect to Europe, Japan, and the rest of Asia in 1980, 1990, and 1995-98. Comparable data for 1985 are not available. The last column of the table gives the change in the (revealed) comparative advantage and thus provides a measure of the change in the international competitiveness of the U.S. in high-technology products. Table 2.2 shows that in 1980 the U.S. exported to Europe $29.59 billion of high-technology products, imported $22.74 billion, for a net balance of $6.85 billion, which represented 4.69% of the total exports of all manufactured goods of the U.S. The positive sign indicates that the U.S. had a comparative advantage in high-technology products with respect to Europe in 1980. The absolute value of the index provides a measure of the degree or strength of the comparative advantage or international competitiveness of the nation. In 1990, U.S. high-technology exports to Europe jumped to $66.57

Competitiveness of the United States, Europe, Japan, and Asia

21

TABLE 2.2 U.S. Trade in High-Technology Products (Billions of Dollars)

Europe

Japan

Asia-Japan

1980 1990 1995 1996 1997 1998 1980 1990 1995 1996 1997 1998 1980 1990 1995 1996 1997 1998

Exports

Imports

29.59 66.57 80.21 84.54 96.78 104.93 5.88 19.92 30.16 32.30 33.49 30.31 16.73 42.39 81.36 86.59 95.15 83.28

22.74 57.98 83.28 89.48 100.50 115.87 23.00 74.12 105.52 96.42 100.11 99.12 7.49 38.84 94.10 100.35 110.71 114.91

Net Balance 6.85 8.59 -3.07 -4.94 -3.72 -10.94 -17.12 -54.20 -75.36 -64.12 -66.62 -68.81 9.24 3.35 -12.74 -13.76 -15.56 -31.63

Comp adv (+) or disadv (-) ' 4.69 2.96 -0.68 -1.02 -0.67 -1.96 -11.73 -18.66 -16.74 -13.23 -12.04 -12.33 6.33 1.22 -2.89 -2.84 -2.81 -5.67

1

Comparative advantage (+) or disadvantage (-) is measured by the net balance as a percentage of the total manufactured exports of the nation (here the United States). Source: GATT/WTO.

billion, its imports increased to $57.98 billion, for a net balance of $8.59 billion, which, however, represented only 2.96% of U.S. total exports of manufactured goods. Thus, while the U.S. net balance in high-technology trade with Europe increased in absolute value, it fell as a percentage of its total manufactured exports, and so we could say that the U.S. international competitiveness position in high-technology products vis-a-vis Europe worsened between 1980 and 1990. This worsening continued after 1990, when the U.S. revealed comparative advantage actually became a comparative disadvantage of-0.68 by 1995, and it was -1.96 in 1998. Thus, despite the widely held belief to the contrary, the U.S. seems to have lost competitiveness with respect to Europe even during the 1990s. The belief that the U.S. had become more competitive vis-d-vis Europe during this decade was based on (1) the elimination of the 1980's dollar overvaluation, (2) the much greater computerization of the American than the European economies, (3) the much more extensive spread of computer-aided design and computer-aided manufacturing in the U.S. economy based on its superiority in software, and (4) the much greater restructuring of the U.S. economy than European economies during the 1980s and

22

Dominick Salvatore

early 1990s. This incorrect belief also seems to have been encouraged by the Geneva-based World Economic Forum, which ranked the U.S. as the most competitive economy in the world from 1994 to 1999, taking the top spot away from Japan, which had occupied that position since 1985 (see Salvatore, 1998a, 1998b). It may be that the U.S. is gaining competitively with respect to Europe, but the trade data up to 1998 do not seem to show it. The U.S., already with a large comparative disadvantage in hightechnology products (i.e., a negative value of 11.73 in the last column of Table 2.2) in 1980 with respect to Japan, continued to lose competitiveness until 1990 (see Salvatore, 1995), but regained some of the lost ground since then, so that in 1998 its competitiveness position (comparative disadvantage) vis-d-vis Japan was about the same as it was in 1980. With respect to other Asian countries, the U.S. went from a comparative-advantage index of 6.33 in 1980 to an index of comparative disadvantage of -2.81 in high-technology products in 1997. The index fell to -5.67 in 1998, but this was due to the sharp decline in Asian imports from the U.S. as a result of the serious financial and economic crisis that engulfed most of Asia from the end of 1997 until 1999. Presumably, with the end of the crisis, the value of the index would return to a value similar to that during the previous three years. IV. CHANGES IN U.S. RELATIVE COMPETITIVENESS IN OFFICE EQUIPMENT AND TELECOMMUNICATIONS

Table 2.3 shows the changes in the international competitiveness in office equipment and telecommunications of the U.S. with respect to Europe, Japan, and the rest of Asia from 1980 and 1998. Office equipment and telecommunications are, of course, part of hightechnology products, but they are here singled out because of their strategic importance to the future rapid growth of the nation. Table 2.3 shows that in 1980 the U.S. exported to Europe $7.12 billion of office equipment and telecommunications, imported $1.37 billion, for a net balance of $5.75 billion, which represented 3.94% of the total exports of all manufactured goods of the U.S. This means that the U.S. had a comparative advantage of 3.94 in office equipment and telecommunications with respect to Europe in 1980. By 1990, this comparative advantage had increased to 4.62, and it then declined to 2.86 in 1998. Table 2.3 also shows that the U.S. had a comparative disadvantage with respect to Japan in office equipment and telecommunications

Competitiveness of the United States, Europe, Japan, and Asia

23

TABLE 2.3 U.S. Trade in Office Equipment and Telecommunications (Billions of Dollars)

Europe

Japan

1980 1990 1995 1996 1997 1998 1980 1990 1995 1996 1997 1998

1980 1990 1995 1996 1997 1998 Source: GATT/WTO.

Asia-Japan

Exports

Imports

7.12 18.02 25.29 25.04 27.83 27.43

1.37 4.60 10.81 10.46 11.02 11.46

5.75 13.42 14.48 14.58 16.81 15.97

1.01 6.02 10.50 12.35 12.28 10.40

4.96 24.66 39.06 33.98 33.97 30.74

-3.95 -18.64 -28.56 -21.63 -21.69 -20.34

3.60 12.94 31.13 32.71 37.13 33.41

5.14 25.68 71.44 74.78 81.63 83.73

-1.54 -12.74 -40.31 -42.07 -44.50 -50.32

Net Balance

Comp adv (+) or disadv (— ) 3.94 4.62 3.22 3.01 3.04 2.86 -2.70 -6.62 -6.34 -4.46 -3.92 -3.64

-1.06 -4.39 -8.95 -8.68 -8.04 -9.02

of-2.70 in 1980. This increased to (-)6.62 by 1990, but then it declined to (-)3.64 in 1998. The U.S. had a comparative disadvantage of -1.06 in office equipment and telecommunications with respect to the rest of Asia in 1980. This increased sharply to (-)8.95 by 1995, and it was -8.04 in 1997 and -9.02 in 1998. Thus, the U.S. had a huge comparative disadvantage (more than twice as large as with Japan) with respect to other Asian countries in office equipment and telecommunications in 1997 and 1998. V. CHANGES IN U.S. RELATIVE COMPETITIVENESS IN MANUFACTURED GOODS

Table 2.4 shows the changes in the international competitiveness in manufactured goods of the U.S. and gives an indication of the degree of de-industrialization allegedly taking place in the U.S. This is not necessarily bad if the U.S. gains in international competitiveness in high-technology services exceed its loss in manufactured goods. After all, the U.S. is the most advanced service economy. Table 2.4 shows that in 1980 the U.S. had a comparative advantage of 3.79 in manufactured goods with respect to Europe in 1980 which, however, became a comparative disadvantage of -1.34 by 1990, -5.01 in 1996, -4.24 in 1997, and -5.91 in 1998. Table 2.3 also

24

Dominick Salvatore TABLE 2.4 U.S. Trade in Manufactured Goods (Billions of Dollars) Exports

Europe

1980 1990 1995 1996 1997 1998 Japan 1980 1990 1995 1996 1997 1998 Asia-Japan 1980 1990 1995 1996 1997 1998 Source: GATT/WTO.

41.58 86.71 104.34 110.05 125.18 134.87 7.91 28.38 44.01 44.35 45.41 40.64 20.86 51.69 99.17 105.97 116.32 100.51

Imports 36.05 90.60 125.61 134.34 148.67 167.85 31.70 90.53 123.95 114.57 120.20 120.56 22.84 95.49 178.46 87.57 208.51 222.90

Net Balance 5.53 -3.89 -21.27 -24.29 -23.49 -32.98 -23.79 -62.15 -79.94 -70.22 -74.79 -79.92 -1.98 -43.80 -79.29 -81.60 -92.19 -122.39

Comp adv (+) or disadv (-) 3.79 -1.34 -4.72 -5.01 -4.24 -5.91 -16.30 -21.39 -17.75 -14.49 -13.51 -14.32 -1.36 -15.08 -17.61 -16.84 -16.66 -21.93

shows that the U.S. had the very strong comparative disadvantage with respect to Japan in manufactured goods of -16.30 in 1980. This increased to (-)21.39 by 1990 and then declined to (the still very large) value of (-)14.32 in 1998. With respect to other Asian nations, the U.S. started with a small comparative disadvantage (-1.36) in 1980 but this increased rapidly as a result of the rapid industrialization of the DAEs during the past two decades and it represented the largest comparative disadvantage (-21.92) of the United Stated in manufactured goods in 1998. VI.

CHANGES IN EU RELATIVE COMPETITIVENESS

Table 2.5 shows the changes in the international competitiveness in high-technology products of Europe with respect to Japan and the rest of Asia from 1980 and 1998 (the change in the international competitiveness of Europe with respect to the U.S. was already examined in Table 2.2). Table 2.5 shows that in 1980 Europe exported to Japan $1.86 billion of high-technology products, imported $12.89 billion, for a net balance of-$11.03 billion, which represented (-)4.17% of the total exports of all manufactured goods of Europe. This means that Europe had a relatively strong comparative disadvantage in

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25

TABLE 2.5 European Trade in High-Technology Products (Billions of Dollars) Exports Japan

1980 1990 1995 1996 1997 1998 Asia-Japan 1980 1990 1995 1996 1997 1998 Source: GATT/WTO.

1.86 10.25 23.91 25.45 22.85 19.16 13.12 33.29 98.33 102.79 102.08 82.77

Imports 12.89 45.63 63.01 59.21 57.98 63.56 3.53 22.91 61.16 69.56 75.06 82.10

Net Balance -11.03 -35.38 -39.10 -33.76 -35.13 -44.40 9.59 10.38 37.17 33.23 27.02 0.67

Comp adv (+) or disadv (-) -4.17 -5.54 -2.43 -2.01 -2.06 -2.52 3.62 1.63 2.30 1.98 1.58 0.04

high-technology products vis-a-vis Japan in 1980. By 1990, this disadvantage had risen to (-)5.54, but then it declined to (-)2.01 in 1996, and it was -2.52 in 1998. With respect to the rest of Asia, Europe had a comparative advantage in high-technology products of 3.62 in 1980. This declined to 1.63 in 1990, and it was 1.58 in 1997 and 0.04 in 1998 (as a result of the sharp reduction of Asian imports from Europe caused by the Asian crisis. Thus, Europe experienced a reduction in its comparative disadvantage with respect to Japan and in its comparative advantage with the rest of Asia during the past two decades. Table 2.6 shows that Europe had a comparative disadvantage in office equipment and telecommunications of-1.74 vis-a-vis Japan in 1980. By 1990, this comparative disadvantage increased to (-)2.29, but it then declined to (-)1.06 in 1998. On the other hand, the comparative disadvantage that Europe had with respect to other Asian countries in office equipment and telecommunications increased from (-)0.31 in 1980 to (-)1.78 in 1990, and it was -1.84 in 1998. Thus, the comparative disadvantage that Europe had in these products declined with respect to Japan but increased with respect to other Asian countries between 1980 and 1998. Table 2.7 shows that in 1980 Europe had an index comparative disadvantage of-2.70 in manufactured goods vis-a-vis Japan in 1980. By 1990, this had increased to (-)3.29, but it then declined to (-)2.04 in 1996, and it was -2.74 in 1998. On the other hand, the comparative advantage of 1.15 that Europe had with respect to other Asian countries in manufactured goods in 1980 had become a comparative disadvantage of-0.43 by 1997 and -2.72 in 1998. Thus, Europe

26

Dominick Salvatore TABLE 2.6 European Trade in Office Equipment and Telecommunications (Billions of Dollars)

Japan

Asia— Japan

1980 1990 1995 1996 1997 1998 1980 1990 1995 1996 1997 1998

Exports

Imports

0.27 0.63 3.15 3.54 3.40 2.81 1.60 4.63 15.80 18.05 21.05 18.88

4.87 19.69 23.39 20.93 19.58 21.49 2.41 16.00 37.42 45.00 48.43 51.37

Net Balance -4.60 -19.06 -20.24 -17.39 -16.18 -18.68 -0.81 -11.37 -21.62 -26.95 -27.38 -32.49

Comp adv (+) or disadv (-) -1.74 -2.29 -1.26 -1.04 -0.95 -1.06 -0.31 -1.78 -1.34 -1.61 -1.60 -1.84

Source: GATT/WTO. TABLE 2.7 European Trade in Manufactured Goods (Billions of Dollars) Exports Japan

1980 1990 1995 1996 1997 1998

Asia^Japan

1980 1990 1995 1996 1997 1998

5.32 24.25 36.44 38.50 34.07 28.78 24.30 62.63 135.81 142.70 141.07 112.52

Imports 18.95 59.68 75.98 72.77 70.77 77.12 18.49 65.31 127.76 142.16 148.46 160.54

Net Balance -13.63 -35.43 -39.54 -34.27 -36.70 -48.34 5.81 -2.68 8.05 0.54 -7.39 -48.02

Comp adv (+) or disadv (— ) -2.70 -3.29 -2.45 -2.04 -2.15 -2.74 1.15 -0.25 0.50 0.03 -0.43 -2.72

Source: GATT/WTO.

gained a strong comparative advantage in manufactured goods with respect to the U.S. between 1980 and 1998 (see Table 2.4), experienced no change in its comparative disadvantage vis-d-visJapan, and went from a small comparative advantage to a small comparative disadvantage with respect to Asia. VII. CHANGES IN JAPANESE RELATIVE COMPETITIVENESS

Table 2.8 shows the changes in the international competitiveness in high-technology products of Japan to the rest of Asia from 1980 and 1998 (the change in the international competitiveness of Japan with

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TABLE 2.8 Japanese Trade in High-Technology Products (Billions of Dollars) Exports Asia

1 980 1990 1995 1996 1997 1998 Source: GATT/WTO.

23.19 67.16 144.19 135.20 131.16 99.60

Imports 1.66 9.12 34.39 38.73 38.81 34.96

Net Balance 21.53 58.04 109.80 96.47 92.35 64.64

Comp adv (+) or disadv (-) 17.30 21.10 26.04 24.75 23.20 17.68

respect to the U.S. and Europe was already examined in Tables 2.2 and 2.5, respectively). Table 2.8 shows that in 1980 Japan exported to the rest of Asia $23.19 billion of high-technology products, imported $1.66 billion, for a net balance of $21.53 billion, which represented 17.30% of the total exports of all manufactured goods of Japan. Thus, Japan had a very strong comparative advantage in high-technology products visa-vis the rest of Asia in 1980. This advantage increased until 1995, when it was 26.04, but it then declined to 23.20 in 1997, and it was 17.68 in 1998. Table 2.9 shows that Japan had a comparative advantage index of 2.68 in office equipment and telecommunications visa-vis the rest of Asia in 1980. This increased to 5.18 in 1990, but it then declined to 4.08 in 1997, and it was 3.19 in 1998. Table 2.10 shows that Japan had a strong comparative advantage index of 25.86 in manufactured goods vis-a-vis the rest of Asia in 1980. This comparative advantage had declined but was still very large at 22.06 in 1990, and it was 22.42 in 1997 and 16.50 in 1998. Thus, there was only a slight degree of de-industrialization in Japan with respect to the rest of Asia between 1980 and 1997, and there was only a slight reduction in the comparative advantage that Japan had in relation to the U.S. (see Table 2.4) and Europe (see Table 2.7). TABLE 2.9 Japanese Trade in Office Equipment and Telecommunications (Billions of Dollars)

Asia

1980 1990 1995 1996 1997 1998 Source: GATT/WTO.

Exports

Imports

3.75 17.90 43.09 39.21 39.07 31.96

0.46 3.64 21.27 24.13 22.85 20.29

Net Balance 3.29 14.26 21.82 15.08 16.22 11.67

Comp adv (+) or disadv (-) 2.68 5.18 5.18 3.87 4.08 3.19

28

Dominick Salvatore TABLE 2.10 Japanese Trade in Manufactured Goods (Billions of Dollars)

Asia

1980 1990 1995 1996 1997 1998 Source: GATT/WTO.

.

Exports

Imports

37.74 91.63 189.40 177.38 173.14 132.01

6.00 30.95 79.89 86.00 83.91 71.71

Net Balance 31.74 60.68 109.51 91.38 89.23 60.30

Comp adv (+) or disadv (-) 25.86 22.06 25.97 23.44 22.42 16.50

VIII. SUMMARY AND CONCLUSIONS During 1970-89, Japan and the Newly Industrializing Economies gained in competitiveness over the U.S. and Europe in mechanical equipment, electronic goods, and scientific instruments, but lost in chemicals and, with respect to Europe, also in aircraft and parts. Comparing the U.S. and Europe in international competitiveness, the U.S. performed relatively better than Europe only in mechanical equipment and electronic goods between 1970 and 1980. U.S. competitiveness in high-technology goods worsened considerably with respect to Europe and Asia excluding Japan and only slightly with respect to Japan between 1980 and 1998. U.S. competitiveness in office equipment and telecommunications declined slightly vis-d-vis Europe and Japan and very much with respect to the rest of Asia. Finally, the U.S. competitiveness in manufactured goods declined very much with respect to Europe and the rest of Asia and improved a little with respect to Japan. In high-technology goods, Europe's competitiveness improved with respect to Japan and declined with respect to Asia between 1980 and 1998. The same is true for office equipment and telecommunications. In manufactured goods as a whole, Europe's position remained about the same with respect to Japan but deteriorated visd-vis the rest of Asia. Japan's international competitiveness increased in high-technology products and in office equipment and telecommunications and declined in manufactured goods between 1980 and 1998. The overall conclusion, therefore, is that the relative international competitiveness position of the U.S., Europe, Japan, and the rest of Asia changed in some foreseen and in some unforeseen ways, and is some ways that supported prior beliefs and in ways that did not, between 1970 and 1998—at least these are the conclusions that can be reached by analyzing the trade data available.

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REFERENCES D'Andrea Tyson, L. (1992) Who's Bashing Whom"? Trade Conflict in High-Technology

Industries, Washington, DC: Institute for International Economics. McKibbin, W. and Salvatore, D. (1995) The Global Economic Consequences of the Uruguay Round,' Open Economies Review, April, 111-129. Salvatore, D. (ed.) (1992) Handbook of National Trade Policies, Amsterdam:

North-Holland. Salvatore, D. (ed.) (1993) Protectionism and World Welfare, New York: Cambridge University Press. Salvatore, D. (1995) 'Can the United States Compete with Japan?' in Kreinin, M. (ed.), Contemporary Issues in Trade Policy, New York: Pergamon Press, 1-10. Salvatore, D. (1998a) 'Globalization and International Competitiveness,' in Dunning, J. (ed.), Globalization, Trade, andFDI, New York: Praeger, 1-18. Salvatore, D. (1998b) 'Europe's Structural and Competitiveness Problems,' The World Economy, March, 189-205.

ADDITIONAL READING Klein, L. and Dominick S. (1995) 'Welfare Effects of the North American Free Trade Agreement,' Journal of Policy Modeling, April, 163-176. Salvatore, D. (1996) 'International Trade Policies, Industrialization, and Economic Development,' International Trade Journal, Vol. 10, No. 1, Spring, 21-47.

3

Environmental Standards and Multinational Competitiveness: A Public Policy Proposal SARIANNAM. LUNDAN

I.

INTRODUCTION

The purpose of this chapter is to re-evaluate the domain of national environmental policy in the light of the growing role of multinational enterprises (MNEs) in the political process. Two important changes have taken place in the world economy, which make the old framework of public policy inappropriate. First is the importance of created (and mobile) assets for national economic growth and the growth of intra-firm trade in the world economy, which has transformed the issue of trade and environment into an issue of multinationals and the environment. Second, the shift from compliance to proactive strategies and the development of multinational environmental strategy has changed both the way in which MNEs respond to regulation as well as the way in which national governments approach the issue of regulation. The impact of such changes is illustrated by the case of evolving environmental standards in the paper industry, and the role MNEs and non-governmental organizations (NGOs) have played in the process. Such cases point towards two possible future scenarios: either a new policy domain where multinationals will gradually become fully fledged participants in the political process, or towards the maintenance of the status quo, where multinationals may be the de facto engines of change, but the de jure policy-makers consider (and oversee) only sporadically their contribution, and where market-led regulation gives unprecedented access to NGOs in the policy process. 30

Environmental Standards and Multinational Competitiveness II.

31

MULTINATIONALS AND ENVIRONMENTAL REGULATION

While laissez-faire economic policies and permissive regimes regarding inward investment have helped to reduce conventional political risk, such as that of expropriation, a new political role is emerging for multinational enterprises, which encompasses not only the strategic actions of multinationals vis-d-vis home and host governments, but also the role MNEs have been granted in multilateral negotiations, as well as their growing involvement along with non-governmental organizations in the national policy process.1 The environmental strategies of multinationals both shape and are informed by the environmental policies of their home and host nations, and it is argued in this chapter, that changes in the global economy and changes in the strategies of MNEs have brought about a new reality which national policy-makers must take into account in order to pursue informed policies on the environment. Specifically, the growing significance of intra-firm trade (see e.g., Gray and Lundan, 1993) has transformed the issue of trade and environment into a question of multinationals and the environment. Similarly, the importance of mobile assets to economic growth has forced policy-makers to consider the implications of policy decisions also in terms of their effects on the attractiveness of the country as both a home and host to multinationals (cf. Gray, 1995, 1999). Following the United Nations (UN) environmental summit in 1992 in Rio de Janeiro, most developed nations have endorsed a commitment to sustainability following Agenda 21 propositions, whereby the goal of (national) environmental policy is to undergo some increase in total costs in the short term to ensure the longterm competitiveness of the economy by protecting its natural resource base. Since environmental degradation as well as recovery take a while to set in, there is inevitably an intergenerational aspect to all environmental policy, and societal attitudes as to the desirability of such of investments are likely to vary considerably between nations. However, regardless of the relative keenness of the policymakers, there are three broad issues to consider when formulating national environmental policy in the global economy, which are: (1) Transborder pollution and global externalities, (2) Scientific uncertainty, such as in the case of global warming, and (3) MNE environmental strategy and the need for flexible regulation. All three areas are rapidly evolving their own literature; the first one in the field of international law, the second one by sociologists and philosophers of science, and the third one in strategy and international business as well as in political economy. The first two issues

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will be touched upon, but will not form the focus of this chapter, as solutions to them are independent of the presence and actions of multinationals. The following section will discuss the changing relationship between government and multinationals, and the move towards target-based, more flexible regulation. This will be followed by a discussion of the case concerning the development and subsequent adoption of Elementary Chlorine Free (ECF) pulp as the standard throughout the global paper industry and the introduction of chlorine-free paper. III.

REGULATORY HARMONIZATION AND COMPETITIVENESS

It is increasingly recognized by lawyers and economists alike (see e.g., Atic, 1995; Nordhaus, 1994), that attempts to forcefully harmonize environmental standards in order to "level the playing field" of competition are inconsistent with the objective of free and open markets, as long as non-discrimination is observed. Thus, for example, the NAFTA environmental side agreement explicitly rejects the objective of harmonization in favor of a (market-led) process of gradual convergence (Rugman, Kirton, and Soloway, 1997), and in the European Union, domestic and community measures complement each other under the principle of subsidiarity (Ziegler, 1996). The continuing trade liberalization and free mobility of investment along with a trend toward flexible, target-based regulation have contributed to a situation, where the de facto standards as regards environmental performance can be created and maintained by multinational enterprises in the first instance, and only secondarily by governments. However, far from saying that such permeability of national borders has rendered the national policy-makers obsolete, it is argued here that informed regulation is perhaps more important than ever, since without learning more about the activities of multinational corporations, policy-making will be blind to an emerging reality of the global economy. In order to understand how the preference for market-led regulation (and divergent standards) came about, it is useful to briefly review the principal arguments used in favor of harmonization. The oldest and probably most well-known argument favoring the harmonization of environmental regulations employed the "pollution haven" hypothesis, which predicted that increased capital mobility combined with a tightening of environmental regulations would lead to the relocation of pollution-intensive industry to

Environmental Standards and Multinational Competitiveness

33

"pollution havens" in less developed countries (LDCs) unless regulatory harmonization was undertaken to remove this incentive. As this argument considered environmental regulations to operate solely on the cost dimension, a tightening of regulations in the home county of a multinational enterprise would precipitate a search for less costly production locales, with the implicit assumption that such locales would mostly be found in the developing countries. Since the 1970s, however, both empirical evidence and theoretical developments have tended to refute the underlying tenets of this hypothesis, namely that (1) regulations only operate on the cost dimension, (2) such cost differentials would be sufficient to induce transborder relocation, and (3) the most likely destination for such direct investment would be in the LDCs.2 The first point, concerning the effects of environmental regulations on total costs has been refuted by Porter and van der Linde (1995) and other scholars based on empirical evidence from pollution-intensive industries on the grounds that "strict product regulations can also prod companies into innovating to produce less polluting or more resource-efficient products that will be highly valued internationally" (Porter, 1991). Second, even if the primary effect of environmental regulations was felt in total costs (at least in the short run), scholars like Gladwin and Welles (1976) and Gladwin (1977) already argued two decades ago that there are other reputational and infrastructure considerations which would tend to weigh more heavily in the decision to relocate abroad than the simple cost differential. It has also been suggested that the costs of environmental compliance have not historically been high enough to significantly influence the decision to engage in FDI and/or the international location decision. Third, and as a corollary to the previous points, it is likely that the developing nations most likely to attract foreign direct investment would be the higher GDP/capita, newly industrializing countries (NICs), whose development strategies have in many instances differed from the traditional path of European and American industrialization.3 In the process of FDI-assisted and export-led growth, many NICs have been able to set environmental standards equivalent to the home countries of the investing MNEs.4 Even if the large-scale migration of polluting industry had never taken place, the harmonization argument has been made employing a variant of the "pollution haven" hypothesis, which for the purposes of this chapter will be called the "competitiveness argument". While the pollution hypothesis saw the MNE as ready

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and able to transfer production abroad in response to cost differentials, the competitiveness argument stresses the relative short-term immobility of productive resources, and the (static) gains accruing to indigenous producers in "pollution haven" locations who, if they sell their product in the global market, subject other MNEs to unfair price competition. In other words, the competitiveness argument is that either strategic or efficiency considerations prevent the MNEs from relocating abroad to capture the cost savings, or alternatively that considerable harm can be done to the competitiveness of domestic industry before such relocation takes place. There is a danger of exaggeration of the competitiveness-eroding effects of divergent environmental regulations on the part of industry, particularly when the divergent regulations are deemed to result in "unfair" competition from abroad. (The implicit assumption here is that the relevant reference point can be found in the domestic industry, and that any harmonization would involve the upgrading of competitors' standards, and not the other way around.) Given compliance with a minimum standard of performance, such as that posed by child-labor laws, it is not generally considered "unfair" for one nation to have a better educated or more skilled workforce than another, although competitiveness gains might well accrue to the latter at the cost of the former.5 Thus, whether a country is seen to benefit from the presence or absence of tough environmental standards, such differences are part of the competitive landscape, and as such, form the basis for trade, rather than a competitive obstacle. IV.

ENVIRONMENTAL DRIVERS IN THE PAPER INDUSTRY

There have been three major areas of environmental concerns in the paper industry, namely water and air pollution arising from the pulping process, the use of recycled fibers, and forestry practices. Over the past two decades, public interest has shifted from chlorine in the wastewater to recycled content in paper, and presently to forest certification schemes, but the issue requiring unprecedented levels of new investment was the removal of chlorine from the pulpmill wastewater. The empirical evidence discussed in this chapter is based on Lundan (1996), and covers pulp and paper producers in Finland, Sweden, Canada, and the U.S. Since the connection between globalization and environmental strategy lay at the heart of this study, the selection of countries (and firms) was based on their contribution to world trade in pulp and paper. In the end, the share

Environmental Standards and Multinational Competitiveness

35

of world sales accounted for by the firms in the sample amounted to 43%.6 The data were collected in 1995-96, and involved interviews with 18 Vice Presidents or Senior Vice Presidents in charge of Environmental Management, as well as a questionnaire survey, which was administered both to the firms already interviewed, as well as to 14 other companies in the industry. Three broad questions were addressed in this research. First, whether the relative importance of consumers had increased in comparison to regulators as instigators of environmental change since the 1970s, and whether, with increasing globalization, foreign rather than domestic sources (whether consumers or regulators) had become more important over time. Second, the study tried to estimate whether the "innovation offsets"7arising from cleaner and leaner technology were a reality in the industry. Third, the study tried to assess the possibility that in addition to a technological payoff, the marketplace could reward firms by an increased market share or a price premium for green products. The overall results indicated that the influence of foreign consumers and regulators on environmental decisions has significantly increased since the mid-1980s. Additionally, the influence of consumers (whether domestic or foreign), has increased significantly over time in relation to that of regulators. However, contrary to expectation, the importance of government regulation has not diminished over time, and in fact domestic regulatory authorities still outrank the other options, including foreign consumers. The results concerning the extent to which the marketplace rewards the activities of firms that have engaged in significant environmental investments provided a mixed picture. On one hand, the reactive option of shielding oneself from an adverse consumer reaction received the highest ranking, but almost equal was the perceived gain from a first-mover image and voluntary efforts to exceed regulations. Following the first wave of environmental investment in the early 1970s in response to new clear water and clean air legislation, a second wave of investment was initiated in the pulp and paper industry when concerns about the effects of chlorinated organics in the mill effluent began to emerge in the mid-1980s, particularly in Sweden and Germany. In Germany, Greenpeace campaigned actively for the removal of chlorine in the bleaching process for fear that the residual chlorine in the waste water would combine with organic matter and form highly toxic substances, such as dioxins. The impact of this (market-led) action on the industry was substantial, as it was

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not possible to allay such concerns though the use of end-of-pipe technology, which in this case would have meant multiple layers of water treatment facilities. Instead, two new processes were developed; the Totally Chlorine Free (TCF) pulping process, which eliminated the use of chlorine, and the Elementally Chlorine Free (ECF) process, which eliminated the use of elemental chlorine (C12), and replaced it with chlorine dioxide. Prompted by the importance of the German market to Scandinavian producers (38% and 33% of Finnish and Swedish exports in pulp in 1992-93, respectively), the industry in these countries invested heavily in the new technologies, and by the early 1990s, chlorine use in the Swedish and Finnish industries had been reduced to almost zero. The remarkable feature of this case is, that the change of heart in Germany concerning chlorine prompted substantial changes in how pulp was made in Scandinavia in response not to exposure by foreign investment, but a change in an important export market. In this example of "trading up" (cf. Vogel, 1995), a window of opportunity was created for the industry to make substantial investments in a technology which, although known in principle, was not adopted earlier despite its significant efficiency and quality improvements, due to the difficulty of undertaking significant capital investments when no concerted demand for such improvements existed it the marketplace. These processes now represent the dominant technology on offer from the major equipment suppliers, and in 1998 the ECF process also became the standard endorsed by the Environmental Protection Agency of the United States. Since most products do not overtly manifest their good qualities, some kind of labeling is needed to convey the environmental properties of the product to the consumer. Such schemes have proliferated in the paper industry, numbering at least a dozen labels in the European market alone. In general, consumers engage in a limited search for information and are often heavily influenced by NGOs like Greenpeace, who help to surface environmental concerns and to frame the alternatives. The consumers also tend to be quite skeptical when it to comes to claims made by industry, and the variety of eco-labels is further eroding confidence. Given that there is little agreement over what good performance consists of, it is not surprising that environmental NGOs have been particularly effective in "naming and shaming" firms which are seen as laggards in the industry rather than rewarding well-performing firms. Furthermore, while consumers frequently express a great deal of concern for the environment in opinion polls, there have

Environmental Standards and Multinational Competitiveness

37

been few instances in which they have voted with their money, and actually paid a premium for "green" products (see e.g., Lampe and Gazda, 1995). From the industry's perspective, however, the lack of common standards is testament to the lure of the market payback, however elusive. If no firm saw a proprietary gain from the adoption of a particular environmental standard, agreeing upon common standards would not be complicated. In fact, even when faced with consumers who are more effective in employing a stick than offering carrots, the pursuit of proprietary gains from environmental investment remains viable, because environmental concerns have become integrated into the overall strategic management of multinationals.8 However, unless consumers are willing to accept some price premia for green products, a situation can be created where too much of a good thing is being demanded. In other words, since consumers are not directly bearing the costs of the investment, industry can be pushed towards alternatives that can become prohibitively expensive and contribute only marginally to overall environmental quality. Thus whether market-based signals can effectively guide investment depends not only on the consumers' level of information, but also on the existence of a long enough planning horizon necessary for major capital investment. V.

THE EXPANDING ROLE OF MULTINATIONALS AND NCOS

Much of the research to date on the political role of multinationals has concentrated on government-MNE relations, with an emphasis on the desirability of policies to attract foreign investment, or the role of political risk in the operations of MNEs, as in cases of expropriation and bribery. In such studies the MNE typically responds to prevailing conditions or chooses between them (Boddewyn, 1988), but until recentiy there has been relatively little interest in the extent to which MNE strategies are affected by conditions in the host countries. In other words, the debate to date has been framed in terms of trade-offs between sovereignty and the economic forces of globalization and the various forms of accommodation reached by multinationals (see Rugman and Verbeke, 1998). In contrast, the picture that is beginning to emerge regarding the environmental actions of multinationals is one of increased political involvement at multiple levels of influence. At the supra-national level, the issue of sovereignty has been revisited in the drafting of

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multilateral agreements, like NAFTA, and the presently defunct Multilateral Agreement on Investment (MAI) negotiations under the auspices of the OECD, which would have given multinationals the right to sue if non-discrimination had not been exercised. As was illustrated by the paper industry case, multinationals (and NGOs) are directly influencing national policy through their role in the standard-setting process, and the political role of the MNE now encompasses elements which were previously solely the domain of national governments, as well as involvement in "grass-roots" issues in response to market demand. The changing configuration of environmental decision-making is illustrated in Figure 3.1. At the top level, there are supranational issues such as climate change, and multilateral negotiations to curb the use of CFCs, for instance. At the level below are the bodies specifically designed to establish rules and codes of conduct in the international domain. Thus WTO rules (and those of a possible environmental subsidiary organization) are operative at this level, as are codes of conduct for multinationals designed by the OECD, and the provisions of the MAI agreement, should it ever come to pass. Below this level are the national policy-makers, who set the basis for industry standards in their geographical area. While a few decades ago, the entire chain of environmental policy would have consisted of the bottom two or, at the most, bottom three levels, today we find not only four levels of governance, but also two new entrants to the table, the MNEs and environmental NGOs. The paper industry case also demonstrates that in a market where the regulators set targets and technological means are found by firms, a relationship with two-way communication is essential for the system to work. While there are substantial differences in the relationship between firms and government in Scandinavia and the U.S., even in the U.S., where the relationship has traditionally been adversarial, there has been a movement towards what the Environmental Protection Agency has labeled "negotiated regulation". Over time, both governments and firms have become more familiar with the possibilities for strategic interaction, and have evolved an ability to accommodate each other's timetables for investment. What is largely unfamiliar to both, is the entry of NGOs into the process. Since the Rio de Janeiro conference and the talks leading to the Kyoto agreement on the curbing of greenhouse gases, hundreds of NGOs have become an integral part of the international regulation of the environment (see e.g., Levy and Egan (1998) on the climate change negotiations). Although their aim is different, by focusing

Environmental Standards and Multinational Competitiveness

39

FIGURE 3.1 The Changing Configuration of Environmental Policy

on the actions of multinationals and by launching campaigns against practices that they feel are damaging to the environment, the NGOs have helped to legitimate the role of multinationals as repositories of technology and knowledge concerning environmental problems. In addition to individual firms, the NGOs have also broadened their attention to include institutions that have been set up for the international control and regulation of multinationals, namely the MAI and the new round of trade talks under the WTO. While the reasons for the demise of the MAI in 1998 were numerous and included developing countries unhappy about their exclusion from the negotiations, along with French (and Canadian) concerns over the preservation of certain cultural exemptions, there was also a significant unease on behalf of many NGOs, that the MAI was giving multinationals the power to effectively regulate labor and environmental standards. It is difficult to know whether the right to sue governments for denying national treatment would give multinationals materially more power than they already have, but particularly in the eyes of the NGOs, the symbolic difference to only governments being able to bring such grievances is enormous. As far as the participation of the NGOs is concerned, there seems to be a direct path that leads from Rio through Kyoto and Paris to Seattle. The exclusive and opaque process of decision-making, particularly in connection with the OECD and the WTO is fundamentally incompatible with what Kobrin (1998) has called the "electronically networked global civil society", in other words, the hundreds or thousands of NGOs mobilizing public opinion, particularly over the internet.

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There is no denying that NGOs play an important role in open democracies, and their participation in processes where decisions are made that affect the living conditions of people around the world should be encouraged. However, it is possible that for every case of beneficial interaction such as the introduction of chlorinefree paper, there will be another one such as the Brent Spar, where considerable amounts of resources were used to combat a problem that independent analyses had indicated wasn't there.9 The paper case illustrated how multinational firms, and particularly those in capital-intensive industries, are faced with many irreversabilities once they embark on a particular approach to address environmental concerns. There is a danger that, if the market increasingly guides public policy and the marketplace is dominated by NGOs, a vacuum is created where none of the three participants is able to set a long-term vision of environmental strategy. While there is presently little evidence to warrant such a negative scenario, an analogy to the evolution of class-action lawsuits in the U.S. presents a cautionary example. The barrage of class-action litigation, where a case is brought with a few plaintiffs representing the collective claims of thousands, has resulted in a situation where firms are effectively blackmailed into settlements, the cost of which is treated as a form of insurance against adverse publicity.10 While no-one would argue that class action lawsuits make it possible for individually powerless claimants to seek redress from powerful corporate entities, if such lawsuits emerge particularly frequently in areas vacated by government regulation, they amount to the substitution of a system of regulation by a system of civil litigation. Similarly, a substitution of markets for regulation in the environmental arena is not desirable if it results in an unpredictable and costly process whereby multinationals try to adjust their actions primarily to the demands of the NGOs. Environmental progress is only achieved when it is possible for firms to engage in large-scale redesigns of the production system, which requires a lengthy planning horizon to be present. As a rule, NGOs do not operate within that kind of a time horizon, and it is up to national governments to balance the consultative role of NGOs with the ability of the multinationals to develop long-term environmental strategy. VI.

CONCLUSIONS

From a national policy perspective, two points relevant to considering the new political role of MNEs emerge. First, MNEs can introduce

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changes to environmental standards either in response to changes in the marketplace, or as a consequence of regulation, and not necessarily domestic regulation. Second, in a process that is market-driven, and achieves its efficiency from capturing the R&D effort firms, there is a limit to the technological competence of any national regulator, and it may find itself unable to effectively regulate without the cooperation of the multinationals. Compared to the very visible role multinationals play in the supranational regulation of the environment, such as in conjunction with the climate change negotiations, the role of the MNEs as the instigators of environmental standards in the presence of national regulation is in some sense more clandestine, but no less consequential for the development of future environmental standards in the global economy. In order for any (national) environmental policy to be truly sustainable, it needs to consider the cost-benefit implications of the proposed course of action (or inaction). If multinationals are the de facto guardians of environmental standards in the world economy, and their performance is responsive to consumer demand, the market system can be a cost-effective means of upgrading standards, developing new technology, and in the process producing a cleaner environment. Increased industry self-regulation by multinationals, and the substitution of bureaucracy by markets can therefore become the future of environmental regulation, although a few very significant caveats are also introduced. The effective oversight of a policy of enlightened self-regulation requires a constant two-way communication between the regulators, who set the targets, and the multinationals that develop technological solutions. However, a market-led system is not really led by a market, composed of large numbers of individuals making decisions on the environmental attributes of products. Rather, the market consists of NGOs that allow individuals to reduce the significant information costs associated with being a "green" consumer. Evidence has been presented in this chapter which has demonstrated the mechanism of "trading up" and the emergence of improved standards in response to the interaction between MNEs and NGOs. However, it is also possible to replace bad regulation with bad markets if excessive short-termism is introduced to the policy process. NGOs are responsible for raising issues, not finding solutions to them, and if MNEs do not continue to develop longterm policy jointly with national regulators, it is possible for environmental strategy to turn into another nuisance tax that firms pay in order to avoid bad publicity.

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Finally, the regulation of domestic industry still remains a policy concern, and such regulation would need not only to be able to learn from the multinationals as they learn about cleaner technologies, but also to regulate by targets in a way that allows the widest possible room for domestic industry to grow its innovative capacity in environmental technology. The emerging reality for national policy-makers is that multinationals are already heavily involved in the standards setting process both at the national and supranational levels. The choice is therefore either to continue the status quo, or to legitimate the role of MNEs, and hopefully as a consequence, to introduce much needed oversight and accountability, but also the required long-term planning horizon, into the process of developing sustainable environmental policy. REFERENCES Atic, J. (1995) 'The Puzzling Relationship Between Trade and Environment: NAFTA, Competitiveness, and the Pursuit of Environmental Welfare Objectives,' Indiana Journal of Global Legal Studies, 3(1):81-103. Boddewyn, J. (1988) 'Political Aspects of MNE Theory,' Journal of International Business Studies, 19 (3) :341-363. Bryant, R.C. (1994) 'Global Change: Increasing Economic Integration and Eroding Political Sovereignty,' TheBrookings Review, 12(4):42-45. Dean, J.M. (1992) 'Trade and the Environment: A Survey of the Literature,' in Low, P. (ed.), International Trade and the Environment - World Bank Discussion Papers, Washington, DC: The World Bank. Gladwin, T.N. (1977) 'Environment, Planning and the Multinational Corporation,' Altman, E.I. and Walter, I. (eds.), Contemporary Studies in Economic and Financial Analysis, Greenwich, CT: JAI Press. Gladwin, T.N. and Welles, J.G. (1976) 'Environmental Policy and Multinational Corporate Strategy,' in Walter, I. (ed.), Studies in International Environmental Economics, New York: John Wiley & Sons. Gray, H.P. (1995) 'The Modern Structure of International Economic Policies,' Transnational Corporations, 4(3):49-66. Gray, H.P. (1999) Global Economic Involvement: A Synthesis of Modern International Economics, Copenhagen: Copenhagen Business School Press. Gray, H.P. and Lundan, S.M. (1993) 'The Importance of Intra-firm Trade,' in Kreinin, M. (ed.), The Political Economy of International Commercial Policy: Issues for the 1990s, London: Taylor and Francis. Kobrin, S.J. (1998) 'The MAI and the Clash of Globalizations,' Foreign Policy, 118 (Fall):97-109. Lampe, M. and Gazda, G.M. (1995) 'Green Marketing in Europe and the United States: An Evolving Business and Society Interface,' International Business Review, 4(3):295-312.

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Levy, D.L. and Egan, D. (1998) 'Capital Contests: National and Transnational Channels of Corporate Influence on the Climate Change Negotiations,' Politics and Society, 26 (3):337-361. Lundan, S. (1996) Internationalization and Environmental Standards in the Pulp and Paper Industry. PhD dissertation, Rutgers University, Newark, NJ, USA. Lundan, S.M. (2000) 'Multinational Strategy and the Evolution of Environmental Standards in the Global Economy,' in Hawkins, R. and Narula, R. (eds.), Essays in International Macroeconomics and Trade, New York: Pergamon. Nordhaus, W.D. (1994) 'Locational Competition and the Environment: Should Countries Harmonize Their Environmental Policies?,' in Siebert, H. (ed.), Locational Competition in the World Economy, Tubingen: J.C.B. Mohr. Porter, M.E. (1991) 'America's Green Strategy,' Scientific American, 168. Porter, M.E. and van der Linde, C. (1995) 'Toward a New Conception of the Environment-competitiveness Relationship,' Journal of Economic Perspectives, 9 (4):97-118. Rugman, A.M. and Verbeke, A. (1998) 'Multinational Enterprises and Public Policy, 'Journal of International Business Studies, 29(1):115-136. Rugman, A.M., Kirton, J., and Soloway, J. (1997) 'NAFTA, Environmental Regulations and Canadian Competitiveness,' Journal of World Trade, 31 (4):129-144. Vogel, D. (1995) Trading Up: Consumer and Environmental Regulation in a Global Economy, Cambridge, MA: Harvard University Press. Waldmier, P. (1999) 'Legal Eagles Rule the Roost' Financial Times, December 1112. Ziegler, A.R. (1996) Trade and Environmental Law in the European Community. Oxford: Clarendon Press.

NOTES 1.

2. 3. 4.

5. 6. 7.

For example, in supranational negotiations, such as those for the Montreal Protocol, multinationals have had an interest as the producers of banned substances like CFCs, and they now also play a crucial role in meeting the U.S. obligations to reduce greenhouse gases under the Kyoto agreement, since the reductions achieved by U.S. MNEs abroad are to be counted under the U.S. obligations. See e.g. Dean (1992) for an excellent, concise review of the trade and the environment literature, including the "pollution haven" hypothesis. Excluding some natural resource-seeking investment, which may be somewhat less sensitive to the infrastructure conditions of the recipient country. Although it should be noted that inconsistencies abound, such as in the case of Indonesia, where state-of-the-art ECF-pulp mills operate under a government that has come under severe criticism for its forest management practices. Bryant (1994) presents a similar argument regarding fair and unfair competition. If Japan (whose paper production is mostly domestic) is included, the share based on sales in 1989 is 37%. Terminology employed by Porter and van der Linde (1995) to describe the efficiency gains that could offset all or part of an environmentally motivated process or product redesign.

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See Lundan (2000) on the development of corporate environmental strategy in the paper industry. 9. The Brent Spar was an oil storage buoy Shell wanted to dispose of by sinking it in the sea. Greenpeace intervened, and got Shell to tow the facility to Norway, where it was due to be dismantled on land. There is no consensus on what the best solution would have been from an environmental point of view, but the cost of the disposal was significantly increased. 10. This section draws on Patti Waldmier's 'Legal eagles rule the roost' in the Financial Times, December 11-12, 1999.

4

MNCs, Environmental Issues and Globalization R. WAYNE COLEMAN

I.

INTRODUCTION

With the growth of public concern about the environment and business response to that concern, the 1990s have been declared the decade of environmentalism (Drumwright, 1994; Kangun, Carlson, and Grove, 1991). For example, a worldwide survey of managers, published in the Harvard Business Review, showed that environmental issues were the managers' second highest social priority (Kanter 1991). In 1995, another study, sponsored by the American Marketing Association, reported that concern over the physical environment had emerged as the most important issue affecting global marketing. With the rapid increase in globalization and the formation of huge networks and trading blocks, the macro-issues such as the environment have never been more important. All business is increasingly international or global in nature and thus firms will confront issues new to them as they join or participate in the global economy. Environmental issues will impact most areas of a firm's operations, management, and marketing, and businesses from manufacturing to retailing and from raw materials to finished product. Firms will be forced to expend resources to deal with these issues and will be looking for help from international standards and agreements on trade and the environment. This is likely to continue, and perhaps even intensify, as we enter the new millennium. While the environment is and may very well remain a high priority issue for MNCs as they enter the global marketplace, one potential problem is the array of standards and regulations they may encounter. Today, there are a number of certification programs for 45

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products as diverse as wood products to electricity. As the globalization process continues and MNCs expand into new markets, a convergence of the divergent standards and regulations would ease the process. Environmental agreements, trade agreements, and a reconciliation between the two will be required to prevent environmental issues from sparking future trade disputes. It will also be important to have organizations such as the WTO for settling trade disputes that do arise. However, many would argue that the WTO must do a better job of incorporating environmental concerns into their consideration of trade issues. II.

ENVIRONMENTAL ISSUES AND INTERNATIONAL BUSINESS

Increasing regulatory obligations, mounting public expectations and new "green" competitive pressures have already led to a seachange in outlook among leading international businesses. These forces can only increase. It is clear from the comments of the corporate executives who contributed to Environmental Strategy Europe 1991 that environmental excellence is already becoming a key component of overall performance (Campden, 1991). The following quote from Electrolux's 1995 Environmental Annual Report: Total Approach provides some insight into how deeply the environment has impacted all aspects of business. "We must adopt a total approach in our operations, based on knowledge of every phase of the life cycle of our products, from raw materials and production to use and recycling. We must choose to minimize negative environmental impact, as well as consumption of raw materials and energy" (Jancsurak, 1998, E25). Porter and van der Linde (1995) suggested that environmental performance may be a competitive advantage to be exploited internationally. It is important for firms to be informed about the regulatory and legal climates on environmental issues from one country to the next. Such variations in legal and regulatory climates may require international firms to modify their behavior from country to country. Germany, for example, requires manufacturers to contribute to the "Green Dot" Program or produce recyclable packaging and have a specific channel for its recycling (Micklitz, 1992). Already, regulatory concerns over the environmental impact of corporate practices and the growing influence of the environmental movement have begun to influence corporate strategies (Menon and Menon, 1997). One way corporations can help meet this challenge is to use an environmental certification program

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where available, preferably one that is recognized in several countries. Certification programs are available for a growing number of products, from recyclable or recycled content, ethical sourcing (SA8000), sustainable agriculture, sustainable fisheries, irradiated foods, ecologically certified or sustainable forestry wood products, organically grown food, predator friendly wool, eco-friendly electricity, and dolphin-safe tuna, to the most comprehensive scheme of international environmental standards, ISO 14000. The number and diversity of such programs continues to proliferate and MSCs participating in the global marketplace may face a bewildering array of labeling requirements which can, in turn, be a barrier to international trade. The wider the acceptance and use of a certification scheme, the easier it will be for MNCs to enter other markets. III.

ISO 14000 AND OTHER CERTIFICATION SCHEMES

Certification schemes are numerous and growing in number. For example, The Environmental Project for Ornamental Horticulture (MPS), which certifies 60% of Dutch production, will expand its eco-labeling for flowers and develop it into a world standard for flowers grown using more environmentally friendly production practices. Other countries reported to be interested include Kenya, Zimbabwe, and Israel (IATP, 1998). Other certification programs include an organization in the U.S. which certifies wool growers who utilize non-lethal methods for controlling predators as Predator Friendly (www.forwool.com); the Social Accountability (SA 8000) certification process for ethical sourcing (Matthews, 1997); and a U.K. animal-welfare certification program, called Freedom Food (www.rspca.org.uk), which assures consumers that the labeled food product was produced as part of a farming system where the animals were reared, transported and slaughtered according to verifiable standards. In Europe, and recently in the U.S., there has been a trend toward "green" electricity. Another product category that has seen a large increased use and demand for certification programs is sustainable forest or ecologically certified wood products. However, the issue showing the greatest potential for disrupting global trade is genetically modified foods (GMOs). This issue has already produced a mushrooming trade dispute between producing and consuming countries and is certainly the most contentious issue on the horizon, with the potential for disrupting future trade relations among countries.

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Wood Product Certification Programs

Wood/timber producers have seen an increase in the number of international certification programs governing every aspect of their operation and requiring them to carry some form of green or sustainable labeling or face being frozen out of international markets. Environmental certification is growing more quickly in Europe than North America, partially due to the influence of buying groups. "Some buying groups are being organized by WWF and consist of retailers, wholesalers, brokers, distributors, traders, municipalities, etc. The goal of these groups is to improve forest management by documenting and evaluating their supply sources and by eventually insisting that all their suppliers furnish certified wood products. Participation in a buying group is attractive for a variety of reasons. For example, by being in a group, a company: (1) might avoid bad public relations related to environmental issues; (2) can act on their corporate ethic of "doing the right thing"; (3) can access group knowledge (e.g., how to document supply sources); and (4) might gain a competitive advantage" (Hansen 1997, 19).

A total of 11 buying groups was being formed and each country was designing its own systems for certification. However, because they want each system to have an equal status in the marketplace and to be applied similarly in the forest, The Nordic Forest Certification Project was created to ensure that the development of standards of sustainable forestry is harmonized among the countries (Hansen, 1997). The last point about being harmonized among countries is an important one and is a direct result of increasing globalization; increasingly, to compete in the global market, firms must meet the global standards or certification schemes available in that product category. The purchasing manager for a retailer in the U.K. reports more and more pressure to deliver on the environment. He says, "Three years ago, it was difficult to go to a buyer and say 'Buy your timber from a well-managed forest' because we weren't sure what one was. But whether you judge it in pounds or people, the environment will always be difficult to pin down in business terms. The measures are not quite there yet" (Edwards, 1997, 25). In an effort to green the supply chain, the U.K. retailer was on target to have all its timber suppliers certified by the Forest Stewardship Council some time this year. And in speaking of sourcing hardwood garden furniture, the firm has begun sourcing from certified forests in Bolivia. The firm's purchasing manager was quoted as saying, "We need to play the Bolivian card. Next year, we can point to the number of containers we are shipping from Bolivia and say to the other countries: 'Not only have you not got the certification to get this business, you are years away from it'" (Edwards, 1997, 25).

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There appears to be some evidence that the trend toward ecologically certified wood products is taking hold in the U.S. as well. Environmental groups such as the Rainforest Action Network have been able to get some U.S. firms to agree to use wood and paper products produced under ecologically sound conditions. Also in 1999, Home Depot, the nation's largest retailer of lumber agreed not to sell any wood from endangered forests. But the biggest deal was an unprecedented arrangement between a lumber company and an environmental group aimed at restricting logging in fragile areas. Westvaco Corp., a major timber company, is allowing the Nature Conservancy to inspect their forests in the United States. The arrangement does not cover the company's forests outside the U.S., but "Still, the arrangement is one of the most sweeping examples to date of how business and the environmental communities increasingly are trying to work together" (Kalish, 1999). International trade in certified timber is still small. "There are just 25 million acres of certified forest worldwide, and 'green' forest products represent less than 1% of the total market" (Holloway, 1998). But because large suppliers have recently announced plans to seek certification, this situation may change. The problem for timber certification may be the WTO, which has already ruled that the U.S. could not block imports of shrimp not caught in nets designed to protect endangered sea turtles. While increased use of ecological certification of wood products, as well as certification programs in other environmental areas, may help MNCs by providing a common standard for global trade, the WTO may yet be a stumbling block. The larger issue is whether timber certification poses a barrier to trade according to the WTO's Agreement on Technical Barriers to Trade. When government bodies in the U.S., such as the New York City Council and California State Senate, considered bills requiring government purchase of certified wood, they were warned of possible international trade agreement violations (Holloway, 1998). Without a formal dispute, the WTO is reviewing the regulations, but the conflict between the growing trend toward timber certification in global trade and trade rules unfavorable to environmental protection will have to be reconciled within the WTO and its member states. Green Power/Electricity Certification

In the U.S., Green Power certification is proceeding on several fronts and some people want to know what green power means—and, by

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extension, environmentally friendly (Rogers, 1998). However, this is not simply a domestic environmental issue. In 1996, the Swedish Society for Nature Conservation (SSNC) created an ecolabeling scheme for electricity which, in May 1998, was adopted and launched for use in Finland and Norway. The companies using energy by renewable sources and who conform to a set of environmental criteria can earn the right to display the ecolabel of the administering groups. "The common labeling system in Norway and Finland will mean 'greener' electricity generated in one country can be sold with the recognizable ecolabel in another country" (IATP, 1998, 6). U.S. utilities may find a way to use their experience with marketing green power by venturing into international markets, especially in the Organization for Economic Cooperation and Development countries, at least seven of which have initiated green power marketing. And because interest in green power is also evident in developing countries, U.S. utilities also have an opportunity take advantage of their expertise in renewables there. A third international opportunity for U.S. utilities to exploit their domestic experience with renewables technology is when developing countries privatize their power companies (Kozloff and Shah, 1998). ISO 14000 Certification Standards

The ISO 14000 series of environmental standards set the agenda for environmental accounting and reporting and will dictate methods of environmental audits, reporting, and product labeling. The new ISO standards will require every company competing in the global market to issue environmental information the same way, and thus a company in Stockholm will have the same guidelines with which to measure environmental improvements as a company in Chicago. These new ISO standards will rule global marketing and management much the way TQM standards dominate now. To remain competitive in the international arena, multinational firms will find it essential to adopt these standards if they are to survive in the global marketplace. These new global green standards will have "more impact on world business and environmental policy than any single or collective action by environmental or government groups" (Wasik, 1996,5). "The bottom line of ISO 14000 is a harmonization of environmental standards. With each company, industry, region, country, and trading block going by a different set of standards, it is impossible to reach an international consensus on environmental performance"

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(Wasik, 1996, 24). ISO 14000 will thus be providing a basis for increased international standardization on environmental issues. Lally (1998, 508) stated, "Worldwide acceptance and incorporation of ISO 14000 effectuates these goals and can actually expedite international trade by harmonizing otherwise diffuse environmental management standards and by providing an internationally accepted blueprint for sustainable development, pollution prevention, and compliance assurance." Concerning the questions of violating international trade agreements, Lally asserted that there would be no GATT violation if market forces dictated that a voluntary standard be adopted by MNCs doing business in certain countries. Many of Thailand's MNCs are already ISO 14000 certified, based on the idea that, "holders of ISO 14000 certificates will find it easier to engage in international trade" (Lally, 1998, 523). While ISO 14000 must remain a voluntary standard, market forces will lead to global adoption of the international environmental standard just as they did for the global adoption of the ISO 9000 as a quality standard. "Following the overwhelming success of ISO 9000, ISO 14000 is poised to become the next gateway to the global marketplace" (Lally, 1998,523). Current Major Trade and Environmental Issue: Genetically Modified Organisms (GMOs)

The growing global dispute over 'Frankenfood' or 'Frankenstein Foods,' now threatens U.S. exports worth billions (Magnusson, 1999) and is already costing U.S. farmers $200 million a year in corn exports (Business Week, 1999c). It all began in California when an American biotechnology company wanted to spray strawberries with a genetically modified bacteria to protect the plants against frost damage. Environmentalists began an unsuccessful 4-year legal fight to stop the company and when they finally lost the battle in 1987, the war over genetically modified foods was just beginning (Connor, 1999). Since 1996, the U.S. has produced gene-altered crops and, while American consumers hardly noticed the innovation, the European consuming public had a far different reaction. The massive negative reaction there highlights differences in how Americans and others perceive science and the environment. Opinion polls of European consumers indicate that two-thirds believe gene-altered plants pose a threat to the environment or to human health (Weiss, 1999a).

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Because of the deepness of the divide between the U.S. and the EU over GMOs, there is the potential that food safety could become a defining issue in transatlantic trade relations in the next few years (Barber, September, 1999). In January 2000, there was a meeting of nations to consider proposed rules that could shut down trade in genetically modified organisms (GMOs). The U.S. is not a signatory to the Convention on Biological Diversity (CBD) and thus was excluded from the negotiations. Another major problem for the U.S. is that the meeting in Montreal was about the environment and not trade. Because the delegates were from the environmental arm of their governments, they were not influenced by industry preferences as delegates from trade ministries might have been (Raeburn, 2000). The chairman of the Montreal talks has said that the countries must conclude a new protocol to regulate trade in genetically modified organisms or risk serious damage to international efforts to protect biodiversity. The issue is one of deciding if the treaty should be an information clearing house or should give countries new powers to restrict imports of GMOs (Financial Times, 2000). While the EU and developing countries want elaborate rules to allow countries to identify and refuse to accept imports of GMOs, the U.S. is determined that such crops be treated no differently than any other traded crop, with rules set and enforced by the WTO. The negotiations in Montreal really center on something more basic: "Should governments be free to enact whatever measures they choose to ensure food safety and protect the environment, or must any restrictions be consistent with WTO rules?" (Alden and Bilefsky, 2000). This may very well be one instance where the biotechnology industry would favor the existing situation with differing national regimes over a restrictive protocol they don't like. Because of the uncertainty in the markets, some major food processors have already begun announcing or planning bans on genetically modified foodstuffs. Cargill, a large U.S. food processor, has announced plans to buy whatever American farmers grow this year but note that next year they may offer a premium for grains which can be certified as GM-free (Economist, 2000). Archer Daniels Midland, one of the largest U.S. food processors, has encouraged their suppliers to segregate non-genetically enhanced crops to preserve their identity. This has left U.S. farmers uncertain if their crops of corn and soybeans, grown with genetically engineered seeds, will actually find a market when harvested (Weiss, May 3, 1999b). In Brazil, the largest soybean producer after the U.S., the

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high-tech soybean seeds have been banned until the government can regulate and define the rules of bio-safety (Epstein, 1999). Food manufacturers and retailers have also announced their own bans on GMOs. McCain Foods, one of Canada's major producer of french fries, will stop using genetically engineered potatoes (Financial Post, 1999). In April 1999, Nestle UK and Unilever UK promise to end use of GM ingredients in their foods. In July 1999, Gerber and Heinz announce that they will not include genetically engineered corn or soybeans in any baby foods. And in August 1999, Japanese beermakers Kirin and Sapparo announced that they will stop using genetically engineered corn by 2001. Sainsbury's, a major European supermarket chain, now requires all their suppliers to provide certification that soya products are from non-GM crops (Magnusson, 1999). It is no small coincidence that Sainsbury began their non-GM food campaign with soya products. Soya protein can be found in about 60% of all processed foods. It also happens that one of the most referenced studies concerning the potential ills of genetically modified foods was performed on a soybean into which a protein from Brazil nuts had been spliced. Pioneer Hi-bred, a giant agricultural seed company, had spliced a Brazil nut gene into its soybeans, trying to build a better soybean. The problem was that the transferred protein was a major cause of Brazil nut allergies (Weiss, 1999a). The magnitude of importance this issue has taken on is hard to overstate. As easily the most written about and discussed environmental issue at the turn of the century, GMOs have been described as the next green revolution in a special report in Business Week, which concluded: "Competitors in the life-sciences industry are convinced they are poised to deliver long-promised healthier, safer, and more productive crops. Now they just have to persuade the world's farmers and consumers to buy them" (1999a, 74). The Economist magazine, in its World in 2000 publication, made the following prediction of the future of the genetically modified organism (GMO) issue: "To watch The war over genetically modified foods. The market continues to grow in much of the developing world and in America, where 50% of soya and cotton is already grown from transgenic seed. But the tide is turning. Groups such as Greenpeace will intensify their opposition to the industry in Europe. Brazil will not lift its ban. Activists in America will take life-sciences companies to court, accusing them of creating a monopoly in agricultural seed. The WTO will also get dragged in as American firms seek access to European markets. Welcome to the century of generic politics." (p. 83)

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Such predictions about the environment forecast continued growth in the numbers of issues and their growing contentiousness within society. As the trend toward globalization continues, the best hope of MNCs for dealing with these environmental issues will rest with multinational agreements and growing use of certification standards. The greater the pace of negotiation toward multinational agreements and adoption of certification schemes recognized globally, the greater the ability of MNCs to effectively deal with such environmental issues as they venture into the global marketplace. IV.

FUTURE ISSUES UNDER THE ENVIRONMENTAL BANNER

The controversy over gene-altered foods is but one of the issues that will confront businesses venturing into international markets in the future. One publication, which monitors and reports on such issues worldwide, is called LABELS: Linking Consumers and Producers, an email newsletter published by the Institute for Agriculture and Trade Policy (IATP). The organization is based on the belief that labeling products with respect to the sustainability of their production, processing, and transporting is a powerful tool for achieving more environmentally sound, economically viable, biologically diverse, and socially diverse communities. This statement of purpose for the IATP speaks to the diversity of issues with which international business will be confronted in the future. The environmental banner will be expanded as more and more issues arise from increasing globalization of world markets. A review of the topics in the April 13, 1999, issue of LABELS (IATP, 1999) sheds more light on the issues that are growing in importance and around which there is growing controversy. The topics include: (1) U.S. irradiation labeling up for comments by U.S. Food and Drug Administration (FDA); (2) the possibility of using labeling as a way out of the dispute between the U.S. and the EU over the EU's 1989 ban on importation of hormone-treated beef; (3) the U.S. Department of Agriculture's (USDA) public hearing to prepare for the upcoming Codex meeting on labeling guidelines; (4) Malaysia's plans to adopt Forest Stewardship Council (FSC) standards into its forest certification standards for sustainably managed forests; (5) an update on the labeling of genetically modified foods in Australia, Canada, the U.K., and the EU; (6) brief news stories on ecolabeling in Zimbabwe, organically grown coffee in the Philippines, and information on the Rugmark program, which is a social certification, monitoring, and labeling program developed to

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discourage the use of child labor in carpet-making in South Asia. These issues are diverse and each will require a response from all organizations that want to conduct international business. V.

WORLD TRADE ORGANIZATION (WTO)

The GATT refused to recognize concerns of environmental groups about the environmental effects of trade. Now, however, the WTO will soon publish a report on the environmental effects of trade which recognizes that trade does indeed have negative impacts on the environment. According to the report, "Sweeping generalizations are common from both trade and the environmental community, arguing that trade is either good for the environment, full-stop, or bad for the environment, full-stop, while the real-world linkages are presumably a little bit of both, or a shade of grey" (Economist, October 9, 1999a, 89). When GATT ruled in the past against the U.S. for banning tuna caught with nets that kill dolphins, it "accepted America's aim of protecting the dolphins. Its objections was to the use of discriminatory trade sanctions to achieve this, and it suggested the alternative of labeling dolphin-safe tuna as such" (Economist, October 9,1999a, 89). There will continue to be disagreements between the developed countries and the developing countries concerning the environmental impacts of trade. MNCs may look to the WTO for help in solving these disputes, but the way is not clear for this at this time. One such issue is possibility of making the WTO more accepting of labeling of eco-friendly products. While the EU broadly agrees, the U.S. and developing countries are against this reform of WTO rules. The developing countries see it simply as one more way for the developed countries to use labeling requirements as another cover for protectionism. The U.S. opposes such reforms out of the fear that the EU might use such labeling requirements to keep out U.S. hormone-treated beef and genetically modified foods (Economist, October 9, 1999a, 90). Indeed the long-running U.S.-EU debate over hormone-treated beef amply demonstrated the limits of the WTO or any other international body to settle international trade disputes concerning environmental issues. Yet it is still the best bet for doing so in the future. In November 1999, the WTO met in Seattle, Washington, to establish an agenda for a proposed new round of trade liberalization talks, dubbed The Millennium Round. The events of that week made news, but not about the start of a new round of trade talks. Instead the U.S.

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coverage of the event was symbolized by Newsweek's (December 13, 1999) cover story, "The Battle of Seattle", and in Europe by the Economists (November 28-December 3, 1999b) cover story titled, "Storm Over Globalisation". The protests, rioting, vandalism and street protests which greeted the WTO delegates and caused so much disruption left many wondering what the long-term impact on the WTO and free trade would be—if, indeed, there are any. The causes for which the WTO protestors rallied included workers rights, saving sea turtles, saving the rain forests, for independence for Tibet, the banning of GMOs, the WTO and free trade. In general, and perhaps, more broadly, they were protesting against the process of globalization for which they blame everything from allowing timber companies to clear-cut rain forests and sneaker companies to exploit Asian workers. According to a Business Week editorial (1999b), there was already a mobilization against globalization underway as the backlash in Seattle clearly demonstrated. The editorial suggest that it may now be time to examine some of arguments and determine possible ways to reduce some of the fear and anger over globalization evidenced in Seattle. This may be the only thing to reduce the recently growing public apprehension about the WTO, free trade and the globalization process in general. It may be time to explain the process. Allen and Yang (1999) point out two ironies of Seattle. One such irony was that even before Seattle, many diehard free-traders had already acknowledged that some of the traditional activists' core demands. "Specifically: that countries be able, without penalty, to bar imports produced under conditions that violate environmental, labor or food-safety standards" (Allen and Yang, 1999, 21). A second irony of Seattle pointed out by Allen and Yang is that while protestors claimed to want to protect the workers and environments of developing countries, delegates from the developing countries believed that the U.S. really wants to drive up their costs and hinder their export-driven export strategy, while using antidumping laws and quotas to block their products. It is clear there is a long way to go before environmental issues play a greater role in trade negotiations under the auspices of the WTO. Many would argue, however, that the benefits of globalization are too good to pass up. While the process of globalization carries a genuine human cost, the benefits to developing and developed countries alike are too good to pass up (Farrell, 1999). VI.

CONCLUSIONS

It is likely, however, that the growth of globalization and the rise of international organizations and agreements will provide a basis for

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settlement of such disputes as they arise. There are now forums for settling these disputes and for forging international agreements between governments. These forums, standards, and agreements will allow corporations engaged in international business—operating in the global economy—to face fewer environmental standards and regulations and also to have an acceptable procedure for settling disputes between countries on these issues. The growing globalization of the world's economy and the growing convergence of environmental standards, such as ISO 14000, should thus assist international businesses as they navigate these and other issues as they arise. In addition to increasing convergence of globally accepted certification systems, there also exists a need for international treaties such as the Convention on Biological Diversity. Such treaties can help provide much needed standardization of environmental certification programs and prevent them from being used as barriers to trade. Now embroiled in a battle over the inclusion of environmental issues into treaties on trade, the WTO already offers a mechanism for settling trade disputes, including those involving environmental issues. This is likely to grow in importance as the process of globalization continues. REFERENCES Alden, E. and Bilefsky, D. (2000) 'World News: Gene-Modified Foods Take Centre of Next Trade Dispute: A New Confrontation Between the U.S. and EU Over Global Rules Is On the Way,' Financial Times, January 24. Allen, J.T. and Yang, D. (1999) Trade's Battle Hits Seattle,' U.S. News and World Report, December 13:20-22. Barber, L. (1999) 'Food Scare,' Europe, September, 8-10. Business Week (2000), 'Commentary: Biotech Foods: Why a Hard Line Could Stunt U.S. Trade,'January 31, 30. Business Week (1999a), 'Field of Genes,' April 12, 62-74. Business Week (1999b), The Lessons of Seattle,' December 13, 212. Business Week (1999c), 'Are Bio-Foods Safe?,' December 20, 70-76. Campden Publishing Limited (1991) Environmental Strategy Europe 1991, London: Campden Publishing Limited. Connor, S. (1999) 'Is It Safe to Eat?,' The Independent, May 21. Drumwright, M.E. (1994) 'Socially Responsible Organizational Buying: Environmental Concern as a Noneconomic Buying Criterion,' Journal of Marketing, 54 (July): 1-19. Economist (2000) 'Genetically Modified Crops: To Plant of Not to Plant,'January 15, 30-31. Economist (1999a) 'Embracing Greenery,' October 9, 89-90.

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Economist (1999b) 'The Battle in Seattle,' November 28-December 3, 21-23. Economist Newspaper Limited (1999) 'The World in Figures: Industries,' The World in 200083. Edwards, N. (1997) 'Here Today, Green Tomorrow,' Supply Management, 2(25): 24-26. Epstein, J. (1999) 'A Seedy Business,' Latin Trade, October, 26-28. Farrell, C. (1999) 'The Benefits of Globalization Are Too Good to Pass Up,' BW Online Daily Briefing, December 3. Financial Post - Canada (1999) 'McCain's Hot Potato: McCain Foods Says it Will Stop Using Genetically Modified Potatoes because of Public Concerns over the Safety of GM Foods. But its Actions Will Only Increase Those Concerns,' December 4. Financial Times (2000) 'World News: Trade: Accord on GMO Protocol 'Vital': Biodiversity Chairman of Montreal Talks Delivers Warning,'January 25, 22. Hansen, E. (1997) 'Forest Certification,' Forest Products Journal, 47(3), March:16-22. Holloway, M. (1998) 'Will It Be 'Timber!' for Green Logs,' Business Week, October 19:89. IATP (1998) 'Worldwide Ecolabel for Flowers,' LABELS: Linking Consumers and Producers, 2(11),June 25:5. IATP (1999) LABELS: Linking Consumers and Producers, 3(3), April 13, 1. Jancsurak, J. (1998) Tn Pursuit of a Greener Bottom Line,' Appliance Manufacturer, 46(l)Jan:E23-E25. Ralish, D.E. (1999) 'Timber Company, Nature Group OK Forest Inspection,' Associated Press, September 10. Kangun, N., Carlson, L., and Grove, S.J. (1991) 'Environmental Advertising Claims: A Preliminary Investigation, 'Journal of Public Policy and Marketing, 10(fall): 47-58. Kanter, R.M. (1991) 'Transcending Business Boundaries: 12,000 Managers View Change,' Harvard Business Review, May-June: 151-164. Kozloff, K. and Shah, S. (1998) 'The Green Equation,' Electrical Perspectives, 23(2), Mar/Apr: 14-24. Lally, A.P. (1998) 'ISO 14000 and Environmental Cost Accounting: The Gateway to the Global Market,' Law & Policy in International Business, 29(4):501-538. Magnusson, P. (1999) 'Furor Over 'Frankenfood',' Business Week, October 18:50-51. Matthews, V. (1997) 'Framework for Ethical Sourcing,' Financial Times, December 12:9. Menon, A. and Menon, A. (1997) 'Enviropreneurial Marketing Strategy: The Emergence of Corporate Environmentalism as Market Strategy, 'Journal of Marketing, 6(l):51-67. Micklitz, H.W. (1992) 'The German Packaging Order: A Model for State-Induced Waste Avoidance?,' Columbia Journal of World Business, 27(3):120-127. Newsiueek (1999) The Battle of Seattle,' December 13, 30-39. Porter, M.E. and van der Linde, C. (1995) 'Green and Competitive—Ending the Stalemate,' Harvard Business Review, September-October: 120-134. Raeburn, P. (2000) 'Commentary: Biotech Foods: Why a Hard Line Could Stunt U.S. Trade,' Business Week, January 31. Rogers, L.M. (1998) 'Green Electricity,' Public Utilities Fortnightly, 136(4) :40-45. Wasik, J.F. (1996) Green Marketing and Management: A Global Perspective, Cambridge, MA: Blackwell Publishers.

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Weiss, R. (1999a) 'A Crop of Questions: Gene-Altered Foods May Offer Benefits, But How Safe are They?,' Washington Post National Weekly Edition, April 23:6-7. Weiss, R. (1999b) 'No Appetite for Gene Cuisine: European Protestors Fight to Keep Engineered Food Crops from Taking Root Overseas,' Washington Post National Weekly Edition, 16(27), May 3:18-19. www.forwool.com www.rspca.com.uk

5

An Analysis of the OECD Convention on Combating Bribery of Foreign Public Officials SIMON H. LANCER AND JOSEPH PELZMAN

I.

INTRODUCTION

The U.S. has attempted to combat corruption in international business transactions since 1977. Although many nations have domestic laws that proscribe criminal consequences for domestic bribery, the U.S., under the U.S. Foreign Corrupt Practices Act of 1977 (FCPA) extended its laws to bribery of foreign public officials.1 As a result, U.S. businesses for a number of years have felt disadvantaged by the FCPA, while competitors from predominantly developed countries were at an advantage in securing foreign business and projects. U.S. companies have been bound to adhere to the FCPA, prohibiting bribes to foreign officials and mandating certain accounting and securities reporting; rules that have been non-existent in the laws governing foreign competitors of U.S. businesses. These foreign competitors have entered emerging markets unrestrained. Corruption, unfortunately, has often been a method of doing business abroad, and the U.S. has been attempting to bring in globally ethical accountability and greater transparency. In more recent years, the U.S. has finally managed to convince many of the developed countries, as represented by the membership of the Organization for Economic Cooperation and Development (OECD) to join in the effort toward global recognition that corruption must be combated. To that end, on December 19, 1997, all 29 member states of the OECD2, as well as five non-member states3, signed the Convention on Combating Bribery of Foreign 60

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Public Officials in International Business Transactions (the "OECD Convention").4 The OECD Convention came into force on February 15, 1999.° It is expected that many more member states of the OECD, as well as non-member states, will deposit instruments of ratification with time. The OECD Convention requires that ratifying countries enact domestic criminal laws, similar to the FCPA, prohibiting bribery of foreign public officials to secure any improper business advantage, thereby leveling the playing field at least with respect to the states binding themselves to the OECD Convention.6 The OECD Convention's Preamble begins with the recognition that corruption is widespread and undermines the economic infrastructure of the world, when it states "that bribery is a widespread phenomenon in international business transactions, including trade and investment, which raises serious moral and political concerns, undermines good governance and economic development, and distorts international competitive conditions." The reason why foreign governments should adopt the OECD Convention, is that the best product and what is best for a country does not equate with the highest briber. Corruption distorts competition, undermines a country's development and is destabilizing for any democracy. Corruption has led international financial organizations to suspend lending where corruption has threatened the integrity of development programs; to investors moving capital from, or being reluctant to enter, a country that cannot demonstrate transparency and accountability; and to the removal of public officials from public office, leading to the economic downfall of governments. The OECD Convention's initial success hinges on widespread ratification, implementation, and enforcement. The OECD Convention does not set a specific time-frame for Parties to enact the requisite domestic legislation, rules and regulations required. This chapter examines and analyzes the provisions of the OECD Convention; the U.S. legislation entitled the International AntiBribery Act of 1998 and how it amends the FCPA in order to comply with the OECD Convention; and factors to consider in implementing compliance and due diligence programs for governments and multinational companies. II.

THE OFFENSE OF BRIBERY OF FOREIGN PUBLIC OFFICIALS

Article 1, Sections 1 and 2, of the OECD Convention sets forth the definition of what constitutes the offense of bribery of foreign

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public officials.7 Article 1, Section 1 states the following with respect to the direct offense: "Each Party shall take such measures as may be necessary to establish that it is a criminal offense under its law for any person intentionally to offer, promise or give any undue pecuniary or other advantage, whether directly or through intermediaries, to a foreign public official, for that official or for a third party, in order that the official act or refrain from acting in relation to the performance of official duties, in order to obtain or retain business or other improper advantage in the conduct of international business."

Article 1, Section 2, states the following with respect to complicity as part of the offense: "Each Party shall take any measures necessary to establish that complicity in, including incitement, aiding and abetting, or authorization of an act of bribery of a foreign public official shall be a criminal offense. Attempt and conspiracy to bribe a foreign public official shall be criminal offenses to the same extent as attempt and conspiracy to bribe a public official of that Party."

The offense of bribery, including complicity in the bribery, of a foreign public official is to be a criminal offense. The OECD Convention Commentaries on Article 1 state that the offense as set forth is a standard, whose exact terms need not be utilized in defining the offense under the Parties' respective domestic laws.8 Parties to the OECD Convention may utilize various approaches, from amending existing criminal laws to creating a new statute, but in no case could the law require proof of elements beyond those stated under Article 1 of the OECD Convention.9 The direct offense under Article 1, Section 1, begins that such criminal offense of a bribery of a foreign public official is applicable to "any person". The utilization of "any person" by the drafters of the direct offence provision arguably applies to both natural persons and legal persons. Under the direct offence, the person subject to the criminal offense is one who partakes to "offer, promise or give" a bribe in question. As such, there need not be an actual exchange of money or asset to constitute a crime, as the mere offer or promise, is sufficient. A business entity which could properly have been awarded the business is irrelevant.10 However, the offer, promise or giving of a bribe must be intentional. Arguably, negligence would be a defense. As there is no knowledge standard stated in the OECD Convention, it remains to be seen whether an "intentional" act will include willful ignorance. The scope of the act of bribery under the OECD Convention includes "any undue pecuniary or other advantage." As such, in principle a small gift is the same as a $US100,000 payoff, as value is

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not determinative. In addition to value not being determinative, but an offense exists irrespective of its results, perceptions of local customs, the tolerance of such payments by local authorities, or the alleged necessity of the payment in order to obtain or retain business or other improper advantage.12 It is not an offense if the advantage is permitted or required by written law or regulation or case law of the foreign public official's country.13 The OECD Convention Commentaries confuse the situation, when in a turnabout it states that "small 'facilitation' payments do not constitute payments made 'to obtain or retain business or other improper advantage' within the meaning of paragraph 1 [of Article 1] and, accordingly, are also not an offense."14 The OECD recognizes that such payments are illegal, and urges countries to address the problem with programs of good governance, but doubts that such facilitation payments will be viewed by some countries as a criminal offense.10 In line with this, the OECD Convention provides for differing punishments under the criminal penalties and sanctions section discussed later. In essence, the OECD Convention leaves the severity of the bribe and the appropriate punishment to the judicial systems of the Parties to the OECD Convention.16 The offense of bribery can be instigated directly by the perpetrator or indirectly through intermediaries.17 This arguably would cover the situation in which a company whose country is bound by the OECD Convention, attempts to circumvent by the use of a foreign subsidiary or a bidding company of a country not bound by the OECD Convention. The offense of bribery must be directed to a "foreign public official". Article 1, Section 4(a), of the OECD Convention defines foreign public official, which "means any person holding a legislative, administrative or judicial office of a foreign country, whether appointed or elected; any person exercising a public function for a foreign country, including for a public agency or public enterprise; and any official or agent of a public international organization."18 Not included are foreign political parties, political party officials and candidates for public or political office, who may wield authority without having a formal role in the government. Another element of the offense of bribery of a foreign public official is that the offer, promise or giving of the bribe is directed for the benefit of that "official or a third party."19 This prevents circumvention if one attempts to provide the benefit of the bribe to an official's family, friends, business partner, or company in which the official has an interest.

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The second definition of the offense of bribery of a foreign public official, as set out above under Article 1, Section 2, is with respect to the acts of complicity, authorization, attempt and conspiracy.20 There are two parts to Section 2. The first part states that "[e]ach party shall take any measures necessary to establish that complicity in, including incitement, aiding and abetting, or authorisation of an act of bribery of a foreign public official shall be a criminal offense."21 The intent appears to widen the offense beyond the direct perpetrator of the offense, but to accomplices. Yet, one who incites or authorizes the bribery offense would also be subject to liability under "complicity". However, under Article 1, Section 1, one who commits the bribery offense, even "through intermediaries," would be liable under the direct bribery offense. As such, there is an inconsistency, since one who is an authorizer or inciter of an act of bribery is by definition both a direct offender, as well as an accomplice under Article 1, Sections 1 and 2.22 Which is it? This inconsistency needs rectification by amendment to the OECD Convention. Attempt and conspiracy to bribe a foreign public official is only an offense to the extent the Party to the OECD Convention has internal laws that make it is an offense with respect to bribery of public officials by its own citizenry.23 Yet, there is no explanation as to how this is rectified by the fact that an "attempt" is no different than an "offer or promise" under the direct offense of Article 1, Section 1? III.

JURISDICTION AND EXTRADITION

Once that it is alleged that an offense of bribery of a foreign public official has occurred, the initial question is where does jurisdiction lie? Article 4 of the OECD Convention sets forth the guidelines on jurisdiction as follows: 1. Each Party shall take such measures as may be necessary to establish its jurisdiction over the bribery of a foreign public official when the offense is committed in whole or in part in its territory. 2. Each Party which has jurisdiction to prosecute its nationals for offenses committed abroad shall take such measures as may be necessary to establish its jurisdiction to do so in respect of the bribery of a foreign public official, according to the same principles. 3. When more than one Party has jurisdiction over an alleged offense described in this Convention, the Parties involved shall,

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at the request of one of them, consult with a view to determining the most appropriate jurisdiction for prosecution. 4. Each Party shall review whether its current basis for jurisdiction is effective in the fight against the bribery of a foreign public officials and, if it is not, shall take remedial steps.24 Article 4, Section 4, states that each Party to the OECD Convention shall review its existing jurisdictional laws in order to determine if they are adequate in handling the bribery of a foreign public official. The OECD Convention provides for "territorial jurisdiction" and "nationality jurisdiction."20 However, Article 4 does not provide for jurisdiction based on where the benefits of the bribery are derived nor the nationality of the foreign public official. Article 4, Section 1, provides for territorial jurisdiction, that is that the offense is committed in whole or in part in a Party's territory. The OECD Commentaries broadens the territorial jurisdiction when it states that "the territorial basis for jurisdiction should be interpreted broadly so that an extensive physical connection to the bribery act is not required" [Emphasis added].26 Where an offense has occurred can be based on several factors. One would look initially to where the bribe was offered, promised and/or given, as such are the elements that were discussed previously that constitute the bribery offense under Article 1, Section 1 of the OECD Convention. In addition, where the elements of any complicity, attempt and conspiracy occurred, pursuant to Article 1, Section 2 of the OECD Convention, would also provide territorial jurisdiction. Article 4, Section 2, provides for "nationalityjurisdiction." It states that each Party which has jurisdiction to prosecute its own nationals for offenses committed abroad, shall extend such laws to include the bribery of a foreign public official under the same principles of its existing law. In theory, in those countries which do not have any existing laws, such laws should be implemented, at least with respect to the bribery offense of a foreign public official.27 Article 10 of the OECD Convention addresses itself to extradition. It states as a generality that "extradition for bribery of a foreign public official is subject to the conditions set out in the domestic law and applicable treaties and arrangements of each Party."28 However, the bribery of a foreign public official is to be deemed an extraditable offense under the laws of the Parties to the OECD Convention and the extradition treaties between them.29 Even if a Party has no extradition treaty with another Party, the OECD Convention is the legal basis for extradition with respect to the offense of bribery of a foreign public official.30 As such, if a

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Party makes extradition conditional on the existence of an extradition treaty when it receives a request for extradition from another Party which it has no extradition treaty, the OECD Convention acts as an extradition treaty between the Parties.31 The Parties to the OECD Convention are to take measures to ensure that its own nationals can be extradited or that it can prosecute its nationals for the offense of bribery of a foreign public official.32 A Party that "declines a request to extradite a person for the offense of bribery of a foreign public official 50/^3; on the grounds that the person is its national, shall submit the case to its competent authorities for the purpose of prosecution." [Emphasis added].33 If the decline is based on grounds other than nationality, then the person accused of bribery of a foreign public official is to be extradited. It is unclear what result ensues if the decline is both for nationality and other grounds. The term "solely" is misleading, since a claim of nationality, even in light of other enumerated grounds, would be sufficient to decline extradition, on the proviso that the declining Party prosecutes the accused in its own country.34 What is the result when we have non-Parties to the OECD Convention involved? A non-Party which has physical domain over the accused will no doubt look to its own domestic laws and extradition treaties. This could lead to results not envisaged by the OECD framers. One will also have to be wary of an accused who attempts to forum-shop for a non-Party host country which will not extradite and whose penalties and sanctions are less severe. The Parties to the OECD Convention have agreed to provide "prompt and effective legal assistance" to one another for the purpose of both criminal investigations and criminal proceedings concerning offenses within the scope of the convention, as well as non-criminal proceedings against a legal person, i.e. business entities.35 One of the more interesting provisions of mutual legal assistance is that a Party shall not decline to render such assistance for "criminal matters" within the scope of the OECD Convention on the grounds of "bank secrecy."36 IV.

ENFORCEMENT, STATUTE OF LIMITATIONS & SANCTIONS

Article 5 of the OECD Convention with respect to "enforcement" states that "[investigation and prosecution of the bribery of a foreign public official shall be subject to the applicable rules and principles of each Party."37 The OECD Convention leaves the

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manner, method and resulting punishment of one accused of the offense of bribery of a foreign public official to the domestic laws and procedures of each Party. This will lead to differing prosecutorial results in procedure and substance. In enforcement, the OECD Convention provides a caveat to Parties utilizing their own internal domestic laws and procedures; that "[t]hey shall not be influenced by considerations of national economic interest, the potential effect upon relations with another State or the identity of the natural or legal persons involved."38 Another aspect that is left to domestic policy of each Party to the OECD Convention is the statute of limitations, the time in which a Party has to enforce and prosecute an offense of bribery of a foreign public official. Article 6 of the OECD Convention states that "[a]ny statute of limitations applicable to the offense of bribery of a foreign public official shall allow an adequate period of time for the investigation and prosecution of this offense."39 Once a Party has obtained jurisdiction, proceeded to prosecute and finds the accused guilty, what then are the sanctions and penalties for the crime? The OECD Convention distinguishes between natural persons (i.e., individuals) and legal persons (i.e., business entities). Article 2 of the OECD Convention states that each Party shall take such measures as are necessary, in accordance with its own legal principles, to establish the liability of legal persons for the bribery of a foreign public official.40 This provides enormous latitude on the liability of business entities who commit the offense, that it need not even be criminal. Although a Party can enact legislation that an offense of bribery of a foreign public official by a business entity has criminal consequences, in reality, one can imprison only natural persons, and so the sanctions against business entities are limited to certain traditional type sanctions, as will be discussed below. Article 3, Section 1, of the OECD Convention with respect to "sanctions" begins with a generalization that the bribery of a foreign public official shall be punishable "by effective, proportionate and dissuasive criminal penalties."41 The range of penalties to be instituted by the Party shall be "comparable" to the existing penalties for domestic bribery of a public official.42 However, by definition, the penalties need not be identical. As for natural persons, the laws shall include the right of the government to deprive an accused of liberty sufficient to enable effective mutual legal assistance and extradition.43 Article 3, Section 2, addresses the situation where a Party's legal system does not provide for criminal

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responsibility on legal persons.44 In that case, the Party is to ensure that such legal persons are subject to "effective, proportionate and dissuasive non-criminal sanctions" [Emphasis added] which would include "monetary sanctions."40 Each Party is to take measures that the bribe and the proceeds of the bribery, or any other property of the value of the bribe proceeds are subject to seizure and confiscation.46 Alternatively, monetary sanctions may be assessed where proceeds cannot be seized or confiscated.47 The "proceeds" of the bribery are the profits or other benefits derived by the briber from the transaction or other improper advantage obtained or retained through the bribery.48 The term "confiscation" includes forfeiture or the permanent deprivation of property by order of a court or other competent authority.49 Each Party is to consider the imposition of additional civil or administrative sanctions upon a person subject to sanctions. V.

THE ACCOUNTING OFFENSE

In order to combat bribery of foreign public officials effectively, the OECD Convention under Article 8 sets forth that each Party legislate accounting principals preventing persons from avoiding detection of bribery transactions. Article 8, Section 1, states the following: "In order to combat bribery of foreign public officials effectively, each Party shall take such measures as may be necessary, within the framework of its laws and regulations regarding the maintenance of books and records, financial statement disclosures, and accounting and auditing standards, to prohibit the establishment of off-the-books accounts, the making of off-the-books or inadequately identified transactions, the recording of non-existent expenditures, the entry of liabilities with incorrect identification of their object, as well as the use of false documents, by companies subject to those laws and regulations, for the purpose of bribing foreign public officials or of hiding such bribery."50

The thrust of the accounting provision of the OECD Convention is that each Party is to legislate its own laws regarding accounting principals, but within the framework of its own laws; as opposed to acrossthe-board accounting requirements which set out specifically and in detail what is necessary to combat bribery. The provision is generalized, not stating what disclosures are required in financial statements, what accounting and audit standards are required and what methods and procedures are necessary in the maintenance of books and records. The provision addresses combating separate books of account and false entries. The typical example is a bribe that is made into a non-existing expenditure such as a consulting fee. However, the OECD contemplates in general terms independent external

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audits and internal company controls. The provision also requires a nexus of the accounting offense to the bribery of a foreign public official and its non-disclosure. Article 8, Section 2, provides for penalties for an accounting offense as follows: "Each Party shall provide effective, proportionate and dissuasive civil, administrative or criminal penalties for such omissions and falsifications in respect of books, records, accounts and financial statements of such companies."52

The provision leaves great flexibility to each Party regarding the punishment for an accounting offense, from civil to administrative to criminal penalties, or a combination thereof. VI. THE OECD CONVENTION'S IMPACT ON THE UNITED STATES FOREIGN CORRUPT PRACTICES ACT

In general, the OECD Convention is loosely based on the FCPA in the U.S. As such, the provisions are similar, with some exceptions. On December 8, 1998, the U.S. officially deposited with the OECD its ratification and adoption of the OECD Convention. The U.S. also has implemented the OECD Convention by legislation, the International Bribery Act of 1998 (the "1998 FCPA Amendment"), which amends the FCPA. There has been a multitude of books and articles written over the years explaining and analyzing the provisions of the FCPA. This chapter has no intention in repeating the material previously published. Rather, the focus here is how the FCPA has been amended, or not been amended, to conform to the OECD Convention, and whether the FCPA provisions are narrower or broader than the OECD Convention. Prior to the 1998 FCPA Amendment, the FCPA in pertinent part made it a crime for a U.S. issuer or domestic concern53 to utilize the mails or any instrumentality of U.S. commerce,54 corruptly,50 in furtherance of a payment, or the provision of anything of value, or an offer, promise or authorization, directly or indirectly, to a foreign public official,56 political party or candidate, for the purpose of influencing his or her official actions or inducing such foreign public official to use his or her influence with a foreign government to affect or influence any act or decision of such government in order to assist the U.S. business in obtaining or retaining business for or with, or directing business to, any person. The FCPA further prohibited payments or the giving of anything of value to any person while "knowing" that such payment or gift will be given to a foreign public official for a business purpose.57

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There are six principal areas in which the FCPA has been amended by the 1998 FCPA Amendment to conform to the OECD Convention. First, the 1998 FCPA Amendment adopts the expansion set forth in the OECD Convention, Article 1, Section 1, by providing that the prohibition on bribery of a foreign public official includes the broader element of payments or offers for the purpose of securing "any improper advantage."58 Second, the OECD Convention calls on parties to cover "any person," while the prior FCPA covered only issuers with securities registered under the 1934 Securities Exchange Act and domestic concerns. The 1998 FCPA Amendment expands the FCPA's coverage to include foreign subsidiaries of domestic concerns, which was not the case previously. It is also expanded to cover all other persons, including foreign persons, who commit an act in furtherance of a foreign bribe while in the United States.59 This includes any officer, director, employee, agent or stockholder of such person.60 The nexus is either the use of the mails or instrumentality of interstate commerce within the U.S. or to do an act in furtherance of the bribery offense, which does not require a connection with the mails or interstate commerce.61 The section does not apply to any facilitating or expediting payment to a foreign public official to secure the performance of a routine governmental action by a foreign public official.62 It is an affirmative defense if the payment, gift, offer, or promise of anything of value is lawful in the foreign public official's country.63 It is also an affirmative defense if the payment, gift, offer, or promise of anything of value is a reasonable and bona fide expenditure, such as travel and lodging expenses directly related to the promotion, demonstration or explanation of products or services or within the parameters of execution or performance of a contract with a foreign government or agency of such foreign government.64 Third, the OECD Convention includes officials of public international organizations within the definition of foreign public official. The 1998 FCPA Amendment similarly expands the FCPA's definition to include officials of such organizations.60 However, only those international organizations that are designated by Executive Order pursuant to the International Immunities Act fall within the FCPA provisions.66 It should be noted that the OECD Convention's definition of foreign public official does not include political parties or candidates, while FCPA is broader in this respect as it includes such persons. Fourth, the OECD Convention calls on Parties to assert nationality jurisdiction when consistent with national legal and constitutional

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principles. Accordingly, the 1998 FCPA Amendment now provides for jurisdiction over the acts of U.S. persons and those acting on their behalf in furtherance of unlawful bribery offenses that take place wholly outside the United States.6/ This is irrespective of whether in doing so they make any use of the mails or means or instrumentality of interstate commerce.68 U.S. issuers are to be liable under the doctrine of respondeat superior for acts of their officers, directors, employees, agents, or stockholders taken outside the territory of the U.S., regardless of their nationality. It should also be noted that foreign companies who are traded on a U.S. stock exchange are by definition an issuer, and are subject to the FCPA.69 The OECD Convention is not as broad to include vicarious liability. Fifth, the OECD Convention calls on Parties to assert territorial jurisdiction. As such, the 1998 FCPA Amendment provides for jurisdiction if the offense is committed in whole or in part in the United States.70 Sixth, FCPA is amended to eliminate the prior disparity in penalties applicable to U.S. nationals and foreign nationals employed by or acting as agents of U.S. companies/1 Previously under the FCPA, foreign nationals employed by or acting as agents of U.S. companies were subject only to civil penalties. Now in conformity to the OECD Convention, such persons are liable for criminal penalties as well.72 VII. MONITORING BY THE OECD As there is no enforcement body at the OECD to assure compliance with the provisions of the OECD Convention by the Parties, a monitoring system under Article 12 has been implemented.73 Article 12 provides for co-operation by the Parties in carrying out a program of "systematic follow-up to monitor and promote the full implementation" of the OECD Convention.74 The monitoring and follow-up is to be handled by the OECD Working Group on Bribery in International Business Transactions.75 At this time the Working Group's mandate is (1) to receive notifications and other information from Parties, (2) to perform regular reviews and make proposals to assist in the implementation of the OECD Convention, which would include questionnaires filled out by the Parties, and reports issued by the Working Group on the Parties, and (3) the examination of specific issues relating to bribery in international business transactions.76 VIII. COMPLIANCE Notwithstanding the continuing and remaining problems that face the OECD Convention provisions; business enterprises, branches,

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subsidiaries and their officers, directors, employees, stockholders, and agents need to be on guard if their home country is a Party to the OECD Convention and if they intend to make international business transactions, or if they intend to do international business with another country Party to the OECD Convention. U.S. companies will need to notify their branches, subsidiaries, and agents of the new changes to the FCPA, while foreign companies will need to address new legislation implementing the OECD Convention in their countries and in countries with which they intend to do business. The U.S. will no doubt continue to be the most stringent in compliance with anti-bribery provisions as set forth in the FCPA. In addition, the Parties to the OECD Convention will need to implement programs and training regarding new legislation in their countries implementing the OECD Convention. Although international organizations are not parties to the OECD Convention, they are covered, and such organizations, if they have not already done so, should implement internal anti-corruption programs and anticorruption conditions if monies are lent to countries. With the advent of the expansion of global business and investment, the emergence of new markets in Eastern Europe, Central Asia, Africa, Latin America, China and India, where bribery is common, the increase of infrastructure projects, the increase in trade, and the privatization of governmental entities, has led business enterprises to confront the issues presented by the implementing legislation of the OECD Convention. This has opened up new opportunities for experienced international attorneys and consultants to advise governments, international organizations, and business enterprises on the implementation of a sound compliance program that includes appropriate accounting and audit oversight, as well as due diligence in conducting international business transactions. The following is what governments and international organizations can do to combat corruption: 1. Establishing a code of ethics and legislative parameters that state what constitutes corruption and bribery by public officials, and the penalties that will result for violations, i.e., dismissal, monetary fines, imprisonment, and so on; 2. Training of, and workshops for, public officials in the provisions of the OECD Convention and the implementing legislation of the country; 3. Setting up an oversight agency to enforce the corruption and bribery laws; 4. Strengthening the judiciary;

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5. Strengthening independent audit institutions; conducting surprise audits; adopting generally accepted accounting and auditing procedures; 6. Establishment of competitive and transparent public procurement systems; 7. Simplification of business licensing and permit procedures, so as to lower the chances of bribery requests; 8. Increased dissemination of the anti-corruption legislation; 9. Public officials' disclosure of assets and liabilities; 10. Denial of tax deducibility of bribes; 11. Establishing an agency to provide guidance and opinions to business enterprises whether a certain course of action would constitute a violation of anti-corruption and anti-bribery laws; 12. Selection of government officials based on a merit system, reducing the scope for nepotism and corruption; and 13. Greater transparency across the board. What should business enterprises do to protect themselves from civil and criminal fines and possible imprisonment of its officers, directors, employees, stockholders and agents? Compliance programs and due diligence will assist in reducing the likelihood of a violation of implementing legislation of the OECD Convention. The following are internal compliance procedures to consider: 1. Establishing strong written company policies on compliance standards and procedures; 2. Establishing a protected procedure and means for employees to report potential or actual violations; 3. Providing a compulsory educational system, training and workshops on the anti-corruption and anti-bribery legislation; 4. Mandatory internal accounting and auditing procedures in compliance with generally accepted accounting procedures and the requirements of the implementing legislation of the OECD Convention; 5. Assigning high level personnel to oversee the compliance program and the international business transaction; and 6. Implementing a due diligence program for international business transactions and procedures to detect possible prohibited conduct and bribery offenses. The following are issues to consider in conducting due diligence on an international business transaction: 1. Document your due diligence;

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2. Consider the country where business is to be conducted; 3. If you are going to be working with a consultant, a joint venture, partner or agent on the international business transaction, you should determine their reputation, integrity and competence; 4. Compensation and payment is another area to closely look at in a transaction. A joint venture or partner will share in the project in both delegation of duties and profits. They should be reasonable; 5. In any contract, whether with a foreign government, partner, joint venture, consultant or agent, include the relevant implementing legislation of the OECD Convention, with representation and a commitment to comply with its provisions, as well as other laws and regulations as applicable; and 6. Maintain accurate books and records of accounting as part of due diligence. NOTES 1. 2.

3. 4.

5.

6. 7.

The Foreign Corrupt Practices Act of 1977 [FCPA], 15 U.S.C. 78m, 78dd-2, 78ff, as amended. The 29 member states are Australia, Austria, Belgium, Canada, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Korea, Luxembourg, Mexico, The Netherlands, New Zealand, Norway, Poland, Portugal, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the U.S. The non-member states that signed the OECD Convention are Argentina, Brazil, Bulgaria, Chile and the Slovak Republic. The OECD member states adopted the OECD Convention on November 21, 1997, prior to the Convention's signing. Commentaries on the Convention on Combating Bribery of Foreign Public Officials in International Business Transactions was adopted by the negotiating conference on November 21, 1997 [hereinafter the "OECD Convention Commentaries"]. In addition, the OECD Convention recognized in its Preamble the Revised Recommendation on Combating Bribery in International Business Transactions, as adopted by the Council of the OECD on May 23, 1997. Countries that have already deposited their instruments are: Iceland (17 August 1998), Japan (13 October 1998), Germany (10 November 1998), Hungary (4 December 1998), the U.S. (8 December 1998), Finland (10 December 1998), the United Kingdom (14 December 1998), Canada (17 December 1998), Norway (18 December 1998), Bulgaria (22 December 1998), Korea (4 January 1999), Greece (5 February 1999), Austria (20 May 1999), Mexico (27 May 1999), Sweden (8 June 1999), Belgium (27 July 1999), the Slovak Republic (24 September 1999), Australia (18 October 1999), Spain (14 January 2000) and the Czech Republic (21 January 2000). The OECD Convention, Article 1. OECD Convention, Article 1 (1) & (2).

OECD Convention on Combating Bribery of Foreign Public Officials 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27.

28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. 45. 46. 47.

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OECD Convention Commentaries, para. 3. Ibid. OECD Convention Commentaries, para. 4. Ibid. Ibid. OECD Convention Commentaries, para. 8. OECD Convention Commentaries, para. 9. Ibid. OECD Convention, Article 3. OECD Convention, Article 1(1). OECD Convention, Article 1 (4) (a). OECD Convention, Article 1(1). OECD Convention Article 1 (2). Ibid. OECD Convention Article 1(1) & (2). OECD Convention Article 1 (2). OECD Convention, Article 4. OECD Convention, Article 4(1) & (2). OECD Convention Commentaries, para. 25. This is surmised by the suggestion that appropriate remedial steps be taken to implement jurisdictional basis over the offence of bribery of a foreign public official under Article 4(4) of the OECD Convention. OECD Convention, Article 10(4). OECD Convention, Article 10(1). OECD Convention, Article 10(2). Ibid.; OECD Commentaries, para. 33. OECD Convention, Article 10(3). Ibid. The term "solely" adds nothing to the concept and should be deleted from Article 10, Section 3. OECD Convention, Article 9(1). OECD Convention, Article 9(3). OECD Convention, Article 5. Ibid. Enforcement is not to be influenced by economic, political or identity considerations. OECD Convention, Article 6. OECD Convention, Article 2. OECD Convention, Article 3(1). The rights of victims is not prejudiced by Article 3. OECD Convention Commentaries, para. 22. Ibid. Ibid. OECD Convention, Article 3(2). Ibid. OECD Convention, Article 3(3). Ibid. There is no preclusion on setting limits to any monetary sanctions assessed. OECD Convention Commentaries, para. 23.

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48. 49. 50. 51. 52. 53.

54. 55.

56.

57. 58.

59. 60. 61. 62.

63.

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OECD Convention Commentaries, para. 21. OECD Convention Commentaries, para. 22. OECD Convention, Article 8(1). OECD Convention Commentaries, para. 29. However, no specificity is provided on the type of procedures and methods that should be utilized. OECD Convention, Article 8(2). 15 U.S.C. 78dd-l(a) & 78dd-2(a), as amended. The term "issuer" covers companies that register with, or are required to file reports with, the Securities & Exchange Commission pursuant to 15 U.S.C. 781 & 780(d), as well as any individuals serving as officers, directors, employees or agents of such companies. The term "domestic concern" has broader meaning, and includes individual U.S. citizens wherever located and any business entity organized under U.S. state laws or has its principal place of business in the U.S. 15 U.S.C. 78dd2(h), as amended. 15 U.S.C. 78dd-2(h)(5). 1977 Senate Report on FCPA, S. Rep. No. 95-114, at 10 (1977) [a payment is given or offered "corruptly" if it is intended to induce the recipient to misuse his official position in order to wrongfully direct business to the payor or his client, or to obtain preferential legislation or a favorable regulation; it connotes an evil motive or purpose, an intent to wrongfully influence the recipient]. 1977 House Report on FCPA, H. Rep. No. 640, at 7-8 (1977) [similar description as the Senate Report, but adds that "corruption" is to have same effect as reflected in court decisions applying the same term under the domestic federal bribery law pursuant to 18 U.S.C. 201. 15 U.S.C. 78dd-2(h)(2). The definition of "foreign official" includes "any officer or employee of a foreign government or any department, agency, or instrumentality thereof, or any person acting in an official capacity for or on behalf of any such government, department, agency or instrumentality." This definition includes officers of government owned or controlled commercial enterprises. United States v. Goodyear Int'l Corp., 2 Foreign Corrupt Practices Act Reporter, at 698.1601; United States v. Sam P. Wallace Co., 2 Foreign Corrupt Practices Act Reporter, at 690.01. 15 U.S.C. 78dd-l(f)(2) & 78dd-2(h) (3), as amended. 15 U.S.C. 78dd-l(a) & 78dd-2(a), as amended. As such, the offense need not be limited to business advantage, and could conceivably include a favorable ruling by ajudge or similar authority. 15 U.S.C. 78dd-3 [new section of FCPA]. 15 U.S.C. 78dd-3(a). 15 U.S.C. 78dd-3(a)(i) & (ii). 15 U.S.C. 78dd-3(b). These include obtaining permits, licenses or other official documents; processing governmental papers, such as visas and work orders; providing police protection; providing mail pick-up and delivery; providing phone service, power and water supply; loading and unloading cargo or protecting perishable products; and scheduling inspections associated with contract performance or transit of goods across country. 15 U.S.C. 78dd-3(c)(l).

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64. 15 U.S.C. 78dd-3(c)(2)(A) & (B). 65. 15 U.S.C. 78dd-l (f) & 78dd-2(h). 66. 15 U.S.C. 78dd-l(f)(l)(B), 78dd-2(h) (2)(B) & 78dd-3(f)(l)(B). See also International Organizations Immunities Act, 22 U.S.C. 288. 67. 15 U.S.C. 78dd-l (g) & 78dd-2(d). This is consistent with U.S. legal and constitutional principles under the grant of power to the U.S. Congress to "regulate Commerce with foreign Nations" and to "define and punish ... Offenses against the Law of Nations. " U.S. Const. Art. 1, Section 8, Clause 3 & 10. 68. Ibid

69. SEC v. Montedison S.p.A.., SEC Litigation Release No. 15164 (Nov. 21, 1996). The SEC brought a civil action against Montedison, an Italian company listed on the New York Stock Exchange for fraud and failure to comply with FCPA's record-keeping and accounting controls requirements stemming from bribes paid to Italian government officials. 70. 15 U.S.C. 78dd-3(g). 71. 15 U.S.C. 78ff(c), 78dd-2(g) & 78dd-3(g). 72. Ibid. 73. OECD Convention, Article 12. 74. Ibid. 75. Ibid. 76. OECD Convention Commentaries, para. 34.

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Corporate Responsibility and Child Labor in Global Business FOAD DERAKHSHAN AND KAMAL FATEHI1

I.

INTRODUCTION

Child labor, the use of children to perform adult jobs in business, has received considerable attention in recent years. Child labor, and related problems, is a complex issue with economic, legal, political and social ramifications. On the economic side, child labor takes root in cost-saving measures particularly called for by increased global competition. Increase in trade activities between developed and less developed parts of the world has spread the use of this form of production in less-developed economies. On the legal side, difficulties in legal interpretations across national boundaries as well as the obstacles in enforcement of legal treaties complicate the issue. On the political dimension, respect for national sovereignty hinders the efforts by international organizations and developed countries to engage in aggressive actions to remedy the problem. This pressure seems to be easing off in recent years. On the social and the cultural side, variations in business customs and interpretations of what is defined as child labor as well as its acceptability is a major hurdle. As examined later in this chapter, these obstacles have hindered, or at least slowed, the pace of pressures applied by international agencies as well as by developed countries on nations such as Pakistan, Indonesia, and various African countries to solve the problem. The December 1999 meeting of the World Trade Organization in Seattle brought a renewed attention to this pressing issue. Consequently, President Clinton signed a United Nations-sponsored child labor treaty designated to root out some of the most severe 78

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instances of child abuse, industry slavery, unsafe work conditions for children, and forced participation in drug trafficking and pornography (PBS News Hour, December 1, 1999a, December 2, 1999a). The President had previously discussed the issue at meetings of the Union of Needle Trades, Industrial and Textile Employees and the Apparel Industry Partnership Event (PBS News Hour, July 23, 1997; White House, April 14, 1997). President Clinton also addressed the issue in his State of the Union addresses in January 1998 and January 1999 (PBS News Hour, January 27, 1998; January 19, 1999). In April 1999, the Chinese Premier, Zhu Rongji, was pressured by the Clinton administration to address the child labor problem during his visit to the United States (PBS News Hour, April 16, 1999). Representative Maxine Waters of California criticized American companies for exploitation of workers and use of child labor during a 1997 discussion on "The Democratic Party at a Crossroads" (PBS News Hour, November 14, 1997). The pressure to address the child labor problem was not only on the Democratic agenda, but was also one of the issues of the Presidential campaign. During the 1996 Presidential campaign, for example, Ross Perot blasted the Clinton Administration for trading with Indonesia despite its widespread use of child labor (PBS News Hour, October 24, 1996). Japan's recent economic problems have also complicated the push for the resolution of the problem. In recent years, the U.S. and the European governments have relied on Japan to act as a change agent to address the child labor problem in Asia. Busy with its own internal economic problems, Japan has not done much in recent years to address the child labor problem in other Asian countries. This issue has been noted by its American and European partners (PBS News Hour, June 17, 1998). On the Chinese front, its bid for WTO membership has been used by the U.S. as a bargaining tool to press for less use of child labor and for other related improvements (PBS News Hour, December 1, 1999b). II.

HISTORICAL BACKGROUND

For most of the past century, the problem of child labor was generally overlooked by the developing nations. This was due to the assumption that the problem was mainly confined to poorer and less developed parts of the world. In recent decades, however, globalization has added this complex problem to the agenda of the multinational businesses, which are mainly headquartered in the developed nations. This, in turn, has brought the attention of the governments

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and social groups in these countries to the problem. Contrary to the popular belief, the use of child labor is neither a new problem nor has it always been restricted to the less developed parts of the world. Historically, children have always been a part of the workforce. Before the Industrial Revolution, children worked as apprentices with the justification that such experiences were a preparation for adult life (Mendelievich, 1979). In the early stages of the Industrial Revolution, children were employed in factories doing menial and repetitive tasks for minimal pay. In industrialized countries, economic as well as social developments pressured governments to pass child labor laws which nearly abolished such practices. Recent cost-saving measures, as well as decentralization of production due to globalization, have increased the demands for child labor in developing as well as in developed countries. A survey of 1,000 working schoolchildren in the north-east of England found that 25% were under the legal working age of 13, 44% had suffered injury at work during the past year, one in seven worked over maximum hour-limits and they earned as little as 33 pence an hour (BBC News, February 10, 1998). Of course, the picture is much grimmer in less-developed countries. In Pakistan, many children under age of 10 work for less than 10 pence an hour stitching soccer balls that are exported (BBC News, October 29, 1997). In Brazil, children work in the hazardous production of sisal with the risk of serious damage to their lungs (BBC News, October 30, 1997). In Pakistan, children are used in the booming carpet manufacturing business with menial pay for long hours. India has the largest number of children engaged in labor, estimated at 100 million (BBC News, October 23, 1998). According to the BBC, an estimated 250 million children work around the world (BBC News, January 17, 1998). Statistics on child labor are fragmentary and sometimes inaccurate. The International Labor Organization (ILO) puts the estimate of the number of working children at 100-200 million, with about 95% living in less-developed and developing countries. Geographically speaking, Africa has the highest proportion, with one in every three children working. Being the world's most populated region, Asia provides 50% of the children who work. Child labor is used in a wide range of economic activities. Family farming, services (domestic servants, restaurants, street vending, etc.), manufacturing (carpets, footballs, garments, furniture, etc.) and prostitution are the major users of children. Many such activities are in the underground or informal economy which is not regulated by laws. Subcontracting industries such as garments, shoes and

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carpets make the distinction between formal and informal economies even more difficult. Export industries which commonly employ children include garments, carpets, shoes, small-scale mining, gem-polishing, food-processing, leather tanning, and furniture. A complicating factor is that, in some industries, for example in the garment and shoe industries, parts fabricated by children in one country are sent to a second country for assembly before being exported. In some cases, government polices to promote exports of low-skilled, labor-intensive products, such as garments and carpets, may have resulted in an increase in the demand and use of child labor. Despite their awareness of the problem, local governments do not seem motivated to address the issue. "We are very concerned about the child labor ... The ultimate solution is for the West to open their markets so we can get more exports, more jobs, so the children can go to school," stated Abdul Razak Dawood, the Minister of Commerce of Pakistan (PBS News Hour, December 2, 1999a). Without strong international pressure and corresponding international assistance, child labor is likely to continue. III.

ROOTS OF THE CHILD-LABOR PROBLEM

Traditionally the main reason behind the use of children at work has been economic. The main incentive for the child's family, if there is one, is to earn money to combat poverty. From the employer's standpoint, less pay and the possibility of worker abuse without the fear of retaliation are the main reasons. From a societal standpoint, the most devastating form of child labor abuse, child prostitution, is often ignored (BBCNews, October 23, 1998, January 4, 1999). For these children, work often eliminates an opportunity for education. This fact perpetuates their poverty and reduces their chances to break out of this vicious circle. Individual Incentives

Poverty is the most commonly prevailing root for child labor. In many less-developed countries, children have no choice but to work for their own survival as well as that of their families. The lack of proper social security networks in most less-developed countries aggravates this problem. In some cases, burdened by heavy debt, families sell their children to their creditors to cover their debt. In India, some parents exchange their children for use as child labor to local moneylenders for an average of 2,000 rupees (Human Rights Watch, 1996). This

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modern form of slavery often continues after payment of the family debt, since the child who has known no other forms of work or alternative continues working for his/her owner for the rest of his/her life. Employer Demands

The economic self-interest of employers is the main source of demand for child labor. Public indifference, poor public policy, government inadequacies, and government corruption fuel this demand (U.S. Department of Labor, 1994). Most of the cases of abuse of children in the workplace are in developing economies, where a strong desire for economic wellbeing outweighs moral and ethical constraints. Lack of public awareness of the predicament and plight of these children, and at times a sense of helplessness, compounded by government apathy or inability to take any legal action, makes the path easier to follow for the employers. From an economic perspective, it is claimed that three main reasons attract employers to children as workers: First, it costs less. This claim, however, is not substantiated. A survey done by the ILO has concluded that the cost savings between paying an adult's or a child's wage is minimal. The difference is about 5-10%, and at this level, the difference could be absorbed by retailers and wholesalers. Second, children have irreplaceable skills (nimble fingers). Children are mostly found to work side-by-side with adults in such industries as carpet-making, glass manufacturing, the mining of slate, limestone and mosaic chips, lock-making and gem-polishing. In most cases, children are assigned to do the unskilled work, while adults do most of the skilled work. Therefore, the gains expected by the use of children's "nimble fingers" are irrelevant. The last reason for using working children is that children are more vulnerable and easier to manage. Due to their ignorance of their rights, they do not question authority and are therefore less troublesome, more compliant, more trustworthy and less likely to be absent from work (U.S. Department of Labor, 1994; Brecher and Costello, 1998; FIET Website, 1998). Societal Roots

Culturally, the lack of education uting factors to child labor. It is earnings as well as low perceived parents to send their children

and low literacy rates are contribthe "pressing need for the child's advantages of school" which cause to work (Badiwala, 1998). Some

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cultural traditions also contribute to this problem. In some countries, children from indigenous societies, former slave families, and other minority groups who have a history of working as slaves, are being exploited in their ancestral history. A recent report by the United Nations paints a horrifying picture of child prostitution in north-west Pakistan where the sexual abuse of young boys is a matter of pride (BBC News, January 4, 1999). At an international level, the issue of child labor has not received much attention until recent years. The International Labor Organization's (ILO's) mandates related to working children, including the Convention (No 138, 1973) entitled Minimum Age for Admission to Employment, and the Forced Labor Convention (No 29, 1930) that are used to examine practices of child slavery, were never ratified by all 156 member states (Lee-Wright, 1990). In the last decade, international organizations and government agencies began to pay attention to the plight of working children. Consequently, the work done by the ILO has been more widely accepted and its recommendations have been implemented in governmental policies. In these countries, however, the shortage of skilled and technically-competent inspectors combined with their inadequate authority to check factories and businesses that engage in child labor is a serious problem. Ironically, some government officials advocate the use of child labor since they have benefited from it themselves. Work for children is not necessarily harmful. Many children work for training and as a step towards preparing for their adult lives (Fyfe, 1989). It is the exploitation of children in the workplace that poses a moral dilemma for the economies of developing nations and is occasionally carried to the industrialized world through the globalization of business. Strategies to solve the problem of child labor are summarized in the following section. IV.

STRATEGIES TO DEAL WITH THE CHILD-LABOR PROBLEM

Strategies to deal with child labor problems can be categorized into three groups. Initiatives by MNCs, initiatives by governments and international agencies, and societal initiatives. The following section analyzes major initiatives in each category. Multinational Companies' Initiatives

MNCs use child labor mostly through subcontracting. Many foreign subsidiaries of multinational corporations, in developing

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countries, subcontract part of their production out to small firms or to families that use child labor. In recent years, several multinationals have been caught up in being indirectly involved in the use of child labor to produce their goods and have had to deal with resulting negative publicity. Some well-known examples are Levi-Strauss, Sears Roebuck, and Nike (Anti-Slavery International Website, 1998). In response to public pressure, some companies have developed codes of conduct and policies, and have taken action to deal with the issue of child labor (Grootaert and Kanbur, 1995). In its company code of practice, for example, LeviStrauss incorporated minimum working conditions and a pledge to set up educational facilities. An increasing number of other companies have also formulated such codes of practice (ILO Website, 1998; Ansari, 1998). Another example of such practices is the code of conduct that was negotiated between the International Confederation of Free Trade Unions (ICFTU) and the International Federation of Football Associations (FIFA) concerning social conditions which were to be respected in the manufacturing of soccer balls bearing the FIFA logo. This was done as a response to the ICFTU accusing FIFA of using soccer balls manufactured through the exploitation of children in the Sialkot region of Pakistan. The code of conduct includes a statement prohibiting the use of child labor in manufacturing soccer balls and set up a system of monitoring the production sites as well as education and training programs for children (ILO Website, 1997; Littlefield, 1996). In response to the same problem, as a joint initiative of UNICEF, Save the Children, the World Federation of the Sporting Goods Industry (WFSGI), the Soccer Industry of America, the ILO, and others, a plan has been set up to ensure the gradual phasing out of child labor in the manufacture of soccer balls in Pakistan. This plan will involve an educational and social program for the children to provide them with other alternatives, as well as a system for independent monitoring of the compliance. This program was also supported by over 50 sporting goods brands including Adidas, Mitre, Nike, Puma, and Roebuck (Save the Children Press Office, 1997). The absence of sufficient monitoring mechanisms is a major obstacle to the enforcement of these codes of conduct. Despite all that has been, and will be, done by multinational companies, it is clear that they cannot solve the problem alone. Initiatives need to come from governments both in industrial countries as well as in the countries where child labor exists.

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Initiatives by Governments and International Agencies

Until recently the most commonly prevailing government reaction to child labor problems was that of denial. Child labor was illegal, and therefore did not exist in governments' data as well as in their policies. Recent pressures from the public and by media reporting, as well as pressure from international bodies such as the ILO, UNICEF, Save the Children and other non-governmental organizations (NGOs) has caused these governments to respond. Many have initiated a review of national legislation and have enacted policies on child labor. (Anti-Slavery International Website, 1998). The Government of India, for example, has passed several pieces of legislation and enacted policies with the goal of eradicating child labor by the early part of the 21st century (Ansari, 1998). In the carpet industry, random checks of potential sites using child labor are carried out and 122 known cases have been registered against offenders. Many countries now have legislation or policies concerning minimum age restrictions and minimum work conditions (Grootaert and Kanbur, 1995; Act No. 677/1991). Various government departments like the education departments, health departments and welfare departments, all have a role to play in implementing child labor policies. (Hilowitz, 1997). The U.S. Government and the EU have been at the forefront of developing legislation aimed at reducing the incidence of child labor. In 1993, Senator Tom Harkin introduced the Child Labor Deterrence Act, more commonly known as the Harkin Bill, which prohibits the import of minerals or manufactured goods into the U.S. if they were produced by child labor (U.S. Congress, 1995). The U.S. Government has included the "respect for workers' rights" as a condition in its Generalized System of Preferences (GSP) which links the granting of trade preferences to foreign countries. Pakistan had some of its trade preferences removed due to its use of child labor in 1995 (Littlefield, 1996). Similar measures are employed by the EU (EU Website, 1998). Additionally, a provision offers incentives in the form of additional preferences for participating countries that can prove that they have adopted and applied legal provisions incorporating ILO Convention No 138 concerning minimum age for admission to employment or work (European Council Regulation, 1994). Societal Initiatives

Societies in developed as well as in developing countries play a major role in eradicating the child-labor problem. A strong force in

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this area is the consumer in developed countries. However, the consumer boycott of products does not always lead to the expected outcomes. Losing their original jobs, children may be forced to take up employment in dangerous environments (e.g. construction, agricultural work with the risk of chemical pollution) or situations far more undesirable than the mere assembly of products (e.g. prostitution, slavery or "bonded labor") to maintain their income (Fyfe and Jankanish, 1997). Therefore it is essential that consumer power is used in conjunction with other measures such as government and corporate programs. Social awareness of child labor can be instigated via a number of channels, namely the media, labeling and international publicity campaigns. The media is the most commonly used, and probably the most effective, way of informing the public. The popularity of television around the world makes it an effective tool. World news organizations play a major role in increasing public awareness of child labor problems, due to their time allocation on televisions around the world. A television report on World in Action showed how Sicom, a subcontractor for Marks and Spencer (M&S), employed girls under the age of 15 in a Moroccan garment factory. Although M&S later denied the allegations, the report seemed to have successfully "panicked some companies into reviewing their supply chains." The ILO's London office was flooded with calls following the program (Littlefield, 1996). Computer websites are newly emerging sources of instant information but mostly for the more educated section of the public. The credibility problem associated with this source has been improved by major newscasters, government agencies and reputable nonprofit groups establishing their own websites. Beginning in 1994, product labels were introduced by several companies voluntarily as a means of guaranteeing that the product had been manufactured without the use of child labor, or if children had been used in the manufacture of such products, they did so under strict adherence to legal requirements. Germany, the U.S., India, Nepal, and the Netherlands have all have set up the Rugmark as an identification for carpets being woven and made by the exploitation of children. Other labels for the carpet industry include the Fair and Care System which is operating in Germany and the Step system which is based in Switzerland. Labeling systems for other products include the Double Income Project system which is based in Switzerland for the textile and garment industry and a voluntary labeling system for the footwear industry in the State of Sao Paulo in

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Brazil. Few countries use labeling programs. Among the industrialized countries, the U.S., Germany, and Switzerland use labels. Among the developing countries, Brazil, Kenya, India, Nepal, and Pakistan have initiated such systems. Labeling systems are usually initiated by companies and are on a voluntary basis (Hilowitz, 1997). The main purpose of labeling is to increase public awareness of the child labor problem. However, certain problems detract from the effectiveness of labeling. These include the credibility of labels, whether labels are being exploited as a marketing tool, channeling of revenues to address the problem, potentials and limits of labeling as a tool in eradicating child labor, and protectionism. International publicity campaigns to increase awareness of child labor problems are effective social actions often organized by nonprofit organizations. The world-wide Global March was formulated by The International Steering Committee of the Global March (ISCGM). The ISCGM consists of an extensive list of international organizations including the African Network for the Prevention and Protection Against Child Abuse and Neglect, Anti-Slavery International (U.K.), Education International (Belgium), and the International Labor Rights Fund (U.S.) (Kochar, 1998). Other sponsors of the March represented a wide spectrum including education organizations (American Federation of Teachers); religious organizations (United Methodist Church); women's groups (Gemal Federation of Women's Clubs); and child labor groups (Child Labor Coalition). The group organizes events, rallies and demonstrations in various parts of the world such as Manila, Rio de Janeiro, Geneva, and California. An on-line march on a number of websites related to child labor will also be organized (National Consumers League, 1998). V.

CONCLUSION

How has globalization affected child labor problems? Insufficient and unreliable data makes it almost impossible to answer this question. Does child labor give less-developed countries a competitive advantage in the international market? A recent OECD study has shown that there is nothing to indicate that countries that have low labor standards achieve better export results globally. In particular, child labor impedes the development of children, both physically and intellectually. Hence, it jeopardizes the future of the economic advantage based on the workforce of that country. Is child labor indispensable to the competitiveness of a country's industry in international commercial markets? The answer is no.

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The claim that child labor is a low-cost, competitive advantage is not substantiated; therefore, the competitiveness of a country's industry in international markets does not have to rely on child labor. In fact, globalization is a vehicle for reducing the incidence of child labor through the economic development opportunities it creates. The existence of child labor does not seem to have a positive influence on a multinational company's decision to invest in a particular country (Kochar, 1998). In the light of recent publicity over the issue, most companies would prefer to avoid countries where child labor exists. REFERENCES Act No. 677/91, 30 May 1991 (1991) 'Amending the Working Environment Act (No. 1160 of 1977),' Svensk forfattningssamling, 677, June 17:115. Ansari, J.A. (1998) 'Government of India - Action Against Child Labor,' http:// www.indiagov.org/social/child/childlabour.htm Anti-Slavery International Website (1998) 'World Trade and Working Children,' http://www.alfea.it/coordns/work/minori/antislavely.html Badiwala, M. (1998) 'Child Labor in India: Causes, Governmental Policies and the Role of Education,' Global March Website: http://Hglobalmarch.org BBC News Website (October 29, 1997) 'Short Kicks off Pakistan Child Labor Project,' http://news.bbc.co.uk BBC News Website (October 30, 1997) 'International Plan to Stop Child Labor,' http://news.bbc.co.uk BBC News Website (January 17, 1998) 'Global March Against Child Labor Begins,' http://news.bbc.co.uk BBC News Website (February 10,1998) 'Children Earn Pittance, Says Survey,' http:/ /news.bbc.co.uk BBC News Website (October 23, 1998) 'UN to Tackle Child Labor in India,' http:// news.bbc.co.uk BBC News Website (January 4, 1999) 'Pakistan's Wall of Silence on Child Abuse,' http://news.bbc.co.uk Brecher, J. and Costello, T. (1998) 'Worksheet: Understanding Globalization,' http://www.inti.be/cesep/isc/phase2/2slen.htm EU Website (1998) 'EU The New Generalized System of Preferences Scheme,' http://www.eunmion.org/legislat/gsp/scheme.htm European Council Regulation, December, 1994. FIET Website (1998) The FIET Commerce Global Child Labor Campaign, Background Document,' http://www.fiet.org/cardiff/comm child labour.htm Fyfe, A. (1989) Child Labor. Polity Press. Fyfe, A. and Jankanish, M. (1997) Trade Unions and Child Labor: A Guide to Action, Geneva: International Labor Office. Grootaert, C. and Kanbur, R. (1995) 'Child Labor: An Economic Perspective,' International Labor Review, 134(2) :187-203.

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Hilowitz, J. (1997) 'Social Labeling to Combat Child Labor: Some Considerations,' International Labor Review, 136(2) :215-232. Human Rights Watch (1996), 17. ILO Website (1997) 'Combating the Most Intolerable Forms of Child Labor: A Global Challenge,' and 'Workshop No. 2: Globalization, Liberalization and Child Labor,' http://www.ilo.org/public/english/90ii3ec/index.htm ILO Website (1998) 'Consumers and Corporations Combat Child Labor,' http:// www.ilo.org/public/english/90il2ec/intinit/consum.htm Kochar, A. (1998) 'Global March Against Child Labor Launched Today: World's First United Stand to End Exploitation of Children,' http://www.globalmarch-us.orag./Nov2Olau.htm Lee-Wright, P. (1990) Child Slaves, Earthscan Publications, p. 15. Littlefield, D. (1996) 'Attempt to Stop Child Labor Gathers Speed,' Personnel Management, 2(2): 8-9. National Consumers League (1998) 'How to Join the Fight against Child Labor,' http://www.nclnet-org/fightbac.htm PBS News Hour (October 24, 1996) 'Where They Stand,' http://www.pbs.org/newshour PBS News Hour (July 23, 1997) 'Uniting Against Guess,' http://www.pbs.org/newshour PBS News Hour (November 14, 1997) 'Identity Crisis,'http://www.pbs.org/newshour PBS News Hour (January 27, 1998) 'The State of the Union,' http://www.pbs.org/ newshour PBS News Hour (June 17, 1998) 'Saving the Yen,' http://www.pbs.org/newshour PBS News Hour (January 19, 1999) 'The State of the Union,' http://www.pbs.org/ newshour PBS News Hour (April 16, 1999) 'China's Business,' http://www.pbs.org/newshour PBS News Hour (December 1, 1999a) 'Clinton Addresses the WTO,' http:// www.pbs.org/newshour PBS News Hour (December 1, 1999b) 'China, Trade and Democracy,' http:// www.pbs.org/newshour PBS News Hour (December 2, 1999a) 'International Views,' http://www.pbs.org/ newshour Save the Children Press Office (1997) 'How to Phase out Child Labor in Football Production Without Driving Children into Poverty,' http://www.oneworld.org/ textver/scf/press/febl397.html United States Congress, 104th Congress, Session 1 (1995) 'Child Labor Deterrence Act of 1995,' http://www.digitalrag.com/iqbal/help/s7O6/pagel.html United States Department of Labor (1994) By the Sweat and Toil of Children: The Use of Child Labor in American Imports. White House, Office of the Press Secretary (April 14, 1997) 'Sweatshop Labor: Remarks by the President at Apparel Industry Partnership Event,' http:// www. pbs. org/ newshour

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ADDITIONAL READING: Amsterdam Child Labor Conference (January 1997). http://www.ilo.org/public/ english/90ipec/intinit/consum.htm BBC News Website (February 13, 1998). 'Child Workers Bill Likely to Fail,' http:// news.bbc.co.uk China Labor Newspaper (January 11, 1994). 'Regulations Concerning Minimum Wages in Enterprises Dated November 24, 1993,' p. 2. ILO (1998) 'Child Labor: Targeting the Intolerable,' International Labor Conference 86th session 1996 Report (VI) 1. ILO Website (1996) 'Child Labor: Action Required at the National Level,' http:// www.ilo.org/public/english/23512ress/pkits/child2.htm ILO Website (1998) 'The Demand for Child Labor,' http://www.ilo.org/public/ english/90ii3ec/index.htm ILO Website (1998) 'How Globalization Affects Child Labor,' http://www.ilo.oria/ public/english/90ipec/factsh/fs96 22.htm ILO Website (1998) 'The Social Dimension of the Liberalization of International Trade,' http://www.ilo.org/public/english/60empfor/cdart/pub3.htm Mendelievich, E. (1997) Children at Work, Geneva: International Labor Office. PBS News Hour (December 2, 1999b) 'Colliding Worlds,' http://www.pbs.org/newshour PBS News Hour (December 6, 1999) 'Colliding Worlds,' http://www.pbs.org/newshour

NOTE 1.

The authors acknowledge the contributions of J. Jeanneret, J. Wong, M. Tan, Z. Ibrahim and W. Ng for their assistance with library research.

Part 111 Economic Development and International Trade

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Part III: Economic Development And International Trade For many decades, economic development has been one of the most frequently studied components of the global economy. The trend will continue well into the new millennium. In fact, the situation will remain so, as long as there is wide disparity of the level of development among different countries of the world. It is often argued that for many developing countries international trade is an engine of economic development - and therefore, the surest, if not the only, way out of their current quagmire. The three studies presented in Part Three provide different perspectives of some of the issues involved in, and the relationship between, economic development and international trade. In Chapter Seven, Professor Terutomo Ozawa examines the concept of economic development based on borrowing in foreign markets. He maintains that "any rapidly catching-up economy experiences a growing deficit in its early stages of growth as it necessarily draws on outside sources ... such a deficit needs to be financed by external borrowing. Thus borrowed growth is the new reality of economic development." Professor Ozawa further argues that "this modality [of growth] is, however, a two-edged sword, since it leads to both super-growth and super-crisis in tandem unless otherwise managed. A ballooning current account deficit, an indicator of borrowed growth, is the Achilles' heel for outer-dependent catching-up countries." Professor Ozawa then examines the experience of East Asia in the late 1990s in light of the above concept. Professors Hubert Gabrisch and Maria-Luigia Segnana examine trade liberalization and structural adjustment in transitional economies in Chapter Eight. The specific objective of their study is "to examine whether trade liberalization ... supports the necessary structural change in the transitional economies that wish to join the European Union." They also "provide some empirical findings on the relationship between trade liberalization and convergence/ divergence of economic structure" in transitional economies. Professors Gabrisch and Segnana argue that "convergence is a 93

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necessary prerequisite for reaping over the long haul the benefits potentially accruing from EU membership for all partners involved." They conclude that to make it possible for the firms from transitional economies to compete effectively with those in Western Europe, "EU's accession ... "must therefore trigger such convergence." In Chapter Nine, Professors Lorene Hiris and Debashis Guha present their work on developing a leading indicator for forecasting trade flows. They maintain that "the acceleration in the growth of world trade has caused policymakers and market participants to increasingly focus on the contribution of exports and imports to total output." They then use "the United States and the United Kingdom as examples, ... offer a leading indicator model, ... [to] successfully forecast a country's balance of trade in goods and services."

7

Borrowed Growth: Current-account Deficit-based Development Finance TERUTOMO OZAWA

I.

INTRODUCTION

A rapidly growing economy tends to encounter a situation in which internal saving is exceeded by domestic investment. How to cope with this deficiency of savings is a critical issue in formulating an effective strategy of economic growth. Any open-economy that invests more than it saves at home will end up with a familiar Keynesian disequilibrium in which the current account (CA) becomes negative (i.e., CA = S - I, assuming G - T). And this CA deficit needs to be financed by capital inflows (external borrowing), since CA necessarily equals capital account. In other words, rapid growth is financed by a surplus on capital account or a net capital (foreign savings) inflow. This type of CA deficit-based development finance may be called "borrowed growth". Borrowed growth is a double-edged sword for developing countries in particular. Helped by capital inflows, "input-driven" industrialization a la Krugman (1994) is made possible and, indeed, accelerated—and results in a miraculous economic growth. At the same time, however, once foreign investors sense some danger of weakness in the developing country's performance, a herd mentality takes over, causing an abrupt and exaggerated reversal in capital flows. All this leads to the familiar pattern of "manias, panics and crashes" a la Charles Kindleberger (1996). The upshot is a currency crisis and a resultant financial debacle. The "East Asian miracle" (World Bank, 1993) and what may be called the "East Asian debacle", which have both recently occurred in tandem, are nothing but the results of excessive debts created through the liberalized financial 95

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markets by way of CA deficits. This exaggerated swing from miracle to debacle represents the perils of borrowed growth. Indeed, a string of the recent currency and financial crises in Mexico, East Asia, Russia, and Brazil have occurred because of the mismanagement (or "non-management") of borrowed growth—and were aggravated by inappropriate policy responses. In addition, some advanced and mature economies also experience the similar phenomenon of borrowed growth, as will be explained below. The purpose of this chapter is first to conceptually explore the "business-cycle-magnification" effect of the CA-deficit-based finance of economic growth—that is, the danger of "externally originated (via capital account) BOP imbalance", and then to examine the implications of this phenomenon for the recent Asian experience of "boom and bust—and quick rebound" and America's longest boom with its record high CA deficit. The paradox of "CA deficit but strong currency" for the U.S. economy is noted and explained by a role reversal between the CA and the capital account with respect to their autonomous versus accommodating characteristics. II.

STAGES OF ECONOMIC GROWTH AND CA DEFICITS

Borrowed growth, which occurs in developing and advanced countries alike, can best be understood in terms of the stages theory of balance of payments. For developing countries, borrowed growth is predicated as an ineluctable feature of their outer-dependent development strategy in the "stages theory of the balance of payments (BOP)" (Kindleberger, 1963). Rapidly growing developing countries are likely to experience CA deficits, whereas those countries which have succeeded in building a strong industrial base start to run CA surpluses. On the other hand, once a country becomes fully developed and mature, it is prone to have CA deficits. Since one country's CA deficit is necessarily some other country's (or countries') CA surplus, a group of deficit countries is necessarily matched by a group of surplus countries in balancing out each other's CA in the world as a whole.1 As a country develops over time, it usually goes through the six sequential stages of external financial relations: (1) "immature debtor-borrower", (2) "mature debtor-borrower", (3) "debtorlender and debtor-repayer", (4) "immature creditor-lender", and (5) "mature creditor-lender", and finally, (6) "creditor-drawer and borrower" (Halevi, 1971). Along these stages, the CA initially deepens in deficit but gradually improves, eventually resulting in a

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surplus; it thereby traces out a J-shaped (stretched-out) curve during the course of economic development. In other words, when at the start of economic development, an economy opens up for international trade and investment, its CA registers a growing deficit, especially if left to free market forces without restrictions on cross-border transactions. This is rather an inevitable consequence of a successful take-off to sustained growth. Advanced capital goods, technologies, services, and hithertounavailable consumer goods are necessarily all imported from the advanced world to modernize the country's industrial base and market demand conditions. Whatever it can produce (normally natural resources/primary goods) is exported but this is not sufficient to cover the value of imports. Hence, the resultant CA deficit needs to be financed by borrowings from abroad. As the economy succeeds in industrialization, however, this deficit is eventually reversed and usually turned into a surplus. Stated in terms of the stages theory of BOP, the above-described situation matches the first two stages of "debtor-borrower" (the bottom initial segment of the J-shaped curve). These early stages represent the most critical (danger-laden) period for a rapidly catching-up economy, since its rising CA deficits require more and more foreign borrowings unless otherwise controlled—and plunging deeper and deeper into debts with rapidly ballooning investment income payments. This tendency is all the more pronounced if exchange rates are fixed, since domestic borrowers are falsely assured that their debts specified in foreign currency are the same as home-currency debts. Yet a devaluation of home currency, which may be triggered by sudden capital withdrawals by foreign investors, would wreak havoc to the debtors. This period can, therefore, be identified as the "perilous CA deficit phase". On the other hand, the subsequent two stages of "creditorlender" are accompanied by CA surpluses, the phase that can be identified as the "robust CA surplus phase". Those countries that reach this phase have successfully entered, or are at the height of, their industrialization drive in which the "secondary" sector (manufacturing and construction) a la Colin Clark (1935) plays the dominant role as an engine of growth—and the "primary" and the "tertiary" (service) sectors the supporting roles. They are specialized in "making things" and their rising national incomes derive mostly from manufacturing goods and exporting them. Their technological progress is focused on product development and production processes. Export and domestic output in manufacturing are

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mutually reinforcing, making the logic of cumulative causation (or "virtuous cycle") work (Kaldor, 1985; Eatwell, 1982; Cantwell, 1987). Finally, the last stage of "creditor-drawer and borrower" may be labeled as the "mature CA deficit phase". There are basically two types of advanced countries which are in this phase: one is those mature economies which are living off their past investments abroad and/ or are capable of borrowing because they have high credit-rating and offer good attractions as hosts for multinational corporations' operations and as financial markets for foreign investors. The other type is those advanced countries which enjoy the privilege of having their currencies used as international reserves by other countries; hence they are able to reap seigniorage. In other words, they can keep running CA deficits by exporting their own currencies so long as the rest of the world is willing to hold their currencies as assets. These two types are not meant to be exclusive of each other; their characteristics combine to create a situation in which an advanced country experiences a prolonged period of borrowed growth. In what follows, the perilous CA deficit phase will first be examined. How a rapidly catching-up economy manages this particular phase is a critical issue in this age of liberalized capital movements. Policymakers in those afflicted economies have failed to control the composition of capital inflows (foreign direct investment, bank loans, portfolio investment, and speculative investment) during the borrowed-growth period. Conventional IMF-sanctioned macroeconomic stabilization measures are designed to solve internally caused CA imbalances. They are not equipped for specifically dealing with flows of hot global money. III. THE FINANCIAL AND THE INDUSTRIAL SECTORS: INTERACTION

CA and capital account represent the two external sectors of an open economy, the former the "industrial/real" sector and the latter the "financial/money" sector. They interact closely in economic development and growth. Industrial-sector transactions require money-sector transactions for finance and settlement of trade accounts, but the financial sector often becomes autonomous (no longer accommodating) in this age of hot capital flows, compelling CA to accommodate. In this connection, the so-called intertemporal theory of production and trade a la Fisher (Fisher, 1930; Krugman and Obstfeld, 1997), which has been developed within the framework

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of conventional neoclassical trade theory (typically presented in terms of a production transformation curve and indifference curves), provides a good starting point in analyzing the interface between the industrial and the financial sectors. This intertemporal theory predicts that any rapidly developing country is likely to import "present spending or purchasing power" (investment goods for domestic capital formation) by exporting "future spending or purchasing power". This means a low relative price of future spending (namely a high relative price of present spending), which indicates a high rate of interest, since highly productive investment opportunities exist. Thus, such a developing country has an intertemporal comparative advantage in present spending; it borrows from overseas to finance productive investment opportunities. In other words, cross-border finance satisfies the needs of its industrial sector. Consequently, domestic capital formation takes place through a CA deficit. This model of intertemporal comparative advantage describes an ideal growth situation with BOP equilibrium over time—ideal, especially if all imports are only investment goods. The financial side of trade equilibrium is satisfied by capital inflows which foreign investors are willing to provide. And what is borrowed today will be paid back out of what it can produce in the future. There is no BOP problem in the long run. The reality, however, is more complicated, of course. What is borrowed (today's debt) may not be used to build up a country's productive capacity. If it is squandered for consumption alone (instead of investment), the country will not be able to pay off debt out of future output. A currency and financial crisis will then ensure. This illustrates how important it is to manage capitalaccount transactions judiciously and to use borrowed capital for productive domestic investments. The financial sector (via the capital account) inevitably interacts with the industrial sector in economic development and growth. In short, an open economy (S = I + CA) thus has a higher degree of freedom in development finance than a closed economy (S = I), because the former can avail itself of its external balance (CA). For a closed economy, domestic savings are the only source of finance, and if domestic savings are not sufficient, it is constrained from growth. But for an open economy, if domestic savings are not sufficient to finance the desired capital formation, it can borrow foreign savings via a CA deficit. In this situation, CA transactions are autonomous—or masters, so to speak—while capital-account transactions

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are accommodating—or servants. But CA-deficit-based finance is accompanied by high risks of excessive capital inflows. For example, it may so happen that unfettered capital inflows are so large that a recipient developing country subsequently ends up with an even larger CA deficit. A sudden surge in capital inflows may not be properly channeled into productive capital formation, spilling into unproductive, purely speculative types of investment and into a greater CA deficit. The domestic need for capital formation thus may be overwhelmed by unnecessary huge capital inflows. In other words, a role reversal occurs: capital-account transactions become masters, whereas CA transactions become servants. Moreover, in the context of an open economy with unfettered capital flows across borders, the rapid growth stage exposes a developing country to the forces of "cumulative causation" (both upward and downward) which are generated in both the industrial and the financial sectors simultaneously. These forces cause both "supergrowth" and "super-crisis" (or a magnified boom-and-bust cycle) in the following scenario: (a) High domestic investment (accompanied by high saving) —> (b) high growth -> (c) capital inflows —> (d) growth acceleration or super-growth —» (e) more capital inflows (which mean a growing CA deficit) —> (f) a danger of inflation (due to a rise in money supply caused by capital inflows) and diminished investment opportunities in the industrial/real sector —» (g) speculative and excessive investment in the "financial/money-and-quasi-money sector" (i.e., securities, and real estate) —> (h) signs of a collapse (busting) of a boom (bubble) —> (i) defaults on domestic debts —> (j) a quick exit of hot global money —> (k) depletion of official reserves —» (1) currency crisis (home currency meltdown) —> (m) defaults on foreign debts —> (n) financial/banking crisis —> super-crisis. The boom (super-growth) period is thus covered by the first-half sequence of (a) through (g), while the bust (super-crisis) is represented by the second-half sequence of (h) through (n). The whole sequence involves interactions (initially complementary/ augmenting but later deleterious/subversive) between the industrial and the financial sectors. IV.

CAPITAL ACCOUNT: TYPES OF CAPITAL FLOWS

Foreign (private) capital inflows comprise three major types: (1) foreign direct investment (FDI) by multinational corporations, (2) portfolio investment by securities firms and investment funds, and

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(3) bank loans. FDI is the most stable type, and not so easily reversible. It involves not only financial capital but also—and more importantly—human capital (industrial knowledge) and physical capital (machinery, equipment, and intermediate inputs). Portfolio investment is speculative by nature, consequently footloose and susceptible to herd mentality. It is a source of instability, since it is easily "cashable" and instantly reversible (Gray, 1999). In fact, it is portfolio investments (including currency speculations) that trigger a crisis when they are suddenly withdrawn from the host financial markets. But they are also the ones that come back quickly, as soon as the host countries show some promising signs of economic recovery, thereby assisting a rebound in the local financial markets. Thus, they are ironically both crisis-triggering and rebound-assisting. In contrast, although short-term in nature, bank loans are relatively stable. However, they tend to be overextended in good times, especially under the moral hazard of bailout by both the debtor nation's central bank and the IMF. They are also slow in returning to (overwithdrawn from) the once-afflicted emerging markets even when the latter show signs of recovery.2 It is now widely recognized that FDI is the type of capital inflow that is desirable for developing host countries, since FDI brings advanced technology, long-term capital, managerial/organizational knowledge, and access to export markets. It is generally posited that an appropriate sequence of capital inflows into a developing country is to liberalize long-term capital inflows (particularly FDI) ahead of short-capital inflows (Eichengreen et al, 1999). And there is an increasing opinion that short-capital inflows, especially hot speculative money in the foreign exchange markets, need to be controlled. V. TWO GENRES OF BOP IMBALANCES: CONVENTIONAL VS. NEW

As mentioned, there has recently been a role reversal between CA transactions and capital-account transactions. The former used to be masters, and the latter servants. When the Bretton Woods system of pegged exchange rates operated with discretionary controls on short-term capital flows and foreign exchange over the 1950-71 period, CA transactions used to be the primary /autonomous part of international economic activities, whereas their capital-account counterparts played the secondary /accommodating role by financing CA activities (Meade, 1951). In those days, CA deficits, when they appeared, were the result of the internal disequilibrium caused by

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excessive domestic demand over real domestic output, as best stipulated in the Keynesian "absorption" theory of BOP (Alexander, 1953). Hence, to correct a serious CA deficit, which is regarded as the result of a country "living beyond its means" (since CA = Y- [C + I +G]), tight macroeconomic policies (monetary and fiscal) are called for and applied to reduce domestic expenditure. The only way for an economy to grow was then to raise domestic savings to finance investment. Under the Bretton Woods system, the BOP served as a guidepost for macroeconomic stabilization. Those countries that could not manage had to seek a bailout from the IMF. The IMF, however, imposed its conditionalities or austerity program on the borrowing governments to solve internal disequilibrium (excessive spending). The governments then had to implement IMF-imposed deflationary policies (to force the country to live "within its means"). If such an austerity program was judged unworkable, the IMF allowed a devaluation of currency in the name of "fundamental disequilibrium". These IMF prescriptions—the austerity program and devaluation—were appropriate and effective to deal with internally originated (via CA) BOP crises, since capital flows (capital-account transactions) were controlled. With liberalization of cross-border capital movements and rising liquidity in the global economy, however, the whole situation began to change. Capital-account transactions have grown larger in volume, as a more autonomous type of capital flows (especially, hot money) rose in importance, overwhelming CA transactions.3 In this type of situation, short-term capital flows (portfolio investments and bank loans) become autonomous in nature—and no longer accommodating in the traditional sense. When a country is flooded with capital inflows (hence with a huge surplus on its capital account), the country is compelled either to let its currency appreciate or to inflate its economy (if exchange rates are fixed). This expansionary pressure created by imported liquidity in turn causes CA deficits for the very purpose of relieving such pressure via imports. In other words, even if the country runs a rising external deficit, it is still possible that its currency keeps appreciating. This phenomenon may be called the "CA deficit but strong currency" paradox.4 This type of CA deficit is externally originated (via capital account) BOP imbalance where the capital account becomes a master (and the CA a servant), an imbalance which is diametrically opposite to the internally originated (via CA) BOP imbalance where the CA is a master (and the capital account remains a servant). In fact, therein lies the very danger of CA-deficit-based finance (Ozawa, 1998).

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The IMF has recently been criticized for its continued imposition of the outdated austerity programs on the bailed-out Asian governments. Those beleaguered Asian countries had been maintaining fundamentally sound macroeconomic conditions: relatively wellbalanced budgets, stable money supply, and price stability. In the case of the Asian crisis, those debtors who misused borrowed money (denominated in foreign exchange) were mostly the private banks, which in turn lent to domestic firms in local currency. Hence, when conventional IMF prescriptions were applied, things were made worse. The bailed-out economies were driven into a severe recession, with super-high interest rates and tight fiscal conditions. Consequently, businesses collapsed, causing even more bad loans— thus aggravating the banking crisis. Banks contracted loans and precipitated a serious credit crunch. In short, the conventional IMF remedies that were once developed to cope with internally originated BOP imbalances proved to be not a medicine but rather a poison for those countries with externally originated BOP imbalances.0 VI.

THE ASIAN EXPERIENCE

How effectively have the East Asian countries managed the perils of borrowed growth? First of all, Japan was lucky, since its catch-up growth occurred during the period of the original IMF regime of fixed exchange rates with officially sanctioned foreign exchange controls. In order to maintain an official exchange rate (Y360 to the U.S. dollar), the Japanese government pursued a BOP-guided monetary policy for growth. Exports were initially encouraged so as to earn as much foreign exchange as possible and build up official reserves. Economic development was promoted so long as its deficitcreating effect on the BOP remained manageable. But, once the BOP started to show a deficit which could no longer be financed by foreign reserves, tight monetary policy was immediately applied to slow down the pace of economic growth (to reduce imports) and promote exports. As soon as the BOP conditions improved, however, Japan quickly returned to expansionary monetary policy and resumed high growth.6 This "stop and go" cycle was then repeated many times until Japan escaped from the perilous CAdeficit phase and moved into the robust CA-surplus phase. Since in those days capital-account transactions were closely controlled, the BOP imbalances Japan faced were only of the internally originated type. Japan was protected by the legitimate capital

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controls under the IMF system. Its financial sector, particularly the banking industry, was strategically used as a vital instrument of high catch-up growth. Japan adopted what may be called "bank-loan capitalism" in which "central-bank-based finance of development" was actively used for the purpose of avoiding external dependence— that is, instead of CA-deficit-based finance (Ozawa, 1999a). In other words, Japan's catch-up industrial strategy was institutionally protected; in effect, it enjoyed an "infant BOP protection", so to speak—thanks to the original IMF system which gave immunity to Japan's capital and foreign exchange controls.7 Japan escaped from the dangers of externally originated BOP imbalances. Not only did Japan minimize external borrowing but it discouraged inward FDI. Japan, however, eagerly purchased technology via licensing agreements from the West, thereby acquiring the technological assets of advanced Western multinationals in an unbundled fashion (Ozawa, 1974). Licensing served as an effective substitute for inward FDI, since Japan had a well-developed absorptive capacity for foreign technology. (Actually this was another form of "borrowed growth" in the industrial/real sector.) When Japan finally began to liberalize capital-account transactions in the early 1980s, it was already structurally developed enough to withstand any major currency fluctuations under managed float. Short-term capital flows were then liberalized without disrupting the real sector. Although the Japanese experience is peculiar to the postwar economic environment and perhaps not comparable with the present-day situation, one fundamental fact still holds. Japan's conservative approach to CA management is perhaps something developing countries should pay attention to. In this respect, China's gingerly approach to CA management and capital-account liberalization is in line with, and comes closest to, the Japanese model. Even a neoliberal mainstream economist, Paul Krugman (1998) approvingly notes: "Why hasn't China been nearly so badly hit as its neighbors? Because it has been able to cut, not raise, interest rates in this crisis, despite maintaining a fixed exchange rate; and the reason it is able to do that is that it has an inconvertible currency, a.k.a. exchange controls. Those controls are often evaded, and they are the source of lots of corruption, but they still give China a degree of policy leeway that the rest of Asia desperately wishes it had."

Moreover, China has been steadily accumulating CA surpluses since the start of the 1990s (except for 1993 when it temporarily registered a deficit of $11.9 billion). Its official reserves stood at $150 billion at the end of 1998 (Economic Planning Agency, 1999).

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Taiwan's fiscal conservatism is likewise an approach akin to the Japanese strategy. Taiwan is managing the stability of its New Taiwan dollar effectively at both economy and company levels. Its CA has long been in the black. When exports dropped, it introduced temporary exchange controls such as a ban on Taiwanese firms' nondelivery forward contracts and a reporting requirement of foreignexchange remittances in excess of US$1 million and certain forward trades of US$5 million or more to the central bank, all designed to discourage speculation. Taiwanese business owners are traditionally conservative in corporate finance, in that many are owned by families, and external borrowing is normally kept to a minimum. Their leading firms have had very low debt-to-equity ratios in the neighborhood of 30%. More importantly, Taiwan has been running solid CA surpluses ever since the start of the 1980s (in 1996, for example, its CA surplus amounted to US$110.3 billion or 4.0% of GDP). Singapore has been similar in its CA management. It has been running CA surpluses throughout the 1990s, with $14.6 billion both in!966 and 1997. The Hong Kong government, too, has been maintaining its currency-board-fixed exchange rate of HK$7.8 to the U.S. dollar; in August 1998, it even supported local stock prices by investing $15.2 billion in Hong Kong's 33 biggest companies to fend off currency speculators (Mungan, 1998). In contrast, all those troubled economies in Asia exhibit two characteristics which are the opposite of the approaches taken by Japan, China, Taiwan, Singapore, and Hong Kong. They all have become hooked to footloose global money because they allowed borrowed growth to take its own course by (1) permitting unfavorable CA conditions to develop and (2) prematurely liberalizing capitalaccount transactions. Thailand, where the Asian crisis originated, had continually been running CA deficits since the mid-1960s (except in 1986 when it recorded a small 247 million surplus). Its CA deficit hovered around 8% of GDP prior to the crisis. In 1987, Thailand began a series of deregulation on interest rates and banking transactions and opened Bangkok International Banking Facilities (BIBF), which served as a duct for capital inflows when rising local interest rates widened the rate differential vis-d-vis the outside world. Borrowed money from overseas was then poured by poorly supervised and inexperienced local bankers into speculative real estate and stock markets, eventually culminating in a boom-and-bust cycle. Indonesia and Malaysia were likewise caught in the trap of the perilous CA-deficit phase (Indonesia from a $1.9 billion deficit in 1985 to a $7.8 billion deficit in 1996; Malaysia from a $613 million

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deficit in 1985 to a $4.9 billion deficit in 1996). Both instituted swift capital liberalization, which made them dependent on ("addicted to") foreign capital. Indonesia's financial liberalization measures introduced in 1983 and 1988 had resulted in large interest differentials (5-10%), causing rapid capital inflows. Korea had closely followed the footsteps of Japan's self-reliant financial approach to industrialization until the late 1980s when it experienced a ballooning CA deficit. In fact, it once used centralbank-based development finance via "policy loans" in a more topdown and micro-managed fashion (Ozawa, 1999b). To finance the deficits, the Korean government then began to take advantage of the favorable climate in international credit markets instead of drawing down foreign reserves. Capital-account liberalization was implemented in the latter half of the 1980s to prepare for the opening of capital markets in the early 1990s (Park, 1994). Until the recent currency crisis in November 1997, Korea had been able to maintain a stable market exchange rate tied to the U.S. dollar, although its real exchange rate remained appreciated (i.e., overvalued) for political reasons (Lee, 1998). Chaebols competed with each other in expanding industrial capacities through borrowing of foreign short-term capital. Overcapacity, an export-market slump (hence, a high CA deficit), and the rising short-term debt-foreign reserves ratio, and recession-caused business bankruptcies in the late 1990s all coalesced into an inevitable condition for a currency and financial crisis which occurred in November 1997. It is clear that those Asian countries that fell victim to the financial crisis were all trapped in the snare of "externally originated BOPimbalance", as they prematurely liberalized their financial markets— prematurely since they were not ready to deal with massive inflows of short-term capital. These excessive short-term capital inflows contributed to the business cycle magnification, creating a fragile boom destined for its eventual bust; hence they were not really needed for a healthy economic expansion. In fact, some argue that high saving rates at home alone were sufficient to finance respectable rates of economic growth without borrowing foreign savings through CA deficits. For example, a study made by the Nomura Research Institute (Kan, 1999) demonstrates that during the period 1991-96, even without external borrowings, Thailand could have grown at an annual rate of 6.7% (instead of 8.2%), Malaysia at 7.5% (instead of 9.0%), Indonesia at 7.5% (instead of 7.8%), the Philippines at 2.4% (instead of 2.8%), South Korea at 7.1% (instead of 7.4%), and China at 11.7% (instead of 11.5%) (see Table 7.1).

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TABLE 7.1 Growth Rates Without Capital Inflows (Foreign Savings) 1991-96

ASEAN Thailand Malaysia Indonesia Philippines South Korea China

S: Saving1 F: Capital I: Investment 1 = S+F (domestic) inflow1

34.9 35.0 32.1 19.0 35.4 40.1

7.7 6.5 2.6 3.2 1.5

-1.0

42.6 41.5 34.7 22.2 36.9 39.2

G: Growth rate1

IGOR2 = I/G

S-based growth rate = S/ICOR

8.2 9.0

5.2 4.6 4.4

6.7

7.8 2.8 7.4

11.5

8.1 5.0 3.4

7.5 7.2 2.4 7.1

11.7

1

As percentage of GDP ~ IGOR: Incremental capital-output ratio. Source: A study made by the Nomura Research Institute cited by Kan (1999), p. 17.

This hypothetical case, however, assumes that all domestic savings—and they alone—are channeled into domestic capital formation without any CA deficit (or surplus), namely a balanced CA. The assumption of a balanced CA means, however, that a developing country is restricted from importing all the necessary capital goods (including modern technology) for fast catch-up growth and therefore, it may not be able to grow at such a brisk rate—that is to say, incremental capital-output ratio (IGOR) will increase under import restrictions. Nevertheless, the study does point to rather small net contributions of capital inflows to total growth in those high-saving countries when the risks of externally caused BOP imbalances are taken into account. VII. AMERICA'S BORROWED GROWTH

The unprecedented 9-year expansion of the U.S. economy is increasingly linked with a bull market in stocks. An economic expansion means continuous upward pressures on national income, which equals to output, Q, times price, P, in a macroeconomic framework. So far (as of this writing), inflationary pressures have luckily been contained, although the labor market is considerably strained with an ever- rising shortage of skilled workers, and oil prices have shot up considerably. Expansionary forces are more and more generated by what Alan Greenspan calls "the wealth-induced excess of demand"8 (i.e., demand created by rising stock prices, which make people feel richer and hence spend). And this "excess" demand is spilling into a record CA deficit, which is estimated at around $300 billion in 1999.

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Thus, America is clearly in a mode of borrowed growth, in the sense that it enjoys CA-deficit-financed growth. But, the U.S. has many unique features as a deficit country. First of all, it is not so much U.S. borrowers but foreign investors that bring money to its capital markets. The U.S. is not really borrowing in order to finance its deficit—that is, a situation of internally originated (via CA) BOP imbalance, but rather it is freely accepting capital inflows that fuel its boom, thereby resulting in a CA deficit—that is, a situation of externally originated (via capital account) BOP imbalance. Moreover, the U.S. dollar is currently the world's dominant (most eagerly accepted) currency, allowing a high level of tolerance for a CA deficit without weakening its value. Hence the paradox of "CA deficit but strong currency" applies to the U.S. economy. In addition to its external debt, already amounting to $1.5 trillion, the private sector of the U.S. economy borrows heavily internally as well. At the end of the third quarter of 1999, for example, the debts of corporations and households stood at $4.2 trillion (46% of GDP) and $6.3 trillion (69% of GDP), respectively (totaling 115% of GDP).9 Especially worrisome is the buildup of household debt in the form of margin debt, which at New York Stock Exchange member firms alone shot up 25% to $229 billion in the last two months of 1999.10 In addition to using borrowed money to make investments in such new areas as Internet-related, e-commercerelated fields, corporations thus also borrow to buy more stocks, further driving up stock prices. The U.S. economic expansion is thus sitting on two time bombs—external and internal debts. This debt-driven boom, notably since late 1997, can be summarized in the following way: Capital inflows (after the Asian crisis) —> continuation of a bull stock market —> more internal borrowings —» further rises in stock prices —> wealth-driven consumption —> more investment (especially combined with the Internet Revolution) —> upward pressures on national income —> greater CA deficits —> price-pressure moderation due to rising imports —> interest rate pressure moderation —> a greater stock market boom —> continuous capital inflows —» a strong dollar (especially against the Euro) —> the "CA deficit but strong currency" paradox. In the fourth quarter of 1999, the U.S. CA deficit reportedly reached a record 4% of GDP as a result of its strong growth rate of 5.8%. This high-strung borrowed growth may no longer be classified merely as "mature" CA-deficit-based finance; it is perhaps becoming more of the "perilous" type. The global financial markets may begin to question the capacity of the U.S. to finance its rising

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external debt and the wisdom of its soaring internal debt, particularly margin debt—now that the Asian crisis is over, offering increasingly attractive returns on investment relative to those already overvalued ones in the United States. Any sudden withdrawal of investments from the U.S. will lead to a rough landing of the stock market boom. Indeed, the next debt crisis may occur in the U.S., as some warn.11 VIII. CONCLUSIONS An open economy (with a macroeconomic constraint: S = I + CA) certainly has a higher degree of freedom in financing its economic growth than a closed (autarkic) economy (S = I). The former can make use of foreign savings in addition to domestic savings through a CA deficit, whereas a closed economy's source of funds is restricted to its own savings. Thus, the availability of foreign savings (i.e., investible capital) through a CA deficit makes an open economy grow much faster without creating upward pressures on prices, since imports of goods and services in excess of exports provide a net increase in aggregate supply at home. Particularly when imports are centered on capital goods, they directly add to domestic capital formation—that is, a buildup in the country's productive capacity. No country can keep running CA deficits forever, however, since the deficits need to be financed by external borrowings. So far as a rapidly catching-up country is concerned, however, the Kindleberger-Halevi stages theory of BOP predicts that its deficit condition will be automatically managed over time and turned into a surplus once the country succeeds in industrialization and structural upgrading by exploiting dynamic comparative advantages. What is envisaged is a success case of borrowed growth—and this is consistent with the long-term equilibrium model of intertemporal trade. The developing country initially imports current spending (i.e., borrowing to build up its productive capacity) in exchange for future spending (repaying in terms of exporting at a later date). Initial deficits are thus canceled out (paid off) by eventual surpluses over time. It should be noted, however, that in this age of financial globalization, hot money flows are rampant across borders. This increases the risks of over-expansion (super-growth) and over-contraction (super-crisis). The perilous CA-deficit phase is rendered all the more treacherous, as the phenomenon of an internally originated

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CA deficit changes to that of an externally originated CA deficit. This was indeed the case of the recent Asian crisis. The well macromanaged economies (stable prices, small government deficits, and high growth rates) of Thailand, Indonesia, Malaysia, the Philippines, and South Korea all fell into the trap of an externally originated CA deficit. Initially, inflows of hot money (a surplus on capital account) stimulated speculative investments and created a boom, but it soon aggravated CA deficits and cast doubt on the sustainability of pegged exchange rates, eventually inducing foreign speculators to bet on devaluation of the Asian currencies and foreign investors to pull out money. All this culminated in a sudden currency crisis and the resultant financial (banking) and economic collapse. Similarly, America may be entrapping itself into a hazardous mode of CA-deficit-based finance by running an ever-widening external deficit. One may argue that the U.S. situation is distinct and less perilous, since its external debt is denominated in its own currency, the U.S. dollar, unlike the crisis-hit Asian countries which borrowed in foreign currencies; besides the dollar reins supreme as the most widely accepted international currency. But U.S. external debt ($1.5 trillion) is compounded by an even larger internal debt (at least $11 trillion). Both debts are basically supported by lenders' expectations about U.S. stock prices. Indeed, America's borrowed growth (or better still "borrowed prosperity") may be in a "perilous" phase of expansion. REFERENCES Alexander, S. (1953) 'Effects of a Devaluation on a Trade Balance,' IMF Staff Papers, II(April): 263-278. Cantwell, J.A. (1987) 'The Reorganization of European Industries After Integration: Selected Evidence on the Role of Transnational Enterprise Activities,' Journal of Common Market Studies, 26:127-152. Clark, C. (1935) The Conditions of Economic Progress. London: Macmillan. Eatwell, J. (1982) Whatever Happened to Britain'? The Economics of Decline, London: Duckworth. Economic Planning Agency (Japan) (1999) Azia Keizai 1999 [Asian Economy 1999], Tokyo: Finance Ministry Printing Office. Economist (2000) 'A Tale of Two Debtors,'January 22, 2000. Economist (2000) 'Debt in Japan and America: Into the Whirlwind,' January 22, 2000. Eichengreen, B., et al. (1999) Liberalizing Capital Movements: Some Analytical Issues, Washington, DC: IMF. Fisher, I. (1930) The Theory of Interest, New York: Macmillan.

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Gray, H.P. (1999) Global Economic Involvement, Copenhagen: Copenhagen Business School Press. Halevi, N. (1971) 'An Empirical Test of the 'Balance of Payments Stages' Hypothesis,' Journal of International Economics, 1:103-117. Kaldor, N. (1985) Economics without Equilibrium, Armonk, New York: M.E Sharpe. Kan, S. (1999) 'Azia Tsuka Kiki to Nihon Keizai eno Eikyo [The Asian Currency Crisis and its Impact on the Japanese Economy],' in Urata, S. and Kinoshita, T. (eds.), Niju Isseiki no Azia. Kasa, K. (1999) Time for a Tobin Tax?,' FRBSFEconomic Letter, 99-12:April 9. Keizai [Twentieth-Century Asian Economy], Tokyo: Toyo Keizai Shimposha: 1-22. Kindleberger, C.P. (1963) International Economics, New York: Irwin. Kindleberger, C.P. (1996) Manias, Panics and Crashes: A History of Financial Crises, third edition, New York: John Wiley. Krugman, P. (1994) The Myth of Asia's Miracle,' Foreign Affairs, 73(6), November:62-93. Krugman, P. (1998) 'Saving Asia: It's Time to Get Radical,' Fortune, Sept:75-80. Krugman, P. and Obstfeld, M. (1997) International Economics, Reading, MA: Addison-Wesley. Lee, Y-S. (1998) 'A Political Economy Analysis of the Korean Economic Crisis,' Journal of Asian Economics, 9(4) :627-636. Meade, J.E. (1951) The Theory of International Economic Policy,' Vol. 1. The Balance of Payments, London: Oxford University Press. Mungan, C. (1998) 'Hong Kong Spent Some $15.2 Billion to Buy Up Stocks,' Wall Street Journal, October 21:A15. Ozawa, T. (1974) Japan's Technological Challenge to the West: Motivation and Accomplishment, 1951-1974, Cambridge, MA: MIT Press. Ozawa, T. (1998) Tandem Growth and Crisis: Did East Asia Emulate Japanese Model of Finance?' Paper presented at the Third South China International Business Symposium, November 23-26, 1998: printed in Antonio, N.S. and Chan, T-S. (eds.), Proceedings, Vol. 1:25-38. Ozawa, T. (1999a) The Rise and Fall of Bank-Loan Capitalism: Institutionally Driven Growth and Crisis in Japan,' Journal of Economic Issues, 33(2), June. Ozawa, T. (1999b) 'Bank-Loan Capitalism and Financial Crisis,' in Rugman, A. and Boyd, G. (eds.), Deepening Integration in the Pacific Economies, Cheltenham: Edward Elgar. Park, Y.C. (1994) 'Korea: Development and Structural Change of the Financial System,' in Patrick, H. and Park, Y.C. (eds.), The Financial Development of Japan, Korea, and Taiwan: Growth, Repression, and Liberalization, New York: Oxford University Press, 325-372. UNCTAD (1998) World Investment Report 1998, New York: UN Publications. Wall Street Journal (1999), 'U.S. Boom: Living on Borrowed Dime?' December 31, 1999: Cl. Wall Street Journal (2000a) 'Stock-Purchase Borrowing Worries Greenspan,' January 27, 2000: A2. Wall Street Journal (2000b) 'Greenspan Warns on Stock-Market Gains,' January 14, 2000: A2.

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Wallich, H.C. and Wallich, M.I. (1976) 'Banking and Finance," in Patrick, H. and Rosovsky, H. (eds.), Asia's New Giant: How theJapanese Economy Works, Washington, DC: Brookings Institution, 249-315. World Bank (1993) The East Asian Miracle: Economic Growth and Public Policy, New York: Oxford University Press. Yoshitomi, M. (1998) Nihon Keizai No Shinjitsu [The Truth about the Japanese Economy], Tokyo: Toyo Keizai Shinposha.

NOTES 1. 2.

3.

4.

5. 6. 7.

8.

This author was reminded of the logic of general equilibrium analysis by H. Peter Gray in private correspondence. These different characteristics are reflected in the coefficient of variation. In general, it is much higher for portfolio investment than for FDI. According to UNCTAD (1998, pp. 14-15), interestingly, bank loans exhibited a much larger volatility coefficient than both FDI and portfolio investment in selected (12) developing countries over the period 1992-97. Most capital flows go through the foreign exchange markets. As Kasa (1999) put it colorfully, "On a typical day in the foreign exchange market roughly $1.5 billion change hands. This means that in less than a week foreign exchange transactions have exceeded the annual value of world trade." When other types of capital flows which are not transacted through the foreign exchange markets (e.g., physical flows of the hard currencies such as the U.S. dollar to be used as a store of value in non-U.S. territories) are included, the volume of capital flows easily exceeds more than seven times the value of trade. During the super-dollar days of the Reagan administration in the early 1980s, Ron Stanfield, a colleague in my economic department asked me a question: "How come the dollar is so strong, though we run a huge trade deficit?" My answer was that capital inflows (capital-account transactions) were overwhelming trade-account transactions, because foreign investors wanted to keep their money in the politically stable and strong U.S. economy. In fact, the Reagan administration said that a strong dollar was a sign of U.S. economic strength. I owe him the above conceptualization of the "CA deficit-strong currency" paradox. This paradox can be best explained in terms of "externally originated BOP imbalances"; massive inflows of foreign capital (and a strong demand for the U.S. dollar abroad) keeps the dollar strong despite America's large CA deficit. A similar view is expressed in Yoshitomi (1998), although this chapter's analyses are different in origin and details. This BOP-guided monetary policy Japan once pursued is well known. For an excellent analysis of it, see Wallich and Wallich (1976). The immunity was certainly meant to be temporary. The IMF kept pressure on Japan to liberalize its financial markets. But Japan had been able to buy time until it entered the robust CA-surplus phase of BOP. As quoted in "Greenspan Warns on Stock-Market Gains," Wall Street Journal, January 14, 2000, A2.

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9.

113

As cited in "U.S. Boom: Living on Borrowed Dime?" Wall Street Journal, December 31, 1999: Cl. 10. This makes the Federal Reserve Board Chairman, Alan Greenspan, worried to such an extent that the Fed may initiate curbs on stock borrowing by raising the 50% margin requirements which has not been changed since 1974. "StockPurchase Borrowing Worries Greenspan," Wall Street Journal, January 27, 2000: A2. 11. See, for example, "A tale of two debtors," and "Debt in Japan and America: Into the whirlwind," Economist, January 22, 2000.

88

Trade Liberalization and Structural Adjustment in Transition Economies: An Empirical Examination1 HUBERT GABRISCH AND MARIA-LUIGIA SEGNANA2

I.

INTRODUCTION

The European Union (EU) has undergone enlargement on many occasions. The one now in progress will involve Transition Economies (TEs) in Central and Eastern Europe whose economic structures differ significantly from those of the countries now belonging to the EU. TEs are burdened with structures inherited from the command economy. They started to compete on international markets with obviously low quality products, low productivity and evident institutional backwardness: disparities which account for their well-known income gap measured in purchasing power parity terms. A major challenge faced by the TEs—according to the majority of economists—is the upgrading of technology in their production process in order to withstand the competition raised by the technologically superior commodities produced by EU firms. Exactly how to trigger this upgrading and catching-up process, however, is a matter of debate. On the one hand, the Washington consensus is for complete trade liberalization, privatization and the removal of any active government (industry or technology) policies that will help to improve skills and technology.3 This strong belief in markets is behind the liberalization of trade between EU and TE and accounts for the weak commitment of TE governments to structural adjustment at the industry or firm level. On the other hand, there are studies on possible market failures or the existence of nonmarkets,4 which may act as a strong barrier against the development 114

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of trade and production structures predicted by free traders. The problem with these studies, however, is the lack of adequate statistical and empirical evidence for their rather theoretical arguments. It is not the intention of this chapter to contribute to the ongoing and somewhat deadlocked theoretical debate on the market failure argument. Rather, the intention is to take an empirical look at trade structures. What is really needed is to show whether TEs have an absolute quality disadvantage. If so, structural policies are needed which resolve the still-open issue of activist governments. Accordingly, this chapter addresses the question by investigating trade structures in the light of different forms of product differentiation: horizontal and vertical. The former generates trade flows of differentiated products of similar quality, the latter differentiated qualities of similar products. The approach is based on theories of intra-industry trade (IIT) and its main components, horizontal and vertical. The increasing importance of vertical trade (VIIT) has led to the development of models for its explanation (Flam and Helpman, 1987; Celi and Smith, 1999) and measurement. The explanation of VIIT rests on factor endowment, technology, pattern of income distribution, quality-based product cycle: all elements different from the equality in relative factor endowments that explains horizontal trade (HUT). From this perspective, we can expect the potential for catching-up not to improve and the adjustment costs for the labor market to be high if trade structures are increasingly based upon vertically differentiated produce. From an empirical point of view, this chapter differs from recent similar studies on EU-TE trade structures (Landesmann and Burgstaller, 1997; Aturupane, Djankov, and Hoekman, 1997; Rosati, 1998; Thorn, 1999) in its (a) clear distinction between liberalized and non-liberalized items in trade,5 and (b) breakdown of trade items whose market position is determined by quality or cost advantages. Aspect (a) may have important consequences for the results of empirical analysis. The unsatisfactory empirical results of recent studies which test intra-industry trade models of EU-TE trade (see Atupurane, Djankov, and Hoekman, 1997, for an example) may be due to the simple fact that liberalized trade is not distinguished from non-liberalized trade. Models of IIT, however, essentially assume free trade, although in reality trade is never completely free, and even less so is EU-TE trade. Aspect (b) reflects an approach recently developed by Aiginger (1997) and used for analysis of German trade, which helps to discriminate between cost and quality

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competition. This is a novelty insofar as this study does not follow the common view in the VIIT literature that price gaps exclusively reflect quality gaps. The chapter is organized as follows: the second section states some stylized facts to describe the emerging pattern of EU-TE trade; the third section presents a tentative interpretation of the results obtained by comparing predictions for HUT and VIIT based on the quality-based product cycle; and the fourth section discusses some policy implications. An Appendix is added in order to explain certain technical aspects of our approach. II. EMERGING PATTERNS IN EU-TE TRADE: SOME STYLIZED FACTS Liberalized and Non-liberalized Trade

In determining the stylized facts of structures of trade between the EU and TEs we have largely followed the traditional methods, identifying the horizontal and vertical components of intra-industry trade (according to Grubel-Lloyd, see annex A) by using relative unit values (RUV). The distinction between liberalized and non-liberalized trade has some influence on the choice of countries and statistical sources. This chapter concentrates on four countries—the Czech Republic, Hungary, Poland, and Slovakia—which were chosen because they were the first countries with which the EU signed the European Agreement (EA). The agreement specified a well-known set of stages and forms of trade liberalization. Since the EAs required a longer period of legislative ratification, their trade chapters came into force earlier (so-called "interim agreements")—in the case of Czechoslovakia, Hungary and Poland, on 1 March 1992. EUROSTAT has published trade data for the years 1993-97, so that there is a 5-year observation period during which it is assumed that firms in these four countries have adjusted in one way or another to the changing institutional framework. The interim agreements (IA) have begun the process of gradual establishment of a free trade area in industrial trade, which should be completed within 10 years or so. Liberalization has been broadly based on a principle of asymmetry of concessions: that is, the Union, as a stronger partner, has started to open its market for many products earlier than the admission country. The symmetry and asymmetry provisions on trade in industrial goods differed according to

Trade Liberalization and Structural Adjustment in Transition Economies

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the commodities concerned: customs duties applicable to some imports to the EU as well as to the TEs have been abolished by the symmetrical implementation of the lAs. However, the cost of hidden protection (for example, certification) imposed by the TE may be included in the price of the item imported from the EU. Other items have been liberalized asymmetrically. The size of these provisions can be obtained from the various annexes and protocols of the EAs. Data is used from the Combined Nomenclature (CN) of EUROSTAT. This method differs from that of most other empirical studies, which select NACE or SITC nomenclature, and it enables the breakdown of product groups according to their degree of liberalization.6 The EA for the above mentioned four countries gives a complete list of eight-digit CN chapters when describing the extent and dynamic of agreed trade liberalization. Because statistical calculation according to our method cannot be performed at the eightdigit level, we have chosen the four-digit one.7 Although none of the TEs under consideration has imposed major quantitative restrictions since applying for EU membership, it is advisable to choose an approach which minimizes the risk of distortions created by protectionism. EUROSTAT reports import value data based on c.i.f. prices and export value data based on f.o.b. prices. In both cases, the official cost of protection (import tariffs) should be excluded. However, these prices may still reflect hidden protection and transfer pricing to a certain extent. Our intention is to describe IIT dynamics in completely liberalized trade items. For this purpose we compare the results for these items with results obtained analogously for less liberalized ones. Hence, the study consists of two product panels: Panel A includes all four-digit CN categories of manufactured goods from CN chapters 30, 33-38, 84, 86, and 88-90, whose trade was almost completely liberalized immediately after the IA with the EU came into effect. However, exact specification of completely liberalized and less-liberalized items is not possible at the four-digit level, compared with the eight-digit one; asymmetry gains some significance. In order to achieve a picture of the extent of liberalization on the four-digit level which is as exact as possible, we selected for panel A all those items for which the EAs fix symmetry; the information source being Annex IV or FVa of the EAs. For the Czech Republic, we found 100 four-digit items, for Hungary only 29 items, for Poland 81 items and for Slovakia 100 items. Panel B includes 137 four-digit items of the CN chapters 50-63: mainly textiles, clothing, footwear, etc. Trade in these items was

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initially not liberalized (with few exceptions). Liberalization was planned to be completed 6 years after the agreement came into effect in March 1992, and therefore by the end of 1998. Of course, both panels may include some items which belong to the other, or even to neither of them. Panel B data (mainly chapters 62 and 63) also include subcontracting. The export component of EU imports from TEs was duty-free until 1997.8 Nevertheless, this product setting seems close to the reality of liberalized and less liberalized trade. Trade between the EU and Hungary is somewhat different concerning panel A: when the interim agreement came into force, custom duties of the Union were not abolished, but were reduced to two-thirds of the basic rate on 1 March 1992, and to one-third on 1 January 1993. Tariffs were abolished from 1994 onwards. Hungary followed the course taken by the other three countries with a oneyear delay—which may be responsible for some differences in pricequality gaps and in IIT and VIIT indices. The Results

There is evidence of a general increase of IIT shares in both panels, although these shares differ significantly among the four countries (Table 8.1). The increase seems to be stronger in panel A than in panel B, with Poland being the exception. For the latter country, the aggregated IIT share of completely liberalized trade items has declined. The most striking increases in IIT can be observed for the Czech Republic and the Slovak Republic. TABLE 8.1 Unadjusted Grubel-Lloyd Indices1 forEU2 Trade with Four TEs from Selected CN Chapters (30-90) Czech Republic

1993 1997 Change (%) 1

Hungary

A3 100

B4 136

A 29

B 136

items 0.296 0.497 67.9

items 0.507 0.563 11.1

items 0.402 0.539 34.1

items 0.364

Poland A 81

items 0.236 0.372 0.172 -27.1 2.2

Calculated as a weighted average according to the panel size. EU-15. 3 Almost completely and symmetrically liberalized trade. 4 Less liberalized trade, CN chapters 50—63. Source: Own calculations on EUROSTAT 1997, CD-ROM. 2

Slovakia

B 136

A 100

B 136

items 0.168 0.229 36.3

items 0.215 0.352 63.7

items 0.203 0.230 13.3

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The VIIT and HUT components of G-L indices are obtained by applying the method used by Greenaway, Hine, and Milner (1994). Relative unit values (RUVs) are calculated from unit values of EU imports (UVMs) from, and of EU exports (UVXs) to, the TEs considered (see annex B). VIIT is defined as the simultaneous exporting and importing of the CN four-digit categories, provided that UVM remains outside a specified range, which we set at 15% on either side of unity. If the RUV of a single item assumes a value greater than 1.00, the import unit value exceeds the export value. If it assumes a value greater than 1.15, the item's G-L index belongs to the VTIT component. A similar interpretation is applied to RUVs smaller than 0.85, the only difference being that the export unit value now exceeds the import unit value. All items with RUVs falling within the defined range qualify as the HUT component of the G-L index. Of course, the range chosen is arbitrary, and does not appear particularly generous, especially as regards TEs whose firms may be newcomers in new markets and are being faced with market penetration problems. However, other authors have proceeded in a similar fashion when tackling the kind of research questions addressed here (for example, Abd-el-Rahman, 1991; Greenaway, Hine, and Milner, 1994; Aturupane, Djankov, and Hoekman, 1997). The latter found that the results are not particularly sensitive to the range selected. TABLE 8.2 RUVs Within the Range of >0.85 and < 1.15 (Identified)1 Country Czech Republic

Hungary

Poland

Slovakia

Total

1

Issue Number of items Within the range Percentage Number of items Within the range Percentage Number of items Within the range Percentage Number of items Within the range Percentage Number of items Within the range Percentage

Panel B

Panel A

1993 100 4 4.0

28 2 7.1

81 7 8.6

100 3 3.0

309 15 4.9

1997 100 6 6.0

28 1 3.6

81 5 6.2

100 7 7.0

309 19 6.1

1993 136

1997 136

23

25

16.9 136

18.4 136

21

24

15.4 136

17.6 136

12 8.8

23

136 13 9.5

544 69

12.7

16.9 136 26

19.1 544 101

18.6

Only items for which RUVs could be calculated. Items for which the values or metric data are unavailable have been ignored. Source: Own calculations based on EUROSTAT on CD-ROM. 1997.

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The calculated relative unit values in most categories fall outside the specified range, and therefore VIIT prevails (Table 8.2). Only about 25% of all items for which RUVs could be calculated for 1997 qualify for HUT, and 75% for VIIT. This is especially the case for items whose trade was completely liberalized between 1993 and 1997 (panel A): only 6% fell within the chosen range for HUT. A significant finding is the increase in the share of items within the range in both panels between 1993 and 1997 (last row of Table 8.2).9 There is an obvious difference between the two panels: The share of items in the overall sample falling within the range increased from 4.9% to 6.1% in panel A, but from 12.7% to 18.6% in panel B. The chances of moving from VIIT to HIIT are visibly better in panel B than they are in A. This is one explanation of why the share of VIIT measured as a percentage of total IIT declines in panel B in a more pronounced manner than in panel A in three out of four countries (Table 8.3). In total IIT, between 59 and 99% was vertical in 1997, using the specified 15% range for RUVs.10 In completely liberalized trade (Panel A), the VIIT share was significantly higher (at more than 90%) than in less liberalized trade. The only and obvious exception is Hungary, whose VIIT shares increased in both panels. This increase can be explained as regards panel A by the decrease in the small number of items falling within the range in both years (see Table 8.2: a fall from 2 to 1 item). Closer inspection of the trade data in panel B reveals that four items with high IIT indices and/or TABLE 8.3 VIIT Indices1 in Elf2 Trade with Four TEs, 1993 and 1996 from Selected CN Chapters (30-90) Issue VIIT index (G-L) Percentage of G-L IIT

Years 1993 1997 1993

0.473 0.352 0.533 0.282 0.163 0.135 0.322 0.152 91.5 96.6 97.0 71.4 77.4 98.1 72.9 66.2

95.3 1997 Change -1.7 in p.p. 1

Hungary A B 0.368 0.241

Czech Republic A3 B4 0.287 0.362

62.5 -8.9

98.9

75.8

7.4

9.6

Poland Slovak Republic A B A B 0.227 0.130 0.211 0.148

95.9 -0.7

59.0 -18.4

Weighted IIT indices outside the range of 0.85 >RUV <1.15. EU-15. 3 Panel A: four-digit items of CN chapters 30, 33-38, 84, 86, 88-90. 4 Panel B: 136 four-digit items of CN chapters 50-63. Source: Own calculations based on EUROSTAT 1997, CD-ROM. 2

91.5 -6.6

66.1 -6.8

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high trade shares were part of the HUT set in 1993 but not in 1997. What is different in Hungary? The answer is not readily forthcoming and requires more detailed research. Quality and Cost Advantages An important aspect of our methodological approach is the theoretical content of (relative) unit values. RUVs may reflect gaps in costs or in quality, depending on the character of traded items and of markets. Greenaway, Hine, and Milner (1994, p. 81) point out that the rationale for using RUVs as an indicator for quality gaps lies in the fact that goods sold at a higher "price" will tend to be of higher quality than goods sold more cheaply. This strong assumption, however, holds only under specific circumstances, namely monopolistic competition among firms, and heterogeneous goods. In this case only the firm realizes profit that reflects the quality differences of the produce. If productivity is a variable dependent on the technology used by a single firm, the profits are included in the higher price. If, on the contrary, perfect competition and homogeneous goods prevail, the price and productivity are given, and profits tend to zero. Then, (labor) cost of production determines the unit value. The pure RUV yields no information on quality or cost advantages. One procedure to group items together with the appropriate pattern of advantage is to link the individual RUVs with the quantities traded; that is the trade balance of the items (Aiginger, 1997). We can identify four cases or examples important for our selection procedure: 1. If RUV <0.85, the export unit value exceeds the import unit value. If this gap reflects a quality advantage, the EU should achieve a trade surplus. Otherwise, the gap reflects a cost disadvantage of the EU, which is hard to reconcile with an export surplus. Hence, if RUV <0.85, we assume that the EU exports higher quality with respect to imports of the same item. Intra-industry trade is ruled by quality and technology. In this way we can formulate the remaining cases: 2. If RUV >1.15 and the EU has realized a deficit in trade, the TE is assumed to have a quality advantage. In this case, the EU exports goods of lower quality compared with imported goods. Again, intra-industry trade is ruled by quality and technology. 3. If RUV <0.85 and the EU has realized a deficit, the TE is assumed to have a cost advantage. Intra-industry trade is determined by factor endowment and other cost-specific factors. 4. If RUV >1.15 and the EU has realized a surplus, the EU is assumed to have a cost advantage.

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According to these four cases we selected and cumulated the VIIT indices for the items considered. Here are the results, taking the total VIIT index (from Table 8.3) as 100. The "quality advantage" columns represent the cumulated values for cases (1) and (2). The "cost advantage" columns represent the cumulated values for cases (3) and (4). The EU has an overwhelming quality advantage in items whose trade was completely liberalized between March 1992 and 1997 (see Table 8.4). The quality advantage of the EU even tends to increase in panel A. The exception is the Czech Republic. However, the lower quality advantage of the EU in the Czech case was not linked with an increase in the Czech Republic's quality advantage. In this case, the cost advantage of the EU increased, but in all other cases the increase in the quality advantage of the Union was linked to a sizeable decline in the previous cost advantage of the TE. Put another way: there is competition between cheap TE products and high quality EU ones, and the cheap products seem to be crowded out. TABLE 8.4 Distribution of Grubel-Lloyd Indices G-L VIIT - 100 Country

feir

VIIT (RUV <0.85; RUV >1.15) Quality advantage Cost advantage EU TE EU TE Panel A— completely liberalized trade 2.4 2.2 13.5 Czech Republic 1993 100 81.8 0.5 9.7 100 71.9 0.5 1997 0.0 1.6 Hungary 1993 100 36.3 62.1 0.5 1997 100 0.2 27.2 72.1 34.4 0.1 3.9 1993 61.7 Poland 100 0.3 96.7 2.8 0.3 1997 100 0.1 0.7 Slovak Republic 100 1993 56.1 43.2 0.0 1997 72.5 100 8.2 19.2 Panel B — less liberalized trade 37.4 2.0 Czech Republic 1993 100 51.5 9.2 1997 100 51.6 7.9 34.4 6.2 Hungary 100 28.4 66.9 1993 2.2 2.6 19.6 59.5 8.8 1997 100 12.1 100 45.1 42.5 4.5 8.3 Poland 1993 28.4 9.8 1997 100 22.7 39.5 69.8 13.6 2.0 14.4 Slovak Republic 1993 100 40.0 37.6 21.0 100 1997 1.2 Source: Own calculations based on EUROSTAT 1997, CD-ROM. Total

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Panel B shows a mixed picture: (1) The EU's quality advantage eroded, with the Czech Republic again proving an exception; (2) The Slovak Republic was able to strengthen its competitive position improving quality; (3) The cost advantage of three out of the four countries improved—cheap products from TEs out-competed high quality products from the EU; but (4) as regards trade with the Czech Republic, the situation is similar to that in panel A. III.

EXPLAINING EMERGING PATTERNS OF IIT

The results reported in the previous section highlight: 1. A general increase in IIT in both panels A and B, with a stronger increase for the A panel (Table 8.1); 2. an increase in HUT and a decrease in VIIT in both panels, where the B panel is more substantially and homogeneously influenced by both effects (Table 8.3), and 3. a higher and increasing quality advantage in panel A for the European Union and a higher and increasing cost advantage in panel B for TE economies (Table 8.4). With respect to our research objective these stylized facts raise three main questions: 1. Do the growing shares of IIT (result 1) reflect an increasing similarity between the EU and TE? 2. What is the significance of rising HUT and decreasing VIIT in panels A and B respectively (result 2)? 3. Is there any connection between the results identified for the quality/cost advantages of trade flows between EU and TE (result 3) and the perspectives of trade patterns? Tentative assessment of the stylized facts in EU-TE trade requires some theoretical predictions. Research on the long-term sources of adjustment according to comparative advantages traditionally identifies factor-supply differences, technological differences, internal returns to scale and product differentiation. Starting from various attempts to find a correlation between IIT indices and the degree of similarity between countries, many economists have identified IIT dynamics with adjustment towards a higher level of economic development.11 IIT is the most important share of trade among developed countries, and an increasing proportion of North-South trade is now assuming the form of intra-industry trade. Even in East-West trade,

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many observers have noted—as we have done—a remarkable increase in IIT since economic transformation began. However, when we disaggregate by HIIT and VIIT we need a different framework in which to focus on the explanations of VIIT. We rely on "second generation" models of IIT, which focus on coexistence and disentangle IIT into its horizontal and vertical components, rather than concentrating on the horizontal character of IIT, as do the "first generation models". The relationships between HIIT and VIIT also play a role in "new geography models" (Krugman and Venables, 1995), which take account of the linkage between integration (trade cost reduction) and the location of production. These models conclude that predictions concerning VIIT or HIIT depend on the concentration/dispersion of the industrial structure induced by trade cost. VIIT has also played an important role in the recent controversy on the nature of the link between trade and adjustments on labor markets.12 A quick review of the HIIT and VIIT literature highlights two predictions, which are here summarized as two conclusions: 1. The volume and share of IIT in overall trade should be negatively correlated with the per capita income differences whenever IIT is mainly horizontal (as capital/labor ratios grow more similar, IIT increases). Put another way: a diminishing income gap yields an increasing HIIT because of increasing similarity between the countries. 2. The link, however, should be positive whenever IIT is mainly vertical, since the predominance of VIIT reflects increasing per capita differences (or increasing differences in capital/labor ratios in so far as they are correlated). Therefore HIIT and VIIT models are able to generate the opposite relationship. On the basis of these two predictions we can now make tentative assessment of our results. The general increase of IIT in both panels (result 1), with a stronger increase in panel A, is in line with a decreasing income gap between EU and TE. At least since 1993, all the observed TEs achieved rates of growth in their GDP, which exceeded those of the EU—which implies the onset of an income-convergence process. Result 2 suggests the persistence of the largest component of EUTE trade—VIIT—although the share decreases somewhat. The dynamics of HIIT (increasing) and VIIT (decreasing) confirm theoretical predictions of the positive and negative link between the assumed income convergence and trade patterns, but this emerges

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clearly only in panel B. The fact that a product moves from VIIT to HUT more easily and more frequently in panel B than in panel A means that the overall reduction in VIIT is related to two different effects in A and B: to a predominant reduction in cost-ruled VIIT in panel A, where quality becomes increasingly important, and to a reduction of quality-based VIIT in panel B, where it is costs that matter most. Result 3, reported in Table 8.4, allows interpretation of the VIIT results in terms of quality/cost advantages: these results suggest an overwhelming quality advantage, which is even increasing in panel A for the European Union, and a remarkable cost advantage, increasing for TE in panel B. The existence of comparative advantages would have implied an exploitation of quality advantages by the EU and of cost advantages by the TE, along the quality spectrum of A and B, respectively, but this does not seem to be the case. There is, therefore, in the panel of completely liberalized trade, a clear dominance of the EU's quality advantages without too much space for exploitation of cost advantages by TEs. The situation is completely different in panel B: the most homogeneous feature in this case emerges from cost-ruled items, where TEs are gaining considerably more than the European Union, and are able to maintain their cost-advantages. The second feature is that the advantages of the EU in quality have declined. An explanation may be that trade barriers to the detriment of EU exporters have induced them to relocate segments of high-quality production to the TE and then import the appropriate commodities. This finding suggests that the exploitation of comparative advantages takes place in different ways in the two panels. The EU's comparative advantage in quality is increasing and turns into an absolute advantage when trade is free: in this case the TEs' production is simply crowded out, and the situation did not seem to improve during the years 1993-97. TEs seem to upgrade their comparative advantages in costs only in not completely liberalized trade flows. A quality-based product cycle, where EU firms abandon low-quality production (or cost-ruled products) and shift them to the TE, is not directly apparent either in panel A or in panel B, because they depict two different phenomena. However, there may be a quality-based product cycle involving panel A as well as panel B or, in other words, a division of labor between high quality products (EU) and low quality products (TEs). In this case, the first stage involves the already well-established dominance of quality advantage products by EU countries producing and

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exporting high-quality products, which crowd out the TE production of similar products. The second stage is the exploitation of costadvantages by TE economies in less liberalized trade, and here they seem to achieve better results. The upshot is that a quality-based product cycle is an empirically relevant feature in EU-TE trade (and production). It is possible to describe the movement of production and consumption to higher quality products according to where the higher rate of technical progress has taken place—in the EU. The result is then very simple: both TEs and the EU could move toward higher quality products, but the EU has progressively abandoned low-quality varieties, which are now produced in the TEs, and concentrates on quality advantages and new products. Obviously, this account requires a qualification based on firms' strategies for product differentiation, which we have neglected thus far. But inspection of country-specific information confirms that TE firms have not strengthened their market position since trade became free in 1993. How far this will lock TEs into lower quality production is still an open question. IV.

CONCLUSIONS

The chapter started with the proposition that the emerging trade pattern between EU and TEs is likely to be important because of disparity in the enlargement currently in progress. The trade patterns revealed may help to identify absolute and comparative advantages/disadvantages. The study's general result is that there is some evidence of an absolute quality disadvantage suffered by the four TEs considered. This absolute quality disadvantage constrains the potential for catching-up and the minimization of adjustment costs. The authors are aware that their results require further empirical testing, especially using regression models. Nevertheless, the study allows some tentative conclusions to be drawn. Concerning catch-up potential, the emerging structure of trade is dominated by vertical intra-industry and by a division of labor along the quality spectrum, where the EU predominates in higher quality production and TEs economies prevail in lower quality. Consequently, it is difficult to identify any improvement in catch-up potential. The tentative conclusion concerning the cost of adjustment is also negative: the emerging structure of trade is not one which minimizes adjustment costs, especially in the labor market, because the vertical structure of trade is not as painless as the horizontal one. If this is the case, an additional argument, different from the market

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failure or the non-existence of markets, is why activist governments should be involved in the process of integrating with the EU. In the period considered, policies in TEs have neglected the positive role that a government can play in creating the conditions for the upgrading of technology, productivity and quality.13 All in all, technological modernization may be contingent on an activist government set on pushing through desirable changes in economic structures without, of course, reverting to the type of state-socialist planning and administrative steering that proved so ruinous for these countries. In the authors' view, given the considerable risk of technological lock-in and the costs associated with trade-induced reallocation of labor in TEs, appropriate policy measures would bolster the competitiveness of the emerging new enterprise sector in TEs through purposeful modernization. APPENDIX Measuring Intra-industry Trade, Its Components and Relative Unit Values

The IIT index of Fof an individual commodity (group) i was calculated on the basis of the Grubel-Lloyd (G-L) equation: (1)

where X and M are the values of exports and imports of any commodity group i. The individual index may assume values between 0 and 1. The former indicates complete intersectoral specialization, or that the reference country exports goods which differ from its imports, while the latter indicates complete intraindustry specialization, or that the reference country exports and imports goods in the same category. Individual indices calculated according to Equation (1) were aggregated using the weights of each commodity group in overall trade as follows: n Y = ^ aft

(2)

i=l

where a is the share of the commodity group i in overall trade and n is the number of commodity groups. In contrast to the individual index, the aggregate index may assume values between 0 and 1 only when overall trade is balanced. Much of the literature on the

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measure concerns the advisability of adjustments to account for imbalances in overall trade. In most applications, however, a correction for trade imbalance is neither advisable nor theoretically well substantiated.14 Hence, this study uses unadjusted indices on the aggregate level.15 The method for disentangling HUT and VTIT decomposes the unadjusted G-L index by using information derived from unit values. The RUV is defined by the import unit value (UVM) relative to the export value (UVX) of a certain item i: RUV.= 1

UVM. '-

uvx;.

(3)

In this chapter we have chosen a range of ± 15% deviation from unity in order to keep HUT and VIIT distinct. Therefore, HUT is the G-L index within the following range: 0.85 <

UVM H I IHTIT T < 1.15 UVM HIIT

(4)

while VIIT falls outside the range. Although this is a problematic16 measure, we calculated the unit values based on metric tonnes in the EU's trade with the above-identified four TEs for 1993 and 1996, in order to disentangle vertical from total IIT. We used unit values based on metric tonnes because the EU's Combined Nomenclature (CN) offers no alternative. On the eight-digit level a calculation of unit values was not possible in most cases. This was the main reason for choosing the four-digit level. Even then, a complete set of observations was not available because of data on metric tonne were lacking in some cases. REFERENCES Abd-el-Rahman, K. (1991) '"Firms" Competitive and National Comparative Advantages as Joint Determinants of Trade Composition,' Weltwirtschaftliches Archiv, 127(1) :83-97. Aiginger, K. (1997) 'The Use of Unit Values to Discriminate Between Price and Quality Competition,' Cambridge Journal of Economics, 21:571-592. Aturupane, C., Djankov, S., and Hoekman, B. (1997) Determinants of Intra-industry Trade Between East and West Europe, CEPR Discussion Paper Series No. 1721, London. Celi, G. and Segnana, M-L. (1998) Trade and Labor Markets. Vertical and Regional Differentation in Italy, Working paper no. 10, Trento, Italy: Dept. of Economics, University of Trento. Celi, G. and Smith, A. (1999) Quality Differentiation and the Labor Market Effects of International Trade, mimeo, University of Sussex.

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EUROSTAT (1997) Internal and External Trade oftheEU, Luxemburg: Eurostat, CDROM. Flam, H. and Helpman, E. (1987) 'Vertical Product Differentiation and NorthSouth Trade' American Economic Review, 77(5):810-822. Fukasaku, K. (1992) Economic Regionalisation and Intra-industry Trade: Pacific-Asian Perspectives, Technical Paper No. 53, Paris: OECD. Gabrisch, H. and Werner, K. (1998) 'Advantages and Drawbacks of EU membership - The Structural Dimension,' Comparative Economic Studies, XXXX(3), Fall. Greenaway, D., Hine, R., and Milner, C. (1994) 'Country-specific Factors and the Pattern of Horizontal and Vertical Intra-industry Trade in the UK,' Weltwirtschaftliches Archiv, 130(1) :77-100. Helpman, E. (1987) 'Imperfect Competition and International Trade: Evidence from Fourteen Industrial Countries,' Journal of the Japanese and International Ecenomies, (1):62-81. Krugman, P. and Venables, AJ. (1995) 'Globalization and the Inequality of Nations,' Quarterly Journal of Economics, CX(4):573—596. Landesmann, M. (1993) Industrial Policy and the Transition in East-Central Europe, Vienna: Wiener Institut fur Internationale Wirtschaftsvergleiche, Research Reports, no. 196. Landesmann, M. and Burgstaller, J. (1997) Vertical Differentiation in EU Markets: The Relative Position of East European Producers. Vienna: Wiener Institut fur Internationale Wirtschaftsvergleiche, Research Reports, no. 234. Lee, Y-S (1989) 'A Study of the Determinants of Intra-industry Trade Among the Pacific Basin Countries,' Weltwirtschaftliches Archiv, 125(2):346-358. Radosevic, S. (1997) 'Strategic Policies for Growth in Post-socialism: Theory and Evidence Based on the Case of Baltic States,' Economic Systems, 21(2):165-197. Rosati, D. (1999) 'Emerging Trade Patterns of Transition Countries: Some Observations from the Analysis of "Unit Valus",' MOCT-MOST, 8, No. 2, 51-67. Stiglitz, J.E. (1998) 'More Instruments and Broader Goals: Moving Toward the PostWashington Consensus.' WIDER Annual Lectures 2, Helsinki 1998 (by internet). Thorn, R. (1999) The Structure of EC-CEE Intraindustry Trade, Working paper no. 1, Centre for Economic Research, Dublin. Vona, S. (1991) 'On the measurement of intra-industry trade: some further thoughts,' Weltiuirtschaftliches Archiv, 127(4) :678-700. van Brabant, J.M. (1998) The Political Economy of Transition - Coming to Grips with History and Methodology, London and New York: Routledge.

NOTES 1. 2.

3. 4.

A longer version of this paper is forthcoming in MOST. Maria-Luigia Segnana gratefully acknowledges the support of M.U.R.S.T. under the project "Infrastructure, Competitiveness, Government Levels: From the Italian to the European Economy." For a critical assessment see Stiglitz (1998). See, for example, Landesmann (1993), Radosevic (1997) and, for an overview, van Brabant (1998).

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5.

6. 7. 8.

9.

10.

11.

12.

13. 14.

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In most empirical research on intra-industry trade also concerning other regions, the trade barriers are rather neglected. A good example of taking into account trade barriers is Lee (1989) who tested the correlation between effective tariff rates and IIT ratios for trade among Pacific Basin Countries. The idea was that the greater the trade barriers the lower the degree of intraindustry trade. Aturupane, Djankov, and Hoekman (1997) uses CN data but does not consider different levels of protection. The level of disaggregation could be very important as shown in Celi and Segnana (1998) because it can yield different results. EU imports from the four countries in panel B amounted to around 3.8 billion Ecu in 1996, and it is likely that subcontracting accounted for the majority of this sum, mainly in imports from Poland and the Czech Republic. Between 1993 and 1996 the share of subcontracting in overall imports declined, not least due to the expected step-by-step reduction in tariffs by 1997. However, the picture may be biased, since the 1993 and 1997 sets both include a different amount of missing data. A check which considered only those items in panel A which already showed an entry in 1993 revealed no significant differences. The unweighted mean was 81%, only slightly lower than 4 years ago (84%). For the sake of comparison, Abd-el-Rahman (1991) calculated the VTIT share for France as accounting for about one-third of total IIT for the period 198597, which was therefore a significantly lower level. For the U.K., Greenaway, Hine, and Milner (1994) calculated a 70% share of VIIT in total IIT for 1988. According to these authors, the incidence of vertical IIT is lowest where EC member states are concerned and highest in the case of geographically distant trading partners—mostly developing countries or newly industrialized countries. Both studies employed the same methodology as specified here and used SITC groups 5-8 (more or less covering our sample). However, they made no distinction between completely and less liberalized trade. In addition, they used more disaggregated data (six- and five-digit, respectively). Direct comparisons between their results and ours are therefore not straightforward. Helpman (1987) presents evidence of a negative relationship between per capita income differences and trade shares as IIT (interpreted as HUT) models predict a positive relationship between the similarity in capital/labour ratio and the share of IIT between countries. This is to say, the presence of VIIT has important consequences on labor markets, but the same does not hold when HUT is dominant; see Celi and Segnana (1998). For an overview and a critical discussion see Gabrisch and Werner (1998). For detailed discussion see Vona, (1991, 686ff). The most important argument against the unadjusted Grubel-Lloyd index is that it does not consider an imbalance in total trade. Imbalances on a disaggregated level are distorted by the imbalance in total trade. However, Vona argues that the imbalances on the disaggregated levels are precisely the reason why an aggregate imbalance does emerge and not vice versa.

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15. Another distortion may stem from a change of trade shares if it is not the entire trade that is studied but only trade with some regions, neglecting others. We also neglect this aspect, although it may be relevant in the case of TE trade with the EU, due to heavy trade re-orientation (see Gabrisch and Werner, 1998). 16. A high-quality product may be made from heavier material so that its value per ton is lower than that of an inferior-quality item. It is not clear how important this problem is for TEs. For further discussion of unit values see Greenaway, Hine, and Milner, (1994, p. 81). Another problem may be the cost of the hidden protection and transfer pricing of firms. However, on comparing the panels we cannot plausibly assume that hidden protection and transfer pricing is different in each of them.

9

A Cyclical Framework for Forecasting Trade Flows LORENE HIRIS AND DEBASHIS GUHA

I.

INTRODUCTION

As members of the global community become increasingly integrated, the international marketplace becomes more of a vital source of demand for output and a source of supply for consumption. Growing trade relationships also foster financial linkages and present formidable challenges to economies in terms of exchange rate stability and labor market friction, as well as having implications for the body politic. Policy makers and market participants, therefore, increasingly focus on the contribution of exports and imports to economic performance and require accurate and dependable methods for forecasting trade flows. Such a method is provided by a leading indicator model that forecasts upswings and downswings in trade flows, based on a cyclical analysis of export growth, import growth, and trade balances for the U.S. and U.K. Charts 9.1 and 9.2, showing the ratios of imports and exports to real GDP for the U.S. and U.K., respectively, provide evidence that these countries have become increasingly integrated with the world economy. Tools and techniques for forecasting trade flows are particularly important for the U.K., since both imports and exports are approaching a third of U.K. GDP, and domestic leading indicators alone cannot do an adequate job of predicting cycles in the overall globally integrated U.K. economy. Specifically, U.K. exports as well as imports represented 14.6% of GDP in 1970 and escalated to 26.7% of GDP for exports and 29.1% for imports in 1998. For the U.S., real exports of goods and services, which ranged between 4.5% and 7% of real GDP from 1970 to 1985, climbed to between 132

CHART I: U.S. Exports and Imports as Percentage of GDP

CHART II: U.K. Exports and Imports as Percentage of GDP

A Cyclical Framework for Forecasting Trade Flows

135

6.5% and 13% from 1986 to 1998. Correspondingly, real imports as a percentage of GDP, which ranged between 5.5% and 9% in the 1970-85 period, accelerated to between 9% and 16% from 1986 to 1998. Because of the rapid secular growth in trade flows, absolute declines in the levels of trade flows have been quite rare in recent times. However, the growth rates of both exports and imports and the level of the trade balance do exhibit pronounced and persistent swings similar to overall economic cycles. This also suggests that methods of analysis and forecasting developed for business and growth cycles are likely to be of use in analyzing trade flow cycles. These growth rate cycles can be anticipated by swings in the growth rates of leading indicators. Leading indicators of business cycles are sensitive not only to recessions, i.e., declines in the level of economic activity, but also to slowdowns in growth that do not lead to recessions. As Moore (1983, p. 62) remarks, when some economists level the accusation that leading indicators have forecast six out of the past nine recessions, apparently they do not realize that their growth rate did forecast nine of the past nine slowdowns. The Future Exports Gauge, the Future Imports Gauge and the Future Trade Balance Gauge have been constructed using cyclical leading indicators and are designed to lead cyclical swings in the growth rate of trade flows. The evidence below shows that these indexes can reliably anticipate these cyclical growth rate turning points before they occur. II.

CYCLICAL THEORY, TOOLS AND TECHNIQUES

As defined by Burns and Mitchell (1946), business cycles are recurrent aperiodic fluctuations in overall economic activity that are pronounced in magnitude, usually persist for several years, and pervade all sectors of the economy. The tools used in this chapter to analyze and forecast long-term swings in trade flows are business cycle analysis methods originally developed by Wesley Mitchell and his co-workers at the National Bureau of Economic Research (NBER), starting in the 1930s, as reported in Burns and Mitchell (1946). These methods, which include techniques for turning point determination, leading indicator selection and composite index construction, have been further refined by Geoffrey Moore and his colleagues at Columbia University and at the Economic Cycle Research Institute (Moore, 1983, 1990). Together, they provide a set of well-established, nonlinear, data-analytic tools that can:

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1. identify the reference cycle, i.e., the timing of the different stages of the business cycle such as expansions and contractions as well as rapid growth periods and slowdowns; 2. identify turning points of the reference cycle, i.e., the transition points between the stages of the cycle, as well as turning points in individual time-series; 3. identify systematic timing patterns among groups of economic indicators, i.e., the set of leading, coincident and lagging indicators; and 4. combine the evidence from groups of indicators into a composite index that can better track or forecast the state of the cycle. The starting point of the analysis is the identification of the dates of the expansion and contraction phases of the cycle, usually called the reference chronology or cycle. In this chapter the turning points of the growth rates of aggregate real imports and real exports and the level of the trade balance were taken as the reference cycle. It is clear that the identification of turning points in time series is one of the most important steps in any analysis of cycles. In this paper the turning points of all series, both indicators and gauges, were determined by the computerized algorithm of Bry and Boschan (1971), based on the systematic codification of judgmental procedures used for several decades at the National Bureau of Economic Research (NBER). It is important to business cycle measurement to have an objective algorithm for the identification of turning points, based on a systematic codification of the judgmental procedures. The Bry-Boschan computer program of the classical NBER procedure makes it possible to evaluate the performance of indicators in terms of timing of cyclical turns. The BryBoschan procedure was used extensively in the decades following its creation (e.g., Klein and Moore, 1985). Other users have included King and Plosser (1989), who provide a description of this procedure. As Watson (1994) and others have pointed out, the BryBoschan procedure provides a good way to define turning points, since it is based on objective criteria for determining cyclical peaks and troughs. The output from the Bry-Boschan program can also be used as the basis for the determination of reference chronologies. The BryBoschan program is also applied to potential leading indicators and their lead profile against the reference chronology is one of the key criteria for the evaluation and selection of leading indicators. Economic variables have been found to display systematic patterns in their timing with respect to the overall cycle. Some tend

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to move before the reference cycle, some move at about the same time and some others follow afterwards. The discovery of these systematic patterns is one of the principal empirical successes of the NBER school and forms the basis of this method of tracking and forecasting cyclical variables. A leading indicator is a variable that consistently anticipates cyclical moves in a target variable, i.e., a coincident indicator of overall economic activity or inflation, or as in the present case, trade flows. Leading indicators are successful because they represent decisions or commitments to activity in the future. For example, building permits, as a leading indicator, leads residential construction expenditures, a coincident indicator. If the number of permits consistently increase, houses may be started, completed, and sold, triggering processes which stimulate economic activity. Other examples of leading indicators include new orders, which reflect decisions to actually purchase for production, and the average workweek, which lengthens or shortens prior to hiring or firing decisions. Economic cycles are represented not merely by fluctuations in one indicator, but rather in the concurrent and confirming patterns in a host of indicators. Arthur Burns (1961, p. 36) offered the following rationale: "... since the cyclical timing of single processes cannot be implicitly trusted, a measure of protection against surprises of the individual cases may be won by combining the indications of the numerous series."

This is why it is necessary to combine the evidence from single economic indicators combined to form composite indexes which are collections of economic time series selected in a systematic manner to capture the cyclical characteristics of its target—in this case trade flows. The overwhelming strength of a composite index may be expressed as the synergy derived from the whole being greater than the sum of its parts. III.

TRADE FLOW CYCLES

Business cycles are international in character and the study of business cycles has always been carried out in an international setting. In their seminal work, Burns and Mitchell (1946) pointed out the importance of considering the international dimension of business cycles. As they state (1946, p. 18) "A man interested solely in the business cycles of the United States could not understand them by studying American data alone; for they would not show the changes in foreign business conditions that stimulated or retarded American expansions, and mitigated or aggravated the contractions."

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Of course, this insight is also applicable to any other country, such as any of the U.S. trading partners. The international character and transmission of business cycles suggests that international flows of goods and services would be affected by business cycles and would display these characteristic cycles and that turning points in trade flows are related to turning points of aggregate business cycles. World trade has seen dramatic growth over the past decades, growing approximately 1,770% over the 1970-98 period (IFS Yearbook, 1999, pp. 128-133). This rapid overall growth has meant that declines in the level of trade flows for most countries, including both the U.S. and the U.K., are rare and that they are too small, intermittent and short to be considered as cyclical swings. However, in both countries a consideration of the growth rate, rather than the level of exports and imports and the level of the trade balance, reveals persistent and pronounced upswings and downswings that can be classified as recurrent and aperiodic cyclical movements. Periods of rising growth rates in exports and imports last somewhere between a few quarters to several years and have alternated with periods of pronounced decline that are of similar duration. The level of the trade balance shows the same pattern. The pronounced character of these swings in aggregate trade statistics and the fact they persist over timescales that are usually associated with aggregate economic cycles, suggests that cycles in trade flows are associated with business cycle dynamics. In an analysis covering the period 1867 through 1938, Wesley Mitchell (1951, p. 258) had already categorized time series of both exports and imports as procyclical. More recently, Zimmerman (1997) investigated business cycle co-movements relating to trade, using data from 19 industrialized economies over 30 years, and found that both exports and imports have a positive correlation with variables of real output. Zimmerman also found that exports seem to be driven by conditions in other countries and that imports are procyclical. The reason for the procyclicality of imports is that the share of imports in total real output is slow to change. This slow response can be attributed to the slow speed of most adjustment mechanisms, including especially the stickiness of the prices of most goods and services, which implies that the share of imports in the national income will not respond readily to changed business conditions. This in turn implies that any decline in the growth of overall economic activity will be reflected in a corresponding decline in the growth of the value of imports.

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A reversal of the same argument implies that cyclical swings in exports to any country are related to cyclical swings in that customer country's overall economic health. It can be concluded that aggregate exports of any country would depend on some sort of an aggregate of the business conditions prevailing in its trade partners. If business cycle conditions in the trading partners are quite unsynchronized, they will tend to cancel each other out and the net result will be that exports will fail to show any clear cyclical movement. This, however, is not true for either the U.S. or the U.K. The business cycle movements in many of the major industrial economies which are the major trading partners of both the U.S. and the U.K. tend to be closely related and this aggregate cyclical influence is reflected in the strong cyclicality of the total volume of exports. The relation between trade flows and real output suggests that composite indexes of leading indicators, which have traditionally been used to forecast the state of the business cycle can be used to forecast growth rates of trade flows. Cullity, Klein, and Moore (1987) used this idea to develop procedures for forecasting U.S. merchandise exports, imports, and trade balances for the year ahead. They concluded that traditional leading indexes when combined with real dollar exchange rates perform well. In addition, their leading indicator method was shown to be superior to forecasts made by simple extrapolation assuming that the next year's percentage change would be the same as that of the previous year. Prior to this research, which included real exchange rates as a component, Moore had investigated whether leading indexes alone could forecast the rate of change in the volume of trade to foreign countries. Moore found that a substantial proportion of the year-to-year changes in trade flows could be accounted for in this manner (Moore, 1983, pp. 84, 86). A broadly based, trade-weighted, real effective exchange rate index, monitoring world market price competitiveness, is an important component in composite leading indexes of trade flows. It is widely believed that currency depreciation or devaluation shrinks a trade deficit or increases a trade surplus further. However, before any improvement in the trade balance takes effect, a worsening of the trade balance is often initially observed. This phenomenon is known as the J-curve effect. It is also probable that a condition such as an inverted J-curve effect is possible when there is a currency revaluation or appreciation. The time lag until a response in the trade balance is observed varies from country to country. The common explanation for the J-curve effect is that the quantities

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exported and imported do not change much in the short run because of contractual obligations, but prices do change. Therefore, more of the home currency is paid for the same volume imported and fewer home currency units are received for the same quantity of exports. The trade balance could also be sticky due to the pricing and measurement difficulties associated with rapid technological change and improvement in quality. In fact, the existence of the Jcurve usually serves to make the short-term effect of a devaluation or depreciation contractionary rather than expansionary. Traditional leading indexes including those used by Cullity, Klein, and Moore (1987) typically have a lead time of six to nine months on average at business cycle peaks, and three to six months at troughs. The delay in the publication of the data often consumes one or two months of this lead time. Even after a leading index has passed a cyclical turn, it can take three or four months or even longer to recognize the turn. This is because of the noise inherent in any index, which makes it difficult in the initial months after a turning point to distinguish between a cyclical turn and irregular movements. In other words, the publication delay and recognition delay can easily consume four to six months of the available lead-time. Under such circumstances, it is possible, at best, to recognize a traditional leading index turning point just before it is about to begin, and much of the time, with little or no advance warning. This is especially true in the international arena where data reporting for many countries is not as timely as that for the United States. Given this problem, it can be very useful to have indexes with longer leads; i.e., indexes of long leading indicators defined as having average lead times of about a year. Such indexes would have a better chance of providing real-time leads than do conventional leading indexes. In addition, longer leads would be better matched with the exchange rate series. The Economic Cycle Research Institute (ECRI) has developed Long Range Gauges for 13 major market economies, which improve on traditional leading indexes by increasing the lead time to a year on average. ECRI's Long Range Gauges can, therefore, serve as predictors of the future demand in its export market economies as well as its own import demand, with longer lead times than traditional leading indexes. These Long Range Gauges themselves are a composite index of leading indicators with particularly long lead times such as housing permits, consumer expectations, manufacturing profitability, manufacturing productivity, money supply

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growth, inverted bond yields, and service sector inflation. All the underlying components used in the gauges, except for bond yields and exchange rates, have been seasonally adjusted. Basically, the traditional composite index methodology has been followed in the construction of the U.S. and U.K. Future Trade Balance Gauges and for all the underlying gauges. However, the method of component standardization and index adjustment is now using the standard deviation of the deviations from the phase average trend. The more common method standardizes by dividing each period's change in the series by its average changes over the historical period. For a detailed analysis of different composite index construction methods, refer to Boschan and Banerji (1990). IV.

FORECASTING EXPORTS, IMPORTS, AND TRADE BALANCES

The first step in the development of leading indexes which reliably anticipate cyclical upswings and downswings in a country's trade balance is to construct leading indexes or future gauges of a country's exports and of its imports. Both the Future Exports Gauge and the Future Imports Gauge also include a broadly based, tradeweighted, real effective exchange rate index monitoring a country's world market price competitiveness. Future Exports Gauges

Separate Future Export Gauges were constructed for the U.S. and for the U.K. In addition to broadly based, trade-weighted, effective exchange rate indexes, components of the future exports gauges include long range gauges of twelve industrial economies that include most of each country's major trading partners. In order to construct the U.S. Future Exports Gauge, Long Range Gauges for major U.S. trading partners including the U.K., Canada, Japan, Germany, France, Korea, Taiwan, Italy, Australia, New Zealand, Sweden, and Switzerland were combined into a single index called the Twelve-Country Long Range Gauge. The corresponding U.K. Future Exports Gauge substitutes the U.S. for the U.K. as a target market for exports. The resulting 12-country Long Range Gauge was then combined with U.S. or U.K. trade-weighted real exchange rate indexes to form the respective final Future Exports Gauges. The performance of the Future Exports Gauges for the U.S. and the U.K. is illustrated in Charts 9.3 and 9.4, which compare the growth rate of the U.S. and U.K. Future Exports Gauges

CHART III: U.S. Future Exports Gauge and U.S. Exports, Growth Rate (%)

oQj

CHART IV: U.K. Future Exports Gauge and U.K. Exports, Growth Rate (%)

>r ^

31 S~n

o"

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Lorene Hiris and Debashis Guha

with their respective growth rates of real U.S. and U.K. exports. Charts 9.3 and 9.4 confirm that cyclical turning points in the growth rates of both the U.S. and U.K. Future Export Gauges consistently anticipated the corresponding cyclical turns in the growth rate of U.S. and U.K. real exports over the period 1970 through 1998. It is interesting to note that the percentages of exports from the U.S. and U.K. to North America, Europe, and Asia have changed markedly from 1970 to 1995, but that the Future Exports Gauge remained successful in capturing cyclical swings throughout this period. In 1970, exports from the U.K to its 12 major trading partners included in this study were 35% to North America, 47% to Europe, and 18% to Asia. In 1995, these percentages were 27%, 62% and 11%, respectively. Correspondingly, in 1970, U.S. exports to Canada were 37%, to Europe 38%, and to Asia 25%. In 1995, the percentages of exports were 38%, 26%, and 36%, respectively. Specifically, the U.S. Future Exports Gauge growth rate has a median lead of one month at peaks and seven months at troughs when compared with cyclical turns in the growth rate of U.S. exports. The U.S. Future Exports Gauge growth rate leads 80% of all turns. The median leads are more consistent for the U.K. Future Exports Gauge growth rate. It leads the growth rate of U.K. exports by a median lead of four months at peaks and four months at troughs for 93% of the time. TABLE 9.1 Future Exports Gauge, Growth Rate: Median Lead

U.S. U.K.

Peaks

Troughs

Overall

%Lead

1

7

7

80

4

4

4

93

Future Imports Gauges

In 1998, real imports of goods and services represented more than an eighth of U.S. real GDP and almost 30% of U.K real GDP. The purpose of Future Imports Gauges is to forecast cyclical turning points in the growth rate of imports of goods and services. Cyclical swings in an economy's imports are related to its future economic health and also to its exchange rate, which determines how competitive imports are relative to domestic products. A country's own Long Range Gauge also proves to be a good predictor of imports. The Long Range Gauge is then combined with a real trade-weighted exchange rate index to form the Future Imports Gauge. Since cyclical declines in the level of imports are relatively rare, these

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future imports gauges focus on cyclical movements in the growth rate of imports. Chart 9.5 tracks the performance of the growth rate of the U.S. Future Imports Gauge with the growth rate of real U.S. imports. Shaded areas mark cyclical downswings in the latter. Chart 9.6 illustrates a similar relationship for the U.K. The growth rate of the U.S. Future Imports Gauge leads 82% of all cyclical turns in imports growth with a median lead of nine months at peaks and six months at troughs. The U.K. Future Imports Gauge has a median lead of seven months at peaks and eight months at troughs and it leads at 75% of all cyclical swings in imports. TABLE 9.2 Future Imports Gauge, Growth Rate: Median Lead

U U.K.

s

!

Peaks 9

Troughs 6

Overall 7

% Lead 82

7

8

7

75

Once gauges that predict turning points in the growth rates of both real U.S. and U.K. exports and real U.S. and U.K. imports have been constructed, the next step is to forecast turning points in their trade balances. Future Trade Balance Gauges

Since the trade balance is the difference between exports and imports, forecasting the trade balance initially requires the development of forecasts for exports and imports. The difference between these two forecasts then becomes the forecast for the trade balance. Future Trade Balance Gauges, therefore, were constructed for both the U.S. and the U.K. by combining the components of each country's Future Exports Gauge and Future Imports Gauge in a composite index. The performance of the resulting Future Trade Balance Gauges, which anticipate cyclical upswings and downswings in the trade balances, is shown in Chart 9.7 for the U.S. and Chart 9.8 for the U.K. The shaded areas mark cyclical downswings in the respective trade balances. These charts illustrate turning points in both the U.S. and U.K. Future Trade Balance Gauges anticipate the corresponding turning points in the U.S. and U.K. trade balances. Specifically, the U.S. Future Trade Balance Gauge leads at 80% of all cyclical turns in the trade balance with a median lead of 13 months at peaks, 16 months at troughs, and 14 months overall. The U.K. Future Trade Balance Gauge records a median lead of five months at peaks and five months at troughs in the trade balance since 1970.

CHART V: U.S. Future Imports Gauge and U.S. Imports, Growth Rate (%)

cu

3 Q,

s?

Cr

CHART VI: U.K. Future Imports Gauge and U.K. Imports, Growth Rate (%)

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o

CHART VII: U.S. Future Trade Balance Gauge (1992=100) and U.S. Trade Balance (Billions of 1992$)

CHART VIM: U.K. Future Trade Balance Gauge (1992=100) and U.K. Trade Balance (Billions of 1995 pounds sterling)

51 3 2

a1 -n

o~

150

Lorene Hiris and Debashis Guha TABLE 9.3 Future Trade Balance Gauge: Median Lead

U.S. U.K.

Peaks 13 6

Troughs 16 5

Overall 14 6

% Lead 80 100

Both the U.S. and U.K Future Trade Balance Gauges are successful leading indexes, which have long and consistent leads over their respective trade balances. It is important to note that Future Trade Balance Gauges could not be constructed until Long Range Gauges covering most major U.S. and U.K. trading partners were available. These long leading indexes are the result of an extensive research program that has produced a large array of international economic indicators that are methodically updated every month. Research continues to develop Long Range Gauges for additional major market economies—especially other U.S. and U.K. major trading partners such as Mexico, China, India, Brazil, Argentina, and South Africa. When complete, these additional Long Range Gauges are expected to further improve the forecasting ability of these indexes of trade flows. V.

CONCLUSION

Using the U.S. and U.K. as examples, this chapter has demonstrated that a leading indicator approach in the form of composite indexes of Long Range Gauges and exchange rates can be used successfully to forecast cyclical swings in exports, imports, and trade balances. Research is progressing at the Economic Cycle Research Institute (ECRI) to develop analogous Future Trade Balance Gauges and underlying Future Exports and Imports Gauges for other major market economies as well. Subsequent revisions of the Future Trade Balance Gauges are expected to be even more encompassing and to track trade flows even more accurately. These Future Trade Balance Gauges could also be used as part of a broader quantitative model to forecast trade deficits and surpluses, but their key strengths lie in their ability to anticipate broad cyclical shifts in exports, imports, and trade balances. Given the growing importance of trade flows and trade surpluses and deficits in the economic and political relationships among nations, Future Exports Gauges, Future Imports Gauges, and Future Trade Balance Gauges, make a significant contribution in appraising trade prospects and in guiding policy decisions.

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REFERENCES Boschan, C. and Banerji, A. (1990) 'A Reassessment of Composite Indexes,' in Klein, P.A. (ed.), Analyzing Modern Business Cycles, M.E. Sharpe, New York. Bry, G. and Boschan, C. (1971) Cyclical Analysis of Time Series: Selected Procedures and Computer Programs, Technical Paper 20, National Bureau of Economic Research, New York. Burns, A.F. (1961) 'New Facts on Business Cycles,' in Moore, G.H. (ed.), Business Cycle Indicators, Vol. I, National Bureau of Economic Research, New York. Burns, A.F. and Mitchell, W.C. (1946) Measuring Business Cycles, National Bureau of Economic Research, New York. Cullity, J.P., Klein, P. A., and Moore, G.H. (1987) 'Forecasting U.S. Trade Flows with Exchange Rates and Leading Indicators,' Working paper presentation, International Association of Forecasters, Boston, MA. International Monetary Fund (1999) International Financial Statistics Yearbook 1999, International Monetary Fund, Washington, DC. King, R.G. and Plosser, C.I. (1989) Real Business Cycles and the Test of the Adelmans, Unpublished manuscript, University of Rochester, New York. Klein, P.A. and Moore, G.H. (1985) Monitoring Growth Cycles in Market-oriented Countries: Developing and Using International Economic Indicators, National Bureau of Economic Research, Cambridge, MA. Mitchell, W.C. (1951) What Happens During Business Cycles—A Progress Report: Studies in Business Cycles No. 5, National Bureau of Economic Research, New York. Moore, G.H. (1983) Business Cycles, Inflation and Forecasting, National Bureau of Economic Research, New York. Moore, G.H. (ed.) (1990) Leading Indicators for the 1990s, Dow Jones-Irwin, Homewood, IL. Watson, M.W. (1994) 'Business Cycle Durations and Postwar Stabilization of the U. S. Economy,' American Economic Review, Vol. 84, 24-46. Zimmerman, C. (1997) International Trade over the Business Cycle: Stylized Facts and Remaining Puzzles: Working Paper No. 37r, University of Quebec, Montreal.

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Part IV Global and Regional Trading Blocs

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Part IV: Global and Regional Trading Blocs One of the most important changes in the global economy in recent decades has been the increase in the number and success of regional trading blocs. During the last half of the 20th century practically every region of the world attempted to create a regional trading bloc. From the successful and much researched ones which included major and already large economies to the obscure ones which aimed more at drawing attention than accomplishing economic development, the stated goal of all such attempts was to eliminate - or reduce - barriers on trade. Regional trade liberalization was indeed in vogue during the latter half of the last century. The results, particularly long-term implications, of such groupings are yet to determined. In the shortrun, however, most have been successful and have met - indeed, surpassed - expectations. Long-term results may not, however, be as positive. It seems that those countries which are not next to, or in the same region as, major economic powers are permanently at a disadvantage. The long-term implications of the widespread use of geography-based regional trading blocs seem to spell doom for many parts of the world including, not surprisingly, the most depressed economies of the world. Long-term concerns notwithstanding, one cannot argue with the short-term success of regionalism in trade. In Chapter Ten, Professors Sarah K. Bryant and Kate J. Massey "explore the benefits and weaknesses of regional trading blocs and their affects upon globalization and market integration. [They] examine issues faced by developing countries in competing in the global marketplace and in the development of regional trading blocs. Professors Bryant and Massey conclude that "future developments in globalization must come from the efforts of regional trading blocs' members and international organizations to assure the development of ... public policy initiatives that stimulate continued global networking and interdependence." Professor Raul Moncarz provides an examination of regionalism and globalization attempts in Latin America in Chapter Eleven. He points out that today "there are more than 30 free-trade agreements in Latin 755

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America. [In addition,] the type of economic integration that exists today is very different from the one prevailing up to the oil crisis of 1973 and the debt shock of 1982." Professor Moncarz argues that at least in Latin America, "the traditional approach to economic integration was a casualty of the new spirit of free enterprise, since the emphasis changed to integration into the world economy." He concludes by citing a number of reasons as to why "regional arrangements can also serve as building blocks for multilateralism. [For example,] they can lock in countries' unilateral reforms, make negotiations simpler by reducing the number of countries involved and may start a process of competitive liberalization in which non-believers can be persuaded to join by the threat of not being part of the regional agreement." Integration in Latin American is also the topic of Chapter Twelve in which Professor Cheryl Hein examines economic integration in South American in the form of MERCOSUR. She points out "MERCOSUR is rapidly becoming a major trading force, although it has been in existence since March of 1991." Professor Hein maintains that MERCOSUR "has achieved many of its objectives. Her analysis of the association has led Professor Hein to conclude that organizationally, MERCOSUR "is in a position between the loose association of the NAFTA countries and the more structured association of the European Union. [And that] it is moving in the direction of the European Union, [it] is involved with free movement of labor from one member country to another. Additionally, social and environmental issues are being addressed, but to a lesser degree than that obtained by the European Union." Chapter Thirteen provides an examination of the role of the World Trade Organization and the history of its development. In this Chapter, Professor Mordechai E. Kreinin traces the development of the WTO through the Seattle Ministerial Meeting. He argues that the meeting was an opportunity to achieve many of trade-specific goals that the WTO should follow and its timing "was highly propitious from the viewpoint of the United States as well as from that of the developing countries ... yet, despite this convergence of interests and propitious timing, the talks failed; and the cause of failure can be laid squarely at the door of the United States." Professor Kreinin concludes that despite the failure of the Seattle meeting, "the Millennium Round of the WTO should NOT be abandoned ...[rather,] the disputes that obstructed the Seattle meeting should be diffused and/or deflected." Some preparatory work to do so must precede a "low-profile WTO meeting ... to hammer out a more restricted agenda for the Millennium Round" which he proposes should include service transactions, foreign direct investment issues, agricultural liberalization, and general trade liberalization."

10 The Effects of Regional Trading Blocs on Globalization SARAH K. BRYANT AND KATE J. MASSEY

I.

INTRODUCTION

For more than two centuries, economists have expounded the virtues of free trade. From Adam Smith and David Ricardo to the present, economists have formulated theories regarding the benefits of open, free trade.1 In that time, too, caveats have been discovered to the smooth application of these theories, such as dislocations in employment and declining returns to capital. As a result, many special-interest groups have made arguments for protection. The movements toward free trade have been littered with cries for protectionism and foreign trade wars. Each country has had to fight the same internal political and economic battles that occur when countries decide to liberalize their markets and trading practices. With all of the benefits of free trade clearly laid out, no country has elected to completely remove all barriers. Even those that are the most developed, and that may have the least to lose, do not choose to open their doors completely. There are fears by these countries of losing their sovereignty and dominance, of being taken advantage of, and of losing valuable market competitiveness. There have been impressive strides made in the past 50 years, however, toward a world trading system through the General Agreement on Tariffs and Trade (GATT) and now the World Trade Organization (WTO).2 Qureshi (1996) reports that "(o)ver the past two decades, world merchandise exports have roughly doubled as a proportion of world output, from 10 to 20 percent. With more and more services being transacted internationally, their (services') 757

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Sarah K. Bryant and KateJ. Massey

share in world trade has risen from 15 to 22 percent ... These statistics all point to globalization—the growing international integration of markets for goods, services, and capital."3 The world has moved from one where nations that have fought each other over trade issues, to one where several major players dominate the global economy. The GATT forum was too large an entity for global trade consensus, and the WTO is struggling to be effective. Concurrent with negotiations within GATT, and now WTO, however, have been far more efforts to negotiate regional trading agreements among partner countries to form regional trading blocs (RTBs)4 to increase trade and development while managing effects on political and economic dislocations that occur with any opening of trade. As RTBs are formed by some trading partners, other countries may feel compelled to join together in other RTBs to take advantage of perceived benefits of cooperation and to compete. Even large, developed countries have found benefit in entering into such trading agreements (e.g., NAFTA and the European Union). This adds pressure on developing countries to affiliate with each other and perhaps with developed countries. As a result, developing countries are better positioned to ensure regional autonomy and success through smaller RTBs. To increase negotiating power and competition, many developing countries rely on these collectives to rival larger developed countries and to ensure a strategic role in the global arena. As many as 80 different trade regions exist, with overlap among countries across regional affiliations. Every member of the WTO, with the exception of Japan, Hong Kong, and South Korea, is affiliated with one or more RTB.5 II.

DEVELOPMENT OF REGIONAL TRADING BLOCS

Trade regions may begin as political bodies for mutual security and support, but as development occurs and comparative advantages are formulated, the regions evolve into economic bodies. The increase in infrastructural development through telecommunications, information technology, and free-trade practices enables countries to link together into trading blocs, forming RTBs. Within these RTBs, countries are compelled to re-address their fiscal and economic policies to retain trading partnerships and alliances. These policy forces challenge the operational sovereignty of a government, that is, its ability to exercise sovereignty (both internal and external) in the daily affairs of politics.6

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Many trade agreements between countries have been unsuccessful, due to uneven trading practices and infrastructural support. However, as globalization thrusts countries forward into "join in or be passed by" conflicts, RTBs have been more defined and lasting and have contributed to developmental steps to further trade liberalization.7 The Andean Community represents an example of a RTB developing in steps from the Andean Pact.8 Since the mid-1980s, the primary goal of economic integration in Latin America has shifted from that of protecting the member states' markets for development purposes towards promoting their efficient and fair participation in the world economy. This has meant revitalizing and readjusting old trade and integration arrangements, like the Andean Pact, to become the Andean Community, and creating new ones, like Mercosur and the G-3, thereby creating a web of international agreements—31 of them according to United Nations Economic Commission for Latin America and the Caribbean (ECLAC)—signed since 1990 to liberalize trade within the region.9 These regional arrangements served to facilitate the re-insertion of the member countries into the world economy within a framework of systemic competitiveness and to support and "lock-up" domestic strategies of growth and economic and political reforms.10 Some economists view trading blocs as disruptive to world trade, in that the most efficient allocation of resources among all countries comes from free trade. In their view, RTBs disrupt that natural occurrence. However, in the development of a "world economy" in which free trade is necessary, developing countries may be left out, or subverted, in negotiations with larger, more developed countries. Particularly, when developing countries have few exports to offer, they can be placed in inferior negotiating positions. Therefore, these countries may feel more comfortable entering into trade agreements with countries in their geographic region, as in southern Africa or the Caribbean, or in their regions of "heritage", e.g., between Europe and Africa, and the U.S. and Latin America. In particular, many African and Latin American countries export only raw products to the developed countries and then purchase finished goods. For example, many African countries export only one or two products. "The lack of economic diversification in exports limits the ability of most economies to react to adverse conditions that may arise in export markets. For example, prices on agricultural products fell during the 1980s, leaving agricultural exporting countries with deteriorating terms of trade and

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increasing debt levels."11 Within the Andean Community, oil represented almost 100% of Venezuela's total exports in 1983, and only decreased to about 80% in recent years, and represented about 85% of its exports to the United States. Specializing in too few products can limit growth and development, if resources are non-renewable and the country negotiates from a weak base. In the case of mineral and ore exporting countries, the worry is, of course, that the export products will be depleted, leaving countries with no source of foreign revenues. The need then is to invest proceeds of current exports in productive uses now, in the areas of renewable resources to diversify production, which can develop along the lines of comparative advantage. Product and market diversification is vital for all economies, especially when continued growth over the long run is at stake. By entering into RTBs with trading partners that value new industries and regional growth, individual countries can achieve long-term development with diversification. Without product and market diversification in RTBs, the regional economies, such as Mercosur, will "remain wedded to beggar-thyneighbor protectionism, and ... prostrated by inflation, instability and debt. Through integration, grow[th] and relatively open market[s] of at least 240 million people, with an output level of over $1 trillion, [Mercosur] will stretch from the Brazilian north-east to Chile's Pacific coast ... This southern cone will be emerging as an agribusiness and mining superpower, with a diversified and modernised manufacturing industry fuelled by cheap and abundant energy."12 Mercosur is "advancing economically, as it achieves its goals and objectives of inter-regional unity and trade liberalization. As Mercosur strengthens, the role of the U.S. in the region is challenged, and Mercosur is able to set its own guidelines for future talks concerning NAFTA. The U.S. will find that it cannot stand behind its traditional policies of protectionism and isolationism forever or economic losses may be seen in the short and long term."13 Benefits of RTBs

The benefits of RTBs depend on their formation, how tightly structured they are, what their purpose is, and the historical patterns of trade and trading partnerships before regions develop. RTBs start at the lowest level of affiliation with the preferential trade arrangement, to a free trade area, a customs union, a common market, an economic union, and a complete economic and monetary union. The tighter

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the union, the more dependent the member countries are on one another, and the harder it can be to keep the alliance together.14 Although a comprehensive form of free-trade area or full customs union may not yet be practicable for most of the developing countries, there are still substantial advantages that can be derived from more ad hoc functional types of regional cooperation short of comprehensive integration. Measures of "partial integration" may help to avoid the costs of "micro-states" and national development along compartmentalized lines. In particular, the complementary development of specific industries through a regional investment policy has considerable potential. The realization of markets of sufficient size, avoidance of duplication, and better location of projects might result.15 RTBs can provide increased market opportunities and comparative advantages for trading partnerships, and further individualcountry market stabilization through trade coordination by members. These benefits can be achieved with each country having a voice in the outcomes. Similar to infant industry model arguments for trade barriers, countries that enter a RTB may increase production within the bloc, as production becomes more cost effective with the increase in the trading area. This activity may lead to import substitution, but may also lead to greater efficiencies in production of products that can eventually compete in the global markets. Diversification in production and exports will lead to a more stable development of the RTB and the individual countries than exports within single countries limited to one or two products, as previously discussed, and hence an increase in the competitiveness of the region. Mercosur has attracted a great deal of foreign investment for food products and automobile manufacturing. Within Brazil and Argentina, distribution and sales within the region by Ford Motor Company and Volkswagen have increased labor market security and training for low-income skilled workers. Regional branding is reshaping the consumer products market. Mercosur's brewers are snapping up local enterprises through regional integration. Hit by competition from Asia, the shoe industry in Brazil is restructuring its facilities and formulating increased efficiencies in product design and quality with access to Argentina. With the increase of financial integration and rapid growth of developing countries within their RTBs, heightened trade and increased competition between industrial and developing countries can lead to long-term benefits. As industrialized countries have stable market forces and policies in effect, solid currencies, and a skilled labor force, they seek more cost-effective supplies of input

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products and labor from their smaller trading partners. Developing countries, with their low wages and high unemployment, can support much of the developed country's need for cost competition. This type of trade can yield greater market opportunities for developing country workers, while industrialized nations may face widening gaps in low versus skilled labor wage equality, as a result of the flow of capital to developing countries. This should stimulate increased competition among workers within the developed countries to be cost conscious and flexible in the face of market forces. RTBs can be a very positive occurrence for the global economy, as outcomes such as the following are produced: greater increases in efficiencies, knowledge sharing among members and industries, increased product and service competition, and availability of goods and services, within and across regions. As economic theory points out, even increases in bilateral trade produce positive effects. These effects may not be optimal, but increase as the trade areas enlarge. RTBs are already causing developing countries to improve their legal systems, currency exchange and convertibility, accounting systems, labor and educational exchanges, and other necessary policies, in order to be fully accepted and integrated into their RTBs. More importantly, as these countries develop infrastructure to deal across borders with their regional trading partners, in many cases they are also putting into place economic and regulatory policies that set the stage for global integration. As RTBs broaden, and as trading alliances between developing nations and industrialized countries strengthen, increases in efficiency and specialization provide a greater quality and variety in goods.16Frankel, Stein, and Wei (1995) conclude, "(A)pparently the optimal path concentrates on extending the scope of the Preferential Trading Arrangements from two-country agreements to wider sub-continental agreements, and then to the continental level, and then finally to the worldwide level, before liberalizing completely within any unit. At least, such a path would under our assumptions raise economic welfare at each step of the way."17 Arguments Against RTBs

There are two basic arguments against regionalism in trade. The first involves fears of trade diversion. That is, if countries within a RTB trade exclusively with each other, then there may be lost benefits, if a supplier outside the region could have sold the same product at a lower cost. As discussed above, trade is diverted to the higher-cost

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supplier only because it is a member of the region. This arrangement, however, may be trade enhancing, at least over time, if the RTB is among countries that are trying to develop new industries to eventually expand trade opportunities and increase competition in the global arena. Many developing countries, particularly those in SubSaharan Africa, currently trade in only a few commodities or natural resources. These countries are vulnerable to volatile commodity prices that can help or impede the countries' development. Again, diversification into new trade products can stabilize income. Therefore, RTBs, whose memberships primarily contain lessdeveloped countries, can lead to trade in non-competing goods and to the creation of new industries upon which broader trade can be based, as compared to RTBs with larger countries as members that can produce what they need (NAFTA). Meier (1989) argues that RTBs will not lead to better utilization of factors of production unless industries are already in place and broader markets are needed to take advantage of economies of scale. Experts may agree that the efficiencies would not be realized, since no such production would exist. One would respond, however, that industries would develop in RTBs that have not had such production, if market demand developed sufficiently. In this way, a RTB is not needed for larger, more developed economies that have mature industries and negotiating clout. For instance, the U.S. has not been forthcoming in opening trade further with Mercosur "as its market matters far more to them than less-than-solid allies for Mercosur when the real bargaining begins."18 Second, there are fears expressed that the proliferation of regionalism will impede globalization of trade.19 One question addresses concerns of whether world trade will be limited to blocs of countries trading among themselves, to the exclusion of other trading partners. Fears are expressed that several large trading regions will develop, where dominant, economically stronger, members will halt further trade integration at a global level. This concern appears to be well founded, except for three points of consideration. First, evidence indicates that even though trade increases within RTBs, there is continued trade activity vis-a-vis the rest of the world.20 Limited or restricted trade flows between RTBs may occur only initially as they are forced to meet product standards, seek investment protection, and follow customs procedures imposed through barriers from other RTBs. Second, current evidence shows that as RTBs continue to proliferate, many countries are members of more than one region, so

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there is cross-pollination and harmonization of investment, tax, and intellectual property policies. Countries that are members of more than one region must generally meet the standards of the most developed region. Third, in support of continued globalization, the WTO has 132 members, with 30 more countries working to meet the criteria to enter.21 This creates a dual effort whereby countries are concerned about having a regional base from which to operate, while concurrently struggling to stabilize market forces and meet global conditions for free trade. III.

RTBS OF THE FUTURE

The near future development of RTBs should continue as in the past, to ebb and flow, in fits and starts. However, these efforts may help global free trade over time. In some countries, having trade open slowly and in a controlled way may help the political debate that ensues after countries start to realign industries, with trade shifting from all-in to comparative advantage production. RTBs will continue to emerge and enlarge, due to economic trends and capital flows that display strong regional patterns of development.22 Countries will not be able to afford to defend and protect their individual sovereignties, due to the highly uneven processes of development and globalization. This unevenness will continue to force countries to reshape their economic and political alignments and distinctions, causing them to attempt to unify and meld into harmonized trade regions. The North versus South paradigm will continue to frame challenges of trade, as developed countries abuse their influence and their historical linkages with poorer countries. Northern, primarily developed, countries will not be able to continue to dictate international economic packages and arrangements for their own interests as "interdependence remains the rule for industrialize (d) countries ... In North-South relations, the coexistence of interdependence and globalization is reflected in the changing mandate of international organizations such as WTO, which no longer focuses exclusively on free trade with an eye on environmental protection and minimum labor standards."23 In addition, there are forces that will continue to pressure, and to ensure, continued globalization. Multinational corporations (MNCs), technology, and capital flows will accelerate national liberalization of trade and transborder labor and capital exchanges.

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"Like technological innovation, the deregulation and liberalization of cross-border economic activity foster an environment that not only permit(s) but compel(s) companies to develop global strategies."24 Developing countries must continue to develop the infrastructure necessary to attract and retain these MNCs. The direction that global trade must take in coming decades will come from increasing economies of scale, increased efficiencies and competition, and continued capital flows in the global marketplace. RTBs will increasingly affect world trade through the enhancement of financial integration, technological innovation, communication, and employee training and education. Productivity gains among trading partners will intensify and lead to greater cost competitiveness and diversification in product and service offerings. Developing country members of RTBs will experience heightened growth in GDP, as they can effectively skip stages of technological advancement, as the costs in telecommunications and information technology decline and the common technical know-how through imports and foreign investment increase. Over time, growth will be more important than, but lead to, trade integration, as growth stimulates demand for industrialized country output and as growth in investment in developing countries boosts demand for imports of capital goods and services. The increasing shift to the private sector and the prospective expansion of infrastructure investment in developing countries offer new opportunities for exports from industrialized countries. In addition, income growth in developing countries will increase demand for more, increasingly sophisticated, consumer goods, boosting imports from industrial countries.20 As globalization touches more and more countries, international institutions and organizations will be required to expand their abilities to handle public policy, regulatory, audit, human welfare, and conflict-prevention issues. Their ability to manage and assist developing countries in these areas will mean assurances of the countries' long-term participation in the global economy. Development assistance will be mandatory as "globalization's success depends on North-South transfers of capital."26 Standards of industrialized countries cannot be applied arbitrarily to all developing countries without severe repercussions and economic and political setbacks occurring. For developing countries to survive and catch up, further economic and humanitarian assistance will be required as a wellexecuted strategy and not as a result of political or economic strife in bailing out foreign direct investors.

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Corporate linkages and public action organizations should share the responsibility for helping to move developing countries forward toward globalization, and challenge individual nation-state sovereignty for the advancement of society, the environment, and social welfare, as a whole. This will require regional governmental policymakers and industry leaders to meet regularly to share experiences and cooperative techniques. Public interest group attacks and their lobbying pressures will have to be removed from U.S. policy decision-making to such a degree that consumers, other trade partners, and the environment are not ignored. Big money and labor union protectionism will only hinder future advancements and economic growth of fledging economies, lessening developing countries' opportunities to enhance technologies and receive shared training and skills formulation from developed country market barriers. The issues used by special interest groups in developed countries to restrict trade with developing countries will only continue and fester until technology transfers, education of labor forces, and environmental concerns are addressed and understood by policy-makers in all countries. From such understanding and involvement by all the players, the field may be leveled, and developing countries may have a fuller hand with which to deal in WTO concerns. The existing friction and power play for individual dominance and world hegemony will become immaterial and less emphasized, as financial markets and corporate alliances fully integrate and penetrate all levels of national governance, production, and consumption. Superpowers will no longer be required to police and govern regions, but to set examples for democratic and humane coexistence among countries and their regions. Further market liberalization and harmonization of trade policies will enhance integration and the benefits to regional membership. Foreign aid and investment through training and product diversification will train workers in developing countries and reduce interregional trading activities. These enhancements will also hopefully mitigate social concerns, such as the practice of child labor, the sale of children and women into prostitution, the spread of communal epidemics, and the drug trade. As countries collectively formulate appropriate social policies, even no-tolerance practices, and educate consumers on the dangers and impacts of such practices upon society and the region, then there will be further benefits of globalization. If careful planning is implemented, more equitable development can occur throughout the world, leading one day to a healthier world economy and society at large.

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CONCLUSIONS

This chapter has examined the issues surrounding the development of RTBs and their impacts on globalization, and has concluded that such development, in step-wise fashion is necessary for equal growth of developing countries vis-a-vis developed countries. We mentioned several benefits of RTBs and dispelled several arguments against. For example, RTBs can help improve negotiations between large and small countries, which in and of itself leads to continued opening of global trade. The future looks bright as countries grow toward membership in the global community. The WTO is available for dispute resolution, as well as being a forum for further trade talks. Trading within blocs is not optimal, but it improves on unilateral trading of the past, where a few strong countries have dominated the landscape. REFERENCES Batten, J. and Bryant, S.K. (1999) 'Trade Finance and Economic Development in Sub-Saharan Africa,' Journal of Developing Nations, February. Economist (1996) 'Remapping South America: A Survey of Mercosur,' Economist, October 12, 1996. Economist (1998) 'Economics Focus: A Question of Preference,' Economist, August 22, 1998. Frankel, J., Stein, E., and Wei, S.J. (1995) 'Trading Blocs and the Americas: The Natural, the Unnatural, and the Super-natural, 'Journal of Development Economics, 47:61-95. Gaviria, C. (1998) 'Trade and Economic Integration in the Andean Region,' in Rodriguez Mendoza, M., Correa, P., and Kotschwar, B. (eds.), The Andean Community and the United States: Trade and Investment Relations in the 1990s, Organization of American States, p. 1-7. Ghosh, S. (1996) 'Reverse Linkages: the Growing Importance of Developing Countries,' Finance & Development, Washington, DC: International Monetary Fund, March. Johnson, H. (1991) Dispelling the Myth of Globalization: The Case for Regionalization, New York: Praeger Publishers. Kaswali, P. (1995) Development Economics, Ohio: South-Western College Publishing. Kirmani, N. (1997) 'An Overview of Recent Trade Policy Developments,' in Wang, C.-H. and Kirmani, N. (eds.), Trade Policy Issues, Washington, DC: International Monetary Fund, 12-19. Massey, K.J. (1997) 'Mercosur: An Inter-regional Common Market Today, Which Finds that U.S. Stalling May Be the EU's Gain?' unpublished, August. Meier, G.M. (1989) Leading Issues in Economic Development, 5th edn., New York: Oxford Press. Nafziger, W.E. (1997) The Economics of Developing Countries, 3rd edn., NJ: Prentice Hall.

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Panagariya, A. (1998) 'Rethinking the New Regionalism,' in Nash, J. and Takacs, W. (eds.), Trade Policy Reform: Lessons and Implications, Washington, DC: World Bank. Qureshi, Z. (1996) 'Globalization: New Opportunities, Tough Challenges,' Finance and Development, Washington, DC: International Monetary Fund, March. Reinicke, W.H. (1997) 'Global Public Policy,' Foreign Affairs, November/December. Schott, JJ. (1999) Launching New Global Trade Talks: An Agenda for Action, Washington, DC: Institute for International Economics.

ADDITIONAL READING Chen, X. (1995) 'The Evolution of Free Economic Zones and the Recent Developments of Cross-national Growth Zones,'Joint Editors and Blackwell Publishers. Foreign Affairs (1997) 'Global Public Policy,' Foreign Affairs, November/December. Krugman, P. (1991a) 'Is Bilateralism Bad?,' in Helpman, E. and Razin, A. (eds.), International Trade and Trade Policy, Cambridge, MA: MIT Press. Krugman, P. (1991b) 'The Move Toward Free Trade Zones,' in Policy Implications of Trade and Currency Zones, A Symposium Sponsored by the Federal Reserve Bank of Kansas City, Jacksonhole, WY, August, 7-42.

NOTES 1. 2. 3. 4.

5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21.

There are numerous publications that explain the theories, for and against, free trade. For a summary of arguments, see Nafziger (1997). Schott (1999) and Kirmani (1997) review trade progress in recent years. Qureshi (1996), p. 30. Examples include the North American Free Trade Agreement (NAFTA), European Union (EU), Mercosur, a customs union among Argentina, Brazil, Paraguay, and Uruguay, and the Southern African Development Community (SADC). Economist, August 22, 1998. Reinicke (1997). Frankel, Stein, and Wei (1995). Countries include Bolivia, Colombia, Ecuador, Peru, and Venezuela. Economist, October 12, 1996. Gaviria (1998), pp. 1-7. Batten and Bryant (1998). Economist, October 12, 1996. Massey (1997), unpublished paper, p. 3. Nafziger (1997), pp. 521-524. Meier (1989), p. 430. Ghosh (1996), p. 39. Frankel, Stein, and Wei (1995). Economist, October 12, 1996. See Panagariya (1998). See for example, Kaswali (1995). Schott, (1999).

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Johnson (1991). Reinicke (1997), p. 133. Ibid., p. 129. Ghosh (1996), p. 40. Ibid., p. 135.

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11 11 Some Measures of Regionalism and Globalization for Latin America RAUL MONCARZ

I.

INTRODUCTION

Regional and global liberalization initiatives have been mutually reinforcing since the European Common Market was created in the late 1950s. As of this chapter, there are more than 30 free-trade agreements in Latin America. The type of economic integration that exists today is very different from the one prevailing up to the oil crisis of 1973 and the debt shock of 1982. The traditional approach to economic integration was a casualty of the new spirit of free enterprise, since the emphasis changed to integration into the world economy (Thorp, 1998, p. 225). The general topic of regionalism and multilateralism in Latin America can be seen as a generalized idea of countries and regions getting together in the hope of attaining certain objectives. Multilateralism in economics denotes a pattern of trade between three or more countries, resting upon the free convertibility of currencies. Where currencies are freely convertible, trade debts between any pair of countries may be setded through the transfer of a credit balance, which the debtor has accumulated in some third country (Borts, Gould, and Wilbank, 1964, 448-450). Multilateral trade is a necessary condition for free trade, but it is not a sufficient condition. Free trade implies not only the convertibility of currencies, but also the absence of tariffs, import quotas, and import licenses. It is therefore possible to have multilateral trade among a group of countries without having free trade. The above can be applied to Latin America as a region, as well as its relations with the rest of the world, in that there is multilateral trade but the process in achieving 770

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free trade is one that continues as a goal. There are a few multilateral organizations trying to achieve the concepts of free trade and convertibility, the best known and seemingly most productive at this time, is the World Trade Organization (WTO). On balance, globalization according to a great segment of the literature, is good for every country, but many governments have been slow to erect the necessary domestic complements. It is obvious that, without adequate safety nets to cushion adjustment burdens, it would very hard for any agreement to move forward. An understanding of the situation, together with workers' training that will convert potential losers into winners who can take advantage of the better jobs and higher wages that become available, will gain political support for globalization. Otherwise it may be impossible to sustain integration in both rich and poor countries alike (Bergsten, 1997a). On the other hand, regionalism as a movement may be defined as a cultural and political movement, seeking to foster and protect an indigenous culture, and to promote autonomous political institutions in particular regions. Regional trade blocs, which account for 60% of world trade, have opened markets, but they cannot substitute for worldwide reciprocity (Bergsten, 1997b). In Latin America, regionalism can be exemplified by CARICOM (Caribbean Community), the CACM (Central American Common Market), the Andean Group and MERCOSUR (the Southern Cone countries in the region), NAFTA (the North American Free Trade Association), and finally the FTAA (Free Trade Area of the Americas). According to Renato Ruggiero, Director General of the WTO, regionalism continues to proliferate, so the issue is whether groupings go off on their own, with possible disastrous consequences, or increasingly fuse into a common global context that eventually wipes out their preferential features (Bergsten, 1997a). The latter outcome is obviously preferable, but the chances of reaching it would be severely jeopardized by a prolonged period of American inaction, as is the case at the present time. The above even though it refers to a very specific U.S.-WTO issue, could also be applied to Latin America, and its relations with other regional entities such as the MERCOSUR and the NAFTA agreements, a key concern of this chapter. It has to be recognized, that countries, or groups of countries, are sometimes free to choose between liberalization in their geographic region or to the word trading system, or of course to both or neither at the same time. Following the same reasoning, Bergsten (1997b, p. 106) states that "as the urgency of competitive

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liberalization has accelerated, however, the regional approach has increasingly come to the fore. It is considerably less difficult to work out mutually agreeable arrangements with a few neighbors than with the full membership of the well over 100 countries in the WTO." The above is a basic point of this chapter. The regional approach is less difficult for Latin America, and even more real for specific areas such as the Caribbean, Central America, and the Southern Cone. This chapter will try to argue that Latin America is not ready for a leap into global free trade by a set date early in the new millennium; that is, the 21st century. The same reasoning can be made for the rich countries and their fear that as a result of freer trade they will become poorer. The argument of this chapter is that nationalistic or regional development has to occur before competing fully in the World arena. II.

CHALLENGES, REFORMS, GROWTH AND DEVELOPMENT

The whole of Latin America has been exposed since the early 1970s to a series of common challenges. In the 1970s the most sudden one was the very significant increase in the price of oil and other commodities, which occurred again in the early 1980s, but at a higher cost, in terms of recessions and significant downturns in the region. A reality that also has to be part of the analysis is that most Latin American countries do not have much freedom in designing their economic policies. Some of the reasons are related to their lack of liquidity, low levels of information and a perceived high risk of their economies, in addition to the pressures coming from the rest of the world, and specifically the rich regions and countries. Meanwhile, the difficult adjustments of the 1970s; devaluation, unemployment and social crisis, were met in an environment of overvaluation of the respective currencies. It was one where currency floating, combined with easier access to international credit markets, left behind a changing pattern of growth; significantly higher oil and commodity prices and the absence of agreed rules governing the international adjustment process (Bank for International Settlements, 1976, 7). The choices for solving the above have varied considerably from country to country, and even in regional terms, according to their traditions, social structure and political organization. It has to be recalled that, politically, all of South and Central American, and at least the Spanish-speaking Caribbean have been characterized by autocratic types of governments. Democracy, and its

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different key variables, like free elections and their concomitant processes, checks and balances as well as market process, were just ideas from other societies and good cocktail party or seminar conversation pieces, but not applicable in the region. It seems that there are two concepts that have been exported successfully from the North or from the prevalent culture and accepted by the region—ones where there seems to be no return to the old ways. The first is democracy, and periodic election for elected officials and a basic understanding of the rule of Law. With the exception of Cuba, all the other countries of the region follow the representative democracy model. It would seem that in terms of regionalization and globalization, Latin America has had a new start in representative democracy and is part of the regional and global political mood. The second is capitalism. With regard to capitalism, it dominates economic society, giving it shape and energy under such names as deregulation, privatization, common markets, free trade areas and so on (Heilbroner, 1997). The most recent experience of transformation had as a precedent the period 1855-1863, in which reforms were very much part of the conventional wisdom, "for spurring a transformation from traditional, corporatist economic dogmas and their long history of poverty and economic stagnation to Anglo-Saxon style competition and free markets. A more recent experience among others, were the changes in the period 1970-1980" (Pettis, 1996). It also applies to the most recent changes in the last decade of the 20th century. There is also the known fact that whenever Latin American countries have unilaterally gone through periods of deregulation and freer markets it has generally been the case due to commodity prices being high, war periods, and times when global liquidity has been available. All of these factors have existed in the early 1990s in addition to the well-known ones of globalization and the new economic order. In summary, Latin America is still very much dependent on events in the World, specifically in the rich countries, such as the U.S., Asia, and the EU. If the economy of the U.S. is booming then it is almost certain that conditions in Latin America will improve significantly. All Latin American booms have had in common the conditions of excess global liquidity resulting in significant capital movements in both directions, both with high prices, and also when the boom is over capital leaves the region. These movements took place whether nations or regions were pro-market or interventionist. For the remainder of the good times, the buzzword in Latin America is one

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of pro-market at the national level, more of a pro-market at the regional level and a cautious one at the global level. III.

A NEW TIME FOR LATIN AMERICA

Strong disruptive forces have been at work for some time, including inflation and debt issues. But the most important, and that which probably lies at the root of many difficulties, including inflation and high levels of debt, has been a gradual yet fundamental alteration in the patterns of income distribution and growth. Among others, Boulmer-Thomas (1996) comments "that, if the new neo-liberal paradigm in Latin American economic policymaking is to imitate the Chilean success story, then time is not on Latin America's side." In general there is a consensus that, growth has been less than anticipated, and as a result increases in social expenditures have been minimal. When one looks at trade liberalization and labor market reforms, they have hurt poorer wage earners, particularly in rural areas. Lastly, the transfer of assets, especially via privatization, has produced a sharp fall in real wages and a deterioration of the way income has been distributed. At the start of the third millennium, on average, the countries of the region suffer from the greatest income inequality in the world. There are exceptions, such as Costa Rica, Jamaica and Uruguay, where inequality is relatively low by regional standards. But the region also has the countries with the widest income gaps in the world, as in Brazil and Guatemala, where the top 10% of the population receive almost 50% of the national income, while the bottom 50% scrape up little more than 10%. As noted by the latest report of the Inter-American Development Bank, the problem shows no obvious signs of improvement (Economic and Social Progress in Latin America, 1998, p.l). These realities are a significant handicap for nation-building and the integrative process. On the theme of economic integration, the traditional approach in Latin America in the 1970s, was that the region was experiencing a number of problems, such as conflicts of interest, and economic policy instability within the countries of the region. In addition, there were external pressures, and short-run measures by the private and official sector in defending their local economies (Ffrench-Davis, 1998). For all of the above and more, integration came to be seen as a form of protectionism, and was rejected from an ideological point of view by the providers of the financial flows and by those seeking new opportunities in the different economies.

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According to Thorp (1998, pp. 233-230), around 1985, integration was included in the agenda again, pushed by the Economic Commission for Latin America and the Caribbean (ECLAC), as a kind of "stepping-stone" to a more open international order. Interestingly, the European Community took fresh interest in supporting integration, for its own national interest following the entry of Spain and Portugal as members of the Community. Accords were signed with the Andean Pact and with the Central American Common Market, as well as increasing aid to integration projects. In the 1980s the most important bilateral agreement signed was the Argentina-Brazil accord of July 1986, which was to form the basis of the Southern Cone Common Market, MERCOSUR. The Andean Pact also experienced resurgence, with bilateral trade links becoming all-important. In 1990, the Free Trade Area of the Americas was proposed by the U.S., building on the concept, originally proposed by Mexico, of a free trade zone including Canada, Mexico, and the United States (the North American Free Trade Agreement, or NAFTA). Even in Central America, a new integration scheme was launched in the 1990s under the name of the Comunidad Economica Centroamericana. The main objective of this new attempt at integration was to preserve earlier gains and to proceed via bilateral agreements. The Caribbean Community (CARICOM) is also trying to bring itself to the new realities of big blocs and negotiations and renegotiations of previous and future agreements. The first task of transformation involves changes to the Community's 25-year old treaty, which is considered inadequate to deal with changes in trade and transportation, agriculture and industry (Canute, 1998, p. 10). Another U.S. contribution together with most of the Caribbean has been the Caribbean Basin Initiative (CBI), conceived by the Reagan administration as a further way of isolating Nicaragua and Cuba, starting in 1983, extended in 1990 and enhanced in 1999. The CBI has been a complement to other measures promoting political and economic stability in the region and contributing in controlling emigration from the region. The basic element of the initiative was the unilateral granting by the U.S. of reciprocal, dutyfree treatment to Caribbean basin exports, excluding Cuba. One of the preoccupations of the U.S. with the new-found concept of integration to the South followed the ideology of the market. Since at the heart of all U.S. initiatives is the idea of leveling the playing field, or the harmonization of rules and regulations so that U.S. investments might flow smoothly into Mexico, and

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presumably to the rest of the region, and facilitate trade and growth (Thorp, 1998, p. 235). It has to be known that the Mexican government at the time was very much interested in these types of negotiations and actively worked for the free trade agreement. The negotiations produced the agreement creating NAFTA. Once NAFTA was a reality, other countries in the region began to move in the direction of being considered for a NAFTA type of membership. In the specific case of Mexico, a member of NAFTA and other regional and multilateral agreements, some the evidence indicates that, even though it has followed the U.S. model of uncontrolled trade such as deregulation, privatization and opening of the economy for more than a decade, one of the results has been a collapse of its currency and a deterioration in the standard of living. This has also occurred in the wake of a speculative boom, and a trade-off a 40% drop in real wages and the impoverishment of its middle class. Instead of helping Mexico get out from under the burden of international debt, the adoption of a new model has raised its foreign debt burden, which workers will eventually have to pay off, by another 50% (Faux, 1997). IV.

OPENNESS IN THE ECONOMY

Outward looking policies are responsible for the current trade boom and the growth being experienced by the different countries in the Latin American region. The average level of tariffs has fallen from 45% before the debt crisis to 13% in 1995, without changing significantly up to the year 1999. The highest tariff fell from its precrisis level of 84% to 41% (Economic and Social Progress in Latin America, 1998, p.l). Findlay (1996, p. 49) asserts that labor-intensive manufacturing exports have turned out to be the solution to the dilemma of whether to rely on primary product exports, with the volatility and risk associated with that option, or on import substitution, with its own drawbacks of inefficiency and stagnation. The east-Asian miracle lasted until more countries jumped on the bandwagon, and competition with one another brought a regional recession, better known as the Asian crisis (Mead, 1998). This indicates that Asia has not found the miracle cure to kill underdevelopment in a single generation. Others maintain that so far, the NAFTA agreement has helped the Mexican economy without hurting the United States. The trade agreement has helped to make sure that Mexico sticks to its program of reforms, and has thereby done much to improve the

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tense relations between the U.S. and Mexico. On the U.S. side, it is important to note that only 117,000 people have signed up for the benefits offered to workers displaced by NAFTA. Compare that with the 1.5 million who lose their jobs each year from factory closures, slack demand and corporate restructure, and the 2.8 million new jobs created each year in the United States of America. Furthermore, its direct investments in Mexico have averaged less than $3 billion a year since 1994, corresponding to NAFTA's first year. This figure represents under 0.5% of total spending on plant and equipment (Economist, 1997a). On trade, intra-regional exports have grown by 18% a year on average since 1990, compared to 9% growth in non-regional exports, and account for 18% in 1996 of the total Latin American and Caribbean exports, up from 12% in 1990 (Economist, 1997a). V.

REGIONALISM AND MULTILATERALISM

There are six distinct sub-regions in the Americas and one multilateral idea. These are the following: NAFTA, MERCOSUR, the Central American Common Market (CACM), the Andean Community, the Caribbean Community (CARICOM), the Group of Three (G-3), and the multilateral area known, so far, as the Free Trade Area of the Americas. Intra-regional trade has its own momentum, with strong growth at the initial stages of the agreement and then as markets get into a new equilibrium unless there is significant growth, there is a need for new initiatives to further liberalize relations or to widen the agreements to also encompass outsiders. Initiatives that are always tempting include protectionism and bilateralism by those that question the superiority of the time-honored free trade model of international economics (Salvatore, 1993, p. 5). The evidence at the end of 1999 indicates that intra-regional exports are growing, but at a slower rate. In all sub-regional markets except NAFTA, growth in intra-subregional commerce has slowed down decisively since 1996. The new initiatives on fast-track by the U.S. met a crushing defeat in the U.S. Congress at the end of 1997, while a number of other initiatives among Latin American and Caribbean countries to deepen and widen their regional trading arrangements continue. These countries are also seeking closer ties with other regional and non-regional parties. As an example of the above, members of the Central American Common Market (CACM) have agreed on a new schedule for convergence to a lower

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common external tariff. They have also taken steps to coordinate future trade negotiations with third countries and blocs; some negotiations may be undertaken jointly by Central American governments. The CACM is an example of a common market that has worked in the past, and is working again, but it needs external stimuli for it to continue being an engine of growth for the region. A new and very valid concern has been the erosion of preferences with the U.S. and Canada due to the NAFTA agreement between these countries and Mexico. The Central American countries expect to have a reciprocal free trade agreement with the U.S., while at the same time they are also engaged in talks for a free trade accord with Mexico and CARICOM, and have voiced their intentions to pursue closer relations with MERCOSUR. The CACM has again almost reached its limits, what it needs to be to expand into a broader regional or multilateral arrangement. Members of CARICOM have advanced steadily in terms of convergence to a lower common external tariff. Recently the World Trade Organization (WTO) judged that the current banana regime with the European Union (EU) is incompatible with multilateral trade rules. In addition other preferences granted by the EU under the Lome IV Agreement will expire in the year 2000, adding to the uncertainties in the investment process. CARICOM is still very dependent on agricultural exports and tourism (Central Bank of Barbados, 1999). Another challenge in their short-run scenario is that they have not been able to secure NAFTA parity as of January 2000. CARICOM and the CACM both suffer from fluctuations in commodity prices, which are sometimes beneficial and most of the time are insufficient to spur increased levels of output and growth in the respective economies. In addition, adverse weather conditions can add to the weak performance of the overall economies. If we add the difficulty encountered by the Caribbean clothing exporters in exporting to the U.S. due to lack of trade parity with Mexico in accessing the U.S., the whole multilateral issue suffers not only with traditional exports, but also with non-traditional ones (Canute, 2000, 10). The Andean Community integration process was fortified in 1998, and trade between its five member countries remained stable despite the international economic crisis. In 1998, the most noticeable achievement of the Community, integrated by Bolivia, Colombia, Ecuador, Peru and Venezuela, was to establish an agenda to result in a Common Market by the year 2005. The Community is

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also trying to conclude their negotiations with MERCOSUR in establishing free trade by 1 January 2000. The latter plans have been postponed due to the financial crisis in 1998 and the Brazilian devaluation of 1999. As of January 2000, MERCOSUR is going through a turbulent period that started in January of 1999 with Brazil's devaluation and its subsequent impact on the region. Commerce between MERCOSUR countries has dropped by about 30% during the first four months of 1999. As a result, there has been increasing tariffs and quotas among members. The Brazilian devaluation has added to the tensions of MERCOSUR, in part due to the competitive impact on Argentinean producers who are stuck by the country's maintenance of its one-to-one exchange rate with the U.S. dollar (Mendoza, 1998). Prior to that time, MERCOSUR was alive and growing, being led by the most powerful nations in the region, Brazil and Argentina. As recently as 1996, MERCOSUR signed free trade agreements with Chile and Bolivia and at this time they are associated members. The area of free trade emerging from these agreements incorporates half of the region's population and almost 60% of its GDP. A possible agreement between the members of MERCOSUR and the Andean Integration System could establish an area of free trade covering almost all of South America. Quoting Bergsten, "It is considerably less difficult to work out mutually agreeable arrangements with a few neighbors than with the full membership of well over 100 countries in the WTO" or even with the neighbor to the North (Lapper, 1999). Since its inception in 1994, tariff reduction among NAFTA members has moved on schedule. In 1997 it was decided to speed up liberalization for some products. NAFTA countries have also progressed in dismantiing non-tariff barriers to trade, which are of particular importance in the agricultural area. It has to be recognized that even though NAFTA enlargement is being delayed by the U.S. government's lack of fast-track negotiating authority the free trade arrangement has helped the Mexican economy without hurting the United States. The trade agreement has also helped in ensuring that Mexico sticks to its program of reform, and has thereby done much to improve relations between Mexico and the U.S. Canada and Mexico are each having bilateral trade talks with other countries in the Americas. Canada has signed a free trade agreement with Chile and shows interest in pursuing other trade negotiations with Latin American countries. In the case of Mexico, it has agreements with Bolivia, Chile, Colombia, Costa Rica, and Venezuela, and is actively

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negotiating with Central America and Ecuador. During 1999 trade within NAFTA has continued to grow; however, at a slower rate. At the hemispheric level, the Free Trade Area of the Americas (FTAA) process represents a blueprint for the launching of a hemispheric free trade zone. The U.S. has already eliminated most of its trade barriers, except for sensitive products such as textiles, footwear and others. Latin American is also advancing in the trade front as evinced by increased membership in the WTO. On many issues, Latin American negotiators are pressing for further liberalization in order to secure improved market access for exports of agricultural and manufactured goods. A practical implication of the above is that any move toward regional integration or free trade will primarily benefit all the economies by providing additional market access. According to Bhagwati, all agreements in the Americas represent a "win-win" situation in areas where the U.S. competitive strength is not in doubt (Bergsten, 1997b). VI.

THE EUROPEAN COMMUNITY

The above scenario has made the European Community take actions of their own to try to protect their interests in the region. Firstly, the Europeans were concerned with diminishing trade shares with Mexico and could only assume that the FTAA would continue what NAFTA started. The EC share of trade with Mexico between 1990 and 1996 fell from 17% to 8.6%. Trying to avoid their Mexican experience, new agreements were signed between the EU and both the Andean Pact and the Central American Common Market in 1993, and the first agreement with MERCOSUR was signed in 1992. It has to be noted that the EU is also Latin America's largest source of public development aid, and since 1993 additional support has been obtained by lending to the region by the European Investment bank (Economist, 1997b). "Eurobonds" became popular and European direct investment in Latin America has grown, supported by institutional innovations within the European Union in the form of the European Investment Bank, European Commission Investment Partners, and AL-INVEST (Iglesias and Marin Gonzalez, 1998). Missing Links

According to Luttwak there are a few missing links with this new capitalism (Thorp, 1998, p. 236). First is the legal system where very

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few governments provide effective instruments for the enforcement of anti-monopoly laws, for the control of financial abuse by enterprises and individuals in charge of the money and capital markets, and for comprehensive tax collection. Still less do they allow consumers, suppliers and lesser competitors to employ the law to contain the overpowering strength of big business and/or government. The laws may exist, but what cannot be done by the simple will of legislatures is to construct the bureaucracies that will actually enforce laws, old and new, against those best placed to resist them. VII. FOREIGN DIRECT INVESTMENTS

The flows of foreign direct investments (FBI) increased in 1996 to $349 billion from $100 billion in 1980. Most of the FBI went into the rich industrial economies, though the shares going to developing countries is growing. According to the Inter-American Development Bank in its 1997 report, the increase in investments in the region is due to a large extent to major expansions of investments in Argentina and Mexico from very depressed levels of 1995 (Luttwak, 1999). Investment in the remainder of the region was disappointing, rising only 2% in Brazil, and declining, on average, in the rest of the countries. Investment fell significantly in the Andean sub-region as well as in Central America and the Caribbean. Also related to the above are international capital flows, continuing once again to be key element in the region. Net capital flows for 1996 came close to the rates achieved in 1993, even though Argentina and Mexico, who were the main borrowers in the early 1990s reduced that activity in 1996. For the other countries, net capital flow reached 4.5% of GDP, mainly accounted for by significant capital inflows to Chile, Bolivia, Brazil and Colombia and to Jamaica where they reached nearly 10% of GDP. The capital inflows were used to finance current account deficits that averaged just over 2% of the region's GDP. It has to be noted that current account deficits increased at potentially problematic levels in a number of countries. Professor Krugman's assertion that emerging economies will in general run trade deficits has to be considered, given that a country that attracts a net inflow of capital must, by definition, be a country where domestic investment exceeds domestic savings (Economic and Social Progress in Latin America, 1997, pp. 5-118). Furthermore, at the end of 1995, when signs of recovery from the Tequila crisis were only beginning to

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emerge, investors were imposing spreads of 9.5-15.5% as compensation for the region's country risk as represented by the Brady bonds. By the end of 1996, because of additional world liquidity, the premium went down to between 5.25 and 8.25, at the end of 1999 the spreads are increasing again due to the contagion of the difficulties in the Brazilian markets. Financial and capital flows are very much related to what is happening in the world economy independent of the effect that specific flows have on the respective or regional economies and of the different tendencies in the adjustment to stabilization and reform in the region. These changes are due to the thinness of markets, and basic structural reasons that have existed for many years. The size and instability of capital flows has emerged as one of the key variables of macroeconomic instability in the area. Because of these financial flows, policy autonomy has become more limited; for instance the tendency to overvaluation associated with inflows of capital threatened to undermine the results of the new commitments to promoting exports in the 1980s and 1990s and still more in the new century. Overvaluation helps relative price stability in the short run, with the danger that the degree of that stability might not necessarily be the case (Krugman, 1997). The lessons for Latin America at the turn of the new century are that free markets cannot thrive on twisted financial foundations. One of the consequences is that borrowing can easily get out of hand, a common feature of the entire crisis in the different emerging markets (Thorp, 1998, p. 237). VIII. INTRAREGIONAL TRADE, COMPETITION OR COMPLEMENT

It is important to note that "whether regional trading agreements compete with or complement the multilateral systems does not lend itself to a clear response. If we follow the Viner approach of trade creation and trade-diversion, and what followed, it must be concluded that the net effect of a customs union on the collective welfare of the members of the multilateral system depends on individual circumstances (Financial Times, 1998). From a systemic perspective, this also appears to be true for nonborder measures (Viner, 1950). Krishna models the political process in the fashion of the government acting as a "clearing house" in response to lobbying by firms (Sampson, 1996). His oligopolistic-competition model shows that preferential trade agreements, such as MERCOSUR and others,

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reduce the incentive of the two member countries to liberalize tariffs reciprocally with the nonmember world and that, with sufficient trade diversion, this incentive could be so reduced as to make impossible an initially feasible multilateral trade liberalization. Levy, who models the political process instead using a medianvoter model, works with scale economies and product variety to demonstrate that bilateral Free Trade Agreements can undermine political support for multilateral free trade (Krishna, 1995). At the same time, a benign impact is impossible in the model: if a multilateral free-trade program is not feasible under autarky, the same multilateral proposal cannot be rendered feasible under any bilateral FTA. The Krishna and Levy models are clear on the incentivestructure model when, as is the case with Latin America, the U.S. and Canada, agents are the lobbying groups, and interests that are affected by different policy options. Bhagwati and Panagariya (1996) conclude that there exist "as-yet unformalized arguments that drive the simultaneous use of PTA's by the United States alongside multilateralism (Levy, 1986). A similar argument is cited by Bhagwati (1986), who brings out the concept of a "selfish hegemony" that, while wedded to multilateral outcomes, uses the PTA approach as a sequential bargaining strategy to divide the nonhegemonic governments and improve the final multilateral outcome in favor of its own demands." Frankel and others' key result is that the desirability of a free trading arrangement depends on whether the extent of regionalization exceeds an optimal level that is determined by the magnitude of transportation costs between regions (Bhagwati, 1994). The ultimate question for policy purposes that Frankel and others ask, is how the international trade rules might be optimally designed to ensure that regionalism is most likely to be welfare improving. Other agreements that have propitiated for a better business environment are the Brady Plan of debt rescheduling, the commercial banks' own restructuring of debt, the lowering of world interest rates and privatization, among others. These have had a positive effect of drawing capital into the larger economies of the region and having the financial sector as an important new element in the economies and integration schemes. Statistics aside, the world's manufacturers and service providers, aided by falling trade barriers, swiftly expanding transportation networks, and an explosion of technology, have established links between the world's regions too numerous to count and almost too difficult to conceive of. These links virtually ensure that the world will

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not break up into trading blocs or slide backward into large-scale protectionism (Frankel, 1996). According to some, the reason for the above is the significant force of global businesses. Just as great trusts covered a national market in the U.S. at the beginning of the 20th century, the global market is dominated by a handful of powerful companies. Almost half of U.S. manufacturing exports come from 100 companies, about one-quarter from only 20, the well-known names like General Electric, Boeing, and General Motors (Carlisle, 1996). IX.

BY WAY OF A TENTATIVE SUMMARY

For the Latin American region in a world of regionalism and multilateralism the distinction between financial and real markets is one to seriously consider. Most of the smaller countries with the exception of Brazil, Argentina, Chile and Mexico don't have a lot of freedom in designing their economic policies, given their smallness and the fact that they are very dependent on the world economy. In the middle run the whole region comes under pressure by the rich countries and the representative World organizations. As it was the case with coffee, sugar, bauxite, copper and other commodities, the same is occurring with the financial and capital markets. Countries that court the attention of financial and capital markets are taking a big risk. Bubbles are fun while they're inflating, but when they burst, it can get very ugly. The size and instability of capital flows has become a major disturbing variable in the continent, and requires that close attention be directed to all the institutions governing the financial sector. Furthermore, the Asian model proved to be short-lived, leaving the region without a magic formula to move from underdevelopment to developed status. From a regional perspective, intra-regional trade has grown more rapidly than trade with non-regional partners in the 1990s as trade liberalization has opened what seem to be natural trading opportunities within the region. These results have also come about by subregional trade agreements aimed at opening markets, and creating new trade and investment links. The smaller regional blocks such as CARICOM in the Caribbean and the Central American Common Market, as well as the larger ones such as MERCOSUR and the Andean Group, are not able to represent themselves properly in international trade talks such as those leading to the creation of the Free Trade Area of the Americas in 2005 and the European Union, unless they create an effective single market. Another reality in regional grouping is the reality in

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considering that no two countries are alike, the big partners influence the smaller ones significantly in their respective markets. As an example, Brazil and Argentina have forced MERCOSUR to adapt higher than average tariffs on capital goods while imposing in the case of Brazil, tariffs of up to 70% on imported cars. From a multilateral perspective the above may be acceptable from a practical standpoint in the short run, as long as it allows the new industries to eventually compete, by lowering tariffs and other devices that go in favor of multilateralism. Otherwise, consumers will end up with a horrible deal. But again, only the multinationals know. Today about 70% of world trade is intra-industry or intra-firm. Both are closely tied to global corporate strategies, and neither has much do with the familiar concept of comparative advantage. What this means is that much of the 1990s international economic activity reflects the internal but cross-border restructuring of corporate activities. Globalization is resulting in the emergence of a single integrated economy shaped by corporate networks and their financial relationships. It is important to recognize the power of ideas, and how the concept of discriminating free-trade can be used for MERCOSUR and for the U.S. In the MERCOSUR case, it feels better being the strong kid in the bloc, rather than just another Latin American country cowering behind tariff and other walls disturbing its members' trade. These external barriers encourage companies in the MERCOSUR countries to make capital-intensive goods, which could have been bought more cheaply from outside the region. For what is known as Latin America and the Caribbean in the U.S., the potential benefits from globalization lie especially in technology; competitive industry that can reach and be competitive in the world arena, and returns to education. In the case of the U.S. it seemed, until fast-track was defeated handily by the U.S. Congress, that the administration was working on a short-term agenda that actually was for the proliferation of free trade areas and not for multilateralism in trade. Current events add to confusion at all levels, but not to the dynamism of the regional and global agenda, which continues to be market access. Countries importing the U.S. model may be missing two countervailing forces that serve to balance its overpowering strength, the rule of law and cultural aspects ascribed to the U.S. type of societies (Borosage, 1997). When all is said and done, it seems that policy changes could swiftly remove most of the obstacles to the new economic order, or maybe it is ancestral cultural traits that would have to change.

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REFERENCES Bank for International Settlements (1976) Forty-Sixth Annual Report, Basle, Switzerland: Bank for International Settlements, 7. Bergsten, EC. (1997a) 'American Politics, Global Trade,' The Economist, September 27:23-25. Bergsten, F.C. (1997b) 'Globalizing Free Trade,' Foreign Affairs, 75(3), May/ June: 106. Bhagwati, J. (1994) 'The World Trading System,' Journal of International Affairs, 48(l),Summer:279-285. Bhagwati, J. and Panagariya, A. (1996) 'The Theory of Preferential Trade Agreements: Historical Evolution and Current Trends,' The American Economic Review Papers and Proceedings, 86(2), May:86. Borosage, R. (1997) 'Fast Track to Nowhere,' The Nation, 265(9), Sept. 20:21. Sorts, G., Gould, J., and Wilbank, G. (1964) A Dictionary of the Social Sciences, Washington, DC: The Free Press, 448-450. Boulmer-Thomas, V. (ed.) (1996) The New Economic Model in Latin America and Its Impact on Income Distribution and Poverty, New York: St. Martin's Press. Canute, J. (1998) 'A Bumpy Road on the Way to Caricom's Single Market,' Financial Times, December 18:10. Canute, J. (2000) 'Bumpy Ride Looms Ahead for Caribbean Clothing Exporters,' Financial Times, January 11:10. Carlisle, C.R. (1996) 'Is the World Ready for Free Trade?' Foreign Affairs, 75(6), November/December: 123. Central Bank of Barbados (1999) Economic Review, XXVI (2), September: 10-12. Economic and Social Progress in Latin America (1997) 1997 Report, Washington, DC: Inter-American Development Bank, 72. Economic and Social Progress in Latin America (1998) 1998-1999 Report, Washington, DC: Inter-American Development Bank, 1. Economist (1997a) 'The NAFTA Effect, When Neighbors Embrace,' The Economist, July 5:21. Economist (1997b) 'Bhagwati on Trade,' The Economist, 345(8039), October 18:2123. Faux, J. (1997) 'The "American Model" Exposed,' The Nation, 265(13), October 27:18-22. Ffrench-Davis, R. (1998) 'Economic Integration in Latin America,' in Naya, S., Urrutia, M., Mark, S. and Fuentes, A. (eds.), Lessons in Development: A Comparative Study of Asia and Latin America, San Francisco, CA: International Center for Economic Growth. Financial Times (1998) 'The Ghosts of Crises Past,' Financial Times, December 28:14. Findlay, R. (1996) 'Modeling Global Interdependence: Centers, Peripheries, and Frontiers,' The American Economic Revieiu, Papers and Proceedings, 86(2), May:49. Frankel, J.A. (1996) 'Stein Ernesto and Jin-Wei Shang, Regional Trading Arrangements: Natural or Supernatural?' The American Economic Review, Papers and Proceedings, 86(2), May:52. Heilbroner, R. (1997) 'Economics by the Book,' The Nation, 265(12), October 20:17.

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Iglesias, E.V. and Marin Gonzalez, M. (1998) 'Foreword,' in Thorp, R. (ed.), Progress, Poverty and Exclusion, Washington, DC: Inter-American Development Bank, xii. Krishna, P. (1995) Regionalism and Multilateralism: A Political Economy Approach, Mimeo. Economics Department, Columbia University, December. Krugman, P. (1997) 'Is Capitalism Too Productive?' Foreign Affairs, 76(5), Sep/ Oct:87-88. Lapper, R. (1999) 'Spectre of Protectionism Fails to Materialise,' Financial Times, November 29:VI. Levy, P. (1994) A Political Economic Analysis of Free Trade Agreements, Economic Growth Center Discussion Paper No.718, Yale University. Luttwak, E. (1999) Turbo-Capitalism, New York: HarperCollins, 24-26. Mead, W.R. (1998) 'Don't Panic,' Esquire 130(4), October:92-97. Mendoza, D. (1998) 'Paises Andinos Lograron en el 98 Mejorar Integracion y Comercio,' EINuevo Herald, 20 de Diciembre:5B. Pettis, M. (1996) 'The Liquidity Trap—Latin America's Free-Market Past,' Foreign Affairs, 75(6), November/December:2-7. Salvatore, D. (1993) Protectionism and World Welfare, Cambridge, UK: Cambridge University Press, 5. Sampson, G.P. (1996) 'Compatibility of Regional and Multilateral Trading Agreements Reforming the WTO Process,' The American Economic Review, Papers and Proceedings, 86(2), May 1996:89. Thorp, R. (1998) Progress, Poverty and Exclusion, Washington, DC: Inter-American Development Bank. Viner, J. (1950) The Custom Union Issue, New York: Carnegie Endowment for International Peace.

12 12 MERCOSUR: South America's Most Powerful Trading Group CHERYL HEIN*

I.

INTRODUCTION

In the period prior to World War II, in the depression years, the economies of many countries were characterized by high tariffs which had the effect of making international trade unattractive. World War II seriously damaged the economies of many countries and it was believed that some benefits could be obtained by reducing barriers to international trade through the elimination or decrease of the high tariffs which had been in effect. To this end, representatives of a large number of countries met in 1947 and established the General Agreement of Tariffs and Trade (GATT). Agreement was reached by the member countries on a general policy directed toward decreasing or removing tariffs, although specifics were left to the individual countries. GATT led to a series of meetings and agreements of which, perhaps, the most important ones were the Uruguay Round which consisted of talks between 1986 and 1993 (Mercosur and Other Trade Agreements, 1996, 2). The Uruguay Round dealt in depth with non-tariff barriers to trade in addition to subsidies and tariffs. It was also concerned with intellectual property rights and services. In 1995, GATT was replaced by the World Trade Organization (WTO) with a membership of 124 countries. The World Trade Organization reached agreement on a framework for settling disputes over the imposition of tariffs, subsidies and quotas. *

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Dr. Cheryl Hein passed away suddenly on July 26, 2000. The International Trade and Finance Association is saddened by the loss of our esteemed colleague.

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Following GATT and probably as a result of it, international and world trade as a whole has greatly increased. The growth of multinational companies by expansion of business and by mergers and acquisitions has been especially marked. II.

TRENDS TOWARD REGIONALIZATION

As the world economy and international trade increased, a corresponding trend has become evident for international trade, especially among the industrialized countries, to form concentrations in certain areas of the world. The reasons are diverse, but geographic proximity, complementary markets and production facilities and business interests can be thought of as causes of regionalization. A prime example of such closeness is the integration of the U.S. and Canadian economies which has taken place in spite of cultural and important political differences. Cultural and political influences can play a part such as those which led to the formation of the European Union and affected Eastern Europe (Holt and Hein, 1998, 41). A realization of the benefits conferred by cooperation and similarity of interests, especially in the economic sphere, has come about as economies have grown. It would be interesting to speculate to what extent the growth of multinational corporations has played a part. The main groups of trading nations until recently may be broadly described as: • • • •

European Union North America Eastern Europe Pacific Rim (Holt and Hein, 1998, 4-2).

Other groups are forming, notably in Central and South America and tentatively in the Caribbean and Africa. Not all important countries have become members of regional groups, notably China and the countries of the Indian subcontinent, even though they have substantial international business. The European Union

The growth of economic regionalization undoubtedly had its beginnings within Europe with the formation of the European Coal and Steel Community (ECSC) as agreed under the Treaty of Paris in 1951. At this time the economies of the European countries had not

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fully recovered from the devastation of World War II and the Treaty provided for a common market and production aims for coal and steel for the signing countries which were Belgium, France, Germany, Italy, Luxembourg, and the Netherlands. In 1957, the Treaty of Rome changed the name of the European Coal and Steel Community to the European Economic Community (also termed European Common Market) and extended its jurisdiction beyond coal and steel. On January 1, 1990, the name was changed to the European Union, reflecting changes in philosophy since the founding of the ECSC in 1951. Broadly, the aims of the European Union are to eliminate trade barriers among member countries, provide for common labor standards, mobility of labor, elimination of customs duties, establish a single currency and many other subjects of social and economic importance. The essential objective is to enable industry and agriculture in one member country to compete fairly with those in other member countries. A central bank has been established and a single currency (the euro) was introduced on January 1, 1999, initially for financial use but it is intended to eventually replace the national currencies. As a result, exchange rate fluctuations within the European Union have been eliminated. The European Union is by far the most highly structured and organized of the world's trading regions and is moving in the direction of political federation. It has a Parliament and a Court of Justice. With the introduction of the euro, monetary union was established, although some member countries have opted out, perhaps temporarily. In 1999, the EU consisted of 15 nations and several other countries have applied for membership. Eastern Europe

The Eastern European bloc countries do not have a formalized regional organization. They consist of the countries which formed the U.S.S.R. and those European countries such as Poland, Bulgaria, Hungary and others which had been under the military and economic domination of the U.S.S.R. Until the break-up of the Soviet Union in 1989, their economies and trade policies were subject to direction from Moscow. The whole group comprised a central command economy. Since obtaining independence, the Eastern Bloc countries continue to trade mainly with each other, although trade with Western and other countries has been increasing rapidly. Many of them have strong cultural and historical

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links and remnants of command economies still exist in some of them. Some have applied for membership in the EU. Pacific Rim Region

Adjacent to and within Southeast Asia is a region often designated as the Pacific Rim, comprising a number of countries in various stages of economic development. They range from Indonesia, which is mostly but not entirely agricultural, to Japan, which is a highly sophisticated, technologically advanced, industrialized country. Many of the Pacific Rim countries have some underlying cultural features in common. The Pacific Rim countries have established various trade agreements with each other but have not developed an organized overall structure. The agreements tend to be loose but in general the objectives are to facilitate trade amongst each other. All these countries are characterized by a strong drive toward industrialization, modernization and the export of goods. South America

A recent and important development in the move towards regional trade groupings has been the formation of a powerful, organized bloc in South America consisting of Argentina, Brazil, Uruguay and Paraguay. It is named the Mercado del Sur (SUL) or Southern Market, sometimes also Southern Cone; the more usual expression is Mercosur and the constituent countries have a total population of some 190 million. Chile and Bolivia have applied for membership in the group but at present are regarded as associate members. Mercosur has as its principal objectives free trade among its members, a common external tariff and a common economic, external policy. North America

Canada, the U.S. and Mexico, comprising North America, have economic and trade links formalized by the North America Free Trade Agreement (NAFTA) of 1994. The NAFTA region occupies a region of major importance, mainly from the size of the U.S. economy and its international trade. Although the U.S. is more concerned with trade outside North America than are Canada and Mexico, U.S. trade with these countries is of great importance. For

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many years Canada has been the largest trading partner of the U.S., reflecting the close integration of their economies. Mexico has been the second or third largest partner for some years with the position changing from year to year and month to month. The U.S./Canada Auto Pact of 1965 was the precursor of NAFTA. It provided for the import of vehicles and parts duty-free into Canada and the U.S. from either country. The U.S./Canada Free Trade Agreement in 1989 superceded and included the terms of the Auto Pact. The objective of the agreement was to progressively remove barriers to trade between the two countries, primarily by removing tariffs over a period of 10 years. A board was set up to resolve disputes. The inclusion of Mexico in NAFTA followed a different path from those of the U.S. and Canada and was driven largely by geographical proximity and increasing trade with the United States. The intent of NAFTA was to progressively eliminate customs duties and other impediments to trade among Canada, the U.S. and Mexico. Restrictions on foreign ownership, movement of capital and entry of transportation companies were to be removed or reduced. Canada's trade with Mexico has been relatively small but U.S. companies have been establishing businesses in Mexico to serve the Mexican market and to take advantage of low labor rates. Maquiladoras, especially, may have directed Mexico's path into NAFTA. Maquiladoras are businesses in Mexico, mostly U.S. owned and near the Mexico/U.S. border, which have a special status like those in a free trade zone. Their raw materials enter Mexico in bond, are processed and the finished goods returned to the country of origin (usually the U.S.) without payment of Mexican customs duties. U.S. customs duties may be levied only on the value added by processing the raw materials into finished goods. NAFTA also covers service industries, investments and entry of technical people. Quotas are also affected. III.

MERCOSUR

The foregoing brief review of the emerging or established regionalization of nations is intended as a prologue to a description and discussion of Mercosur, its origin, growth and current condition. It is appropriate at this stage to consider the forces which led to the concept and the realization of Mercosur as a multi-nation economic and trading entity. Undoubtedly the genesis of the idea lay in the

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discussions and statements which provided the ideology of the European Union, followed by the progressive steps towards the unity of the countries of the EU. Encouragement for the formation of the South American bloc came from the successful implementation of the plans for forming and operating the EU. Admittedly, success has not always been complete but the EU has become a functioning entity and in many ways probably provided a model for a Latin American bloc such as Mercosur later became. Probably the apparent success of the European Union, although not always complete, inspired the establishment of the Asociacion Lationamericano de Integracion (ALADI) which is a somewhat vaguely defined association of 11 Latin American countries and which has the objective of moving toward a common market. ALADI may be regarded as the precursor of Mercosur. Under its terms, if any member country enters a trading agreement over a product of another country which is not a member of ALADI, that agreement shall apply to all ALADI member countries. Impetus toward the formation of a common market in South America was given by the talks which were in progress at that time among Canada, Mexico and the U.S. which led to the signing of the North America Free Trade Agreement which was made effective January 1, 1994. Encouragement came especially from the knowledge that the U.S., which had the world's largest economy, saw benefits in allying itself economically with other countries to improve its trade position. In this climate of discussions on common markets, the next step toward the formation of Mercosur took place when Argentina, Brazil, Uruguay, and Paraguay signed the Treaty of Asuncion on March 26, 1991 which provided that the signatories would establish a common market byJanuary 1, 1995. For some years rather vague discussions had taken place over the possibility of creating a common market for all countries in the Americas to be termed the Free Trade Area of the Americas. But the signing of NAFTA sent a message that the NAFTA countries, especially the U.S., were not ready to apply the free trade concept to all North and South American countries. This message became even more clear when Chile was refused membership in NAFTA due to opposition from the United States. Perhaps consequent to recognition of the unlikelihood of becoming part of a pact including the U.S.; Argentina, Brazil, Paraguay and Uruguay formally established Mercosur by signing the Protocol of Ouro Preto in December 1994. Under its terms, all

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tariffs and quotas for goods originating or trading among member states were to be gradually removed. A further provision was to move towards a Common External Tariff. As of the inauguration of a customs union in January 1995, 804 of all products traded were duty-free within the bloc. Exceptions included textiles, steel, automobiles and petroleum which were protected by tariffs for 4 years (Mercosur and Other Trade Agreements, 1996, 5). Full customs union will be in effect from January 1, 2006. Objectives of Mercosur

The objectives of Mercosur are: 1. Free movement of goods and services among member states including removal of customs duties and non-tariff restrictions on their movement across members' borders. 2. A common external tariff (GET) and a common trade policy toward non-member countries or groups of countries. 3. Coordination and agreement of positions in regional and international economic and trade meetings. 4. Coordination of macroeconomic and other policies of members affecting foreign trade, agriculture, industry, taxes, monetary systems, exchange rates, customs duties, transportation and communication. 5. Commitment by members for legislation to permit the process of integration of states into Mercosur to take place. Institutions and Governance

Each member country designates representatives to the institution of Mercosur. Each country maintains its sovereignty but works with other member countries toward the formation of a common market, which may be regarded as a development beyond that of a customs union. The distinction between a common market and a customs union must be clarified. A customs union of a group of countries requires the elimination of customs duties on products traded among them and removal of some non-tariff trade barriers. If a tariff is placed upon goods from a country outside the customs union, the tariff shall apply to the goods entering all other countries in the group. It is a Common External Tariff, common to all the countries in the customs union. In comparison, a common market includes a customs union but goes beyond it to include provision for the free movement of labor

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and capital among the member countries and it has a common commercial policy toward other countries. It can include harmonization of national legislation by the respective legislative bodies (Embassy of Uruguay, Trade With Third Party Countries, 1999, 1). The European Union has a common commercial policy but the NAFTA countries do not. Mercosur is organized into six sections: 1. Council of the Common Market The highest level organization, in charge of political aspects. It makes decisions toward fulfillment of objectives set out by the Treaty of Asuncion and final implementation of the common market. 2. Common Market Group. The executive body of Mercosur. Its function is to implement decisions of the Council and to coordinate economic policies. It has four members, one from each member state. 3. Trade Committee of Mercosur. Assists the Common Market Group and oversees the application of the instruments of common commercial policy. It is the negotiating unit with other nations and blocs. 4. Joint Parliamentary Commission. The representative body of the parliaments of the countries of Mercosur. It makes recommendations toward establishing a future Mercosur Parliament. It makes recommendations to the Council on steps for continuing integration of member states. It makes proposals for harmonizing laws of member states and submits them to the respective legislative bodies. 5. Social and Advisory Forum. The representative body of the economic and social sectors and is consultative in character. 6. Administrative Secretariat of Mercosur. The operational support providing services to the other bodies of Mercosur. It keeps records, issues bulletins and communicates the activities of the Common Market Group (Holt and Hein, 1998, 4-2). An especially important body is the Joint Parliamentary Commission, even though it is advisory. All proposals must go through it and have its approval before presentation to the Council. It is made up of 64 members, 16 from each member state and an equal number of alternates, all appointed by the respective legislatures of the member states. All members of the Commission stay in office for a minimum of 2 years. The Commission meets at least once a year and it is a requirement that the meetings may only be held when members from each member state are present. Decisions are by consensus.

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Mercosur is a legal entity recognizing international law and can make contracts, own funds, buy and sell goods and appear in court. All decisions are made by consensus by member states and each member state will take all necessary measures to comply with Mercosur decisions. When a member state has included a regulation of Mercosur in its governmental system it will inform the Administrative Secretariat. When all member states have followed this procedure, 30 days later the regulation will be in force simultaneously in all member countries. All decisions will be published in Spanish and Portuguese. Each country has one vote in the decision-making bodies such as the Council of the Common Market. Any country can leave Mercosur at any time. For the time being, Mercosur is not a member of the World Trade Organization. Each member country maintains its own membership in that organization. In time, the treaties and agreements that member states have with other countries and organizations like World Trade Organization will be replaced with agreements with Mercosur. If disagreements or disputes occur among Mercosur members, they are expected to be resolved by negotiation. But if agreement cannot be reached, arbitration will be enforced. The Trade Commission takes a direct part in disputes and claims by reviewing them and, if necessary, attempts to mediate between the opposing parties. When a disagreement initially occurs, it is put before the Common Market Group for recommendation which must be issued within 30 days. If the recommendation is not accepted by the parties to the dispute, it goes before an arbitration board comprising three members from a list of 40 prospectors arbiters nominated by member countries. The decision of the arbitration board is final and binding. Tariffs and Customs Duties

A Common External Tariff will be part of a common trading policy toward countries or trading blocs outside Mercosur. Without a common policy on tariffs by member countries, a common market could not easily exist. With a common tariff all member countries pay the same tariff on goods imported from outside Mercosur. Until the Common External Tariff is fully in effect, a tariff may be applied each time the goods cross the border of a member state. In order to meet the requirements of the World Trade Organization, a Common External Tariff must not be higher than the tariff imposed

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by any member country. This has caused some contention within Mercosur, since Brazil has high tariffs on some goods while other member countries have reduced or removed tariffs on these goods. In spite of these difficulties, Mercosur members agreed in August 1994 to ratify a Common External Tariff structure effective January 1, 1995. The rates are between zero and 20%, depending on the type of goods. A Common External Tariff of 14% on capital goods will be made effective in 2001, although Paraguay and Uruguay will be allowed another 5 years to bring their tariffs in line. One effect of a Common External Tariff is that it leads to a common trade policy. In order to avoid transhipment tariffs, 60% local content for goods traded will be required for Brazil, Argentina and Uruguay and 50% for Paraguay, although the latter country must have local content of 60% by 2001. Exceptions may be allowed. Temporarily, Mercosur countries have a right to establish exceptions to the Common External Tariff, applying their own duties. Argentina, Brazil and Uruguay have been allowed 300 tariff items until January 1, 2001. In the case of Paraguay they are allowed 399 items until 2006. Capital goods (machinery and computers) and telecommunication equipment have a Common External Tariff of 14% and 16%, respectively. In the case of capital goods, Argentina and Brazil should be in a position to apply the Common External Tariff by January 1, 2001 while Paraguay and Uruguay are allowed until January 1, 2006. In the case of telecommunications, uniform tariffs will be reached by January 1, 2006 by the four countries. Parenthetically, Brazil subsidizes some industries quite heavily (Holt and Hein, 1998, 4-2). Common policies on freedom of movement of labor and capital have not been well developed and freedom of movement from bureaucratic restrictions and delays at border crossings is far from complete (Bamrud, 1999, 26). The elimination of customs duties does not remove all obstacles at border crossings. For example, some taxes may have to be paid. Tax harmonization has not yet taken place and each country maintains its own value-added tax with different rates, exemptions, etc. One improvement that could be made would be to remove the value-added tax in the country of origin of goods and replace it with a value-added tax of the importing country. Comparison with the European Union is inevitable. The structure of Mercosur is not as firmly established as that of the EU and is not as deeply involved in social issues such as labor standards and standardization of consumer goods. The EU has a functioning Parliament

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and Court of Justice and on January 1, 1999, a common currency, the euro, was introduced to support the monetary union of 11 of its member countries. A common currency for Mercosur has reached only the initial discussion stage; many people believe that macrocoordination among member countries needs to be greatly improved before giving serious attention to establishing a common currency. The nations of the EU speak with one voice to the rest of the world on economic and other matters and has a central bank to coordinate monetary policies. Yet Mercosur is moving along the same path as the EU in contrast with the countries of NAFTA which has no overriding common policy toward other countries on most matters. External and Internal Relationships

It would seem that the success of Mercosur as a trading bloc is assured, that it would evolve in time to become an entity like the EU. By 1997, trade among the Mercosur member countries had jumped to $18 billion from $4 billion in 1990. Plans are being made to improve the transportation system across South America and in particular across the Mercosur countries. To this end, a feasibility study has been initiated for duplicating an existing highway within Brazil and between Argentina and Uruguay. In 1996, Chile agreed to reduce its tariffs on goods from Mercosur countries within 8 years while Bolivia agreed in principle to reduce tariffs on goods imported from Mercosur. But in January 1999, a damaging blow was struck against the unity of Mercosur. Brazil, partly in response to financial problems in Southeast Asia, abandoned the controlled, fixed exchange rate for its currency, the real, and allowed it to float. The value of the real immediately plunged by 30-40% against the world's major currencies. Argentina still had its currency fixed within a narrow band of exchange rates and was seriously affected since much of its trade was with Brazil. Brazil's move surprised the other Mercosur countries and in reaction Argentina unilaterally announced that it was looking at replacing its currency with the U.S. dollar. Relations among the Mercosur countries soured and trade within the group fell off sharply. Adding to the damage to harmony, on March 10, 1999, the Andean Pact Community agreed to negotiate a free trade deal with Brazil. The Andean Pact countries consist of Bolivia, Columbia, Peru and Ecuador. In 1995, they had formed a customs union and adopted a Common External Tariff (Sims, 1998,

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A10). A separate agreement of a member country of Mercosur and another trading entity would, on the face of it, appear to be a contravention of the Treaty of Asuncion and could certainly damage the spirit of coordination and cooperation within Mercosur. But Brazil has by far the biggest economy in South America and has to be treated with circumspection by the other Latin American countries. Argentina further responded to the uncertainty of the economic situation by reducing tariffs on capital goods from nonMercosur countries by 14-16% (Wall Street Journal, EU, Mercosur Set Free Trade Talks, 1999, A8). Sugar has been the source of dispute between Argentina and Brazil. Argentina had agreed to lower its tariff on sugar, but private interests in Argentina's sugar industry exercised sufficient influence to prevent a lowering of tariffs. They claimed that Brazil subsidizes sugar. The Brazilians were distressed and discussed a possible tariff on Argentine wheat (Economist, Sweet Nothings, 1997, 36). As part of a series of retaliatory actions, Argentina stated that in addition to restrictions on imports of Brazilian steel, it would impose quotas on imports of Brazilian shoes, textiles and clothing. Brazil then, as a consequence and to demonstrate its displeasure, pulled out of talks about trading cars. Argentina has imposed strict new labeling requirements on shoe imports. In June 1999, Andean Pact countries were in negotiation with Brazil over a fixed tariff preference agreement. In the agreement for governance for Mercosur, measures were included to resolve such disputes but they were never firmly in place and have been ineffective. Brazil seems not to recognize that its devaluation of the real has caused serious difficulties or else it is relatively indifferent. Brazil's devaluation seriously affected Argentina's exports, one third of which go to Brazil. Brazil behaves like a very senior partner in Mercosur, very much occupied with its problems without regard to its partners. Evidently everything is not peace and harmony within Mercosur but it is probable that major issues will be resolved and unity will prevail. Chile and Bolivia are in discussion for possible entry into Mercosur but obstacles exist. At present, Chile has an agreement with Mercosur to liberalize various tariffs and an agreement over foreign content of goods but has not yet agreed to adopt Mercosur's Common External Tariff. Chile has applied for membership in NAFTA but so far it has not been accepted due to opposition from interests within the U.S. If it were granted membership, it might handicap entry into Mercosur since Mercosur stipulates that

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members may not become members of other free trade areas. Chile has already joined the Asia Pacific Economic Cooperation (APEC) but APEC is at this stage an agreement in principle only; talks on actual, specific trade agreements are not expected to begin until after 2001. The attitude of the U.S. toward Mercosur in particular, and possibly to other Latin American free trade groups, has been rather cool. U.S. influence may have diminished in spite of discussions on a Free Trade Agreement of North, Central and South America (tentatively called a Free Trade Agreement of the Americas) since a specific agenda and program have yet to be established. Reasons for the perceived lack of interest by the U.S. may include the exclusion of Chile from NAFTA, the U.S. trade embargo of Cuba and an inability of the U.S. president to obtain fast-track authority to conclude trade agreements. Recognizing the difficulties in obtaining a free trade agreement with the U.S. may well have turned other countries in the Americas toward regional arrangements. In spite of the internal friction and differences within Mercosur, the EU has not neglected possible opportunities for trade with it and informal discussions have been taking place with the objective of creating a combined free trade area or at least reducing trade barriers. In June 1999, the EU member governments gave the European Commission a mandate to initiate formal talks with Mercosur, beginning with a meeting in October 1999 to define the structure, schedule and agenda for negotiations. As a consequence a joint statement confirmed that the EU, Mercosur and Chile will begin negotiations toward liberalization of trade (EU and Mercosur Agreed to Negotiate Free Trade, 1999, 1). The rapid growth of Mercosur's imports from Europe increases the EU's interest in a free trade agreement with Mercosur. Mercosur is interested in reducing its trade deficit with Europe. The consequences of Brazil's currency devaluation have not been as disastrous as many had feared and its economy has rebounded while Argentina, Paraguay and Uruguay also suffered less damage than had been expected. Brazil's 1999 trade deficit was $1.19 billion, lower than the $6.59 deficit in 1998. In spite of internal differences it seems likely that Mercosur will survive and strengthen. IV.

CONCLUSION

Mercosur, which was formed on March 26, 1991, with the Treaty of Asuncion, is one of the world's newest and most interesting trading

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groups. It consists of Argentina, Brazil, Uruguay, and Paraguay, while Bolivia and Chile are considered associate members. Mercosur comprises a common market and customs union and has a formal structure somewhere between the stringent rules of the EU and the looser association of NAFTA. Mercosur has agreed to progress toward a Common External Tariff with final rates between zero and 20%. Exceptions are provided for some goods from member countries. Some internal differences have arisen but are expected to be resolved. Mercosur is negotiating for trade agreements with other groups, notably the EU. REFERENCES BamrudJ. (1999) 'Mercosur—Uncertain Future,' World Trade, 12(4), April:26-30. Economist (1997) 'Sweet Nothings?' Economist, 344(8035), Sept. 20:36. Embassy of Uruguay (1999) 'Trade with Third Party Countries,' Bulletin issued by the Embassy of Uruguay, Washington DC. http:/www.embassy.org./uruguay/ econ/mercosur/merc-005.html. 'EU and Mercosur Agreed to Negotiate Free Trade' (1999) :2. http: /www. mercosurin vestment. com/July99 .h tml. Holt, P. and Hein, C. (1998) International Accounting. Houston: Dame. 'Mercosur and Other Trade Agreements' (1996) September: 1-7. http:/www.invertir.com/P7trade.html. Sims, C. (1998) 'Dim Hopes for Trade Discussions,' Corpus Christi Caller Times, April 19:A10. Wall Street Journal (1999) 'EU, Mercosur Set Free Trade Talks,' Wall Street Journal, June 29:A8. Embassy of Uruguay (1999) 'Trade with Third Party Countries,' Bulletin issued by the Embassy of Uruguay, Washington D.C. http:/www.embassy.org./uruguay/ econ/mercosur/merc-005.html.

13 The Seattle Debacle: Beyond The Seattle WTO Ministerial Meeting MORDECHAI E. KREININ

I.

INTRODUCTION

A Fiasco! A Debacle! A failure! These were the terms used to describe the outcome of the December 1999 WTO Ministerial meetings in Seattle, Washington, called to prepare an agenda for the "Millennium Round" of trade negotiations. No agreement was reached on an agenda or on anything else for that matter. And regardless of attempts to put a good face on the outcome, the U.S. has emerged with a black eye and deservedly so. Yet the timing of the Ministerial was almost ideal, and success had been considered highly probable before the delegates arrived. Before addressing the Seattle meeting and its aftermath, the next section offers a historical background. It can be skipped by readers familiar with the history of the GATT/WTO; they should turn directly to Section III. II.

HISTORICAL BACKGROUND

While the World Trade Organization (WTO) was established in 1995, it was preceded by a less formal trade organization known as the General Agreement on Tariffs and Trade (GATT), which functioned from 1948 to 1995. Both institutions were/are headquartered in Geneva, Switzerland, and the WTO inherited the functions of GATT and expanded them in various directions. Following are its main functions:

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Ground Rules

The GATT/WTO laid down and oversees certain ground rules of international trade. Examples are: Most Favored Nation (MFN) Principle, which prohibits an importing country from discriminating between sources of supply; namely it must charge the same tariff rate on a given product regardless of the exporting country in which it originates. Non-members of the WTO such as China are not accorded this treatment automatically; the U.S. Congress passes special legislation every year granting China MFN status. But China is attempting to negotiate admission to the WTO. There are two exceptions to this rule: first, a customs union, such as the 15-nation European Union. It involves two or more countries abolishing all trade restrictions between themselves and setting up a common and uniform tariff against outsiders. The Common External Tariff constitutes the degree of discrimination against non-members, and the measure of preference enjoyed by members. The second exception is a Free Trade Area (FTA), such as the North American Free Trade Agreement, or NAFTA, consisting of the U.S., Canada, and Mexico. It involves two or more countries abolishing all trade restrictions between themselves, but each maintaining their own tariff rates and other aspects of commercial policy against outsiders. There is no common external tariff, and non-members are discriminated against in each country by the level of its tariff. An FTA must maintain border check points and administer rules of origin1 in order to prevent goods coming from the outside into the lowest-duty member and from there passing on, duty-free, to the rest of the FTA. Dozens of regional groupings exist around the world. In the postwar period the U.S. placed the entire focus of its commercial policy on the multilateral non-discriminatory mechanism of GATT. While it supported European regional integration, it eschewed regionalism for itself. This attitude changed in the 1980s partly because of the snail pace of the multinational negotiations at that time (the Uruguay Round) and partly in response to the large number of regional groupings around the world that discriminate against the U.S. In 1989 the Canada-U.S. Free Trade Agreement was concluded (implemented gradually by 1999), enlarged to include Mexico in 1995. In future years, considerations may be given to further expansion to include Chile, and perhaps to a free trade area of the Americas.

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The National Treatment Principle, which requires a country to treat subsidiaries or branches of foreign companies domiciled within its borders, in no less favorable a way than it treats its own firms. Overseeing dumping cases and anti-dumping duties, where dumping is defined as the sale of a product in a foreign country at price below that charged in the domestic market. Under certain circumstances the importing country may levy an anti-dumping duty made up of the price differential between the two markets. Dispute-Settlement Mechanism The GATT/WTO administers a dispute-settlement mechanism, where panels of experts adjudicate trade disputes between countries. An appeal to a panel's decision is also available. This mechanism was strengthened under the WTO, and countries usually abide by the panels' (or appeal panels') decisions. If a country refuses to do so— as in the case of the EU refusal to admit U.S. beef treated with hormones—the injured party is allowed to impose restrictions on an equivalent amount of imports from the offending country. Conferences The GATT/WTO sponsors periodic tariff-reduction and trade-liberalization conferences among its 130 member countries. These negotiating conferences came to be known as Rounds. There were eight such rounds since the war, and it is through them that the average tariff rate in the industrial countries declined from 60% to about 5%. Because in the U.S. tariff-making is a Congressional prerogative, U.S. participation in these negotiations requires prior enabling legislation. Such legislation delineates the limits to which the administration may go in lowering U.S. tariffs (on a reciprocal basis with other countries). Because of the importance of the U.S. in the global economy these limits become the "ceiling" for the entire "round". The legislation also contains fast-track authority, meaning that when the final global trade-liberalization agreement is brought to Congress for approval, it would be voted up or down without amendments. This applies to both the multilateral and regional negotiations. No country would negotiate with the U.S. if it thought that the Congress would modify the final outcome, and the negotiators would be forced back to the "drawing board". In the case of each round, the tariff reductions (and other forms of trade liberalization) agreed upon are staged over 7-8 subsequent years.

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Following is a list of the last three rounds preceded by the enabling U.S. legislation: Date

Round

1964

The Trade Expansion Act

1960s

The Kennedy Round (implemented until 1973)

1974

The Trade Reform Act

1970s

The Tokyo Round2 (implemented until 1988)

1988

The Trade and Competitiveness Act

1987-93

The Uruguay Round2 (being implemented until 2005)

The next session will be labeled the "Millennium Round", and the Seattle meeting of trade ministers was called to set its agenda. III.

TIMING OF THE SEATTLE MEETING

The timing of the meeting was highly propitious from the viewpoint of the U.S. as well as from that of the developing countries such as Brazil, India, or Southeast Asia. The United States For the past several years the U.S. has experienced a non-inflationary economic expansion: A real GDP growth rate of over 3.5% per year; annual inflation of under 2%; and unemployment down to 4% of the labor force by the year 2000.3 If there ever was an ideal time to separate the benefits that flow from expanded foreign trade from the transitional employment cost of such expansion, it is now. During earlier WTO/GATT rounds, and certainly in the debate over NAFTA, the employment cost of trade liberalization was an important focus; it even occupied center stage. We all remember Ross Perot's claim that NAFTA will suck millions of American jobs into Mexico. At times of full employment there is hardly a reason to be overly concerned about employment effects. This is not to suggest that specific industries or regions may not be hurt (at least temporarily) by trade liberalization. These should be aided by adjustment assistance. But the overall net effect will be small, and many displaced workers can be easily absorbed back into the labor force. Moreover, trade contributed significantly to the prosperous times the U.S. has been experiencing since the second half of the 1990s.

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While President Clinton's speech focused (mistakenly) exclusively on the benefits that flow from expanded exports, the primary advantage of increased trade lies on the import side. First, because of the openness of the U.S. economy (relative to that of other countries, including the EU and Japan), imports drive resources to industries in which this country has a comparative advantage. In turn, this results in rising productivity, faster growth, and improving living standards. Hence, imports contribute indirectly to the current prosperity; and the relative openness of the U.S. accounts partly for the differential growth rates here and abroad. Additionally, cheap imports force U.S. manufacturers of competing products to keep the lid on prices. This is accentuated when the dollar appreciates. Along with rising productivity, this factor explains the absence of inflation after several years of rapid growth and low unemployment. Indeed, one may hypothesize that the old-fashioned Phillips Curve relates inflation not to domestic but to global unemployment. When Europe, Japan, and countries impacted by the Asian financial crisis of 1997-99 grow to a point of near full employment, this hypothesis would become testable. This is not to deny the value of increased exports, and the advantage of reducing the current account deficit. But given the differential growth rates here and abroad, the U.S. is the only possible locomotive for global growth. This is not the time to worry about the external deficits and the attendant growing foreign indebtedness. In sum, for the U.S.—but not necessarily for the other industrial nations—this is a good time to plan and open a new round of trade negotiations. True, the Administration now lacks fast-track authority, without which no country would conclude a bargain with the U.S., so its hands are tied for both regional and multilateral talks. But in the past there were instances when negotiations commenced without such authority and Congress passed the enabling legislation after the talks began. The Uruguay Round is a case in point. Developing Countries

What about the developing countries? Until the Uruguay Round these nations were content to sit on the sidelines and receive "freely" the concessions exchanged between the U.S., EU, and Japan. But because the triad countries were not negotiating concessions on commodities of export interest to the developing world, these "free"

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concessions were not meaningful. Only in the Uruguay Round did the developing countries participate actively for the first time offering and receiving concessions. More of that is needed now. Furthermore, studies show that developing Asia sustained significant trade diversion from regional integration schemes among industrial countries, (for example, the Unified Market Program of the EU (EC-92) that was put into effect during 1990-94; and NAFTA in North America). It is not that these regional groupings had trade diversion in excess of trade creation, thereby imparting a negative net welfare effect. On the contrary, especially in the case of European integration, trade creation was a multiple of trade diversion, with beneficial net effect on real income. But trade creation occurs inside the customs union, improving resource allocation there, while trade diversion—however small—impacts the outside world. More often than not it is the developing countries that bear the brunt of this discrimination. And this effect will intensify as the EU admits Eastern European countries to its rank, as these nations compete directly with Asia and Latin America in a wide array of products. The only way to reduce or minimize the adverse effect on their exports is by MFN tariff cuts in a WTO Round that would reduce the margin of preference in favor of members of the customs union. Finally, developing countries have an abiding interest in a reduction of agricultural protectionism and production subsidies in the EU, Japan, and elsewhere. Because of the excessive political power of farmers in several countries, agriculture is the most distorted field in the international trading system, and it is an area in which many LCDs have a comparative advantage. Yet, despite this convergence of interests and propitious timing, the talks failed; and the cause of failure can be laid squarely at the door of the United States. IV.

THE U.S. ADMINISTRATION AND THE DEMONSTRATORS

Although the electronic and printed media in the U.S. highlighted the demands of the street demonstrators, what accounted for the failure of the Ministerial was the position of the U.S. Administration. In some cases (such as "labor standards") it coincided with demonstrators' demands. To the best of my knowledge, the Millennium Round was originally conceived (at least in professional circles) as a vehicle to liberalize service transactions and lower farm subsidies. These and other

208

Mordechai E. Kreinin

issues left over from the Uruguay Round were to be addressed, and the Seattle Ministerial meeting was assembled to hammer out the agenda. But perhaps because of misguided political desire to placate the labor movement, the U.S. delegation introduced the matters of "labor standard" and of the environment into the agenda. These are old issues were injected into the trade arena in a powerful way during the NAFTA debate. Additionally, the Administration raised demands for transparency and openness in WTO deliberations, especially applicable to the work of panels that adjudicate trade disputes. The developing countries strongly resisted the inclusion of labor and environmental standards, viewing it as an attempt to deny them competitive advantage, and interfere with their sovereignty. Indeed, if labor standards and environmental regulations became accepted as an integral component of trade negotiations, it is easy to imagine the EU arguing that European companies should not have to compete with U.S. corporations, since die latter do not offer employees European-level social benefits, have longer working hours, and are subject to less restrictive environmental regulations. Who were the demonstrators? An odd assortment of groups making various demands. Only a few of them represented organized bodies such that they could be labeled Non-Governmental Organizations, or NGOs. Following is a streamlined list: 1. Old fashioned protectionists, such as labor unions. Their desire is to protect jobs (even though this country is experiencing full employment and even shortages of certain skills and in certain locations), and maintain or raise their incomes. The good, old "scientific tariff is often resurrected (although not here); namely, a tariff which equals the wage differential between the U.S. and abroad. It would clearly deprive labor-abundant developing countries of their comparative advantage. Labor standards is one demand that the U.S. government pushed as well, and is responsible for the breakdown of the meeting. It will be taken up in the next section. 2. Environmental groups, demanding that developing countries maintain high environmental standards, again eroding their competitive advantage. It has often been said that if developing countries had labor and environmental standards similar to those of industrial nations they would themselves be developed rather than developing. In the case of both standards the LDCs felt that their sovereignty is being infringed upon, and therefore they balked. The public statement by the U.S. Trade Representative

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209

who chaired the meeting, to the effect that if agreement cannot be reached among all 120 countries represented, she would convene a smaller group that can agree on an agenda, was viewed as abrasive by developing and industrial countries alike and certainly did not help matters. 3. An odd assortment of human-rights campaigners and consumer rights groups demonstrating against genetically modified foods and other matters. On balance, however, the WTO helps rather than hurts consumers, by keeping trade open and prices down. The issue of genetic foods has actually been adjudicated lately in a WTO dispute between the U.S. and EU. It can be brought up again. But it is the U.S. that injects these products into the trading system. 4. Sovereignty-obsessed nationalists with exaggerated concern about the loss of U.S. sovereignty. They forget that the U.S. has a powerful if not dominant voice in all international institutions and that any international agreement involves compromise and concessions on both sides. 5. Development lobbies, who often overlook the benefit that open trade bestows upon developing nations. In threatening trade sanctions against developing countries that would not prescribe to American demands, President Clinton forgot that such sanctions hurt rather than help foreign labor. This is reminiscent of complaints by American "do-good" groups about poor living conditions of Mexican migrant workers (say, Michigan cherry pickers) and demands that they be sent back to Mexico, as if such an act would improve rather than worsen their condition and that of their families. There were probably other groups, misguided or otherwise, that participated in the demonstration for the entire world to see. But the critical issues are those that united the NGOs and the U.S. government through powerful lobbies in the United States. These need to be addressed and diffused, or at least deflected from the trade debate. V.

THE AFTERMATH OF SEATTLE

There will be some inevitable consequences to the botched-up meeting in Seattle. Almost certainly congress will slow down, if not abort temporarily, China's admission to the WTO that had been negotiated by the Administration in 1999. It should be remembered that other countries, such as the EU, Japan, Australia and Canada,

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Mordechai E. Kreinin

also need to conclude agreements with China before it is admitted to the WTO. Also, the U.S. agreement with China is strictly a trade pact, and it does not encompass human rights, the Taiwan problem, and other issues in dispute between the two countries. There may also be further delays in Congressional action granting the Administration fast-track authority. This will postpone U.S. participation in any regional or bilateral negotiations to form or expand preferential trading areas, such as admission of Chile to NAFTA. But among countries other than the U.S., the regional movement will probably intensify. Those who view customs unions and free trade areas as stumbling blocks rather than building blocks towards global liberalization would certainly not welcome this trend. But the Millennium Round of the WTO should NOT be abandoned. To that end the disputes that obstructed the Seattle meetings should be diffused and/or deflected. Consider first the labor standard. This issue can be separated into two distinct categories: Working conditions and remunerations. Under the first category there are topics that require international attention such as slave labor, and grossly abused child labor (not all child labor). But working conditions should not be mixed up with international trade, nor should the problem be considered and dealt with in the WTO. Rather, the International Labor Organization (ILO), with its vast Geneva-based bureaucracy, is the place for their resolution. It would be useful to call a special, highly publicized, international meeting of the ILO (perhaps in Seattle) to focus attention on the abuses of the most fundamental workers rights. While abuses should be minimally defined, such a meeting would serve to focus world attention on the problem, without tying it to trade or to the WTO. Absolutely nothing needs to be done about the alleged low level of compensations, for this is precisely what confers a comparative advantage upon labor-abundant countries in labor-intensive industries. A similar international meeting should be convened by the UN Agency on the Environment to focus global attention on environmental matters. Here too only the most flagrant abuses need to be considered, because environmental degradation, may, at times, confer comparative advantage in certain industries. Developing countries often cannot afford to spend millions on the environment, at least not until they develop. Environmental protection increases with the rise in a country's living standards. The environmental dispute in the WTO originally erupted because of the way

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211

goods are produced (catching fish with nets that kill dolphins), while the WTO focuses on trade and not on methods of production. The environment should be separated from trade; it need not be a focus of attention at the WTO. Following that, a low-profile WTO meeting could be convened to hammer out a more restricted agenda for the Millennium Round. This would include service transactions, Direct Foreign Investment issues, agricultural liberalization, and general trade liberalization. The latter two issues were indeed being contemplated in a low level February 2000 meeting of WTO delegates. NOTES 1.

2. 3.

The rule specifies a minimum proportion of the value of a product that must be produced within the FTA for it to be accorded duty-free entry to other members of the FTA. Only the opening session was held there; the negotiations were carried on in Geneva. Analytically, it is convenient to compare the difficult period of the 1970s with the heavenly 1990s by means of shifts in the aggregate supply curve. In the 1970s aggregate supply shifted to the left because of oil shocks, global draught, environmental regulations and other causes, yielding a difficult period of recession and inflation combined. In the 1990s that curve shifted to the right because of productivity improvements occasioned by the introduction and absorption of new technologies and other reasons. That lifted real GDP and controlled inflation at one and the same time. It was reinforced by a rightward shift in the aggregate demand curve caused by the wealth effect on consumption.

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Part V Investment and Financial Issues in Europe

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Part V: Investment and Financial Issues in Europe Undoubtedly, economic integration in Europe is by far the most successful and most comprehensive ever attempted in the history of mankind. The European Union is the model of economic integration followed - dreamed of- by many economic policy makers, integration specialists, and free trade advocates. The European Union has indeed changed the economic face of the continent for the better, and forever. The Union, from the very beginning, has been the topic of much research and examination. More recently, the research emphasis has shifted to specific issues surrounding the Union. The three chapters which comprise Part Five provide three studies of the European Union from different perspectives. In Chapter Fourteen, Professor Janina Witkowska examines capital movements between Poland, Hungary, and the Czech Republic on the one hand, and the European Union in the light of former group's membership in the European Union on the other. The major focus of this chapter "is to examine the consequences of integration process in the field of capital movement between the countries studied and the European Union." After analyzing "the current state of capital movement with special reference to foreign direct investment between the three countries and the European Union, and a discussion of some of the effects which can be contributed to the introduction of free capital movement, Professor Witkowska concludes that "the signing of the Europe Agreements and the prospects of the EU membership [have] enhanced the locational advantages of all three countries." In Chapter Fifteen, Professor loannis N. Kallianiotis "explores the integration of the European Money and Capital Markets at the threshold of the 1999 European Monetary Union (EMU)." The analysis of the data presented leads Professor Kallianiotis to conclude that "European Union members are not integrated and the majority of them (all except Luxembourg, Britain, Finland, and France) did not fulfill the Maastricht criteria by the end of 1997 [as required by the Agreement] to join the EMU." 215

216

Part Five concludes with Chapter Sixteen in which Professors Bimal Prodhan and Ranko Jelic examine interest rate linkages and foreign exchange volatility between the British Pound and the currencies of Britain's major trading partners from 1987 to 1998. Their objective is "to trace the rate of change in the volatility of pound sterling, and link this volatility with differences in Consumer Price Index (CPI) deflated interest rates to obtain pointers for the medium-term future." Professor Prodhan and Jelic conclude that even though the "United Kingdom has decided not to participate [in the European Single Currency] at least until 2002, [the reason for this decision is] primarily because the U.K. economy might not be in synchronization with the economies of the other participating countries, which may cause structural problems in the British labor market. In spite of this, it is the desire of the British government to prepare the U.K. economy to join in [the European Single Currency] around 2002."

14 14

Capital Movements Between CEE Countries and the European Union JANINAWITKOWSKA

I.

INTRODUCTION

Central and Eastern European countries (CEECs) aspire to membership of the European Union. This has been the strategic goal of their foreign policy since the start of the European Agreement negotiations. After CEE countries submitted answers to a detailed questionnaire in mid-1996, the European Commission evaluated their preparation for membership of the EU (Agenda 2000, 16 July 1997) and recommended that accession negotiations should be opened with some of them. The conditions for EU membership set for the candidate countries by the European Council require the existence of a market economy as well as the capacity to cope with the competitive pressure and market forces within the Union and the ability to implement acquis communataire. With regard to capital flows, this means establishment of full freedom of capital flow between the CEE countries and the EU. The freedom of capital flow—side by side with free flows of goods, persons and services—was one of the fundamental liberties instituted by the Treaty of Rome. The implementation of that liberty proceeded for a long time much more slowly than the other liberties. In accordance with the provisions of the Maastricht Treaty (Article 73b), any restrictions on capital flows between member countries and between member countries and third countries are forbidden and it is also forbidden to make any restrictions on payments between the member countries and between member countries and third countries.

277

218

Janina Witkowska

Poland's, Hungary's, and the Czech Republic's preparations for the freedom of capital movement understood in this way were evaluated positively by the European Commission in the so-called Avis (Avis 2000, 1997). However, it was underlined that further efforts were still required with regard to the liberalization of capital movements. The aims of this chapter are to present the current status of capital movements between three GEE countries (Poland, Hungary, the Czech Republic) and the EU, to evaluate the adjustment processes in the field of capital movements to the membership conditions and to analyze potential effects of future liberalization of capital flows between the GEE countries and the EU for their economies. II. CURRENT STATUS OF CAPITAL MOVEMENTS BETWEEN CEECSANDTHEEU

All of the 13 categories of capital transactions classified in the EU Directives occur in the relations between GEE countries and the European Union. However, only some of them have sufficient statistical documentation to permit identification of their intensity between the integrating countries. The relatively well-documented capital flows include foreign direct investment (FDI). FDI flows into Central and Eastern Europe—the whole group of economies in transition—were more than doubled in 1995. After a decline in 1996, inflows rose by 50% in 1997, to US$19 billion, a level comparable to that achieved by Latin America and the Caribbean in the early 1990s (World Investment Report 1998, pp. 12-13). In 1998, flows to these countries remained almost stable, at a level close to US$18 billion, although the Russian Federation saw its FDI fall by more than 60%. On the other hand, the rest of the GEE region as a whole registered another record year, with FDI inflows topping US$15.3 billion (World Investment Report 1999, p. 480). Nevertheless, the share of CEECs in world FDI inflows remained below 3% in 1998. Among the three Eastern European host countries analyzed, Poland experienced the largest increase of FDI flows both in 1997 and 1998 (US$6 and 10 billion, respectively, according to the national database). FDI commitments to Poland, having increased by more than 50% in 1998, indicate that the upward trend may be maintained in the near future. The implementation of the privatization programs in telecommunications and power-generation

Capital Movements Between CEE Countries and the European Union

219

should be conducive to the rising trend in the flow of FDI into Poland. The data for the first half of 1997 gathered by the Polish Agency for Foreign Investment (PAIZ, 1997) and covering investors who invested at least US$1 million, confirm the above prognosis. The inflow of FDI to Poland in the first half of 1997 amounted to US$4.9 billion, and the total cumulative foreign investment in Poland was estimated at US$35.5 billion (PAIZ, 1997). Poland also became the region's leader in terms of inward FDI stock, followed by Hungary. According to the UNCTAD evaluations, Hungary, which registered a slight decline in FDI inflows in 1998, has been experiencing a smooth transition from privatization-led to greenfield-led FDI. In 1998, non-privatization investment accounted for 94% of FDI flows into this country, compared with 34% in 1995 (World Investment Report 1999, p. 70). The Czech Republic witnessed a significant increase in FDI inflows in 1998 after a decline in the years 1996-97 (World Investment Report 1999, p. 480). Tables 14.1 and 14.2 show trends—according to the UNCTAD data—in FDI inflows and inward FDI stocks in the analyzed countries. The data confirm that Poland and Hungary, together with the Czech Republic, belong to the largest recipients of FDI in the region. These countries accounted for about 61% of total FDI inward stock and about 55% of total inflows in 1998. As a result there is a relatively high concentration of FDI flows and stocks in countries being most advanced in the transformation processes and simultaneously being candidates for membership of the EU. TABLE 14.1 FDI Inflows into the Czech Republic, Hungary and Poland in 1986—98 (US$ million, %) Total CEE countries Of which: Czech Republic

1986-91 1992 658 4439

1993 6757

1994 5932

1995 14266

1996 12406

1997 18532

1998 17513

2540 99 1429 1301 1003 653 862 2561 1935 1471 1146 4453 1983 2085 430 2339 Hungary Poland 84 1875 3659 4498 4908 5129 678 1715 FDI inflows into Czech 44.8 93.2 71.0 69.4 63.8 54.8 65.6 75.1 Republic, Hungary, Poland as % of total inflows into CEE countries Source. UNCTAD FDI/TNC database, World Investment Report 1998: Trends and Determinants, UN, New York and Geneva, 1998: World Investment Report 1999: Foreign Direct Investment and, the Challenge of Development, UN, New York and Geneva, 1999 and my own calculations.

220

Janina Witkowska

TABLE 14.2 FDI Inward Stock in the Czech Republic, Hungary and Poland in 1990—98 (US$ million, %) Country Total GEE countries Of which: Czech Republic Hungary Poland FDI inward stock in above countries as % of GEE total FDI inward stock

1990 2959

1995 37977

1996 46608

1997 68613

1998 83348

13601

7352 11919

7061 14690 1 1463 71.3

6234 15882 16593 62.7

13457 18255

569 109

68.9

7843 71.4

21722 2 60.8

1

Stock data prior to 1992 are estimated by subtracting flows. Estimated by adding flows to the stock of 1997. Source. As in Table 14.1.

FDI plays a different role in the economic development of host countries. Measures of the relative importance of FDI in the Czech Republic's, Hungary's and Poland's economies show some discrepancies between them (see Table 14.3). Although the ratio of FDI stock to GDP for GEE countries as a whole (8.3%) falls behind the world average (11.7%), the situation in the analyzed countries differs significantly. Hungary's ratio of FDI stock to GDP (34.7%) is three times the world average and the Czech Republic's ratio (22.8%) is almost twice the world average. In the case of Poland, the ratio (11.6%) is slightly below the world average. Another measure of FDI importance is FDI inflows as a percentage of gross fixed capital formation. In Hungary and Poland, these ratios (20.5% and 17.1%, respectively) considerably exceed the corresponding average ratio for the world (7.7%). Also such an indicator as FDI inward stock per capita shows differences among the analyzed countries as TABLE 14.3 Selected Indicators of the Importance of FDI in CEECs Country/region

Czech Republic Hungary Poland CEE countries average The world average 1

FDI inward stock over GDP, 1997 (%)

FDI inward stock per capita, 1997 (USD)

22.8

1307

34.7

1799

11.6 (22.5) 1 8.3 11.7

562 (918)' -

FDI inflows over gross fixed capital formation, 1997 (%) 8.1 20.5 17.1 (31.0)1 10.5 7.7

Data in brackets for 1998, my own calculations on the basis of national data. Source. As in Table 14.1 and my own calculations.

Capital Movements Between CEE Countries and the European Union

221

well as between them and CEE countries as a reference group. This ratio is the highest in the case of Hungary, i.e., US$1,805 in 1998. It amounted to US$1,307 in the Czech Republic and only US$562 in Poland in the same year. The data quoted above show that the importance of FDI for the three analyzed economies is much higher than for other CEE countries. The role of FDI in the Hungarian economy is outstanding. Hungary's economic development is strongly dependent on foreign capital. The geographical origin of FDI inward stock in the Czech Republic, Hungary, and Poland has changed during the processes of systemic transformation and implementation of the Europe Agreements (see also Tables 14.4-14.6). At the end of June 1999, over 64% of the foreign capital invested in Poland came from the EU countries, 15.7% from the USA and 5.9% of the total capital was the so-called international capital. Only 0.7% of the invested foreign capital came from Japan (PAIZ, 1999). The data on the geographical structure of FDI in Poland confirm that firms coming from the EU countries continue to be highly interested in investing in Poland. In 1992, FDI coming from the then member countries of the EU accounted for only 27.2% of total FDI in Poland whereas in 1994—when the Europe Agreement was coming into effect—it was 35.4%. The leaders among investors from EU member countries are German firms, with a share of 19% of total FDI in Poland in mid1999, as well as Italian, Dutch and French firms with shares of 9.8%, 9.6% and 8%, respectively. It is worth noting that the share of investment made by American firms in total FDI in Poland decreased three times in the years 1992-99, but U.S. investments increased almost six times in absolute terms. This fact confirms that these firms find Poland increasingly attractive as a place in which to locate capital. The reasons for foreign investors' interest in Poland are, no doubt, a growth in GDP observed since 1992, a large, potentially absorptive sales market and relatively low production costs, which is confirmed by empirical research (Witkowska and Wysokinska, 1997). On the other hand, the economic and political situation in Poland has been stabilized by the signing and implementation of the Europe Agreement. The available statistical data on geographical origin of FDI inward stock in the Czech Republic and Hungary are not as detailed as in the case of Poland (see Tables 14.5 and 14.6), but they still confirm the dominance of European investors among foreign investors involved in these countries. The investors coming from the EU accounted for

Country

UK

Austria Sweden Denmark Ireland Finland Belgium Portugal Spain Greece Luxembourg USA

International South Korea Japan Other 1

6.1 5.2 -

0.4

824.8 163.4

48.4

-

0.3 9.6 -

1.6

0.1

249.2

14.6

1994 US$ % million 4402.9 100 35.4 1558.02 9.4 414.6 365.8 8.3 268.1 6.1 240.4 5.6 2.6 112.2 159.7 3.6 2.0 86.7 1.4 60.2 7.0

21.9 38.3 -

0.2 0.5 0.9

2.1 2.3

1.1 0.1 0.1

1457.6 808.3

33.1 18.4

5.0

0.1 0.3 6.4

47.0

13.8 289.1

1996 US$ % million 12027.7 100 53.0 6368.9 1524.4 12.7 1223.8 10.2 7.5 899.9 7.9 951.7 509.0 4.2 2.6 315.3 3.0 361.3 2.0 238.2 105.7 0.9 0.8 92.9 0.4 46.5 -

94.3 3.6 2.3

2965.6 1493.0 184.5 32.5 983.2

0.8

0.03 0.02 24.7 12.4 1.5 0.3 8.2

1997 US$ % million 17705.4 100 95558.9 54.0 2104.9 11.9 11636.3 9.2 1614.0 9.1 6.9 1213.6 5.7 1002.0 3.7 660.3 565.8 3.2 306.8 1.7 1.1 191.2 0.8 137.9 0.7 115.2 5.0 3.6 2.3

3981.8 1654.0 1077.8 69.5 1363.4

-

0.03 0.02 0.01 22.5 9.3 6.1 0.4

11.6

First half of 1999. European Union of 12 member countries. Source: Lists of Major Foreign Investors in Poland, PAIZ, Warsaw, 1992-99 and my own calculations.

2

1998

us$ million 27279.6 16159.9 5117.3 2037.6 2398.9 1878.9 1929.5 758.3 691.5 558.4 226.1 191.2 156.8 147.2 62.3 3.6 2.3

4911.2 1813.1 1412.4 198.3 2784.7

% 100 59.2 18.8 7.5 8.8 6.9 7.1 2.8 2.5 2.0 0.8 0.7 0.6 0.5 0.2

0.01 0.01 18.0 6.6 5.2 0.7

10.2

1999' US$ % million 100 31988.7 20530.9 64.2 19.0 6073.9 9.8 3145.6 8.0 2562.8 3083.9 9.6 1994.8 6.2 2.4 768.1 736.7 2.3 508.1 1.6 813.7 2.5 200.0 0.6 281.1 0.9 286.8 0.9 62.3 0.2 0.04 11.6 1.5 0.005 15.7 5006.9 1886.6 5.9 1449.8 4.5 0.7 232.9 9.0 2881.6

Janina Witkowska

Total European Union Germany Italy France Netherlands

1992 US$ % million 1702.4 100 463.42 27.2 3.4 58.2 12.6 214.8 74.7 4.4 79.5 4.7 31.0 1.8 122.9 7.2 44.0 2.6

222

TABLE 14.4 Geographical Origin of FDI stock in Poland in 1992-991 (according to the PAIZ data)

TABLE 14.5 Geographical Origin of FDI stock and flows in the Czech Republic in 1991-97 (US$ million, %) Country

1

6762.9

100.0

1995

1996

us$

%

million 567.3 678.6 101.1 735.9 167.5 87.4 220.7

22.2 26.5 4.0 28.8 6.5 3.4 8.3

2558.5

Data for the first half of 1999. Source: National data, 1991-99, Czechlnvest.

100.0

US$ million 249.3

%

17.5

252.5 259.4

19991

1998

1997

US$ million 537.6

21.2

7.6 10.3 7.8

257.8 608.4

10.2 24.0

95.0

7.3

479.3

36.9

244.7 691.1

9.6 35.1

US$ million 391.3

%

30.1

17.7 18.2

99.2 133.8 101.8

208.1

14.6

459.0

32.0

89.7

6.3

83.8 1428.4

5.9 100.0

%

US$ million 338.2

%

25.8

173.4

13.2

213.2 81.5

16.2 6.2

114.1

8.7

256.6

29.9

Q o

/emeni

Germany Switzerland USA Netherlands France Austria Other Of which: Italy UK Total

199 1-9 7 aver age US$ % million 1889.7 27.9 717.1 10.6 893.5 13.2 13.8 930.2 7.8 525.2 492.5 7.3 1314.7 19.4

03

rc

(^

rb

n 196.4 1300.4

15.1 100.0

337.4 1539.6

13.3 100.0

136.0 1313.0

10.4 100.0

9 n>' 0)

Q. 0)

c

3 ft)O) C

o'

224

Janina Witkowska TABLE 14.6 Geographical Origin of FDI Stock in Hungary 1993-97 (%)

Country

1993

Germany USA Austria France Netherlands UK Italy Switzerland Belgium Japan Other Total

28.4 21.0 15.8 4.7 5.6 3.9 3.9 1.9 3.2 2.6 9.0

1995 28.0 24.0 11.0 9.0 4.0 4.0 -

1997 22.0 20.0 10.0 8.0 13.0 4.0 6.0 3.0 4.0 2.0 8.0 100.0

20.0 100.0 100.0 Source: Sass (1996, p. 116); Sass and Elteto (1997, p. 98); World Investment Report 1998: Trends and Determinants, p. 273.

the bulk of FDI inward stock in the Czech Republic and Hungary (57% and 67%, respectively, in 1997). German, Austrian and Dutch firms dominated among the EU investors but the position of Germany as the biggest single source of inward FDI stock was unquestionable (28% in the Czech Republic and 22% in Hungary). The data also show a relatively high interest of American investors in locating their capital in both countries. In the case of Hungary, they were the second biggest source of capital inflow into this country (20% of FDI inward stock in 1997) and in the Czech Republic, they were in third position (13.2%). The available data for the Czech Republic show that in the following years, i.e. 1998-99, the share of investors coming from the EU was rising (about 67%; see Table 14.5). The signing of the European Agreements and the prospect of membership of the EU enhanced the location advantages of all the three analyzed countries. They are attractive both for European and non-European firms as a location for their investment. The integration processes initiated by the Europe Agreement and adjustments to their future EU membership give a stimulus both for optimum seeking and tariff jumping investment in these countries. The intensity of other capital flows between GEE countries and the EU is more difficult to specify. As regards portfolio investment it can be said that its importance for the market is ever increasing. For example in Poland, according to a survey conducted among the Warsaw Stock Exchange (WSE) member firms, foreign investors accounted for about 38% of equity trading and 24% of bond turnover in 1997 (Warsaw Stock Exchange, 1998). However, there are no data on how much of the portfolio investment comes from the EU countries.

Capital Movements Between CEE Countries and the European Union

225

III. EVALUATION OF ADJUSTMENTS IN CEECS IN THE FIELD OF CAPITAL MOVEMENT TO THE ACCESSION REQUIREMENTS

The liberalization of capital flows between the Czech Republic, Hungary, Poland, and the EU was effected not so much in the aftermath of the conclusion of the Europe Agreements as by their membership of the OECD. The Europe Agreements imposed relatively small requirements in that respect on East European countries. On the other hand, their membership of the OECD was conditional on considerable liberalization of capital movement. The degree of Poland's adjustment to full freedom of capital movement binding within the single market should be evaluated separately with respect to capital flows: •

covered by the foreign exchange law and related to public turnover in securities, • related to direct investments made in the country. This is justified by the specific features of these categories of capital flows. The degree of adjustment of the regulations of Polish law to the EU regulations in the area of "free capital movement" is evaluated at present as considerable. The general rule of free movement of capital was introduced at the beginning of 1999 when the Act on Foreign Exchange Law came into being. Most of the existing restrictions on a free flow of capital and payments and, in particular, those on free flow of short-term capital were lifted by the end of 1999. The restrictions used on the remaining forms of capital flows will be lifted gradually, at the latest by the year 2002. Some of the restrictions have a small extent and their removal should not entail repercussions in the Polish economy. The fears related to the process of liberalization of capital movement are concerned with removal of restrictions on movement of short-term capital. The latter may cause considerable disturbances in the financial markets even in a highly developed economy, and thereby cause repercussions on the balance of payments, domestic monetary policy and foreign exchange rates. The experiences of Southeast Asian countries and Brazil and Russia in the years 1997-99 show how dangerous this phenomenon is. With regard to free movement of capital in the form of FDI, the persisting incomplete range of freedom is manifested in: •

limited access to certain investment areas (slot games, casinos, services for air transport, establishment and operation of

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Janina Witkowska

telecommunications networks and equipment for foreign radio communications), • restrictions on foreign investors' stakes in stock capital in the case of investment in radio and TV stations, international telecommunications services or cell phone services as well as sport joint stock companies, • permits required when purchasing shares representing more than 25%, 33%, 50%, 60% or 75% of votes at an assembly meeting that has at least a 15% share in a Polish insurance firm, • unequal treatment of domestic and foreign units in the processes of privatization. The existing restrictions will be removed through legislative changes, in accordance with the liberalization process timetable declared by Poland. An example of such legislative changes is the Act of 19 November 1999 on "The Law of Economic Activity". The Act introduced the rule of national treatment of foreign investors coming from the countries with which Poland has ratified international agreements. This concerns member countries of the EU, OECD and countries with which Poland has signed agreements on investment support and protection. The rule of reciprocity is binding with respect to investors coming from other countries. The use of the national treatment rule means that foreign investors can run economic activity within Poland on the same conditions as persons physically residing in Poland and corporate persons based in Poland. Thereby the restriction concerning the permissible legal forms in which economic activity could be conducted by foreign investors was removed. The Act also admitted the possibility of establishing branches and agencies of foreign firms within Poland. Branches can be set up only in the area of activity in which the parent firm is acting. On the other hand, agencies can be set up exclusively to advertise and promote the foreign entrepreneur. In the case of countries which do not guarantee Poland the rule of reciprocity, the restrictions concerning the legal forms of their activity are still applicable. That is to say they can run economic activity in the form of a limited liability company, a joint stock company or a sleeping partnership. The Act simplified and unified the licensing rules both for domestic and foreign investors. The number of licenses was seriously reduced, i.e. to eight areas. Both licenses and permits are issued on the strength of administrative decision. A license can be denied, for instance for reasons of national security, but a permit to

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run economic activity cannot be refused if the applicant has fulfilled the legal requirements. These regulations will come into force after the transition period, i.e., 1 January 2001. The legislative changes presented above demonstrate that Poland undertook liberalization actions aimed at further liberalization of establishment of enterprises in Poland. This significantly complements the actions liberalizing capital flows in the strict sense. A separate issue is concerned with restrictions on direct investors in purchasing real estate in Poland. In the view of the European Commission, the restrictions in that area are still considerable. The path of the other candidate countries (i.e., the Czech Republic and Hungary) to the establishment of full freedom of capital movement between them and the EU was similar—in a broad sense—to the Polish way. Their membership of OECD accelerated many more adjustments in this field than fulfilling the requirements of the Europe Agreements. As a result, all these countries are relatively well prepared for future membership of the EU in this field but they seem to have the same problem, which is an earlier abolition of barriers to capital movements rather than to goods movements. According to the integration theory (Molle, 1990, pp. 130-132), the introduction of capital mobility between integrating parties without the full abolition of trade impediments existing between them spells a loss to the economy. Introduction of full mobility of capital between the Czech Republic, Hungary, Poland and the EU without liquidating the tariff obstacles existing in trade means a loss for producers and decreased revenues for the government. This is one reason why a customs union should precede the creation of a common market. Although the lifting of the tariff obstacle to trade in industrial products is well advanced in the relations between the analyzed countries and the EU, some industrial goods received a longer tariff protection under the Europe Agreements. Agricultural products are as yet excluded from the creation of the free trade area between them. Also the analysis of the negotiation positions of the analyzed candidate countries shows that two of them (i.e., Hungary and the Czech Republic) will endeavor to obtain some transition periods for the establishment of a custom union with the EU during the integration process (Uniting Europe, 1999, No 39). Hence, the establishment of a free capital movement earlier than a free movement of goods is—paradoxically—a real possibility. As far as EDI is concerned, all of the analyzed candidate countries give basic guarantees for foreign investors. This is corroborated by

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the provisions concerning transfer profits abroad, transfer of stocks in case of liquidation of a company, and compensation in case of damages resulting from expropriation. Moreover, these countries compete with each other in attracting foreign capital in the form of FDI. It boils down to using some incentives for foreign investors although the rule of national treatment is formally prevailing. For example, the Czech Republic announced a comprehensive investment package on 29 April 1998 to boost investment (World Investment Report 1998, p. 289). It was probably a reaction to two consecutive years of declining FDI inflows into this country. The package applies, in principle, to both categories of investors, although foreign firms are widely believed to be in a better position to apply for it, given the minimum investment requirements. It covers corporate taxation, waivers of customs duty and value-added taxes on imported equipment, the possibility of special customs zones for major investors, job-training grants, special job-creation benefits for firms locating in underdeveloped regions, and the provision of low-cost land. Poland also offers investment incentives both to domestic and foreign investors, respecting the national treatment rule. These incentives are dependent on the achievement of an appropriate level of the income/revenue ratio and on the size of invested capital. Incentives cover exports, purchases of machinery and equipment necessary to implement a license, a patent or results of R&D projects, purchases of machinery and equipment necessary for production of pharmaceuticals, recycling of production waste and implementation of the ISO 9000 system. Incentives are applicable also in the case of employing disabled persons. Separate conditions apply to the special economic zones. The solutions adopted in this area are generating much controversy in the process of membership negotiations with the EU (Rzeczpospolita, 1999, no. 9, p. B31). From the Polish point of view, the special economic zones serve to equalize the development level between different regions of the country. From the viewpoint of the EU, the preferences offered by Poland in the special economic zones will impair the efficient functioning of the single European market. The EU thus demands that these preferences be abolished. The concessions made by Poland, i.e., commitment not to set up new economic zones, not to extend the existing ones and not to admit to them investors acting in the sections sensitive for the EU have been recognized as insufficient. Poland's arguments for retaining the preferences are: lack of budgetary resources for compensation due to investors for breaches

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of agreements and reluctance to strip the investors of vested interests, which would undermine Poland's credibility in the international arena. Hungary, like the Czech Republic and Poland, does not use any special tax preferences which would be applicable only to enterprises with foreign participants. On the other hand, there is a possibility for a considerable reduction in tax on condition that the requirements set by law are met. These requirements are connected mainly with making an investment of a certain value, creation of new jobs, growth of sale revenues and undertaking an activity in areas preferred by the Hungarian administration. IV. EFFECTS RESULTING FROM CAPITAL MOVEMENT LIBERALIZATION FOR THE CEECS

The introduction of a fully free movement of capital between the candidate countries and the EU (in the sense of Article 73b of the Maastricht Treaty), together with the implementation of the remaining freedoms, means that these countries will join the single internal market of the EU. The combined benefits which can be expected then spring from savings resulting from the removal of trade barriers within the European Union, savings resulting from full liberalization of the financial market, an increased scale of production, and lifting of the restrictions on access to the market of public procurement (Witkowska, 1996). The process of the creation of a single internal market activates macro- and microeconomic mechanisms which, on the one hand, consolidate the advantages but, on the other hand, cause social and economic costs. An attempt to single out the effects from freedom of capital movement on the CEE countries' economies leads to the following conclusions: The benefits for the integrating area as a whole from the removal of restrictions on capital movement are unquestionable (Molle, 1990). However, the situation of each side to the integration process may be entirely different in this respect. The CEE countries are less endowed with capital, which results in a low supply of capital and its relatively high price (interest rate). On the assumption that the risk and uncertainty related to domestic and foreign assets are the same, it can be expected that the CEE countries will be countries hosting capital. The effects which can be revealed in the CEE economies as a result of the introduction of a free movement of capital are as follows (Molle, 1990; Witkowska, 1997):

230

•

• •

•

•

•

•

•

Janina Witkowska

an increased inflow of capital (in different forms) contributing to growth of its supply in the domestic market will exert pressure on a reduction in the interest rate, or capital may become cheaper; cheaper capital will be more accessible for investors, which implies a possibility of investment stimulation in the country and the ignition of additional growth processes; cheaper capital means a simultaneous decrease in the benefits for the savers and increased benefits for investors; the net welfare benefits for GEE countries will be determined by the difference between investors' benefits and savers' losses; a change may occur in the proportions of distribution of incomes between the main social groups in the country (incomes of the labor factor versus incomes from capital); GEE countries hosting capital can expect an increase in the share of incomes from labor at the cost of capital owners' incomes; such a situation is as a rule welcomed by trade unions; this effect will occur when the markets operate correctly; a change in the proportions of the distribution of incomes between the main social groups in the country is possible as a result of the liberalization of the capital and financial markets, depending on the structure of capital flowing into GEE countries; in the case of a large inflow of short-term capital, escape of capital entailing serious repercussions for monetary and foreign exchange policies is possible when factors unfavorable for financial market stability occur; a simultaneous inflow of capital motivated by a desire for long-term involvement in the East European economies (e.g., foreign direct investment and reinvestment of profits obtained from FDI) may alleviate the abovementioned balance of payment difficulties; integration of the capital markets may facilitate the restructuring accompanying the processes of trade liberalization in the customs union; thus liberalization of capital flows may accelerate the dynamic effects of the customs union; the effect of creation and diversion of capital flows may counteract the effect of trade creation and diversion in the customs union built by the Czech Republic, Hungary and Poland with the EU; there may occur dynamic effects through the strengthened competition between financial organizations in the countries analyzed, increasing their economies of scale and raising the quality of their services; the liberalization will be felt negatively by the

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banking sector protected earlier on, but positively by all those using that market; • the occurrence of a spatial concentration effect is not precluded; i.e., the difference between the three CEE candidate countries and the EU member countries in the development levels of their financial markets combined with the freedom to set up enterprises may result not only in the transfer of surplus demand and supply to the financial centers in the EU but also in a shift of their activity by the borrowers and lenders; the occurrence of that effect would be very unfavorable for the East European countries. It was also underlined (see the previous section) that failure to stick to an appropriate sequence of broadly understood liberalization processes between the integrating sides might lead to losses. The above initial analysis of the effects following from the introduction of free capital movement between the three CEE countries and the EU was conducted on the simplifying assumption that capital flows are a homogeneous category. Foreign direct investment, however, necessitates a separate analysis owing to its specific features. The influence exerted by EDI on the host economy is manifested in many fields. First and foremost, FDI affects the basic macroeconomic determinants such as endowment with factors of production, capital and know-how, employment, productivity, gross domestic product, proportion of income division, and balance of payments. FDI flow is also connected with the creation of the so-called external (technological and pecuniary) effects, mostly positive in the host economy. Taking into account a high degree of liberalization of capital flows in the form of FDI between the three CEE countries and the EU, their membership of the EU can only indirectly strengthen some of the above influences existing independently of the integration process. As regards FDI, the specific benefits at the membership stage are: strengthening of the location advantages of the integrating countries, stimulation of investments seeking optimum location within the integrating area, encouragement of third countries to the socalled tariff jumping investment, strengthening of the restructuring processes, reduction in the investment risk, and improvement in the investment climate (Witkowska, 1997). The threats are related to outflow of capital and losses resulting from the occurrence of the effect of spatial concentration of economic activity.

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The creation of a customs union may result in the above mentioned investment creation and diversion effect (Kindleberger, 1966). Investment creation is understood as an increase in direct investment flowing from non-members in response to trade diversion. And the strategic reaction of firms to the trade creation effect is a diversion of investment from one member country to another, for the trade creation effect requires reorganization of production within the customs unions. The static and dynamic effect of the integration process may cause the following types of investment: defensive import-substituting investment, offensive import-substituting investment, reorganization investment and rationalized investment (Yannopoulos, 1990). For this reason it can be expected that changes will take place in the structure of FDI in the Czech Republic, Hungary and Poland, correcting the effects of the creation of a customs union with the EU. REFERENCES Avis 2000—Commission Opinion on Poland's Application for Membership of the European Union (1997) DOC/97/16, Brussels. Czechlnvest, (economic database) Warsaw, Poland. Kindleberger, C.P. (1966) 'European Integration and the International Corporation,' Columbia Journal of World Business, 1. Molle, W. (1990) The Economics of European Integration (Theory, Practice, Policy), Aldershot. PAIZ (Polish Agency for Foreign Investment) (1997) Status of Foreign Direct Investment in Poland at the End of 1997, Major Foreign Investors. Rzeczpospolita (1999), 9. Sass, M. (1996) 'Foreign Direct Investment: The Case of Hungary,' in: Corado, C., Wysokiriska, Z. and Witkowska, J. (eds.) Foreign Direct Investment - East and West: The Experience of the Czech Republic, Hungary, Poland, Spain and Portugal, Lodz: Lodz University Press, p. 116. Sass, M. and Elteto, A. (1997) 'Motivations of foreign investors — FDI and foreign trade,' in Witkowska, J. and Wysokiriska, Z. (eds.) Motivations of Foreign Direct Investors and their Propensity to Exports in the Context of European Integration Process: Empirical Studies with Special Reference to Eastern and Central European Countries, Lodz: Lodz University Press, p. 98. Uniting Europe (1999), No 39. Warsaw Stock Exchange (1998) Warsaw Stock Exchange: Cash and Derivatives under One Roof: A Guide to the Polish Securities Market, Warsaw, June 1998. Witkowska, J. (1996) Foreign Direct Investment in Central and Eastern Europe: Attempt at Interpretation on the Ground of the Theories of Foreign Direct Investment and Integration, Lodz: Lodz University Press. Witkowska, J. (1997) 'Determinants of Foreign Direct Investment in Poland: Empirical Research Results,' in The Proceedings of 8th Annual Convention COPE, Lodz.

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Witkowska, J. and Wysokiriska, Z. (1997) 'Foreign Direct Investors' Motivations and their Export Propensity in the Context of the European Integration Process: The Case of Poland,' in Witkowska, J. and Wysokinska Z. (eds.), Motivations of Foreign Direct Investors and their Propensity to Exports in the Context of European Integration Process: Empirical Studies with Special Reference to Eastern and Central European Countries, Lodz: Lodz University Press. World Investment Report 1998: Trends and Determinants (1998) New York and Geneva: United Nations. World Investment Report 1999: Foreign Direct Investment and the Challenge of Development (1999) New York and Geneva: United Nations. Yannopoulos, G.N. (1990) 'Foreign Direct Investment and European Integration. The Evidence from the Formative Years of the European Community,' Journal of Common Market Studies, XXVIII(3).

ADDITIONAL READING Rozlucki, W. (1998) 'The Warsaw Stock Exchange,' in The Polish Economy and Capital Markets, Investors' Seminar in Bahrain and Abu Dhabi, February 1998.

15 15 Financial Markets Integration: Real Interest Rate, Saving, and Consumption Paths in the EU IOANNIS N. KALLIANIOTIS1 « "Exaatog ev to) i&ioo vot jtXriQoi|)OQeia6(o.» Poon. 16' 5

I.

INTRODUCTION

In 1952, six European countries (West Germany, France, Italy, Belgium, the Netherlands, and Luxembourg) joined in establishing the European Coal and Steel Community (ECSC), which had as its objective the formation of a common market in coal, steel, and iron ore for its members. However, the European economic state, structure, society, way of thinking, and value system have changed dramatically since then, starting in 1957 (Treaty of Rome) and continuing with the 1987 Single European Act which instituted the 1992 internal market. Later, the 1991 Maastricht Treaty was signed, which came into effect on November 1, 1993 and proceeded with the economic and monetary union (EMU) that was introduced on January 1, 1999. These unanticipated changes have altered production, employment, income, the direction and magnitude of European capital flows, saving, investment, the physical environment, culture, intellectual development, labor movements, illegal migration, crime, and world stability. The growth of European capital and other resources depends on current income, consumption, savings, moral and ethical behavior of all the agents, efficient management of all the available scarce resources, and their fair distribution among all members of society. These savings can be channeled, 234

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235

depending on the interest rate, to ultimate investors throughout the European Monetary System and the international financial system. Governments and tradition encourage the saving-investment process to increase the capital accumulation and, consequently, national wealth, but the capital structure theories of the 1950s, the banks' objectives, and the current "common subculture" discourage saving and encourage borrowing, overconsumption, mismanagement, and the waste of everything that is valuable (from time to resources and everything else). To this end, sovereign governments in Europe (if such a species still exists) have been forced to provide favorable legal, political, social, economic, and financial environments, in which both domestic and international business can function and develop fully. But can these new conditions help people to maximize their social welfare and their ultimate objectives in life as human beings, and can independent countries be developed and prosper materially otherwise? Are the benefits of integration offsetting the costs of the lost sovereign power of the EU state-members? Unfortunately, Western Europe went for an extreme situation; it created a political union on January 1, 1993, and later it had even some more ambitious plans, it imposed an EMU on 11 of its members even though nine of them did not fulfill its own Maastricht criteria. Trade Theory suggests that free capital movements (perfect capital mobility) among EU countries must equalize the price of capital ("factor-price equalization theorem"). 2 However, because the assumptions of this ideal theory do not hold in Europe, a full factorprice equalization is not expected in practice, but only a tendency toward factor-price equalization (partial equalization). The higher this degree of capital-price (interest rate) equalization, the greater the capital market integration. If the European capital market is fully integrated, securities (financial assets) of comparable expected return and risk should have the same required rate of return in each national market of the 15 EU members after adjusting for foreign exchange risk and political risk. An effort has been made to be very careful with the assumptions which will be used here. Most of the models employed today are using unrealistic assumptions and their results are therefore incorrect and untrue. Individuals gather and process as much information as they can, from what is available, but this information is not complete and, of course, is not correct. Thus, people cannot have rational expectations due to inferior information, but instead they have "homogeneous expectations" with the rest of the global population (a trend towards a global culture). The formation of these homogeneous

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expectations is wrong because our reasoning is incorrect.3 Human reasoning can be correct only when people reach perfection; until that time, it would be much better if they did not use their "rational expectations" to affect the world and forecast its future. II. THEORETICAL MODELS OF FINANCIAL MARKETS INTEGRATION

This research aims to examine how integrated are the EU's financial markets. It is clearly an important issue, because those markets have moved toward the EMU. The EU, by allowing its country-members to borrow and lend money efficiently (open capital markets) and equalizing the real risk-free rate of interest, can provide the same services across EU countries that they offer within a single economy, permitting a more efficient use of funds for investment and improving the allocation of consumption, wealth, and welfare over time and among all its members. Amid the main measures used in the literature,4 are comparisons of onshore-offshore nominal interest rates and real rates of interest, the correlation between saving and investment rates among countries, and the common movements of consumption paths across the EU's members. Tests involving nominal and real interest rate comparisons generally indicate a degree of capital mobility if they move towards equalization and this is expected to be much higher among EU states. Those tests involving savings-investment relationships show relatively high levels of mobility (low correlation between domestic savings and investment) if the European capital market is integrated. This research also extends the work of Bayoumi and MacDonald (1995) and Kallianiotis (1998) on capital market integration by looking at a set of the 15 EU countries, and somewhat different estimating equations are derived for determining the variables that affect the real interest rate, with different data sets, frequencies and time periods. A regression analysis is used to determine the factors that affect the real risk-free rate of interest in each EU country-member and to estimate the model for the consumption paths across these countries. Measuring Capital Mobility: Investment Correlation

Real Interest Rates and Saving-

All existing tests of the level of international capital mobility fall more or less into two categories. The first category uses the behavior

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237

of nominal and real interest rates to measure capital mobility. These tests involve a comparison of movements of nominal onshore and offshore interest rates and real ones for the same instruments and currency bloc. Because there are no barriers to capital mobility in the EU, then these interest rates should move very closely together, in order to eliminate arbitrage opportunities. The results from previous tests5 almost uniformly show that international capital markets are slowly becoming more integrated. The real risk-free rate of interest changes over time depending on economic conditions, especially the cost of capital, time preferences for consumption, saving, investment, production opportunities, exchange rate appreciation or depreciation, political risk, budget deficits, trade account deficits and other factors. Thus, a general function of the real risk-free interest rate can be as follows: r = f(i, C, S, I, PO,fd, PR, BD, ND, TD) fi>0,fc>0,fs<0,fl>0,fPO>0,ffd>0,fpR>0

(1)

/BD>0'/JVD>0'/rD>0

where, r= real risk-free rate of interest, i = (nominal) cost of capital, C= consumption, S= saving, /= investment, PO= production opportunities, fd = forward discount or premium of the currency, PR = political risk index, BD = budget deficit, ND = national debt, and TD = trade deficit. A high correlation between r and i values or similar interest rates across the 15 EU countries means capital market integration. Also, the country with the lowest rand i values (Germany, in this case) has been taken as the base for the comparison and interest rates differentials between Germany and each of the other countries and their correlation coefficients are calculated. The smaller the interest differential between Germany and the country in question, the higher their integration. If the European capital market is fully integrated,6 securities of comparable expected return and risk should have the same required rate of return in each national market of the 15 EU members after adjusting for foreign exchange risk and political risk. Arbitrage should keep the market rate of interest equal in all national markets (markets are integrated) if risks are zero. E(r) = E(r*) + E(fd)+E(PR)

(2)

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loannis N. Kallianiotis

or r = r*-FXRP-PRP

(3)

where, E = expected values, FXRP= foreign exchange risk premium, PRP= political risk premium. The second broad category of tests, developed by Feldstein and Horioka (1980), measures capital mobility by using the correlation between domestic saving and investment across countries. The argument behind these tests is that if capital is fully mobile, there is no reason to expect higher saving in any particular country to be reflected in higher investment in that country, which means in our case, that the total pool of EU saving will be used to finance the most efficient investment available across the Union. Where there are barriers to capital mobility, saving will be used domestically, creating a high correlation between saving and investment of that particular country. EU states must have a low correlation between saving and investment, due to factor mobility. The implications from the above two tests are that these tests might be measuring different concepts of capital mobility: a shortterm capital mobility test based on interest differentials and a longterm capital mobility test based on saving-investment correlations. What is clear here is that in the first case, the focus is on the behavior of nominal and real interest rates, while the second test is related to real interest rates. Also, these tests require the assumption that ex ante purchasing power parity (PPP) holds, except for the real interest rate parity test. Consumption Paths in the European Union

Another test has been suggested by Bayoumi and Koujianou (1990) which suggests that consumption paths could be used as a measure of capital mobility. The idea behind this test is that in a fully integrated EU, consumption paths across countries should move together, reflecting the desire of consumers to smooth consumption and, hence, maximize their utility and the social welfare. Of course, this argument is not exactly true because of the tremendous social and cultural differences among EU countries.7 This method uses the real interest rates equalization to test for capital market integration.8 Within the financially integrated EU, consumers can use capital markets to smooth their consumption in response to anticipated

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239

movements in income, as in the U.S. As a result, consumption patterns among EU states should move in the same manner, except for any unanticipated shock to income. To test this hypothesis, consider the intertemporal consumption opportunities characterized by an optimal consumption behavior and the use of financial markets to satisfy their personal welfare. This assumes that "rational", forward-looking consumers maximize the expected value of their lifetime utility

Subject to an intertemporal budget constraint

The equilibrium condition is9

where, E-\ is the mathematical expectation conditional on the information available at t-\, U is utility, Ct is consumption, Yt is income, (3 is a subjective discount factor, r-1 is the real interest rate between t—\ and t, and a is the intertemporal elasticity of substitution. Taking the natural logarithms of Eq. (6), it becomes:

Then, the consumption for our 15 countries will be:11

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Equations (9) assume that each EU country has the same utility function.12 If capital markets are integrated, the expected real interest rates will be equal and then the consumption paths (growth) across the countries will be the same, which means: = E

Equation (10) implies that consumption across EU countries (where financial integration exists) should follow a random walk. Next, we divide the consumption into a proportion (1-A) that is associated with the forward-looking consumers and a proportion (A) that is associated with the change in their income. Then, the aggregate consumption will be:

where, yt is the logarithm of disposable income. Solving Eq. (11) for the real interest rate, it becomes: UKt>

If capital markets are integrated in EU, the ex ante real interest rates will be equal, rUKt = rGt, which implies by equalizing the righthand side of Eq. (12) with a similar one for the other country, because the left-hand side is equal, it gives:

where, £UKGt *s a function of the error terms £UK and £G. Equation (13) is the basic equation which estimates equality of consumption among EU countries. This equation states that, in a situation of high capital mobility due to integration, the growth of consumption in the United Kingdom (UK) is related to the growth in home (UK) income and growth in foreign, German (G), consumption and income. This equation is also a test of the real interest rate parity between these two countries, because it does not rely upon the assumption that PPP holds. Then, Eq. (13) can be used as a test of capital mobility between these two countries and provides a tractable method of investigating the importance of incomes and foreign consumption to domestic consumers and exploring the real interest rate equalization on consumption across countries.

Real Interest Rate, Saving, and Consumption Paths in the EU

241

Consider an unrestricted version of the model written with difference of the growth in consumption on the left-hand side: ACUKt-ACGt = P 0 + p 1 A Y ^ f + p 2 A C G r + p 3 A Y c ? + £[/^

(14)

The coefficients on income (1 and 3) can be used to test the importance of the "rule of thumb" for consumers. Real interest equalization across countries can be tested by looking at the coefficient on foreign consumption (2). A negative 2 would tend to indicate a lack of real interest rate equalization with the other EU countries as it would imply a low level of correlation between domestic (UK) and foreign (G) consumption, even when liquidity constraints have been taken into account.13 From Eq. (13) is derived yUK= 1-A, f ^and then, -^GV(^-^)=-(^ UK+^UK) • 1-A, / G

G

Consequently, Eq. (13) now becomes: ACUKt-ACG! = hUK&yUKt + yUK&CGt-(kUK + yUK)AyGt + eUKG[

(15)

The new Eq. (15) implies that the sum of the coefficients on home income (X UK ), external consumption (yUK) and external income (~^UK~YUK) should equal zero. "The restriction that the sum of the coefficients on income and consumption is equal to zero is a formal test of the integration of real interest rates across countries, even taking account of liquidity coefficients."14 One disadvantage of Eq. (14) is that it includes several variables that may be highly collinear. Often, income growth at home and abroad are highly correlated, which lowers the level of precision of the individual parameter estimates. Results from a simplified version of Eq. (14), in which it is assumed that A,UK=X,G, are also reported. Then, Eq. (14) becomes: ACUKt-ACGt = ^Q + ^]AyUKl + ^2ACGt-^](l + ^2)AyGt + EUKGl

(16)

In Eq. (16), the sensitivity of consumption with respect to income is given by the parameter (3j; the level of correlation of domestic and foreign consumption, and hence the real interest rate equalization, measured by the amount by which parameter (32 differs from zero. Excess sensitivity to consumption can be seen as a test of the degree to which local consumers have access to capital markets (high sensitivity implies that consumers are not taking full advantage of assets

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markets). If home consumption growth has a low correlation with external consumption growth, this implies a failure of real interest rate equalization between national capital markets. A lack of correlation with external consumption is thus a test of the integration of capital markets, where integration is defined as equalization of ex ante real interest rates. Hence, in testing international capital mobility, differentiation must take place between imperfect access of consumers to capital markets and imperfect integration between capital markets. Another test of real interest rate equalization used by Bayoumi and MacDonald (1995, p. 560) is the following: ACUKt = a+V&CEUt + &AyUKt + eUKt

(17)

where, AcEUt is consumption in the European Union. The restriction (3=1 and 8=0 is used as a test of capital mobility and with (3=0 and 8=1 the results show capital autarky and no need for capital movements among nations III.

ESTIMATION OF THE MODELS AND EMPIRICAL RESULTS

The data used here for the estimation of the model, are quarterly from 1957.115 to 1997.4 for the 15 EU countries and the U.S. for comparison; they are taken from Main Economic Indicators and Economic Outlook, OECD; International Financial Statistics, IMF, and Eurostat, European Commission. The results of Eq. (1) are presented in Table 15.1. It is seen that the real risk-free rate of interest (rTB) is affected by different variables, depending on the specific country. There is no homogeneity of the factors that affect the variable in question in the various countries. For example, in Denmark consumption has a significant effect on rTB; in Italy budget deficit; in Germany the national debt; and in the U.K. investment. This, then, is another indication that EU countries are different. Table 15.2A shows the average real risk-free rate of interest (r TB ), its standard deviation ((J r ), and the spread over Germany's rate. The larger the spread, the lower the integration. Countries that have a pretty high integration are Belgium, Ireland, Italy, Sweden, the U.K., and Germany. Table 15.2B presents the correlation coefficients (p) of rTB. The results show that the p is very small which is an indication that capital markets are not integrated. Countries with high correlations are France and Belgium, France and Denmark, France and Italy, and France and Spain.

TABLE 15.1 The Real Risk-Free Rate of Interest [Eq. (1)] (Dependent Variable: rTK) Country Austria

1

Belgium

Denmark

France

Const -

I

Y

.06

-.09*

-.24**

.03

(.04)

(-05)

(.04)

(.05)

-.008*

-

ITB

C

2.82* (1.285)

-2.44

S

.81** -

/d

BD

(.136)

-17.49**

1.37**

(2.15)

(.09)

-25.71

1.31*

-.65

-.16

.20

.0003

(73.38)

(.48)

(.60)

(.19)

(.14)

(.0006)

-5.59

(In)

(40.13)

Germany

-10.33"

(.005) -

-

TD

.38"

1.35"

.63"

SER

DW

F

N

.87

3.43

2.38

7.60 18

.71

2.08

2.26 61.18 103

.84

1.33

1.82 43.32

(.08)

_

-.57**

(.17)

-

(.35) _

_

-

-.18

-.02

-.27

.82

1.70

1.87

3.27 13

(4.90)

(.02)

(.19)

.10

.003

1.41s*

(.08)

(.02)

(.28)

Cy-i 3" CTQ

.76

-

1 §

(2.32) (.40)

.23

_

-.61

ft)

1

28

(.17)

1.07** -

.89** _

R2

(.26)

(.07)

(.0006) -

et.!

.002**

(2.100)

.02**

ND

.71

2.24 10.39 18

Qj

o .41**

.58

2.18

1.83 22.50 105

n o3 C

Greece

Ireland

(1.86)

(.11)

-18.49

-.56

-.07*

.05*

.04

.005

(40.74)

(2.90)

(.04)

(.03)

(.03)

(.005)

-.005

-.005*

(.003)

(.002)

-1.91

_

-.006*

(1.35)

-

(.003)

Italy

-63.92

.02

(In)

(43.01)

(.31)

1.76

-17.51

(1.24) (13.68)

_

_

-

1

(.10) -

.32

9.79

1.81

2.02 28

"Q

Si

Er

_

-.03

.15

.39

5.39

1.95 11.62 98

(.02) (.10)

19.67

-6.380

1 .48**

15.56

(11.134)

(.48)

5"

-

.03

(.23)

-

.56

1.13

2.17

2.70 23

3' ^ Er m

TABLE 15.1 The Real Risk-Free Rate of Interest [Eq. (1)] (Dependent Variable: rr[j) (Cont.)

i

2

-68.11** (18.83)

Portugal

68.30 (40.64) 12.27"

.74**

C

S

I

_

-

_

-

(.817) -

.0002

-.008

(.004)

(.004) .0002*

-

BD

_

-

-

TD

EM

R2

SER

-

-

-

.36

2.86

2.15

14.04

52

-

-

-

.90

1.02

2.68

6.02

6

£

-

.58

.48

1.80

4.53

14

.81

1.83

1.78

66.90

70

.42

5.45

2.01

10.08

60

ND

DW

F

N

S -

(.00009) -

-.13*

-10.42**

1.18**

.054*

(2.12)

(.19)

(.025)

(.07)

U.K

-24.61**

.71*

-

7.61"

(In)

(7.34)

(.41)

Note:

/d

(.15) 1.81

(1.758) Sweden

Y

(2.30)

-

-.0005*

.02*

(.0002)

(.007)

-

-

.76" (.09)

-

-.67

.42"

(.61)

(.13)

r-Y& = the real rate of interest of 3-month Treasury bills, ** significant at the 1 % level, * significant at the 5% level. 1. Coefficient of AUPOP 9.852** (2.876) and et.2 -1.161* (.410). 2. Coefficient of NPOP 4.660** (1.293). Source: International Financial Statistics, IMF and Main Economic Indicators, OECD.

ianiotis

Spain

iTB

i

Netherlands

Const

loannis

Country

Real Interest Rate, Saving, and Consumption Paths in the EU

245

TABLE 15.2A Real Risk-Free Rate of Interest Country AU B D FD F G GR IR I N P S SD U.K.

Range 1988.1-1996.4 1964.1-1997.2 1988.1-1997.2 1995.1-1997.2 1988.1-1997.2 1957.2-1997.2 1986.1-1995.3 1966.4-1997.2 1957.2-1997.2 1976.1-1997.2 1993.3-1995.3 1974.1-1996.4 1963.1-1996.4 1963.1-1995.4

°r 6.90 3.59 3.43 2.52 2.29 3.17 9.87 6.32 4.59 3.18 2.36 3.41 4.43 5.55

4.03

4.40

1.32

1.58

2.61

-1.13

E.U. U.S.

Spread over G 3.96 .62 2.84 1.04 2.54 3.69 -.83 -.56 1.12 4.00 1.64 -.59 -.98

6.67 3.33 5.55 3.75 5.25 2.71 6.40 1.88 2.15 3.83 6.71 4.35 2.12 1.73

r

1957.2-1997.2

TB

Note: rTB = average real risk-free rate of interest (T-bill rate - inflation rate), a r = standard deviation of real risk-free rate of interest, AU = Austria, B = Belgium, D = Denmark, FD = Finland, F = France, G = Germany, GR = Greece, IR = Ireland, I = Italy, N = Netherlands, P = Portugal, S = Spain, SD = Sweden, U.K. = United Kingdom, E.U. = European Union, and U.S. = United States. Source: See Table 15.1. TABLE 15.2B Correlation of Real Risk-Free Rate of Interest (1988.-1995.3) AU B ~AU1.000 B -.067 1.000 D

.321

F G

.096 .709 -.151 .440

.460

D

F

G

GR

IR

I

N

S

SD

UK

US

1.000 .799 .124

-.075 .255

1.000 .324 1.000

GR

.030

.111

-.396

IR

-.013 .530

.462

.443

-.087 .356

1.000

I

.094

.382

.567

.636

.276

.137

.486

1.000

N S SD UK US

.269 .014 -.340 -.014 -.244

.441 .521 .346 -.024 .098

.543 .537 .160 .378 -.314

.556 .603 .283 .238 -.201

-.190 .173 .137 .009 -.085

.212 .305 .141 .236 .191

.445 .575 .275 .097 -.098

.195 .411 -.001 .199 -.220

Source: See Table 15.1.

1.000

1.000 .414 .227 .221 .190

1.000 .424 1.000 .063 .064 1.000 3xlO'5 .063 .007 1.000

246

loannis N. Kallianiotis

Table 15.3 gives the correlation between savings and investment of the EU countries. As it shows, only six markets (countries) are integrated (their correlation coefficients are less than .500), the rest are not integrated at all, they are just investing what they are saving.16 The variables which are estimated for the consumption path model are the real consumption and the real income.17 The real consumption and real income measures have been divided by population to produce corresponding per capita measures. Equations (14) and (17) were estimated using Ordinary Least Squares (OLS). Table 15.4 shows the estimation of Eq. (14). The (3, coefficients reveal the importance of home income on consumption and the (33 coefficients give a small effect of German income on home consumptions. The (32s are negative and significant in all countries, indicating a lack of real interest rates equalization (no integration) and negative correlation in consumption between the home country and Germany. The sums of (315 (32, and (33 differ from zero ([3, + p2 + (33 ^ 0) which means lack of integration of real interest rates. Finally, Table 15.5 gives the results of Eq. (17) by testing home consumption as a function of German consumption ((3) and home income (8). The estimation provides (3 values close to zero and 8 values near to unity which means that the EU country-members are in a state of autarky with respect to capital (no capital mobility and lack of integration).18 IV.

SOCIAL IMPLICATIONS AND CONCLUSION

The objective of this chapter is to examine the European financial market integration (capital mobility) by looking at the different interest rates (T-bill rates and real risk-free rate of interest), at the saving and investment as a percentage of the GDP of the countries, and at the consumption paths (real interest rates equalization and correlation between members' consumption). The results show some integration among Germany, Belgium, Ireland, and Britain. German income is affecting Austria's and Finland's consumption positively and Greece's and Luxembourg's consumption negatively. The correlation in consumptions is negative which means lack of real interest rate equalization (no integration). Also, the countries appeared to be in a capital autarky situation (no significant capital mobility) and above all, the Maastricht criteria were met only in two countries, Luxembourg and France, by the end of 1997. Exceeding these, the major problem of the EU is the high unemployment. The average unemployment rate is about 11%, with a range between 7% (Austria) and 22% (Spain).

Real Interest Rate, Saving, and Consumption Paths in the EU

247

TABLE 15.3 Correlation of Savings and Investment Country

Mean

a

Max

min

AUS

23.94

3.29

26.3

14.9

AUI

25.20

1.05

27.0

23.5

BS

20.02

1.83

21.7

16.8

BI

18.16

1.69

20.4

15.2

DS

16.97

.68

17.8

16.1

DI

17.24

2.17

21.5

14.2

FDS

19.31

4.67

24.8

12.1

FDI

21.26

5.63

29.7

14.3

FS

20.22

1.14

21.8

18.2

FI

20.05

1.88

22.5

17.1

GS

22.42

1.23

24.3

20.5

GI

23.79

1.41

25.9

21.8

GRS

15.30

1.01

17.3

13.8

GRI

21.59

2.09

23.8

17.6

IRS

17.71

1.99

20.8

14.9

IRI

16.82

2.14

20.6

14.4

IS

19.40

1.47

21.4

17.1

II

19.93

1.82

21.5

16.8

NS

24.42

1.08

26.1

22.6

NI

20.94

1.08

22.6

18.9

PS

24.22

2.98

27.8

20.3

PI

26.73

2.31

30.4

23.5

s

20.85

1.43

22.6

18.7

SI

21.25

1.46

24.6

19.9

SDS

16.33

2.56

19.2

11.9

SDI

17.74

2.88

21.9

13.3

UKS

14.36

1.30

16.0

12.5

UKI

17.31

2.20

21.0

15.0

EUS

19.73

1.07

21.2

18.2

EUI

20.64

1.52

22.6

18.3

uss

15.83

.66

16.6

14.6

USI

17.41

1.36

19.4

15.3

Note:

Ps,i -.407 .761 -.447

Markets Integrated Non integrated Integrated

.867

Non integrated

.971

Non integrated

-.043

Integrated

.289

Integrated

.283

Integrated

.665

Non integrated

.704

Non integrated

.672

Non integrated

.067

Integrated

.860

Non integrated

.728

Non integrated

.930

Non integrated

.692

Non integrated

S= savings and / = investment as a percentage of GDP, a = standard deviation, and p si = correlation coefficients between savings and investment. Source: Kallianiotis (1998, Tables 10 and 11).

TABLE 15.4 Estimation ofEq. (14): Unrestricted Model [Dependent Variable: In of Consumption differential (In C- In C o )]

Finland

Po

Pi

P2

-2.130**

.483"

-.726**

(.342)

(.044)

(.092)

(.076)

-1.099"

.093"

-.098

Greece

(.026)

(.018)

.543*

.761"

-1.064"

.024

.507"

(.215)

(.034)

(.056)

(.041)

(.079)

3.139*

Italy

(.032) .377**

-1 .092"* (.055) -1.069**

.581** (.058) -.171

-.207*

.993**

(.113)

(.117)

(.116)

(.011)

-.111

.937"

-.477**

-.414"

.978"

(.039)

(.099)

(.125)

(.022)

-.964**

-.093**

.863"

(.036)

(.027)

(.043)

.965**

.845** (.017)

F

N

.931

.106

648.4

148

-.074

.999

.008

79349.5

155

-.279

.995

.084

6516.8

158

-.183

.841

.094

98.1

79

-.863

.991

.207

4395.7

159

.046

.995

.097

6212.2

126

-.212

.999

.027

30785.3

159

-3.180

.941

(.114)

(1.253)

(.173) 1

.328**

.360

SSR

£ .972**

(.026)

(.535) Ireland

.603**

(.021)

-.674**

F?

EM

(.177)

(.103) France

.932**

P.,

P,+P 2 +P 3

1oannis N.

Denmark

In German In German Consumption Income

i

Belgium

In Home Income

i

Austria

Constant

i

Country

28.860

-3.449

-.619

.888

.949"

(19.63)

(2.091)

(2.415)

(2.258)

(.029)

73.66

569.56

147

S' 3 5' '

TABLE 15.4 Estimation ofEq. (14): Unrestricted Model [Dependent Variable: In of Consumption differential (In Cj-ln C G )] (Cont.) Country

Constant

Po Luxembourg

In Home Income

P.

In German In German Consumption Income

P2

.520**

-1.368"

-.432**

.999"

(47.99)

(.046)

(.077)

(.076)

(.008)

-1.030"

-.602**

.968"

(.108)

(.017)

(.030)

(.021)

Portugal

1.439**

.965**

-1.412"

-.145*

(.284)

(.027)

(.074)

(.056)

.025

.968**

-.920**

-.142"

(.229)

(.027)

(.046)

(.035)

2.693

-.950

-2.501"

2.919**

Sweden1

U.K.

U.S.

.080**

(4.567)

(.720)

(.509)

(.524)

-3.265

.611**

-.940**

-.092*

(2.325)

(.057)

(.037)

(.038)

.556**

-.999"

.050*

(.024)

(.022)

1.281 (1.508)

(.046)

#

SSR

F

N

.997

.086

13474.1

155

£1-1

62.578

Netherlands

Spain

P,+P 2 +P,

.214**

-1.280

3" .018

.996

.112

9716.1

159

§

-.592

.997

.102

11917.2

159

^

-.094

.999

.041

20361.7

158

^ ^

(.080) .896**

g3

S3

(.038) .629**

3 Q.

(.078)

.801"

-.532

.951

3.86

593.65

158

c _3

(.081) .997**

-.421

.998

.016

20403.1

138

5-

-.393

.999

.008

47388.5

158

5?"

(.009) .780**

n

O

Qj

(.081)

Note: ' consumption data might be wrong, standard errors of coefficients in parenthesis, * significant at the 10% level, " significant at the 1% level, p, and p3 test the importance of incomes on consumption, P, < 0 indicates lack of real interest rate equalization (low level of correlation in consumption), p,+p2+p3 = 0 means integration of real interest rates. Source: International Financial Statistics, IMF, CD-ROM, September 1999.

3' 3C

TABLE 15.5 Estimation ofEq. (17): Capital Mobility or Capital Autarky (Dependent Variable: In Country

Austria

Belgium

Denmark

Finland

France

Greece

Ireland

Italy

1

Constant

In German Consumption

In Home Income

a

P

8

-1.023*

.072

.769"

.222**

(.035)

(.082)

(.463)

(.130)

.193

-.060*

(.154)

(.025)

.543*

-.059

.916"

(.021) .776**

.967"

(.024)

-.482"

.201"

.543"

(.175)

(.076)

(.042)

3.196

-.143

.364"

.700**

(2.543)

(.098)

(.105)

(.078)

(.343)

(.086)

.465*

-.011

(.223)

(.038)

.951"

(.038) .885"

(.022)

.871

2.206

F

322.05

N

147

(.078)

.902"

.999

-

.011

61249

155

.255"

.993

.085

.820

.205

.988

.192

3107.6

158

-

.993

.103

5669.9

126

-

.998

.027

-

.944

73.735

5079.2

158

(.078)

.295"

175.63

80

(.078)

28170

159

(.020)

30.193

.853

-3.423*

.943

(18.68)

(2.14)

(1.968)

(.028)

|"

5'

(.044) .973"

^ ^.

b

.513"

(.056)

.332"

SSR

(.020)

(.218)

-1.106"

-

R-

804.35

147

TABLE 15.5 Estimation ofEq. (17): Capital Mobility or Capital Autarky (Dependent Variable: In C;) (Cont.) Country

Luxembourg

Constant

Portugal

Spain

Sweden

U.K.

U.S.

1

In Home Income

SSR

a

P

5

4.072*

-.555**

.579**

.994**

(.050)

(.018)

(1.614) Netherlands

In German Consumption

(.076)

-.484"

.037

1.020**

(.111)

(.032)

(.010)

1.227"

-.465**

(.270)

(.076)

(.027)

-.708*

.031

1.024**

(.356)

(.048)

(.041)

28.042

-.387

(71.51)

(.499)

-3.054

.015

(3.167)

(.033)

1.374

.025

(1.217)

(.021)

.948**

-2.683** (.733) .576** (.055) .557** (.046)

£

,-2

-

.995

.104

10722.9

155

^

159

^

5" -

.994

.012

8324.69

-

.996

.107

14341.6

159

^

.998

.043

17366.3

158

3' ^

(.078) .910**

O>

(.032) .723** (.078) .858** (.081) .837** (.086) .766** (.080)

.256**

CL

(.078) .140*

.942

4.602

617.02

158

.160*

.997

.017

11619.1

137

.999

.009

35024.3

158

(.086) .230** (.080)

n §

c |

(.082)

Note: See Table 15.4 (B = 1 and 8 = 0) means capital mobility, (B = 0 and 5 = 1 ) means autarky in capital. Source: See Table 15.4.

N

£

t-l

.237**

F

§••

•j oT

3' 3-

252

loannis N. Kallianiotis

From the data, the history, philosophy, culture, and tradition the 15 countries of the EU are different. How much they will converge it is difficult to predict, but even if they do converge in the future, what will be the country model and the common culture that the rest will follow? Is it worthwhile to abandon their indigenous culture and tradition? Also, a monetary policy dictated in Frankfurt will severely limit the other members' ability to manage their own economies. It is necessary for a sovereign country, whether it is a member of an economic union or not, to be self-sufficient, economically free and independent to pursue its own public policies and maximize the social interest of its citizens. The country's sovereignty and interest must be above the union's interest.19 The country's first economic concern must be its primary production (agriculture, fishery, mining, etc), then its secondary production (manufacturing and handicrafts), and lastly its tertiary production (services: education, health, social, defense, energy, transportation, commerce, banking, telecommunications, insurance, etc). If the country does not follow this sequence of priorities in its production, it will lose its self-sufficiency, its independence, and its future; and if it will be a future, it will be very short. As it was mentioned, the empirical results show some integration only among a few country-members. Even though a common European public policy exists, regionalism (nationalism) is still very strong in Europe at the end of the 20th century, and hopefully, it will continue. For the new century, the 21st, European countries must save, each one of them, their primary and secondary sector of production and preserve their countryside (villages). Each country must be self-sufficient and promote its own growth, employment, prosperity, culture, education, civilization, and tradition. Political relationships, economic relationships and any other alliances can be mutually determined by the interested parties. We must discourage concentrations of people in one area and the creation of big cities with millions of people and problems. Governments ought to give to them incentives to stay and prosper in small towns and villages.20 There is no need to make them unemployed workers (laborers) in overcrowded cities with high crime and pollution. Furthermore, moral standards, ethics and values are completely different in EU members. Thus, these countries cannot be in union. Italy has an agenda full of "good" intentions: bringing stability to the Balkans (read instability), promoting peace in the Middle East and creating jobs in the EU. It had plans to liberalize telecoms and energy, and to reform Europe's wine and olive-oil industries.21

Real Interest Rate, Saving, and Consumption Paths in the EU

253

Moreover, 52% of EU citizens think that the euro will do nothing to reduce unemployment.22 The Germans, Finns British, Danes, Swedes, and Austrians are against a single European currency.23 Actually, in Britain, only one-third of the population believe that membership has been a "good" thing.24 In addition, Germany's support for the EU has declined sharply since its unification (it has become "Europe" by itself).25 The socialist France is also skeptical and often reactive. Many believe that European integration must have economic affluence (because people have become only consumers) and political confidence (because people cannot trust their own governments any more) if the states of Europe are to find the national will needed to launch and sustain it, but these are not sufficient conditions. Most of the EU countries were unable to meet the Maastricht criteria and only Luxembourg and France met them all. French citizens were bitterly resentful of the state's abdication to policies reportedly decided by the Bundesbank, now by the European Central Bank, and rely on "Europe" as their alibi for rising unemployment, deregulation of their businesses, privatization of their public firms, and growing inequalities. Furthermore, some EU countries fear that the EU is a threat to their national identity, though not all to the point of leaving it. The majority of the people are against EU, but EU is still there and growing (soon it will be expanded to Asia). What are those powers that they support it? There is no need for the EU or any country-member to extend advances that have been seen in economic cooperation into the political sphere. Countries are independent entities, because they are different from each other. Economic interdependence does exist up to a degree, but people are not only economic human beings, they are a lot more. The distinction between economic policy and security policy exists and must be preserved. World peace does not depend on economic interdependence but on traditional security measures, common culture, common philosophy, common history, common tradition, common civilization, common faith,26 and global balance. These common ways of life do not exist in this world and therefore security, safety, and peace cannot be achieved because we are too imperfect, too different, and too "disintegrated". For the new century, countries must have economic cooperation and interdependence, but nothing more, all the other measures are against humanity. The EU's members can continue to have the traditional European political cooperation, because the self interest of a country can go against the interest of the other. It has been seen historically that many countries will betray their own allies, like

254

loannis N. Kallianiotis

the case of Greece with respect Turkey, Skopje, etc. How can there be consensus for issues that are very subjective and wrong? The crisis in Yugoslavia, the creation of Skopje as a new nation, Cyprus and the Aegean issues,27 and many others have disappointed everyone; for these reasons, country-members must not integrate foreign and security policy fully into the EC framework of the Maastricht Treaty. Lastly, the elimination of border controls will increase international crime in each country, illegal immigration, the creation of unassimilated minorities, and drug trafficking. Cooperation on these matters is needed, with all country-members of the EU and with the U.S. through the Justice and Home Affairs field, but they have made Europe an "unfenced vineyard" and some, unfortunately, want to make the entire globe the same. The communication revolution, the virus of globalization, and the unfair competition (oligopoly and monopoly) that have been spread everywhere, in all sectors and institutions, will create the biggest, but the last crisis in human history. Stability and balance cannot come in the world with treaties, international institutions or membership to economic, political or military unions and organizations. Stability and balance are personal, individual, internal values of each person and surely eternal ones. Only when each individual person is in internal balance and stability, will there be stability and balance in this world. The EU, NATO, IMF, UN, World Bank, WTO, OECD, and the other international institutions cannot secure these high virtues. All these well orchestrated and carefully designed movements today, and which are becoming more intensive every day in all sectors of human life, are parts of the "global ecumenism" (political globalization and cultural imperialism) which will trap naive individuals and corrupt politicians and will destroy everything valuable in this world. To avoid this impending destruction, international public policy must respect regional differences and satisfy each country's domestic objectives and intrinsic values. REFERENCES Bayoumi, T. and Koujianou, P. (1990) 'Consumption, Liquidity Constraints and Financial Deregulation,' Greek Economic Revieiu, 12(2):195-210. Bayoumi, T. and MacDonald, R. (1995) 'Consumption, Income, and International Capital Market Integration,' IMF Staff Papers, 42(3), September:552-575. Chacholiades, M. (1978) International Trade Theory and Policy, New York: McGrawHill Book Company, New York. Economist, January 27, 1996, p. 44.

Real Interest Rate, Saving, and Consumption Paths in the EU

255

Eurostat, European Commission, various issues. Feldstein, M. and Horioka, C. (1980) 'Domestic Saving and International Capital Flows,' Economic Journal, 90:314-29. Frankel, J.A. (1993) 'Quantifying International Capital Mobility in the 1980s,' in Frankel, J.A. On Exchange Rates, MIT Press, Cambridge MA, 41-69. International Financial Statistics (1999) International Monetary Fund, Washington, DC, September, CD-ROM. Kallianiotis, I.N. (1998) 'European Capital Market Integration: Interest Rates and Other Macro-variables,' in Rivera-Solis, L.E. (ed.), Northeast Business & Economics Association 1998 Annual Conference Proceedings, Waltham, MA: Bentley College, October 29-30:58-60. Kallianiotis, I.N. (2000a) 'Factor-Mobility and Factor-Price Disequalization in European Union: A State Space Dynamic Analysis,' Presented at the Northeast Decision Sciences Institute 2000 Annual Meeting, March 22-24, Atlantic City, NJ. Kallianiotis, I.N. (2000b) 'Capital-Price Equalization between Greece and the European Union,' North Central Business Journal, Spring:18. Main Economic Indicators and Economic Outlook, Paris: Organization for Economic Cooperation and Development, various issues. Wall Street Journal (1996) December 9, p. Al. Wall Street Journal (2000) January 4, 2000, p. A17.

ADDITIONAL READING Kallianiotis, I.N. (1999) 'Global Business and Economic Interdependence between the United States and the European Union,' in Flowers, E.B., Chen, T.P. and Shyu, J. (eds.), Interlocking Global Business Systems: The Restructuring of Industries, Economies and Capital Markets, Quorum Books, Westport, CA, 37—59. Levine, N. (1996) The US and the EU: Economic Relations in a World of Transition, Lanham, MD: University Press of America. Scott, A. (1995) 'Developments in the Economies of the European Union, 'Journal of Common Market Studies, 33, August: 103-118. Simonis, J.B.D. (1995) 'European Integration and the Erosion of the Nation-State,' International Journal of Social Economics, 22(7) :50—58. Tsakaloyiannis, P. (1996) The Political Dimension of the European Union (in Greek), Papazissis Publishers, Athens, Greece. NOTES 1.

A previous version of this chapter has been presented at the ASSA meetings in January 1999 and the comments and suggestions from the discussant and the conference participants are greatly appreciated. The assistance provided by Suraj Cheruvathoor, Mehdi Hasnain, Vaibhavi Shah, Usman Masrur, and Savas Saymaz is vastly acknowledged. The usual disclaimers apply. 2. See Chacholiades (1978, pp. 255-297) and Kallianiotis (2000b). 3. Rationalism is a poor theory, because it depends on assumptions of men inferior reason, rather than on accumulated practical knowledge, empiricism, and

256

4. 5. 6. I. 8.

9. 10. II. 12. 13. 14. 15. 16.

17.

18.

19.

loannis N. Kallianiotis above all the absolute knowledge. The reason must not be considered as the prime source of knowledge if men want to see any improvement in their irrational society, because human logic and reasoning are not theirs, they are imposed on individuals by "others". Actually, human behavior is not "rational" at all today. See Bayoumi and MacDonald (1995) and Kallianiotis (1998, 2000b). See Frankel (1993). Interest rate parity [i-i* - (r+it)-(r*+n*) = fd or fp] will hold in all markets and inflation rates will be equal (71 = 7i*), because r = r*. There are few traditional countries where their individuals are not consumers, yet they are still human beings; persons with personalities. Actually, three basic tests could be done in this research; interest rate comparisons, saving-investment correlations, equal consumption among countries plus the real interest rate parity test which does not require the assumption of PPP. See also, Bayoumi and MacDonald (1995). A lower case letter means natural logarithm of the upper counterparts. The subscripts UK, F, and G mean United Kingdom, France, and Germany, respectively. For EU, this is a very bold assumption, because of the differences among people in Europe, but it is made here, for simplification reasons. The constant term (|30) is included to take account of possible differences in the real interest rates across countries. See, Bayoumi and MacDonald (1995, p. 559). The year that the Treaty of Rome was signed. The results also show that, if there are investment opportunities in a countrymember of the EU, capital will flow to this nation and out from the other; then, that nation will grow faster than the others. As the time passes, these differences among the EU members will increase, the rich nations will become richer and the poor, poorer; at the end, there are not expected to be many benefits from this artificial, unsustainable, political union. Other authors have used annual data for similar estimations. Better data could had been the nondurable consumption, because the theory is concerned with the marginal utility derived from consumption. Durable goods provide utility over several years. And for the income, the variable must be the household disposable income. A similar test of capital mobility has been done between Greece and each one of the EU countries. The results have shown that in Greece there exists a very small capital mobility and she lacks integration with most of the EU countrymembers. See Kallianiotis (2000a). "The French government is promising big savings to prepare the country for the introduction of a single European currency in 1999. The unions are vowing to resist these and other reforms, such as deregulation and privatization. A similar confrontation over social-security spending last Winter set off public sector strikes that nearly brought the economy to a standstill." (See The Economist, June 1, 1996, pp. 47-48). As has been seen, people are very skeptical about the demands of the Maastricht treaty and the burdens that the EU levies

Real Interest Rate, Saving, and Consumption Paths in the EU

20. 21.

22.

23. 24.

25.

26. 27.

257

upon individual country-members. The governments tried to meet the targets that the EU had set for their countries to qualify for economic and monetary union (EMU) and their citizens were having a very hard time. Serious civil unrest may be seen in the forthcoming future, because of the tremendous pressure that the Union will impose on its citizens. The "loannis Kapodistrias" plan for Greece will result in destruction for her own villages (the heart of the country). It has been heard that the EU wants Greece to take off its vineyards, to cut its olive trees and to slaughter its livestock. Farmers and stock-farmers will receive subsidies for doing this and doing nothing thereafter. The euro has depreciated with respect to the U.S. dollar by 14%, and 23% against the yen, in its first year of creation and it seems that it cannot compete with the dollar as an international reserve currency. See Watt Street Journal, January 4, 2000, p. Al7. See The Economist, January 27, 1996, p. 44. "Britain's Major said his government will continue its 'wait and see' policy toward European economic and monetary union." See Wall Street Journal, December 9, 1996, p. Al. Germans showed their opposition to EMU from the last elections. They voted against the Christian Democratic Party in September 1998 and brought into power the coalition of Social Democrats and Greens. Of course, after allowing them to bomb Kosovo (Spring 1999), their behavior has changed even more. The 55-nation Islamic Summit took place in Tehran, Iran, in December 1997, and its objective was to unite them, because of their common religion. At the Helsinki Summit (December 1999), EU accepted Turkey as a candidate member and some people hope that Ankara will lessen tensions between Greece and Cyprus.

16 16 European Monetary System: Implications for the British Pound BIMAL PRODHAN AND RANKOJELIC 1

I.

INTRODUCTION

The central insight of an Optimum Currency Area (OCA) theory is that countries that experience a high divergence in output and employment trends need a lot of flexibility in their labor markets if they want to form a monetary union, and if they wish to avoid major adjustment problems (De Grauwe, 1996). When two countries with different reputations concerning inflation decide to form a monetary union, the high inflation country is likely to profit from the reputation of the low inflation country. Countries going through the convergence game may act opportunistically at the time, and reveal their true preferences later. In a monetary union, real interest rates will converge, but during the convergence process, the achievement of equilibrium in the money market will be at the cost of equilibrium in the labor market. The equilibrium interest rate of an individual country within the European Monetary System (EMS) may be affected by influences of a number of factors such as the interest rates in other EMS countries or in the rest of the world. One of the under-explored areas in the social sciences is Monetary Geography. In an unceasingly globalized world sharing monetary sovereignty may be a reality, but it works against the grain of the notion of "one nation one money" derived from the conventions of standard political geography and celebrated ever since the peace of Westphalia in 1648. The monopoly control over the issue and management of their own money which was the core of the statecentered model has given in to market-driven competition, greatly 258

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259

altering the monopoly powers of the state. This creeping erosion of monetary sovereignty has been gradual throughout the 19th century. Some of the examples of earlier attempts at monetary union are: The German Zollverein (1834), The Latin monetary union (1865) comprising Belgium, France, Italy, Switzerland and Greece; the Scandinavian monetary union (1873), and the CFA Franc Zone (1945) (Cohen, 1998). Monetary Union in the European Union will have taken half a century to achieve as the following timetable shows: 1952: The establishment of The European Coal and Steel Community 1957: The European Common Market is set up 1972: European Leaders agree to Economic and Monetary union by 1980 1986: An agreement is reached on a tariff free internal market by the end of 1992 1989: Berlin Wall falls 1990: Germany is reunited 1991: Agreement is reached on a European Central Bank and a common currency to start by 1999 for eligible nations 1992 Exchange rate crisis forcing the U.K. and Italy out of the Exchange Rate Mechanism (ERM) 1993: System-wide restructuring following 1992 exchange rate crisis 1995: "Euro" is chosen as the name of the single currency 1998: Eleven countries decide to join the single currency 1999: "Euro" is introduced; European stock and bond markets begin trading in Euro. 2002: National bills and coins no longer legal tender. The decision on eligibility was taken in the spring of 1998, and 11 states have joined. These are: Finland, Germany, Austria, Italy, France, Belgium, Netherlands, Luxembourg, Ireland, Portugal, and Spain. Britain, Denmark and Sweden have chosen not to join at this time, while Greece, which wants to participate, does not meet the criteria. As technological changes make societies more and more interdependent and integrated, incentives for monetary integration accelerate. This desire for integration, in turn, requires a degree of harmonization of macroeconomic indicators such as interest rates and public sector debt ratios. The latest attempt at monetary union is the Euro in the European Union starting from 1 January 1999. EU 1992, article 109j and a related protocol states the four so-called convergence criteria as follows:

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1. Achievement of a high degree of price stability as evidenced by an average rate of inflation of no more than 1.5% above that of the three "best performing" members; 2. Sustainability of the government financial position defined to mean both (i) a level of public debt no higher than 60% of GDP; and (ii) a fiscal deficit no higher than 3% of GDP; 3. Observance of the normal fluctuation margin provided by the ERM meaning (i) no severe tensions and (ii) no devaluation for at least 2 years; and 4. Durability of convergence in the long term interest rate levels, interpreted as an average rate over 1 year that is no more than 2 percentage points above that of the three "best performing" member states. Economic benefits from a monetary union have been grounded in the familiar theory of optimal currency areas (Mundell, 1961) which have subsequently been merged into the theory of choice of exchange rate regimes. Optimal currency area literature includes mobility of factors of production such as capital and labor, inflation trends, sources and timing of payments disturbances etc. While these economic factors matter, politics matters more in the success of a monetary union. This chapter analyzes the behavior of the U.K. exchange and interest rates with regard to the currencies within the European Monetary System (EMS) (German mark, French franc, and Italian lira), as well as the leading currencies outside the EMS (U.S. dollar, and Japanese yen). The motivation for the study stems from the British Government's desire to prepare the U.K. economy to join in EMS around 2002. There are two major questions to be considered in creating a monetary alliance: (i) What motivations do governments have for sharing sovereignty? and (ii) What makes the alliance survive? The motivation for sharing sovereignty is influenced by the gains from joining the alliance. The gains must be large enough to outweigh the losses which include all four of the unique boon associated with a national monetary monopoly: (i) symbol of state identity (ii) seigniorage, (iii) macroeconomic control and (iv) political insulation. The gains are financial, social and politicalmutual security, the membership of a larger entity with consequent influence in the world community, and economic gains such as stability of currency values. These gains are more pronounced for smaller countries such as Luxembourg, Ireland, or Portugal, than for larger countries such as the U.K. Hence there is enough impetus for convergence of macroeconomic indicators, such as output,

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employment, interest rates, and consequently of a stable exchange rate which is likely to cause minimum macroeconomic instability. Stability of exchange rates and issues related to transmission of monetary policy seem to be relevant not only to induce the government to share sovereignty but also helps to make the alliance survive. In this light it is important to investigate: (i) to what extent the ERM was successful in limiting exchange rate variability, and (ii) whether this affected the volatility of currencies outside the ERM. Two critical events during the sample period: (i) the unification of East and West German currencies in 1990 and, (ii) the decision by EU ministers to abandon all attempts to defend each other's currency in 1993 have been considered. Another reason for examining the bilateral relationship between exchange and interest rates for the British pound and other currencies in our sample is inconclusive empirical evidence on the socalled German Dominance Hypothesis (GDH). Politically, this is a very sensitive issue echoed in U.K. public opinion which has expressed concerns about the domination of the ERM by the German Bundesbank. The chapter is organized as follows: Section II summarizes relevant literature. Data and methodology are presented in Section III. Section IV reports the results of tests on changes in volatility in bilateral exchange rates between British pound and other sample currencies. Statistical properties of interest rates together with results for Granger causality tests on interest rates are presented in Section V. Conclusions and suggestions for further research are offered in Section VI. II.

PRIOR RESEARCH

The variability of the pound with regard to EU currencies is situated within the context of Purchasing Power Parity Theory. According to Cassel (1922) the value of any currency is determined fundamentally by the amount of goods and services that a unit of currency can buy within the country of issue. With this statement applying to two countries, the value of one country's currency relative to the others is the short run equilibrium exchange rate, and the ratio of the internal purchasing powers defines the absolute Purchasing Power Parity (PPP). This parity is subject to the limitations of trade restrictions, speculation in the foreign exchange market, anticipated inflation, changes in relative prices, long-term capital movements and government intervention in the foreign exchange markets. Balassa

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(1964) posited that internal price ratio increases with per capita income across countries at a given point of time and for a given country over time. The history of PPP and earlier literature are well documented in Officer (1976). On the question of loss of monetary sovereignty, Mundell (1961) in the discussion on optimum Currency Area observes that "in a world of incomplete risk markets, exchange rate flexibility acts as insurance by turning an incipient decline in output into a terms of trade deterioration that is more even in its domestic incidence than unemployment." This redistribution can be seen as a just system from the societal point of view. There are two major strands in the literature: one is technical— the extent to which Purchasing Power Parity is mean-reverting. Froot and Rogoff (1995) and Rogoff (1996) are excellent survey of this literature. The second is the case of European monetary integration, which is the focus of this chapter. Giavazzi and Spaventa (1990), for example, argue that ERM exchange rates became more stable after the January 1987 realignment. This further indicates that the ERM was successful in its goal to reduce exchange rate variability. Edison and Kole (1995) is an excellent example of this strand which examines the implications of the European Exchange Rate Mechanism (ERM) for the U.S. dollar. The authors examined the history of the ERM to gain insights into what might happen to exchange rates on the road to the European Monetary Union. They analyzed the exchange rates for the period between March 1973 and May 1993 between 15 currencies divided into four groups: "core ERM" countries, peripheral ERM countries, other European countries, and other G-7 countries to identify differences in exchange rate and interest rates among these four country groups. They examined the variability of exchange rates, the transmission of monetary policy between countries, the role of the dollar in the ERM exchange rate crises of 1992, and ERM members' credibility as measured by realignment probabilities prior to the September 1992 crises. They found that ERM reduced exchange rate volatility among member currencies without changing exchange rate volatility among non-members. Further, interest rates in major industrial countries were seen to be closely linked, indicating globalization and interdependencies bringing about macroeconomic convergence among major economies. The two most important factors that contributed to the crisis were high German interest rates and the weakness of the dollar. They also found that the behavior of

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263

exchange rate changes in German short-term interest rates were the key influence on interest rates on other ERM currencies. This dominance of German interest rates on EMS currencies is examined by Giavazzi and Giovannini (1989), Hafer and Kutan (1994), Edison and Kole (1995), and Hafer, Kutan, and Zhon (1997). Hafer, Kutan, and Zhon (1997), for example, addressed the issue of whether movements in the term structure of interest rates in one country are related to movements in the term structure of another. If such a link exists, then macroeconomic shocks, both real and policy-induced, can be transmitted through this avenue. Information contained in the term structure was seen as a better measure to capture the effects of German policy on other EMS countries than using short-term interest rates alone because in addition to capturing information about monetary policy, the term structure may contain information from other domestic policies such as fiscal policy and government debts. A sample of EMS countries was used to test for co-movements on the components of term structure of interest rates since its establishment in March 1979. They found that in every instance the common trend component in each domestic term structure is driven by the movement in the long-term interest rate. Apart from the major survey papers mentioned above, specialized papers in this area are many. Long run PPP relationship has been explored by Abuaf andjorion (1990), Dornbusch (1987), Flynn and Boucher (1993), Frankel and Rose (1996), Hakkio (1984), Mark (1990), Sarno and Taylor (1998), and Taylor (1995). Convergence economics and policy decisions have been explored in De Grauwe (1996), Decressin and Fatas (1995), Eichengreen (1990), McKay (1997), Mckinnon (1993), Sala-i-Martin and Sachs (1991), and Molle and Van Mourik (1988). III.

DATA AND METHODOLOGY

This chapter follows a classic paper by Edison and Kole (1995), and examines the special case for the U.K., by updating the analysis to June 1998. The starting point for our analysis is January 1987, the beginning of the hard European Monetary System (EMS) period, and the data series ends on June 1998. The whole period was divided into two main sub-groups; before and after the withdrawal of the U.K. from the exchange rate mechanism, the break-point being August 1993 when the currencies were realigned following severe speculation on the British pound and the Italian lira. The

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first sub-period was further subdivided in October 1990 to take into account the reunion and currency reunification in Germany. Interest rate data were the changes in short term (three-month) inter-bank rates of the U.K. and those of the five countries mentioned above. Currencies investigated were grouped into three blocks: (i) the major EU currencies: German mark, French franc, and the Italian lira; (ii) the U.S. dollar, being the major world trading currency, and its traditional linkages with the British pound; and (hi) the Japanese yen, being a proxy for the major Asian currencies. Variability was defined as the standard deviation of monthly changes in the natural logarithm of exchange rates. Tests of changes in exchange rate variability over time were performed using standard F-test. Since the special situation for the British currency is the focus, only bilateral rates against the British pound were considered. Sources of data for exchange rates and interest rates were Datastream; for consumer price indices: the International Monetary Fund (IMF) Financial Statistics. Exchange rates were monthly bilateral rates on the first day of trading of every month during January 1987-June 1998. Interest rates were three-month inter-bank offer rates for France, Germany and Japan; middle rates for Italy and the U.K., and treasury constant maturities three-month middle rates for the U.S. Inflation data were the consumer price indices of the six countries. Sources of data were primarily Datastream, supplemented by IMF statistics on macroeconomic variables. Statistical properties of interest rates for the sample currencies are examined by simple Dickey-Fuller unit root tests. The test of the conjecture on the German dominance hypothesis was based on Granger causality, testing the influences of German real interest rates on other interest rates, and vice versa. IV.

VOLATILITY OF EXCHANGE RATES

The first question considered was the volatility of British pound before and after its expulsion from the ERM. A further question considered was the impact of German unification in 1990 on this volatility, if any. Finally we postulate that there maybe a change in behavior of the ERM exchange rates after 1993. Volatility or variability of exchange rates was defined as the standard deviation of monthly log changes of bi-lateral rates. Table 16.1 shows the variability of bilateral exchange rates for the five time series: before and after British withdrawal from the ERM in

European Monetary System: Implications for the British Pound

265

TABLE 16.1 Variability of Exchange Rates (standard deviation of monthly log changes) January 1987-June 1998 1/87-10/9011/90-8/931/87-8/939/93-6/981/87-6/98 German re-unification Withdrawal of U.K. from EMU Post Pre Post Pre w = 34 n = 80 n = 58 n= 138 n = 46 Bilateral rates against £ U.S. 3.5680 4.5459 4.0380 1.9615 3.3122 Japan 3.2956 3.9299 3.1478 3.3950 2.1645 France 2.6918 2.3440 2.1987 2.2779 2.0612 Germany 2.5241 2.2001 2.2534 2.2933 2.1092 Italy 1.9553 2.3056 2.0990 2.3082 2.1821

1993; before and after German unification; and the whole series. As expected, exchange rate for the British pound vis-a-vis selected currencies exhibited higher variability during the 1990-93 period. This period was characterized by speculative attacks and the exchange rate crises, which forced the U.K. and Italy out of the ERM. One result that stood out from Table 16.1 is that the variability of the U.S. dollar vis-d-vis the British pound was significantly lower than for any other currency in the post-1993 regime. Further, variability of the German mark and French franc declined, whereas variability of the Japanese yen and Italian lira increased in the post-1993 realignment. Tests of changes in volatility are measured by examining equality of variances, using a standard F-test, and are given in Table 16.2. The reported results show no significant difference in changes in volatility for the sample currencies, except for Japanese yen during the 1990-93 period (changes in exchange rate volatility significant a t l % level). TABLE 16.2 Tests of Changes in Exchange Rate Volatility pre-post German unification Bilateral rates against £ U.S. Japan France Germany Italy Significant at 5% level. Significant at 1 % level.

1.95 6.31** 0.43 0.78 0.00

pre-post withdrawal U.K. from EMU 0.10 1.32 0.30 0.88 0.04

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V.

Bimal Prodhan and Ranko Jelic

TRANSMISSION OF MONETARY POLICY

The reduction of volatility of bilateral exchange rates of the dollar, mark and the franc in the post-1993 regime as shown in Table 16.1 leads us to the question of the influence of interest rates on exchange rates, and the extent to which one country's interest rate may influence the interest rates of any other country through trade and capital flows. Statistical properties of interest rates and interest rate differentials were considered and are presented in Table 16.3 with Augmented Dickey-Fuller tests. These tests are second-order, with no intercept terms. The time series is subdivided into before and after August 1993, as well as for the whole series. Column 1 reports unit root tests on three-month real interest rates (i.e., nominal rates deflated by CPI). Results indicate that we cannot reject the null hypothesis of a unit root for all interest rates when we consider the entire period; but the results are significant for the pre-1993 period for French and Italian interest rates, and for Germany in the post-1993 period. A possible explanation for Germany lies in the reunification of Germany, while for France and Italy in the political regimes, which began to toe the line following the realignment in 1993. Target zone for eventual monetary unification may also have influenced stability of interest rates. The results of unit root tests on interest rate differentials are mixed. Notably the null hypothesis of a unit root for interest rate differential with the U.K. and other currencies could not be rejected. The null hypothesis of a unit root for interest rate differential with Germany is rejected for France when the whole 138 months are concerned, confirming a Franco-German axis on macroeconomic policy. The lack of stationarity of the German-U.S. interest rate differential in pre-1993 regime is consistent with findings for 1979-93 reported by Edison and Kole (1995). This is, however, in sharp contrast with results for the German-U.S. interest rate differential in post-1993 regime which suggest that there may be a long run relationship between these variables. That is, German interest rates are linked with U.S. interest rates. So far as Japanese rates are concerned, the European rates are not influenced at all by them. To test the impact of one country's change in interest rates on another country's interest rates, Granger causality tests using simple, non-Cointegrated bilateral regressions were used. Table 16.4 shows the cases for Germany, U.S. and Japan for the entire period: January 1987 to June 1998. Results from Table 16.4 confirm causality between Germany and France (1% level) suggesting transmission of

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267

TABLE 16.3 Augmented Dickey-Fuller Test (Unit Root Tests for Interest Rates: Second-order, with Intercept, but no Trend Term) I.January 1987-June 1998 (n=138) DIFFERENTIAL AGAINST

OWN

U.S.

Germany -

U.K. -1.39

German

-0.53

-0.86

French

-1.00

-1.20

-2.79*

-1.82

Italian

-1.27

-1.44

-2.18

-1.67

U.K.

-0.89

-1.26

-1.39

-

U.S.

-1.11

0.00

-0.86

-1.26

Japanese

-0.22

-0.66

-1.68

-1.71

-0.31

II. January 1987-August 1993 (n = 80) German

-1.50

-0.70

-

French

-2.75*

-1.52

-2.44

1.38

Italian

-2.78*

-1.83

-2.03

-1.50

U.K.

0.01

-1.24

-0.31

-

U.S.

-0.01

-

-0.70

-1.24

Japanese

-0.65

-0.94

-0.91

-1.16

III. September 1993-June 1998 ( w = 58) _

German

-3.13**

-3.34**

French

-1.07

-2.39

-1.19

Italian

-1.61 -0.84

0.37

-0.55

-1.61

2.35

U.K.

-1.10

-2.17

-1.61

-

U.S.

-2.79

-

-1.48

-2.34

Japanese

-3.34**

-2.17

-2.15

-0.89

Critical values (Fuller, 1976, p.373): n

at 5%**

at 10%*

58

-2.92

-2.60

80

-2.90

-2.59

138

-2.88

-2.57

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Bimal Prodhan and Ranko Jelic

monetary policy from Germany to France. The results also suggest one way causality running from the U.S. to the U.K. (5% level) and Germany (5% level). Japan does not seem to have any influence in European or U.S. interest rates. The reported causality between Germany and France, and the U.S. and Germany is consistent with results reported in Edison and Kole (1995) for the 1979-93 period.2 Results for post ERM realignment: September 1993-June 1998 are shown in Table 16.5. It would appear that in the period following the TABLE 16.4 Granger Causality Test of Interest Rates (January 1987-June 1998) Autoregressive Model: Joint F test Bi-variate Cases: Germany Country m on Germany Country m France Italy U.K. U.S. Japan II.

0.5452 1.2927 0.3026 2.2738* 0.3661

3.7830** 2.0927 2.0720 0.9713 2.2332

U.S. Country m on U.S. France Italy U.K. Germany Japan

III.

Germany on country m

0.2466 2.7926* 0.7607 0.9713 1.9729

U.S. on country m 1.6842 0.4894 2.8523* 2.2739 0.5673

Japan Country m on Japan France Italy U.K. U.S. Germany

0.7042 1.8384 1.8507 1.9729 2.2332

* Denotes significance at 5% level. ** Denotes significance at 1% level. N = 138; Critical value at 1%: 3.17; at 5%: 2.29.

Japan on country m 0.5907 0.5743 0.1663 0.5673 0.3661

European Monetary System: Implications for the British Pound

269

realignment in the ERM in August 1993, the only significant one way causality is between the U.S. and the U.K. (5% level). This result indicates transmission of monetary policy from the U.S. to the U.K. TABLE 16.5 Granger Causality Test of Interest Rates (September 1993-June 1998) Autoregressive Model: Joint F Test Bi-variate Cases: I. Germany Country m France Italy U.K. U.S. Japan

Country m on Germany

Germany on country m

0.1211 0.7862 0.5626 0.4905 1.3296

1.4796 0.8380 0.9483 0.5976 1.0377

II. U.S.

France Italy U.K. Germany Japan

Country m on U.S. 1.0627 1.0389 1.0527 0.5976 1.2175

U.S. on country m 1.2369 1.8220 2.6942* 0.4905 0.1103

III. Japan Country m on Japan France 1.9110 Italy 2.3697 U.K. 0.5355 U.S. 0.1103 1.0568 Germany ^Denotes significance at 5% level. N= 58; Critical value at 5% level = 2.51.

Japan on country m 1.0668 0.4499 0.1949 1.2175 1.3671

VI. CONCLUSION The motivation for this chapter has been to examine the case for the British pound in the context of the two competing forces shaping the future of the major economies in Europe: 1. a centripetal force urging harmonization and integration of macroand microeconomic variables and institutions, the culmination of

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Bimal Prodhan and Ranko Jelic

which has been the launch of the single currency, the Euro, on January 1, 1999, and 2. a centrifugal force urging the continuation of tradition, local customs, 'sovereignty', and the preservation of the old currency, of which the U.K. has been a prime example. Looking into the analyses presented, it is noted that FrancoGerman, and U.K.-U.S. axes are predominant in the transmission of shocks across countries. The impact of EMS on the British pound has been highly influenced by historical events. The decision by the U.K. not to join the Euro has been both an economic as well as a political one on at least three counts in which self-interest dominates: (i) In any monetary union, small countries gain, and large countries lose influence and independence. The U.K., being a large country, has much to lose; (ii) Historical links with the English speaking world of North America and the Commonwealth which have permeated into trade, culture and institutions have been painful to disentangle. The pull of U.S. dollar on British pound as demonstrated in our analysis is an evidence of this process; (iii) The sticky goods prices problem manifest in the shape of lack of mobility of labor between the U.K. and the mainland of Europe has been accentuated by transaction cost (the geography of being an island nation off the coast of the mainland of Europe). Mobility of labor, which has been easy to achieve in the U.S. due to common language bonding (Eichengreen, 1990), and a continuous land mass, has been less so between the U.K. and the rest of the members of the European Union participating in the launch of the Euro. Clashes of self-interest of larger nations within the EU have also been a prime mover. The geography of a divided Germany necessitating a political process of unification has significantly influenced the history of the European Union. The requirements of the currency union between East and West Germany in 1990, combined with the Bundesbank's commitment to low inflation caused a rise in both German short-term and long-term interest rates, causing a real appreciation of the German mark via capital inflows. While interest rates in Germany has been influenced by national interests, a centrifugal force in the context of European Union, the removal of capital controls in the cause of European integration, gave rise to the centripetal forces. The clash of these two opposing forces increased tensions in the European financial markets. The collapse of the ERM in 1992, and the exit of the British pound, were the culmination of this tension. In this context this study examines the behavior of the U.K. exchange and interest rates and compare them with exchange rates

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271

and interest rates in the U.S., Germany, Japan, France, and Italy. The U.S. dollar was considered because it is effectively the world trade currency. The French franc, German mark and Italian lira represented the major currencies of the exchange rate mechanism (ERM), and the Japanese yen was considered as a proxy for other major currencies. The study hoped to answer the question to what extent one country's interest rate may influence the interest rates of any other country in the sample. In the U.K. context this seems to be a sensitive issue echoed in the U.K. public opinion which has expressed concerns about the ERM domination by the German Bundesbank. An important feature of our study is that we compare behavior of exchange and interest rates for our sample currencies before and after 1993 changes in the ERM currency regime. It was found that the British pound exhibited its highest variability during 1990-93. During this period the highest reported variability was for U.S. dollar vis-a-vis the British pound. In the post1993 regime, however, the variability of the British pound vis-d-vis the U.S. dollar decreased and was significantly lower than for any other sample currency. Tests of changes in exchange rate variability in the post-1993 regime, however, show no significant differences between the British pound and other sample currencies. The results of unit root tests on interest rate differentials suggest that there may be a long run relationship between German and French interest rates. The results also indicate strong link between German and U.S. interest rates in the post-1993 regime. The results of the simple bilateral Granger causality test seem to confirm the links between monetary policies in Germany and France. The results also suggest that the U.S. Granger-causes real interest rates in the U.K., while the U.K. does not Granger-cause real interest rates in any of the countries. The results on unit root tests may be affected by a trivariate relationship between German interest rates, U.K. interest rates and U.S. interest rates. More complex trivariate models would, therefore, shed more light on the relationship between interest rates for sample currencies. Another extension of our analysis could be usage of bivariate or multivariate tests of cointegration in order to test the degree of convergence of interest rates during the sample period. REFERENCES Abuaf, N. and Jorion, P. (1990) 'Purchasing Power Parity in the Long Run,' Journal of Finance, March:! 57-174.

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Balassa, B. (1964) 'The Purchasing Power Doctrine: A Reappraisal, 'Journal ofPoliticalEconomy, 72:584-596. Cassel, G. (1922) Money and Foreign Exchange After 1914, MacMillan, New York. Cohen, B.J. (1998) The Geography of Money, Cornell University Press, New York. De Grauwe, P. (1996) 'Monetary Union and Convergence Economics,' European Economic Review, 40:1091-1101. Decressin, J. and Fatas, A. (1995) 'Regional Labor Market Dynamics in Europe,' European Economic Review, 39, December:1627-1655. Dornbusch, R. (1987) 'Purchasing Power Parity,' in Eatwell, J. et al, The New Palgrave Dictionary of Economics. Economist, (1999) 'The Euro's First Test,'January 9:86. Edison, HJ. and Kole, L.S. (1995) 'European Monetary Arrangements: Implications for the Dollar, Exchange Rate Variability and Credibility,' European Financial Management, 1:61-86. Eichengreen, B. (1990) 'One Money for Europe? Lessons from the U.S. Currency Union,' Economic Policy, 10, April: 119-186. Flynn, N.A. and Boucher, J.L. (1993) 'Tests of Long-run Purchasing Power Parity Using Alternative Methodologies,' Journal of Macroeconomics, 109-122. Frankel, J.A. and Rose, A.K. (1996) 'A Panel Project on Purchasing Power Parity: Mean Reversion Within and Between Countries,' Journal of International Economics, 209-224. Froot, K.A. and Rogoff, K. (1995) 'Perspectives on PPP and Long-run Real Exchange Rates,' in Grossman G. and Rogoff, K. (eds.), Handbook of International Economics, 3, Elsevier, Oxford, 1647-1688. Giavazzi, F. and Giovannini, A. (1989) Limiting Exchange Rate Flexibility: TheEuropean Monetary System, MIT Press, Cambridge, MA. Giavazzi, F. and Spaventa, L. (1990) 'The 'New' EMS,' in De Grauwe, P. and Papademos, L. (eds), TheEuropean Monetary System, Longman, London. Hafer, R.W. and Kutan, A.M. (1994) 'A Long-run View of German Dominance and the Degree of Policy Convergence in the EMS,' Economic Enquiry, 32:684-695. Hafer, R.N., Kutan. A.M., and Zhon, S. (1997) 'Linkage in EMS Term Structures: Evidence from Common Trend and Transitory Components, 'Journal of International Money and Finance, 16(4):595-607. Hakkio, C.S. (1984) 'A Re-examination of Purchasing Power Parity: a Multi-country and Multi-period Study, 'Journal of International Economics, 265-277. McKay, J.E. (1997) 'Evaluating the EMU Criteria: Theoretical Constructs, Member Compliance and Empirical Testing,' Kyklos, 50(l):63-82. Mckinnon, R I. (1993) 'Optimum Currency Areas,' American Economic Review, 717725. Mark, N.C. (1990) 'Real and Nominal Exchange Rates in the Long Run: An Empirical Investigation, 'Journal of International Economics, 28:115-136. Molle, W. and Van Mourik, A. (1988) 'International Movements of Labour Under Conditions of Economic Integration: The Case of Western Europe,' Journal of Common Market Studies, XXVI (3), March:317-342. Mundell, R.A. (1961) 'A Theory of Optimum Currency Areas,' American Economic Review, September:657-665.

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Officer, L.H. (1976) The Purchasing Power Parity Theory of Exchange Rates: A Review Article,' IMF Staff Papers, 23:1-60. Rogoff, K. (1996) 'The Purchasing Power Parity Puzzle,' Journal of Economic Literature, June: 647-668. Sala-i-Martin, X. and Sachs, J. (1991) Fiscal Federalism and Optimum Currency Areas: Evidence for Europe from the United States, National Bureau of Economic Research Working Paper No. 3855, October. Sarno, L. and Taylor, M.P. (1998) 'Real Exchange Rates Under the Recent Float: Unequivocal Evidence of Mean Reversion,' Economic Letters, 60:131-137. Taylor, M.P. (1995) 'The Economics of Exchange Rates,' Journal of Economic Literature, XXXIII, March: 13-47.

ADDITIONAL READING Blanchard, O.J. and Katz, L.F. (1992) Regional Evolutions, Brookings Paper on Economic Activity, 1:1-75. Fuller, W.A. (1976) Introduction to Statistical Time Series. John Wiley & Sons, London. Times (1998) 'Unequal Partners Gamble on Unity,' December 28:13.

NOTES 1. 2.

The authors wish to thank Mr Dominic Chung for his research assistance. Edison and Kole (1995) extended the simple autoregressive model by adding an error-correction term. The error-correction model showed that the some unidirectional causality might be due to mis-specification of the relationship.

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Part VI Financial Crisis in Asia and its Global Implications

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Part VI: Financial Crisis in Asia and its Global Implications The financial crises which engulfed much of East Asia were strong reminders of the volatility of the susceptibility of the emerging economies to normal cyclical changes in the global, regional, or even national economies. No currency is, or can be, immune from such strong fluctuations which these countries faced in the late 1990s. Nevertheless, the pace of depreciation of the currencies of some of fastest growing economies in the world, and the unimpeded spread of each currency crisis into a general economic crisis bordering recession was indeed a surprise to the students of the Asian Miracle in the prior two decades. The three chapters which comprise Part Six analyze the Asian financial crises and their global implications from different perspectives. In Chapter Seventeen, Professor M. Raquibuz Zaman explores the role of trade, foreign direct investment, and private capital flows in restoring growth in East Asia. He "examines the causes and consequences of the East Asian economic crisis with special emphasis on the role of the intra-regional trade, short-term capital movements, bank debts, transparency and accountability." He further argues that "national governments as well as the IMF and the World Bank should share the responsibility for the crisis in the financial markets." Professor Zaman concludes by arguing that "these multilateral agencies [the International Monetary Fund and the World Bank] are beyond reform and should be disbanded to force each nation to pursue prudent market-based policies." In Chapter Eighteen, Professor Balasundram Maniam "provides an overview of the crisis from the standpoint of the most severely affected countries [of] Thailand, Indonesia, Korea, and Malaysia." He points out that "no macroeconomic distortions were observed in Asia [in the years immediately preceding 1997.] The economies of the four countries were characterized by low inflation, budget surplus, and declining government foreign debt." None could be considered a precursor to a financial crisis. Yet, Professor Maniam points out that "in January 1997, Hanbo Steel, a large Korean 277

278

chaebol, collapsed under a $6 billion debt." This, according to Professor Maniam was followed by Thai conglomerates in February and accelerated a chain of events which eventually resulted in the Asian financial crisis of the 1990s. Professor Maniam concludes that in recent months "various areas, such as production ... have reported growth in small percentages. [And some] stability has been achieved while more is expected in the months to come." Professors John Norsworthy, Wolfgang Bessler, Irvin Morgan, Rifat Gorener, and Ding Li provide a different perspective of the Asian crisis in Chapter Nineteen. They "appraise the performance of U.S.-based Asia mutual stock funds during the 1996-98 Asian financial crisis." In the initial phase of their study, the authors compare these funds "against U.S. domestic equity funds to measure the effects of the crisis during the downturn phase. [Their] emphasis is on identifying the timing of the downturn in the emerging Asia-Pacific countries and testing the performance of the funds against the Standard & Poor 500 Index and an index of emerging country stock markets." The authors conclude that "concerning the contraction phase of the Asian financial crisis, the declines in the emerging country stock market indexes started at widely different times, but they all declined until about September 1998. [And] exchange rates followed a similar pattern." The authors point out that despite the financial crisis of the late 1990s,"it is important to note that the Asia-focused funds generally seem to have outperformed a composite emerging market index."

17 Restoring Growth in Asia: A Reexamination of Trade and Investment M. RAQUIBUZZAMAN

I.

INTRODUCTION

The collapse of Thailand's currency, the baht, in July 1997 and the turmoil that ensued in its financial markets produced contagion (i.e., spillover effect) rocking not only the economies of the neighboring East Asian (EA) countries, but also rattling markets elsewhere. Like Japan in the mid- to late-1980s, the EA countries (i.e., China, Hong Kong, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand) were growing at such a rapid rate up until 1997 that they earned the epithet of "East Asian Miracle" (The World Bank, 1993). Yet, in the course of a mere 5 years or so, the "miracle" has turned into a "malice" of such proportion that these nations are experiencing considerable obstacles in regaining their momentum in economic growth and development. Among the EA nations, Thailand, Indonesia, Korea, Malaysia, and the Philippines were particularly hit hard by the collapse of the financial markets. Their plight has earned them the designation of the "affected countries" by the International Monetary Fund (IMF) (Adams, Mathieson, Schinasi, and Chandha, 1998, p. 13). Hong Kong, Singapore, China, and Taiwan have been able to withstand the contagion so far with relatively minor damage to their economic health. However, China still may be vulnerable unless it can effectively restructure its banking and financial sectors soon. This chapter analyzes briefly the immediate factors that contributed to the collapse of the financial markets in 1997 with a special 279

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emphasis on trade, private capital flows, the foreign direct investment (FDI) and the role of the banking and financial institutions. The objective is to evaluate the policy prescriptions that are being pursued now by the East Asian Countries (EACs) themselves and the ones that are being prescribed by various multilateral agencies and development experts, in light of the policies that elevated the EACs to the ranks of the newly industrialized countries (NICs) only a few short years ago. The idea is not only to critique the policy prescriptions but also to show that the descent of the East Asian NICs to the "affected countries" could, and should, have been prevented by the very parties that now are coming up with a new set of policy variables for them. The chapter examines the possible lessons that ought to be learned from the EA experience to prevent repetition of financial market collapse in other regions. Finally, it puts forward some suggestions about the future roles of the multilateral agencies such as the World Bank and the IMF. II.

LITERATURE REVIEW

The frequency with which the world's financial analysts and papers use the term "Asian Contagion" nowadays to describe the EACs' economic turmoil, parallels those accolades that were bestowed upon Japan, albeit with envy, in the late 1980s about how, by the turn of the new millennium, Japan was expected to surpass the U.S. economy! As late as mid-1998, Nye (June 27, 1998, pp. 23-25) suggested that " ... at a more sustainable rate of growth of 6% per head, China would reach $10,000-per-person income in 30 years and its economy would then total about $16 trillion, or twice the size of the current American economy." (Ibid., p. 24). This optimistic view of China contrasted with the realities a few months later when Kaye and Egan (August 17-24, 1998, p. 24) pointed out how Chinese exports were falling as a result of its attempts at propping up the yuan and that out of $600 billion in bank assets, around $200 billion (i.e., one-third) is non-performing loans. Yet, by October The Economist (October 24, 1998, pp. 23-26) concluded that China was possibly in recession at the moment. The point here is that whether it is Japan or China or any of the NICs, the development "experts" as well as monitors of the world economic scene are too quick to forecast long-term growth and development on the basis of short-term happenings. No one can deny that in the course of a relatively short period of time the countries of East Asia, in eluding Japan, have amassed an enviable record

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of economic growth and prosperity that is unmatched by any other country in modern times. The factors that contributed to the transformation of the economies of the EACs are well known. These are discussed elsewhere in detail (Ranis, 1995; Birdsall, Ross, and Sabot, 1995; Krueger, 1997; The World Bank, 1998; and many others), but can be stated briefly thus: Most of the EACs launched economic development with the modernization of their basic economic sector—agriculture— followed by promotion of labor-based technologies to accelerate exports; simultaneously, they instituted policies to improve literacy and education that first emphasized vocational and technical skills and then science and technology, while remaining mindful of policies that reduced income inequality and poverty. In the course of a mere 20 years between 1975 and 1995, the EA region was able to reduce poverty by half, from a population of 716.8 million to 345.7 million (the World Bank, Op. Git, pp. 2-3). While some blame the adherence to the Japanese development model (i.e., targeting industries with export potential for preferred access to capital and protection from competition in the domestic market) for the economic ills of the EACs (Wolf, 1998), others, such as Kuttner (1998, p. 16) blame the floating exchange rates and the speculative capital flows. This latter view is also supported by The Economist (September 12, 1998, pp. 83-85) and Sachs, who also contends that the premature liberalization of capital, often urged by the IMF, has been one of the root causes of the Asian contagion (Sachs, 1998, pp. 23-25). Belatedly, the World Bank (op. cit.) has acknowledged that it was the pursuit of stable exchange rates along with high domestic interest rates at a time when foreign rates were relatively cheap led to heavy short-term borrowing from private sources abroad. These private capital inflows ultimately resulted in abrupt outflows "when markets became worried about the sustainability of the fixed exchange rate in Thailand . . . " (Ibid., p. xiv). That the maintenance of the high domestic interest rates (before the crisis) was the prescription of the IMF to these nations is not mentioned in either the World Bank or the IMF literature dealing with the EA crises (Fischer 1998b, pp. 2-5), is an indirect acknowledgment of the fact that these multilateral agencies failed to provide appropriate counsel to them in their times of need. Fischer (1998a, 1, pp. 23-27) justifies pushing up the domestic interest rates of Thailand, Indonesia and Korea to "restore macroeconomic stability and growth, and to remedy structural weaknesses in each country" (Ibid., p. 23) after the crisis of 1987-88. Barro (1998,

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p. 18) asserts that the flood of low-cost capital that flowed into EA from the U.S., Europe, and Japan to finance speculative real estate buildup and overcapacity was made possible by the assumed "guarantee" of the IMF to bail out lenders. There seems to be a developing consensus among analysts and observers of economic growth about the factors that caused the financial crisis. The World Bank (1998, 1, pp. 3-16) summarizes the causes to be: First, rapid growth in the economies without accompanying development of adequate financial and capital markets and a large public sector made private firms reliant on short-term capital for financing long-term projects. Foreign private capital in search of lucrative returns flowed into the newly liberalized but inadequately regulated financial markets. "The scenario played out as follows: The push from global capital markets, often without due intelligence and beyond prudent limits, interacted with poorly regulated domestic financial systems to fuel a domestic credit expansion. This manifested itself as an asset price bubble, particularly in Thailand, and added to the excessive debt of already over-leveraged firms, which exposed the regions to the shocks of changing investor expectations." (Ibid., p. 4). Similar assertions are made by other observers such as Goldstein (1998), Kuttner (1998), Wolf, (1998), and McLeod and Garnaut 1998. Not only do the discourses on the causes of the EA financial crises abound, but also suggestions for the cures coming from individuals, governments, regional bodies, and even the World Bank and the IMF. An assortment of such treatises are: Eichengreen (1999), Sachs (1998), Fischer (1998a, 1998b), Goldstein (1998), McLeod and Garnaut (1998), Posen (1998), The World Bank (1998), and Adams Mathieson et al. (1998). Before these are discussed in some detail, let us examine some of the basic economic indicators of the EACs, especially those of the "affected countries" as defined earlier. III.

METHODOLOGY AND THE DATA

A careful analysis of selected economic indicators for the EACs that were most affected by the 1997 financial crisis and the contagion that followed is undertaken to clarify the points raised above about the causes of the Asian turmoil. This is then followed by a critique of the proposals and plans that are advanced to restore economic growth in the region and to reassure the investing public. The chapter ends with some suggestions about what role, if any, the World Bank and the IMF should play in today's economic matters.

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The data for the chapter were collected from various IMF and The World Bank publications, with additional information from various business journals and publications. IV.

ANALYSIS OF RESULTS

Table 17.1 presents some macroeconomic indicators of the "affected" EA countries for the first quarter of 1997 through the fourth quarter of 1998. The percentage changes are from four quarters earlier. Thus, the output growth change in 1997Q1 is from that of 1996Q1 and so on. The data show how quickly after the July 1997 currency crisis in Thailand its output growth turned negative and continued to fall in the subsequent quarters of 1997 and 1998. Indonesia was hard hit by Thai contagion—first, output growth declined dramatically and then by quarter 1 of 1998 became negative. Korea and Malaysia also began to experience negative growth at the same time as Indonesia did, but the magnitude of the decline was lower. While output growth declined, inflation soared in all the affected countries, though it goes against general economic principles. However, the IMF-mandated solution for the crisis included raising of interest rates and prices " ... to restore macroeconomic stability and growth ..." (Fischer 1998a, op. cit.)! It was of no concern to the IMF officials how it hurt the average consumers of the EACs. Table 17.1 data on trade balance, import and export value growth also present a bleak picture of the "affected countries". Because of sudden capital flight out of the countries and the drastic declines in currency values, they were unable to maintain their import needs. This, together with declining outputs and slower growth in exports, created positive trade balances with overall weakening economic conditions. The economic growth picture brightened somewhat for Korea, Malaysia, Philippines, and Thailand in 1999 (IMF, May 1999). These economies were expected to experience positive growth in their real GDPs during the year. The current estimate for the 1999 growth for Korea is around 9% (Burton, Nov. 23, 1999, p. 16). Indonesia was expected to see another year of negative growth. "Japan's recession deepened further in late 1998, with real GDP falling to a level 5J/4% below its peak of early 1997" (IMF, May 1999, p. 15). The projected decline in Japan's real GDP in 1999 was around ll/z%. In February 1999 its unemployment rate reached a new peak of 4.6%. Until Japan's economic picture brightens up, it is difficult to see how the economies of the region can restore their momentum for growth.

284

M. Raquibuz Zaman TABLE 17.1 Macroeconomic Indicators of the Affected Countries (Percentage change from Four Quarters Earlier) 1997

Country

1998

Qi

Q_2

Q_3

Q4

Qi

Q2

Q3

Q4

Indonesia Output growth1 Inflation Trade balance2 Imp. value growth3 Exp. value growth3

7.7 5.2 1.7 11.0 10.4

6.6 5.1 2.2 -7.8 7.5

3.3 6.0 0.8 -2.6 9.6

2.4 10.1 17.0 -10.1 2.4

-4.0 29.9 3.9 -31.3 -1.0

-12.3 52.1 4.1 -26.9 -10.5

-18.4 79.7 4.2 -31.2 -6.3

-19.5 79.2 3.4 -38.8 -22.4

Korea Output growth Inflation Trade balance Imp. value growth Exp. value growth

4.9 4.7 -7.3 3.9 -5.6

6.2 4.0 -1.8 0.8 7.1

5.5 4.0 -1.5 -3.8 15.6

3.6 5.1 2.2 -14.8 3.6

-3.6 8.9 8.6 -36.2 8.4

-7.2 8.2 11.3 -37.0 -1.8

-7.1 7.0 9.0 -39.9 -10.8

-5.3 6.0 10.1 -28.7 -5.5

Malaysia Output growth Inflation Trade balance Imp. value growth Exp. value growth

8.6 3.2 0.8 -1.1 6.1

8.3 2.5 -1.9 11.2 0.1

7.4 2.3 0.4 1.5 2.1

6.8 2.7 0.4 -8.2 -5.3

-2.8 4.3 2.3 -19.9 -11.4

-6.6 5.7 3.3 -33.3 -10.1

-9.0 5.7 4.0 -29.3 -10.8

-8.1 5.4 5.1 -20.5 4.5

Philippines Output growth Inflation Trade balance Imp. value growth Exp. value growth

5.5 5.4 -2.9 14.2 17.5

5.6 5.4 -2.7 7.9 26.5

4.9 5.9 -2.8 11.1 24.7

4.8 7.5 -2.3 10.4 22.2

1.6 7.9 -1.2 -4.3 23.8

-0.8 9.9 -0.3 -17.8 14.4

-0.7 10.4 0.5 -21.4 19.2

-1.8 10.6 0.8 -25.1 11.5

3.8 4.4 -3.2

5.1 4.3 -3.1 -7.6

-3.2 6.2 -0.9 -11.4 7.1

-7.5 7.5 2.5 -27.5 6.7

-13.4 9.0 3.1 -39.8 -2.9

-12.8 10.3 2.6 -38.2 -5.3

-9.5 8.1 3.2 -34.3 -8.7

-3.7 5.0 3.4 -18.9 -9.9

Thailand Output growth Inflation Trade balance Imp. value growth Exp. value growth 1

-7.7 -1.0

2.2

Output growth refers to growth in GDP (for Thailand, growth in manufacturing production). 2 In billions of U.S. dollars on national account basis for Indonesia, Korea and Malaysia, and on balance of payments basis for the remaining three countries. 3 Import and export value growth in U.S. dollars and the basis is the same as in (2) above. Source. IMF, World Economic Outlook, May 1999, Tables 2-9, p. 53.

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Table 17.2 shows the private capital flows of the "affected countries" of EA between 1990 and 1997. Net private capital inflows for these countries were rising at a steady pace between 1990 and 1994. These flows jumped to $63 billion in 1995 from $35 billion the year earlier, perhaps because of the speculation that successes of these NICs would continue unabated despite the growing signs of structural imbalances in their economies. Fischer (1998b) claims that the IMF warned Thailand, before the financial crisis broke loose, of the potential problems ahead, but the latter "took no action." (Ibid., p. 4). From the size of the private capital inflows in the five countries in 1996 to the tune of $62 billion, it appears that the financial community as a whole had no clue about IMF's claimed warnings! From $62 billion of inflows in 1996 we see a negative inflow (i.e., outflow of $46 billion in 1998). Such a massive amount of capital flight cannot be sustained even by the mightiest of economies, not to mention the "affected countries". When we examine the composition of the private capital inflows we see the flight came from banks (see the "other" row in Table 17.2) who transferred out more than $44 billion in 1998. The net inflows of both portfolio investments and FDI were also significantly reduced from the 1996 level. Overall, the actions of the foreign bank lenders accentuated the collapse of the financial markets of TABLE 17.2 Private Capital Flows of the Affected Countries1 in East Asia (in $ billions) Capital Flows

1990

1991

1992

1993

1994

1995

1996

1997

1998

Affected countries' net private capital inflows Net FDI Net Portfolio Investment Other3

24.2 6.0 0.3 17.9

26.8 6.1 3.4 17.3

26.6 6.3 5.3 15.0

31.9 6.7 16.5 8.7

33.2 6.5 8.3 18.4

62.5 8.7 17.0 36.9

62.4 -19.72 9.5 12.1 20.0 12.6 32.9 -44.5

-46.2 4.9 -6.5 -44.5

0.3

4.4

2.0

0.8

0.7

1.0

Affected countries' net external borrowing from official creditors 1

4.6

25.6

—

Affected countries are Indonesia, Korea, Malaysia, the Philippines, and Thailand. In the balance of payments under "errors and omissions" the capital outflight is shown to be $20 billion, which is far larger than the one shown here for 1997. 3 "Other" flows largely consist of bank lending. - = not available. Source: Adams, Mathieson et al., International Capital Markets: Developments, Prospects, and Key Policy Issues, Washington, DC: The International Monetary Fund, September 1998; Table 2.1, p. 13 and Table 3.1, p. 52. 2

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the region. One would expect that the banking institutions would have had access to IMF's claimed warnings about the growing structural imbalances in the economies of EA and would have taken actions to modify the borrowing actions of these nations. Once the crisis broke, the IMF reclaimed its preeminence in the financial markets as the 1997 figure for borrowing from official creditors shows. Table 17.3 shows the liquidity and solvency risks of banks of the "affected countries" before and after the financial crisis started in July 1997. The size of liabilities of the "affected countries'" banks visd-vis the Bank for International Settlements (BIS) reflects each country's relative financial predicament. By December 1997, between 30 and 40+% of total loans by Indonesian banks were problem loans. For Thailand, the percentage was between 25 and 40%; for Korea, 25-30%; for Malaysia, 15-25%; and for the Philippines, 8-10%. According to the data in Table 17.3 we find that the recapitalization costs as percentage of GDP are the highest for Thailand, followed by Korea, Indonesia, and Malaysia. The poorest among the "affected countries", the Philippines, seems to be requiring essentially no recapitalization of its banks, thus coming out better off than its neighbors. The rapid spread of Thailand's financial crisis over the rest of EA regions can be better gauged when one examines the data on the growing intra-regional trade in recent years. Table 17.4 presents the data for 1991 through 1997, the latest year for which such figures were available. The trade data are shown with and without trade with Japan. Over the years, intra-regional trade flourished, making the economies more intertwined with each other. It is no wonder how quickly the Thai contagion spread in the region. The data also TABLE 17.3 Banks' Liquidity and Solvency Risks

Indonesia Korea Malaysia Philippines Thailand 1

Banks' Foreign Liabilities1 (in $ billion) Jun97 Dec 97 23.4 24.1 90.6 78.7 25.5 22.6 11.4 10.1 85.7 67.6

Peak Problem Loans (in % of total loans) J.P. Morgan S&P 40+ 30-35 25-30 25-30 20 15-25 n/a 8-10 35-40 25-30

Recapitalization Costs (in % of GDP) J.P. Morgan S&P 20+ 19 20+ 30 18 20 0 n/a 34 30

Vis-d-vis BlS-reporting banks. Source: Adams, Mathieson et al, International Capital Markets: Developments, Prospects, and Key Policy Issues, Washington, DC: The IMF, September 1998, Table 2.7, p. 37.

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1

TABLE 17.4 Intra Regional Trade of the East Asian Countries (Percentage of Total, unless other iirise stated) Country

1991

1992

1993

1994

1995

1996

1997

Indonesia Total Exports ($ billion) EA excluding Japan Japan Total Imports ($ billion) EA excluding Japan Japan

29.2 27.7 37.0 25.9 24.3 24.3

34.0 29.4 31.8 27.3 24.9 22.0

36.8 28.5 30.4 28.3 25.4 21.9

38.2 27.2 30.1 30.3 25.7 27.4

44.0 29.8 28.0 40.2 25.1 24.6

50.0 31.6 25.8 43.0 25.1 19.8

52.2 31.8 24.3 43.0 26.0 21.4

Korea Total Exports ($ billion) EA excluding Japan Japan Total Imports ($ billion) EA excludingjapan Japan

71.9 20.2 17.2 81.5 14.2 25.9

76.6 25.3 15.1 81.8 15.4 23.8

81.7 28.4 14.2 83.8 15.8 23.9

96.0 29.5 14.1 102.3 15.0 24.8

125.4 32.1 13.6 135.2 15.0 24.1

130.5 34.7 12.3 150.4 15.8 20.9

136.1 35.6 10.9 144.5 17.3 19.2

Malaysia Total Exports ($ billion) EA excludingjapan Japan Total Imports ($ billion) EA excludingjapan Japan

34.4 41.3 16.0 36.7 32.4 26.2

40.7 41.3 13.3 40.0 30.8 26.0

47.1 40.8 13.0 45.6 32.7 27.4

58.7 40.5 11.9 60.0 31.0 26.5

73.7 40.2 12.5 77.6 30.7 27.3

78.2 42.8 13.4 78.4 34.4 24.5

78.8 42.0 12.6 80.3 36.4 21.7

Philippines Total Exports ($ billion) EA excludingjapan Japan Total Imports ($ billion) EA excludingjapan Japan

8.8

9.8

18.2 20.5 12.9 27.1 19.4

16.3 17.3 14.6 26.0 21.2

11.3 17.7 15.9 17.6 27.8 22.7

13.4 19.4 14.9 22.5 28.9 24.0

17.4 24.7 15.5 28.3 27.9 22.3

20.5 23.9 18.0 31.8 26.1 21.7

28.5 23.2 16.1 48.4 31.6 19.8

Thailand Total Exports ($ billion) EA excludingjapan Japan Total Imports ($ billion) EA excludingjapan Japan

28.8 20.1 17.7 37.9 25.9 29.0

32.5 21.8 17.5 40.7 26.3 29.2

37.2 25.5 16.9 46.1 24.1 30.4

45.6 29.4 16.9 54.4 25.2 30.1

57.2 30.4 16.6 73.7 23.6 29.3

55.7 32.0 16.9 73.3 24.0 27.8

57.5 32.5 15.1 62.9 25.1 25.8

1

East Asia includes China, Hong Kong, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand. Source: Compiled from The International Monetary Fund, Direction of Trade Statistics Yearbook 1998, Washington, DC: International Monetary Fund, 1998.

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make clear the importance of the Japanese economy in the wellbeing of the region. Until the Japanese economy perks up significantly, the EACs will have a more difficult task in restarting their growth engines. Despite repeated use of fiscal packages to bolster the Japanese economy by the government, there is still no sign of any sustainable economic recovery there. Japan was expected to experience another negative growth rate in its real GDP in 1999 (IMF, op. cit.). There has been a rising number of business bankruptcies in Japan in 1999. This is in spite of the massive credit guarantee scheme to the tune of Y20 trillion that was launched in 1998 (Nakamae, December 15, 1999, p. 6). Help from Japan to lift the economies of the "affected countries" has yet to materialize. V.

RESTORING GROWTH IN EAST ASIA

Japan has been in economic recession for most of the 1990s. It is essentially some variation of the Japanese model of economic growth that the other EA nations followed, and with great success, until July 1997. Attempts to revive the Japanese economy have not been successful as yet. What is the likelihood that the others in the region will meet with better results? First, let us examine briefly the various plans, schemes, and suggestions that are on the table now for reforming and restructuring the financial markets. The proposals are from a number of sources. There are proposals from individual countries such as the U.S., the U.K., France, and Canada. Private proposals come from Soros's credit insurance agency, Kaufman's international regulator and rating agency, Raffer's international bankruptcy court, Meltzer's "true international lender of last resort," Calomiris' rules for IMF lending, Garten's global central bank, Litan's put options in bank credits, Edward's specialized agencies, and Bergsten's target zones. Then there are the proposals from the multilateral agencies, such as the IMF and country group proposals from G-7 and G-22 (Eichengreen 1999, Appendix A, pp. 124-132). These proposals are at times contradictory to each other. Eichengreen summarizes them as follows: "Some recommend that policymakers renew their efforts to liberalize international capital markets, while others plump for the reimposition of capital controls. Some insist on the need for greater exchange rate flexibility, while others regard nothing as more important than the reestablishment of stable, even fixed, rates between currencies. Some suggest that the international community should respond more forcefully to crises, while others recommend

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that it stand back and let nature take its course. Some emphasize the need for more funding for the International Monetary Fund (IMF, or The Fund), while others call for the abolition of the institution. Some suggest that the fund must root out corruption and compel countries to install the institutional prerequisites for stable financial markets, while others insist that it should limit its advice to monetary and fiscal policies and refrain from meddling in the internal affairs of its members." (Ibid., pp. 1-2).

Eichengreen seems to favor proposals in line with the ones put forward by G-22 countries. He cites the compelling benefits of liberalized capital markets but wants financial safety nets to work as insurance against systematic risks. This is because financial crises may arise due to the inherent presence of information asymmetries, even in a liberalized market. He proposes Chilean-style capitalinflow taxes to stem sudden outflows of capital of the type witnessed in the EACs in 1997 (Ibid., pp. 2-7). However, he does not feel the need for reforming the IMF but wants to modify "... the environment in which it works" (Ibid., p. 5). The proposals that are on the table for either reforming or doing away with the IMF fail to address the crux of the problem. Multilateral agencies such as the World Bank and its regional affiliates, the IMF and, for that matter, almost all of the United Nations agencies, are staffed principally by bureaucrats, often selected by member countries' governments. Selection of such personnel is often based more on political connections and favoritism than any particular expertise or talent. Such officials typically gather their information about financial, social, or economic activities of client countries from government bodies with whom they feel close affinity. Often, the correct data remains uncollected, and the policies formulated from the analyses of questionable data serve the interest only of those who supply them (Zaman, 1980, pp. 1 and 4). Misconceived plans and misuse of funds are the common results. The EA crisis of 1997, especially the corruption case of Indonesia, make the point quite clear (Brauchli, July 14, 1998). Until and unless the decisionmakers and implementers are selected competitively on the basis of merit and qualifications, these organizations cannot possibly deliver what they promise to the member states. The EA experience and that of Brazil in early 1999 show that countries with currency boards (e.g., Hong Kong) fared better than those who had to devalue currencies (for example, Brazil, Indonesia and Thailand) under IMF advisement (Rosett, April 22, 1999). Given the absence of transparency and lack of accountability of public officials in most countries, it is quite unlikely that the selection process of personnel is going to be changed anytime soon.

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The IMF and the World Bank served useful purposes in earlier decades. Now these are entangled in bureaucracy, lack of transparency, and in self serving. These institutions have promoted an international cadre of civil servants who are not necessarily attuned to the needs of the client member states. Disposing of these organizations will put the burden of financial institutions' reform and restructuring of economies on the individual countries themselves. A "one set of policies fits all" prescription cannot take into consideration the special needs of each and every country seeking help. Austerity programs, raising of domestic interest rates to stabilize ailing currencies, cutting off of subsidies on essential products and services and the like have caused havoc to the poor people in countries that sought assistance from these multilateral agencies (Rosett, op. cit.). Neither the IMF nor the World Bank and its affiliates can promote transparency and accountability in member countries when they themselves need to abide by these principles first. Real reform of the banking and financial institutions is the prerequisite for restoring economic growth in the EACs. This must come from the governments of the countries themselves. If there were no IMF or the World Bank to bail out countries from crises of their own making, and in some cases errors being committed at the behest of the multilateral agencies, the national governments would have been more careful in formulating and implementing economic policies (Sachs, 1998; Montagnon, 1999). Recapitalization of the banks would possibly restart the engine of economic growth. The stagnation of the Japanese economy in the 1990s, despite "macroeconomic austerity and financial laissez-faire" (Posen, 1998, p. 2) shows the urgency for recapitalization of banks. This is especially so because without Japanese economic growth, economic recovery will remain doubtful for the rest of the EACs. Similarly, without rejuvenation of the EACs, Japan would lose its significant market for exports, investments, and production facilities (Ibid., p. 5). Very little in the way of significant reforms have been undertaken by the EACs since the financial crisis began in July 1997. Thailand, Indonesia, Philippines, and Korea followed the IMF prescriptions, while Malaysia went its own way by reimposing controls on its financial sectors, including movements in capital (Einhorn and Barnathan, November 23, 1998, pp. 70-72). Some notable asset sales and mergers have taken place in Thailand, Philippines, Korea, and Japan. The region as a whole is still suffering from $1.7 trillion in non-performing loans (Ibid., p. 71) and sizeable unutilized industrial capacity. The debt burden of Malaysia, which is already

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around 170% of its GDP, is growing heavier. Its banking system needs approximately $16 billion for recapitalization (Ibid., p. 72). It has done very little, if anything, to restructure its economic sectors. China is still burdened with bad debts of around $250 billion, while Japan's are possibly around $1 trillion. Thailand's non-performing loans are around $45 billion (i.e., 35% of its GDP), and Korea's are $480 billion or so (Ibid., pp. 71-72). The restructuring measures of both Japan (Bremner, February 15, 1999, pp. 48-49) and Korea (The Economist, April 17, 1999, pp. 67-68) have fallen far short of what needs to be done to revive economic growth. Malaysia's economy is sliding down further, so also is that of Indonesia. The Philippines and Thailand have done better jobs in managing their respective restructuring. Restructuring of banking to create transparency and accountability will have significant impact on the various business networks of the region. The networks (i.e., the keiretsus in Japan; chaebols in Korea; quanxi in China) and the overseas Chinese and Indian businesses have been playing a principal "role in spurring, maintaining, and enhancing entrepreneurial activities ..." (Zahra, George, and Jarvis, 1999, p. 55) in the region. The networks were able to perform these functions in an atmosphere of secrecy and absence of accountability. Once banks are recapitalized and their activities are opened to public scrutiny, the way of doing business in the region will need to be adjusted. Until some new arrangements for mutual support are created, entrepreneurial activities are likely to suffer. Aging of the population and the cost of maintaining long-term pension benefits are about to overwhelm the Japanese corporations. Already, the attempts to cover and replenish pension benefits by corporations like Nissan and Nippon Telegraph and Telephone have resulted in heavy corporate losses (Dvorak, November 19, 1999, p. A25). The Japanese companies can no longer offer lifelong job security to their employees. This will have a negative impact on employee morale and productivity with resultant effects on corporate profitability. Yet another problem looms on the horizon for Japan. Beginning in 2000, the Japanese population is expected to shrink, reaching an annual rate of decline of 1.5% by 2014 (The Economist, November 20, 1999, pp. 71-72). The resultant worker shortage is likely to complicate the process of restructuring the Japanese economy. Despite the current difficulties in the economies of the EACs, the long-term prognosis is quite optimistic. The region is already quite developed and it has the overall infrastructure needed for

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economic recovery and progress. What is needed is transparency and a commitment to meaningful economic restructuring. VI. CONCLUSION The East Asian Crisis shows how vulnerable the global economy has become to sudden shifts in the movements of short-term capital. It also brings home the realization that the real estate investment bubble, which is financed by imprudent bank borrowing, does burst sooner or later with painful consequences. Japan, as well as the "affected countries", are the latest examples of this eventuality. Lack of transparency and accountability lead to misdirected policies that cannot be conducive to long-term economic prosperity. The EA Crisis also points out some serious weaknesses in the modes of operation of the Bretton Woods twins—the World Bank and the IMF. Perhaps it is time to let these institutions be disbanded so that each economy can face fully the consequences of the policies pursued by its national governments. REFERENCES Adams, C., Mathieson, D.J., Schinasi, G. and Chadha, B. (1998) International Capital Markets: Developments, Prospects, and Key Policy Issues, Washington, DC: International Monetary Fund, September 1998. Barro, RJ. (1998) 'The IMF Does Not Put Out Fires, It Starts Them,' Business Week, December 7:18. Birdsall, N., Ross, D., and Sabot, R. (1995) 'Inequality and Growth Reconsidered: Lessons from East Asia,' The World Bank Economic Review, 9 (3), September:477508. Brauchli, M.W. (1998) 'Speak No Evil: Why the World Bank Failed to Anticipate Indonesia's Deep Crisis,' The Wall Street Journal, July 14:A1, A10. Bremner, B. (1999) 'Japan's Desperate Deals: They're Just the Prelude to Even Greater Upheaval,' Business Week, February 15:48—49. Burton, J. (1999) 'S. Korea Signals End of Economic Crisis with 12.3% Third Quarter Growth Rate,' The Financial Times, November 23:16. Dvorak, P. (1999) 'Japan, Inc. Starts to Grapple with Aging Workers,' The Wall Street Journal, November 29:A25. Economist (1999) 'The Amazing Portable Sarariman,' The Economist, November 20:71-72. Economist (1999) 'South Korean Restructuring: More Pain, Please,' The Economist, April 17:67-68. Economist (1998) 'China's Economy: Red Alert,' The Economist, October 24:23-26. Economist (1998) 'Time to Turn Off the Tap?' The Economist, September 12:83-85. Eichengreen, B. (1999) Toward a New International Financial Structure: A Practical PostAsia Agenda, Washington, DC: Institute for International Economics, February.

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Einhorn, B. and BarnathanJ. (1998) 'Report Card on Asia: How Well—Or Badly— Is Each Nation Doing?' Business Week, November 23. Fischer, S. (1998a) 'Reforming World Finance: Lessons From a Crisis,' The Economist, October 3: 23-27. Fischer, S. (1998b) 'The Asian Crisis and the Changing Role of the IMF,' Finance & Development, June: 2-5. Goldstein, M. (1998) The Asian Financial Crisis: Causes, Cures, and Systemic Implications, Policy Analyses in International Economics #55, Washington, DC: Institute for International Economics, June. International Monetary Fund (1999) World Economic Outlook: May 1999, Washington, DC: IMF. International Monetary Fund (1998) Direction of Trade Statistics Yearbook 1998, Washington, DC: IMF. Kaye, S.D. and Egan, J. (1998) 'China's New Threat to the World Economy,' U.S. News & World Report, August 17-24:24. Krueger, A.O. (1997) 'Trade Policy and Economic Development: How We Learn,' The American Economic Review, 87(1), March: 1-22. Kuttner, R. (1998) 'What Sank Asia? Money Sloshing Around the World,' Business Week, July 27: 16. McLeod, R.H. and Garnaut, R. (ed.), (1998) East Asia in Crisis: From Being a Miracle to Needing One? London: Routledge. Montagnon, P. (1999) 'False Dawn in Asia,' The Financial Times, April 19:17. Nakamae, N. (1999) 'Rising Number of Business Failures in Japan,' The Financial Times, December 15:6. Nye, J.S., Jr. (1998) 'Clinton in China: As China Rises, Must Others Bow?' The Economist, June 27: 23-25. Posen, A.S. (1998) Restoring Japan's Economic Growth, Washington, DC: Institute for International Economics, September. Ranis, G. (1995) 'Another Look at the East Asian Miracle,' The World Bank Economic Review, 9(3), September 1995:509-537. Rosett, C. (1999) The World's Poor Pay the Price for the IMF's Failures,' The Wall Street Journal, April 22:A22. Sachs, J. (1998) 'Global Capitalism: Making It Work,' The Economist, September 12:23-25. Wolf, C., Jr. (1998) 'What Caused Asia's Crash? ... Too Much Government Control,' The Wall Street Journal, February: A22. World Bank (1998) East Asia: The Road to Recovery, Washington, DC: World Bank. World Bank (1993) The East Asian Miracle: Economic Growth and Public Policy, New York: Oxford University Press. Zahra, S., George G., andjarvis, D.M. (1999) 'Networks and Entrepreneurship in Southeast Asia: The Role of Social Capital and Membership Commitment,' in Richter, F.-J. (ed.), Business Networks in Asia: Promises, Doubts, and Perspectives, Westport, CT and London: Quorum Books, Chapter 2. Zaman, M.R. (1980) 'Development 'Experts'—What They Do Wrong,' Worldwide Projects, August/September:!, 4.

18 18

Asian Miracle to Asian Nightmare BALASUNDRAM MANIAM

I.

INTRODUCTION

The Asian financial crisis seems to have more far-reaching consequences than the two previous crisis — the European monetary crisis of 1992-93 and the Mexican peso crisis of 1994-95. The crisis began about two and half years ago and its effects were felt beyond the Asian region in parts of Latin America and Europe and the U.S. Even President Clinton first said this crisis is "a glitch in the road" in his speech at the meetings of the finance ministers of the Asia Pacific Economic Cooperation (APEC) Conference in November 1997. But, later, he called it "the worst financial crisis in half the century" (The Wall Street Journal, Sept. 24, 1998). The four countries that were affected most by this crisis are Thailand, Indonesia, South Korea, and Malaysia. Although the crisis also affected Hong Kong, Singapore, Taiwan and Philippines, the impact was much less severe. Hence, this chapter only provides an overview of the crisis from the standpoint of the most severely affected countries: Thailand, Indonesia, South Korea, and Malaysia. The East Asian countries, at the center of the recent crisis, were for years admired as some of the most successful emerging market economies, owing this to their rapid growth and the striking gains in their populations' living standards. With their generally prudent fiscal policies and high rates of private saving, they were widely seen as models for many other countries. Table 18.1 shows the nominal GDP over the 6-year period prior to the crisis. All the countries were enjoying double digit growth in GDP ranging from an average of 12% to 17% from 1991 to 1996, 6 years prior to the crisis. No one could have foreseen that these countries would suddenly become embroiled in one of the worst financial crises of the 294

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TABLE 18.1 Nominal Gross Domestic Product (GDP) from 1991 to 1996 Countries Thailand Indonesia Korea Malaysia

1991 14% 15% 18% 11%

1992 12% 13% 11% 14%

1993

1994

1995

1996

Average

11% 24% 10%

13% 15% 13% 14%

14%

9% 16% 10% 13%

12% 17% 13%

11%

17% 14% 14%

13%

Source. Datastream International and IMF.

postwar period and its effects would be felt in many parts of the world. In the years preceding the crisis, no real macroeconomic distortions were observed in East Asia. The economies of the four countries (Thailand, Malaysia, Indonesia, and South Korea) were characterized by low inflation (less than 10%), generally with surplus budgets, and declining government foreign debt. Table 18.2 shows the annual inflation rate from 1991 to 1996. The lowest inflation rate averaged about 4% for Malaysia and the highest averaged about 8% for Indonesia, with an overall average rate about 5.75% for these countries. Other macroeconomic variables were also favorable for these countries. For instance, Indonesia accomplished a 10.4% export growth in the year preceding the crisis, its government budget operated in surplus the previous 4 years, and its current account deficit was only 3-5% of GDP (Marshall, 1998). During the 1990s, these governments engaged in responsible credit creation and monetary expansion. Unemployment rates were low and did not provide an incentive for governments to engage in currency depreciation or monetary expansion as a short-term stimulus. The factors that led to the downfall of Asia began in early 1997 and began to really accelerate in July 1997. Table 18.3 is an initial chronology of the crisis that caused panic in Asia from January 1997 to September 1998. In January of 1997, Hanbo Steel, a large Korean chaebol, collapsed under $6 billion in debts. This was the first bankruptcy of a leading Korean conglomerate in a decade. On TABLE 18.2 Annual Inflation Rate from 1991 to 1996 Countries Thailand Indonesia Korea Malaysia

1991

1992

1993

1994

1995

1996

Average

5%

4%

4%

6%

6%

5%

5%

9%

7%

9%

8%

9%

8%

8%

9% 4%

6% 5%

5% 3%

4% 4%

3% 4%

3% 3%

6% 4%

Source. Datastream International and IMF. (1998a, 1998b)

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Balasundram Maniam TABLE 18.3 Initial Chronology of Asian Financial Crisis

Date Jan. 23, 97 May 14, 97

May 23, 97 June 19, 97

July 2, 97

July 8, 97

July 11, 97 July 14, 97

July 24, 97 Aug. 20, 97

Oct. 29, 97 Oct. 31, 97 Nov. 7, 97 Nov. 10, 97 Nov 23, 97 Dec. 4, 97 Dec. 18, 97 Jan. 7, 98 Jan. 15, 98 Mar. 4, 98 May 21, 98 June 12, 98 June 17, 98 Aug. 14, 98

Event/Description Major South Korean steel maker defaults on loan. Baht comes under attack by speculators who decided Thailand's slowing economy and political instability meant it was time to sell. As the crisis started affecting the Philippines, the central bank of the Philippines raises the overnight rate 1.75% points to 13% and dumps dollars. Finance One, Thailand's biggest finance company, fails. The Thai Finance Minister resigns. The Prime Minister promises not to devalue baht. The Philippines overnight rate rises to 15% as a result of Thai Finance Minister's resignation. The bank of Thailand announces a managed float of the baht and calls on the IMF for "technical assistance". This devalues baht by about 15-20%. This triggers the Asian financial crisis. The Philippines' Central Bank defends its peso heavily. Malaysia's Bank Negara intervenes to defend its ringgit heavily. The Indonesian rupiah starts to fall as Jakarta widens its rupiah trading band from 8% to 12%. The Philippines' Central Bank says it will allow the peso to move in a wider range against the dollar. IMF backs the plan. The IMF offers the Philippines $1.1 billion in financial support under the fast track regulations drawn after the 1995 Mexican crisis. Malaysian Central Bank abandons the defense of the ringgit. Asian currency meltdown. The baht, peso, ringgit, and rupiah all fall heavily as confidence in the region deteriorates rapidly. IMF approves a $3.9 billion credit for Thailand. The package now totals $16.7 billion. Brunei adds $0.5 billion to the bailout package, making it $17.2 billion. Greenspan sees impact of Asia on U.S. as "modest", but not negligible. IMF unveils Indonesia's rescue package for about $40 billion, although frontline defense is $23 billion. New Thai government takes over. IMF approves a $10 billion loan for Indonesia as part of the massive international package. Clinton labels crisis a "few glitches in the road." IMF approves a $57 billion loan for South Korea. Korea elects Kim Dae-Jung as president. Malaysian ringgit, Thai baht, Philippines' peso, and Indonesia's rupiah all drop to new lows against the dollar. IMF and Indonesia sign an agreement strengthening economic reforms in Indonesia. Indonesia cuts fuel subsidies, sparks riot. President Suharto of Indonesia resigns after 32 years in power. Japan's economy sinks into a recession. U.S. and Japan intervene to boost yen. Hong Kong authorities buy stock to prop up their market.

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TABLE 18.3 Initial Chronology of Asian Financial Crisis (Cont.) Date Event/Description Sept. 1,98 Malaysia imposes currency controls. Sept. 9, 98 Japan cuts interest rates. Sept. 14, 98 Clinton calls it "worst financial crisis in half century." Source: Wall Street Journal, Various issues 1997-98. http://www.cnn.com/world/9801/15/asia.chronology.reut.

February 5, 1997, Somprasong was the first Thai company to miss payments on foreign debt. On March 10, 1997, the Thai government promised to buy $3.9 billion in bad property debt from financial institutions but defaulted on this promise. In the middle of May, 1997, Thailand's currency (baht) was hit by a massive attack by speculators who decided Thailand's slowing economy and political instability meant it was time to sell. Both Thailand and Singapore intervened to defend the baht. At the end of May, Finance One, Thailand's largest finance company, failed. Although a string of other events took place from May through June, July 2, 1997 marked the beginning of the financial crisis when the bank of Thailand announced a managed float of the baht and called on the IMF for "technical assistance." The announcement effectively devalued the baht by about 15-20% and it ended the record low of baht to the dollar (Bt. 28.80 to $1). This was a trigger for the East Asian crisis that marked the beginning of constant downfall and continuous intervention from the IMF. After the baht was devalued, Bank Negara (central bank in Malaysia) had to intervene aggressively to defend its currency, the ringgit. During this time period, the Philippines and Indonesia widened the trading bands on their currencies, the peso and the rupiah, respectively. By the end of August, Thailand's rescue package totaled $17.2 billion from the IMF and other Asian nations. By the end of October, the IMF announced a $23 billion multilateral financial package involving the World Bank and Asian Development Bank to help Indonesia stabilize its financial system. In December, South Korea received a rescue package from the IMF of $57 billion, which was the largest package to date. II.

LITERATURE REVIEW

Since the late 1980s, the Asian countries in general began to see double digit growth rates of the GDP (as seen in Table 18.1) and an increase in the standard of living of their people. Many factors contributed to this transformation. Some of the Asian countries pursued policies to increase the literacy rates in their economy while others encouraged labor-intensive foreign investments

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(Zaman, 1998). Trade and financial liberations followed as these nations developed, and the standard of living improved (Krueger, 1997). They pursued aggressive economic policies, which implied higher risk exposure. Their success in achieving the rapid growth can be partly attributed to their ability to maintain relatively stable currency exchange rates. The stable currency exchange rates, together with a favorable tax code, were magnets for bringing a large pool of foreign investors into these countries. Investments came in the form of foreign direct investment (FDI) and portfolio investments by foreign portfolio managers who managed many international and emerging market funds. With once thriving and successful economies, the countries of Eastern Asia are now suffering through a serious financial crisis that has not been witnessed since the financial crisis that hit the developing world in 1982. Countries that were once labeled the "Asian Miracle" because of substantial economic growth have now been experiencing an "Asian Nightmare" or has been diagnosed as suffering from "Asian Flu" due to the implications imposed by this financial crisis. Plunging currencies and stock markets put the economies into deep-freeze, making these countries' survival difficult. No one anticipated the Asian financial crisis would be this severe. There were a few researchers like Paul Krugman, an economics professor at MIT, who were skeptical of the "Asian Miracle". Investors and portfolio managers were too engrossed in the high growth and high return economies of these nations to see the warning signs (Krugman, 1998). Though the entire region enjoyed decades of strong growth and a rising standard of living for its people, it also had some common problems that led to this crisis (Ruben, 1998). The seriousness of this crisis has potential long-term and farreaching effects for foreign and domestic firms. Saving, Cheung, Hall, and Kawai (1998) predict that the crisis is going to take several years for reforms to correct financial and economic matters in Eastern Asia. Roubini (1998) further states that massive capital inflows were the core of the crisis, rising from an average of 1.4% of GDP between 1986 and 1990 to 6.7% between 1990 and 1996. This heavy flow of capital could have possibly led to a false belief in the Asian financial systems, misleading investors. Another interesting suggestion that Corsetti and Roubini (1998) made is that when financial issues began to worsen in the East Asian countries, this created an even bigger incentive for the investors to continue taking risks. This was due to the belief or anticipation that the Asian governments or other agencies such as the IMF would

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provide a bailout for the investors, should things continue to go sour. The moral hazard phenomenon was believed by many to be a crucial problem in determining the financial downfall of the East Asian countries. In addition to poor government decisions and policies, private banks also contributed to the crisis by asserting poor management practices such as over-commitment to other companies that shareholders within the private banks owned. The rules that were broken by financial institutions, inept governance, and political uncertainties spurred the development of the crisis. Maniam, James, and Bexley (1999) also analyzed the Asian crisis but they contend that the crisis was foreseeable from many macroeconomic variable standpoints. They show that the signs of financial and economic deterioration were present in these countries prior to the crisis. Bergsten (1998) proposed some remedies for this crisis by spelling out tough structural changes Asian countries would have to make in order to stabilize their economies. For instance, he stressed that the Asian economies must undertake steps to reform and strengthen their financial institutions in order to improve transparency and supervision. He also added that the political leaders must eliminate the close relationship between them, the banks and other commercial entities. Maskooki (1998) looked at the crisis strictly from South Korea's perspective and analyzed why the crisis took such a toll on the Korean economy. He concluded that Korea's deregulation of the nation's capital market in the absence of an efficient and globally integrated capital market increased the volatility of their currency. Litan (1998) suggested that Asia's troubles are not insoluble and the IMF can help "fix" the economies using his three remedies. He spelled out a three-step program of triage, liquidation or merger, and workouts for the troubled corporations and banks. His three-part proposal is as follows: "First, each affected country must set-up a mechanism for quickly performing triage on all businesses (firms and banks) facing bankruptcy using an exchange rate assumed to be some significant level below the rate before the crisis began but above current, excessively depressed market levels; Second, any banks and firms that are insolvent under this exchange rate should be subject to liquidation or forced merger, unless creditors quickly accept an equity-for-debt swap; Third, all insolvent firms and banks not subject to liquidation should be eligible for Chapter 11-type workouts, with lenders required to exchange some portion of debt for equity to give the restructured firm a reasonable chance of survival" (p. 7).

However, he cautioned that the IMF must act quickly to prevent further crisis and avoid its spread to other economies. Nolan (1998)

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discussed the origins of the Asian financial crisis, the prospective impact of events in Asia on the U.S. economy, and the implications of these developments for the architecture of the international financial system. He outlined four causes of the crisis: exchange rate misalignment, weak financial institutions, export slowdown, and a moral hazard problem. He also predicted that the events in Asia will reduce the growth rate of the U.S. GDP between 0.5 and 1.0% below its current level over the next 2 years (1998 and 1999). Other studies on this Asian crisis include those of Miller (1998), Tobin (1998), and Sato (1998). III.

OVERVIEW OF THE CRISIS

Thailand In Thailand the crisis began with the slump in the property market. Thai banks were over-exposed in this sector, having financed risky speculations without due diligence on industry participants or insisting on proper collateral. It soon became clear that participants would not meet their maturing debt payment. Bad financial management scared foreign investors and prompted the sell-off in Thai currency and devaluation of the baht. By the time that the baht was devalued, Thailand had already begun to feel the pressure of financial turmoil building. The IMF asked Thailand to take early steps to curb its current account deficit, raise productivity, reduce short-term foreign borrowing (which exceeded its $40 billion in foreign exchange reserves), and strengthen a weak banking system excessively exposed to speculative property loans. However, Thailand refused to comply with the IMF's requests, although eventually the enormity of the crisis forced it to ask for an IMF loan and accept whatever economic disciplines were imposed (Sarver, 1997). Through an overall development strategy, it could be argued that it was unwise to persist in pursuing exceptionally high growth through increasing reliance on foreign borrowing. Unlike the typical developing country, Thailand's economy had exceptionally high rates of domestic saving of over 30% of GDP. Thus there was little need or justification to seek augmentation of these investable resources through foreign borrowing. Pushing up investment rates to 40% or more through foreign borrowing could only contribute to a lowering of the rate of return from investment. As it happened, much of the excess investment went into financing asset

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price inflation and the growth of non-tradable activities with relatively low returns. There were danger signals of an overheating economy, such as the abrupt rise in asset prices and the sharply increased reliance on foreign workers (Lee, 1998). Had the extraordinarily high growth rates triggered questioning about the economy's well-being, perhaps the depth of the crisis would have been lessened. Inadequacies in handling the impact of the huge surge in capital inflows existed in the years immediately preceding the crisis. These inflows were very large, amounting up to 12.7% of GDP in Thailand in 1995. Several features of the policy regimes supported these large inflows. The first, in Thailand (as well as some other Asian countries), was the policy of pegging their exchange rate to the dollar. Since this process was viewed as a guarantee against exchange rate loss, both domestic borrowers and foreign lenders were inspired to increase the flow of funds. The second policy came with the creation of incentives to foreign borrowing. This was done by maintaining domestic interest rates that were significantly higher than the world market rate (Lee, 1998). It is evident that these procedures were implemented to try and purify some of the capital inflows, researching other alternatives would have been more beneficial. Thailand suffered an industry downturn with a major hit on its mutual fund companies, interest rates, and yields. By the end of June 1997 the size of assets under management by mutual fund companies in Thailand declined by close to 30% to Btl67.5 billion from Bt2l7 billion from the end of the previous year. The decline was not surprising, given the free fall of the stock market where 52% of mutual funds were invested. Some of these companies were forced to close because of lost investments in small stocks. These losses included assets declining below the minimum Bt50 million. Fixed income mutual funds were forced into a tight situation as well (Ramos, 1997). To compound the existing problem, the number of mutual fund management companies continued to increase. From the beginning of 1997 to October, five new firms had been authorized to deal in mutual funds, which brought the number of participants to 13. Merchant banking in Thailand neglected most of the proper market principles. In a period of 3 years, the number of merchant banking corporations grew from six to 30. These companies, believing that the government would not allow financial institutions to fail, began to make hasty decisions and do business in fields in which they had no working knowledge. A liquidity crisis arose

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immediately when these companies borrowed short-term and lent or invested in long-term deals. Thailand, along with many other Asian countries, placed more emphasis on short-term borrowing and lending rather than longterm. This idea was followed because short-term investments offered high returns, whereas long-term offered low returns. Life assurance firms in Thailand often invested in promissory notes, debentures, and bank stocks to ensure more attractive yields. Fixed deposits and lending to housing development projects were also popular so that companies could fix their yields. While these decisions offered quick high returns, they also offered limited room for mature debt market growth. This problem is not unique to Thailand, it follows throughout most, if not all, of East Asia. Indonesia

Indonesia also suffered similar fates as many of the other Asian countries. It did not take long for the rampant financial crisis that ran through Thailand first, to reach Indonesia. The Asian crisis, which is essentially noted as beginning on July 2, 1997 with the devaluation of the baht, had Indonesia turning to the IMF for assistance by the beginning of October, 1997. The same disadvantages, excessive short-term debt, borrowing heavily abroad, lacking a mature debt market, overspending, and many others that existed in the other countries, appeared in Indonesia as well. At the heart of the matter in Indonesia lies a deadly combination of monopoly power and protectionism. A major cause of this situation leads back to the unruly Government Empire. President Suharto, 76, had ruled for 32 years and received another 5-year term, but suffers from a dangerous myopia. He allowed his sons and daughters to build astronomical business empires through generous financing from government banks, while receiving "special" tax breaks. Even though from the outside looking in, one would obviously note that Suharto's demeanor was unjust, the people of Indonesia did not necessarily share the same views. Essentially, Suharto gained legitimacy for his highly authoritarian regime by steadily improving living standards. But average income is still a modest $1,200 annually (Chowdhury and Paul, 1997). President Suharto was left with the ultimate decision to be made; either conform with the IMF's strict polices and have a chance to see his country survive or continue with his myopia. Finally, seeing that there was no other way to keep his country alive, he conformed to their policies on

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January 15, 1998. With this decision came strict regulations from the IMF, such as, dissolving the "kickbacks", deregulating all domestic trade in agricultural products, consolidation of banks, and giving up the empires that belonged to his children. In January 1998, when Indonesia unveiled the measures to be imposed as part of a $23 billion economic stabilization program backed by the IMF, a key condition was a clean-up in the banking sector. Making a start, the finance minister and central bank governor announced the closure of 16 small and insolvent banks from Indonesia's grand total of more than 230. Approximately 70 smaller banks were coerced into mergers, with a relaxed view about foreign participation. Foreign investors may own up to 49% of a listed bank, ownership of all other listed companies is unlimited. The government also applied restructuring to the state banking sector in order to ensure stability. In order to prevent further panic and chaos, larger banks in difficulty were dealt with quietly. In line with IMF requests, Indonesia cut many social programs and subsidies to tighten government spending, which in turn sparked riots among its people. This created political and economic instability which resulted in the resignation of President Suharto after 32 years in power. The revelation that even the respected technocrats running the Indonesian financial system had been unable to maintain control over banks may come as a shock to some outsiders. But it will not surprise those analysts who have been concerned for some time about the weakness of regional central banks in the face of political interference. The loss of control may have added as much as $15 billion in unrecorded borrowing in Indonesia, where domestic borrowing at the end of 1996 was a reasonably moderate 60% of GDP (Lee, 1998). South Korea

According to Assistant Governor of the Bank of South Korea, South Korea was on the edge of financial turmoil by the end of November 1997. At this time the country's usable foreign currency reserves plummeted to US$7.3 billion, which did not even cover one month's imports. This crisis is regarded as the most severe of the many difficulties South Korea has met with since it launched industrialization in the early 1960s. Many are convinced that the eruption took place when foreign investors turned their backs on South Korea. However, the reality of the story goes much deeper (Jae-Joon, 1998). The

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Korean crisis has many aspects that occurred due to the rapid growth of the economy throughout the last several decades. South Korea is now forced to pay the price of the crisis, but is drawing invaluable lessons as well. Taking advantage of the opportunity presented by the crisis, South Korea is also pressing ahead with all the ongoing reforms that had long been delayed for one reason or another. If for no other reason, the crisis at hand will at least force South Korea into restructuring the economy. Of the many causes of the financial crisis in South Korea, there are three categories into which the causes fall: Lack of transparency, failure to observe market discipline, and inappropriate policy responses to the evolving problems (Maskooki, 1998). If one primary cause of the financial crisis exists, it would have to be the country's loss of confidence in the eyes of international investors, a loss primarily due to inadequate transparency. First, came a lack of accounting transparency. The figures and calculations that international investors rely on when making decisions to lend or invest were not reliable, therefore making it difficult to know where firms actually stood. Often large conglomerates that were portrayed as many independent companies, were in reality linked through a web of affiliations and cross payment guarantees. This in turn, overstated the actual profits by internal transactions among them. The norm surrounding the economic efficiency of South Korea's market principles was beyond comprehension. The Korean government offered special privileges to large-scale enterprises, especially those belonging to large conglomerates, in return for spurring economic growth. These special privileges consisted of: import restrictions, low-cost funding from the financial sector and incentives to keep expanding. All of these were done without evaluating the risk versus the return. They simply lived by the unwritten law, "Conglomerates will never go broke" (Jae-Joon, 1998, pp. 55). The policies that were implemented to overcome the heightening difficulties facing the economy were either ineffective or contradicted one another. An example of this is the policy on foreign exchange. In 1990, a policy of keeping a narrow band on the daily fluctuation of the exchange rate was adopted. However, with the widening current account deficit from 1995, pressure for depreciation of the Korean won had accumulated and expectations of additional depreciation were widespread. Therefore, there was no justification to adhere to a narrow daily fluctuation band any longer. None the less, it was kept in place, resulting in a nearly paralyzed foreign exchange market in late November 1997 (Jae-Joon, 1998).

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Had officials decided earlier to widen the band, the decline on Korean won's exchange value would have been gradual. Malaysia After years of growth, Malaysia found itself sucked into the domino effect taking place in Asia. 'The magnitude of the crisis took everyone by surprise. "When Thailand caved in, we expected a ripple effect," says Mohamed Ariff, executive director at the Malaysian Institute of Economic Research, a government think-tank. "But not such a tidal wave" (Daniels, 1998, pp. 25). It was not so long ago, that Malaysia could boast that it had achieved an average annual 8% growth for 10 years, had the tallest building in the world, and was about to build the world's longest bridge. Unknown to them, the country's rapid growth was sowing the seeds of economic chaos. The first signs of uncertainty were displayed in late 1996 when Malaysia's central bank, Bank Negara, called for lending to be tightened. However, this was not enough to get Malaysia's attention. Instead, they waited for their currency and stock market to collapse and property taxes to suffer, before they would finally take heed. When Thailand decided in July 1997 that it could not sustain the baht's peg exchange against the U.S. dollar any longer, the financial domino effects that followed saw the Malaysian ringgit plummet. Malaysia suffered from the loss of confidence of others in their economy. First, from foreign investors withdrawing their funds; second, from exporters keeping their money abroad; and third from US dollar borrowers selling their Malaysian dollars as soon as possible to minimize their foreign exchange losses. The loss of confidence was again heightened in December 1998, when the government announced the postponement of government projects. The thinking was that the drastic measures implemented would avert any need to ask the IMF for help. In the months to follow, the Malaysian economic landscape changed rapidly. GDP growth slowed to under 5%, which was lower than the government had projected. In January 1998, Malaysia had a positive trade balance for the first time in 3 years. Due to imported items now being 50% more expensive, they are no longer affordable to Malaysians. At the same time, exports were rising in Malaysian dollar terms, imports were falling at an unequal rate. Export manufacturers were finding it hard to obtain bank loans to buy imported components and to open letters of credit.

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As of April 1998, many were of the opinion that tight measures were not needed to ensure reform for Malaysia's abused economy. Instead they felt that the economic slump would be mitigated by two factors. First, there was the extraordinarily high foreign investment in manufacturing in Malaysia. Half of the country's manufacturing assets are foreign-owned and foreign direct investment has run at more than US$4 billion a year since 1992. Even though approvals had fallen 22% over the past year, analysts still believed Malaysia could draw foreign investment due to its developed infrastructure, established legal system, and low rental costs. Secondly, Bank Negara had injected liquidity into the banking system by increasing its lending to banks by M$33 billion in the previous year (Daniels, 1998). Although it is still officially committed to a conservative monetary policy, and the lending is only a way of handing back some of the banks' statutory reserves, it does provide banks with more money to lend. The central bank had to decide to either allow interest rates to rise, to defend the local currency and to subdue inflation, or keep them quite low to limit the pain of borrowers. The solution that they felt best, was to simply stand in the middle between the two options. Even at 17%, interest rates were considerably lower than Thailand and Indonesia, but companies still felt the compression. Unlike Indonesia and Thailand, Malaysia had little dollar debt. Its banking system was also stronger and foreign investments acted as a buffer. GDP per capita in mid-1997 was US$4,460, compared with just over US$1,000 in Indonesia and US$3,000 in Thailand (Daniels, 1998). Despite Malaysia's economy being in better shape than Thailand, Indonesia, and South Korea, it is still in need of reform. The fear of hard times is providing Bank Negara with an opportunity to push through the mergers it has been advocating for years. The Malaysian government wants to ensure that Malaysia has a few banks large enough to survive increased exposure to foreign competition. So far, Malaysia has successfully used internal controls and policies to get back on track. Malaysia is doing its best to avoid asking the IMF for assistance and hopes to make the necessary reforms without IMF intervention. Malaysia is at the crossroads in its economic development: the success of the past 8 years was dependent on being export-oriented and concentrated on manufacturing; growth was primarily a result of foreign capital and foreign labor, not efficiency. The government has been trying to make companies less dependent on foreign labor and more on technology.

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IV.

307

RECENT CHANGES AND UPDATE

Almost 3 years after the horrendous crisis began in Asia, some stability has been achieved while more is expected in months to come. The Institute of International Finance predicted equity investments to rebound in 1999 in Thailand, Indonesia, South Korea, Malaysia, and the Philippines and they did. They expected equity investments to more than double the level reached in 1998. This is a sure sign that while economies of the Asian countries may not be astounding, at least they are showing strong signs of improvement. Various areas, such as the production, reform, and industrial sectors in these countries have reported growth in small percentages. While it is still painful following reforms implemented by the IMF, it is equally encouraging to reap the benefits (Chong-Tae, 1998). The recent trade and other figures indicate that most of the countries have rebounded and are on the road to recovery (Financial Times, May 25, 1999). This upward trend is also expected in the next few years (IMF, 1999). For instance, it is expected that the real GDP growth rate for these countries will be much higher in 2000 then the previous 3 years for Thailand (3%), Malaysia (3.8%), South Korea (4.9%) and Indonesia (5.8%). These East Asian countries have demonstrated a historical record of outstanding achievement over the 6 years prior to the crisis. But the crisis brought some of the fundamental problems into focus, it also served the constructive purpose of "fixing these problems". Most, if not all, the affected countries are in better shape than before the crisis because they were made aware of their problems and they have made changes to restore stability and growth. However, the long run impact of this crisis depends on how these countries make the necessary changes in their financial system and bring about other structural changes in their economy. V.

CONCLUSION

This chapter provided an overview of the Asian financial crisis from the standpoint of the most affected countries— Thailand, Indonesia, Malaysia and South Korea. Even though all the countries had some of the same underlying problems, some of them were more unique than others. In some cases, the crisis also brought about other changes, such as political changes. Some countries (Thailand, Indonesia, South Korea) sought IMF technical assistance or monetary aid to bring the economy back to health and they are complying with the IMF regulations, which have

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resulted in them closing more non-profitable banks and continuing to stamp out cartels and monopolies. They have also begun to repay the loans they received. This is yet another indication of how things have improved over the last year. Others, such as Malaysia, have taken radical steps to reduce the impact of the crisis at least in the short run. For instance, it imposed currency restrictions, halted currency trading, and set various restrictions on foreign stock investors. It is expected that these countries will continue on their road to recovery even though some of them need to take further steps in reforming and making structural changes in their economy. Only such a bold approach will ensure that they do not have another repeat of this crisis. REFERENCES Bergsten, C.F. (1998) 'The Asian Monetary Crisis: Proposed Remedies,' Testimony before the Committee on Banking and Financial Services. Washington: U.S. House of Representatives, November 13. Chong-Tae, K. (1998) 'Economic Recovery,' Business Korea, 15:27-28. Chowdhury, N. and Paul, A., "Where Asia Goes from Here." Fortune. 136. Nov 24: 96-104. Corsetti, P. and Roubini, N. (1998) What Caused Asian Currency and Financial Crisis,

NBER Working Papers, Yale University, March:33-35. Daniels, J. (1998) 'Crying Out for Change,' Asian Business, 34:25-30. Datastream International, (online Services) UK. Financial Times (1997-1999), Various issues. Financial Times (1999) "Recovery at Different Speeds." May 25: 17. International Monetary Fund (1998a) 'World Economic Outlook,' Washington, DC: IMF, May: 1-54. International Monetary Fund (1998b) 'Towards a Framework for Financial Stability,' Washington, DC, May:l-54. International Monetary Fund (1999). World Economic Outlook. May. Washington, DC. IMF: 1-54. Jae-Joon, P. (1998) 'Causes and Solutions to the Economic Crisis,' Business Korea, October 15:54-58. Krueger, A. (1997) 'Trade Policy and Economic Development: How We Learn,' The American Review, 87:1.

Krugman (1998). "Saving Asia: It's Time to Get Radical."FortuneSept 8: 1-2. Lee, E. (1998) 'The Asian Financial Crisis: Origins and Social Outlook,' International Labor Review, 137:81-93. Litan (1998). "A Three Step Remedy for Asia's Financial Flu." Brookings Policy Brief No. 30. Washington, DC: Brookings Institute, February. Maniam, B., James, J., and Bexley,J. (1999) 'Asian Financial Crisis: Why We Didn't See the Warning Signs,' presented at the Western Economic Conference, San Diego, CA, April 29-30:1-22.

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Marshall, D. (1998) 'Understanding the Asian Crisis: Systemic Risk as Coordination Failure,' Economic Perspectives, 22:13-28. Maskooki, K. (1998) 'South Korea's 1997-98 Financial Crisis,' presented at the Academy of Business Association, July: 1—26. Miller, M. (1998) 'Asian Financial Crisis,' Japan and The World Economy, 10(3):355358. Nolan, M. (1998) 'The Financial Crisis in Asia,' Testimony before the House International Relations Committee, Washington: U.S. House of Representatives, February 3. Ramos, A. (1997) 'Turbulent Times for Thais,' Asia Money, 8, October:43-47. Roubini, N. (1998) An Introduction to Open Economy Macroeconomics, Currency Crisis and the Asian Crisis, Working Papers, Stern School of Business, New York University, March 31. Ruben, R (1998) 'Asian Financial Crisis,' Remarks Delivered at Georgetown University, Washington, January 15. Sarver, E. (1997) The Thai Baht Crisis,' World Trade, 10, November: 82-83. Sato, S. (1998) 'Asian Financial Crisis,' Japan and The World Economy, 10 (3):37l375. Saving, T, Cheung, S., Hall, J. and Kawai, M. (1998) 'Thailand's Exchange-Rate Crisis,' Contemporary Economic Policy, 16:136-156. Tobin,J. (1998) 'Asian Financial Crisis,' Japan and The World Economy, 10(3):351353. Wall Street Journal (1997-1999) Various issues. Zaman, R. (1998) 'An Analysis of the Causes and Implications of the 1997 Collapse of the Financial Markets in East Asia,' in Meric, G. and Nichols, S.E.W. (eds.), The Global Economy at the Turn of the Century, II, Laredo, TX: International Trade and Finance Association, 483-496.

19 The Asian Financial Crisis and Performance of U.S.-Based Asia Mutual Funds1 JOHN R. NORSWORTHY, WOLFGANG BESSLER, IRVIN MORGAN, RIFAT GORENER AND DING LI2

I.

INTRODUCTION

There have been several recent studies that analyze the macroeconomic causes of the Asian Financial Crisis of 1997. They have generally looked for causes of the crisis in the policies and actions of governmental, financial and corporate institutions that contributed to the ultimate collapse of the region's financial markets. Corsetti, Pesenti, and Roubini (1998) argue that the crisis was precipitated partly by expansionary and corrupt lending policies that resulted in overinvestment in projects with little or no profitability. These practices created an abundance of loan defaults during the late 1990s. The crisis crystallized in 1996-98 for emerging Southeast Asian economies. Japan and South Korea, who had entered the crisis state several years earlier, are excluded from our study.3 This study focuses on identifying the impact of this crisis on U.S.-based mutual funds specializing in Asia with less than 5% exposure to Japan. It assesses the performance of these funds during January 1995 to April 1999 and examines the relationship between the returns on these funds and the stock market indexes for the emerging economies. The study compares these 20 emerging funds to the performance of 55 U.S. domestic mutual funds, and to an 11 Asian country market price index as well as the S&P 500 index. The study sets out to answer the following questions: 310

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1. What are the significant turning points of the funds compared to the relevant standards? 2. How did the stock market indexes of the emerging market countries (Indonesia, Malaysia, Singapore, Taiwan, Hong Kong, Thailand, and Philippines) relate to the advanced countries in the region (Japan, South Korea) and to the United States? 3. How do the performances of the Asia funds compare against each other? 4. How do the Asia funds compare against the domestic funds? 5. How do the Asia funds' performances compare with an index based on the market returns of 11 countries? 6. How do the domestic funds' performances compare with the S&P 500 index? 7. Are the markets of the Asian countries strongly related among themselves (i.e. are they cointegrated)? 8. Can country weights estimated by regression determine the main elements of the country-by-country allocations of a fund's assets? To address these questions, 20 U.S.-based Asia mutual funds were selected from Morningstar Asian-Pacific (ex Japan) reports from December 30, 1994 through April 1999 reports. The 55 U.S. mutual funds were selected based upon criteria in Table 19.1. The countries whose markets are analyzed for their effects on fund performances as well as the fund names, ticker symbols and the period for which data were analyzed can be obtained from the Center for Financial Technology, CFT, website http://www.cenfmtec.org/publications/. The paper is structured as follows: Section II describes the design of the study, Section III describes the data sources and coverage, Section TABLE 19.1 Mutual Funds Selection Criteria Criteria for Asia-Pacific Rim Mutual Funds 1. Heavily invested in Asian countries common stocks (greater than 25%) 2. Largest proportion of common stocks (greater than 90%) 3. Exposure in Japan less than 5% Criteria for U.S. Mutual Funds 1. U.S. equity funds (bonds less than 10% if include) 2. Mixed sizes (Large, medium, small) 3. Blend (mixed growth and value stocks in the portfolio) 4. Top ratings in Morningstar Mutual Funds Report 5. Minimal Asia exposure (less than 3% of fund assets invested in Asian common stocks) Source. Bloomberg L.P. Online Service.

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IV reports the empirical results of the assessment of the timing of the downturn, Section V assesses the funds' performances, Section VI summarizes the analysis of the cointegration of the funds, Section VII reports the results of estimating the weights of the country indexes in fund performance, and Section VIII states the conclusions. II.

METHODOLOGY

Performance Measurement

Capital Asset Pricing Model is used to measure the volatility of returns of the funds relative to the U.S. market and to assess the comparative fund performances using Sharpe (1966) and Treynor (1965) performance measures. To see the effects of the Asian crisis on the U.S. based mutual funds, the funds are divided into two groups over the period from December 30, 1994 to April 30, 1999. One group is the equity funds that have maximum exposure (greater than 25%) to emerging Asian countries (Pacific Rim funds). In this group, the minimum asset exposure to Japan, less than 5%, fund selection criteria is applied to reduce the direct effects of the separate financial crisis in Japan. The comparison group is U.S. domestic equity mutual funds. The criteria for the funds selection are in Table 19.1. The effects of the crisis on the performance in each of these two categories are analyzed. To evaluate the funds performance, both the risk and return in a portfolio are considered as compared to market standards using the Capital Asset Pricing Model or CAPM (Sharpe, 1964) Rt-Rft = a + pt(Rmt-Rft) + et

(1)

and the (preferred) market model (Ross, 1976; Roll and Ross, 1980), Rt = a + £Rmt+et

(2)

for determining respective betas and subsequent performance measures. Based on these models, |3 was estimated by regression of historical returns of the security in excess of a risk-free rate—excess returns—against excess returns on market proxies. Two proxies were used: the S&P 500 index for comparison to the U.S. domestic funds, and an equally weighted composite of nine Asian Country Market Indexes as the market proxy for comparison to emerging markets. While a broader market proxy could be used, it appears

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more reasonable to U.S. that the appropriate alternative investment from the points of view of the fund managers and their investors is the set of relatively large capitalization equities. Two conventional techniques are used to evaluate the performance of the funds, the Sharpe and Treynor ratios. Returns are calculated in the usual way:

where Pu is the price of portfolio or stock market index i in time period t and dit is the dividend for asset i at time t. There are no dividends corresponding to the emerging market indexes. The Sharpe historical performance ratio is calculated as the excess return per unit of total risk. (4)

where Rp is the average portfolio return, RFis the average risk-free return, and <jp is the standard deviation of portfolio return. This nondiversifiable risk is measured by the historical estimated beta of the funds' returns. The Treynor ratio treats only the nondiversifiable market risk of an investment.

(5) where (3, is the estimated beta coefficient of the portfolio. These two relative measures of a fund's performance compared with the values for other funds and the aggregate markets are used to determine how each fund performed during the Asian crisis. All beta coefficients in the tables below on which the funds are compared are based on the S&P 500 index as the measure of market performance, on the principle that that index is the performance alternative for U.S. investors in both U.S.- and Asia-based mutual funds. Analysis of Market Turning Points December 30, 1994 was the baseline date in calculations of daily price ratios for all studied funds, country indexes, country exchange rates, and equivalent country indexes. Plots of these ratios were used to determine inflection points in exchange rates and in market indexes. These results are reported in Table 19.2. Inflection points for the Asia funds are shown in Table 19.3. Further data analysis was undertaken,

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including descriptive statistics (mean, variance, skew, kurtosis, etc) were calculated for country stock market indexes and exchange rates.4 TABLE 19.2 Exchange Rate and Market Index Maximum and Minimum Turning Points Country Australia Hong Kong Indonesia Japan Malaysia New Zealand Philippines Singapore S. Korea Taiwan Thailand Country Australia Hong Kong Indonesia Japan Malaysia New Zealand Philippines Singapore S. Korea Taiwan Thailand Country Australia Hong Kong Indonesia Japan Malaysia New Zealand Philippines Singapore S. Korea Taiwan Thailand EW S&P500

Exchange Rate (Per Local Currency) Max Min Date Date 12/02/96 0.8164 0.5563 08/27/98 05/26/98 0.1285 10/23/97 0.1300 01/03/95 0.0001 06/17/98 0.0005 08/11/98 04/18/95 0.0124 0.0068 06/21/95 0.2134 01/08/98 0.4105 0.4867 08/26/98 11/21/96 0.7161 01/12/95 0.0220 01/06/98 0.0410 05/02/95 0.7194 0.5579 01/12/98 0.0005 12/23/97 07/03/95 0.0013 0.0283 06/03/98 04/10/95 0.0398 0.0178 01/12/98 06/17/97 0.0432 Stock Market Index (Local Currency) Date Min Date Max 04/27/99 02/08/95 1823.3000 3145.2000 08/07/97 6660.4180 08/13/98 16673.2700 07/08/97 09/21/98 256.8340 740.8330 06/26/96 10/09/98 12879.9700 22666.8000 02/25/97 09/01/98 262.7000 1271.5700 10/22/97 1668.2400 10/02/98 2635.4800 02/03/97 1082.1800 09/11/98 3447.6000 02/05/96 805.0400 09/04/98 2163.1100 12/30/94 06/16/98 1027.3900 280.0000 08/26/97 08/14/95 4503.3670 10116.8400 1472.0400 07/10/95 207.3100 09/04/98 Stock Market Index (U.S. Dollar) Max Date Date Min 2068.4865 07/02/97 02/08/95 1357.2645 08/07/97 08/13/98 2154.1865 859.1939 07/08/97 09/21/98 0.3048 0.0230 04/29/96 10/05/98 212.2778 96.2693 512.5699 02/25/97 09/01/98 65.4386 01/17/97 10/02/98 1724.9876 832.9522 02/03/97 09/11/98 130.8364 24.7495 1532.5634 02/05/96 460.2414 09/04/98 10/12/95 0.1867 12/23/97 1.3237 07/28/97 164.9583 08/14/95 354.7489 59.4704 07/10/95 5.0646 09/04/98 07/31/97 09/01/98 703.5807 344.3453 04/27/99 01/03/95 1362.8000 459.1100

Change -31.86% 1.16% -86.90% -45.24% -48.01% -32.03% -46.38% -22.45% -61.48% -28.94% -58.73% Change 72.50% -60.05% -65.33% -43.18% -79.34% -36.70% -68.61% -62.78% -72.75% 124.65% -85.92% Change 52.40% -60.12% -92.44% -54.65% -87.23% -51.71% -81.08% -69.97% -85.90% 115.05% -91.48% -51.06% 196.84%

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TABLE 19.3 Asian Funds Maximum and Minimum Turning Points (US $) Fund ASDBX

Date

Change

5.25

08/13/98 08/31/98

-61.90% -73.26%

5.12 4.61

09/01/98

-65.73%

04/30/96

08/31/98

-72.46%

21.15

08/07/97

6.74

09/01/98

-68.13%

16.17 23.63 13.39

02/05/96 08/14/97

6.14 3.63 4.89 7.26

08/31/98 08/31/98

-62.03% -84.64% -63.48% -66.86% -72.24%

Max

Date 02/16/96 08/14/97

5.28

CHN CNTAX DFRSX

13.86 19.63 14.94

08/06/97

16.74

EVCGX FSEAX GCH GFABX

GFCHX GTPAX

4.10

09/01/98 08/13/98 09/01/98

11/27/96 08/14/97

3.95 4.30

09/01/98 09/01/98

-72.72% -65.71%

18.61

01/20/97

5.17

09/01/98

18.00

02/05/96

5.77

09/03/98

-72.22% -67.94%

17.67 11.59

02/05/96

5.55 4.88

09/03/98

GTPBX ICRBX

21.91 14.77 14.48 12.54

MBDRX MSAAX MSCAX NPACX PRASX SAGAX SCOPX USCOX

Min

9.76 12.39 17.67 10.04

01/20/97 08/07/97 11/27/96

08/06/97 01/20/97 08/06/97 01/23/97 08/25/97

3.92 4.52 6.84 2.82

10/05/98 09/01/98 09/01/98 09/01/98 09/01/98

-68.59% -57.89% -59.84% -63.52% -61.29% -71.91%

Asian country dollar-equivalent market indexes were compared with the S&P 500.5 Selected Asian Pacific Rim funds were compared to local country equivalent indexes, an Asia Composite Index and the S&P 500 can be obtained from the CFT website http:// www.cenfintec.org/publications/. Finally, a summary time line of the Asian financial crisis is shown in Table 19.4. The basis for the time line is detailed below in Section IV. III.

DATA SOURCES AND COVERAGE

The sample was selected from the Morningstar Pacific/Asia (excluding Japan) Stock Mutual Funds Report and U.S. Stocks Mutual Funds. All funds' daily prices and dividends over the study period were obtained from Yahoo Finance. Twenty Asia Pacific funds and 55 U.S. equity funds met the selection criteria in Table 19.1. Among the 20 Asia Pacific funds, coverage of 15 funds spans December 30, 1994 to April 30, 1999. One fund (GFABX) from June 23, 1996 to April 30, 1999, one fund (GFCHX) from January 12, 1995 to April 30, 1999, one fund (NPACX) from July 7, 1995 to April 30, 1999, and one fund (SAGAX) from July 18, 1996 to April 30, 1999, and

Market June 1996 Japan

Market Feb. 1996 Singapore Thailand

Market August 1997 Hong Kong Indonesia Taiwan

Market Feb. 1997 Malaysia Philippines

May 1996 S Kore

Currency Jan. 1998 Malaysia Philippines Singapore Thailand

Market Oct. 1997 Australia New Zealand S&P 500

Currency June 1998 Indonesia Taiwan

O"^

50

August 1998 Australia Jaoan New Zealand

Dec. 1997 S. Korea

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1

1

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Currency Dec. 1995 Japan

1

1

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Currency June 1996 S. Korea

1

1

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ir

11

1

11

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•tit Currency July 1997 Australia (7/11) Indonesia (7/11) Malaysia (7/11) New Zealand (7/18) Philippines (7/11) Singapore(7/11) Taiwan (7/28) Thailand (7/2)

Market Aug. 1998 Hong Kong

June 1998 S. Korea

TABLE 19.4 Time Pattern of Asian Financial Crisis Source: Datastream; Time: December 30, 1994 to April 30, 1999

Market Sep. 1998 Indonesia Malaysia Philippines Singapore Thailand

Market Oct. 1998 Japan New Zealand

Feb. 1999 Taiwan

C] O:

Asian Financial Crisis and Performance of U.S.-Based Asia Mutual Funds

317

one fund (CNTAX) from June 1, 1995 to April 30, 1999. Abbreviations are used to replace the longer names of the funds to conserve space. Eleven Asian countries' daily stock indexes, exchange rates, and S&P 500 composite index over the period were downloaded from Datastream. Data for the China indexes could not be obtained before July 1, 1997. The 91-day Treasury bill daily yield downloaded from Federal Reserve Economic Data and the S&P 500 return were used as proxies for the "risk free" rate and the market return respectively, In the historical data sets, missing data were encountered for several days in some funds and countries' indexes due to different holidays in different countries.6 Descriptive statistics are shown for currency exchange rates, Asian stock market and U.S. dollaradjusted market indexes in Tables 19.5 to 19.7. The stock index data were converted to U.S. dollars using daily exchange rates to facilitate comparison with the U.S.-based mutual funds. From daily data, we chronicled the exchange rate and market index profiles for 11 Asian countries. The timing of the crisis determined in this way is summarized in Table 19.4. IV. TIME PATTERNS: COUNTRY INDEXES AND EXCHANGE RATES

Table 19.6 shows the stock market indexes for the emerging countries in local currency or index units. The markets in Singapore and Thailand were the first to decline, in February 1996, followed by Korea and Japan in May and June 1996. Markets in Malaysia and the Philippines followed in February 1997. However, the more concerted currency declines, generally referred to as the onset of the crisis, took place in July 1997. At that time, the rates of decrease of other countries already in decline accelerated. After the currency collapses, the markets in Hong Kong, Indonesia and Taiwan declined sharply. Finally, in late October, the markets in Australia, and New Zealand declined. The U.S. market, measured by the S&P 500 Index, flattened out for a few weeks at the end of 1997, and then resumed its rise. The major effect of the Asian crisis in the U.S. market, however, is generally dated in July and August 1998. Recovery in the U.S. began in early October. The largest declines from their respective peaks took place in Thailand and Malaysia. When adjustment is made for exchange rate effects as shown in Table 19.2, Indonesia declined more than 92%. The major exchange rate declines shown in Table 19.5 generally took

TABLE 19.5 Descriptive Statistics of Asian Countries Currency Exchange Rate HKC 0.1292 0.1292 0.0001 1.6612 -0.1515 0.1285 0.1300

INC 0.0003 0.0004 0.0001 -1.4207 -0.6569 0.0001 0.0005

JAC 0.0089 0.0087 0.0012 0.2681 0.7855 0.0068 0.0124

MAC 0.3467 0.3928 0.0658 -1.5281 -0.5673 0.2134 0.4105

NZC 0.6285 0.6527 0.0663 -1.0774 -0.6456 0.4867 0.7161

PHC 0.0334 0.0380 0.0063 -1.5408 -0.5332 0.0220 0.0410

SIC 0.6657 0.6963 0.0520 -1.2996 -0.6252 0.5579 0.7194

SKC 0.0011 0.0012 0.0002 -1.1788 -0.6214 0.0005 0.0013

TWC 0.0344 0.0362 0.0033 -1.3167 -0.4677 0.0283 0.0398

THC 0.0338 0.0389 0.0071 -1.4627 -0.5065 0.0178 0.0432

50

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AUC Mean 0.7177 Median 0.7393 Standard Deviation 0.0650 Kurtosis -1.0542 Skewness -0.5401 Minimum 0.5563 Maximum 0.8164

Er

TABLE 19.6 Descriptive Statistics of Asian Countries Stock Market Index (in local currency) INM JAM MAM 512.94 17812.32 877.57 500.17 17822.91 973.51 104.20 2447.98 272.65 -0.60 -1.07 -1.17 0.11 0.06 -0.48 256.83 12879.97 262.70 740.83 22666.80 1271.57

NZM 2181.73 2155.00 174.87 0.30 -0.03 1668.24 2635.48

PHM 2479.18 2560.65 558.23 -0.76 -0.35 1082.18 3447.60

SIM 1687.42 1781.26 322.09 -0.05 -0.91 805.04 2163.11

03

SKM TWM THM 699.20 6887.91 815.80 733.57 6763.66 716.66 210.33 1351.52 413.89 -1.02 -0.75 -1.63 -0.43 0.21 0.09 280.00 4503.37 207.31 1027.39 10116.84 1472.04

TABLE 19.7 Descriptive Statistics of Asian Countries Stock Market Index (in US$) S&P500 Mean 829.70 Median 779.22 Standard Deviation 243.26 -1.09 Kurtosis Skewness 0.34 Minimum 459.11 Maximum 1362.80

AUD HKD 1730.33 1396.94 1746.18 1373.54 171.65 270.05 -0.79 -0.21 -0.28 0.54 1357.26 859.19 2068.49 2154.19

IND 0.17 0.21 0.09 -1.47 -0.44 0.02 0.30

JAD 159.59 171.48 32.19 -1.41 -0.26 96.27 212.28

MAD NZD 321.16 1375.49 385.26 1405.06 141.23 206.38 -1.50 -0.41 -0.42 -0.50 65.44 832.95 512.57 1724.99

PHD SID 85.73 1137.54 97.54 1242.47 31.41 281.58 -1.42 -0.72 -0.36 -0.72 24.75 460.24 130.84 1532.56

SKD 0.79 0.83 0.36 -1.39 -0.25 0.19 1.32

TWO 235.32 229.33 43.08 -0.04 0.66 164.96 354.75

THD 30.12 27.55 18.83 -1.68 0.06 5.06 59.47

EW 548.68 535.80 83.32 -0.70 -0.17 344.35 703.58

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S&P500 AUM HKM Mean 829.70 2427.56 10813.29 Median 779.22 2425.75 10625.88 Standard Deviation 243.26 297.48 2091.59 Kurtosis -1.09 -0.81 -0.21 0.34 0.00 0.55 Skewness Minimum 459.11 1823.30 6660.42 Maximum 1362.80 3145.20 16673.27

p r-

Asian Financial Crisis and Performance of U.S.-Based Asia Mutual Funds

319

place in early to mid-July 1997. After adjustment for movements in the exchange rates, the dates of the minima for the various countries are generally close to their unadjusted dates (within two or three months). It is clear, however, that the exchange rate movements affect comparative market timings for the emerging market countries, and accelerated the decline of the markets on an adjusted basis in mid-July. Table 19.4 shows the broad time pattern of the exchange rates and market downturns, and shows the clustering of the onset of exchange rate declines in July 1997. Table 19.8 shows the exposure of the Asia-based funds to individual countries in the region, and the industrial sector allocations of the funds' investments as well. The downturn lasted more than 1 year. Unlike the beginning points of decline, the currency recovered before the stock markets. South Korea's exchange rate against the U.S. dollar reached the lowest point in December 1997, followed by the exchange rates of Malaysia, the Philippines, Singapore, and Thailand in January 1998. Japan, Australia, and New Zealand ended their currency declines by the end of August 1998. Stock market recovery took place first in South Korea in June 1998, then Hong Kong in August 1998. The downturn ended in February 1999 when Taiwan stock market began to recover. Asia Pacific Funds Results7

The 20 Asia funds were compared against country dollar-equivalent indexes, the equally weighted Asian index, and the S&P 500. Analysis during the sample period revealed two principal conclusions: first, that all funds had similar volatility patterns in time, and similar turning points to the Hong Kong "Hang Seng" index. The latter observation confirms the relatively heavy investments of most funds in Hong Kong-based securities. Second, the funds' respective departures from the Hang Seng pattern relates to a fund's relative exposures to other countries. The 20 funds are clustered into eight sub-groups of highly associated price movements. There follows a summary of the closely associated funds and their groupings. The asset allocations, that is, country and sector exposures by industrial sector in Table 19.8, form the basis for the analysis of groups of funds and their movements described below. Group 1: CRN, GCH, GFCHX, and EVCGX

These three funds, CHN, GCH, GFCHX, had the highest country exposure to Hong Kong and China (CHN: > 80%; GCH > 90%;

320

J.R. Norsworthy, W. Bessler, I. Morgan, R. Gorener and D. Li TABLE 19.8 Top Five Asset Allocations of Asian Based Mutual Funds,

MorningStar Rating Country Exposures in % * SK PH AU ID DATE TH MA MSR % CH HK TW SI 3 GTPAX 45 10 3 Aug-97 6 30 1 Jul-97 3 CHN 26 (i) 69 Jun-97 8 10 FSEAX 44 13 13 2 4 Jun-97 GCH 26 71 4 Jun-97 GFCHX 1 97 4 5 PRASX 35 15 3 Apr-97 20 Aug-97 MBDRX 8 60 7 7 5 2 Jul-97 11 15 13 9 SCOPX 22 2 Jul-97 8 DFRSX 30 25 20 12 2 1 11 Jun-97 8 MSAAX 36 15 12 6 14 3 Dec-95 15 MSAEX 29 21 Sector Weightings in % ** DATE SE FI TE RE HE UT EN IN DU ST % Aug-97 0.9 9.2 5.6 0 GTPAX 20 13.1 0.9 3.2 4.1 43 7.4 0 24.3 7.8 13.2 22.7 19 3.3 Jul-97 2.3 0 CHN 1.4 0.1 3.7 2.1 41.6 9.6 11.8 6.6 20.5 2.6 Jun-97 FSEAX 1 Jun-97 GCH 5.1 1.4 36.8 18.1 15.9 4.3 16.6 0.9 0 1.4 Jun-97 0.9 0 GFCHX 11.5 3.2 52.8 2.9 15.9 0.6 11 Apr-97 3.3 0.3 0.8 PRASX 1.5 49 11.1 6.2 2.5 18.2 7 3 Aug-97 0 20 0 3.7 10.5 6 MBDRX 3.2 2.8 50.9 5.8 Jul-97 0.5 SCOPX 1.9 45.4 8.4 14.3 2.2 17.4 0 4.1 11 3.8 Jul-97 1.9 3.5 9.9 15.1 DFRSX 0.2 2.3 22.5 30 3.4 Jun-97 0 0 MSAAX 6.9 2.8 46.1 10.7 9.5 4.1 16.5 7.4 Dec-95 44.8 9.1 8.8 4.2 14.5 0 0.6 MSAEX 10.6 0 * CH: China, HK: Hong Kong, TW: Taiwan, SI: Singapore, SK: S. Korea, PH: Philippines, AU: Australia, ID: Indonesia, TH: Thailand, MA: Malaysia, MSR: MorningStar Rating ** UT: Utilities, EN: Energy, FI: Finance, IN: Indust-Cycl, DU: Durable, ST: Staples, SE: Services, RE: Retail, HE: Health, TE: Technology (i) Incomplete information

GFCHX > 96.5%) and rose above the Hang Seng index in April 1997. EVCGX had 5.9% exposure in Thailand. Thailand's dollar equivalent index fell significantly in September 1996. This decrease generated the fund's price departure from Hong Kong index. Group 2: GTPAX, DFRSX, GTPBX

DTPAX and GTPBX had exposures of 8.3% to Singapore; 6.3% to Taiwan; and 2.5% to Thailand. These three countries' market fluctuations affected the funds price changes and lowered the returns

Asian Financial Crisis and Performance of U.S.-Based Asia Mutual Funds

321

compared with the Hong Kong index. All Asian countries' stock market indexes had large declines in October and December 1996. Group 3: MSAAK, MSCAX The 13.4% exposure in Singapore caused a major decrease in the fund's prices. 17.1% exposure in South Korea also affected the prices in October and December 1996. Especially in June 1997, Singapore index decreased but Korea index increased more than 10%, the fund's price had a small increase during that time. Group 4: PRASX, ASDBX The exposure in Singapore was the main factor in the declines of these funds. Group 5: MBDRX, CNTAX Exposures in Singapore and Taiwan were 14.1% and 8.6% in MBDRX and 24% and 0.3% in CNTAX respectively, and this exposure made the funds price ratios depart from Hong Kong index pattern in September 1996 after the Singapore and Taiwan indexes fell. The 13.9% exposure in South Korea of MBDRX resulted in its price falling further from Hong Kong index when South Korea equivalent index decreased on November 19, 1997. Group 6: U.S.COX In the summer of 1997, the increase in the Taiwan market made the fund's return higher than the Hong Kong index. Singapore index's sharp decline in December 1997 reduced the fund's return to below that of the HK index. Group 7: ICRSX, SAGAX ICRBX had 5.8% exposure in South Korea and 3.5% in Singapore. SAGAX had 7.4% proportion in Thailand and 18.3% in Singapore. The Korean equivalent market index declined in August 1996, Thailand in September 1996, and Singapore in October 1996. This resulted in the two funds' prices falling below the Hong Kong index. At the beginning of August 1997, the Thailand index declined first, followed by Singapore. The Korea market climbed continually for

322

J.R. Norsworthy, W. Bessler, I. Morgan, R. Gorener and D. Li

another week then began to fall slowly. These changes brought the SAGAX below ICRBX. Thereafter, the Korean index declined more steeply than Thailand's, and SAGAX reverted to ICRBX level. Group 8: FSEAK, SCOPX, NPACX, and GFABX

The country exposures in South Korea and Singapore of FSEAX and SCOPX, Singapore and Malaysia exposures of GFABX, and Singapore exposure of NPACX lowered the funds' performances and country indexes, beginning in October 1996. These funds all had asset exposure in Taiwan, and thus the returns recovered, partly due to the rise in the Taiwan market in March and April 1997. NPACX had a higher return than the other three funds, because NPACX had no exposure in South Korea or Malaysia, and had 29.5% asset exposure in Australia. Most of these Asian funds had completed their declines by the end of August 1998 or September 1, 1998, the same as the equal weighted country index. The exception is NPACX, which had its minimum point at October 5, 1998. These observations on the funds' movements help to clarify the reasons for similar performance of the several groups of funds during the downturn associated with the Asian financial crisis. Table 19.4 displays the associated time line of major turning points. V. EMPIRICAL RESULTS OF FUND ANALYSIS: FUND PERFORMANCES

The 20 Asia mutual funds had a daily mean return of-0.0002 with a standard deviation of 0.0153. Their returns ranged from -0.00055 to +0.00041. (See Table 19.9). The best performers during this period were two Chinese funds, GCH (Greater China Fund) and GFCHX (Guinness Flight China and Hong Kong). The worst performer was DFRSX (DFA Pacific Rim Small Company). The Asia Funds returns, except CHN, GCH and GFCHX, were negative during the sample period. The positive beta coefficients for the Asia funds as a group result primarily from the increases in most of the emerging country indexes from January 1995 to July 1997, which were also observed in most of the funds. Their Sharpe and Treynor ratios were negative at -0.0245 and -0.08%. When compared to the strong S&P 500, whose mean daily return was 0.00099 with a standard deviation of .010, the Asia mutual funds significantly underperformed. Only three Asia funds outperformed the nine-country Asia composite index.

Asian Financial Crisis and Performance of U.S.-Based Asia Mutual Funds

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TABLE 19.9 Asian and U.S. Funds Comparisons Asian Funds

Mean

SD

Mean Standard Deviation Kurtosis Skewness Minimum Maximum Count U.S. Funds

-0.0002 0.0003 0.2769 0.7819 -0.0005 0.0004 Mean

SD

Mean Standard Deviation Kurtosis Skewness Minimum Maximum Count

0.0007 0.0003 2.9734 -0.2214 -0.0004 0.0016

0.0110 0.0055 40.3522 5.9325 0.0061 0.0479

55

55

20

0.0153 0.0037 2.9764 1.6658 0.0104 0.0260 20

Beta (CM) 0.58 0.2698 3.2537 1.8459 0.2813 1.3589 20

Beta (CM) 0.70 0.2765 5.3419 1.4082 0.2198 1.9079 55

Beta (MM) 0.57 0.2581 3.0589 1.7657 0.2735 1.3167 20

Beta (MM) 0.70 0.2760 5.3640 1.4096 0.2182 1.9041 55

Sharpe -0.0245 0.0187 -0.3789 0.3756 -0.0565 0.0149 20

Sharpe 0.0557 0.0271 -0.7397 -0.2363 -0.0113 0.1056 55

Treynor (CM) -0.08% 0.0007 1 .0273 -0.6105 -0.24% 0.04% 20 Treynor (CM) 0.08% 0.0003 1.9804 -0.0617 -0.03% 0.19% 55

Treynor (MM) -0.08% 0.0007 1.1194 -0.6452 -0.25% 0.04% 20 Treynor (MM) 0.08% 0.0003 1.9743 -0.0768 -0.03% 0.19% 55

Comparison of the Asia funds with the 55 U.S. mutual funds shows similar results. (See Tables 19.9 and 19.10). The mean of the returns for U.S. mutual funds was strong at 0.0007 with an average standard deviation of .0110, which exceeded the daily returns of the Asian sample (-.0002). The returns of all but one of the U.S. funds exceeded Asia funds returns, measured by the average return for the 20 funds. The U.S. funds also outperformed the equally weighted index of emerging Asian country indexes. However, GFCHX outperformed nine U.S. funds, GCH outperformed three, and CHN one. GFCHX and GCH outperformed the equally weighted Asia index as well.8 Both the Asia and U.S. funds had CAPM (0.58, 0.70) and Market Model (0.57, 0.70) betas, respectively. Average Sharpe and Treynor ratios for the Asia-based funds were -0.0245 and -0.08%, from the CAPM. The comparable Sharpe and Treynor ratios for the U.S. funds were 0.0557 and 0.08%, respectively. The Treynor ratios for the market model were the same as for the CAPM for both countries. In summary, the Asia funds experienced a period of overall negative returns during January 1995 to April 1999, and they performed somewhat worse than the Asian market indexes on average: this is the result, of course, of the Asian financial crisis. Meanwhile the U.S. mutual funds enjoyed strong returns. The individual Asia funds' performances as measured by their mean, standard deviation, Sharpe and Treynor ratios are summarized

324

J.R. Norsworthy, W. Bessler, I. Morgan, R. Gorener and D. Li TABLE 19.10 Performance Ranking of Asian Funds

Ranking by Mean Ticker Mean S&P500 0.00099 GFCHX 0.00041 GCH

EWAsia CHN

FSEAX ICRBX CNTAX SAGAX ASDBX EVCGX PRASX USCOX MSAAX SCOPX MSCAX GFABX MBDRX NPACX GTPAX GTPBX DFRSX

0.00029 0.00020 0.00014 -0.00004 -0.00005 -0.00007 -0.00010 -0.00010 -0.00014 -0.00016 -0.00028 -0.00031 -0.00033 -0.00034 -0.00036 -0.00038 -0.00040 -0.00049 -0.00051 -0.00055

Ranking Ranking by Beta(CM) Ticker Beta Ticker Ticker SD 0.28 S&P500 S&P500 0.010 DFRSX SCOPX 0.010 EWAsia 0.33 GFCHX Ranking by SD

EWAsia DFRSX NPACX ASDBX MSCAX MSAAX PRASX ICRBX FSEAX GTPBX GFABX GTPAX SAGAX MBDRX USCOX EVCGX GFCHX CNTAX CHN GCH

0.012 0.012 0.012 0.013 0.013 0.013 0.013 0.014 0.014 0.014 0.015 0.015 0.015 0.015 0.016 0.016 0.018 0.018

ASDBX MSCAX MSAAX GTPBX NPACX GTPAX SAGAX PRASX SCOPX ICRBX FSEAX EVCGX MBDRX GFABX USCOX GFCHX CNTAX S&P500

0.023 CHN 0.026 GCH

0.36 0.38 0.38 0.42 0.43 0.44 0.47 0.49 0.50 0.53 0.55 0.56 0.56 0.60 0.62 0.69 0.90 1.00 1.16 1.36

GCH

EWAsia CHN

CNTAX FSEAX ICRBX SAGAX EVCGX ASDBX PRASX USCOX MBDRX MSAAX GFABX MSCAX GTPAX NPACX GTPBX SCOPX DFRSX

by Sharpe Ranking by Treynor(CM) Ticker Treynor Sharpe 0.08773 S&P500 0.0852% 0.01493 GFCHX 0.0394% 0.00571 0.00511 -0.00011 -0.01151 -0.01314 -0.01360 -0.01557 -0.01679

EWAsia GCH

0.0184% 0.0109%

CHN

-0.0002% -0.0234% -0.0329% -0.0353% -0.0495% -0.0503% -0.0612% -0.01912 -0.0673% -0.02238 -0.0682% -0.02659 -0.0831% -0.03336 -0.03444 -0.0913% -0.0937% -0.03444 -0.1188% -0.03695 -0.1247% -0.04351 -0.1276% -0.04360 -0.1445% -0.04487 -0.04491 GTPBX -0.1545% -0.05652 DFRSX -0.2438% CNTAX FSEAX ICRBX EVCGX SAGAX PRASX ASDBX USCOX GFABX MBDRX SCOPX MSAAX NPACX MSCAX GTPAX

in Table 19.10. The funds are ranked by their mean performances, standard deviations, CAPM betas, and Sharpe and Treynor ratios.9 As a group, these did not outperform the S&P 500, and underperformed most of the U.S.-based mutual stock funds. The results for the U.S. funds were similar to those of an earlier larger study by Malkiel (1995) in that only seven of the 55 U.S.-based funds outperformed the S&P 500 during the observation period based on their mean returns. Far fewer Asia-based funds outperformed the Asia composite index, based on Sharpe and Treynor ratios. VI.

MARKET INTEGRATION

The structure of the emerging stock markets' relationships with major Asian markets and the U.S. market was examined using cointegration. As distinct from some cointegration applications, the technique is applied in this case as an adjunct to the main line of

Asian Financial Crisis and Performance of U.S.-Based Asia Mutual Funds

325

analysis: assessment of the performances of mutual funds. The cointegration analysis was carried out only for the period after August 12, 1997, up to April 30, 1999, a period wherein all of the countries' exchange rates were allowed to float against the dollar and the yen. Two types of cointegration tests were applied: the conventional Engle-Granger test (1987), and the Johansen test (1988). The Engle-Granger test is more robust when the residuals from the cointegrating model are not normal; however, it estimates a separate cointegration model for each variable in the set tested for cointegration (each country market). This procedure may result in different adjustment lags for each country, as occurs in this application. The Johansen test assumes normality and estimates a single cointegration model for all countries, resulting in a single adjustment lag structure. As Table 19.11 shows, the adjustment lag results from the two procedures are considerably different. In order that the cointegration tests are meaningful, the series in the tests must be free of unit roots. A unit root analysis of the stock market indexes themselves shows that unit roots characterize all of them.10 The most usual method of removing unit roots is first differencing. Computation of returns (Eq. 1 above) also removes unit roots, as Table 19.11 shows: the series after differencing are stationary.11 TABLE 19.11 Cointegration Tests for Country Markets E-G Cointegration Unit Root Statistics Market Optimal Lag Unit Root Lags Lags for Cointegrated? Return for E-G Johansen WS DF Group 1: Singapore, Malaysia, Thailand, Indonesia 2 Yes 6 3 6 RSG No RML 3 Yes 6 6 No 6 Yes RTH 16 16 No 2 3 2 RIN 17 Yes 17 No 3 Group 2: Hong', Kong> Taiwan, Philippines 2 Yes 5 RHK 5 6 No Yes RTW 3 3 No 2 2 RPH 6 Yes 6 No 2 2 Group 3: Hong; Kong, Singapore, Jap an, US, South Korea Yes RHK 5 5 No 5 2 Yes RSG 17 17 No 6 2 RJP Yes 3 3 No 3 2 RS5 16 Yes 15 No 2 2 RSK Yes 2 2 No 8 2

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J.R. Norsworthy, W. Bessler, I. Morgan, R. Gorener and D. Li

The rationale for the three-way grouping of countries in the cointegration analysis is as follows. Singapore is a major market, and plays an important role in connecting financial markets in Indonesia, Malaysia, and Thailand to global financial markets. Hong Kong plays a similar role for Taiwan and the Philippines. Singapore and Hong Kong may be viewed as regional banking centers, and thus it is interesting to consider whether those markets are cointegrated with those in Japan, Korea and the United States. Cointegration analysis is thus applied to examine the reasonableness of our prior expectations for inter-market relationships, rather than to determine the relationships. From the point of view that cointegration is a tool for data analysis rather than for the discovery of equilibrium systems, this approach seems comfortable.12 One can find that the emerging country markets are cointegrated in the three groupings assigned. This fact suggests that an equilibrium model may link the grouped country index markets. It does not permit the conclusion that there are no other significant countries or other variables in the putative equilibrium models. The positive cointegration results confirm our expectations, in that the country groups show that their stock market movements are cointegrated, based on returns. VII. WEIGHTS OF COUNTRY INDEXES IN FUND PERFORMANCE

The Morningstar reports on Asia/Pacific funds show country exposure for the top five countries where each fund holds assets. These data are shown in Table 19.8 for the funds where the data could be found. There are difficulties with these data, however. First, as noted, only the top five country allocations are shown. The direct estimation of the country market weights can identify weights for the smaller components of a fund's asset allocation. Second, the allocation data are available only for 11 of the funds. The regressions provide estimated weights for other funds. Finally, there are multinational companies whose stocks are traded on, e.g., the Hong Kong and Singapore exchanges that themselves have substantial exposure in other countries. Our estimation of the weights for different country effects allows for this indirect effect. The weighting model is specified in Eq. (6) below R = a+^WiRl + e

(6)

Asian Financial Crisis and Performance of U.S.-Based Asia Mutual Funds

327

where Rp is the portfolio return, /?• is the return implied by the country index,13 wip is the estimated weight for assets from country i in portfolio p, ap is an intercept term and ep the error term. The index i ranges over the nine countries Australia (AU), Hong Kong (HK), Indonesia (IN), Malaysia (MA), Philippines (PH), Singapore (SI), South Korea (SK), Taiwan (TW), and Thailand (TH). The index p ranges over the funds whose names are given in Table 19.3. The intercept coefficient ai allows for the average effects of other factors or countries. Equation (6) was estimated by the nonlinear least squares (LSQ) procedure in TSP 4.5.14 The results for the model are shown in Table 19.12. The coefficient estimates are shown for each fund as well as their ^-statistics. Generally, the estimated weights agree broadly with the country allocations where the latter are known. Although they are not reported, the ¥\: coefficients are typically in the 45-85% range. Note that the ap coefficients, the intercept terms, are sometimes negative. These intercept coefficients measure a kind of error of closure: the net effect of excluded factors. They are uniformly quite small for all of the funds. All other coefficients, the w{ weights, are restricted to be positive and to sum to one. This normalization of the wi weights has no effect on the relative weights of the country indexes. VIII. CONCLUSIONS The most important conclusion of the study is our finding that the Asia-focused funds generally seem to have underperformed a composite emerging market index for Asian countries. Of course, they also underperformed the S&P 500 Index, and most of the U.S. based mutual funds. The U.S.-based funds did not generally perform so well when compared to the S&P 500 index. Clearly, then, only a few managers of Asia-based funds add value to portfolios of emerging Asian country assets. The conventional wisdom is that their counterpart managers of U.S. domestic funds also do not add value. Concerning the contraction phase of the Asian financial crisis: the declines in the emerging country stock market indexes started at widely different times, but they all declined until about SeptemberOctober 1998. The exchange rates followed a similar pattern. The adjusted country exchange rates tend to reach their minima near the corresponding country market indexes. Links across emerging financial markets in Asia appear to be fairly strong, and, based on

328

J.R. Norsworthy, W. Bessler, I. Morgan, R. Gorener and D. Li

TABLE 19.12 Regression of Returns on Adjusted Country Market Index Returns (Restricted Model) ASDBX Coefficient t-Statistic 0.00002 0.07162 0.00000 0.00000 0.41262 21.60648 0.00353 0.22063 0.00002 0.00070 0.05925 3.48878 0.11931 4.63583 0.00465 0.16677 0.04289 2.12939 0.35771 6.81663 EVCGX Weight Coefficient t-Statistic A 0.00000 0.00017 WAU 0.00000 0.00000 W IIK 0.65987 25.55207 W IN 0.00002 0.00251 WMA 0.00000 0.00001 W PII 0.06311 2.08541 WSI 0.08591 2.95461 WSK 0.00905 0.73931 WTW 0.10682 4.21224 W TII 0.07522 1.36354 GFCHX Weight Coefficient t-Statistic A 0.00036 2.03949 WAL 0.00113 0.05212 WHK 0.86961 45.81580 W IN 0.00086 0.11580 WMA 0.00000 0.00000 WP1I 0.02454 2.54968 WSI 0.01705 0.75746 WSK 0.00299 0.31968 WTW 0.00700 0.34732 WTH 0.07647 1.68200 MBDRX Weight Coefficient t-Statistic A 0.00000 0.00000 WAL 0.00018 0.00503 Weight A WAU W,, K W IN WMA W PII WSI WSK WTO. WTH

CHN

Coefficient 0.00105 0.00000 0.55320 0.00610 0.00000 0.05882 0.02791 0.05706 0.03115 0.26470 FSEAX Coefficient 0.00001 0.00000 0.43914 0.00000 0.00699 0.05590 0.12446 0.03242 0.12232 0.21875 GTPAX Coefficient 0.00000 0.00010 0.51787 0.00000 0.01077 0.06533 0.09937 0.03237 0.05808 0.21611 MSAAX Coefficient 0.00000 0.00000

t-Statistic 1.66704 0.00000 6.84020 0.26813 0.00000 1.53748 0.40700 1.77086 0.61756 1.21099 t-Statistic 0.03573 0.00000 7.13136 0.00003 0.16886 2.43925 3.42912 1.72794 3.55056 1.57125 t-Statistic 0.00001 0.00323 21.05868 0.00000 0.36894 3.37942 3.68349 2.00492 2.42416 4.38620 t-Statistic 0.01101 0.00012

CNTAX Coefficient 0.00000 0.00119 0.69565 0.00000 0.00000 0.03875 0.24864 0.02874 0.02175 -0.03472 GCH Coefficient 0.00106 0.00000 0.67323 0.00452 0.00000 0.03139 0.02398 0.05308 0.07818 0.13454 GTPBX Coefficient 0.00000 0.00926 0.51495 0.00000 0.01127 0.06732 0.09947 0.02928 0.05612 0.21232 MSCAX Coefficient 0.00000 0.00000

DFRSX t-Statistic Coefficient 0.01040 0.00013 0.03266 0.00000 28.411050.26897 0.00000 0.00000 0.00007 0.13746 1.78491 0.01481 7.53122 0.11951 2.09555 0.03068 1.01136 0.01296 -0.61164 0.41549 GFABX t-Statistic Coefficient 1.51563 0.00012 0.00001 0.00000 6.67577 0.40825 0.16753 0.00000 0.00000 0.00839 0.70879 0.04870 0.31315 0.18921 1.35982 0.02807 1.32823 0.07152 0.50663 0.24573 ICRBX t-Statistic Coefficient 0.00000 0.00000 0.30951 0.00158 20.80397 0.52999 0.00000 0.00002 0.39386 0.00000 3.49406 0.04094 3.74511 0.12353 1.81941 0.03394 2.35729 0.07258 4.37449 0.19743 NPACX t-Statistic Coefficient 0.00400 0.00000 0.00003 0.00000

t-Statistic 0.44247 0.00006 11.20927 0.00000 4.00046 0.69158 3.39536 1.09660 0.56198 7.12145 t-Statistic 0.39312 0.00001 14.34120 0.00000 0.18418 2.61385 6.05627 2.08939 2.67399 3.75272 t-Statistic 0.00519 0.06305 24.24970 0.00163 0.00000 2.78771 4.22754 2.48236 3.63570 4.63924 t-Statistic 0.00044 0.00000

Asian Financial Crisis and Performance of U.S.-Based Asia Mutual Funds

329

TABLE 19.12 Regression of Returns on Adjusted Country Market Index Returns (Restricted Model) (Cont.) W HK

0.56230

23.63586 0.39821

15.65902 0.39572

15.61642 0.42007

19.99054

W IN

0.00038

0.04394 0.00000

0.00000 0.00000

0.00000 0.00000

0.00001

WMA

0.00036

0.01070 0.02063

0.67463 0.02115

0.70590 0.00001

0.00030

WPn

0.07971

4.72630 0.06809

3.40915

0.06824

3.41092

0.04140

2.42817

wa

0.13725

5.44929 0.15347

5.43816

0.15850

5.71422 0.12298

4.44707

WSK

0.03373

0.04403

2.89763 0.03667

3.15118

WTO W TII

2.94212 0.04622 2.05878 0.12624

2.99137

0.04018

5.85879 0.12673

5.87734

0.07213

3.72450

2.49029 0.18712 SAGAX

3.93592

3.89179

0.30674

7.70576

0.14590 PRASX

0.18563

uscox

SCOPX

Weight Coefficient t-Statistic Coefficient t-Statistic Coefficient t-Statistic Coefficient t-Statistic A

0.00001

0.05538 0.00004

0.11323 0.00001

0.04083 0.00000

0.00006

WAU

0.00000

0.00000 0.00000

0.00000 0.00000

0.00000 0.00001

0.00013

W IIK

0.48294

25.47048 0.38168

13.84486 0.29529

14.30832 0.57162

18.72468

w!N

0.00000

0.00001 0.00000

0.00005 0.00001

0.00109 0.00000

0.00000

WMA

0.00099

0.02812 0.00693

0.19387 0.00005

0.00139 0.00168

0.03962

wpn wsi

0.07147

3.27124 0.04918

2.25502 0.06241

3.71819

0.11660

3.59443 0.17196

5.02067

WSK

0.03764

WTO WTH

0.07096 0.21939

5.54614 0.21019

0.05612

2.40855

0.12408

5.04299 0.00622

0.11079

2.84276 0.04577

2.74915 0.05563

4.69212 0.02573

4.07585 0.13425

3.86156 0.10975

6.33298

0.04968

1.44221 1.77110

3.59275 0.35278

9.43884

0.28896

4.77678

cointegration analysis, to confirm the expected interrelationships, with Hong Kong and Singapore serving as regional foci for financial activity. Regressions of fund returns on calculated market returns for the Asian markets confirm that country allocation weights may be reasonably approximated by regression coefficients. REFERENCES Bessler, W. and Norsworthy, J.R. (1998) 'A Cointegration Analysis of Interest Rates in Germany,' Managerial Finance, 24(4). Corsetti, G., Pesenti, P., and Roubini, N. (1998) 'What Caused the Asian Currency and Financial Crisis,' presented at the NBER IFM Program Meeting in March 1998, Paper No. 343, Banca D'ltalia, December: 1-74. Engle, R.E. and Granger, C.W.J. (1987) 'Cointegration and Error Correction: Representation, Estimation and Testing,' Econometrica, 50, March:251-276. Hall, B.H. and Cummins, C. (1999) Time Series Processor Reference Manual, Version 4.5, TSP International, Stanford, CA. Johansen, S. (1988) 'Statistical Analysis of Cointegration Vectors,' Journal of Economic Dynamics and Control, 12, June-September:231-254. Malkiel, B. (1995) 'Returns from Investing in Equity Mutual Funds 1971 to 1991,' Journal of Finance, L(2), June:549-572.

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Norsworthy, J.R, Morgan, I.W., Gorener, R. and Li, D. (1999) 'Performance of U.S. Based Mutual Funds with Exposure in Emerging Asian Market and Comparison with U.S. Domestic Funds' in Fatemi, K. and Nichols, S.E.W. (eds.), Globalization in the 21st Century, I, Calexico, CA: International Trade and Finance Association, May:77-112. Roll, R. and Ross, S. (1980) 'An Empirical Investigation of the Arbitrage Pricing Theory,' Journal of Finance, 35, March:1073-1103. Ross, S. (1976) 'The Arbitrage Theory of Capital Asset Pricing, 'Journal of Economic Theory, 13: 341-360. Sharpe, W.F. (1964) 'Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk,' Journal of Finance, 19, September:425-442. Sharpe, W.F. (1966) 'Mutual Fund Performance,' Journal of Business, 39(1), January: 119-138. Treynor, J.L. (1965) 'How to Rate Management of Investment Funds,' Harvard Business Review, 43(1), Jan/Feb:63-75.

ADDITIONAL READING Malkiel, B. (1999) A Random Walk Down Wall Street, rev. edn., W. W. Norton, New York. Pomerleano, M. (1998) 'The East Asia Crisis and Corporate Finances: The Untold Micro Story,' Global Development Finance, Washington, DC: World Bank, August. Roll, R. (1977) 'A Critique of the Asset Pricing Theory's Tests,' Journal of Financial Economics, December: 129—176. Roubini, N. http://www.stern.nyu/~nroubini/asia/AsiaChronologyl.html 'Chronology of Asian Currency Crisis and its Global Contagion.'

NOTES 1. 2. 3. 4. 5. 6.

7. 8.

Additional information on this study can be found at the Center for Financial Technology (CFT) website at http://www.cenfmtec.org/publications/. The access provided by First Albany Corporation to fund performance data is gratefully acknowledged. Japan's, of course, is hardly an emerging economy, and South Korea, which recently joined the OECD, is probably not in that category either. Detailed results are available on request. Charts are available on request. These discrepancies were adjusted by deleting days where the majority of observations were missing, or by repeating prior days where the majority of the observations were present. There were few such occurrences. Each procedure has shortcomings. Supplementary information from some other sources than the Morningstar reports were used in this section. These performance comparisons are quite sensitive to the time periods on which the comparison is based. In our initial analysis, reported in Norsworthy, Morgan, Gorener and Li (1999), the period of analysis was January 1996 to December

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9.

10. 11.

12. 13.

14.

331

1998. During that period, a larger number of Asia funds outperformed the Asia index, and a number of U.S.-based funds as well. Moreover, fewer U.S.-based funds outperformed the S&P 500 index than in the current study. The Sharpe and Treynor ranks for the Asia-based funds are correlated at 0.96; the correlation for the U.S.-based funds is 0.72. (The lower correlation is expected for the larger number of funds.) The Treynor ratio measures based on the CAPM and market model have correlations exceeding 0.998 for both countries. Clearly the CAPM adds virtually nothing, as against the market model, which has more parsimonious assumptions. These results were reasonably uniform. They are not reported here, but may be obtained by e-mailing Norsworthy at [email protected]. The calculation of returns is first differencing with the addition of dividends. A strong trend in dividends could contribute a unit root, but that was not the case here. See Bessler and Norsworthy (1998) for an example of this approach. No dividend is included in the calculation of country market returns. This limitation could introduce bias if some the stocks for some countries have dividends that substantially exceed those for other countries. The country market index is adjusted by the current exchange rate to the U.S. dollar basis. See Hall and Cummins (1999).

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Part VII International Monetary and Investment Issues

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Part VII: International Monetary and Investment Issues In Chapter Twenty, Professor Robert Shelburne provides an analysis of the current international monetary system. He argues that "the poor economic performance of the global economy over the last several years is due significantly to shortcomings in the current design of the international monetary system." He maintains that the problem with the current international monetary system is fundamentally "systemic in nature." He further argues that "the current system (1) fails to adequately distribute global saving in a globally efficient manner; (2) is prone to "irrational" speculative attacks ... and (3) has, at a global level, deflationary bias which keeps global growth below its optimal point." He concludes that despite a serious need for bold initiatives, "what can be hoped for are marginal changes in the design of the international monetary system that can partially alleviate some of the shortcomings... This band-aid patchwork, which is better than nothing, may keep the system going another decade or two. At some point, however, the basic design flaws pointed out by Keynes 50 years ago will have to be squarely addressed." Professors Andre Fourcans and Thierry Warin present a theoretical framework for monetary strategies between the United States and "Euroland" in Chapter Twenty-One. They discuss the role and objectives of the European Central Bank vis-d-visits policy-making function. They ask whether "the new European Central Bank [should] take the Euro-dollar rate as an objective of its policy [and if so] what would then be the consequences [of this decision] on the volatility of the Euro-dollar exchange rate?" Using the game-theory approach, Professors Fourcans and Warin reach provide two suppositions. "First, in the finite horizon case, an optimal Pareto solution can only be attained if both players mutually agree not to disrupt each other's expectations on the exchange rate. Secondly, in the infinite horizon situation, it is in the interest of each player to address a clear and strong signal to the other about its own strategy." The authors conclude by presenting some propositions as to an optimal strategy for the European Central Bank in its future relations with the Federal Reserve Bank. 335

336

In Chapter Twenty-Two, Professor Kurt Jesswein discusses the issue of introducing and adopting international accounting standards using the case of the United States and Germany. He based his selection on the "vastly different perspectives" of the two countries and the significant role that they play in the field. The approach adopted by the author was to mail "questionnaires ... to the senior financial officers of large German and U.S. companies asking for their opinions on various issues dealing with the importance of financial reporting in conducting business activities on a global scale." Professor Jesswein presents the findings of this study in this Chapter. Professors Mo Vaziri and Parviz Asheghian examine capital equity market diversification for American investors in the emerging stock exchanges in Chapter Twenty-Three. The purpose of their study was "to analyze the effect of global diversification on the risk reduction and expected return maximization for American investors. [They used] a linear programming technique ... and the IMF broad-based quarterly index as retrieved from the International Financial Statistics Data Files from 1957-97 to construct [their] portfolios." Analyzing the data, Professors Vaziri and Asheghian conclude that "global diversification does, in fact, provide a higher return while reducing the portfolio risk. However, [they argue that] American investors should take into consideration the types of risks arising from the separate economic policies of each nation, changes in the exchange rates, and differences in the amount and kind of information available for investment decisions." Part Seven concludes with Chapter Twenty-Four in which Professors Damien Besancenot and Radu Vranceanu analyze endogenous corruption risk and foreign investment in the developing countries. The premise of their study is that "the possibility of facing corrupt managers is an important factor explaining foreigner's hesitation in investing in the developing countries." The objective of their study is to "investigate how reputation concerns influence managers; behavior and country attractiveness." Professors Besancenot and Vranceanu conclude "that in an dynamic framework with incomplete information, a rational equilibrium exists where the manager's best choice is related to the weights he assigns to reputation and illegal income." Investigating the macroeconomic implications of their model, they further conclude that "economy-wide corruption, development prospects, and global profitability appear to depend on the duration of the relationship between investors and manager."

20 The Inadequacy of the Current International Monetary System ROBERT C. SHELBURNE1

I.

INTRODUCTION

The poor economic performance of the global economy over the last several years is due significantly to shortcomings in the current design of the international monetary system (IMS). The recent economic crisis of the emerging markets has been the most visible and obvious manifestation of the design defects, but the problems are much more systemic in nature. The current system (1) fails to adequately distribute global saving in a globally efficient manner, (2) is prone to "irrational" speculative attacks which wreck fundamentally sound economies, and (3) has, at a global level, a deflationary bias which keeps global growth below its optimal. These design defects have been central factors in a significant number of global economic problems since the breakdown of the international gold standard during the First World War; these include the Great Depression, the breakdown of the inter-war gold standard as well as the Bretton Woods fixed exchange rate system, the inflation of the 1970s, the high unemployment rates throughout Europe in the 1990s, the emerging market economic crises of the late 1990s, and the decade-long recession in Japan. It is argued in this chapter that global economic integration will ultimately require a global central bank to facilitate the transfer of capital, act as lender of last resort, and control global liquidity. However, the public's desire for national autonomy will now only allow for marginal reforms in current institutions. Section II begins with a discussion of the 'Japanese problem" which has as its source the international financial system's inability 337

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Robert C. Shelburne

to adequately distribute world savings; the Asian currency crises which have largely been created by "irrational" speculation are discussed in Section III. Section IV proposes that the current system has a deflationary bias once disequilibriums occur. Section V provides a summary. II.

JAPAN: (THE IMS'S INABILITY TO TRANSFER SAVING)

Since 1992, the Japanese economy—the world's second largest economy—has turned from being the world's greatest economic success story into an economy of relatively mediocre performance on the brink of economic catastrophe. Although it possible to view this decade-long macroeconomic crisis in Japan as being due to its own domestic shortcomings, when viewed from a global perspective it can also be argued that the Japanese crisis has at its roots the inability of the IMS to transfer savings from one nation to another. Although it is commonly assumed that the world financial system is highly integrated, a number of empirical tests beginning with the results of Feldstein and Horioka (1980) have found domestic capital markets to be surprisingly segmented with domestic investment highly correlated with domestic savings. This outcome is inefficient from a global perspective because savings are not flowing from where capital is plentiful to where it is scarce; this failure results from current design of the IMS. What is Japan's problem? Simply put, it is that Japan saves too much; Japan's gross savings as a percentage of GDP are nearly twice that of the U.S.. Japanese savings are extremely high due to its demographics, culture, and highly regulated oligopolistic domestic markets. Japan's aging population has the highest life expectancy in the OECD and Japan is projected by 2025 to have a ratio of retirees to working age population twice that of the U.S. These demographics combined with a Confucian ethic of self reliance and the lack of a pay-as-you-go social security system results in a high personal savings rate. More importantly, however, private savings are large because business savings are large; this is due to the high level of business profits and the large percentage of these that are kept as retained earnings. The high profit rate is the result of the highly regulated and oligopolistic structure of Japanese domestic industry. During the early post-World War II period, this high savings rate allowed a high investment rate which was a major, if not the major, component of Japan's remarkable high growth rate during its catchup phase. However, now that Japan has caught up technologically

The Inadequacy of the Current International Monetary System

339

with the leading industrial nations, has achieved a relatively high capital-worker ratio, and is facing reduced economic growth due to its demographics, the investment opportunities are fewer. The surplus of desired savings, resulting from the long-run reduction in investment needs and the long-run increase in savings, has been further enlarged by the economic stagnation of the current decade. Uncertainties about the economic future of Japan have increased precautionary savings and made business even more cautious in making long-run investments. The result of all this excessive saving (relative to investment) is that there is a persistent shortage of aggregate demand which produces a typical Keynesian type recession. As a result, Japan has experienced a decades long recession costing over a trillion dollars in lost output; there is a real possibility that the situation in Japan has now deteriorated into something much more sinister, like a liquidity trap. What is the solution? Either Japan must save less, invest more domestically or invest more externally. It is possible that much of the investment shortfall is due to the recession itself (or the busting of the asset bubble of the 1980s), and if the economy can simply get out of its stagnation, due perhaps to a large and temporary monetary or fiscal injection, then the savings surplus will disappear. The situation is reminiscent of the debates in the 1930s as to whether the U.S. was entering a period of permanent demand deficiency; in retrospect the answer was probably no, although the U.S. did adopt a number of structural changes after the World War II that redistributed income to households likely to spend—perhaps Japan will also be so lucky. Even if there is a long-run structural problem of excessive savings, it may also be possible to solve Japan's deficiency of demand with sustained long-run expansionary monetary and fiscal policy. At a sufficiently low interest rate, investment could absorb all the desired savings. However, it appears that a positive real interest rate is too high, and Japan's price stability keeps the real rate from going negative since the nominal rate cannot go negative. Therefore, Krugman (1998) has argued that Japan needs to solve its macroeconomic problem by creating inflation. This would then allow real interest rates to become negative to the degree necessary to increase investment sufficiently to use up the savings. Besides questions about feasibility this solution does not address the problem of the global misallocation of investment. Fiscal expansion is another solution, but like the monetary solution, results in an inferior time profile of consumption, a misallocation of global capital and, in addition,

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creates an undesirable future distributional problem for Japan (i.e., taxpayers to bondholders). In addition, there have been a number of proposals to "structurally reform" the Japanese system in a manner that would reduce savings or encourage investment. But these policies, like monetary and fiscal policy, only address Japan's macroeconomic problem. The point being, a domestic solution to Japan's problem is suboptimal; these internal solutions result in outcomes that are less than satisfactory when viewed from a global perspective since the global supply of capital is not being distributed optimally to where it would be most productive. A number of nations, including the U.S. to some degree, support a domestic solution to Japan's problem because of mercantilist fears about Japanese trade surpluses which are the flip-side of Japanese capital exports. The optimal solution is for Japan's excess savings to be invested externally, but the current design of the IMS limits the amount that can be transferred abroad. If all the world used one currency, there would appear to be no problem with making this transfer. The problem results from having a multiple-currency world where exchange rates are allowed to fluctuate; with this type of monetary system there is a constraint on the amount which can be profitably exported. As capital is exported it depreciates the currency, and when it is repatriated it appreciates the currency. Thus today's capital exports from Japan are likely to turn into capital imports into Japan over the next 10-20 years (due to demographic changes). The result is that a Japanese investor suffers a capital loss due to the future yen appreciation. Thus, the capital loss sets a limit to how far the currency can depreciate which then limits the capital outflow to the current account surplus at that exchange rate. Thus the current exchange rate system limits to a sub-optimal degree the distribution of surplus Japanese savings to investment-deficient areas in the rest of the world. Thus the fundamental problem is that the international monetary system is incapable of transferring saving from one country to another. In some sense this is similar to the Keynes-Ohlin transfer problem regarding German reparations in that the financial system somehow keeps a real transfer from occurring, but is quite different in form since in the original transfer problem the financial transfer occurs (although the real transfer does not) while in this case the financial transfer cannot be accomplished. Although the global misallocation of capital has reduced growth in the (capital-importing) developing nations, these nations have

The Inadequacy of the Current International Monetary System

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had to deal with another more immediate defect of the current system—its vulnerability to "irrational" speculative attacks which have imposed harsh constraints on their ability to maintain internal balance. III. THE ASIAN CRISIS: IRRATIONAL SPECULATION AND THE IMS

There were a number of factors which resulted in the collapse of investor confidence in the Asian emerging markets during 1997-98 including the Japanese quagmire, the January 1994 Chinese depreciation, and the weak regulatory practices in the Asian financial sectors, but the implications of these developments were compounded by the design defects of the IMS. What happened in Asia was not fundamentally different from what happened in Mexico during 1994. The failure of policy makers to correctly understand what happened in Mexico and institute changes to deal with similar future events is one of the great tragedies of the Asian crisis. In both cases the macroeconomic policies in the afflicted economies were reasonably sound; even with the benefits of hindsight, it is difficult to predict with a model which countries would be subject to capital outflows. Investors have come to understand that regardless of the fundamentals, a significant capital outflow can easily result in a depreciation of a currency since central banks do not have the reserves and the IMF is unwilling (and perhaps unable) to provide reserves sufficient to maintain an exchange rate under pressure from capital outflows. In addition, it is not sensible for investors to simply "wait out" the crisis under the assumption that prices will return to their "fundamental" value, since downward rigidity in prices and wages means that the depreciation will lead to economic changes that will validate the depreciation. Even real assets which would be immune to the depreciation's inflationary effects are likely to fall in value due to the recessionary after-shocks. In the case of Mexico, the large provision of foreign exchange by the IMF and the U.S. Government was sufficient to restore investor confidence. However, when a similar attack began in Thailand in 1997 this support was not there. The issue at that time was one of liquidity not solvency, and had the needed reserves been provided the Asian crisis could have been contained. Why were sufficient reserves not made available to the Asian nations? The IMF had the wrong mind-set and the U.S. did not have a sufficient economic interest. The IMF and its programs were ill suited for the type of

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speculative crisis which affected the Asian nations. The IMF programs were designed to deal with fundamental current account crises; IMF programs and resource levels were not designed to deal with capital crises resulting from speculative attacks. Instead of providing reserves to soothe the speculative fever, the IMF imposed contractionary policies which magnified the financial problems by creating credit crunches, bankruptcies and ultimately recessions. The IMF was analogous to the generals, who according to folklore, are always prepared to fight the last war but not the current war. Although Mexico was also forced to impose contractionary policies, the emphasis in that crisis, due to U.S. involvement, was more on providing additional reserves. The U.S. did not have the incentive to help the Asian nations that it had had with Mexico. An economic crisis in Mexico has more direct implications for the U.S. in terms of reduced exports, increased immigration, and investor and commercial bank losses than similar crises in Southeast Asia. Support for Mexico was also provided because officials within the U.S. also needed to save face for their own policies since the NAFTA had just been created and inevitably it would be blamed for the crisis. Once it was clear that the needed support for these Asian nations would not be forthcoming, and depreciation and depression were likely, it become clear to all that any investment in an emerging market was subject to a significant capital loss once the slightest exit of capital began, regardless of the economic fundamentals. The result was irrational and speculative markets where self-fulfilling expectations dominated, although each investor appeared to be acting rationally. Ragnar Nurkse (1944) carefully documented that global capital markets had this characteristic during the world's previous period of global financial freedom in the 1920s and 1930s. Thus this lesson had been learned before but the free market gurus which had come to dominate the global institutions and central banks believed that things were now somehow different. After the currency crises moved through Russia and on to Latin America, a line was drawn in the sand at the shores of Brazil. The fundamentals were not better for Brazil, but by that time it was realized that a severe blunder had been made in not providing more liquidity for Asia. Brazil's rescue was a last ditch effort to contain the crisis before it truly engulfed the rest of the world. Brazil's depreciation against IMF advice also helped. Although the hot money movements were finally contained, much of the developing world was thrown into a recession and net capital flows to the emerging markets in 1999 were half of their 1996 value.

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What is the optimal policy response for a nation experiencing these capital outflows? As is apparent from the prescribed IMF response as well as alternative suggestions by other government and academic economists, there really is no "desirable" policy response; all of the alternatives have some really undesirable consequences for the affected nation. Although this question must still be addressed, since inevitably some countries will find themselves in this predicament, it is natural to ask another question as to whether it is possible to avoid the whole situation altogether with a different set of policies in the years prior to a crisis. What is remarkable about the analysis of the Asian crisis is how the arguments concerning banking solvency, transparency and crony capitalism came to dominate the debate as the crisis unfolded, when in fact, these were largely side issues or consequences instead of causes. That is not to say that these "regulatory" issues are not important and that reforms were not needed; prudent financial regulation is always a good idea, but its absence need not produce global financial panics as is evident by the absence of such panics during much of the post World War II period. If these nations had dollar-based economies, or capital markets closed to foreign investors, it is unlikely that there would have been be any crisis at all other than a few investors losing some money. What has turned some insolvent companies into a full-fledged global economic crisis was the foreign currency aspect of the crisis. The fundamental problem was that the assets and liabilities were denominated in different currencies. Thus the cause of the crisis was in the design of the IMS which allows liberal capital flows but does not provide a lender of last resort for foreign exchange; the fundamental problem is not in the lending and investment practices (in domestic currency) of these nations' banks and nonfinancial firms, although increased vigilance is, nevertheless, warranted. These currency crises are like a run on a bank. In the banking analogy, the term structure of the assets and liabilities are significantly different, making a run possible which can bring down even a sound bank; in the emerging markets, the currency of the assets and liabilities (as well as the term structure) are different. The result is that sound economies can be brought down. Just as bank should not allow its term structure of assets and liabilities to vary if there is no lender of last resort, no country should allow its assets and liabilities to be in different currencies if there is no foreign currency lender of last resort. To avoid future crises, the sensitivity of capital towards speculative outflows needs to be reduced, banks and firms should

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be restricted from taking on foreign currency debt, and there needs to be some mechanism to provide more foreign currency in times of an outflow. Although all capital is potentially capable of participating in a capital outflow, some types are much more susceptible to an outflow and some types entail greater economic costs. The retired school teacher can transfer her retirement savings from domestic to foreign accounts in order to avoid a currency depreciation, but that is far less likely than foreign investors deciding to repatriate their investments or foreign banks deciding not to roll-over short maturity debt. Therefore those forms of capital that are most subject to rapid outflow should be restricted or at least subject to outflow constraints. Chile's restrictions on short-run capital inflows also appears to be a sensible policy since they reduce the amount of short maturity capital that can leave. At the global level, a Tobin tax on foreign currency transactions may also prove beneficial in reducing volatility. In regard to restricting foreign currency debt, the critical issue is the need to limit debt which would be significantly increased in value by a currency depreciation and which could thereby threaten the solvency of domestic firms. Thus portfolio investment, although subject to the same "irrational" speculative flows, may not have the same devastating consequences as direct bank or firm borrowing. Therefore restrictions should be concentrated on direct borrowing in foreign currency; it will take time to determine if an outright ban is required or if disincentives such as eliminating the interest deducibility of foreign currency loans will be sufficient to keep them to manageable levels. Central banks need access to more international reserves; either the central bank can accumulate more international reserves by running current account surpluses, or the reserves can be borrowed from an external source such as the IMF or other arrangements with foreign governments. However, to have the domestic central bank accumulate international reserves during the capital inflow period (i.e., prior to the crisis) does not appear to be an economically sound policy. If the inflows are sterilized which would be necessary to keep inflation under control, the resulting higher interest rates will counteract much of the postulated benefit of the increased foreign investment. In addition, the central bank which accumulates foreign reserves will invest these in low yield (U.S. or other reserve country) government securities. Thus from the developing nation's overall perspective, it is borrowing at commercial rates and reinvesting at U.S. government rates; this hardly seems like a

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sensible policy. In addition, it is not sound government finance since the government has to issue its own bonds (when it sterilizes) paying high interest rates and then reinvest the money in foreign (reserve currency) bonds paying a lower interest rate. In order for some external source to provide the needed international reserves, the external provider is likely to require that it be given some supervisory control in order to avoid irresponsible borrowing; the result is the loss of national autonomy in making economic decisions. The unlimited provision of funds results in a moral hazard encouraging the borrowing government to act irresponsibly; however, charging market interest rates for loans could help reduce the moral hazard problem. Of course, simply having access to an international lender of last resort is likely to significantly reduce the need for one by reducing speculation. The enlargement of IMF resources which was approved by Congress in the fall of 1998 was a step in the right direction but more will be needed. Current IMF resources were designed to deal with current account problems, reserve levels needed to address capital account disturbances will have to be much larger. Enlarging the IMF's resources through quota increases may be sufficient to allow it to act as lender of last resort; however, there may come a time when the IMF (or some other global institution) will have to be given the power to create reserves (as the Federal Reserve has domestically) in order to carry out this function. Giving the IMF the discretionary power to create additional Special Drawing Rights (SDRs) would be one option. A solution will probably require reforms on all three fronts: restrictions on foreign currency loans, larger central banks reserves, and larger and more automatic reserves from the IMF. However, over the last decade, policy has been moving in the opposite direction. Countries have been loosening their restrictions on capital inflows (often at the insistence of the IMF), central banks have not intervened in the exchange markets but have allowed the capital inflows to appreciate (at least in real terms) their currencies (which created large current account deficits), and IMF resources have been allowed to shrink dramatically relative to foreign exchange activity. Thus emerging markets now find themselves in a situation with significant foreign currency debt, minimal international reserves, and an IMF unable and unwilling to lend sufficient amounts to reassure investors. Once a significant currency outflow begins there are basically four options: (1) stop the currency outflows with exchange controls,

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(2) raise domestic interest rates to a level high enough to compensate investors for any depreciation risks, (3) allow the exchange rate to drop to whatever rate is needed to re-establish "equilibrium," or (4) obtain more reserves from the "outside world." The ability to carry out option (4) is not a viable option for most countries (Mexico was a special case) since there is currently no source for these funds. Thus they are left with the first three and there are major costs to each of these options: for option (1) there are transaction and administrative costs and microeconomic inefficiency, and the possibility that controls may limit future capital inflows needed for development, for option (2) recession and unemployment are likely, and insolvency for heavily indebted firms, and for option (3) insolvency for firms with debt denominated in foreign currency, large changes in competitiveness requiring costly reallocation of resources amongst sectors, and cost-push inflation which could start a vicious circle of depreciation and inflation. As can be seen, there is no cost-free or obvious alternative; clearly these emerging market nations are boxing themselves into a corner and there is no way out that doesn't entail significant costs. The question is which policy, or which combinations of policies have the minimum of undesirable effects. In the current environment a combination of policies is usually advanced, but the emphasis differs: Paul Krugman appears sympathetic to the first, the IMF the second, and Jeff Sachs the third (Radelet and Sachs, 1998). Although not currently an option for an individual country, it is being suggested here that it is the fourth option—that of providing more external reserves, that needs to be given more consideration in avoiding future crises. IV. GLOBAL DEFLATION (THE IMS'S BIAS TOWARDS DEFLATION)

Global liquidity needs to be determined by some form of centralized mechanism that determines liquidity based upon the needs of the global economy; however, in the current system global liquidity is determined by default and in most disequilibrium situations is below the optimal level. As a result, the world economy is biased towards deflation. This design flaw was a major contributing cause of the Great Depression, the breakdown of the inter-war gold standard as well as the Bretton Woods fixed exchange rate system, the inflation of the 1970s, the high unemployment rates throughout Europe in the 1990s, and now the current recession in the emerging

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markets. This underlying problem was first identified by John M. Keynes in his assessment of the inter-war monetary system and although he attempted to correct this defect in his proposed design of the post-World War II Bretton Woods system, his views on this matter were largely vetoed by the U.S. Treasury (as were Triffm's in the 1960s). This defect currently persists in the post-Bretton Woods flexible exchange rate non-system. More specifically, the design flaw is that when a disequilibrium develops in the global economy due to a change in either real conditions or investor sentiment, the region from which capital is flowing out is required to adjust by contracting while the regions into which this capital is flowing have the luxury of pursuing their own self-interest by neutralizing these inflows to maintain their desired domestic conditions. The result is a deflationary bias to the world economy. This results from the fact that foreign exchange reserves have asymmetric bounds, they have a minimum of zero but an unbounded maximum. Of course, the current monetary system has attempted to lower the minimum bound below zero with borrowing from private commercial sources, IMF lending, and government swap agreements, and the IMF briefly created a meager amount of Special Drawing Rights. However, the situation remains asymmetric in that losses of foreign exchange are fundamentally different from gains. The result of a disequilibrium is that deficit nations are required to restrict demand which results in recessions and deflation while surplus nations need not increase demand since they can neutralize these capital inflows. Once deflation takes hold in the deficit nations, however, history shows that the economic turmoil in the deficit nations ultimately spreads in a perverse manner through financial contagion and trade flows and ultimately brings crisis even to the fortunate nations spared from the original pain. As the surplus nations' exports fall, and as their investors lose confidence due to accumulating losses on foreign loans, demand falls. The fall in demand and the appreciating currency results in deflationary pressures even in the surplus nations. The surplus nations' central banks generally do too little, too late. In the global financial crisis of 1997-98, the emerging markets had to initiate draconian deflationary policies in order to keep capital from fleeing. Meanwhile the capital inflow nations (mainly the U.S. and Europe) continued to conduct monetary policy towards domestic considerations. If there is no global mechanism (e.g., central bank) to provide liquidity, then a hegemonic national

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central bank must do so. As is usual, unlike the Europeans, the U.S. at least gave minor consideration to its global responsibilities by lowering interest rates; however, the Federal Reserve's action in 1998 was primarily motivated out of concern about a domestic slowdown due to falling exports and errant financial markets. The Bundesbank's and then the European Central Bank's continued monetary tightness despite Europe's high unemployment rates was especially flagrant. Eventually, the G-7 did recommend interest rate reductions and the reductions that did follow were important, especially psychologically, in containing this crisis. Nevertheless, the U.S. and Europe largely neutralized their capital inflows and were able to maintain stable conditions in their regions; globally, however, the overall effect was the destruction of global liquidity which biased the world towards deflation. This pattern has been repeated numerous times this century. The Great Depression was largely the result of surplus nations sucking liquidity out of the global economy. As Kindleberger has argued, the U.K. was unable and the U.S. was unwilling to accept the role of global central bank. During the late 1920s, first it was France that drained gold from the rest of the world by running surpluses due to an undervalued currency; they further reduced global reserves by demanding gold for their British pounds and effectively turned the gold exchange standard into a gold standard. These actions compounded an already low level of world reserves which existed due to the attempt by many nations to return to pre-war parities after the inflation of the First World War. These developments prompted monetary tightness in the deficit nations during 1928 and 1929; France failed to provide an equivalent stimulus and the result was a recession in the U.S. in 1929. After the U.S. recession began, the U.S. also became a surplus nation and also began draining gold reserves from much of the rest of the world. Once again, the surplus nations failed to provide any counteracting stimulus and, as a result, the depression ultimately became global. An even more recent parallel, albeit on a smaller scale, that is instructive has been the high unemployment rates in Europe experienced throughout the 1990s. After the fall of the Berlin Wall, the German government, in order to revitalize the East, went from a budget surplus in 1989 to fiscal deficits of around 3% of GDP for the next 7 years. The result was higher interest rates which had the effect of sucking capital out of the rest of the European Union (EU). Those nations that attempted to maintain their exchange rates with the mark were forced to raise their interest rates to keep

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capital at home. The result was low growth and, due to particularly inflexible labor markets, increases in unemployment in all the peripheral EU countries. The Bundesbank, however, did not allow the fiscal stimulus to inflate the German economy; monetary policy was kept sufficiently tight in order to counter the fiscal stimulus. Thus, once again, the same pattern emerges, the capital outflow nations experience recession while the inflow nation has the luxury of selfishly maintaining stability. The overall result is a deflationary bias. And once again, the same long-run pattern emerges, the deflationary effects ultimately find their way to the capital importer as unemployment in Germany (the western Landers) increased slowly from 5% in 1991 to almost 10% by 1997. Throughout Europe the cyclically unemployed have now become structurally unemployed as human capital is depreciated by periods of unemployment (hysteresis) . The EU members of this currency arrangement clearly realized that it was undesirable to be part of a monetary system where the central bank (the Bundesbank was in effect the central bank of Europe) made decisions not on the economic conditions of the entire region but only on the economic conditions in a sub-part of the region, e.g., Germany. It would be equivalent to the U.S. Federal Reserve making monetary policy based on conditions only in New York state instead of the entire country. Thus the Europeans decided to replace this arrangement with the Euro controlled by a European Central Bank which would base monetary decisions on EU-wide economic conditions and not just conditions in Germany. The Europeans have clearly recognized the basic problem— economic stability requires that monetary policy be determined by a centralized authority which determines liquidity based on the economic conditions of the entire region. The current proposals about dollarization for Latin America only show how poorly the current IMS is performing. The sad fact is that given the current instability in international financial markets, dollarization may actually be a better alternative despite the fact that Latin America and the U.S. have none of the characteristics of an optimal currency area, and Latin America's economic conditions would not be a significant factor in affecting the Federal Reserve's monetary policy. The exception to this pattern of global liquidity contraction during disequilibriums is when, as in the 1970s, the deficit countries are the creators of international reserves; instead of having to deflate to conserve reserves they can simply print them. In addition, in this situation the surplus nations did not neutralize the surpluses

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but instead recycled them. The U.S. has been the great defender of the current architecture because it has this luxury of being able to print international reserves, and is therefore free from ever having to be the economy required to deflate. Thus, although the global inflation of the 1970s would appear to be contradict the view of an IMS biased towards deflation; properly interpreted, the inflation of the 1970s has at its roots the same design flaw. V.

CONCLUSION

The current international monetary system is deficient in a number of ways. Three areas are readily apparent from the global economy's current situation. The current system is unable to transfer savings from nations that "over"-save to those in need of the savings. The current system is susceptible to "irrational" hot money movements that are wreaking havoc on basically sound economies, and the current design is such that these capital flows do not just redistribute demand from one area to another but actually result is an overall decrease in global demand which imparts a deflationary bias on the global economy. The economic recession in Japan, the Asian currency crises, and the recessions throughout the developing world are all significantly connected to these design defects. The problem is that economies that are highly integrated need a central bank to facilitate the transfer of resources, act as a lender of last resort, and control the level of liquidity. Keynes recognized this half a century ago; however, because of the public's desire for national autonomy, a patchwork of institutions and programs has had to oversee the operation of international monetary affairs. The shortcomings of the current approach will continue to become more apparent as economic integration proceeds. The history of the economic integration of the U.S. and Europe clearly bears this out. Currently Tony Blair and Bill Clinton are talking about a new Bretton Woods conference to provide bold initiatives to prepare the world economy for the 21st century. However, it is extremely unlikely that anything bold will be proposed, instead the proposals will likely be small and make very marginal changes in the current design of the international monetary system. Certainly the real issue of a global central bank will not be seriously discussed. The sacrifice of national autonomy to a global institution is well beyond serious consideration at this time. However, what can be hoped for are marginal changes in the design of the international monetary system that can partially alleviate some of the shortcomings. What is likely is

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increased funding for the IMF, with perhaps additional emergency funds from various sources such as the regional banks or more swap agreements. Increased financial regulation and monitoring of banking and commercial lending are likely. Capital controls of some form may be adopted. The need for monetary policy in the reserve currency nations to be more oriented towards global conditions must be accepted. This Band-Aid patchwork, which is better than nothing, may keep the system going for another decade or two. At some point, however, the basic design flaws pointed out by Keynes 50 years ago will have to be squarely addressed. The basic problem with the international monetary system is similar to the basic problem confronting the international trading system and the WTO. Despite all the desirable properties of a capitalist market economy, for optimal performance, an economy requires centralized control. As global economic integration proceeds, the patchwork of agreements amongst sovereign states becomes less effective. In the trading regime the issues are the use of common property resources, labor standards, transboundary pollution and other externalities, environmental dumping, intellectual property rights, and the provision of global public goods. The states of the U.S. and now the nations of the EU have recognized that these trade issues as well as the monetary issues discussed here require centralized decision-making; at some future date, an integrated global economy will realize this as well. REFERENCES Edwards, S. (1999) How Effective Are Capital Controls, NBER Working Paper 7413, Cambridge, MA: National Bureau of Economic Research, November. Feldstein, M. and Horioka, C. (1980) 'Domestic Saving and International Capital Flows,' The EconomicJournal, 90:314-329. Krugman, P. (1998) 'It's Baaack: Japan's Slump and the Return of the Liquidity Trap,' Brookings Papers on Economic Activity, 2:137-187. Fischer, S. (1999) 'On the Need for an International Lender of Last Resort,' Presented at the ASSA Meeting, New York, January 3. Nurkse, R. (1944) International Currency Experience, League of Nations. Organization for Economic Cooperation and Development (1997) OECD Economic Surveys—Japan 1997, Paris: OECD. Organization for Economic Cooperation and Development (1998) OECD Economic Surveys—Germany 1998, Paris: OECD. Radelet, S. and Sachs, J.D. (1998) 'The East Asian Financial Crisis: Diagnosis, Remedies, Prospects,' Brookings Papers on Economic Activity, 1:1-74. Rodrick, D. (2000) 'Who Needs Capital-Account Convertibility?,' Princeton Essay in International Finance, forthcoming.

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NOTES 1. 2.

3. 4. 5. 6.

7.

8. 9.

10.

11.

12.

13.

The views are those of the author and do not represent the official position of the U.S. Department of Labor. Organization for Economic Cooperation and Development (1997) OECD Economic Surveys—Japan 1997, Paris: OECD, Chapter 5:107-152 and Table 42, p. 140. Krugman, P. (1998) 'Its Baaack: Japan's Slump and the Return of the Liquidity Trap,' Brookings Papers on Economic Activity, 2:137-187. Can a central bank create inflation if it can't increase aggregate demand? A good evaluation of the IMF's policy response to the Asian crisis can be found in Radelet and Sachs (1998). Net capital flows to the emerging markets were $328 billion in 1996 and were projected to be only $141 billion in 1999 by the Institute of International Finance. Malaysia did implement some controls on capital outflows beginning in 1998; a preliminary evaluation suggests that they played a positive role in helping stabilize the situation in Malaysia, but further analysis using a longer time frame will be required to fully evaluate their costs and benefits. For a contrarian view, see Sebastian Edwards (1999) who argues that the effectiveness of Chile's controls on inflows have been vastly overestimated. The degree to which restrictions on foreign investment may negatively impact growth will have to be compared to the growth-debilitating effects of macroeconomic crises. However even at a general level, Rodrick (2000) finds no evidence that liberalized capital accounts have been associated with higher economic growth. More generally, any time a developing nation accumulates international currency reserves, the developing nation must give up real goods or assets which deprive them of the benefits of seigniorage. Many commentators seem to imply that countries which have run significant current account deficits have acted irresponsibly, but they usually don't articulate exactly what should have been done otherwise. The only alternatives are capital controls and sterilized intervention. Even ignoring the need for additional resources for capital crises, IMF resources would have to be nine times their current levels just to maintain the same ratio of reserves to world trade that existed in 1945 (Fischer, 1999). Organization for Economic Cooperation and Development (1998) OECD Economic Surveys—Germany 1997, Paris: OECD.

21 Euroland Versus the U.S.: Analysis And Framework For Monetary Strategies ANDRE FOURgANS AND THIERRY WARIN

I.

INTRODUCTION

On 10 December 1991, the Maastricht Treaty on Economic and Monetary Union (EMU) was adopted, paving the way for a single European Union currency by 1999. The Treaty extends the Rome Treaty, providing comprehensive institutional and legal arrangements for EMU, and establishing the so-called convergence criteria. Except for the United Kingdom, Denmark, and Sweden, which did not want to enter the EMU, the remaining countries (except Greece) more or less met the convergence criteria. These criteria did not address unemployment and growth objectives. They were based on a country's fiscal performance and its ability to maintain low inflation. Getting Europe's economies into line hinged on: • • • •

An average rate of consumer price inflation that does not exceed by more than 1.5% the average of the three best performing member states; Budget deficits below 3% of gross domestic product (GDP); Total government debt below 60% of GDP; Long-term interest rates, that do not to exceed by more than 2% the three best-performing member states.

Other considerations included exchange rate stability and independence of national Central banks.

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On 3 May 1998, 11 countries decided on the creation of the EMU, to be started on 4 January 1999. The new currency, the euro, was to be issued and managed by the new European Central Bank (ECB), the leading institution of the "European System of Central Banks" (ESCB), to which all EU Central banks would belong; but only members of the Euroland would sit on the ECB's Governing Council. Born on 1 June 1998, the ECB was an extension of the European Monetary Institute which prepared the monetary ground for the ECB. The Central Bank is managed by an Executive Board (the president, vice-president and four other members). This board, together with the heads of the national Central banks, constitutes the Governing Council, the body in charge of monetary policy. The ECB was given a remarkably strong mandate primarily to maintain price stability, while also supporting the general economic conditions of the euro-zone. Beyond these objectives, it got complete discretion as to its monetary policy and instruments. In the autumn of 1998, the ECB established an inflation target between 0 and 2% with an M3 monetary growth as a "reference value" (4.5% a year). The strategy for the exchange rate remains within the hands of the "Euro-11", i.e., the economic ministers of the euro-zone. The ECB is responsible of the implementation of this policy. Needless to say, conflicts could arise between both bodies, especially if the ECB judges that the euro exchange rate policy is inconsistent with its own objectives, notably the price stability objective. First, European economic imbalances could arise from exchange rate movements which could have an impact on the inflation rate. Second, the ECB has a role to play with respect to the Exchange Rate Mechanism II (ERM2) between the euro and the other EU currencies. The Bank may wish to limit the fluctuations between the ERM2 currencies and the euro, as long this policy does not conflict with the price stability goal. This exchange rate mechanism gives the ECB undisputed dominance in deciding whether or not to support "prein" currencies. The ECB strategy with respect to the value of the euro is therefore of paramount importance, especially insofar as it may influence the inflation level, and the conduct of monetary policy. After one year of implementation of the euro, the Bank did not send any obvious signal that the exchange rate would enter the objective set of monetary policy. Its President, W. Duisenberg, always remains rather vague about the subject as long as, in his own words, "the euro exchange rate does not jeopardize price stability." The Vice-President, C. Noyer, was more explicit, considering that the ECB

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based its strategy on a broad range of inflation-related indicators, such as growth, wages, balance of payments and the exchange rate. By now, the weight of the European currency in terms of GDP or world trade is not very different from that of the U.S. In this context, an unexpected depreciation of the dollar against the euro will still have a negative impact on European growth, at least in the short run. But the ECB may retaliate by trying to have the euro depreciate with respect to the dollar in order to give economic advantages to the euro zone. The reverse situation could also occur. If the euro depreciated vis-d-vis the dollar, the Fed would follow a policy leading to a depreciation of the dollar. In these cases, what would be the optimal policy for Europe (or the US)? Should the ECB (the Fed) take the euro-dollar exchange rate as an objective of its policy? And what would then be the consequences on the volatility of the euro-dollar exchange rate? Depending on the authors, conflicting answers are given to these questions. Some (such as Cohen, 1997; Martin, 1998) consider that the euro-dollar exchange rate will be more stable than the value of the former European currencies with respect to the dollar. On the other hand, for other authors (such as Alagoskoufis and Fortes, 1997; Driskill and McCafferty, 1980; Black, 1983), the euro-dollar exchange rate would be more unstable than the dollar exchange rate of the former national currencies. This chapter analyzes the need for the ECB (or the Fed) to take the exchange rate into consideration while setting its monetary policy. This does not mean that the Central bank should directly intervene on the foreign exchange market. But it may send "signals" as to its policy vis-d-vis the euro in order to influence the information set of players on the exchange market. To study this type of question, a game theoretical approach is an interesting tool. It allows an analysis of different possible strategies and their implication as to the choice of the exchange rate as a policy objective. Section II of this chapter discusses the ECB monetary policy in 1999. Section III analyzes the model within a finite as well as an infinite horizon framework. Finally, section IV concludes and presents some policy implications. II.

ECB MONETARY POLICY AND THE EURO ONE YEAR AFTER

Monetary Policy and The Value Of The Euro

Before the launch of the euro, the European economic situation was a golden mix. Exports in the five largest economies of the euro-zone

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(90% of its GDP)—Germany, France, Italy, Spain and the Netherlands—were growing at their fastest rate in 20 years. Growth was steady and inflation was low. While the impact of Asia's financial crisis was expected to cut European exports, Europe was the least exposed of all developed zones. Skeptics thought that Europe's recovery was built on fragile foundations insofar as the export growth was associated with small consumer demand. But business and consumer surveys were showing signs that the engine for expansion was switching from exports to domestic demand. Even though Europe's resurgent economy did mask some fundamental structural problems—inflexible labor markets, burdensome tax systems and heavy welfare regimes—the favorable outlook was expected to help the launch of the euro. Inflation had also decreased in all EU countries. Long-term interest rates were on a downward trend in the 11 future Euroland countries. Fiscal policies had become more rigorous and budgetary positions had improved. At the end of 1998, short-term interest rates had converged to 3% in all countries. And on 13 December 1998, this rate was chosen as the base rate in the money market by the ECB. In 1999, monetary policy appeared to be geared exclusively towards price stability and the value of the euro did not seem to play a role in influencing that policy. The harmonized consumer-price index had increased by 1.6% in December 1999 compared with December 1998; that is, close enough to the 2% ECB inflation rate ceiling. On 8 April 1999, the ECB lowered its main interest rate by 0.5% to 2.5%, while the euro was depreciating vis-d-vis the dollar, from a value of 1.1827 dollars on 4 January to 1.0893 on 1 March. On 11 March, Oscar Lafontaine, Germany's finance minister and advocate of a weaker euro, resigned. Mr. Lafontaine's departure led to a short-term euro increase. It then continued its decrease to 1.0233 on 1 July. On 15 July, ECB President Wim Duisenberg suggested that the ECB was leaning towards higher interest rates. Combined with stronger than expected German business confidence, this announcement precipitated a rise in the euro value, up to 1.0912 dollars on 15 October. This was a seven-month high resulting in part from negative comments by U.S. Federal Reserve Chairman Alan Greenspan on "overvaluation" of the dollar and of the U.S. stock market. On 4 November, the ECB indeed raised its interest

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rate by 0.5%, bringing it back to its value at the beginning of the year. Then, in spite of the interest rate rise, the euro went down again to around 0.99 by 2 December 1999. For the first time since its birth, the euro dropped briefly below parity with the dollar. Overall, in 1999, the euro had declined by about 14% against the U.S. currency, and did not appear to be sensitive to ECB's interest rate changes. At the beginning of the year 2000, Mr. Duisenberg announced that the European currency had stopped its downward trend and had a strong upward potential for 2000, especially because of the expected increase in Euroland growth from 2% in 1999 to 3% in 2000. The Role of the Euro in 1999 The euro and international trade The euro is the second most used currency in the world, after the dollar and before the yen. This situation is the result of the eurozone economic weight in the world economy. Compared to the U.S., Euroland shows a lower GDP, but represents a more significant part of world exports, while its stock exchange capitalization is significantly smaller (Table 21.1). In terms of trade, the 11 euro-zone countries accounted for about 20% of world exports, excluding trade within the Euroland, compared to 16% for the U.S. and 7% for Japan. Roughly speaking, 50% of world exports are made in dollars. TABLE 21.1 Essential Figures of the Euro-zone, the U.S. and Japan (1998) Population (millions): GDP (billions of euro): % of world GDP: in nominal term intermofPPP Exports of goods and services: % of the GDP % of world exports Stock exchange capitalization (billions of euro): -%ofGDP Source: Eurostat (1999).

Euro-zone 292 5773

US 270 7592

Japan 127 3375

22.2 15.5

29.3 20.8

13 7.4

17.8 20.1

10.9 16.3

11.5 7.6

3655 63

13025 172

2091 62

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The euro and the financial market

The introduction of the euro started to transform Europe's financial landscape. At the euro launch, the U.S. was benefiting from its eighth consecutive year of expansion, while Japan and its Asian partners were struggling to get out of their financial crisis. With time, the euro may be an alternative to the dollar as an international currency. The emergence of a "robust alternative" to the dollar might influence the sensitivity of international investors towards U.S. economic policy. The U.S. stock and bond markets, for example, might become more prone to important sell-offs in the event of policy mistakes; and the demand for dollars may become more elastic to these policies. Countries such as Brazil, Argentina, South Africa, Canada, and the Philippines issued substantial amounts of euro bonds in order to change their currency portfolio of international debt, with a higher weight given to the euro. In addition, there was a clear tendency to increase the financing of mergers within the euro-zone (financial institutions, large industrial companies) via the international euro-bonds market. Over the first two quarters of 1999, new issues of international assets in euros were greater than the sum of old national currencies issues in the euro-zone before 1 January 1999. During the same period, international issues of money and bond market instruments in euros rose to €100 billion against €87.1 billion for those in dollars. Compared to the figures for the first two quarters of 1998, the issues in the old national currencies of the future euro-zone represented €61 billion against €142.5 billion denominated into dollars. At the beginning of the year 2000, expectations are that the European Central Bank may raise interest rates if inflation accelerates. "Mean expectations" seem to be that the Bank will raise its 3% benchmark rate by 50 basis points in the first half of the year, as far as future contracts may indicate. The euro as an international reserve currency

The credibility of monetary policy, and its impact on the confidence in the euro, is a crucial point to influence the euro-dollar exchange rate, but also the use of the euro as a reserve currency. When the European currency was launched, European policy-makers, academics and financial market participants were rather optimistic about its prospects, some going so far as to predict a rapid challenge to the dollar as an international and reserve currency.

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The euro-optimists noted that the euro bloc compares favorably to the U.S. in terms of population, gross domestic product and share of world trade. Does that mean that the euro is a threat to the might of the dollar? The answer to this question depends ultimately upon the economic situation in the euro-zone, European financial markets evolution, and ECB monetary policy. It will also depend upon the European authorities' willingness to promote the international role of the euro. What does a country gain when its currency has an international reserve role? Extra seigniorage revenue is one obvious benefit. Other advantages are the ability to use the currency without exchange rate risks, the possibility of running trade deficits without excessive worries as to the changes in the value of the currency, and the ability to finance public deficits more cheaply. It is too early to know whether the ECB and the European States authorities give much weight to these considerations. At any rate, the different strategies that both the US and the European monetary authorities may follow is an important factor to consider in the future of the euro. Hence, the importance of modeling this type of behavior. III.

THE MODEL

Assumptions of the Model

Why use a game theoretical approach to study that question? The main point is that this method allows one to introduce all the information set and its evolution in a dynamic process. And also to analyze the possible occurrence of exchange rate misalignments in spite of rational expectations. Assumptions about the way expectations are made are a major stake in modern economics. Adaptive, they allow too much room to fluctuations. Rational, they subscribe to the idea that there exists a unique equilibrium towards which all economic forces converge. In the debate on exchange rate policies, adaptive expectations often lead to the defense of a fixed exchange rate regime. Rational expectations are more associated with floating exchange rates. Since Kydland and Prescott (1977) and Barro and Gordon (1983), a second level of analysis has entered the debate. If a Pareto-optimal economic equilibrium exists, the solution chosen by economic agents may be a second best, depending upon whether these agents trust the authorities in charge of monetary policy or not. The concept of "credibility" was born, and with it the demonstration that rational expectations could also leave room to fluctuations.

360

Andre Four^ans and Thierry Warin

Applied to the exchange rates, this approach implies that the external value of a currency depends in all likelihood on fundamentals (Rogoff, 1999; MacDonald, 1999), but also on the expectation of these fundamentals. The Central Bank, through the signal it may send out about its management of the currency, is a very important actor in the way expectations are established. The structure of the economy in the model

• Assumption 1: the International monetary system rests upon two currencies : the dollar and the euro. • Assumption 2: both currencies are regarded as having the same weight on world GDP. • Assumption 3: both currencies are used equally in world transactions. • Assumption 4: both countries produce a single commodity and the PPP holds. As the trigger strategies are not taken into account in the model, the monetary authorities cannot improve their reputation during the game. From these assumptions, the unemployment rate in both countries (i= 1, 2) is represented by: M.

= fi-p(Pj.-pU'- = 1,2,

(1)

where u is the equilibrium unemployment rate, p ( the relative change of the exchange rate and pi the relative change of the expected exchange rate of country i, with i = 1, 2. Obviously, in a two countries model, p, = -p2 . But, in order to emphasize the strategies of both players, different symbols for the countries' exchange rates are maintained. Players' objectives

Both players have the following loss functions (Barro and Gordon, 1983; Persson and Tabellini, 1996): Lf = («(.)2 + a(p,.) 2 ,i = 1 , 2 ,

(2)

where a_> 0 introduces the relative weight of the two partial objectives. A high a implies that a given player gives more importance to the stability of the exchange rate than to the unemployment rate.

Analysis And Framework For Monetary Strategies

361

And conversely for a low a equals one means that the player gives the same importance to both objectives. By substituting Eq. (1) into Eq. (2), the loss functions become: L,. = (S-p(p.- P ;)) 2 + a(p.)2

(3)

Players' strategies

Two strategies are possible: the "hawk" and the "dove". In the first case, player 1 reacts to a previously unexpected depreciation of the other country's currency by a non-announced depreciation of his own currency in the following period in order to mislead the other's exchange rate expectations. In the second case, the first player does not react to an unexpected depreciation of the other currency and does not try to mislead expectations. Repeated Game with a Finite Horizon

The repeated game is played within a complete information framework. Each player knows the strategies of the other as well as the payments. Three occurrences are then possible. The generalized "dove " strategy

In this case, neither player tries to mislead the other's expectations, i.e., does not try to follow a policy that would lead to a depreciation of his own exchange rate. In the model, this means p; = 0 and pf = 0.

Both "dove" loss functions become: D/D

T L,

2

, D/D

= (u) and LT 2

.2

= (u) .

/Ax

(4)

One country's "hawk " strategy

In that case, one country decides to upset the other's expectations. If country 1 is the "hawk" country then pi = 0, but p, must become positive in order to minimize the loss function. Hence, the "hawk" loss function is: L"/D = (S-pp^ + aCpj) 2 ,

(5)

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Andre Fourgans and Thierry Warin

which is minimized with: _

"P

oc+p 2 By substitution, the loss function becomes: cc«2 r H/D

(6)

(V)

As far as the second country is concerned, p 2 = 0, and p^ = 0 which leads to: LD/H

2

22

_ u (a+ 2P )

/ON

2 2

(oc+p )

The generalized "hawk " strategy

The game being played with perfect information, each player knows the other's strategy. The minimization of the loss functions leads to: _ Pi ~

oc+p

(9)

=

r2

a+P

Furthermore, each policy being expected by the different players means that: pf=p2 and p2K=PiTherefore: p, = SB and

P2 =

56

(10)

This result shows a "bias" towards depreciation from both countries, even though they do not improve their unemployment rate which remains at the structural level. The two loss functions become: H/H (U)

H/H

Both of these functions are higher than those of the "dove" strategy. The equilibrium strategy of the game

The results can be presented in the following matrix form (Table 21.2).

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363

TABLE 21.2 Matrix Representation of Strategies and Results Second country: Hawk p2>0

Second country: Dove p2 = 0 [

U

First country: Dove Pi = 0

M 2 (a + 2p 2 ) 2

D/H

D/D _ _ 2 L

\

1

(a +

_2 D/D \L (L2 -~ U

au 2

LH/D

P2)2

rv _L. R2

au2

H/D First country: Hawk Pi>0

H/H

a TD/H

2

2

22

-2X«2

_ u (a + 2p )

,/////_ u (p + a)

~

^T

2 2—

-

(a+p )

With a very close finite horizon, the cooperative behavior ("dove") is dominated by the non-cooperative behavior ("hawk").1 The only equilibrium for both players is not to cooperate and therefore to follow the "hawk" strategy : the (H, H) solution. This is a traditional result of the prisoner's dilemma in a repeated game. The backward induction process implies that the only sub-game perfect equilibrium is when both players do not cooperate at each period. However, as Selten (1978) pointed out, it could appear interesting to cooperate. The two players could prefer to agree and play the (D, D) strategy which leads to a better payment for both of them. Yet, if one decides to play "dove", it becomes interesting for the other to play "hawk" (Table 21.2). As a main result, both will play (H, H), that is to say the sub-optimal strategy. The optimal Pareto combination is (D, D). But, this strategy is only possible if both countries agree on a bilateral contract aiming at a stable exchange rate. Otherwise, the dominant strategy is the discrete one, i.e. (H, H). The Repeated Game with an Infinite Horizon

Now is considered the prisoner's dilemma situation with a repeated game with an infinite horizon or a finite one with a sufficiently distant last period. In that case, the Kreps and Wilson (1982) approach can be used and the game is played with imperfect information. As the interest is about the "hawk" against "dove" strategy with a possible penalty (unexpected depreciation), the "folk theorem" can be used as well with an infinite horizon as with a finite

364

Andre Fourgans and Thierry Warin

but sufficiently distant one (Benoit and Krishna, 1985; Friedman, 1985). The players' possible choices

The gains or costs of distorting the other player's expectations are evaluated with respect to the best possible result: , D/D

L, T

L0

D/D

_2

=u

-2

= M

(12) ^ '

In a one-period game, if the optimal Pareto solution (D, D) is chosen, the above results are obtained. If player 1 plays "hawk" and player 2 plays "dove", player 1, instead of losing u2, only loses O" ) . 2 His gain is: a, + Rp

(13) On the other hand, player 2 loses:

With a multiple-periods game, things may change. Player 2 is able to sanction player 1 in the following periods. Player 2 gains if he plays "hawk" and player 1 plays "dove" in the following period. And player 2 loses less if player 1 plays "hawk". Yet, the latest solution brings about a loss compared to the optimal Pareto situation. It is therefore interesting for both players to minimize the number of periods where the results are sub-optimal. Player 1 must quickly establish his credibility if he does not want to lose continually through the (H, H) strategy, where the loss is:

Given this information, both players decide on the duration of the conflict and thereby on their strategies (Table 21.3).

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365

TABLE 21.3 Matrix Representation of the Profits and Losses Second country: Dove p, = 0

Second country: Hawk

p2>o L

{LOSS - o

First country: Dove

(a+p2)

[Gain = 0

P;=0

^ . Gain —

1

Gain = First country: Hawk p,>0

Lo^

I

2 2

« 2 p 2 (2a + 3p 2 ) _202 « c P

—

a+p _2g2

— a+p2

Loss = —t— a

2

_ « p (2a + 3p ) (a + p 2 )

2 2 Lo- - " P

a

Equilibrium with unknown horizon

A player plays "dove" if the gains resulting from the "hawk" strategy played at one period are lower than the present value of losses of the penalty decided by player 2:2 Gains < t2^ = ) 8 Losses

(16)

where 8 = (1+R) 1 < 1 is the present value factor and R, the real interest rate. A low 8 means that the player does not exploit the penalty strategy for too long a period. After substitution, the condition becomes: , _ (O.U

_202 T U P £ a

p 2 )p 2

(17)

t=

1-6

(18)

If T* is the period where the player can be indifferent between the "hawk" or "dove" strategy, Eq. (18) implies that:

(a+p2)p2

J

-5

(19)

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Andre Fourgans and Thierry Warin

When T > 7*, the present value of losses is higher than the gains from the "hawk" strategy. The latter will therefore not be adopted. When T< 7*, the gains from the "hawk" strategy are higher than the present value of losses. This strategy will therefore be adopted. These results can be graphically presented (Figure 21.1). By defining /(r,8) = 8 ( 1 ~jj i _ i ^ 1 —O 18 can be written: 10

-

5L

)

with /(l,8) = 8,f£>0 and|£>0, Eq. (* L

T~:i
«x+p 2 )p 2

u1

(20)

For illustration purposes, f(T, 5 ) is drawn with 6 = 0.98 (meaning R equals 2%). The gains from the "hawk" strategy do not then depend on Tand are equal to:

8 =

a

(21)

When a = 0 (the loss function depends only of the unemployment rate), g = 0. When a = 1 (the same weight is given to unemployment and to the change in the exchange rate in the loss function), g = ; and when oc-> + °°, g -> +°o. (1+ P )P

When player 1 addresses a signal that he gives more and more weight to unemployment than to the exchange rate (a decreases), the penalty period decided by player 2 becomes shorter and shorter. When less and less weight is given by player 1 to unemployment, the second player's penalty period increases. IV.

POLICY IMPLICATIONS AND CONCLUSIONS

The proposed model has some main policy implications. In the finite horizon case, an optimal Pareto solution can only be attained if both players mutually agree not to disrupt each other's expectations on the exchange rate. In the infinite horizon situation, things are somewhat different. It is in the interest of each player to address a clear and strong signal to the other about its own strategy. In other words, it is in the interest of each player to let the other know that if he tries to mislead his expectations, he will himself fire back by misleading the other player's expectations. Hence, a strong signal on the part of both players would reduce the duration of the possible conflict and therefore would reduce the volatility of the exchange rate.

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367

a increases

FIGURE 21.1 Impact of a. on the Penalty Period

These implications have something to say about the future relationship between the euro and the dollar, i.e. between the European policy-makers and the U.S. policy-makers. From the Maastricht Treaty, the main objective of the European Central Bank must be price stability. If the Bank seeks only to achieve this objective, that is to say internal stability without taking into consideration the euro-dollar exchange rate, it signals to the Federal Reserve that it will always follow the "dove" strategy. In that case, the U.S. policy-makers can upset European expectations about the exchange rate and gain from the operation. In order to avoid this type of occurrence, the European policy-makers would be better off changing their strategy and giving the Americans the signal that they will retaliate by also upsetting exchange rates expectations. In that case, it is in nobody's interest to create a conflict because the gains earned during one period by the U.S. would be more than compensated for by the losses suffered during the other periods, and conversely for the ECB. To go a little further, the model also has something to say about the debate concerning a "new Bretton Woods" reform that would be

368

Andre Fourgans and Thierry Warin

necessary to stabilize exchange rates via a target zone system. In a finite horizon situation, this proposal would be welcome. It could be interpreted as a mean of establishing a bilateral contract between the U.S. and the European Central Banks on a range of values for the exchange rate. In that case, both policy-makers would be likely to follow the "dove" strategy. In the infinite horizon situation, things are different. A target zone could deteriorate the economic situation in one of the two economies in so far as the exchange rate could not adjust enough to avoid an increase in one country's unemployment. What is necessary, here, is that each central bank takes the exchange rate, at least, as an intermediate objective of its policy. In so doing, each central bank has a dissuasive weapon against any misbehavior of the other central bank. REFERENCES Alogoskoufis, G. and Fortes, R. (1997) 'The Euro-dollar and the International Monetary System,' IMF Conferences on EMU and the Dollar, Washington, March 17-18. Barro, R. and Gordon, D. (1983) 'Rules, Discretion and Reputation in a Model of Monetary Policy,'Journal of Monetary Economics, 12:101—122. Benoit, J.P. and Krishna, V. (1985) 'Finitely Repeated Games,' Econometrica, 53:905-922. Black, S.W. (1983) 'The Use of Monetary Policy for Internal and External Balance in Ten Industrial Countries,' in Frenkel, J.A. (ed.), Exchange Rates and International Macroeconomics, University of Chicago Press. Cohen, D. (1997) 'How Will the Euro Behave?,' in Masson, P., Krueger, T, and Turtelboom, B. (eds.), EMU and the International Monetary System, International Monetary Fund, Washington, DC. Driskill, R. and McCafferty, S. (1980) 'Speculation, Rational Expectations and Stability of the Foreign Exchange Market,'Journal of International Economics, 10:91-102. Espinoza-Vega, M.A. and Yip, C.K. (1994) 'On the Sustainability of International Coordination,' International Economic Review, 35(2):383-396. Friedman, J. (1985) 'Trigger Strategy Equilibria in Finite Horizon Supergames,' Mimeo. Kreps, D. and Wilson, R. (1982) 'Sequential Equilibria,' Econometrica, 50:863-894. Kydland, F. and Prescott, E. (1977) 'Rules rather than Discretion: The Inconsistency of Optimal Plans,'Journal of Political Economy, 85:473-491. MacDonald, R. (1999) 'Exchange Rate Behaviour: Are Fundamentals Important?,' The Economic Journal, 109, November:F673-F691. Martin, P. (1998) 'La politique du taux de change de 1'euro: une question de taille,' Revue d'Economie Politique, 108(2):March-April. Persson, T. and Tabellini, G. (1996) 'Monetary Cohabitation in Europe,' American Economic Review, 86(2), May: 111—116.

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Rogoff, K. (1999) 'Monetary Models of Dollar/Yen/Euro Nominal Exchange Rates: Dead or Undead?,' The Economic Journal, 109, November:F655-F659. Selten, R. (1978) The Chain Store Paradox,' Theory andDecision, 9:127-159. Solow R. (1990) The Labour Market as a Social Institution, Basil Blackwell, Oxford.

NOTES 1. 2.

See Appendix. This method is inspired by Solow (1990).

APPENDIX

In fact, the cooperative behavior ("dove") is strongly dominated by the non-cooperative behavior ("hawk") under both conditions : D/H

T L,

H/H

> LT j

j

D/H

T and L 2

H/H

T >L 2

r^,

,. .

.That is:

(. a + p0 2 )2 which leads to a(*/2-l)p" When a(-72-l)p , there exists two Nash equilibria: (L, ,L 9 ) and (L, ,L 2 ). The solution to this "chicken game" consists in playing the cooperation (see Espinoza-Vega and Yip, 1994) which means that when both players give a high importance to exchange rate stability, they will have a high reputation in playing "dove", even with an infinite horizon game. But the most realistic situation consists in having two policymakers interested in both the stability of the exchange rate and in the unemployment objective. This case is represented by a(*j2 - 1 )P 2 , with (3 < 1, i.e. a very low a. In this case, both players give more importance to the unemployment than to the stability of the exchange rate objective. The only equilibrium for both players is not to cooperate. The solution with an infinite horizon is shown in Section III. D / f-f

J-i /D

22 Global Accounting Harmonization: A Comparison of U.S. and German Views KURTJESSWEIN

I.

INTRODUCTION

Rapid change is taking place in the international accounting standard-setting environment. Led by the efforts of the International Accounting Standards Commission (IASC) and the International Organization of Securities Commissions (IOSCO), this process is leading to the worldwide use of a single set of accounting standards for both domestic and cross-border financial reporting. The demand for such standards is driven by the desire for high-quality, internationally comparable financial information that capital providers find useful for decision-making in global public capital markets.1 However, these efforts are not going on without controversy in various countries throughout the world. Two particularly interesting cases are presented and contrasted—Germany and the United States. Germany offers a unique situation because its current standards differ significantly from those developed by the IASC and, consequently, German firms have to find a variety of ways to address the two competing sets of standards. While some multinationals, Bayer and Schering, for instance, have adopted International Accounting Standards (IAS) in their consolidated statements (within the constraints imposed by the German Commercial Code, known as the Handelsgesetzbuch or HGB), the vast majority of companies continue to adhere to traditional German accounting standards. Others, notably, Daimler-Benz and Deutsche Telekom, employ U.S. 370

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371

Generally Accepted Accounting Principles (U.S.-GAAP) as well as German accounting law and thus publish two consolidated financial statements with differing earnings statements. The U.S., on the other hand, is distinct given that its own welldeveloped set of standards (GAAP) is not unlike the IASC standards (although there are several significant differences in the areas of pension cost measurement, accruals of other employee benefits, deferred income taxes, merger accounting, goodwill, research and development costs, investments, and fixed asset revaluations).2 In addition, the U.S. has the unique position of being the dominant financial and capital market in the world. In large part because of this, the Securities and Exchange Commission (SEC) has consistently refused foreign companies a listing of their shares on the New York Stock Exchange (NYSE), the world's biggest stock exchange, unless they submit annual reports in accordance with U.S.-GAAP, or with a reconciliation of the firm's home-country financial statements with U.S.-GAAP. They take the view that the market-oriented accounting aimed at by U.S.-GAAP leads to a better statement of the actual net worth and profitability of the company. For example, it has been claimed that German financial reporting does not aim to give outsiders such as analysts or investors a "true" or merely "fair" picture of a company's financial condition. On the other hand, the SEC finds itself under pressure to work towards a solution that reconciles U.S. market concerns with the concerns of the global market participants. In 1996, the U.S. Congress passed the Capital Markets Efficiency Act. Under the Act, Congress recognized the increasing globalization of security markets and the accounting difficulties foreign issuers face. Congress recognized that the establishment of a high quality set of international accounting standards would greatly enhance the ability of foreign companies to make stock offerings in the United States. With this Act, Congress has ordered the SEC to increase its efforts toward developing a high-quality set of international accounting standards as soon as would be "practicable."3 In response, the SEC has made it known it will work closely with IOSCO and the IASC to develop global accounting and disclosure standards acceptable to it. However, it has also taken the time to set out the specific criteria the new standards must meet in order to be considered a substitute for U.S.-GAAP. The SEC states that any acceptable global standards must: •

Include a core set of accounting pronouncements that constitutes a comprehensive, generally accepted basis of accounting;

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Kurtjesswein

•

Be of high quality, result in comparability and transparency, and provide for full disclosure; and • Be rigorously interpreted and applied.4 The U.S. has thus made it known it will play by the rules set by the international agencies, as long as those rules meet its very clearly defined criteria. The rest of this chapter is organized as follows. In the next section, some of the principal issues of global accounting harmonization are discussed, highlighting differences between German and U.S. accounting standards. This is followed by a description of the empirical study and a summary of the findings of the survey. The chapter concludes with an evaluation of the results and discussion of the possible implications for accounting standard-setters in the U.S. and elsewhere. II.

CONVERGENCE AND HARMONIZATION

The key to international accounting standard setting is that a single set of high-quality international standards is desirable because its use would improve international comparability; reduce costs to financial statement users, preparers, auditors, and others; and, ultimately, optimize the efficiency of capital markets. In addition, such standards are increasingly being demanded by existing market forces.5 The ultimate goal is to arrive at a set of standards that are internationally recognized as acceptable through, for example, endorsement by the relevant capital market authorities of individual nations6 and through acceptance by financial statement users. The current system of standards is very broad. Aside from the IAS, the accounting standards for the countries of the world can be divided into four particular factions based on the similarities of their accounting practices. First, the British-American model, which includes the U.K, the U.S., and the Netherlands, focuses its accounting procedures on the needs of investors and creditors. Second, there is the Continental model, which is used by most of Europe and Japan. Accounting procedures in the Continental model are legalistic in nature and are designed to satisfy government-imposed regulations. The third model is the South American model. This faction, which includes nearly all of South America, is characterized by its persistent use of accounting adjustments for inflation. The final model is the mixed-economy model. Many countries of the former U.S.S.R. and Yugoslavia use the mixed-economy model. Countries under the mixed-economy model operate "dual accounting systems"

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373

which were formed in the wake of the political upheavals in the early 1990s. In the mixed economy system, accounting information is used in aiding the transition from a command to a market economy.7 Most accounting theorists agree that (1) the capital market organization and (2) the tax system are among the most important determinants of a country's accounting system. To provide background into the differing systems employed by the two countries (Germany and the U.S.) of this study, a short summary of the important differences between the two is presented below. Differences in Capital Market Organization and Accounting

In Germany, the securities markets have traditionally played only a minor role in the financing of industry. The main source of external financing for firms is bank loans. Moreover, it is characteristic of the German system of universal banking that banks not only provide loans to companies but also control major proportions of the equity capital of the large corporations, either directly or as trustees for their customers. Due to their influential position, banks typically do not need financial accounting statements in order to obtain reliable information about a company's assets base, profits or liquidity. Larger banks often have direct access to the company's top management. This focal position of bank finance is at least partly responsible for the fact that the principle of creditor protection (Gldubigerschutz) plays such an important role in German accounting. According to German accounting tradition, the primary function of financial accounting is the conservative determination of "distributable income", i.e., that part of the actual income of the company that can be paid out to shareholders without impairing the position of the creditors or the long-term prospects of the firm. In relation to this, orientation according to the information needs of the investors (i.e., the "true and fair view") has to take second place. In the U.S., in contrast with this, it is the primary function of financial accounting to provide investors with information relevant to their decision-making. Therefore, the overriding principle of U.S. accounting is the true-and-fair-view-principle. The Tax System and Accounting

In Germany, financial accounting and tax accounting are closely interlinked and commercial income constitutes the basis for the

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Kurtjesswein

calculation of taxable income. The tax-base function of financial accounting, or Massgeblichkeitsprinzip, implies that accounting is largely influenced by fiscal goals. In years with high profits, firms will aim for a more moderate level of income in order to reduce their payments of taxes. This is achieved by interpreting in the most conservative way possible the scope and numerous options for accounting and valuation that exist in Germany. The silent reserves that result from these accounting practices may be capitalized in later, less profitable, years. German accounting rules thus allow firms to adjust their profits. At the same time, the various possibilities for accumulating and transferring silent reserves also offer management discretion for pursuing personal goals. The potentially massive silent reserves that are characteristic of German accounting are in conflict with the aim of providing investors with a truthful and reliable insight into the current net worth and profitability of the corporation. In the U.S., in contrast, there is a clear distinction between financial accounting and tax accounting. U.S. financial accounting is therefore not distorted by fiscal objectives, and financial statements can be prepared solely under the true-and-fair-view principle. The close connection between financial and tax accounting must be seen as one of the central obstacles to a modification of German accounting according to Anglo-American or international norms. III.

METHODOLOGY OF THE EMPIRICAL STUDY

The results presented in this chapter are based on a questionnairestudy first undertaken in the fall of 1997 in Germany.9 The original questionnaires10 (written in German) were sent to the Chief Financial Officers of all major (listed) German public corporations with revenues of at least DM 1 billion, a total of 103 corporations. Of these, 66 responded. The resulting response rate of 64% is extraordinarily high for a survey of this type. For comparative data from the U.S., the original questionnaire was first edited for content and then translated into English. This second questionnaire11 was then sent to the Chief Financial Officers of the Fortune 500 firms in the spring of 1998. Due to mergers, only 498 surveys were sent, with responses received from 63. Although the response rate was a disappointing 13%, it did produce a sample of comparable size to that of the German questionnaire. An analysis of the responses showed a good cross-section of German survey respondents, although there was a tendency for the

Global Accounting Harmonization: a Comparison of U.S. & German Views

375

larger firms in the sample to respond over the smaller firms. This bias was not found among the U.S. respondents to the survey. However, it should be noted that both the U.S. and German samples were biased towards larger firms in general and not necessarily firms with significant international or foreign experience or exposures. The responses to the individual questions were summarized and analyzed in terms of frequency and distribution of responses to each question. When comparisons were made between the two sets of respondents, two-tailed Rests and %2 tests were performed to test for significant differences in responses. In cases where a second analysis by response type was made, cross-correlations were made and the resulting %2 statistics calculated. Conclusions from the statistical testing of the responses are reported in the next section. IV.

RESULTS OF THE EMPIRICAL STUDY

In order to provide a foundation for understanding the potential differences in opinions between German and U.S. managers regarding international accounting harmonization issues, the participants in the study were first asked how often they were confronted with foreign financial statements. The potential responses, which were based on a five-point scale, included daily (1), often (2), sometimes (3), seldom (4), or never (5). The results to this question, summarized in Table 22.1, were not unexpected given the geographical realities and the relative size of the domestic U.S. market; U.S. managers were much less likely than German managers to have contact with foreign financial statements. The notable exceptions, of course, were the U.S.-based multinationals in the sample group. To develop a better understanding of the U.S. sample respondents (as the responses of the German sample were largely taken for granted), the survey participants were next asked about their knowledge of or familiarity with the international accounting standards (IAS) and of their familiarity with German accounting standards TABLE 22.1 Frequency of Dealing with Foreign Financial Statements Never 5

Seldom 4

Sometimes 3

Often 2

11 U.S. firms 20 16 3 German firms 5 24 6 29 a /-statistic for mean differences = 4.08 (significant at .01 level) Chi-square = 40.13 (significant at .01 level)

Daily 1 10 1

Meana 3.32 2.52

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Kurtjesswein

(HGB). The potential responses varied between very much (4), some (3), little (2), and no (1) familiarity with either international or German accounting standards. Again, probably unsurprisingly, as Table 22.2 summarizes, U.S. managers did not consider themselves very knowledgeable about the international standards and considered themselves even less knowledgeable about the German standards. Having determined the level of familiarity with German accounting standards by the U.S. managers, the U.S. and German managers' views were then compared in terms of the value each group placed on reporting under the German commercial code. First, each group was questioned about the informational value of financial reports developed under the HGB as compared with those developed under U.S.-GAAP. The survey participants were asked whether they felt German financial reporting resulted in financial statements with information values higher (1), the same as (2), or lower (3) than those reported under U.S.-GAAP. The results, summarized in Table 22.3, show that there was an equally overwhelming opinion of both U.S. and German managers that German reporting standards resulted in financial reports of lesser value than those under U.S. standards. Second, the survey participants were asked whether they felt having to present financial reports under the German accounting standards presented any obstacles (in international financial market dealings) for German firms. The responses of no obstacle (1), minor obstacle (2), major obstacle (3), and decisive obstacle (4) provided interesting results. As summarized in Table 22.4, one finds that while both groups felt there were obstacles to reporting under TABLE 22.2 U.S. Manager Familiarity/Knowledge of IAS and HGB Standards

IAS HGB

Very much 4 4 0

Somewhat 3 14 9

Little 2 20 22

Not at all 1 21 30

Mean 2.02 1.66

TABLE 22.3 Information Value of German Accounting Standards Compared With U.S. Standards

U.S. firms

Higher

Same

Lower

1

2

3

0

9

German firms 17 3 a /-statistic for mean differences = 1.12 (not significant) Chi-square = 2.02 (not significant)

30 46

Mean11 2.77 2.65

Global Accounting Harmonization: a Comparison of U.S. & German Views

377

TABLE 22.4 Financial Reporting Under HGB Poses Obstacles to German Firms Decisive Obstacle

Major Obstacle

Minor Obstacle

No Obstacle

4

3

2

;

17 U.S. firms 4 21 German firms 11 14 39 a £-statistic for mean differences = —3.66 (significant at .01 level) Chi-square = 13.88 (significant at .01 level)

7 2

Meana 2.37 2.89

the HGB, German managers were even more of this opinion than their U.S. counterparts were. Given the somewhat perplexing responses from the U.S. managers (i.e., their perception of HGB being less of a hindrance to German firms dealing in international markets than their German counterparts), a further examination of the responses seemed warranted. Therefore, a second test was made to see whether there was any significant difference in the opinions regarding the value of German accounting standards between those managers professing a reasonable knowledge of the standards and those that did not. No significant differences were found, leading to the conclusion that the German standards were generally considered inferior to U.S. standards, even by those with little knowledge of the differences in standards. In addition, U.S. managers seemed to think this posed less of a problem for German firms than their German counterparts did. One of the critical issues most often raised with respect to the introduction and acceptance of global accounting and reporting standards is the strong position taken by the U.S. accounting agencies (SEC and FASB). The somewhat biased U.S. viewpoint has generally been that any international set of standards would need to meet the high-quality financial reporting found in the U.S. Of course, this "high quality" of reporting is not just a product of highquality accounting standards. It is also dependent upon a supporting infrastructure that works to ensure that these standards are interpreted and applied in a rigorous fashion, and that issues and problems are identified and resolved rapidly.12 Given this situation, the next issue looked at was how the international heterogeneity of accounting standards might be affecting U.S. firms and, secondly, given that differing standards might affect operations, whether U.S. corporate managers (as opposed to the SEC or FASB) believed that harmonization along the lines of the IASC was worth striving for. With a range of potential responses of simply yes (3), somewhat (2), and no (1) to the question of whether differing accounting standards affected the operations of U.S. firms, it is clear

378

Kurtjesswein TABLE 22.5 U.S. Managers'Agreement that U.S. Firms' Operations are Affected by Heterogeneous Accounting Standards No 1 1

Operations Affected

Somewhat 2 32

Yes 3 24

Mean 1.60

from the results summarized in Table 22.5 that U.S. managers realized that heterogeneous accounting systems did likely affect their operations, especially for those firms most active in international markets. Furthermore, given the realization that differing accounting standards could indeed affect a firm's operations, U.S. corporate managers also responded to the question of whether current efforts to harmonize or standardize global accounting standards were desirable and worthy goals to strive for. Using the same three-point scale on level of agreement with such efforts (yes = 1, somewhat = 2, and no = 3), it is somewhat astounding to find (see Table 22.6) that the U.S. managers in this study overwhelmingly agreed with the worthiness of the current harmonization efforts. Continuing with the examination of U.S. managers' views rather than the SEC's or FASB's, the final questions in the survey focused on the potential use of international accounting standards in the U.S. capital markets. The managers were asked whether the SEC should allow foreign firms to list in the U.S. based on their own national accounting standards, or alternatively, list based on the IAS. The potential responses ranged from strongly agree (3), somewhat agree (2), somewhat disagree (1), and strongly disagree (0). As the results in Table 22.7 show, U.S. managers were very much TABLE 22.6 U.S. Managers Agreement With Desirability of Globally Harmonized Accounting Standards

Harmonization Desirable

No 1 2

Somewhat 2 9

Yes 3 46

Mean 2.77

TABLE 22.7 Agreement by U.S. Managers of Allowing Firms To Enter U.S. Capital Markets Based on Own (Foreign) National Standards or Based on IAS

Foreign Standards International Standards

Strongly Agree 3 0

Somewhat Agree 2 3

Somewhat Disagree 1 15

Strongly Disagree 0 38

Mean 0.38

9

25

15

6

1.67

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379

against allowing foreign firms to enter the U.S. capital markets using their own national accounting standards. On the other hand, even though they may differ from U.S.-GAAP, the managers appear to be much more willing to accept firms entering the U.S. capital markets using international accounting standards. Finally, to judge U.S. corporate managers' opinions on the overall importance of global accounting harmonization, the managers were asked the extent to which harmonization was worth striving for. Given the potential responses to this question of (1) harmonization not worth striving for, (2) harmonization worth striving for so long as foreign accounting systems are adjusted to fit U.S.-GAAP, and (3) harmonization worth striving for even if U.S.-GAAP needed to be changed to meet the new harmonized standards; this question provided one of the more interesting results of the study. As Table 22.8 shows, U.S. managers were overwhelmingly in favor of global accounting harmonization efforts, even if this meant changing elements of U.S.-GAAP. If this truly is the case, the U.S. accounting standard setters (the SEC and FASB) may need to be more flexible as they work with the IASC and IOSCO in developing globally acceptable accounting standards. On the other hand, these results may simply indicate a certain level of displeasure with the current set of accounting regulations in effect in the U.S. and corporate opinion or hope that acceptable global standards may force U.S. standards to be more agreeable to the corporate managers. TABLE 22.8 Extent to which U.S. Managers Agree with Changes Necessary to Harmonize International Accounting Standards Not

worth it Harmonization of Standards

V.

Even if U.S.Only if U.S.GAAP Unchanged GAAP Changed

1

2

3

2

9

46

Mean 2.77

SUMMARY AND IMPLICATIONS OF STUDY

The results of this study indicate that, although differences exist between U.S. and Germany culturally, economically, and politically, managers in both countries understand and appreciate the importance of global accounting harmonization issues. Given the political and economic forces behind the drive for international accounting standards, the pursuit of this goal may not be far off. There appears to be significant awareness and acceptance that the benefits from global accounting harmonization far outweigh

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Kurtjesswein

the petty turf-battles of "my accounting system is better than your system" and the associated defense of the status quo in both countries. With managers on both sides of the Atlantic willing (and understanding the need) to move in the direction of harmonization, the standards makers and enforcers need to act quickly, particularly in the U.S. where the most resistance towards global standards appears to be found. The more proactive, rather than reactive or defensive, the SEC and FASB become in this process, the quicker and more efficiently the problem can be resolved. The biggest question appears to be not if, but how, global standards should be introduced. The move towards greater harmonization is clearly motivated by the need for efficiencies in international capital markets. The reduction of trade barriers, internationalization of companies, deregulation of capital markets, and growth of cooperative ventures have led to an increased awareness of the inefficiencies arising from the diversity in accounting practices across countries.13 The need is also apparent for a mechanism that requires companies to follow a set of agreed-upon standards regardless of the choice of capital market. Although no international mechanism exists for enforcing an international body of accounting standards, international efforts require some exertion of power for conformance with IOSCO, the most likely organization to enforce conformance. Although IOSCO does not have international jurisdiction, its representatives have significant influence in their respective countries over the orderliness of capital markets. Unfortunately, IOSCO does not develop the accounting standards. The standards themselves will likely need to be developed through the efforts of the LASC. With their current due process approach in which representatives from the accounting professions from various countries participate and offer their expertise, experience, and resources, formal acceptance by IOSCO and the individual nations should be made easier. It is at the national level where domestic priorities reside that the most difficult road to acceptance of global accounting standards may lie. Fortunately, countries such as Germany are experiencing a paradigm shift in both corporate governance and financial reporting. Germany has begun to move from a reporting system focused on communicating with long-standing creditors such as banks in an informal way to a more equitable framework based on the disclosure requirements to all stakeholders.14 Given its traditional role in setting industry standards in many technology areas,

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381

its position in the global economy should continue pushing it towards greater cooperation in the process of developing standards, along with its EU brethren. The same can be said for Japan and the rest of East Asia. Japanese firms are being forced into the international accounting standards to avoid losing their credibility. Introducing IASC standards into Japan is considered part of its "big bang" that involves extensive corporate law reform to deregulate parts of the Japanese economy so it will be more competitive in the long term. The objective of this overhaul of corporate law and financial market practices is to create an environment where the market mechanism prevails and investors' interests are protected through better, more transparent, disclosures.15 Nevertheless, there are also concerns with whether countries such as Japan and other East Asian countries will fully embrace the IASC pronouncements or whether they will modify them to suit local conditions. This practice, known as the implementation of "IASClite," may add to the general view that IASC standards are not as stringent as those operating in the U.S. and other sophisticated capital markets. For example, Japan throughout much of the 1990s took actions that actually reduced the transparency of their banking system. As recently as March 1998, the Japanese government announced a program that actually reduced transparency. Banks are now allowed to report securities at book rather than market value (thus inflating capital), they are allowed to provide their own estimates of the market value of their real estate holdings (inflating capital), and they can net loans and deposits to the same customers (reducing risk-based assets used in calculating capital ratios). More recently, Japanese banks have been allowed to conceal losses on Japanese government bonds by conducting securities trades at artificially set prices.16 However, the greatest impediment to the acceptance of global accounting standards is likely to occur in the U.S. because of strong resistance on the part of the SEC and FASB. lOSCO's regulatory review of the IASC standards is the probable turning point in the entire harmonization process. Since the SEC is its leading member, its acceptance or rejection of the standards is crucial. There is speculation that if IOSCO balks at the standards, an international economic body such as the International Monetary Fund, the World Bank, or the Basle Committee on Banking Supervision may step in to break any impasse.17 Despite the politics associated with the process; as with most things, it will ultimately be the market that will determine its final

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outcome. Market forces are typically much better than regulation at establishing and enforcing reporting requirements. As firms seek money internationally, they will be increasingly forced to comply with international expectations for financial disclosure and corporate governance. Dictating a set of standards can only go so far. Firms will likely continue to incorporate any set of accounting principles they judge most appropriate to their situations. However, in order to maintain the confidence of their constituencies and of the financial markets, there will be tremendous market pressure for the firms to adopt principles that are widely accepted and that make sense. There will also be pressure to disclose whatever information their constituencies deem material. Firms that choose to ignore their constituencies will pay a heavy price. Their stock price will be discounted and could become unmarketable. They will need to borrow at ever-increasing rates and find it more difficult and more expensive to raise capital in international capital markets. Firms that adopt sensible accounting principles will not have these problems. Those that do a good job of adopting financial reporting rules that the market values will be rewarded in the capital markets with a higher stock price and a lower cost of capital. 8 The empirical results of this study seem to bear this out. Corporate managers in both the U.S. and Germany, two countries with significantly divergent accounting philosophies, know or at least sense that a specific set of accounting regulations will make the most sense in the capital markets of the 21st century and beyond. The quicker we get there, whether by governmental or supranational decree, or by the almighty force of the marketplace, the sooner the fruits of this exercise can be enjoyed. REFERENCES Berton, L. (1999) 'Countdown to Harmonization,' Institutional Investor, June:25-26. Bloomer, C. (1998) International Accounting Standard Setting: A Vision for the Future, Norwalk, CT: Financial Accounting Standards Board. Business Wire (1999) 'Germany Should Play an Active Role in Shaping International Accounting Harmonization Recommendations, Says Deloitte Touche Tohmatsu,' Business Wire, December 21. Glaum, M. and Mandler, U. (1996) 'Global Accounting Harmonization from a German Perspective: Bridging the GAAP,' Journal of International Financial Management and Accounting, 7(3) Autumn:215-242. Hora, J. and Tondkar, R.H. (1997) 'International Accounting Standards in Capital Markets, 'Journal of International Accounting Auditing & Taxation 6(2):l7l-190.

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Jordan, J.S., Peek, J., and Rosengren, E.S. (2000) The Impact of Greater Bank Disclosure amidst a Banking Crisis,' paper presented at American Finance Association 60th Annual Meeting, Boston, MA, January 7-9. Available on-line at http://www.cob.ohio-state.edu/~fin/journal/archive_annual_meetings/2000/ papers/81015jordan-pap.pdf, January 27, 2000. Novak, S.B. (1999) 'A Step toward Globalization: The Move for International Accounting Standards,' Indiana International & Comparative Law Review 203, 1998. Available on-line from Lexis-Nexis http://web.lexis-nexis.com/universe/ form/academic/univ_lawrev.html, April 23, 1999. Pacter, P. (1998) 'International Accounting Standards: The World's Standards by 2002,' The CPAJournal, 68(7),July:14-21. Ravlik, T. (1999) Japan Looks to Higher Standards,' Australian CPA 69(10), November:48-49. Turner, L.E. and Godwin, J.H. (1999) 'Auditing, Earnings Management, and International Accounting Issues at the Securities and Exchange Commission, Accounting Horizons,' 13(3), September:281-298. Yoon, Y (1998) 'Financial Reporting in an International Environment: A Look at Regulatory Models and the Case for a Market Approach,' Multinational Business

NOTES 1. 2. 3. 4. 5. 6.

Bloomer, (1998), 8. Pacter, (July 1998), 18. Novak, (April 23, 1999), 3. Novak, 5. Bloomer, 9. The relevant national authority is that organization (or those organizations) with the authority to make decisions about accounting requirements for capital markets and to enforce those requirements. The relevant national authority may differ; for example, in the United States it would be the Securities and Exchange Commission (SEC), whereas in other countries it may be a stock exchange, a government body, or some other organization. (Bloomer, 9). 7. Novak, 2. 8. This section is adapted from Glaum and Mandler (1996). 9. This study was undertaken as a joint effort of Dr. Martin Glaum of the EuropaUniversitat Viadrina in Frankfurt (Oder), Germany and Dr. Gerhart Forschle, of Coopers & Lybrand Germany under the title of "Kapitalmarktorientierung unternehmerischer Entscheidungen und internationale Rechnungslegung." 10. The actual questionnaires were much larger in that two separate issues were being examined. Besides the questions dealing with global accounting harmonization, differences in managerial opinions regarding shareholder value issues were also examined. Among the key findings in this second related study were that, despite a renewed emphasis on shareholder value maximization from both groups, U.S. firms were, not surprisingly, more shareholder and more share-price oriented, tended to focus more on short-term profitability

384

11.

12. 13. 14. 15. 16. 17. 18.

Kurtjesswein rather than long-term value maximization, and relied more on the quantification of investment analysis. The second study was conducted by the author with the assistance of Dr. Martin Glaum and with the support of Dr. Chuck Kwok and the Center for International Business Education and Research at the University of South Carolina. Turnerand Godwin, (1999), 294. Hora and Tondkar (1997), 171. Business Wire, 12/21/1999. Ravlik (November 1999), 48. Jordan, Peek and Rosengren, January 27, 2000, 21. Berton, June 1999, 26. Yoon, (Fall 1998), 34-35.

23 Global Equity Market Diversification for American Investors: The Case of Emerging Stock Exchanges MO VAZIRI AND PARVIZ ASHEGHIAN

I.

INTRODUCTION

In recent years, the world total market capitalization has increased from $2,534 billion in 1994 to $12,623 billion in 1996. Among the world stock markets, the emerging markets of Europe and Asia have shown the greatest percentage gains as American investors benefited from high returns in these strong markets. Many money managers have emphasized the diversification through investing in these emerging stock markets to reduce the variance of the portfolio of domestic stocks without reducing the expected return. In an integrated world capital market, the investor need not restrict portfolio choice to domestic securities since it is possible to combine foreign with domestic securities in a portfolio. Increasing integration of international capital markets has been identified as a major trend in today's business world. In Europe, where each domestic capital market was, and still is, relatively small, institutional investors have routinely invested internationally. Recent research has sparked considerable debate over diversifying risks by spreading domestic portfolios across different national stock markets. Baley and Lim (1991) and Markides (1995) have evaluated the diversification benefits through new countries. Kolodny and Resnick (1991) have emphasized the diversification through investing in emerging stock markets to reduce the variance of a portfolio of domestic stocks. Hamao et al. (1991) have examined the volatility over time of international stock prices. A vector 385

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Mo Vaziri and Parviz Asheghian

autoregression approach, investigating the transmission of innovations across markets, has shown that increased international equity market integration is consistent with consumption-based asset pricing models (Eun and Shim, 1989). According to the single index (world market factor) model, the limit on the diversification benefit from international equity investment is determined by the degree to which national stock markets are correlated with the world market. Many empirical researches indicate that share price changes across countries are substantially less than perfectly correlated and that adding foreign shares to domestic equity portfolios, in general, is likely to reduce volatility while maintaining the desired ex ante return. The purpose of this chapter is to analyze the effect of global diversification on risk reduction and expected return maximization for American investors. II.

PROPERTY OF DATA AND METHODOLOGY OF THE STUDY

According to the intertemporal CPAM framework or the APT model, stock returns are related to such macroeconomic variables as industrial production, the yield curve, Ml, employment, exchange rates, inflation rate, and interest rate. The IMF database published in International Financial Statistics (IFS) contains a wide range of macroeconomic variables for each member country. One of the main advantages of international diversification is that they arise from different industry mixes across countries. If we accept this hypotheses, which has been tested by Roll (1992) and Heston and Rouwenhost (1994), investors may be able to gain the benefits through diversifying their portfolio by investing across a range of global industries. Such a benefit will be higher if correlation coefficients between stock indices are related to industrial structure. Using S&P's Global Vantage, an efficient frontier is estimated using stock data for the selected countries of U.S., the Netherlands, Norway, Sweden, Switzerland, the U.K., Austria, Germany, and Luxembourg for the period between 1989 and 1997. A test of the industrial structure hypothesis of the source of benefit arising from international diversification has been carried out by estimating the efficient frontiers using firms from the U.S. operating in selected countries then estimating the efficient frontiers using firms from selected countries operating in the same selected industry. There are three practical selection rules for obtaining good diversification with reasonable portfolio size. The first of these would be

Global Equity Market Diversification for American Investors

387

to ensure a good geographical diversification by picking stocks across countries. The more conventional way is to select stocks across industries. The greatest benefit would be achieved from a combination of the two, i.e., consciously selecting stocks across both countries and industries. The following set of linear programming has been used to find the optimal weights that minimize the standard deviation that equals the U.S. stock return: Objective: Constraints: Weights sum to one:

Minimize portfolio's risk: Min XI2 Subject to return level: XI3 = B22 X14 = 1 Weights are non-negative: D22 >0, E22 >0, F22 >0, G22 >0, H22 >0

where: XI2 calculates the portfolio's risk XI3 calculates the portfolio's return XI4 sums the weights (Ely, 1996). The market value weighted averages (average daily data) of common shares traded on the major national exchanges (IFC line code 62) of the selected countries along with average daily spot exchange rates (IFC line code.rf: local currency per U.S. dollar) has been retrieved and used in estimating the efficient frontier. Each stock's price fluctuations and correlation are measured by statistical parameters that include standard deviation, covariance and correlation coefficient. The sum of the combined standard deviation and the correlation coefficient of the selected countries calculates the portfolio's variance. The portfolio return is calculated by the individual weighted returns of the stock returns. III.

FACTORS IMPACTING INTERNATIONAL DIVERSIFICATION

Foreign markets, unlike the U.S. market, are at different levels of development and their economies and trade are at different levels of correlation with the U.S. market. Among the many factors affecting the international diversification are risks related to currency, and liquidity of the home-country markets versus the U.S. market. Size: Equity market size consists of total market capitalization; a measure of the total market value of all the shares listed on a given exchange.

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Market activity: Market activity is generally measured by total value traded, turnover, and market concentration. Volatility: Market volatility is measured by the standard deviation of returns, and serves to indicate the extent to which these returns fluctuate about their average level. Standard deviation has been especially high in countries prone to high inflation fluctuations and high exchange rate fluctuations (Niendorf and Lang, 1995). Volatility during a projected holding period is what we consider market risk. Investments in foreign markets can be volatile and this high volatility should be expected in emerging markets. There is a temptation for international investors to chase a "hot country" and because of the increased volatility related to these particular markets the consequences are much worse. When analyzing the volatility of stocks, the volatility can be compared to the volatility of an index such as the S&P500. Emerging markets are immature, vulnerable to scandal, occasionally manipulated, and lack strong government supervision. It is possible that accounting disclosure, trading, and settlement practices of the emerging market will be complicated. Flights of capital, triggered by events in one emerging market, can spread instantly to other markets even when those markets have quite different conditions. Currency risk is important to consider because returns earned abroad can be magnified or diminished by the exchange rates. The appreciation of the dollar reduces the value of foreign investments owned by U.S. investors, and if the dollar weakens, foreign assets rise in value. High returns from rising stock prices could be turned into losses from falling currencies. When the emerging market's capitalization is small then the liquidity risk becomes a factor for investors. Sometimes the buy or sell orders placed by investors may be only partially filled, or remain unfilled with the possibility that subsequent prices paid or received could be significantly different from previous trades. Daily trading volumes in foreign markets range from about 1 million shares to more than 600 million shares traded in U.S. exchanges. In some countries, fewer than 200 stocks trade in quantities that are sufficient to support foreign interest. The limitations placed on foreign investors sometimes permit foreigners to buy only a specified class of shares, often available in limited quantities. In some cases the volume traded hinders trading activities and may result in exorbitant premiums for sought-after shares. There are even countries that restrict foreign investments altogether. Another variable that adds to the risk is the sudden movement of highly speculative

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389

short-term capital, such as market price supports, can trigger an event in one market that spreads to other markets even when the markets have different conditions. Investors diversifying their portfolios to include foreign investments must understand the intricacies involved that make each market unique. IV.

ANALYSIS OF THE FINDINGS

The limit on the diversification benefit from international portfolio investment is determined by the degree to which national stock markets are collected. If all national markets were completely dominated by a single world factor (i.e., if all crossnational correlations were 1.00), then international diversification would have no benefit. On the other hand, if all national markets were completely independent (that is, if all cross-correlations were zero), the international diversification over an infinite number of countries would completely eliminate the effect of variation in national markets. Risk and Return or Undiversified Portfolio (Table 23.1) is unidimensional and measures the degree to which two variables (assets) move together. The correlation lies between +1 and -1. The ideal situation would be to invest into countries with perfectly negative correlation. The U.S. has a positive correlation coefficient with the countries under study, except for Luxembourg (-0.10). The U.S. also has high positive correlation with the U.K. and the Netherlands, followed by Switzerland, Sweden, Germany, Norway, and Austria. This implies that adding equity investment from Luxembourg will benefit a U.S.-dominated portfolio. The positive correlation between the U.S. and other countries under study means that changing the stock prices in these countries would be reflected by changes in the stock exchange in the U.S. However, the degree of these coefficients is not significantly high (maximum of .62 for the U.K.), indicates that for a given expected return, American investors can still reduce the risk and benefit from international diversification by investing in the emerging markets of Europe. The Efficient Frontier table (Table 23.2) proposes 12 alternative investments ranging from 100% of equity investment in the U.S. to 100% investment in Germany or Luxembourg. If U.S. innovators invest in these aggregate proportions, they can obtain respectable expected returns for given degrees of risk measured by the relevant standard deviations. For these 12 sets of alternative investments, U.S. investors can minimize the risk of the intentionally diversified

390

Mo Vaziri and Parviz Asheghian TABLE 23.1 Risk and Return for an Undiversified Portfolio Std.Dev 0.061 0.076 0.102 0.102 0.079

Return 1.89% 2.37% 2.21% 2.89% 2.27%

U.S. 1.00 0.62 0.27 0.38 0.49

Std.Dev U.S. O.061 U.K. 0.097 Austria 0.106 Germany 0.099 Luxembourg 0.079

Return 1.89% 2.24% 2.47 3.07% 0.62%

U.S

U.S. Netherlands Norway Sweden Switzerland

1.00 0.54 0.14 0.35 -0.10

Correlation Coefficients Netherlands Norway Sweden 1.00 0.41 0.46 0.77

1.00 0.35 0.39

1.00 0.44

Switzerland

1.00

Correlation Coefficients U.K Austria Germany Luxembourg 1.00 0.17 0.41 0.05

1.00 0.52 0.15

1.00 0.04

1.00

portfolio by investing 65.4% in the U.S., 12.9% in Norway, 5.65% in Sweden and 16.2% in Switzerland for the first set. The risk minimization can occur at 54.2% in U.S., 8.4% in Austria, 3% in Germany and 34.4% in Luxembourg. The investors can also maximize the TABLE 23.2 Efficient Frontier (%) Std. Dev Return 0.061 1.89% Min Risk 0.057 2.05 0.058 2.21 2.27 0.060 2.37 0.063 Max Return 0.102 2.89

Min Risk

Max return

Std.Dev Return 0.079 0.62% 0.045 1.53 0.048 1.89 0.063 2.42 0.064 2.47 0.099 3.07

U.S. 100

Portfolio Weights Netherlands Norway Sweden 0.0

0.0

0.0

12.9 11.0 10.3

65.4 46.1 39.1 26.4

11.7 16.8 26.0

0.0

0.0

U.S.

U.K.

0.0

0.0

54.2 50.6 41.3 36.7

0.0

10.8 12.0

0.0

0.0

3.0

9.0 0.0

0.0 5.6

17.9 22.1 29.7 100.0

Switzerland 0.0

16.2 13.3 11. 7 Max 8.9 0.0

Portfolio Weights Austria Germany Luxembourg 0.0 0.0 100.0 8.4 3.0 34.4 20.3 14.9 11.2 32.7 0.0 15.2 14.6 36.7 0.0 0.0 100.0 0.0

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391

expected return by investing 100% in Sweden in the first set and/or 100% in Germany. The objective behind forming portfolios is not simply to reduce risk, but rather to select an efficient portfolio. The curve area of the Efficient Frontier graph (not shown) represents the feasible area. Each point in this area represents a particular portfolio with a risk of the standard deviation for the portfolio and an expected return on investment capital. The boundary lines from the U.S. to Luxembourg in the first set and Sweden in the second set define the efficient set of portfolios, which is also called the efficient frontier. The portfolio would provide either a higher return with the same degree of risk or a lower risk for the same rate of return. Portfolios to the right of the boundary line are inefficient because some other portfolio would provide either a higher return with the same degree of risk or a lower risk for the same rate of return. For example, If we invest in Norway, we could not get a bigger return for the same amount of risk by investing in Sweden. To determine the optimal portfolio for a particular investor, we must know the investor's attitude towards risk, i.e., the indifference curve. The more risk-averse the investor is, the more likely it is that they will invest at the lower end of the efficient frontier, which would mean investing a percentage of one's fund in the U.S. and a percentage in Sweden. The higher the percentage invested in Sweden the higher the return and also the higher the risk. This leads to the conclusion that in order to diversify well one must choose the mix of countries or firms in your portfolio carefully because some countries or some firms have faster growing economies which create higher returns and also different countries or different firms are subject to divergent cyclical economic fluctuations unrelated to countries. If we compare our two sets of countries we can see that there is a much higher correlation between the first set of countries than the second. The choice of countries as well as the number of countries for diversification can explain this. Thus, in order to diversify well one must invest in unrelated countries. The performance of U.S. equities, for the period under study, was relatively good when compared to any single European country, even though three of the four European markets had higher absolute returns. While the EU markets had higher individual returns than U.S. equities, their individual standard deviations were also higher—high enough to lower each country's CV below that of the U.S. (except for Germany). Accordingly, we are not surprised to see

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that U.S. stocks are assigned a large weight in many (though not all) of the portfolios on the efficient frontier, as discussed previously. The findings of this study show that the CV for the U.S. is very substantially lower than that for all of the European markets, this time including Germany (see right-hand side of the tables). The relative performance of the U.S. has improved markedly in recent years vis-d-vis EU stocks. A glance at both tables reveals that Germany no longer leads in terms of mean return, that Austria continues its strong performance (both its mean return and standard deviation are slightly higher), and that the U.S. now has the second highest return from the perspective of U.S. investors. The return from U.K. stocks has declined over the years, but so did the standard deviation of returns for U.K. stocks. Luxembourg's performance has improved. While Luxembourg has never been a strong performer, its return is negatively correlated with the U.S., making it a valid choice in a diversified portfolio. In fact, Luxembourg's correlation coefficient with the U.S. has changed substantially. The lower correlation coefficient, coupled with a slightly higher mean return and lower standard deviation, should increase Luxembourg's relative weight in diversified portfolios. V.

POINT OF DEPARTURE

Investing outside the U.S. can offer benefits. Rates of return in foreign markets may be higher than in the domestic market. Foreign markets may offer more growth opportunities than the domestic equity market. Foreign capital markets can lower a portfolio's risk exposure by adding a group of securities whose return is not highly correlated with the portfolio's other holdings. About 15-20 years ago, the U.S. market would have represented roughly 70% of the world's equity market value. Today those relative weights are exactly reversed. Focusing exclusively on the U.S. market means missing 70% of the growth opportunities available worldwide. More than one-half of the world's 100 largest public companies have headquarters outside the United States. More than 90% of the world's 100 largest banks and 60% of the world's 50 largest insurance companies are located outside the United States. Investors who do not consider international capital markets seriously limit their opportunities for investment growth. Finally, the findings here showed that the performance of the U.S. market has improved significantly in recent years vis-d-vis the European markets, both in terms of return and standard deviation.

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In addition, U.S. returns have been less correlated with European returns (after conversion into U.S. dollars) during the past 6 years than during the longer 1957-97 period. Both of these factors would increase the relative weight of U.S. stocks in most efficient portfolios. Furthermore, there appears to be no evidence of a secular trend among EU markets to be increasingly correlated with each other. VI.

RESULTS

From the evidence presented in this chapter it was established that the presence of large country-specific components of return variation, and not industrial structure, is responsible for low intercorrelations of European equity markets. Industrial specialization explains less than 1% of the variance of equally weighted country index returns. Therefore, because industry effects are so small, country diversification is a more effective tool than industry diversification for achieving risk reduction. For international diversification to be effective, one must choose countries with low correlations to invest in. Low international correlation may reflect different geographical location, independent economic policies, and different endowments of natural resources and cultural differences. The gains from international diversification are substantial. However, the American investor seeking to invest abroad should be aware of the presence of some other risk differences found when investing abroad: (1) risks arising from the separate, individual political and economic policies of the nation in which an investment is made; (2) changes in the exchange rates of the currency of foreign nations; and (3) differences in the amount and kind of information available for investment decision-making. The foreign nation may have restrictions on the right to transfer funds, and may impose various withholding taxes for the foreign investment and exchange rate risk. The study concludes that global diversification does, in fact, provide a higher return while reducing the portfolio risk. However, American investors should take into consideration the types of risks arising from the separate economic policy of each nation, changes in exchange rates, and differences in the amount and kinds of information available for investment decisions.

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REFERENCES Baley, W. and Lim, J. (1991). 'Initial Public Offering of Country Funds: Evidence and Implications', Pacific Basin Capital Markets, pp 365-378. Ely, D. (1996). Risk/Return Tradeoff of Internationally Diversified Stock Portfolios, San Diego: San Diego State University, unpublished manuscript. Eun, C.S. and Shim, D. (1989). Exchange Rate Uncertainty, Forward Contracts and International Portfolio Performance, Journal of Finance. Hamao, Y, Masulis, R. and Nq, V. (1991). 'Correlation in Price Changes and Volatility Across International Stock Markets,' Review of Finance Studies, pp. 281-302. Heston, S.L. and Rouwenhorst, G. (1994) 'Does Industrial Structure Explain the Benefits of International Diversification?,' Journal of Financial Economics. 36:3-27. Kolodny, R.C. and Resnick, B.C. (1991). 'Put-Call Parity and Market Efficiency,' Journal of Finance, Dec. Markides (1995). Diversification, Refocussing and Economic Performance. Cambridge. MA: MIT Press. Niendorf, R.M. and Lang, L.R. (1995) 'International Diversification for Individuals,' Multinational Business Review, 3(1 ):Spring. Roll, R. (1992) 'Industrial Structure and the Comparative Behavior of International Stock Market Indices, 'Journal of Finance, 47:3-42.

ADDITIONAL READING Asprem, M. (1989) 'Stock Prices, Asset Portfolios and Macroeconomic Variables in Ten European Counties,' Journal of Banking and Finance, 13:589—612. Bailey, W. and Stulz, R. (1990) 'Benefits of International Diversification: The Case of Pacific Basin Stock Markets, 'Journal of Portfolio Management, Summer:57-61. Bailey, W., Stulz, R., and Yen, S. (1990) 'Properties of Daily Stock Returns from the Pacific Basin Stock Markets: Evidence and Implications,' in Rhee, S.G. and Chang, R.P. (eds.), Pacific Basin Capital Markets Research, Amsterdam: North Holland. Hartmann, M.A. and Khambata, D. (1993) 'Emerging Stock Markets: Investment Strategies of the Future, Columbia Journal of World Business,' 28(2):Summer. Hamao, Yand Masuit, R. (1988) 'Correlation in Price Changes and Volatility Across International Sock Markets,' San Diego: University of California, San Diego, unpublished manuscript. International Monetary Fund (1995) International Financial Statistics, Washington, DC: IMF, February, April, June. Johnson, R. and Soenen, L. (1993) 'Stock Market Reaction to EC Economic and Monetary Integration,' European Management Journal, 11:85-92. Available in Lexis/Nexis EUROPE ALLNWS library. Lexis/Nexis, International Securities Regulation Report, May, 1993. Lexis/Nexis, Reuter News Service—Western Europe, June 1994. February 1995. Lexis/Nexis, Euromoney Supplement, September 1994, September 1992. Lexis/Nexis, Euroweek, June 1994. Solnik, B. (1995) 'Why Not Diversify International Rather than Domestically?,' Financial Analyst Journal, January/February.

24

Endogenous Corruption Risk and FDI in the Developing Countries DAMIEN BESANCENOT AND RADU VRANCEANU

I.

INTRODUCTION

Recent trends show that foreign direct investment, wherein a foreign company either builds from scratch or acquires an existing facility, has become a major method of financing the developing world. Many factors are considered as traditionally determining the foreign direct investment flow. All foreign investors have the same concerns: political stability, economic openness, ready access to inputs at reasonable prices, and laws and regulations that are fairly and transparently enforced. Investors also look to the size and growth of domestic markets and closeness of major international markets; for most developing countries, cheap labor is also an important asset.1 In many developing countries from Asia, Africa, Latin America and Eastern Europe, ambiguity in definition of property rights, widespread corruption of state officials2 and inefficient legal systems pave the way of local managers to appropriate a share of the firms' wealth. This chapter develops a formal model to analyze how the risk of facing dishonest managers influences foreign investment in a small developing country. It puts forward the incidence of reputation concerns on managers' individual and collective behavior and highlights the impact of the length of the relationship between investors and managers on the global performance of such an economy. The idea according to which managers tend to pursue their own objectives, often divergent from those of the owners, was recognized long time ago (see Jensen and Meckling, 1976). In this context, many studies investigated the optimal contract that would prompt the 395

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manager to reveal his effort level when perfect monitoring is impossible (see Hart and Holmstrom, 1987). The analysis carried out in this chapter does not belong to this strand of research, insofar as manager's behavior is perfectly observed by investors. In the context of market economies, the issue of collective or group reputation has already been investigated by Diamond (1991) and Tirole (1996). While they focused on the individual decision of the manager whether to cheat or not, they were able to reach a global result by assuming that the population of managers is divided into three fixed size cohorts (honest, dishonest and opportunistic). However, in a more general framework, reputation concerns would influence not only managers' behavior and firms' profits but also cohort sizes. In the text at hand, the frequencies of the various types of manager are made endogenous by means of a rational expectations model with Bayesian learning, on the lines of classical studies on policy credibility (Barro and Gordon, 1983; Backus and Driffill, 1985; Barro, 1986; Vickers, 1986). A simple model of the developing economy is worked out. During any time period, the population of local managers is made up of two groups of identical size, the "young" and the "old". At the end of each period, old managers cease their activity, the young become old and a new generation of young managers goes into business. Every manager, old or young, runs a firm. He hires variable inputs which, combined with capital assets, produce a homogeneous good. The mono-periodic capital is provided by a foreign investor who is also the residual claimant. In the first part of the text, focus is set on the optimal decision of the representative manager. To introduce fraud risk in a simple way, it is assumed that each manager has the choice between diverting a positive share of the firm's income or preserving the firm's integrity. The representative manager wants to maximize the expected money income, made up of statutory wages and the diverted funds. Managers differ with respect to the subjective value they attach to 1$ of diverted money; it may be nil for the "white knight" manager, or may be very large for the dishonest one. The foreign investor does not know the nature of the manager he faces, but knows the statistical distribution of this characteristic in the population of managers. Investors have a passive attitude: they will provide managers with capital as long as they expect a positive profit. In this text, we assume that the maximal possible fraud is not too important, such that profits are always positive. Of course, the optimal amount of capital depends on investors' expectations about the nature of the manager they deal with.

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It will be shown that a reputation effect occurs when the contractual relationship between the manager and the investor is set-up for more than one period (long-term relationship). In a two period setting, three types of managers can be identified: the "dishonest" who steals during both periods, the "honest" who never steals, and the "opportunistic", honest when young and corrupt when old. The behavior of the latter is quite rational insofar as an image of "reliable person" acquired as a young professional improves investors' confidence and increases the firm's size, thus increasing both his statutory wage and the reward from stealing during the second period.3 The second part of the text puts forward some macroeconomic implications of the microeconomic model. The two-period setting used to study the decision of one manager is converted into an overlapping generations model. In this new context, the longitudinal analysis (the manager is first young, then old) is replaced by a cross section in the total population of managers, half of them young, half of them old. The endogenous probabilities effacing one of the three types of managers are now interpreted as frequencies. The next logical step consists in summing up individual investment and profits. Two extreme situations are portrayed. In the "low equilibrium", investors support only short-term projects. In this case, no reputation effect is at work, and actual fraud is indeed high. As the equilibrium implies low profitability and a low amount of foreign funding, this country is trapped in underdevelopment. In the "high equilibrium", investors commit themselves to long-term projects. In this case, the reputation effect contributes to reducing the number of dishonest managers. Such an economy is characterized by a high average profitability and available funds are considerable. The chapter is organized as follows: Section II introduces the main assumptions, focusing on the microeconomic model. Section III investigates investors' and managers' behavior and demonstrates the existence of a rational expectation equilibrium; special emphasis is placed on the reputation effect. Section IV analyzes the macroeconomic implications of the microeconomic model when investors and managers bind themselves for a varying duration (short-term vs. long-term relationship). The last section presents the conclusion. II.

MAIN ASSUMPTIONS

Structure of the Economy: Managers, Investors and Firms

At the beginning of period /, the population of managers is made up of two subsets: ^F, , the subset of "young" managers and Q f , the

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subset of "old" managers. In order to keep the analysis simple, the size of these two populations is normalized to one (with unit population, frequency or number of managers are equivalent terms). A manager who is young during the t period will be old during the M-l period.4 At the beginning of any time period, each manager will set up a firm to produce a homogeneous good. Labor and other variable inputs must be combined with capital assets to produce the good. While the manager hires the variable inputs, mono-periodic capital is provided by an "investor" who is also the residual claimant. The investor picks his partner at random from the population of managers. A young manager and an investor may tie themselves for one or two periods, according to the specific contractual arrangement between them. More precisely, the investor would commit himself either to provide the manager with capital for one period (shortterm projects) or for two successive periods (long-term projects). Of course, in the context of the two period relationship, at the beginning of each period, the investor must decide on the amount of capital to be provided within the respective period. We analyze hereafter the general case where the investor-manager relationship lasts for two periods, encompassing as a special case the single period relationship. The Manager Behavior

The manager is young during the period beginning at t=l (thus belonging to ¥, and old during the period beginning at £=2 (thus belonging to Q 2 ) . During the period beginning at date t, a manager earns a statutory wage Wt and diverts a total amount Tt. To keep the analysis tractable, the statutory wage is assumed to be proportional to the firm's actual turnover. Denoting firm's output by Yt, the wage is: W, =u(Yt - T), with oc>0 a structural parameter.5 By assumption, this manager may transfer into his own hands a part 1 of the firm's income without the risk of legal pursuit, that is, at each period is Tt =1tYt. To simplify, it is further assumed that a "dishonest" manager would divert a (constant) fraction ^ , while an "honest" manager presents a null theft rate. Formally, that means that T? e {O,T}. However, different managers assign a different subjective value to 1$ of diverted funds. The most honest ones assign a low value to a

Endogenous Corruption Risk and FDI in the Developing Countries

399

stolen dollar; this value may be quite high for the dishonest persons; for some of them, it may be larger than one, as they do not pay income taxes on this money. The manager aims at maximizing total expected money income. Formally, let the intertemporal objective of a given manager be: 2

M =^mt

where m(, the money income at date t, is the sum of the r=1 legal wage and the (subjectively) adjusted illegal income: t,

with o - O

(1)

Parameter a indicates the subjective valuation by the manager of 1$ stolen. More precisely, the characteristic of the young manager JE *Fj should be denoted o~. In this section, subscript j will be omitted in order to simplify notations. A discount factor might also be introduced at this stage; it is omitted for simplicity insofar as the main results do not depend on this additional variable. With previous definitions, the objective function (Eq.l) becomes:

c,)r, +
(2)

and the intertemporal objective may be written as:

t=i

t=i

(3)

The Investment Function

At the beginning of period t=l, investors pick a manager at random from the population of young managers *F, . Although a given investor does not know the characteristic o~ of "his" manager, he knows the statistical distribution of o" in the population of managers. It is assumed that this statistical distribution is well described by the cumulative distribution function F(a) : 4* —> [0,1] • In other words, the random choice of the manager by a given investor can be seen as a draw of the weight o~ from F( ) . Given this "structural" uncertainty, investors use an estimate of the theft rate lt to guide their investment decision. Using the operator E,[ ] to denote the mathematical expectations of any variable given the available information at date t, the expected theft rate is

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The production function is assumed to be linear in capital Y^ where A>1 is a productivity parameter, while the cost function is quadratic: C=0.5(^)2 (in the context of developing countries, this would be justified by the notorious lack of infrastructures like communication and transport networks).6 Then, the expected profit function takes the form: E,[jg=AA;(l-E,[Tj)- 0.5 £ 2

(4)

Since investors are the residual claimants, they choose the optimal capital so as to maximize the expected profit of the firm. The first order condition leads to the simple investment function: *i=A(l-E,[Tj)

(5)

Once the capital in operation, the manager decides whether or not to divert a part of the turnover. Substituting in Eq. (4) the optimal capital given by Eq. (5), after squares completion, the indirect profit function takes the form: E,[7iJ =AKt(\-^ -0.5 A:, =0.5A[(1 - x , ) - [fr-EjT,])] (6) A reasonable restriction, 00 whatever lt and E^lJ. In this case, investors wish to participate to the firm, whatever their expectations and whatever the true type of the manager they actually face. Inspection of Eq.(6) also makes explicit why investors would also like to minimize the expectation error at any moment in time. III.

THE MICROECONOMIC MODEL; MANAGER'S DECISION

As the policy of the manager as a young professional modifies the set of available choices when he gets old, his optimal decision rule should be inferred by backward induction. The Last Period / The Old Manager

During his last period of activity, the manager must solve the truncated problem:

max{m2 (a, T 2 ) = G

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401

As m 2 (a,T 2 ) = t2AK2[G-O,] + const. and denoting a* = a the solution is (recall that the stock of capital K% is set up before the choice of the optimal ^* ) :

That is, a manager characterized by C7 < (7 * will be honest, a manager characterized by G > <3 * will divert a share T of the firm's output. In the simplified case when the relationship between the investor and the manager is established for only one period, the manager decision problem, be he old or young, consists in maximizing such a single period objective. Calculus and solutions are those of this paragraph. The First Period / The Young Manager

During his first period of activity, a young manager has a more complex choice. Because of the reputation effect, his action during the first period will influence investors' expectations. Let us assume for the moment that K^ is given. The intertemporal objective is:

(1-£ 2 [T 2 ])[GT 2

(8)

Let us remark that the strategy adopted during the first period conveys some information about the manager.7 Should he choose Tj = T, investors will correctly infer that he is a dishonest person. They will reduce the amount of investment for the next period. While in this model investors will not fire a dishonest manager once that they have committed for a two-period term, the decision of investing less may be interpreted as a sanction for the manager whose income will be lower at the last period. Profit is still positive, thus the participation constraint of investors is fulfilled. If he carries out a policy Tj = 0 investors cannot unambiguously infer the second period policy; however, this first choice is consistent with a narrow set of manager's characteristics. In this case, he may either belong to the set of really honest managers or to the set of "opportunistic" managers who reverse their policy and become corrupt during the last period (when getting old).

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In order to formalize the expectations updating scheme, E2[T2] must now be defined as the conditional expectation of the theft rate given the first period manager's behavior, i.e.: E 2 [T 2 ]=E[T 2 I'C 1 ]. Define then q as the probability of T 2 =T given T^O, that is
max JM ' (a, T! , T 2 ) = TJ £j (a - <x) - £[T2 1} ] A[oT

-T

Let the critical value be such that this manager is indifferent between a policy of theft and a policy of honesty during the first period (i.e. when young). O verifies: M'(o, T, = 0) = M' (6,Tj = l) thus:

According to the relative position of O" with respect to o? the optimal action during the first period is: < = '

[T, if a > a

(9)

It can be seen that G>o~* whatever T2. Then, contingent upon his own o", a manager will adopt one of the following strategies: a) for GG [0,G*] , the "honest" manager undertakes: T^O, T2=0. b) for ae]G*, 8] > the "opportunistic" manager undertakes: T^O, T 2 =T. c) for <je]S,oo[5 the "dishonest" manager undertakes: Tj=T , T 2 =T . Remark that according to Eq.(7), 12 — 0 f°r C J < G * . A s G * < G , a manager characterized by a < O would never undertake T2=0. On the contrary, this manager would carry out 12 = T • Therefore, the exact definition of a is:

K.-A^l-q)

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403

The Rational Expectation Equilibrium

Given F( ) and the decision rules (9) and (7), q may be re-defined as an endogenous variable:

= ,T|=0]=£Mz£(E!> 1

J

•»—i / ^+s\

F(G)

V JL JL I

Furthermore, as the level of investment during the first period is influenced by the value of a, the capital stock Kv can no longer be considered as an exogenous variable in Eq.(lO):

C(1-F())]

(12)

Then Eq.(lO) may be re-written as G = g(G) where:

^

'

A rational expectation equilibrium is reached if such a value exists. In this case, investors estimate correctly the probability of being cheated and, given the resulting optimal investment rule, strategies (a), (b) and (c) turn out to be optimal too. It can be shown that such an equilibrium exists. Proposition 1. There is a value G > G* > 0 such that G = g(G) . Proof. g(G) is a single valued continuous function of G with: .

= a - -- > a = G* , . hm g(G) = a r

l-TF(a)

As this limit is a finite number, there is a value G > G * such that Clearly, this equilibrium value G depends on the structural parameters of this economy, I and a, as well as on the information structure such as represented by the distribution F ( ) . In this context, the frequencies of honest/ dishonest young managers is an endogenous variable.

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Given the distribution F( ), investors assign the following probabilities to the possible actions of the young manager:

Pr[T 1 =0] = [Pr[T 1 =T] = land the following contingent probabilities to the possible actions of the old manager: Pr[T2 = T T! = T] = 1

Pr[T2 =

! =0] = [F(d)-F(o*)]/F(8f)

Pr[T2 =

! =0] = F(o*)/F(3)

The model puts forward a reputation effect that occurs when the investor-manager relationship lasts for more than one period. Under a short-term relationship, young managers characterized by <J 6 [<J*, S] would divert the firm's turnover; they are honest under a long-term relationship. These young professionals behave honestly only in order to stimulate investors' expectations and to increase the firm's size, thus raising the money reward during the second period. So far, this study has looked at the optimal behavior of one individual manager. It is a logical step now to determine the collective response of the investors facing the continuum of such managers. This reputation effect emphasized before appears to be a crucial element for analyzing the frequency of dishonest managers as an endogenous variable. All the following computations are performed for a given time period, t. During this period, managers in activity belong to ^ (the young ones) and to Qr (the old ones). IV. MACROECONOMIC IMPLICATIONS: SHORT-TERM VS. LONG-TERM RELATIONSHIP

This section aims at investigating the influence of the duration of the contractual relationship between investors and managers on some key macroeconomic indicators. As mentioned in the introduction, investors may commit themselves to long-term projects or short-term projects. Two simplified situations serve as useful benchmark cases. •

Under a "short-term relationship" (designated by the upperscript 57), there is no continuing relationship between foreign

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405

investors and managers. Managers are hired at random for one period only and no record of their behavior is kept. Thus, investors are uninformed about the previous performance of the old managers. In this case, the microeconomic problem reduces itself to the trivial case where no reputation effect is at work and no manager behaves opportunistically. Whatever the manager's priorities, his second period choice must be a plain replication of the first period, such as defined by the rule (7). Therefore, the frequency of dishonest managers is identical in both populations of old and young managers. • Under a "long-term relationship" (designated by the upperscript LT), investors commit themselves to provide young managers with capital for two periods; they are, of course, free to decide the amount of investment during each period. In this case, the former microeconomic model indicates that some young managers may undertake a policy of reputation building, then behave dishonestly when getting old. In the following, the frequency of dishonest managers, the stock of capital and the resulting global profitability are compared for the two benchmark cases. The Frequency of Dishonest Managers

First compute the estimated frequencies of facing a dishonest manager for each of the two groups, the young and the old managers, all of them living during period t. In the case of the short-term relationship, the manager (old or young) adopts the decision rule (7). The frequency of dishonest managers in each of the two subsets *{* and Qf is [l-F(o*)]. In the case of the long-term relationship, the frequency of (young) dishonest managers in the set *P, is [1—F(^)] while the frequency of (old) dishonest managers in Q is [!-/"(a*)]. This leads to the following proposition: Proposition 2. The shift from short-run relationships between investors and managers to long-run relationships contributes to reducing economy-wide corruption.

Proof. According to Proposition 1, Qf > a* thus [l-F( ° )]<[l-/ r (a*)]. While it does not alter the proportion of old dishonest managers, the reputation effect reduces the frequency of young dishonest managers. Thus, long-term investment reduces the global corruption in this economy.

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The Capital Stock

By assumption, each manager meets an investor who is willing to provide him with some capital. The optimal capital (Eq.5) indexed now for the manager j is: K^= A(l - Et[it>J]), for all j in *p u £lt • Short-term relationship

In the short-term relationship case, Et[lt ,] = f[l — F(O*)] for all j in ^p u Qf • As investors are not able to distinguish between dishonest and honest managers, optimal capital is the same whatever the manager, i.e.: Kt 7 = A(l— T[l — F(o*)] ). The global amount of capital K^ (with a unit population of young managers) is: oy^

_

= Z and the global amount of capital KJf old managers) is:

(with a unit population of

- T[l - F(a*)])

(17)

Long-term relationship

In the long-term relationship case, optimal capital differs between the two groups of managers. Investors expect that the theft rate of the young managers is: Et[lt j] = T[l — F(d)] for all j in ^. As investors are not able to distinguish between dishonest and honest managers, optimal capital is the same whatever the manager, i.e.: Kt = A(l— T[l — F(S)] ) . With a unit population of young managers, aggregate optimal capital is given by:

The expected theft rate of the old managers is contingent upon their behavior during the former period. When young, that is

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407

during the t-l period, they were either honest or dishonest. Under a long-term relationship, investors are aware of their past behavior. They expect:

if T,_, - T

T f i = 0

Therefore, the capital given to each manager depends on his previous behavior too: known dishonest managers will get A(l— T ), the others A[l-T(l-F(G*)/F(d))]. Given the unit size of the population ot managers, the number of known dishonest managers is fl — F(o)l, the number of unknown dishonest ones is [F(o) — F(a*)] and the number of honest managers is F(o*) . Thus, global capital provided to old managers is: _a F(g)-F(o*)

F(a)

(19) Proposition 3. In the long-term relationship, the going stock of capital is larger than in the short-term relationship:

sr o

Proof. Comparison of Eqs.(16), (17), (18) and (19) shows that _ _ 7 "T

CT

Ky > KM

an

-t

-m

7T

^T

d that KQ = KQ •

This result is not surprising: as young managers have less incentive to divert the firm's turnover under a long-term relationship, they will be provided with more capital. However, if in the aggregate, old managers receive the same amount of capital under both a short-term and a long term relationship, the allocation is modified insofar as known dishonest managers are endowed with less capital, the other being provided with more capital. The Global Profitability of this Economy

The global profitability of the economy will be assessed by dividing actual profits by the capital stock provided by investors. The profit equation Eq.(6) indexed for firm j is:

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ntj = 0.5A 2 [(l-T fJ) 2 -(ttj - Et[ttt j ] f , V/e {¥, Given the frequency of dishonest managers in each population, actual aggregated profit may easily be computed. The case of firms run by young managers is studied first, then the case of the firms run by old managers. Young managers Global profit is the sum of the profit realized by each manager belonging to the population of young managers. Short-term relationship

As no reputation effect is at work, all investors expect a rate of retention Et[lt • ] = T[l — F(<3*)] for all j in ^ . Furthermore, there are F(o*) honest managers (undertaking T = 0) and [1 — F(O*)] dishonest managers (undertaking i — T ) . Then, the sum of the profits is:

= 0.5A 2 (l-T[l-F(a*)])

(20 )

Long-term relationship

When the reputation effect is in force, the expected theft rate of the young managers is: Et [T? ; ] = T[l — F(d)] for all j in *F, . There are F(6) honest managers (undertaking 1 = 0 ) and [l~F(a)] dishonest managers (undertaking i = ^ ) - The global profit is: =0.5A 2 (1-T[1-F(6?)]) 2

(21)

Proposition 4. The profitability of the projects operated by the group of young managers is lower in the short-term relationship case than in the long-term relationship case.

Proof. Dividing profits (Eqs. (20) and (21)) by the respective capital stock (Eqs. (16) and (18)), we get: Tif / ^r = 0.5 A(l - f[l - F(a*)]) < 0.

Endogenous Corruption Risk and FDI in the Developing Countries

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Old managers

Short-term relationship As no reputation effect is at work, the profits on short-term projects for old managers are the same as those for young managers (Eq. (20)).

(22) Long-term relationship In the case of a long-term commitment, investors may partially discriminate against dishonest managers. Profits will thus differ according to the three types of manager. There are F(<3*) honest managers; each of them realizes a profit equal to 0.5A 2 [l-T 2 (l-F(a*)/F(3)) 2 ]. There are [F(3) - F(o*)] opportunistic managers: each of them realizes a profit equal to 0.5A 2 [(l-T) 2 -T 2 (l-F(a*)/F(d)) 2 ]. Finally, each of the fl — F(G}] managers signaled as dishonest when young will make a 0.5A2(1 — T) 2 profit. Overall profits on projects managed by the group of old managers when long-term commitment is in force are thus: iff = Z<J =0.5A2 F(o*)+[l-F(^)W-f>2 -rt

(2S)

Proposition 5. The profitability of the projects operated by the group of old managers is lower in the short-term relationship case than in the long-term relationship case. Proof. By Eq.(22) and Eq.(23) it appears that:

Q -nn = 0.5A2T2[F(a*)]2

l-F(d) >0

As the going capital is identical, ^Q - ^Q (according to Eqs. (17) and (19)), nLJ I K£ > nSJ IKSJ • Under a two-period relationship, global profitability improves for two reasons. Firstly, there are fewer dishonest young managers. Secondly, the profitability of the projects run by old managers

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increases too, as those who behaved dishonestly when young have already been identified by investors. As investors are now able to partially distinguish between the two kinds of managers, the allocation of capital improves and leads to higher global profitability. V.

CONCLUSION

The possibility of facing dishonest managers is an important factor in explaining foreigners' hesitations about investing in developing countries. This chapter investigates the influence of reputation concerns on managers' optimal decision whether to cheat or not, then uses the main microeconomic results to analyze the global performances of the hypothetical economy. In the first part of the text, a microeconomic model of the firm is worked out. Information is incomplete as investors do not know the priorities of the manager they face. It is shown that a rational expectation equilibrium with Bayesian learning exists. The properties of this equilibrium depend on the duration of the contractual relationship between managers and investors. When the decision horizon covers only one period, two types of mangers, the "dishonest" and the "honest" can be observed. However, in a two-period setting (under a long-term relationship), a third type appears, the "opportunistic" manager, who performs honestly during the first period of the contract, then steals during the last period. At variance with other studies about group reputation, in this chapter, the frequencies effacing one of these managers are endogenous. In the second part of the text, the two-period microeconomic model is re-cast in an overlapping generations framework, which brings the economy-wide population of managers into the picture. At any time period, a generation of young managers coexists with a generation of old managers. Aggregate capital and profits are obtained by adding up individual amounts. By focusing on two extreme cases, the model puts forward the role of the duration of the relationship between investors and managers on the macroeconomic performance of this economy. In a country where investors enter only short-run relationships, the reputation effect is ruled out and actual manager misbehavior is, indeed, high. The global profitability is rather low and investment and output are meager. In a country where investors commit on long-term projects, more young managers will behave honestly. Both configurations are stable. Given that profitability and growth are larger in this "high" equilibrium, a policy of external support to long-term agreements between

Endogenous Corruption Risk and FDI in the Developing Countries

411

managers and foreign investors is justified. Such a policy might bring out a virtuous loop where increased confidence in managers prompts investors to commit on long-term projects and, as a consequence, manager corruption is indeed low. Either governments in developing countries or international organizations may initiate temporary investment friendly policies. REFERENCES Agarwal, J.P. (1980) 'Determinants of Foreign Direct Investment: A Survey,' Weltwirtschqflitches Archiv, 116:739-773. Barro, RJ. (1986) 'Reputation in a Model of Monetary Policy with Incomplete Information,' Journal of Monetary Economics, 17(1): 3—20. Barro, RJ. and Gordon, D.B. (1983) 'Rules, Discretion and Reputation in a Model of Monetary Policy, 'Journal of Monetary Economics, 12,(1):101—121. Backus, D. and Driffill, J. (1985) 'Inflation and Reputation,' American Economic Review, 75(3):530-538. Besancenot, D. and Vranceanu, R. (1997) 'On the Dynamic Consistency of Economy-wide Privatisation, Economic Systems,' 21(2):151-164. Bardhan, P. (1997) 'Corruption and Development: A Review of Issues,' Journal of Economic Literature, 35(3) :1320-1346. Diamond, D.D. (1991) 'Monitoring and Reputations: The Choice Between Bank Loans and Directly Placed Debt,' Journal of Political Economy, 99(4): 689-721. Donges, J.B. and Wieners, J. (1994) 'Foreign Investment in the Transformation Process of Eastern Europe,' International Trade Journal, VHI(2) Summer: 163-191. Dunning, J.H. (1995) 'The Role of Foreign Direct Investment in a Globalizing Economy,' BNL Quarterly Review, 193:125-144. Fama, E.F. (1980) 'Agency Problems and the Theory of the Firm,'/0wrwa/ of Political Economy, 88:288-307. Gibbons, R. and Murphy, KJ. (1992) 'Optimal Incentive Contracts in the Presence of Career Concerns; Theory and Evidence,' Journal of Political Economy, 100(3):468-505. Hart, O. and Holmstrom, B. (1987) The Theory of Contracts,' in Bewley, T. (ed.), Advances in Economic Theory, Fifth World Congress, Cambridge: Cambridge University Press, 71-155. Holmstrom, B. (1982) 'Managerial Incentive Schemes - A Dynamic Perspective,' in Essays in Economics and Management in Honor of Lars Wahlbeck. Swenska Handelshogkolan, Helsinki.. Meyer, K. (1998) Direct Investment in Economies in Transition, Cheltenham: Edward Elgar. Jensen, M.C. and Meckling, W.H. (1976) 'Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,' Journal of Financial Economics, 3(4):305-360. Rayome, D. and Baker, J.C. (1995) 'Foreign Direct Investment: A Review and Analysis of the Literature,' International Trade Journal, IX(1), Summer: 3-37. Tanzi,V. (1998) 'Corruption Around the World,' IMF Staff Papers, 45(4):559-594.

412

Dam/en Besancenot and Radu Vranceanu

Tirole,J. (1996) 'Theory of Collective Reputations (with Applications to the Persistence of Corruption and to Firm Quality),' Review of Economic Studies, 63:1-22. Vickers, J. (1986) 'Signaling in a Model of Monetary Policy with Incomplete Information, Oxford Economic Papers,' 38(3):443-455.

NOTES 1.

2.

3.

4.

5.

6.

7.

Substantial literature analyzes the role of foreign direct investment in developing countries and its determining factors. See Donges and Wieners (1994), Dunning (1995) or the surveys of Agarwal (1980), Rayome and Backer (1995), Meyer (1998). There is an increasing amount of literature about the economic consequences of state officials, corruption of in developing countries (see the surveys by Bardhan, 1997 or Tanzi, 1998). The tendency of managers to work very hard in early years, when the market still assesses their ability, and less hard in later years was emphasized, in a different context, by Fama (1980), Holmstrom (1982) or Gibbons and Murphy (1992). In an overlapping generation framework, at the beginning of period t a new generation of young managers *J* go into business; the generation of managers who begun their activity at the beginning of period t-l become old, that is *P = £^ . During the period t the population of managers is made up of the newcomers vp and Q = X F _ i Considering a more realistic compensation scheme, for instance, with wages depending on profits, would not alter the main insights, but would complicate the calculus. Standard analyses assume concave production function and linear cost functions; in this case, an interior solution obtains to the profit maximization problem. Our assumptions allow us to get a more simple expression for the profit maximizing capital. Such a signaling problem was analyzed by Besancenot and Vranceanu (1997) as applied to economy-wide privatization of transitional economies.

Author Index Asheghian, Parviz xiii, xxi, 336, 385-394 Besancenot, Damien xiii, xxi, 336, 395-412 Bessler, Wolfgang xiii, xxi, 278, 310-331 Bryant, Sarah K. xiii, xx, 155, 157-169

Li, Ding xv, xxi, 278, 310-331 Lundan, Sarianna M. xv, xx, 13-14, 30-44 Maniam, Balasundram xvi, xxi, 277-278,294-309 Massey, Kate J. xvi, xx, 155, 157-169 Moncarz, Raul xvi, xx, 155-156, 170-187 Morgan, Irvin xvi, xxi, 278, 310-331

Coleman, R. Wayne xiii, xx, 14, 45-59 Derakhshan, Foad xiii-xiv, xx, 14—15, 78-90

Norsworthy, John R. xvi, xxi, 278, 310-331 Ozawa, Terutomo xvi, xx, 93, 95-113

Fatehi, Kamal xiv, xx, 14-15, 78-90 Fatemi, Khosrow xi-xii, xix-xxi, xxiii, 3-9, 13-15, 93-94, 155-156, 215-216, 277-278,335-336 Fourcans, Andre xiv, xxi, 335, 353-369

Pelzman, Joseph xvi-xvii, xx, 14, 60-77 Prodhan, Birnal xvii, xx—xxi, 216, 258-273

Gabrisch, Hubert xiv, xx, 93-94, 114-131 Gorener, Rifat xiv, xxi, 278, 310-331 Guha, Debashis xiv, xx, 94, 132-151

Salvatore, Dominick xvii, xix-xx, 13, 17-29 Segnana, Maria-Luigia xvii, xx, 93-94, 114-131 Shelburne, Robert C. xvii, xxi, 335, 337-352

Hein, Cheryl xiv, xx, 156, 188-201 Hiris, Lorene xiv-xv, xx, 94, 132-151 Jelic, Ranko xv, xx-xxi, 216, 258-273 Jesswein, Kurt xv, xxi, 336, 370-384 Kallianiotis, loannis N. xv, xx, 215, 234-257 Kreinin, Mordechai E. xv, xx, 156, 202-211 Langer, Simon H. xv, xx, 14, 60-77

Vaziri, Mo xvii, xxi, 336, 385-394 Vranceanu, Radu xvii, xxi, 336, 395-412 Warin, Thierry xvii, xxi, 335, 353-369 Witkowska, Janina xvii, xx, 215, 217-233 Zaman, M. Raquibuz xvii, xxi, 277, 279-293

413

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Subject Index n=footnote; t=table accounting standards 68-69, 336, 370-382 need for harmonization 380-382 types of 372-373 Africa 5, 78, 80 regional trade in 159-160, 189 Sub-Saharan 163 see also names of individual countries aging of population 291,338 agriculture 47, 51-54, 55, 80, 207, 257n,281 American Marketing Association 45 Andean Community (Andean Pact) 159-60, 175, 177, 178-179, 180, 184, 198 animal welfare 47 Argentina 9n, 74n, 161, 175, 179, 181, 184, 191, 197, 198-199, 200, 358 Ariff, Mohammed 305 Asia 5, 17-28, 80, 173, 205, 207 see also 'East Asian miracle'; East Asian crisis (1997-99); names of individual countries Asia Pacific Economic Corporation (APEC) 199,294 Association of South-East Asian Nations (ASEAN) 107t Australia 54, 317-319 Austria 246, 253, 259, 386, 389 Auto Pact (US/Canada) 191-192 balance of payments (BOP) 96, 99, 101-104, 107, 108, 109 Bank for International Settlements (BIS) 286 Bank Negara (Malaysia) 297, 306 Bank of South Korea 303

Belgium 189, 242, 246, 259 Blair, Tony 350 Bolivia 48, 178, 179, 181, 191, 198, 199, 200 'boom and bust' economics 96, 100 'borrowed growth' 95-96, 104, 105-107, 108-109 Brazil 9n, 52-3, 74n, 80, 86-87, 96, 161, 174, 175, 179, 181-182, 184, 191, 196-197, 198-199, 200, 205, 289, 342, 358 Brent Spar oil rig 40, 44n Bretton Woods talks (1940s) 6,101, 292, 337, 346-347, 350, 367-368 bribery 14,60-74 complicity in 62,64 definition of 61-64, 70 jurisdiction over 70-71 penalties for 66-68, 71 prevention of 68-69, 71-74 Bulgaria 74n, 190 Bundesbank (Germany) 253, 261, 270, 271, 348, 349 Burns, Arthur 137 business cycles 137-141 Canada 34, 39, 53, 175, 179-80, 191-192, 288, 358 Capital Asset Pricing Model (CAPM) 312, 323-324 Caribbean Basin Initiative (CBI) 175 Caribbean Community (CARICOM) 171, 175, 177, 178, 184 Center for Financial Technology (GET) 311,315, 330n Central American Common Market (CACM) 171,175,177-178,180, 184 child labor xx, 14-15, 54-55, 78-88, 166, 210 areas of use 80-81, 82 415

416

Subject Index

reasons for use of 81-83 regulation of 34, 83-87 Chile 74n, 174, 179, 181, 184, 191, 198, 199-200, 203, 210, 289, 344 China 79, 104, 105, 106, 189, 203, 209-210, 279, 280, 291 see also DAEs chlorine (in wood pulp) 35-37, 40 chlorofluorocarbons (CFCs) 38, 43n class-action lawsuits 40 climate change 31, 38, 41 Clinton, Bill 78-79, 205, 206, 209, 294, 350 Colombia 178, 179, 181, 198 common commercial policy 194 Common External Tariff (GET) 194, 196-197, 199, 203 competition domestic 33-34, 61, 230-231 international 13, 17-28, 19t, 21t, 23t, 24t, 25t, 26t, 27t, 28t, 34, 46, 50, 78,183-184 Comunidad Economica Centroamericana 175 consumers and child labor 85-86 and 'green' products 36-37, 41, 46, 51-52, 54-55 role in integrated economy 238-242, 246 Convention on Biological Diversity 52,57 convergence 93-94, 258 criteria for 259-260, 353 corruption among business managers 336, 395-397,410-411 among public oficials 14, 60-74, 289, 412n (see also bribery) estimation of likelihood 397-404, 405, 406-410 Costa Rica 174, 179 Cuba 173, 175 currencies convertibility of 170 within EMS 260-264 see also Euro; France; Germany; Italy; Japan; UK; US

current account (CA) deficit vs. surplus 95-100, 101-102, 104-110 cyclical theory (of economics) 133-141 Cyprus 254, 257n Czech Republic 116, 118, 215, 218-224, 223t, 227-228, 229 Dawood, Abdul Razak 81 debts, national 3, 4t, 93, 95-96, 99, 108, 174, 290-291, 306, 345-346 deflation (global bias towards) 346-350 democracy 172-173 Denmark 242, 253, 259, 353 Department of Agriculture (US) (USDA) 54 Depression (1930s) 337, 346, 348 disparity of wealth between nations 8, 9n within societies 174, 230 Duisenberg, Wim 356-357 Dynamic Asian Economies (DAEs), competitiveness of 20-28 'East Asian miracle' (of economic growth) 95-96,279,280, 294-295, 295t, 297-298 East Asian crisis (1997-99) xxi, 95-96, 103-107, 107t, 110, 176, 184, 206, 225, 277-278, 279-280, 292, 337 causes of 281-282, 298-299, 300-302, 302-303, 304-305, 310,338, 341-346 effect on markets 312, 319-322, 356 progress of 283-288, 284t, 2851, 286t, 287t, 295-297, 296-297t, 300, 302, 303-304, 316t, 317-319 proposed remedies 288-292, 299-300, 306 recovery from 307-308 Eastern Europe 189, 190, 207, 217-232 see also Transition Economies; names of individual countries

Subject Index

Economic Activity Act (Poland, 1999) 226-227 Economic Commission for Latin America and the Caribbean (ECLAC) 175 Economic Cycle Research Institute (ECRI) 133, 140 economic development xx, 93, 95-110, 165-166, 177 rapid, dangers of 95-97, 99-100, 281-282, 305 stages of 96-98 Ecuador 178, 198 education 281 government support for 298 vs. child labor 81,82-83 Eichengreen, B. 288-289 electricity generation 47, 49-50 Electrolux 46 employment levels 172, 205-206, 246, 253, 337, 346, 348-349, 353 environmental issues xx, 13-14, 31-42, 45-57, 208-209, 210-211 certification programs 45, 46-51 prioritization by MNCs 41, 45-46 regulation of 32-34, 38-42,45-46, 52-54 (see also certification programs) Environmental Protection Agency (USA) 36,38 Euro (single currency) 259, 354-355, 355-359, 367-368 European Central Bank 253, 335, 348, 349 administration and role of 354-355 management of Euro 356-357, 358-359, 367-368 European Coal and Steel Community (ECSC) 189-190, 234, 259 European Commission 217-218 European crisis (1992/93) 294 European Monetary System (EMS) 260-264, 269-271 history 258-259 European Monetary Union (EMU) 215,234-235, 256-257n, 353-355

417

European Union (EC/EU) xx-xxi, 5, 156, 158, 173, 206, 208, 215-216, 242-254, 347-348, 351 and the environment 51-52, 54, 55 formation of 170, 184, 189-190, 192-193,234-235, 259 global trading 17-26, 28, 209-210 membership of 189, 207, 217-218, 234, 235 structure of 194, 197-198, 203 trade with Eastern Europe 114-118, 118t, 119, 120t, 121-123,124-127, 130n,131n, 217-218, 221-225, 228, 229-232 trade with Latin America 178,180, 200 see also European Monetary System Exchange Rate Mechanism (ERM) 259, 261, 262-263, 264-265, 270-271,354 exchange rates 19, 139, 179, 198-199,260-261, 262-263, 265t, 266, 281, 297, 305, 314t, 318t, 319, 335, 340, 388 expert analysis, flaws in 280-281 extradition 65-66 Federal Reserve (US) 345, 348, 349, 355, 356-357, 367-368 Finland 34, 36, 50, 215, 246, 253, 259 Food and Drug Administration (US) (FDA) 54 food industry 47, 51-54, 55 Football Associations, International Federation of (FIFA) 84 forecasting (of economic trends) xx, 94,132-133,141-150,142t, 143t, 145t, 146t, 148t, 149t Foreign Corrupt Practices Act (FCPA) 14,60,69-71,72 Foreign Direct Investment (FDI) 336 in East Asia 100-101, 104, 280, 285t, 298, 306 in Eastern Europe 211, 218-224, 219t, 220t, 222t, 223t, 227-228, 231-232 in Latin America 180, 181-182

418

Subject Index

Forest Stewardship Council (FSC) 54 France 39, 130n, 189, 215, 242, 246, 253, 256-257n,259,266-269, 270-271, 288, 348, 356 currency 262, 264-265, 271 free trade agreements (FTAs) 4—6, 203 (see also regional trading blocs) global 157,159, 170-172 regional 116-117, 161, 171-172, 179, 180, 194, 225, 227-231, 235 Free Trade Area of the Americas (FTAA) 171,175,177,180,193 Freedom Food 47 G-3 group 159, 177 G-7 group 262, 288, 348 G-22 group 288,289 game theory (in economic analysis) 359-366, 363t, 365t, 369 General Agreement on Tariffs and Trade (GATT) 3, 6, 9n, 14, 51, 55, 157-158, 188, 202-204 Generally Accepted Accounting Principles (US) (US-GAAP) 370-371, 376, 379 genetically modified organisms (GMOs) 47, 51-54, 209 German Commercial Code (Handelsgesetztmch, HGB) 370, 376-377 German Dominance Hypothesis (GDH) 261,263,264 Germany 35-36, 46, 86-87, 189, 242, 246, 253, 257n, 259, 266-269, 270-271, 340, 348-349, 356, 386, 389,392 accounting standards 336, 370-371, 372, 373-380, 375t, 376t, 377t, 380-381, 382 currency 262, 264-265, 271 global economy 3, 72 future of 164-166, 172 history of 337, 348 andMNCs 30,41,45-46,50-51, 56-57, 184 and national economies 7, 109-110, 132, 157, 184

need for central control 349-51 and RTBs 7, 155-156, 159, 162, 163-164, 170, 171-172, 182-184 shortcomings of 335, 337-338 Global March (for child labor awareness) 87 globalization and child labor 79-80, 87-88 effects of 13,15, 45-46, 51, 56-57, 87-88, 173 opposition to 56 vs. nation state 3, 7, 78, 171, 254 see also global economy gold standard 337, 346 government securities 344-345 Granger causality test 268t, 269t, 271 Greece 5, 246, 253-254, 256n, 257n, 259,353 'Green Dot' program (Germany) 46 'green power' 47, 49-50 greenhouse gases 38-39, 43n Greenpeace 35, 36, 44n Greenspan, Alan 107, 113n, 356-357 Gross Domestic/National Product (GDP/GNP) 3, 4t, 33 of Asian countries 288, 290-291, 294, 295t, 297, 300-301, 305 in Eastern Europe 124, 132-133, 134t, 135t, 220-221, 220t in EU 246, 348, 355, 357t in Latin America 165, 181 of US 205,300 Guatemala 174 Harkin, Tom, Senator 85 Harvard Business Review 45 'hawk' vs. 'dove' (economic strategies) 361-366, 367-368, 369 Hong Kong 105, 158, 279, 289, 294, 311,317-319 see also DAEs; NIEs horticulture 47 human rights 209, 210 Hungary 116, 118, 190, 215,

218-224, 224t, 227, 229

Subject Index

imports/exports as indicators of economic growth/decline 284t, 287t, 305 as ratio of GDP 132-133, 134t, 135t, 141-147, 142t, 143t, 145t, 146t, 150 India 80, 86-87, 189, 205 Indonesia 43n, 78, 79, 105-106, 110, 191, 281, 283, 286, 289, 290-291, 294-297, 302-303, 306, 307-308, 311,317-319 Industrial Revolution 80 inflation in developing economy 100, 102 in Europe 258,260-261,353,356 in Japan 339 in Latin America 172, 174 Institute for Agriculture and Trade Policy (IATP) 54-55 integration, economic in EU 242-254, 243-244t, 245t, 247t, 248-249t, 250-25It in Latin America 174-176 theories of 236-242 Inter-American Development Bank 174, 181 interest rates in Asia 339, 344-346 in EU 236-238, 242-246, 243-244t, 245t, 258, 260-261, 262-263, 266-269, 267t, 268t, 269t, 270-271, 348-349, 356-357 International Accounting Standards (IAS) 370, 378-379 International Accounting Standards Commission (IASC) 370, 377-378, 379, 381 International Anti-Bribery Act 14, 69-71 International Confederation of Free Trade Unions (ICFTU) 84 International Financial Statistics (IFS) 386 International Immunities Act 70 International Labor Organization (ILO) 15, 80, 82-83, 84, 85, 210 International Monetary Fund (IMF) xix, 6, 7-8, 98,101,102,103, 242, 254, 279, 281-283, 285-286,

419

289-290, 292, 297, 298-299, 300, 302-303, 305, 336, 341-342, 344, 345, 346, 347, 350-351, 381 international monetary system (IMS), deficiencies of 337, 338, 343-351 International Organization of Securities Commissions (IOSCO) 370, 379, 380, 381 International Standards Organization (ISO) ISO 9000 228 ISO 14000 47, 50-51, 57 international trade, ground rules of 203-204 International Trade Organization (ITO) 6 intra-industry trade (IIT) 14, 30, 31, 115-116,117-121,1221, 123-126, 127-128, 130n investors, requirements of 395-396, 410-411 Ireland 242, 246, 259, 260 irradiation of food products 54 Islamic Summit 25 7n Israel 47 Italy 189, 242, 252, 259, 266-269, 356 currency 262, 264-265, 271 J-curve effect 96-97, 139-140 Jamaica 174, 181 Japan 13, 43n, 79, 103-105, 106, 158, 191, 206, 207, 209-210, 266-269, 279, 280-281, 286-288, 311, 357-358, 381 currency 262, 264-265, 271 economic problems of 283, 290-291, 310, 317-319, 337, 338-341 international trade 17-28 Kenya 47, 87 Keynes, J.M. 95, 335, 339, 340, 347, 350-351 Korea 106, 110, 158, 279, 281, 283, 286, 290-291, 294-297, 303-305, 306, 307-308, 310, 311, 317-319 see also DAEs; NIEs Krugman, Paul 104, 298, 346 Kyoto agreement 38-39, 43n

420

Subject Index

labeling systems 86-87 LABELS (e-mail newsletter) 54-55 labor costs of 8, 78, 80, 82, 161-162 movement of 177, 197, 205, 260 unions 208, 230 see also child labor Lafontaine, Oscar 356 Latin America 5, 9n, 207, 349 economic history 172-176, 193 regional trade in 155-156, 159-160, 170-185, 189 see also MERCOSUR; names of individual countries law international 31 national 8, 34, 65-68, 181, 226-227 liberalization (of trade) 32, 93-94, 95-96, 102, 114-115, 116-118, 122t, 126-127, 155, 165-166, 179-180, 205, 211, 226-227, 230 Lome IV Agreement 178 Luxembourg 189, 215, 246, 253, 259, 260, 386, 389, 392 Maastricht Treaty (1991) 234-235, 242, 253, 353 Major, John 257n Malaysia 54, 105-106, 110, 279, 283, 286, 290-291, 294-297, 305-306, 307-308, 311, 317-319, 352n see also DAEs managers, conduct of 395-402, 404-411, 412n manufacturing industries 23-24, 24t, 26t, 28t, 80 Mercado Comun de Sur (MERCOSUR) 9n, 156,171, 177, 182, 184-185, 192-200 administration 194-198 composition 191 formation 159, 175, 192-193 objectives 160, 194 trade relationships 161, 179, 180, 198-200 Mexico 5, 96, 175-177, 179-80, 184, 191-192, 205, 209, 294, 341-342, 346

Millennium Round see Seattle meetings mineral industries 184 Mitchell, Wesley 133,137,138 Montreal negotiations (2000) 43n, 52 Moore, Geoffrey 133, 139 Morningstar Asian-Pacific 311,315 Morocco 86 Most Favoured Nation (MFN) principle 203, 207 Multilateral Agreement on Investment (MAI) 38, 39 multilateralism 6, 170, 182-183, 184 multinational corporations (MNCs, MNEs) xix, 13-14, 184 and child labor 79-80, 83-4 and the environment 31-42, 45-47, 51-54 political role of 30-31 regulation of 14, 38-42, 39t, 54, 55-57 relations with national governments 31-2, 37-38, 41-42, 180-181 relations with RTBs 164-165 mutual funds 301,310-329 performance comparisons 319-324, 320t, 323t, 324t, 326-329, 328t, 329t National Bureau of Economic Research (NBER) 133, 136-137 national governments and the environment 30-31 relations with MNCs 31-32, 37-38 national sovereignty, issues of 78,157, 164, 209, 235, 252-254, 258-259 National Treatment Principle 204, 226 Nepal 86-87 Netherlands 47, 86, 189, 259, 356, 386, 389 New Zealand 317-319 newly industrialized countries (NICs) 34, 280, 285 Newly Industrializing Economies (Asia) (NIEs), competitiveness of 17-20

Subject Index

Newly Industrializing Economies (NIEs) (Asia) 28 Nicaragua 175 non-governmental organizations (NGOs) 13-14, 30, 36, 38-40, 85,166, 208-209 see also names of individual bodies Nordic Forest Certification Project 48 North American Free Trade Agreement (NAFTA) 5, 32, 38, 156, 158, 160, 171, 175-178, 179-80, 191-192, 193,194, 198, 203, 205, 207, 208, 210, 342 North Atlantic Treaty Organization (NATO) 254 Norway 50, 386, 389, 391 office equipment, trade in 22-23, 23t, 26t, 27t oil trade 160, 170, 172 open vs. closed economy 95, 99-100, 109, 176-177, 206 Optimum Currency Area (OCA) theory 258, 260, 262 Organization for Economic Cooperation and Development (OECD) 38, 39, 50, 60, 71, 242, 254, 348 membership of 74n, 225, 226, 227 'OECD Convention' (on combating bribery) 14, 60-74 Organization of Petroleum Exporting Countries (OPEC) 5-6, 9n Pacific Rim 190-191 see also names of individual countries Pakistan 78, 80, 81, 83, 87, 189 paper industry 32, 34-37, 38, 43n Paraguay 9n,191,196-197, 200 Paris, Treaty of (1951) 189 Paris meetings 39 Perot, Ross 79, 205 Peru 178, 198 Philippines 54, 106, 110, 279, 283, 286, 290-291, 294, 307, 311, 317-319, 358 'Phillips curve' 206

421

Poland 116, 190, 215, 218-224, 222t, 225-227,228-229 pollution 31 'pollution havens' 32-34 Portugal 5, 175,259,260 prostitution 80, 81, 83, 166 protest activity 7, 56, 207-209 Purchasing Power Parity (PPP) 261-263 Rainforest Action Network 49 Reagan, Ronald 175 regional trading blocs (RTBs) xx, 7, 155, 158-67,171-172 benefits of 160-162, 167, 260-261 drawbacks of 159-160, 162-164 future of 164-167 vs. national economies 7, 235, 252-254,260-261,270 see also free trade associations; names of individual organizations (e.g. EU, MERCOSUR) regionalism 4-5, 162-164, 171, 184 relative unit values (RUVs) 119-122, 119t, 127-128 Ricardo, David 157 Rio de Janeiro summit (1992) 31, 38-39 Rome, Treaty of (1957) 5, 189-190, 217, 234, 353 Rongji, Zhu 79 Ruggiero, Renato 171 Rugmark program 54—55, 86 rural issues 252, 257n Russia/Soviet Union 96, 190, 218, 342 Sachs, Jeff 281, 346 Save the Children 85 savings, domestic 246, 247t, 300, 338-340, 344 Scandinavia 38, 50 see also names of individual countries Seattle meetings (of WTO) 7, 8, 39, 55-56, 78, 156, 202, 205-211 Securities and Exchange Commission (SEC) 371-372, 377, 378, 379, 380, 381, 383n

422

Subject Index

service industries 80 Sharpe ratio 312, 322-324, 331n Singapore 105,279,294,311 see also DAEs; NIEs Skopje 254 Slovak Republic 74n, 116, 118 Smith, Adam 157 South Africa 358 South Korea see Korea Soviet Union see Russia soya products 53 S&P 500 index 310, 311, 315, 319, 322, 327, 330n, 388 Spain 5, 175, 242, 246, 259, 356 Special Drawing Rights (SDRs) 345, 347 sports equipment industry 80-81,84 Stanfield, Ron 112n statute (s) of limitations 66-67 stock markets 310-311,313-317, 314t, 318t, 336, 357t, 385-393 decline in 317-319 emerging 388-389, 389-393, 390t integration within region 324-326, 325t strategy, economic, models of 359-368, 363t, 365t, 367t Suharto, President 302-303 sustainability 31, 47-49, 54 Sweden 34, 35-36, 50, 242, 253, 259, 353, 386, 389, 391 Switzerland 86-87, 386, 389 Taiwan 105,210,279,294,311, 317-319 see also DAEs; NIEs technology, trade in 20-22, 211, 25t, 27t, 104 telecommunications industry 22-23, 23t, 26t, 27t textile industries 80-81, 86, 178, 180 Thailand 105,106,110,279,281, 283-285, 286, 289, 290-291, 294-297, 300-302, 305, 306, 307-308,311,317-319 see also DAEs Tibet 56 Tobin tax 344

trade balance 133, 147-50, 148t, 149t, 284t trades unions see labor unions Transition Economies (TEs) xx, 114-127, 130n,131n Treynor ratio 312, 322-324, 331n Turkey 254, 257n UNICEF 85 United Kingdom 48, 54, 80, 253, 259, 288, 353, 386, 389 currency 260-261,263-265, 269-271 economy 130n, 132-133, 135t, 141-150, 215, 216, 242, 246, 266-269, 348 United Nations xix, 31, 78-79, 254, 289 United States 13, 160, 202, 288 accounting standards 371-372, 373, 374-380, 375t, 376t, 377t, 378t, 379t, 382 currency 262, 264-265, 270-271, 335, 359 economy 96, 107-110, 132-133, 134t, 140, 141-150, 173, 175-176, 179-180, 191-192, 205-206, 266-269, 300, 323-324, 336, 344 and environmental issues 34, 38, 40, 43n, 47, 49-50, 51-2, 209 international dealings 17-24, 28, 86-87,176-178,199-200, 208-210, 221,341-342,347-348, 349, 351, 357-358, 367-368 legislation 47,49,69-71,72,85, 204, 210, 345 links with UK 268-269, 270 stock market 386, 389-392, 389-393, 390t Uruguay 9n, 174, 191, 196-197, 200 Uruguay Round (of GATT talks) 188, 203,206-208 Venezuela 160, 178,179 wage levels 8, 80, 82, 174,176, 208, 230 Washington meetings 7, 8 Westphalia, Peace of (1648) 258

Subject Index

wood products 47, 48-49, 54 see also paper industry wool industry 47 World Bank 6, 7-8, 9n, 254, 281-283, 289-290, 292, 381 World Economic Forum 22 World Trade Organization (WTO) xix, xx, 3, 8, 9n, 202-210, 254, 351 and child labor 78 conferences 204—205 (see also Seattle) and developing countries 166, 206-207, 208

423

and environmental issues 14, 38, 39, 46, 49, 52, 55-56, 57 functions of 167, 171, 202-204 history of 156, 157-158 membership of 79, 164, 179, 180, 188, 196, 203, 209-210 and RTBs 6-7, 167, 178 World War One 337, 348 World War Two 188, 338, 339, 343 Yugoslavia 254 Zimbabwe 47, 54