Speech at the Bank of Korea on Regional co-operation: experiences in East Asia and Europe
by Tommaso Padoa-Schioppa Member of the Executive Board of the European Central Bank, Seoul, 1 July 2003.
It is a great pleasure for me to be here with you today. At the outset, I would like to thank Governor Park (who unfortunately cannot be with us today due to prior commitments), Deputy Governor Lee and the Bank of Korea staff, in the headquarters and the Frankfurt Representative Office, for the excellent organisation of my visit to Korea.
In my remarks today, I would like to share with you some thoughts on recent developments in East Asian regional co-operation against the background of my own experience with the European regional integration process. First, I would like to begin with the main motivation behind my remarks of today. Second, I will briefly touch upon the respective merits of regionalism and globalisation, stressing that the two approaches are not alternatives, but can be combined for the benefit of both those countries involved and third countries. In this context, I will discuss the potential impact of regional integration, both in terms of trade creation and as a way of enhancing competition. Third, I will discuss what is known as "the endogeneity argument", according to which there is a relationship over time between the depth of trade and financial interdependence achieved and the closeness of co-operative arrangements developed by the countries concerned. As developments on the real and institutional sides become mutually reinforcing, this creates momentum towards further integration. Fourth, and connected with the endogeneity argument, I would also like to briefly review some conditions for sustained integration, focusing on sound institutional and legal underpinnings. Finally, before I conclude, I will reflect upon the need to address monetary and exchange rate co-operation at some stage in a regional integration process.
The 1997/98 Asian financial crisis marked an important turning point for the region. On the one hand, it was a traumatic experience that exposed some structural weaknesses of the "growth miracle", on the other hand, it brought about heightened awareness of the risks of contagion and the need for policy co-operation in the region, especially on financial issues. Greater awareness proved instrumental in driving the common goal of strengthened regional co-operation much higher on the East Asian countries' policy agendas. Korea, alongside China, Japan and the ASEAN countries, the so-called "ASEAN + 3" grouping, have played a central role in this respect. Within a short period of time in the aftermath of the crisis, major concrete co-operative steps have been taken, which include the Chiang Mai Initiative (CMI) and the Asian Bond Fund (ABF). A common goal is to help economies in the region to better deal with potential adverse shocks and attendant spillover effects, either through a network of currency swaps or by strengthening the regional financial market foundations. Meanwhile, the ASEAN + 3 has also agreed to work on closer economic partnership and to help lay the foundation of an East Asia Trade Area over the medium term. Thus, in my following remarks, for simplicity, I will use the term "Asia" when in fact referring to the ASEAN + 3.
For somebody like me, who has been involved in the European integration process for most of his professional life, this renewed interest in regionalism in Asia makes the attraction of drawing some sort of parallel with the European experience almost irresistible. Of course, I am well aware of the many major differences between the two experiences. Let me mention only two of them. First, after more than 50 years of sustained initiatives and convergence, the 15 Member States of the European Union (EU) have completed a single market with a single currency adopted by all but three members. By contrast in Asia, trade and financial integration, despite recent progress, remains at a relatively early stage of development. Second, when the process started in Europe, the countries involved were rather homogeneous with broadly similar per capita income levels and industrial developments, which is still deemed to be an important factor in facilitating regional integration. Given the larger differences in income levels and economic and financial structures across Asia, the process can reasonably be expected to be more protracted. However, a counter-argument in favour of integration among heterogeneous countries is that it can bring significant benefits to the less-developed partners, as we have started to experience with the accession of ten new member countries to the European Union. With these caveats in mind, there are still some dimensions of the European experience that might be of some policy relevance and value to other countries in the world pursuing regional integration, including Asia.
Regionalism and globalisation
One major concern often heard about a potential trend towards regionalism is its supposedly negative implications for global welfare. As Bhagwati succinctly put it, the important question is whether trade blocs serve as "building blocks" or "stumbling blocks" for worldwide trade liberalisation. It is generally agreed that regional integration is beneficial to the parties involved as economic factors are more efficiently allocated through increased competition and specialisation. However, depending on its specific economic and institutional parameters, a more integrated region may also imply discrimination against the "outsiders". In my view, provided the regional agreements are fully compliant with the open economy principles fostered and monitored by institutions such as the WTO and the IMF at the global level, the higher economic efficiency resulting from regional integration should also benefit the rest of the world through lower trading costs, trade-creating rather than trade-diverting flows and enhanced global financial stability.
Changes in trade patterns recorded in the European Union over time seem to support the view that regional integration does not necessarily mean trading less with the rest of the world. One needs only to examine two simple measures of intra-regional trade (i.e. sum of imports and exports): as a share of both total trade of the region and total GDP of the region. While the former indicator shows the importance of trade links within the region, the latter - by using the complement to intra-regional trade, i.e. extra-EU trade - captures the degree of trade openness of the region. Back in 1980, intra-EU trade as a percentage of total EU trade was already high, at around 58%. When the integration process was gathering further pace during the 1980s and 1990s, intra-EU trade rose steadily to a peak of 65% of total EU trade in 1992. Since then, the ratio has gradually fallen, dropping to below 60% last year. Over the same period, the degree of trade openness first declined from around 24% in 1980 to just above 20% in 1992, and then increased again to reach 29% in 2002. Since the share of intra-area trade in total trade was similar in 2002 as compared to 1980, this implies that extra-EU trade also increased as a percentage of total GDP of the region. Considering that the single European market was completed in 1992, these changes suggest that trade in a largely integrated region does not necessarily result in ever growing intra-area trade at the expense of openness vis-à-vis third countries. Indeed, the EU experience over the last two decades shows that the reverse may be true.
On a more analytical level, both regional integration and globalisation entail the opening-up of domestic markets to cross-border trade and financial flows. In economics textbooks, we have all learned that an economy will become more efficient under increasing competition. In this context, regional integration may be seen as a second-best policy choice, since there are more potential competitors in the global economy than in a region. However, the gravity model of trade integration suggests that geographic, institutional and cultural proximity matters for cross-borders flows. This model implies that the intensity of competition may be inversely proportional to distance. And one may infer from this tentative proposition that opening up economies in a regional context may result in more intense external competition than trade and financial liberalisation erga omnes. From this perspective, it seems difficult to claim that regional co-operation is less favourable than global integration.
Endogeneity of regional integration
Apart from the exogenous factors I have just mentioned, arguments relating to the endogenous nature of regional integration also need to be considered. Such endogeneity relates to the fact that, over time, the degree of trade and financial interdependence and the corresponding level of co-operative arrangements are likely to be mutually reinforcing. Certainly, co-operation arrangements are based on pre-existing economic interdependence; but it is also true that they foster a furthering of interdependence. For example, if countries in a region mostly engage in intra-industry trade specialisation or are initially susceptible to common demand shocks, then business cycles are likely to become more similar across the countries concerned, as trade increases. In other words, closer trade ties within a region over time may be expected to result in more synchronised business cycles within the region, which in turn would make trade, economic and financial co-operation more desirable. This endogeneity argument appears to be relevant to Asia, in particular given the region's high dependency on IT exports. Cyclical developments in global IT demand are likely to influence domestic business conditions in the region in a rather symmetrical manner, which in turn would call for improved regional co-operation.
This endogeneity argument also extends to the link between institution building and economic integration. In the EU, institutional progress beyond the creation of a customs union towards a single market and an economic and monetary union was associated with a deepening of economic integration. In parallel, increasing economic integration validated and supported the process of institutional integration. From 1968 to 1992 when the EU progressed from a free trade area to becoming a single market, the number of binding legal acts across policy areas adopted by the European Community increased substantially. In the first half of the 1970s, the Community adopted more than 2,600 acts, and the number rose steadily over the next two decades, to around 12,500 acts in 1991–1995. For this reason, institution building appears to be one of the prerequisites for sustained regional integration.
Institutional underpinnings for integration
Admittedly, there are many prerequisites for sustained regional integration. However, allow me to focus on EU institutional and legal underpinnings in three main areas: trade and the EU single market, financial market regulation and supervision, and macroeconomic policy surveillance. In reviewing them, I will try to identify issues of specific relevance to Asia.
Trade and the EU single market
Obstfeld and Rogoff have argued that market segmentation caused by microeconomic factors such as trade frictions and costs, as well as nominal price rigidities can help explain the so-called exchange-rate disconnect puzzle, i.e., "why are exchange rates so volatile and so apparently disconnected from fundamentals?". One policy implication of this argument is that greater integration at the micro level could help reduce exchange rate volatility among the countries involved, while in turn making these countries more vulnerable to exchange rate fluctuations. In line with the endogeneity argument discussed above, the countries concerned would then have a strong incentive to stabilise their exchange rates through strengthened co-operation.
The European experience suggests that to successfully remove these microeconomic obstacles to integration is a very difficult task and requires strong institutional and legal underpinnings. If one takes trade integration as an example, while it may be relatively straightforward to develop a free trade area by removing all internal tariffs, doing away with more opaque "non-tariff" or "regulatory" barriers to trade is a considerably more complex and difficult task. Unlike customs duties, microeconomic regulations cannot simply be dismantled. In practice, the smoothing of technical obstacles to trade requires the harmonisation of a vast array of differing national regulations.
In Europe, only with the "single market programme" from the mid-1980s onwards did the European Community make significant headway in easing market segmentation at the microeconomic level. This was more than ten years after the removal of all customs duties and quantitative trade restrictions. Arguably, the success of the single market programme rested on the combination of a number of elements of the Community's institutional and legal framework. Against this background, a policy question relevant to future regional integration in Asia is whether, at some point, a stronger institutional and legal framework would be needed alongside further trade integration.
Financial market regulation and supervision
The European approach to financial market regulation combines the harmonisation of essential rules with the application of the principle of mutual recognition of national regulations. This approach ensures region-wide financial stability, while allowing financial service-providers who meet the requirements of their domestic legislators to be free to provide services to consumers throughout the Community. A first step in the harmonisation of essential rules has often consisted in the incorporation into Community law of the standards and codes set by international bodies, such as the Basle Committee on Banking Supervision, the International Organisation of Securities Commissions and the International Association of Insurance Supervisors. However, harmonisation has invariably extended well beyond the observance of international standards and codes. At present no fewer than 26 Community legal acts are in force to regulate the activities of banking and securities markets. These Directives cover a broad variety of aspects of financial market regulation, ranging from minimum capital requirements and accounting and transparency standards to deposit guarantee schemes and rules concerning the sharing of responsibilities for supervising multinational institutions. The principle of mutual recognition, which is applied to financial market regulation, also extends to the prudential supervision of financial institutions.
Given the need for Asian countries to continue to develop their regulatory and supervisory frameworks, a relevant policy question that may arise in the light of the European experience is whether Asian countries should continue to pursue national approaches, or whether it might be preferable to develop a harmonised framework at the regional level. A regional approach to financial market regulation and supervision may be preferable given the integrated nature of financial markets and the risk of financial market contagion. It could facilitate financial market consolidation and provide efficiency gains. At least for some of the smaller Asian economies, the development of a single financial market infrastructure may be the only way to benefit fully from sound, diverse and liquid financial systems capable of securing and maintaining the confidence of international investors and thus supporting financial stability.
For co-operative arrangements to be sustainable, mutual surveillance and peer pressure have an important role to play in the macroeconomic field, once a certain degree of economic integration has been achieved. Also in this area, institution building and rule-based policy frameworks have proved instrumental in the EU experience. I will spare you a detailed analysis of institutional arrangements like the European Monetary System, the Maastricht convergence criteria or the Stability and Growth Pact, which have all been essential in furthering or maintaining macroeconomic convergence in the EU. Allow me only to try and identify a few basic principles that may be distilled from the EU experience in the area of regional macroeconomic surveillance. First, there is a need to pool required information and statistical data on the basis of mutually agreed technical specifications. Second, in order to facilitate exchanges of views and common assessments, the countries concerned must agree on common benchmarks against which to assess national performances. In the EU experience, the Maastricht criteria played this role in the second stage of EMU. Third, peer pressure is not likely to be very effective in a purely intergovernmental setting. In the EU context, this difficulty was addressed by creating supranational institutions, like the Commission and later the European Central Bank, endowed with sovereign competencies within well-defined remits and subject to clear transparency and accountability obligations.
Compared with trade integration and harmonisation of financial regulation and supervision, macroeconomic surveillance is probably the area where institution building may turn out to be the most difficult in the context of regional co-operation. The EU experience supports this view, since the introduction of the single currency was designed as the final step following on from trade, economic and financial integration. From this perspective, one may argue that it would be premature for Asian countries to take steps towards further macroeconomic surveillance, in view of their current level of regional integration. I would tend to disagree with this view, since the EU experience shows that long lead times are needed for institutional arrangements to have an impact on a regional co-operation process. To take only one example, the Committee of Governors of the EU central banks, which was the forerunner of both the European Monetary Institute and the ECB, was created in 1964. This was 15 years before the setting-up of the EMS/ERM, which marked the first significant step in monetary and exchange co-operation in Europe. In this connection, I am not sure that it was appropriate to rule out the project of an Asian Monetary Fund, put forward in the aftermath of the 1997/98 Asian crisis, as being premature.
Monetary and exchange rate co-operation
Exchange rate stabilisation has long been at the heart of Europe's integration effort. The lack of progress in trade integration in Europe during the years after the collapse of the Bretton Woods system is to be largely seen as the result of a failure to maintain exchange rate stability. Then, following the establishment of the European Monetary System in 1979, exchange rates once again became more stable, and this period of sustained monetary and exchange rate co-operation significantly coincided with further trade integration.
The history of Asian countries is very different. After the collapse of the Bretton Woods system, while European currencies delinked from the dollar, most Asian currencies, with the Japanese yen being the notable exception, continued to peg their exchange rates to the dollar. This common peg to the dollar provided an informal common monetary standard that contributed to macroeconomic stability in the region but also proved, at some point, unsustainable. Since the demise of this common standard in most Asian countries in 1997/98, there has been a wide range of proposals on possible exchange rate and monetary co-operation, including the adoption of a common currency or a peg to a common basket of currencies.
Although I do not intend to enter this debate, I would like to emphasise that it would be difficult to make further progress towards regional economic and financial integration without having to address, at some point in time, the issue of the "monetary dimension" of such co-operation. From the perspective of policy-makers, exchange rate stability should support an open trade policy and avoid trade-distorting developments. At the same time, by promoting a more efficient allocation of resources, both trade integration and exchange rate stability are likely to support output growth, which should, in turn, facilitate the opening-up of markets and the maintenance of a stable exchange rate. In this context, if Asia does seek to proceed further with economic and financial integration, it seems likely that increasing attention will need to be paid to fostering exchange rate stability. Progress in either of these areas is likely to be more difficult without steps also being taken to strengthen the "monetary dimension" of regional co-operation in Asia.
Ladies and gentlemen,
The development of the European Union is generally regarded as one of the most advanced regional integration processes. In many ways, for example in the initial conditions and country characteristics, it is unique, and, as such, does not, and cannot, offer a blueprint for regional integration in other regions. Nevertheless, the EU is based on core elements that are fundamental to all efforts to deepen regional integration, and identifying these is both insightful and useful for drawing possible lessons. For one, regional integration is not only good for the parties involved, but it is also likely to be beneficial to the rest of the world. Second, the importance of institution building in the European Union in supporting the integration process cannot be overemphasised. Third, the EU experience shows that macroeconomic regional surveillance, preferably through formalised mutual surveillance mechanisms, enhances regional peer pressure. Such a framework is also likely to facilitate the dissemination of best practices in other policy areas (e.g. structural and financial policies, institutional and market infrastructures).
Given the degree of regional integration already achieved, I believe that Asian regionalism will prove to be a sustainable process and, like the rest of the world, we look forward to a greater global role for Asia in the future.