Section 4 Stronger economic relations and regional institutional integration in East Asia

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1 Section 4 Stronger economic relations and regional institutional integration in East Asia <Section 4 Key points> 1. New relations in the East Asian region In pursuit of high-level economic integration in East Asia In East Asia, economic relations are becoming noticeably stronger despite the fact that there are no established institutional frameworks like the European Union (EU) or the North American Free Trade Agreement (NAFTA) in place. The experience of EU market integration suggests that as institutional integration develops in East Asia in the future, so too will the intra-regional division of labor which will enable the countries within the region and the region as a whole to enjoy economic growth. However, in order to rectify intra-regional disparities through market integration, it is necessary to satisfy certain requirements, including the accumulation of human capital, improving financial markets, refining competition policies, and the like. In this light, the East Asian region can be said to be moving toward meeting these requirements and preparing for market integration. In reality, however, as there are big economic disparities among some countries within the East Asian region, it is desirable to proceed with integration in combination with direct economic assistance such as ODA in accordance with the stage of development. Along with this assistance and cooperation, the achievement of high-quality East Asian economic integration which not only reduces tariffs but also liberalizes and facilitates the regional movement of goods, services, people, and capital at a high level will bring the region win-win benefits. 2. Coordination of policy for intra-regional movement of labor in East Asia Towards a greater East Asia-wide human resources policy Not only are trade and investment becoming increasingly stronger and more active in East Asia, but the movement of natural persons is also becoming increasingly active. On the other hand, however, within the region a lag in human resources improvement and a lack of development of rules regulating the movement of natural persons can be seen. There is also the problem of the brain drain of highly-skilled human resources to areas outside of the region such as Europe and the U.S. In order to deal with these problems, an East Asia-wide human resources policy is necessary. Specifically, it is required to set up a network for the movement of natural persons and human resources development in East Asia that is tailored to each level of human resources. 3. Efforts toward the coordination of policy in East Asia Approach to common cross-border issues East Asia has started to make efforts to coordinate regional policies in various fields in pursuit of further deepening economic relations. For example, it is harmonizing the systems in the economic field in each country

2 Specifically, cooperation is taking place and discussions are being held in fields such as the stable supply of energy, currency swap arrangements to prepare for a currency crisis and the nurturing of financial markets, harmonization among standard attestation systems, and measures to deal with global environmental issues. 4. Social harmony in East Asia which shares economic prosperity The East Asian Community concept The discussions over an East Asian Community which pursues not only economic but also political and social East Asian integration to coincide with the deepening relations of economic interdependence are gathering momentum. While there are many issues to be resolved in order to create an East Asian Community, the movement in pursuit of integration in the institutional and social aspects, as well as the traditional functional approach contributes to the formation of high-level East Asian economic integration, and each country is required to make further efforts. In the previous section it was stated that for Japan, which is facing a falling birthrate, an aging society, and a shrinking population economic partnerships with East Asia will be an important part of its economic growth strategy. On the other hand, the economic integration of East Asia definitely does not cause conflicts of interest among countries and regions, but will encourage further development in all of East Asia, not just in Japan. However, the current situation is that institutional integration is lagging behind the de facto deepening of interdependent relations in East Asia. Therefore, in this section we will discuss these issues from a wider perspective and describe the ideal approach to East Asian integration for bringing about the prosperity of all of East Asia. Specifically, we will first of all discuss how the integration of East Asia affects trade and investment, as well as corporate activities. Next, we will examine the establishment of intra-regional rules for human resources development and the movement of natural persons in East Asia and the desirable form of coordination of policy. In addition, we will describe intra-regional coordination of policy regarding cross-border issues before finally mentioning the East Asian Community concept about which lively discussions are currently commencing, as we examine the future direction of East Asia. 1. New relations in the East Asian region In pursuit of high-level economic integration in East Asia As already described in this white paper, in the East Asian region closer de facto economic relations are rapidly developing whereas institutional integration 1 is lagging behind. 1 In this chapter, institutional integration means abolition of border and domestic regulations and harmonization -435-

3 Below we will confirm the strength of interdependent relations among countries and regions in East Asia and then make a prediction concerning how the East Asian economies will change if institutional integration progresses in the East Asian region, with reference to the effects of EU integration. We will also show that in this context institutional integration has the effect of reducing intra-regional internal economic disparities, which contribute to the growth of not only Japan and the other intra-regional developed countries, but also to the developing countries within the region, and bringing about so-called intra-regional win-win development. Yet at the same time we will argue that it is necessary to take a realistic integration approach tailored to the stages of development of each country and region in East Asia, as there are currently large economic disparities in this region. The EU has developed structural funds as a framework for rectifying intra-regional economic disparities; in East Asia Japan s ODA has played that role. Finally we will attempt to sort out the future points for discussion by comparing the degree of progress of institutional integration in East Asia with EU economic integration. (1) Current economic relations in East Asia The de facto deepening of economic relations is progressing As described in Chapter 2, division of labor in East Asia is moving away from the former structure of the division of labor among industries and there is a deepening move toward the intra-industry division of labor structure, including the division of labor among processes in the manufacturing industries, with economic relations among each country and region in East Asia becoming even closer. In the countries and regions of East Asia, the characteristic feature of interdependent relations is that even though there is no solid institutional framework like the EU or NAFTA established, de facto economic relations are continuing to become closer. Figure compares the intra-regional trade ratio in the East Asian region with the intra-regional trade ratio of the EU and NAFTA, respectively. It shows that East Asia s intra-regional trade ratio is higher than NAFTA s and is approaching the level of the EU s ratio at the time of the formation of a single market (institutional integration) there. This is the result of the fact that East Asia-wide production systems and sales networks have been formed, primarily by Japanese companies, which has encouraged increasingly active trade in intermediate goods and final products. of economic institutions, etc. in order to further liberalize and facilitate the intra-regional movement of natural persons, goods, and money between two specific countries or among multiple countries

4 70 (%) Figure Intra-regional trade ratio of each region EU: Signing of European agreement with Central and Eastern European countries. Preparations under way toward market integration EU: Agree to form single market EU: Intra-regional market integration completed ASEAN: CEPT commences EU: Euro introduced NAFTA enters into force East Asia EU15 EU25 NAFTA (Year) Notes: East Asia includes Japan, China, Korea, Hong Kong, Taiwan and ASEAN10. The export and import data for each country and region based on Taiwan is for However, the export and import data for Taiwan based on each country and region is for Source: DOT (IMF), Trade Statistics (Board of Foreign Trade, Taiwan, Chinese Taipei) ( Now that East Asia has reached this stage, developing an institutional framework to facilitate and revitalize economic activities in conjunction with the deepening of de facto economic relations will further promote the economic prosperity of East Asia. Below we will discuss the EU as a prior example of integration and study changes to the division of labor within the EU region, along with the hints they provide for the promotion of integration in the East Asian region. (2) The deepening of economic relations through market integration The example of the EU (a) Background to the formation of a single market With the entering into effect of the Single European Act in 1987, Europe moved to implement its plan for the formation of an intra-regional single market by the end of 1992 and the EC, which had been only a customs union until then, developed into a common market and subsequently deepened its integration into an economic union. 2 In 1958, the year the European Economic Community (EEC) was launched, the EEC Treaty was already calling for the removal of obstacles to the free movement of persons, services, and capital, had established the formation of a single market as an objective, and had stipulated that this should be gradually implemented 2 Balassa (1961) classifies regional integration into five types by degree of integration: (1) free trade area (abolition of intra-regional tariffs), (2) customs union (creation of a common tariff wall against non-member countries), (3) common market (liberalization of capital and labor movements), (4) economic union (creation of common tax measures, regulations, and economic policies), and (5) total economic integration (integration of budget systems and currency mechanisms) (Ministry of International Trade and Industry (2000), p. 104)

5 during a 12-year transition period. However, all that was actually completed by 1968 was a customs union. 3 This situation began to change and a movement to abolish non-tariff barriers emerged because Europe s competitiveness declined relative to that of Japan and the U.S. beginning in the 1970s. In the 1950s and 1960s the European economies were riding a wave of rapid economic growth and had achieved a satisfactory level of development, but in the 1970s they suffered from serious economic stagnation due to the impact of the Nixon Shock and the oil crises (Figure 3.4.2). In the 1980s the awareness emerged that non-tariff barriers, which had not received much attention during the rapid growth period, were gradually obstructing the deepening of economic integration. At that time, the governments of Europe had a variety of regulations (non-tariff barriers such as currency exchange restrictions, quantitative restrictions, import bans, and restrictions on the validity period of patents) in place to protect companies and markets in their own countries. Each company was obliged to establish a subsidiary and carry out production and supply in each country so that inefficient production systems were constructed within the region. 4 The measure that was proposed as a way to overcome this situation was the formation of a single market that would free up the movement of goods, services, capital, and people. (%) 10 Figure Real GDP growth rate of EU15, US, and Japan EU15 US Japan s 1970s 1980s Note: Annual basis for each decade. Source: Ameco_on_line (AMECO Database). 3 It has been pointed out that this is because the authors of the EEC Treaty saw the customs union and common agricultural policy as essential goals, while they thought the formation of a single market was a special long-term goal. As further evidence for this, the EEC Treaty contains detailed provisions concerning the customs union and common agricultural policy whereas provisions related to other forms of integration are only simply described. In addition, there are clauses under which special exemptions can be established and used to indefinitely defer the obligation to liberalize (for example, liberalize the movement of capital) (Tanaka (1991), p. 72). 4 Tanaka (1991), p

6 (b) The abolition of non-tariff barriers The aim of the formation of a single market was to realize efficient intra-regional resource allocation and increase the competitiveness of the European economies through the removal of non-tariff barriers. In Completing the Internal Market: White Paper from the Commission to the European Council, published in 1985, approximately 300 market integration directives necessary for the removal of barriers were advocated. The content of these directives is shown in Table 3.4.3, and they can be broadly classified into three types (physical barriers, technical barriers, and tax barriers)

7 Table Target items of Completing the Internal Market: White Paper from the Commission to the European Council Non-tariff barriers of the EU and effects of their abolition Examples of contents of barrier elimination Examples of results and effects of barrier elimination 1. Elimination of physical barriers Introduction of system that harmonizes classification and Reduction of customs forms by 60 million cases annually codification of goods in each country (1) Border control of goods Reduction of approximately 85% of customs control procedures Application of the new integrated tariff table of the EC for goods (abolition of various Made it possible for traders and road transporters to annually reduce ECU 5 billion whose classification has been harmonized restrictions by customs) (estimate) Introduction of the Single Administrative Document (substitute Economization of around ECU 370 million annually by transporters through various documents, and introduce a new simple document) elimination of delays at borders (estimate) (2) Border control of Emergence of new types of distribution and arrival of new distribution managers in Simplification of intra-regional immigration control persons charge of them Adjustment of visa policies for each country (relaxation of inspections at Reform and price reduction of service content relating to distribution Harmonization among countries of regulations concerning weapons immigration, of belongings, Approximately 62% of the 13,500 businesses surveyed responded that they gained and drugs etc.) profits through elimination of delays at borders 2. Elimination of technical barriers (1) Free movement of goods (standard and authorized) (2) Government procurement (opening of government procurement sector) (3) Free movement of workers and professional employees (mutual accreditation of professional qualifications, diplomas, etc.) (4) Liberalization of services (entry into financial services, transport, new technology services, etc., and liberalization of economic activities) Mutual accreditation of each country's pertinent laws (mutual Application of mutual accreditation, uniform standards, etc. for approximately 64% accreditation) of all intra-regionally traded goods In cases where there are large discrepancies between countries' In the survey, 30-45% responded that they attained profits in the chemical, regulations, substitute with the EU legislation in necessary areas machinery manufacturing, office appliance, food, and automobile industries (technical harmonization) An approval inspection for all models and types is used for approval inspections of Implementation of the New Approach combining the above mutual automobiles, and carmakers have economized development costs by 10% (estimate) accreditation and technical harmonization*1 Uniformization of standards has progressed within Europe and since 1990, more than Require reporting to the European Commission when each country 2,000 standards have been set establishes a new regulation or standard Opening up of major utilities sectors including communications, waterworks, energy, and transportation to foreign companies within the region Public bodies such as central and local governments need bid announcement for contracts exceeding a specified amount Mutual accreditation of professional qualifications Cooperation between educational institutions of member countries and promotion of exchange Development of youth exchange for embarking on job training and overseas volunteering Financial services: Introduction of unified licensing system for banking industry, insurance industry, and securities industry*2; expansion of scope of business in banking industry; and liberalization of sales of investment trusts by the securities industry Transport: Liberalization of intra-regional transport (abolishment of quotas); and liberalization of entry into transport industry by residents of other member countries Others: Establishment of regulations on pan-eu frequency of car phones and EU standards, etc.; and formulation of EU intra-regional broadcasting area (unification of each country's broadcasting related legislation) Liberalization of short-term securities investment Liberalization of opening of personal accounts in and borrowing (5) Free movement of from other countries capital Liberalization of credit relating to financial transactions (loans to (removal of factors that businesses, etc.) prevent the free movement Abolishment of two-tier exchange rate system of capital) (The above items constitute the Fourth Liberalization Directive for Capital Movement.) (6) Condition s requiring (1) Corporate law (introduction of the Societas Europea, rapprochement of each country's corporate laws) (2) Intellectual and industrial property rights (integration of cooperatio n between intra-regional enterprise commercial law, s patents, copyrights, etc.) Promotion of corporate mergers across borders Exemption of publication of accounts by subsidiary Proposal relating to the Societas Europea*3 Integration of regulations in each country relating to trademarks Proposals concerning the location of the office controlling the community trademark Proposals concerning the vocabulary to be used by the community trademark Establishment of a court to appeal patents by the community (3) Taxation system (abolition of tax Introduction of joint tax system relating to dividends among parent barriers related and subsidiary companies to companies Introduction of a joint tax system for joint ventures, etc. that operate across borders) 3. Elimination of financial barriers Bid announcements in the Official Journal of the EU increased from 12,000 (1987) to 95,000 (1995) Procurement from overseas by the public sector increased from 6% (1987) to 10% (1996) Cost of communication facilities and rolling stock fell 20-30% Cost of electricity facilities fell 30-40% Annually 35,000-40,000 qualified persons have attained or are in the process of applying for the right to work as specialists in other member countries within the region Approximately 1 million exchange students receive support from the Erasmus Programme (it is one of the educational and cultural programs of the EU countries, and is a program that aims to promote human exchanges at the university level) and complete a part of their education in other member countries Air fare (discount fares) fell by 41% ( ) Intra-regional airline companies increased from 119 companies (1992) to 133 companies (2002) Charges by water transport businesses fell by about 30% in Germany, Belgium, France, and the Netherlands Cost of domestic calls fell approximately 50%, and cost of international calls fell approximately 40% The communications market rapidly grew from 182 billion euros(1999) to 236 billion euros (2002) With regard to capital movement, the First Liberalization Directive was submitted in 1960, the Second Liberalization Directive in 1962, and the Third Liberalization Directive in 1985, but the Fourth Liberalization Directive, although there are some reserves, is moving toward almost complete liberalization Expenses from raising funds by corporate bonds fell by approximately 0.4% Reduction of costs by approximately 0.5% through the integration of EU stock markets (estimate) Ongoing investigations on ways to remove major conflicts due to difficulty of completely integrating each country's corporate laws The Societas Europea was adopted in 2001 (As a result, it became unnecessary to complete procedures under corporate laws of each member country for the operation of a company including establishment, registration and report of accounts, etc. However, many criticize this law for not including regulations relating to tax systems, and therefore, after establishment of a European company, group businesses and branches in member countries have to individually make tax payments to the country they are in) As a result of creating the choice to attain the community trademark through the office in charge of the community trademark, which began operating from January 1, 1996, 30,000 requests came in the first six months After adopting the EC Directive, each company adjusted its laws (1) Value-added tax (harmonization of valueadded tax among member countries) Minimum tax rate set After adopting the EC Directive, each country adjusted its laws (2) Specific consumption tax (harmonization of specific consumption tax among member countries) Set tax rates for alcohol tax, cigarette tax, and petroleum products tax After adopting the EC Directive, each country adjusted its laws Notes: *1 The method of combining mutual accreditation and technical harmonization and harmonizing the discrepancies among the countries' standards is called the New Approach, and it is *2 Unified licensing system: For example, in the case of banks, if a banking license is acquired in any one of the member countries, then they are free to operate the banking business in all EU countries, open branches and freely offer services across borders. *3 The Societas Europea is a legal system based on the European Union Law, offering companies the option of establishing a European company. Source: Documents from various sources including European Commission (1985), Mario Monti (1998), European Commission (2003), The European Commission's Internal Market and

8 First, physical barriers refer to the variety of regulations that are implemented when goods or persons cross national borders. For example, it can be said that the time it takes to pass through customs and the expenses generated by preparing the related paperwork are factors that hinder the free movement of goods within the region. Completing the Internal Market: White Paper from the Commission to the European Council proposed the abolition of the submission of shipping notification documents and guarantee certificates, as well as the relaxation of passport controls, and so forth as means to eliminate these factors. Second, technical barriers refer to non-tariff barriers that arise from the differences in regulations and practices between the member states of the EU. Many of these barriers exist in a variety of sectors. Examples of their abolition include standardization of product technology and mutual recognition of the results of product testing, expansion of sectors subject to government procurement, mutual recognition of vocational qualifications, introduction of a single licensing system in the financial services industry, 5 relaxation of regulations on entry into the transport industry, abolition of regulations concerning short-term capital movement, harmonization of the content of corporate laws in each country, and the integration of trademarks, patents, and copyrights. Third, tax barriers are barriers arising from the differences among taxation systems in each country. Specifically, the report made proposals concerning the tax rate of value-added tax and specific consumption taxes (alcohol tax, cigarette tax, etc.) including a minimum tax rate for value-added tax of 15% or more, for example. (c) Effects of the formation of a European single market Effects of the abolition of non-tariff barriers (Increase in trade and investment and improved efficiency of industries) As shown in Figures and 3.4.5, trade and investment within the region increased as a result of the removal of the barriers described above. 5 Concerning banks for example, a banking license obtained in any one of the member states in the EU region is automatically valid in the other member states in the region. The bank which obtained the license can establish a branch anywhere in the EU region and provide services across national borders to companies and individuals in the other countries

9 (%) 68 Figure Intra-regional trade ratio of EU Start of single market Release of the Completing the Internal Market: White Paper from the Commission to the European Council (Year) Source: DOT (IMF). ($ million) 800,000 Figure Amount of direct investment from countries and regions to the EU15 600, , , EU US Japan China NIEs ASEAN4 (Year) Source: International Direct Investment Statistics Yearbook (OECD). For manufacturing industries, the benefits produced by the abolition of customs procedures and the mutual recognition of the results of product testing and the integration of standards were particularly great. The abolition of customs procedures brought about a direct reduction of costs and reduced transit times as well. The mutual recognition of the results of product testing and the integration of standards also reduced costs and made it easier for companies to enter the markets of other countries within the region. Looking at the example of the impact on the automobile industry, the EU member states agreed to implement certification testing for entire automobiles rather than for each component (full-body certification testing) and, as a result, an automobile which has been certified as having marketing authorization in any one EU country is automatically -442-

10 permitted to be sold in all the other member states. 6 It is estimated that as a result of this change automobile manufacturers have realized a 10% savings on their development costs. 7 In addition, it is thought that the removal of technical barriers has resulted in a large cost reduction in the highly-regulated food manufacturing and chemicals industries. Looking at service industries, competition is intensifying in many sectors, and restructuring of businesses and improvements in efficiency have been observed. For example, in the distribution industry the elimination of delays when crossing national borders and the abolition of physical barriers has made Europe-wide distribution and sales easier and, as a result, companies and sectors that have formed distribution networks centered on hubs (bases) and radiating out like the spokes of a wheel throughout the region 8 have appeared. Furthermore, in the communications equipment sector there has been an expansion of the content of services and the restructuring of companies. Many of the EU countries state enterprises monopolized the communications sector, but opening up communications markets to overseas providers after the formation of a single market led to a decline in communications-related prices and a qualitative improvement in the content of services. The restructuring of companies progressed, and partnerships were formed between France Telecom and Deutsche Telekom, and between British Telecom and Compagnie Générale des Eaux. In addition, similar effects have been confirmed in the transport and financial industries. These types of industries are industries that play the role of a lubricant, facilitating economic activities in other industries so that achievement of Europe-wide services provision, reductions in prices, and improvements in the quality of the content of services in these sectors has led to increased competitiveness and efficiency in other industries and stimulation of the development of all of Europe. Concerning the restructuring of companies, the relocation of factory branches has often been seen in addition to mergers and acquisitions. 9 It is thought that this is the result of the fact that each company sought to construct production and sales structures that were most suitable for the entire region. Looking at this situation using the industry specialization index reveals that the index is higher in than it was in in all EU countries except the Netherlands. It can be discerned that the formation of a single market within the EU region has led to greater specialization of the industrial structure of each country (Table 3.4.6). 6 Implemented in Mario Monti (1998), p European Commission (1996d), p Hara (2001); Institute for International Trade and Investment (1996); Institute for International Trade and Investment (1997)

11 Table EU: Industry Specialization Index / / /1997- Projection Austria Belgium Denmark Spain Finland France UK Germany Greece Ireland Italy Netherlands Portugal Sweden Average Weighted average Notes: Production data is used. The values in the table are four year averages. Industry specialization index=σ k abs(v k i(t)-v -k i(t)) v k i(t): Industry k 's share of country i 's total production in overall industry at the time of t. v -k i(t): Industry k 's share of the region's total production in overall industry excluding country i When the industry specialization index is zero, country i has an industry structure similar to other countries in the region. When country i does not have a common industry with other countries in the region, the industry specialization index takes Source: K.H. Midelfart-Knarvik, Overman H. G., Redding S. J., and Venables A. J. (2000). (Change in the division of labor within the EU region) We have already seen how the intra-regional trade ratio increased through the formation of a single market (Figure 3.4.4). Next we will examine changes in the quality of intra-regional trade resulting from market integration. Below we will perform an analysis based on a classification of forms of trade into three types; one-way trade, vertical intra-industry trade, and horizontal intra-industry trade. One-way trade refers to the trading of goods that belong to different industrial classifications. For example, if country A exports agricultural products to country B and country B exports industrial products to country A they are engaged in one-way trade. On the other hand, intra-industry trade applies to cases where goods belonging to the same industrial classification are traded between two countries. For example, there is the case where country C exports automobiles to country D and at the same time imports automobiles from country D. Intra-industry trade can be further divided into two types: vertical intra-industry trade and horizontal intra-industry trade, depending on the unit price of the trade goods. Vertical intra-industry trade is the case in which the difference in the unit price of the trade goods between the two countries is large (trade goods are differentiated by quality) and horizontal intra-industry trade is the case where the difference in the unit price is small (trade goods are differentiated by consumer taste) The European Commission (1996g) sets the standard for the difference in the unit price at 15% and classifies -444-

12 The mechanisms giving rise to one-way trade are explained by the existence of comparative advantage in each country in the traditional trade theory of Ricardo and Heckscher-Ohlin. On the other hand, intra-industry trade arises from a complicated combination of a variety of factors including differentiation of goods, 11 the factor endowments of each country, technology gaps, increasing returns, cumulative effects, transport and storage costs, and product life cycles. In addition to production side factors, preference for diversification (liking a diversity of goods) on the consumer side is also one of the factors expanding intra-industry trade. The extent to which these factors have an effect is dependent on the special characteristics of industries, goods, and countries, but depending on how large or small the effect of these factors is either vertical intra-industry trade or the horizontal intra-industry trade is determined. Here we will provide an overview of changes in the forms of trade throughout the EU after the formation of a single market. According to the European Commission (1996g), in 1980 one-way trade accounted for just below 47.5% of all trade among the 12 EU countries, vertical intra-industry trade accounted for approximately 35.0%, and horizontal intra-industry trade was approximately 17.5%. By 1994, however, vertical intra-industry trade was the most common type with approximately 42.3%, followed by one-way trade with approximately 38.5% and horizontal intra-industry trade with approximately 19.2%. It is clear that one-way trade had greatly declined and vertical intra-industry trade had greatly increased. The European Commission (1996g) states that this was due to the advance of the qualitative division of labor within the EU region as a result of the formation of a single market. Looking at the situation by industry, the percentage of vertical intra-industry trade is increasing in the other transportation machinery, general machinery, wood materials and paper, chemicals, food and drinks, and fiber industries, and it is thought that goods in these industries are contributing to the overall increase in vertical intra-industry trade (Table 3.4.7). It is thought that this is due to the fact that the removal of barriers in the other transportation machinery industry and general machinery industry has made it easier for companies to utilize developing countries within the region as production bases so that division of labor among processes expanded, for example. In the food and drinks industry and fiber industry non-tariff barriers were initially high 12 resulting in a large percentage of one-way trade, but in the process of market integration many non-tariff barriers were abolished, leading to an expansion of vertical intra-industry trade due to the effect of the preference for the diversification of goods. 13 intra-industry trade as vertical if the difference in the unit price exceeds 15% and horizontal if it is 15% or less. This figure varies among researchers, for example, when analyzing the forms of trade within the EU region and within the East Asian region, Fukao (2003) uses a standard value of 25% in order to avoid excessive evaluation of vertical intra-industry trade. 11 Differentiation of goods means treating goods as different goods because their quality, configuration, etc., is different even though they are of the same type. 12 For example, in the processed food sector each country had its own strict regulations because of the importance of safety standards, and these regulations constituted large non-tariff barriers. 13 Conversely, one-way trade has expanded in the precision machinery industry and the electrical machinery industry. It is surmised that this is because the impact of the progress of specialization in some specific regions through the cumulative effects resulting from restructuring of the production systems of companies was large

13 Table Trade patterns of EU12 (by industry) Ratio (%) as of 1994 Change in ratio between 1987 and 1994 (% points) Horizontal intraindustry trade industry trade industry trade industry trade Vertical intra- Horizontal intra- Vertical intra- One-way trade One-way trade Automobile Other transportation machinery General machinery Precision machinery Electric machinery industry Wood materials and paper Chemicals Other industries Basic metal Fiber Non-ferrous metal Food and drink Mining Agriculture Overall industry Source: European Commission(1996g). Next, looking at the change in the forms of trade by country, the increase in vertical intra-industry trade stands out in many countries (Table 3.4.8). According to the analysis of the intra-regional trade of luxury products, mid-range products, and low-range products 14 by the European Commission (1996g), the percentage of mid-range product markets in intra-regional trade greatly declined in the period and the percentage of luxury product markets and low-range product markets increased. It can therefore be concluded that specialization in goods differentiated by quality has progressed within the EU region. Table Trade patterns of EU12 (by country) Ratio (%) as of 1994 Change in ratio between 1987 and 1994 (% points) Horizontal intraindustry trade Vertical intraindustry trade One-way trade Horizontal intraindustry trade Vertical intraindustry trade One-way trade France Germany Belgium and Luxembourg UK Netherlands Spain Italy Ireland Denmark Portugal Greece EU Source: European Commission (1997). These results appear to back up the following pessimistic theory concerning the economic effects of the single market on developing countries. This theory states that because low-income countries have a more 14 Concerning trade among the 12 EU countries, goods within ±15% of the EU average were designated mid-range products, goods more than 15% above the average were designated luxury products, and goods more than 15% below the average were designated low-range products

14 abundant labor force than developed countries within the region they will specialize in labor-intensive, low added value sectors and will be forced into relative economic stagnation in the long run. Let us look at the results after EU market integration to see whether this theory is valid or not. Table shows the markets in which each country possesses strength. Table Competitiveness of each country in EU12 (price and quality) Range of price and quality Low-price productsmid-price productshigh-price products Ireland + Germany + France + + UK + Netherlands + Belgium, Luxembourg + Denmark + Spain + + Greece + + Italy + Portugal + Source: European Commission (1996g). According to this table, Ireland, Germany, and France possess strength in luxury products, and Spain, Greece, Italy, and Portugal possess strength in low-range product markets. Except for Italy, all of the countries in this latter group are considered to be low-income countries within the EU region, and it appears as if the above pessimistic theory holds true. At the same time, however, even though Ireland is a low-income country it possesses strength in luxury goods and it has been shown that in the first half of the 1990s in Spain, Greece, and Portugal, all under-developed countries within the region, the percentage of low-range products declined and their trade structures approached those of the other countries. In addition, looking at macroeconomic indicators, the per capita real GDP of the countries which were low-income countries has increased and it can be confirmed that economic disparities among the countries are shrinking (Figure ). These results disprove the above pessimistic theory. On the contrary, the results show that market integration brings about benefits for low-income countries too. Concerning this point, a book written and edited by Tanaka (2002) states that, based on the results of an analysis of the chemicals industry and automobile industry in Spain and Ireland, the increase in vertical intra-industry trade shows that the same industries exist and are progressing in developing countries as in developed countries, and that no matter how labor intensive a territory is, there is great value in developing countries having the ability to enter industrial sectors with strong demand and a great deal of future potential Written and edited by Tanaka (2002), p

15 (EU15 average=100) Italy Ireland Figure Trends in per capita GDP of EU15 Portugal Greece Belgium Denmark Germany 40 UK Notes: 1. Values for Germany until 1990 are those of former West Germany. (Year) 2. GDP is on PPP (purchasing power parity) basis. 3. The per capita GDP of Luxembourg has been hovering at the level of over 160 since1993, and was in Source: White Paper on International Economy and Trade 2004 (METI). Original source: European Economy No.4 /2003 (European Commission). Spain Greece Spain France Ireland Italy Luxembourg Netherlands Austria Portugal The above experience of the formation of a single market in the EU shows that the removal of barriers to trade and investment led to the construction of region-wide production systems and promoted specialization by each country in sectors in which it possessed strength. Furthermore, it shows that progress in the intra-regional division of labor enabled each country, as well as the region as a whole, to enjoy economic growth. So here we will examine whether or not all countries and local areas will necessarily be able to enjoy similar benefits from integration in the East Asian region and what conditions are required for market integration to bring about a reduction in internal economic disparities. Finland Sweden (3) Win-win market integration Market integration and the reduction of intra-regional economic disparities (a) The state of reduction of intra-regional economic disparities and a mechanism by which market integration rectifies intra-regional economic disparities First, let us look at the state of the reduction of economic disparities in the integrated regions of ASEAN, NAFTA, and the EU. If we look at the dispersion of per capita GDP in each country as an indicator of economic disparities in each region, the results are as in Figure In the EU and ASEAN, as market integration has progressed economic disparities among countries in the region have been reduced, albeit gradually. On the other hand, reductions in economic disparities due to market integration cannot be seen in NAFTA. 16 These results show that market integration does not necessarily lead to the reduction of economic 16 Intra-regional disparities did not decline in NAFTA due to the fact that economic growth in Mexico stagnated in the 1990s. According to Tornell (2004) the cause of this stagnation was that a credit crunch occurred because Mexican companies were unable to deal with the deterioration in contract enforceability and an increase in nonperforming loans

16 disparities and that certain conditions are necessary for market integration to lead to the reduction of internal economic disparities. 1.2 Figure Dispersion of per capita GDP (purchasing power parity (PPP) basis) ASEAN: CEPT commences ASEAN NAFTA enters into force ASEAN+3 EU15 EU25 NAFTA 0.2 EU: Agree to form single market EU: Intra-regional market integration completed / Cohesion Fund established EU: Euro introduced 0 (Year) Notes: 1. The figure on the y-axis of the graph is the standard deviation of the natural logarithm of per capita GDP (PPP basis) in each region. 2.Figures for ASEAN exclude Brunei and Myanmar. Source: World Development Indicators 2004 (World Bank) EU15 (excluding Luxembourg) ASEAN4,NIEs+3 Pelkmans (2004) concludes that market integration contributes to the reduction of intra-regional economic disparities through (1) specialization of industries and manufacturing processes, (2) removal of resource allocation distortions, (3) direct investment, and (4) exposure to competition. The fact that market integration leads to industrial specialization and deepening divisions of labor relationships, and the locating of companies in the most appropriate area due to the removal of resource allocation distortions can be seen in the example of the EU. Below we will look at how exposure to direct investment and competition contributes to the reduction of economic disparities and what conditions are necessary for this. (b) The impact of direct investment on economic growth in the recipient country There are multiple routes by which the receipt of direct investment contributes to economic growth in the recipient country. First, in developing countries that have just commenced economic takeoff there are insufficient savings and it is difficult to obtain sufficient funds for investment. For this reason, direct investment is effective for obtaining the funds necessary for economic growth. It is more difficult to withdraw direct investment than other capital inflows so it contributes to stable economic growth. Second, the effect of direct investment on the recipient country is not only an increase in investment; it also brings about a transfer of technology and know-how from the investing country. Third, direct investment encourages the development of local companies that have specialized in order to supply foreign companies that have entered the local market, and this in turn leads to the growth of industries using the intermediate input goods produced by the local -449-

17 company suppliers formed in this manner within the country receiving the investment. It is thought that direct investment contributes to the development of industries and economic growth in the recipient country through these various routes. (Accumulation of human capital) The transfer of technology and know-how from foreign companies in the local market to local companies like those described above is not inevitable. For technology transfer to take place effectively a certain degree of accumulation of human capital is necessary in order to make the acceptance of new technology and the improvement of technology possessed by local companies possible. A great deal of the research results indicate that the positive correlation between direct investment and economic growth is weak in developing countries which have not reached a certain level of educational standards. Furthermore, it has been demonstrated that a condition for direct investment to realize technology transfer effects and improve the productivity of the recipient country is that workers have attained a certain educational standard. 17 On this point it has been shown that East Asia has achieved rapid growth due to its accumulation of human capital, 18 and an environment is in place that makes it possible to realize the technology transfer effects of direct investment. In the future, along with the advancement of technology in industries in which direct investment is carried out, it is desirable to aim to improve the quality of human capital in each country within the region not only for the economic growth of the recipient country, but also for the reduction of intra-regional economic disparities. (Development of financial markets) In order to promote additional investment by local companies arising from the receipt of direct investment, local financial systems that make smooth capital procurement possible are necessary. It is thought that the existence of developed financial systems reduces the investment risk required to accept new technology from foreign companies and has the effect of increasing the pace of innovation. Results of analyses have shown that direct investment brings about positive effects for economic growth only when financial markets are developed and in that case it does not matter whether the financial markets are centered on indirect financing or direct financing. 19 On this point, too, it has been verified that in Asian countries the increase in direct investment has had the effect of stimulating domestic investment. 20 Hermes and Lensink (1999) show that in many Asian countries the foundation has been laid for financial markets that make it possible for direct investment to attract domestic 17 For example, Xu (1999). 18 For example, World Bank (1994). 19 In Alfaro et al. (2002) it is shown that no strong correlation can be seen between direct investment and economic growth, but the correlation terms of direct investment and financial markets (various indicators concerning indirect financing and direct financing) and economic growth are in a positive relationship. 20 Agosin and Mayer (2000)

18 investment. The countries and regions of East Asia have relatively developed financial systems compared to other developing countries that are centered on indirect financing, and much of the research results show that this has contributed to the rapid growth in East Asia. Yet at the same time, the 1997 Asian currency and financial crisis exposed the fragility of the financial systems in East Asian countries and regions. Currently, policy efforts to form more stable financial systems are being made throughout the region (details will be described later). (c) The impact of competition policies on economic growth If intra-regional economic barriers are abolished through efforts towards the liberalization of trade and investment and harmonization of institutions through market integration, the economies of all the countries in the region will be exposed to the pressures of competition. Generally, it is pointed out that competitive pressures have the effect of encouraging the optimal allocation of resources among industries in each country and region in East Asia and promoting innovation, with analyses demonstrating that refining competition policies in developing countries has a positive effect on the promotion of innovation. 21 It has been pointed out that the existence of competitive pressures is important for the early introduction and spread of advanced foreign technology. 22 However, East Asian countries and regions are faced with common problems concerning operation of the law, including the fact that an independent supervisory agency for competition-related laws does not exist and guidelines to provide the standards for implementation of the laws have not been developed. In addition, it has been pointed out that there is the problem that policies such as trade barriers, restrictions on entry to markets by companies, and the granting of licenses to specific companies are weakening the efficacy of competition laws and that there are problems with systems for operating competition laws, including a shortage of personnel in competition authorities and the lateness of trials. In order to improve these problem areas, in recent years many East Asian countries and regions have increased their efforts to study ways to develop and enhance competition legislation and strengthen the implementation of competition-related laws (Table ). It can be said that the conditions are being put in place to ensure that market integration results in increased competition and more innovation within the region. In the future, it will be necessary to further increase the effectiveness of competition policies in East Asian countries and regions and to further harmonize institutions within the region while keeping in mind the stage of development of competition legislation in each country According to Clarke (2005), analysis results have been obtained that show that innovation is progressing in developing countries (Europe, Central Asia) that are formulating and implementing appropriate competition policies. And according to Carlin (2001), results have been obtained showing that the existence of competitive pressures stimulates innovation and raises productivity in developing countries. 22 Urata (1994). 23 The operation of competition laws is also related to the judicial system, and there is the problem that each country has a different concept regarding judicial systems

19 Table Competition-related laws in countries and regions in East Asia Country/region Competition-related law Relevant agencies Indonesia Malaysia Law Concerning the Prohibition of Monopolistic Practices and Unfair Business Competition (2000) [Currently studying a comprehensive competition bill] * Consumer Protection Law (1999) * Communications and Multimedia Law (1998) Commission for Business Supervision (KPPU) Ministry of Domestic Trade and Consumer Affairs Malaysian Communications and Multimedia Commission Philippines Singapore [Currently studying a comprehensive competition bill] * Price Law (1992) * Consumer Law (1993) Competition Law (2004) * Electricity Law (2001) * Gas Law (2001) * Telecommunications Law (1999) Bureau of Trade Regulation and Consumer Protection, Department of Trade and Industry Ministry of Trade and Industry Energy Market Authority Energy Market Authority Infocomm Development Authority of Singapore (IDA) Thailand Vietnam Lao P.D.R. Cambodia China Korea Taiwan Trade Competition Law (1999) Competition Law (2005) Decree on Trade Competition (2004) * Law Concerning Marks, Trade Names and Laws of Unfair Competition * Law on The Management of Quality and Safety of Products and Services [Currently studying a comprehensive competition bill] The Law Countering Unfair Competition (1993) Price Law (1998) Trade Competition Commission (Department of Internal Trade, Ministry of Commerce) Department of Domestic Trade Policy, Ministry of Trade Trade Competition Commission Ministry of Commerce State Administration for Industry & Commerce of the People's Republic of China The State Developing Planning Commission * Monopoly Regulation and Fair Trade Law (1980) Korea Fair Trade Commission (KFTC) * Telecommunications Law (2000) Directorate General of * Broadcasting Law (2001) Telecommunications etc. Hong Kong * Fair Trade Law (1992) Fair Trade Commission Notes: 1. ( ) indicate the year the law entered into force. 2. Laws with an asterisk (*) are competition-related laws; laws without an asterisk are competition laws. Source: Report of the Study Group of the Antimonopoly Law and International Issues (2002) (Japan Fair Trade Commission), Japan Fair Trade Commission website. In this way, market integration in East Asia can bring about win-win benefits for all of the countries and regions that make up East Asia. If the abolition of non-tariff barriers through market integration is carried out, then the construction of optimal production and sales networks through direct investment, as well as specialization of industries and manufacturing processes in each country and region, will progress in East Asia, -452-

20 and the efficiency of industries throughout the entire region will improve. However, this specialization does not necessarily reflect only classical comparative advantage; it is carried out reflecting a variety of factors including the above-mentioned economies of scale, transport and storage costs, and the needs of markets so that intra-industry trade tends to develop in industries with high productivity and strong demand. In other words, industries and sectors which can be expected to have high productivity locate in developing countries within the region. In this way, abolition of intra-regional barriers makes entry into growth industries possible, opening up a way for developing countries within the region to catch-up to the developed countries while the direct investment which is generated in parallel by this process stimulates economic growth in the country receiving the investment through capital accumulation, improvement of efficiency, and promotion of innovation, if certain conditions such as the accumulation of human capital, development of financial markets, and development of competition policies are satisfied. In this manner, as the result of market integration, the economy of the East Asian region will achieve overall growth while at the same time reducing its internal economic disparities. The benefits of market integration are large for the developing countries within the region, but of course market integration within East Asia will also bring about benefits for developed countries like Japan within the region, as shown in the analysis in the previous section. Figure looks at trends in per capita real GDP in the five EU countries with the highest per capita real GDP in 1985, the year that Completing the Internal Market: White Paper from the Commission to the European Council was released, for the period since then. It shows that the developed countries in the EU region are also enjoying the benefits of market integration. 250 Figure Trends in per capita real GDP of five developed countries within EU at the time of the release of Completing the Internal Market: White Paper from the Commission to the European Council Denmark Luxembourg Sweden Germany Austria (Year) Note: The figure illustrates the trends in per capita real GDP from 1985 and beyond of countries which had the top five per capita real GDP in 1985 when Completing the Internal Market: White Paper from the Commission to the European Council was released (per capita real GDP is set at 100 for 1985). Source: WDI ( the World Bank)