Market-driven Economic Integration in East Asia

Economic integration in East Asia has been deepening through the market-driven forces of cross-border trade, FDI, and finance. Trade in goods and services and FDI activities have expanded rapidly over the past twenty years thanks to the multilateral and unilateral trade liberalization processes.¹ International portfolio investments and banking flows, together with cross-border financial services activities, have also grown in many economies due to financial market deregulation and opening, and progressive capital account liberalization. The removal of various types of cross-border barriers and the geographical proximity of East Asian economies have created natural economic linkages among them. In a sense, regional economic integration has been a natural outcome of economic globalization.

(1) Economic integration through trade and FDI with production networks

The expansion of intraregional trade over the last several decades is remarkable. The share of East Asia’s intraregional trade in its total trade has risen from 37% in 1980 to 55% in 2006 (Table 1 [ PDF 50.6KB | 1 pages ]).² This share is higher than the peak figure of 49% for the North American Free Trade Area (NAFTA), achieved in 2001, though still lower than the peak figure of 66% for the original 15 European Union countries (EU-15), achieved in 1990.³ The intensity of regional trade in East Asia is also comparable to that in the EU or NAFTA.⁴ While the rising intraregional trade share has been premised on the existence of American and European markets for finished products, its relative dependence on these outside markets has been declining and is expected to further decline as demand for final products within East Asia continues to grow.

Favorable economic environments and the abundant supply of high-quality, low-wage labor have also contributed to the expansion of FDI. FDI inflows to East Asia over the past several decades have grown rapidly, at a rate much faster than the region’s growth in trade. FDI inflows into East Asia have risen from 7% of world total FDI inflows in 1980 to 13% in 2006. Over the same period, East Asia’s sustained dynamism fueled an increase in FDI outflows from 5% to 12% of world total outflows. Notably, many of these flows have become intraregional—from Japan and the newly industrialized economies (NIEs, i.e., Hong Kong, China; Korea; Singapore; and Taipei,China) to ASEAN and PRC, and from ASEAN to ASEAN and to PRC.

The main driver behind economic integration through trade and FDI is the intraregional business activity of multinational manufacturing corporations—initially those from Japan, Europe, and the United States (US), followed by those from emerging East Asia. These multinational corporations (MNCs) have formed closely organized production networks and supply chains across East Asia, linked with the global market. These arrangements have emerged as a result of each MNC’s business strategy that attempts to divide its whole production process into several sub-processes, and locate these sub-processes in different countries according to their comparative advantage—factor proportions and technological capabilities. Such business arrangements have promoted vertical intra-industry trade within East Asia in capital equipment, parts and components, intermediate inputs, semi-finished goods, and finished manufactured products.⁵

These trends accelerated in the wake of the Plaza Accord in 1985, when Japanese MNCs, compelled to reduce their domestic production activities due to the steep appreciation of the yen, began building regional production bases centering on emerging East Asia—initially in the Asian NIEs and later in middle-income ASEAN countries (such as Malaysia, Thailand, Philippines, and Indonesia).⁶ Facing rising domestic costs, the NIEs soon began also investing in middle-income ASEAN economies and later, in the 1990s, in the PRC. More recently, not only global MNCs from developed economies (such as Japan, Europe, and the US), but also firms from the NIEs and advanced ASEAN countries (like Malaysia and Thailand) have also been providing FDI to other ASEAN members (including Cambodia, Lao PDR, and Viet Nam) and to the PRC, contributing to the formation of a web of regional supply chains increasingly centered on the PRC. The source country (area) breakdown of cumulative FDI inflows to East Asia over the period 1995–2005 deserves attention. Table 2 [ PDF 48.7KB | 1 pages ] indicates that while global MNCs from the major industrialized countries remain important investors in several economies in emerging East Asia, the Asian NIEs’ firms have become much more important, accounting for 35 percent of total FDI inflows to emerging East Asia— particularly in the PRC and Viet Nam. The table also indicates ASEAN 9 (non-Singaporean) firms are becoming active in emerging East Asia.

The PRC is the world’s largest emerging-market recipient of FDI inflows. It has benefited significantly from joining the global trading system (by becoming a member of the World Trade Organization), participating in regional production networks, and transforming itself into an assembly platform for regional and global manufacturing producers. The PRC imports capital equipment, industrial materials, and intermediate inputs from neighboring economies, and exports finished manufactured products. As a rise in the PRC’s exports tends to stimulate its imports from other East Asian economies, its overall trade surplus tends to be accompanied by trade deficits vis-à-vis many regional economies. In this sense, the PRC is building a complementary relationship within East Asia, while at the same time competing against several other emerging East Asian economies—particularly middleincome ASEAN countries—in global markets. This situation implies that exchange rate movements between the yuan and other emerging East Asian currencies have become increasingly relevant to trade and FDI.

(2) Financial integration

Financial markets are also integrating rapidly in East Asia due to the deregulation of domestic financial systems, opening of financial services, and progressive relaxation of capital and exchange controls. Foreign operations by developed country commercial banks and portfolio investment by institutional investors in developed markets have significantly strengthened linkages among the region’s financial markets. Commercial banks in emerging East Asia have also been expanding their businesses in their neighbors. One result was a rising degree of cross-country correlations of regional interest rates and stock market returns across East Asia. The speed, scale, and extent of the contagion of the 1997–98 financial crisis symbolically affirmed this growing financial linkage.

Data analysis shows that levels of cross-market differentials in interest rates and bond yields have been declining in recent years.⁷ Although the cross-market differences of money market interest rates rose significantly during the 1997–98 crisis, these differentials have begun to decline since 1999. Such declines in cross-market differentials are observed in both money market rates and long-term bond yields. For example, the average absolute values of uncovered interest rate differentials, after surging to over 3,000 basis points (for 3- month interbank lending rates) at the height of the crisis, have declined substantially to about half the pre-crisis level. The average absolute distance of the beta coefficient from unity has also declined substantially, particularly for 3-month interbank lending rates (though the decline has been less pronounced for 2-year and 10-year bond yields).⁸ Simple correlation analysis of stock returns demonstrates a relatively high level of co-movements in East Asia’s equity markets, even after eliminating the global common factor, in comparison to those in money and bond markets.

Compared with trade and FDI integration, however, regional financial integration in East Asia has been less pronounced. Table 3 [ PDF 50.7KB | 1 pages ] indicates that cross-border portfolio investment flows— particularly equity investment flows—have been expanding among the East Asian economies, but the share of intraregional portfolio investment flows in East Asia is still low (a mere 6% in 2005) compared with those of EU-15 (62%) and NAFTA (16%). An important reason for the limited degree of financial integration is that, apart from Japan; Hong Kong, China; and Singapore, many economies in East Asia still impose significant capital and exchange restrictions and other barriers, which impede free flows of financial capital. In particular, the PRC and low-income ASEAN countries apply heavy controls and regulations. Another reason is that the domestic financial systems of many emerging market economies are still underdeveloped and shallow and, thus, cannot attract regional investors. East Asian investors tend to direct their international portfolios in North America and Europe, rather than in East Asia.

(3) Macroeconomic interdependence

An important consequence of these growing real and financial linkages—although the latter is limited—is the heightened macroeconomic interdependence and business cycle comovements within East Asia. Growth rates of real macroeconomic activities have become increasingly synchronized. Using annual data for 1980–2002, Kawai and Motonishi (2005) demonstrate that the real activity variables—such as growth rates of real GDP, real personal consumption, and real fixed investment—were highly correlated among major economies in East Asia, notably among Japan; Korea; Taipei,China; Singapore; Malaysia; and Thailand with Indonesia and the Philippines beginning to join this group. However, real activity variables of the PRC and low-income ASEAN members were not highly correlated with those of other East Asian economies. Surprisingly, East Asia’s real activity variables were not strongly correlated with US or European real activity variables.

Using annual GDP data for 11 of the ASEAN+3 countries for which data are available (except Brunei Darussalam and Cambodia), Rana (2007) provides simple 10-year moving correlations between real GDP growth of individual ASEAN+3 members and the group as a whole (excluding the reference member) from 1989 to 2005. Figure 1 [ PDF 280.5KB | 1 pages ] shows that correlations have been increasing, especially after the financial crisis, suggesting greater synchronization of business cycles among ASEAN+3.⁹ Correlations have been converging towards 0.8–0.9 in the Philippines, Indonesia, Japan, Malaysia, and Thailand. They are a bit lower (between 0.6 and 0.7) in Lao PDR, PRC, Singapore, and Viet Nam. On the other hand, correlations of business cycles of the ASEAN+3 group as a whole with those of the US and the EU countries (proxied by France, Germany, and Italy), however, are falling over time (Figure 2 [ PDF 278.9KB | 1 pages ]).

These results suggest that emerging East Asia’s real activity variables tend to be more highly correlated with those of Japan than with those of the US and the EU. One interpretation for this is that major East Asian economies—including Japan and its emerging neighbors—are subject to common supply shocks, which are different from shocks hitting the US or the EU.¹⁰ The PRC did not exhibit strong business cycle co-movements with other East Asian economies in early years, largely due to its limited financial openness and linkages with these economies during those years. In more recent years, however, the country appears to show positive co-movements as its economy becomes more marketbased, as it opens its financial markets, and as it becomes more integrated regionally and globally.

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