Asia-Pacific Trade Economists’ Conference

Trade-Led Growth in Times of Crisis

The US Crisis and the Future of East Asian Production Sharing

Session 1 and 1a: Trade-Led recovery and production networks Authors: Lurong Chen Research Fellow Comparative Regional Integration Studies

The United Nations University Philippe De Lombaerde

Associate Director Comparative Regional Integration Studies The United Nations University

This paper is being posted without formal editing. The opinions, figures, and estimates set forth in this paper are the responsibility of the authors and should not be considered as reflecting the views or carrying the endorsement

of the United Nations.

The US Crisis and the Future of East Asian Production Sharing

Lurong Chen* and Philippe De Lombaerde**

[Abstract]

The East Asian economic zone is well known for its “highly integrated manufacturing

system” that was initialized and is driven by the market mechanism. As participants in a

common production sharing network, East Asian economies are highly interdependent.

Externally, advanced economies in the West make up the main target markets for exports

from East Asia. Moreover, they provide capital to feed the investments required by the

regional growth.

This paper investigates the potential effects of the recent economic crisis on East Asian

production sharing. It suggests that the high interdependency of the global economy has

made it unlikely for East Asia to remain immune to the crisis. Indeed, the impacts of the

crisis on the regional economy in the long run are likely to be more serious than those in the

short term. The crisis could be a factor in accelerating the process of East Asian regional

integration, especially in terms of financial integration.

Fundamentally, the weakness of the East Asian economy comes from the fact that it tends

to “produce what the West claims to produce”. In order to improve its core competitiveness

in the global market, East Asia needs to increase the technical and knowledge based

contents of production sharing. Meanwhile, East Asian countries need to develop a mature

social security system to buffer temporary unemployment. By boosting the intra-regional

market and strengthening inter-regional cooperation with other emerging economies, East

Asia could shift the current production sharing network to a multi-oriented one, allowing

the regional economy to be relatively less dependent on the West, and therefore less

vulnerable to a crisis originating from the West. Last but not least, it is in the region’s best

interests to support the multilateral trade negotiation system in order to secure free trade

and capital movement on a global scope.

* Lurong Chen is Research Follow at UNU-CRIS. lchen@cris.unu.edu

** Philippe De Lombaerde is Associate Director at UNU-CRIS. pdelombaerde@cris.unu.edu

1. Introduction

East Asia’s economic growth is closely linked to that of the world economy. Despite the lack

of a formal state-led approach towards regionalism, production sharing has organized East

Asian economies into a de facto highly integrated manufacturing system, which has

contributed to the “Asian miracle” of fast economic growth. East Asia1 was responsible for

about 20 percent of the world’s total GDP in 2008. Relatively, its overall economic size is

already very close to that of the U.S.2 Initially, East Asian economies were fed by the U.S.

with capital inflows and market potentials. This allowed many East Asian countries to

achieve their industrialization by applying an export-led strategy. Even though East Asia

encompasses Japan and China as two large internal engines of development, it would

nonetheless be very unlikely that the region could already “fly alone” without support from

the U.S. When the U.S. economy experiences major economic shocks, it is just a matter of

time before East Asia “shares” the distress.

The current U.S. crisis calls for adjustments to the international economic order formed

after the breakdown of the Breton Wood system. Generally, this would entail a weakened

the dominating position of the West in the global economy, such as the U.S. and advanced

economies in Western Europe. East Asian countries would see a change in the balance

between the external and the internal driving powers of growth. The external driving force

for economic growth would become relatively weaker, as many advanced economies in the

West dropped into slow growth or a recession. East Asia may have to explore new solutions

to support long term economic growth and stability.

The paper is organized into six sections: Section 2 reviews the U.S. crisis and its global

impacts; Section 3 summarizes the key features of production sharing in East Asia; Section 4

estimates the impacts of the crisis on the East Asian economy; Section 5 focuses on the

strengthening of production sharing and on the fostering of regional integration in East Asia;

and Section 6 concludes the paper.

1 East Asia refers to Japan, South Korea, China (including Hong Kong and Taiwan), and ASEAN 10.

2 In 2008, East Asia’s total GDP was about 12.4 trillion U.S. dollars; while the U.S. GDP was 14.2 trillion U.S.

dollarsData source : IMF(2009), World economic outlook database.

2. The U.S. Credit Crunch and its Global Impacts

The U.S. credit crunch has exposed pervasive weaknesses in the regulation of the financial

industry and the global financial system, of which the root cause is the market’s lax

regulation and loose risk control concerning borrowers’ repayment capacity, and the over-

optimism of the booming house market. The online encyclopedia Wikipedia defines it as “an

ongoing financial crisis triggered by a dramatic rise in mortgage delinquencies and

foreclosures in the United States, with major adverse consequences for banks and financial

markets around the globe.”3

In parallel with various other financial crises, the moral hazard of the financial industry lies

at the core of its many sources.4 As an origin, easy credit conditions financed by low interest

rates and large inflows of foreign funds fueled a housing market boom; while on the

demand side, subprime lending became one of the main channels to stimulate demand and

encourage debt-financed consumption of property. Even people with a poor credit record or

a low refinance capability could easily obtain a mortgage. The significant share of subprime

mortgages relative to the total originations weakened the foundation of the U.S. financial

system. The number of subprime mortgages defaults continued increasing as a consequence

of the high interest rate and the slow growth of housing prices. When the scale of mortgage

defaults had reached a level that the banks could no longer afford, it eventually triggered a

credit crunch in late 2007. The crisis generated a domino effect in the market and very soon

spread from Wall Street to Main Streets, and migrated from the U.S. to other countries.

The IMF (2009) called the U.S. mortgage crisis “the largest financial shock since the Great

Depression in the 1930s.” It could be responsible for costing the world’s financial firms at

least $1 trillion worth of losses. Up until mid-2008, reported losses by major banks and

financial institutions were higher than $400 billion. Within ten months from January to

October 2008, owners of stocks in U.S. corporations suffered approximately $8 trillion in

losses. ADB (2009a) estimated that the global crisis would slash the value of financial assets

3 http://en.wikipedia.org/wiki/Subprime_mortgage_crisis, printed on 2 June 2009.

4 Causes proposed include the inability of homeowners to make their mortgage payments, due primarily to

adjustable rate mortgages resetting, borrowers overextending, predatory lending, speculation and

overbuilding during the boom period, risky mortgage products, high personal and corporate debt levels,

financial products that distributed and perhaps concealed the risk of mortgage default, monetary policy,

international trade imbalances, and government regulation (or the lack thereof).

worldwide by $50 trillion, of which the U.S. market would burden a lion’s share.

The crisis quickly spread throughout Europe, due to the tight economic correlation between

the two continents, especially in the financial sector. This caused many European economies

to fall into a recession. In November 2008, Germany’s federal statistical office announced

that the economy was already in a recession5. Other economies, such as the UK, Sweden,

and Italy, also entered a recession. The IMF (2009) forecasted the average growth rate of

real GDP for the Euro Zone in 2009 to be -0.5 percent, and that the UK economy to contract

by more than one percent. Both the U.S. and the EU have launched bailout programs of

their banking systems and released economic stimulus packages to stabilize the market.

During the EU Spring Summit in 2009, European leaders decided to forge a deal with the

U.S. on stricter financial market regulation in addition to pledging 75 billion Euros in new

contributions to the IMF.

East Asia is not immune to the crisis even though it is not at the epicenter of the turmoil.

Japan, Hong Kong SAR, and Singapore have all officially fallen into recession. Even China has

seen signs of an economic growth slowdown. The ADB (2009b) argued that developing Asia

has suffered the worst among emerging market regions. The IMF (2009) estimated the

growth rates of real GDP in 2008 of newly industrialized Asian economies (NIEs)6 and

ASEAN-57 to be 3.9 percent and 5.4 percent, respectively. Both values are lower than the

average level of emerging and developing economies (6.6 percent).

<Table 1 about here>

3. Production Sharing and East Asian Industrialization

The successive post-war waves of economic industrialization in East Asia are closely

connected to the development of a production sharing network. Ng and Yeats (2003)

concluded that regional production sharing in East Asia was “a positive factor facilitating

regional cooperation and increased interdependence”; and the increasing share of trade in

parts and components in intra-regional trade of manufacturing goods were “positive factors

in any regional trade arrangements”.

5 In the announcement, the “recession” is defined as two quarters of negative growth of GDP in succession.

6 The four East Asian NIEs include South Korea, Chinese Taiwan, Singapore and Chinese Hong Kong SAR.

7 For the IMF (2009), ASEAN-5 comprises Indonesia, Malaysia, Thailand, the Philippines, and Vietnam.

Akamatsu (1962) saw East Asian countries as “a comparatively small [wild-geese-flying]

group with Japan taking the lead” and indicated that industrialization will transmit from

Japan to its followers (four Asian NIEs, followed by the four main ASEAN member states8,

and finally other developing Asian economies). Indeed, the structure of “factory Asia” could

also be described by a “wild-geese-flying” pattern (“Ganko Keitai”). As countries are on a

common path, though at different stages of growth of industrialization via cross-sector

shifts of comparative advantages from relatively labor-intensive production to relative

capital or technology -intensive production, they could share production via the exchange of

intermediate goods and achieve export-led economic growth. As international

fragmentation of production within the region causes more and more “back-and-forth”

transactions in vertically -fragmented production processes, along with corresponding

changes of trade patterns and industry relocation in East Asia, the booming cross border

exchanges of machinery parts and components reflect the vast extension of vertical

production linkages. This could drive East Asian economies to “adapt to specialize in various

stages of the global production process” (Fung, 2005).

The exports of many East Asian countries are closely linked to the import of intermediate

goods. For instance, Kierzkowski and Chen (2007) show that China’s imports of parts and

components from Japan, Chinese Hong Kong SAR, Korea and even the U.S. can significantly

influence its exports to the U.S. Imports of intermediate goods could be responsible for

having enriched China’s factor endowment and strengthening its export capability.

Approximately 50 percent to 60 percent of China’s exports to the U.S. would be at risk of

disappearing if China could not import parts and components. On average, the real surplus

that China gains from trade with the U.S. may account for only one-third of the total value

printed on its balance sheet. A sizable share of the trade surplus would eventually go to

economies that supply China with parts and components (mainly the other East Asian

countries). In other words, the East Asian region as a whole is the prime beneficiary of the

Sino-US trade surplus, rather than China alone. Chen, Cheng, Fung and Lau (2001), Kwan

(2002), and Fung (2005) also illustrate that less than half of Chinese exports can be

interpreted as the direct domestic value-added in China. The remainder of the value is

indeed shared by the foreign suppliers of intermediate goods and services, and a significant

8 The four main ASEAN member states are Indonesia, Malaysia, Thailand and the Philippines.

part of this excess value comes from East Asia.

Generally speaking, production sharing in East Asia is largely outwardly oriented. The region

uses international trade in parts and components as a means of penetrating markets of high

technology-intensive or high skill-intensive products from advanced economies outside the

region. Indeed, in most cases, it is the demand from outside the region that fosters the

increase in trade in parts and components within the region. Chen (2008) estimated that a

1% percent growth in East Asian exports could induce its total imports of parts and

components from the rest of world to increase by more than 3 percent. Quantitatively, the

extra-regional and intra-regional imports of parts and components have almost the same

elasticity on the region’s total exports. The intensification of regional production sharing

would actually further strengthen the interdependence between East Asia and the global

market.

4. Challenges Faced by East Asia

The crisis slowed down economic growth in East Asia by seriously hitting the export sector

in the region. It forced the economies of Japan, Korea, and Singapore to fall into recession.

China and Vietnam still kept positive growth rates of GDP, but significantly slowed down

their pace. The Chinese National Bureau of Statistics reported that economic growth in

China slowed sharply in the fourth quarter of 2008 to 6.8 percent, and to 9 percent for the

whole year, down from 13 percent in 2007.

As the PECC (2009) estimated, growth in the Asia-Pacific region is expected to expand in

2009 at less than half the rate of the previous two years, as the global financial crisis causes

the U.S. economy to contract. The global financial crisis triggered by the U.S. credit crunch

may affect the East Asian economies in various manners. The following sections will discuss

these challenges from four main aspects: (1) Value losses in foreign exchange reserves, (2)

Export and import collapse, (3) Capital outflow, and (4) Unemployment and social instability.

4.1. Value Losses in Foreign Exchange Reserves

The foreign exchange reserves of East Asian economies continued to surge in the past ten

years. Six of the world’s top ten countries/ monetary authorities with the largest foreign

reserves in 2008 were in East Asia9. The rapid accumulation of reserves is often seen as a by-

product of an export-led growth. In principle, large reserves of foreign currency enable a

government to maintain a more favorable economic environment through the stabilization

of foreign exchange rates. Most East Asian countries hold huge U.S. dollar-denominated

assets as part of their foreign reserves. The IMF (2009) estimated that 64 percent of the

world’s (identifiable) foreign reserves were U.S. dollar-denominated assets10. Table 2

calculates the ratio of a country’s holdings of U.S. treasury securities to its total reserves of

foreign currency. The ratio can be regarded as an indicator of the minimum role of U.S.

dollar-denominated assets on the foreign exchange reserves of East Asian countries. It

shows that, on average, more than 40 percent of East Asia’s total foreign exchange reserves

are in the form of U.S. treasury securities.

<Table 2 about here>

As a “world factory”, East Asia exports its products and services to gain foreign reserves.

Meanwhile, the region uses its foreign reserves to pay for techniques, services, and parts

and components that are imported from outside the region to support regional production.

Since trade surplus with the West has brought East Asian countries a large amount of

foreign reserves, unexpected major fluctuations on the exchange rate of the U.S. dollar

results in sizable losses in East Asia’s national wealth by lowering the real purchasing power

of the reserves. Suppose 60 percent of East Asia’s foreign exchange reserves were in U.S.

dollar denominated assets, while the remaining 40 percent were euro denominated assets.

An unexpected change of ten points (0.001) in the exchange rate of the U.S. dollar in respect

to the euro may cause the region to lose the real value of its total foreign reserves by as

much as 2.5 billion Euros.

4.2. Export and Import Collapse

A report released by the DBS (2009) estimated that in the last quarter of 2008, Asia’s

exports fell by a larger amount than they did during the entire Asian financial crisis or the

high-tech bubble burst. Within three months, Asia’s exports (including exports from India)

dropped by almost one-fifth. Exports from China in May 2009 fell by a record amount and

9 They are (in sequence) China, Japan, Chinese Taipai, South Korea, Hong Kong SAR, and Singapore.

10 Data source: The COFER database, IMF. http://www.imf.org/external/np/sta/cofer/eng/cofer.pdf. The file

was downloaded on June 17, 2009.

dropped 26.4 percent compared to the same month in 2008.

Among all the contributing factors to the crisis’s effects on East Asia, the weakened demand

from the global market in the aftermath of the U.S. crisis is a very obvious one. Chart 1

shows a downward trend in the seasonal growth rate of exports from East Asia. The

slowdown of exports first occurred in Japan, and then spread to NIEs, ASEAN, and China.

<Chart 1 about here>

It is likely that export-oriented producers in East Asia are among the biggest victims of the

crisis. In early 2008, most policymakers in the region were discussing how to avoid the

overheating and inflation in the economy11, but only a few weeks later, the export market

suddenly collapsed. This left quite a limited space for producers, even large multinational

corporations, to respond to the unexpected market changes.

The contraction of global demand may have also affected East Asian economies by

triggering a link effect in the regional production sharing network. For instance, when the

Japanese Finance Ministry announced in December 2008 that exports from Sony and Toyota

had plummeted by one-third from the same period in the previous year12, it was a warning

not only to the Japanese economy but also to the whole East Asian economy. As leaders in

the world automobile (Toyota) and electronic industry (Sony), both corporations have

fragmented their production internationally and built up production sharing networks

involving participation from many other East Asian countries. While these exports mainly

depend on the demand for final products from the global market, their needs for parts and

components, services, or assembly activities determines the size of output and exports of

those suppliers in China, Korea, or the ASEAN states that belong to the existing common

industrial value chains. Therefore, the weak demand faced by Japanese producers could

easily “transit” to producers in other countries. As developments in ICT and transportation

have significantly shortened the economic distance, the demand crunch in the West could

11 In September 2008, ADB President Haruhiko Kuroda told Reuters that inflation was the greatest risk in emerging economies in Asia, and the top policy challenge was inflation rather than supporting growth. 12 On January 22, 2009, the Japanese Finance Ministry announced that in December 2008, exports from Sony and Toyota had plummeted by 35 percent from the same period in 2007. The Sony Corporation further warned that it would probably post a net loss of 150 billion yen, or $1.7 billion, for the year ending in March. This is the first such loss for Sony in 14 years and represents a sharp reversal from the 370-billion-yen profit in the previous 12 months.

hit the producers of intermediate goods almost immediately after the export of final

products plummeted.

The link effect may also exist on the supply side. Generally speaking, the emerging East

Asian economies are not yet as equally advanced as developed countries in the West, at

least from the perspective of innovation and technical progress. Access to foreign-supplied

parts and components enables emerging economies in the region to boost their

competitiveness and export capacity without even fully grasping the technology. For

countries participating in the common industrial value chains, decreasing the imports of

intermediate goods or services from upstream producers could subsequently limit the

downstream producers’ productivities, and therefore, further decrease exports.

East Asian imports plunged hand in hand with the export collapse during the last quarter of

2008. Chart 2 shows that regional imports abruptly turned from two-digit growth into two-

digit decline between October and November. In comparison to its 20 percent decline in

exports, China’s imports in the first quarter of 2009 dropped by more than 30 percent from

the same period in 2008.

<Chart 2 about here>

4.3. Capital Outflow

The crisis also affected the East Asian economy through its impacts on the financial market

in the region. The World Bank (2009) pointed out that declining investment was one of the

main sources for the East Asia and Pacific region to feel “the full brunt of the crisis”, aside

from the export collapse and the drop in industrial production. Although the majority of

financial institutions in East Asia had relatively healthy financial positions and strong capital

buffers, and their exposure to American subprime-related instruments was generally

limited, the current financial turmoil may still transfer to the region because of the region’s

high degree of integration in the global financial market (Kato, 2009).

Foreign investment as well as international trade plays an important role in the export-

driven economic growth strategy in East Asia. In the past few decades, expansion of the East

Asian production sharing network was mainly driven by rising global demand. The global

market also supports growth in East Asia by injecting capital into the region. Many banks in

the region were exposed to the process of global de-leveraging because of their reliance on

international wholesale funding. Meanwhile, corporations exposed themselves to

refinancing risks because of increased borrowing from foreign funding.

The global financial crisis caused dramatic capital outflows from East Asia as global investors

rushed to sell the Asian assets they held during the boom. It was estimated that in 2008,

outflows from equity markets alone in emerging Asia amounted to approximately 70 billion

U.S. dollars (Kato, 2009). This made it increasingly difficult for the private sector to borrow

abroad when domestic credit was tightened. Many producers in the export-oriented

industry were forced into bankruptcy under double hits from the sudden market contraction

and the difficulties in refinancing external debts. Since the performances of upstream and

downstream production in a production sharing network are highly correlated, the

dysfunction of one link in the industrial value chain may cause the whole production

network to break down. Bearing in mind that foreign investment to Asia is mainly motivated

by high capital rental in the region, thanks to its rapid economic growth and market

expansion, the out-flowed capital will move back to East Asia until the regional economy is

believed to be back on track in terms of high-speed growth.

4.4. Unemployment and Social Instability

East Asia accounts approximately for one-eighth of the world’s GDP, but hosts one-third of

the world’s total population. The export sector and related service sectors are the main

sources of job creation in many countries. As these sectors were hit hard by the crisis, they

were forced to lay off workers rather than absorbing unemployed labor.

The ILO (2009) estimated the average world unemployment rate in 2009 to be 6.1 percent,

while the unemployed population in East Asia could reach 34 million13. In early 2009, the

Chinese Commerce Minister told the BBC that approximately 10 million migrant workers

had lost their jobs in China as the global economic slowdown deepened (BBC, 27 February

2009). The Japanese government also reported that in April 2009, the seasonally adjusted

unemployment rate in Japan had reached 5 percent (Ministry of Internal Affairs and

Communications, the Government of Japan, 2009). Even South Korea saw its unemployment

13

Both figures are based on the ILO (2009) Scenario 1 estimation.

rate rise for the first time in the last five years to 3.6 percent in January 200914 (Xinhua

News Agency, February 11, 2009). Table 3 lists the unemployment rate for the main

countries in East Asia, based on the latest available data15.

<Table 3 about here>

Unlike advanced economies in the West, most East Asian countries have not yet established

a mature social security system. Due to the lack of an effective “buffer” mechanism, the

majority of lay-off workers do not receive sufficient social support that would allow them to

make a living after losing their jobs. Unemployment in Asia is indeed an issue more directly

linked to social stability. This is probably one of the main reasons that Chinese Premier Hu

Jintao told the former U.S. President G.W. Bush that solving unemployment was still the

most serious problem that China faced.16 Many leaders in other East Asian countries will

share Mr. Hu’s opinion and consider unemployment as the biggest challenge to

development and social stability.

Table 4 shows that the social security systems in most East Asian countries/regions rank

very low in global perspective. Except Japan, all the others’ social security systems were

classified as either the Third-Tier or the Fourth-Tier systems17 based on Dixon (1999)’s

evaluation.

<Table 4 about here>

Maintaining high-speed economic growth to create new job opportunities has for a long

time served as an effective tool for East Asia to fight against unemployment.18 The current

crisis has slowed down the pace of economic growth in East Asia and reduced the market’s

14

The unemployment rate in South Korea further rose to 3.9% in May 2009. 15

The official published data by August 2009. 16

During a meeting between the former U.S. president and China’s premier in April 2006, when Bush asked his

counterpart in China, Hu Jintao, which of the numerous challenges China faced was the most serious, Hu

answered “unemployment” without hesitating. (See Simon Elegant, China’s Worst Nightmare:

Unemployment.) 17

The category of the Third-Tier systems contains countries having a design ranking sore that is 20 to 30

percent below the best-designed social security systems; while The category of the Fourth-Tier systems

contains countries having a design ranking sore that is more than 30 percent below the best-designed social

security systems 18

For China, however, even a two-digit annual growth rate (between 2003 and 2007) could not generate

enough positions to meet the demand, since every year approximately 20 million new job seekers would enter

the market.

capability of job creation. Moreover, the crisis further aggravated the conflicts existing in

the labor market as thousands of new unemployed workers flowed into the market when

many factories were forced to lay off workers due to the market contraction. There is a risk

of triggering social instability unless the accumulating pressure on the labor market can be

timely released.

5. Strengthening Production Sharing and Fostering Regional Integration

Globalization provided an opportunity for East Asia to realize rapid economic growth after

WWII. Many emerging economies in East Asia followed Japan’s footprints, and approached

towards industrialization guided by a trade-led growth strategy. The Asian financial crisis

exposed the weaknesses of the regional economy, particularly in the financial sector. For

the first time, it showed the region that economic liberalization and openness could be a

double-edged sword. Some East Asian countries suffered serious hits from the crisis because

they had liberalized their economies too fast and ignored the fact that the domestic

financial markets and institutions were still immature. The 1997-1998 currency crisis also

showed the importance of deep regional cooperation, which turned out to be a major factor

in fostering East Asian regional integration. One such milestone was the Chiang Mai

Initiative announced by ASEAN plus three financial ministers in May 2000.

Since recovering from the Asian financial crisis, the majority of the region has maintained

sustained growth until the second half of 2008, when the crisis suddenly affected the region.

Despite the “healthiness” of the regional economy’s performance, East Asia experienced

almost as much pain as the rest of the world. It could be time for East Asian countries to

consider improving the region’s role on the global market, so that growth in East Asia can be

more constructive in stabilizing the world economy. In order to do so, East Asian economies

need to: (1) Increase the level of technical/knowledge intensity of regional production

sharing, (2) building an effective social safety net, (3) promote regional financial integration

and (4) construct a multi-oriented production sharing network.

5.1. Increase the Level of Technical/Knowledge Intensity of Regional Production

Sharing

High economic dependency on the West was one of the factors that involved East Asia in

the current crisis. The engine of the “Asian factory” seemed to lose power when external

demand from the U.S and Europe dwindled. This is not only due to the fact that the current

production sharing network is mainly demand-driven, but also because of the region’s

passive position in the world economy. Indeed, it was the U.S. market that actually led the

East Asian flying geese; Japan itself was merely a following goose or a distinctly secondary

sector, compared to America. Even now, most East Asian economies remain “followers” in

the global market, taking into account their achievements in technology innovation and

creation of new products. Essentially, the weakness of the East Asian economy comes from

the fact that it tends to “produce what the West claims to produce”.

Among all the factors to which East Asia should pay attention, a very urgent one is to

promote a domestic technical innovation progress, which as the neoclassical growth model

predicts, is fundamental for long-term economic growth. Production sharing facilitates the

technical transfer from advanced economies and enables developing countries to

participate in producing complex goods, even without grasping all of the required

techniques. In the short run, participation in production sharing could help developing

countries start or speed up industrialization, achieve economic growth and create jobs to

absorb unemployment. In the long run, however, developing countries should also invest in

expanding domestic R&D activities, allowing them to fundamentally improve technology

and core productivity which would feed sustainable growth.

One might often hear East Asia referred to as a “world factory”, but seldom is it referred to

as a “world R&D center”. Although East Asia is now skilled at producing high-tech products

such as computers, mobile phones, and other ICT devices, one can hardly find new products

and new ideas that have originated from the region. Instead of using the production sharing

network to invent new products and create new demand, East Asian countries organize

production primarily based on demand from the West. Comparing the impacts of the

current crisis with that of the 1997-1998 Asian financial crisis, it is evident that the

interdependence between East Asia and the West is indeed asymmetric: when advanced

economies the West got a cold, East Asian economy caught the flu; whereas the West only

sneezed when East Asia caught a cold.

To increase the region’s influence on the global market, East Asia should start to enrich

functions of the existing production sharing network and extend it to a “production and

R&D sharing network”. The basic idea is to improve the region’s ability to discount the

negative impacts of the market contraction by generating market demand on new products.

Ideally, an East Asian R&D sharing network should be the one that allow East Asian

countries to put together their resources, optimize innovation activities at the regional level,

and equally access to new ideas and new technologies that the network will generate.

5.2. Building an Effective Social Safety Net

For East Asian countries, in particular China, another issue associated with long-term

economic development and stability is how to construct and implement a mature social

security system. The Chinese government must have known that rapid GDP growth is not

the whole story of development. Unfortunately, the pressure on the labor market, along

with the lack of a mature social security system, forced the Chinese government to favor

high-speed growth over other aspects of development. As one can see, export and export-

related sectors absorb a large number of the working force.

Generally speaking, the growth of the East Asian economy was quite stable until mid-2008.

In early 2008, most policymakers in East Asia were facing economic overheating and

increasing inflation. In many countries, key economic indicators started to show an

economic growth slowdown beginning in September 2008. The impending unemployment

pressure forced governments to abandon their original policy concerns and make a U-turn

to stimulate the economy. This was somewhat risky, as the other impacts and the duration

of the crisis were not yet discernible at the time.

It seems that without a mature social security system to buffer unemployment, even a

temporary economic slowdown may pose additional pressure on the labor market. Fear of

unemployment induced social instability may drive governments to implement a fiscal

stimulus and/or expansive monetary policies as quickly as possible to create more jobs, with

the aim of fighting against job loss. As a side effect, the potential inflation rate risks to

increase as well. Suppose an economy is indeed on the track of high-speed growth but is

merely temporarily stalled by outside shocks; implementing policies to stimulate the

economy artificially may cause it to win in the short run, but will cost it to lose in the long

run.

It is necessary for emerging economies in East Asia to set up an effective social safety net

that could function as a buffer to support temporarily unemployed workers especially when

economic crises attack. The existence of this system would leave policymakers more space

to evaluate the situation and better prepare the policy instruments to combat the crisis.

This issue is particularly crucial for China. The Chinese government started to reform its

social security system in 1994. An optimistic estimation is that it will need at least 20 years

for China to finish this reform. To some degree, the current economic crisis may even have a

positive effect as it make the Chinese government increase funding to revamp its healthcare

system.19 Though the fiscal stimulus on health care seems to have very limited multiplier

effect through the economy, it will accelerate the process of constructing a mature social

security system for 1.3 billion Chinese people; while in the short term, this can contribute to

prevent social instability result from massive unemployment.

5.3. Foster Regional Financial Integration

Just like a Capesize vessel would be safer surviving turmoil in the ocean than a Handysize

vessel would, an integrated regional economy of a larger size would be more effective in

fighting against economic turmoil in the global market. Compared to what was done during

the 1997-1998 Asian crisis, East Asian countries chose this time to synchronize their pace

and to maintain regional stability cooperatively. To some extent, this is a positive sign of

further integration in the region.

During the ADB meeting held on May 3, 2009 in Indonesia, finance ministers from China,

Japan, South Korea and the ten ASEAN member states (ASEAN plus three) agreed to set up a

$120 billion emergency fund, which will be launched by the end of 2009. This will provide

liquidity to any of them in need of help during the economic downturn.20 The ADB will at the

same time set up a surveillance unit to monitor the region's economies. In addition, the ADB

will create a $3.4 billion fast-disbursing facility fund, while Japan plans to supply up to 6

trillion yen to support its neighbors.

East Asian countries began to explore possibilities for regional financial cooperation after

19 In January 2009 the Chinese government pledged RMB850 billion (about 120 US dollars) to overhaul its

healthcare system. 20

Under the plan, China (including Hong Kong SAR) and Japan would each contribute 32 percent to the

regional fund. South Korea would provide 16 percent, while the rest would come from the 10 ASEAN member

states.

the 1997-1998 Asian financial crises. In 2000, the financial ministers of ASEAN plus three

agreed on a framework of principles of the Bilateral Swap Agreement (the Chiang Mai

Initiative, CMI). Although the agreement was further approved to proceed with

multilateralization in 2005, the CMI faced difficulty in reaching a decision concerning

contribution levels. Since the global financial crisis created a common threat to the region, it

in practice pushed forward the decision-making process and contributed to the birth of the

$120 billion emergency fund.

Most Asian economies are export-oriented. Trade surplus left them with large amounts of

foreign exchange reserves. Due to the fact that instability in the financial market would

adversely affect trade and investment in the region, the creation of the joint emergency

fund could counteract the negative effects of the financial crisis. Finance would therefore

promote international trade and stimulate economic recovery by greasing the wheels of

trade.

In the long run, further integration of financial sectors would leave East Asia more choices to

keep the real value of its U.S. dollar dominating foreign exchange reserves via operations in

the financial market. Based on calculations by the U.S. Treasury/Federal Reserve Board,

from June 15, 2009 until the end of April 2009, more than 50 percent (more than 1.6 trillion

dollars) of the U.S. treasury securities were held by East Asian countries.21 Although this

makes East Asian economies more vulnerable to fluctuations in the exchange rate of the

U.S. currency; on the other hand, such a significant amount of “shareholding” of the U.S.

treasury securities could actually grant East Asian countries power, as long as they move

synchronically as a group to defend themselves, by manipulating the U.S. dollar.

5.4. Constructing a Multi-Oriented Production Network

Here the term “multi-oriented” has two meanings. From a regional perspective, the crisis

could be a factor in accelerating the process of East Asian regional integration. It is

important to encourage an integrated regional market that is large enough to balance extra-

regional demand. For a long time, East Asian economies were interested in initializing new

free trade agreements, while reluctant to join agreements founded by others. The outcome

was a “spaghetti bowl” style of East Asian regionalism: dozens of agreements were

21

Data source: http://www.treas.ogv/tic/mfh.txt. Downloaded on June 16, 2009

initialized, yet, none of which were actually appealing. The consensus and cooperation

between Japan and China is vital in promoting an integrated regional market. The

composition of the Asian emergency fund balances the positions of both Japan and of China:

Japan is the largest individual contributor to the fund, while China and Hong Kong SAR

together reach an equal position to that held by Japan. This type of balance between the

two regional economic powers could serve as a positive reference for further negotiations

on East Asian regional integration. In practice, Japan and China’s roles in the region should

be further centralized. Generally speaking, the Japanese economy and the Chinese economy

are highly complementary. It would facilitate East Asian countries’ access to production

factors, such as capital and labor, via strengthening economic links with Japan, the largest

capital source within the region, and China, the largest labor pool. Many East Asian

countries launched fiscal stimulus packages aiming at stimulating the domestic market. It

would be more efficient if they could design policy instruments in a regional scope and fight

against economic slowdown as a group.

On the global stage, East Asia is will support the multilateral trade negotiation system in

order to secure free trade and capital movement, which are fundamental to production

sharing. The multilateral trade negotiation system has facilitated the integration of East

Asian countries to the global market. Except for Lao People’s Democratic Republic, who is an

observer, all of the ASEAN plus three countries are currently WTO members. The emerging

economies in East Asia would suffer painfully if the world moves towards trade

protectionism. It would be in their best interest to push forward the Doha Development

Agenda, the current trade negotiation round of the WTO.

In addition to boosting the intra-regional market, exploring new markets in developing

economies is another way to relatively lessen the region’s economic reliance on the West.

Geographically, East Asia may also explore inter-regional production sharing with other

dynamic regions, especially Latin America and the Caribbean region. Latin America has

experienced steady economic growth driven by the sustained expansion of the primary

goods exports in the past two decades. The rapid economic growth increased the region’s

demand for goods and services produced in East Asia. Indeed, Latin America and the

Caribbean has been a booming market for the exports of manufacturing from East Asia.

According to the World Trade Organization, interregional merchandise trade between Asia

and Latin America more than doubled from 2000 to 2006. China is Latin America’s third

largest trading partner.

Policymakers in East Asia must have seen the importance of improving links with Latin

America and the Caribbean. About twenty bilateral FTAs are either in action or under

negotiation between East Asian and Latin American countries. The contents of FTAs are not

only limited to trade in goods, but extended to services and investment. This interregional

liberalization facilitates the free movement of goods and production factors between the

two regions. From East Asia’s viewpoint, improving economic links with Latin America and

the Caribbean could not only bring about a big potential market; but also strengthen the

linkages between the regional production sharing and the global value chain. Three East

Asian countries – Japan (1976), Korea (2005) and China (2009), are now members of the

Inter-American Development Bank (IDB). As the largest shareholder in the IDB outside of the

Western Hemisphere, Japan holds a permanent seat on the Bank’s Board of Executive

Directors since 1994. East Asian countries’ involvement into the IDB’s operations allows the

region to directly participate into the development of Latin America and the Caribbean

region, which may open another door to expand interregional production sharing.

6. Concluding Remarks

The U.S. credit crunch, which is “the largest financial shock since the Great Depression in the

1930s” (IMF, 2009), triggered a global financial crisis. Even though East Asia was not at the

epicenter of the financial turmoil, it was unable to be immune to the crisis because of the

integration of the regional economy with the global market. The current crisis resulted in

the slowing down of economic growth in the region and thus set the tone for an exploration

of some fundamental weaknesses faced by the East Asian economy.

East Asia needs to increase the contents of technique/knowledge in production sharing and

improve its core competitiveness in the global market. By boosting the intra-regional

market and strengthening inter-regional cooperation with other emerging economies, East

Asia has better to construct a multi-oriented network that is relatively less dependent on

the West. East Asian countries also need to implement a mature social security system as a

buffer to absorb temporarily unemployed workers. Moreover, it would also be in the

region’s best interest to support the multilateral trade negotiation system with the aim of

securing free trade and capital movement in the global scope.

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Table 1: Real GDP Growth in Select Countries/Regions, 2007-2009

2007 2008 2009

World Output 5.0 3.7 2.2

United States 2.0 1.4 -0.3

European Union 3.1 1.5 -0.2

Euro Zone 2.6 1.2 -0.5

UK 3.0 0.8 -1.3

East Asia

Japan 2.1 0.5 -0.2

China 11.9 9.7 8.5

NIEs 5.6 3.9 2.1

ASEAN-4 6.3 5.4 4.2

Data source: IMF (2009), WEO 2008.

Table 2: Foreign exchange reserves and official gold holdings, world and selected countries

Foreign holdings of US treasury securities,

as of April 2009 ii)

Official gold holdings,

as of March 2009iii)

Rank

Country/monetary

authority

Foreign exchange

reservesi) (billions

of USD) In value (billions of

USD)

As share of total

reserves

In volume

(tonnes)

In value iv)

(billions

of USD)

As share of

total reserves

World v)

7471 3262.6 43.7% 29691.7 877.8 11.7%

East Asia vi)

4195.7 1735.8 41.4% 2280 67.4 1.6%

1 China 1953 763.5 39.1% 600 17.7 0.9%

2 Japan 1019 685.9 67.3% 765.2 22.6 2.2%

4 Chinese Taipei 312.6 78.3 25.0% 423.6 12.5 4.0%

6 South Korea 226.8 35.4 15.6% 14.3 0.4 0.2%

8 Hong Kong SAR 193.4 80.9 41.8% 2.1 0.1 0.0%

9 Singapore 166.1 39.7 23.9% 127.4 3.8 2.3%

12 Thailand 120.5 28.5 23.7% 84 2.5 2.1%

15 Malaysia 87.7 11.6 13.2% 36.4 1.1 1.2%

25 Indonesia 56.6 n.a. n.a. 73.1 2.2 3.8%

33 Philippines 39.3 12 30.5% 153.9 4.5 11.6%

50 Vietnam 20.7 n.a. n.a. n.a. n.a. n.a.

Notes : i) Data source: http://en.wikipedia.org/wiki/List_of_countries_by_foreign_exchange_reserves. Downloaded on 17JuneJune 17, 2009.

ii) Data source: http://www.treas.ogv/tic/mfh.txt. Downloaded on June 16, 2009.

iii) Data source: World Gold Council (2009), World Official Gold Holdings (March 2009).

iv) The value of holdings in gold is calculated using the gold price of $919.50 per troy ounce (the price at the end of January 2009).

v) The sum of all countries/regions.

vi) The sum of counties/regions listed in the table.

Chart 1: Export performance of selected Asian countries, 2008

(percentage changes of 3mma, SAAR, U.S. dollar basis)

Source: Kato (2009).

Chart 2: Monthly Import Growth Rates (Year-on-year, percentage)

Source:

Data of Japan: Ministry of Finance, Japan

Data of China: Chinese Custom Statistics Bureau

Data of Hong Kong SAR: Hong Kong SAR Trade and Industry Department

Data of Chinese Taipei: Department of Statistics, MOF

Data of South Korea: Korean Statistical Information Service

Data of Indonesia: Bank Indonesia

Data of the Philippines: National Statistics Office, Republic of the Philippines

Table 3: Unemployment Rates for East Asia

Seasonally adjusted

unemployment rate Figure as of Source

China 4.3% March 2009 National Bureau of Statistics, China

Japan 5% April 2009 Ministry of Internal Affairs and Communications,

Japan

South Korea 3.9% May 2009 The National Statistical Office, South Korea

Hong Kong SAR 5.3% May 2009 The Census and Statistics Department, Hong Kong

SAR

Taiwan, China 5.8% May 2009 Cabinet-level Directorate General of Budget,

Accounting, and Statistics, Chinese Taipei.

Singapore 3.3% March 2009 Statistics Singapore, Singapore Government

Indonesia 8.4% May 2009 National Development Planning Agency, Indonesia

Malaysia 4.5% February 2009 Malaysian Institute of Economic Research, Malaysia

Thailand 3.8% March 2009 Fiscal Policy Office, Ministry of Finance, Thailand.

Philippines 7.5% April 2009 National Statistics Office, NSO, the Philippines

Table 4: Global social security rankings, East Asia

Country/region Ranking

Japan 20

Chinese Hong Kong SAR 75

China 80

The Philippines 89

Chinese Taiwan 93

Singapore 117

Malaysia 125

Vietnam 131

Thailand 141

Indonesia 151

Source: Dixon (1999), Appendix 10.1