CHINA AND THE DYNAMIC OF ASIAN ECONOMIC INTEGRATION

CCEEC-UIBEWorking Paper

June 2004

PhD Jean-Christophe DefraigneCCEEC Research Fellow

In order to understand China’s economic relations with the rest of the global economy, it is necessary to analyse how the opening of the Chinese economy fits into the process of Asian regional integration that has been taking place for decades. Before the late 1970’s, such an analysis was irrelevant because the Chinese government did not have a regional economic policy. The main concerns of the Chinese Communist Party (CCP) were to insure the defence of the national territory, to resist US imperialism in East Asia and to organize economic autarky to achieve these objectives.

When the CCP decided to open up China’s economy to world trade and investment flows, the latter joined a process that had already begun to shape the economy of East Asia. The Chinese and East Asian economies are now characterized by a high degree of interdependence. It is therefore essential to grasp the dynamic of the East Asian integration in order to look at the opportunities and constraints shaping China’s international economic relations and China’s foreign policy.

1. THE ORIGINS OF THE EAST ASIAN INTEGRATION PROCESS

The Asian economic integration process that can be observed today can be traced back to the 19 th century. It was first shaped by the Western colonial powers, which annexed progressively most of the region. One could oppose this benchmark by claiming it is possible to identify economic integration forces operating at the continental level as early as the 15th century. At that time Chinese merchants were already trading in most of South East Asia. Commander Hong’s naval expeditions were exploring and establishing trading posts as far as the East Coast of Africa, creating communication links all across the Indian Ocean (Kennedy, 7). Suddenly, the Chinese Emperor and mandarins decided put a halt to overseas exploration and trade, most probably because of the political instability created by the rise of prosperous merchants that undermined the Imperial system. The decision the Chinese Emperor and Mandarins to insulate China from the rest of the world in the mid 15th century did not prevent some Chinese immigration from continuing which led to the creation of some trade links across South-East Asia. Nevertheless, these connections were still very limited because they were based on pre-industrial merchant capitalist practices rather than on modern manufacturing and services. They were also constrained by poor means of communication and transport.

1

Western colonisation in the 16th century began to reopen sectors of these economies to global trade and to capitalist industrial production methods. The early phase of this process was very progressive with only limited foreign investments in plantations by Western charter companies such as the Vereinigde Oostindische Compagnie. The length and risks involved in the journeys to Europe limited the scale and the scope of the Asian-European trade and investment flows.

A deeper transformation of the Asian economies by Western capitalism took place in the late 19 th century following two major breakthroughs in transport: the completion of the Suez Canal and the general introduction of the steamship. This shortened by two thirds the travelling time to Europe. As a result, in the 1880’s, the Dutch began to organize large scale plantation production of sugar in Indonesia. Other Western FDI were also made in tin or rubber in the early 20th century (Yoshihara, 14). Western direct investments in Asia were mainly resource-seeking, which implied the growth of intercontinental trade between Asia and Europe but not the direct development of intra-regional trade.

Nevertheless the development of this intercontinental trade led by Western colonisers created new centres of trade such as Hong-Kong and Singapore. The existing networks of ethnic-Chinese –and to a lesser extent ethnic-Indian- merchants proved very useful to the European colonizers who had communication problems with the indigenous population and lacked networks with local producers of basic-needs commodities. The ethnic minority merchants were much more efficient at this task and their networks were considerably strengthened by the extension of Western colonization (Yoshihara, 44). The development of inter-regional trade between Europe and China reinforced the intra-regional trade and services networks of that were to play an essential and lasting role in the Asian integration process during the 20th century and beyond. From the 1880’s to the 1920’s, the ethnic-Chinese (and Indian) networks achieved a qualitative jump. They adopted modern capitalist institutions in respect of contracts, banking and insurance, which modernized and improved their former pre-industrial business practices. They used effectively the new capitalist institutional framework brought over by Western colonizers, which offered more guarantees and more possibilities. They began to imitate Western capitalist firms within their ethnic community market across the region. This development set the foundations of the future success of ethnic-Chinese capitalists after the decolonisation in the 1950’s and 1960’s (Yoshihara, 43). These facts clearly indicate the importance of Western colonisation in the acceleration of interregional and intraregional trade. Quantitative analysis made by Petri confirms the structural change in Asian trade patterns following Western colonisation (Petri, 29). However, under Western colonization, the division of labour between most Western powers and their colonies also hindered intraregional trade. The colonies were seen as providers of exotic raw materials and outlets for the manufactured production of their respective Western colonizing power. There were few manufacturing units of production in the colonies which served only the local markets and not the regional market. During the last decades of Western colonization, while the ethnic-Chinese capitalists might have controlled a network capable of distributing local manufacturing production across the region, they lacked the capital to engage in production which was characterized by high-fixed costs (Yoshihara, 45). During this period, the minimal efficiency size of a firm in most manufacturing sectors increased dramatically in the United States and in Europe due to new possibilities for economies of scale and the scope provided by technological and management innovations (Chandler). Thus ethnic-Chinese capitalists rarely engaged in manufacturing or even in plantations and could not develop on their own intra-regional trade in these sectors.

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2. JAPAN: THE EXCEPTION AND THE MAJOR DRIVING FORCE BEHIND ASIAN INTEGRATION

Japan is by far the most important economy of East Asia: it outweighs all the other economies of the region combined. Japan transnational corporations (TNCs) have been operating across East Asia for decades. But, most of all, Japan is the only non-European country, which managed to catch up with the Western industrialized powers during the 20th century.

It is not possible here to develop in great length the reasons behind Japan’s exceptional economic success. Nevertheless, we need to mention the reasons that exerted a lasting influence on the Asian integration process.

It is obvious that Japan’s success can only be explained by a mixture of both domestic and international factors. However, the international setting is decisive considering that this latecomer economy started its industrialisation at a time when Western industrialised powers began to divide up the rest of the world into colonial empires and protectorates. During its first century of industrialisation, Japan proved exceptionally lucky. Circumstances behind the control of the Japanese political and business elites afforded Japan’s industrial development very special opportunities. No other important developing country in the world benefited from the same combination of such positive exogenous factors as those that affected Japan's economy from the 19th century to the 1960's.

2.1. Three favourable and decisive exogenous factors behind Japan's industrialisation

2.1.1. The limited interest of European colonial powers for Japan

Paradoxically, Japan’s first piece of luck was probably its limited endowment of raw materials. Japan did not possess valuable natural resources such as the spices or high quality commodities already be found in China, India and the rest of Asia (Bairoch I, 497). Furthermore, Japan and Korea were the Asian countries located furthest away from Europe. The priority given by colonial powers to seizing territories in China, Indochina or Indonesia spared Japan from Western occupation and intervention in domestic politics until the mid 19th century. Commodore Perry's American intervention in 1853-54 came late and was quite benign compared to the military expeditions of the Dutch army in Indonesia or the British and the French armies in China. This gave the modern part of the Japanese aristocracy precious time to transform the Japanese society, economy and army such that it could put up resistance to Western expansionism.

Domestic transformation (especially the adoption of Western style legal and political institutions) certainly helped Japan to obtain the status of "civilized nation" among Western powers (Hunter, 22) but military strength was as decisive in that respect also (Oshima, 375). Successful wars against China in 1894-95 and then against Russia in 1905 greatly surprised the Western powers (Hunter, 23). Even though Japan did not gain as much as expected in both conflicts due to Western powers intervention in the post-war negotiations, Japanese military successes nevertheless contributed to transforming Japan into a modern military power in the eyes of Europe and America. These wars insured Japanese national sovereignty but at tremendous economic cost. Military expenditure created a rising public debt and forced the Japanese government to borrow on overseas capital markets (Ohkawa, 71). Import-substitution industrialisation required expensive imports of Western technologies

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that were not matched by exports of primary goods, silk or low-quality manufactured goods. In the early 1910’s, the Japanese economy was facing a very precarious situation characterised a by rising trade deficit, foreign borrowing and inflation. Foreign banks intervention in domestic affairs and a substantial loss of national sovereignty -a fate known by so many Middle-East or Latin American non-colonised countries- was at bay.

2.1.2. World War I, a way out of the crisis

Japan proved lucky again in 1914 with the outbreak of WWI. Japan took the side of the victors but as fighting in Asia was very limited, its participation induced only very limited costs. During the conflict, the European colonial powers directed their industrial production to the war necessities in Europe. This reorganisation of industrial production left Europe’s colonies in need of manufactured products. In Asia, the vacuum was quickly filled by Japanese products. Japanese textiles penetrated British-dominated Asian markets (Hunter, 120). Japanese exports grew six times faster from 1915 to 1919 than from 1911 to 1915 (Yamamura, 302). The Japanese trade deficit amounting to 435.9 millions yen for the period 1908-1913 transformed itself into a massive surplus of 1837.5 millions yen for the period 1914-1919 (Yamamura, 303). Japan became a creditor nation during the war. WWI not only generated a massive increase of industrial production capacity in Japan but also gave Japanese firms new opportunities to develop new capital and technology-intensive sectors. For example; the Japanese infant chemical industry benefited greatly from the disappearance of the German leading firms in the region (Hunter, 120). The consequences of WWI on the Asian economy generated a quantitative and qualitative change of the Japanese industrial structure, setting the base for a sound development of the large Japanese conglomerates, the zaibatsu.

Japan's trade balance 1900-1921(in millions of yen)

-600

-400

-200

0

200

400

600

800

1900 1901 1902 1903 1904 1905 1906 1907 1908 1909 1910 1911 1912 1913 1914 1915 1916 1917 1918 1919 1920 1921

Source: Mitchell 1993

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2.1.3. US policy in Asia and the rebuilding of Japanese industry

Japan's third piece of luck came after WWII. The imperialist policy of Japan from 1938 to 1945 claimed around 30 millions casualties in Asia, mostly in China (Kolko). The massive and horrific war crimes committed by the Japanese army naturally generated strong resentment by the vast majority of the Asian populations. In 1945, Japan was isolated economically and politically. It had lost all national sovereignty as American forces occupied the country until 1952. The Japanese economy was wrecked. Japan’s national wealth in 1945 had shrunk to its 1935 level (Nakamura, 14). There were massive population outflows from urban to rural areas because of food shortages. The loss of the colonies completely disrupted the Japanese economy because of the lack of foodstuffs and raw materials.

The Japanese TNCs were in a precarious situation. With the decolonisation, all Japanese FDI were confiscated. The US occupation authorities had plans to dismantle the zaibatsu, 325 industrial groups were targeted to be split up. The Japanese access to world markets and to raw material sources was also under the control of US occupation authorities. The future of Japan as an economic industrial power was uncertain.

Again, external circumstances created an extremely favourable environment for the rebuilding of Japan's industrial structure. In the late 1940’s, the US’ plans concerning Japan’s economic development were radically altered. Among the Western capitalist powers, only the US possessed the military and financial capacities to check communist expansion and radical nationalist de-colonisation uprisings. The European powers could not even manage to keep control in their colonial empires. Great Britain had openly declared to Washington that it could not engage in any major military intervention after the crushing of the communists in Greece in 1947 (Kindelberger, 507). The situation in Asia was hardly more reassuring for Washington. With any anti-imperialist nationalist or communist uprising in China, Korea, Vietnam or Indonesia, the Western troops based in Asia could be rapidly overwhelmed. Implicit in the so-called policy of "containment" adopted by the Truman administration was the redefinition of Japan’s role in Asia.

Japan was authorised and encouraged to become once again the major economic power in Asia. The attitude of the US occupation forces towards Japanese business and economic elites changed dramatically. The dismantling of the zaibatsu was abandoned and business leaders were rehabilitated. American experts and considerable financial aid contributed to the reestablishment of a sound macroeconomic environment with the adoption of the Dodge plan in 1949. The American forces in Asia provided the Japanese industries with new markets and helped Japan to restore its trade balance. In 1949, Japan was in serious need of imported raw materials but lacked outlets for industrial exports. The so-called tokuju procurements of the US army to Japanese firms during the Korean War helped a moribund Japanese industry to recover (Friedman, 260). The tokuju accounted for more than 70% of the Japanese exports from 1950 to 1952 (Samuels, 133). The American procurements continued with their growing military involvement in Asia, especially after their involvement in the Vietnam War in the 1960s (Hook, 170). Not only did the US administration offer Japanese firms outlets for their production through procurements but it also helped Japanese exporters to re-access world markets. The Eisenhower administration opened the US domestic market to Japanese products in the early 1950's before Japan's accession to the GATT. It imposed on its European and Asian allies the reinsertion of Japan in the capitalist world community. The US government sponsored Japan's application to join the GATT and the OECD. Without this help, it is

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very doubtful whether Japan could have fully benefited from the trend of trade liberalisation occurring within the GATT and therefore whether it would have experienced its exceptional export success.

Even Japan's success in creating dense political and business networks across Asia cannot be understood without taking into account the US diplomacy in the region. The fight against communism and anti-imperialist nationalism often resulted in the elimination of the strongest anti-Japanese political movements throughout Asia and in the rehabilitation of local elites which had collaborated with Japanese during the 1930’s and 1940’s. This was certainly the case for South Korea, for Indonesia and for Thailand.

Another decisive aspect of the US "containment" policy that had profound lasting effects on the Japanese industry was the technology transfer encouraged by the Eisenhower administration. In the early 1950’s, the bilateral Mutual Security Assistance programme provided US financial aid and technological transfers to Japanese defence firms. The Japanese firms benefited from new American engine and machinery technology; from American large-scale engineering know-how to programmes introducing American methods of quality controls and manufacturing process (Friedman, 275). The range of industrial sectors that benefited from these measures varied from wireless communication to propulsion to materials processing (Friedman, 261). The Japanese government managed to negotiate that transferred US patents could also be used for civilian and not exclusively military production. This free ride, without comparison in Asia certainly accounted for a substantial part of the successful rebuilding of its industries in post-war Japan (Hatch, 100 & Doner, 261).

The three exogenous factors mentioned above constituted no sufficient conditions to account per se for the Japanese exception. Domestic factors such as the social structure and the adoption of specific institutions explain how it was possible for Japan to grasp these three exceptional opportunities. Some other countries also benefited from some of these opportunities (e.g. world wars also benefited the industries of large Latin American countries. Taiwan and South Korea also received substantial US economic assistance). However, the Japanese development path remains exceptional because of the extremely favourable timing and combination of these opportunities. These exogenous factors contribute to explaining the leading economic role that Japan took in Asia and how its TNCs became the core of the Asian economic integration process.

2.2. Japan's expansion in Asia

2.2.1. From the war against China to the Asian "co-prosperity sphere"

As previously mentioned, military victories against China and Russia were among the factors that enabled Japan to keep its national sovereignty when the colonial race between Western powers divided the world into spheres of influence. These wars also provided Japan with new colonies. From the war against China, Japan won the control over Taiwan in 1895. After the struggle against tsarist Russia in 1905, the way was cleared for an annexation of the Korean peninsula, which became officially a Japanese colony in 1910. This had long-term economic consequences for the region. Japan relied much more on its colonies to support its industrial development than the Western powers did on their colonial empires. Japan’s limited endowment of raw materials and the need for vertical integration was a strong motivation behind Japan’s expansion in Korea and later in Manchuria.

6

Geographic proximity offered new opportunities to engage in a deeper economic specialisation between Japan and its two colonies. Korea and Taiwan became an essential complement for rice production. The new Japanese landlords By the late 1920's, Korea and Taiwan accounted for 80% of Japan's rice imports (Petri, 31) and Taiwan was the most important provider of sugar to Japan (Bairoch). This helped to release the labour force from the countryside which was necessary for the industrialisation of Japan.

The Japanese also set up an industrial base in their previously rural colonies. In Korea, the Japanese developed mining activities and some metallurgy. Taiwan became a processing centre for raw materials and the Japanese developed important oil refining capacities (Hobday, 96). Korean and Taiwan indigenous capitalists emerged in subcontracting activities and in the local food business. Some of today’s largest firms from South Korea and Taiwan were born under Japanese occupation. South Korea’s Samsung started in the fish and fruit businesses in 1938 (Hobday, 79) and Taiwan’s largest private firm in the 1990’s, Tatung, began in 1919 as a building company, which then moved into mechanical equipment in 1939 because of the requirements of the war economy (Hobday, 112).

During half a century of Japanese occupation, important trade and business links were created between indigenous entrepreneurs and their Japanese colonisers. These links were to be resumed after the Japanese defeat. Furthermore, these countries had experienced a higher industrialization level -especially after the Nippon Empire switched to a war-economy in the late 1930’s- than the Western powers’ colonies (or than the formally independent Thailand). The Japanese colonisers developed a substantial pool of workers familiar with manufacturing activities. This development is crucial to understanding the quick industrialisation of these countries from the late 1950’s onwards. This does not mean that the Japanese colonization generated an overall positive effect on these economies but it produced better long-term results than Western colonisation in Asia. One should keep in mind that the cost for local population was high, particularly for Koreans who experienced a lowering of the level of food consumption during the Japanese occupation. The colonised populations were second rank citizens (Clough, 817). Furthermore, thousands of Korean women were used as sexual slaves by the Japanese army. Economically, local businessmen could only develop services and manufacturing through subcontracting activities for the Japanese zaibatsu or to serve the local market. All capital and technology-intensive sectors remained under Japanese control.

Japanese business had been creating trade links across Asia since the late 19th century. A Japanese trading company opened an office in Singapore as early as 1891 (Yoshihara, 20). However, the first substantial penetration of the Asian markets by Japanese products came with WWI, during which the Western industries serving these markets had to focus on military production in Europe. The return of Western manufactured products on the Asian markets in the 1920’s was an important blow to the Japanese industries. Japanese exporters faced rising trade barriers and quotas during the 1920s as the Western countries became more protectionist as stated by a contemporary economist: “its (Japan) export trade has been considerably retarded by a multitude of economic barbed-wire entanglements in the shape of quota restrictions, high tariffs, and other measures to check the sweep of "made in Japan" products…More than sixty countries have imposed special restrictions on Japanese textile; less than thirty have left the door open on equal terms” (Chamberlin, 219).

The Japanese firms could access only those Asian markets that were not directly under Western control like Thailand and China or those that were under the authority of a weak colonial power without a strong industrial base such as Dutch-controlled Indonesia. Throughout the 1894-1895 war against China, Japan

7

had secured some of the same privileges held by the Western powers (control over the harbour of Dalien, special extra-territorial trade concessions in major coastal cities and in Beijing). Japan penetrated the Chinese markets through Dalien and other coastal cities. By the end of the 1920’s, the level of Japanese FDI in China was similar to that of Britain and larger than all the other Western countries combined (Petri, 32). Indonesia’s imports from Japan were more important than with those from the Netherlands (Petri, 33). The situation was very difficult in the 1920 but it was the collapse of the trading system in the 1930’s that pushed Japan’s back against the wall.

The protectionist measures adopted in America and in the Western colonies in Asia gravely affected the Japanese manufactured exports and also the rural areas in Japan whose production of silk was formerly directed to the US market. These difficulties generated during the 1930's an increasing conflict within the Japanese elites: between those who believed in the possibility of restoring the Japanese economy without either high protectionism or military expansion; and those who favoured a more aggressive policy against the Western colonies in Asia and China. Ambitious imperialist plans for the construction of a so-called "Asian co-prosperity sphere" were put forward in the political circles of the extreme right and the army. It was during these troubled times that economist Akamatsu Kaname launched the first version of the famous theory of the “flying geese” which suggested that the Japanese economy would pull its Asian neighbours along by progressive wave of investments (Yamamura, 27). Not all the political and business leaders where in favour of such a reckless foreign policy. Among the ruling political parties, some liberals like still favoured multilateral negotiations to restore international trade and were backed by some business leaders like Dan Takuma, Mitsui’s managing director. But these voices were progressively suppressed by the violent means of the extreme right groups, which did not hesitate to assassinate those who opposed to the pursuit of the imperialist expansion (prominent business and political figures like Takuma and the finance minister Takahashi Korekiyo were killed in the 1930's). Furthermore, the resumption of free trade was far from imminent in the late 1930’s and liberals did not have short-term solutions for the survival of Japan’s industries. By 1937, the ultra-imperialists had gained control of Japanese society and the economy (Hunter, 279).

The Japanese imperialist scheme for Asia shared many similarities with the German nazi new economic order for Europe. In 1939, the Japanese Showa Research Institute developed an extensive plan for an East Asian Economic Bloc, which would be self sufficient on tin, rubber, bauxite, tungsten, nickel and chromium (Petri, 39). The Japanese government also wanted a large trading zone for its manufactured products and a monetary zone controlled by the Japanese currency. But Japan was even less able to start its ambitious economic plans to dominate Asia as the superiority of the US forces at sea and in the air quickly cut shipping links across the Japanese occupied territories (Cohen, 107). The Japanese imperialist scheme for an “Asian co-prosperity sphere" ended in a bloody defeat and led to a complete isolation of Japan in 1945.

2.2.2. The slow resumption of Japanese expansion 1945-1985

Despite the catastrophic state of the Japanese economy in 1945, Japan’s zaibatsu still held some advantages. They had gained years of experience of large-scale production during the war (Nakamura, 15). Japanese technocrats and managers had also gained some knowledge about how to organize a production process at a continental level. This provided them with intangible assets that none of their Asian counterparts possessed and therefore gave them the potential to open subsidiaries in the region. Two obstacles had to be overcome. The first was the limited availability of foreign currency reserves in

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post-war Japan (Hook, 19). This barrier to Japanese FDI was lifted with the tokuju of the Korean War. The other was the strong anti-Japanese sentiments of most Asian nations. This was smoothened out by the US’ support for Japan's political and economical reintegration in the region. In those countries under Western influence, indigenous businessmen who had collaborated with the Japanese in the war effort were not penalised despite strong resentment towards them by the local populations.

Within a few years after the war, the traditional business networks set up by the Japanese zaibatsu with local businessmen were rebuilt. Japanese trading companies were needed by the Asian economies for their excellent regional trading network. The Japanese companies adopted a low profile and were ready to operate on a joint-venture basis with indigenous entrepreneurs (who had often been subcontractors during the war), (Yoshihara, 20), or through licensing (Yamamura). This gave the Japanese firms an additional advantage over their Western competitors, who were more reluctant to engage in joint-ventures. Many Asian countries were beginning to adopt import substitution strategies and the Japanese firms were able to fit more easily into this framework. Paradoxically, the war reparations that Japan had to pay to Her neighbours facilitated the resumption of trade relations with Burma, the Philippines, Indonesia and South Vietnam (Hook, 18).

As early as 1951, Japanese trading companies were operating in Indonesia (Yoshihara, 22). In Thailand, Japanese firms regained their position by the mid 1950’s. Japanese flows of FDI to Singapore resumed in 1963 (Yoshihara, 23). In South Korea, Japanese business links were restored as early as the late 1950’s but became official with the bilateral economic co-operation agreement of 1965 (Hook, 18). Japanese firms had to wait longer to enter the economies of the Philippines and Malaysia. In the case of the Philippines, the lifting of anti-Japanese measures came only in 1967 (Yoshihara, 22). However, the relatively late resumption of Japanese-Filipino economic relations might also be explained by the high level of American FDI in the Philippines. In Malaysia, Japanese penetration was limited because of the strong British presence and also because of the narrow domestic market. Japanese FDI and trade links with Malaysia increased rapidly after the New Economic Policy of 1971 and the withdrawal of many British firms from the country (Yoshihara, 24).

Until the 1980’s, the Japanese subsidiaries in the region were set up to serve the local Asian markets and to exploit local sources of raw materials, notably in Indonesia (Dicken, 69). Progressively Japanese FDI caught up with the Western investors in East Asia. Their greater adaptation to the demand of indigenous businessmen for partnership gave them an advantage in foreign firms at a time where most of the countries in Asia were adopting import-substitution policies. During the 1950’s and 1960’s, Western TNCs had a substantial presence in the manufacturing sectors (automotive, pharmaceuticals, oil refining or household appliance) but rising Japanese competition forced these Western firms out except in the sectors where they maintained a strong comparative advantage over their Japanese competitors (such as toiletries, pharmaceuticals and food) (Yoshihara, 18).

2.2.3. The first wave of Japanese efficiency-seeking investment 1968-1978.

From the late 1960’s onwards a new form of Japanese direct investment began to take place in Asia. Rising wages began to put pressure on the profit margin of Japanese firms involved in labour-intensive activities. Furthermore, the exceptional development of Japanese exports to the US markets began to change the US trade policy vis-à-vis Japan. The US government pressure on Japanese exporters rose in the late 1960’s and 1970’s and generated the voluntary exports restraints in textiles and automobiles. The

9

third problem that Japanese exporting firms faced was the rise in the value of the yen after the collapse of the Bretton Woods international monetary system in 1971. Until then, the yen had been fixed at 360 yen to the US dollar since the early 1950’s. Thus the Japanese exporter had benefited from an undervalued domestic currency. The yen continued to appreciate throughout the 1970’s. The combination of these three factors encouraged Japanese firms to relocate their labour intensive activities to neighbouring Asian countries (Hobday, 36 & Hook, 19). These countries not only enjoyed low wages but also weak currencies and did not face major trade frictions with the US.

From to the late 1960’s to 1977, Japanese TNCs launched a first wave of efficiency-seeking direct investment. These FDI were not aimed at serving the local market but were a step taken by Japanese TNCs towards the regionalisation of their processes in order to lower their production costs. This new pattern of FDI was also made possible by the concomitant policy switch from import-substitution to export-oriented growth adopted by many Asian host economies (Doner, 182). Nevertheless, market and resource-seeking investment continued to be predominant (Dicken, 69). By the end of the 1970’s, the Japanese TNCs had caught up with their American competitors in their penetration of the East Asian economies. In 1977, cumulated FDI for both countries amounted to $6 billion (Petri, 161).

Japanese wage increase

0

5

10

15

20

25

30

1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982

nominal wage increase in %

Source: Ito 1995 & Nakamura 1995

10

The yen appreciation or " endaka"

0

0,001

0,002

0,003

0,004

0,005

0,006

0,007

0,008

1960

1961

1962

1963

1964

1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

dollar per yen

Source: Ito 1995

Japanese FDI outward stock 1960-1985(in billions of dollars)

0

1

2

3

4

5

6

7

1960 1970 1980 1985

FDI outward stock

Sources: Bairoch 1997 & CNUCED 2003

11

Japanese FDI outward stock 1980-2002 (in billions of dollars)

0

50

100

150

200

250

300

350

400

1980 1985 1990 1995 2000 2002

FDI outward stock

Sources: Bairoch 1997 & CNUCED 2003

2.2.4. Endaka and the second wave of Japanese FDI

The second wave of efficiency-seeking Japanese FDI took place in the late 1980’s. After being stable from 1978 to 1985, Japanese FDI flows to East Asia began to accelerate between 1985 and 1989 (Doner, 182). Most scholars acknowledge the crucial role played by the Plaza Accord of 1985 in generating this new wave of Japanese FDI (Fukasaku, 20; Jones, 101; Hook, 19 & Hobday, 21). The Reagan administration pressured Tokyo to adopt measures to support an appreciation of the yen. In the following two years, the value of the yen rose from 250 to 150 to the dollar, a phenomenon referred as “endaka” by Japanese economists.

Petri claims that after this wave, efficiency-seeking FDI dominated market-seeking and resource-seeking FDI, as the regionalisation of the production process became a priority for Japanese TNCs (Petri, 41). Fukasaku notices the concomitance of this wave with the acceleration of intraregional trade after 1985 (Fukasaku, 16). The geographical reorganization of the production process of Japanese firms implied various types of FDI flows.

The first type of flow was generated by the extension of the relocation of labour-intensive activities to low-waged neighbouring economies. But contrary to the wave of the late 1960’s and early 1970’s, these investments were not directed mainly to the Asian newly industrialised countries (NICs) (South Korea, Taiwan, Hong-Kong and Singapore) but to other East Asian economies, that is the four largest countries of ASEAN (Thailand, Indonesia, Philippines and Malaysia). These less-developed East Asian economies had been so far chosen as recipients for resource-seeking or marker-seeking FDI. By the late 1980’s the four NICs met similar problems to those encountered by the Japanese economy in the 1970’s. Industrial labour costs rose rapidly in Taiwan and in South Korea because of full employment, rising union militancy and new social legislation (Yamamura & Gee). Like Japan, these countries had a trade surplus

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that caused their currency to appreciate. Ultimately, trade frictions with the United States and Europe also became more frequent. Hence, these countries lost their comparative advantage in labour-intensive sectors with low profit-margins to their less developed Asian neighbours. Japanese FDI expanded dramatically in Thailand and Malaysia and then to Indonesia and the Philippines.

At the same time, the four Asian NICs had some mature sectors. They had gained technological and managerial know-how. By the mid 1980’s, South Korea and Taiwan had managed to develop some strong competitors in specific industrial sectors. The Japanese firms adapted to this situation and continued to extend their regional strategy. Many keiretsu continued to invest or to license technology to the four Asian NICs but they focused more on technology-intensive sectors and on services (Doner, 170). By 1990, Japan was the first investor in the four Asian NICs with 38% of the total FDI flows hosted by these economies.

This new wave of Japanese FDI was concomitant with another wave originating from the four Asian NICs and directed to the “ASEAN-4” (Indonesia, Malaysia, Philippines and Thailand). Having assimilated technological and managerial know-how, these firms from the NICs gained intangible assets that made them confident enough to open subsidiaries in neighbouring less developed economies when their domestic macroeconomic environment became less attractive for the location of new labour-intensive activities (see below). This parallel wave of FDI from the four NICs to the ASEAN-4 was of a comparable size to that generated by Japanese TNCs (Hobday, 29). These events made the old “flying geese” model, in which Japan fuelled a dynamic that would drag the rest of the Asian economies into economic development, fashionable again.

These waves that occurred in the late 1980s created a complex regional division of labour. From the late 1960’s to the mid 1980’s Japanese TNCs moved from establishing “hubs” (simple relocations of screwdriver operations) to “clusters” (which implied more local content by local affiliates). After the endaka, Yamamura and Hatch consider that the production process of the Japanese TNCs experienced a qualitative change with the building of intrafirm webs (intraregional and intrafirm trade based on a regional division of labour) that would continue to develop through the 1990’s (Yamamura, 24) 2.2.5. The perfecting of the keiretsu’s regional division of labour

The endaka fuelled the real estate and stock market bubbles in Japan, which eventually burst in January 1990 (Jones, 67). The slowing down of the Japanese economy during the next decade jeopardized the traditional Japanese-specific industrial structure and industrial relations systems. Features such as the relations between keiretsu and their Small and Medium Enterprise (SME) subcontractors, lifetime employment, amakaduri (“the descent from heaven” of civil servants retiring into the private sector) were already growing problems with the maturing of the Japanese economy in the 1980’s but the crisis in 1990 forced a restructuring of these institutions. Breaking up directly these institutions would have been hazardous for the Liberal Democrat Party which had been the main architect of this system and remained one its main benefactor. Most of the Japanese business and political elites were determined not to eradicate the traditional system but needed to increase productivity and the profit margins of the keiretsu. The short-term easiest solution was to deepen the Asian division of labour launched by the Japanese firms and to extend the Japanese specific institutions to the rest of the Asian economies (Hatch, 384).

After the 1990 crash, the keirestsu began to increase the pressure on their subcontractors. Second-tier,

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third-tier and fourth-tier suppliers were squeezed out and many went bankrupt (Hatch, 389). The first-tier suppliers however possessed the sufficient capital and technological capabilities to relocate to Asia. Their relocation brought closer these firms to their parent firms or primary customers. Hatch mentions the case Nisshin, which supplies the brake parts for Honda has shut down its second and third-tier subcontracting plants and establish new plants along the different assembly plants of Honda across Asia (Hatch, 388). Hatch estimates that a third of Japanese TNCs have reconstituted the traditional subcontracting links that they enjoyed in Japan before the relocation of their assembly in Asia (Hatch, 387). Asia became an even more important destination for Japanese FDI. In 1995, East Asia received 79% of the FDI projects and 43% of the value (Hatch, 386).

2.2.6. The importance of the Japanese State through ODA and “regional guidance”

Japanese official development aid played a crucial role in accompanying the expansion of Japanese firms throughout Asia. Japan’s aid programs gave priority to targeting her Asian neighbours. In the 1960’s and 1970’s over 90% of Japanese ODA went to Asian countries (Hook, 18). For most of these economies, Japan became progressively the principal donor, outpacing eventually the United States. In 1992, the Philippines and Indonesia received more than two thirds of their aid funds from Japan. This aid funding amounted to 80.6% for Malaysia and to nearly 60% for Thailand. Even China receives over 50% (Yamamura, 131).

Japanese ODA does not seem to prioritise Asia’s least developed regions. In Thailand for example, a major recipient of Japanese ODA, the poorest region has received little Japanese ODA (Doner, 233). Japanese aid has been conceived to pave the way for the reinforcement of Japanese FDI in the region. The strong links between the private sector and Japanese development aid agencies are seen as a normal and desirable feature of the Japanese ODA system by both the government and the business elites (Lincoln, 28). The Japanese aid administration works closely in relation with keidaren (the Japanese private sector business organisation) (Doner, 231). The Japanese aid programs have been understaffed for decades. This implies a structural dependence on the private sector to insure a proper functioning (Yamamura, 125). In that respect, the large private Japanese trading companies are a vital link for the Japanese ODA programs. They possess a deep knowledge of the aid schemes and provide the necessary information to Japanese SMEs. They are often better at mastering the system of Japanese ODA than the development agencies of the host countries themselves and can advice the national Asian agencies on how to apply for the Japanese funds more efficiently (Yamamura, 126).

Most Japanese aid programs take the form of loans for large infrastructure projects, which rely on Japanese enterprises (Lincoln, 28). As Hatch and Yamamura noticed, the importance of infrastructure in development projects is specific to Japanese aid. In 1992, the share invested in infrastructure projects was about 40.7% of the total Japanese ODA against only 3.5% for the US ODA (Yamamura, 123). In the early 1990’s, $145 millions of Japanese ODA were invested in a dam project in China's Liaoning province. The aid flows were soon followed by $155 millions of FDI to build a Japanese cement plant which would supply the cement for the project (Yamamura, 127).

The Japanese ODA programs became more ambitious in the late 1980's. As mentioned above, the endaka in the second half of the 1980's encouraged the relocation of labour-intensive activities to neighbouring countries. When the yen started to appreciate, MITI drafted a plan called “Project for Comprehensive Co-operation Asian Industrialisation” or “New Aid Plan”. It involved the JETRO, the keidaren and the

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Japanese Institute for Developing Economies. One of its open goals was to facilitate the Japanese industrial restructuring. The plan was never really fully applied because of internal conflict between the various Japanese administrations and conflicting business interests. Nevertheless, many significant measures were passed under this new plan which helped Japanese TNCs to relocate to other Asian economies (Doner, 188).

The launch of ODA programs in countries still not penetrated by Japanese FDI (like former non capitalist Asian countries) is often interpreted by Japanese firms as a green light to invest with the support of the Japanese state (Yamamura, 127). In 1988, Japanese ODA was given to Vietnam for an electric power grid and less than two years later, Japanese trading companies and financial institutions began to open offices in Vietnam (Lincoln, 34). Finally, one should not forget that Japanese aid programs also facilitate the long-term development of Japanese firms by giving an increasing role to the yen as the regional currency. Most Japanese programs consist of yen-denominated loans (Lincoln, 28).

Apart from the effects of the ODA programs, Japanese enterprises can also benefit from the “regional guidance” provided by the Japanese state. Japanese enterprises are supported by the local offices of the MITI across Asia. These provide “regional guidance” on how to develop business abroad. The MITI has opened offices in Bangkok, Jakarta, Kuala Lumpur and Manila (Hatch, 387). The Japanese government has also offered financial support to encourage regional expansion, especially after the endaka. During the ten years following the Plaza Accord, the Export-Import Bank of Japan’s loans to support Japanese firms investing abroad increased 28 fold to reach $331 billions in 1996 (Hatch, 387). This bank not only helped the large keiretsu but also SMEs in their relocation projects (Yamamura, 15)

2.2.7. The impact of Japanese FDI on the neighbouring economies

The Japanese TNCs have built webs of subsidiaries and subcontractors right across East Asia. Of course, not all East Asian economies are similar. South Korea, Taiwan, Hong-Kong and Singapore industrialized faster than the large ASEAN countries and their development strategies were quite different. While Singapore and Hong-Kong always encouraged FDI with a very open policy, South Korea and Taiwan favoured a more interventionist approach. These differences forced the Japanese firms to adapt and to modify the pattern of their business strategies in Asia.

In South Korea, Japanese firms were welcomed in the late 1960's but FDI inflows were heavily restricted from the 1970's until the late 1980's (Dicken, 182). Japanese firms like NEC were even openly ousted by the South Korean government. Nevertheless, the slowing down of Japanese investment did not mean the end of Japanese economic influence. Japanese firms developed many licensing agreements. Many business leaders still admitted their strong dependence on Japanese technology in the late 1990's. Hyundai, Kia, Daewoo and Sangyong all depended heavily on Japanese auto-parts (Yamamura, 37). Japanese firms proved essential in providing some high-tech inputs. Japanese SMEs operating on technology-intensive niche markets proved indispensable complements to the large inflexible chaebol.

Japanese penetration in the Taiwanese economy was completely different due to the different domestic industrial structure. Most Taiwan’s private firms were small firms which specialized in niche markets. They quickly became tied to the Japanese keiretsu through the resumption of the business network that had existed prior to 1945 between the two countries. Another difference with South Korea was the strong

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presence of US TNCs. Nevertheless, it is widely accepted that the Taiwanese firms are still very dependent upon the technology and markets provided by the Japanese TNCs (see below section 6.2).

In other countries like Singapore, penetration was quick due to the government’s total acceptance of the TNCs domination of the private sector. The Japanese TNCs were already well implanted by the 1980's and Singapore often became a starting point in the development of their ASEAN production networks after the endaka. The case of Hong-Kong is similar. The island also played the role of a starting base for the development of operations on the Chinese mainland.

For the other ASEAN economies, the Japanese firms appeared quickly to serve the local market when import-substitution policies dominated these economies in the 60's and 70's. When the structural limits of these policies were reached and the local government turned to export-oriented policies, the Japanese TNCs reacted quickly and started to build a regional export platform to the Western markets and to Japan. In many ASEAN member states, the timing was very fortunate both for Japanese firms and the local domestic economies. The occurrence of the endaka, which played a decisive role in the relocation of Japanese firms, was almost perfectly concomitant to the debt crisis that forced economies like Indonesia or Thailand to give up some of their import-substitution policies and to open themselves up more to export-oriented FDI. This convergence of interests explains why the regionalisation of the Japanese TNCs production process really took off in the mid 1980's.

The most obvious example of the regionalisation of their production processes by Japanese TNCs took place in the automotive industry. The case of Honda has already been mentioned. Mitsubishi has a long established relationship with Hyundai initially through joint-ventures and then licensing. Until the mid 1980's, ASEAN facilities were largely devoted to assembly for the local market (Doner, 179). But with the endaka, many Southeast Asian economies hosted a segment of the regional production process of Japanese firms. The endaka encouraged further use of locally made parts and favoured a more integrated regional intra-firm division of labour (Doner, 179). This led to an improvement of the local subsidiaries’ production standards with the establishment of quality circles and so forth. The Malaysian Proton Saga carmaker became integrated in the Mitsubishi Motor Corporation Asian network and supplied door panels to the rest of MMC Asian affiliates (Yamamura, 34). Toyota began to ship engines from Malaysia to Indonesia, Taiwan and Japan and from Thailand to Portugal (Doner, 180). Firms like MMC, Nissan, Honda and Toyota all used the institutional facilities provided by the ASEAN integration process (Yamamura, 35).

But many other sectors followed. In the household appliances, Japanese firms also built Asian production networks. In sectors like VCRs, Japanese leaders like Hitachi or Fujitsu scaled down units of production in the US and relocated to East Asia to perfect their regionalised production process (Yamamura, 10). In the audio-visual sector, the production of the Japanese subsidiaries in Asia became more important than that of the parent firms (Yamamura, 10)

The impact of Japanese FDI on the local economies cannot be easily overstated. Some figures can be used to illustrate the strong Japanese presence. In 1994 Japanese FDI constituted 40% of total investment (domestic and foreign) in Thailand. In Malaysia, the Matsushita group accounts for nearly 4% of the entire country’s GDP (Yamamura, 6). These already impressive figures do not take account of licensing or franchising which are very common but do not generate important capital flows. Intermediate or non-equity forms of investment generate 40% of the total activity in Asia by Japanese firms (Yamamura, 9).

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3. THE LIMITED ROLE OF WESTERN TNCS IN EAST ASIA

The last sections have emphasized the decisive role played by the Japanese TNCs in developing intra-regional trade through the regionalisation of their production processes. Why was the role of Western TNCs more limited in the region and why did they not generate a dynamic for integration similar to the one initiated by their Japanese counterparts?

The presence of Western TNCs in East Asia was stronger than that of Japan until the 1980's (Petri, 161). In the 1950's and 1960's, most US and European FDI were market-seeking. Western TNCs had a strong foothold in the automotive industry, pharmaceuticals, oil refining, food and household appliances (Yoshihara, 18).

Efficiency-seeking investment began to emerge in the mid 1960’s. More than sixty Western TNCs in the electronic industry such as General Electric, Texas Instruments, Philips or Motorola began to relocate a part of their labour-intensive activities in Taiwan, Singapore and Hong Kong (Hobday, 104 & 140). These countries became export platforms to the Western markets. However, this wave of relocation resulted in a simple and globally integrated organisation of the production process. This was very different from the complex regional division of labour mastered by the Japanese TNCs in the 1990’s and it did not develop intra-regional trade. For the Western TNCs, efficiency-seeking FDI was still the exception rather than the rule, market-seeking and resource-seeking investments were dominant by far.

The Western FDI lost ground in East Asian throughout the 1960’s, 1970’s and 1980’s. In market-seeking FDI, the Japanese firms grew more competitive. They were more flexible to the needs of the indigenous political and business elites. For example, contrary to their Western competitors, Japanese TNCs were keener to give up full ownership control and to accept joint-venture or licensing in order to penetrate a local market. The Japanese firms could also rely on very useful networks with indigenous businessmen created before 1945. Through their business links and aid programs, Japanese firms shaped the national industrial technical standards of many East Asian economies, making the use of US equipment in many sectors more difficult (Doner, 208). The Japanese TNC could rely upon the pro-active policies of Japanese government economic agencies such as the MITI, the JETRO or the development agency while Western firms did not benefit from such government support (Doner, 208). After defeat in Vietnam in 1972, the US government support seemed to falter. Some major US firms in the region scaled down or terminated their operations, such as General Motors (Yamamura). Taiwan, Singapore and Hong Kong remained exceptions.

In Taiwan, American TNCs in electronics, the computer sector and later in sports wear continued to develop or open new subsidiaries throughout the 1970’s, 1980’s and 1990’s (Hobday, 106). The strong American presence in Taiwan cannot be explained purely by economic factors. The very particular relationship between Taiwan and the United States based on geo-strategic considerations also explains the persistence of this American foothold. Nevertheless, in the 1990's the Taiwanese firms became more dependent upon the Japanese TNCs than upon the American ones for the supply of key components and high-tech machinery (Hobday, 108)

In Singapore and Hong Kong, Western firms remained strong in electronics (Philips, GE, HP), oil refining

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(in Singapore), in banking and other services (Yoshihara, 19 & Hobday, 140). Maintaining the presence of Western TNCs was certainly facilitated by the very open policy of both the Singaporean Government and the Hong Kong Authority towards FDI. The absence of an import-substitution policy and the existence of clear, open and enforced rules on investment meant that the special network enjoyed by the Japanese TNCs did not provide them with such an overwhelming advantage. However, given their regional role as warehouse and services providers, Hong Kong and Singapore were naturally drawn in by the centripetal force generated by the intraregional intra-firm trade of the Japanese TNCs. Among Western TNCs, the US came first in 1998 with around 3% of their FDI to Hong Kong and Singapore (Dicken, 65). Despite their historical ties, less than 3% of the British FDI flows were going to Hong Kong, Singapore and Malaysia together (Dicken, 67). For German firms, the figure is even lower with only 0.6% of its FDI flows to Singapore and only 1% to China and Hong Kong (Dicken, 68). Japanese and Korean TNCs directed a larger share of their FDI flows to these two islands. In 1998, they invested more in the two islands than the Western TNCs (OECD, 2000).

Generally, East Asia was not a priority for Western TNCs in the 1970's and 1980's (Doner, 208). During the 1980's, the main attraction for US FDI remained Europe. In 1985, only 11% of US FDI stocks were located anywhere in Asia, about five times less than in Europe (Dicken, 65). The fear of a "fortress Europe" after the Delors white paper in 1985 on the establishment the Single European Market scheme was of greater concern for US TNCs than the penetration of East Asian economies. European TNCs were focusing even less on Asia with less than 5% of their FDI stock usually located in this region (Dicken, 67). It was the fantastic dynamic growth that occurred in the late 1980's and 1990's that changed the Western TNCs perception of the region's opportunities for investment.

The Reagan administration took a tougher stance in the late 1980's on the issue of East Asian market access. It focused particularly on Japan (Ito, 391). However, attacks on Asian protectionism were aimed firstly at justifying US unilateralist protectionist measures like Voluntary Export Restraints or the notorious "super 301" clause in the politically sensitive problem of the US trade deficit. The US government did not really help US TNCs to strengthen their position on the Asian markets until the 1990's.

Contrary to their Western competitors, access to East Asian markets was vital for Japanese firms in the 1960's and 1970's for their development and accumulation of experience in capital-intensive sectors characterized by economies of scale and learning curves. In the 1980's, East Asia ceased to be the main destination of Japanese FDI due to rising protectionism in Europe and the US. This forced many Japanese keiretsu to open subsidiaries in the West. But the endaka gave back to Asia a decisive role in the global strategy of Japanese TNCs with the regionalisation of their production process. Not only did this involve the large keiretsu but also the Japanese SMEs. For these firms, the endaka and the pressures from the keiretsu after the 1990 crisis were push factors that forced them to relocate labour-intensive activities overseas. The limited amount of capital available and the lack of familiarity with international operations implied that only a minority of Japanese SMEs could take this step. Those who did naturally chose a country in close proximity geographically where Japanese government agencies and private trading companies were present to provide financial support and information. In 1995, 92% of the FDI made by Japanese SMEs were directed to Asia (Hatch, 386). Geographic proximity is generally a major characteristic of the pattern of the FDI flows from SMEs. Most European SMEs, which invested abroad chose Eastern Europe or the Mediterranean countries while their US counterparts opted for Mexico, Central America or the Caribbean. The presence of Japanese SMEs in Asia reinforced the Asian-Japanese

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business networks. By the early 1990's, the Western TNCs began to notice the formidable opportunities offered by the rapid growth of the East Asian economies but by this time, the complex networks build by Japanese TNCs constituted formidable barriers to entry for potential newcomers from the US and Europe on East Asian markets.

4. THE AUXILIARY MOTORS: SOUTH KOREA, TAIWAN, SINGAPORE AND HONG KONG

The Japanese firms might have been the major motor behind the economic integration in East Asia but from the 1980's onwards, firms from the Asian NICs began to expand overseas and to organise their own intra-regional division of labour. It is important to see how these latecomer Asian TNCs developed in order to grasp better the Asian integration process and also the perspective of the Chinese TNCs.

4.1. South Korea: the latecomer in the regionalisation process

4.1.1. The role of exogenous factors

After Japan, South Korea certainly constitutes the second best case of the late industrialised economies that managed to reduce the gap with the Western economies. Some South Korean firms have managed to become global competitors in electronics, household appliances and the automotive industry.

Like Japan, South Korea also benefited from some exceptional exogenous opportunities. South Korea was a poor country, one of the most distant from Europe in East Asia and it lacked the resources conveted by the Western traders. These elements explain why it was largely ignored by colonialist countries until it became the subject of dispute between two second-rate powers at the time, Japan and Russia. As it has already been mentioned, when Korea was annexed by Japan in the first decade of the 20 th century, its economy was quickly and deeply integrated within the Japanese imperial economy.

When the Korean War ended in 1953, the economy of the peninsula had disintegrated. The South had not been the most developed part during the Japanese rule. Most of the heavy industries lay in the northern part of the peninsula and many of the plants had been destroyed or confiscated by the Russian occupying forces just after 1945. Nevertheless, the South Korean economy possessed a few assets. There was a small group of indigenous entrepreneurs, some of them familiar with large-scale production due to the militarization of the Japanese imperial economy in the late 1930's. The level of literacy among the Korean population in 1945 was just above 25% (Hobday, 54) which was higher than most developing countries with a similar GDP per capita. But these characteristics were by no means sufficient to account for the Korean success. As in the case of Japan, the South Korean economy benefited massively from American support after the Korean War. The US intervention had long lasting effects on the local economy.

Firstly, like in Japan and for the same political reason, the US administration rehabilitated the indigenous business and political elites which had collaborated with the Japanese imperialist government. This meant that the privileged business and political links between South Korea and Japan could quickly be resumed.

Secondly, the US pushed forward a successful land reform that created a class of independent farmers (Jones, 69). The land reform was clearly made easier by the fact that the largest estates were formerly held by Japanese that were expropriated in 1945. Nevertheless, the first provisional government of Syngman Rhee charged in February 1946 with the administration of Korea's southern zone occupied by

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US forces, was unable to perform any reform as most of its government had close links with the Korean landlords that had taken over former Japanese estates. The paralysis of Syngman Rhee over this issue was considered by the US analysts as the main reason for the popularity of the communists in the region and after the war, the US administration was resolved to complete a swift land reform. This radical change gave more autonomy to the state bureaucracy by moving away from the path taken by most latifundia societies characterised by traditionalist landlord oligarchies, resistant to government industrial and education policy.

Thirdly, the US provided a very important aid package. From 1953 to 1975, US aid to South Korea amounted to $13 billions (Jones, 69). This aid package helped to relieve the serious post-war food shortages and to finance the land reform but it also generated long-lasting effects. US financial flows provided South Korea with foreign currency during the first decade after the war at a time when there were virtually no Korean exports. During this period, the amount of US aid financed 70% of all imports and represented also 80% of the fixed capital investment (Lanzarotti, 36). US military aid also enabled South Korea to avoid paying for its defence costs until the 1970's. This saving certainly helped the government to increase the level of public spending on education, which rose from less than 3% at the end of the war to 22% in 1987 (Hobday, 54). Military co-operation also gave the young Koreans drafted into military duty a valuable technical training. The Korean army built infrastructure thanks to American technical assistance (Lanzarotti, 40). This proved crucial in an economy crippled by a shortage of engineers and trained technicians (Hobday, 53).

Lastly, the US administration helped the South Korean economy by providing a privileged access to its domestic market (Jones, 79). Until the 1980's, successive US administrations were cautious not to block imports from South Korea.

4.1.2. The industrial policy and the chaebol

The latecomer large South Korean conglomerates, otherwise known as chaebol, and the successive South Korean governments were strongly influenced by the Japanese model of industrial policy and management (Hobday, 22). Under the dictatorial rule of General Park, an Economic Planning Board was established based on the model of the Japanese MITI. The Ministry of Commerce and the Ministry of Finance designed jointly the industrial policy based on a co-management system between the state and the private sector (Jones, 71).

In the 1960's, the government encouraged export-oriented FDI to restore their trade deficit problem and to acquire technological capabilities. Exports of transistors started in 1962 made by companies such as Motorola or Signaletics. They were followed by Japanese-Korean joint ventures like Samsung-Sanyo, Toshiba and Goldstar-Alps electronics. The government offered incentives and privileges to TNCs such as fiscal exemptions (Hobday, 58). During the 1960's, foreign firms dominated the sectors in which they were present. However, as early as the 1970's, the Korean firms were moving from providing simple components to their foreign contractors to the complete production of low-tech consumer goods (Hobday, 59)

In 1973, the government decided to encourage a shift from light industry such as footwear and textile to capital-intensive industries. The Heavy and Chemical Industry Plan was launched and resulted in the emergence of the chaebol conglomerates in strategic industries: iron and steel, machinery, non-ferrous

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metals, electronics, shipbuilding, automobile and petrochemicals (Jones, 72). This more active industrial policy was the result of three combined elements. Firstly, South Korea had been experiencing an economic downturn since the late 1960’s. Secondly, through subcontracting, local firms and the Korean labour force had substantially increased their technological capabilities. Finally, the American withdrawal from Vietnam pressured Park to build a more autonomous defence industry and to focus development on of heavy industry (Jones, 72).

In the late 1970’s and during the 1980's, the government protected some sectors by restricting entry to foreign firms and forcing them to enter the domestic market through joint-ventures with the major local firms such as Hyundai, Daewoo, Goldstar and Samsung. They also encouraged Japanese firms to divest by terminating their tax break policy for foreign investors. They developed a long negative list of sectors closed to foreign firms on national security grounds. Foreign firms like the Japanese NEC were forced out of their former joint-ventures and lost their presence in South Korea (Hobday, 53).

This very active industrial policy favoured the strengthening of the chaebol. These firms managed to gain experience in large-scale production thanks to the protection of the state. They also benefited from a much easier access to the largest market in the world than other industrialising states.

The South Korean industrial policy was far from flawless. The level of concentration reached in the 1980's was far too high for efficient domestic competition. The South Korean economy lacked flexibility due to the absence of efficient SMEs, which is the direct result of the government bias in favour of large-scale capital-intensive firms (Jones, 79). Many chaebol are very dependant from Japanese SMEs specialized in high-tech components or machinery and from Japanese keiretsu, which license the most advanced technologies (Yamamura, 88). The banking sector operated as a "handmaiden" serving the government’s industrial policy and the chaebol. This practice generated a dangerously high ratio of non-performing loans that fuelled a real estates bubble (Jones, 78). Finally, the lobbying power of the chaebol and their financial links with the ruling government parties meant that this grave imbalance had little chance of being corrected except under a strong external pressure. Many attempts were made throughout the 1980's and early 1990's to reduce this concentration and encourage a rationalisation of the production capacities. Due to the collusion of some ministries and the chaebol, no government agency, even the strong and prestigious Economic Planing Board, could achieve this reform before the 1997 crisis (Jones, 77).

This nuance having been made, one must recognize the general success of the Korean experience. Some of the chaebol like Samsung or LG have managed to become global competitors in capital-intensive sectors and even in some sectors characterized by a substantial technological know-how. Having gained ownership-specific advantages, the chaebol began to set up overseas manufacturing units in the early 1980's. Nevertheless, the first development overseas did not contribute to the acceleration of East Asia’s regional integration as most of Korea’s FDI was directed to Europe and to the US (Hobday, 60).

4.1.3. The restructuring of the chaebol puts a new emphasis on regional integration

By the late 1980's, the situation became more complex as many push factors in the domestic economy forced the relocation of labour-intensive activities abroad. The reasons were very similar to those behind the relocation wave of the keiretsu. The won was appreciating as exports to Europe and the US were growing. Trade frictions became more numerous with the US and Europe. In the mid-1980's, the students

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and workers began to join forces against the ruling dictatorial elite. Between 1987 and 1990, more than 7000 strikes paralysed shipbuilding, carmakers and textile manufacturers. The government used extraordinary strength to crush the strikes but to avoid an escalation, substantial wage increases were conceded (Yamamura, 90). Some Korean firms began to reorganize their production process at the regional level. Despite strong domestic push factors, this process was very slow and in 1995, the Korean firms were far behind those of Taiwan, Hong-Kong and Singapore (Hobday, 27). This gap is due to two factors. Firstly, the chaebol lacked the regional networks that their Japanese counterparts had built up over decades. Unlike their Singapore, Hong-Kong or Taiwanese competitors, they could not benefit from the old ethnic-Chinese business networks that extended throughout East Asia (see below the section on the Ethnic-Chinese networks). The remoteness and economic isolation of the Korean peninsula since the 16th century (Bairoch, 904) certainly accounts for the lack of Chinese merchants or craftsmen. For the chaebol, the ASEAN economies were unfamiliar economies. Secondly, the patriarchal management and the hugeness of the chaebol meant serious difficulty in switching from fordist large-scale standardized production to a regionalised lean-production process.

The 1997 crisis had the effect of quickening the restructuring of the chaebol. 16 of the top 30 chaebol closed between 1997 and 2002(FT,29/10/2002). This ruthless restructuring did not spare the biggest like Hyundai or Daewoo. The restructuring seems to have weakened the family owners, separating further management and control. The chaebol are now focusing more on core activities. In 2000, the average chaebol was active in 15 industries compared with 20 in 1996 (FT,29/10/2002). At the same time, chaebol such as Samsung, LG Electronics, LG Chems, Ulsan's Hyundai Motor have begun to relocate abroad but they have chosen China rather than the ASEAN countries (FT,25/09/2003). This is not surprising as China is close both geographically and culturally, and notably because of the existence of substantial Korean minorities in northeast China. In the late 1990's, the Korean government and business leaders completely changed their strategy and are pushing regional integration forward. South Korea is negotiating hard to build a free trade area between China, Korea and Japan in the short run while it continues to have the long-term option of joining the ASEAN in an East Asian FTA.

Thus, the Korean economy has not remained passive and contented itself with passively hosting Japanese FDI. During the 1990's, the chaebol began to imitate the Japanese keiretsu in their expansion across Asia to regionalise their production process. Although this expansion is far more modest and more concentrated (mainly in China), it is still an auxiliary force behind the Asian integration process.

4.2. Taiwan

The Taiwanese firms also played in important role in the regional integration process in East Asia. Their particular role and the peculiar industrial structure of the Taiwanese economy are the result of the island’s exceptional political situation.

4.2.1. The role of exogenous factors

Taiwan was under Chinese imperial rule from the late 17th century to 1895 and then became annexed by the Japanese until the end of WWII (Clough, 815). The Japanese occupiers gave Taiwan a pivotal role in the Nippon imperial economy. The island was used as a processing centre for raw materials. This enabled some locals to have business links with the Japanese zaibatsu and with other East Asian business communities. During the Japanese colonial occupation, many Taiwanese gained experience in technical

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professions and management (Hobday, 96). Nevertheless, they were second-rate citizens and the zaibatsu took control of most of the island’s industry (Clough, 817).

After the war, the Taiwanese economy was in a disastrous situation, completely disrupted by the break-up of the Japanese Empire. The level of GDP per capita in 1945 was the same as India (Hobday, 96). Nevertheless, it had a far more advanced infrastructure and technological base than the mainland (Clough, 818 & 829). The local economy had not recovered from the war when it was invaded during 1947-1949 by the KMT troops expelled from the Chinese mainland by the Peoples Liberation Army. By the end of 1949, 2 million KMT soldiers and supporters had colonized this island of six million people (Hobday, 96). The KMT’s domination in the late 1940’s was imposed ruthlessly. Repression of indigenous uprisings claimed thousands of lives (Clough, 831 & Jones, 44). The KMT imposed the martial law for four decades. This violence against indigenous islanders was to create a long term climate of mistrust between the KMT officials and the indigenous business community that would affect the industrial structure and the trade pattern of the Taiwanese economy.

After Japan and Korea, Taiwan was the third most important beneficiary of US aid in Asia. From 1950 onwards, the KMT played a decisive role in the regional “communist containment” policy of US administrations. In the eyes of General Mc Arthur, Taiwan was "an unsinkable aircraft carrier" (Clough, 823). The US also provided Taiwan with military, technological and financial help that amounted to about 10% of the GDP in 1951 (Jones, 81). The US also pressured the KMT to make a land reform in 1950-1953, which proved very successful. By the end of the process, the former tenants controlled 71% of private and public land (Jones, 81). As in 1959, 90% of exports were still agricultural, the reform gave some support to the government as the growth of the economy was “relatively equally” distributed (Jones, 45). In addition, the US also gave privileged access to their domestic market during the 1950’s and 1960’s.

4.2.2. TNCs in Taiwan: a very limited direct effect on regional integration

Like the ROK, Taiwan also adopted restrictive measures to limit and channel FDI inflows (Hobday, 108). The first foreign firms present in Taiwan were the Japanese which resumed their pre-war links with their former local subcontracting partners. Then, in the mid 1960’s, the flows of American aid, the development of a skilled and controlled labour force and government incentives (free trade zones with tax breaks established first in 1966) attracted US FDI at a time when Latin American countries were restricting FDI. An additional advantage was that Taiwan had good access to the US market. This wave of FDI taking place in the late 1960’s involved Sanyo, Matsushita, Orion, Sony, Sharp and Hitachi from Japan and TI, General Instruments, DCI and Singer from the USA (Hobday, 103).

During the 1960's and 1970's, the TNCs' subsidiaries in Taiwan did not develop substantially intraregional trade. In 1964, General Instrument began to relocate its production of diodes, transistors and integrated circuits to Taiwan. 24 US companies followed in the next two years. The US firms used Taiwan as a re-export platform. This fostered Taiwan-US trade but did not affect substantially regional trade. On their side, the Japanese firms served only the local market through joint-ventures and not the regional market (Hobday, 104).

In the 1970's, the local firms began to develop their own technological capabilities by using their subcontracting contracts in the electronics industry. They learned to process high-tech materials and

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upgrade their technological know-how, setting up their own niche production (Hobday, 104). The computer sector took off in the 80’s with global producers like IBM, Wang and Hitachi relying heavily on the Taiwanese SMEs for subcontracting activities. In 1990, the value of PC exports had overtaken that of consumer electronics exports (Hobday, 106).

4.2.3. A major difference with the South Korean economy: the absence of large private conglomerates

Despite these obvious similarities with the ROK and Japan, the Taiwanese economy followed a different path that can partially be explained by the antagonist relations between the indigenous capitalists and the KMT newcomers. Unlike in the ROK, there was no rise of indigenous big conglomerates in Taiwan. The government shielded the domestic market by imposing strict quotas and high tariffs but it did not pursue an active industrial policy (Jones, 81). Contrary to the Korean Economic Planning Board, the Taiwanese government restrained itself to providing a sound macroeconomic environment and infrastructure to local private firms (Hobday, 98). Regulations over FDI entry were less restrictive than in South Korea (Dicken, 186). It was left to competition forces to determine the domestic industrial structure except in strategic military sectors (energy, defence, infrastructure) where large state-owned firms dominated (contrary to the private-owned chaebol). The lack of trust between the indigenous business community and KMT bureaucrats was an important obstacle to the adoption of a South Korean-style industrial policy.

The result was that most Taiwanese firms remained quite small by international standards as they specialized in niche market developed through their subcontracting activities with large US and Japanese TNCs. By the early 1990's, the Taiwanese firms were, for the most part, outward-looking SMEs. They accounted for 71.1% of Taiwan's export earning and 28.9% of the domestic sales (Gee, 13). The Taiwanese firms targeted niche specialist high tech markets rather than large-scale production like the chaebol (Hobday, 107). Even the few large Taiwanese firms like ACER offered a limited range of products and are still dependant upon large foreign TNCs for their outlets (Hobday, 116). The small size of Taiwanese firms is the major obstacle to their becoming truly autonomous global TNCs. To overcome this size problem, Taiwanese SMEs operating in sectors characterized by important economies of scales and externalities (such as electronics, TV, refrigerators and automotive) have teamed up in state-sponsored R&D consortia (Gee, 30). Nevertheless, Taiwanese firms are still highly dependent upon Japanese inputs from the keiretsu and upon access to the North American market (Jones, 87).

4.2.4. The first wave of relocation from Taiwanese firms and regional integration: 1987-1992

The Taiwanese firms began to relocate activities for similar reasons than their competitors from the other Asian NICs. After the lifting of the martial law in 1987, a strong independent labour movement began to emerge (Gee, 17). The labour shortage that characterised the small Taiwanese economy in the mid 1980’s gave the workers a strong bargaining position over the state and employers. They forced the government to concede a social-security system organised by the Labour Standards Law. This law provided social benefits comparable to OECD economies such as paid holidays, pensions, minimum-wage regulations and overtime premium. This reduced the profit margin of many employers (Gee, 15). Furthermore, land became costlier (Hobday, 29) and less readily available as the population also became more hostile to industrial projects jeopardizing their local environment (Gee, 17). The national currency also appreciated despite capital controls (Jones, 85).

The government had been so far very strict on capital control and had prevented outward FDI but the

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pressures became stronger. In 1987, the government relaxed foreign exchange controls and allowed Taiwan FDI outflows (Jones, 85). The lifting of restrictions and the domestic push factors generated a vast relocation wave across East Asia. Many Taiwanese FDI projects were then pursued without the official authorization of the government, especially in the ASEAN countries and in China (Gee, 19). In the late 1980’s and early 1990’s, the ASEAN countries became the first destination for the relocation of labour-intensive Taiwanese firms.

Taiwanese firms acted faster than the chaebol because of their greater flexibility and because of their cultural ties with the overseas Chinese networks. Among the four tiger economies, the Taiwanese economy made the most extensive relocation to ASEAN and China (Hobday, 27). Thailand was the preferred destination among ASEAN countries for Taiwanese FDI followed by Malaysia and Indonesia (Hobday, 27). While only three FDI projects to Thailand were approved by the Taiwanese government between 1980 and 1985, the number rose to 85 between 1986 and 1990 (Gee, 18).

It should not be forgotten that despite this vast relocation wave, the major destination country of Taiwanese FDI in the 1980’s was the US. 248 FDI projects in the US were approved by the Taiwanese government between 1986 and 1990 (Gee, 19). However, these FDI were often one-shot acquisitions to upgrade their technology (Gee, 33). This strategy often failed because Taiwanese firms overestimated their capacities to acquire foreign-designed technology, because of differences in management style and a lack of motivation among the US employees (Gee, 37). The US became a less important destination with the feeble results of this technology acquisition strategy.

The real take-off the Taiwanese FDI took place with the opening of the Chinese mainland economy in the 1990’s. As it will be analysed further (section 5.4.3), China overtook the ASEAN economies as the primary destination for Taiwanese FDI. The Taiwanese firms played an important auxiliary role in the strengthening of the intraregional trade and investment flows. Their strong technological dependence upon their Japanese partners also implies that they have been contributing to create technical harmonization in East Asia based on the Japanese standards.

4.3. Hong Kong and Singapore

Hong Kong and Singapore have been exceptions in East Asia, which share common patterns of development. Until the late 1990's, they experienced a steady fast rate of growth. In 1986, they ranked respectively 28th and 25th in the world in terms of GDP per capita, taking second and third place just behind Japan and far ahead the other Asian countries.

They have played a pivotal role in the trade links of the region since they were both first created by British imperialist expansion in Asia. Both are city-states with a limited population. Six million people live in Hong Kong and three in Singapore. Such a small domestic market might constitute a heavy handicap for many national economies. However, not in these two cases because both city-states benefited from possession of a strategic location with good infrastructure for stocking and transport (the two biggest harbours in Asia), the presence of many Western firms and from a regional network of ethnic-Chinese entrepreneurs. The absence of an important domestic market (with the loss of the Chinese mainland after the US blockade in 1950 for Hong-Kong and with the secession from the Malaysian Federation in the early 1960's for Singapore) meant that they did not have any other option but to pursue an export-led strategy. The concentration of FDI, of transport, stocking and related services was

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sufficiently high to offer sufficient development perspectives for these city-states that did not have to support a massive population like the neighbouring economies.

Both local authorities quickly adopted very open policy towards foreign investors while maintaining their good infrastructure developed under British rule. They also insured the provision of a docile, cheap labour force to indigenous entrepreneurs and TNCs through the enacting of pro-business labour laws (and a qualified labour force through the development of technology education institutes, in the case of Singapore).

While the two city-states still played the role of regional warehouse, interregional trade between East Asia and the Western economies developed faster in the 1960's and 1970's with the relocations made by foreign TNCs. By the late 1980's, the development of both economies put a serious strain on the available local inputs: labour and land shortages began to emerge. At the same time, the development of manufacturing in the cheap-labour neighbouring economies forced the two economies to focus more on regional services and to relocate manufacturing production units to neighbouring countries. During the 1990's, these economies were actively involved in the regional integration process and played a substantial secondary role behind the Japanese TNCs in bringing East Asian economies closer together.

4.3.1. Hong Kong

Since British forces occupied Hong Kong in1842, the island played a pivotal role in the British Chinese trade until the late 1940’s. The island received massive capital inflows from the Chinese mainland in two waves. The first one occurred with capital holders fleeing the Japanese invasion from 1937 to 1941 (Hobday, 163). The second one came with the flight of KMT supporters or other anti-communist capitalists from the Chinese mainland in 1949-1950. The capital inflows amounted to 65% of the island’s GDP during these two years. Many Shanghai entrepreneurs came with their capital, know-how and equipment in textile and cotton (Jones, 88). This inflow fostered the textile exports that led the island’s economy in its early phase of growth after 1945 (Hobday, 163).

The embargo on China decided by the US and other Western governments forced Hong-Kong to build new trade links with the West and to retreat from the Chinese mainland market. The Korean War and later the Vietnam War created substantial outlets for Hong Kong exports. Hong Kong entrepreneurs developed in sectors characterized by low barriers to entry. They opted for easy business rather than pursing a long-term industrial development based on acquiring technology and reaching economies of scale. Hong Kong businessmen bought cheap Japanese ships to start their own sea-transport services; they produced cheap toys or textiles for the British and US markets. This short-term strategy provided a strong growth but generated few technological developments. The local firms remained quite small by global standards. In 1988, 87% of the island’s firms had fewer than 9 employees (Jones, 89).

The local economy was always very open to FDI. The first TNCs in manufacturing to invest in post-1949 Hong-Kong were the Japanese in the transistor radios sectors in the late 1950’s. The US firms followed in the mid-1960’s (Hobday, 164). But like in the other Asian NICs, foreign TNCs did not really generate a strong increase in intraregional trade in the manufacturing trade system.

The traditional ownership-specific advantages possessed by indigenous firms or by manufacturing TNCs are not the main factor behind the integrating force of the Hong Kong economy in the East Asian regional

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integration process. The geographical location of the island, the fact that it was under British rule and its non-interventionist policy played a much more crucial role in this regard. Sitting midway between London and New-York, Hong Kong offered a perfect location for a large offshore financial centre. The strict capital controls and other national barriers that blocked the access to the Japanese financial and stock markets prevented Tokyo from playing this role. Because of its location and its liberal policy on capital flows, Hong Kong hosted many TNCs operating in financial and other services. The location and size of its harbour and the experience gained by its local firms in sea transport maintained Hong-Kong in its function of regional warehouse.

4.3.2. Singapore

The development of Singapore offers many similarities with Hong Kong. Like Hong Kong, it was controlled by the British who transformed the place into a modern harbour in the early 19 th century. It also played the role of regional warehouse for South East Asia (Hobday, 136). More than three quarters of the population have been ethnic Chinese since it became independent in the 1960's (Jones, 48).

In 1950, the local business community was composed of merchants and bankers (Hobday, 136). After obtaining the self-government status, the Singaporean authorities started at first an import-substitution strategy based upon the future integration of the large Malay common market (Hobday, 139). However, after separation from Malaysia in 1965 and the announcement of the British military’s withdrawal, the import-substitution policy was given up and the government launched a strategy of export-oriented growth based on FDI (Jones, 96).

In order to be attractive to investors, the Singapore government suppressed almost all the obstacles to FDI. It also provided good infrastructure through state-owned companies in transport services, shipbuilding, defence, petrol refining, health services and energy (Hobday, 139). The government put a strong emphasis on education programs. These programs were very pragmatic and aimed at offering the technical knowledge required by the TNCs from their labour force. The government created training centres in Japanese and various Western languages to train technicians and engineers. Some were directly linked to private firms like Philips (Hobday, 141).

The Singapore government passed on a series of measures to destroy the bargaining power of the workers (Yamamura, 85). It attacked ruthlessly the Maoist Barisan socialist party in the early 1960's (Jones, 48) and created a government-controlled union (Jones, 93). The social legislation was almost non-existent (Hobday, 139). Furthermore, it also launched the Approved Housing Scheme, which provided low-cost accommodation for the workers but under the tight control of the government administration, which could impose punitive restrictions over the workers' home (Jones, 97). This resulted in "the creation of a highly disciplined and depoliticised labour force in Singapore" (Yeung quoted in Dicken, 187).

Lastly, Singapore offered foreign investors an exceptional level of political stability when the left wing parties were marginalized. The highly centralised PAP dominated domestic policy without interruption since 1959 (Jones, 48). The long PAP rule created an efficient apolitical administration with limited rent-seeking behaviours unlike many other Southeast Asian countries (Jones, 49 & Yoshihara).

This set of policies succeeded in attracting many TNCs to Singapore. Philips was already present in 1951 and continued to develop. US firms like GE and HP settled in the 1960’s followed by other European

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firms and Japanese firms (Hobday, 140). The government did not discriminate in favour of indigenous capitalists, which operated mainly in real estate and domestic trade and services (Yamamura, 85). Many of them were progressively squeezed out by TNCs which used predatory pricing practices to eliminate local competitors (Yamamura, 85).

The fast development of Singapore was impressive. Its GDP per capita ranked 25 th in the world in 1986, the highest in Asia after Japan and far ahead of South Korea (Hobday, 15). However by the mid 1980's, Singapore was facing various problems caused by its limited endowment of inputs and because of the slow growth in the Western economies, its traditional export markets. Rising land and labour costs began to wear out Singapore's comparative advantage in manufacturing over other newcomers and especially China. This generated reactions from the government, the TNCs and the indigenous entrepreneurs.

After a major recession in 1985, the Singapore government decided to change its development strategy and tried to diminish its reliance on foreign TNCs by promoting domestic entrepreneurs (Nesadurai II, 177). The government did not opt for import-substitution in manufacturing activities but focused on the development of services (Dicken, 187). Former state-owned companies in services were privatised although the state often remained the largest shareholder (Jones, 96). Since then, the government has been trying to create Singapore-based TNCs specialized in offering services to enterprises engaged in manufacturing activities in the region. The Singapore government has been hoping to encourage, thanks to a supply of services, the TNCs operating in the ASEAN to establish their regional headquarters of head in Singapore (Dicken, 187 & Nesadurai II, 87). Thus Singapore was pushing forward the ASEAN division of labour by concentrating on the services. The Singapore government actively backed indigenous corporations to open subsidiaries in Malaysia, Indonesia, in Vietnam and as far as China (Jones, 96).

Indigenous firms and TNCs both began to search for new and cheapest location of their manufacturing activities in the two closest regions of neighbouring Malaysia and Indonesia (Liu, 154). The government followed the initial outflows of FDI by the private sector and developed the concept of the "Growth Triangle", made of Singapore and the islands of Johor (belonging to Malaysia) and Riau (belonging to Indonesia) and aimed at facilitating the regionalisation of the production process of TNCs (Ito 93, 301). This sub-regionalisation process has also contributed to bringing some East Asian economies closer.

4.4. The ethnic-Chinese capitalists

Another group of investors that have contributed to dynamic integration in East Asia are the ethnic-Chinese merchants and entrepreneurs. This group is scattered across Southeast Asia but linked together through family and business ties. Albeit that this group constitutes an important economic actor in the region, the role of ethnic-Chinese capitalists has often been overstated by Western economists.

The networks of ethnic-Chinese merchants that existed before the 19 th century were not founded on modern capitalist institutions like those existing in Europe at the same time. They resembled more the merchant networks of ethnic minorities established across the Mediterranean and Europe before the industrialisation of this region (for example Jewish minorities in Christian Europe or Muslim countries and Christian minorities in the Ottoman empire). These personal networks, which were founded on familial or ethnic bonds, developed in the absence of modern institutions, which could enforce property rights across their commercial sphere of influence. With the rise of strong nation states in Europe and of

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national capitalists that used their state apparatus to protect their development and eliminate competitors, the influence of business networks based on ethnic ties diminished considerably and these groups found themselves marginalised as industrial capitalism began to emerge. It does not mean that some individual entrepreneurs belonging to these networks ended in failure. However, those entrepreneurs from ethnic-minorities’ networks who adapted best to the emergence of nation states progressively merged into their class of national capitalists (Defraigne II, 37). To a certain extent, the networks of ethnic-Chinese merchants followed a similar path in Southeast Asia.

The development of ethnic-Chinese networks grew with the Western colonization. The new Western institutional frameworks enabled the Chinese merchants to establish modern capitalist institutions in Southeast Asia (Yoshihara, 43). At the end of the 19th century, the ethnic-Chinese merchant could provide the newcomer Western capitalists with knowledge of the language and the region. At the same time, modern banks and trading companies run by ethnic-Chinese first developed within the Chinese community (Yoshihara, 43). The ethnic-Chinese lacked the capital to engage in activities with high fixed costs. These remained exclusively in the hands of firms from the West until 1945. Almost none succeeded in manufacturing and only a few managed to successfully develop plantations. During that period, the ethnic-Chinese merchants and entrepreneurs were mainly organised as a merchant and banking network that operated across the colonies of the West in East Asia to fill some of the local needs of the colonialists and provided services to the ethnic-Chinese community.

After World War II, however, the wave of nationalization that followed the independence of many Southeast Asian states profoundly affected some groups of ethnic-Chinese entrepreneurs. The import-substitution policies adopted by Indonesia, Malaysia, the Philippines and Thailand divided the regions into more protectionist zones, which hindered the intra-regional trade. At the same time, ethnic-Chinese capitalists were often the most developed group of local entrepreneurs and often they became the beneficiaries of the nationalization and import substitution programs because they were the most important source of domestic capital (Yoshihara, 48). Non ethnic-Chinese indigenous could not enter capitalist activities so easily because of their lack of access to the distribution networks and to easy credit (Yoshihara, 53). The foreign firms entering many Southeast Asian countries had to share their activities in joint-ventures with local and often ethnic-Chinese capitalists. Some ethnic-Chinese entrepreneurs then took progressively the control of the mixed joined ventures (Yoshihara, 49). By the 1980’s, the ethnic-Chinese capitalist controlled a substantial share of various sectors such as plantations, mining, trading, banking, property development and light manufacturing (Yoshihara, 51).

As the ethnic-Chinese entrepreneurs and rent-seekers entered in these capital-intensive sectors, they also moved closer to the national state apparatus. Many of these activities were turned toward the domestic markets and required the protection of the state. Even trading activities included more national monopoly given by the state in the distribution sector than intra-Asian trade. A substantial share of the output in the light manufacturing managed by ethnic-Chinese was directed to the domestic market. Because of the rising importance of inward-looking activities or activities protected by the national state, the ethnic-Chinese capitalists progressively privileged the development of contacts with the indigenous political elites over those with overseas ethnic-Chinese in the region.

The most obvious case of such a pattern is Thailand. As early as the 1950’s, the ruling political Thai elites decided to assimilate actively the ethnic-Chinese entrepreneurs (Yoshihara, 58). Ethnic-Chinese businessmen were given the right to adopt the Thai nationality and the majority did. At the same time,

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Thai military were given posts on the boards of the ethnic-Chinese firms and interethnic marriages were set up (Jones, 129).

For Malaysia and Indonesia, there was no such assimilation. The religious drift and the resentment of the indigenous populations against ethnic-Chinese who benefited from a more advantageous position during the colonial period meant that the political elites could not follow the example of Thailand (Jones, 128). Despite the absence of assimilation and various discriminations (such as the Malaysian NEP, the refusal to give them nationality in the Philippines), the ethnic-Chinese managed to develop strong political connections. They developed under the patronage of political leaders of the dominant UMNO party in Malaysia (Jones, 129), of Marcos in the Philippines (Yoshihara, 59) and of the Suharto family in Indonesia (Yoshihara, 60).

Nevertheless, the Malaysian, Indonesian and Filipino governments chose to support groups of non-Chinese indigenous entrepreneurs to develop some of the domestic industries and services. They managed to block the entry to ethnic-Chinese by open legal discrimination (negative list of sectors only open to national citizens) or by cronyism. This has prevented the ethnic-Chinese from belonging fully to the group of national capitalists in these economies and has kept them in an insecure position. This has pushed the ethnic-Chinese to diversify their activities and to increase the share of outward-looking activities in the field of financial, property, tourism, distribution and enterprises (Jones, 131). Furthermore, as the import-substitution policies were abandoned and as the Japanese FDI flows were being massively directed towards the economies of Southeast-Asia, the inward-looking manufactures controlled by ethnic-Chinese entrepreneurs became more integrated in the networks set by the Japanese TNCs’ regional network. By the 1990’s, many ethnic-Chinese industrialists could be considered as “comprador capitalists reliant on Japanese technology” (Jones, 131).

These facts show that the ethnic-Chinese capitalists of Southeast Asia continue to play an important role in the region. Nevertheless the scope of their activities indicates that they have only played an auxiliary role in the regional integration process of the four last decades. Their labour-intensive industries producing consumption goods, like textiles certainly contributed to increased intraregional trade (Dicken, 348). However, their activities in services could not generate a strong regional integration force as these sectors have remained highly protected in all East Asian economies until the late 1990’s. Furthermore, in the capital-intensive industries, the ethnic-Chinese soon became tied with the Japanese TNCs, the latter taking the most active role in their joint-ventures. Ethnic Chinese certainly helped to develop some trading networks and facilitated the scattering of light industries with low technological content across East Asia. There is ample evidence that the relocation of labour-intensive light industries from Hong Kong and Taiwan to the ASEAN-4 were facilitated by the overseas Chinese networks (Doner, 164 & Dicken, 347). Overall, the role of the ethnic-Chinese capitalists in the East Asian integration process has been limited to some sectors. These sectors are dynamic but they are characterised by a low intensity of technology and they generate limited regional intra-firm trade.

5. CHINA JOINS THE EAST ASIAN ECONOMIC INTEGRATION PROCESS

The preceding sections have highlighted the part played by FDI in the East Asian economic integration process. They have shown the factors behind the exceptional impact of the Japanese TNCs in East Asia and why they played a more decisive role than their Western counterparts in this integration process. The

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roles played by other auxiliary motors such as the firms of the four Asian NIEs and the ethnic-Chinese business communities have also been highlighted. The web of regional intra-firm trade and flows of FDI that resulted from the regionalisation of the production process of East Asian TNCs in the 1980's have brought the economies of the regions closer together and created a rising feeling of belonging to an East Asian economic community among most of the government and business elites of the region.

Until the early 1990's, this process affected primarily Japan, the Asian NICs and the four large countries of the ASEAN (Indonesia, Malaysia, the Philippines and Thailand). The Cold War excluded the communist countries from this process. This trade diversion generated a curious geographical pattern of the economic flows in Asia, which were going around the central location of China and Indochina. When the economic reforms in China and Vietnam were clearly locked-in in the early 1990's, it was quite natural to witness a complete restructuring of the trade and investment flows in East Asia which occurred over the next decade. The most populated country of the world offered an endless reserve of cheap labour which could make the regional division of labour of TNCs more efficient. A new wave of efficiency-seeking FDI was launched and both China and Vietnam now seem to have become the new flying geese with the highest growth rate in the region.

However, the insertion of China in the Asian economic integration process has not been without the creation of major economic and geopolitical imbalances. Firstly, many ASEAN member states have suffered heavy competition from China in attracting resource-seeking investments in labour-intensive activities. FDI flows to ASEAN economies began to stall in the early 1990's. The huge potential size of the Chinese market gave the Chinese authorities a better bargaining position in their negotiations with foreign investors than many Southeast Asian economies.

The mastering of more advanced technology by China combined with the extremely rapid growth of its Chinese economy since the mid 1980’s has rapidly changed the balance of power in East Asia and could threaten Japan’s economic leadership in the region. The following sections will look into the steps taken by China to open its economy and how they affected the regionalisation process so far.

5.1. The Chinese economy cast out of Asia: 1949-1971

Despite being a widely shared view among countries in the West , when the CCP took power in 1949, there was no clear-cut plan to go for economic autarky and full collectivisation of the means of production neither in the short nor medium term. Mao Zedong himself wrote as late as 1950 that " the view that it is possible to eliminate capitalism and realise socialism at an early date is wrong (and) does not tally with our national conditions” (quoted in Teiwes, 77). Many options were left open because there was no consensus over the issue of private business (Teiwes, 69). Actually, during its two first years of rule, the CCP supported private entrepreneurs as long as they were not active supporters of the KMT (Gray, 288). They were called the "national bourgeoisie" and were considered a useful group for national development (Teiwes, 78). Many businessmen and landlords who had been strong supporters of Jiang Jeishi and feared collectivisation fled to Hong Kong or Taiwan but they probably did not represent the majority of the business community (Gray, 288).

The 1949 Chinese revolution was more based on nationalist objectives such as unifying China, insuring national sovereignty and integrity of the territory and developing the national economy through land reforms, education and improving infrastructures. It was very different from the perspective adopted by

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Lenin during the 1917 Bolshevik revolution in which the Russian revolution was seen as the first step towards an international proletarian revolution that would create the socialist united states of Europe and ultimately overthrow capitalism worldwide in a short time. The two main Chinese communist leaders Mao Zedong and Chou En-Lai were more focused on nationalist analysis than a social class analysis (Gray, 207). They imposed the idea that internationalism was a foreign dogma (Gray, 281). This is not surprising as most of the CCP leaders had been influenced by the Bukharin-Stalinist strategy of building "socialism in one country" and had eliminated the Chinese supporters of the internationalist strategy defended by Trotsky (Lew, 111). From that perspective, the CCP did not plan to isolate the Chinese economy from international trade when it took power of the Chinese mainland. It is true that foreign firms were progressively squeezed out by the authorities and the domestic entrepreneurs but this per se did not imply economic isolation as seen through the experiences of other countries such Mexico, South Korea or Yugoslavia. Despite the support given by the US administration to the KMT to fight the Chinese Communists during the 1940s, there were still many Westerners who kept their options open towards China. These were hoping that China would pursue the same path of evolution as Yugoslavia and drift away from Moscow's influence (Lew, 135). Thus, the 1949 revolution did not result in China being completely isolated from the rest of Asia.

The real change that brought about the isolation of China was the US intervention in the Korean War. The US troops began to march above the 38th parallel line in order to push back and then to eliminate the Korean communist forces. When US warplanes violated Chinese airspace, the Chinese leadership felt directly threatened and decided to get involved in the conflict (Lin, 23).

China’s involvement had two long-term consequences for the Chinese economy. The first was the pursuit of rapid development of its domestic heavy industry. The aggressive stance taken by US commander Mac Arthur - who even advocated the nuclear bombing of Chinese Manchuria (Fontaine) - and the threat of a military invasion of the Chinese mainland by the KMT forced the CCP to develop massively its military industry. The transformation of China into a war economy implied economic priorities that clashed with the interests of private entrepreneurs. By the end of the Korean War, most industries had been collectivised. In 1953, the Chinese authorities decided to adopt comprehensive planning model led upon the Stalinist industrialisation strategy (Teiwes, 92). Rapid industrialisation in the context of a war economy implied a highly centralised plan for all aspects, including foreign trade. Under this system exports were not considered as factor of growth but as a way to finance imports (Lardy, 30), following the soviet model of the centralised industrialisation process.

The second consequence was an economic and political isolation from non-communist countries orchestrated by the US. The Truman and Eisenhower administrations organised an economic blockade of the Chinese mainland. Most governments in the region aligned themselves with the US’ position as they were strongly supported by Washington and dependent upon their military and financial aid. This isolation severely restricted China's opportunities to import commodities with technological content and blocked many traditional outlets for Chinese exports. International political tension also resulted in serious limits being placed on China's credit access, whether through international capital markets or through financial international institutions such as the World Bank or the IMF. The Chinese authorities were neither willing nor authorised to finance imports through foreign borrowing. China had therefore little choice but to rely entirely on the Soviet bloc for the technology acquisition and trade.

During the 1950’s, the Chinese economy had strong trade and technological links with the USSR but by

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1960, the rupture with the Soviet bloc was complete for political reasons. The economic links between the COMECON and China were restricted to a negligible level. Since 1945, the USSR had tried to maintain its predominant position among the countries of the “socialist bloc”. Communist parties that had achieved their revolution mainly alone – such as Yugoslavia and China- rather than having it imposed on them by the military might of the soviet army according to Stalin’s repartition plan, could not accept such a submission and quickly moved away from the Soviet bloc dominated by "Great Russian" realpolitik. USSR foreign policy was clearly becoming more aggressive towards China. The 1960’s witnessed a worrying build-up of soviet forces on the Chinese border, which led to some clashes with the Chinese People Liberation Army (Pollack, 408). The invasion of Czechoslovakia in the summer of 1968 was perceived by the Chinese leaders as a sign of the readiness by the Kremlin to use military might to strengthen its geopolitical position vis-à-vis the US heavily engaged in South East Asia.

Therefore, during the 1960’s, China was completely isolated from the world economy. China's share in world trade fell from 1.5% in 1953 to 0.6% in 1977 (Lardy, 31). Although Chairman Mao himself admitted his ignorance of economic issues, being more directly concerned with the revolutionary political and cultural objectives (Perkins, 478), the leaders of the CCP were certainly aware of the bottlenecks created by this isolation in China’s economic development. Despite impressive reforms that improved the education level, the access to health services, the infrastructure network and the corruption level, China was still an extremely poor and under-industrialized nation. Without technology, modern engineers and technicians from the more advanced economies in the world, the Chinese economy could not simply provide a fast increase in standards of living for its people and the technological means to insure the security of the Chine state.

There was a widespread belief in Western countries in the 1960’s that China was pursuing an aggressive expansionist revolutionary foreign policy and that economic autarchy was a chosen option. This perception was built mostly by the anticommunist propaganda fuelled by Western military and intelligence agencies but the dramatic domestic events and the radical language used over foreign policy issues during the Cultural Revolution seemed to confirm this view. More than a decade after the end of the cold war, it is easier for Western analysts to admit that few Chinese leaders actually believed in the desirability and the sustainability of the economic autarchy. Rather, it was the consequence of the will by the Chinese leadership to insure national sovereignty and not to submit to any of the two superpowers.

Apart from the rapidly deteriorating relations with the USSR, the geopolitical situation in Asia and America’s increasing involvement in the Vietnam conflict after 1965 constituted another threat to the survival of the CCP and the national sovereignty of China. The Chinese leadership found itself in the difficult position of having two fronts to defend. This position could not be sustained indefinitely. China was lagging far behind its two potential opponents in terms of technological innovation capacity and the military gap was clearly widening. The Chinese leadership knew that modernisation of the China’s industrial base was an urgent strategic issue and that China lacked the skilled labour force to close the technology gap alone. Political isolation had to be broken if China was to acquire modern foreign technology.

5.2. The geopolitical consequences of the shift of US foreign policy in the early 1970's

China’s isolation ended with the radical transformation of US-Chinese relations operated by the Nixon

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administration in 1969. The economic and political burden of the Vietnam War forced the US governments to reduce their military engagement in the world. Facing two communist powers was getting too costly. Therefore, Nixon administration decided to shift completely its foreign policy in order to play the two communist powers one against another at the diplomatic level. On the Chinese side, the leadership of the CCP was wary of a closer Soviet-US relationship at its own expense. Therefore, the contacts initiated by the Nixon administration in August 1969 could only be welcomed by the Chinese leadership. Nevertheless, it took some time before the US propositions were taken seriously by the Chinese. The invasion of Cambodia by US forces in May 1970 delayed the resuming of US-Chinese relations (Pollack, 412). However, it soon turned out that the US move was aimed at strengthening their bargaining power to negotiate peace with Hanoi. The Nixon administration was eager to disengage militarily from Indochina. Despite some uncoordinated opposition from the Gang of Four and from Lin Piao, Mao and Chou En-Lai managed to impose the shift of foreign policy to the US.

Immediately, the Chinese government urged Hanoi to reach an agreement with the US administration. This policy was going to shift completely the Chinese alliance network in Asia. After the dramatic breakthrough of President Nixon’s visit to China, the internal struggle in the party for Mao and Chou En-Lai succession paralysed Chinese foreign policy for some years. Nevertheless by 1980, the choice was clear and China had made a 180-degrees turn in its foreign policy.

Firstly, the US-China relationship was reinforced when the Carter administration subscribed unequivocally to the principle of "One China" and recognised the Chinese mainland government as the only legitimate Chinese government (Pollack, 442). Secondly, as a direct consequence of the rapprochement with the US, Japan accepted finally to ratify the Sino-Japanese Treaty of Peace and Friendship. This was a significant turnaround for both nations. During the 1960's and early 1970's, Japanese governments had openly supported the Taiwanese KMT government, offering military protection against any military action coming from the mainland. For its part, since the rebuilding of a military force by the Japanese government under the provisions of the US-Japanese Mutual Security Agreement, Beijing had constantly denounced the rebirth of "Japanese Militarism". Thirdly, China refused to renew its Mutual Assistance Treaty with the USSR. Also symbolic because co-operation between the two communist powers had been negligible for more than a decade, this move reassured many capitalist Asian countries that there would be no more threat from a united communist block in Asia as in the 1950’s. The fourth strategic shift was over Sino-Vietnamese relations. The Chinese accommodation with the US was deeply resented by Hanoi. Vietnam decided to strengthen its links with the Soviet Union, which resulted in 1978 in the Soviet-Vietnamese Treaty of Peace and Friendship. The same year, hundreds of thousands of ethnic Chinese living in Vietnam were expropriated and expelled from the country. To counter Vietnamese influence in the Indochina Peninsula, seen now as the extension of Soviet influence, China supported the anti-Vietnamese Khmer Rouge. When the Vietnamese army invaded Cambodia to put a more docile government towards Hanoi, China immediately responded by attacking Vietnam. The short and bloody war was used by the Chinese to show the ASEAN countries that China would check any attempt by Soviet-backed Vietnam to increase its influence in the region. The Chinese leadership even pledged to assist militarily, Thailand in the event of a Vietnamese invasion (Pollack, 448). China moved considerably closer to the ASEAN countries during the international settlement of the Cambodian question as they jointly refuse to recognize the new Cambodian government set up by Hanoi. Furthermore, Beijing also reassured ASEAN governments that it would limit its support for remnant communist guerrilla groups operating in the regions (Pollack, 448).

34

In less than a decade, China had moved from being regarded as one of the two major threat s by capitalist economies in Asia to being an acceptable political and economical partner. Diplomatic relations were resumed and by the early 1980's, the long economic blockade of China had been partially lifted by the US and her allies. The door could be opened, with a cautious US support.

5.3. The opening of the Chinese economy

By 1980, the faction led by Deng Xiao Ping had built itself a strong position inside the CCP. This led to the adoption of a series of reforms that were going to lead China towards a market economy. The first pack of reforms launched in 1978 was cautious, mainly focusing in microeconomic reforms in agriculture but included some significant innovations in the treatment of international trade and investment. These transformations would bring the Chinese economy from autarky to the integration in the global and regional trading systems and were referred as the "open door policy".

Firstly, the government wanted to import machinery and other imports with high technological content. In 1978, it accepted for the first time to finance imports through long-term loans (Lemoine, 34). China joined the World Bank and the IMF in 1980, which gave it new credit access (Perkins, 503). To keep its trade balance in equilibrium, the government also encouraged exports by shifting the focus of industrial development from capital-intensive intermediary goods to light labour-intensive industries producing final consumption goods such as textiles, sewing machines, chinaware and bicycles (Perkins, 498).

As part of a general reform aimed at decentralising the decision-making process over the allocation of economic resources, the state agencies in charge of the control of foreign trade lost progressively their monopoly. There was a decentralisation process by giving more trading powers to local governments and by reducing the number of goods strictly regulated by the plan (Lin, 149). The number of Chinese companies authorised to operate in international trade rose from 12 in 1978 to 12000 in 1996 to reach eventually 35000 in 2001 (Lardy, 41).

Decentralization also occurred in the area of foreign investment. In 1979, the government authorized four experimental Special Economic Zones (SEZs) located in Zhenzhen, Zuhai, Shantou and Xiamen. All these zones were close to the Chinese capitalist enclaves of Hong Kong, Taiwan and Macau. The objective was to develop economic links with Taiwan, Macau and Hong Kong and to create “windows” for learning advanced technology and management (Sum, 61). TNCs were given a preferential tax system or tariff free processing zones. These reforms were still perceived by most foreign investors as reversible. After the further tranche of reforms which extended the facilities of the SEZs to 14 coastal cities and which continued the decentralization process on trade in 1984, the level of uncertainty was clearly reduced and FDI began to accelerate. The Tiananmen repression of 1989 did cause some concerns to foreign investors about a possible reversal of the open door policy however. To reassure TNCs, the Chinese government accelerated more flexible FDI-related rules such as the Income Tax Law for Enterprises with Foreign capital and Foreign Enterprise of 1991 (Luo, 14). The next step came in 1992 when Deng Xiao Ping made his visit trip to the southern province to assess the results of the “open door policy”. Reforms on FDI seemed locked in, especially when the strategy of "socialist market economy" was developed (Luo, 15). China's high growth and low wages made it an attractive place for efficiency-seeking as well as for market-seeking investments. China could now join the Asian flying geese.

5.4. The role of the Asian investors in pulling China into the dynamic of East Asian regional

35

economic integration

5.4.1. The domination of Asian investors in China

The economic reforms gave China in the early 1990's location-specific advantages comparable to those possessed by ASEAN economies. The flying geese pattern of FDI that integrated the East Asian economies extended to China. Of course, Asian TNCs were not the only ones to be attracted by the tremendous opportunities resulting from the opening of the Chinese economy. Western firms invested in China, some to penetrate a huge potential domestic market and others to lower their global costs by relocating their labour-intensive activities. Nevertheless, the Asian investors had more influence on the Chinese economy than their Western counterparts.

Main investing countries in China

0

500000

1000000

1500000

2000000

2500000

3000000

3500000

4000000

4500000

5000000

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

1000

0$

FDI from Japan, Taiwan & HK

FDI from the EU

FDI from the US

FDI total inflows for China

Source: MOFTEC 2002

In terms of quantity, Asian investors clearly constitute the largest share of FDI with more than 73.66% of the existing FDI stock hosted by China in 2001. The US and the EU accounted together only for 17.07% (Moftec). It is true that some of the flows originating from Hong Kong, Taiwan (and to a lesser extent Singapore) are coming from subsidiaries of Western TNCs. These two economies accounted for 55% of the total stock of FDI hosted by China in 2001 (Moftec). Therefore the importance of Asian flows is probably overestimated by the FDI official statistics. It is extremely difficult to speculate by how much but certainly not enough to give a dominant position to Western investors. A substantial part of the 47.3% of FDI flows originating from Hong Kong comes from Taiwanese and Japanese subsidiaries (see below section 5.5.2). Taylor estimates that the bulk of the Hong Kong investment in China is made by overseas Chinese entrepreneurs, who by far constitute the most important group of investors on the Chinese mainland both in terms of funds committed and numbers of projects (Taylor, 141).

36

On the qualitative level, the scope of the nature of Asian FDI flows to China is broader than those from the West. The importance of Asian SMEs in the flows of FDI is much greater than those of their Western competitors. Geographic proximity and cultural links imply that relocating to China is a far easier step for an Asian SME than for a Western one. Furthermore, as large Japanese TNCs began to establish themselves in China, they also asked their traditional subcontracting SMEs to follow them (Taylor). The relocation of activities by Asian SMEs has generated a very dense web of investment and trade links between their domestic economy and China. The development of this web was accompanied by the intervention of government agencies in China, the development of services for expatriate staff, and an increase in the numbers of Asian students in Chinese universities. There is a cumulative process of links creation that integrates the Asian economies with China. By contrast, the Western flows of FDI are mainly made by larger firms. The share of Western firms among the top 500 largest subsidiaries in China is larger than their share in the FDI inward flows to China (Moftec). The average size of a Western FDI project (North America and Europe) is larger than an Asian one. From 1986 to 2001, this average was just over $1.5 millions compared to $0.92 millions for the average Asian FDI project.

It is necessary to outline the general fundamental factors that accounts for the predominance of Asian investors in China. Geographic proximity is probably the most decisive factor. In most FDI patterns, there is often a higher propensity to invest in neighbouring countries. This has been the case for NAFTA and Europe. For example, from 1986 to 2000, the propensity to invest in neighbouring countries by firms of a European country was most often more than five times higher than average (Defraigne, 596).

Qualitative studies point out that cultural factors also account for the weight of Asian investors in China. Three of the four Asian NICs had more affinities with China than any other industrialized countries. The most obvious fact is that three of the four NICs have a population composed mainly of ethnic Chinese. For Taiwan and Hong Kong, family ties are still very strong: Hong Kong hosted many Shanghai businessmen in 1949-1950 while many Taiwanese islanders have families in Fujian or Zheijiang provinces (the latter being the birthplace of the KMT leader Jiang Jeishi). Singapore's links are not so immediate but it shares with China a common heritage of language and culture. South Korea also shares more affinities with China than the Western economies. Many Koreans have some knowledge of the written Chinese and the sizeable Korean minorities in Northern China (about 1 million people) constitute more the most important cultural bridge that Korea shares with any other country elsewhere in Asia apart from Japan. Because of the long-term effects of the Korean War, Korea was among the last countries to normalise its relations with Beijing. However, once this was achieved in 1992, economic and cultural ties developed faster than with any other Chinese neighbours. Finally, Japan is definitely closer to China than the Western economies. Despite the burden of a history of Japanese imperialism in China, which still generates resentment among numerous Chinese, both nations still have many common cultural links. Japan was the first capitalist Asian country to resume trade with China in the 1970's and has become its most trading partner by far. The Japanese TNCs backed by the usual government agencies (JETRO, the Institute for Developing Economies) have extended their regional network to the Chinese mainland with the same efficiency as in the rest of East Asia.

Nonetheless, cultural links and geographical proximity are not the only reasons behind the stronger presence of Asian investor in China. The role of the Asian governments should also be stressed. Their policies back the expansion of their domestic firms to China more actively than those of the governments from the Western industrialised economies. The obvious reason is that the economic evolution of China is far more essential to its Asian neighbours than to Europe or the United States. After the adoption of the

37

"open door" policy, the gigantic size of China both in terms of population and space is bound to modify the structure of intra-Asian trade and FDI. The opening of China has meant the emergence of a new large market in Asia and the availability of a vast reserve of cheap labour. However, for its Asian partners, the exceptional Chinese growth also generates concerns over regional military balance, rising competition from Chinese firms, FDI diversion (for ASEAN member states), the limited East Asian endowments of energy inputs and growing ecological strains. Many of China’s Asian partners are trying to create economic interdependence as a way to stabilise the region. Some of these concerns are shared by the West but are far from having the same weight as in East Asia.

Since the 1990's, the Asian TNCs began to reorganise their production process to take advantage of China's huge reserve of cheap labour. China opened at a time where many TNCs modified their production methods by shifting from “Fordism” to flexible specialisation. Stronger focus on product differentiation implied a fast feed-back between the consumer and the plants. TNCs clearly began to organise regionalised production processes across large integrated markets such as NAFTA or the European Single Market. In many ways, China was still far from being an integrated market like Europe or even North America. Chinese internal transport infrastructure was not sufficiently developed and many barriers to internal trade remained at the provincial level. Nevertheless, most firms continued to anticipate the progressive eradication of these barriers and to consider China as a potential giant market in a not too distant future. Apart from low wages and a potentially huge integrated domestic market, China also benefited from a central location in East Asia. The fourth advantage that China had over other Asian location such as the large ASEAN economies was close cultural, business and family connections. For these reasons, China became the main destination of Asian investors.

It is necessary to distinguish between the different Asian investors and to analyse how they respectively helped to integrate China with the rest of the East Asian economies. This will help to highlight the quite different dynamic created by Asian trade and FDI flows to China from those generated by Western investors.

5.4.2. The flows from Hong Kong

After the CCP adopted the “open door policy”, Hong Kong rapidly recovered its earlier role of export-import platform for the Chinese mainland. In the 1960’s and 1970’s, Hong Kong trade with China was limited. Europe, America and Japan were more important trading partners than China. During the 1990s trade between the two economies increased almost tenfold and China ranked first among the island’s trading partners in 1990. Trade quadrupled again the next decade (IMF).

After the reforms of the 1980’s, Hong Kong became the most important source of FDI inflows to the Chinese mainland. This is hardly surprising considering the location of the first SEZs and the personal links between islanders and mainlanders. In 1992, 80% of the population had relatives in the Guangdong Province (Hobday, 22). The bulk of FDI made by Hong Kong firms consisted mainly of relocations of labour-intensive activities. In 1995, 80% of the Hong-Kong large and medium enterprises had their own plant on the Chinese mainland (Gandini, 2). The average size of the investment projects originating from the island was quite small relative to OECD investors (Luo, 15 & Moftec 2002, 23). However in the late 1990's, Hong Kong based firms were beginning to invest in Chinese heavy industries and infrastructure (Taylor, 144). The Hong Kong great tycoons such as Li Kashing, Lee Shau Kee and Henri Fok now invest

38

massively in real estates, infrastructure and urban development services (Gandini, 2). In 1992, the average FDI project originating from Hong Kong was about $357 000 while in 2001 it had moved up to $5.85 millions (Moftec). FDI from Hong Kong were directed mainly to Guangdong province where they accounted for 75% of the inward FDI stocks in the early 1990's (Adelphi, 41).

The relocation of labour intensive activities has profoundly affected the industrial structure of the island economy. Unemployment has risen to 7.4% and the economy has suffered a long period of deflation since the 1997 crisis. In 2003, the nominal value of the GDP had still not recovered to its 1997 level. Real estate in Hong Kong has lost 70% of its1997 value (Xiao, 15). These trends cannot be explained solely by the pre-1997 financial bubble but reflects the island’s loss of competitiveness compared to the neighbouring Southern Chinese provinces. Hong-Kong is progressively losing its attractiveness as an export processing centre. As a regional transport hub, Hong-Kong, , is progressively being caught up by the coastal areas of the Chinese mainland. In 2003, the container throughput of the Shenzhen port surpassed Hong Kong's Kwai Chung for the first time (FT Hong Kong Report, 19/9/03). Even on financial services, some Hong Kong officials expect the island to loose its edge over Shanghai before the start of next decade (FT Hong Kong Report, 19/9/03). Shanghai is attracting more world class corporations belonging to the Fortune 500 than the Island (Xiao, 19). Furthermore, the Hong-Kong authorities do not perform as well as Shanghai in coordinating their development policies with the objectives of the local community and the central and local government in mainland China (Xiao, 19). The authorities are focusing on the upgrading of financial services and of tourism to keep some comparative advantages over the mainland but their success is far from certain.

Hong Kong entrepreneurs have not focused their efforts on capital-intensive and technology intensive industries like Japan or South Korea. The sectors in which they developed more of their activities are characterised by low barriers to entry. Therefore, they have been challenged rapidly by Chinese mainland firms. The Hong Kong firms have little choice but to attempt to keep their competitiveness by using the same cheap inputs (labour, land and energy) available on the mainland. Most Hong Kong entrepreneurs have not change their sectors of activity but tend to repeat on the mainland their experience gained on the island.

At the same time, mainland investors have been penetrating the island economy, particularly since 1997. In 2002, 1800 mainland enterprises had made some direct investment in Hong Kong (Gandini, 2). Mainland companies like China International Trust and Investment Corporation or China Resources have placed themselves among the top foreign investors on the island, controlling hundreds of subsidiaries in utilities, banking, telecoms, distribution, real estates (Gandini, 2). In 2002, the mainland became the main investor in Hong-Kong.

During the 1980's and 1990's, successive Chinese governments were very careful to claim publicly that economic and legal institutions would not be modified drastically when the island returned to the mainland in 1997. The concept of "one country, two systems" launched in 1984 reassured foreign investors that their property rights would not be infringed upon. During the 1990's foreign investors continued to use their Hong-Kong subsidiaries or local joint-venture partners to open subsidiaries on the mainland. The island was used by firms from Asian economies that did not have direct political links with China such as South Korea and Taiwan (Jones, 90). Other Western and Japanese firms used their Hong Kong subsidiaries or partners because of their special links with the mainland. Therefore, while Hong Kong might be the first investor in the mainland, the FDI flows are not generated only by island-owned

39

firms but rather by other Asian and Western firms in the process of reorganising their regional production networks. Hong Kong has played a key role in the integration of China within East Asia.

The impressive figure of Hong Kong FDI flows to the mainland might reflect not only a reorganisation of the production process of TNCs taking advantage of the opening of the Chinese economy but also an internal transformation of the Chinese property rights system. Hong Kong has been used by many Chinese officials and business leaders as an offshore centre for improving the protection of their property rights or simply for money-laundering. There has been various evidence that "one country-two systems" has enabled Chinese people to smuggle money out the mainland, use the Hong Kong financial services companies as intermediaries and reinvest the funds on the mainland with the legal protection over property rights given to foreign investors (Le Monde, 7/4/03). The vast two-way flows of money generated by traditional trade links between Hong Kong and the mainland facilitate this transfer of capital. As early as 1992, 30% of all Hong Kong dollars notes were circulating in southern China (Adelphi, 40) and the RMB is also widely used on the island. It is difficult to estimate the flows transiting through Hong Kong coming from corruption or stealing state assets but the financial authorities of Hong Kong consider it to be serious issue (FT, Interview with Henry Tang, 19/9/03). Some Chinese economists have estimated that in the late 1980's, the frauds made only by using the dual-track price system (which enabled some managers or officials to obtain material at the undervalued plan price and sell it back at the market price) accounted for as much as 20-25% of the Chinese GDP (Lin, 206). Despite the severe punishments and the continuous fight by the central government, the level of corruption remains high and involves vast amounts of money that has to be laundered. The fact that the Virgin Islands, an opaque offshore financial centre, constitute the second investor in the Chinese mainland might also be explained by the transformation of Chinese capital without clear property rights into foreign direct investment. There are few available figures or even proper estimates covering this phenomena referred to by Huang as “round-trip FDI”. The FDI coming from Hong-Kong and the Virgin Islands but which actually originates from the mainland constitutes between 7 and 25% of the FDI inflows to China according to various estimates (Huang, 38). One should keep this element in mind when considering the impact of Hong Kong FDI in the integration of Chinese economy within the East Asian region. Hong Kong FDI flows might also conceal the phenomena of a national mechanism of property rights transformation, which does not generate the same regional integration dynamic as "classical" FDI.

From the analysis above, one could claim that the flows of FDI originating from Hong Kong only had a limited direct effect in pulling China into the East Asian regional integration process. These flows have helped to integrate the island deeply with the mainland but this process is more "national" than regional. Although it is true that some Hong Kong firms have invested in other Asian economies such as Thailand, qualitative evidence indicate that they are still far from constituting a regional cluster of subsidiaries like the Japanese TNCs (Jones, 89). Furthermore, FDI from Hong Kong to ASEAN countries slowed down considerably in the 1990's as reforms on the mainland accelerated. At the same time, trade flows between Hong Kong and the ASEAN economies have been symmetrical to the trade flows between the Chinese mainland to the ASEAN economies. This suggests that Hong Kong based firms have been using the mainland increasingly as an export platform to the ASEAN economies. Many South Korean or Japanese TNCs also have used their Hong Kong subsidiaries to operate in China, making the latter a part of their regional production process. The economic and political integration of the island with the mainland has developed the infrastructure and business links, which, in turn, facilitate penetration of the Chinese economy through Hong Kong by East Asian TNCs.

40

Hong Kong FDI flows to the Chinese mainland

0

500000

1000000

1500000

2000000

2500000

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

1000

0$

Hong-Kong FDIJapan FDIEU FDIUS FDI

Source: MOFTEC 2002

The Hong Kong indigenous entrepreneurs have contributed to the creation of a "Greater China" economic sphere, which indirectly reinforces China’s trade links with its Asian neighbours. Hong Kong investments have certainly had a positive indirect effect on pulling China into the East Asian integration process as Hong Kong FDI inflows from the island have helped to lock-in the Chinese “open door” policy by creating a high level of interdependence between the southern Chinese provinces and Hong Kong. With the pace of reforms on the mainland and the adoption of a “closer economic partnership arrangement” implemented in January 2004, the doctrine of "one country, two systems" might soon be obsolete on the economic level.

5.4.3. The flows from Taiwan

Settling the long dispute over Taiwan was an important element in the adoption of the "open door" policy by the CCP. The mainland leaders decided to facilitate trade and investment links in order to create an economic interdependence that would in the long run bring back Taiwan to China. In the early 1980's, commodities produced in Taiwan were given national treatment while Taiwanese investors were offered preferential treatment and special guarantees (Gee, 22). Trade between the mainland and Taiwan grew at a lightning speed. In 2000, the Chinese mainland ranked 6th as a destination for Taiwanese exports. But at the same time, Hong Kong was already the second destination of the island’s exports just behind the USA. Overall, China has become the principal destination of Taiwan exports. In terms of imports, though the Chinese mainland ranks in fifth place and though its export have been developing fast, it is still far behind the leader, Japan, which exported over six times more than China in 2000 (IMF).

The Taiwanese government could not resist the pressures of the island's entrepreneurs. Facing higher domestic costs at the end of the 1980's, it was natural for Taiwanese investors to relocate their activities to the mainland which was the closest economy endowed with cheap factors of production (labour, land and

41

energy) once the mainland authorities clearly adopted a supportive attitude. Taiwanese firms invested through Hong Kong or even directly albeit illegal. At the beginning of the 1980's the Taiwanese investments were constrained by the fact they needed to be profitable quickly. This was a consequence of the risk of a reversal of the reforms. But as these became locked-in, the Taiwanese firms became keener on making long-term investments (Gee, 27). The Taiwanese government which had no strong connections with local entrepreneurs could do nothing but accept this evolution. In the early 1990's, it shifted its policy from forbidding all investment in the mainland to a more realistic approach based on a list of 2000 products authorized to be produced on the mainland and excluding the defence-related industries, industries which benefited government-supported R&D, high-tech products and industries with high linkage to the domestic economy (Gee, 24). At the beginning of this decade, the Taiwanese government even authorised Taiwanese firm to build plants producing elementary microprocessors on the mainland (Dicken).

The pattern of Taiwanese FDI flows to the mainland is very similar to those of Hong Kong. In the mid 1990's, most investments were made by SMEs (Jones, 86). For the period that extends from 1986 to 2002, the average investment project made by Taiwanese firms on the mainland was $ 0.57 millions (Moftec, 23). As for Hong Kong firms, most of these investments consisted of labour-intensive processing production units (Jones, 86). The Taiwanese firms usually brought their capital, their production facilities and their trained personnel to the mainland (Sum, 63 & Gee, 26). One notable difference is that the difficult political relations between the Taiwanese and the mainland governments have meant that Taiwanese firms often need to use Hong Kong based subsidiaries as middlemen. The typical Taiwanese chain of production is composed as follows: an order is taken in Taiwan, processed in China, the finished product is transferred to Honk Kong and sold abroad (Gee, 26).

Like in the case of Hong Kong, most of investments were made in the SEZs located in the closest coastal provinces (Fujian and Zhejiang). Another factor that could explain the importance of the Zhejiang province as a host of Taiwanese FDI is the personal links such as Jiang Jeishi is originally from the Ningbo area. Taiwanese firms have been the most important investors in the Ningbo free-trade zone and export-processing zone since they were established in 1993 (Interview 1).

On the technological content of FDI, there have been some differences between Hong Kong and Taiwanese investors. Although, Taiwan benefits from a better technological base than Hong Kong in the electronics and computer industries, the Taiwanese government forbade the island's firms to open subsidiaries in high-tech industries on the mainland during the 1980's and early 1990's (Gee, 24). But this rule was relaxed in the late 1990's, under pressure from the business community afraid of the fiercer competition that followed the 1997 crisis. For example, since 1999, the Ningbo export-processing zone has hosted more than 150 Taiwanese IT subsidiaries, which produce motherboards and peripherals (Interview 1). 12-inch wafer fabrication plants have been established in Beijing by Taiwanese firms (Chen, 10). Joint-ventures between Taiwanese investors and the Chinese state are being developed in the semi-conductor industry. The Semiconductor Manufacturing International Corp (SMIC) between Richard Chang and Shanghai Industrial Holdings or the Grace Semiconductor Manufacturing International between Formosa Plastics and the son of the former president Jiang Zemin are examples of such across-the-strait links (Chen, 10). The important relocation of IT processing activities by Taiwanese firms implies that Taiwan FDI flows to the mainland have a broader technological scope than those of Hong Kong.

42

The limits of the investment made by Taiwanese firms on the mainland were less due to the Taiwanese authorities than to problems on the mainland such as foreign-exchange controls, a unreliable domestic electricity supply, poor local transport facilities and local corruption (Gee, 26). Many of these issues were tackled by the mainland government and new facilities were offered to Taiwanese investors and visitors in the late 1980s. This produced dramatic results. Between 1987 and 1993, five million Taiwanese visited the mainland and 10,000 small and medium enterprises opened subsidiaries in the Chinese coastal areas (Sum,62). Chen estimates that over 500,000 Taiwanese businessmen, managers and technicians are working in China in 2004 (Chen, 1). FDI stocks from Taiwan to the mainland multiplied twenty fold between 1987 and 2001 (UNCTAD).

On the economic level, the level of interdependence between Taiwan and the mainland is now considerable. The Taiwanese business community advocates closer economic integration, facilitating transport links, financial flows and travel procedures. On the political level, the problems are far from being solved. Taiwanese governments have been tetanized by the evolution of the economic links with the mainland. Taiwan’s government is resistant to popular pressure in favour of strengthening ties and facilitating personal trips to the mainland for personal or commercial reasons (Sum, 62). They have been reacting after the facts rather than anticipating them. The first top level contacts between the mainland and the Taiwanese government were made in 1993 in Singapore because the island's authorities could no longer ignore the "open door policy", especially after the acceleration of reforms in 1992 (Adelphi, 42). The Taiwanese authorities cannot reverse the integration trend but can only hope to slow it. The administrative control imposed by the Taiwanese authorities over the movements of people and capital across the Strait hampers the restructuring desired by local entrepreneurs. Again, the economic evolution seems unstoppable and in the autumn of 2003 the island's government agreed with Beijing to create private professional bodies to deal with issues of transport, trade facilitation and educational exchanges with the mainland. Mainland enterprises are now authorized to invest on the island following approval from the Taiwanese ministry of economic affairs (FT, 10/10/03).

The real obstacle to further integration is not the attitude of the Taiwanese authorities per se but the fact that it is ultimately backed militarily by the United States. The US administration uses Taiwan (and in a similar way, South Korea) to keep a strong strategic position in East Asia. Despite an engagement taken twenty years to phase out the selling of military equipment to the island, successive US governments continue to supply modern army equipment to Taiwan. In October 2003, the Bush administration took a more aggressive stance by pressuring Taiwan to acquire more military equipment in order to match the development of the mainland forces (FT, 17/10/03). The US plays a delicate game of maintaining the status quo across the strait in order to retain a role in the area.

Overall, the contribution of Taiwanese investors to the pulling of the Chinese economy into the East Asian economic integration process has been quite similar to that of their Hong Kong counterparts: Taiwan’s and the Chinese mainland’s economies are becoming more integrated while most Taiwanese firms have not built a regional process of production characterized by a dense web of subsidiaries located across East Asia. However, as in the case of Hong Kong, the symmetric movement of trade flows between, on the one hand, the Chinese mainland and the ASEAN, and on the other hand, Taiwan and the ASEAN can be observed. Thus, Taiwanese firms are using the mainland as an export platform for final goods to neighbouring Asian economies and the rest of the world economies (Chen, 3). The Taiwanese FDI and trade flows have also help to lock-in the "open door policy" reforms through its economic interdependence with the provinces of Fujian and Zeijiang. The special links between Japanese TNCs and

43

Taiwanese firms in the IT and electronics sectors have now been extended to the Chinese mainland through Taiwanese FDI, thus creating new indirect technological links between the Chinese mainland and Japan

Taiwan trade balances with main partners

-30000

-25000

-20000

-15000

-10000

-5000

0

5000

10000

15000

1980 1990 2000

millio

ns of

euro

s J apanChinaASEANEUUS

Source: IMF

5.4.4. The flows from Singapore

Obviously, Singapore does not have the same relations with China as Hong Kong and Taiwan. Even though almost three quarters of its domestic population are ethnic Chinese, the city-state has never been part of China. Nevertheless, Singapore has many privileged links with China on a cultural and linguistic level.

On the economic level, the trade between the two countries has always been important and this is hardly surprising considering the role of regional warehouse played by the city-state. Singapore has been among the top ten trading partners of China for decades, even before the adoption of the "open door" policy. The amount of trade between China and Singapore has been nevertheless about ten times less than with Japan or Hong Kong during these two last decades (IMF).

Singapore is also a major investor and is only surpassed by Japan and the United States among the OECD economies (Moftec 2002, 23). Considering the small size of its economy, this figure is quite impressive. Nevertheless, one should not forget that Singapore certainly plays an intermediary role of like Hong-Kong, albeit at a lesser scale. Furthermore, the bulk of the manufacturing activities in Singapore are still controlled by foreign TNCs.

The change in development strategy in the late 1980’s has fostered the expansion across the region of Singapore-based TNCs providing services. This evolution was the result of a drastic transformation of the

44

Singaporean government’s attitude towards indigenous capitalists. In the 1960’s the PAP adopted a development strategy entirely reliant on foreign TNCs because it mistrusted the capacity of indigenous capitalists to enter modern manufacturing industries (Nesadurai II, 117). As most of the indigenous capitalist groups are controlled by ethnic Chinese, the government policy of encouraging indigenous TNCs to expand regionally could strengthen the FDI flows to China. A special trade and investment agreement was reached in the mid 1990’s between Singapore and Suzhou. The size of the average direct investment in China has been higher than those of Hong Kong and Taiwan, reaching over $2 million. This indicates that SMEs account for a smaller share of the FDI flows to China. This corroborates the fact that many Singaporean investors are larger firms, either the newly privatised indigenous services enterprises or foreign-based TNCs. The lesser importance of flows originating from Singapore SMEs compared to those of Hong Kong’s and Taiwan’s is also caused by the greater distance and less direct links with the Chinese mainland.

Despite the rise of FDI and trade flows to China, China is not the priority of either the government or most businesses in Singapore. The main focus is still on the ASEAN in which the newly born Singapore-based TNC backed actively by their government are trying to become the main providers of services for the manufacturing enterprises located across this region. The Singapore government hopes to transform the city-state in a hub of services, which would host the ASEAN headquarters of Western and Japanese TNCs. This strategy is very dependant on the FDI inflows to the ASEAN and on the liberalization of services within the ASEAN Free Trade Area framework. The business and bureaucratic elites are focused on these two objectives, which matter more to them than penetration of the Chinese economy. But Singapore has to keep its options open. Firstly, the ASEAN and China are building stronger economic links, especially following the agreement reached in 2000 on the creation of a free trade area between the ASEAN and China after 2010. Secondly, Singaporean officials and business leaders are becoming increasingly frustrated by the slow pace of service liberalisation across the ASEAN economies (Nesadurai II, 182). This could force a change of strategy, which would give a greater role to the Chinese economy.

5.4.5. The flows from South Korea

South Korea had no official relations with China during the first decade of the "open door policy". Due to the involvement of Chinese forces on the side of the North during the Korean War, a profound distrust remained between Seoul and Beijing. There was no official trade between the two countries for decades. Nevertheless, reforms in China could not be ignored any longer by the Korean authorities and chaebol. China constituted a gigantic neighbouring market of great potential which with the accelerating opening of the Chinese economy was attracting many Asian competitors.

In 1992, diplomatic relations were established and led to a drastic increase in trade and investment relations. Geographic proximity, a relatively good complementarity between the two economies and the special cultural links mentioned above explain this phenomenon.

In less than a decade, China became the third biggest trading partner of South Korea, just behind the US and the EU. It even overtook Japan. For China, just prior to the opening of diplomatic relations, South Korea ranked 16thamong its trading partners with imports and exports amounting to around 600 million dollars, less than 5% of value of China’s trade with Japan. By 2002, it had increased more than ninety fold to equal 43% of the Chinese trade with Japan (IMF).

45

In terms of FDI, the growth was also astounding. Starting from scratch in the 1980’s, the Korean FDI stock was just after the Virgin Islands behind Hong Kong, Taiwan, the US, Japan, the EU and Singapore in 2002 (Moftec 2002, 23). The average size of Korean FDI projects during the 1990's was just around 675 000 dollars (Moftec). This is quite surprising given the high level of concentration that characterizes the Korean industrial structure and shows that a substantial part of the Korean FDI stock must have come from SMEs. According to Keun Lee and Minhsoo Kim, the first Korean investors in China were the SMEs attracted by the cheap labour in China. They dominated the flows of Korean FDI to China until the mid 1990’s (Kim & Lee, 6). The already weak Korean SMEs were put under intense pressure after the 1997 crisis and forced to take the step of relocating labour-intensive activities to cut costs. In the aftermath of the 1997 crisis, the Korean chaebol began to relocate some of their activities to China and they brought along their SME subcontractors (Kim & Lee, 7). In 2003, 7% of South Korean SMEs had already relocated activities to China and 38% were planning to do so (FT, 25/09/03). The small size of the average project does not mean that the larger chaebol were not investing. Indeed, Korean TNCs that rank among the 500 biggest foreign firms were located in China in 2002. However the SMEs have relocated their production facilities to China to a larger extent than the chaebol and they are multiplying their number of small investment projects (Kim & Lee, 7).

The chaebol were slower in their restructuring than some other Asian TNCs but after 1999, they took drastic steps and began to organise regionalised production processes like their Japanese counterparts by relocating labour-intensive activities to China. In the early 2000's, Samsung, LG electronics, LG Chems and Ulsan's Hyundai Motors opened new subsidiaries in China (FT, 25/09/03). In some sectors such as the automotive, Korean subsidiaries are producing mainly for the Chinese market but in other sectors such as electronics a dual strategy is employed, using China as an export platform and as a market. South Korean subsidiaries like those of LG Electronics and Samsung Electronics are among the 100 largest foreign exporters based in China (Moftec). Unsurprisingly, chaebol such as Samsung or LG have established subsidiaries in Tianjin, which faces South Korea, less than 1500 km from its harbours. Korean enterprises in China have been reproducing the role that Japanese TNC played earlier with Korea. Korean networks of chaebol owned subsidiaries and their subcontracting SMEs in China import a substantial amount of key components from South Korea but only re-export a smaller share of their output to Korea (Nam, 14).

From 1986 to 2000, South Korea accounted for less than 3% of the total stock of inward FDI in China. This figure has risen to reach 4.59% in 2001 (Moftec). This acceleration is likely to continue not only because of the growth of the Chinese market but also because restructuring of the South Korean enterprises has only just begun and there are still many possibilities for deepening the regionalisation of the chaebol production process. The growth of the Chinese market is another reason behind the flow of investment from South Korea to China. It is becoming increasingly difficult for Korean firms to access the Chinese market without localizing their operations in China (Kim & Lee, 16). For example, Samsung is selling 20% of its output to Korea compared with 10% to China but expects that the growth of the Chinese market will increase this share to 20% and prepares to extend its facilities in China (Kim & Lee, 10).

Some analysts believe that the Asian Northeast region including the province of Tianjin, Laoling and the rest of Manchuria, the Korean peninsula and Japan could become a highly economically integrated zone once the political problem of the two Koreas is resolved (Liu, 159). The South Korean government has been pushing forward the project of a trilateral free trade area with China and Japan. It has aroused

46

serious interest from the two Korean neighbours even though no agreement had as yet been reached by 2004 (see further section 8.3.). Thus Korean firms are playing a substantial role in bringing the Chinese economy closer to theirs by regionalising their process of production, using the cheap and geographically close Chinese labour supply. The Korean government has also been pushing in favour of deeper economic integration in Northeast Asia.

South Korea trade balances with main partners

-20000

-15000

-10000

-5000

0

5000

10000

15000

1960 1970 1980 1990 2000 2002

mill

ions

of e

uros EU

USJ apanASEANChina

Source: IMF

5.4.6. The flows from Japan

Japanese TNCs also quickly considered China as essential for their regional and global strategy. Like the Koreans, the Japanese share many cultural ties with China. However the Sino-Japanese relations have always been more delicate. This is not surprising given the heavy toll suffered by China in the Japanese imperialist war and the fact that open revisionism has been and continues to be defended by prominent Japanese politicians, especially among LDP leaders (some of whom belong to families that played a political role during the war). But this is not specific to China. The suffering caused by the Japanese occupation of Vietnam, of Indonesia and even of Korea has also created a strong resentment against Japanese. The more fundamental reason behind the Sino-Japanese mistrust is that these are the only two countries than can to play a hegemonic role in East Asia. Japan has been traditionally the economic leader but since the adoption of the open door policy this role has been challenged by the rapid economic and technological development of the Chinese giant.

Japan’s political and business leaders cannot remain passive in the wake of rapid Chinese industrial development. Apart from military and strategic issues, the sheer size of China commands the attention of the Japanese government and TNCs over economic and ecological issues. In the fastest industrialising

47

region on the globe, Chinese economic growth has put severe strains on already insufficient energy resources. This has led to a competition between the two nations for access to local sources of oil such as Siberia. It has also forced the Japanese government to encourage Chinese enterprises and the government to adopt energy-saving technologies with its aid programs. While Japan must be involved in the development of China, it has to be even more cautious than with its other Asian partners due to understandable historical sensitivities. Apart from this caution, the economic policy of Japan vis-à-vis China has been quite similar to the other East Asian developing economies except that it has taken place on a greater scale.

After 1945, the resumption of Sino-Japanese economic relations was slow. When Japan became formally a sovereign state again in the 1950's, it sided with American foreign policy, which put serious constraints on bilateral economic flows. Nevertheless, even before Nixon's change of policy, Japan was China’s main trading partner following the rupture with Soviet Union. Japanese steel and machinery producers were attracted by the large Chinese market as early as the 1960's and lobbied the ruling Liberal Democrat Party to facilitate trade between the two countries (Taylor, 4). The opening of diplomatic relations between the two countries in 1972 was immediately followed by the establishment of Japanese trading companies in China. China imported machinery from Japan and mainly used its oil exports to finance it. The Peace and Friendship Treaty signed in 1978 contained a "Long Term Trade Agreement" with planned targets for Sino-Japanese bilateral trade (Drysdale, 5). The bilateral trade increased dramatically. Japan was already the first trading partner of China by the time the treaty was ratified and its share of Chinese foreign trade continued to increase until the mid 1980's, reaching over 30%.

In 1978, however, relations were still fragile. The bilateral trade agreement did not establish traditional capitalist trade links but rather a barter-like trade (Drysdale, 5) and China offered little guarantee of enforcement of the property rights of potential Japanese investors. From 1979 to 1983, there were on average less than 10 Japanese investment projects per year (Tokunaga, 258). The total Japanese investments stock in 1983 amounted only to $83 millions (Tokunaga, 258).

After 1984, the reforms were confirmed and deepened so that China offered a more stable environment and attracted far more Japanese FDI. In 1988, Japanese firms were given special preferential treatment, which gave additional protection to their investment, including intellectual property rights (Drysdale, 5). The measure was later extended to foreign firms but the priority given to Japanese TNCs highlights the privileged economic relationship that Japan enjoyed compared to its Western counterparts at that time. The Chinese “open door” policy was perceived as irreversible after 1992, at a time where the effect of the 1990 Japanese crisis triggered another wave of relocation. The number of FDI projects soared and reached its record level that year (Moftec). As economic reforms accelerated in the late 1990's, the Japanese flows continued to increase.

In relative terms, the Japanese share in the FDI flows hosted by China decreased throughout the 1990's and so did the Japanese share in Chinese foreign trade. This was quite a natural evolution as investors from the West began to be attracted to China after 1992 and as some Asian firms were transforming themselves into TNCs capable of regionalising their process of production like their Japanese counterparts. As for trade flows, Japan was one of the two main markets in the 1970's and 1980's for Chinese exports. The Chinese exports were mainly composed of energy products. As the Chinese export structure began to diversify and the weight of consumer goods increased, other OECD markets grew in importance, lowering the share of Japan as a destination for Chinese exports. However, in terms of

48

imports to China, Japan continues to lead far ahead, with a strong technological dependence on Japanese machinery.

Share of China's trade with Japan in China's global trade

0

5

10

15

20

25

30

1960 1970 1980 1990 2000 2002

en %

Source: IMF

In many instances, Japanese investors have regained their traditional foothold on the Chinese markets. The port of Dalian, which used to be under Japanese control during the first half of the 20 th century, is now a primary destination for Japanese FDI (Taylor, 75). Japanese investors developed a very strong presence in the area with over two thirds of the local FDI stock in the early 1990's (Adelphi, 47), amounting to $1.19 billions in 1992 (Taylor, 75). Japanese firms also invested massively in Shanghai ($0.81 billion in 1992), in Tianjin ($0.37 billion) and in Beijing ($0.12 billions) (Taylor, 75). This pattern was similar to the one observed in the period prior to 1945. However, Japanese TNCs do not always walk in the footsteps of the pre-war zaibatsu as shown by Japan’s recent significant penetration of the southern Guangdong province, which was traditionally a zone dominated by British economic interests in pre-revolutionary China. Japanese TNCs in electronics developed in Guangdong in the late 1980's and were followed a decade later by Japanese carmakers such as Honda.

The share of Japanese FDI as a part of the total FDI inflows hosted by China since the mid 1980's was usually of similar magnitude to that of the US or the EU, that is, under 10% (Moftec 2002). However, FDI statistics underestimate the real weight of Japanese firms in the Chinese economy. Firstly, it has already been mentioned that Japanese firms use more often licensing and other non-equity forms of overseas investment production than their US or European counterparts (Yamamura, 15). Secondly, the Asian network of Japanese subsidiaries makes it very difficult to see the origin of FDI inflows. Many Japanese firms prefer to invest on the Chinese mainland using subsidiaries located in Hong-Kong or even

49

Taiwanese firms transiting through Hong-Kong. Japanese firms are not the only ones to adopt these practices. For example, in the early 1990's Nike also used its Taiwan subsidiary to organise its implantation on the Chinese mainland (Hobday, 128). Thus a share of the vast amount of FDI inflows from Hong Kong is made by firms controlled in fine by Japanese or Western TNCs. Nevertheless, qualitative studies tend to show that Japanese firms have more joint-ventures, subcontracting and technology licensing agreements with Taiwan or Hong Kong than Western firms (Jones, 87).

Average value of FDI projects in China by the main investing countries

0

100

200

300

400

500

600

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

1000

0$

Hong Kong projectsTaiwanese projectsJapanese projectsEU projectsUS projects

Source: MOFTEC 2002

Qualitative studies suggest that until the 1990's, most Japanese investments were made by SMEs (Tokunaga, 261 & Drysdale, 81). However, the FDI data seems to contradict this claim. The average sized project was quite high in the mid-1980's, reaching almost $1.5 millions, a higher figure than for the average EU and US FDI projects. It fell in the following years to $226,000 in 1992. Afterwards, the average size continued to increase for most of the rest of the decade and by 2001, it was just under $1.8 millions. One element seems certain both from qualitative studies and FDI data: the Japanese keiretsu have been increasing their penetration of the Chinese economy since 1993 onwards. The number of projects has actually gone down which implies that the share of large firms within the FDI flows has increased. This trend is likely to continue. The keiretsu have intensified the relocation of their labour-intensive activities to China and have even relocated some capital-intensive ones with medium-technological content. The Fujian-Hitachi was among the precursors in the 1980’s when they established their television sets. Now their subsidiaries are producing semiconductors (Taylor, 76). Even Canon, which had been a defender of maintaining a substantial part of its production sites in Japan during the 1990's, recently modified its strategy. It has started to shift most of its manufacturing activities to China (FT, 10/2003). Until the late 1980's, FDI in non-manufacturing accounted for almost 80% of the stocks and most of the manufacturing was concentrated in machinery, transport and energy (Tokunaga, 259). This proportion fell as Japanese manufactures began to relocate labour-intensive activities to China after 1992. The entry of large Japanese TNCs into manufacturing also created more trade links with the other

50

Asian economies. Japanese subsidiaries producing in China could not find some of the high-quality inputs needed in the country and thus were forced to import them from their neighbouring Asian subsidiaries, thereby inserting China into their regional production network (Taylor, 139).

As in other Asian countries, the Japanese government agencies continued to play a decisive role in assisting Japanese firms to open subsidiaries in China. Japanese ODA helped the development of Japanese firms on the Chinese domestic market by linking aid projects to the attribution of procurements to Japanese TNCs. In 1992 and 1993, half of the amount of aid funds received by the Chinese authorities came from Japan (Yamamura, 131). The ODA flows continued to accelerate throughout the 1990's and did not seem to be constrained by the rising public debt of Japan. For the three year period from 1996 to 1998, ODA flows amounted to $4.8 billion and in the fiscal year of 1999-2000 the ODA flows totalled $3.25 billion (Drysdale, 121). As in the other East Asian economies, the share of projects targeting the development of infrastructure was higher than European or US aid programmes (Taylor, 60). In 1992, 74% of Japanese ODA was directed to infrastructure in three key sectors: transport, energy and telecommunications (Taylor, 63). By playing an important role in the infrastructure development projects, the Japanese TNCs slowly began to impose their technical standards on the local users of these infrastructures, creating an increased technological interdependence between the two economies.

The Japanese firms also benefit from the important guanxi networks developed by Japanese government agencies. For example, the Sino-Japanese Long Term Trade Agreement made in 1978 created many informal links between Chinese and Japanese officials which increased their familiarity with the Chinese planning system and the functioning of economics ministries (Taylor, 62). The Japanese government is also more involved in the industrial development of China than its Western counterparts. For example, in addition to the Japanese aid agency, the MITI also participated in the creation of industrial parks along with the Japanese TNCs and the Chinese authorities (Taylor, 75).

The Japanese TNCs and government agencies have also strengthened many ties at the provincial and municipal level in all the parts of China where their economic presence is important. This has resulted in a more favourable climate between these local Chinese and the Japanese investors and government agencies. The central government adopts a double strategy of advocating for stronger economic and technological co-operation with Japan while continuing at the same time to denounce the revisionist view of the Japanese past war crimes by the LDP. The local authorities seem more accommodating. In Dalian, interviews made in the mid 1980's showed that the image of Japan perceived by the local population and officials was much brighter than the national average (Drysdale, 23). In Shanghai, businessmen and journalists seem to have "less emotional and more pragmatic views of Japan" (Drysdale, 23). Shanghai officials in charge of hosting FDI adopt a neutral view that put economic efficiency and local development before historical and political considerations. The nationality of investors’ matters little as long at it contributes to economic growth. When the Shanghai authorities host subsidiaries from Taiwan, they do not try to determine whether they are controlled by Japanese or Western TNCs (interview 2).

The elements mentioned above highlight the special economic relationship between Japan and China. Japanese firms were the first entrants on the Chinese market after 1960. The Japanese government’s agencies and trading companies had already established a strong presence in China by 1980. This gave the Japanese TNCs and officials a deeper knowledge of the Chinese economic system than the Western investors. Japanese aid programs in China have imposed many Japanese technical standards and have created a technological dependence on the Japanese firms. The Japanese TNCs have also quickly

51

integrated China into their regional production process, using their subsidiaries or subcontractors from other Asian economies either to provide inputs to their plants in China or to penetrate the Chinese market. One can conclude that the keiretsu have pulled China into their regional web of subsidiaries and the leading flying goose has helped considerably China to join the pack of Asian industrialised economies.

6. THE EAST ASIAN “FLYING GEESE” PATTERN AND THE REGIONAL DIFFUSION OF TECHNOLOGY

6.1. The extent of the technological diffusion by the Japanese TNCs.

The preceding sections have highlighted the decisive role played by the Japanese TNCs in the economic integration of the East Asian region. Successive waves of Japanese FDI have helped to industrialise the former Japanese colonies of Taiwan and South Korea, then reached the ASEAN economies and finally China and Vietnam. The keiretsu and their subcontractors have regionalized their process of production and built a complex regional division of labour in East Asia, which is much more complex than what their Western counterparts could develop in the region.

South Korea, Taiwan, Hong Kong and Singapore managed to industrialise and started to catch up with the most advanced economies. Their domestic firms acquired new technological knowledge and management experience, which provided intangible assets necessary to transform them into global competitors. Major TNCs like Samsung or ACER began to emerge. The flying geese model became fashionable again.

Since the mid 1990’s, however, the Asian NICs have been in crisis. The fantastic increase in GDP per capita that these economies had experienced began to slow down and even stagnate during the last decade. The trade structure of the Asian NICs still indicates a high dependence on Japan for high-tech imports. Many analysts remain sceptical about the innovation capacities of most of the non-Japanese Asian TNCs. It is necessary now to assess to what extent the regional integration led by Japanese TNCs has helped to diffuse technological capacities in the region and what the newcomers can expect from joining the pack of “flying geese”.

There is abundant evidence that the Japanese subsidiaries have transmitted technological capacities to their local subcontractors in many Asian economies. Technical blueprints and/or advice provided by technical staff are given by the Japanese TNCs to their subcontracting firms so as to improve the quality, design and conformity of the inputs. A study conducted by Rhee has shown that about 50% of South Korean firms benefited from such technology transfers from their Japanese buyers (Hobday, 37). Japanese TNCs like Hitachi have played a similar role in the upgrading of the technological capacity of Taiwanese firms in the field of PCs and electronics (Hobday, 106). This transmission started in the 1960’s and 1970’s for Taiwan and South Korea and was extended to the ASEAN economies after the endaka. In Thailand for example, Japanese firms opened joint-ventures in the textile sector. Progressively, they lost their dominant position as Thai capital accumulated and the Thais gained the necessary technological skills. Thai firms then began to phase out progressively their Japanese partners (Yoshihara, 31). More generally, the rising value of the yen implied a further use of locally produced parts. This forced the establishment of quality circles in local subsidiaries (Doner, 180), which in turn led to an improvement in local production standards and in the technological skills of the local staff. All these facts clearly indicate the existence of a diffusion of technological knowledge. The real question is, was it sufficient to create

52

indigenous innovative capacities?

In the cases of Taiwan and Korea, some firms have managed to transform themselves into global competitors in capital-intensive and high-tech manufacturing sectors. chaebol like Samsung, LG or Hyundai and Taiwanese firms like ACER have become internationally well-known brands. The chaebol have opened subsidiaries in North America and Europe. For the other Asian economies, no domestic firms have yet managed to reach that technological level or to open as many subsidiaries outside the East Asian region. Yet, some Thailand-based firms are important exporters of electronic goods and Malaysia has created its own car industry. These are obvious signs of industrial development that are not yet matched by any other region in the world.

6.2. Indigenous innovative capabilities in Taiwan and South Korea

The South Korean and Taiwanese firms have achieved astounding success but this needs to be put into perspective. All of these firms still depend on Japanese technology for high-tech inputs and machinery (Yamamura, 88). The example of Samsung is enlightening. Samsung is considered to be an exception in South Korea for its massive investment in high tech capacities (Yamamura). It has pursued a risky and determinate policy to invest in long-term research in the US despite heavy short-term losses (Hobday, 82). Nevertheless, it still lacks the design skills to produce key final goods in the computer industry. It is still dependent on Japanese and US imports of high-tech machinery (Hobday, 85). By the end of the 1990’s Samsung did not possess the R&D capacities to go beyond incremental innovation in mature and mainstream products (Hobday, 87). The scope of its products was still limited in 2002, although the firm was still engaged in ambitious R&D plans to extend its expertise and catch up with its Japanese competitors (Dicken). In his thoughtful study of technology diffusion in East Asia, Hobday concludes that, as late as the mid 1990’s, the chaebol were still far behind their Japanese competitors in terms of R&D, science, key components and advanced raw materials (Hobday, 90). Despite strenuous efforts to reduce their dependence on Japanese technology and South Korea being the most important R&D spender among the Asian NICs, the structure of the bilateral Korean-Japanese trade indicates that there is an important trade deficit in high-tech products on the Korean side (Liu, 157). Through their interviews, Yamamura and Hatch have found that many South Korean economists and businessmen believed that the technological gap between South Korea and Japan was actually widening in 1997 (Yamamura, 90). The Asian crisis of 1997 did not improve this situation as the restructuring of the chaebol became the priority.

The situation of the most advanced Taiwanese firms is no different. Taiwanese leaders like ACER have acquired companies in the USA in order to improve their innovative capacities but have met little success because of the different management styles, the lack of motivation of American staff or because the best US researchers moved to other US companies (Gee, 37). ACER has tried to develop its brand worldwide. In 1988, as much as 60% of ACER’s output was sold under its own brand but this strategy generated heavy losses. ACER had to scale down its operations and reduce the share of “own-brand” sales (Hobday, 116). Like their South Korean competitors, Taiwanese firms still have to rely heavily on Japanese high-tech equipment and key inputs (Hobday, 108).

6.3. Indigenous innovative capabilities in the rest of East Asia

For the other East Asian economies, the dependency on the Japanese TNCs is much stronger. Apart from

53

Taiwan and South Korea, Singapore is the only economy of the region, which had an ambitious education program to improve the skills of technicians and engineers (Yamamura, 83). But for three decades, this policy aimed mainly at providing foreign TNCs with skilled local personal rather than to support the creation of indigenous manufacturing firms (Hobday, 141). The recent change of government policy during the late 1980’s has modified this situation but the new Singapore-based TNCs are developing mainly in regional services (Nesadurai II, 87). To pursue this strategy, they do not require the highest level of management and scientific skills. This implies that Singapore is still very much dependant upon Japanese and Western technology. The other Asian economies have not invested sufficiently to build a technological and scientific base comparable to Japan or even South Korea. The share of skilled workers among the domestic workforce of most ASEAN economies (except Singapore) was still very low by the late 1990's. In Malaysia (which is considered more advanced than Indonesia or the Philippines), this figure only reached 2.4%, far below the take-off stage that advanced economies like Japan experienced decades before (Yamamura, 83).

Many indigenous firms in ASEAN economies are completely dependent on their Japanese partners even those which are strongly protected and subsidised by their government. Within the ASEAN economies, indigenous high-tech industries able to compete on the global markets have not emerged yet despite decades of intensive industrial policies.

Since 1971, Malaysia has been pursuing a nationalist policy to support indigenous Malay entrepreneurs and upgrade the indigenous industrial capacities. This policy, named the New Economic Policy (NEP), forced foreign investors to develop through joint ventures with indigenous Malay. The Japanese TNCs actually adapted far better to that situation than the Western firms, which preferred to open fully owned subsidiaries (Yoshihara, 24). In the 1990’s, the Malaysian Prime Minister Matathir Mohamad, who was one of the main designers of the NEP, eventually admitted that this highly costly policy was not reaching its original goal of creating an innovative and competitive class of Malay entrepreneurs. Rules on FDI were relaxed throughout the decade (Jones, 114). In early 2000, the last remnants of the NEP were being progressively phased out (FT, Malaysia Report 2003). Malaysian firms are still totally dependant on TNCs in high-tech sectors. A good example of this development is the Malaysian Proton Saga carmaker, which was considered by Matathir as a key project to develop an autonomous indigenous capital-intensive industry. It was a developed under a joint-venture between the state-owned Heavy Industries Corporation and Mitsubishi Motor Corporation. Despite local content rules, MMC was able to disqualify indigenous producers by imposing strict quality control that only its traditional subcontractors could achieve (Yamamura, 35). At the end of the process, the Japanese TNC had the effective control of the joint-venture. Proton Saga was incorporated in the regional network of MMC’s subsidiaries and produced door panels for other MMC subsidiaries (Yamamura, 35). In 2003, Proton Saga was still dependent upon foreign technology. Most analysts do not believe it capable of competing on the global market (that is, without the strong domestic barriers that protect it presently) (FT Malaysia Report 2003). It is even less probable that the Malaysian engineers alone could develop the new models of the Proton in the near future.

During the 1990’s, the Indonesian authorities tried to imitate the Malaysian NEP. They adopted a strong industrial policy to support the emergence of high-tech indigenous groups in order to diminish their reliance on foreign technology (Nesadurai II, 120). In 1989, General Suharto gave the supervision of ten state-owned companies in transport, telecoms and defence to the minister of research Dr Habibie (Jones, 123). This included an aeronautics firm in charge of developing a prototype for a commercial airplane, the

54

N-250. Most of these projects were controlled by close members of the Suharto family and ended in failure. The crisis of 1997 forced the Indonesian government to scale down its subsidies and to open further their market. The Japanese TNCs continue to be the main supplier of technology to Indonesia.

The Philippines with the small size of its economy and being one of the least developed countr ies of the region could not hope to build indigenous autonomous technological innovation capacities. They adopted many protectionist measures to pursue an import-substitution industrialisation for decades but are still dependent upon Japanese and US technology. No Filipino firm is expected to transform itself into a global competitor in a foreseeable future.

Thailand has been a more open economy than the other large ASEAN member states. It adopted exported-oriented policies with an important reliance on FDI in the 1970’s (Katzenstein, 226). After the endaka, Thailand became one of the most important destinations of Japanese FDI in Asia. The Japanese government designed a “new aid plan” for Thailand, which provided loans and facilitated administrative procedures for the relocation of activities by Japanese firms to Thailand (Katzenstein, 228). The Thai conglomerates became partners in joint-ventures established by the Japanese firms which controlled the technology. An example of the Japanese technological and management control on large Thai firms is the Thai corporation Jubao Electronics. It is one of Thailand's most successful exporting firms but the patents of their products are held by the Japanese TNC Sharp which imposes the technical specifications, Jubao's production is handed to Sharp for world wide distribution and it is sold under the Sharp brand (Yamamura, 57).

6.4. Japan, the uncontested flying geese leader

Japan remains the technological leader of Asia. The webs that the Japanese TNCs have built through the regionalisation of their production process have generated technological spin-offs but these were far from giving the other Asian economies a sufficient scientific and technological base to develop indigenous innovation capacities in most of the high-tech sectors. The dependency of Asian economies on Japanese technology is much higher than what FDI figures could imply. Technology licensing accounts for a substantial part of the Japanese firms activities in East Asia (Yamamura). The pattern of trade clearly indicates this dependence. Japan maintains a trade surplus with all its East Asian partners. Among the East Asian economies, Japan has got by far the highest share of high-tech products in its total exports (Fukasaku, 17). Japanese exports machinery and high-tech inputs to the East Asian economies , which in turn process manufactured goods and export them to the global markets. The East Asian economies finance their trade deficit with Japan, their trade surplus with the Western economies.

55

J apan's trade balances with its East Asian partners

-5000

0

5000

10000

15000

20000

25000

30000

1960 1970 1980 1990 2000 2002

mill

ions

of e

uros

ASEANSouth KoreaChinaTaiwan

Source: IMF

The level of development (and when they were touched by waves of Japanese FDI), of the indigenous firms of East Asian countries determines whether they produce more capital-intensive goods (South Korea and Taiwan) or more labour-intensive ones (ASEAN except Singapore). Indigenous entrepreneurs from Hong Kong and Singapore, thanks their traditional role as regional warehouse, have specialised in regional services. The Japanese TNCs have constituted their regional webs through FDI and licensing in which they control the technological diffusion (Yamamura, 102). They have created a regional division of labour in which Japanese firms control most of the operations in R&D, international management, international distribution and in advanced financial services. The R&D facilities and the headquarters of the keiretsu are carefully maintained in Japan (Yamamura, 103). Japan certainly has managed to develop and to keep dynamic clusters in R&D or "Marshallian districts" that provide external economies of scale in technological innovation. In the early 1990's, Japan ranked second in the world in scientific publications while South Korea was not even in the top 30 with less than 4% of the number of Japanese publications (Hobday, 64) and the gap has not been reduced during the rest of the decade (Yamamura, 90). The Japanese flying goose does not seem to be ready to give up its place as leader of the gaggle.

Dependence on Japanese technology is an issue for most governments in the region. Many officials and indigenous business leaders complain about the limited transfer of technology and know-how by Japanese TNCs. There are considered across East Asia to have a more reluctant attitude to the indigenisation of top management and research operations (Yamamura). Some Asian economies are trying to reduce their reliance on Japanese technology but so far, their success has been mitigated. The most obvious successes were achieved by some of the chaebol, which have managed in a narrow range of products to gain indigenous innovation capacities. Taiwanese firms most probably rank second after the chaebol but their small size and their reliance on Japanese (and US) key high-tech inputs and distribution networks means that they do not benefit from the same level of autonomy enjoyed by their Korean counterparts. The other

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East Asian economies have never really tried (Singapore, Thailand or Hong Kong) to build their own technological innovative capacities or have clearly failed (Malaysia's NEP and Indonesia Habibie's high-tech projects). Singapore, Hong Kong and Taiwan are the three economies that managed best to keep alternatives sources of technology by hosting many Western TNCs but this has not reduced the reliance on foreign technology.

Even though, this section has focused on technological innovation capacities in manufacturing, Japanese supremacy in East Asia extends to innovations in global services and management. Only some chaebol such as Samsung, LG and Hyundai can be considered as truly global TNCs. Some other Asian firms (from Singapore, Taiwan and very recently China) have only started to operate recently outside the region but their networks of overseas production units and distribution are far from having the complexity of the regional webs created by the Japanese TNCs across the globe. Japanese firms benefit from an important competitive edge in operating and selling abroad over any Asian competitors, even if some chaebol are beginning to catch up in this field.

The gap will not be easily closed in the next decade by the latecomers to the pack of East Asian flying geese for a number of reasons. Firstly, one should not forget that an important part of the post-war technological base in Japan, South Korea and Taiwan was developed with the financial aid and the technological cooperation of the United States. Free transfers of technology and markets for the new high-tech products were available to these three economies because of the context of the Cold War. The less developed ASEAN economies and China cannot expect to benefit from this exogenous factor.

Secondly, it has been shown that most of the successful Korean and Taiwan high-tech firms started to develop in the 1960’s and 1970’s in partnership with TNCs. However, once they had acquired a technological base, the local governments put very strict rules on FDI and in the case of South Korea went as far as to discourage TNCs from staying in some high tech sectors. Japan, Korea and Taiwan adopted very protectionist tariffs and also pursued active industrial policies, which today would be opposed by multilateral institutions such as the WTO or the IMF. The fact that almost all East Asian countries (except Vietnam, Cambodia, Laos and North Korea) have joined the WTO means that they cannot apply such protectionist industrial policies because of the tariffs & trade, the TRIPs, and the TRIMs agreements (Nolan, 61).

Thirdly, the global economic environment has changed compared to the 1960’s and 1970’s. These two decades were characterized by high growth rates in the OECD countries. Most of the FDI flows were directed towards Europe and the US then considered as the main markets. East Asia was not a priority for Western TNCs, some of which were actually divesting out of the region (Yamamura 37 & Yoshihara). Since the 1990’s, Western TNCs have focused much more on East Asia and the US government has adopted a tougher stance on more open rules for trade and investment in the region. It means that the infant industries of the East Asian economies will face much tougher competition on their regional markets than their Japanese or Korean counterparts did.

Fourthly, there is abundant evidence that in most sectors, the minimal efficient size has been rising drastically in the last two decades. The change from fordist methods of production based on standardized mass production to “flexible specialisation” or “postfordist” methods of production have generated an increase in the size of the global TNCs. Albeit the newer emphasis put on product differentiation since the late 1970’s implied the shift to smaller autonomous production units closer to the market they serve, it has

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required more sunk costs in R&D, design and marketing (Oman, 94). Furthermore, these new methods of organisation required more skills in international management to coordinate globally these different regional production units. The shift from fordist to postfordist methods of production implied an increase in fixed costs, naturally accompanied by a need for bigger financial and management resources. This trend is supported by ample empirical evidence for all the major capital-intensive and high-tech sectors (Defraigne II, 225). For the East Asian indigenous firms attempting to transform themselves into global TNCs in the 2000’s, they will have to overcome much higher barriers to entry than those met by the Japanese or even Korean firms two decades ago. Any potential management and technology leapfrogging by indigenous Asian firms will require tremendous resources, which they do not yet possess.

Yet, China could experience a more favourable situation than its ASEAN counterparts because of the sheer size of its economy. Thanks to its potentially huge domestic market, the bargaining position of the Chinese government is stronger in imposing technological transfers by TNCs investing in China. Even disregarding this more advantageous bargaining position, many TNCs prefer to invest R&D facilities in China to improve “time to market” and to be able to react quicker to a volatile demand keen on new differentiated products (Kim & Lee, 16). Some TNCs have recently established R&D centres for product development aimed at the Chinese market (Chen, 13). TNCs are attracted by the cheap price and availability of high-quality Chinese engineers (Chen, 13). No other developing Asian economies can offer such a large pool of trained scientists. This enabled world class firms like IBM, Microsoft and Intel to engage in basic technology research in China in collaboration with Chinese universities and state-funded research institutes (Chen, 14).

This has generated many fears from neighbouring economies such as Taiwan and Korea which are afraid of being technologically leapfrogged by China (Chen, 15 & Nam, 22). Korean economists believe that China’s technological gap behind Korea is shrinking. Some estimate this gap to be around three to five years for many products (Nam, 22). The most pessimistic view was probably expressed by South Korea’s national science and technology committee. It claimed in December 2003 that the country had a technological gap of only 1.7 years over China and that it would be closed within five years (FT, 21/12/2003).

However impressive, one should not overstate the technological advantages enjoyed by Chinese firms. Most of the R&D facilities are being built by TNCs and target product development research. Product innovation and fundamental research are still lagging far behind OECD economies. There is still no Chinese company in the global top 300 in R&D expenditures (Nolan, 47) which is not true for some chaebol such as Samsung. China’s largest firms are still lagging far behind the world class competitors in technological innovation and their spending on research is less than 1% of the largest TNCs in many key industrial sectors (Nolan). Macroeconomic statistics show that most of the Chinese growth is extensive (based upon the use of additional factors of production) rather than intensive (based upon the better combined use of all factors). Wolf estimates that total factor productivity (which reflects intensive growth and technological improvement) only accounts for a small share of Chinese growth during the 1990’s and that this share is actually decreasing (FT, 8/12/2003). According to some IMF analysts, most of the gains of efficiency increases are due to FDI and not to domestic investors (FT, 8/12/2003). There is still no evidence of major Chinese technological leaders in their sectors that could compare with the chaebol in terms of indigenous technological innovation capabilities. Overall the Chinese firms willing to develop world class indigenous innovative capabilities still face the four challenges outlined above. They show no capacity in the mid-run to leapfrog the Japanese TNCs which remain the incontestable technological

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leaders of the region.

7. REGIONAL INTEGRATION DE FACTO AND DE JURE: INTERACTIONS BETWEEN REGIONAL INSTITUTIONS AND THE FDI DYNAMIC

The preceding sections have attempted to highlight the microeconomic dynamic of the East Asian integration process. FDI flows made by Asian investors (firstly by Japanese TNCs, then by the firms based in the NICs) played a central role in creating a de facto economic integration dynamic. It is now necessary to turn to the institutional developments in the East Asian integration process and to examine how they have interacted with the microeconomic dynamic of FDI flows described in the preceding section.

Since the new millenium, there has been a proliferation of regional institutions and trade arrangements in East Asia. Some of them have conflicting objectives or conflicting trading rules. Amid the ASEAN and the APEC, which have both existed for more than a decade, an agreement to create an operational free trade area from 2010 between China and ASEAN was reached in November 2002. Singapore signed many bilateral free trade agreements with Japan in 2002 and with the US in 2003. In November 2003, India and the ASEAN announced a project to build a common free trade area for 2012. There are currently negotiations between China, Japan and South Korea to create a North Asian free trade area (FT, 09/10/2003). Overall, between 1999 and 2002, around twenty proposals were made to create trading arrangements in the region (Nesadurai, 28). This proliferation has generated confusion and uncertainty among private investors. The mutually inconsistent rules and different liberalization schedules mean that a company operating inside one FTA would face different trade rules according to which FTA partners they would export to or import from (Nesadurai, 33). It is necessary to distinguish among these intertwined trade arrangements which ones are consistent with the strategy of private investors operating in the region. In other words, which ones are most likely to be supported by the microeconomic dynamic of regional integration engaged by the Asian TNC's these last three decades.

7.1. The ASEAN

7.1.1. A slow beginning: from 1967 to 1992

The Association of South East Asian Nations (ASEAN) was inaugurated in 1967 between Indonesia, Malaysia, the Philippines, Singapore and Thailand. Although, the joint declaration of the ASEAN made in Bangkok included elements of economic and development cooperation, its main purpose was to insure regional security and contain communist expansion in Southeast Asia (ASEAN). Economic integration was not on the agenda during the early stage (Yue, 285). The institutional framework was very loose and rules were non-binding (Dicken, 158). Since the 1970's, its member states have tried to use it as a mean to increase their bargaining power in international relations. In 1971, the ASEAN proposed to build a Zone of Peace Freedom and Neutrality aimed at preventing “any form or manner of interference by outside powers”. During the Cold war, reliance on the US limited this evolution towards political regionalism but this initiative stressed the will for more autonomy by local elites, especially in Indonesia and Malaysia (Huxley, 37). The ASEAN agreement constrained the possible escalation of tension between member states in the area. Some analysts believe that competing territorial claims between member states (e.g. the

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Philippines claimed sovereignty over the Malaysian state of Shaba) or support of separatist movement s in one member state by another member state (e.g. Malaysia's sponsorship of Muslim-based separatist movements in Indonesia's Aceh, in Philippines' Mindanao and in Thailand's Patani) were checked through regional security dialogue within the framework of ASEAN (Huxley, 35). It is, however, very difficult to see whether the ASEAN framework alone could have achieved this regional stability and to what extent this success can be attributed to the American administration. The US insisted on regional strategic cooperation among the ASEAN members as it could not afford another conflict among its allies while communism was spreading in Indochina. Nevertheless, it is certain that the relative regional stability of the ASEAN made it a favourable environment for FDI. Japanese investors quickly dominated the region except in Singapore and in some sectors where Western firms still benefited from better ownership specific advantages in activities such as pharmaceuticals or toiletries (Yoshihara, 23).

An ASEAN Preferential Trade Agreement was reached in 1977 but it was never effective as member countries each pursued their import substitution policies. It had only a marginal impact on intra-ASEAN trade (Yue, 287). In the 1970's, the Japanese investors were still adapting to the import substitution policies aimed at serving the local domestic market and had not yet regionalized their production process. Most of these economies were competitive rather than complementary. They had quite similar endowments of production inputs and trade structures except for Singapore. All ASEAN member states were afraid that, if left to the market forces, the regional specialization process would advantage Singapore too much (Yue, 288). The 1977 agreement did not correspond to a dynamic of regional integration supported by enterprises, whether state-owned or private indigenous or the foreign enterprises. The first attempt to impose "from above" an institutional framework in order to encourage regional economic integration was a failure. Another proposition to establish a Free Trade Area came ten years later at Third ASEAN summit in Manila and was rejected again (Nesadurai II, 80).

7.1.2. The launching of the AFTA

The third attempt was made in the end of 1991. Thai PM Panyarachun and Singapore PM Goh Chok Tong launched the project of an ASEAN Free Trade Area (Nesadurai II, 53). In January 1992, an agreement to establish an ASEAN Free Trade Area (AFTA) for 2008 was ratified at the ASEAN summit held in Singapore.

By that time the global and regional contexts were completely different. Firstly, the import-substitution strategy was being abandoned by most developing countries after the debt crisis of the 1980's and because of strong pressure from multilateral institutions - mainly the IMF, the World Bank and the GATT - (Kolko, 258 & Vanderwee, 496). The new post-fordist methods of production encouraged the emergence of regional free-trade areas because TNCs were dividing their global production capacity into more autonomous regionalized production networks (Oman). Many technocrats and officials across developing industrializing countries understood that belonging to a large regional integrated market was an important factor in attracting the TNCs to operate in their region and to transform the latter into an export platform targeting the OECD markets. The ASEAN leaders were conscious of this fact. Europe was about to launch its Single Market and the NAFTA project was made public in 1991 (Nesadurai, 16). They knew that they were facing serious competition in attracting FDI from Latin America, Eastern Europe and China (Yue, 286). China was already considered as the major threat (Nesadurai II, 80). To face this competition, the ASEAN economies had to achieve a higher degree of economic integration.

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The regional context was also different. Since the endaka, the Japanese TNCs had already started to set up a regional network of subsidiaries across the ASEAN member states. Japanese investors had not been active participants in the deliberation prior to the declaration and were pessimistic about the viability of the project. Some have suggested that the Japanese TNCs did not favour such as institutionalised integration. They might have feared loss of their comparative advantage based upon their unique informal regional network to their Western competitors (Nesadurai II, 79). A clear regional institutional framework could ease entry for outsiders by reducing the transaction costs for operating at the regional level. Nevertheless, once the decision was ratified, the Japanese government agencies and the Keidaren gave their full support to the project (Nesadurai II, 79).

Despite these changes, initial implementation of AFTA was still very slow. The problem of competing rather than complementary economies was slowing down the process. Most member states were still defending their indigenous state-owned or private firms and feared increased intra-ASEAN (mostly from Singapore) or extra-ASEAN competition. As soon as the agreement was ratified, many nationalist protectionist resistances began to emerge in Thailand, Indonesia and Malaysia to halt the process of intra-ASEAN trade liberalisation (Nesadurai II, 57). Nesadurai explains this resurgence of protectionism: “politically important domestic distributional coalitions are, in fact, sustained by a set of bargains between political and business elites that ultimately depend on economic growth generated by export industries. During much of the 1990’s, the competitive export-oriented sectors in Southeast Asia, often driven by FDI, helped to maintain the viability of sectors, usually in service-related or non-tradable sectors, in which politically-connected domestic actors were dominant” (Nesadurai, 6). Thus ASEAN governments faced a dilemma. On one hand, political stability implied a quick growth based on exports, mostly made by TNCs. Continuing to attract FDI was a necessity and AFTA was seen as the most efficient way to resist FDI diversion to China. On the other hand, the AFTA threatened the interest of some protected indigenous or local ethnic-Chinese capitalists with good political connections. This explains the stop-and-go implementation of the AFTA during the early 1990's.

Originally, the largest part of the AFTA agreement was dedicated to the establishment of a Common Effective Preferential Tariff (CEPT). The CEPT imposed the reduction of tariffs on manufactured goods from ASEAN member states to between 0-5 per cent by 2008. Thus, the implementation of the CEPT would be made progressively over a fifteen year period (Nesadurai, 16). The CEPT was not very binding. It was a simple document of intent without laying down precise technical recommendations on how to achieve the tariffs reduction, contrary to the NAFTA documents, which contained over 2000 pages of technical details (Yue, 289). The CEPT guidelines enabled local governments to exclude "temporarily" an unlimited number of products from the liberalisation scheme (Nesadurai II, 54). This flexibility enabled strong domestic pressures to slow down the implementation (Yue, 289).

However, after the confirmation of China's economic reforms in 1992, the threat of FDI diversion became more concrete. In 1993, Japanese FDI in China was almost as important as in the ASEAN (Japanese Ministry of Finance). China's share of the total FDI flows to developing countries rose from 10.5% to 34.9% from 1991 to 1993 while the share hosted by the ASEAN plummeted from 32.1% to 20.3% (Nesadurai, 81). Chinese competition became even fiercer after the devaluation of the RMB in 1994 (Yoshihara 1999, 6). Thus this overly flexible implementation weakened the credibility of AFTA among foreign investors (Yue, 289). This together with the rising Chinese threat pushed the ASEAN governments to decide to accelerate the pace of regional integration in 1995. The crisis of 1997 accelerated this trend in liberalisation of intra-ASEAN flows of trade and investment but it also increased

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the openness of the AFTA to extra-ASEAN flows (Nesadurai II, 61). Finally, the slowing down of the US economy after the NASDAQ crash and the recession of the Western economies that followed accelerated the liberalisation to extra-ASEAN investors (Nesadurai, 27). In the second half of the 1990's, the level of integration among the ASEAN economies deepened and the scope of economic flows that fell under the control of the AFTA's institutional framework extended substantially.

7.1.3. The extension of AFTA

Firstly, after the fifth ASEAN summit in 1995, the CEPT implementation was more clearly defined and accelerated. The transition period was shortened by five year and now ended in 2003 (Yue, 292). The rules over the temporary exclusion of products from the CEPT were tightened and quantitative objectives were set to reduce the list of excluded products by 2000 (Nesadurai II, 59). In 2002, 96% of the tariffs had reached the CEPT objective. Average tariffs have fallen down from 12.8% in 1993 to 2.9% in 2002. In 2002, there was a 5-15% difference between the average most-favoured-nation tariff rates given to GATT members and the AFTA preferential tariff rates (Nesadurai, 17). This shows that ASEAN members liberalised their internal trade faster than the WTO members, despite the significant achievement in trade liberalisation made in the Uruguay Round in 1994. Another advance was the inclusion in the CEPT of unprocessed agricultural products (Nesadurai II, 59).

The fifth summit also saw the creation of three new agreements to increase the economic integration of the ASEAN. The first was the ASEAN framework Agreement on Services (AFAS) whose objective was to build a free trade area in services by 2020 (Nesadurai II, 60). The summit also laid down the foundations for an ASEAN Investment Area (AIA). The objective is that any investor based in a member state will not have to face the national investment restrictions of another member states by 2010. Originally, the 1995 agreement foresaw the lifting of national restrictions on investment of each member state by 2020 for extra-ASEAN investors, thus ten years after ASEAN investors (Nesadurai II, 61). The third agreement was the ASEAN Industrial Cooperation Scheme (AICO). Under the AICO, companies located in different ASEAN member states, involved in joint industrial production (i.e. one company producing component for the other) or exchanging products would enjoy tariffs between 0 and 5%. This facility encouraged the development of the regionalisation of production process across the ASEAN member states. At first, the AICO facility could only be used by firms who had 30% of their shares owned by nationals but an exception was soon granted for firms already operating in the region (Nesadurai II, 61).

7.1.4. AFTA as a tool to create ASEAN global champions

For a time, the AFTA and the other agreements were also designed to leave indigenous large firms a possibility to expand on larger markets and transform themselves into global competitors (Nesadurai II, 113). In this perspective, preferential treatment would be granted to ASEAN investors in order to create ASEAN TNCs before opening ASEAN fully to investors. Of course, there were differences among members, Singapore which had little indigenous capital in manufacturing and had adopted a strategy of developing regional services for TNCs operating in the ASEAN favoured a quick opening to extra-ASEAN investors while Malaysia, Indonesia and Thailand wanted a long transition period between the liberalisation of FDI from ASEAN firms and lifting the restrictions to extra- ASEAN FDI (Nesadurai II, 114).

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This strategy of building ASEAN champions before lifting investment restrictions to extra-ASEAN TNCs was soon abandoned after the 1997 Asian crisis, the slowing down of the world economy and the continued rise in FDI diversion to China. In 2001, the ASEAN countries only hosted 13% of total FDI inflows to developing countries while China’s share was 2.5 times larger (UNCTAD). A clear sign had to be given that foreign investors were needed in the ASEAN. In 2001, the AIA agreement was modified in order to suppress the transitory period of ten years between 2010 and 2020 where ASEAN investors would no longer face national investment restrictions while extra-ASEAN investors continued to do so (Nesadurai II, 64). In this new version, foreign investors would receive the same treatment than ASEAN investors in 2010. ASEAN firms operating in the manufacturing sector would receive national treatment as early as 2003 (Nesadurai II, 64). This created a new transitory period of seven years in which ASEAN investors would enjoy preferential treatment over their non-ASEAN competitors. However, two things diminished the impact of this discriminating measure. Firstly, in the aftermath of the 1997 crisis, many restrictions were lifted by the most protectionist member states such as Indonesia. Secondly, there was no common definition of an ASEAN investor (Nesadurai II, 115). Some countries considered a joint-venture as a full ASEAN firm. Singapore and Thailand considered that a 30% "national equity share" was sufficient. This meant that TNCs already engaged in joint ventures in manufacturing activities could develop their activities in the region more easily than the potential entrants. In effect, the AIA and the AICO agreements strengthened the position within the ASEAN of Japanese and Asian NICs investors over Western TNCs. The former already had a stronger presence in the region and were more engaged in joint-ventures or in non-equity forms of investment than their Western competitors which privileged their development in the region through the establishment of fully-owned subsidiaries.

7.1.5. The ASEAN achievements

Although ASEAN has managed to enforce the Common Effective Preferential Tariff and to facilitate intra-ASEAN trade, it is still far from having built a single market comparable to Europe or NAFTA. There are still considerable NTBs such as customs surcharges, technical standards or requirements and state licensing or monopoly arrangements (Nesadurai II, 57). Efforts were made in the late 1990's to harmonise technical standards. An ASEAN Framework Agreement on Mutual Recognition Arrangements was reached in December 1998. It focused on twenty products - mainly electronics, telecommunication equipment and rubber - and adopted the international standards already available (Nesadurai II, 71). The liberalisation package imposed by the IMF in the aftermath of the 1997 crisis lifted many national monopolies and licensing agreements (Nesadurai II, 71). Despite these significant improvements, many NTBs remain. During the ASEAN summit of Bali in October 2003, the Singapore PM Goh Chok Tong still claimed that most businesses did not use ASEAN preferential trading rules because applying them cost too much in terms of delays and red tape (FT, 08/10/2003). This view is shared by many enterprises in the region. In early 2003, Mc Kinsey & Co claimed in a report that most business leaders still considered Southeast Asia as "a disparate mix of 10 largely distinct markets" (FT, 03/10/2003). A further attempt to eradicate NTBs was launched after the summit in order to accelerate the vertical integration of 11 priority sectors including the automotive, electronics, wood, rubber, textile, tourism and selective services industries such as healthcare by 2010 (FT, 08/10/2003)

Overall, the institutional framework of the ASEAN has made a substantial contribution to integrating the economies of Southeast Asia. During the 1990's, intra-ASEAN trade developed faster than extra-ASEAN trade (IMF). Surveys made by the Economist Intelligence Unit and by the Far Eastern Economic Review

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in the late 1990's have shown that the majority of the firms (more than 70%) considered that AFTA had a strong or moderate impact of their operations while only a handful of firms considered it as irrelevant (6% of the respondents) (Nesadurai II, 185). By lowering tariffs and lifting investment restrictions, the ASEAN has helped considerably the TNCs’ firms, which already operated locally, to smoothen the regionalisation of their production process.

Share of the intra-ASEAN trade in the foreign trade of all ASEAN economies

0

5

10

15

20

25

30

1960 1970 1980 1990 2000 2002

% importstrade

Source: IMF

Despite this, ASEAN has not managed to reverse the trend of investment diversion to China. Its share of FDI inflows to developing countries as a share of total world FDI inflows continued to fall while China’s was rising until 2003 (UNCTAD). In February 2004, the Japanese TNC Matsushita was planning to cut its ASEAN sales and production sites by about 40 per cent and relocate them to China. The company declared that: "South-east Asia is becoming more expensive than China. Unless Matsushita takes greater advantage of lower costs in China, it will not be able to compete with low-cost Chinese manufacturers like Haier and TCL" (FT, 06/02/2004).

However, this trend is not certain to continue and the share of flows to the ASEAN countries could be stabilized soon. Studies made by the JETRO and the Japanese Export-Import Bank reveal that most of the Japanese TNCs already established in the ASEAN will not relocate their activities to China. No more than 8% of the TNCs surveyed considered the possibility of relocating part of their ASEAN operation to China and only 2% were thinking of ceasing their ASEAN activities and relocating them in China. The majority of the firms surveyed, especially in the automotive and the electronics industries, considered that they would continue to develop in the ASEAN to take advantage of the emerging large integrated market generated by AFTA (Nesadurai II, 185). Japanese investors could adopt what Nesadurai calls a “two-pronged” strategy in East Asia focused on both China and the ASEAN (Nesadurai II, 185).

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7.1.6. The prospects for the ASEAN: Towards a deepening or dilution?

The ASEAN governments have decided to deepen the regional integration but the process is still slow. The ASEAN summit in October 2003 produced many highly symbolic developments and various new projects to liberalise trade in the region. A new agreement named the “Bali-Concord II” has declared the intention of the ASEAN member states to build an “ASEAN Economic Community”. During the negotiations of the summit, Thailand and Singapore have pushed for the creation of a single market without NTBs for goods in 2010 and for services in 2012. However, this initiative met opposition from Indonesia, Vietnam, Laos and Burma (FT, 03/10/2003 & Le Monde, 08/10/2003). The final target was postponed to 2020 with the creation of an “ASEAN Economic Community” in which free flows of goods, services and investment (FT 08/10/2003). Despite the slow pace of this new agenda, this declaration was highly symbolic as it made an explicit comparison with the European integration process. Indonesian president Megawati Sukarnoputri has claimed that it was “a watershed in ASEAN history” (FT 09/10/2003).

Despite the enthusiasm displayed at the Bali summit, many analysts have expressed their scepticism about the project. Compared to the European Union's experience, the ASEAN has only reached an early and basic stage of integration. The ASEAN can be compared to the European Economic Community in 1968, when the Common Market had been established for ten years. Most tariffs had been suppressed but many NTBs still remained and were preventing the creation of an integrated single European market. The level of supranationality, (that is, the amount of prerogatives that member states allow to be transferred to the supranational institution for their regional integration) is still very low.

The deepening of the ASEAN integration faces serious obstacles. Some new members like Vietnam and Myanmar lag far behind economically and lack the skilled technocrats necessary to enforce the suppression of NTBs and to participate in a complex supranational institutional framework (FT 09/10/2003). Furthermore, many member states are still protecting some key industries (e.g. the automotive industry for Malaysia and petrochemicals for the Philippines). But these might not be the main obstacles on the path to achieving an “ASEAN Economic Community” based on the European Union's model. European integration was mainly pursued to enable the European TNCs to reap the efficiency gains provided by a large domestic market like their US -and later Japanese- competitors (Defraigne, 708). The position of indigenous capitalists in the ASEAN in 2004 is much more precarious than the one of the European TNCs in the Common Market of 1958. AFTA and the other agreements aimed at integrating the ASEAN economies have not really enabled ASEAN firms to transform themselves into global TNCs. No ASEAN firm has managed to reach global dimensions in their sector of activity. Even Singapore’s strategy based on providing regional services to TNCs operating the region has not yet proven itself successful because of the very slow liberalisation in services (Nesadurai, 25). Foreign firms are well entrenched in the ASEAN economies. They have a dominant position in high-tech and export sectors in all the ASEAN economies and have taken advantage of the integration agreement to improve their penetration of the AFTA. One could claim that the US TNCs were also very present in Europe during its integration process but there were major differences. The technological gap between ASEAN firms and TNCs today is probably greater than the one between the US and the European firms during the deepening of the European integration from the 1960’s to the 1990’s. The size gap between the largest European and US firms of the same sector was actually being reduced during the process of European

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integration (Defraigne II, 263). However, such trends cannot be perceived between the largest TNCs and the largest ASEAN firms. Thus, while the dynamic of European integration has been largely supported by the largest European firms, the dynamic of the ASEAN has been much more supported by foreign TNCs operating in manufacturing.

The weak ASEAN indigenous capital might not be able to resist the centrifugal pressures, which begin to emerge against the ASEAN institutions and threaten to dilute the AFTA. Since the new millennium, the ASEAN as a whole and individual member states have been engaged in other FTA arrangements.

In 2001, the ASEAN negotiated with China the launch of an operational bilateral FTA for 2010. This move has both political and economic purposes. Generally, the ASEAN economies fear becoming more isolated by a rising Northeast Asia. Politically, a FTA might be the way to increase economic interdependence and reassure ASEAN states about China's foreign policy in Southeast Asia. It means that China will give more consideration to the ASEAN when engaged in international negotiations and possibly to the creation of a China-ASEAN front in order to strengthen their bargaining position. The ASEAN leaders might also want to avoid forcing foreign investors to have to choose between ASEAN and China as they fear the latter will be more attractive. TNCs engaged in FDI to cover the Chinese market could still opt for locating their subsidiary in the ASEAN. This could prove to be a successful bid in stopping FDI diversion to China especially as it could encourage TNCs to adopt the "two-pronged" strategy described above, towards operating in East Asia. However, the building of an effective ASEAN-China FTA is still far from certain. There will be numerous substantial NTBs that constitute more important obstacles than tariff barriers. They would represent more two competing economic entities than complementary one which implies that indigenous firms in numerous sectors would lobby their domestic governments for protection, causing considerable delays in the implementation of any FTA and possibly halt the whole process. If TNCs do not adopt the "two-pronged strategy", then FDI diversion could accelerate. ASEAN governments are therefore treating this issue very cautiously (Nesadurai II, 181).

ASEAN has also been negotiating to lower barriers impeding its bilateral trade and investment flows with Japan. At the 2003 ASEAN summit in Bali, the ASEAN and Japanese governments clearly reaffirmed the link between their economies (FT, 09/10/2003). Singapore has already signed a FTA agreement with Japan in 2002 which indirectly increases the integration between Japan and the other ASEAN economies.

Finally, also at the 2003 Bali summit, the ASEAN countries have also launched a project to create a FTA with India by 2012 (FT, 09/10/2003). From India’s perspective, it would seem to be natural to avoid being left out of the regional integration processes going on in the world. While a South Asia integration framework has been established in early 2004 between India, Pakistan, Bangladesh, Nepal, Sri-Lanka, Bhutan, and the Maldives, this is only the first step of a long and uncertain process that could be blocked by remaining geopolitical tensions over the Kashmir or the Tamil guerrillas in Sri-Lanka. Trying to improve links with the dynamic East Asian integration might benefit India. Although there are evident cultural connections between Indian and Sri-Lanka minorities in Malaysia and Singapore, ASEAN trade with India is not very important. While in 1960, India ranked 5th among countries exporting to ASEAN, it dropped to the 21st place in 1980 and had only regained 16th place by 2000. For the ASEAN side, India ranked as the 5th destination for their exports in 1960 and had dropped to 20 th place by 1990. Over the last few years, Indian governments have increased the openness of the Indian economy and have tried to boost Indian exports. In 2002, India was ranked in 10th place for imports and 8th place for exports. Nevertheless, it still lags far behind the main ASEAN trading partners. The bilateral ASEAN trade with

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India amounted to less than 11 billion euro compared with 128.8 with the USA, 117.8 with Japan, 106 with the EU, 54.7 with China and 37.1 for South Korea (IMF). India poses a quite similar problem as that of China in that it offers no obvious complementarities with the ASEAN economies, which could lead to the emergence of strong domestic protectionist lobbying pressures on both sides. Existing qualitative studies and surveys have not yet revealed a strong intra-firm regional trade between the ASEAN and India. No major global TNCs seem yet to have regionalized their production process across the ASEAN and the Indian peninsula. At present, there is no obvious strong microeconomic dynamic that would push forward the integration of the ASEAN and the Indian economies. It is therefore very difficult to assess the prospects of this new project and how it might affect the East Asian integration dynamic.

Apart from these FTAs launched by the ASEAN, there are other trade arrangements made by some of its individual member states. Both the Thai and the Singapore governments have expressed their disappointment over the distant target date of 2020 for the completion of the ASEAN economic community. (FT, 06/10/03). They have begun to lift the barriers between their two economies in various sectors such as logistics, banking and telecommunications. The frustration of Singapore over the slow pace of liberalisation in services by the other ASEAN economies has also driven the city-state to launch other bilateral FTAs with Japan in 2002 and with the US in 2003 (Nesadurai, 31). The Singapore bilateral FTAs are very comprehensive as they includes services, FDI and government procurements. This development is likely to strengthen the weight of foreign TNCs in the ASEAN. In 2003, Thailand launched a special FTA with China covering a limited scope of products.

This recent proliferation of FTAs increases the risk of dilution of the ASEAN due to a "spaghetti bowl" of competing trade arrangements before it can reach the next step of integration with the establishment of the "ASEAN economic community". The dissatisfaction of some members like Singapore and Thailand over the slow pace of liberalisation and the scepticism of some investors over the "ASEAN Economic Community" means that the ASEAN institutional framework could quickly become irrelevant. The European integration process was subjected to similar pressures. The Common market faced competing free trade areas projects. Some officials of the US Kennedy administration advocated a transatlantic FTA in the early 1960's. However, this move was fiercely opposed by France on the ground that it would dilute the Common Market and therefore prevent European firms from catching up with their American competitors (Camps 129, Olivi, 92). The British also launched the European FTA between the Western European economies that did not belong to the Common market. The European Economic Community and the EFTA later created a FTA called the European Economic Area and finally most EFTA members joined the EU. But compared to the EU, the ASEAN has opted for a more "open regionalism" and has taken the risk of simultaneously launching many intertwining FTAs while having reached only a limited degree of supranationality and centralisation. There might be little choice. Indeed, the dynamic of integration in East Asia extends much further than the ASEAN and its institutions might not be sufficiently broad to contain it. Rather than be broken or overwhelmed by this dynamic of regional integration, the ASEAN governments and business leaders are trying to continue to play a pivotal role and to improve their bargaining power in this process. Some of them are probably conscious that the institutional forms that will most efficiently support and regulate the East Asian integration dynamic have still not been shaped and that the contribution of the ASEAN in the process is still uncertain. ASEAN could possibly end up playing a role similar to that played by Benelux in the early stages of the European integration process.

7.2. APEC

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The second oldest regional institutional framework in East Asia is the APEC. APEC was first initiated in 1989 by the Australian and Japanese governments who feared a more difficult access to their traditional exports markets due to a conjunction of factors. The launching of the Single European Market and the extension of the US-Canada FTA to Mexico generated fears of a world divided between closed regional economic blocks (Nesadurai, 8). Asian governments were also increasingly worried over rising US unilateralism. Washington was pushing the ROK and Japan hard to open their domestic markets (Ito 372 & Nesadurai, 9). Finally, the failure in Montreal of the Round’s mid-term review, led to a sense of crisis in East Asia (Nesadurai, 9). The Japanese government wanted to create a stronger link between the Asian exporters and their main overseas market, the United States.

These gloomy perspectives over the access to global markets were soon short lived however. Having achieved their Single Market, the European economies continued to open up and to liberalize their economy. The Uruguay round of negotiations resumed and ended beyond all expected successes with the Marrakech Agreement. The institutional framework for multilateral trade talks was reinforced through the creation of the WTO. Finally, many Japanese and South Korean companies reorganised their production network in North America in order to adapt to NAFTA. The need for a stronger institutionalised economic link between East Asia and the US became less obvious.

Within the framework of the newly launched APEC, the US government advocated binding rules on liberalisation but faced strong opposition led by the ASEAN. Finally, the APEC adopted the concept of "open regionalism" which implies that reciprocity is not required for APEC members making trade liberalisation offers (Higott 97, 77). Open regionalism was praised by many Asian leaders for avoiding trade diversion and for encouraging trade liberalisation beyond the APEC members. Concretely, it meant that APEC would not design legally binding trade agreements. By 1991, the Asian economies had managed to transform the APEC initiative into a merely consultative forum (Nesadurai, 10). The result was that: “APEC’s modus operandi is ‘all flexibility and no rigidity’, which many scholars argue has reduced its capacity to offer (…) an effective mechanism for regional trade liberalization” (Nesadurai, 12).

APEC formulated a goal of free trade for 2010 for developed members and for 2020 for non-developed members. Individual Action Plans (IAP) would be made by each member country to reach that goal. However, these IAPs did not go beyond the Uruguay round commitments (Nesadurai, 13). Another plan made in 1997 called the "early voluntary sector liberalization" also ended in fiasco (Nesadurai, 14). On the issue of FDI, the APEC agreed on some "Non-Binding Investments Principles" but those contained too many loopholes to be efficient and enforceable (Nesadurai, 15). At the same time the rapid liberalisation of FDI within the ASEAN and the acceleration of reforms in China clearly made redundant some of the APEC liberalization objectives.

After having failed to enforce concrete measures on trade and investment liberalisation, the APEC focused more on trade facilitation and technical co-operation from 1998 onwards (Nesadurai, 15). The last APEC summit in 2003 has not made any significant breakthroughs on the most important economic issues. Rather than trying to find mechanisms to resolve sensitive issues like the US trade deficit, the recent unilateralist US protectionists, or the under-valuation of the Asian currencies measures, the only result the summit could produce was a declaration on the necessity to fight jointly the so-called “war against terrorism” (FT, 22/10/2003). But even on this there was already an existing consensus as many

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APEC members already use this rhetoric to fight secessionist and radical-Muslim movements in their countries (the Philippines, Indonesia, China, Malaysia are obvious cases).

The failure of APEC to push concrete measures to improve East Asian integration can be explained by a series of factors. The most evident is the will of the East Asian economies to control their liberalization agenda. This accounts for the successful mobilization of the ASEAN against the American approach to set binding rules within the APEC framework. Some Asian communities consider APEC as another forum in which the US pushes forwards its claim for further market liberalisation (Higgott, 257). Rising Asian resentment against US unilateralism is certainly another reason for the American failure (see below, section 7.4.2). Finally, APEC did not correspond to a dynamic of integration led by the TNCs operating in the member states’ economies. Most Japanese TNCs operating in North America during the early 1990’s have regionalized their production networks at the NAFTA level rather than at the APEC level. The generalisation of flexible specialisation methods can account partly for this regionalisation pattern. Some NAFTA specifications also contribute to the explanation of why the production processes of many Japanese TNCs are scattered mainly across North America rather than on both sides of the Pacific. For example one should keep in mind the influence of the NAFTA regulations over local content and rules of origins or the alliances that Japanese TNCs have made with US producers to neutralize their lobbying power on the US Congress.

7.3. A North Asian FTA?

The issue of the creation of a North Asian Free Trade Area emerged just after the 1997 crisis. China, Japan and South Korea have held an annual trilateral summit since 1999. At the 2002 trilateral summit, Zhu Rongji put forward an official proposition for a trilateral FTA (Cho, 5). Despite the official initialisation of this process by the Chinese, the most enthusiastic supporter of this sub-regional integration process is the South Korean government and business elites.

Squeezed between the technological upgrading of the Chinese economy and their technological dependency upon their Japanese neighbours, South Korean enterprises are afraid to lose their comparative advantage in most industrial and services sectors. In the last two years, some Chinese companies such as China National Blue Star Group or BOE Technology have even taken over some distressed South Korean companies in order to acquire their technological know-how (FT, 18/12/2003). The reaction of many Korean economists and businessmen has to been to propose a development project for Korea based upon the creation of a North East Asian hub in which the Korean enterprises could hold a key intermediary position in a regionalized production process due to their central geographical position (Chang Jae Lee).

But the South Korean project to build a North Asian regional hub is being hampered by the geopolitical rivalry and distrust between its two neighbouring giants. On the one hand, Japan fears that China is pushing forwards bilateral FTA deals as a means to strengthen its geopolitical position in the region and has decided to respond by also multiplying regional FTA projects under its supervision (Cho, 14). China is also afraid that Japan would follow “the US probable strategy to build a besieging line of Japan-Korea-Taiwan-Philippines-Singapore against China” (Cho, 16). For these reasons, Japan put forward its own bilateral FTA agreement with South Korea and was quickly imitated by China in November 2002. In that light, Zhu Rongji’s trilateral proposition is probably a way to keep the progress of the Korean-Japan agreement in check (Cho, 15). Despite having agreed in 2003 upon a joint research into a trilateral FTA, progress with the trilateral negotiations has been limited, to the disappointment of Korean officials. Its

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completion will depend ultimately upon the capacity of Japan and China to transcend their geopolitical rivalry despite the numerous obstacles on this road (see below).

7.4. Which future institutional framework to organise the dynamic of integration in East Asia?

7.4.1. The limitations of ASEAN and APEC

ASEAN and APEC have been the two institutions with the potential to transform themselves into a supranational body in order to regulate East Asian integration. Nevertheless, none of the two really embodied the existing regional microeconomic dynamic. On the one hand, ASEAN has not been able to contain the integration process since China began to integrate with the other economies of the region. Its member states carry a too little weight economically, demographically and militarily to be able to design institutions that could regulate a dynamic of integration that could extend much beyond the ASEAN. On the other hand, APEC has also proved impractical. The main microeconomic dynamic carried by the TNCs operating in the area has been limited to East Asia. The regionalisation of their production process did not extent to both sides of the Pacific. Furthermore, the Asian TNCs had already organized informal regional networks that gave them a competitive edge over their Western competitors in East Asia and they were not ready to accept the open rule-binding liberalisation pushed forward by the US.

The qualitative analysis made in the preceding section highlights the extension of the regional integration dynamic carried by the networks of subsidiaries, subcontractors and licensees set up by the Asian TNCs. These networks extend across East Asia and include Japan, the Asian NICs, China and the ASEAN. The whole of East Asia is becoming an increasingly integrated processing zone. This underlying microeconomic integration force will certainly influence decisively the shaping of any potential future institutional framework to organize the regional integration of East Asia. This is why the most probable framework would probably have to be built by an emerging coalition that many analysts refer to as the ASEAN+3 (the three being greater China, Japan and South Korea).

This broader East Asian coalition has been strengthening throughout the 1990's. When the Malaysian Prime Minister Mahathir Muhamad first considered the possibility of strengthening East Asian economic integration on this basis and proposed the creation of an East Asian Economic Caucus, this was rejected by many Asian economies, notably Japan. At that time, Japan favoured the development of APEC. Some Asian leaders believed that Mahathir's proposition too openly excluded the US. But throughout the 1990's, support among Japanese business leaders and prominent politicians for the East Asian Economic Caucus has been steadily rising (Higgott, 261 & Yamamura, 201).

7.4.2. The emergence of a common Asian frustration: American unilateralism

Since the 1980's, successive US administrations have regularly pushed for liberalization of the East Asian economies. The first US demands were directed towards Japan centred on the Japanese economy being unfairly inaccessible to US products (Ito, 372). Financial deregulation was explicitly mentioned between the two countries in May 1984 in the Yen-Dollar agreement (Ito II, 391) and the Japanese distribution system was repeatedly denounced (Ito, 385). Japan was regularly threatened by US administrations with being labelled "unfair trading partner" under the notorious Super 301 clause of the US Omnibus Trade act until the mid 1990's. Throughout the 1990's, US authorities continued to consider that the level of protection of the Japanese domestic market was too high and that only unilateral pressure could bring

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changes (Liu, 139). In the 1990’s, US pressure in favour of liberalisation was extended to the other East Asian economies. While the penetration of the East Asian markets had not been the priority of the US firms and of the US trade department prior to the 1990's, their perception changed after the rapid growth of domestic markets in the area. East Asian economies resisted successfully American pressure and did not concede to the US more than what was stipulated in the GATT multilateral Marrakech agreement of 1994. As mentioned above, the APEC became a consulting forum, which rejected the binding liberalisation agenda supported by Washington.

The East Asian crisis of 1997 was perceived by the US administration and the US TNCs (to a lesser extent, also by their European counterparts) as a unique opportunity to impose on East Asian countries a more open competition institutional framework. The US believed that it would erode the competitive edge that the Japanese TNCs enjoyed in the region thanks to their informal complex network, which was well adapted to the protectionist regulations of the local economies (Beeson, 354). The US secretary of Commerce, Jeffrey Garten, declared at that time that the “worsening financial flu will lower the Asian immunity to US business” (Higgott, 259).

While Japanese involvement in IMF structural adjustments in the Pacific region had been minimal before the 1990's (Frieden, 435), the Japanese government immediately proposed to bail out the countries hit by the crisis by establishing an Asian Monetary Fund. The concept was welcomed by the East Asian countries as it did not require any drastic restructuring but the US administration imposed the maintenance of the IMF monopoly in the role of last-resort lender (Higgott, 259). This was not surprising given that the IMF statutes give a veto right to the US and the EU but neither to Japan nor to the Asian economies (Lenain, 17). The IMF’s dominant role in dealing with the East Asian crisis was eventually endorsed at the Vancouver APEC summit in 1997 (Higgott, 256).

The American move proved to be a Pyrrhic victory. The bluntness of America’s rejection of an Asian solution to the crisis generated a return of populist nationalism in Asia, criticizing the “robbery” by “a new imperialism”, rhetoric almost unheard since 1945 in non-communist Asia. This reaction not only affected traditionally nationalist leaders like the Malaysian PM Matathir but also prominent politicians in Thailand, Indonesia, the Philippines and South Korea (Higgott, 259). The US involvement in the 1997 crisis also reinforced an anti-American feeling that had been steadily rising in Japan throughout the 1990’s. Prior to the crisis, the view that Japan should replace US leadership in Asia was already common in Japan (Yamamura, 200). Japanese newspapers and scholars had long been complaining about “unfair” US policies towards Asia and Japan (Yamamura, 200) and there was a growing support for Mahathir’s “East Asian Economic Caucus” (Yamamura, 201). The gap between the US administration and Asian political and business leaders widened after the crisis and may have served to popularise the concept of an East Asia Economic Caucus (Higgott, 261).

7.4.3. ASEAN+3: the emergence of an inward-looking block?

At the beginning of the new millenium, the name “East Asian Economic Caucus” may have been replaced by “ASEAN+3” but the concept remained the same and is definitely being pushed forward by the Japanese government. Jirio Okuyama, the spokesman for the Japanese Prime Minister Koizumi declared during the 2003 ASEAN summit in Bali that “people are generally speaking of ASEAN+3 (China, SK and Japan) as the final goal. It is not Japan-ASEAN and it is not China-ASEAN. We believe that there should be a kind of arrangement to cover the major chunk of countries in East Asia" (FT, 09/10/2003).

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This view was even expressed by ASEAN senior officials (FT, 09/10/2003).

The underlying integration force developing at the microeconomic level across the ASEAN+3 economies has created common problems. Many economists, whether Asian or Western, believe that the gigantic East Asian processing zone is still too dependent on the access to Western markets (especially the US). The trade pattern in East Asia is very characteristic. Japan has a trade surplus with almost all the East Asian economies as it exports great quantities of key high-tech inputs necessary for the regionalised production processes of most Asian TNCs. The only exception is usually due to the large imports of raw materials by Japan (the price of accounts for the temporary trade deficit with ASEAN countries in 1980). The next most advanced East Asian economies compensate this deficit with Japan in two ways. It is only very partly compensated by exporting high-tech and capital-intensive goods to their less developed partners in the area (i.e Taiwan towards mainland China or South Korea with the ASEAN). The main compensation comes from exports to markets in the West, particularly to the US. The less developed East Asian economies compensate their deficit with their more advanced neighbours by exporting to even less advanced economies but again, the real improvement of their trade balance is generated by their exports to OECD economies, with the US ranking first. This trade imbalance has generated problems that are shared by all the economies, which are part of this regional division of labour launched originally by the Japanese TNCs.

Firstly, all these Asian economies face mounting protectionist pressure from US manufacturers that have not relocated to East Asia. The US trade deficit (the situation is less problematic for the EU economy as it compensates its trade deficit with Asia thanks to its exports to the US market) has become an increasingly sensitive political issue in the US and is considered to be a major factor of destabilization of the world economy. The recent bouts of US unilateral protectionism of steel and textiles in 2003 have not reassured Asian exporters. For most Asian leaders, it is not easy to determine whether these outbursts are due to the political (the 2004 elections) and economic (the cyclical slow down of the US economy) context or if they reflect a new long-term shift in US trade policies towards more protectionism.

Secondly, Western governments led by the US are demanding that the East Asian economies let their currencies appreciate. US pressure on this issue is a recurrent problem for Asian economies. The resistance of Asian economies to giving in on this issue is explained by the recent fragility of their domestic markets. The financial crises, in 1990 for Japan, then in 1997 for the NICs and the ASEAN, have created structural problems in the banking sector of all these economies. Albeit China was insulated by its policy of capital control from the turmoil of the 1997 crisis, it is facing similar problems because of the difficulties encountered in the later phases of its transition to a market economy. Despite repeated interventions by the Chinese government since the late 1990's, the share of non-performing loans in the total amount of loans made by Chinese banks has been rising. The East Asian economies are becoming crippled by "bad" loans. Throughout the region, rising unemployment and economic uncertainty have limited the demand of households and enterprises. Most governments have chosen not to adopt a "cold turkey" approach but to opt for a gradual restructuring of the financial sector. During this long restructuring, East Asian governments have favoured government deficit spending or exports to stimulate demand. This has generated rising public deficits across the region. The Japanese ratio of public debt to the GDP is now around 150%, one of the highest levels among the OECD economies (FT, 14/10/2003). The Chinese State finances are not much better. Many analysts believe that once the non-performing loans of the state-owned banks and the engagements of the emerging national welfare net are included, the ratio will be over 100% (Lyons, 10 & The Economist 8/4/2000). Thailand, Indonesia and the

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Philippines have also followed this trend (CEPII 2000 & CEPII 2003). For most East Asians economies, as deficit spending seems less sustainable, the growth of exports is considered as crucial to avoid a brutal fall in demand which could worsen the financial sector’s situation, jeopardizing the whole domestic economy. Trade surpluses limit considerably the problem of the high public debt ratios because the domestic creditors continue to hold the largest share of the debt. A moderate appreciation of the Asian currencies would not erode substantially the competitive edge of Asian products but any further reduction in exports is considered disastrous by all the Asian governments as their traditional export markets have considerably shrunk since the recession of 2001. Furthermore, some Asian governments, especially China, fear that such an appreciation could indirectly fuel speculation in already overheating sectors of the domestic economy such as real estate and construction. This fear is not unfounded if one recalls the effects of the 1985 Plaza Accord and the endaka on the real estate bubble in Japan. Asian governments have become more exasperated by US demands on the monetary front.

The third problematic consequence of the imbalanced trade flows between the Asian economies and the US for the East Asian economies is that their savings are in foreign reserves. The Asian economies have invested massively in the US bond market and finance a significant part of the American trade deficit. However this imbalance is not without risk in the long term (Smith) and hampers the development of Asian business. Many economists believe that Asian firms are too dependent on bank loans due to the lack of efficient capital markets in the region. In Asia, corporate bonds account for only 14% of financial sector assets compared with 36% in the US (FT, 5/9/2003). Asian capital markets are far from being as fluid and open as capital markets in the West. In most Asian economies, the banking sector is not globally competitive and remains fragile due to its high share of non-performing loans. If the East Asian economies are to pursue economic integration, the question of an integrated Asian capital market will soon have to be placed on the agenda.

Currently, despite the rapid development of Shanghai and the importance of Hong Kong, Tokyo remains the only city that affect a transformation of itself into the most important East Asian financial centre. Nevertheless, the Japanese financial operators are far from playing an active part in achieving that goal (Higgott, 258). As a financial centre, Tokyo is still too inward looking and has been opening too slowly to foreign investors. Before 1974, the Japanese financial markets were completely isolated from foreign financial operators due to high controls on international capital flows (Ito, 316). Controls over international capital flows were relaxed during the next two decades but overall, the Japanese financial markets have been much less liberalized than their counterparts in the West. The lack of openness , and the weakness of the Japanese financial sector after the crisis of 1990, account for the limited internationalisation of the Japanese capital markets and the Japanese currency (Higgott, 258).

Still, the necessity of having Asian capital markets has been felt more acutely since the 1997 crisis. Asian companies have found it increasingly difficult to raise capital on international markets. A common complaint made Asian business and political leaders is “that Asian savings are going to the US and coming back with a lot of costs and strings attached” (FT, 05/09/2003). In the summer of 2003, eleven Asian central banks agreed to pool $1 billion in an Asian Bond Fund managed by the Bank of International Settlements.

In parallel with these developments, a rising number of economists and Asian officials are mentioning the possibility of monetary integration in East Asia. The proposal for an Asian Monetary Fund could be the first step on the way to monetary integration. Despite the marginalisation of this project by the US

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administration and the IMF during the 1997 crisis, some Asian governments like South Korea have put it back on their agenda and have specifically demanded that Japan act as the leading member of this Asian Monetary Fund (Higgott, 257). A Filipino official of the Asian Development Bank Institute has mentioned the possibility of an arrangement similar to the European Monetary System based on the pegging to a basket of currencies (dollar-yen-euro) (Higgott, 257). For the moment no currency can play the leading role of the dollar in the South American economies. The Yen represents only a small portion of World foreign reserves but it rose from 3% in the late 1970’s to 8% in the late 1980’s. In Asia, this share amounted to 25% in the late 1980’s. The debts of the ASEAN and South Korean economies are more yen-nominated than dollar-dominated (Frieden, 435). But for the yen to become the central Asian currency, it would be necessary to have a large regional market for liquid financial instruments. The Japanese markets are not open enough and not sufficiently developed for that purpose (Lincoln, 31). Others believe that the Chinese currency, the RMB could become de facto a common Asian currency as its use was already widely used in greater China, in some parts of Thailand and Malaysia and the Chinese government is progressively lifting capital controls (Smith). However the remark made above for the yen holds even truer for the RMB. Any concrete move towards monetary integration has not materialised as yet and faces more serious obstacles than those faced by the European Monetary System. The volatility and amounts of capital flows have increased over the last two decades and the development gap between Japan and the less developed members of the ASEAN is much larger than what existed within Europe.

Nevertheless, these recent developments reflect a common concern and a common will to build more efficient and integrated capital markets in East Asia and to increase monetary cooperation between the economies of the region. This constitutes a drastic evolution from the situation that characterised East Asia only a decade ago.

The problems emerging from the trade imbalance with - Western economies are already stimulating the will among Asian governments to be less reliant on Western markets in the future and to try to increase the share of East Asia as a destination for finished manufactured products. This will necessitate a restructuring of some key sectors of the domestic Asian economies. The financial sector must offer the opportunity for Asian savings to be channelled more efficiently to enterprises and to provide attractive and relatively safe returns for savers. These reforms could then increase the spending power of the middle classes and create much larger markets for consumer goods and services of a quality comparable to those in the West. The size of the Japan market for Asian manufactured exports has been growing since the 1990s. A substantial and rising share of the production made by the East Asian networks of the Japanese TNCs is directed to the Japanese market. When the Japanese economy returns to normal growth rates, this trend is most likely to become more pronounced. Apart from Japan, the biggest market now is China. Already some 70 million Chinese have the same purchasing power as South Koreans and the dramatic rise in incomes in the cities located in the coastal areas makes it the most dynamic market in the world. Figures clearly indicate a rise in intraregional trade but also the rise of Asian markets as a destination for final consumption goods like textiles (Dicken, 348) or automobile (Dicken 397)

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Share of intra ASEAN+3 trade in the foreign trade of ASEAN+3 countries

0

5

10

15

20

25

1960 1970 1980 1990 2000 2002

%

Source: IMF

These developments do not necessarily imply that the Western markets will lose their predominance as a destination for East Asian exports. In 1999, China's almost certain accession to the WTO triggered a massive relocation by Western firms to China over the last four last years, especially from American firms who have been moving production facilities out of Mexico (Le Monde, 7/4/2003). The new subsidiaries resulting from this wave are efficiency-seeking FDI aimed at serving more efficiently the Western markets. These firms are likely to lobby the US administration to relax protectionist measures against their sector. However, as the Chinese, the ASEAN and the South Korean economies are suppressing more barriers to trade and investment, many Western firms are making market-seeking investment to gain a stronger foothold in this region. Because of these contradictory waves of Western FDI in Asia, it is difficult to see if East Asia will evolve into a more inward-looking area in the future. Further quantitative analysis on the flows of Western investment is thus necessary to assess the impact of Western FDI on the degree of openness of the East Asian region. Nevertheless, it would be logical, given the predominant position of Asian FDI in East Asia, that the Western efficiency-seeking FDI flows will be less important than those induced by the shifts of production by East Asian TNCs to the East Asian markets combined with the market-seeking FDI flows made by Western TNCs in the region. Future intra-East Asian trade is thus likely to continue to increase faster than East Asian trade with the rest of the world.

The fact that perceptions of global and regional economic problems are converging among East Asian economies, the increase of intraregional trade and the institutional arrangements to facilitate economic flows within the area are now interacting and reinforcing each other. This results in an acceleration of regional economic integration. In the near future, the regional institutional framework will have to be strengthened and rationalised. There will be mounting pressure by the TNCs and local firms exporting in the area to smoothen further the obstacles to intra-regional economic flows and to have common regional binding rules to lock-in this process. As the TNCs operating in the region have been building denser and

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more complicated regional networks to organize a complex regional division of labour, they will spend more resources on lobbying local governments to insure that the integration process is not reversed. At one stage, the growing number and scope of common regional binding rules will require a higher level of cooperation between East Asian governments and also permanent supranational institutions to ensure the day-to-day execution of the agreements.

The geographical extension of this regional inter-governmental cooperation is already visible in the regional initiatives launched since the 1997 crisis. Japanese TNCs and governmental institutions are still the strongest motor behind the East Asian integration process and cannot be avoided in the building of an East Asian supranational institutional framework. Since the 1990's China has become a central link between the Northeast Asian and Southeast Asian economic zones. Its growing role as a market for finished goods implies that it cannot be left out of the process. South Korea has been creating stronger trade links with both Japan and China. The links with the ASEAN are also growing with the China-ASEAN FTA, the China-Thailand FTA and the Singapore Japan FTA. All these developments indicate that ASEAN+3 remains the most probable extension of any supranational regional institutions in East Asia.

7.4.4. The East Asian economic integration process and exogenous political factors

Despite the importance of the microeconomic dynamic described in the preceding sections, the institutions of any given society are not exclusively shaped by the evolution of economic flows and the division of labour. The history of the formation of national markets around the globe and of the process of European integration shows that political factors play a decisive role in shaping the institutional framework in which an economy evolves. The East Asian integration process is no exception in this regard.

Exogenous factors such as Western colonialism and Japanese colonialism radically altered the path of economic development of the East Asian economy. Again, after 1945, the cold war divided the region in two and even three zones, which had negligible trade between themselves. The military role of the United States in shaping trade relations in East Asia has been decisive.

The future development of supranational institutions whose powers extend to the ASEAN+3 area could be jeopardized by regional geopolitical tensions. Japan and the small Asian economies fear the rise of China, both in economic and military terms. Independently from any choice of foreign policy, the sheer size of China, the dynamism of its growth and the current upgrading of its technological capabilities are sufficient to shift completely the existing balance of power in East Asia and has already re-centred the regional integration process during the last decade. China has become one of the main regional markets and the biggest recipient of FDI. The Chinese leadership has been very aware of this situation and has adopted a self-contained foreign policy based on the development of trade. The only firm stand of China is on the question of territorial integrity and in particular, on reunification with Taiwan. The recent modernisation of the Chinese navy has generated some worries among neighbouring countries. However, the Chinese army is still lightly equipped and is not suited to engagement in substantial overseas operations. The Chinese forces are still far from reaching the technological level of the Japanese army.

If the Chinese growth gives rise to uneasiness among its neighbours, the Japanese economic leadership, especially in the northeast (China and Korea), continues to generate resentment because of past Japanese

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imperialism. With the passing of generations, the atrocities committed by Japanese troops during WWII are becoming a less sensitive issue in the Southeast Asian nations (Yoshihara). Anti-Japanese feelings are still strong in South Korea but are diminishing because of the strengthening economic ties between the two economies and also because the Japanese government apologized officially for its past abuses. The situation is different in China, which probably suffered the most from Japanese occupation. The Chinese government sees the resurgence of Japanese militarism whenever the Japanese government tries to strengthen its political position in international affairs.

Another obstacle to East Asian integration comes from the United States, which has been trying to maintain the strategic position it gained in the region during the cold war. It is clear that Washington never favoured the emergence of an ASEAN+3 economic bloc and that it will use all of its diplomatic position to avoid such a development. The US government is working on three fronts to keep a strong strategic influence in East Asia. Firstly, it plays on the perceived North Korean threat to maintain a strong strategic position in Northeast Asia. However, the US will encounter increasing difficulties to justify a strong presence as the relations between the two Koreas have been improving since the end of the 1990’s. China and Japan are trying to resolve the tension on the Korean peninsula. Secondly successive US governments since the Carter administration have tried to maintain the status quo in Taiwan, which is the soundest strategy to justify playing a diplomatic and military role so close to China. Thirdly, since 2001, the US has used the pretext of a war against global terrorism to try and keep their strategic positions gained during the cold war, despite the disappearance of the “communist threat”. The Bush administration has been able to reinforce its position in Southeast Asia by helping the Filipino government to fight their Muslim guerrillas. The numerous radical Muslim movements in Southeast Asia could become another pretext for Washington to maintain a strong military presence in the region, as the objectives of the so-called “war against terrorism” are not clearly defined or unattainable.

Unsurprisingly, the real key to the potential political obstacles that could alter the path of economic integration followed by the East Asian economies over the last few decades lies within the relationship between the two giants: China and Japan. For -Japanese political and business leaders, the rise of China is the most difficult challenge they have faced since the 1950’s. The Japanese elites seem to have adopted a two-pronged strategy. On the one hand, they are trying hard to increase the level of interdependence between the two economies to avoid any conflicts of economic interest. This has helped to accelerate the Asian integration through the mechanisms described in the preceding sections. On the other hand, the Japanese government is using the US to counter the strengthening of the Chinese strategic position in East Asia and sides with Washington on Taiwan and the Korean issues. Under the cover of the war against terrorism and humanitarian missions, Japan has managed to transform its self-defence forces, which faced many constraints inherited from the Japanese defeat in 1945, into a classical army that can send troops abroad with the US support. This part of the Japanese strategy could increase the tension with China, who fears a resurgence of Japanese militarism. If China and Japan are to avoid confrontation and are to play together a role similar to that of the Franco-German axis during the building of the European Union, Chinese economic reforms will need to be highly successful and Japan will ultimately have to change its strategy vis-à-vis China over the next decade.

8. CHINA FACING THE EAST ASIAN INTEGRATION PROCESS

The insertion of China into the East Asian regional integration process has profoundly modified the shape

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of the latter. The Chinese economy has become the link between Northeast Asia and Southeast Asia. It has also created a counterweight to the traditional leadership of Japan. This could either slowdown or accelerate the process of Asian integration depending on how political relations between the two Asian giants evolve. The opening of China has certainly generated a pressure, which has resulted in accelerating sub-regional integration between the ASEAN economies as this group of countries has tried to limit the diversion of FDI from Southeast Asia to China. China has also helped the South Korean chaebol and SMEs to restructure faster by offering a space to relocate their labour-intensive activities to, which is closer both geographically and culturally than Southeast Asia. The opening of China also has changed the role and structure of the Hong Kong and Taiwanese economies and their relations with TNCs.

But at the same time the Chinese economy has also been deeply affected by this process. The relocations by the TNCs of the neighbouring economies have accelerated the rise of provincial disparities generated by the economic decentralization reforms. The Chinese regulation of FDI flows is mostly enforced at the provincial level. The inflows of FDI have given more economic autonomy to the local provinces. The networks of personal relations between local officials and foreign investors and their government agencies are strengthening. It means that some provinces will have a privileged relationship with one or two particular countries. The most obvious examples are the special links that Japan enjoys with Liaoling and Tianjin; Hong Kong with Guangdong and Taiwan with Fujian and Zheijiang. Shanghai has had a wider range of investors but Japanese and Taiwanese TNCs hold a dominant position in the largest Chinese urban areas (interview 2).

The economies of these provinces have become heavily reliant on the massive inflows of FDI and are competing between themselves to attract the largest flows. Recently, the provincial government of Zeijiang and the Ningbo municipal authorities have launched a project to build a bridge that could shorten by 50% the travel time from Ningbo to Shanghai and possibly facilitate FDI diversion. Not only do they have to compete against each other but also against many of the interior provinces, which hope to be the next beneficiaries of the flying geese pattern. The richer coastal provinces already experiencing some of the push effects that have already hit Taiwan and Hong Kong: rising rents and real estates prices, a saturated infrastructure and wage increases. The ASEAN economies also offer a constant potential threat as many Asian investors are present in both sub-regions and have sufficient flexibility to adapt their production process to the development of location-specific advantages across East Asia. In that context, it is natural for these economies to increase public spending in order to offset or at least to slow down the strain on local inputs. The provincial authorities need to improve and modernize their transport and energy infrastructure. The improvement and extension of higher education is also necessary to increase the number of skilled workers and avoid local shortages. In order to remain attractive, the province will have to continue to offer advantageous tax breaks and subsidies. In the absence of inter-governmental co-operation, this means that the Chinese provinces and the less developed ASEAN economies could possibly find themselves engaged into a "beggar-thy-neighbour bidding war" for FDI (Oman II, 13). This would result in more tensions between the central government and the coastal provinces over the control of the fiscal revenues.

On the geopolitical level, some neighbouring countries, particularly Japan, may be tempted to support the provincial administrations in their demand for more autonomy in order to weaken the Chinese central state. Thus, any acceleration of the economic integration between China and the rest of Asia could generate long-term and medium-term centrifugal pressures.

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In the short term however, this might not be apparent. The central government is aware of these centrifugal pressures and regularly attempts to contain them. One of its tools are the international agreement, either made in the framework of the WTO accession protocol or with other regional trade arrangements, which give Beijing an important lever to impose stricter discipline on the provinces in matters of trade and FDI.

If the East Asian economies manage to build supranational institutions to regulate the de facto integration process that has been taking place over the last four decades, it will necessarily imply in the long-run the transfer of power from the national level to the regional level but also sub-national level in order to respond the new organisation of the TNCs' production units. This was certainly the case for European integration and there is evidence that this phenomenon is occurring in the NAFTA and MERCOSUR processes. The Chinese economy needs to join this process if it wants to continue to develop its regional links and reduce its dependence on the US market. The Chinese central state cannot allow itself not to participate in the building of East Asian supranational institutions. However, joining this process might foster the already strong centrifugal pressures that characterise China today. This is the inevitable dilemma the Chinese government will have to face during the next decade.

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commission, 28/11/2003.

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