It is a great pleasure for me to be back in Princeton again. As mentioned in the introduction, I spent two formative periods of my life in Princeton, first as an MPA student in the late 1960s, and more recently as a visiting professor in the Woodrow Wilson School. I am especially pleased to be addressing a joint Woodrow Wilson School/East Asian Studies audience, since you include specialists in both public policy and in the region.
One of the most respected Princeton alumni Adlai E. Stevenson once remarked, "I find honorary degrees always tempting, and often bad for me: tempting because we all—even ex politicians—hope to be mistaken for scholars, and bad because if you then make a speech, the mistake is exposed." I now feel much the same way about having unthinkingly accepted an invitation from Professor Collcut to speak before this distinguished audience.
Let me start by outlining the key message of my talk in the following way.
East Asia's rapid recovery from the 1997-98 Asian Financial Crisis, and its return to very impressive growth, has made some observers wonder whether a new Asian miracle is upon us. Certainly there are many reasons for growth in the region to remain robust in the years to come. Gains from further integration into the global economy, rising intra-regional trade (including closer ties with India), and stronger productivity growth stemming from foreign direct investment (FDI) and innovation, are all likely to be significant.
While I share this optimism regarding the region's potential, in my view continued economic success will depend critically on strengthening the institutional framework of the region's economies. One of the key lessons from the Asian crisis is that while capital inflows to emerging markets are beneficial for economic development, a reversal of capital flows is bound to happen. Therefore, it is imperative for the emerging economies in Asia to build a financial and legal infrastructure that is resilient to sudden changes in capital flows.
I. The Evolving Context for East Asian Growth
Before embarking on a discussion of East Asia's future, let me reflect for a moment on the region's formidable record of economic achievement in the last half century. Real per capita GDP in the East Asia and Pacific region has grown by about 4¾ percent a year, on average, since 1960, resulting in a seven-fold increase in per capita income. Real per capita GDP growth has been even faster in China and Korea, at about 5½ percent per year over the same period.
This growth has raised living standards and reduced poverty.Over the last forty years, life expectancy in East Asia and the Pacific has risen from 53 years to 70 years today. This impressive record of economic and social development has shown other emerging regions that with appropriate policies and strong commitment, it is possible for countries to grow rapidly over a long period of time—even in countries with few natural resources or small populations. We should remember that East Asia was not the favored candidate for rapid economic growth among many analysts and observers during the 1950s—too many people, too few resources—with many instead favoring resource-rich African countries then moving towards independence.
How was Asia's remarkable record achieved? Beginning in the 1950s, East Asian countries—some faster, some slower—adopted wide-ranging policies aimed at transforming themselves into fully-fledged market economies. Sound macroeconomic policies were put into place, which provided a stable backdrop for business to grow. At an early stage, the importance of infrastructure investment as an aid to exporters and import-competing firms was recognized—and appropriate measures taken. Later in the reform process, greater emphasis was placed on liberalization of the trade and financial sectors. Thus the main thrust of economic policy became an outward orientation with strong incentives for exporters, and a commitment to growth through trade. Political stability was also an important factor, although it is difficult to disentangle whether stability is a cause or consequence of strong growth (most likely both).
Early studies of the Asian miracle focused on enlightened public policy as a critical factor in explaining East Asia's success. Perhaps the most frequently-cited example of such research was the World Bank's The East Asian Miracle,1 published in 1993, which suggested that Asia's extraordinary growth was due to superior accumulation of physical and human capital―superior not merely in the sense of rapid accumulation of factors of production, but also accompanied by high productivity growth.
However, other research at the time questioned whether the economic miracle was truly miraculous. A closer examination of the determinants of growth suggested that the prominent role accorded to productivity growth may have been exaggerated. (Notable researchers in this area include Alwyn Young and Larry Lau, whose work received considerable attention after being highlighted in a Foreign Affairs article by Paul Krugman2.) This research concluded that it was primarily rapid increases in the quantities of physical capital and labor, rather than in total factor productivity, that explained the region's rapid growth.
The assertion that "perspiration" rather than "innovation" explained the Asian miracle caused some consternation in the region—not least because some policymakers did not welcome a questioning of the exceptional nature of regional growth performance, which they had been attributing to the unique importance of "Asian values". More importantly, the results were worrying because they predicted an end to the miracle—sooner or later, Asia's growth would have to slow, since there was only so much extra growth to be reaped from increasing labor force participation, improving education, and raising investment. Some countries in the region (notably Singapore) that were furthest along the "catch-up" trajectory with the industrialized countries took the findings to heart and launched a broad-based effort to promote productivity growth.
In the event, the eruption of the financial crisis in the late 1990s brought the debate on the Asian miracle to a halt. In the wake of the crisis, academics and policymakers shifted their focus from the determinants of growth to the importance of sound structural policies for reducing vulnerability to crisis, and hence for sustaining economic growth over long periods of time. A wide-ranging structural reform agenda emerged from this debate, focusing on financial and corporate reform and the need to strengthen the legal and regulatory underpinnings of the market economy.
Let me turn now to what I consider to be the main elements of the reform agenda.
II. The Unfinished Structural Reform Agenda
A clear lesson that emerged from the Asian crisis is that strong "market economy fundamentals"—including institutions, regulatory frameworks, and business practices—are essential for sustaining rapid growth and increasing resilience to shocks in countries that are rapidly integrating into the world economy. For the most part, countries in East Asia had pursued prudent macroeconomic policies in the run-up to the crisis, with high saving and investment rates. However, in the absence of strong institutional fundamentals that could impose market discipline, there were insufficient checks and balances to limit investment bubbles—in some cases financed by domestic equity markets and banks (as in Japan), in others by external borrowing (as in Indonesia, Korea, and Thailand)—that eventually severely undermined confidence in Asian financial systems.
Since the late 1990s, significant progress has been made across the region in strengthening the institutional underpinnings of these economies. However, further efforts are needed on this front, not only to reduce vulnerability to crisis, but also to provide the institutions and infrastructure necessary for enabling dynamic and sustainable economic growth. Let me focus more specifically on two major reform areas: financial and corporate sector reform, and strengthening governance.
A. Financial and Corporate Sector Reform
A well-developed and sound financial sector is a key requirement for sustaining economic growth after the first easy stages of low-wage-based industrialization have been realized. As economies become more sophisticated, allocating resources efficiently becomes ever more important. The financial sector, as the intermediary between savers and investors, plays an essential role in this regard. Financial institutions need to be well-capitalized and sensibly managed, and subject to an appropriate level of regulatory oversight; at the same time, vigorous competition is key to ensuring continued financial innovation.
Cross-country generalizations can be risky, but it is safe to assert that East Asian banking systems were weak prior to the onset of the regional crisis. Risk management capabilities were under-developed; related-party lending was imprudently high; supervision systems were weak and vulnerable to political interference; and banks were betting heavily that the good times would continue indefinitely. Corporates, often very highly-leveraged, were also betting on the good times continuing, and on the stability of exchange rates. When capital inflows reversed, exchange rates sagged and interest rates rose, and the weakened corporates dragged down the banks with them. (Rationally) skittish depositors added to the difficulties of the financial sectors, to varying degrees in different countries.
Considerable efforts have been made since the Asian crisis to rebuild financial sectors and increase their resilience to shocks:
· There has been significant consolidation in the banking industry. In Indonesia, for example, the number of banks has fallen from about 240 before the crisis, to 136 today, while in Korea, the number of commercial banks has declined from 33 in 1997, to 19 today.
· The financial condition of banks has also improved. Capital positions have been rebuilt, with average capital adequacy ratios now around 8 percent in emerging Asia, and nonperforming loan ratios have fallen sharply, to about 10 percent of total loans.
· The quality of supervisory and regulatory institutions has also been strengthened across the region. In some countries, like China, Korea, and Japan, new agencies have been created that are dedicated to overseeing financial sector stability. And across the region, capacities in this area are being upgraded, for example in risk assessment.
In the corporate sector, progress has varied considerably across countries. In part, this reflects differences in the initial debt overhang. But it also reflects differences in the speed with which the institutional framework for debt restructuring, which includes bankruptcy laws and asset management companies, has been reformed. Aggregate debt-to-equity ratios in emerging Asia had fallen to about 45 percent in 2003, down from about 75 percent in 1997.3 While this reduction has been welcome, additional restructuring efforts may be needed to reduce leverage in some countries, accompanied by the further development of bond and equity markets to diversify financing sources for the corporate sector.
With regard to the remaining reform agenda, additional operational restructuring of banks should increase the efficiency of banking operations and enhance risk assessment capabilities. This might include rationalizing branch networks, reducing staffing, and revamping loan approval and analysis procedures. Risk management of financial institutions also needs to be strengthened further, as countries move towards implementing the Basle II capital accord. Korea's recent experience is worth heeding in this regard. Following the crisis, Korean regulators reduced controls on credit card lending in an effort to boost domestic demand. Credit card-fuelled spending—and household debt—exploded as a result, so that by 2002 banks were cutting back sharply on credit to delinquent households. This had dramatic knock-on effects on economic growth, which slowed dramatically in 2003.
Although most countries in the region now have an appropriate supervisory and regulatory framework in place, implementation of the rules and regulations could be improved further. Regulators need to insist that banks remedy their deficiencies in assessing asset quality, and they should press creditors to acknowledge the true health of debtors. Regulators must also avoid succumbing to the pressures of regulatory forbearance that hide the true magnitude of the problem. This is a particular concern with regard to state-owned banks, which remain dominant players in many East Asian economies.
B. Corporate Governance Reform
A key motor of any modern economy is its ability to mobilize capital from a wide range of savers and put it to work in businesses that are generally run by others. But for this capital mobilization to take place, savers need to be confident that they will receive a fair return on their investment. This confidence is established by creating a framework of institutions, laws, and practices that encourage the recipients of capital to act in the interest of those who have entrusted them with their savings. This is a challenge not only in Asia, but also in many other parts of the world, ranging from former centrally-planned economies to many countries in Latin America.
In the wake of the Asian crisis, strengthening corporate governance was placed high on the reform agenda. The pattern of corporate ownership and control in East Asia, which was marked by high concentration and low transparency (sometimes referred to as "crony capitalism"), was in hindsight identified as the Achilles heel of these economies—although we need to remember that this concentrated pattern of corporate ownership may well have made a positive contribution in the first stages of rapid industrialization (in a manner reminiscent of the "robber barons" of late-19th century US industrialization). That said, research has shown that countries with sound corporate governance and strong investor protection have deeper capital markets, which in turn gives companies access to cheaper financing. And with international investors paying increasing attention to compliance with international regulations and standards, strengthening corporate governance will be essential for continuing to attract investment to the region.
While some Asian jurisdictions already employ standards and practices that closely reflect recognized international standards and practices, transitioning to full compliance will require substantial changes to national legal and regulatory norms for several Asian countries. These include further improvements of disclosure requirements and accounting standards, and strengthening the rights of minority shareholders, which have traditionally been very weak in Asia. And perhaps most importantly, the advances that have been made in corporate-governance rules now need to be matched by advances in their implementation and enforcement.
The legal framework could be made more supportive of corporate restructuring. Creditor rights are in general comparatively weaker in East Asia than in the OECD countries; this curbs the ability of creditors to monitor or control the activities of dominant large shareholders. Enactment of provisions allowing court approval of majority-approved restructuring plans even when there are dissenting creditors—i.e., cram-down provisions—would be helpful in this regard. Beyond the passage of new legislation, it will also be essential to improve the implementation of these laws. This requires substantial training of existing judges and lawyers and in some cases the entry of additional people into these professions. Court processes and foreclosure proceedings should also be expedited, so that existing judicial backlogs can be cleared, which in some cases amount to several years.
I should also note here that corruption remains a cause for concern, with a number of East Asian economies still rated relatively poorly by international standards. Failure to address the causes of corruption in a resolute manner will have significant economic costs over time. Poor rule of law, weak institutions, and lack of transparency breed corruption and worsen the investment climate for firms outside of a connections-based network. And corruption not only affects international investors trying to access domestic markets, but also prevents less-connected or smaller domestic companies from growing.
C. The IMF's Involvement in Promoting Structural Reform
Given the importance of financial and corporate sector health for macroeconomic stability, the IMF has continued to pay close attention to reforms in this area. In the wake of the Asian crisis, the IMF and the World Bank introduced the Financial Sector Assessment Program (FSAP) in 1999, with a view to strengthening the monitoring of financial systems in the context of the Fund's surveillance and the Bank's financial sector development work. The FSAP aims to help member governments strengthen their financial systems by making it easier to detect vulnerabilities at an early stage. Until now, eight countries in Asia, including Korea, Japan, and Thailand, have undertaken an FSAP. The IMF is hopeful that China will also participate in such an assessment in the near future.
Together with the World Bank, the IMF has also worked to develop a system of Standards and Codes, using internationally-recognized standards to define "best practices" in key areas. These include financial regulation and supervision, as well as "infrastructure issues" such as bankruptcy practices and corporate governance.
III. Other Trends That Will Affect Growth
I would like to touch briefly on three major trends that are also likely to affect economic growth in East Asia over the medium term. Two of these trends are positive, namely the continued expansion of East Asia's international trade and productivity gains from foreign direct investment and innovation, while one trend is negative, namely the aging of Asia's population.
A. International Trade
Asian economies have embraced opportunities to deepen their involvement in the global trading system. As a result, the region has seen a remarkable increase in its share of world trade—from less than 16 percent of world exports in 1980 to over 28 percent by 2003. Trade within Asia has been a growing component of overall trade growth in recent years, with intra-regional trade now accounting for 40 percent of Asia's exports, up from 30 percent a decade ago.
The increasing role played by China in the global economy bodes well for a continuation of the export-led growth of East Asia as a whole. By opening its markets to international trade and joining the WTO, China has emerged as a manufacturing powerhouse, playing a central role in the global supply chain for a wide range of products. This process is providing substantial benefits to China and to the Asian region as China imports intermediate inputs from its neighbors for use in its export industries. Of course, China's emergence as a major manufacturing center also imposes competitive challenges for its neighbors, who need to adjust to this new feature of the environment. The trade agreement between ASEAN and China just signed in Vientiane can be seen as one component of ASEAN members' adjustment strategy.
China's role as a regional manufacturing hub is also leading to significant intraregional investment flows. Large firms in the region, many of them from Korea and Taiwan POC, are increasingly moving parts of their production process to China. In particular, labor intensive assembly operations have relocated to take advantage of China's low labor costs.
Increased economic and financial integration of India with East Asia is likely to be another source of growth for the region. From the attention that has been given to India's outsourcing industry, it would be easy to get the impression that India is a major player in international trade. But India remains a relatively closed economy, with exports of goods and services representing only about 15 percent of GDP and India accounting for less than 1 percent of the world's merchandise exports. Further progress with trade liberalization would allow India to benefit from the dynamism of Emerging Asia, and vice versa.
While prospects for continued export-led growth look bright, greater export diversification would reduce the vulnerability of East Asian economies. The slowdown in regional growth experienced in 2001-02 highlights the risk of overspecialization in IT products as main exports, and reliance on the United States as the primary export market. Greater product and geographical diversification is clearly desirable in this regard. That said, it is an open question whether a further deepening of trade among Asian economies will promote trade diversification or trade specialization for a given Asian economy. What I can say for sure is that it is a very interesting area for further academic study.
B. Foreign Direct Investment and Innovation
East Asia's openness to FDI is also likely to buoy growth by enhancing productivity, especially in the export sector, although experiences will likely differ across countries:
· China has been remarkably successful at attracting FDI, and foreign-owned firms have been a key driver of the growth of higher-value added Chinese exports.
· India has seen relatively little FDI over the years and, although inflows have been rising over the last decade, the stock of FDI is small in relation to GDP, and investment has been primarily geared to the domestic market.
· The ASEAN economies have experienced a significant fall-off in FDI in recent years, with inward FDI declining from some $17 billion in 1997 to about $9 billion in 2003—in part reflecting competition from China, but also, in some countries, reflecting concerns about the investment climate and political risk.
A by-product of increasing openness to FDI should be greater innovation, which is an essential element of stimulating productivity growth. While regional economies have achieved great success in imitating production processes, only some of them have made the important next step to innovation. In China, for example, innovation has played a relatively small role so far. Even though China's massive labor force will be able to sustain high rates of economic growth for many years, at some point in the future growth will need to come from productivity gains rather than from further increases of capital and labor—and this is where promoting innovation becomes important.
Public policy will play an important role in stimulating innovation: to be competitive in the marketplace of ideas, there has to be a supporting structural framework in place. The existence of a proper legal and financial system, protection of shareholder rights, enforcement of contracts, and strengthening of governance and regulatory bodies are needed to encourage inventors. And this brings us back again to the importance of pressing ahead with the structural reform agenda.
The world is in the midst of a demographic transition that is resulting in an unprecedented aging of its population.4 Asia is no exception to the global trends, with the share of the elderly in the total population set to rise from 6 percent in 2000 to 17 percent by 2005. Aging is expected to be most dramatic in Japan, but will also be significant in other higher-income economies such as Hong Kong SAR, Korea, and Singapore. Population aging is expected to have an adverse impact on economic performance, through such mechanisms as declining private savings and intensifying pressures on government budgetary positions
Significant population aging is expected to slow growth in the more advanced economies, which would exert spillover effects for the Asian region as a whole. Slower growth in the advanced economies could translate into weaker demand for exports from the rest of the region. The same could apply to the flow of investment capital, which has increasingly supported economic development and growth in the less advanced economies in the region. While it is difficult to quantify these impacts, IMF research suggests that for emerging Asia, demographic changes could reduce per capita income growth by 0.2 percentage point per year over the 2000-2050 period.
To meet the economic challenges posed by these demographic changes, policies will need to be adopted to boost labor supply, saving, or productivity. In advanced economies in the region, increasing labor force participation may not be sufficient to offset the projected decline in the working-age population, and greater immigration may be needed. Equipping the workforce with a larger and more labor-efficient capital stock could also help to offset the impact of a declining labor supply. In developing countries, in contrast, the key requirement for labor market policies will be to ensure that working-age populations are absorbed into the labor force. This will require reforms to improve the flexibility of labor markets, as well as better education and training to provide the skills necessary for employment.
IV. Concluding Remarks
My talk today was entitled with a question: whether the East Asian miracle can persist. For the immediate period ahead, the outlook for East Asia remains bright. Indeed the Chinese authorities have been struggling to put an effective brake on excessive speed of investment activities. But it is the longer term that really interests us today. While the economies in the region cannot realistically be expected to sustain growth at the pace seen before the Asian crisis, it is quite possible that their performance will remain favorable for many years to come, for the reasons I touched upon in my remarks—primarily solid economic fundamentals and openness to foreign trade and investment.
Asian economic success was motivated by the spirit of "sacrifice now and enjoy fruits later," namely save and invest now to reap accrued benefits over the years to come. In my view, the same spirit should be applied to undertake needed reforms now by Asian countries. We need only look to the experience of Japan to see how costly avoiding reforms can be—failure there to recognize and address deep-seated structural problems in the financial sector and governance structure when they first emerged undermined confidence in economic management. This in turn led to a "lost decade" of economic growth. The example of Japan also shows that structural reform remains a necessary condition for sustaining dynamic economic growth even at the most advanced economy level.
With that call for taking the longer-term view, let me conclude, and thank you all for your careful attention.
1 World Bank, 1993, The East Asian Miracle: Economic Growth and Public Policy (New York: Oxford University Press).
2 "The Myth of Asia's Miracle," Foreign Affairs, Volume 73, Number 6 (November/December 1994)
3 The estimates are biased downwards, but reflective of trends.
4 For a comprehensive discussion of the economic issues involved, I would recommend a perusal of Chapter 3 of the Fund's flagship publication, the bi-annual World Economic Outlook for September 2004, available on the IMF's webpage, www.imf.org.
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