Speaking Notes by Mr. Takatoshi Kato

Deputy Managing Director of the International Monetary Fund
At the 40th ADB Annual Meetings
Seminar on "A Borderless Asia: Vision for Regional Integration"
Kyoto, Japan, May 5, 2007

As Prepared for Delivery

Ladies and gentlemen, thank you for the kind invitation to speak about a possible vision for regional integration in Asia. I should note at the outset that the views I will express are my own, and do not necessarily represent those of the IMF or IMF Policy. A great deal of progress has been made in integrating Asian economies. And I would like to submit today that the experience of the European Community as well as the North American Free Trade Agreement can provide valuable lessons for Asia as it continues to broaden and deepen this integration.

Fifty years ago, in March 1957, the Treaty of Rome was signed, establishing a common market among the six founding members of the European Community. This common market became a launching pad for further economic and political integration in Europe, including several waves of enlargement, the formation of the European Parliament, and the signing of the Maastricht Treaty, and culminating with the full launch of the euro in 2002.

Today, the EU consists of twenty-seven countries and close to 500 million people, with deep trade and financial linkages. Yet despite many achievements, there remain wide disparities in economic structures and income levels among members. In part, this is because recent enlargements have brought into the EU fold countries at different stages of development. However, even among those countries that have adopted the euro, important differences persist. And despite countries sharing a common monetary policy, business cycles remain imperfectly synchronized. These observations underline that regional integration is a long-term process, requiring sustained attention from policy-makers at all levels.

Just as the common market has spurred regional integration in Europe, NAFTA has done much to bring the economies of the United States, Canada and Mexico closer together. For instance, US exports to Canada and Mexico have increased by more than 150 percent since 1993, while US imports from Canada and Mexico have more than trebled. Similarly, bilateral capital flows, not least FDI flows, have also been boosted by NAFTA, as the reduction of trade barriers fostered development of a regional supply chain.

Asia has also experienced deepening regional integration, most notably over the last ten years. Most countries in the region have seen the share of intra-regional trade in total trade rise during the last decade. In fact, intra-regional trade now accounts for close to 50% of Asia's trade. This process has been driven in great part by exports of intermediate goods in response to vertical specialization, a rather different path from that observed in Europe, where intra-EU exports are concentrated on final goods for domestic demand. This difference may owe to the fact that, in Asia, intra-regional trade has been driven by the desire to exploit differences in comparative advantage, while in Europe, where these differences were traditionally smaller, trade stemmed more from a demand for product variety in the context of a large domestic market. In this regard, it is useful to note that the rise in intra-regional trade in Asia over the last ten years is almost fully accounted for by the rise in trade between China and other countries in the region, an example as good as any of regional supply chains at work.

Regional financial integration is also moving ahead, but progress here is more muted. There have been many successful initiatives to promote regional financial integration, including the Chiang Mai and Asian Bond Market Initiatives. And intra-regional financial flows (both portfolio and FDI) have increased, in absolute terms and as a share of GDP. But at the same time, it is fair to say that Asia has integrated more fully with global financial markets than within the region. Much of the recent growth in Asia's foreign asset portfolio occurred through US and EU assets, and a similar story holds for the liability side. This is perhaps as expected, as US and European financial markets are deep and broad, with strong investor protection rights, and the dollar and the euro are international reserve currencies.

Now, how can regional integration in Asia be enhanced? The experiences of Europe and North America with common markets suggest to me that an ASEAN+3 free-trade agreement—built on the platform of the already existing ASEAN FTA—could serve as an anchor for closer regional integration. It is worth asking what could be gained from this on the trade side relative to what has already been achieved, which is considerable. To start, a gradual elimination of tariff barriers between ASEAN countries and the "+3", and among the "+3" themselves, can be expected to spur regional vertical integration and trade even further. But I believe that regional trade under an ASEAN+3 free trade agreement would not just be more of the same. In particular, adding the "+3" would lead to a nine-fold increase in the size of domestic demand under the free trade area, and hence could boost trade in final goods in addition to today's trade, which is largely driven by regional supply chains. This, in turn, could lead to an increase in the real purchasing power of Asian consumers, and perhaps contribute to a welcome rebalancing of regional growth.

That said, as much as Asia stands to gain from a possible ASEAN+3 agreement, it stands to gain even more from trade liberalization on a global scale. In other words, any ASEAN+3 agreement should seek to be as compatible with the multilateral system as possible. And work towards a possible ASEAN+3 agreement should not distract policymakers in the region from striving towards a broad-based Doha accord.

I would like to turn now to the issue of accelerating regional financial integration. In particular, does it make sense to think about a currency stability rule for Asia along the lines of Europe's Exchange Rate Mechanism? I think that, for now, the answer is no. The disparity in per capita incomes and in the speed of economic transformation remains large in Asia, larger than it was among ERM participating countries. Different development paths, divergences in productivity gains, and large resource shifts across economic sectors will have important implications for real exchange rates, capital flows, and macroeconomic policies in the region. In this context, it would be unwise at this stage to commit to a strict currency stability rule. Moreover, having an ERM-style rule requires a set of supporting institutions and a degree of policy coordination that Asia lacks at the moment. Several regional initiatives are taking Asia in the direction of greater coordination, but they are not yet enough to support the commitment to an exchange band negotiated in a coordinated fashion. Perhaps more importantly, I doubt countries in the region see the need for an ERM-style framework. Such a framework cannot succeed until participating countries are fully convinced it is in their best interest. All this said, over time, as regional institutional development proceeds and macroeconomic policies continue to converge in their focus on low inflation, one would expect regional exchange rates to tend to stabilize and fluctuate in a relatively narrow band.

So what, then, can be done to spur regional financial integration? First, an ASEAN+3 trade agreement, which I discussed earlier, likely would, in itself, spur intra-regional financial flows. And this process would be aided by the fact that the ASEAN+3 block is expected to continue to have sizeable net savings in the foreseeable future. Under an ASEAN+3 FTA, firms are likely to increase FDI within the region, as lower trade barriers would enhance incentives in favor of regional supply chains. Non-FDI flows could also be spurred by the FTA, including intra-regional bank lending to support regional operations of Asian firms. In a similar vein, larger FDI flows could lead to a strengthening of domestic financial markets, for example through greater domestic borrowing by foreign firms. The possible impact of an FTA on regional financial flows could be maximized by ensuring that the agreement not be restricted to goods trade, but also include services, notably financial services.

Continued financial sector reforms would, of course, do much to support regional financial integration. The region is already doing a lot in this regard, including recent increases in the financing available under the Chiang Mai Initiative, and the launching of the pan-Asian fund as well as most of the country funds under the Asian Bond Market Initiative. But regional financial systems and linkages would benefit from further development. In particular, more needs to be done to establish full currency convertibility among countries in the region, pursue the development of regional benchmark instruments, enhance the breath and depth of bond and derivatives markets to allow for cross-border risk management, and create regionally recognized credit rating agencies. Yet as important as the development of this regional financial infrastructure will be, and just as enhanced regional flows may contribute to stronger domestic markets as noted before, the key to enhanced financial integration lies in the deepening of domestic markets through enhanced domestic financial policies. Particular focus is needed in the areas of corporate governance, investor rights, credit information, and improved supervision. In other words, stronger domestic markets and deeper financial integration will go hand in hand, but the latter will only go as far as the former allows it.

To sum up, then, I believe that the best possible strategy to spur regional integration would be to advance on the path of an ASEAN+3 FTA, complemented with measures to improve regional and domestic financial infrastructure. As I mentioned at the beginning, regional integration will likely be a long-term process that will require unwavering attention and support. Yet I have no doubt that more rather than less integration is in store for Asia, and more integration in Asia will be good for Asia and good for the world. Thank you very much.


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