EAST ASIA'S ECONOMIC POTENTIAL FOR THE 1990S: A SPECULATIVE ESSAY

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• Document Creation Date: December 22, 2016
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• Sequence Number: 1
• Publication Date: December 1, 1987
• Content Type: MISC

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Directorate of
Intelligence 25X1
East Asia's Economic
Potential for the 1990s:
A Speculative Essay
An Intelligence Assessment
EA 87-10052
GI 87-10091
December 1987
copy
44
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Intelligence 25X1
East Asia's Economic
Potential for the 1990s:
A Speculative Essay
Office of East Asian Analysis, and
of Global Issues.
Comments and queries are welcome and may be
directed to the Chief, Regional Issues Staff, OEA,
Confidential
EA 87-10052
G/ 87-1009/
December 1987
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A Speculative Essay
East Asia's Economic
Potential for the 1990s:
Key Judgments Before the turn of the century, Western observers could be confronted by
Information available several indicators confirming that East Asia is indeed "number one" from
as of 1 December 1987 an economic perspective-a development that would entail decidedly
was used in this report.
mixed blessings for US economic, financial, and political-military interests.
Current trends, for example, suggest the national incomes of East Asian
economies will surpass those of both the United States and the European
Economic Community sometime during the 1990s; the volume of East
Asian savings and capital formation, the root of productivity growth,
already has. At the same time, the area's continued high savings rate
suggests the regional current account surplus, currently about $100 billion,
will grow further if area governments do nothing to focus growth inward or
are not forced to do so by protectionism. When taken together, the
extrapolated growth trend and the continued excess of savings over
investment suggests that East Asia will occupy a position of both the
world's most productive economic block and the world's largest net
creditor-a position that, until 1982, was occupied by the United States.
process from each extreme of the technological spectrum.
Recent market- and growth-oriented initiatives in East Asian policymak-
ing, chiefly financial integration and trade liberalization, suggest that the
region will do even better than historical trends suggest. Such a policy
course will further improve productivity and will accelerate a transforma-
tion of regional output from agriculture to services and an even sharper
shift in sectoral employment in the same direction. Between now and the
turn of the century, we believe services will grow at least 6 percent
annually on average, pulling regional GNP in volume terms to about twice
what it is currently; and one-third more than present US GNP. At the
same time, we think further currency appreciation in Japan and the Newly
Industrializing Countries (NICs) will pull East Asian GNP at market
prices past $6 trillion. Structural adjustment in the region's two largest
economies, a maturing Japan and a developing China, will drive the
In regard to foreign trade competitiveness, technological advances, a high
rate of investment, and a shift away from manufacturing will move the mix
of Japanese exports up the technology scale, enabling the NICs to
concentrate increasingly on more sophisticated product lines, and shifting
comparative advantage in lighter manufactures increasingly to the region's
LDCs. At the same time, efficiency gains in China will press the LDCs to-
ward greater price competitiveness in export markets. China will retain a
Confidential
EA 87-10052
GI 87-10091
December 1987
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large foreign borrowing capacity and, by the mid-1990s, probably will be in
a position to run the largest current account deficit in the region if Chinese
development policy is committed to such a course. Finally, as Japan's
savings rate falls with the aging of the population, the NICs will replace
Japan as the locus of the regional current account surplus.
We believe market forces will drive the region's evolution, principally in
the form of currency realignments, the first of which is almost complete
with the strengthening of the yen and revaluation of the currencies of the
Asian NICs. Similar price adjustments will accompany, and even promote,
a series of shifts in trade competitiveness among the region's economies.
Although we see little on the horizon to suggest substantially more official
economic cooperation among East Asian governments, we believe private-
sector initiatives in a more market-oriented policy environment will
gradually integrate the region to the point that more than 40 percent of
trade is conducted within the region itself-up from about one third
currently. Further, East Asian financial centers will become increasingly
linked to each other and thus more competitive with the West.
The primary risks to East Asian economic supremacy are the possible
failure of Japan to mature into a service economy because of structural ri-
gidities and political obstacles, the chance that political shifts in Beijing
will produce economic policies that direct China's economy inward or back
toward the Soviet Bloc, or disruptions in market-oriented economic policy
caused by unstable political transitions in the region's LDCs. We are
inclined to believe the most likely of these developments is a "stalled
Japan," but fairly rapid economic adjustment to the high yen during the
last two years suggests Japan will mature as we project.
East Asia's success will have a dramatic impact on the United States,
chiefly through its improved competitiveness in high technology and other
product lines. The United States will for the first time since World War II
be confronted by a larger, potentially more influential, economic bloc-one
that a more independently minded Japan will dominate.
Accordingly, East Asia's success means that the United States will have
somewhat less influence over international economic affairs. For example,
international prices and interest rates will be far more independent of US
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policy instruments-a consequence of East Asia's role as primary origina-
tor of international trade and primary creator of financial assets. The
United States will also have less latitude in setting its own fiscal and
monetary policy, especially if US financial obligations to East Asian
creditors continue to grow.
But East Asian success will also generate new opportunities for US exports,
particularly agricultural goods, as the East Asian market for imports more
than doubles. Continued East Asian current account surpluses will also
provide sources of funds for US investment. Further, East Asian heteroge-
neity will limit the region's ability to use its increased economic clout to the
disadvantage of the United States.
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Key Judgments iii
Scope Note ix
Ingredients of the East Asian Edge
1
Glimpses of the Future
2
Japan
6
The LDCs, Australia, and New Zealand
7
Regional Integration Possibilities
8
East Asia's Potential for Economic Supremacy
9
East Asia as Largest Economic Bloc
9
East Asia as World's Largest Creditor
11
Pax Niponica
16
Risks to US Interests: The Consequences of
"Relative Smallness"
18
Opportunities for the United States in East Asian
Success
19
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Scope Note This paper is the fifth in a series of regional economic assessments on East
Asia published by the Directorate of Intelligence. It has two primary
objectives. First, it attempts to project the evolution of the most dynamic
economic region of the world over the next decade or so. Second, it
investigates a claim increasingly made by academic and business analysts:
that East Asia will surpass the West in a variety of key economic, financial,
and technological indicators by the turn of the century. We summarize the
academic case for East Asian supremacy in the text.
This paper is in many ways the most speculative of the East Asian regional
assessments we have published. The time frame is the long term, and this
makes it difficult to deal with evolving trends with precision. We do not,
for example, attempt to factor in discrete changes in international oil prices
such as those of 1978-80, largely because we cannot foretell when, or if,
they will occur; we do note that East Asia has weathered such disturbances
better than most economic regions in the past.
impact on the region's international competitiveness.
The most important qualification of all is that US economic policy will be
an important determinant of the path East Asia takes between now and the
turn of the century. If US budget deficits were substantially reduced, for
example, East Asia's current financial position as largest net creditor
would be at risk. And US trade policy will clearly have a substantial
Accordingly, this paper begins by considering recent trends in relative US
and East Asian economic performance as a baseline. We then consider the
most likely future course of economic policy by East Asian governments
and assess the degree to which such a course may enhance regional growth
and trade performance. We assume no major policy departures on the US
side. Our forecasts draw heavily on the expertise of our own country
analysts, but our task is to "age" the region in a manner that, by
considering competitive relationships among East Asian states, is internally
consistent. Thus our forecasts for some countries are either rosier or darker
than a narrow view of the country would have suggested. And to ensure
that our forecasts for individual countries make sense, we have tested them
against World Bank research results on structural change in developing
economies.
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East Asia's Economic
Potential for the 1990s:
A Speculative Essay
to late 20th century economic realities.
Ingredients of the East Asian Edge'
Academics and journalists have devoted considerable
attention in the last several years to the relative
weakness of US economic performance when com-
pared to that of its East Asian trading partners.
Concern that corrective adjustments in conventional
economic variables such as exchange rates and prices
are not working as textbook economics predicts they
should has even prompted the introduction of legisla-
tion designed to accomplish through administrative
measures what competitive markets presumably may
not-reduce US trade deficits. Broader concerns
among some observers are prompted by more rapid
East Asian growth rates and the possibility that
Japan's higher per capita income is not an accident
produced by volatile exchange rates, but a deeper
reflection of an Asian decisionmaking system attuned
Growth Possibilities Abound. The academic and busi-
ness analyst case that East Asia contains the ingredi-
ents for economic dominance-based on technological
trends, relative rates of investment, natural resource
endowments, and coherent Asian economic policy-
making-is not difficult to summarize. In Japan, this
analysis begins, the region has a source of technologi-
cal expertise that exceeds that of the United States in
some industries. East Asian growth potential is being
enhanced by Japanese direct investment in the region
' The term "East Asian Edge" is taken from a by now well
established body of literature extolling the economic advantages of
the region. Best known among the many books on the subject are
The Eastasia Edge, by Roy Hofheinz and Kent Calder, Basic
Books, New York, 1982, and Japan As Number One, by Ezra
Vogel, Harvard University Press, Cambridge, 1979. A more techni-
cally rigorous academic account, which predates either of these, is
provided by Edward Dennison, Why Growth Rates Differ, Brook-
ings, Washington, 1967. The definition of East Asia adopted in this
paper is somewhat different from that found elsewhere: Japan,
Australia, New Zealand, South Korea, Taiwan, Hong Kong,
Singapore, Indonesia, Malaysia, Thailand, the Philippines, and
China. We exclude some states, such as the Indochina countries, on
Figure 1
The United States and East Asia:
Gross Domestic Product
Billion US $
5,000
1,000 1975 80
Constant 1986 US S.
b Constant 1986 US S using 1986 exchange rates
based on United Nations estimates of purchasing
power parities.
c Constant 1986 prices at prevailing exchange
rates for the US S.
d Estimated.
Projected.
to an even greater degree than Japanese direct invest-
ment is expanding productivity in the United States,
since countries such as Indonesia and Thailand are
just entering the more sophisticated stage of their
industrial development and high returns on invest-
ment are thus easy to come by. The high rates of
savings that prevail in the region-even relatively
poor China saves as much as 30 percent of national
income-ensure that the required financial capital is
available.
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At the same time, Japan and the NICs assure the
region's other countries that the large pool of potential
investable resources is being internationalized, and
thus available to other East Asian states, in the form
of current account surpluses-an estimated $110 bil-
lion in 1986. The high rates of return on investment
that prevail among the region's developing countries
provide reason to believe they will receive a substan-
tial share of these funds for productive capital forma-
tion. The development of better integrated regional
capital markets, underway for several years, ensures
that institutional arrangements are encouraging rath-
er than blocking such transfers.
The region is rich in productive inputs and will grow
richer. Rapid labor force growth-already locked in
place as a result of high birth rates over the last
several years-augment an abundant supply of re-
gional natural resources in most countries (Japan,
Singapore, and Hong Kong are the exceptions). Labor
force growth among the region's LDCs, for example,
ranges to nearly 3 percent. At the same time, the
region's relative youthfulness-and the absence of
Western-style social insurance schemes in most coun-
tries-ensures that high rates of savings will persist in
most countries.
Business analysts agree that area governments contin-
ue to conduct economic policy in such a way that the
region's competitive advantages are realized. East
Asian regimes are bolstered by social mandates that
traditionally have emphasized superior economic per-
formance and, for the most part, by homogeneous
populations that reach consensus quickly.
At the same time, a trend toward deregulation,
financial liberalization, and freer trade regimes-
which has proceeded partly because of pressure from
the West and the sponsorship by the IMF and World
Bank of structural adjustment programs in East
Asian LDCs-is further bolstering regional efficiency
(see inset). Smaller distortions in interest rates, coher-
ent prices for traded goods, market-determined ex-
change rates, fewer restrictions on capital movements,
and enhanced access by foreigners to local financial
markets suggest that investment is being directed to
the highest rate of return in the region and thus to its
most logical location. This pattern contrasts with
Figure 2
The United States and East Asia:
Gross Fixed Investment
500 1975
a Estimated.
b Projected.
those observed in Latin America and Africa, where
policymaking often distorts market signals, suppress-
ing trade and instructing private economic actors to
avoid the risks that would advance national levels of
income and wealth.
Glimpses of the Future
Critics of literature extolling the virtues of East Asia
would argue that the case for East Asian economic
supremacy is closer to an essay than to rigorous
analysis. Indeed, the region has had lagging economic
performers-the Philippines being the foremost ex-
ample-and Japan faces different challenges today
than those that it met in the 1960s and early 1970s by
importing technology and keeping wage growth, and
consumption expenditures, sluggish.
80 86a 87b
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Table 1
East Asia: Regional Labor Force Trends, 1985-2000
Labor Population Labor
Force Force
Millions ofpersons
(except where noted)
Annual Labor
Force Growth
(percent)
120.8
15.8
Indonesia
163.4
67.0
212.0
91.5
2.1
Thailand
51.3
26.5
66.0
35.1
1.9
Malaysia
15.6
6.0
21.0
9.1
2.9
East Asia
1,537.9
702.8
1,854.0
934.0
1.9
United States
239.3
115.2
263.0
131.8
0.9
EEC
321.6
138.4
336.0
146.9
0.4
Source: World Development Report, IBRD, 1986. Totals may not
add because of rounding.
Country-specific analysis nevertheless suggests that
the business and academic approach to forecasting
East Asia's future can be done with some modifica-
tion. In particular, using estimated growth trends for
individual countries and using them to "graduate"
each economy into the economic structure the World
Bank judges is commonly associated with that income
level, we believe two broad trends will develop during
the 1990s. First, the region's more mature economies
will develop a trend already observed in the United
States, becoming increasingly service-sector oriented.
Second, the region's LDCs will deemphasize agricul-
tural output in favor of industrial growth, as LDCs in
other regions of the world have. Statistical analysis
suggests this trend will be most evident in Thailand,
which is just beginning to turn its attention to longer
term industrial development and is attracting consid-
erable foreign investment. From a regional perspec-
tive, we believe the result will be a shift in production
into services at the expense of agriculture-with the
share of industrial output remaining more or less the
same. Assuming these trends prevail, the region's
exports will increasingly involve services, such as
finance and transportation, at the expense of extrac-
tives such as oil, and at the expense of agricultural
commodities such as rubber and rice.
The regional technological hierarchy-wherein Japan
occupies the higher rungs along with Australia, the
NICs and New Zealand the next set of rungs, with
the region's LDCs bringing up the bottom-will
probably still apply. But over the next decade or so the
technological capacities of each country could grow as
productivity improves. The key to this evolution will
be Japan's ability to climb the ladder, vacating the
rungs it currently occupies for the NICs, which in
turn will be making room for the region's LDCs. We
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Figure 3
East Asian Output:
Profile of Structural Change, 1986-20008
Industry
Agriculture
Services
Infrastructure
Mining
Japan
1
1
40
18
130
j
jj
38
50
3
South Korea
1
1
16 39
1 440
30
35
14
5
Taiwan
1
14 1
18 45
40
24
38
12
7
Singapore
51
51
38
35
55
58
1
1
Hong Kong
10
10
22
20
67
69
Australia
7
15 2
17 28
35
42 6
45
3
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Figure 3, Continued
East Asian Output:
Profile of Structural Change, 1986-2000a
Infrastructure
Mining
Agriculture
Services
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believe this process is already under way with the
appreciation of the yen, which is forcing Japanese
firms to adjust their operations and move their prod-
uct lines upscale technologically in order to remain
competitive, vacating the middle ground-in steel,
shipbuilding, textiles, and other industries-to coun-
tries such as South Korea. The next step will be the
completion of the process of currency appreciation by
the NICs, probably by mid-1988, which should bene-
fit more advanced LDCs, such as Malaysia and
Thailand, in the same way.
Economic theory suggests that relative prices in the
region-wages, interest rates, and commodity
prices-will adjust as financial markets become better
developed and more fully integrated and as countries
such as China continue to open further to foreign
trade. China's larger regional role will tend to bid
down wage rates and bid up returns on capital in each
country, a process that will promote investment and
protect East Asian competitiveness in manufacturing,
although at the same time ensuring sluggish growth in
living standards in the LDCs of the region. Better
integrated financial markets will mean that capital
transactions will begin to have the same potentially
powerful effect on exchange rates presently at work in
Western financial centers, where the volume of secu-
rities traded internationally exceeds the volume of
transaction in goods and services by 25 times. This
process is well along in Japan and also has begun in
Australia and New Zealand, whose currencies in the
last two years have become among the world's most
commonly traded in the wake of financial deregula-
tion. Finally, the region will face more favorable
terms of trade with its trading partners as it shifts
away from exporting mining and agricultural com-
modities-a gain in purchasing power that will exa-
gerate the region's emerging advantage in GNP and
income with respect to the United States and Europe-
an Economic Community.
Japan. In our judgment, Japan, which produced al-
most three-fourths of East Asian output in 1986, will
see its share drop to perhaps 60 percent at the turn of
the century, mostly as a result of faster growth in the
region's NICs and LDCs. But the structure of the
economy will also change as it matures. The shift
already under way from manufacturing to service
sectors of the economy-officially endorsed by reports
issued by the government-appointed Maekawa Com-
mission in April 1986 and April 1987 and encouraged
through the market adjustments by the appreciating
yen-will be more pronounced by the year 2000. The
Ministry of International Trade and Industry esti-
mates that domestic restructuring and the flow of jobs
overseas through foreign investment will eliminate
over 500,000 manufacturing jobs during this period.
Tokyo hopes to replace many of the lost jobs with new
ones in the information sciences and applied technol-
ogy through a 30-year plan to create 19 Japanese
counterparts of California's Silicon Valley, part of a
process Tokyo refers to as the "softicization" of the
economy. The shift to services is being aided by
Tokyo's growing role as an international money cen-
ter-four of the world's top five banks ranked by
assets are already Japanese-and financial reform
already under way promises to accelerate the
transition.
Demographic change will accompany the maturation
of the economy. Japan at the turn of the century will
have one of the oldest populations in the world, with
16 percent of its people over 65, versus 13 percent in
the United States. The burden of health and retire-
ment benefits, currently spread easily over six work-
ers, will have to be spread over four. This demograph-
ic change will accelerate the move to services. It will
also depress Japan's savings rate, and the current
account surplus-which is ultimately based on the
excess of liquid savings over investment-will drop
sharply as a result.
The biggest test for Tokyo in meeting the challenge of
maturity will be managing the domestic political
strains that will accompany the gradual international-
ization of the economy, which industrial restructuring
will mandate. Agricultural reform and stepping up
manufactured imports from the rest of the region may
be the most difficult issues to address in the process.
But most indicators, including the fact that the ruling
party, in the face of considerable opposition, initiated
opening agriculture to competition this year with the
first cut in rice subsidies, suggests such a development
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companies now have employees overseas.
result that nearly half of Japanese manufacturing
is inevitable. In the industrial sector, imports of
consumer goods are on the rise and the strong yen has
also forced many firms to look abroad to cut costs
throughout sourcing assembly operations, with the
global trade and finance.
Further, Tokyo has programed a $4 billion escalation
in its foreign aid program, mobilizing private money
for the most part, to the region's LDCs to increase its
presence and consolidate its diplomatic relations, in-
creasingly with aid that is no longer tied to being
spent on Japanese exports. Together, these trends
suggest that, by the turn of the century, Japan will
have assumed an international role roughly equal to
that presently played by the United States-whether
measured in terms of GNP, foreign investment, or
than by Japan.
The NICs. We project that the NICs' share of
regional output will rise by half, to about 12 percent,
or $650 billion, by the turn of the century, as the four
outpace all other East Asian economies. In contrast to
Japan's falling savings rate and vanishing current
account surplus, the NICs' relatively younger popula-
tions will continue saving more than their business
communities can invest. Thus the majority of interna-
tionally recyclable capital generated by East Asia by
the early 1990s will be produced by the NICs rather
We expect that the NICs will undertake various
forms of industrial restructuring as they prepare for
the next century, each program tailored to local
political and economic circumstances. South Korea, in
particular, will lead the way into areas customarily
dominated by Japan-microelectronics, vehicles, and
steel. NIC governments will promote the restructur-
ing by adopting commercial policies that force domes-
tic firms to increase value-added, and thus move
upscale technologically, in traditional industries such
as textiles, clothing, and footwear-which will cap-
ture the increasing attention of the region's LDCs.
The result will be a higher technological content for
NIC manufactures, which will cede the lower end of
product lines to the LDCs. This trend will be most
pronounced in the NICs with the greatest Japanese
economic presence, notably South Korea and Singa-
pore, where Japanese firms will be repeating a trans-
formation they undertook themselves at home in the
late 1970s and early 1980s.
Existing differences in income levels and technology
among the NICs themselves will probably widen
during the 1990s. Singapore and Hong Kong, the two
city-states, in particular have divergent futures. Al-
though Singapore's growth into higher technology
products will require a continued emphasis on manu-
facturing, Hong Kong will move more heavily into
services as it becomes China's trader and financier
with the anticipation of a return to Chinese rule in
1997. A less wide-open political environment in Hong
Kong as the transfer approaches will reduce the
relative weight of Western investment in favor of
investors who meet priorities established in Beijing.
Meanwhile, a relatively conservative leadership in
Taiwan will pursue mildly protectionist economic
policies that gradually widen the developing gap
between Taiwan and the more dynamic South Korea.
It is possible that the group of East Asian NICs in the
mid-1990s will include new entrants into the club by
several of the region's more advanced LDCs, notably
Thailand and Malaysia. Each, indeed, is likely to be a
major player in the regional microelectronics industry
and, along with China, may have automotive indus-
tries nearly capable of export. But we believe that
even with good economic performances and astute
policymaking in Bangkok and Kuala Lumpur, sub-
stantial gaps will still exist between NIC and LDC
income levels and production technology in all but a
few industries. Linkages between more advanced in-
dustries and the rest of the economy in both countries,
moreover, are likely to remain modest.
The LDCs, Australia, and New Zealand. We believe
that several East Asian commodity exporters will
undergo economic transformations nearly as dramatic
as Japan's. Many of these changes will be a product of
long-term structural adjustment programs presently
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under way, most financed and sponsored by the IMF
and the World Bank. The gradual "deprotection" of
import substitution industries in Thailand, the Philip-
pines, Australia, and New Zealand, for example-
coupled with financial reforms designed to channel
investment funds to their most efficient uses-will
streamline indigenous manufacturing in these coun-
tries. In Thailand and the Philippines, this process
should produce a new export potential in light manu-
facturing, where the two have clear comparative
advantages. In Australia and New Zealand, manufac-
turing will become less of a drag on domestic produc-
tivity growth and will free labor and raw material
resources for use in other export enterprises. Structur-
al adjustment programs in Indonesia and Malaysia,
initiated unilaterally and undertaken without
IMF-World Bank sponsorship, will produce less
dramatic-but still noticeable-improvements in
manufacturing efficiency.
Declining petroleum reserves and rising oil consump-
tion in Indonesia and Malaysia, along with less severe
depletions of timber and tin reserves, also will prod
the two toward the industrial development long ex-
pected by Western economic analysts. The key mech-
anism for this transformation will be weakened exter-
nal financial accounts and drastically depreciated
currencies, which will make domestic manufactures
more price competitive with those produced else-
where-a process already under way. Indonesia's
conversion from major oil exporter to large-scale oil
importer will entail considerable political pain and
require overhaul of the petroleum-based tax system.
But it will do more than any other single event to
internationalize what has so far been East Asia's most
inward looking market economy.
The continued opening of China is potentially the
most important development in the evolution of the
region, if also the least certain. Price reforms in
agriculture during 1982-85, coupled with more effec-
tive distribution of agricultural inputs such as fertiliz-
ers, demonstrated the potential gains from market-
oriented policies by producing 14 percent annual
growth and spawning countless new rural enterprises.
But the main thrust in China's export drive is likely to
continue to be manufacturing, where the volume of
output has expanded 13 percent annually since 1979.
If China's GNP grows 7 percent annually on
average-which, in view of the growth record of the
last several years, is easily within reach-and opens to
the degree of many of its Asian neighbors, China's
exports could reach $175 billion in the year 2000, six
times the present level. This would place China on a
par with France or the United Kingdom as a trader.
China would have begun to dismantle its inefficient
system of provincial self-sufficiency in favor of region-
al specialization, and its demand for industrial raw
materials from the region's other LDCs would replace
much of Japan's gradually deindustrializing materi-
als. China at the same time would provide consider-
able competition for the region's slower growing
LDCs in third-country export markets for light indus-
trial products, a prospect that will promote continued
structural adjustment in countries like the Philippines
and Indonesia.
Regional Integration Possibilities. Private initiatives
in a business environment featuring lower tariffs and
more liberal financial regulations will gradually refo-
cus a portion of East Asia's exports inward during the
next decade or so. Closer private cooperation between
the NICs and Japan have already followed direct
investment in the NICs by Japanese firms. Links
between China and Japan have also evolved rapidly
following China's decision to allow a more rapid
infusion of direct foreign investment and a more
liberal environment for imports. These ties will grow
closer with the maturing of the Japanese economy and
Japan's continued opening to a broader range of
manufactured imports.
We believe formal government-to-government cooper-
ation, such as an East Asian trading club or customs
union, is far less probable, in view of the region's
considerable political and economic heterogeneity.
And, under present circumstances, it is far less neces-
sary than private initiatives. We believe only the
region's LDCs would find cause to establish common
tariffs, and even this seems remote in view of competi-
tion among them in trade relationships.
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We believe the region will integrate more rapidly, and
that public-sector cooperation will play a more promi-
nent role in the process, if its exports are threatened
by outside protectionist barriers. A decline in Western
demand for East Asian exports would for a time
retard regional growth, in view of the heavy depen-
dence of especially the NICs on Western markets for
their exports. But, because the capacity to produce
regional output could roughly double between now
and the turn of the century, we believe adequate
demand for East Asian exports is ensured from within
the region itself once adjustments in marketing efforts
take place-and it is probable that area governments
would spur such adjustments if access to the West
were denied. We believe a greater threat to regional
development would be posed by diminished access to
US goods. The evolution of East Asian production
away from agriculture and commodities toward ser-
vices and a broader spectrum of manufacturing enter-
prises would most likely be slowed by a loss of the
ability to import agricultural products at relatively
favorable prices.
East Asia's Potential for Economic Supremacy
East Asia as Largest Economic Bloc. Our analysis
suggests, on the basis of observable savings rates and
policy initiatives already in place, that East Asia will
have little trouble matching, and could exceed, its
1975-85 record of 4.9 percent annual growth between
now and the turn of the century.' Our country-specific
forecasts for East Asia suggest the region could
produce a combined GNP that exceeds that of both
the United States and the EEC at exchange rates that
prevail in the year 2000.
Actual East Asian GNP in the year 2000 will reflect
both expansion in volume terms and improvements in
relative purchasing power over the next 12 years. In
volume terms alone we believe East Asian output will
double. By comparison, US GNP will reach $5.8
trillion if it records the trend growth most Western
forecasting services think it will, 2.4 percent annually;
I The treatment of a number of technical issues, including the
choice of exchange rates to arrive at cross-country comparisons of
GNP, could slightly alter the calculations contained in this para-
graph. But the basic judgment-that East Asian output will be the
largest among the three economic blocks at the turn of the
EEC GNP will reach $3.4 trillion if the EEC follows
predicted trends, expanding 2.2 percent annually.
Although exchange rates are impossible to forecast
with any precision, we calculate that East Asian
currency appreciation of only 0.4 percent annually
over the next 12 years would be sufficent to establish
the region as the largest economic bloc at market
prices; since 1980, the region's foremost currency, the
yen, has appreciated an average of 3 percent annually.
Alternatively, using international comparisons of pur-
chasing power done by US academics under World
Bank auspices, we calculate that East Asian output
will exceed US output at the turn of the century by
about 15 percent, reaching about $6 trillion.
One reason to expect the gap to turn out to be this
large is that present trends in East Asian policymak-
ing can be expected to foster further productivity
improvements-a result of liberalization trends in
financial, trade, and foreign investment policy. This
will produce a more efficient industrial base as time
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ability. Such a development will produce particularly
pronounced improvements in foreign trade competi-
tiveness if governments outside East Asia, particularly
in Western Europe, persist in protecting sunset indus-
tries, thus locking in place low productivity manufac-
turing firms such as those producing standard fila-
ment textiles and cold rolled steel. The result will be
stronger East Asian currencies and a mix of East
Asian exports that commands the highest available
prices in international markets.
Another argument in favor of East Asian success is
that the region is using its higher rate of investment to
amass what will probably soon be the world's largest
and most modern stock of industrial capital. We
calculate, for example, that the region is investing
nearly 20 percent more in real terms than the United
States, an annual gap of roughly $120 billion. Foreign
direct investment by East Asian firms in the United
States is unlikely to grow by more than a small
fraction of this total, and thus will not erode the
emerging East Asian advantage. The investment gap
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Table 2
Trends in East Asian Economic Policy Liberalization
Controls on capital outflows eased: some deregula- Tax reform widens tax base. Continued capi-
tion of deposit rates, foreign banks allowed entry, tal market reforms, restructuring aid for dis-
foreign firms get access to equity market, offshore tressed manufacturing firms, some easing of
banking established; some easing of agricultural sub- quotas protecting agriculture, further privati-
sidies, privatization of several public-sector firms. zation and interest rate decontrol.
Currency float, interest rate deregulation, foreign Tariff reductions to be phased in over seven
bank entry allowed as part of sweeping financial years, reform of wage setting system to im-
reform, tax reform, including value-added tax. prove manufacturing competitiveness.
Currency float, interest rate deregulation, foreign Subsidies to be phased out, import restrictions
banks allowed entry, foreign exchange decontrolled, eased.
tax reform, subsidies cut, state enterprise autonomy
introduced.
Tariff reductions, import restrictions eased, barriers Foreign access to capital markets broadened,
to foreign bank branching and local currency loans further tariff cuts, currency appreciation,
eased, foreign investment allowed in almost all man- gradual opening of service sector to foreign
ufacturing, restructuring of distressed firms, copy- investors.
right and patent laws strengthened.
Tariff reductions on 1,700 consumer items begun, Some easing of foreign exchange restrictions,
some import restrictions eased, modest tax reform, further tariff cuts, more realistic exchange
some easing of foreign investment restrictions. rate.
Business tax cuts, reduced social insurance contribu- Opening of secondary stock market, market
tions, wage hikes rolled back to aid competitiveness, for government bonds, new regulations allow
financial reform in wake of several business failures. broadened corporate access to equity market,
new financial hedging instruments, privatiza-
tion of some state firms.
Hong Kong Personal income tax cuts to reduce budget surplus. Reevaluation of currency, legal status after
1997 resolved.
Bankruptcy legislation, devaluation, several experi- Management reforms in manufacturing, some
ments with market prices for raw materials and urban price and wage reform, value-added tax
interbank funds, labor law reform; fiscal, monetary as part of tax reform, subsidies reduced, some
instruments refined; agricultural price reform for profit repatriation allowed, some foreign ex-
overplan production. Tax reform allows profit reten- change decontrol.
tion, bond issuing authority begun as part of reform
of banking system.
31 percent devaluation, value-added tax as part of Further devaluation, more easing of duties on
measures to broaden tax base, food subsidies re- producer goods, further easing of restrictions
duced, tariffs on 300 producer goods slashed, import on trade. Some reform of foreign investment
monopolies abolished, import quotas liberalized, re- regulations and those affecting domestic
form of customs service. firms.
Tax reductions, reform of banking system designed Tax reforms to broaden tax base, foreign
to streamline finance companies, open equity market. access to equity market broadened, easing of
Tariff reductions, easing of foreign exchange con- foreign investment regulations.
trols, devaluation and currency float.
Revenue collection improved to cut budget deficit, Foreign investment rules eased, tariff reduc-
reduced interest rate subsidies, new foreign invest- tions on imports of producer goods,
ment incentives. devaluation.
Tariff reductions, tax reform, some privatization, Devaluation, import restrictions further liber-
export taxes slashed, most controls on imports re- alized, some deregulation of foreign invest-
moved, trade monopolies dismantled, agricultural ment, value-added tax system implemented.
export quotas removed.
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also means that East Asia is replacing old equipment
at a faster pace than the United States or the EEC, so
that, by the turn of the century, the region will have in
place not only the largest stock of capital equipment
in the world, but that of the most recent vintage and
technology.
East Asia as World's Largest Creditor. The emer-
gence in the last several years of Japan as the world's
largest net creditor and of the United States as the
largest net debtor illustrates the potential combined
effects of more liberal restriction on capital exports in
East Asia and simultaneous large fiscal deficits in the
United States. Last year, Japanese financial institu-
tions alone financed one-third of the US budget
deficit through purchases of US Government securi-
ties. Assuming US budget deficit reductions were to
follow Gramm-Rudman guidelines in the years ahead,
this trend could continue, along with upward pressure
on US interest rates, to recruit the required foreign
capital. Competing demands for Japanese funds-
and, in the 1990s, for surplus capital from East Asia's
NICs-will come from Latin America, Africa, and
the commodity exporters of East Asia, giving the
Japanese and the NICs a greater ability to influence
international financial affairs.
East Asia's ascendancy as largest creditor would have
a marked effect on the competitiveness of private
financial institutions. Japanese banks already have
surpassed US banks as the largest group of private
lenders, accounting for 32 percent of global bank
assets, according to Bank for International Settle-
ments data. Much of this activity is in the interbank
market where Japanese banks have become the domi-
nant players because of a variety of factors, including
their entry into new securities markets, their role in
the management of interest rate positions, and the
opening of the Tokyo offshore banking center. Ac-
cordingly, seven out of the top 10 banks in the world
are Japanese when ranked by deposits. In the years
ahead, they will be joined by South Korean-,
Taiwanese-, and Hong Kong-based financial institu-
tions.
The form of East Asia's lending can be expected to
continue to evolve. Although Japan has become pre-
mier net creditor with assets of $600 billion, 70
percent of its assets are in foreign securities; foreign
lending and direct investment account for only 16 and
12 percent, respectively, of the total. The growth of
overseas loans has slowed considerably because of
LDC debt problems, but direct investment by not only
Japan but also South Korea has picked up sharply in
recent years, and we expect this to continue. East Asia
will probably eventually use direct investment as its
preferred tool for recycling its surplus to the rest of
the world, with what lending does occur confined to
short- and medium-term, trade-related credits. Direct
investment, for one thing, will allow Japan and the
NICs to promote joint ventures that facilitate access
to foreign markets.
East Asia as Technological Leader. On the basis of
existing technological capacities in the United States
and Japan, research and development efforts under
way in key industries in both countries, and Japan's
demonstrated ability to graduate more electrical engi-
neers annually in absolute numbers, there is every
reason to believe East Asia will enjoy at least some
technological edge over the rest of the world by the
turn of the century. After surveying trends in nine key
industrial technologies, we judge that Japan by then
can achieve a clear lead in four-semiconductors,
advanced structural materials, manufacturing tech-
nology, and biotechnology-rough parity in two-
telecommunications and data processing-and will
still lag slightly in three-aircraft, space, and nuclear
power (see table).
The technological capacities of the region as a whole
will be strengthened to the extent that US investors or
the Japanese, themselves at the leading edge in these
areas, disperse second-tier technological know-how
through direct investment and outsourcing produc-
tion. To a degree, this is under way. The region's
NICs, for example, are already a large part of the
regional semiconductor industry and are known to be
focusing future investment efforts on biotechnology.
The structure of East Asia's foreign trade would
reflect this technological superiority to the same
degree that trade reflects country resource endow-
ments. Regarding the region's exports, we believe
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i-onneentiai
East Asian Financial Centers at the
Turn of the Century
East Asia will play afar more prominent role in
international finance 12 years hence and can be
expected to be the dominant player if it becomes the
largest global creditor, as current trends suggest.
Tokyo, by liberalizing its markets, is already compet-
ing more directly with far larger international finan-
cial communities in London and New York. The
establishment of the Tokyo offshore banking center
in 1986, and ongoing developments in Japanese com-
modities and futures markets, are examples of To-
kyo's push to create a linkage to London and New
York for a 24-hour business day. When this is
achieved, the importance of the locale in which
transactions are initiated will be reduced, and Lon-
don and New York will lose an advantage that they
have presently. A key remaining obstacle for the
Japanese is allowing more foreign banks and securi-
ties firms into the domestic market. The Japanese
have traditionally been cautious in removing such
barriers to entry because of the risks of being "over
banked, " a concern exacerbated by numerous bank
failures in the United States in the last two years.
Nonetheless, we foresee Tokyo as a completely open
market by the turn of the century.
Hong Kong and Singapore will continue to be leading
financial "bridges" in the years ahead, but their roles
will begin to diverge in the 1990s, and neither will
Japan will market a different product mix than at
present, deemphasizing motor vehicles and steel in
favor of higher technology telecommunications and
data processing equipment, as well as pharmaceuti-
cals and possibly medium scale commercial aircraft.
The region's motor vehicle exports are increasingly
likely to come from NICs such as South Korea, which
should also be a major producer of office machinery
and possibly the processing of biotechnology products.
Singapore, Hong Kong, and, to a lesser degree,
Taiwan should share in the gains from Japanese
compete with Tokyo. Hong Kong will act as China's
chief private financial agent with the return to Chi-
nese rule in 1997. Singapore, on the other hand,
appears determined to promote itself as a provider of
portfolio management services, at the same time
establishing broader access by foreigners to local
markets for equity and government bonds. Singapore
also will be attractive to outsiders as a result of its
willingness to ensure the confidentiality of transac-
tions, similar to Switzerland.
competition for the rest of the region.
Smaller scale financial centers will continue to devel-
op in Australia and New Zealand, both of which will
be promoting development of their service sectors.
Taiwan has great potential, especially as it develops
as a capital surplus country and the international
demand for Taiwanese Eurodollars grows. But a lack
of communications facilities-attributable to the se-
curities' authorities fears of outside financial ma-
nipulation-will stunt development of Taipei as a
rival to Hong Kong or Singapore. Indeed, Seoul may
achieve more, given South Korea's emerging capital
surplus and the government's long-term plan to inter-
nationalize Korean financial markets. For their part,
the LDCs of the region will concentrate on developing
their domestic banking systems and will provide little
electronic spinoffs as Japanese production moves up-
scale in product lines. Meanwhile, the LDCs, especial-
ly China, will produce a significantly greater share of
East Asia's textile and light industrial exports.
Regarding imports, technological change should shift
the region's demand for ores and other raw materials
from a maturing Japan increasingly to the NICs, and
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Table 3
Current Japanese Technology Relative to the United States
and Prospects for the Turn of the Century
Boldface indicates improvement in Japanese position. The nine
categories selected for this table were chosen for their military as
well as commercial applications.
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Contiaential
the region as a whole will rely on oil imported from
the Middle East and the United States to a greater
degree than at present as its own production falls. The
NICs, China, and the other LDCs will account for a
larger share of the region's imports of Western-
manufactured capital equipment and data processing
machinery to support their technological growth in
industry. At the same time, the shift from agriculture
into industry and services will boost East Asia's
demand for agricultural products, even as it increases
regional production of processed foodstuffs.
Risks to Continued Growth
We believe the principal risks to our forecast are the
possible failure of Japan to adjust policy and change
economic structure to eliminate its surpluses, a possi-
ble reversion to autarky in China (see inset), and
various country-specific political uncertainties, which
may produce discontinuities in economic policy. The
most likely of these contingencies is probably stunted
adjustment in Japan, where political opposition to
deemphasizing agriculture could prove a more diffi-
cult obstacle over the longer run than we think it will,
and where future gains from investment in high
technology could be less certain as time passes.
Political Uncertainties. We believe that political
development in most of East Asia greatly lags recent
gains in economic sophistication, and continuity in
economic policy is at greater risk there as a result. In
the years ahead, the most dramatic changes may
come in China and Taiwan, where uncertain succes-
sion arrangements are already having a bearing on
prospects for economic reform. Beijing's leadership
can be expected to continue to weigh the merits of
employing various export-promoting market mecha-
nisms, including decentralizing control over a variety
of economic decisions at both the plant and provincial
level, at the expense of some loss of traditional
decisionmaking power for the Communist Party. At
stake, because of the potentially powerful effects of
even marginal economic reforms, is the degree of
China's openness to foreign markets. Because reform-
ist elements are probably better entrenched in the
younger generation of party leadership, which will
have a chance at increasing its power at party con-
gresses in 1992 and 1997, the passage of time will
make a reversion to economic isolationism less likely.
In economically more advanced Taiwan, a similar
generational transition is in evidence in a similar
political system, except that the current ruling elite
has pursued a notably conservative course on policy
issues affecting foreign trade and finance, such as
foreign exchange decontrol and financial deregula-
tion. Thus a fairly radical change of political direction
could occur without jeopardizing the economy. In-
deed, we are inclined to agree with some Asian
analysts who argue that Taiwan's economic future
would benefit from such a development, since Taiwan
will require industrial restructuring that the current
leadership has not yet planned if it is to keep up with
its NIC partners.
Indonesia-the region's second most populous coun-
try-and the Philippines face the greatest succession
uncertainties among the region's LDCs because of the
highly personalized nature of politics and less firmly
entrenched elites. A sharp change in political direc-
tion in either country probably would sharply circum-
scribe its economic role in the region. The alternative
to the leadership of President Soeharto in Jakarta, for
example, is probably a more conservative government
that would rely less on market forces and that would
focus growth inward to an even greater extent than at
present. In the Philippines, a weak political center
could give way to forces from the right or the left.
Either change in direction would sharply diminish the
economy's growth and trade prospects by limiting the
moderating influences of Manila's technocrats and its
foreign creditors on economic policy.
Nevertheless, we are inclined to believe that, in the
aggregate, our basic forecasts will hold. South Korean
experience demonstrates that political instability need
not take a toll on economic achievement, and postwar
Asian history is replete with political transitions that
resulted from personal contests for power rather than
differences over policy issues. This suggests that even
political transitions that unseat established elites may
not change economic policy direction. Furthermore, in
Japan, where the Liberal Democratic Party has held
power continuously since the Second World War, the
same mix of political constituencies seems certain to
be making economic policy during the 1990s, and
their LDP factions are for the most part in favor of
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We considered several possible paths for East Asia's
two key economies in preparing this assessment.
The Graying Giant Scenario assumes that Japan
undergoes two related transformations, one produced
by a transfer to services, the other a function of
demographics. Here, Japan in the 1990s is buffeted
by more or less the same forces that drove the United
States in the 1970s. One difference, which may slow
the process of change in Japan, is that Tokyo is less
receptive to imports. On the other hand Japan will
age demographically, whereas the United States in
the 1970s admitted many young, inexperienced work-
ers to the labor force. This suggests Japan may have
less trouble improving labor productivity than in the
case of the United States. Some commercial bankers
in Japan, combining these changes with the recent
attempt by Japanese firms to escape the high yen by
moving manufacturing production into firms in
Southeast Asia and the NICs, but managing opera-
tions from Tokyo call this the Designer Boutique
Scenario, a reference to fashion industry outsourcing.
The Holding Company of the World Scenario, the
principal alternative, assumes that Japan does not
reduce its savings rate or current account surplus,
instead building up claims on both the public and
private sectors in the United States, East Asia, the
EEC, and Latin America. Japan would be prepared
to fund the US budget deficit more or less indefinite-
ly, its current account surplus would be based on
interest earnings, and only direct investment in the
United States would slow the process. In this case,
Japan does little to aid the region, steps up competi-
tiveness with the NICs by hanging on to obsolete
product lines, and suffers anemic local investment
demand because of rigidities in government policy,
which continue to favor agriculture. Because this
scenario entails even more friction between Japan and
its trading partners than at present and assumes
industrial adjustment already under way is interrupt-
ed, we lean to the more optimistic case.
For China, the most pessimistic case is the Reversion
to Autarky Scenario, in which ongoing factional
infighting in Beijing is resolved in favor of the
conservatives. China recentralizes economic decision
making, reorients its economic relations toward the
USSR and CEMA, and closes to foreign investment.
A closed China remains essentially irrelevant in the
evolution of the regional economy, as trade volumes
shrink to levels observed in the early 1970s-less
than I percent of world exports-because of the
preference of planners to satisfy locally pent-up de-
mand for consumer goods.
The Market Forces Reform Scenario is the most
jarring for China, the rest of the region, and the
world. It assumes Beijing moves within the next five
years or so to introduce far-reaching reforms of the
price and trading system that would equalize domes-
tic and international prices, producing a more effi-
cient distribution of resources in China and greater
incentives to export. China would have to weather
considerable short-term economic dislocation and
would require decisive political leadership from the
reformists in Beijing at the same time the role of the
Communist Party in manufacturing is loosened in
favor of factory management. For this reason and
those cited in the text, we are inclined to believe
China's path will fall somewhere between these two
scenarios.
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the economic transition we believe Japan must make
if the region as a whole is to prosper. The impact on
economic policy of changes in government in Austra-
lia and New Zealand, where labor parties dominated
by rightwing factions are pursuing conspicuously con-
servative courses of action, would be only slightly
greater.
East Asia and the Global Balance
East Asia's probable ability to handle the risks and
realize most of its potential means that, by the turn of
the century, Western analysts will be confronted by a
variety of indicators that suggest East Asia is indeed
the "number one" regional economic bloc. East Asian
output, investment, and trade almost certainly will
exceed that of the United States and the EEC. East
Asia will be a dominant player in international finan-
cial affairs and may be the world's largest creditor.
The region also will possess clear leads in a variety of
industrial technologies and will be competitive with
the West in several others.
The heterogeneity of the region will nonetheless limit
its ability to use its leverage to advantage in interna-
tional economic and political-military affairs. Ten
governments will manage economies producing over
40 percent of the region's output (Hong Kong will be
under Chinese control, and Japan will manage 60
percent) and ten Central Banks will control at least
one-third of the region's money supply. Relations
among the industrializing countries of the region and
among its commodity exporters will remain in many
cases competitive. Only if forced by protectionism to
turn inward do we believe that East Asian states will
engage in formal, substantive economic cooperation
such as a trading club or a common currency area. As
a result, the region's ability to convert its economic
clout into an international order that better serves its
interests will depend on the emergence of a yet-to-be-
developed East Asian leadership with a coherent and
convincing vision of what that order should be.
Pax Niponica. Japan, which at the turn of the century
will dominate the world's largest regional economic
bloc, would be the natural choice for such a role, as
several recent US academics have currently speculat-
ed.' That Japan has much to offer in economic
leadership is already openly acknowledged by such
East Asian states as Malaysia and Singapore, where
governments have in one form or another officially
designated Japan as the "model" to emulate. Divisive
memories of Japanese military domination during
World War II, indeed, are giving way to generational
change, and even Australia and New Zealand in
recent years have begun to reassess their relationship
with Tokyo and have begun to view their future as
Asian, rather than as essentially European, states.
What remains is for Japan to consider its own role in
the international economy, an issue that the Japanese
press suggests has just begun to attract popular
attention.
However this is resolved, we believe Japanese individ-
uals will exercise more international leverage collec-
tively than their government. Private-sector Japan
will have the opportunity to exert considerable influ-
ence in financial affairs as its status as creditor grows.
For example, Japanese investors already hold $22
billion in equity in California banks, including five of
the largest 11 and the share is likely to grow further
not only in the United States, but in South Korea and
Taiwan. In addition, Japanese securities firms will be
influential players in other forms of corporate finance.
Tokyo has already lifted restrictions preventing Japa-
nese firms from participating in US futures markets,
and Japanese portfolio transactions will carry increas-
ing weight in determining rates of return in similar
markets.
Tokyo will have the opportunity to expand its influ-
ence in multilateral institutions, including the Bank,
the Fund, and The Asian Development Bank (ADB),
if it wishes. The United States has always been the
member with the largest voting bloc in these institu-
tions, but Japan could challenge for leadership with
further contributions. Indeed, Japan currently holds
equal voting shares in the ADB. Whether such a
development would change Bank and Fund policy is
far less certain. In 1986, Tokyo increased its contribu-
tion to the International Development Association,
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Benchmarks of Regional Economic
Growth at a Glance
A number of key economic developments are almost
certain to occur if East Asia's economy evolves the
way we think is most likely between now and the turn
of the century.
away from manufacturing into services.
The Composition of Regional Output. Regional GNP
expands 4.9 percent annually, reaching roughly
$6 trillion at the turn of the century-or about
double what it is currently. Service output grows
about 6 percent annually, about twice the pace of
agriculture and extractives. This means that agricul-
ture's share of output will shrink in favor of services,
with manufacturing's share remaining about the
same. The regional shift reflects more dramatic
change in the region's LDCs, from agriculture into
manufacturing, and a simultaneous shift in Japan
Regional Foreign Trade Competitiveness. With the
transformation to services in Japan, manufactures
produced by the region's NICs and LDCs become
more competitive in international markets. Japan's
exports are increasingly high-technology items spread
across a broader spectrum of product lines. NIC
exports are produced increasingly by Japanese-owned
firms in the early 1990s, but the diffusion of produc-
tion technology limits the share of Japanese "plat-
form exports" by the turn of the century. The NICs'
share of world exports grows from 6 percent in 1986
to 8 percent in 2000; similarly, the NICs exhibit the
region's strongest import growth. Meanwhile, the
share of total trade conducted within the region
grows from 35 percent in 1986 to slightly over 40
percent in the year 2000, as closer relationships are
forged between the NICs and Japan-based on Ja-
pan's imports of goods previously manufactured at
home and thus sold by the NICs in well-established
markets-and between the NICs and the LDCs-
based on the NICs' demand for raw materials that
formerly were sold to Japan.
Regional Price Adjustments. A variety of price
changes accompany and even facilitate the region's
economic transformation. East Asia's terms of trade
improve at a rate of about 1 percent annually-they
deteriorated slightly during 1975-85-as world com-
modity and agricultural prices remain somewhat
depressed and prompt the transfer out of agriculture.
Interest rates in regional financial markets and re-
turns on equity edge up as markets become more open
and trade volumes grow. The upward trend is most
likely to be observed as a series of small but discrete
increases, as monetary policy by regional central
banks adjusts to new demands for liquidity and new
institutional arrangements. Regional currencies un-
dergo a similar transformation, with several discrete
"realignments " comprising a gradual upward trend in
purchasing power for Japan and the NICs. The first
such realignment, under way currently, is completed
by mid-1988. The second accompanies renewed trade
surpluses in the NICs in the early 1990s.
The Locus of Change. Adjustment in the region's two 25X1
largest economies, Japan and China, drive the growth
process from each end of the technological spectrum.
The external effects of change in Japan are felt most
acutely in the NICs; change in China is felt most
acutely in the LDCs. The variation in output and
technology in the NICs widens; Taiwan at the turn of
the century more closely resembles Thailand and
Malaysia than South Korea.
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the soft loan window of the Bank, and Washington
decreased its voting share to accommodate new shares
for Tokyo. This was conditional, however, on US
retention of veto rights over major policy initiatives,
and a similar constraint would undoubtedly operate in
the future.
It is difficult to predict the results of a more indepen-
dent course for Japanese political-military interests,
since Tokyo itself has not given priority to such a
contingency since the reconstruction. The government
presumably would be less likely to acquiesce on a
variety of international issues, such as arms control,
that it has traditionally agreed on with Washington.
Change in the political-military arena, however,
would come more slowly than on the economic front.
Tokyo's decisionmaking bureaucracy is set up to
establish economic priorities, and much time would be
required to establish the same policymaking capaci-
ties in other fields.
Risks to US Interests: The Consequences of "Relative
Smallness. "Japan's pursuit of its own international
priorities need not work against US economic inter-
ests in East Asia. We believe, for example, that a
refocusing of Japanese attention on the East Asian
region would do much to reinforce market pricing
mechanisms in East Asian countries where the Japa-
nese private sector has an established presence, such
as Indonesia and Thailand. The Japanese are already
using their increased clout in the IMF and World
Bank to promote conditionality on lending that re-
quires market reforms and more liberal foreign invest-
ment regulations.
But whatever role Tokyo chooses for itself in East
Asian affairs, the fact that the United States will be a
relatively "smaller" economy by the year 2000 is of
potentially great consequence for US independence in
policymaking. Most important, in our view, is that
East Asia will make its presence felt in international
markets to an even greater degree than comparisons
in income suggest because of the openness of East
Asian economies. This will occur primarily in two
ways: as foremost originator of foreign trade and as
primary creator of financial assets. Both will poten-
tially give the region extra weight-at the expense of
the United States-in the process of determining
international prices and interest rates. With respect to
trade volumes, for example, East Asia's share of
global exports could rise from about 20 percent at
present to more than 25 percent in the year 2000 if
current trends continue. One result will be greater
East Asian influence in the forums that govern the
rules of international commerce, such as the General
Agreement on Tariffs and Trade and in individual
commodity trading institutions, such as the London
Metals Exchange, the International Rubber Associa-
tion, and the International Tin Council.
We believe the changes in the global balance will be
far more dramatic with respect to finance than with
respect to changes in merchandise trade. More rapid
rates of real economic growth-and particularly on-
going financial liberalization-will sharply boost East
Asia's share of global money creation over the next
decade. We judge that East Asian Central Banks will
manage money stocks of perhaps US $4.0 trillion by
the year 2000-roughly equal to the US $3.9 trillion
estimated by a noted private forecasting service for
the United States. The primary impetus for this
growth will be the development of private financial
markets in the NICs and LDCs, which will allow new
money creation to expand far more rapidly in real
terms than output, a similar phenomenon to that
experienced by South Korea in the 1960s, when the
real money supply expanded sevenfold in just five
years following banking and interest rate
deregulation.
The consequence for the United States of these trends
is that Federal Reserve control over both global and
domestic interest rates will become far less indepen-
dent of portfolio actions undertaken by central banks
in the Far East. The United States, in such a case,
may find domestic interest rates going the way of
those that prevail abroad despite attempts to influence
them with open market operations.
In addition, East Asian states may continue the recent
trend of accumulating claims on US institutions as a
result of large US government budget deficits and
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Confidential
The emergence of East Asian financial centers in the
years ahead suggests that Wall Street will play a less
prominent role in global. financial affairs by the turn
of the century.
New York already shares the limelight in equity
trading with Tokyo, where the stock market is of
roughly the same size and accounts for more than
one-third of global stocks. In addition, Tokyo can be
expected to improve its standing in foreign exchange
transactions, which, at over $50 billion in daily
turnover, roughly equals New York, behind London.
Meanwhile, New York-based securities firms will
have far more Japanese rivals worldwide; Nomura
Securities, Japan's largest, already does business in
25 stock exchanges in over 18 countries.
With the rise of the Japanese, New York will be
forced to share control over financial markets and the
power that accompanies it. A major concern for New
York-headquartered financial institutions will be
their ability to attract depositors and investors, espe-
cially reaching through branches in East Asian
private-sector trade deficits. In that case, large inter-
est payment outflows will narrow Washington's op-
tions in conducting monetary policy by associating
large foreign exchange losses with any potential rise
in global interest rates, while East Asia's options will
expand as interest earnings buoy Central Bank
reserves.
Opportunities for the United States in East Asian
Success. The two primary benefits to the United
States of a significantly more successful East Asia
will be larger markets for US exports and enhanced
opportunities to fund US investment in plant and
equipment with East Asian savings, thus expanding
employment. The East Asian import market, in 1986
prices, would expand to $1 trillion, up from nearly
$500 billion currently, if regional development goes
countries, which will be the world's premier capital
exporters. The development of more open Japanese
financial markets could, combined with the proximi-
ty of Tokyo, leave New York as second choice. This
may lead to a painful adjustment process for Wall
Street, as less competitive firms are pushed out of the
market.
The winners in this scenario will be both US and
foreign investors, who will be presented with expand-
ed options-new instruments in new markets for
placing their funds. Some problems will emerge be-
cause of the potential for rapid movement offunds
globally and the attendant increase in foreign ex-
change risks. One challenge for Wall Street thus will
be developing the financial instruments that will 25X1
allow depositors to hedge their portfolios against
such developments. In addition, the potential for
swings in exchange rates will make for a riskier
environment for Wall Street financial institutions,
and this may favor the larger firms, which are better
positioned to absorb variations in costs and earnings.
the way we think it will. In all, this means the East
Asian market would expand by at least 5 percent per
year on average. The market for US agricultural
goods should be especially strong, growing roughly
twice as fast.
East Asian annual savings should reach $1.6 trillion
at the turn of the century. Of this, $110 billion or so
would be internationalized in the form of current
account surpluses even if the surplus's share of region-
al GNP were to fall by half-a reasonable assumption
since we believe the current 3.8-percent capital export
rate is not sustainable. Thus, the volume of East Asia
finance available to US investors is likely to remain
strong, more or less indefinitely.
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Confidential
Confidential
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