Multilateralism in Asia: Measuring Risk & Rewards for the U.S. & Japan

October 17, 2007

PANELISTS
Robert Hormats, Vice Chairman, Goldman Sachs International Corporation
Glenn Hubbard, Dean, Columbia Business School
Evans Revere, President, The Korea Society

MODERATOR
Michael Auslin, Resident Scholar in Asian Studies, American Enterprise Institute

A distinguished panel of business and policy experts met to share their thoughts on the promises and perils of building regional economic alliances in Asia.

"Whether you look at it from a political angle, an economic angle, a security angle or even an angle of culture and social relations, today the barriers between nations in East Asia are dropping more rapidly than ever before," began presider Michael Auslin, Resident Scholar in Asian Studies at the American Enterprise Institute.

"The rewards for participating in this increasingly advanced process of multilateral engagement are rising faster than ever before, and conversely, the risks of not participating are also rising for Japan and the United States, particularly from the economic angle," he said: 40 percent of Japan's foreign trade is currently with Asia, and Asia accounted for some $850 billion in bilateral trade with the U.S. in 2006.

Panelist Evans Revere of The Korea Society, a veteran of 35 years in the Foreign Service with experience in Japan, China and Korea, observed that "there are lots of competing and complementary organizations that are out there trying to get a handle on this idea of building a community and building a pattern of multilateral cooperation" in the Asia-Pacific region, including the 27-member ASEAN Regional Forum, APEC, ASEAN Plus Three, the East Asian Summit and the Shanghai Cooperation Organization, "which has a bit more of a central Asian focus, but since China plays in that league, it's something that is of interest to us as a regional organization."

"It's not clear, in my view, which of these organizations are going to rise to the top and be the most influential in bringing about greater regional cooperation and perhaps greater stability and predictability," he said; however, it is clear that for both Japan and the U.S., the relationship with China is among the most significant and complex challenges in the region.

China's spectacular economic boom has brought equally spectacular environmental problems--16 of the top 20 most polluted cities in the world are in China--and given great urgency to the country's search for oil and other resources, a search that "is a very, very powerful factor as we talk about cooperation, or the lack thereof, in the Asia-Pacific region." Moreover, on a per capita basis, China remains a poor country and "is going to remain poor for a long time to come," with some 400 million people in China still living in extreme poverty.

These issues "represent a tremendous set of domestic challenges for the Chinese leadership that's going to keep China pretty much inwardly focused, I would suggest, in the coming decades. And that's not necessarily a bad thing," Mr. Revere commented.

China's economic surge has made possible a steep rise in military spending, with "troubling implications for the region, because China is also, and continues to be, a country that is not as transparent as it should be in terms of its military budget, in terms of its ambitions--its goals of its military establishment," he said.

"It's pretty clear that much of China's newfound military capabilities seem to be intended for use in a Taiwan contingency, but, as military experts have pointed out, things that can be used for military purposes against Taiwan could also be used against other neighbors in the region, including of course a country like Japan."

A second big challenge to stability in the Asia-Pacific region is what's going on in the Korean Peninsula, and in particular "what's going on with North Korea's nuclear weapons ambitions, which have now been realized of course," Mr. Revere said. The agreements reached in the Six-Party Talks, "as significant as they are, have some interesting holes in them."

"America is obviously distracted right now by virtue of what's going on in the Middle East, Iraq in particular," Mr. Revere concluded. "It would be in Japan's own interest to continue to prod and urge the U.S. not to forget about the central and critical role that the U.S. should continue to play" in this new multilateral era.

"If you look at the early discussions of economic regionalism in East Asia, thinking about the failure to launch, if you will, of several Japanese proposals since the 1960s, there has been a sea change in the past 20 years in discussions in the region and outside the region on multilateralism," said Glenn Hubbard, Dean of Columbia Business School.

"The $64,000 or ¥7.5 million or 531,200 RMB question that I would put out is what will we see as a result of this," Mr. Hubbard observed. "Fortress East Asia? Fortress America, say focused on the free trade area of the Americas? Fortress Europe, maybe with Eastern European expansion? Or are we going to see something more beneficial?"

"You could say that on the one hand the glass is half empty, because we don't yet see as much regional trade cooperation in East Asia," he said. "On the other hand, I would invite you to look at European experience over the past 50 years, and it is a long and evolving story, and I see no reason that this story won't evolve in East Asia. And even in small starts like ASEAN Plus Three, don't discount the importance of policy dialogue in the same way that the OECD played for the U.S., Japan and Europe."

On the finance side, since the 1997 crisis there have been efforts to assure formal liquidity support in times of crisis, and "several regional initiatives, not entirely successful perhaps, to develop bond markets," Mr. Hubbard said; but the big issue is domestic systems, particularly China's. "Indeed, this is probably the central question for China over the next 20 years: Will it fix its domestic financial system in such a way that would encourage not only domestic demand growth, but better productivity growth?"

"Openness remains critical in the region," he added, "for finance, for mergers and acquisitions, and for markets for spreading risk," as well as for trade; "this, of course, is a Japanese story as well."

For the U.S., "bilateral alliances, particularly with Japan, but also Korea, remain very important; and the U.S. is also looking to China," Mr. Hubbard said. "But I don't think the U.S. should look askance at proposals for more regional institutions." As Asia's share of global GDP grows, "its links through international capital markets to events all over the world have become so large that it becomes topic A for discussion." At the same time, he said, "I think it's naïve to think that the region has decoupled from the U.S. in the medium run, meaning there will be strong continued interest in the region in the U.S. as well."

"A decade ago, in 1997-98, the criticism coming from Washington was the Asians have insufficient transparency, they have companies that are dramatically over-leveraged, their currencies are for the most part overvalued, and financial governance, corporate governance, are not very good--poor in some cases," said Robert Hormats of Goldman Sachs.

"Fast forward 10 years and what's happened?" he asked. Asia has made great strides, and currently "it is the U.S. which has suffered from overleveraging, as we have seen, from a plethora of financial instruments which are anything but transparent."

Today, most deals involving Asia, all but the very largest, can be funded from within the Asian capital markets themselves, without relying on New York or London; Asian countries have set up currency swap agreements to help one another in the event of a currency crisis, and "some are issuing securities in one another's currencies," Mr. Hormats said.

Moreover, central banks in the region no longer operate in isolation: "There is an enormous amount of cooperation between the Asian central banks and say the Federal Reserve or the New York Fed. The People's Bank of China, the Bank of Korea, the Bank of Japan, Singapore Monetary Authority--a whole range of these institutions are working on a very close day-to-day basis. They're talking to one another about conditions in currency markets," about regulatory issues; "you don't hear as much about it, because it's done quietly, which is one reason it works. But it is very important," he said.

In the currency markets, Mr. Hormats observed, "there are still some issues that are going to have to be worked out," as several non-Chinese Asian currencies have begun to appreciate against the dollar but the renminbi has not.

"So, I think we're probably going to see this RMB debate--I wouldn't say heat up, because no one really wants to have a confrontation with the Chinese on this issue. The U.S. doesn't. China is our biggest banker, after all. So, you don't want to have a confrontation with your biggest banker. But I think this notion of what role the Asians play in the global rebalancing that is underway now as the dollar depreciates significantly in some currencies, less significantly in others, this global rebalancing is going to have to be a part of a dialogue that's going to need to involve the Asians to a greater degree, both individually and collectively."

That profit levels in U.S. companies are strong despite the housing-market troubles is due partly to the growth in demand from Asia and the efficiency of intra-Asian supply chains, Mr. Hormats said. Thus American firms gain not only from selling to customers in Japan, China, Malaysia, Indonesia, but also from making goods in Asian countries and selling in regional markets, "or perhaps producing in Indonesia and selling to Germany."

"I think this is one of the reasons we're probably not going to have a recession as a result of the latest difficulties in the housing market," he concluded. "I'm not sure we would have anyway, but I think one of the reasons that I feel even more confident that we're not going to is that there is so much domestic demand and that American companies that are suffering from the decline in demand here are seeing enormous benefits in terms of profitability and in terms of demand for their products. And East Asia, I think, is one critical element."

***

Mr. Auslin began the Q&A:

Politically, why now? Why didn't Asian multilateralism become strong 10 years ago, at the collapse of the Soviet Union and the Cold War?

"It's the economics that drove this to some extent," Mr. Revere replied. The economies are increasingly interdependent. Institutions have matured; and "we've been through a significant period in Asia without a major conflict."

What will drive future developments--will it be something like the great powers, so to speak, in concert, or will it be ASEAN and the like?

"It's very much the players within the region," Mr. Revere said. "ASEAN will continue to be an important player, but not the 800-pound gorilla, if you will, that China and Japan can play. I think the plus three of ASEAN Plus Three is an interesting construct to look at, because you see those three key players pulling ASEAN in a very, very interesting and I think a very productive direction."

With Congress having changed hands, what is your take on how trade agreements such as the Korea-U.S. agreement will fare? And more broadly, are you satisfied with the degree of U.S. involvement? I think we have only two FTAs right now out of two dozen or so that are operative in East Asia.

"Remember even when Republicans controlled the Congress it was very dicey getting support for trade agreements," replied Mr. Hubbard. "I do think there is a way forward with trying to develop greater support for people who are the unintended losers of free trade," a middle ground that's been lacking in these debates.

The Korea FTA is going to be very important for financial services, among other sectors, he said. "There has been significant demagoguery of the Korea FTA including by one major party presidential candidate. I will only indicate that she is a she. I won't name names, but there has been political mischief here. I still think this will happen, but it is going to be difficult," he added.

"Am I satisfied with American leadership here? Absolutely not. I think the U.S. has not played the key role that it must play in international institutions and in leaning on free trade and it means liberalizing at home too, not simply giving the sermons elsewhere."

Asian economies have become so much more intertwined that the ripple effects we saw in '97 could be multiplied today--what are some of the warning flags on this?

In 1997, "it was not so much that it was the dominos one hitting the other, it was sort of a ricochet effect of Thailand and then the effect that that had on financial markets saying we're not going to lend money or banks are not going to lend money to other institutions in that area," Mr. Hormats responded.

"I think what's different now is that these institutions are now far better governed," he said.

Where there's a lot of speculation in equity markets, "there is always a correction in that kind of environment," Mr. Hormats added. "And when that occurs you will see, I think, a deterioration in some of these economies. But it's happened and the interesting thing is that while you get these periods, there is a certain resilience."

Questions from the audience followed:

Asia is still a machine that relies on exports to the U.S.; if consumption falls here, either for economic or currency reasons, how will Asia bring about an integrated economic situation that's also somewhat in balance?

"On the long haul it's hard to see China, in particular, having sustainable, very rapid rates of growth without a better domestic demand situation," said Mr. Hubbard.

Savings rates are so high because one, "the social insurance safety nets are very weak," and two, "the system for matching borrowers and lenders in the domestic economy is very poor--mortgage markets, consumer credit markets, and things like that. So that really is, I would think, on the top of the to-do list for China."

Mr. Hormats commented, "People criticize bundling of mortgages. Well, that's where the liquidity for the mortgage market comes from, as you know if you're in this business."

"You can't just rely on the banks to do it," he added. "You have to have some asset-backed kind of market, and most of these economies do not."

"And they need to. I hope that the mess here doesn't give them the notion that they shouldn't do it--just that they should do it in the right way. And a lot of them are exploring this now."

Have Japan and Korea moved at all towards this, especially with a lot more use of credit cards by the younger generation, a growing my-home phenomenon in Japan?

Korea overdid it with credit card debt, the panelists agreed.

"Just one point on China here," said Mr. Revere. "I served in China in the late 1970s and early '80s and the concept of a mortgage did not exist then. The idea of the credit card was also a latecomer to monetary and financial practice in China. And you look at the conversation that we're having right now about where China is going to be going, where it needs to go. These concepts just didn't exist, not that long ago, in the PRC. So they've come a long way."

"Russia, it's worth pointing out, does have a mortgage market, and it actually works reasonably well in Russia," Mr. Hormats added.

With the fundamental absence of transparency in China, the dominant player in the region, how will it be possible to develop trust in the way we have seen recently with the EU?

"I'm not so sure I'd be as pessimistic as that," responded Mr. Hubbard. The way these things begin to develop is "with countries adopting policies that are in their own interest. China's need for financial reform is not for multilateralism or to please Washington. It's to make sure China can be okay."

The French and Germans started with cooperation in steel and coal, and a parallel building block for establishing confidence in the Asia-Pacific region could be energy cooperation, Mr. Hormats said: These are "common interests--not just to talk, for diplomatic reasons, but very, very concrete, functional ones."

"Somehow Asia, East Asia in particular, needs to get beyond its history," reflected Mr. Revere. "It's possible to do. I harken back to the previous president of South Korea, Kim Dae-jung, who made some tremendous strides at reaching out to Japan during his tenure."

"Keep in mind, it wasn't that long ago that the Japanese books and periodicals were banned in Korea. It was only five, six years ago. And that's something that he managed to reverse during his tenure."

How do you see India's role in these developments?

"The Indian trade minister, Kamal Nath, is one of the most visible in the West and to Western audiences, yet he is also a pretty vigorous defender of Indian special interest groups," responded Mr. Hubbard. "So India, like others in the region, has trade problems that complicate multilateralism, in my view at least."

India has interesting and traditional relations with countries in the Middle East, Mr. Hormats observed. And though India and China see each other as rivals, it's not a question of either-or, for investors. There's tremendous cooperation between Chinese and Indian companies.

In the competition to become Asia's financial center, is there any hope for Japan?

There's certainly room for multiple centers in Asia, though in Japan you have very high rates of corporate taxation and less openness, Mr. Hubbard responded. "It seems to me that Hong Kong will be the preeminent center; I'm more skeptical about Shanghai."
In the U.S., we have multiple centers--New York, but also Chicago, and North Carolina for banking, said Mr. Hormats. "It'll comfort you to know that our biggest Asian office is still Tokyo," in part because of the domestic market.

--Katherine Hyde