Pacific Rim Report No. 28, May 2003
Asia in the World Economy: Globalization, Growth, and the Changing Structure of Trade
by R. Sean Randolph, Ph.D.


Sean Randolph is president and CEO of the Bay Area Economic Forum. He has served on US Congressional staffs, the White House Staff, and in senior international economic and Asian policy positions in the US Departments of State and Energy. Randolph has also served as International Director General of the Pacific Basin Economic Council, and director of international trade for the State of California.

An Asian specialist and Kiriyama Fellow at the University of San Francisco's Center for the Pacific Rim, Dr. Randolph holds a B.S.F.S. and J.D. from Georgetown University, a Ph.D. from the Fletcher School of Law and Diplomacy, and has studied at the London School of Economics. We gratefully acknowledge the Kiriyama Chair for Pacific Rim Studies at the USF Center for the Pacific Rim for funding this issue of Pacific Rim Report.

Asia today finds itself at center stage in the globalization process--the integration and interdependence of nations and their economies brought about by the systemic lowering of barriers to the worldwide movement of goods, capital, and information. While its macro-level results are on balance very positive, the costs and benefits of globalization remain subject to debate. Particularly when coming from a dominant source such as the United States, the intrusion of external economic and cultural influence can provoke backlash in affected societies; even elites feel globalization's destabilizing effects, as their historical monopoly on access to information is diluted by the new communications technology. Once-isolated political and cultural groups are empowered by those same technologies, with both positive and negative effects. Important issues have also been raised about the equity with which the benefits of globalization are distributed within societies, and the willingness of governments to address the needs of those who lose out in the process.

Although anxiety with the accelerated change and loss of control often associated with globalization is common even in societies that are its major beneficiaries, anti-globalization movements as a rule tend to be rearguard actions that seldom prevail in the face of the improved access to information and economic opportunity that come with global engagement. In the end, information and opportunity flow like water, to those places of least resistance that are economically open and offer conditions conducive to global exchange, leaving resistant or less open economies in an isolated and ultimately disadvantaged position.

For developing countries, integration with the global economy has narrowed the economic gap with the developed world. As documented by the World Bank, developing countries that embraced globalization have increased their per capita growth rates from 1% in the 1960s, to 3% in the 1970s, 4% in the 1980s, and 5% in the 1990s (the comparable growth rate for developed economies in the 1990s was 2%). In the same period the number of extreme poor within those countries has fallen sharply, while domestic inequality has not appreciably worsened, and in many cases has improved.1

The economic development of East and Southeast Asia in the 1970s, 80s and 90s was first propelled by the adoption of market-based, export-oriented economic models premised on greater integration with the world economy. These largely supplanted (or at least diluted) the dominant import-substitution model of the 1960s. Asia was not alone in taking this road, as other nations such as Mexico, Chile, and much of Eastern Europe eventually chose similar paths. However, because Asia led the developing world in adopting the global market model, it now finds itself in a pivotal position in the evolving globalization process.

Asia Will Lead the World Economy in 2003

In a global economy characterized by slow growth at best, Asia will once again outperform all other regions in 2003. Though less than the heady growth rates experienced before the Asian financial crisis of 1997, the region (excluding Japan) should see average GDP growth of roughly 6% this year. As in recent years, China will lead the pack with growth of up to 7%. Korea and Malaysia should also perform well with 5% growth, while most of Southeast Asia should see growth in the 3.5-4% range. As this essay is being written, the exact effects of the SARS epidemic are still unknown. While SARS can be expected to shave growth rates--particularly in several economies such as Hong Kong, Singapore and China--overall growth should remain strong overall and well ahead of other regions globally. Latin America's growth, in contrast, will average only 1.5%, and the European Union will grow by scarcely more than 1%.

One element shared by Asia's fastest growing economies is a new emphasis on the development of domestic markets as an engine for growth, reducing to some degree their traditional reliance on exports. While the sustainability of high rates of domestic consumption may in some cases be questionable, in the short-term this spreading of the region's economic base is having positive effects for both trade and growth. On the other hand, economies that are most dependent on manufacturing for global information technology markets, such as Singapore, will continue to experience slower growth, reflecting the global IT slump. Overall, the relatively positive economic outlook in Asia stands in marked contrast to the rest of the world, where growth will be muted at best.

Foreign Direct Investment Drives Growth and Trade

Even more than by trade, Asia's economic growth is being driven by the globalization of capital flows. The central role of investment capital as a critical component in Asian economic development first became apparent in the early 1980s, with a shift by many countries away from reliance on development strategies emphasizing foreign assistance, in favor of policies designed to attract foreign direct investment (FDI). As an indication of the magnitude of this shift, in 2002 global direct investment in emerging markets was estimated to be $107 billion, compared to $12 billion in financial flows from bilateral foreign assistance and international financial institutions.2 While Asia's economic success is commonly measured in terms of exports, foreign in-vestment underpins these flows, transforming industrial structures, creating new divisions of labor and production, and transforming the trading system itself.

Beginning in the early 1990s new information technologies facilitated the rapid deployment and redeployment of financial (portfolio) capital on a global level, helping to fuel stock markets in much of the developing world, including in Asia. The downside of this increased mobility of financial capital was dramatically witnessed in the Asian financial crisis of 1997, when in a cascading pattern liquid capital was withdrawn from Asian and other developing economies following the unsuccessful defense of the Thai bath. The crisis demonstrated both the ability of financial markets to instantly punish failed economic policies, and the risk posed to developing countries of contagion in global financial markets.

One consequence of the crisis that is still being worked out is a renewed interest in capital controls as a means to moderate the effects of highly mobile 'hot' money. Developing economies in Asia and elsewhere clearly remain vulnerable to shifting financial flows. However, to the extent that stable but flexible macroeconomic policies and transparent, global standards of corporate governance are established, the extent and effect of such movements can also be reduced.

Far more important for Asia and its place in the global economy is the role of fixed capital investment, or foreign direct investment. In addition to private sector employment and better wages, FDI frequently brings new technology, better business and management practices, and improved productivity. It can also stimulate economies by putting competitive pressure on entrenched domestic (or foreign-owned) industries. Thus, while official development assistance (ODA) still plays a key development role, FDI typically brings with it a richer portfolio of growth-inducing benefits.

Since the early 1980s, FDI has fueled a dramatic expansion in overseas manufacturing for worldwide markets, reshaping the global economy in the process. In Asia, this permitted countries to secure carve out market niches, such as semiconductor manufacturing in Taiwan, automobile assembly in Thailand, and electronics manufacturing in Malaysia (Japan and Korea, which until recently followed strategies focused on global export markets but with relatively high barriers to foreign investment, are notable exceptions).

Of an estimated $107 billion in FDI flowing to developing countries in 2002, nearly half ($52 billion) was directed to Asia. By comparison, 2002 FDI to emerging economies in Eastern Europe was estimated at $17 billion (but growing), Latin America at $36 billion (and shrinking), and Africa and the Middle East at $2.8 billion (a relatively stable figure over the past five years.) In 2003 global FDI is expected to grow slightly to $108 billion, with the Asia-Pacific region again accounting for half the total ($55 billion).3

Asia has been particularly successful in attracting FDI in the computer and electronics sector, which now accounts for approximately of 30% of regional exports. This sectoral growth supported rapid economic expansion for more than two decades, paralleling the expansion of the global IT sector. Sharply reduced growth in global IT markets since 2000, however, has hurt Asian economies such as Taiwan, Singapore, Malaysia and the Philippines, where FDI is most heavily concentrated on production for export.

Asia's success in attracting investment in the computer and electronics sector reflects the emergence of new patterns of manufacturing and production, in which a product may be designed in one country (usually but not always the parent company's home country) and assembled in one or more offshore locations from components sourced in third countries, for ultimate sale in national, regional or global markets. In this case a computer might be designed in Silicon Valley, but manufactured in Taiwan from components sourced in Korea, China, and Indonesia.

Trade patterns in information technology thus tend to track closely with intra-firm trade (trade conducted between affiliates of the same company) and the foreign investment that supports it. Intra-firm trade now accounts for one-third of the merchandise exports and imports of the United States; in Japan's case, it represents one-third of exports and one-fourth of imports. For the United States, both FDI and intra-firm trade are predictably high with its NAFTA neighbors Mexico and Canada, and since the collapse of the Soviet Union has been growing rapidly with Eastern Europe. Beyond its immediate neighbors, how-ever, US intra-firm trade is strongest with Asia, particularly Japan, Korea, Taiwan and most recently China.4

A return to strong economic growth in much of Asia will be linked to the recovery of global technology markets, which are likely to remain weak through the year. The negative effects of the current technology downturn may be mitigated, however, to the extent that these countries can (prudently) stimulate expansion of their domestic markets, as is now occurring in China, Korea, Thailand, and Malaysia. Despite their heavy reliance on exports and strong ties to the global economy, many Asian nations are experiencing growing domestic demand, and over time this trend is likely to expand. Overall, countries that open their economies and deepen their domestic markets (two elements which often go hand-in-hand) are also likely to attract a disproportionate share of foreign direct investment. This will particularly be the case as investors differentiate both between regions and between countries within regions in their continuing efforts to in-crease returns and lower risk.

China's Emergence Reshapes the Region

Perhaps the most dramatic manifestation of the global deployment of investment capital is the rise of China as a large-scale recipient of FDI. This trend first appeared strongly in the late 1990s and received new momentum from China's entry into the World Trade Organization in 2001. WTO membership assures Chinese access to major markets such as the United States, and has accelerated the opening of its domestic markets to imported goods and services. By subjecting itself to the WTO's rules-based system China's leadership has consciously chosen to institutionalize its engagement with the global economy, reinforcing in the process its continuing market reforms.

This commitment is not without risk because China faces growing unemployment and even political unrest as large numbers of workers at failed state-owned enterprises forfeit their jobs and security to foreign competition. However, this calculated gamble reflects a conviction on the part of China's leadership that foreign competition is necessary to revitalize the country's state-owned industries, compensate for a diminished state sector with private sector growth, and move China to a higher level of international economic competitiveness. It also reflects a strategy specifically aimed at accelerating the flow of foreign direct investment, as foreign companies are drawn both by China's increasingly open domestic market and by its more secure access to major global export markets.

This strategy is paying off. In recent years China has attracted FDI at an annual rate of $40-50 billion. In 2002 DFI passed $50 billion, accounting for the lion's share of all foreign investment flowing to Asia, and placing China's total stock of foreign investment third in the world behind only the United States and the United Kingdom. As a result China is rapidly emerging as a major global manufacturing platform. Investment is being attracted by the added security of investment and market access provided by China's WTO membership, by its large low-cost labor force, and by its growing capacity for quality, value-added manufacturing, including locally-based design, research and engineering. With strong economic growth and a more open domestic market, an increasing share of foreign investment in China is now aimed at production for local as well as global markets.

If current trends continue, and if China can avoid economic and political instability (domestic challenges include a legacy of unproductive state enterprises, unemployment, severe regional disparities between the coastal cities and much of the interior, and ongoing problems with non-performing bank loans), it is likely in the next decade to emerge as key player in both the global and regional economies, with political influence to match. It is also likely that over time (though not as rapidly as many in China and the West would like) the political control of the Communist Party will be loosened in response to the need for a more responsive and flexible political structure.

China's growing strength has stimulated discussion in Washington over whether it is a strategic competitor and should therefore be contained. The political-military balance of power in Asia, where a range of historical security arrangements anchor the US presence, is highly open to US influence. Economic containment is not likely to be effective, however, apart from necessary measures to limit the theft of techno-logical secrets. This is particularly so as large numbers of US, European, Japanese, Taiwanese, and other companies are now deeply invested in China and its economic future. Momentum in the repatriation of corporate profits from China to the United States since 1997 reflects both the large-scale investment of the last decade, and the fact that China has become a place (in contrast to recent decades) where foreign investors can make money. As a result China now accounts for a larger share of US corporate revenue than any other developing country ($7.2 billion in 2000, compared to $4.6 billion from Mexico, $3.5 billion from Singapore, and $1.85 billion from Brazil.5

While national interests will inevitably differ, and occasionally clash, the more effective US course will be to expand on the policy framework adopted in 2000 and 2001 with Congressional approval of Permanent Normal Trade Relations (PNTR). As the implications of PNTR and China's WTO membership become manifest, the importance of consolidating China's integration into the global, rules-based system, and building mutual benefit from economic and (occasionally) strategic cooperation will increase.

China's remarkable success in attracting FDI is already impacting regional and global investment patterns. Particularly since the Asian financial crisis of 1997 and its severe damage to economies in Southeast Asia, a growing volume of FDI has flowed to China, often at the expense of Southeast Asian and other economies with smaller domestic markets and higher labor costs. Where ASEAN was the regional destination of choice in the 1980s and the early 1990s, China now claims that distinction. By strengthening transparency and market access, China's membership in the WTO has increased its appeal to foreign investors. Its magnetic attraction for FDI is being felt as far away as Mexico, where US and Asian investment in the maquiladora sector is increasingly threatened by China's high productivity and lower costs.

A special case, Taiwan is also feeling the mainland's pull. Despite political barriers, integration between the two economies is proceeding rapidly. The process is being led by FDI, as electronics manufacturing has progressively shifted across the Taiwan Straits. Taiwan businesses currently have over 55,000 investment projects in China, employing 5-7 million workers. Taiwanese private investment in China is officially estimated by Beijing at $60 billion, but unofficial Taiwanese estimates range from $100-140 billion. Nearly 750,000 Taiwanese now reside in China, mostly for business purposes. Two-way trade approached $40 billion by the end of 2002. With 20% of total exports going to the mainland, China has supplanted the United States as Taiwan's largest market.

In addition to closer economic integration and possibly improved political relations over time, growing trade and investment between China and Taiwan also brings challenges for Taipei. In the long run, Taiwanese leaders fear increased political vulnerability due to the location of a large segment of Taiwan's industrial capacity on the mainland. Another concern is the potential 'hollowing out' of its industrial base, as Taiwanese manufacturing increasingly moves to China under cost-cutting pressure from US and European customers.

China's emergence is impacting Japanese trading patterns as well, reinforcing a long-term trend in Asia of growing intra-regional trade. In 2002, Japanese exports to the region grew 14%, compared to a 1% increase in exports to the US and a 2% drop in exports to the EU. Much of this intra-Asian growth was driven by the Chinese market, where Japanese exports grew 32%; of this, a large portion was composed of machinery and parts for Japanese-owned factories, a direct reflection of growing Japanese FDI. While total Japanese exports to China are only one-third of those to the US, this continues a trend of sharply increasing China-Japan bilateral trade that began in 1999.6 In the last decade, China's share of Asia's intra-regional imports has more than doubled, from 7% to 15%. In the same period Japan's share has dropped from 20% to 10%.7

Further shifts in the regional patterns of production, trade, and investment are likely, with important implications for the industrial structure of developed economies such as Japan, the United States and Taiwan, as well as developing ones. While it is unlikely that FDI will ever be entirely diverted to China from other destinations--since some investment will always be targeted at national and subregional markets or at concentrated niche production (such as auto-mobiles in Thailand)--more change in the global and regional division of labor is coming. In particular, global investment tends to favor large markets and companies. Other Asian economies will therefore have to focus their strength in specific market niches, or give new consideration to the aggregation of larger regional and sub-regional markets in order to create a more critical economic mass.

Recent trends in Japanese investment in Thailand suggest, in fact, that China's competitive challenge is not insurmountable. Though investing heavily in China, Japanese firms appear to be hedging their bets by also expanding in Thailand, based on a desire for diversification, local markets, and on Thailand's relative advantages in infrastructure, workforce skills, and legal transparency. In the first half of 2000 Japanese FDI in Thailand grew by more than 55% on a year-to-year basis.8 American companies are also continuing to invest in Southeast Asia based on similar considerations. Competitive pressures are clearly intensifying, however, with market size a major draw.

New Pressures Shape Regional Economic Organization

As already noted, the last two decades have seen a trend toward increased intra-regional trade, and increased manufacturing for intra-regional consumption. Intra-regional exports currently represent approximately 40% of Asian trade (a substantial part accounted for by intra-firm trade in the computer and electronics sector). The recent combination of rapid growth in China and slow growth in the US and in the European Union has given new momentum to this shift, as demonstrated by a 40% decline in Japanese foreign direct investment in the United States, but a 20% increase in FDI going to Asia, led by China (which accounted for 64% of the regional total).9

As intra-Asian trade and investment grow, interest is also increasing in new and different vehicles for economic cooperation. Paradoxically, China's growing economic weight is stimulating interest in free trade or other preferential trading arrangements within Asia. In 2002 the United States concluded a free trade agreement with Singapore, its first in Asia, and indicated its openness to further agreements with ASEAN. Bilateral free trade agreements are also being considered by the US with Australia and New Zealand. These agreements may be increasingly attractive to some Asian countries, since their investment protection regimes and preferential market access stimulate trade and offer more secure environments for investment, two key priorities for foreign investors. Free trade agreements with the United States can also serve as a counterbalance to China, diluting the prospect of Chinese dominance. In this sense, the US economic presence in the region may eventually parallel its historic role in Asian defense and security, serving as a balance that hinders the emergence of a dominant regional power.

China's low labor costs and growing domestic market will place new pressure on ASEAN to aggregate its markets by jump-starting the largely moribund ASEAN Free Trade Area (AFTA). In a move that may indicate new momentum in that direction, ASEAN announced in February 2003 that it is accelerating plans to reduce barriers to manufacturing investment between seven of its ten members, bringing the target date forward from 2010 to January 1, 2003. A successful AFTA would create an integrated market of 500 million consumers from a number of relatively small, fragmented ones, enhancing the attractiveness of regional manufacturing to foreign and domestic investors.

China's growth is also stimulating new thinking about regional organization on a larger scale. A-ware of concern among its neighbors over its growing strength, China proposed in 2001 and ASEAN agreed to begin talks aimed at the creation of a China-ASEAN Free Trade Area within ten years. This led in November 2002 to a Framework Agreement on Comprehensive Economic Cooperation, which lays out the scope and timing for a broad agreement that would include both trade and investment, with completion targeted for 2004. Under the plan, tariffs would fall to zero by 2010, with an 'early harvest' of accelerated reductions within three years.

China's proposal was based at least in part on a desire to assuage ASEAN fears of Chinese regional dominance. Secondary goals may also be to stake a claim for regional economic leader-ship ahead of Japan, and to dilute US influence in the region. ASEAN's response, for its part, reflected a recognition that there may be more to be gained from engagement with China and access to its market than from watching China's economy expand from the outside. While closer economic integration with China represents a gamble for ASEAN (one risk is that Southeast Asia could be flooded by lower-end Chinese products) its more competitive industries--such as automobiles in Thailand--may benefit from improved access to larger markets and therefore attract increased foreign and domestic investment. ASEAN's agreement to engage in these negotiations was almost certainly reinforced by the fact that China is poised to supplant Japan's historic (but never fully realized) role as the largest regional market for Asia's developing country exports and as a primary engine for regional economic growth.

This represents a challenge for Japan, as the overseas migration of its manufacturing preceded by more than a decade the hollowing-out that now concerns leaders in Taiwan, but has not been offset by growth in domestic productivity. As the world's second largest economy with highly competitive companies and great technological capacity, it would be premature to write Japan off because of its current economic slump. Nevertheless, as its prolonged stagnation demonstrates, productivity, flexibility and the ability to innovate hold the key to growth, particularly in mature economies. Absent significant cultural and structural change, Japan's long-term position as Asia's economic leader is at risk.

These developments suggest the pervasive influence that China's economic growth is be-ginning to assert on the region, with both integrative and competitive effects. As further evidence of this trend, in November 2002 Japan and ASEAN agreed to negotiate a Free Trade Agreement, with the goal of a achieving a Framework Agreement by the end of 2003, and full free trade by 2012. This follows completion of a Japan-Singapore FTA earlier the same month, and ongoing consideration by Japan of FTAs with South Korea, Thailand, the Philippines, Mexico and Chile. This raft of potential trade agreements represents a significant shift in Japanese policy away from a long-held position favoring multi-lateral, global negotiations. While not abandoning its preference for global-level agreements, Japan appears to be moving toward an "if you can't beat them, join them" stance, spurred by the acceleration of bilateral negotiations else-where in the region.

Japan's interest in FTAs with ASEAN and with its individual members also suggests a defensive response to the proposed China-ASEAN FTA (which caught the Japanese by surprise), as well as a strategy by Japanese business to hedge its bets by not putting too many eggs in the Chinese basket. Taiwan and South Korea have subsequently expressed interest in their own FTAs with ASEAN, and China has suggested that both nations be included in the China-ASEAN talks. In light of the growing breadth of free trade discussions within Asia, US and other APEC members should consider proposing that an expanded ASEAN-China free trade agreement be opened to participation by all APEC members. Though complex, such a move might benefit both the US and the region by stimulating even faster Asia-Pacific growth in an otherwise weak global economy.

The existence of Framework Agreements does not guarantee that Free Trade Agreements will actually be concluded. ASEAN's failure to achieve internal free trade after more than a decade suggests the difficulty of bringing these negotiations to fruition, and points to the relative weakness of ASEAN's position in its negotiations with larger partners such as China and Japan. ASEAN's agreement in 1992 to achieve regional free trade within a decade has subsequently suffered from political backsliding, exclusions and persistent not-tariff barriers. A trend toward bilateral FTAs between individual ASEAN members and other countries could further erode the bloc's cohesion. In addition to Singapore's FTAs with Japan and the US, for example, Thailand - which represented ASEAN in the Framework negotiations with China - is pursuing bilateral free trade agreements with Australia, Bahrain, South Korea and New Zealand. Alternatively, China's imposing presence on the economic landscape may finally provide the critical incentive for ASEAN to set aside national competition among its members and more effectively articulate and act on Southeast Asia's collective regional interests.

A potential China-ASEAN free trade agreement would supplement the existing ASEAN+3 forum, which brings together ASEAN, China, Japan and Korea for discussions primarily related to finance. After the Asian financial crisis of 1997 Japan had proposed creation of a regional monetary organization for Asia that would parallel the IMF, an idea that failed partly due to US op-position. ASEAN+3, with less authority and few resources, revisits the issue of exclusively Asian responses to regional financial challenges, or at the least provides another forum to address concerns that China's growth, independent of its neighbors, could threaten Asia's economic balance.

Asia Pacific Economic Cooperation (APEC), meanwhile, continues as a broader forum for regional cooperation, but generally has not lived up to expectations for its value as a vehicle for trade and investment liberalization. To the extent that it is successful, this will most likely occur in the field of trade facilitation, through agreed measures to lower transaction costs and increase the efficiency of trade operations. The particular US emphasis on security in the wake of the events of September 11 also makes it likely that at least for the present APEC's emphasis on trade processes, as opposed to liberalization, will continue.

The surge in interest throughout the region in bilateral and multilateral FTAs also raises the issue of whether, beyond its role as a meeting place for high level leaders, APEC has lost momentum and may eventually be overtaken by other regional processes. This trend suggests movement away from APEC's original model of 'open regionalism', as a loose, non-institutionalized approach to trade liberalization, in favor of more formally structured, institutional mechanisms the produce more concrete trade results. Were APEC (in which the US is a member) to be eclipsed by Asian-only agreements, this could undermine US economic influence in the region, but accelerate the intra-Asian trade and policy dialogue.

China's growth and the acceleration of interest in free trade agreements within the region therefore present challenges for both ASEAN and APEC. In its 1992 Bogor Declaration, APEC embraced the goal of regional free trade and investment for developed economies by 2010, and for less developed ones by 2020. To remain relevant, APEC may need to return to its roots, reassess its commitment to those goals, and take more concrete, accelerated steps to implement them.

For the United States these changes in Asia's economic environment suggest the importance of continuing a diverse, multi-track strategy toward global trade liberalization: regional (through frameworks such as APEC, NAFTA, and the Free Trade Agreement of the Americas), bilateral (to offset the effect of exclusive FTAs elsewhere and to increase pressure for broader liberalization through the WTO), and multilateral. Bilateral and regional agreements have generally proved their effectiveness, and are likely to become an even more attractive option in light of the difficulty of global negotiations. Given the complexity and potential inefficiency of the trade environment that will result from a vast multiplication of bilateral and regional FTAs, however, it is important that the global, multi-lateral approach to trade and investment liberalization remain the foundation of US policy.

The Next Level: Strengthening Governance, Transparency and Human Capital

An emphasis on education has been critical to Asia's ability to leverage its human capital to accelerate growth. To extract the maximum benefits from public investment in education, a commensurate level of openness to the global economy is needed. Market competition and FDI tend to place a premium on workforce skills, providing higher wages and increased opportunity for workers with the necessary education and training. Asia's relative success in marrying educational investment with economic openness will continue to place it in a highly competitive position.

This is particularly important in Asia, which is impacted more than most regions by the global movement of both financial and human capital. Communications technology has increased opportunities for developing countries such as India, the Philippines, Singapore and Malaysia to expand their activity in business services such as software development, design, and back-office functions. This points toward an alternative mo-del of globalization that is based more on ser-vices than on manufacturing, and more on human than on physical capital.

High levels of technical and scientific education also suggest the potential for nations such as China and India to expand into R&D and other high value-added activities. While this has yet to occur on a large scale, the availability of large numbers of trained engineers and technicians at compensation levels a fraction of those in the United States, coupled with dynamic economic environments, are a formula for faster movement up the technological ladder. Over time, this could challenge developed economies such as the United States, Japan and even Taiwan, that have to varying degrees seen their manufacturing migrate abroad but have retained a domestic advantage in higher-end design, research and engineering functions.

Within Asia the growing importance of human capital to economic development has different implications for developing economies, whose long-run success will turn on developing labor forces capable of competing at higher technological and quality levels, and for developed economies such as Japan, where an aging population, resistance to reforming traditional economic and political structures, and reluctance to accept immigration impede productivity and competitiveness.

Mature Western economies such as the United States, Germany and Australia have compensated for graying populations with immigration, which in the US case has supported both basic services and high-end technological and entrepreneurial activity. This can be seen most dramatically in Silicon Valley, where more than one-third of all new technology start-ups are created by immigrant entrepreneurs, primarily from India and greater China. A long-term failure by Japan to address these issues--by bringing more women into higher positions in its work-force, changing seniority-based promotion, or welcoming increased immigration--increases the prospect of its eventual eclipse by China as Asia's economic leader.

As Asian nations advance, education, stable macroeconomic policies and policies designed to promote trade and investment will be necessary, but not sufficient, determinants of success. The ability to attract foreign investment and foster domestic innovation--factors central to global competition in the coming decades--will also increasingly be linked to rule of law considerations, including respect for property, government efficiency, and economic and administrative transparency (including improved corporate governance and the reduction governmental corruption). Institutional reform can also accelerate the generation of domestic financial capital, and increase the efficiency of its allocation.

As seen recently in Thailand, Indonesia, and Korea, public scrutiny of corruption, which misallocates resources and at the microeconomic level erodes incentives for work and investment, is increasing, and the control of corruption must be a key goal or byproduct of institutional reform. These rule of law factors are particularly important to the creation and protection of intellectual capital, which is critical to the development of modern, knowledge-based economies.

While each of these considerations is important in isolation, their benefits can only be fully leveraged in combination. Put differently, in a competitive global economy with mobile human and financial capital and many options for where they are deployed, the effectiveness of policies to promote growth and development will increasingly be linked to the quality of governance.

This is one area where China, despite the beneficial effects of its membership in the WTO and its efforts to construct a more transparent legal system, lags behind its neighbors and is likely to do so for the foreseeable future. This was manifested in Beijing's communist-style and largely counterproductive response to the initial SARS outbreak, an opaque approach that will ultimately cost it economic growth and possibly foreign investment. It is therefore in China's interest, even more than in the interest of its Asian neighbors, to increase institutional transparency and strengthen the rule of law.

Recent analysis by the International Monetary Fund documents the close correlation between institutional quality and per capita GDP. For developing economies in Asia, the IMF finds that an improvement in institutional quality to the global average could roughly double per capita income, and support a sustained improvement in long-term growth.10

Conclusion

Two decades ago commentators talked about the coming 'Pacific Century'. Widespread pre-dictions of a shift of wealth and power to the Asia-Pacific region were based on a record of growth and economic dynamism sustained over more than two decades. The Asian financial crisis of 1997 set back that vision and challenged these widely held assumptions about Asia's positive economic future. Despite the crisis, however, Asia has quickly reclaimed its mantle as the world's fastest growing and most economically promising region. China's economic rise in particular is impacting global and regional manufacturing and foreign investment flows. This is occurring in ways that will present new opportunities for China's partners, but will also challenge the regional distribution of both economic and political power. Shifts in the pattern of regional economic organization are one early indicator of this change.

While many of the changes that have recently taken place--such as Japan's stagnation, Taiwan's heavy investment in the mainland, and surging FDI in China--were not fully foreseen twenty years ago, the formula for development adopted by most Asian nations has proven both durable and effective. This includes a foundation of policies designed to expand exports, attract foreign investment, and integrate with the global economy. It also includes a broad commitment to education. In a global environment where human capital is increasingly important to development and competition, this investment is paying off.

As a result Asia is positioned for continued growth and for a central role in the integrated world economy. To achieve this--through the continued attraction of foreign investment and by more effectively generating and allocating domestic capital--Asian nations now need to more fully address issues related to governance, transparency, and the rule of law.

ENDNOTES

1. Globalization, Growth and Poverty: Building an Inclusive World Economy, Washington, DC: World Bank and Oxford University Press, December 2001, pp. 2-5.

2. Capital Flows to Emerging Market Economies, Institute of International Finance, January 16, 2003, p. 1.

3. Capital Flows to Emerging Market Economies, Institute of International Finance, January 16, 2003, pp.1-7.

4. Intra-Industry and Intra-Firm Trade and the Internationalization of Production, Paris: Organization for Economic Cooperation and Development, June 2002, pp. 164-165.

5. David Hale, "The Outlook for China Policy", David Hale On-Line, January 14, 2003, p. 2.

6. Sebastian Moffett, "How Japan's Neighbors Give it a Lift", Wall Street Journal, February 13, 2003.

7. Hale, "The Outlook for China Policy," p. 4.

8. Shawn Crispen, "Japan Renews Business Interest in Thailand Amid an Overhaul," Wall Street Journal, August 28, 2002.

9. Ibid.

10. World Economic Outlook, Washington, D.C.: International Monetary Fund, April 2003), Chapter 1, p.13.