THIRD MEETING

OF THE STUDY GROUP ON

China-Japan-US Cooperation in Asia-Pacific Regional

Trade and Investment Liberalization

November 11-12, 1997

Alumni House

University of California at Berkeley

Participating Organizations:

BRIE (Berkeley Roundtable on the International Economy, United States)

CPS (Council of Policy and Strategy, People’s Republic of China)

DIHS (Dentsu Institute for Human Studies, Japan)

with the generous support of the United States-Japan Foundation

The Study Group on US-Japan-China Cooperation in Promoting Free Trade and Investment in the Asia-Pacific Region (aka Trilateral Forum) is a three-year project organized by the University of California’s Berkeley Roundtable on the International Economy (BRIE) in collaboration with the Dentsu Institute for Human Studies in Tokyo and the Council of Policy and Strategy in Shanghai, with lead support from the United States-Japan Foundation. The project structures detailed policy discussions among a small group of senior public and private sector representatives for the purpose of exploring common interests and potential trade conflicts with particular focus on China’s proposed accession to the WTO. The Forum’s first and second meetings were held in Tokyo (July 1996) and Shanghai (May 1997). This report summarizes proceedings of its third meeting, held November 11-12, 1997, on the UC Berkeley campus. Upcoming meetings will continue the project’s long-term work of developing policy recommendations while promoting enhanced public understanding and discussion of the trade liberalization process.

Summary Introduction: the Forum’s Third Meeting

The recent Berkeley meeting examined the role of international currency issues and potential "systems friction" as the region’s differing political economies interact in international markets. Its first session focused on domestic financial adjustments and their impacts on trade and investment. The second session addressed exchange rate shifts and regional adjustment. The developing Asian currency crises intensified discussion in both sessions. The third session turned to systems frictions and in particular, issues surrounding China’s WTO accession and issues arising from differing US-Japanese institutional structures.

 Summary of Third Meeting Proceedings

SESSION I. Domestic Financial Adjustments and Their Impacts on Open Trade and Investment

Briefing Papers

Barry Naughton, Professor, IRPS, University of California, San Diego,
China’s Financial Reform: Achievements and Challenges

Zhiyuan Lin, Senior Fellow, Research Institute of Finance and Banking, People’s Bank of China, Multilateral Economic Cooperation and China’s Macroeconomic and Financial Problem

Shujiro Urata, Professor of Economics, Waseda University
Foreign Direct Investment Diversion

Keynote Speakers

Barry Naughton opened the meeting by reviewing China’s recent economic reforms before turning to current financial-system problems. He described remarkable success in monetarization and financial deepening since 1978, and the growth of the M2 money supply through relatively smooth and gradual reforms. For contrast, he pointed to the former Soviet Union’s transition, with its overall decrease in the money supply, its bank failures, and diminished savings.

Among the most significant of China’s current problems is the level of non-performing loans, which by some estimates, he said, may approach 25% of total GNP. The increased savings accompanying economic growth has meant more money channeled into the banking sector. This has allowed banks, in turn, to rapidly increase the supply of credit in the economy, leading to "over-lending." Of particular concern is the rate of non-performing loans to state-owned enterprises (SOEs). Since the 15th Party Congress, however, there has been an acceleration of SOE reform and with it, massive changes in the banking system, including a transition from the bank-dominated system to financial capital markets. Bank loans are increasingly being converted and sold off.

Further reforms require eliminating factors which insulate China from the global economy. For example, the domestic financial markets are separated from foreign equity markets due to the inconvertibility of the currency. Moreover, in order to strengthen the ability of the domestic financial system to withstand crisis, China must insure the domestic banking system.

In closing, Naughton briefly addressed likely impacts of the regional currency crisis on China’s reform efforts. If there is a quick recovery in Southeast Asia, there will be a renewed increase in exports compared to China, which will put tremendous pressure on China to accelerate its reforms. A slower recovery may mean slower reform. In the immediate future, it is not likely China will suffer contagion from the Southeast Asian financial crises. In the longer term, the devaluation of SE Asian currencies will put pressure on the RMB and may affect China’s competitiveness, raising the question, is the RMB now overvalued relative to regional currencies?

Zhiyuan Lin began her presentation by explaining the need for a cautious pace for Chinese financial reform, in terms of RMB convertibility, commercial bank reform and the opening of the Chinese financial market. China is taking strict policies to control inflation, which has led to tight money supply and growth in foreign reserves, she said.

Inflows of foreign capital must be controlled because of weak central measures and institutions, a situation which indicates that massive central bank reform is crucial. In terms of monetary and banking policies, the central bank must adapt to the burgeoning market economy, and must have supervisory ability over the commercial banks, where the level of bad loans is very high. The IMF and the World Bank have helped with automation, training, information technology, and the various problems of internal organization. Unfortunately, the presidency of the central bank changes frequently, which means the organization is tied to political influences.

Dr. Lin concluded by urging radical bank reform because of the increasing danger posed by non-performing loans as SOE reform continues.

Shujiro Urata discussed the rapid growth of foreign direct investment (FDI) as an integrating mechanism in the world economy, through exports, technology transfer, etc. Equity participation is no longer a prerequisite for the formation of networks, he said, as subcontracting and informal networks have increased their importance.

FDI was an important mechanism of growth in the ASEAN member countries from the late 1980’s to the early 1990’s. China’s FDI peaked in 1995, and has declined somewhat in value since then. Mr. Urata defined three main types of FDI. The first type is FDI in pursuit of natural resources, a mechanism that has become less prevalent now since its high-point in the 1960’s. The second type is market-seeking FDI, which is characterized by investment in a country with a large population and high income, in order to overcome tariffs protecting the domestic market. The requirements for market-seeking FDI are low wages, low inflation, a stable exchange rate, and good infrastructure. The third and most recent type is savings-seeking FDI, which involves the relocation of production with the primary intent being to save on labor costs.

Japanese firms shifted to ASEAN for low cost production in the early 1990s. Since then, cost competitiveness has declined due to poor infrastructure and increased wages. These factors have led Japanese firms to look at China as another platform, one enhanced by the attraction of its huge market. However, in terms of the institutional capabilities of the host government, China does not yet deliver a well-functioning regime. There are frequent changes in FDI code, and different discretion is given by the various bureaucracies. The institutional arrangement and capabilities are critical to business performance.

Discussion

Yuan Tian reviewed China’s considerable progress in economic reforms since 1978 and in particular, the last two decades’ progress in SOE reform, which began in earnest in 1985. The reforms have involved the gradual elimination of planned plant production, the freeing of prices and, beginning in the early 1990s, the development of capital markets. Chen Qiwei added that, although the financial sector remains underdeveloped, it is currently the fastest growing and changing sector.

Mr. Tian itemized China's actions to alleviate SOE debt. First, China is transforming SOEs into share holding companies so that they are enterprises operating under profit motives. Second, China is implementing a law on bankruptcy reform. Third, the government is allocating significant funds towards the alleviation of SOE debt. Some RMB 30 billion was allocated in 1997, with a planned RMB 50 billion in 1998. Last, SOEs have increased their funding from capital markets in Shenzhen and Shanghai.

As a result of SOE privatization, the Chinese government is loosening its grip on the national economy. This has led some to decry the weakening of the Chinese state. Zhiyuan Lin warned of the tendency to assume that a small government is a weak government, and that a large government is strong. In fact, she said, as the government structure adjusts to the market economy, it aims to increase its efficiency and strength, while at the same time, becoming smaller in terms of its ownership of the domestic economy.

Participants from all sides felt that China’s ability to reform its economy and build strong institutions will play a role in continued foreign direct investment. According to Chen Qiwei, there is a general understanding in China of the need to liberalize the banking sector in order to ensure the continued flow of FDI. George Scalise mentioned the unpredictability of the Chinese business environment as a factor in the 10 percent decrease in FDI between 1995 and 1996. Stanley Lubman argued, however, that foreign companies generally recognize governance issues as part of the risks of investment.

Teruhiko Mano reiterated that foreign investment continues to be critical to the Chinese economy, as both a welcome source of technology transfer and a necessary source of funds. Even though the Chinese domestic savings rate is high, the low GDP per capita of less than $1000 means that the overall amount of domestic savings is insufficient for the huge capital needs of the Chinese economy.

Zhongzhou Li suggested that the best way to assure China’s progress towards a rule-based system is through WTO accession. The US, he said, is acting as though this is the last chance to make China reform -- once they are in, it’s too late -- but this is an inaccurate assumption. For example, under the IMF there has been steady progress made in monetary reform. China must reform according to its own conditions, and cannot promise a time table on the creation of a market economy. The Chinese participants stressed that the virtual absence of comprehensive regulations or laws governing the financial sector compels China to move slowly towards liberalization and reform. The Southeast Asian crisis has illustrated the perils of financial liberalization without adequate financial institutions.

SESSION II. Exchange Rate Shifts and Regional Adjustment

Briefing Papers

Shinji Fukukawa, Chairman and CEO, Dentsu Institute for Human Studies,
Development of the Big Bang and Its Impact

Teruhiko Mano, Adviser to the President, The Bank of Tokyo-Mitsubishi Ltd.,
Roles played by the yen in the global and Asian financial and capital markets

Edward Lincoln, Senior Fellow, Foreign Policy, The Brookings Institution,
Evaluating Japan’s "Big Bang" Financial Deregulation

Keynote Speakers

Shinji Fukukawa discussed the ongoing financial reforms in Japan and the difficulties in attaining certain reforms due to disagreement among various interest groups. He stressed the need to transform the Tokyo stock exchange to a level playing field, with clearly defined rules. Towards this end, the exchange is upgrading its systems and procedures to global standards.

Despite such examples of progress, competing interests continue to pose difficulties in achieving liberalization and reform. For example, the private sector wants to decrease the rate of corporate tax, arguing that companies are relocating to lower tax environments. The Ministry of Finance is reluctant to change the securities transaction tax. Japanese banks are calling for privatization of the postal savings system, which now collects 20% of national public savings.

Teruhiko Mano discussed the perils of Asia’s fixed foreign exchange regimes, and their relation to the present economic turmoil. One of the underlying causes of the crisis has been that most countries had set up a currency basket composed predominantly of US dollars. This creates a situation where the foreign currency is too tightly pegged to the dollar. If the underlying economic foundations are in alignment, this linked system can be appropriate. However, when the underlying competitiveness of the Asian economies shifted vis-à-vis the United States, Asia’s postponed adjustment to these new competitive conditions caused the crisis.

The situation worsened when the borrowing of foreign currency continued on the basis of the pegged exchange rate system. In order to link the two currencies, with different levels of competitiveness, the less competitive country must raise interest rates to avoid the higher cost of borrowing. Many countries borrowed in foreign currency without hedging. As long as the fixed exchange rate is kept, interest rates are kept higher than they should be.

Mr. Mano discussed the nature of the international financial system after World War II, and the key role played by the US dollar to gold standard after World War II. During the first two decades after the war, the sound US economy allowed Japan to use its current account balance. Presently, the US dollar is still used as the global currency despite the fact that it is no longer the formal standard of the international monetary system. Part of the cause is the lack of a suitable replacement currency, the flexibility of short and long term money markets in NY, and America’s sustained military and economic might. Japan has supplied finance to the world, through savings and liquidity, but the yen has yet to play a major role as a reserve currency. An important question is whether financial reforms will improve financial allocations to productive investments.

Ed Lincoln proposed that there are several reasons to be skeptical about the impact of Japanese financial reforms, and that the list of reforms encompassed in the "Big Bang" will probably be watered down. He notes that the present political scene may hinder Prime Minister Hashimoto’s attempts to enforce reform. There remains some question as to whether the government will be able to privatize the postal system and insurance. One cannot forget that the same party continues to be in control. Mr. Hashimoto is not a new player, and he may not have the personal or political will to carry out reforms.

In addition to the political factors, there are several features of the domestic economy that will mitigate the effect of reforms. First, Japan has large savings and insufficient demand to use this savings at home. The large supply of savings has led to very low rates of return because there is a great deal of money chasing relatively few investment opportunities. So liberalization can only have so much effect, and may equal the Japanese currency chasing more opportunities overseas.

Second, internal human resource practices in Japanese financial companies, such as the evaluation of risk by loan officers, are not well developed. Financial analysis continues to be far less relevant than personal financial relationships. Moreover, disclosure is rare and financial information does not flow freely.

Another issue is corporate governance. There is a movement from bank supervision of corporations to one in which bond and stock holders have more power and influence on corporations. However, managers still run firms, not the shareholders or the board, which leads to a lack of concern about stock price and shareholder value.

Discussion

The US share of the global economy has steadily declined, from over 40 percent after World War II, to slightly less than 20 percent today. As other nations now account for an increasingly significant proportion of the world economy, one can no longer expect any single country to play the role of global standard currency. With the increased prominence of the yen in the global economy, as well as the emergence of the ECU, the participants considered the future of the international financial system and the possibility of having more than one main reserve currency.

Therefore, a key point of consideration was the future role of the yen as a reserve currency. Several participants suggested that the yen could play a stronger role in the global financial system. Ed Lincoln pointed out that the yen has been suggested as a reserve currency for 20 years, but it has not become one. One factor may be the absence of short term liquid financial markets. Further, it was noted by both Japanese and American speakers that the decrease in Japan’s savings rates, due to the demographic changes of an aging and eventually declining population, will hinder the yen’s role as a future reserve currency. Dennis Encarnation reasons that people will utilize their savings, thereby removing some degree of liquidity from the world economy. Thus, for those countries who wish to peg or link their currency, the only choices may be the dollar or the Euro. However, the impact of the ECU is uncertain, as it suffers from its own sources of instability -- primarily, that the members of the European Union are not yet able to act like a single country in political and economic realms.

A key question following the key speakers was whether there is political and public support for Japan’s "Big Bang." Heizo Takenaka noted that while 80% of the Japanese people support reform, 90% do not expect their life to change. Several participants mentioned that while public opinion strongly supports reforms, it also expects to maintain the status quo in terms of high living standards. This desire has manifest itself in a degree of political conservatism. As Ezra Vogel put it, since the Japanese people are not dissatisfied, there is no sense of crisis to support massive changes.

Regardless of whether there is political support from the Japanese people, there is disagreement about the relative policy making power of the bureaucrats versus the political parties. While Mr. Fukukawa felt that the power of political parties is now stronger than the bureaucrats in the policy making process, Mr. Takenaka countered that Prime Minister Hashimoto makes policy based on bureaucrats. Mr. Takenaka noted that the Ministry of Finance has been very supportive of reform, taking control of finance and pushing strong reforms within its capacity.

US participants voiced concern about the emerging economic imbalances between Asia and the United States. A pattern of trade has emerged wherein the US consumes a vast proportion of Asia’s exports. Europe, despite having higher than anticipated growth, is not expected to absorb a larger share of Asia’s increased exports. If China and Japan continue to export vast quantities of goods without providing complementary access to their own markets, the US dollar may have to devalue relative to the yen and the RMB. Laura Tyson explained that the complication with devaluation is that the US government doesn’t run an official dollar policy; market mechanisms determine the value of the dollar. The US will only try to convince the market to change rates when the G7 feels the market doesn’t reflect its real value.

Within this context, Mr. Mano urged the US to control its accumulated debt in order to preserve the value of the dollar. Otherwise, the low rate of US savings and the consequence of large trade and budget deficits will undermine the US dollar as the reserve currency.

There was some disagreement as to whether the currency crisis, which began in Southeast Asia and later spread to most of the region, would significantly affect the Chinese economy. Jialin Zhang explained that China’s growth rate is primarily supported by domestic capital. The foreign capital that has been invested has been generally used for productive purposes, and not property speculation as in much of Southeast Asia. There is some over-capacity in Shanghai, but this is balanced by under-capacity in China’s inland provinces. The relatively limited exposure to the regional financial crises will allow China to continue with economic reform. However, Barry Naughton noted that due to China’s high inflation in the recent past, and the RMB’s link to the US dollar, it is likely that the RMB has over-appreciated relative to the underlying competitive position of the Chinese economy. Any currency realignment that may take place to correct this disparity could force the Chinese to consider reforms to their economic policy.

Briefing Papers

Zhongzou Li, Minister Counselor (Economic & Trade), Permanent Mission of PRC to the UN at Geneva,
China Plays a Constructive Role in the Dynamic Growth of the Asian and Pacific Economies

Heizo Takenaka, Professor, Faculty of Policy Management, Keio University,
Systems Frictions: Japan’s Standpoint

Richard Steinberg, Professor, School of Law, University of California at Los Angeles,
Institutional Implications of WTO Accession for China

Keynote Speakers

Zhongzhou Li discussed China’s increasing integration with the world economy, and the domestic reforms that have played an integral role in this process. China has taken a decidedly progressive and gradual approach to economic reform, beginning with the rural sector, followed by the much more complex project of urban reform. This moderate approach has been necessary to allay the social tensions and relocation brought about by industrial adjustment, and to continue the steady pace of China’s economic development. The ultimate goal is to complete the transition from a centrally planned economy to a market economic system.

China views WTO membership as an effective instrument to promote integration with the world economy, and is ready to take the WTO framework of rights and obligations as the basis for economic reform. In order to meet WTO entry requirements, China has undertaken significant reforms, which include the abolition of mandatory planning targets and lifting of most state price controls (only 5% of products and services are still controlled), the lowering of average tariff levels from 42% to 17%, and soon to 15%, and the elimination of many non-tariff barriers.

China finds itself pressured by the major trading partners to pay a higher entrance fee and to undertake more obligations than existing members. While China wants to be part of the multilateral trading system, it will not sacrifice its fundamental economic interests, nor accept discriminatory rules to enter the WTO. At this point, China has largely come to terms with Japan on the accession, but has yet to reach a common understanding with the United States.

The US Administration’s position on China’s accession to the WTO has been heavily influenced by the emotional reaction to China’s trade surplus, overlooking the substantial benefits the US has gained in its overall positive economic and trade relations. The US has a trade surplus in services with China of some $72.6 billion, which largely offsets the imbalances in goods. Therefore, the bilateral trade relationship reflects the ongoing structural adjustment and upgrading of the US economy from blue collar to white collar labor. Additionally, the rapid growth of China’s exports has allowed rapid expansion of China’s imports which, with the increase in foreign exchange reserves from exports, has provided an environment for monetary reform.

Heizo Takenaka examined some of the causes of systems friction between the US and Japan, emphasizing that frictions will continue to occur due to enduring national differences in institutions and domestic economic structures.

Japan’s long term trade behavior is a function of its domestic political economy. For example, the nation’s life-time employment practices have been shaped by Japan’s early shortage in skilled labor. While this system creates a secure environment for the labor force, it imposes a high financial risk for Japanese corporations, as labor becomes a fixed cost. The slow down in Japan’s economy since 1992 has threatened the life time employment system as company growth declines.

Another fundamental difference between the US and Japan is the legal system. The most apparent difference is that of numbers, while there are some 50,000 new lawyers annually in the United States, Japanese law only allows 700 people to pass the bar exam each year. Moreover, there are significant differences in Japanese and US legal frameworks, as the Japanese system based on common law tradition, borrowed largely from German law. Japan is the only advanced legal system without the jury system and the central government has the power to override the judgement of the courts. In Japan, law is based heavily on discretion, or implicit agreements and understandings between business and government.

Such fundamental differences in institutional structures cause systems friction -- for example, in the legal enforcement of intellectual property rights, a common issue between US and Japanese trade negotiators. Mr. Takenaka was further interested in how China fits into the US-Japanese discussion about legal differences.

Richard Steinberg discussed the implications of China’s accession into the WTO, for the institutional strength of that body. The WTO currently operates within a "state of nature," that is, there are few clearly defined rules or protocols, and legislative decisions are based primarily on consensus. As his paper suggests, the WTO’s judicial, legislative and administrative systems will have difficulty resolving the frictions associated with China’s entry into the WTO because rules are either weak or missing on several issues that are likely to be sources of friction between the liberal Western trading powers and China. If the WTO is perceived as incapable of dealing with political frictions, it may lose its efficacy and political support.

Mr. Steinberg therefore argued that China must be brought into the WTO process in a politically stable way that strengthens the WTO as an institution. Unless some preventative action is taken, there is a risk that political friction will result from China’s accession, fundamentally due to the large and transitional nature of the Chinese economy. The WTO Protocol of Accession does not provide much guidance for the context of China’s accession, as it is based on the accession of Portugal to WTO. But many of dimensions of China’s political-economic system are not accounted for by current WTO rules, so a typical accession protocol that binds China to follow all WTO rules will still leave room for conflict on certain principles. Therefore, it is essential to change the terms of the protocol in order to reflect China’s unique characteristics, and to develop an institutional structure that promotes cooperation. One possible mechanism to do so is to tailor

China’s Protocol of Accession to explicitly address possible conflicts on tariffs, quotas and non-tariff barriers, among other things.

Discussion

There was agreement, from all three sides, that China is determined to meet the WTO criteria for accession, and has taken extensive reforms in accordance with WTO principles. Despite this immense progress, the US continues to have concerns about China’s entry into the WTO. The US feels that China’s accession is an exceptional case, and that China cannot simply be treated under the same rules and protocols as previous entrants to the WTO system. Due to its immense size (in terms of labor and economic might) as well as its form (in terms of a unique political economy), China poses an unrivaled challenge to the WTO structure, which the Americans feel must be resolved by the WTO protocol of accession, as Richard Steinberg suggested.

China is moving towards consistency with the current WTO rules, but does not want to be subject to different requirements and procedures than previous entrants. As Zhongzhou Li said, "China does not want second class citizenry in the WTO. If there is a benefit to Asia joining the WTO, it is in equal treatment." Moreover, if there are new rules constructed during the accession, they should be applied to all WTO members.

While the Americans tend to view China’s WTO accession as a binding contract, in which China agrees to meet certain conditions as a prerequisite for entry, the Chinese repeatedly expressed the need for flexibility in the protocol of accession to allow developing countries such as China to reform through slow, gradual steps. Luzhi Chen underlined China’s preference for the non-binding APEC approach, which allows its members to define their own unilateral action plans, as opposed to the more formal legalistic framework of the WTO.

The Americans were quick to point out that legality and the goal of transparency are not just Western goals. John Zysman emphasized that the WTO legal approach provides transparency and a stable environment for private sector interests. However, there are questions about China’s ability to implement the transparency principles of the WTO, in part due to the nascence of China’s legal institutions. Stanley Lubman observed that while China is moving towards a rule-based system, China has not had the mechanisms to enforce these rules and laws. Chinese courts are theoretically equal in power to government agencies, and therefore, do not have the power to enforce their judgments on the agencies. Zhongzhou Li made assurances about China’s ability to comply with WTO regulations, despite some legal imperfections. When China signs an international agreement, it becomes part of domestic law. Moreover, China has created new tribunals specifically to address these issues.

Teruhiko Mano, in articulating the Japanese position, expressed support for a rules-based legal framework in international organizations. While China does have different institutions and structures from the US and Japan, this fact does not preclude cooperation and the nurturing of common goals. Finally, it is important that China is not expected to follow a US standard, but the standards of the WTO.

Despite these issues, there is considerable feeling on all sides that China’s entry to the WTO will be an important means to strengthen the momentum of China’s market-oriented reforms.

Steve Cohen concluded the proceedings with strong support for China’s quick entrance into the WTO. As he explained, the US attitude towards China is forgetful of history. The history of both the GATT and the WTO is one of diversity. In the 1980’s, France, Spain, and Italy were all defined, to a great extent, by the principles and realities of state ownership. And as the US managed to live with these structural differences, it will do so with China. The WTO accession should not be viewed as the beginning or end of the discussion, but the symbolic midpoint.