QUESTION 1

1.0 INTRODUCTION

In January 1992, at the summit meeting of the Association of Southeast Asian Nations

(ASEAN)1, the establishment of an ASEAN Free Trade Area

(AFTA) was decided with the participation of all six-member countries

(Brunei, Indonesia, Malaysia, Philippines, Singapore and Thailand). This

agreement provided for the elimination of tariffs and non-tariff barriers within

15 years from January 1993 (revised later to start from January 1994), with

the completion date set at 2008. Until then, tariffs will be reduced to less

than 5%. The main instrument of tariff liberalization under AFTA is the

Common Effective Preferential Tariff (CEPT). The CEPT scheme will

cover manufactured goods and processed agricultural products. Given the

rapid development of regional cooperation in North America and Western

Europe, the 1995 ASEAN summit meeting decided to move the deadline for

the elimination of trade barriers forward to the year 2003, and the coverage of

the CEPT scheme was extended to unprocessed agricultural products, as well

as services. Facing the deterioration of the regional economic situation

following the financial crisis in 1997, the summit meeting of ASEAN in

December 1998 decided to speed up the trade liberalization by accelerating

the time-frame to 2002, with the hope of making ASEAN a more attractive

environment for foreign direct investment (FDI). (Bhagwati et. al., 1996)

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The Association of Southeast Asian Nations or ASEAN was established on 8 August 1967 in Bangkok by the five
original Member Countries, namely, Indonesia, Malaysia, Philippines, Singapore, and Thailand. Brunei Darussalam
joined on 8 January 1984, Vietnam on 28 July 1995, Laos and Myanmar on 23 July 1997, and Cambodia on 30 April
1999. The ASEAN region has a population of about 500 million, a total area of 4.5 million square kilometers, a combined
gross domestic product of US$737 billion, and a total trade of US$ 720 billion.

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Since the mid-1990s, four more countries joined ASEAN: Vietnam in 1995, Myanmar

and Laos in 1998 and Cambodia in 1999. They are also

participating in AFTA with deadlines set for Vietnam in 2006, Myanmar and

Laos in 2008 and Cambodia in 2010.

Compared to other free trade areas, AFTA2 is very unique. It has at least three special

features. First, AFTA was created at a time most member-

countries enjoyed a fairly high economic growth rate, characterized by rapid

export-oriented industrialization. Second, AFTA is located in a wider

dynamic region, characterized by rapid region-wide structural changes.

Changes in the comparative advantage structure of Japan, Korea, Taiwan and

other economies in East Asia have generated markets for products of ASEAN countries,

which are lesser, developed, and induced direct investment flows

from the former economies to the latter. During the rapid growth process,

ASEAN countries have benefited greatly from such regional externalities.

Third, ASEAN countries however are also facing the rapid emergence of

China, a giant in almost the same development stage and with the same factor

endowments. While the development in Japan and the newly industrializing

economies (NIEs) have provided a complement to growth in ASEAN, the

relationship between ASEAN and China may be characterized as competition.

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The ASEAN Free Trade Area (AFTA) has now been virtually established. ASEAN Member Countries have made
significant progress in the lowering of intra-regional tariffs through the Common Effective Preferential Tariff (CEPT)
Scheme for AFTA. More than 99 percent of the products in the CEPT Inclusion List (IL) of ASEAN-6, comprising Brunei
Darussalam, Indonesia, Malaysia, the Philippines, Singapore and Thailand, have been brought down to the 0-5 percent
tariff range.

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Trade creation occurred when a customs union is formed, the member nations

establish a free trade zone amongst themselves and a common external tariff on non-

member nations. As a result, the member nations establish greater trading ties between

themselves now that protectionist barriers such as tariffs, quotas, and non-tariff barriers

such as subsidies have been eliminated.The result is an increase in trade among

member nations in the good or service of each nation's comparative advantage.

The creation of trade is important to the nation entering the customs union in that

increased specialization may hurt other industries. Arguments for protectionism, such as

the infant industry argument, national defense, outsourcing, and issues with health and

safety regulations are brought to mind. However, customs unions are typically formed

with friendly nations, eliminating the national defense argument, and in the long run

serves to create more jobs and output due to specialization.

Trade diversion occurred when a customs union is formed, the member nations

establish a free trade zone amonst themselves and a common external tariff on non-

member nations. Previously a nation may have had a working trade relation with another

nation outside the customs union in which each nation produced to their comparative

advantages, the common external tariff may now make it not as efficient to trade with

that non-member nation than with a nation within the member nation's free trade zone. In

this respect, trade is diverted from the nation outside the union to a nation inside the

union, lowering the total output of the good or service being traded.

Diverted trade may hurt the non-member nation economically and politically and create

a strained relationship between the two nations. The decreased output of the good or

service traded from one nation with a high comparative advantage to a nation of lower

comparative advantage works against creating more efficiency and therefore more

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overall surplus. However, one can argue that the benefits of the free trade zone and

trade creation will ultimately outweigh the introduction of trade diversion.

2.0 THE ECONOMICS OF A FREE TRADE AREA IN THE CONTEXT OF ASEAN

By eliminating trade barriers among member countries, the AFTA removes

discrimination between partner countries and domestic firms.

As a consequence, relatively inefficient domestic production will decrease in

favor of partner country production. This results in trade creation. However, the AFTA

creates a new discrimination between imports from partner countries and those from

non-partner countries.

Imports from partner countries therefore may replace more efficient non-partner products

in the home market. This is a trade diversion. The net trade effect of a AFTA will

depend on the degree of trade diversion compared to the degree of trade diversion. In

other words, this net effect will be bigger, the stronger the

trade diversion effect is, and also the bigger, the weaker the trade diversion

effect is.

The two conditions for strong trade creation effects are that the members of the AFTA

are major trading partners with each other, and that the tariff rates in

the intra-region trade prior to the establishment of the AFTA were high. The

first condition is critical and only in the case that this condition was met, is

the second condition important. The world trade matrix in the first half of

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the 1990s showed that ASEAN countries were not major trading countries

with each other. In 1995 for example, intra-ASEAN trade (all six members

before Vietnam joined in 1995) accounted for only 23.6% of their total trade

(Chia, 1998). If Singapore, a trade entrepot, were excluded, the share of intra-ASEAN

trade would be reduced substantially. For example, trade

among the ASEAN-4 (Indonesia, Malaysia, Philippines and Thailand)

accounted for only 5.2% of their total trade in 1991. That share has risen

subsequently but still remained at 8.3% in 2000 (Mukoyama, 2001).

However, as cited earlier, since ASEAN countries have experienced a rapid

process of export-oriented industrialization, it is more important to look at the trade

pattern of manufactured products, to see the extent of intra-ASEAN

trade under the process of high economic growth. The condition for a weak trade

diversion effect is that, in the AFTA market, the export structures of non-partner

countries are not similar to that of the partner countries.

The trade creation and trade diversion effects are static, referring to a one-time

change in the allocative efficiency. The AFTA also generates

dynamic effects, which refer to long-term implications for economic development of

partner countries. Some of these dynamic effects can be

summarized as follows. First, since the market is expanded beyond each

partner's national economy, the economies of scale in production can be

reaped and thus production of final goods, as well as intermediate goods, will

be concentrated in the most efficient site. The international competitiveness

of these products will be stronger and exports will be expanded, resulting in a

new trade creation effect. Second, direct investment flows from non-partner

countries are expected to expand for three reasons. One is that the foreign direct

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investment (FDI) is induced by the new expanding market in the AFTA. Another reason

is the reaction of multinational corporations in non-partner countries to the trade

diversion effect i.e., FDI is undertaken to overcome the disadvantage brought

about by discriminated tariffs. This is a type of direct investment diversion

from non-partner to partner countries. One more reason is that along with

the implementation of trade liberalization and other reform measures, the

member countries of the AFTA appear to be less risky. The FDI can thus be

expected to increase.

A third dynamic effect is that, under the framework of the AFTA, the pressure of

competition among partner countries will be stronger and therefore resources will be re-

allocated from less efficient areas to more efficient industries.

3.0 IMPLEMENTATION OF THE CEPT SCHEME IN AFTA

The CEPT scheme covers products having 40% ASEAN content (at least 40% of its

content originates from any member country). The scheme has

been implemented on the basis of 4 product lists.

The Inclusion List (IL): Products in the IL are those that have to undergo immediate

liberalization through reduction in intra-ASEAN tariff rates, and

removal of quantitative restrictions and other non-tariff barriers. Tariffs on

these products should be cut to a maximum of 20% by the year 1998, and to

less than 5% by the year 2002 (by the year 2006 or later for new members of

ASEAN).

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The Temporary Exclusion List (TEL): Products in TEL can be shielded from trade

liberalization for a temporary period. After the temporary period,

all of these products would have to be transferred into the IL and begin a

process of tariff reduction.

The Sensitive List (SL): This list contains unprocessed agricultural products, such as rice

and sugar, which are given a longer period for integration into the

free trade area. The commitment to reduce tariffs to 0-5% and to remove

non-tariff barriers is extended up to the year 2010 for the ASEAN-6 to meet

this deadline (for Vietnam up to 2013, for Lao PDR and Myanmar up to 2015,

and for Cambodia up to 2017).

The General Exception List (GEL): The products in this list are permanently excluded

from the free trade area for reasons of national security,

the protection of articles of cultural value, and other reasons. For the six early members

of ASEAN, on average, more than 98% of the products have been put in the IL for tariff

cuts. The average figure for the four new members is close to 60% (nearly 80% in the

case of Vietnam). For these countries, as expected, the large number of

products listed in the TEL is noteworthy. For the six early members of ASEAN, on

average, number of products for which tariffs have been lowered to 0-5% levels

accounted for nearly 93% of the products listed in the IL.

So far, the implementation of CEPT has been made according to the revised

accelerating target for trade liberalization, except for some products,

such as automobiles and petrochemicals. For these products, some ASEAN

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countries requested to be allowed to postpone the schedule for tariff cuts, due to the

difficulties they faced after the financial crisis. Under the export

oriented industrialization regime, increasingly large numbers of products made in

ASEAN have gained international competitiveness. Under these

conditions, the tariff-cutting schedule has progressed smoothly.

4.0 AFTA TRADE PATTERN OF MANUFACTURED PRODUCTS

4.1 Direction of ASEAN Trade in Manufactured Products

With the exception of the Philippines, the ASEAN economies have achieved a fairly

good performance at least until 1997. From 1966 to 1997,

the average annual growth rates for Indonesia, Malaysia, Singapore, and

Thailand were 6.5%, 7.1%, 9.0% and 7.4% respectively. The growth rates in

the 1990s were lower (averaging 4.0%, 6.8%, 8.5% and 5.2%, respectively)

due to the financial crisis in 1997, but, they were still quite high.

The growth performance in ASEAN can be characterized as trade-oriented. The trade

dependence ratios (the ratio of imports and exports in the GDP) for most

ASEAN countries have risen rapidly. For example, the ratio for Thailand

rose from 49% in 1980, to 67% in 1990 and 90% in 1999.

This trade expansion has been led by the expansion of trade in manufactured products.

In particular, the expansion of ASEAN manufactured exports was noteworthy.

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By 1999, more than 90% of Malaysian exports and about 80% of Thailand exports were

manufactured products.

Those countries have also been successful in expanding their shares in world

markets. The share of ASEAN-4 (Indonesia, Malaysia, the Philippines and

Thailand) in world markets for manufactured products rose from 0.9% in

1980 to 3.6% in 1998. In addition to these reasons, since the implementation of the

CEPT scheme in AFTA has been centered on manufactured products, the analysis in

this section will focus on the trade pattern of manufactured products.

Manufactured goods have been the major focus in the relationship between

ASEAN and the rest of East Asia in the dynamic context.

The following remarks can be obtained. First, for the ASEAN-5

as a whole, manufactured exports to the world market more than doubled

from 1992 to 1999, a rate much higher than Korea or Japan. Expansion by

Malaysia and the Philippines is noteworthy. Second, intra-ASEAN trade of

manufactured goods has expanded at almost the same rate as the trade with

the world as a whole. Starting with a smaller base, Philippine exports have

expanded rapidly in almost all markets, not only in the intra-AFTA market.

Third, ASEAN exports to China, Korea and Japan have expanded at a higher

rate than those to intra-ASEAN markets. In particular, exports to Korea rose

3 times, and to China 4 times, compared with 2.4 times for intra-ASEAN exports. Fourth,

the share of intra-ASEAN trade in total exports of ASEAN

is still very small.

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Moreover, if Singapore was excluded, the role of intra-ASEAN trade becomes

much less significant. Fifth, the US has maintained the position of the most

important market for ASEAN manufactured products, even though that

position has declined somewhat.

In short, during the 1990s, ASEAN manufactured exports have shown remarkable

performance but intra-ASEAN trade was not as important as trade

with non-partner countries in East Asia.

4.2 An Observation on the Trade Effect of AFTA

So far we have observed the direction of ASEAN exports. Next, let us observe how the

rest of the world has exported to the ASEAN market. From 1992 to 1999, manufactured

exports from Korea to the world markets increased by 1.8 times and 1.9 times to ASEAN

markets. The same figures for Japan were 16% and 23% respectively. Chinese

performance is noteworthy. Its exports to the world market showed an expansion of 2.6

times while exports to ASEAN expanded 3.8 times. These facts suggest that

the "gravity" of ASEAN has been strong for three major non-partners in East

Asia.

Next, let us have a closer look at the dynamic relation between ASEAN and the rest of

East Asia, by focusing on the industrialization process and the

direction of manufactured exports of Thailand and China. Thailand is one of

the original members of ASEAN and one of the most active partners in

implementing the CEPT scheme of AFTA. China is a rapidly growing

economy and a major non-partner AFTA in the dynamic East Asian region.

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China also has similar factor endowments and is in almost the same

development stage as Thailand.

For analyzing the development process of an industry, one must observe trends in

production, and consumption as well. However, by computing the international

competitiveness index (ICI) of each industry in a given country, we can get an idea of the

trends in the development of an industry. The ICI is defined as the ratio of (exports

minus imports) divided by (exports plus imports) for a

product. The value of this ICI ranges from minus 1 (where exports are

almost zero) to plus 1 (where imports are almost zero). If exports and

imports of a product have almost the same value, its ICI is zero. Thus the

product records a trade deficit if its ICI is negative, and a trade surplus if it is

positive.

It is interesting to remark from that the structures of comparative advantage in Thailand

and China are quite similar and their long-term pattern of change is also almost the

same. For example, the ICI of apparel was nearly plus 1 before the 1990s, and the

industry continued to be the strong competitive industry for both countries. In the case of

television and motorbikes, the ICI of Thailand turned out to be positive in the early

1990s and has rapidly approached plus 1 in the second half of the decade.

For China, the ICI showed some fluctuations in the first half of the 1990s, but

illustrated almost the same pattern as that of Thailand in the latter half of the

decade. For office machines, Thailand changed from a trade deficit to a

surplus in 1990, and has expanded the surplus during the course of the 1990s.

Some years behind, China also showed the same trends. For other industries,

a similar pattern can also be observed.

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5.0 AFTA AND INCOMING FOREIGN DIRECT INVESTMENT (FDI)

It suggested that a free trade area would induce an expansion of FDI. How about the

case of AFTA? Since the mid-1980s, a new wave of FDI has been flowing into ASEAN.

Under the pressure of a sharp rise in the value of the yen against the US dollar

since September 1985, Japanese firms have expanded FDI first in NIEs and

then in ASEAN. Substantial investment from Korea, Taiwan and other NIEs

was also undertaken in ASEAN since the mid-1980s, particularly in the

labor-intensive industries, under the pressure of rising labor costs in home

economies as well as a trade conflict with the US.

Since the early 1990s, firms in Japan and NIEs seemed to show more interest in FDI in

China, a rapidly emerging market. The survey by JETRO conducted in April 1993 for

example, showed that Japanese firms in all 18 industries covered in the survey selected

China as their new FDI site. ASEAN managed to keep second position as favorite host

countries for Japanese FDI in six industries including textiles, electronics, and transport

machines (Aoki, 2001).

Another sharp rise in the value of the yen in 1994-1995 created another wave of

Japanese FDI to ASEAN in the mid-1990s. However, this wave did

not last long due to the financial crisis in 1997.

In the 1986-91 periods, average annual flows into ASEAN were greater than the flows

into China. However, the reverse happened in 1992 and since then, the gap between the

two flows has expanded. In 1999, FDI flows into China were four times greater than

those directed to ASEAN. Thus, in the 1990s, FDI has concentrated on China. However,

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even if the flows into ASEAN were much smaller than China,

except for Indonesia after the financial crisis, FDI in ASEAN has not been

stagnant. This suggests that even if China is emerging as a big market, FDI

may increase in both ASEAN and China so long as economic, social and

political stability is maintained.

The trade data showed the interdependence between ASEAN and other economies in

East Asia. As for FDI, we may expect that multinational

corporations (MNCs) may consider ASEAN as one integral part of a dynamic

East Asia. Therefore, AFTA cannot be the single factor which determines

FDI flows. In fact, FDI expanded in ASEAN before the establishment of AFTA and

turned out to be stagnant in the late 1990s, the period characterized by both substantial

implementation of the CEPT scheme and by the financial crisis.

Let us have a closer look at the behavior of Japanese firms who are major investors in

ASEAN. Most recent surveys showed that the response of Japanese firms to the full

implementation of CEPT was generally passive. For example, according to the survey by

JETRO in November and December 2000, recorded in Aoki (2001), only 5.1% of firms

surveyed are underway in reorganizing their affiliates in ASEAN to exploit the benefits

brought about by CEPT, and only 20.4% of firms have such a plan. The survey by the

Japan Center for Economic Research (JCER) conducted in September 2001,

showed that only 30% of firms surveyed are preparing for a new ASEAN

market under the full implementation of CEPT. Even among firms which

have undertaken investment in ASEAN, only 30% plan to reorganize their

existing operations.

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Results of those surveys suggest that AFTA has not strongly affected the behavior of

Japanese firms, which have undertaken (or will undertake) FDI in

ASEAN. This can be explained by the following reason: First, Japanese manufacturing

firms started to invest in ASEAN in the early 1960s. The projects, which were

undertaken until the 1970s are import substitution and concentrated on textiles,

electronic home appliances and automobile assembly. Most textiles-related FDI projects

have retreated from ASEAN (as well as from other Asian host countries), due to the

diversification of activities of investing firms away from textiles towards

pharmaceuticals, chemicals and other areas. Import substitution FDI projects in

electronic home appliances by the end of the 1990s had been almost completed in the

process of reorganization under the CEPT scheme, since most ASEAN countries put

these products on the CEPT implementation fast track. The automobile assembly case

is special. Most countries still protect this industry and appear to be continuing to keep it

on the temporary exclusion list (TEL) of the AFTA scheme.

On the other hand, the projects undertaken since the 1980s have been export-oriented,

and concentrated on electronics and other machinery related industries. Due to the

export-oriented purposes, imports of parts and other inputs have been exempted from

tariffs. Their operations therefore have little relation with the AFTA scheme. Second,

there are two types of Japanese firms investing in ASEAN. One is that of small and

medium-sized firms. Each firm has only one or two affiliates (or subsidiaries) in ASEAN

so that there is little room for them to reorganize the operations.

The other type is that of large firms which are undertaking operations in a wider region in

East Asia. Due to this feature, and combined with the export orientation of most projects,

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the reorganization of Japanese MNCs is built throughout the East Asian region. AFTA is

just one of many factors affecting their reorganizing strategy.

6.0 IMPLICATIONS FOR FURTHER COOPERATION BETWEEN ASEAN AND

KOREA, JAPAN AND CHINA

Let us summarize major points emerging from the fore-above analysis.

First, the trade and FDI effects of AFTA have not been as strong as the theory of a free

trade area predicts. Intra-ASEAN trade has indeed expanded,

but ASEAN trade with non-partner countries in East Asia has expanded at a

higher rate. Moreover, major non-partner countries in East Asia such as

Japan, Korea and China have also expanded their manufactured exports to the

ASEAN market at a faster rate than to the world as a whole. The effect of

AFTA on FDI inflows also has not been recognized so far. Apart from the

reorganization of import substitution projects, the reaction of MNCs to the

implementation of AFTA has not been substantially positive. The relatively weak trade

and FDI effects of AFTA stem from the unique economic feature of ASEAN. Unlike the

EU or NAFTA, intra-ASEAN trade is relatively unimportant and instead, interdependence

between ASEAN and the rest of the wider East Asian region is strong. This feature is so

strong that it likely will not change in the foreseeable future, even if the CEPT scheme in

AFTA is fully implemented.

Nevertheless, the establishment of AFTA is not meaningless. Liberalization of trade

results in a more efficient allocation of resources in each ASEAN

country. Commitment by each country to liberalize trade and enhance the

necessary industrial adjustment brought about by trade liberalization, has

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certainly contributed to the maintenance of a stable and market-friendly

policy environment. This is essential for keeping ASEAN (as a whole and

for each member) together which is less risky and less uncertain than the

alternative. This point is essential for ASEAN to continue to be an integral

part of the dynamic division of labor in East Asia.

Second, along with the financial crisis in 1997, the emergence of China may be the most

important event for the Asian economy in the last decade.

From the mid-1990s, Chinese manufactured exports have surpassed

ASEAN-4 exports. From 1992 to 1999, manufactured exports

from China to the world market expanded 2.6 times, compared to 2.2 times

for the ASEAN-5, 1.8 times for Korea and 1.16 times for Japan.

FDI inflows into China also expanded rapidly. Moreover, the development

process and the comparative advantage structure in China have also

resembled those of most ASEAN countries, typically Thailand.

What are the implications of this Chinese emergence for ASEAN? We have seen that, in

the 1990s, ASEAN also expanded manufactured exports to most major markets even if

the performance was not comparable to that of China. The same trend was seen for FDI

inflows. Moreover, the expansion of manufactured exports from ASEAN to China was

also noteworthy, even though that should be discounted by the low levels of the

base year. In this respect, the development of China and ASEAN is not a

zero-sum game. Nevertheless, since China is not only a giant but also a giant in a rapid

development process, it may generate a disturbance in the Asian economy.

There are two policy implications here. One is for the development of

ASEAN and the other is for the wider region including ASEAN plus 3.

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Regarding the implication for ASEAN countries, which have almost the same

development stage and factor endowments as China, it is necessary for

the former to speed up the upgrading of its industrial structure to promote a

new division of labor with the latter. Some analysts have attributed the

cause of the financial crisis in Thailand in July 1997 to the slow response of

the country to handle the sudden impact of China devaluing the Renminbi by

35% in 1994.

This factor may be one of the causes, since Thailand exports declined markedly after the

mid-1990s, in contrast to the expansion of Chinese exports, and brought about a

difficulty for Thailand's balance of payments. The related issue is the implication of the

Chinese accession into the WTO. The effect of this event is to open the Chinese market

to foreign products.

However, most products would be highly skilled labor and technology-

intensive ones, for which China does not have a comparative advantage. In

the meantime, those countries which have a higher development stage

compared to China like Japan, Korea and the US, will be major benefactors of

increasing imports into China. The manufactured export value for ASEAN

in the Chinese market is still small. There will be much room for

ASEAN countries to reap the opportunity generated by China, if their

industrial structure is quickly upgraded. One of the obstacles for further

upgrading the industrial structure is the shortage of supply of highly skilled

labor such as engineers, technicians, and management administrators.

Cooperation from Japan, Korea and other advanced countries is essential.

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Thus, in this respect as well, the interdependence between members of AFTA

and non-partner countries in East Asia continues to be significant for the

development of ASEAN.

Regarding the implication for the East Asian region as a whole, a cooperation scheme

for region-wide industrial adjustment seems necessary with the rapid growth of China as

a "world factory", excessive investment and production in the region may happen, and in

fact, such a phenomenon has been seen. Activities of a region-wide cooperation scheme

may include the exchange of information on the industrial development of each country,

collective support for smoothing industrial adjustments (transfer of resources

from comparatively disadvantaged industries to growing sectors), providing a

social safety net in each country, and so on. Recently, the idea of

cooperation on the basis of the ASEAN+3 has been increasingly put forth,

particularly in the field of monetary and financial stability in the region.

This idea should be expanded to cover the area of industrial development and

adjustment. In the meantime, the free trade area of ASEAN +1 has been put

forth, such as ASEAN+China proposed by Chinese Prime Minister Zhu Ronji

in November 2001, Japan-ASEAN comprehensive economic partnership

proposed by Japanese Prime Minister Junichiro Koizumi in April 2002. If

Korea also takes this approach, such ASEAN+1 will be developed into

ASEAN+3 systems which provide an institutional factor for maintaining the

dynamism of ASEAN.

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7.0 CONCLUSION

While AFTA is contributing to the increasing confidence and

stability of ASEAN countries, its effects on the development of these

countries are not as important as the interdependence and dynamic division of

labor between ASEAN and other economies in East Asia such as Japan,

Korea and China. A stronger cooperation of ASEAN+3 is therefore highly

desirable. For assessing the trade effects of AFTA, it is necessary to observe the

changes in the trends of trade of homogeneous commodity categories. The methodology

of analysis on the dynamic effects of AFTA must also be developed and applied to the

case of AFTA. Further studies on AFTA should center on these points.

In this respect, it is worth noting that despite much talk of AFTA, the members of the

Association of South East Asian Nations (ASEAN) have undertaken virtually all

liberalization on a non-discriminatory basis. There is even a formal provision in the

ASEAN AFTA Agreement encouraging the member countries to extend whatever

liberalization they undertake as a part of their AFTA obligation to the rest of the world.

The countries in South Asia will be well advised to take a similar approach to regional

liberalization.

8.0 I CHOOSE AFTA

When the Association of Southeast Asian Nations (ASEAN) was launched in 1967, it

was hard for its founders to predict the establishment of a China-ASEAN free trade area

(AFTA). That was not because of the ideological chasm, dormant economic links, nor

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even the territorial disputes of the time. The time was just not ripe for such an economic

and trade agreement.

Thirty-eight years on, the world has changed a lot. Globalization and free trade have

become irreversible trends. As close neighbours, China and ASEAN cannot afford to

ignore the opportunities to co-operate and benefit from regional integration. Freer trade

relations will benefit both. It will allow all concerned to realize economies of scale and

improve efficiency.

In the coming days, the two entities will share the first basket of fruit from the free trade

area arrangement; they are scheduled to reduce tariffs on industrial goods from July 20,

which is part of a bilateral agreement on commodity trade reached in November last

year. The agreement has led to gradually reduced tariffs for more than 7,000 industrial

commodities excluding agricultural products, which are already free of tariffs between

the two sides.

Thanks to a series of substantial moves to push bilateral trade relations in recent years,

China and ASEAN have reached not only tangible trade agreements, but a consensus

that political will and pragmatism count despite historical distrust. In 2002, leaders of the

two sides inked the China-ASEAN Framework Agreement on Comprehensive Economic

Co-operation in Cambodia, an important step in materializing the call of former Chinese

Premier Zhu Rongji to establish a FTA in 2000.

In 2003, they expanded the scope of co-operation into the political area, with their

leaders signing the declaration to develop a relationship of "strategic partnership." China

and ASEAN countries also reached an understanding on security issues, promising in

November 2002 to solve the South China Sea issue in a peaceful manner.

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And to display its real desire to encourage free trade between the two entities, China has

allowed free-tariff agricultural imports from Thailand, Malaysia and the Philippines, the

first batch of ASEAN countries to join the Early Harvest programme started early last

year. The deal is not mutual, but a one-way goodwill gesture from China.

Given the economic, social and cultural differences between China and ASEAN

countries, the free trade area may not proceed without difficulties. Regarding global

trade, the two entities are competitive in some areas.

China is ASEAN's fifth largest trade partner, while the latter is the fourth largest of China.

This displays the importance of bilateral trade, but the fact that they are not each other's

top export markets suggests a competitive implication. Both are wooing consumers,

capital and technology from developed countries. The rivalry, however, will have to give

way to substantial gains in a Sino-ASEAN free trade area.

By 2010, when the free trade area should be completed, it will have a population

of 1.7 billion and a gross domestic product totalling US$2.5 trillion. Overall trade

volume will amount to US$1.2 trillion. Both cannot afford to miss out on this

fantastic opportunity, and ignore it at our peril.

21
QUESTION 2

2.0 POLAR ARRANGEMENTS AND COMPROMISE SYSTEMS

Financial crisis of the kind experienced in Mexico and East Asia repeat speculative

episodes experienced within the European Monetary System and earlier under the

Bretton Woods3 system and still earlier, as in 1931, when pegged exchange rates came

under attack. In view of this assignment, what needs to be said about such crisis is

the question whether Malaysia should prolong or abolished its currency pegging

system? What are the advantages or disadvantages of having such a system?

The story of minor events and rumors triggering major repercussions is old stuff.

Although chain reactions may be morbidly fascinating, the details are less important than

fragility of the institutional arrangements. In explaining why a house of cards collapses, it

is diversionary to stress someone's cough or the rumble of a train. Yet as Jacques Ellul

(1967) observes, the public has an appetite for the latest news, dramatically portrayed;

and this appetite crowds out attention to fundamentals.

What sets the stage for currency crisis is a lame compromise between the two extremes

of full-fledged monetary unification and freely floating exchange rates between

independent currencies. Each of these polar arrangements has advantages and

3
The Bretton Woods system sought to secure the advantages of the gold standard without its disadvantages. Thus, a
compromise was sought between the polar alternatives of either freely floating or irrevocably fixed rates—an arrangement
that might gain the advantages of both without suffering the disadvantages of either while retaining the right to revise
currency values on occasion as circumstances warranted. The rules of Bretton Woods, set forth in the articles of
agreement of the IMF and the International Bank for Reconstruction and Development, provided for a system of fixed
exchange rates. The rules further sought to encourage an open system by committing members to the convertibility of
their respective currencies into other currencies and to free trade. What emerged was the "pegged rate" currency regime.
Members were required to establish a parity of their national currencies in terms of gold (a "peg") and to maintain
exchange rates within 1 percent, plus or minus, of parity (a "band") by intervening in their foreign exchange markets (that
is, buying or selling foreign money).

22
disadvantages discussed in the abundant literature on optimum currency areas. Merely

having disadvantages does not condemn a system. The central lesson of economics is

that having more of one good thing costs having less of others and those choices must

be made in view of these costs.

Despite its particular disadvantages, each polar arrangement has certain logic of its own.

We do not experience speculative capital flights across the boundaries of the individual

United States. Within the country, no question arises of converting one currency into

another or of whether today's parity will still prevail tomorrow. Nor do exchange-rate

crisis plague freely floating currencies. None occurs as defined in the dictionary: a

relatively sudden turning point at which a disease, for example, changes sharply for

worse or better.

True enough; a floating currency may suffer chronic ill health, even decades-long

depreciation in purchasing power and foreign-exchange value. But this condition is not a

crisis. The required remedy, an internal one, may sometimes be politically difficult to

apply; but it is fairly well understood, thanks to the quantity theory of money.

Of course, not all the requisites for economic health are financial ones. “Real” factors are

vital to growth in productivity and output. These include institutions, morality, and the

ethos of society. Government favoritism, pressures, and corruption reportedly enter into

the East Asian story, including implicit guarantees and other no market influences

operating on banks and other lenders and borrowers.

Here we must focus on the incoherence of trying to keep exchange rates fixed between

distinct currencies, each of which is separately managed by its home country's monetary

authority. This attempt to have the best of both polar worlds defined the Bretton Woods

23
system. In some respects it combines the worst of both. It is vulnerable to one-way-

option speculation. When a change in a fixed rate seems likely or possible, speculators

face an almost heads-I-win-tails-I-break-even bet, winning if the expected change occurs

and losing only a little if it is somehow avoided. Hence the massive speculation

sometimes experienced and the massive official intervention undertaken to defend the

fixed rate. These observations are old stuff, of course. The remarkable thing is how often

policymakers fail to heed them.

Nowadays, as an alternative to the Bretton Woods compromise, currency boards are

recommended (Walters & Hanke, 1992). A currency board operates near the currency-

unification pole: the board fixes the exchange rate of the domestic currency, supposedly

forever, against one foreign currency or a basket of several and makes that rate

defensible by holding foreign-currency reserves worth at least 100 percent of domestic

money (narrowly defined, as specified below). The currency board can never run out of

reserves with which to defend the rate. Besides having the advantages of currency

unification (almost), the system keeps most of the seigniorage 4 from money issue for the

home country, since its board holds its foreign reserves in readily marketable interest-

bearing securities. (If, in contrast, foreign currency actually circulated in the country, its

foreign issuer would reap the seigniorage.)

4
Seigniorage, also spelled seignorage, is the net revenue derived from the issuing of currency. It arises from the
difference between the face value of a coin or bank note and the cost of producing and distributing it. Seigniorage is an
important source of revenue for some national governments. Seigniorage can also refer to a form of tax levied on the
holders of a currency, and as such a redistribution of resources to the issuer. The expansion of the monetary base usually
causes inflation in the long run. The redistribution of wealth to the issuer of currency (government) from the holders of
currency occurs when inflation decreases the real value of money held.

24
The domestic money supply responds to the balance of payments, and the “automatic”

balance-of-payments adjustment mechanism characteristic of currency unification (and

theoretically characteristic of a full-fledged gold standard) operates.

The typical currency board holds foreign reserves worth 100 percent or more not of the

entire domestic money supply, including private bank deposits, but only of paper money

and any other base or high-powered money issued by or essentially on behalf of itself.

These money issues of its own are the only kind that the board is required to redeem in

foreign exchange. Unlike pegging of the Bretton Woods type, this type is secure, or it

can be if the board disregards the situation of other domestic financial institutions. The

commercial banks are responsible for conducting their affairs prudently enough to keep

their own deposits (and banknotes, if any) redeemable in base money.

What happens, however, if the banks have been imprudent or have innocently suffered

some misfortune? The currency board might be tempted to rescue them by lending to

them or otherwise providing them with additional domestic base money. Creating it, the

board shrinks the percentage of foreign reserves against its own liabilities. The domestic

currency becomes potentially exposed, after all, to one-way-option bets on its

devaluation.

This possibility surfaced in Argentina early in 1995, as I understand the story, in the

wake of the Mexican crisis. Previously, the Convertibility Law of March 1991 had

established the peso at parity with the U.S. dollar and had drastically cut inflation. This

reform, along with restructuring of the private sector, had helped bolster investors'

confidence and attract capital inflows. These, along with a “real” appreciation of the

peso, had contributed to a current-account deficit.

25
When the crisis struck, reversal of the capital flows reduced the foreign exchange

reserves from over $14 billion at the end of 1994 to under $9 billion in March 1995 and

domestic currency bank deposits fell by about one-fifth. A substantial easing of reserve

requirements helped the banks cope with the sudden withdrawal of deposits. The impact

of reserve losses on the money supply was further cushioned by an expansion of dollar-

denominated government paper as backing for the monetary base. Finally, the reserves

were rebuilt by substantial borrowing, with foreign official creditors providing over $3-1/2

billion in 1995 and public sector issuance of international bonds amounting to $5 billion

[Bank for International Settlements, 1996].

Thus the worry that the authorities would rescue the banks by loosening the constraints

of the currency-board system was partially borne out. But only partially. The peso's parity

with the dollar endured. Argentina tolerated an episode of sharply increased real

interest rates, tight credit, and deep recession. These conditions helped improve the

foreign-trade balance. Confidence returned and business recovered, industrial

production recovering in 1996. As things worked out, the Argentine authorities resisted

the temptation to rescue the banks by actually abandoning the currency-board system.

In the summer of 1997 rumors occasionally circulated that even Hong Kong might

abandon or modify its currency-board system and allow its dollar to depreciate. Yet

reserves seemed ample, especially since they might be supplemented in case of

necessity by the foreign-exchange reserves of China.

Still another supposed compromise between the polar extremes of independent floating

currencies and monetary unification is managed floating of independent currencies:

official intervention will not resist exchange-rate changes required by fundamentals but

will smooth out fluctuations due to random short-term mismatching of supply and

26
demand and to destabilizing speculation. This verbally attractive prospectus is an old

combination of nice-sounding words rather than a concrete combination of coherent

institutions and policies. And this interventionist solution is bedeviled by “big-player”

effects, explained below. The old proposals for letting exchange rates float, but only

within bands or target zones, deserve the same description: they are hardly more than

superficially attractive combinations of words.

Compromise systems exhibit a frequent problem of interventionism: some interventions

cause disruptions appearing to necessitate further interventions. Something similar can

be true when interventions are undone: mere partial liberalization may leave controls in

effect whose perverse consequences appear to argue for halting or even reversing the

liberalization. Perhaps other and sounder compromises between the two polar

exchange-rate systems are available than those I have mentioned, but I do not know of

any.

2.1 CAPITAL MOVEMENTS

All crisis of one-way-option speculation involve capital movements, of course.

Speculative outflows of recent years, perhaps especially those from Mexico, Argentina,

and Thailand, had been preceded by not particularly speculative capital inflows. These

had been more or less predicated on the perception that the destination country had

made itself attractive to investors by reforming its earlier bad ways.

Under a fixed exchange rate, even one maintained by a currency board, an overall

balance-of-payments surplus due to capital inflows tends to expand the country's

monetary base and broader money supplies and to feed a boom or even inflation.

Sterilization against these monetary effects is scarcely feasible on a large scale and for

27
a long time. Even though thus imported from abroad, monetary expansion is painful to

reverse. This ratchet effect is one characteristic of the Bretton Woods system.

Capital movements among parts of a unified monetary area are rather different. They do

not cause creation of base money in the place of destination. Base and broader money

acquired there has flowed out of the capital-exporting parts of the unified area, with its

total money supply unchanged (perhaps with minor qualifications about different reserve

ratios of different banks). No big player--the central bank--has to decide whether to allow

capital flows to expand and contract local money supplies or to try to resist these

responses by sterilization; and no big player provides a focus for speculators'

conjectures about its actions (as further explained below).

Capital movements among countries with independently floating currencies tend to be

restrained by exchange-rate uncertainty itself and by movements of the rate that

discourage further investment. Appreciation of the currency of a country of destination

makes its investment securities and properties more expensive for foreign investors than

before (but a qualification must be made if rises and falls of prices of investments

translated into foreign currency perversely attract and reverse capital inflows).

Furthermore, volatile exchange rates responding to capital flows affect all sorts of

transactions and not just the capital movements themselves. Floating exchange rates

do, well, float, to the disadvantage of some economic sectors on each occasion.

Again, no particular system has all advantages and no disadvantages. Exchange-rate

pegging replaces rate movements with rises and falls of domestic money supplies and

with uncertainty about whether the pegging will be maintained after all. Monetary

unification sacrifices a kind of quasi-flexibility in regional prices and wages, as well as

the possibility of monetary policy attuned to local conditions.

28
We must distinguish among kinds of claims, securities, and properties acquired by

investors who undertake international capital movements. Inflows into bank accounts

and currency that do not bear interest are presumably slight for that very reason, but

they are the most subject to quick reversal. Flows into portfolio securities are also

awkwardly reversible. Movements of flexible security prices should ideally share the

restraining effect of exchange-rate fluctuations, and more appropriately, since these are

the prices of the specific targets of the capital movements. Again, though, a qualification

is necessary about possible bandwagon speculation.

Foreign direct investment is perhaps a lesser problem because direct investments,

unlike portfolio securities, cannot be quickly dumped in preparation for capital flight. Still

potentially troublesome, though, is the intermediate step of buying the medium of

exchange of the destination country. Even though aimed at direct investment projects,

capital inflows still tend to expand the money supply of the destination country under

exchange-rate pegging or to appreciate a floating exchange rate.

We must not forget about capital moving at the initiative not of foreign investors but of

borrowers in the target country, such as banks incurring debt in foreign currencies and

reassured by the fixity of the exchange rate.

2.2 BIG PLAYERS

Big players have already been mentioned. In our context, these are predominantly

governments, central banks, and international organizations. Expectations of other

transactors focus largely on them. (Witness reactions to denunciations of currency

speculation by the Prime Minister of Malaysia in September 1997.) A big player is

defined as anyone who habitually exercises discretionary power to influence the market

29
while himself remaining largely immune from the discipline of profit and loss (Koppl &

Yeager 1996, Butos & Koppl 1993).

Exchange-rate pegging or intervention is the work of big players. So are changes in the

economic policy regime, such as restoration of relative monetary stability and confidence

after years of inflation. Big players can be the focus of rent-seeking. The International

Monetary Fund is a big player in its decisions whether or not to help support a pegged

currency under attack or otherwise to provide loans. Intentionally or not, the IMF has

occasionally played the role of Vetter of a borrower's creditworthiness, with its extension

of credit giving encouragement to private lenders. Regarding capital inflows into low-

credit-rated countries, The Economist (1997a: 54) wrote: “One reason for investors

sanguine reactions seems to be the feeling that countries are simply not allowed to

default any more: the IMF, together with rich countries, will always come to the rescue''

(see also The Economist 1997b: 70).

Some such ideas find support from a surprising source. Treasury Secretary Robert

Rubin observes that financial rescue packages have protected investors who lent money

to the government or financial institutions of countries like Mexico and Thailand, leaving

the residents of those countries to bear the heaviest costs of unsound policies. If

investors ran a greater risk of losing money, they would act more prudently, forcing

governments to change course sooner. Rubin deplored “a situation where people can do

unwise things and not pay a price for it” (reported in Wessel 1997).

Ian V squez (1997) and Allan Meltzer (1995) inclined to concur in points about activities

of the IMF (and similarly of the World Bank). These tend to support government

domination of economies, despite ``conditionality'' purporting to do otherwise; and

politicization of economies increases the scope for rent-seeking. Thrusting debt onto

30
poor countries, putting them onto a debt treadmill, ill serves economic development.

Funds for bailouts create moral hazard, tending to delay reforming crisis-prone policies

(see The Economist 1997b). New issues of SDRs, which the IMF staff likes to propose,

accomplish international transfers of wealth in a way that most legislators do not even

understand. Self-important international bureaucracies have institutional incentives to

invent new functions for them, to expand, and to keep client countries dependent on

their aid.

2.3 CURRENCY CRISIS AND MONETARIST THEORY

The Asian currency disorders of 1997-98 are not the same as episodes of unsustainable

boom or of recession or depression within a country. Different disorders require different

strands of explanation. Still, these strands reconcile well with one another. “Monetary-

disequilibria” or “monetarist” theory, put briefly, attributes inflationary boom or business

recession to a quantity of money in a country that exceeds or falls short, respectively, of

the quantity that the public desires to hold at the hitherto prevailing general price and

wage level. Monetarist theory stresses the great and varied contributions that money

makes to an economy of fine-grained division of labor and the attendant scope that

monetary disorder has for doing damage. It stresses not only money's medium-of-

exchange function and the damage done by excess or deficiency of that medium. It also

stresses money's function as unit of account and unit in which debts are expressed.

Monetarist theory describes the inevitable complications and delays that bedevil

adjustment of the size of the unit (e.g., the purchasing power of the dollar, peso, or

whatever) when money's supply and demand have become imbalanced at the unit's old

size.

31
In particular, the theory describes a catch-22 aspect of a fall in the price level that might

otherwise remedy an excess demand for holdings of money. Existing debt becomes

more burdensome in real terms. Larger real claims hardly benefit creditors if their

debtors go bankrupt. The difficulties of indebted firms are likely to impair the productive

activities of others as well, notably of supplier firms. Irving Fisher invoked this ``debt-

deflation'' theory in explaining the severity of depression in the 1930s; actually, he had

been anticipated by Pehr N. Christiernin, an 18th-century Swedish economist.

The recent Asian crisis exhibit analogous troubles of banks and industrial firms that had

borrowed heavily in foreign currencies. Depreciation of the local currencies on the

foreign-exchange market means an increased burden of external debt. The demand for

foreign exchange to service this debt is relatively inelastic, contributing to a possible

situation in which depreciation brings on further depreciation in a vicious circle. Debtors,

creditors, and their trading partners all suffer. Calls arise for debt moratoria and

international rescue operations.

The international context is complicated by involvement of two or more currencies.

Change in an insecurely pegged exchange rate, and even the mere prospect of change,

impairs money's unit-of-account function. So does jumpiness of a floating rate

associated with actual or feared inflation of money and prices within a country. All and

all, international currency crisis further illustrate, by contrast, why stable money is vital to

economic coordination, calculation, and business planning.

2.4 TO PEG OR NOT TO PEG: MY VIEW

Let’s stop arguing whether it was the right call to peg the ringgit in the first place. Stop

comparing the performances of he economies of countries similarly affected by the

32
Asian Meltdown 97; South Korea, Thailand, Indonesia and Hong Kong.

Keep in mind that in the long run prices and income adjust to equilibrium. Everyone

wants to avoid unnecessary short term painful adjustment. The macroeconomic

fundamentals are and have been robust, and continue at the same rate for the

foreseeable future, barring any mishap. Current account surplus at record levels 6 years

in arrow.

In a free floating exchange rate, current account will be balanced on average, any

surplus or deficit in current account will result in depreciation or appreciation of

exchange rate, ceteris paribus. Prices and income remains the same; in local currency.

By fixing the exchange rate to an arbitrary value, in this case the USD, at a rate that is

either above or below equilibrium, we run the risk of undergoing short term adjustment.

Finding an equilibrium level of exchange rate is like shooting at a moving target,

however bright is the light and your perfect 20/20 eyesight, you still miss them

sometimes.

Remember Hong Kong 97? Prices fall, businesses incurring losses, unemployment

rises (because of sticky prices and wages) and total income falls. That’s adjustment for

fixing exchange rate above equilibrium. Prices and income moves back to equilibrium

levels. Never mind what is the exchange rate to the USD, because USA has its own

macroeconomic fundamentals too.

By fixing below equilibrium, government will get asset price inflation, bottleneck in

production and runaway demand. Look at China now. In both instances, the weakest

and most vulnerable members of society bear the brunt and suffer, and they are the

ones who can’t speak out and do much about their lot. Losing jobs in the economic

slowdown and cannot keep up with rising prices in a runaway inflation. It is without doubt

33
that current growth rates and current account surpluses afford the government the

increase wealth and income, lower interest rates (fiscal and monetary expansion).

Lets be honest, there have been a lot of benefits that we enjoyed from good economic

times – new housing are more affordable and available, more needed infrastructure

projects are coming on stream; water, electricity (with some glitches) and road.

One thing the current team has been successful to hide so far – support of the inefficient

firms (pointless for me to elaborate here, the government know the firms better than I do)

and farming of government jobs and contracts as a reward for support and patronage at

highly margins.

Meaning cronyism; support your friends in thick and thin, enrich them – enrich yourself.

Let the masses suffer, a couple rounds of vote buying will return ‘their’ team to

Putrajaya. If government must keep the peg, please remember the poor, it is time to take

care of the poor, the sick and those who are unable to provide for themselves food,

clothing and shelter. A universal welfare system and fairer more equitable wealth

distribution in the society – the Islam Hadhari as the government call it (please not just

slogan, but the spirit and the practice as well) – will return ‘their’ team into Putrajaya in

the next election.

We loath those people who profits from our predicaments; the currency speculators.

After all, the reason that we pegged the ringgit in the first place was to frustrate the

currency speculators and give the ringgit its fair value. We don’t want to give away the

profits of our hard work of the past 7 years, the savings and reserves that we salted

away to the currency speculators by unpegging and appreciating the ringgit. The

currency speculators made at least a hundred billion ringgit bet (the difference between

our total current account surplus for the past 7 years or so and our total foreign reserves)

34
that the ringgit will be unpegged one day and they stand to make a windfall.

How come, one might ask?

For every dollar, euro or yen of foreign currency that flows in, whether as foreign direct

investment, export earnings or mere speculative hot money to park in a local bank to

earn interest, Bank Negara has to print ringgit to an equivalent amount and lock away

that foreign currency in a vault as reserve – because one day the foreigner will

eventually want to sell back his/her ringgit for dollar, euro or yen.

This is the problem with pegged currency, theoretically, for every ringgit in circulation

there must be an equivalent amount of reserve. Sounds like my late grandmother salting

away her money under the pillow – even though it is safe and secure, it doesn’t earn

interest or income, no benefit to anyone and worse has a contracting effect on the rest of

the world economy. In reality, most central banks would put their reserves in gold, and

other currencies – usually USD and euros. While reserves in USD and euros may earn

interest if they are in deposit form (T-Bills and bonds), gold reserve doesn’t earn interest.

My suggestion is: instead of hoarding away the reserves against imagined future attack

by currency speculators, we should invest the money for future productivity and well

being of our citizens, meaning fiscal expansion. Fiscal expansion increase income,

hence increase our future tax base. Mankiw explained it better that in small open

economy with fixed exchange rate like ours, only fiscal expansion would be effective to

increase income. We could invest in infrastructure, housing, education and skill upgrade

for our people, not to mention the necessary spending on welfare for our less fortunate

citizens and retirees. While fiscal expansion might eat away our reserves and reduce

current account surplus (through increase import), it has much greater benefits to our

citizens than ‘the security of knowing bountiful reserves’. The fiscal expansion will

channel the benefits of reserves to our citizens.

35
Of course, if we suddenly unpeg tomorrow, the ringgit will almost certainly appreciate

because of continued current account surplus, this will transfer benefits of reserves to

those who hold ringgit – including speculators. For our citizens, the benefits tend to be

minimal in the short term, asset prices tend to be sticky and stay high, and some of us

might even lose jobs through export industries relocating to lower cost countries.

When and how to unpeg? Set a target date well in advance – say 6 month to one year

from date of announcement. Let everyone get ready and prepared. In the meantime

continue the program of fiscal expansion. Use the fiscal measure to achieve internal

targets; unemployment, income, higher savings rate that match investment rate and

better living condition. Knowing that the ringgit will appreciate upon free float will dampen

inflationary expectations – provided there is no barrier to import.

Meet any speculative large inflow of capital by printing more ringgit; monetary

expansion. This will lower interest rate and increase investment. More benefit to our

citizens.

Aim for the ringgit reaching equilibrium exchange rate upon free float.

What if the ringgit depreciates upon free float? This will make us even more competitive

in the world market, and Bank Negara could always mop up excess liquidity using open

market operation.

2.5 CONCLUSION

The key to avoiding crisis is not international gimmickry. Instead of fiddling with

exchange-rate arrangements, policymakers should pay attention to the currencies

themselves. So far, absurdly, these remain undefined in value; and their values depend

precariously on the changeable policies of central banks, which are constantly badgered

with short-run-oriented advice from home and abroad.

36
In recent years critics have castigated the Federal Reserve for continuing to fight an

inflation that, they say, does not exist. They seem not to realize that the several

consequences of monetary policy stretch out over many years, and with lags of different

lengths. The Federal Reserve must attend to whatever early signs it can detect of

inflationary pressures that would show up unambiguously in prices only several or many

months later. The (near) absence of inflation that critics so often cite is due precisely to

the policy that they do not bother to understand. A major defect of the existing system is

its depending so heavily on the ability of the Federal Reserve chairman to resist the

badgering of ignorant critics.

Fundamental reform would avoid such dependence. It would avoid sudden unpredictable

changes in policy regimes and in official transactions; it would hold down the scope of

large centralized decisions, whose effects are harder to cope with than the gradually

occurring cumulative effects of innumerable decentralized private decisions; it would

reduce the role of official big players on whose dominant decisions the changeable

expectations of the public focus. It would provide money of stable or at least of

predictable purchasing power.

Although it is not my task here, I am tempted to describe how to achieve these results by

getting money issue out of the hands of governments. Each competing issuer of notes

and deposits would take pains to remain able to honor its own commitments. Each, in

accepting deposits and issuing currency, would have reason to take account of the

possible reversal of inflows of funds; it would pay due attention not only to its own asset

portfolio but also to the terms on which it incurred monetary liabilities. It would be a

shame to foreclose such fundamental reform by embracing pseudo-internationalism in

the realm of exchange rates and money.

37