Japan-Korea FTA as a New Initiative in East Asia: Beyond Bitterness

Yukiko FUKAGAWA (Associate Professor, Aoyama Gakuin University)

Korean initiative: a victory of "big-pull" policy

If you want to win in a Sumo or Judo match, you have to learn how to "pull" on the best timing, instead of just pushing ahead. President Kim Dae Jung was the first Korean president who understood this theory when negotiating with Japanese. His visit to Japan in October 1998 made historical success in improving bilateral relations by two means: First, he took a low profile and did not argue historical issues. He simply proposed that the problems of the 20th century should be resolved within the century. Second, he committed to abolish traditional restrictions on cultural exchange with Japan, despite the heated debates in Korea. Conservatives attacked him for making too many concessions with Japan, but as far as these two years are concerned, his pragmatism seems to have won: Japan started to regard Korea as the real partner in the region. Japan's acceptance has been symbolized by recent booming tourism to Korea, rising human exchange, and increased numbers of ministry meetings. Some long-term issues including compensation for Korean military workers during the War have started to see solutions, supported by political initiatives. Japanese opinion leaders have shown unusual respect for Korea's economic recovery with 10.7% GDP growth in 1999, comparing it with the sluggish performance at home. Not only economic performance, but also frenzied activism in political and other reforms has impressed Japanese with the dynamism in Korean society, and the positive attitude has balanced and mitigated the expected criticism from conservatives in Korea. Finally, Japan and Korea have committed to the "Action Plan for the New Korea-Japan Partnership for the 21st Century", which has sought to increase comprehensive cooperation through to joint hosting of the World Cup in 2002.

· Joint Study on FTA
In economic reforms, Korea has made strong commitment to rapid market opening and deregulation, believing that only an "invisible hand" should revive the Korean economy in globalization. Korea abolished special import restrictions against Japan, and actively started to promote negotiation for BIT (Bilateral Investment Treaty) to attract more FDI from the U.S., Japan, European countries, Taiwan and other economies, while initiating a free trade agreement (FTA) experiment with Chile. Korea has shown interest in FTA and other closer relations with Mexico, New Zealand, Singapore, Thailand etc., to proceed gradually into free trade with matured economies. On the other hand, Japan and Korea have been loyal to the non-discriminatory principle of the GATT-WTO regime traditionally, but have started to be sympathetic to FTA ideas as the bridge to realize global-scale liberalization. Technocrats in both countries had a threatened feeling in international negotiations that among the world's 100th largest economies, now only five economies in North East Asia--Japan, Korea, China, Taiwan, and Hong Kong--are left without any regional cooperation frameworks.

When then-prime Minister Obuchi made a visit in Seoul in March 1999, Japan and Korea finally agreed to strengthen economic relations comprehensively and to conduct a joint study on the feasibility of FTA. The study was completed and made public in May 2000. Traditionally, Japan had been sharply criticized by Koreans for its ever-growing trade surplus, and indeed, many expected that the conventional argument might be repeated in Korean report that Japan should do something to improve the imbalance. Unfortunately, when the report was announced, Korea's trade deficit had already started to increase again, along with rapid recovery in consumption and facility investments. However, despite the fear especially from political groups, when the symposium was held on the topic in Seoul, general discussions have been straight but constructive and practical, to the surprise of many Japanese. What has changed?

· The expected results in Japan-Korea FTA
In fact, the basic results of the joint study were nothing very unusual. Although Japan and Korea are major players in world trade, according to the CGE estimate of the Institute of Developing Economies (IDE), the effect of FTA will increase world trade only by $5.82 billion (0.10%, see Table). The effects will be greater for bilateral trade through the abolition of tariff and non-tariff measures, reduction in prices in the domestic market in sectors with clear comparative advantage, and boosting trade. Trade diversion effects are expected to reduce imports from third countries, to which tariffs are still imposed. However, the level is minor, for example only -0.27% of import reduction in Japan's trade with the United States. In bilateral trade, since Korean import tariff is about 7.9% on average against Japan, but Japan' tariff is 2.9%, increase in Japanese exports to Korea (16.30%) would surpass the increase of Korean export (8.30%) to increase trade surplus by 34.4%. Korea's exports will increase mostly in apparel, leather products, and agriculture/fishery products, and Japanese exports will gain in sophisticated machinery, metal, and chemical products. However, Korea's total export will increase by 2.80%, faster than Japan's total export, improving over-all trade balance. Based on their CGE model in different settings, the Korean team estimated that Korean exports to Japan will increase by $4.02 billion, but the trade balance against Japan will deteriorate by $6.09 billion. Therefore, the real GDP will be reduced by 0.07% as the result of FTA, if the effects are only computed statically.

However, beyond stereotype arguments on the trade imbalance, both teams focused on two aspects: service trade, and the dynamic effects through division of labor and industrial cooperation. Service sector including travel, transport, construction, telecommunications, and finance usually have either no or very low tariffs and non-tariff barriers, and could not be calculated in the static analysis above. In service sectors, the enhanced integration of the market is expected to intensify competition between Japan and Korea, taking into account the fact that the similarities in cultural and social structures in both countries would contribute to market integration. The competitive environment would not only stimulate domestic firms but must also attract foreign direct investment from third countries.

The dynamic effects are expected to be the most important focus here. To truly integrate the markets both countries need a taxation treaty, agreements on investment, mutual recognition of standards and certification, intellectual property rights, and standardization of customs and clearance procedures and other trade facilitating measures. Promotion of foreign direct investment and efficiency improvement is positioned as the core effects. Though stereotype arguments have stressed the competitive industrial structures such as shipbuilding, steel, petrochemicals, semiconductors, electronic appliances, telecom equipment, automobiles and many others, in reality there has been a certain degree of intra-industrial trade already. The FTA framework is expected to produce a more competitive environment for these industries, paving the way either to strategic alliances for more horizontal division of labor, or restructuring of the over-capacities based on market mechanisms. Industrial cooperation is stressed to enhance efficient technology transfer, joint R&D activities, and improvement of supporting and related service industries.

Shared dynamic gains

Specifically, there are several dynamic gains expected: First, a competitive environment will accelerate the restructuring efforts. Without FTA, while Korea started restructuring since 1998, specific decisions have started to be made in Japan since 1999-2000. In some industries, like oil refinery, petrochemicals, shipbuilding and automobiles, both have over-capacity problems, and one of the gains will be rationalization of redundant capacities. Generally, Japan has older plants in these industries and the case of capacity reduction has been faster than in Korea with much merging of new facilities.

A second gain of industrial cooperation is to evolve from the restructuring process. Unlike big international mergers across borders in Europe and North America, the over capacity problem has been hanging around between Japan and Korea as the result of endless competition without cross-boarder cooperation. In Japan, distrust against Korean firms has been dominant, claiming that disorderly investment has cancelled out Japanese efforts for capacity reduction and created profit-less competition. On the other hand, Koreans also tried to catch up by being solely dependent on economies of scale, instead of technology development. As a result, when challenged by Koreans, Japanese have tended to cooperate with third parties such as Taiwan in LCD and home electronic appliances in Thailand or Malaysia, creating another round of over-capacity problems in the region. Recently, in some industries such as steel, several cases of cooperation are being found with Korean firms in the form of cross shareholding or Japanese investment. FTA is believed to accelerate clearer division of labor with Korea, while setting Korea free from the pressure that they might be kicked out from the market unless they are big enough to compete.

Third, once industrial cooperation advances into technology cooperation through mutual recognition of standards and certification, efficiency of both countries will be improved based on a common base. One of the problems of Korean over-capacity was that since they were exposed to unexpected innovation in major technology, they have often tried to increase the capacity for their presence and early depreciation backed by policy supports in the past. However, in some high-tech industries in dog years like hand-phones or DVD players, investment timing is crucially important as well as who controlled the standards. Since Japan and Korea have a high share in leading industries such as 80% of shipbuilding, 40% of steel, 70% of home electronics and 40% of DRAM semiconductors, cooperation for technology standards and other certification is believed to increase their influence.

· The gains for Korea
In addition to shared gains, there will be several different gains for each. First, as far as static estimation goes, the major concerns for the Korean side on trade deficit will be inevitable. However, Korea will enjoy a surplus in service trade, and if the dynamic effects continue its overall trade balance is expected to improve. The Korean side argued that if $3 billion FDI to Korea as the result of Japan-Korea FTA is assumed, total factor productivity in Korea would increases by 0.853% in heavy industries. Assuming 1% growth of productivity annually for 10 years, they computed that dynamic effects of FTA on Korean exports to Japan will increase $0.24 billion, but trade balance would improve from -$1.53 billion in the static case to +$3.01 billion in the dynamic case. As a result, the total effect on over-all trade balance will be still plus $1.48 billion, and in real GDP will be plus 2.81% growth. The positive effect on the total trade-balance of Korea was only to confirm the result of Japanese team. Consistent direct investment from Japan as well as third countries was discussed as the best source for dynamic effects for Korea, and Korean team proposed the establishment of a Korea-Japan Investment Develop Bank.

Second, faced with open competition with Japanese, reckless facility investment will be disciplined. One of the causes of the crisis may be attributed to the negative tradition in Korea against FDI to protect chaebols. Instead of introducing FDI for better management resources, chaebols have tried to borrow capital or introduce portfolio investment, being spoiled by the government to realize "independence" from foreign multi-nationals. However, in terms of technology, chaebols were generously dependent on multi-nationals, and their investment behavior has had to be influenced by the product life cycle and other market factors. Especially, as industrial structure got closer to Japanese multi-nationals, they started to be more vulnerable to yen-dollar exchange rates for their competitiveness. When yen was appreciated, Korea tended to increase investment intensively being optimistic about the future. If a volatile yen had provided risky environments for Korean industries in the past, the strategic division of labor with Japan may stabilize their investment.

Third, advantages for Korea may come from finance, especially by yen. Korean history had witnessed only two challenging times, when investment turned to be difficult to be finances. Otherwise, the economy has enjoyed 8.2% of GDP growth for 35 years with a constantly increasing trade deficit against Japan. Among the two cases, one was after the oil crisis, and the other was the last liquidity crisis. Traditionally, Korean imports from Japan have been dominated by capital and intermediate goods, which were to increase when exports performed well in Korea. As long as this structure was maintained, Korea scarcely had difficulty, because the deficit grows only when the economy goes strong.

However, after the crisis, Korea has substantially opened its capital market as well as foreign exchange control, and a liquidity crisis can happen without relation to trade performance against Japan from now. Based on the experience in the crisis, Japan has recently promoted so-called "yen internalization", trying to make the last lender in East Asia. In the region, Korea has now the most liberalized regime after Hong Kong and Singapore, and if greater presence of service trade is taken into an account as well as relatively large goods trade, Korea could be in a group of first partners for yen transactions. When in crisis Japanese banks were criticized for triggering the liquidity crisis in Korea, but yen transaction will mitigate the risk in times of similar crunch.

Finally, Korea has a political gain when an integration agenda is to be built. After intensive liberalization, the Korean capital market is now directly exposed to political and security risk with North Korea. Even if a regime for peaceful co-habitation is established, the South Korean burden for supporting the North Korean economy will be intolerable. What South Korea can do is to mobilize private capital from interested countries to reduce budgetary supports. If Japan-Korea FTA exists before integration, Japanese commitment towards the Peninsula will inevitably be greater because of market integration. Since the market is the driving force instead of politics in FTA, Korea will be freed from traditional paranoia for superpower intervention, at least from Japan. To boost North Korean recovery, Japan and Korea will provide integrated markets for export industries.

The gains for Japan

Indeed, despite her concern about rising trade deficits, the implied gains on the Korean side will be substantial. However, what would happen to Japan? In fact, the South Korean market, about 10% of Japanese market in size, will not be so keenly attractive for Japanese multi-nationals, nothing to compare with Chinese market potentials, for example. However, if Japan opts to increase the efforts for the efficient use of her stock--financial stock, technological stock, and other know-how stock-- as an investor, instead of hectically competing with East Asian countries in cost reduction, Korea would probably be one of the best partner for the transition, with the best institutional arrangements of FTA, consistent with the WTO regime and based on the common OECD framework.

Without productive investment of assets and proper international division of labor, how Japan with such a rapidly aging population without foreign labor will be able to compete with East Asian countries? If Japan stops sticking to the skill-intensive manufacturing intensively while focusing on her return on assets as a matured economy, Japan will be able to gain fully from further dynamic growth of East Asian countries. Even if Korea maintains a trade deficit, Korean real sector could be given stable environment if it can be financed smoothly by capital from Japan, while Japan can enjoy high-return investment. To enhance further strategic relations, making an international division of labor structure instead of a self-fulfilling structure is crucial not only for Korea without large domestic market but also for Japan: Strategic transformation from a pure hardware manufacturer into a balanced manufacturer/investor seems to be important. Industrial adjustment with Korea would be the first opportunity for Japan to shift into this new economy.

A second gain for Japan is more pressure from Korea to shift into high value-added and high performing businesses. Japan's competitive edge has to be changed drastically from highly-trained, skilled labor into knowledge-creating human capital, for a young labor supply will be extremely tight in the very near future. The situation will be the same in Korea, but in fact, similar timing comes at least two decades later demographically, which means a spurt will be possible for Korean competitors in existing industries. To achieve some soft-landing in over-capacity issues, it is necessary to stop intensive competition in hardware without profit with Korea, and instead, to shift more focus on new business opportunities. More importantly, in terms of human capital, Korea can be a prominent human capital resource also, as was already proved by rising entrepreneurs from Korean-Japanese in IT and other venture business. Japan needs more hybrid human capital from different background and culture to go global in knowledge-based business, and Korea can also be a good partner with probably minimum cost for Japanese society to accept, because of similar but different language and culture, and Korea's location so close to Japan.

Finally, another important gain for Japan would be more pressure for deregulation and speedy actions for the reform. Since the crisis, Korea has committed intensive and substantial deregulation, checked and supported by citizens and consumer movement. Even though the participation is still not sophisticated yet and it has often created conflicts in the society, Korean reform has been sustained by this social energy, which is lacking in Japanese society. With better deregulation, application of IT, and efficient infrastructure building, Korea may be able to supplement the inefficient sectors in Japan in many service trades, including marine transportation and other distribution services in FTA environment. Also, if Korea succeeded in establishing FTA with Chile and other economies, liberalizing agricultural trade, the experience will also pressure Japan for reconsidering the benefits of consumers and economic welfare of free trade.

In the end, what Japan or Korea really gains from FTA idea depends on each effort and capacity to make the best use of the potentials. Changing the industrial structure more for division of labor is the most expected gain. However, beyond this gain for each economy, Japan and ROK FTA probably has two important meanings: First, Japan and ROK have been fully enjoying the business opportunities provided by free trade. By establishing first FTA based on advanced countries' framework in East Asia, two countries will be able to provide a model of free and dynamic trade in the region, including best practice in electronic commerce and others. Second, FTA will inevitably increase the social interface, which has been complicated endlessly by historical bitterness. By successfully establishing FTA, the two countries will kick-off the new stage in East Asian relations in that economic dynamism can make an opportunity to go beyond bitterness.