How will the countries of East Asia modify their exchange rate
policies to prevent inflationary overheating? A variety of solutions
are possible. They could introduce wider exchange rate target bands
in order to let their currencies appreciate modestly when capital
flows are large, or to depreciate if the current account deficit
increases significantly. They could also develop new exchange rate
pegs spread over a basket of currencies, not just the dollar. As a
result of East Asia's rapidly increasing trade and investment links
with Japan, there has been some discussion of replacing dollar pegs
with yen pegs. It is doubtful that any Asian country will link its
exchange rate to the yen during the foreseeable future because of the
extreme fluctuations in the yen's value during the past decade.
Nonetheless, the increasing economic integration between Japan and
East Asia could still make the yen a more important reserve currency,
despite East Asia's traditional preference for the dollar as a policy
anchor.

Such a trend could have major implications for the United States and
for U.S.-Japanese relations, and the trend seems clear enough. In the
case of trade with Southeast Asia, the yen now denominates 52.5
percent of exports and 25.7 percent of imports, compared to 41
percent and 11.5 percent in 1987. The yen-denominated share of
Japan's international bank loans has also expanded from only 10
percent in 1980 to 43 percent in 1990 and 65 percent in 1994. A large
share of these loans are made to Japanese companies, but many
non-Japanese firms now have yen loans as well. The yen's share of
foreign exchange reserve is still only about 7.1 percent on a global
basis, but it is much higher in several East Asian countries with
growing financial links to Japan--30 percent or higher in Indonesia,
Taiwan, Singapore, and the Philippines, and in the 15-25 percent
range in China, Korea, and Malaysia.

In recent months, the Japanese government has announced plans to
liberalize Tokyo financial markets and promote greater use of the yen
as a global currency. This policy was prompted by concern about
Tokyo's stagnation as a financial center during the 1990s, and by the
movement toward the creation of a new European currency in 1999. But
even though the Japanese government is now supporting the emergence
of the yen as a reserve currency, it is difficult to imagine the yen
challenging the dollar's role during the next decade. The Japanese
payments system is much less developed than America's. Japan lacks
large liquid markets for short-term government debt, while its
long-term government bond market is dominated by public sector trust
funds. The Bank of Japan estimates that less than 5 percent of yen
bank notes circulate outside of the country, compared to 60 percent
of America's dollar bank notes and 35 percent of Germany's Deutsche
Mark currency. If America reverts to inflationary monetary policies
that jeopardize confidence in the dollar, the changes now occurring
in Japan's financial policies will increase the potential for the yen
to become a more important global currency. But at present it appears
that the yen's evolution as a reserve currency will be gradual and
incremental, not rapid.

The dollar's entrenched role is not the only barrier to the yen's
emergence as a more important reserve currency. The movement toward
monetary union in Europe could produce a new currency supported by
well developed financial institutions, large domestic government debt
markets, and an existing offshore bond market with a market value of
$500 billion--compared to $680 billion for the U.S. dollar and $260
billion for the yen. If European monetary union actually occurs in
1999, the euro will rank as the world's second most important
currency during the first decade of the twenty-first century, not the
yen.

Microeconomic Challenges

The macroeconomic challenges that will confront Asia during the next
few years should be manageable because of the region's high savings
rate and potential for sustaining investment with domestic resources.
But Asia will also have to address the microeconomic challenges of
how to finance its infrastructure boom and how to encourage efficient
resource allocation within its private sector. As Asian economies
become more mature, they will not be able to sustain high rates of
growth merely through high levels of savings. They will also have to
develop corporate governance systems capable of producing adequate
levels of profitability and of reallocating resources when the return
on assets declines.

As noted earlier, the World Bank estimates that East Asia will need
to spend $1.5 trillion on infrastructure during the next decade.
Private investors will no doubt finance most of that amount. Indeed,
many Asian countries have already privatized their phone companies
and some of their electricity-generating companies, but the share of
infrastructure-related investment in the Asian stock markets varies
greatly by country. Despite China's massive investment needs,
infrastructure companies account for only 3 percent of Hong Kong's
stock market capitalization, while utilities and telecommunications
companies account for 20-30 percent of stock market capitalization in
Indonesia, Singapore, Malaysia, Thailand, and the Philippines.

There have been three major problems with attracting private capital
to infrastructure and utility projects. First, some countries, such
as India, have had conflicts with investors over rates of the return
that should be permitted on investment in electricity generation.
Second, in some countries well-connected political families have
played an influential role in obtaining licenses for services such as
telecommunications or toll roads. The children of President Suharto
in Indonesia, for example, have major interests in toll roads,
telecommunications services, and broadcasting; they have been
indispensable allies in obtaining access to such businesses, but
investors are concerned that such relationships could become a
liability should the family lose power. Third, there is no
well-established history of Asian countries using stock markets to
finance infrastructure, and this is likely to make investors highly
sensitive to the performance of the first companies to go public. The
record of the early telecommunications companies on Asian stock
markets has so far been positive, but in China both toll roads and
electricity-generating companies have produced very mediocre results.
If these problems are not solved, and if the necessary large-scale
infrastructure investment is not forthcoming, Asian growth will be
stymied by supply bottlenecks such as traffic congestion, power
failures, and debilitating levels of air pollution.

The re-allocation of capital within Asia's private sector to adjust
to fluctuating profitability will pose other challenges, too. One of
the most striking features of the corporate sector in some Asian
countries during recent years has been a declining rate of return on
capital. In contrast to their American counterparts, Asian companies
have been emphasizing growth of assets and sales, not profitability.
In some countries, this bias has resulted from government credit
allocation policies (Korea) while in others it has resulted from
ownership structures that emphasize goals other than profitability
(Japan). Short-term business cycle factors explain some of the
divergence in profitability, but if one compares the performance of
corporate sectors during the 1990s as a whole, the U.S. corporate
sector has out-performed those of both Asia and Europe by a large
margin.

The return on capital is an important determinant of long-term
economic success because of its impact on a country's savings rate,
level of investment, and capacity for increasing future output. If a
country's business enterprises experience a long-term decline in
profitability, the national rate of savings and investment will
diminish over time as well. As a result, Asia's future economic
performance will depend heavily upon the ability of its corporate
sector to improve profitability and the strategies chosen to do so.
Will management emphasize share prices and profits by engaging in
American-style restructuring? Will Asian shareholder groups encourage
firms to emphasize profits over the interests of other stakeholders,
such as workers and customers? Will governments concerned about
declining profitability alter the regulatory policies that influence
corporate investment decisions? Will the rise of pension funds create
a new class of investors who attempt to influence corporate
governance through aggressive use of their proxies at company
shareholder meetings?

The answers to these questions will vary greatly by country. Several
Asian countries have large stock markets, but there is no established
tradition of outside shareholders playing an important role in
guiding corporate investment decisions through the threat of takeover
bids or proxy fights. In Japan, corporate shareholdings are dominated
by industrial groups and friendly financial institutions, including
banks and insurance companies. Japan's recession during the 1990s has
been the most intractable of the modern era precisely because the
interaction of the 1980s asset inflation with the cross-shareholding
system encouraged massive over-expansion of the capital stock and a
broad collapse in profitability when the economy sank.

South Korea, which has imitated many aspects of the Japanese model of
development, is suffering from similar problems. It has pursued
competition and credit allocation policies that have encouraged a
small number of large industrial groups to dominate the country's
capital intensive export industries. In 1993, the top thirty
conglomerates produced 43 percent of GDP and 70 percent of exports.
Korea's credit policies have turned the country into an extraordinary
industrial powerhouse--the world's second-largest producer of
consumer electronics, second-largest shipbuilder, third-largest
producer of semi-conductors, fifth-largest producer of autos and
petrochemicals, and the world's sixth-largest producer of iron and
steel. But despite these achievements, the Korean stock market has
been anemic in recent years because corporations have focused on the
growth of assets and market share, not profitability. Korea's system
of "stakeholder capitalism" has performed so poorly during the
mid-1990s that the government recently announced major changes in the
country's labor laws in order to give firms more freedom to reduce
employment. This led to major industrial labor disturbances, but the
Korean government has stuc