American Enterprise Institute

October 23, 2007

[Edited transcript from audio tapes]

8:45 a.m.	Registration
9:00		Panel I: The Road to Rivalry? Security Challenges in Asia
	Panelists:	Brigadier Arun Sahgal, United Service Institution of India
		Lanxin Xiang, Graduate Institute of International Studies
		Masafumi Ishii, Embassy of Japan
	Moderator:	Michael Auslin, AEI
10:30		Panel II: Is Growth Sustainable?  Fault Lines in Asia’s Economic Future
	Panelists:	Richard Katz, Oriental Economist
		Philip I. Levy, AEI
		Beth Anne Wilson, Federal Reserve Board of Governors
	Moderator:	Claude Barfield, AEI
12:00 p.m.	Luncheon
	Keynote Speaker:	The Honorable John D. Negroponte, U.S. Department of State
1:00		Panel III: Transnational Challenges and Regionalist Responses
	Panelists:	Richard Cronin, Henry L. Stimson Center
		Keiichi Hori, Asian Forum Japan
		Da Wei, China Institutes of Contemporary International Relations
	Moderator:	Christopher Griffin, AEI
2:30	Adjournment

Proceedings:

Panel I:  The Road to Rivalry?  Security Challenges in Asia

Michael Auslin:  Good Morning.  Welcome to AEI, and thank you for coming.  My name is Michael Auslin.  I’m a resident scholar in Asian Studies here.  We are very happy to have you all here today to join our three panels of distinguished commentators to discuss Asia 2012:  Security Challenges and Opportunities for Development.  Because of our packed schedule and time constraint, I’m not going to give an extensive introduction at all but just to set the stage very briefly.

Our goal today, what we hope, is to strike a middle ground between the quick response to daily headlines that we often see in the city and the over-horizon estimative approaches that sometimes also take up much of our time.  Our goal, rather, is to take a look at the key trends and coming issues in Asia from the security, political, economic and transnational viewpoints over the next half decade.

Our panelists, many of whom traveled from Asia to join us today, will provide, we hope, a roadmap of sorts for policy makers and analysts over the midterm.  As you know, we are particularly fortunate to have Deputy Secretary of State, John Negroponte, join us at lunchtime to give his thoughts on the crucial issues facing this region and what posture the United States should adopt in response.

Very briefly before we start, I just want to make a few acknowledgments.  The first one is to thank the Japan Foundation’s Center for Global Partnership for their generous support to make this conference possible.  Also, most of the real work that was done, i.e. getting the lights on and the food delivered was done by my assistant, Jenni Gregg.  Jenni, if you could stand up for a second.  If you have a chance to thank her because I was out traveling and doing various and sundry things while Jenni was here making sure everything would come off this morning.  So thank you, Jenni.

We do have three panels today.  We are going to try to keep very strictly to our time limits and give us all just a few minutes of breaks in between.  So in order to do that, without further ado, let us go right into our first panel.  I will switch positions and start from there.

So our first panel is going to be on security issues which we have entitled, “The Road to Rivalry?  Security Challenges in Asia.”  We have three distinguished commentators: Brigadier Arun Sahgal of the United Service Institution of India, Lanxin Xiang, Graduate Institute of International Studies in Switzerland, and Masafumi Ishii from the Embassy of Japan.  We will go in that order.

I’m going to try to bring up your PowerPoint and then, we will get started.  Brigadier, please.

Arun Sahgal:  Thank you very much.  I’m indeed delighted to be here this morning and share some perceptions on how we look at the security challenges in Asia.  My presentation actually is in four different parts, but due to paucity of time, I would be focusing on two major issues.  That is, the contemporary dynamics, how the relationships in Asia are revolving and secondly and importantly, a view from India.

This is the broad outline of my presentation of which, I think, the copy is with you in your folders.  Should you have any questions on that; subsequently, I will be glad to answer.

Contemporary dynamics -- from our perspective, we try to look at Asia in series of systems comprising of various subsystems.  Here, we have looked at Asia from six different subsystems.  We believe that if you have to -- the whole edifice of trying to understand Asia from a systemic point of view is to look at connectivities.  Here, if you would focus on -- let’s take the West Asian, the South Asian or the Eurasian system.  Some of the overlap you could see has been designed to indicate to you that there is this connectivity.  If you remove this connectivity, then the systems come apart, and if the systems come apart, then they are prone to the problems and the inconsistencies of the subsystems that are inherent in these areas.  So then, you will have a rise of regionalism; you will have several forces playing a much greater role, et cetera.  So this is what we are trying to look at.  And I’ll explain it a little further.

We are also looking at the Asian systemics in terms of metastability.  What is relevant?  What is -- see, looking to be stable at this point in time is part of an inherently unstable dynamic system, an evolving system.  Here, I’ll try to give a highlight - the constituents of this system of systems.

The constituents extend beyond Asian systems.  Asia per se is not the sole controller.  There are likely extra-regional influences.  For example, the United States is a virtual Asian power, not in a geographical sense, but it is pervasive all over, and it has a great degree of influence of the events in Asia.

Each subsystem has its own systemic dynamics.  South Asia has got its own dynamics, but the implications of those dynamics will cross subsystem and then, impact the other system.  So this is something which we are trying to look at.  I’ll give a greater explanation as I go along.

So in Asian system of systems, while we have competitive forces in terms of geopolitics, economics, social, culture and technology, then we also look at cooperative forces in terms of trade, development and geopolitics.  And to provide a contextual relevance to all this, we look at the landscape.  What is the context in which these systems are operating?

First issue is there is this whole issue of historical legacies without closure.  We have the China-Japan equation which still has not formulated even after 60 years.  Then, there is this China-Taiwan issue.  Then, the Japan-Korea issue -- the Korean issues are getting even greater salience now with the portents of unification of Korea emerging on the horizon.  Then, there is this India-China equation which is like a yo-yo; it keeps improving, diving back into the old systems, and it is on an ongoing transitional relationship.  Then, there is this proverbial Indo-Pakistan relationship which still has not found any viable stability in the sub-region.

Then, there is exclusive regional equations that we find China is extending its footprints in South Asia.  This is based on two primary early causes.  One is that China is looking for linkages in the Indian Ocean region.  This is being done through proxies with overriding relationships in terms of infrastructure development, arms sales and defense cooperative relationships.  The second issue that is emerging now is China is also acting as a part of a Eurasian system that has come into play and trying to exert its influence, not only directly itself but part of the larger Eurasian construct, and I’ll talk about that in a moment.

There is this East Asian trilateral and quadrilateral too -- basically, from our perspective, we are looking at the emergence of two major subsystems developing in Asia which are inherently confrontational in terms of what they are trying to achieve.  There is this emergence of what we call Eurasian axis - close relationship between Russia and China.  They are trying to push these relationships both on the eastern and the western frontiers. 

The eastern frontier is in East Asia - China’s role at the six-party talks, China’s role in Korea.  The western frontier is in China; Chinese extended footprints in West Asia - Chinese-Iran equation, the Chinese assertion for Caspian energy resources.  The whole issue correlate that with the Russian resurgence and attempts of assertion both, again, in East as well as in West and Central Asia.

So the whole issue is at -- the linchpin of that -- the recent example everybody is looking for is what has happened in Indonesia.  Indonesia is now being carved out as a frontier post, so to say, of both these - in the Indian Ocean region straddling the most strategic of the strategic straits called the Malacca Strait.

Then, we have the SCO and CSTO.  You are all familiar with the recent exercises.  The SCO has really transgressed now from a benign economic forum into a more assertive anti-terrorist but closely forming a security block.  Along with that is the CSTO which has now, again, gained prominence, and the highlight of that was the recent exercise in September in Russia where a large number of Chinese and Russian and the Central Asian forces took part.

Now you transplant this in the dynamics that are taking place in Afghanistan.  When you look at that, what we are seeing from our little perch is that there are trench lines being created as far as Afghanistan situation is concerned.  I’m saying it here because the audience here would like to know this.  The trench lines in terms of the northern areas of Afghanistan are slowly being converted into “no go” areas. 

Our understanding of the situation is that even if the ISAF mandate was to - I will not say collapse - but if it were to get reduced and there would be a diffusion in that mandate for whatever reasons, then NATO starts unraveling for large number of reasons and we can discuss that.  I’m talking about 2012, please.  I’m not talking about 2007. 

I’m talking about 2012.  We have done some simulation exercises on that.  When you see that, you come to a conclusion that there would be a greater regional assertion, and a regional assertion would be read by the Russians-Iranian combined through the organizations like the CSTO and the SCO.  So these organizations are not to be looked upon only in terms of economic, trade and et cetera, et cetera.  They have to be looked upon also from the larger geopolitical construct.

Then, there are visions of empire -- that is something we can talk about when --

In the competitive politics, we also have linkages beyond Asia Pacific.  China -- what is China all about?  China is not only linkages within Asia.  China also has linkages -- and the prima donna of the linkages is the United States and the linkages with Europe.  There are strong consumers -- manufacturing base needs these markets.  So they have to have linkages with extra-regional and looking for that, they are looking at passages.  They are looking at corridors.  The trade corridors become important.  Here, the maritime dynamics of these sea lanes of communication becomes very, very critical issue.

Then also, what is being seen by us in Central Asia is, a new Silk Road routes are emerging which are providing the Chinese an access to Europe by land routes.  These are multilane corridors which are connecting to Central Asia and things like that.

South Asian system has its own interesting paradoxes.  The Chinese need a direct access to Indian Ocean and they are building what we call strategic land bridges.  The strategic land bridges are the connectivities which the Chinese are trying to make with Western China as well as the Yunnan province.  The Yunnan province connectivity is to the Gulf of Akyab through Myanmar, a 535-kilometer pipeline, and the Gwadar is the linchpin of the investment connectivity.  So this is what -- energy, quest for control over access - I already talked about these issues.

I’ll come now to a view from India.  This map denotes an interesting formulation.  The red dots are inimical interest around India, essentially, China on one side and Pakistan.  The deep purple are what we could look at as states that are not really proxies but more pleasantly disposed towards China and not so pleasantly disposed towards India.  The light purple, if you see, is far away.  The blue is looking slightly different but blue like Japan, Australia, and India. 

From Indian perspective, the so-called access of democracy is not the East Asia, Pacific region.  There is no connectivity.  So what a lot of the India does -- and India would like to ensure happens, has to be looked upon from this perspective, from the so-called access of democracy, unless there is a movement westwards and we have common connectivities.  For example, with Japan, and Japan wants to invest more heavily - I guess it does not care - we have a greater connectivity or we have a greater joint collaboration in Southeast Asia, there is going to be a problem because India would have to secure its own interests, have to manage this environment. 

We also talked about a greater extended region which is essentially is from Central Asia to Northern Indian Ocean region and towards West Asia to the Malacca Strait of the South China Sea.  Here again, there is very little comfort for us.  That comfort -- although it is a relatively more comfortable environment, but this environment is getting saturated.  This environment is getting saturated by larger number of forces.  Now, with the emergence of this - what we call the East Asian access, the number of acrimonious players is increasing in Indian Ocean region.  So that is an issue that we have to be concerned about.

So this is what I have talked about.  Immediate land instability and conflict is all around us.  There are external critical influences in having little moderating impact.  There is lingering historical baggage.  There is a cooperative potential but essentially unutilized at this point in time.

Immediate maritime periphery -- benign.  I’ll give you a small example.  Recently, I was in Beijing and I was in a panel discussion with friends in CIISS, the PLA think tank, and I talked about Asian energy for the Asians.  The theme was we have the highest degree of energy resources in Asia and the biggest energy consumers are in Asia.  There is a requirement that we must join hands together and do something about this in order to ensure our own economic development. 

But the perspective from the Chinese side was -- let’s say, it is a greater global issue and one of the issues I dared say so, that Japan was not even conceived by them as a part of a possible relationship.  So it is an interesting perspective.  So there is going to be this competition, and this competition is going to remain a very major source for us.

The U.S. is a major Asian-Pacific stakeholder.  We acknowledge that, but I dare say to this audience, we see there is a decline in strategic footprints of United States and this is going to have its own impact.  The bottom line in this whole issue is that if there is a decline in America’s footprints, then the regional players would have to devise their own strategies in order to fill up the gap.

The second issue which I talked about earlier was the connectivity.  The other members of the axis of democracy are too far apart to make any difference.  So therefore, sometimes in India, despite this very good relationships with United States and it wants to build very strong and purposeful political, economic - in that order - and strategic relationship - particularly in that order - you have to understand as to why we have to be more accommodating and play a role of relative reasonableness vis-à-vis the other players who denote primarily the red color around us and the shades of red.

In the end, I have tried to highlight in these two slides how to build up Asia.  Presently, Asia is in low trust system.  There are very limited connectivity.  Every subsystem is operating on its own, carving out its own relationships and getting caught up in the wider balance of power relationships either as a proxy or as a supporter to that wider balance of our relationship. 

What we are trying to look at is a high trust system, and a high trust system in which each one would play a much bigger role, a more cooperative role and build up relationships in Asia which will support the cooperative structures which I have talked about in my presentation.  The copy is with you.  I’m sorry I have not had the time to put it across.  So with that, I’ll close. 

Thank you very much for your attention.

Michael Auslin:  Thank you very much.  I should mention, of course, that you have the full biographies of all our participants in your packets, and that is why I have not gone through and discussed each of their eminent qualifications.  We are going to move right on now to Lanxin Xiang from the Graduate Institute of International Studies who will give us a view more oriented towards China.

Lanxin Xiang:  Thank you very much, Mike.  Within the limited time, what I intend to say are two things.  One is:  What is wrong with the assessment in the United States, in particular, about Asian security since the end of Cold War?  The second is:  What would be, in my view, the possible remedies for these assessments?

The basic point I want to make is that since the end of Cold War, the Asian security issue has certainly become a hot topic, not so much because of the serious attention being paid to Asian security issues, rather than it is, at least from academic community point of view, this is one area they can invest a lot of energy to rescue the very much bankrupt international relation theories which have failed in Europe, obviously, as far as Cold War is concerned. 

So they tried to figure out, “Well, maybe there is a case we can make in Asian security, precisely, because it looks so chaotic, so complicated.”  There is bound to be a rivalry one way or another because it is an easy bet, in other words, because you look at maps, so many flash points from Taiwan, Korea, subcontinents, the Spratlys, the Sino-Japan, US-China, so it is easy to bet at some point one of the flash points is going to explode.  Therefore, they are going to prove their theory is correct.

So far, I think these predictions seem to be, if not entirely wrong; certainly, it is off-base as we can see especially in this town.  The preoccupation for the past 15 years about the rise of dragon and a variety of other struggle for mastery in Asia, the concept of the history issue will bring in a major geopolitical rivalry among Asian countries; and of course, the Taiwan Strait itself could explode. 

All these predictions, so far, have not been realized in any way.  The reality is, since 1997, there is no major conflict, not to mention war.  There are many disputes but these disputes seem to be, not easily, but certainly, it is managed in a relatively peaceful and reasonable way including the very difficult issue between China and Japan on the issue of history which I, myself, also engaged in this debate in the past.

So what are the foundations of this judgment about almost -- I think it is almost an overwhelming view that there will be major confrontation in Asia-Pacific.  I think -- several arguments basically.

One is reading of the European history, and basically saying, Europe is the past; Asia is the future.  I think this is not so much misreading of Asian history, but it is misreading European history, especially for Asian scholars who - it seems to me - are less familiar with the European history where the mastery flow for power in Europe has entirely different context.  I do not believe there is an Asian identity to begin with.  No matter how you argue, there is no Asia.  Therefore, Asia, as a region itself, is rather a Eurocentric creation.  Therefore, it is very difficult even to talk about Asian security, Asian regionalism which is even a worse concept.

Recently, I was in Paris debating with the French.  The French, of course, invented almost all “isms,” but even the French began to worry about whether or not using Asian regionalism is a useful concept to describe why Asia has cooperated rather than go to war.

So in my view, it is that the correct reading of European history - if you want to apply to Asian security setting - the best example, in my view, would be Anglo-German relationship before the First World War rather than anything else.  That is, there is enormous potential for great powers in Asia-Pacific region to misread each other’s intention, rather than actually going into a war based on real conflict. 

On that issue, I do not think I need to cite -- I will say Henry Kissinger has made the best case.  The Germans -- why the Germans should offer the British that, “We are going to help you protect the British Empire.”  The British automatic reaction is, “We want to take over.”  So you offer something the British do not want and you want something from British you do not really need. 

This is where I think the great power of misconception could take place.  This is what I see is more a problem than the actual conflict in their basic interests so far.  So this is the historic analogy.  Certainly, it is an incorrect analogy.

Now, there is another aspect, that is, IR theories argument about institutions.  Here, I’m talking about the more liberal side of the argument who also come to the same conclusion that Asia will be a conflict-ridden place.  That is to say that these are the groups who emphasize on regime theories, institution building and the basic - I have been saying - well, there is just not enough institutions there.  Therefore, there is deficit as compared with the most stable areas such as European Union and many other regional organizations where Asia - it seems to me -- to many IR theory scholars that it is hopeless because they are unable to build real institutions or sub-institutions. 

In reality, I think there are too many institutions already but not necessarily as normative, formalized institutions.  I can see from Brigadier’s slides, and also you can list - at least, I can list at least twenty-five formal/informal institutions already there.  So that is not necessarily a reflection of Asian system without collective security institutions.

Well, I have several other criticisms, but I do not have enough time to go into history of philosophy and the misunderstanding of Chinese intentions.  I basically want to argue that.  However, despite my criticism of the past assessment in United States, in particular in the Washington area, which, as a community, I have been associated for a long time, we have to see there are real potential for conflict.  I’m not necessarily led to the other direction saying this is a peaceful player -- everybody want prosperity, want peace, or using Chinese propaganda of a harmonious world to explain why Asia will not have a conflict.  That is not, of course, what I mean.

What I do see the roots of conflict:  One, as I already said it, there is a strong potential of misreading each other’s mind or intentions.  Therefore, the institution that really lack in Asian Pacific is an institution or mechanism of explaining each other’s long-term strategic vision, including United States.  I’m particularly worried about the US-China relationship in this perspective. 

So far, there is no reliable channel of laying out each other’s strategic vision.  Let’s say, ten years or fifteen years from now, what exactly they intend to do.  Both sides are guessing each other’s intentions, and it usually leads to the spiral of arms race and other defensive measures from both China and the United States.  The space issue is a typical example.  The Chinese somehow downed a satellite.  It turned out to be such a big deal.  I do believe it is a big deal if I were American.  Of course, it is a big deal, but how do you explain?  What is mechanism you can explain to each other?  Here, I think this is what really, is lacking in Asia.

Of course, there is also the problem of the value systems.  This is, I think, probably even more serious a source of conflict in the future.  I do not subscribe to the argument of Asian value as the Singapore leadership tends to do for the past - almost twenty years.  I must say not even Beijing likes that idea, not to mention the rest of Asia.  However, I think there are some fundamental misconceptions about Asian-Pacific especially about the so-called rise of the major powers there. 

I understand Indians prefer to say, “We are emerging.”  Never use the word – “rise” is only reserved for China.  I think even that is a wrong language.  There is no “rise” of China.  If we think that what China is doing really is restoring its traditional position.  If we are thinking it is a process restoration - sorry, I have been debating with the French a lot on these - if it is a restoration issue, then you will see nothing the Chinese is doing is really new. 

Have we never seen trade deficit before?  Of course, I mean a surplus - we always have a surplus until the 19th century - huge surplus.  Have we not seen accumulation of huge quantity of hard currency?  Well, yes.  We sucked in the whole world’s silver, up until the 19th century - those days of course.

So what else is really new here?  Is the Chinese embracing of world market reflecting Chinese going liberal, accepting western values?  Now, this is another misperception.  The Chinese actually invented world market globalization.  I dare to say, even William McNeil, the most famous Eurocentric historian of global history in recent years began to change his mind.  He had to add a new chapter on who invented world market. 

So it is misperception in the United States, in particular, to see China participating in international economic system at receiving end of globalization.  It is a reactive -- simply accepting a free market, laissez faire economic philosophy.  Therefore logically, that would lead to -- is eventually, this will lead to Chinese efforts to get rid of its bad political system or it is a principle of political governance - domestic governance.  I do not think this is a correct assessment.  If Chinese system did not work in the past, it will not work in the future, will not work now. 

So the question whether or not China should be democratized - it is a very popular phrase in Washington D.C. - I would strongly challenge that argument.  The real issue we need to ask is why we need to have China accept a western style democracy rather than seeking some kind of middle-of-the-road approach and try to figure out its own way of the political system.  In other words, the fundamental issue for me at this moment is we need a fundamental shift in our language context.  In this, I’m very fully in line with the French - the post modernism - and the Europeans in general.

Let me conclude since I’m running out of time.  I simply want to say:  Who did not get Asian security issue wrong?  I think the Europeans did not.  You do not see the same kind of debate in Europe - the worry about dragon and so on - but precisely because the Europeans themselves have moved beyond Westphalian system.  They are using a different language - a language Washington D.C. may not understand.  I think it will take time or maybe a Democrat Party come forward, but I doubt even Hillary Clinton would understand the European language. 

So thank you very much.  I will stop here.

Michael Auslin:  Thank you very much, Professor Xiang.  Minister Ishii, please.

Masafumi Ishii:  Thank you, Michael.  Looking at the lineup, I think Michael is asking me to be bureaucratic and diplomatic part, but I’m going to try to do is to be practical - to give you the practical view and personal view.

I’ll talk about basically three or four things - overall assessment of what is going to happen in Asia from the viewpoint of Japan, I’ll talk a little bit about the future of Japan-China relation, and the potential of Japan-India relation.  Then, I will end with a few practical recommendations or questions to be answered by you.

The overall assessment -- in a word, Japan is the past.  I think China is the present.  I think India is the future.  Having said that China is the present, I think China will have to face with a lot of uncertainties, difficulties in the years to come - five years, ten years.  India will emerge as a major economic and political power, I think, beyond ten years from now.

Take the example of aging.  I do not have time, so I will just take the example of aging as one example to show Japan is the past and China is the present and India is the future.

When we talk about aging, we take the figures called dependency ratio.  Dependency ratio is a ratio of the population who are not working.  In other words, below fourteen and over sixty-five divided by the total population.  So the more the ratio is, the working population has to support more non-working population.  That means aging. 

Japanese dependency ratio started increasing from mid 1990s already - more than ten years ago - and it is now 33 percent.  That means two people have to support one.  China is still declining but amazingly enough it will start increasing from mid-2010, a few years from now.  So that means China is catching up with Japan with ten to fifteen-year gap.  Aging in China is dramatically developing maybe because of the One Child Policy. 

And the dependency ratio in India will continue to decline until 2040.  Then the increase after 2040 will be very, very mild.  So basically, what it means is we need to be careful about the future of China.  We need to be mindful of the uncertainties China has to face with in dealing with the stability in the region.  And in whatever future endeavor, we need to involve India.  I think that is the message.

Second, what is the future of Japan-China relation?  I’m afraid, if you talk about the five years now, we will continue to be in a difficult period.  But after that, I think we will have a much, much better future.  And the key word after five years from now is the, I think, common interest.  Well, democracy, maybe, but common interest.  I think I vote for common interest.

Why am I pessimistic about the near future?  Many reasons -- I mean, historically, it is quite new that both countries see themselves as a major power, both in terms of economic terms and the political terms.  We need sometime to get used to that kind of new strategic situation.  And you know, Japan is already the past, so we are losing confidence rapidly.  We need to be able to find new source of national strength. 

We need to be confident again.  Until we become confident, I think what is happening in China -- we have seen is a lot of -- we do not like it basically.  China has its own problem as well.  I think China’s problem will continue to be the lack of legitimacy.  I think the system needs legitimacy for better stability.

But why am I optimistic about the future of Japan-China relation, because of the clear existence of the common interest.  I’ll take three examples.  Economy -- China has been the number one trading partner for Japan in the past four years.  Trade volume is more than $200 billion.  Environment -- whatever happens in China will have a big impact on us.  We have all the reason to help China for better environment, and there is a huge business over there.  I mean, what if every Chinese drives a Toyota Prius.  There is a very big market.  And we have most state of the art technology in Japan.  So I think many Japanese companies are going for that market.  So it is a win-win situation. 

Last example is, I think, energy.  In a word, Russia has been helping us in realizing that is the common interest.  I think we have more incentive to have a collaboration among Japan, China, and Korea, three major consumers in the region.  Rather than divided by Russians, we need to get together.  And I think China has taken that point already.  They called energy ministers meeting of five countries last December.  Who are called?  Japan, China, Korea, U.S.  Who else?  Indians.  No sight of Russians.  So I think China does share the same viewpoint with us in terms of energy as major consumers.

Now, moving on to future of Japan-India relation, I should say there are a lot of potentials, lot of potentials.  You know the bilateral relation -- you know the volume of Japan-India bilateral trade volume?  It is 8.5 billion compared with 200 billion between Japan and China - 8.5 billion.  It is nothing.  And you know the number one trade -- number one import of Japan from India?  It is prawn.  It is prawn.  Number two item, industrial diamond.  There is a huge, huge potential and we are going for that.  You know that in the past three years, a number of Japanese companies operating in China has been doubled from 230 to more than 450. 

Direct investment has been increasing fairly rapidly.  And I think beyond the bilateral context - I think multilateral context - you may have noticed that this year only, we have done the multilateral naval joint exercise involving Japan, U.S., and India twice already - April near Guam, September in Indian Ocean.  So you have to watch what is going to happen in that area and we will do that every year I think - Japan-U.S.-India joint naval exercise every autumn.  I think we will do that.

Now, my last point -- I mean, I think that I’m not too pessimistic about the future of the relations of -- among these three major powers or five major powers.  But the question is, as the two gentleman already said, is how to connect them, how to introduce a better infrastructure to connect them.  And I think obvious things we are going to do is we will try to strengthen Japan-U.S. security alliance.  That is a core from Japanese viewpoint.  We will do that. 

But beyond that, I think after February next year, you will see the revival of Japan-U.S.-Korea trilateral.  I think those are trilateral.  This is a trilateral among allies.  And you will continue to see Japan-U.S.-Australia.  This is also a new alliance.  So this, too, will happen anyway.  It is happening.  And maybe Six-Party will continue to be there as a mechanism to talk about the nuclear issue.  What is the future of Six-Party still unclear because unless and until we solve nuclear issue, I think there is no point in using Six-Party as a confidence-building mechanism because in order to be confident with each other, you need to solve the nuclear issue.

So I think for the time being -- in five years, I see Six-Party as a mechanism for the nuclear issue, but beyond five years, maybe we can use that as a future infrastructure for the confidence-building in the North East Asia.  But these are the obvious things which are already going on but I think, I will end up with -- I will end with three questions as I predicted -- as I told you in the outset.

The first question is the future of East Asia Summit.  What is going to happen?  What should happen?  East Asia Summit, as you know, is a loose infrastructure that includes Japan, U.S., China, ASEAN-10, Australia, New Zealand, plus, more importantly, India.  And our intention has been to use it as a base for economic integration.  Without involvement of the United States, there is no point in using this as an infrastructure for security. 

Economic integration -- can we come up with a better economic integration among these countries?  You know, the Professor Xiang talked about the Asian value.  When Japan first proposed East Asia community with more seats, our idea was to include Australia and New Zealand and India.  So it happened as we proposed. 

But when we first proposed it, I think people like Prime Minister Mahathir was saying that Australia is not Asia, so we say that, “Who cares?”  I mean, it is not the value; it is a geographical destiny for the economic integration.  You need to be able to involve Australia and New Zealand.  You need to be able to involve India. 

And in this city, we often talk about APEC, right?  APEC is great.  We support APEC, too.  In APEC, there is Taiwan.  It is very important for us to bring up the institution that includes Taiwan.  But the shortcoming of APEC is that it does not involve India and there is no hope for including India in near future.  There is a twenty-five-country waiting list; once you open up the door, you end up with a forty-five-country meeting and that means nothing.  So we will continue to commit ourselves to APEC, but I think our heart is always more with the EAS as a base of economic integration.  So I just want to know your opinion about it.

Second is Japan-U.S.-China dialogue.  What do you think about it?  The reality is Japan has been asking China to join to that and we end up having to track 1.5 type, track 2 type trilateral Japan-U.S.-China.  Are we ready to do it in a government to government level?  I think Professor Xiang was talking about misunderstanding, misperception, and lack of communication.  I do see some errors in doing this.  We are almost ready because we have been proposing that - not 100 percent yet.  I’m wondering if China is ready or not.  My impression is China is now more ready for doing that.  They are more confident and there are more things to talk about among three now.  So I bet, perhaps, $100 for that to happen before 2012 - $100 maybe, not thousand dollars perhaps.

Last question -- Japan-U.S.-India-Australia, what are we going to do about this?  This quadrilateral started at the time of the tsunami.  We call this Tsunami Four.  These four countries worked as a core group for coordinating the International ACE Corporation at the time of the Indonesian tsunami.  Well, this quad is often talked about in relation to democracy - sort of a league for democracy or something.  Maybe, maybe, but I think how we see it in Japan is a little bit beyond democracy, more practical thing.  What can they do? 

Security of sea lane of communication -- can we use this in the future as some sort of loose coalition of countries to secure the security of sea lane and communication?  In five years, maybe.  This corresponds to the membership of the annual Malabar joint naval exercise: Japan, U.S., India and this year, joined by Australia and also Singapore.  I think there is some prospect about this - using this as a mechanism for securing sea lane of communication - loose gathering. 

If that is the case, the most challenging question is how about inviting China into this, after we become confident?  After all, when we talk about energy -- I think they talked about the new [indiscernible] land communication.  I’m sure we will depend more on the sea lane of communication because after all, the most of the resource exists in Middle East.  So what I mean is that China does share the common interest in securing the sea lane of communication through Indian Ocean. 

I say why not?  Not now, but after we become confident among the quad plus perhaps Singapore and plus perhaps countries like UK.  Once we get confident about the mechanism, we may try to involve China.  And if China is ready to do it, I think that is a splendid way to bear the burden to the internationally sort of responsible stakeholders.  So I end here.

Michael Auslin:  Thank you very much.  Obviously, you can tell from the comments of our panelists, we could probably just talk about this all day long.  Maybe we will do a future conference just on the security issues which encompass so much else of what we are going to talk about.  We will open it up for discussion but I want to start it off by asking our panelists briefly to consider the factor of domestic politics in all of these.  We asked for a five-year outlook and some of what we have talked about this morning can spin out twenty years or more.  There are certainly historical lessons I think to be learned about the failure usually to come to common interest or get to high trust systems without having gone through often systemic conflicts as we saw in World War I and World War II. 

So I think that that is, again, another issue of discussion, but in all of the countries that we are talking about, all of the major players, there will be very important domestic shifts in the coming five years.  In Korea and Taiwan, we are heading into electoral seasons right now.  In China, they have just finished up the congress which will set the stage for a turnover within five years.  Japan may be entering into a period of more political paralysis. 

So the question of domestic politics knocking the ball off the line, so to speak, on all of these processes, do you think that that is significant or do you think that what you are talking about is a gestation period that will actually transcend whatever is going on domestically?

Arun Sahgal:  Yeah, absolutely right.  I mean, domestic politics is a big thing.  Perhaps you are aware that long-labored India-U.S. nuclear deal is in a bit of a limbo.  But what I would like to say is that yes, domestic politics will have a say, but in case of India it is an evolving issue and evolving issue in terms of the fact is that is the political leadership in the country -- the old leadership, that is, by major political parties like Congress and the right-wing BJP.  They understand the strategic ramifications of right decision making, the timings, and they would go along with it.  But the regional formulation and the other players are not so confident and then, there is a huge ideological construct in our left-wing parties.  So what I will try to suggest is there will be delay, there will debate but eventually, it will fall in place.

And that also goes for my comment for quadrilateral.  Please do not look for an immediate Indian position changing overnight.  But India will remain committed to the dialogue - I can say with some degree of assertion, but it will like to play a much lower key role than it would be.  And it has also got to do with the internal debate within the country is that we are talking in terms in India of a national security strategy based on growth and interest, both hand together.  The growth strategy essentially meaning is that we need a ten to fifteen-year period of internal consolidation to be able to play a much more bigger, meaningful, externalized role.  That is the kind of consideration that the people are talking about.

Lanxin Xiang:  I do think the domestic factor is crucial in the case of China.  I do believe that despite all my criticisms, there is one group of which actually got China right, at least, in certain sense is the Neocons who actually say it, who always consistent about link between domestic and foreign policy while many other mainstream panda hugger, whatever you call them, tend to separate the two things saying, “Well, China has a basic fundamental national interest to protect; therefore, they can just separate from --.” 

But in my view, the 17th Party Congress is a crucial moment for two reasons.  One is China pretty much declare that we will not accept the Western value political system despite the quotation of democracy, maybe twenty times, which is misread in the Western press.  Now, what you really need to read is the key word socialism in Chinese characteristics.  This is emphasized at least fifty, sixty times.  Now that is one area I think - that is what I’m saying - could be source of value conflict with the United States in particular.

The second thing is -- I look at the composition of the Member Central Committee; you do see quite a drastic increase of the military presence - I will say, almost 80 percent increase.  Now, what does that mean?  Everybody’s guess whether or not Mr. Hu actually is in control PLA or is not in control PLA.  It is hard to judge but then, you would look at each of them, what they are doing, who promote them.  The picture is clear.  They are very clear.  It still needs time to consolidate it.  I put it mildly now as far as the military; therefore, security policy is going to be quite influential -- very much influenced by the military opinion as well.

Masafumi Ishii:  I think we need five more years to see stronger political parties -- stronger government.  I think that the coming five years will be a very, very difficult years from the viewpoint of domestic politics - ups and downs in Japan - I’m sorry, in Japan being paralyzed.  But I think you simply cannot stop the trend moving around you and you need to catch up with that; otherwise, you will be just left over. 

And the one worried about the U.S. -- I think whoever comes in because -- partly because of the uncertainty U.S. people see in the future of China.  I think, I dare say, the importance of Japan will increase rather than decrease in the mind of Americans; we are very confident about it.

Michael Auslin:  Absolutely.  Of course, I should have mentioned the American political system is well rotated.  We have about fifteen minutes for questions.  We want to open it up.  We do have two mics that will be coming around the room.  I ask you to please stand, just tell us who you are, where you are from, and please make sure that your question is a question, so we can get to as many people as possible, so if you just want to raise your hands and I will call on folks.  Why do we not start with the lady in yellow right here.

Chatrine Siswoyo:  Thank you.  I’m Chatrine Siswoyo from American University.  I actually have two questions.  Would that be okay?

Michael Auslin:  Sure.

Katherine Siswoyu:  Okay, thank you.  Okay, my first question is actually about the role of Indonesia.  As a neighbor, how do you see Indonesian role in the region and what it could have done better?  And then, the second question is about China.  When you mentioned that the preferred language for China is becoming the world power now is restoring its way, do you see that ordinary people of China are ready for the restoring process?  I mean, observing the unjust development that happening right now.  So thank you.

Arun Sahgal:  Indonesia -- me?  Okay.  No, there is nothing wrong with Indonesia is doing but what is happening is what we are -- incidentally, we have shared a maritime boundary.  Indonesia is just fifty nautical miles away from our Andaman and Nicobar Islands, our island territories.  Also, the major naval presence on the western side of the Malacca Strait is the Indian Navy.  So for practically every single situation that happens in that archipelago, we have a role to play.  Therefore, we are extremely involved and interested in the developments in Indonesia. 

Apart from its domestic politics - which there is no time to talk about -- but what we are looking at is that Indonesia is slowly getting drawn into this balance of power relationship.  The Russian president goes to Indonesia, signs big deals in terms of selling Kilo-Class submarines, operation of military -- has also large amount of technological assistance and contracts for gas.  Indonesians reneged on their already made commitments to Japan and other countries in terms of liquefied petroleum gas supplies and to Korea. 

And then, we also see the Indonesians signing a large amount of deals with PLA to enhance its missile and proprietal systems.  What we are not concerned -- we are not concerned so much about this development per se; we are okay with that.  But what is happening in the South East Asian dynamics is concurrent problems. 

So South East Asian countries are getting worried about as to why this is happening.  And is Indonesia being brought within the ambit of the so-called initial signs of this developing axis which I have different perceptions in this region, primarily, because of the sea lanes stability which the minister talked about.  The sea lane stability is going to be a major issue and right now, it is deemed by the Chinese and the other Chinese interests as a part and parcel of a western-oriented system which has a total control.  Is it diffusion of that control that has been talked about?  That is the issue we have to look at.

Lanxin Xiang:  The China coalition I think is very simple.  I just checked out the best selling list in China.  These days, of course, everything about Confucius is selling.  Now, what worries me is whether or not the leaderships going to misinterpret this in a modern way rather than post-modern way, which the latter way is what I would prefer.  If you would interpret modern way, meaning nationalistic way about our tradition which is using that for the purpose of that, then it is worrisome.

Rob Warne:  Rob Warne, consultant.  I’d like to ask Minister Ishii.  He pointed out that Japan needs to have confidence and needs to restore its robust attitude.  How do you go about doing that?  How will you accomplish that?

Masafumi Ishii:  Ask Prime Minister.  Identify the area where Japan is strong; invest limited resources on that.  I think as simple as that.  We will try to be at frontrunner for whatever new, mainly in a technological aspect.  But we can even use things like aging as a base for new industry.  We will have the most advanced experience failure and success of aging.  But if we establish a new industry for coping with aging, I think the frontrunner of everything new -- I think that is the direction we are going for.

Michael Auslin:  That is a great point.  Thank you.  Other questions?  Let’s go in the back.  There is a hand there and we will come up front again.

Mike Choi:  Hi.  I’m Mike Choi with ITA.  Professor Xiang, you mentioned a need for institutions where perhaps U.S. and China can talk about their long-term strategic visions.  I guess I’m wondering since U.S. is based on short-term election cycle especially if you view from China’s perspective, when the U.S. foreign policy structure is so constantly in flux, how do you see U.S. and China having a consistent long-term dialogue and long-term strategic visions?

Lanxin Xiang:  I truly think the current system is not working, that is the government-government level and the military-military kind of second channel, none of them seem to be effective, precisely because -- first of all, you talk about the short-term vision of the U.S. government.  Yes, Henry Kissinger used to say, “Which telephone number are you going to call in Europe.”  Yes, you have a White House phone number but you know his mind is elsewhere. 

Then, in China, you do not have a telephone call.  The problem is that the institution in China, the Military Commission, which is officially under the party, has no civilian member except Hu Jintao himself.  The foreign ministry, if you try to talk with our chief foreign military spokesman about military, they would refer you to talk to military.  It is a very chaotic decision making process. 

So therefore, the only thing it may work, in my view, is at a top level, summit level, or at least, at a level of person with presidential mandate on both sides.  Could be Nicker Bundy [phonetic] versus Dai Min Guo [phonetic], I do not know who these two suppose to be but there is no such thing.  It is impossible so far.  And do not forget China been debating about NSC for at least 10, 15 years now to establish equivalent of National Securities Council.  It did not work out precisely because of the nature of the system.

Michael Auslin:  Other questions?  We have one on the front, right here.

Male Voice:  Thank you very much, Chairman.  My name is [indiscernible].  I’m from the Chinese Embassy.  I got a question to the panelists and it seems there is one missing in your remarks it is about the Korean Peninsula because we are talking about in five years from now on.  So my question actually to the panelists:  What is your perspective, presumably, after the post-nuclear Korean Peninsula?  Thanks.

Arun Sahgal:  Move ahead but remain unresolved.

Michael Auslin:  Succinct.  Anybody else want to jump -- but your question presumed a post --

Male Voice:  Post nuclear issue -- let’s assume the nuclear issue would be solved, [indiscernible] partners.

Masafumi Ishii:  I think I tried to touch up on that a little bit - Six-Party.  It is after -- that is going to happen to unification to a great extent I think.  If you assume that there is a unified Korea, I think that will bring in many new elements - bigger country, missile technology, used to have nuclear technologies.  Can we maintain united Korea as nuclear-free country?  If we can, we still have some other issues to address. 

What will happen to U.S. force in unified Korea?  Are they ready to keep them?  Are they ready to keep the forward deployment of U.S. forces?  It is open question.  If U.S. is asked to leave, what will happen to U.S. force in Japan?  There will be no longer threat of North Korea.  What is the rationale of having forward deployment of U.S. force in Japan?  How can we explain that to the public?  I personally think there is still rationale but how can we explain that to the public? 

And if that means we need to say goodbye to U.S. forces in Japan as well, what will be the framework for maintaining a better security in that region.  We need to be very creative about that.  I think that is where -- that is why I think we are now seeing a development of trilateral reason like Japan-U.S.-Australia.  I think if after the unification, there is no U.S. force forward deployment, we do not mind having a helping hand coming from the south, whatever small it is.  So I think those are the issues we have to address.

Michael Auslin:  To build off of that for a second, I would like to ask each of the panelists to consider from the viewpoint of the region, what role you believe the U.S. should be playing over the next five years, either discreetly or as a springboard to the following period.  I mean, the Brigadier talked about the possibility of a diminishing U.S. strategic footprint.  Minister Ishii, you mentioned the EAS of which United States is not a member.  So to consider very briefly, if you would, from the point of view of the region, where you see the United States; where it should be going. 

We have the bases for Asian cooperation just on the panel here, so if we could move that to the next level.

Masafumi Ishii:  I think we need a continuous engagement of the United States in the region as a stabilizing factor.  We need it; China needs it; India needs it, too.  I think China needs it for somehow being more confident about the future of Japan.  So when we start talking about the security infrastructure, we will try to involve you as a part and parcel of that framework.  That will continue to be the case. 

Economic integration, I do not know.  East Asia Summit is interesting endeavor.  That may work as a sort of incentive for the United States to keep their eyes on what is going on East Asia or East Asia community.  It is kind of a lure -- sort of in our mind.  And also, it will make, perhaps, things like Japan, U.S., FDA, or EPA, or economic integration at least symbolically more relevant.  So I think there are many ways to engage United States even if U.S. is not part of EAS.

Lanxin Xiang:  I think I agree.  Even China wants U.S. to be there.  There is no doubt about it.  Now, whether China wants U.S. to assume leadership roles is another issue.  Once again, I think the U.S. strategic vision - what exactly the U.S. wants in that area - is not clear.  U.S. has been building, let’s say, Canberra, Tokyo, and Washington kind of access Chinese interpret as petit NATO.  Now, that is not very a pleasant word, of course.  It is a small NATO for a long-term containment against China.  At least, that is the perception if they want to build things like that. 

And the Tsunami Four you talk about.  If it becomes a pure democratic alliance, then of course, who is the undemocratic enemy target for the future?  So you have all this group building that may cause concern if there is no clear interpretation what the U.S. intends to do.  This is I think is the most important issue for China, at least.

Arun Sahgal:  I share the sentiments of the Minister Ishii.  We also look at a continued engagement of United States in the region with very, very important part and we look at this engagement, both from the Western perspective as well as the Eastern perspective which basically means that we are also looking at American to remain committed in Afghanistan for the immediate future that is in the perspective of 2012 we are talking about.  Build up relationships in Central Asia because Central Asia is an important area particularly the Caspian energy resources and the new linkages that we need to look at. And here, I may as be a little unpopular but I would like to strongly suggest that we need to calibrate response vis-à-vis Iran because in the new scheme of things, Iran is emerging as a center of gravity particularly as the Eurasian Block, so to say.  I’m using this word loosely.  It is not a security originally but these continuing forces that is emerging and Iran is becoming a centerpiece of that.  So that again is -- and Iran can be leveraged both positively and negatively.  So that is an issue.

But as far as the eastern part is concerned, certainly, the South East Asia as well as in Eastern Asia, we would like Americans to be there because of the primacy of their naval power, the primacy of their engagement with the region, and also, in terms of providing - well, I’m a military man, so I do not use diplomatic language - as a strategic hedge, in terms of ensuring that the balance of our relationships remain balanced, at least, from our perspective in the next 10 to 12 years.  And that is what we are looking at. 

I mean, we are looking at very selfish reason and that is why -- that is one of the logics and the reason that we have -- despite tremendous amount of internal dissonance, we have agreed and going ahead with this Malabar and then a series of exercise.  They are not too distinct but the whole idea is to build up a relationship and capacity and understanding within the region and particularly, the littoral states around us.  Thank you.

Michael Auslin:  We have time for one more quick question.  We have a hand up here.  The young man in the blue --

Max Tedford:  Yes, I’m Max Tedford from American University.  You all touched a little bit on this already but I would like to direct my question to Mr. Ishii.  I was hoping you could comment a little bit about the U.S.-Japan military strategic alliance and maybe a little bit about the proposed structure changes during the Two-Plus-Two Talks in 2005.  Maybe what sort of progress you have seen with that -- the transformation of the alliance and a little bit about how you see the implications of that - sort of being to show themselves throughout Asia.

Masafumi Ishii:  It is an ongoing thing, so it is a little bit boring to talk about this, perhaps.  But core of the transformation is to make the presence more flexible -- strategically flexible.  For that, U.S. is ready to get Marine out of Okinawa and to be positioned in Guam.  They are ready to consolidate bases in Okinawa while the strategic importance in Okinawa remains the same. 

I think we are proceeding reasonably well but because of the political situation in both countries, we will see a few stumbling blocks in coming months and years.  We are still striving in maintaining our navy in the Indian Ocean as well, so that is part of why alliance in wider sense.  So you know how difficult the political situation over there now.  But system is there; we are proceeding slowly but steadily.

Panel II: Is Growth Sustainable?  Fault Lines in Asia’s Economic Future

Claude Barfield:  I’m sorry.  I wonder if we could be seated please so we can get started on the second panel.

Good morning.  I am Claude Barfield, a resident scholar here at the American Enterprise Institute, and I would like you to all sit down.

Male Voice:  [Speaks away from microphone]

Claude Barfield:  That is right.  There is no free enterprise here; it is command and control, at least with the beginning.

Okay, the title of the second panel is, “Is Growth Sustainable?  East Asia’s Economic Future.”  When I looked at that I thought, “You know, this could be read in a number of ways.”  Is growth sustainable, East Asia’s economic future?  It could have to do with internal questions of different models of growth.  And we look at the three panelists who will be talking about Japan, China and India, that immediately comes to mind, over-simplifying. 

You have a contest between the large developing countries, India and China, which is sometimes -- it is said that it is between the tortoise and the hare.  That the democratic decentralized Indian political science and economy, with all the problems of the fractionalization of democracy and yet moving, it seems to outside observers, fairly steadily if more slowly forward, versus a highly authoritarian government in China, which can move on a dime and has moved forward quite rapidly economically but has the challenge of how you juxtapose or how you balance political reform or political advance with economic advance.

And indeed, in listening to the first panel this morning, particularly Professor Xiang, and also there is very timely for us a piece in the Financial Times this morning which is titled, “Russia and China Challenge the West.”  The point of the piece is that unlike thinking, at least in some political science and relations theory, that you would move in China particularly from an authoritarian government, which would change as you gradually opened up its economy to investment and trade, it looks as if that has certainly to date has not happened. 

And indeed, we are seeing an experiment in the ability of a government, of what will become the largest economy, to be able to maintain an authoritarian government while it is presiding over a relatively open both trade and investment.  And indeed, Professor Xiang made the point this morning that there is a misinterpretation in the West that somehow the Chinese will change, that the Chinese intend - and he cited the current Congress as the proof of that - to maintain that particular combination.

Then, one could argue I suppose that there is even a third model that Mr. Katz will be talking about.  We forget about this today, but Japan for four decades after 1945 was, at least in the minds of the West and the United States, the model for Asian growth.  And the question there is the degree to which after this decade of being, as it were, out of the center, Japan has revised its model, its economic model to the extent that it can now move forward back to a growth path of the normal developed and not a developing country.

So you got the internal models.  But then it occurred to me, finally that this all could mean a model of Asia per se, that is, an Asian model versus the models of the rest of the world whatever the internal differences.  And there I was thinking I was talking with Mr. Katz that it is very timely here in 2007 if we think about ten years ago with the Asian financial crisis, there was all this discussion that the Asian model - and we lumped all these countries together - had reached an end point that it would not be able -- at least for many countries it would not be able to go forward as it has.  We see the remarkable recovery.  We also saw some economies, particularly the Chinese economy which is, by and large, insulated.

Today, interestingly enough though, I do not want to push this too far, you will find the situation where there is at least financial turmoil in the West.  And in which, at least until now, this seems not to have spilled over into Asia, whether or not there is an Asian model.  So there, as I say, are a number of interpretations that we could have.

A couple of points about the panel: We must finish at a quarter of 12 because our lunch speaker is under time constraints and so that I’ll ask the three speakers to follow the guidelines of ten to fifteen minutes.

I’m going to go in the order that we have in the program - Mr. Katz first and then Philip Levy and then Beth Anne Wilson.  You have got, as Mr. Auslin pointed out to you, you have got full bios; I’ll just tick off a couple of things in each case.

Richard Katz is the editor of Oriental Economist, which is a monthly newsletter on Japan and the semiweekly TOE Alert.  He is also the author of two recent books on Japan – Japan: The System that Soured: The Rise and Fall of Japanese Economic Miracle; and Japanese Phoenix: The Long Road to Economic Survival.

Philip Levy is a resident scholar here at the American Enterprise Institute, and he deals with international trade and international development issues.  Before coming to AEI, he was in the Bush administration first as a staff member of the Council of Economic Advisers, and then on the policy planning staff of the Department of State.

Finally, Beth Anne Wilson is a senior economist at the international financial division of the Federal Reserve Board.  She currently covers India and has followed emerging market issues since 1999.

I want to get started with Mr. Katz.

Richard Katz:  Thank you very much.  I’m very happy to be here.  Let me try to go through briefly four points.  One is one of the medium term and short term perspectives for Japanese economic growth.  Secondly, what are some of the political and -- maybe it is not four - geo-political ramifications of that.  I guess there are four.  Third is a sort of what the Fukuda administration will or will not do about these problems, which is sort of a subset of two.  And finally, the U.S. response or range of responses to that situation.  So let us begin.

Everybody agrees that Japan is, more or less, now operating at full capacity.  In other words, employment is, more or less, towards full employment, capacity utilization of factories and equipments and store shelves, whatever.  So the question is what is the trend growth?  What is the sustainable trend growth going forward?

The conventional estimates are between 1.5 to 2 percent.  I lean more towards the 1.5, but certainly fewer people can disagree.  But basically, in any economy, the growth you can have over a long period of time operating at full capacity is basically how many additional people are working every year and how much additional output can each person produce.

Well, Japan has got a problem on both sides.  One is that the working age population is now shrinking.  And you see in the period from 2000 to 2005, about half percent a year; 2005 to 2010, about seven-tenths percent a year; 2010 to 2015 over one percent a year.  That is a lot of shrinkage of workers, which automatically deducts in this period from growth potential.  What makes it even more difficult, economically and politically, is that the working age population is shrinking faster than the total population.

Which means, for example, if you have a situation, say, in the coming five years or the current five years where the total population is basically the same - a shrinkage of one-tenth to one percent a year - but the number of workers or working age people is shrinking minus 0.7, which is six-tenth percent faster, then even if the per worker output remains the same, the per capita GDP will actually fall six-tenths of a percent a year. 

We then consider that some of this population is gradually getting older, and older people cost more to support than younger people because of health care assisted living, whatever.  That even if the numbers in terms of per capita income will remain the same, the actual living standard would actually fall.

Now this has ramifications economically but has tremendous political ramifications - you think about budgets, you think about the fight over consumption tax.  This is one of the reasons why the LDP lost the election for the upper house in July.  They have a whole debate about whether they should or should not raise the consumption tax and they are heading into the election within the next year or two that will determine who is the Prime Minister.  And they do not want to do it but they feel economic pressure to do it so it is a very, very big political issue and it explains a lot of the political indecisiveness paralysis in Japan.

Now, we are now in a situation where jobs are growing, but because they are hiring so many part-timers because they are paid lower wages, that the number of actual hours of work has not been growing really for the past fifteen years.  So the sole source of growth has been growth in output per hour - that is the sole source of growth.  So unless you can get an acceleration of that growth per hour, then because of the drop in the working age population, you are actually going to -- your growth rate will shrink.  You have got to accelerate, just run faster just to stay in the same place in terms of growth ability.

So do we see an acceleration of growth?  We have a lot of people saying so.  We hear GE Japan is back; it is doing a lot of reform for the activities accelerated.  Well, there has been a lot of reform but as we know from the experience of the U.S. and other countries, when you have a really big ship it takes a lot to turn it around.  You need a certain critical mass of reform and you need a long gestation period before the results finally come to fruition.

There really is no acceleration reform in productivity.  If you look at the productivity figure, you can see -- I do not want to blind you but you can see that it follows very closely with the GDP numbers; it is very cyclical.  You could then do a trend line.  So if we have, for example, the 1991 to 2001 trend line and above it 1991 to 2007, we see there is no change; there is no acceleration.  And these gray boxes are two-quarter moving averages, and if we were seeing acceleration of productivity, all the gray boxes, at least most of them, would be above the trend line. 

In fact, they got more below the trend line than above.  There is no acceleration productivity.  There has been a lot of reform, yes.  But it requires even more reform and what you got is political leaders in Japan saying, “Hey, we swam a third of the way across the river.  Look how far we have come.  We can stop right here.”  Well, that is the route to drowning, as far as I can see.

And now with a divided government, indecisiveness, I think it is not the case that Fukuda is going to turn the clock back.  I think people who say that are being way, way, way too pessimistic.  There is a lot of reforms that are already baked into the cake that have a life of their own and those are going to continue.  But, and the momentum and the need for reform is going to continue because of the aging of the things, sort of political compulsion to do something is going to continue.  But what to do?  I think that the additional top-level government policy-led reform is really going to slow down and that is a problem.  It is going to take a while to shake ourselves out of -– [indiscernible] what Mr. Ishii talked about a five-year interregnum.  Mr. Ishii is right about that.  It is a subject to discussion with Q&A but certainly for some period of an interregnum.

Now, let me go one more point on this then move on, which is how would we know if the kind of reform we need is occurring?  Well, if you look at the U.S. experience, the U.S. productivity revolution, it was not nanotechnology; it was not a so-called new economy.  The two-thirds of the acceleration of growth in U.S. productivity did not come from the so-called new economy sectors of IT.  It came from the old economy sectors consuming the IT or just taking off-the-shelf technologies under the pressure of globalization and higher competition to improve themselves - and that is retail, and that is banking, and that is rust belt manufacturing.  And the same thing is true in Japan.

So if we were seeing real reform, Japan’s weakest sectors would be really reforming and we would see that most reform in what is currently the backwards sectors which can really zoom by just catching up to the world benchmarks.  Instead, what we are seeing here is that the biggest reform, the biggest change of productivity is occurring in the sectors that are already the strongest.  So Japan is having the most reform where it is least urgent and the least reform where it is most urgent.  The dual economy which is a productive, competitive, globalized Japan, and insulated, protected, weak Japan, that still continues.  And the political issue of dealing with that is very, very difficult.

Let’s move on now to the demand side.  This is more of the short terms.  The trend line, we are talking about one-and-a-half maybe decelerating with aging, maybe accelerating with more reform, but somewhere around that level.  This is an extremely unbalanced and risky economic recovery.  This is the gray bar is the share of investment of trade surplus or consumption in GDP.  The share of it is investment amounts, so it is a level of 16 percent of GDP; yet, in the last five years, investment by businesses that provided 34 percent of all the growth in GDP.  There has never been a recovery in the last fifty years where investment has played such an inordinate role for such a long period of time.

The trade surplus is now about 4 percent of GDP, yet it has provided 37 percent of all growth in the last five years; that is absolutely remarkable.  So Japan’s growth is hinged to its ability to have ever larger trade surpluses with the rest of the world, which means the rest of the world has gotten ever larger trade deficits, which primarily means right here.  Okay?

Now, what about consumption?  Well, again, consumption is 54 percent of GDP but only 34 percent of growth.  This has not been a consumption-led recovery, and why?  Because the wages are at the lowest share of GDP they have been in a couple of decades.  And the reason for that is that the strategy for recovery is really a covert transfer of income from households, either as workers or as savers.  From them to either the corporations to create profits or to the banks to pay off bad debts so the banks could pay depositor zero and gradually write off the bad debts to these zombie companies.

So it looks like non-performing, well, the problem has been solved; and from a financial standpoint it has and that is a terrific thing, but there was a cost.  And costs are fine.  There have got to be costs; someone has got to pay.  But this was done in a very covert way and built in a situation where wages are still now suppressed, even the error of recovery, which means consumption cannot grow.  So Japan’s will to grow depends upon its export machine.

Now, which then brings us to - this is the trade surplus record share of GDP - the fact that the idea of decoupling, that Japan has decoupled from the U.S. because now it is exporting to China, I think they are just totally wrong.  We have a huge correlation, except for this drop in export area here, between Japanese GDP and U.S. GDP.  There has never been, in the post-war period, such a close correlation over an extended period of time between U.S. and Japanese GDP.  And, you know, the U.S. is the dog and Japan is the tail in this case, all right?  Now, why?  It is because the U.S. is the market.  Japan’s global exports mirror U.S. global imports.

People say, “Well, Japan is exporting to China.”  Yeah, Japan exports to China, but if you look at those exports, Japan’s exports to China did not correlate with Chinese growth.  They did not correlate with Chinese investment.  They correlate with Chinese exports to the U.S., except for this one period where there is the anti-Japan boycott in China because of Koizumi going to Yasukuni Shrine.  So in other words, Japan’s ability to export to China depends upon China’s ability to export to the U.S.

Now, this is Japan to Asia-ex China which is twice as a big a share of Japan’s exports as China.  Again, Japan’s ability to export to Asia directly depends upon Asia’s ability to export to the U.S.  In fact, Japan’s exports to Asia correlate just as well as that with China’s exports to the U.S.  Get that.  So Japan exports to Asia, Asia exports to China, China exports to the U.S.  The end of the road is here; here is the domino:  So if the U.S. is not importing as much, guess who is not going to sell as much?

Now what about this capital investment?  Well, the Japanese capital investment depends upon Japanese exports.  So much of that investment is for big manufacturers exporting where else the service industries will supply those manufacturers.  So if the exports stop, the capital investment stops; the train stops.

That is a strategy which was very risky.  Suppressing internal living standards to solve a non-performing loan problem, to solve the -– to have raised corporate profits and basing yourself on the U.S. locomotive.  Politically it was horribly risky and the LDP got thrashed for it in July.  They got that “It was the economy, stupid” all over again.  And Shinzo Abe thought the economy is in great shape.  It was not.  Good GDP numbers were not translating into the lives of ordinary people and the LDP was punished for it.

These charts explain a lot of politics in Japan in my view.  Now the problem for Japan is look at U.S. imports.  The growth rate is decelerating.  It is still positive, but it is decelerating as the U.S. goes to a growth slowdown.  Now, the most common projection is the U.S. will experience only a growth slowdown, not an actual recession.  I think it is probably true.  I’m pretty bullish of the U.S. given the circumstances relative; it has been pretty resilient.  But the economists say that the odds of a U.S. recession are about a third to 40 percent.  That is a pretty high risk.  So that is a very high risk strategy.  If the U.S. has a recession, Japan is going down.  It is just like in 2000.  So it is not the most likely case, but it is a risk scenario that Japan’s policy makers need to pay attention to, not to mention U.S. policy makers.

Now, geopolitical ramifications of this: look at Japan’s weight in the world.  Japan’s share of GDP is declining.  This is the purchasing power already adjusted, and this is China’s.  It is very, very clear who is getting the stronger weight, who is getting the lower weight.  This is all about imports - creating dependency relations where people use you as their market.  China is not only an export superpower, it is becoming an import superpower.  And also, unlike Japan, importing manufactured goods and importing goods in the same industry for exports, which create dependency relationships which has geopolitical ramifications.

So this is only up to 2004 because that is the data.  Well, if you look China has already surpassed Japan, and also look at the rate of growth.  So by 2006, who knows who might be up here?  And the next couple of years can be even higher.  You are talking about a nation with an awful lot of weight in the world relative to Japan.  China imports more for most Asian countries than does Japan.  In fact, Europe imports more from a lot of Asian countries than does Japan and, of course, does the U.S.

Now, some of the implications here: The U.S. has an interest in a strong Japan, very clearly.  And when the Bush administration came in, they worked really, really hard to help Japan solve the non-performing loan problem and that was a very good thing.  And the U.S. fortunately had in Koizumi somebody that we are going along with because he believed in economic reform.  He even follows a particular recipe – [indiscernible] the best even if he did not quite do as much as he pretended he did, but still, right direction.  God bless him.

He also believed Japan to take a more active role on the world stage.  He did not agree with everything the U.S. did, but in terms of the old debate about Japan being activist or “let George do it, let Uncle Sam do it,” Koizumi was saying, “Japan has got to take a bigger role.”  So on both security and economics, he was basically moving in a direction that the U.S. wanted - that is terrific.  Now the U.S. has taken the point of view that Japan’s economy is in great shape, which it is not.  So its sole focus is really on security.

My fear is that on the one hand, the U.S. needs a strong, vibrant Japan not to contain China; that is impossible and undesirable, but to integrate Japan into the global community and as a counterweight to arise with Japan as a balance.  So the U.S. needs a vibrant Japan.  Japan needs a vibrant Japan.  Maybe even China needs a vibrant Japan.

But the reforms required to get a vibrant Japan are going to cause political problems in the LDP and we are going to get this whole trade-off between people we support because they agree with the U.S. and it is this or that particular security stance, versus people who really want to do the right thing on economics.  This is Shinzo Abe, who is not against reform but basically he did not think about it.  He was a way, way, way on the backburner.  All he cared about is revising the constitution. 

And the U.S., in this situation, supported Shinzo Abe when it was very clear the guy was doomed.  If people want to discuss the whole new notion, then we can do it, but the point I’m saying is this trade off between economics and security.  Now, what I’m arguing with is economic vibrance and positive security rule are two sides to the same coin, and the U.S. is going to have some dilemmas to face in an unreformed Japan.

So let me stop there and pass the baton.

Claude Barfield:  Thank you very much.  That was a fascinating start.  Now we turn to Phil Levy who will give us the same fascination with China.

Philip I. Levy:  Thank you.  Well, I actually have the easiest task by far of all the panelists up here.

Whereas with India and Japan, one needs to think about all the vagaries of economic development, all the shocks and mishaps that can occur, with China, it is somewhat different.  With China, we have scientific development, which means that we know that per capita GDP should quadruple by 2020, and with a number of fairly straightforward calculations, some assumptions about population increase and so forth, has an implied annual growth rate of 12.5 percent.  And so taking the time line for the conference seriously, by 2012, China’s economy will be 80 percent larger than it is today.  So there you have it.

Or if you prefer Rodrigo de Rato over Hu Jintao, the IMF World Economic Outlook just came out last week.  For those who have not gotten through reading it yet, they forecast only through 2008.  But what was striking was that they forecast fairly positive things and very much more of the same.  They described China as the biggest contributor to world growth, which is a little bit odd and I think a lot of Richard’s points here are very well taken.  They are a part of a chain and, in fact, in some of the discussions that occurred after the release of the World Economic Outlook, they noted as how this is sort of a technical description if you look at the size of the economy and what was happening, but not the sort of end-market driving force for very much the reasons that I think Richard laid out.

And I thought the IMF was really rather daring in its prediction that things will keep going pretty much as they are.  And that would be a lot of the substance of my remarks is to why that is daring since that is something of a forecasting norm.  But you will note that if you look at what they are predicting for GDP growth, it will only go through 2008, you would have – this is sort of showing where we have been - 10.4 percent, 11.1 percent, 11.5 this year and then some moderation.  They state that this is assuming that some of the measures that are being taken to reign things back in will be effective.  You see with inflation that it has spiked up.  We will come back to that, but again assuming there will be sort of moderation.

The last column may give one pause a bit and I’ll sort of do this in colorful charts in a second, but this does not look so much like “steady as she goes.”  You have just seen rather large numbers for current account surplus as a percentage of GDP and still growing fairly rapidly.  But anyway, so we got two predictions now about basically forecasting fairly rosy scenarios for China in the future and I could yield the rest of my time, but the mandate here was to find fault in this.  So let me sort of point out a number of reasons why there is cause for concern with the China forecast.

So with a sort of a very distinguished figure from AEI’s history, Herb Stein had the insight that if something cannot go on forever, it will stop.  And there are a number of proofs in the appendix.  There are a number of things going on here that will be a lot of what I’ll get to, which sort of lead us that there are many, many things in China’s current development process which cannot go on forever. 

So I would note as a sort of a general comment before getting into these on the error bounds, that when economists do forecasts - for those who are not forecasting mavens - you sort of say the number that you think you are going to have frequently with a continuation of where one is going, and then you sort of express to some extent how confident you are in that number by the scope of the error bounds, how surprised would you be if it were a couple of percentage points higher or lower. 

I think in the case of forecasts about China’s future, these bounds are huge.  We have very, very little confidence.  I have very little confidence in how well these forecasts have pegged what will happen in the future.  And I would also argue in general, if you are giving your best guess, that July is right in the middle of where you expect things to be.  In this case, I think it is much easier to think of problems that could emerge with these forecasts than to construct even more optimistic scenarios.  I mean if that sounds pessimistic, realize that things like, you know, 12.5 percent growth over thirteen years would be even faster than what China has done remarkably so far.  I’ll have a chart on that in just a second.

So, I think the overall message that I want to get across is, with China we have an economy that is kind of hurtling forward wildly.  So “steady as she goes” seems a fairly unlikely outcome to me.  They have careened fairly successfully up until now, but I will sort of enumerate a number of things which could bring that to an unfortunate conclusion.

Before I do, just recapping here where China is coming from, and this is the growth from 1993 from the IMF World Economic Outlook forecast through 2007.  And you see these are fairly remarkable numbers.  These are very, very, very impressive and sustained period of very rapid growth; this is real GDP growth.  Now, I always remind myself on this:  It is true that China was emerging from a really astonishing self-inflicted disaster with the Cultural Revolution, where you were not making particularly good use of your factor resources and human capital.  But this is, nonetheless, very, very impressive and the effect of course has been to lift millions of people out of poverty - hundreds of millions.

So let me note some caveats to this very, very impressive Chinese growth.  And some of these rules actually sound fairly remiss in some of the things with Japan.  So, there is a heavy dependence on investment.  This is not domestic consumption that is driving this.  And now we get to these trends that cannot continue and therefore are likely to stop. 

Hoffman and Kus [phonetic], two World Bank authors based in Beijing, note that you currently have a very, very high percentage of GDP within China stemming from investment.  They forecast on the current trends, if China sort of keeps going with the same path that it is on, that [indiscernible] rises from a very high 37 to a very, very high almost 50 percent of GDP, which means that you are taking 50 percent of your output and rather than consuming it, you are reinvesting.  So to maintain this really rapid pace of growth, you are having to pedal faster and faster.

Another feature of the way that China has done this is it has been a fairly capital-intensive growth with relatively little job creation.  So from 1993 to 2005, in Kus’ report, 1.1 percent per annum job growth.  That is not that surprising when you look at what has been done within the Chinese economy.  You have had financial repression; you have had sort of fairly low interest rates and so the companies have responded with fairly capital-intensive investments.  The problem with that is that one of the major challenges facing the Chinese government is you have got this sort of very large and underemployed rural population pressing in towards the urban centers, and the path that they have been on is not one that necessarily addresses that problem terribly well.

And then much like Japan, there is a heavy dependence on international demand and foreign capital.  And the theme, actually, of both the IMF and some World Bank reports has been the necessity for China to rebalance its growth and not to continue on the present path.  This one is -- and they also both note this is not sort of going to be too particularly easy because many of the things that one thinks of that sort of makes such a rebalancing go more smoothly, whether this is a really well-functioning financial system to intermediate, whether these are social safety nets to cushion the changes for the citizenry, those are not necessarily China’s strengths.

Let me now show you a couple of things just to illustrate the extent to which there has been this independence and to justify descriptions like careening.  Here, we see China’s global current account balance as a percentage of GDP.  One thing I would just note about this from a U.S. perspective is in the U.S.-China’s bilateral trade surplus with the U.S., it has been a source of concern for a very long time.  It seems like it is certainly when we were in the Council of Economic Advisers staff together, this was a point that was commonly raised, and that was around 2003.  But what you see is that the bilateral surplus is a sustainable thing; that can go on forever.  There is nothing wrong with triangular trade and this is the point that economists frequently made saying why one should not worry about China up until about this point that you can have, you know, one country’s exports to a second country’s exports to a third who exports back to the first.  Bilateral trade imbalances are nothing to worry about.

Multilateral trade imbalances are another story.  And when you have a graph of it that it starts to point almost straight up, this does suggest that there is something there that maybe difficult to sustain.  So that cannot keep going indefinitely at that pace.

Another way of looking at the same thing is this is the mountain -- foreign reserves that China is holding.  And it is just an illustration of the same point, but one of the things I would note is not only is this sort of staggering like, again, we have one of these graphs that gets fairly vertical, but it also means a mounting adjustment cost that they are facing as time goes on.  And I’ll return to that point.  And this, by the way, in the context, since we are talking about Asia more generally on the [indiscernible], that the regions -- this is something of a regional pattern.  The region’s reserve now topped $4 trillion, which seems rather large.

Okay, let me just make a note.  The way one would -- one sort of classical mechanism for how you sort of stop those very rapid ascents is you get adjustments in prices, and the key price here is the exchange rate.  And unless you are more perceptive than I am, you will look at this and you will not see the sharp break occurring in 2005; I think it is about the summer of 2005.  You will see that things actually go somewhat horizontal there. 

I raised it because that is the point at which the Chinese government says, “We have delinked - we are no longer pegging the currency anymore.  And from now on it will respond to market forces.  It will be linked to a basket and it will be allowed to move a certain amount each day.”  And since then we have seen really very little - these are three different measures and they all kind of squiggle around, but you have not seen on a multilateral basis any dramatic change in China’s exchange rate, and this is the real effect of exchange rates so it is balancing of what is happening with the relative prices.

You have seen bilateral changes with the U.S., which sort of addresses some of the political pressure here.  That has been on the order of 10 percent or so, which are what some of this are quite credible estimates that I have heard, and I did not make these things myself, calling for something like a 30 percent or more or greater appreciation of the Chinese currency as a means of addressing those rapidly mounting imbalances that we are seeing. 

In the interest of time, let me get to my mounting reservations.  This buildup of foreign exchange reserves is unsustainable.  One of the ways you do reserves -- other things equal, bringing in foreign reserves expands the money supply and you get pressures for inflation.  China has fought this by sterilizing this, which meant distributing lots of government bonds to the banks.  The deputy governor of the People’s Bank of China was in town last week and said, “We realize this is not sustainable.  It is something that just buys us some time to make the internal adjustments that we need in the Chinese economy.  We are okay for now but this is not sustainable.”  And one does -- limits on just how much banks can force fed these bonds as the sort of pressure grows.

Now, the point that I deferred from earlier is, as you get those mounting reserves, you get a double cost to adjustment, and it is a cost that grows.  There is a cost because if China were to radically change its behavior and begin to -- rather than saving an immense amount, begin to consume an immense amount and this was reflected then in the global savings investment balance, you would then see a change, a rise in interest rates to the extent that they are holding international bonds in the reserves that would drive down the price of those bonds. 

And further, the currency appreciation, given that these are foreign currency denominated bonds, the appreciation to renminbi will again cut the value of China’s holdings.  So as that mountain of reserves grows, these costs mount.  These are the costs that one has to face so it is deferring to the future costs that one is going to have to take on.

Those are the sort of financial costs that one could put a dollar or yuan value on, but there are domestic adjustment costs as well to the extent that what is maintained in the currency rate to keep certain Chinese exporting industries viable that would not be viable if you had, say, a 15 percent appreciation, you are getting investment in those sectors and the amount is going to have to then eventually move when you do have an appreciation.  It worsens the problem for the future.

Okay,