Project: Global Public Goods and the Hegemonic Structure
Modelling
The seminal paper [On the Number and Size of Nations, Quarterly Journal of Economics 112 (1997) 1027-1056] by Alesina and Spolaore was motivated by the question of how new nations are formed after the collapse of the Soviet Union. They use a functional form of utility in which utility derived from a public good depends on the distance to a public good provider. The border between nations is decided by majority voting where the citizen at the border is indifferent between two sides of the border.
This project seeks to understand the provision of public goods at the supranational level instead of the national level in the context of two superpowers competing for political and economic influence in Asia Pacific. Naturally distance in our project is interpreted as economic distance proxied by trade and investment relationships. When we consider interactions among nations, we need to allow countries to change their economic distance with respect to each other. To maintain a meaningful mass to calculate cost, we consider a discrete number of countries.
We also allow for the possibility of one country to single-handedly provide a public good and establish a hegemonic structure. If countries would like to form alliances, all countries must find a compromise as to where public goods should be located. This is different from forming nations. While decision to change a nation’s public good is decided by majority voting, decision regarding international coalitions require approval by all members—the principle of sovereignty.
The discrete setup allows us to change the economic locations of countries and perform comparative statics on the resulting structure and as a result, derive implications for future coalitions and hegemonies.
The public good considered in our model is a club good, that is, it is excludable. Goods are non-rival, i.e., one country’s consumption will not diminish another country’s consumption. (The utilisation of special drawing rights (SDR) in the IMF by one country does not affect other countries’ SDR.) However, including more members has implications for the location of the public good—the headquarters of decision making may be Beijing, Tokyo or Washington—and hence the benefits to existing members. As a result, the optimal size is not necessarily the largest possible size.
One of the major concerns in the current political economy scene is the uncertainty over both the US’s commitment in the region and China’s willingness to take a more leading but not aggressive role. Therefore, we would like to examine the robustness of a hegemonic structure under exogenous shocks and prescribe the best responses for other countries facing uncertainties.
Quantitative analysis
“Distance” and “public good” are the model’s key parameters and they are intricately linked. Choosing a particular data set for “distances” necessarily narrows the range of relevant public goods, and vice versa. For example, if we use trade data to model distances, the most immediate public goods are Free Trade Areas such as the Trans Pacific Partnership (TPP), Regional Comprehensive Economic Partnership (RCEP), the Free Trade Area of the Asia-Pacific (FTAAP) and the ASEAN Economic Community (AEC).
To what extent is the growing degree of international financial integration in Asia Pacific a regional phenomenon? Do the various types of intra-regional capital flows involving bonds, equity as well as foreign direct investments (FDI) reflect the “preferences” of the countries in Asia Pacific for public goods? If we use foreign direct investment (FDI) data, the most immediate public goods are the US dollar as the currency for foreign reserves and trade settlement or the governance structure in the World Bank, the ADB and the IMF, and now in the AIIB and NDB which may be proxied by voting powers in these institutions. Thus the project will investigate how trade and investment relationships can proxy “preferences” for such public goods.
Some earlier works on intra-regional capital flows in the Asian region such as Hattari and Rajan (2009) for instance, have empirically tested for the importance of distance in explaining intra-Asian FDI flows. The paper specifically examines intra-Asian FDI flows using bilateral data to test if the so-called “distance puzzle” that seems to have characterised trade and FDI based gravity models also apply to the case of intra-Asian FDI flows. They find that both informational distance and physical distance as well as bilateral trade flows strongly condition intra-Asian FDI flows.
Of importance is also the fact that a large part of the upsurge in global FDI flows has been due to mergers and acquisitions (M&As) as opposed to greenfield FDI and M&A activity has been quite significant to the region. In this context, Li, Hattari and Rajan (2014) examine the extent and determinants of M&As to and from developing Asia with particular emphasis on the financial drivers of intraregional M&As. The results suggest that country sizes and distance appear to be robust predictors of intraregional M&A flows, with global risk and liquidity conditions also showing up as an important driver of such flows.
Interestingly, an analysis of M&As are becoming important in the region also because of the major concerns about the quality of available FDI data at the bilateral level. Such data used to assess de facto real linkages between countries is based on flow of funds rather than ultimate ownership. This implies that a large part of such flows are channelled through offshore financing centers limiting the usefulness of assessing bilateral real linkages. Considering that the quality of available bilateral FDI data presents a potentially misleading picture in trying to understand economic linkages between countries, as Gopalan and Rajan (2014b) propose, reconciling FDI data with M&As could be a potential alternative as M&A data are based on actual ownership.
Hattari and Rajan (2011) also test whether distance affects both foreign portfolio investment (FPI) and FDI flows equally? In other words, does distance change the composition of capital flows? The paper finds that distance affects FDI relatively more than FPI. Further, consistent with the fact that FDI in the form of M&A does not involve as much sunk costs compared to greenfield and is also much easier to liquidate, the results suggest that distance seems to hinder greenfield investment relatively more than M&A. The findings also suggest that distance has an almost equal inhibiting impact on FDI in the form of M&A and FPI, consistent with the fact that they are broadly similar financial transactions with different ownership thresholds. An important area for future research would be to try and ascertain whether the extent of foreign equity stakes matter, i.e. ownership versus control.
Thus there are different implications of distance that could be factored in as an extension of prior literature. We propose that when investigating distance capturing trade and investment relationships, we would aim to develop an index that incorporates information on political capital and the vested interests of the government in power besides traditional measures such as trade and non-trade barriers, regulations and rule of law. The index will measure the degree of financial as well as trade liberalisation and the political feasibility of such liberalisation. The index will reveal the preference of each country for joining one or the other multinational organisations mentioned above.