We are meeting in the midst of a particularly challenging global economic environment. The US and Japan are in recession. Growth in Europe is faltering. The IT sector is going through a prolonged correction from the bubble of the late 1990s. Sept 11 has given new uncertainty to the prospects for recovery in the US and globally in the coming year. The collapse in Argentina this week compounds the nervousness in financial markets. Taken together, it is a confluence of events that has added to fears of a ‘perfect storm’ in the global economic system.

Growth in East Asia has fallen sharply. The economies most exposed to the global electronics cycle are in recession. Only China, powered by a continental-scale domestic economy, continues to show robust growth.

The slackening in East Asian economic performance, three years after the Asian financial crisis, has renewed concerns over the commitment to reforms needed to address the structural and institutional weaknesses that contributed to the crisis. Despite significant progress in shoring up Asian banks, several East Asian financial systems remain vulnerable. The balance sheets of corporate borrowers remain fragile. Large amounts of non-performing assets have yet to change hands, transferring ownership to new managers.

The overall mood in East Asia is defensive. Looking at day to day events – economic, financial, political, or judicial – it is easy to think that East Asia has lost its way. Prolonged stagnation in Japan and recession in the economies that formerly showcased the ‘East Asian miracle’ has also led to perceptions that the East Asia economic model based on export-oriented growth is now defunct.

This fundamental pessimism over the East Asian model is overdone. East Asian economies are well-placed to capitalise on their accumulated skills and capabilities in export-oriented manufacturing, while taking advantage of growing opportunities in the service and knowledge-based economy. They will be aided by looking outward, and seeking to grow deeper regional and global inter-linkages, rather than a turn inward towards growth based on domestic consumption. Domestic markets that are less competitive than export markets will offer higher margins in the near term. But a strategy that focuses on domestic consumer markets instead of competition in global markets will ultimately reduce the pressure to innovate and to continually find new efficiencies. It is not a strategy for sustained productivity growth, which is fundamentally what it takes for superior long run economic growth. Strategies to acquire and retain external competitiveness must remain central to the East Asian economic model.

The East Asian economies will not be disadvantaged by a high natural propensity to save. It is a feature that will hold them up well as their societies begin to age over the next 10-20 years. But a more decisive shift towards market-based financial systems will be required to ensure that savings are not invested unproductively, as had been the case in many East Asian countries.

What is needed therefore is not a ‘reconstruction’ of the entire edifice of the East Asian economic model but substantial ‘renovation’ work. In some aspects, we even require ‘restoration’ work, such as a return to the conservatism in credit appraisal that characterised some Asian banking systems in earlier years. The restoration of independence in government policy making, free from capture by powerful interest groups that we now see in many East Asian countries, will also be essential for sustained economic competitiveness.

What really matters for East Asia is a shift towards open, competitive markets, and away from the state driven industrial policies and the collusive domestic networks that have led to low returns on investment. East Asian countries that persist with institutional reforms, the opening of their financial systems, strengthening of their corporate governance and restructuring of their industries to focus on areas where they are able to create true comparative advantage in the new global environment, will see renewed growth and dynamism. Those that defer reforms, fail to unwind domestic rent-seeking networks, and retreat from open markets will lose the confidence of investors and see their growth ebb.

Going forward, the ability of East Asian countries to revitalise themselves will depend in particular on their responses to three critical challenges. First, developing the innovative capacities required to participate successfully in the knowledge-based economy. Second, reforming corporate governance and building stronger capital markets. Third, responding to the challenges and opportunities posed by China’s rapid emergence as a major regional and global player.

The rapid growth of the global knowledge-based economy, both in manufacturing and services, presents an important challenge for East Asian countries. The higher-income countries in East Asia are also at an important transition point. Their relevance in the Asian and global economy is coming to depend on their ability to move up the innovation ladder. They will otherwise be unable to compete with the new lower cost producers, especially with China.

The drivers of growth in the knowledge-based economy are at the micro-level – the quality of individuals and teams, the strength of entrepreneurs, and the social and business networks that support innovation. Social capital will increasingly matter for economic competitiveness. The traditional macro prerequisites for growth – sound fiscal balances, low inflation, avoidance of excessive external imbalances – remain important. But the drivers will be at the micro level, and the increasingly critical role of government will be to provide a framework that develops talent and buoys the enterprise of individuals and firms.

The first priority in building competitiveness lies in getting education right. East Asian educational systems have by and large been a competitive strength. The more developed school systems, in Japan and the NIEs, are recognised to be superior to those in the West for the vast majority of students. However, the challenge now is to produce a greater spirit of innovation, self-learning and enterprise, beginning in schools and extending through to universities. In the less advanced East Asian countries, there is also a considerable amount of catching up to do in providing access to tertiary education, and especially in producing sufficient numbers of technical and engineering manpower.

East Asian countries that seek to be at the forefront of knowledge creation will have to build deeper local pools of research expertise, which can link up with the best international centres of research. Internationally, the cutting edge research is increasingly done in networks that pull together talent from across the world, and seek to cross-fertilise ideas developed in local clusters. An example in biomedical research is the pioneering work in developing embryonic stem cell lines by Prof Ariff Bongso, a Sri Lankan Muslim leading a team in Singapore, working in collaboration with scientists in Monash, Australia and Israel. The globalisation of innovation has been aided by the international flow and reflow of knowledge professionals themselves – especially East Asians and Indians – moving to where they find the opportunities most attractive and conducive to their work.

Going it alone strategies will not therefore succeed in the knowledge based economy, and especially not for small countries. The East Asian players that put themselves in the fast lane of international traffic of ideas, knowledge workers, and transnational investment will thrive.

Good governance will be more important, not less, in the knowledge-based economy. Government cannot create the ‘animal spirits’ of entrepreneurs, but they can either spur entrepreneurship or dampen it by way of the rules and environment they provide for enterprise. Individuals and companies involved in innovation want to minimise the uncertainties inherent in developing and exploiting new knowledge. They want transparent and stable property rights and an efficient system of legal administration. They also want a business environment that allows for rapid commercialisation of ideas, and fair competition among those seeking to develop new products and services.

East Asia has to do more work in this area. A few countries are addressing the legal issues required to meet intellectual property concerns and seeking to strengthen enforcement of the laws. But overall progress is slow. More generally, the East Asian business environment is also marked by unpredictability of regulation, and barriers to both entry and exit of firms. Notwithstanding the dot-com bust of the last two years, one of the main conduits of innovation remains the entry of new firms. East Asian countries have to remove barriers to fair and open competition, and move away from providing life support to loss-making enterprises. In other words, allow the market to work, within a framework of predictable and judicious regulation.

East Asia’s financial systems need repair. They worked relatively well in supporting economic growth for a few decades, but are now a major source of economic weakness.

The Japanese model of financial system, followed in Korea and to varying extents in some other East Asian countries, exemplifies this. Crudely described, the system had positioned banks as passive financial intermediaries, serving to channel savings to industrial borrowers and especially the large conglomerates favoured by government industrial policies. This worked well so long as industrial corporations were themselves protected from international competition, and earned the high returns on investment that characterised a phase of catch-up in industrial development and low domestic labour costs. It was also sustainable as long as savers were willing to accept low returns on the funds they placed with banks, especially where capital controls shielded the system and limited the options open to savers. These conditions have been either weakened or eliminated over time. Businesses can no longer be protected, and savers no longer restricted in their options. Institutions and housewives will increasingly seek higher yields on their savings, and their decisions will have major implications for banks and other financial intermediaries. By 2003, it is estimated that more than 20% of public pension funds and 17% of private pensions in Japan will be in the hands of foreign managers, compared to just 1% fifteen years ago. This will gradually transform Japanese finance, bringing an end to financial socialism as we have seen it.

Inconsistent and poorly supervised deregulation has accentuated the problems of East Asian banking systems. In Japan, while the deregulation of the capital market since the late 70s encouraged large borrowers to raise funds directly from the market, the large banks were restricted in their lending to smaller borrowers and prevented from engaging in new financial activities. So they went into real estate loans in a big way. Many other East Asian banks did the same in the mid-90s. In some instances, they were allowed to borrow hefty sums of short-term loans from foreign banks, to finance what appears to have been a boom in 'conspicuous construction'. Credit analysis in banks was weak, and bank supervision was less than diligent.

The basic priorities going forward are to build sound and competitive banking systems, and to diversify East Asia’s financial systems by developing more mature capital markets. A particular focus is required on building stronger risk management capabilities and better supervision of banks, which will remain for some time to come the dominant players in East Asia’s financial systems, including their capital markets.

These priorities – strengthening banks and building more mature capital markets – ultimately boil down to a more efficient pricing of risk in East Asia. It will depend in the first instance on the clear definition of property rights, independent and competent judicial officers and consistent enforcement of laws against unfair market practices. These will take time to set in place, particularly in countries where the rule of law has had little history. The efficient pricing of risk will also require improved corporate governance and disclosure practices among market participants. Some progress is being made. But a true risk culture, involving disciplined appraisal of risks and returns by lenders and borrowers, and by institutional and individual investors in capital markets, will take years to evolve.

Corporate governance is at the core of the exercise. We can have the rules and laws and more efficient enforcement of the law, but it will ultimately be the codes of conduct that evolved among market participants, and that corporations and substantial shareholders believe to be in their interests to practice, that will determine if we have got a successful financial system going.

We cannot force improvements in corporate governance too quickly, or force East Asian systems of corporate governance onto a single model. It is quite unlikely that we will see global convergence on the Anglo-American model in particular, with its reliance on takeovers as the core solution to problems of governance. The Anglo-American model has by and large out-performed the rest, but there is a certain top-of-the-cycle triumphalism in its advocacy in recent years. A longer view of history suggests that not all the merits of Anglo-American corporate governance are likely to endure.

Two countries have had the greatest influence on East Asia’s development in the last half-century, the US and Japan. Overall, the US has been the more influential player – economic, social and geopolitical – and will likely continue to be so over the foreseeable future. Japan remains a major player by virtue of its foreign direct investments, technology transfer and economic diplomacy. But Japan’s influence has waned with the continued weakness in its economy and growing disillusion with its ability to address its own problems. The flock of ‘flying wild geese’ that was used to describe an earlier phase of Japan-led economic development in East Asia is now buried in past imagination.

Asia now faces the big new fact of China’s emergence as a formidable competitor in export markets, and for foreign direct investments. It is also emerging as a regional power whose concerns have to be factored in by all parties, including the US and Japan.

China’s engagement in global trade will be subject to severe internal stresses, and its economic growth is unlikely to be smooth or uninterrupted. But it has calculated that the benefits of integrating with global markets far exceed the dislocations. It will stay engaged, and the continued expansion of its influence as a global player in coming decades is now very likely. Its weight in Asia is now expected to exceed Japan’s within 10-15 years, and will increasingly pose a challenge to that of the US. This period of rebalancing of influence in Asia will be a delicate one, and will require adjustments by all countries, including China itself.

This view is misleading. The crux of the matter is that China’s entry into global markets presents a major new source of potential supply as well as the largest new source of potential demand for products and services the world has seen in the last half-century. There will be significant disruption to existing industrial structures in other countries, but also massive new opportunities to satisfy the growing Chinese market for imports. China’s growing middle class, expected to reach 400 million by 2010, will have increasingly differentiated tastes. It is unthinkable that they will restrict themselves to locally-manufactured products, any more than the American consumer buys only American products. Internal barriers to trade within China, sometimes higher than those to external trade, will also not disappear soon. Chinese provinces, especially in the coastal region, will continue trade actively with foreign suppliers, in both services and manufacturing products. Further, global companies will seek to diversify their manufacturing facilities geographically. They will seek complementarities between their facilities in China and other Asian economies. In doing so, they will not ignore the value of accumulated technical skills, design capabilities and logistical networks in the East Asian countries where they have had a long-established presence.

I will briefly conclude. East Asia’s future prosperity will lie in allowing open and competitive markets, building stronger innovative capabilities and pursuing deeper integration within the region.

East Asian countries have to firmly entrench the institutions and the rule of the law required for a market-based economy. They will have to press on with reforms to strengthen financial systems, unwind collusive arrangements and improve transparency and accountability in corporate governance.

Competitiveness in the innovation-based economy will increasingly operate between clusters of knowledge professionals and firms rather than whole economies. Competition will also take place between groups of inter-linked clusters – cutting across national boundaries. Global connectivity will be the key to success. The nations that thrive in this environment will be those that develop the social capital essential for innovation to flourish, provide an open business environment that enables them to garner successful knowledge-based clusters, and generalise their dynamism to the rest of the economy. Good governance will be at a premium in the knowledge-based economy, more than in previous phases of economic development.

East Asia’s big opportunity is to achieve complementarities with China’s growing economy so as to boost regional prosperity. The proposed Asean-China FTA seeks to achieve this. Together, they have a workforce of more than one billion and a GDP of over US$1.5 trillion. Integration will allow businesses to better exploit scale economies in virtually every niche of industry, and to enhance value by creating more dense networks of communications, transport and trade. Achieving economic integration with China is East Asia’s biggest opportunity for the future, and managing its social, political and strategic implications its biggest challenge.