The McKinsey Quarterly - United Nationsunpan1.un.org/intradoc/groups/public/documents/... · The telecom sector is a case in point. ... 42 The McKinsey Quarterly 2004 Number 1 Integrating

The McKinsey Quarterly 2004 Number 136 Integrating Southeast Asia’s economies 37Lee Tra

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The McKinsey Quarterly 2004 Number 136 Integrating Southeast Asia’s economies 37

On the face of it, Southeast Asia should be an investor’s paradise. It offers a market of 560 million people, rich natural resources, skilled labor, and an export industry concentrated in global high-growth sectors—all tied together in a free-trade area created by the Association of Southeast Asian Nations (Exhibit 1, on the next page). In fact, ASEAN’s $330 billion consumer market equals that of China’s booming coastal region in value and is bigger than any other market in Asia. The group’s ten member countries (Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand, and Vietnam) control 40 percent of the oil and gas resources in the Asia-Pacific region and boast a strong industrial base benefiting from relatively low wages in attractive sectors such as consumer electronics, PCs, and semiconductors.

Yet after achieving higher economic growth than virtually any other part of the world since ASEAN’s inception, in 1967, the region has slipped dramatically in the wake of the Asian financial crisis that began in 1997. Foreign direct investment shrank by two-thirds, and aggregate economic growth dropped by 50 percent—in stark contrast to China’s surging investment, exports, and GDP growth (Exhibit 2 , on the next spread). Although the financial crisis hit investment and growth hard, the pain-fully slow recovery—and the widening gap with China—signal more basic problems. In an increasingly globalized economy, investors can pick and choose their markets according to the cost of labor, capital, and materials as well as the productivity of companies using these factors. Southeast Asia is losing its competitive edge.

Integrating Southeast Asia’s economies

The region is falling behind its rivals. Turning it into a true single market would boost its competitiveness and help restore its economic luster.

Adam Schwarz and Roland Villinger


Our yearlong study1 of the region has led us to conclude that ASEAN can no longer compete on low labor costs alone. In 2002, a civil engineer in Thailand earned an average of $397 a month, compared with $163 in China. A software developer made $927 a month in Thailand, compared with $490 in India. To make the region competitive again, ASEAN’s leaders must raise workers’ productivity and cut costs across the production value chain, thereby boosting demand, foreign direct investment, and exports. By extension, the rate of GDP growth will rise as well, since each time a company increases its productivity, it generates an economic surplus, which becomes available to consumers as lower prices, to employees as higher wages, or to shareholders as higher profi ts.

1McKinsey’s ASEAN Competitiveness Study, whose fi nal report was completed in August 2003, was commissioned by ASEAN’s economic ministers. The work was carried out by Jim Ayala, Eleanor Chye, Ken Gibson, Tobias Hoschka, Tsun-yan Hsieh, Nicholas Kukrika, Vincent Palmade, David San Pedro, Adam Schwarz, Roland Villinger, Soegeng Wibowo, and Angeline Yeap.

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ASEAN’s productivity challenge must be tackled through both national reforms and regional integration. Member countries should remove homegrown barriers that raise costs, reduce competition, and deter new investment (see sidebar, “The domestic agenda,” on the next spread). Equally important, ASEAN must find the political will to reduce further the tariffs and nontariff barriers that raise the cost of doing business across the region’s borders.

These reforms would in effect create a single production platform—as well as a large home market—throughout Southeast Asia, thus enabling companies to realize economies of scale and to capitalize on the region’s comparative advantages.2 They would also provide the incentive global companies need to increase direct investment in Southeast Asia.

The price of fragmentationToday the ASEAN countries are less a unified market for goods and services than a collection of disparate markets. The consequences aren’t lost on investors, who shy away from the higher costs, uncertainty, and subscale markets that fragmentation creates.

2 The leaders of ASEAN took an important step down that road at their annual summit in October 2003, when they endorsed an accord to create a single market—the ASEAN Economic Community (AEC)—by 2020.

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A lack of unity . . .Intraregional trade as a percentage of the region’s total trade is perhaps the best measure of ASEAN’s economic integration. From 1994 (when the group launched its free-trade area) to 2001, intraregional trade as a proportion of total trade fell by 19 percent. By comparison, it rose by 41 percent in the first ten years of the European Union, by 17 percent in the first seven years after the inception of the North American Free Trade Agreement (NAFTA), and by 67 percent in the first nine years of Mercosur’s existence.3

A second sign of ASEAN’s economic fragmentation is the continuing high divergence of consumer prices in the region’s countries, as we found when we analyzed the cost of 70 common household products in most of them. The same packet of instant noodles, for example, costs nearly twice as much in the Philippines as it does in Malaysia. On average, prices for the same goods varied by 31 percent across the region. In an integrated market, prices should converge—and fall—as the lowest-cost suppliers export to the rest of the region and less efficient producers must improve their productivity. In the European Union, price differences for the same goods fell to an average of 5 percent after the launch of the single European market, in 1992, compared with 17 percent in the mid-1980s.

. . . puts off global investorsAs our 100 -plus interviews with investors and executives in the ASEAN

countries and around the world show, the higher costs of doing business in the region’s fragmented market stand in stark contrast to the integrated Chinese market’s larger economic potential. Investors cited three main concerns about ASEAN:

Subscale markets. Since ASEAN isn’t integrated, companies can’t manufacture and market goods for the whole region’s large and attractive consumer market. The challenge for ASEAN’s companies is to reach production levels allowing them to operate at an economically efficient and globally competitive scale. Every carmaker in the region, for example, has production runs of fewer than 150,000 units a model—the low end of the minimum efficient scale for auto manufacturing.

Unnecessary costs. Different product standards across member countries prevent businesses from standardizing products—a problem that can add 10 to 15 percent to operating costs. Until recently, for instance, a company that served both the Indonesian and Thai soap markets needed different production runs to manufacture 100-gram (0.22-pound) soap bars because in Indonesia weight is measured at the factory while in Thailand it was measured on the shelf. Evaporation during transport meant that soap bars

3 Mercosur is a free-trade zone comprising Argentina, Brazil, Paraguay, and Uruguay.

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had to be produced at 104 grams for the Thai market. Thailand ended this anomaly last year, but countless similar cases remain across the ASEAN

region. An executive at a processed-foods company, for example, told us that different product standards for ice cream routinely add three months to intraregional deliveries, thereby lengthening factory-to-shelf times, causing stock-outs in shops, and ultimately raising consumer prices and the company’s cost of working capital.

Unpredictable policy implementation. Investors expressed frustration over the way certain policies are implemented and doubted ASEAN’s willingness and ability to integrate. An executive at a consumer goods company, making a common complaint, explained that ASEAN’s tariff rates were determined more by the whim of customs officials than by government policy. Although the ASEAN Free Trade Area (AFTA) has a 0 to 5 percent tariff band on raw materials, officials in some countries demand higher payments, adding millions of dollars to the company’s charges. A represen-tative of an electronics company noted that identical parts can take from one day to more than five weeks to clear customs.

The domestic agenda

ASEAN countries must make two broad reforms for the region’s businesses to reach their productivity potential. The first is to remove regulatory barriers protecting companies from competition, the second to stop keeping small, unproductive firms afloat by tolerating their evasion of taxes, labor rules, and product regulations.

The McKinsey Global Institute’s study of Thailand’s productivity performance1 found that sectors protected by entry barriers such as investment restrictions and licensing requirements are characterized by low productivity, in contrast to competitive sectors, which rapidly improved their productivity. The telecom sector is a case in point. State ownership and archaic regulations hold back fixed-line telephony, whose productivity, as measured by the number of installed lines per employee—a key indicator—is only 60 percent of the US level. Yet companies in the liberalized mobile-telephony sector have roughly the same number of installed connections per employee as their US counterparts. This difference demon-strates the powerful forces unleashed by sectoral reforms that increase competitive intensity.

Unequal enforcement of regulations in many ASEAN countries encourages small, unproductive firms (in residential construction and retailing, for example) to remain inefficient and go on evading regulations. Enforcing tax and labor laws would compel these firms to raise their productivity or be replaced by more productive companies. Illegal logging, for instance, is a problem in nearly all ASEAN wood-producing nations and threatens the whole regional forestry industry. Improving enforcement would cut the available supply and squeeze nonproductive operators (which can afford only illegal wood) out of the market. Competitive players would have to use wood in the most productive way by making higher-value-added products. And ensuring sus-tainable forestry would secure the future of the raw material the industry needs to survive.

1 The study was undertaken in 2001 by McKinsey in collaboration with two leading Thai economic-research institutes. See Pornchanok Tanskul and Roland Villinger, “Thailand’s chance for no-pain gain,” The McKinsey Quarterly, 2001 Number 4 special edition: Emerging markets, pp. 24–7 (www.mckinseyquarterly.com/links/10796).

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The benefits of integrationWhen markets integrate, increased economies of scale and scope, competi-tion, and productivity at the company level all lead, at the regional level, to higher investment fl ows, more intraregional trade, and the emergence of robust, globally competitive enterprises. Judging from the European Union’s experience, the benefi ts of deeper integration across the ASEAN

economy would be on the order of 10 percent of the regional GDP, distributed over several years.

For a better understanding of how economic integration would benefi t businesses in these countries, we studied two sectors in detail: consumer goods and electronics. Consumer goods, the region’s largest traded sector, account on average for 58 percent of household spending. Electronics, the region’s most important export sector, represents some 50 percent of ASEAN exports. Jobs are at risk in this sector unless rapid action is taken to boost the region’s competitiveness.

Our case study in the electronics sector reveals that market reforms to increase regional integration could cut the costs of companies by 10 to 20 percent (Exhibit 3). Manufacturing costs will fall for two reasons. First, a bigger consumer market reduces per-unit overhead and direct-labor charges. Second, lower tariffs on components and the ability to buy the cheapest inputs regardless of country of origin within the region lead to lower components costs. Thanks to improved effi ciency in collecting customs, logistics costs will fall—both directly (because of speedier deliveries and lower warehousing and administrative costs) and indirectly (through improved inventory management).

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The study of the consumer goods sector yielded similar results. In all, greater market integration could cut the expenses of companies by up to 20 percent. Scale economies could eliminate about 10 to 12 percent of the cost of production by concentrating it in fewer, more specialized plants in the region. Faster factory-to-shelf times—particularly important in the food business, where freshness is critical and shelf life limited—could provide a further 5 or 6 percent worth of savings, since every individual food shipment would no longer be subject to inspection and regulatory approval, which now take up to three months. Faster factory-to-shelf times would also reduce working-capital requirements, with a cost effect of around 2 percent.

Achieving a single marketOur study highlights a number of factors that have diluted ASEAN’s previous efforts to integrate its ten economies. Foremost among these factors has been a lack of political will in most of the region because of widespread uncertainty among policy makers and business executives about the end goal of economic integration and its benefits for individual countries.

This lack of political will is also reflected in ASEAN’s past reluctance to create regional institutions to expedite decision making and raise investor confidence in the integrity of the group’s commitments. ASEAN remains primarily a government-led trade group. Members propose and consider policies collectively, make decisions by consensus, and rely on mutual trust to implement policies. This approach has helped preserve regional stability but is less suited to dealing with the myriad technical policies that economic integration requires. The ASEAN Secretariat has neither the power nor the resources to formulate and propose policies, coordinate their implementation, monitor compliance, and settle disputes. Weak regional institutions have been a key reason for the relatively low impact of ASEAN’s previous initiatives to reduce tariffs, eliminate nontariff barriers, and enhance regional cooperation.

To set in motion the benefits that increased regional economic integration can bring—and to overcome the factors now blocking it—ASEAN countries should implement a two-pronged integration plan: a sector-based approach to focus the region’s integration efforts and a set of reforms to create regional institutions and processes strong enough to manage the urgent and complex tasks involved.

Fast-track sectorsReforms across the entire economy are not only politically difficult but also risky. A well-targeted approach focused on sectors, by contrast, would show more clearly the benefits of integration over time and generate political support for extending the program.


We recommend that ASEAN begin an accelerated integration program in selected critical sectors—mainly consumer goods and electronics—and then roll out the program more broadly.4 Four initiatives should be pursued to achieve genuine economic integration:

Eliminate nontariff trade barriers. ASEAN’s most urgent priority is to remove nontariff trade barriers. The group must increase the efficiency of customs, harmonize or mutually recognize product and technical regula-tions, and remove duplication in testing and licensing procedures. In the electronics sector, for example, most ASEAN countries don’t recognize one another’s technical regulations, testing requirements, and certification procedures. The result is a confusing welter of rules that indirectly raise costs for companies. ASEAN must accelerate the work of harmonization and move toward regional performance directives—a more flexible and cost-effective way of synchronizing regulations across countries. Instead of indicating detailed product-specific technical requirements that may change, performance directives identify the essential performance requirements for a given type of product.

Enhance tariff reform. Eliminating internal (intraregional) tariffs on trade as soon as possible will diminish the amount of paperwork and speed up customs clearance. In electronics, for instance, average internal tariffs are about 3 percent across ASEAN. These low tariffs (the International Monetary Fund calls them “nuisance tariffs”) can be eliminated with little effect on government revenues. In addition, the closer alignment of each member country’s external (interregional) tariffs, which today vary by up to 30 percent, would discourage countries from using tariff policies as a competitive inducement to investors and make it easier for ASEAN to negotiate trading arrangements with other countries and trade groups. Starting with important inputs in priority sectors, ASEAN should institute bands with maximum tariffs for each line of products.

Create a level playing field for capital. Eliminating restrictions on cross-border investments within ASEAN will let more companies reach greater scale in the region. Introducing an ASEAN-wide competition policy will discourage cartels and anticompetitive behavior and ultimately lead to a more level playing field.

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4 At the October 2003 leaders’ summit, ASEAN decided to accelerate the pace of integration in 11 priority sectors. Efforts are to be coordinated by different member countries: wood-based products and automotive by Indonesia, rubber-based products and textiles and apparel by Malaysia, agriculture-based products and fisheries by Myanmar, electronics by the Philippines, e-ASEAN (IT linkages and development) and health care by Singapore, and air travel and tourism by Thailand. While the ambitious effort to deepen integration across 11 sectors is praiseworthy, two key problems should be highlighted: timetables with milestones for progress have not yet been specified, and little progress has been made streamlining and clarifying ASEAN’s decision- making processes.


Improve regional collaboration. Greater and more targeted cooperation in several important areas will reinforce the development of a single market. One important task is to promote an easier flow of skilled labor across the region. Cooperation is also needed to streamline the management of financial and technical support for less developed members, to establish and share regional testing facilities to certify products, to automate and network customs departments, and to create regionally enforceable protection for intellectual-property rights (perhaps by establishing one patent bureau for the region).

Strengthening institutionsASEAN’s current governance model, in which existing national structures (such as ministries of trade) hammer out agreements, can work well for free-trade areas like NAFTA with few members. But for a large regional grouping, such as the European Union, with its deeper aspiration of creating a single market, strong regional institutions are needed to handle complex integration efforts involving many countries, sectors, and issues. ASEAN will realize its ambition to create an economic community only if it also develops effective regional institutions and efficient decision-making processes. Without institutions representing the interests of the whole group, ASEAN in effect grants a veto to any country that resists regional economic integration. It is important to stress that stronger regional institutions need not diminish the sovereignty of any member country or take away its rights over the political agenda of integration. Rather, stronger institutions are needed to facilitate and implement the direction determined by the group’s political leaders.

ASEAN will need to develop an institutional framework, representing global best practice among successful trade groups, in five critical areas:

1 To set the direction, ASEAN should develop and formally approve a detailed economic action plan explicitly stating the group’s economic goal as well as the time lines, resources, and institutions required to achieve it.

2 To formulate policies more efficiently and professionally, ASEAN should entrust the development of technical policies to a strengthened Secretariat responsible for outlining the scope of the policies, assessing their potential impact, developing recommendations, and syndicating draft policies with members. Responsibility for political decisions would remain with each government. For technical policies, ASEAN should move from consensus to qualified majority voting.

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3 To support the effective implementation of policies, each member country should establish one national coordinating unit that would communicate policies to domestic ministries and coordinate domestic implementation and compliance.

4 To monitor the implementation of policies, ASEAN should move away from its current ad hoc data collection and set up an objective monitoring bureau using regularly updated, publicly disclosed “scoreboards” to publicize member countries’ compliance records.

5 To settle disputes, ASEAN ought to establish an independent, professionally administered mechanism to handle any failure of member countries to implement their integration commitments.5

Building momentum nowTo build on the momentum generated by the October 2003 announcement of an ASEAN Economic Community, the group should move quickly to provide a more robust vision and to lay out a clear development plan for

the region’s economic future. Such a plan—the foundation of any integration effort—would be critical for driving the dramatic change involved in creating a single market.

ASEAN must also launch a com-prehensive and well-endowed communications plan to explain the objectives and expected benefits of greater economic integration to the region’s government officials, the general public, and other key stakeholders—global investors, large local companies, and

small and midsize enterprises. Understandably, many stakeholders worry that regional integration will hurt them. Some countries, especially the less developed ones, fear that the benefits of deeper economic integration will pass them by, others that the region spans too broad a range of economic-development levels for integration to work well.

Our analysis suggests that such concerns are largely unfounded; it is the diversity of these economies that makes regional integration beneficial

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5 ASEAN leaders agreed at their October 2003 summit to establish a monitoring function and to revise the dispute-settlement process.


Adam Schwarz is a consultant in McKinsey’s Singapore office, and Roland Villinger is a principal in the Bangkok office. Copyright © 2004 McKinsey & Company.

All rights reserved.

for the whole group, since the comparative advantages of one country complement those of another. Consider the television value chain. Semiconductor parts for TVs are made in Malaysia, the Philippines, and Singapore. Cathode ray tubes, a core component, are produced in Malaysia, Singapore, and Thailand, which together command 35 percent of the global market. Other components are sourced mainly from Indonesia and Thailand. TV sets are assembled and tested in most ASEAN

countries. ASEAN’s less developed economies (Cambodia, Laos, Myanmar, and Vietnam) could leverage their cost advantage in this chain—a role they now largely can’t play, because of the high transactional costs of moving goods from one ASEAN country to another.

Experience from other trade groups suggests that these less developed countries have the most to gain from integration. In the European Union, GDP growth has been far higher in Ireland, Portugal, and Spain, which were largely agricultural when they joined, than for Britain, France, and Germany. Similarly, in NAFTA, Mexico has grown faster since integra-tion than the United States or Canada (Exhibit 4). Studies indicate that regional economic integration significantly contributed to the relatively high growth rates the less developed countries experienced after integration.

ASEAN’s less developed members will continue to need assistance, both technical and financial, from the wealthier members and from bilateral and multilateral donors. This assistance is crucial not only to ensure the timely implementation of integration initiatives but also to bridge the development gaps between countries.

ASEAN has come a long way since its beginnings, but both the group and the world have undergone dramatic changes over this period—changes that have presented new challenges and demands. Closer and deeper integration of the ten ASEAN economies will play a critical role in rebuilding the group’s competitiveness and paving the way for higher rates of growth and wealth creation. Q

Documents

The McKinsey Quarterly - United Nationsunpan1.un.org/intradoc/groups/public/documents/... · The telecom sector is a case in point. ... 42 The McKinsey Quarterly 2004 Number 1 Integrating