Document View

Asia is now considering its economic prospects as China enters the World Trade Organization (WTO). Some investors are concerned that China will become a major deflationary force in Asia. Others are worried that China will inflict significant damage on Asia's growth by pulling away foreign investment and by increasingly hollowing out Asia's manufacturing base as facilities continue to shift to the mainland.

Though the deflation concern is valid, as entry to the WTO will help consolidate China's competitive power, the second fear is flawed. Asia has not lost, and will not lose, foreign investment to China. Rather, China's improving economic well-being will benefit Asia's exports in the long term and will exert external pressure on Asian economies to restructure.

China will not enjoy a free lunch in the WTO, however. The short-term economic pains from creative destruction will be high. This creative destruction has been under way for some time and includes the ongoing reform of China's inefficient state sector, which now produces less than 25 percent of China's total industrial output, down from over 80 percent in the early 1980s. In recent years, the closure of state-- owned enterprises has released about 7 million surplus laborers into China's economy annually, raising China's true unemployment rate to an estimated 8 percent or more, as opposed to the official 3.1 percent. But the country's positive cyclical and reform outlooks point to steady economic growth, in turn encouraging continued reforms. China thus will remain an attractive investment hub while Asia struggles in the short term to find balance in an ever-more competitive world.

A formidable force

Enlarge 200% Enlarge 400%

Chinese exports recovered quickly after the 1997-98 Asian financial crisis, even though China was not a WTO member and did not devalue its currency like its Asian neighbors. Indeed, other Asian countries were unable to prevent a loss of market share to China despite their currency devaluations. China now accounts for 24 percent of US imports from the Pacific Rim, up from less than 20 percent in 1997 (see Figure 1). The composition of these imports has remained relatively unchanged during this period and includes electrical and power-generation equipment, apparel, furniture, and plastics.

China's advantage over other Asian nations is that it has the lowest labor costs in the region after Indonesia (see Figure 2). In addition, China's excess capacity remains high, despite inventory reductions in the past few years (see Figure 3). Inventory liquidation has put pressure on supply levels and, together with low labor costs, enabled China to cut export prices and win market share from its neighbors.

WTO-induced reform and rising competition will increase China's competitive power and put downward pressure on most Asian currencies in the years to come. China's export push has already exerted deflationary pressures on Asian export prices (see Figure 4) and currencies, though China's currency has not come under such pressure itself. There is nevertheless a chance that volatility in the foreign-exchange market could lead to a vicious cycle of competitive devaluation, which could pressure China to lower the value of the renminbi (RMB).

Enlarge 200% Enlarge 400%

Enlarge 200% Enlarge 400%

A difficult transition

Opening up to foreign competition will inflict short-term negative shocks on the Chinese economy. The dismantling of nontariff trade barriers, such as burdensome administrative and customs procedures, will cause a greater competitive shock than the nominal tariff cuts imply. Industries that have relied on these protective barriers to survive will suffer. Rising competition will also shock China's financial system, given its shaky foundations.

WTO membership will boost China's labor-- intensive industries and increase exports that rely on imported inputs, since imports will become cheaper. However, capital-intensive industries, such as steel, automobiles, agriculture, machinery, and heavy chemicals, will suffer in the short term, given China's comparative disadvantage in capital-intensive production.

In the next few years, China may opt to undertake policies, like those that other Asian countries have implemented, to boost exports further. These include granting exporters lower taxes and loans at lower interest rates, and even devaluing the RMB. China is unlikely to choose devaluation in the short-term, however; there is actually strong underlying pressure on the RMB to appreciate, not depreciate, because of the country's strong balance of payments surplus. There is also little political necessity. Beijing wants to avoid any move that could trigger instability, including currency devaluation, in the run up to the leadership change late this year.

Challenging Japan

Chinese exporters are already competing with Japanese companies, as China's export structure has shifted rapidly towards electronics and machinery and away from primary goods (see Figure 5). Last year China's trade surplus with the United States finally surpassed Japan's US trade surplus (see Figure 6).

Japan has good reason to worry: the fast climb of Chinese exports up the value-added ladder has led to a record trade surplus with Japan. The cheap prices and rising quality of Chinese exports have prompted many Japanese industries to seek government protection. The irony is that, after the initial wave of expansion into China's vast domestic market in the late 1980s, Japanese firms are rediscovering China as a cheap production base for export back to Japan. Thus, many of the products on Japan's protection list are actually made by Japanese subsidiaries in China.

Pressuring Asia

China's enhanced competitive power will not only have short-term economic effects on Asia, it will become a long-term source of deflation for tradable goods, squeezing Asia's pricing power. Foreign capital inflows will augment China's supply of capital while an abundant labor supply, which will include surplus labor resulting from structural reforms, will curb any sharp rise in Chinese labor costs. China's downward pressure on Asian currencies will also continue under WTO.

Enlarge 200% Enlarge 400%

Enlarge 200% Enlarge 400%

Economies with export structures similar to China's will feel most of the competitive stress. Thailand, the Philippines, and even Taiwan will face enormous competition from China in primary and low value-added industries, such as agriculture and textiles, respectively. Taiwan faces a particularly daunting next few years, as Taiwan investment moving to the mainland will speed up. Hong Kong serves as a case in point. Hong Kong's entire manufacturing base relocated to China within a decade in the 1980s to escape high local production costs, leaving only the high value-added segments, such as logistics and marketing, in the territory. Taiwan manufacturers are experiencing the same pressure from falling export prices and rising Chinese competition. Hong Kong succeeded in rejuvenating itself into a financial and services center, thanks to its strong entrepreneurial spirit and unique geographical and political positions. Taiwan's challenge is to reinvent itself under the shadow of its political and economic problems (see p.28).

A growth and investment engine

Nevertheless, the emergence of Chinese economic clout will also benefit Asia's growth by being a source of demand. As a percentage of its GDP, China imports as much from Asia as Japan does. China has also been running a trade deficit with Asia since 2000. This trend is likely to continue as the WTO opens more doors for Asian exports to China and as China's import appetite grows in step with incomes and demand for industrial upgrades.

Contrary to common perceptions, China has not gained foreign direct investment (FDI) at the expense of the rest of Asia. In fact, FDI inflows to Asia have risen along with inflows to China (see Figure 7). This is in part because multinational companies want to be closer to their customers and production partners and therefore have invested throughout the global production chain. Also, Asian economies are at different stages of development and FDI has gone to areas with comparative advantages-- some to countries with abundant labor and some to countries with technological know-how.

Economic ties between China and Asia are buoying intraregional investment and trade flows, providing a cushion for Asian exports against slowing demand in the United States and Japan. While China is likely to continue to receive the bulk of foreign investment to Asia, global outsourcing means that the Asian investment pie is still growing. Strong FDI inflows to China will benefit the rest of Asia via intraregional demand for goods and services.

A push for reform

More subtly, China could also become a force for reform in Asia. Most governments slipped on reforms as their resolve eroded during the sharp economic rebound after the 1997-98 Asian crisis. Firms have been reluctant to sell off assets and reduce debts, and banks have been slow to write off bad loans.

The failure of many governments to implement reforms after the Asian crisis is worsening Asia's economic drag, as weak banks and inadequate corporate reform have crimped domestic expansion. Interest rate cuts have become ineffective in boosting demand, as banks saddled with bad loans are reluctant to lend and debt-- ridden companies cannot borrow.

Enlarge 200% Enlarge 400%

Enlarge 200% Enlarge 400%

Japan is a prime example of how fiscal expansion without reform produces minimal growth. Tokyo has reportedly spent around $1 trillion since 1993 on stimulus packages, but the economy has only crawled along at an annual average growth of 1.6 percent. Thus, from a reform perspective, Asia's large trade surplus is not a sign of economic vigor; rather, it reflects, in part, a failure to generate strong domestic demand because of insufficient reforms. Asia's economies still rely on export demand for growth.

Southeast Asia, except Singapore, is at risk of being marginalized as a site for foreign investment because the region lacks the aggressive reforms and the economic size of China. Beijing has pushed ahead with structural reforms since the Asian crisis, while many Asian governments have failed to sustain their restructuring efforts. As Beijing continues to liberalize its economy according to WTO mandates, other countries will be pressed to follow to meet the Chinese challenge.

China's success will ideally spur Asia's reform efforts and lead to a more productive region in the long term. In reality, Asia may experience uneven development on its road to greater efficiency, with areas of strong performance coexisting, uneasily, with areas of weakness. Nevertheless, a strong Chinese economy will not be a bull in the china shop, but rather will raise the level of welfare across all of Asia.

Enlarge 200% Enlarge 400%