Asia should be now considering its life after China's WTO entry. Some are concerned that China would become a major deflationary force in Asia. Others are worried that China would inflict significant damages in Asia's growth by pulling foreign investment away from the rest of Asia and by intensifying Asia's production hollow-out process to the Mainland.
While the first concern is valid, as entry into 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 act as an external force to push Asia's economic restructuring. There is no free lunch for China though, as the short-term economic pains from creative destruction under WTO will be high.
A formidable force
Despite being outside the WTO and without currency devaluation during the Asian crisis, Chinese exports recovered sharply after the regional shock. Crucially, China's US export market share has risen to 24% of US imports from the Pacific Rim from less than 20% in 1997, while currency devaluation was unable to prevent ASEAN countries' market share from falling.
China possesses a big advantage of having the lowest labour costs in Asia, except Indonesia. Her excess capacity remains high, despite inventory reduction in the past few years. The supply pressure from inventory liquidation on the back of low labour cost has enabled China to cut export prices, exerting strong competitive pressure on neighbour countries. WTO-induced reform and rising competition are going to increase China's competitive power further and put downward pressure on most Asian currencies in the years to come.
China also has a few other ways (that other countries have already used) to boost exports. These include granting exporters lower taxes and lower interest-rate loans, and even devaluing the currency. The devaluation option is unlikely in the short-term due to the underlying strong appreciation pressure on the yuan and the lack of political need to do so. Beijing wants to avoid instability, including currency devaluation, in the run up to the leadership change late next year.
More importantly, the quality of Chinese exports is rising rapidly, as China's export structure has shifted rapidly towards electronics and machinery goods and away from primary goods. This suggests that Chinese exports were climbing up the value-added ladder fast, challenging even exports from Japan. This challenge can be seen in China's trade surplus with the US, which has surpassed Japan's since last year. The recent rise in Japanese protectionism mirrors Japan's fear about China's competitive threat. Since April, Japan has imposed restrictions on various Chinese imports ranging from textile to primary products. The irony is that Japanese firms are using China as a cheap production base for exports back to Japan. Thus, many of the products on Japan's protection list are actually made by Japanese subsidiaries in China.
A post-WTO China will exert financial and economic pressures on Asia. First, China's enhanced competitive power will become a long-term source of tradable goods deflation, squeezing Asia's pricing power. Foreign capital inflows will augment China's supply of capital, while an abundant labour supply (including surplus labour resulting from structural reforms) will curb any sharp rise in Chinese labour costs.
Second, economies with export structure similar to China's will feel most of the competitive stress. Thailand, the Philippines and even (surprisingly) Taiwan will face enormous competition from China. Taiwan has a particularly daunting challenge ahead, as the hollowing out process of Taiwanese investment to China will speed up. Hong Kong gives an example in this regard.
Hong Kong's whole manufacturing base was 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. Taiwanese manufacturers are going through the same pressure due to falling export prices and rising Chinese competition.
Hong Kong has succeeded in rejuvenating itself into a financial and services centre, thanks to its strong entrepreneurial spirit and unique geographical and political positions. Taiwan's challenge is to re-invent herself under the shadow of her political and economic problems.
Engine for growth and investment
Nevertheless, the emergence of China's economic clout will also benefit Asia's growth by being a source of demand. As a percentage of GDP, China absorbs as much imports from Asia as Japan. China has also been running a trade deficit with Asia since 2000. This trend is likely to continue as WTO opens more doors for Asian exports to China, whose import appetite will also grow under rising income growth and demand for industrial upgrading.
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
One reason for this complementarity is that Asian economies are at different development stages, so that FDI may be drawn to comparative advantages in the region - some to abundant labour and some to technological know-how.
Another reason is that multinational companies' desire to be closer to their customers and production partners often drive investment along the global production chain. Hence, foreign investment has been diversified in Asia's dispersed marketplace and production base.
Rising foreign investment into China is not a zero sum game. Economic ties between China and Asia are buoying intra-regional investment and trade flows, providing a cushion for Asian exports when demand slows in the US and Japan. While China is likely to continue to get the bulk of foreign investment inflow, global outsourcing means that the investment pie is growing in Asia. Strong FDI inflow to China will benefit the rest of Asia via intra-regional demand for goods and services according to the law of comparative advantage.
Push for reform
More subtly, China could become a force pushing reforms in Asia. Most governments slipped on reforms during the V-shape economic rebound after the 1997/98 Asian crisis. Firms have been reluctant to sell off assets and reduce debts. Banks have been slow in writing 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 more and debt-ridden corporates cannot borrow more.
Japan is a prime example of why fiscal expansion without reform only produces minimal growth. Tokyo has spent around $1 trillion since 1993 on stimulus packages, but the economy has only crawled at an annual average growth of 1.6%. Thus, from a reform perspective, Asia's large trade surplus is not a sign of economic vigour, because it partly reflects a failure to generate strong domestic demand due to insufficient reforms so that Asia's economies have to rely on export demand for growth.
Southeast Asia, except Singapore, is at risk of being marginalised as a site for foreign investment because the region lacks the reform aggressiveness 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 liberalise its economy under the WTO, other countries will be pressed to follow to meet the Chinese challenge.
At the end of the day, China's success will spur Asia's reform efforts. There may be uneven development in Asia on its road to become more efficient, with specific spots of strong performance coexisting, uneasily, with areas of weakness. China could well be a catalyst for raising the level of welfare across Asia, but not a bull in the china shop.
By Chi Lo, Chief Economist (NE Asia), Standard Chartered Bank Global Markets, Hong Kong