Emerging Asia Riskwatch Volume 6: The Challenge from China
asialine.dfat.gov.au
23 August 2002
In the first volume of Emerging Asia Riskwatch we suggested that one key driver of country risk for the region over coming years would be the challenges and opportunities posed by the growing economic importance of China.
The pessimistic view of the rise of China as a world trading power is that hyper-competitive Chinese exporters will squeeze producers in other regional economies, while a more attractive Chinese market will capture a steadily greater share of the foreign direct investment and other capital flows into the region. In contrast, the optimistic view is that a faster growing, more open Chinese economy will provide a dynamic export market for the rest of emerging Asia, and hence provide an important boost to regional output and trade.
Over the longer term, we expect a variant of the optimistic scenario to prevail, with China becoming an important driver of regional growth, provided that policymakers persist with the necessary economic and structural reforms. Nevertheless, it seems likely that some regional economies and industries may have to deal with a painful transition process in the short- and medium-term.
A look at the data confirms that China and the rest of emerging Asia compete in many of the same third markets. But while China has made significant gains in terms of its share in world trade, there is no clear evidence at the aggregate level that this been at the expense of the rest of the region. There are also significant differences in export structures across the region, although the data does reveal a growing degree of overlap in terms of products traded. An examination of the correlation between Chinese manufacturing exports and those of the rest of the region, for example, finds that the similarity of export structures has risen over time, and that competition is likely to be most intense in sections of the clothing, footwear and electronics industries. At the same time, the numbers also confirm that China is becoming an increasingly important export market for the rest of the region.
China in the world economy
China is an increasingly important player in the global economy. In 2000 accounted for about 11.5% of world output when GDP is measured on a purchasing power parity basis. In the same year, China was the world's fifth largest exporting nation, the source of about 4% of total world exports.
Source: IMF World Economic Outlook and WTO
China's economic weight in the world has been rising steadily since the 1980s, and the country's accession to the World Trade Organisation (WTO) on 11 December last year marked another significant step in China's growing international integration. Of course, the aftermath of entry to the WTO will pose a series of stiff economic and social tests, including the probably painful reform of state-owned enterprises and banks. But if China can manage the process successfully, most studies suggest that WTO membership will further boost China's share of international trade.
The challenge from China
China's sustained rise in economic importance inevitably has implications for the region. Indeed, in the first volume of Emerging Asia Riskwatch we suggested that one key driver of country risk for the region over coming years would be the challenges and opportunities posed by the growing economic importance of China. (Note 1) One frequently canvassed risk, for example, is that China now represents a severe competitive threat to rest of emerging Asia.
The most pessimistic version of this argument suggests that a huge supply of cheap labour, combined with the economies of scale generated by a massive domestic market, have turned China into a formidable export machine that can undercut the region's other producers across a wide range of markets and products. Moreover, these same factors ensure that China is increasingly the destination of choice for the vast bulk of foreign direct investment (FDI) into the region. In turn, this new investment will allow Chinese exporters to further improve productivity while moving into ever more markets and products. As a result, the rest of the region's economies will find themselves being squeezed into steadily smaller exporting niches.
Eventually, the argument continues, as China becomes more competitive in increasing numbers of export markets, a flood of low cost Chinese exports will produce a continuous fall in export prices and a sustained adverse movement in the terms of trade for the rest of the region. The remainder of emerging Asia will find that it is only able to compete by repeatedly devaluing exchange rates. For the open economies of the region, this will mean falling living standards and - ultimately - deteriorating country creditworthiness.
Source: IMF Direction of Trade Statistics
At first glance, there is some circumstantial evidence supporting this pessimism. China's share of regional exports has risen steadily over the past decade, climbing from around 22% of total exports in 1991 to more than 32% by 2000. And while the rest of emerging Asia's exports have slumped over the course of the past year, exports from China have held up reasonably well.
Source: National statistics offices
What's more, China clearly has been the recipient of the lion's share of FDI into the region over the past decade. (Note 2) According to estimates by the Institute of International Finance (IIF), for example, China was the destination for more than 74% of net FDI into emerging Asia in 2000, compared to just under 50% in 1990.
Source: IIF. Data do not include Taiwan.
A case of history repeating itself?
In contrast to the pessimistic view, optimists argue that, in many ways, the rise of China as a trading power fits comfortably into an existing, historical model of regional development and integration. The so-called 'flying geese' paradigm describes the way in which industries and production processes have migrated to countries according to their changing comparative advantage in a steady process of specialisation and expanding intra-regional trade. (Note 3) In the case of East Asia, this began with the industrialisation and technological development of the Japanese economy. As Japan moved through various stages of industrialisation - from light (labour-intensive) industries via heavy (capital-intensive) industries to technology-intensive production - this created new opportunities for other economies in the region. First the 'Newly Industrialising Economies' of Northeast Asia (including Korea and Taiwan) benefited from the positive spillovers - including FDI and new export markets - generated by Japanese development, and then the 'Tiger' economies of Southeast Asia followed. According to this view of the world, China is simply following a well-trodden path already taken by most of the rest of the region.
Maybe so, say pessimists, but what's different this time around is the scale and the speed of China's integration into the global economy. Chinese exporters are moving up the value-chain so quickly and across such a broad range of products - from low-tech production of clothes to high-tech production of computers - that the adjustment pressures this creates are far greater than, say, anything that Japan had to face from Korea, or Korea from Thailand and the other Southeast Asian economies. In 1990, for example, electronics exports accounted for just 5% of total Chinese exports. By 1999 the share of electronics had jumped to more than 15%.
Threat v Opportunity
In its crudest form, the pessimistic view of the implications of the rise of China for the rest of the region sees international trade as a zero-sum game between countries. But there are several problems with this view of the world.
For example, a key part of the argument is that China's relatively low wage costs will allow its exports to drive out the rest of the region from export markets across the board - leaving no products in which the rest of the region is competitive. But international trade theory tells us that a country can always find some goods in which it has a comparative advantage, even in the extreme case in which there are no goods in which it has an absolute advantage.
Moreover, to focus only on China's low wage costs is to miss an important part of the story. Low wages typically reflect low labour productivity. It is therefore helpful to look at more comprehensive measures of industrial competitiveness, such as unit labour costs, that take both productivity and wage levels into account. In the manufacturing sector, for example, analysis by the United Nations Conference on Trade and Development (UNCTAD) finds that big productivity differentials between China and other countries in the region mean that economies with much higher wages can have lower unit labour costs. Thus the following table shows that although wages in the manufacturing sector in Korea were almost 13 times higher than in China, much higher labour productivity in the former meant that average unit labour costs in Korea were still lower than in China. (Note 4)
Source: UNCTAD Trade and Development Report, 2002
In addition, the story of an ever-more competitive China crowding out the rest of the region from global markets neglects the offsetting economic forces that will be at work. A Chinese economy that is as successful in international trade as the pessimists predict will experience rising wages and upward pressure on its real (and probably nominal) exchange rate, which will have a mitigating effect on relative competitiveness. Perhaps more importantly, the wealthier economy that results will also demand more imports, creating new and growing export markets for the rest of the region.
In contrast to the pessimistic view that sees China as a threat, economic theory tells us that a more globally integrated China can be viewed as an opportunity - as an important source of demand, which will allow the other economies of emerging Asia to benefit from increased trade in those products in which they enjoy a comparative advantage.
Still, some of these benefits will only materialise in the medium/long run. In the meantime, there will undoubtedly be some significant transition costs, as individual sectors and industries lose out to greater competition from Chinese exporters. And dealing with these transition costs will represent an important challenge for the region.
Evaluating the challenges
Taken overall, an increasingly internationalised China will present the region with a mixture of challenges and opportunities. Clearly, it will be those regional economies with export sectors particularly exposed to competition from Chinese producers that face the biggest challenges. Exposure to Chinese competition will be a function of two factors - the countries in which the rest of the region's exporters compete with China (direction of trade) and the products traded (composition of trade).
(i) Direction of trade
As already noted, China has made significant gains in market share over the past decade. At the global level, for example, China's share of world exports has risen from less than 2% in 1990 to around 4% by 2000. But at this level of aggregation there is no sign that its gains have come at the expense of a fall in 5% to 4.2% over the same period, while the share of exports accounted for by Korea and Taiwan has also increased, from 3.8% to 5%. (Note 5)
Source: WTO
What about competition in specific third markets?
The direction of trade statistics in the table below show that China and the rest of the region are both heavily reliant on the US as an export market, followed by Japan and the EU. Indeed, the US is the largest single export market for every emerging Asia economy except Indonesia.
The box below shows that China has increased its share in the imports of all three of these major markets. Again, however, there is little evidence overall that this has resulted in a fall in market share for the rest of the region. The four Southeast Asian economies considered here have also increased their overall market share in all three markets over the same period, while Korea and Taiwan have maintained (or slightly increased) market share in the EU and Japan. However, the two Northeast Asian economies have seen a decline in their share of imports into the US. (Note 6) Tracking third market competition
Between 1991 and 2000 China has increased its share of US imports from 4% of total imports to 8.6%. Over the same period, Southeast Asia has also increased its share from 3.9% to 5.5%. However, the share of US imports accounted for by Korea and Taiwan has fallen from 8.3% to 6.1%.
Over the same period China's share in EU imports has risen from 1.1% to 2.5% of the total, while Southeast Asia's share has risen from 1.2% to 1.9% and Korea and Taiwan have increased their share from 1.7% to 1.9% of total imports.
China's share of Japanese imports has risen from 6% in 1991 to 14.5% in 2000. Southeast Asia's share has risen from 11.3% to 12.8% and Korea's and Taiwan's has increased marginally, from 9.2% to 9.7%.
Source: IMF Direction of Trade Statistics
(ii) Composition of trade
Even though China and the rest of emerging Asia are exporting into the same countries, it does not necessarily follow that their exports are in direct competition. That is also a function of the degree of overlap in the products traded, which will be determined partly by comparative advantage.
An analysis of revealed comparative advantage (RCA) by UNCTAD finds that China's most competitive exports are concentrated in traditional labour-intensive manufacturing sectors such as clothing, footwear and other household items, and in labour-intensive assembly operations in electronics products like computers. (Note 7) UNCTAD calculates that labour-intensive products with high RCA account for more than 37% of China's total exports, compared to 18% for technology-intensive products with high RCA. The analysis also finds that China's comparative advantage is continuing to evolve, with particularly strong gains in high technology sectors.
This pattern of comparative advantage is visible in China's top 12 exports by product.
Also worth noting is that for several of these products - toys and sporting goods, footwear, travel goods, and apparel and clothing accessories - Chinese exports account for more than 20% of total world exports.
How does this pattern of exports stack up against the rest of the region? The pie charts below compare China's export (and import) structure with the other emerging Asian economies by breaking exports down into the following categories.
Several features stand out.
· China's exports are dominated by manufactures (88% of total exports), with clothing and footwear accounting for almost 20% of exports and electronics more than 15%.
· The relative importance of electronics exports is significantly higher in the Philippines (63% of total exports), Malaysia (52%), Taiwan (36%), and Korea (30%).
· Along with China, the biggest exporters of clothing and footwear are Indonesia (11% of total exports), the Philippines (8.5%) and Thailand (7%).
· Indonesia (fuels and minerals, 28% of total exports and food and agriculture, 15%) and Thailand (food and agriculture, 20%) both have significant non-manufacturing export sectors, while machinery and transport exports (24% of total exports) are relatively more important for Korea than the rest of the region.
At this relatively 'high' level of comparison, there are some obvious overlaps between the region's exports, but there are also some fairly significant differences. What about at a more disaggregated level?
The table below looks in more detail at the degree of similarity between the region's manufactured exports using data at the three-digit SITC level. (Note 8) It reports correlation coefficients between China's exports and the rest of the region in 1990 and in 1999, and as well as looking at the degree of correlation across the manufacturing sector overall, it also reports correlation coefficients for four sub-sectors. We judge a significant degree of correlation to be a coefficient greater than 0.4 (in bold) and a high degree of correlation to be a coefficient greater than 0.6 (in bold italic). (Note 9)
The table above highlights several features that are of note.
· The degree of correlation (similarity) between China's manufactured exports and those of the rest of the region has increased markedly between 1990 and 1999, with a clear rise in the number of significant correlations.
· As expected, the highest correlations are found in the machinery and transport sub-sector (which here includes electronics) and the miscellaneous manufactures sub-sector (which includes clothing and footwear).
· Within these two categories, the highest correlations are with Indonesia, Taiwan and the Philippines in machinery and transport, and with Indonesia, Thailand and the Philippines in miscellaneous manufactures.
(iii) Summing up
Where does this leave us?
The evidence on export structures and direction of trade reviewed in this section suggests that at present China's biggest competitive challenges to the region are in the categories of labour-intensive manufactures such as clothing and footwear, and in electronics, and in the sale of these products into the US. Indonesia, Thailand and the Philippines face competition in the clothing sector, while the Philippines, Malaysia, and possibly Taiwan and Korea face challenges in electronics.
Moreover, the changing correlation between regional export structures is an important reminder that comparative advantage can be a dynamic process, and there is evidence that the degree of similarity between China's exports and the rest of the region is rising over time.
... and the opportunities
As well as providing competitive challenges, a growing China also creates important opportunities for the region's exporters. Rapid industrialisation and development means that there is already a strong demand for imports of capital goods and raw materials, and in the longer term rising living standards are also likely to generate increased demand for consumer goods. In fact, China is already a significant export market for the rest of emerging Asia. Regional exports to China have risen from US$3.3b in 1991 to US$33.4b in 2000.
Source: IMF Direction of Trade Statistics
Indeed, the rapid growth of China's exports itself represents an important source of import demand, given the high level of import content. For example, work by China's Ministry of Foreign Trade and Economic Cooperation has found that foreign funded companies account for around 48% of total Chinese exports. Most of these firms are involved in processing and assembly operations, with an average import content of around 50%. And for those companies involved purely in processing, the average import content is estimated to be even higher, at around 70%. In the clothing sector, for example, production is reportedly heavily reliant on imports of textiles from Korea and Taiwan. Similarly, much computer production is dependent on imported components from the same two economies.
Most analyses of China's entry into the WTO predict that accession will lead to a substantial rise in imports compared to a much more modest increase in exports. The years following accession will bring significant declines in China's average weighted tariff rate, from around 14% to closer to 6%. Of course, these falls will be in addition to a significant amount of liberalisation that has already been undertaken - the average weighted tariff rate has fallen from more than 40% in 1992 - but they will tend to be concentrated in the most protected sectors of the Chinese economy.
Which regional economies will benefit the most from any increased Chinese demand for imports? Direction of trade data show that while all of the region's economies have increased the share of their exports going into the Chinese market over the past decade, this process has been most pronounced in Korea (and more recently, in Taiwan).
Empirical work carried out by economists at the World Bank suggests that China's WTO membership will boost intra-regional trade in the period up to 2005, but that most of the benefits will accrue to Northeast Asia. Gains to Southeast Asia will be much smaller. Indeed, because several of these economies compete directly with Chinese exports - particularly in the clothing sector - the study estimates that the net effect of China's accession to the WTO will be a fall in national income over this period, mainly because of the removal of restrictions on China's clothing exports. (Note 10)
The role of Foreign Direct Investment (FDI)
Finally, how does FDI fit into the picture? We noted above that the pessimistic take on the rise of China sees the rest of the region losing out in terms of lower capital inflows, and a look at the data showed that China did account for the vast majority of FDI entering the region in recent years.
If the pessimists are correct, this will have significant negative implications for the region's longer-term growth prospects. FDI is an important vehicle for transferring best-practice technology, skills and management techniques into recipient economies, and as such it can be a major force for change; FDI has undoubtedly played a key role in facilitating China's swift move up the value chain.
In some regional economies FDI approvals have fallen significantly in recent years - with Indonesia probably the clearest example. But other economies, such as Korea, have seen a rise in FDI flows. How much these divergent trends reflect competition from China as opposed to factors internal to the economies in question (political and economic stability, growth prospects, privatisation programs, investment regulations and protection) is not clear. Still, the current attractiveness of China as a destination for FDI should provide the rest of the region with one more reason for pursuing the kind of structural and institutional reforms that encourages foreign investors and boosts growth potential.
Besides, a large proportion of the FDI entering China may be complementary to production and export opportunities in the rest of emerging Asia - part of the process of linking China into a regional production chain in line with the 'flying geese' paradigm discussed above. Clearly, FDI coming from other Asian economies does not reflect the diversion of investment from outside the region away from the rest of emerging Asia and into China. The World Bank, for example, has estimated that about three-quarters of the flow of FDI into China during the 1990s came from Japan and the Newly Industrialised Asian Economies, and by the mid-1990s it reckons that about half of all FDI in East Asia was intra-regional.
Conclusion
The rise of China as an economic power provides the rest of emerging Asia with a mixture of challenges and opportunities.
The challenges arise from the need to adjust to changes in relative comparative advantage brought about by the growth of Chinese exports, and to manage the associated transition costs, which for some sectors and industries could be substantial. For now, exporters in the clothing, footwear and electronics sectors seem likely to bear the brunt of these developments. But the dynamic nature of comparative advantage means that competition from Chinese exporters is likely to spread into other sectors and industries.
The opportunities are based around the growth of a major export market for the rest of the region.
Dealing with both challenges and opportunities provides an incentive for the region to persevere with economic and institutional reform. The development and maintenance of sound financial systems and efficient corporate sectors, along with the pursuit of stable fiscal and monetary policies, will help emerging Asia to manage the process of structural change, as well as attract the FDI and other capital flows that can support it. If the region follows this course, then the positive longer-term implications of the rise of China should outweigh the short-term adjustment costs.
Notes
1. See Country risk in 2001-2002: Review and Outlook. Emerging Asia is defined here to comprise China, Korea and Taiwan in Northeast Asia and Indonesia, Malaysia, Thailand and the Philippines in Southeast Asia. This is our standard definition of the region, but it should be noted that in this case it has an important shortcoming in that it neglects the key role played by Hong Kong in China's re-export business.
2. Several commentators have questioned the reliability of Chinese FDI statistics. Much of China's FDI comes from Taiwan and Hong Kong, and sceptics suggest that a significant proportion of these flows represent the 'round tripping' of what is really mainland investment.
3. See for example Chapter Three, Maintaining Trade and Investment Competitiveness, in East Asia Recovery and Beyond, World Bank, 2000.
4. This is not to deny the fact that China will benefit from significantly lower unit labour costs in those sectors and industries in which it has a comparative advantage. Just to stress the point that there is a difference between the industry level and the economy as a whole.
5. Of course, this does not take into account the counterfactual proposition that the rest of the region would have enjoyed even higher market shares in the absence of competition from Chinese exports.
6. Moreover, even to the extent that there has been a decline in regional exports at the same time as a rise in Chinese trade, this is only circumstantial evidence - it says nothing about causality.
7. See Chapter Five in the 2002 UNCTAD Trade and Development Report.
8. An example of a three-digit SITC category is SITC code 776, which covers 'thermionic, cold and photo-cathode valves, tubes, and parts'.
9. Note that a high correlation coefficient need not signal a competitive relationship. It may also indicate a high degree of intra-industry trade.
10. See Ianchovichina and Martin, Trade Liberalization in China's Accession to the World Trade Organisation, World Bank working paper, June 2001.
Mark Thirlwell
Senior Economist
mthirlwell@efic.gov.au
7 June 2002
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