The new East Asian economic model
By Robert Feldman and Andy Xie
(15 August 2001) With the imminent entry of China into the World Trade Organization, the collapse of exports in many parts of the Asian region, and renewed weakness of the Japanese economy, the entire structure of the economy in Asia is now being reassessed.
Economic resources—land, labor and capital—will have to be reallocated in all parts of the region in order to maximize the contribution that integration of China into the world economy will bring. In short, Asia must reorganize itself around a new source of productive power and capital accumulation in China.
Heretofore, the predominant model of growth in Asia has been one that followed by Japan, Taiwan and Korea, i.e. the export-oriented development model. These economies built capital stock and wealth by serving markets abroad first, and then serving domestic markets after income had risen far enough to become self-sustaining.
In terms of the savings-investment identity, a high export surplus allowed savings to be so high that investment could also be very high, and sustained. In some cases (Japan and Korea), the role of the state has been highly interventionist, and in others more laissez-faire (Taiwan). However, the source of incremental demand was largely foreign, and the source of incremental capital was largely domestic.
Interestingly, from the end of the Cultural Revolution (1976) until the late 1990s, China followed the same model to a great degree. Most of the development in China has been in the coastal regions and has relied on incremental demand from abroad, with domestic consumption held down.
Trade data may suggest that China is already shifting toward a trade deficit-based development model.
However, an important change has come over China in the last few years. China has come to rely on foreign capital (Japanese, Taiwanese, American and European) for a greater portion of incremental savings and on domestic sources for incremental demand.
In short, the development model in China has turned upside down. This reverse model will not only be sustained but will likely accelerate.
Unlikely role model?
There is a precedent for the new Chinese development model: the United States in the 19th century. Early in the 19th century, the U.S. economy was driven by new technologies in transportation (canals, railroads) and communication (telegraph).
The U.S. imported capital from the United Kingdom, through financial centers in New York City and Boston, and used the funds to purchase the output of new industries such as steel making and coal mining in New York state, Pennsylvania and Ohio.
The goods were shipped to the interior, to such newly developing cities as Chicago, and to cities on the West Coast. These new cities in turn developed new agricultural lands in the American heartland that served world markets. In addition, countries on the edges of the United States, such as Canada, Mexico and the Caribbean nations, provided raw materials to feed the U.S. industrial machine.
With this model from economic history in mind, the future of Asia becomes clearer. First, China as a whole must run a trade deficit; there is nothing to worry here, any more than there was to worry when the United States ran a trade deficit to build the railroads.
Attracting huge capital inflows is a key part of the model, however. While huge inflows are not impossible, China must convince foreign investors, particularly in Japan, that investing in China is a good idea.
In other words, China must convince the advanced industrial nations, particularly Japan, to send real goods to China (mostly capital goods and technology) in return for little pieces of paper with promises written them (i.e. financial claims).
In fact, trade data may suggest that China is already shifting toward a trade deficit-based development model. This can be seen by looking at Hong Kong and Chinese trade data as a unit. A large portion of Hong Kong's imports flow to adjoining Guangdong province, without being recorded by the customs service in China. The correct trade balance for China is thus the total of the two.
Of course, not all of the shrinkage of the China-Hong Kong surplus is due to structural factors. Indeed, the growth difference between China and the world is clearly showing up as well. However, even once the global economy recovers, it would be a surprise if the China-Hong Kong trade balance returns to its former heights.
Complex trade paterns
Second, the story becomes more complex when the geography enters the picture. The farther from the coast, the less able foreigners are likely to be able to judge the value of investment projects in China.
This means that different parts of China will specialize in different parts of the production process. The coastal areas will specialize in the goods and services, e.g. investment in the Chinese heartland, that other countries need but cannot provide themselves, while the heartland will specialize in producing goods for the coast, and to an extent for the world.
This complex geographical picture can be seen in the evolving trade patterns among Japan, China and the United States. Already, the U.S. trade deficit with China is larger than that with Japan. The Japanese trade balance with China has now turned to a deficit for the first time in history.
Moreover, the share of Japanese imports coming from China and Taiwan has now risen to 15 percent from 6 percent in 1990, while that coming from the United States has fallen to 19 percent from 23 percent.
While the import picture for Japan has changed dramatically, the export picture has changed less so. The United States still provides Japan with 30 percent of its global export market, while China provides 13 percent, up, but still far away.
In short, China is becoming for Japan what Japan became for the United States 40 years ago, an essential supplier from Japan's point of view, and, from China’s view, an essential market.
Role of regional markets
Third, countries on the edges of China will serve as suppliers of raw materials and play support roles in the supply of capital goods to China for eventual use in the heartland. The peripheral countries will run their economic growth off the Chinese engine. This category of countries includes not only those in Southeast Asia but also the resource rich areas of the Russian Far East.
One of the more difficult parts of this strategy comes in determining the balance that foreign countries will accept between receiving real goods or receiving little pieces of paper from China in payment for capital, technology and goods exports. When both goods and capital are essential parts of the story, determining the optimal exchange rate is a tricky business.
A weak yuan would have the benefit of creating many jobs in China but also would reduce the amount of capital that foreign nations send. While Chinese autonomy in domestic investment would be greater, the peripheral benefits of foreign investment—such as adherence to global investment standards and the benefits of cross-fertilization of methodologies—would be reduced.
Moreover, the net employment benefits of a weak yuan are not certain, since the jobs created in export industries might also have been created in capital investment industries.
In contrast, a strong yuan would lower the amount of goods that China could sell abroad with adverse consequences for job creation but would free labor for capital accumulation projects. The benefits of foreign investment would also increase.
Currency questions
At the moment, the yuan is priced for China's job demand. Because the current China-Japan relationship cannot allow fully free capital flows, the yuan has to be kept low in order to encourage money inflows from Japan through the trade channel, i.e. by pushing the Japanese savings rate down with cheap imported goods.
This is the old model, however. Over time, capital and trade flows between the two countries will likely be liberalized further. Such liberalization would allow the yuan to appreciate and capital flow to take place normally, since domestic demand will be stronger as a result and job needs in China can be met.
Improvement of the bilateral economic relationship between China and Japan would allow China to create jobs and Japan to maintain living standards. In this context, it would be only natural for authorities in both countries to consider the exchange rate as a device to achieve these symbiotic objectives.
Finding the right mix
One must next add the question of how the exchange rate among China's trading partners, e.g. the yen/dollar exchange rate, affect the balance in China between selling goods to foreigners and selling claims to them.
A strong yen against the dollar would reduce the Japanese trade surplus and leave less capital for Japan to send to China, or anywhere else. That said, a strong yen would raise the trade surpluses of other countries in the region such as Taiwan, which might send more capital to China than Japan would have.
In contrast, a weak yen against the dollar would raise the Japanese surplus, but there is no guarantee that this capital would flow to China. Indeed, it might simply recycle back to the United States. This is very complex question of exchange-rate effects among China's trading partners.
This new Asia is already a very interesting place for investors. In light of the analysis above, however, the most interesting parts, and the most profitable parts, are likely to lie in the growth of productivity from resource reallocation, rather than in trying to guess where exchange rates will go.
As China grows, investors around the world stand to benefit most from focusing on productivity-enhancing investments, both in China itself and in other countries that are helping China integrate itself into the world economy.
About the authors:
Robert Feldman is managing director and economist of Morgan Stanley, Japan. Andy Xie is a Hong Kong-based economist covering greater China for Morgan Stanley (http://www.morganstanley.com/about/index.html). He has worked at The World Bank as an economist covering Indonesia and at Maquarie Bank as associate director of corporate finance. Andy has a Ph.D in economics from Massachusetts Institute of Technology. These remarks originally appeared in Xie’s July 25 e-newsletter and were reprinted here with permission. Morgan Stanley is a global financial services firm focusing on three business areas: securities, asset management, and credit services. For information contact indivfeedback@morganstanley.com. |
