East Asia and China

 

 

 

 

 

Written Testimony for the U.S.-China Commission
Hearing on December 4, 2003

 

 

 

 

Edward J. Lincoln

Senior Fellow

The Council on Foreign Relations

 

 

            East Asian nations have experienced a rapidly expanding economic relationship with China in the past two decades.   From an economic standpoint, that relationship is positive—hollowing out of Asian economies due to the rise of China is not occurring.  Overall, other governments have embraced the expanding economic relationship with China because they understand that to do so is both to their direct economic benefit and creates ties that draw the Chinese government into a more productive relationship.   Obviously, the large size of the Chinese population, rapid growth of the economy, and anecdotes of hollowing out imply a certain amount of anxiety about the growing economic ties, especially in media.  Those anxieties notwithstanding, East Asian governments are clearly on track to stick with this economically and politically advantageous course. 

            This paper makes three main points concerning these relationships.  First, the rise of China as a trade partner has been substantial and sustained.  Second, hollowing out is not occurring in any meaningful sense.  Third, although attitudes of politicians and the media around the region may be mixed, policy actions taken by governments in the region indicate a clear choice to embrace China economically, but that embrace hardly represents any dominance of the region by China.

            For purposes of this paper the term “East Asia” refers to Japan, South Korea, Hong Kong, Macau, Taiwan, and the ASEAN nations of Southeast Asia.  The following discussion generally separates Japan, the huge developed economy in the region, from the rest.  Also, because of the confusion in trade and investment statistics caused by the transshipment of goods through Hong Kong and the use of Hong Kong as a hub for investment into China, the trade data presented here include Hong Kong (and the much smaller Macau) as part of the Chinese area. 

 

1.         Rising Trade Linkages.

            As China has opened up to trade and investment, and as the Chinese economy has continued to grow rapidly, China has become a more important trading partner for many nations, and the rest of East Asia is no exception.[1] 

            Figure 1 shows the exports of East Asian countries other than Japan to the China area as defined above.  Beginning in the second half of the 1980s, the region’s exports to China rose fairly steadily from 5 percent to 12 percent of their total exports.  Meanwhile, exports to Japan fell sharply (from 27 percent in 1981 to only 13 percent by 2001.  As a result of these two trends, China is now as important an export destination for this region as Japan.  There has, however, been little real change in the share of exports destined to the United States, which, except for a bubble in the 1980s when the dollar was very strong, have fluctuated between 17 and 20 percent.

            Figure 2 shows Japan’s exports by region.    Japan’s exports to China have also risen, though not as much, slowly drifting up from 7 percent in 1981 to 13 percent in 2001.  Meanwhile, the rest of East Asia other than the China area and the United States both remain much more important export destinations for Japan.  Other than the unusual bubble in Japanese export dependence on the United States in the first half of the 1980s when the dollar was strong (and the yen unusually weak), the share of Japan’s exports destined to the United States has fluctuated between 25 and 30 percent.  The notion of Japan’s economic relationships shifting away from the United States toward China is not true (a conclusion that other data in this paper will reinforce). 

            Figure 3 shows the source of imports of the region other than Japan.  The trends are quite similar to the export trends in figure 1.  Imports from the China area have expanded moderately from 3 percent to 9 percent in 20 years.  Imports from Japan have fallen, from a peak of 26 percent in 1986 to 17 percent by 2001.  The United States has been a source of a steady 17-18 percent of the region’s imports until the very end of the 1990s, declining to 14 percent in 2001.  The recent drop in the share sourced from the United States does not appear to be due to any displacement by China (since the Chinese share was up only 2 percentage points, and the earlier upward drift in China’s share was not associated with any decline in the share imported from the United States). 

            Figure 4 shows the source of Japan’s imports.  Japan has experienced a much more pronounced increase in the share of its imports sourced from China than was the case for the rest of the region—climbing from only 4 percent in 1981 to 17 percent in 2001.  Meanwhile, the United States has been the source for 18 to 24 percent of Japan’s imports (and the rest of the region for a somewhat similar share).  The share of imports from the United States shows a sizable drop, from 24 percent back to 18 percent since 1998.  In fact, if this figure included 2002 data, it would show that imports from China had become slightly larger than from the United States.  Once again, however, it is not at all clear that the drop in the U.S. share is at all caused by the rise of China’s share since the earlier sustained rise in China’s share was not associated with any drop in the U.S. share.  The more likely explanation is that Japan’s recession of 2000-2001 affected the kinds of capital goods that Japan tends to import from the United States, while the shift toward low value-added imports from China (such as textiles and apparel) continued unabated. 

            The trade data confirm the rise of China as a global trading partner, though obviously that impact varies for Japan and the rest of the region and is different for exports and imports.  China certainly does not dominate East Asian trade patterns, though the increase in its importance as a trading partner is unmistakable.  In addition, the rise of China is all the more noticeable because it has come at a time of sharply diminishing trade linkages with Japan.  Thus, within the region all players are well aware of the relative rise of China and decline of Japan.  Trade ties with the United States, however, appear to be little affected by the rise of China; we have remained an important trading partner for Japan and the rest of the region even as they have expanded their relative ties with China. 

2.         Hollowing Out?

            As in the United States, some concerns have been expressed around the region concerning the possibility that China is hollowing out their economies.  In Japan, these come in the form of fears that cheap imports from China are displacing domestic production—either from indigenous Chinese firms (as in textiles) or from Japanese firms that have relocated production.  In Southeast Asia, the concern revolves more around foreign direct investment, with fears that foreign firms will shift the focus of their investments from Southeast Asia to China. 

            Conceptually, hollowing out is a difficult concept, and one that economists find dubious.  One could, for example, argue that a rising trade deficit with a particular trading partner represents a net loss of manufacturing jobs, thereby hollowing out the manufacturing sector.  However, economists argue that bilateral trade balances have little meaning; a nation might have a rising deficit with one partner offset by a rising surplus with another.  Nevertheless, for the sake of argument, the following discussion looks at the trade balances of Japan and the rest of the region with China. 

            Figure 5 shows Japan’s trade balance with China—shown as both the balance with mainland China alone, and with the broader China area.  With China alone, Japan has shifted from balance or a small surplus in the 1980s to a deficit of $27 billion by 2001.  That rising deficit has become the principal reason for some Japanese to argue that they are being hollowed out by China.  However, there are three critically important problems with this view:

            1.         If one accepts the view that much of trade with Hong Kong is really trade with China, then the picture changes considerably.  With the broader China area, Japan has had a surplus until 2001.  Admittedly, a decline in the surplus set in after 1993, and the balance turned negative in 2001—a trend that might continue.  Nevertheless, the picture is considerably different than when looking at mainland China alone.

            2.         How can one talk of Japan hollowing out when the nation continues to have a sizable global trade surplus?  In 2001, for example, Japan had a global surplus of $48 billion.  In that context, the deficit with China has little meaning, since the deficit was more than offset by surpluses with other trading partners (such as the United States).  In fact, to the extent that Japan’s deficit with China represents imports of low value-added products, and the surplus with the United States represents exports of high value-added products, Japan is losing nothing important.  That is, it might experience a shrinkage of labor intensive industries, but that shrinkage is more than offset by expansion of sophisticated, capital intensive industries.

            3.         Even if one were to take the extreme view and regard the $27 billion deficit with mainland China as a net loss, this is a minor development in the broader context of the Japanese economy.  In 2001, gross domestic product originating in the manufacturing sector amounted to 104 trillion yen, or $858 billion at the average exchange rate for the year.[2]  Thus, the $27 billion deficit with China represented only 3 percent the size of the total manufacturing output in the Japanese economy (keeping in mind that even this estimate is excessive since the import figure is the total value products while the manufacturing sector figure is only for the value added, which excludes the value of raw material inputs purchased by the manufacturing sector).  This is hardly a percentage that is very meaningful.

            Figure 6 shows the trade balance of the rest of East Asia with China.  For this set of countries, the whole question of hollowing out is moot.  Even looking at trade with mainland China alone, these nations have been close to balance, with very small deficit in the 1980s and small surpluses of $1 billion to $4 billion in recent years.  Trade balance with the broader China area shows a rapidly rising surplus, rising to a level of $20 to $25 billion in recent years.  The more important conclusion is that both exports and imports with China have been expanding very rapidly for this set of economies, implying that the region is benefiting from the unusually rapid growth in trade.  

            Viewing the question of hollowing out through investment is difficult.  At any moment in time, multinational firms have only a fixed amount of funds available for investment around the world.  Therefore, a decision to invest in one country means less investment somewhere else.  Sorting out why firms choose to invest or not invest in particular countries, however, can be difficult.  With those difficulties in mind, the following discussion looks at some of the investment developments.

            For Japan, the issue has been whether domestic manufacturing firms are shifting their production abroad.  In a very general sense, this has been happening since the 1980s.  As shown in figure 7, the ratio of overseas production to domestic production in manufacturing has increased from a very low 3 percent in 1985 to 14.5 percent by 2000.  Until 1985, Japanese firms demonstrated an unusually strong desire to keep production at home.  Thereafter a combination of the doubling of the yen against the dollar from 1985 to 1987, rising fears that some principal markets like the United States were moving in a protectionist direction, and a rising need in some industries to be close to their overseas customers, caused firms to change their policies.  It is difficult, however, to regard this as hollowing out:  what was unusual was the rather extreme aversion firms had to overseas production prior to 1985 and not the subsequent shift. 

            Furthermore, even one were to regard the relocation of production overseas to represent a hollowing out, little of this investment has gone to China.  Figure 8 shows the destination of the annual flow of Japanese foreign direct investment in manufacturing.  China has been the destination of 10 percent or less of Japanese annual investment, except for a short period when it peaked at 18 percent in 1995.  In 2002, Japanese manufacturing investment in China was only 9.6 percent of the total flow of new investment, coming to only 171 billion yen ($1.4 billion at 2001 exchange rates).  Even using investment in broader China makes little difference.  In 2002, the combined Japanese investment in China plus Hong Kong was only 176 billion yen (still $1.4 billion).  

            In contrast, the United States and Europe have attracted far more Japanese manufacturing investment, with 30-to-40 percent of the total coming to the United States in most years, and 30 percent to Europe in the past several years.  The dominance of manufacturing investment in developed countries rather than developing ones like China indicates the importance of Japanese fears of protectionism, and the importance of locating manufacturing close to customer bases as a motive for investment.  Investment in China to take advantage of cheap wages is simply not a very dominant motive in Japanese investment. 

            These data on Japan suggest that if the Japanese want to worry about hollowing out, they should be blaming it on the United States and Europe, which have taken the bulk of Japan’s investment in manufacturing (and an even higher share of total foreign direct investment).  Furthermore, the amount of investment in China is almost trivial.  In fiscal 2002, the Japanese economy had 71.5 trillion yen ($600 billion) in non-residential fixed private sector investment.[3]  The flow of direct investment to China, therefore, was only 0.2 percent the size of domestic investment. 

            The story for Southeast Asia is slightly more complicated.  Here the question is about the behavior of foreign firms; are they shifting their direct investment from Southeast Asia to China?  This worry has certainly been expressed in the years since the Asian financial crisis of 1997.  While the annual flow of direct investment to China has been on the order of $40 billion in recent years, the flow of direct investment into the ASEAN countries has dropped—from a peak of $30 billion in 1997 to $13 billion in 2001.  It is understandable that ASEAN governments would feel that perhaps investments that might have come to their countries were now going to China.  There are three important reasons why the fears expressed in ASEAN are unfounded.

            Figure 9 shows direct investment flows into ASEAN, and largely debunks the notion that the region is suffering because China is sucking in these investments. 

            1.  Note that the average annual flow into ASEAN from 1989 through 1994 was $14 billion.  The jump to $30 billion by 1997 appears to have been more of a speculative bubble since the annual flow has now subsided to the pre-1995 level.  To be sure, with economic growth in the region, one would also expect the level of inward direct investment flows to be rising over time, but certainly the drop from the unusual peak of 1997 provides an exaggerated picture of the situation.

            2.  The drop in inward investment is very uneven.  To a large extent, the decline since 1997 is due to an actual withdrawal of direct investments from Indonesia and a sharp decline in 200-2001 of investment into Malaysia.  In Indonesia, foreign investors became uneasy about the continuing political instability of the country.  Malaysia has also experienced the consequences of both its decision to impose some capital controls in 1997 during the crisis and uncertainties surrounding the eventual change in political leadership.  Neither of these developments is at all related to China.  Perhaps investments that might have gone to these two countries ended up in China, but the cause lies within Indonesia and Malaysia. 

            3.  Even this level of annual inflow represents a substantial level of investment inflows.  Table 1 shows inward direct investment flows as a share of domestic gross capital formation.  Even with the drop in the dollar value of flows, the principal ASEAN countries (with the exception of Indonesia) are generally attracting as much investment as China relative to their total capital formation.  This level of inward direct investment is also close to the global average for developing countries. 

            Therefore, while it was convenient for Southeast Asian governments to fret that they were losing out to China in attracting investment to their region, there is little reason to believe that this represents a real concern.  If Indonesia can convince investors that it has a stable, business-friendly government and can contain terrorist threats, then investment will return. 

3.  Regional Institutions and Policies

            Two developments have occurred in East Asia since the mid-1990s: the initiation of a regional dialogue among cabinet ministers and leaders called ASEAN+3, and the formation of bilateral and sub-regional free trade areas.  These represent an interesting and largely positive willingness of other governments in the region to engage in discussion with the Chinese government on economic policy matters. 

            ASEAN+3 brings together the ASEAN governments with China, South Korea, and Japan.  Begun initially as a mechanism for coordinating views in advance of the dialogue between East Asian governments and the EU in 1996, this group now brings together both various economic ministers and leaders of its members.  This mechanism provides an opportunity for East Asian governments to talk among themselves without the American government in the room.  The two major powers in the group are Japan and China, so in a crude sense, the Chinese government has an opportunity to act as more of a regional leader (as does Japan).  Certainly it is an interesting development that the other governments in the region have been willing to talk with the Chinese and Japanese without the Americans around.  Overall this represents a positive development, demonstrating a rising level of confidence among East Asian governments (and especially the smaller economies of ASEAN) in engaging in discussions with the Chinese government without the cover of the United States in the room as a balancing power. 

            A principal cause for East Asian governments to emphasize their interaction through ASEAN+3 was their frustration over the response of the U.S. government and the IMF during the 1997 Asian financial crisis.  Believing that they had been treated shabbily, they were eager to talk among themselves about regional issues.  This motivation might suggest that the region is pulling away from its close relationship with the United States, moving toward greater dominance of the two giants in the region, China and Japan.

            However, the only real policy decision made by this group has been a very weak move to enhance the ability of regional central banks to borrow money from one another for the purpose of defending their currencies.  This development is embodied in the Chiang Mai Initiative endorsed by the ASEAN+3 governments in 2000 and a set of subsequent individual bilateral swap agreements between pairs of central banks. Table 2 shows the status of these agreements as of the fall of 2003.  The Chinese government has chosen to participate in these swap agreements by offering to lend money to some other central banks, suggesting a new regional activism on their part (since it is one of only three central banks along with Japan and South Korea that are on the lending side).  These swap agreements represent an interesting development in which central bankers in the region have managed to hammer out agreements among themselves, but there are several important reasons why these agreements are not important in substantive terms and do not represent any real drift of the region into a China-centered regionalism.

            1.  The agreements themselves are largely trivial.  The total of $30 billion negotiated so far is actually quite small when viewed in the form of how much is available to any individual borrower to defend its currency.  Thailand has only $6 billion available, an amount that could be overwhelmed by foreign exchange markets rather quickly.  Therefore, the agreements are more symbolic than real.

            2.  Initial concerns that these agreements might enable the region to act with greater independence from IMF guidance (by using their own regional funds to help countries defend currencies rather than giving in to IMF policy guidance in times of crisis) have not materialized.  The Japanese government insisted during the negotiations leading up to the Chiang Mai Initiative that only 10 percent of the amounts shown in this table be activated by the individual decision of the lending country; the remaining 90 percent can be activated only with explicit approval from the IMF.  Therefore, these agreements do not represent a move of the region to a more independent stance.

            3.  China’s role is largely symbolic.  It has offered only $6 billion so far, in individual amounts of $1 billion to $2 billion.  This gets the Chinese government some international recognition as a player in this game, but hardly represents a dominant position.

            4.  The whole mechanism is rendered at least partially moot by the decision of a number of countries in the region to switch to floating exchange rates (which obviates the need to mobilize sudden large amounts of foreign exchange reserves to defend a currency, since the currency is moving on a daily basis which eliminates fears of sudden large movements).  Therefore, these agreements are unlikely to be activated in the future.

            The other regional policy development has been the evolution of bilateral and sub-regional bilateral areas.  Table 3 shows the status of these agreements as of late 2003.  China has made an interesting move by beginning negotiations with ASEAN for a free trade area.  That SAEAN countries were willing to enter into this negotiation represents an increased level of confidence on their part that they could negotiate a fair agreement with their giant neighbor, and that such an agreement would be politically acceptable in their countries.

             However, viewed broadly, these agreements—existing and under negotiation—do not represent the incipient formation of a regional bloc or a move toward Chinese dominance of the region for three important reasons.

            1.  There is no indication that governments have a strong preference for agreements with partners within the region as opposed to those outside the region.  Singapore has already signed a number of agreements with governments outside the region, including the United States, Australia, and Canada.  South Korea’s first FTA has been with Chile.  Thailand is now negotiating with the United States.  Therefore, there is no indication that East Asian countries will end up locked into a bloc dominated by China.

            2.  There is no evidence that the Chinese government is very interested in pursuing free trade agreements with other partners in East Asia (that is, South Korea or Japan).  In general, China’s interests lie with the WTO as a mechanism to gain better access to global markets and as a lever to bring domestic reform.  The FTA with ASEAN has its roots more in political strategies than economic ones.  Trade between China and the ASEAN countries is not large, so that an FTA would not have a major impact on either side.  However, the offer has gone a long way to allay the fears in ASEAN about being hollowed out at the expense of China. 

            3.  For a bloc to emerge, it would be necessary for Japan to join in a broader grouping including China.  So far the Japanese government has had no real interest in engaging China in such a negotiation.  Indeed, the Japanese government has been unable so far to even counter the Chinese offer to the ASEAN grouping, largely because of an unwillingness to address the problem of removing barriers at home to agricultural imports. 

            For all these reasons, it is difficult to discern any real move in East Asia to form a more cohesive economic bloc built on regional free trade agreements, and especially one centered on China.  The more important conclusion from both the swap agreements and free trade agreements is the rising comfort level that governments in the region have in engaging the Chinese government.  There is no reason to expect that this trend of embracing China economically will be reversed, barring some unfortunate security policy move by the Chinese. 

Conclusion

            The emergence of the Chinese economy on the global economy has had an important impact on the other economies of East Asia.  As has been the case for the United States and other countries, China has become a far more important economic partner than it was 10 or 20 years ago.  Given the enormous size of the Chinese population, this has understandably led to some concerns around the region that China’s emergence and continued high growth could be detrimental to others in the region.  Those fears are not borne out by the analysis in this paper. 

            China has certainly become a more important trade partner for other a nations in the region.  But in no meaningful sense has China been hollowing out the manufacturing sectors of the others.  In fact, the rapid rise of two-way trade without the emergence of large bilateral deficits implies that the other nations of the region have benefited from expanded export sales.  Looking at direct investment flows, the fears in ASEAN that they are losing in the competition for new foreign direct investments are not true.  The drop in foreign direct investment has more to do with political turmoil in Indonesia and questions about political transition in Malaysia than with China.  Finally, there is no strong indication that the region is coalescing around China through regional institutions and regional policy decisions.  The more important conclusion on regional institutions and policy discussions is that the regional governments are now showing a healthy ability and willingness to engage the Chinese government in economic policy discussions (even if the actual importance of regional agreements is limited).


 

Source:  International Monetary Fund, Direction of Trade. 

 

Source:  See figure 1.

 

 

 

Source:  See figure 1.

 

 

 

 

Source:  See figure 1.

 

 

Source:  See figure 1.

 

 

Source:  See Figure 1.

 

Source:  Ministry of Economics Trade and Industry, Chusho Kigyo Hakusho (Medium and Small Enterprise White Paper), 2001 edition (on CD-ROM).

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Source:  Ministry of Finance, http://www.mof.go.jp/english/e1c008.htm.

 

 

 

 

Source:  ASEAN Secretariat, Statistics of Foreign Direct Investment in ASEAN 2002 Edition, http://www.aseansec.org/14549.htm.

Table 1: 

Inward Direct Investment Flows as a Share of Gross Fixed Capital Formation

Country

1989 to 1994 Average

1995

1996

1997

1998

1999

2000

 

 

 

 

 

 

 

 

All Developing Economies

5.7

 

9.1

11.1

11.4

13.4

13.4

 

 

 

 

 

 

 

 

Indonesia

4.0

7.6

9.2

7.7

-1.5

-9

-12.2

Malaysia

19.4

15.0

17

14.7

14

22.2

16.5

Philippines

7.5

8.9

7.8

6.2

12.7

4

9.2

Singapore

30.3

31.2

24.6

29.4

20.8

42.4

19.8

Thailand

5.0

2.9

3

7.1

20.5

13.9

10.4

 

 

 

 

 

 

 

 

China

7.9

14.7

14.3

14.6

12.9

11.3

10.5

Source:  UNCTAD, World Investment Report 2002,Annex Table B.5 (and similar table in 2001 report).

 

 

 

 

 

Table 2:

 ASEAN+3 Foreign Exchange Swap Agreements

Amounts in Billions of U.S. dollars

 

 

 

 

Lender:

Japan

South Korea

China

 

 

 

 

Borrower:

 

 

 

 

 

 

 

Japan

--

 

 

South Korea

2

 

 

China

3

2

 

Malaysia

1

Under negotiation  1

Under negotiation 1

Thailand

3

Under negotiation  1

2

Philippines

3

Under negotiation  3

Under negotiation 1

Indonesia

3

 

 

Singapore

under negotiation 3

 

 

 

 

 

 

Sum:

18

7

5

 

 

 

Table 3

Status of Bilateral and Regional Free Trade Areas 2003

 

 

Japan

China

South Korea

Taiwan

Singapore

Other ASEAN

Agreement signed and implemented or in process of implementation

Japan-Singapore

Bangkok

     Agreement

Bangkok

     Agreement

Korea-Chile

 

Singapore-Japan

Singapore-

     N.Zealand

Singapore-U.S.

Singapore-EFTA

AFTA

Thailand-Laos

 

Under negotiation

 

Japan-Mexico

 

China-ASEAN

 

 

ASEAN-China

Singapore-Mexico

Singapore-Canada

Singapore-

     Australia

 

ASEAN-China

Study group (either joint or simultaneous but separate by both parties)

Japan-South Korea

Japan-Malaysia

Japan-ASEAN