China Rising: East Asian Responses Rising: East Asian Responses

Copyright 2006 by Park Bun Soon et al. All rights reserved. No part of this book may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without permission in writing from the publisher, except by a reviewer who may quote brief passages in a review. inquiries should be addressed to: Samsung Economic Research Institute 7-8th Fl., Kukje Center Bldg., 191 Hangangro 2-ka, Yongsan-ku Seoul, 140-702 Fax: 82-2-3780-8152

ISBN 89-7633-324-1 93320

Printed in the Republic of Korea China Rising: East Asian Responses

Park Bun-Soon Choi Ho-Sang C.H. Kwan Chu-Chia Lin Shin Jang-Sup

SAMSUNG ECONOMIC RESEARCH INSTITUTE contents

CHAPTER I INTRODUCTION: PURPOSE AND OVERVIEW

Park Bun-Soon Research fellow, Samsung Economic Research Institute 1 Growth Patterns of East Asian Economies 11 2 Implications of China’s Rise for 15 3 Organization of the Book 22

CHAPTER II KOREA’S RESPONSE TO CHINA RISING

Choi Ho-Sang Research fellow, Samsung Economic Research Institute 1 Introduction 33 2 The Growth Potential of Korea’s Economy Being Undermined 35 3 Economic Cooperation with China and Its Impact 43 4 Policy Suggestions: Creating a Basis for an Economic Hub in Northeast Asia 56

CHAPTER III THE RISE OF CHINA: CHALLENGES AND OPPORTUNITIES FOR

C.H. Kwan Senior fellow, Nomura Institute of Capital Markets Research 1 An Evaluation of the Chinese Economy 67 2 Complementary Relations between Japan and China 75 3 The Macroeconomic Impact on Japan of China’s Rise 84 4 Japan Coping with the Rise of China: A Microeconomic Perspective 94 5 In Search of a Win-Win Game 101

CHAPTER IV : INVESTMENT IN CHINA AND STRUCTURAL CHANGE

Chu-Chia Lin Professor, National Chengchi University 1 Introduction 107

6 2 Bilateral Trade across the Taiwan Strait and Taiwan’s Investment in China 110 3 Economic Impact and Structural Change for Taiwan 119 4 Production Integration and International Competitiveness 130 5 Taiwan’s Economic Policy toward China 137 6 Conclusion 142

CHAPTER V RESPONSES TO THE EMERGING CHINA: AND KONG

Shin Jang-Sup Associate Professor, National University of Singapore 1 Introduction 149 2 Singapore and : Different Paths of Economic Development 151 3 Embracing China’s Growing Economy 157 4 Responding to Competition from China 165 5 Conclusion 180

CHAPTER VI THE RISE OF CHINA AND THE ECONOMIC INTEGRATION CHAPTER VI OF EAST ASIA

Park Bun-Soon Research fellow, Samsung Economic Research Institute 1 Introduction 189 2 Japan and Economic Cooperation in East Asia 191 3 The Collapse of Existing Order 196 4 The “Lily–Pad” Model of Regional Development 207 5 Conclusion 214

7 CHAPTER I INTRODUCTION: PURPOSE AND OVERVIEW Park Bun-Soon, Samsung Economic Research Institute 1

Growth Pattern of East Asian Economies

Since the 1960s the economy of East Asia has grown at an unprecedented rate. The growth in the region differs from that in other countries in several respects. First, East Asian countries have grown in a sequential manner. Japan was first to achieve dramatic growth, in the 1950s and 1960s, followed by the newly industrializing economies in the 1970s, some early-developing Southeast Asian countries in the mid-1980s, and China in the 1990s. Second, East Asia has accumulated capital for accelerated growth, pursued industrialization, and advanced into overseas markets. Even though East Asia, a monsoon region, was until the 1960s heavily dependent on agriculture, the countries there transformed themselves rapidly into global production bases. Third, East Asian governments have played a pivotal role, developing their economies through various policies that have been both practical and flexible. Behind these policies have stood the goals of improving market functions and increasing competitiveness.1 With the dramatic growth in East Asian economies, the region’s economic

1 The describes the East Asian approach to rapid economic growth as functional. High- performing Asian economies have used a variety of policies to achieve accumulation, allocation, and productivity growth. Stable macroeconomic management, human-resource development, limited price distortion, and acquisition of foreign technology have provided the basis for growth. Careful policy intervention, including financial controls (lower real interest rates), support of selected industries, and nonconventional trade policy to strengthen exports, has been used to achieve the integration and adjustment of economies. East Asian countries have, in other words, coordinated competitiveness with government intervention. Such policies have in turn contributed to sustainable rapid growth and a fair distribution of income, as well as accumulation, allocation, and productivity growth. (World Bank, The East Asian Miracle: Economic Growth and Public Policy, New York, Oxford University Press, 1993.)

1 Growth Pattern of East Asian Economies 11 structure has also changed rapidly. The agriculture industries of East Asian countries have shrunken, while urban sectors have grown and other industries have expanded. Since a disguised unemployment rate has decreased in rural areas, the income discrepancy between rural and urban areas have narrowed, and the benefits of growth have been distributed relatively fairly. In other words, quality of life has improved drastically in East Asia in a short time span. According to the headcount index, which identifies the percentage of a population living below the poverty line,2 in 1975 around 60% of East Asian population lived on the same amount of money. In 1995, however, only two of every ten people lived on less than one dollar per day. Thanks to income growth and improvements in medical services, life expectancy has also increased in the region. While Indonesians born in 1970 have an average life expectancy of 47.9, those born in 1995 a life expectancy fully 15 years longer. The rapidly growing economies of East Asia faced a crisis in 1997 and 1998. East Asian currencies depreciated drastically against the US dollar, and most East Asian countries saw their economies fail to grow during these two years, though China and Hong Kong were spared the devastation because they had pegged their currencies to the US dollar. Between 1996 and 2000, the economic growth rate of all East Asian countries except the Philippines was lower than that between 1990 and 1995. Only Taiwan, , and China recorded more than 5% annual economic growth from 1996 to 2000; the growth rate in and stayed at around 1% during the same period. The East Asian economies have not recovered their pre-crisis momentum. Though Southeast Asian countries witnessed a mild economic recovery in 2003, they remained dissatisfied with their growth rates, which were much lower than that between 1990 and 1995. While it may be premature to say that the countries of East Asia have left the currency crisis behind, it is clear they have survived it, and that their economies have at least stabilized. Japan’s economy has recovered dramatically since 2003. As for NIEs, despite lower economic growth rates, their foreign exchange market has

2 The poverty line is based on the 1985 purchasing power parity of US$1. People who live on less than US$1 per day are defined as living below the poverty line.

12 CHAPTER I Introduction: Purpose and Overview Table 1-1 Growth Rates of East Asian Countries (Unit: %) 1960-69 1970-79 1980-89 1990-95 1996-2000 2001 2002 2003 Japan 10.5 5.1 4.0 2.1 1.4 0.4 -0.3 2.4 Korea 7.6 9.3 7.8 7.8 4.6 3.8 7.0 3.1 China - 9.6 9.5 10.7 8.2 7.3 8.0 9.4 Taiwan 9.1 10.2 8.1 6.4 5.7 -2.2 3.6 3.2 Hong Kong 8.7 8.9 7.3 5.0 3.2 0.5 1.9 3.2 Singapore 8.7 9.4 7.3 8.6 4.8 -1.9 2.2 1.1 Malaysia - 8.0 5.8 8.9 6.7 0.3 4.2 5.3 Thailand 8.0 7.3 7.3 9.0 0.7 2.1 5.4 6.8 Indonesia 3.0 7.7 5.3 8.0 1.0 3.8 4.3 4.5 Philippines 4.8 6.1 1.9 2.3 4.0 3.0 3.1 4.7

Note: Growth rates are simple average of annual rates. Source: Statistical bureaus of each country, Asian Development Bank. stabilized, and foreign reserves have surged. Southeast Asian countries made their way out of the crisis through financial restructuring measures such as the injection of public funds. Though they have neither fully recovered their growth momentum nor reduced their heavy dependence on foreign markets, some early-developing Southeast Asian countries have also succeeded in stabilizing their economies. Entering the twenty-first century, however, East Asia was confronted by a new and unexpected challenge: the rise of China. China, which has affected East Asia’s economy since the mid-1990s, joined the World Trade Organization in 2001. This landmark event has been called the second opening of China—the first being the opening of the 1970s. In fact, until the nineteenth century, China had been arguably the most advanced country in the world for over 2000 years. Its per capita income was higher than that of Western countries until the twelfth century, and higher than the world’s per capita income until the eighteenth century. It was in China that printing technology and gunpowder were invented and unrivalled shipbuilding skills developed.3 In 1820, China accounted for around 33% of global

3 Carl J. Dahlman & Jean-Eric Aubert, China and the Knowledge Economy: Seizing the 21st Century, The World Bank, 2001, pp. 1-2.

1 Growth Pattern of East Asian Economies 13 GDP. Though the Chinese economy has since deteriorated because of famine and a series of civil wars, China now has a new opportunity to become a global leader, thanks to the potential imbedded in its population (1.3 billion), its long history, and its reputation as a past source of technological innovation. China, which will host both the 2008 Beijing Olympics and the 2010 Shanghai Expo, is expected to grow considerably as an economic power. The implication is that East Asian countries, struggling to recover momentum lost in the currency crisis, will now face a strong challenge from China. Therefore, these countries need to study how China’s rise will affect them.

14 CHAPTER I Introduction: Purpose and Overview 2

Implications of China’s Rise for East Asia

China has grown rapidly since it opened its doors to foreign countries. Behind this successful growth has been an outward-looking development strategy similar to that adopted by other early-developing East Asian countries. In fact, this similarity has put China, which has been rapidly integrating into the global economy, on a collision course with its East Asian neighbors. China’s major export items have shifted from labor-intensive goods such as textiles, clothing, and footwear to household electronic appliances, computers, and computer peripherals. Through this transformation, China has become a stronger competitor in the region. China’s competitive relations with Japan, the NIEs, and other East Asian countries differ according to the stage of economic development and comparative advantages of each country or group. China and Japan compete for about 20% of their exports (by value) to the US.4 Given the competitive structure in the global market of the two countries, China is not considered a direct threat to Japan. However, China has created a considerable diplomatic burden for Japan since expanding its influence in East Asia. China has competed more fiercely with NIEs than it has with Japan, encroaching on the electronic appliances market as well as on labor-intensive industries, which have been generally led by NIEs. In addition, with China growing rapidly, companies located in the NIEs have increasingly advanced into China, while reducing investment in their own local economies. For

4 Chi Hung Kwan, Overcoming Japan’s “China Syndrome,” Research Institute of Economy, Trade and Industry, Feb. 19, 2002.

2 Implications of China’s Rise for East Asia 15 example, a considerable number of Hong Kong and Taiwan manufacturers have transferred their factories to . For their part, Korean companies have dramatically increased their investment in China. And many multinationals originating in Singapore have begun to channel their financial resources into China. As a result, unemployment rates have soared to unprecedented levels in the NIEs. Southeast Asian countries are exposed to fiercer competition from China than the NIEs are. They compete in low-technology products and in attracting foreign direct investment. Southeast Asian countries have accommodated multinational corporations and pursued mass manufacturing while increasing exports. Because of their weak absorption capability for technology—a result of mass production manufacturing—they have failed to incorporate the latest technologies from multinationals. Recently, China has attracted multinationals by offering entry into the enormous Chinese market in exchange for access to their state-of-the-art technologies. These strategies have wreaked havoc on Southeast Asian countries. Unless the world’s demand for imports from East Asian countries is able to exceed the pace of China’s export growth, further increases in China’s share of the global economy will diminish the market share of its competitors. Worse yet, not only market share but also total exports may shrink as a result of China’s rapid growth. This phenomenon has been felt in the US market, where China’s market share quadrupled from 3.1% in 1990 to 12.1% in 2003. Meanwhile, Japan’s share of the American market halved from 18.1% to settle at 9.4% over the same period,

Figure 1-1 Asian Countries’ Market Share in the US (Unit: %)

20 China ASEAN 5 16 Korea + Taiwan + Hong Kong Japan 12

8

4

0 1990 1995 1998 2000 2001 2002 2003

Source: US Department of Commerce.

16 CHAPTER I Introduction: Purpose and Overview and the aggregate market share of Korea, Taiwan, and Hong Kong decreased from 10.1% to 6.1%. The combined market share of the five ASEAN countries managed to increase only slightly, from 5.5% to 6.0%. Further complicating matters is China’s absorption of resources such as raw materials and foreign capital needed by East Asian countries. Multinational corporations have also advanced into China to tap the low cost of labor. This movement has come at the cost of decreased investment in Southeast Asian countries. Because of their heavy reliance on foreign direct investment, NIEs desperately need foreign investment to grow. Between 1991 and 1996, China drew US$25.5 billion in FDI annually. Three East Asian NIEs (Korea, Taiwan, and Singapore) recorded annual FDI of US$15.4 billion, while four Southeast Asian countries (the Philippines, Malaysia, Indonesia, and Thailand) tallied US$11.6 billion. Investment in China continues to increase dramatically, however, while FDI in the other countries continues to fall. Investment in NIEs has increased temporarily since the currency crisis, but only because companies in these countries have had to sell assets to survive the emergency. Once China’s participation in the WTO was determined in 2001, investment in China began to increase dramatically, while investment in the three NIEs and

Figure 1-2 Foreign Direct Investment in China, NIEs, and ASEAN

(Unit: US$billion) 60.0 NIEs 3 53.5 China 52.7 50.0 ASEAN 4 46.8 44.2 43.8 40.3 40.8 40.0 30.7 28.4 30.0 25.5 22.8 20.0 18.6 15.4 16.1 15.6 13.0 11.6 11.6 9.8 10.1 10.0 6.2 3.9 2.4 4.0 0.0 1991-96 1997 1998 1999 2000 2001 2002 2003

Note: The NIEs 3 are Korea, Taiwan and Singapore. “ASEAN 4”refers to the Philippines, Malaysia, Indonesia, and Thailand. Source: UNCTAD, World Investment Report 2003 and 2004.

2 Implications of China’s Rise for East Asia 17 the four aforementioned Southeast Asian countries started to decrease sharply. In 2001, foreign investment in the four Southeast Asian countries came to US$2.4 billion, much lower than US$16.1 billion in 1997, the year the currency crisis swept through East Asian countries. By 2003, investment in China had surged to US$53.5 billion, while investment in the three NIEs and the four Southeast Asian countries amounted to US$15.6 billion and US$4 billion, respectively. It has been argued that a considerable part of foreign investment in China comes from East Asian countries, and that, for this reason, a decrease in investment in East Asian countries will not negatively affect themselves, so long as their investment in China yields high profits. This argument has some validity. China’s rapid industrial growth can be ascribed to the fact that an increasing number of companies from Japan, Korea, Taiwan, and the West are manufacturing their products in China. Moreover, half of China’s exports are produced by multinational corporations, which generally import parts and components from their home countries or parent companies, as the Chinese economy has not matured enough to provide the parts and components needed. As long as this division of labor continues, countries investing in China can gain at least half of the benefits that China does through exports. It is certain, however, that the lack of investment in East Asian countries and the resulting surge in unemployment have reduced the dynamism of their economies. China’s expanded exports have also aggravated East Asian countries’ terms of trade. Because of China’s export of labor-intensive products, prices for such goods have declined in the global market. These falling prices benefit importing countries but harm other East Asian countries. Another point should not be ignored: while the increase in China’s import of parts and intermediate goods may improve global terms of trade—especially for countries that export them to China, who will see their purchasing power rise—if Chinese companies improve their technological prowess. If that happens, multinational corporations would begin to face greater competition, and state-of-the-art technologies may start to be transferred to Chinese companies. Once China acquires cutting-edge technology, it will be able to manufacture intermediate goods and parts locally, a development that would reduce the exports of East Asian countries to China. A technologically advanced China, capable of procuring parts by itself, will pose a formidable

18 CHAPTER I Introduction: Purpose and Overview challenge to East Asian economies. China’s rapid growth also presents East Asian countries with opportunities. Chinese imports have increased dramatically in recent years, so that, as East Asia’s exports to advanced countries such as the US have stalled, China has become their most important export market. Also, in the past, growth in one country has spread to others through regional trade and direct investment. However, considering the dramatic change in the global business environment and China’s enormous demand for resources, it is not certain that China’s growth will stimulate growth in other economies in the region. Under the General Agreement on Tariffs and Trade and WTO systems, East Asia was developed as a manufacturing and supply base for industrial products. With the global trend of trade liberalization, East Asia’s exports increased, a development that played a critical role in pulling the region out of poverty. The Uruguay Round agreement proved a watershed event, one that dramatically changed the global economic environment. East Asian economies have been forced to open service and financial sectors in which they were not competitive. Trade of goods (based on exports) increased 5% a year between 1995 and 2000, decreased 4% in 2001, and then turned upwards again, growing 4% in 2002. On the other hand, exports of services rose 4% a year between 1995 and 2000, stagnated in 2001, and then rose 6% in 2002.5 In other words, the terms of trade in East Asia that concentrated on the export of industrial goods have been aggravated. More significantly, the foreign exchange market has been a source of concern for East Asia since the mid-1990s, when the area’s liberalization of financial markets began. With the onset of the currency crisis, portfolio investment and commercial loans flooded out of the region. According to a report by UNCTAD, net inflow of portfolio investment into Asian countries amounted to US$56.6 billion in 1999 but fell to US$20.1 billion in 2000. In 2001, the inflow turned to a net outflow of US$54.4 billion. Between 2001 and 2003, the net outflow approached US$60.0 billion a year.6

5 WTO, International Trade Statistics 2003, pp. 19-20. 6 UNCTAD, Trade and Development Report, 2004, pp. 58-59.

2 Implications of China’s Rise for East Asia 19 The rapid formation of regional economic blocs is another change in the global economy. In 2004, ten Eastern European countries joined the European Union, and the US continues its attempts to establish the Free Trade Area of the Americas (FTAA). While the rest of the world has been forming economic blocs, among East Asian countries there has been a no-holds-barred competition that has deteriorated terms of trade—which have been further aggravated by the fact that China has snatched significant market share from its neighbors. Regionalization and the deterioration of terms of trade are a great challenge to East Asian economies, which have grown through industrialization and robust exports. In some respects, however, these long-established strategies were showing their limitations even before the currency crisis. East Asia’s market share soared from 13.4% in 1980 to 20.4% in 1990 and 25.6% in 1995 and then stopped growing. In fact, it shrank to 25.4% in 2003. Up to 1995, the market share of all East Asian countries grew in the global market. Subsequently, however, China’s market share has risen, while that of other countries, taken together, has fallen.

Table 1-2 Weight of Countries or Economic Blocs in Global Trade (Exports)

(Unit: %)

East Southeast Japan NICs China US EU World Asia Asia 1980 13.4 6.4 3.8 2.3 0.9 11.1 37.1 100.0 1990 20.4 8.3 7.8 2.5 1.8 11.4 43.7 100.0 1995 25.6 8.6 10.4 3.7 2.9 11.3 4.04 100.0 2000 25.7 7.4 10.3 4.1 3.9 12.1 35.9 100.0 2003 25.4 6.3 9.5 3.7 5.9 9.7 38.7 100.0

Note: NICs are Korea, Taiwan, Hong Kong and Singapore. is Malaysia, Thailand, Indonesia, and the Philippines. Source: World Trade Organization.

East Asia’s development model has emphasized industrialization and outward-looking development strategies. However, as shown in the above table, it now faces critical challenges with the rise of China and a changing global

20 CHAPTER I Introduction: Purpose and Overview economic environment. For sustainable growth, East Asia needs to establish a new growth model. It must take advantage of China’s dramatic growth and manage the risks presented by the changing global economic environment. For this to happen, East Asian countries have to diversify industries, expand trade, and exchange human resources and materials.

2 Implications of China’s Rise for East Asia 21 3

Organization of the Book

This book is a study of East Asia’s response to China’s emergence as an economic power. It analyzes each country’s response to China’s growth, as well as the newly established economic order, production structure, and cooperative measures undertaken by East Asian countries to achieve sustainable development. Existing research on East Asia’s economic order has largely fallen into two categories: studies of the relationship between China’s economic growth and its regional competitors, and studies of cooperation in East Asia. In addition, a number of studies have looked at how China’s economy affects the global and East Asian economies in the wake of its integration into the WTO, at the increase in China’s trade volume since its entrance into the WTO, at the recent surge in foreign direct investment in China, and at industrial hollowing-out in other East Asian economies. Most of these studies have been conducted by Japanese researchers, the World Bank, and the Asia Development Bank. Existing studies analyze the integration of East Asia in response to China’s economic growth from a macro perspective.7 This book analyzes how the rise of China has affected the economic environment of each of the countries of Northeast Asia, and how each has responded to the dramatic growth of China. In other words, it aims at finding what relations Korea, Japan, Taiwan, Hong Kong, and Singapore have established with

7 Some of them are as follows: World Bank, East Asia Integrates: A Trade Policy Agenda for Shared Growth, 2003; World Bank, Regional Integration in East Asia: Challenges and Opportunities, 2003; ADB Institute, An Overview of PRC’s Emergence and East Asian Trade Patterns to 2020, 2002; Development Bank of Japan, China’s Economic Development and the Role of Foreign-Funded Enterprises, 2003.

22 CHAPTER I Introduction: Purpose and Overview China, and how they view their formidable competitor. Moreover, it examines how factors that have determined East Asia’s economic order have changed in the face of China’s dramatic growth, and hazards some predictions about future economic relationships. Finally, it identifies cooperative measures that will be vital to the sustained growth of the East Asian economies. While the primary subjects of the study are the early-developed East Asian countries, some Southeast Asian countries are included in the discussion when appropriate. The article “The Emergence of the Chinese Economy and the Response of Korea,” in Chapter 2 written by Choi Ho-Sang, a senior economist at Samsung Economic Research Institute, focuses on the shift in economic relations between Korea and China, and asks how these relations will change as China continues to grow. The author points out that Korea’s growth potential has weakened and analyzes how China will affect Korea’s economy. He argues that the rise of China cuts both ways. In terms of opportunities, Korea’s exports to China have been on the rise, thanks to the latter’s dramatic economic growth. Korea’s exports to China surged by 47.8% between 2002 and 2003, to US$35.11 billion. In addition, China has become the biggest importer of Korean products, surpassing the US. In 2003, Korea’s trade surplus with China accounted for 88.1% of its total trade balance. However, Korea is likely to suffer from industrial hollowing-out, thanks to China’s rapid growth and the desire of Korean companies to move their factories to China. Korean investment in China has grown rapidly since China joined the WTO in 2001. In fact, China has become Korea’s biggest investment destination, surpassing even the US. From 1990 to mid-2004, 90.8% of Korea’s investment in China has concentrated on the manufacturing industry. What is causing particular concern regarding investment in China is that money is increasingly being channeled into capital-intensive industries, such as the electronics industry, rather than into labor-intensive light industries. Surging investment in China has already contributed to slowed investment in Korea and less job creation. As mentioned above, Korea’s heavy investment in China’s manufacturing industry is considered by many to pose a threat to Korea. Since Korean companies have transferred their manufacturing facilities to China, local investment in plants and equipment has decreased. Worse, this transfer affects job creation in Korea,

3 Organization of the Book 23 Figure 1-3 Cases of Investment in China’s Manufacturing Industry and the Ratio of Foreign Investment to Facility Investment (Units: billions of dollars, %) Investment Ratio 1.4 2.2 2.5 2.0 Investment into China/ 1.2 Facility investment Investment (13.6) 2.0 1.0 1.5 0.8 (7.1) (7.2) 1.5 (5.9) 1.0 (8.5) 0.6 1.0 0.6 0.4 (5.4) 0.5 0.2 (2.9) 0 0 1995 1996 1997 1998 1999 2000 2001 2002 2003

both directly and indirectly. The author argues that Korea’s investment in China and a decreasing rate of employment has diminished the momentum of Korea’s growth. The author also assesses the Korean government’s attempts to position Korea as an economic hub of Northeast Asia while minimizing the dangers posed by China’s rise and maximizing the opportunities. According to Choi, the Korean government plans to establish logistics, IT, and business infrastructure by which it can enjoy a comparative advantage over other countries, continue to open its doors to the world, and maintain peaceful relations with . In Chapter 3, “The Rise of China: Challenges and Opportunities for Japan,” C.H. Kwan of the Nomura Institute of Capital Markets Research analyzes economic relations between Japan and China. The author argues that the rise of China has presented Japan with more opportunities than threats. A considerable part of China’s economic growth and trade has been made possible by multinational corporations, including Japanese businesses. Moreover, despite China’s rapid growth, economic relations between Japan and China are characterized as complementary rather than competitive, due to the technological gap between them. Kwan finds in his analysis a considerable gap between the two countries in terms of both economic and technological development, such that the rise of China contributes positively to Japan’s economy through improved terms of trade. In

24 CHAPTER I Introduction: Purpose and Overview Figure 1-4 Competition between China and Japan: Conceptual Framework

Amount China(A) Japan(B)

C Shoes TV Semiconductors Product Sophistication Index($) Low-tech Products High-tech Products

other words, the prices of imports from China decrease, while the prices of exports to China increase. There has been some concern over deflation resulting from the surge in imports from China. However, Kwan points out that increased imports from China both increase production and lower production costs, while pushing down the prices of parts and intermediate goods. Thus imports from China contribute to an increase in Japan’s production, making the economic relations of the two countries complementary rather than competitive. The author recognizes that China will provide opportunities for Japanese companies, becoming a massive market and production base for Japan. For the two countries to establish mutually beneficial relations, however, Japan has to avoid industrial hollowing-out, and, accordingly, needs to transfer factories that have already lost competitiveness to China. At the same time, because their relationship is complementary, a free trade agreement between the two countries would benefit both. The author admits that there are obstacles to concluding an FTA agreement between Japan and China, but argues that they must be overcome so that a free trade arrangement can enhance the integration of East Asia through political leadership. Chapter 4, “Taiwan: Investment in China and Structural Change,” by Chu- Chia Lin of National Chengchi University, examines the effects of Taiwan’s trade with China and FDI in China on Taiwan’s economic growth and structural change. Economic relations between Taiwan and China started in 1979 when China began its open-door policy. Since 1988, Taiwan’s investment in China has increased dramatically. Bilateral trade volume has grown sharply because each country has

3 Organization of the Book 25 distinct comparative advantages. The author asserts that Taiwan’s exports to China and its trade surplus have contributed significantly to growth in Taiwan’s GDP. According to Lin, the annual contribution of bilateral trade to Taiwan’s GDP had reached almost 20% by 2002, and hovered around 30% in 2003. Lin points out that robust investment in China has improved Taiwan’s economic structure. Since low-wage and low value–added industries have moved to China, the proportion of Taiwan’s economy devoted to manufacturing has decreased, while the proportion taken by the service industries has increased. He argues that the low share held by the manufacturing sector has not necessarily entailed a hollowing-out of those industries. Taiwan’s economic structure, he explains, has improved since the focus of exports has shifted from labor-intensive low value–added products to capital-intensive high value–added products. In fact, the share of high value–added products in Taiwan’s exports surged from 18% in 1987 to 47% in 2002. The author argues that employment in Taiwan has not suffered because of the rapid growth of China. Taiwan began to invest in China in earnest in 1987, but Taiwan’s unemployment rate stayed at the 3% level until 2000. Accordingly, he writes, the recent increase in Taiwan’s unemployment rate should not be attributed to China’s economic growth, but rather to internal factors. The relocation of Taiwanese companies to China has increased Taiwan’s influence there. However, corporate performance differs according to company size. In general, Taiwanese companies that have advanced into China to take advantage of the country’s low labor costs and to pursue vertical integration have seen their international competitiveness enhanced, while companies that have attempted to tap into the massive Chinese market and to pursue horizontal integration have found their competitiveness in the global market diminished. In short, it appears that Taiwanese companies can increase their international competitiveness only when they pursue vertical integration with the production lines of subsidiaries, and that this is where their priorities should lie. The author concludes that the rise of China does not pose a threat to the Taiwanese economy, but rather presents Taiwan with a variety of opportunities. However, the Taiwanese government has maintained a cautious attitude when it comes to expanding economic relations with China. Taiwan’s government allows

26 CHAPTER I Introduction: Purpose and Overview only indirect trade with China and puts strict regulations on investment there. Lin argues that Taiwan cannot avoid expanding economic relations with China, and thus should not isolate its economy from that of its mainland neighbor. Only expanded economic exchange with China will enable Taiwanese companies to differentiate themselves from other companies operating there, to take advantage of low-priced production factors, and to secure the massive market China represents. Chapter 5, “Responses to the Emerging Chinese Economy: Singapore and Hong Kong,” by Shin Jang-Sup of the National University of Singapore, considers how Singapore, a city-state competitive in service industries, has responded to China’s economic growth. The author explains that Singapore has taken a number of measures in response to the rise of China. First, the government has worked aggressively to reach FTAs with various trading countries. Although Singapore was once a hub of Association of Southeast Asian Nations, or ASEAN, an economic slump in the region cost the city-state its competitiveness. Singapore has established FTAs with major countries, including the US, Australia, and Japan, that make it an attractive environment for multinational corporations. According to the author, these FTAs do more than just expand trade volume, they also help draw foreign investment. Second, Singapore has responded efficiently to the possibility of hollowing- out. Even though its per capita income is high, it has maintained a significant portion of its manufacturing sector, relative to other advanced countries. Thus it has dealt with the pressures that might lead to hollowing-out while realigning and upgrading its industries. Singapore has recognized that for the Singaporean economy to thrive and remain competitive, low value–added industries should be transferred overseas. In addition, it has sought to upgrade its economy while continuing to invest in such manufacturing industries as bioengineering and IT. The government has not discriminated between foreign companies and local ones, but instead has maintained an open economic policy while drawing money from local and foreign investors and directing it to state-of-the-art industries. Such strategies may suggest future policy directions for other Asian countries affected by the rapid growth of the Chinese economy. Third, while Hong Kong and Shanghai have emerged as rivals, Singapore has worked to maintain its status as the region’s financial hub. With the Chinese economy growing dramatically, Hong Kong has watched the demand for its

3 Organization of the Book 27 financial services increase rapidly. Singapore has responded to these challenges by further liberalizing its financial industry to attract major financial institutions and foreign investment from all over the world. Chapter 6, “The Rise of the Chinese Economy and the Economic Integration of East Asia,” by Park Bun-Soon, chief economist at Samsung Economic Research Institute, studies how China’s dramatic growth has affected established economic integration efforts within East Asia’s current economic order, and explores how that order might develop in the future. Since the 1960s, linear vertical economic integration, as well as the so-called “flying-geese” economic development pattern led by Japan, contributed to the development of East Asia. In the flying-geese pattern, the economic dynamism of Japan spread to the NIEs, to early-developed ASEAN countries, and to China. However, this model ceased to be applicable around the mid-1990s, thanks to the rise of China and slowed innovation in Japan. When the Plaza Accord was reached in the mid-1980s, investment by Northeast Asian companies in Southeast Asia began to increase, and a new economic cooperation model known as “bamboo-capitalism” appeared in the region. This model entailed intricate intra-regional production networks through which East Asian countries, working in close cooperation, increased trade volume by expanding supply chains and focusing on the exchange of parts, components, and other intermediate goods within the region. In addition, production increases in one country led to production surges in other countries. Though it might seem that “bamboo capitalism” has made East Asia’s economic integration more complex, compared to conventional vertical economic integration, labor is still vertically divided. The author argues that a more dynamic economic development pattern will appear in East Asia. In the past, economic clusters formed within the borders of a single country. Now, however, the greater openness of markets encourages neighboring countries to share an economic cluster. Park argues that large-scale cross-border economic clusters grow with the help of investment from neighboring countries. Such clusters first appeared in China: the Pearl River Delta and the Yangtze River Delta, for instance, developed through direct foreign investment from neighboring countries. While the basic economic unit under bamboo capitalism was the East Asian region as a whole, the basic unit in the new paradigm is the cross-border economic cluster. This shift of perspectives will help

28 CHAPTER I Introduction: Purpose and Overview Figure 1-5 Development Model of East Asia

Flying-geese patternBamboo Capitalism Lily-pad pattern

1960 1985 1995~1997 2001~2003

to integrate economies and to secure the benefits of that integration. The author predicts that, with increasing economic cooperation and institutional development, such as establishment of FTAs, a number of large-scale economic areas that take the shape of ‘lily pads’ will appear in East Asia. In addition to the two delta areas cited above, the Northeastern three provinces in China, the Malay Peninsula, and the Mekong River basin are also likely to become large-scale economic clusters. The eastern Indian region, which connects ASEAN with and is well positioned to draw investment from neighboring countries, is another strong candidate. Though India is highly competitive in the IT and software industries, these two sectors are not enough, on their own, to lead the economy of such a populous nation. Thus India is expected to nurture labor- intensive and export-driven manufacturing industries. As this process unfolds, the eastern Indian region is highly likely to grow into a large-scale economic cluster, one that draws attention and investment from other countries. The author proposes that a large-scale economic cluster of this sort passes through three stages: formation, development, and maturity. As a result, he explains, the cluster is internally integrated, as seen in bamboo capitalism. In the formation stage, other early-developed economic clusters invest in the region, which imports intermediate goods from them. In the development stage, benefits from economies of scale gradually disappear, and investors start to find new investment destinations. In short, several economic clusters grow in sequence, a development pattern that keeps the economies of East Asia robust and dynamic.

3 Organization of the Book 29 References

ADB Institute, “An Overview of PRC’s Emergence and East Asian Trade Patterns to 2020,” 2002.

Dahlman Carl J. and Jean-Eric Aubert, China and the Knowledge Economy: Seizing the 21st Century, The World Bank, 2001.

Development Bank of Japan, “China’s Economic Development and the Role of Foreign-Funded Enterprises,” 2003.

United Nations Conference on Trade and Development, Trade and Development Report, 2004.

World Bank, The East Asian Miracle: Economic Growth and Public Policy, New York: Oxford University Press, 1993.

World Bank, East Asia Integrates: A Trade Policy Agenda for Shared Growth, 2003.

World Bank, Regional Integration in East Asia: Challenges and Opportunities, 2003.

World Trade Organization, International Trade Statistics, 2003.

30 CHAPTER I Introduction: Purpose and Overview CHAPTER 2 KOREA’S RESPONSE TO CHINA RISING Choi Ho-Sang, Samsung Economic Research Institute 1

Introduction

Despite a recent export boom, Korea’s economic growth is decelerating because of slack domestic consumption and investment. Since the Asian financial crisis of 1997-98, the fundamentals of the Korean economy have weakened as investment decreases and R&D stagnates, developments that have diminished long-term competitiveness. Per capita GNI, which had reached US$10,000 in 1995, plunged in 1998 to US$7,335. While it rose again to US$10,841 in 2001, the economy’s growth rate remains stagnant. If the current situation persists, economic growth is certain to slacken, lowering Korea’s standing in the global economy. Export-led growth can no longer be achieved through the price-competitiveness once ensured by low labor costs. Nor are efforts to achieve export competitiveness through technological innovation, increased productivity, and accommodating business environments particularly reliable. Korea is heavily dependent on foreign trade, and a diminished role in the global economy makes Korea’s economic prospects unclear. Seen in this context, the rise of China is a double-edged sword, presenting both threats and opportunities. The Korean export sector benefits from China’s high growth rate. However, China is an economic powerhouse, increasingly gaining market share in major world markets as it takes advantage of price competitiveness and economies of scale. As China makes further pushes into major export markets, Korea will be as hard pressed as the proverbial “walnut in the nutcracker.”1

1 In the words of a 1997 report by Booz, Allen & Hamilton, an American consulting firm, “[s]queezed between China’s cost advantage and Japan’s efficiency, Korea is like a walnut in the nutcracker.”

1 Introduction 33 China is thus very likely to pose a threat to Korea’s economy. Korea’s major manufacturing industries are losing price competitiveness to developing countries a including China, and its high-tech industries, including IT, are far behind those of advanced countries such as the US and Japan. Even more threatening is China’s industrial structure, which is making a transition from labor-intensive industries like textiles and clothing to high-tech industries such as IT. Korean companies, constrained by high wages and investment regulations in the local market, are actively making inroads in China. Furthermore, the Korean manufacturing sector is creating fewer jobs, as investment in China’s manufacturing sector intensifies. Considering the scale of its economy, Korea’s total overseas investment has not, at least until recently, been very high, compared to that of competing economies. This is no longer the case, however, as Korean investment in China grows steadily. As said, investment pattern into China is shifting from labor- intensive to capital-intensive industries like electronics and telecommunications. This transition is noteworthy, since the industrial hollowing-out that has been experienced in advanced countries may materialize in China, a development that would rapidly undermine the competitiveness of major manufacturing industries in Korea. Added risks posed by Korea’s deepening trade relations with China are a severe shortage of raw materials and fallout from a hard landing by the Chinese economy after years of rapid economic growth. Without a doubt, the emergence of China as a global economic giant will affect Korea’s economy significantly. The following section explains how factors like low economic growth, the polarization of the economy, slack facilities investment, and low job creation have weakened Korea’s growth potential. Section 3 examines Korea’s deepening economic cooperation with China by looking at issues like trade and investment growth. The final section assesses a plan put forward by the Korean government in response to the emerging Chinese economy.

34 CHAPTER 2 Korea’s Response to China Rising 2

The Growth Potential of Korea’s Economy Being Undermined

2-1 Low Growth Rate and Stagnant Investment

Since the 1960s, Korea has enjoyed one of the highest economic growth rates in the world. During this time, it has transformed itself from a war-torn agriculturally-based economy into a top exporter of industrial products. The major force behind this growth has been high investment and export-oriented industrialization. A closer look at the GDP growth trends since 1970 shows that investment has contributed significantly to the growth of the Korean economy. While the average annual growth rate was 7.6% in the 1970s, the investment ratio (gross fixed capital formation ratio) surged by 14.0% and facilities investment by 20.0%, surpassing the rate of increase in private consumption, which was 6.5%. During this period, Korea focused on nurturing the heavy and chemical industries. Since the 1970s, investment has continued to play a significant role in Korea’s economic growth. The rate of investment has increased faster than GDP growth, while the rate of increase in private consumption has remained below that of GDP growth. The situation changed, however, after 1997. GDP growth plunged to 3.9%, while gross fixed capital formation and facilities investment each increased by a mere 0.8%. In contrast, private consumption rose 2.2%. The main culprit behind the sluggish investment was the uncertain business environment faced by Korean companies that could not afford to expand investment in the wake of corporate restructuring. A falling investment-to-GDP ratio, resulting from low GDP growth, also had a negative effect.

2 The Growth Potential of Korea's Economy Being Undermined 35 Table 2-1 Average Annual growth rate of GDP and investment (Unit: %)

1970-79 1980-89 1990-97 1998-2004 GDP 7.6 7.1 7.0 3.9 Private Consumption 6.5 6.5 6.8 2.2 Gross Fixed Capital Formation 14.0 7.9 8.8 0.8 Facilities Investment 20.0 7.2 8.3 0.8

Source: Bank of Korea.

Investment trends since the currency crisis reflect other features of the Korean economy. One is the plunge of the investment ratio (the ratio of gross fixed capital formation to GDP), which was 39% in 1996, had fallen to 25.2% by 1998, and has been declining continuously since then. Similarly, the ratio of investment to GDP dropped from 14.1% in 1996 to 8.4% in 1998, right after the crisis. Although it climbed back to 12.8% in 2000, it fell to 9.6% in 2003, and further to 9.2% in the first quarter of 2004. Sluggish facilities investment reflects changes in domestic corporate investment patterns after the currency crisis. In other words, domestic companies were focusing more on securing profitability and paying down debt than on their past practices of aggressive and quantity-based investment. Also, the economic slowdown created fewer investment opportunities. Notably, the investment ratio has been lower than the savings ratio since 1998. Generally, a higher ratio of investment indicates a current account deficit. Indeed, in the case of Korea, a high current account deficit triggered the outbreak of the currency crisis. Ironically,

Table 2-2 Average Annual growth rate of investment and saving [Unit: %]

1996 1997 1998 2000 2002 2003 2004 Ratio of Facilities Investment 14.1 12.2 8.4 12.8 10.4 9.6 9.2 Gross Domestic Investment Ratio 39.0 36.1 25.2 31.1 29.1 30.1 30.3 Savings Ratio 35.5 35.5 37.5 33.7 31.3 32.8 34.9 Facilities Investment Increase Rate (9.2) (-9.6) (-42.3) (33.6) (7.5) (-1.2) (3.8) Facilities Investment’s Share (15.6) (13.4) (8.3) (12.8) (11.3) (10.8) (11.2)

Source: Bank of Korea.

36 CHAPTER 2 Korea’s Response to China Rising Figure 2-1 Korea’s Real Growth Rate and Potential Growth Rate

[Unit: %] 8 7 6 5 4 3

2 Potential Growth Rate 1 Real GDP Growth 0 1970 1980 1990-1997 1998-2004

Source: Bank of Korea

Korea now has to deal with an overly high current account surplus. The decline in investment causes, in the short term, an economic slowdown, and diminishes economic growth potential in the mid-to-long term. Recently, capital and labor inputs have been declining, and, moreover, with scarce R&D investment and a wide technological gap between Korea and advanced countries, productivity improvement through technological innovation has not been up to the mark. As the scale of the economy grows and capital accumulation deepens, the law of diminishing returns is coming into effect, while potential output is being undermined by, among other things, slowed population growth. In sum, Korea’s potential growth rate has dropped continually since the currency crisis, falling toward 4% in the 1998–2004 period.2

2.2 Polarization of the Economy

Various sectors of the Korean economy are polarizing. This is particularly

2 The H-P (Hodrick-Prescott) filter was used to calculate potential growth rate.

2 The Growth Potential of Korea's Economy Being Undermined 37 noticeable in the gap between exports and domestic demand, as investment and private consumption remain contracted. Widening gap among export-oriented companies is also serious, with some high-tech products enjoying booming exports, while labor-intensive light industries suffer from sluggish overseas sales. Since 2002, exports by the heavy and chemical industries have grown steadily, after falling in 2001 because of a global downturn caused by the burst of the IT bubble. In contrast, light industry exports dropped for three consecutive years, from 2001 to 2003, before rebounding in 2004. It is also noteworthy that exports by light industry are declining steadily as a portion of total exports. In 1995, light industry accounted for 22.5% of total exports, but this figure has dropped every year since, coming to 18.0% in 1999, and 12.4% in 2003. Even in 2004, growth in light industry exports could only manage to take up 12.8% of Korea’s export total.

Table 2-3 Export Trends for Heavy and Chemical Industries and for Light Industry

(Unit: US$billion, (% change in yoy))

1995 1999 2000 2001 2002 2003 2004 Heavy and Chemical Industries 90.91 111.45 139.56 121.71 134.33 164.45 221.39 (Increase rate) (37.6) (14.8) (25.2) (-12.8) (10.4) (22.4) (34.6) (Share) (72.7) (77.6) (81.0) (80.9) (82.7) (84.8) (87.2) Light Industry 28.08 25.88 27.93 24.62 24.15 24.08 25.57 (Increase rate) (7.3) (4.4) (7.9) (-11.9) (-1.9) (-0.3) (6.2) (Share) (22.5) (18.0) (16.2) (16.4) (14.9) (12.4) (12.8)

Source: Korea International Trade Association.

As the exports of the two industries have become polarized, the top five export items, including semiconductors and automobiles, have increased as a percentage of total exports. Prior to the financial crisis, they hovered at around 30%, but in 2000 they rose to 41.4%. Their share shrank temporarily in 2001, but have recovered from 2002 on, recording 43.2% in 2003 and 44.1% in 2004. Three of the five major items in 2003 and 2004—semiconductors, wireless communications devices, and computers— are IT products, exports of which are sensitive to changes in the global IT cycle.3 Korea’s dependence on exports rather than domestic demand after the

38 CHAPTER 2 Korea’s Response to China Rising inancial crisis is equally reflected in the export dependence of the major items. As shown in the above table, the polarization of heavy and light industries has increased steadily. The fact that exports of light industrial products are sluggish in the midst of stagnant domestic demand indicates that the growing gap between these two industries may lead to a polarization between large companies and small and medium-sized enterprises (SMEs). It is inevitable that heavy industry will experience high growth as the economy grows. This has been a particular characteristic of the Korean economy for a long time. Nonetheless, the growing gap between the two industries since 2001 is worth noting.

Table 2-4 Export Shares of Top Five Export Items (Unit : %) 1995 2000 2003 1H 2004 Item Share Item Share Item Share Item Share 1 Semiconductors 14.1 Semiconductors 15.1 Semiconductors 10.1 Semiconductors 10.4 2 Automobiles 6.7 Computers 8.5 Automobiles 9.9 Automobiles 10.0 3 Vessels 4.5 Automobiles 7.7 Wireless Commun- 9.6 Wireless Commun- 9.9 ications Apparatus ications Apparatus 4 Broadcast and 3.9 Petrochemical 5.3 Computers 7.7 Computers 7.5 Video Apparatus Products 5 Computers 3.8 Vessels 4.9 Vessels 5.8 Vessels 6.9 Total 33.1 41.4 43.2 44.7

Note: Each item is based on MTI unit 3. Source: Korea International Trade Association.

In fact, polarization is spreading to all areas of the Korean economy. There are gaps growing among companies, among income brackets, and among regional economies. In 2003, the gap between the highest and the lowest income brackets started to grow, and the operating-profit-to-sales ratio between large companies

3 With global IT plunging into recession in 2001, exports of semiconductors and computers declined by 45.2% and 23.4% respectively, and Korea’s total exports dropped by 12.7%.

2 The Growth Potential of Korea's Economy Being Undermined 39 and SMEs also widened. Moreover, total output of the Seoul metropolitan area in 2002 accounted for almost half that of the nation. All of these factors could weaken Korea’s growth potential. Booming IT industries such as semiconductors and wireless telecommunications devices are not effectively spurring growth in their related industries. Their overseas dependence for parts and components exceeds 40% on average, making it difficult to expand domestic investment, create jobs, and increase consumption. In addition, the growing gap between large companies and SMEs in terms of asset growth and profitability has resulted in weakened competitiveness for smaller companies in terms of wage growth.

Figure 2-2 Output Growth Trends for Heavy and Light Industry

output of heavy and light industries(in yoy) Gap(%) 35 25 Heavy Industries 30 Light Industries 25 Gab 20 20 15 15 10 5 10 0 -5 -10 5 -15 -20 0 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

Source: Korea National Statistical Office.

Table 2-5 Polarization Since the Currency Crisis (Unit: % )

1998 2000 2001 2002 2003 Ratio of Highest Income Quintile to the Lowest 5.41 5.32 5.36 5.18 5.22 Large Companies 6.5 8.2 6.0 7.5 9.0 Operating Profit–Sales Ratio Small- and Medium-Sized Companies 5.2 5.8 4.5 5.3 4.5 Weight of GRDP of Metropolitan Area 45.2 48.0 47.9 48.7 -

Notes: 1. Operating Profit–Sales Ratio is that of listed manufacturing companies; 2003 figure is for the first half of the year. 2. GRDP refers to total output. Sources: Bank of Korea, Korea National Statistical Office.

40 CHAPTER 2 Korea’s Response to China Rising 2.3 Reduced Potential for Job Creation

The Korean economy is showing signs of a hollowing-out of manufacturing and a de-industrialization similar to what advanced countries have experienced in the past. Whether hollowing-out is happening or not can be determined by looking at manufacturing’s proportional contribution to GDP and to total employment. As for the former, except for 1998, the Korean manufacturing industry has undergone steady growth. The share of manufacturing in real GDP (based on 2000 prices) came to 28.7% in 2004, the highest level since 1970. This robust growth might appear to resolve any concerns about hollowing-out. However, manufacturing employment tells a more worrisome story, as the industry has been losing its ability to create more jobs since the 1990s. Manufacturing as a percentage of total employment dropped to 19.0% in 2004, down 8.2 percentage points from its 1990 figure of 27.2%, and it has been hovering below 20% since 2001. The number of manufacturing jobs has declined three years in a row. In 2003, despite economic growth of 3.1%, total employment in manufacturing dropped by 30,000 jobs, a sign of jobless growth. During the same period, Korea’s employment rate (i.e., the ratio of employment to population aged 15 to 64) stood at 63%, lower than that of the US and Japan, and lower than the OECD average. The ratio of employment to population aged 15-24 was also off compared to other countries at 30.8%—less

Figure 2-3 Manufacturing Share of Total Employment and of GDP

(unit: %) 30 Production 28 Number of Employed 26 24 22 20 18 16 14 12 10 1990 1992 1994 1995 19971998 1999 2000 2003 2004

Sources: Bank of Korea, Korea National Statistical Office.

2 The Growth Potential of Korea's Economy Being Undermined 41 than half of the total employment-to-population ratio. The low ratio can be ascribed to the direct and indirect effects of increased SME overseas investment— capital that would have strong potential to create jobs in Korea were it invested domestically.

Table 2-6 Employment-to-Population Ratios of Major Countries (2003)

(Unit : %) Korea US Japan OECD

Total 63.0 71.2 68.4 65.0 Aged 15-24 30.8 53.9 40.3 43.6

Note: Total employment-to-population ratio includes persons aged 15 to 64. Source: OECD.

The recent decline in manufacturing jobs can be attributed to the discrepancy between the brisk export activity in high-tech industries and the sluggish activity of traditional industries. Job loss in manufacturing employment, however, does not lead to job growth in the high-tech industries, which have relatively low job creation potential. For example, jobs in the IT industry only accounted for 5.6% of total employment in 2001. Making matters worse, large corporations are adopting high-tech facilities to maintain their competitiveness in the global market, or exporting high value–added products, which have only a marginal effect on job creation.

42 CHAPTER 2 Korea’s Response to China Rising 3

Economic Cooperation with China and Its Impact

3.1 Trade Cooperation with China

Before diplomatic relations were established in 1992, Korea’s exports to China were below US$1 billion. However, following the creation of formal ties, exports to China more than doubled, reaching US$2.65 billion the following year. Since then, exports have grown sharply every year, except for 1998 (-12.0%) and 2001 (- 1.4%). In 2003, Korean exports to China surged to US$35.1 billion—47.8% higher than the previous year, and 13.2 times higher than in 1992. In 2004, exports to

Figure 2-4 Korean Exports to China: Amount and Rate of Growth

US$100 million % change(yoy) 550 60 Amount of Exports to China(left axis) 500 Growth Rate of Exports fo China 50 450 Total Export Growth Rate 40 400 350 30 300 20

250 10 200 0 150 100 -10 50 -20 1996 19971998 1999 2000 2001 2002 2003 2004

Source: Korea International Trade Association.

3 Economic Cooperation with China and Its Impact 43 China jumped by 41.7% to US$49.76 billion. China’s share of total exports by Korea accounted for a meager 3.5% in 1992, but has increased annually, posting 19.6% in 2004. Exports to China versus nominal GDP leaped from 0.8% in 1992 to 7.3% in 2003. Imports from China have also grown steadily each year since 1993. Since 2000, China’s share of total Korean imports has exceeded 10%, accounting for 13.2% in 2004. As a result, Korea’s trade with China jumped nearly twelve-fold between 1992 and 2004 from US$6.38 billion to US$79.3 billion. This trade with China accounted for only 4.0% of Korea’s total in 1992 but by 2004 had soared tenfold to 39.2%. As long as exports to China outpace imports from China, Korea will continue to enjoy a trade surplus. The trade balance with China in 2003, in particular, posted a US$13.2 billion surplus, accounting for a whopping 88.1% of Korea’s total trade surplus. In 2004, as well, the trade balance with China posted a US$20.18 billion surplus, 68.7% of Korea’s total surplus. Thus a plunge in the trade surplus with China could translate into an overall trade deficit for Korea.

Table 2-7 Trade Volume and Trade Balance with China

(Units: US$billion, (%))

1992 1998 1999 2000 2002 2003 2004 Trade Volume 6.38 18.43 22.55 31.25 41.15 57.02 79.35 (Export share) (3.5) (9.0) (9.5) (10.7) (14.6) (18.1) (19.6) (Import share) (4.6) (7.0) (7.4) (8.0) (11.4) (12.3) (13.2) Total Trade Balance (A) -51.4 390.3 239.3 117.9 103.4 149.9 293.8 Trade Balance with China (B) -10.7 54.6 48.2 56.6 63.5 132.0 201.8 Ratio (B/A) 20.8 14.0 20.1 48.0 61.4 88.1 68.7

Source: Korea International Trade Association.

3.2 Expanding Investment Cooperation

Based on total value, Korean investment in China has passed the US$100 million mark, reaching US$140 million in 1999. In 2004 there were 2,517 instances of investment in China, 57.1% of the total number of overseas investments. The total

44 CHAPTER 2 Korea’s Response to China Rising value of investment in China in 2004 amounted to US$2.19 billion, 37.9% of the total overseas investments in terms of value. Looking at manufacturing alone, Korean investment in China has now reached 1,684 cases and US$1.96 billion, figures that account for 75.5% of the total 2,230 cases and 59.9% of the total US$3.27 billion, respectively. It would appear that Korean overseas investment by the manufacturing sector is heavily biased towards China. In the 1990s, Korean investment in China jumped by an average of 33.1% a year, topping Korea’s overall overseas investment growth (16.0%). While investment in China slowed somewhat around the time of the financial crisis, in 2001, immediately after China became a member of the WTO, Korean investment in China started to grow dramatically, posting US$990 million in 2002, the year in which China surpassed the US as the single largest destination for Korean overseas investment. It was in this period that investment in China recovered the pre-crisis level ($US900 million) recorded in 1996. Between 2003 and 2004, Korea’s investment in China surged by 42.1% to US$2.19 billion, a record high. Between 1997 and 2004, overall Korean overseas investment edged up by 3.3% annually, while investment in China grew by 10.4% annually over the same period. Based on total investments, Korean investment in China has been on the rise annually since 1998, and has continuously exceeded 1,000 instances since 2001. Most Korean companies actively investing in China are manufacturers taking advantage of low production costs. Between 1990 and 2004, manufacturing’s share of Korean investment in China was 87.3%, based on the number of investments, and 86.5%, based on the total funds invested. Manufacturing’s share of investment in China averaged 92.6% from 1990 to 1994, shrinking to 87.5% between 2000 and 2004. Meanwhile, the service industry showed steady growth, progressing from a mere 5.9% in the early 1990s and rising to 10.5% after 2000. From 1990 to 1994, Korean investment in China showed a 6:4 ratio between heavy and light industries. Among light industries, the textile and clothing sector claimed the highest level of investment during this period, averaging 22.4% of total investment in light industry. Since the mid-1990s, however, the ratio of investment between the heavy and chemical industries and light industry has widened to 8:2. In the heavy and chemical industries, every sector’s investment share rose in the early 1990s. The electronics and telecommunications device

3 Economic Cooperation with China and Its Impact 45 Figure 2-5 Korea’s Overall Foreign Investment and Investment in China

Increase Rate(% change in yoy) Investment Amount in China(US$100 million) 16 100 Increase Rate of Korea’s Total Investment Increase Rate of Korea’s Investment in China 80 Amount of Korean Investment in China 14

60 12 40 10 20 8 0 6 -20

-40 4

-60 2 1995 1996 19971998 1999 2000 2001 2002 2003

Source: Export-Import Bank of Korea.

industry showed the greatest increase in investment, jumping from 14.3% in the early 1990s to 28.6% between 1995 and 1999. In contrast, in light industry, excluding the paper and printing sector, every sector’s share dropped after 2000. The textile and clothing sector posted the most drastic decline, plummeting from 22.4% in the early 1990s to 10.5% after 2000. This is attributable to the movement by light industry of its production base to China in the 1980s and early 1990s, in response to worsening price competitiveness in Korea. Meanwhile, the capital- intensive heavy and chemical industries are now investing aggressively in China, which presents a promising market for exports. Investment from the manufacturing industry differs according to the size of the enterprise. Between 1990 and 2004, large companies accounted for 50% of investment in China, marginally higher than SMEs’ share of 49.2%. However, except for the period of the mid-1990s, the size of investment by SMEs actually exceeded that of large companies. In the initial stages, SMEs were the major players investing in China, tapping into the country’s cheap labor cost, whereas large enterprises made aggressive investments in China somewhat later. Recently investment in China by SMEs has started to rise once more, and their share has

46 CHAPTER 2 Korea’s Response to China Rising Table 2-8 Share of Investment in China by Sector

(Unit : %) 1990-94 1995-99 2000-2004 1990-2004 Manufacturing 92.6 79.5 87.5 86.5 Light Industry 40.1 23.0 19.7 27.6 (Textiles and Clothing) (22.4) (10.9) (10.0) (14.6) Heavy and Chemical Industry 59.9 77.0 80.3 72.4 (Electronics and Communications Apparatus) (14.3) (28.6) (25.1) (22.6) Service Industry 5.9 15.6 10.5 10.6

Notes: 1. This table displays each industry’s share of total investment made by all industries. 2. Service industry share excludes shares for agriculture, forestry, fisheries, manufacturing, mining, and construction. Source: Export-Import Bank of Korea.

again surpassed that of large enterprises. Average investment project in terms of capital by large companies was 4.6 times larger in the early 1990s than that held by SMEs. After 1994, as investment in China by large companies’ started in earnest, the figure leaped to over 40. This dramatic rise can be attributed to massive investments in the electronics, cement, steel construction, and automobile sectors. Since 2000, SMEs and self-employed individuals have also been moving their production bases to China. Investments in China by SMEs and self-employed persons jumped in 2004 to US$1.35 billion and accounted for 61.9% of Korea’s total investments in China. One feature of Korean investments in China is that they are concentrated in specific regions. In terms of total number of investments in China by Korean companies, since 1990 fully 85.4% of investments have been located in the eastern region, 13.7% in the central region, and 0.9% in the western region. In terms of investment value, 90.6% is concentrated in the eastern region, 7.9% in the central region, and 1.5% in the western region. Looking specifically at investment in eastern China between 1988 and 2004, in terms of number of cases, investment favored Shandong Province (36.1%), followed by Jiangsu Province (11.3%), Liaoning Province (10.0%), Tianjin (9.5%), Beijing (8.2%), and Shanghai (7.0%). In terms of value of investment, the

3 Economic Cooperation with China and Its Impact 47 Table 2-9 Investment in China by Manufacturers (by Size of Enterprise) (Unit : %)

1990-94 1995-99 2000-2004 1990-2004 Large Enterprises 38.3 67.4 46.7 50.8 Share SMEs 61.7 32.6 53.3 49.2 Large Enterprises 239.6 1,911.8 1,945.2 1,365.5 Investment Value per Case SMEs 52.4 46.8 63.5 54.2

Source: Export-Import Bank of Korea.

breakdown for eastern China for the same period shows the Yellow Sea Rim region (Beijing, Tianjin, Shandong Province, Hebei Province) accounting for 51.6%, followed by the littoral region (Jiangsu Province, Shanghai, Zhejiang Province) at 22.3%, and Northeastern China (Heilongjiang Province, Jilin Province, Liaoning Province) at 17.0%. Until the early 1990s, both the Yellow Sea Rim region and Northeastern China attracted a large portion of investment from Korea. After the mid-1990s, however, investment in the former outstripped that in the latter. Since 2000, Korean investment has been concentrated in Shandong Province, Jiangsu Province, Liaoning Province, and Beijing; the combined investment (total investment value) for these regions accounts for 69.2% of the total. Since 1992, the combined value of investments in Shandong Province and

Table 2-10 Korean Investment in China by Regional Share (Unit : %) 1980-1999 2000 2004 1990-2004 Number of Number of Number of Number of Value Value Value Value Cases Cases Cases Cases Eastern China 82.6 90.0 86.0 85.1 93.6 95.1 85.4 90.6 Central China 16.7 8.9 13.2 8.7 5.2 3.8 13.7 7.9 Western China 0.7 1.1 0.8 6.2 1.2 1.1 0.9 1.5 (Yellow Sea Rim (48.2) (51.8) (56.7) (57.7) (57.1) (47.6) (51.0) (51.6) Region) (Northeastern (36.3) (20.4) (26.3) (13.9) (14.1) (10.0) (30.3) (17.0) China) (Littoral Region (9.7) (18.9) (11.9) (17.1) (21.3) (33.4) (12.6) (22.3) in Eastern China)

48 CHAPTER 2 Korea’s Response to China Rising Jiangsu Province has reached 42.4% of total investments, indicating a high concentration of investment from Korean companies in these particular regions. According to a survey examining the motivations of Korean companies for investing in China, 36.6% of the surveyed firms cited local market development, followed by cost savings including wages (35.7%) and suppliers moving abroad (15.2%). Thus it appears that Korean companies are investing in China in a strategic move to secure market share in China. A breakdown by enterprise size reveals that most large enterprises that enter China do so to take advantage of the local market opportunities (63.6%), while others invest there because suppliers have moved abroad (18.2%) or to achieve cost savings (13.6%). In contrast, many the SMEs surveyed cited cost savings as the prime reason (37.0%), followed by local market development (34.5%) and suppliers moving abroad (15.5%). Thus large enterprises and SMEs appear to differ in their investment goals in China. SMEs, it seems, want to strengthen their exports to China by investing in a country where production costs are lower than in Korea. One factor that has led Korean companies to move their production bases to China since the 1990s is low production cost and locational advantage. Between 1986 and 2001, monthly wages in Korean manufacturing averaged US$1,031, 19.5 times higher than those in China (US$53).4 The minimum wage provided for by Korean law is nine times greater than the minimum wage in China (JETRO, 2003).

Table 2-11 Motivations Cited by Korean Companies for Investing in China (Unit : %) Rank All Companies Large Enterprises SMEs

1 Local market development (36.6) Local market development (63.6) Cost savings including wages (37.0) 2 Cost savings including wages (35.7) Suppliers moving overseas (18.2) Local market development (34.5) 3 Suppliers moving overseas (15.2) Cost savings including wages (13.6) Suppliers moving overseas (15.5) 4 Labor shortage (6.4) - Labor shortage (6.7) 5 Advance into a 3rd country’s market (2.4) - Advance into a 3rd country’s market (2.5)

Source: “Survey on Overseas Investment from Korean Manufacturers,” Ministry of Commerce, Industry and Energy, Nov. 2003.

4 “China’s Economic Rise and Korea’s Industrial Policy Direction,” Bank of Korea, 2003.

3 Economic Cooperation with China and Its Impact 49 In addition, average hourly wages are seven to eight times higher in Korea than in China, and the lowest rent for an industrial complex in Korea is 4.8 times higher than the highest rent in China. In addition to cost savings, Korean firms cited confrontational labor-management relations and burdensome investment regulations in home country as motivations to invest in China.

3.3 The Hollowing-Out of the Manufacturing Sector

It is not easy to predict how the emergence of the Chinese economy will affect the Korean economy. All other things aside, it is clear that growing exports to China are helping to drive the Korean economy, especially now that Korea’s exports to the US are on the decline. In fact, exports to China have been steadily driving Korea’s economic growth since 2000. The contribution of China-bound exports to China to Korea’s total economic growth rose from 1.07% in 2000 to 2.41% in 2004. Given that the Korean economy expanded 7.4% in 2004, it is reasonable to say that exports to China accounted for almost a third of Korea’s economic growth.

Table 2-12 Motivations Cited by Korean Companies for Investing in China

(Units: %, %p) 2000 2002 2004 Nominal GDP Growth Rate 9.30 10.0 7.04 Contribution of Exports to China to Economic Growth 1.07 1.15 2.41 Contribution of Imports from China to Economic Growth -0.88 -0.85 -1.26 Overall Contribution of Trade with China to Economic Growth 0.19 0.30 1.15

Sources: Bank of Korea, Korea International Trade Association, Export-Import Bank of Korea.

However, we cannot rely only on the above figures in assessing China’s effects upon Korea’s economy, because China is also Korea’s competitor in the global market. That competition has recently grown fiercer than ever, for China has strengthened its export competitiveness in almost all of the core sectors of Korea’s manufacturing industry. China has emerged as a formidable rival in terms

50 CHAPTER 2 Korea’s Response to China Rising of wages, light industry, and prices, and is quickly catching up with Korea in the heavy and chemical industries as well, thus threatening the market share of Korean products. For example, the share of Korean products in the US market dropped from 3.7% in 1990 to 3.1% in 2003, whereas China’s share surged four-fold between 1990 and 2004, from 3.1% to 13.4%.

Figure 2-6 Market Shares of China and Korea in the US

Market Share (%) 14 China 12 Korea

10

8

6

4

2 1990 1991 1992 1993 1994 1995 1996 19971998 1999 2000 2001 2002 2003

Source: Korea International Trade Association.

Moreover, we have to re-estimate the role of investment in China as well. Korea’s growing investment in China is one of the factors behind sluggish domestic investment, the transfer of manufacturing bases to China, and job loss. In fact, investment in China by Korea’s manufacturing sector have risen steeply since 1997. In 1999, Korea’s manufacturing sector invested only US$290 million in China, but that figure grew to some US$1.96 billion by 2004—a seven-fold increase. The Ratio of Korea’s investment in China to Korean domestic facility investments rose from 0.6% in 1999 to 3.1% in 2004. These figures may seem small at first glance, but given the fact that Korea’s facilities investments make up a large part of the total investment amount in Korea, the ratio of investments in China is higher than it seems. Moreover, statistics compiled by the Export-Import Bank of Korea often fail to reflect actual investment statistics because they focus mostly on equity, and do not include delit-

3 Economic Cooperation with China and Its Impact 51 raised investments made by Korean companies that have established a presence in China. For this reason, the actual value of investments made by Korean companies in China is much higher than the official Korean data shows. In fact, Chinese statistics show that Korean companies invested US$6.25 billion in China in 2004, making Korea China’s largest investor country for the first time. Based on these figures, we can conclude that the hollowing-out of Korea’s manufacturing sector has become a very serious problem.

Figure 2-7 Cases of Manufacturing Investment and Ratio of Investment in China to Facility investment

US$billion % 2.5 3.5 Ratio of Investment in China to Total Facility Investment Total Investment Amount 3.0 2.0 2.5 1.5 2.0 1.5 1.0 1.0 0.5 0.5

0 0 1995 1996 19971998 1999 2000 2001 2002 2003 2004

Note: ( ) indicate total amount of investment in China. Sources: Bank of Korea, Export-Import Bank of Korea.

The question is how to assess the effects of Korean investments in China. So far, these investments have proved effective in spurring Korea’s economic growth by boosting exports to China. In fact, intermediate and capital goods manufactured by Korean enterprises in China make up the largest proportion of Korea’s exports to China. It is valuable in this context to compare Korean exports to the US with Korean exports to China. In 2004, computer parts topped the list of Korea’s exports to China, followed by synthetic resin. In fact, parts and intermediate goods took all of the top twenty spots on the list of export items. In contrast, exports to the were mostly end-user products, with passenger cars topping the list, followed by wireless phones and semiconductors; monitors came seventh,

52 CHAPTER 2 Korea’s Response to China Rising heavy construction equipment tenth. Korean exports to China are mainly intermediate goods and parts for two reasons. First, Korean companies that have established their presence abroad receive parts from their parent companies in Korea, as evidenced in a survey conducted by the Ministry of Commerce, Industry, and Energy in 2003, which showed that 38.5% of raw materials used by the overseas subsidiaries of Korean companies are received from Korea, while only 44.3% are purchased on the local market and 17.2% imported from third countries.

Table 2-13 Korean Exports to China and the US as of 2004

(Units: US$ billion, (%) ) China US Amount Amount Item (Ratio) Item (Ratio) 1 Computer parts 3.11(6.3) Passenger cars 10.03(23.4) 2 Synthetic resin 3.06(6.1) Wireless phones 6.83(15.9) 3 Parts for wireless communications apparatus 2.93(5.9) Integrated circuit semiconductors 4.45(10.4) 4 Integrated circuit semiconductors 2.92(5.9) Auto parts 1.14(2.7) 5 Monitors 1.85(3.7) Knitted garments 0.85(2.0) 6 Synthetic fiber raw material 1.81(3.6) Color TVs 0.79(1.8) 7 Optical components 1.78(3.6) Monitors 0.75(1.8) 8 Auto parts 1.74(3.5) Knit fabric garments 0.69(1.6) 9 Hot-rolled steel plates 1.52(3.1) Tires 0.62(1.4) 10 Petrochemical intermediate material 1.38(2.8) Heavy Construction Equipment 0.56(1.3)

Notes: 1. Export items are based on MTI, the Ministry of Commerce, Industry and Energy’s export/importproduct classification system. 2. Ratios are to total export amount. Source: Korea International Trade Association.

In addition, 43.6% of total sales by Korean companies went to third countries, while 40.6% went to China and 15.8% to Korea. This means that while Korea’s China subsidiaries are buying raw materials or intermediary goods from Korea, they are exporting finished goods to China or to third countries. This sales structure contributes greatly to Korea’s large trade surplus with China. Also, about 80% of Korean parts exported to China are used by Korean companies operating

3 Economic Cooperation with China and Its Impact 53 there in manufacturing finished products.5 This means that the international division of labor between Korea and China is becoming vertical as a result of Korea’s direct investment and China’s industrialization.

Figure 2-8 Raw Material Procurement by Overseas Subsidiaries of Korean Companies

Imported From Third Countries (15.9%) Imported from Korea (63.7%)

Purchased on Local Markets (20.4%)

Source: Ministry of Commerce, Industry, and Energy.

The second reason Korea’s exports to China are mainly intermediate materials is closely related to China’s export-driven industrialization. In addition to importing parts from other countries, China exports finished products assembled by cheap labor , and can do so despite its low technological level. Thus China’s growing share in the global market contributes greatly to the growth of Korean exports of intermediate goods to China. The result is a strong correlation between China’s exports and Korean exports to China.6 But the current pattern of Korean exports to China will change significantly in the future. Specifically, the growth of exports to China will slow down, thanks to several factors. First, China is expected to implement policies designed to promote the localization of parts and materials. If the technological level of Chinese companies improves, and if more companies expand their investments in parts and materials, China’s imports of parts and intermediate materials will decline. To

5 Young-Sook Nam, “Facing the Challenges of China’s Industrial Rise: The Korean Case,” KIEP, March 2003, p. 9. 6 The correlation between China’s exports and Korean exports to China was 0.98 in the period between 1992 and 2004.

54 CHAPTER 2 Korea’s Response to China Rising promote the local procurement of parts, China may lure investment from either multinational corporations or Korean companies. Second, when competition in the Chinese market intensifies, as it will when more multinational corporations have established a presence in China, Korean companies will be pressured to purchase more parts on the local market. Thus Korean companies are likely to advance to the Chinese market along with their partners, or to purchase more of the parts they need from local companies. Whichever is the case, Korean manufacturers of parts and materials will expand their investments in China, which will undermine Korea’s export growth in the future. Therefore, the positive effect on the Korean ’s rising import demand will subside in the medium-to-long term, and in the long run will bring about more negative than positive effects. The rapid increase of Korean investment in China will emerge sooner or later as a serious problem. It will be the culprit behind the hollowing-out of the manufacturing base in Korea.

3 Economic Cooperation with China and Its Impact 55 4

Policy Suggestions: Creating the Basis for an Economic Hub in Northeast Asia

4.1 Background and Basic Concepts

The fast-growing Chinese economy poses a considerable threat to the Korean economy. Korea’s export goods are losing market position due to China’s greater price competitiveness. Korea’s manufacturing base is also being undermined by the tendency of local companies to move their production bases to China. There is reason to worry that slack domestic investment will weaken the economy’s growth potential, and concerns have even been expressed about a long-term recession like the one recently endured by Japan. The mounting economic uncertainty created by China’s rapid growth, as well as by other internal and external factors, mean that Korea’s economy and industry require structural changes—changes that would be brought about in part by political measures. The Korean government has proposed the creation of a “Northeast Asia Business Hub” that would use China’s emerging economy to prompt expanded economic cooperation with neighboring countries like Japan.7 Korea would secure its position as an economic hub by opening up to logistics center and businesses from across Northeast Asia.8 In other words, while expanding intra-economic cooperation in Northeast Asia, an effort that would be directly linked to

7 Ministry of Finance and Economy, “Master Plan to be Northeast Asia’s Business Center,” July 2002; Presidential Committee for the Northeast Asian Business Hub, “Northeast Asian Cooperation Plans among Northeast Asian Countries,” July 2003.

56 CHAPTER 2 Korea’s Response to China Rising peacemaking in the region, Korea would foster a Northeast Asian economic community through trade liberalization and economic interdependence. The government has presented a blueprint for Korea’s economic future, one that should be put into practice. The crucial role of inter-country trade has been amply demonstrated by the success of economic blocs such as EU and NAFTA and by the spread of FTAs. The government’s basic plan also includes support for economic development in other Northeast Asian countries, including North Korea.

4.2 Principles and Strategies

The Korean government has put forward three principles and four strategies for making the nation the economic hub of Northeast Asia. The three principles are pacifism, reciprocity, and open regionalism. The first of these means cooperation among Northeast Asian countries, as well as mutual development of inter-Korean economic cooperation that will induce North Korea into gradual reform and opening. Resolving North Korea’s nuclear issue is the first task in relieving tension on the Korean peninsula. “Reciprocity” is the government’s term for economic cooperation for the benefit of all countries involved. It emphasizes coexistence and aims at mutual prosperity through maximizing the benefits of mutual interdependence among Northeast Asian countries. Finally, “open regionalism” refers to the formation of an economic community that conforms to WTO principles while valuing friendly nations and blocs like the US and the EU. It is part of this approach to acknowledge as partners any countries that recognize the necessity of Northeast Asian economic cooperation. The four strategies by which Korea may become Northeast Asia’s economic hub are as follows. The first is to show leadership in matters of coexistence and mutual prosperity. Korea must present a long-term vision for a Northeast Asian community and take the lead in promoting the region’s integration. Toward this

8 Construed narrowly, Northeast Asia includes Korea, Japan, the northeastern district of China (three provinces of northeastern China and inner ), Mongolia, and the Russian Far East. More broadly, it includes all of China and Russia, as well as Taiwan, Hong Kong and Macao. (The Korean Development Bank, 2003.)

4 Policy Suggestions: Creating the Basis for an Economic Hub in Northeast Asia 57 end, Korea needs to prepare a base for regional integration by collaborating closely with Japan and China. The second strategy is to approach issues on the Korean peninsula as matters in which all countries of Northeast Asia have a stake. Peace is most likely to take root in Northeast Asia when all Northeast Asian countries, as well as the US and EU, are involved in economic collaboration while working toward a peaceful resolution of North Korea’s nuclear issue. The third strategy is to arrive at a phased, gradual approach to international cooperation in Northeast Asia. The approach should be directed toward economic and functional cooperation at first and toward economic and systematic integration later on. For example, Korea might promote economic and security integration through FTAs and through an institution analogous to the Organization for Security and Cooperation in Europe (OSCE). It is important, however, that these cooperative mechanisms take account of the different political systems and the economic distinctiveness of each country. Indeed, strategies should be shaped in such a way as to maximize the special economic features of each Northeast Asian country. Finally, the fourth strategy is to enhance cultural homogeneity and to build a spirit of Northeast Asian solidarity. The animosity between Korea, China, and Japan that began in World War II has not fully dissipated. Thus Korea needs to encourage mutual tolerance among the different cultures of Northeast Asia, a tolerance that acknowledges the uniqueness of each culture even as it emphasizes the values and economic interests they share.

4.3 Tasks

The government needs to accomplish several tasks if it is to make Korea the economic hub of Northeast Asia and establish a Northeast Asian community. First, located as it is between fast-emerging China and Japan, the world’s second-largest economy, and near as well to Russia’s abundant energy resources, Korea has a comparative advantage in building an infrastructure network that connects Northeast Asian regions. With no existing international logistics center in

58 CHAPTER 2 Korea’s Response to China Rising Northeast Asia, Korea can work as an intermediary toward economic cooperation among China, Japan, and Russia. To do so, Korea must focus on developing related infrastructure. Specific plans regarding such infrastructure include the restoration of the Gyeongui and Donghae railways. Once reconnected, the Gyeongui Line will not only be able to expand inter-Korean economic trade, it can also work as a transportation and logistics line connecting Russia, China, and even Europe. The essential condition here is that the countries involved discuss and co- promote large-scale facility investment to reconnect the railways between South and North Korea. Plans would need to be drawn up for financing the modernization of North Korea’s railways. Also, systematic consolidation would need to be accompanied by agreements on freight transport passing through, for example, China or Russia. Next, in response to the scarcity of raw materials and the high oil prices that have persisted since early 2004, Korea should foster cooperation on energy at a regional level. Northeast Asian countries are unlikely to suffer an energy crisis if the countries of the region collaborate in developing Russia’s vast energy resources. A charter and treaty on energy cooperation should be instituted phase by phase, in tandem with the establishment of an organization on energy cooperation. Korea can also facilitate cooperation on science and information technology. Korea will be able to distinguish itself from other countries attempting to establish themselves as an IT hub for Northeast Asia if it reinforces its comparative advantage in cultural contents and online games. Considering the strides China has taken recently in the IT sector, Korea must enhance its IT infrastructure if it is to position itself as Northeast Asia’s economic hub for IT. Additionally, it’s important that Korea build close cooperative ties with Japan, China, and other neighboring countries so as to heighten its status as an IT hub. An organization should be established to actively and internationally develop IT-related technologies and to facilitate the movement of professional IT workforce. At the same time, Korea should advance trade liberalization and financial cooperation through FTAs to become Northeast Asia’s business center. Such FTAs should be general enough to accord with the trade regulations and economic policies of a Northeast Asian country or countries involved. Of course, Korea’s approach needs to be different for different countries. For instance, an FTA

4 Policy Suggestions: Creating the Basis for an Economic Hub in Northeast Asia 59 between Korea and Japan should be concluded promptly so Korea’s economy can advance systematically and attract prominent SMEs that manufacture core parts. This will be a crucial opportunity for Korea to establish itself as Northeast Asia’s logistics and R&D center. After successfully concluding an FTA with Japan, Korea should quickly form other FTAs with China and other ASEAN countries. Monetary and financial cooperation is necessary for Northeast Asia, as well as international financing for regional development. First, there should be a system to ensure the free use of foreign currencies, including the US dollar, within special economic zones. Adopting a single currency within the economic bloc on a trial basis should also be considered. This would be an opportunity for Northeast Asian countries to form the fundamentals to integrate their currencies and to create a base for an international financial center. International financing is necessary for regional development within the Northeast Asian economic bloc. While actively using existing international financial organizations to finance infrastructure projects in Northeast Asia, Korea must also conceive a plan to make the most of Korean, Chinese, and Japanese private capital. In the mid-to-long term, a system for financial cooperation like a Northeast Asian development bank should be established to supply development capital to underdeveloped Northeast Asian regions, including North Korea. Government support for regional tourism and for cultural and sports exchanges among countries would help build a sense of Northeast Asian solidarity. This sort of international exchange would put Korea at the center of a Northeast Asian community committed to the pursuit of peace and prosperity. Toward this end, a co-marketing system should be established for cooperation on cultural matters, in concert with efforts by municipal officials to bring cultural exchange centers into being. To boost tourism, Northeast Asia’s travel and visa regulations need to be improved; for instance, the process of applying for visitor visas and travel passes could be made more convenient. Inter-Korean tourism also demands co-development. Therefore, a Northeast Asian tourism committee should be established to seek cooperation on raising related funds and improving systems. Above all else, Korea should prepare itself to play a central role in Northeast Asia. Apart from promoting “hardware,” the Korean government should secure a business-friendly environment and advance “software” such as tourism, cultural,

60 CHAPTER 2 Korea’s Response to China Rising and educational facilities. One of the aspects of Korean life most worrisome to foreign companies investing in Korea is our confrontational labor-management relations. The Korean government should help foreign companies understand Korea’s labor-management culture, and at the same time change practices not up to global standards that deter foreign investors. Beyond easing labor-management relations, to improve Korea’s labor market conditions the government must help develop high quality human resources. Globally competent workers with foreign language skills and specific areas of expertise are needed for leadership roles in various sectors throughout Northeast Asia. Professional training facilities should be established in logistics, finance, and

Figure 2-9 Korea’s Master Plan for the Northeast Asian Era

High Northeast Asia in the Era of Peace and Prosperity

International Level of cooperation Cooperation Financial Cooperation Industrial Cooperation Cultural Homogeneity

Inter-Korean Energy FTA Cooperation Railroad Tourism IT, Science & Intellectual & System- Technology related Infrastructure Intensifying Expanding Human Kaesong Domestic Competence Political Stability Interchange Industrial Logistics Complex R&D Finance

High Low Economic Welfare

4 Policy Suggestions: Creating the Basis for an Economic Hub in Northeast Asia 61 IT, and the quality of foreign language education should be improved. Quality-of- life issues for resident workers of foreign companies should also be addressed. For instance, regulations on international schools and foreign medical institutions should be eased so that the services they provide meet the needs and wishes of the foreigners who use them. Finally, tourism resources need to be broadened to enhance Korea’s image abroad. The recent increase in Chinese and Japanese tourists demonstrates the effect the Korean wave has through soap operas and movies. At the same time, traditional images of Korea should be highlighted, and accommodations and services for foreign tourists further developed.

62 CHAPTER 2 Korea’s Response to China Rising References

Bank of Korea, “Changes in Revenue Structure of Korean Conglomerates and SMEs,” Dec. 2003.

Cheong, Young-Rok, “The Emergence of China’s Economy: An Analysis of its Effect on Korea,” The Korean Economic Review, Jan. 2003.

Choi, Yong-Ho and Kim, Sang-Wook, “Trends in China’s Special Economic Zones and Suggestions for Korean Economy,” Journal of International Economic Studies 7:2 (2003), pp. 33-51.

Export-Import Bank of Korea, “New List of Industries in Mid-Western Regions with Comparative Advantage in Foreign Investment,” Aug. 2004.

Federation of Korean Industries, “Trends and Tasks from Relocating Korea’s Manufacturing Overseas,” Jun. 2003.

Japan External Trade Organization, “Investment Cost Comparison between Major Cities and Regions in Asia,” 2003.

Korea Development Bank, Northeast Asia 2003: Country Profiles toward Building a Northeast Asian Economy, 2003.

Korea International Trade Association, “Survey on Management of Companies Investing in China,” Trade Research Institute, Oct. 2003.

Korea Trade and Investment Promotion Agency, “China’s economy and Korea’s Choices in the WTO Era,” Nov. 2001.

Ministry of Commerce, Industry, and Energy, “Analysis of Facts and State of Foreign Investment in Manufacturing,” Nov. 2003.

Nam, Young-Sook, “Facing the Challenges of China’s Industrial Rise: The Korean Case,” Korea Institute for International Economic Policy, Mar. 2004, p. 9.

References 63 Presidential Committee for the Northeast Asian Business Hub, “Northeast Asian International Cooperation Plans,” July 2003.

Presidential Committee for the Northeast Asian Business Hub, “Visions and Tasks for Northeast Asia’s Economy,” Feb. 2004.

Shin, Tae-Young, “Study on Hollowing-Out in Manufacturing: Effects of FDI on Trade Balance and the Manufacturing Industry,” 2003–2004 Policy Research Report, Science and Technology Policy Institute, Nov. 2003.

Yoo, Jin-Seok, “Consequences of and Countermeasures to Economic Shock from China,” CEO Information no. 451, Samsung Economic Research Institute, May 2004.

64 CHAPTER 2 Korea’s Response to China Rising CHAPTER 3 THE RISE OF CHINA: CHALLENGES AND OPPORTUNITIES FOR JAPAN C.H. Kwan, Nomura Institute of Capital Markets Research China’s emergence as an industrial power has caused concern that Japan’s hollowing-out problem may worsen and its international competitiveness diminish. Because economic relations between Japan and China are complementary rather than competitive, however, economic cooperation can be a win-win game, that is, an interaction that benefits both sides. The key to success for Japanese companies doing business with China is to use China’s strengths to make up for their own weaknesses. To fully exploit the complementarity between the two countries, Japan should relocate declining industries to China, while at the same time promoting new industries at home. The two countries should also pursue a free trade agreement (FTA) that removes trade barriers between them. By giving Japan’s high-tech industries access to the fast-growing Chinese market through trade instead of through foreign direct investment, an FTA would help Japan to keep “good jobs” at home and achieve industrial upgrading without hollowing out. 1

An Evaluation of the Chinese Economy

Although China has been growing at an annual rate of nearly 10% over the last twenty years, its , at US$1.41trillion in 2003, is still just one-third that of Japan (US$4.28trillion), while its per capita GDP has just recently topped US$1,000, a scant one-thirtieth of Japan’s. China’s current level of economic development is comparable to that of Japan in the early 1960s. China has emerged as a production base for multinational firms, but it is still heavily dependent on foreign investors for funds and technology, as well as for supply of key parts and components. Therefore, China has no choice but to rely upon low wages to compete in international markets.

1-1 A Forty-Year Gap between Japan and China

Major development indicators show that China still lags behind Japan by about forty years (Table 3-1). At present, China’s life expectancy at birth, infant mortality rate, primary sector as a percentage of GDP, Engel’s coefficient, and per capita electricity consumption are all similar to those of Japan around 1960.1 Furthermore, many aspects of present-day China, including its high economic growth rate, its ongoing construction boom, its massive influx of labor from rural areas to the cities,

1 Per capita GDP figures are not used in this comparison because, when such factors as inflation and the price disparity with other countries are taken into account, the purchasing power of one dollar would be very different for the Japan of forty years ago and for present-day China.

1 An Evaluation of the Chinese Economy 67 and its serious environmental problems, are similar to conditions in Japan forty years ago.

Table 3-1 Key Economic Indicators for China and Japan

Present-Day China* Japan around 1960* Life expectancy (years) 71.4(2000)* 71.5(1967)* Infant mortality rate (per thousand) 28.4(2000) 28.6(1961) Primary sectot as a share of GDP (%) 15.4(2002) 14.9(1960) Engel’s coefficient (%) 37.7(2002) 36.7(1962) Per capita electricity consumption (kwh) 1,158(2001) 1,236(1960)

Note: Life expectancy is the life expectancy for men and women averaged. Sources: Official statistics of China and Japan. *The numbers of 2nd, 3nd columns inside parenthesis represent the years of the years of statistics observed

However, conclusions based only on these sorts of national indicators may not apply to individual regions and sectors. In fact, regional disparities are much greater within China than they are, or were, within Japan, and China’s coastal area around Shanghai, which is seeing tremendous economic growth, is probably less than forty years behind Japan. At the same time, there are rural areas in China that still lag more than 100 years behind Japan. On the one hand, thanks to the recent development of information technology–based industries, China is beginning to establish itself in fields that did not exist forty years ago. On the other, because China does not have its own technology to build a high-speed rail link between Beijing and Shanghai, it is still debating whether to use Japan’s Shinkansen technology, which was developed in the early 1960s, or the linear technology offered by Germany, which is still at an experimental stage. Also, while China may be ahead of the Japan of forty years ago in terms of hardware, such as high- rise buildings and expressways, it must be said that in establishing such institutions as a legal system and a democratic form of government, China lags well behind the Japan of the 1960s. Although I say that there is a forty-year gap between the economies of Japan and China, it is not my intention to underrate the high pace of economic growth

68 CHAPTER 3 The Rise of China: Challenges and Opportunities for Japan observed in China in recent years. In fact, when I tried to make a similar comparison ten years ago, I had to go back to before World War II to find Japanese figures comparable with China’s then-current data. (Faced with the abnormal situation during the war, and with the discontinuity of the statistics, I abandoned the attempt.) When we look at the disparity between Japan and China today, the salient fact is not that there is still a gap forty years wide, but that it is now only a gap of forty years. Coming late to the process of economic development, China can acquire technology from overseas at a lower cost and can also learn from the experience of industrialized nations. Therefore, it will probably maintain a higher rate of growth than Japan for the time being. As a result, the gap in economic development between the two countries will likely continue to shrink, and it may not take China forty years to reach the economic level of present-day Japan. However, barring some dire circumstance in which the Japanese economy does not grow at all for several decades, China will not surpass Japan in terms of economic development, even when it reaches Japan’s present level.

1-2 The Need to Distinguish between “” and “Made by China”

Ever since it launched its market-opening reforms, China has been working to integrate into the global economy through trade liberalization and by welcoming foreign direct investment. The pace of China’s integration has quickened since its entry into the World Trade Organization in 2001. Exports in 2003 grew by 34.6% over the previous year to US$438.37 billion, while imports rose 39.9% year-on-year to US$412.84 billion. Total trade for the year came to US$851.21 billion, making China the world’s fourth-largest trading power after the United States, Germany, and Japan (Table 3-2). Such figures need to be taken with caution, however, as indicators of China’s real strength, in view of the country’s heavy dependence on foreign capital and processing trade. Foreign companies have played the greatest role in the expansion of China’s trade. Since 1979, investment in China by foreign firms, including firms based in

1 An Evaluation of the Chinese Economy 69 Table 3-2 Top Trading Nations in 2003

(Unit: US$billion) Exports Imports Total

Rank Country Amount Rank Country Amount Rank Country Amount 1 Germany 748.4 1 US 1,305.6 1 US 2,029.6 2 US 724.0 2 Germany 601.7 2 Germany 1,350.1 3 Japan 471.9 3 China 412.8 3 Japan 854.9 4 China 438.4 4 France 388.4 4 China 851.2 5 France 384.7 5 UK 388.3 5 France 773.1 6 UK 303.9 6 Japan 383.0 6 UK 692.2

Source: World Trade Organization.

Taiwan and Hong Kong, has exceeded US$500 billion in total, and foreign companies now account for 30% of China’s industrial production. Thanks to the participation of foreign companies, the percentage of industrial products in China’s total exports now exceeds 90%. Exports and imports by foreign firms in 2003 increased by 41.4% and 44.7%, respectively, and comprise 54.8% and 56.2% of the respective totals (Figure 1). In addition, 80% of exports and 60% of imports of foreign companies fall into the category of processing trade. “Processing trade” here refers to processing imported raw materials and components provided by foreign firms according to their quality and design requirements and receiving payment upon delivery. In order to promote exports, China has given tax breaks to foreign companies and domestic firms involved in processing trade, and many multinational corporations are using China as a production base for exports by taking advantage of such preferential treatment as well as China’s cheap labor. This surge in trade has led China to be called the “workshop of the world” or the “market of the world.” Nevertheless, China’s industrial power is still weak on the production front. For one thing, the high proportion of labor-intensive products in China’s exports is typical of a newly industrializing economy. This trade structure is different from that of developed countries, where the major export items, such as machinery, are technology-intensive. Although China is increasing its share in the global market for manufactured goods, including some IT products

70 CHAPTER 3 The Rise of China: Challenges and Opportunities for Japan Figure 3-1 Share of Foreign Companies in China’s International Trade

(Unit: %) 60

50 Imports

40 Exports 30

20

10 91 9293 94 95 96 97 98 99 00 01 0203

Source: China’s customs statistics.

that are classified as high-tech, its exports are still highly concentrated in lower-end products. In the case of televisions, for instance, Japan specializes in high-definition and other higher-end models, while China produces standard models whose unit values are much lower. Reflecting China’s emphasis on processing trade, goods that are “made in China” contain many imported components that do not count towards China’s GDP. Moreover, the proportion of this imported content is higher for high-tech than for low-tech products. A computer labeled “made in China” is likely to have had the bulk of its components (for example, an Intel microprocessor, a Microsoft Windows operating system, a liquid crystal display) produced in Japan, , or elsewhere. In addition, approximately half of China’s exports are produced by subsidiaries of foreign companies, to which dividends, interest charges, royalties, and other fees must be paid. Even among Chinese companies with no capital ties to overseas companies, the majority of exports are processed under original equipment manufacturing (OEM) contracts and sold with foreign brand names. Thus, only a very small percentage of the value-added of products labeled “made in China” is actually “made by China.” The latter phrase represents economic activity that contributes to China’s gross national product, and excludes import charges on

1 An Evaluation of the Chinese Economy 71 intermediate goods and investment income paid to overseas countries. China depends heavily on foreign partners for cutting-edge technology and internationally recognized brand names. Moreover, Chinese companies are inferior to their overseas counterparts in virtually every respect, be it capital, human resources, or business management. Indeed, the majority of the value China adds to its exports lies with the cost of labor, and the very low wages in China, averaging less than US$100 a month, keep this contribution very small.

1-3 Are Low Wages China’s Strength or Its Weakness?

The low wage levels in China relative to those in industrial countries are said to give products made in China strong international competitiveness. Moreover, the very large gap between wages in Japan and China makes Japanese corporations feel daunted by the task of beating their Chinese counterparts in international markets. But while it is certainly true that low wages have been a major factor contributing to China’s competitiveness in labor-intensive products, when one looks at Chinese industry as a whole, low wages in fact reveal a weakness. Wages alone do not decide the competitiveness of a country’s industries. If the simple formula that “low wages equal high competitiveness” actually held, we would find that countries like Bangladesh and Somalia, with wage levels even lower China’s, were highly competitive. We would also expect foreign investment in China to focus on the inland regions where development lags behind that of the coastal regions. In reality, these trends have not materialized, because labor productivity is as vital a part of competitiveness as wage levels are. In other words, in countries where wages are cheap relative to productivity, competitiveness should be strong, but in low-wage countries where productivity is even lower, competitiveness should actually be weak. A cross-section comparison among countries at different levels of economic development reveals a strong positive correlation between productivity and wages (Figure 3-2). Thus, in developed countries, high productivity is reflected in both strong international competitiveness and high wage levels, while in developing countries, low productivity is reflected in low international competitiveness as well as low wage levels.

72 CHAPTER 3 The Rise of China: Challenges and Opportunities for Japan Figure 3-2 An International Comparison of Wages and Labor Productivity

Wages (US = 100) US 100 Labor Unit Labor Wages Productivity Cost(A/B*100) 80 US 100.0 100.0 100.0 China 2.1 2.7 76.9

60 Japan Singapore Taiwan 40

China Korea 20 Mexico Turkey 0 20406080100 Labor Productivity (US = 100) Source: United Nations Conference on Trade and Development (UNCTAD), Trade and Development Report, 2002.

The large gap in productivity between China and the developed countries means that, when China participates in global markets, it can do so only by specializing in labor-intensive products (or in labor-intensive processing for technology-intensive products) in accordance with its relative advantage based on low wages. For the time being, China should have no problem sustaining its competitiveness in labor-intensive products, because its enormous labor supply in rural areas will mitigate the upward pressure on wages coming from an increased demand for labor in manufacturing areas. In these circumstances, however, low wages could actually be a factor retarding the advancement of industries, since they mean that the optimal strategy for Chinese corporations is to expand (low-cost) labor input rather than to improve productivity. So long as China depends on low wage levels to compete in international markets, it can at best be an offshore production base for multinationals rather than an “industrial power” that rules over such high value–added areas as product standards, brand names, and core technologies. Since low wages also imply a low standard of

1 An Evaluation of the Chinese Economy 73 living, no doubt they should be taken as a sign of China’s weakness rather than of its strength.

74 CHAPTER 3 The Rise of China: Challenges and Opportunities for Japan 2

Complementary Relations between Japan and China

Although manufactured goods have come to make up the bulk of China’s fast- expanding exports, the country’s competitiveness still lies in low value–added products and processes. For this reason, Chinese exports do not compete directly with Japanese exports, which tend to be high value–added; rather, Japanese and Chinese exports complement each other. China’s export structure also lags behind that of Asia’s NIEs and the major members of the Association of Southeast Asian Nations (ASEAN). Despite the rapid pace of industrialization in China, the flying- geese pattern of economic development still holds when it comes to the division of labor among Asian countries.

2-1 Division of Labor by Production Process

One way to confirm the complementary relations between Japan and China is to compare production activities in the two countries in terms of their position along the supply chain. Imagining the supply chain as a stream, one finds, in many industries, that production processes at the upstream and downstream ends are high in added value, while midstream activities are low in added value. With personal computers, for example, upstream processes, which include the development of operating systems and microprocessors, and downstream processes, including branding and maintenance services, exhibit high profitability, while computer assembly and other labor-intensive midstream processes add the least value. Stan Shih, Chairman of Taiwan-based Acer Inc., is said to have coined the term “smiling

2 Complementary Relations between Japan and China 75 curve” to describe the U-shaped path a product takes as value is added to it along the supply chain (Figure 3-3).

Figure 3-3 The Smiling Curve

Value added

High

Low After-sales services Assembly Marketing and branding R & D Key parts Supply-chain processes Upstream Downstream

In terms of the smiling curve, China’s industrial capability, like that of other developing countries, is largely limited to low value–added assembly-type processes, while Japan and other industrialized nations specialize in the high value–added activities at the upstream and downstream ends, such as R&D and marketing, and outsource midstream activities to developing countries. This division of labor across the supply chain means that production activities in Japan and China complement, rather than compete with, one another. Chinese firms need the leverage of brand power to penetrate overseas markets. Most Chinese firms so far have done this by “using” foreign brands through the OEM relationship, thus avoiding the huge investment and high risk of developing a brand from scratch. For this reason, despite the flood of products made in China on world markets, not a single Chinese brand ranked among the world’s top 100 brands as listed in 2004 by the US magazine Business Week.2 Similarly, under the OEM system Chinese firms can avoid the cost and risk of developing their own technologies.

76 CHAPTER 3 The Rise of China: Challenges and Opportunities for Japan 2-2 Division of Labor by Product Sophistication

The complementary relations between Japan and China can also be confirmed by looking at the division of labor between the two countries in terms of the level of product sophistication. The export structures of Japan and China can each be represented by a distribution over the range of industrial goods from low- to high- tech (Figure 4).3 The size of the distribution is proportionate to the country’s total exports, and the further it lies to the right, the more advanced or sophisticated the country’s export structure. Where the distributions of Japan and China overlap is the range of products in which the two countries compete. The larger the area of overlap (C), the more competitive the relationship, and the smaller the overlap, the more complementary the relationship. For Japan, the size of the overlap, as a proportion of its total exports (B), serves as an indicator of the degree of competition with China in international markets.4 Over time, the complementary and competitive relations between the two nations change with the size and position of their respective distributions. Specifically, from Japan’s point of view, the degree of competition with China increases with the growth in China’s exports and the advancement of its industrial structure, and falls with a rise in Japan’s exports and its own industrial progress.

2 Fifty-eight of the “100 Top Brands” listed by Business Week (August 2, 2004) were American, a cohort led by Coca Cola, Microsoft, and IBM. Seven Japanese brands (Toyota, Honda, Sony, Canon, Nintendo, Panasonic, and Nissan) were also ranked. Meanwhile, according to the Beijing Famous-Brand Evaluation Co., Ltd., “China’s Most Valuable Brands” in 2003 were Haier (electrical appliances), Hongtashan (tobacco), Wuliangye (Chinese spirits), Legend (computers), FAW (automobiles), TCL (electrical appliances), Changhong (electrical appliances), Midea (electrical appliances), Liberation (automobiles) and Tsingtao (beer). Though well known in China, these brands have virtually no impact overseas. 3 To rank export items along the horizontal axis, we need to find an appropriate method to assign a score to each of them. Our starting point is to note that high valued–added products are likely to be exported from high-income countries, while low value-added products are likely to be exported from low-income countries. For each specific product, an indicator of its level of sophistication (to be called product sophistication index) can be found in the weighted average of the per capita GDP of its exporters, using their respective shares of global exports as weights. Thus a product with a sophistication index of $30,000, for example, is produced in countries with an average per capita GDP of $30,000, and is likely to be more sophisticated than one with a corresponding index of $10,000 (which indicates that it is produced in countries with an average per capita income of $10,000).

2 Complementary Relations between Japan and China 77 Figure 3-4 Competition between China and Japan: A Conceptual Framework

Amount

Japan (B)

China (A)

C

Product Sophistication Index ($) ShoesTVs Semiconductors

Low-Tech Products High-Tech Products

Based on this framework and using US import statistics, we can calculate that the extent to which Japan’s products competed with those from China in the US market rose from 3.0% in 1990 to 20.5% in 2002 (Table 3).5 However, there is still a clear division of labor whereby Japan exports high value–added products while China ships low- and middle value–added goods. The degree of competition is even less if we consider that, first, within each product category, exports from Japan tend to be up-market, while those from China tend to be down-market, and, second, that

4 It should be noted that the degree of competition between any two countries (China and Japan, for example) can actually be calculated without referring to the product sophistication index explained above. For each product category, compare the corresponding figures for China and Japan to obtain the minimum value of the two. The total amount of overlap between the two countries’ exports can be calculated by summing these minimum values for all product categories. For China, the degree of competition with Japan can be obtained by dividing this overlap amount with total Chinese exports; for Japan, the degree of competition with China can be obtained by dividing the same amount with total Japanese exports. Even so, in order to understand whether the competition between the two countries is in high value–added or low value–added product categories, it is useful to base our analysis on the product sophistication index. 5 US import statistics have been used here, rather than export statistics of exporting countries, because the former provides a consistent set of data based on classification of products up to HS (Harmonized System) 10 digits covering all exporting countries. Since the United States is the largest market for both Japan and China, the degree of competition between the two countries there should serve as a good approximation of their degree of competition in the global market.

78 CHAPTER 3 The Rise of China: Challenges and Opportunities for Japan Chinese exports tend to have much higher imported content. Thus, Japan has continued to dominate high-tech areas, where there is little competition from China, and any competition between the two is limited to low value–added products in which Japan no longer enjoys a relative advantage.

Table 3-3 Competition from China Encountered by Japan and other Asian Countries in the US Market

(Unit: %)

1990 1995 2000 2002 Japan 3.0 8.3 16.3 20.5 South Korea 24.0 27.1 37.5 41.1 Taiwan 26.7 38.7 48.5 57.1 Hong Kong 42.5 50.5 55.9 64.4 Singapore 14.8 19.2 35.8 44.2 Indonesia 85.3 85.5 82.8 83.5 Malaysia 37.1 38.9 48.7 54.5 Philippines 46.3 47.8 46.1 57.0 Thailand 42.2 56.3 65.4 76.1

Source: Calculated from US import statistics (using about 10,000 product categories of manufactured goods based on the ten-digit HS commodity classification system).

In the future, competition with China can be expected to increase, as China will likely begin to export products with higher added value, shifting the distribution of its export structure to the right, as it also expands its total exports. Were Japan to decide to protect those industries in which it is in competition with China—the ones dealing in low- and middle value–added goods—not only would its domestic industrial structure be held back, but the area in which it competed with China would broaden. Such a policy would not be beneficial for either Japan or China. Rather than trying to retard countries that are gaining from behind, Japan should adopt, for its own benefit as well as that of other countries, a strategy of continuing to upgrade its own structure. In doing so, it will maintain its complementary economic relations with China, and both parties will benefit greatly through trade with each other.

2 Complementary Relations between Japan and China 79 2-3 The Rise of China and the Flying-Geese Pattern of Economic Development

The spread of industrialization from Japan to the Asian NIEs (South Korea, Taiwan, Hong Kong, and Singapore) and then further to ASEAN countries (Indonesia, Malaysia, the Philippines, and Thailand) and China during the postwar period has been characterized as a “flying-geese pattern” of development. According to this model, countries specialize in the export of products in which they enjoy an advantage commensurate with their level of development, and at the same time seek to upgrade their industrial structures by augmenting their capital stock and their technology. Foreign direct investment by the more advanced countries within the less developed ones, through relocation of industries from the former to the latter, is a vital part of this process. In the wake of the recent Asian currency crisis and the subsequent disparity in the performance of Japan’s and China’s economies, it has become fashionable to claim that the rise of China, supported by the IT revolution, has rendered the flying-geese model irrelevant, in that it no longer describes the division of labor among Asian countries. A closer look at the evolution of the trade structure of Asian countries over time, however, shows that the geese are still flying in an orderly manner. China has certainly made great progress in industrialization over the last twenty years; manufactured goods now account for 90% of China’s total exports, up from 50% in 1980. Still, China’s competitiveness in international markets is mainly based on an abundant supply of cheap labor, a circumstance broadly in line with its level of economic development. Chinese exports are dominated by labor- intensive products such as textiles; in high-tech product categories, China’s main role is still in labor-intensive processes like assembly. Despite a gradually shrinking gap between forerunners and latecomers in the process of regional development, Japan continues to lead other Asian economies in terms of both income level and competitiveness in high-tech industries, with the Asian NIEs, the ASEAN countries, and China all playing catch-up, in that familiar, indeed traditional, order (Figure 5).

80 CHAPTER 3 The Rise of China: Challenges and Opportunities for Japan Figure 3-5 The Flying-Geese Pattern of Asian Countries’ Exports to the United States

Share (%) 40

35 Singapore 30 Taiwan Philippines 25 Malaysia Korea 20 Thailand Japan Indonesia 15 Hong Kong 10 China

5

0 1,000 10,000 100,000 Product Sophistication Index ($)

Low-Tech Products High-Tech Products

Source: Same as Table 3.

In line with the flying-geese model of economic development, a country’s relative advantage usually shifts from the production of primary commodities to labor-intensive manufactured goods and later on to capital- and technology- intensive products. These shifts are reflected in its trade structure, which progresses from that of a developing country to that of a newly industrializing country and finally to that of an industrialized country. We can summarize a country’s relative advantage (as revealed in its trade structure) at a given time in terms of its relative specialization in primary commodities (represented by SITC sections 0-4), machinery (SITC section 7, representing capital- and technology-intensive products), and other manufactures (SITC sections 5, 6, 8, 9, representing labor-intensive products). We define the specialization index as the trade balance (exports – imports) divided by the volume of two-way trade (exports + imports). Thus the value of the specialization index will range from –1 to +1, with a higher value implying stronger international

2 Complementary Relations between Japan and China 81 competitiveness. A country typically passes through four successive stages defined by the area of relative specialization: 1) Developing country stage. Primary commodities are more competitive than other manufactures and machinery. 2) Young NIE stage. Other manufactures become more competitive than primary commodities, which maintain their lead over machinery. 3) Mature NIE stage. Machinery overtakes primary commodities, while other manufactures maintain their overall lead. 4) Industrialized country stage. Machinery overtakes other manufactures, which maintain their lead over primary commodities. Most Asian countries have followed this sequence in the course of their economic development, with some moving faster than others. Applying this framework to China confirms that its relative advantage structure has transformed rapidly since it began its ambitious reform program in the late 1970s (Figure 6).

Figure 3-6 Stages of China’s Relative Advantage Structure

Developing 0.6 Young NIE Mature NIE Country 0.4 Other Manufactures 0.2 0.0 -0.2 Machinery -0.4 Primary Commodities -0.6 -0.8 -1.0 8586 87 88 89 90 91 9293 94 95 96 97 98 99 00 01 02

Note: Specialization index = (exports – imports) / (exports + imports). The four stages of trade structure are defined as follows:

Stage Specialization Index Developing Country Primary Commodities > Other Manufactures > Machinery Young NIE Other Manufactures > Primary Commodities > Machinery Mature NIE Other Manufactures > Machinery > Primary Commodities Industrialized Country Machinery > Other Manufactures > Primary Commodities

Source: Compiled by the author from Chinese trade statistics.

82 CHAPTER 3 The Rise of China: Challenges and Opportunities for Japan Starting as a typical developing country, China became a young NIE in 1992 when the specialization index of other manufactures surpassed that of primary commodities. Subsequently, it attained mature NIE status in 1999 when the specialization index of machinery also overtook that of primary commodities. The current relative advantage structure of China corresponds to that of Taiwan in the early 1970s.

2 Complementary Relations between Japan and China 83 3

The Macroeconomic Impact on Japan of China’s Rise

With China-related business booming, the argument that China is a threat to Japan is rapidly losing force. Exports to China especially are surging, and soaring demand in China is becoming a driving force behind the recovery of the Japanese economy. Japan is enjoying an improvement in its terms of trade vis-à-vis China, a development that reflects lower prices of imports from China (good deflation) and higher prices of exports to China (good inflation).

3-1 Improvement in Japan’s Terms of Trade vis-à-vis China

Discussions of the effects of China’s progress on the Japanese economy often focus on changes in absolute prices, as embodied in the concept of “China-induced deflation.” Instead, more attention should be paid to changes in relative prices brought about by Japan’s improved terms of trade vis-à-vis China, for the improvement signifies a transfer of income from China.6 Looking first at how China’s advance affects its own terms of trade, we see that

6 Terms of trade are defined as the ratio of export prices to import prices. When the numerator (export prices) rises or the denominator (import prices) falls, the terms of trade improve, and that country’s purchasing power increases. In contrast, when export prices fall or import prices rise, the terms of trade deteriorate, and the real income of the country falls. For example, for Japan, which is an oil importer, an increase in oil prices (import prices) translates into deterioration in its terms of trade and signifies a decline in the real income of its people, while a fall in oil prices means an improvement in the terms of trade and a rise in real income. The first instance can be seen as a transfer of income from Japan to oil-producing nations, while the latter means that income is transferred from oil producers to Japan.

84 CHAPTER 3 The Rise of China: Challenges and Opportunities for Japan over the past twenty-five years, the country has become tightly integrated into the global economy through market-opening reforms. In the past, China had stuck to its mantra of self-reliance and self-sufficiency, but since opening its markets in 1978 it has abandoned this policy and left matters to market principles, so that it now exports low value–added, labor-intensive products and imports high value–added, technology- and capital-intensive goods, a situation in line with its comparative strengths. Reflecting this change in the supply-demand relationship, export prices have fallen relative to import prices. Thus China’s export-driven growth has brought about over time a deterioration in its terms of trade. We cannot calculate the extent of this deterioration directly because China does not release statistics on export and import prices, but the sharp decline of the since the late 1970s provides indirect evidence of its magnitude. In contrast to China, Japan exports technology- and capital-intensive products and imports labor-intensive goods. Therefore, while China’s terms of trade are the price of labor-intensive goods divided by the price of technology-intensive goods, the numerator and denominator for Japan’s terms of trade are exactly the reverse, meaning that the deterioration in China’s terms of trade signifies an improvement in Japan’s.7 For the Japanese consumer, real income rises as imports from China (and from countries that compete with China) get cheaper, while for Japanese companies profits increase through a fall in input prices and a rise in output prices. In fact, according to Japanese statistics, the prices of Japan’s exports to China have risen by 1.9% over 1990 levels, while prices of imports from China have fallen 22.9% over the same period (Figure 7). As a result, Japan’s terms of trade vis-à-vis China have improved by some 32.1%. The fact that exports to China in 2003 came to 6.6 trillion yen while imports came to 8.7 trillion yen means that, had the price of exports and imports remained at 1990 levels, Japan’s export earnings would have been 0.1 trillion yen less, while Japan’s import costs would have been 2.6 trillion yen more (Table 4). In other words, Japan saved some 2.7 (0.1 + 2.6) trillion yen a year as a result of the improvement in its terms of trade vis-à-vis

7 In terms of the “smiling curve,” the slopes of the two sides have become steeper and steeper, so that the terms of trade are turning against China in favor of Japan.

3 The Macroeconomic Impact on Japan of China’s Rise 85 China. This is a huge figure, equivalent to 0.5% of Japan's annual GDP, and roughly eight times the foreign direct investment that, according to statistics from the Ministry of Finance, Japanese companies pumped into China in fiscal 2003.

Figure 3-7 Improvement in Japan’s Terms of Trade vis-à-vis China

(1990 = 100)

140 Terms of trade vis-à-vis China Prices of exports to China 130 Prices of imports from China

120

110

100

90

80

70

60 199091 9293 94 95 96 97 98 99 00 01 022003

Source: Bank of Japan, “Corporate Goods Price Index, Export and Import Prices.”

Table 3-4 Japan’s Income Gain Resulting from Changes in its Terms of Trade vis-à-vis China (between 1990 and 2003)

Amount in Price Index Amount in (A – C) 2003 prices (A) (1990=100) (B) 1990 prices (C)

Exports to China ¥6.6trillion 1.019 ¥6.5trillion ¥0.1trillion (D) Imports from China ¥8.7trillion 0.771 ¥11.3trillion – ¥2.6trillion (E) Income gain (D – E) ¥2.7trillion

Source: Japanese Ministry of Finance, “Trade Statistics.”

However, to grasp fully the effects of China’s progress on the Japanese economy as a whole, we must look not only at such direct effects on relative prices between China and Japan, but also at the indirect effects on the export and import

86 CHAPTER 3 The Rise of China: Challenges and Opportunities for Japan prices of Japan’s other trading partners. First, Japan’s exports to China are, like its exports to other regions, primarily machinery, and increased demand in China should lead to an overall rise in export prices. Meanwhile, on the import front, as for labor-intensive goods that compete with those from China, an increase in supply should lead to a fall in overall import prices. Of course, just like Japan, China is a net importer of some primary products, such as crude oil, and a rise in imports by China can lead to a rise in prices, but as China’s share of global trade in these items is still very small, the impact should be limited. Overall, the indirect price effects reinforce the direct effects, and Japan’s total gain should be even larger than what the initial calculation suggests. Thus, the emergence of China has been a huge blessing for the Japanese economy, thanks to the deterioration in China’s terms of trade and the corresponding improvement in Japan’s. China is in a situation somewhat like that of the farmer whose income falls as a result of a good harvest, in that the more it exports, the more export prices go down—a catch-22 sometimes described as “immiserizing growth.” Japan is reaping the benefits of that good harvest, and the transfer of income from China to Japan is supporting the ’s standard of living during the current economic downturn.

3-2 Can a Stronger Yuan Help the Japanese Economy Recover?

In recent years, China’s remarkable progress in industrialization has been regarded as a major cause of deflation in Japan, and Japanese financial authorities are calling for a stronger yuan to resolve the problem. However, if we consider the fact that imports from China amount to less than 2% of Japan’s GDP, as well as the fact that there is very little competition between the two countries on the trade front, it is clear that any decline in prices in China has only a limited impact on the Japanese economy. Even if we assume, for the sake of argument, that deflation in China is accelerating deflation in Japan, the trend may not be problematic. To know whether it is, we need to discern whether the fall in prices of Chinese goods results, on balance, in “good deflation” that prompts an increase in output, or in “bad deflation”

3 The Macroeconomic Impact on Japan of China’s Rise 87 that brings about an output decline. Perhaps unsurprisingly, the Japanese media has focused on “bad deflation,” in which China’s exports, as they get cheaper, take market share from Japanese products, not just in Japan but also in third-country markets. Shown in the framework of supply and demand, this means that Japan’s demand curve shifts to the left, as in the lower panel of Figure 8. The shift has a deflationary effect on prices as well as a negative impact on Japan’s output.

Figure 3-8 The China Factor in Japan’s Deflation

Price level

Output

Price level

Output

However, if Japanese firms import various parts and intermediate goods from China, a fall in the prices of Chinese goods mean lower production costs in Japan, leading to “good deflation.” In economic textbook terms, the supply curve corresponds to the marginal cost curve. Cost reductions brought about by importing cheaper products from China shift Japan’s supply curve to the right, and, as a result,

88 CHAPTER 3 The Rise of China: Challenges and Opportunities for Japan output increases even if prices fall. Which type of deflation has a greater impact on Japanese output depends on whether economic relations between Japan and China are competitive or complementary. If the two economies are in a competitive relation, then the impact on the demand side is greater, with a negative effect on output. If the economies complement each other, however, there is a greater impact on the supply side, with a positive effect on output. And it has already been established that the two economies are in a complementary relation. Thus “good deflation” is likely to outweigh “bad deflation,” in which case the overall impact of a fall in Chinese prices on output in Japan will be positive. For the same reason, even if an appreciation of the yuan reins in China’s deflation, demand will not shift significantly from Chinese to Japanese goods; rather, there is a strong possibility that output would fall because of the rise in import costs. Indeed, according to a Nihon Keizai Shimbun survey of major Japanese firms conducted in early September, 37% of respondents said that an appreciation of the yuan would have a negative impact on their business. This figure was much higher than the 16% of respondents who replied that such a situation would have a positive effect (Table 5). An appreciation of the yuan would certainly improve the international competitiveness of some Japanese products, leading to increased sales not only in the Chinese market but also in third-country markets. However, many firms that import products and parts from China (including those that procure from

Table 3-5 Anticipated Effects of a Stronger Yuan on Japanese Companies

A rise in exports to China can be expected. Positive(16%) The competitiveness of Chinese products will decline. The value of our yuan holdings will rise. The scale of our China-related business is small. More or less neutral (47%) Our imports from and exports to China are balanced in value terms. We have the ability to absorb exchange rate fluctuations. Prices of imports from China will rise. The competitiveness of our production facilities in China will decline. Negative (37%) The cost of Japanese staff in China will rise. A strong yuan may have a dampening effect on the Chinese economy.

Source: Nihon Keizai Shimbun (Sept. 20, 2003).

3 The Macroeconomic Impact on Japan of China’s Rise 89 their own manufacturing bases there) are concerned that a stronger yuan would lead to a rise in the prices of Chinese imports and push up production costs.Thus far we have considered the perspective of Japanese producers. From consumers’ point of view, there is no need to distinguish between good and bad deflation. The fall in the prices of imports from China, as in the case of a fall in oil prices, signifies an improvement in the terms of trade, and a rise in consumers’ real income. Conversely, a stronger yuan would make imports from China less affordable to Japanese consumers. This analysis refutes both to the notion that the rise of China is the cause of deflation in Japan and the theory that a stronger yuan would solve the problem. Until the need for structural reform is recognized as the underlying cause of Japan’s deflation, the domestic economy will not see a real recovery from the protracted slump that accompanies that deflation, no matter how strong the yuan becomes.

3-3 Whither Japan’s “China Syndrome”?

During the 1997-98 Asian financial crisis, most Japanese were concerned about the future of their gigantic neighbor. Political risks aside, they worried about whether China would be forced to devalue its currency because of the financial turmoil in neighboring countries; about whether it would default on its external debt; about whether its banking sector would collapse under the weight of a mountain of bad debt; and about who would feed China. This “China syndrome” was also fueled by the protracted downturn of the domestic economy and a subsequent loss of confidence on the part of the Japanese. Pessimism turned abruptly to unreserved optimism as the new century opened. By 2001, speculation abounded in the Japanese media that China was leapfrogging into the new economy without undergoing the usual, gradual, cumbersome process of industrialization—that it had dramatically shortened the time it needed to catch up with Japan. Some even suggested that China should allow its currency to revalue to help Japan out of its recession. The relative strength of the Chinese economy in the midst of a global recession and China’s WTO accession certainly contributed to the euphoria.

90 CHAPTER 3 The Rise of China: Challenges and Opportunities for Japan With the Chinese economy continuing its robust growth and China-related business booming, Japan’s “China Syndrome” began to subside in 2003. By early 2004, soaring demand in China was widely recognized as a driving force behind Japan’s economic recovery. According to Japanese statistics, Japan’s trade with China in 2003 totaled US$132.4 billion, marking a record high for a fifth consecutive year. Of this amount, exports to China surged 43.6% to US$57.2 billion, while imports from China rose 21.9% to US$75.2 billion. In contrast to the steady rise in its trade with China, Japan’s trade with the United States has been slumping, with exports falling 2.6% and imports increasing by a scant 1.7% in 2003. In fact, Japan’s imports from China have exceeded those from the US since 2002, and in 2003 they comprised 19.7% of total imports to Japan (imports from the US making up 15.4%). As for exports from Japan, China-bound exports made up 12.2% of the total, still way behind the 24.6% bound for the US, but when Hong Kong and Taiwan are factored in, we find that in 2003 Japan’s exports to “Greater China” exceeded those to the US for the first time ever (Figure 9). The predominant goods among Japan’s China-bound exports are general machinery, electric equipment, and transport equipment (Table 6). Among these,

Figure 3-9 “Greater China” Replacing the US as Japan’s Largest Export Market

(Share of Japan is expoxt, %) 35

30

US 25 Taiwan Hong Kong 20 China

15

10

5

0 199091 9293 94 95 96 97 98 99 00 01 022003

Source: Japanese Ministry of Finance, “Trade Statistics.”

3 The Macroeconomic Impact on Japan of China’s Rise 91 there have been notable increases in semiconductors and other electronic parts, semi- finished audio-visual equipment, telecommunications equipment, and visual equipment, as well as industrial equipment such as construction machinery and office machinery. Furthermore, against a backdrop of increased automobile production in China, there has been a sharp and continuous rise in exports of such items as auto parts, automobiles, and steel and chemical products chiefly used in automobile production. China’s economic expansion is one factor behind the increase in Japan’s China- bound exports, but the growth in China’s exports and investment, as well as the rise in the number of Japanese firms setting up business in China, are creating an

Table 3-6 Japan’s China-Bound Exports by Product (2003)

Value Share Rate of Contribution Item (US$millions) (%) change (%) (%)

Total 57,239 100.0 43.6 43.6 Food 194 0.3 19.0 0.1 Textiles and textile products 3,183 5.6 13.8 1.0 Chemical products 6,615 11.6 33.4 4.2 Nonmetallic mineral products 788 1.4 25.9 0.4 Metals and metal products 5,238 9.2 25.4 2.7 Steel 3,706 6.5 26.8 2.0 General machinery 12,753 22.3 53.0 11.1 Office equipment 2,307 4.0 79.0 2.6 Construction and mining machinery 667 1.2 99.2 0.8 Electric equipment 16,181 28.3 51.0 13.7 Visual equipment 135 0.2 114.9 0.2 Semi-finished audio-visual equipment 2,176 3.8 113.9 2.9 Telecommunications equipment 924 1.6 54.7 0.8 Semiconductors and other electronic parts 6,161 10.8 45.6 4.8 Transport equipment 3,819 6.7 58.1 3.5 Automobiles 1,913 3.3 30.1 1.1 Automotive parts 1,782 3.1 104.9 2.3 Precision equipment 2,756 4.8 69.7 2.8 Other 5,713 10.0 40.9 4.2

Source: Japan External Trade Organization, “Japan’s Trade with China in 2003.”

92 CHAPTER 3 The Rise of China: Challenges and Opportunities for Japan especially advantageous export environment for Japanese firms whose strengths lie in the machinery sector. As China-bound exports increase thanks to surging demand in China, production and prices in Japan rise (“good inflation”). Of course, the surge in prices of imports from China (as well as the prices of raw materials procured from other countries) will increase Japanese companies’ production costs, and this may offset the output increase to a certain extent (“bad inflation”). However, compared to the direct “income effect” of economic expansion in China, this indirect “price effect” on Japanese output is likely to be relatively small.

3 The Macroeconomic Impact on Japan of China’s Rise 93 4

Japan Coping with the Rise of China: A Microeconomic Perspective

There are two ways for Japanese firms to gain access to the continually expanding Chinese market: they can produce locally and sell locally in China, or they can produce in Japan and export to China. All other things being equal, the latter option is less risky and can create more employment opportunities at home. As the present surge of Japanese exports to China clearly shows, Japan still possesses international competitiveness in technology-intensive industries, such as machinery, and it is entirely possible for Japanese companies to profit by producing domestically and exporting to China. If the relative advantages of both countries can be realized through trade, China’s advancement, far from posing a threat to Japan, will create a win-win game in which both countries prosper.

4-1 Complementarity Means Business Opportunities

Although many Japanese view China’s remarkable progress as a threat, the situation presents more of an opportunity than a challenge for Japan, as the two countries are in a complementary relation rather than a competitive one. The term “complementary relation” is used here to describe a situation in which China is weak in areas where Japan is strong, and vice versa. China’s growth potential in markets such as housing, automobiles, and distribution, and the international competitiveness, thanks to low wages, of its labor-intensive products, comprise areas of strength compared to Japan, while its relative lack of technological know-how and the seriousness of its environmental problems signify areas of comparative

94 CHAPTER 3 The Rise of China: Challenges and Opportunities for Japan weakness. When undertaking business in China, Japanese firms tend to be dazzled by China’s strengths, but they should have more confidence in their own. The housing and real estate industries are expected to be the future pillars of the Chinese economy. In 1998, the government abolished its policy of allocating housing, thereby triggering a shift from a pattern in which the state lent housing to citizens to one in which individuals freely purchase homes on the market. Coming at the same time as high economic growth and a rise in income, this policy change initiated a strong demand for housing that has not abated. Anticipating even stronger demand in the future, some Japanese manufacturers in housing-related businesses have already begun entering the Chinese market. With the recent liberalization of banking activities, developments in business areas such as housing loans are also drawing attention. The auto industry is another area that is gaining attention. Against a backdrop of rising personal income and improved expressway networks, motorization in China is proceeding at a rapid pace. With China’s participation in the WTO, tariffs on automobiles will be slashed to 25% by 2006, and import restrictions will also be abolished. Japanese automakers have already made moves to penetrate the Chinese market, in expectation of a future expansion in demand. Not only are we likely to see expansions in car exports from Japanese manufacturing headquarters and in local domestic production, there will probably also be more technology transfer, as well as business alliances in which luxury cars are manufactured in Japan while more popular models are made in China. In addition, business opportunities deriving from automobiles, such as auto loans, sales, insurance, and after-sale servicing, are sure to be exploited. Furthermore, China’s WTO accession will enable Japanese firms to enter distribution and service sectors. The abolition of restrictions on investment quantity and regions of operation will pave the way for increased efficiency in distribution and coordination in China. In addition, Japanese firms will also be able to enter the fields of after-sale servicing and other related businesses. In sum, Japanese companies have been successful in a number of areas, among them the housing and automobile industries and the distribution and service sectors, in which China is conspicuously weak. Therefore, the application of past experience can be an effective strategy. The development of China’s economy is an opportunity for

4 Japan Coping with the Rise of China: A Microeconomic Perspective 95 Japanese firms to apply business know-how cultivated in one industry to other sectors as well. At the same time, notwithstanding its increasing appeal as a major consumer market, China remains an attractive production base for labor-intensive goods, as its wage levels are still one-thirtieth those of Japan. Moreover, China’s competitiveness in labor-intensive goods is likely to persist for some time, because excess labor in rural areas will hold down wage increases in the industrial sector. Japanese companies that understand China’s new strengths as a consumer market, and grasp as well its ongoing strengths a production base, particularly for “mid-stream” activities such as assembly and processing, will find a rich source of business opportunities there. If China is to be a good production base in the future, however, the issue of technological upgrading will have to be tackled. Currently China has little world- class technology of its own, and its capabilities in research and development are weak as well. For this reason, it is necessary to introduce technology to China from abroad, so as to improve the country’s economic efficiency and upgrade its industrial structure. Given the large economic development gap between Japan and China, technology that has already become outdated in the one can still be very useful in the other. Furthermore, China is beset, as Japan was in the past, with serious environmental problems. This is not just a domestic issue, as some problems, such as acid rain, extend beyond national borders and adversely affect Japan. For this reason, Japanese official development assistance to China has shifted from traditional investment in infrastructure projects to funding for projects that tackle environmental problems. The environment is certainly a sector in which the experience and technological resources of Japanese companies can be fully utilized.

4-2 Should Japanese Firms View China as a Production Base or as a Market?

When Japanese companies consider business opportunities arising from China’s emergence, they need to ascertain whether market advantage and production

96 CHAPTER 3 The Rise of China: Challenges and Opportunities for Japan advantage lie with China or with Japan. The fact that wage levels in China are much lower than those in Japan does not mean that all products can be manufactured more cheaply there. Japan continues to be very competitive in the production of technology-intensive goods. At the same time, as a developing country, China has a consumption structure that differs greatly from that of industrialized nations. Therefore, whether China is best viewed as a production base or as a market differs from industry to industry. Japanese companies can choose among four different strategies, according to where production and market advantages lie (Figure 10). In areas where China has the advantage on the production front but Japan has predominance as a market, it is better to manufacture in China and then re-import to Japan. In areas where China enjoys advantages both as a production base and as a market, Japanese firms should strive to produce locally and sell locally. In areas where China is superior only as a market and Japan is more competitive on the production front, it would be advantageous to produce in Japan and then export to China. Machinery industries, such as automobiles, fall into this category. Finally, when Japan is dominant in both production and consumption, Japanese companies should concentrate on domestic production and domestic sales. When they consider business operations in China, Japanese firms should also recognize that direct investment and trade are substitutes for each other and that there are various hybrid forms of the two. In the case of direct investment, the influence a

Figure 3-10 Models of “China Business” for Japanese Firms

Production Advantage China

Production in China Production and re-import to Japan sales in China The world’s factory Market Japan China Advantage Production and Production in Japan, sales in Japan export to China

The world’s market Japan

4 Japan Coping with the Rise of China: A Microeconomic Perspective 97 firm wields over management matters increases in proportion to the ratio of its investment, but then so does the risk. In contrast, in the case of trade, which is supposed to be a one-time transaction, the risk is small. Therefore, regardless of whether a firm views China as a production base or a market, it does not necessarily have to set up its own factories in China. As in the first and second strategies outlined above, when a Japanese company wants to utilize China as a production base, it has a wide range of options, including (1) purchasing directly from a Chinese firm, (2) signing an OEM contract with a Chinese company and selling products under its own brand, (3) setting up a joint venture with a Chinese firm, and (4) making a 100% direct investment. Even when no investment is made, against the backdrop of market dominance it is possible to have Chinese subcontractors fully accept Japanese management’s policies, as in the case of Uniqlo, a major casual clothing supplier that outsources most of its production to China. In addition, as in the second and third cases, even when Japanese companies are targeting the Chinese market, they should not forget that market penetration can be achieved not only by manufacturing locally but also by producing in Japan and exporting to China.

4-3 The Need to Distinguish between “Good FDI” and “Bad FDI”

While there are firms in Japan making use of China’s vitality, there are still concerns that increased investment in China will lead to a hollowing-out of industry at home. In essence, if the market mechanism is functioning properly, the overseas expansion of companies should encourage an efficient allocation of resources. If hollowing-out occurs anyway, it should be attributed to the high cost structure created by excessive regulation at home, and to trade barriers raised by trading partners. Japan's foreign direct investment (FDI) can be placed in two broad categories: investment that places priority on production costs and exports, and investment that aims to avoid trade barriers and trade friction. The latter is more likely to lead to a hollowing-out of industry. Direct investment that places priority on production costs and exports aims to reduce costs by securing advantageous production factors overseas and by improving export competitiveness. For example, many Japanese firms have set up production bases in China to exploit its cheap labor, and rather than

98 CHAPTER 3 The Rise of China: Challenges and Opportunities for Japan sell what is produced there locally, they export most of it to Japan and other countries. Such investment improves the efficiency of resource allocation, and both the investing country and the host country benefit. In contrast, direct investment that aims to avoid trade barriers and trade friction occurs in situations where import restrictions block exports from Japan, so that firms have no choice but to produce overseas for the local market. The resulting division of labor distorts resource allocation because it runs counter to the relative advantages of both the investing and the host country. A typical example of this type of direct investment is that made by Japanese automakers in China. There is no doubt that China’s auto market will see rapid expansion, and, to gain access to that market, Japanese automakers are investing in facilities to produce cars in China, rather than exporting higher quality cars they can produce more cheaply at home. Their main reasons for choosing to invest in local production facilities are to avoid trade friction and to circumvent China’s high import tariff on automobiles, which even under China’s agreement with the World Trade Organization will hold at 25%. In terms of the aforementioned business models, trade barriers force Japanese automakers into local production and local sales in China, even though production and market advantages dictate that they should manufacture in Japan and export to China. If Japanese automakers were to manufacture one million cars in Japan and export them to China, they would create many employment opportunities at home, high-wage “good jobs” in an area in which Japan excels. Producing the same number of vehicles in China, they create fewer jobs, even if they do manufacture some parts in Japan, and the opportunity cost is very large. Thus direct investment that aims to avoid trade barriers or friction is “bad FDI,” for it leads to a decline in production efficiency and, in the end, a hollowing-out of domestic industry. Conversely, direct investment that places priority on production costs and exports is “good FDI,” in that it achieves an efficient allocation of resources. Unfortunately, public opinion regarding the hollowing-out of industry in Japan supports bad direct investment over good direct investment. When firms in industries where Japan still has a relative advantage, such as automobile manufacturing, invest in less efficient factories in China, their moves are praised as efforts to open up a new market, and there is no opposition at home. But when firms in industries where Japan no longer has an advantage over China relocate factories

4 Japan Coping with the Rise of China: A Microeconomic Perspective 99 there—because of lower wages or other efficiency considerations—they are denounced for creating a hollowing-out problem and for costing Japanese employees their jobs. This popular misunderstanding of the nature of direct investment leads to the protection of declining industries through measures such as import restrictions, and at the same time delays the advancement of Japan’s more vigorous industries

100 CHAPTER 3 The Rise of China: Challenges and Opportunities for Japan 5

In Search of a Win-Win Game

The key to success for Japanese companies doing business with China is to use China’s strengths to make up for their own weaknesses, and vice versa. To exploit the complementarity between the two countries fully, Japan and China should pursue a free trade agreement (FTA) that removes trade barriers between them. This would set an example for other Asian countries to follow.

5-1 Japan Should Aim at Economic Upgrading Without Hollowing-Out

The rise of China is posing both challenges and opportunities for Japan. For many Japanese companies, China is a potential market and investment destination. For others, increasing imports from China have created a need for industrial restructuring at home. In sectors that compete with China, this may take the form of more bankruptcies and higher unemployment. This situation has led to growing fears of a hollowing-out of domestic industries and escalating trade friction between China and Japan. Japan should not respond to these challenges with protectionist policies that safeguard domestic industries that have lost export competitiveness. Establishing barriers to limit imports and to prevent declining industries from being transferred overseas is treating symptoms instead of the disease. Declining industries in Japan are unlikely to recover competitiveness as a result of government protection. Such policies merely delay the improvement of industrial structure in both Japan and China. Rather, Japan should seek a division of labor with China based on their relative

5 In Search of a Win-Win Game 101 strengths. This would mean promoting new growth areas through deregulation and investing in research and development at home, while at the same time relocating declining industries to, and expanding imports from, China. This strategy would not only help promote China’s economic development but would also free up resources for emerging industries in Japan. With increased imports from China, Japanese producers and consumers would realize gains in real income, as the nation’s production and import costs diminished.

5-2 Japan-China FTA to Play a Pivotal Role in Asian Economic Integration

Japan should also pursue a free-trade agreement with China to encourage more “good direct investment” and to relieve the pressure for “bad direct investment.” If import tariffs are eliminated, trade between the two countries will become increasingly active. Japan’s key industries, in particular the automobile industry, would no longer have to take on the risks entailed in producing in China. An FTA with China is the ultimate way for Japan to prevent the hollowing-out of its industry. Asian countries, including Japan and China, are actively exploring the possibility of forming FTAs. There seems to be a tacit agreement to proceed with small-scale FTAs first—between Japan and Singapore, between Japan and ASEAN, and between China and ASEAN—and then converge these into a region-wide “ASEAN plus three” (those three being Japan, China and South Korea) FTA. When it comes to the specific combination of member countries, however, or to the order in which the various necessary steps should be taken, the region is still at a trial and error stage, and no convincing theory exists that can serve as a guide. Standard economic theory distinguishes between an FTA’s positive “trade creation effect” and its negative “trade diversion effect.” The former is an expansion of intra- regional trade thanks to the removal of trade barriers. The latter is a replacement of highly competitive goods imported from non-member countries with less competitive substitutes from member countries, and is a result of the fact that trade barriers have been removed only within the free trade area. The trade creation effect tends to exceed the trade diversion effect, so that trade liberalization yields greater benefits, when the

102 CHAPTER 3 The Rise of China: Challenges and Opportunities for Japan FTA is formed between countries with complementary rather than competitive relations. As explained above, stronger complementarity is generally observed between countries with a large gap in their levels of economic development, while competition is stronger between countries at similar developmental stages. China has strong complementary relations with Japan and the newly industrialized economies (NIEs), but competitive relations with ASEAN members. Thus economic theory indicates that an FTA between China and Japan should yield large benefits to both parties. In practice, however, political considerations are given higher priority than economic theory in determining the membership of an FTA—as seen, for instance, in the signing of the Japan-Singapore Economic Partnership Agreement, which presented a combination unlikely to face stiff political or popular resistance. This presents a problem on two fronts. First, Asia’s attempt to start from politically easy FTAs and move on to more difficult ones may be stymied before the ultimate vision—an amalgamation of small-scale FTAs into broader multilateral trade liberalization—is realized. Second, politically easy FTAs tend to bring little economic benefit, and FTAs with great economic benefit tend to require more adjustments in affected industries and thus to elicit stronger resistance. In terms of the economic benefit to be derived from a division of labor, Japan and China make the most desirable combination for an FTA. Politically, however, this combination is the most difficult to realize. Even putting aside agricultural products, labor-intensive industries in Japan such as the textile industry are bound to oppose an FTA, while liberalization initiatives in high-tech industries will provoke strong resistance in China. In addition to opposition from certain corners of their respective domestic industries, historical grievances and lingering distrust between the two countries will hinder moves toward a Japan-China FTA. In Europe, however, France and Germany, which of course fought two world wars in the first half of the twentieth century, are overcoming their past antipathies through economic integration. The sort of strong political leadership and perspective shift seen in France and Germany are now required of Japan and China. Both countries should view regional integration as a way to achieve peace and stability, not as a means to establish hegemony in the region. Together, Japan and China account for 80% of East Asia’s overall gross domestic product. Were they to form an FTA, other Asian countries would rush to join, and regional integration would gather momentum.

5 In Search of a Win-Win Game 103 CHAPTER 4 TAIWAN: INVESTMENT IN CHINA AND STRUCTURAL CHANGE Chu-Chia Lin, National Chengchi University 1

Introduction

Economic relations between Taiwan and China began when China shifted, in late 1978, from a policy of isolation to its so-called “open-door” policy. Since then economic conditions, including different factor endowments and different comparative advantages, have prompted bilateral trade across the Taiwan Strait to increase sharply, in spite of a political situation that remains sensitive.1 Taiwanese businesses began investing in China in 1988, after the Taiwanese government abolished martial law in November of 1987 and allowed citizens to visit their relatives in China. The growth rate of bilateral trade across the Taiwan Strait is even greater now that numerous Taiwanese firms are investing in China. This bilateral trade has had a significant impact on Taiwan’s gross domestic product, its exports, its unemployment rate, and its industrial structure. Exports to China have contributed appreciably to the growth of Taiwan’s GDP, but the country’s GDP structure has changed significantly in the process. Because most of Taiwan’s labor-intensive firms have invested in China, Taiwan’s output structure has shifted quickly from labor-intensive to high-tech industries. And while the total output of the manufacturing sector has shrunk, the service sector has expanded at the same time. Is Taiwan facing a hollowing-out problem, as labor-intensive firms shift their

1 The United States ended formal diplomatic relations with Taiwan in 1979 and opened formal relations with China in the same year.

1 Introduction 107 production bases to the mainland and the manufacturing sector contracts? This question is a subject of considerable debate in Taiwan, and the answer depends largely on how one defines “hollowing-out.” If one looks simply at the percentage of GDP contributed by the manufacturing sector, it does appear that Taiwanese industry is hollowing out, since manufacturing’s share of the GDP is shrinking. However, most economists in Taiwan would find this approach deficient. In advanced countries like the US and Japan, the manufacturing sector has declined as the economy develops, suggesting that it is in fact normal for manufacturing to shrink as an economy matures past a certain stage. Thus pointing to a diminished manufacturing sector as evidence that an economy is hollowing out is dubious at best. Indeed, even as the share of GDP given to manufacturing has dropped, the output and export structures for manufactured goods have shifted to high-tech products, suggesting that Taiwan’s manufacturing sector is not hollowing out so much as adapting to changed circumstances by upgrading itself. The impact of bilateral economic relations on Taiwan’s unemployment rate is also a subject of debate. Historically, Taiwan’s unemployment rate has generally been less than 2%, but when it jumped abruptly to 5% in 2002, some in Taiwan accused China of exporting its unemployment to Taiwan. This sounds like a convenient account of Taiwan’s unemployment problems. However, considering that economic relations with China started in 1979, and that Taiwan’s foreign direct investment (FDI) in China began in 1988, but unemployment in Taiwan held at around 2% until 1995, and then jumped to 4.57% in 2001, the relation of Taiwan’s unemployment rate to its FDI in China is far from clear. How, then, should Taiwan respond to the rise of China? For that rise is inevitable, and its impact has been, and will continue to be, dramatic. Perspectives on this issue vary widely in Taiwan. Most Taiwanese businesspersons, as well as most economists, urge the government to be more open in economic dealings with China. The government, however, has been somewhat conservative about economic (and other) relations with China, so that, for instance, there are still no direct flights from Taiwan to China, and tourists from Chinese are not allowed to visit Taiwan. Meanwhile Chinese investment in Taiwanese firms is capped at 40% of a firm’s total equity, or less in the case of larger firms. But even while the government tries to minimize China’s economic impact on Taiwan, Taiwan’s

108 CHAPTER 4 Taiwan: Investment in China and Structural Change economic dependence on China grows deeper. If the government sincerely wants to restore Taiwan to economic vitality, it should be bold in developing the country’s economic relationship with China, capitalizing on China’s cheap factors and its huge market to enhance the competitiveness of Taiwanese products. The purpose of this chapter is to analyze the effects on Taiwan’s economy of economic relations across the Taiwan Strait. It will concentrate on the impact of bilateral trade and Taiwan’s FDI in China on Taiwan’s economic performance and industrial structure. One goal is to resolve misunderstandings about the putative hollowing-out of Taiwan’s manufacturing sector, and about the impact of relations with China on Taiwan’s employment levels. Another is to examine the integrated production process made possible by Taiwan’s FDI in China and to assess its impact on Taiwan’s international competitiveness. A final goal is to offer policy suggestions to the Taiwanese government for its economic dealings with China. The following section describes the trade relationship between Taiwan and China and Taiwan’s FDI in China. Section 3 discusses the impact of Taiwan’s economic relationship with the mainland on Taiwan’s economic performance and industrial structure. Section 4 introduces indexes for production integration and for international competitiveness, and tries to gauge how these two factors will interact over the long run in the Taiwan-China economic relationship. Section 5 evaluates Taiwan’s current economic policies towards China, and the final section summarizes the chapter’s findings and draws some conclusions.

1 Introduction 109 2

Bilateral Trade across the Taiwan Strait and Taiwan’s Investment in China

2-1 Trade Interdependence

Bilateral trade between China and Taiwan started in 1979 when China shifted to an open-door policy and began to trade with other countries and regions. In that year, total exports from Taiwan to China amounted to US$21.5 million, while imports from China to Taiwan totaled US$56.3 million (Table 4-1). In 1980, however, Taiwan’s exports to China jumped dramatically, and Taiwan has enjoyed a huge trade surplus since then. Taiwan’s total trade with China has increased rapidly since 1979. Exports ballooned from US$21.5 million in 1979 to US$35.4 billion in 2003, an average annual growth rate of 36.15%.2 Meanwhile, imports from China to Taiwan have increased from US$56.3 million in 1979 to US$11 billion in 2003, a lower (but still very robust) average annual growth rate of 24.56%. The average growth rate for total trade over the period has been 35.5% per year. While total trade is increasing quickly, Taiwan’s trade surplus with China is also growing at a high speed. In 2003, Taiwan enjoyed a surplus of US$24.4 billion, larger even than its total world trade surplus of US$16.9 billion. In fact, Taiwan’s trade surplus with China has been larger than its world surplus since 1993. The cumulative trade surplus with China from 1979 to 2003 is US$220.2

2 If we instead count the annual growth rate from 1980, it still comes to 24.36% per year. 3 In fact, the Taiwan’s cumulative trade surplus with China exceeded Taiwan’s total balance of foreign reserves at the end of 2003, which came to US$206.6billion.

110 CHAPTER 4 Taiwan: Investment in China and Structural Change billion, just a little smaller than Taiwan’s world trade surplus of US$245.6 billion.3 The burgeoning trade relation across the Taiwan Strait quickly established trade interdependence between Taiwan and China. Taiwan’s export share to China increased from 0.13% to 24.52% between 1979 and 2003, its import share from

Table 4-1 Bilateral Trade across the Taiwan Strait (Unit: US$million)

Taiwan to China to Taiwan’s Surplus Taiwan’s Surplus Year Total Trade China Taiwan with China with World 1979 21.5 56.3 77.8 -34.8 1,329.0 1980 235.0 76.2 311.2 158.8 78.0 1981 384.8 75.2 460.0 309.6 1,412.0 1982 194.5 84.0 278.5 110.5 3,316.0 1983 157.9 89.9 291.3 111.5 4,836.0 1984 425.5 127.8 553.3 297.7 8,497.0 1985 986.8 115.9 1,102.7 870.9 10,624.0 1986 811.3 144.2 955.5 667.1 15,680.0 1987 1,226.5 288.9 1,515.4 937.6 18,695.0 1988 2,242.2 478.7 2,720.9 1,763.5 10,995.0 1989 3,331.9 586.9 3,918.8 2,745.0 14,039.0 1990 4,394.6 765.4 5,160.0 3,629.2 12,495.2 1991 7,493.5 1,125.9 8,619.4 6,367.6 13,299.1 1992 10,547.6 1,119.0 11,666.6 9,428.6 9,463.5 1993 13,993.1 1,103.6 15,096.7 12,889.5 8,030.3 1994 16,022.5 1,858.7 17,881.2 14,163.8 7,699.6 1995 19,433.8 3,091.4 22,525.2 16,342.4 8,108.8 1996 20,727.3 3,059.8 23,787.1 17,667.5 13,572.0 1997 22,455.2 3,915.4 26,370.6 18,539.8 7,656.0 1998 19,840.9 4,110.5 23,951.4 15,730.4 5,917.0 1999 21,312.5 4,522.2 25,834.7 16,790.3 10,939.8 2000 25,009.9 6,223.3 31,233.2 18,786.6 8,309.9 2001 21.945.7 5,902.2 27,847.9 16,043.5 15,658.7 2002 29,446.2 7,947.4 37,393.6 21,498.8 18,066.7 2003 35,357.7 10,962.0 46,319.7 24,395.7 16,931.0 Total 277,998.4 57,830.8 335,872.7 220,211.1 245,648.6

Source: Mainland Affairs Council, Cross Strait Economic Statistics Monthly (2003), 135.

2 Bilateral Trade across the Taiwan Strait and Taiwan’s Investment in China 111 0.38% to 8.61% over the same period (Table 4-2).4 In fact, as of 2002, China has replaced the US as Taiwan’s largest trading partner. It is worth noting that, while Taiwan’s export dependence on China is increasing, China’s import dependence on Taiwan is growing too. That said, China’s import share from Taiwan increased between 1979 and 1997, when it

Table 4-2 Trade Dependence across the Taiwan Strait (Unit: %) Taiwan China Year Export Import Total Trade Export Import Total Trade Share Share Share Share Share Share 1979 0.13 0.38 0.25 0.14 0.38 0.26 1980 1.19 0.39 0.79 1.17 1.17 0.82 1981 1.70 0.35 1.05 1.75 1.75 1.04 1982 0.88 0.44 0.68 1.01 1.01 0.67 1983 0.80 0.44 0.64 0.94 0.94 0.67 1984 1.40 0.58 1.06 1.55 1.55 1.03 1985 3.21 0.58 2.17 2.34 2.34 1.58 1986 2.04 0.60 1.49 1.89 1.89 1.29 1987 2.28 0.83 1.71 2.84 2.84 2.06 1988 3.70 0.96 2.47 1.01 4.06 2.65 1989 5.03 1.12 3.31 1.12 5.63 3.51 1990 6.54 1.40 4.23 1.23 8.24 4.47 1991 9.84 1.79 6.20 1.57 11.75 6.35 1992 12.95 1.55 7.60 1.32 13.09 7.05 1993 16.47 1.43 9.32 1.20 13.46 7.71 1994 17.22 2.18 10.02 1.54 13.85 7.55 1995 17.40 2.98 10.46 2.08 14.71 8.02 1996 17.87 3.02 10.95 2.03 14.93 8.21 1997 18.39 3.42 11.15 2.14 15.77 8.11 1998 17.94 3.93 11.13 2.24 14.16 7.39 1999 17.52 4.09 11.12 2.32 12.86 7.16 2000 16.87 4.44 10.84 2.49 11.18 6.60 2001 17.86 5.50 12.10 2.22 9.01 5.46 2002 22.56 7.60 15.39 2.44 9.98 6.03 2003 24.52 8.61 17.07 2.50 8.56 5.44

Source: As for Table 4-1.

112 CHAPTER 4 Taiwan: Investment in China and Structural Change reached its highest point, 15.77%, and has since dropped sharply. Although Taiwan’s exports to China are still growing rapidly, China’s import growth rate is even greater, yielding a net decrease in China’s import share from Taiwan.5 There are several reasons for the rapid increase in bilateral trade between Taiwan and China. The first is provided by traditional trade theory, which says that because the two countries have different factor endowments, firms on both sides will try to realize comparative advantages. Second, since Taiwan and China are at different stages of economic development, with, for example, per capita GDPs in 2003 of about US$13,000 and US$1,000 respectively, many trade opportunities exist for goods and services on both sides. Third, Taiwan and mainland China share a common language, Mandarin, as well as similar customs and cultures, so that the transaction costs entailed from trade are very low. Finally, Taiwanese firms that invest in China, whose numbers are growing yearly, import raw materials, parts, and semi-products from Taiwan, and also export raw materials, parts, and semi-products to Taiwan. In other words, these firms have, by investing in China, helped to establish the massive bilateral trade between the two countries.

2-2 Taiwan’s Foreign Direct Investment in China

After China’s ruling party the (KMT) retreated from the mainland to Taiwan in 1949, Taiwanese citizens were forbidden from visiting China for any reason. This prohibition remained in place well after trade between the two countries had begun to flow. Only near the end of 1987, when the Taiwanese government abolished martial law, were citizens permitted to visit their relatives in China. Taiwanese businesspeople who did so discovered in China an almost unlimited supply of cheap labor. Taiwanese firms in labor-intensive industries, attracted by this inexpensive labor supply, reassured by the absence of a language

4 The export share does not include goods exported directly to Hong Kong. If we count Hong Kong a part of China and include them, the export share in 2003 rises to 34.52%. 5 For instance, China’s import growth rate was 39% in 2003.

2 Bilateral Trade across the Taiwan Strait and Taiwan’s Investment in China 113 barrier and impressed by how small an investment was required to establish a production base, started to invest there, primarily in labor-intensive industries like footwear, clothing, and toy manufacturing. Suddenly, as the 1990s began, Taiwanese firms started to rush into China, even though the Taiwanese government would permit only so-called “indirect investment.”6 According to the Taiwanese government’s records, there have been 31,151 cases of Taiwanese investment in China between 1991 and 2003 (Table 3). The average amount of investment for each case is US$1.1 million, the cumulative total value US$34.3 billion. However, both the total number of cases and the total value of investment are much greater according to the records of the Chinese government, which put the total number of cases at 60,186, the total contracted amount of investment from Taiwan at US$70.0 billion, and the total realized amount at US$36.5 billion.7 The first feature to note about Taiwan’s FDI to China is that the average amount of investment has been increasing. An especially sharp rise was seen in 1995, when the average amount more than doubled, according to the Taiwanese government’s records, from US$1.03 million to US$2.23 million. The scale of investment changed so dramatically in 1995 because more large firms had started to invest in China, in particular several large information technology (IT) enterprises. A second feature to notice is that the investment locale has been shifting from Guangdong and Fujian to Jiangsu province (Table 4). While Guangdong has the largest number of firms from Taiwan, Jiangsu has the largest amount of investment, indicating that there are more large firms in the latter. In fact, the three provinces between them account for 80.2% of total investment from

6 In fact, though there are more than 50,000 Taiwanese firms invested in China, technically there is no “direct” investment at all, since every investment from Taiwan to China has to go to an intermediate location first, and only then to China. Properly speaking, we are discussing not foreign direct investment, but foreign indirect investment, though the investment in question is direct in all but name. 7 In fact, the total amount of investment is probably higher still. Taiwanese investment in China has to be “indirect,” as said, and some Taiwanese firms choose Hong Kong as their intermediary, others countries at a greater remove, such as the Virgin Islands or the Bahamas. As it happens, depending on their choice of intermediary, some of these firms are not considered, even in the Chinese statistics, to be from Taiwan. Thus it is very likely that, for political reasons, the total amount of investment by Taiwan in China is badly underestimated.

114 CHAPTER 4 Taiwan: Investment in China and Structural Change Taiwan. When investment from Taiwan began, most firms chose to locate in Guangdong and Fujian for two reasons: they were right next to Taiwan, so transportation costs were lower,8, 9 and they are on the coast, which lowered export

Table 4-3 Taiwan’s FDI in China, by Value (Unit: US$million) Taiwanese Government Records Chinese Government Records

Year Total Average Contracted Average Realized Realization Cases Cases Amount Amount Amount Amount Amount Ratio (%)

1991 237 174.16 0.73 3,446 2,783.00 0.81 844.00 30.33 1992 264 246.99 0.94 6,430 5,543.00 0.86 1,050.00 18.94 1993 1,262 1,140.37 0.90 10,948 9,965.00 0.91 3,139.00 31.50 (8,067) (2,028.05) (0.25) 1994 934 962.21 1.03 6,247 5,395.00 0.86 3,391.00 62.85 1995 490 1,092.71 2.23 4,778 5,777.00 1.21 3,162.00 54.73 1996 383 1,229.24 3.21 3,184 5,141.00 1.61 3,475.00 67.59 1997 728 1,614.54 2.22 3,014 2,814.00 0.93 3,289.00 116.88 (7,997) (2,719.77) (0.34) 1998 641 1,519.21 2.37 2,970 2,982.00 1.00 2,915.00 97.75 (643) (515.41) (0.80) 1999 488 1,252.78 2.57 2,499 3,374.44 1.35 2,598.70 77.01 2000 840 2,607.14 3.10 3,108 4,041.89 1.30 2,296.28 56.81 2001 1,186 2,784.15 2.35 4,214 6,914.19 1.64 2,979.94 43.10 2002 1,490 3,858.76 2.59 4,853 6,740.84 1.39 3,970.64 58.90 (3,950) (2,864.30) (0.73) 2003 1,837 4,594.99 2.50 4,495 8,557.87 1.90 3,377.24 39.46 (8,268) (3,103.80) (0.38) Total 34,308.57 1.10 60,186 70,028.90 1.16 36,487.82 52.10

Note: Figures in parentheses represent the cases or amount for registration of previously unregistered investments. Source: As for Table 4-1.

8 Because there are no direct flights from Taiwan to China, Taiwanese citizens have to fly to cities in China by way of Hong Kong. This makes Guangdong, the province adjacent to Hong Kong, the most convenient location for Taiwanese firms. 9 Lin and Png (2003) have shown the impact of distance on investment mode for Taiwanese FDI in China.

2 Bilateral Trade across the Taiwan Strait and Taiwan’s Investment in China 115 costs—most of the early investors being export-oriented firms. Larger firms investing in China, however, aim not just to export but to sell goods and services within China, making Jiangsu province a better choice, as it is near the center of China’s domestic market. Thus, as more large firms have entered China, the balance has shifted toward Jiangsu.

Table 4-4 Taiwan’s FDI in China, by Region

Region Cases Amount (US$million) Percentage by Amount (%) Jiangsu 8,589 14,189.7 41.36 Guangdong 10,585 10,512.3 30.64 Zhejiang 1,622 2,051.3 5.98 Fujian 4,194 3,031.8 8.84 Hebei 1,999 1,665.3 4.85 Sichuan 466 391.9 1.14 Hubei 464 316.2 0.92 Shandong 788 582.9 1.70 Liaoning 483 346.3 1.01 Hunan 276 148.9 0.43 Others 1,705 1,072.1 3.12 Total 31,151 34,308.6 100.00

Source: As for Table 4-1.

A third noteworthy feature of Taiwan’s FDI in China is that investment has shifted from labor-intensive to high-tech enterprises. The electronic and electric (EE) appliances industry is now the number one industry investing in China (Table 4-5), both in terms of number of firms and total amount of investment (32.06%).10 Interestingly, excluding the EE industry, all of the others, including basic metals,

10 As it happens, the total share for the IT industry in the manufacturing sector in Taiwan is about one-third, too. Thus one reason so many investing firms are in the electronic and electric appliance industry is just that [they are affordable to do that].

116 CHAPTER 4 Taiwan: Investment in China and Structural Change chemicals, plastic products, and textiles, show about the same percentage of investment. This suggests that the basic reason for Taiwanese firms to invest in China is similar across industries, namely, the low cost of labor and the large domestic market.11

Table 4-5 Taiwan’s FDI in China, by Industry

Region Cases Amount (US$million) Percentage by Amount (%) Electronic and Electric Appliances 5,578 10,999.9 32.06 Basic Metals and Metal Products 2,698 2,962.7 8.64 Chemicals 1,938 2,349.8 6.85 Plastic Products 2,603 2,307.9 6.73 Food and Beverage Processing 2,433 1,844.3 5.38 Textiles 1,155 1,298.1 3.78 Non-Metallic Minerals 1,388 1,723.2 5.02 Transport Equipment 994 1,320.9 3.85 Machinery Equipment 1,214 1,157.4 3.37 Precision Instruments 2,887 1,894.3 5.52 Agriculture and Fisheries 528 205.2 0.60 Services 1,628 1,163.6 3.39 Others 6,107 5,081.3 14.81 Total 31,151 34,308.6 100.00

Source: As for Table 4-1.

China is clearly the single most important locale in the world for Taiwan’s FDI. There were 19,751 cases of FDI from Taiwan to the rest of the world between 1991 and 2003 (Table 4-6). In this same period, the total number of cases of FDI in China was 31,151. In other words, 61.2% of all of Taiwan’s FDI cases were in China over this period. In terms of value of investment, 36.95% of the total value

11 Kao et al. (1992, 1995) discuss in some detail the incentives for Taiwanese firms to invest in China.

2 Bilateral Trade across the Taiwan Strait and Taiwan’s Investment in China 117 of Taiwanese FDI went to China. Even though the average investment scale of investment in China remains smaller than in other areas, the sheer number of cases of investment makes China undeniably the most important destination for Taiwan’s outward FDI.

Table 4-6 Taiwan’s FDI in the World

Proportion of Taiwan’s Taiwan’s FDI in the World Taiwan’s FDI in China World FDI in China Year Amount Amount Cases Cases Cases(%) Amount (%) (US$million) (US$million)

1991 601 1,830.19 237 174.16 39.43 9.52 1992 564 1,134.25 264 246.99 46.81 21.78 1993 1,588 2,801.31 1,262 1,140.37 79.47 40.71 (8,067) (2,028.05) 1994 1,257 2,578.97 934 962.21 74.24 37.31 1995 829 2,449.59 490 1,092.71 59.11 44.61 1996 853 3,394.64 383 1,229.24 44.90 36.21 1997 1,487 4,508.37 728 1,614.54 48.96 35.81 (7,997) (2,719.77) 1998 1,538 4,815.51 641 1,519.21 41.68 31.55 (643) (515.41) 1999 1,262 4,521.79 488 1,252.78 38.67 27.71 2000 2,231 7,684.20 840 2,607.14 37.65 33.93 2001 2,574 7,175.80 1,186 2,784.15 46.08 38.80 2002 2,415 7,228.81 1,490 3,858.76 61.70 53.38 (3,950) (2,864.30) 2003 2,551 8,563.58 1,837 4,594.99 72.01 53.66 (8,268) (3,103.80) Total 19,751 58,687.01 31,151 34,388.60 61.20 36.95

Note: Figures in parentheses represent the cases or amount for registration of previously unregistered investments. Source: MOEA , Monthly and Annual Statistical Reports of Overseas Chinese and Foreign Investment in the ROC, Outward Investment and Technical Cooperation from the ROC, and Indirect Investment in Mainland China, 2003, Executive Yuan, ROC.

118 CHAPTER 4 Taiwan: Investment in China and Structural Change 3

Economic Impact and Structural Change for Taiwan

The large amount of Taiwanese FDI in China has created a significant intra- industry trade across the Taiwan Strait. At the same time, a large trade surplus has contributed significantly to Taiwan’s GDP growth rate. As labor-intensive firms move to China, they lay off workers in Taiwan, nudging the unemployment rate there higher. Meanwhile, because a large proportion of these firms have shifted their operations to China, Taiwan faces significant structural changes in its industrial base, for the GDP share of the manufacturing sector is shrinking rapidly, even as the service sector’s share climbs sharply. Taiwan’s export structure too has moved quickly from labor-intensive to technology-intensive goods. As we will see, when an industry in Taiwan integrates its production processes vertically with subsidiaries in China, it achieves greater international competitiveness, whereas it becomes less competitive if it integrates production horizontally with Chinese subsidiaries.

3-1 Intra-Industry Trade

In order to utilize the massive supply of cheap labor in China, Taiwanese firms there usually set up on a much larger scale than their parent firms in Taiwan. Just as other multinational firms do, Taiwanese firms import a large proportion of their raw materials, parts, and semi-products from their home country.12 In the early stages of investment, according to Kao et al. (1992, 1995), more than half of the raw materials and parts used by Taiwanese firms in China, and more than three-quarters

3 Economic Impact and Structural Change for Taiwan 119 of the machines, are from Taiwan. Even when Taiwanese firms in China have become localized, and there are Chinese firms close at hand to supply the needed materials and parts, still more than one-third of raw materials and parts come from Taiwan.13 In fact, it is not just labor-intensive sectors that draw important raw materials and parts from Taiwan; some high-tech industries are importing parts and semi- products as well. Indeed, a number of major IT products are now produced in China out of materials largely imported from Taiwan (Table 7). For example, in 2002, about 40% of a laptop PCs made by a Taiwanese firm was made in China, even while it is Taiwan and not China that boasts, rightly, of being the world’s number- one producer of laptops. The situation is similar for desktop PCs, motherboards, LCD monitors, CDT monitors, optical disk drivers, and digital still cameras.14

Table 4-7 Output Share of Taiwanese Firms in China for Major IT Products in Taiwan (Unit: %) 2002 Taiwan’s World Item 2000 2001 2002 Market Share Notebook PC 0.0 5.2 40.0 61.0 Desktop PC 45.0 48.0 55.0 23.4 Motherboard 45.0 52.8 61.6 65.0 Server 9.0 16.0 19.2 30.0 LCD Monitor 1.0 28.4 60.5 51.0 CDT Monitor 58.0 66.3 71.2 61.0 Optical Disk Driver 78.0 91.2 94.2 45.0 Digital Still Camera 44.0 54.0 68.7 38.6

Source: Chou (2003).

12 According to traditional FDI theory, there are several reasons why subsidiaries will import parts and raw materials from their home countries. One is that managers in a subsidiary know the parent firm well and thus know how and where to locate parts in the home country. Another is that parent firms can use a transfer pricing strategy to transfer subsidiaries’ profits to the home country. 13 For a more detailed discussion on this point, see Kao et al. (1992, 1995), Chiu (1996), and Kao (2000). According to Taiwanese customs statistics, 82.13% of goods exported from Taiwan to China in 2003 were parts and semi-products. 14 For the production integration of the IT industry between Taiwan and China, see Li and Kao (2002), Kao (2003), Chou (2003), and Lin (2004).

120 CHAPTER 4 Taiwan: Investment in China and Structural Change When Taiwanese firms shift the production of final goods to their subsidiaries, they allow their parent firms to concentrate on producing raw materials and parts. As this vertical integration gradually takes shape, the degree of intra-industry trade increases. In fact, 13 of the top 20 export goods from Taiwan to China are electronic and electric appliances (i.e., HS Codes 84 and 85) (Table 8).

Table 4-8 Major Export Goods from Taiwan to China via Hong Kong (2003)

HS Amount Proportion Rank Description code (US$million) (%) 1 854221 Monolithic digital integrated circuits 1,653.9 14.0 2 847330 Read/write heads for disc devices 1,383.8 11.7 3 854229 Other monolithic integrated circuits 744.9 6.3 4 390330 Acrylonitrile-butadiene-styrene (ABS) copolymers 431.8 3.7 5 852990 Other parts suitable for assembly of televisions 286.2 2.4 6 852520 Digital mobile telephones 207.3 1.8 7 852520 Hybrid integrated circuits 190.9 1.6 8 390319 Other polystyrene, in primary forms 175.2 1.5 9 850490 Parts of transformers and static converters 158.2 1.3 10 852290 Parts and accessories of turntables and record-players 141.6 1.2 11 390210 Fabrics of cotton, impregnated, coated, covered or 129.8 1.1 laminated with polyvinyl chloride 12 900691 Parts and accessories for cameras 129.2 1.1 13 550320 Staple fibers of polyesters, not carded, combed, or 120.3 1.0 otherwise processed for spinning 14 590310 Polypropylene 116.7 1.0 15 853690 Electrical apparatus for switching or protecting 104.1 0.9 electrical circuits, or for making connections to or in electrical circuits 16 540742 Other dyed woven fabrics, containing 85% or more 102.7 0.9 by weight of filaments of nylon or other polyamides 17 853400 Rigid single-layer printed circuit board (PCB) 102.6 0.9 18 854110 Storage units 100.9 0.9 19 854190 Molds 99.6 0.8 20 847170 Disc devices 79.6 0.7 Total 6,459.3 54.8

Source: As for Table 4-1.

3 Economic Impact and Structural Change for Taiwan 121 However, 14 of the top 20 goods imported from China to Taiwan are also electronic and electric appliances (Table 9). Clearly then there is a high degree of intra-industry trade between Taiwan and China.

Table 9 Major Import Goods from China to Taiwan via Hong Kong (Jan.-Nov. 2003)

HS Amount Proportion Rank Description code (US$million) (%)

1 847330 Automatic data processing machines and units thereof 632.1 5.8 2 270112 Bituminous coal 576.8 5.3 3 847170 Storage units 521.8 4.8 4 847160 Input or output units, whether or not containing storage 487.6 4.4 units in the same housing 5 850440 Static converters 356.7 3.3 6 854219 Others, concluding circuits combined bipolar and metal 340.1 3.1 oxide semiconductor technology (BIMOS) 7 854240 Hybrid integrated circuits 271.1 2.5 8 901380 Liquid crystal devices, appliances and instruments 264.7 2.4 9 853669 Other plugs and sockets, for a voltage not exceeding 1,000 v 252.7 2.3 10 847130 Portable digital automatic data processing machines, 163.9 1.5 weighing not more than 10 kg, consisting of at least a central processing unit, a keyboard, and a display 11 790111 Containing by weight 99.99% or more of zinc, not alloyed 134.3 1.2 12 854230 Other monolithic integrated circuits 125.1 1.1 13 760110 Aluminum, not alloyed, unwrought 117.7 1.1 14 720712 Other semi-finished products of iron or non-alloy steel, 115.8 1.1 containing by weight 0.12% or less of carbon, of rectangular (other than square) cross-section 15 854110 Chip and wafer of diodes, other than photosensitive or 114.8 1.0 light emitting diodes 16 854441 Other power supply wires and wire sets, fitted with 109.2 1.0 connectors, for a voltage not exceeding 80 v 17 852990 Other parts used for radio receivers 98.3 0.9 18 852540 Still image video cameras and other video camera recorders 98.0 0.9 19 850450 Other inductors 82.6 0.8 20 250590 Other natural sands of all kinds, whether or not colored, 80.4 0.7 other than metal-bearing sands of Chapter 26 Total 4,943.7 45.1

Source: As for Table 4-1.

122 CHAPTER 4 Taiwan: Investment in China and Structural Change 3-2 GDP and Unemployment

As Taiwan’s export share to China and its trade surplus with China continue to grow, the contribution of bilateral trade to Taiwan’s GDP becomes more and more significant. Taiwan’s GDP maintained a high growth rate from 1979 to 2000 (Table 11). Though the GDP growth rate has declined a little since then, the average growth

Table 4-10 Macroeconomic Performance of Taiwan (Unit %) Year GDP Growth Rate Unemployment Rate CPI Growth Rate

1979 8.20 1.27 9.80 1980 7.30 1.23 19.00 1981 6.20 1.36 16.30 1982 3.60 2.14 3.00 1983 8.40 2.71 1.40 1984 10.60 2.45 -0.04 1985 5.00 2.91 -0.20 1986 11.60 2.66 0.70 1987 12.70 1.97 0.50 1988 7.80 1.69 1.30 1989 8.20 1.57 4.40 1990 5.39 1.67 4.10 1991 7.55 1.51 3.60 1992 7.49 1.51 4.50 1993 7.01 1.45 2.90 1994 7.11 1.56 4.10 1995 6.42 1.79 3.70 1996 6.10 2.60 3.10 1997 6.68 2.72 0.90 1998 4.57 2.69 1.70 1999 5.42 2.92 0.20 2000 5.86 2.99 1.30 2001 -2.18 4.57 -0.01 2002 3.59 5.17 -0.20 2003 3.24 4.99 -0.28

Source: Council for Economic Planning and Development, Taiwan Statistical Data Book, 2003.

3 Economic Impact and Structural Change for Taiwan 123 rate for the period of 21 years is 7.07%. Economic relations with China over the past 20 years appear to have had no negative impact on Taiwan’s GDP growth rate.15 The contribution of bilateral trade to Taiwan’s GDP has fluctuated widely since 1990 (Table 11), but the average contribution over the period is 19.72%. If we include trade with China and Hong Kong, the average contribution is even higher,

Table 4-11 The Contribution of Bilateral Trade across the Taiwan Strait to Taiwan’s GDP Growth Rate

Contribution of Contribution of Contribution of Taiwan’s Contribution of bilateral trade with bilateral trade with bilateral trade with GDP bilateral trade with China and Hong China and Hong China on Taiwan’s Rank growth China to Taiwan’s Kong to Taiwan’s Kong to Taiwan’s GDP growth rate as rate (%) GDP growth rate in GDP growth rate as GDP growth rate in a percentage (1) pointsa (2) a percentage points (3) (4)=(2)/(1) (5)=(3)/(1) 1990 5.39 0.73 1.46 13.54 27.08 1991 7.55 2.65 2.45 35.10 32.46 1992 7.49 2.03 1.59 27.09 21.26 1993 7.01 2.04 1.53 29.17 21.78 1994 7.11 0.43 1.06 6.06 14.91 1995 6.42 0.79 1.53 12.30 23.90 1996 6.10 0.50 0.40 8.27 6.59 1997 6.68 0.27 0.22 4.01 3.30 1998 4.57 -0.94 -1.27 -20.60 -27.70 1999 5.42 0.39 0.91 7.23 16.84 2000 5.86 0.65 2.08 11.02 35.55 2001 2.18 -0.85 -1.01 38.90 46.19 2002 3.59 2.60 3.30 72.33 91.83 2003 3.24 1.03 2.46 31.71 75.84

Note : a. The contribution of bilateral trade with China to Taiwan’s GDP growth rate in points = (growth of exports to China * export share to China over total exports of Taiwan * share of trade exports of Taiwan over total GDP) – (growth rate of imports from China * import share from China over total imports of Taiwan * share of total imports of Taiwan over total GDP). Source : This study.

15 The sharp decline in GDP since 2001 is primarily due to the inexperience of the new governing party, the DPP.

124 CHAPTER 4 Taiwan: Investment in China and Structural Change 27.85%. Moreover, the contribution has been still higher over the last three years, as Taiwan’s domestic market has faced a serious recession. The impact of bilateral economic relations on Taiwan’s unemployment rate is also mild. Long after Taiwanese firms had rushed into China (starting in late 1987) and many labor-intensive jobs had been transferred there, the unemployment rate in Taiwan remained below 2% (Table 10). In fact, even in 2000, the unemployment rate remained under 3%. It was only in 2001, with the coming to power of a new governing party, that unemployment started to rise toward 5%. Taiwan does face a structural change in the labor market, and we have in fact seen an increasing number of older, unskilled workers unemployed in the past few years. But the figures show that this problem was insignificant before 2000, and thus not attributable to bilateral trade with China, which had begun in earnest over ten years earlier. The high unemployment rate seen in Taiwan from 2001 on is primarily the result of a recession with domestic causes.16

3-3 Structural Change

As Taiwanese firms have shifted production to their subsidiaries in China, Taiwan’s GDP structure has come to face a significant change, for the manufacturing sector is shrinking even as the service sector is growing quickly. Before 1987, Taiwan’s secondary industries, industry classification comprising mostly of manufacturing industries, had for a long time held a GDP share of about 46% (Table 12). That share began to drop in 1988, the year Taiwanese firms started to invest in China. As more firms shifted their production to Chinese subsidiaries, the parent firms’ production dropped further, and by 2002 the GDP share of secondary industries had fallen to 31%. Since most Taiwanese firms investing in China are manufacturing firms, the GDP share of the manufacturing sector has been falling at about the same rate, moving from a high of 39.4% in

16 Regarding the relationship between economic recession and unemployment in Taiwan, see Lin and Wu (2004).

3 Economic Impact and Structural Change for Taiwan 125 1986 to just 25.7% in 2002. As the manufacturing sector shrinks and releases workers, the service sector is picking up quickly: its GDP share rose from 48% in 1987 to 67.1% in 2002. Since both the secondary and the service industries started to change in 1988, there can be little doubt that the structural shift is related to Taiwanese investment in China.

Table 4-12 Taiwan’s Structural Change, by Industry (Unit: %) Year Agriculture Industry (Manufacturing) Service 1979 8.6 45.3 (35.9) 46.1 1980 7.7 45.7 (36.0) 46.6 1981 7.3 45.5 (35.6) 47.2 1982 7.7 44.3 (35.2) 47.9 1983 7.3 45.0 (35.9) 47.7 1984 6.3 46.2 (37.5) 47.5 1985 5.8 46.3 (37.6) 47.9 1986 5.5 47.1 (39.4) 47.3 1987 5.3 46.7 (38.9) 48.0 1988 5.0 44.8 (37.1) 50.1 1989 4.9 42.3 (34.6) 52.8 1990 4.2 41.2 (33.3) 54.6 1991 3.8 41.1 (33.3) 55.1 1992 3.6 40.1 (31.8) 56.3 1993 3.6 39.3 (30.6) 57.0 1994 3.5 37.7 (29.0) 58.8 1995 3.5 36.4 (27.9) 60.1 1996 3.2 35.7 (27.9) 61.1 1997 2.5 35.3 (27.8) 62.1 1998 2.5 34.6 (27.4) 63.0 1999 2.6 33.2 (26.6) 64.3 2000 2.1 32.4 (26.4) 65.5 2001 1.9 31.1 (25.6) 67.0 2002 1.9 31.0 (25.7) 67.1

Source: As for Table 4-10.

126 CHAPTER 4 Taiwan: Investment in China and Structural Change Some worry that the speed with which manufacturing’s GDP share is dropping signifies a serious hollowing-out problem. However, if one compares the 2002 GDP share of secondary industries in Taiwan (31.0%) with that in the US and Japan, one finds the figures in these two countries even lower—26.9% and 28.1% respectively in 2000. And no one would claim that the US or Japan is facing a hollowing-out problem. In fact, because a decline in the manufacturing sector after a certain stage of development is a natural phenomenon, it is pointless to use the GDP share of the

Table 4-13 Taiwan’s Structural Changes, Exports (Unit: %) Labor Intensity Capital Intensity Technology Intensity Year High Middle Low High Middle Low High Middle Low 1982a 47.2 30.8 21.9 26.9 45.4 27.6 18.3 32.6 49.1 1983 46.6 34.3 19.0 24.5 46.6 28.9 18.2 33.4 48.4 1984 47.0 35.4 17.5 23.0 48.7 28.3 18.3 34.0 47.7 1985 45.9 35.6 18.5 24.5 48.7 26.8 18.8 33.6 47.6 1986 47.0 36.9 16.0 22.9 49.4 27.7 18.4 33.7 47.9 1987 47.9 37.2 14.9 22.4 50.5 27.1 19.4 35.2 45.4 1988 46.3 36.8 16.9 23.5 51.5 25.0 22.6 36.9 40.6 1989 43.4 37.8 18.8 26.6 50.7 22.7 24.2 38.1 37.7 1990 41.0 38.3 20.7 28.9 50.5 20.5 26.7 38.6 34.7 1991 40.1 38.8 21.2 29.8 51.0 19.2 27.2 38.5 34.3 1992 39.2 0.3 20.5 29.3 53.0 17.7 29.5 38.5 32.0 1993 38.9 41.2 19.9 28.9 54.8 16.3 31.4 40.3 28.3 1994 38.7 39.8 21.5 31.0 55.0 14.0 32.5 42.0 25.6 1995 36.4 40.6 23.0 31.9 56.5 11.6 36.5 41.4 22.0 1996 33.9 43.6 22.5 31.8 57.4 10.8 39.7 28.9 21.4 1997 34.9 43.1 22.1 30.3 60.6 9.1 39.7 41.1 19.2 1998 34.3 44.4 21.3 29.3 62.3 8.4 41.1 40.5 18.4 1999 35.4 43.7 20.9 28.4 63.8 7.9 42.1 41.0 16.9 2000 37.6 41.2 21.2 28.1 64.4 7.5 42.5 43.2 14.3 2001 33.3 43.1 23.6 30.9 60.7 8.4 46.4 38.8 14.9 2002 34.8 40.4 24.8 31.9 58.4 9.7 46.6 40.1 13.3

Note: a. These statistics began to be collected in 1982. Source: See Table 4-10.

3 Economic Impact and Structural Change for Taiwan 127 manufacturing sector as a measure of industrial hollowing out. Export structure may actually be a better index of possible hollowing out, since the export of goods usually represents the international competitiveness of the country in question.17 Looking at structural changes in Taiwan’s exports, we see that from 1982 to 1988, labor-intensive goods held steady at around 46% (Table 4-13).

Table 4-14 Taiwan’s Structural Changes, Imports (Unit: %) Labor Intensity Capital Intensity Technology Intensity Year High Middle Low High Middle Low High Middle Low 1982 31.0 14.8 54.2 55.4 27.0 17.6 61.5 17.3 21.2 1983 31.0 14.9 54.1 55.8 27.5 16.7 60.7 18.6 20.7 1984 32.7 17.0 50.3 52.1 30.9 16.9 57.5 21.1 21.4 1985 31.7 17.6 50.8 53.0 29.1 17.9 58.1 20.2 21.7 1986 34.5 19.2 46.3 48.6 34.9 16.5 55.5 24.0 20.5 1987 33.8 22.7 43.5 45.6 39.2 15.2 55.9 25.7 18.4 1988 30.5 29.0 40.5 41.7 43.6 13.7 60.5 23.2 16.3 1989 32.8 23.6 43.6 46.6 39.9 13.5 57.7 25.4 16.9 1990 33.2 23.3 43.6 46.4 39.8 13.8 57.5 25.8 16.6 1991 34.1 31.5 44.4 47.3 40.0 12.7 57.3 26.5 16.2 1992 34.0 23.1 42.9 46.1 41.6 12.3 56.5 27.4 16.1 1993 35.5 21.8 42.7 46.3 41.9 11.9 51.2 32.8 16.0 1994 37.3 21.4 41.3 45.0 42.9 12.1 50.0 33.9 16.1 1995 37.3 21.4 41.3 44.5 44.0 11.5 50.6 34.9 14.5 1996 37.9 21.5 40.6 43.4 44.1 12.4 50.9 34.0 15.1 1997 39.5 21.1 39.4 42.6 45.2 12.2 49.9 36.6 13.5 1998 38.9 23.9 37.3 40.5 47.3 12.2 51.5 35.8 12.7 1999 39.3 26.5 34.3 37.6 50.4 12.0 50.0 37.8 12.2 2000 40.9 24.7 34.4 37.7 50.4 11.9 48.3 41.5 10.2 2001 34.5 25.9 39.5 43.2 43.6 13.2 50.6 36.3 13.1 2002 33.9 25.5 40.6 44.0 43.7 12.2 51.3 36.1 12.7

Source: As for Table 4-10.

17 The other index is the growth rate of labor productivity. If a country’s labor productivity is growing, then it does not matter whether its economy is concentrated in the manufacturing sector or in the service sector. Regarding the measurement of labor productivity in Taiwan after 1988, see Kao et al. (1995).

128 CHAPTER 4 Taiwan: Investment in China and Structural Change After 1988, however, the export share of labor-intensive goods began falling, recording only 34.8% in 2002. This result is consistent with the large-scale movement by Taiwanese firms after 1988 of their labor-intensive production bases to China. As production of labor-intensive goods moves abroad, the export share of those goods naturally decreases. In contrast, technology-intensive goods held a relatively small share (around 18%) of total exports up to 1987. Subsequently, as labor-intensive firms have moved to China, the export share of high-tech goods has grown rapidly, reaching 46.6% in 2002. Over this same period, the export share of low-technology goods has fallen from 49.1% to 13.3%. Import trends shows a similar pattern (Table 4-14).

3 Economic Impact and Structural Change for Taiwan 129 4

Production Integration and International Competitiveness

We have seen that a complicated production integration exists between parent firms and their subsidiaries across the Taiwan Strait, one that generates a huge amount of intra-industry trade between Taiwan and China. We might ask now why parent firms would choose to integrate production across the Strait. How will integration affect their international competitiveness? Also, what specific shape should that integration take? Common sense, which should of course be tested by analysis, indicates that to exploit comparative advantages across the Taiwan Strait, parent firms in Taiwan should form a vertical integration with their subsidiaries, shifting certain stages of production to China and producing domestically those goods that offer a comparative advantage in Taiwan. With vertical integration, parent firms in Taiwan can import cheap raw materials and parts from their subsidiaries in China, making their products in Taiwan cheaper to manufacture and thus more competitive. Other parent firms in Taiwan can ship higher-quality raw materials and parts to China, making the products there more competitive as well. Common sense dictates, then, that when parent firms in Taiwan choose vertical integration in production with their subsidiaries in China, they will enhance their international competitiveness. If, instead, they choose a more horizontal integration, they will likely lose competitiveness in the long run. To test these common-sense propositions, we can compute the relation of production integration (and thus intra-industry trade) to international competitiveness. To do so we apply two indices. The first one is the commonly used Grubel-Lloyd index (GL index), which represents the extent of vertical integration.18 The GL index is as follows—

130 CHAPTER 4 Taiwan: Investment in China and Structural Change —where i is the i-th industry and j is the j-th sub-industry in the i-th industry.19 The variable represents export value and represents import value. By definition,

In Equation (1), for the i-th industry, if sub-industry j has a large amount of exports and imports, will approach 0, and so will be larger. This implies that there is more intra-industry trade for two regions with more horizontal integration. In contrast, if the import value and export value for a sub-industry j are quite different, the two regions are producing different goods for different sub- industries. In other words, they are demonstrating a more vertical integration, and so is near 0.20 In order to compute international competitiveness, we apply the revealed comparative advantage (RCA) as an index. The RCA index is defined as follows—

—where k stands for the exporting country, j for the importing country, and i for the goods in question. When is higher, the k-th country has a relatively high competitiveness in exporting i-th good to country j.21

18 For a full explanation of the GL index, see Grubel and Lloyd (1975) and Aturupane et al. (1999). 19 We have defined the i-th industry using the two-digit HS Code, so that there are ninety-nine industries for i-th industry. For the j-th industry, i.e. the sub-industry in i-th industry, we have used the six-digit HC Code. 20 In general, is considered highly horizontal integration, is considered horizontal integration, is considered vertical integration, and is considered highly vertical integration. For more details on the definition of IIT, see http://tcir.cier.edu.tw/itc/index.asp.

4 Production Integration and International Competitiveness 131 Table 15 lists six representative industries in Taiwan (out of the ninety-nine indexed by the two-digit HS Code).22 These six industries—whose exports accounted for 64.28% of Taiwan’s total exports in 2003—show a dramatic trend in the relationship between IIT and RCA (Table 15). Figures for IIT, RCA, and export share (ES) are listed from 1995 to 2003 so that any important trends can be revealed.

Table 4-15 Intra-Industry Trade (IIT) and Revealed Comparative Advantage (RCA) in Taiwan: Major Industries

21 In general, when , the k-th country is the strongest competitively in exporting goods i to j-th country; when , it is the second strongest; when , it is neither strong nor weak; and when , it is the weakest. For more on the definition of RCA, see http://tcir.cier.edu.tw/itc/index.asp. 22 In fact, the three indices have been computed for all ninety-nine industries, but for space reasons six have been chosen as representative.

132 CHAPTER 4 Taiwan: Investment in China and Structural Change Notes: a. IT is the GL index, that is

where and are exports and imports of industry i , and and are exports and imports of goods j in industry i.

b. , where i is the exporting country, j is the importing country, and k is the industry index.

Only the goods that Taiwan exported to the US are presented here. c. ES is the share of total exports. Source: http://tcir.cier.edu.tw/itc/index.asp.

In terms of exports, the electronic and electric appliance (EE) industry (HS 84) is the most important industry for Taiwan, with a 30.51% export share in 2003. The IIT of the EE industry drops from 38.94 in 1995 to 25.52 in 2001, signifying greater vertical integration. Over the same period of time, the RCA of Taiwan’s EE industry in the US increases from 1.49 to 2.01, signaling greater competitiveness. Furthermore, the export share (ES) of the EE industry is also increasing. The iron and steel industry (HS 72) has a similar profile. From 1995 to 2003, its IIT dropped from 86.12 to 14.35, and its RCA increased from 0.21 in 1995 to 0.86 in 2001. Meanwhile, its ES rose from 1.74% to 3.78%. The EE and the iron and steel industries are two typical cases showing that when an industry integrates its production across the Taiwan Strait, its international competitiveness grows and its export share rises.

4 Production Integration and International Competitiveness 133 The story for the furniture (HS 94) and toy industries (HS 95) is completely different. The IIT of the furniture industry increases at first and then drops, implying that the industry has integrated horizontally. Meanwhile, its RCA drops from 3.33 to 1.39, and its export share falls from 2.21% to 1.03%. The IIT for the toy industry is relatively stable, but its large absolute value (97.17) implies that the firms in this industry too have integrated horizontally. This correlates with a falling RCA (from 2.56 to 1.20) and a diminished export share (from 2.46% to 1.20%). The plastic industry shows another pattern: the IIT holds stable at a low level (around 4 or 5). This low value implies that the industry has maintained a strong vertical integration across the Taiwan Strait in its production. This integration has kept its international competitiveness stable (with an RCA nearing 1.70) and has thereby kept its export share stable (at around 6%) as well. The machinery industry may be the only exception to the general pattern. Between 1995 and 2001 its IIT rises from 14.21 to 43.91—implying that horizontal integration has been increasing—but its RCA rises as well, from 1.92 to

Table 4-16 Coefficients of Correlation of IITa and RCAa

RCA Weighted RCAb RCA for RCA for RCA for RCA for RCA for RCA for Year Taiwan’s Taiwan’s Taiwan’s Taiwan’s Taiwan’s Taiwan’s Products in Products in Products in Products in Products in Products in US Japan China US Japan China 1995 -0.0688 -0.1762 -0.1313 -0.1075 -0.1545 -0.1763 1996 -0.0193 -0.1079 -0.0775 -0.1016 -0.1398 -0.1561 1997 -0.0312 -0.0873 -0.0946 -0.0813 -0.1168 -0.1383 1998 -0.0212 -0.0322 -0.0299 -0.0494 -0.0787 -0.1181 1999 -0.1253 -0.1119 -0.0284 -0.0997 -0.1159 -0.1654 2000 -0.1030 -0.0895 -0.0619 -0.1022 -0.1103 -0.1501 2001 -0.0512 -0.1067 -0.0158 -0.1014 -0.1156 -0.1695 Totals -0.0595 -0.1062 -0.0552 -0.0909 -0.1164 -0.1526

Notes: a. The definitions of IIT and RCA can be found below Table 15. Notes: b. Export share of products in each year is used as weight. Source: This study.

134 CHAPTER 4 Taiwan: Investment in China and Structural Change 2.34. However, the industry’s ES begins to fall after an initial increase. If our hypothesis is correct, in the long run the machinery industry’s commitment to horizontal integration will harm its international competitiveness, and its RCA will follow the path of its export share. It is important now to determine the general relationship of IIT and RCA between 1995 and 2003 for all ninety-nine industries. The first step is to calculate the coefficients of correlation for IIT and RCA in all ninety-nine industries in the same year, the next to calculate the coefficient of correlation within a single industry from 1973 to 2003 (Table 4-16). The RCA may be different for different countries, so the table lists the figures for Taiwan’s most important trading partners, namely the US, Japan, and China (including Hong Kong). The results are very consistent: the coefficient of correlation of IIT and RCA is always negative both for different years and for different regions. This means that when IIT is smaller (more vertical integration), RCA will be larger (more competitiveness.). Finally, applying the export share as a weight to calculate the weighted coefficients of correlation between IIT and RCA, we again find that the coefficients of correlation are uniformly negative.23 The final task is to check the relationship between IIT and export share. The coefficients of correlation from 1989 to 2003 are negative for each year (Table 4- 17), which means that IIT has a negative effect on export expansion. This result is further confirmation of the hypothesis that an industry with more vertical integration in production across the Taiwan Strait will see, in the long run, greater international competitiveness and a higher export share. Conversely, if an industry chooses a horizontal integration, it will lose international competitiveness over time and will watch its export share grow smaller.

23 The absolute values of the weighted coefficients of correlation are actually even larger than those of the unweighted ones. This means that the influence of vertical integration on competitiveness is even more significant if we consider the importance of different industries to Taiwan’s economy.

4 Production Integration and International Competitiveness 135 Table 4-17 The Coefficient of Correlation of IITa and Exporting Shares

Year Coefficient 1989 -0.0912 1990 -0.1206 1991 -0.1305 1992 -0.1502 1993 -0.1674 1994 -0.1790 1995 -0.1768 1996 -0.1328 1997 -0.1451 1998-0.1839 1999 -0.1873 2000 -0.2043 2001 -0.1804 2002 -0.1719 2003 -0.1904 Average -0.1622

Note: a.IIT is the GL index. See note for Table 4-15. Source: This study.

136 CHAPTER 4 Taiwan: Investment in China and Structural Change 5

Taiwan’s Economic Policy toward China

Taiwan has been deeply affected in myriad ways by its economic ties with China. The Taiwanese government, however, approaches those ties very conservatively. The government is cautious, of course, not just because the economic effects of trade with China are controversial, but also because of the highly sensitive political relationship between the two Chinas. Mainland China, insisting that Taiwan is a part, a province, of China, has tried to draw Taiwan into its sphere in numerous ways. China’s dedication to this effort has made its political and economic policies toward Taiwan quite consistent. But the story across the Taiwan Strait is quite different. Though the impact of economic relations with China remains controversial, most economists agree that the net gains from trade are huge and clear. Thus most economists and businesspeople in Taiwan urge their government to adopt a more open policy towards China. However, the rest of the country displays a wide range of attitudes towards the mainland, some advocating complete independence, others supporting unification, and a third group, the majority, hoping to preserve the status quo indefinitely. These political complexities force the Taiwanese government to be very cautious in both its political and its economic dealings with China. Unfortunately, the more energy the government puts into coping with the political problem, the more it tends to sacrifice potential economic benefits. At present, Taiwan’s economic policies towards China are costing Taiwanese businesses opportunities to increase their production competitiveness by exploiting China’s cheap and abundant labor supply. And yet, even as the government struggles to minimize the economic relation across the Taiwan Strait, and thus to

5 Taiwan’s Economic Policy toward China 137 lessen China’s impact on Taiwan’s economy, Taiwan continues to be profoundly affected by its neighbor on the mainland.

5-1 Trade

International trade has always been crucial to Taiwan’s economic development. It would be impossible, therefore, for the government of Taiwan to bar exports to China. However, in order to reduce imports, and thus to reduce Taiwan’s potential unemployment, the government has placed serious restrictions on goods from China. One such restriction is the requirement that every trade transaction with China be indirect, meaning that Taiwanese businesses have to trade with China through an intermediary like Hong Kong. Another restriction is on the kinds of goods that can be imported. As of the end of June 2004, 8,528 kinds of commodities were allowed to enter from China, but 2,469 items were not. Whenever Taiwanese authorities review whether import of a particular item from China should be allowed, they solicit the opinions of the domestic producers of that product. The exercise is generally meaningless, for most domestic producers can be counted on to oppose, out of their own self-interest, importation of products they themselves make.24 Even though Taiwan and China are now both members of the WTO, the Taiwanese government remains reluctant to open the domestic market to goods from China, for fear that, in the case of a dispute, China will not file a suit with the WTO, but will treat the matter instead as an internal affair.

5-2 Investment in China

The most significant restriction of all is that Taiwanese investment in China has to

24 These severe restrictions have a clear effect on imports from China. The total value of imports from China to Taiwan in 2003 was US$11.0 billion, while the total value of Taiwan’s exports to China came to US$35.4 billion. See Table 1.

138 CHAPTER 4 Taiwan: Investment in China and Structural Change be “indirect”: capital has to travel to China through an intermediary. Any Taiwanese business that wants to transfer money to China has to set up a company in a third country, though it may be a company that exists on paper only. Further limitations are placed on individual industries. High-tech goods, infrastructure investments, and the financial industry are all highly restricted. Though the definition of high-tech products will be reviewed for a period of time, enterprises making high-tech products are generally banned from investing in China. Though Taiwan’s biggest wafer producer, TSMC, was recently allowed to build a factory in China to produce 8-inch wafers, this is the first such investment the Taiwanese government has permitted in China.25 Other important electronic and electric enterprises have been banned, including a 12-inch wafer factory, a DRAM design house, and a masking factory. Investment in infrastructure in China, including power plants, highways, and , is completely banned. Finally, investment by financial institutions is also highly restricted. Banks and securities firms in Taiwan can set up offices in China, but cannot establish branches or form joint banking ventures there, which means that Taiwan’s financial institutions cannot provide any business services in China.

5-3 Capital Movement

In order to reduce capital movement from Taiwan to China, the Taiwanese government also restricts the amount of investment for each investment case and the total investment a company can make. For example, the limits on total investment in China are 40%, 30%, and 20% of net worth for firms with capital stock worth, respectively, less than NT$5 billion, NT$5 to 10 billion, and more than NT$10 billion. Furthermore, no matter how much money a subsidiary in China has returned to its parent firm in Taiwan, that money may not be sent back to China.26

25 Though TSMC is the first Taiwanese company to receive official permission to invest in China, other Taiwanese wafer fabrication facilities were built in China a few years ago. For example, UMC, the second largest wafer maker in Taiwan, invested in China three years ago, avoiding the government’s restrictions by operating under a different name.

5 Taiwan’s Economic Policy toward China 139 5-4 Transportation

For what the government describes as “national security reasons,” there are no direct flights between Taiwan and China in either direction. There are only “indirect” flights that travel via Hong Kong or . The cost of an indirect flight is more than double that of a direct flight, in terms of both money and time.27 Direct cargo shipments are not permitted either; a ship from any city in Taiwan to any city in China has to go first to a in a third country. Usually, international ships traveling from Taiwan pass through Hong Kong or through the port of Ishigaki on Okinawa before going on to China.28

5-5 Travel

Many Taiwanese citizens have relatives in China. Thus they have a strong incentive to visit the mainland and, once there, to travel as tourists. There is also a strong demand for business trips, because of the many Taiwanese firms operating in China. In fact, the total number of visitors from Taiwan to China is 2.7 million. Citing national security reasons, Taiwan does not allow government officials to visit China without special permission. Every Taiwanese citizen who visits China is required to register with the Taiwanese government, though the huge number of visitors prevents the law from being enforced, and few people pay attention to it.

26 One consequence of such a serious restriction on capital movement is that Taiwanese firms try to avoid reporting their investment to the Taiwanese government. For this reason, Taiwan’s official figures for total number of investment cases and total amount of investment are much lower than the figures reported by the Chinese government (see Table 3). Another result is that little money is sent back from China to Taiwan; most of the profit made by the subsidiaries in China is parked in a third country like Hong Kong or the Virgin Islands. 27 A direct flight from Taipei to Shanghai would take about one-and-a-half hours. The same trip takes about six hours when routed through Hong Kong. 28 In order to attract international ships to Taiwan, the government has set up an offshore shipment center in the port of Kaoshiung, from which international ships can go directly from Taiwan to China. However, because the cargo the ships carry cannot be imported to Taiwan, they still have little incentive to cross the Taiwan Strait.

140 CHAPTER 4 Taiwan: Investment in China and Structural Change The restrictions are greater for Chinese citizens who wish to visit Taiwan. In general, the Chinese are allowed to visit Taiwan only for business purposes, not as tourists. Thus the total number of visitors from China to Taiwan was under 140,000 in 2003, around one-twentieth the number of visitors from Taiwan to China.29

29 In order to attract more Chinese people to visit Taiwan, Taiwan government started to allow Chinese people to visit Taiwan as tourists two years ago, but only for Chinese people who stay in overseas and not for the 1.3 billion people living in mainland China. Again, the effect of this kind of open policy is trivial.

5 Taiwan’s Economic Policy toward China 141 6

Conclusion

Economic relations between Taiwan and China began in 1979 when the latter adopted an open-door policy. Bilateral trade picked up quickly, as Taiwanese firms acted to exploit the comparative advantages of Taiwan and China, and a huge amount of capital was invested in China by Taiwanese firms after 1988. In 2003, the total value of exports from Taiwan to China was US$35.4 billion, the total value of imports from China to Taiwan US$11.0 billion. Taiwan’s export dependence on China that year sat at 24.52%, making China Taiwan’s largest trading partner and the primary source of its large trade surplus. Taiwan’s investment in China began in November 1987, when Taiwan abolished martial law and started allowing citizens to visit their relatives in China. China is now the most important location for Taiwan’s outward FDI. Over the past fifteen years, Taiwan’s investment in China has shifted from small to large firms, from labor-intensive to high-tech products, and from the southeast region to the Yangzi River Delta. Taiwan’s huge investment in China has created a strong flow of intra-industry trade across the Taiwan Strait, and has had a powerful impact on Taiwan’s economic performance and economic structure. Over the last fifteen years, bilateral trade between China and Taiwan has contributed 19.72% annually to Taiwan’s GDP growth rate. The contribution rate has been even higher over the past three years, when Taiwan’s domestic economy has had to cope with a serious recession. While economic relations with China do tend to nudge employment upward in Taiwan, the impact is far milder than some have made out. In fact, Taiwan’s high unemployment rate over the past three years has been due primarily to the domestic recession. Meanwhile, with massive

142 CHAPTER 4 Taiwan: Investment in China and Structural Change Taiwanese investment in China, thousands of firms have shifted their production bases to China, a development that has sharply reduced the GDP share of Taiwan’s manufacturing sector. Taiwan has experienced a significant structural change since 1988, in that the contraction of the manufacturing sector has been matched by strong growth in the service sector. At the same time, Taiwan’s export profile has been transformed, in that the export share of labor-intensive products has fallen quickly, while the share of high-tech products has climbed just as fast. Thus the data indicates that Taiwan does not face a hollowing-out problem. Taiwan’s FDI in China will have a long-term effect on the international competitiveness of its export products. Applying the GL index as a measure of production integration between parent firms in Taiwan and their subsidiaries in China, and the RCA index as a measure of international competitiveness, and using Taiwanese trade data from 1995 to 2003, we find that when an industry in Taiwan chooses vertical integration with its subsidiaries in China, both its international competitiveness and its export share improve over the long term. Conversely, when an industry chooses a more horizontal integration, its international competitiveness diminishes over the long term. The implication is that the government of Taiwan, instead of impeding their investment activities in China, should help Taiwanese firms establish vertical production integration with their subsidiaries there. Though on balance the impact of economic relations with China on Taiwan’s economy is clearly positive, the government has been very cautious in its economic dealings with China. Every economic relation with China has to be indirect—indirect trade, indirect investment, and indirect travel. Many Chinese goods cannot be imported to Taiwan at all. Investment in China’s infrastructure is banned entirely. Taiwan’s high-tech industries and financial institutions meet prohibitions every way they turn. Neither direct flights nor direct shipments are permitted. Taiwanese citizens have to report to the government when they visit China, and Chinese citizens can travel to Taiwan only for business. Since economic relations with China are inescapable, Taiwanese firms need to exploit China’s cheap production factors and tap into its huge domestic market by making themselves distinct from their competitors in China. The best thing the government can do to help them is to get out of the way. The last thing Taiwan should do is isolate itself economically from China, for if it does, Taiwan, whether independent nation or renegade province, will be left out in the cold.

6 Conclusion 143 References

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References 145 CHAPTER 5 RESPONSES TO THE EMERGING CHINA: SINGAPORE AND HONG KONG Shin Jang-Sup, National University of Singapore 1

Introduction

Singapore has often been compared with Hong Kong in academic1 and journalistic discourse, for, as the most advanced international cities in East Asia. Vying with each other for supremacy as trading, logistics, and financial hubs, they share a number of characteristics. Both city-states developed as strategic entrepôts in East Asia under British administration before the end of the Second World War and thus share a similar colonial legacy. However, their patterns of economic development since then have been quite different, a reflection of differences in polity and geography. These differences have led in turn to dissimilar engagements with the rapidly emerging Chinese economy. This chapter studies the origin and development of Singapore’s responses to the rise of China, making a particular comparison with responses by Hong Kong,2 and provides policy implications for other countries. It starts by comparing the different paths of economic development the two city-states have taken, and emphasizes Singapore’s retention of a vibrant manufacturing sector, in contrast with Hong Kong’s rapid de-industrialization (section 2). It then discusses how Singapore engages with the Chinese economy, looking in particular at the strategies and organizations through which it trades with and invests in China

1 For example, see Young (1992) and Chiu et al. (1997), among others. 2 It would be more accurate to use terms like “mainland China” and “Hong Kong, China,” as the latter is now part of the former. However, because Hong Kong functions within the “one country two systems” framework, it still makes sense to deal with it a separate economic entity. Thus, in this treatment, “China” refers to mainland China, excluding Hong Kong.

1 Introduction 149 (section 3). The chapter then considers three major competitive challenges posed by the rise of the Chinese economy: the stagnation of ASEAN, the danger of industrial hollowing out, and threats to Singapore’s position as the region’s preeminent international financial center. It also considers Singapore’s responses to these challenges—Free Trade Agreement initiatives, ongoing industrial upgrading, and the development of a robust international asset management sector—in some detail (section 4). The chapter concludes with a summary of its main arguments and a discussion of policy implications (section 5).

150 CHAPTER 5 Responses to the Emerging China: Singapore and Hong Kong 2

Singapore and Hong Kong: Different Paths of Economic Development

Unlike Hong Kong, which remained a colony of Britain until it was handed over to China in 1997 as a semi-autonomous city, Singapore has been an autonomous country since 1965, when it was forced out of the proposed Malaysian Federation and belatedly started the process of nation-building. As a young independent nation, Singapore had genuine concerns for its political security, which were the more serious for the proximity of unfriendly neighbors like Malaysia and Indonesia. Its economic development strategy was designed to respond to this political need. Developing a domestic manufacturing sector was regarded as a key to maintaining national security; if Singapore were simply to play the role of service center and to leave manufacturing activities to its neighbors, it would jeopardize its own survival. Thus attracting direct investment from multinational corporations (MNCs), and thereby establishing diverse foreign economic interests within the country, was not merely a quick and easy way for Singapore to embark on industrialization, but also a way to ensure national survival. Lee Kuan Yew (2000), the founding prime minister of Singapore, puts it this way in his memoir: I gradually . . . settled on a two-pronged strategy to overcome our disadvantages. The first was to leapfrog the region, as the Israelis had done. . . . Since our neighbors were out to reduce their ties with us, we had to link up with the developed world—America, Europe, and Japan—and attract their manufacturers to produce in Singapore and export their products to the developed countries. . . . The second part of my strategy was to create a First World oasis in a Third World region. . . . If Singapore could establish First World standards in public and personal security, health, education,

2 Singapore and Hong Kong: Different Paths of Economic Development 151 telecommunications, transportation, and services, it would become a base camp for entrepreneurs, engineers, managers, and other professionals who had business to do in the region. (pp. 57-58) The Singaporean government has adhered to this strategy of nurturing a manufacturing sector led by foreign interests. Even in the 1990s, when its per capita income had reached that of a developed country, Singapore still set a goal of “ensur[ing] the continued expansion of the manufacturing sector by at least 7 percent a year, and . . . maintain[ing] the sector’s contribution to GDP at a minimum of 25 percent” (Wong et al. 1998)—unusually ambitious benchmarks for a developed country. If a significant portion of the manufacturing sector was to be maintained in an open economy where costs were increasing as income levels rose, it was imperative to upgrade the manufacturing sector continuously towards higher value–added industries, through infusion of new capital and technologies. The Singaporean government achieved this objective by providing MNCs with incentives to upgrade their investments within Singapore, and by simultaneously upgrading its own public enterprises, called government-linked companies (GLCs). The state played a vital role in this process, setting strategic visions for the future and creating a favorable investment environment by providing necessary fiscal incentives and infrastructure. Though the government still sits at the top of the economic system, Singapore’s economy is nonetheless ranked as one of the “freest” in the world in market surveys conducted by think tanks like Heritage Foundation and the Cato Institute. In contrast, in the latter half of the twentieth century, Hong Kong had no security concerns of its own, and did not need or intend to use economic policy to protect itself. Though its manufacturing sector flourished into the 1970s, this success had little to do with conscious efforts on the part of the state apparatus, being due rather to low-wage labor advantages and the nimbleness of local entrepreneurs who had migrated from the mainland during and after the civil war.3 The British colonial administration was imbued with a free market ideology and

3 The population of Hong Kong grew from 1.6 million in 1941 to 2.36 million in 1950 (Chiu et al. 2002).

152 CHAPTER 5 Responses to the Emerging China: Singapore and Hong Kong resisted temptations to employ industrial policies. Chiu et al. (1997) put it this way: The colonial state of Hong Kong pursued an arms-length approach to industrial development and resisted pressures for assistance from the manufacturing sector. The state mainly provided solid infrastructural supports, an efficient administrative and legal system, and even embarked on offering various social services . . . which had the effect of facilitating the reproduction of labor power. However, . . . these services were universal and sector-neutral. The state has anxiously guarded its policy of dispensing no selective incentives to the industrial sector. (emphasis in original; pp. 123-24) So the administration did not give in to the demands of Hong Kong industrialists that it set up industrial districts, instead selling public lands by public auction whenever the occasion arose. This practice contrasts with that of Singapore’s government, which developed industrial parks and provided an array of incentives to industrialists who invested there. The Hong Kong administration also declined to establish industrial banks, whereas the government of Singapore set up the Development Bank of Singapore for industrial financing. Hong Kong industrialists had to rely for their ventures on self-financing and on limited lending from commercial banks. This differences between Singapore’s strategic approach and Hong Kong’s free-market approach became apparent in the 1970s, when the phase of labor- intensive industrialization was brought to an end by rising labor costs. Hong Kong manufacturers did little to upgrade their domestic facilities and technologies to overcome rising costs, choosing instead to expand or move their production horizontally to mainland China, where they could capitalize on low-cost labor. The Hong Kong administration introduced no policy measures to steer or intervene in this transformation of the economy. In contrast, the Singaporean government introduced a “high-wage policy” to speed up structural changes towards higher value–added manufacturing. It also directed investment towards high-tech industries, notably information technology industries in the 1980s and 1990s and bio-medical industries from the late 1990s on. As a consequence of this difference, we see a rapid de-industrialization in Hong Kong and an extremely slow de-industrialization in Singapore. The share of

2 Singapore and Hong Kong: Different Paths of Economic Development 153 Hong Kong’s gross domestic product held by the manufacturing sector was 23.6% in 1980. This figure had fallen to 17.5% by 1990, to 8.3% by 1995, and to 4.5% by 2002 (Table 5-1). The share of total employment held by the manufacturing sector shows an equally precipitous decline, falling from 49.3% in 1980, to 31.3% in 1990, to 16.2% in 1995, and to 8.2% in 2002.

Table 5-1 Composition of Hong Kong’s GDP (Unit: %) Transport/ Trade and Year Manufacturing Construction Storage and Finance Other Wholesale Communication 1980 23.6 6.6 7.4 17.4 23.0 22.0 1985 22.0 5.0 8.1 18.3 16.1 30.5 1990 17.5 5.4 9.5 20.6 20.4 27.6 1995 8.3 5.3 10.0 23.0 24.8 29.0 2000 5.8 5.2 10.2 23.3 23.7 32.0 2002 4.5 4.4 10.6 24.3 22.2 34.0

Source: Hong Kong Census and Statistics Department (HKCSD) (2004).

In contrast, Singapore has shown few signs of de-industrialization, in terms of the relative contribution of the manufacturing sector to GDP. The GDP share of manufacturing was 29.1% in 1980, and was only marginally lower in 1990 (25.8%), 1995 (24.7%), and 2002 (26.5%) (Table 5-2). The share of total

Table 5-2 Composition of Singapore’s GDP (Unit: %) Transport/ Trade and Year Manufacturing Construction Storage and Finance Other Wholesale Communication 1980 29.1 6.4 14.0 21.7 19.7 8.9 1985 21.8 10.7 13.3 13.3 22.9 18.0 1990 25.8 5.4 13.1 13.8 23.0 19.0 1995 24.7 7.0 11.9 13.3 24.3 18.7 2000 26.7 6.2 11.3 12.7 23.9 19.1 2002 26.5 5.4 11.5 12.8 24.5 19.4

Source: Statistical Yearbook of Singapore(various years).

154 CHAPTER 5 Responses to the Emerging China: Singapore and Hong Kong employment held by the manufacturing sector was 30.1% in 1980. Since then it has fallen slowly, to 28.4% in 1990, 23.7% in 1995, and 18.2% in 2002. Alongside this difference in de-industrialization, we see a divergence in the size and quality of investments in the two city-states. Before industrialization began in earnest in Singapore, Hong Kong’s ratio of investment share to GDP was nearly twice that of Singapore. However, from the 1970s on, Singapore consistently outpaced Hong Kong in the investment race by a large margin. The average investment-to-GDP ratio in Singapore between 1970 and 2000 was 45.5%, a figure 1.6 times Hong Kong’s 28.2% (Figure 5-1). This difference is not surprising, for, given the strategic importance of the manufacturing sector, Singapore had no choice but to maintain its competitiveness by continuing to invest heavily in facility upgrades.

Figure 5-1 Investment Trends: Singapore and Hong Kong

Source: Penn World Tables (2004).

In the same way, Hong Kong’s investment in research and development (R&D) has lagged far behind Singapore’s. Gross expenditure on R&D (GERD) over GDP in Hong Kong between 1996 and 2000 was only 0.4%, below even the figure for Tunisia (0.5%). The comparable figure for Singapore was 1.9% (United Nations Development Program [UNDP] 2003). A consulting firm assesses the

2 Singapore and Hong Kong: Different Paths of Economic Development 155 technological capability of Hong Kong as follows: The Hong Kong domestic electronics industry is among the smallest in the region, and is the only one which has been contracting in real value over the past five years. . . . In terms of capabilities, the Hong Kong industry is grouped with the new low-cost manufacturing bases in Thailand, Malaysia and China as a cost- based competitor with relatively few capabilities in product innovation and development. (Boston Consulting Group 1995, quoted in Chiu et al. 2000) Of course, Hong Kong’s de-industrialization and its low investment rate are basically a reflection of its historical and geopolitical peculiarities. During the postwar period under the British administration and before China’s open-door policy of the 1990s, Hong Kong was the only gateway between mainland China and the capitalist world, and it benefited from its unique position.4 Upcoming integration into the Chinese economy was also a major force in the 1980s driving manufacturers to expand their businesses horizontally into and/or to shift them wholesale to the mainland. The result was the rapid de-industrialization of Hong Kong. The 1997 handover simply accelerated a process of integration already well underway. A hinterland with a vast pool of low-wage labor and a rapidly expanding market was an advantage only Hong Kong could enjoy, and the city has thrived accordingly. The fact remains, however, that Hong Kong has missed an opportunity to retain its manufacturing sector by upgrading it. As a consequence, the city lacks high-tech capabilities, and has staked its future primarily on service activities. The Hong Kong Special Administrative Region (SAR) government is aware of this weakness in its economy and has introduced several initiatives to strengthen its high-technology capability.5 But it remains to be seen whether these initiatives will go beyond the “hesitant involvement” (Chiu et al. 1997, p. 123) that typically characterizes the Hong Kong administration’s dealings with its industries.

4 For instance, China earned an estimated 30-40% of its foreign currency through Hong Kong trade during the period (Chiu et al. 2001). 5 For instance, it has set up a Council of Advisers on Innovation and Technology and established a $US5 billion Innovation and Technology Fund (Tung 2001).

156 CHAPTER 5 Responses to the Emerging China: Singapore and Hong Kong 3

Embracing China’s Growing Economy

3-1 Strategy and Organization

Differences between the industrial composition of their economies, their institutional development, and their proximity to China have produced differences in how Singapore and Hong Kong interact with the growing Chinese economy. As in the management of its domestic market, the Singaporean government assumes an active role in trade with and investment in China. The government agency responsible for foreign trade and investment is International Enterprise Singapore, formerly the Singapore Trade Development Board. IE Singapore is a unique institution, in that it promotes both exports and outbound investments by Singapore-originated firms, whereas most comparable government agencies, for instance the Japan External Trade Organization and the Korea Trade and Investment Promotion Agency, promote exports by domestic firms and, to a lesser extent, inbound foreign investments. In Singapore, the Economic Development Board is responsible for attracting inbound investments, while IE Singapore helps Singapore- based firms make outbound foreign investments and also helps promote their exports. Within IE Singapore, a department called Network China is principally responsible for the China portfolio. “Network” has two connotations here. First, as China is a huge country, one office is far from sufficient to handle the entire portfolio, so IE Singapore has set up offices across China (in Shanghai, Beijing, Guangzhow, Chengdu, Shandong, Dailian, and Hong Kong) and has networked them.6 Second, Network China aims to be a networking platform for Singapore-

3 Embracing China’s Growing Economy 157 based companies setting up businesses, looking for business partners, and/or investing in China. Tham Poh Cheong, Director of Network China, says that “a main reason why Singapore needs this organization is that most Singaporean firms are small- and medium-sized enterprises and have limited resources to penetrate the market.”7 Thus, in managing the domestic economy, the Singaporean government still plays a major role in high-risk enterprises (such as R&D investments and bio-medical ventures), because local companies, generally SMEs that began as subcontractors to MNCs, are not well equipped to enter high-risk ventures on their own. Similarly, government agencies help MNEs enter the Chinese market by using their resources to make up for the companies’ relative lack of marketing capabilities. IE Singapore does not, however, dictate what, where, or how Singapore-based companies trade with and invest in China. Its major function is to facilitate local firms’ businesses by providing information and helping to establish contacts. It even contacts regional governments on behalf of Singaporean firms and helps them “establish valuable guanxi with influential government officials” (IE Singapore 2004). To bolster private initiatives, Network China recently appointed eight private businesspersons as regional representatives in China, so that companies wishing to engage the Chinese market could tap their business experience and their knowledge of local conditions, customs, and laws. The network of contacts built up by the representatives will also be a boon to new enterprises, which “will not need to start from scratch to build up the intricate web of guanxi, or personal connections, which forms part and parcel of business in China.”8 Hong Kong has its own counterpart to IE Singapore, the Hong Kong Trade Development Council, but the organization is for the most part geared to promoting trade generally. The Hong Kong SAR government also actively promotes the city as a “one-stop service center” for companies that want to do business with China and provides them with the necessary infrastructure. However, these efforts do not extend to helping Hong Kong–based firms set up businesses in China. In Hong

6 For the same reasons, IE Singapore also maintains Network India and Network Indonesia departments. 7 Interview conducted by author in Singapore on 2 July 2004. 8 The Straits Times, 9 July 2004.

158 CHAPTER 5 Responses to the Emerging China: Singapore and Hong Kong Kong, foreign investment is what individual companies do on their own, and no one expects a helping hand from the government.

3-2 Trade

Singapore’s trade with China began to accelerate in the mid-1990s. China’s share in Singapore’s total trade had increased only slightly over the prior fifteen years, inching up from 2.1% in 1980 to 2.8% in 1995 (Table 5-3). Trade then jumped over the next five years to 4.6% (in 2000), and over the subsequent three years to 7.7% (in 2003), a trade volume increase of more than 300% over eight years. Including Hong Kong as part of China reveals a similar trend: the combined share of China and Hong Kong in Singapore’s total trade increased marginally between 1980 (6.7%) and 1995 (8.7%) and then leapt to 14.2% in 2003. The accelerated growth is primarily due, however, to the sharp increase in direct trade between Singapore and China, for bilateral trade between Singapore and Hong Kong stagnated during this period. Despite the rapid growth of trade with China, Singapore still maintains

Table 5-3 Singapore’s Trade with China

Total Trade Exports Imports Amount CH Amount CH Amount CH Year Sharea Share Share (US$ Shareb (US$ Share (US$ Share (%) (%) (%) millions) (%) millions) (%) millions) (%) 1980 935 2.1 6.7 309 - - 626 - - 1985 2,565 5.3 9.3 328 1.4 7.8 2,237 8.5 10.4 1990 2,869 2.5 7.2 628 1.2 7.6 2,075 3.4 6.4 1995 6,844 2.8 8.7 2,776 2.3 11.0 4,068 3.3 6.6 2000 12,507 4.6 9.9 5,385 3.9 11.8 7,121 5.3 7.9 2001 12,569 5.3 11.0 5,345 4.4 13.3 7,224 6.2 8.6 2002 15,748 6.5 12.4 6,870 5.5 14.7 8,877 7.6 10.1 2003 21,041 7.7 14.2 10,053 7.0 17.0 10,987 8.6 11.0

Notes: a. The share of trade with China in Singapore’s total trade. Notes: b. The share of trade with China and Hong Kong in Singapore’s total trade. Source: Statistical Yearbook of Singapore (various years).

3 Embracing China’s Growing Economy 159 diversity in terms of its trade destinations. China was only Singapore’s fifth largest trading partner in 2003, after Malaysia, the US, the EU, and Japan (Table 5-4). Even China and Hong Kong as a single entity is only Singapore’s third largest trading partner, a position it has (or they have) occupied since surpassing Japan (in 2001) and the EU (in 2002).

Table 5-4 Singapore’s Major Trading Partners in 2003

Partner Value (US$billions) Share (%) Annual Growth (%) 1 Malaysia 77.2 16.3 0.3 2 United States 64.5 13.6 3.3 3 EU 61.2 12.9 16.3 4 Japan 43.7 9.2 3.8 5 China 36.9 7.8 31.3 6 Hong Kong 30.5 6.4 19.3 7 Taiwan 23.3 4.9 12.9 8 Thailand 20.3 4.3 2.0 9 South Korea 19.2 4.1 12.8 10 Australia 12.0 2.5 20.8 World 473.9 100.0 9.6

Source: IE Singapore (2004).

This situation contrasts sharply with the case of Hong Kong, which as a gateway to China has found its trade with the mainland critical to its trade overall. Trade with China already accounted for 13.4% of Hong Kong’s total trade in 1980, and China became Hong Kong’s largest trading partner in the early 1980s (Table 5-5). China’s share increased to 25.8% in 1985, to 30.8% in 1990, and further to 34.8% in 1995. During this fifteen-year period, the volume of bilateral trade increased by a factor of 22.8, from US$5.37 billion in 1980 to US$128.32 billion in 1995. The trend continued in the 1990s as China’s share of Hong Kong’s trade increased to 38.9% in 2000 and further to 43.1% in 2003. Between 1995 and 2003, the volume of bilateral trade expanded by a factor of 1.5, from US$128.32 billion to US$198.66 billion.

160 CHAPTER 5 Responses to the Emerging China: Singapore and Hong Kong Table 5-5 Hong Kong’s Trade with China

Total Trade Exports Imports Year Amount Amount Amount Share (%) Share (%) Share (%) (US$millions) (US$millions) (US$millions) 1980 5,639 13.4 1,249 6.4 4,389 19.7 1985 15,622 25.8 7,957 26.0 7,664 25.5 1990 51,286 30.83 20,589 24.8 30,697 36.8 1995 128,320 4.8 58,187 33.3 70,132 36.2 2000 163,535 38.9 70,587 34.5 92,948 43.1 2002 172,941 40.3 79,721 36.9 93,219 43.5 2003 198,661 41.8 96,533 39.3 102,128 44.3

Source: HKCSD (2004).

Singapore can never match Hong Kong in terms of trade volume with China. For instance, Singapore’s trade with China was only 10.6% that of Hong Kong in 2003. However, Hong Kong’s exports to China mainly consist of re-exports. Domestic exports accounted for only 4.9% of the city’s exports to the mainland in 2003 (Table 5-6). Major export items are electronics-related goods (70.5% of exports to China in 2003), machinery (11.7%), and building materials and hardware (4.4%), but again, they are mostly re-export items. These trade figures confirm that Hong Kong functions mainly as a service center for China.

Table 5-6 Composition of Hong Kong’s Trade with China

Total Exports Domestic Re-Exports (C) Year to China (A) Exports (B) B/A(%) C/A (%) (US$millions) (US$millions) (US$millions) 1997 64,605 7,934 12.3 56,671 87.7 1998 59,019 6,990 11.8 52,028 88.2 1999 57,439 6,363 11.1 51,076 88.9 2000 69,619 6,930 10.0 62,688 0.0 2001 70,052 6,350 9.1 63,701 90.9 2002 78,037 5,262 6.7 72,775 93.3 2003 95,230 4,699 4.9 90,530 95.1

Source: HKCSD (2004).

3 Embracing China’s Growing Economy 161 In contrast, domestic exports accounted for 51.8% of Singapore’s exports to China in 2003 (IE Singapore 2004). Major export items are electronics-related goods (46.1% in 2003) and oil-related goods (28.5% in 2003) (Table 5-7). A larger portion of the latter are re-exports; electronics-related goods are mostly domestic exports. The data implies that Singapore’s manufacturing sector, especially the electronics sector, plays a significant role in expanding exports to China.

Table 5-7 Singapore’s Major Exports to China by type

Export Share (% of total exports SITC Category to China) 1990 2000 2003 7 – Machinery and transport equipment 16.0 57.8 56.7 77 – Electrical machinery, apparatus, and appliance 1.8 25.6 31.9 75 – Office machines and automatic data processing equipment 1.3 19.5 14.2 3 – Mineral fuels and lubricants and related materials 39.4 14.0 9.9 5 – Chemicals and related products 15.0 14.5 18.6

Sources: Figures for 1990 and 2000 are from Song (2004). Those for 2003 are from UN Comtrade database.

3-3 Investment

Singapore’s outward investments began in earnest in 1993 with the official launch of the Regionalization Program, through which the government encouraged its domestic firms to invest overseas and to take part more actively in growing economies in the region. Singaporean firms have concentrated their foreign direct investment (FDI) on China and Indonesia, seeing them as emerging markets with strong potential for growth. Between 1993 and 1995, Singapore’s FDI in China grew over five-fold, from S$444 million (US$275 million) to S$2.4 billion (US$1.7 billion). A relatively insignificant destination for outward investment from Singapore throughout the 1980s, China had emerged as the third largest recipient of Singaporean investment

162 CHAPTER 5 Responses to the Emerging China: Singapore and Hong Kong by 1996. From 1998 to the present, China has topped the list of host countries of Singaporean FDI. By the end of 2003, Singapore’s total stock of foreign equity investment in China stood at S$442 billion (US$254 billion), accounting for 13% of Singapore’s investment abroad. Singapore is also China’s seventh largest investor, and there were about 30,000 projects in 2003 in China in which Singaporean firms were involved. The number of Chinese firms in Singapore grew from 509 in 1999 to 1,161 in 2003. (Figure 5-2).

Figure 5-2 Singapore’s Investment in China(cumulative to 2003)

Source: IE Singapore (2004).

Singapore’s investments in China are different from Hong Kong’s in three important ways. First, reflecting Singapore’s strength in the manufacturing sector, manufacturing investment is dominant. By 2003, this sector had accounted for about 60% of Singapore’s cumulative investments in China, with real estate a distant second at 20%. Second, although China recently emerged as the number- one destination for Singapore’s foreign investment, Singapore’s FDI is nonetheless

3 Embracing China’s Growing Economy 163 diversified: Malaysia, Indonesia, and the US remain important investment destinations. Third, within China, Singapore’s investments are more widely dispersed geographically. Jiang Su heads the list at 24%, while Shanghai (16%), Guang Dong (14%), and Zhe Jiang (12%) all receive sizeable portions of Singapore’s FDI (Figure 2). In contrast, Hong Kong’s trade and investment have been predominantly directed at the Pearl River Delta (PRD) region. The Hong Kong SAR government’s initiatives to facilitate trade and investment with China are have focused on this region because, with a population of 40 million, among them many affluent urban consumers, the region is “an enormously attractive market” (Tung 2001 to Hong Kong. The SAR government considers promoting economic co- operation between Hong Kong and the PRD as “a key element in our efforts to consolidate and enhance Hong Kong’s position as an international centre for finance, trade, transport and logistics.”

164 CHAPTER 5 Responses to the Emerging China: Singapore and Hong Kong 4

Responding to Competition from China

4-1 The Stagnation of ASEAN and Singapore’s Free Trade Initiatives

The trends in bilateral trade with China show that the Singaporean economy has thus far benefited greatly from the explosive growth of the Chinese economy. Singapore’s major export items are less competitive with than complementary to China’s major products. The latter are mostly based on low-to-medium-level technologies, while Singapore is positioned as a high-end manufacturing and service provider. In particular, there is a high demand in China for electronic components and chemical-related goods made in Singapore on the part of Chinese companies who need them as intermediate goods. Thus the growth of the Chinese manufacturing sector or its exports does not pose a direct challenge to Singapore’s economy. It does, however, pose great challenges to Singapore indirectly, because Chinese manufacturing products are in direct competition with those of the Southeast Asian countries—the very countries whose need for a regional manufacturing and service hub brought Singapore to its present affluence. If the countries of the Association of Southeast Asian Nations (ASEAN) stagnate because of competition with China, some of the wind will leave Singapore’s sails as well. As it began to industrialize in the 1960s, Singapore worked strenuously, as explained above, to reduce its over-reliance on the region and to diversify its trade globally. But Singapore’s economic ties with its neighbors grew stronger once more as the region achieved political and economic stability in the 1970s and as its economic growth accelerated in the 1980s. Despite the fact that bilateral trade with

4 Responding to Competition from China 165 China has recently grown rapidly, it is only about one-third the volume of Singapore’s trade with ASEAN. It is still an open question what portion of Southeast Asian exports are in direct competition with their Chinese counterparts.9 But the fact remains that the Southeast Asian region is currently losing the export game to China on the world market. Between 1991 and 1996, ASEAN’s exports grew at an average annual rate of 15.4%, a healthy rate of growth, though lower than China’s 19.9%. Between 1997 and 2002, however, the annual growth rate of ASEAN exports fell sharply to 3.4%—only a quarter of China’s 14.1%. Even if we exclude the abnormal period of the Asian financial crisis and consider only the 2000–02 period, ASEAN’s annual export growth rate was only 4.9%, still about a quarter of China’s 19.0% (Table 5-8).

Table 5-8 Export Growth Rates and Relative Values of Exports for ASEAN, Singapore, and China

Value of ASEAN Period ASEAN (%) Singapore (%) China (%) Exports to Value of China Exports (ratio) 1991–1996 average 15.4a 11.0 19.9 2.3b 1997 4.7 5.3 21.0 2.0 1998 -8.7 -1.0 0.5 1.8 1999 9.5 5.7 6.1 1.8 2000 19.7 22.4 27.8 1.7 2001 -10.1 -8.3 6.8 1.5 2002 5.0 2.7 22.3 1.2 1997–2002 average 3.4 4.5 14.1 - 2000–2002 average 4.9 5.6 19.0 -

Notes: a. Average export growth rate of five ASEAN countries. Figures for 1997–2002 are for ten ASEAN members. Notes: b. Export value for ten ASEAN members divided by that for China in 1996. Sources: ASEAN Statistical Yearbook (2003), IMF (2004).

More illuminating of the competition between Southeast Asia and China, however, is the data on FDI inflows. In 1990, ASEAN attracted the largest chunk

166 CHAPTER 5 Responses to the Emerging China: Singapore and Hong Kong of FDI that went into developing countries. The region received US$11.3 billion in FDI, 32.6% of total FDI inflows to developing economies that year, and 3.2 times China’s FDI inflow. However, ASEAN gave the top spot to China in 1993, and since then has been rapidly eclipsed by its rising neighbor. In 2002, ASEAN drew US$13.96 billion in FDI inflows, 8.6% of those to developing economies that year, and only about a quarter of the amount drawn by China. FDI inflows into ASEAN rose by only 23.5% from 1990 to 2002. Meanwhile inflows to China rocketed skyward, growing 1,511% over the same period (Table 5-9).

Table 5-9 FDI Inflows into Singapore, ASEAN, Hong Kong, and China

Developing Singapore ASEAN Hong Kong China Economies Year Amount Amount Amount Amount Amount (US$ % (US$ % (US$ % (US$ % (US$ % millions) millions) millions) millions) millions) 1990 5,575 16.1 11,299 32.6 1,728 5.0 3,487 10.1 34,689 100 1991 4,888 12.0 11,694 28.6 538 1.3 4,366 10.7 40,889 100 1992 6,730 12.3 16,449 30.0 2,051 3.7 11,156 20.4 54,750 100 1993 6,829 9.3 16,364 22.3 1,667 2.3 27,515 37.5 73,350 100 1994 8,550 8.1 20,370 19.4 7,828 7.5 33,787 32.2 104,920 100 1995 7,206 6.4 25,367 22.7 6,213 5.6 35,849 32.0 111,884 100 1996 8,984 6.2 29,370 20.3 10,460 7.2 40,180 27.7 145,030 100 1997 13,533 7.0 30,369 15.7 11,368 5.9 44,237 22.9 193,224 100 1998 7,594 4.0 18,504 9.7 14,766 7.7 43,751 22.9 191,284 100 1999 13,245 5.8 19,691 8.6 24,580 10.7 40,319 17.6 229,295 100 2000 12,464 5.1 11,056 4.5 61,937 25.2 40,772 16.6 246,057 100 2001 10,947 5.2 13,241 6.3 23,775 11.4 46,846 22.4 209,431 100 2002 7,655 4.7 13,957 8.6 13,718 8.5 52,700 32.5 162,145 100

Sources: ASEAN figures for 1995–2001 are from the ASEAN website. Figures for other periods were calculated by adding FDI inflows into ten ASEAN member countries, as reported in World Investment Report (2003, 2000, 1995).

The decline of Southeast Asia is reflected in its GDP growth rates. In the first

4 Responding to Competition from China 167 half of the 1990s, ASEAN was one of the world’s fastest-growing regions, recording a 7.3% average annual growth rate from 1991 to 1996, though even then it trailed well behind China’s 11.6%. By 2000, however, ASEAN had become an average growth region, posting an average growth rate of 3.4% in the 2000–2002 period, a figure less than half that of China, 7.6% (Table 5-10).

Table 5-10 GDP Growth Rates for ASEAN and China (Unit: %) Period ASEAN ASEAN 5a Singapore China 1991–1996 average - 7.3b 8.8 11.6 1997 4.1 3.8 8.5 8.8 1998 -7.1 -8.9 -0.9 7.8 1999 3.6 3.1 6.4 7.1 2000 5.9 5.5 9.4 8.0 2001 3.2 2.5 -2.4 7.3 2002 4.4 4.1 2.2 8.0 1997–2002 average 2.3 1.7 3.9 7.8 2000–2002 average 3.9 3.4 3.9 7.6

Notes: a. The ASEAN 5 are Indonesia, Malaysia, the Philippines, Singapore, and Thailand. Notes: b. Growth rate for ASEAN 5 from 1991 to 1996 is a simple average of growth rates of the five countries. Sources: ASEAN website, IMF (2004).

As the region stagnates economically, opportunities for Singapore to function as a business hub for Southeast Asia grow fewer. Thus it appears that one factor behind the slowdown in Singapore’s economy since the late 1990s has been the slowdown general to the region. No matter how hard Singapore’s government or companies work to find business opportunities in the emergence of China, Singapore can never be a business hub for China. Its neighborhood is Southeast Asia, and its prosperity is inextricably linked to the growth prospects of the region. Thus, if Singapore wants to regain its growth momentum, it must overcome the constraints presented by the stagnation of its neighbors. A major initiative in this regard is Singapore’s global push for Free Trade

168 CHAPTER 5 Responses to the Emerging China: Singapore and Hong Kong Agreements (FTAs). Although Singapore is a member of ASEAN and an ASEAN Free Trade Agreement (AFTA) is being negotiated, the government aims to speed up the process of trade liberalization and the diversification of its markets by concluding FTAs worldwide (Table 5-11). Beginning with the FTA signed with HYPERLINK "http://www.mti.gov.sg/public/FTA/frm_FTA_Default.asp?sid=32" New Zealand in August 2000, Singapore has concluded FTAs with six entities (New Zealand plus Japan, the European Free Trade Association, Australia, the US, and Jordan), and is currently negotiating FTAs with ten further countries (China, India, Sri Lanka, Bahrain, Canada, Egypt, South Korea, Mexico, Chile, and Panama).

Table 5-11 Singapore’s FTA Initiatives(as of July 2004)

FTAs Concluded FTAs under Negotiation

New Zealand ASEAN and China Japan India European Free Trade Association Sri Lanka Australia Bahrain United States Canada Jordan Egypt South Korea Mexico Pacific Three (New Zealand, Chile, Singapore) Panama

Source: Ministry of Trade and Industry (2004).

From Singapore’s point of view, the FTA initiative is a game with little to lose and much to gain. As a small open economy developed as an entrepôt, it has already abolished most trade barriers and has little to fear from removing the few that remain. For Singapore, FTAs are mainly a way to open its trading partners’ markets further and thereby to increase the overall size of its overseas market. Maintaining and furthering the cause of free trade is always beneficial to Singapore’s economic well-being.

4 Responding to Competition from China 169 It is important to note that Singapore’s FTA initiative does not aim simply to increase trade volume but also to increase inward foreign investment. As already explained, the stagnation of inward FDI into ASEAN is a serious problem for Singapore, because ASEAN has developed by relying on FDI, and Singapore has prospered by riding the wave of ASEAN’s development. Indeed, Singapore too has relied heavily on FDI to upgrade its economy. Positioning itself as a free-trade champion in the region, Singapore bolsters its strategic importance as a business hub for MNCs. In fact, while Singapore was in the midst of FTA negotiations with the US and Japan, MNCs based in Singapore vigorously lobbied their home country governments to complete and sign the agreements.10 For MNCs that have already established regional headquarters or production facilities in Singapore, it is in their interests for Singapore to thrive on the continued expansion of trade. It remains to be seen how successful the FTA initiative will be in drawing FDI into Singapore and in increasing the country’s trade volume. Currently, Singapore is experiencing the same slowdown in inward FDI and exports as its neighbors are. Overall, however, Singapore’s policies seem to be in line with its interests and strategic goals. FTAs are also a means by which Singapore can further exploit the Chinese market. However, the market opening Singapore can expect to gain from China falls well short of what Hong Kong has already achieved. When Singapore attempted in 2000 to open talks with China towards a bilateral FTA, in response China proposed negotiations towards a multilateral ASEAN–China FTA (ACFTA). At the ASEAN+China Summit in November 2001, the two parties agreed to launch negotiations towards an ACFTA that would be established within ten years. So the proposed Singapore–China FTA has been subsumed within an ACFTA negotiation whose end is still a long way off. In contrast, Hong Kong has already concluded a Closer Economic Partnership Arrangement (CEPA) with China, a free trade agreement that offers Hong Kong products, companies, and residents special access to the Chinese market. As of 1 January 2004, 273 manufacturing goods, including specified electrical and

10 Author’s interview with an official in Singapore’s Ministry of Trade and Industry, October 2003.

170 CHAPTER 5 Responses to the Emerging China: Singapore and Hong Kong electronic products, plastic articles, textiles and clothing items, chemical products, and pharmaceutical products, became duty free when imported from Hong Kong to China. China also gave Hong Kong free market access in eighteen service sectors, including management consulting, convention and exhibition services, advertising, accounting, real estate and construction, medical and dental services, logistics, transport, tourism, legal services, banking, securities, insurance, and telecommunications.11 The degree of market opening that China has conferred to Hong Kong under the first phase of the CEPA is already beyond what ASEAN expects to achieve from the ACFTA that is (vaguely) scheduled for completion in 2011. An FTA overture to China through ASEAN is definitely a reasonable measure, one that will give independent countries like Singapore broader access to the Chinese market, but that access will fall far short of what Hong Kong already enjoys as an integral part of China within the “one country two systems” framework.

4-2 Resisting the Pressure to Hollow Out

A major concern of other East Asian countries coping with the emergence of the Chinese economy is the possibility their own economies will “hollow out.” As we have seen, Hong Kong experienced a very rapid hollowing out once its integration with China began in earnest in the mid-1980s. This hollowing out does not pose a serious problem for Hong Kong because its economy, already a part of China’s, has a service industry premised on the reliable and rapidly expanding economic activities of its hinterland. However, no country in East Asia can enjoy the special position Hong Kong does in interacting with China. For the rest of the region, the fear of hollowing out, with the attendant prospects of rising unemployment, lost industrial competitiveness, and retarded economic growth, is a legitimate fear. Remarkably, Singapore has shown few signs of hollowing out in this period of deepening interaction with China. The GDP share of the manufacturing sector has

11 Details of the CEPA may be found at Hong Kong Trade Development Council (2004).

4 Responding to Competition from China 171 remained stable, sitting at 25.8% in 1990, 24.7% in 1995, 26.7% in 2000, and 26.5% in 2002 (Table 5-2). In fact, Singapore has already adapted to pressures that might otherwise hollow out its industrial base. After Singapore successfully industrialized in the 1970s and began facing rising production costs in the early 1980s, instead of taking steps to block low valued–added businesses from moving abroad, the government adopted a high-wage policy as part of a two-pronged effort to further modernize its economy. Specifically, as it worked to expedite the relocation of low value–added industries or production segments to suitable destinations abroad, it also took steps to attract investments in higher value–added businesses, offering local and foreign companies an array of fiscal incentives to upgrade their production activities. In this way the government resisted the threatened hollowing out of the manufacturing sector. As a result, Singapore is largely immune to the hollowing-out pressures that the rise of China now brings to bear on the economies of East Asia. The co-existence of an inward FDI promotion agency and an outward FDI promotion agency within the government reflects this established practice of continuous upgrading-cum-relocation. Since the beginning of Singapore’s industrialization, the Economic Development Board (EDB) has been the key agency responsible for attracting inward FDI. It has been given comprehensive powers to build infrastructure necessary for new investments and to negotiate with prospective foreign investors by offering various fiscal incentives. Meanwhile, IE Singapore, doing little to coordinate with the EDB, promotes foreign investments by Singapore-based firms. The possibility of hollowing out is not a concern for IE Singapore; the burden of maintaining the competitiveness of the domestic economy rests solely on the shoulders of the EDB. It is a myth promulgated by the popular media and liberal think tanks that Singapore maintains the “freest” market economy in the world. In fact, the government has always been an active player in the economy, as evidenced in its ongoing efforts to upgrade Singapore’s manufacturing sector and thus to forestall de-industrialization. The government continually enacts policies that target future growth industries or industrial segments, allocating resources in such a way as to maintain the competitiveness of Singapore’s manufacturing sector. Singapore looks like a “free” market economy mostly because its policies are market-friendly. For

172 CHAPTER 5 Responses to the Emerging China: Singapore and Hong Kong one thing, they do not involve protectionist measures like tariffs or quotas, which do not come naturally to a country that grew up without an agricultural sector as an entrepôt open to foreign trade and investment. Instead the government has used subsidies as a major tool for upgrading Singapore’s industries. It is a peculiarity of the Singaporean economy, then, that industrial and technology policies have been delinked from trade-related protectionist policies. Moreover, because Singapore has needed to ensure free movement of products, services, and personnel, and has relied heavily on MNCs for the economic activity they bring, the government has made it a central feature of its industrial and technology policy to offer MNCs incentives to remain and expand within Singapore.

4-3 Maintaining a Position as East Asia’s International Financial Center

Another challenge that faces Singapore with the emergence of the Chinese economy is maintaining its status as the international financial center for East Asia. As Singapore’s Economic Review Committee (2002) says, “the trend towards consolidation of financial activities in leading financial centres has . . . intensified the competition for ‘location-independent’ financial activities and top talent. Economic vibrancy of North Asia vis-à-vis Southeast Asia has also increased the relative attractiveness of Hong Kong and Shanghai” (p. 1). Compared with Hong Kong, which, thanks to the economic growth of China, and especially that of the PRD region, enjoys rapidly increasing demand for financial services, Singapore is at a disadvantage: it is difficult to expect strong “location-dependent” spillover effects in a region where stagnation rather than robust growth is the norm. Moreover, as many financial services become “location- independent” as part of the global financial integration underway, competition with other global financial centers such as New York, London, and Tokyo is growing more intense. Singapore has responded to these challenges by further liberalizing its financial industry and thus attracting financial institutions and money from around the world. Singapore’s traditional strength as an international financial center has been in foreign exchange trading. Since 1992 it has retained its fourth-place position behind

4 Responding to Competition from China 173 London, New York, and Tokyo in foreign exchange trading, managing to stay ahead of Hong Kong, whose rank slipped from sixth in the first half of the 1990s to seventh more recently (Table 5-12). The daily net transaction volume of foreign exchange in Singapore grew from US$74 billion in 1992 to US$101 billion in 2001. Singapore has also set up the first derivative exchange in Asia, the Singapore International Monetary Exchange (SIMEX),12 which has become a key Asian node in the global network of leading futures markets. Singapore’s continued strength in foreign exchange trading is due primarily to the early establishment of the Asian Dollar Market in the 1960s, which was formed to emulate the Euro Dollar Market in Europe.

Table 5-12 Daily Net Transactions of Foreign Exchanges (Units: US$billions, (rank))

Exchange 1992 1995 1998 2001 UK 291 (1) 465 (1) 637 (1) 504 (1) US 167 (2) 244 (2) 351 (2) 254 (2) Japan 120 (3) 161 (3) 136 (4) 147 (3) Singapore 74 (4) 105 (4) 139 (3) 101 (4) Switzerland 66 (5) 87 (6) 82 (6) 71 (6) Hong Kong 60 (6) 90 (5) 79 (7) 67 (7) Germany 55 (7) 76 (7) 94 (5) 88 (5)

Source: Bank for International Settlements ([BIS], 2001), adapted from Chang and Chun (2004).

Singapore has also been successful as a center for international commercial lending. As of the end of March 2003, the external assets and liabilities of Singapore-based banks were US$4.21 trillion and US$4.17 trillion respectively, putting Singapore sixth in the world in terms of the size of total external transactions—ahead of Hong Kong, which held seventh place (Table 13). The growth of commercial lending in Singapore is notable because it is conducted

12 SIMEX and the Stock Exchange of Singapore (SES) merged in 1999 to become the Singapore Exchange (SGX).

174 CHAPTER 5 Responses to the Emerging China: Singapore and Hong Kong Table 5-13 External Assets and Liabilities of Commercial Banks in Major Financial Centers (as of March 2003) (Unit: US$billions)

Center External Assets External Liabilities Total Rank UK 2,645 (6.3) 2,881 (6.9) 5,526 (6.6) 1 US 1,315 (3.1) 1,615 (3.9) 2,930 (3.5) 2 Germany 1,500 (3.6) 1,267 (3.0) 2,767 (3.3) 3 Japan 1,251 (3.0) 522 (1.3) 1,773 (2.1) 4 Switzerland 810 (1.9) 711 (1.7) 1,521 (1.8) 5 Singapore 421 (1.0) 417 (1.0) 838 (1.0) 6 Hong Kong 391 (0.9) 241 (0.6) 632 (0.8) 7

Note: Figures in parentheses are ratios to Singapore’s figures. Source: BIS (2003), adapted from Chang and Chun (2004).

primarily by foreign banks that bring in their own money (rather than raising deposits in Singapore) and lend them to international borrowers. However, development of the capital market has been relatively slow, reflecting the small size of Singapore’s economy. Market capitalization of the Singapore stock exchange was US$101 billion in 2002, one-ninetieth that of the New York Stock Exchange, one-eighteenth that of the London Stock Exchange, and one-fifth that of the (Table 5-14).

Table 5-14 Status of Stock Markets in Major International Financial Centers (2002)a (Unit: US$billions)

Stock Market Market Capitalization Transaction Volume Number of Listed Companies New York 9,060 10,953 2,937 (520)b London 1,800 4,001 2,272 (382) Tokyo 2,069 1,564 2,153 (34) Frankfurt 686 1,212 934 (219) Switzerland 547 599 398 (140) Hong Kong 463 194 978 (10) Singapore 101 63 501 (67)

Notes: a. Market capitalization and number of listed companies are year-end figures, while transaction volumes are year-long figures. Notes: b. Figures in parentheses refer to number of foreign companies. Source: World Federation of Exchanges ([WFE], 2002), adapted from Chang and Chun (2004).

4 Responding to Competition from China 175 The bond market is also relatively small, recording US$55.1 billion at the end of 2001. Even within East Asia, it was smaller than those of Korea (US$262.4 billion), Taiwan (US$82.4 billion), and Hong Kong (US$63.3 billion) (Table 5-15).

Table 5-15 Bond Markets in East Asia (at Year-End) (Unit: US$billions)

Market 1994 2001 China 33.4 - Hong Kong 11.5 63.3 Indonesia 9.1 5.4 Korea 161.0 261.4 Malaysia 39.5 49.7 Philippines 25.1 3.2 Singapore 44.9 55.1 Taiwan - 82.4 Thailand 13.7 42.6

Source: Chang and Chun (2004).

Singapore currently places particular importance on international asset management for ensuring its future growth as an international financial center. The global trend of securitization of financial assets that has already set in will likely intensify. Moreover, as the bulk of the world’s savings are generated within Asia, and are likely to continue to be for a long time, there is strong growth potential in the circulation and management of newly created assets in Asia. In particular, Singapore emphasizes the importance of wealth management (i.e., private banking) in response to the proliferation of high net worth individuals (HNWIs) in Asia. The Economic Review Committee’s (2002) recent report on the financial sector gives wealth management top priority in Singapore’s effort to become a “pre-eminent financial center in Asia.” Singapore has already established itself as a financial center for “managing Asian investments of global clients and global investments of Asian clients in Asia.” (Loong, 2004) According to a survey by the central bank of Singapore, the Monetary Authority of Singapore ([MAS], 2004), 70% of the S$183.4 million in discretionary assets managed in Singapore in 2002 were sourced overseas, while the

176 CHAPTER 5 Responses to the Emerging China: Singapore and Hong Kong remaining 30% were sourced domestically (Figure 5-3).

Figure 5-3 Sources of Discretionary Funds, by Region

Source: MAS (2004).

However, the bulk of the discretionary funds were invested in Asia: 14% in Singapore, 46% in the rest of the Asia-Pacific region, 10% in Europe, and a mere 8% in North America (Figure 5-4). Singapore’s asset management business is also recording strong growth. Total assets under management (AUM) grew 2.8 times over five years, from US$124.1 million in 1997 to US$343.8 million in 2002. The value of discretionary assets, which are the assets in play in private wealth management, grew from effectively nil in 1997 to US$160.4 in 2002 (Figure 5-5).

Figure 5-4 Investment of Discretionary Funds, by Region

Source: MAS (2004).

4 Responding to Competition from China 177 Figure5- 5 Growth of Assets under Management

(Unit: US$billions)

Note: Non-discretionary assets include funds under advisory service and funds contracted by Fls in Singapore. Source: MAS (2004).

Singapore aims at further strengthening its position as a financial hub for asset management, and here it is in direct competition with a Hong Kong also keen to develop its international asset management industry and to become the Switzerland of East Asia (see, for instance, Tung 2004). As the asset management business becomes more internationalized, Singapore and Hong Kong are competing for the same group of largely East Asian new customers. The Singaporean government has introduced several policies in response to the competition from Hong Kong. First, it is exercising the financial power that emanates from its huge assets to consolidate Singapore’s position as an international asset management hub. Two major public investment agencies, the Government of Singapore Investment Corporation (GIC) and Temasek Holdings, are currently outsourcing management of their funds to the private sector, in a bid to attract more international asset management companies to Singapore and thus bolster the country’s position as East Asia’s wealth management hub. Thus GIC, which is thought to manage more than US$100 billion and has already entrusted US$30 billion to outside fund managers, announced in July 2004 that it will farm out US$5 billion every year, and will eventually have most of its funds managed by

178 CHAPTER 5 Responses to the Emerging China: Singapore and Hong Kong the private sector. Ng Kok Song, GIC’s managing director of the public market, makes the government’s intention clear: Our selection of fund managers is driven by the primary objective of having them add value to our portfolio, but at the same time, we want to do whatever we can do to help develop a fund management industry (Straits Times, 2004). This carrot-dangling policy has been central to the government’s success in inducing global asset management companies to expand their Singapore operations. For instance, Fidelity Investments, the largest mutual fund company in the US, decided in 2003 to manage US$2 billion in global equities and investments from its new office in Singapore, where it plans to market as many as seventy-three funds. Vanguard Group, the second-largest US mutual fund company, also started managing money from Singapore in 2003. The availability of huge government assets constitutes a major competitive for Singapore over Hong Kong (Straits Times, 2004). Second, the government is in the process of reducing corporate and individual tax rates to close the gap with those of Hong Kong. It reduced the corporate tax rate from 24.5% to 22% in 2003, and plans to lower it further to 20% in 2005. It also reduced the top marginal income tax rate from 26% to 22% in 2003, and plans to reduce it further to 20% in 2005. To promote wealth management enterprises in Singapore, the government is also exempting interest income as well as many types of foreign- sourced income from taxation. Singapore’s tax rates are still higher than Hong Kong’s, which stood at 17.5% in 2003. But it is important to note that Hong Kong recently increased its rates to that level from 15% to handle demands on its public coffer. Meanwhile Singapore is reducing tax rates to become more competitive. Third, the government is investing heavily to develop a pool of talent in wealth and fund management. The government believes that Singapore’s success as an international financial center will eventually hinge on the availability of “talented and dynamic professionals from a broad range of disciplines and experiences” (Loong 2004). For this purpose, the MAS set up a S$500 million Financial Sector Development Fund in 2001 to assist human capital development related to wealth management. GIC and Temasek Holidings have also jointly set up the Wealth Management Institute (WMI), Asia’s first graduate center for wealth management education and research. WMI plans to open its first Master of Science program in Wealth Management in January 2005.

4 Responding to Competition from China 179 5

Conclusion

Examining Singapore’s responses to challenges posed by the rise of China, we have seen, first, that the government continues to be actively involved in the structural adjustment of the country’s economy. It sets strategic goals for future development of the country, provides the private sector with infrastructure and fiscal incentives, and, if necessary, directly takes on the role of investor. In helping companies trade with and invest in China, IE Singapore plays an important role, dispensing information and facilitating networking. To survive the downward pressure created by the current stagnation of the regional market, the government is actively seeking FTAs with trading partners. The rapid growth of the asset management industry in recent years is also largely due to the government’s initiatives to maintain the country’s position as a leading international financial center. Second, the government continues to treat the manufacturing industry as essential to future growth and to Singapore’s political security. It is a daunting task for a high-income country to maintain its manufacturing sector’s share of GDP at such a high level. But Singapore has managed to do so by continuously upgrading its industries. Finally, Singapore has continually worked to diversify its market and investments, though the degree of diversification has changed over time, reflecting changing market circumstances. Though China has become tremendously important recently as a trade and investment destination, it is still only one of many markets on which Singapore depends for economic growth. One might argue that the experience of a small city-state with a population of just over four million offers few lessons for other, larger countries in East Asia.

180 CHAPTER 5 Responses to the Emerging China: Singapore and Hong Kong And it may well be true that Singapore’s small size has kept it nimble as it responds to a changing international environment. With little to protect in its domestic economy, it is in a position to be bold in pursuit of FTAs with its trading partners, and the enormous financial resources the government can mobilize for economic development makes Singapore unusual in East Asia. However, it is certainly less unlike its neighbors than Hong Kong, which now enjoys a unique geopolitical position as a gateway to mainland China, and an integration into the Chinese economy impossible for other countries in the region. The experience of Singapore might provide other countries with some useful policy implications, for its strategic approach to economic management has been successful in a number of important ways. One area that especially warrants attention is Singapore’s ongoing “upgrade- cum-relocation” of its industries in response to the danger of industrial hollowing out. The country does not fear relocation of its companies abroad but, on the contrary, promotes it. Singapore saw that upgrading its domestic economy was imperative, a matter of survival, and established a system to do so that continues to serve it well. It is vigorously upgrading its manufacturing sector by investing in bio-medical and IT industries, and actively promoting its asset management industry to maintain its status as a leading international financial center. It should also be noted that Singapore’s approach to industrial upgrading is consistent with WTO regulations: it does not use protective measures and for the most part relies on subsidies that do not discriminate between foreign and domestic companies. The key to successful adjustment to the rise of China, for other countries in the region as for Singapore, is to upgrade the manufacturing sector continuously, to draw higher-end investments from local and foreign sources, and all the while to maintain an open economy. Each country needs, of course, to settle on the specific methods most appropriate to its circumstances, but Singapore’s approach provides a sound general template. In promoting trade with and investment in China, Singapore has found a method of networking that could be useful to other countries. IE Singapore helps Singapore-based companies by establishing links between the private and public sectors and by forming networks that join different regions of China. Because China maintains a , in which the division between public

5 Conclusion 181 and private sectors is not clearly established, public initiatives on the part of other East Asian countries would likely help private companies based in those countries to establish contacts and share business information. These initiatives would be similar to those undertaken by IE Singapore but adapted to each country’s specific circumstances. Other East Asian countries could also learn from Singapore’s promotion of its asset management industry. Though they might not be able to build international financial centers comparable to Singapore or Hong Kong, many of them have accumulated considerable financial assets, including foreign reserves, thanks to prior economic successes and high domestic savings rates. They might use these holdings to develop asset management industries within their own territories, rather than letting them be managed by financial centers abroad. In outsourcing management of public financial assets, they could create “win-win” situations in which their assets are capably managed and robust asset management industries are promoted within their own borders.

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References 185 CHAPTER 6 THE RISE OF THE CHINA AND THE ECONOMIC INTEGRATION OF EAST ASIA Park Bun-Soon, Samsung Economic Research Institute 1

Introduction

Since the 1960s, East Asian countries have sought economic development through an outward-looking industrialization policy. Japan has played a crucial role in this process: East Asian governments have referred to Japanese experience to foster their own industries, and Japanese companies have provided capital and technology to companies across the region. Thus the economic policies of “Japan Inc.” have stimulated the development of East Asian economies through various channels. By the 1990s a sort of developmental pyramid had taken shape, with Japan at the apex, and below Japan a first tier of newly industrializing economies (NIEs), a second tier of early-developing Southeast Asian countries, and a third tier occupied by China. Alternatively the pattern might be characterized as a “flying geese” model of vertical integration. However, the growth of the East Asian economy came to a halt with the Asian economic crisis of the late 1990s. The crisis was characterized by a prolonged recession in the Japanese economy, by diminished economic vitality in emerging markets because of lack of investment, and by retarded industrial development in late-developing Southeast Asian countries. Even in the thick of the crisis, however, the Chinese economy continued to grow. Its seeming immunity to the economic recession that plagued the rest of East Asia has had a profound effect on the other economies of the region. Indeed, it has signified the end of the existing economic order in East Asia and a new order in which China plays a central role. This chapter analyzes the impact of China’s rise on the economic order and integration of East Asia. China has both facilitated the existing development model of East Asia—the so-called “bamboo capitalism” that displaced the flying geese

1 Introduction 189 model after the 1985 Plaza Accord prompted the countries of Northeast Asia to increase their investments in Southeast Asia—and, more recently, induced the creation of a new growth model in the region. For, while the nature of the new model is still open to question, it is clear that bamboo capitalism is under intense pressure to change. This chapter argues that, as China becomes a major production base on the strength of growing domestic demand, and as its growth influences the ongoing economic integration of East Asia, a new regional growth dynamic is arising, one best represented by a “lily pad” model. Economic integration means the deepening of institutional and economic cooperation. Because our concern here is how China is affecting the economic integration of East Asia generally, we will touch on the issue of institutional integration during the discussion. Changes in East Asian economic cooperation have been facilitated by changes in the region’s trade and investment structure resulting from the rise of the Chinese economy. East Asian countries have undergone two major economic changes since the mid-1990s: the Asian financial crisis in 1997 and China’s entry into the World Trade Organization (WTO) at the end of 2001. The financial crisis was an opportunity for East Asian countries to build a new economic development model. Meanwhile, China’s WTO entry is expected to improve China’s export competitiveness by allowing further market openings, inducing structural reforms, and improving conditions for foreign investment inflow. The effect on other East Asian countries will be considerable.1 In short, while the Asian financial crisis shook the economic order of East Asia, China’s WTO entry will probably shake it up even more. But this chapter intends to show that an economic order is not transformed by a single event, and that the economy of East Asia is constantly evolving as production relationships shift. A careful analysis on trade and investment relationships will show that current state of economic cooperation in East Asia under the influence of China is part of a natural progression from one development paradigm to another.

1 Various studies have looked at the likely effects of China’s entry into WTO on the East Asian economy and on the global economy as a whole. Most of these studies, regardless of methodology, argue that WTO entry will boost China’s exports and inbound foreign direct investment.

190 CHAPTER 6 The Rise of the China and the Economic Integration of East Asia 2

Japan and Economic Cooperation in East Asia

2-1 Flying Geese and Vertical Integration

Between the 1960s and the mid-1990s, East Asian countries achieved rapid economic growth through a catch-up strategy called the “flying geese” development model. The model, which drew its name from the way countries followed the paths of their predecessors like geese flying in formation,2 explains the transfer of maturing industries from a developed country to developing countries. With Japan taking the lead in the 1960s, a first-tier of NIEs appeared in the 1970s, and early-developing countries of the Association of Southeast Asian Nations (ASEAN) followed as a second-tier in the 1980s. During the industrialization process, developing countries acquired technology and capital from developed countries and exported products outside the region. The flying geese model was first applied strategically to the Japanese textile industry, which shifted from importing goods to manufacturing and then exporting them. East Asian countries adopting the flying geese model were able to become major

2 Japanese economist Kaname Akamatsu first proposed the flying geese model of economic development in the mid-1930s. He advocated this type of development while conducting research on trade in the textile industry. Akamatsu argued that a country would tend to import cotton goods or cotton thread when they were not available within that country, but that, as time passed, these goods would come to be produced within the country and thus exported. In other words, the level of imports would rise at first and then decline as domestic production and then exports rose. The model gained notice with the development of Vernon’s Product Life Cycle Theory in the 1960s. The two models were later integrated into a single theory that explained how an industry in a developed country would be transferred to developing countries, enabling industrialization of those countries in their turn. For more on the flying geese model, see Kiyoshi (2000).

2 Japan and Economic Cooperation in East Asia 191 exporters of industrial goods. East Asian countries accounted for 20.4% of total global exports in 1990, up from 13.4% in 1980 (Table 6-1). Japan and the NIEs accounted between them for 8.3% and 7.8% of the global export market in 1990, up from only 6.4% and 3.8% in 1980. Between 1990 and 1995, however, Japanese exports stagnated, while those of the NIEs and the Southeast Asian countries rose sharply.

Table 6-1 Share of Global Export Market by Country or Region (Unit: %) Year East Asia Japan NIEs ASEAN 4 China US EU Total 1980 13.4 6.4 3.8 2.3 0.9 11.1 37.1 100.0 1990 20.4 8.3 7.8 2.5 1.8 11.4 43.7 100.0 1995 25.6 8.6 10.4 3.7 2.9 11.3 40.4 100.0

Note: The NIEs include Korea, Taiwan, Hong Kong, and Singapore; the ASEAN 4 are Malaysia, Thailand, Indonesia, and the Philippines. Source: World Trade Organization (WTO).

The major characteristic of the flying geese model is outward-looking industrialization. Taking advantage of cheap domestic labor supplies, East Asian countries moved into the declining industries of their predecessors and developed them into export-oriented industries. Kiyoshi Kojima (1978) argued that the “Japanese-style direct investment” that facilitates trade growth for the countries following was preferable to the “US-type direct investment” that was directed at the domestic market.3 The increase in trade contributed to these economies by raising the efficiency of resource distribution and increasing the surplus of both producers and consumers. Flying geese development was connected to an export-oriented strategy that contributed to growth in East Asian countries. As fading industries of more advanced countries were transferred to developing countries, the flow of trade took the form of

3 In other words, Kojima theorized that there was a distinctive Japanese-style FDI. He argued that Japanese investment in developing East Asian countries, in industries where Japan was losing comparative advantage, would create trade for both parties. He claimed that East Asian countries would be able to secure comparative advantage through Japan’s transfer to them of its fading industries. In contrast, he said, US-style FDI was engaged in capital- and technology-intensive industries that did not take into account the factor endowments of East Asian countries, and was therefore a trade-reducing FDI.

192 CHAPTER 6 The Rise of the China and the Economic Integration of East Asia developed countries exporting parts to developing countries, which exported finished goods outside the region. Radelet and Sachs (1997) claim that East Asian countries’ economic growth was backed by an export-led policy, which focused on exporting even simply manufactured goods. They argue that the flying geese model was a market-led model, in that industries moved on the basis of comparative advantages. After the Second World War, Japan’s Ministry of International Trade and Investment (MITI) initiated policies to foster development of the steel, automobile, and electronics industries. The NIEs, including Korea, followed Japan’s industrial policy, selecting and fostering target industries. Japanese capital and technology served as the basis for the industrial growth of other East Asian countries that lacked their own technological skills and capital. In the 1960s, Japan started to transfer labor-intensive industries like textiles and needlework throughout East Asia, for based in Japan they were starting to lose competitiveness. Consequently, other countries in East Asia developed these sectors into export-oriented industries. Thus the integration of East Asian economies through the 1960s, 1970s, and 1980s took the form of a typical flying geese pattern, with Japan in the lead.

2-2 Production Sharing and Bamboo Capitalism

With the signing of the Plaza Accord in 1985, Northeast Asian countries started to invest in Southeast Asian countries, a process that facilitated the division of labor in manufacturing industries across East Asia. Japan’s investments in the region increased sharply at around this time: in the four NIEs, the value of its investments soared from US$720 million in 1985 to US$4.9 billion in 1989, while over the same period in the ASEAN 4, they jumped from US$600 million to US$2.78 billion. Meanwhile, two NIEs, Korea and Taiwan, started to invest in Southeast Asian countries, particularly in labor-intensive industries that would manufacture products for export to third countries. Companies in Korea and Taiwan sourced parts and intermediate goods from their own countries, manufactured finished products in Southeast Asian countries where they were investing, and exported these goods outside the region. As Southeast Asian economies grew, Northeast Asian countries started to

2 Japan and Economic Cooperation in East Asia 193 advance into their domestic markets. While their initial purpose of investing in Southeast Asian countries after the Plaza Agreement was to produce goods using cheap labor, and then to export these goods to foreign markets, they now started to produce goods for the domestic markets of their host countries as well. Japan focused on investing in the electronics sector, while Korea and Taiwan advanced into the shoe, textiles, and electronics industries. With competition growing among Northeast Asian firms, large companies even sought to bring their part suppliers with them into Southeast Asia. At the same time, they started to source parts from these countries at the lowest price. The eventual result was the creation of a supply chain. Direct investments by Northeast Asian companies in Southeast Asia resulted in production sharing across the East Asian region. Production sharing is international production through vertical production chains formed among a number of countries. The term can also refer to the creation of a distribution network such as those found in Germany, Hungary, the Czech Republic, the US, and Mexico. The mechanism of production sharing begins with a country producing parts in which it has a comparative advantage over other countries. These are then gathered to make finished products, perhaps in another country. Through this modularization process a supply chain is formed. High value–added and high-tech parts and products are manufactured in developed countries, low value–added and low-tech parts and products in countries with an abundant supply of cheap labor. Over time, the number of countries participating in this supply chain increased, and the growth of industries in each country had spillover effects for other countries’ industries. Companies became more inter-linked in terms of investment. This horizontal network and expansion of a supply chain differs from the flying geese model, which is, as said, characterized by the vertical transfer of technology from more to less developed nations. The new model was more like a stalk of bamboo, in which each joint bears leaves that point in several directions, and which come together to form a dense thicket. The term “bamboo capitalism” (Roland- Holst 2003, p. 15) refers to the FDI-driven supply chain that has created diverse and vibrant local industries around East Asia. Indeed, from the mid-1980s until early 2000, East Asian countries were all able to grow in such a way that each one’s specific industries stimulated another country’s industrial growth. Production sharing, or supply networking, was most vital in the auto and

194 CHAPTER 6 The Rise of the China and the Economic Integration of East Asia electronics industries. In the former, Toyota and Honda of Japan created a horizontal supply chain with Southeast Asian countries through ASEAN's Brand-to-Brand Complementation (BBC) scheme. Korean and Japanese electronics manufacturers created a similar supply chain in Southeast Asia. In 2001, office machinery (SITC 759) and telecommunications equipment (SITC 764) accounted for 37.5% and 27.7% respectively of East Asia’s total components trade (Ng and Yeats 2003a). Considered as an international division of labor, production sharing is a key factor in the development of bamboo capitalism. Promoting foreign investments and production by means of fragmentation, companies make the most of their comparative advantages over other countries, which are a function of technological gaps and differences in relative factor endowments.4 Production sharing applies the Heckscher-Ohlin factor endowment theory, which explains the principles of comparative advantage. Further preconditions of production sharing are agglomeration and the internationalization of companies. When the necessary preconditions are in place, production sharing will boost investments in less developed countries, and the development of one area will lead to the economic development of the entire region. In the case of East Asia, every country in the region wanted to participate in the production-sharing network, and enhanced inter-country cooperation expanded trade within the region. Companies took the expanded trade as an opportunity to grow and specialize. For example, ASEAN promoted the BBC scheme to foster automobile industries in its member states. The scheme provided tax benefits to companies exporting and importing auto parts, which resulted in the specialization by each country in particular parts—leading in turn to a sharp increase in intra- region trade. As of 2001, export of parts accounted for 26% of the total industrial goods exported in East Asia (Ng and Yeats 2003a). Intra-regional export of parts grew 15% annually on average between 1984 and 1996, surpassing the total export growth rate of 11% by a margin of four percentage points (Ng and Yeats 2003b).

4 “Fragmentation” refers to breaking the production process into more than two parts. In the present case the fragmentation is by region. When the production costs of fragmentation are lower than those entailed in a single plant, it can be said that there has been production sharing. For production sharing to be realized, the entire cost of production, including all service link costs, in other words costs entailed in linking each area’s manufactured products, must be cheaper than production in a single plant.

2 Japan and Economic Cooperation in East Asia 195 3

The Collapse of Existing Order

3-1 China Ascendant

Since 1978, when it took up reform and adopted open-door policies, China has grown rapidly, in large part by attracting foreign direct investment. It drew FDI by creating special economic zones and watched its international creditworthiness improve steadily through the 1980s. Though in the early stages of China’s market opening, European and American investors were reluctant to invest, overseas Chinese were willing and able. Foreign investment in China faltered after the events in Tiananmen Square in 1989 but had recovered by 1992. In 1993, FDI in China stood at US$27.5 billion, up from only US$4.4 billion in 1991. China’s economic development drew particular attention after the 1997 Asian financial crisis. East Asian countries that had relied on exports for their growth suffered negative economic growth rates after the crisis. China’s economy, meanwhile, grew by as much as 7.9% between 1996 and 2000, and by an average of 8.1% between 2001 and 2003 (Table 6-2). In particular, China’s GDP growth rate stood at 9.1% in 2003, about three times the growth rates recorded by Korea, Taiwan, and Hong Kong, and higher still than Singapore’s 1.1%. Meanwhile the GDP growth rates of the Southeast Asian countries came in between 4% and 6% in 2003. Inbound FDI contributed significantly to the Chinese economy in terms of both quantity and quality, as it resulted in increased capital, the creation of high value–added industrial structure, higher tax revenues, and an expansion of trade. Foreign-invested enterprises (FIEs) played a large part in China’s economic

196 CHAPTER 6 The Rise of the China and the Economic Integration of East Asia Table 6-2 GDP Growth Rates in East Asia (Unit: %) Country 1991-1995 1996-2000 2001 2002 2003 Japan 1.5 1.4 0.4 -0.3 2.5 Korea 7.5 4.9 3.8 7.0 3.1 Taiwan 7.1 5.7 -2.2 3.6 3.2 Hong Kong 5.3 3.5 0.5 2.3 3.3 Singapore 9.0 6.2 -2.0 2.2 1.1 Malaysia 9.5 4.7 0.3 4.1 5.2 Thailand 8.6 0.4 2.1 5.4 6.7 Indonesia 7.8 0.7 3.5 3.7 4.1 Philippines 2.2 3.9 3.0 4.4 4.5 China 11.6 8.3 7.3 8.0 9.1

Sources: Asia Development Bank, Chinese Statistical Yearbook (various years).

system reforms, including technology and management innovation and the restructuring of industrial sectors. Moreover, technology transfer facilitated by foreign investments contributed greatly to the development of the country’s manufacturing sector and to the upgrading of its industrial structure. Since the mid-1990s, when domestic demand started to grow rapidly, FIEs have brought advanced facilities and research and development (R&D) centers into the country, as a result of which the technologies in China’s electronics, consumer electronics, and automobile sectors were brought up to global standards. Foreign capital also stimulated exports, enabling China to integrate into the world economic system. In mid-1980s, China’s exports stood at US$18.2 billion, equivalent to only 8.2% of total exports by the US and 14% of Japan’s. But by 2004, China’s exports had climbed to US$593.6 billion, its imports to US$568 billion, beating out Japan and displacing China to third in the world. There is no question that foreign capital contributed significantly to the expansion of China’s trade: in 2004, FIEs accounted for 57.8% of China’s total imports and 57.1% of its total exports (Figure 6-1). However, the export share of FIEs (by volume, US$340 billion in 2004) grew faster than their import share, climbing from 40.7% in 1996 to the aforementioned 57.1% in 2004.

3 The Collapse of Existing Order 197 Figure 6-1 Exports of Foreign-Invested Enterprises in China

US$billions %

Source: Ministry of Commerce in China.

3-2 China, Flying Geese, and Bamboo Capitalism

The flying geese model started to show its limits after the mid-1990s. Granted, the region’s market share grew from 13.4% in 1980 to 25.4% in 2003, and East Asia, excluding Japan, saw exports increase during this period; in 1995 in particular, exports surged by as much as 25.6% (Table 6-3). However, they began to stagnate or decline after that point, while China’s exports continued to rise. Thus the overall global market share for East Asian exports fell. The flying geese model stopped working because Japan lost the ability to innovate at the same time as China entered the global market. Japan started to suffer economically in the early 1990s because of sluggish reform efforts and a declining capacity for technological innovation. And yet, though the lead goose was faltering, other East Asian countries found it difficult to shift the direction of their economic development. China’s advance onto the global stage further complicated matters, as it created fierce competition for its Asian neighbors, the NIEs and Southeast Asia. As a result, the terms of trade for these countries were

198 CHAPTER 6 The Rise of the China and the Economic Integration of East Asia badly undermined, which expanded their current account deficits. Eventually, the region was hit by a currency crisis.

Table 6-3 Relative Shares of the Global Export Market (Unit: %) Year East Asia Japan NIEs ASEAN 4 China US EU World 1995 25.6 8.6 10.4 3.7 2.9 11.3 40.4 100.0 2000 25.7 7.4 10.3 4.1 3.9 12.1 35.9 100.0 2003 25.4 6.3 9.5 3.7 5.9 9.7 38.7 100.0

Note: NIEs are Korea, Taiwan, Hong Kong, and Singapore. The ASEAN 4 are Malaysia, Thailand, Indonesia, and the Philippines. Source: WTO.

In the 1980s, when the flying geese model was performing effectively, the US was the major export market for developed countries in East Asia. The dependency of Japan and Korea on the US as an export destination was already high in the 1970s, higher than that of other East Asian countries, and it reached a peak in the 1980s, with Japan’s dependency ratio standing at 36.8% and Korea’s at 38.9% in 1987. Singapore, one of the emerging market economies, increased its export dependency to the US faster than other emerging markets, exceeding 20% in 1984. However, its dependency on the US has since fallen as it has started, with the growth of Southeast Asian countries, to serve as an entrepôt to the region. Malaysia and Thailand, which began developing economically later than other East Asian countries, saw their export dependency on the US peak in the 1990s, mainly with the help of investment from Japan and Korea (Table 6-4). Malaysia’s export dependency on the US stood at 20.3% in 1993 and Thailand’s at 22.7% in 1990. Following the path taken by its predecessors, China started to increase exports to the US. Although its US exports rose steadily from the 1970s, its dependency grew more abruptly in the 1990s, rising from only 8.5% in 1990 to 18.5% in 1993. This competition affected the exports of Malaysia and Thailand severely, as they had only started to export to the US a little earlier. In short, the surge in China’s exports to the US undermined the competitiveness of East Asia–made products in the global export market.

3 The Collapse of Existing Order 199 Table 6-4 Asia’s Export Dependency on the US Market (Unit: %) Year Japan Korea Singapore Malaysia Thailand China 1975 20.2 30.2 13.9 16.1 11.1 1.0 1978 26.8 32.4 16.1 18.6 11.0 2.8 1981 25.7 26.7 13.2 13.1 12.9 7.0 1984 35.6 36.0 20.0 13.5 17.2 9.3 1987 36.8 38.9 24.4 16.6 18.7 7.7 1990 31.7 28.6 21.3 16.9 22.7 8.5 1993 29.5 21.2 20.4 20.3 21.5 18.5 1996 27.5 16.0 18.4 18.2 18.0 17.7

Source: IMF.

China’s competition with East Asian countries, more specifically Southeast Asian countries, had unfavorable consequences for East Asia. Each country in the region had its own export-oriented strategy that contributed to economic growth, but China’s emergence brought about excessive competition among them, leading eventually to a “fallacy of composition.”5 In short, China’s rise threw the flying geese model into disarray, as China did not follow the path of its predecessors in Southeast Asia who had been manufacturing labor-intensive products (Erturk, 2002). In addition, as competition became intense, East Asian countries that depended heavily on mass production had no choice but to cut their export prices, thereby worsening their terms of trade. This deterioration in terms of trade undermined real purchasing power, in turn lowering standards of living. Once tensions caused by the Tiananmen Square incident eased in early 1990s, exports by East Asian countries to China increased rapidly. Investment by Japanese companies in China surged from US$350 million in 1990 to US$4.5 billion in 1995 (Figure 6-2). Investment by Korean companies jumped to US$700 million in 1995 from just US$15 million in 1990. With the Taiwanese government

5 Warnings of a “fallacy of composition” had been sounded repeatedly since the 1980s, when East Asian countries started to export industrial goods on a massive scale. According to this view, while a country can achieve independent growth through an export-oriented industrial policy, if another country uses the same strategy, the system will eventually fail due to worsening terms of trade.

200 CHAPTER 6 The Rise of the China and the Economic Integration of East Asia allowing indirect investment in China after the late 1980s, Taiwanese companies made aggressive investments in China in the 1990s.

Figure 6-2 Japanese FDI in East Asia (1990–2003)

(Unit: US$millions)

Early investment by East Asian countries took advantage of China’s cheap production factors to manufacture goods and export them outside the region. Companies that used China as a production base tended to bring in intermediate goods or parts from parent companies in their own countries. As a consequence, the trade between East Asian countries and China took on a vertical division of labor in production. A good example is the contract manufacturing of Taiwanese information technology (IT) goods in China. In 2002, Taiwanese companies manufactured, 40% of laptops, 55% of desktop computers, and 68.7% of digital cameras in China. China’s rise spurred an expansion of the existing production-sharing network. As the Chinese market grew, investments were now extended to the country’s domestic market to produce durable goods for domestic consumers. In this way, investment increased in home electronics, IT goods, and automobiles. In addition, investments in industrial materials like steel products and petrochemicals increased. In short, investments in China expanded the supply chain, the network of parts and intermediate goods characteristic of bamboo capitalism, a process that had spill-over benefits for the developing economies of Northeast Asia and China. However, bamboo capitalism began to show its own weaknesses in 2000.

3 The Collapse of Existing Order 201 Because of China’s rapid growth, foreign capital was increasingly flowing into the Chinese market to the exclusion of other markets (Figure 6-3). When FDI declined in East Asia in the latter half of 1990s, in the wake of the economic crisis, China was no exception—but FDI in China started to bounce back in 2000, while investments in Southeast Asian countries continued to fall. FDI in Korea, Taiwan, and Singapore also fell drastically. It appeared that the joint development of East Asia was being thrown off by the sheer mass of the Chinese economy. The multiple linkages that bamboo capitalism had made between Northeast and Southeast Asia were not indestructible.

Figure 6-3 FDI in the East Asian Region

(Unit: US$billions)

Note: NIEs and Korea, Taiwan and Singapore, The ASEAN4 and Malaysia, Thailand, Indonesia, and the Pilippines Source:UNCTAD(2003).

3-3 Economic Integration and the Reduction of Service Link Costs

China’s trade, which had started to increase rapidly in the mid-1990s, accelerated further with its entry into the WTO in 2001. China was the third largest trading nation in the world in 2004, with imports from East Asian countries outpacing such imports by Japan (Table 6-5). One implication is that China has a far better market creation capacity than Japan. Another is that East Asian countries depend more on China than on Japan as

202 CHAPTER 6 The Rise of the China and the Economic Integration of East Asia an export destination. In fact, China has become the center of East Asian integration. China’s imports from East Asia stood at US$292.9 billion in 2004, far surpassing Japan’s US$195.8 billion. In particular, the import figure climbed by US$69.7 billion from 2003 for China, whereas it rose only US$34 billion for Japan (Figure 6-4).

Table 6-5 Weight of Chinese and Japanese Imports in East Asia

(Unit: US$billions, (%)) Rate of 1998 2000 2002 2003 2004 Change Total imports (A) 140.4 224.7 295.4 412.8 560.8 (26.0) Total imports from East Asia 79.0 108.0 160.6 223.1 292.9 (24.4) China Imports from East Asia excluding Japan (B) 50.7 57.9 107.1 149.0 198.7 (25.7) Weight (B/A) 36.1 30.2 36.3 36.1 35.4 - Total imports (A) 280.8 381.1 336.8 381.5 454.3 (8.3) Total imorts from East Asia 97.6 150.8 139.4 161.8 195.8 (12.3) Japan Imports from East Asia excluding China (B) 60.7 95.5 77.7 86.6 101.6 (9.0) Weight (B/A) 21.6 25.1 23.1 25.3 22.4 -

Note: East Asia includes Japan, China, NIE 4, and ASEAN 4. Sources: UN, JETRO, Ministry of Economic Affairs of Taiwan.

Figure 6-4 Chinese and Japanese import Creation with Respect to East Asia

(Unit: US$billions)

3 The Collapse of Existing Order 203 The basic strategy of Northeast Asian countries coping with the rise of China has been to exploit China’s domestic market and to maintain a technological advantage in order to avoid competition on the global market. In order to stay ahead in technology front, Northeast Asian countries are nurturing high value–added activities and intermediate goods, as well as logistics, R&D, and the travel service sector, while transferring low-tech production to China. These steps imply that the countries of Northeast Asia aim to avoid direct competition and to maintain a vertical relationship with China that can benefit both parties. In other words, if Northeast Asian countries continue to transfer production activities to China, their investments in China will increase, facilitating the continued economic integration of East Asia. China, however, is moving to upgrade its technological skills in order to sustain its growth, and as part of this endeavor will continue to attract foreign capital. China is also likely to acquire advanced technologies on the back of its abundant foreign exchange reserves, and to move towards acquisition of Northeast Asian companies. If it does, we may see, instead of the sort of unidirectional relationship that has held between Northeast and Southeast Asian countries, a more equal relationship in which technology and FDI flow both ways. The deepening economic integration between Northeast Asia and China will facilitate their institutional integration as well. Over the long term, trade and investment will increase within East Asia, prompting countries and companies to support FTAs that will reduce the cost of trade. Japan, China, and Korea are currently in discussions or negotiations toward bilateral FTAs with Southeast Asian countries (Table 6-6). The ASEAN Free Trade Agreement (AFTA), a multilateral FTA, has already been completed. ASEAN, Korea, China, and Japan are all promoting FTAs. Research on an FTA among three Northeast Asian countries is currently being conducted and will soon be ready for discussion. These various efforts are likely to come together eventually as an East Asian Free Trade Agreement (EAFTA).

Table 6-6 Status of FTAs in East Asia (as of the end of 2004)

Country Status Korea–Japan Under government negotiation, completion scheduled for 2006. Japan–Malaysia Under negotiation.

204 CHAPTER 6 The Rise of the China and the Economic Integration of East Asia Japan–Philippines Negotiations completed Nov. 2004. Korea–ASEAN Negotiations starting in 2005, FTA formation scheduled for 2009. Japan–ASEAN Negotiations starting in 2005, FTA formation scheduled for 2012. China–ASEAN Negotiations completed Nov. 2004, FTA formation scheduled for 2010. Korea–China–Japan Under review.

Although political conflicts persist between Japan and China, the two countries will nonetheless promote institutional integration. In fact, as pointed out in an earlier chapter, the two have an economically complementary relationship. Japanese companies believe that an FTA with China will open considerable business opportunities (Figure 6-5). China needs Japan’s technology and capital, while Japan needs China’s market. There are also political movements to shift the current ASEAN+3 system to the East Asia community at large. East Asian countries inaugurated the ASEAN+3 system after the currency crisis in a bid to promote economic cooperation and to discuss common interests, and an ASEAN+3 summit is now held annually. But the summit takes the form of ASEAN inviting the three Northeast Asian nations as a group, and some have argued recently for a system in which each Northeast Asian country can participate in the summit as an independent party. To this end, the 2004 ASEAN+3 Summit decided to hold the first in 2005.

Figure 6-5 Japanese Business Circle’s Perceptions of FTA Business Opportunities

(Unit: %)

Source: Kajita(2004).

3 The Collapse of Existing Order 205 Popular support for FTAs in the Northeast Asian region and the establishment of EAFTA will help reduce service link costs among the countries involved. As explained above, economic integration reduces service link costs entailed in production sharing by allowing unhindered trade, by simplifying FDI procedures, and by reducing information acquisition costs. Specifically, service link costs can be reduced as production processes are fragmented in the context of deepening economic integration. That deepening integration in turn facilitates investment.

206 CHAPTER 6 The Rise of the China and the Economic Integration of East Asia 4

The “Lily Pad” Model of Regional Development

4-1 Large-Scale Economic Clusters in the Northeast Asian Region

The concentration of economic activity in certain areas in the process of development has been an important topic in the study of economic geography. The Tokyo area and the Kansai region encompassing Osaka and Nagoya are such areas; Korea has the Kyongin Industrial Region and the Southeast Industrial Region. These economic clusters are areas that have achieved high economic growth. Krugman (1991) believes that economic agglomeration is facilitated when there are increasing returns to scale in production. Venables (1996) insists that a cluster is formed in cases where transportation costs are reduced in vertically linked industries under imperfect competition. An agglomerated region is an industrial cluster or cluster of economic activity that creates external economies of scale. When economic activity is concentrated in a certain area, agglomeration tends to be facilitated, according to the theory of “external economies of scale” proposed by Alfred Marshall. Marshall believes that an external economy is created within a cluster because of the accumulation of labor, the efficient supply of intermediate materials, and the spread of technology. External economy facilitates diversification within a cluster by inducing more companies and industrial activities. It also transforms industries with low productivity into sectors with high value–added productivity. Specifically, manufacturing industries can be upgraded into capital-intensive industries producing high value–added technologies. In the process, financial and distribution services will develop to support the manufacturing industries, and R&D activities will expand.

4 The “Lily Pad” Model of Regional Development 207 Once an area has become a cluster, as time passes it will face diseconomies of agglomeration such as overpopulation, surging real estate prices, and labor shortages. When a cluster reaches this stage, companies located in it will shift their facilities to areas that offer locational advantages, in particular to areas where they can minimize production costs. The best location for an alternative cluster is often near a country’s border, where foreign investments can be applied efficiently to production fragmentation and cost reductions. As companies agglomerate in one of these regions, the cluster expands in scale and crosses the border as companies invest in the neighboring country. Thus a cross-border cluster is formed that links two or more countries to one other.6 Once a cross-border cluster is created, it grows and forms a market, drawing more industries into the area and propelling further growth. Since China opened its market, its coastal region has experienced rapid economic growth backed by foreign investment. That growth has created three economic clusters: the Pearl River Delta in Guangdong, which was the first area in China to implement the new opening-up policies; the Yangtze River Delta around Shanghai, which has recently shown rapid growth; and a third cluster encompassing Beijing and Tianjin. The PRD is a large cluster encompassing Guangdong and crossing the border to draw in parts of Taiwan and Hong Kong, while the YRD and the Beijing-Tianjin cluster are connected with the Korean peninsula. One reason for governments to foster cross-border economic clusters is that they reduce service link costs. Indeed, countries that want to attract foreign capital will try to reduce such costs by creating industrial complexes and enhancing relevant infrastructure. When service link costs are reduced, parts production can be divided according to each nation’s comparative advantage.7 In this process, a government

6 Kim (2004) refers to this type of agglomeration in East Asia as “inter-local cross-border cooperation.” He argues that this sort of cooperation can induce regional integration, and that it will be facilitated by economic complements, geographic proximity, and cultural intimacy. 7 It is a longstanding theory that agglomeration (either within a country or cross-border) occurs during the process of economic development. It is also generally accepted that agglomeration raises profits (externality). Recently, however, it has been argued that dis-agglomeration is being promoted because of the emergence of production sharing. That is, if the increasing returns to scale regarding service linkage costs are achieved in the fragmentation process (dividing manufacturing process over countries or regions), then production sharing has the advantage over agglomeration. See Jones and Kierzkowsky (2003).

208 CHAPTER 6 The Rise of the China and the Economic Integration of East Asia typically encourages foreign investments, or promotes a “regionalization of production” to concentrate resources in a certain area (Table 6-7).8

Table 6-7 Process of Cluster Expansion

Globalization Large-Scale Domestic Clusters (Foreign Investments) Economic Clusters �Increasing returns to scale �Reduction of production costs �Economic integration - Existence of trade costs - Fragmentation of production - Tariff cuts - Drop in service link costs �Economies of agglomeration �Technology acquisition �Expansion in markets and externality �Advancements into markets �Economies of agglomeration in - Existence of trade costs a large-scale economic cluster

4-2 A New Leaf: The “Lily Pad” Model

FDI is the key force in this new pattern of regional economic development in East Asia. In particular, Taiwan’s heavy investment in China has been a key factor in the formation of two economic clusters there. The first was the Pearl River Delta, where growth came about through fragmentation of production by Taiwanese and Hong Kong companies. In time, however, the region encountered diseconomies of agglomeration, including a surge in real estate prices and a shortage of both unskilled and skilled labor. As a result, investment inflow into the region stagnated. Taiwan’s investment in Guangdong accounted for only 23.6% of its total outward investments between 1998 and 2003, down from 32.5% (US$3.5 billion) in the 1993–1997 period. The figure fell further to 19.9% in 2004 (as of the end of August). Inward investment in the PRD accounted for around 45% of

8 The Singaporean government made it a national strategy in the early 1990s to promote domestic companies’ foreign investments. It encouraged Singaporean companies, mainly government-linked companies (GLCs) to invest in China, India, and Indochina on a massive scale. At the same time, the government promoted construction of the Suzhou town complex in China.

4 The “Lily Pad” Model of Regional Development 209 total inward investment in China in 1990, but had fallen to just 15% in 2003. In contrast, the share of investment in the Yangtze River Delta increased from 10% to 40% over the same period (Figure 6-7). Jiangsu province in the YRD is now the most popular destination for Taiwanese companies, with 55.4% of their total outward investment flowing into this area in 2004. Meanwhile, Korean companies that had until recently directed their investment to the Yellow Sea area have also shifted to large-scale investments in the YRD region. The type of investment has also changed, from conventional labor-intensive manufacturing in Shandong for export to countries outside the region, to domestic-oriented investments in newly growing areas such as Shanghai and Jiangsu.

Figure 6-7 Shift of Foreign Investment in China’s Two Economic Clusters

US$billions %

Source: China Statistical Yearbook (various years).

Thus, just as in the case of its predecessor, the YRD has become a large- scale cluster thanks primarily to foreign investors. With the help of increasing investment by Western as well as Korean and Taiwanese companies, the YRD area has grown to encompass Shanghai, Zhejiang, and Jiangsu. Moreover, with increases in revenues contributing to the expansion of domestic demand, the YRD is now attracting foreign investment directed towards the domestic

210 CHAPTER 6 The Rise of the China and the Economic Integration of East Asia market. The “lily pad” model of regional development holds that large-scale economic clusters of this sort will be created in the East Asia region, one after another, just as the leaves of a lily pad form. New clusters will be created through market functions when the comparative advantages of an existing cluster change. Specifically, as a cluster develops and takes on more technology- and capital-intensive production activities, concentrated investment will tend to shift to other areas where production factors are cheaper. For example, as the PRD and the YRD grow more advanced, the provinces known as the “Northeast Three” are emerging as a new cluster in China, aided by proactive policies and resource development by the Chinese government and by links with Korea and Japan. Moreover, as East Asia works towards institutional integration through FTAs and other means, new leaves can form in areas outside China (Figure 6-8). In the Southeast Asian region, the Malay Peninsula and the Mekong River area are poised to develop as major clusters. A new cluster may also develop in the Southeastern Indian region as India deepens its cooperation with Southeast Asian countries through the formation of FTAs. The lily pad model of regional economic development can be explained as

Figure 6-8 Actual or Potential “Lily Pad” type Clusters in East Asia

Northeast Three Kyeongin Region Beijin-Tianjin

Yangtze River Delta(PRD) Kanto Region

Pearl River Delta Hanshin Region

Mekong Region Southeastern India

Malay Peninsula

4 The “Lily Pad” Model of Regional Development 211 follows. The leaf of a lily pad goes through growth stages, from budding to expansion to maturity. During this process, it will maintain an organic relationship with other leaves. Specifically, as the maturing leaf starts to face diseconomies of agglomeration, it will create an offshoot through the export of components, that is, a new leaf in the form of increased investments elsewhere in the region. This new leaf will attract investment from the mature leaf, and will depend on it for parts and intermediate goods until it enters its own expansion phase. During the process, the integrated economy of East Asia (through EAFTA and the East Asia Community) will serve as root and stem, connecting and nourishing the various clusters as they arise.

4-3 East Asian Economic Integration through the Lily Pad Model

As large-scale economic clusters develop, East Asian countries, which achieved growth through the flying geese model of development and then through bamboo capitalism, will shift to a lily pad pattern of continued growth and deepening economic integration. In the flying geese model, low value–added industries were transferred to countries following the path of their predecessors, and one after another East Asian countries developed as exporters of industrial products. During this period, agglomeration took the form of small clusters such as industrial complexes. With the shift to bamboo capitalism, East Asian economies were able to grow through production sharing and networking of parts production. This expanded the division of labor to the entire East Asian region. Small-scale clusters expanded somewhat, but large-scale clusters were yet to develop. In the lily pad pattern now coming into play, one leaf after another will arise—one large-scale regional economic cluster after another. Like the growth of the lily pad, the process is an organic one, in which the maturation of each leaf prompts the budding and expansion of new leaves. Thus the lily pad model enables the region to achieve and maintain growth momentum. As a cluster’s maturation causes production cost increases, the transfer of investment to other regions will give rise to new clusters. Though at first the new leaf will take nourishment from its parent leaf, in time it will become an independent, self-sufficient body. That is, as companies transfer

212 CHAPTER 6 The Rise of the China and the Economic Integration of East Asia their production bases to a new region, that region will see an increase in foreign investment, which will bring about an expansion in trade, but once capital has accumulated and an independent market forms, the region will be a self-sustaining cluster. This large-scale cross-border cluster will see intra-industry trade and investments increase even after reaching self-sufficiency. Once the cluster is self- sustaining, the potential for new export creation may decline, but as diseconomies of agglomeration occur, the cluster will provide capital and products to nourish a new leaf. Consequently, although the new leaf will function as an integrated body, the entire East Asian region will be a set of loosely linked large-scale clusters.

Figure 6-9 Life Expectancies of East Asian Development Models

Flying-geese patternBamboo Capitalism Lily-pad pattern

1960 1985 1995~1997 2001~2003

China has played an important role in the growth of East Asia’s economy. When the Plaza Accord was reached in 1985, the flying geese began to fade from view as bamboo capitalism emerged. In this time China was beginning to harvest the fruits of its market opening. By the early 1990s, as China overcame the effects of the Tiananmen Square incident and encroached on the export markets of other Asian countries, the flying geese had disappeared almost entirely. China’s entry into the global economy at that time contributed to the expansion of bamboo capitalism, but the currency crisis significantly undermined this development model. Meanwhile, in the latter half of the 1990s, China’s growth offered the basis of a new development model, an opportunity for the formation and expansion of large-scale clusters in East Asia. Indeed, since 2002, China has been contributing to the East Asian economy through significant imports from East Asian countries.

4 The “Lily Pad” Model of Regional Development 213 5

Conclusion

Starting in the 1960s, East Asian countries achieved strong economic growth through an outward-looking policy. These countries’ economies grew one after another, following the path taken by their predecessors, with Japan in the lead. However, their dependence on Japan’s direct investment produced in time a vertical division of industry, the eventual result of which was a chronic trade deficit with Japan. Although in the early 1990s these countries began to invest aggressively in the materials industry to make up for their lack of technology, they fell nonetheless into the currency crisis of 1997–1998. As the century came to a close, they were faced with a new paradigm, one created by that crisis and the restructuring that resulted. China’s influence in East Asia increased rapidly after the currency crisis. The growth potential of East Asian countries had been undermined considerably, whereas the Chinese economy continued to grow robustly. With the further boost of entry into the WTO at the end of 2001, China introduced strong market-opening policies, worked aggressively to attract foreign investment, and concentrated on mass production on the basis of cheap production costs. In this way, China became a world production base in short order. At the same time, China has absorbed quickly goods from East Asia into its vast market, becoming, as a result, the world’s third largest importer, ahead of Japan. East Asian countries have now come to depend on China to make up for their sluggish exports to the US and Japan. Increased investment in China by East Asian countries has also facilitated a division of industries between the two—a division based on a horizontal relationship, different from the vertical relationship that linked Japan and East

214 CHAPTER 6 The Rise of the China and the Economic Integration of East Asia Asian countries in the past. Clearly, rising foreign investment in China will eventually contribute to the growth of other East Asian economies. Nevertheless, China will not eclipse Japan immediately. Japan still possesses a higher level of technology, as well as abundant capital on which even China continues to depend heavily. Emerging markets and Southeast Asian countries will have to work continuously to capitalize on China’s rapid growth, while at the same time acquiring technology and capital from Japan. In other words, the East Asian region will develop between two pillars of strength, China and Japan. Both countries will strive to increase their economic influence over other East Asian countries—as evidenced in the current competition to conclude FTAs. Southeast Asian countries that have been targeted for economic integration by both countries will likely seek to maintain an equal distance from each. In the long run, however, East Asia will be integrated into a single economy, as Japan seeks closer cooperation with China. Though Japan’s economy has rebounded from its long recession, its potential growth rate is falling because of the rapid aging of its population, and Japanese companies are eager to catch up with other multinationals in their advance into the Chinese market. The economic integration of East Asia will create a new pattern of regional development based on trade liberalization and foreign direct investment. The clusters that are presently forming, expanding, and producing offshoots, as described in the lily pad model, will over the long term revitalize economies across East Asia. Crucial to this growth, however, are continued economic integration and the further liberalization of foreign investment. The countries of East Asia need to continue to open trade and investment and to enhance networking between the large-scale, cross-border clusters taking shape across the region. In other words, they need to allow one leaf after another to form in a timely manner, and to ensure that trade and investment can flow freely between them.

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