Trade Profile: China Stands Its Ground

15 MINS READSep 25, 2017 | 09:00 GMT
The skyline of Shanghai, November 2016.

The skyline of Shanghai.

Editor's Note

Global trade is changing. The kinds of multilateral agreements that characterized the postwar years have stalled over the past two decades, prompting countries and economic blocs to try to negotiate smaller deals with fewer partners. Nations and blocs have more leeway under this new model to negotiate the trade agreements that best suit their interests and to avoid those that don't. Now, more than ever, the future of international trade depends on a country or bloc's defensive interests, offensive interests and underlying factors of production. Our fortnightly Trade Profiles aim to break down these factors to facilitate an understanding of where global trade stands today and where it's headed.

In the 10th installment, we focus on China.

A snapshot of China

Economic Background

China's economic rise has been nothing short of astounding. In the span of a few decades, the country brought itself out of isolation and into the center of the global economy. Though the country followed a similar trajectory to that of Singapore, Taiwan, South Korea and Hong Kong — the so-called Asian Tigers — as it developed its economy, the challenges and considerations it dealt with along the way set its story apart. And its transformation isn't over yet.

For nearly all of its four millenniums of recorded history, China has been the dominant player in its trade dealings. The vast fertile lands of the Central Plain and Jiangnan regions along the Yellow and Yangtze rivers, coupled with revolutionary advances in agricultural methods and technology, helped support a large and industrious population. Soon enough, China had established itself as an economic force to be reckoned with (though from time to time the empire had to contend with invading nomadic hordes). Merchants from Japan, India, Europe and the Arab lands flocked to the country to buy coveted Chinese goods such as silk and porcelain. With an unmatched reputation for quality and a steady stream of foreign capital pouring into its coffers, China grew supremely confident of its place in the world.

By the 19th century, however, its fortunes had turned. European traders, empowered by the technological progress of the Industrial Revolution, forcibly opened China up to trade on their terms. China dubbed the ensuing period the "Century of Humiliation," when between 1839 and 1949, Western powers and then a newly industrialized Japan forced their way onto the mainland and entrenched themselves there using lopsided treaties or, in Japan's case, full-fledged invasion. China emerged from the tumultuous era having lost Taiwan, Hong Kong, Macau and Tibet.

When the Communist Party took power in 1949, it focused on restoring China's sovereignty. The country quickly regained control of Tibet and severed ties with the outside world. Its government then established manufacturing bases in remote, mountainous inland regions to protect them against foreign invasion and capture, while collectivizing agriculture and nationalizing private industry. Together, the moves created huge inefficiencies in the Chinese economy that, along with disastrous experiments such as the Great Leap Forward, Beijing's attempt to prioritize heavy industry above all else, left China isolated and poor.

A few decades later, China began rethinking its approach. Deng Xiaoping came to power and launched the "reform and opening" period in 1978, reversing many of his predecessor's policies. Beijing disbanded collective farms, and agricultural productivity rapidly increased. The central government also improved its relations with developed powers such as the United States and Japan, opening the doors for student exchange programs and technology transfers. At the same time, Beijing shifted the economy's focus from heavy to light industry while creating liberalized special economic zones along the coast that soon became magnets for investment from nearby Hong Kong and Taiwan. Critics in China decried the policies as a return to the days of treaty ports and foreign domination. But Deng emphasized sovereignty and national control at every turn to ensure that this time, the country would open up its economy at its own pace and on its own terms.

His timing couldn't have been better. Improved communications and the advent of the container ship meant that a country such as China, which offered cheap labor and reliable infrastructure, could become a manufacturing hub for the whole world. Thanks to the previous administration's focus on promoting population growth, the country was entering a period of demographic plenty as young workers with low wage requirements flooded the workforce. The Chinese government, meanwhile, raised interest rates and channeled much of the resulting revenues into infrastructure projects to boost manufacturing and export efficiency. And because China's currency, the yuan, was pegged to the U.S. dollar in the 1990s, its value didn't automatically appreciate as the country's economy boomed, making China even more competitive on the global market.

Many of these policies echoed measures that other Asian nations had implemented on their own paths to development. But the circumstances of China's economic evolution set the country apart from its peers. While states such as Japan, South Korea and Taiwan benefited from U.S. postwar investment and access to the enormous U.S. market as they built their economies, China had no such advantage. To make itself competitive with its neighbors, the country had to entice foreign companies to bring their operations — and with them, their capital and technology — to the mainland. Foreign direct investment into China soared as Beijing welcomed foreign businesses into the country. Under the resulting arrangement, China's exports consisted mainly of foreign-branded products, rather than the domestic goods that Japan and South Korea grew to rely on from firms such as Toyota Motor Corp. and Samsung Electronics. Yet like Japan and South Korea, China gradually moved up the value chain with its industrial manufacturing, progressing from light industry, such as textile production, through heavy industry and on to high-tech assembly.

China exports under foreign brands.

As Beijing cultivated its domestic manufacturing industry, it also introduced competition into the economy in fits and starts. Massive state-owned enterprises dominated industry at the start of reform and opening, but corruption and inefficiency plagued the businesses, which increasingly operated at a loss. Recognizing the need for reform, Beijing released township and village enterprises from state control, though the central government continued to supervise their operations. The firms flourished throughout the 1980s and helped form the foundation of China's fledgling socialist free market. Beijing continued its reforms in the 1990s, when it dismantled the larger state-owned enterprises, breaking them into various competing companies under the guidance of state-backed shareholders. (Even so, state-owned enterprises — and, by extension, the government — still predominate in upstream sectors such as energy and commodities.) Domestic private companies, meanwhile, slowly gained ground, albeit with considerable oversight from Beijing.

China's domestic market developed largely behind barriers that protected national firms from outside competition, while also letting foreign technology into the country as part of Beijing's strategy to attract outside investment. Today, most of the country's major private brands, such as electronics manufacturer Huawei, produce goods at prices low enough to offset their slightly inferior quality relative to the foreign competition. China often offers its domestic brands tax breaks, subsidies and hefty procurement contracts that it doesn't extend to foreign companies. Along with cheap inputs, the state's support helps Chinese firms keep their goods competitively priced and gives them an edge on the domestic market. But it also makes it harder for Chinese companies to make a dent in markets abroad, where they don't enjoy the same advantages that Beijing affords them at home. China struggles to create consumer brands nimble and flexible enough to keep up with their Western peers, particularly on quality. Despite countless attempts to challenge foreign manufacturers' ascendancy on the automotive market, for instance, Chinese cars can't stand up to their competition at home or abroad. A dearth of innovation, moreover, has kept Chinese companies from establishing themselves as leaders in technological advancement as their Japanese and South Korean counterparts have.

E-commerce is an exception to this trend. China has outperformed its Western peers in the burgeoning industry with help from lax anti-trust laws that have enabled single platforms to dominate the country's gigantic market. And though companies such as Alibaba Group Holding Ltd. and Tencent Holdings Ltd. built their businesses using ideas borrowed from the West, they have taken the concepts to new heights. Their giant interconnected ecosystems, for example, have fostered efficiencies in areas such as electronic payment that Western consumers can only dream of. Their innovations have paid off. In 2016, Tencent displaced Samsung as Asia's most valuable brand — a title Alibaba claimed for itself this year.

In 2001, Chinese exports got a major boost when China joined the World Trade Organization (WTO). The country's accession left other states with fewer options to counter its super-competitive goods, and in the export boom that followed, China rose to become the world's second-largest economy and largest trading country. Nevertheless, WTO membership came at a cost for Beijing. Joining the organization meant that China had to dramatically reduce its trade barriers around sensitive sectors such as agriculture and services. To mitigate the effects of the WTO's enforced liberalization, Beijing used non-tariff barriers to tip the scales in favor of key industries in its domestic market. A system of quotas, unique standards and phytosanitary requirements on foreign produce enables China to protect its agricultural sector, while heavy restrictions keep foreign investment and activity in the country in check. By maintaining these protections, China has largely managed to block foreign companies from penetrating its banking sector. Strict capital controls also allow the government to closely regulate flows of money into and out of the country.

China's trade partners, too, had recourse to defend their domestic markets after the country's induction to the WTO. Under the terms of its entry, China would not be eligible to receive official recognition as a "market economy" for 15 years. That period has now elapsed but many countries still have not recognized China as a market economy. The stipulation provided other WTO member countries with a way to legally block China's exports.

Regardless, China's export-driven growth stalled within the decade. The global crisis in 2008 dampened demand for Chinese goods abroad and forced Beijing to change tack. The government drastically expanded access to credit and flooded the economy with easy money. Infrastructure construction surged as a result, but because the country already had robust infrastructure — a stark contrast to the conditions of the last construction boom in the 1980s and 1990s — the returns on investment shrank rapidly. Furthermore, since loans rather than export revenues financed the projects, China's overall debt soared to over 250 percent of its gross domestic product. Reduced demand for construction then led to excess capacity in sectors such as steel and coal, and global prices for the commodities sank as Chinese producers unleashed their enormous surpluses on the international market.

The fallout of the past decade of investment-driven growth has proved that the strategy is not sustainable. Given the sheer size of the Chinese economy relative to the global market, and the diminishing returns on investments in the country, Beijing will have to find new ways to stimulate growth. The demographic trends underway in China also will force it to amend its behavior. China's population is aging quickly, and the effects of its "One Child Policy," which limited birthrates starting in the 1980s, are starting to manifest in the country's labor pool. On top of that, China's economic success over the past two decades have increased wage expectations among its dwindling workforce. Gone are the days when Beijing could rely on an abundance of cheap labor to run its factories and produce its export goods. Instead, China will have to wean its economy off investment and exports in favor of a model centered on consumption and services — assuming its massive debt doesn't cause a catastrophic financial crisis before it has the chance.

Implications for Trade

Trade Strategy

Like the Asian Tigers before it, China has worked to develop and open its economy on its own terms, resisting Western demands to liberalize sensitive sectors. But the country also has a few unique concerns that have guided its trade strategy over the years. Because its nonmarket economy status serves as a lingering barrier to its exports abroad, for instance, China requires countries to recognize it as a market economy before it will negotiate bilateral trade deals with them. Similarly, external territorial concerns have long influenced China's bilateral trade dealings. Beijing established its first special economic zones in Fujian and Guangdong to encourage trade ties with Taiwan and Hong Kong in hopes of bringing the territories back under its control. In the years since, China has used partnership agreements with Taiwan, as well as Hong Kong and Macau — now part of the country once again — to shape the terms of its relationships with them. (Beijing also has used trade agreements with other countries to assert its power over Taiwan, for instance by signing pacts only with nations that recognize its "One China" policy and discouraging its partners from making similar deals with Taipei.)

China's special economic zones

These considerations, along with a growing suspicion of China among developed nations, have limited Beijing's free trade deals to mainly developing countries. In addition, China's emphasis on goods has deterred developed trade partners from entering pacts with the country. While developed nations have set their sights on competition and government procurement in drafting trade deals such as the Trans-Pacific Partnership or Transatlantic Trade and Investment Partnership, China has no interest in broaching those topics. The country instead pursues bilateral and multilateral pacts on its own terms, focusing largely on lowering tariffs. The strategy doesn't always achieve the desired effect, however: In five years of negotiations over the Regional Comprehensive Economic Partnership, China and its partners repeatedly have missed target deadlines for signing the deal because of disagreements over its scope.

Apart from these priorities, China has some more pragmatic concerns behind its trade strategy. The country, for example, strives to safeguard the power and influence of the WTO, having grown accustomed to the global market access the organization affords it. It also has tried to build strategic trade partnerships with the world's major mineral and commodities exporters, including Chile, Peru and Australia, to ensure its supply of the natural resources it needs to fuel its manufacturing industry. To keep steady prices on its manufactured goods, Beijing requires state-owned enterprises to absorb the shock of fluctuations in the cost of commodities. But China hopes to obviate that difficulty in the long term by locking in prices on raw materials through free trade agreements.

Offensive Interests

China, like Japan and South Korea before it, built its economy on manufactured goods exports with help from low wages and strong infrastructure. Though the clock is ticking for its current economic model, Beijing will continue to push for lower tariff barriers on goods in potential markets abroad and to keep its existing trade partners from raising new barriers against it.

Overseas investment has become increasingly important to China's trade relations over the past decade. Flush with capital after decades of growth, Chinese companies are eager to invest abroad, particularly since returns on investments at home have weakened. Beijing has cracked down on the practice recently, introducing new capital controls and issuing guidelines limiting outbound investment to projects that fall under the Belt and Road Initiative. Even so, the central government understands that China is no longer solely a destination for investments but an avid investor, and that as such, it must protect the money it sends abroad. China tried to add investment to the list of subjects to be addressed at the next WTO ministerial conference in 2018 to that end.

E-commerce, likewise, is emerging as a trade priority for China. Internet-based companies such as Alibaba make convenient conduits to foreign markets, and conversely, Argentina and Mexico have started using the platform as an inroad to Chinese products and consumers. Considering their strategic potential as tools for projecting soft power abroad, China will work to increase its e-commerce companies' access to international markets.

Defensive Interests

China has yet to pull off the success it has achieved in e-commerce in its services sector. Financial services are weak in China thanks to its historical use of repressive regulation and capital controls to promote growth. To reorient its economy toward consumption, the country likely will have to develop its services sector. Indeed, the process has already begun. Doing so comprehensively, however, probably would require changes to the education system and more liberalizations than the central government would feel comfortable with. As a result, the transition to a more services-focused economy will be a slow one.

Agriculture is just one of many sensitive sectors that China has guarded with non-tariff barriers since joining the WTO. Beyond its use of standards to fend off external competition, Beijing has faced criticism for its stance on government procurement and competition, which countries in the developed world argue unfairly skew the market. China may gradually lower its non-tariff barriers over time as its internal market becomes more competitive. But for now, any steps it takes to that end likely will be aimed at increasing internal, rather than external, competition.

Over the years, China's currency has been the subject of much international discussion. The global community complained for much of the 2000s that Beijing was keeping the yuan artificially weak to stimulate exports. Since 2014, though, the general consensus has been that China's economic frailty and capital outflows are to blame for the currency's depreciation and that the central government is trying to raise its value, rather than depress it. Either way, so long as China maintains close control over the yuan's value, it will invite pressure from other countries to ease up. But China remembers well the economic woes that befell Japan after it agreed to boost the yen's value in the 1985 Plaza Accord and is determined not to make the same mistake. With that in mind, Beijing will fiercely resist outside attempts to sway its currency policy.

China's trade pacts
China's imports and trade balances
China's exports and trade balances
China's top 5 goods imports, 2016
China's top 5 goods exports, 2016
China's service imports, 2016
China's service exports, 2016
China's current account balance as a percent of GDP

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