China in Transition

Toward Economic Integration in Asia
- Japan-China FTA should play a pivotal role -

Chi Hung KWAN
Consulting Fellow, RIETI

While global or broad-based multilateral trade liberalization - such as initiatives under the World Trade Organization and the Asia-Pacific Economic Cooperation forum - stagnates, East Asian countries are activating moves toward free trade agreements (FTAs). There seems to be a tacit understanding to first proceed on small-scale FTAs - those between Japan and Singapore, between Japan and Association of Southeast Asian Nations, and between China and ASEAN - then converge them into a region-wide ASEAN plus three (Japan, China and South Korea) FTA. When it comes to the specific combination of member countries and the sequencing of steps to reach that goal, however, the region is still in the stage of trial and error, and there exists no convincing theory that can serve as a guide.

A textbook on international economics distinguishes a positive "trade creation effect" and a negative "trade diversion effect" of an FTA. The former effect refers to the expansion of intra-regional trade as a result of removing trade barriers, whereas the latter refers to the replacement of highly competitive goods imported from non-member countries by less competitive substitutes from member countries as a result of removing trade barriers only within the free trade area. Trade creation effect tends to exceed trade diversion effect, and thus the benefits is greater, when an FTA is formed between countries in complementary relations than those in competition with one another. Generally speaking, stronger complementary relation is observed between countries with a large gap in their levels of economic development, while competition is stronger between those at similar development stages. Based on this theory, China has strong complementary relations with Japan and newly industrialized economies (NIEs), but competitive relations with ASEAN members. Complementarity is especially strong between Japan and China, and an FTA between the two countries should yield large benefits to both parties.

In reality, however, greater priority is given to political considerations to choose a combination that is likely to face minimum political resistance, as exemplified by the signing of the Japan-Singapore Economic Partnership Agreement, in disregard of what economic theory says about its efficiency. Here, we face a dilemma on two fronts. First, if we start from, and proceed on, easy ones, we would be left with only difficult ones and we may get stymied before realizing our vision to elevate small-scale FTAs into broader-based multilateral trade liberalization. Secondly, politically easy FTAs tend to bring little economic benefit, and FTAs with great economic benefit tend to require more adjustments in concerned industries and invoke stronger resistance. In terms of economic benefit derived from the division of labor, Japan and China are the most desirable combination for an FTA. Politically, however, this is the most difficult. Even putting aside agricultural products, labor-intensive industries (such as textiles) in Japan are bound to oppose this idea, while liberalization initiatives in high-tech industries will invoke strong resistance in China.

In addition to opposition from certain corners of their respective domestic industries, the problem of historical perception and the resulting mutual distrust between the two countries will also hinder moves toward a Japan-China FTA. In Europe, however, France and Germany - which fought two world wars against each other in the first half of the 20th century - are trying to overcome their history through economic integration. Strong political leadership and a shift in mindset, as seen in the two European countries, are required of Japan and China. Both countries should take regional integration as a way to achieve peace and stability, instead of a means to establish hegemony in the region. Together, Japan and China account for 80 percent of East Asia's overall gross domestic product (GDP). Should they form an FTA, other Asian countries would rush to join, and regional integration should gather momentum.

July 19, 2002

July 19, 2002