China in Transition

The Rise of China as a Win-Win Game for Japan
- Immense income transferred from China through the terms of trade effect

Chi Hung KWAN
Consulting Fellow, RIETI

When discussing the effects of China's progress on the Japanese economy, the focus is often on the changes in absolute prices, as symbolized by the concept of "China-induced deflation." However, more attention should be paid to the changes in relative prices as a result of the improvement in Japan's terms of trade vis-a-vis China, which signifies the transfer of income from China ( note ).

First, let us look at what effects China's advance has on its own terms of trade. During the past 20 years, China has become tightly integrated into the global economy, through market-opening reforms. In the past, China had stuck to its banner of self-reliance and self-sufficiency, but since opening its markets in 1978 it has abandoned this policy and left matters to market principles. It has come to simultaneously export low value-added, labor-intensive products and import high value-added, technology- and capital-intensive goods, in line with its comparative advantages. 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 a deterioration in its terms of trade over time. We cannot determine how much its terms of trade have deteriorated, because China does not release statistics of export and import prices, but the sharp decline of the yuan 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, so the two countries are in a complementary relationship. Therefore, while China's terms of trade correspond to 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 the exact opposite. This means that the deterioration of China's terms of trade signifies an improvement in Japan's. For the Japanese consumer, real income rises as imports from China (and countries that compete with China) get cheaper, while for Japanese companies, profits increase through the fall in input prices and the rise in output prices.

In fact, according to Japanese statistics, prices of Japan's exports to China have risen by 3.0% compared to 1990 levels, but prices of imports from China have fallen 18.4% ( diagram ). As a result, Japan's terms of trade vis-a-vis China have improved by some 26.2%. Calculations based on the fact that exports to China in 2002 came to ¥5.0 trillion while imports came to ¥7.7 trillion show that had the price of exports and imports remained at 1990 levels, Japan's export earnings would have been ¥0.2 trillion less while Japan's import cost would have been ¥1.7 trillion more ( table ). This shows that Japan saved some ¥1.9 (0.2 + 1.7) trillion in foreign currency annually as a result of the improvement in its terms of trade vis-a-vis China. This is a huge figure that is equivalent to 0.4% of Japan's gross domestic product and roughly 10 times the foreign direct investment that Japanese companies pumped into China every year (according to statistics from the Ministry of Finance).

When trying to grasp the effects on the Japanese economy as a whole from a wider perspective, we must not only look at such direct effects of China's progress, but also its indirect effects on the export and import prices of Japan's other trading partners. Firstly, Japan's exports to China are, as in the case of its exports to other regions, focused on 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, in terms of some primary products such as crude oil, China is a net importer just like Japan, and a rise in China's imports can lead to a rise in prices, but as China's share of global trade in these items is still very small, its impact should be limited. Therefore, the indirect effects reinforce the direct effects, and Japan's total gain should be even larger than what the above calculation suggests.

As this shows, the emergence of China is a big blessing for the Japanese economy through the deterioration of China's own terms of trade and the improvement of Japan's. For China, this is a situation similar to the falling income of farmers as a result of a good harvest (or immiserizing growth), as the more it exports, the more export prices will go down. (However, this is occurring in the industrial sector, not the agricultural sector.) In contrast, Japan is benefiting from a part of that good harvest, and this transfer of income from China to Japan is supporting the standard of living of the Japanese people amid the current economic downturn.

The improvement in Japan's terms of trade vis-a-vis China:

The improvement in Japan's terms of trade vis-a-vis China

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

Table: Japan's income gain resulting from changes in its terms of trade vis-a-vis China:
(A comparison between 1990 and 2002)
(2002 prices)
Price index
(at 1990 prices)
Exports to China ¥5 trillion 1.030 ¥4.8 trillion ¥0.2 trillion (1)
Imports from
¥7.7 trillion 0.816 ¥9.4 trillion -¥1.7 trillion (2)
Income gain
- - - ¥1.9 trillion
August 29, 2003

The terms of trade are defined as the ratio between export prices and 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 a deterioration in its terms of trade, and signifies a decline in the real income of its people, but a fall in oil prices means an improvement in its terms of trade and a rise in real income. The former can be seen as a transfer in income from Japan to oil-producing nations, while the latter means that income is transferred from oil producers to Japan.

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August 29, 2003