China in Transition

China Should Create a Huge Unified Market Through Domestic Free Trade Agreements

Chi Hung KWAN
Consulting Fellow, RIETI

Regional competition brought about by decentralization has been the driving force behind China's economic development since the start of its market-opening reforms. On the other hand, however, it has created regional protectionism as a side effect. Moves toward regional protectionism are the result of policies implemented by regional governments with a desire to maximize their own benefits, but they have brought about many serious problems such as the waste of resources and the widening of the gap in economic development between various regions. This can be called a sort of "fallacy of composition," in the sense that the rational actions of individual economic entities have led to irrational results.

Regional protectionism is a policy where the local government of a particular region limits the movement of products and factors of production through administrative measures. Specifically, it can be categorized into two types: outflow restrictions and influx restrictions. In the case of the former, the outflow of resources such as agricultural raw materials and energy from a region is restricted. The latter tries to protect local producers and workers by limiting the entry of industrial products and labor into the region. In recent years, protection has shifted from preventing the outflow of resources to stopping the inflow of products. As a means to achieving this, in addition to a variety of clearly defined fees that are the equivalent of "tariffs" in international trade, we often see such "non-tariff barriers" as volume restrictions and certification requirements. Typical examples are the measures taken by provinces to foster their own automobile industries, such as higher vehicle registration fees and taxes on cars from other regions and vehicles imported from abroad, and the enforced use of locally-produced cars for taxis.

Under a free trade regime, participants secure "gains from trade" and "gains from specialization." Consumers can import cheaper products from other countries, while efficiency can be boosted through improvements in resource allocation as factors of production, such as capital and labor, shift to sectors where there is a comparative advantage. This is not limited to international trade, but also applies to domestic trade. If a domestic unified goods market is created, the efficiency of resource allocation for the whole country can be improved, as each region specializes in sectors where it is strongest (and has a comparative advantage) and trades with other regions. However, if the market is divided as it is in present-day China, each region must make products that can essentially be "imported" more cheaply from other regions, and cannot sufficiently reap the benefits of the division of labor brought about by comparative advantage and economies of scale. The merit for foreign firms in entering the Chinese market would also be greatly diminished should the sales of their products be limited to a small region. In order to correct such a situation, artificial barriers between regions that block the movement of goods, people and money must be removed.

The establishment of a unified market for goods and factors of production not only improves efficiency but also helps reduce the income gap between regions. If restrictions on the movement of labor such as family registration are removed, labor will shift from the inland and rural areas where wage levels are low to the coastal and urban regions where industrialization is in progress. Through this, wage levels will level out, and when remittances to families by migrant workers are also taken into account, the movement of labor can become a factor that reduces the income gap between the various regions. In addition, as indicated by the famous "Factor Price Equalization Theorem" of international economics, if trade is liberalized between the regions of a country, the prices of factors of production in them will converge, even if there is no free movement in the factors of production. For example, under a free trade regime a division of labor can be established in which the coastal regions, which have plenty of capital but lack labor, can produce capital-intensive goods and trade them for the labor-intensive goods produced by the inland regions, which while lacking capital have an abundance of labor. The labor of the inland regions - which is "embodied" in their products - flows to the coastal regions, while the capital of the coastal regions - "embodied" in their products - moves to inland regions, and this serves to level out the prices of these factors of production, just like the actual movement of labor and capital does.

China is striving to sign free trade agreements with neighbors, aiming to invigorate its economy through market expansion. Standard economic theory suggests that the more mutually dependent the participants of an FTA are and the stronger the complementary relationship between them, the greater the benefits from the agreement will be. Such conditions are better met between China's own regions rather than between China and its neighbors. In order for the Chinese economy to develop further, it should first vigorously pursue FTAs among its own regions rather than with foreign countries.

February 6, 2004

February 6, 2004