China in Transition

# The Rise of China as a Trading Superpower - Global impact through the terms-of-trade effect

Chi Hung KWAN
Consulting Fellow, RIETI

In 2004, China for the first time surpassed Japan to become the third largest trading country, trailing only the United States and Germany. China's external trade further increased in 2005, amounting to $1.42 trillion, of which imports accounted for$762 billion and exports 660 billion. China's evolution into a trading superpower is causing real income transfers and industrial realignment on a global scale through the change in relative prices, primarily, the deterioration of China's terms of trade and the improvement of those of its trade partners. In the process, developed countries and primary commodity exporters - both of which are in complementary relationship with China - are to benefit. However, some among the newly industrialized countries, which are in direct competition with China, may suffer. In the era of its planned economy, China was virtually sealed off from the outside world; economic interactions with other countries stagnated under the slogan of "self reliance." In 1978, China ranked only 27th in the world with its external trade amounting to20.64 billion, of which exports accounted for $9.75 billion and imports$10.89 billion. At that time, China was already the world's most populous country but it was a "small country" in terms of its impact on the world economy. Then China made a major policy shift and embarked on a reformist policy under the leadership of Deng Xiaoping. Ever since, it has been actively promoting foreign investments and expanding both imports and exports by leveraging original equipment manufacturing (OEM) and processing trade, and the pace of opening up has accelerated since China's accession to the World Trade Organization in 2001.

Through the process of opening up its economy, thereby expanding trade, China has been integrated into the world economy according to its comparative advantage. Needless to say, the primary source of China's comparative advantage is the abundant workforce bolstered a population of 1.3 billion. By bringing in foreign capital and absorbing surplus rural labor, China has been specializing on labor-intensive products (or processes). Consequently, the global supply of labor-intensive products has increased and so has the global demand for technology-intensive products such as capital goods, as well as for energy and other primary commodities. Such changes in the supply and demand relationship have worked to lower the prices of labor-intensive products relative to those of technology-intensive products and primary commodities, resulting in deterioration of the terms of trade for China and improvement of those for the rest of the world ( box ).

This is why we are being increasingly convinced that prices go up on whatever China is buying and go down on whatever it is selling, an increasingly conspicuous phenomenon in the recent years. Through such real income transfers, other countries are able to benefit from China's economic development.

However, both winners and losers are among those affected by the rise of China. For countries in complementary relationships with China (i.e. those importing labor-intensive products and exporting capital-intensive products or primary commodities, a trade pattern opposite to that of China), the deterioration of China's terms of trade translates to the improvement of their own terms of trade. Typical examples of such countries include developed countries, such as Japan, and oil exporting countries ( box ). In contrast, the terms of trade for countries competing with China -- those exporting labor-intensive products and importing technology-intensive products or primary commodities, as China does -- would deteriorate on the heels of the deterioration of China's terms of trade. Typical examples include newly industrialized countries, among them member countries of the Association of Southeast Asian Nations (ASEAN).

In foreign countries, sectors that are complementary with China -- those relating to technology-intensive products or primary commodities -- expand in tandem with the ongoing changes in relative prices brought by China's economic development, but sectors competing with China -- those related to labor-intensive products -- are forced to downsize. These adjustments can only be achieved by transferring production factors from declining industries to growing ones. However, in the process a temporary increase in unemployment and corporate bankruptcies would occur, which may provoke trade friction and protectionist responses. Indeed, certain developed countries are implementing measures including antidumping duties to restrict massive flows of imports from China on the grounds that they disrupt their domestic markets.

By focusing on the international division of labor and changes in relative prices caused by changes in supply, our analysis here goes beyond the conventional Keynesian approach that emphasizes the income effects of changes in demand on GDP growth. The latter approach has led to a rather simplified perception that countries with growing exports to China are to gain and those with growing imports from China to lose.

Note: Improvements of terms of trade for developed countries and oil exporting countries are partly offset by rises in the price of primary commodities and technology-intensive products, respectively.

January 30, 2006

## Box: Analysis based on a standard trade model

Consider a model consisting of two types of goods, namely, labor-intensive and technology-intensive products. The supply side of the model can be described by the production possibility curve of the world (including China), whereas the demand side can be described by the indifference curve of the world (including China). At the point where the two curves touch (E), equilibrium between supply and demand is established. Meanwhile, the common slope of the two curves (t) represents the relative price of labor-intensive products to technology-intensive products (= terms of trade for China). The rise of China is described by an outward shift of the position of the production possibility curve whereby the common slope of the two curves at the new equilibrium point is steeper and the relative price of labor-intensive to technology-intensive products is lower than at the original equilibrium point. Incidentally, when the country under consideration is a small one such as Singapore, production expansion would have an extremely small impact on the world production possibility curve and thus the resulting changes in relative prices would be negligible.

January 30, 2006

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