Riding on the Vigor of an Economic Superpower: Japan should seek an FTA with China

Chi Hung KWAN
Consulting Fellow, RIETI

After surpassing Japan in terms of GDP in 2010, it now looks increasingly possible that China will overtake the United States to become the world's largest economy before 2020. China has become an economic superpower and gained in importance not only as a production base but also as a market for end products for Japan. When accessing the Chinese market, Japanese companies have two choices: manufacturing and selling products locally or manufacturing products in Japan and exporting them to China. To avoid an outflow of technologies and jobs, the latter is preferable to the former. That in turn requires fostering a free trade environment by reaching a free trade agreement (FTA) between the two countries.

China: From "workshop of the world" to "market of the world"

China's GDP in U.S. dollar terms has been rising sharply in recent years, driven by high economic growth and the appreciation of the renminbi (RMB) against the U.S. dollar. In 2011, it stood at 48.4% of the level of the United States. Assuming the annual economic growth rates of China and the United States until 2020 to be 8% and 2.5%, respectively, and the real exchange rate of the RMB against the U.S. dollar, taking changes in the price levels in both countries into account, to rise by 7.2% annually?equivalent to the actual rate from 2006 to 2011?then the former will overtake the latter and become the world's largest economy by as early as 2017 ("China May Overtake the United States in GDP before 2020: Future course of the RMB appreciation rate holds the key," China in Transition).

The rapid progress in the Chinese economy hinges heavily on growth in trade, and China is on its way to becoming the world's largest trading power, even before it claims the world's largest GDP title. The sum of China's exports and imports stood at $20.6 billion in 1978, ranking 29th in the world. By 2011, the figure had reached $3.64 trillion, with exports and imports at $1.90 trillion and $1.74 trillion, respectively. China was by then the world's second largest trading power, only behind the United States (with trade at $3.69 trillion, combining exports of $1.48 trillion and imports of $2.21 trillion). It is very likely that these positions will reverse in 2012.

Chinese exports have been driven by industrial goods. In fact, China became known as the "workshop of the world" around 2001 when it joined the World Trade Organization (WTO). While imports have also been increasing together with the rise in exports, intermediate goods have been accounting for a larger percentage of imports than finished products for the domestic market, as the weight of processing trade has been extremely heavy. In recent years, however, the situation has been changing rapidly, symbolized by a significant fall in the ratio of processing trade to imports from 49.3% at the peak in 1997 to 26.9% in 2011, as incomes have been increasing. For foreign investors, China is gaining in importance not only as the workshop of the world serving the overseas market but also as the market of the world.

Access to the Chinese market through exports more desirable than local production

In contrast to the buoyant Chinese economy, the Japanese economy has remained mired in long-term stagnation. With a recovery in domestic demand unlikely, Japanese companies must seek out new opportunities overseas, and many companies are moving into China with hopes of capitalizing on the booming Chinese market. However, Japanese companies do not necessarily need to produce locally to expand sales in China. Even with much lower wages, not everything can be produced more cheaply there, and the Japanese high-tech industry in particular should be competitive enough even if it manufactures domestically and exports to China. In practice, however, even in the high-tech industry, Japanese companies are frequently forced to shift from exporting to China to local production and sales there to avoid trade barriers.

The automobile industry is a typical example. Annual auto production and sales in China reached 18.42 million units and 18.51 million units, respectively, in 2011, exceeding the combined totals for Japan and the United States. To access the Chinese auto market, which is expected to continue growing in the years to come, there should be a choice of manufacturing vehicles in Japan and exporting them to China instead of producing them locally. However, the tariff rate China imposes on imported automobiles still remains high at 25% although this has been reduced since it became a member of the WTO in 2001. Japanese automakers have no choice but to use local production to overcome the high tariff barrier despite the fact that they are able to produce quality automobiles in Japan more cheaply. As a result, Japan will lose employment in areas in which it is supposed to be competitive and domestic industries will be hollowed out, in comparison with the case of manufacturing products at home and exporting them to China.

FTA between Japan and China as a growth strategy beyond a simple response to hollowing out

To circumvent this, Japan must eliminate trade barriers in China, such as tariffs on imports, by entering into an FTA with China. Should this happen, its key industries such as the automotive sector will no longer need to take on the risk of advancing into China as these industries will be able to generate sufficient profits even if they manufacture products domestically and export them. This will not only help create high value-added jobs in Japan but also will prevent technologies from flowing out of the country.

There are other reasons why Japan should step up its efforts to enter into an FTA with China.

First, as China has been actively concluding FTAs with neighboring countries and regions, Japan is at risk of being left behind. China has already concluded FTAs with ASEAN, Hong Kong, Macau, and Taiwan, as well as many other countries and regions, but it has yet to even begin negotiating one with Japan. While those countries and regions are able to export their products to China without tariffs in principle, Japan has to add tariffs to the prices of its products, placing itself at a disadvantage when competing in the Chinese market.

In addition, China has replaced the United States as Japan's largest trade partner, accounting for 19.7% and 21.5% of Japan's exports and imports, respectively, in 2011. Given that Chinese economic growth is likely to continue to outpace that in other regions, Japan will be even more dependent on trade with China in the future. Since the trade structure between the two countries is more complementary than that between Japan and the United States and given there is a greater scope to reduce the rate of import duties imposed by China than those imposed by the United States, with the former (10.0% in 2010) higher than the latter (3.5%), the trade creation effect and, in turn, the effect of pushing up GDP should be larger from an FTA with China than one with the United States.

It goes without saying that Japan need not limit its FTA partners to China. If Japan were to widen its scope to other Asian countries and the United States, the benefits it will receive from the international division of labor would be even larger. As such, promoting FTAs is an effective growth strategy for Japan, going beyond a simple response to its industrial hollowing out. We should thus welcome as a positive step in that direction the news that Japan is seeking to proceed with FTA negotiations with South Korea and China, while at the same time joining the Trans-Pacific Partnership (TPP), in which the United States is expected to be the dominant member.

March 13, 2012

March 13, 2012