the consequences of china's wto accession for its neighbors · economy case, the interesting...

Consequences of Chinarsquo s W TO A ccess ionConsequences of Chinarsquo s W TO A ccess ion

The Consequences of Chinarsquos WTOAccession for Its Neighbors

Warwick J McKibbinResearch School of Pacific andAsian StudiesAustralian National UniversityCanberra ACT 0200AustraliaandThe Brookings Institution1775 Massachusetts AvenueNWWashington DC 20036USAwmckibbinmsgplcomau

Wing Thye WooEconomics DepartmentUniversity of CaliforniaOne Shields AvenueDavis CA 95616USAwtwooucdavisedu

Asian Economic Papers 22 copy 2003 The Earth Institute at Columbia University and the Massachusetts

Institute of Technology

AbstractOur simulations of a global macroeconomic model suggest thatChinarsquos WTO accession could create significant welfare losses inthe ASEAN-4 if foreign direct investment (FDI) is significantly re-directed away from these countries toward China and if theASEAN-4 countries are unable to implement policies to make upfor the slower rate of technological diffusion from the reducedFDI inflow If the ASEAN-4 do not fall behind technologically thenthey will be able to find lucrative niches within the lengthened in-ternational manufacturing production chains The ASEAN-4 musttherefore strengthen their abilities to absorb new foreign technol-ogies quickly and to engage in indigenous technical innovations

1 Chinarsquos emergence as a major trading nation

At the end of 1978 China made the historic decision to ini-tiate the process of allowing its economy to converge to anormal market economy which is characterized by thepredominance of private ownership and by integration

We thank Iwan Jaya Azis Jonathan Anderson Huang YipingLu Ding Jeffrey D Sachs Raed Safadi Xiao Geng Wang Zhiand Jennie Woo for insightful discussions on this topic We aregrateful to Rakhi Mehra Alison Stegman and Wu Ruojun forexcellent research assistance We bene ted from the discussionsof an earlier version of this paper presented at the Seminar onAsian Competitiveness organized by the Socio-economic ampEnvironmental Research Institute in Penang Malaysia on30 September 2002 and at seminars at the Economics Depart-ment of the National University of Singapore and the ChinaStudies Center at the University of Michigan The views ex-pressed in the paper are those of the authors and should not beinterpreted as re ecting the views of those who have helpedwith the paper the trustees of cers or other staff of theBrookings Institution the Australian National University or theUniversity of California Davis

into the international economic system Before this momentous decision China hadwithheld a quarter of the worldrsquos population from participating in the internationaldivision of labor During the period of Chinarsquos self-imposed isolation the rest of theworld created new wealth on an unprecedented scale (with some notable excep-tions such as Africa) It is now conventional wisdom to attribute this generalized in-crease in prosperity to the open international trading system that was institutional-ized at the end of World War II1 Clearly China agrees with this conventionalwisdom China has stated numerous times that its full participation in the interna-tional trading system is fundamental to keeping its economic growth sustainable2

This explains why China has tenaciously pursued arduous trade negotiations withthe United States for over a decade in order to win WTO membership

Although there is general agreement that Chinarsquos WTO accession would bene tChina there is no general agreement that it would also bene t other countries espe-cially Chinarsquos neighbors in East and Southeast Asia For example in his address tothe country on its national day in 2001 the Prime Minister of Singapore Goh ChokTong told his fellow citizens that

China poses a big economic challenge Some economists describe China as an800-pound trading gorilla A Hong Kong newspaper added that this gorilla wasvery hungry

Even India is being ooded with cheap but good quality Chinese goods SomeIndian manufacturers are nding it hard to compete So they have done thenext best thing They stick ldquoMade in Chinardquo labels on their products to boostsales

Our biggest challenge is therefore to secure a niche for ourselves as Chinaswamps the world with her high quality but cheaper products Chinarsquos economyis potentially ten times the size of Japanrsquos Just ask yourself how does Singaporecompete against ten post-war Japans all industrializing and exporting to theworld at the same time

I do not mean that China will overpower every other economy and grow at theexpense of everybody else As China develops and exports more its imports willgrow too There will be many opportunities to invest in China We must graspthose opportunities

2 Asian Economic Papers

Consequences of Chinarsquos WTO Accession

1 Sachs and Warner (1995) present convincing evidence in support of this professional consen-sus

2 For an overview of Chinarsquos economic growth and a survey of the competing interpretationson the sources of the growth see Woo (1998 1999a 1999b 2001) Sachs and Woo (2003) andLardy (2002)

Goh is certainly correct in pointing out that China cannot be an exporter withoutalso being an importer But the crucial issue is whether the composition of goodsthat China would import would require a complete overhaul of the productionstructures of East and Southeast Asia Will Indonesia Malaysia the Philippines andThailand (the ASEAN-4) de-industrialize and return to the roles they had in the1950s and 1960s as primary commodity exporters Or will there be suf cient lucra-tive niches in which the ASEAN-4 can specialize within the manufacturing produc-tion chains

The second scenario is certainly a possibility particularly for Singapore Taiwan andSouth Korea Examples of niches abound ldquothe Swiss make watches and run topbanks and the Italians produce shoes for the eliterdquo3 In the opinion of StanleyFischer the former deputy managing director of the IMF

there is little cause for fear a big dynamic economy in the neighborhood is abene t not a curse for those around itmdashlook at Canada or Mexico Or onemight add look at Asia after Japan emerged as an economic power from the1970s onward4

Boom or doom This is the question that is the focus of this paper To anticipate ourquantitative analysis our short answer to this question is that beyond the underly-ing international repercussions generated by Chinarsquos emergence into the interna-tional economy Chinarsquos WTO accession is likely to

generate additional substantial bene ts for China have little additional impact on the OECD economies and create signi cant welfare losses in the ASEAN-4 only if foreign direct investment

(FDI) is signi cantly redirected away from these countries to China and even inthis case only if the ASEAN-4 countries fail to absorb new foreign technologiesquickly and to engage in indigenous technical innovations

2 Guidance from theory

An adherent of standard international trade theory as embodied by the Heckscher-Ohlin (H-O) model might nd it amusing that a large part of this paper focuses onthe implications of Chinarsquos WTO membership for other economies It is amusing be-



3 ldquoRising China to Be Key Importer of ASEAN Goodsrdquo Straits Times 30 August 2002

4 ldquoDonrsquot Fear China Threatrdquo Straits Times 4 September 2001 Hong Kongndashbased analysts atGoldman-Sachs and the Deutsche Bank have also disputed the notion that Chinarsquos rise willbe deleterious to its neighbors see Anderson (2002) and ldquoReport Plays Down Chinarsquos Drainon Aseanrdquo South China Morning Post 4 February 2003 respectively

cause Chinarsquos WTO membership means the lowering of Chinarsquos trade barriers andthe H-O model shows unambiguously that the welfare of Chinarsquos trade partners hasonly upward potential their welfare will be either unaffected or improved What isnot obvious from the H-O model is the impact of Chinarsquos tariff reduction on its ownwelfare The answer depends to a large extent on whether China is a small countryin the economic sense A small economy is de ned as a price taker in the internationalmarkets that is its terms of trade are exogenous

If China is a small country in the economic sense then its tariff reduction willde nitely bene t itself and (by de nition) will have no repercussions on other econ-omies However if there are short-run rigidities in labor movements (such as stickynominal wages) in China then the additional imports will create (temporary) unem-ployment immediately and this cost has to be balanced against the present dis-counted value of the long-run bene ts from the more ef cient allocation of re-sources So if China is a small country the interesting question about Chinarsquos WTOmembership is not the welfare implications of that membership for other economiesbut its welfare implications for Chinarsquos economy

If China is a large country in the economic sense then the answer depends on whereits present effective tariff rate stands with respect to what we will call the optimumtariff rate (tA) the threshold tariff rate (tB) and the trade-terminating tariff rate (tC)Figure 1 locates these three tariff rates in the inverted U-curve which shows the re-lationship between Chinarsquos welfare level and its tariff rate The U shape emergesfrom the changes in two different welfare components induced by an increase in thetariff rate (1) a welfare decline from reduced consumption of the imported goodand (2) a welfare gain from the improvement in the terms of trade

Figure 2 shows the relationship between the welfare level of a hypothetical tradepartner and Chinarsquos tariff rate This is a monotonically declining relationship be-cause an increase in Chinarsquos tariff rate will (1) drive down the amount of goods thetrade partner will export to China (a negative quantity-welfare effect) and (2) drivedown the price of the reduced amount of goods that it will export (a negative price-welfare effect) The unambiguous conclusion is that any lowering of Chinarsquos tradebarriers will increase the welfare of the trade partner As in the (China as a) smalleconomy case the interesting question about Chinarsquos WTO membership is not itsimpact on other economies but its impact on Chinarsquos own economy

We will now state two ldquostylized factsrdquo On the basis of the agreements reached in or-der for China to become a WTO member the rst stylized fact is that to a rst ap-



proximation WTO membership will require China to lower its effective tariff rate toa low enough level that the resulting welfare level in the country is close to the freetrade welfare level The second stylized fact is that Chinarsquos present tariff rate islikely to be above tB This stylized fact arises from two considerations First Chinawas virtually an autarkic economy before 1978 and since then the biggest reduc-tions in trade barriers have occurred in the area of imported inputs required by theexport-processing industries Trade barriers to nal-consumption goods are in gen-eral still very high in China Second China was not coerced by its trading partnersto join the WTO it sought WTO membership voluntarily and pursued the matterwith great tenacity (the US-China bilateral trade negotiations took over a decade tocomplete) Such perseverance indicates that the effective tariff rates in China in 2000created a welfare level in the country that is lower than the free trade welfare level

The puzzling point about Chinarsquos pursuit of WTO membership that we want toraise is that even if Chinarsquos present effective tariff rate is indeed higher than tB thebest thing to do is to move not to the WTO-required almost-free-trade position butto tA the optimum tariff In short if China is indeed a large economy then it is notclear why it should not undertake the amount of unilateral tariff reduction requiredto bring it to tA rather than to join WTO Obviously WTO membership must involveanother bene t that has been missed in the literature



Figure 1 Relationship between welfare level and tariff rate in China

Note Figure assumes that China is a large economy

To summarize the discussion so far the H-O model can explain Chinarsquos eagernessto join WTO only if China is a small economy in the economic sense in which casetariff reduction will surely increase its welfare If China is a large economy thenChinarsquos eagerness to join WTO is a mystery because H-O would predict that Chinawould reduce its tariff from beyond tB to tA but not to the very low tariff rate agreedto during the WTO negotiations Furthermore the H-O model cannot explain whysome of Chinarsquos trade partners especially the Southeast Asian economies havebeen so anxious about Chinarsquos WTO membership Because we do not regard any ofthe following three reasonsmdashignorance in China about optimum tariff pervasiveparanoia in Southeast Asia and widespread macroeconomic rigidities in SoutheastAsian economiesmdashto be the motivating factor behind Chinarsquos eagerness to joinWTO and behind Southeast Asiarsquos worries we conclude that there is somethingmissing in the logic of the H-O model about Chinarsquos WTO membership

Before we turn to discussing the additional elements that are needed to make theH-O modelrsquos analysis more relevant to the focus of the analysis presented in thispaper we temper the strong conclusions of the H-O model to arrive at what we seeto be the two most useful broad messages from standard international trade theoryFirst it is likely that the economy that will experience the biggest impacts fromChinarsquos WTO accession will be China Second it is likely that the majority ofChinarsquos trade partners will experience few signi cant negative effects from its ac-cession to the WTO



Figure 2 Relationship between welfare level of Chinarsquos trade partner and Chinarsquos tariff rate

Note The assumption is that China is a large economy

3 Supplementing theory with the speci c situation in East Asia

The fundamental reason for Chinarsquos enthusiasm for WTO membership which ismissed by the H-O model is that WTO membership will greatly enhance Chinarsquoseconomic security Until China became a WTO member the US Congress had toapprove most-favored-nation (MFN) status for China annually in order for Chinarsquosexports to compete in the US markets on equal terms against the exports fromWTO countries This annual congressional-approval requirement inevitably ren-dered Chinarsquos exports vulnerable to passing passions in the US political arena forexample over accidents such as military airplane collisions in the South China Seaand the burning of the US consulate in Chengdu following the unintended USbombing of the Chinese embassy in Belgrade The importance to China of continu-ing high export growth and maintaining the access of its exports to the US marketis hard to overstate

The high and growing global demand for Chinarsquos exports in the last two decadeshas been a powerful force in hastening the transformation of China from a subsis-tence peasant economy to an industrialized economy The contribution of exports toChinarsquos growth has become more important since 1998 when the quickened pace ofstate enterprise reform interacted with the dysfunctional nancial system to imparta de ationary tendency to the economy De cit spending and exports are the twogrowth engines that have kept recent GDP growth rates above 7 percent The prob-lem is that Chinarsquos weak scal position makes de cit spending an unsustainable en-gine of growth5 Its present scal situation is marked by the constant need to recapi-talize the state banks the need to fund future pension claims and the inability of thegovernment to increase revenue collection substantially Hence if exporting is alsonot a sustainable engine of growth then a drastic slowdown in growth is inevitable

The United States is Chinarsquos biggest export market Until the recent restrictions onsteel imports the United States had been perceived as ideologically committed tofree trade and consequently less prone to protectionism than Europe and Japan6

Clearly in order for exports to be a sustainable growth engine China must secureassured access to its biggest market And only WTO membership can prevent theUnited States from the impulsive unilateral action of switching off one of Chinarsquos



5 See Sachs and Woo (2003) for a discussion of Chinarsquos dif culties in macroeconomic manage-mentmdasha situation that is increasingly recognized in the press for example ldquoPublic SpendingExplodesrdquo Far Eastern Economic Review 30 January 2003

6 A recent well-known example of a Europe-China trade dispute is the imposition of restric-tions on Chinese cigarette lighters and a recent example of a Japan-China trade dispute isover the alleged dumping of Chinese garlic

most important growth engines by simply denying MFN status to China in any yearit chooses to

What are the implications for Chinarsquos trade partners of the enhanced economic secu-rity it derives from WTO membership By removing the annual uncertainty aboutChinarsquos exports WTO membership has increased Chinarsquos reliability as a supplier tothe international markets This development has two immediate consequencesFirst buyers can source a larger proportion of their purchases from Chinese produc-ers without increasing the risk of nondelivery or late delivery Second producers oflabor-intensive goods destined for sale in the high-income economies can now re-duce management costs by reducing the geographical diversi cation of their pro-duction facilities

The primary competitors to Chinarsquos mostly labor-intensive exports are its East Asianneighbors South Korea Taiwan Hong Kong Singapore Indonesia Malaysia thePhilippines and Thailand Of these countries the last four commonly referred to asthe ASEAN-4 engage in export-processing activities and are competitors to Chinafor FDI The ASEAN-4 are therefore likely to be negatively affected by the abovetwo developments resulting from Chinarsquos enhanced reliability as a supplier The factthat labor costs in China are lower than those in the ASEAN-4 magni es the nega-tive effects of these two channels

Before discussing the possible diversion of FDI to China from its trade partners weturn to tables 1 and 2 to review the relative importance of FDI to growth in theAsian economies Table 1 reports the inward and outward FDI stock as a proportionof GDP in selected economies and table 2 reports the inward and outward FDI owas a proportion of investment in those economies The net FDI7 stock (normalizedby GDP) data show that Japan has been a capital exporter at least since 1980 andTaiwan became a capital exporter by 1990 South Korea Hong Kong Singapore andthe ASEAN-4 are net capital importers Combining the FDI stock data in table 1with the FDI ow data in table 2 we see that Hong Kong and South Korea until theAsian nancial crisis of 1997ndash99 were in the process of relocating a signi cantamount of their labor-intensive industries abroad as evidenced by their outwardFDI owrsquos being bigger than their inward FDI ow during 1990ndash95 The biggest re-cipients of the outward FDI ows from Japan Taiwan South Korea and Hong Kongwere China and the ASEAN-4

The economic health of the ASEAN-4 has become highly dependent upon foreigncapital with some apparent exceptions (tables 1 and 2) Although Indonesia has



7 Net FDI is inward FDI minus outward FDI

been experiencing net FDI out ow since the Asian nancial crisis its net FDI stockGDP ratio in 2000 still stood at 38 percent which is the same as Malaysiarsquos ratio andhigher than Thailandrsquos ratio of 18 percent Although the net FDI stockGDP ratio of14 percent for the Philippines in 2000 makes it the country with the lowest ratioamong the ASEAN-4 the proportion of Philippine investment funded by net FDIin ow was over 7 percent during 1990ndash95 and reached 84 percent in 2000 The de-gree of foreign nancing in the Philippinesrsquos investment in 2000 was lower than thatin Thailand (102 percent) but higher than that in Malaysia (77 percent)

The above conclusion about the great importance of FDI to the economies of theASEAN-4 also holds for Chinarsquos economy Chinarsquos net FDI stockGDP ratio of 30percent places it below Malaysia and Indonesia but above Thailand Net FDI in owhas been accounting for an increasing proportion of Chinarsquos investment rising froman average of 84 percent in 1990ndash95 to 103 percent in 2000 On the eve of Chinarsquos



Table 1 Inward and outward FDI stocks as a percentage of gross domestic product byeconomy (percentage)

Economy 1980 1990 2000 Economy 1980 1990 2000

ChinaInward 31 70 323Outward mdash 07 24

Selected OECD economies Selected Asian economies

United States TaiwanInward 30 69 124 Inward 58 61 90Outward 78 75 132 Outward 02 80 159

Canada Hong KongInward 204 196 288 Inward 4362 1981 2638Outward 89 147 324 Outward 05 159 2249

Japan SingaporeInward 03 03 11 Inward 529 779 1038Outward 18 66 58 Outward 317 213 575

South Korea IndonesiaInward 23 21 137 Inward 132 340 396Outward 02 09 111 Outward mdash 01 15

Australia MalaysiaInward 79 237 292 Inward 207 234 588Outward 14 98 209 Outward 08 61 208

New Zealand PhilippinesInward 103 182 494 Inward 39 74 166Outward 23 147 108 Outward 05 03 26

France ThailandInward 82 82 199 Inward 30 96 200Outward 36 99 334 Outward mdash 05 20

GermanyInward 39 71 241Outward 46 88 252

ItalyInward 20 53 105Outward 16 52 168

United KingdomInward 118 206 305Outward 150 232 632

Source UNCTAD (2002)

WTO accession China resembled the ASEAN-4 with regard to its strategy of har-nessing FDI to accelerate economic development

Our conclusion on the importance of FDI to the economic development of theASEAN-4 is con rmed by the inward FDI performance index for 140 countries thatwas constructed by the United Nations Conference on Trade and Development(UNCTAD) (2002) Table 3 compares the inward FDI performance indexes for se-lected Asian and OECD countries The FDI performance index for a particular coun-try is the ratio of that countryrsquos share in global FDI to its share in global GDP Avalue of 1 for a country on the performance index denotes that the country is receiv-ing FDI exactly in line with its relative economic production As the table shows theindex values in 1988ndash90 for the ASEAN-4 were generally very high the value for



Table 2 Inward and outward FDI ows as a percentage of gross xed capital formation byeconomy (percentage)

Economy1990ndash95(annual average) 2000 Economy

1990ndash95(annual average) 2000

China 98 105Inward 14 02Outward


United States TaiwanInward 43 175 Inward 25 68Outward 61 96 Outward 62 92

Canada Hong KongInward 59 473 Inward 153 1449Outward 66 337 Outward 374 1389

Japan SingaporeInward 01 07 Inward 305 198Outward 22 26 Outward 117 182

South Korea IndonesiaInward 08 71 Inward 48 2122Outward 14 38 Outward 20 04

Australia MalaysiaInward 90 141 Inward 194 165Outward 37 60 Outward 34 88

New Zealand PhilippinesInward 252 332 Inward 79 92Outward 77 100 Outward 05 08

France ThailandInward 60 169 Inward 44 104Outward 88 691 Outward 06 02

GermanyInward 09 487Outward 53 124

ItalyInward 18 63Outward 30 58

United KingdomInward 97 464Outward 147 1010


Malaysia was 44 that for Thailand was 26 and that for the Philippines was 26Only Indonesia was signi cantly low at 08

Chinarsquos attractiveness as a location for FDI in 1988ndash90 was the same as IndonesiarsquosThe two countriesrsquo respective ranks of 61 and 63 on the FDI index were greatly be-low those of Malaysia (8) Thailand (25) and the Philippines (39) In the aftermath ofthe Asian nancial crisis and after a decade more of economic opening by Chinahowever Chinarsquos value on the performance index rose whereas those of theASEAN-4 fell In 1998ndash2000 Chinarsquos rank had risen to 47 compared with 41 forThailand 44 for Malaysia 89 for the Philippines and 138 for Indonesia There is lit-tle doubt that most of the downward movement in the rankings of the ASEAN-4was caused by the Asian nancial crisis but one cannot rule out that a part of thedownward movement was due to the diversion of FDI from the ASEAN-4 to China

Analytically the removal of the MFN threat when China of cially became a WTOmember at the end of 2001 was equivalent to a reduction in the risk premium de-manded by investors in Chinarsquos export-oriented industries A complete picture ofChinarsquos WTO membership involves more than a reduction in Chinarsquos effectivetariffs it also includes a reduction in the risk premium for investment in export-oriented production inside China The effect of the tariff reduction is to reallocate



Table 3 Values of and country rankings by the UNCTAD inward FDI performance index(from sample of 140 countries)

Value Rank

1988ndash90 1998ndash2000 1988ndash90 1998ndash2000

China 09 12 61 47

Selected OECD economiesUnited States 11 08 50 74Canada 13 16 46 30Japan 00 01 128 131South Korea 05 06 93 87Australia 28 06 22 88New Zealand 40 10 10 54France 09 08 60 69Germany 03 13 106 43Italy 06 02 79 115United Kingdom 33 18 16 25

Selected Asian economiesTaiwan 09 03 58 112Hong Kong 54 59 4 2Singapore 138 22 1 18Indonesia 08 206 63 138Malaysia 44 12 8 44Philippines 17 06 39 89Thailand 26 13 25 41


Note FDI performance index is the ratio of a countryrsquos share in global FDI ows to its share in global GDP An FDI performance in-

dex value of 1 for a country denotes that the country is receiving FDI exactly in line with its relative economic share

the composition of Chinarsquos output from importables to exportables and nontrad-ables and the effect of the risk premium is to recon gure the global distribution ofFDI in Chinarsquos favor

There is indeed evidence of an FDI diversion effect created by Chinarsquos WTO mem-bership The Japan Bank for International Cooperation (JBIC) conducts an annualsurvey of Japanese transnational corporations (TNCs) to nd out which countrieswill be the top 10 locations for manufacturing FDI over the three years subsequentto the survey Table 4 presents the results from the surveys undertaken in 1996 2000and 2001 These results indicate that 68 percent of Japanese TNCs listed China asone of the top 10 locations in 1996 and 65 percent did so in 2000 These responsesmade China the location most frequently identi ed as promising for FDI in bothyears that is China was ranked rst in the list of top 10 locations

The evidence in favor of our FDI diversion hypothesis is captured in the 2001 sur-vey It became clear to the international community at the end of 2000 that Chinarsquosaccession to the WTO was imminent The upshot was that the proportion of Japa-nese TNCs in 2001 that identi ed China as one of the 10 most promising locationsfor manufacturing FDI jumped to 82 percent from 65 percent in 2000 Most telling ofall the ldquoidenti cation gaprdquo between China and the United States which wereranked rst and second respectively in 2000 and 2001 widened from 24 percentagepoints in 2000 to 50 percentage points in 2001

The frequency with which the ASEAN-4 economies were identi ed as top 10 loca-tions for FDI dropped between 1996 and 2000 and the most important reason forthis change in the TNCsrsquo perception could be the Asian nancial crisis The fre-quency with which Thailand was identi ed as a top 10 location for FDI fell from 36percent to 24 percent Indonesia from 34 percent to 15 percent Malaysia from 20 per-cent to 12 percent and the Philippines from 13 percent to 8 percent In terms ofranking within the 10 most-cited locations Thailand slipped from 2 to 3 Indonesiafrom 3 to 4 and the Philippines from 8 to 10 whereas Malaysia improved from 6to 5

As the Asian nancial crisis was over by early 2000 changes in the frequency ofidenti cation and ranking of the ASEAN-4 economies on the list of pro table FDIlocations between 2000 and 2001 can therefore justi ably be attributed to the WTO-created improvement in Chinarsquos reliability as an international supplier Thailandand Indonesia were identi ed as desirable FDI locations with nearly equal frequen-cies in 2000 and 2001 but the gaps between their frequencies of identi cation andthat of China increased signi cantly The China-Thailand gap went up from 41 per-centage points to 57 percentage points and the China-Indonesia gap from 50 per-



centage points to 68 percentage points The frequency with which Malaysia wascited in the top 10 declined from 12 percent to 8 percent and the Philippinesdropped out of the top 10 list Malaysiarsquos rank moved from 5 to 9 and the China-Malaysia identi cation gap soared from 53 percentage points to 74 percentagepoints These differences in the survey results of 2000 and 2001 are certainly consis-tent with our hypothesis of WTO-induced diversion of FDI to China

Even more direct evidence for our FDI diversion hypothesis is found in a survey un-dertaken by the Japan External Trade Organization (JETRO) in October 2001 JETROasked Japanese TNCs whether they would relocate their existing production facili-ties to China in response to Chinarsquos accession to WTO and 21 percent replied thatthey were planning to do so Of those intending to relocate 675 percent of themwould be relocating from Japan 90 percent from Hong Kong 66 percent from Tai-wan and 60 percent from the ASEAN-4 The complete breakdown of the locationsto be abandoned is given in table 5 Although 99 percent of Japanese TNCs withexisting investments in ASEAN-4 and Singapore stated in another survey thatthey would stay put UNCTAD (2002 44) insightfully noted that ldquo[this] does notof course mean that their production in China will not expand faster than inASEANrdquo

The JBIC and JETRO surveys had two main ndings

1 There was a 17 percentage point jump in 2001 in the frequency with which Chinawas identi ed as a top FDI location and a general decline in the frequencies withwhich the ASEAN-4 economies were identi ed as top FDI locations



Table 4 Ten most promising destinations for manufacturing FDI by Japanese TNCs over thenext three years (frequency expressed in percent with which a particular country isidenti ed as a promising location for FDI by Japanese rms responding to annual surveysconducted by Japan Bank for International Cooperation)

Rank 1996 survey Ratio 2000 survey Ratio 2001 survey Ratio

1 China 68 China 65 China 822 Thailand 36 United States 41 United States 323 Indonesia 34 Thailand 24 Thailand 254 United States 32 Indonesia 15 Indonesia 145 Vietnam 27 Malaysia 12 India 136 Malaysia 20 Taiwan province

of China 11Vietnam 12

7 India 18 India 10 Taiwan provinceof China 11

8 Philippines 13 Vietnam 9 Republic of Korea 89 Singapore 10 Republic of Korea 9 Malaysia 8

10 United Kingdomand Taiwanprovince of China 7

Philippines 8 Singapore 6


Note Ratio is share of rms that consider a particular country as promising in total respondent rms (multiple responses) Fiscal year

2 Twenty-one percent of rms indicated that they would move their existing pro-duction to China

It appears reasonable to us to conclude from these ndings that Chinarsquos WTO mem-bership is encouraging producers to choose China over the other East Asian econo-mies as the site for their investments in additional capacity andor to move their ex-isting production capacity to China We realize that the JBIC and JETRO surveys didnot cover non-Japanese TNCs but anecdotal evidence from the authorsrsquo visits toEast Asia suggests that (1) there is ongoing relocation of existing investments toChina and (2) the location of new production capacity in China also applies to USHong Kong South Korean and Taiwanese producers

A recent news report makes it clear that the drop in inward FDI in Malaysia hasbeen substantial in 2002 and that the Malaysia government has no doubt that muchof the drop is attributable to FDI diversion to China

Malaysia attracted approved manufacturing FDI of only RM 216 billion forthe rst six months of this year [2002] This is a sharp drop from the RM 1882 bil-lion it pulled in for the whole of last year

ldquoEverybody is feeling the pinch because the amount of FDIs has shrunk andthen a lot of that is going to Chinardquo Dr Mahatir [prime minister of Malaysia]told a news conference later8



Table 5 Japan External Trade Organization survey undertaken in October 2001 of the 21percent of Japanese TNCs that intended to move to China because of Chinarsquos accession toWTO

Planned relocation of production sites of these Japanese TNCs (percentage of TNCs responding)

From Distributive share

Japan 675Hong Kong China 90Taiwan Province of China 66ASEAN-4 60

Malaysia 30Indonesia 12Philippines 12Thailand 06

United States 42Singapore 18Republic of Korea 12Other Asian countries 12Mexico 12United Kingdom 12

8 ldquoMalaysia Turns Inward for Growthrdquo Straits Times 21 September 2002 Six months later TheStraits Times reported (rdquoMalaysia Is Losing Investors to China Vietnamrdquo 6 February 2003)that ldquoAsia-Taiwan Businesses Association honorary president Tan Kun Huang said that the

Indeed the consulting rm AT Kearney just released (in September 2002) a surveyof senior executives of the worldrsquos largest corporations that found that ldquoChina hasfor the rst time supplanted the US as the most attractive destination for foreign di-rect investmentrdquo9

We now ask whether the effects generated by the diversion of FDI from theASEAN-4 can be fully captured by a decrease in the capital stock of the ASEAN-4and a corresponding increase in the capital stock of China In our opinion the an-swer is no for at least two reasons The rst reason is that the diversion of FDI doesnot necessarily produce a new steady state in which there are winners and losers Ina dynamic optimizing general equilibrium model the new steady state could haveonly winners distinguished by big winners versus small winners Ceteris paribusan increase in the rate of return on investments in China (ie a decrease in the sizeof the risk premium required for investments in China) could motivate the world tosave more and produce a larger global capital stock in the new steady state The factthat a bigger proportion of the expanded global capital stock is now located inChina does not rule out the possibility that the nal capital stock in the ASEAN-4would be larger than the original capital stock We note that it is almost a mathemat-ical necessity that a zero-sum outcome in economic welfare is very much more likelyin a static general equilibrium model (such as a computable general equilibrium[CGE] model) because the size of the global stock is xed by assumption In shortwe can analyze FDI diversion adequately only if we use a model in which the globalcapital stock is endogenously generated

The second reason why FDI diversion should not be thought of as a simple reloca-tion of the capital stock is that FDI can also generate externalities The East Asian ex-perience suggests that FDI can facilitate technological transfers (ie generate tech-nological spillovers) not only to domestic rms in the same industry but also todomestic rms in other industries10 Furthermore FDI can help solve the dif cultiesof access to the international markets in these goods In short a country gaining FDIcan experience not only a bigger capital stock but also possibly a (perhaps tempo-rary) increase in its total factor productivity (TFP) growth rate whereas a country



82-percent contraction [in FDI from Taiwan] compared with the previous year was largelydue to Malaysia losing its edge as a cheap labor market Sin Chew [a newspaper] quotedDatuk Tan as saying that Taiwanese investors were looking increasingly towards cheap andlarge labor pools in China and Vietnam Meanwhile Nanyang Siang Pau [a newspaper]reported than an in ux of cheap China-made goods was threatening the competitiveness oflocal businessesrdquo

9 ldquoChina Attracts More Foreign Investors than USrdquo Financial Times 22 September 2002

10 See Okabe (2002) for a recent con rmation of the existence of these technological spillovers

losing FDI can experience a (perhaps temporary) slowdown in TFP growth as wellas a (perhaps temporary) lower capital stock

We now close the theoretical discussion by summarizing the guidance provided bystandard international trade theory on thinking about Chinarsquos WTO membershipand the analysis of how to supplement standard theory in order to analyze the issuemore adequately There are three levels of answers to this question

The rst level is the most straightforward because it is the standard analysis of aunilateral cut in effective lower rates The expectation is that WTO accession wouldhave the biggest impact on China and a zero or a positive impact on most tradepartners We call the rst-level answer the naive analysis

The second-level answer recognizes that not only would there be tariff cuts as re-quired by WTO membership but also the risk premium required for investing inChina would be lowered as a result of the removal of the annual MFN threat toChina The expectation generated by the latter development is that there would bediversion of FDI to China especially from its East and Southeast Asian neighborsWe call this second-level answer the FDI diversion analysis

The third-level answer enriches the second-level answer by pointing out that FDInot only would increase the domestic capital stock but would also increase techno-logical transfers to the whole economy and facilitate the access of more Chinesegoods to foreign markets We call this the analysis of the diversion of FDI with techno-logical spillovers

4 Modeling Chinarsquos economic linkages to the world The G-cubed(Asia-Paci c) model

Any analysis of the implications of Chinarsquos joining the WTO on the Asia-Paci c re-gion needs to be undertaken using a model that adequately captures the importantlinkages between China and the region through the trade of goods and services andcapital ows The G-cubed Asia-Paci c (AP-GCUBED) model is ideal for such anal-ysis having both a detailed country coverage of the region and rich links betweencountries through goods and asset markets11 The AP-GCUBED model encompasses



11 Full details of the model including a list of equations and parameters can be found onlineat httpwwwmsgplcomaumsgplapgcubed46nindexhtm The AP-GCUBED is basedon the GCUBED model (described in McKibbin and Wilcoxen 1998) which is in turn an ex-pansion of the MSG2 model founded by McKibbin and Sachs (1991) Roughly speaking theparameters are estimated from data up to 1996 and we performed the simulations by shift-

the United States Japan Australia New Zealand South Korea the rest of OECD(ROECD) China Indonesia Malaysia the Philippines Taiwan Thailand HongKong Singapore India OPEC members EEFSU (Eastern Europe and the former So-viet Union) and the rest of the world (ROW) Each of these 18 economic entities inthe AP-GCUBED model has six sectors energy mining agriculture durable manu-facturing non-durable manufacturing and services

Each core economy or region in the model consists of several economic agentshouseholds the government the nancial sector and the six production sectorsIntertemporal budget constraints are imposed on households governments and na-tions (the latter through accumulations of foreign debt) To accommodate these con-straints forward-looking behavior is incorporated in consumption and investmentdecisions The investment process is assumed to be subject to rising marginal costsof installation Aggregate consumption is chosen to maximize an intertemporal util-ity function subject to the constraint that the present value of consumption must beequal to human wealth plus initial nancial assets

We take each regionrsquos real government spending on goods and services to be a xedshare of GDP and assume that it is allocated among nal goods (consisting of bothdomestically produced and imported goods) and services and labor in xed propor-tions which we set to 2000 values We assume that agents will not hold governmentbonds unless they expect the bonds to be paid off eventually A government that isrunning a budget de cit today must run an appropriate budget surplus in the fu-ture Otherwise the government would be unable to pay interest on the debt andagents would not be willing to hold the governmentrsquos bonds

International trade imbalances are nanced by ows of nancial assets betweencountries (except where capital controls are in place) We assume that existingwedges between rates of return in different economies are generated by various re-strictions that generate a risk premium on country-denominated assets Thesewedges are assumed to be exogenous during simulation Thus when the model isrun the induced changes in expected rates of return in different countries generate ows of nancial capital reacting to return differentials at the margin

As a result of this structure the AP-GCUBED model contains rich dynamic behav-ior driven on the one hand by asset accumulation and on the other by wage adjust-



ing the constants in all the equations to ensure that the starting point of our projections is2000 In short the model starts off in 2000 with all the variables having their actual valuesin 2000 for example the model uses the actual pattern of trade in 2000 to generate the simu-lations in this study

ment to a neoclassical steady state It embodies a wide range of assumptions aboutindividual behavior and empirical regularities in a general equilibrium frameworkA computer algorithm computes the rational-expectations equilibrium of the globaleconomy It is important to stress that the term ldquogeneral equilibriumrdquo is used to sig-nify that as many interactions as possible are captured not that all economies are ina full market-clearing equilibrium at each point in time Although it is assumed thatmarket forces eventually drive the world economy to a neoclassical steady-stategrowth equilibrium unemployment does emerge for long periods because of wagestickiness to an extent that differs among countries as a result of differences in labormarket institutions The model has approximately 7400 equations in its currentform with 140 jumping or forward-looking variables and 263 state variables

To recapitulate there are three signi cant qualitative differences between the AP-GCUBED model and the standard computable general equilibrium (CGE) model12

1 The AP-GCUBED is based on explicit intertemporal optimization by the agents(consumers and rms) in each economy In contrast to static CGE models timeand dynamics are of fundamental importance in the AP-GCUBED model

2 There is an explicit treatment of the holding of a range of nancial and real assets(money bonds equity household capital physical capital etc) in the AP-GCUBED model Money is introduced into the model through the restriction thathouseholds require money to purchase goods The model distinguishes betweenthe stickiness of physical capital within sectors and within countries and the exibility of nancial capital which immediately ows to where expected re-turns are highest This important distinction leads to a critical difference betweenthe quantity of physical capital that is available at any time to produce goods andservices and the stock market valuation of that capital as a result of decisionsabout the allocation of nancial capital So the AP-GCUBED model has linkagesbetween the nancial markets and the real sectors unlike the usual CGE modelswhich do not have nancial markets

3 In the AP-GCUBED model the behavior of agents is modi ed to allow for short-run deviations from optimal behavior resulting from either myopia or restric-tions on the ability of households and rms to borrow at the risk-free bond rateon government debt The model also allows for short-run nominal wage rigidity(by different degrees in different countries) and therefore allows for signi cant



12 Adhikari and Yang (2002) Jiang (2002) Ianchovichina and Martin (2001) Lejour (2000) andWang (2002) are recent examples of CGE-based analyses that ignore the role of capital owsand dynamic adjustment Surveys of such CGE-based studies are undertaken in McKibbinand Tang (2000) and Morrison (2001)

periods of unemployment depending on the labor market institutions in eachcountry The deviations from intertemporal optimizing behavior take the form ofrules of thumb which are chosen to generate the same steady-state behavior asoptimizing agents so that in the long run there is only a single intertemporal op-timizing equilibrium of the model The AP-GCUBED modelrsquos assumptions hencediffer from the market-clearing assumption in most CGE models

5 Speci cations of the simulations

We will undertake four sets of simulations that are guided by the theoretical discus-sions in sections 2 and 3 (1) baseline simulations (2) naive simulations (3) reduc-tion-in-risk-premium simulations (the FDI diversion case) and (4) diversion-of-FDI-with-technological-spillovers simulations

51 Baseline simulations

The baseline simulation generates the future values of all the endogenous variablesbased on the assumption that the existing policy regimes in the world will persistinde nitely into the future for example China is not a WTO member To generatethe results we rst solve the model from 1999 to 2070 to generate a model baselinebased on a range of assumptions One set of assumptions is that the year 2000 tariffrates are constant forever Other crucial assumptions needed for generating thebaseline include assumptions about population growth (from World Bank projec-tions) and sectoral productivity growth by country as well as scal and monetarypolicy settings Productivity growth in each sector in each country is assumed tocatch up to the rate of productivity growth in the equivalent sector in United Stateswith the gap in the growth rates closing at 2 percent per year The initial ldquoproductiv-ity gapsrdquo for each sector in each country are calibrated to be consistent with the un-derlying catch-up model and the average growth rates of economies from 1990 to1995 The issue of projection used in this paper is discussed in detail in BagnoliMcKibbin and Wilcoxen (1996)

The tariff rates we use are based on the GTAP 4 database (Global Trade AnalysisProject Purdue University) which estimates both tariff and nontariff barriers Weassume that the tariff rates in 2000 are continued forever

52 Counterfactual simulation 1 Naive simulation

The naive simulation is the straightforward simulation in which the only changesfrom the baseline model are the reduction in Chinarsquos trade barriers (both tariff andnontariff barriers) We assume that trade barriers are reduced gradually over time



by an equal amount (measured in percentage points) over the 10-year period from2003 to 201213 There is some uncertainty about the size and timing of tariff reduc-tions The assumptions we use in this paper are meant to be illustrative of the ordersof magnitude of the changes Speci cally for commodities we specify the following

1 Energy tariffs are reduced by 01 percentage point (with respect to the baselinetariff rate) each year beginning in 2003 until they are reduced by a total of 1 per-centage point (compared with the baseline) in 2012

2 Mining tariffs are reduced by 02 percentage points each year to reach a total re-duction of 2 percentage points in 2012

3 Agriculture tariffs are reduced by 28 percentage points each year to reach a totalreduction of 28 percentage points in 2012

4 The tariffs on manufactured durable goods are reduced by 06 percentage pointseach year to reach a total reduction of 6 percentage points in 2012

5 Tariffs on manufactured non-durable goods are reduced by 12 percentage pointseach year to reach a total reduction of 12 percentage points in 2012

An important aspect of Chinarsquos accession to the WTO is the opening of trade in ser-vices that China has promised as a condition of accession This is a wide-ranging re-form that will have important implications for the services sector in China Ourspeci cation of the liberalization of services is based on the arguments in McKibbinStoeckel and Tang (2000) namely that the entry of foreign service providers gener-ally causes the formerly sheltered domestic service providers to improve theiref ciency to meet the new competition For example the entry of McDonaldrsquos intoBeijing has caused domestic fast-food outlets to improve their service package mostnoticeably in the provision of clean restrooms for the use of customers In short theliberalization of trade in services forces ef ciency improvements that lower the costcurves of the domestic service industries (hence improving the bottom lines of allconcerned) We will hence specify the liberalization of the service sector as an im-provement in labor-augmenting technology of 012 percentage points beginning in2003 to reach a total improvement of 108 percentage points (above baseline) in2011 that is a temporary rise in the rate of labor-augmenting technology growth for9 years

53 Counterfactual simulation 2 Reduction in the risk premium demandedby FDI

The reduction-in-risk-premium simulation supplements the naive simulation with a1-percentage-point reduction in the risk premium demanded by foreign investors in



13 This assumption of proportional reductions is from Wang (2002) and is consistent with thereductions agreed to by China as part of the WTO accession negotiations

China This 1-percentage-point reduction is small compared with the jump of 8 per-centage points in the risk premium demanded by foreign investors in SoutheastAsia at the height of the Asian nancial crisis

54 Counterfactual simulation 3 FDI creates technological spillovers in the hosteconomy

In the rst two counterfactual simulations international capital ows respond to thechanges in expected rates of return to capital However capital ows are assumednot to have any direct effect on technological change There is a large debate as towhether FDI ows might alter the rate of technical change in economies In thediversion-of-FDI-with-technological-spillovers simulation we incorporate this effectto illustrate how the results for the rst two counterfactual simulations mightchange as a result of FDI-induced technological change Our modeling of possibletechnological spillovers created by FDI ow from a richer country to a poorer coun-try is based on the following four assumptions

Assumption 1 There is a ldquonaturalrdquo steady-state TFP growth rate for every sectorand this rate is determined by the expansion of global scienti c knowledge that isrelevant to that sector The difference between a developed economy and a develop-ing economy is that the developed economy is on the ldquonaturalrdquo steady-state TFPgrowth path and the developing economy is operating below the frontier de nedby the ldquonaturalrdquo steady-state TFP growth path This is illustrated in gure 3 inwhich the developed economy is proceeding on the ldquofrontier TFPrdquo growth path andthe developing economy is operating at point 0

Assumption 2 Because of the natural process of technological diffusion techno-logical transfers from FDI and catch-up programs in science established by the gov-ernments of the developing economy the developing economy is converging to-ward the world TFP frontier at a rate that is proportional to the distance between itspresent TFP level and the frontier TFP level This is also illustrated in gure 3 whichshows the developing country catching up to the (moving) technology frontier ofthe industrial economies via the ldquostatus quordquo growth path (the catch-up TFP growthpath) which is the baseline TFP growth rate of the developing economy

Assumption 3 We assume that changes in FDI alter the speed of catch-up over adecade When the FDI out ow from the richer economy increases the TFP growthrate in the developing economy increases temporarily above the baseline TFPgrowth rate The faster the developing economy can absorb the new technologicalknowledge contained in the additional FDI in ow the higher is the TFP growth rateabove the baseline TFP growth rate and the shorter is the length of the transitionperiod to the new catch-up path In the limit where the developing country instan-



taneously grasps the new knowledge fully it jumps right onto the new catch-up TFPgrowth path This too is illustrated in gure 3 in which the new TFP growth rate ishigher than the baseline TFP growth rate for 10 years and at the end of each yearthe developing economy is on a higher catch-up path

Assumption 4 When the FDI out ow from the richer economy decreases the TFPgrowth rate of the developing economy decreases (with the lower bound of zerogrowth rate) We assume that the authorities in the developing economies will atsome point establish effective catch-up scienti c programs to bring the TFP growthrate back to the baseline TFP growth rate The result is that the developing economywill be on a lower catch-up TFP growth path In the limit where the authorities areable instantaneously to raise its scienti c base adequately to prevent the slowdownin FDI in ow from lowering the TFP growth rate then the developing country willstay on its baseline TFP growth path (the ldquostatus quordquo path in gure 3)

In line with the above four assumptions we supplement the simulation of the FDIdiversion case with the following ve conditions

1 A temporary decrease in the TFP14 growth rate of the manufactured durablegoods industries located in Indonesia Malaysia the Philippines and Thailand



Figure 3 Transition dynamics from changes in FDI ows

14 In our model TFP growth is the residual contribution to output growth after the contribu-tion from capital accumulation and the contribution from the growth of effective labor sup-ply have been taken into account Effective labor is ldquorawrdquo labor multiplied by the level oflabor-augmenting technology

We assume an annual decline of 1 percentage point beginning in 2003 until theTFP level is 10 percentage points below the baseline TFP level in 2112

2 A temporary decrease in the TFP growth rate of the manufactured non-durablegoods industries located in Indonesia Malaysia the Philippines and ThailandWe assume an annual decline of 1 percentage point beginning in 2003 until theTFP level is 10 percentage points below the baseline TFP level in 2112

3 A temporary increase in the TFP growth rate of the manufactured durable goodsindustries in China We assume an annual increase of 1 percentage point begin-ning in 2003 until the TFP level is 10 percentage points above the baseline TFPlevel in 2112

4 A temporary increase in the TFP growth rate of the manufactured non-durablegoods industries in China We assume an annual increase of 1 percentage pointbeginning in 2003 until the TFP level is 10 percentage points above the baselineTFP level in 2112

5 A temporary increase in the TFP growth rate of the service industries in ChinaWe assume an annual increase of 1 percentage point beginning in 2003 until theTFP level is 10 percentage points above the baseline TFP level in 2112

The above ve conditions are assumptions about the stances of public policy andthe steepness of the learning curves in the ASEAN-4 and China We assume that itwill take a decade for the ASEAN-4 to improve their scienti c bases suf ciently tooffset the slowdown in technological diffusion resulting from the lower FDI in owsWe also assume that it will take a decade for the Chinese sectors to master fully thenew technology contained in the diverted FDI Again these are assumptions ratherthan predictions but they give indicative estimates of the impacts of a range ofplausible assumptions

55 Some considerations in thinking about the simulation results

It is important to keep in mind that we are not forecasting the future value of eachvariable rather we are forecasting the WTO-induced deviation in the future valueof each variable under a range of different assumptions We are not arguing that anyof the simulations are more or less realistic but are presenting alternative possiblescenarios for consideration The closest we come to forecasts of future values are thebaseline projections that are conducted under the assumption of the credible main-tenance of the status quo (existing policy regimes) from 1999 for example no WTOmembership for China into the inde nite future Our rules of thumb for simplifyingthe assessment of the simulation results are as follows

1 Deviations that are less than 1 percentage point from the baseline will be re-garded as having little practical importance



2 The deviation in 2005 will represent the short-run effect3 The deviation in 2020 will represent the long-run effect

The focus group of our study consists of China the United States Japan AustraliaNew Zealand South Korea ROECD (the rest of the OECD) Taiwan IndonesiaMalaysia the Philippines and Thailand

6 The results of the simulations

61 The naive simulation

The overall results indicate that as long as the removal of trade barriers in China isnot accompanied by a diversion of FDI into China Chinarsquos WTO membership willhave signi cant economic effects only on Chinarsquos economy All 12 economic entitiesin the focus group have deviations in exports GDP consumption and investment ofless than 1 percent from the baseline Figure 6 indicates that Chinarsquos exports will beslightly above the baseline by 1 percentage point in the long run The next highestdeviation is a long-run increase of 08 percentage points for US exports ( gure 4)The short-run deviations in Chinese and US exports are about half of the long-rundeviations The other 10 economies in our focus group have deviations that are lessthan 03 percentage points from the baseline



Figure 4 Change in exports Naive case

Figure 5 displays the deviations from baseline GDP for 11 countries in the naivecase None of the GDP deviations are more than 02 percent from the baseline All ofthe consumption and investment deviations are less than 1 percent from the base-line Figure 6 shows that the short-run impacts on Chinarsquos GDP consumption andinvestment are almost negligible and the long-run impacts on these variables arerespectively 25 12 and 08 percentage points above the baseline The interestingfeature of this naive simulation is that it shows that the immediate impact (2003and 2004) on China is slightly de ationary re ecting perhaps the increased in owof imports

62 Simulation of the FDI diversion case

The overall results in the FDI diversion case are qualitatively similar to those in thenaive case in the long run but the key difference is that the quantitative effects onChina are magni ed Figure 9 reports an interesting ip- op impact on Chinarsquos ex-ports In 2005 Chinarsquos exports will be 7 percent lower than the baseline but in 2020they will be almost 4 percent higher There are two alternative (and equivalent)ways of thinking about this adjustment The export drop in 2005 is caused by therise in consumption and investment (whose movements we will explain later) andthe rise in the domestic absorption of goods and services means less goods and ser-vices are leftover for exports Chinarsquos investment boom (see gure 9) will mean that



Figure 5 Change in real GDP in other countries Naive case



Figure 6 Real effects on China Naive case

Figure 7 Change in exports FDI diversion case

more capital goods (ie manufactured durable goods) will be imported The alter-native insight is that the large in ow of capital into China causes a real exchangerate appreciation in the short run that makes Chinese exports more expensive andChinese imports cheaper The in ow of real resources results from the exchange rateadjustment and the net deterioration in net exports Over time the returns to the for-eign investment in China are repatriated to foreigners and this shows as an im-provement in Chinese net exports induced by a weakening exchange rate Thein ow of capital into China is an out ow of capital from the United States whichweakens the US dollar and increases the demand for US exports ( gure 7) Someof these exports are capital goods to China For the rest of the countries in the focusgroup the export deviations are minor

Figure 8 reveals that although the deviations in GDP for most of the countries ex-cept for China ( gure 9) are negative the magnitudes of the deviations are trivial In2020 the deviations of 10 economies are below 03 percent and South Korearsquos devia-tion is almost 05 percent It is hard to say that any of the 11 economies are hurt in anontrivial way Figure 9 shows China embarking upon a sustained boom uponWTO accession Chinarsquos GDP jumps to 36 percent above baseline in the rst yearslows down in the following 3 years and then resumes its high rate of growth to be5 percent higher than the baseline by 2020 The end of the annual MFN threat to



Figure 8 Change in real GDP in other countries FDI diversion case

Chinarsquos exports increases the effective rate of return on capital in China and causesthe long-run level of investment to be almost 20 percent above the baseline Thesigni cant but temporary rise in Chinarsquos consumption in the short run may re ectthe relaxation of the liquidity constraints imposed by Chinarsquos inef cient nancialsystem Given Chinarsquos expected higher future income it would be rational for eco-nomic agents to smooth their consumption but the absence of consumer credit pre-vents this from occurring The WTO-induced in ow of foreign funds relaxes the li-quidity constraint and allows consumption to jump

63 Simulation of the case of diversion of FDI with technological spillovers

The overall results for the case in which FDI out ows induce slower technologicalchange and in ows induce faster technological change show large gains for Chinaand sizable losses for the ASEAN-4 ( gures 10 and 11) There is very little impact onthe other countries other than Hong Kong (not shown here) Figure 12 shows along-run increase in Chinarsquos exports that is 31 percent above baseline whereas g-ure 10 shows that Indonesian exports are down by 17 percent Malaysian exportsare down by 64 percent the Philippinesrsquos exports are down by 47 percent and Thaiexports are down by 68 percent The other countries shown in gure 10 have exportdeviations of less than 1 percent from baseline export levels



Figure 9 Real effects on China FDI diversion case

Figure 11 shows substantial long-run GDP losses by four Southeast Asian econo-mies 7 percent for Thailand 5 percent for Malaysia and the Philippines and 3 per-cent for Indonesia Figure 12 shows that Chinarsquos GDP consumption and investmentdecline initially but then recover to move strongly to reach long-run levels that arerespectively 25 percent 15 percent and 30 percent above their baselines Althoughthis is not shown in the gures presented here we note that because Hong Kong isso deeply integrated into Chinarsquos economy Chinarsquos high growth raises Hong KongrsquosGDP 27 percent higher than its baseline This high growth still does not generatemuch in the way of positive growth effects on the other non-ASEAN trade partnerseven on East Asian neighbors that do not depend much on FDI Japanrsquos GDP is only04 percent higher in 2020 South Korearsquos GDP is 06 percent higher Taiwanrsquos GDP is03 percent higher and the rest of the OECDrsquos (ROECD) GDP is 03 percent higher

7 Changes in the composition of exports De-industrialization ornew niches

In this section we quantify the changes in the export compositions of Chinarsquos tradepartners in each scenario discussed above Table 6 shows the total exports of eacheconomy (or grouping) generated by the four simulations The naive and FDI



Figure 10 Changes in exports Case of diversion of FDI with technological spillovers



Figure 11 Change in real GDP in other economies Case of diversion of FDI withtechnological spillovers

Figure 12 Real effects on China Case of diversion of FDI with technological spillovers

diversion simulations show no case (not even for China) in which exports deviatemore than 5 percent from the baseline In the simulation of the diversion of FDIwith technological spillovers large deviations were seen for four countriesmdashChina(33 percent) Malaysia (7 percent) Philippines (5 percent) and Thailand (8 per-cent)mdashsuggesting that these four economies might be the ones with the biggestchanges in their production structures as a result of Chinarsquos WTO accession

There are two other noteworthy points to be made from the results presented in ta-ble 6 First the main reason why the developed countries appear to be relatively un-affected by Chinarsquos WTO accession may be that Chinarsquos imports of advanced capitalgoods account only for a small portion of OECDrsquos exports The outcome is that evena large percentage change in the amount of Chinarsquos imports from OECD would notcause total OECD exports to show noticeable changes

Second it is important to note that during the adjustment period competitivenessimprovements in China caused by lower tariffs and cost reductions resulting frominduced technical change make Chinese exports more competitive but the capitalin ows induced by a rise in the return to capital in China causes an appreciation ofthe Chinese real exchange rate which makes Chinese exports less competitive over-all These two offsetting effects explain why trade ows respond by less in the shortto medium term than might be expected

When we examine the export composition in each scenario for every country andthe changes in each export component we nd no substantial changes in any coun-try under the naive simulation The only export composition under the FDI diver-



Table 6 Total exports in 2020 (US$ billion 1999 prices)

Baseline Naive caseFDI diversioncase

Diversion of FDI withtechnological spillovers

United States 133452 134479 134597 134325Japan 76117 76077 76309 75945Australia 12305 12324 12324 12343New Zealand 3231 3234 3235 3231Indonesia 10852 10868 10890 10505Malaysia 15418 15415 15411 14346Philippines 4842 4848 4848 4589Singapore 27682 27699 27715 27596Thailand 13406 13414 13401 12321China 31303 31801 32462 41521India 5592 5593 5589 5594Taiwan 22775 22764 22725 22750South Korea 29733 29819 29850 29948Hong Kong 12334 12443 12540 12635ROECD 217398 216848 217259 215956LDC 79915 80135 80214 79982EEFSU 31633 31656 31714 31678OPEC 56905 56779 56761 56894

sion simulation that shows substantial changes is Chinarsquos (see table 7) In the exportcompositions from the diversion-of-FDI-with-technological-spillover simulation weobserve signi cant deviations from the baseline only in the ASEAN-4 and China15

Table 7 indicates the following with regard to the simulation depicting diversion ofFDI with technological spillovers

1 Manufacturing exports account for 27 percentage points of the 33 percent in-crease in Chinarsquos total exports above the baseline

2 The manufacturing sectors in the ASEAN-4 show substantial long-run declinesvis-agrave-vis their baselines In Indonesia and the Philippines the drop in manufac-tured exports exceeds the drop in total exports and in Malaysia and Thailand thedecline in manufactured exports accounts for respectively 97 percent and 91 per-cent of the fall in total exports

The simulations reveal that the only economies that may be de-industrialized byChinarsquos WTO accession are the ASEAN-4 but for that to happen they will have tobe slow in reversing the reduced rate of technological diffusion a by-product of thereduced FDI in ow When the ASEAN-4 are able to reverse this rate quickly thenwe are back in the FDI diversion case In the FDI diversion case Chinarsquos insertion ofone-third more workers into the international division of labor leads to further divi-sion of labor (ie to even ner specialization in production activities) within the



Table 7 Deviation of exports from baseline in 2020

China Indonesia Malaysia Philippines Thailand

1 Simulation of FDI diversion

Deviation of total exports from baseline (percent)370 034 2004 012 2004

Contribution to deviation from baseline (percentage points)Energy 011 064 001 004 000Mining 001 2002 000 001 000Agriculture 2010 2002 008 004 012Durable manufacturing 144 2001 2008 002 2001Non-durable manufacturing 087 2014 001 002 2002Services 136 2010 2006 2001 2013

2 Simulation of diversion of FDI with technological spillovers



15 The rest of the countries do not show large deviations in their top two exports

manufacturing sector worldwide rather than to the displacement of the ASEAN-4from manufacturing The lengthening of the production chains in manufacturingcreates niches in manufacturing activities into which the ASEAN-4 can t them-selves because they are technologically versatile For the ASEAN-4 to have such ver-satility their governments must invest in strengthening the scienti c and technolog-ical capabilities of their citizens

8 Changing the course of the fate of the ASEAN-4

There are two ways in which the ASEAN-4 can enhance their technological capaci-ties and get new cutting-edge technology (1) to innovate indigenously and (2) toobtain technology transfer from elsewhere for example technological diffusion viaforeign direct investment The Global Competitiveness Report 2000 published by theWorld Economic Forum ranks 59 countries according to a technological capacity in-dex determined by averaging two other indices the indigenous innovation indexand the technology transfer index The rst three columns in table 8 show the na-tional ranking of various countries and the ASEAN-4 overall in the two componentindices and in the overall technological capacity index

We see from the table that in the ranking based on the overall technological capacityindex Malaysia (18) the Philippines (32) and Thailand (43) are above China (48)whereas Indonesia (50) is only slightly below China However when we see that thehigher average rank of the ASEAN-4 comes from the higher technology transferfrom abroadmdashthe rank of Malaysia is 7 that of the Philippines is 19 that of Thailandis 36 that of China is 43 and that of Indonesia is 45mdashwe realize how critically theASEAN-4 average depends on technological diffusion through FDI FDI diversionas a result of Chinarsquos WTO membership is therefore likely to cause the future rankof Indonesia Malaysia the Philippines and Thailand in the overall technology in-dex to fall and that of China to rise

The ASEAN-4 have a lot of work to do in enhancing their indigenous technologicalcapabilities In the indigenous innovation index China ranks almost as high as Ma-laysia and signi cantly higher than the Philippines Thailand and Indonesia

Of course the growth rate of a country depends on several other important factorsbesides technological capacity For example the Soviet Unionrsquos story was one ofworld-class accomplishments in basic scienti c research but of abysmal perfor-mance in applied scienti c research and hence in overall economic growth The fun-damental problem in the former Soviet Union was the absence of a market economy



which meant that there were grossly inadequate incentives to mobilize people totranslate basic research into commercial applications For market economies factorssuch as economic openness meritocracy adequacy of infrastructure ef cient andincorruptible government quality of nancial institutions and astuteness in macro-economic management are of fundamental importance in economic growth Thegenerally low rankings of the ASEAN-4 on these other dimensions (World Eco-nomic Forum 2000) along with their low ranking in technological capacity help ex-plain why ASEAN-4 countries have performed quite poorly in the index for growthcompetitiveness for the 59 countries as shown in the nal column in table 8 Thehigh rankings that Hong Kong has on these other dimensions (eg 1 in trade open-ness and 4 in sophistication of nancial markets) boosted its overall growth compet-itiveness index ranking despite its being ranked 30th in technology level

Clearly although the ASEAN-4 countries should boost technological capacity by fo-cusing on applied research they also need people at the frontier of research Thismeans that there should be more investment in higher education and not in airplanefactories The establishment of linkages between the universities and the businesssector should be fostered and the establishment of state-owned factories should bestopped



Table 8 Indices of technological capacity and of growth competitiveness across countries in2000

Indigenousinnovation index

Technology transferindex

Overall technologicalindex

Growthcompetitivenessindex

United States 1 Singapore 1 United States 1 United States 1Finland 2 Ireland 2 Finland 2 Singapore 2Germany 3 Luxembourg 3 Singapore 3 Luxembourg 3Switzerland 4 Malaysia 7 Ireland 4 Netherlands 4Japan 5 Taiwan 12 Germany 5 Ireland 5Singapore 14 South Korea 13 Switzerland 6 Finland 6Taiwan 16 Hong Kong 17 Japan 7 Canada 7South Korea 22 Philippines 19 Malaysia 18 Hong Kong 8Hong Kong 27 India 26 Taiwan 24 Taiwan 11Malaysia 30 Thailand 36 South Korea 25 Japan 21China 34 Japan 39 Hong Kong 30 Malaysia 25India 38 China 43 Philippines 32 South Korea 28Philippines 47 Indonesia 45 India 37 Thailand 31Thailand 50 ASEAN-4 (average) 27 Thailand 43 Philippines 37Indonesia 55 China 48 China 41ASEAN-4 (average) 46 Indonesia 50 Indonesia 44

Ecuador 58 India 49Bolivia 59 Bulgaria 58ASEAN-4 (average) 36 Ecuador 59

ASEAN-4 (average) 34

Source World Economic Forum (2000)

Note The indigenous innovation index and technology transfer index are the two components of the overall technology index The

overall technology index is combined with the startup index (relative ease in establishing a new rm) to produce the economic creativity

index The growth competitiveness index is constructed from the economic creativity index the nance index (relative ef ciency of the

nancial system) and the international index (degree of integration into the international economy)

We should be clear that our suggestion that aggressive technology policies beadopted in Southeast Asia is compatible with our acceptance of the comparative-advantage principle and the importance of pursuing market-compatible economicpolicies Speci cally the comparative-advantage principle would counsel againstthe use of industrial policies to ensure that a countryrsquos chief export is technology-intensive goods when the inherited factor endowment of the country shows ahigher ratio of unskilled labor to skilled labor compared with the ratios in othercountries16 The comparative-advantage principle would not however counselagainst policies to increase human-capital formation in a country and to enhancetechnology and capital transfers from abroad so that the country will begin to ex-port more goods that are technology-intensive Our point is simply that there is noinconsistency between producing an output composition that is in accordance withthe existing relative factor endowment of the country and seeking to change the rel-ative factor endowment by increasing the amount of human capital and raising thelevel of technology This is why the US government one of the most laissez-faire-oriented governments in the world is spending US$90 billion this year to increasethe technological capacity of the United States

9 Final remarks

The naive simulation con rms the prediction from standard trade theory that thetariff reductions required of China by WTO membership will render China better off(GDP is 25 percent above baseline in the long run) without hurting any of its tradepartners When we take into account that the removal of the annual MFN threatover Chinarsquos exports will divert FDI toward China Chinarsquos welfare is increased fur-ther (GDP is then 5 percent above baseline) again with practically speaking nonegative repercussions on other economies

If we now assume that it is possible that FDI in ow into a developing economy cre-ates technological spillovers then we see that the 25 percent higher GDP in China isaccompanied by GDP losses of 7 percent in Thailand 5 percent in Malaysia and thePhilippines and 3 percent in Indonesia We must mention however that these re-sults have been generated under the assumption that it will take 10 years of im-provements in the scienti c bases of the ASEAN-4 before they can restore the TFPgrowth rates in their domestic manufacturing sectors to the steady-state TFP growthrates in the manufacturing sectors of the advanced economies If the improvementsin the ASEAN-4 scienti c bases can occur faster then their GDP losses will be



16 The theoretically more correct ratio is the ratio of unskilled labor to total capital stock (hu-man capital and physical capital)

smaller A key part of the adjustment for ASEAN-4 in response to the diversion ofFDI to China should therefore be an accelerated upgrading of their indigenous tech-nological capabilities a large part of which will consist of raising the skill level ofthe workforce and widening the range of skills represented within the workforce

Our simulations suggest that the full integration of Chinarsquos huge labor force into theinternational division of labor will not reduce the size of the manufacturing sectorsin the OECD countries Only the ASEAN-4 face the possibility of de-industrializa-tion but de-industrialization will occur only if FDI ows affect domestic technologi-cal change (and this is an open question) and if the ASEAN-4 economies allow thedrop in FDI in ow to lower the rate of technological diffusion to their economies Ifthe ASEAN-4 can prevent themselves from falling behind technologically then theycan also nd lucrative niches in the lengthened production chains in manufacturingactivities This nding suggests that the ASEAN-4 must give the highest priority todeepening and widening their pools of human capital by speeding up the diffusionof new knowledge to their scientists and managers and providing appropriate re-training programs for the workers displaced by Chinarsquos exports

The entry of China into the WTO and its taking its place in the international eco-nomic system will permit further specialization of tasks in the workplace and this isa wealth-creating outcome The country that can provide its workforce with thedepth and range of scienti c training required in the new workplace will be in lineto receive some of the newly created wealth The country that is slow in building upits scienti c and technological capability is one that does not understand the rightremedy for the constant structural adjustment forced by globalization

Finally we must mention that the estimates presented here are conditional on manyassumptions and we want to draw particular attention to three of these assump-tions that are key The rst key assumption concerns our use of GTAPrsquos estimates ofeffective protection rates There are claims that GTAPrsquos estimates of nontariff barri-ers are too low and this means that our estimates of the increases in exports toChina from the rest of the world might be understated The changes to Chinarsquos im-ports reported here should perhaps be regarded as the lower limit on how muchChinarsquos imports would increase with Chinarsquos WTO accession

The second key assumption in this analysis is that China will be able to adjust rela-tively smoothly to the massive structural shifts forced by the economic opening re-quired by WTO membership This is clearly a debatable assumption As Sachs andWoo (2003 17) put it ldquoConservatively almost a fth of Chinarsquos workers might haveto change jobs and this could be a politically destabilizing process if not handled



adeptly and if external shocks were to slow down economic growthrdquo The state-owned-enterprise (SOE) sector in China employs over 60 percent of the urban laborforce and at least one-third of SOEs have been losing money for a decade andwould have been closed if not for continued state subsidies and trade protectionFurthermore about a third of the loans extended by the monopoly state-ownedbanking sector are nonperforming WTO membership will now require China tostop subsidizing the SOEs and to give foreign banks national treatment within 5years It is no wonder that Gordon Chang (2001) has received so much attention as aresult of his warning of forthcoming industrial depression and nancial sector col-lapse In our opinion such a pessimistic scenario is a possibility but we think thatChina has the ability to handle this problem see Sachs and Woo (2003)

The third key assumption in our simulations is that the world economy will con-tinue to have stable economic growth The international situation at the beginningof May 2003 certainly requires one to have second thoughts about this assumptionJapan shows no signs of recovering from its decade-long stagnation the two largesteconomies within the European Union are being pressed to reduce their budgetde cits (as required by the Stability Pact) when both show sluggish growth and in-ternational economic activities are being threatened by possible con icts in Iraq andNorth Korea If one were superstitious one would also note that the Chinese-Vietnamese-Korean Lunar New Year which fell on 1 February 2003 began on amost inauspicious note the disintegration of the space shuttle Columbia Althoughwe are not beginning the Year of the Ram with a ying start we remain hopefulthat the best is yet to be

References

Adhikari Ramesh and Yongzeng Yang 2002 What Will WTO Membership Mean for Chinaand Its Trading Partners Finance and Development September International Monetary Fund

Anderson Jonathan 2002 The Five Great Myths about China and the World Greater China An-alyst (May 30 June 20 July 11 September 17 and October 3) Goldman Sachs

Bagnoli Phillip Warwick McKibbin and Peter Wilcoxen 1996 Future Projections and Struc-tural Change In Climate Change Integrating Economics and Policy edited by Naki NakicenovicWilliam Nordhaus Rich Richels and Ferenc Toth CP 96-1 Vienna Austria International Insti-tute for Applied Systems Analysis

Chang Gordon 2001 The Coming Collapse of China New York Random House

Ianchovichina Elena and Will Martin 2001 Trade Liberalization in Chinarsquos Accession to theWorld Trade Organization World Bank Policy Research Working Paper no 2623 WashingtonDC World Bank

Jiang Tingsong 2002 Chinarsquos WTO Accession and the Regional Economy Unpublishedmanuscript Australian National University Canberra



Lardy Nicholas 2002 Integrating China into the World Economy Washington DC BrookingsInstitution Press

Lejour Arjan 2000 China and the WTO The Impact on China and the World Economy TheHague Netherlands Centraal Planbureau (CPB) the Netherlands Bureau for Economic PolicyAnalysis

McKibbin Warwick J and Jeffrey Sachs 1991 Global Linkages Macroeconomic Interdependenceand Cooperation in the World Economy Washington DC Brookings Institution Press

McKibbin Warwick J Andrew Stoeckel and Kam Ki Tang 2000 Productivity Risk and theGains from Trade Liberalisation Pelham Papers no 9 Melbourne Australia Melbourne Busi-ness School

McKibbin Warwick J and Kam Ki Tang 2000 Trade and Financial Reform in China Impactson the World Economy World Economy 23 (8)979ndash1003

McKibbin Warwick J and Peter Wilcoxen 1998 The Theoretical and Empirical Structure ofthe G-Cubed Model Economic Modelling 16 (1)123ndash48

Morrison Wayne 2001 Summary of Studies of the Impact of WTO on Chinarsquos Trade Centrefor Cooperation with Non-Members Organisation for Economic Cooperation and Develop-ment Paris

Okabe Misa 2002 International RampD Spillovers and Trade Expansion ASEAN Economic Bulle-tin 19 (2) August

Sachs Jeffrey D and Andrew Warner 1995 Economic Reform and the Process of Global Inte-gration Brookings Papers on Economic Activity 11ndash64

Sachs Jeffrey D and Wing Thye Woo 2003 Chinarsquos Growth after WTO Membership Journal ofChinese Economic and Business Studies 1 (1)1ndash32

United Nations Conference on Trade and Development (UNCTAD) 2002 World Investment Re-port 2002 Transnational Corporations and Export Competitiveness Geneva SwitzerlandUNCTAD Division on Investment Technology and Enterprise Development

Wang Zhi 2002 WTO Accession ldquoGreater Chinardquo Free Trade Area and Economic Relationsacross the Taiwan Strait Paper presented at the Fifth Conference on Global Economic Analysis5ndash7 June Taipei Taiwan

Woo Wing Thye 1998 Chinese Economic Growth Sources and Prospects In The Chinese Econ-omy edited by Michel Fouquin and Franccediloise Lemoine London Economica

mdashmdashmdash 1999a The Real Reasons for Chinarsquos Growth The China Journal 41 (October)115ndash37

mdashmdashmdash 1999b The Economics and Politics of Transition to an Open Market Economy China ParisOECD Development Centre Technical Paper no 153

mdashmdashmdash 2001 Recent Claims of Chinarsquos Economic Exceptionalism Re ections Inspired by WTOAccession China Economic Review 12 (23)107ndash36

World Economic Forum 2000 The Global Competitiveness Report 2000 Oxford Oxford Univer-sity Press



into the international economic system Before this momentous decision China hadwithheld a quarter of the worldrsquos population from participating in the internationaldivision of labor During the period of Chinarsquos self-imposed isolation the rest of theworld created new wealth on an unprecedented scale (with some notable excep-tions such as Africa) It is now conventional wisdom to attribute this generalized in-crease in prosperity to the open international trading system that was institutional-ized at the end of World War II1 Clearly China agrees with this conventionalwisdom China has stated numerous times that its full participation in the interna-tional trading system is fundamental to keeping its economic growth sustainable2

This explains why China has tenaciously pursued arduous trade negotiations withthe United States for over a decade in order to win WTO membership

Although there is general agreement that Chinarsquos WTO accession would bene tChina there is no general agreement that it would also bene t other countries espe-cially Chinarsquos neighbors in East and Southeast Asia For example in his address tothe country on its national day in 2001 the Prime Minister of Singapore Goh ChokTong told his fellow citizens that

China poses a big economic challenge Some economists describe China as an800-pound trading gorilla A Hong Kong newspaper added that this gorilla wasvery hungry

Even India is being ooded with cheap but good quality Chinese goods SomeIndian manufacturers are nding it hard to compete So they have done thenext best thing They stick ldquoMade in Chinardquo labels on their products to boostsales

Our biggest challenge is therefore to secure a niche for ourselves as Chinaswamps the world with her high quality but cheaper products Chinarsquos economyis potentially ten times the size of Japanrsquos Just ask yourself how does Singaporecompete against ten post-war Japans all industrializing and exporting to theworld at the same time

I do not mean that China will overpower every other economy and grow at theexpense of everybody else As China develops and exports more its imports willgrow too There will be many opportunities to invest in China We must graspthose opportunities



1 Sachs and Warner (1995) present convincing evidence in support of this professional consen-sus

2 For an overview of Chinarsquos economic growth and a survey of the competing interpretationson the sources of the growth see Woo (1998 1999a 1999b 2001) Sachs and Woo (2003) andLardy (2002)






















































Economy 1980 1990 2000 Economy 1980 1990 2000








































Value Rank


China 09 12 61 47

























































































































































































































9 Final remarks















References

















































































Economy 1980 1990 2000 Economy 1980 1990 2000








































Value Rank


China 09 12 61 47

























































































































































































































9 Final remarks















References






















































Value Rank


China 09 12 61 47

























































































































































































































9 Final remarks















References















































































































































































































































9 Final remarks















References





































References




























the consequences of china's wto accession for its neighbors · economy case, the interesting...

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