China in the ‘Big Three’

It is almost a decade since China’s coming-out party in the global economy – its accession to the WTO. Back then, China imported “global order”: it absorbed pre-existing, mainly US-designed policies, rules and institutions.

It acted rather like a small or medium-sized economy that could only adapt to the international terms of trade.

Now China is one of the ‘Big Three,’ alongside the USA and EU. It is the world’s second largest economy (at market prices) and its leading exporter of goods. It is the biggest post-crisis contributor to global growth. More than ever, the rest of Asia revolves around China. Gradually, China is asserting itself in international organisations. Its footprint is ever-more visible elsewhere in the non-Western world – in its east-Asian backyard, and in South Asia, Central Asia, Africa and South America.

Given its market size, China now exports global order: decisions made in China reverberate around the world – much more so than any other BRIC. Its policy terms of trade have shifted decisively. It now wants to influence international prices and shape global rules.

But it has evident difficulty in acting like a rule-setter and system-shaper – in other words, like a leader (or co-leader) of the world economy. This creates uncertainty and instability for China and the rest of the world; and it increases the risk that China might be a “spoiler”.

China’s policy shift

Global trade issues best reveal China’s policy shift. There is much positive news. China’s membership of the WTO has been a resounding success. It has become a strong WTO stakeholder. It has implemented the bulk of its huge WTO commitments in timely fashion, and it is active in multilateral rule-enforcement and dispute settlement. This has defused manifold international trade tensions and smoothed China’s rapid integration into the global economy.

On the other hand, the US accuses China of breaching its WTO commitments in several key areas, mainly concerning export restrictions, subsidies, product standards and services regulation. This has resulted in several cases taken to WTO dispute settlement. China has also been a conspicuously passive and marginal player in the Doha Round. Its default position is still to be reactive in WTO negotiations, leaving other big players to take initiatives.

China has been very active in negotiating FTAs – in contrast to its Doha Round passivity. It is the driving force of FTAs in East Asia. Clearly, China is more comfortable with proactive bilateralism than proactive multilateralism. With the former, it feels it can better shape its external order, especially in its East-Asian neighbourhood.

But China’s FTAs are pretty weak; they are “trade light”. Even its flagship FTA – with ASEAN – does not really go beyond tariff elimination to tackle the non-tariff and regulatory barriers that constrict bilateral trade. Its FTAs are driven more by foreign-policy “soft power” – diplomacy and relationship-building – than hard economic strategy.

Unilateral trade policy

China’s policy shift over the past decade is most evident in its unilateral trade policy – trade measures undertaken at home rather than in the WTO or FTAs. Here the big news is that China’s historic opening to the world economy has stalled since about 2006. There has been paltry unilateral liberalisation beyond China’s WTO commitments.

The Hu-Wen leadership is much more cautious than its Jiang-Zhu predecessor. Anti-liberalisation interests – ministries, regulatory agencies and resurgent state-owned enterprises – are more powerful. Policy-making is more complex and tends to take place in regulatory silos. Not least, China’s greater global economic clout translates into unwillingness to open markets unilaterally and to haggle hard over reciprocal concessions – just like the USA and EU.

Stalled liberalisation is of a piece with greater industrial-policy intervention, aimed to promote a hard core of about fifty SOEs, mainly in “strategic” manufacturing and resource-based sectors, and a handful of state-owned banks that dominate the financial system.

Protectionist trade policy and dirigiste industrial policy meet at several junctions. Export restrictions have increased. The decision to cut export quotas on rare-earth metals – in which China has over 90 per cent of world production – by 40 per cent is a blatant attempt to shift international terms of trade – to raise world prices and lower domestic input prices.

Tax incentives, subsidies and price controls, as well as administrative “guidance” on investment decisions, are used to favour domestic sectors over imports. China-specific standards, e.g. on 3G mobile phones, can create high compliance costs for foreign enterprises. Services barriers, notably in financial and telecommunication services, have come down very slowly.

Internet restrictions have increased, benefiting local providers (such as Baidu) over foreign competitors (such as Google). Foreign-investment restrictions have been tightened in a range of sectors where SOEs operate. Discriminatory government procurement is a tool for “indigenous innovation” – code for promoting domestic technology companies at the expense of foreign counterparts.

Joint-venture and technology-transfer requirements on foreign multinationals are used to promote national champions in high-speed rail, electric cars and renewable-energy sectors. Finally, “investment nationalism” extends to China’s Go Out policy. Resource-based SOEs in particular are buying up foreign assets with cheap capital provided by state-owned banks.

Hybrid domestic economy

These patterns are but a reflection of China’s hybrid domestic economy. Despite massive product-market liberalisation, factor markets, particularly for land, capital and energy, remain tightly controlled. That goes far to explain SOE dominance of capital and resource-intensive sectors. Over-saving and over-investment accompany repressed consumption. Externally, surplus savings plus an undervalued exchange rate spill over into large current-account surpluses and generate extra trade tensions, especially in post-crisis conditions of depressed global demand.

China’s crisis response was a supercharged fiscal and monetary stimulus, mainly directed to SOEs via state-owned banks. It bolsters the public sector and state power at the expense of the far-less-subsidised private sector. It exacerbates China’s structural fault-line of over-investment and under-consumption. Its command-and-control mechanisms take market reform backwards. And there is the real risk of surplus manufacturing capacity flooding into anaemic export markets in Europe and North America, thereby inviting protectionist retaliation against China.

China has a clear-cut stake in open and stable global markets. As one of the Big Three, its policy signals are now critical. If it doesn’t contain its own protectionism, neither will others contain theirs. Hence it is in China’s own interests to restrain its industrial-policy activism and its protectionist spill-over.

And it should proceed with “WTO-plus” reforms. It could further reduce applied import tariffs, especially on industrial goods. It should reverse export controls on raw materials and agricultural commodities. But its more substantial – and politically very tricky – challenge is to tackle high trade-related domestic regulatory barriers in goods, services, investment and public procurement.

The primary thrust of trade-related reforms must be unilateral, i.e. outside trade negotiations, and hitched firmly to domestic reforms to improve the business climate and to “rebalance” the economy – to make it more consumption- and less investment-oriented, with more freedom for the private sector and less public-sector control. But China should also move to the foreground in the WTO and play an active co-leadership role, especially to finish the Doha Round. It should also clean up its weak FTAs and make them more compatible with multilateral rules.

Constructive engagement

At the same time it behoves China’s main trading partners – especially the USA – to strengthen “constructive engagement” with China, while containing protectionist forces at home. This will encourage Beijing to step up economic reforms at home. But the American obsession with a quick fix on the RMB and the Chinese current-account surplus, with threats of retaliation, do not display constructive engagement; they are misguided and dangerous.

Realism tells us that most of this wish list is not on today’s Beijing agenda. It is not minded to curtail industrial policy and proceed with WTO-plus reforms. The latter are “second-generation” reforms “behind the border”. They concern factor markets as much as product markets. They lie at the heart of domestic economics and politics.

They are much more difficult politically than “first-generation” reforms, such as the earlier phase of trade and FDI liberalisation “at the border”. In China, needed reforms go to the core of the Communist Party-government-public sector nexus and its grip on power. It is unlikely to happen soon.

But there is a silver lining. China’s dynamic private sector, economic globalisation, embeddedness in multilateral rules and institutions, and regional and bilateral trade relationships, all hem in aggressive mercantilist tendencies. Up-front protectionism increased marginally during the crisis, but it was heavily constrained by China’s integration in global supply chains and its strong WTO commitments.

Fundamental market reforms, including external liberalisation, have not been reversed. FDI continues to increase. At bottom, the Beijing leadership remains pragmatic and internationally engaged. It does not want to “rock the boat” too much.

Hence pro-market reformers should work to make the wish list above tomorrow’s, or the day-after-tomorrow’s, agenda – so that it can be achieved, however partially and patchily, when political conditions are ripe.

(Razeen Sally is Director of the European Centre of International Political Economy and on the faculty of the London School of Economics.)