Thursday, March 12, 2015

Dynamics of Korea-China economic relations

First published in The Korea Herald.

The much-awaited Korea-China Free Trade Agreement was initialed in late February, taking a step closer to implementing what is seen as Korea’s most significant trade deal.

The initialing came about three months after the two countries concluded FTA negotiations that began in May 2012, and is expected to eclipse its deals with the U.S. and the EU, as China is already its largest trading partner.

China, the world’s largest destination for Korean goods, accounted for more than one-quarter ― $145.28 billion ― of Korea’s overall exports of $572.66 billion in 2014. The next biggest national-level markets for Korean exporters are the United States at 11 percent and Japan at 6 percent.

According to news reports, the agreement, currently written in English, will be translated into the two countries’ native languages before it is officially signed.

“The two governments have agreed to work toward the official signing of the FTA within the first half of 2015,” the Ministry of Trade, Industry and Energy said in a press release.

The pact requires approval from both the respective legislatures for implementation, and will come into force immediately after it is passed.

Under the deal, Korea will completely eliminate its tariffs on 79 percent of all products, or 9,690 items, imported from China within 10 years of its implementation. China will reciprocate the move on 71 percent of the products, or 5,846 items, from Korea during the same period.

Within 20 years, Korea will eliminate its tariffs on 92 percent of all goods, with China eliminating its own import duties on 91 percent of products from Korea.

“The government will do its utmost to have the agreement ratified by the National Assembly without any disruption so that our companies can start benefiting from the Korea-China FTA at an early date,” the Trade Ministry said.

Soon after initialing the deal, Deputy Trade Minister Woo Tae-hee pointed out that some new and positive elements had been added to the agreement since the conclusion of negotiations on Nov. 10.

According to the government, 310 products from the inter-Korean joint industrial complex in Gaeseong will immediately benefit from a reduction or elimination of Chinese import tariffs.

The two countries have also added a new standstill clause in their bilateral agreement that will prevent either side from raising or adopting new customs duties on any products or services.

Through additional dialogue, Korea has gained better market access and established a better business environment in China for financial and communications service providers, the Trade Ministry said.

The two countries have also agreed to provide preferential treatment to each other’s financial firms and to set up a new committee to jointly deal with any business problems for the firms. They also guarantee nondiscriminatory access to communications networks by companies entering each other’s markets.

In addition, the Korean government moved to quieten fears of damage to its farmers, as 596 out of 2,240 agricultural and fisheries products currently imported from China will be permanently excluded from market liberalization, while 16 others, including rice, were excluded from negotiations from the beginning.

Following its implementation, the FTA is expected to help boost the countries’ annual bilateral trade to over $300 billion, a 21.54 percent hike from $235.36 billion in 2014.

Also, according to the government, Korea’s trade territory, represented by the combined gross domestic product of countries with which it has a free trade pact, will grow to 73 percent of global GDP from the current 61 percent.

There is no doubt that this a very significant deal and could have a very great impact on the economies of both countries.

However, as many analysts have pointed out, China’s rise puts Korea in a strategic dilemma between the U.S. and China. Traditionally, Korea and the U.S. have been close allies. Their alliance has been a major factor in Korea’s political and economic success. Due to China’s consistent rise, market growth and size, it so happens that Korea is now increasingly dependent on its neighbor’s economy. Consequently, it has to dually manage its security, which is grounded in the alliance with the U.S., and its economic well-being, which depends on its economic partnership with China.

It is therefore important to check how the economic relations panned out prior to the implementation of the FTA.

Economic relations

China established trade relations with Korea as early as the mid-1970s. However, due to the lack of formal diplomatic relations, most of the trade was conducted indirectly via Hong Kong, thus limiting trade volume.

Experts have suggested that their economic cooperation developed through three stages. In the early 1990s, many Korean politicians were eager to construct a dialogue with key political leaders of China. Business executives of Korean conglomerates then joined the politicians in opening channels for dialogue with China. Finally, in August 1992, a diplomatic relationship was established between both sides which opened a new chapter for bilateral economic relations.

The first stage started with diplomatic normalization and the beginning of the first China boom ― both trade and investment increased sharply from almost nothing. This trend continued until the second half of 1997, when the country was hit by the Asian financial crisis. Following this, the second stage brought about a slowdown bilateral economic relations, including the pulling out or canceling of many investment projects in China because of difficulties with Korean companies’ cash flow.

This did not last too long, however, since China became a member of the World Trade Organization in late 2001, which once again saw foreign companies flocking to the country, and Korea was no exception. Since then, China once again has been the biggest economic partner of Korea, including the development of a new destination of informal migration. As a consequence, it did not take long for the relationship to solidify, and in 2004, China became the exporting and investing country of first importance to Korea.

In the meantime, the trade structure has also changed considerably. In the early 1990s, trade from China to Korea was often in primary goods, as well as labor-intensive products, while China imported technology-intensive and capital-intensive manufactured products from Korea. In recent years, trade between the two countries is mostly in technology- and capital-intensive goods. Foreign-invested enterprises, especially those with investment from Korea, played a critical role in the structural changes of the bilateral trade.

As noted by Cheong Young-rok, professor at the Graduate School of International Studies at Seoul National University, “There are two different schools of thought in Korean academia: One school argues that China is a mere clone or extension of other Asian countries that were once glorified as newly industrializing economies or high-performing Asian economies. In this context, China could be a really tough competitor for Korean companies, especially for Korea’s exporting industries, and could undermine the export basis of Korean growth.

“The other school of thought tries to prove that China’s growth is intrinsic in the sense that it has resulted from a combination of improved resource allocation and a new model for a sizable economy that has been carried out by China’s own design. As a result, Koreans hope that China will become an additional country for quick economic interaction.”

The flip side of this increasingly tight economic relationship is, first, that Korea is now more dependent on the fate of the Chinese economy, and second that the risk of friction is higher than in the past.

Any fluctuation in the fortunes of the Chinese economy has an immediate impact on the Korean economy. If there is a slowdown in China, Korea’s trade is hurt badly, which has a ripple effect on other sectors.

Trade figures

If we look at the bilateral trade figures between both the countries in 2014, a number of important facts emerge.

According to latest available trade figures, Korea’s total exports to China in 2014 slipped by 0.4 percent on-year. The slowdown started in May 2014 when there was zero growth, and since then the monthly exports have registered consecutive negative growth. This was the first decline in five years.

This is significant, given that Korea relies heavily on its neighbor.

If we look at the export components, the picture becomes clearer. Korea’s exports to China are mostly comprised of intermediate and capital goods.

At the disaggregate level, in 2013, Korean exports to China were dominated by machinery and transport equipment (48 percent), followed by manufactured goods (24 percent), chemicals and related products (19.5 percent), and minerals, fuels and lubricants (6 percent). Crude materials, food and live animals, beverages and tobacco, commodities transactions, and animal and vegetable oils make up for the remainder of exports.

Now, if we look at the growth rate of these categories, something interesting emerges.

Export of machinery and transport equipment grew 4.6 percent on-year (from $70.49 billion to $73.72 billion) in 2014. This does seem positive, but if we look closer, the pace of growth has actually fallen drastically. In 2013, growth was at 21.8 percent. Since this group accounts for almost half of total exports, it is worrisome.

Next, the export of manufactured goods to China shows a negative growth of 5.4 percent, down to $22.82 billion. Chemicals and related products were down 4.2 percent at $27.14 billion; minerals, fuels and lubricants down by 12.5 percent; crude materials, food and live animals, commodities transactions, animal and vegetable oils all declined, by 6.6 percent, 1.6 percent, 39.6 percent and 43.3 percent, respectively.

Some explanations can be provided for this decline in South Korean exports to China.

Many news reports and studies have noted that Chinese manufacturers are now increasingly producing the parts and equipment that once were imported from Korea. However, many Korean companies still continue to regard China as a production base for exports to other countries. This is a fallacy because Chinese companies have fast developed their consumer goods market and are increasingly becoming self-sufficient in intermediary goods.

If, as has been the norm, Korea continues to export to China mostly products that are actually being exported to a third country, they will be in trouble if China’s exports falter.

Also hurting Korean exports is China’s growing self-sufficiency, with greater investment and technological abilities in industries where Korean companies have historically supplied exports.

As noted in many news reports, officials at the Trade Ministry agree and attribute this decline to the fact that China is improving its own supply capacity and therefore has reduced dependence on Korean intermediary goods. Chinese firms have started producing more of the intermediary goods on their own.

Local Chinese companies appear to be giving tough competition to Korean firms.

This is a view also taken by the state-funded think tank Korea Institute for International Economic Policy, which noted recently that China has been ramping up its own production capacity for intermediary goods and has less demand of its own for finished products because of moderating economic growth.

Hopefully, the FTA will set things right for Korea on the trade front. For this, the government needs to undertake a more detailed analysis to understand the cause for this decline and how Korean companies can overcome the situation.

Investment situation

Another important form of interaction between the two economies is foreign direct investment. FDI into China tends to be dominated by Asian investors, and Korea plays an increasing role in this respect.

In 2014, Korean companies’ investment in China ― financial sectors such as banking, securities, insurance were excluded ― hit an eight-year high last year and entered the $60 billion zone. By contrast, Japan’s investment in China dramatically decreased during the same period.

Recently, the Korea International Trade Association announced that the real investment of Korean companies in China in 2014 was $3.97 billion, which was 29.7 percent higher than that of the previous year. This is the highest in eight years and is a similar number to that of 2006 ($3.99 billion). Moreover, it is a significant increase when considering the recent annual investment in China has been only around $2 billion to $3 billion. Accordingly, last year, Korea accounted for 3.3 percent, of the total foreign investment in China, which was higher than 2.6 percent in the previous year. In addition, at the end of last year, Korean companies’ cumulative investment in China was $59.82 billion.

While Korean companies’ investment in China rapidly grew, Japanese companies greatly reduced their investment there. Therefore, the annual investment gap between the two countries in China has narrowed to $300 million, KITA has noted.

Japanese companies’ investment in China last year was only $4.33 billion, which was 38.8 percent lower than the previous year. When taking into consideration that Japan’s investment in China was around $7 billion for three years since 2011, which was double that of Korea, last year’s investment was an exceptional figure.

According to the trade agency, Korea’s highest investment in China in eight years is understood as Korean companies gaining interest in entering Chinese domestic markets now that the settlement of the Korea-China FTA is helping to mature the economic cooperation between the two countries. It is expected that the scope of investment will expand, not only because of the reduction of tariff on items owing to the FTA but also because of the opening of service sectors.

Clearly, while the FTA does provide investment opportunities for Korean firms, the bilateral trade between both sides is vulnerable to external pressures and also geopolitical developments.

Some economists have criticized the Korean government for promoting FTAs in such a way as to make the number of FTAs and not their contents the central object. They have pointed out that the conclusion of an FTA should not be its own object since an FTA is only a means to strengthen competitiveness and enhance efficiency, and since Korea’s basic FTA policies focus on external expansion, the effects of trade liberalization are less than what are expected. It remains to be seen how the effects of the Korea-China FTA pan out.