1. 1 China’s External Economy: Issues, Challenges and Prospects by Dr Charles C L Kwong Associate Professor and Programme Leader Economics Programme School of Arts and Social Sciences The Open University of Hong Kong [Content of this seminar should not be quoted without prior approval from the author.]

2. 2 This seminar aims to: review China’s foreign trade reform and its impacts on the Chinese economy explain China’s rationale for entering World Trade Organization (WTO) examine China’s adaptation and trade pattern after WTO admission evaluate the recent trend of China’s foreign direct investment discuss the issues of appreciation, convertibility and internalization of RMB assess preliminarily the feasibility of linking Hong Kong dollar to RMB

3. 3 1. Foreign Trade Sector during the Pre-reform Period 1949-1978 1.1 The Trade Pattern 1952-1960: about 67% of trade with communist countries, 48% of China’s total trade was with Soviet Union Import of industrial materials such as steel and fossil fuel, as well as machinery All these imports were crucial for China to support its industrialization during the First Five Year Plan (FYP, 1953-58).

4. 4 1. Foreign Trade Sector during the Pre-reform Period 1949-1978 1.1 The Trade Pattern The Great Leap Forward (GLF, 1958-60) followed by extensive famine and economic crisis forced the Chinese government to minimize its imports in order to leave more foreign exchange for grain imports. China’s trade volume was further reduced after the political and ideological conflict between China and Soviet Union in the late 1950s and early 1960s. The trade volume with Soviet Union was less than 1% of China’s total trade by 1970. In 1970-71, China’s trade participation ratio (E + IM / GDP) was only 5%.

5. 5 1. Foreign Trade Sector during the Pre-reform Period 1949-1978 1.2 Foreign Trade System A highly centralized system that tightly controlled the flows of goods and money. Twelve foreign trade corporations (FTCs) were set up to exercise monopolies over both imports and exports. Foreign exchange rate was officially set and renminbi (RMB) was not fully convertible. Individuals and enterprises could not freely exchange RMB for foreign currency.

6. 6 1. Foreign Trade Sector during the Pre-reform Period 1949-1978 1.2 Foreign Trade System Imports and exports were determined by central authorities. The ‘foreign trade plan’ was heavily affected by the consideration of self-reliance and the speeding up of industrialization, particularly for heavy industry. Imports were minimized except for raw materials, products, and technology which could not be produced by China. The primary objective of imports was to source inputs needed for domestic industrial development. Exports were to earn enough foreign exchange to pay for the necessary imports

7. 7 1. Foreign Trade Sector during the Pre-reform Period 1949-1978 1.3 Repercussions of the Centrally Planned Foreign Trade System Separation of producers and consumers (end-users): lack of market information e.g. consumer preference), low in competitiveness Lack of foreign exchange: when China started to accelerate its import of machinery and technology in 1978-79, its foreign exchange was only US$0.167 billion in 1978, in contrast with US$1,946 in 2008. 1 Overvalued currency: it reduced the costs of imports, but at the same time decreased the competitiveness of China’s exports. 1 National Bureau of Statistics of China, Zhongguo Tongji Nianjian CD-ROM 2009 (ZGTJNJ CD-ROM hereafter, China Statistical Yearbook 1985), (Beijing: Zhongguo Tongji Chubanshe), Table 19-10.

8. 8 2. Foreign Trade Sector during the Post-reform: 1978 onwards 2.1 Reform in the 1980s and 1990s Demonopolization of trading rights: decentralize trading rights to local authorities, industrial ministries, and production enterprises. Local governments and special economic zones (SEZs) were allowed to set up FTCs. The number of FTCs increased substantially to 5,000 and 10,000 enterprises were approved the direct trading rights in imports and exports in 1988 Naughton (2007: 384).

9. 9 2. Foreign Trade Sector during the Post-reform: 1978 onwards 2.1 Reform in the 1980s and 1990s Loosening of Foreign Trade Plan: By early 1990s, all mandatory export planning is abolished and only 11 items of imports were still under foreign trade plan (Chai 1997: 142). More Market–Oriented Pricing Principles: decentralization of trading rights and profit motive. Trading enterprises have to set prices according to world prices in order to maintain price competitive. Devaluation of RMB: to reflect a more realistic exchange rate, but RMB is still not fully convertible.

10. 10 2. Foreign Trade Sector during the Post-reform: 1978 onwards 2.2 Accession to World Trade Organization (WTO) 2001 The Path of China’s Accession to WTO China was one of the 23 founding members of General Agreement on Tariffs and Trade (GATT, the predecessor of WTO) in 1948. China lodged its application to join GATT in 1986, but failed. GATT was reinstituted from a set of rules and agreements into an international trade organization covering not just traded goods, but also service trade and intellectual property rights. WTO was formally set up in January 1995. In December 1995, China resumed its effort to negotiate its WTO membership. China was formally admitted into WTO in December 2001.

11. 11 2. Foreign Trade Sector during the Post-reform: 1978 onwards 2.2 Accession to World Trade Organization (WTO) 2001 Why was China so eager to join WTO? Economic growth: It was estimated that China’s GDP growth would grow by 0.5 percentage point each year after entering WTO. The fact turns out to be an average annual growth of 9.9 percent from 2001 to 2005. Promote economic reform: pressure for further institutional reform.

12. 12 2. Foreign Trade Sector during the Post-reform: 1978 onwards 2.2 Accession to World Trade Organization (WTO) 2001 Why was China so eager to join WTO? Enhance competition: exposing domestic enterprises to foreign competitors, through which enhancing the efficiency of domestic industries. Participate in formulating international rules (a rule setter)

13. 13 2. Foreign Trade Sector during the Post-reform: 1978 onwards 2.2 Accession to World Trade Organization (WTO) 2001 China’s commitments and adaptation to WTO  Dispute settlement China has to follow WTO's dispute settlement system in case of international trade disputes.

14. 14 2. Foreign Trade Sector during the Post-reform: 1978 onwards 2.2 Accession to World Trade Organization (WTO) 2001 China’s commitments and adaptation to WTO  Transparency and predictability China is committed to provide a more transparent and predictable system for business dealings. Laws and regulations including those not previously available to the public will be regularly published. A 30-day period for obtaining information and commentary is instituted prior to the implementation of new laws and regulations.

15. 15 2. Foreign Trade Sector during the Post-reform: 1978 onwards 2.2 Accession to World Trade Organization (WTO) 2001 China’s commitments and adaptation to WTO  Tariffs China has significantly reduced its tariffs on industrial products by January 2005 to 8.9% (down from an average of 25%). Tariffs on furniture, toys and beer are eliminated. Tariffs have been significantly reduced on medical equipment, scientific equipment, motor vehicles, cosmetics, distilled spirits, paper products, and textiles. Tariffs on products (such as semi-conductors, computers and telecom equipments) under the Information Technology Agreement which China joined have been eliminated by January 2005.

16. 16 2. Foreign Trade Sector during the Post-reform: 1978 onwards 2.2 Accession to World Trade Organization (WTO) 2001 China’s commitments and adaptation to WTO  Service Commitments Market access restrictions has been liberalized in service sector including telecommunications, insurance, banking, and professional services such as accounting, legal and management services.

17. 17 2. Foreign Trade Sector during the Post-reform: 1978 onwards 2.2 Accession to World Trade Organization (WTO) 2001 China’s commitments and adaptation to WTO  Trading Rights and Distribution The previous restriction on the number of companies that have the right to import and export goods are relaxed. All enterprises in China are granted full trading rights (except for limited products reserved for trade by state enterprises). The previous prohibition on foreign companies distributing products through their own wholesale and retail systems or to provide related distribution services, such as repair and maintenance are lifted under China’s commitments. At accession, China also committed to allow foreign service suppliers to distribute chemical fertilizers, processed oil and crude oil.

18. 18 2. Foreign Trade Sector during the Post-reform: 1978 onwards 2.2 Accession to World Trade Organization (WTO) 2001 China’s commitments and adaptation to WTO  Import Licensing China's import licensing system previously posed a trade barrier. This is, to a large extent, relaxed. In the businesses where licensing is still in place, it must comply with the principles of national treatment and non-discrimination.

19. 19 2. Foreign Trade Sector during the Post-reform: 1978 onwards 2.2 Accession to World Trade Organization (WTO) 2001 China’s commitments and adaptation to WTO  Importation and Investment Approvals The WTO Agreement on Trade-related Investment Measures and the TRIPS (trade-related aspects of intellectual property rights) Agreement will be followed to ensure an easier application and application procedures for importation and investment approvals.

20. 20 2. Foreign Trade Sector during the Post-reform: 1978 onwards 2.2 Accession to World Trade Organization (WTO) 2001 China’s commitments and adaptation to WTO  Trade-related Intellectual Property Rights China has to protect intellectual property rights by full implementation of the TRIPS Agreement.

21. 21 2. Foreign Trade Sector during the Post-reform: 1978 onwards 2.2 Accession to World Trade Organization (WTO) 2001 China’s commitments and adaptation to WTO  Technical Barriers to Trade China will comply with WTO Technical Barriers to Trade (TBT) Agreement (e.g. inspection, testing, domestic taxes, and other measures). Technical regulations will be based on international standards and will be applied equally to domestic and foreign products.

22. 22 2. Foreign Trade Sector during the Post-reform: 1978 onwards 2.2 Accession to World Trade Organization (WTO) 2001 China’s commitments and adaptation to WTO  Taxes China will ensure that its laws and regulations relating to internal taxes (national, provincial and local) and import charges comply with WTO rules, and are applied in a non- discriminatory way.

23. 23 2. Foreign Trade Sector during the Post-reform: 1978 onwards 2.2 Accession to World Trade Organization (WTO) 2001 China’s commitments and adaptation to WTO  Subsidies All subsidies on industrial goods prohibited under WTO rules are not allowed. Source: http://www.agrifoodasia.com/English/acc_CN/cn_wto.htm

24. 24 2. Foreign Trade Sector during the Post-reform: 1978 onwards 2.3 Post-WTO Period (2001 onwards) 2.3.1 Foreign Trade Dramatic drop in tariff (Table 1) – China becomes one of the countries with lowest tariffs.

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26. 26 2. Foreign Trade Sector during the Post-reform: 1978 onwards 2.3 Post-WTO Period (2001 onwards) 2.3.1 Foreign Trade China has reduced the coverage of import licenses from 1,247 in 1992 to 261 items in 1999. In terms of import volume, about 50 percent of imports were subject to import licenses at the end of 1989s while such figures declined to 5 percent in 2001. To align China’s laws and regulations with those of the WTO, China has revised about 3,000 laws, regulations and sectoral rules since its accession to WTO and China enacted the Foreign Trade Law in 2004 to institutionalized the business practices corresponding to WTO principles (Wu 2007: 6). Though China has lowered its tariffs substantially, its trade volume and trade surplus continue to grow after 2000 (Table 2).

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28. 28 2. Foreign Trade Sector during the Post-reform: 1978 onwards 2.3 Post-WTO Period (2001 onwards) 2.3.1 Foreign Trade China has become the second largest manufactures exporting countries in the world in 2005 (Table 3). It indicates that China maintains its comparative advantages of producing manufacturing products, in particular those labour-intensive products.

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30. 30 2. Foreign Trade Sector during the Post-reform: 1978 onwards 2.3 Post-WTO Period (2001 onwards) 2.3.2 Foreign Investment Foreign direct investment (FDI) from abroad rose to USD45.5 billion in 1998 from USD11 billion in 1992, representing an annual increase of 26.7%. It declined in 1999, but then picked up afterwards by an average growth of 10.6% for the period of 2000 to 2007, reaching USD82.7 billion in 2007. After China’s accession to WTO, contrary to conventional wisdom, the shares of FDI from major developed region/countries such as Hong Kong, U.K. and the U.S. demonstrate a gradual decline while respective share of Taiwan indicates a rise from 8.8% in 1997 to 11.2% in 2006 (Table 4).

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33. 33 Note (a): The total amount represents FDI inflows to non-financial sectors only. Note (b): Cayman Islands and British Virgin Islands are leading offshore financial centers. Based on estimation, about 53% of the total funds from these centers originated from Hong Kong whereas about 37% from Taiwan. Adjustments were made to present a clear picture of the source of the Mainland ’ s FDI inflows. The respective amounts of Cayman Islands and Virgin Islands on the table represent the remaining 10%, which originated mainly from the US, Singapore, E.U., and South Korea. Source: China Statistical Yearbook (various issues); Shik and Yim (2008: 3)

34. 34 3. China’s Exchange Rate Regime 3. China’s Exchange Rate Regime DateMajor Changes 1969The Chinese currency was renamed as Renminbi (RMB). 1972-1979China began to list an Effective Rate for RMB against US$ in 1972. Since then, the official rates were adjusted periodically. RMB was appreciated from 2.04 yuan per US dollars to 1.5 yuan per US$ in Dec 1979. 1980 onwardsRMB depreciation (see Table 6) 1985-1993Dual track system-coexistence of official exchange rate and a lower swap rate (8.7 yuan per US$ in 1993), which was more close to the market rate. Swap centers were originally set up in 1985 to allow enterprises to transact foreign currency. By 1991, individuals were allowed to sell foreign currency at swap centers.

35. 35 DateMajor Changes 1994-2004Abolition of the dual track system in 1994-since then, China’s foreign exchange rate system became a managed floating system. The RMB exchange rates were primarily determined at swap centre, but closely monitored by the government. Prior to 2005, RMB devaluated continuously 2005-2008On that 21July 2005, the People’s Bank of China proclaimed – after a minor initial revaluation of 2.1% - a switch to a managing float regime with reference to a basket of currencies, instead of pegging to US dollar. RMB appreciated about 20 percent during this period. 2008RMB appreciated beyond the level 7 yuan per dollar in April 2008. The Chinese government reinstituted its peg with US$ within a permissible range in July 2008. Note: The shaded boxes indicate periods of RMB appreciation. Source: ‘ Historical Exchange Rate Regime of Asian Countries ’ from http://intl.econ.cuhk.edu.hk/exchange_rate_regime/index.php?cid=8 (accessed on 28 April 2010); Chai (1997: 145); Hu et. al. (2010: 45)

36. 36 3. China’s Exchange Rate Regime 3.2 Can RMB appreciation reduce US unemployment rate? The labour force in China and the US was 792.43 million and 154.59 million in 2008 respectively. 2 China has maintained its comparative advantage over the US in producing labour intensive product. 2 Ibid. Table 4-1; US data from http://www.economagic.com/em- cgi/data.exe/blsln/lns11000000:(rev) (accessed on 28 April 2010).

37. 37 3. China’s Exchange Rate Regime 3.2 Can RMB appreciation reduce US unemployment rate? The wage ratio between US and Chinese workers is 7.9:1, 3 which indicates a huge gap in labour costs. If RMB appreciation could be an effective mean to reduce trade imbalance between the US and China, the extent of appreciation must be very substantial, say 20- 40%, as claimed by some American economists. 4 Table 6 shows that the appreciation of RMB by about 20 percent from 2005 to 2008 could not effectively correct the trade imbalance. 3 Author’s calculation based on the data from Hu et. al. (2010: 43) 4 Paul Krugman has recently argued in a strong way that China should substantially appreciate its currency. For a discussion of Krugman’s viewpoints, see http://www.economist.com/blogs/freeexchange/2010/03/chinas_currency (accessed on 28 April 2010)

38. 38 3. China’s Exchange Rate Regime 3.2 Can RMB appreciation reduce US unemployment rate? Further, such an appreciation will mean that the US consumers have to pay higher prices for imports from China. More importantly, if the US market is free and rational, US importing enterprises will only source their imports from other Asian countries such as India and Vietnam. This trade diversion will not benefit the US workers.

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40. 40 Note: *US exports, imports and trade balance was in billion US$ from 1980 to 1984 while the figures from 1985 onwards were in million US$.

41. 41 Source: Exchange rates from Naughton (2007: 383); ZGTJNJ (1984: 415; 1985: 519); ZGTJNJ CD-ROM Table 17-2; and http://en.wikipedia.org/wiki/List_of_Renminbi_exchange_rates (accessed on 27 April 2010); State Administration of Foreign Exchange of the People's Republic of China and People's Bank of China (quoted from http://www.chinability.com/Rmb.htm accessed on 27 April 2010). Trade data are derived from U.S. Census Bureau http://www.census.gov/foreign-trade/balance/c5700.html#questions (accessed on 27 April 2010) and Ho (1993: 17.29)

42. 42 3. China’s Exchange Rate Regime 3.3 What are the impacts of RMB appreciation on the Chinese economy? Reduction in import price will increase China’s demand for import, which increase the welfare of Chinese consumers in terms of consumer surplus.

43. 43 3. China’s Exchange Rate Regime 3.3 What are the impacts of RMB appreciation on the Chinese economy? Reduction in import prices decreases the risk of import inflation. Price reduction in primary products, in particular raw materials, helps lower the costs of production in China, through which lessens cost push- inflation. In 2007, 25.4 percent of China’s total imports were primary products while the figure soared to 32 percent in 2008. 5 It indicates that China is increasingly relying on imported raw materials. 5 Author’s calculation based on the data from ZGTJNJ CD- ROM Table 17-1.

44. 44 3. China’s Exchange Rate Regime 3.3 What are the impacts of RMB appreciation on the Chinese economy? RMB appreciation reduces China’s net exports and foreign exchange reserves. It decreases the monetary base in China, which results in lower money supply and inflation. Related to the previous point, RMB appreciation will alleviate investors/speculators’ expectation on further RMB appreciation. It can downsize massive inflow of capital, or more specifically hot money, speculating on RMB appreciation. It in turn reduces the risks of assets inflation.

45. 45 3. China’s Exchange Rate Regime 3.4 Feasibility of linking Hong Kong dollar to RMB If Hong Kong is to maintain its linked exchange rate system, Hong Kong dollar should be pegged with a stable international currency. To become an international currency, it has to be demanded by other countries as:

46. 46 3. China’s Exchange Rate Regime 3.4 Feasibility of linking Hong Kong dollar to RMB  Settlement currency: as a medium and unit of account (pricing) of international exchanges for goods and service. China has recently signed a number of Swap agreements with emerging countries such as Malaysia, Indonesia and Argentina. The agreement stipulates a fixed amount of RMB and a fixed amount of foreign currency. The two trading partners are then entitled to exchange their currency at a fixed exchange rate within a specified period of time to facilitate their bilateral trade. It allows bilateral trade between China and its trading partners to bypass US dollar (Murphy and Yuan 2009: 12). Swap agreement speeds up RMB internationalization at bilateral and regional level, but fails to become a vehicle (or settlement) currency for third-party trade.

47. 47 3. China’s Exchange Rate Regime 3.4 Feasibility of linking Hong Kong dollar to RMB  Investment currency: as a medium of exchange and unit of account for international financial products. There have been so far very limited financial products denominated in RMB exchanged in international financial markets.

48. 48 3. China’s Exchange Rate Regime 3.4 Feasibility of linking Hong Kong dollar to RMB  Reserve currency: held substantially by countries as foreign exchange reserves. To become a reserve currency, it must establish a sound financial system in which foreign countries have high degree of confidence. More importantly, the reserve currency country is likely to run a current account deficit and foreign countries must have current account surpluses so that the foreign countries can acquire the reserve currency. China is probably reluctant to give up its current account surpluses due to employment consideration. In additional, Table 7 robustly indicates that the dominant status of US$ as reserve currency was not much changed in the past decades, though some fluctuations exist.

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50. 50 3. China’s Exchange Rate Regime 3.4 Feasibility of linking Hong Kong dollar to RMB To become an international currency, China must first make RMB fully convertible. Before RMB can reach a higher level of internationalization, pegging with it may not be very appropriate as no country/region will peg to a currency of lower circulation than its domestic currency. Moreover, RMB stability is another consideration. Is RMB a stable currency? Would it be stable if it gave up its managed float system and allowed RMB to be fully convertible?

51. 51 References Ho, Yin-Ping (1993) ‘China’s Foreign Trade and the Reform of the Foreign Trade System,’ in Cheng, Joseph Y S and Maurice Brosseau (eds.) China Review 1993, Hong Kong: The Chinese University Press, pp. 17.1-17.41. Hu, Jinyan (2010) ‘Reactivating Foreign Exchange Reform’ Caijing, No. 260, pp. 41-47. Ianchovichina, Elena, and Martin, Will (2004) ‘Economic Impact of China’s Accession to the WTO’, in Bhattasali, Deepak, Li Shantong and Will Martin (eds.) China and WTO- WTO Accession, Policy Change and Poverty reduction Strategy, Beijing: China Finance and economics Press.

52. 52 References Joseph C. H. Chai, China: Transition to a Market Economy (New York: Clarendon Press Oxford, 1997), p. 118 Murphy, Melissa and Yuan, Wen Jin (2009) ‘Is China ready to Challenge the Dollar?: Internationalization of the Renminbi and Its Implication for the United State,’ A Report of CSIS Freeman Chair in China Studies, Centre for Strategic and International Studies, Washington DC., pp. 1-21. Naughton, Barry (2007) The Chinese Economy: Transition and Growth, Cambridge: MIT Press, pp. 379- 92.

53. 53 References Shik, Thomas and Yim, Joanne (2008) ‘Mainland China’s Inward Foreign Direct Investment – the Past and the Future’, Economic Focus, Hang Seng Bank. Wu, Angang (2007) ‘Tentative Evaluation of China’s Accession to WTO: Impact on World Trade Growth Pattern’, paper presented at the International Conference on ‘China in 5 Years After WTO Accession: Sharing Experiences with Vietnam’ September 24 - 25, 2007 in Hanoi and September 27-28 in Hochiminh City For China’s WTO commitments, see http://www.agrifoodasia.com/English/acc_CN/cn_wto.htm (accessed on 31 October 2008)

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