By Drew Thompson
Nixon Center's China Director
Despite the global economic crisis, China appears to have weathered the storm well; its stimuluspackage was robust, its economy achieved positive economic growth throughout the crisis(though it was close to zero in 2008) and its banks remain solvent.Its vast floating population oflow-cost labor, high savings rates, massive foreign currency reserves and political adeptness hasserved China’s interests well in a time of great crisis. Rather than succumb to domestic chaos from mass layoffs stemming from the collapse of export markets, China has avoided stagnation, inflation and managed its chronically high unemployment while continuing to deploy its capitalat home and abroad to its own advantage.China hopes its political-economic model — now proven to be particularly resilient — isappealing to developing countries seeking to replicate China’s success. China’s vast marketlures global companies with their capital and technology, providing Beijing with considerablegeopolitical leverage and in some cases, political clout abroad. Economic influence is asignificant aspect of China’s soft power. China’s strategy of a closed political system focused oneconomic growth, and the maintenance of stability on its periphery is central to achieving itsgreat power objectives. Enhancing regional economic integration is a key component of thisstrategy.However, security challenges in East Asia remain despite this expanding integration,just as tensions in the U.S.-China security relationship have not been ameliorated by trade andinvestment. Pyongyang’s repeated provocations, despite North Korea’s dependence on trade with China, is only one example of the limits of economic integration in addressing broader strategicand security issues.Overview of China’s economy and economic growthSince the reform and opening period began in 1979, China has sought to maintain steadyeconomic growth, targeting 8% growth since 1982 as adequate to create enough jobs to absorbunder-employed workers, farmers and new graduates entering the labor pool, yet not so high asto drive inflation which contributes to social unrest. Their strategy is undoubtedly successful;China is currently the world’s third largest economy and the country appears on track to overtakeJapan as the second largest economy at some point in 2010.China’s economic output wasslightly less than Japan’s in 2009 and its economy is currently growing faster than its neighbor.China’s economy grew by 10.3% in the second quarter of 2010, a slight reduction from brisk11.9% growth in the first quarter of the year. Consumer inflation fell to 2.9% in June, from 3.1%in May. The government’s official inflation target for 2010 is 3%. With China’s population of 1.3 billion people, multinational companies look to Chineseconsumers for their future success.China’s total consumer expenditure in 2008 was $1.52billion. China is now the third biggest consumer of luxury goods, after the United States andJapan, generating more than $2 million in luxury consumer goods sales a year. Sales in somesectors are growing 20 to 30% each year. By 2020, Chinese consumers are forecasted to have anannual disposable income of $9.57 billion, an increase from $2.19 billion in 2008.It is estimatedthat 55% of China’s population will be in the middle class household income between $8,700 and $29,215) by 2020.2In 2009, China’s per capita GDP wasestimated to be $6,600.Though many countries are facing gloomy economic forecasts, China’s government stimulus inthe wake of the financial crisis has left it with relatively upbeat predictions of future growth. The IMF forecasts 9.9% economic growth for China in 2011.3The World Bank projects GDPgrowth of 9.5% for 2010 as a whole and 8.5% for 2011. Growth is also expected to be lessinvestment-driven and benefit from more favorable external trade.4As in recent years, China’sofficial target for GDP growth in 2010 is 8%.China-ROK Trade and InvestmentSince Beijing’s 1992 establishment of diplomatic relations with Seoul, China has balanced its market based relationship with South Korea and its socialist friendship with North Korea. The scope of China’s trade and investment with South Korea overshadows its economic relationshipwith North Korea. In 2009, South Korea was China’s fourth largest trade partner with a volumeof $156.2 billion, though this represented a decrease of 16% from 2008.South Korea was also China’s fourth largest export destination in 2009 with a volume of $53.7 billion, a 27.4%decrease over 2008. South Korea ranked second in China’s top import partners in 2009 with avolume of $102.6 billion, a decrease of 8.5% from 2008.8According to data from China’s Ministry of Commerce, China’s trade with South Korea had a value of $16.671billion in 2009, a 45.9% increase compared to the same period in 2008.The export value of Chinese goods was$5.746 billion and import value $10.925 billion in 2009.9For South Korea, China is a more important trading partner than the U.S. China overtook the United States as the biggest export market for South Korea in 2003, while South Korea is the United States’ seventh largest trading partner.South Korea plays a significant role investing in China and is concurrently working to increase FDI flows from China. According to calculations of the actually utilized value of foreign capital from January to October 2009 in China, South Korea ranked sixth in the list of top countriesinvesting in China with a value of $2.261 billion.China is one of the top targets for SouthKorea’s overseas investment. More than 20,000 South Korean companies have invested inChina in the past 20 years. South Korea’s cumulative FDI in China was $29.3 billion as of 2010, accounting for 21% of its total FDI.In May 2010, South Korea set up a new “China Desk” in KOTRA to promote increasing inflowsof Chinese FDI. China invested $55.9 billion overseas in 2008 but only 0.2% of that ($100million) was invested in South Korea. In comparison, South Korea attracted $11 billion inforeign investment in 2009, a sum expected to increase to $13 billion by the end of 2010.China-DPRK Trade and InvestmentWith Pyongyang’s international isolation, China occupies the top position on the short list of North Korean trading partners. Beijing’s assertion that normal trade is exempt from U.N. sanctions is an attempt to shield its trade with the DPRK from international pressure tied to North Korea’s nuclear program. China’s share of North Korea’s foreign trade is expected to increase in the aftermath of the Cheonan incident and resulting halt in North-South trade. In thefirst five months of 2010, overall trade between China and North Korea grew by 18%. North Korea imported $727 million of goods from China while exporting $256 million to China.In 2009, bilateral trade between China and North Korea was estimated at $2.7 billion, though according to China’s Ministry of Commerce, the total value of China’s trade with North Korea was $379 million in 2009, a 20.8% decrease compared to the same period in 2008, with anexport value of $315 million and an import value of $65 million in 2009. The official figures donot account for rampant smuggling, barter trade and small scale border trade which is duty free.According to KOTRA, the value of North Korea’s total foreign trade dropped to $5.09 billion in2009. China accounted for 53% of that total, with a value of $2.68 billion. If shipments acrossthe North-South border are excluded, 78.5% of North Korea’s trade is commerce with China.16In 2008, North Korean exports to China totaled $754 million were while exports to South Korea totaled $930 million. The value of North Korean imports from China was $2033 million in 2008 and $888 million from South Korea.Domestic challenges associated with China’s economic riseEconomic success has increased Beijing’s influence and interests around the world, but this economic rise has not come without a price. Serious domestic challenges encompassing economic, environmental and political issues continue to occupy Beijing’s attention and couldjeopardize its future. Domestic economic factors such as increasing competition and rising wages influence trade andinvestment patterns in China. Rising labor costs in China affect the calculations of companiesdoing business in China. The CFO of Yum Brands Inc expects “very high labor inflation” for the second half of 2010. Labor costs in China for the company rose by $12 million in the firsthalf of 2010 and are expected to rise by $32 million in the second half of the year.According to a JP Morgan analyst, labor costs in China rose 14.9% in the second quarter of 2010. Rising wages are partly a result of labor shortages in key manufacturing regions and industrial sectors. Even in 2006, a Shenzhen labor research group estimated that turnover in some low-techindustries approached 50%. That year, Guangdong province reported 2.5 million unfilled jobs with Jiangsu, Zhejiang and Shandong provinces also reporting shortages of qualified workers. In 2010, Chinese media reports estimated a labor supply gap of 1 million people in Guangzhou andneighboring cities in the Pearl River Delta, forcing employers to raise salaries.Minimum wages in China’s 14 provinces have risen more than 20% in 2010. The minimum wage inShenzhen is expected to increase by 15.8% to 1100 yuan ($161) per month beginning in July 2010.Rising wage costs present significant challenges for Chinese economic planners. Rising wagesand greater investment in social spending, while generally seen as positive contributors to socialstability, also causes inflation. Inflation however creates hardships on the large segment of thepopulation whose incomes are not increasing. Shifting employment patterns potentially alsocontribute to social dislocation as companies relocate facilities further inland from China’s east coast or to lower-cost countries in Asia such as Vietnam, in a bid to reduce costs. A high-profile example is Foxconn’s announced plans to move its main production line from Shenzhen to Hebei province in the wake of intense scrutiny over low wages and difficult conditions following multiple suicides among workers.An appreciating currency is another issue confronting companies in China. Ahead of the G20Summit, China announced an end to the peg of the yuan to the U.S. dollar. Instead, the People’s Bank of China will maintain a 0.5% daily trading band and set daily reference rates so the renminbi rises slowly against the dollar. China faces U.S. pressure to make more dramatic changes to its currency policy. Though an appreciating currency benefits companies selling into China and allows companies to take advantage of China’s growing consumer market, Chinese exporters will face disadvantages in selling abroad.Additional market factors that present enormous economic challenges include hyper competition and local protectionism. Chinese companies have generally identified price rather than quality or innovation as their competitive advantage. In a phenomenon sometimes described as, “the Chinaprice,” Chinese companies undercut one another to gain market share by slashing costs through corner cutting, taking advantage of a weak regulatory environment that enables companies toskirt regulations. Many Chinese companies disregard the 2008 labor law provisions that include generous overtime and social benefits that can reach 50% of salary. China’s fiscal decentralization gives local governments a strong incentive to protect their tax base, and local governments often shelter their companies from regional competition. Locally owned SOEs area source of political power and present an opportunity for patronage as well as a source ofrevenue. Industries that generate both high profits and taxes in particular benefit from policy and administrative measures.An example is provincial-level indigenous innovation catalogues that exclude ex-province companies from bidding on locally funded projects. Environmental degradation threatens to undermine China’s continued economic rise. A joint report published in 2007 by the World Bank and the Chinese government estimated thecombined health and non-health cost of outdoor air and water pollution is approximately $100 billion a year, or about 5.8% of China’s GDP. Water pollution worsens China’s severe water scarcity problems, with the overall cost of water scarcity estimated at 1% of GDP.The reportalso estimated that 750,000 people die prematurely each year, primarily from air pollution inlarge cities and an additional 300,000 people die prematurely each year from exposure to indoorair pollution.24Cultivated land area has decreased in many areas while in others, cultivated land increased at the expense of natural ecosystems. Soil erosion is a significant problem in China’swest with lost nutrients in the soil that must be replaced artificially and creeping desertification. Water consumption has skyrocketed and much of the increased consumption was satisfied by drilling, not from utilizing replenishable surface water, which can be too polluted even forindustrial use. In 2007, 60% of China’s cities faced water scarcity, with 110 cities facing serious water shortages.These conditions have contributed to a growing number of Chinese outbound investment projects in Russia, Australia, Africa and Latin America that seek to acquire croplandfor Chinese companies to produce food for export to China. China’s rapidly growing economy creates ever growing demand for energy. China perceivesitself as having significant energy security concerns, particularly over the long term, with some predicting future conflicts between China and developed nations over access to energy. The International Energy Agency estimated in July 2010 that China was the world’s largest energyconsumer. China’s demand challenges are exacerbated by state-controlled pricing and glaring inefficiency (China is 25% less efficient than the U.S. or Europe), though it has the potential toincrease its sense of security by investing in efficiency and renewable sources. Beijing is encouraging energy efficiency and has a target of reducing energy intensity (energy consumedper unit of GDP) by 20%, based on 2005 levels, by the end of 2010.However, despite officialpronouncements by senior leaders that they are on track to meet this target, official data indicatesthat China is probably lagging far behind its own objectives. Unfortunately, China’s stimulusefforts will likely make it even harder to reach its energy intensity targets.Heavy government involvement in the economy may also constrain China’s economic future.State-owned enterprises dominate China’s trade and investment. The government controls accessto capital, planning and has a strong preference for investing in infrastructure that is often underutilized or otherwise wasteful. State interference in the allocation of capital may resultgreater inefficiencies, high loan default rates and the lost opportunity to encourage greatermarket dynamism driven by private enterprise.Lastly, the slow pace of political reform and thelack of institutional checks and balances represent a drag on economic growth and a disincentive for investment. The lack of an independent court system, weak intellectual property rightsprotections, pervasive corruption and other regulatory issues ensure a difficult operating environment for private companies and the likelihood of re-occurring commercial problems suchas food safety scares.Implications of China’s Economic Rise—China’s Foreign PolicyChina’s large population, growing economy and rising standards of living are the chiefcomponents of China’s soft power. For the first time in its modern history, China’s economicrise has resulted in an expansion of economic and security interests beyond its borders. However,China’s economic growth has not been matched by corresponding evolution in political reform,foreign policy or expanded military capability. Despite the dramatic expansion over the pastthree decades, China’s military capabilities have not expanded at a similar rate. Likewise,Beijing has until now demonstrated great reluctance to assert itself militarily abroad. Of course,China contributes to U.N. peacekeeping operations and participates in anti-piracy operations inthe Gulf of Aden but otherwise, its closest security allies, most notably North Korea and Pakistan, have chosen to invest in developing their own deterrent, leading to significant regionaluncertainty.Deng Xiaoping reached an accommodation with the PLA at the outset of the reform and openingperiod, telling them to wait until the nation had acquired wealth before expecting a greater shareof national resources. However, China’s global interests have expanded faster than its military capabilities and doctrine, revealing a gap that they appear to be actively trying to close. Within China, consensus exists on the need for military modernization to continue so China can close the disparity with the major powers and wield a military equal to its status as an economic great power.China’s 2010 defense budget is officially $77.9 billion; a 7.5% increase from the militaryexpenditures budgeted for 2009, and only the second year since the military modernization program began in 1989 in which annual growth was less than 10%.28The economic crisis has likely reduced China’s available resources for military modernization, though it seems unlikely that a smaller than average budget increase will have a substantially negative impact on the PLA.There is little doubt that China will eventually have the capability to reach key security benchmarks, such as overseas bases and an aircraft carrier that will enable it to project power abroad.Implications of China’s Economic Rise—for South KoreaGlobal concerns about China’s rising military are balanced by the allure of the China market,making it a key aspect of China’s “soft power.” Undoubtedly, this is a key factor for most countries, including South Korea, that do not necessarily identify economically or politically with China’s system, but instead see an economic future in which China is a major player. This is reflected in South Korean people-to-people contacts as well as bilateral investment and trade.However, recent events have raised questions for some about striking an appropriate balance between political and security interests and economic integration.The number of students studying in China is one way to gauge China’s soft power and its relationship with South Korea. In 2006, the number of South Korean students in China reached 54,000; at the time, they consisted of 38% of the total foreign students in China. South Korean students formed the largest group of foreign students in China.29Of the foreign students studying in South Korea in 2006, Chinese students consisted of 61.7% of the total. As of April2009, South Korea had 75,850 foreign students with 70.5% of the students coming from China.According to Korea’s education ministry, 66,806 South Koreans studied in China in 2009, upfrom 57,504 students in 2008, while 68,124 South Korean students went to the United States tostudy. The number of students enrolling in universities and graduate schools in China doubled from 2006 to 2009, showing more students are seeking degrees in China instead of short term language training. China is soon expected to surpass the U.S. as the top destination for South Korean students.China is the biggest opportunity and the biggest threat for the South Korean economy. China’squick recovery and stimulus spending has lessened South Korea’s impact from the global financial crisis. Likewise, China’s position as the largest export market for South Korea shielded it from downturns in the U.S. economy. South Korea, like the United States, must maintain a competitive advantage over Chinese competitors. This is a tougher task for South Korean companies. It is especially difficult tomaintain a competitive advantage with rising costs on the mainland coupled with industrial policies that are unfavorable to Korean firms. Indigenous innovation, import substitution and technology transfer policies are all detrimental to China’s international competitors. Weak intellectual property rights protection in China is a particular threat for South Korean industries.As South Korea shifts from labor-intensive to knowledge and technology-intensive investments,protecting intellectual property becomes even more critical.South Korea has lost jobs and international market share to China, making it a political imperative for South Korean leaders to articulate the benefit of the South Korea-China economic relationship to Korean workers, not just Korean companies. South Korean investments in Chinaare politically justifiable so long as products from Korean-invested companies can enter the Chinese market. Pushing back against discriminatory indigenous innovation policies and protectionist measures is vital for South Korean companies.The Cheonan incident reveals the limits of South Korea’s ability to influence Chinese strategic choices.Despite South Korea’s position as a major investor and China’s sixth largest tradingpartner, economic ties have not translated into political influence over China or its relationship with North Korea. China’s almost instinctive response to shield North Korea in the aftermath ofthe Cheonan sinking reveals the limits of South Korea’s economic leverage over China. China’s nationalistic response to South Korean investors pulling out of the country in 2007-2008 is evidence of geopolitical risks of increased investment and China’s economic rise. South Korean enterprises began shutting down in China, particularly in Shandong Province, due torising costs caused partly by changes in corporate tax rates and also by an appreciation of the renminbi against the won.In March 2008, before the global financial crisis, the exchange ratewas 130 won per yuan. A year later, the rate almost doubled to 230 won per yuan making Chinese operations on the mainland considerably more expensive for South Korean companies.By one estimate, there were 20,000 South Korean investors in China in the late 1990s, only one-third of those investors remain today. In March 2008, reportedly 20 to 30% of the 6,000 South Korean companies in Qingdao were losing money.34Beginning in 2007, executives in Korean invested companies began fleeing their factories at night to avoid retaliation by workers whowere owned back wages and other creditors. The Export-Import Bank of Korea reported 206 Korean business owners who left Qingdao, Shandong province from 1999 to 2007 without goingthrough the correct procedures to shut down their business.According to one South Koreannewspaper, however, only 1 percent of South Korean companies folded without following legalprocedures. Under growing public attention, the South Korean government held talks withChinese officials and set up a team at its consulate in Qingdao to help South Korean investorsundergo liquidation formalities.36However, Chinese media widely covered the South Koreanexodus in negative terms (rarely explaining the causes for the corporate failures or the rise inviolence directed towards expatriate managers), straining bilateral relations and souring Chinesepublic opinion towards South Korean investors.Implications of China’s Economic Rise—for the DPRKEconomically, North Korea is dependent on is main ally, China, for trade, aid and investment.Despite Pyongyang’s dependency on China, Beijing has proven unable to shape the DPRK’sstrategic choices or deter it from threatening its neighbors. Though China accounts for anincreasing share of North Korea’s economic relationships, Beijing has been unable to curb NorthKorea’s pattern of aggressive provocations, including nuclear tests in 2006 and 2009 and the2010 torpedoing of the Cheonan.China’s economic engagement policy presents an opportunity for North Korea to reform its own economy, which some hope would moderate Pyongyang’s belligerent posture. Chinese strategists hope economic engagement improves North Korea’s sense of security and contributes to the DPRK’s domestic stability. However, Chinese investments in DPRK infrastructure and inthe Chinese border area have not stimulated economic reform in North Korea, nor has itmoderated Pyongyang’s antagonistic rhetoric or increased its social stability. China’s continuedeconomic growth may not make any difference in persuading North Korea to reform. Just as South Korea’s economic ties to China appeared to have little influence regarding China’s choices surrounding the Cheonan incident, it appears that China’s economic relationship with North Korea has not yet provided Beijing with a reliable means of influencing the DPRK’s strategic choices.ConclusionsAfter the sinking of the Cheonan, President Lee Myung-bak and Kim Jong-il each traveled to Beijing to present their respective cases to the Chinese leadership. China’s delayed reaction tothe loss of South Korean lives and Beijing’s efforts to weaken the U.N. statement on North Korea’s behalf demonstrated the limits of South Korean influence over Beijing. Indecisive responses to North Korean aggressions reflect Beijing’s overarching desire to preserve positive relations with both Koreas and its preference that North Korea continues to survive.In its relations with the U.S. and South Korea, China has generally managed to separate its economic interests from the security issues stemming from North Korea. Sanctions have nottargeted Chinese companies, and China’s political preferences for North Korea have not visibly dampened enthusiasm for China’s economic potential. China’s position as North Korea’sbiggest trading partner would appear to give it leverage over Pyongyang’s actions, though it hasproven reluctant to use economic coercion, fearing that constricting aid or “normal” trade wouldhasten North Korea’s collapse or drive North Korea to reject Chinese entreaties entirely.Most Chinese trade and investment is not designed with the objective of accomplishing broader geostrategic goals vis-à-vis North Korea. Of course, China provides North Korea food andenergy aid, as well as “friendship” projects which transfer technology to North Korean units. Allthese political investments are distinct from commercial ones in that they are intended to gain Beijing influence.However, Chinese commercial investors in North Korea do not appear tohave similar political goals. The Chinese government strategy regarding trade with North Koreais largely a local one, led by China’s northeast provinces, particularly Jilin and Liaoning. Thesesub-national governments’ operational objectives are economic development, not regional peaceand stability. Perhaps confirming that Chinese companies are not acting as agents of the stateseeking a broader geostrategic outcome, there are similarities in investment outbound patterns bound for North Korea and elsewhere around the world. Increases in the numbers of investorsand the ratio of investments in different sectors are consistent when comparing Chineseinvestments in North Korea with other states neighboring China.Chinese investments in North Korea are not necessarily a source of leverage for Beijing overPyongyang. As South Korea’s experience in the Kaesong Industrial Complex illustrates, theDPRK is adept at using foreign investments as a means to leverage governments. Likewise,despite its dependence on foreign direct investment in the 1990s, Beijing was very adept at using American businesses as its lobby in Washington. While foreign investors in North Korea shouldnot be considered political hostages, they do constrain Beijing to a degree. Chinese investmentsin North Korea amplify Beijing’s reluctance to endorse broad-based sanctions and raise concerns about possible reprisals against Chinese investors should Beijing decide, however improbably, toresort to economic coercion.Fears of North Korean collapse underpin Chinese economic commitments to the DPRK. These fears are intensified by Kim Jong-il’s apparently worsening health and an opaque leadership transition in Pyongyang. An economic and political collapse in North Korea could result ininstability spilling across the border, with China’s northeastern provinces vulnerable to a flood ofrefugees and a break down of law and order. North Korean regime collapse might cause Korean unification on terms antithetical to China’s interests; particularly a peninsula unified in South Korea’s likeness.Economics, as much as security, is at the heart of challenges confronting unification. Unificationwould likely be costly and disruptive for the South Korean economy, though a 2009 Goldman Sachs report identified upside potential in a unified peninsula that was able to realize growth from abundant human and natural resources. The report predicted that the GDP of a united Korea could exceed France and Germany in 30 to 40 years if the growth potential of North Korea was realized.However, such a scenario might not be welcomed by China. Unification of the Korean peninsula would possibly result in a steep decline in investment from South Korea to China as Korean capital becomes concentrated in rebuilding the North. Chinese investments inmines and factories would lose their government partners in the event of a collapse of the DPRK,raising questions about the rights of Chinese investors and how China would recognize newauthorities.Undoubtedly, Chinese investors facing the loss of their rights would actively lobbylocal and central authorities to intervene to protect their interests.China’s steady economic growth, rising affluence and political stability are the envy of thedeveloping world. Its immense scale, expanding middle class and low cost labor pool hasprompted uncounted multinational CEOs to declare that China is a vitally important market forthem. China has eclipsed Japan to become the center of economic gravity for Asia, making it themost important market and manufacturing base for the region. While the global economic crisishas slowed the pace of growth, China appears to have emerged unscathed and newly confident inits authoritarian political-economic model. However, growing economic integration has notameliorated festering security challenges, and mistrust is unabated by trade in northeast Asia.
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Mr. Drew Thompson, Nixon Center's director of China Studies and Starr senior fellow, serves as special contributor for The Seoul Times. He earned his M.A. in government from Johns Hopkins Univ. and studied Chinese language at Beijing Univ. His articles on Sino-US ties & int'l security have appeared on world's respected media including Foreign Policy, Financial Times, and Int'l Herald Tribune. He was also interviewed by CNN, Fox News, Bloomberg, BBC, and others.
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