China-ASEAN free trade: Lessons for Indonesia

China-ASEAN free trade: Lessons for Indonesia

Rizal Ramli, Economist, Jakarta

The Seventh ASEAN summit meeting held in November last year
endorsed a proposal to establish an ASEAN-China Free Trade Area
(FTA) within 10 years. The idea, which will initially take the
form of a framework of cooperation between China and the ASEAN
countries, was greeted enthusiastically by Chinese Premier Zhu
Rong Ji at the meeting in Brunei Darussalam.

Establishing an FTA is a huge economic and political step. As
demonstrated by the growing importance of the ASEAN Free Trade
Agreement (AFTA), the creation of an FTA can have serious
implications -- both positive and negative -- for member
countries. It is certainly not a decision that can be taken
lightly. The speed with which the Association of Southeast Asian
Nations has embarked on the proposed China-ASEAN link raises the
question of whether sufficient consideration has been given to
the likely costs and benefits of the proposed FTA. Is the
proposal based on sound economic reasoning or is it a spontaneous
reaction to immediate events?

Experts are in broad agreement that China will achieve the
status of the region's dominant economic power within the next
decade. In all likelihood, China will replace Japan as the Asia's
economic powerhouse by the year 2010.

Over the last two decades, China has posted historic rates of
economic growth, averaging 10 percent per annum for the period.
Economic reforms launched by Deng Xiao Ping beginning in the late
1970s set in motion a process of economic transformation
analogous to the experience of Japan in the 1950s. At these rates
of growth, China, like Japan in the earlier period, doubles its
national income every seven or eight years.

One of the important consequences of economic modernization in
China is that the country has replaced ASEAN as the most
desirable destination in Asia for foreign direct investment
(FDI). Declining rates of new FDI in the ASEAN countries have
been accompanied by a stunning rise in the volumes and importance
of FDI in China. In the year 2000, according to UNCTAD, FDI in
China totaled US$41 billion, while last year new flows decreased
to $32 billion. The value of Chinese exports last year amounted
to $190 billion per year and the country holds foreign exchange
reserves in excess of $203 billion.

Remarkably, this outstanding economic performance has not yet
resulted in social and political instability. In China's recent
history this contrasts sharply with the experience of Soviet
Russia during the Gorbachev reforms of the 1980s. Perestroika and
glastnost, Gorbachev's ambitious program of economic and
political reforms, came to an end with the disintegration of the
Soviet Union and the subsequent collapse of the Russian economy
and living standards in Russia and the other former Soviet
republics. Russia's 1998 default on its foreign obligations
symbolized the fall of the former Soviet Union from superpower to
developing country status.

Meanwhile, China's gradualist strategy, in which economic
reforms have preceeded political change, has so far succeeded
beyond even the most optimistic predictions of the early 1980s.
From this perspective, the sequence of economic and political
reforms in Russia and China holds important lessons for
Indonesia.

Importantly, China's approach to its foreign exchange regime
and the exchange rate has been characterized by extreme caution.
Despite massive pressure from the international financial
institutions, particularly at the time of the East Asian
financial crisis of 1997/98, China has continued to intervene
systematically to defend the value of the renmimbi and has
resisted calls to open the capital account and allow full
convertability of the currency.

China's monetary authorities have demonstrated a clear
understanding of the principle that financial liberalization must
be preceded by liberalization of the real side of the economy.
Financial sector reforms are only viable on the basis of previous
and substantial increases in real sector productivity, trade
surpluses and the accumulation of foreign exchange reserves.
Changes in the foreign exchange regime and liberalization of the
capital account can only be considered once these prerequisites
are in place.

These steps have created a buffer against external shocks and
speculative attacks on the currency. China's capacity to resist
short term speculative threats is therefore much stronger than
the Asian countries affected by the recent financial crisis,
particularly the ASEAN countries.

The sequence of liberalization in Indonesia was precisely the
opposite of that undertaken by China. When then Minister of
Finance J.B. Sumarlin proudly unveiled the acceleration of
Indonesia's financial liberalization in October 1988 -- now
widely known as Pakto 88 -- the real side of the economy was just
emerging from a serious recession and was still extremely
fragile.

The proliferation of hundreds of new banks following on from
the Pakto 88 were inadequately financed, under-skilled, and
unsupported by effective central bank supervision. When the time
bomb exploded in 1997 most of these banks collapsed, leading to
the disintegration of the national financial system,
macroeconomic volatility, and the collapse of the real economy.

In other words, from the perspective of the promotion of
investment, the acceleration of economic growth, macroeconomic
stabilization and structural transformation, Indonesia has much
to learn from the Chinese experience.

China's superior performance over a period of more than two
decades has important implications for the proposed China-ASEAN
free trade area. For example, recent estimates suggest that
China's industrial costs are on the order of 30 to 40 percent
less than Indonesia's. This fact alone suggests that the ASEAN
countries should proceed with caution.

China's low industrial costs reflect the country's low labor
costs and better technological capacity. The size of the domestic
market and greater internal economic integration mean that
Chinese industry is less dependent on foreign finance and
imported inputs.

In addition, the planned construction of the southern China
rail network extending from Kunming through Laos, Cambodia,
Vietnam, Thailand and Malaysia to Singapura will reduce transport
costs for exports of Chinese finished goods to the ASEAN
countries by at least 10 percent. The combined effects of these
cost advantages will contribute to the flood of Chinese goods
into ASEAN markets. These effects are indeed already being felt
in all of the ASEAN countries.

The proposed FTA encompassing China and the ASEAN countries
would increase Chinese exports to ASEAN. Yet there is little
reason to expect an increase of Chinese investment in ASEAN
industries over the coming 10 years with the exception of natural
resource-based industries, particularly energy.

In other words, Indonesia and ASEAN would increase the size of
China's export market over the coming decade while the potential
economic benefits to the ASEAN countries would remain fairly
limited. The reason is that China-ASEAN trade relations are
fundamentally competitive rather than complementary.

There are of course Indonesian exports that China needs, but
these are broadly limited to energy and other primary products
such as palm oil. Liberalization of trade in these commodities
would not boost Indonesia's market position. In short, Indonesia
should approach the issue of economic integration with China with
extreme caution.

Indeed, given Indonesia's structure of production the country
has more to gain from trade agreements with other countries and
regions, specifically those that are complementary rather than
competitive in nature.

The government should undertake a thorough study of the
potential costs and benefits of all trade agreements, including
the proposed China-ASEAN FTA. Careful consideration of potential
gains from increased trade would help us to prioritize our trade
agenda in conceptual and strategic terms, and would prevent us
from making commitments on the basis of ill-considered reactions
to short term events.