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.