Introduction

The very rapid economic growth of the People's Republic of China (henceforth PRC), its dramatic success in world export markets and its heavy receipts of foreign direct investment (FDI) have generated much thought and debate in policy and business circles in different parts of the world. From Malaysia to Mexico and from Indonesia to India the simple 'threat or opportunity' question has been posed in relation to the 'rise of PRC'. Given the impact of geography on trade and investment patterns, such concerns have been greatest amongst PRC's most immediate neighbors. This paper examines the evidence from a number of recent empirical studies that address different aspects of this issue in the context of PRC- East-South East Asia economic relations. The broad consensus is that whilst there may be risks to individual sectors in all countries concerned the pattern of regional trade and investment that is emerging is mutually beneficial, provided enterprises and governments in PRC's regional partners respond effectively to the adjustments required.

This paper is organized as follows. The remainder of the introduction sketches out briefly some of the conceptual issues. The second section illustrates the differing trade structures between PRC and its regional partners, since the degree of complementarity is critical to the potential gains from expanded trade. The third section examines evidence on changes in export market share in third country markets to assess the extent to which regional partners are losing market share to Chinese exports. The fourth section examines the FDI diversion argument. The fifth section looks at the potential benefits to the region (and to PRC itself) from various forms of trade liberalization arrangements. The final section draws some brief conclusions.

The 'stylized fact' view of PRC is of a large, very rapidly growing economy with very high domestic savings, attracting large absolute values of FDI (but not it should be noted in per capita terms) and achieving dramatic export growth (averaging nearly 17% annually 1990- 2002). With a large rural population as a source of labor supply PRC's 'modern sector' growth is seen as based on a near perfectly elastic labor supply at a low real wage based on low rural opportunity costs (a contemporary version of the 'Lewis model' for a labor surplus economy). Given its size PRC thus becomes the marginal supplier for labor-intensive goods on the world market, and its real wage level and productivity set world prices in these products. FDI inflows and domestic investment in skills and technology upgrading allow a shift into more technologically sophisticated product ranges, particularly where laborintensive segments of international supply chains can be relocated to PRC through FDI (although PRC remains well behind the Republic of Korea and Taipei,China, for example, by technology indicators such as enterprise R and D expenditure per capita).

Falling trade costs (import tariffs, transport and freight charges, time in transit, the cost of information and of managing international supply chains) have facilitated rapid regional integration in trade and capital flows within the East-South East Asian region. Added to this, PRC's rapid expansion provides an opportunity for regional partners to both export to and invest in its large domestic market. However, PRC is also an export rival in third country markets (and a country's own domestic market) in a range of goods from simple laborintensive products to the more technologically complex (for the latter principally because of its large FDI sector). If FDI to the region is treated as a fixed sum then higher inflows to PRC will be at the expense of other economies and there will be FDI diversion as an additional possible negative effect that will have consequences for trade flows.

The competitive 'threat' from PRC for particular goods can be seen in terms of changes in market share domestically (negative import substitution) and in third country markets. However whether rising international competition leads to income and welfare losses will depend upon the flexibility of economies. In a world of zero adjustment costs economies will simply adapt to changing relative costs and if market share is lost in one product, resources will shift into another where market prospects and returns are higher. The familiar argument that only firms, not nations, compete strictly rests on the set of simplifying assumptions related to perfect markets and hence zero adjustment costs. In other words, with positive adjustment costs trade competition need not always be mutually beneficial for all different parties.

The impact of 'the rise of PRC' and falling trade costs more generally can be thought of in simple terms of 'trade diversion' and 'trade creation'. For any one economy, trade diversion arises where lower cost or higher quality goods (for example from PRC) displace those of the economy concerned, creating a potential loss of income if new markets are not found and the resources involved are not shifted to other activities. Trade creation is where growth elsewhere (for example in PRC) creates a demand for an economy's exports.¹ It will make a difference what type of products are the subject of this diversion and creation process. In general it is desirable for economies to shift up the 'ladder of comparative advantage' that runs from simple labor-intensive goods, through capital-intensive, to human capital-intensive technologically sophisticated products. How this process is affected by closer trade links with a large fast growing regional neighbor will clearly be important and the dynamic implications of any new regional division of labor will matter. If an economy adapts by specializing in products with a static global market or a lack of technological dynamism, this new specialization pattern may offer lower growth prospects than the initial pre-adjustment one. A priori it is expected that the more adaptable are the firms in an economy, the greater is the scope for mutually beneficial outcomes from closer trade links. Also the greater is the scope for complementarity between partner economies, in terms of resource and human capital endowments, the greater the potential for trade creation and thus the greater will be the gains.

Adaptability in this context implies the ability of firms to identify new market niches, to reequip and re-train, to identify, purchase and adapt new technology and to establish alliances within international supply chains. These firm-level responses are aided by a supportive and flexible policy environment, which encourages firms to take risks, provides adequate public education, training and research expenditure, ensures firms have adequate support from the financial sector, encourages R and D activity with collaboration, where appropriate, and gives an overall strategic direction to 'national competitiveness policy.'

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