Introduction

The rapid integration of the People's Republic of China (PRC) into the world economy has been a prominent feature of the global economic landscape over the past two decades. In 2008, the ratio of the PRC's trade (the sum of merchandise exports and imports) to gross domestic product (GDP) reached 58.7%, nearly double the 32.6% level in 1990. Its share of world merchandise trade has also risen from a mere 1.6% to 8.0% over the same period. The PRC is now the world's third-largest merchandise exporter after Germany and the United States (US). On the investment front, the PRC is the largest foreign direct investment (FDI) recipient in the developing world. Its share of the world stock of inward FDI rose from 1.1% in 1990 to 2.2% in 2007.¹

Despite efforts to diversify its export markets in recent years, the PRC's trade is still heavily oriented toward affluent developed economy markets, with the US, the European Union (EU), and Japan—the G3 economies—as its most important export markets. In 2008, the G3 markets accounted for 46.3% of the PRC's total exports. The share of exports to the G2 markets—excluding Japan—was 38.2% in the same year, a significant increase from 18.7% recorded in 1990.

Underlying the increased dependence of the PRC's exports on western markets is the changing pattern of regional production and trade in Asia. In recent two decades, rising vertical integration of production chains has been the key feature, driving the changes in trade in the PRC and other Asian economies. Underpinned by low labor costs and massive FDI inflows, the PRC has established a strong comparative advantage in the downstream stages of production processes of various products. As the final stages of production were relocated from neighboring Asian economies to the PRC, the country's demand for intermediate parts and components from other parts of Asia has grown sharply while its exports of final goods to developed economies have also increased significantly. As a hub for regional production chains supported by trade and investment, the PRC has played a unique role as an essential assembly center for many exports from Asia to the US and EU.

With economic growth stagnant for more than a decade in Japan, its role as a leading regional market for manufactured products has declined. During the period 1990–2008, the share of Japan in the PRC's total exports declined from 14.7% to a mere 8.1%. However, as the largest and most advanced economy in Asia, Japan is still a very important trade partner for most East Asian economies, including the PRC. Moreover, FDI from Japan has been essential for the economic development of East Asian economies. Actually, Japanese multinational corporation (MNC) FDI in developing/emerging Asian economies, stimulated by the appreciation of the yen following the 1985 Plaza Accord, has played a vital role in shaping Asian regional production networks, especially in electrical machinery, electronics, automotive, and other machinery sectors (Kawai & Urata, 2004). In the 1990s, four Association of Southeast Asian Nations (ASEAN) economies—Indonesia, Malaysia, Thailand, and the Philippines (ASEAN4)—were the key host countries for Japanese FDI in Asia. With the Asian financial crisis hitting Southeast Asian economies in 1997–1998 and the PRC's World Trade Organization accession in 2001, the PRC has emerged as the most favored destination of Japanese FDI among Asian countries (Figure 1 [ PDF 48.8KB | 1 page ]). Some Japanese MNCs shifted their operations from ASEAN4 to the PRC to both tap the abundant supply of low-cost labor and to target the potentially huge domestic market.

The three giants—the US, Japan, and the PRC — play critical roles in Asian regional production networks. The US serves primarily as the final destination of a large proportion of Asia's final output. Once the US demand for PRC exports goes down—as it did amid the recent global financial crisis—many emerging and developing Asian economies are clearly affected, through shrinking PRC demand for imports of parts and components from them. Japan plays the leading role of providing finance, technology, and marketing know–how for the operation of regional production networks and supply chains. The global strategy of Japanese MNCs is a key determinant of regional production, supply networks, and trade in Asia. The PRC's strong competitive edge in downstream, labor-intensive stages of manufacturing production makes it a conduit for many exports from Asia to western countries. The PRC's high penetration in the manufacturing markets of advanced countries, together with its fast-growing domestic market, has provided important export opportunities to its Asian neighbors.

The market-driven economic integration of the PRC, Japan, and the US over the past two decades has reshaped the economic landscape of Asia and the world, and significantly contributed to the recent vast increase in economic prosperity in developing Asia. However, this has not come without costs. The heavy reliance on the final demand in the US makes the PRC and other Asian economies extremely vulnerable to the turbulence in the US economy. Moreover, this triangular trade pattern between non-PRC Asia and the US through the PRC has partly contributed to the global current account imbalances, under which the US runs unsustainably large trade deficits, and the PRC, Japan, other East Asian economies as well as oil-producing countries run significant surpluses.² As the global imbalances are unsustainable and need to be corrected in order to settle down to a new, more sustainable level, an adjustment in the trade pattern among the PRC, Japan, and the US is also inevitable.

With the eruption of the global financial crisis, originating from the US, a market-led, disorderly adjustment in global imbalances has already started. A sharp increase in US household savings has contributed to the significant improvement of the US current account deficit. However, this adjustment has been rapid and disorderly—despite the absence of a US dollar collapse, which was feared by many experts and policymakers before the outbreak of the financial crisis—because it has been accompanied by sharp contraction of manufacturing output, exports and imports, and rising unemployment in both the US and Asia. Given that the global imbalances were created by a number of structural features—such as the savings and investment patterns in the US and Asia, outward-oriented growth strategies in Asia, and the preference of Asian policymakers to maintain trade surpluses—the adjustment of global imbalances will be a medium- and long-term process and will likely go beyond the time horizon of the current crisis.

Against this backdrop, this paper assesses the long-term implications of global rebalancing for Asian economies and explores the benefits of PRC-Japan-US economic integration. It attempts to tackle the following three questions:

What are the impacts of a decline in export demand—due to the evaporation of US consumption—on the trade and production patterns in Asia?

What would be the long-term welfare gains of institutional economic integration—through a free trade agreement (FTA)—among China, Japan, and the US?

Should the integration process involve other emerging Asian economies, like the Asian newly industrialized economies (NIEs; i.e, Hong Kong, China; the Republic of Korea (hereafter Korea); Singapore; and Taipei,China) and ASEAN countries?

We use a multi-country, global computable general equilibrium (CGE) model to simulate different scenarios for global rebalancing and FTAs for the PRC, Japan, the US, and possibly other Asian economies. The model is static and assumes continuous full-employment, so its results should be interpreted as describing long-run equilibrium situations.³ Our simulations suggest that the long-term decline in US consumption—accompanied by a US GDP growth slowdown—and its consequent current account correction would force the East Asian economies to undergo substantial structural adjustment. A combination of domestic reform aimed at boosting services sector productivity and external liberalization aimed at fostering broader economic integration will be critical for East Asian economies in order to facilitate their economic rebalancing and achieve sustained growth over a long period.

This paper is organized as follows. Section 2 describes the model and a set of underlying assumptions used in the analysis. Section 3 discusses the design of three types of simulation scenarios—including consumption evaporation and growth slowdown in the US, East Asia's productivity hike in the services sector, and FTAs—and explains their results. Section 4 offers conclusions.

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