International Trade and Investment Junhui Qian 2014 October

Content International Trade Trading reform Processing trade Inbound Investment FDI Into China Other capital flows Outbound Investment

Trade Reform “Double Air Lock” State monopoly of foreign trade Inconvertible RMB The reform began with an urgent attempt to increase and diversify sources of foreign exchange. The first step in opening came in 1978 when Hong Kong businesses were allowed to sign “export-processing” (EP) contracts with Chinese firms in the Pearl River Delta. Four Special Economic Zones (SEZ) were set up in Guangdong and Fujian. Liberalizing the Foreign-Trade System Devaluation of RMB De-monopolize trade Creation of tariff and nontariff Barriers Import substitution and export promotion

Toward An Open Economy China formally applied to rejoin the GATT (General Agreement on Trade and Tariffs, the forerunner of WTO) in On Dec 11 of 2001, China finally joined WTO (which was created during the Uruguay Round negotiations in 1996). China implemented substantial reforms before formal accession into WTO. There reforms were on reformists’ agenda anyway. WTO membership was a powerful excuse for pushing through reforms that reduced dualism in the economy. China has been committed to open its trade system and lower its tariffs. The average nominal tariff was reduced in stages from 43% in 1992 to 17% in 1999, the year when the breakthrough in WTO negotiations finally came. In the actual agreement, China agreed to lower average industrial tariffs to 9.4% by 2005, and this rate was actually achieved in The agreement lowered average agricultural tariffs to 15%, which was also easily achieved.

More and more open

Trade By State of Production

Composition of Trade

Regional Distribution of Trade

China’s Free-Trade Zones

Processing Trade Processing trade involves domestic firms obtaining raw materials or intermediate inputs from abroad, processing them locally, and exporting the value-added goods. Chinese firms started with “processing with assembly”. An example: A Hong Kong firm would ship fabric to a Chinese firm and have it sewn into shirts. The Chinese firm would be paid a processing fee, while the fabric and shirts would be owned by the Hong Kong firm at all times, so they did not have to pass through the foreign-trade system. In this way, the export production network already created by Hong Kong could expand into China, but Chinese industrial firms were not exposed to import competition. Soon Chinese firms started to purchase raw material (e.g., fabric) and build their own production network. This is called “processing with intermediate inputs”. Globally, there is a redistribution of the stage of production.

Rising share of processing with intermediate inputs

Current Account The current account of an economy reflects net income (income flow). In the current account, we have Current account balance= trade surplus + factor income + transfer. Trade surplus includes surpluses in goods and services trade Factor income includes labor income and capital income Transfer includes remittance, donations, etc.

Current Account Balance

Factor Income

Content International Trade Trading reform Processing trade Inbound Investment FDI Into China Other capital flows Outbound Investment

Attracting FDI to China The policy of attracting FDI also starts from the want of foreign currency reserve. Local governments, in the “GDP contest”, compete for FDI. What they offer include tax reduction, rent discount on land use, low environmental standards, etc.

China as a favorite FDI Destination Labor cost/quality Infrastructure Stable governance and law enforcement Consumer market size Intermediate goods markets

Foreign Direct Investment (FDI)

FDI/GDP (%)

International Comparison (USD ml)

Characteristics of FDI Into China Foreign direct investment has been the predominant form in which China has accessed global capital (as opposed to portfolio capital or bank loans). An unusually large proportion of Chinese FDI inflows are in manufacturing industry, as opposed to services or resource extraction. FDI inflows have predominantly come from other East Asian economies, especially Hong Kong and Taiwan.

Main Sources of FDI

Modes of FDI in China

Capital Account In international finance, the capital account reflects net change in ownership of national assets (capital flow). In the capital account, we have Capital account balance= FDI + portfolio investment + other investment + official reserve changes. “Other investment” include bank loans and other flows into bank accounts. As an accounting identity, we must have Capital Account Balance + Current Account Balance + Statistical Error = 0

External Debt

Decomposition of the External Debt

Measure of “hot money” Despite the heavy regulation on the capital account, investors or speculators may find ways to move money in or out of the country. This illegitimate form of capital flow is often called “hot money”. Different measures of “hot money”. Statistical error All other = (Current account balance – trade surplus) + (Capital account balance – gross FDI inflow) + statistical error

“Hot Money”

Korea’s Capital Account Balance

Content International Trade Trading reform Processing trade Inbound Investment FDI Into China Other capital flows Outbound Investment RMB Internationalization

Inbound and Outbound FDI (USD 100ml)

Case Study: Chinese Investment in Europe As investors fled Europe in the worst days of its sovereign debt crisis, China- based companies moved in the other direction and surged in, with cash flowing from China into some of the hardest-hit countries of the eurozone periphery. In 2010, the total stock of Chinese direct investment in the EU was just over €6.1bn – less than what was held by India, Iceland or Nigeria. By the end of 2012, Chinese investment stock had quadrupled, to nearly €27bn.

Chinese Investments and Contracts in Selected European Countries ( Jun, $bn)

Toward An Open Capital Account In 2014, China has announced to establish the “Shanghai-Hong Kong Connect”, a mechanism that allows international investors to purchase A-share stocks in the Shanghai Securities Exchange and domestic investors to purchase stocks in Hong Kong Stock Exchange. A “Shenzhen-Hong Kong Connect” is already in discussion. It can be conjectured that restrictions on portfolio investments, inward and outward, would soon be lifted.

Major Stock Exchanges (ranked at June 2014 )

Content International Trade Trading reform Processing trade Inbound Investment FDI Into China Other capital flows Outbound Investment RMB Internationalization

The objectives of RMB internationalization Invoicing in RMB Trade settlement in RMB Investment in RMB A reserve currency

Benefits of RMB Internationalization to China Reduce exchange rate risk for international trade, investment, and finance. Less need for foreign exchange reserve (e.g. USD). Seigniorage income.

Benefits of RMB Internationalization to the World The international monetary system over-relies on USD as the dominant reserve currency, but the US fiscal future is highly uncertain. RMB internationalization would provide an alternative reserve currency which is backed by a strong flow of fiscal revenue. RMB internationalization would also supply Chinese assets, including the risk-free government bonds, to the world. As a result, there would be less pressure on creating safe assets by financial engineering, one cause of the Global Financial Crisis.

The Implications of RMB Internationalization The Chinese capital market will be fully open to the world. The Chinese outbound investment, especially from the private sector, will take off. The foreign exchange reserve will decline as private outbound investment increases.