Executive Summary

• Given the current progress, China is likely to complete its bid for World Trade Organization (WTO) membership by year-end. After its accession, China will gradually let down its trade barriers and allow increased foreign participation in its markets. As control on trade and foreign investment are relaxed, domestic enterprises will have to compete not only with the increased variety of imports but also a wider range of locally manufactured foreign product brand names. Although increasing competition will force inefficient enterprises to close down, it will also prompt domestic companies to speed up reform and improve efficiency.

• With the reduction of tariffs and easing of other quantitative restrictions, China will see a surge in imports after its WTO entry, which would dampen the country's trade surplus. The impact on China's balance of payments position is, however, expected to be countered by an increase in foreign direct investments seeking to take a bigger slice of China's vast markets. Moreover, the rise in productivity of Chinese enterprises as they step up investment to counter the foreign competition would enhance their ability to raise funds in the international debt and equity markets. Increased access to foreign capital should lend support to the Renminbi, which is likely to remain stable on the strong side after China's WTO entry.

• Along with other foreign investors, Asian investors would benefit from the opening up of China's markets. Hong Kong and Taiwan investors would, in particular, enjoy better competitive advantage in tapping the China market given their well-established business connections in China as well as their sharing of a common language and culture with the mainland. Meanwhile, Taiwanese businesses could further look forward to increased economic exchanges with China after its own accession to the WTO following China's entry, possibly paving the way for a smoother resolving of the long-standing cross-strait issue.

• However, easier access to the China market would also mean increased competition for foreign funds among some Southeast Asian countries. Given China's vast market, which provides higher potential for expansion, some foreign investors will naturally choose to concentrate their investment on China. To this extent, Southeast Asian countries may become victims of China's WTO entry if they fail to improve their investment environment to maintain foreign investor interest. Despite the challenges, the growth in China's foreign trade would stimulate intra-regional trade and bring new business opportunities to Asian countries.

Having sealed a bilateral trade agreement with the European Union (EU) in May on the country's entry to the World Trade Organization (WTO), China has reached the final stages of its bid to become a member of the multilateral trade body. As of the end of June, China needed only to reach bilateral WTO agreements with four more nations; namely, Ecuador, Guatemala, Mexico and Switzerland, before the final application or the "draft protocol of accession" could be submitted to the WTO General Council. For China to successfully gain WTO membership, the draft protocol needs to be passed by two-thirds of the 136 WTO members, after which China's National People's Congress (NPC) would have to ratify the agreement. China will formally become a member of the WTO thirty days after the NPC's ratification. Given the current progress, China is likely to become a member of the multilateral trade body before year-end.

The bilateral trade agreements reached between China and other WTO member countries focused mainly on the elimination of protective trade policies by China and the gradual relaxation of controls on foreign investment. In accordance with WTO rules, the concessions that China offers to any other member country will be enjoyed by all WTO members after China's accession to the WTO.

On reducing trade barriers, China has agreed to cut average tariffs on agricultural products from 31.5% to 14.5-15% by 2004. Average tariffs on industrial products will be reduced from 24.6% in 1997 to 9.4% by 2005, by which time the 13.3% tariff on high-tech goods will also be abolished. Non-tariff protective measures such as import quotas on industrial products will also be phased out within five years. Moreover, China will gradually relax the regulations which require foreign-invested companies to import and export through government middlemen, and also allow them to distribute and sell products directly in China.

On relaxing controls over foreign investment, China has agreed to gradually open the highly protected sectors such as financial services and telecommunications to foreign participation. Upon entering the WTO, for example, foreign companies are allowed to own 25% stake in mobile telecommunications ventures and 50% stake in insurance business. Foreign ownership in mobile telecommunications ventures could be raised to 49% after three years, while foreign equity restrictions in the insurance sector will be lifted in five years. Five years after China's entry to the WTO, all geographic and customer restrictions on foreign banks will also be removed.

IMPACT ON CHINA

Foreign trade and investment

As the world's ninth largest exporter, China's accession to the WTO is deemed positive to the Chinese economy and the impact is expected to be long term. Apart from fully incorporating China into the international trading system, China's WTO membership would provide a multilateral platform for the country to resolve trade disputes with other member countries, giving China more protection against unilateral sanctions by aggrieved trading partners. As a member of the WTO, China could also participate in global trade talks to counter possible changes in international trade rules that may be unfavorable to the country's exports. Meanwhile, the passage of China's permanent normal trade relations (PNTR) status with the US, which is a precondition for the 1999 Sino-US WTO trade agreement, would give the country more secured access to its largest export market.

To enjoy the benefits that come with the WTO membership, China will have to gradually phase out the protectionist policies that have shielded its enterprises from foreign competition in the past years. Upon entry to the WTO, China will have to cut import tariffs and open up its markets. The sharp reduction in tariffs and non-tariff trade barriers would inevitably lead to a surge in imports and a reduction in China's trade surplus. The extent to which China's trade balance could deteriorate should, however, not be exaggerated, as trade barriers will only be let down gradually. Increased inflow of foreign investment would also help offset the negative impact on the balance of payments position resulting from the faster growth of imports.

As China improves the transparency of its trade regime to meet the standards set by the WTO and given the more secured access of Chinese goods in the overseas market, more foreign investors would seek to establish export-manufacturing operations on the mainland. Increased distribution capability in China would also attract large multinational retail companies to set up a foothold on the mainland. Moreover, the opening of China's vast markets to foreign banks, insurance underwriters and telecommunications companies would attract further massive inflow of foreign direct investment in the services industries in the coming years. Meanwhile, the rise in productivity of Chinese enterprises as they increase investment in new technology to counter the foreign competition would enhance their ability to raise funds in the international debt and equity markets.

Increased access to foreign direct and portfolio capital after WTO entry should lend support to the Chinese currency, which is expected to remain stable on the strong side after China's WTO entry. In the longer run, with more rapid foreign trade growth following China's accession to the WTO, exchange rate would inevitably become a more important macroeconomic policy tool for the government. It may, therefore, be necessary for China to adopt a more flexible exchange rate regime. Representing a move in this direction, the People's Bank of China (PBOC) has gradually allowed the Renminbi to trade within a wider fluctuation band since early this year.

Enterprise reform

The opening up of the domestic market to foreign trade and investment would, however, increase competition and put mounting pressure on the Chinese enterprises. Domestic enterprises will have to compete not only with the increased variety of imported goods but also a wider range of locally manufactured foreign product brand names. It is, therefore, feared that more inefficient Chinese enterprises would be forced to close down business and unemployment would edge up accordingly.

The exact impact of increased foreign competition on Chinese enterprises should, however, not be overstated. Local enterprises generally have an edge over foreign companies in terms of their understanding of the domestic market and grasp of the mainland's distribution network. Given that the liberalization schedule is phased gradually and it would normally take considerable time for foreign entrants to assess existing market opportunities and formalize actual investment, there should be enough time for the well-equipped local enterprises to gear up for the intensifying competition. Meanwhile, with public debt amounted to only 16% of GDP, well within the international safety threshold of 60%, the government can afford to increase borrowing to spend more on social security to deal with the rise in unemployment due to the closure of inefficient enterprises.

In the longer run, increased foreign competition could well be stimulants to the Chinese economy. As Chinese enterprises increase investment in new technology to counter the foreign competition, productivity would improve. Tremendous business and job opportunities will also be created in the local economy after China opens its services sectors to foreign companies. These, together with the increased inflow of foreign capital and the transfer of technology and expertise should help to sustain the growth of China in the long run.

Banking reform

To meet the increased foreign competition, China is also expected to step up efforts to reform the banking sector. As restrictions on foreign banks are gradually relaxed after China's entry to the WTO, the PBOC is expected to unify the supervision standards for domestic and foreign banks to level the playing field for all banks. For one, the favorable 15% income tax rate that foreign banks currently enjoy would eventually be raised to 33% to match those of their local counterparts. Secondly, in conjunction with the gradual liberalization of interest rate controls in China, the PBOC would also allow local banks to determine their own deposit and lending rates on foreign currencies, same as the foreign banks. Apart from the regulatory changes, the PBOC has sought to restore the financial strength of the state banks. Over the past year, the four state commercial banks had set up asset management companies to take over their problem loans. The extension of new loans has also been more prudently considered.

Meanwhile, local banks are expected to embark on major expansion plans to protect their market shares in face of increased competition. While weaker banks may choose to merge into bigger entities and leverage on each other's competitive advantages, more established Chinese banks may seek public listing to fund their expansion. Steps have also been taken by domestic banks to diversify their products and services, such as participating more actively in the retail market through financing consumers' housing, automobile and education needs. Given a five-year grace period provided under the WTO agreements before full liberalization of foreign bank franchise takes place, domestic banks could take advantage of their better market knowledge, more established branch networks and customer relationships to head an early start in the competition.

IMPLICATIONS FOR ASIA

The opening up of China's services sector would greatly benefit Hong Kong's investors along with other foreign investors. The services sector, ranging from financial services and telecommunications to retail, which accounted for 85% of Hong Kong's economy, is the area in which Hong Kong companies can particularly capitalize on their expertise. Moreover, given their long- and well-established business connections in China as well as their sharing of a common language and culture with the mainland, Hong Kong firms have a further competitive advantage over their foreign counterparts in tapping the China market. Increased investment by Hong Kong companies in China would benefit Hong Kong's economy in terms of generating more income earned from abroad.

Furthermore, with more secured access of Chinese goods to the overseas market after China's WTO entry, Hong Kong manufacturers producing goods in mainland plants for exports abroad would stand to benefit. The export/import trade and other trade supporting services industries of Hong Kong such as transportation, banking, insurance, etc. will also receive a boost given Hong Kong's unique status as a foreign trade and services center for China. Although Hong Kong's middleman role may diminish in the long run as foreign traders opt to trade directly with China and set up their own trade supporting services operations on the mainland, Hong Kong companies could still benefit from the expansion in business volume, thanks to the increase in intra-Asian trade following China's entry to the WTO.

Taiwan

Along with other foreign firms, Taiwan companies already doing business with China would benefit from the increase in trade opportunities and the improved access to mainland markets after China's accession to the WTO. Same as Hong Kong, Taiwan investors tapping the domestic market would also enjoy a lead over other foreign investors given its sharing of a common language and culture with the mainland consumers. Over and above all the benefits offered by a more open China market, Taiwan's businesses could further look forward to possible breakthroughs in cross-strait economic relations after China's entry to the WTO, which could bring additional business opportunities.

With Taiwan also expected to become a WTO member after China's accession to the WTO, cross-strait trade and investment issues would find a new platform for negotiation - outside the reunification focus. Under WTO rules which call for non-discriminatory and reciprocity treatment among members, Taiwan government will have to abolish the restrictions on mainland-bound investments that have been maintained on the grounds of national security and economic independence. The easing of outward investment restrictions would enable more Taiwan businesses to improve their price competitiveness by relocating the labor-intensive parts of their operations to the mainland. Meanwhile, the ban on direct shipping with China would also have to be lifted. This would free Taiwan's traders from the trouble of routing trade through a third party, thereby saving money and time. Increased economic exchanges between China and Taiwan may, in return, help to ease the lingering cross-strait political tension, possibly paving the way for a smoother resolving of the long-standing cross-strait issue.

Southeast Asia

As the attractiveness of China to foreign investors increases after the country's entry to the WTO, foreign investments could be diverted to China which could pose a threat to some Southeast Asian countries. Thanks to the protection offered by WTO's trade rules and China's PNTR status with the US, exporters in China would be able to gain more secure access to the overseas market. Improved market access for China-made products together with the country's abundant supply of low-cost land and skilled labor would make China a more attractive production base to foreign manufacturers after its entry to the WTO. Some multinational companies are, therefore, likely to shift their production bases to China from Southeast Asian countries such as Thailand, the Philippines, Malaysia and Indonesia that are also exporting labor-intensive light industrial goods.

Meanwhile, the opening of China's large and highly under-developed services sectors is likely to attract further foreign investment away from Southeast Asia. After fully meeting the targets of market opening for its entry to the WTO in five years' time, China's restrictions on foreign investment in the financial services and telecommunications sectors will be greatly reduced and made comparable to those in some Southeast Asian countries. Given China's vast market, which provides higher potential for expansion, some foreign investors will naturally choose to concentrate their investment on China. To this extent, Southeast Asian countries may become victims of China's entry to the WTO if they fail to improve their investment environment to keep the foreign investment.

Despite the challenges, the growth in China's foreign trade would stimulate intra-regional trade and bring new business opportunities to trade-supporting services industries across the region. Moreover, as China has agreed to substantially lower the average tariffs on agricultural products by 2004, Southeast Asian countries, which have traditionally been leading exporters of these products, could look forward to increased access to China's vast markets after the country's accession to the WTO.

CONCLUSION

The opening of China's markets after its entry to the WTO will attract substantial foreign investment and steer the country through a faster yet more sustainable pace of structural reform. In the process, China would inevitably face increasing incidences of failed enterprises and higher rates of unemployment, but none of these challenges are insurmountable. Over the long run, the reform process would in fact strengthen the competitiveness of domestic enterprises, enabling them not only to gain a firmer foothold on the mainland market but also further their expansion overseas. Meantime, increased investment opportunities for foreign investors in China would also mean tougher competition for foreign capital among some Southeast Asian countries. However, initiatives taken by these countries to improve their investment environment to maintain foreign investor interest, together with the additional business opportunities following the increase in intra-regional trade, should create a new impetus for the region's continued economic growth.

CHINA MAJOR ECONOMIC INDICATORS

Jason Kwok
North Asia Chief Economist

Joe Lo
Senior Economist

Ellen Cheuk
Economist

Alice Chan
Senior Information Officer