The investment test that has Beijing trailing

China may be a potent force in world trade but it lags on foreign investment – a far better indicator of economic integration and intimacy.

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In a recent trip to several countries in South East Asia, many academics, think-tankers, journalists and even officials offered the opinion that China would soon dominate the region economically – eventually forcing countries to change their strategic orientation away from Washington and ever closer towards Beijing. Some Australian strategists proffer the same opinion, the most prominent being Professor Hugh White in his widely read book, Power Shift: Australia’s future between Washington and Beijing.

At the heart of these arguments is the observation that Chinese economic growth and importance in the region will surely pull countries into its sphere of influence, even if they go kicking and screaming. Trade is often cited as evidence of this China-dominated economic power shift away from the West. In reality, and although significant, trade numbers are less important than is often made out. The key is to look at investment flows in Asia. And if we do, it becomes clear that China is far from the dominant economic force now and into the future that many people assume to be the case.

The China trade story is well known. Trade between China and major regional countries has been growing rapidly over the past two decades. China is already the largest trading partner for Japan, South Korea, Vietnam, Indonesia, India and Australia. It is the largest trading partner with the 10 ASEAN nations considered as a whole.

In predicting the strategic future why put more emphasis on foreign direct investment or FDI (defined as equity ownership of 10 per cent or more in a foreign business), even if trade remains important? To explain, consider the following scenario.

You go to the same butcher every day to buy meat for your family. Lately, you've also been buying your meat for the restaurant you own from the same butcher, making you a major customer and the proprietor very happy.

But in the midst of a promising relationship, you have an argument with the town mayor, who bans you from entering the shopping strip where the butchery is located.  

There are few winners from the mayor’s rash decision. From your point of view, this is enormously inconvenient since you'll have to now order your family and restaurant meat from a neighbouring town, leading to increased costs for your restaurant business and a delay in getting your domestic requirements. From the proprietor’s point of view, the loss of significant business will hurt his bottom line and he'll have to work harder to increase sales elsewhere.

Now imagine that you're an investor in the butchery. A breakdown in your relationship with the mayor – and a resulting ban against you coming anywhere near the butchery – is much more serious. You can no longer oversee the running of the business, let alone work in it. If things take a turn for the worse, it'll be difficult to sell your stake in the business. If the mayor decides to seize your equity in the business, you lose a major asset. It's in your overriding interest to do whatever it takes to make peace with and appease the mayor. At the very least, you'll be reluctant to invest again in that town until a new mayor is in office.

In essence, trade is a series of generally recurring but stand-alone transactions that is of benefit to both parties. Once the transaction is completed, the relationship potentially ends. If Country A needs less of our stuff, we quickly move on and build relationships with Country B – recognising that there are normally transaction costs with shifting suppliers or identifying new buyers. But trade is ultimately much more indiscriminate and fluid.

The relationship between governments on the basis of trade is also much more indiscriminate. Sure, Canberra wants a good relationship with Beijing in order to facilitate a smooth trading relationship for Australian firms. But if Australian firms move on and identify new opportunities in, say, India, Indonesia or Vietnam, Australian diplomacy will follow suit. At the end of the day, Canberra doesn't care whether Rio Tinto receives the bulk of its revenues from China or from some other rising giant in the future – as long as it gets its share of taxation revenue. 

The FDI relationship – in the eyes of both governments and firms – is very different. From the firm’s point of view, FDI is an investment of considerable capital, manpower and the firm’s brand and reputation in a foreign jurisdiction and political-economic system for a substantial period of time, meaning that it is a far better indicator of economic integration and intimacy than trade. Getting out prematurely will invariably entail a significant sunk cost and loss of the firm’s and management’s reputation. Any private or government-owned firm – generally in step with their own government’s advice – needs to be confident about the economic opportunities available in that country. It's also a vote of confidence in the current and future stability, fairness and trustworthiness of that political-economy, and that the firm’s equity, interests and promised commercial access will be protected by the host government.   

Moreover, well over two-thirds of trade between China and other major countries is intra-firm processing trade – that is, importing raw material and parts into China for assembly or further processing, and then shipping these products out again. Around three-quarters of the final destination of products stamped ‘Made in China’ is America or the European Union.

This is important in this context because it means that China has simply become a major part of a regional production chain for the Western consumer – rather than a domestic consumption market that can compete with the industrialised Western world. China’s emergence as an export manufacturing hub is great for manufacturing multi-national corporations seeking efficiency gains. But it also means that there is intense competition for manufacturing jobs between China and economies such as Vietnam, Thailand, the Philippines, Indonesia and Malaysia.   

Moreover, much of Asia, aside from advanced economies such as Japan, needs foreign capital to develop rapidly – which is why FDI matters at least as much as trade. Note that a massive influx of Chinese capital and aid for ‘nation building’ infrastructure projects – more so than trade – is the main reason Cambodia believes it has no choice but to enter Beijing’s political sphere of influence. But host governments in the more important maritime Asian economies are reluctant to allow foreign equity (whether it be private or sovereign-owned) into key sectors of their economy unless there's a pre-established diplomatic relationship and political trust between the two governments – as well as adequate harmonisation of regulatory, taxation, legal and other standards.

Incidentally, this is Huawei’s problem in Australia, and the reason why Swedish company Ericsson is far more welcome than Huawei despite our trade relationship with the Chinese.

Let’s look at some comparative figures of FDI in the economies of key players in Asia.

Let’s begin with Japan. In 2012, the cumulative FDI into Japan was over $US206 billion. The US accounted for almost $US62 billion, EU over $US95 billion, and Singapore $US15.4 billion. Cumulative Chinese FDI was only $US552 million or less than 0.26 per cent of all FDI in Japan.

A similar story can be told for a so-called strategic ‘swing states’ such as Thailand and Indonesia. Cumulative Chinese FDI into Thailand is under $US2 billion. This compares to over $US46 billion by Japan, $US26 billion by the EU, $US24 billion by Singapore, and $US13 billion by the US. In Indonesia, Japan accounted for about 28 per cent of FDI in 2010, US 4.3 per cent, and the rest of ASEAN as a whole 44.4 per cent. China accounted for only 2.7 per cent.     

The same can be said for Chinese FDI in Australia despite all the attention it receives. The US, UK and Japan account for the top three positions in cumulative FDI into Australia at 24 per cent, 14 per cent and 11 per cent respectively. The Netherlands, Switzerland, Singapore, British Virgin Islands, Canada and Germany follow. China is 10th at about 3 per cent of FDI stock in Australia.

These figures bring more accurate perspective in countering runaway talk about a China-dominated Asian economic century. It also proves that trade – especially of the processing kind – is not the be all and end all, and that major regional economies have abundant alternatives to Chinese capital.

So to the economists and strategists out there: plan for an Asian Century if you must, but don’t assume that it will be a Chinese dominated one.

Dr John Lee is the Michael Hintze Fellow and adjunct associate professor at the Centre for International Security Studies, Sydney University. He is also a non-resident senior scholar at the Hudson Institute in Washington DC and a director of the Kokoda Foundation in Canberra.