China and the WTO

Will its entry unleash new prosperity or further destabilize the world economy?

William Fung is a practical man. As group managing director of Hong Kong's Li & Fung Ltd. (LFUGF ), a giant Hong Kong trading company, his job is to find ways to produce and ship goods to global markets in the fastest and cheapest way possible. So he already has a plan for China's imminent entry into the World Trade Organization, the global body that enforces free-trade rules. One of the trade barriers that Li expects to fall is U.S. and European import quotas on clothes made in China for children up to 2 years old. Most of the apparel Li & Fung trades in that category is now produced in Egypt, Thailand, Sri Lanka, Honduras, and Guatemala. Fung plans to shut operations in those countries and move all baby-clothes production to southern China. Sure, the labor will cost a bit more in China, "but the productivity!" he says. Moreover, transportation to the key U.S. market is faster. "Shipment time from China to California is 14 days, vs. 30 days from Sri Lanka," he notes.

The same kind of cold calculation is under way inside corporations across the world. In their race to slash costs as the global economy slows and profits plunge, companies are looking anew for lowest-cost manufacturing centers for everything from clothing to cellular phones to computers. And after they do the math, the winner, very often, is China. Even as the new war against terrorism is realigning the political world, China's arrival as a manufacturing superpower is reshaping world trade. Its advantages are formidable: abundant cheap labor, millions of talented engineers, good infrastructure.

And thanks to the terms Beijing formally accepted on Sept. 17 in order to enter the WTO, that enormous market will eventually be thrown wide open to foreign competition. So multinationals in industries from semiconductors to Internet routers to passenger cars are increasingly beating a path to China's door.

There's a very dark side to this story, though. For every gleaming factory on the China coast that's producing world-class goods, there's a rusting hulk of a state-owned enterprise that's barely holding on. While many Chinese are now joining the middle class, millions are slipping into a new underclass of displaced peasants, unemployed factory workers, and low-level laborers whose working conditions are horrendous and whose wages barely sustain them. Beijing has managed to keep the lid on these mounting social problems by pumping out billions of dollars worth of exports that in turn have sustained government spending and eased the pain of transition to a market economy. That balancing act is now going to get very hard. With the U.S. and Britain raining bombs on Afghanistan, still more uncertainty has been introduced to already shaky markets. "This war will have a major impact on the world economy," says Michelle Wang, a sales rep at an office-supplies shop in Beijing. "And because China is about to enter the WTO, China is becoming a part of the world. So it's clear we will be affected, too."

The short-term effect could be nasty indeed. Last year, China's exports grew 30%; this year, they will be flat. Slowing growth means China has fewer jobs for the growing legions of unemployed.

China's executives and policymakers are aware of these great risks. So are the multinationals involved in the mainland. But they are willing to make a big bet--that Beijing, which has managed over 20 years to transform its economy, can maintain enough stability to make their investments pay off. The new Chinese industrial machine "is an unstoppable force," says Michael E. Marks, CEO of contract-manufacturing giant Flextronics Corp. (FLEX ) in San Jose, Calif. Flextronics is rapidly expanding its two sprawling manufacturing complexes in China, where it now makes cell phones and computer products. Within seven years, Mexico and the Caribbean will lose thousands of garment-industry jobs to China as the U.S. and Europe lift their last restraints on Chinese-made textile products. In Taiwan and Malaysia, two of the high-tech export hot spots of the 1990s, new investment in semiconductor, disk drive, and computer plants is drying up as companies such as Intel (INTC ), Motorola (MOT ), and Dell Computer (DELL ) move production to China. Matsushita (MC ), Sony (SNE ), and Samsung (SSNLF ) are preparing a wholesale transfer of production facilities in anticipation of a competitive onslaught from low-cost mainland rivals. And at a time when most emerging markets are desperate for outside capital, direct foreign investment in China was up 20.4%, year-on-year, for the first eight months of 2000, to $27.4 billion. That's more than the rest of non-Japan Asia combined.

Beijing had been planning a big bash to celebrate its entry into the WTO when it hosts the Asia-Pacific Economic Cooperation meeting in Shanghai from Oct. 15-21. A raft of world leaders, including President George W. Bush, are scheduled to attend. Of course, the military action that began on Oct. 7 in Central Asia has taken some of the bloom off that occasion.

But even if the summit is low key, China's leaders are justified in raising a glass to their achievements. When China first launched its quest to join what is now the WTO back in 1986, it asked for special favors, citing its poverty and backwardness. Beijing demanded the right to control key industries tightly, limit foreign ownership of factories, and protect access to telecom and financial services. U.S. and European negotiators wouldn't budge. A wise move: As time passed, President Jiang Zemin and Premier Zhu Rongji increasingly saw the market discipline required by WTO rules as an opportunity to force reform on industries and bureaucracies.

Jiang and Zhu hope the restructuring has prepared China for the time when it formally enters the WTO, which is likely to be in early 2002. At that point, new trading rules start to kick in. Over the next five years, China will eliminate all the quotas and other nontariff mechanisms that have kept out foreign goods. Duties, which have already dropped from an average of 44% in 1992 to 15% today, will fall to 9%. Foreign banks will have the right to open 100%-foreign-owned branches anywhere in China and take deposits from Chinese in local currency. "We will provide finance services to individuals for the first time and contribute to the creation of a consumer class," says Lionel Johnson, director of international government relations for Citigroup (C ), which is applying for its first consumer branch license in China.

Foreign telecom operators will be able to freely own parts of Chinese networks. Multinationals will have the right to set up their own distribution networks rather than working through Chinese corporate middlemen, as they must now. Foreign carmakers will make and sell whichever models they wish and set up nationwide dealerships and service networks. In telecom gear, computers, and semiconductors--sectors that Beijing tried to protect for decades--imports will be duty-free by 2005.

Part of the incentive for foreign investors is that after WTO rules kick in, they can operate in China with a greater measure of security. Nobody expects China to develop legal institutions to enforce WTO rules overnight. Indeed, China's trade practices are widely expected to trigger a spate of antidumping suits, intellectual-property infringement cases, and other legal actions as officials in Beijing and the provinces do all they can to protect Chinese companies. Still, the arbitrary power that Communist Party cadres long wielded over foreign investors can be challenged. "The key thing is that the rules will now be on paper," says Andy Xie, chief economist at Morgan Stanley & Co. in Hong Kong. "That will be the biggest shock." Adds Kouki Katayosei, managing director at the Association for the Promotion of International Trade, a Tokyo think tank, the reforms "mean the traffic light for investing in China has changed from a cautionary yellow to a go-ahead green."

Assuming Beijing lives up to its promises, the opportunities are tremendous. One study of the WTO deal, by U.S. Agriculture Dept. economist Zhi Wang, estimates that China will import some $264 billion worth of capital-intensive manufacturing goods such as vehicles, machinery, and electronics over the next 10 years. Half of those goods will be exported from Western Europe, the U.S., and Japan. Exports from Hong Kong, Taiwan, Singapore, and South Korea will surge as well. Western farmers will win big. China's pledge to sharply limit import barriers on wheat, corn, rice, and other agricultural commodities could boost its food imports by $73 billion over 10 years.

In information technology, China has already passed the U.S. as the world's biggest user of mobile phones. By 2005, the number of cell-phone users in China is expected to more than double, to at least 260 million. In personal computers, China should pass Japan this year, with 10 million PCs sold. Jun Ma, a Deutsche Bank economist based in Hong Kong, predicts that a decade from now, the China effect will raise world economic growth by a quarter percentage point. And the economic gains in Singapore, Taiwan, South Korea, and Hong Kong will be much higher than that.

In China itself, WTO entry should add three percentage points to the growth of gross domestic product over the next decade. Beijing is betting that the new boost from trade--and from more dynamic domestic industries--will prolong the upward march in living standards. Although hundreds of millions of Chinese still live in poverty, economists say that about 100 million have now joined the middle class, which in China means earning at least $2,500.

You can see this affluence when you cross the border from Hong Kong. Mainland Chinese are now buying homes in leafy suburbs that are sprouting on the edges of wealthy coastal metropolises such as Guangzhou. To move to and from those cities, China's middle classes are traveling on extensive new highways and will soon be riding on high-speed trains designed to reduce the country's fabled congestion. Chinese play golf at private clubs and educate their children at private schools. In glitzy Hong Kong-style shopping malls, these consumers are buying up the latest in home appliances and IT gadgetry, from televisions and air conditioners to personal digital assistants.

The combination of rising wealth, industrial sophistication, and the promise of market-friendly reform has persuaded many companies worldwide to invest in China. Even executives in South Korea, long one of the premier manufacturing sites in Asia, are playing the China card. China, says Jung Choong Ki, vice-president at Samsung Group's China headquarters in Beijing, is the natural place to make almost everything. The Korean conglomerate has already invested $2.7 billion there, mostly to produce TVs, audio products, computer monitors, and other electronics. Korea's Taechang Ltd., a $50 million maker of of specialty fabrics, such as Gore-Tex, sees the writing on the wall. By 2005, it expects to be outsourcing up to $100 million worth of fabrics to suppliers in China. "Korean textile companies are still stronger in designing high-end materials," says CEO Lee Ju Yeoung. "But China won't take much time to catch up."

LOW-COST PRODUCER. What makes China such a formidable manufacturing center? It has an abundant pool of young, high school-educated workers earning about $1.50 a day, with millions more entering the workforce each year. China's many universities and institutes are turning out well-trained yet relatively low-paid engineers. The cost of industrial land is among the cheapest in the world--about $25 per square meter in Shanghai, half the price of Kuala Lumpur and Bangkok and 60 times cheaper than Yokohama, Japan.

Phone service, ports, electrical power, and other infrastructure in China's key coastal cities are among the best in the developing world. China's bureaucracy has become so streamlined that officials sometimes grant the necessary approvals for new factories in days--unheard of in commercial rivals such as Thailand.

China is also fast accumulating a full complement of supporting industries, something that rival production centers in Latin America and Southeast Asia can't match. Thanks to $320 billion in foreign investment over the past decade, much of it from small manufacturers in Taiwan and Hong Kong, China has everything from first-rate plastic molding shops and electronic component makers to giant petrochemical plants. That allows foreign companies to operate supply chains smoothly. "You make a call, and tomorrow the parts are in your factory," says Sam Lo, president of Tai Sun Plastic Novelties, a family-run Hong Kong company that makes toys in southern China's Guangdong province for J.C. Penney (JCP ) and Carrefour.

In electronics, as recently as the mid-1990s, Chinese factories did little more than screw together radios, telephone handsets, and electronic toys from components shuttled in from Hong Kong, Taiwan, and Japan. Now, foreign manufacturers are relocating semiconductor, high-end circuit-board, and other sophisticated electronics plants to China. Intel Corp. (INTC ) operates a big memory-chip plant in Shanghai, and on Sept. 21 the company announced that it will spend $300 million to double its size, mostly to serve the mobile-phone industry. "China is already the No. 1 wireless market in the world," says Jason Chen, vice-president and general manager of Intel's China operation. "We have to be there to work with that industry." Intel also operates several research labs across the country as part of its effort to recruit Chinese engineers. "We look at China as a very big engineering resource pool," says Chen. In cities such as Guangzhou, Beijing, and Nanjing, world-class electrical and mechanical engineers can design products for global markets. In digital phones, "pockets of China already are on par, and are even ahead, of what Malaysia is offering right now," says Ash Phardwaj, Flextronics' Asia president.

Even Chinese industries that stand to suffer in the short term because of WTO may become stronger. Take the auto sector. Today, China turns out just 750,000 cars a year, and most of them are far too expensive for ordinary middle-class Chinese to afford. By lowering tariffs and encouraging auto imports, WTO entry will cost the industry five points of growth by 2005. But longer term, the business stands to grow as foreign rivals and investment make it more competitive, argues Norio Matsumura, Nissan's executive vice-president for global sales and marketing. He predicts that China will become "a global production base" in autos. The consolidation process is well under way. From more than 100 auto makers a decade ago, China has about 40 today. The likely survivors will be companies that have already hooked up with foreign partners. Shanghai Automotive Industry Corp. has joint ventures with Volkswagen (VLKAY ) and General Motors Corp. (GM ) Tianjin Automotive has teamed up with Toyota Motor Corp. (TM )

China's success comes at the expense of workers and companies throughout the developing world that offer cheap labor but not much else. Even in India, which has some of the planet's lowest wages, low-tech industries can't compete with the Chinese in productivity. Shops in Bombay and Calcutta are flooded with Chinese goods. The Indian government is so worried about China that it has refused to allow Chinese software companies to locate in Bangalore and scotched plans by software powerhouse Infosys Technologies to train 200 Chinese employees in India.

Hardest hit is Southeast Asia. A decade ago, the Association of Southeast Asian Nations took half of the foreign direct investment in non-Japan Asia, compared with just 20% for China. Now, those numbers are reversed. "Our products out of ASEAN will become less competitive because of the surge of made-in-China goods," says Yukio Shohtoku, managing director in charge of global business for Japanese electronics giant Matsushita Electric Industrial Co.

Taiwan is both a victim and a long-term benefactor of China's rise. True, the mainland is sucking factory jobs out of its island rival by the thousands. But Taiwan will join the WTO at the same time China does, which means Taiwan's own restrictions on trade with the mainland will fall, too. "There are 50,000 Taiwanese-owned factories in mainland China screaming for banking services," says Jeffrey Koo Sr., chairman of Taipei-based Chinatrust Commercial Bank, which hopes to open its first office in China soon.

One Taiwan business mogul who has accepted the inevitable is Morris Chang, head of Taiwan Semiconductor Manufacturing Co. (TSM ) After insisting for years that China would never be a serious player in the chip industry, he now concedes he was wrong. Mainland companies will spend $1.8 billion building chip plants this year and $3 billion more in 2002, says Chang. With Taiwan President Chen Shui-bian ready to lift a ban on the construction of mainland chip operations by Taiwan companies, Chang is planning to open an office in Shanghai. "We want to start talking to authorities about what incentives they might offer," he says. Within five years, he adds, TSMC will sell $3 billion worth of chips in China, making it the company's second-biggest market after the U.S.

China's WTO debut is not uniformly good news for the 1.3 billion Chinese. The threat of social instability is real. Even after shedding 50 million workers over the past three years, Chinese state-run companies are still likely to fire 20 million more as they prepare for a flood of imports, says Morgan Stanley's Xie. Moreover, an additional 12 million Chinese join the labor force every year. With the U.S. appetite for Chinese exports suddenly not so certain, finding jobs for those millions will, in the short run, get much harder.

In the poverty-stricken countryside, the situation is only going to deteriorate after WTO entry triggers imports of cheap foreign grain. "Everybody is saying that the WTO is both a challenge and an opportunity for China," says Xia Ying, a research fellow at the China Academy of Agricultural Science in Beijing. "But for agriculture, the challenge is very real, and the opportunities are largely invisible." The average Chinese farm is just half a hectare--too small to compete against American agro-giants.

PROTESTS. Already, more than 100 million peasants have flocked to the cities in search of work, and that number is likely to increase, adding to China's angry underclass. Frank Lu, director of the Hong Kong-based Information Center for Human Rights & Democracy says that in 1999, the most recent year for which he has statistics, there were some 100,000 demonstrations by workers and farmers protesting against low wages, unpaid pensions, and corruption.

One way to prevent the problem from worsening is for the country to embark on a major urban-development program. Currently, there are 300 cities in China with populations above 100,000. But the biggest cities--Beijing, Shanghai, Tianjin, and Guangzhou--still attract the biggest chunk of the migrants. Rather than having those cities overwhelmed, argues economist Ma, the government must build up smaller cities to receive them. "The big cities are already too big," he says.

As Beijing struggles with the social pressures aggravated by greater import competition, a big question is how faithfully policymakers will honor their WTO commitments. Old ways won't die quickly. Many foreign companies operating in China have long complained that locals enjoy unfair advantages thanks to their guanxi, or connections. "They pay less tax, they get cheaper electricity," gripes Lo, the 39-year-old president of toymaker Tai Sun, which employs 2,000 workers in China. After WTO, Lo predicts that it will be easier for Hong Kong companies to compete. "But still," he says, "I think our costs will be much higher."

One reason: The government will still own a stake in many players. Take TCL International Holdings, a Guangdong-based producer of televisions, mobile phones, and other consumer electronics. The company is a leading local producer, with $1.1 billion in sales last year. Yet in late August, TCL said that first-half profits were off 31%. So even as he talks bravely about taking on the competition overseas, Chairman Tomson Li expects a boost from the state, since the Huizhou city government still owns a big stake in TCL. "We will continuously be supported by the Chinese government," says Li. While WTO entry should eliminate many barriers, "some things are visible, others are not," he says.

Such resistance is inevitable, which is why many critics doubt whether Beijing has the wherewithal to push through necessary changes. "There is a great deal of skepticism regarding China's willingness and ability to carry through on its commitments," says Fred Hu, Goldman, Sachs & Co.'s chief economist in Hong Kong. But there are also reasons to believe China will honor its WTO membership more than it will abuse it. The Chinese have built up a solid track record of more than two decades of economic reform. And the long-term stability of the country depends on the growth that can come only when foreigners are convinced China will play by global rules. "A whole new world is opening," says William Fung of Li & Fung. The world--and China--had better be ready.

By Bruce Einhorn in Hong Kong, with Mark L. Clifford in Hong Kong, Chester Dawson and Irene M. Kunii in Tokyo, Manjeet Kripalani in Bombay, Moon Ihlwan in Seoul, Dexter Roberts in Beijing, Alysha Webb in Shanghai, and Pete Engardio in New York

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