Indonesia–China relations: Rethinking trade policy

by: Magda Safrina

Amid the growing concerns among businesses, small-scale industries, workers and farmers in Indonesia over a possible decline in Indonesia’s competitiveness since the full implementation of the China–ASEAN Free Trade Agreement (CAFTA) in January 2010, we have limited our discussions on how to improve productivity, efficiency, trade facilitation and trade financing.

Too little attention has been paid to the importance of Indonesia’s trade policy in relation to the current global economic environment. We tend to undermine the long-term implications of our current trade policy, particularly in the context of today’s growing global imbalance.
Why does this matter?

To put the issue into perspective, the United States has been running a current account deficit for many decades now.

In 1992, the deficit was only US$51.6 billion. This figure has been growing over the years and reached a record high of $803.5 billion in 2006.

In 2007, 2008 and 2009, the US current account deficit amounted to $726.5 billion, $706.1 billion and $419.9 billion respectively.

This implies the United States has been experiencing a large trade deficit, growing foreign ownership of domestic assets, and growing foreign debt.

On the other hand, China’s ownership of US assets has been growing and includes dollar accumulation from exports, portfolio investments in US companies, and investments in US government bonds.

Today, China has approximately $2 trillion in its currency reserves and holds $755 billion in US treasury bonds.

The large exposure of US assets has put China at huge risk and, to some extent, has caught China in a very complicated economic situation.

To secure its US dollar assets, China needs to ensure that the US economy does not collapse. It is very unlikely for China to see the US dollar depreciate, and it is in China’s interest to reduce its risk associated with US dollar assets it owns.

Any steps China takes to reduce its exposure to US dollar assets, however, would corner China because a reduction would result in the eventual depreciation of the dollar, something China would not want to see.

What is puzzling now is how this ongoing global imbalance will evolve.

Theoretically, as China takes in more dollars from its export activities and from foreign investors investing in China’s domestic assets, the Chinese currency, the yuan, should have appreciated.

Due to the pegging of the yuan to the dollar, however, this didn’t happen. China’s export-led growth strategy demands the yuan stay low to maintain China’s competitiveness in the global market.

The currency peg also has theoretical inflationary implications for China. As China keeps sterilizing the yuan from its domestic market, it artificially maintains its currency’s competitiveness and avoids economic turmoil.

Additionally, rather than increasing interest rates, the People’s Bank of China increased banks’ required reserve ratio from 15 percent to 15.5 percent in January 2010, as the Chinese economy was overheating and the threat of inflation loomed.

China’s reluctance to raise interest rates, which would eventually appreciate the yuan, also endangers China by leading to asset overvaluation, often called an asset bubble.

If the accusations by the United States regarding China’s intervention in the currency market to keep the yuan low are true, China will have to work even harder to curb inflation and ensure asset overvaluation does not happen.

In such a complicated context, it is very difficult to predict how this will end. But one thing is very clear: It will come to an end since neither the United States nor China can maintain this situation forever.

What many economists believe is that China will continue to accumulate US dollars and gradually have to let its currency appreciate.

But how long will that take? Again, it is hard to predict since China’s domestic market is not quite ready to overtake its export market and absorb the difference from its massive production capacity.

If US economists’ predictions about the real value of the yuan are correct, the yuan could probably appreciate by 20 to 40 percent from its current nominal value, should a currency adjustment occur.

What does all this mean for Indonesia?

In the CAFTA framework, Indonesian businesses, from large ones to home industries, are faced with
a very challenging price competition from cheaper Chinese-made products.

Price components embodied in Chinese products include high Chinese labor productivity, massive economies of scale of Chinese industries, and possibly also some export subsidies, assuming the yuan’s real value is higher than its nominal value.

Faced with such tough competition, many Indonesian businesses could go out of business soon.

Although free-trade supporters believe that price competition is an efficient way to reallocate resources to productive sectors, price competition in reality, also partially including export subsidies, would not reallocate resources to ensure their efficient use but rather displace them from the productive
sectors.

Should the yuan gradually appreciate as illustrated earlier, the price of Chinese products would very likely increase in accordance with the yuan’s appreciation.

By then, I believe our products will be as competitive as Chinese products, both in the domestic and in the export markets.

Since the adjustment of the yuan will take some time, however, many of Indonesia’s domestic industries will not be around by then.

That is why Indonesian policymakers should rethink the country’s trade policy for long-term purposes, particularly because once businesses are forced to exit the marketplace, re-entry will not be easy.

During the planned visit to Indonesia next month by Chinese Prime Minister Wen Jiabao, I suggest Indonesian policymakers carry out this agenda to ensure that the implementation of the CAFTA should not be a legal form of predatory trade mechanism that would, probably in a mid-term horizon, not only displace efficient domestic industries, but also jeopardize Indonesian consumers to limited options of relatively more expensive Chinese products given the fact that many domestic competitors could go out of the marketplace.

The writer is a graduate student at Brandeis University’s International Business School, in Massachusetts, the United States.

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