Nascent China-South Korea FTA and financial agreements are expected to boost and channel growth

Closer economic and financial ties between China and South Korea are expected to have a significant impact on the two countries and the Asia-Pacific as a whole.

China and South Korea substantially concluded a free trade agreement in Beijing during the Asia-Pacific Economic Cooperation meeting in November. The two countries also signed a bilateral currency agreement during Chinese President Xi Jinping's visit to Seoul in July.

The China-South Korea FTA negotiation, which was concluded after 12 rounds of negotiations over the past three years, significantly reduces barriers to bilateral trade, except for those on rice and motor vehicles. The FTA is pending legal and parliamentary reviews from the two countries early this year.

China and South Korea achieved bilateral trade of $229 billion in 2013, compared with $6 billion in 1992, representing growth of over 36 fold. When completed, the China-Korea FTA will help foster a united market between the two countries with a combined total population of 1.35 billion and GDP of $11 trillion.

This agreement covers 17 areas such as goods, services, e-commerce, government purchasing and investments. Each side would remove tariffs on at least 90 percent of items. Within 20 years, China would eliminate tariffs on 91 percent of trade items and 85 percent of imports ($137.1 billion), while South Korea would eliminate tariffs on 92 percent of trade items and 91 percent of imports ($73.6 billion).

Complementary areas of the two countries' industries led to structural differences in their exports, even though most of the bilateral trade is electronics. For China's exports to South Korea, electronics, base metal and machinery are the top three subcategories in terms of trade volume, accounting for 37.5 percent, 12.8 percent and 9.8 percent of total 2013 exports to South Korea, respectively.

For South Korea's exports to China, electronics, optical devices and machinery are the top three subcategories, accounting in 2013 for 42 percent, 12.9 percent and 8.6 percent, respectively.

A further breakdown of subcategories reveals the technology gap between the countries. A large proportion of electronics exported by China to South Korea were low-end integrated chips, telephones and controllers, while those exported from South Korea to China were high-end integrated chips, signal devices and semiconductors.

What this means is that electronic subcomponents South Korean firms bought were used to manufacture high-end electronic devices and then sold to customers in China. There is a similar pattern for machinery manufacturing - South Korea is at a higher level on the value-added ladder and exports complete machines to China, while China exports parts and subcomponents to South Korea.

Given the current average tariff levels in South Korea and China of 8 percent and 4.1 percent, respectively, waiving tariffs for 90 percent of all products traded following the FTA will further boost their bilateral trade and investment. It will benefit China's low-end electronics sector, further contributing to its penetration in the South Korean market. Lower tariffs will also further strengthen the price advantages of steel and non-ferrous metals exported from China.

The two sides also pledged to continue negotiations on a negative list for services and investment. A negative list is a list of items to which a pact will not apply, the idea being to apply it to everything else.

The bilateral currency agreements the two countries signed in July consist of direct trading between the renminbi and Korean won, a new renminbi settlement center in Seoul, renminbi bond issuance in South Korea, and 80 billion yuan of the Renminbi Qualified Foreign Institutional Investor quotas in South Korea. This program enables yuan held outside of China to be invested in the country's securities.

A new renminbi clearance center will be established in Seoul, with the Bank of Communications taking the role of renminbi clearing bank. South Korean companies are encouraged to issue renminbi bonds. These four arrangements are helpful in promoting trade settlement with agreed upon currency and in developing offshore markets.

Despite high bilateral trade, renminbi settlement represented only 0.9 percent of total trade between China and South Korea in 2013. The renminbi has been used increasingly in trade settlement in the past five years. In the first quarter of last year, up to 18 percent of China's trade value, equivalent to 1.09 trillion yuan, was settled in renminbi, significantly up from 14 percent in the last quarter of 2013 and only 1 percent in 2009. The percentage could rise significantly in coming years with the rise in renminbi trade settlement.

Major South Korean commercial banks such as Woori Bank, Industrial Bank of Korea, Shinhan Bank, and the policy bank, Korea Development Bank, have set up branches across China. The main beneficiaries of China-South Korea currency agreements in the financial sector will be China's commercial banks with a global presence, such as Bank of China, ICBC and Bank of Communications. Their South Korean investment banking business is expected to expand at a faster pace, supported by the establishment of an offshore renminbi settlement center and issuance of renminbi bonds in Seoul. The issuance of renminbi bonds was previously handled in Hong Kong since there was no market for renminbi bonds in South Korea.

For example, South Korea's largest food company, CJ Corporation, issued 1.1 billion yuan in three-year dim sum bonds in Hong Kong in June 2011. It was the first South Korean firm issuing renminbi bonds. A new offshore renminbi bond market in South Korea would enable South Korean firms with a high level of activity in China to reduce their cross-border financing costs and contribute to offshore renminbi products. Seoul is likely to be the fourth renminbi bond offshore market, following Hong Kong, London and Singapore.

Deepening economic cooperation between the two countries could have a profound impact on trade and financial integration across the Asia-Pacific region.

The FTA between South Korea and China is likely to diversify South Korean trade and put pressure on Japan to register some progress in the China-Japan-South Korea FTA initiative. Negotiations on that started in 2012 but have made limited progress. Given the similarity in industrial structure and economic specialization between South Korea and Japan, the China-South Korea FTA is likely to divert trade away from Japan.

South Korean car makers are direct competitors of Japanese manufacturers. Pricing strategies and the quality of cars from South Korean brands such as Hyundai and Kia are very similar to those of Toyota and Honda. South Korean car makers have already taken a significantly larger share of the Chinese market than their Japanese peers. Specifically, motor vehicle sales of Hyundai Kia Group in China reached 1.58 million units in 2013, ranked No 2 among all foreign car brands following Volkswagen, while those of Toyota and Nissan combined amounted to only 1.69 million units. As a result, China's current tariffs of 25 percent and 10 percent for motor vehicles and auto parts, respectively, would put Japanese car makers at a great disadvantage after the China-South Korea FTA takes effect.

South Korea and Japan are also direct competitors in other fields, including electronics, machinery, optical devices and consumer products. That would push Japan to be more active in advancing China-Japan-South Korea FTA negotiations with pressure from the China-South Korea FTA.

The agreement between Beijing and Seoul could also help promote and mold growth through the Regional Comprehensive Economic Partnership initiated by the 10 countries of the Association of Southeast Asian Nations.

The partnership aims to establish a regional FTA by China, Japan, South Korea, Australia, New Zealand, India and ASEAN by the end of this year. China has been playing an important role in RCEP negotiations. RCEP covers a total population of 3.5 billion with an aggregate GDP of $23 trillion, accounting for one-third of the world's total.

Four rounds of negotiations were conducted, but a regional FTA is hampered by different levels of development and openness among members. Specifically, Japan is highly sensitive on agricultural goods; Australia is interested in adding terms related to the environment and labor protection; India has concerns about reducing its tariffs, the highest among all RCEP members.

The framework of the China-South Korea FTA could serve as a basis to reach agreements between countries with significantly different structures of specialization.

The RCEP negotiations would be probably easier if most members had bilateral trade agreements. The China-South Korea FTA signals a closer tie between two major economies among RCEP members. Australia concluded negotiations on an agreement with China and the two countries signed a statement of intent in November. That leaves Japan and India as the only two regional economies that have not wrapped up an FTA with China or stand very close to doing so.

Reaching an agreement with South Korea therefore will increase China's influence in shaping a regional agreement, and represents a credible alternative to the US-led Trans-Pacific Partnership.

The author is chief economist of Haitong International, based in Hong Kong. The views do not necessarily reflect those of China Daily.

Zhang Chengliang / China Daily

(China Daily European Weekly 01/16/2015 page12)