Simulation Models and Econometric studies

Another group of the literature studying the macroeconomic impact of China on different geographical regions are the simulation models and gravity models studies. Simulation models are popular with international multilateral agencies for predicting China’s impact on different regions within the global economy. A number of World Bank studies are based on results generated from the Global Trade Analysis Project (GTAP), a variant of computable general equilibrium (CGE) modelling. Briefly, model

simulations are based on systems of equations and mimic the behaviour of households, governments, the labour market and businesses, with market-clearing assumptions built into the model. CGE modelling simulates the different impacts on overall GDP growth on different areas and sectors of the global economy. Normally they compare a baseline scenario with another scenario to which shocks or intervention are applied to the model.

These CGE models are generally used for predictive studies.

CGE-based studies such as that of Winters and Yusuf (2007) believe that China’s rise benefits East and South-east Asia due to the existence of the

15 production network in the region, and that the effect on Latin America is neutral because Latin America’s export basket is different from China’s.⁶ International multilateral agencies take a similar view: that China’s effect on other Asian exporters is positive at a regional level. Ianchovichina et al.

(2003, p.78) of the World Bank sums up the impact of China’s WTO accession:

Because trade intensity with China is high for all emerging East Asian economies, they stand to benefit from this dynamic growth. Growth in the region’s exports will also be fuelled by the increased demand from China’s major trading partners that benefit directly from China’s accession.

Similarly, (Yang, 2003) of the IMF finds no long-term negative effects of China’s entry into the WTO on developing countries.

Multilateral agencies’ optimistic view of the effects of China’s rise is dismissed by Eichengreen and Tong (2007) as ‘…blanket statements concerning China’s impact are not particularly supportable. The country’s emergence is a mixed blessing requiring a nuanced analysis’.⁷ Furthermore, Yang (2003) model simulations unrealistically assume adjustment costs to China’s rise for the developing country to be zero when in reality shifting labour across different sectors of industry, as a result of loss of certain exports sectors by developing countries to China will not be costless.

The above criticism of CGE models brings us to the next group of studies, econometric-based gravity model studies. A gravity model is basically a regression model, and these are generally divided into trade and

investment models. A gravity model is premised on the idea that the size of a country’s trade is related to its trade partners based on distance,

6 High-technology sectors in OECD countries are not easily affected. However, South Asia is already being negatively affected, with its textile exports facing competition in third markets (Winters and Yusuf, 2007).

7 For a full critical view of China’s impact, refer to Kaplinsky (2005).

16 whether they share borders, size of trading-partners’ economies, and income level of the trade partners. Although variations exist in different authors’ gravity models, most test the relationship between neighbours’

exports and Chinese exports (as the independent variable). Investment gravity models test the relationship between China’s neighbours’ and China’s inward FDI.

Interestingly, Winters and Yusuf (2007) believe that China’s rise poses the biggest challenge to Asian and Latin American middle-income countries compared to low or high income countries because China is likely to expand into the same product space. As part of the MNC production network, these countries will be affected if China moves into component manufacturing (Winters and Yusuf, 2007). However, Winters and Yusuf (2007, p.40) admit that ‘the situation is less clear’ for electronic

components, a major East and Southeast Asian export, because China is expanding its exports while simultaneously the centre of production in East Asia, increasing the interdependence of trade in the area.

The conflicting findings of gravity model studies make it difficult to

determine whether China is a competitive threat or a complementary force to its neighbours’ exports. Eichengreen et al. (2007) and Greenaway et al.

(2008) trade gravity models find that China’s exports have an overall displacement effect on other Asian exporters. Conversely, Athukorala (2009) finds that China plays a complementary role in the region by

separating exports into parts and components and final goods. Devadason (2010) also concludes that China’s exports are not displacing those of other East Asian exporters. ⁸ Kong and Kneller (2015, p. 4.) review previous

8 Devadason’s (2010) study focuses on ASEAN (Malaysia, Singapore, Thailand, Indonesia, the Philippines, Cambodia, Laos, Myanmar, Vietnam), while Athukorala (2009) includes Japan, Hong Kong, Korea, Taiwan, Indonesia, Malaysia, Philippines, Singapore, Thailand, and Vietnam.

17 studies and report that the gravity models of Eichengreen et al. (2007), Greenaway et al. (2008) and Athukorala (2009) show sensitivity to both the time period and the methodology used.

Investigating China’s effect on aspects of its neighbours’ FDI inflows, an early study by McKibbin and Woo (2003) simulates the impact of China’s ascension to the WTO on its neighbours using a modified general

equilibrium model, and predicts that FDI will be diverted from ASEAN-4, which includes Malaysia, resulting in lower economic growth there. Hence the ASEAN-4 countries must improve their technology diffusion capability in their industry to avoid these negative effects from China. Weiss (2006) argues that McKibbin and Woo (2003) assume the diversion of FDI in their model simulation; this is contestable as the amount of FDI into China also corresponds with the size of the economy and population.

Investment-based gravity model studies examining whether China has diverted FDI away from its neighbours have also produced inconclusive findings. Chantasasawat et al. (2004) and Eichengreen and Tong (2007) find that China’s FDI inflows are complementary to the total FDI inflows of its East Asian neighbours.⁹ Narrowing it down to Japanese outward FDI to the East and Southeast Asia region, Eichengreen and Tong (2007) find that Japanese FDI to China correlates positively to Japanese FDI inflows of neighbouring Asian countries. Conversely, Salike (2010) finds that Japanese FDI outflow to the region has been diverted away from its Asian

neighbours.¹⁰ When FDI inflows are disaggregated by industry, Eichengreen and Tong (2007) find that Japanese FDI into China is

complementary to the regional FDI for the electrical industry. In contrast,

9 Chantasasawat et.al (2004) refer to the Asian region as the East and South Asia region, while Eichengreen and Tong (2007) define the Asian region as including East, Southeast, and South Asian countries.

10 The Asian region comprises Hong Kong, India, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan, Thailand and Vietnam.

18 Salike (2010) finds that China’s total inward FDI from Japan competes with that of its neighbours in the E&E industry. Details of the gravity models of regional trade and investment studies are shown in Table 2.2 below.

Table 2.2 Main findings of various gravity models

Authors Model Results

Trade

Eichengreen et al. (2007) 1990-2003 OLS and instrumental variable estimator (IV)

comparison

Competitive

Greenaway et al. (2008) 1990-2003 (IV) Competitive Athukorala (2009) 1992-2005 IV based on

the generalised method of momentum (GMM-IV)

Complementary

Devadason (2010) 1995-2006 OLS Complementary Kong and Kneller (2015) 1994-2008 two-stage IV

model Salike (2010) 1990-2004, GMM Chinese inward FDI

competes with its neighbours for Japanese FDI

IV= instrumental variables, GMM=Generalised Method of Moments, OLS=Ordinary Least Squares

Source: Adapted from Paniagua (2014)

It is important to note that gravity model studies focus on China’s regional effects at an aggregated level. According to Weiss (2006) in Humphrey and Schmitz (2007, p. 29.) ‘they assess whether total FDI to the region is influenced positively or negatively by FDI to China, rather than looking at individual country effects.’ Although some gravity model studies still divide effect at country level the findings are nevertheless for the electronics industry on the whole, and this hides the effect at a disaggregated level, where China has different effects depending on the technological level of the export.

19 The data input for investment gravity model studies is more prone to measurement error, as investment data is less standardised than trade data because different countries have different definitions of investment.

For example, some countries might recognize reinvestment as investment but others may not and therefore, reinvestment is not captured by the investment statistics. In view of this Weiss (2006) in Humphrey and Schmitz (2007, p. 29) concludes that ‘FDI diversion, whilst it may exist, has not been found conclusively in recent studies.’

Other studies considered here (Mercereau, 2005, Zhou and Lall, 2005);

(Wang et al., 2007) do not specifically mention the gravity model term, but the regression model works on the same principles. These studies find that China FDI inflow effects on its neighbours FDI inflows are largely neutral or even complementary. Mercereau (2005) model design regards only a portion of total inward FDI into China as diverted rather than treating the whole of its inward FDI as a diversion. This point is reinforced by Zhou and Lall (2005), who dismiss their own conclusion citing the absence of credible ways of discerning inward FDI into substitutable investment, typically in export-oriented sectors, compared to resource-seeking or market-seeking investment in China.¹¹ Finally Wang et al. (2007) find that China’s effect on investment flow could be complementary for its neighbours at the

aggregate level but at disaggregated levels their model finds that Chinese inward FDI investment competes with that of Malaysia, Taiwan, and South Korea while it complements that of India and the Philippines. Again, these studies of investment are inconclusive about China’s effect on its

neighbours; however the point to note is that there is a need to distinguish between different types of investment data for the models to be credible.

11Zhou and Lall (2005) mentioned that some industry is more ‘substitutable’ than others by location. For example, heavy chemical industries are less substitutable compared with electronics, because the industrial process itself.

20 Reverting to CGE model studies, Ianchovichina et al. (2010) simulate

China’s impact on Malaysian trade from 2005-2020 at the macroeconomic level. The results show that Malaysia benefits from rising prices in

commodity exports but its manufacturing sector will suffer

disproportionately with a 7.0% decline. Ianchovichina et al. (2010) propose future work on China’s impact at a sectoral level because their findings are based on highly-aggregated data and therefore cannot account for

heterogeneity in exported goods. The present study aims to address this limitation.

From the discussion above, gravity models are known to be sensitive to data periods and model specification and are therefore inconclusive about China’s effect on its neighbours. Likewise, the CGE model-based study is more of a predictive tool and is sometimes based on the unrealistic

assumption that adjustments in the regional economy will be costless with China’s rise. Winters and Yusuf (2007, p.22) comment ‘Modelling exercises are parables, not predictions. One should not take the precise numbers literally, and within each of our aggregates (say, electronics) there will be a wide range of effects across different products’, precisely pointing out why CGE-based studies are not suitable for use in my study. This sectoral study requires more disaggregated detail of the impact on Malaysia’s E&E industry by sub-sector. I now turn to the next area of literature, the competitiveness studies.