STRATFOR NEWS ANALYSIS

China and South Korea reach a new trade agreement

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THE conclusion of free trade negotiations between China and South Korea marks merely the latest in a series of new trade deals in the Asia-Pacific region. Beijing is hoping that its agreement with Seoul will further China’s broader strategic aims involving its Asian neighbor, while South Korea is looking for greater access to the Chinese market to incentivize domestic exports and revitalize a sluggish economy at home. However, the agreement could be harmful to some South Korean industries over the long run, particularly as China shifts its economy toward higher-value industries.

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During a Nov. 10 bilateral meeting at the Asia-Pacific Economic Cooperation summit in Beijing, Chinese and South Korean leaders announced that they had reached a broad consensus on a much-anticipated free trade agreement. The deal will be subject to legal and parliamentary reviews by both countries that could begin as early as the end of 2015.

Beijing’s Agenda
In recent years, the Chinese government has been actively promoting the formation of free trade zones among its Asian trading partners. As one of the world’s biggest trading nations, China’s motives for pursuing greater access through free trade go beyond economic incentives alone. In addition to accelerating regional economic integration, free trade agreements increase the economic influence of China’s large market, laying the groundwork for Beijing to pursue its broader strategic aims in areas such as energy and security throughout the region. As part of this strategy, Beijing has initiated or participated in a host of bilateral and multilateral trade arrangements with partners including Hong Kong, Taiwan, and the Association of Southeast Asian Nations and its members. Negotiations also exist for a trilateral free trade agreement among China, Japan and South Korea, though these talks are currently stalled. Beijing has recently accelerated its efforts to promote a more advantageous trade climate in response to Washington’s push to fast-track the Trans-Pacific Partnership, which China perceives to be an economic and geopolitical challenge to its regional agenda.

China’s trade deal with South Korea comes against the backdrop of a significant expansion of the countries’ strategic partnership over the past two years. The new Chinese leadership has shown its intention to reshape its policies toward the North Korean regime, all while seeking to complicate US relationships in Northeast Asia by exacerbating South Korea’s mistrust of Japan. At the same time, South Korea has been actively seeking access to the Chinese market in the hopes of boosting exports and its relatively weak economy.

Once finalized, the free trade agreement will reduce tariffs for an additional quarter of South Korean exports, widening access to markets in China — South Korea’s largest trade partner and investment destination and a rapidly growing source of South Korean investment. Tariffs will be removed or reduced for some 90 percent of the goods traded between the two countries, including top South Korean exports such as electronics, medical equipment, machinery, refinery products and petrochemical goods. However, automobiles and some agricultural products, including rice, pepper, pork and beef, were excluded from the agreement because of the sectors’ sensitivity and feelings of protectionism on both sides.

The importance of free trade for Seoul’s economy
The free trade agreement is critical to Seoul’s proactive strategy of gaining access to free trade worldwide. Since the end of the Korean War, South Korea has relied almost exclusively on multilateral trade agreements to support its rapid industrialization and export-oriented economy. Seoul’s strategy has two main pillars: supporting the growth of Chaebol (family-owned multinational conglomerates that have fostered the country’s rising export production) and adopting government policies that further integrate South Korea with the global economy. This strategy has given South Korea, a resource-poor country in an inhospitable region, the means to become the world’s 12th-largest economy while remaining resilient in the face of external financial crises.

South Korea has pursued its ambitious free trade strategy since the 1990s, striking deals with economic powers in North America, Asia and Europe. Seoul’s trade deals are noted for their scale and scope; currently, they cover more than 40 percent of all South Korean exports. Because of these trade policies, South Korean conglomerates have enjoyed relatively unrestricted access to overseas markets and have been able to gain a strong competitive advantage in a variety of global industries, including auto parts, electronics and energy.

Nevertheless, the persistence of the global economic downturn is testing the resilience of South Korea’s export-oriented economy. Though such crises inevitably bring with them economic hardship and suffering, Seoul is far more concerned about the profound reconfiguration of the global economy that will result from this particular crisis. Demand from Europe and China is unlikely to pick up in the near-to-medium term, and economic uncertainty will grow as China prepares to implement deeper reforms as it restructures its economy over the next one to three years. Most notably, the rise of high-end manufacturing and a more complete industrial chain in China could gradually eliminate the cost advantages that South Korean manufacturers have enjoyed until now, particularly for products like mobile headsets, electronic parts and automobiles, which together account for more than 40 percent of South Korean exports.

Seoul’s economic performance has showed signs of weakening since last year. Indeed, economic growth has either slowed or plateaued for five consecutive quarters, while inflation rates have plummeted. Despite initially encouraging signs in external trade levels during the third quarter of 2014, domestic consumption and private demand remain weak. These problems may be complicated by some of the country’s long-term challenges. It is unlikely that South Korea’s weak labor market will strengthen anytime soon, and a stagnating domestic property market combined with a downward demographic spiral (the country’s working-age population could start shrinking as early as 2017) point toward a growing risk of deflation.

A mixed bag for South Korean businesses
These considerations not only frame the new free trade agreement between South Korea and China but also provide some context for Seoul’s broader effort to move its own economy further up the industrial value chain while easing its dependence on exports through the promotion of service sectors, capital investment and the growth of small and medium-sized enterprises to boost productivity and domestic demand. Greater competition in the global market will only increase South Korea’s need to pursue further economic integration to maintain export resilience with trading partners.

The new free trade agreement is expected to be most beneficial to South Korean energy firms, which are highly dependent on exports to China. Electronics producers, as well as high-value and innovative technology companies, could also benefit from Beijing’s initiatives to boost domestic consumption, at least until China’s own economy moves up the industrial value chain. Greater openness to investment may also facilitate Seoul’s goals to incentivize its lagging service sectors in areas such as finance and distribution, as well as infrastructure investment, as Chinese investors look to diversify from saturated markets at home.

However, the new free trade agreement is not without risk. Its rapid implementation could be opposed by small and medium-sized enterprises in South Korea that would face greater competition from their Chinese counterparts. Additionally, the agreement’s inclusion of some agriculture and fisheries products — the two most sensitive areas for South Korea during the trade negotiations — may generate public resistance that could delay the deal’s eventual ratification. Still, greater access to South Korea’s most important export destination is something Seoul simply cannot turn down, especially amid broader unfavorable changes in the global economy.

© 2014, STRATFOR GLOBAL INTELLIGENCE

Publishing by The Manila Times of this analysis is with the express permission of Stratfor.

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