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Cityscape of Shanghai City

Uncertainty in Growing Asia

November 16, 2018

The decline of the United State in Asia is overstated, despite all the negative headlines.

As the world’s largest single market and still the only global superpower, the voice of the U.S. will, for the foreseeable future, still greatly influence developments in the region. However, even before Donald Trump’s election as President, his withdrawal from the Trans-Pacific Partnership (TPP), and his administration’s turn to protectionist and unilateral trade policies, it was apparent that the U.S. would face an increasingly complex political environment in the greater Asia-Pacific region, as China’s power and influence grew and reordered longstanding political, economic, and military institutions. Meanwhile, as in other regions, populism and nationalism have become more important in domestic politics, which affects foreign policies, the treatment of foreign investors, and participation in multilateral agreements. In short, while the U.S. remains a “Pacific power,” with a significant military presence, strong allies, and deep economic ties with the region, its ability to guarantee the peace, stability, and prosperity of the region may be increasingly limited as China and the region’s other major powers pursue their own strategies, independent of Washington.

As the region’s politics become more complicated, businesses must adapt to these changes, because if improperly managed, they may raise costs, generate reputational risks and, in the worst case, lead to exclusion from certain markets instead of presenting new opportunities for entry, growth, and supply chain development. For instance, the current trade dispute between Beijing and Washington, changes in labor and infrastructure availability, and the pursuit of new multilateral and bilateral strategies on trade across countries will likely continue to reshape cross-border supply chains. The Asia-Pacific region will also be the center for intense competition to win market share in emerging advanced technology sectors. While China’s “Made in China 2025” plan to shift resources into advanced technologies has drawn the most attention, Japan, South Korea, and other states have also developed plans to promote their own advanced manufacturing industries. The race to get an edge in the technologies of the “Fourth Industrial Revolution” – robotics, Big Data and artificial intelligence, biotechnology, and autonomous vehicles for example – will intensify the competition within the region to set trade and investment standards. In this race, local upstarts will in some instances challenge even global brands, a phenomenon now in China and emerging among the lower-income countries with China-branded technologies. In Asia, this competition will occur against the backdrop of rising nationalism and populism, as public dissatisfaction with unrestrained globalization (mainly because of previous crises and inequality) will strengthen the political willingness of governments to engage in nationalist behavior, even though these types of policies may penalize longer-term growth or economic efficiency. Therefore, sensitivity to domestic sensibilities can determine failure or success for both Chinese and Western companies.

Despite these uncertainties, Asia will still be among the most dynamic regions, even as medium-term growth in China slows to around 6.5 percent from the 7percent trend (which the political leadership is expected to tolerate). India’s growth is expected to exceed 7 percent starting next year, while in the Association of Southeast Asian Nations (ASEAN), growth will be roughly 5.3 percent according to International Monetary Fund (IMF) estimates. With the region accounting for 60 percent of the world’s population, its middle class will only continue to grow, if at different paces in different places. Serving them will require new logistical arrangements, new infrastructure, new manufacturing, and, most of all, new rules for trade and investment. The logic, therefore, seems unassailable – that Asia needs new rules that reflect these changing economic patterns. But their development has been anything but certain.

Why Uncertainty Abounds

The narrative for the better part of the two previous decades has been that China’s inexorable economic rise would eventually increase its political clout and military capabilities. This expectation only grew after 2008, as China avoided a deep recession while the U.S., Europe, and Japan struggled with slow growth following the Global Financial Crisis. With the U.S. focused on internal issues and preoccupied with crises in other regions, Beijing would inexorably become the region’s dominant power. The only debate was how quickly China would emerge as Asia’s hegemon – and whether it could happen without open conflict with the United States.

The Obama administration sought to combat this narrative, most notably through its “Asia rebalance” strategy, which would bolster U.S. military deployments in the Asia-Pacific region, strengthen longstanding alliances and establish new partnerships (with Vietnam, for example), and promote the TPP as a new set of rules to govern trade and investment across the region. While the Obama administration claimed that it was not trying to “contain” China, inevitably this strategy led to friction with China, whether over freedom of navigation in the South China Sea or former President Barack Obama’s warnings that without the TPP China would “write the rules” for Asian economic integration in the twenty-first century. The rebalance was flawed: too focused on military deployments and too dependent on a trade agreement that Obama was unable to convince his own party to support, arguably a casualty of political dysfunction in Washington that stymied other policy initiatives. Nevertheless, the rebalance strategy was a useful symbol of Washington’s willingness to update long-standing regional institutions for a more fluid era and challenge the narrative that China would inevitably inherit regional leadership.

However, with the transition to the Trump administration and U.S. withdrawal from the TPP, Washington has been vexed by the problem of how to reassert its leadership in Asia not just through security guarantees and military deployments that spur alliances, but through rulemaking and institution building that promote regional development and integration. While the administration has been focused on specific problems in the region – North Korea’s nuclear program, China’s island-building in the South China Sea and its trade practices – it has not articulated a comprehensive regional strategy that would address these and other issues. This is most visible on trade and economic integration, where Washington has pursued an aggressively unilateral approach to trade that not only led to the withdrawal from the TPP but has also led the U.S. to impose tariffs on national security grounds on major U.S. allies, including those in the region, thereby antagonizing otherwise willing partners in the process of drafting trade and investment rules to combat many of China’s most harmful trade and industrial policies.

As a result, Beijing has perceived an opportunity to emerge as a champion of free trade and globalization both in the region and globally. In January 2017, days before Trump’s inauguration, Chinese President Xi Jinping rejected protectionism and trumpeted the benefits of globalization in his first-ever speech at the World Economic Forum in Davos. Xi has returned to this message repeatedly since then, and communiques from meetings between Chinese officials and their counterparts in Asia and Europe now regularly include language upholding the value of economic integration and decrying protectionism.

However, Beijing’s bid to assume a leadership role in promoting global economic integration has not been an unalloyed success – and, to the extent that China’s ambitions could be stymied, is therefore a source of regional uncertainty. Notwithstanding Beijing’s support for free trade, the Regional Comprehensive Economic Partnership (RCEP), a “megadeal” that includes ASEAN, China, Japan, South Korea, Australia, New Zealand, and India, has been stuck in talks for years, not least because China and India have been unable to agree on appropriate terms for the liberalization of trade in goods and services.

Meanwhile, the Belt and Road Initiative (BRI), launched early in Xi’s first term, is both a paramount economic program and foreign policy strategy, but despite a tremendous amount of fanfare (investment promises that could be more than one trillion U.S. dollars and dozens of countries across the globe signing up to receive Chinese investment in infrastructure) the reality has thus far been disappointing. Not only have outlays been far less than promised, but in places where China has invested through the BRI, it has sparked concerns about debt sustainability, transparency, and environmental standards. Recent episodes have reinforced these concerns. In December 2017, Sri Lanka ceded Hambantota Port, a project that had been built and financed by China, to Beijing on a 99-year lease after it was unable to service its debt. Pakistan has struggled to service its BRI-associated loans and may seek assistance from the IMF. Chinese infrastructure investment has encountered domestic resistance across the region, including in Malaysia, where newly elected Mahathir Mohamad immediately suspended Chinese projects pending review and renegotiation and in Myanmar, which in July asked China to reduce a port project for fears that it could see a repeat of the Hambantota episode. Other would-be BRI partners have been reluctant to accept Chinese financing in the first place. While the region’s middle-income countries are still hungry for infrastructure development, they are increasingly wary about the BRI as a source for investment. ASEAN is particularly divided on all of these issues, mindful of how overexposure to Chinese funds and investment could generate domestic labor and debt problems, but at the same time, not wanting to miss out on opportunities in the Chinese market and the benefits of Chinese technology and investment.

Finally, China’s bid for regional economic leadership could be hampered by its domestic economic issues. Even before the Trump administration embarked on a “trade war” with China, China’s growth was slowing; trade friction could exacerbate this trend. China’s domestic debts remain a looming concern and potential constraint on growth. And, just around the corner, China could face a demographic crunch even as it tries to build a more robust social safety net.

Given these foreign and domestic constraints, China’s assumption of regional leadership will be far from unchallenged. It will be an important, even indispensable partner for most of the region’s economies, but it is far from guaranteed that it will be able to translate its economic might into an ability to write the region’s trade and investment rules or redraw the region’s economic map through infrastructure investment and “debt book diplomacy.”

Japan Emerges as an Alternative to China

With the U.S. and China preoccupied with other issues and otherwise unable to spearhead the regional institution-building process in the near term, other governments have stepped forward to exercise leadership.

Since the U.S. withdrawal from TPP, Japan has emerged as the most consistent proponent of regional and global economic integration. Japanese Prime Minister Shinzo Abe has been no less a champion of globalization than Xi, but as the leader of a relatively open and free economy that has abandoned many of the kinds of trading practices that have led to tensions between China and the U.S., Abe is a more credible champion than Xi.

Japan is no stranger to regional economic leadership, having contributed to the development of Southeast and South Asian countries since the early 1950s, beginning with reparations during the early postwar period and continuing to significant amounts of official development assistance (ODA) and investment as Japan’s economy achieved takeoff growth. To a certain extent, through the BRI China is following a path forged by Japan, which realized during the postwar era that by investing in the industrialization of Asia’s less-developed countries, it could create market opportunities for Japanese firms, strengthen Japan’s relations with strategically important countries, and secure access to raw materials.

Under Abe’s leadership, the Japanese government has upgraded this regional strategy in the face of Chinese competition. This process began shortly after Abe returned to power in December 2012 – by spring 2013 the Abe administration was drafting an infrastructure export strategy and had established a target of JPY 30tn in orders for infrastructure exports by 2020, three times larger than its 2010 exports – and expanded as the administration matured. Over time, the Abe administration developed an approach to regional development and infrastructure investment that emphasized “quality” as opposed to quantity, a clear contrast with China’s approach in the BRI. Most notably, in 2015, Japan updated its Development Cooperation charter, stressing the need for “quality growth” that is inclusive, sustainable, and resilient, and later that year created the Partnership for Quality Infrastructure, which entailed both streamlining the process of investing in regional infrastructure and increasing public funds available for lending.

But the development of an updated regional economic strategy assumed a new urgency after the U.S. withdrew from the TPP. The Abe administration shared the Obama administration’s view of the TPP as a strategic tool for binding the U.S. to the region, as well as for contributing to the drafting of new rules and supporting the development of emerging market members like Vietnam and Malaysia. With the U.S. out of the TPP, Tokyo had to consider whether to revive the TPP without the U.S., find a way to draw the U.S. back in, or emphasize RCEP or other alternative arrangements. After several months of deliberation, the Abe administration opted to revive the TPP, which after only a few months of talks and small tweaks to the 2016 agreement, resulted in the signing of the Comprehensive and Progressive Agreement for the Trans-Pacific Partnership (CPTPP), which includes all 11 remaining members. In a few short years Japan had gone from a reluctant participant in the TPP negotiations to the leader of a revived pact that remains Asia’s highest-standard agreement and which is attracting interest from prospective members both within the region, and as distant as the United Kingdom, even before coming into force. As the bloc grows, it could pose a greater challenge to China, which could eventually have to choose between participation (and domestic reforms to conform with the rules) or exclusion from an increasingly dense network of trade and investment. Of course, it could also pose a challenge to the U.S., which could also find itself excluded from market opportunities in Japan and other CPTPP countries – which arguably is one reason why Japan decided to revive the TPP without the U.S., as well as pushing for swift conclusion to negotiations for an economic partnership agreement with the European Union (EU), an agreement that was signed in July 2018.

At the same time that Japan decided to prioritize these mega trade deals, it was also deepening its commitment to quality infrastructure investment. 2017 saw the emergence of a partnership between Japan and India as part of a shared commitment to the “Free and Open Indo-Pacific” and as an implicit challenge to the BRI. Japan has both engaged India as a partner for advancing quality infrastructure investment in Asia and neighboring regions – in May 2017, they unveiled the Asia-Africa Growth Corridor, which would fund projects linking Asia to the east coast of Africa – and used India’s reluctance to receive Chinese investment to increase its own investment in Indian infrastructure.

While Japan may not be able to match China dollar for dollar, Tokyo clearly has assets that have enabled it to assume a leadership role to rival Beijing’s. Its companies have a long history of investing in Asia and are all too willing to shift manufacturing to developing countries in Southeast and South Asia; its government lacks China’s ambitions for regional predominance; and it is willing to lend on friendlier terms to borrowing countries. Japan is not going to supplant China – and may in fact be willing to cooperate with China under the auspices of the BRI on a limited basis – but it is fully capable of providing Asian countries with an alternative to dependence on Beijing.

South Korea Looks South

As Japan has moved into the region’s leadership vacuum, South Korea has taken its own steps to increase its footprint in the greater Asia-Pacific region, particularly in Southeast Asia. While visiting Indonesia in November 2017, South Korean President Moon Jae-in announced a “New Southern Policy” that would strengthen South Korea’s already-strong economic links with ASEAN. The new policy entails a series of agreements with ASEAN’s largest economies to encourage the expansion of trade and create new opportunities for public and private investment by South Korea across Southeast Asia. South Korea could also follow Japan in deepening trade and investment links with India; on a trip to India in July 2018, Moon referred to India as South Korea’s “next China” in terms of its potential political and economic importance.

However, while South Korea will offer the region’s countries another source of investment, South Korea will still be a second-tier player next to China and Japan. Not only is it smaller than Japan, but South Korea has also remained aloof from the regional rule-setting process, opting to stay out of the TPP, for example. The Moon administration, meanwhile, is preoccupied with slowing growth and concerns about inequality and the lack of opportunity for young Koreans. Finally, South Korea’s export-led growth model makes it uniquely vulnerable to the trade tensions between the U.S. and China, its two largest trading partners. However, the U.S.-China trade war and trade tensions with China due to South Korea’s deployment of the Terminal High-Altitude Area Defense (THAAD) missile defense system highlight the need for South Korea to diversify away from its giant trading partners, so the Moon administration is likely to deepen its commitment to the New Southern Policy during its remaining years in office.

Getting the U.S. Back in the Game

The biggest question across the region, however, is whether the U.S. will find a way to recommit to a regional economic strategy for the Asia-Pacific. The Trump administration took some initial steps towards articulating this strategy in July 2018 when, shortly before a trip to Southeast Asia, U.S. Secretary of State, Mike Pompeo, outlined Washington’s “Indo-Pacific Economic Vision” and how the U.S. intends to contribute to economic development in a region stretching from the East Coast of Africa to the Central Pacific. It is an attempt to reframe an approach to Asia which has so far been dominated by crisis management during the past two years, on the Korean peninsula, in rising trade tensions with China, and the continuing standoff in the South China Sea. While the administration fully embraced the Indo-Pacific concept – renaming the U.S. military’s Pacific Command to Indo-Pacific Command in May 2018, for example – it has been slow to flesh out this concept as a comprehensive military and economic strategy.

However, Pompeo offered less of a comprehensive economic strategy than what he described as a “down payment on a new era in U.S. economic commitment to peace and prosperity in the Indo-Pacific region.”  This speech was long on principles consistent with the president’s “America First” approach to trade policy, Pompeo stressed “fair and reciprocal” trade and “transparent agreements” – but short on specifics when it comes to Washington’s regional priorities and its policy tools. For example, the secretary’s “down payment” was USD 113mn for investments in the digital economy, energy security, and infrastructure, a sum that pales in comparison to the headline numbers of China’s BRI and is also considerably less than what Japan has proposed in new infrastructure investment. While Pompeo suggested that other funds could be forthcoming, he also stressed that only the private sector could fill Asia’s infrastructure gap; this happens to be true, but there is a risk that it will be an excuse for under-resourcing an infrastructure strategy instead of using public money to leverage private-sector investment, as Japan has done through loan guarantees, access to public credit, and insurance schemes.

The upshot is that the region’s players are still waiting for the U.S. to signal how deeply it will be involved in shaping regional economic integration in the coming years. Governments across the Indo-Pacific still want the U.S. to be more engaged economically. They want the U.S. to offer a positive agenda for strengthening economic links within the region and across the Pacific, not least because many of the region’s governments are uneasy about the risks of accepting Chinese financing for infrastructure projects. However, none of the region’s major economies are passively waiting for Washington to flesh out a more detailed strategy. They are all moving ahead with policies to strengthen their links within the region, particularly with the fast-growing, middle-income countries of Southeast Asia.

The Region’s Promising Growth Prospects

Regional uncertainty will not be resolved soon. China’s approach has largely been transactional, offering investment in exchange for access in parts of South Asia and bargaining its way through maritime territorial disputes. On the other hand, the U.S. approach still lacks the coherent values and ideas that drew in diverse countries in the past decades. The more the U.S. continues with a transactional approach to negotiations, the faster China’s role in the region will grow. Japan has staked out a leadership role for itself in both infrastructure development and trade and will continue to strengthen these ties in the coming years, but it will take time for these initiatives to bear fruit. Bringing new members into the CPTPP, for example, will take time – and it is unclear whether RCEP, to which Japan has also committed, can overcome the considerable obstacles that have prevented its conclusion. In the absence of overarching agreements, the rules governing trade and investment are likely to become more complex.

There is an old adage that form follows function in Asia, and that eventually, as governments and economies adapt and reshape their policies, rules will become set and institutions will take on modified roles. New institutions may emerge that reflect the shifts in the balance of power. Trade agreements may eventually unify for a Free Trade Area for Asia and the Pacific. However, monitoring these risks will not be sufficient. Taking advantage of emergent opportunities or mitigating risks will most likely require a presence on the ground in Asia, and a seat at the table in industry associations and regional dialogues. Managing relationships from afar, at a time of unpredictable change and when the complexity of rules and interconnections is growing, can increase, rather than decrease, risk. The geopolitics of Asia will continue to be in the headlines for the coming years, as the region’s established powers and rising powers compete to upgrade or build institutions that will govern the growth of what remains the world’s fastest growing region.