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CIAO DATE: 12/02
The Economic Future of China
Nicholas R. Lardy
April 29, 2002, Houston
Thank you very much, Steve. I am delighted to have a chance to be here and particularly under the sponsorship of both Rice University and the Texas Asia Society.
I want to address basically two fundamental questions. One, the economic future of China. Is it going to be a global economic power? Or should we look forward, as one recent book title put it, to the coming collapse of China, which is specifically a forecast about an economic collapse leading to a political collapse?
And I would like secondly to look at the question of what is China's likely role going to be now that, as Steve mentioned, it is a member of the World Trade Organization. Is it going to be a successful economic integrator following the rules of the international trading system? Or is it likely to become a flagrant violator of most WTO norms and likely to contribute little, for example, to the new round of trade negotiations that was launched late last year?
I think those are the two key questions one would want to look at since China's entry into the World Trade Organization. There is certainly a range of opinions from various people looking at these questions.
Let me begin by sketching what has happened in the recent past, even before China became a member of the World Trade Organization. China has grown at an unprecedentedly rapid rate. I do not want to bore you with lots of numbers but real GDP last year was about seven times what it was when economic reform began in China a little over twenty years ago.
And China has made substantial progress in recent years in improving some of its long-term problems in the state-owned manufacturing sector. They have laid off about thirty-five million people, a third of the work force. There has been an up-turn in profitability in the state-owned sector for the first time ever in the Reform Period. And China has done extremely well in maintaining reasonably rapid economic growth, even last year in the face of a global economic downturn that left some economies in the region actually in worse shape than they were in the Asian financial crisis of 1997-1998.
So there has been robust performance, at least as measured by gross domestic product. There is also been very robust performance as measured by China's trade growth. Indeed, if you look over this period since reform began in China, from 1977 to 2001 their trade has grown from about fifteen billion dollars to five hundred and ten billion dollars last year. It now ranks as the seventh largest trading country in the world.
No country has increased its role in the international trading system as fast as China did in the last twenty-five years. It is even more rapid than the growth of Japan's role as a trading country, say in the 1960s and 1970s, in the heyday of very, very rapid domestic economic growth, and very rapid expansion into international markets.
Another point to keep in mind is China's success in attracting what is by now a huge amount of foreign direct investment. By the end of last year China had in place, up and running, about four hundred billion US dollars in foreign direct investment. That is not a number you will remember for very long but maybe you will remember that about a third of all foreign direct investment in place in developing countries on a global basis is in China. And most of it came into China in the last ten years; that is, during the 1990s and in the last couple of years.
So, we have an economy that is growing fairly rapidly, has had remarkably rapid trade growth, and has had a very significant inflow of foreign direct investment. And the foreign direct investment, I should emphasize, is really quite different than the patterns we have seen elsewhere in East Asia. If you look at Taiwan, if you look at Japan, if you look at South Korea, foreign direct investment has played a relatively modest role in those economies.
Foreign technology has come into some of them under licensing arrangements and other kinds of arrangements, but these economies in general have not been very open to foreign direct investment, at least during the periods of rapid economic growth. And China has been very, very open to foreign direct investment over the last two and one-half decades, since reform began in the late 1970's.
What are the implications of this combination of rapid growth, rapid trade growth, and large inflows of foreign direct investment? Most importantly, foreign direct investment has become an engine of growth in the domestic economy. If you look at the interaction among these three elements, the transfer of technology, the transfer of managerial know-how, has been a very important part of China's rapid growth over the last fifteen to twenty years. Exports have also become a significant source of economic growth in the domestic economy.
Moreover, if you look regionally, China has become a very important factor in economic growth in the region. I think the best examples are probably China's trade with South Korea and Taiwan.
As little as fifteen years ago these economies had virtually no interaction with their giant neighbor to the west. Now their trade relationships are extraordinarily deep and growing extremely rapidly. It is quite interesting, for example, that since November last year, in every month, Taiwan's most important export market has been the Mainland. The Mainland has replaced the United States as the most important export market for Taiwan. And I think that is likely to continue to be the case as economic relationships between the Mainland and Taiwan expand as they both come into the WTO and bring down trade barriers.
In effect, China is coming to play some of the role that Japan played in the 1970s and 1980s when it led regional economic growth because of its importance in the region. That is a role increasingly that China plays. A second implication of the three factors that I mentioned at the outset is that foreign firms have now played, are now beginning to play, a really unprecedented role in generating exports from China. Again this is quite different from South Korea, Taiwan and Japan where foreign firms have not been big producers of exports. There has been little foreign investment to begin with and foreign invested exports have been a relatively small factor in the trade performance of these economies.
But in China this has grown steadily since the 1980s, when foreign direct investment first began to trickle in. And by last year, for the first time, over half of all the exports of China sold in international markets, about two hundred seventy-five billion dollars, were produced by firms with foreign investment, either joint ventures or wholly foreign owned companies. Nothing like this has ever occurred in a big continental size economy like China's. This is the kind of thing you would expect to see in Singapore, and in a few places like Hong Kong where foreign firms have played a much larger role and exports have been much more important.
Finally, as a consequence of the interaction of these three factors of rapid growth, rapid trade growth and foreign investment inflow, China has become the world's preeminent low-cost manufacturer, not only of traditional labor-intensive goods like footwear and toys and apparel and sporting goods, but increasingly things like information technology, hardware and electronics. Indeed, in recent years China has become the third largest producer of what is referred to as information technology hardware -- computers, telecommunications equipment and so forth. Interestingly, about half of this output in the Mainland is being produced by Taiwanese companies. So again, it is the openness to foreign direct investment that is driving this process.
What we have seen as a result is that China is increasingly becoming integrated into global production networks. It began in the late 1980s and early 1990s when Taiwanese companies began moving production of very simple computer peripherals to China: power supply units, keyboard, mice, etc. By the mid-1990s Taiwanese companies were beginning to produce PCs in China. By the late 1990s they were beginning to produce laptops in China. These are enormously important developments because Taiwanese companies are producing about sixty percent of the world's laptops and about twenty-five percent of all PCs.
So as this production migrates to China it is having a very important effect. And there is a large flow of parts, components and assemblies going back and forth between Taiwan and the Mainland. As I say, it reflects China's integration into global production networks, particularly those involving firms elsewhere in East Asia, and I think Taiwan is probably the most notable example.
As a result China is becoming a major exporter of information technology hardware to international markets, and new products are moving to China for production all of the time. LCDs are one. Notebooks, starting last year or the year before, are examples of recent products that have been migrating to China and transforming the nature of trade relations in East Asia and, indeed, the nature of trade relations between East Asia and advanced industrial economies as well.
So this economy has been really doing fairly well in terms of growth, trade, and attracting foreign direct investment. It is having a major effect on the region and it reflects, I think, China's increasing integration into global production networks as well.
Well, what is added to this mix once we get China in the WTO? It happened, as Steve mentioned, late last year. What will WTO membership add to the equation?
Now, as I have already indicated, one of the popular hypotheses is that the Chinese economy is going to collapse. The basic argument is fairly straightforward. There will be more international competition. There will be more unemployment domestically. There will be increasing worker unrest, and the cost of restructuring socially-politically will be overwhelming. The economy will go into collapse and the rule of the Chinese Communist Party is likely to end. So in a sense, the argument is that the WTO will be the straw that breaks the camel's back and brings down the whole political/economic system on the Mainland.
I tend to be a little bit skeptical about this argument simply because I think it underestimates how much international competition has already increased in China over the past two decades, particularly over the last five to ten years. Economists are fond of looking at things like tariffs and non-tariff barriers, and I will give you some of the indicators.
Tariffs, by the time China came into the World Trade Organization, on average were about fifteen percent. They have been reduced by about three-quarters from the peak level in the 1980's. Fifteen percent is relatively low. Indian tariffs are about thirty-five percent. It is about half the level of tariffs that exist, for example, in Mexico and Brazil. So the tariff levels are fairly low.
More importantly, China is committed to going to about nine percent by the year 2005. They already went to about thirteen percent at the beginning of this year. So they have gone from something like sixty percent down to fifteen percent, now they are down to thirteen percent, and they have to reduce it by a further four percent over the next five years. So competition has already increased dramatically as a result of this reduction in tariffs over the past decade and a half. It will increase more. There will be additional adjustment costs. But a lot of the adjustment has already occurred because tariffs have been reduced.
Similarly for non-tariff barriers, quotas and licenses are the most important form of non-tariff barrier in China. At their peak they restricted about forty-five percent of all imported goods coming into China in the late 1980s. By the time China came into the World Trade Organization last year these restrictions only applied to about four percent of all import lines in their tariff schedule. And again, over the next five years all of those will be phased out. They are on a glide path. They have already reduced the quotas and licensing requirements on most products. They have a few more to get rid of over the next five years.
Another very important indicator of competition that I think is frequently overlooked is the role of competition that is introduced into the system by foreign goods produced in China. I have already indicated there is a lot of foreign direct investment in China, but in effect these foreign firms in China have hugely increased competitive pressures on domestic firms. About three-quarters of all this foreign investment is in manufacturing. There is a little bit in real estate and a few other smaller sectors, but the vast majority of it is actually in manufacturing.
Two years ago, for the first time, the share of manufactured goods output produced in foreign-invested firms, as we call them, actually exceeded the output being produced in firms that were wholly owned by the state. So there is a great deal of additional competitive pressure being introduced into the economy by goods produced by foreign firms in China.
And those goods have many of the attributes or have many of the advantages as goods produced in North America, Japan, or Europe. They have the advantage of access to advanced technology, which they can bring into China on a duty-free basis. They have foreign management if they think it is going to improve their productivity. And so forth.
So this is a very important source of competition that quite frankly does not apply in very many economies, and I think it is frequently overlooked. But I think in the Chinese case one has to recognize that in addition to the reduction of tariff and non-tariff barriers you have a lot of foreign goods competing against domestic goods; and the foreign goods are being produced in China itself.
So the theme to take away from all of this, quite frankly, is that basically China has a running start on meeting its WTO obligations. It is not at a standstill and is going to try to catch up with all the vast obligations that it has undertaken. It has restructured very substantially over the last decade and a half and particularly over the last five years.
If I can switch the analogy. The coming collapse story is that China is going to be nudged into having more competition and the economy is going to fall off a cliff. And I think it is basically more a glide path, which I mentioned earlier. They have been adjusting to a big increase in competition over the last fifteen years. Their WTO commitments will increase that somewhat, but not as much as the collapse theory suggests.
So I am a little bit more optimistic than the collapse theory suggests. But why do I think that the WTO is going to add to the equation after they have already gotten rid of all of these trade barriers and have a lot of competition? Where's the beef, so to speak, in terms of the WTO obligations?
I think the real market opening in China that is going to occur as a result of its membership in the WTO is going to be additional investment liberalization and investment in sectors that have been relatively closed, and these are all in the services sector. Investment in telecommunications, financial services and distribution will be the most important liberalizations that occur.
As I mentioned, manufacturing, with a few exceptions, has been pretty open to foreign investment for a long time. But telecommunications, by contrast, has been completely closed to foreign investment. You can sell equipment to them if you are Lucent or one of the other telecom equipment producers. But you have not been able if you are a service-provider; you have not been able to enter the market to provide services, whether wired or wireless, and so forth.
It is an extremely attractive market in certain respects. China is now the world's largest wireless phone market, starting from the year 2000. China Mobile is likely to overtake Vodafone as the world's single largest mobile phone operator. The market is growing very rapidly and the penetration rates are still relatively low, so obviously there is a substantial future for additional expansion of the market.
Under China's WTO obligations, it is going to allow foreign service-providers into the wired market, the wireless markets, the value-added areas such as Internet service-providers and so forth. Foreign firms will be able to enter into all of these markets in the form of joint ventures. China is not completely throwing open the doors. There will be requirements to come in as a joint venture with some restrictions on ownership, and the Chinese, in most cases, will maintain a majority ownership of these joint-venture service-providers. But the market, nonetheless, is opening up.
A second area is financial services, which includes banking, insurance, securities, and asset management. This is a very important area for the economy. The domestic financial services sector is large. Financial assets in the system are already over twice gross domestic product, which is very high for an economy with a relatively low level of per capita income. But these resources, for the most part, have been allocated relatively inefficiently, and I think there are substantial opportunities for improving the efficiency of the financial system through a greater role for foreign banks and foreign insurance companies, securities companies, and asset management.
Just to take the asset management area for example. China is trying to shift away from pay-as-you-go pension system to a funded system in which people will have a compulsory IRA. That will put them ahead of the United States and a lot of Western countries that run entirely on a pay-as-you-go basis. They want to have a blended system that has a pay-as-you-go system, similar to our Social Security in certain respects, but then adds a mandatory IRA and a voluntary 401K-type program. And obviously once that gets up and running and expanded over the market, there is going to be a very large business in asset management, which does not now exist. Foreign asset management companies are going to be able to participate in that market.
So in summary I think that is where the challenges are for China - the opening up these services sectors. There are big gains for China in this as I indicated. There is the provision of additional services in telecommunications, which are still under-provided. Foreign capital will help in increasing the penetration rates.
The opening of distribution services is extremely important for many joint venture companies that want to expand their presence in the market.
I had a very interesting, or at least to me interesting or illuminating, discussion with somebody from General Electric a few weeks ago. Among the many businesses General Electric has is medical equipment. They sell their medical equipment to hospitals, and the biggest barrier to getting a bigger market share for their equipment is after-sales service, which is covered by distribution.
Now that China is in the WTO, they will be able to set up their own servicing network, which they could not do before. They will be able set up repair centers around the country. They will be able to guarantee to Chinese hospitals that if they buy their equipment, and something goes wrong with it, GE will have somebody there to fix it within twenty-four hours. And they will be able to dramatically expand their marketing of the equipment.
So distribution sounds kind of boring, but for many businesses it is quite important and will allow them to be more successful in their manufacturing and sales activities in China. It is another area that is going to be quite important, I think, going forward, for many, many firms. So I think there are gains to China and there will be new opportunities for Western firms in these areas as well.
Well, let me turn next to the question of the challenges for China once it is in the WTO. As I have indicated, I am not a subscriber to the coming collapse theory, but yet I certainly do not want to underestimate the challenges that China faces in coming into full compliance with its WTO applications. I think there will be a huge challenge of maintaining political stability and moving forward on political reform. Already, as I have indicated, increased competition has led to a dramatic reduction in employment in the state sector.
As many as thirty-five million people have lost jobs over the last four years in state-owned enterprises. There has been a fraying of the social safety net. The pay-as-you-go pension system is bankrupt. They do not have a social security system like the United States where in twenty years payouts are going to be greater than inflows. They are already in a situation in which they are beginning to make social security payments from general tax revenues because the contributions coming into the system cannot cover the benefits, even though the contribution rate is already roughly twice what it is in the United States. It is in the twenty-two, twenty-three percent range, between employer and employee, which is roughly twice the US rate.
And so we read of increasing labor unrest and demonstrations, particularly in the Rust Belt provinces of the Northeast which have traditionally concentrated on heavy industry and which are most impacted because China has the lowest comparative advantage in those sectors. And so we see widespread unrest in which the government is facing enormous challenges.
Another thing that is worth highlighting is growing inequality in China. In this period, in which China has grown very rapidly and done all of these other things which are fairly positive, inequality has increased at an unprecedented rate. In fact I do not think one can find a society, perhaps with the exception of wars or natural disasters, which has had such a rapid deterioration in income distribution in a twenty-year period.
China has gone from being one of the most equal income distributions in the developing world to one of the worst. China now has an income distribution by most measures that is much more unequal, for example, than India, whereas twenty years ago India was much more unequal than China. This too, I think, poses significant challenges for the government as they manage this transition in meeting their WTO obligations. Obviously what this underlines is the need for maintaining fairly robust economic growth in order to generate jobs to replace those that are being lost in the state sector.
And generating fairly rapid economic growth is also very important, I believe, in making inequality more manageable. One of the reasons inequality has been manageable to date is that even the poorest members of Chinese society have much higher incomes today than they did twenty years ago. Relatively speaking they have fallen further behind. But in absolute terms they have done, with very few exceptions, extremely well. Their absolute living standard has gone up enormously.
So it has been a combination that I think has made increased inequality more politically sustainable, if you will. But if economic growth were to slow down, that whole equation would change dramatically. Then you might have a situation in which as inequality gets worse, the people at the bottom of the income distribution might be experiencing an actual decline in their real living standards, rather than an increase. And I think that would be much, much more difficult for the regime to manage. So I think maintaining a robust economic growth and delivering rising living standards is a precondition for maintaining political stability.
I also think the regime will have to move ahead a little bit more rapidly on political reform. I do think there is a tendency to characterize China as having a lot of economic reform and no political reform. I think that is inaccurate in certain respects. I think there has been a lot of political reform in China. They began more than two decades ago the process of electing officials at the village level. This is a process not very different from the process that began in Taiwan in the early 1950s when elections started at the village levels and then gradually moved up the administrative hierarchy over time and led to the democratic transition that we have witnessed in Taiwan in the last decade.
So China has begun the process, but has not moved up the hierarchy very far. And I think they will have to start moving up these elections higher than the village level, and they have to start introducing them in the urban areas as well as the rural areas.
There are other things that have been done to increase government accountability. Local people's congresses in China now sometimes hold hearings on controversial issues to solicit public opinion, something that would have been unheard of in the Maoist days of the 1950s, 1960s, or 1970s. And they have passed an administrative law which allows citizens to sue the government, again something that would have been unheard of in the pre-reform era.
Many, many cases exist in which citizens have sued the government and actually collected damages for failure, for example, of the government to enforce anti-pollution laws. Down-steam communities have sued the government for failure to close factories that are in violation upstream, and so forth.
So there is an increase in accountability and an increase in the responsiveness of the government to the needs of the populace, but it is only the beginning of a political reform process and I think it will have to go further. Otherwise the disparity between the relatively advanced economic reforms on the one hand and the less advanced political reforms will be increasingly a challenge for the regime.
I have already indicated that Taiwan might be something of a model for China to emulate in its gradual transition, as Taiwan has a multi-party system. And that is certainly much more attractive than some of the alternatives that come to mind. But, of course, China is much more complex because of its size. Its living standards are much lower than those in Taiwan and so the political transition in China could be much more protracted than it was even in Taiwan's case which, of course, took several decades.
Finally I would mention specifically corruption. I think the regime is well aware of how corrosive corruption is. And we have seen some dramatic examples in recent months of corruption in the financial system, where high-level officials have absconded with huge amounts of depositors' money. And in some cases this threatens the very foundations of the financial system. So there are at least four challenges that China has to deal with going forward: maintaining political stability, maintaining economic growth, accelerating the pace of political reform, and dealing more effectively than they have in the past with corruption.
I would identify a couple more challenges that I think are important. One in particular is the development of a modern commercially-oriented financial system. China, as I mentioned, is committed to allowing foreign financial service providers to come into the market, but domestic financial institutions have a long way to go before they will be competitive, and in the transition period they need to accelerate the process of developing a domestic capital market.
They have had a stock market now for almost ten years but insignificant amounts of funds are raised through that market. And the regulation of the stock market remains weak with widespread market manipulation, insider trading, non-compliance with disclosure standards, and other shortcomings that have led domestic critics of these markets to characterize them as casinos rather than as a mechanism for providing funding for new kinds of economic activities.
Banks also need to develop a commercial credit culture rather than acting as cashiers for the government, as they have historically. There is some progress on this front in recent years, but there is a very, very long way to go. And China now only has five years to get ready for full-fledged competition with foreign banks because foreign banks are going to be able to do business in China with very, very few restrictions five years from China's entry into the WTO in December of 2001. The door is opening up very, very slightly before them, but in five years the door really completely opens up for foreign banking services.
I have talked a lot about the challenges for China. Let me close with something on the challenges for the United States and the challenges for the West more generally.
The focus in the United States in particular, and especially in the business community that lobbies on these issues is, of course, concern that China fully complies with its obligations. And they anticipate selling a great deal more product in China.
Those are the exporting industries, but as an economist can tell you fairly quickly, China is going to have to export a lot more into international markets if it is going to be able to buy more goods from abroad. I think we will see now, as China has joined the WTO, a potentially even more rapid rise in Chinese exports than we have seen in the last fifteen years. This is particularly true of products like apparel, which have been highly constrained by a quota system that governs trade and apparel through the WTO, but which is going to be phased out in only two years.
China has an opportunity when those restrictions phase out to dramatically increase its production of apparel and its export of apparel. The reason is that the quota system in effect now basically provides protected market shares for higher cost producers. So when the quota system is eliminated we are going to have a much more market-driven system.
China is a much lower cost producer of many kinds of apparel than those countries that have market share today. And so what will happen is there will be a displacement and a displacement of production and of market share of some of these countries. I am thinking in particular that countries in Southeast Asia like the Philippines, Thailand and Malaysia will probably lose market share as China gains market share. Even Mexico is likely to lose market share to China. Mexico has gained market share since the advent of NAFTA, which has given them a preferred position in the US market, for example, but it will be closer to a level playing field once the quotas are phased out.
So the challenge for the West is preparing to accept substantially higher levels of Chinese goods. We already have a record trade deficit with China. Last year, for the first time, the deficit with China was greater than our deficit with Japan. Japan had been number one for quite a long time, more than a decade. China is now firmly number one and is likely to continue to be our largest deficit-trading partner because of this displacement effect.
We are going to buy lots of additional things from China that we used to buy from other countries. We have already been through this in footwear and toys, now it is going to come in apparel, consumer electronics, and, not very far down the road, computers and other kinds of information technology hardware as well.
There are also adjustment costs in terms of foreign direct investment in other countries, particularly those in Southeast Asia. They probably will get a little bit less foreign direct investment inflow as those inflows are increasingly concentrated in China. For inflows of foreign direct investment into East Asia and Southeast Asia, outside of Japan, at the beginning of the 1990s, eighty percent or so were going to Southeast Asian countries, with only twenty percent going into China.
Now it is eighty percent going into China and a much, much smaller percentage going into Southeast Asian countries. So China's liberalization of telecoms and some of the other sectors that I mentioned probably will reinforce that trend so that other countries in the region will have to accelerate their reforms or figure out how to do with smaller inflows of foreign direct investment.
As I have indicated, even the most advanced economies, the United States, for example, and Japan, will face the challenge of adjusting to rapidly increasingly imbalances in their trade with China because of the displacement effect that I have already mentioned. Now unfortunately, from my point of view as an economist who believes very much in free trade, the terms of China's coming into the World Trade Organization included several clauses that are potentially highly protectionist.
A safeguard clause makes it very easy for the United States and other WTO members to restrict the inflows of Chinese goods if they begin to grow too rapidly. We have already seen Japan putting restrictions last year on Shiitaki mushrooms, green onions and the rushes that they use to make tatami mats. They put sixty-three percent tariffs on those products as their market share had gone up quite a bit.
If those kinds of protective responses are fairly widespread it will reduce the hope that China will be able to adjust to increased openness, because China is going to have to reduce its output in many non-competitive sectors which tend to be capital intensive. They need to expand production and exports of more labor-intensive products, including the apparel that I have mentioned.
Also, there are vegetables and other crops which are more suited to China's agricultural endowments, than are grains, which they are going to import more of. So they need to expand production and exports of labor-intensive manufactured goods, which will be extremely difficult if the rest of the world is relatively protectionist.
Finally, another challenge for the United States in particular is to seek an alignment of our trade interests between China and the United States. It is possible that China could become a significant positive force in multilateral trade liberalization. One of the reasons is that I do not think China is going to necessarily line up with developing countries on all issues.
China frequently talks about how it is a developing country, but in fact in some areas their interests are more similar to those of an advanced industrial economy. The fact that they have already lowered their tariffs so much more than most other developing countries is going to give them a stronger stake, I hope, in supporting multi-lateral trade liberalization in the Doha Round of trade negotiations. And there could thus, with a little skill from diplomacy, be an alignment of interest between the United States and China on some issues.
Now unfortunately this is not likely to be achieved if the United States continues to use non-tariff barriers to restrict access to our markets, especially anti-dumping procedures, and safeguard protectionism that we have seen increasing in recent months and of which China, of course, has been the chief victim, if you will. China has been the subject of more anti-dumping cases than any other economy on the globe, and the numbers are growing rapidly even as China has come into the WTO.
So I think the challenges are there not just for China but also for the West in terms of maintaining open markets and being prepared to accept large trade imbalances with China, not because we are going to lose a lot of jobs in the United States but because there is a displacement effect somewhere else and we should try to work for an alignment of our trade interest with those of China.
In summary, China is on track to have a continued rise as a global economic and trading power, but there are significant risks. There are risks to the financial system, there are some risks to political stability. But if these risks can be overcome, I think China is likely to emerge within ten years as the largest producer in the world of information technology hardware and to emerge as the second largest trading country in the world.
They have already gone from about number thirty-seven in the late 1970s to number seven today. Within four to five years they could move up to number four and then in the next five years they could overtake both Germany and Japan to become the second largest trading country in the world, after only the United States.
That would be a very dramatic transformation in a relatively short period of time, but I think it is within their reach if they can manage the kinds of risks that I have talked about and maintain this openness to foreign direct investment which, as I have said, is really unprecedented for a large continental-sized economy.
The second point in summary is that WTO accession will provide substantial new opportunities for foreign firms, including US firms, particularly in the sectors that are being liberalized for foreign direct investment: telecommunications, distribution, and financial services. China is going to gain substantially in the medium and long run from its membership in the World Trade Organization, but it will face substantial challenges in maintaining political stability in the face of rising transitory unemployment, particularly in the early years when it takes a while to move people out of uncompetitive sectors into new sectors.
There is that transitory unemployment and also there is the challenge of developing a modern, commercially-oriented financial system, which is also essential to supporting this kind of restructuring that will be required. And I would just close by saying that the whole adjustment process would be in jeopardy if countries like the United States and Japan and other advanced industrial countries made widespread use of these potentially protectionist measures that are a feature of China's accession to the World Trade Organization. If those were invoked it would substantially reduce the opportunities China has to expand employment in labor-intensive industries as unemployment falls in response to increased foreign competition in agriculture and certain heavy industries.
So it would threaten the whole internal adjustment process within China and make it more likely that China would fall badly out of compliance with its commitments to the World Trade Organization. I think it would give an unfavorable outcome to the question that I posed at the beginning about China's likely role in the World Trade Organization.
Frequently people focus on whether or not China is going to comply with its commitments, and they think of it as something that is entirely up to the Chinese. At one level it is. But at a more fundamental level, unless the international community remains open and willing to accept increased quantities of Chinese goods it will be very unlikely that China will be able to absorb or substantially increase quantities of imports and to undertake the domestic restructuring that those increased levels of imports would require.
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