Can free trade become a catalyst for reform and productivity gains in Asia once more?

China's accession to the World Trade Organization (WTO) in late 2001 ignited a period of rapid integration in global trade: by 2006, China's merchandise exports to GDP ratio swelled from 20.1% in 2001 to 35.7%. The world economy experienced a similar, if somewhat more muted, up-trend. This was the era of 'hyper-globalization," driven by a feverish search for low-cost manufacturing opportunities, nearly all of which seemed, for a while, to reside in China.

Then the Great Recession hit, and things were never the same again-not for China, at least. China's merchandise-exports-to-GDP ratio only feebly recovered in 2010 but has since steadily retreated: in 2014, it stood at a 12-year low of 22.7%.

Does this mean globalization is dead? Is China disengaging from the world economy?

We believe the answer is no, on both counts.

For one thing, many global measures of trade activity are back to pre-recession levels. IHS Economics estimates global merchandise exports reached $18.8 trillion in 2014, 19.4% above the pre-recession peak. These exports equaled 24.3% of world GDP, not far off the 2008 peak of 25.1%. And while China's ratio of exports to its own GDP has fallen, this largely reflects the incredible pace of growth it had experienced over the past decade. China's dollar GDP (nominal) nearly quadrupled from 2001 to 2014, now being the world's second largest. Meanwhile, China's share in total world exports has, in fact, continued to grow, rising steadily from less than 4.0% in 2001 to 12.5% last year. No other single country even comes close: the United States' share in world exports was 8.7%; Japan's was a mere 3.7%.

This is hardly a disengagement story. Nevertheless, it is true that the driving forces behind China's global trade integration are changing, to some extent precisely because of its earlier success.

Perhaps the single biggest factor shaping these changes is China's rising labor costs. The decade of the 2000s saw China establish itself as the undisputed low-cost manufacturer of the world. WTO accession opened the floodgates of foreign capital, and multinational firm after multinational firm lined up to establish production facilities in China. Labor demand soared and wages began to rise. Within several years, China closed its wage gap with other low-cost Asian producers. A comparison with Thailand illustrates the point: in 2001, a Chinese worker earned about 73% of what a Thai did. By 2006, Chinese average wages exceeded Thai, and's and by 2013 they were 81% higher.

While sheer size means China can't-and won't-be elbowed out of the manufacturing ring, regional competition in Asia's low-cost manufacturing space has greatly intensified over the past decade. The accession of Cambodia and Vietnam to WTO in 2004 and 2007, respectively, and much improved political and macroeconomic conditions in large countries such as Indonesia and the Philippines, means there are "new kids on the block." And they are quickly growing: upon joining the WTO, Vietnam has experienced just as impressive and rapid an integration in global manufacturing flows as China had seen several years prior. Measured simply by the share of merchandise exports to GDP, Vietnam is now Asia's third most open economy, overshadowed only by trade hubs Hong Kong and Singapore.

With cost advantages now less clearly differentiated geographically, supply chains have become more complex and more fragmented across borders, both globally, but especially so in Asia. This process has been aided by a multitude of regional free trade agreements (FTA), many with China at its center. The ASEAN-China Free Trade Agreement signed in 2004, for instance, has greatly reduced barriers to merchandise trade among the two partners.

Services are the next big frontier

What this all suggests is that the next big frontier is not so much in goods but in services trade. And this is why the recently signed FTA between China and Australia is so important.

In November 2014, China and Australia announced the conclusion of negotiations for a China-Australia Free Trade Agreement (ChAFTA), as well as signed formal declarations to adopt the appropriate legal changes necessary to bring the agreement into force. The conclusion of ChAFTA negotiations was a highpoint among FTA announcements coming from China at the time, including with South Korea as well as ASEAN and APEC members. While those other FTAs vary from "substantively concluded" to only in the very early exploratory stages, the scope of opening under ChAFTA is an encouraging signal of the ambition and willingness for new market access agreements by China. Even the concluded ChAFTA will take at least four years to be fully implemented for most openings, highlighting that China's free trade and investment push is more about securing medium- to long-term growth, rather than immediately accelerating the economy in the very near term.

It is difficult to overstate the level of new market access achieved under the agreement, which reportedly was reached over a period of nine years and 20 negotiating rounds. Under the agreement Australia will lower tariffs on essentially all imported goods gradually, while China has committed to reduced tariffs in agricultural, resources and energy, and manufactured goods over at the latest within 11 years, with four years the most common phase-in period cited.

Key outcomes by sector

While both parties provided considerable concessions, on merchandise trade Australia is likely to enjoy greater final benefits, simply because existing Chinese tariff levels are on average higher as well as applied to a greater number of goods. According to data from the World Trade Organization, China's average tariffs exceed Australia's in 14 of 22 broad sectors; within the remaining mostly manufacturing sectors, Australia's tariffs only significantly exceed China's in one, textiles, where Australia applies tariffs averaging 41.4%. China also maintains very few zero tariff product-lines relative to Australia; while Australia provides duty-free access to 77% of agricultural goods and 45.9% of manufactured goods to most favored nations, China only offers similar duty-free access on 7.2% of agricultural goods and 6.9% of manufactured goods. In the case of other FTAs under discussion for launch or expansion, particularly with ASEAN and APEC, China stands to gain more substantial tariff reductions for non-agricultural goods that matter more for its manufacturing sector.

Reform via competition

While tariff reductions will likely benefit net exports in Australia to a greater extent, potentially weakening China's trade surplus as full implementation is phased in, it's crucial to highlight that China also stands to enjoy considerable gains from the agreement in other dimensions. Oddly enough, the greatest gains for China's domestic economy come especially from openings offered to Australian firms. Under the agreement, China will provide a substantial and first-time opening in many of its long-protected and state-dominated service sectors, including finance and telecommunications. Ian Birks, chief executive of the Australian Services Roundtable, commented that the new market access made for a "sensationally good deal" for Australian services firms. It remains unclear if service sector concessions to Australia in the long run will primarily apply in China's growing but still geographically limited free trade zones, or nationwide-a critical difference in determining whether the deal is truly as meaningful as advertised.

In China services have been the largest contributor to Chinese employment since 1994, to output and real growth since 2013, and continues to attract more and faster-growing investment than industry, perhaps making it seem like there is little outside parties could add. Importantly, services such as finance and telecommunications, critical to any modern economy, remain largely state dominated in China. Domestic private sector investment in the service sector in China only accounts for about 54% of the total, well below the nearly 80% private sector dominance in industry and construction. Following a round of reform of state-owned enterprises in the 1990s and WTO entry in 2001 China saw its industrial sector productivity grow substantially at both private and state-owned firms, helping secure high total factor productivity gains throughout the 2000s. While there are still productivity gains to be made in some corners of China's industrial sectors dominated by SOEs, there are many more in the ever-larger services sector.

As a result of relatively limited liberalization there, China has seen its service sector imports grow at nearly twice the rate of service sector exports since 2009, resulting in a services deficit that increasingly is eroding the growth contribution from the merchandise trade surplus. Market entry by Australia, and presumably other foreign firms as FTAs increase in geographic coverage, potentially could help secure another productivity boost (or stabilization) in China in the coming years as well as help balance China's services trade.

While the openings hold great potential for both sides, the most promising areas are also the most ambiguous in their final outcome. China's commitment to open its service sectors via an FTA is being interpreted as forcing domestic reform via international obligations and competition; such was partly the case with WTO entry.

That said, some service sector commitments were made in the past and largely ignored or limited as implementation deadlines arrived. Moreover, China has included some important caveats in its ChAFTA service sector openings. For example, telecommunications, legal, and transport services will be restricted to establishment within the Shanghai Free Trade Zone (SHFTZ). While initially that may be a welcome opening relative to the past, policies dealing with local branch establishment by mainland headquarters located in the SHFTZ will be important in assessing how serious China is about truly opening those sectors to competition nationwide, rather than in special zones.

Big picture - Asia integrated?

In addition to the concluded ChAFTA, in the fourth quarter of 2014 China and partners also announced a nearly concluded FTA with South Korea, the intention to expand an existing FTA with ASEAN, and the launch of a feasibility study by Asian Pacific Economic Cooperation (APEC) members for an FTA of the Asia-Pacific. In general, tariff reductions would primarily benefit trade partners more than China in these agreements, given that China accounts for a greater share of their trade and production portfolios. Moreover, in Australia and South Korea the trade surplus is strongly on the partners' side, rather than with China. That said, if such agreements include equally substantial openings in service sectors and investment, that could further improve the level of competition, innovation, and productivity growth within China, and would provide a complementary effect to China's plans to reform its domestic financial sector and state-owned enterprises in a bid to boost economic efficiency.

For the moment, most of those possibilities remain big "ifs." While the South Korea FTA was confirmed in January 2015 as likely to enter into force in the second half of 2015, it reportedly includes a 20-year phase-in period. Further out is the ASEAN FTA expansion, which both sides hope to complete before 2016; and the most significant, FTAAP, which will not begin negotiations for at least two years.

Outlook and Implications

For the time being ChAFTA, the one new FTA solidly "in hand," signals improved trade access and flows over the next 11 years or so, with most important changes in merchandise trade tariffs occurring within four years. More significantly for China, the agreement demonstrates a relatively high appetite for reform within China, including in long-protected "sacred cow" sectors. That is tempered by the varying depth and speed of opening within the ChAFTA, and many questions related to implementation may not be answered for months or years, until specific challenges are encountered and overcome (or not). Still, the agreement is consistent with the IHS view that China is establishing the policy framework for a relatively ambitious reform agenda, with implementation mostly to take place during the 13th Five-Year Plan (2016-2020).

Brian Jackson is senior economist, IHS Economics & Country Risk