By Ronald Man

Take a step back and put things into perspective. While China’s policymakers have reduced the growth target of the world’s second largest economy to 7.5 percent, this number is still consistent with GDP doubling every 10 years. Given that there is further easing in the pipeline, this target could be exceeded, so another strong year remains very much on the cards. As China continues to grow, even if at a potentially slower pace, what does this mean for Korean trade?

Korea, once strong in basic production, now specializes in high value-added goods. Up until around 1980 Korean exports were driven by manufactured goods, similar to China today. Over time, advanced machinery and transport equipment began to dominate. This is a natural progression. Countries acquire advanced technology and switch from input to productivity-led growth as they become richer.

This raises the question: will China soon follow the same path? We don’t think so, despite there appearing to be good reasons to suggest otherwise. First, the world’s second largest economy is developing at a terrific pace. A back-of-the-envelope estimate shows China’s GDP per capita will overtake Korea’s by 2050 if the two countries continue to grow at 8 percent and 4 percent a year, respectively.

And then there’s the fact that China, already the world’s largest exporter with a growing domestic base, will undoubtedly attract strong foreign investment and technology as it gradually removes its trade barriers. While foreign direct investment (FDI) funds grew for both countries, the ratio between Chinese and Korean FDI rose to 8.5 times in 2011 from as low as 2.5 in 1999. With an increasing number of Chinese students studying abroad, advanced foreign knowledge will also be brought back home and channelled into the domestic economy.

Consequently, as China’s manufacturing sector moves up the value chain, it will also have its own globally competitive national champions. Some will be specialized in technology just like Korea’s mighty chaebols. In turn, this means Korea’s economy must depend more on growth that is led by productivity and innovation as opposed to input.

But that does not tell the whole story. China is now Korea’s biggest trading partner. Bilateral trade between the two countries has grown to $221 billion from just $31 billion since China joined the WTO in December 2001. While other countries that have increased trade with China saw a sharp deterioration in their trade balance, Korea has enjoyed a trade surplus that has shown consistent growth. Net exports from Korea into China were valued at $48 billion in 2011, a new annual record high. This suggests that China, despite its strong growth over the past decade, has not posed a critical threat to Korean exports on the aggregate level. Instead, the argument is stronger from the opposite end: China’s rise complements Korean shipments.

Of course, Korea is not a net seller of all goods to China. Rather, the distribution is varied. But this is where there is clear evidence of both countries working together by using their comparative advantages.

On the one hand, Korea sold more machinery and transport equipments than any other goods to China on a net basis in the past decade. Probing deeper into this category, we find the largest component is electrical machinery. In part, this is the result of allocating more resources to developing new high value-added goods.

On the other hand, Korea buys more manufactured goods than anything else from China on a net basis. The deficit is concentrated in purchases of iron, steel and non-metallic minerals. That said, a lot of this is used as inputs for export production ― a quarter of which heads back to the Mainland. We don’t have the exact breakdown, but we know 40 percent of Korean imports are used to satisfy foreign demand (the percentage is likely higher for these specific goods). Therefore, Korea should be less worried about its manufacturing goods deficit with China as this is largely a by-product of specialization, with both countries working to their relative strengths with respect to each other and on the global stage.

To see how far an economy has developed, we can look at its drivers of growth. As economies mature, their growth becomes increasingly productivity-driven, as opposed to relying on increasing labour and capital, which is ultimately unsustainable. Our analysis finds that Korea’s growth has become increasingly productivity-led, especially during the ‘noughties.’ China, however, remains very much an input story.

Without clear signs that China is in a position to wear down Korea’s comparative advantage, a potential free trade agreement (FTA) with the world’s second largest economy may benefit Korea. There are currently two cards on the table. First is the China-Japan-Korea FTA. Second is a China-South Korea FTA.

Note that the expected gain from a bilateral FTA with just China (2.4-3.2 percent of GDP) is estimated to be roughly the same as that achieved under a trilateral FTA that includes Japan (2.8 percent of GDP), according to a joint-study group that has crunched the numbers. Therefore, most of Korea’s gains from a trilateral FTA may be sourced from China alone, especially given that it has run a trade deficit with Japan since records began in 1971.

Which card will Korea play (if not both)? That’s a tough call. Much will depend on negotiations between China, Japan and Korea over the coming months. For now, however, a China-South Korea FTA is likely to bring more benefits from Korea’s perspective. This is based on two considerations. First, Korea’s expected gains from a bilateral FTA with China are likely to be similar to that from a trilateral agreement. Second, current trade imbalances with Japan may stimulate resistance to a trilateral FTA within Korea at a particularly sensitive time, given the upcoming parliamentary and presidential elections.

Overall, China’s rise complements Korean exports. We do not believe China has developed sufficiently to erode Korea’s comparative advantage anytime soon and, in turn, more gains to trade may be unlocked by potential trade pacts between the two countries. We expect China to remain Korea’s largest export market, with Korean shipments to China rising over 80 percent by 2015.