During the annual China-Japan-Korea summit, held mid-May in Beijing, Premier Wen Jiabao, Prime Minister Yoshihiko Noda, and President Lee Myung-bak announced their intention to begin negotiating a trilateral free trade agreement (FTA).

The news closely followed the implementation of the Korea-U.S. FTA and negotiations over the Trans-Pacific Partnership (TPP) FTA championed by the Obama administration, both taking place in March. It potentially places Japan and Korea on awkward footing as they balance relations with China, an important regional leader, and the United States, an ally of many decades’ standing.

What could this proposed East Asia FTA mean for the United States, for the three countries pursuing it, and for global economics and security?

Joseph L. C. Cheng, a visiting professor at Shorenstein APARC and a professor of international business at the University of Illinois where he also serves as director of the CIC Center for Advanced Study in International Competitiveness, suggests the FTA could have a far greater impact beyond boosting economic growth in East Asia. Possible outcomes range from reducing resources for strengthening the U.S. domestic infrastructure to providing leverage for negotiating with North Korea over its nuclear program.

In a recent interview, Cheng spoke in-depth about the nuances of the trilateral East Asia FTA.

If the proposed China-Japan-Korea FTA is realized, what could the impact be on the U.S. economy and economic policy?

These three countries are currently ranked the second (China), third (Japan), and fifteenth (Korea) largest economies in the world. With a combined population of 1.5 billion, they account for about 20 percent of the world’s GDP and total exports. In 2011, their three-way trade reached $690 billion, and the United States sold them a total of $213.6 billion worth of merchandise (over 14 percent of U.S. total world exports in 2011).

If realized, the proposed FTA could have both negative and positive effects on the U.S. economy. On the negative side:

• First, cross-border trade and investment would most likely increase among China, Japan, and Korea, but not with the United States. Whether the FTA would result in decreased U.S. trade and investment with these countries and by how much will depend on the range of industries and product categories covered by the FTA and how rigorously it will be enforced. Most of this negative impact from the FTA would be with China. This is because the United States already has an FTA with Korea, and Japan (along with Canada and Mexico) is likely to join the U.S.-led TPP FTA which is currently under negotiation.

• Second, if the FTA did cover the industries and product categories that disadvantage the United States, small-and-medium sized export firms (SMEs) would be the most negatively affected by the decline in U.S. exports to the three member countries. This is because over 90 percent of U.S. SMEs do not conduct manufacturing overseas (and thus cannot produce and sell in these three countries to benefit from the FTA), and their market access is dependent on the U.S. government’s trade initiatives. The SMEs account for about one-third of total U.S. exports and provide most of the domestic job growth.

• Third, not only would the three member countries import less from the United States, they would also invest less in the United States (but invest more in one another). When announcing the FTA talks, China’s Premier Wen expressed hope that Japan and Korea will be the primary destination for China’s outward investment. This decline in foreign investment from the three member countries in the United States could have a negative impact on domestic job growth and funding for business expansion and public revitalization projects (e.g., infrastructure replacement and modernization).

• Fourth, because FTAs disadvantage trade from non-member countries, U.S. multinational corporations (MNCs) could be forced to produce and sell goods from their plants in the three member countries (instead of those in the United States) in order to stay competitive. This would mean moving jobs overseas. Also, because these member countries have bilateral FTAs with many other countries in Asia (e.g., the China-ASEAN FTA introduced in January 2010), U.S. MNCs might find it beneficial to increase production there (China, Japan, and Korea) for export to the region. Again, this would result in transfers of jobs overseas and also reduced investment by U.S. MNCs at home (which could help create jobs and grow the domestic economy).

On the positive side, the proposed FTA could result in fewer imports from the member countries into the United States. This would provide an opportunity for U.S. manufacturers, particularly the SMEs, to increase their domestic production to fill the demand-gap and recapture the market-share that has been lost to imports. If U.S. manufacturers could produce unique, high-quality products at an affordable price, they would be able to not only attract new domestic customers and keep them but also open new export markets in other countries, including China, Japan, and Korea.

As for potential impact on U.S. economic policy, the Obama administration might feel the need to speed up the TPP negotiations (which might require making the final FTA less comprehensive and less rigorous than originally proposed) and put the agreement in place ahead of the proposed China-Japan-Korea FTA. Also, the administration might be pressured by the business community to start FTA talks with China, as has been suggested by Maurice Greenberg, chairman of Starr International Company Inc. and former AIG chief. These FTA talks will take years to conclude and implement. In the meantime, the United States should introduce new economic policies to revitalize the domestic manufacturing sector and help position it for enhanced international competitiveness.

Could there be an impact on the struggling economies of Europe?

The proposed FTA would most likely have a similar impact on Europe, namely decreased trade and investment with the three member countries of China, Japan, and Korea (assuming the agreement included industries and product categories that disadvantage Europe). Because of Europe’s worsening debt crisis, the negative impact there would likely be greater than it would be on the United States. Currently, the European Union (EU) has an FTA with Korea, but not with China or Japan. Also, with the exception of Norway, none of the European countries is in FTA talks with China. Switzerland is the only European country with an FTA with Japan. This is not good news for Europe if it wishes to benefit from increased trade and investment with China, Japan, and Korea.

Is there a potential upside for the global economy?

Most of the expected economic benefits resulting from the proposed FTA will go to the three member countries of China, Japan, and Korea. The Chinese government estimates that the FTA could raise China’s GDP by up to 2.0 percent, Japan by 0.5 percent, and Korea by 3.1 percent. The Korean finance ministry estimates that the FTA could boost the nation’s economic growth by up to 3.0 percent and create as many as 330,000 jobs over a decade. This is consistent with the experience of the introduction of the China-ASEAN FTA in January 2010, which caused trade in the region to increase by about 50 percent in that year.

The expected economic growth in the three member countries (and the Asia-Pacific region) could, in the longer term, lead to increased imports from the United States and other Western countries for goods and services that they cannot produce or do not produce enough of. This might result from increased spending by individual consumers on luxury and unique goods and/or government purchase of advanced technologies for infrastructure projects. The increased imports would certainly help lift the global economy by creating more jobs and generating greater incomes in the exporting countries.

When announcing the proposed FTA in Beijing, the three leaders from the member countries made it a point that they will work together to ease regional disputes and tensions, particularly on the Korean Peninsula. They also expect the FTA to help provide a comprehensive and institutional framework in which a wide range of bilateral and trilateral cooperation would evolve, with the goal of maintaining the Asia-Pacific region as the growth center of the world economy. (Currently over 50 percent of the world’s economic growth is taking place in Asia.) To the extent that this can be accomplished, the proposed FTA will have farther-reaching consequences than being just a regional trade agreement.

What is driving the announcement about the intended FTA at this specific point in time?

It is not clear if the announcement was purposefully timed to meet certain strategic objectives. However, a number of factors and recent developments suggest that the timing is quite beneficial to the member countries.

First, the three countries had been in discussion about the proposed FTA for over ten years prior to the announcement. Two of the three principals, China’s Premier Wen and Korea’s President Lee will be leaving office by year’s end and would certainly like to be remembered as architects of this important treaty by participating in its announcement. 

Second, the deteriorating economic crisis in the EU and the slow recovery of the U.S. economy make it very clear to the three leaders that they need to stimulate internal consumption and investment to maintain economic growth in their respective countries. Announcing the proposed FTA now helps ease concerns about the global economy and signal to international investors that the Asia-Pacific region will remain the center of the world’s economic growth for many years to come.

Third, from China’s standpoint, the recent scandals of Bo Xilai and the blind civil rights activist Chen Guangcheng brought negative attention to the country for the entire month of April. The mid-May announcement of the proposed FTA helps redirect the world’s attention to the economic success of China and its influential role in shaping the future of the global economy.

Finally, the recent threat of a third nuclear test from North Korea might have been another contributing factor to having the announcement made sooner rather than later. China might have thought about the proposed FTA as a message to North Korea that China is now working closely with South Korea and Japan to maintain the Asia-Pacific region as the world’s center of economic growth, and thus any new nuclear provocation from North Korea would be considered an unfriendly act.

What could be the biggest challenges to the ratification of the FTA? Can they be overcome?

Historical animosity and territorial disputes between the three member countries will be the greatest challenges to both the FTA negotiation and its final ratification. Korea has recently suspended the signing of agreements on military cooperation with Japan because of public opposition, particularly from the older generations who have bitter memories of Japan’s colonial rule. Japan and China have long been in dispute over territorial claims in the East China Sea. Both Japan and Korea have also been calling for China to put more pressure on North Korea to stop further nuclear provocations. 

In addition to these historical and political obstacles, there will be opposition from interest groups within each country against the proposed FTA for fear of negative economic consequences. For example, Chinese manufacturers might not want increased imports from Japan and Korea to reduce their market share. Japan currently has a big surplus from trade with Korea; thus Korea might not want to have more imports from Japan. Also, the three member countries are quite unbalanced in terms of the liberalization steps that they have already taken and they also have different visions for their economic future.

It will take great diplomatic skills on the part of the negotiators to overcome these challenges. The FTA talks will be difficult and take many years to produce an agreement. Alternatively, the three member countries might choose to smooth the negotiations by avoiding sensitive issues and making the agreement far less comprehensive and rigorous. This would, however, also make the FTA less economically important and consequential.