89450 IMPLICATIONS OF A CHANGING CHINA FOR BRAZIL: A NEW WINDOW OF OPPORTUNITY? ECONOMIC REPORT IMPLICATIONS OF A CHANGING CHINA FOR BRAZIL: A NEW WINDOW OF OPPORTUNITY? THE WORLD BANK 2014 © 2014 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org E-mail: feedback@worldbank.org, informacao@worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. 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TABLE OF CONTENTS PREFACE ....................................................................................................................................... 7 EXECUTIVE SUMMARY ............................................................................................................ 9 A Changing China in a Changing World .............................................................................. 10 Brazil’s Evolving Linkages with China ................................................................................ 12 Policy Implications for Brazil ............................................................................................... 14 INTRODUCTION ........................................................................................................................ 19 In Context: Brazil’s Growing Connections with China ........................................................ 19 The Outlook: Relevance of a Changing China for Brazil ..................................................... 20 This Report: Objective, Scope and Structure ........................................................................ 21 PART 1. A CHANGING CHINA IN A CHANGING WORLD ................................................ 23 I. China’s Journey of Structural Transformation ................................................................... 23 A. The Past Three Decades: China’s Journey of Economic Reform ........................... 23 B. The Next Two Decades: A New Phase in China’s Development ........................... 25 II. China in the World: Growing Integration and Mutual Dependence ................................. 31 A. China’s Position in the World ................................................................................. 31 B. Relations between China and the World ................................................................. 34 PART 2. BRAZIL’S EVOLVING LINKAGES WITH CHINA................................................. 39 I. Looking Back: Facets and Characteristics over the Last Decade ...................................... 39 A. Facets of the Brazil-China Relationship: Trade, Investment and Indirect Effects .. 40 B. Characteristics of the Relationship: Complementarity and Similarity .................... 47 II. Looking Ahead: Impact of a Changing China on Brazil .................................................. 61 A. Changes in China: A More Detailed Analysis ........................................................ 61 B. Implications for Brazil: Rising Complementarity, Changing Similarity ................. 65 PART 3. POLICY IMPLICATIONS FOR BRAZIL .................................................................. 69 I. Growth Expectations and Structural Reform ..................................................................... 69 A. Recent Developments: Muted Growth Expectations .............................................. 70 B. Structural Reform: The Unfinished Agenda ............................................................ 72 II. Scope for Enhancing Global Integration .......................................................................... 75 A. Has Trade with China Made Brazil Too Outward Oriented? .................................. 75 B. Has Brazil’s Trade Structure Become Too Concentrated? ...................................... 82 C. Has Brazil Become Too Specialized in Commodities? ........................................... 87 III. Leveraging External Connections with China................................................................. 93 A. Tackling Home-Grown Supply-Side Constraints .................................................... 93 B. Enhancing the External Environment for Trade and Investment ............................ 98 REFERENCES ........................................................................................................................... 107 APPENDICES ............................................................................................................................ 113 A. Main Features of the Envisage Model ................................................................... 113 B. Brazil’s Top Exports by Destination ..................................................................... 119 C. Brazil’s Most and Least Dynamic Products by Destination .................................. 123 D. Export Similarity between Brazil and Other Countries ......................................... 126 E. Export Sophistication by Destination and Lall Category ...................................... 127 F. Comparison of Number of Products Traded by Classification .............................. 129 G. Technical Notes ..................................................................................................... 130 PREFACE This report – a product of the Economic Policy Unit of the Latin America and Caribbean Department (LCSPE) of the World Bank – reflects a collaboration between the World Bank’s Brazil and China country teams, the Development Economics Prospects Group, and the International Trade Department. It builds on earlier work in China, including “China 2030” (World Bank and Development Research Center of the State Council of the P.R. China, 2013) and “China Quarterly Update: Sustaining Growth” (World Bank, 2012b), as well as related work on “A Changing China: Implications for Developing Countries” (Schellekens, 2012). The report has benefited from the work and insight of many people. The report was led and managed by Philip Schellekens (Senior Country Economist for Brazil and formerly China) under the guidance of Deborah Wetzel (Country Director for Brazil), Klaus Rohland (Country Director for China), Humberto Lopez (LCSPR Sector Director), Auguste Tano Kouame (LCSPE Sector Manager) and Roland Clark (Brazil Sector Leader). The team of contributors consisted of Maryla Maliszewska and Marcio Jose Vargas da Cruz under the guidance of Maurizio Bussolo and Hans Timmer (DECPG); Karlis Smits and Xiaoli Wan under the guidance of Chorching Goh (EASPR); Jorge Thompson Araujo, Fabio Sola Bittar, Laura de Castro Zoratto, Cornelius Fleischhaker and Aleksandra Iwulska (LCSPE); Thomas Farole, Claire Honore Hollweg, Jose Daniel Reyes, Luis Diego Rojas Alvarado and Swarnim Wagle under the guidance of Mona Haddad, Daniel Lederman and Jose Guilherme Reis (PRMTR). Helpful comments were received by Otaviano Canuto, Indermit Gill and Jose Guilherme Reis, who were the peer reviewers of this report, and the Office of the Chief Economist for Latin America and the Caribbean. A special word of thanks goes to Renato Baumann and his team for organizing a seminar at IPEA and commenting on a draft version of the report. Three staff visits were organized to Brazil (Brasilia, Rio de Janeiro and Sao Paulo). In this connection, the team wishes to thank representatives of government, think tanks, industry associations and companies for helpful discussions: Agencia Brasileira de Desenvolvimento Industrial (ABDI), Banco Nacional de Desenvolvimento Economico e Social (BNDES), Ministerio da Fazenda (MF), Ministerio das Relacoes Exteriores (MRE), Ministerio do Desenvolvimento, Industria e Comercio (MDIC); BRICS Policy Institute, Conselho Empresarial Brasil-China (CEBC), Centro Brasileiro de Relacoes Internacionais (CEBRI), Centro de Estudos de Integracao e Desenvolvimento (CINDES), Fundacao Fetulio Vargas (FGV-Rio), Fundacao Centro de Estudos do Comercio Exterior (FUNCEX), Instituto de Estudoes para o Desenvolvimento Industrial (IEDI), Inter-American Development Bank (IADB, Brasilia Office), Instituto de Pesquisa Economica Aplicada (IPEA), Tendencias; Associacao Brasileira da Industria de Maquinas E Equipamentos (ABIMAQ), Associacao Brasileira das Industria da Alimentacao (ABIMA), Confederacao Nacional da Industria (CNI), Federacao das Industrias do Estado do Sao Paulo, Instituto Aco Brasil; Banco Itau, Bunge Brasil, Embraer and Vale. The team further thanks Adriana Abdenur, Claudio Frischtak, Edith Kikone, Tom Kenyon, Gilberto Libânio, Luis-Felipe Lopez-Calva, Joana Silva and Shahid Yusuf for helpful comments and suggestions, Mauro Azeredo, Paula Castello Branco, Marcela Sanchez-Bender, Juliana Braga Machado and Mariana Kaipper Ceratti for external relations support, and Fernando Viana Braganca, Patricia Chacon Holt, Angela Nieves Marques Porto and Diana Mercedes Lachy Castillo for office support. 7 EXECUTIVE SUMMARY As Brazil and China have become two of the largest global economies, they have also become increasingly connected. Three decades of fast-paced growth and structural change have turned China into the world’s second-largest economy and have transformed it into an upper- middle income country. Brazil, which had experienced its own episode of high growth between 1965 and 1974, has also become one of the largest economies. Over the last decade, Brazil and China have developed increasingly close linkages, which has come as no surprise given the scale of their economies, the complementary structure of resource endowments as well as the differences between the two countries in the structure of production and demand. While the most apparent connection between the two countries is the increased volume of bilateral trade and investment, other important indirect linkages have developed, such as through the influence of Chinese demand on the global prices of Brazil’s commodity exports. The expansion and deepening of connections between the two economies resulted in new forms of partnership as well as competition, and has brought significant benefits to both countries. Given the closer ties between both countries, the question of how the Chinese economy will evolve over the longer term has been of considerable interest to Brazil. In recent years, cyclical and structural factors have combined to slow down China’s economic growth. The slowdown has been further facilitated by a shift in focus by the Chinese authorities from the rate of expansion to the quality of development – as articulated in the 12th Five-Year Plan and reinforced recently by the Third Plenum of 18th Central Committee of China’s Communist Party. Over the longer term, this shift of focus is expected to result in different patterns of growth as well as a growing sophistication of Chinese production and exports. These developments have been followed with much interest in Brazil as well as elsewhere, and have sparked several questions. How the transition to a new growth equilibrium in China can be managed with little disruption to the economies of the rest of the world? What new opportunities as well as challenges might arise from China’s structural transformations? While Brazil’s economy will remain primarily based on its large domestic market, external impulses from a changing China could nevertheless generate a considerable impact. Direct linkages with China – primarily in the form of trade and investment – have grown rapidly from a low base, but relative to Brazil’s large internal market and given its well-diversified economy the direct contribution of these linkages to Brazil’s growth dynamic remains small. Yet, it is on account of indirect linkages – the impact of China on world commodity prices, world interest rates, the availability of lower-priced consumption and capital goods, and more broadly its contribution to global growth – that the relevance of Chinese developments for Brazil has been non-negligible and the impact of change in China going forward will be non-trivial. Furthermore, as this report will argue, how Brazil adapts to the new opportunities and challenges arising from a changing China will also have broader implications for Brazil’s economic links with other countries as well as for its internal growth dynamic. In other words, the changes in China could be a catalyst for reforms that would bring benefits to the Brazilian economy beyond those narrowly related to its interactions with China. 9 This report examines how structural change in China is expected to present new opportunities and challenges for Brazil to enhance its global position and energize growth. Building on recent work (World Bank and Development Research Center, 2013), this report identifies three potential longer-term transformations of the Chinese economy – structurally slower growth, a rebalancing on the demand and supply side, and a move up the value chain – and examines their implications for Brazil. The report shows how the slowdown and rebalancing of China may also present new opportunities for Brazil, even if China’s progression up the value chain is likely to present also new challenges. It lays out how Brazil could generate greater benefits from its interactions with China and how the changes in China would offer a new window of opportunity for Brazil to press ahead with its structural reform agenda. Overall, Brazil could gain tremendously from the anticipated structural changes in China, even though realizing these gains will require a proactive policy stance to enhance external ties and address internal growth and productivity constraints. A CHANGING CHINA IN A CHANGING WORLD China’s Journey of Structural Transformation The last three decades have seen the structural transformation of China into an upper middle-income country and global economic powerhouse. At the beginning of this period, in 1978, China’s per capita income level averaged less than a third of Sub-Saharan Africa’s. Since then, Chinese living standards have improved considerably and more than half a billion people have been lifted out of poverty. China also returned – after an absence of nearly two centuries – to the center stage of the global economy: China became the world’s second-largest economy and import market, the largest producer and exporter of manufactured goods, and the largest holder of foreign exchange reserves. Through these transformations, China exerted increasing influence over the development path of other countries: directly through bilateral trade and financial flows and indirectly through growth spillovers, exchange rate developments, and terms of trade effects. The coming two decades are expected to register continued structural transformation as China enters the next chapter of its development towards a high-income society. While economic commentary has recently focused predominantly on the near-term challenge facing China as it transitions to slower growth, the broader – and perhaps more important – picture relates to the longer-term outlook which will be shaped by profound structural transformations. Three key transformations are anticipated. First, China is expected to register a structural slowdown that could reduce growth rates by 4 to 7 percentage points by 2030. Second, as China rebalances the patterns of growth, the structure of expenditure, production and employment is expected to change significantly. Key features of the rebalancing process include rapid growth of private consumption (between 8 and 11.5 percent through 2030) and services (between 7 and 8 percent). Third, the technological sophistication and human capital intensity of production is likely to rise further in response to rising wage pressures. As China moves up the value chain, it will redefine its competitive advantage in the global marketplace. 10 China in the World: Growing Integration and Mutual Dependence As China continues its transformation into the next two decades, the global footprint of its economy is expected to evolve in new directions. China’s position in the world economy has risen as the country has become more integrated in it. Looking ahead, the transformations underway in China are expected against a backdrop of a world that is also changing: other developing countries, including Brazil, are expected to enhance their role as major driving forces for growth and come to contribute over 40 percent of future global growth. If both China and the rest of the world continue to develop along their changing pathways, the relationship between them is bound to adjust as well. While there may be bumps along the road, the general picture is one of rising mutual dependence as China and the world continue to benefit from closer integration in trade and increasingly also investment and cooperation. Even if China grows more slowly, the fact that such a slowdown occurs against a high base should provide ample opportunities for countries like Brazil to tap into rising Chinese import demand. If China were to gradually halve its growth rate by 2030, it would still be expected to become the world’s largest economy and achieve high-income status. Despite the slowdown, China’s national income would rise through this period, adding the equivalent of approximately one Republic of Korea to the world economy every year. This growth, combined with a rising propensity by Chinese consumers to import, should offer new opportunities for other countries to benefit from increased exports. The patterns of import demand are likely to change though, favoring consumption goods in relative terms over investment goods. Rising labor costs in China are expected to affect production pattern and could trigger a relocation of low-cost manufacturing, creating opportunities for low-wage countries. The pace of this development remains uncertain and depends on the type of manufacturing activity. Recent survey data for the manufacturing-dominated Pearl River Delta show that the preferred response of 61 percent of firms is to raise capital intensity. While some firms may wish to lower costs by relocating overseas, others prefer to remain in proximity to Chinese consumption demand. The grand-scale out-migration of low-cost, labor-intensive manufacturing will therefore unlikely happen overnight and may indeed never play out fully. Moreover, if other countries do not have the collective ability to absorb the manufacturing activities migrating out of China, the most likely trend will be a reversal of the China price effect and a return to pricier manufactured goods. This would dampen the purchasing power of the world’s middle classes whose rise was helped by the availability of cheaper imported goods from China, as was the case in Brazil. China is expected to boost productivity and move up the value chain, which could generate heightened competition in new areas. Past competition from China has challenged the manufacturing sectors of lower-cost producers. As China continues to move up the value chain, this challenge is likely to progressively shift to higher-cost countries. Rising competition with respect to skills and technology-intensive production is expected to generate new pressures onto countries that seek to expand or even maintain their market shares domestically as well as internationally. While rising competition could constrain some countries’ efforts in moving up the value chain, it also presents an opportunity to boost innovation efforts. To remain externally competitive as competition from China rises, entrepreneurial capacity to innovate and political determination to introduce structural reforms that support innovation will be very important. 11 BRAZIL’S EVOLVING LINKAGES WITH CHINA Looking Back: Trends and Characteristics over the Last Decade Initially merely a blip on each other’s radar screens, Brazil and China have developed increasingly close economic connections over the last decade. Bilateral trade and investment linkages have expanded significantly, with China emerging as Brazil’s most important export destination and an important foreign direct investor by the early 2010s. Conversely, Brazil played an increasingly important role in China as a supplier of natural resources and contributor to energy and food security. The two countries also developed cooperation arrangements and agreements in various areas. Even more so, Brazil and China developed economic connections in indirect ways through terms of trade effects, exchange rate developments, and growth spillovers. The multi-faceted economic relationship between Brazil and China is characterized by partnership and competition and has produced both opportunities and challenges. The characteristics of partnership and competition arise from features of complementarity and similarity, which generate opportunities for beneficial exchange but also challenges in the form of competition. While the most discernible interaction has been in the area of bilateral trade (and to a lesser extent Chinese investment), indirect effects have played an important role as well. China’s resource-intensive growth lifted commodity prices, which raised the return to commodity exports and allowed Brazil to build on earlier structural reform efforts and expand its consumption frontier. However, as commodity demand increased, so did the pressure of currency appreciation, which in combination with domestic bottlenecks has hurt the external competitiveness of other sectors, particularly manufacturing. The Brazilian manufacturing sector has borne the brunt of increased competition from China, yet this competition may be receding and changing. The strength of Brazil’s natural resource sector in the face of rising demand from China has meant that the share of Brazilian manufacturing exports in total exports has shrunk, at the same time as that of increasingly sophisticated manufactured imports from China in total imports has been rising. The analysis of Brazil’s competitiveness position suggests that Brazil has lost market share in several overseas destinations – even though Brazil remains more dynamic than China in certain product groups. The analysis suggests that Brazil’s exports remain subject to competition from China even though the strength of that pressure has diminished. In the Latin American region, some 45 percent of Brazilian exports remain subject to significant competition, compared to 29 percent in Europe and 21 percent in the US. Brazilian manufacturing also faced competition from China in the domestic market, which afforded consumption benefits in terms of access to cheaper intermediate and final goods but also led to production displacement of less competitive domestic firms. Between 2003 and 2011, the average import penetration coefficient rose from 12 to 22 percent. 12 Looking Ahead: Impact of a Changing China on Brazil Looking ahead, as the Chinese economy slows, rebalances and moves up the value chain, a key question is how this will affect the economic linkages with Brazil. For this purpose, this report developed illustrative scenarios on the basis of a global general equilibrium model that takes into account the anticipated developments in China as well as their interactions with developments in other parts of the world. The results suggest an overall positive outlook for the Brazilian economy.  Even with slower growth in China, Brazil is expected to be one of China’s fastest- growing import sources. The scenarios suggest a continued and significant rise in China’s share of global imports and imply a continued trend of rising Chinese import demand for key commodities. Brazil is expected to register growth in exports to China at an average of 8-12 percent per year. Thus, even if growth in China slows, it slows from a high base and the rebalancing associated with the inward orientation of the Chinese economy is expected to produce robust consumption demand that would offer new opportunities for Brazil.  Brazil’s natural resource endowments make the country ideally-suited to take advantage of rising Chinese demand for agricultural and food products. Increased protein demand is expected from China as its population becomes wealthier and food habits change, creating higher demand for soybeans and meat. Industrial commodities such as iron ore may benefit comparatively less as China moves away from its investment-led, resource-intensive growth model even though the sustained strength of demand for residential housing and consumer durables continues to present opportunities for such commodities.  Brazilian manufacturing is expected to face changing competition as well as new market opportunities as China moves up the value chain and rebalances. As China carves out new niches to retain its global competitive advantage in manufacturing, the knowledge intensity and technological sophistication of Chinese manufacturing is expected to rise. Recent indicators such as patent registrations indicate that this process is occurring at a rapid pace. This, in turn, should generate a new wave of competition for Brazilian manufacturing. At the same time, however, new opportunities will open up for Brazilian manufacturers across the technology spectrum as China continues to expand its domestic market.  The changes in China present an opportunity for Brazil to improve the efficiency of its services sector and expand its international reach. To the extent that services productivity in China remains insufficient to meet rising demand domestically, there may be large opportunities for countries to export tradable services to China. The simulations suggest that higher-income countries would be best positioned currently to tap into this opportunity, but it would also present an opportunity for Brazil, providing it can strengthen the efficiency of its services sector. 13 POLICY IMPLICATIONS FOR BRAZIL Growth Expectations and Structural Reform Over the last decade, Brazil has seen a significant growth acceleration followed by a recent moderation against a backdrop of changing demand pressures and structural change. Brazil registered high growth from 2004 to 2008 benefiting from both domestic and external tailwinds, which have faded in strength and produced lower growth since 2009. The recent growth slowdown took place against a backdrop of inflationary pressures and tight labor market. In addition, productivity growth has been relatively sluggish and Brazil is undergoing a demographic transition that has led to a deceleration of growth of the working-age population. The above factors have caused concern that the relatively slow growth rate Brazil is currently experiencing reflects a diminished structural growth capacity. Even though significant progress has been made in various areas, the structural reform agenda remains unfinished while the urgency to press ahead has increased. In addition to the macroeconomic reforms that provided economic stability, Brazil liberalized significant parts of the economy and introduced reforms in education and health during the 1990s. During the 2000s, reforms continued, particularly in the financial and social sectors. However, the structural reform process may have lost some momentum as the urgency of addressing difficult supply-side issues receded in the wake of buoyant consumption growth, an external commodity boom and an international environment of low global interest rates. Therefore, important bottlenecks remain to be addressed, particularly in infrastructure, labor markets and the tax system. With growth slower now and the external environment less favorable, the urgency to press ahead with the reform agenda has increased. Scope for Enhancing Global Integration With growth having slowed, the question of how Brazil can leverage its connections with China has become more pertinent than before. Brazil will likely remain an economy propelled mainly by its internal market. At the same time, the recent growth acceleration and subsequent deceleration were not just related to internal factors but also to external ones. Chinese economic developments played a significant role. As China undergoes structural change, new opportunities will avail themselves. It is clear that the way in which Brazil responds to these will have implications that go beyond the confines of the Brazil-China relationship. For example, to the extent that heightened competition from China in high-end manufacturing fuels innovation effort in Brazil, this would not only benefit Brazil’s external competitiveness but also infuse productivity improvement into the domestic growth dynamic. Herein lies the real significance of Brazil’s changing linkages with China: the extent to which evolving connections contribute to transforming the supply side of the Brazilian economy. As mentioned earlier, the recent slowdown of growth in an environment of elevated inflation, has led to concerns about whether the underlying growth capacity of the Brazilian economy has declined. To the extent that the windfalls of the boom years contributed predominantly to the expansion of domestic consumption as opposed to investment, the result has been a pick-up in headline growth but not a corresponding expansion in the capacity of the economy to deliver more rapid growth on a sustained basis and in a non-inflationary manner. 14 Looking ahead, the transformations anticipated in China are expected to play out in Brazil’s favor to a large extent, generating therefore a new window of opportunity to leverage on the external connections and enhance underlying growth. Scope remains for Brazil to derive benefits from global integration. The Brazilian economy remains relatively inward-oriented and therefore there is potential for continued integration into the global economy alongside ongoing efforts to further develop and integrate the domestic market. In addition, this report suggests that Brazil does not have a ‘concentration problem’ with respect to its external orientation to the world either in terms of markets or products. However, an asymmetry stands out in terms of the relations with China, where Brazil is much less diversified in terms of products on the export than on the import side. While this result carries through to other countries’ relations with China, it also points to opportunities going forward to broaden and deepen linkages. Finally, while Brazil’s exports to China are concentrated on natural resource-related commodities, there is nothing intrinsically wrong with exporting commodities, provided efforts are made to ensure that the natural resource sector contributes to the economy more broadly and that its development does not come at the expense of other sectors. Leveraging Brazil’s Connections with China Alleviating home-grown supply-side constraints represents one way in which Brazil could leverage on its changing connections with China. Productivity-enhancing reforms would not only contribute to home-grown economic dynamism; it would also allow Brazil to better leverage its evolving connections with China. Important areas where further structural reform effort would help Brazil accelerate growth include the investment climate (ranging from reducing the administrative burden of the state, improving the quality and profile of public spending, strengthening the goods and labor market) as well as physical and human capital accumulation (strengthening logistics and enhancing the skills base of the work force). A more favorable investment climate and more investment in infrastructure and skills would also position Brazil better to tap into Chinese demand. It would also position the country better to meet increased competition in higher-end manufacturing. Brazil faces opportunities to enhance productivity and take full advantage of its connections with China in all sectors of its economy. Opportunities exist in all sectors to increase productivity and respond to rising demand going forward. Similarly, all sectors hold significant potential to do better in terms of their productivity performance. Moreover, the performance of any single sector has come to depend more than ever before on the performance of other sectors given that products have become bundles of value-added derived from different sectors. Therefore, the objective of raising productivity would favor a comprehensive approach that tackles bottlenecks across sectors, as has been well recognized by the Plano Brasil Maior.  Natural Resources: Widening Economic Impact. With the demand for Brazil’s natural resources expected to remain strong, the challenge will be to respond to robust demand by enhancing the economy-wide potential of the sector. The possible pitfalls of buoyant natural resource demand are well understood. The recent discovery of vast offshore oil reserves in Brazil adds to these opportunities and challenges. The appropriate response will not be to limit commodity exports or to erect costly import barriers to protect 15 domestic industries, but rather to alleviate demand and supply constraints on productive activity by improving infrastructure, creating a conducive investment climate, and facilitating private sector access to capital, skills, technology, and markets.  Manufacturing: Strengthening Competitiveness. Insofar as China will remain a competitor, the need to enhance external competitiveness will likely become more significant as China moves up the value chain. The prospect of changing competition underscores the need for Brazil to redouble its efforts to foster innovation and strengthen external competitiveness. Upgrading will not only help withstand competition from China, it will also enable Brazil to better tap into emerging opportunities in China. Brazil will need to build its endowments of human and physical capital in order to develop comparative advantages in manufacturing products that China imports intensively.  Services: Raising Efficiency. While the need to raise productivity is relatively well understood, the role of the services sector is generally less than fully articulated in the domestic debate on productivity. However, large segments of the services sector remain largely informal and are found to be expensive and of poor quality. Services inflation has outpaced that of other sectors as a result of rapid wage increases – partly tied to minimum wage adjustments – and has led through the wage-price spiral to rising unit labor costs that have dampened industrial competitiveness. Strengthening the efficiency of services would bring large benefits to the Brazilian economy. Services play a key role in economic growth and job creation and improvements in the productivity, quality and range of services would have positive spill-over effects for the productivity and competitiveness of other sectors of Brazil’s economy. In addition to advancing the domestic reform agenda, this report argues that further improvements to the external environment for trade and investment could strengthen Brazil’s development prospects. Given their importance in the bilateral relationship, the discussion focuses on trade and investment. While the report also offers perspectives on how China could contribute, the focus will be on Brazilian policies. Finally, the trade and investment agenda is closely related to Brazil’s domestic agenda of generating productivity growth and therefore needs to be seen in conjunction with the previous section. Possible ways to improve the external environment include the following:  Trade Policies. Significant progress has been made in lowering tariffs but tariff barriers remain high in Brazil and China. In addition, both countries impose higher barriers on products where the other has a comparative advantage. Together with tariff escalation, this has particularly affected Brazil’s ability to diversify into higher value -added exports to China. Trade in services remains relatively unencumbered but the degree of openness varies depending on the mode by which services are delivered (e.g. cross-border supply or overseas commercial presence). Non-tariff measures are ubiquitous and pose economically important trade barriers to both countries and the use of temporary trade barriers has caused additional frictions in the trade environment. Further progress is also needed on the regional trade agenda. 16  FDI Policies. While Brazil has a highly liberal policy regime for FDI, however, the de- facto process of setting up a foreign-owned subsidiary remains relatively cumbersome – taking more than 2.5 times longer than in China. Brazil holds potential for broadening and deepening its FDI in China, especially in services. The growing impetus for outward FDI from China will also benefit Brazil, where it can be expected that the composition of such flows will become more diversified. A changing China is expected to bring about a new window of opportunity for Brazil to leverage on its external connections and augment the domestic engine of growth. Brazil will face many new opportunities to benefit from a changing China insofar as the two economies are expected to become more complementary in that the demand for Brazil’s natural resources is expected to rise, even if new competitive challenges are also likely to arise as China continues to move up the value chain. Seizing these opportunities as well as meeting the challenges would however require additional efforts on the domestic structural reform agenda as well as with respect to the environment for cross-border trade and investment. Further progress in these areas would not only allow Brazil to derive greater benefits from its connections with China but also provide impetus more broadly to productivity and growth. 17 18 INTRODUCTION This report explores the implications of a changing China for Brazil and examines whether these changes may present a new window of opportunity for Brazil to accelerate growth. By way of introduction, it is useful to first provide context by examining Brazil’s growth path in recent decades along with the importance of the growing connections with China over the last decade. Next the significance of the possible changes in China – particularly over the longer term – are discussed with reference to the evolving economic linkages between Brazil and China. This introduction concludes with an overview of the objective, scope and structure of this report. IN CONTEXT: BRAZIL’S GROWING CONNECTIONS WITH CHINA Brazil’s post-war era is marked by a prolonged episode of fast-paced growth, intermittent bouts of macro instability, and – until recently – a period of renewed growth momentum. Between 1947 and 1980, Brazil grew at an annual average rate of 7.5 percent. Rivaling the likes of South Korea, Brazil reached upper-middle income status on the back of a sophisticated business community and one of the world’s largest internal markets. The following two decades saw much slower growth (2 percent between 1981 and 2003), with the Latin American debt crisis of the early 1980s setting off a period characterized by macro instability and stabilization efforts. Inflation was brought under control with the Real plan in 1994, which led to a brief pick- up in growth, which was however interrupted again by the currency crisis of 1999. Subsequently, Brazil introduced inflation-targeting and strengthened its fiscal policy framework. Over the last decade, Brazil experienced a period of renewed growth momentum, starting in the mid-2000s (4.8 percent between 2004 and 2008), which in recent years has lost some of its strength (2.7 percent between 2009 and 2012). The recent pick-up and subsequent moderation of growth was related to not only forces internal to Brazil but also major changes in the external environment. With Brazil’s new macroeconomic framework laying the foundation for renewed growth, financial reforms contributed to a long cycle of credit expansion whereas well-targeted social programs and rapid growth of the formal labor force enlarged the size of the middle class and reduced poverty and inequality. The growth impulse of these internal forces was reinforced by external factors as Brazil benefited from record-low world interest rates, buoyant capital flows and favorable terms of trade. The 2008/09 financial crisis caused a short recession but growth resumed soon thereafter at 7.5 percent in 2010. Since then, however, the economy has slowed significantly as the long cycle of credit expansion came to an end and infrastructure bottlenecks and labor market constraints became more prominent with unemployment at historic lows around 5 percent and the working-age population growing more slowly. External factors again contributed significantly as the slow U.S. recovery, long recession in much of Europe and slower growth in the emerging world dampened Brazil’s exports, commodity prices and investment. An important aspect underlying the changing external environment faced by Brazil as well as other countries has been the rise of China to the global stage. China’s transformation over the last three decades into an upper-middle income country has lifted the country to the center stage of the global economy: China became the world’s second-largest economy and import market, the largest producer and exporter of manufactured goods, and the largest holder of foreign exchange reserves. Through this transformation and particularly over the last decade, 19 developments in the Chinese economy have exerted increasing influence on other countries: directly through an increase in trade and financial flows and indirectly through growth spillovers, exchange rate developments and terms of trade effects due to higher prices for commodities and lower ones for manufactured goods. Conversely, given the importance China has attained in the global economy, the recent slowdown of the Chinese economy has affected the direction and intensity of these cross-border effects. Brazil and China have over the last decade developed increasingly close economic linkages. Bilateral trade and investment linkages have expanded significantly, with China emerging as Brazil’s most important export destination and an important foreign direct investor. Conversely, Brazil played an increasingly important role in China as a supplier of natural resources and contributor to energy and food security. The two countries also developed cooperation arrangements in various areas. The development of these linkages came as no surprise given the size of the two economies, the complementary structure of their resource endowments as well as the differences between the two countries in the structure of production and demand. While these linkages developed at a fast pace from a low base, their importance in Brazil’s overall growth dynamic needs to be placed in perspective. On the one hand, the significance of direct linkages with China must not be overstated as exports to and imports from China only represent a couple of percentage points of Brazilian GDP. Brazil also remains a well-diversified economy: it produces a broad range of products and exports these to a wide range of trading partners. On the other hand, the impact of China goes well beyond any direct effects. A number of important – but harder to measure – indirect effects need to be taken into account (e.g., China’s impact on commodity prices, the new consumption possibilities afforded by lower- priced consumer goods imports from China, and the efficiency enhancements arising from the availability of cheaper capital goods). While these external tailwinds are widely believed to have raised the pace of economic growth, Brazil remains an economy primarily driven by the independent growth dynamic of its large domestic market. THE OUTLOOK: RELEVANCE OF A CHANGING CHINA FOR BRAZIL The question of how the Chinese economy will evolve over the longer term has been of considerable interest to policy makers and the business community in Brazil. While their pace and timing is subject to uncertainty, three anticipated developments in China have been of key interest to Brazil. First, as the Chinese labor force shrinks and China becomes more oriented towards services, growth is likely to structurally slow, hereby affecting the relative strength of import demand and overseas investment. Second, as China rebalances its growth model, the patterns of production and expenditure are expected to shift in favor of services and consumption relative to manufacturing and investment, thereby affecting the relative patterns of import demand for commodities and creating new opportunities for Brazilian exports. Third, as wages continue to rise, China will need to raise productivity and move production and exports up the value chain, which could mean intensified competition for higher-cost countries such as Brazil. The discussion in Brazil about the impact of a changing China has been surrounded by a considerable degree of negativism, which is unwarranted as this report will argue. Brazil and China have over the last decade established a relationship of partnership and competition. Looking ahead, it appears that along both of these dimensions there is considerable negativism 20 about the impact of prospective developments in China. Insofar as Brazil and China have forged a close partnership in the trade of natural resources, the prevailing concern is that a slowing and rebalancing China would hurt the commodity trade as both the rate and patterns of import demand would negatively affect Brazil. Insofar as the two countries are competitors such as in medium and high-end manufacturing, the concern is that China’s moving up the value chain will heighten the competition on Brazilian industries and cause further deindustrialization. The question of how Brazil could leverage its external connections with China to energize its own growth engine has become more pertinent than before. Following a recent growth slowdown amidst elevated inflationary pressures, concerns have emerged in Brazil about a reduction in the country’s structural growth capacity. As this report will argue, how Brazil adapts to the new opportunities and challenges arising from a changing China will also have broader implications on how Brazil could improve its global competitiveness as well as how it could energize its domestic growth dynamic. Herein lies the real significance of Brazil’s closer ties with China: the extent to which the bilateral relationship could contribute to transforming the supply side of the Brazilian economy and how these transformations enhance the capacity of the Brazilian economy to grow on a sustained basis in a non-inflationary manner. THIS REPORT: OBJECTIVE, SCOPE AND STRUCTURE This report examines how structural change in China will present new opportunities and challenges for Brazil to improve its global competitiveness and energize growth and productivity. Building on the recent China 2030 report (World Bank and Development Research Center, 2013), this report presents scenarios for the development of the Chinese economy over the next two decades and examines the implications for Brazil. The report shows how the slowdown and rebalancing of China may present new opportunities for Brazil, even if China’s progression up the value chain will present new challenges. It also lays out how Brazil could gain greater benefits from its interactions with China but also shows how changes in China increase the urgency of completing Brazil’s structural reform agenda. Overall, the report presents a narrative of conditional optimism: Brazil could significantly benefit from the anticipated structural changes in China, even though realizing these gains will require a proactive policy stance to enhance external ties and address internal growth and productivity constraints. In terms of scope, this report will emphasize the Brazilian angle, focus on trade and investment, and offer broad rather than specific policy guidelines. First, the focus of the report will be on the impact of a changing China on Brazil, where the anticipated changes in China are taken as a starting point and eventually the focus is on the impact on Brazil. The other side of the coin, i.e. the impact of Brazilian developments on China, while interesting and relevant in itself, is left outside the scope of this report. Second, the report will emphasize economic interactions in the areas of trade and investment – which have thus far represented the most important linkages – abstracting thus from other types of bilateral linkages such as bilateral and multilateral cooperation. Third, the report will emphasize longer-term economic developments that are expected to affect the external environment Brazil is facing and based on these, will lay out general policy directions or areas of reform that demand urgency, leaving specific, more targeted suggestions for future work. 21 The remainder of this report is structured as follows:  Part 1. A Changing China in a Changing World. The first part centers on China and its changing development trajectory over the last three decades and the next two. The purpose of this part is to motivate scenarios that will be analyzed with reference to Brazil and situate the development of China and its cross-border impact in the context of a global economic environment subject to change.  Part 2. Brazil’s Evolving Linkages with China. In a second part, the evolving economic linkages between Brazil and China are examined: how they have come about, what they consist of, and how they would be affected by a changing China. Focusing on trade and investment, this second part will provide a structured analysis of the implications of different scenarios of a changing China.  Part 3. Policy Implications for Brazil. The third part of the report considers the policy opportunities arising from the anticipated changes in China and their projected implications for Brazil. This third part will be primarily focused on Brazil and lay out how ties with China could be enhanced and how Brazil could accelerate growth of its economy by leveraging on its external connections with China. 22 PART 1. A CHANGING CHINA IN A CHANGING WORLD China’s stellar growth record during a period of unprecedented global integration has raised the question to what extent this remarkable performance can be sustained into the future. Three decades of rapid growth and structural change have transformed China into an upper middle-income country and global economic powerhouse. This stellar performance occurred against a supportive global backdrop that enabled China to develop increasing interactions with the rest of the world as well as wield increasing influence across its borders. Meanwhile, it has become evident that China has entered a phase of slower growth and is facing structural challenges to transition into a new growth model. It has also become clear that the global environment is significantly different compared to a decade ago. I. CHINA’S JOURNEY OF STRUCTURAL TRANSFORMATION Following three decades of rapid growth and structural change, China has arrived at a crossroads indicating a new direction for the next two decades. The last three decades saw some remarkable transformations, which led to considerable improvements in Chinese living standards but were also associated with rising imbalances in a number of spheres. Looking ahead, the question is whether the growth dynamic can be sustained into the future. The answer offered below is that this has become increasingly unlikely. China is currently at a cross-road, which carries with it both the opportunity and the challenge to maintain the momentum of the makeover of the Chinese economy. This section will identify key transformations that are expected to shape economic developments in China over the coming two decades. A. The Past Three Decades: China’s Journey of Economic Reform Over the last three decades, China experienced an economic transformation through fast- paced growth and structural change (Table 1, Figure 1 and Figure 2). A key aspect of China’s economic transformation was the change from a command-based economy to a more decentralized system with a greater role for the market mechanism. Another important change occurred through urbanization, where China transformed itself from a primarily rural, agricultural economy into an increasingly urban one with a more diversified economic structure. Together, market orientation and urbanization coalesced to produce large efficiency gains and made it possible for China to sustain rapid growth that averaged 10 percent annually over three decades. Industry and services grew most rapidly on the production side, with agriculture registering a diminishing relative importance despite solid growth. On the expenditure side, the key growth drivers were in the first place rapid investment growth as well as sustained consumption growth. Exports and imports grew quickly too, even though on a net basis their direct contribution to GDP was more limited. This economic transformation led to considerable improvements in living standards, which allowed the country to quickly climb up the income ladder (Figure 3). In 1978, the year that marked the beginning of China’s opening up and economic transformation, the country’s per capita income stood at merely one third of the average income in Sub-Saharan Africa. Compared to Brazil and South Korea, which both had enjoyed a period of strong growth in the 1960s and 1970s, China’s income was just one tenth. China did catch up, however, very quickly and managed to realize significant advances in per capita income terms. Considering its per capita 23 Table 1. Industrialization and capital accumulation Figure 1. Industry dominated the supply side, with fueled growth, among other factors services becoming more important Decennial growth rates (real, annualized, percent) Share in GDP by production (percent) 50 46 47 1980s 1990s 2000s 1981 42 1991 GDP 9.4 10.5 10.5 40 2001 Agriculture 6.2 3.8 4.2 32 2011 Industry 9.6 13.6 11.5 30 22 Services 12.4 10.9 11.2 20 Consumption 9.5 10.2 6.3 12 Investment 11.0 11.6 13.6 10 Exports 3.0 16.2 18.6 Imports 6.2 17.9 15.3 0 Agriculture Industry Services Source: National Bureau of Statistics of China; World Bank staff calculations. Source: National Bureau of Statistics, China; World Bank staff calculations. Figure 2. On the demand side, investment and trade Figure 3. As a result of rapid growth, China climbed up rose relative to GDP, but consumption fell the income ladder quickly Share in GDP by expenditure (percent) Gross national income per capita (current US$, Atlas method, logs) 70 66 High South Korea 1981 60 1991 51 10000 2001 Upper 50 44 2011 middle Brazil 40 Lower 33 33 middle 28 30 1000 Sub-Saharan Africa 20 13 12 Low Low 10 5 1 China 0 100 Cons. Inv. Exports Imports Net exports 1978 82 86 90 94 98 02 06 10 Source: National Bureau of Statistics, China; World Bank staff Source: World Development Indicators; World Bank staff calculations. calculations. Note: Light gray lines are WB income classification thresholds. gross national income expressed in current dollars and adjusted for exchange rate fluctuations, China became a lower-middle income country in 1998 and joined merely a decade later in 2010 the upper-middle income league. By 2012, Chinese per capita income stood at four times the level of Sub-Saharan Africa’s, one half of Brazil’s and one quarter of South Korea’s. China’s rapid growth and change into a more diversified economy created plenty of income-earning opportunities that led to significant improvements in living standards. In the process, China reduced the national poverty rate from 65 percent to below 10 percent and lifted over a half a billion people out of poverty. While benefitting the country in many respects, rapid growth and structural change have also resulted in a series of imbalances. Spurred by high savings, cheap finance and other inputs and export-oriented policies, the expansion of industry stunted the development of the services sector, particularly in productivity terms, while the focus on physical capital accumulation constrained investment in human capital (Bosworth and Collins 2008). With wages lagging productivity growth, the wage share in national income was a mere 47 percent in 2011, with the 24 consumption share at comparatively low levels for a major economy. Income disparity widened and social imbalances were exacerbated by unevenness in access to basic public services and by tensions surrounding land transactions. Furthermore, the scale and concentration of industrialization as well as pace of urbanization meant that China became the world’s largest energy user and fast growth led to serious environmental pollution. Finally, many of the policies that produced internal imbalances also contributed to external imbalances that have fueled protectionist pressures in key foreign markets. B. The Next Two Decades: A New Phase in China’s Development The China 2030 report identifies three structural transformations that are likely to guide China into a new phase of its development. These transformations reflect underlying structural developments relating to demographics and other factors as well as policy directions that have been laid out in the China’s 12th Five-Year Plan as well as the recent Third Plenum of the 18th Central Committee of the Communist Party of China. The first transformation is that China, like other developing countries, is likely to slow down, but, depending on the scenario, the slowdown could be more significant than elsewhere given the high growth rates enjoyed in the recent past. The second transformation concerns the shift in the pattern of growth, which will likely be driven on the demand side by a rise in consumption and imports and on the supply side by a rebalancing in favor of the services sector. The third transformation relates to the patterns of production and trade, where China is expected to gradually move up the value chain and hereby increase the sophistication of its output and exports. The implications of these transformations for Brazil will be assessed on the basis of global scenarios that were developed using the World Bank’s Envisage model (Appendix A).1 Recognizing that the analysis of structural change does not permit the mere extrapolation of past trends, it is necessary to resort to model-based assessments that provide a structured way of analysis of the implications of the changes. In addition, given the uncertainties about the depth and breadth of China’s transformations as well as of the changes that are likely to occur in the rest of the world, it is necessary to recognize the degree of uncertainty by developing illustrative scenarios that are based on reasonable assumptions about certain structural changes. Transformation #1: China Registers a Structural Slowdown Due to slower growth in recent years, economic commentary on China has increasingly focused on the downside risks to the near-term outlook. Weaker global growth and tighter domestic policies have combined over the last few years to slow Chinese GDP growth from 10.4 percent in 2010 to 7.8 percent in 2012. Against this backdrop, concerns have heightened about domestic risk factors related to local government debt and credit-levered exposure to real estate. As a result, the recent economic commentary on China has become preoccupied with the tail risk of a hard landing, even if the baseline scenario of most observers, including the World Bank’s, remains for a gradual and orderly slowdown (World Bank 2013). 1 The global scenarios correspond to those presented in Part II Chapter 5 of World Bank and DRC (2013). 25 Adding to the short-term uncertainty is the expectation that China will experience a structural slowdown in the longer term. China appears to be in a situation where its economy is registering a cyclical slowdown against the backdrop of slowing potential growth. While the traditional driving forces of growth are far from exhausted, many signs suggest that they are likely to gradually weaken over time (Eichengreen, Park, and Shin 2011):  Much of the growth obtained by shifting resources from agriculture to industry has already occurred. Going forward, the continued accumulation of capital, although sizable, will inevitably contribute less to growth as the capital-labor ratio rises, even though further capital accumulation will be needed given that China’s current capital stock per worker is estimated at only about a tenth of the U.S. level.  China is poised to go through dramatic demographic change. The old-age dependency ratio will double in the next two decades, reaching the current level of Norway and the Netherlands by 2030 (between 22 and 23 percent), and the size of China’s labor force has started to shrink, dampening savings and therefore investment and growth. Yet workers will become more productive as the physical and human capital stock per worker continues to rise. These demographic changes should have a sizable impact on the rate of potential growth (Cai and Lu 2013).  Total factor productivity growth (a measure of improvements in economic efficiency and technological progress) is expected to decline, in part because the economy has exhausted gains from first-generation reforms and the absorption of imported technologies that were relatively easy to access, adopt, and adapt. As a result, the distance to the technological frontier has shrunk, and second-generation policy reforms are likely to have a smaller impact on growth. To capture these longer-term uncertainties in China as well as elsewhere, the following two scenarios are considered.  The first scenario foresees significantly lower growth due to an aging population and a shift into lower-productivity services. Technological progress within sectors is assumed to continue at the pace it was previously. Population aging will constrain labor force growth and reduce savings and hence investment rates and lower growth. In addition, the demand for services will rise as countries become richer (given that the income elasticity of services is typically larger than unity) or grow older (given the rising demand for health and public services). This will boost the services sector, but given that productivity growth in services is typically lower than in other sectors, the shift in services will result in lower economy-wide productivity growth as well. 2 2 Bosworth and Collins (2007) report that total factor productivity (TFP) in China’s services sector grew at 1.9 percent annually between 1978 through 2004, whereas industry TFP grew at 4.4 percent. During the shorter period of 1993 through 2004, services TFP grew at only 0.9 percent, whereas industry TFP picked up to 6.4 percent. 26  The second scenario is characterized by sustained growth at high levels thanks to productivity-enhancing structural reforms. Specifically, growth at elevated levels can be sustained because of productivity-enhancing reforms and innovations, especially in the services sector. This higher productivity is supported by globalization of both the production and consumption of services, boosting innovation, competition and economies of scale. Thus, even if on the demand side there is a pull into services, the corresponding shift of production does not lead to a result in significantly lower aggregate productivity growth and therefore overall economic growth. Figure 4. By 2030, China’s could grow 4 to 7 percentage points more slowly than in 2010 Average annual GDP growth (percent) 12 11.2 11.2 10.5 9.5 10 8.5 8.4 8 6.9 6.2 6 4.9 4 3.5 2 0 Low High 2005-10 2010-15 2015-20 2020-25 2025-30 Source: World Bank and Development Research Center of the State Council 2013. Note: Actuals for 2005-10. Other values are simulated with Envisage. Depending on the effectiveness of services sector reform, the illustrative scenarios suggest that long-term growth could slow down by anywhere between 4 and 7 percentage points (Figure 4). Whereas in the high-growth scenario growth is expected to settle at 6.9 percent by 2025-30, the low-growth scenario would be characterized by much-lower growth at 3.5 percent. This would represent a decline in the growth rate by 7 percentage points compared to 2010 (compared to 4 percent for the high-growth scenario). Transformation #2: China Rebalances the Patterns of Growth Not only is China’s rate of economic growth likely to decline, the pattern of growth is also expected to change as the components of demand grow at different speeds (Table 2). The low-growth scenario foresees a pick-up in private consumption growth, whereas investment growth is expected to decelerate gradually turning into an actual decline by the year 2030. Exports continue to grow, albeit at a decelerating pace, whereas imports register also slower growth. The high-growth scenario in turn projects an even faster pick-up in private consumption, whereas the deceleration in investment is dampened. Predictably, export and import growth are more buoyant in the high-growth scenario, with the stronger pick-up in domestic demand leading to rising import demand. 27 Table 2.The two scenarios foresee rather different expenditure growth patterns through 2030 Average annual growth rate (percent, constant prices) 2005-10 2015-20 2025-30 Low-growth scenario GDP 11.2 6.2 3.5 Private Consumption 5.9 9.4 7.0 Public Consumption 10.1 4.8 4.0 Investment 14.1 4.2 -3.0 Exports 13.0 6.7 4.3 Imports 11.4 7.5 3.7 High-growth scenario GDP 11.2 9.5 6.9 Private Consumption 5.9 13.2 10.3 Public Consumption 10.1 9.6 7.3 Investment 14.1 6.6 -0.5 Exports 13.0 9.5 7.9 Imports 11.4 10.7 7.4 Source: World Bank staff simulations Note: Actuals for 2005-2010. All other values are simulated with Envisage. This process is expected to lead to considerable ‘internal rebalancing’ as well as some ‘external rebalancing’ (Figure 5 and Figure 6). In both scenarios, China manages to realize a significant reorientation of its economy towards private consumption. This is accompanied by a significant decline in the share of investment in GDP, particularly in the low-growth scenario.3 China is expected to continue its integration into global economy, even though the share of net trade in GDP declines somewhat. The slow-growth scenario depicts a somewhat less favorable environment for export and import growth. The share of net trade is expected to decline somewhat to about 3 percentage points of GDP. On the supply side, the Chinese economy would see a larger shift to services (Figure 7 and Figure 8). In both scenarios the services sector is the fastest growing one in volume terms. This results from the changing demand patterns outlined earlier, including population aging and the rising propensity to consume services as incomes rise. In terms of value share in GDP, however, services rise a lot more quickly in the low-growth scenario. This is because the low-growth scenario is associated with lower productivity growth in the services sector which constrains the supply of services at a time when demand is rising, thus producing an increase in the relative price of services. This effect is much less pronounced in the high-growth scenario where services productivity is boosted through productivity enhancing reforms, which would entail also a redistribution with the services sector towards higher-productivity services. 3 Despite a significant drop in the investment rate the capital stock to output ratio increases very slightly from 2.4 in 2004 to 2.5 in 2030. This is in the range of the US capital to output ratio which reaches 2.6 by 2030, but significantly lower than that same ratio for the EU (3.1) or the rest of high income countries (3.4), but also lower than the rest of East Asia (2.9). 28 Figure 5. The share of private consumption in GDP Figure 6. The high-growth scenario is associated with a rises considerably in the low-growth scenario stronger degree of rebalancing Low-growth scenario High-growth scenario Share in GDP (percent, current prices) Share in GDP (percent, current prices) 70 70 2010 2030 2010 2030 60 60 50 50 40 40 30 30 20 20 10 10 0 0 Private Public Investment Exports Imports Private Public Investment Exports Imports cons. cons. cons. cons. Source: World Bank staff simulations Source: World Bank staff simulations Note: Actuals for 2010; 2030 values are simulated with Envisage. Note: Actuals for 2010; 2030 values are simulated with Envisage. Figure 7. On the production side, the services sector is Figure 8. Price increases make the share of services rise expected to see most rapid growth more in the slow-growth scenario Average annual growth rate between 2010 and 2030 (percent) Share in total value added (percent) Agriculture and food 7 Agriculture and food 3.2 5.6 average 6 GDP growth Low-growth 10 Low-growth Energy and mining 5.3 Energy and mining 8 2010 Manufacturing 30 Manufacturing 4.2 11 2030 Services 53 Services 6.9 75 7.1 average Agriculture and food 8 Agriculture and food 3.3 GDP growth 7 High-growth High-growth Energy and mining 11 Energy and mining 6.7 12 Manufacturing Manufacturing 33 6.3 25 Services Services 49 8.2 57 0 2 4 6 8 10 0 20 40 60 80 Source: World Bank staff simulations. Source: World Bank staff simulations. Note: Values for both 2010 and 2030 are simulated with Envisage. Note: Values for both 2010 and 2030 are simulated with Envisage. The evolving patterns of growth are expected to reduce social and environmental imbalances. Income inequality would likely flatten and eventually decline as: (i) faster growth in the middle and western regions would further reduce the gap with coastal areas; (ii) migrant wages would continue to rise rapidly, reducing the income gap with urban residents; and (iii) as urbanization continues, rural-urban migration would likely slow as the structural shift from agriculture to manufacturing eases and the rural-urban wage gap narrows. Finally, China would likely consume energy less intensively and produce less pollution. This is because it would have less industry and, within industry, less heavy and dirty industry, largely because of better pricing of energy, commodities, and environmental degradation. 29 Transformation #3: China Moves Up the Value Chain China’s growth success has been mainly the result of rapid productivity growth. The growth of labor productivity—a key indicator of economic efficiency and a fundamental determinant of real wages—was sustained at high levels, particularly in industry. China’s performance in industry has been closely tied to its ability to facilitate industrial upgrading, and, during its recent past, China has gone through several such stages. As a result, the structure of production and exports has progressively shifted from resource-intensive raw materials and primary products to labor-intensive manufacturing of textile and clothing, and eventually machinery, electronics, and other products supported by more sophisticated production processes. Figure 9. The sophistication of China’s exports is Figure 10. China’s technological catch-up is expected to growing quickly continue at a rapid pace Index of product sophistication relative to Japan Growth in USPTO utility patents granted, 2000-10, 100 1988 1990 1995 2000 2005 2010 average annual growth in percent 40 80 China 30 60 India 20 40 South Korea Hong Kong SAR 20 10 Taiwan PRC 0 Japan 0 South China Russia India South Brazil 10 100 1000 10000 100000 Korea Africa Source: World Bank staff calculations. Number of USPTO utility patents granted, 2000, log scale Note: Index is EXPY relative to Japan’s, with PRODY averaged over 2000-09. EXPY maps export mix into per capita income level typical Source: United States Patent and Trademark Office and World Bank of the development level of the countries that produce such goods. staff calculations. China’s 12th Five-Year Plan lays the foundation for the country’s aspiration to move further up the value chain as a source for sustained productivity growth. For China to sustain relatively rapid growth and maintain its competitiveness in the global marketplace, the key is to sustain productivity growth. China has already made significant progress in strengthening its technological capabilities and upgrading the technological sophistication of production and exports (Figure 9 and Figure 10). These efforts were supported by large investments in physical infrastructure, such as logistics, renewable energy, and communications. In addition, China’s expanding education system and large supply of workers with science and engineering skills bode well for the future (World Bank, 2012b). China is expected to continue to advance up the value chain by deepening human capital and technological capability. China is expected to further deepen its human capital base and to impart the flexible core competencies that workers of the future will need to remain productive across their working lives in the face of rapid technological change and structural shifts in China’s labor market. Rising educational standards and brisk growth in tertiary education will position China well to move up the value chain. In addition, China is expected to upgrade its technological capabilities by fostering a learning and research environment that encourages new ideas and lateral thinking and gradually making the pursuit of innovation more sensitive to market signals, with the government playing a more facilitating role (World Bank, 2012b). 30 II. CHINA IN THE WORLD: GROWING INTEGRATION AND MUTUAL DEPENDENCE As China continues to change, its position in and relationship with the global economy are also expected to evolve. China has elevated its position in the world by interacting more closely with it. If both China and the rest of the world continue to develop along their changing pathways, the se interactions are likely to adjust as well. This section will present simulations based on a global general equilibrium model that captures the anticipated changes in both China and the world, providing insights into the evolving relationship between them and the possible impact on Brazil. A. China’s Position in the World China Re-Emerges onto the Global Stage A key element in China’s growth success has been the economy’s increasing openness and orientation towards the rest of the world over the last three decades. This time period saw the make-over of an initially poorly integrated economy into one with deep connections to the rest of the world. China’s gradual opening fostered the global demand for Chinese products and the Chinese demand for imports from the rest of the world. By reducing import barriers, domestic firms became more efficient as competition was strengthened and access to imported inputs improved. This also helped promote China’s participation in the parts and components trade and helped fuel China’s overseas expansion through reciprocal reductions in foreign import restrictions and eventual entry into the WTO. By dismantling many barriers to FDI inflows, China benefited from better access to foreign technologies and business practices, whereas the integration of foreign standards into regulation and business practices allowed for an improvement of the quality of domestic production. Finally, China enhanced its exposure to foreign ideas through the education of Chinese students abroad and increasing communications over the internet. Conversely, the global economy has benefited considerably from China’s outward re- orientation. The expansion of China’s trade was made possibly primarily through its participation in global production networks, with nearly half of China’s exports being processing exports with significant import content and more than half of all exports exported by foreign multinational companies. Enterprises from many countries have therefore participated either directly or indirectly in China’s success. Moreover, China has become the world’s second-largest – and also one of its fastest-growing – import markets, where its formidable demand for raw materials, advanced machinery and consumer products have brought significant benefits to exporters overseas in both developing and developed economies. As China increased its economic importance, its relations with the rest of the world changed profoundly, especially over the last decade. Following its meteoric growth performance, the Chinese economy overtook Japan as the world’s second-biggest economy in 2010 (third-biggest if the countries of the European Union were to be treated as one economy) and is forecast at current growth rates to replace the US as the world’s top economy in about a decade. Its outward-oriented growth model elevated China to become the world’s largest exporter and its biggest manufacturer. On the back of persistent current account surpluses, China also became the largest holder of foreign exchange reserves and a premier creditor in sovereign 31 debt markets. As the Chinese economy has grown, its domestic policies have come to matter in terms of their impact on the global economy. The fiscal stimulus package in 2009, for example, helped shore up global demand during the Great Recession, whereas China’s demand for commodities and overseas investment have played an increasing economic role for its trading partners. For other countries particularly in the developing world, China’s re-emergence onto the global stage has created both opportunities and challenges. The upsurge of commodity prices, which resulted partly from China’s resource-intensive growth, benefited for example, net producer countries, but hurt the terms of trade of net consumer countries. In turn, access to lower-priced manufacture imports from China expanded the consumption possibilities of many countries and elevated their middle classes, but at the same time it also created tough competition for domestic manufacturing industries at home and in third markets. Global Integration of China and the Wider Developing World Deepens The recent dynamism of the global economy has been driven mainly by rapid growth in developing countries. Developing economies grew at an average of 4.6 percent between 1990 and 2010 and, with prices rising quickly, the share of their collective GDP in global output rose from 16 to 31 percent. While a big chunk of the strong economic performance of the developing world reflected the rise of China (which raised its share in global GDP from 2 to 9 percent), the share of other developing countries rose equally substantially (from 15 to 22 percent). High- income economies, however, registered much slower growth (at 2.1 percent), which along with lower inflation, led to their declining importance in global GDP. Looking ahead, the changes in China will occur against the backdrop of a world that is also changing. Fundamentals in developing countries remain strong, but there are limits to the current patterns of growth if only because the share of services in these economies is likely to increase over time. In addition, there is the question of whether other developing countries will be able to become a major driving force for global growth and whether high-income countries will be able to reignite their growth engines in the face of structural problems that restrain competitiveness. Relative to other countries, it is expected that China will maintain strong growth even if it slows down considerably (Table 3 and Figure 11). Over the next two decades, developing countries are expected to grow between 4.9 in the low-growth scenario and 7 percent in the high- growth scenario. This represents a significant deceleration compared to the last decade, particularly compared to the two years that preceded the global financial crisis when developing countries registered more than 8 percent growth. Over time, by 2030, growth would come down to 3.5 and 6 percent in the low- and high-growth scenarios. Among developing countries, the growth decline in China is forecast to be somewhat larger, even if China remains among the fastest-growing economies in the world. Despite the slowdown in China and other developing countries, the developing world is expected in both scenarios to continue growing twice as fast as high-income countries. 32 Table 3. Growth trends for developing and high- Figure 11. China could potentially slow down a lot more income countries likely continue diverging than other developing countries Annual GDP growth rate (5-year moving average, percent) Developing countries High-income countries 14 GDP growth rate (decennial average, percent) 12 1990–00 3.3 2.7 China 2000–10 5.9 1.6 10 2010–20 5.6–7.4 2.0–3.1 8 2020–30 4.2–6.6 1.3–2.7 6 Developing countries GDP per capita growth rate (decennial average, percent) excluding China 4 1990–00 1.6 2.0 2000–10 4.6 1.0 2 High-income 2010–20 4.4–6.1 1.6–2.6 0 countries 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030 2020–30 3.4–5.8 1.1–2.4 Source: World Bank and Development Research Center of the Source: World Bank and Development Research Center of the State State Council 2013; World Bank staff projections. Council 2013; World Bank staff projections. Note: Bounds reflect low- and high-growth scenarios simulated Note: Solid and dotted lines reflect high- and low-growth scenarios with Envisage. simulated with Envisage. Figure 12. Developing countries are expected to contribute more to global growth Contribution to global GDP growth as share of total (percent) Low-growth scenario High-growth scenario 100 100 High-income High-income 80 countries 80 countries 60 60 Developing world Developing world 40 40 excluding China excluding China 20 20 China China 0 0 1980 1990 2000 2010 2020 2030 1980 1990 2000 2010 2020 2030 Source: World Bank and Development Research Center of the State Council 2013; World Bank staff projections. Regardless of these scenarios and even excluding China, developing countries are expected to replace high-income countries as the main contributor to global growth (Figure 12). By 2030, developing countries without China will account for more than 40 percent of global economic growth, with only one-third coming from the current high-income countries. About a quarter of global growth, however, will originate in China – slightly less in the low-growth scenario and slightly more in the high-growth scenario. The rise of developing countries other than China will have profound implications for the future configuration of world trade patterns, which is the subject of the next section. 33 B. Relations between China and the World If both China and the rest of the world continue to develop along the changing pathways described above, how will the relationship between them evolve? Given the current size of the Chinese economy and the complex ways in which it connects with the world economy, it would be safe to conjecture that as China changes, so will the rest of the world, and vice-versa. Thus, structural changes driven by technological catch-up, demographic transformation and further capital accumulation will set in motion changes in the way countries interact: comparative advantages change, countries move up the value chain, production and trade patterns shift and relative prices adjust. China and the rest of the world are likely to see closer integration. China’s growing middle class will become an even more important source of global demand as well as investment, the country’s industrial upgrading and expanding trade will lead to further specialization and increased efficiency in world markets, and its increasingly educated labor force will become a force for global innovation. Both China and the rest of the world stand to benefit from closer integration. Just as increasing openness has been a critical driver of China’s remarkable growth performance over the last three decades, many of the opportunities and solutions to the challenges that may emerge in the next few decades can be found in global markets. While trade will probably remain dominant, interaction and cooperation in other areas are expected to become more important in the future relations between China and the world. Outward flows of foreign direct investment are likely to continue rising as Chinese firms attempt to establish themselves on a regional or global footing. The prospect of the increased opening of China’s services sector may create new opportunities for overseas firms. As China expands its presence in international financial markets, it may consider gradually opening up the capital account and possibly internationalize its currency. China is also becoming an important source of development assistance to other developing countries – a trend which is expected to continue. And, finally, with its growing share in the world economy and its rising per capita income, China has become a key partner in the provision of global public goods, where China’s participation is essential in addressing a growing number of global challenges. The Great Slowdown: Impact on Import Demand? Even if China grows more slowly, the fact that such a slowdown occurs against a very high base should give ample scope for other countries to tap into rising Chinese import demand. If indeed, as predicted, China were to gradually halve its growth rate from the 10 percent in recent decades to 5 percent by 2030 – which lies somewhere in the middle between the low- and high-growth scenarios described before – it would still be expected to become a high-income economy and outstrip the U.S. economy by then as well. Despite the slowdown, China’s national income would rise through this period, and this would add an equivalent of 15 of today’s Republic of Koreas to the world economy. Of course, due to the size of its massive population, China’s per capita income would still remain a fraction of richer high-income economies. But the slower rise of income from a high base should create tremendous opportunities for trade; since in addition the income elasticity of China’s imports is expected to rise as the country becomes richer, providing a further boost to import demand. Thus, even if China slows and rebalances, the intensity of import demand is expected to remain robust. 34 The patterns of China’s import demand are likely to change. China’s recent growth patterns have brought large benefits to exporters of commodities as well as capital goods—even if China has itself become a significant exporter of capital goods (Eichengreen, Rhee, and Tong 2004). As China rebalances and looks more inwardly, it is likely that competition from China in third would recede and also that new opportunities would open up in China’s domestic market that could be accessed by these exporters. Such opportunities could be accessed directly through the export of consumption goods or indirectly by exporting inputs into the production networks supplying such goods to China, of which a large share are expected to remain located within China itself. China’s efforts to raise domestic consumption are also expected to raise the demand for services, part of which again would be produced domestically, but others could be supplied from overseas. Erosion of Cost Competitiveness: Whither Low-Cost Manufacturing? While productivity growth partially explains and absorbs growth in wages, rising labor costs appear to be eroding China’s external competitiveness (Figure 13 and Figure 14). While debate continues about whether China has passed the Lewis turning point 4 and data on labor market developments is hard to come by, anecdotal evidence suggests that it is becoming increasingly evident that it is no longer possible to tap into a surplus pool of low-wage labor without raising wages (Lewis 1954). Indeed, for several years now, nominal wage growth has been persistently robust, translating into significant increases in real wages. Even if the recent slowdown brought a slight softening of labor market conditions, urban demand-supply ratios remain at high levels. Whereas rapid productivity growth has to some extent dampened the impact of these cost pressures somewhat, the rise in manufacturing unit labor costs remains significant. These developments, as well as the observation of significant foreign direct investment outflows from China to establish industrial zones in other countries, underpin the concern that China’s industrial competitiveness in low-cost, labor-intensive manufacturing is being affected by underlying cost pressures. However, the pace at which this will play out is highly uncertain. First, not all manufacturing will be affected. Firms that are less labor intensive (as determined by the share of wages in total costs) or have more pricing power (and therefore the ability to pass on rising wage to prices) are likely to be less affected. Competitive industries such as low-value footwear, garments, and toys are therefore more likely candidates of out-migration, and indeed, some of China’s production in these sectors has already shifted to countries such as Cambodia, Indonesia, and Vietnam. Second, the process is also slowed by the fact that rising wage costs cause firms to raise capital intensity. Recent survey data for the manufacturing-dominated Pearl River Delta suggest that the primary response (61 percent, Figure 14) of companies to higher wage costs is to invest in capital equipment (Lau, Narayan, and Green 2013). 4 The Lewis turning point refers to the point at which excess labor employed in lower-productivity sectors/subsistence sectors is fully absorbed into higher-productivity/modern sectors and further reallocation of labor requires wages to rise. 35 Figure 13. Labor productivity growth in China helped Figure 14. Wage pressures are triggering labor contain the rise of labor costs substitution and relocation Growth rate (percent) Share of respondents (percent) to the question: 20 "How do you plan to respond to labor shortages?" 100 15 Q4 80 2012 10 60 2013 5 40 0 20 -5 Labor productivity growth in manufacturing industry 0 Unit labor cost in manufacturing industry Raise capital Move capacity inland Move capacity -10 intensity abroad 2007 2008 2009 2010 2011 Source: National Bureau of Statistics of China, CEIC, and World Bank Source: Lau, Narayan, and Green 2013. staff calculations. Note: Survey of manufacturers operating in Pearl River Delta. The presumed large-scale out-migration of low-cost, labor-intensive manufacturing is unlikely to happen overnight and may never fully play out. Indeed, the concern among lower- income countries is precisely that, while China moves up the value chain and acquires new comparative advantages, it continues to encapsulate within its borders the wage-sensitive chunks of the cross-border supply chain. Thus China, being a vast country of multiple regions with varying endowments, is not only acquiring new comparative advantages, but also keeping its existing ones, whereby China would straddle the full span of technologies and labor intensities (Yusuf and Nabeshima 2010). Other countries would need to have the collective ability to absorb the out-migration of manufacturing activities from China. It may well be that China’s specific development path provided the world with a unique and one-off opportunity to productively tap into vast pools of surplus labor (Chandra, Lin, and Wang 2012). Hence, if other developing countries that are set to benefit from China’s gradual loss of competitiveness in low-cost, labor-intensive manufacturing are collectively unable to supplant China’s production capabilities, then what appears the most likely trend going forward will be a reversal of the ‘China price’ effect and a return to more expensive final and intermediate manufactured goods. Moving up the Value Chain: A Surge of Competition? As China has moved and continues to move up the value chain, the competitive challenge is increasingly shifting from lower-cost to higher-cost countries. As a result, a new group of countries characterized by different endowment structures, and therefore different comparative advantages, is likely to face head-to-head competition from a changing China. To some extent, this is already happening as evidenced by the increasing technological sophistication of China’s exports and the increasing share of capital good exports from China. Going forward, however, the process is likely to intensify if China succeeds in its efforts to drive growth through innovation (figure 10). As a result, countries that are currently active or aspire to become active in production, investment, or trade of human capital–intensive and technologically sophisticated goods and services would likely face significant competitive challenges (Economist Intelligence Unit 2011). 36 Rising competition in skill- and technology-intensive production is expected to produce various effects. Some countries may have more difficulties in retaining their overseas market share and may also experience higher import penetration in their domestic markets. The rise in competition may also constrain the efforts of other countries to move up the value chain, dampening the prospects of these countries to generate productivity-led growth and impacting negatively on global economic growth. At the same time, the rise in competition could trigger proactive responses from the private sector to boost innovation and move up the value chain so as to be able to compete with China. It may also lead to a healthy competition in policy frameworks among similarly endowed economies to ensure that business environments are conducive to and fully support private sector entrepreneurship and innovation (Schellekens 2011; World Bank 2011a). 37 PART 2. BRAZIL’S EVOLVING LINKAGES WITH CHINA While the economies of Brazil and China were initially hardly linked, they have become increasingly connected over the last decade. Bilateral trade and investment linkages between the two countries expanded significantly, with China emerging as Brazil’s most important export destination and an important foreign direct investor. Conversely, Brazil has played an increasingly important role as a supplier of natural resources and a contributor to energy and food security in China. While beyond the scope of this report, the two countries have also enhanced their ties through enhanced cooperation agreements such as in technical and scientific areas. Moreover, Brazil and China also developed economic connections in indirect ways, such as through terms of trade effects, exchange rate developments and growth spillovers. The importance of these growing connections must be placed in perspective. On the one hand, while direct linkages grew rapidly, they grew from a low base and their significance should not be overstated. With respect to trade, for example, Brazil remains a relatively closed economy that trades with a diversified group of trading partners, thus diluting the importance of China. On the other hand, the linkages between the two countries are also indirect, such as through China’s impact on commodity prices, the new consumption possibilities afforded by lower-priced consumer goods imports from China, and the efficiency enhancements arising from the availability of cheaper capital goods. It is on account of these indirect effects that the linkages with China have a greater significance in Brazil, even though domestic market developments continue to play a key role in Brazil’s economy. Against this backdrop, the evolution of these linkages as China undergoes structural change is of key interest to policy makers and the business community in Brazil. However, the discussion in Brazil about the impact of a changing China has been surrounded by a considerable degree of, as this report will argue, unwarranted pessimism. In what follows, the discussion will first focus on the trends and characteristics of Brazil’s economic connections with China over the last decade. It will then adopt a forward-looking perspective and examine how these connections could evolve over the next two decades as China slows, rebalances and moves up the value chain. I. LOOKING BACK: FACETS AND CHARACTERISTICS OVER THE LAST DECADE The economic linkages between Brazil and China have evolved rapidly over the last decade. Bilateral trade expanded considerably as did to a lesser extent cross-border investment and cooperation between the two countries. To be able to understand how the linkages between the two countries may evolve going forward, the key trends and characteristics of the relationship as it has evolved up to the present are first examined. The economic connections between Brazil and China are complex as the countries are both strategic partners and competitors. These characteristics arise from the fact that their economies are simultaneously complementary and similar, which generates opportunities for beneficial exchange and also challenges manifested by competition. 39 A. Facets of the Brazil-China Relationship: Trade, Investment and Indirect Effects China Became Brazil’s Most Important Trading Partner The value of Brazil’s trade with the world has grown fast over the last decade, but remains low relative to the size of the Brazilian economy (Figure 15 and Figure 16). Following a period of relative stagnation during the 1990s, the last decade saw a rapid rise in the value of Brazil’s external trade. Between 2000 and 2011, export and import values of goods more than quadrupled, representing an annual growth rate of 15 percent in nominal U.S. dollar terms. Relative to GDP, however, exports and imports represented a rather small fraction of the overall economy at about 9-10 percent each in 2011 (although it was much higher in the mid-2000s). This expansion of exports and imports occurred during a period of rapidly rising commodity prices and significant exchange rate appreciation (Figure 17 and Figure 18). Partly in response to the commodity-intensive rise of other emerging markets, including China, commodity prices grew at unprecedented rates during the period of 2004-2008 as well as following the global financial crisis until recently. For Brazil, a major commodity producer with an open capital account, this was associated with a rapidly appreciating exchange rate – both in nominal and real terms as in effective and bilateral USD terms. These trends were reinforced by the liquidity-generating policy responses to the global financial crisis by high-income economies and by the pattern of interest rate differentials that favored emerging markets. The resulting exchange rate volatility also explains a large part of the variations seen between Figure 15 and Figure 16. Against this backdrop, trade with China has grown even faster, albeit from an even lower base and remaining at a relatively low share of GDP. Although Chinese merchandise exports and imports comprise only a small share of Brazil’s GDP, China has emerged as an important partner. Merchandise exports and imports to China were insignificant when compared to GDP in 1991 and by 2000 had increased to only a quarter of a percent. Nevertheless, the average annual growth rate of exports and imports over this period was 19 percent and 36 percent, respectively. By 2011, exports to China rose to 2 percent of GDP and imports to 1 percent, corresponding to growth rates since 2000 of 40 percent and 35 percent. The trade balance with China has been in surplus for Brazil for over most of the last decade, and continued to be in surplus through 2012. The increase of exports to China occurred at a time when export growth to the rest of the world was slowing. While growth in advanced economies was almost nonexistent, China’s growth continued, and Brazil’s direct trade relationship with China provided resilience on the export side that helped Brazil whether the period of volatility in 2008. Between 2008 and 2009, when exports to the rest of the world declined by 27 percent, exports to China grew by 23 percent. However, due to the slow growth of advanced economies, China was making greater efforts to access the markets of emerging economies. Between 2009 and 2010, when imports from the rest of the world increased by 39 percent, in part due to the rebound after a fall in 2009, imports from China increased by 61 percent. 40 Figure 15. During the 2000s, Brazil’s trade with the Figure 16. Relative to GDP, however, the increase was world including China, picked up significantly less marked USD billions (current prices) Share in GDP (percent) 250 Total exports 14 Total exports Total imports Total imports 200 Exports to China 12 Exports to China Imports from China Imports from China 10 150 8 100 6 4 50 2 0 0 91 93 95 97 99 01 03 05 07 09 11 91 93 95 97 99 01 03 05 07 09 11 Source: UN Comtrade; World Bank staff calculations. Source: UN Comtrade; World Bank staff calculations. Figure 17. Brazil’s rising trade values occurred against Figure 18. Commodity price inflation led to significant a backdrop of commodity price inflation exchange rate appreciation Commodity price index, 1990=100 Various indices, 1990=100 400 250 Real effective exchange rate Energy Terms of trade Non-energy 200 Export price 300 Precious metals Import price 150 200 100 100 50 0 0 90 92 94 96 98 00 02 04 06 08 10 12 90 92 94 96 98 00 02 04 06 08 10 Source: World Bank Prospects Group. Source: World Bank Prospects Group. Figure 19. Among countries, China has become Brazil’s Figure 20. China has become Brazil’s second-most most important export destination important source of imports Share in total exports (percent) Share in total imports (percent) 40 35 30 30 25 20 20 15 10 10 5 0 0 91 95 93 97 99 01 03 05 07 09 11 91 93 97 95 99 01 03 05 07 09 11 USA CHN USA CHN EU27 South America EU27 South America KOR JPN KOR JPN Source: UN Comtrade; World Bank staff calculations. Source: UN Comtrade; World Bank staff calculations. 41 Figure 21. The rest of the world contributed much more Figure 22. As to final demand, the US remains above to export and especially import growth than China China as most important export partner Contribution to growth (percentage points) Share of Brazilian value-added embodied in foreign final domestic 30 demand (percent) 92-97 98-03 04-08 09-11 25 Rest of world 20 EU27 15 10 USA 5 China 0 2005 Japan -5 2009 China Rest of world China Rest of world Mexico Contribution to Brazil export Contribution to Brazil import growth growth 0 5 10 15 20 25 30 Source: UN Comtrade; World Bank staff calculations. Source: OECD Trade in Value-Added (2013); World Bank staff calculations. The surge in trade elevated China to Brazil’s most important export destination (Figure 19 and Figure 20). China has overtaken the United States that had traditionally been Brazil’s main trading partner. Although rebounding, exports to the United States and the European Union still remain below levels achieved in 2008 prior to significant declines in 2009. The importance of China as an import market grew as well, becoming the second most import destination in 2011, just behind the United States. However, total exports and imports to the European Union as a region still remain above any other country, representing some 21 percent of overall trade. The increased importance of China must be qualified in two respects: first, China continues to represent only a fraction of total trade (Figure 21). Even though China has provided resilience to Brazil’s export industries at a time when advanced economies were slowing in the period following 2009, China’s direct contribution to Brazil’s export growth was far more limited in the periods prior to that. Perhaps surprisingly, given the highly visible penetration of Chinese imports into the Brazilian domestic market, this is even more so the case for Chinese imports, as the rest of the world has contributed far more to Brazil’s import growth than China. Second, when considering final demand of Brazilian value added, the United States remains ahead of China as the most important export destination (Figure 22). Value-added embodied in foreign final domestic demand shows how industries export value both through direct final exports and via indirect exports of intermediates through other countries to foreign final consumers. They reflect how industries (upstream in a value-chain) are connected to consumers in other countries, even where no direct trade relationship exists. Considering this indicator, it becomes clear that, while China helped Brazil diversify its export markets, exports appear to still be quite concentrated across destinations in terms of value added and linkages through supply chains. The indicator shows that the EU27 and the US are much more important players in terms of final domestic demand for Brazilian value-added. However, the United States’ importance in terms of final domestic demand has decreased significantly between 2005 and 2009 while China’s has increased, since final domestic demand there has grown steadily. 42 Investment Flows Have Taken Off From a Low Base Official FDI flows from China to Brazil have grown from almost nothing to over 100 million dollars annually in recent years. However, official flows only scratch the surface because a large share of investments (especially for M&A) is recorded through offshore tax havens. Various sources estimate actual FDI from China to lie somewhere between 10 and 15 billion dollars in 2010; and, the China-Brazil Business Council (CBBC) estimates FDI at just under 11 billion dollars in 2011. According to Sobeet, Chinese FDI in Brazil amounted to somewhere between 13 and 17 billion dollars in 2010. These estimates suggest that China has established itself as an important investor in Brazil. Overall FDI into Brazil has grown on average 14 percent annually since 2003, reaching a record of 66.6 billion dollars in 2011 (65.3 billion in 2012), but Chinese FDI grew even faster. As a result, the importance of China as a foreign direct investor has increased significantly. By value of FDI, China was the fifth largest investor in 2011, following the United States, United Kingdom, Japan and France. Depending on the source of the estimates, China accounted for between 7 and 15 percent of FDI. As a result, the stock of Chinese investments in Brazil, accumulated over the period 2000-10, may have risen to around 20 billion dollars, while Brazilian investments in China are estimated to represent around 500 million dollars. Figure 23. Chinese outward FDI has grown significantly Figure 24. As with trade, the importance of Brazil in across a number of destinations FDI flows has increased from a low base China’s FDI flows to select destinations (US$ million) Percent 1,600 3 2.5 1,343 03-05 1,400 03-05 1,200 09-11 2 09-11 1.6 1,000 770 1.1 800 1 0.6 544 0.5 600 0.4 0.1 0.1 400 243 197 0 139 104 121 146 Share of Share of Share of Share of 200 68 10 9 25 4 Chinese imports Brazilian Chinese FDI Chinese FDI 0 from Brazil in exports to China into Brazil in into Brazil in USA Canada Russia Brazil Mexico South India total Chinese in total Chinese total outward total inward FDI Africa imports exports FDI by China into Brazil Source: UN Comtrade, ITC, Government of China (Ministry of Source: UN Comtrade, ITC, Government of China (Ministry of Finance) Finance) The scale of outward FDI from Brazil to China is small but has grown. In contrast to Chinese FDI in Brazil, it is more diversified in terms of companies and industries. Natural resources sectors dominate Brazil’s exports to China but represent a small share of FDI (21 percent). Most activity is service-related. According to a study by CBBC, half of investors are in the services sector and most manufacturing FDI is in service activities (e.g. sourcing, distribution). 43 Figure 25. Brazilian outward FDI to China has picked up but remains limited FDI flows from Brazil to China China share in Brazilian FDI (US$ million) (percent) 200 0.10 0.08 150 0.06 100 0.04 50 0.02 0 0.00 2001 02 03 04 05 06 07 08 09 10 Share of Brazil's outward FDI (right axis) Annual FDI flows (left axis) Three-year moving avg FDI flows (left axis) Source: Central Bank of Brazil. Indirect Effects Have Played an Important Role While the rise of the trade with China has been remarkable, the overall size of external trade is small relative to the size of the Brazilian economy. The Brazilian economy is relatively closed, which is not untypical for a large economy but nevertheless uncharacteristic for most of its peers. As a result, external demand plays only a minor role in overall GDP. On top of that, Brazil is very well diversified economy, in the sense that its production as well as its global exports straddle a wide spectrum of the product space and that it exchanges the goods it produces with a wide range of countries. Thus, not only did overall external demand represent a small fraction in Brazilian GDP of less than 2.5 percent over the past decade, the importance of China in overall GDP has been just a tenth of that fraction.5 An assessment of the economic relevance of trade between the two countries must go beyond national accounting measures of external trade. There are several ways in which cross-border trade and investment flows can augment the productive capacity of the economy, either directly by providing inputs or indirectly by enhancing productivity. 5 These numbers apply to net exports over nominal GDP over the period 2000-2011. Gross exports and imports to the world hovered around 11 and 8.5 percent of GDP, whereas those to China were around 0.9 and 0.7 percent. 44 Table 4. Directly and indirectly, China’s transformations have created opportunities and challenges for other countries Opportunities Challenges Chinese demand for other Displacement of local producers countries’ exports by Chinese imports Direct Cheaper inputs and capital Displacement of local firms by Effects goods from China Chinese investors Lower prices for consumer goods Rising world commodity prices Rising world commodity prices for net exporters for net importers Better integration into global Competition from Chinese goods Indirect production networks in third markets Effects Diversion of FDI from third- Growth spillovers countries to China Currency appreciation Source: Adaptation of Jenkins (2012) More broadly, interaction with China has led to opportunities and challenges that manifest themselves both directly and indirectly (Table 4). Direct opportunities were created through China’s demand for exports, but also challenges through import penetration, and increased domestic competition. In addition, lower prices of capital goods of high quality have created opportunities for upgrading and productivity improvement. Indirectly, China has created opportunities for net commodity exporters through increased world commodity prices, massive terms of trade improvements, pressure of currency appreciation, growth spillovers, as well as challenges through third market competition both in terms of trade and investment flows. In addition, China has contributed to global stability and growth and created the ability of countries to operate is a low inflationary environment with low global interest rates. One powerful indirect mechanism is China’s impact on commodity prices. China’s resource- intensive growth and China not being a ‘small economy’ in an economic sense has been a fundamental driver of the recent global commodity price trends. Prices have risen dramatically over the past decade across different types of commodities, and particularly since 2005. In fact, just recently China has overtaken the United States as the world’s largest net oil importer. Not only has Brazil benefited from greater demand and higher prices of direct trade with China, but China has indirectly created significant windfalls for Brazil from commodity trade with the rest of the world. The favorable external environment, combined with the benefits from earlier macro- and micro-economic reforms, has helped Brazil expand its ‘consumption frontier’ (Figure 26). Lower-priced consumer goods imports from China created increased consumption opportunities for poorer households. Partly as a result, alongside improvements in domestic economic conditions, ownership of durable goods including telephones, computers, televisions, and refrigerators increased considerably between 2001 and 2011. In addition, as China remained resilient through the global financial crisis, it contributed indirectly to macro stability in Brazil and thus helped generate monetary and fiscal conditions conducive to economic growth and poverty reduction. China thus has played at least a part in Brazil’s long cycle of consumption - fueled growth. 45 Figure 26. Durable goods ownership has risen over the last decade Ownership of durable goods (percent) 100 2001 80 2011 60 40 20 0 Stove Refrigerator TV DVD Water filter Car Telefone PC PC/internet access Source: IBGE-PNAD Figure 27. Commodity prices registered rapid increases Figure 28. … which led to currency appreciation and a after 2004 terms of trade improvement for Brazil Commodity price index, 2004=100 Various indices, 2004=100 400 200 Real effective exchange rate Energy Non-energy Nominal USD exchange rate 300 Precious metals Terms of trade 150 200 100 100 0 50 00 02 04 06 08 10 12 00 02 04 06 08 10 Source: World Bank Prospects Group. Source: World Bank Prospects Group. Note: Upward movement in exchange rate indices denotes appreciation of the BRL. As the prices of Brazil’s commodity exports increased, so too did the pressure of currency appreciation (Figure 27 and Figure 28). These trends have created significant terms of trade improvements for Brazil. Since 2008, export prices have been increasing at a significantly faster rate than import prices. The terms of trade are additionally influenced by the exchange rate as a rise in the value of Brazil’s currency further lowered the domestic price of its im ports. Although many factors can affect a country’s exchange rate, clear correlations exist between the prices of commodities and the price of Brazil’s currency. When the demand of Brazil’s commodity exports was high, so too was demand for the currency to pay for those exports. This correlation is particularly strong for energy prices and precious metals. The significant appreciation of the exchange rate – which has been somewhat reversed recently – has led to formidable pressures onto the non-commodity related industries and has also been associated with concerns about Dutch disease and a construction boom. 46 B. Characteristics of the Relationship: Complementarity and Similarity Complementarity: Brazil and China as Partners Brazil and China are Opposite Images in Several Respects The economic partnership between Brazil and China is largely built on complementary natural resource endowments (Figure 29 and Figure 30). Brazil and China – as well as the US – have a similar land mass, but the distribution of agricultural and forest land over this mass differ markedly and so does the availability of freshwater resources. In addition, there are differences in climatological conditions. Once population mass is controlled for, the differences in natural resource endowments are accentuated even further, with Brazil coming out very positively especially compared with China but also the US and the Latin America and Caribbean region more generally. These complementary endowment structures generate a strong mutual interest in the agri-business sector. But there are also other areas, such as in metals and minerals where there is complementary resource availability. The structures of production in Brazil and China also exhibit a high degree of complementarity, which is partly due to differences in stages of development (Figure 31). Brazil and China are currently at different stages of development. Their economic structure, however, was much more similar when comparing Brazil in 1961 with China in 1991. Moreover, in the two decades that followed, the structure on the supply side evolved in almost identical way: agriculture lost 9 versus 13 percentage points in GDP, industry gained 2 versus 5 percentage points, and services gained 7 versus 8 percentage points, and all from roughly similar initial levels. What makes the economic structure of both economies so different, and therefore complementary, is that Brazil saw the services sector take over in the three decades after 1981, which was accompanied by significant de-industrialization. As a result, Brazil today is a much more services-oriented economy than China, where industry continues to play a key role. 6 This then also points to the potential for beneficial mutual exchanges in industry and services – the former having happened already and the latter expected to take place. A further source of complementarity exists on the demand side, where different growth strategies in Brazil and China have led to divergent expenditure patterns (Figure 32). Throughout the last five decades, Brazil has been a consumption-focused economy with a correspondingly low share of investment and external demand. China’s pursuit of an investment- led and export-oriented growth model generated almost opposite results, where investment and external demand represented a much larger share in total demand and vice-versa for consumption. In this respect, Brazil and China are almost opposite images of each other and they are likely to remain so for some time, as the rebalancing agenda for both countries (towards more investment and external demand in Brazil and more consumption in China) is not likely to be addressed overnight. Until then, these different patterns will in their present form continue as drivers of complementarity. 6 Differences in the characteristics of these sectors will be discussed later in this report. 47 Figure 29. Brazil is well endowed with land for Figure 30. In per capita terms, Brazil’s resources are agriculture, forests and freshwater resources especially abundant when compared to China Millions of hectare Trillions of cubic meter Hectare per person Thousands of cubic meter per person 600 6 3 30 agricultural land forest land agricultural land other land forest land freshwater (RHS) other land 400 4 2 20 freshwater (RHS) 200 2 1 10 0 0 0 0 Brazil China United States Brazil China United States LAC Source: FAO; WB staff calculations. Source: FAO; WB staff calculations. Note: Data for 2011. Note: Data for 2011. LAC = Latin America and the Caribbean region. Figure 31. Services have come to represent a much Figure 32. Brazil’s economy has throughout been more larger part of GDP in Brazil compared to China consumption oriented than China’s Share in GDP (percent) Share in GDP (percent) 70 90 60 80 70 50 60 40 50 30 40 20 30 20 10 10 0 0 Brazil China Brazil China Brazil China Brazil China Brazil China Brazil China Brazil China Agriculture Industry Services Consumption Investment Exports Imports 1961 1971 1981 1991 2001 2011 1961 1971 1981 1991 2001 2011 Source: National authorities; World Bank staff calculations Source: National authorities; World Bank staff calculations Note: Data for 1961 is missing for China. Trade and Investment Flows Reflect Complementarities These three sources of complementarity – in natural resource endowments, structure of supply and pattern of demand – are reflected in the trade flows between the two countries. China’s focus on resource-intensive, investment-led growth and exports has resulted in high demand and rising prices for commodities in which Brazil has a comparative advantage, which helped support Brazil’s consumption-oriented growth pattern 7 and fueled the demand of manufactured imports. Indeed, exports to China have become increasingly concentrated in extractive resources and agriculture, at the detriment of machinery, metals, chemicals, and food and beverages. Brazil has increasingly imported machinery from China that has replaced imports of agriculture, food and beverages, and extractive resources. 7 Consumption-led growth in Brazil may be fostered by the imports of cheaper manufacture goods imports. In addition, given the size of its economy, China has been instrumental, at least in the past, in contributing to disinflationary pressure globally, which has indirectly enabled Brazil to lower structurally high interest rates in an open-capital account environment. 48 The pattern of trade between the two countries suggests that Brazil and China are tapping into each other’s comparative advantages (Table 5 and Figure 33). The trade flows are broadly consistent with the claim that Brazil has a comparative advantage in non-manufactures and vice-versa for China. Comparative advantage should be interpreted strictly in the Ricardian sense, i.e. both countries may be good at producing manufactures, but one is comparatively better, which in turn leads to gains of trade for both countries if they specialize according to their comparative advantage. By examining how a country’s exports share of a particular good exceeds the global export share of that good, Table 5 demonstrates that the products were Brazil has developed a ‘revealed’ comparative advantage are products where China is relatively underrepresented and vice-versa, which again points to the complementarity of trade. Table 5. In the top ten sectors where Brazil has the strongest revealed comparative advantage, China is relatively weak, and vice versa. Revealed comparative advantage Sectors in which Brazil has the greatest RCA Sector Sector Description RCA of Brazil RCA of China 17 Sugars & sugar confectionery 16.7 0.2 12 Oil seeds, misc. grains, medicinal plants, straw 12.7 0.2 26 Ores slag & ash 12.4 0.03 9 Coffee, tea, mate & spices 11.1 0.3 47 Pulp of wood, waste & scrap of paper 9.1 0.03 2 Meat & edible meat 8.4 0.1 23 Residues from food industries, animal feed 6.5 0.3 24 Tobacco and manufacturing tobacco substitutes 5.4 0.3 41 Raw hides & skins & leather 4.8 0.2 20 Preps of vegetables, fruits, nuts, etc. 4.2 0.9 Sectors in which China has the greatest RCA Sector Sector Description RCA of Brazil RCA of China 66 Umbrellas, sun umbrellas, walking sticks, whips, riding-crops & parts 0.01 6.6 67 Prepared feathers, human hair & articles thereof, artificial flowers 0.01 5.7 95 Toys, games & sports equipment, parts & accessories 0.02 5.4 46 Manufacturing of straw, esparto, or other plaiting materials, basket ware and wickerwork 0.02 5.4 65 Headgear & other parts 0.05 4.7 42 Articles of leather, saddler & harness, travel goods, handbags, articles of gut 0.07 4.4 50 Silk, including yarns & woven fabrics thereof 1.1 4.2 64 Footwear, gaiters & the like 1.2 4 62 Articles of apparel & clothing accessories – not knitted or crocheted 0.02 3.6 63 Made-up textile articles nesoi, needlecraft sets, worn clothing, rags 0.3 3.4 Source: UN Comtrade; World Bank staff calculations. Note: RCA = revealed comparative advantage = the proportion of the country's exports in a given product category divided by the proportion of world exports of that category in total world exports. A comparative advantage is ‘revealed’ if RCA > 1. Furthermore, trade with China also seems to have changed the overall composition of Brazil’s trade. Brazil’s worldwide export basket saw large changes over the last decade, where the direction of these changes was closely correlated with the emergence of trade with China. Exports of machinery, food and beverages have declined since 2001, even though they continue to make up a sizeable share. Exports of commodities, extractive as well as and agriculture resources have seen a marked increase. Brazil’s import structure underwent a less radical transformation. Despite a significant increase in imports of machinery from China, overall, Brazil’s imports of machinery have fallen slightly, while imports of extractive resources and metals have increased. 49 Figure 33. Brazil’s trade with the world is well diversified across products; trade with China is more specialized in natural resource-related products (export side) and machinery (import side). Share of exports to the world (percent) Share of exports to China (percent) 100% 100% Other Other 80% 80% Machinery Machinery Metals Metals 60% 60% Textiles Textiles 40% Chemicals 40% Chemicals Extractive Extractive 20% 20% Food & beverages Food & beverages Agriculture Agriculture 0% 0% 1991 2001 2011 1991 2001 2011 Share of imports from the world (percent) Share of imports from China (percent) 100% 100% Other Other 80% 80% Machinery Machinery Metals Metals 60% 60% Textiles Textiles 40% Chemicals 40% Chemicals Extractive Extractive 20% 20% Food & beverages Food & beverages Agriculture Agriculture 0% 0% 1991 2001 2011 1991 2001 2011 Source: UN Comtrade; World Bank staff calculations. These patterns are also evident in foreign direct investment flows (Table 6). A sectorial breakdown of FDI inflows from China into Brazil indicates that over the period 2004-2010 the primary sector gained importance mainly at the expense of the tertiary sector, while the secondary sector remained relatively steady.8 The sectors growing in share show clear evidence of the commodities boom: mining and metals (7 to 29 percent share in overall FDI) and petroleum and energy (9 to 17 percent). FDI to manufacturing sectors not linked to natural resources such as textiles, automotive, electronics, machinery & equipment, and precisions instruments has been either stagnant or in decline. While the services sector generally declined in relative importance, FDI inflows to certain subsectors actually increased: finance (6 to 11 percent) and construction (1 to 3 percent). 8 Primary sector refers to agriculture, forestry, fishing, mining and extraction of oil and gas; secondary sector refers to manufacturing and tertiary sector to services. 50 Figure 34. The patterns of foreign direct investment Table 6. FDI in extractive industries and finance has have changed over time picked up significantly Percentage shares in overall FDI Percent share in total 60 Change 2004 2007 2010 2004 2004-10 Mining and Metals 6.8 14.3 28.6 21.8 2007 Petroleum and energy 8.9 11.7 17.4 8.5 40 2010 Finance 6.1 14.5 10.8 4.7 Construction 1.2 2.5 2.6 1.4 Trade 6.8 9.4 6.9 0.1 Other mfg 1.6 2.2 1.1 -0.4 Business services 7.0 12.4 5.7 -1.3 20 Chemicals, rubber, plastics 7.8 5.2 5.4 -2.4 Other services 6.2 2.2 3.2 -3.0 Machinery, auto, equipm. 12.1 7.3 5.9 -6.2 Agri, forestry, food, fishing 14.9 11.4 8.6 -6.2 0 Transport, storage, comm. 20.6 7.0 3.7 -16.9 Primary Secondary Tertiary Source: ITC Source: ITC. Note: Primary sector refers to agriculture, forestry, fishing, mining and extraction of oil and gas; secondary sector refers to manufacturing and tertiary sector to services. The type of FDI also sheds light on the sectors that investment is made in.  The bulk of Chinese investments have been merger & acquisitions of a resource- or asset-seeking nature. Chinese investments in Brazil are found to have followed two patterns during the recent period of 2010-11: the inclusion of Brazil in the international base of suppliers of raw materials for China, and the entry of Chinese products into the consumer market and the Brazilian industrial arena. In a review of 25 existing Chinese investments in Brazil, CBBC (2011) categorizes 15 of them (60 percent) to be motivated by resource or asset seeking, with 10 (40 percent) as market seeking (none were categorized as efficiency seeking). While a large majority of overall investment in Brazil is greenfield, FDI from China has been dominated by mergers and acquisitions, including many partial, minority positions. This is in line with China’s emphasis on accessing natural resources, where there are existing, large companies, and its desire to secure supplies.  Most Chinese investment up till now has come from central state-owned enterprises, even though this seems to be changing. CBBC (2011) estimates that 93 percent of the capital invested by Chinese companies in Brazil in 2010 came from firms classified as central state-owned enterprises, which have traditionally focused on natural resource sector investments. However, there is increasing evidence of a recent shift towards more investment in manufacturing and R&D (CBBC, 2011). This newer wave of investments also includes medium-sized and smaller Chinese companies. While these investments are likely to remain small relative to the major resource-seeking investments, they may have more strategic importance over time given the potential for productivity-enhancing spillover effects. In addition, there is some early evidence of investment beginning to come into the services sector, in particular financial services. This follows a typical pattern of China’s investments in other important markets. 51 Similarity: Brazil and China as Competitors While complementarities have brought mutual opportunities for Brazil and China, similarities have produced competitive challenges. As noted before, the Brazilian and Chinese economies exhibit important complementarities in terms of natural resource endowments as well as productive and expenditure structure. At the same time, Brazil and China show similarity in a number of respects, primarily with regard to the types of manufacturing products that they produce. These similarities have given rise to competition both domestically and overseas in third markets. Competition in Third Markets Intensified Although Brazilian exports are more similar to those of high-income countries, the commodity boom in the mid- to late 2000s appears to have reduced this similarity (Appendix D). Compared to China, Brazil’s overall export basket is more similar to the United States and the countries European Union as well as Argentina, as suggested by the export similarity index which measures the extent to which two countries are active exporters across individual product categories. The more limited similarity with China would suggest that Brazil and China export different baskets of goods and that therefore China is not a major third-market competitor of Brazil in the sectors where Brazil has a comparative advantage. The limited similarlity with China comes at no surprise given the complementarity in trade. However, the Figure also shows that the similarity index between Brazil and the US, EU and Argentina has declined since 2005. This is likely a reflection of the commodity boom since Brazil’s similarity with other commodity exporters such as Peru and Chile has remained roughly constant. To examine the decline in similarity further, it is useful to distinguish how different product groups have evolved over time (Figure 35). Disaggregating flows into primary, resource-based, low-, medium- and high-technology groups, the general complementarity is again born out: Brazil is a diversified economy and trade with China does not reflect trade to the rest of the world. However, close examination suggests the following pertinent developments:  The share of Brazil’s low- and high-technology manufacturing exports to the world has shrunk since 2001 as primary and resource-based sectors expanded. Most striking is the rise of primary products exported to China between 1991 and 2001 (from less than 5 percent to 40 percent) and the associated fall in high-, medium-, and low- technology manufacture exports to less than 10 percent in 2011.  The technological content embedded in Brazil’s imports from China has risen dramatically, likely at the expense of other trading partners. Brazil’s imports from China, previously dominated by primary products and resource-based manufactures, are now comprised to almost 90 percent of low-, medium-, and high-technology imports. The technological content of Brazil’s overall imports remained relatively constant since 2001, suggesting the changing composition of Chinese imports could displace other countries. 52 Figure 35. Brazil’s trade with the world and China according to product group (Lall classification ) Share of exports or imports by Lall classification (percent) Brazil’s exports to world Brazil’s exports to China 100% 100% 80% 80% High technology High technology 60% Low technology 60% Medium technology Medium technology Low technology 40% 40% Primary products Primary products Resource based Resource based 20% 20% 0% 0% 1991 2001 2011 1991 2001 2011 Brazil’s imports from world Brazil’s imports from China 100% 100% 80% 80% Resource based Resource based Primary products Primary products 60% 60% Not classified Not classified 40% Low technology 40% Low technology Medium technology Medium technology 20% 20% High technology High technology 0% 0% 1991 2001 2011 1991 2001 2011 Source: UN Comtrade; World Bank staff calculations. Figure 36. Mercosur becomes more important than the Figure 37. The shares of primary and resource-based US as a market for Brazil’s manufacture exports exports however remain relatively constant Share of Brazil’s low-, medium- and high-technology manufacturing Share of Brazil’s primary and resource-based manufacturing exports exports to destination market in total such exports by Brazil (percent) to destination market in total such exports by Brazil (percent) European Union European Union 50 50 Mercosur Mercosur United States United States 40 40 30 30 20 20 10 10 0 0 88 90 92 94 96 98 00 02 04 06 08 10 88 90 92 94 96 98 00 02 04 06 08 10 Source: UN Comtrade; World Bank staff calculations. Source: UN Comtrade; World Bank staff calculations. Note: For definition of Lall categories, see Table 7. Note: For definition of Lall categories, see Table 7. 53 To what extent does Brazil’s changing export composition represent a loss of competitiveness in its manufacturing industries (Figure 36, Figure 37)? A first glance suggests that Brazil’s changing export composition could be due to loss of market share of manufacturing in third markets. But a falling share of manufacturing exports could also be driven purely by primary products and resourced based exports growing at a faster pace, not necessarily manufacturing losing its competitiveness. Comparing Brazilian versus Chinese exports in foreign markets according to technological content – using a measure of dynamic revealed competitive position (DRCP) – sheds light on the extent to which China is a competitor in third markets at a more detailed level.9 Table 7 analyzes Brazil’s dynamic revealed competitiveness position. The table shows three destination markets. For each destination market, the average DRCP measure is calculated and expressed in basis points and classified according to product category. This means for example the United States registered an increase over the last decade of .17 percentage points in the share of Brazilian imports in total imports of primary products, whereas China’s share remained constant. The table also shows the average share in percent over the last decade of the presence of each country in the destination market for that product category. For example, 1.7 percent of total US imports of primary products came from Brazil whereras 1.3 percent came from China. Table 7. Evolution of Brazil’s dynamic revealed competitive position Average dynamic revealed competitive position (basis points) and average share (percent), 2000-11 USA market EU27 market Mercosur+ market Average Average Average Lall DRCP Share DRCP Average Share Average DRCP Average Share Brazil China Brazil China Brazil China Brazil China Brazil China Brazil China PP 17 0 1.7 1.3 -2 1 2.0 0.8 79 9 11.5 0.9 RB1 5 65 3.5 7.2 2 14 1.9 1.5 -16 58 16.9 3.4 RB2 -4 21 2.1 4.1 10 9 1.5 2.0 -46 22 11.3 5.1 LT1 -11 226 1.1 35.8 -1 145 0.5 18.5 -76 290 12.7 35.1 LT2 -1 144 0.8 40.0 -1 57 0.3 11.2 -6 166 14.3 20.0 MT1 -1 27 0.5 2.2 -1 10 0.2 0.6 22 59 25.9 3.8 MT2 12 42 3.6 7.7 4 12 0.5 1.8 2 95 16.4 5.8 MT3 0 100 1.1 17.7 0 63 0.3 7.1 10 118 11.8 9.8 HT1 -1 316 0.4 28.5 0 192 0.1 15.0 -61 353 13.0 17.7 HT2 -17 13 2.1 4.1 -3 6 0.3 1.4 28 26 6.1 3.0 Source: UN Comtrade; National authorities; World Bank staff calculations. Note: The dynamic revealed competitive position (DRCP) is the change in the market share of a product (group) in an importing market. The average DRCP is the average between 2000 and 2011. Lall categories are defined as follows: PP=Primary Products, RB1=Resource Based Manufactures 1 (agro-based products), RB2=Resource Based Manufactures 2 (others non-agro based products), LT1=Low Technology Manufacture 1 (textiles, garments and footwear), LT2=Low Technology Manufacture 2 (others), MT1=Medium Technology Manufacture 1 (automotive), MT2=Medium Technology Manufacture 2 (process), MT3=Medium Technology Manufacture 3 (engineering), HT1=High Technology Manufacture 1 (electronic and electrical), HT2=High Technology Manufacture (others). 9 DRCP measures the annual change in Brazil’s or China’s market share of a product in a third market. In the analysis, the product is treated as the aggregate exports within each category, and the DRCPs are then averaged for the period 2000 to 2011 to capture how the average market share has changed. See Technical Appendix for a discussion and formal presentation of the DRCP. 54 The analysis of Brazil and China’s DRCP suggests the following:  China is emerging as an important player in Brazil’s traditional export markets (United States, European Union, and Mercosur+).10 China has gained market share across the board, in each export category and across each destination market. China is most dynamic in each market in low technology manufacturing of textile, garment, and footwear (LT1) and high technology manufacturing of electronic and electrical products (HT1).  Although Brazil has lost market share across many product groups, Brazil is more dynamic than China in others. Brazil’s most dynamic products in the United States and the European Union are non-automotive medium technology manufactures (MT2), as well as primary products (PP) in the United States and other resource-based manufactures (RB2) in the European Union. In Mercosur+, an important destination for Brazilian manufactured products, Brazil is gaining market shares in primary products (PP), other high technology manufacturing (HT2), and medium technology manufacturing of automotive (MT1). Overall, however, even in those sectors where Brazil expanded its market share, China managed to increase its market share by more, especially in Mercosur+ and the United States. Figure 38. Brazil occupies a large share of the market in Figure 39. China has penetrated various markets, Mercosur+ especially the US Brazil’s average market share over 2000-11 in destination market, by China’s average market share over 2000-11 in destination market, by Lall category (percent) Lall category (percent) PP PP Mercosur+ RB1 Mercosur+ RB1 RB2 RB2 LT1 LT1 LT2 LT2 EU27 EU27 MT1 MT1 MT2 MT2 MT3 MT3 US HT1 US HT1 HT2 HT2 0 10 20 30 40 0 10 20 30 40 Source: UN Comtrade; National authorities; World Bank staff Source: UN Comtrade; National authorities; World Bank staff calculations. calculations. Note: For definition of Lall categories, see Table 7. Note: For definition of Lall categories, see Table 7. Also striking is the size of the market that China has been able to penetrate, although the Chinese penetration of the European market has been much smaller (Figure 38 and Figure 39). Some markets in Mercosur+ are becoming dominated by Chinese products. For example, China has maintained a market share of on average 40 percent of other low-technology manufactures (LT2) imports in the United States and 36 percent in low technology manufacturing of textile, garment, and footwear (LT1) in both the United States and Mercosur+. Although most of China’s shares are in low technology manufacturing, China is also making headway in increasingly sophisticated goods, as indicated by non-trivial market shares in high 10 Mercosur+ refers to Argentina, Brazil, Paraguay, Uruguay, Venezuela, Bolivia, Chile, Colombia, Ecuador, and Peru. 55 technology manufacturing. In contrast, Brazil’s market shares in the United States and the European Union do not exceed 4 percent overall. Many of Brazil’s most dynamic products are related to its natural resource base, but specific manufacturing items are also quite dynamic.11 Aggregating across categories fails to capture the significant amount of variability within each category at a more detailed product level. Many products have achieved an average growth in the market share over the last decade of above 5 percent (especially in Mercosur+). And although many are related to commodities, it is not necessarily the ‘typical’ commodities like iron ore or soybeans, but instead, for example, cashew nuts, tobacco, and orange juice. Graders and levelers achieved an average growth in the market share over the last decade of 7 percent with an average of 60 percent of the US market and steel products continued to grow in the Mercosur+ market. However, many of Brazil’s most dynamic exports are concentrated in commodities that China does not consistently export to these destinations, and this is particularly true in Mercosur+. Figure 40. Competition from China remains high Figure 41. Brazilian medium-tech manufactures are Share of Brazil’s exports where China exerts a direct or strong-partial especially under competition in Mercosur+ competition over 2000-11, by market (percent) Share of Brazil’s exports where China exerts a direct or strong-partial 80 competition in 2011, by market and Lall classification (percent) PP RB LT MT HT 60 M+ 1 7 9 25 4 40 EU27 13 4 5 7 2 20 Exports to USA Exports to EU27 Exports to Mercosur+ USA 2 5 6 9 2 0 00 01 02 03 04 05 06 07 08 09 10 11 Source: UN Comtrade; World Bank staff calculations. 0 10 20 30 40 50 Source: UN Comtrade; World Bank staff calculations. To better capture the significance of the competition at a more disaggregated level, an analysis of competition is conducted (Figure 40 and Figure 41). The analysis that follows is based on measures of how the dynamic revealed competitive position (DRCP) of Brazil compares with that of China at a disaggregated product level (HS 6-digit). If the DRCP of Brazil is negative (meaning that Brazil has lost market share in that product in a given third market) whereas the DRCP of China is positive, then the product is considered to be subject to direct competition from China. If the DRCP is positive for both Brazil and China, then the product is under partial competition, where the partial pressure is strong if the DRCP for China is larger than Brazil’s. These measures are then aggregated to the higher levels of aggregation shown in Figure 40 (total exports by destination market) and Figure 41 (exports by Lall category and by destination market). 11 See Appendix for a list of Brazil’s most and least dynamic prod ucts in each market. 56 The analysis suggests ongoing competition with respect to manufacturing exports to Mercosur+ and the US and primary and resource-based exports to the EU.  China continues to exert strong competition on Brazil’s exports to key destination markets. The competition (direct and strong-partial) is highest with respect to Brazil’s exports to Mercosur+, where over 45 percent of all products are under pressure. This is followed by the EU (29 percent) and then the US (21 percent).12  Overall, competition has however diminished greatly. Interestingly, across all markets, competition was much higher in the past, especially in Mercosur+. Back in 2000, the EU and US faced similar pressures but by 2011 this subsided more in the US, which reflects the fact that import penetration from China has already worked its way much more extensively in the US than in the EU (see also Figure 39). The decline is also partly due to the commodity boom in Brazil, as Brazil is exporting more commodities to these countries that China does not export.  Manufactured products have been subject to most competition, especially in Mercosur+. Some 82 percent of exports under pressure in the Mercosur+ market are manufactured exports.13 These numbers are even more significant when considering the importance of manufacturing exports to Mercosur+, as 64 percent of Brazil’s exports to this destination are manufactures. A similar story occurs in the US market, where 69 percent of exports under pressure are manufactured exports. The competition seems to be somewhat lower in the EU market, where Brazil’s exports of primary products face increased competition.  Exports of medium-technology manufacturing accounted for the greatest share under competition in Mercosur+ and US markets. However no one product stands out in accounting for this type of pressure. In Mercosur+, the top shares under competition related to vehicles, mechanical shoves, polyethylene, and footwear. In the United States, the top shares subject to competition tended to be machinery and mechanical appliances.  In contrast, primary products and resourced-based manufacturing accounted for the majority of exports under competition to the European Union. Some 61 percent of all exports under pressure in 2011 reflected primary and resource-based goods. The significance of this pressure is even more striking when considering the importance in the export basket of the European Union. Primary products and resource-based manufacturing accounted for 24 percent of exports and 17 percent were under pressure. Two products, soybean oil cake and soybeans, accounted for 13 percent. 12 The numbers tell the share of exports at risk, but not the intensity of that risk. For example, a product is considered to be under direct and strong-competition when China’s average market share between 2000 and 2011 has increased b y more than Brazil’s. However, what is measured does not take into account the intensity of the change or the extent to which China’s share increases more than Brazil’s. In addition, any changes in the share of products under direct and strong -partial pressure are driven entirely by compositional changes in exports. 13 Some 45 percent of all exports to Mercosur+ are under competition and 35 percent of all exports are manufactured exports under pressure. 57 Competition in Brazil’s Domestic Market Also Increased Brazil faces increased competition from China not only in overseas markets but also at home in the domestic economy. Domestic industries have to compete with the import of overseas products from countries around the world. China’s growing importance in the world economy, as well as in the Brazilian economy, has meant that the demand for low-cost manufactures from China has increased tremendously. While this has afforded Brazil with benefits in the form of access to cheaper intermediate and final goods, it at the same time implied greater competition for firms that produce and sell such goods domestically. The general picture is one where Brazil’s tendency to import has increased since 2003, whereas its proclivity to export has somewhat diminished (Figure 42). The import penetration coefficient, or the share of imports on apparent consumption, has risen significantly, from 12 to 22 percent between 2003 and 2011. The export coefficient, or the export share of Brazilian industrial production, on the other hand steadily increased up until 2006, peaking at 20 percent before dropping to 18 percent in 2011. One possible explanation for the declining export coefficient is that Brazilian producers have lost competiveness in international markets. However, the financial crisis of 2008 and sluggish recovery in the global economy may have reduced demand for Brazilian products as well. A third possible explanation is that increased internal demand may be absorbing some of the production exported in the past (Canuto, Cavallari and Reis, 2013). Figure 42. Import penetration is rising while export Figure 43. The extractive and machinery industries coefficient is falling experienced opposite patterns Percent Percent 25 100 Extractive industry: export coeff. Extractive industry: import coeff. 20 80 Machinery industry: export coeff. Machinery industry: import coeff. 15 60 10 40 5 Export coefficient 20 Import penetration coefficient 0 0 96 98 00 02 04 06 08 10 96 98 00 02 04 06 08 10 Source: FUNCEX Source: FUNCEX These patterns however differ greatly across industries, where for example the contrasting developments of extractive industries and machinery are instructive (Box 1). The extractive industries appear to be more integrated into the global economy as evidenced by much higher import penetration and export coefficients compared to machinery manufacturing. And the export coefficient of extractive industries has been high and steadily increasing since 2000, in contrast to a declining and low coefficient in machinery manufacturing since 2005. It thus appears that, even if Chinese manufactured goods have penetrated many of Brazil’s markets, import penetration has been more likely in sectors where Brazil is a less inclined to export. See Box 1 for more details on the machinery industry and how the China trade has affected the entire iron ore-steel-capital goods supply chain. 58 The patterns also differ greatly when one considers the geographical dimension (Box 2). Box 2 documents how the impact of greater competition has differed significantly across states in Brazil, depending on whether these states have a complementary relationship with China that helps them offset some of the negative impacts of increased competition. The analysis suggests that the majority of Brazilian states seem to have benefited from trade linkages with China, while the states that have been affected the most by the penetration of Chinese imports are, as expected, São Paulo, Santa Catarina, Amazonas, Rio Grande do Sul and Paraná, which export similar goods vis-à-vis China. Box 1. Partnership and Competition: The Iron Ore, Steel, and Capital Goods Supply Chain The characteristics of partnership and competition can be observed even within the narrow confines of a single supply chain. A good example is the iron ore, steel and the capital goods supply chain. Traditionally, Brazil’s domestic supply chain used domestically sourced iron ore that was then transformed into steel to be used for assembly of capital goods. But the rise of China fundamentally altered these relationships and has created both opportunities and challenges for domestic participants in the supply chain. Consider first the iron ore producers. Following the rise of China and in tandem with the associated commodity boom, iron ore producers such as Vale (the largest mining company in the world for iron ore) have increasingly oriented themselves externally towards satisfying the rising demand from overseas. As a result, between 2001 and 2011, the value of Brazil’s agglomerated and non-agglomerated iron ores and concentrates to China increased by 3,358 percent. Consider next the machinery & equipment industry in Brazil, which has faced considerable competitiveness challenges in the face of rising competition from China, an appreciating exchange rate as well as domestic factors that have hampered competitiveness. These factors have coalesced to dampen the demand in Brazil for domestically produced machinery and equipment goods, as evidence by rising Chinese import penetration. They have also reduced the export potential of this industry in third markets as evidenced by the analysis of competition, which shows that manufacturing is especially subject to Chinese competition in Mercosur+ and the United States. The implications for the domestic steel industry are even more significant. As noted, China increasingly exports capital goods and many of these capital goods embody significant amounts of steel. So not only has the competition with China displaced some of the domestic production of machinery and equipment but the domestic demand for steel is also being reduced by the displacement of those products with steel content. Ironically, the steel is being produced primarily with iron ore from Brazil. 59 Box 2. Partnership and Competition: The Subnational Dimension The characteristics of partnership and competition in the Brazil-China relationship are also observed at the subnational level. Given that Brazil’s exports are highly diversified, the country’s productive structure is both complementary and similar to China’s. This multi-faceted aspect of the Brazil-China relationship is also borne out at the subnational level: 17 out of the 27 Brazilian states have limited similarity in their export bundles with respect to China (Blasquez- Lidoy et al, 2006), giving therefore rise to greater complementarity and hence opportunity for partnership; other states have a much more similar export bundle, including São Paulo, Santa Catarina, Amazonas (which is dominated by the Zona Franca de Manaus), Rio Grande do Sul and Paraná. These latter states tend to export medium and high technology manufactured goods and are therefore more likely to be subject to competition from China. The degree of complementarity with China seems to have been associated with the economic growth performance at the state level. Libânio (2012) finds that the growing demand for agricultural commodities and minerals led to above-average growth over 2000-2009 in states producing and exporting such products. These states also recovered more quickly from the effects of the economic crisis in the late 2000s. Figure 44. Index of trade competition: China and Figure 45. Exports by Region (2010) according to Lall’s Brazilian States classification 100% 0.5 0.4 80% HT 0.3 60% MT 0.2 LT 40% RB 0.1 PP 20% 0.0 MT TO MS MA MG AP PA PI ES AC SE PB BA PE AL PR SC SP RR DF RN CE RS AM RO RJ Brazil GO 0% N NE SE S CO Source: Libânio (2012); MDIC and Intracen Note: Average for 2002-2010. Source: Libânio (2012); MDIC. The interactions with China have affected Brazilian states quite differently due to differences in export mix and their similarity with China. The South and Southeast regions are more diversified and export a larger share of manufactures. The North and Northeast are more concentrated on natural resources, whereas the Midwest region—the important agricultural frontier—concentrates 80 percent of its exports in primary products. As such, while the China effect is felt nationwide, China’s demand for Brazilian commodities, the penetration of Chinese manufactured goods and additional displacement in third markets has different effects for Brazilian states depending on their export similarity or complementarity with the Chinese economy. Libânio’s analysis suggests that most Brazilian states benefit from trade linkages with China, while more similar states have recorded a strong competitive impact as in São Paulo, Santa Catarina, Amazonas, Rio Grande do Sul and Paraná. 60 II. LOOKING AHEAD: IMPACT OF A CHANGING CHINA ON BRAZIL China’s successful economic development is expected to continue but is likely to change, as the Chinese economy slows down, rebalances and moves up the value chain. These transformations are anticipated as China enters a new stage in its development towards a high- income economy. While there is considerable uncertainty about the pace and extent of these changes, it is nevertheless useful to think ahead and prepare for the eventualities that China’s changes may entail, particularly in terms of their effects on other countries. This is especially the case for economies that have developed closer ties with China as well as economies that are expected to be influenced in a significant way by China’s prospective changes – where Brazil is thought to belong to both categories. This section examines mainly how China’s changes would affect trade – the most prominent facet of the Brazil-China interaction – and how Brazil might be affected. Simulations are presented on the basis of the multi-regional, multi-sectorial Envisage model that was used earlier to analyze China’s domestic transformations. Here, however, the Envisage model simulations discussed in the previous sections will be used to analyze the trade patterns between nations and groups of nations, allowing for a more detailed discussion about the impact on Brazil. A. Changes in China: A More Detailed Analysis Chinese Import Growth Is Expected to Remain Healthy The illustrative scenarios suggest that, despite the anticipated slowdown, Chinese import demand will continue growing at a healthy rate for an economy the size of China’s (Figure 46). The two scenarios that were simulated in the earlier section capture the structural slowdown and rebalancing of the Chinese economy, where Chinese GDP growth slows to 3.5 percent by 2025-30 in the low-growth scenario and 6.9 percent in the high-growth scenario and where a key difference between the two scenarios derives from the rate of growth of productivity in services. As the GDP base of the Chinese economy has become very large and the share of imports in GDP is rising in both scenarios as China rebalances, the rate of growth of import volumes should remain rather healthy regardless of the slowdown (6 percent in the slow-growth scenario and 9 percent in the high-growth scenario). However, the structure of this demand is set to evolve quite differently in the two scenarios (Figure 47), where in the low-growth scenario:  The share of services in total imports almost doubles. There are three main factors behind this. First, as Chinese consumers become richer their demand for services increases relatively faster than for goods (income elasticity of demand is greater than one). Secondly, with productivity in services lagging behind, their relative prices increase. While domestic prices of services increase by 77 percent relative to the 2004 base year, the increase of import prices of services is much lower (Figure 52), which leads to a shift in demand towards imports. Finally, as countries grow richer their integration with the global markets typically deepens leading to a further growth of trade as a share of output in all sectors. 61 Figure 46. Import demand of agriculture & food, energy Figure 47. ... which would lead to a change in the and services is expected to grow quickly … structure of Chinese import demand Growth rate of import value, 2010-30 (annualized, percent) Change in value share in total imports, by sector (percentage points) 6 Total 9 9 Agriculture and food low 25 10 high Agriculture and food 17 2 Energy 7 6 Energy 11 low -31 3 Manufacturing Manufacturing high -32 5 10 20 Services Services 9 0 0 5 10 15 20 -40 -20 0 20 40 Source: World Bank staff simulations. Note: Simulations with Envisage for 2010 and 2030 in low- and high- Source: World Bank staff simulations. growth scenarios. Note: Simulations with Envisage for 2010 and 2030 in low- and high- growth scenarios. Figure 48. Plenty of scope exists in expanding the Figure 49. … which has on the import side played a services trade … much smaller role in China than in Brazil Nominal GDP, 2011 (current prices, USD, log) 31 China Brazil Value share of services imports in total (percent) 29 30 27 25 25 20 23 15 21 10 19 0 20 40 60 80 100 Brazil 5 Share of services in total trade, 2011 China Source: UNCTAD; WDI; World Bank calculations. Note: Trade = exports plus imports. 0 1980 1985 1990 1995 2000 2005 2010 Source: UNCTAD; World Bank staff calculations.  As the share of services in total imports rises, their share in absorption14 doubles from the level of 2010 but remains relatively low at 10 percent in 203015. In addition, when considering the level of development and the share of services in total imports, it is notable that several countries with similar levels of GDP have relatively high share of services trade in total trade (Figure 48). Considering just services imports, the comparison with Brazil suggests that there is plenty of remaining scope in China to boost the share of services imports (Figure 49). 14 Absorption is defined as domestic production - exports + imports. 15 In the rest of East Asia region the share of imported services in domestic absorption is projected to increase from 13 percent in 2010 to 18 percent in 2030. 62  Imports of agricultural and food products and their share of total domestic absorption increase dramatically in the low-growth scenario. Prices of imports of food and agricultural products decrease over time due to productivity gains and production shifts to locations with comparative advantage in the production of agriculture such as e.g. the US, Europe16, but also Brazil.  The manufacturing sector is subject to much faster productivity growth than agricultural production. This leads to a fast expansion of production and increased price competitiveness, resulting in a relatively slow growth of imports of manufacturing products and therefore halving of their share of total imports in the low-growth scenario. In the high-growth scenario, the share of services imports remains roughly constant whereas the share of agriculture and food imports rises considerably. With a faster growth of productivity of services the price of domestic production decreases relative to imports and therefore the demand for imports of services is growing in line with total imports. The increase in the price of Chinese agricultural and food products is faster in this scenario due to stronger demand stemming from expanding income. Faster economic growth along with a relatively significant increase of agri-food prices stimulates demand and leads to a further increase of imports of agri-food products. Changing Patterns Are Bound to Affect Global Markets and Prices The scenarios result in a continued and significant increase in China’s share of global imports and imply a continued trend of rising Chinese import dependence on critical commodities (Figure 50 and Figure 51). From a global perspective, China is expected to continue expanding its market share in import markets, even in the low-growth scenario. The market share for China is expected to increase from 10 percent in 2010 to 16 percent of global imports in 2030 in the low-growth scenario and to 19 percent in the high-growth scenario. From a Chinese perspective, the scenarios point to further global integration and hence increased import dependence. As China continues to grow, the share of imports relative to absorption is likely to increase dramatically in certain sectors, particularly in the high-growth scenario and especially in the agriculture & food and energy & mining sectors as well as services. Even though China’s market share in global agricultural and food imports rises to high levels, such a substantial increase would not disrupt global food and agricultural markets. These goods have historically been much less traded than manufacturing products and remain broadly so throughout the simulations. The increase of the share of global imports of agri-food products only represents a shift away from self-sufficiency on the part of China and a substantial opening to imports of agri-food products. In the realm of the simulation model where producers and consumers only respond to relative prices, such a shift away from domestic production and towards imports is perfectly feasible. Whether this outcome would be politically feasible in the future remains to be seen. Concerns about commodity security (especially in food and energy) are likely to lead to some resistance towards the significant increase in China’s dependence on overseas products and may therefore dampen somewhat the model-based trajectories. 16 The modeling exercise assumes that agricultural productivity grows at 2.5 percent per annum for all countries/regions. Consistently with past trends the productivity growth in manufacturing and services in high income countries is slower than in agriculture. Rapid productivity growth in agriculture makes these countries more competitive on international markets. 63 Figure 50. China’s market share in world imports rises Figure 51. China’s domestic dependence on overseas considerably in several sectors markets may rise depending on scenarios Value share of China’s imports in world imports (percent) Value share of imports over absorption (percent) Agriculture & food 14 Agriculture & food 9 41 27 11 13 Low-growth Low-growth Energy & mining 20 Energy & mining 19 10 2010 10 2010 Manufacturing 8 Manufacturing 6 11 2030 5 2030 Services 26 Services 10 Total 10 Total 9 16 10 Agriculture & food 15 Agriculture & food 9 57 42 High-growth High-growth Energy & mining 11 Energy & mining 14 27 21 Manufacturing 10 Manufacturing 11 11 6 Services 9 Services 4 17 3 Total 10 Total 9 19 9 0 10 20 30 40 50 60 0 10 20 30 40 Source: World Bank staff simulations Source: World Bank staff simulations Note: Values for both 2010 and 2030 are simulated with Envisage. Note: Values for both 2010 and 2030 are simulated with Envisage. Absorption defined as production plus imports minus exports. Figure 52. Services become more expensive in the low- growth scenario than when growth is high Global relative price indices 2030 (2010=100) 94 Agriculture and food 107 128 Energy and mining 136 96 2030 low Manufacturing 97 2030 high 119 Services 102 0 50 100 150 Source: World Bank staff simulations. Note: 2030 values in low- and high-growth scenarios are simulated with Envisage. Since the Chinese economy is very large, changes in its import demand are expected to affect global prices (Figure 52). 17 With China accounting for above 15 percent of global imports and above 20 percent of global exports by 2030, one would expect that an increased demand for services (especially in the low-growth scenario) and to a lesser extent of agricultural products (in the high-growth scenario) would contribute to the growth of their relative prices. Indeed the world price of services increases by 22 percent relative to their benchmark (2004) level in the low-growth scenario, while it remains roughly constant in the high-growth scenario (increase of 3 percent). In the high-growth scenario global prices of agricultural products increase more than the price of services or manufacturing products. With the same fast productivity growth in manufacturing and now also faster productivity growth in services in the 17 The global model foresees relative price developments which are a function of differential growth rates in the regions, changes in the demand patterns, relative sectoral productivity growth rates, differential factors of production growth trends, global trade patterns etc. These results should not be treated as a price forecast rather as a relative development compared to the model's numéraire which is an index of OECD exports of manufacturing products. The model only captures the real phenomena, not monetary phenomena, therefore the prices only reflect relative changes in global demand and supply. 64 high-growth scenario, agricultural products with their relatively slow productivity growth and strong demand from, among others, China, become relatively more expensive. At a global level the prices of energy and mining record relatively slow growth i.e. 1.6 percent per annum in the low-growth scenario and 1.8 percent per annum in the high-growth scenario. B. Implications for Brazil: Rising Complementarity, Changing Similarity As the total volume of Chinese imports is seen to grow at an average of 6 to 9 percent per year in both scenarios, Brazil is expected to be among China’s fastest-growing import suppliers (Table 8). Over the next two decades China is expected to import more products from developing countries. In both scenarios their share is expected to increase about 4 percentage points to 32 percent of total imports. Latin America and the Caribbean is expected to see its exports increase at an average 7 or 11 percent per year over 2010-2030 (in the low- and high- growth scenarios, respectively), at the same speed or faster than the average developing country (in the high-growth scenario) or many other developing regions. Only imports from the US increase at a slightly faster rate in both scenarios. The share of LAC products in total Chinese imports increases by 10 percent, but it remains rather low at around 4 to 6 percent in 2030. Table 8. China’s imports from Brazil are expected to grow among the fastest in the world Growth rate of China’s import value, 2010-30, by geographical source (annualized, percent) Average growth rate Value share in imports Low High Low High 2010-30 2010-30 2010 2030 Change 2010 2030 Change World total 6.2 8.7 High income countries 5.9 8.1 72.4 68.1 -4.3 72.0 64.6 -7.3 United States 8.0 12.9 10.7 15.1 4.4 10.9 23.2 12.3 EU27 & EFTA 7.5 8.0 17.6 22.5 4.9 16.5 14.5 -2.0 Japan 2.2 4.4 13.5 6.3 -7.2 13.9 6.2 -7.8 Rest of high-income 5.0 6.6 30.5 24.1 -6.4 30.7 20.8 -9.9 Developing countries 7.0 10.0 27.6 31.9 4.3 28.0 35.4 7.3 Latin America & Caribbean, excl Brazil 6.2 9.8 2.4 2.4 0.0 2.5 3.0 0.5 Brazil 8.0 12.0 1.4 2.0 0.6 1.5 2.6 1.2 East Asia 6.9 10.0 13.5 15.5 2.0 13.7 17.3 3.6 South Asia, excl India 7.7 10.2 0.3 0.4 0.1 0.3 0.4 0.1 India 7.5 10.0 1.5 1.9 0.4 1.4 1.8 0.4 Europe & Central Asia, excl Russia 5.8 9.3 0.7 0.6 -0.1 0.7 0.8 0.1 Russia 3.1 6.1 3.2 1.8 -1.4 3.4 2.1 -1.3 Middle East & North Africa 6.9 9.6 2.0 2.3 0.3 2.0 2.3 0.3 Sub-Saharan Africa 9.8 12.5 2.6 5.0 2.5 2.6 5.1 2.5 Source: World Bank staff simulations. Note: 2030 values in low- and high-growth scenarios are simulated with Envisage. Brazil Is Poised to Gain From Increased Complementarity Even if growth in China decelerates, it slows from a high base, while the rebalancing of the Chinese economy is expected to offer significant opportunities for Brazil going forward. China’s shifting away from domestic investment-led growth and export-led growth to domestic consumption-led growth will increase the share of consumption over GDP, causing consumption to grow at levels higher than GDP. And the implications on Brazil’s exports to China are arguably greater under the scenario of rebalancing than had China continued on its current development path, given Brazil’s export basket. 65 Rebalancing in China offers room for Brazil to deepen the complementary trade relationship and grow the commodity sector in which it has a well-established comparative advantage. Three separate factors will come together to boost this result. First, China’s consumption growth creates a significantly larger response in Brazil’s commodity exports than China’s GDP growth. Second, most of Brazil’s exports to China are classified as commodities according to this definition. And third, consumption growth rates are expected to be higher than other components of GDP. Brazil’s abundant endowments of natural resources make the country well suited to take advantage of China’s rising demand for agricultural and food products. The Brazilian agribusiness sector in particular is expected to benefit from the anticipated changes in China. Increased protein demand from China is expected as Chinese food habits change, creating higher demand for soybeans and meat. Brazil has a comparative advantage in production of these products and is among the best suited to respond to rising Chinese demand. The rise in Chinese demand is thus expected to generate many new opportunities for Brazil to widen the economic impact of the natural resource-related part of its economy. Figure 53. Agriculture & food and manufacturing Figure 54. China’s market share in world exports exports to China are expected to grow most rapidly continues to rise in manufacturing Growth rate of Brazii’s export volume to China, 2010-30 (annualized, Value share of China’s exports in world exports (percent) percent) Agriculture & food 3 2 8.0 2 Low-growth Total Energy & mining 1 12.0 19 2010 Manufacturing 32 11.1 2 2030 Agriculture and food Services 1 12.9 13 Total 19 4.4 low Agriculture & food 3 Energy 1 9.9 high High-growth Energy & mining 2 1 10.7 18 Manufacturing Manufacturing 38 12.5 Services 3 3 7.3 13 Services Total 23 9.3 0 10 20 30 40 50 60 0 5 10 15 Source: World Bank staff simulations Source: World Bank staff simulations. Note: Values for both 2010 and 2030 are simulated with Envisage. Note: 2030 values in low- and high-growth scenarios are simulated with Envisage. Commodities such as iron ore may benefit comparatively less if China’s investment-led, resource-intensive growth model is decelerating. Yet interestingly, this also provides an opportunity. Whereas demand for many commodities such as soy is related directly to consumption, commodities such as iron ore can be used for both consumption (for steel to make cars) and investment (construction or machinery). Therefore, more iron ore and steel will be needed if there is to be, for example, increased demand for cars as China develops its internal market. 66 As Similarity Changes, Competition is Likely to Alter China’s integration with the world economy is expected to continue on the export side but the composition of its export basket is expected to change significantly (Figure 54). Both the low- and high-growth scenarios in China foresee that the market share of Chinese exports in global exports continues to rise. By 2030, China exports could present between 19 and 23 percent of the global exports. Much of the increase is driven by an increase in manufactured goods, a sector in which China has long held a comparative advantage. Within the manufactured goods sector, however, large changes are expected in terms of the type of products and, even more importantly, the underlying processes used to produce them. Another dimension of world trade concerning Brazil and other countries is the future volume and structure of Chinese exports. Despite increased competition from low-income countries and relatively slower growth in high income countries, there will be still opportunities for China to further expand its exports in existing and new markets. The fast-growing emerging markets will provide a new source of demand for Chinese products. As China's population becomes better-educated, its workers more skilled and the wage competitiveness diminishes over time, the incentives for the Chinese firms to expand investment abroad and acquire new technologies will become stronger. Globalization of Chinese firms will create new opportunities as they move to higher value added segments of the global markets. The simulations indicate that several skilled labor intensive sectors would be likely to expand, with some of the fastest growth likely to occur in the exports of chemicals, rubber and plastics; motor vehicles and transport equipment along with other manufactured products. A fast increase of exports of manufactured products is seen to allow for a further expansion of the share of Chinese exports in global exports (Figure 54). Further growth of the Chinese contribution to global trade is feasible in the foreseeable future. China is rapidly becoming the biggest economy in the world, expected to overcome the US in the next two decades, with a population four times as big as that of the US. The US, for example, used to account over 30 percent of global exports of professional and scientific instruments or transport equipment in the 1990s, which serves as a reminder that a single country’s world market share can reach high levels providing it produces competitively. It is possible that taking advantage of economies of scale and new technologies China might further expand its exports in several manufacturing subsectors in the future. As China continues to expand its market share and redefines the source of its comparative advantage in manufacturing, competition with Brazil is likely to remain intense. China moving up the value chain may make it more difficult going forward for Brazilian manufacturing firms to compete domestically and internationally. As China carves out new niches to retain its global competitive advantage in manufacturing, the knowledge intensity and sophistication of Chinese manufacturing is expected to significantly increase. Given that China is expected to increasingly make inroads into such higher-end activities, the competition with Brazil in these segments is likely to intensify further. 67 A fresh wave of competition from China could produce further consolidation in Brazil’s industrial sector. Increased competition at home and in third markets may continue to affect the industrial sector. Yet, while some further consolidation may be inevitable and necessary, it is also clear that industry will have a continued role to play in the domestic economy. Domestic demand will continue to grow given the rising middle class, which may carve out niches for industry to respond to. In addition, just like certain segments of the Chinese manufacturing sector are less vulnerable to rising wage pressures and the associated erosion of external competitiveness, there are similarly segments in the Brazilian manufacturing sector that are more resilient to competition than others. For example those for which the proximity to final demand is critical due to logistics costs or the benefits to innovation from being close to the customer base. Although Brazil today exports mostly commodities to China rather than differentiated products, future opportunities also exist for Brazilian manufacturing exports. To the extent that the Chinese economy will continue to add large increments of external demand to the global economy, the Brazilian manufacturing sector could tap into at least two types of opportunities: First, as the Chinese economy undergoes rebalancing, the increased focus on the domestic market may diminish some of the competition abroad and Brazil could regain some of the market share lost domestically but also internationally. Second, rebalancing in China offers opportunities for Brazilian firms to develop new niches and to tap into new opportunities to respond to changing needs of Chinese consumers. The changes in China also present an opportunity for Brazil to improve the efficiency of its services sector and expand its international reach. While the Brazilian services sector would remain propelled by rising consumption demand through the ongoing development of the domestic market, the inefficiency of certain services subsectors (such as logistics) pose a productivity constraint to the commodity and manufacturing sectors. By addressing these inefficiencies, Brazil could enhance the external competitiveness of these other sectors, allowing them to respond more effectively to the opportunities and challenges posed by China. Moreover, to the extent that China’s domestic economy shifts into services but low productivity growth in services constrains domestic supply, significant future opportunities may materialize in the international services trade with China. The simulations suggest that higher-income countries would be most likely to tap into this demand, with services exports to China from the US, Japan, Europe and other high income countries expected to rise in the order of 10 to 11 percent annually over 2010-2030. 68 PART 3. POLICY IMPLICATIONS FOR BRAZIL The report has thus far highlighted how structural change in China is likely to turn out broadly positive for Brazil, bringing plenty of opportunities while also few new challenges. The report identified three transformations of the Chinese economy – structurally slower growth, a rebalancing on the demand and supply side, and a move up the value chain. The implications of these anticipated changes were examined with respect to Brazil and the report discussed how the slowdown and rebalancing of China may present new opportunities, even if China’s progression up the value chain is likely to present new challenges as well. Industrial and especially agricultural commodities are set to benefit despite the slowdown and rebalancing of the Chinese economy. New opportunities will present themselves for the services sector given the projected excess demand for services in China. The continued development of China’s domestic market will also present new opportunities for manufacturing even though China’s moving up the value chain will likely lead to intensified competition in higher-end products. The subject of this final part is how the changes in China could contribute to economic growth in Brazil. The recent slowdown has raised attention about Brazil’s underlying capacity to grow and unfinished structural reform agenda. In this context, the question has arisen whether Brazil could leverage its external connections to infuse growth momentum into its economy and thereby complement the growth dynamic of the internal market. The report reflects on three questions about Brazil’s ongoing integration into the global economy: (i) Has Brazil become too outward oriented?, (ii) Did its trade structure become too concentrated in terms of products or markets, and (iii) Has trade become too oriented towards commodities? The report will argue that there is sufficient space for Brazil to broaden and deepen its external orientation and leverage on these linkages to generate growth and productivity. In this respect, the report identifies domestic policy areas as well as issues in the cross-border trade and investment environment that could beneficially contribute to this agenda. I. GROWTH EXPECTATIONS AND STRUCTURAL REFORM Brazil has experienced episodes of successful economic and social development. In the post- war era, Brazil joined the ranks of upper-middle income countries at remarkable speed and developed a large internal market and sophisticated business community. Following a period of macro instability, the country re-established the foundations for a resumption of growth. Over the course of the last decade, Brazil has also recorded significant successes on the social front, where it has managed to reduce poverty and to a lesser extent also inequality. It has raised over 20 million people out of poverty since 2003 and was able to overcome the 2008/9 crisis successfully. Brazil is making progress toward environmental sustainability and deforestation in the Amazon is on a downward trend. Child health outcomes have improved, and access to basic education is now almost universal. Following the recent growth slowdown, however, Brazil’s growth challenges and its unfinished structural reform agenda have come into sharper focus. Amidst concerns that Brazil’s recent slowdown reflects a decline in the underlying structural growth capacity, the need to reenergize growth and productivity through structural reforms has become more apparent. The authorities have launched a series of measures to boost productivity (as under the Plano Brasil Maior), which represent welcome steps towards the objective of accelerating growth. 69 A. Recent Developments: Muted Growth Expectations Brazil’s post-war era is marked by a prolonged episode of fast-paced growth, intermittent bouts of macro instability, and – until recently – a period of renewed growth momentum (Figure 55). Between 1947 and 1980, Brazil grew at an annual average rate of 7.5 percent. Rivaling the likes of South Korea, Brazil reached upper-middle income status on the back of a sophisticated business community and one of the world’s largest internal markets. The following two decades saw much slower growth (2 percent between 1981 and 2003), with the Latin American debt crisis of the early 1980s setting off a period characterized by macro instability and stabilization efforts. Inflation was brought under control with the Real plan in 1994, which led to a brief pick-up in growth, which was however interrupted again by the currency crisis of 1999. Subsequently, Brazil introduced inflation-targeting and strengthened its fiscal policy framework. Over the last decade, Brazil experienced a period of renewed growth momentum, starting in the mid-2000s (4.8 percent between 2004 and 2008), which in recent years has lost some of its strength (2.7 percent between 2009 and 2012). Figure 55. Brazil’s growth and inflation patterns were markedly different before and after 1980 Decennial GDP growth rate Decennial inflation rate (annualized, percent) (annualized, percent, log scale) 10 1000 9 8 7 100 6 5 4 10 3 2 GDP growth (LHS) 1 Inflation rate (RHS) 0 1 57 62 67 72 77 82 87 92 97 02 07 12 Source: World Development Indicators; World Bank staff calculations. Underlying Brazil’s growth patterns over the last six decades was a rapid acceleration of productivity growth followed by a dramatic collapse and an incomplete recovery (Figure 56). This is most evident when comparing the post-war period through 1980 and the period afterwards up till now when labor productivity grew annually by 4.1 and 0.3 percent, respectively. The sharp decline was due to the pace of capital deepening and total factor productivity growth coming to a virtual halt. Following macroeconomic stabilization, labor productivity started to grow again – albeit at a modest pace – due to growth total factor productivity as well as, to a lesser extent, capital accumulation (Bacha and Bonelli, 2012). Total factor productivity levels have yet to recover fully relative to their earlier levels as well as the patterns observed in other economies. 70 Figure 56. Labor productivity was also dampened by a slow rate of capital deepening Contribution to growth of output per worker (percentage points, period averages) 6 Capital deepening 5 2.4 Productivity enhancement 4 3 2.5 2.7 2.7 2 1.4 3.3 0.6 1.8 0.2 1 1.7 1.6 1.4 0.9 0.3 0.9 0.5 1.0 0.5 0.3 0.3 0 0.0 -1.0 -1 1948-11 1948-80 1981-11 1948-62 1963-67 1968-73 1974-80 1981-92 1993-99 2000-11 2005-11 Source: Bacha and Bonelli (2012). Note: Capital deepening = growth rate of capital employed per worker (multiplied by capital share); productivity enhancement = total factor productivity growth. Meanwhile, with the tailwinds of the 2000s receding, headline growth in Brazil has slowed. Following the years of rapid growth associated with a buoyant domestic market and favorable external conditions, economic growth slowed to 2.7 percent in 2011 and a lackluster 1.0 percent in 2012. The slowdown was driven by domestic and external factors. A tighter policy mix aimed at curbing earlier overheating pressures helped rein in domestic demand growth, whereas external demand was dampened by protracted weakness and uncertainty in advanced economies and slowing growth in major emerging economies such as China. While the slowdown was felt across the board, industry on the supply side and investment on the demand side were affected the most. Figure 57. Following 2012, market expectations about longer-term growth in Brazil have moderated Evolution of growth forecasts for two years later (daily median GDP forecast averaged over the year, percent) 4.5 4.5 4.5 4.0 4.1 4.2 4.1 3.9 3.8 3.7 3.7 3.5 3.5 3.5 3.5 3.0 3.0 2.8 2.5 01 02 03 04 05 06 07 08 09 10 11 12 13 14 1. Source: Central Bank of Brazil; World Bank staff calculations Amid the recent slowdown, the question has arisen whether Brazil’s underlying growth capacity has declined (Figure 57). Despite cyclical weakness, inflation has approached the upper levels of the inflation target range. The elevated inflation rate in combination with a buoyant labor market suggests the economy is operating close to potential, even if the growth rate currently is well below what it has typically been over the last few years. Market participants 71 have interpreted this development as indicating that Brazil’s underlying growth capacity has declined. Since 2012, growth forecasts of medium-term growth have progressively deteriorated, reflecting increasing pessimism of the median forecaster about potential growth (assuming that output at these horizons remains at potential). Whereas median growth forecasts two years out were between 4 and 4.5 percent in the beginning of 2012, these declined significantly to under 3 percent by 2014. The need of increasing productivity growth has become more pressing, particularly in light of changing demographics. The growth of Brazil’s working-age population has seen a steady decline over the last decade (reaching about 1.2 percent from earlier high levels of 3 percent in the 1970s) and the expected continuation of this decline is reducing the demographic growth dividend that Brazil had enjoyed previously. Similarly, much of the growth contribution arising from a rising participation of the working-age population in the labor force has already occurred (approaching 80 percent from previously low levels around 55 percent in the 1970s). Given these demographic factors, generating growth will require additional emphasis to raise labor productivity growth. This would among other factors require accelerating the rate of capital accumulation (both human and physical) as well as improving the overall efficiency with which inputs are combined – i.e. strengthening total factor productivity. B. Structural Reform: The Unfinished Agenda While significant progress has been made in various areas, the structural reform agenda remains unfinished. In addition to the macroeconomic reforms that contributed to macro stabilization, Brazil liberalized significant parts of the economy during the 1990s. External trade was liberalized further through tariff and non-tariff reductions, and domestic liberalization occurred through privatization and the institution of independent regulatory agencies. Social programs were reformed by expanding coverage of healthcare and education. During the 2000s, Brazil’s reform momentum continued, particularly in the financial and social sectors. However, important bottlenecks continue to exist, particularly in labor markets and the tax systems and the structural reform process may have lost some of its momentum as the urgency of addressing difficult supply-side issues lessened in the wake of buoyant consumption, an external commodity boom and an international environment of low global interest rates (Table 9; Ter-Minassian, 2012). With growth slower now and the external environment more competitive, the urgency to press ahead with the reform agenda has increased. 72 Table 9. Brazil has improved the investment climate, but important challenges remain Country rankings (1-144) Brazil's Global Competitiveness Index: Total Ranking 48 in 2012/13 (66 in 2006/07) 73 38 Innovation and 39 Basic requirements Efficiency enhancers (84) (51) sophistication (36) Primary education 106 Competition 133 Innovation 49 Quality of higher education and Public institutions 80 108 Business sophistication 33 training Transport infrastructure 79 Labor market flexibility 105 Quantity of higher education and Health 75 64 training Electricity and telephony 63 ICT use 54 infrastructure Financial market trustworthiness Private institutions 62 51 and confidence Macroeconomic 62 Quality of demand conditions 46 environment Efficient use of talent 46 Technological adoption 43 Financial market efficiency 38 On-the-job training 32 Foreign market size 24 Domestic market size 7 Brazil’s Global Competitiveness Index: Subcategories with Rankings > 99 Basic requirements Efficiency enhancement Innovation and sophistication Burden of government Availability of scientists 144 Extent and effect of taxation 144 113 regulation and engineers Wastefulness of 135 Imports as a percentage of GDP 144 government spending Quality of port 135 Exports as a percentage of GDP 140 infrastructure Quality of air transport 134 No. days to start a business 139 infrastructure Quality of primary Quality of math and science 126 132 education education Quality of roads 123 Total tax rate, % 131 Business costs of crime No. procedures to start a 122 130 and violence business Organized crime 122 Burden of customs procedures 129 Diversion of public funds 121 Trade tariffs, % 123 Public trust in politicians 121 Flexibility of wage determination 118 General government Legal rights index (financial 109 118 debt, % market development) Quality of overall Quality of education system 107 116 infrastructure (higher education and training) Quality of railroad 100 Hiring and firing practices 114 infrastructure Malaria cases/100,000 100 Prevalence of trade barriers 103 pop. Source: World Economic Forum (2012). 73 A key objective is to re-energize growth through faster productivity improvements. Raising the rate of labor productivity growth – the main driver of long-term economic growth – will be key in this respect. Labor market reforms to promote flexibility and lower the structural rate of unemployment would not only produce transitory gains in growth momentum, but also enhance productivity by strengthening efficiency in labor market allocation. In addition, while Brazil has made tremendous progress in improving the access and quality of human capital, more remains to be done to bring the skills base in line with the goal of accelerated long-term growth (Figure 58). There is scope to further increase the average length of schooling (which now stands at about 7.25 years) as well as the quality of education, which will help raise living standards and productivity growth. In addition, there is a need to raise public and private investment, to address growing infrastructure bottlenecks and lay the foundations for innovation-led growth. Further key challenges relate to the importance of developing a private long-term capital market and a more agile business environment that enhances internal competition and external competitiveness. Figure 58. Human capital per person has improved significantly but remains comparatively low Index of human capital per person, based on years of schooling and returns to education 4.0 3.0 2.0 Brazil 1.0 China Japan South Korea United States 0.0 1950 1960 1970 1980 1990 2000 2010 Source: Penn World Tables version 8.0; Feenstra, Inklaar and Timmer (2013); Barro and Lee (2012); Psacharopoulos (1994); World Bank staff calculations. The Brazilian authorities have launched several efforts to raise productivity. The Plano Brasil Maior (2011-2014) by the Ministry of Development, Industry and Trade (MDIC) aims to boost the competitiveness of the Brazilian economy by tackling cross-cutting bottlenecks as well as providing sector-specific support. The plan aims to reduce business costs, accelerate productivity growth and strengthen Brazil’s external competitiveness in the global marketplace. In addition, recent initiatives were launched to stimulate private investment in infrastructure and to reduce electricity costs. The plan demonstrates the authorities’ increased emphasis on (i) boosting investment (in addition to consumption) as a means for accelerating the economic recovery, (ii) strengthening the foundations for sustained medium-term growth (not just the short-term recovery) and (iii) enhancing private sector participation in infrastructure development, complementing the limited fiscal space for rapidly expanding public investment. 74 II. SCOPE FOR ENHANCING GLOBAL INTEGRATION With growth having slowed, the question of how Brazil could position itself to a changing external environment has become more pertinent than before. Brazil will likely remain an economy propelled mainly by its internal market. At the same time, the growth acceleration during the 2004-2008 and subsequent deceleration were not just related to internal factors but also to external ones. Chinese economic developments played a nontrivial role. Going forward, as China undergoes structural change, new opportunities will avail themselves. It is clear that the way in which Brazil responds to these will have implications that go beyond the confines of the Brazil-China relationship. For example, to the extent that heightened competition from China in high-end manufacturing fuels innovation effort in Brazil, this would not only benefit Brazil’s external competitiveness with respect to China and other countries but also infuse productivity improvement into the domestic growth dynamic. The real significance of Brazil’s changing linkages with China is the extent to which the evolving connections contribute to transforming the supply side of the Brazilian economy. The boom period of 2004-2008 occurred against the backdrop of favorable demand-side pressures, which originated both domestically and externally and led to an acceleration of headline growth. Once the tailwinds started to recede, however, Brazil registered a significant growth deceleration and, as mentioned earlier, concerns have arisen about whether the underlying trend growth of the Brazilian economy has indeed declined. In other words, to the extent that the windfalls of the boom years contributed predominantly to the expansion of domestic consumption as opposed to investment, the result has been a pick-up in headline growth but not in the capacity of the economy to deliver more rapid growth on a sustained basis and in a non-inflationary manner. Looking ahead, the transformations anticipated in China are expected to play out in Brazil’s favor to a large extent, generating therefore a new window of opportunity to leverage on the external connections and enhance underlying growth. But is there additional scope for Brazil to leverage on its external environment and in particular on its connections with China? The evolving links with China have sparked a discussion in Brazil about the extent and nature of the dependence of the economy on external demand, particularly from China. Three questions in particular have arisen: (i) Have growing connections with China made Brazil’s economic structure too outward oriented?, (ii) Has the trade with China made Brazil’s trade structure too concentrated in terms of products or markets and (iii) Has the trade with China caused Brazilian trade to be primarized and has this reflected negatively on the future opportunities for growth? These questions will be addressed in turn. A. Has Trade with China Made Brazil Too Outward Oriented? One key question is whether Brazil should slow the pace of global integration or rather should step it up in new areas. China, with other developing countries, is expected to continue growing twice or three times as fast as high-income countries (Table 3). More than ever before the developing world will present opportunities for mutually beneficial exchanges in the areas of trade, investment and cooperation. As the discussion below will suggest, Brazil’s trade openness remains low in international perspective. There is scope for more participation in cross-border production networks and broader participation by firms in external trade. 75 Brazil’s Trade Openness Remains Relatively Low While large economies tend to rely more on the domestic market, even among large economies Brazil stands out in terms of its low share of external trade in GDP. Brazil’s share of exports in GDP was merely 12 percent, compared to (simple) average of 28 percent for the world’s 9 other largest economies as well as for the other BRICs. The import share in GDP stood at 13 percent in 2011, compared to an average of 28 percent for the 9 other largest economies and 26 percent for the other BRICs. Thus, while larger economies tend to be more dependent on their domestic markets, even when compared to the 9 largest economies and the other BRICs, Brazil is an economy that is rather closed as measured by the importance of external trade in GDP. Figure 59. Among the world’s largest economies Figure 60. Brazil also ranks the lowest in terms of its (including BRICs), Brazil ranks lowest on export share import share Share of exports in GDP, in 2011 (percent) Share of imports in GDP, in 2011 (percent) Germany 50 Germany 45 UK 32 UK 34 Mexico 32 Mexico 33 China 31 France 30 Russian Fed. 30 India 30 France 27 China 27 India 24 Russian Fed. 22 Japan 15 US 18 US 14 Japan 16 Brazil 12 Brazil 13 0 10 20 30 40 50 0 10 20 30 40 50 Source: WDI; World Bank staff calculations. Source: WDI; World Bank staff calculations. Note: Largest 10 economies were chosen in terms of 2011 GDP Note: Largest 10 economies were chosen in terms of 2011 GDP (PPP-adjusted current international dollars). (PPP-adjusted current international dollars). Brazil’s Connections to Global Production Networks Are Limited Brazil’s low trade openness is partly explained by the extent and nature of its connections to global production networks. Brazil does not appear to be as connected to global production networks as other countries particularly in East and South East Asia (Canuto, Cavallari and Reis, 2013). There are certainly important exceptions, such as Brazil’s aircraft industry which, more than any other industry, relies on the global sourcing of parts and components and due to the still-limited scale of Brazil’s domestic market for this product needs to orient itself outwardly to access a larger customer base. In other activities, Brazil is integrated into global production networks, but plays an upstream role – such as in the case of the commodities trade – where the scope for parts and components trade is more limited. 76 Figure 61. Compared to China, Brazil adds lots of domestic value to total exports Share of total domestic value added in exports (percent) Russian Fed. Rest of the World Brazil United States Australia Norway Indonesia Japan South Africa Chile New Zealand Canada Turkey India China Mexico EU Israel Iceland Korea 0 20 40 60 80 100 Source: OECD Trade in Value-Added Database; World Bank staff calculations. Rather than tapping into cross-border supply chains, Brazil has predominantly relied on developing vertically integrated industries within its national borders. This approach was advocated as Brazil industrialized its economy and relied on import substitution to initiate virtuous cycles of backward and forward linkages that would help the country in creating value- added through competitive industrial clusters. While the import substitution industrialization approach yielded mixed results and resulted in some distortions, it did also produce considerable growth and industrial diversification. However, because of the vertical integration of many of its industries, Brazil’s participation in cross-border production network has been limited (except perhaps for the regional supply chains for the car industry). The relative lack of cross-border integration is noticeable in the large share of domestic value-added in Brazil’s exports. Compared to other countries, Brazil’s exports contain a lot of domestic value. This partly derives from the nature of Brazil’s exports, as commodity-based exports such as iron ore and soybeans naturally have higher value added. Within the manufacturing sectors, Brazil’s value-added export ratio is also higher than in other countries. This is particularly so for food products, beverages and tobacco; transport equipment; manufacturing and recycling; and machinery and other equipment. In comparison, China adds much less domestic value in all of these industries. Thus, while one avenue for Brazil to enhance trade openness will be to participate more fully in cross-border production networks, this is likely to lead to lower levels of vertical specialization and domestic value-added on the one hand but may contribute to greater productivity and scale on the other hand. 77 Figure 62. Considering just manufacturing, the same results holds true Share of total domestic value added in exports (percent) Food products, beverages and tobacco Transport equipment Brazil Brazil Indonesia Japan Japan Indonesia Australia United States United States Australia Turkey Israel South Africa Turkey Mexico China New Zealand Chile Israel Norway Canada Mexico China Korea Norway New Zealand Chile EU EU Canada Korea South Africa 0 20 40 60 80 100 0 20 40 60 80 100 Manufacturing (not elsewhere classified) and recycling Machinery and equipment (not elsewhere classified) Brazil Brazil United States Japan Indonesia United States Japan New Zealand Norway Turkey Australia Australia South Africa Norway China China New Zealand Canada Chile Canada Korea Turkey Israel EU EU Korea Mexico Mexico Chile Israel Indonesia 0 20 40 60 80 100 0 20 40 60 80 100 Source: OECD Trade in Value-Added Database; World Bank staff calculations. Firm-Level Participation in External Trade Remains Low and Uneven Based on a new database of exporter dynamics, it is possible to compare the participation of Brazilian firms involved in export activities internationally. The Exporter Dynamics Database is the first database providing measures of exporter characteristics and dynamics across 45 countries across all geographic regions and income levels. The Exporter Dynamics Database contains close to 100 measures covering the basic characteristics of exporters, their distribution by size, the diversification in their products and markets, their dynamics in terms of entry, exit and survival, and the average unit prices of the goods they export (Cebeci et al, 2012). International comparison suggests that export participation among firms is low, with low entry rates and high survival rates. Given its per capita income level, Brazil stands out as having a relatively low number of exporting firms per capita, a result which carries through during both the 2001-05 and 2006-10 periods. For a given number of firms that export, the entry rate is relatively low. Interestingly, Brazil has about the same number of export firms as Norway, but has a markedly lower rate of new entrants into the export business. While this could be explained by factors of economic geography, it does suggest that the export sector shows less dynamism. While the entry rate is low, the survival rate is relatively high. While it is therefore less likely for new firms to enter the export business in Brazil, it is more likely that once they do they continue to export in the years that follow. 78 The low entry rate of exporters in Brazil is a cause for concern. Studies in other contexts, such as Clerides, Lach and Tybout (1998) for Colombia, Mexico and Morocco and Bernard and Jensen (1999) for the United States, show that new exporters are on average more efficient than firms that do not export. Low entry rates can be attributed to low productivity at the firm level and/or high costs to export. This is an area that requires further analysis to guide policy actions (Canuto, Cavallari and Reis, 2013). Brazilian firms are more dynamic with respect to China as importers rather than exporters. While the number of Brazilian firms that export to and import from China has risen steadily over the period 2001-2011, the increase in the number of importing firms has been much more rapid than that of the number of exporters. Among the Brazilian firms that import worldwide, more than half imported from China by 2011. This contrasts with Brazilian firms that export worldwide, of which only a tenth exported to China. Brazilian exporters to China have registered lower entry and survival rates than those who import from China. The reason thus why growth in the number of exporters to China has been more muted than what happened on the import side is a combination of two factors. First, the export entry rate has been much lower than the import entry rate, with exception of the initial period prior to 2004. Second, those that import from China are more likely to remain importers than those that export. Brazilian firms’ trade with China is characterized by average export values per firm greatly exceeding average import values. This is consistent with the observation that fewer firms are exporting than importing, while both aggregate export and import values have increased significantly. This result is despite the fact that an increasing number of the largest exporting firms are also importing from China. 79 Figure 63. Compared to the rest of the world, Brazil stands out as having a relatively concentrated export base, characterized by low entry and relatively high survival rates. Exporters per capita versus GDP per capita: 2001-05 Exporters per capita versus GDP per capita: 2006-10 Ln number of exporters per capita Ln number of exporters per capita -4.0 -4 -5.0 SWE EST NZL -5 -6.0 BGR NOR MUS ESP EST MKD PRT MUS ESP SWE -6 BGR -7.0 BWA SLV LBN MKD KWT BWA CHL -7 JOR CRI -8.0 DOM NIC CRI MEX JOR CHL TUR PER -8 SLV DOM MEX -9.0 BRA GTM COL PAKMAR KEN ECU IRN CMR -9 MAR SEN BRA -10.0 KHM KHM CMR BFA MWI LAO MLI BGD -10 BFA -11.0 MLI BGD YEM -11 NER -12.0 6 7 8 9 10 11 -12 ln GDP per capita 6 7 8 9 10 11 ln GDP per capita Entry rate versus total number of exporters: 2001-05 Entry rate versus total number of exporters: 2006-10 Entry rate Entry rate 0.6 0.6 UGA MWI KWT CMR 0.5 CMR 0.5 NER BWA BGR LAO TZA BFA EST TZA DOM MLI DOM IRN SEN PER BWA ESP JOR ECU KEN 0.4 MKD NOR MEX 0.4 BGR JOR NIC CRI LBNMKD CHL PAK KHM ALB KHM SLV ZAF TUR MEX ALB MAR MUS GTM NZL TUR 0.3 0.3 GTM MUS SWE CRI COL PRT SWE EST BRA BGD BRA 0.2 0.2 4 6 8 10 12 4 6 8 10 12 Ln total number of exporters Ln total number of exporters Survival versus entry rate of new exporters: 2001-05 Survival versus entry rate of new exporters: 2006-10 Survival rate Survival rate 0.6 0.6 BGD KHM PAK TUR BRA TUR EGY BRA JOR 0.5 0.5 CRI LAO NZL MKD MUS MLI BFA JOR PER BWA ALB MKD MUS ZAF CRI MAR PRT KHM NIC MEX 0.4 TZA 0.4 BWA MEXECU DOM GTM SWE SLVNORSEN COL GTMLBN IRN EST ALB DOM UGA CHL KEN ESP CMRBGR 0.3 0.3 EST TZA MWI NER CMR 0.2 0.2 0.2 0.3 0.4 0.5 0.6 0.2 0.3 0.4 0.5 0.6 Entry rate Entry rate Source: World Bank Exporter Dynamics Database; World Bank staff calculations. 80 Figure 64. Brazilian firms that import from China have Figure 65. Half of all importers import from China, multiplied compared to those that export whereas only a tenth of exporters export to China Number of Brazilian firms trading with China Share of firms that trade with China 25,000 0.6 Export Exporting firms 0.5 Import 20,000 Importing firms 0.4 15,000 0.3 10,000 0.2 5,000 0.1 0 0.0 2001 02 03 04 05 06 07 08 09 10 11 2002 03 04 05 06 07 08 09 10 11 Source: Brazilian Ministry of Development, Industry and Trade Source: Brazilian Ministry of Development, Industry and Trade (MDIC); World Bank staff calculations. (MDIC); World Bank Exporter Dynamics Database; World Bank staff calculations. Figure 66. Following 2003, the import entry rate Figure 67. The import survival rate has trended up exceeded the export entry rate whereas the export survival rate trended down Entry rates of new Brazilian firms exporting to or importing from China Survival rate of Brazilian firms exporting to or importing from China (percent) (percent) 70 60 60 50 50 40 40 30 30 20 Export survival rate 20 Export entry rate Import survival rate 10 Import entry rate 10 0 0 2002 03 04 05 06 07 08 09 10 11 2003 04 05 06 07 08 09 10 11 Source: Brazilian Ministry of Development, Industry and Trade Source: Brazilian Ministry of Development, Industry and Trade (MDIC); World Bank staff calculations. (MDIC); World Bank staff calculations. Figure 68. Average export values per firm are much Figure 69. Some 60 percent of Brazil’s top exporters higher than average import values import from China Average value of trade with China per Brazilian firm (thousands of US Share of Brazil’s top 250 exporters worldwide that import from China dollars) (percent) 70 25,000 Average export value 60 20,000 Average import value 50 15,000 40 30 10,000 20 5,000 10 0 0 2001 02 03 04 05 06 07 08 09 10 11 2001 02 03 04 05 06 07 08 09 10 11 Source: Brazilian Ministry of Development, Industry and Trade Source: Brazilian Ministry of Development, Industry and Trade (MDIC); UN Comtrade; World Bank staff calculations. (MDIC); World Bank staff calculations. 81 B. Has Brazil’s Trade Structure Become Too Concentrated? A second question that is prominent in the discussion on Brazil-China linkages is whether Brazil has become too dependent on China. This question arises in the context of an evolving relationship that has through its multiple facets manifested itself in various demand-side impulses and supply-side pressures. On the export side, the concern is that increased exposure to China has raised the vulnerability of Brazil to a potential Chinese slowdown. On the import side, the concern relates to the proliferation of Chinese imports in the domestic market in Brazil. In what follows, both of these questions will be addressed by analyzing the developments in market and product concentration of Brazil’s trade flows with China and the world and also comparing these with indicators on the relationship between China and its trading partners. This report suggests as a response to this question that Brazil remains highly diversified in terms of markets and products. Indeed, it is thanks to the rising trade with China that market diversification has increased. As a result, Brazil has become one of the most market-diversified economies in the world. On the product side, while the trade with China is highly concentrated in commodities, Brazil’s overall export bundle remains highly diversified. Market Diversification Has Improved Thanks to Rising Trade with China Although Brazil remains a relatively closed economy, it trades with a diversified range of overseas partner. 18 The stronger trade relationship with China helped promote market diversification of imports and exports. As shown in Figure 19 and Figure 20, the rapidly growing trade between Brazil and China diminished the relative importance of its traditional high-income trading partners – the EU and the US – in total exports and imports, while the share of its Latin American trading partners remained roughly unchanged. This has resulted in a more balanced export and import structure, reducing as a result the extent to which trade is concentrated with respect to markets. Figure 70. Rising trade with China made Brazil more diversified in export and import markets Herdindahl-Hirschman index of concentration (squared formulation) 0.11 Export market concentration Import market concentration 0.10 0.09 0.08 0.07 0.06 0.05 0.04 91 93 95 97 99 01 03 05 07 09 11 Source: UN Comtrade; World Bank staff calculations. Note: A higher index corresponds to higher concentration. 18 See Technical Appendix for a formal presentation of the Herfindahl-Hirschman Index of market concentration. 82 Brazil has become one of the most market-diversified exporters in the world. Brazil was in fact already a rather diversified economy before the growth in bilateral trade with China occurred. However, after China established itself as a major trading partner, Brazil’s export and import structure became even more diversified. The China trade turned Brazil into one of the most diversified economies in the world in terms of markets. In this respect, Brazil and China exhibit similarity as they are both more highly diversified in terms of both export and import markets than the world average. Interestingly, Brazil is slightly more diversified in terms of export markets, whereas China is somewhat more diversified in terms of import markets. Figure 71. Export destination concentration compared Figure 72. Import source concentration compared Herfindahl-Hirschman index of export destination concentration, 2011 Herfindahl-Hirschman index of import sources concentration, 2011 (square root formulation) (square root formulation) 1.0 1.0 0.8 0.8 0.6 0.6 0.4 0.4 China Brazil 0.2 0.2 China Brazil 0.0 0.0 1 10 100 1 10 100 GDP per capita (current USD in thousands, logs) GDP per capita (current USD in thousands, logs) Source: UN Comtrade; World Bank staff calculations. Source: UN Comtrade; World Bank staff calculations. While increased diversification lessens the vulnerability to shocks in overseas markets, this benefit should not be overestimated. Brazil’s expansion of the trade with China provided some resilience recently when demand from high-income economies turned sluggish. While these benefits exist, they should not be overstated. First, a significant share of China’s import demand relates through the processing trade to final demand in high-income economies. Viewed from this angle, the importance of Brazil’s traditional trading partners continues to exceed that of China, even though China is catching up quickly in the value-added trade as it develops its own domestic market (Figure 22). Second, given the scale and connectivity of the Chinese economy, the vulnerability of Brazil to a slowdown is raised through the ripple effects that could be transmitted onto third markets. Such correlated risks would diminish the benefits of market diversification. In sum, Brazil does not appear to have a ‘market concentration problem’ as a result of the rise of the Brazil-China trade relationship. To the contrary, trade with China has allowed Brazil to develop a more diversified interaction with the world in terms of its export destinations and import origins. Whether the contribution of China to higher market diversification in Brazil has also reduced Brazil’s trade vulnerability remains to be seen. In any case, the impact on Brazil’s overall economy is mitigated not only by market diversification but also by the low share of external trade in the economy as a whole. 83 Product Diversification Remains High, With Asymmetry in Trade with China Brazil’s trade structure is highly diversified in terms of the range of products it exchanges with the rest of the world. 19 Brazil is in fact more diversified on both the export and the import side than countries with a similar per capita income level. China is also highly diversified on the product side, especially in terms of exports where it stands out as one of the most diversified exporters in the world. On the import side, while China is less diversified than Brazil, it is nevertheless not more concentrated than other countries at similar per capita income levels. Figure 73. Brazil is well diversified in its export Figure 74. Brazil is also well diversified in its import products to the world products from the world Export product concentration (total exports), Herfindahl- Import product concentration (total imports), Herfindahl- Hirschman index of concentration, 2011 (square root formulation) Hirschman index of concentration, 2011 (square root formulation) 1.0 1.0 0.8 0.8 0.6 0.6 0.4 0.4 China 0.2 0.2 China Brazil Brazil 0.0 0.0 1 10 100 1 10 100 GDP per capita (current USD in thousands, logs) GDP per capita (current USD in thousands, logs) Source: UN Comtrade; World Bank staff calculations. Source: UN Comtrade; World Bank staff calculations. Figure 75. Export product concentration to China is Figure 76. As elsewhere around the world, Brazil high, but this is not unique to Brazil imports a diversified range of products from China Export product concentration (exports to China), Herfindahl- Import product concentration (imports from China), Herfindahl- Hirschman index of concentration, 2011 (square root formulation) Hirschman index of concentration, 2011 (square root formulation) 1.0 1.0 0.8 0.8 0.6 0.6 Brazil 0.4 0.4 0.2 0.2 Brazil 0.0 0.0 1 10 100 1 10 100 GDP per capita (current USD in thousands, logs) GDP per capita (current USD in thousands, logs) Source: UN Comtrade; World Bank staff calculations. Source: UN Comtrade; World Bank staff calculations. 19 See Technical Appendix discussion and formal presentation of the Herfindahl-Hirschman Index of product concentration. 84 Brazil’s trade with China exhibits an asymmetry between a high degree of product concentration on the export side and a low degree on the import side. Brazil’s exports to China are much more product-concentrated than those to the world. In contrast, Brazil’s imports from China however, are even more diversified than Brazil’s imports from the wo rld. China has thus permeated the Brazilian domestic market with a broad spectrum of products. The asymmetry in the trade relationship with China is, however, not unique to Brazil and, in fact, is quite moderate in international comparison. Brazil is less diversified in its entire export bundle to China than to the rest of the world, while imports are significantly more diversified. However, this phenomenon is not unique to Brazil. Other countries are having the same experience with China. An international comparison shows export products being more heavily concentrated to China than imports from China. Nearly all countries in the world maintain a diversified import basket from China and a concentrated export basket to China. In fact, Brazil is slightly more diversified on both accounts than other countries given its income level. Figure 77. Brazil’s top five export products to China Figure 78. Brazil’s top five export products to the world represent 80 percent of total exports to China represent a much smaller share Share of top five products in total exports to China (percent) Share of top five products in total exports to the world (percent) 100 100 Raw cane sugar Raw cane sugar Iron ores (aggl.) 80 Iron ores (aggl.) 80 Petroleum oils Petroleum oils Soya beans 60 Soya beans 60 Iron ores (non-aggl.) Iron ores (non-aggl.) 40 40 20 20 0 0 1991 2001 2011 1991 2001 2011 Source: UN Comtrade; World Bank staff calculations. Source: UN Comtrade; World Bank staff calculations. In the case of Brazil, the high degree of export product concentration is accounted for by five commodity products. The top five products accounted for over 80 percent of Brazil’s exports to China in 2011. All of these were commodity-related: non-agglomerated iron ores and concentrates (41 percent), soybeans (25 percent), and petroleum oils (11 percent), agglomerated iron ores and concentrates (4 percent), and raw cane sugar (3 percent). To the world, together these five products account for 35 percent of exports. Comparing 2001 with 2011, the concentration ratios for Brazil’s top five export products have risen significantly, both with respect to China and the world. In contrast, the top five products imported by Brazil from China comprise only 15 percent of overall imports from China – and just 12 percent when considering the world’s total imports from China (not shown in chart). These top five import products were all machinery or electrical equipment. 85 Figure 79. Brazil’s export product mix remains very Figure 80. Trade with China has made Brazil’s overall diversified despite trade with China import product mix even less concentrated Herfindahl-Hirschman index (HS 6-digit products, squared Herfindahl-Hirschman index (HS 6-digit products, squared formulation) formulation) World World 1991 1991 USA 2001 USA 2001 2011 2011 EU27 EU27 China China Argentina Argentina 0.00 0.05 0.10 0.15 0.20 0.25 0.00 0.05 0.10 0.15 0.20 0.25 Source: UN Comtrade; World Bank staff calculations. Source: UN Comtrade; World Bank staff calculations. Figure 81. Both Brazil and China trade with the world a Figure 82. In terms of the trade between them, however, very broad spectrum of products there is an asymmetry Number of products traded at 6-digit HS level Number of products traded at 6-digit HS level 5000 5000 Maximum 4000 4000 Exports China to Brazil Exports Brazil to China 3000 3000 Maximum Exports China to world 2000 2000 Imports China from world Exports Brazil to world 1000 Imports Brazil from world 1000 0 0 88 90 92 94 96 98 00 02 04 06 08 10 88 90 92 94 96 98 00 02 04 06 08 10 Source: UN Comtrade; World Bank staff calculations. Source: UN Comtrade; World Bank staff calculations. This contrast in product concentration of trade embodies an asymmetry that also stands out when comparing Brazil’s trade across major trading partners. When considering an index of product concentration, exports to China have becoming exceedingly concentrated over the past twenty years while imports from China have become extremely diversified. Whereas trade with China has increased Brazil’s diversification of export markets, it has increased Brazil’s concentration of export products. On the import side, however, an increase in diversification is observed both in terms of markets and products. Although China has contributed to rising product concentration, Brazil’s overall well- diversified export structure somewhat dampens the exposure to Chinese commodity demand. Exports are far less concentrated to other export destinations than to China. On average over the last decade, Brazil’s top five exports to the European Union accounted for 34 percent of total exports, to the United States 24 percent, and to MERCOSUR 15 percent. 20 Thus, the 20 See the Appendix for a list of top export products to each destination based on their average share between 1997 and 2011. 86 increased concentration of exports to China is somewhat offset by a more diversified export portfolio elsewhere, which should help dampen somewhat the vulnerability to a near-term sudden slowdown in Chinese demand. Yet, to the extent that commodities are correlated, the impact would be expected to be larger. On the flipside, Brazil is also expected to be significantly exposed to the longer-term structural developments in China which, as argued before, are expected to impart a positive impact. The asymmetric trade relationship also becomes apparent when comparing the number of products Brazil and China trade with each other as opposed to the world. Both Brazil and China trade with the world a very broad range of products, which attests to the diversified nature of their tradable sectors. However, when it comes to the bilateral trade between Brazil and China, a striking asymmetry pops up in terms of the broad range of products China exports to Brazil and the narrow range Brazil exports to China. The asymmetry is apparent in a broad range of product categories which Brazil exports to the world but not to China (see Appendix). As elsewhere in the world, China is present in nearly everything that is imported by Brazil but especially in manufacturing. Although Brazil could be importing the same product from different countries, the analysis suggests there is likely some substitution across import destinations as the total number of imports in these categories has changed little. In addition, even within primary products and resource-based manufacturing, the number of exports to China is limited compared to what is exported to the rest of the world. The asymmetrical structure of the Brazil-China trade relationship points to opportunities for further bilateral diversification. While the finding of asymmetrical breadth is consistent with the earlier analysis of product concentration, it also suggests that for both countries, although especially for Brazil, there appears to be a significant gap in the number of products that could potentially be traded. This then leads to the question whether trade policies have affected the patterns of trade in accentuating the existing asymmetry. C. Has Brazil Become Too Specialized in Commodities? A third question is whether the Brazilian economy is too strongly oriented towards commodities. The simultaneously similar and complementary relationship between the two countries seems to have contributed to such a direction, as the commodity sector seems to have benefited to a greater extent from the rise of China through both volume and price effects, whereas the manufacturing sector has visibly suffered from heightened competition in domestic and third markets. This development has sparked concerns about the respective contribution of commodities and manufacturing to economic growth and development. It has also led to concerns about de-industrialization in Brazil and its assumed consequences for the country’s capacity to continue climbing up the income ladder through sustained and inclusive growth. 87 The response to this question is that while Brazil has become more oriented towards commodities, this is not a reason for concern per se. Measures of export ‘sophistication’, which reflect export similarity with higher-income countries, suggest declining sophistication both with respect to Brazil’s overall export bundle and manufactured exports. As will be discussed below, however, what matters more for development than sophistication is productivity and as long as the development of the commodity sector – in which Brazil has a well-established comparative advantage – does not come at the expense of other sectors, the pursuit of natural resource wealth could impart an overall positive contribution to growth and development. The Overall Sophistication of Brazil’s Export Bundle Has Declined One way to address this question is to examine how the product sophistication of Brazil’s external trade has evolved. While sophistication may convey different meanings in different contexts, here it refers to the similarity of a country’s export (or imports) bundle to what is typically exported by (imported from) higher-income countries.21 Thus, if a country exports a high share of high-technology products, these products are considered sophisticated not because they are high-technology per se but because high-income countries tend to be more likely to produce and export them. The presumption therefore is that commodity exports are less sophisticated in the sense that they are less frequently exported by high-income countries, from which it then is inferred that too strong a reliance on ‘unsophisticated’ products may hamper a country’s efforts to develop into a high-income economy. Brazil’s exports to China are less sophisticated than those exported to other destinations, as they bear less resemblance to what high-income countries typically export. The United States and Mercosur+ are contributing the most in terms of Brazil’s similarity towards higher income countries’ exports. Brazil’s export basket to Mercosur+ is the most sophisticated of Brazil’s main destinations and is associated with an average level of development of $16,000 constant 2005 international dollars. This is followed by the US, Europe, and China is the least sophisticated, at only $8,000. Due to rising exports of less sophisticated products to China, overall export sophistication has declined as well, especially in recent years. The sophistication of Brazil’s overall export bundle to China is low and has been declining since 2003, suggesting that Brazil has been increasingly exporting products associated with a lower level of development. The evolving characteristics of trade with China have also been driving a decline in Brazil’s overall export sophistication to the world since 2006, after having increased between 1997 and 2000 and remaining steady through 2005. This is due not only to the average level of sophistication of Brazil’s exports to China falling, but also to the share of total exports to China increasing. Only for Europe did the sophistication of exports increase throughout the period. China therefore contributed to diminishing the similarity in Brazil’s exports with those of advanced economies. 21 The notion of export sophistication is based on Rodrik (2007) and Hausman, Hwang and Rodrik (2007), who propose a measure denoted by EXPY that measures the export-weighted level of GDP per capita associated with a country’s export bundle. The index is derived on the basis of the PRODY for a particular product which is the GDP per capita level of the typical country that exports that good. See Technical Appendix for a discussion of the different measures of export sophistication used in this report. 88 Figure 83. Overall export sophistication of Brazilian Figure 84. Including imports, Brazil’s seems to have exports has declined, due to exports to China built up a ‘sophistication deficit’ in recent years EXPY for Brazilian exports by destination (GDP per capita in EXPY2 for Brazilian exports by destination (GDP per capita in thousands of constant 2005 PPP-adjusted international dollars) thousands of constant 2005 PPP-adjusted international dollars) 5 17 3 15 1 13 -1 11 -3 9 -5 7 -7 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 China EU27 Mercosur+ China EU27 Mercosur+ USA World USA World Source: World Bank staff calculations. Source: World Bank staff calculations. Note: For a formal presentation, see the Technical Appendix. Note: EXPY2=EXPY of exports – EXPY of imports. For a formal presentation, see the Technical Appendix. Taking into account import product characteristics as well, Brazil’s net trade with the world seems to have built up a ‘sophistication deficit’ in recent years. Across destinations, it is clear that Brazil’s trade with Mercosur+ is the most sophisticated on a net basis, in the sense that what it exports to the region is more sophisticated than what it imports. The largest deficit in sophistication is observed in the trade with China, which results from the increasing share of commodities on the export side and capital goods on the import side. Over time, the decline in net sophistication with respect to China is striking. This trend has also contributed to a decline in Brazil’s overall net sophistication with respect to its trade with the world, which suggests that over time Brazil’s net export bundle is bearing less resemblance to the typical trade patterns of high-income countries. The profile of Brazil’s exports varies considerably across export destinations (Appendix). Mercosur+ it is the only destination where Brazil’s export basket is associated with richer countries exports. Comparing the sophistication of exports across product categories shows that this is resulting from exports of medium-technology manufacturing versus commodities. In contrast, primary products and other resource-based manufactures (RB2) are contributing most to Brazil’s level of export sophistication to the world, China, and the European Union. The profile of exports to the United States is also different than those of other destinations, with agro-based manufacturing (RB1) and other high technology manufacturing playing a larger role. 89 Manufacturing Exports Have Become Less Sophisticated Controlling for composition effects by focusing on manufacturing only, it appears that the sophistication of manufacturing exports has declined as well. The sophistication of Brazil’s exports of manufactured goods to the world increased between 1997 and 2000 but then gradually decreased over the ten years that followed back to approximately the level of 1997. Across export destinations, it is notable how the level of sophistication of exports to China is much higher when considering only manufactured exports. Although the most sophisticated manufactured goods remain destined for Mercosur+, manufacturing exports to China are just as sophisticated as those to the European Union and the United States, and all are only slightly below Mercosur+. Figure 85. Export sophistication of manufactures Figure 86. Brazil has registered a steadily rising declined after 2000 sophistication surplus in the trade of manufactures EXPY for Brazilian manufacturing exports by destination (GDP per EXPY2 for Brazilian manufacturing exports by destination (GDP per capita in thousands of constant 2005 PPP-adjusted international capita in thousands of constant 2005 PPP-adjusted international dollars) dollars) 22 3 21 2 20 19 1 18 17 0 16 15 -1 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 China EU27 Mercosur China EU27 Mercosur USA World USA World Source: World Bank staff calculations. Source: World Bank staff calculations. Note: For a formal presentation, see the Technical Appendix. Note: EXPY2=EXPY of exports – EXPY of imports. For a formal presentation, see the Technical Appendix. Taking also into account the import side, it is clear that Brazil’s manufacturing sector runs a sophistication surplus with respect to its main trading partners.22 This is especially the case for Brazil’s manufacturing trade with China and Mercosur+, where thus the sophistication of Brazil’s exports exceeds that of its imports from these destinations by a considerable margin. The difference is less considerable for the EU and the United States, however. Another interesting development is that Brazil’s net trade in manufactured goods has seen rising sophistication since the mid-2000s in China, the EU and the United States, whereas it remained roughly constant in Mercosur+. Considering Brazil’s manufacturing exports to the world, the sophistication surplus has steadily increased. 22 Thus, while sophistication of manufacturing exports has declined, manufacturing exports have remained more sophisticated than manufacturing imports. 90 Productivity Matters More for Development than Sophistication While Brazil’s export bundle may bear decreasing resemblance to that of high -income economies, this is not necessarily a bad thing. Several caveats therefore apply to the interpretation of the analysis above.  Brazil’s commodity exports are far from technologically unsophisticated. Although Brazil’s overall export sophistication is reduced by the commodities trade with China, it should be noted that the concept of sophistication should be interpreted in the narrow context of product similarity with high-income countries. The adopted analysis of sophistication fails to distinguish between a product and the process or factor intensity of its production. In addition, a change in the indicator does not necessarily entail a change in the technological content of exports. In fact, for Brazil, many of these commodities are produced in very sophisticated manners – some of the most sophisticated in the world.  Brazil’s revealed comparative advantage in the natural resource sector has been well-established. Although the analysis simply indicates the average level of development of economies that have a comparative advantage in exporting a particular product, the export basket of Brazil does reflect the endowments or technological capabilities that have allowed Brazil to develop a comparative advantage in commodity exports. Every country is different, and regardless of whether this would imply a different development path than one typically pursued by high-income countries in a different era and a different context, it would appear self-evident that for Brazil not to tap into its natural resource wealth and realize the productive opportunities in this sector would amount to undermining the country’s overall development potential. What matters more for development than sophistication is the capacity of the commodity sector to contribute to the creation and sustained growth of value-added. The challenge is not to pursue similarity with advanced economies, but to produce and grow value added. In this respect, the merits of the pursuit of commodity wealth need to be evaluated against whether the commodity sector contributes to productivity growth within the sector and also generates broader economy-wide benefits that stimulate development. Even if these benefits and spill-overs may have been limited so far, the desirable approach would be not to dismiss the commodity sector due to a lack of sophistication but to identify instead how the sector can realize its counterfactual potential and make sure that any demand-side windfalls arising from strong commodity demand translate into supply-side improvements that sustainably raise the growth capacity of the entire economy. Brazil’s strong commodity base should not imply that it cannot or should not develop a competitive edge in other sectors. As the analysis of a changing China in a changing world has suggested, there will be substantial opportunities in other sectors going forward. Brazil can build on its established manufacturing sector and carve out innovative niches in which it can develop global brands and establish a presence in China or elsewhere. In addition, China’s demand for tradable services is expected to rise significantly which should provide opportunities to Brazil as well. 91 From a supply-side perspective, opportunities to enhance productivity growth exist in all sectors of the Brazilian economy. Manufacturing and especially services hold significant potential to boost efficiency. In the commodity sector itself there are plenty of opportunities left to raise productivity and respond more efficiently to demand that is expected to remain strong going forward. Moreover, there are important inter-linkages between sectors, where the competitiveness of one sector depends on that of another sector. Consider for example the inefficiencies in Brazil’s logistics industry which are spilling over into diminished competitiveness and productivity of the commodity and manufacturing sectors. In sum, the discussion of whether Brazil has become too specialized in one sector or another is best framed in the context of maximizing the productivity potential that exists in every sector. Opportunities exist in all sectors to respond to rising demand going forward. Similarly, all sectors hold significant potential to do better in terms of their productivity performance. Moreover, the performance any single sector has come to depend more than ever before on the performance of other sectors. Therefore, the question of which sector to promote is best reframed in terms of how the untapped potential at the firm level can be boosted regardless of what sector the firm belongs to. 92 III. LEVERAGING EXTERNAL CONNECTIONS WITH CHINA The previous sections suggested there is scope for Brazil to further develop its connections with China. This is indicated by the result that the Brazilian economy remains relatively inward- oriented and therefore there is potential for continued integration into the global economy alongside ongoing efforts to further develop and integrate the domestic market. In addition, it was suggested that Brazil does not have a ‘concentration problem’ with respect to its external orientation to the world either in terms of markets or products. However, an asymmetry stands out in terms of the relations with China, where Brazil is much less diversified in terms of products on the export than on the import side. While this result carries through to other countries, it does point to opportunities going forward to broaden and deepen linkages. Finally, while Brazil’s exports to China are concentrated on natural resource-related commodities, there is nothing intrinsically wrong with commodities per se, provided efforts are made to ensure that the natural resource sector contributes to the economy more broadly and that its development does not come at the expense of other sectors. The discussion below lays out in broad terms what efforts Brazil could consider to leverage its connections with China. In what follows the discussion will focus on trade and investment – the two dominant facets of the Brazil-China relationship. The analysis points to static as well as dynamic benefits. Statically, adjustments could be made to develop greater mutual benefits from the existing structure of the interaction between the two countries. Dynamically, as the interaction changes following the broad directions outlined earlier, there will again be scope for both countries to engage so that greater mutual benefits can be derived from changing patterns of trade and investment. A. Tackling Home-Grown Supply-Side Constraints Further productivity-enhancing reforms would not only contribute to home-grown economic growth; it would also allow Brazil to better leverage its evolving connections with China. Important areas were further structural reform effort would be welcome include the investment climate (ranging from reducing the administrative burden of the state, improving the quality and profile of public spending, strengthening the goods and labor market) as physical and human capital accumulation (strengthening logistics and enhancing the skills base of the work force). Progress in these areas would help Brazil accelerate growth. A better investment climate and more investment in infrastructure and skills would also position Brazil better to tap into Chinese demand. It would also position the country better to meet increased competition in higher-end manufacturing. Brazil faces opportunities to enhance productivity and take full advantage of its connections with China in all sectors of its economy. Opportunities exist in all sectors to enhance productivity and respond to rising demand going forward. Similarly, all sectors hold significant potential to do better in terms of their productivity performance. Moreover, the performance of any single sector has come to depend more than ever before on the performance of other sectors given that products have become bundles of value-added derived from different sectors. Therefore, the objective of raising productivity would favor a comprehensive approach that tackles bottlenecks across sectors. In what follows, the discussion will briefly discuss the opportunities that avail themselves in different sectors. 93 Natural Resources: Widening Economic Impact Despite slower growth in China, global demand for Brazil’s natural resources is expected to remain strong. As noted elsewhere in this report, overall commodity demand should remain strong in light of China’s ongoing process of urbanization and given that the capital stock remains only a fraction of the U.S. level. The composition of that demand may be affected however by the rebalancing of China’s growth model in that natural resources related to consumption demand may grow more strongly than those related to investment demand. Among the former, for example, agricultural products should remain in high demand, particularly given that the rise in the middle class should also lead to a rise in protein demand. Among the latter, metals and minerals might be more significantly affected by the slowdown in investment, even if continued residential construction demand, as well as demand for durable goods such as automobiles, caps some of that slowdown (Yu 2011). Brazil’s natural resource sector is also expected to benefit from the continued growth of the developing world outside of China. The challenge going forward will be to respond to this robust demand by enhancing the economy-wide productivity potential of the natural resource sector. The potential pitfalls of natural resource-related growth are well understood. If not properly managed, there is a risk that the pattern of specialization into natural resources can result in negative side effects. These include the prospect of real exchange rate appreciation that may render the manufacturing sector uncompetitive, the risk of becoming trapped in low-value structures that limit the scope for vertical or horizontal links, and the possibility of heightened volatility due to commodity price fluctuations (Chandra, Lin, and Wang 2012; IMF 2011; De Cavalcanti, Mohaddes, and Raissi 2012). The appropriate response to these potential negative effects is not to limit commodity exports or to erect costly import barriers to protect domestic industries, but rather to alleviate demand and supply constraints on productive activity by improving infrastructure, creating a favorable investment climate, and facilitating private sector access to capital, skills, technology, and markets (IMF 2011). The recent discovery of vast offshore oil reserves in Brazil provides new opportunities and challenges to raise productivity. Conservative estimates by the U.S. Energy Information Administration suggest that Brazilian oil production may expand by between 70 and 90 percent between 2010 and 2020, reaching at least 3.4 million barrels of oil equivalent per day. As a result, Brazil may turn into a large net energy exporter. Brazil’s newfound oil wealth offers opportunities to raise investment and savings and alleviate long-standing infrastructure bottlenecks in the country. The new resources could also be used to raise consumption, particularly to assist the poor in a well-targeted manner.23 The technical complexities associated with extracting pre-salt oil also offer opportunities to upgrade the country’s knowledge base (Fajnzylber, Lederman and Oliver, 2013). 23 Care must be given to ensure that any rise in public and private consumption and indebtedness is based on conservative projections for oil production growth, else slower-than-expected growth could result in painful adjustment. 94 Manufacturing: Strengthening Competitiveness Insofar as China will remain a competitor, Brazil’s competitiveness challenge in manufacturing will likely be accentuated by the projected changes in China. If growth in China continues to slow as its economy rebalances and redefines its competitive advantage towards higher-value products, then Brazil may well face a situation where it enters tougher competition with China on the supply side (particularly with respect to higher-end manufacturing) even though market opportunities on the demand side will continue to multiply. The prospect of more intense competition from China underscores the need for Brazil to redouble its efforts to foster innovation and strengthen competitiveness. While innovation and competitiveness enhancements would benefit all sectors, it appears that the manufacturing sector may stand to benefit the most due to the perceived erosion of industrial dynamism. Systemic shortcomings in the investment climate that relate to conditions outside the factory floor – such as infrastructure, logistics, red tape, tax burden – will require attention from the relevant government agencies where possible in partnership with private investors. However, to the extent that inefficiencies occur within the factory gates, Brazilian businesses will need to do their part to respond to the potential of intensified competition. And this will require upgrading of products, processes and organizational forms so as to carve out new competitive niches. Figure 87. Capital accumulation has slowed and Figure 88. Investment has hovered at low levels in scope remains for further deepening GDP, financed primarily by domestic savings Capital stock at constant 2005 national prices per worker (2005 US$ thousands) Share in GDP (percent) Share in GDP (percent) 1000 25 10 8 20 6 4 100 15 2 0 10 -2 10 -4 Brazil Current account balance (RHS) China 5 -6 Total investment Japan South Korea Gross national savings -8 United States 0 -10 1 1950 1960 1970 1980 1990 2000 2010 1980 1990 2000 2010 Source: Penn World Tables version 8.0; Feenstra, Inklaar and Source: IBGE; World Bank staff calculations. Timmer (2013); World Bank staff calculations. Upgrading human and physical capital will enable Brazil to better tap into emerging opportunities in the Chinese market. The evolving nature of China’s import demand suggests that there is scope for upgrading in Brazil, especially in manufacturing. The human and physical capital intensity of Brazilian manufacturing exports to China as well as to the rest of the world appears to be considerably lower compared to what China imports from the world. This difference in revealed factor intensity does not seem to apply to Brazil’s commodity exports to China: even though these exports appear to be somewhat less physical capital intensive than China’s commodity imports from the rest of the world, the human capital intensity and especially the land intensity of Brazilian commodity exports is higher. 95 Figure 89. Human and physical capital upgrading in Brazil would open up opportunities in China Revealed human capital intensity: Revealed human capital intensity: manufacturing (standardized value) commodities (standardized value) 0.7 0.7 0.6 0.6 Brazil's Exports to China China's Imports from World 0.5 0.5 Braizl's Exports to World 0.4 0.4 0.3 0.3 0.2 0.2 Brazil's Exports to China 0.1 China's Imports from World 0.1 Braizl's Exports to World 0 0 -0.1 -0.1 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Revealed physical capital intensity: Revealed physical capital intensity: manufacturing (standardized value) commodities (standardized value) 0.8 0.8 0.6 0.6 Brazil's Exports to China China's Imports from World 0.4 0.4 Braizl's Exports to World 0.2 0.2 0 0 Brazil's Exports to China -0.2 China's Imports from World -0.2 Braizl's Exports to World -0.4 -0.4 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Revealed land intensity: Revealed land intensity: manufacturing (standardized value) commodities (standardized value) 1.3 1.3 1.1 Brazil's Exports to China 1.1 0.9 China's Imports from World 0.9 Braizl's Exports to World 0.7 0.7 0.5 0.5 0.3 0.3 0.1 0.1 -0.1 -0.1 Brazil's Exports to China -0.3 -0.3 China's Imports from World Braizl's Exports to World -0.5 -0.5 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Source: UN Comtrade; World Bank staff calculations. Note: Vertical axis is measured as a trade-weighted standardized value (the indicator’s value minus the mean divided by the standard deviation). See Appendix for a formal presentation. The product-based type of analysis examines the endowment profile of countries that typically export the product in question, but there is no control for supply chains. Thus, a country with moderate levels of human capital can be associated with exporting sophisticated electronics goods while the domestic value added consists merely of assembly. 96 Continued structural reform in Brazil is therefore needed to meet the challenge of changing competition as well as to tap into opportunities in the Chinese market. To take fully advantage of the opportunities created by its relationship with China, Brazil will need to build its endowments of human and physical capital in order to develop comparative advantages in manufacturing products that China imports intensively. Upgrading human capital will increase the skill base and allow Brazil to gain a comparative advantage on knowledge intensive products. The same is true with the physical capital intensity of production in Brazil. As China imports products from countries with a high physical capital stock, tapping into Chinese demand in the future will require augmenting factors such as machinery and infrastructure. Services: Raising Efficiency While the need to raise productivity growth is relatively well understood, the role of the services sector is often over-looked. Indeed, much of the debate in Brazil, both in academic and policy circles, has focused on such issues as whether to promote commodities or manufacturing, how to protect the erosion of industrial competitiveness through industrial policy, how to leverage the opportunities afforded by pre-salt, and how to boost the opportunities in the all- important agri-business sector. As good as absent in these discussions is the role played by the services sector, which nevertheless accounts for the majority of value-added and employment. Large segments of the services sector are expensive and of poor quality. Services inflation has outpaced that of other sectors.24 Given the labor intensity of services, services inflation has been closely related to rapid wage inflation, which has contributed to rising unit labor costs that have dampened industrial competitiveness (Pastore, Gazzono and Pinotti, 2012). 25 Arbache (2012) attributes the rise in real wages between 2005 and 2011 to the heating up of the economy, skills shortages and a demographic slowdown of the working-age population. Canuto, Cavallari and Reis (2013) note that the services sector has been the largest beneficiary of favorable terms of trade and accommodated larger wage increases. Improving the efficiency of services would bring large benefits to the Brazilian economy. Services play a key role in generating economic growth and job creation. Improvements in the productivity, quality and range of services produced in an economy contribute to economic growth directly but also indirectly in the form of spillover effects through the role of services as inputs into other sectors (such as agriculture, mining and manufacturing), particularly given the increased dependence of industrial enterprises on service providers and outside services (Arbache, 2012). There are further reasons, why services are critical to Brazil’s longer-term development objectives. Increased job creation in services, along with real wage growth through productivity gains, can contribute to poverty alleviation; and, enhanced service delivery in the areas of education and health can also promote human capital development to the benefit of longer-term growth prospects. 24 The surge of non-tradable inflation over tradable inflation is a relatively recent phenomenon in the era of Brazil’s new macroeconomic framework. Non-tradable inflation consistently exceeded tradable inflation from the beginning of the Real Plan until 1999. Following the introduction of an independently floating exchange rate and an inflationary targeting regime in 1999, Brazil consistently registered lower inflation in non-tradables than tradables. In 2004, however, and ever since afterwards, non- tradable inflation systematically surpassed tradable inflation. 25 While exchange rate appreciation has affected the competitiveness of Brazil’s exporters, Bonelli and Pinhei ro (2012) find that sluggish industrial sector productivity performance and higher real wages are more important factors. 97 B. Enhancing the External Environment for Trade and Investment In addition to advancing the domestic reform agenda, Brazil could consider further improvements to the external environment for trade and investment. Given their importance in the bilateral relationship, the discussion focuses on trade and investment. While the report also offers perspectives on how China could contribute, the focus will be on the Brazilian perspective. Finally, the trade and investment agenda is closely related to Brazil’s domestic agenda of generating productivity growth and therefore needs to be seen in conjunction with the previous section. Greasing the Wheels of Trade While significant progress has been made to reduce tariffs during the past two decades, tariff barriers in both Brazil and China remain high from an international perspective (Figure 90). Brazil has lowered the simple average tariff including preferences by 20 percentage points between 1990 and 2011 while China has decreased the rate by 34 percentage points between 1992 and 2011. Although China has reduced tariffs to levels below Brazil’s, both countries rank low when benchmarking against others. Brazil and China ranked in the bottom 20 out of a sample of 92 countries according to their simple average applied tariff including preferences in 2009. Figure 90. China has lowered tariffs to levels below Figure 91. Tariffs are higher on each other’s Brazil’s comparative advantages Average tariffs (import-based, percent) Weighted-average tariffs (export-based, percent) 16 Tariffs imposed by Brazil on China 14 Brazil Tariffs imposed by China on Brazil 20 12 China 10 16 8 12 6 4 8 2 4 0 Simple average Trade-weighted Simple average Trade-weighted 0 average average Total Agri/food Mineral Remaining Applied including preferences MFN applied products products products Source: UNCTAD; UN Comtrade; World Bank staff calculations. Source: UNCTAD; World Bank staff calculations. Note: Weighted average applies MFN tariff that the importing country Note: Simple average across all product lines with non-zero trade imposes on the exporting country, weighted by share of exports in flows to any country in the world. Trade-weighted average with total exports of the exporting country to the world at the product level country’s import shares as weights. (as such it weights the importing country’s tariff by the structure of the exporting country’s comparative advantage). Agri/food covers HS 01- 24 and minerals HS 25-27. Both countries impose higher tariff barriers on products where the other has a revealed comparative advantage (Figure 90 and Figure 91). The lower trade-weighted than simple average tariff of both countries to the world suggests that each country imposes lower tariffs on the products that are more heavily imported. Yet China imposes higher tariffs on the sector where many of Brazil’s comparative advantages exist, and the same is true vice versa. This can be seen by incorporating the export structure of the trading partner when calculating the trade- weighted average tariff by placing higher weights on the products for which the other country 98 has a comparative advantage. As illustrated, China imposes higher tariffs on agriculture and food products while Brazil imposes higher tariffs on non-commodity based products. Tariff structures in part determine the trade patterns between the countries, but the impact on diversification differs between Brazil and China. This result likely influences the asymmetry in the number of products Brazil exports to China versus the rest of the world. However, as shown above, it has not prevented China from exporting a significant amount of manufactured products to Brazil. Differences in regional tariff structures are a further factor that have shaped trade patterns. In this respect, Baumann and Ceratti (2012) point to competitive pressure onto Brazilian manufacturing exports to China’s regional neighbors arising from preferential concessions to the region. Brazilian exports of higher value-added products to China have been relatively limited compared with such exports to other countries (Figure 92). Although Brazil produces many commodities, commodities themselves may contain significant amounts of value-added potential. To some extent, Brazil has reaped that potential already, but in many respects there remain plenty of opportunities that could be tapped into. For example, Brazil exports green coffee beans but is absent in the export of processed coffee; Brazil exports iron ore but is struggling to export steel; Brazil exports soybeans but to a much lesser extent soy oil. While domestic factors in Brazil affecting external competitiveness may offer a partial explanation, China-related factors regarding access seem to matter as well, as suggested by Brazil’s exports of processed versus unprocessed food to the Chinese market standing in stark contrast to other countries in the world. Figure 92. In contrast to elsewhere, Brazil exports of Figure 93. Tariff escalation exists in Brazil’s main food food products to China are mostly unprocessed exports Brazil’s exports of food and beverages: primary and processed, by Simple average MFN applied tariff (percent) destination in 2012 (millions USD) China Vegetable Oil Germany Spain Primary Sugar USA Processed Netherlands First stage Japan Chicken Second stage Italy Third stage Belgium Beef Russian Fed. Venezuela 0 10 20 30 40 50 60 Source: UNCTAD; World Bank staff calculations. Egypt Note: Examples taken from USITC (2001). Processing stages for Hong Kong vegetable oil: soya beans (1), soya bean meal (2) and crude and refined soya bean oil (3); sugar: raw (1), refined (2) and containing 0 2000 4000 6000 8000 10000 12000 added flavor or coloring (3); poultry: whole birds (1) , poultry cuts (2) and processed poultry products (3); beef: cattle (1), beef carcasses Source: UN Comtrade; World Bank staff calculations. (2) and fresh or frozen boneless beef (3). Tariff escalation in China may be one underlying reason why Brazil has been unable to diversify its exports to China into more value-added products (Figure 93). The literature has documented that China pursues a policy of tariff escalation that discriminates against products with higher value-added (WTO Trade Policy Review 2010). This policy is aimed at keeping the processing content low and impedes foreign companies from accessing opportunities in the 99 Chinese market. China applies higher tariffs to the more processed form of some of Brazil’s most important export commodities to China. For example, a low tariff is applied to raw sugar (stage 1), but then jumps to nearly 50 percent when sugar is refined (stage 2) or contains added flavor or coloring (stage 3). The same is true for vegetable oils, with lower tariffs applied to soybeans (stage 1), but higher on soybean meal (stage 2) and crude and refined soybean oil (stage 3). In beef, higher tariffs are applied to beef carcasses (stage 2) and fresh or frozen boneless beef (stage 3) than cattle (stage 1). The services trade between both countries is relatively unencumbered by trade policy limitations, but openness varies by supply mode (Figure 94). Brazil is an open economy with respect to services trade but with some minor restrictions. China allows entry and operations but imposes restrictions that are neither trivial nor stringent. Domestic policy constraints in services may, however, dampen competition and create an anti-export bias. In addition, openness in services trade is linked with the performance of the sector. For example, it has been shown that economies that are more open in logistics services perform better across a range of logistics performance indicators. For Brazil, most of the restrictions are through limits on cross-border supply of services. The professional services sector, which includes accounting, auditing, and legal services, faces the highest barriers to trade, with cross-border supply entirely closed. Telecommunications and retail, on the other hand, are completely open. In China, professional services are also the most restricted, with restrictions through commercial presence. Figure 94. The services trade between both countries is relatively open, but openness varies by supply mode Services trade restrictiveness index (0-100, 100 most restrictive) 80 70 Brazil China 60 50 40 30 20 10 0 Overall Mode 1 Mode 3 Mode 4 Source: World Bank Services Trade Restrictiveness Index (2012). Note: Mode 1=cross-border supply, Mode 2=consumption abroad, Mode 3=commercial presence, Mode 4=presence of a natural person. Further reduction of tariffs, in particular in agriculture, will benefit both Brazil and China. On the multilateral agenda, both Brazil and China would benefit from continued progress on multilateral negotiations. The removal of subsidies to agriculture in the advanced economies like the United Sates and the European Union would be in Brazil’s interests, as these regions are competitors of Brazil in the sectors in which Brazil has comparative advantages. China could consider addressing policies such as tariff escalation to grant greater market access to Brazil, which would also have domestic benefits by lowering the price of food for the poor. 100 The scale and scope of non-tariff measures is extremely high in Brazil and China. Non-tariff measures (NTMs) can be a significant obstacle to trade, as the cost of compliance of such measures is high and can erode countries’ competitive advantage. Yet these types of indirect policies are increasingly replacing tariffs to hinder free trade between countries. India, China, Indonesia, Argentina, Russia, and Brazil together accounted for nearly half of all new NTMs imposed worldwide between 2008 and 2011 (Cadot, Malouche and Sáez 2012). China imposed at least one type of NTM in 100 percent of its products in 2012, while for Brazil NTMs affected about two thirds of the product lines and corresponding import value in 2008 (albeit all were partial coverage). Non-tariff measures are important barriers to trade in both countries, but more so in Brazil. Taking into account NTMs, Brazil’s uniform equivalent applied tariff including preferences in 2009 jumped to 20.33 percent, whereas in China it increased to 9.83 percent. In addition, Brazil has increased the use of NTMs in recent years, including local content requirements, import licensing and quotas, and export incentives. Figure 95. Non-tariff measures are applied across the Figure 96. Non-tariff measures are more targeted in board in China Brazil Application of NTMs on China’s imports (percent) Application of NTMs on Brazil’s imports (percent) Machinery Quantity control Machinery Quantity control Base metals Price control Base metals Price control Textiles TBTs Textiles TBTs Rubber SPS measures Rubber Pre-shipment Chemical inspection Pre-shipment inspection Chemical Food SPS measures Food 0 20 40 60 80 100 Source: UNCTAD; UN Comtrade; World Bank staff calculations. Note: TBTs=technical barriers to trade; SPS=sanitary and 0 20 40 60 80 100 phytosanitary standards. Source: UNCTAD; UN Comtrade; World Bank staff calculations. Note: TBTs=technical barriers to trade; SPS=sanitary and phytosanitary standards. While China applies non-tariff measures across the board, Brazil targets food products and chemicals, where many of its comparative advantages exist (Figure 95 and Figure 96). These tend to materialize in the form of sanitary and phytosanitary standard (SPS) measures and technical barriers to trade (TBTs), however quotas are also important in these sectors. Tariff rate quotas are applied to agricultural goods, where low ‘in-quota’ tariffs are applied to a limited volume of imports, after which high ‘off-quota’ tariffs are applied. TBTs are also applied to over half of machinery and equipment imports, a domestic sector that has been under pressure from Chinese imports. China’s non-tariff barriers affect a large percent of what Brazil exports to the rest of the world (Table 10). All of Brazil’s exports to China are affected by SPS measures and TTBs. To put this in perspective, this accounts for almost one fifth of Brazil’s exports to the world, due to China’s importance as an export destination for Brazil. While the bilateral coverage ratios for China’s exports to Brazil are also high, for example over 40 percent from TTBs, as a share of 101 world exports they are much smaller, due to Brazil being a less important destination of China’s exports. Streamlining NTMs could assist to increase private sector productivity. While many NTMs are justified on the basis of health and safety standards, they can also act as barriers to trade. Given the complexity and variety of NTMs, when poorly designed they can hurt competiveness through high costs of compliance and hurt consumers by raising prices. Identifying which NTMs are particularly burdensome for firms at the country level through consultations with the private sector would be beneficial as a focal point for streamlining. After this process, regulatory improvements could be adopted through careful analysis and private/public dialogue so as to increase transparency of regulations and reduce the compliance costs for firms. Table 10. Non-tariff measures have a broad impact on trade partners’ exports Coverage, 2008 (percent) Non-tariff measures (NTM) Share of China’s NTMs on Share of Brazil’s NTMs on classification Brazil’s Exports… China’s Exports …to China …to World …to Brazil …to World Sanitary & phyto-sanitary 100 19.1 10.5 0.2 standards Technical barriers to trade 100 19.1 43.3 0.6 Pre-shipment inspection & 0.8 0.1 1.9 0.03 other formalities Price control measures 100 19.1 4 0.06 Licenses, quotas, prohibitions & 100 19.1 30.4 0.45 other quantity control measures Charges, taxes & other 0.01 0.002 0 0 para-tariff measures Anti-competitive measures 100 19.1 0.3 0.004 Intellectual property <0.001 <0.001 0 0 Export-related measures 42.9 8.2 0 0 Source: UNCTAD; UN Comtrade; Nicita and Gourdon (2012); World Bank staff calculations. Note: For Brazil, all NTMs are partial coverage. The use of temporary trade barriers has increased somewhat between 2001 and 2011, creating additional frictions in the trade environment between the two countries. After the global financial crisis of 2008/9, many developed and developing countries increased the use of temporary trade barriers (TTBs) to protect domestic industries, and China and Brazil are not exceptions.26 Most TTBs have appeared as anti-dumping investigations, but recently there have also been a few instances of countervailing duties being initiated in both countries. China increased the share of import product lines subjected to at least one import-restricting TTB from 0.3 percent to 1.4 percent between 2001 and 2011. In Brazil, the share increased from 1.2 percent to 1.9 percent. This corresponds to 3.2 percent of Chinese imports and 1.7 percent of Brazilian imports being affected by TTBs in 2011. 26 Temporary Trade Barriers include anti-dumping duties, safeguard measures, and countervailing duties. Anti-dumping duties are allowed to be imposed on goods that are deemed to be dumped (sold below the price in the exporting market) and harming producers of competing products in the importing country. Safeguard measures are actions taken in the importing country to protect a specific industry from an unexpected build-up of imports. Countervailing measures are actions taken by the importing country, usually in the form of increased duties, to offset subsidies given to producers or exporters in the exporting country. 102 Brazil and China could work together to improve the trade environment. This would involve lowering tariff rates and eliminating other types of TTBs like subsidies, tax benefits for particular sectors, and local content requirements as these would contribute to sustained productivity growth by enhancing the exposure to competition. At the same time, the concerns underlying these measures would need to be addressed and this would involve concomitant efforts to boost firm level capabilities so as to boost their international and domestic competitiveness. Similarly, in the case of demonstrated unfair trade practices, these would need to be resolved as well. Expanding Foreign Direct Investment Brazil has a highly liberal policy regime for foreign direct investment . Except for domestic air transport and media, almost all other primary, manufacturing and services industries allow full (100 percent) of equity ownership by foreign investors. According to the World Bank Group's FDI Regulations database (published in 2010 as the Investing Across Borders indicators and updated in 2012), the domestic air transport sector permits only a maximum of 20 percent of foreign equity ownership. Among the 104 economies assessed, this is the most restrictive rule in place with the exception of Iraq and Ethiopia, and comparable to Canada (25 percent). 27 In newspaper publishing and television broadcasting, Brazil restricts foreign equity ownership to 30 percent.28 Most sectors are fully open: indeed, even within transport, industries covering freight by road, rail or internal waterways, port operation and courier activities permit full foreign participation. Following constitutional amendments in 1995, there is no discrimination in the legal treatment of foreign and national capital under equal circumstances (WTO, 2013). In contrast to the liberal de jure provisions, the de facto process of setting up a foreign- owned subsidiary in Brazil is relatively cumbersome (Table 11). It takes, on average, 16 distinct procedures and 152 days to set up a foreign subsidiary in Brazil’s largest commercial city (World Bank, 2010). Among the 15 countries examined in Latin America and the Caribbean region, only Venezuela fared worse (17 procedures and 325 days on average) in its ability to facilitate a swift process for foreign investors to set up subsidiaries. Among BRICS nations, the average number of days it takes to establish a foreign subsidiary in Brazil is longer by a factor of 2.5 than in China. While government approval is not required, foreign investments must be registered with the Brazilian Central Bank and only a few entities are entitled to hold a foreign currency bank account (World Bank, 2010). Brazil is also one of the slowest countries in the world, and certainly among BRICS, in enforcing arbitral awards in cases of commercial disputes involving foreign investors. The number of days it takes between the filing of a request for arbitration to the constitution of the arbitral tribunal is much longer than in China and Russia, but comparable to India and South Africa. For recognition and enforcement of any foreign arbitral award, the delay in Brazil again stands out. However, on measures of openness to FDI by sector, Brazil fares better than China, India and South Africa, and is almost as open as Russia. 27 It is worth noting that both Brazil and Canada have two of the world’s most successful regional jet manufacturing companies, Embraer and Bombardier, respectively. 28 Naturalized citizens with 10 years of residence in the country can manage newspapers, magazines, and other publications as well as radio and TV networks; cable TV services are completely open (WTO 2013, p. 36). 103 Table 11. Compared to other BRICS, setting up shop in Brazil is de jure highly liberal but de facto relatively cumbersome Investing across sectors Starting a foreign business Arbitrating and mediating disputes Length of Length of Average foreign equity Number of Number of arbitration recognition and ownership permitted procedures days proceedings enforcement (percent) (days) proceedings (days) Brazil 93 16 152 560 2325 China 75 17 63 164 420 India 81 15 35 569 1654 Russia 94 9 19 119 138 South Africa 88 8 57 528 1178 Source: World Bank Group (2010), with updated data from 2012 Brazilian businesses hold potential for broadening and deepening FDI into China, especially in services (Figure 97). To the extent that sectoral restrictions on foreign equity ownership matter for FDI inflows, there is much room and likelihood of China further opening up its key services industries. This includes the sub-sectors of fixed line and wireless telecommunications, life and health insurance, some forms of transportation, water supply, and electricity transmission and distribution. Brazilian companies engaged in outward FDI in China are highly diverse; but about half of the investors are services-related and most manufacturing FDI is also related to services activities such as sourcing, distribution and sales (China-Brazil Business Council, 2012). From this perspective, Brazil’s outward FDI is not trade-substituting: as there is scope for barriers to both imports and FDI in services to continue to fall in China, both trade and investment from Brazil can broaden and deepen. This is because productivity growth in services will be a growing priority for China to sustain its high growth and to support a more sophisticated move up the manufacturing value chain. For this, greater exposure of the services sector to international competition is inevitable. The growing impetus for outward FDI from China will also benefit Brazil. China’s export success over the past three decades was built in large measure on the strength of inward FDI that brought with it new technologies, business practices and world markets.29 Increasingly, however, China will need to encourage outward FDI – and greater globalization of its firms – to seek higher value-added segments of global production, as well as to skirt the scarcity of low-skilled labor availability within China. Brazil is well placed to receive more market-seeking FDI from China given its large base of middle-income consumers. In addition, the country’s complete policy openness to FDI in almost all sectors of interest to China is a plus, particularly when China continues to face high-profile market access restrictions in several Western economies.30 A shift away from the extractive sector will also temper any impressions about Chinese FDI being tempted merely by natural resources. 29 Today, China hosts 700,000 partly foreign-owned companies that account for 22 percent of tax revenues, 55 percent of exports and 50 percent of technology imports (World Bank 2012, p. 385). 30 This includes, in the 2000s, the failure of China National Offshore Oil Corporation to take over the California-based Union Oil Corporation, and that of the Aluminium Corporation of China (Chinalco) to bid for a stake in Rio Tinto, an Australian- based iron ore producer. 104 Figure 97. Brazil’s permits a higher share of foreign equity ownership than China across a range of sectors Permitted foreign equity ownership share by sector (percent) Brazil China Agriculture and forestry Agriculture and 100 100 100 forestry Mining, oil and Education gas Mining, oil and gas 100 100 75 Manufacturing 100 100 Accounting 50 Manufacturing Electricity 100 80 25 Waste management 100 75 & water supply Financial 0 Electricity services Transportation 87 75 Tourism 100 100 Waste Media 30 0 Telecom management & water supply Telecom 100 49 Financial services 100 67 Media Transportation Brazil China Tourism Accounting 100 99 Education 100 99 Source: World Bank Group (2010), with updated data from 2012 The composition of Chinese FDI into Brazil is expected to diversify. So far, Chinese investment into Brazil has been primarily motivated by securing access to natural resources (particularly oil and metals). There is, however, emerging anecdotal evidence of a shift towards more investment in services as well as manufacturing. Examples include Huawei (R&D), Foxconn (screens), and ZTE (telecoms plant), Chery Automobile (cars), and others in steam turbines, construction machinery, and soybean processing. The newer generation of investments also includes medium-sized Chinese companies, not just large SOEs. In terms of geographic concentration, Chinese FDI initially followed the presence of resources (oil and gas in Rio and Minas Gerais for mining). The smaller investments in the auto, electro-electronic and other manufacturing sectors are more dispersed throughout the country, a trend likely to continue. Finally, Brazil and China also have an opportunity to craft a new South-South model for a Bilateral Investment Treaty. The two countries differ significantly in their approach to signing Bilateral Investment Treaties (BITs). BITs are designed for the reciprocal encouragement, promotion and protection of investments in their territories. Most also contain a powerful international arbitration mechanism that allows investors to bring claims directly against the host state alleging violations of these protections under international law. China has well over 100 BITs in effect, whereas Brazil has signed 14, none of which are in force. The two countries also do not have a BIT with each other. Reconciling the legitimate development concerns of countries like Brazil with the urgency for China’s outward FDI to receive National Treatment (assuring Chinese investors and others to be treated alike),31 the two countries can craft a new model of South-South BIT that is worthy of emulation by other developing countries. Such a model treaty could enshrine in its preamble broad development objectives and guard policy space in pursuit of legitimate public welfare measures and regulations that an agreement which is silent on 31 The most recent Chinese BITs do allow for the continuation of provisions that discriminate against existing foreign investors, subject to a “best effort” commitment to roll back such measures over time (World Bank 2012, p. 389). 105 development objectives may occasionally undermine.32 Indeed, now that countries like Brazil and China are engaged in significant outward FDI, the issue of whether there is a need for an overarching Multilateral Investment Agreement (in lieu of the hundreds of overlapping bilateral investment treaties) deserves consideration (Berger, 2013). 32 For more on these issues, see Halle and Peterson (2005). 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This section covers the main features of the Envisage, a full description is provided in van der Mensbrugghe (2010). At its core the ENVISAGE model is a relatively straightforward recursive dynamic CGE model. A simple climate module has been incorporated in the model that links economically-generated greenhouse gas (GHG) emissions to changes in global mean temperature. The climate module then generates (generally negative) feedbacks on the economy through damage functions. ENVISAGE is therefore in the class of models known in the literature as Integrated Assessment Models (IAMs). The current version of ENVISAGE largely relies on release 7.1 of the GTAP database. 33 The data base allows for a flexible aggregation of 112 countries/regions and 57 sectors. For computational and analytical purposes the version employed in this study includes 14 countries/regions34 and 20 sectors. The core specification of the model replicates largely a standard global CGE model. 35 Production is specified as a series of nested constant elasticity of substitution (CES) functions for the various inputs—unskilled and skilled labor, capital, land, natural resources (sector-specific), energy and other material inputs. The structure of the CES nest aims to replicate the substitution and complementary relations across inputs. ENVISAGE uses a vintage structure of production that allows for putty-semi putty capital. In addition, it is assumed that old capital is less flexible than new capital. This implies that countries with relatively high rates of investment, such as China, will tend to have more flexible economies as their share of new capital tends to be higher. ENVISAGE allows for a multi-input/multi-output structure. Hence production from multiple activities can be combined to produce a single output (for example the electricity sector has a single output that is the combination of different generation technologies). And a single activity, can in principle, produce multiple outputs. In the labor market we introduce market segmentation by allowing rural to urban migration to be a function of relative wages. Aggregate land supply follows a logistic curve with an absolute maximum available supply calibrated to FAO data. Domestic demand has four components—intermediate demand, a single representative household, government current expenditures and investment. Household demand is implemented with a consistent demand system. Envisage allows for four different specifications: LES/ELES (extended/linear demand system), CDE (Constant differences in elasticity) and AIDADS (An Implicitly Directly Additive Demand System). LES/ELES have poor Engels behavior, which makes it unsuitable for the long term simulations. CDE has more flexibility, but is also restrictive in a dynamic setting. AIDADS allows for the marginal budget shares to change with income providing more plausible Engels behavior, but its estimation and calibration in the model are much more complex than of other demand system and is still a focus of research. 33 The GTAP database is developed and maintained by the Global Trade Analysis Program based at Purdue University (www.gtap.org). 34 The regions included in this applications: Japan, rest of high income countries, United States, EU27, China, Rest of East Asia, India, Rest of South Asia, Russia, Rest of Europe and Central Asia, Middle East and North Africa, Sub-Saharan Africa, Brazil, Rest of Latin America and the Caribbean. 35 The model is a derivative the World Bank’s Linkage model (van der Mensbr ugghe, 2001). Other well-known models in this class include the GTAP model (Hertel 1997) and CEPII’s Mirage (Decreux and Valin, 2007). 113 Demand by each domestic agent is specified at the so-called Armington level, i.e. demand for a bundle of domestically produced and imported goods. Armington demand is aggregated across all agents and allocated at the national level between domestic production and imports by region of origin. A top level CES nest first allocates aggregate (or Armington) demand between domestic production and an aggregate import bundle. A second level nest then allocates aggregate imports across the model’s different regions thus generating a bilateral trade flow matrix. Each bilateral flow is associated with three price wedges. The first distinguishes producer prices from the FOB price (an export tax and/or subsidy). The second distinguishes the FOB price from the CIF price (an international trade and transportation margin). And the third distinguishes the CIF price from the user price (an import tariff). Government derives its income from various taxes: sales, excise, import duties, export, production, factors and direct taxes. Investment revenues come from household, government and net foreign savings. Government and investment expenditure function are derived from the CES functions. The standard scenario incorporates three closure rules. Typically government expenditures are held constant as a share of GDP, fiscal balance is exogenous while direct taxes adjust to cover any changes in the revenues to keep the fiscal balance at the exogenous level. The second closure rule determines the investment savings balance. Households save a portion of their income with the average propensity to save influenced by demographics and economic growth. Government savings and foreign savings are exogenous in the current specification. As a result, investment is savings driven, so that the total amount of savings depends on household savings, but the price of investment goods is determined by the overall volume of investment as well. Finally, the last closure determines the external balance. In the current application we fix the foreign savings and therefore the trade balance. Therefore changes in trade flows will results in shifts in the real exchange rate. As the model is recursive dynamic, the dynamics are relatively simple and straightforward. Population growth is based on the medium variant of the UN population’s projection. Labor force growth is equated to the growth of the working age population—defined here as the demographic cohort aged between 15 and 64. Investment is equated to savings. Savings are a function of demographic dependency ratios. Savings rises as dependency ratios decline. Thus countries that have declining youth dependency rates tend to see a rise in savings. This will eventually be offset by countries that have a rising share of elderly in their population which will result in a fall of savings. Capital accumulation is then equated to the previous period’s (depreciated) capital stock plus investment. Productivity growth in the baseline is ‘calibrated’ to achieve a given trend in long-term growth in line with historical growth rates (i.e. up to 2011), and then productivity growth remains fixed. Finally, ENVISAGE has been developed into an Integrated Assessment Model (IAM) with a fully closed loop between economics and climate change. Economic activity generates greenhouse gas emissions. ENVISAGE accounts for the so-called Kyoto gases that comprise of carbon (C or CO2), methane (CH4), nitrous oxide (N2O) and the fluoridated gases (F-gases). Greenhouse gas emissions are added to the existing stock of atmospheric gases—that also interact with terrestrial and oceanic stocks—leading to changes in atmospheric concentration. Using a reduced form set of equations, changes in atmospheric concentration convert into 114 changes in radiative forcing that in turn drive changes in atmospheric temperature. ENVISAGE closes the loop between the climate and the economy by converting the climate signal as summarized by the global mean temperature into an economic impact. The long term projections rely on the assumptions regarding the developments in the core macroeconomic variables. These include variables such as population and the main components of GDP, which in the neoclassical model consist of labor, capital and productivity. We take United Nations’ population forecast revision from 2008 for the current simulations36. According to UN projections the world populations will increase from 6.5 billion in 2005 to 8.3 billion in 2030, while Chinese population is expected to increase from 1.29 billion in 2005 to 1.44 billion in 2030. Figure A1 displays UN forecast for China and seven major World Bank regions: high- income (HIC), East Asia and Pacific (EAP), South Asia (SAS), Europe and Central Asia (ECA), Middle East and North Africa (MNA), Sub-Saharan Africa (SSA) and Latin America and the Caribbean (LAC). Figure A1. Population scenario, various regions through 2050, millions 2,500 hic 2,000 eap chn 1,500 sas 1,000 eca mna 500 ssa lac 0 2005 2010 2015 2020 2025 2030 Source: UN Population Division, 2008 Revision According to UN projections, almost all growth of population in 2030 comes from developing countries, with the population of HICs growing by only 92 million out of the 1.8 billion total population’ growth. ECA is the only region where the UN expects a drop in total population of 6 million over this period. The average annual population growth in China is expected to slow down from 0.64 percent in 2005 to 0.13 percent in 2030. As a result the share of Chinese population in world population will drop from 20 percent in 2005 to 17 percent in 2030. 36 The UN has released a new projection in May 2010. There are relatively modest changes with respect to the older projection with the total population in 2050 increasing to 9.31 billion versus 9.15 billion in the 2008 projections. 115 The evolution of labor force is assumed to be in line with the growth of the working age population- i.e. population between 15 and 6437. According to UN forecast (Figure A2), high income countries and ECA would see their labor force declining from 2015 onwards. The labor force in South Asia is expected to increase by 50 percent, while Sub-Saharan Africa’s labor force is expected to double over 2005-2030 period. From 2020 onwards the Chinese labor force stabilizes and then declines at an average annual rate of 0.3 percent. This will likely pose a challenge to the continuation of the fast economic growth. According to UN projections the global average youth dependency ratio is expected to decrease, from 44 to 35 youth per 100 in the working age population over the period 2005-2030 (see Figure A3). All regions see a declining trend with the highest drop recorded in South Asia and Sub-Saharan Africa. In China the youth dependency ratio falls from 31 to 25 per 100 in the working age population and by 2030 it reaches the levels typical of the high income countries. Figure A2. Working age population (15-64) through 2050, millions 1,600 hic 1,400 eap 1,200 1,000 chn 800 sas 600 eca 400 mna 200 ssa 0 lac 2005 2010 2015 2020 2025 2030 Source: UN Population Division, 2008 Revision Figure A3. Youth dependency ratio, Number of persons aged under-15 relative to 100 working age population 90 hic 80 eap 70 chn 60 sas 50 40 eca 30 mna 20 ssa 10 lac 0 wld 2005 2010 2015 2020 2025 2030 Source: UN Population Division, 2008 Revision 37 This is a simplistic assumption given that the overall labor force participation rates are likely to increase as more women enter the labor force in developing countries or due to the rise in the retirement age in high income countries. 116 While youth dependency ratios decline, the elderly dependency ratios increase in all regions (see Figure A4). The world average elderly dependency ratio increases from 11 to 18 per 100 in the working age population. The highest elderly dependency ratio is typical for the high income countries, where the share of the elderly in total population increases to 23 percent in 2030 from 15 percent in 2005. However the elderly dependency ratio increases rapidly for all regions. In China the elderly are expected to constitute 16 percent of total population in 2030 with the old-age dependency ratio increasing from 11 per 100 in the working age population in 2005 to 25 in 2030. The aging of the population is likely to affect not only the saving rates and fiscal solvency of the pension system, but it is also likely to lead to a shift in consumer demand toward services (notably health-related) and away from consumer goods, durables an housing. The effects of population aging on consumer demand are not captured in the current version of the ENVISAGE model. Figure A4. Elderly dependency ratio, Number of persons aged over 65 relative to 100 working age population 40 35 hic 30 eap 25 chn 20 sas eca 15 mna 10 ssa 5 lac 0 2005 2010 2015 2020 2025 2030 Source: UN Population Division, 2008 Revision While the national savings are determined by income and demographic factors, the foreign savings are exogenous in the baseline. We assume the foreign savings level such that the current account balances decline to a sustainable level. In the case of China the current account surplus is consistent with the observed values up to 2010 and then declines from the projected 8 percent of GDP in 2011 to 3 percent of GDP in 2030. In the low growth scenario the historical trend of a faster productivity growth in manufacturing as compared to agriculture and services is extrapolated. The productivity growth in developing countries is faster than in developed countries, as they catch up quickly to the productivity frontier. This results in faster economic growth in developing countries, overall. However, due to slower growth of productivity in services, their relative price increases. This results in an increasing share of services in the economy and therefore slower overall economic growth, as low productivity sectors (services) become relatively more important. The demand side developments also lead to the expansion of the share of services. In high income countries the demand for health and personal services is expected to grow with the aging of societies. In developing countries ageing will play a similar role, but demand for services is also likely to increase as income per capita rises. The increasing importance of services will lead to a flow of capital to these sectors, which will further reduce overall growth rates. 117 The previous paragraphs discussed core dynamic drivers of the model, the resulting per capita growth rates are depicted in Figure A5. In the baseline low growth scenario the average annual per capita growth in China slows down dramatically towards the end of the projection period from initial 10 percent to only 3 percent. The pattern of per capita income growth in the East Asia and Pacific is very similar to that of China, which dominates the region. The average per capita income growth in high income countries slows down from an average of 2 percent in 2015 to 1 percent in 2030. South Asia becomes the fastest growing developing region with an average growth of 5 percent per annum in 2030. This implies that in constant prices (2004 USD) China’s weight of the world economy increases from 5 percent in 2005 to 13 percent in 2030, while the weight of developing countries almost doubles from 21 percent to 42 percent over this period. Similar weights in constant purchasing power parity prices would amount to 19 percent for China in 2030 (up from 9 percent in 2005) and 66 percent for developing countries (up from 44 percent in 2005). One should expect the nominal shares at market exchange rates to be even higher as prices are expected to grow faster in developing countries relative to high-income countries (Balassa-Samuelson effect). Figure A5. Per capita income growth rates, percent per annum. 12 hic eap chn sas eca mna ssa lac 10 8 6 4 2 0 2010 2015 2020 2025 2030 Source: World Bank Envisage model. 118 B. Brazil’s Top Exports by Destination Exports to China (Average Share 1997-2011) Code Product Share Cumulative Lall's Class. 120100 Soya beans, whether or not broken. 0.26 0.26 pp Iron ores and concentrates, other than roasted iron pyrites :-- 260111 Non-agglomerated 0.23 0.49 rb2 Petroleum oils and oils obtained from bituminous minerals, 270900 crude. 0.07 0.56 pp Iron ores and concentrates, other than roasted iron pyrites :-- 260112 Agglomerated 0.06 0.62 rb2 150710 Crude oil, whether or not degummed 0.05 0.67 rb1 Oil-cake and other solid residues, whether or not ground or in the form of pellets, resulting from the extraction of soyabean 230400 oil. 0.05 0.72 pp 470329 Semi-bleached or bleached :-- Non-coniferous 0.04 0.76 rb1 240120 Tobacco, partly or wholly stemmed/stripped 0.02 0.78 pp Aeroplanes and other aircraft, of an unladen weight exceeding 880230 2,000 kg but not exceeding 15,000 kg 0.01 0.80 ht2 Aeroplanes and other aircraft, of an unladen weight exceeding 880240 15,000 kg 0.01 0.81 ht2 Spacecraft (including satellites) and suborbital and spacecraft 880260 launch vehicles 0.01 0.83 ht2 Other bovine leather and equine leather, parchment-dressed 410431 or prepared after tanning :-- Full grains and full grain splits 0.01 0.84 lt1 In coils, not further worked than cold-rolled (cold-reduced) :-- 720917 Of a thickness of 0.5 mm or more but not exceeding 1 mm 0.01 0.85 lt2 720293 Other :-- Ferro-niobium 0.01 0.86 mt2 Other bovine leather and equine leather, tanned or retanned but not further prepared, whether or not split :-- Bovine 410422 leather, otherwise pre-tanned 0.01 0.87 lt1 370320 Other, for colour photography (polychrome) 0.01 0.88 mt2 Containing by weight less than 0.25 % of carbon :-- Other, of 720712 rectangular (other than square) cross-section 0.01 0.89 mt2 Raw sugar not containing added flavouring or colouring 170111 matter :-- Cane sugar 0.01 0.89 rb1 440799 Wood sawn or chipped lengthwise, sliced or peeled 0.01 0.90 rb1 740311 Refined copper :-- Cathodes and sections of cathodes 0.01 0.91 pp 119 Exports from Brazil to EU27 (Average Share 1997-2011) Code Product Share Cumulative Lall's Class. 120100 Soya beans, whether or not broken. 0.09 0.09 pp Oil-cake and other solid residues, whether or not ground or in the form of pellets, resulting from the extraction of soyabean 230400 oil. 0.09 0.18 pp 90111 Coffee, not roasted :-- Not decaffeinated 0.07 0.25 pp Iron ores and concentrates, other than roasted iron pyrites :-- 260111 Non-agglomerated 0.06 0.31 rb2 470329 Chem wood pulp, soda/sulphate, non-conifer, bleached 0.03 0.34 rb1 Petroleum oils and oils obtained from bituminous minerals, 270900 crude. 0.03 0.37 pp Iron ores and concentrates, other than roasted iron pyrites :-- 260112 Agglomerated 0.03 0.40 rb2 200911 Orange juice :-- Frozen 0.03 0.42 rb1 240120 Tobacco, partly or wholly stemmed/stripped 0.02 0.44 pp 890590 Floating docks, special function vessels nes 0.02 0.46 mt3 Aeroplanes and other aircraft, of an unladen weight exceeding 880240 15,000 kg 0.02 0.48 ht2 Meat and edible meat offal; Of fowls of the species Gallus 20714 domesticus :-- Cuts and offal, frozen 0.01 0.49 pp 760110 Aluminium, not alloyed 0.01 0.51 pp 890520 Floating or submersible drilling or production platforms 0.01 0.52 mt3 Aeroplanes and other aircraft, of an unladen weight exceeding 880230 2,000 kg but not exceeding 15,000 kg 0.01 0.53 ht2 20230 Bovine cuts boneless, frozen 0.01 0.55 pp 260300 Copper ores and concentrates. 0.01 0.56 rb2 200919 Orange juice :-- Other 0.01 0.57 rb1 840999 Parts for diesel and semi-diesel engines, Other 0.01 0.58 mt3 Other bovine leather and equine leather, tanned or retanned but not further prepared, whether or not split :-- Bovine 410422 leather, otherwise pre-tanned 0.01 0.59 lt1 120 Exports to MERCOSUR (Average Share 1997-2011) Code Product Share Cumulative Lall's Class. Other vehicles, with spark-ignition internal combustion reciprocating piston engine :-- Of a cylinder capacity exceeding 870323 1,500 cc but not exceeding 3,000 cc 0.05 0.05 mt1 852520 Transmission apparatus incorporating reception apparatus 0.03 0.08 ht1 Petroleum oils and oils obtained from bituminous minerals, 270900 crude. 0.03 0.11 pp Petroleum oils and oils obtained from bituminous minerals, other than crude; preparations not elsewhere specified or included, containing by weight 70% or more of petroleum oils 271000 or of oils obtained from bituminous minerals, these oils b 0.02 0.13 rb2 Other vehicles, with spark-ignition internal combustion reciprocating piston engine :-- Of a cylinder capacity exceeding 870322 1,000 cc but not exceeding 1,500 cc 0.02 0.15 mt1 Diesel powered trucks weighing 5-20 tonnes, Other, with compression-ignition internal combustion piston engine (diesel or semi-diesel) :-- g.v.w. exceeding 5 tonnes but not 870422 exceeding 20 tonnes 0.01 0.16 mt1 Diesel powered trucks weighing < 5 tonnes, Other, with compression-ignition internal combustion piston engine 870421 (diesel or semi-diesel) :-- g.v.w. not exceeding 5 tonnes 0.01 0.17 mt1 870899 Motor vehicle parts nes 0.01 0.19 mt1 271600 Electrical energy. (optional heading) 0.01 0.20 n.a Chassis fitted with engines, for the motor vehicles of headings 870600 Nos. 87.01 to 87.05. 0.01 0.21 mt1 401120 Pneumatic tyres new of rubber for buses or lorries 0.01 0.22 rb1 870190 Wheeled tractors nes 0.01 0.23 mt3 870120 Road tractors for semi-trailers 0.01 0.24 mt1 390110 Polyethylene having a specific gravity of less than 0.94 0.01 0.25 mt2 Iron ores and concentrates, other than roasted iron pyrites :-- 260112 Agglomerated 0.01 0.26 rb2 390120 Polyethylene having a specific gravity of 0.94 or more 0.01 0.27 mt2 870829 Parts and accessories of bodies nes for motor vehicles 0.01 0.28 mt1 300490 Medicaments nes, in dosage 0.01 0.28 ht2 Engines of a kind used for the propulsion of vehicles of 840820 Chapter 87 0.01 0.29 mt3 Other paper and paperboard, not containing fibres obtained by a mechanical process or of which not more than 10 % by weight of the total fibre content consists of such fibres :-- 480252 Weighing 40 g/m2 or more but not more 0.01 0.30 rb1 121 Exports from Brazil to USA (Average Share 1997-2011) Code Product Share Cumulative Lall's Class. Petroleum oils and oils obtained from bituminous minerals, 270900 crude. 0.08 0.08 pp Aeroplanes and other aircraft, of an unladen weight exceeding 880230 2,000 kg but not exceeding 15,000 kg 0.06 0.14 ht2 640399 Other footwear :-- Other 0.04 0.18 lt1 Non-alloy pig iron containing by weight 0.5 % or less of 720110 phosphorus 0.04 0.21 mt2 Petroleum oils and oils obtained from bituminous minerals, other than crude; preparations not elsewhere specified or included, containing by weight 70% or more of petroleum oils 271000 or of oils obtained from bituminous minerals, these oils b 0.03 0.24 rb2 90111 Coffee, not roasted :-- Not decaffeinated 0.03 0.28 pp Aeroplanes and other aircraft, of an unladen weight exceeding 880240 15,000 kg 0.03 0.30 ht2 470329 Chem wood pulp, soda/sulphate, non-conifer, bleached 0.03 0.33 rb1 Iron and Steel, Semi-finished bars, i/nas <0.25%C, 720712 rectangular, nes 0.02 0.35 mt2 852520 Transmission apparatus incorporating reception apparatus 0.02 0.38 ht1 Gold, semi-manufactured forms, Non-monetary :-- Other 710813 semi-manufactured forms 0.02 0.40 n.a 890520 Floating or submersible drilling or production platforms 0.02 0.41 mt3 840999 Parts for diesel and semi-diesel engines, Other 0.01 0.43 mt3 841430 Compressors of a kind used in refrigerating equipment 0.01 0.44 mt3 240120 Tobacco, partly or wholly stemmed/stripped 0.01 0.45 pp 200911 Orange juice :-- Frozen 0.01 0.46 rb1 Undenatured ethyl alcohol of an alcoholic strength by volume 220710 of 80 % vol or higher 0.01 0.47 mt2 840991 Parts for spark-ignition engines except aircraft 0.01 0.48 mt3 870323 Automobiles, spark ignition engine of 1500-3000 cc 0.01 0.49 mt1 680293 Worked granite 0.01 0.50 rb2 Source: UN Comtrade; World Bank staff calculations. 122 C. Brazil’s Most and Least Dynamic Products by Destination More Dynamic Products USA Market : 2000-2011 Average DRCP Average Share Lall's Code Product Brazil China Brazil China Classification 842920 Graders and levellers 7.152 n.a 0.625 n.a mt3 720690 Iron or non-alloy steel, primary nes, <99.94% iron 6.671 0.285 0.200 0.181 mt2 6.538 292241 Amino-acids and their esters, other than those containing more than one kind of oxygen 2.042 0.363 function; salts :-- Lysine and rb2 0.171 thereof its esters; salts thereof 854610 Electrical insulators of glass 5.997 3.027 0.137 0.127 mt3 220710 Undenatured ethyl alcohol of an alcoholic strength by volume of 80 % vol or5.372 higher n.a 0.331 n.a mt2 282090 Manganese oxides other than manganese dioxide 3.484 0.604 0.141 0.121 rb2 842930 Scrapers 3.360 n.a 0.300 n.a mt3 80131 Cashew nuts :-- In shell 3.066 n.a 0.603 n.a pp 240130 Tobacco refuse 2.940 n.a 0.510 n.a pp 210220 Inactive yeasts; other single-cell micro-organisms, dead 2.936 0.812 0.176 0.047 rb1 530890 Yarn of other vegetable textile fibres 2.862 5.165 0.129 0.232 lt1 721914 Hot rolled stainless steel coil, w >600mm, t <3mm 2.817 -0.378 0.176 0.234 mt2 392510 Reservoirs, tanks, vats and similar containers, of a capacity exceeding 3002.765 l 0.238 0.027 0.019 lt2 420690 Articles of gut, goldbeater skin, bladder, tendons nes 2.689 -0.205 0.077 0.024 lt2 30265 Other fish, excluding livers and roes :-- Dogfish and other sharks 2.598 n.a 0.067 n.a pp 680293 Granite 2.473 1.215 0.320 0.174 rb2 2.431 400211 Styrene-butadiene rubber (SBR); carboxylated styrene-butadiene rubber (XSBR) :-- Latex0.020 0.059 0.001 rb1 391220 Cellulose nitrates (including collodions) 2.392 0.159 0.136 0.010 mt2 2.389 850212 Generating sets with compression-ignition internal combustion piston engines (diesel 0.494 engines)0.027 0.055 or semi-diesel :-- Of an outputht1 exceeding 75 kVA but not ex 470200 Chemical wood pulp, dissolving grades. 2.360 n.a 0.064 n.a rb1 Least Dynamic Products USA Market : 2000-2011 Average DRCP Average Share Lall's Code Product Brazil China Brazil China Classification 722490 Semi-finished products of alloy steel except-5.795 stainless 0.373 0.315 0.010 mt2 260111 Iron ores and concentrates, other than roasted iron pyrites n.a -5.206 0.498 :-- Non-agglomerated n.a rb2 220720 strength n.a -5.103 Ethyl alcohol and other spirits, denatured, of any 0.277 n.a mt2 630691 C amping goods nes, of cotton -4.765 5.125 0.228 0.432 lt1 293810 Rutoside (rutin) and its derivatives -4.519 5.017 0.322 0.409 ht2 440724 Lumber, Virola, Mahogany -3.272 n.a 0.132 n.a rb1 500400 -3.045 Silk yarn (other than yarn spun from silk waste) not put up1.116 0.103 for retail sale. 0.297 lt1 80122 Brazil nuts :-- Shelled -3.037 n.a 0.189 n.a pp 640691 Parts of footwear of wood -2.681 1.719 0.120 0.162 lt1 170290 Sugar nes, invert sugar, caramel and artificial-2.629 honey 0.430 0.174 0.041 rb1 160300 molluscs-0.107 -2.620 Extracts and juices of meat, fish or crustaceans, 0.272 or other aquatic 0.011 invertebrates. rb1 440839 Veneer, tropical woods -2.272 1.400 0.093 0.106 rb1 292421 Cyclic amides (including cyclic carbamates) and-2.271 1.253 salts their derivatives; 0.269 0.050 thereof :-- rb2 derivatives; salts ther Ureines and their 250629 Quartzite :-- Other -2.266 0.641 0.132 0.158 pp 200891 Palm hearts, otherwise prepared or preserved -2.264 n.a 0.341 n.a rb1 852729 -2.145without Radio-broadcast receivers not capable of operating 1.767 source of0.176 0.095 an external mt3 power, of a kind used in motor vehicles, 760521 Wire, aluminium alloy, t > 7mm -2.130 0.332 0.043 0.007 pp 470319 C hem wood pulp, soda/sulphate, non-conifer, -2.122 unbleached n.a 0.458 n.a rb1 841829 Refrigerators, household type :-- Other -1.926 2.382 0.058 0.352 mt3 730810 Bridges and bridge-sections -1.900 9.082 0.087 0.195 lt2 123 More Dynamic Products EU27 Market : 2000-2011 Average DRCP Average Share Lall's Code Product Brazil China Brazil China Classification 200919 Orange juice :-- Other 3.459 0.000 0.437 0.000 rb1 2.896 170111 Raw sugar not containing added flavouring or colouring matter :-- Cane sugar 0.001 0.185 0.000 rb1 151521 Maize (corn) oil and its fractions :-- Crude oil 2.102 n.a 0.073 n.a rb1 21090 Meat and edible meat offal cured, flours, meals nes 1.935 n.a 0.543 n.a rb1 711420 Gold, silversmith wares, base clad with precious metal 1.729 -0.892 0.044 0.115 lt2 150810 Crude oil 1.616 -1.053 0.123 0.016 rb1 844519 Machines for preparing textile fibres :-- Other 1.595 2.216 0.055 0.044 mt3 260200 Manganese ores and concentrates, including ferruginous manganese ores 1.409 0.293 -0.013with a and concentrates content of 20 rb2 0.002 manganese % or more, calculated on the dry 470329 C hem wood pulp, soda/sulphate, non-conifer, bleached 1.398 -0.001 0.289 0.000 rb1 250629 Quartzite :-- Other 1.391 -0.251 0.391 0.057 pp 240120 Tobacco, partly or wholly stemmed/stripped 1.308 0.231 0.214 0.021 pp 292690 Nitrile-function compounds, nes 1.295 0.416 0.038 0.053 rb2 250490 Natural graphite, except powder or flakes 1.252 1.206 0.043 0.184 pp 284329 Silver compounds:-- Other 1.170 n.a 0.188 n.a rb2 481620 Self-copy paper 1.119 0.023 0.028 0.002 lt2 1.097 260111 Iron ores and concentrates, other than roasted iron pyrites :-- Non-agglomerated -0.003 0.477 0.000 rb2 440920 Non-conifer wood continuously shaped along any edges 1.043 1.600 0.082 0.140 rb1 160232 Fowls meat and meat offa 1.026 0.115 0.126 0.003 rb1 120720 Cotton seeds 0.997 n.a 0.089 n.a pp 0.994 290919 Acyclic ethers and their halogenated, sulphonated, nitrated or nitrosated derivatives 0.035 :-- Other 0.036 0.002 rb2 Least Dynamic Products EU27 Market : 2000-2011 Average DRCP Average Share Lall's Code Product Brazil China Brazil China Classification -5.422not exceeding 880220 Aeroplanes and other aircraft, of an unladen weight n.a 0.049 2,000 kg n.a ht2 200911 Orange juice :-- Frozen -2.712 0.000 0.374 0.000 rb1 80121 Brazil nuts :-- In shell -2.456 n.a 0.247 n.a pp 470319 C hem wood pulp, soda/sulphate, non-conifer, -2.285 unbleachedn.a 0.092 n.a rb1 -2.238 160300 Extracts and juices of meat, fish or crustaceans, molluscs 0.012 0.285 or other aquatic 0.001 invertebrates. rb1 720293 Other :-- Ferro-niobium -1.754 0.015 0.505 0.003 mt2 440724 Lumber, Virola, Mahogany -1.742 -0.011 0.068 0.001 rb1 20230 Bovine cuts boneless, frozen -1.646 n.a 0.219 n.a pp 292242 Amino-acids and their esters, other than those containing 0.175 -1.518 0.035 more than one rb2 0.100 function; kind of oxygen salts thereof :-- Glutamic ac -1.508 420690 Articles of gut, goldbeater skin, bladder, tendons nes -1.131 0.030 0.281 lt2 293293 Piperonal -1.486 0.576 0.129 0.615 rb2 80122 Brazil nuts :-- Shelled -1.482 -0.001 0.085 0.002 pp 630691 C amping goods nes, of cotton -1.457 2.366 0.105 0.494 lt1 440121 Wood in chips or particles :-- Coniferous -1.443 n.a 0.039 n.a pp 293810 Rutoside (rutin) and its derivatives -1.407 -2.255 0.149 0.190 ht2 -1.361exceeding 880230 Aeroplanes and other aircraft, of an unladen weight 0.081 n.a 2,000 kg n.a 15,000ht2 but not exceeding kg 21020 Meat of bovine animals -1.329 n.a 0.042 n.a rb1 stainless 0.073 722490 Semi-finished products of alloy steel except-1.315 0.031 0.004 mt2 -1.241 470429 C hem wood pulp, sulphite, non-coniferous, bleached 0.002 0.033 0.001 rb1 -1.179 292800 Organic derivatives of hydrazine or of hydroxylamine. 0.583 0.016 0.031 rb2 124 Most Dynamic Products MERCOSUR+ Market: 2000-2011 Average DRCP Average Share Lall's Code Product Brazil China Brazil China Classification 521022 Bleached :-- 3-thread or 4-thread twill, including cross twill 12.217 0.591 lt1 In coils, not further worked than cold-rolled (cold-reduced) :-- Of a 720915 thickness of 3 mm or more 11.007 0.307 lt2 722720 Of silico-manganese steel 10.659 0.618 lt2 10210 Pure-bred breeding animals 8.958 0.311 pp 722592 Other :-- Otherwise plated or coated with zinc 8.765 0.788 lt2 220430 Other grape must 8.464 0.368 rb1 860310 Powered from an external source of electricity 8.344 0.512 mt2 284310 Colloidal precious metals 8.2 0.316 rb2 640691 Other :-- Of wood 8.069 0.557 lt1 90700 Cloves (whole fruit, cloves and stems). 7.6 0.677 pp 681190 0ther articles 7.41 -1.14 0.273 0.029 rb2 Mechanical stokers, including their mechanical grates, mechanical ash 841630 dischargers and similar appliances 7.17 -0.29 0.247 0.039 mt3 441090 Of other ligneous materials 7.141 0.21 rb1 Sack kraft paper, creped or crinkled, whether or not embossed or 480820 perforated 6.946 -0.65 0.643 0.069 rb1 521129 Bleached :-- Other fabrics 6.499 0.071 0.348 0.158 lt1 740819 Of refined copper :-- Other 6.466 0.092 0.45 0.003 pp Other vehicles, with compression-ignition internal combustion piston engine (diesel or semi-diesel) :-- Of a cylinder capacity not exceeding 870331 1,500 cc 6.283 0.618 mt1 320630 Pigments and preparations based on cadmium compounds 6.265 0.393 mt2 230210 Of maize (corn) 6.228 0.173 pp Containing 85 % or more by weight of staple fibres of nylon or other 550912 polyamides :-- Multiple (folded) or cabled yarn 6.114 0.441 lt1 Least Dynamic Products MERCOSUR+ Market: 2000-2011 Average DRCP Average Share Lall's Code Product Brazil China Brazil China Classification 81010 Strawberries -10.646 0.402 pp 580123 Of cotton :-- Other weft pile fabrics -9.114 7.156 0.2 0.441 lt1 80719 Melons (including watermelons) :-- Other -8.44 0.714 pp 80711 Melons (including watermelons) :-- Watermelons -8.201 0.478 pp 290490 Other -7.574 2.015 0.346 0.265 rb2 722490 Other -7.57 0.818 mt2 Other mineral or chemical fertilisers containing the two fertilising 310551 elements nitrogen and phosphorus :-- Containing nitrates and phosphates -7.305 0.167 mt2 520812 Unbleached :-- Plain weave, weighing more than 100 g/m2 -7.082 1.061 0.52 0.226 lt1 Other, with at least one outer ply of non-coniferous wood :-- With at least 441222 one ply of tropical wood specified in Subheading Note 1 to this Chapter -6.866 0.502 rb1 722599 Other -6.654 0.165 lt2 722230 Other bars and rods -6.61 0.242 lt2 790112 Zinc, not alloyed :-- Containing by weight less than 99.99 % of zinc -6.528 0.471 pp 200919 Orange juice :-- Other -6.306 0.401 rb1 Carboxylic acids with phenol function but without other oxygen function, their anhydrides, halides, peroxides, peroxyacids and their derivatives :-- 291821 Salicylic acid and its salts -6.273 1.842 0.398 0.134 mt2 110814 Starches :-- Manioc (cassava) starch -6.198 0.421 rb2 560721 Of sisal or other textile fibres of the genus Agave :-- Binder or baler twine -6.04 0.207 0.541 0.05 lt1 Tunas (of the genus Thunnus), skipjack or stripe-bellied bonito (Euthynnus (Katsuwonus) pelamis), excluding livers and roes :-- Skipjack or strip- 30343 bellied bonito -5.975 0.271 pp 521112 Unbleached :-- 3-thread or 4-thread twill, including cross twill -5.948 0.618 lt1 70990 Other -5.941 0.513 pp 530911 Containing 85 % or more by weight of flax :-- Unbleached or bleached -5.933 5.183 0.283 0.251 lt1 Source: UN Comtrade; World Bank staff calculations. 125 D. Export Similarity between Brazil and Other Countries Export similarity index: Brazil (graphs by country) China United States European Union Argentina 0.4 0.4 0.4 0.4 0.3 0.3 0.3 0.3 0.2 0.2 0.2 0.2 0.1 0.1 0.1 0.1 0.0 0.0 0.0 0.0 97 99 01 03 05 07 09 11 97 99 01 03 05 07 09 11 97 99 01 03 05 07 09 11 97 99 01 03 05 07 09 11 Paraguay Uruguay Venezuela Bolivia 0.4 0.4 0.4 0.4 0.3 0.3 0.3 0.3 0.2 0.2 0.2 0.2 0.1 0.1 0.1 0.1 0.0 0.0 0.0 0.0 97 99 01 03 05 07 09 11 97 99 01 03 05 07 09 11 97 99 01 03 05 07 09 11 97 99 01 03 05 07 09 11 Chile Colombia Ecuador Peru 0.4 0.4 0.4 0.4 0.3 0.3 0.3 0.3 0.2 0.2 0.2 0.2 0.1 0.1 0.1 0.1 0.0 0.0 0.0 0.0 97 99 01 03 05 07 09 11 97 99 01 03 05 07 09 11 97 99 01 03 05 07 09 11 97 99 01 03 05 07 09 11 Source: UN Comtrade; World Bank staff calculations. Note: Vertical axis is the export similarity index that takes a value between 0 and 1. See Technical Appendix for a discussion and formal presentation of the export similarity index. The index measures the extent to which both countries actively export a product or category of products in world markets. 126 E. Export Sophistication by Destination and Lall Category Contribution to export sophistication by Lall classification (GDP per capita in thousands of constant 2005 PPP-adjusted international dollars) Exports of Brazil to the World PP RB1 RB2 LT1 LT2 5 5 5 5 5 4 4 4 4 4 3 3 3 3 3 2 2 2 2 2 1 1 1 1 1 0 0 0 0 0 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 MT1 MT2 MT3 HT1 HT2 5 5 5 5 5 4 4 4 4 4 3 3 3 3 3 2 2 2 2 2 1 1 1 1 1 0 0 0 0 0 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 Exports of Brazil to China PP RB1 RB2 LT1 LT2 5 5 5 5 5 4 4 4 4 4 3 3 3 3 3 2 2 2 2 2 1 1 1 1 1 0 0 0 0 0 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 MT1 MT2 MT3 HT1 HT2 5 5 5 5 5 4 4 4 4 4 3 3 3 3 3 2 2 2 2 2 1 1 1 1 1 0 0 0 0 0 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 127 Exports of Brazil to EU27 PP RB1 RB2 LT1 LT2 5 5 5 5 5 4 4 4 4 4 3 3 3 3 3 2 2 2 2 2 1 1 1 1 1 0 0 0 0 0 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 MT1 MT2 MT3 HT1 HT2 5 5 5 5 5 4 4 4 4 4 3 3 3 3 3 2 2 2 2 2 1 1 1 1 1 0 0 0 0 0 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 Exports of Brazil to Mercosur+ PP RB1 RB2 LT1 LT2 5 5 5 5 5 4 4 4 4 4 3 3 3 3 3 2 2 2 2 2 1 1 1 1 1 0 0 0 0 0 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 MT1 MT2 MT3 HT1 HT2 5 5 5 5 5 4 4 4 4 4 3 3 3 3 3 2 2 2 2 2 1 1 1 1 1 0 0 0 0 0 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 Exports of Brazil to United States PP RB1 RB2 LT1 LT2 5 5 5 5 5 4 4 4 4 4 3 3 3 3 3 2 2 2 2 2 1 1 1 1 1 0 0 0 0 0 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 MT1 MT2 MT3 HT1 HT2 5 5 5 5 5 4 4 4 4 4 3 3 3 3 3 2 2 2 2 2 1 1 1 1 1 0 0 0 0 0 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 97 00 03 06 09 Source: UN Comtrade; World Bank staff calculations. 128 F. Comparison of Number of Products Traded by Classification 1500 Brazil: Number of products exported 1500 Brazil: Number of products imported Primary Products Primary Products 1200 to China 1200 from China to World from World 900 Maximum Number 900 Maximum Number 600 600 300 300 0 0 1988 90 92 94 96 98 00 02 04 06 08 10 1988 90 92 94 96 98 00 02 04 06 08 10 1500 Brazil: Number of products exported Brazil: Number of products imported 1500 Resource Based Manufactures Resource Based Manufactures 1200 1200 900 900 to China 600 to World 600 Maximum Number 300 from China 300 from World Maximum Number 0 0 1988 90 92 94 96 98 00 02 04 06 08 10 1988 90 92 94 96 98 00 02 04 06 08 10 Brazil: Number of products exported Brazil: Number of products imported 1500 1500 Low Technology/Manufactures Low Technology/Manufactures 1200 1200 900 to China 900 to World 600 Maximum Number 600 from China from World 300 300 Maximum Number 0 0 1988 90 92 94 96 98 00 02 04 06 08 10 1988 90 92 94 96 98 00 02 04 06 08 10 Brazil: Number of products exported Brazil: Number of products imported 1500 Medium Technology/Manufactures 1500 Medium Technology/Manufactures 1200 1200 to China 900 to World 900 Maximum Number 600 600 from China 300 300 from World Maximum Number 0 0 1988 90 92 94 96 98 00 02 04 06 08 10 1988 90 92 94 96 98 00 02 04 06 08 10 Brazil: Number of products exported Brazil: Number of products imported 1500 1500 High Technology/Manufactures High Technology/Manufactures 1200 1200 to China from China 900 to World from World Maximum Number 900 Maximum Number 600 600 300 300 0 0 1988 90 92 94 96 98 00 02 04 06 08 10 1988 90 92 94 96 98 00 02 04 06 08 10 Source: UN Comtrade; World Bank staff calculations 129 G. Technical Notes Revealed Comparative Advantage The revealed comparative advantage (RCA) of country in product and year is calculated as: where is the share of product in total exports of country and is the share of product in total exports of the world . A comparative advantage is revealed in product if . Dynamic Revealed Comparative Position The dynamic revealed comparative position (DRCP) of country in product between years and is calculated as: where is the share of imports of country from country in total imports from the world in product and year . There is direct competition if the average DRCP between 2000 and 2011 of country is greater than zero and the DRCP of country is less than zero in country . There is partial competition if the average DRCP is positive for both country and country . Partial pressure is strong if the average DRCP of country is greater than the average DRCP of country . Otherwise partial pressure is weak. Note that when comparing the share of products subject to competition across years, the change in the series is purely compositional, since the products subject to competition are not changing, only the product’s shares. Export ‘Sophistication’ (EXPY and EXPY2) Haussman, Hwang and Rodrik (2006) propose a measure of export sophistication, denoted by EXPY, that measures the export-weighted average level of GDP per capita associated with a country’s export bundle. It is computed in a two-stage process. The first stage is to measure the income level associated with each product in the world, termed ‘PRODY’. The PRODY of a particular product is the GDP per capita of the typical country that exports that good, calculated by weighting the GDP per capita of all countries exporting the good. The weight given to each country is based on ‘revealed comparative advantage’, defined as the share of its exports that comes from that good relative to the ‘average’ country. Therefore, a product that typically makes up a large percentage of a poor country’s export basket will have stronger weights towards poor countries’ GDP per capita. This will be less the case for a product that makes up a small percentage of a poor country’s exports but is a significant component of many rich countries’ export baskets. Accordingly, the sophistication of a product is linked to the per capita income of the countries that export that product. 130 The second stage is to measure the income associated with a country’s export basket as a whole; this is its EXPY. From the first stage, each product that a country exports will have a PRODY. The EXPY is calculated by weighting these PRODY by the share that each good contributes to total exports. If butter makes up 15 percent of a country’s exports, its PRODY will be given a weight of 0.15. Countries whose export baskets are made up of ‘rich-country goods’ will have a higher EXPY, while export baskets made up of ‘poor-country goods’ will have a lower EXPY. Accordingly, the sophistication of exports is linked to per capita income of the countries that export similar products. The calculations are: ⁄ ∑ and ∑ ∑ ⁄ where is GDP per capital of country and is the share of exports of product in total exports of country in year . The PRODY is calculated for each year and the average PRODY across years is then used. EXPY2 is constructed using PRODY2, which is PRODY of exports minus PRODY of imports. A positive (negative) PRODY2 indicates that the product tends to be exported (imported) by richer countries. A positive (negative) EXPY2 suggests a country’s export basket is associated with richer (poorer) countries’ export basket. Revealed Factor Intensities The measure of revealed factor intensity (RFI) is similar to that of the export sophistication measurement, using a two-stage process. It measures the export-weighted average level of a factor associated with a country’s export bundle. The factors are: human capital, measured as average years of schooling for the 15-year old and above population; physical capital, measured as the capital stock per capita; and arable land, measured as per capita. The first stage is to measure the factor level associated with each product in the world, termed ‘IND’. The IND of a particular product is the factor level of the typical country that exports that good, calculated by weighting the factor level of all countries exporting the good. The weight given to each country is based on ‘revealed comparative advantage’. The IND is then standardized (its value minus the mean divided by the standard deviation) across countries. The second stage is to measure the standardized factor level associated with a country’s export basket as a whole; this is its underlying indicator of endowment or RFI. From the first stage, each product that a country exports will have an IND. The RFI is calculated by weighting these IND by the share that each good contributes to total exports. The calculations are: ⁄ ∑ and ∑ ∑ ⁄ where is the factor of country , and is the share of exports of product in total exports of country in year . The IND is calculated for the years 1995, 2000, 2005, and 2010 and the average indicator across years is then used. 131 Herfindahl-Hirschman Index of Market and Product Concentration The Herfindahl-Hirschman index (HHI) is used to measure concentration of exports or imports across markets or products, and for year is calculated as: ∑ where is the share of exports or imports of product or market in total exports or imports in year . When considering export (import) market concentration, the shares of total exports (imports) to (from) each market are used. When considering export (import) product concentration, the shares of each product’s exports (imports) to (from) the world are used. In addition, export (import) product concentration can be calculated across markets, in which case the shares of each product’s exports (imports) to (from) each market are used. When benchmarking across countries, the root of the Herfindahl-Hirschman index is used. Export Similarity Indexes The export similarity index (ESI) between country and country in year is calculated as: ∑ where is the share of country ’s exports of product in total exports to the world. 132