We hear a lot of talk about the TPP? So what is it, and how does it affect China?

The Trans-Pacific Partnership is a proposed 12-nation trade pact, led by the United States. Current negotiating members include Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore, the US and Vietnam.

Together, these countries account for almost 40 percent of global output and about a third of global trade, making it one of the largest free trade areas in the world. Negotiations were originally slated to be completed this month, but contested issues, primarily in the area of agriculture, remain unresolved.

As a “21st century trade agreement,” the TPP encapsulates a wide range of issues. It is reported that only five of its 29 chapters relate to traditional trade matters. Other aspects range from environmental protection to labor unions and intellectual property rights.

In the simplest sense, TPP members would enjoy lower tariffs and simplified customs procedures. China would miss out on these benefits if it does not enter into the agreement.

Yet a bigger concern lies with rules of origin. It is likely that TPP countries will offer lower tax rates only for products using materials imported from member countries. The most prominent example of this is the US’s “yarn-forward rule of origin,” applied under North American Free Trade Agreement. The rule stipulates that all contents in a garment from the yarn stage forward must be made in one of parties to the agreement in order to be eligible for tariff benefits. If the same rule were applied to the TPP, non-members such as China would be punished. China’s textiles and garment sectors stand to lose the most. Under a worst-case scenario, TPP members would refrain from engaging China in the textiles manufacturing process altogether.

If the “yarn-forward rule” were applied, Vietnam would benefit the most in Asia. The Peterson Institute forecasts that Vietnam by 2025 would be 14 percent richer than if it stayed out of the TPP, assuming China does not join. In fact, Vietnam could potentially usurp China’s role as a global textiles hub. Some Chinese manufacturers, including listed ones, are already considering relocating to Vietnam.

The potential success of the TPP is a threat to China because its exports to TPP countries accounted for 36 percent of its total exports in 2012. Textile exports to TPP countries comprised more than 36 percent. The potential economic losses from not joining could be enormous.

External factors are more forceful in driving China’s reforms than domestic factors. The China (Shanghai) Pilot Free Trade Zone is one example of externally driven change. The zone is highly likely a response to deepening TPP negotiations, the most telltale sign being the speed of its setup.

Potential trigger

Japan’s intention to enter TPP talks earlier this year also was a potential trigger because that country has huge economic and political significance to China. Japan is China’s fifth-largest trading partner and third-largest source of foreign direct investment.

Looking one step ahead, Japan’s joining the TPP would hasten South Korea’s interest in joining. Japan is also the first country to join the TPP that does not have an existing free-trade agreement with the US. This implies there is potential for even more countries to enter negotiations and build up a significant critical mass that would harm China’s interests if it chooses not to join.

Due to inherent differences in economic systems, China has in the past refused to conform to the rules of Western institutions on key international issues. Likewise, the principles of TPP are ideologically different from China’s existing economic wiring.

Yet with so much at stake, China might eventually soften its stance and consider making some accommodations. However, it is technically inconceivable for China to overhaul its systems overnight. That is why China has probably devised the Shanghai free trade zone as a gesture of its willingness to converge with TPP principles.

Indeed, we are able to identify similarities between the new free-trade zone and the TPP. These include tariff reductions, a “negative list” system for foreign investment and, most recently, the introduction of an e-commerce platform that embraces the principles of consumer protection and intellectual property rights protection.

Looking ahead, developments in the zone will further emulate the requirements of the TPP. The speed of TPP negotiations will likely expedite China’s pace of reforms within its new trade zone and hasten plans to replicate the zone across the country.

Another strategy China is adopting in response to the formation of the TPP relates to the Regional Comprehensive Economic Partnership.

Led by the Association of Southeast Asian Nations, the partnership currently has 16 members and the potential to become the largest trading bloc in the world, accounting for some 40 percent of global trade. Negotiations on the partnership are slated to be completed by 2015. At this stage, this is probably China’s strongest counterweight against the TPP.

In recent years, China has been pursuing bilateral trade agreements with Japan, South Korea and Australia. Even so, there is a possibility that the impact of the TPP will override bilateral free-trade agreements. As such, bilateral agreements may not be perfect substitutes for regional trade agreements.

Because the TPP is non-discriminatory and does not provide special mechanisms for economies at different stages of development, the most obvious challenge to China’s entry is the fact that its current state of affairs widely diverges from the requirements of TPP.

No matter how successful the Shanghai free trade zone, it would not bring China up to the mark for TPP entry.

For one, the Shanghai zone is small and still experimental. Second, the zone covers only certain elements in the TPP, namely creating a level playing field for foreign and domestic entities. It does not explicitly address TPP issues such as environmental protection or labor unions. Sectors such as telecommunications remain unopened to foreign competition.

Conditions of entry

That said, we doubt the conditions of entry are as rigid as they seem.

Vietnam stands out among existing negotiating members because it looks able to enter the TPP even with its limited economic freedoms. Despite the existence of an export-oriented private sector, the state-owned sector still exerts much influence on the economy, with pre-tax profit from state-owned entities accounting for 43.3 percent of the total in 2011.

The ultimate challenge rests with geopolitics. It is possible that Vietnam won a negotiating seat primarily due to its diplomatic ties with the US. Most of the Asian-Pacific members of the TPP have treaties or cooperation commitments in the military or security spheres with the US, this could be an unspoken criteria for gaining entry.

While it is impossible to meet all the stringent requirements of the TPP in the short term, China can effectively demonstrate its willingness to realign its policies and show some sincerity in cooperating on international issues.

These gestures could have important implications for China’s potential entry into the TPP. Given the numerous sticking points in TPP negotiations, China can bide its time in implementing reforms at home.

China has reached a critical juncture whereby structural reforms are needed to promote its sustainable growth, and the TPP just happens to be a powerful external push factor.