China’s status as the global darling for foreign investment and trade is facing some competition these days from Southeast Asian nations that, while small, are forming an increasingly important economic bloc. Though the 10-member Association of Southeast Asian Nations, or ASEAN, comprises a market of 610 million people — less than half the size of China’s — the bloc’s more affluent consumers are looking increasingly attractive, especially to Japanese companies wary of risks stemming from escalating territorial disputes with Beijing.

While most Japanese companies remain committed to their investments in China, the proposed formation of the ASEAN Economic Community — an economic integration of the 10 member countries, similar to the European Union — by 2015 is especially tantalizing. From a demographic and production cost point of view, the ASEAN bloc – which includes Indonesia, Malaysia, the Philippines, Singapore, Thailand, Brunei, Burma (Myanmar), Cambodia, Laos and Vietnam — is nudging China aside as the Chinese labor force begins to shrink and wages rise. Thailand, Indonesia and Malaysia are attracting foreign manufacturers as well as financial and other service companies drawn by the region’s quickly growing, and relatively big spending, middle class.

Japan’s investment expansion into ASEAN is expected to persist for at least the next few years, as other countries, including China and the U.S., also pour resources into the region. For the time being, however, China remains ahead in terms of FDI: China’s incoming foreign investment from the world in 2012, totaling US$121.08 billion, was still bigger than ASEAN’s US$111.29 billion, according to the United Nations Conference on Trade and Development.

Japan’s direct investment in ASEAN from January through June 2013 increased sharply, up 88.7% at 998.6 billion yen, while its FDI into China fell 18% from a year earlier to 470.1billion yen, according to the Japan External Trade Organization (JETRO). “It’s not just because of the deterioration of China-Japan relations; there are other important factors,” notes Koichi Ishikawa, an ASEAN economy specialist at Asia University in Tokyo. “ASEAN is becoming a bigger consumer market, as its middle class is growing rapidly and consumption was very strong in 2011 and 2012 in Thailand, Indonesia, the Philippines and Vietnam.” Affluent consumers are crowding into newly built shopping malls, and car and motorcycle sales hit new records in Indonesia in 2011 and 2012.

“ASEAN has become a very attractive market as well as a manufacturing base.”–Isamu Wakamatsu

Though ASEAN also includes relatively poor countries like Myanmar, Cambodia and Laos, the region’s potential purchasing power is huge. “The biggest reason for the increase in FDI into ASEAN is that ASEAN has become a very attractive market as well as a manufacturing base,” says Isamu Wakamatsu, director of the Asia and Oceania division and an ASEAN trade specialist at JETRO.

China’s Troubles

Despite all the noise about China’s ultra-wealthy nouveau riche, there is a big gap between the rich and the rural poor populations in China. “Not every one of China’s 1.3 billion people can afford to buy much,” notes Murray Hiebert, a senior fellow and deputy director of the Sumitro Chair for Southeast Asia Studies at the Center for Strategic and International Studies (CSIS) in Washington, DC.

Apart from the promise of its own markets, ASEAN’s growing competitiveness as a manufacturing base has emerged as an important factor for multinational companies. China’s once seemingly limitless legions of rural laborers are a thing of the past, thanks to increasing urbanization and the low birth rate enforced through China’s one-child policy. The working population began shrinking in 2012, falling 3.45 million to 937.27 million, according to the China National Statistics Bureau, while ASEAN’s working age population continues to expand at a healthy speed: At nearly 390 million in 2012, it will not peak until 2042, at about 472 million, according to a report on ASEAN FDI by Bank of America Merrill Lynch.

“This is quite a contrast to a decade ago, when there were widespread fears that FDI into ASEAN would be marginalized and crowded out by China’s rise,” Hak Bin, ASEAN economist at Bank of America Merrill Lynch, said in the report. He added that China’s higher wage increases, labor shortages and reminbi appreciation have made ASEAN, by comparison, more attractive for investment. China’s manufacturing wages are now some 30% higher than those in Thailand, Indonesia and Vietnam.

ASEAN’s lower wages are a draw for Chinese manufacturers, as well as those in the West and Japan. “If you compare wages in major cities in China and ASEAN from 2005 and 2012, wages in Vietnam are about one-third of China’s,” says JETRO’s Wakamatsu. For example, workers’ wages in Ho Chi Min City averaged US$148 a month in 2012, only 37.5% of the average wage of US$395 in southern China’s Guangzhou, according to a JETRO survey. (In 2005, wages in both places were roughly the same.) Japanese investment into Vietnam increased to 230.6 billion yen in the first six months of 2013 from 142.1 billion yen a year earlier. “I would not be surprised if this trend … continued for a few years,” notes Wharton finance professor Franklin Allen.

China’s economy is expected to slow down, but it remains a huge market, so service industries and retail will continue to invest in China. Wakamatsu notes that Japanese companies by no means are likely to drop China from their global strategies. However, they are adopting a “China plus one” strategy to help balance the increasingly apparent risks of only investing in the Chinese mainland. Such risks were driven home by the virulent anti-Japanese protests in China a year ago, after Japan nationalized islands in the East China Sea that are claimed by both countries. “Japanese companies became aware of the risks in China more acutely after the demonstrations and destruction in 2012, so they think they need to diversify their investments,” Wakamatsu says. Allen agrees: “The risk has gone up for Japanese companies. If the islands issue goes bad again, Japanese companies will be at risk.”

In fact, according to some China experts, the decline in FDI in the first half of 2013 mainly reflects a “boom” in 2011 — when it climbed 60% — and a more modest increase in 2012. Moreover, looking at only a half-year trend may not accurately reflect the future outlook, says Tomoo Marukawa, a professor at the Institute of Social Sciences at the University of Tokyo and a specialist on the Chinese economy. Most Japanese companies investing into ASEAN added production capacity in Southeast Asia, rather than shifting production lines away from China. “Virtually no Japanese companies withdrew from China and then moved to ASEAN,” says Wakamatsu of JETRO. “In the past, everyone used to invest only into China, but now more and more Japanese companies first compare conditions in China with those in ASEAN countries and then decide where they will invest.”

China still has the advantage when it comes to good infrastructure and supply chains, though Thailand is catching up in terms of automotive-related industries. Vietnam is gaining ground and has lower labor costs, experts note, but Cambodia and Laos lag behind, especially in terms of electricity supply.

“The risk has gone up for Japanese companies. If the islands issue goes bad again, Japanese companies will be at risk.”–Franklin Allen

“With the possible exception of Myanmar, about which it is too soon to be at all certain, I have very dim expectations regarding Cambodia and Laos,” says Bernard Gordon, a professor emeritus of political science at the University of New Hampshire. Cambodia, he points out, still suffers from the disastrous legacy of the Khmer Rouge regime of the 1970s. “Sadly, its economy so far has shown few of the necessary ingredients for becoming active in the modern world of manufacturing,” he says.

Trading Places

The trade front shows similar trends when it comes to Japan’s dealings with China and ASEAN. Japan’s total trade with China fell 10.8% in the first six months of 2013 to US$147.27 billion from the same period a year earlier, according to JETRO. The organization forecasts that total trade with China will decline in full-year 2013 after slipping 3.5% in 2012. Japan’s trade with ASEAN rose by 4.9% to 10.97 trillion yen in the first six months of 2013 from the same period a year earlier, according to data from the Japanese Finance Ministry.

ASEAN likely will replace China as Japan’s biggest trading partner in the future, Gordon says. “The reasons are two: first, because China’s emphasis over at least the next 10 years will be to promote internal purchasing power and domestic economic activity — which is aimed at promoting internal political stability. Second, because ASEAN’s prospects, especially in Indonesia, Vietnam and the Philippines — and [eventually] Myanmar — are so bright and are accompanied by excellent demographic profiles.” Each of those nations, moreover, has internal and long-term historic reasons to keep its relationship with China at a manageable arms-length, and that factor will help smooth the way to growing Japan-ASEAN economic ties, he adds.

Prospects of the launch of an integrated ASEAN Economic Community by 2015 are attracting Japanese financial institutions and other service industries, in addition to manufacturers. But the regional market is unlikely to be fully unified by 2015, analysts say. “They [are aiming] to get rid of all tariffs in the region and [create a free trade agreement for] ASEAN, which will be a plus for the ASEAN economy,” says Ishikawa of Asia University. “But they have issues such as unified product standards and infrastructure to deal with. How are they going to narrow the income gap among the member countries? There is a big gap between Singapore and Myanmar. It will take time to improve [that].”

World trade talks also are likely to affect trade and investment into ASEAN and China. So far, China has not decided to join the U.S.-led Trans-Pacific Partnership (TPP), perhaps because the TPP’s standards will extend well beyond “traditional” trade issues like tariff reductions. TPP members have to make commitments that will alter each member’s domestic economic interactions in whatever ways that they affect foreign trade.

China’s prospective membership in a Regional Comprehensive Economic Partnership (RCEP) with ASEAN is based on agreements between ASEAN and its other free trade agreement partners, including Australia, China, India, Japan, South Korea and New Zealand. Among ASEAN countries, Malaysia, Vietnam, Singapore and Brunei have joined the TPP.

“The TPP is likely to happen much faster and be more demanding than the RCEP. I think that China is not quite willing to go that fast, but they are certainly thinking about it,” says Peter A. Petri, a finance professor and international trade and investment specialist at Brandeis University’s International Business School. While China experiments with reforms to satisfy TPP requirements, TPP countries like Vietnam, which exports high-tariff items like garments, and Malaysia, which is closely connected with North American supply chains, will gain the advantage. As a result, “We do estimate faster trade and somewhat faster GDP growth in parts of the ASEAN region,” Petri notes.

Other ASEAN countries, including the Philippines and Thailand, have shown interest in joining the TPP, and if the coalition grows, it could end up excluding China from free trade, Ishikawa says. “China should join now, so that their arguments and the terms they would like may be reflected in the TPP agreement,” he notes.

“Unless China is incorporated into the TPP during the next five years or so … the future trend for FDI will favor ASEAN rather than China,” says Gordon. China would be wise to join and adopt important TPP requirements such as those pertaining to protection of IP (Intellectual Property) and state-owned enterprises, he suggests, adding that if Beijing were to make that leap, “China’s prospects for once again becoming the world’s FDI magnet would greatly improve.”

“Unless China is incorporated into the [Trans-Pacific Partnership] during the next five years or so … the future trend for FDI will favor ASEAN rather than China.”–Bernard Gordon

China’s investment expansion so far has mostly focused on Laos, Cambodia and Myanmar. Territorial disputes over the South China Sea have limited its commitment to expanding dealings with Malaysia, Vietnam and the Philippines. “Certainly, going forward the next few years, Japan will be a much bigger investor in ASEAN than China,” says Hiebert. The scale of most investment from China may remain limited. “You see local provincial Chinese companies moving to Myanmar, Vietnam, and Cambodia for mining and agriculture,” he notes.

U.S. Investment

Despite President Barack Obama’s vows to shift America’s military and economic focus back to Asia and ASEAN, U.S. investment in the region is still limited, though it is increasing. The American Chamber of Commerce in Singapore released results in August 2013 from a poll of 475 senior executive at U.S. companies operating across the region, showing that 79% of the companies had increased trade and investment in ASEAN during the past two years. Among them, 91% expect those investments to grow over the next five years. “ASEAN is going to become increasingly important to the U.S. and U.S. companies,” Allen said.

Gordon does not anticipate a major surge in U.S. investment in Asia and ASEAN. The U.S. domestic market has strong growth prospects, and the traditional tendency to focus on Europe and the Americas means there is less of a push into Asia, he says. “Indonesia, if it can maintain its recent economic growth, will remain an important U.S. FDI sector, but it is likely to be outshone by Vietnam, the Philippines and Myanmar,” he notes. U.S. FDI into ASEAN was US$6.9 billion in 2012, according to the U.S. State Department, up from US$5.78 billion in 2011.

Ultimately, ASEAN will benefit from its recent growth spurt, but it is unlikely to ever eclipse China in importance, says Marukawa. Since both regions are vital for Japan’s own economic well-being, “we should engage with both markets with our best efforts.”