One Belt One Road: The Transaction Cost Approach

What is the underlying economic theory of OBOR, and how should China choose its allies to ensure its success?

By Liu Xin, PhD student, School of Accountancy, CUHK Business School

Since the One Belt One Road (OBOR) initiative was introduced in 2013 by the Chinese government, it has attracted lots of global and media interests. Although there are many OBOR-related articles being published, many discussions are focused on these questions: What is OBOR? How will OBOR reshape the international structure, especially on its influence of China on United States and other countries? How can the countries along the OBOR region participate in and benefit from the plan?

This article, however, tries to uncover the underlying economic theory of OBOR, as well as share my thoughts on how China should choose its allies to ensure the success of OBOR.

OBOR Is Globalization

Introduced in 2013, OBOR intends to revive two famous ancient trading routines from China to Europe. Its aim is to extensively facilitate the cooperation among countries on the land-based “Silk Road Economic Belt” and oceangoing “Maritime Silk Road”. If successful, OBOR will grant this region great economic benefits and competitive advantages.

Regardless of the details, OBOR is essentially a plan towards globalization. By forming regional economic partnerships to countries within the ‘belt’ and the ‘road’, China will be able to integrate itself to the world’s economy, while strengthening its influence in these regions.

Some scholars have reached a consensus that “globalization has been naturalized as the inevitable pathway to economic prosperity and success”. For governments that “act strategically in order to attract economic activity to their jurisdiction with the ultimate aim of boosting aggregate growth, globalization is undoubtedly the way to go”.

In fact, globalization is nothing new to China after the Chinese Economic Reform and Opening Up in the late 1970s. Besides China, over the past few decades, other governments are also more willing to open the national economy to global market forces.

The Transaction Cost Theory on Globalization

In 1960, Ronald Coase proposed the transaction cost theory. Oliver Williamson enriched the theory by adding the relationship mechanism. Taken literally, transaction cost refers to the costs to complete a market transaction. Transactions can be completed through the market, relationships and inside the firm. The important question is: Which of the three mechanisms offers the lowest transaction costs?

In fact, we can apply the transactions cost theory into international setting. The simplest interpretation of globalization is to do transactions with other countries. There are also three ways to transact between countries.

Taking China for example, the first way is the market, where all other countries are treated equally and there are straightforward and explicit contracts. The second way is the relationship mechanism. OBOR is the best example for this. Countries along the OBOR region can transact relatively easily with each other and negotiate when necessary. The third way is to form a firm-like organization. Countries inside the organization can transact and negotiate with each other whenever necessary. A close example to this is World Trade Organization (WTO).

Therefore, if globalization is to be the destination, the question to ask is: Is OBOR more preferable to the market or to WTO?

OBOR Versus Market

The market mechanism provides most benefits because all profitable transactions will take place. However, not all transactions’ benefits outweigh the corresponding costs, especially in an international setting. These costs take various forms, geographic, political, military, and so on. Therefore, free trade is not working for the majority of the world. In other words, the high transaction costs prohibit lots of cross-border transactions from happening.

The OBOR, if successful, will significantly reduce transaction costs mentioned above and thus induce more cross-border transactions. These reductions can be reflected in the following ways: transportation costs will be lower due to investments in cross-border infrastructures; tariffs costs within the OBOR region will be lower due to favorable policies; frequent co-operations improve OBOR members’ knowledge of each other, thereby reducing the cost of information searching; the trust built within the region can guarantee a steady transaction environment, thereby reducing the policy enforcement costs.

In short, for members within the OBOR plan, OBOR is more preferable to the free market since it offers lower transaction costs.

OBOR Versus WTO

Although both WTO and OBOR aim to facilitate cross-border transactions by lowering transaction costs, there are a few very important differences.

Firstly, OBOR treats its members differently, while WTO treats its members equally. Each OBOR member can make contract with another member in differently terms and conditions based on their relationships, while all members within WTO need to follow the same rules.

Secondly, OBOR offers more flexibility than WTO. The contracts and rules can easily be re-negotiated when necessary, while it is unlikely for WTO to constantly change its rules.

Lastly but most importantly, the two have different beneficiaries. Clearly, the equilibrium of OBOR requires that everyone inside OBOR is a winner. However, for WTO, there is only one winner – WTO as a whole. Worse more, WTO is highly biased towards the developed and rich nations and thus failing developing nations and therefore lowering their true incentives to participate.

In a world where each country pursues its own interest, the OBOR initiative is clearly more feasible than the WTO. In fact, some experts have already pointed out the failures of WTO based on the above analysis in recent years. Therefore, OBOR is more likely to sustain in the long run than WTO.

References:

1. R.H. Coase (1960) The Problem of Social Cost. Journal of Law and Economics, Vol. III, 1960, pp. 1–44.

2. Dicken, Peter (1998) Global Shift: Transforming the World Economy. New York: Guilford Press.

3. Dreyer, J. T. (2015) The Rise of China and the Geopolitics of East Asia. Orbis, Vol. 59, No. 4, 837, 2015, p. 518-529.

4. Williamson, Oliver E. (1979) “Transaction-Cost Economics: The Governance of Contractual Relations,” Journal of Law and Economics: Vol. 22: No. 2, Article 3.