Speeches

Calming the Waters: Stormy Issues in the U.S.-China Trade Relationship

Presented at the International Conference on Industrial Development in East Asia and the Change of Global Trade Pattern at Fudan University, Shanghai, China.

Introduction

U.S. President George Bush will visit China this month amid growing tensions in the bilateral relationship. Likely to be among the issues he raises with Chinese leaders are the usual American grievances: the bilateral trade deficit, the value of China’s currency, and intellectual property piracy.

It won’t be a one-way conversation, though. The Chinese will push back against what U.S. Federal Reserve Chairman Alan Greenspan calls America’s “creeping protectionism,” which threatens to metastasize into a real problem in the not-too-distant future. U.S. textile restraints, antidumping mischief, and political interference in the acquisition of American companies are sure to make China’s list of discussion topics.

Buried beneath the disputes that earn widespread coverage in the world press is the fact that the bilateral relationship has been broadly successful. Two-way trade has more than doubled since China acceded to the WTO in 2001. The United States is China’s largest export market, and China is the fourth largest and fastest growing market for U.S. exporters.

Behind those trade figures are billions of dollars of international investment; thousands of joint production operations; technology-sharing arrangements; intricate transnational supply chains; and burgeoning business relationships that benefit workers, consumers, and investors in both countries, as well as in others.

Meanwhile, there are important geopolitical objectives advanced by this developing relationship. Countries with mutual economic stakes are far more inclined to work together constructively to minimize and avoid the possibility of armed conflict. Indeed, an ever-increasing number of economic and strategic interests are vested in the harmony of trade relations between the United States and China.

Despite this growing interdependence and the prospects for more growth and cooperation it portends, U.S. policymakers, in particular, are registering concerns about this trend. Many of Mr. Bush’s issues have been thrust upon him by a U.S. Congress that has become so alarmed by China’s rapid growth that even liberal Democrats and conservative Republicans are finding common cause in arresting the threat it is perceived to imply. The political left frets about China’s impact on U.S. manufacturing jobs, while the right grows increasingly suspicious of China’s military ambitions.

Accordingly, a number of proposals designed to isolate, vilify, and punish China for its alleged transgressions have been introduced in the Congress in 2005, some garnering a disconcerting level of bipartisan support. In light of what is at stake, American and Chinese policymakers must work to defuse a potentially explosive situation made volatile largely by misconceptions and the regrettable willingness of politicians to extract opportunity from matters otherwise benign.

The Issues

Fueling the anti-China sentiment in Congress is, above all else, the bilateral trade deficit. Without the large and growing deficit, the other issues about which Congress complains would have little significance, political or otherwise. Many in Congress view trade through mercantilist lenses. To them, exports are good and imports are bad. You (meaning your producers) either win or you (meaning your producers) lose, and the trade account keeps score. Thus, the $200 billion bilateral trade deficit means that the United States is losing and that China must be cheating.

Of course this perspective completely discounts the value and significance of the contribution of imports to the U.S. economy. And it belies the real macroeconomics that explains the large trade imbalance.

Imports are necessary and good for the U.S. economy. They help keep prices in check through competition, extending family budgets and reducing the cost of production to U.S. manufacturers. The corollary to the mercantilist logic that imports are bad and exports are good is that since exports create jobs, imports must necessarily destroy them. But that is simply untrue.

U.S. imports rose throughout the 1990’s as employment levels and unemployment rates reached record highs and lows, respectively. Over the past 25 years, U.S. imports more than tripled while the number of people employed in the U.S. increased by 32 million. And as imports rose, so did GDP.

Contrary to popular belief, the data show a very strong positive relationship between imports and manufacturing output. In periods when imports rise, manufacturing output increases. And when imports fall, so does manufacturing output. This reflects a fact conveniently ignored by those with protectionist leanings: U.S. producers, like those in China, rely heavily on imported raw materials to manufacture final goods.

The trade balance has precious little to do with trade policy. It has everything to do with habits of saving and consumption. Americans save very little—around zero percent at the household level—while Chinese savings rates—around 25 percent—are among the highest in the world. That excess savings finds its way into the U.S. treasury, which must borrow to fund the American budget deficit. The willingness of the Chinese to invest their savings in the United States helps keep interest rates lower, the dollar higher, and American consumers feeling wealthier. Thus, they continue to consume Chinese and other products.

In many ways, U.S. spending habits are the product of the success of American institutions. Transparent government and the rule of law, a sound banking system, easy credit, high levels of home ownership, respect for property rights, an independent judiciary, widespread and generally credible retirement plans and health insurance, rewards for entrepreneurship, and a generally optimistic outlook all serve to reduce the cost of uncertainty and to deter savings. For those same reasons, the United States is a magnet for foreign capital. The confluence of these factors explains the U.S. trade deficit.

But policymakers prefer to ignore of fail to understand the macroeconomics behind the trade deficit, often choosing to adopt the explanation proffered by import-competing American manufacturers, to whom many are beholden politically.

The belief is that the trade deficit reflects some intentional policy decisions of the Chinese government, which subsidizes its industries at the expense of U.S. manufacturers. The most often cited form of subsidization is the undervaluation of the renminbi.

U.S. manufacturers have long been complaining that China’s currency is undervalued, and as such, bestows an unfair advantage on its exporters, who can sell their products at artificially low prices. Likewise, the undervalued currency causes the prices of U.S. exports in China to be artificially inflated. Most economists who have weighed in on the subject concur that the renminbi is undervalued (particularly in light of the massive inflows of capital over the past several years, which should be driving the value up), but there is no consensus regarding how much. Estimates have ranged from 5 to 50 percent.

In 2003, Senator Charles Schumer (D-NY) introduced legislation calling for an across-the-board tariff of 27.5 percent on all Chinese imports unless and until China allowed the renminbi to rise by about that rate. Of course, the 27.5 percent tariff proposal was the product of a precise and scientific analysis—it is the midpoint in the range of estimates of renminbi undervaluation. While the legislation went nowhere in 2003 or 2004, it was reintroduced jointly by Schumer and Senator Lindsey Graham (R-SC) in 2005, and serves as an example of liberal left-conservative right cooperation in addressing the China “threat.” While the bill has been put on the back burner since China’s initial revaluation in the summer, it may be given serious consideration if the renminbi does not rise considerably more in the near future. By a margin of 2-to-1, the Senate voted to give the bill consideration at a later date, if necessary.

The relationship between the Chinese currency and the bilateral trade deficit is likely overblown. Relative currency values do influence trade flows, but so do other important factors, including relative prices, the availability of domestic or other foreign substitutes, and the economic and opportunity costs of finding new suppliers. Recent U.S. experience indicates that these other factors can mitigate the effects of currency changes.

The dollar declined against major currencies for three years, yet the trade deficit continued to rise. From the beginning of 2002 through the end of 2004, the Federal Reserve’s nominal index of major currencies shows a dollar depreciation of 28 percent. But the U.S. trade deficit in goods—excluding trade with China—increased by 51 percent during this period. Why then does Congress have so much faith that raising the value of the renminbi will reduce the bilateral deficit?

The evidence shows that while the dollar has been declining against floating currencies, U.S. consumers have been choosing to pay more to continue consuming imports. Unless U.S. consumption of Chinese products declines by at least the same percentage that the currency appreciates, import value will rise. And unless Chinese consumption of U.S. products increases by at least the same percentage that the currency appreciates, U.S. export value will decline. Thus, it is quite plausible that renminbi appreciation would bloat the bilateral deficit.

Furthermore, proponents of currency adjustment fail to account for the fact that China runs a trade deficit with most of the rest of the world. Like the United States, China relies heavily on imports to feed its industries. Renminbi appreciation would reduce the relative prices of imported raw materials, enabling Chinese producers to lower their selling prices. So, while appreciation is touted as a “cure” to the bilateral U.S. trade deficit, the fact is that such appreciation would enable Chinese producers to lower their own costs of production, and hence their prices for export, possibly erasing the intended effect of the currency adjustment.

That policymakers would even consider imposing a 27.5 percent tariff as a proxy or prod for currency adjustment is inane enough. But to do so in the name of a policy for which the consequences have not been properly considered is irresponsible. There is not a whole lot of upside to a tariff that would tax U.S. consumers, violate U.S. international trade commitments, incite retaliation, and encourage other countries to disregard their own international obligations.

Furthermore, China is the second largest holder of U.S. debt. With $252 billion invested in U.S. treasury bills, any appreciation of the renminbi vis-à-vis the dollar will reduce the value of those holdings. By insisting on a 27.5 percent rise, U.S. policymakers are effectively telling the Chinese that they will repay them $.82 cents on the dollar. That is clearly not in China’s interest.

The Chinese are aware that market forces will cause at least some appreciation in the renminbi vis-à-vis the dollar, and as any rational investor would, they are looking for opportunities to diversify their portfolio. An abrupt retreat from the dollar to the euro, for example, could cause a rapid decline in the value of the dollar and/or a steep increase in U.S. interest rates. If the dollar declines dramatically, the value of Chinese holdings of U.S. debt will drop dramatically. If the United States is forced to raise interest rates precipitously, the economy could slow or recede, reducing U.S. demand for Chinese products.

China’s strategy for dealing with this potentially precarious situation has been to look for direct investment opportunities. By purchasing hard U.S. assets instead of government securities, China could reduce its exposure to a sudden and dramatic decline in the value of the dollar. But recent Chinese efforts, in particular the attempted purchase of UNOCAL by CNOOC, engendered so much opposition from Congress that the deal was abandoned. Since then, Congress has introduced legislation to make foreign purchases of U.S. direct assets more difficult.

This is yet another inane and reactionary policy proposal. U.S. laws already exist to ensure that commercial transactions that would genuinely threaten American security are blocked. But to extend that discretion to block benign commercial transactions that would benefit American asset-holders and Chinese buyers would only reduce the value of U.S. assets, frustrate China’s efforts to diversify its portfolio, and inspire similar harsh treatment of would-be U.S. investors in China.

The issue of intellectual property piracy has become one of the more prominent sticking points in the bilateral relationship. It is unique in the sense that it is probably the single trade issue over which the United States occupies the moral high ground. China has a bleak record of intellectual property rights enforcement, while America’s capacity to produce intellectual property is one of its most significant competitive strengths. U.S. copyright industries contributed about $535 billion to GDP in 2001, and between 1977 and 2001, those industries grew twice as fast as the rest of the U.S. economy.

The International Intellectual Property Alliance, a group representing 1,300 U.S.-based copyright companies, estimates that Chinese piracy cost U.S. firms $2.6 billion in 2003. While IPR issues have been at the fore of bilateral discussions since well before China’s entry into the WTO, adequate enforcement of the laws has yet to materialize.

Last month, the United States filed a request through the WTO for China to furnish evidence of its efforts-to-date at enforcing its intellectual property laws with respect to U.S. copyrighted products. It is possible that if the evidence of enforcement is deemed to be insufficient, the United States would bring a formal complaint against China under the rules of WTO dispute settlement.

It is unlikely that the Chinese government could improve its enforcement to the extent that infringements constitute a marginal loss of business to U.S. interests, but it is quite conceivable that China could and should do a more effective job.

Another long-running source of tension in the bilateral relationship has concerned trade in textiles and clothing. The broad-based system of quotas imposed by the United States and other rich countries under the auspices of the Multifiber Arrangement expired on January 1, 2005, pursuant to the WTO Agreement on Textiles and Clothing. But consistent with provisions of China’s WTO accession agreement, the United States reserved the right to reimpose quotas on Chinese imports if certain conditions were met.

In 2004 and again in 2005, the United States reimposed quotas at 7.5 percent growth over the previous year’s volume on several categories of Chinese exports that were found to be surging and causing market disruption. Under the threat of reimposing additional quotas, the United States and China attempted to negotiate a settlement whereby Chinese textiles and clothing would be restrained across the board at a slightly higher rate of growth than 7.5 percent. But a deal never materialized, and U.S. imports have slowed somewhat on account of the uncertainty of more cases being filed.

Fortunately, the United States has recourse to this particular protectionist tool for only three more years. The specter of cases being filed or even a negotiated settlement is sure to curtail trade through 2008. While the United States is within its rights to engage in this type of restraint, there is question as to whether the condition of market disruption has been met in any or every case. China could ultimately challenge the U.S. measures in the WTO on the grounds that the law was applied in a manner contrary to the WTO agreement, but realistically, resolution in dispute settlement might not be forthcoming until 2008 anyway.

It is unfortunate that the United States has expended so much capital on an issue about which China is particularly incensed, and which operates to the benefit of a small and economically insignificant U.S. constituency at the expense of broader U.S. interests.

Likewise, U.S. antidumping actions against China have been relentless and arbitrarily applied. From China’s perspective, U.S. antidumping policy is perhaps the single greatest irritant in the bilateral relationship. From January 2001, the first month of the Bush administration, through December 2004, the United States launched 32 antidumping investigations against China. That was almost triple the number of investigations against the next most frequent target during this period (India with 12), and amounted to one new investigation every 45 days.

It is not only the frequency of case initiations, but the manner in which investigations are conducted and antidumping duties calculated that agitate China. Despite dramatic market-oriented reforms instituted in China over the past quarter-century, China’s WTO accession protocol allows members to use an alternative methodology to calculate margins of dumping in Chinese cases because it is deemed a non-market economy (NME).

In NME cases the DOC attempts to estimate what prices would be if the country’s economy were market based. It does so by determining the quantity of inputs (e.g., labor, electricity, materials) required to produce the subject product and then valuing those inputs using wage rates, usage rates, and prices of material inputs prevailing in some third country. It then combs the financial statements of select third-country companies, culling figures to serve as approximations for selling, general, and administrative expenses, as well as profit rates. These figures are consolidated with all the other constituent cost components to produce an estimated normal value, which serves as the benchmark to which U.S. price is compared. Thus, affirmative dumping findings do not reflect price discrimination or selling below cost, but rather differences between an exporter’s price in the U.S. market and a fictitious hodgepodge of estimated components serving as a proxy for his home market price.

The Stakes

With the exceptions of certain specific complaints, the basis for U.S.-China trade tensions is rooted largely in misconception and opportunism. Indeed the potential consequences of some of the proposals being considered are directly at odds with their objectives.

While the logic behind Congressional complaints is often poorly considered and even contradictory, there are no assurances that nonsensical ideas won’t find their way into policy. While cooler heads have prevailed since the renminbi’s initial rise last summer, the honeymoon period seems to be waning and could end abruptly when next month’s trade figures are released. Furthermore, trade demagoguery knows no bounds in an election year, and 2006 is just around the corner.

Accordingly, it is in the interest of U.S. and Chinese stakeholders to work together to calm the waters in this potentially stormy, bilateral relationship. Most of the onus falls on U.S. policymakers to gain a measured understanding of the mechanics of the trade relationship, which could help prevent the enactment of shortsighted, self-defeating proposals. But China too has an obligation to do what it can to ease the tensions. With economic success comes the responsibility to demonstrate that that success is truly in the interest of the world at large. Furthermore, to an extent, China owes some measure of its success to the WTO and a relatively open U.S. market. Here’s what needs to be done.

The Solutions

First, U.S. policymakers need to acknowledge that there is no action they can take to slow China’s success without hurting the U.S. and global economies. It is profoundly in the interest of the United States, Asia, and the world that China has a strong and growing economy.

It may be useful to recall that the relatively good health of China’s economy had a lot to do with cutting the Asian crisis shorter than it might have been. China’s commitment to the currency peg at a time when many of its neighbors experienced major depreciations enabled it to be a strong export market for its Asian neighbors struggling to grow out of recession.

This relationship still holds today, as China runs a fairly large deficit with the rest of Asia. If U.S. policymakers erected trade barriers to “correct” the deficit, China’s demand for imports would slow, adversely affecting the region, and the world. Policymakers should also remember how incapable the European and Japanese economies have been at picking up the slack when U.S. demand has faltered. A world where an economy besides America’s can be relied upon to drive economic growth is preferable to the alternative.

In a world where national economic interests are no longer defined by geographic boundaries, the “us versus them” characterization of the world economy no longer holds. The world is a wealthier place precisely because of the institutions most responsible for diminishing the significance of those geographic distinctions: the emergence and accessibility of capital markets; foreign investment, reduction of trade barriers; proliferation of most favored nation and national treatment principles; overhaul of customs procedures; reduced information, communication, and transportation costs and the rise of logistics and supply chain management; the success of mass retailers at wresting away market power from the mass producers; and, greater embrace of the rule of law. Together these trends have inspired economic integration and blurred the lines of national economic interest and have bolstered the case against government interventions in trade flows. Erecting obstacles to China’s growth would necessarily affect many U.S. interests adversely.

If and when the Chinese economy slows or contracts, U.S. interests, including U.S. manufacturers operating in China, U.S. companies sourcing in China, exporters selling to China, U.S. businesses that feature China in the supply chain or that are exposed through investment or the investment of its customers, and U.S. consumers will feel the pain. It has been said that when the United States sneezes, the world catches a cold. While this metaphor still prevails, the world is now heavily vested in China’s well being as well. Hence, the “us versus them” characterization of the world is no longer appropriate where trade policy is concerned.

Second, the trade balance is not a function of trade policy. As such, attempts to address it through import restraints are misguided.

Third, U.S. policymakers need to recognize that China is a sovereign nation that will act in a way it perceives to be in its best interests. America cannot simply expect its demands of China to be met consistently and expeditiously. Often those demands are contrary to China’s interests, as may be the case with the currency issue, for example.

Fourth, the U.S. needs to recognize that it has a finite amount of political capital with respect to China. And in many ways it has expended much of that capital already, by hammering the Chinese on textiles and antidumping, and by badgering the Chinese about the value of the renminbi. The United States should reserve that capital for issues that are of importance to broader U.S. interests, like those concerning intellectual property enforcement.

Fifth, the United States should attempt to replenish its political capital with China. One way to do so is by formally granting market economy status to China. China’s status as a non-market economy for the purposes of antidumping calculation has been a major irritant to the Chinese—and it has been the single most important issue on China’s much shorter list of grievances with the United States. China’s economy has already become largely market-oriented and it will continue to become more so through international ownership and investment, which will continue to crowd out fledgling state-owned enterprises. China’s interest in graduating to market economy status is not driven by the desire to make dumping easier. To China, it is a matter of respect and acknowledgement that their economy has made great strides and that they are entitled to a seat at the table with the other big economies.

Through this gesture, the United States “gives up” very little because its industries will still have access to the antidumping law, which produces wildly unrealistic dumping rates under market economy methodology anyway. As small a sacrifice as it would be for the United States, it would be received by the Chinese as a huge gesture of goodwill. And that goodwill could inspire China to contribute its part to calming the waters.

First, China should continue its efforts at diversifying foreign investment away from U.S. government securities. Its current level of U.S. debt holding contributes to an unbridled American consumerism that benefits Chinese companies in the short-run, but could end abruptly through punitive trade measures or a decline in the value of the dollar. China’s efforts to purchase UNOCAL were thwarted by a spooked Congress, but that does not mean other attempts at direct U.S. investment should be abandoned.

Second, China has accumulated about $715 billion in foreign reserves. It should use a chunk of those reserves to stimulate domestic demand. To a certain extent, this objective has been articulated in China’s “Eleventh Five-year Program,” which provides a road map for China’s development of the next five years. But China should also undertake steps that would empower its citizens to spend more of their savings. Easing credit and improving social safety nets like health insurance and retirement plans would reduce the risk and uncertainty that Chinese citizens contend with today. And typically, that type of environment reduces the need for thrift and encourages consumption. Of course, allowing the currency to rise would also go a long way toward shifting the economy from one that relies on exports to one that is driven more by consumer spending.

Third, China should cooperate to the fullest extent possible with U.S. efforts to resolve the issues related to intellectual property theft. If there is any issue on which China’s actions or inactions can be questioned with justification, it is its failure to curb this growing problem. While there may be limits to what the Chinese government can do, the U.S. perception, and probably the reality, is that those limits have not even been approached yet.

Fourth, China should strive to avoid the perception that it is asserting its growing influence at the expense of U.S. interests. Efforts to exclude the United States—or even the perception thereof—from various Asia-focused economic and security arrangements, and questions regarding China’s military budget have only inspired suspicion about Chinese intentions among U.S. policymakers. Of course, China should act according to its own interests, and if it is perceived to be in China’s interest to make the United States feel excluded or even threatened, then there is no reason to change tact. But, if calming the waters of the bilateral trade relationship is a priority, that advice should be considered.

Conclusion

Many important issues will be discussed at this month’s meetings between the leaders of China and the United States. In light of the success of the bilateral relationship and the growing number of interests that rely on continued harmony, it is imperative that these meetings produce a mutual understanding of the stakes. It should also produce concrete proposals for calming the relationship’s currently stormy waters.

Daniel J. Ikenson is associate director of the Center for Trade Policy Studies at the Cato Institute.