Speeches

China: Mega-Threat or Quiet Dragon

Presented at the SBB/AIIS conference in Chicago on March 6, 2006.

Is China a mega-threat or a quiet dragon, as the question to this panel asks? Well, China is certainly not a quiet dragon. Its rise and continued growth will pose some tremendous challenges for producers and policymakers in the United States, and even greater challenges for producers and policymakers in other countries—particularly developing ones. But to view China as a mega-threat is to see the glass as half empty.

While there is some credibility to the common complaints about Chinese policies, much of the furor over China is driven by myths and half-truths. Yes, we have a large bilateral trade deficit with China, but that deficit has remained stable at about 25 percent of our overall deficit for the past 7 or 8 years. The absolute increase from China has occurred while there has been an absolute decrease from other Asian countries, reflecting a shift in production to China. In fact, share of imports from Asia has been about the same, even slightly declining over the past 15 years.

What should be so disconcerting about the fact that Americans spent $250 billion—less than 2 percent of U.S. GDP—on imports made by 20 percent of the world’s population? Most of those imports are lower end consumer goods, like shoes and clothing, toys and consumer electronics, appliances and furniture, and computers and telephone equipment, which help Americans to afford the basic necessities, and the necessities of modern life.

Lost in the shuffle is the fact that China is our fastest growing, and fourth largest export market behind Canada, Mexico, and Japan. U.S. exports to China grew by 20 percent in 2005, which came on top of 25 percent growth the year before that. In fact, since China joined the WTO in 2001, U.S. exports to China have more than doubled.

Despite rumors to the contrary, companies are not departing the United States to set up factories in China en masse. American companies invest about $12 billion directly in Chinese factories, real estate, and other hard assets. That constitutes less than 1 percent of the stock of U.S.-owned direct investment, and is a tiny fraction of the amount Americans have invested in rich countries, like those in Europe and Canada. By way of comparison, American companies usually invest more each year in the Netherlands than they do in China and they employ more workers in Germany than they do in all of China.

And the notion that importing from and offshoring to China is hollowing out American manufacturing is not supported by the facts. China has lost more manufacturing jobs than we have in recent years, and for the same reasons: labor productivity has been rising dramatically in both countries. Producing the widget efficiently requires far fewer workers on the line than in the past.

I suppose the bright side of the Dubai Ports World imbroglio is that China is enjoying a respite from its day job as Capitol Hill’s favorite piata. But Congress won’t soon forget about China. In fact, 2006 might surpass all others as the most contentious year in the bilateral trade relationship.

For starters, this is an election year. Hence, trade bashing is even more en vogue than it was last year, when legislation that would make Senator Smoot and Congressman Hawley proud was considered and deferred until this year. That bill mandates a 27.5 percent tariff on all Chinese imports unless and until China revalues its currency by an amount deemed sufficient by the Congress.

The House has already passed legislation establishing the position of trade enforcement “czar,” whose only responsibilities would be to monitor China’s—only China’s—trade compliance, and to recommend issues for the U.S. trade representative to pursue in WTO dispute settlement. Other measures are also under consideration in the Congress.

Unlike the past few years when Congress has been outspoken about alleged Chinese transgressions, this year the administration appears poised to be more indulgent of lawmakers’ demands for tougher action toward China. A few months ago, former USTR and current assistant Secretary of State Robert Zoellick gave an important speech calling for China to be a more responsible stakeholder in global affairs. I believe that speech marked a turning point in the administration’s policy toward China.

The idea behind the speech was that China has benefited considerably from its economic engagement with the world, and that China now has a responsibility to help ensure that the system and its institutions endure and thrive. That China should act in a manner consistent with its rising importance and influence.

Those sentiments were reflected again last month when the current USTR, Rob Portman, spelled out a new phase in U.S. trade policy toward China. In his “Top-to-Bottom” review of U.S.-China trade relations, Portman acknowledged that China has made great progress in implementing its WTO commitments, but that there were still several areas that needed vast improvement. The report implies that the United States will push harder for Chinese compliance, and will use WTO dispute settlement if necessary.

But the rhetoric used by Portman and the administration is much more diplomatic than the rhetoric of Congress. It reflects the fact that the administration does not view China’s emergence as a mega-threat, but rather as an opportunity of a lifetime to embrace and nurture. It reveals an understanding of the degree of interdependence of our economies.

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

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.

China’s economic success is something to celebrate and embrace, not to fear and oppose. It is a testament to the potential of engagement and globalization, and an indictment of isolationism. Economic growth in China over the past 25 years is one of the greatest success stories in history. Over this period, the number of Chinese people living in absolute poverty has declined by 400 million. That’s an anti-poverty program to put the World Bank to shame.

Over two decades of double-digit economic growth have propelled China into the ranks of a middle-income country with an emerging middle-class. Economic success has also brought greater independence and freedom for Chinese citizens, and the capacity to exchange ideas more freely. While the government is still in firm and sometimes brutal control, oppression is becoming harder to sustain.

The U.S. policy of engagement with China has helped loosen the reigns of the Chinese government over economic decisions. Ultimately, U.S. trade policy concerns boil down to the desire to see much more political and economic liberalization in China. The common denominator in all of those concerns is a central government that has too much control. The right policy toward China continues to be one of engagement, pushing China to do the right things without senseless or gratuitous provocation. Some of the proposals floating around Congress, I believe, could provoke responses that would harm the bilateral relationship. Some are designed to isolate, vilify, and punish China for its alleged transgressions.

Fueling the anti-China sentiment in Congress is, above all else, the $200 billion bilateral trade deficit. The fixation on the trade balance as a sign of economic weakness is mind-boggling, though. Japan has had a large trade surplus since time immemorial, but with the exception of the past year, has experienced anemic economic growth for the past 13 years. Germany, with its large and long-running trade surplus, suffers from a chronically high—currently 14 percent—unemployment rate.

Yet, too many policymakers view exports as good, imports as bad, and the trade account as the scoreboard. To them, the deficit means we’re losing at trade, and we’re losing because our partners are cheating. In China’s case, the alleged cheating involves currency manipulation, intellectual property theft, unfair labor practices, government subsidization of industry, opaque market barriers, and other underhanded practices.

There is probably some truth to the allegations, but also a lot of hyperbole. Regardless, the relationship between any of these policies and the trade deficit borders on insignificant. I’ll explain why momentarily.

But the mercantilist view on trade 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. Competition keeps prices in check, extends family budgets, raises average productivity, and reduces the cost of production to U.S. manufacturers. And the impact of imports on U.S. jobs is generally benign.

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. The record increase in imports in 2005 occurred alongside the creation of 2 million net new jobs, a decline in the unemployment rate to 4.7% and a 3.5% increase in GDP. Now I ask: what’s better a trade surplus or significant and sustained economic growth?

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 rely heavily on imported raw materials and components to manufacture final goods. In fact, if we remove trade in oil products from the equation, U.S. exports grew faster than imports in 2005.

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, and rewards for entrepreneurship all serve to reduce the cost uncertainty and to deter savings. For those same reasons, the United States is a magnet for foreign capital.

The confluence of those factors explains the U.S. trade deficit. If the objective of policy is balanced trade, then policymakers should focus their attention on tax and fiscal policy to incentivize new patterns of savings and consumption.

But many policymakers believe 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, but there is no consensus regarding how much. Estimates have ranged from 5 to 50 percent. The midpoint of that range is 27.5 percent, which corresponds to the Schumer-Graham bill, which proposes a tariff of that magnitude on all Chinese imports to compel the government to revalue the currency. 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.

From the beginning of 2002 through the end of 2004, the Federal Reserve’s nominal index of major currencies (which excludes China’s) shows a dollar depreciation of 28 percent. But the U.S. trade deficit in goods with those same countries 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. China’s world trade surplus is about $100 billion. Factor out its $200 billion surplus with the United States and China’s trade balance with the rest of the world is in deficit by $100 billion. So, if the purpose of China’s fixed currency has been to keep imports out, the policy has been a spectacular failure. China is now the world’s third largest importer—behind only the United States and Germany.

Like the United States, China relies heavily on imports to feed its industries. Renminbi appreciation would reduce the relative prices of imported raw materials—like oil, copper, and iron ore, 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. Thus, the issue about which Congress is most animated, and about which it is most insistent that the administration take action, could be much ado about nothing. Furthermore, China is the second largest holder of U.S. debt. With $260 billion invested in U.S. treasury bills, any appreciation of the renminbi vis-a-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 their loans at 72 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-a -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.

This is a delicate issue that will require gradual adjustment.

The issue of intellectual property piracy has become one of the more prominent sticking points in the bilateral relationship. 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.

Last October, 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 can improve its enforcement to the extent that infringements become only a marginal loss of business to U.S. interests, but it is quite conceivable that China could and should do a more effective job.

U.S. policymakers need to recognize that there aren’t too many actions they can take to slow China’s success without simultaneously hurting the U.S. and global economies. It is profoundly in the interest of the United States 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.

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. The “us versus them” characterization of the world is no longer appropriate where trade policy is concerned.

The United States has finite 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, and other explicit commitments on which China may be falling short.

Meanwhile, China should not view every U.S. effort to resolve differences as examples of hypocrisy and protectionism. There are likely some legitimate trading rights being denied U.S. interests. China should work with the United States to resolve legitimate issues before they enter WTO dispute settlement.

China should also 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.

With its accumulation of about $715 billion in foreign reserves, China has plenty of resources 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. And, in many regards, market forces are leading the economy toward a domestic orientation already.

The extraordinary growth in Chinese exports over the past decade has been driven by enormous investment in the export-oriented sectors of the economy. The Chinese government and foreigner investors viewed China’s short-term potential as a manufacturing platform for exports. But now that incomes have risen and are continuing to rise and China is accumulating wealth, it potential as the world’s largest market is moving closer to reality. This trend will likely divert investment away from export-oriented sectors in favor of investment geared toward domestic consumption and infrastructure development.

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 (through competitive firms in the private sector) 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 and investment.

There isn’t anything wrong with holding China’s feet to the fire. China should be held to account over the important commitments it made when it joined the World Trade Organization in 2001. It has certainly enjoyed enormous benefits and experienced phenomenal economic growth as a member. But the United States has reaped huge benefits from China’s membership as well.

Most experts, including the office of the U.S. Trade Representative, believe that China has done a pretty good job implementing the numerous commitments it made to liberalize its trading regime when it joined the WTO. The doubling of U.S. exports to China during the first four years of its WTO membership is testament to that. But there is certainly room for improvement.

But if we are to hold China to account, it must be done within the rules. The 27.5 percent tariff would clearly violate U.S. WTO commitments and could inspire a full scale trade war, while inviting other countries to disregard their own obligations.

Pursuing resolution of differences in a diplomatic, respectful manner will help facilitate long-term, harmonious relations. China’s engagement with the world has produced, and will continue to produce unprecedented opportunities for world economic growth. Accordingly, China is not a mega-threat.

Thank you.

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