The Future of NAFTA: “Hecho en China”?

By Daniel Griswold
November 15, 2006

Presented at Laredo, Texas, and Monterrey, Mexico, November 15-17, 2006.

My most recent “globalization moment” occurred the other day at a department store in Northern Virginia where I live. I was sifting through shirts on a rack when I noticed on the label the words, “Hecho en China.” This was Lou Dobbs’ worst nightmare. Not only were the shirts “Made in China,” but the labels also contained a translation in Spanish! The label offers a fitting metaphor for my subject today.

The rise of China is one of the great stories of our time, with mostly positive implications for the countries of North America. My subject today is what China’s rise means economically for the United States, and what it means for Mexico. My message is that Americans and Mexicans alike should not fear the economic rise of China. China presents an opportunity, not a threat, to the NAFTA partners. I’ll first examine impact of China’s rise on the U.S. economy, then its impact on U.S.-Mexican trade, and explain in both cases why fears are unfounded.

Much of the controversy focuses on China’s exchange rate, but the real complaint is the rising competitiveness of China in a broad range of sectors. Everyone can agree that imports stamped “Made in China,” or “Hecho en China,” have soared in the past decade. In 2005, imports from China reached $243.5 billion, a huge increase from the $38.8 billion in goods imported from China in 1994. During that same period, imports from China as a share of total U.S. imports rose from 6 to 15 percent. Since 1994, imports from China have grown more than twice as fast as imports from the rest of the world.

Displacing other imports

A key to understanding our trade relationship with China is to see China as the final assembly and export platform for a vast and deepening East Asian manufacturing supply chain. Even in mid-range products such as personal computers, telephones, and TVs, rising imports from China have typically displaced imports from other countries rather than domestic U.S. production. Final products that Americans used to buy directly from Japan, South Korea, Taiwan, Hong Kong, Singapore and Malaysia are increasingly being put together in China with components from throughout the region.

China’s more economically advanced neighbors typically make the most valuable components at home, ship them to China to be assembled with lower-value-added components, and then export the final product directly from China to the United States and other destinations. As China imports more and more intermediate components from the region, its growing bilateral trade surplus with the United States has been accompanied by growing bilateral deficits with its East Asian trading partners.

While imports from China have been growing rapidly compared to overall imports, the relative size of imports from the rest of East Asia has been in decline. In 1994, the year China fixed its currency to the dollar, imports from East Asia accounted for 41 percent of total U.S. imports. Today imports from that part of the world, including those from China, account for 34 percent of total U.S. imports. In other words, the rising share of imports from China has been more than offset by an even steeper fall in the share of imports from the rest of Asia, as shown in Figure 3.[1]

The sharp rise in imports from China is not primarily driven by China’s currency regime, but by its emergence as the final link in an increasingly intricate East Asian manufacturing supply chain. Benefits to U.S. Economy from Trade with China

While the critics of trade with China mistakenly focus on the alleged harm it causes, they tend to overlook the benefits. Those benefits include lower-priced imports for U.S. consumers and businesses, expanding export opportunities to China, and the economy-wide benefits of Chinese capital flowing to the United States.

Imports from China allow Americans to stretch their paychecks further, raising real wages for millions of workers. Money saved because of lower prices for Chinese imports allows U.S. consumers to spend more on other, non-Chinese goods and services, including those produced in the United States. Those savings are especially important for low- and middle-income American families who spend a relatively larger share of their budgets on the discount-store shoes, clothing and other products made in China.

American producers and workers have gained tremendously from growing export opportunities to China. China’s fixed currency has allegedly discouraged exports to China, but that is not supported by the trade numbers. Since 2000, U.S. exports of goods to China have increased by 158 percent, from $16.2 billion to $41.8 billion in 2005. The rate of growth of U.S. exports to China since 2000 is more than 12 times the rate of growth of U.S. exports to the rest of the world other than China during the same period.[2] Our leading exports to China are soybeans, cotton, and other agricultural products; plastics, chemicals, wood pulp, and other industrial materials; civilian aircraft; and semiconductors, computer accessories, industrial machines and other machinery.[3]

The dollars earned by producers in China by selling in the U.S. market are not stuffed under mattresses. They either come back to the United States to buy our goods and services, or they are used to invest in the United States through the purchase of U.S.-based assets. The large majority of Chinese investment in the United States comes through official purchases of U.S. Treasury bills by China’s central bank. As of December 2005, Chinese monetary authorities hold $262 billion in U.S. Treasury bills.[4]

China’s investment in the United States, while a relatively small share of the total U.S. securities market, does put upward pressure on bond prices and thus downward pressure on U.S. interest rates. Lower rates, in turn, mean lower mortgage payments for American families and lower borrowing costs for U.S. business. Lower borrowing costs have also stoked demand for durable goods such as cars and appliances, benefiting U.S.-based manufacturers. And, of course, lower interest rates paid on U.S. Treasury bills means less spending by the federal government and savings for U.S. taxpayers.

A one-sided view of trade with China—a view that only considers the alleged harm while ignoring the real benefits—will likely result in misguided policies that would put those benefits in jeopardy.

Impact of China’s rise on U.S.-Mexican trade

Millions of Mexicans benefit everyday from trade with China for all those very same reasons. The rise of China has delivered lower prices and more choice for Mexican consumers, export opportunities for Mexican producers, and more capital and lower interest rates for households, companies and government.

Although all those blessing are real, China’s rise has had a different impact on Mexico than it has on the United States. Because China and Mexico are at a more similar stage of development, their producers tend to compete head to head in a broader range of products.

On a very simple level, China is bound to rise relative to Mexico just because it is a much larger country. China’s population is twelve times larger than Mexico’s, representing 20 percent of the world’s population. Its growing presence in the U.S. economy is not a negative reflection on Mexico, but of the simple fact that China is reclaiming its rightful place in the global economy.

So it was not great shock when China surpassed Mexico in 2003 as the number two supplier of imports to the U.S. market. As a market for U.S. exports, Mexicans still buy two and a half times as many American-made goods as do the Chinese, but that ratio is falling rapidly and China will probably be buying more U.S.-made goods and services than Mexico within a decade. And by my calculations—and you heard it here first—sometime this fall China surpassed Mexico as America’s number two trading partner in terms of two-way goods trade, behind only Canada. The most politically sensitive of those measures for Mexico is its competitiveness in the U.S. import market. Mexico’s share of U.S. imports has gone through two transitions in the past two decades. The first occurred in 1994 when Mexico joined the North American Free Trade Agreement.

As the chart shows, Mexico’s share of total U.S. goods imports began to rise sharply at that point, rising sharply from 6.7 percent in 1993 to 11.8 percent in 2002. But starting in 2003, Mexico actually began to lose market share, bottoming out at a low point of 10.2 percent in 2005 before it began to recover in 2006.

One obvious cause was the economic slowdown in the United States, which curbed demand for imports from Mexico, in particular vehicles, auto parts and heavy machinery. But another cause was clearly China’s growing success in the U.S. market, in particular its rapid expansion of apparel and other labor-intensive manufacturing imports. As the figure also shows, Mexico’s market share began to dip just as China entered the WTO and began to ramp up its imports to the United States.

The story is more complex than Chinese products simply replacing Mexican products in the U.S. market. Mexico’s comparative advantage has been shifting relative to China. Mexican producers have continued to enjoy a strong comparative advantage in petroleum products, food and beverages, passenger cars and parts, and industrial machinery. In each of those product categories, Mexico has expanded its exports to the United States alongside increasing imports to the United States from China. With the sharply increased price of oil in recent years, U.S. imports of Mexican petroleum products soared by $15.7 billion from 2001 to 2005. The huge increase in America’s oil bill from Mexico has probably had the effect of keeping the peso strong relative to the U.S. dollar and thus partially crowding out non-petroleum imports from Mexico.

Mexican and Chinese producers both appear to enjoy comparative advantage in such mid-range products as telecommunications equipment and TVs, radios and other audio-visual equipment. Producers in both countries have seen significant increases in their exports to the United States in those products since 2001.

Producers in China are clearly cutting into Mexico’s market share in several important manufacturing sectors. The most obvious is textiles and apparel. When China entered the WTO in 2001, it immediately benefited from the ten-year phase out of global quotas on textile and apparel trade. From 2001 to 2005, China’s apparel and footwear imports to the United States rose by $18.9 billion while Mexico’s imports to the United States fell by $1.8 billion. Textile and apparel employment in maquiladora factories fell by more than 100,000. Even after the post-China WTO decline, the Mexican textile and apparel sector still employs more workers than it did before NAFTA.

Chinese producers also expanded their market share at the expense of Mexican producers in computers, parts and peripherals, expanding imports to the U.S. by $30.9 billion while Mexican imports fell by $3.6 billion; and toys, sporting goods and bicycles, where Chinese imports also grew sharply while Mexican imports to the United States declined. Chinese producers also dramatically increased their imports to the United States of furniture, appliances and household goods, while imports from Mexico increased only slightly.

Mexicans should not mourn the relative decline of the country’s textile and apparel industries. The growth in those industries in the years immediately after NAFTA was an artificial phenomenon. It was a textbook example of “trade diversion,” which allowed Mexican producers to supplant more efficient producers outside of NAFTA because of its tariff-free access to the U.S. market. As global quotas on textile and apparel trade were dismantled, Mexico’s artificial advantage diminished. The coup de grace was China’s entry into the WTO in 2001 and its full participation in the more open and non-discriminatory global trading system.

The result has not been an overall decline in Mexico’s export competitiveness and industrial output. Like the United States, Mexico has seen a shift in the nature of its output in response to China’s rise, with further specialization in those products in which Mexico enjoys its strongest comparative advantage. Overall employment in the maquiladoras has not suffered long-term decline in the face of rising competition from China, but rather a change in the mix of jobs. Since 2003, employment has been rising overall, from 1,042,085 to 1,213,841 in 2006.

As the chart shows, employment has been rising in chemicals, services, electronics, machinery, furniture, and transportation. The exception is textiles and apparel, for all the reasons we just discussed. As a recent report by the Dallas Fed concluded, “Mexico’s export industries will continue to benefit from being on the doorstep of the greatest consumer market on earth. But for textiles and apparel, NAFTA isn’t what I used to be.”[5]

Mexico’s Three Advantages over China

Mexicans enjoy three important advantages in competition with Chinese producers. One is proximity, or as those in the real estate business would say, “Location, location, location!” A previous Mexican president once lamented that it was part of Mexico’s burden as a nation to be “so far from God and so close to the United States.” I’ll leave it to others to ponder Mexico’s relationship to God, but in more earthly terms of trade and economic growth, it is clearly in Mexico’s advantage to share a 2,000-mile border with the world’s largest and most advanced economy. Proximity means that Mexico can become a key supplier in an integrated supply chain that values “just-in-time” delivery. Delivery by truck and rail through Laredo and other ports of entry can mean goods can be delivered in just a few days compared to the three-week delivery time typical of shipments from China. This is especially advantageous with heavier goods such as machinery or auto parts in which shipping costs are higher. It also means that companies can ship goods between affiliates far more easily, quickly, and cost effectively.

The second advantage is the North American Free Trade Agreement. More than 12 years after its implementation, the NAFTA has succeeded by any objective measure. It has stimulated a sizeable increase in U.S.-Mexican trade and helped to institutionalize Mexico’s economic reform and modernization. Despite a few loose ends, such as trucking and sugar, our two economies have essentially achieved the goal of free trade. And although U.S. trade barriers are quite low in general for imports from the rest of the world, some of the U.S. government’s highest remaining barriers apply to sectors where China enjoys its strongest comparative advantage, such as lower end, labor-intensive consumer products such as apparel, footwear, toys, and sporting goods.

As a result of those first two advantages, the Mexican and American economies are far more deeply integrated than the Chinese and American economies. For Americans, China is the big-box retailer on the edge of town, while Mexico is our next door neighbor and business partner.

While China has been storming ahead to dominate goods trade, Mexico’s commercial ties to the United States surpass China’s ties by almost every other measure. In services, Mexico’s two-way trade with the United States totaled $35.3 billion in 2005 compared to $15.6 billion in China-U.S. trade.[6] American-owned affiliates in Mexico sold more than twice as much in the Mexican market in 2004 as did American-owned affiliates in China. American companies employ more than twice as many workers in Mexico as they do in China.

The story is the same with foreign direct investment. As of the end of 2005, American firms owned $71 billion of foreign direct investment in Mexico compared to $17 billion in China. From 2001 through 2005, U.S. firms channeled $39 billion in FDI to Mexico compared to $9 billion to China. Mexican firms own $8.6 billion in FDI in the United States compared to $0.5 billion owned by Chinese firms in the United States. Propelled by all this cross-border investment, U.S.-Mexican trade flows are far more likely to be intra-firm trade than U.S.-China trade. Some 30 percent of U.S.-Mexican goods trade occurred between affiliates of the same company in 2003, compared to less than 1 percent of U.S.-China trade.

As for labor-market integration, there is no comparison. The number of Mexican-born people living in the United States dwarfs the number of Chinese-born. Since 1990, 3.80 million Mexicans have immigrated legally to the United States compared to 642,000 Chinese. Since 2000, the number of Mexicans entering the United States each year on temporary, non-immigrant visas has averaged 4.36 million compared to 481,000 Chinese. Mexicans have the edge in virtually every visa category—pleasure, business, and temporary workers, including highly skilled H1-B workers. Mexican workers in the United States send home an estimated $20 billion a year in remittances, far greater than the amount remitted by Chinese workers in the United States. Compared to other inflows, those remittances are stable and countercyclical.

Mexico’s third, and profoundly important advantage, is its maturing democratic system. Mexico’s recent election was a difficult test of that system, and the system worked. Although democracy can be messy, as we’ve seen in both our countries, it is ultimately more stable and transparent than authoritarian systems. Public frustrations with policy can be addressed through elections and incremental change rather than through confrontations and violence.

At the end of the day, nations do not compete with one another in some kind of zero-sum sporting contest. China’s gains do not necessarily translate into Mexico’s losses. The two countries can prosper together. The key to Mexico’s continued growth and development does not lie in Beijing or in Washington but within Mexico itself. My advice to our friends in Mexico is that same as the advice I give, free of charge, to the U.S. government. Our focus should be on free trade and free-market reforms at home, not on complaints about our foreign trading partners.

Thank you.

[1] U.S. Department of Commerce, “U.S. Trade in Goods (Imports, Exports and Balance) by Country,” www.census.gov/foreign-trade/balance/index.html#C.

[2] U.S. Department of Commerce, “U.S. Trade in Goods (Imports, Exports and Balance) by Country,” www.census.gov/foreign-trade/balance/index.html#W.

[3] U.S. Department of Commerce, “U.S. Exports to China from 2001 to 2005 by 5-digit End-Use Code,” www.census.gov/foreign-trade/statistics/product/enduse/exports/c5700.html.

[4] Timothy D. Adams, Undersecretary of the U.S. Treasury for International Affairs, Testimony before the Senate Finance Committee, Hearings on “U.S.-China Economic Relations Revisited,” March 29, 2006.

[5] SouthwestEconomy, September/October 2006.

[6] One of the few areas where Chinese bought more U.S. services than did Mexicans was in educational services.

Daniel Griswold is director of the Center for Trade Policy Studies at the Cato Institute.