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China and the WTO

Next year China is likely to surpass Japan to become the single largest source of the U.S. trade deficit. Administration officials attribute this to unfair Chinese trading practices and propose to use China's desire to become a member of the World Trade Organization (WTO) as a lever to force far-reaching changes in China's trade regime. This approach runs the risk that China, the world's tenth-largest producer of export goods and the largest trading country in the world not already subject to the disciplines of the established international trading system, will elect to remain outside the WTO indefinitely.

Such an outcome would be undesirable for the future of the world trading system, China's economic evolution, and the U.S.-China relationship. China's membership in the WTO will serve U.S. interests by providing a mechanism for dealing with inevitable trade frictions on a multilateral rather than a purely bilateral basis. It would also allow the United States to concentrate in the bilateral diplomatic channel on critical strategic issues. As a result, the United States should moderate its demands for reform as a precondition for China's membership in the WTO. In exchange the United States should expect China to agree to a schedule that would gradually bring the country into compliance with WTO standards.

POLICY BRIEF #10

In June for the first time ever, the U.S. monthly trade deficit with China edged ahead of the deficit with Japan. The pattern recurred in August by a much wider margin, almost $1 billion. If present trade trends continue, the annual U.S. trade deficit with China will surpass that with Japan in 1997, making China the single largest source of America's global trade deficit.

Government officials have been quick to attribute the burgeoning deficit to China's unfair trading practices. According to Commerce Secretary Mickey Kantor, the deficit is "the result of unfair practices on the part of China, not only the piracy of U.S. products but also keeping U.S. products out of the Chinese market." Officials seek to use the negotiations over China's membership in the World Trade Organization (WTO) to create a more level playing field for U.S.-China trade relations.

The U.S. Deficit with China

The basis for using this approach is flawed at several levels. Unlike Japan's global trade surplus, which soared from $2 billion in 1980 to a peak of $120 billion in 1994, China's trade account has fluctuated between deficit and surplus. But since China began its opening up and economic reforms in the late 1970s, its cumulative trade balance is close to zero. Unlike Japan, China has not adopted macroeconomic and exchange rate policies that have resulted in growing global trade surpluses.

In addition, U.S. data on bilateral trade with China are seriously flawed. Although this year U.S. firms will sell about $6 billion to China via Hong Kong middlemen, the Department of Commerce insists on calling these transactions sales to Hong Kong. But the department counts as imports from China all Chinese products reexported from Hong Kong to the United States. Unfortunately, the department also includes the value added by Hong Kong companies as part of the total value of imports from China. In the process U.S. officials will overstate imports from China this year by $7 billion. The upshot is that this year the real U.S. trade imbalance with China is likely to total about $25 billion, one-third less than a projection of $38 billion based on U.S. government data. That would represent an increase of about 10 percent, the slowest rate of increase since the real bilateral deficit first emerged in the late 1980s, and one-third less than an anticipated 1996 deficit with Japan of $40 billion. In short, the U.S. deficit with China is not increasing rapidly. It looms large primarily because the deficit with Japan is shrinking dramatically.

Moreover, the trade deficit with China primarily reflects its openness to foreign investment, not unfair trading practices. As a result of the liberalization of its domestic economy, in recent years China has attracted about 40 percent of all foreign direct investment flowing to emerging markets. It is so open to foreign investment that in just the last five years it has attracted far more foreign direct investment than Japan has in all the years since World War II. Most of this investment has come from Hong Kong, Taiwan, and South Korea. Entrepreneurs from these countries have moved facilities that produce footwear, garments, toys, sporting goods and other labor-intensive products to China to take advantage of cheap labor. These products also account for a large share of our imports from China. The growing deficit the United States has experienced in its trade with China not surprisingly has been accompanied by sharply declining deficits with Hong Kong, Taiwan, and Korea. Thus the argument that the growing deficit with China has caused a large loss of manufacturing jobs in the United States is wrong.

Finally, although many features of China's trade regime are not fully compatible with the WTO system and should be reformed, one should not lose sight of just how well U.S. firms have done in selling to China. U.S. exports to China, including those sold via Hong Kong companies, have jumped from $6 billion in 1990 to a projected $17 billion this year, outpacing the growth of U.S. exports to any other major foreign market.

WTO: Costs and Benefits for China

It is easy to overestimate the leverage that negotiations for China's WTO membership provides to the United States and other advanced industrial economies as they seek further reforms of China's trade regime. The benefits China would attain through WTO membership are relatively modest. The country's size and geopolitical influence are both sufficiently large that the single most important economic benefit associated with membership in the WTO—permanent most-favored-nation (MFN) trading status in the markets of member countries—was bestowed by all countries, except the United States, in advance of China's first indication in the mid-1980s that it was interested in participating in the General Agreement on Tariffs and Trade, the predecessor to the WTO. And the United States has provided MFN status for China one year at a time for more than fifteen years.

With the principal benefit of membership already in hand, what is the incentive for China to incur the considerable costs of domestic restructuring and adjustment that would inevitably accompany the dismantling of its remaining import barriers? These barriers primarily protect state-owned industries that grew up during a period of relative autarky when international cost competitiveness was irrelevant. But these state-owned entities still employ almost two-thirds of all urban workers. China's political leadership appears unwilling to risk the high levels of urban unemployment that could result if restructuring was too rapid. Thus the costs of conforming immediately to expectations of the West on openness to trade are relatively high for China while the gains from membership in the WTO are relatively small.

A Framework for Agreement

What is the solution to the apparent standoff, reflected in the lack of progress in recent years in the negotiations over China's WTO membership? The central issue is not whether China becomes a member of the WTO on "commercially viable terms" but rather the length of time it is given for meeting these terms. The United States, Europe, and Japan have insisted that China must dismantle most of its trade barriers as a precondition for membership. This insistence could result in China's remaining outside the WTO indefinitely.

The appropriate analogy is buying a house. The United States and other WTO members want China to purchase the house, that is, to buy into the standards built into the structure of the established international trading system. But they should not lower the price of the house, (allow China to be a member on concessionary terms). In particular, the international community should not agree to China's joining the WTO as a developing country, a status that automatically would provide it with the longest possible times for coming into compliance with some standards and would exempt it entirely from a few. What the WTO members should do is lower the down payment on the house to a level that is politically affordable to China. That means requiring it to come into compliance with many but not all WTO standards as a precondition for membership. And it means a "mortgage" of sufficient duration to allow China gradually to come into compliance with those criteria that it is unable to meet at the outset.

Specifically, China should be allowed relatively long phase-in periods for dismantling the barriers protecting a few of its most sensitive industries. This would allow it to stretch out the very substantial costs of adjusting to international competition, thus making them politically more palatable. In return, the international community should insist on more rapid reduction of trade barriers in less sensitive sectors and immediate reforms with respect to transparency, trading rights, and other features of China's trading system. Granting trading rights would mean that foreign firms could purchase Chinese products for resale abroad and also sell in China goods produced abroad. Improving transparency would mean not only that China would promptly publish all government regulations influencing trade, but also disclose the annual foreign trade plan which identifies imports associated with priority projects for which foreign exchange is earmarked by the central government. These more rapid reforms would be of considerable immediate benefit to firms that seek to trade with or invest in China. In short, the down payment should be reduced, but it should still be substantial.

The main criticism of this approach is that once China is a member it may not fulfill its obligations under the protocol and would in effect be given a free ride. But the criticism overlooks four elements.

  • First, the U.S. government will still have available all of the defenses provided for in U.S. trade law. The government will still be able to investigate Chinese trade practices under the provisions of section 301 of the U.S. Trade Act and impose sanctions, if warranted. Disagreements over intellectual property rights can also be addressed bilaterally if need be. In addition, surges in exports of Chinese goods to the United States that either cause or threaten to cause serious injury to a U.S. industry can be addressed under the Agreement on Safeguards of the Uruguay Round Treaty. That agreement allows countries to impose quantitative restrictions on imports under certain conditions.

  • Second, the protocol governing Chinese accession can be written to embody very tight reviews of the progress China makes in coming into full compliance with the time-specific commitments set forth. Periodic reviews could be conducted under the provisions of the Trade Policy Review Mechanism set forth in the Final Act of the Uruguay Round, supplemented or modified as specified in the protocol in order to provide more assurance of compliance.

  • Third, as China comes into compliance with various provisions of the WTO, the United States and other members can use the WTO dispute-resolution procedures to challenge it on trade practices that appear to be in violation of the Uruguay Round Treaty. The United States contributed much to the creation of these procedures as the treaty was negotiated. China's membership in the WTO sets the stage for applying them to one of America's largest trading partners.

  • Finally, China's record in its participation in international organizations provides some basis for confidence that it would meet the obligations specified in any protocol it signed. One example is its relationship with the International Monetary Fund. When China joined the IMF in 1980, its foreign exchange system was distorted. Its domestic currency was greatly overvalued and the country was not even close to meeting its obligations under Title VIII of the IMF Charter, which limits the ability of members to "impose restrictions on the making of payments and transfers for current international transactions.

Over the next fifteen years China undertook important reforms of its foreign exchange system. These included several major devaluations, the introduction of a secondary swap market for some types of foreign exchange transactions, increased access to foreign exchange for Chinese with approval to travel abroad, the unification of the foreign exchange market at the beginning of 1994, and the introduction of convertibility for trade transactions, also at the beginning of 1994. The process culminated earlier this year when China announced that by allowing foreign firms access to the interbank market to purchase foreign exchange to be able to remit profits, it would achieve convertibility on all current account transactions. At almost every step the role of the IMF in providing guidance and advice was critical. This example suggests that China has established a credible record in meeting the obligations inherent in membership in major international economic organizations.

In addition to allowing China longer phase-in periods to meet WTO standards, the United States should take the lead in ensuring that the economic benefits China would receive from membership in the World Trade Organization are at least somewhat proportional to the very real costs that still would be associated with coming into compliance with the organization's standards. Two possibilities seem most obvious. First, upon China's entry into the WTO the United States could provide it with the benefits of the phaseout of the Multifiber Agreement (MFA) specified in the Uruguay Round Trade Agreement. Assuming that the United States would invoke Article XIII (Non-Application of Multilateral Trade Agreements between Particular Members) of the WTO, unless there were a separate agreement providing for it, China would not be eligible for the phaseout of the MFA in the U.S. market. That would mean that China's exports of apparel to the United States would still be constrained by quotas, even as these restrictions were being phased out with respect to other suppliers.

Second, the United States should pledge to repeal, at a specific point in the future, the Jackson-Vanik Amendment as it applies to China so that Chinese goods would be eligible for permanent most-favored-nation treatment in the U.S. market. This repeal should be made conditional on China's coming into compliance with specific trade-related standards according to the timetable specified in the protocol governing its membership. This approach is based on the widespread recognition that the annual congressional debate on renewing China's MFN status has vastly diminished the amendment's effectiveness as a tool to improve human rights in China and that overall U.S. interests are best served through facilitating China's further integration into the world economy.

U.S. Interests

China's membership in the WTO would serve U.S. interests at least as much as China's. The protocol governing China's membership would not only provide for eliminating nontariff trade barriers and further reducing tariffs, but would also delineate the additional economic reforms China needs to bring it into compliance with WTO standards. Most important, the protocol would require that such steps be taken on a specific schedule. China has reduced tariff and nontariff barriers significantly in recent years, but the timing of these steps has been entirely at its discretion. Moreover, the protocol would make these tariff reductions binding and should contain other provisions that would preclude the Chinese from introducing new protectionist trade measures.

Just as significantly, bringing China into the WTO would provide a way for the United States to address inevitable trade frictions on a multilateral rather than a purely bilateral basis. The bilateral approach that has been pursued in recent years places the burden of opening up China's market and reforming its intellectual property rights regime almost entirely on the United States. When improvements are made, Japanese and European firms are quick to exploit the new opportunities. But U.S. firms still have to face Chinese partners that wonder when the next bilateral trade dispute will break out and whether the U.S. government will impose sanctions that will harm them commercially. Moving trade disputes largely into multilateral channels would also allow the United States to concentrate in the bilateral diplomatic channel on critical strategic issues in the relationship.

China's trading partners have already bestowed on it the principal benefit associated with WTO membership, and the domestic economic costs to China of coming into compliance with international trade standards would be high. Given this unfavorable cost-benefit ratio, China is not likely to agree to membership under a formula requiring as a precondition that it meet all international trade standards. Thus the United States should take the lead in drafting a protocol that provides long phase-in periods to mitigate the costs China will face in restructuring its domestic industries to meet the full force of international competition. The United States should also lead in taking other steps that would increase the benefits China would receive in exchange for agreeing to an acceptable WTO protocol. The alternative is the risk that China, the world's tenth-largest producer of export goods and the largest trading country in the world that is not already subject to the disciplines of the established international trading system, will remain outside the WTO, a situation that is undesirable for the future of the world trading system, China's economic evolution, and the U.S.-China relationship.

SERIES: Brookings Policy Brief Series | # 10