The United States and China are intensifying their negotiations on China's entry into the World Trade Organization (WTO), hoping to pave the way for the announcement of an agreement when Premier Zhu Rongji visits in early April. Their task is daunting, however, since each side has less room for maneuver than last year, when an attempt failed to resolve long standing differences on the terms of China's membership prior to the Clinton-Jiang summit. In China, economic growth is weakening, unemployment is at an historic high, and social unrest is rising. In the United States, the widening bilateral trade deficit with China increases the political pressure for an agreement that provides much greater market access. There are also calls to deny China WTO membership as a sanction. Despite such constraints, U.S. policymakers should vigorously pursue an agreement. It would strengthen the WTO, increase access for U.S. goods in China, and provide China with a fixed timetable for fully opening its markets.
POLICY BRIEF #47
In the prelude to Chinese Premier Zhu Rongji's visit to the United States, both governments express the hope that the trip will provide the impetus for a breakthrough in China's protracted effort to become a member of the World Trade Organization. China's chief trade negotiator, Long Yongtu, reportedly has been granted new authority to cut a deal. Several high level officials from the Office of the United States Trade Representative traveled to China in the early months of 1999 in an attempt to revive bilateral talks on membership, which have been stalled for months. Despite these improved atmospherics, the two sides face enormous obstacles to reaching an agreement. Indeed, they have increased since President Bill Clinton's trip to China in mid-1998, when the previous attempt to move the negotiations forward failed.
The pace of China's economic growth has slowed substantially, increasing the challenge the regime faces in restructuring its state-owned industrial sector. That process already has brought unprecedented high levels of unemployment and related social unrest, leading Premier Zhu and other Chinese leaders to selectively moderate the pace of domestic economic reform with the deepening Asian crisis. The leadership's increasing emphasis on political stability in 1999, the year marking the tenth anniversary of the Tiananmen crisis and the fiftieth anniversary of the founding of the People's Republic, has diminished the regime's appetite for opening its markets further to foreign competition.
The United States also faces more constraints in reaching an agreement. The Asian financial crisis has reduced the demand for American goods in the region, contributing to an all-time, record-level global trade deficit in 1998 (Figure 1). China is close to overtaking Japan to become our largest trade deficit partner. The mounting deficit heightens political pressure in the United States to make expanding access to China's domestic market a precondition for a WTO agreement. Moreover, concern over increased Chinese human rights violations, a perception of an increased Chinese missile threat against Taiwan, and allegations that the Chinese stole sensitive nuclear weapons designs from the United States are likely to magnify congressional scrutiny of any WTO-accession package for China. But congressional support of China's WTO membership will be necessary; after an agreement is reached, the administration will have to request an amendment of the Jackson-Vanik legislation, which currently precludes granting China permanent normal trading relations status [previously called most favored nation status (MFN)] with the United States.
The bilateral trade deficit of the United States with China has grown every year since 1985. The Department of Commerce estimates that the trade gap grew by 15 percent, reaching an all-time high of $57 billion in 1998. That is only a few billion less than the deficit registered with Japan, our largest trade-deficit partner. U.S. officials, notably Commerce Secretary William Daley, repeatedly have cited the bilateral deficit as evidence of the closed character of the Chinese economy. He and other U.S. officials view the WTO negotiations as an unparalleled opportunity to pry open China's markets.
The reality is far more complex. While the bilateral deficit has ballooned in recent years, U.S. firms have had considerable success increasing sales to China. Indeed in 1998, despite a drop in China's global imports, U.S. firms boosted sales to China by more than 10 percent, according to Commerce Department data. From 1990 to 1998, exports by U.S. firms to China expanded at an average annual rate of 15 percent, making China far and away the most rapidly growing among the top-ten U.S. export markets. (When U.S. goods sold to Hong Kong and then re-exported to China are taken into account, China was the sixth largest export market of U.S. firms in 1998.) By comparison, for example, U.S. exports to Japan grew only 2 percent annually over the same period (Figure 2). Moreover, most U.S. exports to China are high value-added goods, such as aircraft and computers, produced in industries that pay American workers above-average wages.
Rather than reflecting a restrictive import regime, the long-term rise in the bilateral deficit largely reflects the combination of China's openness to foreign direct investment and robust economic growth in the United States. Foreign investment began to trickle into China in the early 1980s, and by the 1990s the trickle became a flood. Since 1993, China has been the second largest recipient in the world of foreign direct investment, behind only the United States. By early 1999, foreign direct investment in joint ventures and wholly foreign-owned companies exceeded one-quarter of a trillion U.S. dollars, several times larger than cumulative foreign direct investment since World War II in Japan, Korea, and Taiwan combined.
Since much of this investment is export-oriented, the share of China's exports produced in foreign-funded plants has increased steadily from 1 percent in 1985 to 45 percent in 1998 (Figure 3). In none of the world's other top-ten trading countries do foreign-funded companies play such a large role in generating exports. Beginning in the mid-1980s, Nike, for example, increasingly shifted production of athletic shoes from Korea and other Asian locations to China, now its most important manufacturing site.
As corporations have shifted their production from elsewhere in Asia to China, above-average economic growth in the United States has stimulated an increased demand for imports from all over the world. As a consequence, our imports from China have grown more rapidly than our exports to that country. U.S. consumers reap the benefit of lower-priced goods produced in China, where costs are lower than in other Asian locations. Moreover, the job losses associated with rising Chinese exports of footwear, as well as several other important products, primarily occur elsewhere in Asia, not in the United States.
The Weakening Chinese Economy
But China's success in attracting foreign investment and building its export markets obscures internal economic weaknesses. While the Chinese reported economic growth of 7.8 percent in 1998, few external observers give the claim much credence. A modest 2.5 percent increase in electric power generation, a shrinking of imports despite a strengthening currency, a decline in the volume of cargo transported, and a sharp slump in the profits of state-owned manufacturing firms all point to substantially less growth than the official number indicates.
The prospects for Chinese economic growth in 1999 also are far from bright. Exports were flat in 1998, a result of declining shipments to Asia and swelling sales to the United States and Europe. In four of the last five months of 1998, and again in January and February 1999, exports dropped below the previous year's level. For the first time since reform began more than two decades ago, 1999 could be a year of significantly lower exports.
Consumption demand is likely to expand only weakly, in large part because urban households have reined in spending as income growth has slowed and the expectation of lifetime employment with state companies has evaporated. The central bank's repeated efforts in 1998 to stimulate consumption spending by cutting interest rates failed because households were determined to build their savings. Growth was propped up somewhat in 1998 with a massive 15-percent increase in spending on fixed investment, mostly financed by increased bank lending. Since many of the projects undertaken will not generate sufficient returns to service the loans, the program probably weakened the quality of banks' assets. The lending gap has increased the ultimate cost to the state of restoring the financial health of the state-owned banking system, one of China's other key policy goals.
For almost two years, China escaped the worst effects of the Asian financial crisis. As international banks reduced their credit exposure to emerging markets generally beginning in late 1997, China too suffered from reduced access to loans. The inability of the Guangdong International Trust and Investment Company (GITIC), China's second largest non-bank financial institution, to service its foreign debts beginning in the last quarter of 1998 has forced foreign lenders to confront the underlying structural weaknesses of many of their Chinese borrowers. Like other borrowers in the rest of Asia, they relied on short-term debt to finance long-term projects, incurring maturity mismatches; they borrowed in foreign currency to finance projects with little or no foreign-exchange earnings, incurring currency mismatches; and they concentrated investments in property and real-estate development, a sector almost certain to collapse due to high vacancy rates for first-class office and retail space in many Chinese cities.
In the wake of the October 1998 GITIC collapse, and the subsequent revelation of the insolvency of a growing number of other government-backed Chinese borrowers, international banks cut their lending exposure at an accelerated pace. China also has been shut out of international capital markets. A number of stock offerings planned for the Hong Kong market in the first quarter of 1999, so-called H-share listings, have been postponed and at least one international bond offering also has been deferred. The prospects for Chinese financial institutions and companies raising funds in international markets are at a record low. The only bright spot is foreign direct investment inflows, which were $45.6 billion in 1998, almost the same level as the previous year, but this inflow too is likely to drop in 1999.
China, in an attempt both to avert an even greater economic growth slump and to adjust to less favorable access to international capital markets, has adopted economic policies inconsistent with the basic principles of the WTO and with its commitments to the International Monetary Fund (IMF). For example, it has sought to impose price floors on a broad range of products subject to competition from imports, a clear violation of WTO principles. China appears to have adopted new nontariff barriers such as import licensing requirements and smaller quotas that inhibit the import of foreign pharmaceuticals, telecommunications equipment, construction materials, and certain petrochemical products. And it has restricted access by importers and foreign-funded firms to foreign exchange--apparently in some cases, retreating from its December 1996 pledge to the IMF to allow free access to foreign exchange to purchase imports or remit profits abroad. The Chinese government's recent pledge to "do everything possible to sustain export growth" gives rise to the concern that export promotion policies will include export subsidies, probably in the form of export credits that would be a violation of the Agreement on Subsidies and Countervailing Measures, to which all WTO members are subject.
U.S. Policy Options
U.S. economic policy toward China has proven increasingly problematic. U.S. policymakers have praised the Chinese leadership for not devaluing the Chinese currency, but failed to recognize that China has adopted more restrictive trade policies in response to the Asian crisis. U.S. policymakers continue to press for a rapid opening of China's financial market even as it is increasingly clear from the experience of the past two years that a premature opening can have catastrophic economic consequences. Furthermore, the U.S. negotiating posture on Chinese WTO membership continues to ignore the fact that China already receives permanent MFN status--the major benefit of membership--from every country in the WTO except the United States.
President Clinton, Treasury Secretary Robert Rubin, Federal Reserve Chairman Alan Greenspan, and, most recently, Secretary of State Madeleine Albright lavishly have praised China for holding its exchange rate constant in the face of massive devaluations of other Asian currencies. But having ruled out, at least to date, the use of exchange-rate policy to counter slumping aggregate demand, China has adopted alternate policies to achieve the same objective. Some of these policies, such as increasing the rebate rate of the domestic value-added tax on goods that are exported, are fully consistent with the principles of the WTO, despite uninformed criticisms by senior U.S. government officials. Others, particularly the increased use of nontariff barriers, clearly are inconsistent with WTO principles.
The lesson, however, should be clear: the United States cannot expect China to hold its exchange rate constant indefinitely in the face of massive devaluations elsewhere in the region at the same time it opens the economy even wider to the outside world. Encouraging Chinese currency stability made sound policy at the height of the Asian crisis in the latter part of 1997 and through much of 1998--a devaluation of the yuan could have set off an additional downward economic spiral in the region. But by the fall of 1998, the currencies of several countries affected by the contagion strengthened considerably, and short-term interest rates fell, suggesting reduced regional vulnerability to a modest Chinese devaluation. It is time to quit rewarding China for maintaining the stability of its currency by overlooking policies that move it away from widely accepted international trade principles.
Despite this lesson of the Asian financial crisis, the United States appears not to have modified its stringent demands for China's entry into the WTO. The premature opening of several of the Asian economies to international capital flows, to a significant degree in response to the urgings of the United States and major international financial institutions, contributed to the Asian financial crisis. Despite this lesson, and the increasing evidence that China's domestic financial structure is extraordinarily weak, the United States has not publicly modified its longstanding demand for a rapid opening of China's financial system. The time has long since arrived to ease such pressure and accept more gradual reform.
Finally, U.S. trade officials are negotiating from a weak position. They act on the presumption that WTO membership is a huge plum that they will award only after the Chinese make major concessions on market access. China has reduced its tariff rates substantially and eliminated nontariff barriers on a large number of products over several years of tough negotiations in which the United States threatened to curtail Chinese access to its market. There is a limit to what the United States can extract without more carrots. More recently, U.S. policymakers have sought additional leverage by suggesting that China should make more concessions in order to join the WTO prior to the launch of the next world trade liberalization round, likely to start in late 1999. They argue that WTO membership now would give China an opportunity to help shape the evolution of the international trading system and get in before more far-reaching trade liberalization is agreed to by WTO members.
Yet China has not sought to redesign or even strongly influence the policy orientation of the other international economic organizations in which it participates. And incumbent members will be subject to whatever higher standards the WTO agrees to in the next round of trade liberalization, undermining the argument that getting in now would provide China some advantage.
Lastly, some have suggested that if China does not make a more forthcoming offer now, it runs the risk that Taiwan will become a member of the WTO first, an outcome that the Chinese have vociferously opposed. The late January completion of bilateral negotiations between the European Union and Taiwan on Taiwan's membership would appear to heighten this possibility. But there is little evidence that Japan or any European country is prepared to support Taiwan's entry prior to China's. Because membership in the WTO is by consensus, without Japanese and broad European support, the prospect for Taiwan's admission before China is dim, even if the United States advocated it.
Long-term interests of both the United States and the world will be best served if China becomes a WTO member. Over time, the integrity of the world trading system will be difficult to maintain if one of the largest trading countries in the world avoids complying with WTO disciplines. All of this argues against denying WTO membership as a sanction for alleged theft of nuclear secrets. The challenge U.S. negotiators now face is to craft membership terms to assure that China's trade practices will comply with WTO norms and to allow sufficient transition periods. China's leadership will need to find a reasonable balance between the modest gains that membership confers, on the one hand, and the economic and political risks associated with further trade liberalization, on the other. For example, China already has agreed to fully comply with standards on protection of intellectual property immediately upon entry. But rebuilding its fragile domestic banking system, which is an essential precondition if China is to allow foreign financial institutions complete access to its domestic market without triggering a domestic financial crisis, could take as long as a decade. U.S. negotiators should allow a correspondingly long transition period for full financial-sector liberalization. Absent a balancing of commitments with flexible scheduling, China may elect to remain outside of the WTO indefinitely. For its part, China must be prepared to commit to specific end points. Long transition periods may be reasonable on a selective basis, but the United States cannot accept uncertain dates for coming into full compliance with WTO obligations.