Debunking America’s China Syndrome

Erik Berglöf
Erik Berglöf Director of the Institute of Global Affairs - London School of Economics and Political Science, Former Brookings Expert, Former Chief Economist - European Bank for Reconstruction and Development

April 20, 2006

LONDON After his visit to Washington, President Hu Jintao of China might wish he had stayed home. In all likelihood, he will have encountered an onslaught of accusations of currency manipulation, unfair trade and intellectual property rights violations

The alarm over China’s economic ascension is akin to the China Syndrome, made famous by the 1979 film of the same name: the idea that a nuclear meltdown could penetrate the earth. It is strange that this fear of China is so strong in the United States. The impact is much greater and more uncertain for many other countries.

Let us start with Europe. In Italy, Portugal and most worryingly in Turkey, Chinese competition is threatening key industries like textiles and shoes. These countries are facing important choices about whether to move up the value-added chain in these industries or abandon them.

At first sight the prospects for the economies in Central and Eastern Europe look rosier. They are emerging from a period of remarkable institutional change driven by EU accession and rapid increases in productivity, after extraordinary inflows of foreign direct investment. And these economies are competitive: Their growth in exports to rich countries is strong, surpassed only by China.

But the long-term prospects for the Central and Eastern European economies are more uncertain. So far, catch-up growth has been confined to foreign- controlled companies and banks. Even more worrying, investments in research and development as a share of gross domestic product are at the same low levels as in the mid-1990s. Over the same period, China doubled this share, despite a higher GDP growth rate.

Despite huge political challenges, China’s low cost advantage may well persist for decades. Unlike exports from Eastern Europe, where low wages are likely to be short-lived, especially for high-skilled labor, Chinese exports could retain their cost advantage for many years to come. The movement of hundreds of millions of underemployed workers from rural agriculture to urban manufacturing will take at least another decade.

The repercussions from China’s growth are most immediate in Asia. Vietnam, like many other Asian countries, has been a successful exporter to developed markets. But now the country’s exporters, cajoled for years by its “soft” planners into raising the value-added content of their output, are rapidly turning into suppliers of raw materials and semifinished goods for Chinese producers.

The effects extend well beyond Asia. In Brazil, drastic steps to open up the economy and improve the investment climate were designed to free the country from its dependence on raw material exports. But Brazilian manufacturing has now for several years been wilting under the stress of Chinese competition, while Brazil’s iron mines have stepped up production to supply China’s mushrooming steel industry.

Conventional wisdom argues that the more a country’s economy differs from China’s, the more it will benefit from China’s economic growth. But the impact on a particular country also depends on whether the goods it produces complements or competes with those produced in China. Here the impact differs much more across countries, and ultimate outcomes will depend on the response of these countries. As the Nobel laureate Paul Samuelson shows in a recent article, if skills build up faster in China, the current competitive advantage of more advanced countries will erode.

Whether the China impact will be positive or negative in the long run depends on a country’s ability to keep up the innovation gap. Australia, for example, opened up early to international competition and its flourishing high-end manufacturers have been exposed for decades to international competition. Countries that held on longer to protectionist policies are more likely to suffer.

Governments in emerging economies can respond by simply enjoying the ride on the Chinese wave, as many Asian countries are currently doing, hoping that it will be sustained in spite of China’s growing pains and rising protectionism in developed markets. Or they could seek to maintain the innovation gap by attracting high-tech investments.

But the nature of the game changes as countries move up the value-added ladder and need to innovate rather than imitate. Building and transforming institutions requires political will to break loose from the fetters of entrenched interests. The gravitational pull of successful neighbors can help, as in Central and Eastern Europe, but as the Asian countries are learning the hard way, it may also limit your options.

Science has soundly refuted the China Syndrome. It is time to debunk its economic version. Despite the current debate in the United States, most of the fallout, positive and negative, from China’s economic expansion will be in countries that are close to China in geography and in skills. For them, there is no time to wait for the movie.