Hearings on Normalizing Economic Relations with China

Nicholas R. Lardy
Nicholas R. Lardy Anthony M. Solomon Senior Fellow

May 22, 1997

[See also: “Is China MFN an Effective Foreign Policy Tool?” background paper by Nicholas R. Lardy, May 22, 1997.]

In my judgement the annual debate either to condition the continuation or to suspend China’s most favored nation (MFN)status in the United States has not been an effective foreign policy tool. The principal basis for this judgement is that no other industrial country has ever seriously contemplated either withdrawing or conditioning MFN treatment for China. Absent a multilateral approach, conditioning or revoking China’s MFN status in the United States is unlikely to have any significant effect on China’s security or human rights behavior. Conditioning or revoking MFN, on the other hand, will substantially damage the interests of economies in Asia in which we have a vital interest and impose huge costs on both U.S. consumers and businesses. Consequently, the threat of the United States either significantly conditioning or revoking MFN is not credible.

The perception that conditioning or revoking China’s MFN status might advance our foreign policy interests is based in part on four misperceptions about the nature of the bilateral economic relationship.

The first misperception is that the bilateral trade relationship between the United States and China is not reciprocal, that the benefits accrue mostly to the Chinese side. One conclusion that follows from this misperception is that conditioning or threatening to revoke China’s MFN status provides the United States with significant leverage with which to advance our interests. The reasoning is that we would loose little from the resulting disruption of the bilateral trade relationship while the Chinese, who have a great deal more at stake, will capitulate to U.S. demands rather than risk a disruption of the trade relationship. This reasoning is mistaken for at least three reasons. First, it is widely agreed that the largest potential loser from the conditioning of MFN would be Hong Kong, followed by Taiwan. Both Hong Kong and Taiwan have made huge investments in China to produce goods that are sold largely in developed country markets. The United States is far and away the largest of these markets. The loss of this market, which as explained below would be the inevitable result of revoking MFN, would impose huge losses on Hong Kong and Taiwanese businesses. But given the relatively small share of output of manufactured goods produced in foreign invested firms, around ten percent last year, this would impose relatively small costs on China. The United States has a vital interest in the continued economic prosperity of both Hong Kong and Taiwan. Even the threat of revoking China’s MFN status in our market imposes economic costs on both. Conditioning China’s MFN status in 1997, just at the time of the reversion of sovereignty over Hong Kong to China, would have particularly adverse consequences.

Moreover, revoking MFN for China would automatically result in very high tariffs on a broad range of consumer goods imported from China, imposing a huge burden on U.S. consumers. For many products the higher column two tariffs imposed on goods from countries that do not have MFN status in the United States would mean Chinese goods would no longer be competitive in this market. Thus the supply of these goods would fall and retail prices in our market would rise. In the case of garments, the ability of other suppliers to increase their exports, thus mitigating the rise in prices, is severely limited by quotas imposed under the MultiFibre Agreement. Thus not only would there would be no increase in supply from other producers in response to higher prices, it is likely that these alternative suppliers also would raise their prices, imposing even higher costs on U.S. consumers.

Finally, exports of U.S. firms to China have almost tripled since 1990, out pacing the growth of U.S. exports to any other major market. The sales of U.S. firms have grown so rapidly that China by 1996 had become the eighth largest export market of the United States. The vast majority of U.S. products sold to China are produced in sectors with above average wages.

In short, revoking China’s MFN status would impose large burdens on both Hong Kong and Taiwan, areas where the United States has a substantial stake in continued economic growth and prosperity. In addition, since the vast majority of our imports are consumer goods and the loss of MFN status would lead to the imposition of higher tariffs, U.S. consumers would be large losers. Finally, China is our fastest growing large export market, a country that buys goods produced in high wage industries.

The second misperception is that conditioning or threatening to revoke MFN is justified since China is a closed market and extreme measures are warranted as part of an attempt to open up the market. The reality is that China’s imports last year were US$ 135 billion, more than 17 times the level on the eve of reform. No other country in the world has expanded its imports more rapidly over any time period of similar length and, as a result, no other country has ever experienced such a rapid rise in its share of total world imports. China does maintain a variety of tariff and non-tariff measures that are used to protect some of its industries. The United States should use the negotiations for China’s membership in the World Trade Organization to reduce and eventually to eliminate all barriers and trade practices that are inconsistent with the multilateral trading system. But the idea that China’s market is closed is mistaken.

A third misperception is that China is the next Japan, a country that is likely to become the country with which we experience our single largest trade deficit. But unlike Japan, China does not run a large global current account surplus. Rather it has experienced pattern of trade in which its global current account balance swings back and forth between deficit and surplus. Its biggest recent deficit was $12 billion in 1993. Since that time it has run surpluses. But these recent surpluses are tiny. In 1995 China’s current account surplus was $1.62 billion, under one-quarter of one percent of its gross domestic product. In 1996 the number is estimated to have been $1.08 billion, about one-tenth of one percent of gross domestic product. In short, unlike Japan China has not adopted macroeconomic and exchange rate policies that have resulted in growing global current account surpluses.

A fourth misperception is that our large and growing bilateral trade deficit with China has led and will continue to lead to a large loss of manufacturing jobs in the United States. The reality is that the major burden of adjustment in employment as a consequence of China’s rapidly increasing exports of labor intensive manufactured goods is elsewhere in Asia, particularly in Hong Kong and Taiwan and to a lesser extent in South Korea and Southeast Asian countries. The reason is simple. China’s rising share of world exports of clothing, toys, sporting goods, and footwear reflects a geographic realignment in the production of labor intensive goods within Asia. The combination of an open environment for foreign direct investment and relative low labor costs in China has attracted record inflows of foreign direct investment, largely from other Asian countries. Employment in these labor intensive industries in the United States declined in the 1950s, 1960s, and 1970s, when rising wages in the United States resulted in the movement of these jobs to Asia and other developing countries. Now the burden of restructuring employment as a result of the rise of China as a major trading country is borne primarily within Asia, not in the United States.