Is China an Effective Foreign Policy Tool?

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

May 22, 1997

[Background paper prepared for testimony to the Senate Foreign Relations Committee, Subcommittee on East Asian and Pacific Affairs, May 22, 1997.]

United States Economic Interests in China

United States firms have substantial interest in our economic relations with China. U.S. firms sold $17.5 billion in goods to China last year, either directly or through Hong Kong, making it our 8th largest export market. U.S. exports to China have been growing at an average annual compound rate of 20 percent since 1990, tripling in value over the period. That makes China our most rapidly growing export market among our top twenty export destinations.

In addition U.S. firms have invested significant amounts in joint ventures, wholly foreign-owned companies and in natural resource development projects in China. Through the end of 1996 cumulative U.S. investment in China was $13.5 billion, making U.S. firms the third largest source of direct investment in China, following Hong Kong and Taiwan.

The U.S. Trade Deficit

Although U.S. firms have had considerable success in selling to China, the United States has nonetheless experienced a growing deficit in its trade with China. This deficit quadrupled from about $10 billion in 1990 to almost $40 billion last year, according to the Department of Commerce. In several months over the past year the trade deficit of the United States with China exceeded that with Japan. This has led some to conclude that China’s economy is relatively closed and that China will replace Japan in the future as our most troublesome trading partner.

However, it should be noted that the Commerce Department figures for our bilateral trade with China are quite misleading. They both understate the success of U.S. firms in selling to China and overstate the success of Chinese firms in selling in our market. In 1996 U.S. firms earned $5.5 billion from the sale of goods to Hong Kong that were then immediately re-exported to China. None of these sales are reflected in Commerce Department data on U.S. exports to China. The Commerce Department also includes, in its data on the value of imports from China in 1996, more than $7 billion in profits earned by Hong Kong firms that reexported goods of Chinese origin to the United States. The overstatement occurs because the Commerce Department attributes the entire landed value of these products to China, whereas about 25 percent of the value has been added in Hong Kong by Hong Kong companies that are responsible for the design, marketing, and financing of these goods.

Interestingly the valued added in Hong Kong for goods of Chinese origin reexported from Hong Kong has increased by half over the past 8 years. The reasons is simple. More and more of the products that Hong Kong firms reexport are produced in factories that they own that are located in China. Most of the high value-added functions remain in Hong Kong; only the inexpensive labor intensive processing is carried out in China. By contrast a decade ago the role of Hong Kong firms was far more limited. They were simply middlemen between production in China and demand in the outside world.

Table One shows the bilateral trade data for the years 1990 through 1996, both as reported by the Department of Commerce and as adjusted to take into account the two factors just discussed. The official data substantially understate the level of U.S. exports to China in recent years. More importantly, since the share of U.S. exports sold to China via Hong Kong companies has grown over time, the growth of real U.S. exports to China since 1990 is much more rapid than official data show. The table also shows that the Commerce Department consistently overstates the magnitude of our trade deficit with China by half.

Table One: US Bilateral Trade Deficit, 1990-96
(US$, billions)

US Exports US Imports US Deficit
Commerce Data Plus Sales through Hong Kong Real US Exports Commerce Data Less Hong Kong value added Real US Imports Commerce Data Real
1990 4.8 1.2 6.0 15.2 1.8 13.4 10.4 7.4
1991 6.3 1.6 7.8 19.0 2.7 16.2 12.7 8.4
1992 7.5 2.1 9.6 25.7 4.1 21.5 18.2 11.9
1993 8.8 2.9 11.7 31.5 5.7 25.9 22.8 14.2
1994 9.3 3.5 12.8 38.8 6.3 32.5 29.5 19.7
1995 11.7 4.7 16.5 45.6 6.8 38.7 33.8 22.3
1996* 12.0 5.5 17.5 51.5 7.2 44.3 39.5 26.8
Sources: U.S. Commerce Dept. and Hong Kong Census and Statistics Dept.
*Annualized based on January-November 1996.

In addition it is worth noting that the United States has a modest surplus in trade in services with China. This surplus roughly doubled between 1992 and 1995, reaching $937 million in the later year.

Explaining the U.S. Trade Deficit

The United States global merchandise trade deficit reached an all-time high of $188 billion in 1996, almost three-quarters more than the level of 1990. The underlying cause of our growing global trade deficit is the low U.S. savings rate. As long as we are able to finance only a small portion of our domestic investment with our own savings, the United States must borrow funds from world capital markets. Our trade global deficit is the inevitable consequence of this ongoing borrowing. Until the U.S. savings rate rises substantially relative to the rest of the world, we will continue to have a global deficit.

The question then becomes, given a large U.S. global trade deficit, what is its geographic distribution? In recent years our deficit with China has grown dramatically in absolute terms but relatively more modestly as a portion of our total global trade deficit. Based on the Commerce Department data our deficit with China rose from about one-tenth of our total deficit in 1990 to one-fifth in 1996.

The chief reasons that our deficit with China has grown in recent years is the relocation to China of production facilities that previously were in Hong Kong, Taiwan, and elsewhere in East Asia, and the continued large and growing U.S. demand for inexpensive consumer electronics, apparel, footwear, toys, and leather goods. China’s openness to foreign investment is unprecedented in East Asia and has led to a substantial geographic realignment of labor intensive production of these products in the region. As a result China’s market share of world exports of clothing, toys, sporting goods, and footwear rose from 14 percent in 1984 to 39 per cent in 1994.

Interestingly, although our deficit with China has grown in recent years, this growth largely represents the transfer to China of what otherwise would have been rapidly growing bilateral trade deficits with other countries in Asia. For the products given above, the share of world exports of Hong Kong, South Korea, Singapore, and Taiwan combined actually fell by more than China’s share rose. The resulting fall in the combined share of China plus these four Asian tigers indicates that China is not even replacing the export shares previously produced by these countries. Thus the argument that our growing deficit with China has caused a large loss of manufacturing jobs in the United States seems misplaced. Other countries in Asia have moved up the technology ladder, increasingly leaving China to concentrate its production on the most labor intensive goods. The major adjustment of employment that this process entails has been within Asia. Very little labor displacement has occurred in the United States.

The importance of foreign direct investment to China’s overall trade growth is also underlined by the growing share of its total exports produced by foreign invested firms. The first year their share exceeded 1 per cent was 1985. Since that time exports of foreign invested firms as a share of China’s total exports have grown steadily to reach 20 per cent in 1992 and 31 percent by 1995. Then in 1996 their share jumped to an astounding 44 per cent.

In addition, foreign firms are also central to the development of processed exports produced by Chinese firms. In processing the foreign firm provides parts and components and pays the Chinese side for assembling or processing these inputs. Since the foreign firm is providing the inputs for the product, the marketing, and financing, their role in the international sale of the final product is substantial. However, since there is no foreign ownership of the facilities in which the processing occurs, these firms are not classified as joint ventures. Together exports of foreign-funded firms and export processing on behalf of foreign firms by Chinese firms now account for between two-thirds and three-quarters of China’s total exports.

In sum, most of the growth of China’s exports can be explained by its relative openness to inward foreign direct investment and rising real wages elsewhere in Asia. This has made China the natural location for the production of an increasing share of the world’s labor intensive commodities. The U.S., as the largest world market for these goods, has emerged as China’s largest export market.

China’s Global Trade Position

The increase in our annual bilateral deficit with China to become second only to that with Japan, has led many in the United States to assume that like Japan, China must be running an ever growing global trade surplus. Many go further and assume that China is a relatively closed economy that in its international trade does not play by the rules of market economies. Yet this reasoning by analogy obscures a fundamental difference between the two countries. China does not have a systemic global current account surplus. Rather it has experienced a 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 per cent 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. Cumulatively over the reform period since 1978 China has no global current account surplus at all.

China’s State-Owned Sector

While China has been experiencing an export boom since 1985, the growth of exports from China’s state-owned firms has been relatively modest. Exports produced in indigenous factories actually fell sharply last year. This poor export performance, in turn, reflects the deeply troubled state of China’s state-owned industries. This troubled status is revealed in several different ways, in addition to their weak export performance.

Perhaps most significantly state-owned enterprises have experienced a dramatic decline in their return on assets from 15 per cent in 1987 to 5 per cent in 1994. Second, the share of state-owned firms actually running in the red quadrupled from just under 10 per cent in 1985 to more than 35 per cent in 1996. Third, the asset:liability ratio of state-owned enterprises has plunged over the past decade. By 1994 more than one-quarter of Chinese state-owned enterprises had liabilities exceeding assets and another fifth of all firms had liabilities approximately equal to assets. Thus, almost half of all state-owned firms were at or beyond the brink of solvency. And these calculations understate the financial problems of state-owned firms since they do not include unfunded pension liabilities. These have ballooned enormously during the reform period.

Because the contribution to output of state-owned enterprises has declined so much during the reform era, some have suggested that restructuring state-owned firms through bankruptcies and mergers is now a much easier task than would have been the case a decade ago. This view seems mistaken on several grounds. First, state firms continue to employ two-thirds of all workers in urban areas, a share that has barely budged over the past decade. The specter of rising open urban unemployment is one that haunts Chinese leaders as they consider reform options before them.

Second, the declining performance of state-owned firms has had devastating consequences for China’s banks, all of which are effectively state-owned. More than four-fifth’s of enterprise financial liabilities are loans owed to state banks. In turn, more than four-fifths of all bank loans outstanding are to state-owned firms. China’s largest state banks now have non-performing loans that are several times the value of their own capital, meaning that these institutions are insolvent. The cost of writing off nonperforming loans and rescuing households, which are the source of about four-fifths of the banks’ funds, from massive losses on their savings deposits will be many times larger, relative to gross domestic product, than was the cost of resolving the savings and loan crisis in the United States.

Implications for U.S. Policy

The United States should take as one of its principle objectives in its relations with China the normalization of bilateral economic relations. This should include three fundamental steps.

Lifting of Tiananmen Sanctions

First, the remaining economic sanctions from the Tiananmen era should be lifted. Although sanctions were imposed by industrialized countries in a coordinated fashion, every other country has long since lifted them.

But the United States continues to suspend Overseas Private Investment Corporation (OPIC) programs of insurance, reinsurance, financing and guarantees in China; continues to suspend the activities of the Trade and Development Agency in China; and to effectively block U.S. firms from supplying nuclear power generation equipment to China. In addition, although not a part of the Tiananmen sanctions, the United States Export-Import Bank has refused to consider financing of U.S. equipment for the Three Gorges project in China.

These sanctions substantially disadvantage U.S. firms vis a vis their European and Japanese competitors without imposing any significant penalty on China. In short, economic sanctions provide the United States with virtually no leverage since there are alternative sources of supply for all major products U.S. firms sell or might sell to China. For example, it is estimated that U.S. firms over the past five years have lost six billion dollars in sales of nuclear power generation equipment to European firms.

U.S. policy should seek to provide a level playing field vis a vis our economic competitors. Thus the economic sanctions currently imposed on China should be lifted.

China’s Membership in the World Trade Organization

Second, the United States negotiating posture with respect to China’s entry into the World Trade Organization should be based on a more realistic assessment of the costs and benefits of China’s participation. The U.S. side tends to emphasize the long-term benefits China will gain as a result of opening its economy more fully to international competition and to overlook the short term structural adjustment costs that must be borne in the short-run. The analysis above of the continued importance of financially weak state-owned firms as the dominant employer in urban areas suggests that these short-term adjustment costs will be quite substantial.

While underestimating the short-run adjustment costs to China of membership, the U.S. negotiating position appears to recognize insufficiently the gains to the U.S. from China’s participation in the WTO. Three deserve highlighting. First, a protocol governing China’s participation would lock China into a time-specific path of future economic reform. For example, the protocol and its annexes will specify precisely when China will have to dismantle import quotas and licensing requirements that the Chinese government currently imposes on 384 product categories. Should negotiations break down and China not become a member of the WTO, U.S. businesses would face enormous uncertainty with respect to when China might phase out these quota and licensing arrangements. From a commercial perspective there is a significant advantage to knowing precisely when such barriers must be phased out.

Second, China’s entry will lead to significantly increased U.S. exports of capital goods and agricultural products, increasing employment in industries with above average wages in the United States. Increased imports from China are likely to be concentrated in apparel. Imports of these products by industrialized nations currently is governed by the Multifibre Agreement. But under the terms of the Uruguay Round Treaty industrialized nations have agreed to phase out quotas in apparel and textiles over a ten-year period. Since China is a low cost producer of many of these products the phase out of the restrictions will allow it to displace other producers in world markets whose position is currently maintained artificially by quotas. One simulation of the effects of China’s entry into the WTO suggests that because most of the increase in U.S. imports of labor intensive goods from China will displace workers in Taiwan, Hong Kong, and South Korea that the dislocation of unskilled labor in the U.S. textile industry between now and the year 2010 will be less than 5,000 jobs a year on average.

Third, once a member China will be subject to the dispute settlement procedures of the WTO, providing a more effective way of addressing bilateral trade frictions.

Permanent Most-Favored Nation Status

Third, as part of China’s entry into the WTO the United States should provide permanent most-favor nation trading status to China. Since China already has been granted permanent MFN status by all the rest of its trading partners, permanent MFN status in the U.S. market is perhaps the most important benefit China could receive from becoming a member of the WTO. However, this will require specific action on the part of the U.S. Congress to repeal the Jackson-Vanik amendment with respect to China.

The present atmosphere, in which even the annual renewal of China’s MFN status is judged by some to be in doubt, erodes any incentive the Chinese have to make further concessions in the talks on WTO membership. Why should the Chinese in the Geneva talks table more far reaching proposals to further reduce tariffs and dismantle other trade barriers when the ability of the administration to deliver a congressional vote that would provide permanent MFN trading status for China is in doubt? Absent strong White House leadership on this issue, the prospect of a conclusion of a satisfactory WTO protocol is jeopardized.