Issues in China’s WTO Accession

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

May 9, 2001

In the course of the 1980s and 1990s China emerged as a major player in the global economy, indeed no other country has ever expanded its role so rapidly. Its foreign trade increased explosively, from about $20 billion in the late 1970s to $475 billion in 2000. After China’s inward looking Cultural Revolution decade (1966-1976) drew to a close, China’s trade began to grow dramatically faster than world trade. By 2000 its share of total world trade had sextupled as compared with 1977 and as early as 1995 China had become one of the top ten trading countries in the world. Simultaneously China attracted record amounts of foreign direct investment. For much of the decade of the 1990s China was the world’s second largest recipient of foreign direct investment, following only the United States. By the end of the 1990s the total stock of foreign direct investment in China accounted for almost a third of the cumulative foreign direct investment in all developing countries. Cumulative foreign investment in China far exceeded the total stock of foreign direct investment in countries such as Mexico and Brazil, which opened their doors to foreign direct investment decades before China.

Less noticed, Chinese firms also have become major investors abroad. As early as the mid-1990s China was the largest outward investor among developing countries and the eighth largest supplier of outward investment among all countries. Finally, China raised significant amounts of capital on international bond and equity markets. Initially most of the funds were raised by the sale of sovereign bonds, but by the latter part of the 1990s major Chinese companies sought listings and raised billions of dollars on overseas equity markets.. China Mobile (Hong Kong), PetroChina, Unicom, and Sinopec together raised more than $15 billion through equity sales in New York and Hong Kong in 2000.

Despite this extraordinary performance, China remained in certain respects only shallowly integrated into the world economy. High tariffs and an array of nontariff barriers meant that some critical sectors of the Chinese economy remained relatively insulated from international competition. More generally, the state controlled imports by limiting both the type and number of companies authorized to carry out international transactions; imposing onerous inspection and safety licensing requirements on imports; developing technical standards designed in part to protect domestic industries; discriminating against foreign goods in government procurement, and imposing high local content requirements on foreign and joint-venture firms producing in China. And certain sectors of the economy, such as distribution, telecommunications, and financial services, remained entirely or largely closed to foreign direct investment.

Shallow integration also was reflected in the extraordinarily important role that foreign firms played in China’s foreign trade. Foreign firms began to establish operations in China following the passage of a joint venture law in 1979 and the creation of four special economic zones on the southeast coast in 1980. Naturally, the initial contribution of these firms to China’s exports was quite modest. Not until 1985 did their share of total exports exceed 1 percent. But, as foreign investment continued to grow, the share of exports produced by foreign-invested firms expanded, exceeding 10 percent by 1990. By 2000 foreign invested firms, which accounted for only about one-eighth of all manufacturing output, were responsible for almost one-half of all of China’s exports. But these exports were assembled or processed largely from imported parts and components, so their rapid growth created only a limited demand for inputs produced by domestic firms. Thus to a certain extent a large part of the foreign invested sector could be regarded as something of an enclave, with limited linkages to the domestic economy.

The WTO Decision
Given the rapid growth of the Chinese economy after 1978, the explosive growth of its trade, and its ability to attract record amounts of foreign direct investment, it is not immediately obvious why China’s leadership came to view membership in the World Trade Organization as central to the country’s economic future. Given the apparent success with what might be called shallow integration, why did the leadership decide to incur the costs of a much deeper opening of the economy to international trade and investment? This question is all the more puzzling because the scope and depth of demands placed on entrants into the formal international trading system have increased substantially since the formal conclusion of the Uruguay Round of trade negotiations in 1994, which expanded the agenda considerably by covering many services, agriculture, intellectual property, and certain aspects of foreign direct investment. Since 1994, the international community has added agreements covering information technology, basic telecommunications services, and financial services. WTO membership now entails liberalization of a much broader range of domestic economic activity, including areas that traditionally have been regarded by most countries as among the most sensitive, than was required of countries entering the WTO’s predecessor organization the GATT.

The terms of China’s protocol of accession to the World Trade Organization reflect the developments just described and more. China’s market access commitments are much more far-reaching than those that governed the accession of countries only a decade ago. And, as a condition for membership, China was required to make protocol commitments that substantially exceed those made by any other member of the World Trade Organization, including those that have joined since 1995. The broader and deeper commitments China has made inevitably will entail substantial short-term economic costs. These costs will be reflected in rising rates of unemployment in sectors that will shrink as they face increased international competition, both from imports and from goods and services provided by foreign-invested firms in China. The efficiency gains from restructuring the economy can be anticipated to be significant but, since they will require the reallocation of both labor and capital, are achievable only in the medium and longer term. Political leaders rarely are willing to impose high short-term economic costs in order to reap benefits in the medium and long term. Why does China appear to be an exception?

The answer to this question perhaps can not be fully known to external observers, but several pieces of the answer appear clear. Perhaps the most important background factor is that the regime, over the first two decades of economic reform, increasingly has staked its legitimacy on its ability to deliver sustained improvements in consumption and living standards of the Chinese people. While China’s leaders have hotly debated many of the details of economic reform, there appears to be a nearly unanimous view that economic growth is the sine qua non for staying in power. Appeals to ideology, so characteristic of the Maoist era, are long gone. Appeals to nationalism have increased, but are distinctly secondary to appeals to economic self-interest. Against this background, several factors suggest that the leadership has accepted the stiff demands of the international community in an attempt to continue its ability to deliver rising living standards to the population.
The Chinese leadership has increasingly come to the view that one of the principal benefits of becoming a member of the World Trade Organization is the increased competition it would bring to China’s domestic market. Increased competition is seen as an essential additional source of pressure on state-owned banks and enterprises, forcing them both to undertake badly needed structural reforms. By the time of his trip to the United States in April 1999, Zhu Rongji was openly articulating the view that China’s membership in the World Trade Organization could be a lever for promoting domestic economic reform. At his joint press conference with President Clinton in Washington Premier Zhu stated “the competition arising (from WTO membership) will also promote a more rapid and more healthy development of China’s national economy.”

More profoundly, it appears that China’s top leadership in the wake of the Asian crisis came to believe that there was no viable alternative to the globalization of production and that, indeed, China would benefit from greater participation in the trend. They recognize that globalization means that production of an increasing range of goods is global rather than national. While complex products such as automobiles, aircraft, computers, and telecommunications equipment are assembled in only a few locations, the parts and components for these goods are made in many locations throughout the world, based on comparative advantage. The Chinese have come to realize that their liberal foreign investment regime and low-cost labor markets give them a wonderful opportunity to participate in these cross-border production networks, and that deeper participation in these global networks could provide a new and sustainable base for the continued growth and development of their domestic economy.

But the Chinese leadership has also come to realize that participation in an increasingly globalized economy requires not simply drastically reduced tariffs, but also the development of a market economy. In the words of Long Yongtu, Vice-Minister of Foreign Trade and China’s chief global trade negotiator, “Countries with planned economies have never participated in economic globalization. China’s economy must become a market economy in order to become part of the global economic system, as well as to effectively participate in the economic globalization process.”

These lessons have been reinforced by the fact that economic growth in China, though still strong by developed country standards, has been slowing considerably. China’s headline figure for GDP growth declined steadily for seven straight years during the mid to late 1990s. As China’s GDP growth has declined, the official numbers have come under closer scrutiny as many observers, both within China and abroad, have begun to suspect that China’s GDP growth has been overstated during this period and that real growth in the economy has been markedly slower than the official figures reflect. Added to this skepticism is the fact that China’s state-owned enterprise sector, which comprises the backbone of the domestic economy, has become increasingly inefficient and debt-ridden as enterprises are constrained by substantial pension and social welfare obligations, even as they have continued to operate at a loss and produce and accumulate large inventories of unsaleable goods. China was spared the worst effects of the Asian crisis due to its closed foreign exchange policies and large forex reserves, but the crisis served as a wake-up call to the Chinese leadership because many of China’s large state-owned firms and financial institutions exhibit the same symptoms as those of Korea and some other nations affected by the crisis. The leadership in Beijing came to realize that economic reform and developing a market economy is a “reform or die” proposition, and that the risk of failure could well be their own economic crisis.

Summary of Commitments
China’s commitments to further open its economy in order to gain membership in the World Trade Organization are sweeping. They include significant reductions in tariffs that will bring the average level to under 10 percent by 2005; the introduction of a tariff-rate quota system that brings the tariff rate for key agricultural commodities, such as wheat, almost to zero for a significant volume of imports; the gradual elimination of all quotas and licenses that have restricted the flow of some imports; a substantial reduction in the use of state trading as an instrument to control the volume of imports of agricultural and other key commodities; and the opening of critical service sectors such as telecommunications, distribution, banking, insurance, asset management, and securities to foreign direct investment. In addition, the protocol governing its accession sets forth China’s commitment to abide by international standards in the protection of intellectual property and to accept the use by its trading partners of a number of unusual mechanisms that could be used to reduce the flow of Chinese goods into foreign markets.

Implications of China’s WTO Entry
While the likely immediate economic gains in the form of increased Chinese imports as a result of reduced tariffs and nontariff barriers may have been somewhat oversold, there is little doubt that China’s entry into the World Trade Organization is a landmark event for at least three reasons. First, China’s membership commits it to comply with the principles and rules of the international trading system. China was far and away the largest trading country outside the system; its participation is essential for the future effectiveness of the World Trade Organization. Second, China’s commitments are a lever its reform-oriented leadership can use to complete the transition to a more market-oriented economy. The strategy of relying on increased international competition to induce domestic firms to improve their efficiency is not without both economic costs and political risks. Even if the strategy is successful there inevitably will be high transition costs. Further increases in unemployment, even if only transitory, could lead to more frequent and more intense demonstrations and urban protest. Third, China’s commitment to open its markets to increased investment in telecommunications, financial, and distribution services is genuinely revolutionary. This commitment not only offers enormous potential commercial opportunities for foreign firms, but also will contribute to the further transformation of the domestic economy.

Implications for the United States
United States trade negotiators played the lead role in negotiating China’s entry into the world economy. This was natural given the large economic stake of the United States in the creation of more open markets globally. China was a particular focus both because of its rapidly increasing role as a global trader and because beginning in 1991 the terms of its entry were seen as providing a template for WTO membership for a number of formerly centrally planned economies. Moreover, as the United States became far and away China’s largest export market, the resulting expanding bilateral deficit with China became a major preoccupation of U.S. policy makers.

Trade Expansion
Bilateral trade between China and the United States has grown extremely rapidly since trade relations resumed in 1978. Trade turnover (the sum of exports and imports) grew from $1 billion in 1978 to $116 billion in 2000. However, bilateral trade flows became increasingly imbalanced over the decade of the 1990s. By 2000 the U.S. bilateral deficit reached $84 billion and for the first time exceeded the bilateral deficit with Japan. The growing imbalance frequently is cited as evidence of the closed nature of China’s economy. China, it is sometimes said, “has an economic vision that is fundamentally not free-market oriented but mercantilist.” Some fear China will displace Japan as our most troublesome trading partner.

This argument is fundamentally flawed for several reasons. Perhaps most importantly the U.S. global trade deficit, which reached an all time record of $330 billion in 1999, primarily reflects the extraordinarily low rate of savings in the United States. Because of meager domestic savings, a large fraction of U.S. domestic investment must be financed by borrowing from abroad. But the rest of the world would be unable to lend to the United States if it did not have a trade surplus with the United States. Policies that open specific markets abroad for U.S. firms, of course, would lead to more U.S. exports to those individual markets. But, at least in the short run, the U.S. global trade deficit would be unaffected. In short, the U.S. global trade deficit is the mirror image of its low savings rate relative to its rate of investment. Until the U.S. savings rate rises or the rate of investment falls, no amount of trade liberalization abroad will reduce significantly the global U.S. trade deficit. Selective trade liberalization abroad only affects the country-by-country distribution of the U.S. global trade deficit, not its overall size.
Second, most of the growing U.S. deficit with China reflects China’s rapid displacement of alternative foreign sources of supply, primarily of labor-intensive manufactures. That, in turn, reflects the migration of labor-intensive manufacturing to China from other locations in Asia, notably Hong Kong, Taiwan, and Korea. In the 1980s and 1990s, as wages in these countries rose and China increasingly liberalized its foreign direct investment environment, Asian entrepreneurs moved a growing share of their labor-intensive production to China. Thus a very large share of U.S. imports from China are produced in joint venture or wholly foreign-owned factories. In contrast, the U.S. deficit with Japan is primarily the result of the import of much more capital-intensive goods, produced in Japanese-owned factories, which displaces production not in third countries but in the United States.
The third flaw in the argument that the ever growing bilateral trade imbalance reflects a fundamentally closed Chinese economy is that exports of U.S. firms to China have grown extremely rapidly since China’s reforms and opening up began in the late 1970s. Since this growth initially was from a very low base, China did not become a significant market for most U.S. firms in the 1980s. In the 1990s U.S. exports to China continued to grow rapidly, almost quadrupling between 1990 and 2000. But since the base for this growth was much larger, by 2000 China had become the eighth largest international market for U.S. firms. Moreover, from1990 to 2000 exports of U.S. businesses to China grew more rapidly than to any other large export market. The contrast with Japan is striking. Exports to Japan grew only 20 percent between 1990 and 2000, in part because sales to Japan by U.S. firms reached a peak in absolute terms in 1996 and then fell through 1999. The U.S. deficit with Japan is rising in large part because U.S. exports are falling; the deficit with China is rising despite rapid export growth of U.S. exports. The key reason for the latter is the huge buildup of foreign direct investment in labor-intensive export industries in China.

Why China’s WTO Accession Matters
The United States has a substantial stake in China’s further domestic economic reforms and its deepening integration in the global economy. Most obviously it serves U.S. economic interests. China’s commitment to liberalize the terms under which foreign firms can invest in telecommunications, distribution, and financial services creates enormous opportunities since these are areas in which U.S. firms are very competitive on a global basis. China in the 1990s was already the most rapidly growing large foreign market for U.S. goods and services. China’s WTO commitments will increase the access of U.S. firms to this market and increase the prospect that the bilateral trade relationship remains robust. Increased access for agricultural products and automobiles is likely to be especially important for the United States. In short, China can continue to contribute to the dramatic growth of U.S. trade, which doubled to $2.5 trillion in the eight years ending in 2000. Trade expansion was an important source of the record rates of growth of output and employment during the 1990s. Equally important, the availability of lower cost imports allowed this growth to occur with an unusually low rate of price inflation. Obviously the United States has and will continue benefit enormously from the shift of production within Asia discussed earlier in this chapter, since imports of these goods help to hold down prices in the United States.

Second, China’s deeper integration in the global economy may make China more a constructive participant in a new round of global trade liberalization. China’s leadership already has recognized the economic advantages of increased globalization and has even gone so far as to suggest the formation of a free trade area with the Association of Southeast Asian Nations, something that would have been unthinkable even a few years ago.

Third, deeper integration, and the concomitant acceleration of domestic economic reform, also will make it more likely that China will be able to meet the expectations of its population of 1.3 billion for improved living standards. An economically failing China, by contrast, would impose substantial costs on the United States and the rest of the world.
Fourth, the implications of rising living standards based on an increasingly market-oriented economy are overwhelmingly favorable to our long-term interest in the development of a more pluralistic political system in China. As was true in the case of Taiwan from the 1950s onward, a rapidly modernizing economy is likely to generate gradually growing pressure for political change, away from one-party, authoritarian rule. In Taiwan it took almost four decades of rapid economic growth between the time popular elections for county and city officials were introduced in 1950 and the time martial law was lifted and opposition parties legalized. Another decade elapsed before the first national popular election for president. Although China has been conducting popular elections at the village level for more than a decade, at least another decade or two of sustained economic growth probably will be required before a more pluralistic political system begins to emerge.

Finally, China’s entry into the World Trade Organization will lead to stronger trade and investment ties between China and Taiwan that may contribute to a gradual reduction of tensions between the two. Given the strong interest of the United States in the peaceful resolution of the Taiwan straits issue, this is a very important potential benefit of China’s deepening integration in the global economy. Even prior to each becoming a member of the World Trade Organization, bilateral economic links between China and Taiwan were growing rapidly. In the decade of the 1990s, as China became a more and more important part of the production chain for many Taiwanese firms, more than two-fifths of all Taiwanese foreign direct investment was in the mainland. And trade ties have burgeoned. By 1999 a quarter of Taiwan’s exports went to the mainland, making that market almost as important as the United States.

Membership of both China and Taiwan in the World Trade Organization will accelerate these linkages for several reasons. First, membership is almost certain to end Taiwan’s long-standing ban on direct shipping and air travel between Taiwan and the mainland. Second, Taiwan will have to eliminate important nontariff barriers on Chinese goods, notably the import ban imposed on a large number of goods of Chinese origin. Finally, Taiwan will ease many restrictions on investment in China that have been in place as part of “go slow, be patient” policy that the Kuomingtang adopted in 1996 to govern economic relations with the mainland.

All of these developments—the opening of direct trade, the elimination of Taiwan’s bans on the import of a broad range of Chinese products, and liberalization by the Taiwanese government of restrictions on the outflow of foreign direct investment to China, will contribute to closer bilateral economic relations. These closer bilateral economic relations will likely act as a powerful disincentive to leaders on both sides of the Taiwan Strait against any destabilizing political or military moves which might upset an increasingly interdependent and mutually beneficial economic relationship. The exchanges resulting from a closer economic relationship could also provide a platform of mutual trust and provide contacts for a broader cross-straits dialogue which might further reduce the tensions and anxiety which presently handicap relations across the strait. Given the substantial role that Washington plays in relations between Taipei and Beijing, any reduction in tensions across the strait which resulted from closer economic cooperation would be a huge benefit to US interests in the region, both political and economic.

In conclusion, China’s accession to the World Trade Organization is a landmark event, one that has wide ramifications for China, the United States, the WTO, and the world as a whole. It has the potential to transform China’s economy, its relations with its neighbors, and perhaps even (someday) its political system. It will impel China to be accountable to an internationally agreed set of rules and bind them to wide-ranging economic and systemic changes in order to meet the commitments they have agreed to undertake as a part of WTO accession. Although China’s full compliance with its commitments will be difficult and there are likely to be many disagreements to come about issues related to China’s accession agreements, China’s WTO entry remains an important step in its move toward greater involvement on the world stage, a move which the U.S. should continue to fully support and encourage.