U.S.-China Economic Relations: Implications for U.S. Policy

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

April 25, 2001

Since its economic reforms began in the late 1970s, China has had one of the fastest-growing economies in the world. Between 1979 and 2000 real gross domestic product (GDP) increased more than six-fold. Although per capita income remains low, China’s huge population means that in aggregate terms it is already among the larger economies in the world, much larger for example than Russia or India, or even the two combined. During the same period, the growth of China’s international trade has been even more impressive, such that the country’s share of world trade has more than quintupled, to about 4 percent at present. No other country has ever increased its share of world trade so rapidly. Since 1995 China has been one of the world’s top 10 trading countries.

China’s Economic Rise

China’s prospective membership in the World Trade Organization (WTO) is of enormous potential consequence both for China and the international trading system. The commitment of China’s leadership to further open its domestic markets for imports, foreign services, and foreign investment will mean increased domestic competition that the leadership expects to leverage into accelerated domestic economic restructuring. The goal is not so much to increase the headline rate of growth, but to improve the quality of growth and insure its sustainability. China wishes to reduce environmental degradation, increase the share of consumption in national income, promote productivity growth, and reduce waste. If this strategy can be implemented successfully China will continue to narrow the still very large gap in per capita income levels between itself and the most advanced industrial economies.

Unless these trends change fundamentally, China’s economy is expected to surpass that of all individual European countries in terms of GDP size and rank only behind the United States and Japan within two decades. Over the same period China may become the world’s second-largest trading country, exceeded by only the United States.

Implications for the World Trading System

China’s entry into the WTO depends on successful completion of the multilateral phase of accession negotiations that are currently underway. China’s membership would be of great significance for the future of the international trading system for several reasons. First, the terms of its admission will serve as a template for a number of other transition economies that are seeking WTO membership, including Russia. Given the extraordinarily demanding conditions that the Chinese have accepted during the bilateral phase of WTO admission negotiations, the bar of entry conditions for new members has been set very high. Second, although China has taken important steps toward meeting some of its WTO obligations, the speed with which it is able to complete the process may disappoint some members of the organization. Given the large volume of its international trade, there is a risk that trade conflicts involving China could overburden the dispute settlement capacity of the WTO. Third, China is likely to play a significant role in shaping the agenda for the next round of multilateral trade negotiations. As the first developing country to be one of the world’s top 10 trading countries and a WTO member, China may become a forceful advocate in the next round for the interests of developing countries. Finally, China’s entry is likely to require significant adjustments in the informal governance structures of the WTO. China has been critical of procedures and practices that give an unusual informal agenda-setting role for the so-called quad countries and has argued that the interests of developing countries are underrepresented in WTO decisionmaking. Thus it may seek adjustments in the informal governance structures of the organization.

Implications for the U.S. Trade Deficit with China

China’s entry into the WTO is not likely to reduce the bilateral trade deficit or eliminate trade friction with the United States for a number of reasons. First, the benefits of China’s accession may have been oversold by an administration seeking authority to extend permanent normal trade relations (PNTR) to China to avoid being frozen out of the benefits of China’s WTO commitments. Although the bilateral agreement between China and the United States, which will become part of China’s multilateral commitments, does provide increased market opening, China’s markets for merchandise are on average far more open than is commonly recognized. For example, by early 2001 China’s average tariff rate had been cut to 15.3 percent, about half the level prevailing in India and roughly equivalent to tariffs in Brazil and Mexico. Moreover, 60 percent of all imports enter China under one of many import duty exemption programs. As a result, actual tariff collections in China are extremely modest—under 5 percent of the value of imports.

Similarly, import quotas and licensing requirements, which used to be pervasive, have been steadily reduced and by 2000 covered only 4 percent of all import commodities. Thus, although the lower tariff and nontariff barriers accompanying China’s entry into the WTO will lead to a dramatic increase in U.S. exports of a few products that are now highly protected, the rate of expansion of our exports to China in the aggregate is not likely to accelerate dramatically.

Second, the agreement on China’s WTO entry conditions does nothing to reduce the United States’ overall trade deficit, which is determined by macroeconomic factors such as the national savings and investment rates. Until the savings rate rises, the investment rate falls, or the rate of expansion of the United States’ economy declines (as has been the case since the middle of 2000), the overall trade deficit will remain large. In those circumstances it is inevitable that an appreciable fraction of investment in this country will be financed by foreign capital, including Chinese capital. Our global trade deficit is simply the mirror image of this large capital inflow. The ever-growing use of United States currency in many foreign countries also helps to finance the trade deficit.

Third, under the terms of its WTO accession agreement, China, like other developing-country textile and apparel producers, will benefit from the phaseout and elimination at the end of 2004 of quotas that historically have restricted international trade in these products. These quotas have artificially restricted China’s apparel exports to the United States since the first bilateral textile agreement was signed in September 1980. Since China is a lower-cost producer than many other current suppliers of apparel to the United States, it almost certainly will displace at least some apparel exports from other countries as the restrictions are phased out. While total apparel imports into the United States may not rise significantly, the share originating in China almost certainly will. The result is that total U.S. imports from China will rise further as the restrictions on textile and apparel trade are liberalized.

Fourth, China will almost certainly continue to benefit from the relocation of industries from other production sites in Asia. In the 1980s and early 1990s, the industries were mostly concentrated in toys, footwear, and apparel. Starting in the early 1990s Taiwan began to move part of its computer component manufacturing capacity to China, which quickly became an important producer of motherboards, monitors, and other PC hardware. In the mid-1990s, China began to emerge as a significant production site for finished computers. By 2000, two-fifths of all Taiwanese PCs were made in China. The migration of production facilities from Taiwan to the mainland is so far advanced that China is expected to replace Taiwan as the world’s third-largest manufacturer of information technology hardware in 2001. China is also making efforts to develop its software industry, but is relatively less advanced in this area than in technology hardware manufacturing.

The trends sketched above will almost certainly accelerate. Taiwanese companies are poised to begin to move their notebook computer and semiconductor production to China. Although Taiwanese government regulations now prohibit these investments in China, these regulations are almost certain to be modified once China and Taiwan are both members of the WTO. Japanese firms are following a similar pattern, with some delay. During much of the 1990s they curtailed their investment in China as a result of a general reduction in overseas investment and the perception of operating difficulties in China. But by the turn of the millennium Japanese investment in China was on the rise again as firms shifted production of consumer electronics and other products, particularly to southern China. As in the case of apparel, China is likely to displace alternative sources of supply with a resulting increase in U.S. imports from China.

As a result of these factors, it is unlikely that the imbalance in bilateral trade between China and the United States will diminish any time soon. Any policy approach to China that seeks to reduce the deficit through trade restrictions or administrative intervention seems almost certain to fail, at least in the short run. The good news is that an expansion of the bilateral trade deficit with China due to the displacement effect will be compensated by reduced deficits elsewhere in the world and not contribute to an expansion of the United States’ global trade deficit. Whereas the bilateral trade deficit will need to be monitored, it is important to note that the United States may derive substantial nontrade benefits from greater participation in domestic distribution and service industries in China that WTO membership will make possible.

A further reason to anticipate continued trade friction is that China may not be able to fully implement all of its WTO obligations within the agreed time schedules. On the positive side, even before concluding its WTO negotiations, China had taken care of some of the commitments that it had made in bilateral negotiations with the United States in 1999 and with the European Union in 2000. For example, the government has already approved a deal allowing AT&T to acquire a 25-percent stake in a joint venture to provide broadband telecommunications services in Pudong, Shanghai, something it was not required to allow until after it entered the WTO. China also implemented reductions in tariffs on items covered by its commitment to participate in the WTO’s Information Technology Agreement. Some of the tariff cuts made in early 2000 were not required until 2004 or 2005. China has also taken early steps to meet some of its commitments to liberalize foreign participation in audiovisual services, construction, retailing, legal services, and distribution services. To level the playing field for domestic and foreign firms operating in China, fiscal, financial, and regulatory agencies have begun the process of adjusting many rules and systems, as required under WTO rules.

Also on the positive side, China’s legislative body, the National People’s Congress, has already amended a number of important domestic laws covering patents, copyrights, trademarks, and foreign investment to make their provisions consistent with WTO commitments. Although these examples do not necessarily guarantee that China will be able to meet all of its commitments, they do suggest that the government is making a very substantial effort to comply with a broad range of its obligations and that it believes that further economic liberalization and opening up are essential to meeting its own long-term economic goals.

Despite these efforts, it would be extraordinary if China were able to implement all of its WTO commitments in every detail and on schedule. As part of the process of accession negotiations the Chinese government identified 177 domestic laws and regulations dealing with customs administration, the administration of foreign investment, intellectual property, and services that must be amended to insure consistency with WTO obligations. Although a start has been made, the work of revising all of these laws and getting them approved by the legislature is likely to take several years. It will take even longer to train the judges and develop the legal institutions and processes necessary to insure that these laws are fairly and impartially upheld and that legal judgments are enforced.
Deeper Integration of China in the Global Economy Serves U.S. Interests
Although trade friction between the United States and China will not be eliminated, there is little doubt that China’s deepening integration in the world economy will serve several U.S. interests. First, it will serve our economic interests. China’s commitment to liberalize the terms under which foreign firms can participate and invest in telecommunications, domestic distribution, financial services, the entertainment sector and many other services, creates significant opportunities in areas where American firms tend to be internationally competitive. During the 1990s, China was already the most rapidly growing large foreign market for U.S. exports of goods and services. The trade and investment liberalization that China is committed to under WTO will increase our access to this market and enhance the prospect that the economic relationship will remain robust. Increased access for agricultural products and automobiles is likely to be particularly important for U.S. firms. In short, China can continue to contribute to the growth of our external trade and our economic welfare associated with trade. Because China is an efficient producer of a wide range of commodities, imports from that country may also contribute to low price inflation in the United States.

Second, successful integration in the global economy is likely to insure China’s constructive participation in a new multilateral round of trade liberalization. China’s leadership recognizes the actual and potential benefits 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 (ASEAN) that would also comprise Japan and South Korea. A proposal of this kind coming from China would have been unthinkable even a few years ago. Should such a trade block eventually materialize, it seems likely that Taiwan would be part of it.

Third, deeper integration, and the concomitant acceleration of domestic economic reform, also increases the likelihood 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 lead to regional instability and impose substantial costs on the United States and the rest of the world.

Fourth, the implications of rising living standards within an increasingly marketized economy are overwhelmingly favorable to the development of a more pluralistic social and political system in China. As was true in the case of Taiwan, South Korea, and Thailand, a rapidly modernizing economy is at some point likely to generate effective pressure for political change, away from authoritarian rule. In the case of Taiwan, it took almost four decades of rapid 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, a long period of sustained economic growth and stability will probably be required before a more pluralistic political system begins to emerge.

Implications for U.S. Policy

Given our long-term trade and investment interests and the linkage between economic and political change that has been demonstrated in other countries in East Asia, what are the implications for U.S. economic policy toward China? First, policies that have given rise to the perception in China that the United States seeks to delay or even block China’s emergence as a major economic power must be abandoned. That means the new administration should drop the more than a decade old sanctions that remain in place as a legacy from the Tiananmen crisis of 1989. These include, inter alia, the requirement that the U.S. director on the Executive Board of the World Bank vote against or abstain from all China loans that are not strictly for basic human needs and the selective withholding of Export-Import Bank loans and credit guarantees for noneconomic or nonsecurity reasons. For several years the United States has been the only country in the world still imposing such sanctions. U.S. opposition to China loans from the World Bank does not block such loans and under a waiver program some loans from the Export-Import Bank have gone forward. These sanctions are therefore largely symbolic. They send an incorrect message that the United States seeks to delay or block the emergence of China as a major economic power.

Second, the United States ought not to remain the only advanced industrial country that has no systematic technical assistance program to help the Chinese government meet its WTO obligations. Japan, Australia, Canada, and the European Union, as well as many other member countries, provide assistance ranging from training government officials to providing WTO-related legal assistance. Although the Ford Foundation has funded some WTO-related legal training programs in the United States, the U.S. government has never funded the rule of law program that was announced with such fanfare by President Clinton in 1997 at the time of his summit meeting in Washington with President Jiang Zemin. Similarly, a number of departmental technical cooperation programs with China remain underfunded. The absence of a well-functioning government program of technical assistance on WTO-related issues feeds the impression in China that the United States is more interested in imposing tough conditions than in assisting China’s historic transformation.

Third, the United States should be very judicious in applying the highly protectionist features that we insisted China agree to as a condition for WTO membership. For example, under the product-specific safeguard included in the bilateral agreement of November 1999, the United States will have the option of imposing unilateral restrictions on imports from China under conditions that no other member of the WTO has ever been required to accept. Moreover, these conditions are relatively easy to meet and restrictions based on them can be directed solely against imports from China. Under normal WTO safeguard arrangements, if conditions for their use are met, restrictions must be imposed proportionately on all supplying countries. Since the product-specific safeguard conflicts with the most fundamental WTO principle of equal treatment for all countries, the United States should only invoke this instrument against China under extraordinary circumstances.

Similarly, China has agreed to be subject to a special textile safeguard that allows the United States to impose unilateral restrictions on the import of Chinese textiles and apparel for a period of four years after the current quota system is phased out. During the period 2005-2008, China will be the only member of the WTO potentially subject to quota restrictions on its textile and apparel products.

If either of these two safeguards is invoked by the United States under conditions that are perceived to be based on pressures from industries that claim to be adversely affected by imports from China without clear evidence of injury to their firm, it would probably undermine support for the WTO within China and probably among other WTO members as well. That, in turn, would complicate, if not effectively terminate, efforts by the United States to launch a new round of multilateral trade negotiations.