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This chapter is from the book

Coming to America

In the nineteenth century, the West forced a weak China to accept a series of unequal and humiliating treaties, forcing it to open its doors to foreign trade. The United States was a signatory to one of those treaties. The problem was that while the West coveted such Chinese products as tea and silk, it had little to offer in return that the Chinese would want (which is partially how the British got into the opium trade). Close to two centuries later, trade between the former adversaries is booming, and, again, Americans seem more interested in Chinese goods than Chinese are interested in America's. This time around, the Chinese want to sell, and American and European ports handle a lot more made-in-China merchandise than tea and silk.

Exhibit 1-1 displays China's trade in goods and services with the United States. Numbers are provided not only for mainland China (The People's Republic of China, or PRC for short), but also for Greater China (including Hong Kong, Taiwan, and Macao, but not Singapore), both to acknowledge the increased integration of these Chinese economies and to address a major complaint of the U.S. China Business Council, a U.S. trade group consisting of major U.S. exporters to China, that the trade numbers for the PRC are distorted because they do not account for Hong Kong's entrepôt position. (That is, many exports coming from the PRC come via Hong Kong, and many U.S. exports with a Hong Kong shipping address are destined for mainland China.) We include services because unlike merchandise trade in which it has a chronic deficit, the United States has a considerable surplus in the trade of services (such as transportation and consulting).

Figure 1.1Exhibit 1-1 China’s Balance of Trade with the United States.

The U.S.-China Business Council also holds that the U.S. trade deficit with China is inflated, because the U.S. calculates imports and exports differently: U.S. imports are measured on a CIF (inclusive of cost, insurance, and freight), while its exports are calculated on an FAS (free alongside ship) basis. The Council contends that conversion of both imports and exports to an FOB (free on board) basis would adjust exports upward by 1 percent and reduce imports by as much as 10 percent.1 Even with such adjustments, China would still post a huge trade surplus with the U.S., and considering the rate of growth for the deficit, the new numbers would merely reflect a six-month time lag. Furthermore, adjusting U.S. trade figures would not alter China's position relatively to other U.S. traders. The defensive position of the U.S.-China Business Council is revealing: It is a reminder of the powerful business lobby for China, which consists of major exporters to this market, such as Boeing, and those who rely on Chinese imports to remain competitive.

No less important than the overall numbers of the trade deficit is the composition of the deficit—in particular, Chinese imports into the United States. According to the Foreign Trade Division of the U.S. Census Bureau, the four highest import categories from China in 2003 were all technology related: miscellaneous manufactured articles at $28.5 billion (CIF value), office machine and automatic data processing equipment at $24.3 billion, telecommunications and sound recording equipment at $17.5 billion, and electrical machinery at $12.6 billion. The labor-intensive categories of apparel/clothing and footwear are in fifth and sixth place, at $12.6 and $11.1 billion respectively, continuing a downward trend in ranking but not volume.2 In 1999, in comparison, textile and apparel (together) and footwear placed second and third, respectively.

Economists are divided over how important a trade balance is. Some point out that the U.S. trade deficit is not huge as a proportion of GDP, even though it has already crossed five percent, which is an arbitrary red line. Others point out the danger of an increasing proportion of American financial obligations held in the hands of foreigners, who, if they were to lose faith in the American currency, could cause a crisis of confidence in the United States and destabilize a global economy in which the U.S. dollar remains the main reserve currency. It is commonly accepted that trade brings about mutual benefits to trading partners, with some suggesting that trade is beneficial even when not reciprocal (for example, U.S. consumers benefit from cheap Chinese products). An economic perspective is too narrow to capture the complexity of trade, its variable impact on diverse regions and industries, and, in particular, its social, political, and geopolitical repercussions. It is easy to make the macro economic argument that "free trade benefits us all"; it is also easy to make the often-political argument for "fair trade." It is much more difficult to pinpoint the parameters for fairness, identify who is playing fair in a new game, or pick winners (and losers). The China game may redefine all three.

Why is the United States the most vulnerable to (some would say the major beneficiary of) Chinese imports? In contrast to Japan, who for decades maintained a huge trade surplus with the outside world, China has been running only a small surplus in its global trade, and recently its imports have been rising faster than its exports. As its trade surplus with the United States expanded to $11.5 billion in January 2004, China's overall trade balance for February 2004 expanded to $8 billion—in the red. This means that other trading partners are doing quite well, maintaining a smaller deficit (the European Union, or EU) or a substantial surplus (Asia) in their China trade. (With the EU, China had a surplus of close to 50 billion euros in 2002, running a surplus with every EU country with the exception of Austria and Finland.)

How is this disparity between the United States and China's other trade partners possible? The answer is quite complex, as is explaining the variations, say, between the United Kingdom (UK), which proportionally runs an even greater deficit with China, and Germany, whose deficit is relatively small. The explanations are important in that each has its own supporting constituencies, each sheds different light on the China impact, and each offers its own repertoire of strategic responses at the national, industry, firm, and individual levels. The following sections present some of the explanations.

The Chronic Importer

The United States has been running a trade deficit with the rest of the world for a quarter of a century, a gap which now approaches the half a trillion dollar mark annually. Nominally, this is the largest trade deficit in the world, and hovering around 5 percent of GDP, it is also one of the highest ratios among industrialized nations. The U.S. has a substantial trade deficit with the EU, Canada, and Japan, among others, but its trade deficit with China is the largest and the fastest growing. One reason for China's lead is the global shift of manufacturing operations to the country. As Japanese, European, and American firms have been moving their manufacturing operations to China, their sales in the United States register as Chinese exports. For instance, over the past few years, the Japanese trade surplus with the U.S. has not grown, while the deficit with China has soared. Obviously, this argument does not explain why the U.S. overall trade deficit has not declined, which suggests that there may be other factors at play, such as competitiveness, exchange rates, the increasing offerings of global exporters, and the diversity of the U.S. population that supposedly enhances its appetite for foreign goods.

The Naïve Trader (or the One with More to Lose)

The United States is an open market, which many Americans (but not necessarily everyone else) believe has less tariff and nontariff barriers than those of it partners, and trade policies that Americans and many others would characterize as naïve (such as allowing relatively open access to American markets without insisting on reciprocity). In this view, the U.S. is being taken advantage of by its trade partners, especially China. China's defenders point to the gradual opening of its markets and its World Trade Organization (WTO) commitments. They argue, not without justification, that many American firms have not invested the necessary time and energy in understanding the requirements of a rapidly opening Chinese market. Nicholas Lardy, a noted China scholar with the Institute for International Economics, observes that China's ratio of imports to GDP likely reached 30 percent in 2004 compared to 8 percent in Japan and 14 percent in the United States.3

As a global leader in technology and innovation and a net technology exporter, the United States can be said to suffer more from China's lax regime of intellectual property protection than other trade partners. Analogies are often drawn with Japan and the "four tigers" that started with disregard for property rights but later enhanced compliance though Chinese violations persist on a much grander scale and are tolerated, often supported and protected by powerful local interests. As China moves up the technology ladder, states the optimistic argument, it will be in its own interest to offer such protection. After all, in the nineteenth century, the United States was a major violator of intellectual property rights, as Charles Dickens, among others, learned to his dismay. The difference is that this time around, the share of research and development in product costs is much higher, and copyrighted products take up much more of the economic pie. We are also in a global economy, meaning that pirated and counterfeit products now find their ways to multiple markets. And, perhaps most worryingly, recent trends show a rise rather than a decline in the rate of violations.

Follow the Curve

In this explanation, the U.S.-China trade imbalance results from the different point of the two countries along the development curve. In the same way that the United States lost agricultural employment a century ago, it is now shedding low-end manufacturing jobs, replacing them with higher-end, knowledge-intensive manufacturing and service jobs. In so doing, China plays a positive role by relieving the United States to do what it does best: producing and implementing knowledge at the upper rung of the ladder. The argument is understandably attractive to China's defenders, who point out that China and the United States overlap only on a narrow range of products (10 percent according to the Council on U.S. China Trade). Naturally, the development curve story implies that the trade gap between the two countries will diminish once China progresses.

The argument is appealing but also vulnerable. The range of products on which the United States and China compete is probably larger than the Council attests, and most importantly, is growing rapidly, which should not be surprising given the faster growth that China has been experiencing and the massive technology transfer into the country. Toyota, Nissan, and Honda started with lower-end vehicles before they established the luxury divisions of Lexus, Infiniti, and Acura; inquiries by the International Trade Commission reveal that Chinese TV sets and furniture already target both the low and high end. The development curve argument typically draws a parallel between economies shifting from manufacturing to services and from agriculture to manufacturing, but as we will argue later in this book, the parallel may be fundamentally flawed. Finally, unlike Japan and the tigers before it, China intends to retain its labor-intensive advantage as it moves into more sophisticated product lines; if it manages to do so, the range of products on which the two countries compete will grow still further.

Foreign-Generated and "Self-Inflicted" Imports

Looking at the trade data, you may see a picture of unscrupulous Chinese firms trying to elbow their way into the U.S. market. Before you jump to conclusions, however, keep in mind that more than half of China's global exports are by foreign multinationals that have set up shop there to supply their home and global markets (see Exhibit 1-2). In fact, the Chinese, like the Japanese before them, tend to subtract such exports from their trade figures, producing much lower export numbers.

Figure 1.2Exhibit 1-2 China's Exports and the Share of Foreign Affiliates.
Source: UNCTAD 2003.

"Foreign Invested Enterprises" (foreign subsidiaries and cross-border joint venture companies) account for a big chunk of China's export growth because they have the know-how, quality level, reputation, distribution channels, and markets necessary for foreign market entry. Many—although by no means all—are American firms, driven by economic fundamentals (that is, it is cheaper to manufacture in China even when you take into account shipping and related costs) or by agreements they have signed with the Chinese government requiring a high export to sales ratio as a condition for domestic market entry or to obtain certain investment incentives. While some dispute the numbers, it is clear that American firms support Chinese imports into the U.S. if not as manufacturers than as buyers (such as Disney). Furthermore, the contribution of U.S. manufacturers to China's exports is likely to grow, and it is easy to see why: China's technology products are the fastest growth segment of its exports, foreign multinationals account for three-quarters of technology exports (more in the case of high technology), and the U.S. remains the largest repository of technological knowledge. And there is one more reason: Compared to other developed economies, in particular the European Union, it is relatively simple to shut down operations in the United States, so manufacturing operations can be moved more easily to China and start exporting back into the U.S. In contrast, EU firms (in particular in Germany and France) face enormous obstacles in shutting down domestic plants, which erode the cost/benefit equation of moving production off-shore and, at least in the short run, reduce exports into the region.

The Currency Play

The almost pathetic view of the U.S. Secretary of the Treasury, John Snow, making a pilgrimage to China to plead for a revaluation of the yuan only to be turned down, focused attention on the role played by the renminbi (literally, "people's money") in the trade imbalance between the two countries. Most economists (as well as competitors and developed country unions) are convinced that the yuan is undervalued, although they disagree about the margin as well as on how risky a sudden appreciation would be for China and the global economy. Now that the U.S. dollar has declined against the euro (especially) and the Japanese yen, the pressure is on China to revalue to make Chinese products more expensive in the U.S. market.

The currency game was played vis-à-vis Japan during the 1980s, when, in the wake of the Plaza Accord, the dollar plunged in value against the yen. Yet, the drastic realignment in exchange rates hardly made a dent in the U.S. trade balance with Japan, leading frustrated economists to offer alternative explanations (such as that consumption patterns were not dependent on cost alone) and even to suggest that "Japan does not fit the economic models." Today, the yen is worth more than double its early 1980s dollar value, but the U.S. trade deficit with Japan is still the same (in 1980s dollar terms). Although the deficit would have been higher without the realignment, it was probably held back more by Japanese factories moving to the United States (especially in the case of the automotive industry, which accounts for a big chunk of the U.S. deficit with Japan) and China.

The constituencies pressuring for revaluation would like China to do one of the two: let the yuan free float, thus letting market forces determine exchange rate, or set a new, higher exchange rate band. In the past, China has rejected such pressure as intervening in its internal affairs, reminding everyone how it agreed not to devalue its currency in the face of massive devaluations by competitors such as South Korea, Thailand, and Indonesia during the Asian Financial Crisis. China's offer to use its huge reserves to support the Hong Kong dollar, then under attack, also gives credence to its stance that it will not yield on exchange rate pressures. While giving some signals regarding its future readiness for a modest revaluation, an emerging deficit in its overall trade balance will give China further rationale for opposing a change in current rates. Opposing the yuan revaluation are also the many U.S. manufacturers who import components or finished products from China and would be affected adversely by such change.

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