The future of U.S.-China trade ties
China in the past few decades has emerged as the world’s largest exporter and the United States’ second largest trading partner after Canada. Despite being a relatively poor developing country, China has built up the largest trade surpluses in human history, creating economic problems for the United States. Trade with China has led to the loss of American manufacturing jobs, reduced real wages for semi-skilled workers, and devastated some communities dependent on low-end manufacturing jobs. These negative effects have naturally given rise to protectionist sentiments in the U.S. presidential campaign and given trade in general a bad name.
While protectionism is tempting, it is almost certain to backfire and cause more economic harm to the United States. Inducing China to become a more normal trading and investing nation will require a mix of carrots and sticks from the next administration, a policy that could be characterized as “responsible hardball.” As a departure from current policy, the most promising option would be imposing new restrictions on Chinese state enterprises purchasing their competitors in the United States until China opens up reciprocally. The United States can also use leverage over China’s desire to be granted market economy status in order to negotiate significant reductions in excess capacity in steel and other heavy industries.
Economists generally agree that trade between the United States and China has had negative effects on U.S. manufacturing employment, though estimates of the impact vary. What is not in dispute is that U.S. manufacturing employment declined sharply, dropping from 17 million in 2000 to 11 million in 2010. Some have estimated that China’s reform and opening up explained 25 percent of the decline in American manufacturing jobs between 1991 and 2007, and 40 percent of the loss after 2000.1 Others emphasize that the U.S. trade deficit was already large in 2000, and find that trade accounted for little of the job loss in the 2000s. Still, they agree that if the U.S. trade deficit were eliminated completely—a big “if”—then U.S. manufacturing employment would be 25 percent higher (3 million more jobs on the current base).2
Trade with China also put downward pressure on real wages for semi-skilled labor in the United States. Frankly, some of this was predictable when China began its reform and opening up. China had a large and rapidly growing labor force when it began economic reform in the late 1970s: Its working-age population was 475 million in 1980 and nearly doubled over the next 35 years. After years of self-imposed isolation, its technology was outdated and productivity low. Hence, China joined the world economy as a low-wage economy, but one with a vast labor force and good potential to raise its productivity through foreign investment and economic reforms.
In this situation, economic theory predicts that China would export labor-intensive manufactures and import the things that were relatively scarce in its economy (many primary products, advanced manufactures, and high technology goods). This is basically what transpired as China became a major manufacturer of garments and textiles, and then simple electronics (assembling imported components) and eventually more sophisticated electronics and machinery. Had China imported in the manner trade theory predicted, then the corresponding effect in the United States would have been job losses in labor-intensive sectors but job gains in high-end manufacturing (and services), including sectors such as aircraft, machinery, and equipment. Some of this occurred, but it did not import as much as it exported. This became a problem in the U.S.-China relationship.
The United States had problems earlier with large trade surpluses in Asian partners such as Japan, South Korea, and Taiwan. China was different in at least three ways. First, trade surpluses emerged at an earlier stage of development than in the other Asian economies. China was still a relatively poor, capital-scarce economy when it started running trade surpluses. Second, China has a much bigger population than its East Asian neighbors, making it a greater challenge for the world to absorb Chinese surpluses. Third, the Chinese economy is a complex hybrid of private entrepreneurship, on the one hand, and a large state enterprise and government sector on the other. A trade surplus reflects an excess of savings over investment. China has had a lot of distortions that tended to keep both savings and investment high, but savings especially high. In recent years, China is a complete outlier among major economies, with a national savings rate near 50 percent of GDP.
One of the key distortions in the economy has been management of the exchange rate. China pegged its currency, the yuan, to the U.S. dollar at a rate of 8.3:1 in 1994. This was a reasonable and not unusual choice for a developing economy. At that rate, the trade balance was close to zero for the first few years, making it hard to argue against that level. The problem is that China had rapid productivity growth that required some appreciation over time; furthermore, the relevant exchange rate is a trade-weighted index, since China trades with many countries. China is fortunate that the dollar was appreciating in the late 1990s so that the yuan appreciated with it in trade-weighted terms. China’s mistake was in following the dollar down in the first half of the 2000s. This resulted in trade-weighted depreciation, just as Chinese productivity really took off. It was at this point that China developed a very large trade surplus that rose above 10 percent of GDP. Pegging the currency to the dollar in the face of a large trade surplus requires the central bank to accumulate reserves, and China’s reserves over this period rose to a global high of $4 trillion.
For many years, Chinese state-owned enterprises (SOEs) largely deployed the savings in-country. But now, with problems of excess capacity emerging in many sectors, SOEs have turned outward and are on a global buying spree.
Currency manipulation was one important distortion in the Chinese economy, but not the only. There is still a large state-enterprise sector in China that earns profits, but pays effectively no dividends to anyone. If firms were owned by households, then some of the profits would end up stimulating consumption; but in China those profits all end up as savings. For many years, Chinese state-owned enterprises (SOEs) largely deployed the savings in-country. But now, with problems of excess capacity emerging in many sectors, SOEs have turned outward and are on a global buying spree.
This creates a new set of problems for the United States and other advanced economies. First, this relates to the issue of the trade surplus. China shifted off the peg to the dollar in 2005, and over the past decade has allowed significant appreciation of its currency—about 20 percent against the dollar since 2005. The trade-weighted appreciation is more significant (above 40 percent) because the dollar has trended upward over the decade. As a result of this new currency policy, China stopped intervening in the foreign exchange market to accumulate reserves. In fact, for the past year China has been selling reserves to keep the value of its currency high. Its $4 trillion stockpile of reserves has declined to $3.1 trillion. In the face of this new currency policy, China’s trade surplus initially declined. But now it has started to rise again, and one factor is the shift of SOE investment outward. There are also net private outflows of capital, though it is hard to measure these exactly. The growing net capital outflow from China is threatening to take China’s trade surplus back to levels that pose problems for the global economy.
A second and related problem is that China’s policy towards foreign direct investment is highly asymmetric. China is now encouraging its firms to invest abroad in virtually all sectors. Meanwhile, according to an OECD measure of investment restrictiveness, China is the most closed of major economies. It is significantly less open than other emerging markets such as Brazil, India, Mexico, or South Africa.3 China is partially open in manufacturing, though important sectors such as motor vehicles have to operate through awkward 50-50 joint ventures that force global auto companies to pair with local partners. Most of the modern services sectors such as finance, telecom, media, and logistics are almost completely closed to foreign investment. Even in sectors that are ostensibly open, U.S. firms are often reluctant to invest in China because there is poor protection of their intellectual property rights, as well as property rights more generally. This creates an unlevel playing field in which Chinese firms can earn profits in a protected market at home and then buy their competitors in the United States and Europe. The Committee on Foreign Investment in the U.S. (CFIUS) can review mergers and acquisitions for their national security implications, but there are relatively few transactions that can be legitimately stopped on those grounds. In the past year the review process approved Chinese purchases of Smithfield and Syngenta (a Swiss agricultural chemical company with large U.S. operations).
China’s policy towards foreign direct investment is highly asymmetric
In addition to trade with China, America’s trade with other partners has also been called into question during the current election season. In particular, the North American Free Trade Agreement (NAFTA) has been castigated for costing U.S. manufacturing jobs—however, there is little evidence of this. The non-partisan Congressional Research Service, in its study “NAFTA at 20,” concluded: “NAFTA did not cause the huge job losses feared by the critics or the large economic gains predicted by supporters. The net overall effect of NAFTA on the U.S. economy appears to have been relatively modest.”4 NAFTA, unfortunately, was largely being implemented at the same time that China was entering the global economy, and effects on the U.S. economy from China trade were misattributed to NAFTA.
One reason that it is hard to find any net negative job effects of NAFTA is that trade between the United States, on the one hand, and Canada and Mexico on the other has been relatively balanced. The same point holds for the group of economies that have negotiated the Trans-Pacific Partnership (TPP): This group includes Canada and Mexico, as well as Japan and a total of 12 Asia-Pacific economies. China is not included. In 2014, the United States imported $750 billion of goods from these partners and exported a similar amount, $726 billion. In the same year, the United States imported $467 billion in goods from China, but only exported $124 billion. On average, TPP partners are also more open to investment than China’s economy. At the end of 2014, the United States had more than $1 trillion of foreign investment stock in the TPP partners, 15 times more than its paltry $67 billion of investment in China.
A final important piece of background is that the growth of the U.S. economy slowed significantly between the 1990s and the 2000s. It would be hard to attribute any significant part of the slowdown to China. While the large trade gap with China is annoying, it is still small compared to the U.S. economy: For example, the $467 billion of imports in 2014 represented less than 3 percent of the U.S. economy. The slowdown in U.S. growth can be attributed to a multitude of factors, including the aging population, under-investment in education, under-investment in infrastructure, and the financial crisis that emanated from Wall Street. And although the share of manufacturing in employment has been on a slow but steady decline since the 1950s, the share of manufacturing in GDP has been stable.5 This pattern reflects the relatively faster productivity growth in manufacturing compared to services. What distinguishes the 2000s from the 1990s is that overall employment growth has been so slow. In thinking about how to deal with China, there is a risk that that issue will distract from more important considerations about how to make U.S. output and employment grow more quickly.
POLICY OPTIONS FOR U.S.-CHINA TRADE AND INVESTMENT
The next president will want to shape a policy of “responsible hardball” with China—hardball, because China needs incentives to open up to the standards of other large emerging markets; responsible, because there are real risks that trade and investment restrictions will be either ineffective or counter-productive.
Restrictions on SOE investments. The new imbalance in the relationship is that Chinese state enterprises are buying their competitors in the United States and Europe, especially in high-tech sectors. U.S. firms are not allowed to make similar purchases in China because of China’s restrictions. The CFIUS review process, by statute, is focused narrowly on national security issues, not on broader issues of national interest or economic fairness. The United States and China have been negotiating a Bilateral Investment Treaty (BIT), and to be in the U.S. interest (not to mention to have any chance getting passed in Congress), the treaty should require China to open up virtually all of its economy to foreign investment. Interestingly, President Xi Jinping’s administration has prioritized this negotiation, but there is a lot of resistance from state enterprises and different parts of the government bureaucracy. Chinese technocrats hold out hope that an agreement can be reached before the end of the Obama administration, but frankly the Chinese offer seems a far cry from something that would be advantageous to the United States.
The next administration should consider legislation that restricts the ability of foreign state enterprises to invest in the United States, especially through mergers and acquisitions. It would be reasonable to have some exceptions—such as investments from countries with which the United States has investment agreements. This could be crafted to provide incentives for China to reach an investment agreement with the United States, as well as sensible protections for us in the meantime, given that investment negotiations could drag on for years.
Trade war with China. Republican presidential candidate Donald Trump has proposed a 45 percent tariff on imports from China. This idea is “irresponsible hardball” that will certainly backfire. Such tariffs would violate our commitments to the World Trade Organization, which we should not take lightly. Most important, Chinese leaders would definitely not buckle under such pressure. For one, exports to the United States are not that important to the Chinese economy anymore, and China’s leaders have many avenues to keep its economy growing. For another, China’s authoritarian leaders could not buckle to U.S. pressure without risking their hold on power. The population is nationalistic and its attitude towards the United States is quite ambivalent. A direct trade attack on China would certainly whip up popular support for retaliation. The retaliation would not have much direct effect on the U.S. economy, since we export so little to China. But it would create an uncertain environment for trade and investment that would slow U.S. growth.
If employing any heavy-handed protectionist move, the U.S. leadership would face a dilemma: target it only at China, or at developing countries more generally? If directed only at China, then production of labor-intensive manufactures is likely to shift to other developing countries; those jobs are not coming back to the United States. If the protection is aimed at all developing countries, then that really is a sea change in the global order. Developing countries have benefited enormously from the opportunity to specialize and use exports as an engine of growth. It is not a coincidence that this modern era of globalization has seen the most poverty reduction in human history. The United States garners considerable soft power around the world by being an open economy that absorbs imports from the developing world, as well as by leading global institutions such as the WTO and the International Monetary Fund. There would be a serious cost to turning our backs on that in pursuit of dubious economic benefits from punishing China’s mercantilist ways.
Trade remedies. While all-out trade war with China is not a good idea, there are tools the United States could deploy to address China’s WTO violations, as well as dumping or import surges that violate U.S. trade laws. Both Trump and his Democratic counterpart Hillary Clinton have stressed that they will use these measures to the fullest to make China play by the rules—but the Obama administration already does that. The administration has brought more WTO cases against China and has used trade remedies more than its predecessors. That is sensible, but in general China is following WTO rules, which do not set a very high standard. The distortions in China noted above—such as restricting foreign investment or maintaining a large state-enterprise sector—are not covered by WTO disciplines at all.
Still, using trade remedies is an important part of U.S. trade policy. One practical issue at the moment concerns China’s status as a non-market economy. When China joined the WTO in 2001, it agreed that for up to 15 years it could be treated as a non-market economy. The practical import is that in anti-dumping cases, the United States can look at costs in similar economies (such as Brazil) in determining whether Chinese exporters are selling below cost. The 15 years end in December, and China is expecting to receive market economy status—in fact, it may bring a WTO case against the United States if it does not. U.S. law has a definition of a market economy and, while somewhat subjective, a good case can be made that China does not meet the standard. In the current political environment, it is impossible to imagine that Congress would vote in favor of giving China market economy status.
Anti-dumping procedures are very relevant at the moment, because China has developed extremely large excess capacity in steel and other heavy sectors. The next administration should use market economy status as a bargaining chip to negotiate specific reductions in excess capacity, especially in steel. China would have a good case in the WTO if it chose that route, but a WTO case would take years and China is likely to prefer a negotiated settlement.
The main value of the (TPP) agreement in fact is strategic. Asia-Pacific partners are looking for U.S. leadership in maintaining and extending an open trading system with fair rules.
TPP as an incentive. It is ironic that China has given trade a bad name and that the negativity has spilled over to feelings about the TPP. As detailed in “The Trans-Pacific Partnership: The politics of openness and leadership in the Asia-Pacific,” this is a gold-standard agreement among like-minded countries with which the United States has relatively balanced trade (including both advanced economies and developing ones such as Vietnam, Mexico, and Peru). Because these are relatively open economies, the economic benefits of further opening are modest. By the same token, any adjustment costs in the United States are likely to be small. The main value of the agreement in fact is strategic. Asia-Pacific partners are looking for U.S. leadership in maintaining and extending an open trading system with fair rules. China is not one of the negotiating countries, and it would be hard for China to meet TPP standards because it would require the country to open up its trade and investment and adjust other regulations. We should hold out hope that China will one day aspire to meet these standards and join, but we should not hold our breath about China’s system changing quickly. If the TPP is implemented, South Korea and ASEAN members could be attracted to join. It has the potential to spur new supply chains among a group of countries that have to some extent harmonized their regulations on investment, environmental protection, and labor standards. The TPP could be a positive incentive for China to reform, but if the United States turns its back on the agreement, Asian economies will naturally adjust to a world in which the United States retreats from Asia, and China rises as the economic power in the region.
If the United States turns its back on the agreement, Asian economies will naturally adjust to a world in which the United States retreats from Asia, and China rises as the economic power in the region.
Name China as a currency manipulator. This option is truly fighting the last war (we could call it “irrelevant hardball”). In 2015, Congress wrote a formal definition of a currency manipulator: at its heart is the criterion that the country in question is intervening in the currency market accumulating foreign reserves. For much of the past decade, China would have met the criteria of this definition. But for at least a year now, China has been selling reserves to keep the value of its currency high, not low. It is hard to find economists or investors who think that that situation might turn around. To the contrary, there are plenty of investors betting that China will not be able to prevent the market from depreciating its currency. The underlying problem is the enormous savings rate in China. With diminishing investment opportunities, a vast amount of capital is trying to get out of the country. At this point, it is a mistake to focus any dialogue with China on the currency market; we should in fact be happy that China is intervening to keep its currency high, since a large Chinese depreciation would likely destabilize global financial markets. Just the hint of significant devaluation in August 2015 and again in December sent financial markets tumbling.
Focus the economic dialogue with China on the distortions that keep the savings rate high. The United States has a range of government-to-government dialogues with China. The most prominent, the Strategic and Economic Dialogue, has become too big and formal to be of much use. But certainly the United States will continue various dialogues at different levels. We should focus these economic dialogues on the distortions in China that keep the savings rate high—this is the fundamental problem behind a trade surplus that is large and growing. Some of the distortions are directly concerned with trade and investment. For example, consumption at China’s stage of development is mostly in services, but the service sectors are closed to foreign trade and investment. This results in markets with little competition, poor-quality service, and monopoly rents. Chinese people would benefit from opening these markets so that they had more choice, better quality, and lower prices. Other distortions are not directly related to international trade. The fact that so much of the economy is state-owned and that state-owned enterprises do not pay dividends to anyone is a good example. If the state collected significant dividends and used them to finance health, education, and pensions, this would reduce national savings and increase consumption.
Adjustment assistance. If China were to open up and reform, there would be many more export opportunities for U.S. firms and workers and more balanced trade between the world’s two biggest economies. Still, there will be winners and losers on each side. Expanded trade with China on a balanced basis would create a lot of jobs in the United States, but would lead to job losses in some sectors. The United States has done a poor job providing re-training and other support to workers and communities hurt by trade. (Or by technological change, which is actually more common.) To get the maximum benefit from trade and to maintain popular support for it, we need more extensive and effective adjustment assistance in the United States.