After the SED: Evaluating the U.S.-China Economic Relationship

Last month’s Strategic Economic Dialogue (SED) meeting between a cluster of Chinese cabinet ministers and their U.S. counterparts intensified the spotlight that has shone upon the bilateral economic relationship for the last several years. In the aftermath, the U.S. contingent presented a few trophy deliverables but largely praised the healthy exchange of views that had taken place. Congress, meanwhile, seethed at the continued lack of movement on the exchange rate and plotted new legislation to address the problem. One virtue of such summitry is that it presents an opportunity to take stock of a relationship. Before declaring the SED a success or failure, it is worth tallying up the successes and problems in Sino-American economic relations and then asking what role such a dialogue might play. To a large extent—due to the different way economists and politicians assess the same set of facts—the positive aspects of the relationship are economic while the negative aspects are political.

From a strictly economic perspective, both countries have enjoyed growth and relative prosperity in recent years. This is not solely due to the bilateral economic relationship, of course, but the relationship certainly played a role. In 2001, the year China acceded to the World Trade Organization (WTO), its imports to the United States were roughly $130 billion (in 2006 dollars). By 2006, Chinese exports had more than doubled to $328 billion [1]. Over this period, China has worked to implement the vast array of commitments to liberalize its economy that it made when it joined the WTO [2]. If this were a political tally, the fulfillment of those commitments would be recorded as a “plus” in the U.S. column. As an economic tally, China clearly benefits from the rationalization and reform that the changes bring. Among other benefits, they have helped draw a surge of foreign direct investment into the country. At a time when world FDI flows faltered, flows into China grew. One recent study estimated that foreign invested enterprises in China were responsible for over 40 percent of China’s remarkable recent economic growth [3].

China’s dramatic burst of exports to the United States has benefited both countries. This double-counting gets to the essence of why trade is not a zero-sum game. When U.S. consumers choose to purchase an inexpensive toy or microwave made in China rather than a less desirable one made elsewhere, they are demonstrating a very real benefit from bilateral commerce. If one were to adopt a more mercantilist view, however, in which benefits are derived from exports, the United States’ shipments of goods and services to China have grown almost as quickly as its imports, from $31 billion in 2001 to $72 billion in 2006. Given the lower base and slower growth rate, however, this has meant a widening bilateral trade deficit.

In general, there is no economic meaning to bilateral trade balances, but in the case of U.S.-China trade, the bilateral imbalance reflects imbalances that apply worldwide. The United States runs a large current account deficit with the world, and China runs a large surplus. The flip side of this trade imbalance is a savings and investment imbalance. The United States borrows a great deal from the rest of the world, and China is a major lender. In terms of the bilateral economic relationship, this imbalance has helped fund years of inexpensive credit that has benefited Americans through lower mortgage rates and cheap financing for business activity.

Amidst these positive aspects of the relationship, there remain important sources of economic concern. Poor Chinese protection of intellectual property rights is very problematic. State-directed credit flows in China have also had disruptive effects on world markets. The recent concerns about the health safety of China’s food and other product exports are serious (China Brief, May 30). Nevertheless, when assessing the state of the bilateral economic relationship, a key question must be asked: compared to what? Presumably, we are assessing the U.S. policy of openness and engagement. Of these major concerns, only the food and product safety problems would have been diminished under a less open approach. Moreover, even this issue may be temporary, since the Chinese either will likely find a means of regulating quality or will suffer severe reputational effects on world markets.

Thus, from a purely economic standpoint, the bilateral economic relationship has been broadly successful in recent years. To the extent that closer economic cooperation has facilitated cooperation on political and security issues such as North Korea’s pursuit of nuclear technology, this has been an important additional benefit.

Yet, this rosy assessment of Sino-American economic relations bears little resemblance to the heated and derogatory public discourse in the United States. There are a couple of reasons for this.

It is natural that when governments engage with one another, they focus on matters of public concern rather than wallow in self-congratulation. When the United States Trade Representative’s (USTR) office documents the state of China’s WTO compliance, it acknowledges that much of the focus will be on areas where U.S. firms or individuals have lodged complaints, rather than an exhaustive documentation of all that has gone well. When playing down commercial disputes between the United States and the European Union, for example, it is common for officials to emphasize what a small fraction of the trading relationship is being contested. The Sino-American economic relationship is different, though. Even if Administration officials were tempted to point out things that were going well, all but the bravest would be deterred by the Congressional outrage that would surely follow.

Both Congressional concern and the public sentiment it reflects have focused almost exclusively on the bilateral trade balance and the yuan-dollar exchange rate. The obsession with the bilateral trade balance is based upon two fallacies: the mercantilist belief that exports are good and imports are bad; and the belief that the bilateral balance is a natural indicator of a healthy economic relationship while imbalance must reflect foul play.

One way to describe the trade and financial flows of recent years is that China, a poor nation, has been making large loans to the United States, a wealthy nation. Those “loans” have ultimately been in the form of manufactured goods while the Chinese have received IOUs in exchange (e.g., U.S. treasury notes). While not a very sound policy for the Chinese, the United States has prospered.

It is certainly true that U.S. manufacturing employment has declined in past years, but this trend predates China’s emergence on the trading scene. Rather, China’s perceived culpability for U.S. manufacturing woes stems from a reorientation of trade in Asia. Manufactured products may now be produced and assembled across a number of countries but are listed as products of whichever country applies the finishing touches. Goods that were formerly finished elsewhere in Asia are now being completed in China. This is reflected in the trade data; China’s share of the U.S. trade deficit has soared while broader Asian measures that include China have held steady or declined. It is also an illustration of why bilateral balances are economically meaningless [4].

Yet, the U.S. trade imbalance with China continues to be a politically central issue, even when China enjoyed relatively balanced trade with the rest of the world. In the last several years, as China has piled up international reserves, the bilateral deficit has climbed dramatically. The popular culprit is the yuan-dollar exchange rate. While China began to allow some movement in the exchange rate beginning in the middle of 2005, that movement has been carefully controlled and limited (China Daily, October 18, 2005). China’s buildup of reserves is the best evidence that its exchange rate continues to be misaligned globally.

There are systemic reasons to be concerned about these imbalances, but the bilateral impact is far more political than economic. Even one of the strongest advocates of Chinese currency appreciation estimates that in a best-case scenario, a 25 percent appreciation of the yuan against the dollar accompanied by currency appreciation throughout Asia would result in a 20 percent reduction in the global U.S. current account deficit [5].

Nonetheless, exchange rate movement has virtually become the sole indicator of the health of the Sino-American economic relationship to many U.S. observers. The Strategic Economic Dialogue is judged a failure when China refuses to take bold action on its currency. At the conclusion of the recent meeting, the U.S. side did present classic “deliverables,” such as a new air services agreement for more passenger flights and air cargo and a tempering of China’s financial services barriers. Beyond this, participating Cabinet secretaries described numerous conversations on topics of mutual concern. These topics included the exchange rate but also precautions against pandemic influenza, cooperation on social safety nets, energy and the environment. None of this, however, won them plaudits from Congress.

In the standard political calculus of summitry, little credit is given for frank and open discussions. Yet, Treasury Secretary Henry Paulson has stated clearly that beyond short-term results, the SED is important for building confidence and improving the relationship over the longer term [6]. And though the cynical might view this as a way of lowering expectations, there are real differences in views between the United States and China on economic matters. These often involve issues in which the United States and China share ultimate goals—a cleaner environment and energy security are two examples—but have not settled on the means to achieve these goals. A healthy dialogue would seem to be a valuable way of overcoming these differences. The payoff will come only over a long period, though, and may be more likely to manifest itself in disputes that are avoided than in flashy new policy announcements.

In this light, the SED was successful as one step in laying the foundation for a stronger bilateral economic relationship in the future. Political impatience and misplaced priorities, however, may preclude any building on that foundation. Following the conclusion of the SED, bills were introduced in Congress to increase pressure on the Treasury Department to label China a currency manipulator. The Chinese have indicated that such bilateral pressure would be unwelcome.

Even before the SED in May, a number of new irritants emerged to threaten the economic relationship. On March 30, the Commerce Department announced that it would reverse its long-standing policy and permit countervailing duty cases against alleged Chinese subsidies [7]. After that precedent was changed, a number of cases have been filed challenging Chinese practices and requesting trade protection. Then in early April, USTR filed two World Trade Organization cases against Chinese intellectual property rights practices. Both of these actions addressed strong pressures from the Congress and both drew negative responses from the Chinese (People’s Daily, April 10). The negative response on the WTO cases was particularly noteworthy since China had earlier been very responsive to U.S. WTO filings. In this case, the Ministry of Commerce warned that the cases would “seriously damage” bilateral cooperation (Financial Times, April 10). This reaction seemed to come from a sense that the United States had abandoned dialogue and turned to litigation instead [8].

The United States would certainly benefit from greater protection of intellectual property in China and would likely benefit from fewer Chinese subsidies and an appreciated yuan. It is not at all clear, however, that the more confrontational approach being pushed by U.S. legislative leaders will deliver these benefits, and there is a risk that it will destabilize cooperation across a much broader range of issues. To the extent that this confrontational approach is inescapable and politics trumps economics, difficult times loom ahead for the Sino-American economic relationship.

Notes

1. Source: U.S. Department of Commerce, Bureau of Economic Analysis. Calculations used GDP deflator.

2. A selective account of progress toward those commitments is in the United States Trade Representative’s 2006 Report to Congress on China’s WTO Compliance, December 11, 2006.

3. Whalley, John and Xian Xin, “China and FDI,” May 3, 2007. Presented at the Brookings Trade Forum, Washington, DC.

4. See The Economic Report of the President, Washington: Government Printing Office, 2004, Chapters 2 and 11. Subsequent data is available from the Bureau of Economic Analysis website at https://bea.gov/index.htm.

5. Goldstein, Morris, “A (Lack of) Progress Report on China’s Exchange Rate Policies,” Peterson Institute Working Paper 07-5, June 2007, p. 8.

6. See Treasury Secretary Hank Paulson’s opening remarks at the SED, available online at: https://www.treasury.gov/press/releases/hp414.htm.

7. See Department of Commerce press release for the details of the Anti-Subsidy Law: https://www.commerce.gov/opa/press/Secretary_Gutierrez/2007_Releases/March/30_Gutierrez_China_Anti-subsidy_law_application_rls.html.

8. On the subtleties of this case see Philip I. Levy, “China and the WTO: Handle with Care,” Forbes.com, April 16, 2007.