RIETI Report June 2008

U.S.-China Relations - Developments, Prospects, and Risks

China's global role continues to expand, and its relationship with the United States is growing increasingly complex and presenting greater opportunities and risks. How will China's domestic developments affect its external policies? How will the U.S. and Chinese economies compete? How will the next U.S. president handle China? To answer these and other pressing questions, RIETI last month invited noted U.S.-China relations expert Dr. Harry Harding to the RIETI International Seminar, "The Future of U.S.-China Economic Relations." This month RIETI Report presents a summary of his presentation.

This month's featured article

U.S.-China Relations - Developments, Prospects, and Risks

Harry HARDING

University Professor of International Affairs, The George Washington University
Counselor and Chair, China Task Force, Eurasia Group

Before assuming his current position, Dr. Harding served as the Dean of the Elliott School of International Affairs and as Professor of International Affairs and Political Science at the George Washington University from 1995-2005. His areas of expertise include Chinese domestic politics, Chinese foreign policy, U.S.-China relations, and international relations in the Asia-Pacific region. He served on the faculties of Swarthmore College (1970-'71) and Stanford University (1971-'83), and was a Senior Fellow in the Foreign Policy Studies Program at the Brookings Institution (1983-'94). In 2005-'07, he was Director of Research and Analysis at Eurasia Group, a political risk research and consulting firm headquartered in New York, and he remains a Counselor to the firm and the Chair of its China Task Force. Dr. Harding is also a Visiting Fellow at the Asia Society Center on U.S.-China Relations. He received his Ph.D. and M.A. in political science from Stanford University and his B.A. in public and international affairs from Princeton University.

His major publications include The India-China Relationship: What the United States Needs to Know (with Francine Frankel, Columbia University Press, 2004); A Fragile Relationship: The United States and China Since 1972 (Brookings Institution Press, 1992); China's Second Revolution: Reform After Mao (Brookings Institution Press, 1987); and Organizing China: The Problem of Bureaucracy, 1949-1976 (Stanford University Press, 1981). Dr. Harding's first book, Organizing China, won the 1986 Masayoshi Ohira Memorial Prize, which honors outstanding books on subjects concerning the Pacific Rim.

May 28, 2008: RIETI International Seminar - Summary

"Assessing Risk in U.S.-China Relations: Trade, Investment, Climate Change"

Presentation by Professor Harry Harding

The 2006 report issued by the Eurasia Group's China Task Force was a comprehensive examination of the risk environment in China. The report identified 21 risks that might confront China itself, other governments, and multinational corporations. The "top risks," those with a high probability and a potentially high impact, were threefold: environmental disasters, an epidemic of acute communicable disease, and economic nationalism that results in "value destruction" for foreign firms.

In the 2007 report, three specific domestic risks were assessed. These were deemed in the 2006 report to be secondary risks, namely: a political crisis; inflation; and an economic hard landing. Attention was paid to the vulnerabilities that could make possible each of these risks, and the shocks that could trigger them. It was found that in each of these three cases, how government responded to the shock would make a big difference. The approach to analysis of each of these risks was to formulate three scenarios: a base case (the scenario believed to be the most likely to occur), a worse case with less favorable outcomes, and the worst plausible case. The base cases were found to be relatively benign, which reinforced the 2006 finding that these risks were secondary. The following were seen as having a 40%-60% chance of occurring: divided leadership with chronic localized protest; relatively short periods of high single-digit inflation; and short periods of slower growth focused in specific economic sectors. Looking back over the past year, the political crisis and inflation base cases have been playing out in China.

The China Task Force, when compiling its 2008 report, was asked to analyze three risks in the U.S.-China relationship: a confrontation over trade, conflict over investment flows, and controversy over climate change. For each risk, the three most likely scenarios were identified, and the implications charted.

In terms of vulnerabilities in the U.S.-China trade relationship, the basic problem is that there is a large and growing bilateral trade imbalance and mutual recriminations over responsibility. The U.S. argues that the Chinese have engaged in a variety of unfair trading practices, including the alleged undervaluation of the renminbi, the pursuit of various trade policies that reduce access to the Chinese market, and continued violations of intellectual property rights. Concerned first and foremost with the buoyancy of their labor market, the Chinese have resisted U.S. calls to appreciate their currency, even though it would ease inflationary pressures created by the chronic trade surplus that China is running. China is wary of rapid shock therapy of any sort and dramatic trade liberalization. The U.S. is resisting Chinese calls to relax export controls, though it has streamlined them. One of the big issues in 2007 was product safety cases: were such cases to be repeated, they could trigger unilateral action by the U.S. Gains by the Democrats in upcoming elections could lead to more U.S. protectionism.

But the U.S.-China trade relationship is also characterized by resilient factors. There is enormous economic interdependence between the two countries. A trade war is not in the interest of either side; powerful interests in both countries would suffer considerably, and therefore will resist unilateral actions. In any case, a variety of mechanisms exist for addressing trade issues: there are a number of bilateral trade dialogues, and the WTO dispute resolution mechanism. What is more, the Chinese are moving to some degree. There has been a significant appreciation of the renminbi over the past two years. At the same time, a cheaper U.S. dollar means that the export bill is increasing. The U.S. global trade deficit is beginning to stabilize and decline.

Taking all these factors into account, three scenarios were envisioned. The most likely one is "managed tensions" wherein tensions continue but do not lead to unilateral sanctions and counter-sanctions. In the near future, the U.S. is likely to use the WTO dispute resolute mechanism more aggressively, and will be looking for the support of Japan and the EU when pursuing complaints against China on issues such as barriers to market entry and continued violations of intellectual property rights. A less likely scenario is that of "reduced conflict," in which a declining U.S. trade deficit with China, an improved American global trade balance, and greater access to the Chinese market reduces tensions over bilateral trade issues. Under this scenario, it is possible that U.S. pressure for currency revaluation would shift from China to Japan. Another less likely scenario is that of "worsening trade battles": each side's concern for economic vitality leaves neither side willing to make compromises, leading to a reduction in U.S.-China trade. Under this scenario, some Japanese firms would see a competitive advantage; but other companies, especially those that produce in China and export to the U.S., could be caught in the crossfire.

Moving on, conflict over investment flows stems largely from growing Chinese economic nationalism that focuses on efforts by the government, with the backing of the Chinese people, to promote "national champions" and to capture more of the value chain. The Chinese have captured a very large percentage of the middle of that chain: the low-profit, low-valued-added part. Chinese economic nationalism works both inside and outside China: its advocates seek to promote national champions going abroad, and defend them against competition within China. Chinese outbound investment, too, is increasingly controversial, not only due to its competitive nature, but also because investments are being made in rogue regimes (such as Myanmar, Iran, and Sudan) and in strategic sectors in advanced economies. The U.S. has tightened the review process for incoming Chinese direct investment, which will be subject to special scrutiny, as part of its increasing investment protectionism. It is worth noting that there are no multilateral dispute resolution mechanisms that could mitigate any investment crises that might arise, though bilateral channels exist.

Just as with confrontation over trade, the resilient factor of economic interdependence carries weight in the context of conflict over investment flows. Powerful interests in both countries will suffer in the advent of an investment war, so they will press their governments not to go too far in imposing unilateral sanctions. Another resilient factor is that there are mutual perceptions of benefits from inbound foreign direct investment.

A Chinese bid for a sensitive or iconic American asset would constitute an unfavorable shock to this system, as would allegations in China that American firms are "doing too well" in their domestic market. Economic difficulties in either country would make incoming investment appear predatory, and diverging foreign policy objectives would make investment flows more sensitive. New protectionist leadership in either country would also be an unfavorable shock, but were economic leadership in China to become more liberal, a favorable trigger would result. Robust economic growth in both countries would also be favorable. The same would be true of an increase in cooperation on foreign policy issues, as this would reduce the sensitivity of investment issues.

Three scenarios were formulated for conflict over investment flows. The most likely was "continued standoff," in which existing limits are maintained but not elevated, with controversy surrounding specific regulatory decisions. If restrictions were to be targeted at American firms, then Japanese companies stand to benefit. A less likely scenario is that of a "deteriorating investment climate," in which stricter, more politicized across-the-board review and rejection of investment proposals are conducted, resulting in reductions in investment flows. Japan would suffer if restrictions were to be applied universally. A far less likely scenario is an "improvement in investment relations." This would entail mutual positive developments in legislation and regulation. In the extremely unlikely event that this scenario was to be realized, Japanese firms would benefit only if Chinese investment policy liberalization extended to include them.

Regarding the last of the three risks gauged in the 2008 report, some important shifts are underway in both the U.S. and China in relation to the controversy over climate change. In both countries there is growing concern about climate change, an increasing realization that the problem will grow worse unless action is taken, and a greater acknowledgement that each of the two countries is obliged to take measures to tackle climate change. The Chinese, in particular, are worried that they will suffer directly from the consequences of climate change.

Despite these shifts, there is a lack of consensus in each society over the severity of the problem and the most appropriate response. Currently, the focus in China is on energy efficiency, and there is no consensus on setting emission targets, let alone making them mandatory. Both China and the U.S. are waiting for the other side to act; there is still the sense that the other side is to blame for the problem. Even if a general framework were to be agreed, negotiating the details of the respective responsibilities would be difficult.

Further evidence of the effects of climate change will increase the willingness of China and the U.S. to act more constructively. Dialogue could produce agreement between the two countries on their "common but differentiated responsibilities." The trigger that everyone is waiting for is a technological breakthrough that makes mitigation of climate change both cheap and easy. Unfavorable shocks would include the possibility of the new U.S. leadership demanding further concessions from China, and disputes over implementation of agreements or targets. Economic difficulties in either country could make sacrificing growth or carrying out mitigation strategies less politically acceptable. What is more, differences on other issues make compromise more difficult, and may cause any agreement that is reached to break down.

On the controversy over climate change, three scenarios were envisaged. The most likely one is a "failure to agree" on a package, which might lead to the U.S. imposition of carbon tariffs, known as "border adjustment mechanisms," on imports from China. Japan would have to deal with the consequences of any "carbon trade war." A slightly less likely scenario is "orchestrated obstruction," a kind of negative cooperation in which the U.S. and China continue to agree to block the rest of the world's attempts to impose mandatory emission limitations on either country. In this scenario, Japan may find itself able to evade pressure for further emission reductions. The least likely scenario is a "collaborative push for a climate change regime," which would entail agreement on mandatory targets, financing, and technology transfer. Were this scenario to be realized, Japan would be expected to become even more efficient.

To summarize, the U.S.-China relationship is a very complex blend of vulnerability and resilience. That is why it is so difficult to come up with any clear, unequivocal forecast for the future of U.S.-China relations. The most likely scenarios involve moderate levels of risk: they are more or less continuations of the status quo. The least likely scenarios are the most optimistic ones.

Question and Answer Session

Q: Could you comment on the U.S. political context in which China-related issues are raised?

A: There is a range of views on China. No matter whether a Republican or a Democrat is elected as the next president, the opposition party will contain elements that are critical of China. In the past 30 years, a pattern has developed: candidates of both parties take positions critical of China during the election campaign, but upon assumption of office, they return policy on China to the previous mainstream. This enduring mainstream has three elements: the One-China policy toward Taiwan; a policy of comprehensive engagement with China; and the attempt to integrate China into the international community. In the past eight years this mainstream has shifted, becoming somewhat tougher on China, at least in tone. But in the presidential election campaign so far, China has been a secondary issue.

Q: Could you comment on U.S. public opinion on China?

A: The situation is hard to analyze right now. Until this February, U.S. public opinion toward China had shown a very clear trend of gradually improving attitudes toward the country, from the 1989 low. But in the past few months favorable opinion of China has declined, probably due to the issues of product safety and Tibet.

Q: Where do you see the overall U.S.-China relationship going?

A: Recent Taiwan Straits developments are positive, in the sense that the Taiwanese political spectrum has shifted dramatically in a moderate direction in terms of cross-strait relations. This will provide a better context for U.S.-China relations. Generally speaking, trends across a range of issues are either stable or improving.

Q: How are the Beijing Olympics likely to affect U.S. perceptions of China?

A: The Olympics will greatly influence how Americans view China, but the question is one of how well the event goes. The Olympics could prove to be a huge reputational disaster for China, for reasons such as air pollution and protests. If any particular event sparks controversy, emotions could be aroused in both the U.S. and China. Chinese nationalism is more of a worry than American nationalism.

Q: To what extent do you think changes in the political leadership may impact the economic relationship between the U.S. and China?

A: The U.S.-China economic relationship is at the same time both a stabilizing factor and a destabilizing factor. In international relations theory, economic interdependence is usually seen as a positive, stabilizing factor because it builds mutual relationships that neither side wants to disrupt. But we also know from the literature that issues are explained by relative gain. It is not whether both sides are benefiting but which side is benefiting more. The problem of the U.S.-China relationship is that both sides believe that the other side is benefiting more; maybe the U.S. thinks China is getting more on the trade side and China thinks the same way about the U.S. and the investment side. If their relationship deepens and expands, both factors will increase, which means that the U.S. and China will be more interdependent but there will be more mutual frustration. The changes in policy and perception addressing relative gains will determine whether the deepening relationship is going to be a stabilizing or destabilizing factor.

If a Democrat is elected president, the U.S. is likely to push more rigorous pursuit of its interests through the WTO, and the new administration may take a more critical look at FTAs, including both existing FTAs like NAFTA and the new FTAs under negotiation. However, I think the impact on U.S.-China trade relations will be relatively modest even if a Democrat is elected.

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