Key Issues in U.S.-China Economic Relations

The National Bureau of Asian Research is a non-partisan, independent research institute based in Seattle, with an office in Washington, DC. It conducts research on a variety of topics, and is launching an ambitious initiative called the Pacific Energy Summit, designed to examine the energy and environmental issues of the region.

China's rise is part of a broader trend toward the rising weight of Asia in the global economy. Together with the increasing financial resources available to oil-producing states, that is one of the key developments of recent years. The more enduring phenomenon is the rise of key emerging economies in Asia. In 1990, Asia accounted for 26% of global GDP on a purchasing power parity basis; now it is nearly 40%. China is now the third largest trading nation, and has displaced the United States as the top market for many of the key Asian economies. The European Union is also rising as a trade partner with Asia, which is contributing to the relative decline in the importance of the U.S. as a final market.

Asia is not only rising, but it is integrating more rapidly. Trade and investment flows within the region are burgeoning. Institutional development through bilateral and regional free trade agreements, and the intensification of existing institutions, can also be observed.

Looking at the financial importance of Asia within the global economy, a number of the key economies have very large current account surpluses. The regional current account surpluses are well over $2 trillion. China itself may be on track to achieve $2 trillion in foreign exchange reserves in the near future. As a result of these trends, the management of global macroeconomic imbalances now requires the active participation of key Asian economies, including China. Chinese policy alone has an increasingly important impact on the region and on the global economy. The very slow pace of appreciation of the Chinese currency has a major impact on the exchange rate policies of every other Asian country competing with China.

As a result not of U.S. failure but of Asian success, the U.S. has experienced a relative decline particularly China and India. For decades India underperformed, but looks set to sustain, perhaps, 7%-8% growth rates. The U.S. now has diminished ability to shape outcomes in the global economy. The Bretton Woods era is being eclipsed by the accelerating trend toward a multi-polar international economic system.

There is no question that the International Monetary Fund (IMF) has faced significant challenges in recent years. The IMF received a lot of criticism for its inability to quickly marshal the resources necessary to arrange bailout packages for stricken economies during the Asian financial crisis. In the years that have followed, the IMF has proven unable to build its resource base to a level commensurate with international financial flows. The IMF is increasingly unrepresentative of the global economy: the system has chronically underweighted emerging economies, specifically Asian ones, in its voting shares. It is very clear that European governments have little willingness to move more quickly to address this mismatch. Consequently, the IMF has been undermined.

Looking at the role of the G7 process in the management of global macroeconomic imbalances and the coordination of macroeconomic policies among the core economies in the global system, the G7 faces increasing challenges in accomplishing these core tasks given the current membership. Integrating China into the G7 would likely be a difficult process. The experience of Russia's participation in the G8 process is proof of the challenges that can be posed by a new member that may not share some of the policy views of the existing membership. Still, the G7 needs to think very hard about whether it is possible to achieve the core goals of that forum in the absence of Chinese membership. The question will likely also apply to India, although not in the near term.

It is very clear that the Doha Round of World Trade Organization (WTO) negotiations face many challenges in moving toward a successful conclusion. Much of the blame for that must lie at the feet of the EU, and to some extent at the feet of the U.S., given the impasse over agricultural policy issues. But the increasing importance of the emerging economies, the so-called BRICs (Brazil, Russia, India, and China) in the WTO process is a very significant complicating factor for the negotiations, particularly in that these players have often been unhelpful in terms of shaping the parameters of a final deal. China has repeatedly stated that as a recently acceded member it has no intention of making significant contributions to the successful conclusion to the Round. But China is now a core member of the international trading system. The idea that China can be a passive player in the Doha negotiations and that the WTO will still be able to move forward in a healthy fashion, is rather implausible. Given that much of China's economic growth and development has been predicated on its ability to participate in an open international trade environment, this appears to be a risky strategy for China.

Asia is increasingly seeking regional solutions. There have been a profusion of bilateral free trade agreements, as well as increased regional cooperation in the area of monetary policy. While the U.S. reacted with alarm to the Japanese proposal to create an Asian Monetary Fund in 1997, there has been significantly diminished sensitivity in Washington over the issue of multilateralization of the network of bilateral exchange swaps between Asian central banks taking place under the auspices of the ASEAN+3. With a total value nearing $80 billion, it is evolving into a multilateral financing mechanism that sounds increasingly like an Asian Monetary Fund.

With respect to U.S.-China economic relations, the Office of the U.S. Trade Representative has argued that we have entered a new phase of the bilateral relationship. The Bush administration has said publicly that China should be treated as a mature member of the international trading system, and will be held to account for its performance. That means that when China has not implemented its WTO commitments, it is entirely appropriate that the U.S. and other WTO members initiate dispute settlement actions against China. Consistent with this approach, the U.S. has now filed a series of WTO cases against China over the past several years.

The U.S. has consistently argued that China needs to reform its currency to make it a more fully market-responsive currency mechanism. The U.S. has also argued that China needs to undertake domestic financial sector reforms. First and foremost, China should do this out of its own economic interests. China increasingly faces the challenge of managing its macroeconomic growth trajectory, but its fixed exchange rate has reduced its ability to use monetary policy to regulate growth, increasing the risk of a boom-bust cycle. The unwillingness to allow faster currency appreciation has become an increasing problem for China in managing the rise of inflationary pressures. We are seeing faster appreciation today not because of pressure from overseas, but because China is beginning to realize that the administrative mechanisms to control domestic pressures in the economy are no longer effective, and that the exchange rate mechanism and freeing of monetary policy must be utilized. The U.S. has also pointed out that China, as an increasingly important player, needs to contribute to the adjustment of global macroeconomic imbalances. It is likely that the Chinese are going to continue to move relatively slowly on the exchange rate. The risk is that they will move too slowly and lose control over inflationary pressures.

Chinese outward investment is a relatively new issue. The U.S. has a very robust and effective mechanism to review the national security implications of foreign investment in the U.S. Regardless of that, there has been rising anxiety over foreign investment in the U.S. in recent years: it is in some ways similar to the concerns over rising Japanese investment during the 1980s and early-1990s, but is made much worse by the rise in overall economic anxiety in the U.S. and the fact that China is viewed as a future competitor. The establishment of China's sovereign wealth fund has caused anxiety in Europe as well. There is a significant risk of protectionism and a deterioration of the global investment climate that could damage the economic prospects of both developed and developing economies.

Intellectual property protection is a longstanding issue. Approximately 70% of pirated goods seized by U.S. Customs are from China. The U.S. has filed two related cases at the WTO; one focused on the level of thresholds for criminal prosecution of violations of IPR and the other on restrictions on market access for legitimate audio visual products and publications.

Industrial policy concerns also have a very high priority in U.S.-China relations. These include subsidies (tax rebates and other preferential tax treatment, below-market access to capital, and subsidized input prices), standards (mandatory national standards can have a very large impact on trade patterns when they exclude foreign products), discriminatory regulations, competition policy, and government procurement.

Another very important issue is the food, drug, and product safety issue. There are growing concerns over threats to human health from Chinese products, ranging from dog food to toys. China now understands that its global brand is under attack, and it is facing a severe problem of credibility. A significant change in Chinese attitudes is underway, and that is reflected in the signing of two memorandums of understanding (MOUs) between the U.S. and China on food, drug, and product safety at the last Strategic Economic Dialogue (SED) meeting. But in many ways it is an enforcement issue. Even if China develops a more robust regulatory system, it will still be necessary to continue progress in establishing the rule of law. This will likely be a long-term process.

It appears that there is an ongoing debate in China about what should be the core principles that guide economic policy. While it is a bit of an oversimplification to describe it in this way, it seems that there are some voices in this debate who are techno-globalists, who argue that China should further open itself to international investment and competition, while there are others we might characterize as techno-nationalists, who seek a very active industrial policy, including mandatory and restrictive national standards that will deny access to some foreign technologies that compete with homegrown technologies. It is difficult to say which group is more influential in shaping Chinese policy at present, but some Western observers are concerned that techno-nationalists may be on the ascendance.

China is now too big and too influential, for any one trading partner to dictate policy changes to it. China is very comfortable about saying "no" to the U.S. on a wide range of issues. The international community, in order to be effective in shaping China's behavior, needs to send clear and convincing signals about what actions China should take and why they are in China's own interest. The responsibility of other leading members of the international system is to help define what it means to be a responsible stakeholder in the international system, and to engage with China to reach consensus about what this means in terms of specific policy choices. U.S.-Japan cooperation can play an important and positive part in shaping what kind of role China will play in the international community. Of course domestic economic, political, and social change in China will be the predominant factor.

The U.S. and Japan need to make cooperating closely on the messages being sent to China a high priority. The process should be institutionalized. Common approaches should be sought on a variety of key trade and economic issues, because the U.S. and Japan have very similar interests.

Both capacity building efforts and messages need to be coordinated. This is a matter of helping China to become a cooperative global partner. But there will also be occasions when a very clear signal must be sent to China by all the leading members of the international system: this includes taking joint cases to the WTO. Too often, other states are free-riding on WTO cases brought by the U.S. against China.

Although it is likely to be extremely controversial, the U.S. and Japan should be open to the prospect of considering China as a future G7 member. Very careful consideration has to be given to whether the G7 can be effective without China's participation, given its growing weight in the international economy.

The leading members of the international system need to deepen economic cooperation and integration so that they serve as a more powerful model for the Asian region, and China. There has been a lack of ambition in the U.S.-Japan economic relationship, and more political capital and energy should have been invested in it. More work should be undertaken to determine which areas for cooperation have the greatest potential. Regarding the Asia-Pacific Economic Cooperation (APEC), APEC should be made a more robust institution to drive progress on economic issues. It is the only regional institution that brings together the U.S., Japan, and China.

Q: What are the prospects for a proposed U.S.-Japan-China trilateral meeting?

A: It is an interesting proposal, but one challenge is that these meetings can sometimes generate dissatisfaction among other regional players (such as South Korea, Australia, Russia, and the ASEAN countries) who are left out, and who may fear that the trilateral meeting is designed to create an agenda for the region.

Q: China's membership in the WTO did not satisfactorily change Chinese behavior in the international trade regime, so would membership of the G7 significantly change Chinese attitudes to international macroeconomic issues? What kind of downside will it have, and how can it be managed?

A: There is no question that there are a variety of concerns that have been raised by the U.S. and other countries about China's implementation of its WTO commitments in some areas. But it is also clear that China has made dramatic domestic reforms across nearly all sectors of the economy. So, while, there are still a number of areas where we have not seen the progress that was expected, I think it is hard to argue that the pace of economic reform in China would have been much slower if China had not been brought into the WTO system. Through WTO membership China has been socialized in many important respects and overall the WTO has been an important contributor to shaping China's development.

With respect to the G7, if one of the key priorities is to facilitate cooperation and the building of relationships of trust to manage threats to the global economy, leaving China on the outside looking in is going to become an increasingly untenable situation. If coordinated actions with respect to macroeconomic and exchange rate policies are to be successful, China's participation will be necessary. Why should China feel it has relationships of trust with the members of the G7 when it is not a G7 member? Bringing China into the G7 would just be a part of a longer-term process for building the multilateral mechanisms for cooperation with China on these kinds of key issues.

Q: Do you have some specific conditions for China's participation in the G7?

A: Formulation of benchmarks would certainly have to be part of the process of the consideration given to bringing China into the G7, and this would require the active participation of all of the current members.

Q: With the next U.S. administration, what kind of changes do you expect regarding U.S. policy on China?

A: It is very hard to know, frankly, because there has been surprisingly little discussion of China by any of the presidential candidates. The candidates need to come to grips with what their respective approaches to China will be. Senator Barack Obama has not said much on U.S. relations with Asian countries, and Senator John McCain has also not focused on Asia much to date. Senator Hillary Clinton has expressed some significant skepticism over the Bush administration's handling of China issues more broadly, has called for a tougher stance, and has been extremely critical of U.S. trade policy more generally.

With respect to trade and economic policy, China will be a very high priority issue for the next administration. China remains a central concern of the U.S. trade policy community. The American public has focused many of its anxieties about globalization on China. It will be critically important to effectively manage these key issues in U.S.-China economic relations. Expectations about what can be accomplished will also have to be managed carefully. Whether the next president decides to keep the SED or not, high level mechanisms to engage Chinese leadership will have to be put in place. Multilateral coordination with other developed economies will also be an important component of any effective China strategy.

It is going to be a very difficult period. China is increasingly focused on the challenges of the next phase of its development process. There was significant consensus for undertaking the reforms and liberalization required for WTO accession and implementation. But China now has significant domestic financial resources and many in the leadership appear to support a path of more selective liberalization. This will likely create new stresses for the U.S.-China economic relationship.

Q: Regarding the issues of food prices and global warming, what cooperation between the U.S. and Japan would you propose in order to change Chinese attitudes and policy?

A: With respect to food prices, it is not immediately apparent what policies might be most effective. It is certainly appropriate for the U.S. and Japan to emphasize the need for policies that are consistent with market mechanisms. Otherwise agricultural policies will not be successful in meeting rising demand over the medium and long term. That goes against some of the short-term political pressures that are being faced, particularly in Asia. It must be said that both Japan and the U.S. have their own respective agricultural policy issues with regard to protectionism and subsidies.

Regarding climate change, this is such a challenging subject and we are likely to have a very complex debate over the issues in the run up to the Conference of the Parties meeting in Copenhagen. But China is clearly a critical player, by dint of the dramatic rise in its energy demand and in its level of greenhouse gas emissions. China needs to participate in whatever the ultimate global post-Kyoto framework turns out to be. That means that China will have to be engaged with very closely in the process leading up to the agreement. The extent to which there is a convergence of views between the EU, the U.S., and Japan is unclear, but it clear that India and China have little appetite for taking on ambitious caps. Managing the growth of emissions is a challenge in the context of very rapid economic growth and relatively low per capita income in those two countries.

Q: What about the general U.S. climate on trade issues next year?

A: Frankly, it is a very worrisome situation for trade policy in the U.S. In recent years we have seen a steady deterioration of the base of support in Congress for open trade and investment. The pro-trade centrist wing of the Democratic Party has been in decline in recent years. Both Senators Obama and Clinton have expressed skepticism on trade issues. There has been a decline in support for trade in the Republican Party as well, although John McCain has been an outspoken advocate for free-trade policies.

This change is somewhat difficult to explain because the deterioration of support for trade occurred during a period when the U.S. experienced relatively high economic growth, although there was a slowdown in wage growth. There is a popular perception that the benefits of open trade are accruing to the holders of capital, rather than wage-earners. There is a general dissatisfaction with the kind of uncertainties that individual workers face with the rapid restructuring of the economy as well as a view that the government has failed to address these very legitimate concerns. As a result, Americans are less willing to support economic openness. For Americans to be more supportive of open trade, it may be necessary to shore up the social safety net through health care reform, more robust worker-retraining programs, and so forth.

It is very clear that the overall U.S. economy has benefited significantly from openness to the international economy, but giving people a complex lesson in economic theory as applied to the U.S. economy has not proven to be a winning political strategy. What is needed is a more realistic discussion of optimal economic policies and a more ambitious effort to take on the very tough task of reforming health care, social security, and other core domestic programs, but that is an agenda that takes a lot of political courage.