United States–China Ties: Reassessing the Economic Relationship

by Nicholas R. Lardy, Peterson Institute for International Economics

Testimony before the House Committee on International Relations
US House of Representatives
Washington, DC
October 21, 2003



Thank you very much Chairman Hyde for inviting me to appear before this House Committee on International Relations hearing on United States China economic ties.

Bilateral trade between China and the United States has grown rapidly in recent years. China is now our third largest trading partner. Firms located in China are now the second largest supplier of imports to the United States, having gone ahead of Japan in 2002 and Mexico this year. China is the sixth largest market for firms located in the United States. The United States is China's second largest trading partner. The United States has long been the single largest export market for firms located in China, taking over 30 percent of total exports produced in China. It has been a more modest supplier of imports, for reasons explained below.


Causes of the Bilateral Trade Imbalance

While bilateral economic ties between China and the United States are robust, they have been characterized for more than two decades by a growing bilateral trade imbalance. Initially the balance in China's favor was small. But in recent years it has grown substantially and now constitutes the largest single bilateral deficit of the United States. The principal cause of the growing imbalance is not the nature of China's exchange rate system or Chinese protectionist measures that keep out foreign goods. It is rather that China has become a leading location for the assembly of a broad range of manufactured goods, most of which previously were assembled elsewhere in Asia. The major parts and components that comprise these goods are purchased mainly from other Asian countries and the final goods are sold predominantly in North America and Europe. The vast majority of these goods are assembled by foreign firms that have relocated their assembly activities to China. It is no accident that as the U.S. bilateral deficit with China soared from US$10 billion in 1985 to over US$100 billion last year that the share of China's exports produced by foreign firms rose from 1 percent to 52 percent over exactly the same period.

As a result of China's emergence as a major base for foreign firms to assemble manufactured goods, China runs a trade surplus with the United States and Europe and a significant deficit with Asian countries. Its overall trade surplus, however, is quite modest. As measured by its current account, its surplus has averaged only 2 percent of gross domestic product since it pegged its currency to the U.S. dollar in 1994. This year, for reasons explained below, its current account surplus will be below 2 percent.

China's global pattern of trade—surpluses with the United States and Europe but deficits with most of its Asian neighbors—stems from several sources. First, and most importantly, it reflects Chinese policies welcoming foreign direct investment, particularly in manufacturing. Foreign firms by the end of the first half of 2003 had invested about US$480 billion in China, far and away the largest amount of foreign direct investment in any emerging market. A little over half of all this investment has been in the manufacturing sector. Not only does China place few restrictions on foreign ownership of manufacturing firms, through its tariff and other policies it allows foreign firms that produce for the export market to operate at international prices. Machinery and equipment that goes into foreign joint ventures and wholly foreign-owned firms is entirely exempt from import duties. And the foreign-sourced parts and components that are assembled into finished goods are also exempt from all import duties when they are reexported in the form of finished goods. Moreover, manufacturers are eligible for a rebate of almost all domestic valued-added taxes they have paid for any content in their exported goods that is sourced from within China. Combined with relatively low cost, high productivity labor, these policies have made China one of the most competitive global locations for the assembly of manufactured goods for export.

China's globally competitive position is clearly reflected in the pattern of U.S. imports. China, not South Korea and Taiwan as in the past, became in the early 1990s the single largest source of imported footwear in the United States market. China, not South Korea, Taiwan, and Hong Kong as was the case in earlier years, for more than a decade has been the single largest source of imported toys and sporting goods in the United States market. And China last year replaced Japan and Mexico as the largest single source of U.S. imports of consumer electronic products and information technology hardware such as computers.

The pattern of trade mentioned above, in which China runs trade surpluses with the United States and to a lesser extent the European Union while running trade deficits with its Asian neighbors, stems also from two additional factors. First, firms based in other Asian countries have undertaken the vast majority of foreign direct investment in China. Contrary to the common impression here, United States and European firms are relatively minor investors in China. Asian firms, notably those from Hong Kong, Taiwan, Korea, and Japan account for about 70 percent of China's inward foreign direct investment. Firms based in these countries tend to source their high valued added parts and components for their China operations from their home countries. As a result China, for example, last year ran a massive trade deficit of more than $25 billion in its trade with Taiwan. Two-thirds of China's imports from Taiwan last year consisted not of finished goods but of parts and components that subsequently were assembled in factories owned by Taiwan firms. The resulting final goods were exported into the global market, predominantly to the United States and Europe.

A second factor is that unlike other Asian firms that tend to use China as an export platform, most U.S. and European firms operating in China have invested there primarily to sell into the domestic market rather than to export. The best example would be Volkswagen, which has had a dominant share of the Chinese car market for over a decade. The output of Volkswagen's joint ventures in Shanghai and Changchun is sold entirely on the domestic market. Firms producing for the domestic market tend also to source their inputs largely on the domestic market rather than from their home countries.

In short, American and European investment in China is relatively modest and geared primarily to the domestic market. The investment of Asian firms in China is not only much larger but it tends to be directed to sales in North America and Europe. And these Asian firms source a large share of parts and components they use from their home countries. The combination of these factors creates the pattern of trade sketched earlier.

Finally, I would underline that China's large and growing bilateral surplus in its trade with the United States does not constitute evidence that China's trade practices are systematically protectionist. Yes, China does protect some specific sectors and products, at times in violation of its commitments to the World Trade Organization. But China is certainly one of the most open; perhaps the most open of all emerging market economies.

China's high degree of openness is reflected in several measures. First, its global imports have been growing at a prodigious rate in recent years. China's imports grew from US$53.4 billion in 1990 to US$295 billion last year, a growth rate of more than 15 percent annually. This year China's imports in the first nine months increased by 40 percent, more than double the rate of increase in the first nine months of 2002, and are on track to expand by well over US$100 billion for the year as a whole. China's global imports this year, which are likely to exceed $400 billion, will for the first time exceed those of Japan, making China the third largest importing nation in the world after only the United States and Germany. China's economic growth this year is exhibiting a distinct up tick. It is a measure of the relative openness of its economy that as economic growth has accelerated this year that Chinese import growth has accelerated at an even more rapid rate.

A second measure of China's economic openness is the ratio of its imports to gross domestic product, sometimes called the import ratio. China's import ratio increased from under 15 percent in 1990 to almost 25 percent last year. This year the ratio likely will reach 30 percent. Thirty percent is almost four times Japan's import ratio of 8 percent and twice the likely 14 percent import ratio for the US this year.

A third measure of China's openness is the degree of protection provided by its import tariffs. Even prior to the time China became a member of the World Trade Organization it had reduced its average import tariff rate by about three-quarters, from a peak of 55 percent in 1982 to 15 percent at the beginning of 2001. Today China's average import tariff is 11.5 percent and the average tariff on manufactured goods is only 10.3 percent. This, of course, is significantly higher than the tariff levels of the United States and other advanced industrial economies. But China's average tariff rate on imported manufactured goods is far lower than the rates prevailing in other large emerging markets. For example, when their Uruguay Round commitments are fully implemented in 2005 the average tariff on manufactured goods in Argentina will be 31 percent, in Brazil 27 percent, in India 32 percent, and in Indonesia 37 percent. China's current import tariff rate of 10.3 percent on manufactured goods is scheduled to drop to 9 percent by 2005, only one-quarter to one-third the rates that will prevail in these four countries.

In short by all three standards—the large size and rapid expansion of the volume of imports, the high and rising ratio of imports to gross domestic product, and the sharply declining and relatively low degree of tariff protection—China is a relatively open economy. That conclusion does not absolve China of its need to fully implement its WTO commitments. The Office of the United States Trade Representative and other U.S. government agencies should continue to press China to fulfill all of its trade commitments. While China's full compliance with its commitments could be quite important for some individual U.S. exporters, it is important to bear in mind that it is unlikely that full compliance would have a major impact on the bilateral deficit the United States has in its trade with China. That deficit is a function of the structural factors discussed above, not protectionism in China.


China's Exchange Rate

Is China's currency undervalued? If so what is the appropriate Chinese response? What difference would this response make to bilateral trade between the United States and China?

There is little doubt that the Chinese currency is undervalued. Since it pegged its currency to the dollar in 1994 China has had a current account surplus averaging two percent of its gross domestic product. And in the four years since the Asian financial crisis China has also had a capital account surplus of a little over 1 percent of gross domestic product. To keep the currency pegged at 8.28 yuan to the dollar China's authorities have had to purchase significant amounts of foreign exchange in recent years and reserves have risen accordingly.

The Chinese authorities, through their own recent actions, have implicitly admitted that the yuan is undervalued. To date they have chosen to try to reduce the pressure on the currency through a series of ad hoc measures, rather than making any change to their exchange rate regime. Just last week the government announced that it would reduce by an average of three percentage points the rate at which it rebates the value-added tax on products that are exported. That will tend to make Chinese exports more expensive in international markets. But, unlike an exchange rate change, this will have no effect on the relative price of imports. The authorities also have signaled an easing in the approval process for outward-bound foreign direct investment; liberalized outbound Chinese tourism; and allowed one domestic financial institution to issue dollar-denominated debt. They are contemplating allowing domestic insurance companies to purchase foreign-currency denominated financial assets; approving a qualified domestic institutional investor program that would allow Chinese, within carefully defined limits, to invest in securities traded on foreign markets; and so forth. All of these measures would tend to increase the demand for or reduce the supply of foreign exchange, which would contribute to a lessening of the build-up in official foreign exchange reserves.

The United States policy of encouraging China to adopt a more flexible exchange rate system is certainly appropriate as a long-term objective. The Chinese authorities over the years have repeatedly expressed the goal of moving toward a convertible currency and a more flexible exchange rate regime. There is no debate on the long-term desirability of such a policy.

In the short and medium run, however, a convertible currency and a floating exchange rate is not a viable option for China. Chinese households have more than ten trillion yuan deposited in savings accounts in the banking system. Very few Chinese savers have had any opportunity to diversify the currency composition of their financial savings. Eliminating capital controls could well lead to a substantial move into foreign-currency denominated financial assets, most likely held outside of Chinese banks. Given the well-known weaknesses of China's major banks, such a move could easily precipitate a domestic banking crisis. As a result, the authorities do not anticipate relaxing capital controls on household savings until they have addressed the solvency problems of the major state-owned banks.

My colleague at the Institute for International Economics, Morris Goldstein, and I recently have written two articles outlining the case for a revaluation of the Chinese currency. Our tentative judgment is that the currency is undervalued by an amount in the range of 15 to 25 percent. We believe that the currency should be revalued and at the same time the authorities should widen the band within which they permit market forces to determine the value of the currency and that at the new parity the Chinese currency should be pegged to a basket of currencies rather than pegged simply to the U.S. dollar. I have submitted these two articles, which appeared originally in the Financial Times and The Asian Wall Street Journal, for the record so will not repeat the case for revaluation here.

What difference would a revaluation of the yuan by 20 percent, the mid-point of our range, make to the bilateral trade relationship? A 20 percent revaluation of the yuan would reduce China's current account position by about US$40 billion, that is imports would increase and exports would contract by an amount summing to US$40billion. Since the U.S. accounts for somewhat less than one-quarter of China's trade, the expected reduction in the U.S. bilateral trade deficit with China would be under US$10 billion. Given the lags with which in the price effects of an exchange rate change work through the markets, the US$10 billion likely would be reflected in a slowdown in the rate at which the bilateral imbalance grows, rather than a reduction in the absolute size of the deficit.

The effect of a Chinese revaluation on the overall U.S. current account, however, is likely to be much larger than the influence on the bilateral trade balance alone. The reason is that China may be the key to a general realignment of Asian currencies. Given China's increasing competitiveness as a global exporter, Taiwan and South Korea, for example, have been reluctant to let their currencies appreciate. Instead they have been intervening in the market, adding substantially to their foreign exchange reserves to prevent their currencies from appreciating. China's revaluation could well be a catalyst for revaluation of the Taiwan dollar and the Korean won, as well as helping to sustain the recent appreciation of the yen vis-à-vis the U.S. dollar. The cumulative effect on the overall U.S. current account deficit of such a general realignment of Asian currencies in response to a 20 percent revaluation of the yuan would be several times the $10 billion estimated reduction in the U.S. bilateral trade deficit with China.

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