The rise of China at the dawn of the twenty-first century is not only about a flood of cheap imports, the decline of certain segments of the manufacturing sector in other countries, or the offshore transfer of jobs—as important as these trends are. It would be no exaggeration to say that China's rise is a watershed event that will change the global landscape and that is on par with the ascent of the United States of America as a global economic, political, and military power a century earlier. If current trends continue, China will surpass the U.S. to become the world's largest economy (in purchasing-power parity terms) in two decades—possibly sooner. Crossing this benchmark has little practical significance but will symbolize China's coming of age, from an economic backwater to an industrial powerhouse, and underpin its emergence as a world power. Even before this benchmark is crossed, China will become the dominant manufacturer and exporter in industries ranging from the labor intensive to the technology driven. It will also be a strong contender, though not yet a leader, in product lines associated with advanced technology and will start to play an important role in the higher end of the market. Chinese-made cars will become a common sight on American and European roads, sporting not only the familiar name brands of Ford and VW (which already sells Chinese-made cars in Australia) but also the marks of SAIC and Dongfeng Motors. Made-in-China regional jets will enter commercial aviation, and Chinese missions to space—while not leading edge—will cease to be a news item.
At stake are economic clout, global stature, and military prowess. Within a decade, China will become the hub for an east- and southeast-Asian market that will rival the economies of Europe and the Americas. It will be a broker and arbiter of global diplomatic affairs not only in Asia but the world over. Rising military prominence will allow China to counterbalance what it views as a Western-dominated world, redrawing the political and security map and turning what it sees as single player hegemony into a two- or three-player game. China will remain true to its nonexpansionist tradition, but will utilize its economic muscle in the service of a broader international and political agenda and vice versa.
The advance will not be linear. While no fan of Chairman Mao Zedong, I buy into his spring metaphor for progress—circuitous yet unequivocally pointed forward. In the coming years, China will need to transform its banking sector, diffuse a social security crisis, and respond to growing discontent on the part of laid-off and rural workers as well as other have-nots. Its leadership will walk a fine line between relaxing an autocratic political system and needing to retain effective control so as to maintain law and order and one-party rule. Fears of unemployment and resulting unrest will continue to feed its export engine, but the same fears may work to avert a trade war. To manage this acrobatic feat, China will put a premium on building and sustaining global and domestic coalitions with vested interest in open trade—for instance, enlisting foreign manufacturers who are dependent on the Chinese market for exports, production inputs, and assembly, as well as the large retailers for whom it has become a key business model ingredient.
The China impact is already visible in the form of pricing, from deflationary pressures at the retail level to inflationary pressures on raw materials and logistics. In retail, Chinese imports are squeezing the margins of all but the largest players and forcing smaller fries that lack a sophisticated supply chain out of the water. This is now apparent in product lines where China dominates (such as toys), where the likes of Wal-Mart are squeezing both small and large dedicated players. At the same time, Chinese demand is exerting upward pressures on the prices of copper, titanium, nickel, rubber, iron ore, steel, coal, and oil, and even cardboard, among other materials. The price of scrap steel—a key raw material for many U.S. producers that is now imported en masse by Chinese buyers—is skyrocketing, up by more than one-third just in the first quarter of 2004.
Immediate impacts aside, the aftershocks from the China impact will reverberate for years even if they are under the radar for now since they take time to evolve, are less visible, or are more difficult to discern because they involve multiple variables of which the China impact is only one. One example is the impact on pollution and global warming; another is the integration of the Asian economy with China at its hub. Still another example is a fundamental shift in global immigration flows. The China impact is therefore not a one-two punch, but rather a gradual restructuring of economy, business, and politics that will play for years and decades to come.
Playing down the economic impact of China's ascent on the U.S. and other developed economies, economists have repeatedly posited the analogy that America's transition from an industrial to a service economy is—in essence—a repeat of its shift a century earlier from an agricultural to an industrial economy. The analogy—used, for instance, by former labor secretary Robert Reich in a Wall Street Journal essay[1]—implies that the exit from multiple segments of the manufacturing sector represents a natural evolution of an economy that is ahead on the evolution curve and implies that the new companies and new jobs created as a result of the transition will be more plentiful, better endowed, and higher paying than those lost in the reshuffling. Manufacturing employment will decline, but industrial output will be diverted toward ever-higher-end technologies and products. In the meantime, just as investment shifted from agriculture to manufacturing, an increasing portion of capital and human resources will be redeployed in the service sector.
Analogies are comforting. They reduce our uncertainty about the future and provide the reassurance of “been there, done that.” Unfortunately, analogies can also be misleading and this one is no exception. The shift from an agricultural to a manufacturing economy was the result of strong productivity gains anchored in technological improvements in machinery and fertilizers; it was not accelerated by trade competition because the world was not as globally integrated as it is today. The agricultural sector was (and, to a considerable extent, remains) protected, and logistics were less developed and more expensive. The reduction in agricultural employment did not result in the loss of production capacity and capabilities. Producers did not leave the country to grow their crops elsewhere, and workers (by-and-large) transited into higher-paying (though probably more alienating) jobs. While the shift to services is associated with productivity gains, it is also taking place in a relatively open global market with trade playing an important—though, by no means, exclusive—role. Displaced employees are driven, on average, to lower-paying jobs.
Although U.S. industrial output remains strong, there is no guarantee that it will be sustained into the future. The implications may be far reaching: “Experience has taught me that manufactures are now as necessary to our independence as to our comfort,” wrote Thomas Jefferson in an 1816 letter to Benjamin Austin.[2] The words still ring true today and national security, while pivotal, may not be the only consideration. No less important is the possibility that the wholesale exit from mainline manufacturing activities will endanger (in the long range) the main competitive advantage of the U.S., namely its technological know-how and its ability to innovate. Already compromised by China's failure thus far to offer proper protection and compensation for intellectual property rights, erosion in technological capabilities will have ominous ramifications for the U.S. competitive position.
American advances in agricultural machinery were possible, among other reasons, because the country remained a major agricultural producer. This created demand and provided a testing ground for new inventions, many of which were later extended to industry. Today, the manufacturing sector fulfills the role of an innovation springboard and engine. According to the Institute of Electrical and Electronic Engineers (IEEE), manufacturing accounts for 62 percent of the research and development conducted in the U.S. (not to mention the bulk of its exports). Can such a feat be repeated when the agglomeration effect of multiple domestic competitors and supporting industries is gone? It is not clear that it can, and neither is it evident that the service sector can pick up the slack; after all, we have no precedent of a major economy that is predominantly dependent on services (the survival of Luxembourg, Hong Kong, and Hawaii as service economies—not without pain—can at least be partially attributed to their small size). It is also useful to recall that the forecasting record of economists, who promise us a replay of past patterns, isn't exactly stellar. The truth is, we are dealing with terra incognita.
In the same vein, it should not be taken for granted that it is possible to retain high-end manufacturing and research work at home while outsourcing other manufacturing activities. It is naïve to assume that China, or any other nation for that matter, will accept such a division of labor in the long run. In fact, all indications are that it won't. Exhibit 9-1 shows that while the U.S. high-technology exports have been on the increase, so have China's; the trend is likely to not only continue, but also accelerate. In fact, in the first quarter of 2004, China's high-tech exports were up more than 67 percent from a year earlier, according to China's Ministry of Commerce. While it is true that China-based foreign multinationals account for the bulk (75 to 85 percent, according to some estimates) of its high-tech exports and that much of the technology used by Chinese firms is not exactly leading-edge, the level of technology transfer to Chinese players—whether wittingly or not—is unprecedented. It would be imprudent to believe that China cannot eventually catch up with the West as it did over a millennium ago or as the U.S. did a century ago when it passed over the old world to become the world's leading economic power.
Source: World Bank, World Development Indicators, 2002.
Figure 9-1. High-Technology Exports of the U.S. and China
China's R&D investment remains modest as a proportion of gross domestic product (GDP), though the growth in the Chinese economy means that the same proportion now buys much more. To compensate, China continues to provide preferences to foreign investment involving technology transfer and turns a blind eye to the free ride many of its firms enjoy as a result of lax intellectual property protection. Overall, as Exhibit 9-2 illustrates, China's payments for technology are very low but the numbers are skewed downward by technology transfer within multinational firms and by many Chinese producers avoiding payments for technology rights. Exhibit 9-2 also shows that though U.S. receipts for technology increased three fold from the 1980s to the 1990s, its technology payments have also been rising—a reminder that the nation does not have monopoly over new technology and innovation that some observers imply. The IEEE notes that China ranks second only to the U.S. in publishing technical papers in nanoscience and nanotechnology, and while the Chinese have been weak in bringing innovations to market, they are working hard on improving this handicap. Whether and how soon China will become a major innovation source remains to be seen, but it would be unwise to rule out the possibility. The country's firms have the ambition and determination and (increasingly) have the capital, human resources, and scale of operations to get them there.
Source: World Bank, World Development Indicators, 2002.
Figure 9-2. Royalty and License Fee Payments and Receipts for the U.S. and China
The video recorder, the industrial robot, and many other technological developments should remind us that invention and patenting do not guarantee commercial production, return on investment, or market dominance. Is the U.S. moving on to bigger and better things or is it simply giving away its technological edge by being overly transparent, selling too cheaply, transferring too easily, and allowing rampant copying without compensation or recourse? China is now receiving, copying, and assembling technology but it is clearly aiming at the most valuable type of know-how—the ability to create new knowledge and technology. In that, China is no different than Japan and the tigers, except that it has an historical record of innate innovation and that is building a formidable structure to do so. Surely, Britons were skeptical of the American ability to catch up with its know-how centuries ago; should we not consider the possibility that China will catch up with us one day?
Many assessments on how China's impact will play out use the country's entry into the World Trade Organization (WTO) as an indicator of things to come. They see enhanced transparency, an open regulatory climate, and fortified protection of intellectual property rights augmenting opportunities for global exporters and investors in China's domestic market and otherwise leveling the playing field. Skeptics, in contrast, question whether the country will comply with the letter and spirit of its WTO accession agreements or rather find ways to avoid their full impact whenever perceived to be adverse to its domestic interests.
The record so far has been uneven. Side by side with considerable progress in some areas, violations—both fragrant and subtle—are abundant. A December 2003 report to Congress dedicated to China's WTO compliance asserted that while the country lived up to many of its WTO accession commitments, mostly in the areas of tariff reduction (for instance in chemicals, which resulted in a significant boost to U.S. exports), “in a number of different sectors, including some sectors of economic importance to the U.S., China fell far short of implementing its WTO commitments, offsetting many of the gains made in other areas….” The report goes on to cite agriculture, services, intellectual property rights, and transparency as problem areas already singled out in the 2002 report—all of which remain a concern today. The report concludes that, “China's uneven and incomplete WTO compliance record can no longer be attributed to start-up problems.”[3]
The report paints a picture of systematic discrimination against foreign competitors. China is alleged to hand in subsidies to domestic producers who use them to lower prices in China as well as in global markets for goods ranging from machinery and petrochemicals to biomedicine. In other areas (such as semiconductors and fertilizers), value added tax (VAT) rebates are handed to domestic but not to foreign producers. On January 1, 2004, China reduced rebates on the exports of its domestic manufacturers (typically from 17 to 13 percent) but retained them for key lines such as automotive components. Many domestic producers pay much less since the declared value, which serves as a basis for the rebate, can be easily manipulated; others don't pay at all, benefiting from a chaotic environment or from protective local jurisdictions that are invested in the enterprise or are fearful of unemployment and unrest should local firms become less competitive.
Domestic players also receive preferences on consumption tax rates as well as on trading and distribution rights. WTO commitments regarding wholesaling services and commission agents' services provided by foreign firms were fulfilled to the extent that they relate to made-in-China products but not to imports. A variety of nontariff barriers (such as administrative guidance) keep foreign competitors out while the export of raw materials and intermediate products that support the competitiveness of domestic producers is curbed. China is also formulating unique standards in areas where international standards already exist, though it is certainly not the first country to do so. Foreign firms that wish to enter the Chinese retail sector face a myriad of regulatory approvals from which local players are exempt, and are denied majority control—except if they demonstrate, among other conditions, that they have purchased large amounts of Chinese goods.
Crucially, technology transfer continues to be used as a condition for investment approval or for the meting of incentives. China managed to escape an explicit clause banning all forms of such a tie-up when negotiating its WTO accession agreement, a risky concession on the part of foreign negotiators, though the link appears to be challenged in certain parts of the agreement. Many problems also continue in services, an area where the U.S. has a strong competitive advantage. All in all, this picture raises serious questions about the prospects of a sharp increase in U.S. exports to China at a pace sufficient to counterbalance projected growth in Chinese imports.
Forecasting the future is a tall task under any circumstances, and more so when the subject is a country of which it was once said: “The only thing certain about China is uncertainty.” The subject of the China impact is complex and emotionally charged. It is multifaceted, involving multiple constituencies in different countries, with divergent interests, and whose actions cannot always be predicted. Future scenarios regarding the course of U.S.–China trade are hence difficult to draw, though it is possible to specify a range: from the optimistic soft landing, where China's trade surplus gradually declines as labor and material costs rise and the country fails to catch up with strong U.S. productivity and technology gains, to the less appealing scenario where an economically belligerent China—desperate to create jobs at home—encounters a rising protectionist sentiment in the U.S. and in other international markets, bringing the global economy down in the process.
Exhibit 9-3 shows alternative U.S.–China trade scenarios in 2008, calculated by the National Association of Manufacturers (NAM). The data show that if Chinese imports were to grow by 10 percent per year, a rather modest projection, the U.S. would need to increase exports by at least 25 percent annually in order to make a dent in the trade imbalance. This is not impossible: China is already the U.S.' fastest-growing export market and export growth in 2003 was well above that level. The question is whether that pace is sustainable given global competition and continuous preferences for domestic firms. Furthermore, even if U.S. exports were to sustain this rapid export pace, the growth of Chinese imports would have to fall to under 10 percent in order for the trade deficit to shrink; this too is unlikely. The NAM projections for 20 percent annual growth may be understated even under a currency revaluation scenario.
Source: National Association of Manufacturers, 2003.
Figure 9-3. Projected Changes in U.S. Trade Deficits with China in 2008 (in Billions of U.S. Dollars): Alternative Scenarios
The soft-landing scenario is based on the predominant economic view of China as one more link in the natural evolution of international trade. Over time, Chinese wages will rise to a point where the country is no longer competitive in labor-intensive industries and thus vacate its position to Vietnam, Bangladesh, and others. China will channel more resources into its lagging service sector, relieving the intense pressure to attract more manufacturing capacity. The optimistic scenario calls for a gradual change in the exchange rate (there are signs that the Chinese government is considering this, to tame budding inflation, anyway) coupled with Chinese market-opening measures and a phase out of subsidies and other barriers that stack the cards against the foreign competitor. A real crackdown on piracy, motivated by both international pressure and Chinese interest in protecting domestic innovation, will restore the market share of U.S. and other country multinationals. In this scenario, China will also make a serious effort to buy American that—given the considerable power the government still holds—will lead to a rapid and sustained increase in U.S. exports focusing on big-ticket items such as aircraft. The trade deficit will shrink, alleviating protectionist pressures in a restructured U.S. economy that will produce more jobs.
There are a number of problems with the soft-landing scenario. It assumes that U.S. manufacturers in the low- and mid-technology segments will quickly climb to higher-end, high-technology production. The problem is that U.S. firms will not be the only ones trying to move up the ladder as a way of escaping vicious competition at the bottom. With other contenders—including China—vying for high value-added production, life at the top will get pretty crowded. The soft-landing scenario also assumes that the Chinese government will be willing and able to take on local interests that protect piracy and market manipulation, something the government has been reluctant to do in the past, and that the employment situation in China will stabilize to a point where export growth can be relaxed. It should also be noted that the soft-landing scenario, by definition, will play out over the long term. By the time it is consummated, China will have become much more efficient at directing capital and human resources and hence will have become a more formidable competitor.
The hard-landing scenario sees a looming crisis between China and the U.S. that culminates in a clash with economic, political, and national security undercurrents. Pressured by continuous job losses in the manufacturing sector, the administration and/or Congress will undertake tariff or other protectionist measures—this time moving beyond WTO approved quotas on bras, robes, and knitted fabrics to cover such goods as automotive components, appliances, and other products with industry constituents who can muster enough political support. Union constituencies will continue to attack Chinese infringement of human rights but will invoke fair trade and reciprocity rather than protectionism. They may borrow a page from Tench Cox, who in a 1787 speech to the Pennsylvania Society for the Encouragement of Manufactures and Useful Arts said, “We must carefully examine the conduct of other countries in order to possess ourselves of their methods of encouraging manufactories and pursue such of them as apply to our situation, so far as it may be in our power.”[4]
China will continue to defend its domestic industry, adding strong antidumping measures to its stable of subsidies and other market protections while continuing its strong defense of domestic players in trade disputes (China is known to transfer foreign filing information to domestic parties named in the complaint, providing them with judicial ammunition and commercial advantage). At the same time, it will mount aggressive defense toward antidumping investigations abroad. China will follow the U.S. (who was the first nation to appeal to the WTO on a China-related matter) and launch its own appeals in the trade body. Case merits notwithstanding, the U.S. will not get much sympathy. Asia (which, as a whole, enjoys a considerable trade surplus with China) and Europe (which has a relatively small deficit) are unlikely to back an aggressive stand on Chinese violations. World public opinion may not help either: surprising to many Americans, many view the U.S. as the unfair trader. In a survey by Transparency International, a nonprofit, 58 percent of respondents ranked the U.S. government as most likely to use political pressure such as tied foreign aid to gain an unfair advantage in international markets. Number two, France, received only 26 percent. China ranked fifth, with only 16 percent of the sample believing it was using unfair advantage. Taiwan and Hong Kong received 5 and 1 percent, respectively.
Feeling increasingly isolated, the U.S. will turn inward, tuning to domestic currents rather than to international trade partners. From there, the situation may quickly deteriorate. Under increased pressure from unions and small manufacturers, the U.S. government will undertake unilateral measures (such as punitive tariffs) to protect its industry outside the WTO framework, threatening the global trade system. China will then dump its enormous dollar reserves, bringing about a dollar crash and a global financial meltdown.
Such a scenario is possible but unlikely. The report to Congress on China's WTO compliance notes that: “China has sought to deflect attention from its inadequate implementation of required systemic changes by managing trade in such a way as to temporarily increase affected imports from vocal trading partners, such as the U.S.” Indeed, with the U.S. media and politicians increasingly criticizing China for its trade surplus in late 2003, the Chinese prepared a shopping mission to the U.S. but later scrapped it in reaction to the tariffs imposed on some apparel imports. To diffuse trade tensions, China will revalue the Yuan by a modest percentage—enough to placate the critics who have zeroed in on this issue, but hardly enough to make a difference in all but the most tightly contested product lines. Some Chinese firms will follow Haier and start U.S. manufacturing, but given wage and material cost differences, it will be a far cry from the scale of Japanese investment twenty-years ago.
A doomsday scenario is more likely to be triggered by internal Chinese problems that will then spill into the outside world. China faces a number of serious risks: Its financial system is close to insolvency and if the government were to lose its ability to prop it up, it could implode. A decline in the growth rate could send an already high unemployment rate into the stratosphere at a time when the social safety net is still nascent. Inequality between the coast and the hinterland and between the rich and the poor is growing by the day, which increases resentment and further erodes the fragile legitimacy of the Communist regime. In this environment, a trigger in the form of a steep and sudden revaluation could ignite social unrest and set off a violent reaction. A fall in domestic demand will then cause China to dump its enormous capacity in world markets and, given global overcapacity in many industries, the impact will be devastating. Foreign competitors will be pushed to sell at a loss, governments will set emergency tariffs, and exports will chase fewer and fewer open markets. The end result will be global depression on a scale not seen since the 1930s.
A quarter of a century ago, U.S. car makers successfully lobbied the government to set “voluntary” quotas on Japanese-care imports. Today, this is unlikely to happen. The industries that are being hit hard (such as apparel and furniture) are much more fragmented, and many of their manufacturers and retailers are as dependent on Chinese inputs as the Chinese are on U.S. exports. Indeed, there is as much lobbying today to protect free trade (including Chinese imports and outsourcing) as to limit the flow of imports and outsourcing. The newly formed pro-trade Coalition for Economic Growth and American Jobs includes not only the expected Chamber of Commerce and trade groups, but also the National Association of Manufacturers. The coalition has set as its goal the defeat of legislation limiting outsourcing by U.S. government entities and is seeking to preserve the current number of work visas issued to foreign skilled employees. The U.S.–China Business Council, which includes some of the biggest exporters to China, has been also working hard to oppose any limitations on the flow of Chinese goods. With such strong internal support, it is no wonder China can afford to spend less than desolate Malawi on paid U.S. lobbyists.[5]
The battle lines drawn in the China debate may signal a permanent shift in the U.S. political landscape. Small manufacturers who are not adapt at outsourcing and lack global capabilities find themselves at odds with their big brothers who are relying on China for components and assembly. Unions are faced with more determined management who can threaten to walk away and offshore the operation, and will continue to lose ground as they rehash the old but ineffective China bashing on human rights. Individual voters find themselves embroiled in an internal conflict—their roles as employees, consumers, and shareholders stretch across the two sides of the debate: As consumers, they benefit from cheap Chinese products; as shareholders, they benefit from the profitability of China outsourcing; as employees, they are concerned with their jobs and with their ability to find new jobs in declining industries even if mitigated by the promise of renewed growth in a restructured economy.
In the U.S., states that are more dependent on China manufacturing are more likely to oppose limitations on China's exports, especially if they are not likely to lose many jobs as a result of Chinese imports. An example is the state of Washington, for whom China represents more than 11 percent of its total exports (see Exhibit 9-4) while its projected job losses from China trade (at about 7,000 according to the Economic Policy Institute) are among the lowest in the country. Southern states that are about to lose employment in mills and garment factories will see less benefit in an open trade with China, and so will Midwest states. China does not currently represent a big export market for the Midwest (except in agriculture), but employment losses from Chinese imports in the manufacturing sector—which are disproportionably represented there—are quite substantial. Hence, the China factor may create yet more schisms between the coasts and the hinterland, weaving it into the emerging political map. Similar phenomena will be observed in other countries where regions relying on labor-intensive or mid-technology industries find themselves on the opposite side of the table from those relying on agriculture or services who hope to benefit from the China trade.
Outside the U.S., a crucial impact of China's rise will be the declining fortunes of the many developing economies that find it difficult to compete with China on exports and foreign investment. Nations that rely on labor-intensive industries (such as Egypt, Bangladesh, Sri Lanka, and many Central American and Caribbean countries), apparel in particular, will be especially hard hit since they have no substitute for those export industries. The result may be a sharper North–South divide, an ironic consequence given China's once championship of third-world causes. Pressured by Chinese competition in their most lucrative market, Latin American nations led by Mexico (which is seeing some of its hard won NAFTA benefits melt away) will press the U.S. to limit Chinese imports. These nations will invoke their traditional alliance of the Americas and will solicit the help of southern states such as North Carolina who have been the traditional suppliers to Central American clothing plants.
If Mexico and its southern neighbors were to continue to lose manufacturing jobs, illegal immigration to the U.S. would rise—but this time there would be fewer employment opportunities for the newly arrived. While agriculture, meatpacking, construction, and the restaurant trade will pick up some slack, it may not be enough to compensate for disappearing jobs in textile, apparel, carpet weaving, and simple manufacturing. In textile and apparel alone, the U.S. will likely lose at least half of its one-million current jobs, many of them staffed by first or second generation immigrants. Even agricultural jobs are not immune as Chinese produce exports grow (China is already an exporter of corn), though more jobs will likely be created at least in the short range as a result of increased agricultural exports to China.
Obstacles notwithstanding, the twenty-first century will see China restore its namesake as the Middle Kingdom. An industrial, commercial, and political hub, it will reach beyond East Asia—its traditional sphere of influence—first into Central and Southeast Asia and then into the world beyond, where it is destined to become one of two or three key players. It is only a matter of time (for instance) before China becomes closely involved in the Middle East, whose oil reserves it increasingly covets, or takes the lead in helping Africa out of its economic quagmire. Rather than being a guiding light for the “barbarians” surrounding it, China—this time around—will become a leading force in a competitive and interdependent world. As such, China may rewrite some of the same rules that other countries now expect it to abide by—whether on property rights or on international trade—challenging nations, firms, and individuals to adjust their business models and expectations. The massive movement of production factors that China is triggering may not only turn our economic theories and political assumptions on their head, but will also test fundamental threads in our society. How the coming challenge is handled will define much of the world our children will inherit.