U.S.-China trade: Implications of U.S.-Asia-Pacific trade and investment trends
Statement to the U.S. International Trade Commission
By Peter Morici
My name is Peter Morici. I am an economist and Professor of Business at the University of Maryland. Thank you for this opportunity to participate in these hearings. I wish to devote my remarks to developments in China and how those affect the growth and structure of the U.S. economy.
Chinese Industrial and Trade Policies
Since economic reforms began in the late 1970s, China has enjoyed dramatic growth and modernization. Important structural changes have included a much greater role for town and village enterprises, private businesses and foreign-invested enterprises, and a smaller, though still major, role for large state-owned enterprises. Exports, in particular exports to the United States, have played a key role in driving growth.
China has sought to foster industrialization through both export driven growth and import substitution. Growth in these sectors has been accomplished, to some extent, by sacrificing progress in domestically oriented industries and rural development.
Specifically, in addition to exploiting areas of international comparative advantage in labor-intensive manufactures, China has aggressively applied a variety of industrial policies, trade barriers and regulation on foreign investment to steer investment and ensure the rapid development of industries where it lacks the comparative advantage or resources to effectively compete.
Important examples include the steel and auto sectors. In steel, China lacks adequate metallic resources and capital equipment must be purchased on global markets; its only advantages lie in lower labor costs. Yet, it exports steel even when the transportation costs to destination markets are greater than total labor costs in those markets. Though the analysis would be more complex, China should be importing many more automobiles than it does; and foreign firms should be playing greater roles in its financial sectors.
When China entered the WTO in 2001, it agreed to scale back and remove many of these policies, and to undertake legal and regulatory reforms that would open its economy to wider foreign investment. China has failed to act as promised on many counts. Consequently, the United States has begun WTO complaint processes regarding both China's use of various subsidies—which include various corporate income, value-added and employment tax exemptions, and low interest loans awarded by China's state-directed banks—and lack of adequate intellectual property protection.
Perhaps, the most significant industrial policy has been China's intervention in currency markets. For many years now, it has intervened in foreign exchange markets, consistently buying dollars, U.S. Treasury securities and other reserve currency assets, to maintain an undervalued yuan.
In 2006 Chinese monetary authorities purchased more than $200 billion in U.S. and other foreign currency and securities—these purchases were about 8 percent of China's GDP and 21 percent of its exports. The resulting subsidy on exports distorts global trade by boosting Chinese exports and stunting Chinese imports, and contributes importantly to the large U.S. trade deficit, as well as the trade deficits of other countries. The Chinese people are consuming about 8 percent less than they produce to finance China's large trade surplus and trade deficits in the United States and elsewhere.
Given rapid productivity growth and foreign investments in China, we would expect the dollar value of the Chinese currency to rise with its development progress. However, in 1995, the Chinese government began pegging the yuan at 8.28 per dollar.
In July 2005, China adjusted this peg to 8.11 and announced the yuan would be aligned to a basket of currencies. However, the yuan still tracks the dollar quite closely and is rising in value quite slowly. Currently, the yuan is trading at about 7.74. (March 5, 2007)
Since 1995, the annual U.S. trade deficit with China has grown from $34 billion to approximately $233 billion in 2006. The annual overall U.S. current account deficit has grown from $113 billion to about $860 billion. In contrast, when China was granted most-favored-nation status by the Congress in 1980, the U.S. bilateral trade and global current accounts were in surplus at $2.8 billion and $2.3 billion, respectively.
Other nations in Asia are compelled to follow similar strategies, lest they lose competitiveness in the vital U.S., Canadian and EU markets. Overall, U.S. trade with Asia accounted for about 60 percent of the U.S. non-oil trade deficit in goods.
Consequently, reduced sales and layoffs in U.S. import-competing industries caused by Chinese competition have not been matched by increased sales and new jobs in U.S. export industries at the scale a market driven outcome would require. The free trade benefits of higher income and consumption to the U.S. economy have been frustrated by currency market intervention.
Consequences for the U.S. Capital Markets and Economy
Massive foreign government purchases of U.S. securities affect U.S. capital markets, trade flows, industrial structure and productivity, and investments in R&D.
In particular, foreign government purchases of U.S. securities sustain the value of the dollar against the yuan and other Asia currencies, reducing sales and precipitating layoffs in U.S. import-competing and exports industries. This deprives the U.S. economy of many of the benefits of free trade.
In theory, increased trade with China and other Asian economies should shift U.S. employment from import-competing to export industries. Since export industries create more value added per employee and undertake more R&D than import-competing industries, this process would be expected to immediately raise U.S productivity and GDP. These are the essential gains from specialization and comparative advantage increased trade should create.
Instead, growing trade deficits with China and other Asian economies have shifted U.S. employment from import-competing and export industries to nontradable service producing activities. Import-competing and export industries create about 50 percent more value added per employee, and spend more than three times as much R&D per dollar of value added, than the private business sector as a whole. By reducing investments in R&D, a study published by the Economic Strategy Institute indicates the overvalued dollar and resulting trade deficits are reducing U.S. economic growth by at least one percentage point a year, or about 25 percent of potential GDP growth.
Importantly, this one percentage point of growth has not been lost for just one year. The trade deficit has been taxing growth for most of the last two decades, and the cumulative consequences are enormous. Had foreign currency-market intervention and large trade deficits not robbed the U.S. economy of this growth, U.S. GDP would likely be at least 10 percent greater and perhaps 20 percent greater, than it is today. GDP and tax revenues would be higher, and other things remaining the same, the federal budget deficit would be smaller.
Individual industries are particularly hard hit. Since 2000, U.S. manufacturing has shed about 3 million jobs. Judging from past business cycles, it should have regained many of those jobs during the recent recovery.
Financing Trade Deficits
Finally, these mounting deficits have to be financed. For example, in the third quarter of 2006, U.S. investments abroad were $233.8 billion, while foreigners invested $400.2 billion in the United States. Of that latter total, only $44.1 billion or 11 percent was direct investment in U.S. productive assets. Most of the remaining capital inflows were foreign purchases of Treasury securities, corporate bonds, bank accounts, currency, and other paper assets. Essentially, in the third quarter, Americans borrowed more than $350 billion to consume 6.8 percent more than they produced.
By purchasing these paper assets, foreign governments in effect loaned Americans $80.8 billion or 2.4 percent of GDP. That well exceeded net household borrowing to finance homes, cars, gasoline, and other consumer goods.
The cumulative effects of this borrowing are frightening. The total external debt is now about $6 trillion. That comes to about $20,000 for each American, and at 5 percent interest, $1000 per person or $2000 for each employed American.
Revaluing the Yuan
Regarding Chinese options, several arguments have been made against the Chinese government allowing the yuan to rise to a value that balances its external trade, but the underpinnings of these arguments are questionable.
It is true that permitting the yuan to rise 30, 40 or 50 percent would impose difficult adjustments on Chinese state-owned enterprises, disrupt Chinese labor markets, and further stress the balance sheets of Chinese banks. However, adjustments of these kinds will only be larger if the yuan is revalued two or five years from now. To avoid such adjustments and sustain its current development model, China will have to purchase ever-larger amounts of dollars, and transfer ever-larger amounts of what it makes to world markets. Can that be sustained indefinitely?
A revaluation of the yuan would cause a productivity burst in China; however, this would not be large enough to wipe out completely the competitive effects of yuan revaluation. Moreover, to the extent that a 30 to 50 percent jump in the dollar value of the yuan did not wipe out China's trade surplus and the excess demand for yuan in currency markets persisted, the dollar value of the yuan could be further adjusted without imposing additional hardships. Productivity gains in China would cushion inflationary effects all around, and Chinese living standards would likely increase by fifty percent or more.
The U.S. is dependent on Chinese and other official purchases of Treasury securities (currency market intervention) to finance its federal budget deficit. However, absent this intervention, the exchange rate for the dollar and trade deficits would be lower, and GDP and tax revenue would be higher. To the extent additional tax revenue did not close the federal financing gap, the Fed could purchase additional Treasury securities to maintain interest rates - something it routinely does to expand and regulate the money supply. Instead of the Chinese and Japanese monetary authorities purchasing Treasury securities, the Fed could make those purchases.
Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.