NOTE

US-China Economic Relations: An Update

by Daniel H. Rosen | September 11, 2013

Daniel Rosen prepared and delivered these remarks as a briefing for the President of a leading Chinese international relations thinktank on September 9, 2013 in New York.  Such bilateral exchanges have stepped up this year in light of ongoing reforms under the new leadership in Beijing. Analysts both in the US and China are gauging whether a window for bolder bilateral economic ambitions has opened. These remarks were made in that context.  

The present environment of US-China economic relations is superficially positive, despite negative political shocks to the bilateral relationship such as the Snowden NSA revelations. Going forward, there will inherently be more sources of “normal” state-to-state frictions in the economic relationship as China’s external engagement grows beyond trade and inward foreign direct investment (FDI) to include new channels of global interaction. But fundamentally, the potential for positive economic relations should increase significantly as a result of the transformational economic and political reforms being implemented by the Xi-Li government in Beijing. Successful reforms will pave the way for US-China cooperation, which currently seems unrealistic.

Present Conditions

US attitudes on economic relations with China are relatively mild at this time. Previously heavily focused on trade balances, exchange rates, intellectual property protection and cyber intrusion on US commercial actors, Congress’s attention is now diverted by Chinese policy reform (renminbi strengthening), revelations of US cyber programs (which forced the US government to tone down its indignation toward China), and other urgencies (Syria). And the general strengthening of US economic conditions and clear weakening of Chinese economic conditions has generally reduced American decline anxiety.

Four areas of economic relations which do continue to play important parts in the bilateral relationship are institutional cooperation and governance, trade, bilateral investment, and cyber-intrusion as it relates to intellectual property protection. There are many other economic-related issues – such as the hydrofluorocarbon (HFC) commitments made by Presidents Obama and Xi at Sunnylands – which are also important, but which fall beyond the primary themes defining the current economic relationship.

On institutional cooperation and governance, US senior officials continue to communicate a positive picture. The intention is clearly to emphasize the health of US-China economic relations. The Obama-Xi relationship is described as cordial, professional, constructive; it facilitates the two nations in identifying how to “cooperate on the major regional and international challenges”. The two are respectful of one another’s efforts to support the international economic system by spurring domestic growth and job creation, while managing the necessary adjustments for fiscal sustainability and structural reform. Senior US officials handling China have a sound appreciation of the enormity of economic reforms taking place in China: most think the US needs to ensure that SOE reform and IPR protection improvements are high enough priorities; some are more confident that those two imperatives are already hard-wired into China’s reform process (as evidenced by the investigation of corruption at China National Petroleum Corporation and dismissal of SASAC Chairman Jiang Jiemin). This sense of progress on Chinese reforms has engendered a generally optimistic mood on prospects for working with China on broader institutional matters.

The state of the trade relationship is a second major theme still critical to US-China economic relations. The biggest Chinese concern in this area is likely to be that a pre-mature “tapering” of quantitative easing of liquidity by the US Federal Reserve could directly or indirectly stall drivers of China’s growth – notably export recovery – which might otherwise help China get through the current period of weak growth. Over the past six months US demand conditions have improved thanks to a modest property sector recovery. That property turn-around has resulted from the Fed’s liquidity policy, and has facilitated Chinese exports. The prospect of tighter Fed policy threatens that growth, leaving more weight on the shoulders of domestic demand in China which is not yet ready to bare the whole burden of providing 7%+ GDP growth without recourse to further unhealthy asset bubbling and additional overbuilding of uneconomical infrastructure and property. Hence there is some private Chinese alarm over tapering, and some mild official public statement of concern (domestic monetary policy being a sovereign matter, bilateral criticism is generally inappropriate, but PBOC’s Yi Gang has called for regional cooperation and emphasis of non-dollar commerce to buffer shocks: in the short-term, such new efforts will of course have limited impact). Further, the threat of US tapering could indirectly impinge demand for Chinese goods in other emerging markets, which are similarly vulnerable to crumbling sentiment should the Fed call its credit home to bed. However, markets have already priced-in the expectation of tapering, and yet the US-China economic relationship has not suffered majorly. Further, if US jobs data continues to look weak, as it has through September, the risks may be to the upside in terms of delaying tapering to remain supportive of US growth.

Bilateral investment appears to many observers as a source of strain in the US-China  relationship, with frequent references back to the failed CNOOC-Unocal deal even though it was long ago, in a different era. The reality is that this channel in the relationship is presently quite strong. Large Chinese direct investment overtures in the US have met with approval, even in strategic and sensitive sectors such as natural resources, aerospace and food production. The two sides have agreed to upgrade talks on a bilateral investment treaty (BIT) thanks to changes in China’s negotiating posture: pre-establishment national treatment is accepted, and a negative list is to be used for defining exceptions. While US (and other) firms have a great many concerns about investment market access in China, these and other signs of major domestic opening on the investment front are sufficient cause for optimism at present, and US officials and business leaders are working toward reciprocal demonstrations of the benefits of taking this liberal path. For instance, significant efforts are underway to clarify the opportunities available for Chinese participation in US infrastructure renewal in the decades ahead.

Finally, on the impacts of cyber conflict developments on the economic relationship, what is most notable is that despite disquieting revelations about cyber intrusions originating from both sides (viz. PLA Unit 61398 and the NSA’s Edward Snowden), the collateral damage on the bilateral economic relationship has been limited – so far, and on the surface. In leaders’ exchanges on cyber and the economy, both sides have attempted to be restrained and measured, and to contain the potentially unbounded damage that could arise. But away from the headlines, there are far more worrying patterns evident, as Beijing contemplates more systematically de-globalizing large swaths of its information and communications technology (ICT) infrastructure in favor of indigenous players, which of course the US has been doing for some time. But at present, US-China economic relations on these matters have been as measured as one could expect under the circumstances.

Looking Forward

Chinese officials look forward more than their US counterparts. That is not a criticism of US officials, but rather a function of the fact that China is coming out of a state planning tradition, a tradition that has in fact gotten China into a sub-optimal situation in terms of many current market structures and regulations, and the Xi-Li leadership must wrestle with a heavy burden of shifting away from those antecedents. As the market plays a more important role in China – as President Xi and Premier Li intend – China’s leaders will spend less time planning and more time strengthening institutions and due process, and reacting to organic developments in the economy, like their US counterparts do.

That said, US analysts both inside and outside government spend considerable time looking forward for likely directions in US-China economic relations. From my perspective there are two relatively new forward-looking points that deserve analyst and leader attention at present.

First, China is just now reaching the inflection point at which its global economic interests extend beyond trade in goods and related recycling of official foreign exchange surpluses. China has gone from a trivial position to top three in terms of outbound global direct investment in little over half a decade. Its stock of external direct investments will rise from less than $500 billion today to $2.5 – 5 trillion, most likely, in the coming decade. These flows are arriving at America’s doorstep, but also are presenting new investment competition to US firms in third locations. Two-way goods trade is already abundant for China, but now and in the years just ahead a wave of two-way Chinese services trade activity will join the mix. Services are one area where the US has a trade surplus, which is an important moderator of our problematically large balance of payments deficit. Depending on how China’s service industry SOEs operate abroad, there could well be considerable new tensions between Washington and Beijing on this front. And finally, while factory to the world, China’s portfolio investment flows represent less than 1% of the global stock: trivial. As a function of wealth creation, diversification, and to some extent capital flight in light of domestic risks, outbound flows of Chinese portfolio savings will likely grow precipitously in the years just ahead, presenting new regulatory challenges and pulling along new attitudes about external force projection in Beijing. Already, China’s foreign policy leadership is talking about projecting force to protect legitimate Chinese interests inside foreign nations – rhetoric that was rare under the doctrine of non-interference that prevailed until recently.

The second critical forward looking consideration shaping Washington thinking about US-China economic relations, and in any clear assessment the most important development in 2 decades, is the program of systemic economic policy reform now getting underway in China. Since shortly after the People’s Congress this spring, the scope of a broad, comprehensive program of economic reforms has been understood, although many people failed to believe that it would be implemented due to vested interest opposition including from political power holders. Recent moves to confront the misuse of power by large SOEs and government bodies that protect them has made it more obvious that reforms are for real. The first areas getting reform focus are financial market reforms (including interest rate liberalization); RMB internationalization and further capital account opening; exchange rate system modernization; and natural resource price reform. In each of these areas initial steps of significance have already been made, such as the BIT-related concessions noted above, and the Shanghai free trade zone (FTZ) initiative. Taken together these reforms will dramatically change the functioning of the Chinese economy, making it more compatible with the contestable, market-oriented approaches favored in the United States and other OECD economies – though this will take time.

These reforms will cause near-term stress and aggressive resistance to competition from many parties, which may raise bilateral tensions. On the other hand, the reforms will lay the groundwork for much more manageable and mutually beneficial US-China economic relations down the road. Most likely, the reforms will produce Chinese firms that are more competitive and capable in an international market economy, which will bring “normal” state to state economic policy challenges to be managed. But this is by far preferable to clash-of-systems type challenges already becoming acute under business as usual. Therefore we can expect a “new type of great power relations” between China and the United States in the economic realm, but this new relationship will be more like traditional relations among incumbent advanced economies, rather than the abnormal relations that have sometime characterized reactions to China in recent years.  

These expectations of medium-term improvements in the systemic compatibility of China and the US in the economic realm, together with the reality that China’s GDP growth rates are moderating to less threatening levels due to income effects, improve the prospects for the full range of bilateral, regional and multilateral economic regime arrangements that seem unattainable to many observers today. For example, most commentators still treat a US-China BIT as unlikely to come to fruition; but with China unilaterally choosing to converge with international norms for its own domestic reform reasons, the distance between the two sides is far narrower than once thought. Most US officials privately remain extremely skeptical that a US-China free trade agreement is worth talking about, or that China could meet the criteria for inclusion in the Trans-Pacific Partnership (TPP) agreement in a future round of expansion; but if the broad set of reforms Premier Li has assigned working groups at the State Council to develop implementation plans for are achieved, then these stretch goals are not unrealistic. Likewise, continued normal treatment for the review of prospective Chinese direct investments in the US, including by SOEs, is entirely reasonable assuming China is further normalizing investment market access in its own economy, and making corporate governance more transparent in Beijing. The Shuanghui acquisition of Smithfield is a typical example. Reforms to enshrine competition policy and consumer orientation in China will reduce misgivings about the abuse of market power by Chinese firms with privileged access to inputs at home, about the quality of Chinese products shipped abroad, and about the ability of Chinese courts to enforce IPR protection.

Conclusion

This is just a brief snapshot on the state of play and current thinking on US-China economic relations from an American perspective. Most of the longstanding irritants in the relationship have moderated as a result of Chinese reforms and changing international demand conditions – for the time-being. Other, new problems, such as cyber and absorption of swelling Chinese outbound capital flows, are just beginning. But given the momentary calm in the economic relationship and the structural factors moving China and its economic system more in the direction of global incumbents’ economic policies, the atmosphere for building further confidence in policy cooperation is relatively strong at this time. These conditions will not last forever, and whether there is sufficient goodwill in the relationship to offset the challenges likely to arise from the period of painful economic adjustments soon needed on both sides of the Pacific Ocean depends on what the two sides do now to demonstrate mutual interests.