INSTITUTE FOR INTERNATIONAL ECONOMICS
Working Paper 95-6

CHINA AND THE INTERNATIONAL ECONOMIC SYSTEM

Marcus Noland - 1995

Paper prepared for the International Conference on Sino-American Economic Relations, Centre for Asian Pacific Studies Lingnan College, Hong Kong, 21-23 June 1995. I would like to thank Chi Zhang for research assistance.

Since the inception of economic reforms in 1979, China's economic performance has been nothing short of spectacular. Between 1979 and 1994, China's real growth rate has averaged more than 9 percent annually. Agriculture has been decollectivized, the management of state-controlled firms has been decentralized, and property rights reforms have facilitated an explosion of businesses outside central government control. Goods and factor markets have been liberalized to a significant extent: most prices are now determined by markets, state control of labor markets has been reduced, and previously repressed capital markets have experienced rapid, if uneven, development. China nevertheless retains a significant state-owned sector, and problems associated with lack of reform in this sector, combined with the relatively primitive nature of macroeconomic policy instruments, has lead to a stop-start pattern of growth and problems with inflation. The time path of Chinese economic growth is subject to considerable uncertainty.¹

The level of output in China is likewise subject to considerable uncertainty, and various attempts to measure the purchasing power adjusted level of GDP have generated a wide range of estimates (Lardy, 1994, Table 1.3). Indeed, the estimate of Chinese GDP per capita reported in the most widely cited source, the Penn World Tables, changed by 40 percent in successive versions of the Tables. Thus any attempt to put the size of the Chinese economy into international perspective is subject to enormous uncertainty. With this caveat, an estimate of the Chinese share of world output derived from purchasing power adjusted data reported by the United States Central Intelligence Agency is reported in Table 1.

As can be seen in the first column of Table 1, China accounted for just under 9 percent of world output in 1993, making it the world's third largest economy following the United States and Japan. The remaining columns show China's share ten years hence under various scenarios.² The Chinese growth rate is subject to the greatest uncertainty due to questions about the character of Chinese economic policy in the post-Deng era. The bottomline is that even under the slow growth scenario, China clearly emerges as the world's second largest economy in the next decade. This conclusion is further reinforced if the figures for Hong Kong's share of output are added to China's.

China's participation in international trade also has grown rapidly during the period of reform, and its share of world trade has risen from 0.6 percent in 1977 to 2.5 percent in 1993, making it the world's 11th-largest trading nation . Chinese economic reforms not only spurred an enormous growth in trade, but the reforms have transformed the commodity composition as well, aligning China's pattern of trade more closely with its true pattern of comparative advantage (Table 2). Between 1980 and 1992, the share of exports accounted for by the light manufactures of SITC 8 rose from 16 percent to 40 percent. Similarly, imports of capital equipment (SITC 7) rose from 25 percent to 39 percent during this period.

The rapid growth of China's international trade has posed particular problems for high income countries, including United States. Imports have been concentrated in labor-intensive manufactures, and economic theory suggests that this exerts downward pressure on the wages of low-skilled labor.³ Moreover, China has a rapidly growing bilateral trade surplus with the US, even according to Chinese data, and even when the miscounting of re-exports through Hong Kong are taken into account (Table 3). Nor can this growing Chinese surplus be explained away as a function of the relocation of production from Hong Kong and Taiwan to China as was conceivable a few years ago (Table 4). Differences in political values, the growing bilateral imbalance, and the concentration of imports in light manufactures all act as political lightning rods in the US. What is truly striking about the trade politics in the US is how China policy has been driven by exporters, not import-competing interests.

The potential for Sino-American economic conflict is likely to worsen. Table 5 reports the shares of US trade accounted for by different trade partners, and projections of how these shares might change obtained by plugging the Table 1 figures, estimates of per capita income, measures of distance and other factors into a gravity model of bilateral trade.⁴ As indicated in Table 4, China's share of US trade is likely to grow significantly, and China may become the United States' fifth largest trade partner after Canada, Mexico, Japan, and the European Union.

Beginning in May 1992 and four times since, the US Treasury has cited China for manipulating its currency "to prevent balance of payments adjustment and gain unfair advantage" under section 3004 of the 1988 Trade Act. Trade frictions are likely to be exacerbated by import surges and illegal behavior. To cite one example, China's share of the US bicycle market increased from 14.6 percent in 1993 to 23.7 percent in 1994, and in April 1995 three American manufacturers filed an antidumping suit against China. This suit follows the imposition of antidumping duties on Chinese bicycles in Canada, Mexico, and the EU (Financial Times 7 April 1995).

These are the two central points that must be kept in mind in analyzing China in the world economy: The reform process is incomplete and China is huge. The inevitable bumps along the way in the reform process that the rest of the world could largely ignore in the case of a smaller economy cannot be overlooked in the case of China. A few examples should suffice. China is the world's largest importer of sugar and cooking oil, and the number of commodities for which it is the world largest importer may soon include wheat, corn, barley and cotton as China grows and incomes rise. In April 1995 China reimposed import quotas on sugar, vegetable oil, grain, and cotton; China is sufficiently large that actions of this sort can wreak havoc on global markets. Internally, China has opened commodity futures markets, but the pricing of futures can be rendered impossible if the government remains willing to undertake significant price controls.

Other examples from the financial markets include the (eventually resolved) dispute over Citic Shanghai's refusal to pay $40 million in debts owed to fourteen brokers on the London Metals Exchange, and the same firm's refusal to comply with an unfavorable arbitral ruling in the Revpower case. On 23 February 1995, on the same day Nick Leeson was blowing up Barings, Shanghai International lost something on the order of $100-120 million (the proximate value of the firm) by trading 20 times the regulatory limit in government bond futures. The government's response was in effect to erase the final 8 minutes of trading.

North Korea has defaulted on debts and has tried to pay off creditors with fish instead of cash, but North Korea's total merchandise trade is only around $2 billion and the world can easily absorb erratic economic policy by a marginal participant in the world economy. China is not North Korea. China's sheer size means that the rest of the world has to take developments in China very seriously, if for no other reason than developments in China are the single biggest potential threat to the stability of the international economy. Just imagine a Mexican-style crisis in China.

CHINA'S EXTERNAL ECONOMIC RELATIONS

In addition to its rapid emergence in goods markets, China has also become a major player in international capital markets. China is now the leading developing country destination for foreign direct investment. The stock of inward foreign direct investment now exceeds $100 billion, though some of this is due to "roundtripping" as Chinese investment is routed through Hong Kong to take advantage of the more favorable treatment of foreign investors. Firms with foreign equity participation accounted for two-thirds of the increase in Chinese exports in 1992 and 1993.

With regard to portfolio investment, external debt does not appear to be a problem: World Bank figures estimate annual repayments on the order of $12-14 billion, well within China's service capacity, though some private analysts claim the burden is higher.

China is a major recipient of multilateral and bilateral official lending. The US has recently questioned whether China should continue to receive concessional finance through the International Development Agency (IDA), the World Bank soft loan window. IDA funds have accounted for about a quarter of China's $22 billion in World Bank loans since 1980, and China has been receiving approximately $1 billion annually from IDA for the last several years. The US appears to be isolated on this issue, though Japanese attitudes may be changing in light of its dispute with China over nuclear testing.

As might be expected because of the rapidity of the growth of its exports, China has become embroiled in a number of trade controversies. Evasion of textile and apparel restrictions have been a major point of contention.

China circumvents its bilateral textile and apparel quotas, mainly by transshipping products through third countries which are also covered by bilateral quotas. In other words, the Chinese substitute their products for the unfulfilled quotas of third countries. A US Customs Service study put the value of these transshipments at $2 billion. The main transshipment points are the high wage locations of Hong Kong, Taiwan, Macau and Singapore. Textile and apparel imports from these four countries were $8.5 billion in 1993. In other words, the Treasury figure implies that nearly 25 percent were transshipped.

A bilateral agreement on this issue was signed in January 1994. Government sources indicate that the problem appears to be getting worse, however. According to the Customs Service, there appears to be roughly $10 billion in Chinese textiles and apparel floating around the world not properly accounted for. For example, Chinese customs officials reported $13 billion in exports to 120 countries in 1992. Eighty-one countries alone reported $23.7 billion of imports from China in the same year. (MOFTEC reports $7.7 billion in textile and apparel exports in 1992, making the discrepancy even bigger.)

China reports $6.4 billion of textile and apparel exports to Hong Kong in 1992. Hong Kong reports $8.6 billion in consumption imports (a enormous figure), and $9.7 billion in re-exports. Even allowing for high re-export markups, these discrepancies are huge.

The US Customs Service found that half of the 36 fastest growing apparel suppliers to the US market had no significant domestic production for export, but report a significant increase in imports from China. Kenya, for example has recently experienced a 790 percent growth rate in apparel imports from China, and a 212 percent growth in exports to the US. Other countries, including Belize, the Czech Republic, Ecuador, and Qatar, exhibit similar triple-digit growth rates. All in all, the Customs Service estimates that at least $200 million of illegally transshipped apparels is coming into the US through these countries.

Transshipping is currently subject to criminal prosecution, and Customs and the Justice Department have launched a major campaign to prosecute transshippers. There was recently a major conviction involving a Chinese state-owned firm. In May 1995 the US cut China's cotton underwear quota by 35 percent and also reduced some other quotas because of illegal transhipping though Hong Kong, and mislabeling them as video rewinders and metal furniture.

This sort of problem is not limited to the US. In April 1995 the EU announced that it was deducting 9.3 million garments (less than 1 percent of the Chinese quota) for three years because of illegal transshipping through Hong Kong, Dubai, Morocco, Bangladesh and Kenya (Financial Times, 19 April 1995).

The point is simple: Although as an economist and as a consumer I might benefit from illegal behavior of this sort, differences over political values combined with illegal acts which arguably disadvantage some of the poorer members of American society may do significant harm to China's image in the US. The result may be a significant worsening of US-China relations. A recent public opinion survey found that both elites and the general public believe by substantial majorities that the US has vital national interests at stake in China (Rielly, 1995). This view of China's growing importance is not translated into warm feelings, however: China's ranking is in the lowest quartile of countries, below the EU, Japan, and Russia, and just above the Cedras dictatorship in power in Haiti at the time of the poll. Moreover, this is not partisan. Both liberal Democrats and conservative Republican politicians in the US have expressed antipathy towards China, and China's image in the US will further suffer by comparison next year when Taiwan directly elects its President for the first time. Such a political atmosphere poses a potential threat to China's diplomatic interests. The US Congress recently voted overwhelmingly to support the admittance into the US of Taiwan's President Lee Teng-hui to receive an honorary degree at his alma mater, Cornell University.⁵ Ironically, the brouhaha over the Lee visit may actually improve China's prospects for getting into the World Trade Organization—having caused a diplomatic flare-up, the US may now take a softer line.

PROSPECTS FOR CHINA IN THE WORLD ECONOMY

• Great powers do not want to be snubbed or shunned. The most critical junctures in human history have always been the moments when a new power struggles to its feet and begins to take a fresh look at the existing world order. We cannot repeat mistakes made at the turn of the last century, when a newly-industrialized and united Germany and Japan came on the world scene but were excluded from established international systems. And we certainly cannot afford to make that with a country that has one fifth of the world's citizens, that suffered a 200 year history of colonial oppression and territorial losses, that is about to become the world's largest producer of acid rain, and that possesses a nuclear arsenal.

—Lawrence H. Summers, Undersecretary of the Treasury.

The outside world has limited abilities to affect the development of the Chinese economy—the outcomes of the major economic policy issues that China faces will largely be determined internally. To give but one example: If the political leadership in China began to fear that centrifugal forces were pulling the country apart, there might well be a retrenchment of economic reform, and the Chinese government would become less responsive to the interests of foreigners and to fulfilling international obligations. In such circumstances there would probably not be a whole lot that foreigners could do to reverse such a tendency.

Thus the overarching goals of US economic policy toward China are to promote political and economic liberalization within China (which the Clinton Administration explicitly views as linked), integrate China into global institutions, and pursue US commercial interests (which the Administration largely identifies as exporters' interests).

The Administration regards technical assistance as the primary channel through which it can influence economic reform in China (and by extension encourage political liberalization). Among the avenues of technical assistance which have recently been created (or revitalized) has been the US-China Joint Economic Committee led by the Treasury Department, with working groups on financial reform and the foreign exchange system. The Securities and Exchange Commission has a group that works on securities regulation, and the Treasury and the Federal Reserve Board have a group to provide assistance on banking regulation and the implementation of monetary policy.

The US government's direct influence is undoubtedly greater on the question of China's integration into world economic institutions, where the most prominent issue is China's accession to the WTO. The US (and other countries) are understandably cautious on this issue because of China's enormous size and the likely precedential effect that the terms of China's accession will have on the protocols of approximately 20 other economies in transition which wish to join the WTO.

To join the WTO a signatory must agree to uphold the basic requirements of membership: transparency of the trade regime; uniform, non-discriminatory application of trade rules; and national treatment for goods and, to a more limited extent, service providers. In the case of China, foreigners have encountered significant difficulties in a lack of transparency in the application of trade restrictions, as well as non-uniform application of trade policy in different parts of China.

In these negotiations the US has tended to put more emphasis on obtaining access to the Chinese market (this would be consistent with the US domestic political emphasis on exports), while the EU has put more emphasis on securing liberal safeguard provisions to protect against imports from China.⁶ (Japan has tended to align itself more closely with the US position.) Ironically, the US insistence on market access (which is, after all, trade expanding and welfare-enhancing) has been criticized in China, while the EU's demands for safeguards (which restrict trade and reduce welfare) has received less opprobrium.

Beyond these fundamental issues, the main points of contention regarding China's application to join the WTO have been whether China will enter as a developed or developing country (and thereby the length of the transitional period granted for bringing domestic practices into compliance with treaty obligations) as well as the issue of trading rights and state trading monopolies and the subsidization of state-owned firms.

China has argued that it should be allowed to enter the WTO as a developing country, and China is a developing country on any measure of per capita income. The United States has argued, however, that significant parts of China are sufficiently developed that it would be folly to permit China the additional leeway granted developing countries. (China's case is complicated by the fact that Taiwan has indicated that it is prepared to join the WTO as a developed country.) The likely outcome will be to classify China as a developing country for some WTO obligations and a developed country for others.

China maintains state trading monopolies, and unless foreigners are freely allowed to import and export, concessions on tariffs and other impediments to trade would be meaningless.⁷ The current negotiations center on the dismantling of these monopolies, and foreign monitoring of the operations of state-owned firms to insure that they do not run afoul of the WTO's anti-subsidy provisions. US firms also argue that the "trade balancing requirement" of the current foreign exchange allocation system is in effect a nontariff barrier and a clear violation of the TRIMs agreement.

With regard to market access, the United States has asked China to join the "zero for zero" group which eliminated tariffs on construction equipment, medical equipment, steel, beer, distilled spirits, pharmaceuticals, paper, toys, and furniture, and which greatly reduced tariffs on chemicals and electronics. The European Union has requested that China bind industrial product tariffs at 20-25 percent. Although neither demand is likely to be satisfied, China will undoubtedly increase market access as part of its WTO accession.

With regard to investment, foreign investors have to go through a protacted administrative approvals process, which is subject to corruption, and the US has requested a streamlining of this process. The US has also insisted that China accept international standards on expropriation and compensation, and avail investors to international binding arbitration for settlement of disputes with the state (Cheng, 1995).

The situation in services is more complicated. China has resisted opening up its telecommunications services market to foreign providers on national security grounds. However, without a modern telecommunications system, concessions in other areas, such as banking, are less valuable. Again, the most likely outcome is a highly detailed set of provisions specifying which forms of telecommunications are open to foreign participation. In the insurance negotiation, the Chinese proposal is excessively vague. This has led some foreign observers to wonder if the timidity exhibited by the Chinese negotiators is not evidence of the great deal of uncertainty surrounding policy in the post-Deng era, and the unwillingness of the Chinese negotiators to "stick their necks out" until some of this uncertainty is clarified. For these reasons most observers in the US do not foresee a rapid resolution of the China WTO issue.

Lastly, China is also a participant in the Asia Pacific Economic Cooperation (APEC). The major achievements of APEC thus far has been the holding of the first pan-Asian meeting of heads of government (ironically held in the US in November 1993) and the declaration a year later of a commitment by the leaders to free trade and investment in the Asia Pacific region. Concrete progress toward this goal has been less evident, however, and observers are looking to the upcoming Osaka meeting to see if APEC will be more than a talking shop.

Were the APEC countries to actually implement free trade and investment in the region, the results could be quite impressive. One recent study concluded that the static income gains to China of such an agreement would be 2.2 percent of real GDP, while the dynamic gains would be even larger (Lewis, Robinson, and Wang, 1995). (Interestingly China is shown to experience an income gain even if it were excluded from any such arrangement—the impact on the other Asian economies would be sufficiently large that China itself would gain through the spillover from the others' income boost.) Another study, undertaken by the Australian government, put the gains to China of an APEC free trade agreement at 4.2-5.5 percent of GDP depending on model and specification (Office of National Assessment, 1994).

CONCLUSIONS

Integrating large, rapidly emerging countries into the international order is always problematic. In the case of China, this is made more difficult by differences in political values, and the fact that the rapid growth of the Chinese economy is likely to force significant adjustment costs onto the incumbent powers due to the complementarity of their economies. As a consequence, one must expect that China will be involved in intermittent trade conflict with the US and others for the foreseeable future. Moreover, due to China's size, the inevitable mishaps that may accompany the process of reform could well have international ramifications.

From this perspective it becomes highly important that China be brought into international bodies such as the WTO to try to contain and intermediate these prospective frictions. At the same time, China must assume the obligations that come with membership—otherwise China's entry may eviscerate these groups.

These issues require hard bargaining, and given the uncertainty surrounding the future political leadership in Beijing both Chinese and foreign negotiators may have a tendency to be cautious. This suggests that a prolonged period of transition may be in the offing before China is firmly integrated into international economic institutions on a more permanent and stable basis.

NOTES

1. One consequence of these difficulties is that growth may be overstated. Inflation was officially 24.2 percent in 1994, but many observers believe the true figure is higher. The basket of goods and their weights in the price index are not reported and apparently subject to change, and the sampling techniques used to assemble the underlying data is poor. The industrial and producer price deflators diverge significantly after 1992, and an unofficial recalculation puts real GDP growth at 9.0 in 1993 and 7.8 in 1994, significantly below the official values.

2. See Noland (1994) for further details on the underlying scenarios and the derivation of the projections.

3. There is considerable academic debate in the United States as to whether this indeed has been occurring. See Lawrence and Slaughter (1993) and Leamer (1995) for opposing views.

4. Again, see Noland (1994) for details of this estimation.

5. The vote in the House of Representatives was 396 to 0, and the tally in the Senate was 97 to 1. The sole Senator voting against the resolution had previously announced that he would not stand for reelection, and reportedly has two sons doing business in Shanghai.

Chinese confusion over the Administration's policy of "comprehensive engagement" is readily understandable. At the same time, China must surely grant the average American a similar degree of perplexity over Chinese outrage about Lee's visit, during a period when China and Taiwan were deepening high-level contacts.

6. The US also faces a legal issue on the apparent conflict between US application of the WTO to China and the Jackson-Vanik amendment which inhibits the extension of unconditional MFN treatment to communist countries which restrict emigration. Although USTR maintains that only an explicit change in the law would resolve the issue, many legal observers in the US believe that this conflict can be finessed when the time comes.

7. Under current practices, foreign-funded enterprises can only export goods produced by themselves, and import equipment and raw materials needed for their own production. China, which only grants trading rights to a limited number of domestic firms, fears that if trading rights were generally available, the resultant competition would cause a deterioration in China's terms of trade, and a spate of dumping suits in foreign markets.

TABLE 1 - WORLD INCOME SHARES

Note: Shares are calculated from purchasing power adjusted national income figures.

Source: Marcus Noland, "Implications of Asian Economic Growth," Asia Pacific Economic Cooperation Working Paper Series Number 94-5, Washington: Institute for International Economics.

TABLE 2 - CHANGES IN CHINESE EXPORT AND IMPORT SHARES

Source: Statistics Canada, World Trade Database 1980-1992.

TABLE 3 - US-CHINA BILATERAL TRADE BALANCES ($ Billions)

Source: K. C. Fung, "Accounting for Chinese Trade: Some National and Regional Considerations," paper presented at Conference on Research in Income and Wealth, Geography and Ownership as Bases for Economic Accounting, Washington, 19-20 May 1995, Table 15.

TABLE 4 - BILATERAL US-CHINESE ECONOMIC
AREA TRADE BALANCES ($ BILLIONS)

Note: customs valuation.

Source: Department of Commerce.

TABLE 5 - U.S. TRADE SHARES

Source: Marcus Noland, "Implications of Asian Economic Growth," Asia Pacific Economic Cooperation Working Paper Series Number 94-5, Washington: Institute for International Economics.

REFERENCES

Cheng, Leonard K.H. 1995. "US Attitudes and Policy Towards Investment in China," paper presented at the International Conference on Sino-US Economic Relations, Hong Kong, 21-23 June.

Fung, K.C. 1995. "Accounting for Chinese Trade: Some National and Regional Considerations," paper presented at the Conference on Research in Income and Wealth Geography and Ownership as Bases for Economic Accounting, Washington, 19-20 May.

Lardy, Nicholas R. 1994. China in the World Economy, Washington: Institute for International Economics.

Lawrence, Robert Z. and Matthew J. Slaughter. 1993. "International Trade and American Wages in the 1980s: Giant Sucking Sound or Small Hiccup?," Brookings Papers on Economic Activity 1993:2 161-226.

Leamer, Edward E. 1995. "A Trial Economist's View of U.S. Wages and 'Globalization'," paper presented at the Brookings Institution Conference on Imports, Exports, and the American Worker, Washington 2-3 February 1995.

Lewis, Jeffrey D., Sherman Robinson, and Zhi Wang. 1995. "Beyond the Uruguay Round: The Implications of an Asian Free Trade Area," China Economic Review, 6:1 35-90.

Noland, Marcus. "Implications of Asian Economic Growth," Working Papers on Asia Pacific Economic Cooperation 94-5, Washington: Institute for International Economics.

Office of National Assessments. 1994. "APEC Liberalization Gains," Canberra, mimeo.

Rielly, John E. 1995. American Public Opinion and U.S. Foreign Policy 1995, Chicago: Chicago Council on Foreign Relations.

Summers, Lawrence H. 1995. "An Assessment of American Economic Thinking and Policy Toward China," United States-China Relations, 23:2 1-8.

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