China-US Economic and Trade Relations Will Enter an Eventful Period

By Zhou Shijian*

1. The US Economy and a Strengthening US Dollar 

After experiencing the worst recession since the end of the Second World War, the US economy started to recover in 2010. For about seven years, the recovery has only been moderate. Investors don’t have enough confidence in the real economy. The money issued by three rounds of quantitative easing has been pumped into the stock, bond and housing markets, creating prosperity of the virtual economy. As the economies of Europe and Japan are in a bad shape with a weak euro and yen, the US economy is the only bright spot among Western countries with a strengthening US dollar. 

On 12 December 2013, the US Dollar Index (USDX) exceeded 80. On 2 January 2015, it exceeded 90. From 25 November to 2 December 2015, it exceeded 100. However, it was suppressed by the US Federal Reserve and fell back to a bit more than 90. On 10 October 2016, the USDX topped 97. Between November and 23 December 2016 (by the date of this article), the USDX was above 100 for one and half months and reached 103.36 on 22 December, a record high for 14 years since 2002. To forestall inflation, the Federal Reserve will raise the interest rate at least twice in 2017. This means that the dollar will continue to strengthen for some time to come. As revealed by Wind Data, since the 1990s, the USDX was above 100 for only two periods of time: from 15 May 1989 to 22 September 1989, and from 30 July 1997 to 15 April 2003. That was about the same time as the financial crisis in Japan and the financial storm in East Asia. 

Why could the USDX exceed 100 and stabilize at such a level this time? First, the European and Japanese economies have been sluggish for a protracted period of time. The QE monetary policy and negative interest policy adopted by the European Central Bank and the Bank of Japan have failed to pull their economies out of the quagmire. China is under downward economic pressure and is adjusting its industrial structure. Brazil and Russia have been in recession for two years. Under such circumstances, given the notable recovery momentum in the US economy, there is the need for its currency to appreciate. The expectations for the Federal Reserve to raise the interest rate and the second interest hike on December 14 have pushed up the value of the US dollar. As a result, capital has flown back to the US at a faster pace, causing volatility on the capital markets of other countries and even local financial risks in some places. 

The Pros and Cons of a Strong US Dollar for the US Economy.

On the upside, it will help attract foreign capital. On the downside, a strong US dollar harms export and tourism.US exports fell by 9.1% in 2015 and by another 5.1% from January to September 2016. A strong US dollar has a negative impact on the profits of multinationals. The US has more multinationals than any other country, with its companies all over the world. Because local currencies depreciate against the US dollar, the subsidiaries in developing countries will negatively impact the total profits of their parent companies which are calculated in US dollars. This will, in turn, weigh on the tax income and GDP of the US. A strong US dollar also pushes up the cost of enormous debt payments by the US government. 

One prominent issue in the US economy is the explosive increase of national debts. Since the beginning of the new century, the US has launched two invasions and worked to tackle the financial crisis. National debts have increased at an unprecedented speed. For 204 years from the founding of the United States to the year 1980, the US government issued US$907.7 billion treasury bonds. In the 28 years from 1980 under the Reagan administration to early 2009 under the Bush administration, national debts shot up to US$10 trillion. In the 8 years alone from early 2009 when Obama took office to the end of 2016, US national debts grew to US$20 trillion. Government debts account for 110% of the GDP, far above the alarming level of 60%. In the past two years, the US needs to raise US$700 billion annually to pay the interests on its debts, which is like a precarious “quake lake” over its head.

President-elect Donald Trump mocked President Obama for his economic incompetency, as the US GDP has only grown by 2% annually under his watch. Trump claimed that under his leadership, the US economy will grow at an annual pace of 3.5-4% and return fast to prosperity. Then how to achieve it? Massive tax cuts. Trump has made it clear in his political platform that corporate income tax will be slashed from 35% to 15%. Taxes on the rich will be cut from 39.6% to 30%. This will certainly stimulate investment, attract overseas capital back to the US and boost consumption. Trump wants to model on the massive tax cuts (more fiscal deficits) as adopted by President Reagan to achieve economic prosperity. The problem is that Trump lives in a different age than Reagan. When Reagan took office in 1981, he was confronted with less than US$1 trillion national debts, compared with the US$20 trillion debts Trump has to grapple with when he is inaugurated on 20 January 2017.Every year, he needs at least US$1 trillion to pay the principal and interests of the debts. Where does the money come from? He can only pay back old debts with new debts. According to the predictions of US economists, US national debts will increase by US$10 trillion the first year after Trump comes into power. However, great historical changes have taken place. In 1985, the US was the largest creditor in the world, while it is the largest debtor now. 40 years ago, the US treasury bond was known as the “Gilt-edged Bond”. Now, it has become a hot potato. According to foreign media reports, central banks worldwide sold US$393.1 billion of US treasury bonds from January to September 2016. According to the Bloomberg report on 16 June 2016, China had reduced its holding of the US treasury bonds by US$250 billion since 2014 until March 2016. From June to October 2016, China reduced its holding of the US treasury bonds by US$128.3 billion. What has happened shows that the US treasury bond is no longer a safe haven asset. Issuing treasury bonds to raise money would be unsustainable. 

2. Current China-US Economic and Trade Cooperation

The biggest highlight in China-US economic and trade cooperation is the rapid growth of China’s investment in the US.

According to China’s statistics (Investment in the US via a third place is not included. For example, Shuanghui International Holdings acquired Smithfield Foods with US$7.1 billion. This was not counted as investment of the Chinese mainland, as the company was registered in Hong Hong), Chinese investment in the US was US$4.348 billion in 2012, US$4.01 billion in 2013, US$5.24 billion in 2014, US$8.39 billion in 2015, and US$18.63 billion from January to November 2016. By the end of November 2016, Chinese investment in the US had reached US$49.12 billion in accumulative terms.

According to the statistics of the Rhodium Group, Chinese investment in the US was US$14 billion in 2013, US$11.9 billion in 2014, and US$15.8 billion in 2015. By the end of 2015, Chinese investment in the US had totaled US$61.8 billion. On 27 May 2016, the Chicago Tribune cited Stephen Orlins, Chairman of the National Committee on US-China Relations, as saying that the China-invested enterprises in the US created 100,000 jobs. 

Since the outbreak of the financial crisis, more and more big Chinese companies are keen about investing in the US. The US boasts a well-established and transparent legal environment, advanced technologies, well-trained labor force, abundant and cheap energy supply, sound infrastructure and first-class R&D capabilities. Most importantly, the US has complete sale channels and a huge consumer market. For any product, entering the US market means opening the world market. 

Since the outbreak of the financial crisis, inbound investment in the US has been on the decline. According to the statistics of the US Department of Commerce, foreign investment in the US was US$306.37 billion in 2008. But it dropped to US$160.57 in 2012 and US$86 billion in 2014, trailing the Chinese mainland and Hong Kong and ranking 3rd in the world. In 2015, thanks to a strong US dollar, the US attracted more investment, which rebounded to US$384 billion. As the largest economy in the world, the US needs capital from the rest of the world to support its economic recovery and return to prosperity. 

US investment in China has continued to rise. According to Chinese statistics, US investment in China was US$3.13 billion in 2012, US$3.35 billion in 2013, US$2.37 billion in 2014, US$2.09 billion in 2015 and 2.21 billion from January to November 2016. By the end of November 2016, accumulated US investment in China had reached US$79.68 billion. 

According to the calculation of the author, as Chinese investment in the US has outpaced US investment in China, China’s total investment in the US is expected to exceed accumulated US investment in China by the end of 2018. 

China and the US started negotiations on the Bilateral Investment Treaty (BIT) in 2008. During the Strategic and Economic Dialogue in 2013, the two sides agreed to carry out negotiations on the basis of pre-establishment national treatment and a negative list. Since then, the negotiation has entered a substantive stage. The two sides completed negotiations on the text of the treaty at the end of 2014 and started negotiations on the negative list at the beginning of 2015. Both China and the US wanted to reach an agreement within the tenure of President Obama. 

BIT is an important part of China-US economic relations. A high-standard BIT will help forge closer links between the two countries and improve the quality of economic and trade cooperation. And it will be a crucial step towards a China-US Free Trade Area. 

Even if the two sides won’t reach an agreement before the end of this year, they should continue to work together after the inauguration of the new administration and complete the BIT negotiations at an early date by overcoming non-economic interferences. After all, this serves the vital economic interests of both countries. 

China-US bilateral trade has shown a weaker momentum in recent years. 

According to Chinese statistics, China-US trade totaled US$558.3 billion in 2015, increasing slightly by 0.58% over 2014. China’s exports to the US were US$409.5 billion, a year-on-year increase of 3.4%. According to US statistics, US-China trade was US$598.1 billion, a moderate growth of 1.25% compared with 2014. US exports to China were US$116.2 billion, the first negative growth (-6.3%) since 2009. 

According to Chinese statistics, bilateral trade was US$418.03 billion from January to October 2016, falling by 9.1%. Chinese exports to the US were US$312.57 billion, falling by 8%. Chinese imports from the US were US$105.46 billion, dropping by 12.2%. China’s trade surplus with the US was US$207.1 billion, decreasing by 5.6%. According to US statistics, US-China trade totaled US$488.49 billion from January to October 2016, down by 5.4%. US exports to China were US$92.03 billion, dropping by 3.5%. US imports from China were US$396.46 billion, down by 5.8%. US trade deficit with China was US$304.43 billion, down by 6.5%, slightly better than the first half of the year. 

There are several reasons for the falling China-US trade. First, the global trade is in a slump. According to the statistics of the WTO, global exports in 2015 were US$16.48 trillion, a fall of 13.3% compared with the US$19 trillion of 2014. The data released by the WTO on July 27 shows that global exports in the first quarter of this year dropped by 7.7% over the first quarter of 2015. In 2015, the foreign trade of the US decreased by 5.6%, exports fell by 7.2% and imports dropped by 4.5%. In 2015, China’s foreign trade went down by 8%, exports fell by 2.9% and imports by 14.2%.

Second, both the Chinese and US economies are under downward pressure, with weak demand. 

Third, the US dollar has been strengthening since late 2013. A strong dollar has dampened the international competitiveness of the US products and undermined the export competitiveness of the US. 

According to the report released by the US-China Business Council on 18 August 2016, China continued to be the third largest export market of the US in 2015 and an important contributor to US economic growth. (China was America’s eleventh largest export market in 2000 and surpassed Japan as the third largest export market in 2007, note by the author). 

The report also pointed out that US exports to China in the service sector has maintained a momentum of sustained and fast growth, with an annual increase of 17% over the past 10 years. In 2014, the US service exports to China totaled US$42 billion, making China the fourth largest service export market of the US. 

 (1) Trade Deficit with China

For many years, the US has run a big trade deficit with China. In 2014, US trade deficit with China was US$342.6 billion, accounting for 50.6% of the total US trade deficit. In 2015, US trade deficit with China was US$365.7 billion, accounting for 49.6% of the total US trade deficit of US$737.1 billion. In the first half of 2016, the US had a deficit of US$161 billion, accounting for 46.2% of its total trade deficit of US$348.3 billion, which has come down slightly. 

The US trade deficit is composed of three parts. First, competitive deficit. Japan’s automobiles and the Airbus aircraft from Europe constitute a threat to their counterpart industries in the US and must be handled carefully. Second, resource deficit. The US imports a huge amount of crude oil from the Americas and Middle East and mineral resources from Africa and Asia. This is an important part of its trade deficit and cannot be resolved easily. Third, supplementary deficit. The US imports daily consumer goods from China, East Asia and Southeast Asia as an important supplement to its economy, industrial structure and people’s life. This is nothing but beneficial to the US. 

Most of China’s exports to the US are daily consumer goods of high quality yet low cost. This helps alleviate the inflation in the US and benefits the low and middle-income groups. 

Traditional trade statistics cannot explain the current issue of trade imbalance. 

First, since the start of reform and opening-up, about 70% of the foreign investment in China has come from East Asia. Products that used to be the source of deficit between other East Asian economies and the US have been made on the Chinese mainland, causing the “effect of trade balance transfer”. Most of the parts and components in these products are from East Asia. They are not “Made in China”, but “Made in East Asia”. The income from the exports is shared by East Asia, not solely owned by China. However, according to the principle of place of origin, all the value of the exports to the US is traced back to China. China-US trade cannot be simply characterized as bilateral trade. It is multilateral trade, trade between the US and East Asia. 

Secondly, one prominent feature of the China-US trade is that 60% of it is processing trade. China only gets a fraction of the profits from processing. The US importers, wholesalers and retailers get a far larger share of the profits than Chinese manufacturers and exporters. Hence the phenomenon of “surplus in China, profits in the US”.As US economist Charles Kadlec said, according to the principle of place of origin, the US$178manufacturing cost of an iPhone is put under China’s account, because China is the final assembly place. China, however, only gets US$6.5 of the added value. 

It has been 46 years since the US started running foreign trade deficit in 1971. According to the statistics of the US customs authorities, the US has trade deficits with more than 90 countries and regions. The blame should not be all put on the RMB exchange rate. Rather, it is a natural result of economic globalization, industrial adjustment and massive international division of labor. This is a structural issue that cannot be reversed. 

 (2) The Issue of RMB Exchange Rate

It has been the practice of the successive US governments over the years to force the currencies of their trading partners to significantly appreciate, so as to reduce trade deficits. The US has done so to the Deustchemark in the early 1980s, to the Japanese yen in the mid-1980s, to the New Taiwan Dollar in the late 1980s, and to the ROK won in the early 1990s. Since the beginning of the new century, the US has pushed hard for significant RMB appreciation. But what has been the result? Over the years, the US has maintained trade deficits with Germany, Japan, the Taiwan region, ROK and China. This has never been reversed. In 2015, the US ran trade deficits of US$74.2 billion with Germany, US$68.6 billion with Japan, US$14.8 billion with the Taiwan region, US$28.3$ with ROK and US$365.7 billion with China. 

Once again, take China for example. RMB appreciated by 36% from July 2005 to early August 2016, while US trade deficit with China increased from US$201.6 billion to US$365.7 billion in 2015, up by 81.4%. 

These facts show that the trade surplus or deficit of a country or region does not have much to do with its exchange rate. The exchange rate is not the deciding factor. Rather, deficit or surplus is a trading activity. It is the result of comparative advantages on a market basis. The competitiveness of the products of a country or region is determined by a host of factors. Simply forcing the currency appreciation of the counterparty to reduce one’s own trade deficit is a traditional and narrow-minded thinking on international trade. Time has changed, and the situation is more complicated. Such a traditional thinking must be adjusted and updated. 

After 11 years of exchange rate reform, the RMB exchange rate has basically become market driven. The band of the exchange rate fluctuation has increased from the original 0.3% to 0.5%, 1%, 2% and current 3%. In the latest half a year, the RMB exchange rate has been once again pegged to a basket of currencies and basically maintained stability. Now, people are more focused on the depreciation of the RMB against the US dollar and neglect its appreciation to different degrees against the yen, euro and pound. 

The main reason for RMB’s depreciation against the dollar lies in the dollar itself, not the RMB. On 10 October 2016, the USDX exceeded 97, and the central parity rate of the RMB was 6.7098 the following day. On 15 November, the USDX exceeded 100, and the central parity rate of the RMB was 6.8592 on 16 November. On 22 December, the USDX rose to 103.36, a 14-year high since 2002. The central parity rate of the RMB was 6.9463 the next day. In the face of the significant appreciation of the US dollar, the currencies of quite many developing countries have experienced relatively sharp depreciation. By comparison, the fluctuation of the RMB is comparatively moderate. This is a widely recognized fact that must not be distorted. 

On 1 October 2016, the International Monetary Fund officially included the RMB into the SDR basket as one of its five reserve currencies. This is a recognition of the market-based reform of the RMB exchange rate and the global use of the RMB. 

There is no reason that China should be labeled as a “currency manipulator”.

3. China-US economic and trade relations will enter an eventful period in 2017. 

After the strongly protectionist Trump team take office, they will inevitably push for trade protectionism globally, which will for sure meet with opposition and reprisals across the world. As a consequence, it will hurt all and benefit none, and the world economy will backslide. There are examples in history. In the 1930s when the US experienced the Great Depression, President Hoover raised import tariffs by a great margin to protect domestic industries. That was opposed by the rest of the world. When goods cannot move across borders freely, soldiers go beyond national borders. The Second World War thus broke out. 

China has no intention to wage a trade war. Nor is it afraid of a trade war. In the 44 years of China-US economic exchanges, there has been only one trade war: the textile trade dispute in 1983. It ended with compromise made by the US government. It is worth noting that China’s GDP in 1983 was less than 5% of that of the US, while China’s GDP in 2015 was 61% of US GDP. Today’s China is not what it was 33 years ago. Any US administration should never belittle China. In 2015, China imported 22% of US cotton, 56% of US soy beans, 26% of Boeing aircraft sold overseas and 33% of the GM vehicles sold to other countries. Substitutes for these products can be found elsewhere in the world. The US is fully aware of that.  

Dialogue is better than confrontation, and cooperation is better than friction. China and the US are each other’s big market. Since 2010, China has been the largest market for US agricultural products. Trump nominated the governor of an agricultural state to be the US ambassador to China in the hope of promoting agricultural exports to China. 

China has become a vital trading partner for the US long time ago. US-China trade in 2015 was US$598.1 billion, accounting for 16% of US foreign trade. If Hong Kong and Macao are included, US-China trade will be US$642.6 billion, accounting for 17.2% of US foreign trade. 

That said, the US is also a very important trading partner of China. In 2015, China-US trade was US$558.3 billion, accounting for 14.3% of China’s foreign trade. China’s exports to the US were US$409.5 billion, accounting for 18% of its total exports. If the US$481.9 billion exports via Hong Kong are included, it will account for 21.2% of China’s total exports. Since 2012, the US has surpassed the EU as China’s largest export market. 

China-US economic and trade cooperation faces broad prospects, with both major opportunities and daunting challenges. The two countries will lose from confrontation and gain from cooperation. The two governments should strengthen dialogue and cooperation in a win-win spirit. This will not only benefit the Chinese and American people, but also promote the development of the world economy. 

* Zhou Shijian is Senior Fellow, the Center on US-China Relations, Tsinghua University.