China's Industrial Policy ' Not its Currency Policy ' Threatens American Competitiveness

Over the last 6 months, China has embarked on a series of economic policies that, taken together, shed light on what may be the beginnings of an industrial policy aimed at increasing competitiveness in high-technology industries. Surprisingly, this effort has all taken place without much notice inside Washington, where politicians exaggerate the effect of China's overvalued currency on U.S. competitiveness while ignoring a possibly more profound transition in the Chinese economy.

As recently as March 2006, China announced a plan to become an 'innovative country' by 2020, and a global scientific power by 2050. To back it up, China announced a dramatic increase in its R&D budget, and the government will offer tax incentives to companies to offset R&D expenses against taxable income. The state-owned China Development Bank will also begin issuing low-interest loans to high-tech companies. All in all, China intends to double its R&D spending as a percentage of GDP over the next 15 years.

This is just one in a series of moves by the Chinese government to become a dominant player in high value-added industries, ranging from integrated circuits to medical devices. Oddly, none of this has had much of an effect on Capitol Hill, despite the fact that trade with China remains a hot-button issue. Members of Congress are still upset that the Administration did not label China a currency manipulator, which many believe is largely to blame for the substantial U.S. trade deficit with China.

Not a Currency Issue

To be fair, China's currency is not 'fairly' priced, which is to say, if the market valued it, one yuan would probably be worth more than 12 U.S. cents. That being said, the Hill's ' and to some extent, the Administration's ' focus on China's currency as a source of trade imbalance is a red herring.

First, while an undervalued yuan may make Chinese imports cheaper than they might otherwise be, most Chinese imports are of products no longer produced in the United States, such as consumer electronics, toys, household plastics and tableware, and apparel. And, the currency imbalance did not cause U.S. manufacturers to outsource production ' U.S. companies have left the U.S. market because of cheap labor in China (and elsewhere), which more than trumps the imbalance between the currencies. If the yuan were revalued, imports would simply shift from China to other low-cost countries, such as Vietnam, Indonesia and Malaysia. Production would not necessarily return to the United States.

Second, while a stronger yuan would make U.S. exports less expensive in the Chinese market, the impact in the Chinese market would probably be small. Well over 50% of the goods the U.S. sells to China are of products the Chinese simply do not produce ' such as integrated circuits, turbines, optical instrumentation, medical devices, high-tech chemicals and aircraft. Add to that other goods that the Chinese simply do not produce in sufficient quantities, such as soybeans and cotton, and most of the U.S. exports entering the Chinese market are competing with other exports.

And, here is the irony: The dollar peg has actually made U.S. exports more competitive in China than they would otherwise have been. Since January 2003 (through May 2006), the dollar has weakened against most major developed-country currencies, including by 17.5% against the Euro and 5.1% against the Yen. Because of the dollar peg, the yuan has weakened against these currencies too (by 14.9% and 2.1%, respectively), making European and Japanese goods less attractive to Chinese buyers than competitive U.S. products.

China Pushes for Innovation

The data make a pretty compelling argument that the risk to American competitiveness arises more from China's new resolve to enter innovative industries, not from its undervalued currency.

No one can blame China for trying to create an innovation-based economy. The path is well worn (see, Japan, South Korea, Taiwan, etc.). However, the challenge for U.S. policymakers is to monitor whether China competes fairly and lives up to the commitments it made when it joined the World Trade Organization (WTO).

While some of China's policies, such as its enforcement of intellectual property rights, have clearly registered on Washington's radar screen, many others have not generated any political heat:

• Subsidies. Domestic subsidy programs usually tip the scale in favor of domestic producers who compete against foreign manufacturers. That's why the United States has recently accused China of illegally subsidizing its steel sector and has threatened to bring the issue before a WTO dispute resolution panel. However, the U.S. view is that this may be just the tip of the iceberg. China recently announced that it was expanding subsidy programs for high technology companies, and China has not yet provided the WTO with much detail on these new subsidy programs, a process Beijing agreed to when it acceded to the WTO. The subsidies may be perfectly legal under international rules, but know one will know until the programs are made public.
• China-Specific Product Standards. What if the CEOs of General Motors and Ford woke up one day to discover that Beijing was requiring all cars sold in China to contain catalytic converters that meet Chinese standards ' standards that are at odds with the rest of the world. Would they retrofit their cars for sale in China? Or walk away from the world's largest and fastest growing market? No one can turn away from 1 billion Chinese consumers, and that's why a variety of industry leaders outside of China are concerned by China's recent move to create China-specific standards in industries ranging from distilled spirits to fertilizer. Country-specific standards ' which are normally inconsistent with WTO rules ' are often viewed as a method of protecting domestic industries from foreign competition because they tend to act as significant barriers to trade.
• Price Controls. In some industries, China is imposing price controls in order to clamp down on prices. Price controls have been in place on pharmaceutical products for some time, and now the government has proposed expanding controls to medical devices. Both are industries in the United States that increasingly export to China, so any attempt to cap profitability will inevitably hurt U.S. producers.

The point here is that the United States must watch to ensure that China competes fairly under established international disciplines. In essence, this is what the United States does with all of its major trading partners ' and China is no different. But the U.S. should stop playing politics on currency issues that will have no long-term benefit for the U.S. economy because, within the foreseeable future, China will be producing the high-tech products that currently form the basis of the United States' comparative advantage in the manufacturing sector. U.S. policymakers need to engage in an informed dialogue that addresses the most significant bilateral economic concerns rather than focusing on scoring domestic political points.

Over the last 6 months, China has embarked on a series of economic policies that, taken together, shed light on what may be the beginnings of an industrial policy aimed at increasing competitiveness in high-technology industries. Surprisingly, this effort has all taken place without much notice inside Washington, where politicians exaggerate the effect of China's overvalued currency on U.S. competitiveness while ignoring a possibly more profound transition in the Chinese economy.

As recently as March 2006, China announced a plan to become an 'innovative country' by 2020, and a global scientific power by 2050. To back it up, China announced a dramatic increase in its R&D budget, and the government will offer tax incentives to companies to offset R&D expenses against taxable income. The state-owned China Development Bank will also begin issuing low-interest loans to high-tech companies. All in all, China intends to double its R&D spending as a percentage of GDP over the next 15 years.

This is just one in a series of moves by the Chinese government to become a dominant player in high value-added industries, ranging from integrated circuits to medical devices. Oddly, none of this has had much of an effect on Capitol Hill, despite the fact that trade with China remains a hot-button issue. Members of Congress are still upset that the Administration did not label China a currency manipulator, which many believe is largely to blame for the substantial U.S. trade deficit with China.

Not a Currency Issue

To be fair, China's currency is not 'fairly' priced, which is to say, if the market valued it, one yuan would probably be worth more than 12 U.S. cents. That being said, the Hill's ' and to some extent, the Administration's ' focus on China's currency as a source of trade imbalance is a red herring.

First, while an undervalued yuan may make Chinese imports cheaper than they might otherwise be, most Chinese imports are of products no longer produced in the United States, such as consumer electronics, toys, household plastics and tableware, and apparel. And, the currency imbalance did not cause U.S. manufacturers to outsource production ' U.S. companies have left the U.S. market because of cheap labor in China (and elsewhere), which more than trumps the imbalance between the currencies. If the yuan were revalued, imports would simply shift from China to other low-cost countries, such as Vietnam, Indonesia and Malaysia. Production would not necessarily return to the United States.

Second, while a stronger yuan would make U.S. exports less expensive in the Chinese market, the impact in the Chinese market would probably be small. Well over 50% of the goods the U.S. sells to China are of products the Chinese simply do not produce ' such as integrated circuits, turbines, optical instrumentation, medical devices, high-tech chemicals and aircraft. Add to that other goods that the Chinese simply do not produce in sufficient quantities, such as soybeans and cotton, and most of the U.S. exports entering the Chinese market are competing with other exports.

And, here is the irony: The dollar peg has actually made U.S. exports more competitive in China than they would otherwise have been. Since January 2003 (through May 2006), the dollar has weakened against most major developed-country currencies, including by 17.5% against the Euro and 5.1% against the Yen. Because of the dollar peg, the yuan has weakened against these currencies too (by 14.9% and 2.1%, respectively), making European and Japanese goods less attractive to Chinese buyers than competitive U.S. products.

China Pushes for Innovation

The data make a pretty compelling argument that the risk to American competitiveness arises more from China's new resolve to enter innovative industries, not from its undervalued currency.

No one can blame China for trying to create an innovation-based economy. The path is well worn (see, Japan, South Korea, Taiwan, etc.). However, the challenge for U.S. policymakers is to monitor whether China competes fairly and lives up to the commitments it made when it joined the World Trade Organization (WTO).

While some of China's policies, such as its enforcement of intellectual property rights, have clearly registered on Washington's radar screen, many others have not generated any political heat:

• Subsidies. Domestic subsidy programs usually tip the scale in favor of domestic producers who compete against foreign manufacturers. That's why the United States has recently accused China of illegally subsidizing its steel sector and has threatened to bring the issue before a WTO dispute resolution panel. However, the U.S. view is that this may be just the tip of the iceberg. China recently announced that it was expanding subsidy programs for high technology companies, and China has not yet provided the WTO with much detail on these new subsidy programs, a process Beijing agreed to when it acceded to the WTO. The subsidies may be perfectly legal under international rules, but know one will know until the programs are made public.
• China-Specific Product Standards. What if the CEOs of General Motors and Ford woke up one day to discover that Beijing was requiring all cars sold in China to contain catalytic converters that meet Chinese standards ' standards that are at odds with the rest of the world. Would they retrofit their cars for sale in China? Or walk away from the world's largest and fastest growing market? No one can turn away from 1 billion Chinese consumers, and that's why a variety of industry leaders outside of China are concerned by China's recent move to create China-specific standards in industries ranging from distilled spirits to fertilizer. Country-specific standards ' which are normally inconsistent with WTO rules ' are often viewed as a method of protecting domestic industries from foreign competition because they tend to act as significant barriers to trade.
• Price Controls. In some industries, China is imposing price controls in order to clamp down on prices. Price controls have been in place on pharmaceutical products for some time, and now the government has proposed expanding controls to medical devices. Both are industries in the United States that increasingly export to China, so any attempt to cap profitability will inevitably hurt U.S. producers.

The point here is that the United States must watch to ensure that China competes fairly under established international disciplines. In essence, this is what the United States does with all of its major trading partners ' and China is no different. But the U.S. should stop playing politics on currency issues that will have no long-term benefit for the U.S. economy because, within the foreseeable future, China will be producing the high-tech products that currently form the basis of the United States' comparative advantage in the manufacturing sector. U.S. policymakers need to engage in an informed dialogue that addresses the most significant bilateral economic concerns rather than focusing on scoring domestic political points.