Coping with its new power

As he pumped the hands of visiting BusinessWeek editors in a Beijing conference room on Mar. 27, Foreign Trade & Economic Cooperation Minister Shi Guangsheng was ebullient. Just four days earlier, China's chief trade negotiator, Long Yongtu, had concluded a "very constructive" meeting in Washington with new U.S. Trade Representative Robert B. Zoellick, Shi said. The two sides had dramatically narrowed their differences over the agricultural and insurance issues that had been holding up China's long quest to enter the World Trade Organization. If all went smoothly, Chinese hopes were high that the final details would be hammered out in late April in meetings scheduled with the U.S. and other trade partners in Geneva. President George W. Bush and President Jiang Zemin would even celebrate the achievement in Beijing in October, during an Asian trade summit.

But as has happened so often in the dozen years since the Tiananmen Square crackdown, every time Washington and Beijing seem to be building positive momentum, diplomatic disaster strikes. The Apr. 1 emergency landing of a U.S. EP-3E spy plane on Hainan Island, following a midair collision with a fighter some 70 miles off China's coast, has quickly snowballed into another crisis. The U.S., insisting its plane was operating legally over international waters, is warning of severe damage to bilateral relations unless China immediately returns the crew and plane. Beijing is angrily demanding an apology and an end to U.S. surveillance flights off its coast, and has inflamed Washington by holding 24 servicemen and women and possibly boarding the plane and seizing sensitive surveillance equipment.

The spy plane crisis may be resolved soon: As BusinessWeek went to press, signs were mounting that the U.S. was looking for a face-saving way out of the confrontation. But resolution or not, the nasty slide in U.S.-China relations could continue. Even though leaders from both sides have every reason to keep events from spinning out of control, both Bush and Jiang are being pushed by hard-liners in their own governments and by public opinion to stand tough. Chat groups on Chinese Web sites are filled with vitriol against American hegemonism.

In the U.S., meanwhile, the China-bashers are back in force. Already, Congress is pushing a resolution to oppose China's bid to host the 2008 Olympics. And a Gallup poll shows more than 80% of Americans view China as dangerous. Temperatures are likely to get much hotter in the coming months. Among the potential flash points: the Bush Administration's imminent decision on whether to sell destroyers equipped with advanced Aegis radar to Taiwan, its plans to sponsor a U.N. resolution condemning Beijing's human rights record, and what promises to be another hot congressional debate in June over China's trade status. Last year, the U.S. agreed to give China permanent normal trade relations--and halt these annual debates--but only when China enters the WTO. That's unlikely to take place until the trade body meets in November. "Who knows what will happen if the overall climate deteriorates?" says Johns Hopkins University Sinologist David M. Lampton, an expert on the ups and downs of U.S.-China relations since the days of ping-pong diplomacy. "Obviously this is bad for business."

No two incidents--the promising WTO talks and the EP-3E crisis--could better sum up the complex foreign policy quandary that the U.S. faces with Asia's rising superpower. Already, it is a balancing act that the Bush Administration, torn between pressures from Big Business and from military hawks, is struggling to pull off.

On the one hand, China is a regime that still resembles Washington's cold war rivals: a secretive, one-party state that is unapologetic about repressing human rights, is quick to fan local nationalism, and is rapidly building a military to expand its influence in a region dominated by the U.S. Factions in the People's Liberation Army like to stoke public antagonism because "it suits their agenda of modernizing the military," says a Western diplomat in Beijing.

But how to reconcile this China with the market-driven nation rapidly taking shape? The transformation since 1989 has been breathtaking. State-owned industries, which then accounted for about two-thirds of economic output, are now responsible for just 28%. The once-minuscule private sector, which the government only endorsed three years ago, now accounts for one-third of output and is the main driver of job growth. A decade ago, Shanghai was a drab, isolated city stuck in a socialist time warp. Walk the streets near the Nanjing Road shopping thoroughfare today, and you will see Buick sedans, Esprit boutiques, and Starbucks coffee shops. You'll also hear plenty of frank criticism of the government: Prosperity has loosened the strict controls on information and expression that characterized the much poorer Maoist regime.

Even though WTO entry isn't technically a done deal, it already has become a catalyst for change. After two decades of steady but halting reforms, Beijing is now racing to dismantle the last vestiges of a command economy. "There is a revolution under way," says Brookings Institution China economist Nicholas Lardy. Beijing's leaders "really have come to appreciate the benefits of plugging China into the global economy." China is breaking up state monopolies in telecom and distribution. Protections aimed at nurturing national champions in cars, electronics, and machinery are crumbling, and multinationals are gaining unprecedented market access. "The government wants to keep control of only the biggest state enterprises" and privatize the rest, says Beijing University political scientist Wang Yong.

All of these changes will accelerate under the commitments China has made to the WTO--which in many cases it is implementing ahead of schedule. Except in a few sectors, most nontariff barriers to imports will disappear. Duties, which already have dropped from an average of 44%, in 1992, to around 15% now, will plunge below 10% in five years. North America, Europe, and Australia will be able to export millions of extra tons of wheat, corn, cotton, and soybeans.

The market openings Beijing has agreed to were unimaginable a decade ago. China's imports of U.S. high-tech gear, which have swelled from $970 million in 1992 to $4.6 billion last year, could really explode: Computers, telecom equipment, and semiconductors will come in duty-free. With WTO in force, multinationals in China no longer will be forced to give technology to state-controlled partners. Foreign auto makers will be able to sell their cars anywhere, while foreign banks also will be able to open 100%-owned branches and lend directly to consumers. No longer will foreigners have to rely on middlemen to distribute and retail their products.

Of course, WTO membership won't be a magic wand that will make all trade frictions disappear. The next few years may well be marked by anti-dumping suits, counterfeiting charges, and cries of protectionism. That's partly because the deal with the U.S. gives trading partners wide latitude to curb growth in certain Chinese imports if they rise too rapidly and to file antidumping charges. But more important, China's weak legal and regulatory system means it will be years before Beijing can enforce its WTO commitments and overcome the resistance of recalcitrant officials and companies in the provinces. In fact, it often will be hard to tell when China is deliberately breaking a rule or making an innocent mistake. Deciding "when we need to go in and beat them on the side of the head" will be tricky, says a diplomat in Beijing.

Nevertheless, it's easy to see why Western business wants the WTO deal wrapped up pronto, and why Corporate America will likely press Republicans to show restraint in this spring's trade debate. In Beijing, meanwhile, Trade Minister Shi bluntly warns that the U.S. will have much to regret if tensions worsen. "If the U.S. loses the huge market of China, it will constitute a major loss to the economy," he says. In a recent meeting with foreign visitors, Premier Zhu Rongji recalled that the U.S. military recently tried to stop buying Chinese-made berets, but then realized few substitutes were available. "Very likely the clothing they wear, even their underwear, is made in China," he joked. "They cannot expose themselves by throwing everything away."

The U.S. Army can clothe itself, of course. The real point is that China is fast becoming integral to the global economy. Its share of world trade has nearly quadrupled, to 3.6%, since 1978. It now supplies 7.3% of the goods America imports, and nearly 14% of what Japan imports. The shares are likely to grow. The Development Research Center of China's State Council estimates that in a decade, annual world trade would be 3.2% higher than it would if China didn't enter the WTO. Some Western economists think that even this projection is a big understatement, since it does not take into account the leap in productivity that greater competition and inflows of foreign equipment and technology will provoke. World Bank economist Will Martin calculates China's share of world trade will double by 2005 if it enters the WTO this year.

The biggest impact of WTO entry will be felt in industries like garments, toys, and consumer electronics. China's enormous pool of $2-a-day labor, as well as its well-developed industrial parks, give it a huge edge. In 2005, the U.S. and Europe will be required to drop all remaining import quotas on garments and shoes. That could enable China to boost its share of global apparel exports, from 20% to 47%, according to the World Bank. That will send shockwaves through Mexico, India, Indonesia, and other nations whose exports rely on cheap labor. The most profound changes, however, will be in China itself. Brookings' Lardy notes that China is still "shallowly integrated" into the global economy. Half of its exports come from companies in which foreign corporations own stakes--even though they account for just one-eighth of manufacturing output. When foreign-invested companies are excluded, China drops from being the world's 9th-largest exporter to the 15th. China's growth rate, meanwhile, has fallen from 10% five years ago to a projected 7% this year. Even that number is puffed up by heavy public spending and overproduction.

DRAMATIC DOWNSIZING. Chinese leaders know that greater trade and more foreign capital are essential if they are to achieve their goal of doubling the size of the $1.1 trillion economy in a decade. Trade also is vital in order to create jobs for up to 9 million people entering the workforce each year, especially since downsizing at bloated state industries and the civil service is throwing millions of others out of work. The Chinese are confident they will get that capital: Central Bank Governor Dai Xianglong told BusinessWeek he expects China to lure $45 billion in foreign direct investment annually for the next five years, trailing only the U.S. as a recipient of investment.

And that means much deeper economic engagement by America's biggest corporations. After years of travails, many are finding that the China market finally is living up to its hype. In the past three years, Kodak (EK ) has invested more than $1.2 billion into factories acquired from ailing Chinese film manufacturers. It has opened more than 6,000 franchised Kodak shops around the country. Now, China is Kodak's second-largest market for consumer film and paper, and it should overtake the U.S. in a decade. "China is the potential opportunity of a lifetime," says Kodak Asia President Henri Petit. After 12 years of steadily investing in plant and equipment, Motorola Inc. (MOT ) now has one-third of China's huge 53 million-unit annual market for cell phones. It will plow an additional $1.9 billion into new plants for semiconductors, mobile handsets, and networking equipment.

Multinationals also are finding state companies, now worried about getting buried by imports when duties fall, to be eager partners. General Motors' (GM ) deepening involvement in the once-cosseted auto industry is evidence of China's new thinking. Just a couple of years ago, Beijing strictly controlled which and how many foreign auto makers could operate in China, which models they could produce, and with whom they teamed up. The authorities until recently confined GM's new $1.5 billion joint venture in Shanghai to making $40,000 Buicks.

Now, Beijing is letting GM and other foreign carmakers into the sectors they really covet: vehicles that meet the modest budgets of Chinese consumers. Soon, GM is to buy a 34% stake in Liuzhou Wuling Motor Co., located in impoverished Guangxi province. In contrast to the money-losing state-owned behemoths foreign carmakers usually are stuck with, Wuling is doing well. It commands a quarter of China's 400,000-unit minivan market.

But with local competition intensifying and with car duties set to plunge, Wuling needs help. "We've been making cars for 10 years, but our production volume isn't big enough for us to compete in the global market," explains Wuling General Manager Shen Yang. With the aid of dozens of GM experts, Wuling already has started to redesign its factory along the lines of GM's in Shanghai, down to the bulletin board that tracks materials, defects, and output.

What the leadership really wants to achieve by opening up, though, is to enable China's own companies to learn to stand on their own and compete globally. That's starting to happen in consumer electronics, where domestic competition has long been fierce. Now Chinese air conditioners, televisions, and microwave ovens hold their own against imports from Japan and Korea. And brands like Haier, TCL, Galantz, and Konka are starting to be exported around Asia and even to the West. Yukio Shohtoku, managing director of overseas electronics for Matsushita Electronics, says these producers have "very strong advantages" that will enable them soon to take over the low-end market in Japan.

Legend Holdings Ltd. is one company that's starting to achieve China's high-tech ambitions. The Beijing-based computer maker began as a small assembler of PCs for foreign brands who dominated the Chinese market. Now, it's a $2.6 billion powerhouse that holds more than 30% of the market. IBM (IBM ), the top foreign maker, now has just 4.8%. "Our goal is to go abroad," says Legend Executive Vice-President Yang Yuanqing. Legend already is exporting $400 million worth of equipment to its Asian neighbors, and is collaborating with IBM to build an information services business.

AMBITIOUS GOAL. China's rise is unsettling its Asian rivals. "China is fast becoming a manufacturing threat to many Asian countries, not just in low-tech areas but also in some high-tech sectors," says Hong Suk Joon, executive vice-president of Samsung SDI Co., Korea's largest maker of computer screens and picture tubes. Beijing has set the ambitious goal of tripling exports of machinery and electronic products to $360 billion by 2005. That would equal half of all projected exports.

While the outside world may be watching China nervously as a rising economic rival, many Chinese state enterprises simply won't be able to shape up before foreign competition arrives in force. Their weakness will open enormous opportunities for the private sector, even in such sensitive industries as finance. Chengdu-based New Hope Group, a $500 million conglomerate whose interests range from animal feed to real estate, now runs a publicly listed bank that is opening branches across China. President Liu Yonghao credits the imminent deal on WTO for paving the way for his success: In five years, institutions such as Citibank and HSBC will be able to open wholly owned branches in any city, presenting a huge challenge for China's shaky and backward state banks. So authorities are tearing down hurdles for entrepreneurs like Liu. "The WTO is a great opportunity for private companies," he says.

All true, providing political spats get settled quickly. What U.S. business leaders don't want is a repeat of 1996, when Beijing discriminated against Boeing and other companies, after the Clinton administration granted a visa to Taiwan's then-President Lee Tenghui. Even then, the damage got repaired, so much so that after the next serious rupture, the accidental bombing of the Chinese embassy in Belgrade, the two sides were able to sign a WTO agreement six months later. "That shows how we've matured in our relationship," suggests Tim Stratford, chairman of the American Chamber of Commerce in Beijing.

Beijing needs cooler heads to prevail. If the hard-liners in China manage to use the current crisis to stall movement toward WTO, they could also begin to influence other key policy decisions in a sensitive time: Both Zhu Rongji and Jiang Zemin are to step down within two years. If their plan to get China into the global market economy derails, China could lose the billions in foreign capital it needs to create jobs for the millions displaced by reforms.

Still, there's no doubt that Beijing will assert itself on the global stage. Leaders from Zhu Rongji down repeatedly stress to visiting Americans that they see freer trade as vital to China's own emergence. A China that competes peacefully in free markets is something no other nation can really oppose. The concern for U.S. policymakers is that China's economic rise fuels its growing military might and expanding ambitions in the region. That formula guarantees more confrontations. For the West, dealing with this new power is the great foreign policy challenge of the new century.

By Mark Clifford and Dexter Roberts in Beijing and Pete Engardio in New York, with Alysha Webb in Liuzhou, and bureau reports

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