China and the U.S.: The Ties That Bind

Boston Consulting Group's David Michael thinks the U.S. and China have much to lose from a trade warand much to gain from cooperation

Before the U.S. plunges into a trade war with China, policymakers and political leaders should look beyond the trade deficit numbers and consider the complex and changing nature of the U.S.-China economic relationship.

The U.S.-China trade deficit exceeded $232.5 billion in fiscal 2006, according to U.S. government figures. This does represent a real economic imbalance. It also creates a complex set of challenges. But there is no easy solution.

While it is natural for economists and politicians to look for external causes, the fact is that neither Chinese companies nor the Chinese government are primarily responsible for the imbalance. The majority of China's exports are driven by foreign companies, and many of China's domestic markets are relatively open to foreign products and brands. So the trade deficit reflects the complicated reality of globalization.

Western Brand Names in Abundance

It also reflects the decisions of many non-Chinese companies, which on balance are made to benefit those companies and their customers. Consider this: Nearly 60% of all of "China's" exports are driven by non-Chinese companies seeking to take advantage of China's low-cost manufacturing and state-of-the art infrastructure.

Consumers in the U.S. buy these products every day at Wal-Mart (WMT), Costco (COST), Circuit City (CC), Macy's (M), and other leading retailers. Many of these products display Western brand names, with Western designs and quality standards, but they are made in China. Indeed, to keep the sourcing stream flowing, U.S. and other international companies are investing $1 billion a week to further expand their China operations.

By contrast, China has yet to produce a large number of purely Chinese-owned export powerhouses. This is quite different from Korea or Japan, where local companies dominate the export landscape. In China, the export game is driven by foreign companies.

WTO Entry Accelerated China's Momentum

How about China's own market? Is China importing much from abroad? While it may not be importing enough to erase the trade deficit, China is buying a lot more from the U.S. than it did just a short while ago, and it is likely to buy significantly more in the future as its booming economy grows.

Since China joined the World Trade Organization (WTO) in 2001, for instance, U.S. exports to China—the second-largest economy in the world—have increased by 190%, making it America's fourth-largest export market, according to the Office of the U.S. Trade Representative (and if U.S. exports to Hong Kong are included, then China is our third-largest export market). The rate of increase in U.S. sales to China has been 12 times higher than the growth of American exports to other countries during the same period, according to the U.S. Commerce Dept.

Indeed, Chinese consumers like foreign brands. And as incomes continue to rise, more Chinese consumers will seek foreign-made goods. U.S. and other non-domestic brands already dominate many sectors in China, including passenger cars, mobile phones, computer printers, and high-end televisions.

Fast Food, Aircraft, and Medical Devices

For instance, one of the most popular automobile brands in China today is Buick. And if you enjoy coffee or fried chicken, you'll have no problem finding Starbucks (SBUX) or KFC (YUM). While these products and services may be produced in China, they call upon management and design talent provided by the U.S. and U.S. employees. U.S. and other foreign companies also dominate the growing commercial aircraft market and are the suppliers of virtually all high-end medical equipment.

The reasons why U.S. and other foreign products do so well in China are many.

One of the most important is that the Chinese market is generally quite open to their products, far more so than the Japanese and South Korean markets historically have been. Foreign brands play a large role in the daily lives of most Chinese people. And that should be our cue: Keep the momentum going.

The main exceptions at this time are in the service sectors, such as financial services, communications, media, and entertainment. This is an area where trade negotiators should legitimately focus their attention, and where an opening of Chinese markets would benefit the U.S. economy. Another promising area is travel. Chinese consumers are eager to visit the U.S. and to spend money there. American policy should evolve to better capture this opportunity.

Lax Environmental Laws

It's important to keep the big picture in mind. Let's make sure we are advocating the benefits of greater trade to both sides, rather than seeking to erect barriers. If we successfully do so, the U.S. might also gain the leverage it needs to convince China to make some tough economic and social choices. For instance, the Chinese might be convinced that it's in their own interest to crack down on copyright and foreign patent violations and improve intellectual property protections, issues that greatly concern U.S. companies.

The U.S. also might be in a better position to encourage China to move forward with meaningful environmental protection. This would include implementing much stronger environmental emissions standards, investing in new refineries capable of processing cleaner fuels, and mandating that domestic Chinese producers comply with globally accepted pollution standards. Because the U.S., Japan, and Europe have much stricter environmental regulations, China's lax laws can effectively act as subsidies for its manufacturing industries. China is making progress in this area.

China also needs to confront other problems. Despite its emergence as a global economic powerhouse, China is still home to 18% of the world's poor, with 150 million people subsisting on less than $1 per day. But China's rapid economic development is lifting tens of millions of people out of poverty, according to the World Bank. That is something we should be happy about.

Millions Have Left Poverty

We should also be happy that the Chinese people have an overall favorable opinion of the U.S. A 2006 Pew poll of global attitudes, for example, revealed that the Chinese peoples' attitudes towards America are far more favorable than the opinions held by some of our more traditional allies.

As we consider our trade relationship with China, let's reflect upon this: The past decade of rising trade with China has helped tens of millions of people in China rise out of poverty, has helped fuel generally pro-American attitudes, and has helped provide important export and investment markets for U.S. companies, with the potential for substantially more growth in the future. Is there some other plausible scenario more positive than that?

The U.S. and China each bring to the table distinct advantages and disadvantages. China's main advantages are its low-cost labor pool, its impressive infrastructure that enables companies to gain access to this labor, and its pro-investment policies. Neither currency adjustments nor trade barriers will change this situation. Indeed, Oxford Analytics has recently reported that even a 25% appreciation in China's currency would bring about only a marginal change in the trade deficit.

Important Issues For Everybody

Asking China to turn back the clock on its growing role in the global economy is not the answer. Indeed, what will become really crucial in the years ahead will be the task of working with China on issues of vital common interest.

The decisions that China makes about growth, environmental and energy policies, and global warming will soon be the most important questions for all of us. The U.S. would be well served to ensure that these issues are prominent in our overall China relationship.

Before it's here, it's on the Bloomberg Terminal.