Ties That Bind

RETHINKING U.S.-CHINA TRADE

U.S.-China trade relations have been on a fast track since the two countries signed a historic trade agreement in November 1999. That accord culminated nearly 15 years of difficult negotiations and helped pave the way for U.S. congressional approval of permanent normal trade relations with Beijing in 2000. Last year, further agreements in such sensitive sectors as agriculture, retail, and insurance were hammered out, facilitating the deal of all deals: China's entry into the World Trade Organization (WTO).

Notwithstanding this success at the bargaining table, the heavy lifting of U.S. trade negotiations will not do much to dent the outsized U.S. trade deficit with China, which topped $80 billion in 2001. While the negotiators were talking, the ground beneath U.S.-China commercial relations was shifting. Over the past decade, shallow links based on trade have been transformed into a more complex relationship shaped by rising U.S. foreign direct investment (FDI) and sales by U.S. foreign affiliates in China. Mirroring the global norm, sales by these affiliates, rather than U.S. exports, have become the preferred way to deliver American products to the Chinese market. As a result, U.S. export figures -- which do not count these affiliate sales -- understate the true level of commercial engagement between the two countries.

Meanwhile, more U.S. multinational corporations are using China as an export platform in the face of unrelenting global competition. An increasing percentage of the products these affiliates export from China is destined for the U.S. market. These goods count as Chinese exports to the United States -- even though they are shipped by U.S.-owned entities -- and they contribute to the ever-widening American trade deficit. European and Japanese multinationals are following a similar strategy of manufacturing in China for export, further adding to America's import bill from that country. Together, the delivery of U.S. goods through affiliates and the increasing use of the mainland as an export base by the world's leading multinational corporations could inhibit any significant improvement in the American trade deficit with China.

Despite this stubbornly large trade deficit, U.S. policymakers must recognize just how much successful trade negotiations have enhanced market access to China. Many U.S. firms, in both manufacturing and services, are poised to reap the windfall of a more open Chinese market. But increased market penetration does not necessarily imply a corresponding reduction in the U.S. trade deficit with China. American firms prefer to leverage their global core competencies through FDI rather than through trade, particularly in such a strategic and competitive market as China. Failing to understand this dynamic will only fuel resentment in Washington and heighten the risks of errors when crafting policy toward Beijing, possibly even provoking a protectionist backlash. If the relationship between the United States and China is destined to be among the most important in the world, then American policymakers must rethink how the two countries do business with each other.

GREAT LEAP OUTWARD

Although open to the West for the past quarter-century, China really emerged on corporate America's radar screen only in the past decade. Through the early 1990s, U.S.-China commercial ties were relatively underdeveloped and based almost exclusively on trade. Despite a fourfold increase in trade between the two economies in the 1980s, more than three-quarters of it in 1990 consisted of U.S. imports from China. Meanwhile, U.S. exports to the mainland remained modest, at around one percent of the U.S. total.

Even more indicative of underdeveloped links with China, U.S. investment roots there were virtually nonexistent ten years ago. American FDI in China was less than $400 million in 1990, among the smallest of all U.S. investment positions in Asia. Fewer than 50 majority-owned U.S. foreign affiliates were operating there, and they employed a mere 13,600 workers out of a global U.S. affiliate work force of nearly 7 million. With such a minuscule investment base, U.S. foreign affiliate sales in China tallied just $775 million in 1990, compared to a global total of $1.2 trillion. Affiliate sales within China accounted for less than 15 percent of total American exports to the mainland -- at a time when global affiliate sales of U.S. firms were more than double total U.S. exports. In sum, U.S.-China commercial relations were "shallow," or trade-based, as opposed to "deep," or based on both trade and investment.

But commercial relations entered a new phase in 1993. Inland cities were opened up to foreign firms, and certain restrictions in such sectors as power generation and telecommunications services were lifted. Beijing began to reform its tax system and overhaul the exchange-rate regime. Encouraged by a more liberal investment environment, foreign firms gained greater access to the local market and tighter control over how to structure their mainland operations. American firms responded by sinking more capital into China in 1993-94 ($1.8 billion) than during the preceding 12 years combined. Amid the quickening pace of reform and China's robust growth, the number of U.S. foreign affiliates on the mainland nearly tripled between 1993 and 1995 -- as did the number of Chinese workers on U.S. affiliate payrolls.

Thanks to this new opening, the pace of U.S. FDI in China accelerated over the second half of the 1990s. American investment flows to China rose by an annual average of $1.3 billion in 1996-2000, up from an average annual increase of $365 million in 1990-95. Of the $8.7 billion that U.S. firms invested in China between 1990 and 2000, roughly 75 percent occurred from 1996 on. Including Hong Kong, the strategic gateway that many U.S. firms use to access the mainland, China became a preferred location for American business not only in Asia but among developing nations in general. Among the latter, only Mexico (a partner in the North American Free Trade Agreement) and Brazil (which undertook large-scale privatization sales) attracted more U.S. investment than China and Hong Kong did in the second half of the 1990s.

The rapid American investment buildup in China after 1996 stands in stark contrast to the halting pace of trade talks over the same period. The U.S. trade deficit with China rose from $10.4 billion in 1990 to nearly $70 billion in 1999, heightening the impression that China was playing by its own rules at the expense of U.S. jobs and income. As the trade deficit rose, so did the animosity in Washington.

But while negotiators were talking, U.S. firms were investing in China. Total assets of U.S. multinationals there ballooned from $2.1 billion in 1990 to nearly $33 billion by 1999. By the end of the decade, the number of U.S. majority-owned foreign affiliates in China topped 450, up from just 45 in 1990. American firms employed some 262,000 workers, one of the largest affiliate work forces in developing Asia. More assets, more operations, and more workers meant more U.S. foreign affiliate sales. In fact, total sales by U.S. majority-owned affiliates exploded in the 1990s, rising from $775 million in 1990 to $20 billion in 1999. (U.S. exports of goods and services also rose sharply over the same period -- by roughly 220 percent -- but not nearly at the same pace as affiliate sales.) Once U.S. minority-owned affiliates are factored in, affiliate sales totaled $23 billion in 1999. That year marked a new zenith in U.S.-China relations and capped a remarkable decade of bilateral integration, as U.S. affiliate sales exceeded exports for the first time.

Thanks to the growing American presence in China, the greater Chinese market (comprising Hong Kong and the mainland) is now the largest source of U.S. foreign-affiliate income among developing nations. Affiliate income from greater China rose more than sixfold during the 1990s, topping $7 billion in 2000; in 2001, the figure dipped but was still 18 percent higher than earnings from second-place Mexico. What that means is that, contrary to popular perception, China is now a source of considerable earnings for many U.S. firms. American lawmakers should not forget this as they debate and craft policies toward China. Nor should Washington lose sight of the fact that U.S.-China commercial relations are poised to enter a new phase following China's WTO accession.

MORE THAN A MARKET

U.S. multinationals initially entered China to gain access to the mainland's large but untapped consumer market. In the early 1990s, reaching the Chinese consumer required "barrier-jumping" investment to overcome tariffs and other measures that discriminated against trade. Once inside China, U.S. foreign affiliates were largely independent (or stand-alone), with minimal links to the parent company. High transportation costs and trade restrictions hindered integration between parent firms and affiliates. Hence the bulk of what affiliates produced in China was not for export but for the local market. Accordingly, local sales by U.S. affiliates accounted for more than 90 percent of their total sales in 1990. That share then declined slightly but still hovered around 84 percent in 1995, well above the global average of 67 percent.

Today, access to the Chinese consumer remains a key motivation of U.S. multinationals. Customer proximity is critical in a country as fragmented as China. The mainland is not a unified market but a collection of markets with different dialects and varying levels of development, infrastructure, and per capita income. These variables, along with high levels of brand sensitivity, interprovincial barriers, and cost- and quality-control issues, dictate that U.S. firms adapt to local tastes and market conditions. Coca-Cola's mantra to "think local, act local" helps explain that company's long track record of success in China.

But China has become more than just a market to U.S. firms. As the country's investment policies and economic conditions changed over the past decade, so did the strategies of U.S. multinationals. By the mid-1990s, American firms had moved beyond the stand-alone affiliate strategies. Market-seeking investment was increasingly complemented by efficiency-seeking investment as more U.S. firms turned to the mainland as a low-cost manufacturing base in the face of mounting global competition. Cheap labor, falling transportation costs, and more liberal economic policies allowed firms to outsource more functions and transfer more activities to their affiliates. Meanwhile, U.S. parent-affiliate linkages became tighter and more intricate. This increased integration was centered largely on labor-intensive production and the manufacturing of goods for both the local market and for export.

Taken together, these developments altered the direction of affiliate sales. Whereas affiliate sales to the local Chinese market rose more than fivefold between 1994 and 1999, affiliate exports to the United States rose more than twelvefold, soaring to $2.7 billion in 1999, according to the U.S. Bureau of Economic Analysis (BEA). Exports to third markets rocketed up as well -- likely reflecting rising shipments through Hong Kong -- and hit $3.5 billion in 1999, up from $500 million in 1994. Figures from the U.S. Census Bureau show a large increase in affiliate trade over the past half-decade as well: related-party imports from China to the United States, or affiliate shipments to their parents, tripled between 1994 ($5.1 billion) and 2001 ($18.5 billion).

OPENING UP

China's entry into the WTO has sparked a fierce American debate over the possible impact on the U.S.-China trade balance. Optimists believe the mainland's participation in the world trade body will stimulate U.S. exports and help narrow America's trade gap with China. Others are far less sanguine, pointing to the removal of global textile restrictions and China's continued unfair trade practices as two major impediments to any gains in trade. Whatever the merits of each position, these arguments fail to see that U.S.-China relations are rapidly being transformed by the investment-driven strategies of multinationals.

At its core, China's WTO accession is about greater access to China's markets and resources. Governments and multilateral institutions brokered that deal. But at the end of the day, firms, not governments, will largely determine the delivery of goods and services to China. In general, U.S. companies view China no differently than they do other foreign markets. That is, they would rather sell their products directly through their foreign affiliates than export them from the United States. When advantages such as cheap labor and a large internal market are present in a host nation, U.S. companies are all too willing to exploit these endowments.

China's massive consumer and labor markets do set it apart from the rest of the world. So for many American firms, there is no choice but to be on the ground. Eastman Kodak, for instance, cannot compete at arm's length from China against its global rival Fuji Photo Film. Nor can Motorola, which confronts an uphill battle there against Nokia, cede the mainland's massive consumer cellular market to the Finnish cell-phone giant. General Motors similarly requires an in-country presence if it hopes to chip away at Volkswagen's leading market position. Even though Chinese tariffs on foreign automobiles are expected to be lowered over the next few years, it is highly unlikely that gm will opt to serve Chinese consumers from afar, through trade, rather than nearby, through investment. For IBM and Compaq, stiff local competition requires a local presence if they are to have any chance of surviving in a highly competitive Chinese market.

For these companies and many others, China's WTO accession represents a green light not so much to trade but to invest, and to enhance existing ties with their foreign affiliates or create new ones. The price of admission into the WTO -- lower tariffs, the elimination of numerous nontariff barriers, industry deregulation, and improved intellectual property rights -- will allow U.S. parents and affiliates to become even more integrated. Lower tariffs will allow both parties to exchange materials, parts, and finished goods on a more cost-effective basis. The once-simple integration strategies of firms, centered on the processing or assembling of manufactured goods, will become more complex as value-added manufacturing functions are increasingly transferred to Chinese affiliates. The latter will become more specialized as they are brought into the global production networks of the parents. As a result, the quality of affiliate production will rise and become more internationally competitive.

Furthermore, affiliate output for both the local market and for exports will become more interchangeable, promoting increased related-party trade of U.S. exports and imports and greater trade flows in general. And expanded in-country distribution rights will give affiliates better access to the Chinese consumer. The upshot is that the key trends of the late 1990s -- increased reliance on foreign affiliate sales as the primary way to deliver goods, and greater use of China as an export platform -- will accelerate in the years ahead.

This change will not happen over night. There will be hiccups and hang-ups. But short-term setbacks should not obscure the fact that the two nations are entering a new phase. American firms have already begun to upgrade their investment base in China, as seen in the expanding research and development presence of such technology leaders as Cisco, Microsoft, and Intel. These firms are driving deeper into China to adapt their technology to the local market and tap the potential of China's low-cost but well-educated work force. For the same reasons, world technology leaders such as Advanced Micro Devices, Matsushita, Amkor, and Philips Semiconductor have also made major investments in the mainland. In the end, although everyone agrees that Beijing's entry into the WTO entails deeper U.S.-China links, few realize how these ties will materialize.

"MADE IN CHINA"

Overcoming a U.S. trade deficit in excess of $80 billion is not going to be easy if more American firms are using the mainland as a low-cost export base. But the task will be made even tougher by the fact that U.S. firms are not the only ones exporting goods from the mainland. Asia's developing economies have been deploying this strategy for years. European and Japanese multinationals are also rapidly expanding their outsourcing capabilities in China. Indeed, Beijing's WTO accession has only enhanced China's role as the world's preeminent low-cost factory.

One of the most overlooked aspects of the U.S.-China trade relationship is the large percentage of U.S. imports from the mainland produced by foreign enterprises operating there. Cell phones, televisions, video cameras, and printers are typical imports from China -- but they are purchased from firms headquartered outside China. Most of the profits from these sales accrue to the parent company, even though these goods, and many others like them, bear the familiar "Made in China" label.

The paucity of data makes it hard to compare U.S. imports from indigenous Chinese firms with imports from foreign enterprises and affiliates. But it is clear that the contribution of foreign enterprises to China's export ascendancy is staggering. From a share of less than two percent in 1985, aggregate exports of foreign-invested enterprises accounted for nearly half of China's total exports in 2000. Affiliate exports from China in 2000 -- nearly $120 billion -- were double Brazil's exports in the same year and exceeded total exports from central Europe. It was export-oriented investment from Hong Kong, Singapore, Taiwan, and South Korea that helped transform China from a producer of primary commodities in the early 1980s into one of the world's leading exporters of light manufactured goods in less than a decade. To offset rising costs at home and exploit China's rock-bottom labor costs, manufacturers of footwear, toys, garments, sporting goods, and other consumer items began to decamp from their own markets for the mainland in the late 1980s. Most of the production in China was for export, which had the effect of boosting America's trade deficit with China while lowering America's deficit with Hong Kong, South Korea, and Taiwan.

In the 1990s, a similar pattern occurred as the world's leading technology firms also migrated to China, shifting the composition of investment from low-end goods to information technology. Once again, China's exports reflected that change. As a share of China's total exports, office machines and telecommunications equipment leapt from a virtually nonexistent share in 1990 to

17.4 percent by 2000. Exports in that category surged by 44 percent in 2000 alone, totaling $43.5 billion and vaulting China into the global high-tech big leagues. The mainland has now become a leading global exporter of machinery and transportation equipment, boosted by annual export growth of 23 percent over the 1990s. China's share of the world's manufactured exports more than doubled again in the last decade, rising from 1.9 percent in 1990 to 4.7 percent in 2000.

China now ranks as the world's sixth-largest exporter of manufactured goods. It could even overtake Japan, which had a global share of 9.7 percent in 2000, as more Japanese firms turn to China as a low-cost export platform. Although Japanese investment flows to China have blown hot and cold over the past decade, China's accession into the WTO and Japan's ongoing recession pushed Japan's investment in China to a record high in 2001. Japan's corporate elite is raising its investment stakes in China, where wages are one-tenth of those in Japan. This change could shift more of Japan's trade deficit with the United States onto the shoulders of China.

COMPETITOR OR PARTNER?

America's trade deficit with China is here to stay. But the perennial trade gap need not be a poisonous thorn in the side of both parties if new analytical tools are used to understand and measure the commercial linkages between the United States and China. Trade statistics were useful measurements in the 1980s, when U.S.-China relations represented nothing more than the simple two-way exchange of goods. But today, bilateral links are much more complex, shaped increasingly by foreign investment and the global strategies of multinationals.

Against this backdrop, it is time for one of the best-kept secrets in Washington to be boldly broadcast: American firms deliver their products to foreign customers through not only exports but foreign-affiliate sales. An increase in the ratio of U.S. affiliate sales to exports, as in the case of China, indicates deepening commercial linkages. This variable, not the trade deficit, should be what shapes and influences U.S. economic policy toward China. A single-minded obsession with trade is a recipe for misguided policies.

With this fact in mind, the Bush administration must allocate more resources for the accurate and timely collection of foreign-affiliate data. Last March, the BEA finally released such data for 1999 -- an unacceptable lag that keeps policymakers in the dark and makes earlier-released trade figures, by default, the official scorecard of U.S.-China commerce. The administration also needs to take the lead in articulating to Congress how firms' strategies influence bilateral trade flows and how a corporate presence in China can positively affect U.S. corporate profits, exports, and jobs. In addition, many in Washington need to understand that although China's trade surplus with the United States is relatively large, a portion of the surplus is recycled back to the United States. China alone accounted for roughly 10 percent of net foreign purchases of U.S. securities last year. In other words, if the United States should opt to curtail commercial links with the mainland, it may be effectively cutting off a key source of foreign capital -- something the world's largest debtor nation can hardly afford. For their part, senior managers of corporate America should better explain to the public how their companies compete in one of the most promising yet competitive markets in the world. An interagency committee should be formed to debate and discuss these issues, with subsequent consultations with the Chinese.

These endeavors are not arduous or expensive, but they would pay huge dividends. Rethinking U.S.-China engagement would set the stage for a more informed dialogue with Beijing as China phases in various WTO commitments. It would promote greater cooperation and a spirit of trust between the two parties. Less controversy over trade would help promote a new global trade round and minimize bilateral disputes. It would also provide a more constructive backdrop for other thorny issues between the United States and China.

U.S.-China trade relations have progressed rapidly in the past few years. Future prospects, boosted by China's entry into the WTO, are quite promising. But the bilateral relationship will never reach its full potential as long as policymakers continue to interpret America's large trade deficit with China as a loss of global competitiveness or a result of unfair trade practices. The greatest danger on the U.S.-China trade front is that while many in Washington view China as a "strategic competitor," American businesses have increasingly embraced the mainland as a "strategic partner." This divergence represents a dangerous disconnect that must be reconciled in short order.