A Codependent Relationship: The United States and China's Unhealthy Relationship

by Sabina Dewan

This article was published by the Center for American Progress.

The United States and China are tethered together by a complicated economic relationship—one that today’s troubled economic time is testing to the limit. The two economies are deeply intertwined through linked currency exchange rates, trade, and capital flows, yet neither country is wholly content with codependencies that are clearly unsustainable in their current forms.

Reducing the U.S. trade deficit with China is critical to addressing the unhealthy part of this relationship. To do so, several moves are required by both countries. Specifically, the United States must:

• Work with our international partners to prod China to address its exchange rate policies. The European Union is now doing so, but Washington needs to enlist additional partners in Asia and Latin America that also suffer from China’s beggar-thy-neighbor exchange-rate policies.
• Continue to enhance our economic competitiveness. This entails capitalizing on our innovative culture and aggressively investing in the development of new technologies, especially green technologies and renewable sources of energy, to revitalize our manufacturing sector. Concomitantly, we need to invest more in human capital and social protections, which are vital to improving our competitiveness.
• Deepen our trade ties with a wider range of countries to counterbalance the trade relationship with China. Washington must cultivate trade and help build government institutions in developing countries, particularly emerging economies such as India and Brazil, to help raise their living standards and thus create new markets for our own goods and services.

These three steps are not only necessary but possible; although not immediately and not without effort. To understand why we can and must do so, let’s first look at our current bilateral economic relations with China.

Understanding the codependency

China needs the United States. We are China’s top trading partner and its top destination for exports. Chinese exports of goods and services to the United States account for a 35 percent share of China’s gross domestic product, and have exceeded its imports from the United States every year since 1990. In 2000, China ran a bilateral trade surplus of $83 billion; a figure that increased to $268 billion by December 2008.

The surge in Chinese exports is a direct result of the Chinese government holding down the value of their own currency. For much of the past decade, the Chinese pegged the yuan to the U.S. dollar at below-market rates, making Chinese exports cheaper for buyers thereby contributing to our trade deficit. This distorts global trade flows not just between the United States and China but with all of China’s trading partners.

The United States also needs China. Beijing is the biggest purchaser of U.S. government debt, with net holdings worth about $799 billion. The Chinese have accumulated vast reserves of foreign assets, valued at approximately $2.27 trillion, 65 percent of which is in U.S. dollars.

This causes some economists to fear a precipitous decline in the value of the dollar should the Chinese decide to sell their hoard of greenbacks. A declining dollar could fuel our exports but could also lead to inflation, which in turn would require the Federal Reserve to raise interest rates in the United States, perhaps sharply, thereby crimping economic growth. The Chinese are unlikely to spark a run on the greenback—after all, their national wealth and economic well-being are strongly tied to a steady dollar—yet this unhealthy foreign exchange relationship will inevitably change over time.

Changing the codependency

This means that we must rethink how to narrow the U.S. trade deficit. The Great Recession drove down imports from China to $212 billion in 2009 as of September, from $321 billion in 2007. But the U.S. economy is now slowly on the mend. To shrink the trade deficit, we must borrow less and learn to be less reliant on government spending funded by selling U.S. treasuries to the Chinese. Setting up measures to address the projected long-term deficit once today’s fledgling economic recovery takes hold is key to this end.

But nudging China to rectify its exchange rate policies is critical. Redistributing the voting shares (or quotas) in the International Monetary Fund to better reflect China’s weight as a member of the global economy, and simultaneously empowering the IMF to better monitor and report on exchange rate policies may help steer China toward more responsible behavior. Indeed, as the world becomes more engaged with China and vice versa, the Chinese are more likely to succumb to the international pressure and stray away from intense negative publicity. This may also be a more preferable approach rather than confronting China on the issue bilaterally, which has so far proved to be difficult.

Another way to reduce our trade deficit is for the United States to improve its own economic competitiveness. In 1990, the United States ran a $35 billion trade surplus in advanced technology products. As of September this year, it has a trade deficit of $37 billion. The U.S. trade deficit in advanced technology products was $6 billion in September up from $2 billion in January this year. As of September 2009, our year to date trade deficit with China in advanced technology products was $49.4 billion.

To reduce our overall technology trade deficit, we need aggressive investments in leading U.S. sectors for export and investments, especially high-tech computer and electronic products, green technology/renewable energies, and medical equipment. We must also work to maintain our current surplus in tech services that has declined in recent years.

We cannot underestimate the will and the capacity of other countries to compete with us in these areas. In order to sustain the high level of economic growth that the Chinese have grown accustomed to, they must upgrade the structure of their exports from low-cost manufacturing to high technology and high-value-added products and services. This makes innovation imperative—a fact that Beijing is keenly aware of. It has launched a major national strategy to transform its economy and society into an innovation-driven one by 2020. Chinese expenditures for research and development in science and technology grew by approximately 19 percent since 1995 reaching $30 billion in 2005, the sixth largest worldwide.

In the race to herald in the next generation of technology, especially in the manufacturing of clean energy and its deployment, we must not underestimate other countries, and more importantly we must not fall behind. To get ahead of the curve and improve our economic competitiveness swiftly and aggressively, we need to invest in research and development to promote science and technology innovation in both public and private sectors.

There is a need to make good on President Obama’s call for a national innovation policythat strengthens regional economies in the United States so they can capitalize on key strengths of local businesses, universities, research and development institutions, nonprofits, and community organizations. And the United States needs to provide flexible financing that will support the development of the most promising new technology, especially in clean energy. This will also require investing in human capital through better education, including vocational and skills training/retraining programs.

Although China is frequently blamed for the job losses that we incur in the United States, China is still an important market that offers significant future potential for our exports. Some economists question whether this potential is just a mirage since personal consumption in China as a percentage of its gross domestic product has been declining while capital investment has been rising. Yet, the recent economic crisis starkly reveals the unsustainability of a growth model that relies so heavily on U.S. consumption.

That Americans will learn to save more and consume less and the Chinese will learn to consume more and save less over time is not that far-fetched a notion. In fact, Beijing’s $124 billion health care reform plan announced earlier this year is partly intended to improve household financial security that will help promote consumer spending.

Still, putting all our eggs in the Chinese basket will keep us tethered in this codependent relationship. We have to find additional and diverse sources of demand for our goods and services. Other emerging countries in Asia such as India and South Korea, and in Latin America such as Brazil offer significant opportunities to expand market share for our exports. This is important to keep in mind when considering a renewal of Generalized System of Preference benefits for India and Brazil, and discussions of bilateral, regional, or multilateral trade agreements. To the extent that we can help these nations raise their living standards by promoting trade and building government institutions, we can create new markets for our own goods and services.

Going forward, China and the United States must loosen the tight knot between them, but they must remain friends in coparenting the global economy and in dealing with global challenges like climate change, nuclear nonproliferation, and pandemics. We must focus on aggressively bolstering our own competitiveness. Cultivating and diversifying trade with additional countries is essential to the future health and progress of our economy.

Sabina Dewan is Associate Director of International Economic Policy at the Center for American Progress.