Print PDF

Practice Areas

Report Examines China’s Economic Challenges and Policy Implications for U.S.

Tuesday, September 02, 2014
Sandler, Travis & Rosenberg Trade Report

The Congressional Research Service published recently a report investigating the history, trends and challenges associated with China’s economic rise and their implications for U.S. policy. The report states that while some economists forecast that China will overtake the United States as the world’s largest economy within a few years, China’s ability to maintain a rapidly growing economy in the long run will depend largely on the ability of its government to manage certain challenges. In the meantime, China’s economic rise has significant implications for the U.S.; on the one hand, it is a significant market for U.S. exports and a major manufacturer of inputs and consumer goods imported into the U.S., but on the other hand it maintains policies that can undermine U.S. economic interests.

Major Long-Term Challenges. According to the report, economists believe that China will continue to enjoy fairly healthy economic growth in the near future only if it continues to make major reforms to its economy, including with respect to the following.

Incomplete transition to market economy. While the government appears to accept and allow the use of free market forces in a number of areas to help grow the economy, it still plays a major role in the country’s economic development.

Industrial Policies and SOEs. China has become one of the world’s most active users of industrial policies and administrations, according to the World Bank. State-owned enterprises continue to dominate a number of sectors, are shielded from competition, are the main sectors encouraged to invest overseas, and dominate the listings on China’s stock indexes. SOEs account for only 3.1 percent of all enterprises in China but hold 30 percent of the value of corporate assets in the manufacturing and services sectors, and one estimate holds that China’s SOEs may account for up of 50 percent of non-agriculture GDP. The World Bank estimates that more than 25 percent of China’s SOEs lose money.

Banking System. China’s banking system is largely controlled by the central government, which attempts to ensure that capital (credit) flows to industries deemed by the government to be  essential to China’s economic development. SOEs are believed to receive preferential credit treatment by government banks, while private firms must often pay higher interest rates or obtain credit elsewhere. It is believed that SOEs often do not repay their loans, which may have saddled the banks with a large amount of nonperforming loans. Many analysts contend that one of the biggest weaknesses of China’s banking system is that it lacks the ability to ration and allocate credit according to market principles, such as risk assessment.

Undervalued Currency. Although the renminbi has appreciated against the dollar in real terms by about 40 percent since reforms were introduced in July 2005, some analysts contend that it remains highly undervalued, making exports less expensive and imports more expensive than would occur under a floating exchange rate system. Many economists argue that China’s industrial policies have sharply limited competition and the growth of the private sector, caused over-capacity in many industries and distorted markets by artificially lowering the costs of various factors (such as capital, water, land and energy) below market levels in order to promote targeted industrial sectors.

Overdependence on Exporting and Fixed Investment. A 2009 International Monetary Fund report estimated that fixed investment related to tradable goods plus net exports together accounted for over 60 percent of China’s GDP growth from 2001 to 2008 (up from 40 percent from 1990 to 2000), which was significantly higher than in the G-7 countries (16 percent), the euro area (30 percent) and the rest of Asia (35 percent). China’s gross savings and gross fixed investment as a percent of GDP are the highest among any of the world’s largest economies, while its private consumption as a share of GDP is the lowest.

Growing Pollution. China’s economic growth model has emphasized the growth of heavy industry, much of which is energy-intensive and high polluting, and the Chinese government often disregards its own environmental laws to promote rapid economic growth. As a result, the level of pollution in China continues to worsen; e.g., two-thirds of all Chinese cities are estimated to have “severely polluted” water, seven Chinese cities are among the ten most polluted in the world, and air pollution in China caused an estimated 470,649 deaths in 2008.

Corruption and Rule of Law. The relative lack of the rule of law in China has led to widespread government corruption, financial speculation and misallocation of investment funds. In many cases government connections, not market forces, are the main determinant of successful firms in China. Many U.S. firms find it difficult to do business in China because rules and regulations are generally not consistent or transparent, contracts are not easily enforced and intellectual property rights are not protected (due to the lack of an independent judicial system). Laws and regulations often go unenforced or are ignored by local government officials. As a result, many firms cut corners to maximize profits, which has led to a proliferation of unsafe food and consumer products being sold in China or exported abroad.

Economic Reform Plans. Various government officials have publicly stated the need for China to change course from its traditional model of economic growth at all costs to one that balances growth with a number of social goals in order to develop a “socialist harmonious society” and further modernize the economy, the report notes. China’s last two five-year plans have placed strong emphasis on promoting consumer demand, addressing income disparities (such as by increasing spending on social safety net programs), boosting energy efficiency, reducing pollution, improving the rule of law and deepening economic reforms. They have also identified seven strategic emerging industries that are intended to become the backbone of China’s economy in the future and to be able to compete well on a global scale: biotechnology, new energy, high-end equipment manufacturing, energy conservation and environmental protection, clean-energy vehicles, new materials and next-generation information technology.

Some of the goals of the most recent five-year plan (covering 2011 through 2015) are as follows: achieving an average real GDP growth rate of 7 percent and ensuring that incomes rise at least as fast as GDP; consolidating inefficient sectors and promoting the services industry (with the goal of expanding service sector output to account for 47 percent of GDP, four percentage points higher than at present); welcoming foreign investment in modern agriculture, high-technology and environmental protection industries; turning coastal regions from the “world’s factory” to hubs of research and development, high-end manufacturing and services; lengthening high-speed railway and highway networks; and increasing the minimum wage by no less than 13 percent on average each year.

A government communique issued in November 2013 elevated markets from having a “basic” role in resource allocation to a “decisive” role but also emphasized the importance of the public sector in the economy. This could be an indication that the Chinese government will continue to actively support and protect SOEs, but it could also mean that they will be subject to structural and market-based reforms. Other proposed areas of reform include improving IPR protection, implementing new financial reforms, liberalizing rules on foreign investment and establishing new free trade zones, and improving macroeconomic control over the economy while reducing government involvement in market operations.

Challenges to U.S. Policy. The report states that many believe the key challenges for the U.S. are to convince China that (1) it has a stake in maintaining the international trading system, which is largely responsible for its economic rise, and to take a more active leadership role in maintaining that system; and (2) further economic and trade reforms are the surest way for China to grow and modernize its economy. However, many U.S. stakeholders are concerned that China’s efforts to boost the development of indigenous innovation and technology could result in greater intervention by the state (such as subsidies, trade and investment barriers, and discriminatory policies), which could negatively affect U.S. IP-intensive firms. In addition, failure by China to take meaningful steps to rebalance its economy could increase tensions with its trading partners, especially if China’s share of global exports continues to increase rapidly and if that increase is viewed as being the result of non-market policies that give Chinese exports an unfair competitive advantage.

Opinions differ as to the most effective way of dealing with China on major economic issues. Some support a policy of engagement using forums such as the U.S.-China Strategic and Economic Dialogue; others support a somewhat mixed policy of engagement when possible coupled with a more aggressive use of the World Trade Organization’s dispute settlement procedures to address China’s unfair trade policies; and still others advocate a policy of trying to contain China’s economic power and using punitive measures when needed to force China to “play by the rules.” Complicating matters is that China’s growing economic power has put it in a position to advance or frustrate U.S. interests on broader issues such as global economic cooperation, climate change, nuclear proliferation and North Korean aggression.

View Document(s):

To get news like this in your inbox daily, subscribe to the Sandler, Travis & Rosenberg Trade Report.

Customs & International Headlines