Terra Firma

Most US and Chinese policymakers well understand that their two countries’ economies have become increasingly interdependent. That’s why each side has committed considerable domestic political capital to a “Strategic Economic Dialogue”; twice-a-year senior-level negotiations intended to harmonise policy and to forge compromises on the questions that generate friction between them. Were the high-profile dialogue to fall apart, the issues that divide them might add new momentum to legislative steps toward protectionism in Washington and poison the relationship – with significant consequences for the US, Chinese, and even global economies. The chances that this will happen are growing.

Growing Economic Interdependence…

Business between the two countries continues to boom. Between 2000 and 2006, bilateral trade flows grew from about $116 billion to just shy of $343 billion. China badly needs US consumers to spend freely, because the United States is China’s largest foreign market. About one-fifth of China’s exports are now destined for the United States. Americans continue to profit from access to China’s inexpensively manufactured products, drawing about 40 percent of their consumer goods from that country. Many American investors and companies continue to profit from China’s economic openness. Annual US foreign direct investment in the country has hovered around $3 billion in recent years.

The growing economic interdependence takes other forms, as well. As we’re often reminded, China owns a lot of US debt. As of January 2007, the Chinese government held about $353.6 billion in US Treasury securities and probably controls hundreds of billions of dollars in other types of US debt and dollar-denominated assets. Best estimates are that China now spends 70-80 percent of its foreign exchange reserves, which have now topped the $1 trillion mark, on US Treasury bonds and other dollar assets. Add all these trade, investment, and debt numbers together and, generally speaking, a bad day for one country’s economy is a bad day for both.

But the United States and China have two very different sorts of economies. America’s developed free market economy is driven by consumption, innovation and entrepreneurial energy. China’s manufacturing-based economy is still largely driven by investment and exports. This basic difference generates all sorts of problems, both economic and political.

Some in the United States charge that low-cost manufacturing in China kills American jobs and that state manipulation of China’s currency aggravates an exploding bilateral trade deficit that pushed past $230 billion last year. The leaders of some US companies operating in China insist that Beijing simply refuses to throw its weight behind enforcement of intellectual property rights protections and demand that Congress do something about it. US lawmakers appear poised to respond.

Legislative steps towards protectionism?

Dominating the Senate debate is a revised version of a draft bill introduced last year by Senators Max Baucus (D-Montana) and Charles Grassley (R-Iowa) which would establish new rules for engaging countries that are found to have “misaligned” currencies. For the moment, the danger to US-Chinese trade flows is limited. The final bill is unlikely to contain substantive provisions that would allow for unilateral sanctions.

But harsher measures loom in the House – like one sponsored by Duncan Hunter (R-California) and Tim Ryan (D-Ohio) that would define currency manipulation as an unfair trade subsidy that is subject to US sanctions. Ominously, the failure of US-China talks to slow momentum toward open conflict has discredited participants on both sides within their respective bureaucracies and empowered those most suspicious of the other government’s intentions.

Knowing that bilateral economic ties are increasingly valuable (and necessary) for both countries and that protectionist legislation might badly damage them, Treasury Secretary, Henry Paulson, has staked his considerable credibility on negotiations with Chinese officials that are meant to both build on opportunities for strategic co-operation and smooth over areas of discord. Fairly or not, the dialogue’s high public profile ensures that it carries considerable (and unrealistic) political expectations.

Unfortunately for all concerned, the most recent meeting of the Strategic Economic Dialogue produced little more than exasperation. As is its habit, Beijing offered modest policy concessions on the eve of the meeting to keep the dialogue moving forward and help sate the appetite of Congress for more substantial reforms. In a nod toward US concerns over exchange rates and the swelling bilateral trade imbalance, the two most troublesome issues on the table, China widened the daily trading band for its currency and announced tariff/tax adjustments on dozens of export products and import goods. Many US lawmakers were less than impressed.

Genuine policy differences aside, there are two political reasons why China and America remain far apart on key issues. First, China’s political leadership is deeply distracted at the moment by preparations for the most sweeping internal personnel shuffle in more than a decade. With the approach of the five-yearly party Congress this fall, senior officials are preoccupied with the bureaucratic horse-trading that will settle the fates of thousands of central government and party officials. The negotiation process encourages caution on all aspects of foreign and economic policymaking, because officials are hardly keen to take bold policy risks just before their career trajectories are determined.

A convenient political scapegoat for the US

Second, the conventional view in the United States is that the loss of manufacturing jobs in key states and the Bush White House’s unwillingness to “get tough” on China to reverse the trade deficit helped ensure the defeat of several Republicans in last fall’s congressional elections. In both houses of Congress, Democrats are now in charge. With the approach of presidential and congressional elections next year, China has emerged as a convenient political scapegoat for domestic US frustration over changes in the global economy. Democrats are eager to jumpstart the protectionist bandwagon, and Republicans have no intention of missing the ride.

Chinese product safety issues don’t help

China has played a key role in making itself a political punching bag in America. Just as the release of trade deficit figures added pressure on Congress, a growing number of defective Chinese-made products have raised public safety concerns across the United States. It began with official warnings that Chinese-made pet food was killing household dogs and cats. Then on June 26, the National Highway Traffic Safety Administration ordered the recall of nearly 450,000 tyres imported from China over concerns that they might shred during highway driving. When 100 Panamanians died earlier this year after ingesting cough syrup containing diethylene glycol, a chemical than can produce kidney failure, the US Food and Drug Administration yanked thousands of boxes of Chinese-made toothpaste containing the same chemical from US store shelves. Every toy that the US Consumer Product Safety Commission has recalled this year was made in China, and Americans have grown fearful that US regulators lack the resources to properly examine the growing wave of Chinese imports entering the United States.

For US lawmakers already eager to score political points by demonizing China, the news that Americans’ Chinese-made toothpaste can kill them, that their children are playing with Chinese-manufactured toys covered in lead-based paint, and that their imported Chinese tyres may come apart on the highway makes their work much easier.

The product safety issue reveals how tensions in the economic relationship could escalate. In mid-July, the Chinese government responded to the controversy by halting the importation of a wide variety of chicken and pork imports from America, citing chemical and bacterial contamination. This move appears meant to signal to US regulators that continued attacks and restrictions on Chinese goods will carry economic consequences for US producers. Yet, American consumers are hardly prepared to simply accept toxic products from China in order to safeguard US-Chinese trade relations.

US and Chinese Economies are vital for future global growth

There’s a lot at stake here – for American companies and consumers and for China’s continued growth. What’s bad for these two economies is bad for the global economy, because a slowdown in one or both would have ripple effects all over the world. The importance of US economic growth for the health of the global economy is well-documented. But China’s economic impact is now impossible to avoid, as well. The country’s fast-growing demand for energy, minerals, metals and other resources are adding considerable upward pressure on commodities prices. Its low-cost manufacturing has helped reduce international labour costs.

Trade frictions are inevitable between any two countries with so many competing interests within them, such different political and economic systems, and so much at stake. But if the wheels come fully off the efforts at constructive engagement, those in both capitals who support a more confrontational approach will surely get their way.

Such a worst-case scenario is unlikely; the mutual economic interests that bring the two sides together are impossible for them to ignore. But conflicts of political interest and real divisions of opinion on what is possible are undermining mutual trust. Given the importance of these two economies for the future of global growth, it’s a problem that needs watching closely.

Ian Bremmer, President, Eurasia Group

Ian Bremmer is president of Eurasia Group, the world’s largest political risk consultancy. He is also a columnist for Slate, a contributing editor at The National Interest, and a political commentator on CNN, Fox News and CNBC.