The China Effect

Assessing the impact on the US economy of trade and investment with China

by Erik Britton and Christopher T. Mark, Sr.

This article is adapted from a report published by the China Business Forum, Inc. (www.chinabusinessforum.org). The forum was established in 1987 by the US-China Business Council (publisher of the CBR) to promote broad-based policy discussion and greater understanding in both China and the United States of the economic systems and business methods of each country and of the role of commerce in the overall relationship between the United States and China. For the full report, see www.chinabusinessforum.org/pdf/the-china-effect.pdf

Despite the growing US-China trade imbalance that has been capturing headlines, the long-term benefits to the United States of trade with China are substantial and likely to endure.

This conclusion is based on a detailed assessment of US-China trade and investment since 2000 and projections to 2010, as depicted by an Oxford Economic Forecasting (OEF) macroeconomic model, which captures trade and financial flows among all major economies.

This assessment reflects the complex impact on the United States of growing trade with China, which works through a variety of channels: net trade, prices, employment, and productivity. The wider global context is also reflected, as the implications for the US economy cannot be properly assessed without taking into account the interaction of the United States and China with the rest of the global economy.

Once this complex web of effects has been taken into account, the implications of this research are straightforward. For the United States—indeed, for all countries—international trade spurs both innovation and economic efficiency. While improvements in economic efficiency are often associated with painful dislocations in certain sensitive industrial sectors, in the end, the whole economy benefits. Thus the costs that we identify tend to be transitory and sector-specific, while the benefits tend to be permanent and distributed across the economy. To some extent, the impact can be aggravated or mitigated using trade and economic policy instruments that are available to US authorities.

The impact of China's economic reform on US-China trade and investment

To assess the impact of China-US trade on the United States, there must first be a definition of the "counterfactual"—the alternative case—against which to compare the actual situation. Fortunately, China's World Trade Organization (WTO) entry at the end of 2001 provides a basis for a more plausible alternative scenario. As many commentators at the time pointed out, the terms of China's accession to the WTO did not really imply substantial changes in how the United States treated imports from China, but they did commit Beijing to opening the Chinese market to US and other exporters, albeit in a staged implementation process (and the full benefits of China's market openings have not yet been realized by US firms).

What would have happened to China-US trade and investment had China not embarked on the process of economic reform and opening, cemented by its WTO entry? And what would have been the impact of that scenario on the US economy?

Although the treatment of US imports from China was largely unaffected by the terms of China's WTO accession, the growth in those imports increased rapidly. This growth in imports was not due to the lowering of US tariffs or import controls, but instead reflected the massive post-WTO inflows of new investment into China from the United States and other countries, which boosted the productive capacity of the Chinese export sector. (In fact, according to official PRC figures, 40-60 percent of China's total exports are produced by foreign-invested enterprises.)

The OEF model assumes that if China had not embarked on the process of economic reform and opening associated with its entry to the WTO, its trade growth would have been roughly in line with economic growth outcomes achieved by other emerging Asian economies over the same period—that is, fairly robust but not spectacular growth. The basis for this assumption is that inflows of foreign investment into China would not have materialized to the degree they actually did.

The factors that apply to overall Chinese trade growth in this scenario also apply to bilateral US-China trade flows. We estimate that PRC exports to the United States in 2005 were around $90 billion higher than they would have been if China had not committed to its economic reform package, although the OEF model also suggests that in such a case, this figure would have been to a large extent offset by higher US imports from other East Asian economies.

The OEF model also projects China's imports from the United States to be around $10 billion higher in 2005 than they would have been if China had not embarked on its economic reform path. It is likely that at least some of these US exports would have gone to other Asian economies if China had not joined the WTO, though there may also have been an incremental increase in overall US exports.

Thus, the net impact of China's WTO entry and accompanying economic reforms on the bilateral US-China trade imbalance was an increase of some $80 billion in 2005. Yet if China had not entered the WTO, lower imports from China would, to a large extent, have meant higher imports from other East Asian trade partners. The OEF model therefore suggests that the impact of China's economic reform program on the US global trade deficit was to increase it by around $15 billion in 2005.

We also assume that the signal about Chinese intentions toward economic reform and growth that China's WTO entry sent to global investors was the driver for a large proportion of the foreign direct investment (FDI) inflows to China observed since then, including US-sourced FDI, which accounts for about one-tenth of China's total FDI. The growth in output that China has achieved was in part due to the extra productive capacity resulting from those accumulated FDI inflows.

The impact on the US economy as a whole

The OEF model finds negative short-run effects (lasting a few years) as a result of the impact on US net trade, and positive long-run effects (lasting indefinitely) as a result of the impact on US prices and productivity.

Table 1: Impact on the US Economy of Increased Trade and Investment with China
Year	GDP (%)	Net jobs (persons)	Consumer price level (%)	Current account (% GDP)
2001	-0.20	-66,000	0.0	-0.18
2002	-0.15	-64,000	-0.1	-0.15
2003	+0.05	+30,000	-0.2	-0.12
2004	+0.30	+35,000	-0.4	-0.10
2005	+0.40	+15,000	-0.5	-0.05
2006	+0.50	+25,000	-0.6	-0.05
2007	+0.60	+10,000	-0.7	-0.03
2008	+0.60	+5,000	-0.7	-0.01
2009	+0.60	+5,000	-0.8	0
2010	+0.70	+5,000	-0.8	0
Note: Changes represented as deviations from "counterfactual" case of no Chinese WTO entry. Changes are not cumulative. Source: OEF

Effects 2001-05

The OEF model assesses the impact of China's economic reform program as it ripples through the US macroeconomy, capturing all of the main channels of that effect. Our model suggests that US import prices were pushed down significantly, in aggregate, as a result of the increase in trade with China. These price effects reflect both the direct impact of the lower price of Chinese imports and the indirect effects as other exporters to the United States were forced to lower their prices to compete effectively with China. As a result, by 2005, according to OEF estimates, the aggregate US price level might have been about 0.5 percent higher had China not embarked on its program of economic reform.

This represents a direct benefit to US consumers and firms, boosting their real incomes and profits by 0.5 percent in 2005. As a result, aggregate demand in the United States also got a boost, as consumers had more money to spend. While some of this extra real income would have been saved, and some spent on additional imports (including those from China), a significant portion would have been spent on goods and services produced by US-based firms, boosting US GDP in the short run.

Moreover, increased trade with China as a result of the FDI inflows associated with China's WTO entry has had a positive effect on US productivity. According to the OEF model, this effect was significant, even by 2005.

Overall, taking all the effects into account, and applying the most realistic assumptions, we find that the impact of China's economic reforms was to increase US GDP by around 0.4 percent in 2005 and to increase unemployment by about 50,000—about 0.035 percent of the total US labor force. To put this in perspective, in a single month (October 2005), according to the US Department of Labor, net non-farm payroll employment in the United States rose by 56,000.

The fact that any loss of jobs occurs is sure to be an unpopular notion among those whose jobs are actually at risk. The model suggests, however, that the aggregate unemployment effects are temporary, while the long-term effects on GDP are not, as the next section demonstrates. (Naturally, there is a great deal of uncertainty around these estimates. In our judgment, the likely impact in 2005 probably lies in the range of 0 percent to 0.5 percent of US GDP.)

Effects to 2010

The effects this model calculates, through 2005, are a mix of transitory effects that have not yet fully worked through to prices and some effects that are permanent. By 2010, the transitory effects gradually wash out of the US economy, leaving the permanent effects in place. Figure 1 shows the impact of US-China trade on US GDP projected to 2010.

According to our estimates, the impact on the US economy of China's economic reform program will be to increase US GDP by 0.7 percent by 2010. US consumer prices are projected to be 0.8 percent lower in 2010 than they would have been without increased trade with China.

As with the effects to date, there is a great deal of uncertainty around these estimates. A plausible range for the impact on US GDP in 2010 would, in our view, be a boost of 0 percent to 1 percent, as a consequence of increased trade and investment with China. Table 1 shows how the impacts build up over time for key economic variables.

Under this scenario, the average US consumer will benefit in two ways: First, his or her average income will increase to the same extent as does aggregate GDP, by about 0.75 percent. Second, the consumer price level will fall, to the extent that the price of PRC and other imports in the average basket of consumer goods has fallen.

Taken together, these benefits are significant, increasing the purchasing power of the average US household by around $500 per year in 2005, and $1,000 per year in 2010. However, the impacts on output and employment—particularly in the short term—will not be distributed uniformly across all sectors or all individuals in the US economy.

Quantifying the impact on industrial sectors in the United States

The distribution of the impact of increased trade and investment with China across all US industrial sectors depends on two factors: first, the relative size of each sector within the US economy; and second, the proportion of that sector's imports that come from China.

Table 2 shows how US output and employment are distributed across a selection of key industrial sectors, using data taken from OEF's International Industry Model.

Combining these figures with China's share of total US imports within each sector, and with the economy-wide impacts for output and employment already calculated, we estimate the impact of US-China trade and investment on various industrial sectors in the United States. These estimates, for 2005 and 2010, are set out in Table 3.

Table 2: Distribution of US Output and Employment Across Key Industrial Sectors
Sector	Output (% of total, 2004)	Employment (% of total, 2004)
Agriculture	1.5	1.5
Food	1.8	1.3
Mining	0.4	0.4
Manufactures	13.2	10.4
Of which:
Chemicals	1.7	0.7
Machinery and transport equipment	1.1	0.9
Office and telecom equipment	0.3	0.3
Electrical machinery & apparatus	1.9	0.5
Textiles	0.3	0.5
Fuels	0.3	0.1
Utilities	1.6	0.4
Construction	4.3	5.4
Transport	3.3	3.0
Communications	4.2	1.8
Distribution	17.0	24.5
Business services	20.9	14.2
Financial services	10.0	4.6
Other services	23.2	33.0
Source: OEF

Employment

Whereas the aggregate employment effects are small and temporary, the effects on employment within a given industrial sector can be more substantial and permanent: The FDI inflows associated with China's WTO entry, and the resulting stiffer competition for US producers, are hastening a decades-long shift in the composition of employment in the United States.

Those specific sectors in which imports from China make up the biggest share of total imports bear the brunt of this change. These include the manufacturing industry as a whole. In 2005, according to OEF estimates, the impact of increased trade with China was to reduce US manufacturing employment by about 1.5 percent, or 205,000 jobs. Within the manufacturing industry, the sectors worst hit are textiles, office and telecom equipment, and electrical machinery. By contrast, however, US service sector employment has risen. By 2005, that increase was not sufficient to fully offset the decline in manufacturing employment, leaving economy-wide employment down, but only by an estimated 50,000 jobs (substantially less than the decline in manufacturing employment).

By 2010, employment in the US economy as a whole will have returned to its base level, since China's WTO entry has no impact on supply-side factors in the United States that determine economy-wide employment in the long run—factors such as the working-age population; the proportion of earned income that is taken in taxes; the ease with which firms are able to hire and fire workers; the level of unemployment benefits; the ease with which workers can move from one part of the country to another; and the bargaining power of the labor force. These factors, therefore, are assumed to be the same as in the "no-WTO" scenario.

By 2010, however, US manufacturing employment will be about 500,000 (or 3.5 percent) lower than it would have been had US-China trade not expanded the way it did since 2001—a figure offset exactly by higher service sector employment. Some of the individuals previously employed in the manufacturing industry will, by 2010, have found jobs in the service sector. Others will not, and might remain permanently unemployed, while new entrants to the labor market are recruited into the newly available service sector jobs.

The fact that the employment costs at an economy-wide level are transitory does not imply that they are trivial, or that the shifts in the sectoral composition of employment should be ignored. Yet shifts in employment from one firm to another and from one sector to another are constantly happening in advanced, flexible economies. In a single month (June 2005), for example, 4.3 million jobs in the United States were lost, equivalent to 3.3 percent of total employment. In the same month, there were 4.6 million new hires. That kind of turnover rate, from one job to another, and from one sector to another, is fairly standard in economies like the United States. Attempts to resist such shifts can often prove futile in the longer term and are costly in terms of the loss of economy-wide productivity that they can imply.

Table 3: Impact of Increased Trade with China on US Industrial Sectors
	*Output effects (%)**		*Employment effects ( %)**
Sector	2005	2010	2005	2010
Agriculture	-0.1	+0.6	-0.1	0.0
Food	-0.1	+0.6	-0.1	0.0
Mining	-0.0	+0.8	-0.1	-0.5
Manufactures	-1.0	-0.1	-1.5	-3.5
Of which:
Chemicals	-0.2	+0.6	-0.3	-2.3
Machinery and transport equipment	-0.7	+0.1	-1.1	-3.1
Office and telecom equipment	-1.4	-0.6	-2.2	-4.2
Electrical machinery & apparatus	-1.3	-0.4	-1.9	-3.9
Textiles	-1.2	-0.4	-1.8	-3.8
Fuels	+0.6	+0.8	+0.1	+0.5
Utilities	+0.6	+0.8	+0.1	+0.5
Construction	+0.6	+0.8	+0.1	+0.5
Transport	+0.6	+0.8	+0.1	+0.5
Communications	+0.6	+0.8	+0.1	+0.5
Distribution	+0.6	+0.8	+0.1	+0.6
Business services	+0.6	+0.8	+0.1	+0.5
Financial services	+0.6	+0.8	+0.1	+0.5
Other services	+0.6	+0.8	+0.1	+0.5
Total	+0.4%	+0.7%	-0.04%	0.0%
* Changes represented as deviations from "counterfactual" case of no Chinese WTO entry. Source: OEF

Output and productivity

A similar story emerges for sectoral output. The model predicts a permanent loss in output in the US manufacturing sector, although—particularly by 2010—it is much less pronounced than the loss in employment in that sector, since average productivity will increase. But the output loss in manufacturing, such as it is, is more than offset by a permanent gain in output in the service sector, so that economy-wide output in the United States is likely to be 0.7 percent higher by 2010 as a result of increased trade with China.

With economy-wide output up by 0.7 percent in 2010, and aggregate employment unchanged, labor productivity at the economy-wide level will also be up by 0.7 percent by 2010. Nearly all of that productivity gain at the sectoral level will accrue to the sectors most directly affected by increased trade with China: the manufacturing sectors. Average labor productivity in the US manufacturing sector will increase by 3.3 percent by 2010, compared to an average productivity increase of only 0.3 percent in the service sectors. Growth in manufacturing productivity will have been boosted by 0.3 percent per year over the period 2001 to 2010. The boost in service sector productivity growth will have been negligible, although the boost to service sector output is substantial, resulting from higher employment in the service sector.

China's entry to global markets, as a result of its economic reforms, exposed US manufacturing firms to increased competition. Some were forced to cut employment as a result, with some firms perhaps going out of business forever. But those that remain in business are obliged to increase their productivity to compete effectively. Meanwhile, firms in the service sector boost their employment, although their productivity is barely affected. Thus, the net impact on the United States, at an economy-wide level, is higher average productivity and unchanged employment over the long run.

The decline in US manufacturing employment

Manufacturing employment in the United States has been in decline for a long time, particularly when expressed as a share of total employment (see Figure 2). The recent global recession saw a pronounced fall in economy-wide employment, within which the manufacturing share fell more than the share of other sectors—consistent with past recessions.

Although, according to our estimates, the impact of China's economic reform program on US manufacturing employment is substantial by 2010, reducing manufacturing employment by around 500,000 jobs, the impact appears relatively small when viewed in the context of overall manufacturing employment (13.9 million in 2005). The FDI inflows associated with China's economic reform program cause a marginal acceleration in the rate at which the manufacturing share of overall US employment is already declining—perhaps pulling forward changes in the composition of overall employment that would have been inevitable in the long run anyway.

Some observers may ask whether there are circumstances under which the shift of resources across sectors that our model shows does not hold or requires modification. The answer is yes, if one believes that "hysteresis effects" are pronounced. That would mean, for example, that a shock that drives up unemployment then leads to discouraged workers, or perhaps implies issues to do with labor mobility (so that laid-off manufacturing workers in Detroit, for example, cannot relocate to take advantage of service sector opportunities in Atlanta). Or perhaps these effects would combine with skill shortages in certain service sectors, or other kinds of labor market rigidity (such as insider-outsider effects, whereby the prevailing wage is determined by those in employment, and therefore remains "too high," keeping the demand for labor low even when unemployment is high).

All of these would mean the negative employment effects might be longer lasting than projected. But, in our view, these effects are not pronounced in the United States, where big macroeconomic cycles in recent years have not resulted in a ratcheting up of unemployment, which would have occurred if these effects were important. In Europe, in contrast, macroeconomic swings and these other factors have had a much greater impact on overall unemployment patterns.

Some analysts in the United States have also debated whether the vitality of the US economy could be sapped and its long-term growth potential reduced by shrinking the manufacturing sector "too much." A full answer to this question is beyond the scope of this study. In our model, however, there are countervailing effects on the manufacturing sector—lower employment, offset by higher productivity—so that manufacturing output is little changed in the long run. Thus, although manufacturing employment shrinks, manufacturing output does not.

Long-term benefits

According to our estimates, the long-term benefits to the United States of trade with China are substantial. Although US-China trade that flowed from China's commitment to its economic reform program has been characterized by a substantial deterioration in the US bilateral trade position with China, its overall impact on the US economy—including output, employment, prices, real incomes, and productivity—is nevertheless significantly positive.

While these long-term benefits affect the economy as a whole, there are significant costs to certain import-sensitive industrial sectors. The people whose jobs are at stake in those sectors are likely to consider the long-term benefits to the entire economy much less important to them personally. That trade-off, between temporary or sector-specific costs and permanent whole-economy benefits, is at the core of the policy debate in the United States and elsewhere on this issue.

The RMB and US-China Trade

One interesting question that inevitably arises in discussions about US-China trade is: To what extent does the value of the renminbi (RMB) against the dollar contribute to the US-China trade imbalance? According to the Oxford Economic Forecasting (OEF) model, the answer is not much. Chinese exporters to the United States are likely to protect their market share in the event of an exchange rate revaluation, even if that means cutting their profits and/or squeezing their costs, including labor costs. As a result, RMB revaluation is unlikely to have much impact on the dollar price of US imports from China. US exporters to China would benefit, as they would enjoy greater profits or a chance to increase their market share. But since US exports to China are small compared to US imports from China, the impact of higher US exports on the bilateral deficit would be marginal.

The OEF model suggests that a 25 percent revaluation of the RMB would result in a reduction of around $20 billion in the US-China bilateral trade deficit after two years.

Of course, just as higher US imports from China meant lower US imports from other Asian economies, the reverse is also true to an extent. So, according to our model, a $20 billion reduction in the bilateral US-China deficit would imply only a $10 to $15 billion reduction in the US trade deficit overall after two years—and a correspondingly higher deficit against other Asian economies.

—Erik Britton and Christoper T. Mark, Sr.

US-China Trade in Context

Measurement problems

Data on bilateral trade between the United States and China have long been beset by measurement problems. In recent years, US figures on the amount of imports from China have been as much as twice the amount that China reports as exports to the United States, with much of the discrepancy attributed to differences in how the two countries account for the trade flows going through Hong Kong. In general, US Customs data tend to detail bilateral trade by country of manufacturing origin and final destination, whereas Chinese data show bilateral trade on a "next stop" basis. Because Hong Kong is a major conduit for China's import and exports—as much as 30 percent of Chinese trade passes through Hong Kong—the difference in reporting procedures accounts for much, although not all, of the observed discrepancy. OEF reconciled these discrepancies in US-China trade in goods (see Table 1). The result is a $132 billion deficit for 2004, about $30 billion lower than the US government reports, but still large.

Chinese exports to the United States

Chinese exports have grown rapidly and have taken an increasing share of the US import market. To a large extent, those increases have come at the expense of other Asian exporters to the United States. Indeed, the "swing" in China's share of US imports between 2000 and 2005 offset the declining shares of other East Asian exporters, with the result that the overall share of US imports coming from East Asia (including China) remained constant (see Table 2).

US exports to China

Part of the explanation of the increase in the overall US current account deficit is that US exporters are losing market share everywhere, not just in China. The bilateral merchandise trade deficit with China accounts for a significant proportion of the overall US trade deficit—the largest share of any single country, although smaller than that attributable to the Middle East/North Africa region, as a result of higher oil prices—but by no means all of it. And the overall US trade position has been deteriorating much more rapidly than the bilateral imbalance vis-a-vis China can explain. Looking at the Figure, it is far from clear that the story of the overall US trade deficit is really a story about trade with China, as much of the media commentary seems to suggest. If anything, the reverse appears to be true. In fact, since 1992, the bilateral deficit with China has constituted a roughly constant share of the total US merchandise trade deficit.

The figures suggest there are other, more important, fundamental drivers of the overall US current account position. The rapid deterioration of the US current account position in recent years reflects the reality that the rest of the world has a much higher willingness to save than does the United States. In other words, the United States as a whole wants to borrow at a time when the rest of the world (on average) wants to save. The US government, along with US firms and households, are borrowing foreign currency and using it to buy foreign goods and services. To finance its operations, the US government issues notes, and foreign countries, including China, are major purchasers of these notes. The result is a current account deficit in the United States—with all countries, including China.

Trade by sector

It is also important to consider the sectoral composition of bilateral trade flows between the United States and China. China's import-share gains in the United States between 1995 and 2003 were focused in a few sectors. In 2003, China accounted for nearly 40 percent of US imports of consumer goods, within which its share of toys and games, footwear, and travel goods was even higher. Similarly, China's share of US imports of machinery grew rapidly between 1995 and 2003. China's share of overall US manufactured imports more than doubled over that period.

Thus, some sectors within the US economy are more exposed to competition from China than others—potentially posing a problem for US-based producers and producers from other countries (outside China). To the extent that there are job losses in the United States as a result of trade with China, they are likely to be concentrated in these sectors, while the benefits are spread across the whole economy.