Courtship and censure in US's China policy

By Benjamin A Shobert

Several years ago, while attending a conference on United States-China business relations, I heard a well-respected leader in the field finish his presentation and take questions from the audience. Perhaps the most interesting question was also the simplest: "What could happen in the United States that would shift our relationship with China?" With only the slightest of pauses, his answer was "a long and protracted recession in the US".

The exchange was certainly interesting that particular moment, when the idea of such an event seemed distant and easy to trivialize. Today, in the midst of precisely that situation, his comments are difficult to ignore.

The recent release of the annual 2009 congressional report from the US-China Economic and Security Review Commission (USCC), the product of a congressional committee long known for its suspicious view of China's modernization and military growth, reinforces the idea that US-China relations are vulnerable to any number of things, but the state of the US economy remains the predominant threat. Many of the committee's comments are not surprising, especially for those who have followed the growth of its role in policymaking over the past several years. Ongoing concerns over Taiwan echo throughout the report, while at the same time acknowledging the small gains that have transpired in 2009 regarding travel restrictions between China and Taiwan.

Similarly, the committee continues to push for greater transparency from the Chinese government regarding its objectives for the burgeoning military budgets coming from Beijing. Perhaps because 2009 was a year with its share of economic conflict, the most recent USCC report does a remarkably good job at casting a more balanced light on the growth of the Chinese military, and its potential to contribute to military conflict. The report goes so far as to say that " ... the expansion of China's military and security activities abroad are more evolutionary than revolutionary in nature. Although the PLA [People's Liberation Army] is operating more frequently abroad, it should not yet be considered a global military or a military with global reach."

Even more surprising was the report's contention that "The Chinese military's more international orientation is not a fundamentally negative development. A more activist PLA could in some circumstances provide a 'public good' by contributing more to global stability." Given the many criticisms the report usually has for China, these points suggest that even the most hawkish forces in Washington are being forced to recognize that they will have to co-exist with Chinese power, and that doing so need not be detrimental to peace or prosperity.

The report to congress makes a total of 42 recommendations, of which 10 are deemed to be "key". Of the 10, four are economic: push for more aggressive World Trade Organization trade remedies; legislate in ways that force the yuan to "become flexible"; determine how the Chinese value added tax (VAT) impacts on US manufacturers; report back on how Chinese subsidies on clean energy are impacting US companies in this field.

Five are military: increase funding for "anti-access" technologies to the US Department of Defense; better respond to Chinese espionage; make sure prevention [measures] from Chinese computer attacks are properly funded; suggest that China begin to "draw down" its forces positioned against Taiwan; review how potential dual-use technologies are making their way from Hong Kong to China.

Only one of the 10 key recommendations is focused on human rights, that congress should better track the role of US companies whose technologies or services might enable the People's Republic of China (PRC) to censor the Internet from its own people.

While many of these points are not necessarily new, a handful of interesting and challenging narratives do emerge. The most problematic is the idea, fostered by a number of witnesses who testified during the year to the USCC, that China is partly to blame for the US's current economic woes.

The congressional report goes so far as to state, "The policies that China adopted generated a huge flow of liquidity - or money that can be easily lent to borrowers - into US markets. This excess liquidity created perverse incentives in the United States that encouraged banks to make risky loans to US households, which in turn grew even more indebted."

As political dynamite goes, this kind of statement could not be more troubling, not least because it potentially mistakes context for cause. During a period when US politicians are not looking to discriminate between the two, blame assignment of this nature does great damage not only to US-China relations, but to a meaningful and honest review of what the US needs to do differently to better manage its fiscal house.

Admittedly, the USCC 2009 report does at points find some balance on this topic, possibly said best when the committee reports, "By continuing to consume more than is produced, the United States must continue to borrow. Meanwhile, China continues to add manufacturing capacity, producing more than it can consume domestically."

While testifying to the committee, Stephen Roach, author of The Next Asia and currently based in Hong Kong as chairman of Morgan Stanley's Asia office, took a dim view of those who would assign blame for the US's economic problems on China: "... we made dumb mistakes that were reinforced by, I think, poor policies and poor behavior across our economy, from politicians to central banks to regulators to Wall Street to Main Street, and I think it is really incorrect to even think that the Chinese are responsible for those poor decisions." Observers of the USCC will note that the economic conditions of the past 18 months have made it more difficult for testimony like that of Roach to be heard, as this year's report and its key recommendations suggest.

Yes, the context within which the US economy has gone into recession is one where high savings in China have created pools of capital for investment, some of which has gone overseas to create excess liquidity, some of which has caused severe overcapacity in key manufacturing industries globally.

But to say that this excess liquidity is the cause of the US's problems is to look past the enormous differences and responsibilities which should characterize both countries. It seems a profound statement about the US's own responsibility in this affair to put much blame on China. One country has been an economic powerhouse for over 50 years, with a financial and governing system so strong that its currency has become the denomination of global reserves, and its political system the envy of many.

The other is a country dealing with very recent trauma, with severe problems in feeding itself, providing social services to its citizenry, defending its borders, and frequent bouts of famine coupled to severe economic contraction. That the latter would find its footing and begin the process of political reformation, only to find enough success to even have a pool of money to invest is a remarkable feat.

Courtship and censure in US's China policy
By Benjamin A Shobert

To turn a phrase that is often used by US policymakers about China, it seems that with respect to the question of how to best invest China's newfound savings, the US could have done a better job as the "responsible stakeholder". It was the choice of the US government to design public policy in such a way that new home ownership programs could be supported with low interest rates, just as it was the choice of consumers to view inexpensive capital as a right, not a privilege, and one that could go away if not used properly.

In both cases - the government and consumers - other options for using this pool of Chinese capital existed. Inexpensive capital could have fostered much-needed investments in infrastructure and education. Testifying to the USCC, Robert Skidelsky, an economist, stated, "It is one thing to borrow from abroad for investment, a different matter to borrow for consumption, since this does not create assets which can service the debt."

The 2009 USCC report does attempt to represent both sides to this question, but the overarching storyline that predominates is that, at a minimum, China has some blame in the US's economic situation and that, at worst, its policies were contributing causes to the US's fall. This is very troubling as the report serves to educate many in congress about the role of China's policies and practices within the US. To the extent the report distracts American politicians from a single-minded focus on what the US can control, and what it must do differently, it is unlikely to create meaningful change or have a lasting impact.

But, the report does draw out one particular point regarding China's economic policies that is likely to have teeth: the use of VAT to rebate particular industries once they export products manufactured in China. All imports into China face a 17% VAT, but only a handful of exports must pay this tax. In recent years, China has made moves to adjust this policy, and now selectively provides the VAT rebate to key industries, defined as such either by their inclusion into the PRC's 11th Five-Year Economic Plan, or industries that have made investments in special economic development zones.

Practical application of this adjusted VAT policy has forced many low-technology, high-labor content products further inland into China, or simply moved out entirely. But the VAT remains a tool that Beijing deploys when it suits its own purposes, and these purposes are at odds with many of the remaining manufacturing sectors in the US which need to export into China if they are to capture meaningful market share in the country.

The USCC commissioners, William Reinsch and Robin Cleveland, write towards the end of the 2009 report, "There are only so many times one can review Chinese exchange rate policy, for example, and still learn something new." The yuan's path towards a fully floating currency, tradable outside the country, seems to be reasonably clear, if not happening in a time frame that many in Washington would like to see.

The pressure of congressional groups like the USCC have done much to elevate concerns over the yuan, but beyond the internal agenda within China to only gradually lose control over its currency, there are much greater strategic issues against which little can be done. Consequently, concerns over China's "unfair" trade practices are seeking another actionable venue, and VAT is likely to provide one means for putting these concerns forward.

Because the VAT grievance has impact on China's WTO status, Beijing cannot simply ignore it. Manufacturers in the US have long known that their Chinese counterparts could export at cost, counting on Beijing to pay them back the 17% VAT. This, in conjunction with the yuan's fixed exchange rate, has combined to force many US manufacturing companies out of business, a concern the USCC has long been monitoring and growing increasingly alarmed about.

While Beijing's adjustments to its VAT policies were beginning to take effect, the country's stimulus plan actually rolled back many of these, allowing some manufacturing sectors to continue and enjoy selling at or near cost with only the VAT as their profit. The net result has been that even in low-technology industries, which Beijing would like to see move inland or relocate out of the country entirely, the VAT rebate has proven an effective tool for keeping jobs and contributing to some economic growth.

Unfortunately, at least from China's point of view, it is unlikely they can both maintain their current VAT policies at the same time their currency policy stands as it does. As the full weight of a slow to no-growth economy in North America begins to realize itself, the US Congress is not going to be able to look past the conclusions of the USCC, and will have to act more deliberately than it has in the past. Beijing is likely to find that it can defend its currency position, but not the VAT policy. Given a choice between one or the other, increasingly aggressive moves cutting VAT rebates are likely to occur.

Taken together, the 2009 USCC report to congress seems to draw a slightly more brittle tone than in the past, a point made perhaps most eloquently by commissioners Reinsch and Cleveland, who both write, "This year's report, as usual, is critical of China on many points. Some are well taken, but they are too often made out of fear rather than out of confidence. While blame is tempting in global policy debates - and often well placed - it is our destiny we control, not China's. Faulting Beijing for doing things in their own interest may be politically expedient, but ultimately an empty gesture."

Past reports from the USCC have occurred within a much different economic and political environment. The depression we hope to have averted has strained the ties that have bound the US and China together over the past 20 years, and the USCC report reflects this. The report also reflects a political need on the part of congress to begin to act more substantively on the question of China, in ways that are perceived to benefit American stakeholders more directly and immediately.

As President Barack Obama has courted China, very aware of the potential risks in not taking a conciliatory tone with Beijing, the US government's reliance on China holding and continuing to purchase US debt has prevented him from taking more strident positions. But congress, as advised by and reflected in the USCC's 2009 report, has slightly different objectives, not only to distinguish itself from Obama's position, but to be perceived by its constituents as working to eliminate any unfair advantages that China may now enjoy.

Benjamin A Shobert is the managing director of Teleos Inc (www.teleos-inc.com), a consulting firm dedicated to helping Asian businesses bring innovative technologies into the North American market.

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