How Much to Feed a Dragon

A few weeks ago the Bush administration took action to cap the growth of Chinese textile imports to no more than 7.5 percent a year, professing grave concern for what is left of America’s textile industry. The controversy generated by that move largely obscured a far more profound decision by the administration only a week earlier. In a formal report to Congress, Treasury Secretary John Show refused to designate China as a currency manipulator despite massive evidence of China’s continuous intervention in global currency markets-keeping the yuan at levels far below what most economists believe is its true value. Snow stated that Chinese officials “have repeatedly vowed” to move toward “a more flexible” currency. When they will move or how far they will move is an issue that Snow will apparently continue to leave to the discretion of China’s central planners.

While this issue sounds arcane, it may also rate as one of the most important economic issues of this generation. The intense manipulation of the Chinese yuan impacts greatly on numerous problems facing American households, ranging from high gas prices to weak job growth and stagnant wages. It has materially contributed to the problem of our growing foreign debt, the weakness of the dollar and a potential worldwide currency crisis that could lead to global depression. In addition, it has serious implications for the balance of global power in the decades ahead.

How has China impacted U.S. gasoline prices? World demand for energy grew by more than 3.4 percent last year-the largest yearly increase since the gas lines of the 1970s and more than twice the average yearly growth over the past two decades. Furthermore, it is clear that the big players in world energy markets see this spike in demand as anything but temporary. They are not only buying up oil futures and the shares of companies that own and sell oil but companies that explore and drill for oil as well.

The reason for this rapid growth in oil demand is attributable to one single fact: Oil consumption in China is growing at astronomical rates. During 2004 Chinese consumption of oil averaged more than one million barrels a day above the previous year, an increase of 19.3 percent, or eight times faster than the growth of energy consumption in the rest of the world. Without China, the global growth in oil consumption during 2004 would have been just 2.2 percent-a rate that the normal expansion of world oil exploration and production can accommodate without significant upward pressure on oil prices. Even in per capita terms, China’s oil consumption is growing three times faster than the rest of the world.

Why is China guzzling so much petroleum? China’s skyrocketing demand for energy is largely a function of the nation’s skyrocketing rate of economic growth. For several years China has been growing at a rate of more than 9 percent per annum even after accounting for inflation. Some experts expect growth in the 8 to 10 percent range for the indefinite future. This rate of growth drove China last year to consume 40 percent of the globe’s increased demand for crude oil in 2004-more than the rest of the developing world combined.

How can China maintain such a rapid pace of growth? The answer to that is also relatively simple. According to a report released in Beijing last month by the State Information Center, foreign trade is the major driving force of China’s economy. In particular, China’s net exports, or trade surplus with the rest of the world, are credited with bringing strong growth to the nation. The report discloses that Chinese exports totaled $156 billion in the first quarter of 2005 while imports totaled only $143 billion. More than 60 percent of Chinese surplus came at the expense of the United States. Last year, the U.S. bilateral trade deficit with China exceeded $162 billion, while the rest of the world actually ran a trade surplus with China. As a result, it is almost entirely the Chinese trade surplus with the United States that is providing the country with this extraordinary pace of expansion.

What makes China so competitive with U.S. and other foreign producers? It is important to remember that China is not a market economy. Prices in a particular sector can easily be manipulated by central economic planners. This goes for all inputs: labor, land, capital and energy. If China wants to compete and be the low price producer for a particular product, no other producers functioning in a market economy with fixed prices can match the price at which China will be able to sell.

But even more important has been China’s manipulation of its currency, the yuan. The central government has gone to extraordinary lengths to cap the value of the yuan to no more than 8.3 to the dollar. As Secretary Snow points out, leaders in Beijing have talked at great lengths about future plans to allow the yuan to trade more freely on world currency markets. But they have taken no such action and the rapid export-led growth of the Chinese economy would drop back to more normal levels if they did. Since rapid growth is seen by the leadership in Beijing as central to the nation’s economic, political and geopolitical goals, it is hard to imagine that significant change will occur without strong external pressure. Since the United States alone represents nearly all of China’s net trade surplus, the lever to force revaluation of the yuan is almost entirely in the hands of the United States.

Isn’t China’s growth good for the world? It depends on what part of the world you are talking about. Oil producing countries are having a bonanza. Saudi Arabia, a country in danger of not being able to make payments on its foreign debts just a few years ago, is now raking in revenues at a rate that dwarfs even the oil price boom of the 1970s.

Oil executives in this country are also prospering. The 3 million shares of Exxon Mobil held by Board Chairman and CEO Lee R. Raymond are now worth about $170 million, up more than $62 million or about 59 percent from the level such shares would have sold for only 18 months ago. Raymond is only one of thousands of oil company executives enjoying the new prosperity that China’s demand for petroleum has created for the industry.

There are also other domestic winners in the unbalanced trade relationship between the U.S. and China-at least over the short term. Companies ranging from Mattel to Boeing have increasingly moved production operations from the U.S. to China in recent years. They reap two benefits in such transactions. First, the lower wages paid in the Chinese factories provide savings that go largely to the bottom line on corporate balance sheets. Chinese workers make about one-twentieth of what U.S. workers make.

But secondly, the mere threat of moving more production to China keeps downward pressure on wages paid to U.S. workers. Since 2001, the hourly output of U.S. workers has increased by more than 16 percent, but the average wage production and non-supervisory worker wage remained virtually flat after adjusting for inflation. Corporate profits, on the other hand, have jumped by about 58 percent since the beginning of 2001 despite slower than normal economic growth. Not since the 1920s have workers’ wages fallen so far behind their increases in productivity and at no time in the post-World War II era have corporate profits accounted for such a large portion of the growth in national output.

So while American corporations have at least thus far been winners in U.S. acceptance of China’s trade and currency policies, U.S. workers have been major losers. Not only have wages been stagnant, but so have the number of jobs. The number of Americans with manufacturing jobs has dropped by 2.8 million, or 16 percent, since January of 2001. At the same time, the U.S. population has continued to grow. About 12 million more individuals are now being supported with paychecks that are no bigger in either size or number.

Whether or not U.S. corporations-outside the oil patch-will be long-term winners in this arrangement is a matter of increasing concern on Wall Street. Many on the street are expressing concerns that U.S. corporate profits cannot grow over the long term if American families have less and less income with which to make purchases. Since production and non-supervisory workers make up about 80 percent of the total workforce, the long-term health of the U.S. consumer is inextricably linked to the earning power of the U.S. worker.

There are also losers in other countries around the world. Underdeveloped countries with large pools of low-wage and underutilized labor are among those who suffer the most. Their dreams of development have been stymied by China’s export gluttony and they have not only lost out in the struggle to attract industry and earn hard currency, but they now live in a world where the winner has driven the cost of energy they need for their own development to prices they can no longer afford.

But there are implications to our unbalanced trading relationship with China that may be grimmer than the impact it is having on the U.S. and world economy. Those implications involve China’s geopolitical ambitions, which are clearly less benign than proponents of unbridled U.S.-Chinese trade would want us to believe.

While the CIA may have overestimated Iraq’s military capabilities, it has consistently underestimated (at least until recently) the pace of Chinese military modernization. China has taken the politically painful steps of slimming down its uniform forces to levels compatible with high-tech, modern, Western military doctrine. It has invested heavily in the development of highly capable fighter planes, air-to-air missiles, radars, landing craft and other military resources needed to confront U.S. forces in the Formosa Straits and eventually in other parts of Asia.

China now has hundreds of nuclear weapons which are both strategic and tactical in type. It maintains at least twenty intercontinental ballistic missiles capable of hitting targets in the western United States and is believed to have recently recommissioned a submarine capable of launching nuclear missiles from waters off U.S. coasts. China is working on the DR-41 missile, believed to have greater range, accuracy and a shorter launch time than existing Chinese ICBMs. They are believed to be working on between four to six new submarines capable of launching nuclear armed missiles.

As Thomas Kane wrote last year in Parameters, a publication of the U.S. Army War College, “Nuclear weapons allow the People’s Republic of China to take diplomatic and military positions with a much greater level of confidence.”

China’s booming economy also has geopolitical implications beyond the mere contribution it makes to military modernization. If China’s economy continues to experience real growth in the 9 percent range, it could surpass the United States as the world’s largest economy within a single decade, even if GDP growth in the United States remains relatively strong. As the magnitude of China’s economy grows, so will its geopolitical will. One does not need to go to Asia to find examples. Brazil has become a major source for Chinese raw materials and in turn China is discussing financing the construction of a long sought after road from the Amazon basin across the Andes to ports on the Pacific= Korea is becoming something of a “Silicon Valley” for Chinese industry, and even old adversaries such as India and Japan have to rethink how to accommodate the new reality that a rapidly growing China presents.

Some of these changes are inevitable. China needs to grow and will grow almost regardless of U.S. policy. But does China have the political maturity to absorb such a rapid increase in economic, political and military power and use it wisely? Its record on human rights, democratic reform and the treatment of its own citizens should raise serious doubts. We should want a growing economy and rising prosperity for the world’s most populous nation, but we should question whether the current torrential rate of growth-growth driven almost entirely by huge net export surpluses with the United States-is a positive for the economic well-being of our own citizens or the prospects for world peace over the coming decades.

Scott Lilly is a senior fellow at the Center for American Progress.

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Scott Lilly

Senior Fellow