Recapping the Evolution of the U.S.-China Economic Relationship

As we’re now in the throes of the summer season, we thought it would be a good time to recap the evolving U.S.-China relationship, including some of the key structural changes that have occurred over the past 20+ years.

The U.S.-China relationship has entered a new phase of geopolitical and economic rivalry. “Decoupling” may not be feasible in the most literal sense, but both countries are seeking to enhance domestic resiliency and to undo vulnerabilities that threaten each other’s vital domestic and economic interests. Trade policy is now inseparably linked to national security. Global value chains, after the halcyon era of rapid global expansion in search for lower costs and higher returns on capital and lean logistics systems, are now increasingly re-configuring under the luminescence of geopolitics.

The evolution of this relationship since 2001 can be partitioned into three broad phases. In the first seven years since China’s accession to the WTO, the sentiment within the business community was one of optimism. There were no doubt warts in the economic relationship, e.g., weak enforcement of intellectual property rights and trade secrets, copyright infringements, several major sectors still cordoned off from foreign entry. But the business community was bullish on the prospects of China’s continued opening and the ineluctable rise of the Chinese consumer.

The Global Financial Crisis reset many of these expectations. The state sector, after a period of painful reforms in the late 1990s, became resurgent, largely through the rapid proliferation of local government finance vehicles under prefecture-level State-owned Assets Supervision and Administration Commissions (SASAC). Productivity fell (see this discussion by Loren Brandt et al), worsened by rising labor costs as rural migrant labor became scarce, population growth began to slow—a product in part of the One Child Policy—state enterprise borrowing crowded out private firms, encouraging the growth of unregulated shadow banking, interurban and rural-urban inequality rose rapidly, and the low productivity housing sector became a growing source of investment and local government revenues. Non-financial sector debt as a share of GDP rise from 140% in 2008 to 270% in 2021, along with declining economic growth rates. The “China Model” that was essential to global value chains began to fray.

The third phase of this relationship came on the heels of a growing chorus of complaints and grievances among U.S. businesses invested in China and a U.S. manufacturing employment base that, while on a long arc decline since the early 1980s, accelerated since China’s entry into the WTO, losing six million jobs, of which an estimated one million can be directly tied to competition from China. The Trump Administration then inaugurated this third phase, introducing punitive tariff rates on Chinese imports under Section 232 of the 1962 Trade Expansion Act and Section 301 of the 1974 Trade Act, sanctions on Chinese technology firms, and a growing list of export controls. China’s “zero-Covid” policy may reflect an implicit acknowledgement—and embrace—that China can continue to grow without the influx of foreign visitors and ideas.

Global value chains are at the very nexus of national security and industrial power. Multinational corporations (MNCs) are evaluating, at least on the margins, whether to relocate some aspects of their supply chains, moving toward retrenchment; re-shoring, near-shoring, or “friend-shoring”; and, in the wake of disruptive shortages and shipping bottlenecks over the past year, pursuing redundancy over lean, just-in-time logistics systems. Advancements in automation, including in robotics and artificial intelligence, are—at least in some industries—reducing the cost differential between continuing production in China versus bringing some back to the United States.

Both Sides Responding to Global Value Chain Vulnerabilities

The U.S.-China Trade War, and the broader set of U.S. policies designed to inhibit overreliance on Chinese technology and bolster U.S. national security—including export controls and sanctions on Chinese tech firms—has rapidly deepened a widening rift between the two countries. The effects are being felt on both sides. U.S. businesses and consumers have been forced to bear the costs of onerous punitive duties on Chinese imports, since many of these goods are considered, at least in the near term, to be inelastic (with respect to demand) and with no viable alternative. U.S. exports, such as commodity exporters from the Pacific Northwest and Midwest, have been subjected to much higher tariff rates in China as part of China’s retaliation for U.S. escalated rates. Meanwhile import duties on products entering China from other countries have been effectively reduced, eroding U.S. exporter market share. The pandemic and sudden uptick in demand for personal protective equipment (PPE), and subsequent shortages early on, further pronounced this heavy reliance on China for many basic goods consumed in the United States.

Chinese leaders, painfully alerted to their country’s over-dependence on the United States and its allies for critical technological intermediate inputs, have shifted their focus to domestic economic and supply chain resiliency. The “Dual Circulation” (双循环) framework released by the Chinese Communist Party (CCP) in the fall of 2020 articulated the Party’s vision for how to enhance both its export competitiveness and build domestic supply chain capabilities. For years, China’s growth model entailed a heavy focus on final assemblage, whereas many of the more complex (and higher value-added) intermediate inputs were imported from abroad for re-export. This model allowed Chinese businesses, entrepreneurs, and state planners to learn from foreign practices and begin to build out the supporting indigenous ecosystem, albeit not fast enough to withstand the sudden advent of U.S. and ally policies aimed at closing off these important imports.

Growing cynicism within the U.S. government, businesses, and public at large is palpable. The U.S. Innovation and Competition Act and the America Competes Act, passed by the Senate and House with large bipartisan majorities and now being reconciled, both include investment in domestic semiconductor chip manufacturing and steep increases in scientific research and development funding. Both are directly in response to the perceived “China Threat.”

China watchers and policymakers alike have pointed with alarm to China’s growing shift towards industrial policy, particularly in areas where China either seeks global dominance or vulnerabilities. The history of these efforts can be traced back many years, from the 2006 15-year “Medium- to Long-Term Plan for the Development of Science and Technology,” “Indigenous Innovation,” and “China 2025.” But seldom have these actually worked, hindered by China’s high degree of fiscal decentralization (85% of fiscal revenues below the central government) and incentive structure that encourages redundancy, short-term economic goals, and oftentimes wasted investment. See this excellent review of China’s industrial policy, and its pitfalls, by Professor David Bulman in his testimony to the U.S.-China Economic and Security Review Commission last month. According to his analysis, which we concur, China’s growth during the reform era was primarily a function of serendipitous timing (during a period of rapidly expanding global trade and de-verticalized supply chains), East Asian geography (proximity to the broader Chinese community, and investors, in Hong Kong, Taiwan, and Singapore), comparative advantage (e.g., deep pool of underemployed, low-cost labor), and policy choices.

Despite the many billions of RMB invested in advancing China’s industrial goals, local implementation has faltered. The government’s industrial policies have thus far really enjoyed success in emerging, low- to medium-industries such as solar cells and high-capacity batteries. From a supply chain resiliency standpoint, this means China remains highly vulnerable to disruptions introduced by sanctions, U.S. export controls, and other U.S. and partner country policies aimed at limiting technology transfer. According to Bulman’s analysis, “China remains considerably more asymmetrically dependent on the U.S. than vice versa, as indicated by China’s financial vulnerabilities (i.e., potential for exclusion from Swift) and dependence on U.S. technology, as seen in the recent ZTE and Huawei cases.”

The Trade War represented a widespread disillusion over the course of trade and U.S.-China relations since China’s accession to the WTO. In the view of many policymakers and commentators, China’s entry to the WTO and, more broadly, U.S. engagement helped make China stronger—economically, and increasingly militarily—without the commensurate domestic political liberalizations widely thought to come in tandem with greater economic integration. An array of recent, widely read and cited publications has lamented this disillusionment and the decades-long unforced errors of American policy vis-à-vis China.

Despite this perceived failure, prior to the Trade War, businesses across the U.S.—from exporters to ports to importers of Chinese goods—have successfully taken advantage of the relationship and profited from it. Some regions, such as the Pacific Northwest, have benefited enormously from China as a leading export market—from aircraft (Boeing), cherries (for which Chinese consumers are willing to pay the hefty premium for airfreight due to perishability), potato products, and medical devices, as well as the inflow of Chinese capital from tourists, students, and household and corporate inbound investments.

These developments will have vast, lasting impacts for American national security and global competitiveness. The Trump Era heralded a new phase of economic relations that overtly linked trade and supply chains with national security. U.S. businesses that had previously doubled down on China’s growth and domestic market must now, increasingly, determine the extent to which their current and future investment decisions conflict or run afoul of U.S. trade and national security policies.

Economic “decoupling” in the crude sense, often depicted in public discourse, will not take effect. But for several reasons—some directly tied to the growing geopolitical rift with China, others (such as rising labor costs) related to China’s own inherent domestic challenges—future foreign direct investment and global value chains will migrate to other markets. This will specifically be the case for firms that either: 1) do not rely on the Chinese domestic market for sales and/or highly cost-sensitive and highly responsive to rising labor costs, energy and land costs, shipping rates, and other factors; or 2) producers of goods and services that directly intersect with U.S. national security concerns.

Chinese governments at the center and local levels will continue to offer conflicting development agenda. While the central government will seek to further enhance domestic, indigenous capabilities, local governments will continue efforts to attract and retain foreign investment in key areas.

Despite the rhetoric from Washington D.C., the approach as laid out in such documents as the Indo-Pacific Economic Framework or Secretary Blinken’s most recent speech at the Asia Society in May leave out key details. U.S. firms, nonetheless, are beginning to revise their internal calculus on how to avoid being caught unprepared in this rivalry.