Implications of US-China Economic Relationship

The US China Economic and Security Review Commission (USCC) was set up in 2000 to keep the US Congress informed about national security implications of the bilateral trade and economic relationship between the US and China. On November 20, the Commission released the 2008 Annual Report to Congress.

Prior to it, IAR Staff Writer Jacob Mohs talked with Patrick Mulloy, a member of the USCC and former Assistant Secretary of Commerce under President Clinton. The discussion focused on security issues, the erosion of American competitiveness and what can be done about it. The opinions expressed are those of Patrick Mulloy, and do not necessarily reflect the position of the USCC.

IAR: Lets start by talking about the new USCC report. I know you’ve been busy working on that. What are the new major issues in this report? Have there been major improvements on issues such as export controls, the defense industrial base or the currency?

Mulloy: I think the Chinese have made some improvement on their export control system.

As far as our U.S. industrial base? It continues to erode. You cannot run massive current account deficits in your manufacturing sector and expect to have a robust defense industrial base. You know your industrial and technological base is what produces so much of your regular weaponry and advanced weaponry. And when that’s eroding, your military industrial base is eroding.

IAR: Which do you think is the best forum for resolving the currency issue? If it is argued that the weak currency functions as an export subsidy then that would be in violation of WTO rules. Is that the best forum for resolving this?

Mulloy: You have to understand this in terms of why did China so want to get into WTO? We were giving them Most Favored Nation (MFN) trade treatment a year at a time. I don’t know if you remember that…

IAR: Yeah back in the Clinton administration it was somewhat controversial.

Mulloy: Both under Clinton and Bush we were giving them MFN trade treatment annually, and each year the president would renew it, and Congress could have voted against it in a rather complicated procedure. China was getting it year after year, but they were very keen to get into the WTO. Why?

IAR: To make it permanent.

Mulloy: To make it permanent, now why?

IAR: Access to U.S. market.

Mulloy: Without MFN, the average tariff on Chinese goods would be about 42%. With MFN, the average tariff on Chinese goods is about 2.5 %. Ok, now what the Chinese were looking for was not just guaranteed access, but the investment. 60% of China’s exports are from foreign investment companies. Those companies weren’t going to want to invest in China and export the technology and knowhow unless they were pretty sure they could export the finished products back out. Locking in the WTO was very important for investment and technology flows into China. And that’s what they got. You can see the investment figures go up quite dramatically at the beginning of 2001. China’s trade surplus increased dramatically after 2001. So it worked.

In our very first report to Congress in 2002 this is what we were saying about why we wanted China in the WTO - help democracy in China, help internet users and all that. What they were saying to their own people is this is very important to attract investment, and increase exports.

IAR: Shifting topics a bit, share your thoughts on the U.S. China Strategic Economic Dialogue (SED) . In what way can it be improved? What are some criticisms or compliments for the way it has been going under Secretary Henry Paulson?

Mulloy: I think its important to have a dialogue. When I was in the Clinton administration as Assistant Secretary of Commerce, we used to have the Joint Commission on Commerce and Trade (JCCT). They still have the JCCT. That was chaired by Commerce and the United States Trade Representative (USTR). I think along the way, in the last 4-5 years with the Chinese managing their exchange rate, they are accumulating massive amounts of dollars because one of the ways they keep their currency undervalued is to intervene in currency markets and buy dollars, and put them in the central bank. And the central bank wanting to get a return on those dollars will put them into U.S. Treasuries and Freddies and Fannies. So we liked it because it helped us keep interest rates lower, particularly in the face of Bush’s massive budget deficit. . And it would have made interest rates much higher, and harder to maintain those budget deficits without more political resistance if we weren’t getting the lower priced money coming in from China. Treasury then, because of both the exchange rate and the Chinese being major purchasers of U.S. Treasuries and others, wanted to take the lead on this dialogue and that is when the SED was set up. Treasury runs it and brings in the other agencies. It became the main focus. Prior to Paulson taking that on, remember Robert Zoellick (current President of the World Bank) ran the key dialogue over in the State Department. But Paulson took it on.

The key things he wanted, were to get the Chinese to move on their currency and to open up to U.S. financial firms more than they were committed to on their WTO entry. I don’t think he achieved a lot in that area.

Now it was nice to have the discussions, and there were some things along the way that they got, but overall, although its nice to have that channel, I cant say we’ve achieved any major successes in that Strategic Economic Dialogue.

It’s an important channel, and I think a different administration, which has a little more determination about what it really wants to achieve, can achieve some things, but I don’t think we’ve achieved a whole lot in the last three years under Secretary Paulson.

IAR: Looking forward to the next administration, we will continue to interact with China through many different agencies: Treasury, Commerce, State Department, USTR, etc. What key principles should be applied as America engages China at all these levels?

Mulloy: It’s very important to have a good relationship with China. We have got to address environment issues, global warming, ocean pollution and helping to control proliferation of weapons of mass destruction. There are many things that we can and should be working with the Chinese on. When there are rules of the game in trade like the IMF Article IV - you’re not supposed to engage in currency manipulation or the WTO where you are supposed to protect intellectual property, where you are not supposed to be providing massive subsidies for your exports.

It’s not protectionist to call the Chinese to account on those matters and to use the means that you have available to defend your own interests. The Chinese are undervaluing their currency, there is nothing wrong with both taking them to the WTO, or permitting us to treat that as an export subsidy that can be countervailed by a countervailing duty clause. That is just common sense that you would want to use if they are not living up to their obligation. It doesn’t mean that you don’t like China; it means that there are rules of the game, and you want them to live up to them.

Otherwise you have such an imbalance in the economic and trade relationship that it hurts both countries. China should be moving towards more domestic led growth of the economy rather than pushing for an export led growth. We’re maxed out. That’s what this whole financial crisis is about…. The United States has been living beyond its means, and we cannot be the buyer of last resort in the global economy. Its impossible, unless we want to hand over the whole economy to foreign control. That’s what sovereign wealth funds are all about. That’s dollars that are being accumulated by other governments to buy up chunks of our economy.

IAR: Some people have argued these sovereign wealth funds are altering the basic logic of the capitalist system. On a similar note, when foreign firms, sometimes state owned, are buying up stakes of U.S. firms, it might be to access U.S. technology so there is sort of this challenge to balance here. What measures can be taken to safeguard security without cutting off access to capital for U.S. firms.

Mulloy: The key to both those are two very important points, and they are both addressed in the new China Commission report.

IAR: I’ll link to the report on the website.

Mulloy: I testified before the senate banking committee both on sovereign wealth funds, and I
testified on the Committee on Foreign Investment in the United States (CFIUS).

IAR: You were actually involved in some of the earlier legislation on that right?

I was general counsel of the Banking Committee when we wrote the law that gave the President the authority to block foreign takeovers of American companies. The CFIUS previously existed by executive order, but it didn’t have any authority. The President put that new legislative authority into the existing CFIUS. Okay, that happened in 1988, and also in ‘88 the Congress, and I was general counsel of the committee, wrote the law telling the treasury secretary to identify countries which are manipulating their currency and at first the treasury actually used that authority, and identified Taiwan, Korea and China, but somewhere in ‘93 they stopped using it. Therefore they aren’t telling Congress the reality of what is going on out there, contrary to the law. And I testified before about that.

Let me help you understand what a sovereign wealth fund is. The dollars are flowing out to the oil exporters because we are dependent on foreign oil. And the other part – our other major trade deficits are with the Asian countries, which are all under pricing their currencies, and have very mercantilist trade practices: they accumulate massive trade surpluses with the United States. Then they have the dollars and they come back to buy chunks of the U.S. economy.

IAR: A particular concern also is the fact that, Sovereign wealth funds, generally aren’t from democratic countries with the exception of Norway.

Mulloy: There is a new article put out by the Council on Foreign Relations, by a guy named Brad Setzer dated September 2008. Brad testified before the China Commission back in April. One of his points is that in order to accumulate those funds, they have to hold down the standard of living for their people, and its much easier to do that if you are an authoritarian nation. Most of these countries aren’t exactly the model that we aspire to in international affairs, you know democratic countries.

One more thing about CFIUS. Congress rewrote the law last year. The final regulations aren’t out yet, but they are expected out shortly and it will be very important for Congress to have very good oversight because there is going to be a lot of foreign purchases in the U.S. economy. Over time, the fact that we have and have had these massive trade deficits, is going to make the dollar fall in value, and it will make the US a pretty good place to buy bargains.

IAR : What would you say to criticism that Congress could slow the process down too much, or wouldn’t have broad interests of the U.S. economy in mind.

Mulloy: The provisions of law are written by the Foreign Investment and National Security Act, (FINSA), and the time frames are set into the law, so its not like its an open ended time frame for Congress. But they want the intelligence agencies much more involved in seeing who buys what, and to look at patterns of who buys what in this country. In other words, I think Treasury is looking at these things on a case by case basis. Rather than: are there patterns where you can see these types of companies being acquired with these types of technologies because of some reason?

IAR: You think that could reveal something that can’t be seen when you look at it on a case by case basis.

Mulloy: Absolutely.

IAR: How can the U.S. regain competitive advantage in the global economy, but remain an open and democratic society?

Mulloy: We have major advantages in this country. But we’ve been living in a never- never world of massive budget deficits, and without recognizing that other countries have clear strategic, industrial strategies and we have none to be able to counter what is going on. Other countries are incentivizing our corporations to move our technology and industry out of this country to their countries, and then to ship the goods back here. And we are losing important industries, and not only are we losing important industries, but we are losing the know-how in our people. So these skills, built up over generations are being lost. And the United States doesn’t have a way of coping with this. We’re a smart people, and I think once we have an administration that’s not blinded by some ideology of the markets determine everything, we’ll be able to cope with these matters. About rewarding companies that keep good jobs in these countries through the tax system… I mean what’s wrong with that?

And then we have got to build our infrastructure. We have got to let go of this idea that we cannot put any money on roads and highways and communications systems and railroads. You go over to Asia, and you see that they are building it as part of making their societies more competitive, while we’ve completely let it fall apart in this country for 30 years.

I think we’ve got a lot of rebuilding to do. But we’re a smart dedicated people and if we have good leaders that can guide the people and tell them what is going on, I have great faith that we can deal with these matters.

IAR: So from a basic Keynesian perspective, rebuilding infrastructure could be sort of a kickstart to the economy too?

Mulloy : Absolutely … You remember this guy who ran on the Republican ticket, Mike Huckabee. Do you remember when they were talking about the stimulus, and they were going to give back $60 million? People were going to get this check in the mail and he said, and I thought he really hit a homerun when he said this: “We are going to give our people money, they are going to use the money to go to Walmart and buy Chinese goods. That sounds like a very good stimulus package for China.” Wouldn’t it make more sense to take that money and rebuild Interstate 95 running down the whole east coast? And make that a really good highway, widen it and fix it, wouldn’t that be a better use of the money? And I think that is where we are headed as a nation, we’re going to start putting some money into infrastructure and rebuilding our own economy.

IAR: So you’re optimistic over the next 10 years?

Mulloy: I think we’re going to have a period of digging ourselves out of this massive hole that we’ve dug for ourselves. And again you have so many of these so called free trade economists who say “gee he sounds like a protectionist,” but Warren Buffet, has been saying the very same thing I am.

He’s saying we are moving towards a sharecropper economy. The first reference was on page 19 of a 2005 letter to shareholders of Berkshire Hathaway; where the other guys own it and we work on it.

IAR: Mr. Mulloy, thanks for taking the time to do this.

Mulloy: Well it’s your generation that’s going to have to dig us out!

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