Order Code RL33534 CRS Report for Congress Received through the CRS Web China’s Economic Conditions July 12, 2006 Wayne M. Morrison Specialist in International Trade and Finance Foreign Affairs, Defense, and Trade Division Congressional Research Service ˜ The Library of Congress China’s Economic Conditions Summary Since the initiation of economic reforms in 1979, China has become one of the world’s fastest-growing economies. From 1979 to 2005 China’s real GDP grew at an average annual rate of 9.7%; it grew by 9.9% in 2005. During the first quarter of 2006, China’s real GDP grew by 10.2%. Many economists speculate that China could become the world’s largest exporter within the next few years and the largest economy within a few decades, provided that the government is able to continue and deepen economic reforms, particularly in regard to its inefficient state-owned enterprises (SOEs), the state banking system, and fixed exchange rate system. In addition, China faces several other difficult challenges, such as pollution and growing income inequality, that threaten social stability. Trade continues to play a major role in China’s booming economy. In 2005, exports rose by 28.4% to $762 billion, while imports grew by 17.6% to $660 billion, producing a $102 billion trade surplus. China is now the world’s third-largest trading economy after the United States and Germany. China’s trade boom is largely the result of large inflows of foreign direct investment (FDI) into China, which totaled $60 billion in 2005. Over half of China’s trade is accounted for by foreign-invested firms in China. China’s economy continues to be a concern to many U.S. policymakers. On the one hand, China’s economic growth presents huge opportunities for U.S. exporters. On the other hand, the surge in Chinese exports to the United States has put competitive pressures on various U.S. industries. Many U.S. policymakers have argued that greater efforts should be made to pressure China to fully implement its World Trade Organization (WTO) commitments (especially in terms of protecting U.S. intellectual property rights) and change various economic policies deemed harmful to U.S. economic interests, such as its currency policy and its use of subsidies to support its state-owned firms. This report replaces IB98014, China’s Economic Conditions, by Wayne M. Morrison, and will be updated as events warrant. Contents An Overview of China’s Economic Development . . . . . . . . . . . . . . . . . . . . . . . . 2 China’s Economy Prior to Reforms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 The Introduction of Economic Reforms . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 China’s Economic Growth Since Reforms: 1979-2006 . . . . . . . . . . . . . . . . 3 Causes of China’s Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Measuring the Size of China’s Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Foreign Direct Investment in China . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 China’s Trade Patterns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 China’s Major Trading Partners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Major Chinese Trade Commodities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Major Long-Term Challenges Facing the Chinese Economy . . . . . . . . . . . . . . . 10 Outlook for China’s Economy and Implications for the United States . . . . . . . . 12 List of Figures Figure 1. China’s Foreign Exchange Reserves: 1990-March 2006 . . . . . . . . . . . . 8 List of Tables Table 1. China’s Average Annual Real GDP Growth Rates, 1960-2006 . . . . . . . 3 Table 2. Comparisons of United States, Japanese, and Chinese GDP and Per Capita GDP in Nominal U.S. Dollars and PPP, 2005 . . . . . . . . . . . . . . . . . . 5 Table 3. Major Foreign Investors in China: 1979-2005 . . . . . . . . . . . . . . . . . . . . 6 Table 4. China’s Merchandise World Trade, 1979-2005 . . . . . . . . . . . . . . . . . . . 7 Table 5. China’s Top Five Trading Partners: 2005 . . . . . . . . . . . . . . . . . . . . . . . 9 Table 6. Major Chinese Exports, 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Table 7. Major Chinese Imports, 2005 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 China’s Economic Conditions The mercurial rise of China as a major economic power within a time span of only 26 years is often described by analysts as one of the greatest economic success stories in modern times. From 1979 (when economic reforms were first introduced) to 2005, China’s real gross domestic product (GDP) grew at an average annual rate of 9.7%. The Chinese economy in real terms was 11 times larger in 2005 than it was in 1979, and real per capita GDP was 8 times larger. By some measurements, China is now the world’s second largest economy and some analysts predict China will become the largest within a decade. China’s economic rise has led to a substantial increase in U.S.-China economic relations. Total trade between the two countries has surged from $4.9 billion in 1980 to $289 billion in 2005. For the United States, China is now its 3rd largest trading partner (2005), its 4th largest export market and its 2nd largest source of imports. Many U.S. companies have extensive manufacturing operations in China in order to sell their products in the booming Chinese market and to take advantage of low cost labor for manufacturing products for exports. These operations have helped U.S. firms remain internationally competitive and have supplied U.S. consumers with a variety of low cost goods. China’s large-scale purchases of U.S. Treasury securities have enabled the Federal government to fund its budget deficits and keep U.S. interest rates relatively low. However, the emergence of China as a major economic superpower has raised concern among many U.S. policymakers. Some express concern over the large and growing U.S. trade deficits with China, which have risen from $10.4 billion in 1990 to $202 billion in 2005, and are viewed by many Members as an indicator that U.S. commercial relations are imbalanced or unfair. Others claim that China uses unfair trade practices (such as an undervalued currency and subsidies to domestic producers) to flood U.S. markets with low cost goods, and that such practices threaten American jobs, wages, and living standards. A more recent concern has been efforts by Chinese state-owned firms to acquire U.S. companies and China’s accumulation of U.S. Treasury securities. Congressional concerns over perceived negative China’s economic practices have led to the introduction of numerous bills, including some that would impose sanctions against China unless it reformed its currency policy and others that would apply U.S. countervailing laws on Chinese products deemed to have been subsidized by the government. This report provides background on China’s economic rise and current economic structure (such as GDP, trade and foreign investment), and describes Chinese economic policies that are of concern U.S. policymakers. CRS-2 An Overview of China’s Economic Development China’s Economy Prior to Reforms Prior to 1979, China maintained a centrally planned, or command, economy. A large share of the country’s economic output was directed and controlled by the state, which set production goals, controlled prices, and allocated resources throughout most of the economy. During the 1950s, all of China’s individual household farms were collectivized into large communes. To support rapid industrialization, the central government undertook large-scale investments in physical and human capital during the 1960s and 1970s. As a result, by 1978 nearly three-fourths of industrial production was produced by centrally controlled stateowned enterprises according to centrally planned output targets. Private enterprises and foreign-invested firms were nearly nonexistent. A central goal of the Chinese government was to make China’s economy relatively self-sufficient. Foreign trade was generally limited to obtaining only those goods that could not be made or obtained in China. Government policies kept the Chinese economy relatively stagnant and inefficient, mainly because there were few profit incentives for firms and farmers; competition was virtually nonexistent, and price and production controls caused widespread distortions in the economy. Chinese living standards were substantially lower than those of many other developing countries. The Chinese government hoped that gradual reform would significantly increase economic growth and raise living standards. The Introduction of Economic Reforms Beginning in 1979, China launched several economic reforms. The central government initiated price and ownership incentives for farmers, which enabled them to sell a portion of their crops on the free market. In addition, the government established four special economic zones along the coast for the purpose of attracting foreign investment, boosting exports, and importing high technology products into China. Additional reforms, which followed in stages, sought to decentralize economic policymaking in several sectors, especially trade. Economic control of various enterprises was given to provincial and local governments, which were generally allowed to operate and compete on free market principles, rather than under the direction and guidance of state planning. Additional coastal regions and cities were designated as open cities and development zones, which allowed them to experiment with free market reforms and to offer tax and trade incentives to attract foreign investment. In addition, state price controls on a wide range of products were gradually eliminated. CRS-3 China’s Economic Growth Since Reforms: 1979-2006 Since the introduction of economic reforms, China’s economy has grown substantially faster than during the pre-reform period (see Table 1).1 From 1960 to 1978, real annual GDP growth was estimated at 5.3% (a figure many analysts claim is overestimated, based on several economic disasters that befell the country during this time, such as the Great Leap Forward and the Cultural Revolution). During the reform period (1979-the present), China’s average annual real GDP grew by 9.7%; it grew by 9.9% in 2005. During the first quarter of 2006, real GDP grew by 10.2% over the same period in 2005. Since economic reforms were begun, the size of the economy in real terms has increased eleven-fold, and real per capita GDP (a common measurement of living standards) has gone up eight-fold. Table 1. China’s Average Annual Real GDP Growth Rates, 19602006 Time period 1960-1978 (pre-reform) 1979-2005 (post-reform) 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 (first quarter) Average annual % growth 5.3 9.7 3.8 9.3 14.2 14.0 13.1 10.9 10.0 9.3 7.8 7.6 8.4 8.3 9.1 10.0 10.1 9.9 10.2 Source: Official Chinese government data. 1 In January 2006, China made major revisions to its GDP data for 1993-2004. The revisions indicated that, based on new estimates of growth in the service sector, the size of China’s economy and its GDP growth were significantly higher than previously estimated. For example, real GDP growth in 2004 had been originally measured at 9.5%, but the revised figure puts this rate at 10.1%, and the overall size of the economy in 2004 was estimated to be nearly 17% bigger. CRS-4 Causes of China’s Economic Growth Economists generally attribute much of China’s rapid economic growth to two main factors: large-scale capital investment (financed by large domestic savings and foreign investment) and rapid productivity growth. These two factors appear to have gone together hand in hand. Economic reforms led to higher efficiency in the economy, which boosted output and increased resources for additional investment in the economy. China has historically maintained a high rate of savings. When reforms were initiated in 1979, domestic savings as a percentage of GDP stood at 32%. However, most Chinese savings during this period were generated by the profits of state-owned enterprises (SOEs), which were used by the central government for domestic investment. Economic reforms, which included the decentralization of economic production, led to substantial growth in Chinese household savings (these now account for half of Chinese domestic savings). As a result, savings as a percentage of GDP has steadily risen; it reached nearly 50% in 2005, among the highest savings rates in the world.2 Several economists have concluded that productivity gains (i.e., increases in efficiency in which inputs are used) were another major factor in China’s rapid economic growth. The improvements to productivity were caused largely by a reallocation of resources to more productive uses, especially in sectors that were formerly heavily controlled by the central government, such as agriculture, trade, and services. For example, agricultural reforms boosted production, freeing workers to pursue employment in the more productive manufacturing sector. China’s decentralization of the economy led to the rise of nonstate enterprises, which tended to pursue more productive activities than the centrally controlled SOEs. Additionally, a greater share of the economy (mainly the export sector) was exposed to competitive forces. Local and provincial governments were allowed to establish and operate various enterprises on market principles, without interference from the central government. In addition, foreign direct investment (FDI) in China brought with it new technology and processes that boosted efficiency. Measuring the Size of China’s Economy The actual size of the China’s economy has been a subject of extensive debate among economists. Measured in U.S. dollars using nominal exchange rates, China’s GDP in 2005 is estimated at about $2.3 trillion; its per capita GDP (a commonly used living-standards measurement) was $1,700. Such data would indicate that China’s economy and living standards are significantly lower than those of the United States and Japan, respectively considered to be the number-one and number-two largest economies (see Table 2). 2 In comparison, the U.S. savings rate was about 10% in 2005. Savings defined as aggregate national savings by the public and private sector as a percentage of nominal GDP. (Economist Intelligence Unit database.) CRS-5 Many economists, however, contend that using nominal exchange rates to convert Chinese data into U.S. dollars substantially underestimates the size of China’s economy. This is because prices in China for many goods and services are significantly lower than those in the United States and other developed countries. Economists have attempted to factor in these price differentials by using a purchasing power parity (PPP) measurement, which attempts to convert foreign currencies into U.S. dollars on the basis of the actual purchasing power of such currency (based on surveys of the prices of various goods and services) in each respective country. This PPP exchange rate is then used to convert foreign economic data in national currencies into U.S. dollars. Because prices for many goods and services are significantly lower in China than in the United States and other developed countries (while prices in Japan are higher), the PPP exchange rate raises the estimated size of Chinese economy from $2.3 trillion (nominal dollars) to $8.4 trillion (PPP dollars), significantly larger than Japan’s GDP in PPPs ($3.9 trillion), and about 67% the size of the U.S. economy. PPP data also raise China’s per capita GDP to $6,386. The PPP figures indicate that, while the size of China’s economy is substantial, its living standards fall far below those of the U.S. and Japan. China’s per capita GDP on a PPP basis is only 15.2% of U.S. levels. Thus, even if China’s GDP were to overtake that of the United States in the next few decades, its living standards would remain substantially below those of the United States for many years to come. Table 2. Comparisons of United States, Japanese, and Chinese GDP and Per Capita GDP in Nominal U.S. Dollars and PPP, 2005 GDP in PPP ($ billions) Nominal Per Capita GDP Per Capita GDP in PPP 12,458 12,458 42,130 42,130 Japan 4,571 3,914 35,880 30,720 China 2,262 8,359 1,700 6,386 Country United States Nominal GDP ($ billions) Source: Economist Intelligence Unit Data Services and Global Insight. Note: PPP data for China should be interpreted with caution. China is not a fully developed market economy; the prices of many goods and services are distorted due to price controls and government subsidies. Foreign Direct Investment in China China’s trade and investment reforms and incentives led to a surge in foreign direct investment (FDI), which has been a major source of China’s capital growth. Annual utilized FDI in China grew from $636 million in 1983 to $72.4 billion. in 2005 3 The cumulative level of FDI in China at the end of 2005 stood at about $633 3 Chinese officials recently revised its 2005 FDI total from $60.3 billion to 72.4 billion, (continued...) CRS-6 billion Analysts predict that FDI will continue to pour into China as investment barriers are reduced under China’s WTO commitments and Chinese demand for imports continues to increase. Based on cumulative FDI for 1979-2005 about 42%of FDI in China has come from Hong Kong. In 2005, Japan replaced the United States as second largest overall investor in China. The United States ranked third accounting for 8.2% ($51.1 billion) of total FDI. Other major investors include the British Virgin Islands, Taiwan, and South Korea (see Table 3).4 U.S. FDI in China for 2005 was $3.1 billion (compared to $3.9 billion in 2004), accounting for 5.1% of FDI for that year, and ranked 5th after Hong Kong, the British Virgin Islands, Japan, and South Korea.5 Table 3. Major Foreign Investors in China: 1979-2005 ($ billions and % of total) Cumulative Utilized FDI: 1979-2005 Utilized FDI in 2005 Amount ($ billions) % of Total Total* 632.8 100.0 72.4 100.0 Hong Kong 259.5 41.8 17.9 29.7 Japan 53.3 8.6 6.5 10.8 United States 51.1 8.2 3.1 5.1 British Virgin Islands 45.9 7.4 9.0 14.9 Taiwan 41.8 6.7 2.2 3.3 South Korea 31.1 5.0 5.2 8.6 Country Amount ($ billions) % of Total * Total FDI figures reflect revisions China made to its FDI data for 2005. However, data for individual country investors (amounts and percent of total) reflect China’s previous FDI estimates. Revised FDI total by country have not yet been released. Source: Chinese government statistics. Top six investors according to cumulative FDI from 1979 to 2005. 3 (...continued) claiming previous estimates excluded FDI in the banking, insurance, and securities sectors. (See, People’s Daily, June 9, 2006). However, revisions were not made for previous years. 4 According to the Chinese Ministry of Commerce, major U.S. investors in China (based on 2003 sales volumes) include Motorola ($5.8 billion in sales volume), General Motors ($2.2 billion), Dell Computer ($2.1 billion), Hewlett Packard ($1.3 billion), and Kodak ($0.6 billion). 5 The British Virgin Islands is a large source of FDI because of its status as a tax haven. Much of the FDI originating from Hong Kong comes from non-Hong Kong investors, such as Taiwanese. CRS-7 China’s Trade Patterns Economic reforms have transferred China into a major trading power. Chinese exports rose from $14 billion in 1979 to $762 billion in 2005, while imports over this period grew from $16 billion to $660 billion (see Table 4). In 2004, China surpassed Japan as the world’s third-largest trading economy (after the United States and Germany). China’s trade continues to grow dramatically: From 2002 to 2005, the size of China’s exports and imports more than doubled. In 2005, exports and imports rose by 28.4% and 17.6%, respectively. China’s trade surplus, which totaled $32 billion in 2004, tripled to $102 billion. Table 4. China’s Merchandise World Trade, 1979-2005 ($ billions) Year Exports Imports Trade balance 1979 13.7 15.7 -2.0 1980 18.1 19.5 -1.4 1985 27.3 42.5 -15.3 1990 62.9 53.9 9.0 1995 148.8 132.1 16.7 2000 249.2 225.1 24.1 2001 266.2 243.6 22.6 2002 325.6 295.2 30.4 2003 438.4 412.8 25.6 2004 593.4 561.4 32.0 2005 762.0 660.1 101.9 Source: International Monetary Fund, Direction of Trade Statistics, and official Chinese statistics. Data for the first three months of 2006 indicate that China’s rapid trade growth is continuing, although at a slightly slower pace than 2005 levels. During this period, exports and imports rose by 26.6% and 24.8%, respectively over the same period in 2005. Merchandise trade surpluses, large-scale foreign investment, and its peg to the U.S. dollar have enabled China to accumulate the world’s largest foreign exchange reserves. As seen in Figure 1, China’s accumulation of foreign exchange reserves has been particularly acute over the past few years. China’s total reserves reached $875.1 billion at the end of March 2006, more than double the level China had at the end of 2003. Many analysts contend China’s reserves could hit $1 trillion by the end of 2006. CRS-8 Figure 1. China’s Foreign Exchange Reserves: 1990-March 2006 ($ in billions) $1000 $875.1 $818.9 $800 $609.9 $600 $408.2 $400 $291.1 $215.6 $200 $107 $132.8 $168.3 $149.2 $157.7 $76.4 29.6 34.7 $20.6 $22.4 $32.9 0 1991 1990 1993 1992 1995 1994 1997 1996 1999 1998 2001 2000 2003 2002 2005 2004 March 2006 Source: Official Chinese government data. China’s Major Trading Partners China’s trade data often differ significantly from those of its major trading partners. This is due to the large share of China’s trade (both exports and imports) passing through Hong Kong (which reverted back to Chinese rule in July 1997 but is treated as a separate customs area by most countries, including China and the United States). China treats a large share of its exports through Hong Kong as Chinese exports to Hong Kong for statistical purposes, while many countries that import Chinese products through Hong Kong generally attribute their origin to China for statistical purposes. According to Chinese trade data, its top five trading partners in 2004 were the European Union (EU), the United States, Japan, Hong Kong, and the 10 nations that constitute the Association of Southeast Asian Nations (ASEAN) (see Table 5). China’s largest export markets were the United States, Hong Kong, and the EU, while its top sources for imports were Japan, the EU, and Taiwan (the United States ranked sixth). U.S. trade data indicate that the importance of the U.S. market to China’s export sector is likely much higher than is reflected in Chinese trade data. Based on U.S. data on Chinese exports to the United States (which, as noted, do not agree with Chinese data), and Chinese data on total Chinese exports, it is estimated that Chinese exports to the United States as a share of total Chinese exports grew from 15.3% in 1986 to 32.0% in 2005. A growing level of Chinese exports is from foreign-funded enterprises (FFEs) in China. According to Chinese data, FFEs were responsible for 58% of Chinese exports in 2005, compared with 41% in 1996. A large share of these FFEs are owned by Hong Kong and Taiwan investors, many of whom have shifted their labor- CRS-9 intensive, export-oriented, firms to China to take advantage of low-cost labor. A significant share of the products made by such firms is likely exported to the United States. Table 5. China’s Top Five Trading Partners: 2005 ($ billions) Country Total trade Chinese exports Chinese imports China’s trade balance Trade Balance as Reported by Partner Hong Kong 246.8 124.5 122.3 2.2 -4.7 European Union 219.3 143.7 75.6 68.1 -132 United States 211.6 162.9 48.7 114.2 -201.6 Japan 184.5 84.0 100.5 -16.5 -28.5 ASEAN* 130.4 55.4 75.0 -19.6 N/A Sources: Official Chinese trade data and Global Trade Atlas. Note: Chinese data on its bilateral trade often differ substantially from the official trade data of other countries on their trade with China. * Association of Southeast Asian Nations (ASEAN) member countries are Indonesia, Malaysia, the Philippines, Singapore, Thailand, Brunei, Cambodia, Laos, Myanmar (Burma), and Vietnam. Major Chinese Trade Commodities China’s abundance of cheap labor has made it internationally competitive in many low- cost, labor-intensive manufactures. As a result, manufactured products constitute an increasingly larger share of China’s trade. A large share of China’s imports, such as raw materials, components and parts, and production machinery is used to manufacture products for export. For example, China imports cotton and textile-production machinery (and cotton) to produce textile and apparel items. A substantial amount of China’s imports is comprised of parts and components that are assembled in Chinese factories (major products include consumer electronic products and computers), then exported. China’s top five exports in 2005 were (1) automatic data processing machines and units, (2) garments and clothing accessories, (3) textile products, (4) parts of data processing machines, and (5) radio telephone handsets (see Table 6). China’s top imports were (1) electronic integrated circuits and microassemblies, (2) crude oil, (3) liquid crystal display panels, (4) steel products, and (5) plastics (see Table 7).6 6 Rankings differ according to which trade classification is used and at what digit level. CRS-10 Table 6. Major Chinese Exports, 2005 ($ billions and % change over previous year) Amount Percent Increase over 2004 Automatic data processing machines and units 74.5 28.6 Garments and clothing accessories 73.4 20.0 Textile products 40.9 23.9 Parts of data processing machines 27.7 20.4 Radio telephone handsets 19.7 44.8 Source: China’s Customs Statistics. Estimated, based on January-November 2005 data. Table 7. Major Chinese Imports, 2005 ($ billions and % change over previous year) Percent Change over 2004 Amount Electronic integrated circuits and microassemblies 79.3 32.0 Crude oil 47.2 43.5 Liquid crystal display panels 26.8 27.5 Steel products 25.0 20.7 Plastics 24.1 18.6 Source: China’s Customs Statistics. Estimated, based on January-November 2005 data. Major Long-Term Challenges Facing the Chinese Economy China’s economy has shown remarkable economic growth over the past several years, and many economists project that it will enjoy fairly healthy growth in the near future. However, economists caution that these projections are likely to occur only if China continues to make major reforms to its economy. Failure to implement such reforms could endanger future growth. CRS-11 ! State-owned enterprises (SOEs), which account for about onethird of Chinese industrial production, put a heavy strain on China’s economy. Over half are believed to lose money and must be supported by subsidies, mainly through state banks. Government support of unprofitable SOEs diverts resources away from potentially more efficient and profitable enterprises. In addition, the poor financial condition of many SOEs makes it difficult for the government to reduce trade barriers out of fear that doing so would lead to widespread bankruptcies among many SOEs. ! The banking system faces several major difficulties due to its financial support of SOEs and its failure to operate solely on marketbased principles. China’s banking system is regulated and controlled by the central government, which sets interest rates and attempts to allocate credit to certain Chinese firms. The central government has used the banking system to keep afloat moneylosing SOEs by pressuring state banks to provide low- interest loans, without which a large number of the SOEs would likely go bankrupt. Currently, over 50% of state-owned bank loans now go to the SOEs, even though a large share of loans are not likely to be repaid. The precarious financial state of the Chinese banking system has made Chinese reformers reluctant to open the banking sector to foreign competition. Corruption poses another problem for China’s banking system because loans are often made on the basis of political connections. This system promotes widespread inefficiency in the economy because savings are generally not allocated on the basis of obtaining the highest possible returns. ! Public unrest over pollution, government corruption, and growing income inequality poses threats to social stability. The Chinese government reported that there were over 74,000 protests (many of which became violent) involving 3.8 million people in 2004 (up from 53,000 protests in 2003) over such issues as pollution, government corruption, and land seizures. Pollution in China continues to worsen, posing series health risks to the population. The Chinese government often disregards its own environmental laws in order to promote rapid economic growth. According to the World Bank, 16 out of 20 of the world’s most polluted cities are in China, and the direct costs to the economy (such as health problems, crop failures and water shortages) is estimated to be hundreds of billions of dollars yearly. The Chinese government estimates that there are over 300 million people living in rural areas that drink unsafe water (caused by chemicals and other contaminants). Toxic spills in China in recent months have threatened the water supply of millions of people. Rising income inequality, particularly between people living in the urban coastal and those living in the inner rural regions of China, has become another source of tension. A number of protests in China have stemmed in part from frustrations among many Chinese (especially peasants) that they are not benefitting from China’s economic CRS-12 reforms and rapid growth, and perceptions that those who are getting rich are doing so because they have connections with government officials. Protests have broken out over government land seizures and plant shutdowns in large part due to perceptions that these actions benefitted a select group with connections. A 2005 United Nations report stated that the income gap between the urban and rural areas was among the highest in the world and warned that this gap threatens social stability. The report urged China to take greater steps to improve conditions for the rural poor, and bolster education, health care, and the social security system.7 ! The lack of the rule of law in China has led to widespread government corruption, financial speculation, and misallocation of investment funds. In many cases, government “connections,” not market forces, are the main determinant of successful firms in China. Many U.S. firms find it difficult to do business in China because rules and regulations are generally not consistent or transparent, contracts are not easily enforced, and intellectual property rights are not protected (due to the lack of an independent judicial system). The lack of the rule of law in China limits competition and undermines the efficient allocation of goods and services in the economy. Outlook for China’s Economy and Implications for the United States The short-term outlook for the Chinese economy appears to be positive, but it will likely be strongly influenced by the government’s ability to reform the SOEs and banking system to make them more responsive to market forces, increase the flexibility of its exchange rate policy, and to assist workers who lose their jobs due to economic reforms (in order to maintain social stability). Global Insight, an economic forecasting firm, projects that China’s real GDP will average 7.8% over the next 10 years, indicating that China could double the size of its economy in less than 10 years.8 The Economist Intelligence Unit projects that China will become the world’s largest exporter by 2010 and the world’s largest economy by 2020. China’s rise as an economic superpower is likely to pose both opportunities and challenges for the United States and the world trading system. China’s rapid economic growth has boosted incomes and is making China a huge market for a variety of goods and services. In addition, China’s abundant low-cost labor has led multinational corporations to shift their export-oriented, labor-intensive manufacturing facilities to China. This process has lowered prices for consumers, boosting their purchasing power. It has also lowered costs for firms that import and use Chinese-made components and parts to produce manufactured goods, boosting 7 China’s Human Development Report 2005. 8 Global Insight, China: Interim Forecast Analysis: Economic Growth, December 15, 2005. CRS-13 their competitiveness. Conversely, China’s role as a major international manufacturer has raised a number of concerns. Many developing countries worry that growing FDI in China is coming at the expense of FDI in their country. Policymakers in both developing and developed countries have expressed concern over the loss of domestic manufacturing jobs that have shifted to China (as well as the downward pressures on domestic wages and prices that may occur from competing against low-cost Chinese-made goods). Many analysts contend that China’s currency policy, despite reforms undertaken in July 2005, is having a negative impact on the economies of many of its trading partners by artificially making its exports cheaper, and imports more expensive, than they would be under a floating system. They have urged China to move toward a floating exchange rate regime as soon as possible, contending that such a move would benefit China’s economy and those of its trading partners.9 For example, China’s accumulation of large foreign exchange reserves has forced it to increase the money supply, which may eventually lead to inflationary pressures on the economy. In addition, many analysts contend that easy money policies have led to overinvestment in certain economic sectors. However, Chinese officials have expressed concern that further currency reforms, if implemented too quickly, could prove disruptive to the economy. A number of bills have been introduced in Congress to address Chinese currency policy, including some that would impose a 27.5% tariff on Chinese goods unless China appreciated its currency to market levels. Failure by China to implement further reforms to its currency regime could prompt Congress to take up currency-related legislation. On the other hand, some analysts have raised concerns that currency reforms may induce China to diminish its purchases of U.S. Treasury securities, which could affect U.S. interest rates. China is attempting to establish and promote companies that can compete globally, especially in advanced technologies. In some cases, China has attempted to purchase large foreign companies. For example, in December 2004, Lenovo Group Limited, a computer company primarily owned by the Chinese government, purchased IBM’s personal computer division. In June 2005, the China National Offshore Oil Corporation (CNOOC) made a bid to buy a U.S. energy company, UNOCAL, for $18.5 billion, although strong opposition in Congress forced CNOOC to withdraw its bid. China’s possession of large currency reserves and desire to become a world leader in the production of a variety of goods and strategic commodities will likely lead the Chinese government to expand efforts to take over major international corporations. Many Members charge that China’s use of extensive subsidies to support state-owned firms, especially to fund takeover bids, threatens U.S. economic interests and may violate its WTO commitments. China’s rapid economic growth and continued expansion of its manufacturing base are fueling a sharp demand for energy and raw materials, which is becoming an increasingly important factor in determining world prices for such commodities. China is now the world’s second largest consumer of oil products (after the United States) at 6.7 million barrels per day, and that level is projected to double to 13.4 9 For a discussion of this issue, see CRS Report RS21625, China’s Currency: A Summary of the Economic Issues, by Wayne M. Morrison and Marc Labonte. CRS-14 million barrels per day by 2025.10 According to the U.S. Energy Information Administration, around 40% of world oil demand growth over the past four years came from China and this demand is “a very significant factor in world oil markets.”11 China has also reportedly become the largest consumer of steel, cement, and copper. Some U.S. policymakers have expressed concern over China’s rising ownership of U.S. government debt, due to fears that China might attempt to use its holdings as leverage in its dealings with the United States on economic and/or political matters. China is the second largest foreign holder of Treasury securities (after Japan), and both the level of those holdings and China’s share of total foreign holdings have increased sharply over the past few years. These went from $51.8 billion in 1999 to $265.2 billion at end of February 2006. China’s U.S. Treasury securities holdings as a share of total foreign holdings over this period have grown from 4.1% to 11.9%. Some have raised concerns that threats by China to halt future purchases, or to sell existing holdings, could cause the value of the dollar to depreciate in world markets (raising import prices), increase U.S. interest rates, lead to a decline in U.S. stock and bond markets, and possibly cause the U.S. economy to slow. However, any such disruption to the U.S. economy would also hurt China’s economy since about a third of China’s exports go to the United States. 10 Global Insight, Global Petroleum Outlook Forecast Tables (Long-Term), January 2005. 11 U.S. Energy Information Administration website at [http://www.eia.doe.gov/].