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Start | US-China Trade and Economic Relationship | China's Security-Related Activities | China's Energy and Environmental Policies and Activities | China In Asia | China's Media and Information Controls Conclusions | Additional Views | Appendices
The legislation passed by Congress in 2000 to establish the Commission sets forth specific topical areas of concern with respect to the People’s Republic of China and associated issues, and requires the Commission to investigate and report to Congress on those topics. Congress has modified those topical areas in the intervening years. Today there are eight ‘‘mandated’’ topics. (They can be found at 22 U.S.C. 7002 and at the Commission’s website—www.uscc.gov.) At the beginning of each section of this Report, the mandated topical area (or areas) that section addresses is identified.
‘‘The Commission shall investigate and report on—
‘‘WORLD TRADE ORGANIZATION COMPLIANCE—The compliance of the People’s Republic of China with its accession agreement to the World Trade Organization.
‘‘UNITED STATES-CHINA BILATERAL PROGRAMS—Science and technology programs, the degree of non-compliance by the People’s Republic of China with agreements between the United States and the People’s Republic of China on prison labor imports and intellectual property rights, and United States enforcement policies with respect to such agreements.’’
This year marks another milestone in the relationship between the United States and the People’s Republic of China. As the year began, China faced the deadline to implement the great majority of the commitments it made to gain entry into the World Trade Organization after negotiating for 15 years to gain admission, and after phasing in reforms during a five-year transition period. China, indeed, has met many of its WTO obligations, particularly those relating to lowering tariffs and making progress in removing such import barriers as its previous restrictions on distribution and sales of foreign goods within China. China also has partially opened its doors to extensive foreign investment and foreign participation in its economy, although it has balked at outright foreign ownership in some sectors.[1 2 3]
In addition, authorities can point to thousands of changes in China’s laws and regulations intended to comply with WTO rules and procedures. ‘‘A large number of trade-related laws have been reviewed and revised as part of China’s accession to the WTO,’’ according to a comprehensive WTO review of legal changes.[4] Officials of the central government in Beijing have been diligent in instructing their peers as well as provincial and local officials in their obligations under WTO membership.[5]
In the case of some important commitments, however, particularly those involving implementation and enforcement, China is lagging far behind schedule for meeting its actual WTO obligations for the marketplace. Three areas stand out starkly: China’s extensive regime of state subsidies to favored industries, China’s continued failure to stem the widespread theft of intellectual property, and China’s manipulation of the value of the renminbi that creates an unfair trading advantage for China.[6]
As part of its agreement to join the WTO, China committed in 2001 to end government subsidies designed to spur exports. China, however, still maintains a wide array of such subsidies as part of a policy to attract foreign investment and to promote the development of certain sectors. China has not instituted an effective mechanism for protecting copyrights, trademarks, and patents from gross violations despite WTO requirements that it do so. In addition, China still manipulates the value of its currency through repeated intervention in the currency markets.[7] In 2007, the United States brought to the WTO two complaints relating to some of these unmet obligations, one about China’s lack of intellectual property protection, the other about its extensive restrictions on access to the Chinese market for American films, books, and music. A third WTO complaint focused on China’s export subsidies.[8]
Authorities in China also have been reluctant to undertake negotiations to liberalize the economy further. For example, despite promises to do so, China has not begun talks to join the WTO’s Agreement on Government Procurement that ensures a fair and transparent system for bidding on government contracts. Because an estimated 40 percent of China’s economy remains under government control or outright ownership, there is a huge potential market—in addition to government offices at the central, provincial, and local levels—in which foreign suppliers are at a considerable disadvantage.[9] China has agreed to follow generally accepted guidelines for government procurement, but use of WTO enforcement tools is not possible without a formal agreement.
In some cases, China appears to have backtracked on its WTO commitments. There has been ‘‘an upsurge in industrial planning measures as tools of economic development by China’s central government authorities,’’ according to the Office of the U.S. Trade Representative (USTR). ‘‘China appears to want to expand the government’s role in directing the economy and in developing internationally competitive enterprises, while also restricting the role of international companies in certain sectors.’’[10] This issue is examined in Section 2 of this Chapter.
Certain practices such as currency manipulation, which some have labeled mercantilist and are detailed below, have contributed directly to China’s reputation as an unfair trader.[11] These practices have helped to make China the world’s factory floor and provided it with the world’s largest goods and services trade surplus, which reached $177 billion in 2006.[12] By the end of September 2007, China’s global trade surplus, at $187 billion for the first nine months, had already surpassed last year’s figure.[13] The implications of China’s export-oriented industrial policy also are apparent in China’s rapidly increasing global current account surplus: $250 billion in 2006, a 55 percent increase from the $161 billion surplus in 2005.[14] Also significant is China’s enormous amount of foreign exchange reserves, reported by Beijing to be $1.4 trillion by mid 2007, the largest in the world.[15]
China’s most unbalanced trading relationship is with the United States. In 2006, China exported $287.8 billion worth of goods to the United States and took in $55.2 billion in imports from the United States. That left the United States with a trade deficit of $232.5 billion. Imports from China exceeded exports to China by a ratio of more than five to one. China accounted for 26 percent of America’s global trade deficit. (While U.S. exports to China are growing at a faster rate than are imports from China, the ratio is so imbalanced that the trade deficit continues to grow and it is inconceivable that the value of U.S. exports to China will equal imports from China in the foreseeable future.)
| 1999 | 2000 | 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | |
|---|---|---|---|---|---|---|---|---|
| U.S. Exports to China | 13.1 | 16.3 | 19.2 | 22.1 | 28.4 | 34.7 | 41.8 | 55.2 |
| Percent Change | -8% | 24.4% | 18.3% | 14.6% | 28.5% | 22.2% | 20.5% | 32% |
| U.S. Imports from China | 81.8 | 100 | 102.3 | 125.2 | 152.4 | 196.7 | 243.5 | 287.8 |
| Percent Change | 14.9% | 22.3% | 2.2% | 22.4% | 22.7% | 28% | 23.3% | 18.2% |
| U.S. Balance | -68.7 | -83.7 | -83.1 | -103.1 | -124 | -162 | -201.7 | -232.5 |
| Source: U.S. International Trade Commission, 2007 | ||||||||
In 2007, China’s exports are growing faster still. For the first nine months of 2007, China’s exports rose 27 percent, year over year, to $878 billion.[16] China’s global current account surplus for the first four months of 2007 stood at $63.3 billion, an increase of 88 percent from the same period last year. At this rate, China’s current account surplus easily will exceed 10 percent of China’s GDP this year, a record amount. In comparison, the U.S. global current account deficit reached a new high in 2006, rising to $858 billion or 6.5 percent of GDP.[17]
China’s exploding trade surplus illustrates just how central China’s export-dependent industrial policy is to its overall economic strategy and helps explain why Chinese authorities are so reluctant to institute some particular reforms. In 2006, China’s net export growth accounted for 25 percent of its overall economic expansion.[18] Export growth’s contribution to overall Chinese GDP remains at that level for the first half of 2007. In fact, net exports, or the trade surplus, constituted the largest single factor in China’s economic expansion.[19] By contrast, the U.S. trade deficit, (or net exports) subtracted 0.5 percentage points from U.S. GDP growth in the first quarter of 2007.[20] In the first seven months of 2007, China’s exports of goods and services grew by 29 percent, compared with the same period last year. That created a trade surplus of $137 billion,[21] an 80 percent increase from the same period a year earlier.
Economists and policymakers identify several causes for China’s growing trade surplus with the United States, but no consensus exists on their relative importance. Also, not all the causes stem from unfair trade practices or WTO violations by China. For example, America’s high productivity provides its manufacturers with a competitive edge. In the case of the most labor intensive industries, however, America’s productivity does not compensate for the advantage conveyed by China’s low wages and employee benefits and its restrictions on labor rights. In China in 2004, the average hourly wage rate of all workers was $0.67.[22] The average U.S. hourly production wage in 2004 was $15.65.[23]
Today, average hourly wages of production workers in the United States (exclusive of the value of fringe benefits) are about $17.40.[24] This gives Chinese manufacturers a substantial edge in production costs, particularly after America’s higher business expenditures on health care, pensions, worker and consumer safety, and environmental protections are taken into account.
Too much can be made of the wage differential, however. Wages account for only five percent of the total production cost for semiconductors and no more than 20 percent for clothing, for example.[25]
The United States and Germany, whose workers enjoy among the world’s highest earnings, also historically have been the world’s largest exporters. Futher, some nations with even lower wages than China are not large exporters proportionately.
In an attempt to delineate the reasons for China’s low export prices, University of California professor Peter Navarro examined ‘‘major drivers’’ of Chinese competitiveness. He ranked the three most important drivers when he testified before the Commission:
Almost half of the China price advantage is [the result of] unfair mercantilist beggar-thy-neighbor policies which, in effect, are transferring jobs in a zero sum game between the U.S. and China. . . . . [There are three predominant factors. The first is] currency manipulation. It’s important, but not as important as you might think. The big item in the unfair trade practices is the export subsidies. [China provides] subsidized energy, water, virtually free capital to underperforming industries because the banks don’t call in the loans, VAT tax rebates. There’s just a whole web of complex subsidies that should be subject to WTO complaints and other types of complaints, but for some reason this town is silent on that. The third element is counterfeiting and piracy. The cost advantages vary by sector, but they include things like not having to pay for Information Technology, not having to pay marketing expenses to market your brand, and not having to do things like research and development which for pharmaceutical companies and industries like automobiles is particularly important.[26]
Another factor frequently cited by economists to explain China’s trade surplus with the United States is China’s extremely high savings rate contrasted to the extremely low rate of savings in the United States. Chinese consumers save half their income according to some estimates; Americans save less than five percent of their disposable income and in some months dip into their savings. The personal savings rate in the United States was minus one percent in both the first quarter of 2006 and the first quarter of 2007, for example. U.S. business savings are in the positive range but are overwhelmed by government and household borrowing.[27] The U.S. Federal Government, which accounts for roughly a quarter of GDP, routinely runs large deficits in financing its expenditures—$248.2 billion in fiscal 2006.[28] Total outstanding federal debt, the accumulation of all Federal Government borrowing, is nearly $9 trillion or about 69 percent of GDP in 2006. China’s public finances are in good shape, with a budget deficit below 1 percent of GDP in 2004 and public debt around 23 percent of GDP, down from 50 percent in 1999.[29]
In fiscal 2006, the U.S. government paid $406 billion in interest on its accumulated debt—$80 billion of that to Chinese holders of U.S. Treasury securities.[30] For the past 20 years, foreigners have been buying more Treasury securities than has the U.S. public and an estimated 54 percent of Treasury securities are now in foreign hands. The United States is now the world’s largest debtor.[31]
In contrast to ‘‘dissavings’’ by the U.S. Federal Government and citizens, Chinese personal savings add to China’s ability to finance investments and infrastructure improvements, a fact that has been acknowledged by economists and U.S. policymakers alike. There is general consensus on the cause as well. Chinese workers exercise ‘‘precautionary savings’’ in order to make up for a lack of government-sponsored education, pensions, and health care. Meanwhile, insurance and consumer and home mortgage credit are far less available to Chinese consumers.[32]
Only about one-seventh of the [Chinese] population, for example, is covered by basic health insurance, so many households save to cover medical expenses. Families also save for retirement because the basic pension scheme covers only about 16 percent of the economically active population—and in any case provides a pension equal to just 20 percent of average wages. Finally, households save for education. Primary school fees are a large financial burden, particularly for poorer rural households.[33]
Particularly hard hit are those who live in rural areas where closings of health clinics and schools formerly operated by nowdefunct state-owned companies have created great hardship. China has not yet developed a pension system, which forces the elderly to rely on China’s traditional means of providing for old age—their children. But China’s one-child policy has limited this means of retirement support. Chinese officials have acknowledged these problems and have stated an intention to provide better government services.
Economic theory holds that a high savings rate encourages businesses to invest in factories, equipment, and software. This shift stimulates investment-led growth in the economy and leads to industrial over-capacity. This is typical of China today, where businesses have easy access through banks to the considerable savings of Chinese workers.
Because savings are inversely proportional to spending, Chinese workers who choose to save much of their earnings necessarily limit their purchases. Workers therefore pass up luxury items and discretionary purchases, which tend to be imported goods, in order to concentrate their spending on essentials that generally are produced within China. What goods China does import from the United States tend to be manufacturing inputs such as metal scrap, electronics for recycling, or capital goods such as electrical machinery and commercial aircraft used to generate business income. In fact, while 70 percent of GDP in the United States is consumption, the figure for China is 41 percent.[34]
Another explanation for China’s rising global trade surplus is its role as the final assembler of Asian and American parts and components into finished products. Manufactured goods assembled in China from imported parts now account for about 55 percent of China’s total exports and about 65 percent of the goods China exports to the United States, according to one estimate.[35] The entire value of such goods exported from China to the United States is counted as Chinese exports, regardless of where their components originated or the amount of value added in China.
Foreign investment flows provide another explanation for China’s trade surpluses. The large amount of foreign investment in China is concentrated in manufacturing, which frequently produces goods intended for export. The cumulative level of foreign direct investment (FDI) in China at the end of 2006 reached $698 billion, placing it among the world’s largest destinations for FDI. (U.S. investors accounted for $54 billion of that total.) China’s largest recipient sector last year was manufacturing, accounting for 58 percent of the total.[36] More than half of China’s exports in 2006 originated from foreign-invested factories.[37]
Table 1.2 Top Ten Origins of Foreign Direct Investment in the People’s Republic of China*
Country/Region of Origin
2005 2006 Growth
US$ bil. US$ bil (%)
Hong Kong $17.95 $20.23 13
British Virgin Islands $9.02 $11.25 25
Japan $6.53 $4.60 ¥30
South Korea $5.17 $3.89 ¥25
United States $3.06 $2.87 ¥6
Taiwan $2.15 $2.14 ¥1
Singapore $2.20 $2.26 3
Cayman Islands $1.95 $2.1 8
Germany $1.53 $1.98 29
Western Samoa $1.36 $1.54 13
* Note: Does not include financial sector flows. Source: MOFCOM, U.S.-China Business Council
One cause for the trade imbalance between China and the United States on which most economists and policymakers agree, however, is China’s manipulation of its currency. In simple terms, maintaining a low value for the renminbi means that Chinese exports will be cheaper than they would be if the currency were allowed by the central government to rise in value in response to market forces. Conversely, U.S. exports to China are more expensive when purchased with undervalued renminbi. The result is that Chinese goods are cheaper in the United States and American exports are more expensive in China. How much of an advantage that disparity provides to China is in dispute. Not in dispute is the fact that the undervalued renminbi provides China with an offbudget job and export subsidy.[38] Mr. Grant Aldonas, former Under Secretary of Commerce in the George W. Bush Administration, told the Commission, ‘‘There is no doubt that the Chinese have to intervene massively in the currency markets in order to maintain their peg to the U.S. dollar. And, there is no doubt in my mind that the intent is mercantilist—they want to keep exporting to the United States because of the employment that their export production provides in an economy where they have to create many millions of jobs every year just to keep up with the growth in their population.’’[39] Economists who have studied the issue have estimated that the renminbi is from 20 percent to 50 percent below where it would be relative to the dollar if it were traded freely on international currency markets.[40] No one can be certain because the international currency markets have not been given the opportunity to set a price for the renminbi. As a point of reference, the Peterson Institute for International Economics estimates that a 20 percent revaluation of the renminbi, matched by other Asian currencies now pegged to the dollar, would reduce the U.S. global current account deficit by up to $80 billion per year, or about 10 percent.[4]1 In contrast, most developed nations do allow their currency to be traded on the open market and intervene only occasionally to try to temporarily influence short-term price swings. Such nations include the United States, the United Kingdom, the European Union, Sweden, Switzerland, Australia, Canada, and Japan. Some of China’s Asian neighbors also keep their currencies undervalued against the dollar so as to remain competitive with China on exports. As China has done, Hong Kong, Taiwan, Malaysia, and Korea have purchased U.S. dollars in an effort to control the value of their currencies.[42]
There is somewhat less agreement on why China’s government has been so adamant about controlling the value of the renminbi rather than letting it seek its natural market value. China contends that it must limit the renminbi’s rate of appreciation to protect China’s fragile banking system, citing the example of Japan whose yen rose in the mid 1980s after which there was a decade of declining asset values, bank failures, and slow growth. Critics of China point out that currency manipulation has long been an effective tool for gaining an export advantage—so much so that rules of the International Monetary Fund proscribe members from pegging their currency except in very limited circumstances—for example, when a country is about to run out of foreign exchange entirely.
With China holding the world’s largest foreign exchange reserves, it is in no danger of running low on foreign currencies to pay for imports. Chinese officials also worry that any deviation from China’s high economic growth rate, averaging about nine percent over the past two decades, would make it difficult to provide jobs for a growing population and for the workers who increasingly leave rural areas for higher wages in the coastal manufacturing hubs. However, using currency manipulation to accomplish such economic policy goals amounts to exporting unemployment.
China accomplishes its dollar peg by purchasing about $20 billion each month at a fixed rate against the dollar. Without those purchases, the supply of dollars in circulation in China would rise and lose value relative to the renminbi. Without the fixed rate, the value of the renminbi also would be expected to rise. Critics of China’s currency policy have suggested that China revalue its currency by fiat, much as it last did in July 2001, and reduce its purchases of dollars and allow Chinese citizens to hold and invest dollars.
Under considerable pressure from the U.S. Administration and Congress, China has taken some small steps in this direction, all the while claiming that the government will not respond to pressure. In July 2005, China engineered a 2.1 percent overnight rise in the value of the renminbi and announced a policy that would allow a ‘‘managed float’’ of the renminbi within a very narrow daily trading band of 0.3 percent. Shortly before the second Strategic Economic Dialogue in May 2007, the trading band was raised to 0.5 percent. In July 2007, China announced that it no longer will attempt to purchase all the dollars flowing into the country—as a result of exports or foreign investment—but rather that it will leave some of the dollars in the hands of Chinese citizens who presumably will invest them.[43] In theory, this step should add to the upward pressure on the renminbi. China also has announced that it plans to allow its citizens to buy the shares of some foreign stocks listed on the Hong Kong exchange, although the date of the proposed change has been postponed indefinitely and questions persist about the methodology that will be employed.
These are all welcome steps, but they are too small to have a significant effect on the growing trade imbalance between the United States and China. Since a small 2.1 percent revaluation July 21, 2005, at which time the renminbi was allowed to fluctuate within a narrow trading band, the renminbi has increased in value only an additional 7.4 percent against the dollar because the Chinese central bank seldom allows it to climb the maximum amount within its daily trading band.[44]
The suppression of worker rights in China also has been identified by critics as a reason for China’s unfair export price advantage and its trade surplus. The AFL-CIO twice has petitioned the Administration to undertake a Section 301 investigation[45] of the violation of workers’ rights as an unfair trade practice.[46] The Administration rejected the petitions, filed in 2004 and 2006, and has not launched an investigation. In its response, the USTR said an investigation was not necessary ‘‘to know that there are serious concerns with labor rights and working conditions in China.’’[47] The Administration said it preferred to pursue the matter in negotiations and by providing ‘‘technical cooperation to further advance labor laws and workplace protections.’’
But workers in China still are not provided basic rights. China has developed ‘‘a political agenda that requires repression of free speech and free association, and the prohibition of independent unions or other non-governmental organizations that might challenge the government’s power,’’ Ms. Thea Lee, the AFL-CIO’s policy director, told the Commission. ‘‘Labor [in China] is not just cheap. It is deeply disenfranchised and disempowered, which leads to horrible abuses of workers’ individual liberties, but also to dangerous and unsafe working conditions, unpaid wages, and abuse of prison labor.’’[48] Bringing a case to the WTO alleging the suppression of workers’ rights as an unfair trade practice is supported by Mr. Aldonas: ‘‘Even if we lost, [it would be desirable] just to highlight the fact that this ought to be on the agenda in any trade negotiation we enter into.’’ [49]
The Administration thus far has chosen not to bring a WTO case against China on the currency issue or to bring a formal complaint to the International Monetary Fund that has some jurisdiction over international currency matters. Nor has the U.S. Department of Treasury in its biannual reports on global currency manipulation been willing to cite China for that transgression. The Administration has justified its decision not to cite China by pointing to the 1988 law that requires the report, to a provision stating that a country can be cited only if it has deliberately manipulated its currency value to gain an export advantage.[50] The Administration argues that it cannot discern Chinese leaders’ intent and therefore cannot cite China for currency manipulation. Several bills have been introduced in the U.S. House and Senate to address this discrepancy.
The Administration did bring three WTO cases against China in 2007, citing China’s lack of intellectual property protection; the limited market access in China for U.S. books, journals, movies, videos, and music; and China’s widespread industrial subsidies. As of this Report’s publication, none of the three cases has yet been adjudicated by a WTO panel.
Like all WTO members, China is required to comply with international norms to protect copyrights, patents, and trademarks. Although China has passed many regulations and laws to comply, and has signed nine memoranda of understanding and other agreements with the United States and others to adhere to international standards, even it agrees that its enforcement is lacking. In marked contrast to his statements the previous year, during the Commission’s April 2007 trip to China, Mr. Jin Xu, the Deputy Director General of the Ministry of Commerce, acknowledged that China‘s actual protection of intellectual property rights (IPR) is lagging behind its promises. Mr. Qui Zhongyi, from the State Intellectual Property Office (SIPO), acknowledged that IPR protection now is considered important for China’s own economic and political development.
Losses to U.S. industries have been severe, according to the USTR complaint. Citing 2006 industry sources, the USTR reports that piracy in China ‘‘across all lines of copyright business ranges between 85 percent and 93 percent, indicating little or no improvement over 2005.’’[51] Those industries include ‘‘films, music and sound recordings, publishing, business and entertainment software, pharmaceuticals, chemicals, information technology, apparel, athletic footwear, textile fabric and floor coverings, consumer goods, food and beverages, electrical equipment, [and] automotive parts and industrial products, among many others.’’ The Congressional Research Service estimates that counterfeits constitute 15 to 20 percent of all products made in China and account for about eight percent of China’s GDP.[52]
Most critics of China’s intellectual property protection record fault its weak enforcement rather than point toward inadequacies in its laws and regulations. The vast majority of cases are handled as civil rather than criminal matters, and moderate fines are the typical outcome. Such fines are not sufficient to deter counterfeiters from their highly profitable businesses. For example, retailers are able to stock 499 pirated DVDs and CDs without facing criminal prosecution.[53] Even that is an improvement. The previous 2006 judicial threshold for criminal prosecution required 1,000 or more pirated DVDs or CDs. Some high profile cases are concluded with press conferences in which the media record bulldozers running over pirated DVDs and CDs. Inside the adjacent counterfeit factory, however, the owners are permitted to dismantle the reproduction equipment and ship it to another facility where the counterfeiting starts anew.[54] The U.S. complaint to the WTO notes that Chinese ‘‘rules appear to permit goods to be released into commerce following the removal of fake labels or other infringing features, when WTO rules dictate that these goods normally should be kept out of the marketplace altogether.’’[55]
China is moving very slowly to comply with WTO requirements on IP protection, such as lowering the threshold for some criminal prosecutions by considering the retail value of counterfeit goods seized rather than the raw material or production value. Mr. Qui of SIPO insisted to the Commission in April 2007 that China’s measures were not the result of pressure from the United States, but have been taken because they are in China’s own interests. Regardless of whether it is doing so because of pressure from the United States and other WTO members or for its own self interest, China’s pace in reforming its IPR regime indicates reluctance rather than willingness.
There have been encouraging signs of increased cooperation by China in the pursuit of large counterfeiters. In July 2007, for example, a joint investigation by the Federal Bureau of Investigation and Chinese authorities resulted in 25 arrests and the seizure of 290,000 CDs containing counterfeit Microsoft and Symantec software.[56] One organization that tracks compliance with intellectual property enforcement, the International Intellectual Property Alliance, surveyed members in China and found the raid had little effect. Eric Smith, President of the organization, testified before Congress that the highly visible ‘‘100 days campaign’’ resulted in ‘‘very little change in the market.’’ Mr. Smith said, ‘‘The [authorities] take the pirated product out of the store, but the store reopens the next day and the pirated product goes into a catalogue and is sold online the next day.’’[57]
The Chinese government historically has undertaken high profile enforcement actions just prior to major diplomatic meetings with U.S. officials. A better indicator of China’s intent would be weekly, if not daily, enforcement actions receiving prominent coverage in government controlled media.
The WTO case against China on market access is directly linked to the piracy problem. While China has dismantled its state-owned distribution networks for most imports into China, it still maintains state restrictions for U.S. copyright-intensive industries such as books, movies, CDs, DVDs, and video games and their distribution. China severely limits the showing of foreign films. The American film industry, which counts on foreign sales for half its total revenue, pegged its losses in 2005 at $244 million in China alone, not counting pirated DVDs exported from China. Nine of every 10 DVDs sold within China are counterfeit, according to Mr. Dan Glickman, President and CEO of the Motion Picture Association of America (MPAA).[58] The industry lost $6.1 billion to piracy worldwide according to MPAA figures,[59] due in part to exports of those Chinese DVDs.
Unable in many cases to see the movies that they read so much about, Chinese consumers turn to pirated DVDs sold cheaply on the street. The central government, despite its protestations and the evidence it offers of strengthened laws and regulations, plays an indirect but strong role in encouraging piracy of American entertainment software by limiting legitimate distribution.
The third U.S. complaint against China filed in 2007 with the WTO concerns a different matter entirely: China’s subsidies to favored industries intended to support China’s goal of boosting China’s net exports. At issue are six subsidies tied to export performance and three subsidies meant to discourage purchases of imports in favor of domestically produced goods. Both categories of activities violate the letter and the spirit of the WTO’s rules. Among the subsidies prohibited by those rules, according to the complaint, are income tax reductions and refunds for companies that satisfy certain export requirements, value-added tax (VAT) exemptions and tariff reductions for exporters, discounted lending rates for exporters, exemptions from mandatory worker benefit contributions for exporters, and VAT refunds for companies that purchase Chinese-made equipment and accessories rather than imports. The Chinese government has noted that many of these subsidies are available to U.S.-based manufacturers that have moved some operations to China. The argument is that since such subsidies also benefit American companies operating in China, there is no harm. Those subsidies, however, certainly have harmed small and medium-sized enterprises (SMEs) that have maintained their operations in the United States and so cannot take advantage of the subsidies.[60] These SMEs compose a critical portion of the U.S. manufacturing sector, providing 40 percent of the value and 60 percent of the number of manufacturing jobs in America.[61] About 90 percent of U.S. exporters to China are SMEs, and these account for over 35 percent of U.S. merchandise exports to China. ‘‘Every sale lost to subsidized products disproportionately impacts SMEs and can threaten a company’s continued financial viability, given the smaller size of SMEs and more limited financial resources.’’[62]
‘‘The Commission shall investigate and report on—
‘‘WORLD TRADE ORGANIZATION COMPLIANCE—The compliance of the People’s Republic of China with its accession agreement to the World Trade Organization.
‘‘ECONOMIC TRANSFERS—The qualitative and quantitative nature of the transfer of United States production activities to the People’s Republic of China, including the relocation of high technology, manufacturing, and research and development facilities, the impact of such transfers on United States national security, the adequacy of United States export control laws, and the effect of such transfers on United States economic security and employment.’’
The decisions by Presidents Bill Clinton and George W. Bush and by Congress to support the entry of China into the World Trade Organization (WTO) were predicated on expectations that membership would commit China to a path toward free-market capitalism. Six years after joining that body, China is still trudging along the path of economic liberalization, with a mixed record of meeting its many WTO accession commitments. Although China has had some notable successes, concerns are now growing over the pace and direction of China’s economic reforms.
Certainly the current version of China’s economy bears little resemblance to the one that existed three decades ago. China has made extensive market reforms that contributed to the impressive economic growth rates it has seen over the last thirty years. China’s industrial output in 2000 was ten times what it was in 1978 when Deng Xiaoping initiated his economic reform program and opened China to the outside world.[63] Also, Chinese poverty has declined significantly; between 1981 and 2001 the proportion of China’s population living on an income below the level the World Bank defines as China’s poverty line[64] dropped from 53 percent to just eight percent.[65] Economic liberalization has benefited China enormously.
The Chinese Communist Party’s (CCP) ultimate goals for economic liberalization may not match the expectations of many in the West, however. Recent CCP actions and announcements indicate that Beijing has no intention of giving up control over significant elements of the economy or relinquishing its outright ownership of key industrial and high technology sectors. This dynamic is particularly apparent in the efforts of China’s government to retain control of a large number of state-owned enterprises.
It now is becoming evident that Beijing plans to reform its economy only partially, embracing elements of both free-market capitalism and centralized planning. While the Chinese prefer to call this system ‘‘capitalism with Chinese characteristics,’’ economists testifying before the Commission used such terms as ‘‘a partially marketized economy,’’[66] ‘‘an economy with private elements,’’[67] ‘‘state-guided capitalism,’’[68] and ‘‘a politicized and government-distorted market economy.’’[69]
The Congressional Research Service defines state-owned enterprises (SOEs) as those firms in which a central or local government holds an equity stake, either directly or through a holding company, sufficiently large to give it control over the firm.[70] Because China’s regulatory systems are opaque, it can be difficult to trace the ownership of any enterprise in China. Beijing has been able to shroud its stake in a variety of firms by listing a portion of each such enterprise on public exchanges while maintaining ownership of the remaining equity, usually through a parent company.
While China’s state-owned business sector is greatly diminished from its pre-1978 reform period, it still is a major factor in China’s economy.[7]1 The current number of SOEs is thought to be roughly 127,000.[72] Even more important, China has indicated it intends to revitalize significant numbers of its failing state-owned companies with a wide variety of subsidies that would violate free market principles and China’s WTO commitments. This would represent a large step backward from the expectations of the American proponents of China’s entry into the WTO. The result would be a unique hybrid economy with a scale that could create serious challenges and potential harm for the world economy.
The reduction in size of China’s state-owned sector has resulted from efforts to consolidate the strongest state-owned enterprises and to allow the weakest to ‘‘fade away.’’[73] SOEs made up 38 percent of industrial output in 2004, down from 49.5 percent in 1998, a reduction of 23 percent.[74] SOE employment numbers also have fallen. In the early 1990s, SOEs employed an estimated 70 million workers. By 2003 that number had declined to 40 million.[75]
Local governments, rather than the central government in Beijing, own and direct the majority of the smaller SOEs. In 2002, local governments’ share of total employment in the state-owned sector stood at 76.3 percent.[76] Most of these smaller, local SOEs operate at a loss and rely on government subsidies to remain viable. Many of these firms once had been operated by the central government but have been transferred to local authorities in the hope they might be ‘‘turned around’’ to profitability, privatized, or closed. Many of them remain open to maintain local employment levels and, in some cases, to provide illicit income for corrupt local politicians. But as the smaller, local SOEs have been shrinking in number and importance, the larger but fewer centrally-owned SOEs have been gaining in importance.[77] ‘‘The local sector [SOEs] . . . seem to be steadily . . . privatized and transformed [with] the local government officials act[ing] more like entrepreneurs,’’ says Dr. Barry Naughton of the University of California/San Diego.[78]
The central government plays a small role in the activities of the local SOEs and instead focuses on several hundred larger firms that Beijing sees as critical to China’s future. While local SOEs do employ the majority of the state-owned sector’s workforce, the central government controls a disproportionately large share—48.3 percent—of the state-owned sector’s assets.[79] The firms that fall in this category are the principal beneficiaries of much of China’s industrial policy.[80]
Dr. Naughton quoted a senior Chinese official as saying, ‘‘state ownership is appropriate in four sectors: national security, natural monopoly, important public goods or services, and important national resources. In addition, a few key enterprises in ‘pillar’ (priority) industries and high-tech sectors should be maintained under state ownership.’’[81] Dr. Naughton testified that ‘‘the five sectors of oil, metallurgy, electricity, telecommunications, and military industries represent two-thirds of the labor force and three-quarters of the capital in [the] state sector core.’’[82]
The largest state-owned firms fall under the Chinese version of a holding company: the State-Owned Assets Supervision and Administration Commission (SASAC). SASAC was created to ‘‘manage the [CCP’s] efforts to control more effectively China’s SOEs, while increasing the SOEs’ economic returns and maintaining the political returns to the government.’’[83] SASAC has jurisdiction over China’s best SOEs and has been given explicit instructions to advance a number of the CCP’s economic goals.
SASAC’s mandate directs it to consolidate its control over larger SOEs and dispose of smaller ones. To accomplish this goal, SASAC divided tens of thousands of SOEs into two groups: those from strategic industries to be owned by the central government and the remainder to be run by provincial and local governments with help from the Ministry of Finance. The smallest and weakest were, in many cases, given to local authorities to shut down or merge. Through restructuring and consolidation, SASAC appears to have pared its list from the original 198 companies to 155 companies.[84]
SASAC has been candid in revealing its plans for China’s stateowned enterprises. These include its intentions to provide government subsidies to the ‘‘national champions’’ it intends to create. The ‘‘goal of reforming is to reorient state capital away from poorly performing companies in non-crucial areas to priority sectors,’’[85] explained Shao Ning, Vice Minister of SASAC.
In December 2006, SASAC and China’s State Council jointly announced the ‘‘Guiding Opinion on Promoting the Adjustment of State-Owned Capital and the Reorganization of State-Owned Enterprises.’’ The Guiding Opinion identifies seven ‘‘strategic industries’’ in which the state must maintain ‘‘absolute control through dominant state-owned enterprises,’’ and five ‘‘heavyweight’’ industries in which the state will remain heavily involved. (See the box below.) China Daily and the Asia Times estimate that between 40 and 50 of the 155 SASAC-controlled SOEs are engaged in the seven ‘‘absolute control’’ sectors, accounting for 75 percent of SASAC’s total assets[86] and as much as 79 percent of SASAC’s total profits.[87] They include such highly profitable companies as China Mobile, PetroChina, and Air China. A complete list of these SOEs is included as Appendix VII-C.[88]
INDUSTRIES THE PEOPLE’S REPUBLIC OF CHINA HAS IDENTIFIED AS ‘‘STRATEGIC’’ AND ‘‘HEAVYWEIGHT’’ Strategic Industries: Heavyweight Industries: 1) Armaments 1) Machinery 2) Power Generation and Distribution 2) Automobiles 3) Oil and Petrochemicals 3) Information Technology 4) Telecommunications 4) Construction 5) Coal 5) Iron, Steel, and Non-Ferrous metals 6) Civil Aviation 7) Shipping
According to China’s official news agency Xinhua, the ‘‘Guiding Opinion proposes 10 actions to promote the reorganization of stateowned enterprises, including stock exchange listing for sound companies and the addition of foreign investors.’’[89] Other proposed actions include shutting down money-losing companies, reorganizing management in other firms, linking manufacturers to state research institutes, and tightening budget controls.
The announcement indicates that Beijing may be looking to foreign, or ‘‘strategic,’’ investors to help China create what economic planners like to call ‘‘market socialism.’’ This phenomenon already can be seen at work in the information technology sector to which SASAC attached such great importance. Dr. Zhi Wang, an economist at the U.S. International Trade Commission, recently said that 90 percent of China’s high technology exports to the United States are from Foreign Invested Enterprises (FIE), many of which involve joint ventures with Chinese firms.[90] American venture partner companies may be helping a SASAC-targeted industry climb the technology ladder.
Beijing goes to great lengths to hide the fact that many Chinese firms thought to be private are, in fact, SOEs. Many companies in China whose stocks are traded on China’s exchanges are in reality SOEs in which the government keeps as much as a 75 percent stake, says Mr. Frederick Jiang, manager of the Ivy Pacific Opportunities Fund. By only listing part of an SOE on domestic exchanges, the Chinese government is able to maintain control of the firm. This association with China’s government ‘‘often means the companies are assured of maintaining their dominant position,’’[91] said Mr. Jiang. Studies have shown that when foreign investment capital is attracted to SOEs through this opaque process, there typically is an increase in their competitiveness. ‘‘Foreign capital participation in an SOE is associated with higher innovative activity. . . . There is a positive effect of FDI on SOEs that export, invest in human capital or R&D, or have prior innovation experience.’’[92]
Of course, at the same time, Beijing isn’t anxious to see control of its strongest SOEs pass to foreigners. The State Council reportedly is planning to establish an interdepartmental committee to ‘‘scrutinize large-scale mergers or acquisitions of state-owned enterprises by foreign companies.’’[93]
Another way for Beijing to support companies in SASAC’s favored industries is to use government subsidies. SASAC public pronouncements confirm what external studies have already observed: China already is deeply involved in such activity. University of New Haven professor George Haley testified before the Commission that these subsidies are most frequently provided at the provincial and municipal levels in China. They are listed in the box below:
Forms of Provincial and Municipal Government Support for SOEs[94]
1) Low Cost Loans. Provincial governments use their influence over the state banks to ensure that SOEs receive low-cost and sometimes free loans that amount to an outright transfer of capital.
2) Asset Injections. Provincial and municipal governments transfer assets, such as toll roads and toll bridges, to their SOEs at prices far below market value or replacement costs.
3) Subsidized Inputs. Provincial and municipal governments subsidize purchases of equipment, component parts, raw materials, and supplies for SOEs by requiring other SOEs or pressuring their own suppliers to provide these inputs at below-market or even below-cost prices.
4) Tax Breaks. Provincial and municipal governments provide tax breaks of various types to their own SOEs. Tax breaks include reduced utility costs, reduced income-based taxes, and reduced general taxes.
5) Energy Subsidies. Provincial and municipal governments sell energy and other utilities to their SOEs at below-market prices.
6) Land Subsidies. Provincial and municipal governments consolidate land parcels and sell them to their SOEs at below-market prices.
7) Purchasing SOE Products. Provincial and municipal governments purchase goods and services from their SOEs at abovemarket prices, often higher than less well-connected companies’ lower bids.
A 2006 European Union report noted these advantages: ‘‘China has channeled significant subsidies to favored national industries, in particular companies destined to become national or regional champions. These companies also have benefited from preferential policies such as privileged access to the banking sector. In some cases, such as the automotive and steel sectors, whole sectors benefit from an integrated industrial policy intended to support domestic production and boost exports. China also has developed a taxation system granting tax preferences contingent on the use of local content or export performance.’’[95] An article in the China Business Review’s November-December 2006 edition listed auto, steel, energy, financial services, telecommunications, and information technology sectors as strategic sectors ‘‘where barriers to access are already being erected.’’[96] During a recent fact-finding trip to China, Commissioners learned how industrial planners in Liaoning province are using these tactics to develop the local economy:
Case Study of a Chinese Province’s Economic Development Efforts, Partially Dependent on the Role of SOEs and the Application of Various Government Subsidies: Liaoning Province
In April 2007, members of the Commission traveled to China to directly assess Sino-American economic and security relations and other issues related to the Commission’s mandate. During the trip the delegation visited the cities of Dalian, Anshan, and Shenyang in China’s northeastern province of Liaoning. While in Liaoning the Commission toured private manufacturing facilities and state-owned enterprises, and discussed the region’s economic development plans with local officials and business executives. The Commission learned that businesses in the area have modified their practices and growth strategies to take advantage of Dalian’s port location and new trade promotion policies. For example, the delegation visited Brilliance (Huachen) Auto Company in Shenyang, a majority state-owned firm that once manufactured solely for domestic markets but now produces high-end sedans for export to Europe. Upon final assembly these sedans are transported from the factory to Dalian’s newly constructed Auto Terminal where they are loaded onto ships at a government owned facility with a capacity of 750,000 automobiles per year. Access to this facility has expanded the ability of firms like Brilliance to export their products.
The Commission learned that other incentives in addition to the auto loading facility are offered by the government to promote the growth of exporting companies. For instance, the Dalian Free Trade Zone manages a new bonded port area that will become fully operational by the end of 2007. The central government has identified three of the new container terminals and their surrounding areas as bonded ports that are outside the administration of Chinese customs officials. Once domestic cargo enters one of these areas, it instantly will be considered exported and domestic producers will be able to claim a tax rebate for their exported goods.
Case Study of a Chinese Province’s Economic Development Efforts, Partially Dependent on the Role of SOEs and the Application of Various Government Subsidies: Liaoning Province—Continued
The delegation also toured the facilities of two state-owned enterprises in the region: an iron and steel factory and an oil refinery. The Anshan Iron and Steel Group Corporation is the second largest steel producer in China and produces pipes, rails, containers, and automobile frames. PetroChina Fushun Petrochemical Company (PFPC) produces gasoline, industrial chemicals, and waxes for export. Both firms fall within sectors considered strategic by the Chinese government and both are heavily influenced by Beijing’s industrial policies. In fact, in PetroChina’s English language brochure, the firm proudly boasts that ‘‘PFPC will fulfill the target of ‘1145’ during ‘the eleventh Five-Year Plan,’ i.e. 11.5 million t/a[97] refining capabilities, 1 million t/a ethylene production capacity and four world level petrochemical raw material production bases . . . and reach a goal of more than 50 billion renminbi in sales income.’’[98]
Dalian is seeking to acquire a reputation as a center for hightechnology development and is establishing software parks to attract businesses. While preparing for its visit, the Commission learned that Dalian was offering various financial incentives as part of its strategy to attract foreign and domestic investment. This policy was well received by U.S. firms in Silicon Valley that may be interested in doing business in China. Just before the Commission left for China, the Intel Corporation announced it had signed a deal with Dalian to build a massive $2.5 billion chip fabrication facility there, a big win for Dalian and for a nation committed to advancing its economy’s high-tech, knowledgeintensive industries. It is estimated that Intel negotiated nearly $1 billion in financial incentives from the Chinese government.[99] Had the new facility been built in the United States, new jobs and increased high-tech production capacity would have been created domestically.
SOEs have distinct advantages when competing internationally and within their home market. In addition to the several varieties of subsidies that SOEs enjoy, indigenous companies benefit from sympathetic government regulators. The competitive challenge SOEs pose for U.S. companies in those sectors singled out by SASAC soon may intensify, particularly in third country markets worldwide. Beijing has announced that its ultimate goal is eventually to create ‘‘80 to 100 globally-competitive (state-owned) corporations.’’[100]
According to the official People’s Daily Online, in 2003 14 Chinese SOEs nudged their way into the Fortune Global 500, compared to just three in 1998.[101] In 2005 that number rose to 19.[102] One expert testified before the Committee on Ways and Means of the U.S. House of Representative that SASAC hopes China will have 30 to 50 globally competitive firms by 2010.[103]
Case Study: Steel
China’s steel policy shows how state ownership and control combined with extensive government subsidies can threaten a U.S. industry—in this case, one that is vital to both civilian and military manufacturing. Beijing has adopted an explicit industrial policy to support steel production using a wide variety of subsidies. The consequence has been a dramatic increase in steel output in China, so far exceeding even China’s skyrocketing domestic steel consumption that huge overcapacity has resulted.
In just four years, China transformed itself from a large steel importer to a large steel exporter by adding capacity at a record rate. In 2002, imports of iron and steel in China exceeded exports by 450 percent; by 2006, exports of iron and steel from China exceeded imports by 230 percent.[104] As a result, China now produces 35 percent of the world’s steel. According to the American Iron and Steel Institute (AISI), ‘‘Chinese crude steel production more than quadrupled in the last ten years, growing from an estimated 100 million metric tons in [1996] to approximately 420 million metric tons in 2006 . . . [,which is] the rough equivalent of building three entire American steel industries in one decade.’’[105]
China’s steel industry remains largely state-owned and controlled. Nine of the 10 largest producers in China are stateowned, accounting for 57 percent of total Chinese production.[106] China is now a larger steel producer than the next three producers combined: the United States, Japan, and Russia.
When the Chinese government decides how much of a good to produce, and subsidizes the production, the discipline of the marketplace no longer holds. Government-run industries continue to produce despite the rise in supply and the fall in price, which in a market-driven economy would signal producers to cut back on shifts or hours in order to minimize financial losses. But in a government command sector of the economy such as China’s steel industry, prices can keep falling because a glut on the market is not rectified by natural economic forces. Those falling prices can harm workers and industry sectors in nations that do not provide huge government subsidies. The U.S. steel industry is imperiled. AISI figures show that in 2006, China shipped over five million net tons of steel products to the United States, more than double the level of imports from China in 2005.[107] Although steel exports from China have declined somewhat from their peaks in 2006, the long-run threat from China’s overcapacity remains. ‘‘On level terms, [the U.S. steel industry] can compete with steel industries anywhere, but we simply cannot compete against the . . . government of China,’’[108] according to Barry Solarz, AISI Vice President.
Over the last several decades the Chinese have accumulated an enormous stockpile of foreign exchange reserves. A fixed exchange rate and an ever-growing export sector have worked in tandem to accumulate excess foreign currency valued by the People’s Bank of China at $1.43 trillion as of October 2007. In 2006 China’s reserves of $1.2 trillion surpassed Japan’s to become the world’s largest. These numbers are likely to continue to grow at a rate of $300 to $400 billion a year[109] if Beijing persists in refusing to ease its capital controls and allow market forces to determine its currency’s value or reverse its export-oriented growth strategy.
To date, the vast majority of these reserves have been managed by China’s State Administration of Foreign Exchange (SAFE). This agency has tended to invest the currency in low-risk, low-yield debt investments. Most estimates show 70 percent of the reserves are invested in U.S. corporate bonds, government backed securities, and treasury bills[110]—meaning that China has roughly $1 trillion invested in U.S. securities, mainly bonds. China currently is the largest purchaser of U.S. Treasury securities.
Until recently, Beijing seems to have been satisfied with concentrating its dollar investments overwhelmingly in U.S. debt instruments. China announced in March 2007 that it intends to diversify some of its reserves by moving them out of U.S. debt securities and into higher yielding investments—presumably equities—through a new investment institution. Many of the details surrounding the new institution—the China Investment Corporation (CIC)—remain unclear. The new fund initially was allotted $200 billion dollars,[111] but details surrounding its eventual size, what its processes will be for determining where it will invest, and what its investment criteria and priorities will be remain unclear. The Chinese official chosen to run the fund, former Deputy Minister of Finance Lou Jiwei, has said little about the structure of the fund or its future investment plans.
The methods and goals China will employ to diversify its unprecedented hoard of dollars have prompted great interest on Wall Street and in other international financial capitals for a number of reasons, including the fact that movement of such sums in and out of investments can roil financial markets. Concern in the United States focuses on the fact that China’s government is the single largest actor in the foreign exchange market and the single largest buyer of U.S. debt instruments. Many financial companies will be interested in capturing the transaction fees associated with these new trades.
The CIC could be modeled after similar sovereign wealth funds (SWF) run by the governments of Singapore and Norway. These institutions invest a portion of their nations’ foreign exchange holdings in foreign equities and domestic investments with higher yields than the government bonds in which SAFE has invested. Singapore’s Government Investment Corporation manages roughly $100 billion while Norway’s State Pension Fund manages roughly $300 billion. In Singapore, the institution also acts as a holding company, housing many of that nation’s SOEs. It is unclear whether China will make similar arrangements and transfer certain SASAC assets to CIC, but Singapore’s success may encourage such a move.
China’s pool of dollars is growing ever larger. Dr. Brad Setser, senior economist at Roubini Global Economics, estimated that by 2010, on the current trajectory, the various state entities that manage China’s external assets will hold $3 trillion.[112] Dr. Setser argues that the immense growth of China’s foreign exchange reserves makes it inevitable that China increasingly will diversify its portfolio into equities and warns that the switch will generate friction. ‘‘I think it is quite possible that, as a result of those frictions, [for] what so far has been a very stable and not terribly volatile process for financing the U.S. external deficit, the level of volatility and friction will rise, and that could at some point generate less benign outcomes associated with our large deficit than we’ve seen to date.’’[113]
Not only is the investment strategy of great interest to the markets, but also there is great interest in what China’s goals will be for such investment. Thus far, the best known CIC investment is the $3 billion stake it took in the New York-based private equity firm The Blackstone Group. Some worry that the new fund may be used to capture more than China’s fair share of natural resources, to bolster the international competitiveness of Chinese SOEs, or to capture advanced technology by acquiring foreign IT or other technology companies outright. Regardless of China’s intentions, its activities will be closely watched as ‘‘China could be in the top four outward investors in the next five years . . . just behind the United States, the [United Kingdom], and Japan. . . .’’[114] Indeed, with the world’s largest pool of foreign currency holdings, China could purchase nearly eight percent of all the 2,249 U.S. companies listed on the New York Stock Exchange, worth a cumulative $15.5 trillion.
The world is no stranger to centrally-planned economies. In East Asia, in particular, several nations have used government industrial policies since the end of World War II in an attempt to accelerate their economic development. These have included, most notably, Japan, Taiwan, and South Korea. The key differences between what those nations did and what China currently is doing are the sheer size and scope of the Chinese model and the nature of the Chinese government.[115] For these reasons, China’s policies will have a much larger impact on the international community.
The general theme of China’s 11th Five-Year Plan[116] is to further strengthen China’s industrial sectors and foster the growth of a more highly-developed, knowledge-based economy. According to Dr. Naughton, the plan states that ‘‘the Chinese government is now going to substantially step up the amount of money . . . it invests in research and development, [and] it’s going to substantially step up the activity of the government in using procurement to foster a high-technology sector in China and . . . the flow of resources from the government to subsidize credit through the policy bank system[117] in particular.’’[118]
While the WTO says nothing specifically about the legality of SOEs and state-directed development, it does have strict rules on the use of subsidies intended to influence trade. China still uses illegal export subsidies and import substitution to further its industrial policies.[119] China’s own 2006 report to the WTO on its remaining subsidies, and the subsequent U.S. complaint to the WTO in 2007 on those subsidies, provide a detailed record.[120]
The Chinese have a very different view than other members of what they are expected to do as a WTO member. They cite the examples of Korea, Taiwan, and Japan—all fellow WTO members. Says Mr. Clyde Prestowitz, President of the of the Economic Strategy Institute, who long has studied the efforts of governments to enhance their competitiveness through industrial policy: ‘‘We can argue that elements of this game are at variance with the rules of the WTO, and I believe they are, but we’ve never challenged that. We’ve never challenged [that] in the case of Japan or Korea or Taiwan or Israel or Ireland or any of the other guys who play this game. And so, [based on] precedent, the Chinese are in a position to argue . . . ‘What are you talking about? . . . We’re just doing what people do when they’re trying to develop their economies.’ ’’[121]
Nevertheless, the United States does have some tools with which to defend itself. The United States brought a case before the WTO’s dispute panel in early 2007 charging that China employs illegal subsidies, although not directly linking the issue to China’s SOEs. No decision has yet been reached in that case.
Another possible remedy is the use of countervailing duties (CVDs), rather than a lengthy WTO case, to counteract subsidies, according to Mr. Thomas Howell, an attorney at Dewey Ballantine.’’[122] In October 2007, the U.S. Department of Commerce cleared the way for such an approach by determining that it would be justified in applying antidumping and anti-subsidy CVDs on Chinese glossy paper exports to the United States. In doing so, the Department also ruled for the first time that it is able to determine the extent of subsidies from the Chinese government to a favored industry—in this case, paper production. This final ruling marked the first application of the CVD law against a non-market economy since the mid-1980s.[123] China has responded by formally requesting, through the WTO, consultations with the United States over the decision, which is the first step in bringing a formal complaint to be adjudicated by the organization.[124] China also has held open the possibility of bringing the issue before the U.S. courts.
As other U.S. industries have been preparing similar CVD cases against Chinese competitors, both houses of Congress began considering legislation that would allow CVD cases to be brought against non-market economies. The prospects for enactment of such legislation are unclear.
‘‘The Commission shall investigate and report on—
‘‘WORLD TRADE ORGANIZATION COMPLIANCE—The compliance of the People’s Republic of China with its accession agreement to the World Trade Organization.
‘‘ECONOMIC TRANSFERS—The qualitative and quantitative nature of the transfer of United States production activities to the People’s Republic of China, including the relocation of high technology, manufacturing, and research and development facilities, the impact of such transfers on United States national security, the adequacy of United States export control laws, and the effect of such transfers on United States economic security and employment.’’
During the past two decades, the U.S. defense industrial base has undergone three significant changes: A substantial reduction and redirection of defense expenditures in the period immediately following the end of the Cold War; effects from the dramatic expansion of globalization including increased reliance on imported components and end items in defense applications; and halting the reliance by the U.S. Department of Defense (DoD) on a dedicated, exclusive development and production pipeline for its military weapons and materiel.
During the Cold War, co-production with foreign defense companies often was a means of integrating American systems and components with those of U.S. allies, and served as a mechanism for strengthening alliances and ensuring inter-alliance standardization and interoperability. Still, manufacturing of American defense articles was located predominantly in the United States, creating weapon systems with high, if not total, domestic content. Policymakers believed this offered the greatest possible assurance that U.S. defense systems would be reliable and superior to those of other nations, notably the Soviet Union. The higher costs of this approach were considered to be acceptable trade offs for the benefits, one of which was the establishment of a strong and productive indigenous defense industrial base that was able to develop and field the weapons and other equipment that constituted an effective deterrent to the Soviets.
One of the characteristics of this model was that the Pentagon created its own specifications for a wide range of items used by the nation’s military forces. This extended well beyond weapon systems, to include such disparate items as field rations with sufficient calories to sustain a combat soldier on the battlefield and communications gear able to withstand the rigors of aerial combat. Policymakers of the time believed such needs could not be fully satisfied with commercial off-the-shelf (COTS) components. The military’s specifications (‘‘mil specs’’) had the additional effect of supporting a strong domestic defense industrial base in the United States.
When the Cold War ended, U.S. defense budgets were trimmed substantially in constant purchasing power. The defense industrial base absorbed much of the effect of this major redirection, and reduced its workforce and its aggregate physical plant. During the same period, major businesses, including defense firms, began to employ some of the same business practices being used by successful commercial firms in an increasingly globalized economy: they began to procure parts and components wherever they could be obtained at the lowest costs. More and more frequently this led to offshore sources. When it did, the subcontractors and other suppliers in the United States whose businesses had depended on contracts from the major defense manufacturers and prime contractors found it difficult or impossible to survive. This, too, resulted in diminution of the once-massive U.S. defense industrial base.
The following table illustrates how U.S. defense spending fell in the years between 1990 and 2000 (and then, accelerating dramatically between 2000 and 2005—a 48 percent increase during that period—transformed the reductions of earlier years into a gain of almost 11 percent for the entire period of 1990 to 2005). It compares the U.S. experience during this fifteen-year period with the changes in the defense budgets for eight other key nations including China, and provides world totals.
Table 1.3 Comparative Defense Budgets 1990–2005[127]
In millions of U.S.$
(all figures adjusted to constant 2003 prices)
Percent Percent Percent
Change Change Change
from from from
1990 1995 1990 2000 1990 2005 1990
United
States 431,282 336,635 ¥21.9 322,309 ¥25.3 478,177 10.9
France 50,040 46,089 ¥7.9 43,797 ¥12.5 46,150 ¥7.8
Germany 51,160 37,852 ¥26.0 36,021 ¥29.6 33,287 ¥35.2
United
Kingdom 51,479 43,101 ¥16.3 40,533 ¥21.3 48,305 ¥6.2
China 12,300 14,000 13.8 22,200 80.5 37,700 206.5
(est.) (est.) (est.) (2004 est.)
India 10,533 10,983 4.3 15,487 47.0 20,443 94.0
Israel 7,677 7,809 1.7 9,330 21.5 9,579 24.8
Japan 37,668 40,483 7.5 41,755 10.9 42,081 11.7
Russia 126,400 16,000 ¥87.3 14,100 ¥88.8 21,000 ¥83.4
World 1,003,000 768,000 ¥23.4 784,000 ¥21.8 1,001,000 ¥0.2
Exchange rates utilized are specific for each calendar year.
During this same period, three realities drove the Pentagon to move away from its long-standing, predominant reliance on ‘‘mil specs’’ and toward greater use of COTS procurement:[128]
1. The costs of a totally separate research and development (R&D) process dedicated to weapons and military equipment, plus the costs of a totally separate supply chain for those weapons and equipment that was necessary to manufacture mil-spec parts and components that were neither needed nor used for commercial purposes, were so high they could not be supported in the post-Cold War era of smaller defense budgets.
2. Military planners knew that, increasingly, U.S. forces would derive critical advantage from their ability to integrate and effectively utilize high technology in their war fighting, and that it would be this ‘‘edge’’ that would be crucial to realize military victories with acceptable casualty and other costs. High technology increasingly was employed in all weapon systems and in myriad support functions. Further, the United States sought and found military advantage in greatly expanded and enhanced command, control, communications, computers, intelligence, surveillance, and reconnaissance (C4ISR) activities, all of which were fundamentally dependent on extensive and integrated high technology. The dedicated defense R&D processes were incapable of satisfying this rapidly expanding universe of defense high-technology product needs, and the only way the U.S. military could satisfy them was to tap the cutting-edge products of the prolific commercial marketplace—either as complete systems or as components of specialized military systems.
3. Military systems dependent on high technology are subject to the same patterns and pace of obsolescence as commercial products. But the mil-spec process of system development and production proved incapable of keeping pace as anticipated product life spans grew ever shorter. In a growing number of cases planners projected that the mil-spec product development and production process would not place weapons or equipment in the operational inventory until after the items were obsolete. Even in circumstances where cost was no object, this reality forced DoD to begin using COTS components and subsystems in the weapons and equipment it procures and, in some cases, to procure and utilize complete COTS systems.
Because using COTS components in defense systems is faster, more efficient, and less expensive in most cases, it now is the rare exception when there is a separate supply chain for a defense-related product. Generally, defense-related products now emerge from the same supply chains from which civilian commercial products emanate. Deputy Under Secretary of Defense for Industrial Policy William C. Greenwalt testified to the Commission:
[T]he Commissioners may ask . . . why are we buying commercial items at all? Can’t we insulate ourselves from commercial supply chain globalization trends? I believe that we cannot affordably do so. Globalization of supply chains is the reality of the 21st century and the Department has to develop a strategy to reap the benefits of this globalization and mitigate the risks.[129]
Deputy Under Secretary Greenwalt further noted that, as production trends continue to move supply chains across the globe, DoD will continue to develop policies that aim to reap the benefits of globalization, including cost reduction, while seeking to mitigate attendant risks to national security.[130] Deputy Under Secretary Greenwalt said that while it would be better for the U.S. defense industrial base if DoD could influence the companies to retain their supply chains in the United States, DoD is, in fact, too small a customer of many of these companies to wield sufficient influence to accomplish this.[131]
In his testimony to the Commission, Mr. William Hawkins, Senior Fellow at the U.S. Business and Industry Council, confirmed that although reliance on COTS items is not new for DoD, it is a growing trend:
Since the 1980s, defense policymakers have encouraged the use of more and more commercial off-the-shelf or ‘‘dual use’’ components and products in military systems, largely because of their growing ubiquity in these systems and because innovation appeared to be proceeding faster in civilian industries than in defense-specific industries. This is not as new a situation as is often supposed.[132]
Components, on the U.S. Defense Industrial Base, and on U.S. Security During the past two decades, China’s economy has grown (as documented in the other sections of this chapter). Beginning with cost advantages attributable to a host of factors (its low wage base, the absence of many social programs and supports available to U.S. workers, refusal to recognize workers’ rights, failure to establish and adhere to environmental standards, etc.), manufacturers in China have been able to wrest sales from firms in the United States. This has resulted in the creation of a cycle in which many U.S. companies wanting to remain profitable have concluded they either must move their own manufacturing operations to China or halt their manufacturing operations and purchase parts and components, and sometimes assembled products, made in China by other firms.
In some industries, reliance on China as the source of products or of parts and components is high—indeed, in some cases that reliance is complete. However, because U.S. policymakers see China as a possible strategic rival, DoD has established policies, as Deputy Under Secretary Greenwalt told Commissioners, that prohibit purchase from China of items with a significant military purpose. He also noted that broader statutory prohibitions, such as the Buy America Act, prevent DoD from directly acquiring many Chinese commercial items.[133]
Mr. Hawkins noted in his comments to the Commission, however, that as China’s share of global manufacturing continues to increase, the American defense industrial base could become more reliant on Chinese components, and this might occur largely without the knowledge of policymakers. In fact, the Pentagon does not know how extensive this problem currently is because it does not keep track of the origin of many components of the weapon systems and other materiel it procures. Mr. Hawkins told the Commission that even the few government reports that have been released in recent years tracking the trend have failed to examine sub-tier suppliers and those reports that do look beyond the end-user level only examine a very small number of weapon systems.[134]
Deputy Under Secretary Greenwalt acknowledged that the potential exists for DoD unknowingly to acquire COTS items that have Chinese components:
[W]e are prohibited by law from incorporating Chinese munitions items at any tier in the contracting process. There is, however, the potential of buying commercial products that incorporate Chinese parts at the sub-tier level from either U.S. or foreign sources [that] are statutorily exempt from the Buy America Act. . . . [T]here may be some Chinese content in commercial off-the-shelf auto parts we buy. As commercial companies set up manufacturing operations in China, it is possible that some of these products will turn up in the DoD supply chain. If they do, DoD needs to do the risk/benefit analysis necessary to ensure that these products do not pose any national security risk through, for example, tampering, and then to mitigate those risks if necessary. My biggest concern for the future is in the microelectronics area.[135]
The difficulty of maintaining an accurate awareness of the scope of this problem appears likely to grow in the future. According to Mr. Hawkins, the major U.S. defense contractors are moving away from manufacturing and toward the role of systems integration, which compounds the task of tracking the origin of the components they assemble:
[T]he trends don’t look good here because our prime defense contractors are finally becoming systems integrators. They outsource most everything to somebody else and they’re looking more and more to putting more emphasis on overseas partners. . . . [W]e know that the real trend in supply chains is to Asia, and China is getting a larger share of that everyday. An April IMF report in microelectronics . . . says that China is taking a larger and larger market share globally of that industry. So if we’re going to go down that route of off-the-shelf technology and foreign purchasing, then China is going to be in the mix if we don’t keep a sharp eye out for it.[136]
Security risks resulting from tampering with or specially engineering foreign-manufactured parts and components are, of course, only one of the risks of using such parts and components in defense applications. Arguably a more likely problem is the reliability of such products, which may not be subject to the same rigorous production or testing standards that apply in the United States, or where manufacturers may not have the same set of incentives to produce quality products (such as the degree of probability they will be held liable, and forced to pay a substantial penalty, for product failure).
Further, outsourcing or moving portions of U.S. defense supply chains to China or other countries may risk the security of those supply chains and therefore the availability of the weapons and other equipment that depend on them, particularly when supply surges are necessary or while the U.S. is engaged in conflict with a supplying nation or one of its allies. The supply of foreign-manufactured parts and components is far more easily interrupted by acts of nature or national governments than the supply of domestically-manufactured parts and components. Reliance on foreign-produced parts, and inability to meet needs for them from alternative sources on a timely basis, threaten failure in whatever activities depend on the items that, in turn, depend on those parts for their operation.
The Costs to the Defense Industrial Base of Outsourcing Defense Manufacturing to China and Elsewhere: Loss of the Manufacturing Facilities and of Uniquely Skilled Labor
As American companies have either shut down operations in the United States or moved manufacturing overseas, or both, companies have reduced their domestic capacity and lost some of their American workforce. Both have had immediate economic impacts stretching well beyond effects on defense capability and readiness, and even the ability to surge production when necessary. The workforce loss is of particular concern with respect to workers with unique skills in such fields as tooling, shipbuilding, and aircraft and submarine production.[137] These skills are highly specialized, requiring unique training and industry know-how. Some of the skills involved are so specialized and precise that it takes workers not months but a number of years to acquire them through both concentrated training programs and on-the-job apprenticeship. Manufacturing downsizing attributable to offshoring has resulted in fewer Americans being trained in these fields, leaving a skills gap as the aging defense manufacturing workforce moves toward retirement.[138] Testifying before the Commission, Mr. Owen Herrnstadt, Director of Trade and Globalization for the International Association of Machinists and Aerospace Workers, noted this trend:
Despite these concerns, DoD is considering relaxing the prohibitions on obtaining defense components from China other than those found in COTS items. Deputy Assistant Secretary of the Army for Policy and Procurement Tina Ballard testified before the Commission that the Army is considering purchasing the rocket and missile propellant butanetriol trinitrate from China that is used in weapons such as the Hellfire missile.[140] With less than an 18month supply remaining and with no American sources, the Army may need to acquire this chemical from China, according to Deputy Assistant Secretary Ballard[141] -- although DoD is continuing to examine the possibility of developing an American or allied source.[142]
Despite the wrenching changes it has experienced in the past 20 years, U.S. defense firms remain the most profitable in the world. Currently, seven of the top ten defense firms in the world are located in the United States.[143] The strength and size of the top American companies are in part due to the growth they enjoyed prior to the cutbacks in the mid 1990s. However, a number of them grew even during the leaner years, because they merged with and acquired other firms that were buffeted by the defense spending cuts.[144]
The following table shows the ten U.S. defense firms with highest revenue and their ranking compared to other defense companies around the globe.
Table 1.4 World Rankings of the Top 10 U.S. Defense Firms According to Revenue[145]
Percent of
U.S. World 2005 Defense 2005 Total Revenue
Rank Rank Company Revenue * Revenue * from Defense
1 1 Lockheed Martin 36,465 37,213 98
2 2 Boeing 30,791 54,845 56
3 3 Northrop Grumman 23,332 30,700 76
4 5 Raytheon 18,200 21,900 83
5 6 General Dynamics 16,570 21,244 78
6 8 L–3 Communications 8,549 9,445 91
7 10 Halliburton ** 7,552 20,994 36
8 12 United Technologies 6,832 42,700 16
9 13 Science Applications 5,400 7,792 69
International Corp ***
10 14 General Electric **** 3,500 149,700 2
* Figures are in U.S. $ million.
** Defense revenue from KBR Federal and Government Division.
*** For fiscal year ending 1/31.
**** Defense revenue from GE Aerospace Engines.
It is important to note while considering the revenue statistics presented in this table, however, that they provide no information whatsoever about the extent to which the products the listed American firms sell to DoD are manufactured in the United States or abroad, nor about the status or trends of their domestic manufacturing facilities or workforces. As previously noted, the major U.S. defense contractors increasingly are systems integrators that operate globally, and their revenues have no certain linkage to the health and survivability of the U.S. defense industrial base.
At the upper tiers, the leading U.S. defense companies dominate the international defense market, and can supply current U.S. requirements. There are key uncertainties regarding the future health of the defense industrial base at lower tiers, however. For two years, the Commission has tried unsuccessfully to ascertain the extent to which the industrial base relies upon Chinese components to supply critical weapon systems. Given trends in the SinoU.S. trade relationship and the loss of manufacturing capacity in the United States, the ability of the U.S. defense industrial base to meet future U.S. military requirements is uncertain.
In the summer of 2007, the Commission, after issuing a public request for proposals, approved a contract for a private firm to research and document the parts supply chains of three significant U.S. weapon systems: the Air Force’s F/A–22 Raptor fighter/attack aircraft, the Army’s UH–60 Blackhawk utility helicopter, and the Navy’s new DDG–1000 Destroyer. The Commission had hoped the results of this research would be available in time to comment on them in this Report. However, the contractor has experienced considerable difficulty in obtaining access to parts and component data bases, and its initial work suggests that information beyond the secondary or tertiary levels is sparse or nonexistent.
As soon as this research is completed, the Commission will provide it and the Commission’s analysis of it to interested members of Congress, and will post it on the Commission’s website. This also will serve as one point of departure for further Commission investigation of this topic, which is a matter of considerable concern to its members.
For the last 25 years, the United States has been the world leader in research and development, including R&D focused on defense applications.[146] While for years Japan has been second to the United States, China’s R&D achievements in more recent years have been rapidly approaching those of the two leaders.[147] The technology China is acquiring, in part because of China’s R&D achievements, is being applied to Chinese weapon systems, helping to bolster PLA capabilities. (Advances in the capabilities of the PLA are discussed further in Chapter 2, Section 1, ‘‘China’s Military Modernization,’’ and China’s advances in science and technology are discussed further in Chapter 2, Section 3, ‘‘China’s Science and Technology Activities and Accomplishments.’’)
The United States, Japan, and the European Union have averaged annual increases of 4 percent to 5 percent in R&D spending over the last 12 years, while China has increased its R&D spending an average of 17 percent annually during the same period. During the past five years, China registered annual increases of more than 20 percent.[148]
In 2006, China’s R&D expenditures surpassed those of Japan.[149] Expectations are that China’s R&D investments will continue to surpass Japan’s in coming years by large margins.[150] China’s R&D infrastructure is showing signs of strong growth as well. From 1991 to 2002, China’s industrial research workforce grew from 16 percent to 42 percent of that of the United States.[151]
China’s emergence as an increasingly capable R&D power, coupled with its low business costs, special incentives in the form of government subsidies, and lax enforcement of environmental and workplace standards, is making it an ever more attractive destination for outsourcing R&D. Recent surveys have indicated that U.S. industry is seriously considering outsourcing select segments of its R&D activities.[152] India remains the premier destination for the outsourcing of computer and software R&D, but in all other sectors China is the leading choice of multinationals for R&D outsourcing.[153]
Figure 1.1 What Factors Contribute to Companies Choosing China for R&D?
Figure 1.2 Where are you investing in R&D facilities?
The question in the title of the preceding graph titled ‘‘Where are you investing in R&D facilities?’’ was posed to readers of R&D Magazine, who the magazine identifies as being primarily representatives of U.S. companies. The survey does not reflect whether the companies investing in the indicated foreign locations are or are not also investing in the United States. The table’s value is its indication of the propensity of U.S. companies to choose China over other foreign locations as a destination for their R&D investments.
Worldwide R&D spending in 2008 is expected to increase by 7.6 percent from 2007, primarily due to the rapid R&D expansion in China where such spending is expected to grow nearly 24 percent in 2008.[154] A recent report by R&D Magazine noted the R&D explosion in China:
R&D growth continues in all geographical regions as well, although at less inflated rates than [in] China. Much of the present attention is given to the very significant growth of the offshore R&D out-sourcing practices involving activities throughout Asia—in China, India, South Korea, and Singapore. . . . There is a long history of R&D interactions among the U.S., Western Europe, and Japan. It is only in relatively recent times that the linkages have spread—and then multiplied almost exponentially—to include the rest of Asia and Eastern Europe. Current literature is replete with reports on the expanding R&D activities in China and India.[155]
Some factors driving this increase in R&D outsourcing include (1) the outsourcing of manufacturing that depends on on-site technical support of R&D personnel; (2) products sold in target countries that need to be modified to meet local or regional cultural, legal, and environmental standards in those countries; and (3) overseas manufacturing conditions that contain ‘‘local content’’ clauses that extend to the research and support of the product, and the possibility of significant labor-related cost savings for companies that utilize resident talent when R&D is outsourced.[155]
The following charts illustrate the rapid increase of China’s share of global R&D, and the United States’ declining share—even while U.S. R&D spending continues to increase.
Table 1.5 Global R&D Spending[156]
GDP
(PPP[157]) 2006 R&D % R&D PPP R&D PPP R&D PPP
Billions U.S. GDP 2006 2006 Billions 2007 Billions 2008 Billions
$ Percent U.S. $ U.S. $ U.S. $
U.S. 12,416 2.76 343.0 353.0 365.0
China 8,815 1.61 141.7 175.0 216.8
Japan 3,995 3.40 136.7 143.5 150.4
Europe 14,072 1.88 264.3 276.3 288.8
Table 1.6 Share of Total Global R&D Spending[158]
2006 2007 2008
U.S. 32.7% 31.4% 30.1%
China 13.5% 15.6% 17.9%
Japan 13.0% 12.8% 12.4%
Europe 25.2% 24.6% 23.9%
In June 2007, the Commission received briefings on U.S. defense R&D activities from each of the U.S. armed services’ science and technology (S&T) units as well as from DoD’s Defense Advanced Research Projects Agency (DARPA). Each gave a brief overview of its approach to R&D and some of the projects on which it has been working. Presenters from the services’ units indicated that China, at present, is considered to possess significant, but not world-class S&T capabilities,[159] and they expressed considerable interest in building partnerships for joint research with China because those might enable U.S. defense researchers to better understand the progress Chinese researchers are making. Such partnerships, however, raise a number of serious security and intelligence concerns. U.S. Army
The Army is striving to transform itself into a smaller and more capable fighting force. As the anticipated battlefield changes from one focused on large-scale tank assaults through the Fulda Gap to one focused on small-scale urban warfare against non-state combatants, the Army is trying to transform itself into a smaller, lighter, and more agile force.[160]
In response to this shift, the Army is focusing its R&D efforts on such technologies as functional brain imaging, robotics, nanotechnology, quantum computing, and biotechnology. The Army utilizes a range of R&D partnerships and sources other than in-house research to perform R&D, including collaboration with universities, private industry, and foreign partners. In addition, maintaining awareness of global R&D trends and developments in S&T allows the Army to benefit from the latest technology already developed by international sources, and to identify potential partners for the co-development of next-generation technologies.[161]
The Army’s Director for Research and Laboratory Management noted China’s growing presence in the world’s S&T landscape and told the Commission that although China is behind the United States in most fields, China is intently focused on achieving progress and has made considerable progress in both nanotechnology and biotechnology. (China’s advancements in these fields are addressed in greater depth in Chapter 2, Section 3—‘‘China’s Science and Technology Activities and Accomplishments.’’)
The U.S. Navy’s Office of Naval Research (ONR) is responsible for managing the Navy’s basic, applied, and advanced R&D efforts.
While recognizing that globalization threatens U.S. technical superiority and competitiveness for reasons described at the beginning of this section, the Navy sees opportunities to leverage current U.S. technological insights for future benefit.[162] Currently, ONR recognizes that its knowledge of China’s S&T activities is very limited, and that it is important to increase that knowledge and develop a closer relationship with China’s S&T institutions.[163] The Navy maintains global technology awareness and varying levels of engagement with many countries around the globe. Yet China continues to represent a gap in the Navy’s international S&T access and technological understanding. If policy concerns related to U.S.-China cooperation in some of these areas can be resolved, ONR anticipates opening an office in the U.S. Embassy in Beijing in the next two to three years.[164]
The Air Force Research Laboratory (AFRL) is responsible for ensuring that the Air Force is capable of maintaining global leadership in the ‘‘discovery, development, and integration’’ of technologies used in air, space, and cyberspace combat scenarios.[165] Much as the other services are adjusting their anticipated combat scenarios, the Air Force is shifting from a traditional warfare focus to preparing for non-traditional scenarios such as cyber attacks and insurgencies.[167]
The AFRL, however, is concerned about the small percentage of American college students pursuing education in critical fields such as the sciences and engineering.[168] Only 17 percent of the undergraduates in the United States receive degrees in science and engineering, while over half of all undergraduates in China obtain such degrees. This trend is troubling for American researchers, as the R&D activities of U.S. companies increasingly are being moved overseas. In 1996 Chinese R&D accounted for four percent of global R&D while American R&D accounted for 38 percent. In 2006 Chinese R&D accounted for 13 percent of the world’s R&D and American R&D dropped to 32 percent.[169] The Air Force’s Asian Office of Aerospace Research and Development (AOARD) establishes and maintains R&D relationships with countries across Asia, hoping to make new S&T discoveries through collaborative efforts. Currently, AOARD has partnerships with several nations in this region including South Korea, Japan, Australia, and India, but does not have any significant joint programs with China.[170]
Most defense R&D carried out by the Army, Navy, and Air Force focuses on the near- to mid-term. DARPA is responsible for the Department of Defense’s mid- to long-term defense R&D.[171] Like the R&D agencies of the services, DARPA maintains government labs and partners with universities and private industry in its research. Currently, DARPA is conducting R&D in quantum information science, new materials, power and energy, microsystems, and neuroscience, among other fields.[172]
‘‘The Commission shall investigate and report on—
‘‘WORLD TRADE ORGANIZATION COMPLIANCE—The compliance of the People’s Republic of China with its accession agreement to the World Trade Organization.
‘‘ECONOMIC TRANSFERS—The qualitative and quantitative nature of the transfer of United States production activities to the People’s Republic of China, including the relocation of high technology, manufacturing, and research and development facilities, the impact of such transfers on United States national security, the adequacy of United States export control laws, and the effect of such transfers on United States economic security and employment.’’
Over the past several years, the Commission has conducted field hearings in Ohio, California, Washington, South Carolina, New York, and Michigan. The Commission chose North Carolina as the location for its 2007 field hearing because the state’s economy has been profoundly affected by trade with China, and because the state has had the collective foresight to identify and take a number of steps to assist industries and companies operating there to enhance their international competitiveness.
The Commissioners believed an examination of North Carolina’s situation would help them understand how trade with China has affected employment, wages, benefits, and communities at the local and state levels. That knowledge could be useful in understanding the effect trade with China has had on the entire nation, and the actions the United States might take to ensure the stability and prosperity of its economy as trade with China continues.
Chinese exports of textiles, clothing, and furniture to the United States have had severe effects on North Carolina’s three signature manufacturing industries. The result has been dramatic job loss, shuttered factories, and the near devastation of some rural factory towns. Yet North Carolina’s economy has survived through a mixture of planning, quick reaction, and resilience. For example, in 1959 North Carolina created one of the first and largest high technology research and development parks in the United States, the 7,000 acre Research Triangle Park (RTP). Conceived as a lure for the science and engineering graduates of the three universities that define its boundaries—Duke University, North Carolina State University, and the Chapel Hill campus of the University of North Carolina—the research park has exceeded those initial expectations and has become a recognized, leading center for advanced research.
Today the RTP draws scientists and engineers from around the United States while it increasingly attracts foreign investment.[173] Software engineering and biotechnology were more concept than reality at the time of the RTP groundbreaking ceremonies in 1959, and no one had heard of personal computers, much less nanotechnology. Yet the RTP attracted those technologies as they emerged, and today they are prominently represented.
Although North Carolina’s manufacturing job loss has been among the most severe in the nation over the past decade, its overall unemployment rate is close to the national average, thanks in part to the state’s proactive record in attracting new service industries to North Carolina.[174]
More than once, North Carolina was described during the Commission’s September 6, 2007 hearing in Chapel Hill as a ‘‘microcosm’’ of the U.S. economy.[175] The job loss in manufacturing has occurred throughout the United States—some 3 million manufacturing jobs have been lost in the United States since 2000, continuing the acceleration of a decades-long trend in which jobs in the services industry have increased sharply in number and as a share of overall employment. Between 2000 and 2006, despite the loss of factory jobs, 4.3 million net jobs were created in the United States.[176] Similarly in North Carolina, the addition of service sector jobs there more than offset the number of manufacturing jobs the state lost.
The share of the U.S. job market represented by manufacturing has been in decline for more than fifty years, dropping from 35 percent in 1950 to below 13 percent today.[177] There have been many causes of national job losses in manufacturing—including increases in the productivity of workers as a result of both technological advances and large amounts of capital investment. Some jobs have been lost to international trade as plants closed or downsized. Some factories faced with import competition chose to substitute capital for labor, resulting in job loss.[178] In some cases, U.S.-based manufacturers have moved production offshore or have begun buying goods manufactured offshore and selling them in the United States under a brand name familiar to U.S. consumers. In such cases, U.S. job losses have been the result.
Some manufacturers argue that the decline in manufacturing employment does not necessarily mean that production also is in decline. The overall output of American manufacturing has more than doubled in the past 25 years to $1.6 trillion, even as manufacturing employment and the overall share of the economy represented by manufacturing declined.[179]
However, the relative role of one of the causes of the decline in manufacturing employment—foreign competition, particularly that from China—is more apparent in North Carolina than in the U.S. economy as a whole, for a variety of reasons.
As late as 1995, compared to the rest of the country, North Carolina still had the highest proportion of its workforce engaged in manufacturing—23 percent.[180] Over the past decade, however, factory jobs in the state plummeted by 32 percent to just 553,300, down from 809,400 in 1996.[181] Furthermore, the trend of declining manufacturing employment shows few signs of abating.
Because the services sector has been adding jobs even faster than they were lost in manufacturing, overall employment in the state has risen since 2003. However, because the services sector wage rates, benefits, and number of hours of work generally are below those in manufacturing, wage growth in North Carolina has barely exceeded inflation, and North Carolina’s wages have fallen relative to other states.[182] The state’s per capita income fell from thirtyfirst among the states in 2001 to thirty-sixth in 2006—when, at $32,234, it was 11 percent lower than the U.S. average of $36,276.[183][184]
A closer look at North Carolina’s workforce and its unemployed workers shows why it has been so difficult for workers there to replace their former incomes. Dislocated workers are disproportionately middle-aged or older, with lower levels of education than the population as a whole; for example, 85 percent of those who lost jobs in 2003 in North Carolina had a high school diploma or less.[185] Both the age and educational factors complicated efforts to retrain workers who lost jobs they had held in manufacturing— workers who in most cases are many years past their last classroom instruction. Only 42 percent of North Carolina workers 55 and older who were laid off in 2002 found a new job within a year, and they earned just 61 percent of their former wages.[186] One-third of dislocated workers of all ages brought home less than half their previous earnings.
Laid-off workers in North Carolina also tended to be from rural areas with a strong sense of community. ‘‘The sense of place is very important to people here,’’ according to Dr. Betty McGrath, a manager at the Employment Security Commission of North Carolina. ‘‘People don’t want to leave their homes where generations of their families have lived and worked hard for years to make their companies successful. When jobs were not available in the communities in which they lived and had worked for many years, many of the laid-off workers were unable or unwilling to consider relocating to areas with greater employment prospects.’’[187] Just less than half of rural dislocated workers laid off in North Carolina in 2002 were able to find work within a year.[188]
When displaced manufacturing workers in North Carolina found new employment, often it was in part-time work. Even if the hourly wage levels were equal—and often they were lower—such jobs obviously produce lower total wages. Also, part-time jobs seldom provide such benefits as retirement or health insurance. For example, researchers examining the fate of 4,800 workers laid off in 2003 from a group of Pillowtex textile factories in North Carolina found that 15 percent of these dislocated workers moved into an employment category of ‘‘professional and business services.’’[189] But with in that grouping are employers who pay no benefits and often hire workers for part time or temporary jobs. ‘‘At first glance, professional and business services sounded like a good transition, but a substantial number of those [jobs] were in temporary help agencies,’’ said Dr. McGrath. ‘‘[The displaced Pillowtex workers who took those jobs] most likely received no benefits.’’
Women and minority dislocated workers have experienced special problems in regaining economic stability. The workers displaced by trade in North Carolina are disproportionately female, but because of family obligations they often find it more difficult than males to relocate where jobs are available. Although the rural North Carolina workforce is just 18 percent black, 42 percent of dislocated workers in rural areas are black.[190] Of the eight counties in which African-Americans compose 50 percent or more of the population, the unemployment rate in 2006 was 6.9 percent, compared to 4.8 percent in the state as a whole.[191] When the displacements resulting from China trade caused the closure of many North Carolina manufacturing plants and the black workers in those plants lost their jobs, they found themselves added to the substantial pool of unemployed African-Americans for which job training and placement already had proved inadequate.
Statistics compiled by federal programs that aid manufacturing workers whose jobs are lost to imports show that North Carolina has led the nation in import-related layoffs. In fiscal year 2006, for example, of the 120,000 workers nationwide who were eligible to receive special benefits to laid-off workers who had lost their jobs as a result of import competition, a third were in North Carolina.[192][193]
Private sector employment gains in the state were almost wholly concentrated among 131,000 new jobs in private education and health care and 61,000 new jobs in the leisure and hospitality industries. The better-paying factory jobs making textiles, clothing, and furniture were replaced by lower paying services-sector work, including jobs waiting tables, cleaning hotel rooms, and caring for hospital patients. Average compensation for employment in the manufacturing sector was 128 percent of North Carolina’s average wage in 2005 while that for health care was 91 percent and compensation in the leisure and hospitality sector was considerably lower.[194] For example, compensation in hotels and resorts was just 50 percent of the average statewide compensation while restaurant work paid just 34 percent of the average. Fortunately for workers in the services sector, while services work on average is not as well paid as work in manufacturing, services jobs generally are not as import sensitive as manufacturing jobs.[195]
Why were North Carolina’s signature industries hit so hard by imports, particularly those from China? China’s admission to the World Trade Organization in 2001 is one of the reasons. By joining the WTO, China also joined those textile- and apparel-exporting WTO member nations whose 30-year-old export quotas were being phased out on textile and clothing shipments to the United States, Japan, and Europe. Had China not joined the WTO, it would have remained under the quota system known as the Multi Fiber Arrangement of 1974. In that case, China’s clothing and textile exports to the United States and elsewhere would have remained curtailed by quotas, just as the rest of the world’s clothing and textile exporters were freed from such quotas. Instead, China benefited from joining the WTO at the very end of a ten-year quota phase out that had begun in 1995. China quickly seized the new, unrestricted opening and became the world’s dominant, vertically integrated, low-cost producer, displacing all other clothing producers including the United States.[196]
In the first quarter after China was freed from the quotas, Chinese textile and apparel exports to the United States increased 62.5 percent overall. Some categories jumped as much as 1,500 percent.[197] By the time the quota phase-out was completed, the U.S. textile and apparel industry lost more than 44,000 jobs; 11,000 of those were in North Carolina.[198]
In response to persistent complaints from U.S. industry and under the pressure of lengthening lines at unemployment offices in North Carolina and several other states, the Administration successfully pursued with Beijing an agreement to limit some categories of Chinese clothing exports to a 7.5 percent annual increase through 2008. After that date, any remaining quotas will be lifted. The temporary agreement slowed the job loss in the United States,[199] but job losses are likely to reaccelerate once those restrictions are lifted. China has continued to invest heavily in textile and apparel production capacity. According to National Council of Textile Organizations (NCTO) figures, during the past ten years, the Chinese textile sector purchased 65 percent of all knitting machines, 62 p