The Pandora's Box of Trade With China

Statistics released last week confirmed that China became the second-largest producer in the world, overtaking Japan. This marker received much more breathless media attention (see "Fareed Zakaria GPS" ) than another, more significant milestone. In 2009, China surpassed Germany to become the world's largest exporter. In the first half of this year, China increased its export lead over Germany.

As Leo Hindery wrote recently in the Huffington Post

China's overall trade surplus surged in July to $28.7 billion, its highest level in 18 months. Its surplus with just the U.S. was about $26 billion, or an almost unbelievable 90% of the total. China's exports rose 38% year on year, while its pace of growth in imports slowed sharply....Yet China's enormous positive trade balance with the U.S. alone reduces each year our country's GDP by more than $400 billion or nearly three percent.

My studies of the Chinese steel, paper and glass industries indicate that these extraordinary increases in Chinese production and exports have arisen through massive Chinese government subsidies and concomitant expansion of Chinese production capacity. Labor costs, a traditional explanation for China's rise, are small portions of total costs in the capital-intensive industries in which China has export prowess.

Two millennia ago, the military strategist, Sun Tzu wrote that if you know neither your competitor nor yourself, you will succumb in every battle. The U.S.'s ballooning trade deficit with China, and associated job losses, testify to this dictum. As every student of economics knows, free trade leads to efficient resource allocation only when three conditions hold: lack of subsidies to distort true prices, lack of monopolies and lack of negative externalities so companies, rather than societies, bear production costs such as pollution. China's subsidized, government-bolstered and polluting manufacturing industries negate these conditions. Consequently, the markets have failed, and U.S. government intervention needs to close the Pandora's Box.

A cogent letter from 104 U.S. Senators and Representatives highlighted the effects of Chinese trade. Citing a study I conducted on Chinese subsidies , the bi-partisan Congressional letter called on President Obama to conduct an in-depth examination of China's unfair subsidization of its domestic paper industry. Congress asked the President to use the study as the basis for action to remedy these unfair trade practices:

America's paper industry is the most efficient in the world and is part of a supply chain that promotes sustainable forestry practices and good-paying jobs. This industry should not be asked to continue to compete on the unlevel playing field that China has constructed through heavy subsidization of domestic production.

Let us examine the facts on China's paper industry to which Congress alluded. Since 2000, China has tripled its paper production. In 2008, China overtook the U.S. to become the world's largest producer of paper. In 2009, China produced over 17% of the world's paper output and consolidated its place as one of the world's largest paper exporters. However, the research showed that rather than economies of scale or scope or labor costs, China's rapid rise in the global paper industry was fueled by over $33.1 billion in government subsidies from 2002 to 2009.

China has no inherent cost advantages in the capital-intensive paper industry. Labor makes up only 4% of the costs in this industry; in contrast, imported recycled paper and pulp comprise over 35% of the costs. Raw materials, which make up three-fourths of the costs of producing Chinese paper, as well as electricity, coal, and transportation, have doubled in price over the last decade. Yet, Chinese paper sells at a substantial discount compared to U.S. or European paper. The Chinese paper industry has limited economies of scale or scope, with 88% of the companies being small and 12% medium-sized. The industry is geographically fragmented as well, operating in 30 of 31 Chinese provinces.

China's forest base is among the smallest in the world per capita. With no natural advantage for the production of paper, China is the largest importer in the world of pulp and recycled paper. Despite global overcapacity, China's paper industry has added on average 26% of new capacity every year from 2004. With saturated domestic markets, exports have led the development of China's paper industry, with detrimental effects on the U.S. and global economy.

The U.S. trade deficit with China on paper has been increasing exponentially since 2002. Imports from China are rising faster than those from any other country for this industry. In February 2010, the annualized growth rate of Chinese paper and paper-product imports into the U.S. approximated 22%.

Government involvement occurs every step of the way in China. The Chinese government's policies on forestry have systematically aimed to reduce China's dependence on imported raw materials and to subsidize the paper industry's restructuring. Central and local governments' subsidies and soft loans have also protected debt-ridden, state-owned enterprises and small, local companies with excess-production capacity in China.

Only timely U.S. government intervention on trade with China will forestall the demise of U.S. manufacturing. This is not protectionism, but wise competitive policy in a global environment where market failures stave off the benefits from free trade. As U.S. manufacturing jobs in paper and elsewhere evaporate, never to return, so do interlinked competencies in other U.S. manufacturing sectors, including high-technology and green manufacturing. President Obama must realize that inaction too constitutes action, and with respect to trade with China, would be an irreversible, strategic mistake.