China as No. 1

In the 15th century, Venice was one of the world's richest cities and ranked among the great powers because its navy controlled the Mediterranean and its merchants controlled the trade in goods, especially spices. Then Portuguese Captain Vasco da Gama arrived in India in 1498. By 1515, the Portuguese controlled the Straits of Hormuz, the Indian Ocean, the Moluccas (or Spice Islands), and the trade with China. The spices, gems, and silks that for centuries had passed from Asia through the Middle East to Venice and then to the rest of Europe were now carried around Africa on Portuguese caravels. The Egyptian sultans had been able to keep the price of pepper for Europe very high by limiting shipments to 210 tons annually. With the Portuguese in the game, the price of pepper in Lisbon dropped swiftly to one-fifth the price in Venice. The Egyptian-Venetian trade was destroyed overnight, and Portugal knocked Venice out of the ranks of the great powers without firing a shot.

That history came to mind during President Bush's recent inaugural address. His assumptions of indefinite American hegemony were quite at odds with what I have been seeing on recent trips to Asia, and especially to China.

In Singapore, high officials describe the recent rise of China as akin to the arrival of a new sun in the solar system. All over Asia, one hears talk of a shift, not in the balance of power but in the “balance of influence.” In a poll asking Thais which nation they considered their country's closest ally, the response was 75 percent for China against 9 percent for the United States. In the Philippines, pop stars from China have risen to the top of the ratings. Filipino businessman John Gokongwei says, “China isn't interested in military expansion. It will seek tribute through trade, like it did before the Western powers came to Asia.”

During a recent trip to Australia to meet with business, government, academic, and media leaders, I was told repeatedly that America must not ask Australians to choose between the United States and China. Two years before, President Bush traveled Down Under only to be followed within a week by Chinese President Hu Jintao. Whereas Bush stayed only a couple of days, held no press conferences, and got a distinctly cool reception, Hu kissed babies, toured the country, and was treated like a conquering hero.

Go to Newman in Australia's big-sky country. There you can watch as the front-end loaders take big bites out of the 60-foot walls of iron ore in the open strip mines and load the trains that will take the ore on the first leg of its trip to China. Or just drive north of the U.S. border to Alberta, Canada, where provincial officials are deep in negotiations to strike large deals giving China access to Canadian oil reserves previously destined exclusively for the U.S. market. Brazil, South Korea, and even Japan all now export more to China than to the United States. After more than 20 years of rapid growth, the Chinese economy has become the world's second-largest behind the United States in terms of purchasing power parity.

No one wants to alienate a good customer. And China is quite simply becoming everyone's best customer. Well, almost everyone's.

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In contrast to many other countries, the United States has seen its exports to China increase only modestly in recent years while its imports have gone off the chart. Last year China passed Mexico and Japan to become the second-largest exporter to the U.S. market after Canada. Because Canada also buys a lot from U.S. suppliers, however, China now has by far the largest trade surplus ($150 billion) with the United States that any country has ever had. Behind this statistic lie several powerful new forces.

First, China has become the location of choice for global manufacturing. This is usually attributed to its low wages. Chinese factory workers today earn 50 cents to $2 an hour and often work long shifts, getting minimal time off for weekends and holidays. But low wages are not the only factor; after all, wages in places like Vietnam, Myanmar, and Africa are even lower. China's workers are not just inexpensive but literate, hard working, already reasonably skilled, and eager -- nay, desperate -- to be trained. There is also a sizable and growing cadre of university-educated technologists and professionals. For example, China is now graduating 330,000 engineers and scientists annually, as compared with 398,622 for the United States. China has also invested extensively in infrastructure and now has a very workable system of airports, harbors, communications, and roads. Indeed, your mobile phone will work a lot better in China than in the United States, and you'll get from the airport to downtown in Shanghai a lot faster than in any major U.S. city.

Today, China is already the largest market in the world for steel, mobile phones, cement, aluminum, and electronic components. Within 20 years, it will likely be the largest market in the world for just about everything. If you are a manufacturer, you will pretty much have to succeed in the China market to have a chance of surviving anywhere else. In theory, you can serve the China market by exporting, but there are some good reasons why you might not. Because Chinese labor is inexpensive, production processes that are capital-intensive in the advanced countries can be “dumbed down” and made much less capital-intensive in China. As a manufacturer, you cut both your wage and your investment costs. On top of that, the Chinese government at local, provincial, and national levels will offer substantial investment incentives -- such as long tax holidays, capital grants, free land, low utility rates, worker training, and other benefits -- to companies willing to put plants and research-and-development facilities in China.

These investment incentives confound free-trade theory. They are, in fact, distortions of the market, and therefore of questionable legitimacy under the rules of the World Trade Organization. This has never been challenged because other countries have investment subsidies, too. (American states offer tax deals to induce companies to invest.) China, however, subsidizes investment strategically to capture new industries at higher levels than anyone else.

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But why is the United States the outlier when it comes to China trade? Why isn't every nation running a large trade deficit with the Chinese? Commodity suppliers like Australia, Brazil, and Chile, of course, have trade surpluses with China because China needs their materials. But what of Japan, Korea, Taiwan, and the European nations? Their industries are also locating plants in China. But there are mitigating circumstances. A big one is that these countries have maintained a broader, more robust manufacturing base than the United States. One of America's biggest exports to China and the rest of Asia is waste paper. Germany exports high-speed trains, specialty steels, and machine tools. In addition to these, Japan exports loads of electronic components and ships. America long ago gave up making any of this stuff.

A second factor is differing business and government attitudes. Japanese executives, for example, make a point of saying that they “keep the brain work in Japan.” Indeed, Canon has publicly stated that it is bringing formerly outsourced work back to Japan in order to keep key technologies proprietary in Japan. Some European companies take a similar attitude. But given the shareholder-as-king basis of U.S. business, this is a very difficult position for U.S. executives to take. Nor are there government policies to maintain U.S. advantage; it is assumed that American genius and free markets will automatically result in U.S. leadership. If the Chinese are foolish enough to exchange low-priced consumer goods for cheap U.S. paper, let the party continue.

That brings us to the 800-pound gorilla of the story -- the dollar. It is, of course, the world's money. As such, it allows Americans to buy things in international markets simply by printing green pictures of presidents and exchanging them for real goods and services. Unlike others who have to make and sell something to earn dollars with which to buy oil or soybeans or whatever, the Americans only have to run the printing presses.

In the short run, the U.S. budget and trade deficits can be financed at unprecedented levels by the foreigners who lend us money. The U.S. trade deficit is exacerbated by the fact that China keeps its currency artificially low to promote exports. But because the United States needs a net inflow from abroad of about $2 billion every day to keep itself afloat, it doesn't seriously complain. Worse, the U.S. government actually likes a strong dollar, to keep the price of imported goods and the cost of borrowing low. Of course, such a dollar absolutely kills the export and manufacturing industries, but it makes consumers and the government feel very good, so the government doesn't want to do anything that might interrupt the flow of that foreign capital. Besides, to do so could throw the U.S. economy into a nasty recession, if not a depression. Obviously, this cannot continue indefinitely.

The second-biggest lender to the United States after Japan is China. Those who think this dependence has no diplomatic consequences are naive. For more than 50 years, American policy was to keep China out of the Korean Peninsula. Today, the U.S. government has outsourced the handling of North Korea to Beijing. When Chinese Prime Minister Wen Jiabao came recently to Washington, American supporters of Taiwan were shocked and disappointed by his warning to the Taiwanese against any deviation from the long-standing “one China” formulation. American trade officials who ask Beijing to offer more protection for U.S. intellectual property, or to revalue its currency, are politely rebuffed.

The United States has lost substantial leverage with China, along with our loss of manufacturing industry and dependence on Chinese loans. China is both symptom and cause of America's dwindling economic leadership. This loss has geopolitical consequences far beyond our relations with Beijing, and it mocks Bush's hegemonic grand design. At this rate, we risk becoming the Venice of the 21st century.

Clyde Prestowitz is president of the Economic Strategy Institute and author of the forthcoming 3 Billion New Capitalists.

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