China's economy is opening up to the outside world. This worries those who fear the huge pool of low-cost labor will drain jobs from U.S. shores, and less expensive goods will spark trade problems. The author points out that China's untapped market presents huge opportunities for U.S. businesses that would surely outweigh any loss of jobs, and also that the sort of jobs that would move to China left the U.S. a long time ago. And with respect to fair trading practices, China has made much progress.China ; Economic conditions - China

Nicholas R. Lardy

English

Research Papers in Economics

a third, respectively, inflows into China
continued to expand, reaching $52.7
billion last year, making China the
world’s number-one destination for 
foreign direct investment.  
But China’s outstanding economic perfor-
mance over the past two decades is no
guarantee of its future success. China’s
leadership faces profound challenges as 
it seeks to sustain rapid economic growth
and deliver rising living standards to its
population. It must further cut tariff levels
and eliminate most nontariff barriers in
order to meet its schedule of commit-
ments to the World Trade Organization.
This process will open up the economy to
even more foreign competition and stimu-
late further structural changes that, at least
in the short run, will add to unemploy-
ment and potentially social unrest as well.
China’s leadership must also grapple with
income inequality, which on virtually
every identifiable dimension has
increased dramatically since reform
began. A third major challenge is environ-
mental deterioration, which, according to
August 1, 2003
Federal Reserve Bank of Cleveland
The Economic Rise of China:  Threat or
Opportunity?
by Nicholas R. Lardy
ISSN 0428-1276
China’s economy is opening up to the
outside world. This worries those who
fear that country’s huge pool of low-
cost labor will drain jobs from U.S.
shores, and less expensive goods will
spark trade problems. The author
points out that not only does China’s
untapped market present huge
opportunities for U.S. businesses that
would surely outweigh any loss of
jobs, but the sort of jobs that would
move to China left the U.S. a long
time ago. And with respect to fair
trading practices, China has made
much progress.
Rapid long-term economic growth, a
quickly expanding share of global trade,
and record-breaking foreign direct
investment inflows all justify describing
China as a rising economic power.
Americans view China’s rise variously
as a threat to jobs in the United States or
as a market of unprecedented potential.
Some manufacturers and labor unions
believe that a large portion of the more
than two million factory jobs lost in the
United States during the past two years
can be blamed on the rapidly rising
bilateral trade deficit that the United
States has with China. Others focus 
on China as the fastest-growing large
U.S. export market and see substantial
opportunities.
Is China’s economic rise a threat or an
opportunity to American firms, workers,
and consumers?  Does the rising U.S.
bilateral trade deficit with China suggest
that China’s market is closed? Or does it
suggest that China’s openness with
respect to inward foreign direct invest-
ment means that China is now supplying
the United States and other advanced
industrial countries with goods that pre-
viously were produced elsewhere, pri-
marily in emerging Asia? Would trade
protection in the United States likely
preserve many jobs or simply deprive
American consumers of lower-cost
goods produced in China? 
■ China’s Economic Prospects:
Growing and Growing 
China’s gross domestic product last year
was more than eight times that of 1978,
the year when Deng Xiaoping launched
the country’s economic reform program.
The long-term rate of growth has been
about 9 percent, the fastest of any coun-
try on the globe during the two-decade-
plus period. China’s expansion has been
particularly impressive recently, when it
maintained its growth even in the face of
a global growth recession in 2001 and an
anemic recovery in 2002.  China’s econ-
omy is now so large that it is beginning
to serve as an engine of growth not only
in Asia, but even globally. In 2002, for
example, the expansion of the Chinese
economy in absolute terms was more
than 10 times that of Japan. And glob-
ally, China, which accounts for only
one-twenty-fifth of world output,
accounted for one-sixth of global 
expansion last year.
China’s external trade has expanded
even more rapidly than its economy,
reflecting a substantial increase in open-
ness over the past two decades. In 1977
China accounted for only 0.6 percent of
world trade, a share that by 2000 had
sextupled to 3.7 percent, in the process
catapulting China to become the world’s
seventh-largest global trading economy.
China’s trade performance continued to
be very strong in 2001, when global
trade shrank for the first time since 1982,
and in 2002 when global trade recovered
weakly. China alone accounted for one-
quarter of the expansion of world trade
last year. 
China’s inflows of foreign direct invest-
ment are a third indicator of its economic
rise. China signaled its intention to open
its economy to foreign investment when it
passed a joint venture law in 1979 and
created several special economic zones
on the southeast coast in 1980. Initially
the inflows were modest, a few hundred
million dollars a year. But by the early
1990s, this trickle had increased to a flood
of more than $25 billion. Even in 2001
and 2002, when global flows of foreign
direct investment fell by about a half andthe World Bank, is generating substantial
excess mortality and morbidity. Finally,
China faces the challenge of continuing
to reform its financial sector, particularly
its fragile banking system. The major
state-owned banks remain insufficiently
capitalized and suffer from poor risk
management. Despite pressures from the
government to commercialize their lend-
ing operations, China’s largest state-
owned banks, which dominate the finan-
cial landscape, remain burdened with
high levels of nonperforming loans.
Their profitability levels, extremely low
by international standards, to date have
impeded the more rapid write-off of non-
performing loans and the achievement of
levels of bank capital that meet domestic
and international standards. 
While this short list of economic chal-
lenges could easily be increased,
China’s growth prospects nonetheless
remain strong. In large part, this is
because of the cumulative effect of
more than two decades of economic
reform. Most importantly, the process of
gradual price liberalization has pro-
ceeded so far that markets now set the
prices of almost all commodities.
Equally important, reforms have dra-
matically increased competition, not
just in manufacturing but in construc-
tion and much of the service sector as
well. The pervasiveness of market-
determined prices and competitive 
markets has improved the efficiency 
of resource allocation.  Finally, the rates
of savings and investment remain
among the highest in the world.
The role of the external sector in
increasing competition in the domestic
market is especially important, and all
too frequently underestimated. Even
before China entered the World Trade
Organization, it had cut tariffs by almost
three-quarters compared to their peak
levels of the 1980s. In addition, several
nontariff barriers were largely phased
out over the same period. At their peak,
quotas and licenses, for example,
restricted almost half of all commodities
listed in China’s tariff schedule. But 
by the time China came into the World
Trade Organization in 2001, only 
4 percent of all commodities were so
restricted. Trading rights have also been
liberalized so that the government’s
ability to limit imports by assigning
exclusive rights to import specific com-
modities to a single or small number of
state-owned trading companies has been
very substantially reduced.
Finally, while it has been little noticed,
foreign firms operating in China are
adding substantially to competition in
the domestic market. Foreign firms
account for more than a quarter of the
output of manufactured goods. While it
is true that many foreign firms use China
as an export platform, about three-fifths
of foreign-produced output is actually
sold on the domestic market. From the
point of view of local firms, the competi-
tion added to the market from the avail-
ability of these goods is every bit as real
as if the goods were imported. In 2002
the value of domestic sales of foreign
affiliates was almost as great as the value
of imports.
As a result of the increase in competition
in the domestic market, China’s state-
owned sector has undergone a substan-
tial restructuring in recent years.
Employment is down by about two-
thirds from its peak, the excessive rate of
inventory accumulation has been
reduced, and profitability has turned up
for the first time in 20 years. It is true
that the restructuring process is far from
over. But the view that China’s WTO
commitments will cause increasing
unemployment and concomitant social
unrest fails to take into account that
restructuring was well under way even
prior to the time China entered the World
Trade Organization. 
■ Implications for the United
States
The implications of China’s rise as a
major economic power for the United
States are more difficult to judge. Those
who believe China represents a chal-
lenge point to the large and growing
bilateral deficit in trade with China as
evidence that the Chinese domestic mar-
ket remains closed. Further, they point to
the large buildup of official holdings of
foreign exchange in China as evidence
that the authorities are preventing an
appreciation of their currency, which
tends to make their products more com-
petitive. The U.S. bilateral deficit with
China now far surpasses that with Japan. 
But the suggestion that China has
replaced Japan as our most common
source of trade disagreements seems
somewhat misguided. At the time Japan
had its record-setting surplus in its trade
with the United States it also had a mas-
sive global trade surplus. By contrast,
China’s global trade surplus in recent
years has been relatively small. In addi-
tion, China has a deficit on its services
account and in its foreign income
account, so that its current account, a
better reflection of its overall trade bal-
ance, is relatively small, only about 1.5
percent of its gross domestic product.
Far from being a closed economy, China
for the past decade or so has been the
fastest-growing large export market for
U.S. companies. Just last year, for exam-
ple, U.S. sales of aircraft to China soared
42 percent to $3.1 billion, sales of inte-
grated circuits rose 38 percent to reach
$1.2 billion, and chemical fertilizer sales
rose 58 percent to reach $650 million. 
China has the largest surplus of any
country in its bilateral trade with the
United States, not because its own mar-
ket is closed, but largely because it has
emerged as a major global production
base for labor-intensive manufactured
goods. Global exports of foreign-
invested companies in China have
grown from US$300 million in 1985,
when they comprised only 1 percent of
China’s total exports, to US$170 billion
in 2002, when they comprised over 50
percent of China’s total exports. Most of
foreign direct investment in China origi-
nates in Hong Kong, Taiwan, and Korea.
As a result of rising real wages and
appreciation of their domestic curren-
cies, firms in these economies became
less competitive in labor-intensive man-
ufacturing beginning in the mid-1980s.
To survive, these firms in these
economies in the second half of the
decade began to move their production
off shore, first to Southeast Asia and
later increasingly to China. China subse-
quently rapidly displaced the exports of
other Asian economies in third-country
markets such as the United States. For
example, China displaced Taiwan and
Korea as the major supplier of footwear
to the U.S. market. It also displaced
Hong Kong, Taiwan, and Korea as the
major supply sources of toys, games,
and sporting goods. This displacement
began in the mid-1980s and was largely
completed by the end of the 1990s.
A similar transformation has been under
way for some time in some consumer
electronics products and appears to be
under way in information technology
hardware, a category that includes per-
sonal computers, notebook computers,
monitors, scanners, personal digital
assistants, PC servers, and so forth. Globally, information technology hard-
ware is a $300 billion industry, a large
portion of which is produced in Asia.
The most notable development in the
last decade has been the migration of
production capacity from elsewhere in
Asia, particularly from Taiwan, to
China. As a result, China’s production
of information technology hardware
soared in the second half of the 1990s.
By 2000, China actually displaced Tai-
wan to become the world’s third-largest
producer of information technology
hardware, after only the United States
and Japan, and last year China dis-
placed Japan to rank number two 
globally. Taiwanese firms alone
accounted for almost two-thirds of the
mainland’s $32 billion output of com-
puters and related equipment in 2002. 
In the United States, imports of infor-
mation technology products from
China are increasingly displacing prod-
ucts previously made elsewhere in
Asia. For example, the share of U.S.
computer imports originating in Japan,
Singapore, and Taiwan in the early
1990s was almost 70 percent but has
now fallen to well under 40 percent. On
the other hand, the share originating
from China has increased from nil in
the early 1990s to almost 15 percent. 
But the mainland’s production of infor-
mation technology hardware is based
on the import of high-valued-added
parts and components, almost all of
which originate within Asia. The 
production of liquid crystal display
monitors in China, for example, now is
based largely on liquid crystal modules
imported from Taiwan, South Korea, or
Japan. Thus, even as China displaces
other Asian sources of supply of fin-
ished goods in third-country markets, it
is emerging as a huge market for high-
value-added parts and components pro-
duced mostly in Asia. The result is a
pattern of triangular trade. China
imports huge quantities of parts, com-
ponents, and electronic assemblies
from other Asian countries, in the
process running very large bilateral
deficits. China’s deficit with Taiwan
last year was $31.5 billion. And China
runs a surplus in its trade with countries
like the United States that have a large
number of consumers of these elec-
tronic products. But overall, its result-
ing global trade surplus is relatively
small.
■ China: An Opportunity for
the United States, a 
Challenge for Asia
China’s rise presents opportunities and
challenges for the global economy.
China’s rapidly expanding trade vol-
ume has become a major engine of
growth in the Asian region, largely
because of the imported capital goods
and parts and components used in
export processing. And it has become
an increasingly important market for
U.S. firms as well.
On the other hand, China represents a
significant challenge for producers of
labor-intensive manufactured goods.
Many, particularly in Asia, have
adjusted by investing directly in China,
with a resulting loss of employment at
home. Taiwan and South Korea face the
challenge of continuing to move up the
technology ladder into the production
of more technologically sophisticated,
more capital-intensive goods.  Although
China is displacing some production in
the U.S. market, the challenge is sub-
stantially less. Production of footwear,
toys, and sporting goods largely moved
out of the United States to other loca-
tions in Asia before it then migrated to
China. The U.S. economy adjusted to
the loss of these jobs years ago. The
story is similar with respect to most
information technology hardware, most
of which has not been produced in the
United States in significant quantity for
quite some time. Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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material to the editor.
Nicholas R. Lardy is a senior fellow at the
Institute for International Economics. 
This Commentary is adapted from a speech
given at the Federal Reserve Bank of 
Cleveland. 
The views expressed here are those of the
author and not necessarily those of the Federal
Reserve Bank of Cleveland, the Board of 
Governors of the Federal Reserve System, or
its staff. 
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The economic rise of China: threat or opportunity?

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