The Real Challenge From China: Its People, Not Its Currency

I love the idea of bipartisanship. Just the image of Democrats and Republicans coming together makes me smile. "Finally," I say to myself, "American government is working." But then I look at what they actually agree on, and I begin to pine for paralysis.

On Sept. 29, the House of Representatives passed a bill with overwhelming support from both Democrats and Republicans. It would punish China for keeping its currency undervalued by slapping tariffs on Chinese goods. Everyone seems to agree that it's about time. But it isn't. The bill is at best pointless posturing and at worst dangerous demagoguery. It won't solve the problem it seeks to fix. More worrying, it is part of growing anti-Chinese sentiment in the U.S. that misses the real challenge of China's next phase of development.

There's no doubt that China keeps the renminbi, its currency, undervalued so it can help its manufacturers sell their toys, sweaters and electronics cheaply in foreign markets, especially the U.S. and Europe. But this is only one of a series of factors that have made China the key manufacturing base of the world. (The others include low wages, superb infrastructure, hospitality to business, compliant unions and a hard-working labor force.) A simple appreciation of the renminbi will not magically change all this.

Chinese companies make many goods for less than 25% of what they would cost to manufacture in the U.S. Making those goods 20% more expensive (because it's reasonable to suppose that without government intervention, China's currency would increase in value against the dollar by about 20%) won't make American factories competitive. The most likely outcome is that it would help other low-wage economies like Vietnam, India and Bangladesh, which make many of the same goods as China. So Walmart would still stock goods at the lowest possible price, only more of them would come from Vietnam and Bangladesh. Moreover, these other countries, and many more in Asia, keep their currencies undervalued as well. As Helmut Reisen, head of research for the Development Center at the Organisation for Economic Co-operation and Development, wrote recently in an essay, "There are more than two currencies in the world."

We've seen this movie before. From July 2005 to July 2008, under pressure from the U.S. government, Beijing allowed its currency to rise against the dollar by 21%. Despite that hefty increase, China's exports to the U.S. continued to grow mightily. Of course, once the recession hit, China's exports slowed, but not as much as those of countries that had not let their currencies rise. So even with relatively pricier goods, China did better than other exporting nations.

Look elsewhere in the past and you come to the same conclusion. In 1985 the U.S. browbeat Japan at the Plaza Accord meetings into letting the yen rise. But the subsequent 50% increase did little to make American goods more competitive. Yale University's Stephen Roach points out that since 2002, the U.S. dollar has fallen in value by 23% against all our trading partners, and yet American exports are not booming. The U.S. imports more than it exports from 90 countries around the world. Is this because of currency manipulation by those countries, or is it more likely a result of fundamental choices we have made as a country to favor consumption over investment and manufacturing?

Coming: The New China

The real challenge we face from China is not that it will keep flooding us with cheap goods. It's actually the opposite: China is moving up the value chain, and this could constitute the most significant new competition to the U.S. economy in the future.

For much of the past three decades, China focused its efforts on building up its physical infrastructure. It didn't need to invest in its people; the country was aiming to produce mainly low-wage, low-margin goods. As long as its workers were cheap and worked hard, that was good enough. But the factories needed to be modern, the roads world-class, the ports vast and the airports efficient. All these were built with a speed and on a scale never before seen in human history.

Now China wants to get into higher-quality goods and services. That means the next phase of its economic development, clearly identified by government officials, requires it to invest in human capital with the same determination it used to build highways. Since 1998, Beijing has undertaken a massive expansion of education, nearly tripling the share of GDP devoted to it. In the decade since, the number of colleges in China has doubled and the number of students quintupled, going from 1 million in 1997 to 5.5 million in 2007. China has identified its nine top universities and singled them out as its version of the Ivy League. At a time when universities in Europe and state universities in the U.S. are crumbling from the impact of massive budget cuts, China is moving in exactly the opposite direction. In a speech earlier this year, Yale president Richard Levin pointed out, "This expansion in capacity is without precedent. China has built the largest higher-education sector in the world in merely a decade's time. In fact, the increase in China's postsecondary enrollment since the turn of the millennium exceeds the total postsecondary enrollment in the United States."

The Benefits of Brainpower

What does this unprecedented investment in education mean for China — and for the U.S.? Nobel Prize–winning economist Robert Fogel of the University of Chicago has estimated the economic impact of well-trained workers. In the U.S., a high school-educated worker is 1.8 times as productive, and a college graduate three times as productive, as someone with a ninth-grade education. China is massively expanding its supply of high school and college graduates. And though China is still lagging far behind India in the services sector, as its students learn better English and train in technology — both of which are happening — Chinese firms will enter this vast market as well. Fogel believes that the increase in high-skilled workers will substantially boost the country's annual growth rate for a generation, taking its GDP to an eye-popping $123 trillion by 2040. (Yes, by his estimates, in 2040 China would be the largest economy in the world by far.)

Whether or not that unimaginable number is correct — and my guess is that Fogel is much too optimistic about China's growth — what is apparent is that China is beginning a move up the value chain into industries and jobs that were until recently considered the prerogative of the Western world. This is the real China challenge. It is not being produced by Beijing's currency manipulation or hidden subsidies but by strategic investment and hard work. The best and most effective response to it is not threats and tariffs but deep, structural reforms and major new investments to make the U.S. economy dynamic and its workers competitive. That's where we need bipartisan agreement. Someone? Anyone?