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In the early 1990s, the United States began to run a significant trade deficit with China due to the dual forces of greater trade liberalization and China’s transition from a command economy towards a market economy. Proponents of free trade with China argue that greater integration will lead to a convergence of interests that reaches beyond economics. Despite growing economic and cultural ties with China, the U.S. still maintains military assets to defend Taiwan. Large scale conflicts on the order of cold war expectations are unlikely due to the growing importance of multinational entities such as international institutions, corporations, and nonprofits. This means that developed nations must contend with world opinion or forego the assistance of these groups in pursuing national interests. Situations such as Taiwan could limit economic integration and potentially introduce long term political risk with an impact on the U.S. economy similar to the Middle East effect on oil price. While the Chinese government presents itself as a monolithic entity to foreigners, the ability of the central government to enforce policy differs greatly throughout the country. The potential for political instability will likely increase as China becomes more integrated with the rest of the world. Western nations have already experienced the challenges of applying World Trade Organization regulations on market driven economies. The effects will be even more difficult to manage in China’s hybrid economy. The Chinese government’s primary concern is to govern the entire nation with diverse cultures, languages, and economic interests despite a lack of infrastructure and strong institutional development. To do this without some form of participatory government requires a population which is not critical of government policies. This is achieved through the promise of economic growth. The first section of the paper will review the current literature on financial integration and trade liberalization. Many analysts have commented on China’s increasing foreign reserves. The US trade deficit with China is primarily financed through the sale of US treasury bonds and the Chinese central bank is one of the largest buyers of these securities. A substantial decrease in the demand for these securities could lead to a dramatic increase in the US interest rate. While China may not reduce the amount of Dollars purchased, the use of these reserves is also controversial. China’s accumulation of Dollars has been used to secure resources in Africa and oil in the Middle East. While China’s leaders may be inclined to keep large currency reserves to support future exchange rate policy, there remains an increasing amount of Dollars which cannot be spent. This Dollar surplus is a potential threat to world economic stability. The second section will describe the current trade relationship and the challenges ahead. In addition to the trade deficit and the exchange rate, the U.S. has recently imposed countervailing tariffs on glossy paper products to offset subsidies provided by the Chinese government. The terms of China’s accession to the WTO have been difficult to implement due to both caution on the part of the Chinese government and the ability of the government to enforce policy. Over the past several months, the U.S. has adopted a tougher stance on Chinese trade conflicts largely as a response of the Bush administration to a democratic congress rather than a change in American trade policy. Previous incidents have introduced temporary volatility into American financial markets, but could China introduce sustained volatility? If so, what would be the long term impact of sustained market volatility to the U.S. economy? The third section will explain the degree to which the U.S.-China trade relationship can introduce volatility in the U.S. markets and explain its long term effects. The U.S. attracts large amounts of foreign portfolio investment based on the relatively low risk and efficiency of American markets. A lack of capital controls combined with America’s dependence on foreign capital could cause a significant decrease in investment if the market were perceived to be too risky when compared to the rate of return. While capital flight on the scale of the Asian financial crisis is unlikely, any substantial loss of foreign investment could significantly impact American economic growth. The long term impact of a sustained current account deficit must be considered in terms of the valuation and portfolio balance effects. The relationship between the current account, exchange rate, and the national debt will be examined in order to determine the amount of a sustainable current account deficit. The conclusion will place the U.S.-China trade deficit in perspective with a brief description of the Gulf Cooperation Council’s relationship with the U.S. This section will also describe the U.S. policies necessary to prepare for a stronger Chinese economy with a floating exchange rate.