Looking ahead, and over your shoulder

Talk with most anyone about manufacturing (China), it doesn't take long (China) for the conversation to turn to a certain topic (China). And it ain't the dish kind of China, either.

To many, China is both Public Enemy #1 and the biggest opportunity for growth. With a fast-growing economy, many see China as a great new market opportunity. But with growing sophistication and the biggest labor supply under one roof, China has become a manufacturing dynamo and that has a lot of U.S. manufacturers looking over their shoulders.

In a member survey this year by the National Association of Manufacturers (NAM), nearly half of respondents cited China as the major source of import competition, easily ahead of any other country. A 2003 survey of manufacturing firms by Minnesota Technology found that the number of firms that view China as a benefit to their business were outnumbered by a margin of four to one.

The nervousness and anger over China comes from different sources—from piracy to labor supply to environmental regulations—but all of them have to do with the United States' competitive position on the global manufacturing totem pole. For example, China's seemingly boundless, low-cost labor force—average Chinese wages are about 5 percent of U.S. wages—has long been feared as a sleeping giant. That giant is now rousing as the country undergoes the rural-to-urban population shift that the United States underwent many decades ago as farmers seek better-paying jobs in the country's burgeoning cities. Even Mexico is feeling China's heat, having relinquished its niche as the low-cost leader and having reportedly lost more than 200,000 jobs since late 2000.

As China's manufacturing sector feeds off and propels the Chinese economy—it has averaged annual growth of about 7 percent for the last decade—it has displaced both U.S. firms and employees, though some evidence suggests that widespread fear over job flight might be misplaced.

And as job losses mount in U.S. manufacturing, a new villain has appeared in the form of a reportedly undervalued yuan, the Chinese currency, which is pegged to the dollar. But as more manufacturing advocates blame the vagaries of currency exchange for compounding the China problem for U.S. firms, there is little proof that their solution—a flexible or "floating" dollar-yuan exchange rate—would be an improvement.

800 lb. gorilla, speaks Chinese

For every ship loaded with containers of Chinese goods that arrives in the United States, it could be sent back full of anecdotes of lost orders and job flight overseas. Steve Holland, director of the Montana Manufacturing Extension Center (MEC), sees the China affair firsthand from his clients, who are looking to become more competitive.

Firms that seek Holland's counsel "generally complain about loss of markets" induced by the combination of high costs in the United States and low costs and poor protection of intellectual property in China. "We've seen a lot of jobs go overseas for a lot of reasons," Holland says, adding there are "easily a half-dozen to a dozen" firms that have left Montana in the last year. Those that have moved tended to be more of the mom-and-pop variety rather than large corporate firms, according to Holland. "That's kind of scary to me."

Holland is hardly alone in his anxiety about job flight to overseas markets. Randy Schwartz of the North Dakota Manufacturing Extension Partnership knows of one large manufacturer in the state that was told by a major customer that its production "would have to move" to a lower-cost, off-shore location in the near future if it wanted to keep the client's business.

Today, it's accepted as fact that a lot of jobs are going overseas and south to Mexico. But no one will be able to tell you how many because no one collects any official data, not even the Bureau of Labor Statistics. An official at the Minnesota Department of Employment and Economic Development (DEED) says it is "impossible" to know exactly how many Minnesota jobs have been lost to other countries.

But some information from DEED suggests that the number might be pretty modest. For example, employers reported 67 mass layoff events (more than 50 jobs for longer than 30 days), between fourth quarter 2001 and third quarter 2002. Only two employers attributed the mass layoffs to a relocation of jobs to another state or country.

The Dislocated Worker Program in Minnesota also tracks mass layoffs and provides assistance to workers displaced by so-called job adjustments stemming from certain free trade pacts. (Countries that trigger the assistance include Canada, Mexico and other countries mostly from the Caribbean, Latin America, South America and Africa.) In 2002, about 8,900 manufacturing jobs were lost through mass layoffs, but only 680 qualified for the trade-related assistance, or less than 8 percent of mass layoffs in manufacturing.

But make no mistake, a broad-angle view of manufacturing shows a slow migration to lower-cost locations has long been under way, even within the country and district. Whatever the rate of overseas job flight, it is likely just the next phase of cost-cutting hopscotch for some firms—a phenomenon that has come most recently to Sunbelt states and rural areas where manufacturing growth has been strong over the past decade or two. Indeed, data on peak manufacturing employment for states show a striking, mostly westward shift of manufacturing jobs to low-wage and low-density states (see map).

In 1969, for example, the Twin Cities had two of every three manufacturing jobs in Minnesota, according to a research article by Dave Senf of DEED. But over the next three decades, manufacturing jobs in the Twin Cities grew just 16 percent; in greater Minnesota, where wages are considerably lower, manufacturing jobs grew 77 percent.

As such, any trend in job or firm flight is largely an extension of that cost-cutting trend. Still, that doesn't mean U.S. manufacturing is headed to China in some Manifest Destiny in reverse. Again, it's hard to say exactly the extent to which plants and jobs are headed anywhere, including China. But government data suggest two things: Investment in U.S. manufacturing is still strong by a number of measures, and when U.S. firms invest elsewhere, it's usually in higher-cost foreign markets, not lower-cost ones like China.

When firms invest in structures, equipment and other organizational assets (but not including stock purchases) outside their national border, it's called foreign direct investment (FDI). Many anxiously point out that, for the first time ever, China received more FDI (about $53 billion) last year than the United States. While Chinese FDI has seen steady growth of 10 percent to 20 percent annually over the last few years, the flip-flop in ranking has much more to do with a precipitous—and likely temporary—drop in U.S. FDI, falling from a high of $300 billion in 2000.

Nor does it mean that the United States has fallen permanently out of favor. Most experts see it as a "capital retooling" of sorts as the U.S. economy works through the capacity glut that had built up during the raging 1990s. Earlier this year, the Economist Intelligence Unit (a research sister company of the Economist magazine) published an FDI forecast through 2007. It predicts that the United States will receive three times the annual FDI over this period—an average of $214 billion—than the next closest country (China, at $66 billion).

And in spite of the anecdotes, U.S. firms are not fueling China's rise in foreign investment. A report on U.S. manufacturing FDI earlier this year by Deloitte Research, a branch of the consulting firm Deloitte & Touche, estimates that U.S. manufacturing firms invested an average of about $1 billion in China annually from 1998 to 2001, a lower average than nine other countries tracked in their report. U.S. manufacturers have also pulled back their total investments abroad by 60 percent from 2000 to 2002 because of the sluggish domestic economy.

Maybe more surprisingly, when U.S. manufacturers do spend money outside our borders, it usually goes to higher-wage countries like the United Kingdom, Germany and Canada. Deloitte Research found that low-wage nations "consistently under-perform high-wage economies" in attracting investments from U.S. manufacturers, "despite the common perception that overseas investments are a way to access low-cost labor."

And the trend is accelerating. In 1996, 65 percent of all U.S. manufacturing FDI went to high-wage countries, and by 2001 it hit 94 percent, a phenomenon Deloitte called a "high-wage paradox." Rather than merely moving plants to low-cost countries, "U.S. manufacturers seem to be aimed more at accessing markets and completing their global networks ... than finding low-cost workers."

A report last summer by the Federal Reserve Bank of Chicago echoes that theme. "While many believed the attraction of low wages would cause shifts in investments, American manufacturers seem to be more concerned with skills and education of workers rather than wages, which are a relatively small percentage of their total costs."

Don's yuan

What worries many is not a single competitive factor, like cheap Chinese labor, but the steady buildup of many competitive factors over time. The most recent concern is the obscure subject of currency exchange rates, where many have been loudly complaining that China has been manipulating its currency to the point of it being seriously undervalued against the dollar.

This issue matters—a lot—because a weak yuan means that Chinese goods are cheaper here, and U.S.-made goods are more expensive in China. U.S. interests are crying foul, saying the pegged yuan is akin to giving the Chinese an extra arm to fight with.

Several manufacturers and numerous other sources mentioned the undervalued yuan in conversation. Jerry Jasinowski, head of the National Association of Manufacturers, has called the yuan issue "by far the largest factor distorting our trade." Sixteen members of Congress signed a bipartisan letter in late July telling President Bush "it is time to consider action regarding the undervaluation of China's currency, the yuan." In September, Treasury Secretary John Snow went to Beijing—as part of a larger Asian tour—with the yuan being tops on the agenda.

Later that month, both houses of Congress saw proposals to slap a 27.5 percent tariff on all Chinese imports if China did not implement currency changes.

Whether the yuan is undervalued, and by how much, is a more complicated matter than general news reporting and conventional rhetoric tends to let on. Even one of the most oft-cited papers—a 2002 report by the Manufacturing Alliance—acknowledges that the "impact this manipulation [of the yuan] has had on exchange rates and the U.S. trade deficit is a much more difficult question, and there is no precise answer." This and other studies have estimated the yuan to be 15 percent to 40 percent undervalued—figures that have been widely repeated and implied as fact.

Without digging too deeply into arcane exchange rate regimes—and it's a big, messy hole—there is some evidence to suggest that such estimates are no more than wild guesses because they imply that the use of a different exchange rate system—a floating exchange rate, currently used by most countries—would make the yuan's value not only predictable, but predictably higher in value against the dollar than the current peg system allows.

That's a big leap, one that might make sense on paper. The argument—one often made even by economists—is that the market supply and demand of individual currencies under a floating regime will reflect the underlying fundamentals—like output growth, balances of trade, productivity and other indicators—of a particular economy. Those fundamentals are then reflected in the value of that economy's currency (say, the dollar) against other currencies.

Many, including the Bush administration, have been pushing the Chinese to move to a flexible or floating exchange rate where currency values are said to be set by market supply and demand. Touted by many as at least a partial solution to the China problem, the perceived predictability of currencies under floating exchange rates is not demonstrated even among the many currencies governed today by such a system.

Though it might seem counterintuitive, the so-called market fundamentals theory at work here doesn't translate in the real world of currency exchange. If it did, you'd be able to find clear examples of currencies weakening or strengthening on cue according to a country's economic performance. But you won't find any such relationship in monthly or even annual data for currency exchange values. Put simply, floating exchange rates have not produced anything close to systematic predictability in valuing one country's currency against another.

According to research by economists Neil Wallace, Richard Meese and Kenneth Rogoff dating back some 25 years—and yet to be disproven—there's no traceable pattern between economic fundamentals and the dollar's value, particularly in the short term. Wallace's research points out that currency values under a floating regime are set entirely on speculation, rather than on economic indicators, because the things being traded—fiat currencies—are intrinsically useless, unbacked and costless to produce. As such, they are not the same "thing" in a market sense as a banana or widget. "For fiat currencies, there are no inherent fundamentals that determine equilibrium exchange rates," Wallace wrote in the Fall 1979 Quarterly Review of the Federal Reserve Bank of Minneapolis.

A few years later, Meese and Rogoff demonstrated that a fundamentals model was less useful for predicting the dollar's future value than a naive model—which simply means that the best forecast of a future exchange rate is the current rate. With a floating exchange rate, one could likely do as well predicting future exchange rates by flipping a coin.

This lack of predictability is easy to find. Go back to about May 2002. The United States was finishing its first year in recession, yet the dollar was still very strong against most currencies worldwide. Maybe ironically, manufacturers were not complaining about an undervalued yuan at the time, because it was also comparably strong because of its fixed value against the dollar.

Some would point out that the dollar has since weakened against many major currencies, particularly the euro. But the development of a worldwide cottage industry in currency hedging also shows the unpredictable volatility of floating exchange rates—a harbinger of risk that is a potent poison pill for trade.

Soft or hard?

There is some evidence that the yuan's value has been dampened by Chinese attempts to keep it pegged (or fixed) for about the last decade at roughly 8.3 yuan to the dollar. The problem is China's soft (rather than hard) peg system, according to Steve Hanke, a Johns Hopkins economist and currency expert.

Under a soft-peg regime, the Chinese are trying to control both currency value and money supply at the same time—a particularly hard task. Most countries choose to put one on market autopilot, so to speak. In the United States, for example, the value of the dollar is allowed to float, and money supply is controlled through interest rates set by the Federal Reserve.

China's soft-peg system means the Bank of China is selling domestic bonds to soak up dollars flowing in from the nation's positive trade balance with the United States, which in turn expands the domestic money supply in China and keeps inflation there in check. "The upshot" of the soft-peg system, Hanke responds in an e-mail, "has been modest deflationary pressures [in China], which have put a lid on the yuan's real exchange rate appreciation."

Hanke, for one, advocates that China merely move to a hard peg, which means the exchange rate would remain fixed and the Bank of China would refrain from buying up dollars. Such a move would tighten the yuan supply in circulation in China and likely lead to higher price inflation there. How much higher? That's hard to say, in part because it would depend on which part—currency value or money supply—you want to put on market autopilot, and neither choice would lead you straight to a hard answer.

But even assuming the yuan is undervalued, that's not as bad for the United States as many would have you believe, because it keeps Chinese prices low for goods sold in the United States, freeing up resources for other purchases, be they widgets, cars or education, all of which have their own economic benefits. It's a classic demonstration of the economic benefits of free trade.

Steve Hine, acting research director of Labor Market Information, a research arm of DEED, acknowledges that workers and business owners understandably worry over the threat to their livelihood posed by foreign competitors. "Clearly, a lot of manufacturing jobs have left permanently ... and a lot of cyclical and transitory jobs are not coming back," Hine says. "But that's what open trade is all about—jobs going to where there is competitive advantage. ... People will eventually get the courage to fly again."

Exchange rates aside, there are legitimate gripes about the fairness of trade between countries. Steve Holland, from the Montana MEC, points out that intellectual property theft and counterfeiting by foreign competitors is rife in countries like China, which don't have the same standards and safeguards as the United States. As a result, when ideas are pirated and knockoffs hit the shelves at fraction of the cost for U.S. manufacturers, "that's just stealing stuff from us," Holland says.

And Holland, for one, is confident that U.S. firms can compete with the likes of China, as long as everyone is playing by the same free-trade handbook. If China was "playing by the rules, I don't know that anyone would be complaining," Holland says, because the country offers a potential export boon to U.S. manufacturers. "If things are fair, [U.S. manufacturers] would go and compete." But the lack of perceived trade fairness "is just becoming more of a sore spot."