The Decline of U.S. Export Competitiveness for Manufactures and Its Consequences for the World Economic Order

The Decline of U.S. Export Competitiveness for Manufactures And Its Consequences for the World Economic Order

By Ernest H. Preeg Senior Advisor for International Trade and Finance

Manufacturers Alliance for Productivity and Innovation 1600 Wilson Blvd, Ste 1100, Arlington, VA 22209 | T 703.841.9000 | F 703.841.9514 | mapi.net The Decline of U.S. Export Competitiveness for Manufactures And Its Consequences for the World Economic Order

Policy Analysis | April 2015 By: Ernest H. Preeg, Ph.D., Senior Advisor for International Trade and Finance [email protected] PA-155i Table of Contents

Introduction 1

Part One: The Decline of U.S. Export Competitiveness for Manufactures 2 The Declining U.S. Share of Global Exports of Manufactures Since 2000 2 Table 1 – Leading Exporters of Manufactures ($billions) 3 Table 2 – The BRICS Disconnect for Trade in Manufactures ($billions, 2013) 4 Table 3 – U.S. Trade in Manufactures by Region 5 The Surging U.S. Trade Deficit in Manufactures Since 2009 6 Table 4 – Trade Balances in Manufactures 7 Table 5 – U.S. Bilateral Trade With China in Manufactures* ($billions) 7 Table 6 – U.S. Trade Balances in Manufactures With Principal EU Members ($billions) 8 Table 7 – U.S. and Chinese Exports of High-Technology Industries ($billions) 9 Table 8 – U.S. and Chinese Trade Balances in High-Technology Industries ($billions) 10 The Peaking Out of the U.S. Trade Surplus for Business Services Since 2010 10 Table 9 – Trade in Business Services ($billions) 11 Table 10 – Trade in Computer and Information Services ($billions) 11 A Brave New Trading World for Technology-Intensive Manufactures 12

Part Two: The Game-Changing Consequences for the World Economic Order 14 The Multilateral Economic System in Serious Decline 14 The Dollar Twilight Dilemma 18 A Two-Track Initiative to Restore a Fair and Balanced Multilateral System 22 The Indispensable U.S. Leadership Role 27

About the Author 30

Policy Analysis | April 2015 By: Ernest H. Preeg, Ph.D., Senior Advisor for International Trade and Finance [email protected] PA-155i

Introduction Technology-intensive manufactures make up two-thirds or more of global merchandise exports and are at the center of export competitiveness among the advanced and newly industrialized economies. The United States was the dominant exporter from the 1940s through the end of the century, but since 2000 the U.S. share of global exports of manufactures has declined sharply, from 18% in 2000 to 12% in 2013, while the Chinese share almost quadrupled, from 6% to 23%, and the EU share (in trade with non-members) was down only slightly, from 21% to 20%. Even more disturbing for U.S. export competitiveness, the U.S. trade deficit in manufactures surged by $206 billion from 2009 to 2013, while the EU surplus soared by $300 billion and the Chinese surplus was up by an amazing $492 billion. In 2014, the U.S. deficit rose by a further $61 billion, and the five-year increase in the deficit resulted in a net loss of about 1.7 million American manufacturing jobs. Based on early month trade and the strong dollar, the U.S. deficit is headed toward another large increase in 2015. This rapid decline in U.S. export competitiveness for manufactures is having game-changing consequences for the international trade and financial systems. U.S. leadership capability has been reduced for pursuing a more open, non-discriminatory trading system while trade relationships are shifting from the rules-based multilateral World Trade Organization (WTO) to a spreading network of preferential bilateral and regional trade agreements. And the dollarized international financial system of the past seven decades is in transition to some form of multi–key currency relationship as a growing share of trade is financed in other currencies and the U.S. official foreign debt of $11 trillion, as a result of protracted large trade deficits, continues to rise. This study addresses these issues and is in two parts. Part One traces the radical changes in the geographic composition of exports of manufactures from 2000 to 2013 and the rapid rise of the U.S. trade deficit and the Chinese surplus through 2014. For U.S. and China trade, the 10 largest high-technology sectors are examined, with Chinese exports far larger and growing faster. The peaking out of the U.S. trade surplus in business services since 2010 is also addressed. A net assessment of this radical restructuring of world trade in manufactures since 2000 concludes Part One. Part Two analyzes the consequences of this radical restructuring of trade in manufactures for the world economic order and makes proposals to restore a rules-based multilateral policy framework for fair and balanced trade that will strengthen U.S. export competitiveness and reduce the trade deficit for manufactures. Issues addressed include the transition away from the multilateral WTO trading system, IMF obligations related to exchange rate policy, and the twilight of the dollarized financial system. The point of departure for the multilateral restora-

Copyright © 2015 MAPI All rights reserved. 1 tion proposals is that the trade and financial systems are deeply linked, with exchange rates now the principal international trade-adjustment policy instrument for maintaining balanced access to markets, particularly for price-sensitive manufactures. The proposals are thus on two connected tracks. U.S. actions to restore the IMF obligation not to manipulate currencies to gain an unfair competitive advantage in trade, most importantly related to China, would move forward in parallel with negotiation of an open-ended plurilateral free trade agreement (FTA) within the WTO, which would consolidate the spreading With the sharp decline network of preferential bilateral and regional FTAs into a in oil and other broadly based, non-discriminatory trade relationship. Such an agreement could include over 70% of U.S. manufactured commodity prices in exports even if China chose not to be an initial participant. 2014, manufactures will probably be about A recurring theme throughout the study is the still indis- 75% of merchandise pensable U.S. leadership role for restoring a balanced, multilateral economic system, despite waning political leverage exports in 2015 as a result of the declining U.S. share of global exports. The other principal key currency participants, China and the EU, are not up to the task, and the alternative to forceful and effective U.S. leadership is the decline of international policy management to deal with trade and financial imbalances, and the threatening rise of financial market forces to do the job, which could be highly disruptive to international trade and investment.

Part One: The Decline of U.S. Export Competitiveness for Manufactures Total U.S. exports in 2013 were $2,262 billion, of which $1,580 billion, or 70%, was merchandise, and $682 billion, or 30%, was services. The manufacturing sector dominated merchandise exports, with $1,124 billion, or 71%, while agriculture accounted for $176 billion, or 11%, and fuels for $149 billion, or 9%. With the sharp decline in oil and other commodity prices in 2014, manufactures will probably be about 75% of merchandise exports in 2015. For services exports, $171 billion, or 25%, was business services, closely integrated with manufactures, and the remainder was for travel, transportation, and other commercial services. These are the broad dimensions of U.S. exports. Part One of this study is about the decline of U.S. export competitiveness for the dominant manufacturing sector, and is in four sections. The first addresses the declining U.S. share of global exports of manufactures from 2000 to 2013 and the second the surging U.S. deficit for manufactures from 2009 to 2014. The third section presents the peaking out of the U.S. trade surplus in related business services since 2010, and the fourth provides a summary assessment of the radical changes in trade in manufactures since 2000.

The Declining U.S. Share of Global Exports of Manufactures Since 2000 Table 1 presents exports of manufactures by the 13 largest exporters of manufactures from 2000 to 2013, which together accounted for $7,807 billion, or 86%, of global exports in 2013. Three overriding relationships tell the extraordinary story of the course of trade in manufactures over only 13 years.

Copyright © 2015 MAPI All rights reserved. 2 Table 1 – Leading Exporters of Manufactures ($billions) % % 2000 2013 Increase 2000 2013 Increase World* 3,534 9,071 157 Canada 176 207 18 China 220 2,077 844 Switzerland 74 201 172 EU* 736 1,772 141 India 35 186 431 United States 650 1,124 73 Thailand 55 168 205 Japan 450 626 39 Malaysia 81 139 72 South Korea 155 481 210 13 Listed 3,025 7,807 158 Singapore 118 288 144 8 Asians 1,250 4,218 237 Mexico 139 285 105 2 West Europeans 810 1,973 144 Taiwan 141 253 79 3 North Americans 965 1,616 67 *EU exports to non-members, as also calculated for World, which is used throughout this study Source(s): WTO, International Trade Statistics

First, all 13 exporters are from three dominant exporting regions: 8 in Asia, 2 in West Europe, and 3 in North America. Moreover, if other smaller Asian exporters are included, the 86% of global exports for the three regions would rise to 90%, leaving only 10% of global manufactured exports by the rest of the world—South and Central America, Africa, the Middle East, and East Europe including Russia. This three-region concentration in export-oriented industrialization since 2000 is, if anything, intensifying, making the other regions of the world increasingly dependent on exports of fuels, industrial raw materials, and agricultural commodities, which are vulnerable to disruptive swings in prices and quantities. Second, among the three dominant exporting regions, the Asian share has risen sharply from 2000 to 2013, principally offset by a major decline in the North American share. As shown in the bottom three lines of the table, exports of the 8 Asians grew by 237%, to $4,218 billion in 2013, while West European export growth was 144%, to $1,973 billion, and North American export growth lagged far behind at 67%, to $1,616 billion. As a result, the Asian share of exports by the 13 rose from 41% in 2000 to 54% in 2013, while the North American share declined from 32% to 21%, and the West European share was down only slightly, from 27% to 25%. The Asian century is thus already in full bloom for exports of manufactures, and the rise will be accelerated by the new, Chinese-led Asian Infrastructure Investment Bank (AIIB). The third and most politically charged changed relationship is by and among the “Big Three” exporters—China, the EU, and the United States, whose aggregate share of world manufactured exports rose from 45% in 2000 to 55% in 2013. Most important is the dramatic changing of places among the three, with Chinese export growth of 844%, EU growth of 141%, and U.S. growth of only 73%, or about half EU growth and less than a tenth of Chinese growth. As a result, the Chinese share of global exports almost quadrupled, from 6% in 2000 to 23% in 2013, the EU share declined slightly, from 22% to 21%, and the U.S. share declined sharply, from 18% to 12%. In absolute terms, U.S. exports of $650 billion in 2000 were almost three times larger than the $220 billion of Chinese exports, while by 2013 Chinese exports of $2,077 billion were 85% larger than the $1,124 billion of U.S. exports. In 2014, based on national trade statistics,1 Chinese exports rose by 6%, to $2,228 billion, while U.S.

1 The WTO multilateral trade data for 2014 will not be available until November 2015. The U.S. and Chinese data are on a slightly broader definition of manufactures, SITC 5-8, than the WTO definition, which is SITC 5-8 minus two small sectors of trade that account for about 2% of U.S. manufactured exports.

Copyright © 2015 MAPI All rights reserved. 3 exports grew by only 3%, to $1,388 billion, and during the fourth quarter Chinese exports, for the first time, more than doubled U.S. exports.2 These stark trade figures for the dominant manufacturing sector of trade raise a number of policy issues, principally related to trade relations among advanced and newly industrialized exporters in the three regions, with a decisive, central role for the Big Three, which is the principal substance of the second part of this study. Just a couple of comments about trade with the rest of the world are offered here, as related to Table 1. The very low 10% share of manufactured exports accounted for by the rest of the world is a complex subject worthy of in-depth investigation. It is largely the result of national economic strategies that do not attract investment in export-competitive manufacturing industries, which for poorer countries begin with labor-intensive industries, as has recently been happening in Asian nations such as Bangladesh, Myanmar, and Vietnam. It is also related to the decline of the rules- based multilateral trading system, whereby the 10% grouping of exporters is largely excluded from preferential bilateral and regional free trade agreements. Even more important, the mercantilist, undervalued exchange rates of some exporters of manufactures, particularly in Asia, cannot be matched by the 10%, which, if anything, try to maintain overvalued exchange rates so as to pay for large imports of manufactures, which at the same time discourages investment in export-oriented manufacturing industry. A true exchange rate policy conundrum for the 10%. A special note of striking regional contrast in export competitiveness for manufactures falls within the much-publicized geopolitical BRICS grouping, as shown in Table 2. China was by far the number one global exporter of manufactures in 2013, with $2,077 billion of exports and an unprecedented trade surplus of $942 billion. India has substantial and rapidly growing manufactured exports, with trade roughly in balance, but is still at only about a tenth of the Chinese export level. And the other three—Russia, Brazil, and South Africa—are inconsequen- tial exporters, with $101 billion, $85 billion, and $40 billion of exports in 2013, respectively, and all are in large deficit, with imports more than double exports for Russia and Brazil. EU manufactured exports in 2013 were 18 times larger than Russian exports, and Mexican exports were more than three times larger than Brazilian exports. What this means for the policy analysis in this study is that the BRICS grouping, while an outspoken geopolitical voice, is a disconnected grouping with little mutual interest for trade strategy related to manufactures, although individual members China and India will be increasingly important participants in the trade and financial system in the decade ahead.

Table 2 – The BRICS Disconnect for Trade in Manufactures ($billions, 2013) Exports Imports Balance China 2,077 1,135 +942 India 186 181 +5 Russia 101 258 -157 Brazil 85 173 -88 South Africa 40 65 -25 Source(s): WTO, International Trade Statistics

Finally, Table 3 presents U.S. exports, imports, and trade balances in manufactures for 2013 by region and principal trading partner, and is thus a bridging table for the discussion in the

2 See Ernest H Preeg, U.S. Trade Deficit in Manufactures in Fourth Quarter and Chinese Surplus Both Surge by 14% (MAPI Foundation, February 2015).

Copyright © 2015 MAPI All rights reserved. 4 following section of the surging U.S. trade deficit since 2009. It also highlights the highly disparate regional orientation of U.S. export markets for manufactures as related to the policy discussion in Part Two.

Table 3 – U.S. Trade in Manufactures by Region Exports Imports Balance Total 1,124 1,651 -527 North America 398 369 +29 Asia 295 838 -543 China 74 444 -370 Japan 44 135 -91 South Korea 31 57 -26 India 17 33 -26 West Europe 224 353 -129 EU 202 321 -119 South and Central America 111 48 +63 Brazil 34 14 +20 Middle East 61 27 +34 Africa 21 10 +11 Commonwealth of Independent States 13 7 +6 Russia 9 6 +3 Source(s): WTO and U.S. Census Bureau, FT-900

Five salient geographic dimensions of U.S. trade emerge that are fundamental to a U.S. strategy to restore U.S. export competitiveness for manufactures: (1) The three dominant exporting regions also dominate U.S. manufactured exports. U.S. manufactured exports to North America, Asia, and West Europe were $917 billion, or 83% of global exports of $1,102 billion; (2) Among the three regions, North America is well out front as the number one region for U.S. exports. U.S. exports to North America were $398 billion, compared with $295 billion to Asia and $224 billion to West Europe. North America thus accounted for 35% of U.S. global exports of manufactures, well ahead of the 26% for Asia and the 20% for West Europe; (3) The contrast in the U.S. trade balances among the three regions is even greater than for exports, and far more consequential for U.S. export competitiveness. The U.S. trade balance with its NAFTA partners was a small surplus of $29 billion, with a moderate surplus with Canada offsetting a smaller deficit with Mexico. Trade with Asia, in stunning contrast, was in deficit by $543 billion, larger than the $527 billion global deficit, and the $129 billion deficit with West Europe added substantially to the huge net deficit with the three regions of $643 billion; (4) As for bilateral balances, the three largest deficits by far were with China, at $370 billion, the EU, at $119 billion, and Japan, at $91 billion. Together, the deficit for the three was $580 billion, well above the global deficit of $527 billion. The Chinese deficit alone equated to 70% of the global U.S. deficit, with imports of $444 billion six times larger than the $74 billion of U.S. exports to China;

Copyright © 2015 MAPI All rights reserved. 5 (5) For the rest of the world, beyond the three dominant exporting regions, which accounted for only 18% of U.S. exports, the United States had a surplus of $113 billion. This reflects the very large trade deficits in manufactures in these regions, as commented on earlier. Noteworthy related to the BRICS is that U.S. manufactured exports to Brazil of $34 billion were only 3% of global exports, and the $9 billion of exports to Russia were less than 1%. As for the relationship of this regional orientation of U.S. trade in manufactures to the policy proposals in Part Two, two relationships are of central importance. The first is the severe and growing deficits for price-sensitive U.S. manufactured exports from exchange rate policies of others, which centers on China and the EU, which together with the United States also have the “Big Three” global currencies, and will thus determine the future course of the deeply troubled international monetary system. And second, the proposal put forward for a plurilateral free trade agreement within the WTO could include 70% or more of U.S. manufactured exports even if China chose not to be an initial participant. The 35% North American share of U.S. exports, the 20% West European share, and other free trade agreements in place, as with South Korea, or being negotiated within the Trans-Pacific Partnership (TPP), including Japan, would bring the share of U.S. exports to at least 70%, while the 7% share of U.S. exports to China is relatively small.

This concludes the discussion of the serious decline of the U.S. global share of exports of manufactures from 2000 to 2013, headed to 10% over the next couple of years, and the corresponding extremely large increase in the Chinese share, headed toward 25%. Even more important for U.S. export competitiveness, however, is the surging U.S. deficit in the sector since 2009.

The Surging U.S. Trade Deficit in Manufactures Since 2009 The most definitive measure of the recent decline in U.S. export competitiveness for manufactures is the surging trade deficit since 2009. The trade balance is the bottom line for the impact on American production and jobs. Manufactured exports can have imported components and imports can have previously exported components, but this all nets out in the bottom-line trade balance. As for the impact on U.S. jobs, estimates range from 4,000 to 10,000 American manufacturing jobs lost for each $1 billion increase in the trade deficit, depending largely on the mix of industries being examined. The midpoint of 7,000 jobs is used throughout this report as a reasonable approximation of the job loss from the growing trade deficit. Table 4 presents the trade balances for manufactures in 2009 and 2013 for the same 13 largest exporters listed in Table 1. The central, overriding development is the huge increases in the Chinese and EU surpluses, largely offset by the surging U.S. deficit, which together, among other things, have greatly increased the financial challenge facing the Big Three global currencies. The Chinese surplus soared by $492 billion, to an unprecedented $942 billion in 2013, the EU surplus was up by $300 billion to $529 billion, and the U.S. deficit, in the other direction, rose by $206 billion, to $527 billion. The next two largest exporters, Japan and South Korea, had large surpluses of $226 billion and $218 billion in 2013, but their increases from 2009 were much smaller—$48 billion for South Korea and an insignificant $4 billion for Japan. Of the other listings, the next largest surplus was Taiwan, at $90 billion, up by $22 billion from 2009, while fellow North American Canada had the second largest deficit, at $134 billion, up by $49 billion.

Copyright © 2015 MAPI All rights reserved. 6 Table 4 – Trade Balances in Manufactures 2009 2013 09-13 2009 2013 09-13 China +450 +942 +492 Switzerland +29 +38 +9 EU +229 +529 +300 India -9 +6 +15 United States -321 -527 -206 Thailand +19 +10 -9 Japan +222 +226 +4 Malaysia +16 +3 -13 South Korea +137 +218 +81 Singapore +36 +60 +24 13 Listed +775 +1,444 +669 Mexico -16 -17 -1 8 Asians +939 +1,555 +616 Taiwan +68 +90 +22 2 West Europeans +258 +567 +309 Canada -85 -134 -49 3 North Americans -422 -678 -256 Source(s): WTO, International Trade Statistics

In 2014, based on national trade statistics, the Chinese surplus increased by a further $85 billion, to $998 billion, which rounds to an astounding $1 trillion, while the U.S. deficit rose by $61 billion, to $562 billion. Moreover, based on early month trade and the stronger dollar, the U.S. deficit is headed for a further large increase in 2015. The dominance of the growth of the trade imbalances by the Big Three cannot be overempha- sized. From 2009 to 2013, the $492 billion increase in the Chinese surplus and the $300 billion increase in the EU surplus, or $792 billion together, accounted for 86% of the $925 billion surplus increases among the 13 largest exporters. And the $206 billion increase in the U.S. deficit was 74% of the $278 billion of increased deficits among the 13. Thus, any reversal of these growing trade imbalances among the major advanced and newly industrialized exporters will have to center on the Big Three exporters, which also have the three global currencies, a trade/exchange rate policy linkage that is central to the discussion in Part Two of this study. Even more politically charged than these extremely large and growing multilateral trade imbalances, however, is their concentration in the bilateral imbalances among the Big Three, the surging U.S. bilateral deficits with China and the EU. Tables 5 and 6 present these bilateral imbalances for years 2009 through 2014, based on U.S. trade statistics. Table 5, for U.S.-China trade, shows U.S. exports to China up by $37 billion from 2009 to 2014 and imports up by $167 billion, with a resulting increase in the deficit of $130 billion. The $312 billion bilateral deficit in 2014 was 66% of the $562 billion global deficit.

Table 5 – U.S. Bilateral Trade With China in Manufactures* ($billions) 2009 2010 2011 2012 2013 2014 09-14 Exports 45 58 63 65 76 82 +37 Imports 287 354 387 413 427 454 +167 Trade Balance -242 -296 -324 -348 -351 -372 -130 *SITC 5-8 Source(s): U.S. Census Bureau

The 66% Chinese share of the U.S. global deficit is down from 80% in 2009, but this is principally because of the large rise in the EU share of the deficit, from 17% in 2009 to 24% in 2013. The two deficits together thus remain in the order of 90% of the global U.S. deficit. This rising U.S. deficit with the EU is presented in Table 6 for the five principal EU trading partners, with the first four—Germany, France, Italy, and Spain—members of the eurozone, and the fifth,

Copyright © 2015 MAPI All rights reserved. 7 the United Kingdom, not in the eurozone. This currency distinction tells the story of how the rapidly growing U.S. deficit with the overall EU is related to what, in effect, has been an undervalued euro to the dollar.

Table 6 – U.S. Trade Balances in Manufactures With Principal EU Members ($billions) 2009 2010 2011 2012 2013 2014 09-14 Germany -27 -36 -51 -61 -68 -73 -46 France -4 -8 -9 -8 -11 -13 -9 Italy -12 -12 -16 -18 -20 -23 -11 Spain +2 +2 +1 -1 -1 -3 -5 4 eurozone -41 -54 -75 -88 -100 -112 -71 United Kingdom -2 -1 +2 -1 +1 +1 +3 *SITC 5-8 Source(s): U.S. Census Bureau

All four eurozone members recorded increased U.S. bilateral deficits, totaling $71 billion from 2009 to 2014, but with the $46 billion increase in the deficit with Germany accounting for 65% of the total. For the others, increased U.S. deficits of $9 billion with France, $11 billion with Italy, and $5 billion with Spain helped these eurozone economies offset their larger trade deficits with Germany and other northern-tier eurozone members. The net result, however, is that the entire eurozone is in large current account surplus with the rest of the world, of over 2% of GDP, largely from its rapidly growing trade surplus in manufactures with the United States. The U.S. trade balance with the non-eurozone United Kingdom, in contrast, has been balanced and relatively stable, with a $3 billion rise for the United States to a $1 billion surplus in 2014. A final vital and decisive dimension of the growing U.S. trade deficit in manufactures is that most of these industries are technology-intensive. About 70% of U.S. civilian R&D expenditures and 90% of new patents derive from the manufacturing sector. Top priority for national economic strategies throughout Asia, most importantly by China, Japan, South Korea, and India, and among EU members, is for high export-oriented growth for these technology-intensive industries. This involves a range of domestic policies and special importance for an export-oriented trade strategy in view of the very high trade engagement of manufacturing industry. This international rivalry to be at the forefront of technological innovation and development is clearly evident in trade terms, and of deepest concern for the United States from the recent rapid rise of Chinese export competitiveness for high-technology industries. The final two tables of this section present U.S. and Chinese global trade for the 10 largest high-technology industries in 2009 and 2014, for exports in Table 7, and for the trade balances in Table 8. These 10 industries accounted for 67% of total U.S. manufactured exports in 2014, and 51% of Chinese exports. If other, smaller high-technology industries were included, the high-technology shares of exports would be still higher. It can thus be said that well over two-thirds of U.S. and well over half of Chinese manufactured exports are now in technology-intensive industries. The bottom line of Table 7 shows the rapid rise of Chinese exports of these 10 industries, pulling ever further ahead of U.S. exports. Chinese exports grew from $625 billion in 2009 to $1,135 billion in 2014, or by 82%, while U.S. exports rose from $525 billion to $769 billion, or by 46%. The $510 billion increase in Chinese exports thus more than doubled the $244 billion U.S. increase over the five-year period, resulting in Chinese exports in 2014 48% larger than U.S. exports.

Copyright © 2015 MAPI All rights reserved. 8 Table 7 – U.S. and Chinese Exports of High-Technology Industries ($billions) 2009 2014 09-14 U.S. China U.S. China U.S. China Medicines and pharmaceutical products 44 9 49 13 +5 +4 Power generating machinery and equipment 30 19 44 37 +14 +18 Machinery specialized for particular industries 40 17 54 40 +14 +23 General industrial machinery and equipment 49 50 79 102 +30 +52 Office and data processing equipment 39 147 50 222 +11 +75 Telecommunications and sound recording 36 159 53 280 +17 +121 Electrical machinery and appliances 85 134 114 279 +29 +145 Road vehicles 70 29 132 71 +62 +42 Other transport equipment 87 30 132 32 +45 +2 Professional and scientific instruments 45 31 62 59 +17 +28 10-industry total* 525 625 769 1,135 +244 +510 *SITC 54, 71-72, 74-79, 87 Source(s): U.S. Census Bureau, FT-900, and China’s Customs Statistics

The full story of the export competitiveness rise for Chinese high-technology industries, however, is revealed by the performance of the individual industries. The only two industries where the United States maintains a large lead are road vehicles, centered on the deeply trade-integrated North American automotive industry The Chinese lead centers within NAFTA dating back to the U.S.-Canada free trade on the IT industries— Auto Pact of 1965, and other transport equipment, thanks office and data largely to Boeing. The United States also has a lead in processing equipment, medicines and pharmaceutical products, although the telecommunications and trade is relatively smaller. sound recording, and The Chinese lead centers on the IT industries—office and electrical machinery and data processing equipment, telecommunications and appliances sound recording, and electrical machinery and appliances. Chinese exports for the three industries grew by $341 billion, six times the $57 billion U.S. growth, while Chinese exports in 2014 of $781 billion were 3.6 times larger than the $217 billion of U.S. exports. In the three machinery industries, listed 2 through 4, Chinese exports grew by $93 billion, versus $58 billion for the United States, shifting from a large $33 billion U.S. lead in 2009 to a $2 billion Chinese lead in 2014. And for professional and scientific instruments, Chinese export growth converted the $14 billion U.S. lead in 2009 to a much smaller $3 billion lead in 2014, with five-year growth of $28 billion by China compared to $17 billion by the United States. These are the striking figures for the rapidly growing Chinese lead over the United States for exports of high-technology industries. Unfortunately, the corresponding figures for trade balances in these 10 industries, presented in Table 8, are even more detrimental for U.S. export competitiveness. For all 10 industries, the United States had a deficit of $131 billion in 2009, which more than doubled to $289 billion in 2014, while the Chinese surplus of $156 billion in 2009 also more than doubled to $322 billion in 2014.

Copyright © 2015 MAPI All rights reserved. 9 Table 8 – U.S. and Chinese Trade Balances in High-Technology Industries ($billions) 2009 2014 09-14 U.S. China U.S. China U.S. China Medicines and pharmaceutical products -16 +2 -28 -6 -12 -8 Power generating machinery and equipment -9 +1 -22 +13 -13 +12 Machinery specialized for particular industries +16 -8 +7 +1 -9 +9 General industrial machinery and equipment -1 +4 -14 +50 -13 +46 Office and data processing equipment -52 +105 -68 +164 -16 +59 Telecommunications and sound recording -83 +124 -99 +211 -16 +87 Electrical machinery and appliances -7 -65 +45 -67 -38 -2 Road vehicles -58 +1 -126 -18 -68 -19 Other transport equipment +66 +16 +95 +1 +29 -15 Professional and scientific instruments +13 -24 +11 -27 -2 -3 10-industry total* -131 +156 -289 +322 -158 +166 *SITC 54, 71-72, 74-79, 87 Source(s): U.S. Census Bureau, FT-900, and China’s Customs Statistics

Again looking at the individual industries, the only large increase in the U.S. surplus was for other transport equipment, up by $29 billion, while for the three IT industries the U.S. deficit rose by $70 billion and the Chinese surplus surged by $144 billion, and for the three machinery industries the U.S. deficit was up by $35 billion as the Chinese surplus rose by $67 billion. This concludes the presentation of the sharp decline of the U.S. share of global exports of manufactures since 2000 and the rapid rise in the trade deficit since 2009. Before moving to the analysis of why this happened and what should be done to restore a more balanced trade relationship for the technology-intensive manufacturing sector, a briefer presentation is made on related trade in business services, which is much smaller than trade in manufactures and has been subject to unsubstantiated, misleading commentary.

The Peaking Out of the U.S. Trade Surplus for Business Services Since 2010 Trade in manufactures and business services are deeply linked, often within manufacturing companies. U.S. exports of business services in 2013 of $378 billion were about 30% as large as manufactured exports, and were in surplus by $44 billion, which amounted to about 8% of the deficit for manufactures. This surplus has led some observers to project that a rising U.S. surplus for business services could go a long way toward offsetting the growing deficit for manufactures. Chinese officials have likewise responded to U.S. complaints about the rising bilateral deficit for manufactures by saying that this is largely offset by a growing surplus for business services. Such optimism, however, is no longer justified, if it ever was.3 Trade statistics for business services are not as detailed as for manufactures, but the WTO does provide annual statistics for principal trading nations for three categories of business services: communications, computer and information services, and other business services, the latter including legal, management, R&D, engineering, and other technical services. Exports and trade balances for the Big Four exporters, which adds India to the Big Three exporters of manufactures, for all three categories, are presented in Table 9 for 2009 through 2013. The basic picture is that while

3 For a more detailed analysis, see Ernest H. Preeg, U.S. Trade Surplus in Business Services Peaks Out (MAPI Foun- dation, 2014). The briefer presentation here updates the trade figures through 2013, reinforcing the conclusions in the earlier analysis.

Copyright © 2015 MAPI All rights reserved. 10 U.S. exports grew steadily over the four years, the trade surplus, after a substantial increase in 2010, has since leveled off through 2013, while the surpluses of the other three principal exporters have all grown two to five times faster.

Table 9 – Trade in Business Services ($billions) 2009 2010 2011 2012 2013 09-13 Exports EU 263 283 335 344 378 +115 United States 117 137 146 166 171 +54 India 64 87 85 94 103 +39 China 53 72 72 83 97 +44 Trade Balance EU +67 +85 +106 +112 +132 +65 United States +31 +39 +35 +44 +43 +12 India +38 +44 +56 +61 +71 +33 China +16 +33 +28 +35 +42 +26 Source(s): WTO, International Trade Statistics

U.S. exports rose from $117 billion in 2009 to $171 billion in 2013, or by 46%, Indian exports were up from $64 billion to $103 billion, or by 61%, and Chinese exports were up from $53 billion to $97 billion, or by 83%. The EU, by far the number one exporter, increased exports to non-members from $263 billion to $378 billion, or by 44%. The growth pattern of the U.S. trade surplus is even more decisive in dispelling earlier optimism about offsetting the growing deficit in manufactures. The U.S. surplus was up by $12 billion over the four years, of which $8 billion was in 2010. And the other three exporters all registered much larger and sustained growth in their surpluses over the four years. As a result, from 2010 to 2013, the EU surplus was up by $47 billion, the Indian surplus by $27 billion, the Chinese surplus by $9 billion, and the U.S. surplus by only $4 billion, or an insignificant 2% of the increased trade deficit for manufactures. The trade performance of the computer and information services sector, presented in Table 10, is important as related to the rapidly growing U.S. deficit for IT manufactures, shown earlier in Table 8, and the central role of IT industries for new technology development and application. Unfortunately, U.S. exports of computer and information services lag behind the other principal exporters, and the United States runs a growing trade deficit in the sector.

Table 10 – Trade in Computer and Information Services ($billions) 2009 2010 2011 2012 2013 09-13 Exports EU 42 49 57 56 62 +20 United States 13 14 16 17 18 +5 India 34 41 44 47 50 +16 China 7 9 12 14 15 +8 Trade Balance EU +24 +30 +37 +36 +36 +12 United States -4 -5 -9 -8 -8 -4 India +31 +38 +42 +45 +47 +16 China +4 +6 +8 +11 +10 +6 Source(s): WTO, International Trade Statistics

Copyright © 2015 MAPI All rights reserved. 11 U.S. exports grew by only $5 billion from 2009 to 2013, while Indian exports rose by $16 billion, Chinese exports by $8 billion, and front-runner EU exports soared by $20 billion. The U.S. trade deficit doubled from $4 billion to $8 billion, while the Indian surplus was up by $16 billion, the EU surplus by $12 billion, and the Chinese surplus by $6 billion. Thus, in 2013, the other three exporters had a combined surplus of $93 billion, while the United States was in deficit by $8 billion. This serious weakening of U.S. export competitiveness for IT services, together with the far larger and growing deficit for IT products, raises questions about the projected impact on U.S. trade from the U.S.-China agreement at the November 2014 Beijing economic summit to negotiate an expanded, plurilateral trade-liberalizing Information Technology Agreement. The overall assessment for U.S. trade in business services is thus threatening, with a possible decline rather than increase in the long-standing trade surplus. This reflects the growing technical capability of Indian and Chinese service providers, and the fact that export competitiveness in business services, perhaps even more than for manufactures, is highly price-sensitive to the much lower labor costs of technology-oriented personnel in India and China, many with degrees from American universities.

* * *

A final international commercial account related to U.S. export competitiveness for technology-intensive industries does not involve cross-border trade in goods or services, but rather cross-border rental of property, namely intellectual property. This is one area where the United States has maintained a large international surplus, but, as elsewhere, the future course of this surplus is in doubt. According to WTO statistics on royalties and license fees, The issue of intellectual the United States had a surplus of $57 billion in 2009, but this surplus has risen only slowly since then, to $57 property rights is highly billion in 2010, $63 billion in 2011, $62 billion in 2012, complex, largely beyond the and $65 billion in 2013. realm of trade policy, and subject to frequent dispute The issue of intellectual property rights is highly complex, largely beyond the realm of trade policy, and subject to frequent dispute, often over cyber warfare and the theft of patents, including between the United States and China. The substance of this issue extends beyond the scope of this study, and only two broad conclusions are offered here. First, this subject should receive high-level, in-depth attention by the U.S. government, as a vital dimension of U.S. export competitiveness for technology-intensive industries, and second, the figures provided above indi- cate that the large U.S. surplus is vulnerable as others put high priority on increased R&D and other technology-driven incentives, and engage in violations of intellectual property rights.

A Brave New Trading World for Technology-Intensive Manufactures This completes the presentation of the radical geographic restructuring of trade in manufactures since 2000, and the consequences for the United States and the global economic system are far-reaching. Manufactures amounted to 65% of global merchandise exports in 2013, and with the subsequent sharp decline in oil and other commodity prices, the manufacturing share will likely rise to at least 70% in 2015. More important, as has been highlighted throughout

Copyright © 2015 MAPI All rights reserved. 12 this presentation, the manufacturing sector is highly technology-intensive, which is central to a number of national economic strategies, including the objectives of export-oriented growth and a large trade surplus. In this process, however, the United States has seriously lagged behind, with an ever-smaller share of global exports and an ever-larger trade deficit. These are the central policy issues addressed in Part Two of this report, and Part One therefore concludes with a pointed summary assessment of the radical restructuring of trade in manufactures, as presented in the 10 foregoing tables, as the analytic foundation for discussion of the policy course ahead for the United States and the global economic system. A central finding is that manufactured exports are highly concentrated geographically, with 90% of global exports from three regions—Asia, West Europe, and North America—within which the Big Three exporters are China, the EU, and the United States, whose combined share of global manufactured exports increased from 45% in 2000 to 54% in 2013. There has also been a decisive change in global market shares among the three dominant exporting regions. From 2000 to 2013, the Asian share of exports by the 13 largest exporters surged from 41% to 54%, while the North American share declined sharply from 32% to 21%, and the West European share was down only slightly, from 27% to 25%. And again, shares among the Big Three were even more pronounced, centered on the dramatic changing of places between the two largest exporting nations, with U.S. manufactured exports almost three times larger than Chinese exports in 2000 shifting to Chinese exports doubling U.S. exports by 2014. The most disturbing change and most threatening to the trading system has been the rapid rise of trade imbalances for manufactures among the Big Three from 2009 to 2013, with the Chinese surplus up by $492 billion to $942 billion and the EU surplus by $300 billion to $529 billion, while in the other direction the U.S. deficit rose by $206 billion to $527 billion. In 2014, the Chinese surplus rose by a further $85 billion and the U.S. deficit by $61 billion. And all three imbalances are headed higher in 2015. Moreover, the soaring U.S. global deficit in manufactures is highly concentrated in the growing bilateral deficits with China and the EU. In 2014, the $372 billion U.S. bilateral deficit with China amounted to 66% of the global deficit, and the bilateral deficit with the EU brought the combined deficit to about 90%. U.S. manufactured imports from China in 2014 were 5.5 times larger than U.S. exports to China. The trade impact of a mercantilist trade strategy for technology-intensive manufacturing industries is most glaring in the Chinese strategy vis-à-vis the United States since 2009. For the 10 largest high-technology industries, which account for the majority of manufactured exports for both countries, Chinese exports grew by $510 billion from 2009 to 2014, while U.S. exports were up by only $244 billion, or less than half as much. Even more bleak, the Chinese surplus in these industries rose by $166 billion to $322 billion, while the U.S. deficit surged by $158 billion to $289 billion. For the three strategic IT industries, Chinese exports in 2014 of $781 billion were almost four times larger than the $217 billion of U.S. exports, and the $308 billion Chinese surplus compared with a $212 billion U.S. deficit. As for trade in business services, from 2010 to 2013, the EU surplus was up by $47 billion, the Indian surplus by $27 billion, the Chinese surplus by $9 billion, and the U.S. surplus by only $4 billion. There is finally the precarious and potentially unstable outlook from the structure of trade in manufactures between the three dominant exporting regions and the rest of the world, which

Copyright © 2015 MAPI All rights reserved. 13 accounts for 10% of global manufactured exports and relies principally on exports of oil and other commodities that are vulnerable to disruptive swings in prices and quantities. This is the story of the radical geographic restructuring into a brave new trading world for technology-intensive manufactures. It clearly raises important policy questions as to how governments should manage the trade policy course ahead, to which this presentation now turns.

Part Two: The Game-Changing Consequences for the World Economic Order Part One documented the serious decline of U.S. export competitiveness for the dominant manufacturing sector of trade since 2000, driven by export-oriented economic strategies by principal competitors in Asia and West Europe. Part Two addresses how this decline in U.S. export competitiveness poses a life-threatening challenge for the multilateral trade and financial systems of the past seven decades and makes proposals for restoring a more fair and balanced multilateral policy framework. It begins with a brief history The dollar was viewed as the only of the multilateral trade and financial systems currency that would have market adopted at Bretton Woods in 1944, with a focus confidence in the devastated on the serious deterioration of both systems postwar global economy since 2000. It then assesses the likely course ahead for the dollarized financial system into some form of multi–key currency relationship, characterized as the dollar twilight dilemma. This is followed by policy proposals, which center on ending mercantilist currency manipulation and consolidating the spreading network of bilateral and regional free trade agreements into an open-ended plurilateral agreement encompassing the majority of world trade. A recurring theme is that if the critical decline of the multilateral economic system is to be reversed, strong and sustained U.S. leadership over the next several years will be indispensable, while absent such leadership, financial markets are likely to precipitate conflicts among governments that could be highly disruptive for international trade and investment.

The Multilateral Economic System in Serious Decline Economic leaders from 44 nations gathered at Bretton Woods, New Hampshire, in July 1944 to replace the rampant currency manipulation and protectionist bilateral trade agreements of the 1930s—referred to as “beggar-thy-neighbor” policies—with a new multilateral system of increasingly open and balanced trade with reasonably stable exchange rates. The meeting took place in the midst of the economic destruction of the Second World War, and the need for a bold postwar economic recovery plan was paramount in the minds of the delegates. Leadership for building the new economic system centered on the United States and the United Kingdom, with roots back to the 1941 Atlantic Charter, when President Roosevelt and Prime Minister Churchill agreed on postwar goals, including the right of all nations to equal access for trade and raw materials. There were important differences between the two governments, however, particularly regarding exchange rates and the role of the dollar. The U.S. proposal, which was basically adopted, was for a dollarized system with other currencies pegged to the dollar on a relatively rigid basis, requiring approval by the newly created International Monetary Fund for changes of more than 10%, and with the dollar convertible to gold. All currencies were also to become convertible on current account. The dollar was viewed as the only currency that would have market confidence in the devastated postwar global economy, while rigid links to the dol-

Copyright © 2015 MAPI All rights reserved. 14 lar were meant as a deterrent to the widespread competitive devaluations of the 1930s. There were also commercial benefits for the United States from the dollarized system, however, which were criticized, particularly by the United Kingdom and France. The alternative proposal put forward by the UK delegate, John Maynard Keynes, was for an international currency, the bancor, very large quantities of which were to be allocated to IMF members to finance postwar trade deficits, principally with the United States. This proposal was a political non-starter since the proposed $26 billion of bancors, or about $16 trillion in today’s dollars, would essentially become unconditional loans by the United States to finance trade deficits by others, which was vehemently opposed by the U.S. Congress. As for the rigid link of other currencies to the dollar, the highly able U.S. delegate, Harry Dexter White, based on his Treasury experience of the 1930s, aptly observed: “Given the choice, every country pre- fers to have its currency undervalued rather than overvalued.”4 And so the dollarized financial system, with other currencies rigidly linked to the dollar, and the dollar convertible to gold, was created and endured until 1971. Moreover, the U.S. economic strategy was comprehensive, including a multilateral trading system agreed in principle at Bretton Woods and launched in 1949 as the General Agreement on Tariffs and Trade (GATT), which engaged in progressive trade liberalization on a non-discriminatory, most-favored-nation basis, and financial assistance through the newly created International Bank for Reconstruction and Development, later expanded to become the World Bank Group, and greatly supplemented by the United States in the immediate postwar years by the Marshall Plan. This comprehensive U.S. strategy for postwar economic recovery and the creation of a multilateral economic system proved to be an extraordinary success. Despite widespread postwar pessimism, within 10 years, sustained export-led growth was achieved by the major West European nations, which formed the free trade European Economic Community in 1957, while there was a similar robust economic recovery for the war-torn Japanese economy. In fact, this success story became the cause for the rigidly dollarized Bretton Woods exchange rate system to be overtaken by events sooner than anticipated in 1944. The European and Japanese economies, with their exchange rates linked to the dollar, soon shifted from trade deficits to trade surpluses, mostly at the expense of a growing U. S. trade deficit, which intensified during the 1960s. In effect, the other currencies were increasingly undervalued to the dollar, while their governments, as had been observed by Harry Dexter White, resisted rais- ing their currencies, and the IMF system lacked obligations for adjustment for undervalued currencies. This led to the Triffin Dilemma, discussed in the following section, which resulted in the United States, in August 1971, ending the dollar link to gold and calling for a transition to market-based exchange rates in order to achieve prompt and full trade adjustment. To jump- start this transition, the United States imposed an interim 10% surcharge on imports, which shocked trading partners and became known as the “Nixon Shock.” The ensuing shift toward market-based exchange rates led to the adoption in 1978 of a revised IMF Article IV, obligating

4 Ben Steil, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of the New World Order (Princeton University Press and the Council on Foreign Relations, 2013), p. 33. Harry Dexter White is best known for his personal tragedy when it was revealed toward the end of the Bretton Woods deliberations that he was a Soviet intelligence agent. White, however, had been highly respected and was in line to become the first manag- ing director of the IMF when the scandal broke. Indeed, as a historical footnote, if White and successor Americans had headed the IMF instead of the Europeans who rose to the post-scandal occasion, IMF policy orientation over the decades would likely have been more favorable to the United States, especially as related to exchange rate policy.

Copyright © 2015 MAPI All rights reserved. 15 members not to manipulate their currencies to gain an unfair competitive advantage in trade, with currency manipulation defined as protracted, large-scale official purchases of foreign exchange, which have the direct and immediate effect of holding a currency below its market- based level. And thus the second stage of the IMF exchange rate system was launched, with largely market-based exchange rates for major currencies, but still with the dollar playing the central role as reserve and transaction currency. This system worked reasonably well until about There is currently no 2000, with trade adjustment responding to very large market-based changes in exchange rates. From 1971 coherent system for to the mid-1980s, the Japanese yen rose from 360 to exchange rate policies and about 100 to the dollar, the Swiss franc did likewise, no serious discussion in from 4.3 to 1 to the dollar, and other European cur- the IMF about compliance rencies experienced triple-digit appreciation as well. with IMF exchange rate In systemic terms, economists studied the declining obligations need for official reserve holdings with predominantly market-based exchange rates, and made proposals for an orderly decline in excessive official holdings. The call for greatly reduced official reserves, however, was premature, and was soon overtaken by financial system stage three. The third stage of the IMF exchange rate system, since about 2000, is largely a misnomer: there is currently no coherent system for exchange rate policies and no serious discussion in the IMF about compliance with IMF exchange rate obligations. China and some other newly industrialized economies, especially in Asia, do not abide by the IMF prohibition on currency manipulation, while their share of global exports and trade surpluses of price-sensitive manufactures have increased dramatically. The formation of the eurozone monetary union has led to financial crises within the eurozone and bailouts, including by the IMF, to the point where the majority of IMF loans are to IMF members that do not have national currencies or exchange rates. And the United States, still playing its centralized dollar role for reserve currencies, is in policy denial, most glaringly in the required semiannual reports by the secretary of the Treasury to the Senate Banking Committee, stating that no IMF member, including China, has been manipulating its currency in violation of IMF Article IV. More specifically, recent IMF discussion centers on External Sector Reports by the secretariat of the international accounts and policies of the largest economies. These reports encompass a wide range of “norms,” such as appropriate levels of exchange rates, temporary influences, and the performance of monetary, fiscal, healthcare, and other policies. This procedure has been appropriately summarized: “Too much judgment makes norm-setting a black box.”5 In any event, these judgmental deliberations are certainly not going to lead to serious discussion of currency manipulation in violation of IMF Article IV. In parallel, protracted, large-scale purchases of foreign currencies continue, including by nations that have current account surpluses and excessively large currency reserves, some of which is conveniently invested abroad through sovereign wealth funds. And the dollar remains at the center through a passive U.S. exchange rate policy, making the United States the importer of last resort for the mercantilist exchange rate strategies of export competitors. This current international financial non-system is the most threatening to the overall multilateral economic system, as its mercantilist workings lead to unsustainable trade imbalances, in political as well as commercial terms, most importantly for trade in technology-intensive 5 From a presentation by Joseph Gagnon, “Comments on the IMF’s 2013 External Sector Report,” during a meeting on this subject at the Peterson Institute, September 27, 2013.

Copyright © 2015 MAPI All rights reserved. 16 manufactures between the United States and China, as explained in Part One. It is also accel- erating the transition of dollarized financial markets to some form of multi–key currency relationship, as addressed in the following section. The Bretton Woods trading system has also experienced a far-reaching decline away from the original multilateral structure, but it held together longer than the financial system and does not currently face a major protectionist reversal from the much lower-level trade barriers achieved on a multilateral basis. The GATT conducted eight “rounds” of trade liberalizing negotiations beginning in 1949, principally among the industrialized nations. The two most important rounds were the Kennedy Round, concluded in 1967, with the central undertak- ing an across-the-board 50% reduction in industrial tariffs, a bold U.S. initiative to reduce trade diversion from a more inwardly oriented European Community, and the Uruguay Round agreement of 1991, which included greater participation by the newly industrialized nations and creation of a more broadly structured and permanent World Trade Organization. But during the more than 40 years of progressive trade liberalization on a multilateral, non- discriminatory basis, there was also a second track of selective free trade agreements, as permitted by GATT Article XXIV. The European Coal and Steel Community was launched in 1951, only six years after WWII, and has since expanded greatly in policy scope and membership as the European Union (EU). The United States and Canada also implemented a free trade Auto Pact in 1965, which was broadened to a comprehensive U.S.-Canada FTA in 1988, and extended to include a major newly industrialized country, Mexico, to become the North American Free Trade Agreement of 1993.6 These two comprehensive regional free trade agreements, however, largely reinforced the momentum toward free trade on a multilateral basis, which was occasionally discussed. This multilateral trade-liberalizing course has fundamentally changed since 1991, however, with the failure of the WTO to continue the process of multilateral trade liberalization during the 14 years of Doha Round negotiations and the wide-ranging proliferation of bilateral and regional FTAs outside the WTO to the point where most-favored-nation tariffs inscribed in WTO schedules have largely become least-favored-nation tariffs in practice. This radical shift away from a trade-liberalizing multilateral trading system is the result of growing differences in trade strategy among the highly diverse trade interests of developing countries and rigidities within the WTO structure, such as the consensus rule for some agreements and one vote per member on other decisions where developing countries with a small share of world trade have a majority of WTO votes. The result has been near-hopeless impasse in the Doha Round and the growing network of FTAs outside the WTO. Moreover, these FTAs have been predominantly within and among the three industrialized regions that account for 90% of manufactured exports, while the majority of WTO members within the 10% residual export grouping are increasingly outsiders to the FTA networks. More specifically for the 10% grouping, within the Americas, when negotiations for a Free Trade Area of the Americas (FTAA), from 1994 to 2005, failed, the United States negotiated bilateral FTAs with like-minded free traders, including Chile, Colombia, and Peru, while members of the Mercosur grouping, centered on Brazil and Argentina, have become increasingly oriented toward commodity exports and are more protectionist in their trade strategies. Likewise, the Eurasian Economic Union between Russia and some former members of the Soviet Union has resisted more open trade with the EU and other liberal trade forums. The adverse results for export competitiveness for manufactures for Brazil and Russia were presented in Table 2. 6 See Ernest H. Preeg, NAFTA: A 50-Year Success Story for U.S. Manufacturing, (MAPI Foundation, 2014).

Copyright © 2015 MAPI All rights reserved. 17 As for the proliferation of FTAs, it has moved forward on both the bilateral and regional levels. U.S. FTAs in the Americas have already been noted. The EU, since the end of the Cold War, has actively negotiated FTAs with Central and East Europeans, in some cases leading to EU membership. And Asians are pursuing numerous bilateral and sub-regional FTAs, recently including participation by China and India, which are likely to have substantial preferential trade-creating results. And there are now two major regional FTA negotiations underway across the Pacific and the Atlantic: the Trans-Pacific Partnership negotiations, with participation by NAFTA members, South American free traders, and some Asians, including Japan, Malaysia, and Vietnam, and the Trans-Atlantic Trade and Investment Partnership (TTIP) negotiations between the United States and the EU. These wide-ranging paths for trade liberalization within preferential FTAs, sweeping aside multilateral trade liberalization within the WTO, raise the systemic question of whether these many FTAs should be consolidated into a plurilateral FTA, linked to the WTO, and open- ended for other WTO members to join. Such an initiative is addressed in the policy proposals that follow, but is raised here in the context of FTA proliferation to highlight the path-break- ing role in this direction being played by South Korea. South Korea has concluded FTAs with the United States and the EU, and is in the final stages of FTA negotiations with China. Seoul There are now two major would therefore be the ideal location for an ini- regional FTA negotiations tial consultative group discussion for launching such a plurilateral consolidation of bilateral and underway across the Pacific and regional FTAs, as proposed below. the Atlantic: the Trans-Pacific Partnership (TPP) negotiations, This concludes the historical account of the and the Trans-Atlantic Trade and serious decline since 2000 in the multilateral financial and trading systems created at Bretton Investment Partnership (TTIP) Woods 71 years ago. Before turning to proposals for restoring a more balanced, multilateral system, however, a fundamental shift underway in financial relations, that will critically influence the international economic course ahead, needs to be addressed: The transition of the dollarized financial system of the past seven decades into some form of multi–key currency relationship.

The Dollar Twilight Dilemma In 1960, Yale Professor Robert Triffin predicted that the exchange rate system adopted at Bretton Woods of currencies pegged to the dollar and the dollar convertible to gold would soon end, and this became known as the Triffin Dilemma. It was a dilemma because either of the two alternative courses ahead—continued large U.S. trade deficits financed by others in dollars or a substantial devaluation of the dollar to reduce the deficit—would produce the same fatal result for the dollar peg / gold convertibility system. And this is what happened in August 1971, as described earlier. The financial system today, with historic irony, faces a similar dilemma, which can be called the dollar twilight dilemma. The same two alternative courses lie ahead: continued large U.S. trade deficits financed by others in dollars or a substantial devaluation of the dollar to reduce the deficit. The dilemma impact on the financial system this time, however, will be more far- reaching and involve transition from the dollarized system of the past seven decades into some

Copyright © 2015 MAPI All rights reserved. 18 form of multi–key currency relationship. And this, in turn, will have greater consequences for international trade and investment than occurred in the 1970s. I first presented this looming dollar twilight dilemma in 2013,7 but at that time almost all financial experts dismissed such an outcome in view of the continued overwhelming role of the dollar as a transaction and reserve currency.8 Developments have since been moving away from such a dollar-centric financial relationship, however, and there has been growing interest in where the dollarized system is heading. For example, in the fall 2014 edition of The International Economy, 24 financial experts were asked whether the dollar will remain the reserve currency. Most replied that the dollarized system would remain for a long time if not permanently, with responses such as “The dollar will not be replaced,” “The U.S. dollar is far from being challenged,” and “I see no shift from the dollar.” Some others, however, saw a likely transition underway from the dollarized system: “A tectonic shift is beginning,” “The world is gradually evolving toward a multi-currency system,” and “We could eventually see a global system with three blocs.” My response to the question is that transition to a multi–key currency relationship is not only underway but closer upon us than almost all experts project because analysis of recent forces in play has not been adequately addressed. The radical restructuring of world trade in the dominant manufacturing sector presented in Part One is the most important such driv- ing force. The decline of the U.S. share of global exports of manufactures from 18% in 2000 toward 10%, and the almost doubling of the sectoral U.S. deficit since 2009 toward $600 billion, are hard facts pointing to a more imminent dollar transition. The following four inter- acting forces in play will also influence the path toward a multi–key currency world, but face uncertainties and are in need of more in-depth analysis: • the shift from the dollar to other currencies to finance trade; • the rise of the euro and the Chinese yuan as reserve currencies; • the rapidly rising official U.S. debt to $18 trillion, of which $11 trillion is held by foreigners, and; • anticipated actions by the United States to curtail currency manipulation.

The shift from the dollar to other currencies to finance trade. This is the most clear and best- documented dimension of the decline of the dollarized financial system. Trade in the European region is shifting to financing in euros and other European currencies, while the share of Chinese trade financed in yuan has soared from almost nothing in 2009 to about 25% in 2014. The yuan has risen to become the fifth largest currency for international payments from number 23 in 2013. In December 2014, 45% of international payments were in dollars, 28% in euros, 8% in sterling, 3% in yen, and 2% in yuan. Thus less than half of payments are now financed in dollars and this share will continue to decline. China has actively promoted this shift to yuan financing through the recent establishment of a network of clearing banks that makes the yuan convertible for financing trade. Such yuan financing had been carried out principally through Hong Kong, but in March 2014 the Bank of England and the People’s Bank of China signed such a clearing account, and eight other accounts were established in Frankfurt, Luxembourg, Sydney, and elsewhere during the course

7 Ernest H. Preeg, Twilight of the Dollar With Technology-Intensive Manufacturing at Center Stage (MAPI Founda- tion, 2013) pp. 9-17. 8 “Will the Dollar Remain the Reserve Currency? Is the rising global chorus to replace the dollar a reflection of far deeper problems in the world financial system?”, The International Economy, Fall 2014, pp. 16-31.

Copyright © 2015 MAPI All rights reserved. 19 of the year. One provision related to the China–South Korea FTA, now in the final stages of negotiation, is that bilateral trade will be financed in the two currencies of the participants and no longer in dollars. A connection of this issue with the trade analysis for manufactures in Part One is the dispar- ity of U.S. export concentration by region, far higher for North America, where trade financing in dollars will remain dominant, and much lower in Europe and Asia. Overall, almost all predictions are for a continued rise of trade financing in yuan and other currencies and a corresponding decline in dollar financing of trade. In view of the leading-edge importance for the dollarized financial system of this shift away from dollar financing of trade, it would be useful if some organization provided quarterly reports of trade financing by the five major currencies, broken down by principal regions of trade. The rise of the euro and the yuan as reserve currencies. This is a less clear dimension of the dollar twilight dilemma than trade financing because of uncertainties about the course ahead for the euro and the yuan. Since 2009, the dollar has accounted for a little more than 60% of total official reserve holdings, the euro about 25%, and the remainder has been scattered among smaller reserve currencies, with the yuan at less than 1%. The reasons for the uncertainty about the euro and the yuan, however, are entirely different. The problem with the euro is not its availability as a convertible currency for reserve holdings, but uncertainty about its future, even its survival, in the face of continued large internal financial and trade imbalances. Each time an internal financial crisis intensifies, as in the current case of a possible Greek exit from the eurozone, there is a modest shift in reserve holdings out of euros and into dollars, and then back to the 60/25 relationship when the crisis subsides. No attempt is made here to predict how and when the uncertainty about the future of the euro will be resolved. The only conclusions offered are that as long as the uncertainty continues, the 60/25 dollar/euro relationship is also likely to continue, and if resolution of the internal One provision related to the eurozone financial crisis is achieved to the sat- isfaction of financial markets, the euro share of China–South Korea FTA, now in global reserve holdings will rise significantly at the the final stages of negotiation, expense of the dollar share. is that bilateral trade will be financed in the two currencies The outlook for the yuan as a reserve currency is more important for the course ahead, and while of the participants and no also fraught with uncertainty, is likely over time longer in dollars to experience a rise to become one of three principal reserve currencies, together with the dollar and the euro. Chinese policy is to have the yuan become a major international currency, including as a reserve currency, and the central barrier to this is the lack of yuan convertibility, which is maintained to prevent a rapid rise of the exchange rate and a consequent decline in export competitiveness. But small, cautious steps for convertible yuan financial assets have been taken over the past several years and market pressures are building for such convertibility to accelerate. The “dim sum bond” market for yuan-denominated debt issues outside of China has soared from $1 billion in 2010 to $12 billion in 2013. The rapid rise of yuan trade financing facilities has already been noted. In November 2014, the Shanghai-Hong Kong Stock Connect was launched. It allows offshore investors to buy $49 billion in mainland stock shares, which is a first step toward opening the Chinese stock market to global investors. Together, these are still relatively small openings to currency convertibility, but they point to the direction being pursued by Chinese authorities.

Copyright © 2015 MAPI All rights reserved. 20 As for foreign central bank purchases of yuan assets, the Canadian province of British Colombia was the first to add a dim sum bond to its reserve holdings in 2013. The UK government issued $1 billion of yuan-denominated bonds in October 2014, and Australia announced the intent to hold 5% of its reserves in Chinese bonds. These are all small steps, but the growth could quicken, especially if the Chinese government were to facilitate the acquisition of yuan bonds or other convertible yuan-denominated financial assets by central banks. Looking ahead, a decisive point for transition from the dollarized financial system will be when the share of official reserves in dollars drops from 60% to below 50%. The rapidly rising U.S. official debt to $18 trillion, of which $11 trillion is to foreigners. The potential impact of this development on the dollar twilight dilemma has received almost no attention, but it could be a large, market-driven force for transition out of the dollar. The rise of total U.S. official debt to $18 trillion is the subject of frequent political discussion. It is rarely reported, however, that the foreign-owned share of this debt has more than quadrupled from $2.6 trillion in 2000 to $11 trillion in 2014. About half of this $11 trillion is held by foreign central banks and the remainder by private creditors. An important link of this surge in foreign official debt to the dollar twilight dilemma is the negative impact of interest payments on this debt for the U.S. current account deficit. These interest payments have been relatively small over the past several years because the Treasury rate has been extremely low, thanks largely to the Fed’s quantitative easing policy, which has now ended. And again, while increased interest payments from a higher Fed rate on the fiscal deficit is discussed, little account is taken of the corresponding adverse impact on the current account deficit, which will be relatively greater, and involves two mutually reinforcing dimensions. A 1% rise in the interest rate paid on the $11 trillion of foreign official debt translates into a $110 billion increase in the current account deficit, currently about $400 billion per year, and a 3% rise would almost double the current account deficit to 4% of GDP, excessive by IMF standards. As for the two dimensions, they can be referred to as the macro-policy and exchange rate effects. The macro-policy dimension is simply the anticipated rise in interest payments as the Fed rate rises in response to higher inflation, and with the end of quantitative easing this is a question not of whether but of when. A rise in the Fed rate of 2% or more over the next couple of years is not unreasonable, and as these higher rates are applied for refinancing existing foreign debt and financing continued large trade deficits, the current account deficit will also rise. The exchange rate dimension is far more difficult to predict, but it could be more powerful and pointed in its impact. If financial markets—and central banks—judge that the prolonged U.S. large trade deficit will likely lead to a substantial decline in the dollar, some holders of the foreign official debt will shift their dollar holdings to other currency financial assets. And this, in turn, will lead to an even larger actual decline in the dollar, a still higher Treasury rate, and a further increase in the current account deficit. A key indicator to watch therefore is the U.S. current account deficit. If it grows substantially as a result of a further increase in the trade deficit for manufactures and higher interest payments on the foreign debt, the market signals to shift out of dollars will also increase. Anticipated actions by the United States to curtail currency manipulation. This final development relates to market reactions to anticipated U.S. policy actions to curtail currency manipulation. The subject is discussed in the following section, including a proposal for such U.S. action. It is raised here, however, because market—and central bank—anticipation of a successful U.S. action, which would mean a substantial rise in the Chinese and some other currencies, and a

Copyright © 2015 MAPI All rights reserved. 21 corresponding decline in the dollar, will motivate yet further shifting out of the dollar into other currency financial assets, and again a further increase in interest payments on the foreign debt, with adverse impact on the U.S. current account deficit.

* * * *

This concludes the assessment of the dollar twilight dilemma, or perhaps the Preeg dilemma for short, based on the outlook for a continued large U.S. trade deficit, centered on the manufacturing sector, leading to a substantial decline of the dollar at some point, with a resulting transition from the dollarized financial system of the past seven decades to some form of multi–key currency relationship. No precise timetable is attempted for this transition. The dollar has been rising, which is leading to a larger trade deficit in manufactures, bottoming out of oil prices and reduced domestic drilling mean a smaller decline in oil imports, and interest payments on the foreign official debt will rise. As a The fundamental systemic result, the current account deficit will grow, perhaps change will be that the substantially, over the next couple of years, while United States will no longer anticipation of a decline in the dollar will conse- be the dominant center of quently grow, confirming the assessment that the the system, maintaining a transition to a multi–key currency financial world is passive exchange rate policy moving at a faster pace than most observers realize. and acting as importer of last But the precise time scenario cannot be predicted. resort for export competitors The dollar transition also raises a number of policy engaged in mercantilist questions as to what kind of multi–key currency exchange rate policies relationship will emerge, how it will operate, and in particular what rules might be adopted to limit mercantilist exchange rate policies. The fundamental systemic change will be that the United States will no longer be the dominant center of the system, maintaining a passive exchange rate policy and acting as importer of last resort for export competitors engaged in mercantilist exchange rate policies. One approach would be restoration of a rules-based exchange rate system for major currencies, as proposed in the following section. A more threatening alternative would be even more powerful financial market forces in play, with more autonomous national exchange rate policies, and a greater threat of currencies wars.

A Two-Track Initiative to Restore a Fair and Balanced Multilateral System The previous two sections described the serious deterioration of the rules-based multilateral economic system created at Bretton Woods in 1944, centered on growing trade imbalances in the dominant manufacturing sector and the transition of the dollarized financial system into some form of multi–key currency relationship. Current official discussions are not seriously addressing actions to reduce these imbalances and restore a rules-based multilateral system, most importantly related to the trade impact of exchange rate policies. Such a restoration strategy is therefore proposed here to help focus the official minds. The United States, as explained in the concluding section of this report, will have to play a strong and sustained leadership role if there is to be such restoration. The U.S. initiative would thus begin with a comprehensive strategy statement by the president. He or she would state that the United States is no longer able or willing to sustain extremely large and growing trade

Copyright © 2015 MAPI All rights reserved. 22 deficits in strategic, technology-intensive industries, with consequent large current account deficits and a further buildup of the $11 trillion official foreign debt. A major reduction if not elimination of the deficits is needed and will require both a domestic economic agenda to stimulate technology-oriented job creation and growth and major changes in the international economic system to ensure fair and balanced trade in ever more globalized markets. The domestic economic agenda is not addressed here, and the following focuses on the trade and exchange rate policy dimensions of the agenda. The starting point for the international agenda to restore a rules-based multilateral system is that exchange rate and trade policies are deeply interrelated and need to be dealt with jointly. Moreover, since the trade-distorting impact from mercantilist exchange rate policies is currently by far the larger deterrent to fair and balanced trade, while trade barriers are relatively low among the largest trading nations, the proposed agenda begins with restoration of IMF and WTO obligations not to pursue such mercantilist exchange rate policies, followed by a two-stage trade strategy to negotiate an open-ended plurilateral FTA within the WTO, and concludes with the linkage of exchange rate and trade policy commitments within the restored multilateral system. Restoration of IMF and WTO obligations not to pursue mercantilist exchange rate policies. IMF Article IV obligates members not to manipulate their currencies to gain an unfair competitive advantage in trade, with manipulation defined as protracted, large-scale official purchases of foreign exchange that have the direct and immediate effect of lowering the exchange rate below its market-based level. IMF members are also obligated to maintain convertible currencies, at least on current account. The WTO, under GATT Article XV, states that members shall not, by exchange rate actions, frustrate the intent of the agreement, which centers on reciprocal access to markets for trade. As recounted earlier, these exchange rate obligations, despite periodic disputes, were generally honored from 1971 to about 2000 by the principal industrialized trading nations, but have since been greatly violated, most importantly by China. China has purchased about $4 trillion of foreign exchange over the past dozen years, which is protracted and large scale by any con- ceivable definition. As a result, China has run a very large current account surplus, centered on a growing trade surplus in price-sensitive manufactures that reached $1 trillion in 2014, and holds a greatly excessive level of $4 trillion of foreign currency reserves. Some other Asian nations, with China their dominant trading partner, have linked their currencies to the yuan, which has resulted in currency manipulation on their part as well, and growing trade surpluses in manufactures, particularly with the United States. The de facto repudiation of IMF Article IV has come from the United States. Twice each year, over more than 10 years, the secretary of the Treasury, as required, has reported to the Senate Banking Committee that no nation, including China, has manipulated its currency in violation of its IMF obligations. In other words, currency manipulation does not exist, and therefore there is no reason to discuss it in the IMF. This has also created a trade policy conflict between the president and the Congress. Bipartisan majorities in both houses have pressed the president to include a provision within the TPP trade agreement prohibiting currency manipulation. But if the secretary of the Treasury states every six months that currency manipulation does not exist, how can the trade representative pursue a major provision for such a nonexistent problem? The obvious U.S. policy response is for the secretary of the Treasury, in his next semiannual report, to state that China and some others are indeed manipulating their currencies to gain an unfair competitive advantage in trade, and that such manipulation should stop, or else. This,

Copyright © 2015 MAPI All rights reserved. 23 in fact, almost happened in 2012, when presidential candidate Romney stated that, if elected, he would declare China a currency manipulator on day one of his presidency, but, of course, he lost the election. If the United States does take on the currency manipulation issue, as proposed here, the question is what happens next after the initial accusation, and what is meant by “or else”? This will depend on how China and others accused of currency manipulation react. There would certainly be bilateral consultations and discussion in the IMF. Perhaps China, taking the United States seriously and realizing the weakness of its position related to IMF Article IV, would agree to a prompt and orderly transition to a market-based, convertible currency, free of currency manipulation. Essentially, China would end official foreign currency purchases, at least as long as it maintains a current account surplus, and make its currency convertible on current account, which is what the major industrialized trading nations have done since the 1970s. There are reasons such agreement might emerge. China needs to restructure its economy away from greatly excessive, environmentally devastating industrial production, driven by a $1 trillion annual trade surplus in manufactures. And the United States has trade-bargaining If the United States does take leverage, with imports from China of strategically on the currency manipulation important manufactures five to six times larger than U.S. exports to China. issue, as proposed here, the question is what happens next If, however, early agreement cannot be reached, after the initial accusation, and the United States would have to take countervail- what is meant by “or else”? ing action, which cannot be proposed in specific terms without knowing the initial Chinese reaction. There could be an interim surcharge imposed on imports from China, as the United States did in similar circumstances in August 1971. Since the IMF does not have a dispute settlement mechanism, the United States, in parallel, could request a WTO dispute panel based on GATT Article XV obligations, which would follow the same substantive lines as being raised in the IMF consultations. Additional steps could include counter U.S. purchases of Chinese bonds and other convertible financial assets to the extent they were available. A more forceful action, as practiced against currency manipulation during the 1930s, would be some form of import licensing requirement for currency manipulators, with a set quantity of licenses put up for auction. Whatever the U.S. strategy for confronting Chinese and other currency manipulation, it should be pursued in concert with trading partners also suffering the adverse trade effects from the manipulation. Certainly NAFTA partners Canada and Mexico would fall in this category, and the EU should likewise want to restore IMF exchange rate obligations, especially as long as the United States remained out front in dealing with China. Within Asia, the reactions would be mixed, but at least some would see the benefits over the longer term of more secure and balanced trade relationships with China and the United States. In addition to the specific form of currency manipulation contained in IMF Article IV—protracted, large-scale official purchases of foreign exchange—other charges of currency manipulation have been made, including by members of the U.S. Congress, which would need to be addressed, although a case for violation of existing IMF obligations would generally not be feasible. For example, when senior officials talk down their currency to gain a competitive advantage in trade, even when their economy is in sustained large current account surplus, as has been the recent practice by eurozone leaders, this can be considered unjustified currency manipulation with mercantilist intent. The far more important monetary policy issue of

Copyright © 2015 MAPI All rights reserved. 24 maintaining extremely low if not negative interest rates through quantitative easing and other measures, which also puts downward pressure on the exchange rate, is far more complex. The United States led the recent way in this area, a path that is now being followed by the eurozone and Japan. One distinction that can be raised is that the mercantilist result from such monetary policy is more detrimental for balancing external accounts when the quantitative easer is in large current account surplus, as is the eurozone, than when done by a nation in large current account deficit, as was the United States. But this monetary policy relationship to currency manipulation will center on bilateral discussions rather than IMF obligations. A two-stage trade strategy to negotiate a plurilateral FTA within the WTO. The deterioration of the multilateral trading system adopted at Bretton Woods, based on the most-favored-nation principle of progressively lower, non-discriminatory barriers to trade, was addressed earlier in terms of the proliferation of discriminatory bilateral and regional free trade agreements in recent years, together with stalemate in WTO multilateral trade liberalization. These FTAs lead to more open and liberal aggregate trade, but the political orientation of competing economic blocs poses the threat of more inward-directed regional economic strategies, which could lead to trade conflict. In any event, the gains from trade for all nations would be increased through a return to a non-discriminatory multilateral trade relationship among all, or almost all, major trading nations, as proposed here. The proposal is for a two-stage process over the next several years to consolidate the many bilateral and regional FTAs into an open-ended plurilateral FTA within the WTO. Stage one would be completion of the two major regional FTAs under negotiation—the TPP and the TTIP—plus any other FTAs that may be concluded, especially within Asia. These two regional FTAs, in particular, would become comprehensive building blocks for the consolidation of all FTAs within the plurilateral agreement. The current outlook for the TPP and the TTIP is not elaborated here. They are in the final stages of negotiation and will likely reach a decisive conclusion, one way or the other, over the coming year. The United States should place high priority on their successful conclusion, and the bipartisan congressional support needed for approval would be greatly strengthened if the United States, in parallel, took firm action to end mercantilist currency manipulation, centered on China, as proposed in the previous section. The mutual gains from trade for the United States from the FTAs could then be more clearly demonstrated, especially in trade with countries with higher levels of protection to begin with, such as Malaysia and Vietnam within the TPP negotiations. The stage two consolidation of all FTAs into a plurilateral agreement would be a broadly defined initiative launched by preparatory discussion within a high-level consultative group. Such a group could be established in 2015 or 2016, and its conclusions, including a decision to begin formal negotiations, would probably take at least a year, during which time the outcome for the regional FTAs and actions to end currency manipulation would become clear. The ideal location for launching the consultative group, as noted earlier, would be Seoul, South Korea, in view of South Korea’s FTAs concluded or under negotiation with the United States, the EU, and China, and the fact that the four of them together account for 60% of global exports of manufactures. A big initial question is whether China and India would participate in the consultative group, and there is good reason to believe that they would. Both have recently become engaged in FTA negotiations within Asia, so participation in preliminary discussion of a broader, plurilateral FTA should be in their interest. A recent analysis of the mutual benefits of a U.S.-China

Copyright © 2015 MAPI All rights reserved. 25 FTA was favorable for both countries, and the benefits from a broader FTA should be even more so.9 The linkage of a plurilateral FTA to prohibition of currency manipulation, as discussed below, would likely be opposed by China, but this should not prevent China from participating in preparatory trade discussions. The engagement of India in a plurilateral FTA initiative is more promising in view of the economic reforms, including more open trade and investment, being pursued by Prime Minister Narendra Modi, and the fact that Indian economic growth is now comparable to that of China. The recent strengthening of U.S.-Indian relations, as declared during President Obama’s visit to India in January 2015, also demonstrated mutual foreign policy as well as commercial interests in a deepening economic relationship between the two largest democracies. Indeed, a more immediate trade initiative, which would add greatly to the momentum for a stage two plurilateral agreement, would be negotiation of a U.S.-India bilateral free trade agreement over the next couple of years, which should be given serious consideration by both governments.10 For U.S. manufactured exports, it is important to note that even if China chooses not to be an initial participant in a plurilateral FTA, at least 70% of U.S. global manufactured exports could still be to markets open to free trade, as shown in Table A more immediate trade 3: 35% of U.S. manufactured exports go to NAFTA trad- initiative, which would add ing partners, 20% to West Europe, and another 15% to greatly to the momentum South Korea and other actual or potential FTA partners, for a stage two plurilateral including Japan and other Asians within the TPP. Only agreement, would be 7% of U.S. manufactured exports go to China, although negotiation of a U.S.- 27% of imports come from China. India bilateral free trade A plurilateral FTA would be broad in scope, in effect a agreement trade and investment agreement, although not as comprehensive and detailed as some U.S. bilateral agreements, such as NAFTA and the pending TTIP. But it should eliminate almost all tariffs and other border restrictions on trade, and include a number of non-tariff barriers. Some of these issues were discussed by the principal participants in the Doha Round or are contained in existing plurilateral agreements within the WTO, such as for government procurement, all of which could be strengthened in a plurilateral FTA. In systemic terms, the plurilateral agreement would be incorporated in the WTO, with access to dispute settlement and other procedures within the organization, although with an independent management structure for the implementation and continuing evolution of the plurilateral agreement. Important in this regard would be an open-ended provision to welcome entry by other WTO members as they saw it in their interest to be inside rather than outside a free trade agreement accounting for the majority of world trade. The linkage of exchange rate and trade policy commitments within the multilateral system. A successful outcome for an initiative to end currency manipulation, centered on the United States and China, would be the principal linkage between exchange rate and trade policies, but some explicit commitment within the WTO plurilateral FTA would also be appropriate. The fact that the IMF does not have a dispute procedure for dealing with violations of IMF obligations related to trade, together with the underlying linkage of trade and exchange rate policies, 9 See C. Fred Bergsten, et al., Bridging the Pacific: Toward Free Trade and Investment between China and the United States (Peterson Institute for International Economics, 2014). 10 For background and analysis of a U.S.-India FTA, see Ernest H. Preeg, India and China: An Advanced Technology Race and How the United States Should Respond (MAPI and CSIS, 2008).

Copyright © 2015 MAPI All rights reserved. 26 justifies some form of explicit inclusion in the plurilateral agreement. It could take the form of a statement of how the policies are deeply related and that GATT Article XV is available to resolve any dispute that should arise, including as related to IMF obligations. It could also be emphasized that an undervalued exchange rate has an across-the-board mercantilist impact on trade, providing increased protection for all imports and a subsidy for all exports. An alternative would be to build a trade/exchange rate dispute procedure within the FTA, although a more targeted commitment to Article XV obligations would probably be sufficient and preferable.

* * *

This is the proposal for a two-track initiative to restore a fair and balanced multilateral trade and financial system. It is practical and feasible, although the showdown over currency manipulation with China would likely be the most important international economic issue of dispute since August 1971, or even greater in view of current Chinese financial policies essentially operating outside the IMF system of currency convertibility and the prohibition of specifically defined currency manipulation. The decisive question as to whether such a comprehensive initiative will be launched over the next couple of years is whether the necessary strong and sustained leadership will be forthcoming, and the judgment offered here is that this can only come from the United States.

The Indispensable U.S. Leadership Role Henry Kissinger’s recent, monumental World Order11 traces the course of nation state relationships as defined and launched by the Treaty of Westphalia in 1648, stressing the importance of balanced power relationships to maintain a peaceful, rules-based system of sovereign states. His focus is on political relationships and the tragic wars that occurred when one participant— France, Germany, the Soviet Union—became overly powerful and felt itself beyond rules- based, nation state constraints. The Kissinger book, however, treats economic relationships lightly, and this study therefore constitutes an adjunct work for the economic order as created at Bretton Woods in 1944, a rules-based trade and financial system among nation states, and their often-troubled power relationships that have intensified since 2000. A parallel can indeed be drawn that China, with a $1 trillion annual trade surplus in manufactures and $4 trillion in the central bank, now feels itself beyond rules-based IMF financial constraints. The Kissinger book also stresses the critical role of leadership for maintaining an orderly nation state system, and is most detailed for the U.S. leadership role during the 20th century of hot and cold wars: “American leadership has been indispensable, even when it has been exercised ambivalently.”12 And again, such American leadership has characterized the course of the Bretton Woods economic system, as recounted here, and it is fitting to conclude this study with comment on the daunting and indispensable U.S. leadership challenge for the world economic order in the immediate years ahead. Restoration of the rules-based trade and financial system will center on the Big Three global economic powers—the United States, China, and the EU—but the indispensable leadership for achieving this rests solely with the United States. The other two are currently beset by over-

11 Henry Kissinger, World Order (Penguin Press, 2014). 12 Kissinger, op. cit., p. 373.

Copyright © 2015 MAPI All rights reserved. 27 riding internal economic interests and lack the forward-looking political cohesion necessary to confront the serious and possibly fatal challenges facing the world economic order. Chinese economic strategy is heavily oriented to high export growth and a massive trade surplus for the technology-intensive manufacturing sector, while the top-priority EU economic challenge is to resolve financial crises within the eurozone, which benefits from a large trade surplus with non-members. This leaves the United States as the only one of the Big Three in a position to provide the necessary forceful and sustained leadership for restoring the rules-based multilateral system. U.S. leadership, in fact, has been at the forefront for 70 years, from the creation of the multilateral system at Bretton Woods through the series of trade-liberalizing GATT rounds, the reformula- tion of exchange rate policy obligations in August 1971, and the more recent proliferation of bilateral and regional FTAs. But the economic power base for forceful U.S. policy leadership has substantially diminished since 2000, as presented in Part One, with the U.S. global market share for the dominant manufacturing sector of trade down toward 10% and the sectoral trade deficit approaching $600 billion. And this, in turn, is precipitating transition of the dollarized financial system into some form of multi–key currency relationship. The conclusion drawn here, however, is that despite this decline in the U.S. relative power position within the economic system, the United States still can and should play the decisive leadership role, in the mutual economic interest of all trading nations, for restoration of a multilateral, rules-based economic system. Such leadership will require a forward-looking strategy based on two fundamental economic relationships that have not been part of recent official deliberations. The first is that trade and exchange rate policies are deeply linked substantively and need to be brought together within the multilateral system. In a world of ever-lower trade barriers, Despite this decline in the exchange rates are the principal policy instrument U.S. relative power position for achieving fair and balanced trade, particularly within the economic system, for price-sensitive manufactures. And second, the United States is no longer able or willing to sustain the United States still can a passive exchange rate policy at the center of a dol- and should play the decisive larized financial system, and thus accepting the role leadership role for restoration of importer of last resort with a very large current of a multilateral, rules-based account deficit. economic system From these two fundamentally changed relationships, a specific strategy to restore a linked and rules-based multilateral trade and financial system has been outlined in the previous section. Implementation of such a strategy would proceed on three distinct tracks with trading partners. The first track would be to build a consolidated grouping of like-minded advanced and newly industrialized trading partners in support of the strategy. This should be relatively straight- forward given forceful and forward-looking U.S. leadership. Canada and Mexico are in basic conformity with the strategic objectives within NAFTA, and the EU is essentially in line, albeit in shorter-term eurozone financial difficulties. Asian reactions would be mixed, but Japan, South Korea, and some other newly industrialized exporters should see the strategy in their longer-term interest, especially if the United States confronts China over exchange rate policy. And some South American and other nations would also prefer to be inside rather than outside the like-minded grouping. The second track would be with China, and it would be a showdown between China’s widespread disregard for the Bretton Woods rules-based economic system, most importantly as

Copyright © 2015 MAPI All rights reserved. 28 related to exchange rates, and a restoration coalition led by the United States. It could lead to impasse and the imposition of interim U.S. sanctions to reduce the huge trade imbalance in the dominant manufacturing sector of bilateral trade, but more hopefully the two global economic powers could engage in serious discussion as to how they can collaborate within an economic order that would result in mutual and balanced benefits for both nations and for the broader international trading community. The United States, in any event, should make abso- lutely clear that continuing the current Chinese mercantilist route is no longer acceptable. The third track would be with the rest of the world, with a wide diversity of economic interests, from predominantly oil-exporting nations to newly industrialized nations on a more protectionist trade policy course to the large number of least-developed nations that account for a relatively small share of world trade. The most important member of this grouping is India, now engaged in a more open trade and investment strategy that should be compatible with the first track grouping. Other important trading nations, such as Indonesia and Brazil, should at least engage in serious discussion of joining in the preparatory talks, as well as about the disadvantages of remaining outside the grouping. In any event, the proposed plurilateral FTA within the WTO, linked to IMF obligations for exchange rate policy, should be open-ended as outside nations come to see it in their interest to join. And the least developed should continue to receive preferential access to markets for their exports as aid programs for job-creating, export-oriented investment move forward. * * * This is the broad picture of a U.S. leadership strategy to restore a rules-based multilateral trade and financial system. To be successful, however, as has been the case for U.S. leadership since Bretton Woods, there would need to be strong bipartisan political support. Certainly linking together further multilateral trade liberalization with a determined end to Chinese and other currency manipulation would be a big help for building large bipartisan majorities of support in the Congress. And at the risk of appearing wildly optimistic, the most important step to ensure strong U.S. leadership in the critical years ahead would be if both presidential candidates in 2016 supported restoration of a rules-based trade and financial system as a high priority, with agreement expressed during the debates. And to close on a far less optimistic note, what lies ahead in the absence of such U.S. leadership? The current course of growing trade imbalances centered on the strategically important manufacturing sector, largely without rules to contain mercantilist exchange rate policies, is headed toward conflict. National economic strategies will likely be more combative rather than cooperative. Financial markets will gather momentum in judging and acting to anticipate the next turn of events. And disruption of international trade and investment will almost certainly be increasingly painful, including for the United States.

Copyright © 2015 MAPI All rights reserved. 29 About the Author Ernest Preeg holds a Ph.D. in economics from the New School for Social Research. His engagement with international trade began by sailing from ordinary seaman up to chief mate in the American merchant marine. His government positions included member of the U.S. delega- tions to the Kennedy and Uruguay Rounds of trade negotiations, Deputy Assistant Secretary of State for International Finance and Development, Chief Economist at USAID, White House Executive Director of the Economic Policy Group, and American Ambassador to Haiti. His books include Traders and Diplomats: An Analysis of the Kennedy Round of Negotiations under the General Agreement on Tariffs and Trade (The Brookings Institution, 1970); Economic Blocs and U.S. Foreign Policy (National Planning Association, 1974); Traders in a Brave New World: The Uruguay Round and the Future of the International Trading System (University of Chicago Press, 1995); The Emerging Chinese Advanced Technology Superstate (MAPI and the Hudson Institute, 2005); India and China: An Advanced Technology Race and How the United States Should Respond (MAPI and CSIS, 2008); and Twilight of the Dollar with Technology-Intensive Manufacturing at Center Stage (MAPI, 2013).

1600 Wilson Blvd Suite 1100, Arlington, VA 22209 | mapi.net

Copyright © 2015 MAPI All rights reserved. 30 We are the thought leader and solution provider for manufacturers. Our Councils provide an op- portunity for executives to share best practices, discuss solutions to shared challenges, and become more effective leaders. Our global- eco nomic research and forecasting equips members to make better decisions. We are the thought leader on issues and policies that impact the competitiveness of the U.S. manufacturing sector.

Thought Leadership Manufacturing executives, policymakers, the media, and the association community rely on MAPI’s research to gain unbiased insight into the issues facing the manufacturing sector. Rather than lobbying, we leverage our position as a thought leader to raise awareness of what U.S. manufacturing needs to remain innovative, productive, and best-in-class. Our experts are regularly featured in outlets such as the Wall Street Journal, Businessweek, and the New York Times.

Economic Intelligence Members use MAPI’s economic intelligence to navigate the increasingly complex global marketplace. Our research sup- ports a variety of member decisions, such as expansion into new markets, scenario planning, and facility location. Our work includes forecasts and analyses for the U.S., China, India, Japan, Latin America, Europe, and Canada.

Best Practices & Executive Education By leveraging the experiences of their peers, members use MAPI to make their enterprises more competitive and to increase their personal effectiveness. Each Council holds semiannual meetings where members exchange expertise in a vendor-free roundtable setting. Outside the meeting room, members participate in group polls and benchmark surveys that provide insight into current and best practices.

List of MAPI Councils Human Resources Quality CFO Information Systems Management Risk Management Division Finance Internal Audit Sales Division Leadership Investor Relations Strategic Planning & Development Engineering / R&D Law Sustainability Environmental Health & Safety Manufacturing Tax Ethics & Compliance Marketing Treasury Financial Presidents Global Logistics & Transportation Purchasing