Globalization – session 4: The China shock and its economic consequences

1. Introduction – the China Shock

This course will help us understanding what exactly happened with that kind of globalization
in the international trade.
➥We will look at the case of the China shock.

❑ Introduction
China’s emergence as a great economic power has induced and epochal shift in patterns of
world trade. Simultaneously, it has challenged much of the received empirical wisdom about
how labor markets adjust to trade shocks. Alongside the heralded consumer benefits of
expanded trade are substantial adjustment costs and distributional consequences.
➥These impacts are most visible in the local labor markets in which the industries exposed to
foreign competition are concentrated.

❑ Summary of findings
Adjustment in local labor markets is remarkably slow:
⇢ wages and labor-force participation rates remaining depressed
⇢ unemployment rates remaining elevated for at least a full decade

Exposed workers experience greater job churning and reduced lifetime income.

At national level:
→ employment has fallen in the US industries more exposed to import competition, as
expected,
→ but offsetting employment gains in other industries have yet to materialize.

Better understanding when and where trade is costly, and how and why it may be beneficial,
is a key item on the research agenda for trade and labor economists.

❑ Background
Mainstream economists have long argued that international trade improves welfare. Although
trade may redistribute income, theory assures us that under standard conditions the gains to
winners are more than sufficient to offset any losses incurred by those suffering adverse
effects from foreign competition.

Belief in the Pareto-improving nature of trade made economists frontline advocates for the
broad-based liberalization of commerce that was embedded in the General Agreement on
Trade and Tariffs (GATT) and other institutions built to manage the global economy after
World War II.

Paul Krugman states this view vividly in his 1997 JEL article: “If economists ruled the world,
there would be no need for a World Trade Organization (WTO). The economist’s case for
free trade is essentially a unilateral case: a country serves its own interests by pursuing free
trade regardless of what other countries may do.”

 Of course, introductory trade theory also teaches us that international trade is not generally
Pareto-improving.

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In their undergraduate textbook, Krugman & Obstfeld (2008, p64) write, “Owners of a
country’s abundant factors gain from trade, but owners of a country’s scare factors lose …
Compared with the rest of the world the US is abundantly endowed with highly skilled labor
and (…) low-skilled labor is correspondingly scarce. This means that international trade ends
to make low-skilled workers in the US worse off-not just temporarily, but on a sustained
basis.”

 For the first three decades of the Bretton Woods era, however, there was little occasion to
scrutinize the benefits of trade.

Most goods flows were North-North, between nations with relatively similar average
incomes, which helped subdue distributional impacts.

View on how trade affects wages and employment turned less sanguine in the 1900s. As wage
inequality rose, low-skill wages and employment fell, and manufacturing employment
contracted in the US, globalization was seen initially as a prime suspect.

After vigorous inquiry, concern about the labor-market consequences of trade receded.
Economists did not find trade to have had substantial adverse distributional effect in
developed economies, either for low-skill workers specifically or for import-competing
factors and sectors more generally.

The broad sentiment that emerged in the literature was that labor-market developments were
primarily attributable to technological changes that complemented high-skill workers and
reduced labor demand in manufacturing.
⇢ the impact of international trade on these outcomes seemed to be modest (at best).

Several pieces of evidence favored these conclusions.

1) The share of US employment in manufacturing had been in decline since the end of
World War II, peaking at 39% of US nonfarm employment in January of 1944 and
then falling decade after decade to a low of 8,6% in June 2015.
➥the disappearance of manufacturing jobs was nothing new.

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 2) The steep rise in wage inequality and fall in fall in real wages of low-education
workers in the US and many other developed countries did not coincide closely with
rising trade openness

⇢ As Feenstra and Leamer note, the ratio of merchandise trade to GDP in the
developed world rose steeply during the 1970s but stabilized thereafter, which greatly
weakened the case for trade having caused rising wage inequality and falling low-skill
wages during the 1980s and early 1990s

3) Contrary to the predictions of textbook trade models, manufacturing industries in

developed countries appeared to be substituting toward high-skill workers despite
rising skill prices, suggesting that these industries were experiencing a skill-biased
demand shift that emanated logically from the adoption of new technology.

⇢ Although trade in the form of offshoring may produce such demand shifts, its
modest scale in the 1980s and early 1990s meant that its estimated impacts were far
smaller than those of investments in high-tech capital and equipment.

4) Finally, simple factor-content calibration exercises → which rescaled trade-good

imports into embodied labor imports → found that rising trade integration could
account for only a small part of the fall in relative wages of low-skill workers in the
US.

❑ CODA
The trade and wages debate reached something of a coda around the year 2000. The following
is a reasonable summary of the contemporaneous consensus:
1) Trade had not in the recent decades been a major contributor to declining
manufacturing employment or rising wage inequality in developed countries.
2) Workers employed in regions specializing in import-competing sectors could readily
reallocate to other regions if displaced by trade.
3) Due to the laws of one price skill, any labor-market impacts of trade would be felt by
low-skill workers generally, not by trade-exposed workers specifically.

 A corollary of these observations is that trade should affect prevailing wage levels
nationally but not employment rates locally or regionally. Moreover, given the presumed
fluidity of US labor markets, even in the short or medium run, the aggregate gains from trade
in the US should be positive.

❑ Background
Just as economists were reaching consensus on the consequences of trade for wages and
employment, an epochal shift in patterns of world trade was gaining momentum. China, for
centuries an economic laggard, was finally emerging as a great power and toppling
established of trade accordingly.
➥the advance of China, has also toppled much of the received empirical wisdom about the
impact of trade on labor-markets.

In particular, 2 myths were shattered:

1) Trade could be strongly redistributive in theory but was relatively benign in practice.

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 2) Trade adjustment is relatively frictionless, with impacts that diffuse over large skill
categories rather than being conc entreated among groups of workers in trade-
competing industries or locations.

In quantifying these impacts and adjustment frictions, recent evidence further suggests that
the short-and medium-run adjustment costs demanded by large trade shocks are sizeable
entries in the accounting of gains from trade.

China’s rise has provided a rare opportunity for studying the impact of a large trade shocks on
labor markets in developed economies. An emerging literature on this topic offers a wealth of
evidence and surprises that should catalyze and discipline research for many years.
➥This evidence calls into question the consensus of the early 2000s and makes clear that,
after the early Bretton Woods era aberration, the distributional consequences of trade are
alive and well.

Although these results do not at all suggest that international trade is in the aggregate harmful
to nations (indeed ⇢ China’s unprecedented rise from widespread poverty bears testimony to
trade’s transformative economic power) they make clear that trade not only has benefits but
also significant costs.

These include distributional costs, which theory has long recognized, and adjustment costs,
which theory has long recognized, and adjustment costs, which the literature has tended to
downplay.
➥Better understanding when and where trade is costly, and how and why it may be
beneficial, is a key item on the research agenda for trade and labor economists.

 Developing effective tools for managing and mitigating the costs of trade adjustment
should be high on the agenda for policy makers and applied economists.

This review discusses finding from the rapidly growing literature on China’s rise that have
enriched our understanding of the impact of trade shocks on developed countries.
 Discuss why China’s long-awaited re-emergence is helpful for studying the impacts of
trade on labor-market outcomes.
 Offer a simple theoretical framework that guides inquiry on measuring and
interpreting these impacts.
 Present evidence on how the China (trade) shock has affected industries and plants,
local labor market housing those plants, and individual workers employed in those
industries and local markets.
 Suggest how these results should cause us to rethink the short-and medium-run gains
from trade.
 Finally, argue that having failed to anticipate how significant the dislocations from
trade might be, it is incumbent on the literature to more convincingly estimate the
gains from trade, such that the case for free trade is not based on the sway of theory
alone, but on a foundation of evidence that illuminates who gains, who loses, by how
much, and under what conditions.

2. China’s Rise

Wall Street Journal marked the publication of its centennial edition (1989) by predicting what
the global economy would look like 25 years hence. It selected the countries that it thought
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would be growth leaders: Bangladesh, Thailand, and Zimbabwe. And those it saw as future
growth laggards: China ⇢ the newspaper prognosticated, would fail to shake off the
stultifying bureaucracy of hardline communis.
➥WSJ’s prediction reveals just how uncertain China’s future appeared in the late 1980s.
After a decade of “reform and opening” under Deng Xiaoping, hardliners had re-
established control over economic policy.

Their resurgence, fueled on the economic side by rising inflation and on the political side by
the events at Tiananmen Square, caused the reform to stall and cast doubt on China’s market
transition → Naughton 2007.

Scepticism about China’s future, although far off the mark from today’s vantage point, would
then have been entirely warranted.

China’s one-quarter century of dizzying export growth began once the reformist camp
reaffirmed its authority over economic policy in the early 1990s. Deng, launched his famous
“southern tour” in 1992 to focus national attention on the successes of earlier policy
experiments in a handful of locations on China’s east coast.

These efforts had included the creation of SEZs, which allowed foreign companies to set up
factories that imported inputs and exported final outputs, relatively free from the interference
of government minders.

 As reformers retook the helm, China embraced global markets more fully, pushing the
number of SEZs from 20 in 1991 to 150 in 2010. Inflows of FDI, which had averaged only
0.7% of GDP during the 1980s, surged to 4.2% of GDP during the 1990s and 2000s.

Production for foreign markets began a spectacular ascent, with China’s share of world
manufacturing exports growing from 2.3% in 1991 to 18.8% in 2013

To provide context
for China’s reintegration into the world economy, we highlight key aspects of its recent

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performance that inform the analysis of labor-market outcomes in developed countries. One is
the idiosyncratic nature of China’s transition from central planning to market orientation.

The momentum of this transition (which has propelled China’s trade) owes much more to
dismal conditions in China at the time of Mao’s death than to China’s subsequent responses to
contemporaneous shocks in high-income economies.

Also important is the nature of China’s post-reform manufacturing surge. When and how
China became “the global factory” are important for defining the scope and intensity of the
China trade shock.

Finally, there is the structure of global trade balances. China’s penchant for running large
current account surpluses has shaped the temporal distribution of trade gains and losses
arising from its growth.

1) China’s Rise: Making use of trade shocks

We are interested in China for 2 reasons:
 It’s large quantitative importance as an exporter of manufactured goods.
 The paucity of natural experiments in international trade.

Challenge for empirical analysis: Changes in trade policy in one country are often dictated by
changes in the behavior of its trading partners.

Consider the NAFTA, enacted in 1994: after investing heavily in Mexico in the 1980s & early
1990s, MNCs lobbied hard for the US Congress to approve the pact. The treaty’s passage,
which contributed to a further expansion in FDI, was arguably induced at least in part by the
earlier FDI.

In the NAFTA case, as in similar episode of economic opening, identifying trade’s impact on
labor markets is complicated by the joint determination of trade barriers and trade and
investment flows.

Three features of China’s experience help to overcome these challenges in identifying the
causal effects of trade shocks.
i. The first is the unexpected nature of China’s export growth, which caught many
observers (including those at the WSJ) by surprise. Even after the launching of the
reform in the 1980s, few anticipated how important China would become for the
world economy. Between 1984 and 1990, China’s share of world manufacturing
exports ticked up only modestly → from 1.2% to 1.9%.

⇢ Its trade expansion did not begin in earnest until the 1990s, 15years after Mao’s
death.

China’s post-Tiananmen crackdown made it difficult to foresee the confluence of

events that would allow it to unleash its potential. After all, the Chinese economy
had underperformed relative to Western Europe during every epoch since the
1500s.

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 ii. Second is the degree of China’s isolation under Mao, which created abundant
opportunities for later catch up. The distortions of the Maoist era kept China far
inside its production frontier.
Between 1952 and 1978 → from 3 years after the Communist Party’s rise to power
until Deng’s rehabilitation following Mao’s death → China’s GDP per capita sank
from 59th in the world to 134th out of 167 countries.

By 1991, China’s income ranking ↑ modestly from 134th to 126th.

⇢ Convergence did not begin in earnest until the rapid globalization of the ensuing
two decades.
By 2001, China’s income ranking ↑ to 101st and by 2011 it ↑ 77th.

Once China’s economy took off, it ignited a phase of transitional growth that was
governed largely by the country’s accumulated productivity gap with the
developed world.

iii. A final key feature of China’s rise is its distinctive comparative advantage.
Manufacturing is at the heart of the country’s economic turnaround. Between 1991
and 2012, China’s share of world manufacturing value added increased by a factor
of 6, from 4.1% to 24%.

Whereas many large emerging economies specialize in primary commodities

(Brazil in iron ore, Indonesia in rubber, and Russia in oil and gas) → China’s
advantages is overwhelmingly in industrial goods.

Over 1990-2013, manufacturing sector averaged 88% of China’s merchandise

exports, compared to 50% for Brazil, 46% for Indonesia, 20% for Russia.

Over time, China has become even more specialized in manufacturing. Between 1990 and
2007, the share of manufacturing in China’s merchandise exports rose from 72% to 93%, a
level at which it has since stabilized.

This trade concentration means that China’s growth has represented a large positive net global
supply shock for manufacturing and a large positive net global demand shock for raw
materials.

 The impacts of China’s rise are consequently likely to vary across regional and national
economies according to their initial patterns of industry specialization.

2) China’s Rise: The Global Factory

China’s manufacturing performance reflects a comparative advantage in the sector that
remained latent during the
Maoist era. Today,
China’s net exports in
manufacturing are
strongly positive and its net
exports of raw materials are
strongly negative. ⇢
figure 3a

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Its true strength in the sector emerged only in the 1990s. Figure 3b plots revealed comparative
advantages for China in 2 broad sector, manufacturing, and primary commodities, where the
latter group comprises foods, fuels, ores, and metals.

 RCA: a country’s share of global exports in an industry divided by its share of aggregate
global exports.

It was not until 1992 that China moved from disadvantage to advantage in manufacturing, as
indicated by positive log RCA values, and from advantage to disadvantage in primary
commodities, as indicated by negative log RCA values.

The strength of China in manufacturing surely reflects its abundant supply of labor relative to
the rest of the world. The massive increase in China’s industrial labor force has resulted from:
1) The de-collectivization of agriculture
2) The closing of inefficient state-owned enterprises
3) The migration of 250 million workers from farms to cities.

This has made China the default location for all type of labor-intensive production. However,
factor abundance cannot be the whole story behind the country’s specialization. Its advantage
is far from uniform across labor-intensive industries.

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 Figure 4 plots the
change in net import penetration from China between 1991 and 2007 against the share of
production workers in total employment in 1991 for 397 four-digit US manufacturing
industries.
➥Import penetration the ratio between the value of imports as a percentage of total
domestic demand.

Industries are ground into 10 sectoral aggregates, which share a common marker in the figure.
That few point in Figure 4 show a negative change in net import penetration over the period
reveals how US imports from China grew by more than exports (often substantially by more)
in nearly every industry.

The dominant pattern in Figure 4 is that:

 Industries within a sector tend to occupy a relatively narrow range on the horizontal
axis ⇢ indicating similar within-sector labor highly varying.
 Butt a wide range on the vertical axis ⇢ indicating highly varying within-sector
changes in import penetration.

Apparel, leather, and textiles stand out in Figure 4 as the most labor-intensive activity, with an
average initial share of production workers in industry employment of 0.85. Still, the
industries within this sector diverge sharply in their changes in import penetration.

In some (e.g., women’s non-athletic footwear, waterproof outerwear), the increase in

penetration approaches or even exceeds 100%.
 This indicates that the 1991 to 2007 growth in imports from China is nearly equal to or
greater than initial domestic spending on goods produced by the industry.
 Other industries in the sector (e.g., coated fabrics, automotive and apparel trimmings)
show near-zero increase in import penetration.
 Similar patterns of dispersion hold for sectors with comparably high labor intensity, such
as furniture and wood products (average initial production worker share of 0.82) and toys and
miscellaneous products (average initial production worker share of 0.72).

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The cross-industry variation in Chinese export growth evident in Figure 4 is far from unusual.
The distribution of comparative advantage across industries for a country tends to be fat-
tailed, such that for most countries relatively few products dominate exports. Because of this
skewness, US industries (and the regions in which they locate) vary widely in their exposure
to imports competition from China.
 This variation is useful for identifying the labor-markets consequences of trade shocks.

China’s export surge in manufacturing accelerated after 2001, the year in which the country
entered the WTO ⇢ Figure 2.

On first consideration, one wonders why WTO accession mattered much for China’s trade.
Europe and the United States had granted China most-favored nation (MFN) status as far back
as the 1980s. WTO membership would seem to have done little more than formalize trade
relations that were already 2 decades old.

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