Senior U.S. and Chinese economic officials will meet in Washington, DC on May 22-23 to discuss economic and trade policies at the second Strategic Economic Dialogue. That the meeting is headline news attests to the increasing amount of trade and trade policy friction between the two countries. While trade continues to grow, trading relationships appear to be guided more by Chinese government policy rather than by market forces.

This can be seen in agricultural trade. In fiscal year (FY) 2006, the year that ended September 30, 2006, U.S. agricultural exports to China were $6.7 billion, 9.7 percent of total U.S. agricultural exports. Excluding our NAFTA partners, China was the third largest market following Japan at $8.2 billion and the EU at $7.1 billion. The USDA forecast for FY 2007 has exports to China at $8.3 billion, 10.6 percent of total agricultural exports.

U.S. agricultural exports to China in FY 2006 were dominated by two bulk commodities, soybean at $2.4 billion and cotton at $2.3 billion, which accounted for 70 percent of total U.S. agricultural exports to China. China is also a dominate buyer of both products taking 49 percent of U.S. whole soybean exports and 37 percent of raw cotton exports. Consumer-oriented products, which include meats, fruits and vegetables, accounted for only 10 percent of exports compared to 43 percent for U.S. agricultural exports to all countries. China’s recent announcements of large purchases of soybeans from the 2007 crop were meant to give a positive spin going into next week’s talks, but reinforce the narrow base of agricultural exports to China.

With 1.3 billion people and an economy growing 10 percent per year, a reasonable assumption would be that China’s demand for U.S. consumer-oriented agricultural products would be a larger share of total agricultural exports. Exports to China of red meat were only $83 million in FY 2006, poultry meat $147 million and dairy products $99 million. Fruit, vegetable and tree nut exports were $211 million. U.S. agricultural officials will obviously be pressing their counterparts about government regulations that impede growth in exports of consumer-oriented agricultural products.

Chinese agricultural imports to the U.S. were $2.1 billion in FY 2006 and are forecast by USDA to be $2.6 billion in FY 2007. Consumer-oriented product imports in FY 2006 were $1.3 billion dollars, 62 percent of total imports from China. Fruits, vegetables and tree nut imports were $850 million, 40 percent of all U.S. agricultural imports from China.

Total U.S. merchandize exports to China have grown rapidly since they joined the WTO in 2001, increasing from $19 billion in calendar year 2001 to $55 billion in 2006. Electric machinery, sound and TV equipment, etc led the list at $10.2 billion, followed by nuclear reactors, boilers, and etc at $7.7 billion and aircraft at $6.1 billion. Total U.S. imports from China grew from $102.3 billion in 2001 to $287.8 billion in 2006. While consumer goods get most of the attention on imports from China, the largest categories were electric machinery, sound and TV equipment, etc at $64.9 billion and nuclear reactors, boilers, etc at $62.3 billion. After those items come toys, games and sports equipment at $20.9 billion, furniture, bedding etc at $19.4 billion, footwear at $13.9 billion and apparel at $11.9 billion. The trade balance has gone from a negative $83 billion 2001 to negative $233 billion by 2006.

The concerns go beyond trade in goods to include access to the Chinese markets for banks and other financial firms where the U.S. clearly has expertise that could be used in China. Press reports indicate that foreign firms may be allowed to purchase up to 49 percent of the stock in banks, except for the five largest, up from 25 percent now.

The most talked about issue is the value of the Chinese Yuan which was set in 1995 at a fixed exchange rate of 8.28 to the dollar. Since July of 2005 the central bank has allowed its value to increase about 7 percent against the U.S. dollar, with 1.5 percent coming since January 1, 2007. Chinese officials believe that slow revaluation is the best approach to avoid putting too much pressure on the domestic banking system.

There are two basic approaches to the trade policy issues between the U.S. and China. One approach is to focus on the value of the Yuan to the dollar and explain the trade flows in terms of the relative values of currencies. In recent years various measures have been proposed in Congress to require the Chinese government to increase the value of the Yuan by 20-40 percent or face punitive tariffs of roughly the same amount.

The other approach is to focus on regulatory programs that impede the flow of imported products and capital and limit foreign ownership of assets in China. This approach argues that the command and control mentality of China’s recent past continues to cause distortions in trade flows. The situation in agriculture is an example where the sharp increase in U.S. exports to China has come mostly from two commodities, whole soybean and raw cotton, where the government does not discouraged imports.

Arguments that government regulations contribute to trade imbalances are not counter to the idea that the Yuan value versus the dollar should be increased. That must happen, but the change cannot come at such a rapid pace that it does damage to both the Chinese domestic economy and international trading partners. It is in China’s best interest to also unravel their regulatory and tax programs that increase costs and lowers incomes for Chinese workers, contribute to trade imbalances and encourage policy retaliation by trading partners. That is the message that the Administration needs to deliver to Chinese officials next week.