Quotes of the Day

It is 6 p.m. on a Thursday afternoon, and the aisles at the new Wal-Mart in Shanghai are about as packed as they can get. The food sections are jammed, as are electronics and household goods. Most of the products that fill Wu Jingqing's shopping cart are made in China. But not all of them. In the DVD and CD sections, Wu looks for a children's movie for her 6-year-old. This is the real thing she's buying—a DVD of Beauty and the Beast priced at $1.85 that is absolutely, positively not one of the pirated versions for which China is infamous. "I could maybe find one on the street somewhere for five or six renminbi (about 67¢)," Wu says, "but I know the quality here is good, and the price still isn't too bad."

Chinese housewives buying genuine American DVDs at a Wal-Mart in Shanghai is about as close to trade nirvana as it gets for the U.S. these days. If there were more—lots more—Chinese with Wu's buying habits, the strident anti-China rhetoric coming from Washington could be dismissed as election-year political theater, rather than portents of a potentially damaging rupture in the commercial relations between the two countries. Simply put, China sells far more stuff to the U.S.—more than $200 billion last year—than the U.S. sells to China, a situation economists (and many politicians) say cannot continue indefinitely. The U.S. current-account trade deficit reached $805 billion in 2005. That amounted to 6.4% of GDP, or more than twice the size of the trade deficit in 1985, when the U.S. took the drastic step of devaluing the dollar—and the rate at which the gap is expanding is accelerating. China trade alone accounts for more than one-fourth of the deficit. That's why U.S. Commerce Secretary Carlos Gutierrez has bluntly warned Beijing that something has to give. "China's failure to address economic frictions will have consequences," he said in a speech last week. "Without concrete results, the Administration, and the American people, may be forced to reassess our bilateral economic relationship."

It's also why two U.S. senators are scheduled to arrive in Beijing this week, brandishing the negotiating equivalent of stone axes. Lindsey Graham and Charles Schumer are co-sponsors of a bill that would slap a 27.5% tariff on all Chinese imports unless Beijing allows its currency to appreciate significantly against the dollar, an adjustment some trade experts believe would reduce the deficit by making China's exports more expensive in the U.S. and U.S. products cheaper in China. Chinese Prime Minister Wen Jiabao, at a press conference last week, suggested the two Washington politicians could save U.S. taxpayers the airfare. There was not going to be any major, one-off revaluation this year. China, said Wen, would allow the yuan to float within a relatively tight band, as it has done since a 2% upward adjustment last year. Too bad, Graham responded before he left Washington. He has, he insisted, a "veto-proof" majority in support of the bill in the Senate.

With tensions rising ahead of Chinese President Hu Jintao's scheduled trip to Washington next month, is it possible that the U.S.-China trade relationship is about to go off the rails? Global markets shrug it off when the French throw a hissy fit and race to protect their vital national yogurt industry, as they did last year, or when pundits pretend it matters which European Union country owns what gas utility. But a trade war between the U.S. and China—with each side taking punitive, protectionist steps to shut out the other's products, services and investments—poses a real danger to the world's biggest economy (the U.S.) and the world's fastest-growing economy (China). Together, the two countries have accounted for nearly half of total global economic growth since 2002. China is now the U.S.'s third-largest trade partner, and that relationship, though prickly at times, is mutually beneficial. But it's possible to have too much of a good thing. "China is a developing country that saves too much, and the United States is a developed country that spends too much. The result is a big trade gap," says Andy Xie, chief China economist for Morgan Stanley. "Does something have to give? Yes. But it's not clear when that will happen, and in the meantime both economies are performing pretty well."

Financial markets, at least, have not been rattled despite the worsening political atmospherics. The Dow Jones index, the most-watched barometer of the U.S. stock market, neared a six-year high last week, and the dollar has been firm, despite the massive trade deficit which, in theory at least, is eventually supposed to drive the greenback's value down. Moreover, at a moment when the U.S. needs China's help in the U.N. Security Council to bring Iran's nuclear program to heel, U.S. President George W. Bush is plainly eager to finesse the trade issue as best he can. Asked a leading question at a press conference about trade with China earlier this month, Bush not only didn't take the bait, but offered a crisply cogent description of the economic reality Hu faces every morning: "Listen," Bush said, "China's a country that has to create 25 million jobs a year just to stay even. Think about that." He left it to Commerce Secretary Gutierrez to play what one former U.S. trade official called "the standard 'He Tarzan, me Jane—I may not be able to rein in the big brute' routine." Congress, Gutierrez warned last week, "may go down a path that none of us want."

If that happened—if, say, the Graham-Schumer bill became law and steep tariffs were levied on Chinese imports—Beijing would likely retaliate. Inside the Communist Party, Hu's leadership is under increasing pressure from party members who are questioning the benefits of the country's integration into the global economy. During the annual National People's Congress, which ended last week, former National Bureau of Statistics director Li Deshui was scathingly critical of government policies that give foreign firms preferential tax treatment in return for investment, and warned against allowing foreign companies to make "malicious acquisitions" until "China's national industries disappear." The China Daily newspaper—the English-language mouthpiece of the Party—later picked up the theme, warning that foreign companies could gain monopolies in China, noting that Microsoft controlled "95% of its market."

Unless you count counterfeit software as Microsoft products, that claim is absurd—nine out of 10 personal computers sold in China come with pirated versions of Windows, according to the U.S. Commerce Department. But Beijing may have been sending a deeper message to Washington. The signal (as one Western diplomat put it): "We've got our own antiglobalization, antitrade zealots to deal with, so how about you keep yours under control and we'll do the same, because otherwise we're both in trouble."

Keeping things under control, surely, is what the Bush Administration prefers. But the White House is currently politically weakened—Bush's approval ratings are near all-time lows in the U.S.—and the Administration desperately needs to show some progress on trade when Hu arrives late next month. In particular, the Administration would like to see China come up with more substantive proposals to crack down on intellectual-property theft, and seeks evidence that Beijing is abiding by its wto commitment to open up key markets such as telecommunications to participation by U.S. companies.

If Bush—and Hu—manage to mollify those in Congress spoiling for a fight, then the risk of a trade war breaking out will ease. And eventually, free-market mechanisms—not ham-handed political intervention—may resolve the current bilateral trade tension. Jun Ma, chief China economist at Deutsche Bank, believes China is now in the midst of a historic economic shift. Investment spending is decelerating and consumption is picking up, although the shift is likely to take years to unfold. That, in turn, could bring China's trade surpluses down, as new opportunities open up for foreign companies that make everything from digital cameras to medical equipment to pollution-control devices. U.S. exports to China, in fact, were up 20% last year to a record $41.8 billion, and since 2001 they have grown five times faster than exports to the rest of the world. The question of the moment is whether this transition will happen fast enough to allow both sides to avoid a showdown. The guys with the stone axes are in town this week, and they're not happy.

• Bill Powell | Shanghai
• Tension between Washington and Beijing is rising as the U.S. trade deficit soars