Will Technology Be a Source of Chinese Influence in Asia?

May 13, 2005

Unedited transcript prepared from a tape recording.

Proceedings:
MR. BARFIELD:  [In progress.] ...Claude Barfield, a Resident Scholar here at the American Enterprise Institute, and I'd like to welcome you to the third of our series, a series jointly sponsored by the AEI and the National Defense University, the third in series entitled "Will Technology be a Source of Chinese Influence in Asia?," which I am co-moderating this morning with my colleague and friend, Phil Saunders from the National Defense University.

Before turning the floor over to Phil to introduce the speakers and get us started, just a couple of announcements.

Our next session, which will be June the 15th--I'm not sure what--I forget what part of the day it is--will be--

MR. SAUNDERS:  Ten a.m.

MR. BARFIELD:  Ten a.m., again.  Will be on the role of Taiwan in China's Asian Policy.  And we will take a look at, among other things, the political implications of the growing economic ties between China and Taiwan.

The only other thing to note--and I forget to do this, so let me do it at the beginning--is that for those of you who want to take notes and extensive in trying to follow all this as we go along, I should say that all of these sessions--and this goes back to the first one--and it will continue to be the case--will be on the AEI web site.  So there's a video of it.  So if you need to go back and take more extensive notes, all the sessions have been and will continue to be on our web site.  This will be on by tomorrow or the next day.

So now, I'll just turn it over to Phil.

MR. SAUNDERS:  Great.  Well delighted to be here this morning and to introduce our speakers.

We'll have three speakers today.  Ernie Preeg, who's the Senior Fellow in Trade and Productivity at the Manufacturers Alliance, will be speaking to us first.  He has worked at a variety of places during his career, including CSIS, AID, and the State Department.

Tai Ming Cheung will be speaking to us on the military dimensions of Chinese technology.  He's currently a Research Fellow at the Institute on Global Conflict and Cooperation at the University of California, San Diego, but he's also a number of other things; has worked as a journalist and is finishing a doctoral degree at Oxford.

MR. MING:  London School.

MR. SAUNDERS:  Excuse me--at London.  So he'll talk about the military side, and then we will have Will Martin from the World Bank who will be a commentator on the presentations.  He's done a variety of things at the World Bank, including work on the East Asia financial crisis and was a major contributor to their China 2020 series, which really is a landmark in a look at the Chinese economy.

So we've got excellent speakers, and we look forward to hearing what they have to tell us about technology.

MR. PREEG:  Thank you, both, and I'm delighted to be here with you, and I'm pleased to see the great interest expressed in advanced technology industry in China by the attendance today.

I'm just at the final stages, thank goodness, of this book length study on the subject.  The book will be out next month, and with the title "The Emerging Chinese Advanced Technology Super State."

The full book is in two parts.  The first half is analytic.  Will, good morning.  Good to see you--is analytic--what's going on within China and where is it going over the next five or 10 years.

The second half is a rather detailed recommended policy response from the U.S. as to how we should respond.  But I'm going to concentrate this morning in the time I have on the first half, the analytic side and perhaps save just a couple minutes to tick off some of the policy issues at the end.

A place to start is a couple of quotes.  Whoops.  Somebody help me out?

MR.          :  That's it.

MR. PREEG:  Okay.  The first is a quote from Chinese Prime Minister Wen Jiabao just a month ago when he was visiting India, and he was with his counterpart where he--here it is: "It is true India has the advantage in software and China in hardware.  If India and China cooperate in the information technology industry, we will be able to lead the world, and it will signify the coming of the Asian Century of the information technology industry."

So there is certainly a sense of national purpose.  Several other similar quotes in my study of the objective from the official Chinese leadership.

And the second quote, maybe even more significant.  It's from John Chamber, the CEO of CISCO, which, as you know, the leading edge producer of computer networking equipment.  Here it is last September: "China will be the information technology center of the world."  That was at a press conference last September in Beijing, when he announced a major CISCO R&D program that will be put forward over the next two or three years in China.

What is a super state?  In broadest terms, it's here.  China almost inevitably will achieve giant economic, technological, and financial stature; will likewise become financially and politically powerful in international affairs, and in the not-too-distant future will become a military superpower as well.

That broad definition, with only minor modification incidentally, is the definition futurologist Herman Kahn did in  book 35 years ago called the "Emerging Japanese Super State."  I do devote some time in the book as to why China is different from Japan, and we should take this emerging super state a lot more seriously as likely to take place, which I won't go into detail here.

Getting into the specifics.  The point of departure in a sense is this is all taking place just over the last 10 years.  China first opened to the outside world with its export-led industrial strategy in the last '70s, with the four modernizations, and particularly special economic zones on the coast.

But for the first 15 years, it was basically labor intensive industry--apparel, textiles, footwear, toys, sporting goods.  And it was only in 1995 and since that a number of basic decisions were taken in terms of resources devoted to advanced technology, incentives, particularly for foreign investors, and a whole strategy to put this as the top priority, along with military modernization, and the two are linked.  These are two of the four modernizations that were low priority 25 years ago, but they're the two top priorities in the last 10 years.

Four basic dimensions of it, starting with R&D.  Here's a chart on R&D as projected by the OECD.  You see it's just 10 years; 1995 you've got China at the bottom.  It was only about one-quarter of Japan, and a little more than one-tenth of the U.S. level.  You come up to 2005, which is a projection.  The most recent figures are only 2002.  China is just likely to pass Japan by this year, and coming up to about 60 percent of the EU level and at least 40 percent of the U.S., and these projections to 2010 incidentally are less than what they were.  From '95 to '02, Chinese R&D grew 22 percent a year versus five or six percent in the other three.  The 2010 was the more conservative 15 percent projection, but just to give you an idea of this one.

In R&D, of course, it's very heavily manufacturing for the companies that make up 60 or 70 percent of total in China.  That's similar to the U.S., where about two-thirds of the R&D, commercial R&D that is, is in manufacturing.

In the public sector, though, both countries are very heavily into military-related R&D.  I think we're the two largest militaries in terms of R&D expenditures.

But on the other side, the commercial side, the U.S. is predominantly in the health care area.  The National Institutes of Health, $30 billion a year; National Science Foundation, which is more information technology, $5 billion, and in this year, in fact, it was cut by $100 million.

I don't have a counterpart figure in China, but I'm sure the health care is smaller than what's going into manufacturing and now more and more basic R&D.

Education is the other big commitment, an even more extraordinary change in China since 95.  In less than 10 years, China has tripled its college program.  University graduates now are about--went from one million to about three million a year, more or less the same as in the U.S., but very heavily oriented toward math and science, engineering, much more so than in the U.S.  And the indicator looked at most carefully for advanced technology industry by National Science Foundation, OECD are doctoral degrees in science and engineering.  The chart has it doctoral degrees in engineering.  And here you see that if you go back to '90 and '95, China is still way below Japan and the others.  But by this year, '05, it's already number one.  And again, in this case, the Chinese doctoral degrees in engineering, '95 to '02, grew 16 percent a year, whereas in the U.S. it was minus one or two percent.  And it may be four or five percent in Europe, Japan.

And these figures don't even--they don't even include the fact that a lot of engineering doctoral degrees in Europe and the U.S. go to Chinese students, many of whom then go back home.

Foreign direct investment.  That's a chapter in my book, which is called the "Decisive Catalyst."  Again, very little in the first 15 years, because you don't need much foreign investment for apparel and textiles and footwear.  There's not much, and it's labor intensive.  And a lot of those firms weren't Chinese in any event.

So you see it only begins to take off '93, '94, and that has a lot to do with the changes--then it's very heavily into information technology, telecommunications in particular.  And you see it going way up in '97, '98.  There are some reasons why it dropped off in '99 and 2000; partly it was hesitancy on foreign companies to have joint venture partnerships with Chinese companies in high tech.  Then they greatly liberalized the ability to go in with 100 percent foreign-owned company, which is now the dominant, the very large dominant share of new investment, foreign investment in information technology and telecommunications.  And you see it taking off again, '02-'03, and the record last year $62 billion in '04.

Another extraordinary--these are all extraordinary--figures as I was getting into them last year.  This is the figures that China puts out on the share of Chinese exports by foreign companies.  And again, I really haven't seen anything quite as extraordinary as this in any other country in my many years tracking these sorts of things.

As you can see, the lighter left one is the exports.  This is total Chinese exports.  In 1990, it was only 13 percent.  By '95, it was up to 32 percent, and in '04, the last one, that export figure it's 57 percent.  In other words, the export by foreign companies, that's the left one, was 57 percent of total Chinese exports last year.  And that's total exports.

And if you bear in mind that textiles and footwear--that's a lot of Chinese companies.  If you get into information technology, high tech, it's a lot more than 57 percent.

So that's why this has been so important up until now as to why there's been this great surge in the output and the exports of China.

Then finally moving on to trade, which is very important because it's the most up to date figures.  It's only six or seven weeks behind.  It's the most detailed in terms of product and sector breakdown, and in effect it's the bottom line of international competitiveness.  You're competitive in exports vis a vis other countries.

The first chart, from OECD sources, shows high--it says very high and medium high technology exports by the four big units here, which for EU it excludes intra-trade.  And you see back only in '92, China was way down at the bottom on high tech, you know, like one-eighth or one-tenth of the other three.  By '01, it's moving up to half the China level--I mean the Japan level.  I projected it to '04.  Unfortunately, OECD is three or four years behind the curve, which is normal for their figures unfortunately.  But I projected based on total exports, which are predominantly manufacturers and such for the four units.  So you've got by last year, China is approaching Japan.  This is the absolute value of high tech exports.  And on current costs, within several years, they will clearly be above Japan, approaching the U.S.  In fact, last year, as probably know, China passed Japan by to be for total exports the number three exporter--U.S., Germany--Germany is mostly intra-EU--and China.

On current costs, within three or four years, China will be the number one trading nation--net number one export nation in the world.

Chinese high tech exports.  These are up to date.  This is calendar '04 from Chinese sources.  They have categories of high tech products and mechanical and electrical products, which are very related.  There's some overlap in these two, so you can't add those two together, but I've compared those with what's called labor-intensive products.  That's apparel, textiles, and footwear.  You can see in 2000, that's just four years earlier, labor-intensive was bigger than high tech just four years ago, and more than half as large as the mechanical-electrical products.  Whereas, in '04--and these are actual figures--you can see high tech is already 50 percent higher than the apparel-footwear, and the mechanical-electrical product category has more than doubled--and this just every year.  I'm sure this year--well, this year there will be a little bump.  There will be a significant bump in apparel and textile exports.  But the trend is very clear that it's away from labor intensive, and, as we saw in the previous, in fact--I'm not sure I have the chart here.  I don't.  But there's another OECD projection that shows that high-medium and high-high Chinese exports are now, this year, I project a little bit, over 50 percent.  Whereas, the low and lower tech are obviously lower than 50 percent.  And that's just a very strong trend line of their restructuring of their trade.

To the U.S. side, just a couple of charts.  This is our total deficit, which, of course, is way up in the 60 last year.  China here you see is the biggest deficit.  Japan has leveled off.  It just gives you an idea of the relative levels, but more important, and this is the U.S.--this just is another mind boggling imbalance I've never seen before in my life.  It's about five to one, the U.S.-China bilateral trade balance.

But what's more pertinent to what we're doing today is this category of U.S. trade called advanced technology products, ATP.  These are individual products--this was developed in the mid '80s--where the industry experts at the Census Bureau picked out those products that have the highest content of R&D and engineering scientist input value added.  And you can see the U.S.--this is global--was very much in surplus up until '98, $30 billion, and then it's been steady downhill to minus $37 billion last year.  This is a bigger drop, a steeper drop than for the overall U.S. trade balance going into deficit.

And this year, the first three months, it looks like it's even--that downward slope will be even sharper this year based on the first three months.

But where is China in this?  Well, China is really the main source of that decline.  This is U.S. trade balance--incidentally, advance technology products account for about 30 percent of U.S. trade and manufacturers.  It's a very substantial share.  Here you can see in '98, only six years ago, we had a trade balance with China in ATP.  Last year, you can see it's about three or four to one.  And the deficit between imports--it was $37 billion.  It was roughly comparable to the global deficit.  So that's where the deficit comes from.

Well, those are some of the basic dimensions of this emerging Chinese advanced technology super state.  Three important developments to watch--and on these we don't have good data for the most part, but they're all important, and I only have some broad comments.

The one is this export platform issue, where the foreign investor comes in, brings in the high tech components, and then reexports.  Not much hard data on the Chinese value added, you'll get some plant, you know, episodic.  They'll say 80 to 90 percent of the value added is Chinese.  And you'll get another one that says 80 to 90 percent is Korean--imported.  I have a rough calculation in the book showing that for information technology, telecommunications sector, which is where the bulk of this takes place, probably over half, well over half on average, is Chinese value added, but that still doesn't get around the fact that of the imported value added, you can have high tech components.

The other I think very important and very clear point is it's not American export platforming.  We don't export that much advanced technology products to China, as we saw in the previous one.  And most of what we do is two categories:  commercial aircraft--Boeing--that's not export platforming--and the advanced design in semiconductors--the Intel, et cetera, which go into all kinds of products around the world, but that's not export platforming.  The export platforming, which is where the foreign direct investment is concentrated, is Taiwan most of all, South Korea, and Japan, particularly in these industries, and I should say that of the overall $62 billion last year of FDI, Taiwan is number one, but nobody knows how much exactly.  It comes in indirectly.  It's probably $20 billion or $30 billion, perhaps maybe Will has a better number on this.

Until '02, the U.S. was number two, followed by Japan and South Korea.  But in '03 and '04, and especially last year, South Korea became number two, with $6 billion; Japan, number three at $5 billion; the U.S. dropped back to $4 billion.  So this is very East Asia oriented.  There's a policy relationship, because Taiwan, South Korea, and Japan and China--I won't get into it today--but these are the four great currency manipulators that we're faced with, but it's all interrelated in this platform relationship.

And finally, there's no question that the Chinese value added is steadily moving up within China.  There's all kinds of incentives, all kinds of pressures to do so and almost all these companies are developing supplier relationships, helping them to upgrade the quality and within the FDI, the foreign companies themselves, they're moving up the ladder.  In fact, another point FDI related:  Only three years ago, the number of R&D centers with foreign company participation or total foreign was estimated to be 200 or 300 R&D centers.  This year, it's estimated to be over 700.  I mean that's the number of R&D centers with foreign companies in three years.  I mean this is extraordinary.  That's the export platform.

The second one participation of Chinese firms.  Are they going to start to participate and become multinational?  Something that bears watching.  I've listed the companies that are beginning to become familiar.  Lenovo, of course, with the buyout of the IBM PC.  Wah Wei [ph.] in telecommunications.  The Shari and Shanghai Automotive, they both announced beginning to export to Europe and the U.S. in the next couple of years.  They have the common objectives.  You have to have a brand name recognition.  You have to have quality product reputation and a leading edge R&D program.  It's certainly the objectives of these companies, which are all mostly now already into the billions and they're all multinational, but it's a three-stage marketing.  They almost all start with the Chinese market, which is huge, and they have certain advantages; then it's developing countries--South East Asia, India, and then finally U.S. and Europe.  So this bears watching.  The companies are certainly there and getting a lot of support from their governments to do so--from their government, I should say.

Finally, technology innovation.  This is the most important point, because the real issue is will China overtake U.S. leadership and challenge us, and this has major national security as well as commercial implications.

I just have a couple quotes.  Again, we don't have that much.  I have some more in the book, and I'm sure we'll hear some more from Professor Cheung in a little bit.  This is Premier Wen again, just last month:  "Independent innovation is the national strategy."  And that's part of a more specific detailed statement about why this is so.  It has to be Chinese companies, he says, not foreign companies or just the interim stage.

And the second one is a task force in this country.  "China has been investing heavily in nanotechnology and already leads the U.S. in some areas and is making rapid progress on biotechnology."  This was a group--I think it was 24 members.  Some of the big organizations--the American Physics Society, the American Electronics Association--the big companies--Intel, Microsoft--they're all in there.  So this is--this task force has real heavy hitters that should know what they're concluding.

Two additional sources--I have another five minutes or so--is that?

Geopolitical.  Very important in East Asia.  China will be the economic hegemon.  They all know it out there, and it creates great dilemmas, certainly for Taiwan.  Three years ago, the U.S. was still a major, number one, trading partner of Taiwan.  Last year, this year, it's China.  It's way up, an the investment relationship is so deep.  It's a real--we won't get into it.  Your next session will be on this I' sure.

Japan, too, is struggling and Korea--for all of these countries.  Also China took the trade policy initiative of a free trade agreement with the ASEAN countries.  By 2012, this will give them a big leg up on establishing their primacy, because in ASEAN high tariffs in all these areas--20, 30 percent and that will be a preferential margin China will have over U.S., European, Canadian exporters to the region.

So the geopolitical is being talked about more and more.  China always protests.  We are not the economic hegemon, but, in my view, it's protesting a little too much.

Geostrategic.  Chinese military modernization.  Again, it really got started in 1997-99, very recently.  We'll hear more I'm sure from Professor Cheung.  I just mentioned the two things.  The restructuring.  It was really jettisoning the old Soviet model and picking up the U.S. model for defense industry in effect.  They moved the military defense companies from military to civilian control.  They integrated more with the commercial enterprises in a competitive relationship, including, to some extent, competitive bidding, and the two sectors are very linked, particularly I go into the navy and the cyber warfare are probably moving ahead more quickly than some of the other areas.  And no question the navy is linked to the rapid growth of the Chinese merchant marine ship building--maritime shipping.  They will be the number one maritime power in East Asia within a few years, the way the U.S. was a hundred years ago.  This has fundamental geopolitical as well as national security implications.

And finally, here's the DoD assessment.  During that--right up to the end of the 1990s, every year, they said Chinese military is at least 20 years behind the United States.  Last year, they had a much more cautious, but a very different, it said was that China would have uneven success in catching up in five to 10 years.  I suspect this year's report, which come out in the next couple of months, is going to be even a little more narrowing the gap.

So that's extraordinary change in four years in terms of the DoD assessment of Chinese military modernization.

Finally, policy response.  I'll just tick off.  I've got full chapters.  International financial policy--largely the currency manipulation issue, the immediate big issue.  But once they do get to a convertible market-based currency, it will be a major currency.  It will be the financial currency, the yuan, in Asia.

These are just--it's a quick chart related to currency manipulation.  It shows the basic balance, the relevant measure, current account plus long-term capital.  A huge net inflow.  This is the right bar of China over four years in each year.  That would usually put extreme upward pressure on the currency, whether it's fixed or floating.  Even a fixed rate, it would be an informal black market rate.  But you can see the central bank purchases are far--equal to or greater in each year, and that's really what we're talking about when we're talking about currency manipulation.

In trade policy, a number of bilateral issues are engaged.  It's a very comprehensive, the most comprehensive trade negotiation I've ever seen--WTO implementation.  For advanced technology industry, certainly intellectual property rights, it's number one.  But technology transfer conditions on investment approval, technical standards; taxes are others.  There are several others that I go into in the book.

There's also FTA's policy.  If we get through Central America, if that's approved, there's a real question what do we do in East Asia?  The only way--we're not going to just tell East Asia we're opposed to a China-ASEAN free trade agreement, and South Korea and Japan are now trying to--they're also doing the same thing.  The only way the U.S. stays even is if we have agreements across the Pacific as well.  We're engaged with Taiwan, and I describe how Taiwan, South Korea--I'm sorry--Thailand.  We are negotiating.  With South Korea and Taiwan, a three-spoke, if you will, thing would keep us engaged toward the agreed objective of Asia Pacific free trade at the appropriate point.

The U.S. domestic economic policy response is critical.  And my last point will react to why not much is happening.  There's a macro issue of saving more so that we don't have to borrow as much and have such a big trade deficit, 83 percent of which is in manufacturing.  A very large portion and growing proportion of that is advanced technology products.

Also a number of specific issues of economic policy where the U.S. has a significant or major disadvantage vis a vis our competitors, particularly China.  The weak education performance, particularly science, engineering.  Stagnant R&D and the NSF, and relatively small.  Much higher corporate taxes.  Out of control tort litigation which makes a lot of R&D shift to China.  Rapidly rising health costs.  Sarbanes-Oxley is very big and gets prominent notice in my study.

So finally, what is most lacking?  This is what it's all about in my presentation today.  It's--there's just not a sense of national purpose that I see in the U.S. today.  This is a major challenge, perhaps the most important issue in our international relations in the coming years, commercially certainly.  National security.  Foreign policy.  And yet you just don't feel it.  It certainly is not felt in the government policy making circles.  Nothing like--and the analogy keeps popping up in recent things.  What about--what happened in the '50s, when we had the Sputnik.  And the Soviets got ahead of us.  Well, now we had to put a man on the Moon in 10 years.  We had the National Defense Education Act.  Thousands of Ph.D.'s in technical areas, of which I happen to be one of the very happy recipients.

We need something today, and you just don't have it.  And my last point is that there was a big debate last year when they cut, absolute cut of $100 million, in the NSF budget.  It's only $5 billion.  The debate was back and forth on all sorts of things.  Not once in the debate was the Chinese challenge to U.S. leadership in advanced technology, in the R&D things we saw earlier.  China was not mentioned.

So that's what I say--there has to be a focus that this is a national--we need a national purpose, and a vision very much like the Premier Wen's vision up front.  The Chinese do it, and so I hope my study and our meeting today, to some extent, will begin to get the word out, begin to get people more focused so that we can develop the political support in this country for a sense of national purpose as to how important this issue is.  Thank you.

MR. CHEUNG:  Sorry.  We have this remote mouse, which is probably designed in the U.S. and made in China, which doesn't work.

[Laughter.]

MR. CHEUNG:  So that's one criticism of this relationship.

So from the excellent overview at the macro level, I'll go down into the weeds now and look at the rise of China's dual use technological base and the implications for Asia, and I forgot to put the U.S. there, because I'm from California.  I've been there for about nine months, and it's--and I'm not quite sure if California is part of the U.S. yet.  So I'm still trying to adjust to that.

What I'll look is some of the key characteristics.  I won't go too much in terms of the defense sector, because I'm giving a talk at the NDU this afternoon that looks at some of the issues, especially on defense technological innovation.  But this looks primarily at the nexus between the civilian, the commercial, and the military interactions and the impact upon China's technological trajectory.

One of the key characteristics is that the forging of a dual use economy has been a strategic priority, especially since the late 1990s, and when I talk about the dual use economy and the strategic focus, it focuses especially in terms of the spin on dimension from the civilian to the military.  During the '80s and '90s, there was--the focus primarily was in terms of spin off from the civilian side to the military.  But now, there is a focus from the leadership to a much more balanced development of this dual use process.

A significant characteristic is that I would define the dual use technology where it's like there are pockets of excellence, but the overall standards remain fairly poor compared to international standards.  A lot of the output is in terms of--it's like fairly rudimentary cars and motorbikes.  And all the focus is in terms of like mass production.  And one of the key measures of how good a technological base is in terms of efficiency, and the Chinese dual use technological base as well as many parts of technological base is not particularly efficient.

Of course, the dual use technological base forms a very important, in fact, a critical, component of the height, of the strategic high tech economy, and I'll go into that a little more.

What we've seen is that there an increasing focus in terms of innovation capabilities.  If you look at China, there's three stages in terms of how you go from like an imitation to innovation.  And I would put China in terms of at the second stage.  The first stage is in terms of what developing countries do is they copy, and it's imitation.  The second stage is what we call creative imitation, where there's a lot of imitation, but you begin to add your own innovations into it.  And this is sort of like where China has been, especially since the 1990s.  And now, the key question is can they cross between the second stage, between the creative imitation towards indigenous innovation.  And it's this jumping from this one stage to the next stage that is critical.  And it's not completely clear that the Chinese have managed to make this transition, but it's--in many ways, it's similar to where South Korea was in the '80s and early '90s, and where Japan was a decade or two before that.

Some of the leading dual use sectors is in terms of aviation, space, ship building, the nuclear sector, electronics, and IT.  And both key civilian and defense enterprises form the core of this dual use technological base, and I'll talk about that a little bit more.

I see a large--the doctrine or the development strategy for China's science and technology development and also in terms of the development of its dual use technological base is in terms of this Kerjao shingwa [ph.] strategy that was enunciated back in the mid 1990s, in which the focus was on raising innovation capability, especially at the enterprise level.  So the focus for the leadership is from the state, which had dominated during before like the mid-1990s to emphasize it much more in terms of enterprises and on entrepreneurship, and we've seen from the previous presentation that this is an important driver.

This is not to say that the state doesn't have a number of key initiatives, and there is quite a significant number of important innovation, technology development projects that the state continues to fund, although it's much more focused than it used to be in terms of the 8-6-3 high technology development program and other projects.

So some of the practices of this Kerjao shingwa strategy, as I've said, is boosting investment in educational and the R&D apparatus and also reforming these apparatuses, emphasizing like the concentration, because despite significant expansion in the funding and resources devoted to technological development, a lot of it has been wasted.  It's like it's been spread out rather than focused, and now there is this significant change in strategy to emphasize in key projects and less important projects find their own funding.

And another important priority is focusing on the cultivation of key talent, because there is also--there's a generational change within the technological establishment and the technical work forces, where a significant number of the scientists and engineers that were trained and had experience from the '60s and '70s are now at retirement age, and China needs to very much cultivate these newer generations of more talented professionals.

Another focus is on the generation of patents and also monitoring and incorporation of global developments.

As I've said, while there's been the focus increasingly on letting enterprises and the commercial market to be like--take a much more important role, this--a large aspect of the technological strategy is still a state-based techno nationalism in which the state takes a very strategic approach and it sees technology development as very much an important component of China's comprehensive national strength, and especially the focus of this techno nationalism is in terms of at the basic R&D level, while enterprises and the commercial market focuses more on the applied side.  The state sees the long-term focus is in terms of basic R&D and supporting high-risk areas that may not otherwise get much funding and resources.

Looking at the two components of the dual use technological base.  This is the defense industrial component.  It's a vast sprawling apparatus.  On the left, there's the 11 key defense industrial enterprises that employ about two million workers.  Although it may seem big, it was much bigger a decade or so ago.  And today, it's probably about--it has declined in size by about 50 percent, and the focus is now--is not in terms of sheer size, but in terms of quality.

And the civilian component is very much--contrasts very differently from the defense side.  Where the defense side is large and it's in very much state-led, the civilian component of the dual use technological base it's much more in terms of the non-state and private high tech enterprises.  A lot of these civilian technological companies, although they are considered to be part of the dual use base, they themselves don't really pay that much attention.  A lot of their activities is primarily on commercial, and military is often an afterthought or sometimes that they have to do that because of state or state pressure.

And, in fact, what we're seeing is like we see a small number of companies, especially on the high tech side, like Kwawei, Jungshing and Daitong [ph.], et cetera, but in the last year or two, we're beginning to see significant policy initiatives to enhance and expand the participation of civilian companies, and a lot of problems that have prevented civilian companies, such as LEGO licensing, et cetera, are now being intensively researched by the defense sector and how to integrate much better.  So it's--so what we're seeing in many ways is just the tip of the trends that will take place over the next decade.

This is a chart that tries to look at the balance between defense and civilian production within the defense industry as one aspect of--it's like this is focused on a more balanced development.  At the beginning of the reform process, about 80 to 90 percent of the defense industry's output was on military, and only 10 percent was on the civilian side.

By 2000, it reached its--in terms of the spinoff, it reached its peak in which about 85 percent of the defense industry was focused on civilian production.  And now in the past couple of years, there's been a strategic decision to refocus and so you have this--so like this U curve, in which the goal by the year 2020 is that the defense industry will reduce the focus in terms of civilian production from the 80 percent that it is currently back down to about 30 percent and the defense side will go up.  That's a goal, and whether they achieve it, we'll have to wait and see.

And so in terms of the long-term development plans, in terms of the 10- and 5-year plan or the 11- 5-year plan that begins next year, there is a lot of overlapping civilian and military priorities that allow them to have these very fundamental synergies in areas such as microelectronics, space, aerospace, high performance computers, et cetera.

And the PLA's requirements for high technology in many ways mirrors what the civilian sector is also developing in terms of information warfare, electronic warfare, joint operations, C4I [ph.], strategic intelligence, et cetera--all those where requirements can be met as much as well in many ways by the civilian sector as well as the defense sector.

There was a study done I think in the late 1990s within China that said about 90 percent of the PLA's information technology needs comes from outside of its traditional defense industrial base, meaning within the defense--within the civilian sector.

And this is like a chart looking at the overlap between the dual use economy, the act--it's like the beginning of the 1980s, but there was a very small overlap, and then there were these phases, which I've explained, three phases of what the Chinese call the juminjerher [ph.] strategy of combining the military and the civilian side.  And so today, this is just illustrative, so don't take the little grey circle to be the actual size, but this just shows the increasing overlap there.

And so there's some of the key features in terms of both on the spinon and the spinoff side, and in terms of the spinon, there's lots of areas where a lot of their civil military integration in terms of telecommunication, semiconductors, computers, manufacturing, composite materials.

And so there is at least four key sources for the dual use and military technologies, both in terms of the main priority over the long term is in terms of indigenous development.  But as part of this tech nationalist focus, the Chinese are also much more willing to have selective acquisition from the West of civilian and dual use technologies.  Russia is a very important source, less on the dual use side but much more on the hard military side.  And we've seen also in terms of Sino foreign commercial joint ventures, where, as we've heard, that the numbers of these are rising very rapidly.

And so what are the benefits of the dual use technological pace?  Especially for the military sector, it's a faster development cycle.  They were saying it's like China is--one of China's latest fighter aircraft, the FC-1, was designed using computer aided technologies in half the time than past generations of fighter aircraft.  And the savings are also comparable, about 20 to 50 percent.  So it's faster, smarter, cheaper, and of better quality.

And so some of the key projects I've already mentioned.  There's the 8-6-3 program.  The Chinese Academy of Sciences has also a number of programs, and it's in a number of key areas, such as in lasers, space, information technologies, et cetera.

And so what are the key trends for dual use over the next decade for China.  This--what is happening will continue--

[END OF TAPE 1, SIDE A; SIDE B]

MR. CHEUNG:  --Accelerated pace.  The Chinese have said it's only since the late 1990s have the Chinese leadership in particular grasped the importance of civil-military integration, and this is increasingly a top priority for them.  And a lot of this focus will be in terms of electronics, IT, space, and avionics.  And this is one way that will help China in terms of its goal by the year 2020 to catch up with the world's advanced defense industrial powers.

So what are some of the implications?  And I go fairly quickly.  Some of the strategic implications.  I mean in many ways one of it is a matter of prestige.  When China launched its first man into space, one of the implications for Asia that the Chinese pointed out was that they were the first ones.  They beat Japan to it, and even though a lot of the technologies were comparable to what the Americans or the Russians did back in the '60s, there was a great surge of national pride, and this is increasingly an important component in terms of feeding Chinese nationalism.

What are the military implications?  Of course, as I've pointed out, the dual use space is a very important component on the PLA's modernization, especially in terms of the focus for the PLA to today is in terms of information operations.

The defense industrial implications is that one of the interesting developments over the past decade or so is that China has become a net importer of defense products, weapons systems, et cetera.  It really hasn't had too much to offer to the outside world in terms of its defense exports.  But with the dual use space, I think a significant aspect you will see the defense industry and this dual use space to become an important exporter in the coming decades or so.  And you will see the Chinese be much more active in the coming years to offer hardware and technology transfers to a lot of its Asian neighbors, because the Chinese need the funding to reinvest in a lot of what they're doing.

And so lastly, I would just focus in terms of the trade and proliferation implications.  As the Chinese economy--and a large part of it--becomes increasingly this dual use focus, a lot of the efforts to try to prevent China from getting access to defense-related technologies that the U.S. in particular has tried to do will be extremely difficult to continue, as we've seen with the EU and the arms sanctions.  I mean how relevant is that when an increasing proportion of the European high tech trade with China can be in terms of dual use.  So the export restrictions--against China by the West will become increasingly under pressure with the rise of this dual use technological base.

So I'll end it there.

MR. SAUNDERS:  Before Will starts, could I ask you a question just for clarification?  That go back to the U-shaped--chart of the defense side of the defense establishment and the civilian, and you showed the change.  What do you mean by that?  Do you mean that this rising defense part of the defense institutions, does that mean that there is a separate--that something all the way from scientists and engineers right through production, they're setting up separate plants?  What does the defense side mean versus the civilian?  I'm not clear.

What is it you're talking about there?

MR. CHEUNG:  The statistics there are in terms of the defense industrial base and in terms of the 11 core corporations and the subcontractor base.

It's just one way.  One indicator.  I don't talk about in terms of the civilian side and how much of the civilian firms are involved in terms of military development and production, because there's very few statistics there.

What I'm saying--the bottom line I'm saying that is that the focus in the past was that the defense enterprises, they were allowed to primary focus on civilian production over the past 15 to 20 years, and now there's this strategic emphasis to say that, well, your focus now, your key priority is to switch back and focus on military modernization, while you can allow to continue to do the civilian side, you should limit that in terms of your overall priorities and your strategic priority now is to concentrate much more on what you used to do before.

So it's this transition back to military as their top priority.

MR. MARTIN:  Thanks very much, Claude.  Thank you Ernie and Tai Ming for very interesting presentations based on excellent work.  I can--Ernie said with feeling just how much time and effort he'd put into the manuscript we're discussing today.  And it's really evident when you work through.  It's a very long, very detailed, very capable.  I think the analytics in the book are really, really fascinating.  The documentation of the changes in trade, the changes in the patterns of trade, and then the linkage of that back to the underlying changes in the factor endowments.  I think one thing that' often forgotten in discussions of high tech--everybody wants to be an exporter of high tech products.  I remember well Nigeria used to be the world's largest exporter of ground nuts, and after oil came along, policy makers were determined not to go back to that, and they've succeeded.  But what hasn't happened there is changes in the factor endowments that are needed to produce high tech products.

And what Ernie points out is if you want to be producing high tech products, you need to have a high tech labor force.  You need to have big increases in education, and you need to have loads of loads of investment and physical capital if you're producing physical capital intensive goods, and Ernie documents the dramatic changes that are occurring there.

I think--and I think that's a very, very important contribution, a tripling of the number of graduates and so on.

I think one thing on the trade--the composition of trade in some work that Vlad Minol [ph.] did for a recent global economic prospects at the Bank, we looked at China and India and other countries that were low income, 20, 25 year, and back around 1980.  And what you find that group of the other low income countries, you see also a dramatic shift in the composition of exports.  The countries like Thailand, Indonesia, the Philippines, they've also been using the foreign direct investment.  Like China, their modus operandi has been very different from Korea and Taiwan.  They've used foreign investment, and they've been able to push very fast into medium and high technology products.

So I think that it's a salutary lesson to look actually at what's been happening with other low-income developing countries.  I think another important feature that perhaps could warrant a bit more attention is the dramatic reforms in trade policies.  Many of those countries back in the '80s had extremely high protection.  They had overvalued exchange rates and other taxes on exports that really created terrible problems, especially for export processing activities.

All of these manufacturers' goods, as Ernie points out, use a lot of--or rather the export processing phenomenon uses a huge amount of intermediate inputs, and if you have a high tariff regime and you don't have a duty exemption set up of the type that China has so successfully worked, then you just simply won't be able to produce those input-intensive goods.  You'll end up with domestic factor intensive products, agriculture and resource materials, which were the staple of developing country exports 20, 25 years ago, before they moved so heavily into manufactures.

I think one other point that really should go in the analytical part--it would be very useful, and helpful to square the circle with Tai Ming's point that there are pockets of excellence in the Chinese economy, but the overall standards lag behind world levels--much of the output is low tech productivity and efficiency and not high.  Why is that?

Well, in absolute terms there are huge numbers of trained engineers coming onto the labor market in China.  There is a huge amount of investment.  It's phenomenally high investment rates, as Ernie points out.  But at this point, this is not a skill intensive, in terms of the overall factor endowments, or capital intensive economy.  It still remains very, very poor.  Three million degrees per year, roughly comparable with the number in the United States, but that's only one-fifth of the size of the cohort receiving that education, and it's going to take a long time for the stock of skilled people to catch up with the huge stock in the United States.

So while China's moving very rapidly in an absolute terms, there's a huge amount of accumulation of the factors needed for high tech, it's still, in terms of relative intensity, a low skill and low capital, capital scarce, economy.

So but overall, I think the analytics are terrific.  There's just those couple of suggestions.

I also really liked the policy discussion, especially in chapter 10, which I only received recently, pointing to the fact that if a country has a large or a large current account deficit as the United States does, the fundamental driving force there is an imbalance between savings and investment or income and expenditure, and that really nothing much can be done about that without changing those fundamental determinants of the current account deficit.

Where I guess I was a little more worried in the manuscript was some of the discussion of the foreign exchange regime and the bilateral trade deficit.  The talk, the discussion about currency manipulation made me worry a little bit.  I mean here we have a trade regime--and this is a foreign exchange regime where the exchange rates are being pegged roughly at 8.28 yuan per dollar since 1994.  The central bank has been buying foreign currency.  Well, if you've got a fixed exchange rate, the central bank has to buy foreign currency, and the amount of foreign currency it buys is really outside its control and the money supply consequences of that are outside its control.

As Ernie points out, China can do something about that by open market operations to try to soak up some of the injection of liquidity into the domestic economy.  But that's hard to do, increasingly hard to do.

If we were talking about just an undervaluation of the currency, say, China had devalued the currency, then what we would expect in the short term is some sort of shift towards a surplus, some sort of build up of reserves, an injection of money into the--high powered money into the economy, and a rise in domestic prices that would choke off the competitiveness, the induced competitiveness.  We're not really seeing that.  What we are seeing is a funny situation where China has this phenomenally high savings rate, even relative to the very high investment rate, and despite the fact that that investment includes a large amount of demand for investment goods from foreign investors.

So it seems to me that the current account surplus is really being driven by that very, very high savings rate.  And then the question is what's going to happen?  Well, what about if there were just an appreciation of the yuan.  Tracing that through is quite complicated.  And Warrick McCuban and Andy Stoker have done a nice job of that in a paper from a year or two back.  Their point is that if you just had an appreciation of the yuan, there would be some small changes in the trade balance, but that they wouldn't be very large, because there's nothing in that scenario that really changes that income expenditure balance, the fundamental income expenditure balance.  So that really wouldn't suffice to bring about much change at all is their point.  And I think that makes eminent sense.  What you really need to get a big change in that in the current account would be a change in expenditure relative to income or savings relative to investment.  China could go to a situation where if it did that, it could go to a situation where it ran a current account deficit and pulled in imports--I'm sorry, and pulled in imports.

Now, there are a couple of problems with that scenario.  As Ernie points out in the manuscript, it wouldn't actually do terribly much to the bilateral deficit between the U.S. and China.  It would do quite a bit potentially for the overall current account of China.

The other thing I think if China did switch around and run a large current account deficit by or instance, by reducing savings, there would be an impact on world capital markets.  The United States is pulling in savings from the rest of the world at the moment and other countries like Australia are pulling in savings from the rest of the world, and those savings are being supplied by China and other saving economies.  If you had that turnaround, say, a fall in savings in China, then there would be upward pressure on world interest rates.  So it's not clear that that would be something that would be terribly welcomed in the United States.

The issue of dispute settlement, some of the points about dispute settlement I thought were--it seemed to me perhaps a little cavalier.  Taking China, there are suggestions that China should be taken to dispute settlement at the IMF.  That's pretty hard to do.  Dispute settlement at the WTO over currency manipulation, I think China's point would be, you know, the Breton Woods Agreement, for instance, the whole Breton Woods basis was that people pegged to the U.S. dollar.  China has been in its eyes perfectly innocently pegged to the U.S. dollar since 1994.  That's going to be pretty hard to make that charge stick.

So I don't know that--you know, I'm not an international trade lawyer, so I wouldn't want to sort of prejudge the answer of how all that might go, but I noticed that Eric Denters from the American Society of International Law is extremely pessimistic about the prospects of dispute settlement and argues that any sort of outcome of this exchange rate issue is much more likely to come about via diplomacy or I think by China's consideration of its own interests.

There are good reasons why China may wish to go to undertake an exchange rate appreciation or to float the currency, and China has sort of indicated it wants to go that way in the long term.  A couple of other points.  One other point I guess on this that bothered me.  The notion that capital account convertibility in one place is said to be the core of the exchange rate since World War II, and really that came an awful lot later.  Capital account convertibility in general didn't come until countries had floated exchange rates.  I well remember trying to get $500 from my friendly bank in Australia for a trip to Fiji and having to explain in great detail to the bank manager why I needed this and how I wasn't going to blow it on a--I mean and this was in the early 1970s.  It really did take a long time to get capital account convertibility under regimes of fixed exchange rate.

Then finally the bilateral deficit issue.  It always kind of puzzles me, as Ernie says in parts in the book, the key issue is the overall trade balance.  If you have a sound balance between income and expenditure, then your overall trade balance will be okay.  I don't really understand the concern about bilateral trade balances at the individual or at the national level.  I'm eternally grateful that at the personal level that I supply it when I supply services to the World Bank and ran a surplus with the World Bank that I'm not required to make all my expenditures at the World Bank shop in order to balance the bilateral trade between me and the World Bank.  There are situations one can remember from history where people were required to do that.  Coal miners required to spend all their income at the company store.  Sharecroppers required to spend all their income at the store.  Really, this is not a very good model.  I think there is no reason whatsoever that we would expect bilateral trade balances between a country like the United States and Japan to be in balance even if each had their own current accounts or trade accounts perfectly in balance.  We have a whole lot of triangular trade.  China imports a whole lot of resources and intermediate goods, sells final goods to the United States.  The United States, if it had an overall trade balance, would be running surpluses with many of those suppliers.  Countries like Australia, China always has a surplus with Australia.

We would expect all sorts of triangular trade where overall trade balance, but--but no bilateral trade balances--no bilateral trades were balanced.  So I think subject to those couple of concerns, though, I think the volume really makes an amazingly large contribution to our understanding of a really important change in the world economy, the shift towards high tech in China's manufactures.  Thank you.

[Applause.]

MR. BARFIELD:  Thank you very much for those great presentations.  I'd like to just make one comment, and immediately thank another think tank in Washington, the Brookings Institution, for what I'm going to say because I'm going to pick up on some things that happened at a conference yesterday.

Brookings, once a year some of you probably know, has--or I think it's almost every year--has what they call a trade forum, and they bring together leading trade economists in the United States and from other countries.  And it's going on yesterday and today.  This year, their theme all the papers are built around--outsourcing.  But the opening paper yesterday I thought had direct relevance to the things that we've talked about this morning, because one of the things that the opening paper went into was the projections that China and India will catch up quickly or fairly quickly with the West and with developed countries.  The paper giver I should say for those of you who are economists was Dan Treffler from the University of Toronto.  But his commentators were James Marcuson, who I think is from MIT, and Jean Grossman from Princeton.  And while they had some things to say about some technical details of the paper, they didn't disagree with it.

And the point that he was making--one of the points that he made was basically saying, you know, there's nothing in traditional comparative advantage theory that would stop the United States from losing out to the Chinese in terms of high technology or even absolute impoverishment in terms of that, but he said a lot in recent years there's a growing literature and a growing school in terms of economic growth theory which really keys in on the role of domestic institutions, and particularly domestic institutions in innovation.

And what he argued was that quite soon, as China and India--India now before China, but China will move in this direction--as it moves in the direction of becoming both a services economy and also, Ernie's terms, a high technology economy, it will depend, in his words, on what he called constant innovation.  And I'm just going to pick up a couple of sentences.  And "in the new institutional and growth view of innovation, innovation cannot occur without institutions that protect property rights, that provide a fully functioning legal framework for arms length transaction or contracts that support thick equity and debt markets, and that balance the needs of inside innovators against those of outside innovators."

And then he took a look at the Chinese economy and argued that the role of the government prevents still and will continue to prevent, and it will only be a slow change, the efficient allocation of resources.

And secondly that there--which is commonly known--the very weakness of the financial system will also hold them back for a long time and that this is not something you can change quickly.

Thirdly, he talked about the fact that there is no social safety net in either country and that this will lead to continual labor market inflexibilities.

And then he said, and argued, an indigenous lack of the capability to innovate, because innovators are hemmed in continually by corrupt government officials and bureaucrats.

And so, in the end, he argued that despite the other things that are happening, they will run--these two countries--up against these kinds of barriers and that these kinds of barriers are not easily overcome.

I just want to throw that out in terms of what we've heard today to say that there is a whole set--or a number of economists, and he pointed out that there are other economists who don't agree with this--who are quite skeptical of this catch up, even with the numbers that Ernie presented to us.

So I'll turn it back to Phil, and we can get on to questions.

MR. SAUNDERS:  Well, why don't we go to questions.

MR. BARFIELD:  Okay.  Let's just go to questions.  We have a moving mike here.  Please raise your hand and identify yourself.  Why don't I start here and then go to Sylvia.

Questions and then short statements if they're statements.

MR.          :  These are both to the SI's.  Thank you for two excellent initial presentations.  Extremely interesting and comments.

I'd like to start by fully associating myself with the comments on the currency and the capital account issues that were raised by Will Martin.

But my question is really directed to Tai Ming Cheung and also to Mr. Preeg.  It relates to the last comment you made, Mr. Cheung, namely the meaningfulness of U.S. technical export restrictions, not only on China, but perhaps on other countries as well.

Whenever you discuss the question of the bilateral trade deficit with the Chinese, they will respond, without any hesitation, but you don't allow us to buy what we want to buy.

Now, I don't know how important that is quantitatively, but it is an issue I think that needs to be addressed, particularly now in light of the prospect that in some areas that Chinese may be in a position or may become in a position where the could do to the U.S. what the U.S. has been trying to do to the Chinese, namely holding back technology development.  What do we know about these export restrictions?  Who is watching that?  I mean is this becoming an important issue now?  How many of them are still valid?  Are we--is anybody seriously looking at these issues.  That's my question.

And if I may, Mr. Barfield, in response to your comment, I think what the commentators at Brookings said yesterday is very true.  There are all sorts of institutional limits, breaks, on innovation in China, but the really important question I think is a different one.  How do you explain that the Chinese are making so much progress and doing so much innovating in spite of all of this?  That's the real question in my opinion.  Thank you.

MR. CHEUNG:  I'm not a U.S. expert, but I'm sure that it's the Commerce Department and the Defense Department that is paying particular attention to this.  And given what's been going on in the last few years, I mean these restrictions are getting tighter rather than loosening up.  And as you said, the Chinese arguments is that if you open up your markets, whether it's on nuclear, on defense related.  It's like we can buy tens of billions of dollars worth of your products every year if you want.

Interestingly, on the question about innovation, it's like--and what the Chinese are doing.  It's one of the key focuses of Chinese leadership, especially in the last five years has been they realize that the state has played too big a role, and that there has been all these institutional problems such as the lack of patents, the lack of intellectual property developments.  And this is one of the key issues that they are beginning to address.  I mean they realize that.  And the Chinese, in fact, they pay particular attention to this whole literature of technological innovation much more than in many other countries, and they, in particular, follow what the Europeans are doing in this, and they are addressing these issues.  So beyond what we see in terms of--on top of the iceberg in terms of the exports et cetera, what is going on within the Chinese institutional processes are that they are realizing what are the crucial weaknesses and obstacles, those fundamental ones, and they are beginning to tackle this.

So this means that the pace of technological innovation is only going to continue as they deal with these fundamental issues.

MR. PREEG:  Well, I'll defer to the audience, as well as my fellow commentators up here, but I--except for high-end computing, I'm not sure that there's--and obviously defense systems and subsystems that are really directly related--but I don't--are there large restrictions on what the Chinese can buy?  I say that as a question.  I'm not familiar that there are.  I mean I know that this is where it's--in the Congress it's focused on the--sort of the supercomputers and the ability to--you can't really tell the difference between the civilian versus defense use there.  But I'm not familiar with any other particular products or even whole sectors of categories--

MR. CHEUNG:  I mean there's satellites and space and all those--

MR. PREEG:  Satellites.  Space satellites.  Yeah.  Something like that.

But even there, I would guess--I don't know what the situation is with the Europeans, but on civilian satellites, you could probably buy that, I would imagine, or the capability or hook into it, as I think the Chinese have done with other satellites.  Anyway, that's just a question.  Sorry.  Go ahead.

MR. SAUNDERS:  Just a comment on that.  There are still a lot of restrictions, some under things like the missile technology control regime.  There's the U.S. domestic export license process, but what I think you get increasingly is a split between the things that are dual use, but primarily commercial, and as the state of things like high speed computing, electronics, satellite communications, the state of the art advances, and it's being driven on the commercial side, it gets harder and harder to do that.  But there are still important military technologies that are closely controlled.  And even if you take an issue like GPS, for example, where some of those restrictions have been loosened, but China is involved in the European Galileo Program, and the Europeans are not giving them access to the most accurate information.  They're keeping them out of the part of the Galileo system that provides the most militarily useful and accurate information on national security grounds.

And so there is still a role for export controls.  But it gets harder and harder as the state of art in the commercial side kind of overwhelms a lot of that.  But nevertheless, and maybe we may engage Tai on this, and that was one of the questions.  You have--I think you've accurately laid out a lot of what's happening in China in terms of the dual technology base.  If you had done the charts a little bit differently, we probably would see the commercial side increasing in overall value and growth, not least because China's actually military procurement from these defense industries has been down, and it may be starting to come up again.  That's been kind of a mystery among those who follow the Chinese military.  They're spending all this money on defense, but not a lot of it on procuring domestic systems.

Now, that's starting perhaps to change in the last couple years as they're building new systems that are more capable, but is there a split between what's going to happen on the commercial side, which in a lot of areas like electronics and space is going to be a lot closer to state of art and does have dual use applications, and I think your arguments are pretty persuasive that that's going to factor into Chinese military hardware versus the purer military specific technologies, things like, for example, stealth technology or electronic countermeasures where some of the commercial things feed into that, but you need a lot of hard purely military applied R&D and a lot of experience in building in and learning how to use it to really get the payoff on the military

So where we see a divergence where the civilian side works pretty well, but there's maybe still a lag on the military side.

MR. CHEUNG:  It's very difficult to find out exactly what's happening in terms of the military's participation within the civilian sector.  I mean I've been trying to follow some of this.  I guess one example I would give as a factor to indicate the extent of the shift in defense procurements within the civilian sector is in terms of Wah Wei, which is the most advanced IT company within China.  It's--a lot of the initial funding for Wah Wei came from the military, and the military indeed, from my calculations, procures between about six to 10 percent of Wah Wei's annual output, and Wah Wei's annual output has been growing by significant, double-digits, and this is only going to increase because the types of products that companies like Wah Wei or Daitung or Jungshing, et cetera, are exactly what the military wants.  And so I think over the coming years, increasing amounts of this procurement will go.

More importantly, on the R&D side, the military and the defense industrial base is having much closer cooperation with the civilian sector.  So while a lot of it in the past has been off the shelf purchases, increasingly it's this cooperative relationship where they begin both at the basic R&D levels, but also at the applied R&D levels, so that this relationship becomes even more integrated over the longer term.

MR. PREEG:  Just a quick factual point.  Certainly, the innovation is processes at the center of this and this business of how effective our export controls are is very complicated and it seems to be gradually weakening.  But, for example, because I--in the innovation section, I do have some specifics.  There's not enough to draw hard conclusions, but what I have here, maybe you have a comment.  This is China--the dawning--this is the name of the--Dawning 4000A Shanghai Supercomputer--this is in the last year or two--it's put forward that it can operate at 10 trillion calculations per second, putting it in third place behind U.S. and Japanese supercomputers.  This is the frustration of these export control task forces that they have couple years.

Five years ago, you know, you wouldn't see this.  So already they have the third fastest supercomputer made in China by a Chinese company.

MR. SAUNDERS:  Okay.  I want to--I've got somebody in the back, but I had recognized Sylvia first, and then I'll come back over here.  We'll go a little bit beyond, to maybe quarter of twelve or 20 of or quarter of twelve.  Sylvia.

DR. OSTRY:  I think I'm glad that--I'm Sylvia Ostry [ph.], University of Toronto.

I'm glad you mentioned Dan Treffler's paper.  I'll get hold of it.  I think it's a good example of how conventional wisdom is assaulted by China.  I happen to feel that if you think the United States is exceptional, and it is, then China is a class of exceptionalism by itself.  There was this [inaudible] an article by Andre Schliefer [ph.] on this conventional wisdom about rule of law, blah, blah, blah, all of which doesn't apply to China, and asking how come they're so much investment, a point that was raised here, into China if it's that awful.  It's a jungle.  And his argument, which I don't entirely buy is that it's actually less than it would be to have a mathematical model.  But I don't think that there's any evidence that says that--and clearly, it's not true--that you can't grow except if you have all the right institutions and transparency and so on.  I won't go into it, but clearly, that's not true.

But the point I want to make is the point Ernie makes, which is what is the United States view of this?  What is United States policy?  I don't know the answer, but I don't get the impression that there' a real discussion going on.

Let's take history.  I mean the Americans were able to do the Soviet Union in because the Soviet Union made the fundamental error that they should catch up with them military, and they did them in.  I mean Ronald Reagan did them in.  They would have been done in anyway, but in their effort to balance the United States, they invested in the military, and my impression is that China's policy, in the military as well as other things, is unique.  I mean dual use technology.  Do you know of another country that did that?  Japan.  Oh, that's good.  I didn't know that, because I want to get to Japan.

But I mean when I read on--

MR. SAUNDERS:  Could you just another minute, Sylvia.

DR. OSTRY:  But I mean when I read on asymmetry, which is their defense policy, that's brilliant.  They'll attack the United States where they can have the innovation and do it.  I think it's very clever.  They're not going to be done in, and they'll use Taiwan, et cetera.

But I think the other thing--I didn't know they followed Japan on that--the other thing is tech transfer.  And I don't see this as new.  In the work I did in China, my impression was overwhelming in the '90s that there was only one thing that was at the top of their goals, which is the tech transfer.  And they were very skilled.  Ernie, you don't cite the Department of Commerce study which shows how skilled they were when they got the multinationals in, and I think the figure of 700 R&D centers is so unbelievable--

MR. PREEG:  Three years ago--

DR. OSTRY:  No, but I mean there's nothing else in the world's history or anything else.  So this is extremely important.  I don't think the WTO can cope with that.  So I don't know what you do, and clearly the two things are linked, but I think one of the things one has to look at is climbing the ladder of dual use and others through tech transfers.  It's a very complex issue.  What does that mean to the rest of the world.  We don't know.

MR. SAUNDERS:  Let me go back to the gentleman in the back, but let me just point out that you got to be very careful as to somehow the Chinese are doing the economic activity that is their policies and then in terms of tech transfer and an open investment policy is what economists tell developing countries to do.  And so we got to be very careful about saying, and somehow in the United States, this is increasing being transfers as somehow this is unfair, because they're successful, ipso facto, this is unfair.  I don't want to get to the currency thing for the moment.  But just in terms of the innovation, you know, my reaction is so far, is that, you know, we should react to this just the way finally did to Japan:  tend to our business here.  But let me--I'll come back.  Oh, go ahead, Ernie.

MR. PREEG:  Yes, one point.  You raised WTO.  Big problems, but one of the specific obligations China took on in WTO accession, beyond the basics, was a flat out obligation they would not make technology transfer or exports a condition for approving a foreign investment.  Period.  And it happens all the time, and USTR does a lot of things, good things, on IPRs and other things, they have not pursued this issue.  And I've got several examples in here.  The GE one got front page treatment in the Wall Street Journal a few months ago.  But that's a categorical commitment that they are just ignoring.  In fact, I--if you read the chapters--incidentally, the whole book is only $10, so I hope all you go buy a copy.  They have an official policy for foreign investment on their web site that says in the high tech industries they will only approve if they bring in technology, which is a blatant violation of their commitment in the WTO.  So there are things out there.  If we had a policy response that was firm?  Huh?

MR. SAUNDERS:  All right.  Let's go to the--let's keep moving here.

MR. OSTERMAN:  Good afternoon.  Andrew Osterman [ph.].  I think the frustration you all feel in looking at this event is that you're trying to apply a 1960s innovation model to what's going on in China.  If you presume that highly bureaucratic centralized structured peer reviewed academics are the source of technology, then you have missed the entire experience in the Silicon Valley.  What the Chinese have done, very carefully and brilliantly, is understand where innovation comes from.  Study the Silicon Valley and work very carefully with the Japanese to make it happen.

So what you're witnessing is right now is a perfect storm.  You have tremendous amounts of internal innovation desire, fueled by people outside of the classic bureaucracy.  Anybody who's ever dealt with the Shanghai banking families or the Chingwah [ph.] mafia certainly knows what I mean.  But what you're watching now is Chinese innovation being driven by three things:  internal demand outside the bureaucracy, an incredible willingness of Japanese firms to ship not only products, but entire factories, industries, and processes to China, and in addition a willingness of American firms to provide not only the capital for that transfer, but also the management skills for it.

So the Chinese in the next five years are sitting in the perfect sweet spot.  They have infinite access to American capital.  They have infinite access to all of Japan's advanced material and equipment technology, and they also have infinite access to an innovation model that says that large bureaucratic enterprises and the policies that exude from them will never be successful.  So, as a result, our export control plans are now becoming completely irrelevant, and someone needs to have a long, serious look at that, but it starts at the foundation.

Let me give you one reference.  If you have--

MR. SAUNDERS:  Please wrap it up in the next 30 seconds, please.

MR. OSTERMAN:  I'll give you five.  Read Christiansen's book on the innovator's dilemma or the innovator's solution.  Once you've read that book or you've worked in the Silicon Valley, the problem and the solution is amazingly clear.

MR. SAUNDERS:  Okay. Let's come--let's see.  Right here, in the front row.  I guess come around because it's the easiest to get to.

I guess I have to come back to the thing that all this means is more economic activity in the world and that usually produces good results, but come ahead.

MR. ZIGLER:  Hi.  Bill Zigler [ph.].  I definitely appreciate the speakers today, their comments.  They're not--I mean this is not new to the people that track this problem.  But one of the things that I'd like to say is that how have they achieved it so quickly is the evolution of the Internet.  I think we really need to start making tighter control and having that world policy on the Internet and getting people up to speed in education of stricter security and encryption.  And I'm not going to make any more comments to hang myself, but that's enough.

MR. SAUNDERS:  Okay.  Right here behind you and then I'll go on back.

DR. PRAKASH:  My name is Dr. Prakash [ph.], and I run Bridging Nations here in Washington, D.C, but I'm an entrepreneur.  For the last 28 years, I have been doing this innovation issues in Silicon Valley as well as here and the Midwest.

So I have to ask the panel--and you are welcome to answer--all of you or whatever--for innovation there are some facilitators, education being one major one.  And there are obstacles or the roadmap that is not fast enough.  So the discussion we're having today of the innovation in technology is a purely competitive issue.  Now, we are finding there are two new competitors on the scene.  Now, how do we deal with it?

What I would do in my business is the same thing.  I would try to identify exactly what is my strength.  What is my barrier to entry and how long will it take the competition to catch up.

So I would like to ask the question what do we feel are our real competitive advantages and what truly are the barriers to entry from the U.S. perspective, and what--the same thing applies to India and China.

MR. PREEG:  Well, you've mentioned--there's no single silver bullet or whatever.  There's a lot of elements to a book that I co-edited two years ago with Tom Dusterberg [ph.], my colleague in Boston at Manufacturers Alliance, called Manufacturing as the Engine for Growth in a Global Economy, and there are six economists.  All did chapters on different parts.  Innovation is obviously part of it, but then to apply market development and all sorts of things have interactions up and down the supply chain.

So it's a complicated procedure.  What governments need to do is facilitate it, because it's happening among competitive companies that are global for the most part, and the Chinese are beginning to go global.  And there are certain areas, though, and you mentioned education obviously and public sector R&D if it's properly targeted, where the government does have a role in terms of resource commitment.  And the Chinese have it big time at this stage, where in our--currently in the U.S., this is not a priority quite frankly.

MR. SAUNDERS:  Okay.  Back here, and then I'll come--I hadn't seen you before.

MS. PARK:  Thank you.  My name is Johanna Park, and I'm interning at AEI.  I'd like to ask you about trading with North Korea since Dr. Cheung showed us the trading.  Like [inaudible] technology and also you are the expert about military sector--Chinese military sector.  I'd like to as you how much--

[End of Tape 1, side B; Begin Tape 2.]

MS. PARK:  Military stuff with North Korea.  Thank you.

MR. CHEUNG:  The only dual use components that the Chinese give the North Koreans is [inaudible] and fuel.  But most of that is for civilian use, but it gets diverted for the military.  But I don't think that the Chinese, whether it's their defense industrial apparatus or the civilian apparatus actually does much trading with North Korea.  I mean there was a reasonable, a modest arms relationship back in the '70s and '80s, but there is very little in terms of trade these days.  The North Koreans can't afford and they don't buy much military equipment from the Chinese--mostly maintenance, spare parts for what they have.

I mean the interesting thing, though, is that there's a lot of North Koreans that come to China that get technologies and they buy that from the market and that's probably one area that they may be able to get access, whereas in China they have less restrictions than in elsewhere.

So I think in terms of if there's a high tech trade, that is where it would be in terms of North Koreans quietly going into China rather than at the state level.

MR. CROCKETT:  Good morning.  My name is Ryan Crockett with the Joint Military Intelligence College.  I wanted to direct my question to Mr. Preeger and Mr. Cheung.  How much do you feel China's military innovation is derived directly from U.S. R&D in the academic and commercial venues, and if that estimate is significant, how should that impact the fundamental research exemptions we apply to state and commerce export controls?

MR. CHEUNG:  The Chinese look very carefully at what the U.S. is doing in terms of military innovation, especially in terms of the dual use side.  The blueprint, the game plan, for the Chinese is very much copied on what the U.S. has been doing since the mid 1990s, so in terms of the fundamental basis, it provides China with the strategy and the direction.

But I think it actual, in terms of--I mean there are different types of military innovation, especially in terms of absorbative [sic] capacity, which many people say is one of the most important parts of innovation for them to be able to absorb.  The Chinese are much more focused on getting support and assistance from the Russians.  I think the Russians play a more pivotal role in that than on the American side.  But the Chinese also around the edges in terms of what American corporations can provide in areas such as electrical [inaudible], they can get some advantages.

MR. SAUNDERS:  Sorry.  Go ahead.

MR. PREEGER:  Well, I don't have a specific answer to you except that these kinds of questions of their military capability, that's an intelligence task I would say, and I want to just comment on a topic or issue that kept coming up two weeks ago.  There was a two-day meeting in Palo Alto on high tech Chinese industry by the U.S.-China Economic Security Review Commission.  And when it came to these advanced technologies--the military or even some of the more, you know, bio tech and such--the thing was the U.S. government, it's just totally different than the Cold War.

During the Cold War, we kept track within the intelligence agencies of every single little technology being developed by the Soviets because that was the highest priority.  And intelligence gatherers--these are not mine--this is from others who knew our intelligence agencies--says they have almost no resources.  I don't know where you are--to develop this because there's no real interest that this is a first top need at the top level of our government, and intelligence agencies are only going to use their resources where somebody is at the top saying this is what we want to know, and the contrast between how closely we tracked Soviet advanced technologies, particularly related to military, was much more intense and we have much fuller knowledge than we have today because it's just not a priority.

MR. SAUNDERS:  I think the question was about scientific literature and a research exemption.  We have an open science system here.  I do not see how we can exclude the Chinese without excluding the Europeans, the Japanese.  I mean certainly we would not want to stop our academic; if you're talking about scientific literature, we would not want to stop our academics from having an open system, because we are the ones who benefit from that; that it's our other scientists and scientists around the world, and we just have to take our chances with the Chinese, as we did with the Russians.

MR. BARFIELD:  On that specific point, though, our proposals now to have what are called deemed exports and to basically change the U.S. system of export controls so that, let's say a researcher from China or India wants to work in a U.S. lab that has export-controlled technology, the proposal is now to have the lab get an export control license to hire that person to work in the lab.  So that's something that is at least under consideration or under debate right now.  And, you know, you have to think hard about that.  What are the advantages of it, but it certainly does impact upon freedom of research at the laboratory and the corporate level.

MR.          :   Dr. Preeg, you had talked about a lack of national purpose equivalent to what we had seen earlier in our response to the Soviet Union.  While that is not yet really reached our national consciousness, I'm curious if there are any specific individuals in the higher levels that are looking at this right now and that we might expect leadership to emerge from?

MR. PREEGER:  Well, it's getting certainly attention again, I mentioned the U.S.-China Economic Security Review Commission, with 20 commissioners--oh, no, 12 I guess it is.  Pardon me.--from both sides of the House was congressionally initiated.  There are  a number of members of the Congress I believe who are understanding this.  I--there was the--cite right up front.  Just one more citation.  This is from a year ago--in fact, a little over a year ago, it was pretty much how I got started on this.  The President's Council of Advisors on Science and Technology, PCAST, a little over a year ago, came in saying while not in imminent jeopardy, a continuation of current trends could result in a breakdown of our innovation ecosystems, and has major implications for national security, and they raise China in considerable detail.

And there was another task force I mentioned earlier on innovation.  So there are groups out there, but it still has coalesced.  Certainly, I don't see a focus on it within the executive branch in terms of one of the top concerns we should have in terms of a comprehensive more forceful U.S. response to maintaining our longstanding leadership in advance technology, innovation, production, exports.

MR. SAUNDERS:  Okay.  I'll take two more questions, and then we'll wrap it up.

MR. RAUSCH:  Hi.  I'm Larry Rausch [ph.] with the National Science Foundation.  One of the indicators that we've longed used to track national capacities for developing new technologies are U.S. patent data and trends in U.S. patent data.  And we've--you could certainly look at trends from Japan and then South Korea and Taiwan and really corresponding quite closely with their development--other sorts of indicators.

We don't see that with China, and looking at the more recent data from Chinese inventors patenting in the U.S., it's really going up.  It's really not to a corresponding fashion with their growth in their other indicators.

Now, one could speculate that certainly there is somewhat lack of attention to intellectual property rights might be part of an explanation, but I was wondering if the dual use strategy might be another explanation.

MR. CHEUNG:  The dual use side has some aspects, but I guess it's having reviewed the whole process, the Chinese leadership hasn't really paid attention to the patent system and to the IP system until I think the last two to three years.  Only since then, they've begun to study and direct attention, and now there is some major restructuring going on, and now you see increasing amounts of literature and press articles where they say we need an effective patent system.  We need to--because the fundamental aspect is that--if you don't have a proper patent, an IP system, you don't have incentives to have entrepreneurs and companies to develop things, et cetera.  And they've begun to realize that.

And as part of this restructuring of R&D apparatus, they are now beginning to say we have to address this problem, and it's going to take time because of the history of counterfeiting and of lack of attention.  But they are now beginning to pay more focus.

I mean in terms of secrecy, I mean there is aspects of that, but I think they also realize that it's like you have to have a certain amount of transparency in their dual use apparatus, and you can't keep things hidden as in the old Soviet system.

So I think it's not as much to do with the closed system that they used to have.

MR. PREEGER:  I might, Larry, respond to the question with a question to you: certainly, patent applications is one of the performance indicators that's tracked and is important.  China in the mid '90s was very, very low.  But really what counts is what's happened these last four or five years, 'cause that's when it's all trade, investment--it's all taken off.  And unfortunately, and as you know, NSF-OECD in your latest biannual you only go up to 1999 in your patent applications.  And what I have is the best I could get in my table--from '95 to '99 in the U.S., Chinese patents were going up 39 percent a year, compared with five percent for the U.S.-Europe here, but from a very low base.  But there's nothing there for five years, and my question is why can't the NSF have at least '02, if not '03, '04, because what--the big question is how fast is--has it still been going 39 percent a year in the last five years?  If so, it will begin to be much more interesting.

MR. SAUNDERS:  That's because the Administration just cut their budget a hundred million dollars; right?

MR. RAUSCH:  I think actually the most indicators for 2004--I was--I'm guessing that you pulled the data from--that data certainly went through 2001 in terms of patent grants, and I don't recall what I had put in there for patent--

MR. PREEGER:  Patent application.

MR. RAUSCH:  For patent application.

MR. PREEGER:  It is the leading indicator.

MR. RAUSCH:  It was certainly 2001, and, you know, I think the patent--like the trade data, the patent application data are administrative data, and you can get fairly recent data, especially certainly for the U.S.  Once you start going to international comparisons where you're pulling in countries from--data from around the world, you lose a few years.

But U.S. patent data fortunately have been a very good indicator of national capacity for technology development.  The U.S. market, you know, attracts technologies from around the world, and those data are available and I think that you would certainly find 2001 data in the last indicators, which was published a year and a half ago, and you'll see 2003 data in the one that's published next January.

MR. SAUNDERS:  Okay.  I think--though I said, two, I think I'll just hold it to one, 'cause that went on a bit.  Please join me in thanking our commentators and the audience for a really rich performance.

[Applause.]