Trade Peace, When The Time Is Right

Daily discussion of trade war tactics has obscured the objectives that could be realized from an agreement.  I believe a mutually beneficial outcome is possible, but political pressures could make it more difficult to conclude a deal. This review is not intended as a forecast, but a summary of issues and related risks that provides a framework for understanding news that may appear in coming months.

Merchandise Trade Balance

• China is rumored to have offered commitments for large increases in US imports that could be mostly satisfied by shifting purchases from other countries, for example buying soybeans from US instead of Brazil and “freedom gas” from US instead of Australia etc…
• US exporting industries would benefit from a predictable long-term market. Mainstream economists recognize that the overall US trade deficit is attributable to capital flows. The US runs a capital account surplus (that must be balanced by a current account deficit) due to accumulation of US dollar reserves by foreign central banks and by the large US fiscal deficit which is partially financed with capital inflows from foreign investors. Trump’s view of the aggregate trade deficit as a “loss” was more common in the 1980s.
• Issues and Outlook. A lower deficit can be delivered through shifting of some commodity purchases and possibly aided by some statistical changes. For example, the price of an iphone is deemed to have have been imported from China even though most of the value is attributable to parts made in other countries. It may be difficult to mandate and enforce a fixed target for reduction of the trade balance while also demanding less Chinese government role in its economy – what if Chinese companies and individuals opt not to buy US products? It may also be difficult for China to substantially increase imports if the US bans export of high value products like semiconductors. It may be difficult for China to meet an import target if high value Boeing planes are not airworthy.

Market Access

• China restricts/prohibits foreign participation in many industries including media, internet, communications, financial services, education, auto, steel, and energy. China has continually promised to improve openness and made some changes in 2018 (LINK).
• US businesses strongly support efforts to improve access and American companies could be strong competitors in many currently restricted industries.
• Issues and Outlook. China has pledged support for increased market access (example) so in principle it should be easy to make progress. Sticking points are likely to be China’s insistence that foreign companies abide by existing Chinese laws in areas such as media censorship and informal restrictions documented in this June 2018 White House report) that create obstacles to operate businesses which are technically allowed.

Foreign Exchange Rate

• China uses strict controls on movement of capital and influence over major banks to maintain a relatively stable exchange rate and has pledged to continue doing so.
• US businesses long claimed that the yuan was artificially undervalued in order to boost exports and reduce imports, however most economists see the current exchange rate as close to fair value. Trump promised to label China a “currency manipulator” during his first 100 days in office, but the Treasury Department has not followed through (LINK).
• Issues and Outlook. It sounds like the US wants China to agree to not manipulate the exchange for trade benefit. In principle China agrees, but the definition of manipulation and the evaluation of any future disagreement seem to be sticking points in negotiation. The “fair value” of the exchange rate will fluctuate over time due to economic factors which may be difficult to foresee at the time that a trade agreement is signed.

Technology Transfer and Theft

• China denies that any theft has occurred and pledges protection of intellectual property. China claims that technology transfers have been fairly negotiated as part of normal commercial transactions. China has a new proposed law governing foreign investment that would strengthen protection against administrative measures that are perceived as having being used to coerce some foreign companies into exposing technology secrets, for example as part of safety or licensing tests.
• US businesses strongly support changes.
• Issues and Outlook. This article (Is the US right to cry foul about forced technology transfer to do business in China – and what is Beijing’s position?) provides a good review of the issue. Significant progress was made on cybercrime following a Xi/Obama summit meeting in 2015 (LINK), but Chinese hacking efforts rebounded after Trump was elected with an anti-China agenda (LINK)

State Intervention & Subsidies

• China describes itself as a “socialist market economy” within the context of Marxist Leninst theories of historical development. The revolutionary role of the Communist party has faded in relevance, but under Xi Jinping the party and the state seem to see their purpose as safeguarding stability and morality, a role evocative of Confucian traditions (LINK) that were once reviled (LINK). In this context management of the economy is an essential function of the government and efforts to promote leading industries (e.g. Made in China 2025) are a natural part of those responsibilities.
• US businesses see state support as providing an unfair advantage to Chinese companies against which they are competing. In the 1980s US Trade Representative Robert Lighthizer aggressively pushed for changes in Japanese government policies at a time when direction from the Ministry of International Trade and Industry was perceived to create collusion among Japanese companies to improve their position against international rivals. The post-1990 stagnation of the Japanese economy revealed that corporate Japan was not as strong as had been believed and industries favored by MITI such as supercomputing and mag-lev trains did not end up being meaningful in the global economy.
• Issues and Outlook. While it’s very clear that China’s government provides significant support to favored industries with the intention of boosting their global competitiveness, it’s not clear that this will be successful. Brilliance Auto illustrates many reasons why state involvement retards innovation and efficiency (LINK). Access to state support provides a Chinese company with greater resources, but it’s not clear that it leads to superior performance due to the accompanying political interference in business operations. Decades of support have not made China competitive in production of autos (aside from JVs with US and other foreign OEMs), semiconductors, or aircraft. Every country’s government intervenes in its economy in various ways. The Trump administration seems to be pursuing a Made In America 1925 strategy of promoting the leading industries of the 20^th century (steel coal and autos). This is a difficult area to negotiate because it’s not clear what would be the best outcome for the United States and American businesses while China sees state participation in the economy as a fundamental right and responsibility.

National Security

• China restricts foreign participation in many sectors deemed essential to its national interest. The recent ban on sales of technologies to Huawei highlights China’s dependence on certain American technologies and will serve as a “sputnik moment” leading to greatly increased commitment to development of domestic production capacity. This will reduce the long-term market potential of current American suppliers.
• US initiatives to ban business with certain Chinese companies like Huawei may be justified if they present true risks to American security, however the sudden emergence of these issues at a late stage of trade negotiations gives the impression that the ban is just a lever to force concessions on other negotiating points. The national security justification would be more credible if there were any US strategy to identify critical industries and develop domestic production capacity. What US interest is served by limiting Chinese access to android phone software and Windows 10?
• Issues and Outlook. Genuine security issues cannot be resolved as part of a trade agreement and each side is likely to be more aware of the sourcing of essential civilian technologies.

China appears to be willing to make concessions on trade balance, market access, exchange rate, IP protection and cybersecurity. This weekend’s release of “China’s Position on the China-USEconomic and Trade Consultations” takes a conciliatory tone on these issues. Commitments in these areas can be described as serving China’s own interests rather than surrendering to US pressure. Agreement in these areas would be welcomed by American businesses and global financial markets.

China’s Communist Party no longer promotes revolution as a source of its legitimacy, but Xi Jinping has tapped nationalism which he summarized as The Chinese Dream Of The Great Rejuvenation Of The Chinese Nation as a unifying purpose. Tough US trade negotiating tactics risk resemblance to the “unequal treaties” forced upon China by western powers in the 19^th century. Even if certain concessions made sense in economic terms, they would be unacceptable if they undermined the role as protectors of national pride that the party and government have defined for themselves. China’s favored terms in all international negotiations are “win-win” and “mutual benefit”. China will be more amenable to concessions if the US permits them to couched in this type of rhetoric. China’s paper on the negotiations repeatedly emphasized the importance of “sovereignty” “dignity” and “respect”.

The confrontational trade policy is driven by Trump, but the details of what sort of deal the US is seeking are unclear. Trump’s staff and his advisors have varying preferences and Trump is famously uninterested in most policy details. He is confident that his gut instinct will guide him to a superior deal and said  “When the time is right, we will make a deal with China.”  I believe this has two aspects:

1. His negotiating strategy is like Tony Soprano, he will keep hitting you until he feels that he has gotten everything you can give him. Robert Lighthizer may never be fully satisfied with details of a draft agreement, but at some point Trump will decide that there’s nothing more that China can give up.
2. Trump has made clear that he sees the greatest threat to America is not from China, or Iran, or North Korea, but from Joe Biden. A China trade agreement will be evaluated largely based on how it will impact the 2020 election. Tough talk on trade continues to hold great appeal to many Trump supporters. On the other hand trade tensions that slow the economy to the brink of recession and crash the stock market would make re-election impossible and would erode the support he needs to resist congressional investigations.

Trump’s achievements have been scarce. He delivered increased mercury emissions, but Mexico hasn’t built our wall, immigration is a mess, health policy is going nowhere, infrastructure week became a joke, the huge tax cut benefited corporations rather than individuals, the new NAFTA is mostly the same as the old NAFTA and he may have sunk it with his new tariff threats against Mexico. A China trade deal could be one meaningful achomlishment.

Raising criticisms of Chinese policies as part of trade negotiating tactics has hardened American public opinion about China. I believe that engagement and interdependence reduce long-term risks, but we seem to be moving in the other direction. Some even relish the prospect of a racial clash of civilizations. I believe that policies which promote such a conflict would be a terrible mistake, but they may be coming anyway. Chinese policy looks more at odds with Western values than it did five years ago, but considering the changes in China over the past 100 years it would be foolish to assume that current policy will be immutable. Last month Angela Merkel urged Harvard graduates to “tear down walls of ignorance and narrow-mindedness, for nothing has to stay as it is.” I hope that America does not turn away from the economic freedom, flexibility, and openness that have been the foundation of American prosperity.