Tuesday, December 4, 2018

Ready for a China Deal?

By Roy C. Smith

The only significant thing that happened at the G20 talks in Buenos Aires was the dinner between President Trump and Chairman Xi. It occurred six months after the two-day session in May during which the US side presented its “demands,” which were followed by a continuous and noisy barrage of incremental tariff hikes, criticisms and other threats. The tactics were more intense than those used by Trump’s immediate predecessors in dealing with the China trade imbalance, but not necessarily more so than the tactics used by Richard Nixon and Ronald Regan to get Japan to reduce its surplus in the 1970s and 1980s.

In May it was clear that the two negotiating sides hardly knew each other and the issues to be resolved were very wide ranging. It is also true that the US economy is growing faster than before, while China’s is in danger of sliding below the 6% level that many observers believe must be exceeded to prevent serious disruption in the labor force and society in general.

The leaders agreed to put future US tariff increases on hold for three months, while negotiations on the issues continue. The Trump team essentially wants to be able declare a victory in the talks by gaining concessions in four areas: (1) stop requirements for technology transfers to US-China corporate joint ventures, (2) reduction of stifling non-tariff barriers to US imports, (3) improved enforcement of intellectual property protections, and (4) increased purchases of US agricultural and other goods to reduce the trade deficit. These are the four right areas. China has already agreed to some accommodations on them, and Mr. Trump has already tweeted that great progress has been made, but he has also appointed his hardliners to manage the negotiations from here, replacing Treasury secretary Mnuchin. 

China joined the World Trade Organization in 2001, when its global trade surplus was $360 billion. In 2006 the surplus peaked at $761 billion, and since has declined to $560 billion in 2017.  But, China’s trade surplus with the US reached $276 billion in 2017, a record high, when exports to the US totaled $2.9 trillion. The greatest volume of goods are electronic devices and components, followed by toys, furniture, clothing and shoes, and household appliances. Imports of high volumes of these goods, well-made and at lost cost, constitute the carefully engineered supply chains of large US retailers and manufacturers. The US is China’s second largest trading partner behind the EU – China had a trade surplus with the EU of $176 billion in 2017.

Just as happened in Japan, China’s trade surplus is shrinking under its own weight. Its local manufacturing costs are rising, skilled labor is becoming scarce, and, particularly under the Trump administration, it is encountering stronger resistance to its trade policies from its major trade partners over practices prohibited by WTO rules. US importers are beginning to source supply chains from countries other than China, Chinese companies are seeking to acquire US businesses or establish factories in the US, and one of the founders of the China export boom, Foxconn Technologies, a Taiwanese company that assembles Apple iphones in China announced a $10 billion new factory in Wisconsin, and a $900 million acquisition of a US electronics manufacturer in 2018.

Calculating net job losses from trade with China is very inexact in a competitive economic system with lots of “creative destruction.” The perception of the public is that imports from China have been a major contributor to the “hollowing out” of the working-and-middle classes of the US.  However, whatever job losses resulted from China’s imports happened in the past, and are not much of a factor in today’s low unemployment economy.

Still, a tariff war could be harmful to growth in both countries and probably would affect China more than the US. Even so, economists do not believe tariffs will plunge the US economy into a recession – Justin Wolfers recently reported in the WSJ that the average US tariff rate in 2017 was only 1.4%, adding the metals and the first round of China tariffs raised the average to about 3.2% in 2018. Another incremental round of China tariffs in 2019 could boost the average to 4.5%, and if all Chinese imports are to be subject to a 25% tariff, as has been threatened, the average rate might go to 7.2%. This much of a change is unlikely to happen, but even if it did, it probably would not be sustained, but the magnitude of the economic drag on the US economy from price increases would be modest.

The idea is for both sides to undo their tariffs after negotiating improved arrangements in the four areas.

China has only authorized US manufacturers to invest in China through joint ventures with Chinese partners. To be approved, the incoming US corporation must agree to bring their latest technologies so the joint venture (i.e., the Chinese partner) can benefit from it. This has been the price of getting into the potentially vast Chinese market, and corporations have been willing to pay it. (Mr. Trump has called the requirement “stealing our technology”. If China emerges as the world’s largest market for autos, semiconductors and chips, the foreign companies will need to use their latest technologies there. Anyway, technology turnover requirement is obsolete (China is no longer justified in protecting” infant-industries”), and China should be willing to remove it and give Mr. Trump’s team  an easy victory. What foreign companies would prefer is eliminating the requirement that they operate in China only through joint-ventures.

Reducing other non-tariff barriers to entry in China is more difficult. Many US products sell easily in China because of their styles and other features. Other stuff does not because it doesn’t appeal to Chinese consumers. But a lot of stuff is blocked by tariffs (e.g., on US cars) which China should acknowledge it is time to reduce. Bit other non-tariff barriers remain, such as requirement for licenses, testing, distribution agreements, etc. These will be argued over piecemeal, and some cosmetic concessions may be gathered, but many of the barriers will persist.

The real stealing of intellectual property through illegal copying and industrial espionage through hacking has probably past its peak, but hacking skills are increasing and foreign companies may still be exposed to the risk. But most companies know they are vulnerable and it is up to them to protect themselves.  China is likely to agree to better enforcement and remedies, but there isn’t much that the US government can do to be sure they do.

Finally, there is the demand that China purchase more commodities from the US to offset the trade surplus. Agricultural products and possibly liquid natural gas, which the US is just starting to export. This should also be an easy fix.

This leaves one important topic on the table – the Trump Administration’s opposition to the “Made in China 2025” strategic initiative announced earlier by Mr. Xi.   This is a plan to use all necessary resources of the state to develop a world leading high technology manufacturing capability aimed at further reducing China’s export dependence and shifting to a consumer-driven economy. Most economists think this is something China must do as its next stage of development. It is also an industrial policy typical of a centrally controlled economic system, which China still is, so grants, subsidies and protections of various kinds can be expected. These sorts of overt assistance are prohibited by WTO rules, but China, many think, will simply ignore them. The best way to address this issue is for the US, EU, Japan and other counties to band together, using the WTO dispute resolution framework, to force China to come to terms with them. Mr. Trump is unlikely to pursue such a globalist program – he likes bi-lateral deals – so this will probably be a struggle for the future, but it doesn’t have to be dealt with now.

All in all, the makings of a deal are there. Mr. Trump will want to squeeze all he can out of it, so there may be some bluster yet come, but ending the trade war in three or six months seems likely. So far, we have the precedent of renegotiations of South Korean and NAFTA trade agreements that did not change things all that much, and allow business to be done much as before.

But with Mr. Trump you never know.


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