The December agreement doesn't mark a major breakthrough, nor does it come anywhere close to resolving the real contentious issues that separate the two countries. To reach the next phase will require each side to determine what fundamental concessions it might be willing to offer the other. In the interests of Chinese and American prosperity - not to mention the health of the global economy - negotiators must find a way to come to a compromise. The ultimate goal of the next stage of negotiations for both sides should be very clear: to reach an equitable deal that lowers barriers to trade and investment. If both countries follow the same rule-based system, freer trade lowers consumer prices, promotes competition, improves efficiency, stimulates innovation, and ultimately leads to greater economic growth. In the service of this aim, each country must determine what its real objectives are and prepare to make important concessions.
What Both Sides Must Do to Forge a Better Peace
January 13, 2020
Temporary cease-fires and false dawns have punctuated the 19-month-long trade war between China and the United States, only to dissipate with a sudden setback in negotiations, or a tweet from U.S. President Donald Trump that dialed up the heat on China while chilling global markets. And so the world heaved a sigh of relief when the two sides announced Phase I of a trade deal in December, the first step toward a negotiated peace.
Predictably, the Trump administration claimed a major victory, calling the deal "historic." The Chinese side offered a positive spin of its own, noting that the deal would promote high-quality growth and facilitate necessary economic restructuring. As part of the deal, the United States agreed to cancel the 15-percent tariffs that had been scheduled to take effect on December 15 on $160 billion worth of Chinese goods, and to halve an earlier set of tariffs on another $120 billion worth of goods. In exchange, China agreed to increase its purchase of U.S. products by $200 billion in the next two years.
Beyond these accomplishments, however, the victory rings hollow for both sides. The December agreement doesn't mark a major breakthrough, nor does it come anywhere close to resolving the real contentious issues that separate the two countries. To reach the next phase will require each side to determine what fundamental concessions it might be willing to offer the other. But in the interests of Chinese and American prosperity-not to mention the health of the global economy-negotiators must find a way to come to a compromise.
THE MIRAGE OF A BREAKTHROUGH
The Phase I agreement doesn't substantially bridge the impasse between the United States and China. Trump's 25 percent tariffs on $250 billion of Chinese imports will remain, as will China's retaliatory tariffs on U.S. goods. Washington presented several Chinese pledges as concessions to U.S. concerns about Beijing's trade practices. But these promised measures are either vague or extensions of policies already in place. Indeed, China had initiated most, if not all, of these measures-including steps to reform foreign ownership limits, currency exchange policies, and intellectual property protections-well before the trade war began.
As early as 2017, China had begun lifting foreign ownership restrictions-limitations that prevented foreigners from having controlling interests or, in some cases, any interest at all in firms operating in China-in many industries, ranging from financial services to the automotive sector, with the aim of removing all limits in a few years. In financial services, including banking, securities, asset management, and insurance, majority foreign ownership was allowed for the first time in June 2018, and ownership limits (now at 51 percent) are set to be completely removed in 2020. Ironically, the pace of change might have been faster if not for the trade war, which forced China to withhold some reforms.
China's currency exchange rate, too, should have been a fading source of contention. The Trump administration has accused China of keeping the renminbi, or yuan, artificially low to make exports cheaper. In reality, China has been allowing its currency to strengthen since 1994, when the exchange rate stood at its historic low of 8.72 yuan to the U.S. dollar. China kept its currency stable throughout the Asian financial crisis of 1997-98, even while almost all of its neighbors devalued theirs. In the decade from 2005 to 2015, which included the global recession of 2008-09, the yuan gained more than a third against the dollar. It weakened slightly between 2015 and 2016 after China lifted capital controls (and lost about a quarter of its foreign exchange reserves, nearly $1 trillion) and has since settled at about seven yuan to the dollar. Since 1994, China's central bank has usually intervened to prop up the yuan, not to weaken it.
China has significantly tightened intellectual property rules and enforcement in recent years.
Regarding intellectual property, China has significantly tightened rules and enforcement in recent years. Beijing set up specialized intellectual property courts in three major cities in 2014 and intermediate-level tribunals in 17 provinces in 2017. In the last four years, China's Supreme Court has issued guidelines and policies on the judicial protection of intellectual property rights. These have strengthened the courts' jurisdiction over intellectual property infringement cases and provided a framework for damages. The Supreme Court inaugurated its own permanent intellectual property court on January 1, 2019.
China's total intellectual property payments to foreigners have grown on average 20 percent per year since 2000, far outpacing the median growth rate of 9.5 percent across all countries, according to a study by Shang-jin Wei, a professor at Columbia University. The improved regime of intellectual property protection helps explain why China attracts more foreign direct investment than any other country except the United States.
For those watching China closely, the increased effectiveness of intellectual property protection has been clear to see. Convinced that China was serious about enforcing intellectual property rights, my company, a foreign private equity firm with several investments in China, made a modest $60 million investment in a Chinese digital music platform in 2014. At the time, that business's only asset was a repertoire of copyrights in lyrics, music scores, and albums, purchased or licensed from local artists and international record labels. The platform grew rapidly to become the backbone of what is now Tencent Music Entertainment, the dominant digital music provider in China. TME listed on the New York Stock Exchange in December 2018 and now has a market capitalization of about $20 billion, all thanks to the enforceability of copyrights in China.
NO VICTORS IN SIGHT
The trade war has so far failed to achieve Washington's stated objectives-namely, to bring manufacturing jobs back to the United States and narrow the country's trade deficit. By September 2019, U.S. manufacturing had sunk to a more than ten-year low, and it has continued to weaken since. The U.S. trade deficit with the rest of the world has ballooned from $544 billion in 2016 to $691 billion in the 12 months ending in October.
Tariffs on Chinese goods have backfired, in that U.S. consumers have paid almost their entire cost, according to a recent study by economists at the Federal Reserve Bank of New York. The tariffs were expected to work by forcing Chinese exporters to lower their prices to compete. However, China's export prices to the United States have not really changed since the trade war began.
There are, of course, no winners in this trade war, and to think otherwise is delusional. Tellingly, this magazine recently conducted a survey framed around the question not of which side is winning the conflict but, rather, which country is losing more than the other.
The longer the trade war drags on, the more damage both countries will sustain.
The longer the trade war drags on, the more damage both countries and the world economy will sustain. Already, global supply chains are disrupted. More consequential will be the oft-talked-about "decoupling" of U.S. and Chinese technological systems. Technology companies used to boast that "the world is our market." No longer. The United States has chosen to restrict exports of high-technology products to China, and so Beijing is making every effort to become less dependent on U.S. supplies. The rupture will not help anybody.
The United States' leadership in technology will slip if it shuts itself out of the biggest and one of the fastest-growing markets in the world. Bart van Hezewijk, innovation officer at the Consulate General of the Netherlands in Shanghai, reckons that the ten largest U.S. semiconductor companies earn a combined revenue in China ($79.3 billion) nearly three times their sales in the United States ($28.1 billion). All of these firms are now forecasting significantly lower sales to China.
With so much at stake, the Phase I deal between the two countries is indeed a welcome, albeit modest, step in the right direction. But tariffs and other trade restrictions persist, and they continue to inflict serious damage on both economies. With Phase II negotiations ahead, a wide gap still separates the two sides on major issues, and the prospect of serious compromise remains distant.
Neither side has provided concrete details on what it hopes to achieve in the next round of negotiations. But China's main objectives are unequivocal. Beijing wants Washington to remove all the tariffs imposed since the trade war began, and it will be prepared to reciprocate in kind. It wants the United States to drop its sanctions on Chinese technology firms such as Huawei, and to relax restrictions on Chinese investments in the United States.
The United States will likely be reluctant to amend policies designed to thwart China's advances in high technology, such as pressuring third-country governments not to buy telecommunications equipment from Chinese suppliers, blocking U.S. exports of microchips and software to Chinese technology companies, and restricting Chinese investments in the United States. Washington has also repeatedly criticized the Chinese government's support for its state-owned enterprises and taken issue with Made in China 2025, a Chinese plan to increase domestic capacity in technology-driven fields such as pharmaceuticals, semiconductors, and robotics in the next five years. But China is unlikely to abandon its ambition to catch up and compete with the United States in developing and producing new technology.
Each country must determine what its real objectives are and prepare to make important concessions.
The ultimate goal of the next stage of negotiations for both sides should be very clear: to reach an equitable deal that lowers barriers to trade and investment. If both countries follow the same rule-based system, freer trade lowers consumer prices, promotes competition, improves efficiency, stimulates innovation, and ultimately leads to greater economic growth. In the service of this aim, each country must determine what its real objectives are and prepare to make important concessions.
The United States must decide whether what it really wants is access to the Chinese market and better prices for U.S. consumers, or whether it simply wants to contain China's rise at all costs. Washington cannot have it both ways. The former aim could ultimately lead to a trade deal, but the latter never will.
For its part, Beijing must finally decide what to do with the most pernicious holdover from its planned economy days: China's inefficient state-owned sector. Business leaders generally believe that this sector will be the complicating factor in Phase II negotiations. But it need not be. China's own stated goal is to let the market be the decisive force in the allocation of resources in the country. China should continue to restructure, reform, downsize, and privatize the state sector in accordance with this goal, not just because doing so may entice the United States to stop the trade war but because such reforms will be good for China. Whenever China has undertaken market reforms, for example in 1992 and in the early 2000s, its economic growth has surged. Conversely, its growth suffers when the pace of reform slows down.
The process through which the parties reached their Phase I agreement was torturous, and Phase II will likely be even tougher, because more is at stake. At issue will be not only economic considerations but also political ones: for example, how a final trade deal could influence the U.S. presidential election in November. The talks may need to proceed through multiple phases for the countries to resolve their differences. But the global economy will benefit from continued work, on both sides, toward reducing trade tensions. If Phase II leads the United States and China to more trade and greater economic cooperation than they had before the trade war, then both countries will have managed to win.