Building a Better Deal with China
January 28, 2019
With Chinese vice premier Liu He coming to Washington, D.C. this week to engage in trade negotiations with his U.S. counterparts, this is an important time to take stock of the U.S.-China relationship, assess the goals of the talks, and chart a pathway forward.
The old foundations of the U.S.-China commercial relationship have cracked, and a new basis for the two is still unsettled. For decades, bilateral trade and investment ties were on balance, mutually beneficial, and did not directly threaten U.S. national security. Losses in some U.S. manufacturing jobs were offset by gains elsewhere, lower prices for consumer goods lifted household buying power, and the economy broadly shifted away from low-margin activities that were migrating to China toward knowledge-intensive innovation upstream and high-value consumer services downstream. But over the last decade, that balance between benefits and challenges shifted. There are multiple reasons for this, but the most important is that China has altered its policy mix in ways that are inimical to market economies and the liberal international order they have built. Since 2012, China has reverted to reliance on state-led industrial policy to generate growth as successive marketization steps became more difficult.
For a time, statism seemed to deliver higher growth at least in China, but the required inducements extended to state-owned enterprises, and pliant domestic firms led to massive distortions at home and abroad that now erode the gains. Rather than create stability, intervention is simply leading to new and probably worse concerns about instability, as the tab for politicized lending comes due at home and resistance to distortions in competition coalesces abroad. In the United States and beyond there is a growing consensus—despite impolitic U.S. unilateralism—that Beijing must change course on economic governance.
At their most recent presidential meeting in Argentina, the United States and China agreed to a 90-day timeline for reaching an agreement to resolve their differences. The debate over whether to expect a big deal, a small deal, an extension of negotiations, or a collapse of talks and a new wave of protectionist penalties has been unending. We believe there is a need to reconceptualize the goal of the process. The question is not whether China will become a market economy overnight and U.S.-China relations will return to “normal,” but what kind of system China believes serves its interests and what sort of relationship with the United States that choice permits. Washington has already decided, after a debate that started in the previous administration but was largely settled under Team Trump, that the commercial relationship with China must be bounded both by fairness and the expanding needs of U.S. national security. If China wants maximum engagement with the United States, it needs to make substantial economic governance changes so that the division of benefits is far more symmetrical. If China prioritizes political engineering of its economy and firms, there is less scope for linkage with the United States. Beijing will do what it thinks is right for China, and Washington must be prepared for either outcome—or something in between. Think of a sliding scale: China will decide if it wants to converge with advanced economy liberal norms, and the United States will calibrate how engaged it can be in response. That is the basic equation on which an enduring U.S.-China deal must be built, whether this March, this year, or in the years to come.
Immediate Reforms and Long-Term Structural Changes
To the extent China wants a broad and extensive relationship, it will need to make structural reforms to its economy. Catching up on the reform and opening agenda will take time, after notable delays in recent years, but Beijing can make meaningful progress immediately. Above average tariffs on autos and other manufactured products can be normalized; foreign joint venture requirements can be eliminated (yes, now, and across every sector); China’s negative list for inward direct investment can be cut by three-quarters to the advanced economy average; applications for U.S. banks in China to buy out their partners can be approved; licenses for Visa and Mastercard to offer electronic payment services and for Moody’s, Standard & Poor’s, and Fitch to issue domestic ratings in China can be issued; quotas on U.S. movies can be eliminated entirely; state-owned enterprises can be held to antitrust guidelines for mergers and acquisitions instead of shielded; industrial and agricultural subsidies can be capped and made available without discrimination to domestic and foreign firms (and fully reported to the World Trade Organization); and market access for U.S. companies in high value-added services including healthcare, education, logistics, cloud services, and e-commerce can be announced and expedited. If this looks like a run-on sentence, it is. It is far from comprehensive but describes the right degree of ambition for a negotiating outcome that would break the ice forming over the relationship.
These immediate changes would build goodwill and serve as a starting point for structural reforms to be implemented over years to come on a feasible schedule. Listing out all the elements of institutional and policy changes that Beijing will pursue if it is earnest about marketization would take hundreds of pages. Indeed, it has taken hundreds of pages, because this has been done before. The World Bank-State Council Development Research Center study China 2030, the Communist Party’s 60 Decisions of the Third Plenum in 2013 and companion materials: these and other lengthy documents have elaborated what China needs to do to make the market work, and why. Rather than reiterate every micro-element of such a package, we recommend looking for decisive action to reform in three acid test areas that if done right will flow down to the rest of the system.
First, the commitment to make the financial system commercially oriented instead of an extension of state planning must be made manifestly clear. That will be a long and challenging task, but it starts with an acknowledgment that the financial system is not operating in a wholly commercial or sustainable manner today.
Second, the essence of sustainable financial intermediation is increasingly about returns on investment in intellectual property. China has many years of hard structural work ahead to create healthy incentives to protect intellectual property rights (IPR). The formal basis of Washington’s unilateral tariffs and action against China is a set of four arguments about technology and IPR. A serious structural outcome in these negotiations must include some agreement that if IPR is not better protected in China in practice, then restitution for the damage to private property will be necessary, and that abundant evidence of past patterns of pressure on foreign firms require a radical improvement in transparency and pathways for legal recourse today.
Third, Beijing needs to align its competition policy goals with the goal of protecting consumers instead of protecting producers. Even today Chinese officials talk about “excessive” competition as though it should be reduced until all incumbents are happy with their profitability. If China is serious about being pro-competitive, then national treatment for foreign-invested enterprises with regard to registration, market access, and other elements of regulation should take precedence over protecting domestic margins. Fears about “excessive” competition, price wars, and overcapacity should be addressed not by bureaucratic gatekeepers but by the discipline resulting from a commercially-based financial system and a competitive environment that rewards quality and penalizes poor performance. As the Chinese Communist Party avowed in the 60 Decisions manifesto issued early in the Xi era, reiterating an insight the leadership had stressed in 1993, China needs a “unified, open, competitive and orderly” market system that corrects defects plaguing the economy as a result of excessive government interference which suppresses marketization. Absolutely correct: now it needs to be visibly realized.
This set of three must-have elements is illustrative, not comprehensive. Myriad other commitments need attention, from non-discriminatory recognition of industrial standards, certification and testing, to the system of explicit and implicit subsidies to profit repatriation.
Enforcement and the Sliding Scale
Ultimately, the room for U.S. engagement with China should be calibrated to the degree of convergence with advanced economy norms and structural market reform Beijing intends. The duration and extent of interim safeguards and transition mechanisms should be geared to how much time China requires to implement that marketization, not an arbitrary timetable. It is no sin for China to require time to implement reforms; but nor is it benighted for the United States or any other market economy to maintain temporary safeguards to remedy distortions arising from China in the meanwhile. Such safeguard tools as a Transitional Review Mechanism (TRM) for the first five years after China’s accession to the World Trade Organization (WTO) and a non-market economy pricing methodology for trade remedy cases made compromises possible in the past and have a role in a deal today.
In the years following China’s WTO entry, the United States focused its trade remedies narrowly on individual cases, not—given the seeming clarity of intentions China’s WTO accession was understood at the time to convey—on larger questions of systemic directions. Alas, today we are told, even by some Chinese leaders, that we misconstrued China’s future course; that we only wanted to believe that Beijing had a liberal model of market economics in mind. Regardless whether this is valid or revisionist, the United States must take a more holistic view of China’s trajectory now to prevent such misunderstanding. If elements in China harbor hostile or predatory intentions toward liberal nations, the United States will take a series of self-protective steps far more hawkish than transitional safeguards, including restrictions on visas, educational and professional exchanges, technology sharing, and cooperation arrangements. These would add up to profound disengagement, and this outcome would be costly and unfortunate even if deemed necessary.
Measures of progress and compliance should not be based on subjective impressions or political passions but instead need to be rooted in objective data on the macroeconomy, the financial system, specific industries, and in some instances companies. To make an objective approach to the relationship possible improvements in the quality and transparency of economic statistics are essential. Economic data generally improved in past decades (as lengthy analyses have described), but presently that progress seems to be eroding. Reliable and transparent data is the wellspring both of Beijing’s ability to trumpet its accomplishments, hence arguing for a sunset to safeguards, and of Washington’s case that marketization is fading.
Escaping the Win-Lose Trap
We have laid out elements that add up to a successful U.S.-China trade negotiation. Success cannot mean winning or losing for either side. And the U.S. interest requires a wider set of options than simply yes, no, or never. A collapse of talks and escalation of tariffs and countermeasures is neither the first-best nor the worst outcome. It would destabilize both a China suffering from slowdown and sagging business confidence, a U.S. economy that won’t enjoy a debt-financed fiscal stimulus forever, and the rest of the world left wondering what the future holds for almost half the global economy. A deal limited to Chinese purchases of U.S. products at the expense of other exporters, meanwhile, would just rearrange problems, not solve them. Closing the entire U.S.-China bilateral trade gap in just a few years is impossible; closing it without causing trade diversion from other nations’ shipments of natural gas, soybeans, airplanes, and other products is not even half-possible. If the U.S.-China outcome is at the expense of other nations—especially our allies—or leaves China’s structural economic problems unaddressed then it will dissolve within months.
The good news is that China needs to embrace a structural reform agenda as much as the United States and other advanced economies need to insist on it. China’s entrenched interests will fight tooth and nail, but just as with WTO accession, China as a whole will benefit immensely from restored internal structural adjustment and external stability in its relationship with the United States and its other trading partners. Beijing will have a better opportunity to make its economic transition sustainable and avoid the middle-income trap, and mitigate the difficulty of financial distress. For all sides, it is more important to get the right kind of deal than a superficial one based on false achievements.
The prospects are not black and white. Even if China is committed to marketization, it will take years to realize that intention, and we are all awake to the risk that consensus toward that end-point could slip along the way. A deal based on a sliding-scale principle will require U.S. flexibility: if China is ready to reform, Washington must temper plans for permanent disengagement in favor of transitional safeguards instead. If China is not prepared to do so, then the United States should accept that choice, however disappointing, and adjust accordingly with much less malice in mind and more focused self-interest.
Daniel H. Rosen is a senior associate (non-resident) in the Freeman Chair in China Studies at the Center for Strategic and International Studies (CSIS) in Washington, D.C. and Founding Partner of the Rhodium Group. Scott Kennedy is a senior adviser in the Freeman Chair in China Studies and the director of the Project on Chinese Business and Political Economy at CSIS.
Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).
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