Does the Phase One China Deal Measure Up? Depends on How You Measure

The United States has been conducting a highly disruptive experiment in its trade negotiations with China and the waves of tariffs imposed over the past 18 months. With a “Phase One” deal now signed, we need to clarify what this experiment aims to achieve to understand what constitutes success. This is not as easy as it seems, since at least three divergent metrics could be used to measure success. Ironically, the deal may look the strongest using the negotiating metric employed by past U.S. administrations and strongly rejected by the Trump administration.

Alternative Metrics

First, one could assess whether this deal addresses the issues actually identified in the investigation of China under Section 301 of the Trade Act of 1974 launched in August 2017. After all, it was two concerns—(1) forced or subsidized technology transfer, and (2) government cybertheft of sensitive business information, including intellectual property, for commercial gain—that provided the legal justification for the tariffs on $370 billion of products after China failed to address U.S. complaints.

Second, one could ask if the deal meets the Trump administration’s broad goals of achieving a paradigm shift in China’s economic policies to create a long-term, level playing field. It was telling that by May 2018, two months after the Section 301 report was issued, a sweeping U.S. negotiation document had leaked making this broad ambition evident. The document demanded changes across the board in China, covering most of Chinese industrial policy and the trade deficit, to boot. The document included sections on trade “rebalancing,” intellectual property theft, agriculture trade barriers, and market access, as well as the removal of subsidies, excess capacity, and other elements of Chinese industrial policies. The Section 301 topics of technology transfer and cybertheft were folded in, as was a rudimentary enforcement section. This multi-section structure and wide-ranging coverage reappeared in the Phase One deal with China that was just signed.

Third, one could ask how this deal would stand up under the lens of the “incrementalist” negotiating model used by previous administrations. This approach continuously pushed for progress in multiple specific areas of China’s economy, chalking up incremental steps forward in various areas over time. The Trump administration forcefully rejected the incrementalist approach to China’s reform taken by past administrations as woefully insufficient to stop China’s predatory trade behaviors.

Through the Lens of the 301 Report

Using the first metric, the U.S. Trade Representative’s (USTR) March 2018 Section 301 report cites only two issues to be resolved: forced or subsidized technology transfer and government cybertheft for commercial gain. The report even notes that intellectual property (IP) theft and other problems raised by stakeholders could be tackled in future investigations. Yet the Phase One deal does not even mention cybertheft, and rumor has it that President Xi has said cybertheft will never be on the table. (This is not surprising, given the exquisite difficulty of trying to discipline covert spying activities.) Using the Section 301 report metric, then, the maximum possible grade is 50 percent, assuming the technology transfer issues have been resolved.

So where are we on stopping forced technology transfer, the other 50 percent? The agreement took a few arguably “incremental” steps forward on this issue. China already has a number of broad commitments on the books. When China joined the World Trade Organization (WTO) in 2001, it promised to keep government hands off technology transfer decisions, leaving them to the commercial parties. China confirmed and supplemented that promise with several bilateral commitments to the United States as far back as 2010. In other words, Chinese promises regarding technology transfer litter the landscape.

However, the new deal does reinforce and add some specificity to China’s existing tech transfer commitments, in case China had any doubt it needed to stop pressing for technology transfer in every interaction with foreign companies. China’s new Foreign Investment Law also for the first time enshrines that principle in domestic law and indicates that there are (undefined) legal liabilities for violating the rule. This development likely occurred due to the Phase One negotiations and signals domestically some increased political risk from engaging in forced technology transfer. Finally, the enforcement provisions in the Phase One deal do allow the U.S. government an expedited route for attacking troubling new Chinese initiatives, understanding as a practical matter that only publicly announced formal legal measures are likely to end up being disciplined. U.S. companies fear retaliation and will hesitate to raise a complaint over individual transgressions.

Overall, then, the tech transfer commitments fall into the “sunshine as the best disinfectant” category. They may help deter formal, overt Chinese policies of this sort. That said, if Chinese priorities include gaining a particular technology, they will work hard to do so, aided by the difficulty of disciplining informal actions and the limited recourse under Chinese law or the Phase One enforcement apparatus. Under the first metric, then, the administration deserves partial credit.

Generating Fundamental Change across the Board

Given the many Chinese commitments in diverse sectors of the economy included in the seven chapters of the Phase One deal, the second metric seems more relevant than simply Section 301’s standards: what progress was made toward the transformation of the Chinese economic environment, specifically toward eliminating major sources of trade distortion and discrimination?

Looking chapter by chapter:

Purchases: Promises to buy more U.S. goods, of course, look like managed trade, not a market- based approach. If this represented a new trend for China deals, global trade distortion and discrimination would be on the rise, rather than disappearing. The agreement calls for major purchases as well, so it remains to be seen if the purchase targets can be met. In the short term, promised agriculture purchases presumably reflect the goal of creating more stable conditions for U.S. farmers and helping them come back from the financial stresses the trade war imposed on them. But in terms of promoting systemic marketization in China, this chapter seems to go in the wrong direction.

Currency: This chapter does not seem to represent new progress, although its principles are important in terms of avoiding major global economic distortions. Economists indicate the currency commitments in the Phase One deal simply echo commitments China made in the past at the G-20 and reflect China’s high-level policy decision several years ago not to engage in currency manipulation, given the associated costs to China’s long-term welfare. Most independent observers believe China has not engaged in competitive devaluation of its currency in at least five years.

Agriculture policy changes: Even for non-agriculture experts, the agriculture chapter is worth a scan. It reveals the dismaying, multilayered webs of regulatory barriers China has erected to a wide range of agricultural imports, illustrating the Kafkaesque dead ends U.S. and other foreign producers quickly get mired in when Chinese bureaucrats do not want to import their products.

In the agriculture chapter, China makes detailed commitments to eliminate a litany of barriers erected against each of the various U.S. products listed, promising to act within specific time periods and to base its decisions on internationally recognized standards. The substantial number and the detailed, individualized nature of the commitments for each product seem likely to offer better export prospects for the covered goods. The U.S. negotiators seem to have tried very hard to box Chinese regulators out of using their many import-restraining tools. Unfortunately, this effort does not change the mindset of the bureaucrats running the system in China. That means China will not extend the commitments to any products that did not make the list. Likewise, there is little doubt that China will find other ways to keep U.S. products out of the market if it wants to, even without breaking the specific commitments it has made. In other words, while these commitments could generate strong short-term gains, they do not demand a fundamental change in China’s policies regarding agricultural trade.

Financial Services: Over the past few years, Chinese leaders had independently indicated the importance of increasing competition in this sector by opening up to foreign competition in order to strengthen China’s financial system in the long term. That underscores the potential for systemic change from the market-opening reforms outlined in this chapter but also indicates that most of these changes may well have emerged on their own.

That said, China’s commitments in this chapter do accelerate the market-opening timetable in some cases. On a micro level, they also include some safeguards against bureaucratic hostility in industries where this has been a severe problem. For example, in the insurance industry, China commits to remove business scope limitations, discriminatory regulatory requirements, and overly burdensome licensing and operating requirements. (The absence of most of these commitments for other industries does raise an eyebrow in terms of the future leeway it offers for a hostile Chinese official operating in other areas.) Likewise, for payment services, where China’s massive state-owned enterprise apparently blocked—despite past commitments—any market-opening for years, China made a very particular procedural commitment to at least allow U.S. suppliers’ applications to proceed.

Overall, the commitments in this chapter, even if many were already underway at China’s own initiative, could represent a healthy change toward the market in China—if China does not interfere with the new foreign participants. It may also signal a fairer balance in bilateral market access and some incremental progress in the areas where China has previously snarled trade and investment with multiple bureaucratic roadblocks.

Intellectual Property: This chapter includes highly detailed commitments across a broad range of IP disciplines, offering many incremental improvements in both IP protections and in the effectiveness of IP enforcement mechanisms. These commitments, if implemented, will continue to move China toward an improved IP regime. However, they do not transform the Chinese system or change the sometimes ambivalent attitude of the Chinese government’s IP enforcement officials.

Technology Transfer: As the discussion above regarding Section 301 indicated, China’s commitments in this chapter to eliminate forced technology transfer do not represent a transformative new obligation. The specific actions prohibited in China’s commitments may restrict Chinese officials’ actions to some extent. However, absent fundamental changes to the top-down state capitalist system, the Chinese industrial development priorities generated by this system seem likely to continue to create incentives for opportunistic informal pressure that will be extremely hard to detect or curb.

Enforcement: This chapter does not transform China’s economic policies, although it creates an incentive for China to implement its commitments, some of which do have systemic implications. This chapter actually may be most important as evidence of the political commitment made by the top Chinese leadership to a trade truce. Top Chinese leaders now also know enough about the detailed issues being raised to be able to keep an eye on the line ministries and reduce recidivism. However, the actual enforcement mechanism may only work on the margin, if an official public measure is issued that seems inconsistent with commitments, or if public data can establish a violation. U.S. companies seem unlikely to raise individual complaints, and it could be hard to catch informal actions. Further, if a complaint results in “proportionate action” as a punishment, it may not create any real additional pressure, particularly given that $370 billion of Chinese imports are still subject to punitive tariffs. The real enforcement club seems likely to be the threat of more tariffs and ending the deal, generating more instability and insecurity in the trade relationship. This chapter may be systemically important on another level, a backwards move to many jurists; instead of neutral parties managing dispute settlement, the disputing countries themselves will try to call the balls and strikes.

Overall, then, the Phase One deal does not transform China. It pressures China on dozens of points, and if agreed-upon changes are implemented, it could eliminate many previously intractable obstacles, although China could create new ones.

The Incremental Approach Metric

After China joined the WTO in 2001, a concerted effort ensued to try to integrate China more deeply into the existing trading system. That translated into efforts to cooperate, educate, cajole, and pressure China with WTO cases and other demonstrations to signal that they were operating outside of any acceptable norm. This was meant to move the Chinese economy to a place where it allowed open and fair trade and provided balanced, adequate, and fair legal protections to all comers, not only Americans. Incrementally, it seemed, China could and would move to this end point.

One form of pressure for change came from periodic high-level consultations between the U.S. and Chinese governments focused on resolving bilateral economic and trade issues. That typically translated into three months of intense dialogue with Chinese officials about China market barriers and unfair and highly discriminatory Chinese behavior against foreigners across many areas of official Chinese action. A given dialogue might lead to Chinese improvements on a handful of specific, but significant issues out of dozens that were being discussed. These improvements would sometimes solve a problem; at others it was the equivalent of scraping one layer of lead paint off a wall, only to find a further layer, and with the wall still standing, too.

That was incremental progress. Work continued, with opportunities two to three times per year to repeat this arduous process and make small amounts of headway toward a fairer outcome and better business environment for dozens of industries in a market of 1.4 billion people. The bias in China’s line ministries toward extracting maximum value from foreigners while giving maximum advantage to domestic champions seems deeply engrained. No yearly bonuses accrue to those who compromise with a foreigner and perhaps weaken a Chinese industry’s position; it is much safer to fend off that foreigner’s demands entirely.

This deeply held attitude is too big to tackle with dialogue. So individual, specific, egregious laws or actions had to be identified, to provide proof of a problem, and then had to be elevated above the ministries to the very top of China’s system in order to even get a balanced evaluation of whether China, in its own self-interest, should change. Only a small number of issues can make that trip above the bureaucratic morass to the vice premier level or beyond.

If you look at the Phase One deal through the lens of the “incremental progress” model, ironically, it seems like a bonanza event. It offers the prospect of progress on dozens of the issues the United States has pressed China to fix for years rather than just fixing a handful of the roadblocks. In the IP arena alone, if China implements its commitments, there will be: stronger and perhaps more useful protections for trade secrets, trademarks, and copyrights; removal of a provision that stymied effective IP policing of the internet; creation of a viable means to ensure that the Chinese FDA does not give marketing approval to someone who is infringing an existing patent; the possibility of penalties that actually deter IP theft; and perhaps improvements to the court procedures that now stymie foreign IP holders trying to get justice. Multiple significant U.S. agricultural exports may see actual prospects for market success with the bureaucratic underbrush burned away. Many critical financial services industries may gain real market access as well.

The Chinese system is not being transformed, but practical, near-term trade impediments that hold back many U.S. companies and industries are being tackled.

Now, if those old-style dialogues had continued through the last three years, and China had wanted to cooperate, there might have been progress on up to 30 of the issues represented in the Phase One deal—and no massive tariffs imposed with all their disruptive consequences for both economies, other trading partners, and the WTO. But China’s attitude in recent years has been increasingly indifferent to other trading partners’ trade and investment complaints, and it is impossible to know how much pressure or what kind of approach was required to get their attention.

Looking narrowly at the harvested outcomes here, and assuming China follows through, the Phase One deal made the largest incremental headway against Chinese barriers that we have seen in many years.

Overall Assessment

So, the Section 301 metric yields partial credit at best; the fundamental change metric suggests there is little to show;, and the incrementalist metric, looking only at the four corners of the Phase One deal, would suggest a significant number of real barriers to trade are being eliminated. At the same time, we cannot yet fairly assess this experiment under any metric without looking at the broader context. It has caused serious disruption, and it is not over.

We do not know the full cost of this experiment on the U.S. economy and the global system. If high tariffs remain, small U.S. businesses, in particular, could suffer badly. We also do not know whether there will be a Phase Two deal, and if so, how quickly it could come and what it would cover. It is hard to envision generating the level of additional pressure needed to achieve systemic change in China—regarding the role of state-owned enterprises, top-down industrial planning, subsidies, or cybertheft—if blocking almost all trade with China has not allowed the United States to achieve that goal. Maybe the lesson of Phase One is that since we have started down this path, it makes sense to press for another quick bonanza of the other incremental changes that will make the trading relationship less imbalanced and more tolerable, then ratchet down the tariffs while looking elsewhere for how the United States can thrive long term in twenty-first century competition with China.

Claire Reade is a non-resident senior associate with the Trustee Chair in Chinese Business and Economics at the Center for Strategic and International Studies and senior counsel at Arnold & Porter.

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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Claire Reade
Senior Associate (Non-resident), Trustee Chair in Chinese Business and Economics