Finding the Right Off-Ramp from the Trade War

We are entering a new, disruptive trade world, where unfamiliar weapons and new thinking will determine whether we face a hard-nosed negotiation with China, a brief trade skirmish, a serious trade war, and/or a new orientation for U.S. policy. There is little certain ground here; the outcome will depend on how well the United States and China understand each other and how realistic their goals are. Significant questions exist on both these scores.

This new world began last week, when for the first time in more than 15 years, the United States used its authority under Section 301 of the Trade Act of 1974 to issue a massive report detailing China’s unfair technology transfer regime, its discriminatory technology licensing rules, its cyber-enabled intellectual property theft, and its problematic, non-market investment strategies in the United States. President Trump immediately responded to these findings by signing an order imposing new 25 percent tariffs on about $50 billion of imports from China. The list of products facing these proposed tariffs is due out soon, with an estimated 60-day comment period before the final list is developed and tariffs are imposed. Additional administration actions include the filing of a World Trade Organization (WTO) complaint and direction to the secretary of the treasury to develop new restrictions on Chinese investment into the United States. Further, President Trump has indicated that this is only the first of many Section 301 cases the administration plans to bring.

The Section 301 tariffs are fully legal under U.S. law, but the same cannot be said under international trade rules. They seem likely to run afoul of WTO rules on when and how new tariffs can be imposed. So, what will happen next? And what off-ramps are available to keep this new challenge to the status quo from creating trade chaos?

The first obvious off-ramp is the 60-day delay built into the administration’s time line for imposing tariffs. If China and the United States can come to an agreement in this time frame to eliminate the problems cited or remove the burden they cause to U.S. commerce, no U.S. tariffs will be imposed, and the situation may be defused. This may offer the United States the best negotiating scenario with maximum leverage. Let us play out the alternatives and then return to the difficult question of how and whether there can be a meeting of the minds.

If the United States goes forward and imposes the tariffs on $50 billion of imports, the trade skirmish begins. History tells us that China will respond swiftly and at least proportionately. For example, when the Barack Obama administration placed restrictions on Chinese tire imports in a WTO legal fashion, China quickly launched antidumping cases that tied up a large value of U.S. exports of poultry and autos for years.

China can be expected to respond even more strongly to actions it will characterize as blatantly WTO illegal. The U.S. trade restrictions will not create an existential threat to the Chinese economy, and President Xi Jinping, who has just consolidated his power in China, will need to look strong to his people. He has encouraged a nationalist pride, which appears to preclude any turning of the cheek if the United States inflicts economic injury. China will place a priority on coming to any negotiating table with equal leverage to the United States.

The only question will be whether China chooses to use the same street fighting tactics the United States has employed, by slapping on immediate tariffs. It is possible that China will try to maintain the moral high ground, steering clear of obvious WTO violations. China could instead exercise its rights to have its state-owned enterprises (SOEs) choose non-U.S.-made airplanes or non-U.S.-grown soybeans for purchases, or it could check U.S. agricultural imports very carefully for health rule infractions and stop all shipments with problems. It may also repeat the same tactics it used against South Korea to demonstrate its anger over South Korea’s cooperation in deploying the Terminal High Altitude Area Defense (THAAD) missile defense system, halting tourism and increasing inspections and punishments of South Korean businesses in China. In this scenario, China also could well challenge the Section 301 tariffs as WTO inconsistent, paving the way eventually for a WTO award of “compensation” from the United States.

What will the United States do, when China responds, and $100 billion of trade is then affected? President Trump has opined that trade wars are easy to win, and other administration officials, while less sanguine, do appear ready to take a hard line. As the most recent U.S. National Security Strategy indicated, the administration views China as perhaps its top strategic economic competitor, a power that aims to shape a world antithetical to U.S. interests. If China is seen as a long-term existential economic threat to the United States, what administration official would let them off the hook? In this environment, Congress, too, seems unlikely to want to take a moderate line that could be seen as defending China.

That means the historic demands of U.S. commercial stakeholders to avoid extreme “America First” protectionism may fall on deaf ears. Multinational corporations care about profits and shareholder value, not simply the U.S. jobs and exports that government leaders prize. Long-term national interest may override the pain inflicted on any individual sector, even agriculture. The administration also has pointed out that the incremental negotiating approach of the past has not significantly reduced China’s market distortions and discriminatory practices, so that a new approach is needed. This environment also means that past U.S. interlocutors with Chinese leaders may not have influence with the White House. The Chinese will need to absorb this new reality as they consider the overall situation.

However, if the United States takes counter-retaliatory action in light of new Chinese restrictions on U.S. goods or services, the United States should expect the same from China in return. China does export more to the United States than vice versa, but this does not mean China will back down. First, economists have indicated that even if China lost all its exports to the United States, this would represent only 3 percent of its gross domestic product in value-added terms. That means that China will not face economic collapse even if the United States blocked China out of its market entirely. Second, President Xi has made it clear that China is a preeminent world power and will not be bullied. That means China will react. Third, China’s population has persevered through numerous severe economic dislocations and can be rallied through an appeal to their national pride to endure a trade fight for the long term. Some China hands have even speculated that this would strengthen Xi’s position, if he is seen as standing up to, and perhaps even reducing dependence on, the United States.

If the value of trade tied up in knots by a U.S.-China trade spat rises high enough, of course, it can create significant spillover problems for the global economy, which would hurt both the United States and China in more fundamental ways. Even if the two sides choose to engage in retaliatory demonstrations of their resolve, one hopes that both sides would try to keep any escalation within bounds that do not cross these redlines. The same is true for how the two sides use the WTO dispute settlement system. The question is whether they can accurately predict where these lines fall. Trial and error may create significant trade turbulence, as well as risk.

Barring disaster through serious miscalculation, it seems that sooner or later the two sides will try to come to the table to find an off-ramp. This raises the next difficult questions: what does the United States want from China, and what can it get?

The Section 301 investigation report identified two categories of Chinese government practices that harm the United States and appear to be justifying the tariffs (in addition to a technology licensing regime that will be pursued in the WTO and Chinese government support for investments to harvest U.S. technology that apparently will be pursued via new U.S. investment restrictions):

  • Chinese restrictions on foreign ownership and a range of administrative review and licensing processes that force or pressure U.S. companies to transfer technology to Chinese entities; and
  • Chinese government-supported cyber intrusions into U.S. companies to access sensitive commercial information.

It will be extremely challenging to find a satisfying solution to either problem. China’s foreign ownership restrictions and pressure tactics permeate the Chinese economy, in laws and regulations, and are deeply engrained Chinese government practices. They reflect high-priority Chinese industrial policy designed to let China leapfrog into the forefront of key new industries. Removing all foreign ownership restrictions, then, would seem to clash directly with Xi’s vision of how to achieve a powerful, innovative China that can shake off dependence on foreign technology.

Perhaps the Chinese eventually will conclude that much of their economy in fact would thrive with foreigners permitted to operate there independently, and they will remove ownership restrictions in enough areas to allow a settlement. To be credible, President Xi himself might have to announce the change in philosophy, given the consolidation of power in his hands. Unfortunately, though, this outcome seems difficult to achieve, given the current strength of China’s techno-nationalism.

As for the cyber intrusions, in September 2015, President Obama obtained a commitment from President Xi to stop all cyber intrusions designed to steal commercial secrets. If Xi has broken that commitment, it is difficult to see what other credible steps the Chinese could take to assuage the United States. In fact, China’s actions may be signaling that it does not want to change.

Perhaps President Trump will make a deal he likes with President Xi on terms no one can anticipate. Reductions in the trade deficit and market openings for nontechnology sectors may suffice. Perhaps the initial U.S. tariffs will stay on indefinitely, the Chinese eventually will impose counter tariffs, if they get a WTO win, and the United States will tolerate a WTO loss without storming out of the organization. At $100 billion, both economies can cope.

The worry? Ratcheting up tariffs tit for tat now, new Section 301 cases yielding more and higher tariffs, and, perhaps, even more fundamentally, U.S. trade representative Robert Lighthizer’s assessment of China. He told the Senate Finance Committee last week that “China is always going to challenge the system and want to take over the world.” If that is correct, the United States will need to find other tools besides trying to impose tariffs or other bilateral trade restrictions on China to sustain a free market, rules-based system or making temporary deals in areas that leave Chinese core industrial policies intact. It would be good to find and apply these other tools soon.

Claire Reade is a senior associate (nonresident) with the Freeman Chair in China Studies at the Center for Strategic and International Studies in Washington, D.C., and a 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