The US-China economic relationship: A comprehensive approach

Aides gesture as U.S. Trade Representative Robert Lighthizer, Chinese Vice Premier and lead trade negotiator Liu He, and U.S. Treasury Secretary Steven Mnuchin line up for a photo before the opening session of trade negotiations at the Diaoyutai State Guesthouse in Beijing, Thursday, Feb. 14, 2019. Mark Schiefelbein/Pool via REUTERS - RC1BB7FBA400

Executive Summary

The U.S.-China economic relationship has reached a critical juncture. Over the past year, the U.S. has imposed tariffs on $250 billion worth of Chinese imports and China has retaliated, raising tariffs on U.S. exports. At the G-20 leaders’ summit in November 2018, Presidents Trump and Xi agreed to resolve the trade dispute within 90 days—by March 1, 2019, though this deadline has been recently extended.

The U.S. concerns that underpin these bilateral trade tensions stem from specific practices endemic to China’s economic model that systematically tilt the playing field in favor of Chinese companies domestically and globally. Progress on specific trade issues will require China to comply with its World Trade Organization (WTO) commitments and to make certain reforms that will likely touch on areas of state control over the economy. In addition, new trade rules are needed to address China’s economic practices not covered by its WTO commitments, including in areas such as state-owned enterprises (SOEs), certain subsidies, and digital trade. These issues also come at a time of increasing U.S. concern over the national security risks China presents, particularly with respect to technology access.

Despite the challenges the U.S. has had at the WTO, the WTO should be central to resolving U.S.-China trade tensions. From this perspective, we outline a multipronged strategy, including bilateral, multilateral, and unilateral actions, as well as working with allies, that together would constitute positive next steps for this critical economic relationship. In taking this multifaceted approach, the U.S. also needs to stay true to its values and not accept short-term gains or “fig leaf” deals. In particular, creating a managed trade relationship with China would not be a constructive outcome. The resulting deal should address the real issues at hand in a free market manner and strengthen the multilateral global trading system and rule of law that the U.S. has championed in the post-World War II era.

All of these matters underscore the complexity of U.S.-China bilateral negotiations as well as the stakes at play. Resolving U.S.-China differences in a meaningful way will take time.

The state of the bilateral economic relationship

In order to assess what might constitute a sustainable economic relationship going forward, it is important to be clear about the costs and benefits of U.S. trade and investment with China.

The U.S.-China economic relationship delivers more benefits to the U.S. than is commonly understood. For example, recent data shows that U.S. exports to China support around 1.8 million jobs in sectors such as services, agriculture, and capital goods.However, trade with China has also led to job destruction in some U.S. industries—particularly low wage manufacturing. Despite these costs, the frequent focus by the administration on the bilateral deficit is not a meaningful yardstick for assessing U.S.-China trade or its impact on employment. The U.S. trade deficit is less a product of restrictions on U.S. imports than it is a reflection of a low U.S. domestic savings rate, which requires overseas capital to fund U.S. domestic investment needs and the growth in U.S. government debt. In addition, the trade deficit does not account for the activities of affiliates of U.S. and Chinese companies in each respective market, a calculus that shows the U.S. selling more to China than vice versa.

Nevertheless, the economic costs of the bilateral economic relationship are very real. China’s economic practices now risk harming the U.S. service and knowledge economy. As identified in the United States Trade Representative (USTR) Section 301 report, intellectual property (IP) theft and forced technology transfer and other Chinese unfair trade practices threaten high-wage jobs and high-value-added manufacturing in the U.S. The role of the state in effectuating these policies with larger aims of supplanting U.S. leadership in high-tech industries makes these Chinese policies all the more concerning.

Why China’s economic model matters

Despite the rapid growth in its economy and acceptance of a role for competition and markets, the Chinese Communist Party (CCP) remains firmly in control of China’s economy. China is not the first country with an economic model premised on state control and coordination between the government and business on economic and trade priorities. Elements of all these systems were, and continue to be, present in places like Japan, with the keiretsu, or South Korea, with its chaebols. Yet China’s economic model is different from both Japan and Korea. In addition, due to its sheer size, how China grows will affect the rest of the world in ways that even Japan’s economy at its economic height did not.

China’s economic model has a range of growing implications for the U.S. and globally. First, the move towards self-sufficiency in emerging technologies is inconsistent with a trading system based on comparative advantage. Second, use of SOEs, their access to subsidies, and limited rule of law in China support state companies within China and globally. Third, China’s use of industrial policy to pick winners is expected to lead to excess production and dumping overseas. This has already occurred, for instance, in steel and solar photovoltaic (PV) with negative impacts for U.S. and global industries, and is expected to occur in more advanced industries identified in China’s recent industrial policies, such as robotics, high-speed rail production, new energy vehicles, and batteries.

The impact on the WTO

While President Xi continually affirms China’s commitment to the multilateral rules-based trading framework, China continues to renege on its WTO commitments. Moreover, China’s economic model makes it difficult to use the WTO and its dispute settlement system to challenge noncompliance. For instance, state control over public and private businesses makes it difficult to distinguish between what is a public body and what is private, thereby making unclear whether the there is a rule or regulation issued by a public entity that is subject to WTO rules. In addition, the state’s role in the judicial and administrative system, including the use of informal notices and verbal demands on foreign businesses, undermines the ability to show that a WTO-inconsistent measure exists. More broadly, China’s industrial policy—which distorts the playing field in favor of Chinese companies—is at odds with most WTO members’ market-based systems.

Given these challenges, there is a real question as to the capacity of the WTO to respond to the China challenge. While the WTO is not able to address all the issues that China poses, in the context of a comprehensive approach to the China challenge, the WTO remains central, contingent on strong U.S. leadership. The WTO is the only global set of trade rules that both reflects core U.S. values, such as non-discrimination, transparency, and rule of law, and forms a baseline on which to build global support to critique and push back against Chinese economic practices.

Making progress in US-China economic relations

In seeking mutually beneficial outcomes, the U.S. should take a comprehensive approach to the negotiations based on market-orientated solutions, which strengthen the global trading system and rule of law.

Bilateral negotiations

U.S.-China bilateral outcomes need to be verifiable, enforceable, and market-based—not simply a restatement of prior Chinese commitments such as to do better on IP protection and enforcement or forced technology transfer, or to buy more U.S. products. The bilateral track should include commitments from China to implement all of its WTO commitments. Additional WTO plus commitments should be negotiated in areas such as SOEs, cross-border data flows, and determining the application of nonmarket economy (NME) status for trade remedy purposes. Where feasible, enforcement should be through the WTO dispute settlement mechanism, and recourse to arbitration under Article 25 of the Dispute Settlement Understanding (DSU) could be used to produce speedier results.

Given that the tariffs imposed to date by the U.S. and China are not WTO consistent, as discussed below, any U.S.-China deal should aim to bring tariffs back to their WTO-bound levels when specific benchmarks are met, but with scope for tariff snapbacks in the event of noncompliance. The U.S. and China should make such a deal WTO consistent by seeking a WTO waiver. Such an approach is a pragmatic compromise that recognizes that the U.S. and China will likely focus on bilateral negotiations to address their trade issues, while minimizing the harm to the WTO as an institution.

The U.S. and China should also renew efforts to complete a comprehensive bilateral investment treaty (BIT) with an aggressive nine-month schedule.

A bilateral deal should avoid commitments by China to increase purchases of U.S. exports, and reducing the bilateral trade deficit should not guide the negotiations or determine success. Increased U.S. exports, whether to China or elsewhere, need to be in response to market forces and not undercut broader U.S. demands for less state intervention. Such an arrangement would be inconsistent with U.S. values, adopt a managed trade framework more akin to the Chinese model, would likely be WTO inconsistent, and could disadvantage U.S. allies.

The role for the WTO

The WTO is a set of globally agreed upon trade rules that provide a basis for identifying where China fails to comply with existing commitments. The U.S. could then also identify where Chinese practices are of concern, but not disciplined by WTO rules, to justify where bilateral or unilateral action may be necessary.

In terms of what the U.S. could seek to pursue at the WTO:

  • The U.S. should work with China to agree to an in-depth review at the WTO of China’s compliance with its WTO commitments.
  • The U.S. should work through the WTO to ensure that China gives a full accounting of its SOE activities and subsidies as required of any WTO member and pursuant to its Protocol of Accession.
  • The U.S. should work with allies and China to reintroduce the China specific safeguard as well as craft an agreement with China regarding its ongoing use of NME methodology until such time that China is able to substantiate that it has become a market economy. Progress on this issue could be the result of a negotiated settlement of the WTO case that China has brought against the EU and U.S. regarding their continued use of NME methodology in trade remedy cases.
  • The U.S. should work to reform the WTO dispute settlement system to ensure quicker dispute settlement proceedings, including potential injunctive relief for unfair trade practices, would be an institutional change that could be useful vis-à-vis China.
  • The U.S. and China should use a bilateral deal or a BIT as the basis for re-energizing the negotiation of new rules at the WTO on areas such as technology transfer, SOEs, and digital trade.

Work with US allies

A key part of the U.S. strategy with respect to the China challenge needs to include new trade agreements with allies, which raise the standards for trade. This strategy would provide benefits to the parties to such free trade agreements (FTAs) and create economic costs to China from nonparticipation, which should further encourage China to reform its economy and trade practices with the aim of joining the new trade agreements.

The Trans-Pacific Partnership (TPP), from which the U.S. withdrew in 2017, included important new rules in areas that matter for the U.S. such as on SOEs, IP, digital trade, and transparency and due process in the making of regulations affecting trade. With China outside the trading block, TPP could have created costs for China. According to one estimate, TPP would have decreased Chinese income by $40 billion annually and this would have grown as more countries joined the agreement. Taken together, TPP would have been an important part of the “comprehensive toolkit” USTR refers to in creating pressure on China to reform. The TPP has now been reconstituted without the U.S. as the Comprehensive and Progressive TPP (CPTPP) and most of the rules for addressing U.S. concerns with Chinese trade practices remain. The importance of the CPTPP for addressing the China challenge warrants the U.S. to reconsider its position on the agreement and rejoin.

In the event that bilateral FTAs remain the focus for the time being, the U.S. should aim to conclude agreements with its strategic allies in the Asia-Pacific region and beyond.

Unilateral US action

How the U.S. fares in its competition with China will ultimately be determined by actions that the U.S. takes at home. Apart from focusing on its own competitiveness through domestic policies, which are beyond the scope of this policy brief, the U.S. should thoughtfully control access to U.S. technologies through foreign investment and export controls, and effectively use WTO-consistent tariff policies to minimize the harm from Chinese economic practices on U.S. businesses.

The U.S. has already made progress domestically on addressing technology transfer issues with the enactment of the Foreign Investment Risk Review Modernization Act (FIRRMA), which included the Export Control Reform Act (ECRA) of 2018. While companies now largely decide which technologies to transfer overseas, the careful implementation of FIRRMA/ECRA is critical to making this a matter for U.S. policy and for considering the national security costs that may not be properly included in private sector decisions regarding the transfer of technology to China.

FIRRMA/ECRA also recognizes the importance of working with allies to strengthen multilateral export control regimes and to prevent diversion through U.S. allies in attempts to avoid FIRRMA review. The U.S. will need to convince other governments to adopt similar investment and technology export restrictions in order for these U.S. reforms to be most effective. U.S. restrictions on access to U.S. technology will be less effective and hurt U.S. competitiveness if similar technology is available from the EU or Japan.

Making progress on China’s compliance with its WTO commitments will be most effective where the U.S. is also complying with its WTO commitments. This would require the U.S. to calibrate its unilateral use of tariffs, which have undermined the WTO. Instead, the U.S. should expand its use of trade remedy measures—antidumping and countervailing duties—that are consistent with U.S. WTO obligations and provide recourse to U.S. business for China’s unfair trade practices.