NR Digital

Trade Reciprocity with China

by Derek Scissors

Some main points of a fair policy

Our economic policy with regard to China has been wrong for almost 20 years. We were wrong in the late 1990s to believe that the Chinese Communist Party was committed to pro-market reform for the long term. We were wrong in the mid 2000s to discourage the U.S. government from retaliating against discriminatory Chinese regulations. We were wrong as recently as two years ago when we, Democrats and Republicans alike, failed to see how much trade with China had contributed to populist anger.

There is, one could say, huge room for improvement in economic relations with the People’s Republic of China (PRC). This does not mean that all the ideas President Trump and his key aides have floated will make things better. We cannot turn back the clock, and the American manufacturing sector cannot simply return to where it was before China joined the World Trade Organization in late 2001.

The challenge for the incoming administration is to consider what China has done in the past but choose responses that work now and in the future. Currency manipulation, for example, is now less of a problem than theft of intellectual property. Trade remains paramount at the same time that investment is increasingly important. Mere words will not make China change. Yet while disruptive action is necessary, it will help only if dictated by current facts rather than outdated rhetoric.

Trump strained credulity in some of his campaign comments, such as calling the North American Free Trade Agreement the “single worst trade deal,” even though manufacturing employment rose in the four years after its enactment. Nonetheless, he repeatedly and correctly tapped into a key element of the U.S.–China economic relationship that many veteran observers continue to get wrong: America does have much greater leverage than it has so far used to bring about Chinese reforms.

Trump’s critics and those who are worried about a U.S.–PRC trade conflict often make sweeping statements that both sides would lose in such a clash, or even that China would come off better. Usually they are incorrectly imagining a simple tariff duel. It is true that limiting voluntary trade and investment transactions would make both countries lose, but one country has far more at stake. Rather than anticipating some sort of strategic victory from a serious trade conflict, the PRC will fear correctly that it would lose, in absolute terms and also relative to the U.S., and will work to contain conflict.

The United States sells a good amount of aircraft, auto parts, soybeans, and a few other products and services to the PRC. American consumers would be hurt if goods produced or assembled over there became costlier because of import duties. The poor would be hurt the most, since our main imports from China are cell phones, personal computers, and clothing made more affordable because trans-Pacific supply chains allow production lines to tap cheap labor and technical know-how at the same time. If production lines lacked these, prices would rise. Even with higher prices, the middle class could afford new phones, computers, and clothes, but the poor would more frequently go without.

A fading concern is Beijing’s holdings of U.S. Treasury bonds. These holdings, both direct and indirect through countries such as Belgium and offshore centers such as the Caymans, have dropped by at least $350 billion in the past three years and will continue to fall, both through a drop in sales and simply from Beijing’s not buying new bonds as existing holdings come to term. The decline has had no significant impact because the PRC’s holdings are trivial compared with our internal financial conditions — specifically the sustained, historically low U.S. interest rates and the Fed’s unwillingness or inability to lift them.

Much more interesting is the reason that China’s bond holdings are falling: Beijing has less money to spend on everything, including American bonds. In July 2014, the total amount of foreign exchange held in the Chinese banking system — including but not limited to official reserves — peaked at more than $4.8 trillion. By November 2016, that number had dropped by roughly $1.2 trillion. (This number is difficult to calculate because the PRC changed the statistics it publishes, probably to obscure the amount of money leaving the country.)

It hardly seems like a problem that “only” $3.5 trillion or so is left. Yet throughout 2016, the steepness of the decline in foreign exchange led to episodes of international financial instability over fears that China, out of choice or necessity, might either give in to the pressure and let the yuan fall sharply or fight it by forbidding capital to leave China. Moreover, the $1.3 trillion drop in less than 30 months occurred even while the PRC gained approximately $750 billion in hard currency from its goods-and-services trade with the United States. Without that huge sum of money, China’s balance-of-payments position — the net of hard currency coming into the country minus the currency leaving it — would be perilous.

For his part, Trump during the campaign repeatedly made the protectionist claim that the trade deficit causes job loss. There are crippling flaws in this view (see below), but if the president really holds it, he may see even radical steps to zero out the trade deficit as worthwhile for the United States. Ultimately in play is $300 billion heading from the U.S. to China each year, money Beijing now needs to insure against a balance-of-payments crisis.

America faces no risk of that magnitude — the PRC’s greater vulnerability should be obvious. So should the considerable damage that the U.S. has suffered from its bilateral economic relationship with China. We know from labor-market statistics that manufacturing employment and wages suffered after the U.S. affirmed permanent normal trading relations for China 16 years ago. This was not entirely due to China, of course, but a widely accepted series of academic papers by David Autor, David Dorn, and Gordon Hanson have isolated the impact of China. Rising exposure to Chinese imports by itself, apart from all other factors, caused lower American manufacturing employment, lower labor-force participation, and lower wages.

While tough competition for American manufacturers was expected, economists thought that there would eventually be equivalent opportunities to sell to Chinese buyers. This has not happened, essentially because the Communist Party likes competition only in other economies. The biggest problem is that the U.S., the world’s most competitive services producer, faces state-owned Chinese enterprises that are guaranteed by the Communist Party to retain a controlling share of their sectors. The Trump campaign correctly indicted Chinese subsidies, and the most powerful subsidy is a guarantee that a firm will not fail.

A second harm deliberately inflicted on the U.S. by China was minor in 2001 but has grown enormously since: theft of trade secrets and other intellectual property, also correctly criticized by the Trump campaign. Documenting the amount of theft is difficult, but it’s probably tens of billions of dollars annually over the past decade. It’s not just American technology companies that are being robbed; it’s American innovators of all shapes and sizes and the many millions of people whose jobs are connected to intellectual property.

President Trump, as he noted while campaigning, will have a big economic stick and good reasons to use it. But the Trump campaign’s rhetoric about China did not include an explanation of how to bring about better results for the United States. The first step is to avoid harmful mistakes that would make future improvements impossible. The incoming administration may find these don’ts particularly disagreeable.

Trump and his staff have repeatedly vowed to be tougher negotiators than past administrations have been. It might not matter. The United States has conducted formal economic talks with the PRC since the Joint Commission on Commerce and Trade was formed in 1983. Negotiated outcomes have depended less on who was running the American team than on who was running the Communist Party. If current leader Xi Jinping wants to limit foreign participation in the Chinese economy simply because it is foreign, as it appears he does from Chinese actions against foreign companies since he assumed power, it will be impossible to make China a good economic partner. The Trump administration will have to act unilaterally, which will make the diplomatic community nervous.

In that case, the next point would be crucial: The trade deficit should not be the focus of American policy, because it does not signify lost American jobs. Organized labor insists that the trade deficit represents production that could have been located in the United States. If imports are cut, the theory goes, American production will rise to replace them. But facts and logic say otherwise. In 2006, the highest annual trade deficit in history coincided with the lowest U.S. unemployment and highest labor-force participation in the past 15 years. In 2009, our trade deficit fell by more than $300 billion, yet unemployment and labor-force participation worsened sharply.

Protectionists make several mistakes, but their key error is confusing accounting with causation. They claim that the trade deficit causes job loss because it reduces gross domestic product. But GDP is just an accounting tool; it cannot cause anything. What actually causes jobs and trade to change is household income. When we are wealthier, we buy more of everything, including imports. The opposite occurs in down years. Sound economic policy can therefore boost the trade deficit, while poor policy can yield a trade surplus, as occurred during the Great Depression.

This misunderstanding of the trade deficit matters in two ways. First, our largest bilateral deficit is with the PRC, so attacking the deficit implies restricting imports from China first and foremost. Yet in the age of supply chains, emphasizing a bilateral deficit makes less sense than emphasizing the overall deficit. For instance, when China conducts the final assembly of cell phones, its exports to the U.S. are credited with the phones’ full value even though components made in Japan, Korea, and elsewhere account for most of that value. Our true deficit with China is smaller than reported; our deficits with some countries are larger.

The second, more hotly discussed area in which misunderstandings of the deficit need correction is currency manipulation. Currency manipulation seems esoteric until someone insists that it costs hundreds of thousands of American jobs. This claim relies on the underlying beliefs that currency manipulation increases the trade deficit (true) and reduces GDP (only in an accounting sense). That lower GDP means fewer jobs is assumed. But a direct comparison of the value of the Chinese yuan with U.S. employment and labor-force participation shows no relationship over time. The PRC’s currency policy has not mattered to American jobs.

It might matter in the future. It is fashionable to criticize Trump by saying that Beijing now manipulates the yuan to keep it from falling against the dollar. This is true but superficial. The deeper question is why the yuan is falling against the dollar when the Communist Party insists that the Chinese economy is strong and its financial system healthy. This traces back to the PRC’s financial vulnerability, which shines through its propaganda. It is possible that the yuan will drop sharply at some point because of foolish Chinese policy. If so, the U.S. should then consider retaliating. The U.S. can allow the PRC to try to right the ship by using exchange rates, but it has no obligation to be tolerant if China’s correction hurts the American economy.

Any action, however, should not include across-the-board tariffs. Across-the-board tariffs are appealing, given the extent of the problems in the U.S.–PRC economic relationship. But no matter how high the tariffs are, they cannot set back the clock to a time when America had a total of 19 million globally competitive manufacturing workers, compared with barely 12 million now. This is a false hope. Moreover, across-the-board tariffs (i.e., import duties) hurt the poor most, as mentioned above. In general, we should make policy not to try to restore the past but to help Americans in 2017 and beyond.

There are various options the Trump administration can pursue to improve the economic relationship with the PRC without relying on the Party’s goodwill or good sense. Most, but not all, feature punishment of bad Chinese behavior. Campaign statements and the backgrounds of incoming officials, such as Commerce Secretary–designate Wilbur Ross, make tariffs on auto parts, steel, and textiles, for example, very likely. But without a strategy guiding such steps, they would be mainly symbolic.

A foundation for a sound strategy, one that has been invoked by Trump and his staff, is the principle of reciprocity. There are perhaps two dozen sectors, such as insurance, that are effectively closed to American goods and services because the Chinese government protects its state-owned enterprises through regulatory and financial subsidies. In this context, the U.S. has justification to restrict Chinese trade and investment to parts of the American market, selected by the incoming administration to fit its larger economic strategy.

Simple reciprocity — closing to China all the sectors that China closes to the U.S. — would be a mistake, however. Closing off parts of the economy to competition should always be the last resort, because it hurts us as well as them. The Communist Party clings to the hope that closed markets and suppressed competition are compatible with prosperity. With disposable income in China less than one-tenth that in the U.S., state-led development has not brought prosperity yet. And with the PRC in the process of recording arguably the biggest debt splurge in world history, the future does not look bright, either. The U.S. should also exercise caution by not breaking commitments on specific sectors made to other economic partners and the World Trade Organization (WTO).

Instead, the Trump administration should adopt narrow responses that make better sense than China’s more sweeping anti-competitive policies. A WTO that permits the PRC’s anti-competitive practices should not object to documenting the benefits granted to state-owned enterprises; nor should it object to invoking reciprocity to restrict Chinese participation in a few American industries. The documentation of how the PRC blocks U.S. competition and of the retaliatory restrictions placed on Chinese goods and services in target sectors should include a pledge to restore Chinese access to U.S. markets when Beijing improves its policies.

There will be objections of various sorts to closing even one or two major sectors of the American economy to Chinese participation. These objections will have merit, but the only realistic alternative is the status quo. The Communist Party is intensely committed to its “national champions,” its ever-larger state-controlled companies, and mere talk will not open the PRC further. The record on this is especially clear.

The second major area of action, also mentioned by the Trump campaign, is intellectual property. American leaders have talked incessantly about how unacceptable intellectual-property theft is but have done basically nothing to stop it. A grand jury in Pennsylvania issued unenforceable warrants in 2014 for a few Chinese hackers, and Congress signed the Defend Trade Secrets Act of 2016, but no American administration has drafted meaningful sanctions. If intellectual-property theft does amount to tens of billions annually, the equivalent of strongly worded letters hardly constitutes an effective response.

Who steals the intellectual property is not the main commercial issue. Instead, it is who receives the stolen property and thereby benefits from an unfair advantage at the expense of American companies and workers. U.S. Steel Corporation has accused Chinese rival Baosteel of accepting intellectual property stolen from U.S. Steel and using it to create new, competing products. U.S. Steel has asked for compensatory American sanctions. While it can be hard to uncover the identity of the thieves, independent researchers can, to some extent, document the sudden appearance at one firm of technology developed by another. The American government could certainly use evidence provided by the intelligence community and targeted American companies to maintain a list of Chinese firms that are benefiting from intellectual-property theft.

Perhaps the biggest obstacle is the American companies themselves, which may not want to provoke Beijing or admit to stockholders that their intellectual property is vulnerable to theft. To the extent that corporate fear can be overcome by government protection, the policy choice is simple. Foreign firms that use stolen intellectual property should be banned from our market in terms of trade, investment, and any activity through third parties, and the length of the ban should depend on the extent of the theft. This will give Chinese companies a substantial reason — not merely words — to stay clear of stolen intellectual property.

There are also carrots to offer the PRC that are consistent with President Trump’s economic agenda and may spur job creation. With the exception of banned firms and a few sensitive technologies, America should welcome Chinese investment and the participation of globally experienced firms such as China National Machinery (Sinomach) and its many subsidiaries in infrastructure-building projects. Discriminatory practices such as the requirement to “buy American” when federal or local governments are purchasing products or undertaking construction should be waived for PRC companies that have not broken American laws.

The chief area of government-to-government economic cooperation with China under President Obama has been the negotiation of a bilateral investment treaty. The Obama administration believed that the rules laid out in a successful treaty would cause the PRC to treat American companies operating in China much better than previously, and that they might even set an example for how to improve other aspects of the economic relationship. But the same China that knowingly steals enormous amounts of intellectual property and refuses to allow competition with state-owned enterprises is not going to change its behavior because of a new piece of paper. Only an America that retains the ability to punish theft and invoke reciprocity can craft a valuable agreement with China.

Next year will probably be difficult for Sino–American economic relations. It should be. The United States has for many years avoided coming to grips with problems that will be painful to solve. The incoming administration will have to adopt and, crucially, hold to a strategy that makes sense for 2017, not 2007 or 1997. If it does, Beijing can be pushed away from some of its anti-competitive practices, and President Trump can fulfill a key promise to make trade and investment with China work better for America.

– Mr. Scissors is a resident scholar at the American Enterprise Institute and the chief economist for the China Beige Book.

Send a letter to the editor.

Get the NR Magazine App
iPad/iPhone   |   Android