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US-China Trade Deal: Analysis of the Phase One Agreement

Interviewed By TAB RadioFinance

In this session with NUS East Asian Institute Director Prof. Bert Hofman, Phase 1 of the Economic Trade Agreement will be dissected, studied, and analysed to truly uncover what it really means for the two economic giants.

In mid-2018 the two largest economies of the world started a trade war that placed tariffs on over $550 billion worth of Chinese products and $185 billion worth of US goods.

After nearly two years of talks, threats and escalating tariffs imposed on bilateral trade, on 15 January 2020 the United States and China signed an “Economic and Trade Agreement”. 

At first glance, the trade agreement seemed remarkably in favour of the US as the document contains a total of 105 times a commitment by China (“China shall”), compared to 88 joint commitments (“Parties shall”) and only five commitments of the United States alone (“the United States shall”). Is the agreement lopsided or is there more than meets the eye?

In this session with NUS East Asian Institute Director Prof. Bert Hofman, Phase 1 of the Economic Trade Agreement will be dissected, studied, and analysed to truly uncover what it really means for the two economic giants.

 

Mobasher Zein Kazmi (MK): Good afternoon. I would like to welcome you all to The Asian Banker’s live RadioFinance, our online broadcast platform that aims to enhance the understanding of industry by bringing together senior opinion leaders to examine current critical issues.

I am Mobasher Zein Kazmi, head of research at The Asian Banker.

In mid-2018 the two largest economies of the world – the United States and China – started a trade war that placed tariffs on over $550 billion worth of Chinese products and $185 billion worth of US goods. After nearly two years of talks, threats and escalating tariffs imposed on bilateral trade, on 15 January 2020, the United States and China signed an economic and trade agreement.

At first glance, the trade agreement seemed remarkably in favour of the US, as the document contains a total of 105 commitments by China, compared to 88 joint commitments and only five commitments of the United States alone. Is the agreement lopsided or is there more than meets the eye?

In this session, we have Professor Bert Hofman as our guest speaker, who is the Director of the East Asian Institute at the National University of Singapore. He has closely dissected, studied and analysed the economic trade agreement and with his thought leadership, we look to truly uncover what this agreement really means for the two economic giants.

I would now invite Professor Hofman to share his presentation with us.

Prof. Bert Hofman (BH): Thank you, Mobasher. I'll talk about the trade agreement, but I do want to bring it a little bit into context for your viewers to understand where we're really coming from.

I'd like to start with a little bit of context, and that context goes back to when I was 12 years old, in 1974. That was the last year that the United States had a surplus in the trade of goods and services. So brilliantly, the United States has – for more than 40 years – run a deficit financed by capital inflows, because the United States is so attractive to place your capital in.

So China and the bilateral deficits with China are only one in a series of bilateral deficits. In the very old days, it’s actually Germany that ran large surpluses – they’re a little bit back. Then, during the ‘70s and the ’80, it was very much Japan that ran the bilateral surpluses with the United States. Then, as Japan reduced, the rest of Asia [were] largely that next came up and Korea came up. But since China's entry in WTO (World Trade Organisation) in 2000, it's been China. The reason of course is that the United States runs a structural deficit largely determined by investor sentiment, i.e. a lot of people want to invest in the United States, but also macroeconomic stance, i.e. the United States has run large fiscal deficits which need to be financed as well. Asian countries have taken turns and filling up that deficit, and now it’s as if China's turn.

But there's more to it, to China and the US relationship. Really, China is now at the centre of global value chains and the sight that you see is an illustration of that 2016 [statement] “China is really the centre of the world”; whereas 20 years ago, China was a bit of a backwater supplier to a supplier to Japan, so a completely different role today than in the past. It also makes the trade war between the United States and China risky because disentangling the intricate web on the right side will be very costly.

China has increasingly reduced its reliance on imported value added, but that's if you weren’t in line with what has been happening. But, it has been increasing value added to the exports of other countries. What it really means is that they have been exporting lots of intermediaries. Today, we're fighting with the coronavirus and you'll see that effect in the short term. But in the medium term, China has been increasing its supply to other countries. Every other country will rely much more on the export of China, including the United States, but especially here in the [ASEAN] region – Vietnam and Singapore are standing out here in the region.

In tech, the dependence on China from a value added point of view is even larger. If you look at how much China supplies, it's been rising, and trading partners with China have been supplying less and less value added to China. In part, that’s because now, far more companies that used to be abroad then are actually in mainland China and supplying to the Foxconns of the world there. To illustrate, in the first version of the iPhone that was made in China, China's domestic value added was only 3%. The last version of the iPhone now has 25% of China domestic value added. So, China is enlarging its supply chain.

Final point on the context and it's trivial, but how large China is. I mean, if you start disrupting global value chains, if you create trade tensions, you have to understand that in the short term, there is very little alternative. People talk a lot about Vietnam benefiting from the tensions. People talk a lot about Mexico benefiting from the tensions. Fair enough, but China has 28% of world manufacturing; Vietnam has 0.6% of world manufacturing, so it's very hard to see any kinds of substitute in Vietnam. Mexico, 1.5%, still a very, very small player compared to China and, in fact, compared to the United States itself. There is really no alternative in the short run to all the supply from China in a multilateral sense, in a global value chain sense, but also in a bilateral sense.

Now, let's come to the agreement, and the agreement indeed came after almost two years of haggling, with accelerating tariffs, with an almost agreement in April next year that then, in the end, fell apart because of political opposition in China to the terms and the way the United States thought of enforcing it. But we now have something of a truce, a phase one agreement.

There's a little bit of tariff reduction, but very little and I’ll explain a little bit later how much it actually is. Some issues in intellectual property rights are being addressed. It's always been a bone of contention between China and the US. Frankly, China had moved already and this was rather actually easy to agree on.

Technology transfer. Frankly, since the entry of China in WTO in 2001, the policy was that there was no forced technology transfer, but the practice worked out a little differently. Now, there is a commitment as part of the agreement.

Agriculture – a very interesting area where China promised not just to buy more from the United States, but also to actually recognise their product safety rules, and that is quite exceptional to have a one-sided recognition of those rules.

Financial services – again, China had already said it would open up for fully 100% owned foreign entities. Now, they have reconfirmed that. There’s a chapter on currency, and by and large says ‘Well, you need to not manipulate your currency’. That's already a commitment at G20, this confirms it.

And then there is what is very important for President Trump, I would say: the expanding trade chapter – in part that's agriculture, in part that’s manufacturing. In total, it should be $200 billion in two years.

You said in the beginning, Mobasher, that that this was an uneven treaty. It is in a way, but at the same time, China commits to a number of things that it had already moved on. And so, just counting the commitments is, in a way, a little bit of a distortion. But nevertheless, it is quite striking how uneven the “China shalls” and the “United States shalls” are, as indeed the majority of commitments come from China, or the joint commitments and the United States commits to very little, frankly.

The additional $200 billion and this is a slide that that I borrowed from the Deutsche Bank, I should say. Somehow, the recognition is not there, but it's from the Deutsche Bank. We looked at the additional import commitments that China made. Well, it's a lot of agriculture, quite a bit of energy, but it's also manufacturing and it's also services. Services a little tricky, because we really shouldn't count it as import [with] the way it is defined in the phase one agreement; but nevertheless, it does count.

The tricky part here is that the base taken is only about $130 billion itself. So, it is less than the actual trade between China and the United States, which makes it much harder for China to meet the $200 billion increase. Big beneficiaries are the [US] farmers, probably big losers will be farmers in other countries such as Brazil, such as Canada, such as Australia. Energy, big win for the United States energy suppliers, notably the fracking-based oil and gas. Big losers will probably be the Middle East and Australia, who are both very big suppliers to China in that sphere. So, there's a lot of trade displacement.

Strikingly though – and this is something where I would have expected China to win – despite all the commitments from the Chinese side, the tariffs barely go down. This is a chart made by Chad Bown from Peterson Institute for International Economics, a fantastic observer of the trade issues. He shows basically that this tiny little decrease in tariffs at the very end is basically negligible. So basically, the tariffs stay in place.

China, meanwhile, has an answer that they will reduce the tariffs, the retaliatory tariffs that it had imposed on exports from the United States. But they had to, because they need to buy more. For them, it's simply reducing the cost of importing from the United States. It would have been silly to import more of those goods that they already tariff. But within the agreement, there is no commitment, there is no review of the tariffs. There is no ‘Let's look at it again in six months with the view of reducing it if things go well’ – none of that. So that's all taken out of the agreement. It's basically at the discretion of the parties, and largely at the discretion of the United States. Quite surprising and a little uneven, if you want [to call it that].

But given that these tariffs stay in place, there's more going on. What will also continue to happen is this trade diversion caused by the tariffs. These are some numbers that show that trade diversion that happened until, in this case, October [2019]. There are lower numbers, but they look the same.

These are the changes in the US trade deficit broken up by country, and you see that China indeed is now exporting a lot less to the US, so they have contributed far less to the trade deficit. But others are contributing more – Canada, Europe, Mexico. Everybody wins, China loses – a classic case of trade diversion, any economist would say.

Secondly, though, which is also important – this is the China growth year on year, exports year to date year on year – you see that China's export to the United States is down and ended up at -15% over the year. But in many other countries, including especially ASEAN, exports are strongly up. Why is that? Well, because China needs to put its stuff somewhere and they found the market in ASEAN. So, the US-China trade relationship also caused a lot of trade diversion and a lot of negative effects, if you want, for other countries.

Let me stop here and let's take it into the discussion.

MK: To begin with, we'd like to understand what compulsions drove both China and the US to sign the phase one agreement, and as a follow up, is this really a win-win for both countries?

BH: Well, if you look at it from an economic point of view, there's very, very few wins to be detected, frankly. Those commitments that would be used for China were already made and, if you want, were put in the agreement that it looked, it made that agreement make those commitments a bit more credible. But overall, the tariffs stay high, a lot of the very difficult issues are not addressed, such as state enterprises, industrial policies, subsidies – difficult issues that were part of this draft agreement back in April, they are now out. This voluntary import commitment, very disruptive for world trade.

From a political point of view of course, it looks quite different. Trump wanted to have a win. And he wanted to, and I think he was well positioned. He can now say two things: ‘Hey, I’ve been very tough on China and you see, it's working because they're buying more from us’ and ‘I haven't reduced the tariffs’. So I've been tough on China and continue to be tough on China until they really equal out the deficit with China. That's a very good political position for him to be in and to carry into the elections, no question.

Of course, some of his electorate, notably the farmers, would be relatively happy with it. Others in manufacturing will not be happy with this because on net, the tariffs imposed have actually been quite negative for manufacturing in the United States. That has caused job losses rather than job gains, and so that's not so good.

For China, I think China signed in part because, you know, they look like big commitments but in a way, they already wanted to do that. It looks like a big commitment, but it's all right. Second, I think they overestimated their own capabilities a little bit. The big shock to China in the trade war was actually the listing of Huawei on the entities list. And there, it suddenly became clear that China actually missed a lot or that the United States was carrying very big stakes in this conflict. So I think they were sort of keen to come to some agreement, buy some peace, buy some quiet time, because also the uncertainty around this whole negotiation was actually undermining investments, was undermining economic growth in China. So they wanted to buy some peace and maybe some time to build up their own capacity domestically. So for them in the end, it is probably an acceptable agreement – in part political, but in part also economic.

MK: Very good. And we spoke about the tariffs as well. But the phase one agreement does not have a commitment or a guarantee to reduce those tariffs, does it?

BH: Correct. There's nothing about tariffs, basically, in the agreement except the final chapter, which talks about what would happen if commitments are not made, and then the answer is more tariffs. But there is not a commitment to reducing the tariffs or even reviewing the tariffs over time. So that would have to be handled somewhere else. Hopefully, it will be handled somewhere else but maybe at least for the United States, they might feel quite comfortable with the tariffs, so it would have to be China that would argue this.

MK: Right, good. In terms of the unilateral recognition of standards, we do see that it's fairly unusual in trade agreements. But in this instance, China has accepted the imposition of US food safety regulations on its agricultural exports. What drove China to accept this?

BH: There are a couple of ways to look at that. One is that they were forced, i.e. the United States would’ve argued that ‘Look, you know, we've had always this access, but it never happened because you always found some safety requirement that we didn't meet, and then we could export.’ And that happens not just in China, that happens around the world, that happens in Europe – there are different standards, and it’s always very hard to do agricultural exports. And so, the United States may have argued very strongly to get rid of it.

But the second point is that the reality is, of course, the United States has much higher standards, in part because of their very litigious society. If there’s something wrong with food safety, it would cost you a lot of money. China is still relatively weak. Maybe China just said, ‘Well, look, this might be something, that we import their standards and then our own suppliers would have to meet those standards in order to be able to compete’. I think they’re also solving a bit of a domestic problem knowing China quite well, having discussed a lot with China's Food and Drug Administration on these issues. They have had a bit of a difficulty in upping their own domestic standards. So, in a way, this is maybe reformers using that external pressure to get domestically some things done.

MK: Okay, that's quite interesting that it emerged that way. It's very interesting to see what happens. I also had a question concerning dispute resolution, given that retaliatory tariffs are not allowed, and the only recourse is reverting to the standoff that existed prior to the phase one agreement. Is there a possibility of the cancellation of the phase one agreement if there is no dispute resolution?

BH: I think it's, right now, very unattractive, more so now that the coronavirus is laying havoc with the Chinese economy, but I think the Chinese will be quite patient and I think they're seriously committed to meeting the commitments. If there is a bit of a degrading and if there were to be a retaliation, I don't think they would walk away. I think for now, they want some quiet time on the trade front and they can regroup and rethink their strategies. But also, I think the commitments are there to make this agreement work, so maybe dispute resolution will never be used.

MK: Okay, absolutely. Looking at the specific steps that the US can take to revamp its manufacturing base, because you did allude to that in your slide presentation. This was one of the key objectives – at least for the US and for the Trump administration – that they were looking to revamp their manufacturing base, create employment and bring jobs back home. Will this happen? Is this likely to happen or is this happening now?

BH: Well, the evidence thus far – and that's not my evidence – but there’s evidence from researchers at the Federal Reserve Board shows that actually, the tariffs have overall been damaging to employment in manufacturing, as I said. And that's simple, that's not just the tariffs with China, but it's the overall tariff program of the Trump government, in part because they put tariffs on steel, which made steel products in the United States less competitive and the downstream sectors that use steel, they have more employment than the upstream sectors. I mean, upstream steel is just very, very big machines pouring molten iron and downstream is where the jobs are. So if you make upstream more expensive, you become less competitive downstream – and that's basically what happened.

So, tariffs is not the way to go and managed trade is really not the way to go to revamp, to make a major rejuvenation of manufacturing. There may be good reasons to think about rejuvenation of manufacturing. Let me say it, one of them is national security, there's no question that that is the case. But in others, it is also if you have a certain labour force that really can only do manufacturing, only trained to do manufacturing, getting some manufacturing back is important to create some employment for people that you feel have gotten the short stick of globalisation.

So, what do you do? Well, those are very, very different fields, frankly. It's, in part, investing more in research and development. If you want to do more manufacturing, you need the infrastructure to match, because big manufacturing requires big logistics and big infrastructure, so you're going to build more of that. Modern manufacturing is quite sophisticated, a lot of it is quite automated. So if you want to create more jobs, you need to have more sophisticated workers, which means retraining the ones that are looking for a job, but also thinking about the next generation of workers on how they should look and invest in those people by means of a better education system. If you want, I could sketch a plan. With more time, I could make a plan to revamp manufacturing in the United States. Tariffs is not it.

MK: It’s not the solution. Very good. Professor Hofman, how has the agreement created a better environment for technology and intellectual property dependent industries in China?

BH: It's sort of interesting because on the one hand, everybody fears China and China's technological development and how fast they go. On the other hand, they say, ‘But oh, intellectual property is terrible there and it's very hard to invest’.

Now, the fact of the matter is that China, since the earlier part of the 2010s, they realised that they needed to improve by mid-century. Mid-decade, there had been quite a bit of reforms in better protecting intellectual property rights, special courts for enforcement of intellectual property rights. There's currently revision of the law ongoing.

With regard to technology transfer, there's been a number of policy pronouncements of senior leaders, but also the foreign investment law already included explicit clauses on this. China had already moved quite a bit, but then this agreement is maybe the icing on the cake, i.e. because there is an external force – the United States – that's basically pushing China to meet its obligations, the likelihood of them meeting those obligations are a bit better.

It actually means that China has improved its environment, and that's the irony, I think, in all of this. If you look at the bottom line, China makes itself ready for the future – more intellectual property, more sophisticated industry technology – and the United States exports agriculture and energy. That I think, is something for United States policymakers to reflect on because I think, in the end, for their long term interest, this may not be the way to go.

MK: Absolutely. My final question for you, Professor Hoffman is: where do you think we'll go from here? Will there be a consensus reached by both parties on issues of industrial policy, state-owned enterprises and subsidies in a potential phase two agreement?

BH: Well, first, I think that we are all going to take a break. At least China, US are going to take a break, and I don't think much will happen ‘til the [US] elections. Then, as far as I understand, President Trump wants to negotiate first with the EU and then with the UK. So it may be that it will take a while before people start looking at phase two.

There's a big question on whether these difficult areas – industrial policy, state-owned enterprises, subsidies, all of them – are only very weakly addressed or regulated in the WTO agreement. There's a huge grey area. China says, ‘Look, we have the right within that grey area to have a bit of a darker shade of grey compared to some of the Western countries’. And, in a way, they're not wrong there.

However, those Western countries think very differently and they see these areas as the big bone of contention, actually much more important than the one on intellectual property rights. They have been working on this without China to formulate a number of positions. It's actually the US, Japan and the EU that came out with a joint statement in these areas that sound pretty tough on China, i.e. what China's doing now that they can no longer do.

Now the question is whether that is acceptable to China and the question in the end is whether they need to give in. The objective question of course is how important is industrial policy for a country? How important are subsidies? What role can subsidies play in there? Can some of that be WTO compatible or not? Whether such subtle discussions will be raised during the process remains to be seen, but it would be really important.

There are, in my view, rules that can be thinkable that can be put in WTO where everybody would agree and it would be reasonable to the benefit of the whole world. Whether that happens remains to be seen. A bilateral negotiation is really not the right platform for that. That should be a WTO negotiation, should be a WTO discussion. Hopefully, that will happen in the coming months or a year before phase two negotiations start so that there is a broader consensus on what is allowed and what is not.

MK: Yes, absolutely, I think you're absolutely on the right track in that sense that there needs to be a broader consensus reached. Hopefully, we do see these materialise.

I would like to thank our guest speaker, Professor Hofman, for sharing with us your deep insights with us today. We hope our audience has found this session interesting and useful.

If you've missed any part of this session recording, this will be available on The Asian Banker website, so do visit the website should you like to listen to a playback of this session. Until the next event. We wish you all a good day. And thank you to Professor Hofman again for his insights for this unique RadioFinance session. Thank you.

Click here to read the article on the Phase 1 of the US-China trade deal by Prof. Bert Hofman


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