A new trade deal could open opportunities for foreign and domestic private firms if China is willing to open sectors and protect intellectual property

The US and China trade conflict has come at a bad time for China. The growth of its economy was already slowing for domestic reasons, and the tariffs imposed by the Trump administration only add to the difficulties and uncertainties. The right trade deal could be quite helpful for China, but the devil is in the details.

China’s economy: Export-oriented and protectionist growth 

China has enjoyed impressive growth for a long time with a mixed economy. Manufacturing is largely private and export-oriented, and most of its exports come from foreign-invested firms. Additionally, most of the domestic value added in China’s exports come from the domestic private sector. 

This export-oriented growth model, which was followed in the period before and after joining the WTO in 2001, enabled China’s dynamic private sector to expand its share of GDP and employment, which provided a key boost to the country’s overall growth performance.  

Other sectors of the economy were dominated by state-owned enterprises (SOEs), especially in services such as finance, telecommunications, media, and airlines, as well as a few manufacturing sectors, such as automobiles. The Chinese government limited competition in these sectors principally by restricting both foreign and domestic private investment. 

On the OECD’s foreign direct investment (FDI) restrictiveness index, China is more closed to FDI than other large developing countries in the G20. Its restrictiveness is particularly strong in the sectors noted above.

China’s slowing economy

  • Transitioning from manufacturing to services

It was natural that China’s export-oriented model would run out of steam over time. In the 2000s, China’s exports were growing faster than 20% per year. Once it became the largest exporter in the world, it was difficult for those exports to grow faster than world trade. 

The global financial crisis in 2008 accelerated the natural process in which the growth of exports, and hence manufacturing, slowed. In the meantime, domestic consumption – primarily services – took on an ever more important role. For several years now, domestic consumption has been the main source of demand on the expenditure side, and services have been the rapidly growing sector on the production side.   

  • Attempts to stimulate growth: Investment and credit 

For a time, China was able to slow this adjustment process by stimulating investment, especially in infrastructure and housing. Local governments borrowed to build transport and power infrastructure, and to develop housing in expanding parts of their cities. China’s debt-to-GDP ratio was stable during the export-oriented growth period, but began to climb as credit was issued to stimulate government and SOE investment.

Today, the debt ratio has reached nearly 300% of GDP. The authorities slowed the growth of credit in 2017 in an effort to stabilise leverage. However, as the trade war started in early 2018, they hit the credit accelerator again in an effort to keep growth at an acceptable level. 

  • Low GDP and high debt: Poor capital allocation

It is natural for the growth rate to slow down as an economy matures, but in China’s case the slowdown has been extreme. In the 2000-2007 period, GDP growth averaged 10.5% per year; last year the official figure was 6.6%. However, there is evidence that in recent years China’s GDP growth has been exaggerated in official figures by about 1 percentage point.  

Hence, in actuality, China’s growth has declined by roughly a half.  This is partly the result of a relative shift from sectors dominated by private firms to ones dominated by state enterprises. The state-run financial system is particularly important here as the alarming run-up in debt to GDP suggests that the system does not allocate capital very efficiently. 

Trade conflict: Tariffs and retaliation

In the short run, the trade conflict between the US and China is an additional source of uncertainty. As of early 2019, the US had imposed a 25% tariff on US$50 billion of products from China, and a 10% rate on an additional US$200 billion imports from China. China had imposed retaliatory tariffs aimed at key imports from the US, such as soybeans.  

These amounts are not large enough to have much direct effect on either economy, but the threat of escalation has no doubt influenced investment and consumption decisions. Consequently, both the US and Chinese economies show signs of additional slowing in 2019.

Negotiating a deal

The two sides have been negotiating intensely to reach a deal. What might it entail?  It is useful to distinguish three issues: 

1. Chinese purchases of specific US products

  • Trade imbalance: Surplus and deficit 

The first issue addresses the alleged problem of a trade imbalance between the US and China. Before the global financial crisis, China had a large overall surplus – its current account balance, which serves as the broadest measure of trade, reached 10% of GDP. The US had nearly as large a trade deficit. Subsequently, China’s surplus has basically disappeared, amounting to 0.4% of GDP in 2018. The US deficit also came down as a share of GDP in the years immediately after the Crisis. 

  • Global value chains and natural resources

China has a large bilateral surplus with the US, which is partly the result of its place in global value chains, which tends to be at the end. For example, large numbers of smart phones are air-shipped from China to consumer markets in the US and Europe. The value added in the phones includes US technology, sophisticated parts from Japan, South Korea, and Taiwan, and labour-intensive parts and assembly in China. It is also the case that China is a natural-resource poor country that runs trade deficits with large numbers of resource-rich countries and trade surpluses with advanced consumer markets.  This is how trade is supposed to work.

  • Chinese statism and US production capacity

As part of the negotiations, China is willing to make commitments to purchase products such as soybeans, liquefied natural gas (LNG), aircrafts, and telecommunications equipment from the US. Unfortunately, this reinforces statist tendencies in China as these purchases will all essentially be made by state enterprises. 

What’s more, they are not likely to have much effect on the US economy or the bilateral trade balance. The US is already producing near full capacity, so additional exports are likely to be diverted from existing US sales to third countries or from domestic consumption.

2. Better market access through the lifting of Chinese import and investment restrictions

The negotiations over market access, on the other hand, address key remaining distortions in China. The authorities have shown some willingness to open up financial services and automobile production.  A key question is whether China is willing to expand this to more sectors of the economy. This could create competition, productivity growth, and new areas for investment, counteracting at least in part some of the natural tendency for growth to slow down.  

3. Forced technology transfer and intellectual property rights (IPR) protection

The issue of forced technology transfer is closely tied to market access as it is the requirement to work through joint ventures that results in many foreign firms transferring their technology. The larger issue of IPR protection is something that China is gradually addressing as it becomes a more innovative economy itself.

Conclusion

China could help itself through a trade deal if it is willing to make some bold openings of now-closed sectors and to continue to gradually improve IPR protection. However, if the deal largely consists of state enterprises agreeing to make specific purchases, it is hard to see how such a deal will benefit either economy. 

Editor’s Note: This is part of our series on the US-China trade war.

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