The October Truce on US-China Trade Failed to Address Subsidies

Chad P. Bown (PIIE) and Jennifer A. Hillman (Council on Foreign Relations)

October 22, 2019 12:45 PM
Photo Credit: 
REUTERS/Thomas Peter

The “Phase One” truce with China announced by President Donald Trump in October avoided a planned escalation of the US-China trade war. But the “agreement in principle” with Beijing left many issues untouched, most notably the administration’s top priority of ending Chinese subsidies. There is little hope of easing US-China tensions if that issue remains unresolved. Yet the failure to make progress stems not simply from Chinese intransigence but from the administration’s wrongheaded unilateral approach on this complex issue.

In a recent paper, we diagnose sources of the conflict and explore ways to fix it. The fundamental strategic difference involves how the United States should actively engage—instead of ignoring—the World Trade Organization (WTO) system.

The October 11 announcement did not roll back the hundreds of billions of dollars of tariffs that China and America have placed on each other’s products. Rather it deferred threats to impose tariffs scheduled for mid-October in return for apparent Chinese pledges to buy more US farm products. But equally important, not once during his meandering, 40-minute Oval Office “lovefest” with China did Trump or any other administration official mention how his deal would tackle the Chinese subsidies that were the impetus for launching this trade war in the first place.

Trump’s silence was deafening. After all, unfair subsidies were featured dozens of times in the March 2018 report that the administration continues to rely on to justify its tariffs on more than $360 billion of Chinese imports. China’s subsidies were also central to the administration’s argument for imposing tariffs in 2018 on over $50 billion of imports of steel, aluminum, and solar panels. Those tariffs mostly hit US imports from economic allies—and not China—but they too remain in place today.

But the challenges posed by China’s industrial subsidies and state-owned enterprises were never something the United States could successfully fix by itself.

Improving the WTO rulebook

The WTO rules on subsidies have plenty of shortcomings, and the Chinese economic model has brought those limitations to the fore. But fixes are possible after some careful diagnostics. Here are three of the current rulebook’s biggest problems.

First, the WTO needs to redefine what counts as a subsidy in light of the Chinese economic model. China’s nonmarket system and its strategic use of other measures create policies that an economist would label a subsidy but that a lawyer—sticking to the letter of WTO rules—would not.

State-owned enterprises (SOEs) are not disciplined by market forces, for example. Other companies that are not state owned, but that exist throughout the Chinese economy, benefit from SOEs offering them extra cheap inputs. Another concern arises when the Chinese government restricts exports of raw materials—making them unfairly inexpensive to local companies that use those inputs but increasing the cost to foreign competitors by making them scarce overseas.

Second, the evidentiary burden-of-proof under the WTO may need to be reversed. Right now, the complaining country must prove where and how Chinese subsidies caused them harm. That burden could be shifted to the subsidy-granting country to show that its subsidies are benign. Such a shift would also relieve the fears of foreign companies that China will retaliate if they complain too loudly.

Third, a new system of enforcement may be needed. The current punishments—retaliatory tariffs or orders to withdraw the subsidy after the horse has left the barn—for breaking subsidy rules are weak and ineffective.

At best, US tariffs can work as partial punishment—and thus subsidy deterrent—only if the United States is the major consumer of the subsidized production. Tariffs are less effective if the United States is just one of many importing countries. Even worse is if the pain caused by a subsidy hurts US companies trying to compete with Chinese exports in a third country market.

The experiences of US companies that make steel, aluminum, and solar panels reveal the limits of a tariffs-only strategy. Historically, US tariffs on China have pushed subsidized exports of these products into third markets. US imports from other countries rose instead. US political pressure built up, as these American industries wanted additional duties on those other countries, even though they did not subsidize. The clear result from 2018 has been an expansion of these trade conflicts beyond China.

And the end result is little deterrence against granting subsidies in the first place.

But how big is the subsidy problem?

The WTO’s rules on subsidies may have many imperfections, but so what? Are Chinese subsidies imposing such large costs on the US and global economy to justify the disruption to Americans caused by the Trump administration’s trade war?

Perhaps surprisingly, the answer is unclear. There are precious few reliable estimates of just how costly Chinese subsidies are to Americans, and thus on which sectors—or even policies—negotiators should focus their priorities.

American policymakers are now negotiating blindly. They treat subsidies to inefficient Chinese steel mills, for example, as if they are a bigger global scourge than their disastrous role in climate change. For its part, China has made matters worse by refusing to acknowledge its subsidies and that they pose problems for other countries. Despite remaining a relatively poor country in per capita terms, China’s sheer economic size means that sometimes its subsidies shift trade flows so much that companies and workers outside of its borders are hurt.

But an independent economic assessment is sorely needed to introduce some real numbers into the mix.

A historical model does exist for how to come up with cost estimates. In the 1980s, world trade in agricultural products faced a similar subsidies problem. There were few rules and even less information. Governments around the world were subsidizing farmers in so many noncomparable ways that negotiators did not even know where to start. Should they focus on reducing domestic price support programs for dairy, export subsidies for wheat, or input subsidies for fertilizers?

To help solve this problem, the Organization for Economic Cooperation and Development (OECD) created a framework to estimate and report the size of subsidies across countries and agricultural products. With those estimates, 1980s policymakers could then begin to negotiate over the subsidies. While the system and outcome for agricultural subsidies remains imperfect today, discussions there have become more coherent and fact-based than the current fights over China’s industrial subsidies.

Toward this end, the OECD published a recent study of the global aluminum industry, constructing estimates for who subsidizes and by how much. It found that Chinese subsidies were large and took many different forms. But its study also showed that China wasn’t alone.

This is important: China can’t be singled out. Tackling the Chinese subsidy problem will require other countries to put their own pet policies and industries under the economic spotlight. The United States, the European Union, Japan, and others will also need to open their books. The ongoing Boeing and Airbus subsidy litigation, as well as the Trump administration’s continued bailout of the US farm sector, reveals the potential for hypocrisy.

The negotiating path forward

Prior to the trade war, Japan, the European Union, and the United States initiated a trilateral process to write new rules on subsidies. The trilateral work has continued behind the scenes throughout 2018 and 2019.

That process now needs to be put front and center. And China must be engaged. While the biggest beneficiary to Beijing’s subsidy reform would be China itself, any new rules will need to be part of a bigger package applicable to all major economies.

And any deal with China will involve trade-offs. The answer can’t simply be to redefine rules to make it easier for countries to impose punishing tariffs on China. The clear lesson from the limited scope of “Phase One” is that US tariffs alone aren’t solving the problem. There must be carrots as well as sticks.

Economics, not politics

Trump’s mini deal left no doubt that he was more concerned about the political problem of the pain to American farmers hit by Chinese tariffs than in addressing Chinese industrial subsidies. His Oval Office announcement mentioned farmers a dozen times. But farmers were largely doing fine—selling tens of billions of dollars of US agriculture to China—before this trade war started. It was Trump’s tariffs and China’s response that cut farmers off at the knees.

Trump’s October deal with China was not the answer. Reversing the administration’s go-it-alone, tariffs-only strategy and adopting a new approach on subsidies is the only way to resolve the conflict.