Trump's phase one deal relies on China's state-owned enterprises

President Donald Trump’s trade war with China has been counterproductive from the start. His tariffs raised prices and punished American consumers. China retaliated against US agricultural exports as expected, hurting American farmers. But now even Trump’s trade deal with China is undermining his administration’s professed policy agenda. The phase one accord committing China to buy additional US goods seems certain to strengthen Chinese state-owned enterprises (SOEs) and state control of the economy—the very policies the administration’s trade war supposedly sought to combat.

The clock is now ticking on the phase one agreement, in which China says it will import an additional $200 billion of American-made goods and services before the end of 2021. Indeed, as Trump boasted in Davos: “We’ll be taking in an excess of $200 billion; could be closer to $300 billion when it finishes.”

It will be hard enough for China to meet this commitment as it stumbles through an economy now afflicted by the coronavirus disease. But a key flaw in the deal was baked in long before the COVID-19 outbreak: Beijing is not cutting its tariffs on billions of dollars of American exports, which would have made them less expensive for Chinese consumers. With few market incentives for China’s private sector to purchase US goods, Trump is apparently banking on the Chinese government to direct its SOEs to pick up the slack.

This contradiction adds to an increasingly long list of forces challenging the phase one agreement’s economic viability and jeopardizing the long-term health of the US-China relationship. By signing a deal that left in place Chinese tariffs on tens of billions of dollars of American exports, Trump has relegated to the sidelines the buyers who determine nearly 75 percent of Chinese purchases of imported goods.

As for the SOEs filling the $200 billion breach, the data do not look promising. But even if they did, Trump’s move undermines a separate and important pillar of stated US trade policy. In fact, the growing economic clout of China’s state-driven sector is one of the few trade policy concerns shared by many outside Trump’s narrow band of trade advisers.[1]

As a result, with the legal terms of this deal, Trump is effectively urging China to become more state directed. Here is why.

The phase one deal discourages the Chinese private sector from buying American exports

The cornerstone of Trump’s deal was a Chinese pledge to purchase an additional $200 billion of American exports over 2020 and 2021. But quizzically, the agreement’s legal text makes no mention of Beijing committing to cut its tariffs to facilitate those purchases. [2]

This omission is deeply puzzling. As of the agreement’s implementation on February 14, 2020, an enormous difference remained between Chinese tariffs on purchases from America relative to purchases from any other country (see figure 1).[3] Throughout the trade war, China repeatedly retaliated against Trump’s tariffs by increasing duties imposed on American companies and farmers. Meanwhile, Beijing lowered its tariffs toward exporters in the rest of the world during the conflict.

Thus, the deal appears to lock in a number of American exporters as the least attractive choice for Chinese buyers. The second best choice for China’s 1.4 billion people are imports from farmers or companies in Brazil, Europe, or Japan, which face lower Chinese duties. And the best, of course, is to source from a local supplier and not face any tariff at all.

Trump’s deal promises an additional $19.5 billion of Chinese purchases from American farmers in 2021, for example. But Beijing has raised tariffs on US farm exports to 41.5 percent, on average, while lowering duties on agricultural exports from other countries to 16.4 percent. As a result, American agricultural products remain 25 percent more expensive. This trade war penalty for being an American farmer exists in oilseeds (Iowa soybeans), meats (North Carolina pork), cereals (Kansas sorghum), seafood (Maine lobster), and cotton (Texas).

It’s not just farmers. US manufacturing companies scattered across the country have been promised an additional $44.8 billion of Chinese purchases in 2021, yet their products generally face higher tariffs than competitors in Germany, Japan, or South Korea. (Exceptions are pharmaceuticals, vehicles, and aircraft.)

And while Trump is campaigning on Beijing’s promise to buy an additional $33.9 billion of American energy products in 2021, the Chinese tariff differential for liquified natural gas, coal, and other refined products remains 25 percentage points or more.

Failure to address China’s tariffs is important for at least two reasons.

Politically, the deal illustrates the emptiness of Trump’s goal of reciprocal tariffs. His agreement “successfully” achieves such a relationship with China—each country now charges the other an (extraordinarily high!) average tariff of roughly 20 percent. The result of Trump’s version of reciprocity is reduced access for American exporters to the Chinese market.

But more critical is how the deal worsens—rather than resolves—one of the frictions underlying his trade war. Trump’s agreement pushes China even farther away from markets and toward a state-driven economy. China’s private companies now face strong disincentives to buy American exports. For Beijing to placate Trump between now and 2021 and get close to the targets, China’s SOEs will almost surely need to expand their purchases, as well as redirect them toward American sellers.

China’s SOEs will be challenged to meet phase one purchase targets

By ignoring the Chinese private sector, Trump may expect Beijing to direct its SOEs to buy from American suppliers, instead of other sources where the tariffs are lower.[4]

This will be a challenge. In 2019, SOEs purchased only 26 percent of Chinese total merchandise imports. While a slight uptick relative to its 2016 low (23 percent), it is only roughly half as large as it was 25 years earlier (figure 2).

As the second largest importer in the world, Beijing, in theory, could meet the targets by somehow directing its SOEs to shift their 26 percent of imports entirely toward American suppliers.[5]

Yet, even under state direction, there are at least three countervailing forces.

First, some US exports are not good substitutes for what Chinese SOEs traditionally buy. Second, China’s private sector—not its SOEs—is the main Chinese purchaser of a number of products covered by the phase one agreement. Third, some key American exporters have limited existing capacity and may be unwilling to undertake the costly and risky investment needed to significantly expand their supplies by 2021.

Some US exports are not a good fit for China’s SOEs

Not everything that China’s SOEs buy has an easily substitutable, American-exported counterpart. For example, China’s SOEs recently imported more than $500 million of cane sugar. US sugar exports to China were zero; in general, the United States is an inefficient global supplier of sugar.[6]

More generally, the top 10 goods that China’s SOEs recently purchased from the United States illustrate the problem (figure 3). The American versions of aircraft, aircraft engines, copper, and even cotton are all significantly more expensive than varieties of those same products China’s SOEs purchase from other sources.

One important explanation is potentially large differences in quality. China’s SOEs (funded by Chinese taxpayers) may not need all of the latest bells and whistles common to America’s cutting edge varieties and so may opt for a lower-priced, but lower-quality, alternative.

For some products, admittedly, quality differences are likely less of a deterrent. SOE purchases of soybeans, liquified propane, sorghum, and dried distiller grains, for example, each have much smaller price differentials that may make American and other varieties relatively substitutable (see again figure 3).

Many phase one products are imported primarily by China’s private sector, not SOEs

The next problem is that the Chinese private sector purchases most of China’s imports of many products in the agreement. SOEs take in less than 20 percent of China’s imports from the rest of the world of electrical equipment and machinery, pharmaceuticals, industrial machinery, and optical and medical instruments (figure 4). (These purchases from the rest of the world are the ones Beijing could, at least in theory, force China’s SOEs to divert to US suppliers instead.)

SOEs do purchase the bulk of Chinese imports of energy—e.g., crude oil, liquified natural gas, and coal—as well as aircraft. But for everything else, the Chinese private sector does most of the importing.

Even in agriculture, SOEs purchase only about one-third of China’s imports. This includes oilseeds (soybeans), where more than two-thirds of imports are by China’s private companies.

Figure 4 thus also illustrates why the Trump administration may overestimate the economic might of China’s SOEs. For half of the categories spelled out in the deal, US exporters are already more reliant on Chinese SOE buyers than exporters from other countries.

US exporters may face supply constraints for many products that China’s SOEs import

The American Petroleum Institute has already warned the Trump administration that it will be unable to meet China’s phase one commitments for energy products due to US supply side constraints, according to Bloomberg.

This is backed up by the data (figure 5). Crude oil, liquified natural gas, coal, and other refined products make up some of the smallest export values of all the goods inscribed in the deal. To reach the $40.6 billion target in 2021, the agreement pledges an additional $33.9 billion of American energy exports relative to 2017 levels of $7.7 billion. (A separate important concern is that deal’s starting point is much lower than 2017 levels; e.g., energy exports fell to only $3.6 billion in 2019 with the trade war.)

While energy is more readily substitutable (figure 3), and China’s SOEs do the bulk of the importing (figure 4), unfortunately many American exporters may remain limited in their supply response.

But supply side constraints are not limited to energy. Even for agricultural products like meat, cotton, and cereals, for which China’s SOEs are considerable purchasers (see again figure 4), US farm exports have traditionally been small (figure 5).[7] To get to the $40.4 billion export target in 2021, China needs to purchase an additional $19.5 billion of American farm exports, relative to 2017 levels of $20.9 billion.

The export supply response will also be muted by the deal’s short-termism. Major export expansion requires establishing new relationships with Chinese buyers, or resuming old ones cut off during the trade war. It also mandates new investment, a commitment that both sides may be reluctant to make, given the hostility that the Trump administration has fomented. Despite the phase one deal, White House aide Peter Navarro’s seemingly unrelenting talk of “decoupling” means trust remains nonexistent. Uncertainty about the future trade relationship is the new normal.

For many of the goods covered in the agreement, all three necessary conditions for achieving phase one targets—substitutable products, China’s SOEs being the major importer, and US exporters having the supply response—just aren’t there. When the Chinese private sector faces strong disincentives to buy American, all it takes is one missing ingredient for US export goals to remain unrealized and unrealistic.

Directing Chinese SOEs to buy more, and buy more from the United States, sets back separate goals

For some products, Trump’s deal could turn out a success. Despite the tariffs, Beijing may coerce its SOEs to overcome market disincentives and purchase from American suppliers anyway. This trade diversion would be not only economically inefficient but also extremely problematic for the rest of the world. It would be a major setback for the rules-based system that has long battled against such attempts to “manage” trade.

Nevertheless, even “success” would be a problem. The Trump administration justified its costly trade war as a necessary evil to confront the Chinese economic model. Yet, by structuring the deal so that US exports grow only if China’s SOEs increase in importance and at the expense of the Chinese private sector, Beijing hears double talk. The message is that the Trump administration cares little about China becoming more market-oriented after all.

And the rest of the world will hear it the same way. Odd, then, is the Trump administration choosing now to issue its belated and separate plea to other World Trade Organization (WTO) member countries that they should join its side in the bigger, systemic trade fight with China. On February 20, the administration requested the WTO to admonish China on “serious concerns with non-market-oriented policies and practices that have resulted in damage to the world trading system.”[8]

Trump’s trade deal with China and treatment of markets is massively inconsistent with what was allegedly one of his administration’s biggest policy objectives. Expect those WTO admonishment pleas to fall on deaf ears.

Notes

1. See Nicholas R. Lardy, 2019, The State Strikes Back: The End of Economic Reform in China? (Washington: Peterson Institute for International Economics), as well as Chad P. Bown and Jennifer A. Hillman, 2019, WTO'ing a Resolution to the China Subsidy Problem, Journal of International Economic Law 22, no. 4: 557–78.

2. On February 14, Beijing cut in half the very last round of retaliatory tariffs it had imposed on US exports on September 1, 2019, in response to Trump’s February 14 action to cut in half the US tariffs imposed in September 2019. The Chinese government announced this tariff cut only on February 6, after the phase one signing on January 14.

3. Like the United States, China has periodically announced rounds of product exclusions for goods that would be temporarily exempted from its tariffs. The tariff implications of the product exclusion announcements are reflected in figure 1.

4. In practical terms, the Chinese government could promise to rebate the tariffs it collects on SOE purchases.

5. Strictly speaking, we estimate that shifting 100 percent of China’s SOE imports to the United States in the phase one product categories could meet the targets.

6. This is due to a highly restrictive set of import quotas that has shielded the US sugar industry from foreign competition for decades.

7. Figure 5 illustrates US exports to China only. It is possible that to overcome supply constraints US companies could shift existing export orders from other buyers (e.g., from the European Union, Japan, or Canada) to China instead. Obviously, however, if exports to China merely occur at the expense of US exports to the rest of the world, that is hardly “expanding trade” for US exporters overall.

8. “The Importance of Market-Oriented Conditions to The World Trading System,” Draft General Council Decision, Communication from the United States, WTO Legal document WT/GC/W/796, February 20, 2020.