Why Not to Expect Much from US Trade Talks With China

Even though Mr. Market is now in a tizzy about the future of tech high-fliers, he was very happy last week when the US backed off from its trade war saber-rattling against China and the two sides agreed to talk.

The Administration still has its threat of a 25% tariff on $60 billion of yet to be determined Chinese goods in play, and has said it will launch a Section 301 trade action against China’s unfair technology licensing rules. Keep in mind that past Section 301 cases have served as bargaining chips to force trade concessions. Trump has said he wants the trade deficit with China reduced by $100 billion and also wants more reciprocity. Bear in mind that even a $100 billion improvement would only be a dent in a yawning trade gap of $375 billion last year.

As Treasury Secretary Mnuchin put it, per Reuters:

Mnuchin told Fox News that he was pursuing an agreement with the Chinese “for them to open up their markets, reduce their tariffs, stop forced technology transfer. These are all the things we want to do.”

The Administration is out to throw sand in the gears of China’s economic strategy. From the Financial Times:

But behind the tariffs is what analysts consider to be a broader objective from the White House to disrupt a high-level Chinese strategy, called “Made in China 2025”, that aims to make a number of companies world leaders in sectors such as robotics, semiconductors, aviation and computing.

A crucial element of Beijing’s development plan has been to partner with foreign companies or acquire overseas technologies that will help Chinese groups rise to global dominance in their respective industries. It is these companies the US is expected to take action against.

It is a awfully late for the US to be waking up to the Chinese buying as well as appropriating US technology. The Section 301 case is expected to target the well-established practice of Chinese firms requiring US partners to make substantial technology transfers as a condition of establishing joint operations. I am hardly connected, but I have been hearing for a very long time of Chinese companies also engaging in intellectual property theft, and I don’t mean bootlegging movies.

In addition to these priority areas, the US also wants China to let US firms take controlling stakes in financial firms, reduce tariffs on auto imports, and buy more US semiconductors.

The current state of play is that the Administration gave temporary waivers on its steel and aluminum tariffs to major trade partners like Canada and the EU so as to force the economic impact onto China. So even though Trump says he doesn’t do cooperation, this is effectively a joint action against China.

The problem is the Administration would not doubt like a fast win like the one it scored with South Korea in the form of renegotiation of some terms of a six year old trade deal that had become Trump’s poster child for “the US is getting screwed on bad trade agreements.” The US-South Korean merchandise trade deficit doubled after it was signed and Trump had threatened to scupper the deal entirely. The US oddly is keeping pretty mum, perhaps because Trump does not want to look like he relented. Or perhaps he intends to hold that talking point back till closer to the midterms so it won’t seem like old news.

I would not expect things with China to change much. Recall that when the US was faced with burgeoning trade deficits with Japan in the 1980s, it had a great deal of difficulty making any progress. The most effective tool was the blunt instrument of the Plaza Accord of 1985, an agreement among the then G-7 which drove the yen to the moon, with the overshoot so bad that the G-7 then entered into the Louvre Accord in 1987 to push the greenback back up.

While Japanese exports to the US fell as a result of the currency move, US companies made almost no progress in their pet aim of increasing exports to Japan. There were two major non-tariff barriers. One was the fabulously fragmented Japanese distribution system, which among other things helped Japan keep employment levels high. I recall US pharmaceutical companies desperate to buy 49% stakes in drug distributors as a way of improving access and not having much success (note that the idea of selling a company outright would be akin to selling your children, so that was another barrier to getting a foothold in Japan. Japanese attitudes towards M&A have changed since then). Another was that Japanese consumers had a very strong preference for Japanese goods, out of the often-accurate view that they were better made.

Mind you, the US had limited success despite Japan being a military protectorate. However, it was able to press Japan to deregulate its financial system rapidly. The result, as we’ve written elsewhere, was that the resulting speculation (which the Japanese then called zaitech) intensified the spectacular Japanese asset bubbles, making the bust even worse.

China has studied Japan’s economic history carefully and is mindful of its errors.

While it is obviously not possible to predict how things will play out, particularly with an erratic figure like Trump, the Chinese know that time is on their side. The more they look cooperative but find ways to draw out the talks, say by suggesting that they need to be comprehensive or multilateral to succeed, the more likely that they bog down or that the Americans decide they need to settle for some symbolic wins since getting any big prizes will be really hard. Remember, the Republicans are likely to take serious losses in the midterms and 2020 isn’t all that far away either.

Even if Trump were to impose his threatened tariffs, the impact on China won’t be significant and will also blow back to other trade partners. From the South China Morning Post:

If Trump were to slap a 25 per cent duty – as the US Trade Representative recommends – on US$50 billion worth of Chinese imports, we estimate the direct and first-order impact could be worth 0.1-0.2 percentage point of Chinese GDP.

While this impact could be amplified by a broader list of products, a higher tariff rate, and second-round effects, the order of magnitude is not large enough to derail the Chinese economy. In reality, this impact could be even smaller as the shock will be spread across the global supply chain.

Tech and electronic products, which are on top of the list for tariffs, are prone to supply-chain production, which involves countries specialising in parts of the production with inputs assembled at the end. China is well integrated into this process, with nearly 40 per cent of its exports in 2017 being processing trade with imported materials.

Hitting China on these products will create a negative spillover onto the likes of Japan, Korea and Taiwan. Even the US could suffer from the reverberation, with companies like Apple taking the lion’s share of profits from products that are assembled in China.

It’s hard to see how much progress the US can make without a major focus on upgrading and rebuilding domestic capabilities. We featured a post yesterday on how manufacturing entrepreneurship has fallen in the US due to a loss of skills. For instance, as reader Scott 2 pointed out:

The best engineering in the world won’t help your startup unless you can find a skilled machine shop, and they are disappearing quickly as the machinists retire and their children stare into their phones. It doesn’t help that trades aren’t learned in high school (actually discouraged) and a nice 5 figure sum is needed to get the training to use a 5-axis milling machine for which a starting wage is $15/hour.

It’s also going to be hard to push China around all that much given our dependence on them for rare earths, which is expected to lessen but will still be significant. As we pointed out in 2010:

In fact, the while the article does discuss US versus foreign engineering expertise in rare earths mining, it describes in some detail how difficult rare earths mining is in general (more accurately, not the finding the materials part, but separating them out) and the considerable additional hurdles posed by doing it in a non-environmentally destructive manner. Thus the rub is not simply acquiring certain bits of technological know-how, but also breaking further ground in reducing environmental costs.

And this issue has frequently been mentioned in passing in accounts of why rare earth production moved to China in the first place. It’s nasty, and advanced economies weren’t keen to do the job. China was willing to take the environmental damage.

Fast forward to an article in The Diplomat in August 2017:

Called “the vitamins of modern society,” rare earth elements play a critical role in our daily life — in both the economic and security domains. These elements are key components of a vast array of products, including smart phones, computers, light bulbs, electric cars, wind turbines, satellites, cruise missiles, and stealth aircrafts. Some elements, like neodymium and dysprosium, are highly demanded for the production of permanent magnets, which are used for sensors and motors of these products. The most noteworthy fact is that the more we go green and technology-oriented, the more important these elements become to our society.

Today, China enjoys a monopoly in the rare earths market. It is estimated that in 2016, more than 80 percent of rare earth elements produced in the world were excavated in China. The country is also believed to hold more than 30 percent of the planet’s remaining rare earth element reserves. While many stopped paying attention to rare earths after the dispute settlement at the WTO, the market has been preparing for more potential turmoil. For instance, Australian companies have been working to open rare earth mines in Australia and Tanzania for producing elements such as neodymium and dysprosium. Likewise, Canada, through collaboration with the national government and industrial associations, seeks to gain up to 20 percent of global rare earth production by 2018.

Having said that, a shuttered US mine is set to repopen….with a Chinese company as part of the consortium.

Let’s put this more tersely: if the US were serious about reducing its trade deficit, with emphasis on advanced technologies, it would have launched an industrial strategy. Now you might say we don’t do that. But in fact we do, just very selectively. Military spending is one way we do industrial policy on the sly. Why do you think Google is the world’s spymaster? That was no accident.

If we want more buying of US chips, rather than try to shove them down China’s throat, we might get the armed services and military contractors to eat more of our own cooking, through minimum content rules that phased in over time. Similarly, we also rely on the Chinese to make military uniforms and boots. The optics and the dependence are poor. There should be a way to repatriate some of the production and distribute other parts to countries that aren’t geopolitical competitors, like South Korea, India, and Vietnam.

The Chinese may make a clever concession or two to lower trade tensions a bit, but don’t expect Trump to make much headway. Remember, he hasn’t made much progress towards getting his wall done, and that’s a vastly easier project.