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Phase two of US-China trade deal will be more challenging and less transparent than phase one

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With the phase-one trade deal between the U.S. and China about to be signed, a key threat hanging over the global economy has diminished. After 18 months of wrangling about Chinese purchases of U.S. goods and opening of its markets, investors are hopeful that the current pause in the trade war will be maintained.

But many trade experts are wary. One reason is that disputes inevitably will arise over specific features of the agreement, the most notable being the volume of Chinese purchases of U.S. farm goods. If so, enforcement mechanisms call for the two sides to settle them during subsequent rounds of talks. But if that doesn’t work, U.S. Trade Representative Robert Lighthizer has indicated the U.S. could re-impose duties on China.  

A second reason is that the easiest part of the trade dispute is now past. The hard part is about to begin that will cover long-standing issues relating to intellectual property violations and forced technology transfer by China, as well as subsidization of Chinese industries.

The tactics the U.S. government pursues to prod China on these issues will entail less reliance on tariffs, which have been a hallmark of the trade conflict thus far.  Over the past two years the U.S. government has been laying a legal and regulatory foundation for the next phase.

In 2018 Congress enacted legislation to enhance controls on the export of new technologies, such as advanced robotics and artificial intelligence, as well as bolstering reviews of foreign investment in the U.S. More recently, the White House and Congress took steps to block U.S. companies from using Chinese telecom equipment in the U.S., with Huawei being the highest profile case.

Meanwhile, the Trump administration has discovered there are diminishing returns to relying on tariffs as a prod. As the trade conflict broadened this past year to cover virtually all imports from China, the administration’s original plan of applying duties to producer goods rather than consumer goods fell by the wayside. This concerned U.S. trade negotiators, who worried it could produce a backlash by U.S. households. Ultimately, the round of tariff hikes set for December was cancelled as a quid pro quo for China stepping up purchases of farm goods. 

Another discovery is that the longer tariffs are in place, the more time businesses have to alter supply chains. One of the most visible examples has been the relocation of production facilities from China to other Asian economies. For example, U.S. imports from Vietnam have increased by 34 percent in the last 12 months, while the bilateral trade deficit with it has risen. Even then, the U.S. bilateral trade imbalance with China has increased over the past two years.

Looking ahead, the most difficult issue to resolve relates to Chinese government subsidies of state-controlled businesses. When China entered the World Trade Organization at the end of 2001, the U.S. government was hopeful China’s economy would become more market-oriented. In the meantime, however, two developments have stood in the way.

The first was the 2008 global financial crisis, which caused China’s leaders to question the desirability of following the model of western economies. The other was the emergence of Xi Jinping as China’s leader in 2012. He has been active in reinstating the state’s role in the economy even though it is less efficient than the private sector. 

It remains to be seen whether China will make concessions about subsidization of state-controlled businesses. But the most likely outcome is that they will be very limited. As Robert Lighthizer has acknowledged, “Whether the whole agreement works is going to be determined by who is making decisions in China, not the United States.” He indicated that the U.S. is hoping reformers rather than hard-liners will call the shots.

Investors, therefore, must be prepared for the possibility that an impasse will be reached; if so, they will have to determine how markets will react. 

My take is that President Trump will not respond as he did in late 2018 and this past summer by escalating the trade war. Such a response would risk undermining the phase one agreement at a time when U.S. elections are approaching.

Consequently, a more measured response is likely — one that will not cause financial markets to erupt. This is possible because it is difficult to monitor the effect of non-tariff measures: President Trump can merely assert whether progress is being achieved without markets knowing what is happening behind the scenes.

The pending agreement over USMCA offers insights about what may be in store.  Namely, after considerable sound and fury about the shortcomings of NAFTA, Congress and the White House are about to sign a bill that some have called NAFTA 2.0. I believe the struggle between the U.S. and China over the past 18 months makes it more likely that forthcoming changes in trade will entail inevitable compromises, as well.

Nicholas Sargen is an economic consultant and a lecturer at the University of Virginia Darden School of Business. He is the author of “Investing in the Trump Era: How Economic Policies Impact Financial Markets.”

Tags China Donald Trump Foreign trade of the United States Huawei International trade North American Free Trade Agreement Robert Lighthizer Robert Lighthizer tariffs Trade War United States–Mexico–Canada Agreement USMCA WTO Xi Jinping

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