Trade deal China-US: Phase One, Phase None

17 January 2020 17:30 RaboResearch

The Phase 1 trade deal signed by the US and China in January 2020 has created a temporary but unstable equilibrium. The deal could still collapse and a re-acceleration of trade tensions in 2020 remains our base scenario.

Trade war concept USA versus China Eagle and Dragon on gray background

Deal with it!

So here it is: the long-awaited Phase I deal between the US and China. After the start of the bilateral trade war back in 2018, there have been on and off negotiations between both sides – not leading to a concrete outcome, at least not a (part of a) deal. So almost one and a half years of trade talks have now finally led to an 85-page document. Below we give some of the highlights of this agreement and then we ask ourselves what we should make of it.

A few ‘highlights’

IP and forced technology transfer

The first chapter deals with the protection of intellectual property (IP), which includes topics such as geographical indications (GI), patents, trademarks and the prevention of the trade in and production and export of counterfeit goods. There is also agreement on cooperation and enforcement of fines etc. China will promulgate an Action Plan to strengthen IP protections within 30 days of the signing of this agreement. But what really stands out from this chapter is that i) the US affirms that it is already compliant with these obligations (in contrast to China) and ii) that this chapter lacks concrete indicators and goals to measure and assess compliance. To some extent these comments do also apply to the second chapter of the agreement where it is basically acknowledged that the transfer of technology between natural or legal persons when operating in the jurisdiction of the other country should take place on a voluntary basis and on market-based terms. Administrative and licensing requirements and processes, as well as their enforcement, should be fair and transparent. But this chapter clearly lacks a lot of detail, which suggests there is a clear risk of non-commitment.

Trade in food and agricultural goods

The third chapter on the trade in food and agricultural products is almost the opposite and carries many ‘technical’ annexes where cooperation, alignment and acceptance of (sanitary and phytosanitary) regulations are described. Parties recognize the importance of their agriculture sectors and there are many references to the ‘ever growing market’ for such goods in China. As such this chapter is clearly intended to support the agreements made in chapter 6, where China commits itself to the additional purchase of agricultural goods over the next several years; there is very little on the opposite side of the trade, except for the opening up of the US market for certain goods, such as Chinese ‘fragrant pear’.

Opening up financial services, no (more) currency manipulation?

In its core Chapter 4 outlines obligations that should ensure participation and access within the market for financial services. Both participation and access should be based on effective and non-discriminatory policies. ‘Effective’ mainly refers to previous practices that significantly hampered an expeditious process for handling requests in order to obtain the proper licenses to be allowed to provide financial services. The phase-1 deal provides specific time frames that China should comply with in the case of both new as well as existing/pending requests for, amongst others, payment services. The phase-1 deal should also ensure that in case of insurance services ‘overly burdensome licensing and operating requirements, business scope limits and discriminatory regulatory processes and requirements’ are abandoned no later than the first of April 2020. In general the chapter financial services puts a lot of emphases on the ability to wholly own an entity that is active in the financial services sector in China.

Especially interesting is the fact that US financial services will gain access to the market for non-performing loans. Chinese (state owned) enterprises have increasingly be ‘allowed’ to go bankrupt although the decision to let enterprises go bankrupt or not still seems to be a rather arbitrary process. Also, the credit-driven growth that has characterized the Chinese economy in recent years has elevated credit risks and the domestic crackdown on the shadow banking sector in general has raised domestic funding needs. So, in a sense, this chapter also contains something for China. Finally, the allowance of fully US owned Credit Rating Services to rate bonds sold to both domestic as well as international investors. This seems to imply that Credit Rating Services should gain full access to financial data of all types of (state owned) enterprises that have issued or want to issue marketable assets.

Chapter 5 is a relatively small chapter and hardly provides anything new regarding monetary and/or currency related topics. Article 5.4. (the enforcement mechanism), however, provides some interesting details. In general, non-compliance to any of the articles of the phase-1 agreement could lead to the termination of the complete agreement. However the enforcement mechanism mentions that when the Bilateral Evaluation and Dispute Resolution Arrangement fails to “arrive at a mutually satisfactory resolution”, both parties may request that the IMF undertakes rigorous surveillance or initiate formal consultation. Aside from ourselves being sceptical of seeing the IMF strong-arm either the US or China into complying with this part of the agreement, one can question the value of article 5.4.2 if failing to reach a mutually satisfactory resolution could lead to the determination of the whole agreement (including article 5.4.2) altogether.

Show me the money!

On top of these pledges by China to respect intellectual property rights, open its financial services sector to the US, and refrain from currency manipulation, it has agreed to buy more US goods and services. According to Chapter 6 of the document, China shall ensure the purchase of an additional – on top of the 2017 baseline – $200bn worth of US goods and services over a two year period, from 1 January 2020 through 31 December 2021. This package consists of $77.7 bn in manufactured goods, $32.0 bn in agricultural products, $52.4 bn in energy, and $37.9 bn in services (see Annex 6.1 of the document).

In exchange for these Chinese concessions, the US did not carry out its plan for additional tariffs on the remaining Chinese goods that have not been subject to tariffs (on 15 December 2019), and will halve the 15% tariffs on $120 bn of Chinese consumer goods (such as cell phones, toys and laptops) implemented on 1 September 2019. However, the earlier 25% tariffs on $360bn of Chinese industrial goods and components remain in place. Moreover, the US Treasury department decided recently to no longer call China a currency manipulator.

What to make of this deal?

First let’s look at what is in the deal, and second at what is not. In our view, any assessment should answer the following three questions:

  1. How realistic are these commitments?
  2. What are the implications?
  3. And how will the compliance to these agreements be monitored, enforced and, if necessary, corrected?

One high-level observation is that the agreement foresees the total amount of goods and services exports from the US to China to reach above USD 325bn by end-2021. The implication of this is that the chart for US exports to China should basically look like in figure 1 for the next two years.

Figure 1: US goods and services exports to China: realistic?

Source: Macrobond, Census

There are probably very few economists that would deem such a trajectory feasible, seeing that it took the US more than 15 years to raise exports from around USD 21bn in 2000 to USD 187bn in 2017. Moreover, the Chinese purchases of goods are beneficial to US companies, but at the cost of other countries, and the agreement is only for two years. If China will buy more aircraft from the US, will that be to the detriment of the EU?

According to the document “the parties project that the trajectory of increases … will continue in calendar years 2020 through 2025.” Well, ‘to project’ does not sound as firm as ‘shall ensure.’ So are we going to see a repetition of the 2019 turmoil caused by the phase 1 trade negotiations after those two years? Or is this supposed to be solved in the phase 2 deal that is very unlikely to be made? What’s more, while the remaining tariffs provide leverage for US trade negotiators, they are still a tax on US importers and US consumers of Chinese goods.

And what is not in the deal?

What is not in the deal is a credible implementation of China respecting US intellectual property rights. Keep in mind, they made promises before. Of course, the document (Chapter 1) is full of pledges. However, the most concrete step is that China will within 30 working days make an Action Plan to strengthen intellectual property protection (Article 1.35). What is also lacking from the deal is the end of China subsidizing its state owned enterprises. So on one key trade issue, China has made promises again and on the other it did not even have to.

Monitoring and enforcement remain key

A trade agreement is ‘strong’ and committal when it describes clear goals, monitoring indicators and measures to enforce compliance to agreements. Apart from the hard numbers, such as the USD 200bn, there is very little of this in the agreement. What if by mid-2020 (which is not that far away!), US exports to China have not increased materially? Does that imply non-compliance by China, or should we then see reinvigorated actions on both sides to close the gap?

In terms of overall enforcement of the deal, Chapter 7 describes the creation of a Trade Framework Group to discuss the implementation of the trade agreement every six months, which shall be led by the US Trade Representative and a designated Vice Premier of China. Each party shall establish a Bilateral Evaluation and Dispute Resolution Office, headed by the USTR (US) and the Vice Premier (China). If one party believes that the other party is not sticking to the agreement, the complaining party may submit an appeal to the Bilateral Evaluation and Dispute Resolution Office of the other party. The dispute procedures are actually a highway to the exit: “if the party complained against considers that the action of the complaining party was taken in bad faith, the remedy is to withdraw from this agreement by providing written notice of withdrawal to the complaining party.” So, if one party is not satisfied with the implementation of one aspect of the deal, and the other thinks it is a deliberately false accusation, the whole deal collapses.

A fragile truce

So while the Phase 1 deal is a temporary equilibrium, it is an unstable one. After all the turmoil we have been through last year, this deal has failed to address the key conflicts between the US and China. Basically, the Chinese are going to buy more stuff from the US, but only in the next two years, in exchange for lower tariffs. Hence, we don’t regard it as a big, beautiful monster. It is unrealistic to assume that China will fully cooperate on all the aforementioned topics, as they would need to make these kinds of changes under (US) pressure with regard to their own economic model and sovereignty.

The remaining question is whether this deal will prove sustainable going forward, especially if one takes into account the outcomes after previous rounds of negotiations. Part of the deal is related to postponement of looming tariffs and China also would like to see imposed tariffs to be reversed. In China’s view, negotiations can only lead to a successful outcome if they are conducted on an equal footing. The US, however, have already stated that they are not planning to roll back any tariffs before the November elections. Indeed, a further unwind of previously installed tariffs will hinge on a successful outcome of ‘Phase 2’ negotiations, for which neither a plan nor a time line exists at the moment. And bear in mind that the main reason for the US to up the ante in terms of higher tariffs in August 2019 was dissatisfaction about the way China had lived up to the agreements made during the June G20 summit.

Whilst the new ‘Bilateral Evaluation and Dispute Resolution Arrangement’ could now be a first stop (and thus make the process more technocratic), the agreement leaves room for an escalation to the highest level, as Chapter 7 (Art. 7.4.5) stipulates that “[…] if either the United States Trade Representative or the designated Vice Premier of the People’s Republic of China considers that an implementation issue is a matter of urgency, either one may raise the matter directly at a meeting between them without prior discussions at lower level meetings. If such a meeting cannot be timely scheduled for this purpose, the Complaining Party may resort to taking action as provided in subparagraph 4(b).” The latter article allows for proportionate remedial action (let’s call it a hike in tariffs) or withdrawal from the agreement. Which would bring us back to square 1.

In the next section we take a closer look at the damage that already has been caused by the trade war and how we think the trade war will evolve in the future.

The damage done

The developments since the start of the trade war underline our view that the trade war is a lengthy conflict on various fronts (see for instance here and here). Despite this Phase I deal, there have been economic losses as a result of the escalation over time. To assess the magnitude of these losses, however, is difficult as these effects are difficult to isolate and surrounded by much uncertainty. Nevertheless it is possible to gauge the impact based on our scenario study that we conducted late 2018. We have differentiated between two scenarios here: one in which 250 billion of China's exports are levied by the US at 25% and the Chinese raise tariffs of 25% on 110 billion of American exports to China. We also looked at a full escalation scenario in which all bilateral exports are subject to 25% higher import taxes on both sides (among some other key assumptions, such as a weakening of the CNY). We would argue that we are now roughly in between those the two scenarios (Figure 2).

Figure 2: Trade war timeline

Source: Rabobank, US Census

We estimate that since the start of the trade war the Chinese economy has suffered approximately 50bn USD of damage compared to a situation without a trade war. For the US, the negative impact is roughly 40bn USD. These effects are limited given the size of both economic behemoths. These figures imply that for 2018 and 2019 taken together the economic damage boils down to 0.25 percentage points of lower economic growth in both economies.

Economic impact under a lingering or escalating trade war

Our base case remains that tensions will re-emerge and the US and China will head towards full escalation later this year. US and China are not expected to solve a number of more structural problems next to their trade imbalances, such as infringement of intellectual property rights (IPR), substantial government subsidies to Chinese state-owned enterprises (SOEs) and forced technology transfer of foreign companies that want to do business in China.

Despite the signing of this Phase 1 deal, it remains to be seen whether China will live up to these agreements. In any case, we are a lot more pessimistic than the financial markets seem to be at the moment.

If the trade war continues to linger or escalates, the economic damage would be much more substantial than the losses that both China and the US have faced until now. The pressure gradually builds as tariffs feed into the economic system and it takes times before the negative impact fully materializes (Figure 3).

Figure 3: Economic losses increase over time

Source: Macrobond, Rabobank

Tariffs need to pass-through to higher retail and business-to-business prices, resulting in a shift of consumer and producer (in case of intermediates) preferences and subsequently declining market shares, and finally lower exports, investment and private consumption. The adverse productivity effects of a trade war also become visible only after a certain period of time.

China as an emerging economy will especially face fewer opportunities to benefit from so-called foreign knowledge spillovers, for which trade and foreign direct investment are important conduits. Finally, lingering uncertainty caused by higher tariffs will erode investor appetite and speed up offshoring plan of foreign manufacturers active in China. In the event of a complete escalation, we expect the economic losses will be greater for China than for the US. Under our scenario of full escalation, China could even lose out on cumulatively 5 percentage points of economic growth in the long run (Figures 4 and 5).

Figure 4: China misses out on 5% of GDP growth in case of full escalation…

Source: Macrobond, Rabobank

Figure 5: ...whereas the US has other problems to worry about (i.e. a 2020 recession)

Source: Macrobond, Rabobank

Impact on third countries

Next to the bilateral spat, one should bear in mind that third countries such as EU economies are also indirectly affected by the trade war as lower global trade activity and economic growth dampens market opportunities. This effect dominates positive export substitution effects due to improved price competitiveness. Exporters may be caught up in the supply chain between the US and China and face price increases on their intermediates. Take, for instance, a supplier active in the semiconductor industry that ships its intermediates to China. Consumers in third countries will also feel the impact of disrupted supply chains: think of more expensive electronic products, such as laptops and computers that use more expensive Chinese intermediates and are shipped from the US to European shores. Our calculations show that the Netherlands, as an open economy with relatively strong trade relations with the US, has currently already faced economic losses of 1.8bn USD compared to a situation of no trade war. This could even rise to 6.5bn USD by 2021 if our expectations are correct that the Americans and Chinese will eventually fail to reach an overarching deal and the conflict will escalate again later this year.