It has been said that many of President Trump's complaints about China's trade practices are legitimate. The Europeans and the Japanese share many of the same complaints including still high barriers to trade, weak protection of intellectual property rights, and subsidies to firms, especially state-owned firms, that lead to unfair competition in the international market. It is true that China can do more to make its economic system simultaneously more efficient and fairer. At the same time, it is important to recognize that the United States (U.S.) and many other high-income countries can also undertake further policy changes to make the global trading system more efficient and fairer.
Before we go into the details, let me make it clear that this is not a piece about what is likely to happen in the short term, but what it should happen in the medium term.
Policy changes to be undertaken by China
Let us start with what China should do. First, both the tariff rates and non-tariff barriers are higher than those of the United States and other high-income countries. There are also many restrictions on foreign firms wishing to operate in China, including restrictions on maximum foreign ownership shares in financial service firms. While these barriers are no higher than most other developing countries at the comparable per capita income level, China can certainly do more to reduce these barriers. The reductions of these barriers will not only benefit foreign producers. Most importantly, they will benefit both Chinese households and Chinese firms that use imported parts and components. Greater liberalization of the trade regime is like a tax cut that raises income and improves efficiency without requiring the government to increase budget deficits. China's own experience with trade liberalization following its accession to the WTO 18 years ago shows that, as long as the Chinese labor market remains sufficiently flexible, it will not lead to a spike in unemployment.
Second, stronger protection of intellectual property rights is both beneficial and feasible. The Chinese government has said that it had abandoned the policy of mandatory technology transfer from foreign multinational firms nearly two decades ago, but the U.S. and European chambers of commerce in China say that there are many instances of actual practices that deviate from the declared policy. I see clear room for improvement on the Chinese side and the strong possibility of reaching an agreement between China and other countries. In the past, when Chinese domestic innovative capacity was weak, stronger IP protection merely meant more profits for foreign firms. Today, partly in response to rising domestic wages, Chinese firms have become more innovative and their foothold in the U.S. and other markets has become more extensive, and therefore stronger and reciprocal IP protection will benefit Chinese firms as much as firms from other countries.
Third, the Chinese subsidy programs and industrial policy regime can benefit from some major reforms. It is useful to distinguish between policies that are meant to address externalities and other market failures and policies that create distortions and inefficiencies. Most countries have some tax and subsidy programs that favor certain economic activities over others. The first U.S. Secretary of Treasury, Alexander Hamilton, a graduate of what is now called Columbia University, practically invented the concept of industrial policy more than two hundred and thirty years ago. The United States, Europe, and Japan even today have extensive industrial policy programs, whether or not they are called by this name. Still, in my observation, the proportion of government programs that create distortions and inefficiency is higher in China than in high-income countries. In any case, the existence of inefficient subsides in other countries is not a valid reason to pursue the same kinds of inefficient programs. Chinese subsidy programs tend to systematically favor state-owned firms relative to private sector firms, resulting in resource misallocation. Government programs should be subject to both increased and systematic cost-and-benefit analysis. Reducing and eliminating inefficient programs in the end will create a more leveled playing field not only between foreign and domestic firms, but more importantly, also between domestic private sector firms and state-owned firms. By making better use of tax-payer funded resources, such reforms will boost China's growth potential and bring forward the date when China will achieve a high-income per capita status.
Fourth, the current WTO rules do not impose enough restraints on member governments to effectively deter market distorting subsidies, especially for state -owned firms. This requires reforms of the WTO rules, in addition to policy changes by China.
Policy changes to be undertaken by the United States and other countries
The U.S. and other industrial countries also need to pursue policy reforms. First, the U.S. trade barriers on Chinese goods are not as low as what many Americans think. The U.S. tariff rates on many textile and garment products, of which China has been the world's most efficient producer over the last two decades, are in the 20% range--much higher than the average U.S. tariffs across all products. The anti-dumping regime is considered by many trade economists as inefficient and in practice often an instrument of trade protection. Chinese exporters bear the brunt of very high anti-dumping tariffs that result from dumping criteria that are biased against Chinese producers. In other words, the seemingly low U.S. average tariff rate is a misleading understatement of the actual U.S. tariff rates applied to Chinese products.
Second, the U.S. free trade agreements have artificially tilted U.S. demand away from the more efficient Chinese producers to less cost-effective firms in Mexico and other countries. The free trade agreements, despite the word "free" in the name, are often discriminatory in nature, creating an uneven playing field between producers inside and outside a free trade area. This can result in global resource misallocation favoring less efficient firms inside a free trade area at the expense of more efficient firms outside it. It is unfair to workers outside an FTA and often simultaneously unfair to low-income households inside the FTA zone. The current WTO rules do not provide sufficient deterrents against pursuing discriminatory policies dressed up as free trade agreements.
Third, while the U.S. is very proud of its legal and regulatory regimes being fair, predictable, and transparent, its regime governing foreign investment is not considered fair, predictable, or transparent. The criteria for labeling an investment deal in the U.S. as affecting national security appear to be low and discretionary. Because the U.S. national security screening process creates extra uncertainty for deals involving Chinese investors with respect to the time it takes to complete the screening and the ultimate outcome, U.S. lawyers advising cross-border mergers and acquisitions told me that Chinese firms often have to pay an extra 15% in order for potential target firms in the U.S. to be willing to consider a bid from Chinese firms. In other words, the U.S. foreign investment regime effectively expropriates a portion of the capital of Chinese firms wishing to invest in the United States.
Most statements about market access and investment regimes in the United States apply equally to Europe and other industrialized countries. Because the de facto trade barriers on Chinese products hurt low income families in these countries more than high-income households, they contribute to a worsening of income distribution in these countries.
A grand bargain
Inefficient and unfair policies do not exist out of stupidity, but are there because they benefit powerful or well-organized special interest groups. This means policy changes in both China and the United States will meet resistance. Nonetheless, most of these policies are unfair to most citizens as well as wasteful. China, the United States, and other countries can reach a grand bargain on a package of policy changes that each side can undertake. This will help each government to better overcome domestic resistance to reforms.
There can also be a negotiated grand bargain on WTO reforms—changes of rules to restrict member countries' abilities to abuse the anti-dumping measures, to reintroduce discriminatory policies through free trade agreements, to use government subsidies to create unfair competition in the international markets, and to use opaque practices of state-owned firms to bypass WTO rules.
The Chinese government has recently declared its intention to pursue further reductions in trade barriers and further easing of restrictions on foreign firms operating in China including relaxation of ownership restrictions. It is important to translate these policy plans to policy actions on the ground. China, the United States, and other countries can undertake a package of policy reforms that will help the global trading system to be fairer and more efficient. This will not only help to ease cross-border trade and investment tensions, but will also help to achieve a fairer income distribution at home.
These reforms should be done regardless of who the U.S. and Chinese presidents are. But the rhetoric of a trade war and the risk of a collapse of the world trading system have heightened public awareness of the problems and perhaps even increased the willingness to do something. Let us make the best use of this trade war.