Understanding the US-China Trade Disconnect

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Understanding the US-China Trade Disconnect

Without evidence that its basic economic system will fail, talks will not force China to change its development path.

Understanding the US-China Trade Disconnect
Credit: Official White House Photo

Heading into May, global markets were on the rise amid optimism for an imminent trade deal between the world’s two largest economies. Throughout the spring and into that first week of May, U.S. negotiators reported continued progress on key national security issues and trade laws to reduce intellectual property theft. China appeared willing to substantially increase its imports of U.S. goods, narrow the mounting bilateral trade imbalance, open its markets to U.S. financial services, and reduce its overseas “dumping” of artificially low-cost, subsidized goods.

In China, too, expectations ran high. In early April, the state-run Xinhua news service reported that the eighth round of talks had achieved new progress in matters pertaining to technology transfer, agriculture, and enforcement. Yet barely a month later, negotiations sputtered and then stalled altogether. U.S. President Donald Trump slapped additional tariffs on Chinese imports, China retaliated with tariffs of its own, and pressure on both sides escalated. “China has always been reluctant to fight but is not afraid to fight,” noted a Xinhua commentary, “and will fight when necessary.”

Now the United States and China have agreed to reopen trade talks. To avoid another failure, here is what both sides need to understand about the collapse of the last round.

If a deal is to be struck, it will require a greater understanding of what types of provisions key constituencies in China are willing accept, and which issues Chinese leadership views as foundational to core economic philosophies that they are not willing to abandon.

Some U.S. analysts have blamed the collapse on U.S. hardliners fretting about Chinese hegemony rather than trade; others on a “greedy” China, which they claim returned a draft of the agreement that undid the commitments it had agreed to. On the Chinese side, there were allegations that the Trump administration’s claims were “untruthful and deliberately confusing,” and that the United States continued to add new demands, including the implementation of immediate market reforms.

What is clear is that both sides were overly confident. Both understood the other’s behaviors and messages through the prism of their own political cultures. This led each side to overestimate its leverage and, at the end, to accuse the other side of reneging.

The Chinese have a saying that there is “no triviality in diplomacy;” that any issue, no matter how small, matters greatly if it concerns a foreign government. Its government’s economic and political linkages are such that all decisions must accord with the incentives of senior political leaders. Even with a powerful leader at the helm, the Politburo and Council of Ministers, along with the Central Committee (the governing body of the Communist Party), must consent or a deal is meaningless. Moreover, all major decision-making powers are vested in the hands of provincial or regional party secretaries.

From the composition of the Chinese delegation, it should have been evident that China is ready to address issues at the interface, or technical, level such as trade, finance, market access, and IP protection, but is not prepared to do a deep dive into structural reforms or enforcement mechanisms that require a much broader degree of buy-in.

China’s Ministry of Commerce (MOFCOM) was prominent in the trade delegation. The lead negotiator, Vice Premier Liu He, received most of the spotlight, but his responsibility is limited to commerce, finance, and technology. Not present was Vice Premier Han Zheng, who supervises the National Development and Reform Commission (NDRC), which tends to structural questions such a subsidies or industrial planning. The State-owned Assets Supervision and Administration Commission of the State Council (SASAC) reports to State Councilor Wang Yong. A powerful defender of the state enterprise system. it was not represented in the meetings.

The U.S. side was deaf to what exactly the Chinese have been touting about their changing role in the world. The word “big” has become commonplace in Chinese government proclamations, with “big nation diplomacy,” for example, and “big ambition Belt and Road.” Even more ubiquitous is President Xi Jinping’s most-used slogan: “never forget your true heart.” Its implication is that the Communist Party is saving people from the corrupting influence of capitalist and materialist pursuits, and focusing instead on building a socialist market economy with full legitimacy in the global community.

This schism over structural reforms looms behind the trade negotiations and the technical details of tariffs and quotas. It lies at the heart of Xi’s resolve that China’s development path and economic system have evolved and taken root together; that each contributes to the success of the other. Moreover, through its economic order, China seeks to offer development solutions to other emerging economies and a “common destiny” for the world. As such, China has shown that it is prepared to lose money on overseas investments as it builds alliances and trade partnerships worldwide and positions itself as a rival to the U.S. system of liberal internationalist order.

Thus, if a deal is to be hammered out, it’s important not to underestimate that in a profound philosophical sense, many Chinese, like Tsinghua University economist Hu Angang, believe that their socialist market economy will outperform any free-market economy based solely on individualism.

The U.S. system, they argue, encourages individuals to act according to the lowest aspects of human nature, not to its “better angels.” Nor do they believe it works well in the early stages of development. Self-serving individuals may outperform altruistic ones within a cohesive group, but in the long run, when there is conflict between groups, collectivists will defeat selfish individuals. The socialist model, they maintain, offers a viable alternative trajectory with superior poverty-eradicating efficiency at the early stages of economic growth.

They also believe that Trump’s push to curb China’s state-owned enterprises will subvert these very qualities that make the socialist market economy unifying and propitious for the future. Xinhua has gone further, saying that U.S. demands on China’s state-owned industries would violate sovereignty and constitute an “invasion.” The U.S. side rejects such concerns as delay tactics. This does not bode well.

Under Xi, China’s system of public administration has been overhauled to instill socialist values into managerial personnel at all levels, recognizing that understanding and cooperation at the lower levels will foster implementation and enforcement. Thus, contrary to many people’s understanding of old-school communism, management of China’s economy is the task of the entire populace in a mass mobilization. It is not unlike the nationwide economic wartime efforts among U.S. civilians during World War II, and is encouraged at all levels of the political hierarchy. Those lower in the system must feel that their interests, ideals, and values are part of the national fabric. A trade deal that lacks appeal to the various constituencies that must carry it out will be obstructed.

Although a deal that would meet this higher bar has yet to be mapped out, there remains much about which both parties can agree. What is salvageable? Is it still possible to pursue a deal that keeps the goodwill alive even as the West concedes that China’s rise is not without some costs to its partners?

Deng Xiaoping, the Communist Party leader most strongly connected with China’s market opening, depicted the relationship with the United States as going nowhere good or nowhere bad, neither honeymoon nor hostility. There will be unhappy encounters, he warned, but divorce is impossible. Deng’s message of restraint, which has many admirers, might mean a deal is still possible — but only if the U.S. side avoids overplaying its own hand and doesn’t miscalculate the way decisions are actually made in China.

China has already revised its foreign investment law, opened more sectors to direct foreign investment, allowed foreign financial services to operate more freely, and introduced a specialized IP court. It has expressed its willingness to buy more U.S. goods, such as agricultural produce and natural gas. The hundred-day action plan agreed to by the two presidents at Mar-a-Lago in April 2017 was implemented to the satisfaction of both sides. But China will not stop its efforts to accelerate the development of homegrown core technologies via subsidies and supportive policies. This is nonnegotiable.

Liu He cites the absence of mutual respect as the chief reason for the breakdown of talks in May. Should he take home a deal dictated to him by the United States, he would be denounced as the man who sold his country, as was the discredited Li Hongzhang. In 1901, Li signed what’s known in the West as the Boxer Protocol — one of the so-called “Unequal Treaties” foisted by on East Asia — capitulating to 11 Western powers and embodying China’s “century of humiliation.”

The most persuasive argument for a trade deal does not reside in the boasts of one side or another, but in a shared confidence that there are plenty of mutual benefits to China’s long-term development. Reduction of the trade imbalance ensures a sustained export market; IP protection contributes to China’s innovation drive; treating foreign firms as national firms can restrain the monopoly of state-own firms and bring about efficiency that reduces debt level; and the rule of law helps social stability and enhances China’s international credibility.

In short, an agreement that Xi can be present as a welcome move toward deepening China’s own economic reforms would give him greater leverage and stand a chance of being accepted at all the levels of Chinese society that are necessary to its success.

With respect to the rule of law and IP protection, both sides agree in concept that such legislation is needed, but that China lacks the requisite legal and judicial institutional capacity. This is why China keeps requesting that both parties recognize the “differences in national development and in stages of development.” Thus an agreement on protecting intellectual rights must include joint training programs to promote more common understanding among national legal specialists. But again, China cannot accept any deal that does not recognize the legitimacy of its aspirations to achieve economic parity with the United States via whatever mechanisms it prefers, including state-owned enterprises.

The United States must educate itself on why, historically, the Chinese state has led its economy, and why China may be heading into what Xi is calling a new “long march” toward a self-reliance that reinforces the people’s allegiance to their Party leadership and government. For the Chinese, this means pride in their Confucian tradition and the harmony it finds with socialist core values. Their acceptance of hardship and willingness to obey authorities go well beyond the imagination of most Americans.

The Chinese, by solid consensus, agree their current economic structure can propel them to greater global economic stature, and that their state-owned enterprises, even more than the private sector, are responsible for a competitive economy. The risks of a global technology war only strengthen their resolve. China will not alter its fundamental development path until there is conclusive economic evidence to prove that its model is destined for failure. In the meantime, they view U.S. criticisms as doctrinal and without basis. A financial meltdown or massive bankruptcy of some initiative would be far more effective at bringing about change than the dictates of an alien economic dogma.

Only time and evidence, not the prescriptions of a foreign ideology, will tell which economic model is best suited to China’s interests. For now, the United States must understand that it has only two options. Since both sides have assets the other lacks — China has manufacturing capacity and a large user and customer base; the United States leads in innovation and research — neither can definitively win from unending economic warfare. The best outcome for both sides is to pursue a deal within the realm of what is feasible and to transform vague promises into verifiable agreements with language and mechanisms that make it enforceable.

Liu Baocheng is a Professor at the University of International Business and Economics, Beijing and Hilton L. Root is a Professor at George Mason University, Virginia, a former U.S. Treasury Department Official and Senior Fellow at Mercatus.