Thursday, 2 August 2018

Can Donald Trump’s ‘bully diplomacy’ resolve real problems with China’s trade practices? by Ken Davies

This article appeared in the South China Morning Post on August 3rd, 2018:

It is not yet clear how the current trade dispute between the US and China will play out. It could develop into a full-scale trade war, or it might be resolved by negotiations which begin to address serious long-term problems in the relationship. The uncertainty stems in part from President Trump’s capriciousness, also from the heightened risk that every conflict produces.

By now Trump has begun to build up an initial track record of bully diplomacy, especially in the field of nuclear weapons proliferation. After threatening North Korea with “fire and fury”, Trump has brought Kim Jong-un to the negotiating table, and is now trying to use the same tactic on Iran. 

Economic disputes are receiving the same treatment. In the case of the European Union, Trump switched almost instantly from branding it as a “foe” in mid-July to announcing a deal with it less than two weeks later. As with North Korea, the details are still to be inked in, and could well involve a return in practice to Obama-era policies. In the case of the EU, this could mean a reopening of negotiations on the Transatlantic Trade and Investment Partnership (TTIP) – or the same thing under a different name.

Will this approach work with China? Bluster and hostile trade measures might eventually produce another superficial summit with hugs and handshakes, even a framework agreement to continue negotiations on trade-related issues. But, as currently implemented and conceived, they do not seem likely to lead to long-term changes that will benefit the US, China, and the world as a whole.

Trump’s characterization of the US’ trade relationship with other countries is based on ignorance and economic illiteracy which should be surprising in a Wharton graduate. His quack nostrums on trade flow from the mercantilism of English economists like Thomas Mun, whose books on the subject were published nearly four centuries ago. Mun, a successful merchant and a director of the East India Company, argued that England’s wealth would be increased by promoting exports and curbing imports to create a positive balance of trade. 

This fallacy was rebutted by the classical economists of the late 18thand early 19thcenturies, Adam Smith and David Ricardo. Smith showed that if countries specialized in what each did best, wealth would be greater all round. Ricardo developed this further into the theory of comparative advantage, which demonstrated that international specialization would benefit all countries even if some countries were better at producing everything. 

The fundamental misconception of mercantilism is that trade is a zero-sum game, which is based on the curious illusion that global output is fixed. The classical economists argued for free trade on the grounds that it would allow total output to grow more rapidly than it would if countries remained closed or pursued a beggar-thy-neighbor mercantilist strategy, so making everyone better off.

Trump’s characterization of the overall US-China economic relationship is also misconceived because it isolates one element, China’s surplus on merchandise trade with the US, from the other elements with which it is inextricably bound up. Those other elements add up to tremendous benefits for the US.

Since the reform program began in 1978, China has massively expanded its exports, including to the US. This has only been possible because of huge inflows of capital to the US from other countries, including China. China’s trading surplus resulted in the piling up of trillions of dollars in foreign exchange, the bulk of which is still held in the form of Chinese government holdings of US Treasuries, buttressing the US economy while providing a feeble return on investment. China’s corporate sector has also in recent years been investing large sums in US industry and real estate. 

So US consumers have been able to enjoy a higher living standard in the form of a plethora of low-priced goods of all kinds from China, while borrowing heavily from other countries, especially China. 

Many of those exports from China to the US are produced by US companies or their subsidiaries in China, with most of the value-added going back to the US. So China’s exports benefit the US in many ways and it is absurd to think of them as ways in which China is eating the US’s lunch.

The US does, though, have legitimate grounds for complaint about other elements of the economic relationship, more in the investment area than in trade. 

Limitations on US direct investment in China (and that of other countries) are harmful to both home and  host countries, in the same way as are restrictions on trade. China would benefit from the abolition of enterprise ownership caps in the automotive and other manufacturing sectors, just as it would gain from opening up the financial and other services sectors completely to foreign participation to enable them better to fulfill their role in supporting the wider economy.

Another major issue to be addressed is the persistent violation of intellectual property rights in China. According to the most recent update to the US IP Commission Report, China remains the “world’s principal IP infringer”, with China (excluding Hong Kong) accounting for over 87% of counterfeit goods seized coming into the US. The update also points out that China “continues to obtain American IP from US companies operating inside China” through means which include “coercive activities by the state designed to force outright IP transfer or give Chinese entities a better position from which to acquire or steal American IP.”

As I pointed out in three major reports on China’s investment policies which I wrote for the OECD, better enforcement of existing intellectual property rights protection by China’s legal system would be advantageous not only to foreign investors, but also to small and medium-size Chinese domestic enterprises struggling to protect their inventions and process innovations against state-owned enterprises. Combined with stricter enforcement of competition legislation, this would provide a more nurturing environment for private enterprise in China.

The US and China should move sooner rather than later from tariffry to summitry, and the Xi-Trump summit should end with more than handshakes and anodyne press conferences: there should be a firm commitment to work on major issues identified by both sides and produce results within a reasonable time frame. It is regrettable that resolution is not possible through dialogue within international institutions like the WTO and OECD, but right now we live in the Trumpian world, where the best we can hope for is constructive bilateralism.      

[Ken Davies is the former Chief Economist, Asia and Chief China Economist with the Economist Intelligence Unit (EIU) in Hong Kong and Senior Economist in the OECD’s Investment Division in Paris, where he worked with the Chinese government on improving China’s policies towards investment.]

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