US-China trade deal: Understanding the Phase 1 Agreement

• China made the bulk of commitments in the trade agreement
• Tariffs and other US-imposed measures were largely left untouched
• Phase Two may address industrial policy, state-owned enterprises and subsidies

United States President Donald Trump remarked during his speech at the World Economic Forum Annual Meeting, in Davos, Switzerland that “America is winning like never before”, siting as example the trade agreement with the US, which China signed on 15 January 2020.

As trade agreements go, this one appeared remarkably one-sided with China making the bulk of the commitments. The agreement has 96 pages, 8 chapters, 67 articles and numerous annexes that provide more details. It contains a total of 105 commitments by China (“China shall”), compared to 88 joint commitments (“Parties shall”) and five commitments by the United States (“the United States shall”). In most clauses, the United States simply “affirms” that its existing policies already meet the requirements of the article in the agreement.

Why did China sign?

First, the agreement commits China to a number of steps that solidify its ongoing reforms in intellectual property (IP) protection, technology transfer and the financial sector. The reforms committed are already in place, but tying these to an agreement with the United States can reinforce the impact of reforms. This will further improve China’s business environment, make it a more attractive place to invest in new technologies, and over time, improve the efficiency of investments made by a more diverse financial sector.

Second, the agreement may lead to some calm and lower policy uncertainty, which could boost China’s growth at a time when the domestic reform agenda may slow it down. Indeed the International Monetary Fund, in its World Economic Outlook Update, upped its growth projection for China by 0.2 percentage point for 2020, largely because of the reduction in uncertainty that the trade agreement brought.

Calm is not a given, however. The agreement itself provides for further negotiations and President Trump seems keen to start negotiating Phase 2 right away. The Trump administration is also turning its attention to others, including the European Union and the United Kingdom, so calm on the broader trade front may remain elusive.

A third explanation for China’s willingness to sign this Agreement is that in the past two years of trade tussle, China has come to realise that the ultimate aim of the United States is decoupling, containing and slowing down China. The trade dispute has revealed China’s dependence on the United States for key foundational technologies and its need for more time to prepare for an unavoidable confrontation down the road. Thus, the agreement was signed to buy time.

Irrespective of which explanation holds true, the seeming unbalanced nature of the agreement is striking. The concessions to China do not match the commitments that China has made in terms of structural reforms. 

For one, the agreement leaves largely in place the tariffs imposed thus far. Only the 15% tariffs on China’s $150 billion export imposed in September 2019 was reduced to 7.5%, a rather meagre step back towards normal. In addition, the tariffs on another $180 billion of imports from China, which had been announced for mid-December 2019, were postponed. 

The agreement also leaves untouched other measures that the United States have recently imposed on China. These include: (1) the “entities list” on which Huawei and some 28 other companies have been placed in the course of the trade dispute; (2) the sharper Committee on Foreign Investment in the United States rules aimed at further reducing China’s foreign direct investment in the United States; and (3) the export restrictions for national security reasons that Chinese companies increasingly face.

A modest win for China is the removal of China from the US Treasury List of Currency Manipulators. The US Treasury had put China on that list last August, a move that surprised many, as China had long given up on its policy of intervention to keep the currency weak. Instead, since the onset of the trade war with the United States, China had been intervening to strengthen its currency. Whatever may have been the case, the designation as currency manipulator did not mean much when it happened, neither does the abolition of this designation.

The consequences of managed trade

China agreed to increase purchases from the United States by $200 billion in the coming two years. Oddly, this is not a number to be added to China’s overall imports of about $2.2 trillion in 2017 – the “baseline year” – nor is the $200 billion in addition to China’s total 2017 imports from the United States of $180 billion. The increased imports are for a subset of goods and services imported from the United States, amounting to some $130 billion in 2017. This narrow definition of what import counts makes it harder for China to meet the targets, but probably reflects lobbying by special interest groups within the United States than anything else.

China’s import commitment will affect the exports of other countries to China. Specifically, countries such as Brazil, Russia, Canada and Australia are likely to lose out on their commodities exports. In manufacturing, Europe, Japan and Korea stand to lose. EU Trade Commissioner Phil Rogan expressed his concern on the agreement and the consequences for the EU’s exports to China.  Moreover, Europe and others will continue to face additional pressures from China’s exports, which were redirected to their markets because of the tariffs on China’s exports to the United States.

The purchasing agreement transgresses against the World Trade Organisation’s (WTO) most basic rule of “Most Favourite Nation” (MFN). MFN means that members should treat all other members at the most favourable terms granted to any. Exceptions can be made for a free trade agreement between countries if such agreement is broad-based, i.e. comprising most of the trade in goods and services. In addition, Voluntary Import Expansion, as the purchasing agreement is called in the trade literature, need not be WTO-incompatible, if the commitment is general and not limited to imports from a specific country. 

The US-China agreement clearly does not meet WTO conditions. While it stipulates that “purchases will be made at market prices based on commercial considerations”, Article 6.2 is very clear that the import expansion by China is for US good alone.  And the US left little doubt that this was about American exports.

Evaluation and dispute resolution

Disputes on a lack of implementation of the agreement will go through consultations at various levels. If disagreement persists, the complaining party can impose “remedial measures in a proportionate way”. These measures are presumably to be determined by the complaining party alone. The most likely “remedial measure” will of course be tariffs, and because China has made far more commitments than the US, it is also more likely to miss one, and thus more likely to be on the receiving end of “remedial” tariffs.

The agreement prevents either party to retaliate if the other were to impose remedial tariffs.  The only counter-remedy allowed is to cancel the agreement altogether, which would bring both countries back to the standoff they were in before the Phase 1 agreement.  

Remarkable, too, is the lack of a mechanism for regular review of the tariffs already imposed. Even if both parties were to fully fulfil the commitments made, the agreement provides no guarantee that tariffs will be cut. Instead, this will remain at the discretion of the parties. From comments made by the US side, they are in no hurry to reduce tariffs and it seems highly unlikely that this will happen before the US elections in November.  Thus, the world will have to live with higher tariffs for longer.

What next?

The bottom line of the agreement is that China is creating a better environment for technology and intellectual property-dependent industries, which are more likely to invest in China. The United States can sell more goods to China in return, particularly agriculture produce and energy. The bilateral trade deficit of the United States with China is likely to go down due to the commitment of China to buy more and the continued effects of tariffs imposed on China’s exports.

Overall, though, the US trade deficit will not go down because of this agreement. Trade deficits depend on macroeconomic policies, not trade policies. All signs point to the United States, which has been running a trade deficit since 1974, continuing its loose fiscal and monetary policy that is driving overall deficits.

Furthermore, the tariff war does not seem to have achieved what the United States has set off to attain: revamping US-based manufacturing. A working paper by staff of the US Federal Reserve Board finds that US manufacturing industries more exposed to tariff increases experience relative reductions in employment, as the positive effect of import protection is offset by larger negative effects from rising input costs and retaliatory tariffs.

As for the next phase of negotiations, it will have to address industrial policy, state-owned enterprises and subsidies — highly contentious issues that did not make it in Phase 1. The “Joint Statement of the Trilateral Meeting of the Trade Ministers of Japan, the United States and the European Union” on 14 January provided a preview of what the United States expects China to agree on. This bluntly states that the WTO policies on subsidies fall short, that the WTO appellate body has been too lenient on the issue of subsidies and state entities in the past, and that both need fixing.  Though China is not mentioned, it is clear that it is the main target of such fixes. Expect therefore more fireworks in the Phase 2 negotiations.

Bert Hofman is Director of the East Asian Institute at National University Singapore