Overview

China is the world's largest trader, and trade liberalization played a key role in its post-1978 economic success. But despite past reform, China has a persistent, systemically large trade surplus still shaped by residual and new forms of protectionism, undermining trade relations abroad and productivity and consumer welfare at home. To sustain its growth potential, China needs to remove trade and investment barriers that are inefficient for its own consumers and cause structural friction with foreign partners.

To gauge trade liberalization progress, we assess the change in China's imports of a selection of highly protected goods and services using a composite trade liberalization index (CTLI). Scores higher than 100 indicate a growing role for these imports relative to GDP since 2013; lower scores indicate a falling role. Supplemental gauges look at other variables in China's trade picture: current account-to-GDP ratios for goods and services, whether goods imports are consumed in China or just reexported, the services trade balance by component, renminbi exchange rates, and trade trends in overcapacity sectors.

Quarterly Assessment and Outlook

Our data show no meaningful change to China's trade regime reform status in the third quarter of 2017. The CTLI gauge of China's openness to imports of highly protected goods and services depicts no net improvement. Two categories improved over the five-year window (agriculture and information and communication technology (ICT) goods) and two worsened (services and - especially - manufactured goods), but none improved this quarter. The overall current account balance remained moderate, as a high services trade deficit partially offset a massive goods surplus. Implementation of trade liberalization plans in services - such as easing foreign investment caps in financial services, which has been promised - is a future possibility, but not a current reality. Newly announced tariff cuts on imports of certain consumer goods, such as pharmaceuticals and cosmetics, made public after our review period, are encouraging.

The outlook for the coming quarters is stormy. Strong global demand conditions, amplified by stimulus-inducing tax cuts in the United States and matching efforts elsewhere, will tend to bolster China's export surplus. At the same time, the United States and other economies are poised to challenge China over intellectual property protection, overcapacity, and subsidies. U.S.-China trade relations showed signs of deterioration in the third quarter, with Washington putting the Comprehensive Economic Dialogue on the back burner, initiating a trade investigation under Section 301 of the Trade Act of 1974 on Chinese unfair trade practices on intellectual property rights (IPR) and clarifying that it would not provide China with “market economy status” with respect to U.S. antidumping investigations. If the United States decides to impose restrictive measures against Chinese imports and investment, Beijing will need to decide whether to respond with corresponding actions, further reform/opening, or some combination thereof. If it does decide to take the reform route, our index may improve notably in the next two periods. Alternatively, we could see a scenario whereby tit-for-tat retaliation clouds the trade relationship for months to come.

China’s industrial overcapacity and the effect it has on global trade flows and prices are still critical issues.

This Quarter's Numbers

As in the previous quarter, our CTLI shows no net improvement in China’s openness to imports of highly protected goods and services in 3Q2017. The third quarter shows a lower CTLI reading than in the first half of 2017, indicating that, relative to five years ago when economic reform plans were announced, import liberalization is stagnant. The biggest marginal change was falling import growth of agricultural and high-tech goods. While fruit, nut, and wine imports increased at a high rate throughout 3Q2017, China’s meat imports fell by 26% year-on-year (yoy) in three-month moving average (3mma) terms, despite promised market opening to U.S. beef. Imports of high-tariff ICT goods started trending lower. Services imports excluding tourism remained at the same low level – more than 10% lower than in 2013 – for the past four quarters. Imports of highly protected manufactured goods started to pick up in 2017, though they are still below 2013 levels.

Our supplemental indicators add further perspective. External Trade shows China’s current account balance fell to 1.2% of GDP in 3Q2017 from 1.7% the previous quarter, mirroring the quarter-on-quarter (qoq) downturn in China’s goods trade surplus from 4.5% of GDP in 2Q2017 to 3.8% in 3Q2017. Higher raw material import prices contributed to the lower goods surplus. The share of China’s imports for processing and reexport remains high, at just under a quarter, while generally China’s exports are made with indigenous content. Both numbers are stable presently and reflect price effects rather than structural adjustment in trade patterns (see Structural Change in Goods Trade).

After reaching a record high of US$74.4 billion in 2Q2017, the services deficit moderated to US$68.1 billion in the third quarter, which was 2.1% of GDP. Tourism accounted for 82.2% of this deficit, though recent U.S. Federal Reserve research finds tourism import data distorted by hidden financial outflows. The trade balance compositions of other services subsectors more relevant to Services Trade Openness changed minimally. The biggest shift was in China’s telecommunications, computer, and IT services surplus, which at only US$1.2 billion in the third quarter was the lowest quarterly level since 4Q2009. China’s narrower IT services trade surplus was due to stronger imports, which rose 75% yoy to US$4.9 billion in 3Q2017.

China posted a small but nonetheless record high surplus (US$600 million) in financial services in 3Q2017. If Beijing’s recently announced plan to loosen foreign investment caps in financial services is implemented, the balance in this subsector may revert to a deficit in the medium term, as foreign affiliates face fewer barriers to selling services in China.

Currency value conditions (Exchange Rate Fluctuation) were largely a nonissue in the third quarter. The yuan strengthened modestly against the U.S. dollar and a trade-weighted basket of currencies but depreciated against the euro. While conditions external to China drove those trends more than domestic factors, Chinese regulators demonstrated openness to additional exchange rate flexibility by tolerating the renminbi’s two-way movements.

China’s industrial overcapacity and the effect it has on global trade flows and prices are still critical trade issues. Trade and Overcapacity shows that China’s exports of overcapacity goods in 2017 remain elevated, though generally down from 2015–16 highs. That said, four of six overcapacity goods we track saw significant export upticks in the third quarter, which is sure to fuel more trade friction. Net exports of paper, chemicals, and batteries increased, while goods at the center of both domestic supply-side production cuts and international trade tensions, particularly steel and aluminum products, were mostly flat as compared to the second quarter.

Policy Analysis: Winter 2018

Policy developments were ostensibly positive, as usual, and could move the needle of trade outcomes in the future, if implemented fully and faithfully. In late November, beyond our review period for the third quarter, Beijing announced import tariff cuts on nearly 200 consumer goods, including food, pharmaceuticals, cosmetics, clothing, consumer electronics, and home appliances. The lower duties came into effect December 1, 2017. Beijing also announced plans to relax and eventually eliminate foreign equity caps in certain financial services industries – a key preliminary to higher services imports. These commitments could address some international pressure on Beijing to speed up trade and investment reforms, if only temporarily. Our CTLI – which captures changes in Chinese imports of financial services as well as several consumer goods slated for tariff cuts – will indicate whether these liberalizations actually result in market outcomes.

China initiated a nationwide campaign to protect the IP of foreign enterprises in the third quarter.

Not all regulatory action at this stage for China is liberalizing; much new governance is potentially restrictive. Beijing is revising its export control regime to address national security concerns and to consolidate excessive administrative rules and regulations that made enforcement and compliance difficult. A draft Export Control Law, circulated in July for public comment, increases the scope of goods and services subject to export restrictions. More activities will be subject to export control, including reexports of foreign-manufactured goods containing a certain percentage of China-controlled content. In our view, this tighter regulation is normal and healthy for a more advanced economy and should not automatically be taken as a sign of reform backsliding. However, regulations such as these certainly can be bent to protectionist purposes. How transparently and even-handedly regulations are implemented is what matters.

In the third quarter, Chinese officials reiterated promised reform and opening in trade policy (such as opening financial services and improving intellectual property (IP) protection), but pressures from abroad shaped any action. IP protection is a key pressure point for Washington. The U.S. Trade Representative’s Office announced in August that it would investigate China’s IP practices under Section 301 of the Trade Act of 1974. The scope of the inquiry covers business concerns such as trade secrets theft, unfair licensing agreements, forced technology transfers for U.S. firms in China, as well as Chinese acquisition of U.S. technology assets. Under this statute, President Trump has wide discretion to take unilateral action, which could come as soon as 1Q2018.

Beijing appears to be taking the threat seriously. China initiated a nationwide campaign to protect the IP of foreign enterprises in the third quarter. According to a September joint action plan, 12 departments said they would conduct investigations from September to December 2017 to crack down on trade secret theft, trademark infringement, patent violations, and online property rights violations. These commitments parallel State Council directives to strengthen IP courts in major cities. It remains to be seen how these measures will be implemented.

Debate at the World Trade Organization about China’s market economy status as it concerns antidumping cases heated up, reflecting persistent doubts among the international community about Beijing’s trade reform intentions and concerns about its industrial policies. Washington formally opposed granting China market economy status in a lengthy Department of Commerce memo and separately in a legal brief supporting the EU’s position in November 2017. The United States continues to use nonmarket economy methodology to calculate dumping margins on Chinese imports and has revived seldom-used measures including government self-initiation of antidumping and countervailing duties investigations.

Looking ahead, we should expect both further opening from China and retaliatory steps in response to actions taken by trading partners, particularly the United States. If implemented well, these policy promises will improve China’s trade patterns for longer-term growth. At the same time, there are unmistakable signs of rapid change in trade policy dynamics abroad. International trade partners are increasingly responding to Chinese trade protectionism in-kind. Beijing must choose between retaliation and additional trade liberalization that promotes domestic consumption, reassures the international community, and adjusts its structural imbalances.

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