The Story So Far
In the decades following China’s 1978 decision to reform and open, its growth was driven by demographics and structural adjustment – letting market logic reshape the economic landscape. But in recent years, as the easier phase of development gave way to middle-income challenges, Beijing has attempted to reassert control over investment and markets. This was not the first choice. President Xi Jinping’s inaugural 2013 Third Plenum economic plan – while still couched in Communist Party nomenclature – was distinctly geared toward a decisive role for markets. Implementation of those goals, rather than aspiration, has been most lacking. By tracking China’s own 2013 objectives across 10 economic domains, The China Dashboard seeks to inform public debate with objective data on just how close to or far from those aspirations China is trending.
Gauging China’s policy progress objectively is essential for understanding what sort of economy – and polity – China will have domestically in the future, and just as critically what role China will play in the international community. The current tensions between China and the United States represent the sort of situation we previously anticipated at the conception of the Dashboard project and seek to temper through the dissemination of respected data indicators and interpretation. For this reason, we eschew normative advice or prognostication about the future of the Chinese economy, though we do point out clear conundrums in the outlook.
The coronavirus pandemic embroiling China and slowing large swaths of its economy, likely for a prolonged period, comes on the back of two sets of policy problems in China: the decline of economic reform and the U.S.-China trade war.
The pandemic relates to our China Dashboard policy appraisal in profound and complicated ways. Nevertheless, the virus is not a reason to put the reform discussion on hold, but rather a pressing cause for bolder leadership. Given that the economic system is already under great strain, aspects of reform that require near-term pain and sacrifice are off the table for now. The need for a credible commitment to a reform agenda, however, has never been greater. For firms, individuals, and international partners to remain engaged with China for the long term, they need better assurance that a reformed economic system lies ahead. Even before the virus hit, expectations were eroding in the face of evidence of economic weakness, credibility problems with other data, and indications of the radical slowing of reform and, in some cases, reforms being walked back.
A brave face and insistence that business as usual will be maintained do not match the reality of the economic standstill. Locking down the economy is, in part, a central effort to control the virus, but a radically franker acknowledgment of the collateral effects, for instance on the banking system, is essential. It is not overnight reform that is called for, but leadership and a rededication to policy adjustment that puts transparency and market functionality above doctrine and political pride.
Our ten gauges of policy movement in the most recent quarter collectively show a system not moving sufficiently in the direction of market efficiency to sustain medium- to long-term economic growth. By incentivizing officials to deny and cover up bad news rather than acknowledge and respond to it, China is making hard problems harder still to solve.
- This was true of swine flu, where local fiscal limits led officials to turn a blind eye rather than accept the loss of livestock.
- It is true of the financial system, where debt levels have grown unsustainable because the premise of stability and growth was too precious to relinquish.
- And now the coronavirus has spread worldwide, in part because frontline medical professionals were silenced rather than supported when they offered warnings.
While Beijing may have learned its virology lesson and has been transparent about infection rates since the World Health Organization was permitted inside the country to help in February, there has been a distortion of facts when dealing with the economic consequences of the outbreak. For instance, officials have been ordered to run government office air conditioners in winter, including over weekends, to make it appear that demand for electricity (and hence productive activity) is recovering.
Xi Jinping warned in 2013 that if efficiency-enhancing reforms were not implemented, China would find itself in a dead end. He was right. Yesterday’s reform was deferred until today on the grounds that stability was too important and headwinds would abate in the future. Today has come, and it turns out now is not an option either. The price for implementing reform tomorrow will be much greater than it would have been in the past, and paying it will require acknowledging the mistake of not having started sooner. As painful as that seems, it will be much less expensive than standing still.
The data available through the third quarter of 2019 (those available for this edition) show limited economic reform progress, and much of the data needed to make a credible evaluation was delayed and not available even then – a problem exacerbated further by the virus. Three areas saw modest improvement over the previous quarter: competition policy, state-owned enterprise (SOE) reform, and cross-border investment opening. Policy in these areas remains far from sound, but after years of stalled movement modest improvements were positive signs. However, fully half of our ten policy dials show backtracking quarter-on-quarter. Systemic reform has been piecemeal at best. It has not been the central thrust of the government’s economic policy efforts.
The structural impediments we have examined most in the Dashboard include the over-expansive role of SOEs, the distortive role of the financial system and fiscal affairs, competition policy regimes that favor domestic interests, and many other concerns. The U.S.-China trade deal defers real attention to these issues to a future Phase Two.
A Managed Trade Deal – Not a Reform Package
Is there reform light at the end of the dark tunnel of the past three years? As 2019 wound down, hopes rose that a U.S.-China agreement might improve the structural reform outlook. Donald Trump had sworn he would not settle for a weak deal and claimed to be content to raise tariffs on China even further if he did not get a breakthrough. A deal was indeed announced on January 15, 2020. Of seven substantive sections, three touch on aspects of the Chinese system that can be called structural: one each on intellectual property rights (IPR) protection and technology transfer, and one on macroeconomic and exchange rate issues.
The reality is that the macro and exchange rate chapter of the agreement offers little more than a provision to consult on these issues in the future. On IPR and technology, the agreement offers promises to some industries and not others, and obliges a defendant to bring evidence that it is not infringing on another’s patents. While vague, these pledges (like those that have come before) could be important if fulfilled.
Chapter 7 of the agreement covers evaluation and enforcement. But the baselines for gauging compliance will be kept largely secret because they were selectively based on a mishmash of U.S. and Chinese 2017 trade data to provide the most dramatic results. This calls the credibility of the enforcement chapter into great doubt: how can something not made public be taken as credible?
This leaves the remaining three chapters of the agreement which promise to improve U.S. exports of agricultural products, financial services, and everything else. This amounts to a managed trade arrangement to lift China’s purchases of some U.S. goods and services by $200 billion over two years. As such, it does not meaningfully improve prospects for Dashboard outcome indicators in most cases.
The structural impediments we have examined most in the Dashboard include the overexpansive role of SOEs that perform poorly relative to private firms, the distortive role of the financial system and fiscal affairs (preventing adjustment by continuously rolling over credit to unproductive firms and subsidizing political incentives), competition policy regimes that favor domestic interests, and many other concerns. The U.S.-China trade deal defers real attention to these issues to a future Phase Two. The deal promises changes to intellectual property rights protection and technology transfer conditions but is vague on implementation. Proposed dispute settlement arrangements are predicated on the threat of dissolving the whole deal more than a clear arithmetic for application.
The meaty commitments in the deal are found in chapters on trade in food and agriculture, financial services and “Expanding Trade” – that is, purchases of U.S. goods. The agreement outlines a managed trade program in which Beijing is to increase U.S. purchases from 2017 levels by $77 billion in 2020 and $123 billion in 2021 in four categories (manufacturing, agriculture, energy, and services). Stand-alone chapters on agriculture and financial services mostly serve to support this purchase commitment, rather than promote systemic reform in China. The purchase commitments are the most robust and detailed, but they will not lift our expectations for trade reform indicators going forward because they only consider American interests and not overall liberalization. The agreement is to be measured by China’s bilateral position with the United States, not its global trade position.
Making things even murkier, the 2017 baseline could be either U.S. export data, or Chinese import data, but we will not know because this will be kept secret. Stronger Chinese imports from the United States may displace imports from other countries, casting doubt on whether the arrangement complies with international trade rules. Can we at least be confident that the benefits for U.S. trade are assured? Maybe not: increased purchases of certain U.S. products could come at the expense of other U.S. products not subject to purchasing targets.
Is it reasonable to expect China’s economy to generate enough growth in the next two years to absorb $200 billion of additional exports from the United States? Pre-virus, the answer was maybe: if Beijing eschewed general policy reform, including in trade and finance, and instead primed the demand pump with more debt to stoke consumption, and if China diverted trade away from other trading partners to make Washington happy, and if prices for U.S. energy exports held up, and if we allow selective reference to U.S. or Chinese trade statistics to find the bigger numbers, then the $200 billion increase goal might be achieved in two years. In light of this, it is ironic that one reason broader structural reform was not pursued first in a U.S.-China agreement is that it would have made it harder to achieve the special gains just for U.S. exporters that Trump wanted.
Make no mistake: a reforming China would grow slower (and thus consume less) for the next couple of years, but it would mean long-term sustainable growth. It would not take markets away from others to hand quotas to Americans.
What the Virus Means for Trade
Even with all these illiberal ifs, can China fulfill its Phase One import commitments given the coronavirus’s economic impacts? It seems extremely unlikely. When the deal was signed, world markets were hoping to put the volatility and uncertainty from trade tensions behind them. At a minimum, a down-payment agreement would signal de-escalation and a more constructive atmosphere. Even non-U.S. firms were looking forward to a more predictable period.
The virus turned that expectation on its head. First quarter 2020 GDP growth will be negative quarter-on-quarter, and second quarter results will be weighted down as well. High-frequency data from China offer early warning signs of the fall to come. Population flows measured by passenger trips, one of the most important available indicators of the scale of the forthcoming slowdown, show an 82% drop year-over-year for the 25 days after Chinese New Year’s eve in 2020. Even if bans on travel are lifted, production shutdowns will continue as long as workers, including migrants, stay home. Coal consumption, averaged for six major power plants, fell 42% compared with the post-holiday period in 2019. One of the biggest sectoral risks is the property sector – at once a pillar of China’s economy and a hotbed for financial speculation and indebtedness. Daily property sales by floor space in February collapsed to practically zero, and developers who had been pre-selling property on leverage to finance construction are faced with cash flow problems and more defaults ahead.
Once the virus is tamed – if the virus is tamed – there may be a rebound in production of some products for which demand is pent up; but for many items consumption once foregone does not return. You do not have dinner twice tomorrow because you skip it today, and the same goes for vacations, movies, fuel to commute to work or take business trips, and many other activities. The crisis will greatly exacerbate nonperforming loan rates at virtually all commercial banks and financial insolvencies at firms. In our view, this financial washout from debt was bound to happen anyway, but the current morass amplifies the shock. Under our assumptions, China’s imports both for domestic consumption and for reexport (since the global demand picture is depressed by the virus as well) soften rather than strengthen this year. Price effects (falling oil import costs for China) amplify this trade balance shock, making it much harder to satisfy U.S. expectations and trade diversion much more likely if Beijing attempts to do so.
Tariffs and Other Factors in the Escalation/De-escalation Equation
The specificity and scale of China’s purchasing targets only reinforce the state’s role in managing trade, rather than letting the market play a more decisive role. That is deeply troubling. And the same goes for the role of the U.S. government, which has been extraordinarily interventionist and distortionary in the past three years. Twitter overshadows the Federal Register. But at least interventionist governments can remove discretionary economic barriers as quickly as they were implemented. But is that what is happening?
Both sides have only partially reduced tariffs:
- Before the Phase One deal was concluded, the United States dropped a planned tariff increase for December 15.
- After signing the deal in mid-February, the United States followed through with announced halving of the 15% tariff rate on $120 billion in Chinese goods but kept 25% tariffs on imports worth $250 billion in place. In effect, the deal slightly reduces average U.S. tariff rates on Chinese imports from 21% to 19.3%, versus only 3% in January 2018, according to the Peterson Institute.
- China’s Ministry of Finance halved tariff rates for $75 billion of U.S. goods imports including crude oil and soybeans upon signing of the deal in mid-February to facilitate increased purchases under Phase One commitments.
- Trade authorities in both countries have since created more opportunities for firms to apply for exemptions from tariffs, while Beijing has had to proactively cut tariffs in grappling with the virus’s impacts.
While the public’s attention is drawn to the tariff drama as a gauge for de-escalation because it offers simple percentage numbers, myriad other non-tariff barriers to economic engagement are not under discussion and in many cases are ratcheting up unilaterally. None of the new U.S. restrictions on inward investment or export controls have been removed. President Trump stated (via Twitter proclamation) that he would not permit overreaching national security claims to impede American business, and specifically squashed an attempt to block U.S. aircraft engine sales to China. But official exposés about nefarious Chinese commercial dealings as well as law enforcement and political campaigns against U.S. institutions and individuals deemed too China friendly continue to be a daily occurrence. Many business leaders privately observe that the risk of engagement is growing larger, not more manageable, since January 15.
Neither patterns to date nor the nature of the Phase One deal improves our Dashboard Net Assessment of prospects for future economic reform. The approach to policy adjustment detailed in depth in the ten sections of this appraisal reveals Chinese leadership looking for modest, piecemeal ways to make some progress, not bold moves. The virus emergency stymies even that minimal activism. In the financial system, the emergency measures rolled out to avoid defaults are making the debt problems worse, and this is true in other areas. The U.S.-China deal does not significantly move the reform objective ahead.
There remains the hope that this government intervention is a necessary intermediate step – a down payment to address U.S. objectives while a more systematic plan to address structural matters is developed. That is the idea behind restarting the strategic economic dialogue (a macroeconomic dialogue to be held twice a year, and a trade dialogue) and setting expectations for a Phase Two negotiation on the deferred structural issues including subsidies and SOEs. Contradictory signals (from both sides) abound about the timing and scope of a Phase Two, as well as the role that the dialogues are to play in paving the way. President Trump has made conflicting statements, at times claiming that negotiations would begin following the Phase One signing ceremony, and at others indicating that they would not begin until after the next U.S. presidential election. In January, China’s lead negotiator Premier Liu He told state media that China was in no rush to start Phase Two negotiations.
The utility of formal bilateral dialogues should not be underestimated, if the goal really is to identify mutually beneficial actions that can be taken to supplement the deal landed so far. Multiple steps can signal upside potential for structural reform: among others, a halt to symbolic expulsions of journalists, release of individuals under political detention, joint actions to mitigate the virus emergency, and the identification of additional industries that can be opened to full commercial interaction now and not later. But the heavy economic policy lifting remains in Beijing’s court. To hold back forward movement as leverage for a Phase Two negotiation that might not start for a year – if ever – and will take years to conduct would be regrettable.