Trade War Casualty: Why the Days of Cheap Chinese Goods Are Over

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Flexport’s Phil Levy and Mary E. Lovely from Syracuse discuss what’s ahead in the U.S.-China trade dispute.

As President Trump and his Chinese counterpart, Xi Jinping, are set to meet at the G20 summit in Osaka, Japan, on June 28-29, expectations are low for a meaningful truce on the trade war that has defined their relationship over the last three years. More than 640 U.S. businesses and trade groups — including giant retailers like Walmart and Target — sent a letter to President Trump on June 13 asking him to cancel his threat to increase tariffs on some $300 billion worth of imports from China. That is on top of tariff increases the U.S. imposed in May on $200 billion worth of Chinese imports, after several attempts to forge a trade deal.

The U.S. has had several sticking points in its negotiations with China, such as Chinese government subsidies to local enterprises, controls on U.S. businesses operating in that country, and China’s laws on intellectual property rights. China has attempted to placate the U.S. on some fronts. In March, it announced a new foreign investment law where it promises a level playing field for foreign investors.

The businesses that wrote to Trump — organized under a group called Tariffs Hurt the Heartland — warned of disruptions to supply chains, higher consumer prices and erosion of U.S. competitiveness in global markets if the Trump administration goes ahead with its threat to extend tariffs.

If the Trump administration proceeds with higher tariffs on the remaining $300 billion worth of imports from China, the damage to businesses and consumers would be greater than in earlier rounds of such tariff increases, said Phil Levy, chief economist at logistics firm Flexport.

“When the Trump administration was putting its tariffs on China, it went first with the products that were supposed to be least painful and easiest to handle,” Levy pointed out. “That means the stuff that is left is harder and more painful. That is what these companies are describing as serious interruptions to supply chains, which will really hit consumers in the pocketbook.”

Numerous companies are set to give their testimonies before the U.S. Trade Representative beginning Monday to protest the proposed tariff extensions. Those testimonies are important because they explain “how they’re using these complementary inputs and how difficult it is to find alternative supplies,” said Mary E. Lovely, economics professor at Syracuse University’s Maxwell School of Citizenship and Public Affairs; she is also a nonresident senior fellow at the Peterson Institute for International Economics.

In earlier rounds of the trade dispute, the administration’s belief that firms would be able to find alternative suppliers was not entirely accurate, which is why it attempted “to reduce the pain” with some rollbacks, Lovely said. “One can very glibly say, ‘Well you can just get it someplace else,’ and that just seems to be completely ignorant of the reality that there aren’t alternative suppliers.”

Levy and Lovely discussed the likely future directions of the U.S.-China trade relationship on the Knowledge@Wharton radio show on SiriusXM. (Listen to the podcast at the top of this page.)

“One can very glibly say, ‘Well you can just get it someplace else,’ and that just seems to be completely ignorant of the reality that there aren’t alternative suppliers.” –Mary E. Lovely

The U.S. was comfortable with China in earlier years as long as it produced low-cost goods for U.S. consumers, said Wharton emeritus management professor Marshall W. Meyer, who is also a longtime expert on China, in a separate interview. “However, once China announced that it would compete at the high end of the value chain and directly with us, U.S. policy shifted sharply and the Trump administration took actions aimed at thwarting Chinese aspirations.” The current tariff war and U.S. actions like declaring that Chinese firms like Huawei are agents of the Chinese government are manifestations of that shift, he explained.

Erosion of Business Confidence

If the proposed new tariffs take effect, the biggest impact would be on U.S. “business confidence and business expectations,” said Lovely. In the initial stages of the tariff moves against China, U.S. businesses viewed them as “preliminary and temporary,” she recalled. “The administration has always promised us a big win and a reset of the relationship [with China] that would open up new opportunities for American businesses. As it gradually becomes clearer that that’s not where this is going to end up, businesses start to rethink investments and they see their costs going up.”

As businesses pull back on their investments, U.S. economic growth could also slow down and have ripple effects elsewhere in the world, she warned. Some of that may also have been deliberate, Lovely suggested. “Making the Chinese economy grow more slowly may be part of a ‘make them-hurt-until-they-give’ strategy,” she said. “But it’s also bad for the global economy. We have to remember that the U.S. is the second-largest exporter in the world. So what happens outside of U.S. borders still remains important to U.S. businesses.”

Levy explained why businesses are also complaining that the new tariffs will hurt their competitiveness. “The secret to how many American businesses have managed to be competitive is that they do parts of the production process in the U.S. using those skills we have and the capital we have. But they complement that with work that occurs in other countries. You put it together and have a competitive product. If you cut the second part out of that, you don’t have a competitive product and you’re in serious trouble.”

Hastening China’s Slowdown

An escalating dispute with the U.S. would of course hurt China as well. However, China’s economy would hit headwinds even without a trade war, said Meyer. “The trade war makes the nearly inevitable slowdown in China a little more inevitable,” he added. The slowdown is inevitable because “China’s episode of high growth, above 6%, has been unusually long. Sooner or later, the law of regression to the mean operates and growth decelerates dramatically.”

Secondly, China’s GDP growth has been driven “as much or more by investment than by consumption,” said Meyer. He noted that investment as a percentage of GDP has remained above 40% since 2004 or 2005; a stimulus program now underway may increase that share. By contrast, private consumption as a percentage of GDP has dropped steadily since the 1970s and has remained below 40% since 2007, he added. “Excessive investment leads to declining returns on investment and declining productivity.”

According to Meyer, China’s growth has been at the expense of productivity in most sectors. Barring select industries such as information and communication technology, productivity has declined across industrial sectors, he said. “Sustainable economic growth isn’t possible without productivity growth. You can juice up GDP by injecting a lot of capital into the economy.” As returns on capital and productivity start to erode, China’s debt will increase, he warned.

“The trade war makes the nearly inevitable slowdown in China a little more inevitable.” –Marshall W. Meyer

Threat of Chinese Tech Leadership

That setting explains why the Chinese government is pushing investments in advanced technologies like AI, 5G, genomics and green energy, where there are opportunities for productivity improvement, he explained. “This shift, called Made in China 2025, is the source of the trade war,” he said. Through that program, China aspires for technological leadership, using tools like subsidies and acquisition of intellectual property rights

“If China becomes a global leader in advanced technologies, this will go hand in hand with developing sophisticated capabilities in the likely tools of 21st century warfare,” Wharton Dean Geoffrey Garrett wrote in Knowledge@Wharton last December when Huawei’s CFO Meng Wanzhou was arrested in Canada at the request of U.S. authorities. “This is why Huawei is so central to U.S. concerns. Huawei is poised to be a world leader, if not the world leader, in the rollout of 5G digital networks in the next few years — not American companies like AT&T and Verizon.” The U.S. has charged Wanzhou with multiple offenses including bank fraud and wire fraud; she faces extradition hearings in Canada beginning January 2020.

Do Business Protests Work?

Lovely said that in the first rounds of tariff increases, protests by U.S. businesses did result in some “very small adjustments” to placate them, but other than that, their complaints have been “largely ignored.” Trump has often looked at stock market sentiments as endorsement of his policies. He may feel emboldened this time around, too, as the markets have stayed “fairly steady” while businesses oppose the tariff moves, she added.

At the same time, as business testimonies are heard on Capitol Hill, members of Congress sometimes are moved to intervene, Lovely noted. She pointed to the recent threat by the Trump administration to impose 5% tariffs on all imports from Mexico unless it complied with U.S. demands on curbing illegal immigration. That prompted opposition from members of Congress, especially behind-the-scenes moves by Republicans to speak directly to Trump, and he eventually “found an alternative route,” she added.

Nine days after it made the threat to impose those tariffs on Mexican products, the Trump administration dropped the plan, and Trump claimed a victory in securing an immigration agreement. As Levy saw it, the probability of Congress acting similarly on the proposed China tariffs is “significantly higher than six months ago.”

“The Trump administration has been noted for a different approach [with China] which is, ‘We’ll hold the big stick and we’ll hit you with it if you don’t agree to the right answer.’” –Phil Levy

All the same, it is unlikely that Trump would fundamentally changes his views on tariffs, Levy said. “When he speaks out about this, he says our best solution is to bring in many billions of tariffs revenue from abroad. Never mind that that’s not quite how it works.”

What the Talks Could Produce

Meyer saw two likely outcomes of the current trade dispute – one later this month and another over the long term. At the upcoming meeting in Osaka, “Trump and Xi may announce a face-saving trade ‘deal’ but it’s likely to be little more than a temporary truce since the larger strategic issues won’t be addressed,” he said. He also foresaw longer-term price impacts for businesses and consumers. “Business people will grasp that the days of China as synonymous with cheap are over, and supply chains and prices will adjust accordingly.”

Lovely also did not expect the issues to be meaningfully resolved in the Trump-Xi meeting. “We see these high level meetings creating a lot of heat but very little light in it,” she said. She noted that “very little” has come out of other high profile meetings Trump has had with world leaders in the past. “You cannot negotiate a trade agreement or fundamental changes on very difficult issues like the role of state-owned enterprises in international trade with simply a meeting between the two heads of state.”

Lovely is not optimistic about a breakthrough deal also because she did not see the right atmosphere for backroom negotiations. “What has transpired over the last six months has had a chilling effect on relations between the two countries,” she pointed out.

Typically, government officials do much of the spadework before such meetings between heads of state. “You have a lot of staff working for a long time setting everything up and then the leaders come together and they remove a few brackets and they close the deal,” said Levy. He added that it is not clear that such activity has occurred or is occurring now ahead of the Trump-Xi meeting.

“What has transpired over the last six months has had a chilling effect on relations between the two countries.” –Mary E. Lovely

The stakes have also risen as the trade dispute has gathered momentum. Last month, it appeared that China might strike a deal by promising “some new market access, some purchases of liquid natural gas and stuff like that, but basically just accept something and call it a win,” said Levy. There was no sight of a solution that would address “deeper, structural issues,” he added.

Meanwhile, the dispute has gained other layers that make it more “compounded,” such as nationalism, animosity and national security risks, Levy noted. The U.S. had made the first move by voicing its concerns over security issues such as cyber espionage using Chinese telecom equipment, for example, and China responded that it would not be pushed around by U.S. aggression, he said. “Those [issues] are hard to peel back quickly,” he added.

Levy pointed out that no easy answers exist for issues like how China treats foreign investors, its plan to deal with cyber attacks or the acceptable level of government subsidies. For instance, with government subsidies, ”there is no chance that we’re going to snap to a right answer in six months even if we had one,” he said.

Previous U.S. administrations have attempted to achieve “slow and steady progress” to resolve those issues, but “with mixed success,” Levy said. “The Trump administration has been noted for a different approach [with China] which is, ‘We’ll hold the big stick and we’ll hit you with it if you don’t agree to the right answer.’” Lovely added: “Unfortunately, the big stick doesn’t work with big countries and particularly not with China.” According to her, that strategy is “doomed to failure.” She expected the Trump-Xi meeting to produce “a little bit of window dressing if there’s even any sign of a victory.”

Other countries are unlikely to support the U.S. strategy on China, nor are U.S. businesses, said Lovely. “It’s almost absurd on its face to think that the rest of the world will not want to be part of the growth of the Chinese economy,” she added. Along with China, businesses also have to take note of India, which is set to grow rapidly. “Businesses have to be looking at where they’re going to get their global sales and profit growth. American companies want to have better conditions for their businesses inside China. Unfortunately, they’re going to be sadly disappointed by what comes out of this in the end.”

Fresh Approaches

According to Levy, the correct approach would probably be a series of steps, such as “patient commercial diplomacy,” even if such tactics do not necessarily achieve dramatic results overnight. Here, he noted that the U.S. might have had better negotiating power with China had it stayed within the Trans-Pacific Partnership. The Trump administration pulled the U.S. out of the TPP in January 2017, shortly after Trump assumed office.

“Business people will grasp that the days of China as synonymous with cheap are over, and supply chains and prices will adjust accordingly.” –Marshall W. Meyer

The upcoming U.S.-China talks could also cover issues such as China’s requirement that U.S. firms that desire to operate in the country must form joint ventures with local entities, instead of creating wholly owned subsidiaries. Lovely said the ability for U.S. companies to form wholly owned subsidiaries would also help address issues relating to intellectual property protection.

The U.S., on its part, must also refresh its thinking on some issues, such as government subsidies, said Lovely. “We need to have a clear view of what we think is fair trade,” she added. “Saying that all goods will be produced by private companies that have no subsidies from the government is on its face a nonstarter.” She pointed out that the U.S. might find fingers pointing at itself, where defense contracts to a company like Boeing might be characterized as a form of subsidies.

Sputnik Moment?

Meyer saw an opening for the U.S. to reclaim the narrative with China. “Why can’t the U.S. recognize that this is another Sputnik moment — that China is challenging the core of our economy, and that the U.S. will need to respond competitively rather than coercively?” The answer to that lies in the country’s leadership, he added.

According to Meyer, the immediate issues the U.S. and China are trying to resolve are merely the early signs of a larger contest. Describing them as a trade squabble is “our mis-framing of the problem,” he said. “It is a race for leadership in what are likely to be the critical technologies of the 21st century and beyond.”

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