Wharton's Minyuan Zhao and Penn Law's Jacques deLisle discuss what lies ahead for China and its relationship with the U.S. in 2019.

First, the good news. Stock markets in China and Hong Kong strengthened on Monday with the start of the two-day talks between negotiators from the U.S. and China to iron out their trade conflicts. It helped symbolically that China’s vice-premier, Liu He, widely considered the country’s economic czar, “dropped by the talks to spur on the negotiators,” The Washington Post reported.

Yet, simmering below the surface are deep divisions between the two countries involving allegations of state-sponsored theft of intellectual property rights and discriminatory trade practices. Over the past year, a hardening China stance by the Trump administration and a defiant Chinese President Xi Jinping resulted in tit-for-tat tariff hikes until a temporary, three-month truce was arrived at before duties jump from 10% to 25% on $200 billion worth of U.S. imports from China. In fact, both the U.S. and China would lose in what looks more like a “cold war” rather than a trade war, as Wharton Dean Geoffrey Garrett wrote in Knowledge at Wharton recently.

While the threat of higher tariffs will certainly hurt China’s exports, it is also forcing the economy to do a reality check, according to Wharton management professor Minyuan Zhao. “It is poking the bubble that has been building since 2008. We’ve seen a lot of investment in real estate, in construction, and in the so-called virtual economy.”

The trade war apart, several counter currents are dampening China’s expectations of delivering GDP growth of more than 6% this year, according to Jacques deLisle, professor of law and political science at the University of Pennsylvania, who is also director of the Center for East Asian Studies and deputy director of the Center for the Study of Contemporary China. On the domestic front, declining consumer confidence reflects the failure of the government to implement market-oriented reforms, said deLisle. They include promises by Xi early in his regime to level the playing field between previously favored state-owned enterprises and other companies, he explained.

Zhao and deLisle shared their perspectives on the economic outlook for China, especially with respect to its relationship with the U.S., for a Knowledge at Wharton radio show series titled “2019: A Look Ahead.” (Listen to the podcast at the top of this page.)

“The U.S.-China economic equilibrium of the past 20 years has gone, and as we look into 2019, it is not yet clear when and where a new equilibrium will form,” notes a report by McKinsey. “The uncertainties will lead to lower levels of long-term investment by businesses in 2019 and to greater levels of volatility in market growth and in the valuations of many kinds of assets.”

Demand Drag

China is facing slowing consumer demand not just within its domestic economy, but also in the U.S. and elsewhere in the West, deLisle pointed out. Many elements of its economic strategy “rely on engagement with the outside world,” he said. At the same time, China realizes that an economy of its size cannot continue to grow through exports, and some of the decline in external demand “is just inevitable.”

“The silver lining in the trade war between the U.S. and China … is that it is bringing back reality, partly because of the wider discussion about politics and economics.” –Minyuan Zhao

China’s difficulties in the U.S. market are in part “a blowback against things that China has done that the U.S. and others see as profoundly unfair trade practices with their intellectual property piracy,” said deLisle. “People see a tilted playing field for foreign companies operating [in China] — it’s a long list of complaints from the Trump administration.” He pointed to a statement last week by Larry Kudlow, the director of the National Economic Council, that the Chinese may have stolen Apple’s technology, as CNBC reported. “You’ve got to have rule of law…. There’s no enforcement; there’s nothing concrete,” Kudlow had said.

In recent days, the Chinese government has been more vocal about supporting small and medium enterprises, which happen to be strong job creators, deLisle noted. In response to falling domestic demand, the Chinese government plans to unveil a stimulus package to stabilize its economy.

Stimulants such as lower reserve ratios for banks to encourage lending could lead to other problems, deLisle warned. “We’ve seen China [launch stimulus programs] before when demand weakens. The downside of that is even if it works, it can create speculative investment and a new problem of bad loans, so they’re walking a fairly familiar tightrope there.”

A Thicket of Issues

Notwithstanding the increased importance the Trump administration has placed on intellectual property rights protection, deLisle explained why he is “skeptical” about the trade talks making any meaningful progress on that front. First, he noted that little has been achieved since the two sides announced a 90-day suspension of the proposed increase in trade tariffs that were supposed to take effect on January 1, 2019. “The clock is ticking toward March, and there is a lot on the agenda. This is a very complicated set of issues, even if you focus just on the intellectual property protection,” he said.

If the higher tariffs kick in, the bulk of the direct pain will be felt by businesses in the U.S., according to the McKinsey report cited earlier. The report noted that nearly three-quarters of Chinese exports to the U.S. are intermediary goods and not direct-to-consumer goods. “Consumers will feel price increases largely to the extent that U.S. producers choose to pass through their higher costs.”

U.S. companies operating in China face “protectionist or catalyst economic policies … that benefit domestic Chinese firms in a variety of ways and sometimes lead to pressure on foreign companies to license their technology as part of the price of doing business in China, or part of the price of access,” deLisle said. “[Whether] that [is] government policy or hard bargaining is often hard to unpack.”

Another area of tension is China’s industrial policy, which encompasses its so-called innovation economy policies and its Made in China 2025 program that aims to increase Chinese content in its products to 40% by 2020 and 70% by 2025, deLisle said. The U.S. complaints are that some of those goals are “over the line in terms of permissible industrial policy and [involve] too much state intervention.” Layered on top of those issues are concerns over security threats the U.S. government has raised in buying Chinese equipment, particularly from Huawei.

“[The Trump administration has] made it very hard for China to compromise rather than capitulate.” –Jacques deLisle

The U.S. government last year also banned Chinese semiconductor maker ZTE for selling equipment to North Korea and Iran in violation of U.S. sanctions against those countries, and “quietly” began shutting out other Chinese companies from U.S. government purchases, the McKinsey report noted. Concerns over risks heightened after the publication of the so-called “Supermicro bug” article in Bloomberg, and “an even broader range of companies now see a perception of risk in buying from Chinese suppliers and are making the conservative choice to go with a non-Chinese brand name,” it added.

Innovation is the casualty of those conflicts. “What is really going on is not about trade; it is about who will lead global innovation in the 21st century,” Garrett wrote in another Knowledge at Wharton opinion piece about the ongoing dispute between the two countries.

Stronger Competition

Zhao sought to put some of those issues in perspective. She pointed out that while the U.S. has blocked Huawei, China has raised its own set of security concerns, citing the Edward Snowden leaks as sufficient reason. The ban last year on Chinese semiconductor maker ZTE from sourcing components also gave China “strong incentives to develop indigenous technology,” she added.

Zhao pointed out that U.S. brands might be losing market share in China for reasons beyond government policies promoting local products. “It could simply be due to stronger local competition,” she said. Western multinationals operating in China may also face consumer concerns because they tend to be more rigid than Chinese companies, for a variety of reasons. “Chinese companies are a lot more flexible, and they’re willing to cater to nonstandard requests from customers a lot more than foreign companies. What I’m concerned about is when you read in the media about declining market shares, it’s immediately attributed to protectionism.”

The issue of protecting intellectual property is not easy to resolve. Zhao said that while she is all for a strong IP protection regime, it is difficult to implement its various aspects. “You can talk with the IP lawyers in Silicon Valley and ask them how difficult it is to implement strong IP,” she said. Moreover, China is increasing its own R&D, and there is a fine line between imitation and stealing. IP is likely to remain a thorny issue between the two countries, but she cautioned against leveling “a blanket accusation of stealing” against China, adding that that would reduce China’s incentive to police itself. “The only way for China to improve its IP system is to show that it is in its own interest.”

Stalled Investments

As China promised to open its markets in its quest for GDP growth rates of 7% to 8%, businesses from the U.S. and other countries “maybe were a little naive in thinking that [the reforms would] continue,” said deLisle. However, that “romanticism” was misplaced, and “we’ve seen certainly in China that when Chinese nationalism gets poked, consumers can engage in sometimes full-blown boycotts,” he added.

The frictions on trade issues between the two countries no doubt have spilled over to limit Chinese investments in the U.S. The Committee on Foreign Investment in the U.S. (CFIUS) has tightened its processes, said deLisle. “A big concern is with China coming in and buying up U.S. companies that have sensitive technology,” he noted. “So you’ve seen Chinese investment deals scrutinized more closely than those from other countries — perhaps for good reasons, perhaps sometimes not for good reasons. There’s a sense of hostility towards Chinese investment.”

Chinese investments into the U.S. have fallen by more than 70% last year and will likely fall further in 2019, the McKinsey report stated. “No Chinese company wants to be caught up for months in a review process with the CFIUS, with the high risk of the transaction being turned down. U.S. sellers do not want this uncertainty, either.”

“There is perhaps a legitimate sense that the politics and economics have become deeply entwined.” –Jacques deLisle

Zhao noted that Chinese investors head to the U.S. market for three reasons. One is to diversify their portfolio and to balance their risks, especially when the institutional environment in China tightened up in the past few years. However, those efforts have been frustrated by more scrutiny on the banking system, she said. The second incentive is to learn foreign technologies, but there again, they face bans or high hurdles, she added. The third purpose is to extend beyond their home market and reach U.S. customers, and they face difficulties on that path as well. “In all three cases, we see barriers either erected by China or by the U.S.” In such a scenario, it is not surprising that Chinese investments in the U.S. are declining, she added.

Reality Back in Sight?

Overall, the outlook for U.S.-China trade and investment ties in 2019 is far from encouraging. There may be unintended benefits for China, such as a reality check on its stimulus program and the threat of a bubble it could create. “The silver lining in the trade war between the U.S. and China … is that it is bringing back reality, partly because of the wider discussion about politics and economics,” said Zhao. “The reality will drive past the rhetoric.”

China may not immediately feel a great deal of pain if the tariff issues are not resolved. “The narrow short-term GDP impact on China of the tariffs alone is modest, on the order of 0.5% to 0.8% of GDP,” the McKinsey report said. “But if tariffs lead to job losses in China and then a decline in consumer confidence, the medium-term impact will be much, much greater.”

Expectations run low of a thawing in the U.S.-China trade relations in the meetings this week. “I’m not terribly hopeful of a breakthrough there,” said deLisle. “But For Xi Jinping, the strategic question is: How much do you do to satisfy foreign complaints, particularly those coming from the U.S., which you can do perhaps on the cheap, versus how much do you undertake structurally to address some of these problems?”

According to deLisle, “There are good economic reasons for both sides to try to work this out.” However, “brinkmanship from the Trump administration” is worrisome, he said. “Sometimes, for valid reasons, they have made it harder for themselves to back down and compromise. They’ve [also] made it very hard for China to compromise rather than capitulate.” He cited U.S. Vice President Mike Pence’s recent speech and Xi Jinping’s New Year address where he talked tough on Taiwan’s independence and China’s ambitions in the South China Sea. “There is perhaps a legitimate sense that the politics and economics have become deeply entwined,” deLisle said. “There’s a whole bunch of points of friction. Are they manageable? Sure, but on almost every front there is reason for concern.”