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

We downgrade our assessment of trade reform this quarter from neutral to negative. The failure of China’s General Administration of Customs to provide key merchandise trade data in 2Q2018 due to reported technical issues means our indicators cannot fairly gauge China’s trade reform progress. This is a negative development, not least because transparent assessment of trade flows is critical for reducing the risk of “stumbling into (trade) war.” The data points we can access show no significant change in trade reform outcomes.

China’s trade policy over the past two quarters centered on expanding imports, which continues the shift from export-oriented growth to consumer- and services-oriented growth. While positive, official proclamations mostly restated standing goals rather than meaningfully advancing the effort.

U.S.-China trade relations deteriorated badly this quarter. The United States implemented new tariffs on $200 billion of Chinese imports, and China reciprocated with tariffs on $60 billion in U.S. goods. As detailed in our Net Assessment, U.S. Vice President Mike Pence’s October speech formalized and expanded the list of U.S. grievances well beyond trade. Highlighting national security and geopolitical charges complicates any effort to de-escalate talk of a trade war and likely sets the stage for a more prolonged worsening of relations.

The United States, the European Union, and Japan, among other advanced economies, expressed increasingly frank concerns about structural impediments to fair trade with China.

This Quarter's Numbers

Our quantitative analysis of China’s trade dynamics this quarter is hampered because the General Administration of Customs stopped reporting data for major commodities and countries in March 2018. Chinese officials attribute the data gap to technical problems with a vendor company. As of October 23, trade data used in our primary indicator and a supplemental indicator of overcapacity trade had still not been published.

Based on data that have been released, our primary indicator of trade openness shows no net improvement this quarter. The services trade index remained below 100 in 2Q2018, indicating that imports of highly protected services remain below 2013 levels (see Composite Trade Liberalization). The lack of improvement suggests inadequate policies to open up the services sector despite the priority it was given at the 2013 Third Plenum. By contrast, liberalization of highly protected agricultural goods trade did progress in 2Q2018 and has proven to be the most improved sector in our window of analysis.

While our primary indicator is inconclusive, supplemental indicators are mixed. Progress in external rebalancing, an explicit 2013 Third Plenum objective, means relying more on domestic demand and less on external demand for economic growth. As External Trade shows, China continued to rebalance gradually in 2Q2018 and is on track for its first annual current account deficit in a quarter century. The current account surplus (a measure that includes China’s balance of trade) rose slightly to $5.3 billion (0.2% of GDP) in 2Q2018 after its first deficit since 2001 the previous quarter. China’s goods trade surplus shrank 20% compared to last year to the lowest level in five years (for a second quarter in a row), while its large services deficit remained unchanged. Merchandise import growth continued to outpace export growth in 2Q2018, which likely reflects higher prices for key imports like oil as well as resilient domestic demand. This is positive.

China’s central bank, the People’s Bank of China (PBoC), is experimenting with a more flexible exchange rate, and in 2Q2018 market forces tested the PBoC’s tolerance for additional depreciation. As we predicted in the last update, the renminbi (RMB) weakened this quarter, falling more than 6% against the U.S. dollar from 1Q2018 to 2Q2018 as shown by Exchange Rate Fluctuation. The PBoC intervened directly and indirectly to stabilize the currency during periods of depreciation pressure in 2Q2018. Intervention was weaker than past levels, which is arguably a sign of progress. We believe that export growth was not a deliberate outcome of exchange rate weakness – not only because doing so would undermine the PBoC’s effort to build credibility in currency management and risk inviting capital flight but also because it would risk further escalation of trade conflict. The U.S. Treasury agreed with this logic, after this review period, by declining to label China a manipulator.

Real structural reform of China’s economy would change the nature of China’s trade as tracked by greater imports of consumer goods, and a higher proportion of exports using domestic inputs. Structural Change in Goods Trade shows higher trends in both measures in 2Q2018 than the prior quarter, but the changes were minimal and suggest progress may be stalling. The United States, the European Union, and Japan, among other advanced economies, expressed increasingly frank concerns about structural impediments to fair trade with China.

Moving up the value chain and boosting consumption will mean a bigger role for the service sector. While the services deficit excluding tourism increased only marginally in 2Q2018 as shown in Services Trade Openness, the changing composition of services trade indicates some reform progress. First, tourism was equivalent to only 77.5% of the total services deficit in 2Q2018, its lowest level since 2013. Aside from tourism, the industries weighing down the services deficit were transport, which covers international freight and passenger transport services, and royalties, which measure charges for the use of intellectual property. Telecommunications and financial services surpluses remained unchanged in 2Q2018, suggesting a lack of opening up.

Unfortunately, five of six goods we track to gauge Trade and Overcapacity did not report data in 2Q2018; thus, any analysis would be hard to defend. The only product we can track is paper, net exports of which fell below previous levels in 2Q2018, indicating progress in reducing the overflow into global markets for this product.

The outcome of the [U.S. midterm] elections is unlikely to shift current U.S. thinking on China, as faith in the benefits of engagement and the promise of reform has eroded broadly, not just in the White House.

Policy Analysis

Trade policy developments centered on expanding imports and extending efforts to shift the economy from export-oriented to consumer- and services-oriented growth. While positive, official proclamations mostly restated, rather than advanced, existing 2013 Third Plenum goals. Expanding imports means more market access for foreign goods, though new policy statements emphasized utilizing foreign trade and investment in high technology to facilitate domestic industrial upgrading. This will aggravate international concerns about technology transfer practices.

On July 9, the State Council circulated an opinion titled “Expanding Imports to Promote the Balanced Development of Foreign Trade.” The “Opinions,” which were co-signed by 20 government departments, elaborated on guidelines issued during the Communist Party’s 19th Party Congress last year. The core of these proclamations is the balancing of trade by keeping exports stable and increasing imports in line with broader economic goals: promoting consumption, accelerating innovation, raising international trade competitiveness, and upgrading the quality of economic growth.

The “Opinions” called for expanding imports linked to people’s livelihoods like daily-use goods, pharmaceuticals, and medical equipment to boost consumption. As detailed in our previous update, the State Council had already taken some measures to boost consumption imports, including July tariff reductions on nearly 1,500 consumer products, pharmaceuticals, and autos and auto parts. Agriculture products, energy products, and high-tech equipment and components are also flagged for import expansion to facilitate domestic upgrading in those industries. The “Opinions” also emphasized promoting services imports including building design, logistics, consulting, research and development (R&D), and environmental protection services. This change is needed – China’s imports of commercial services have not risen since 2016.

Expanding imports of technology and equipment to support China’s high-tech ambitions received particular attention. The “Opinions” encouraged foreign investment in strategic emerging industries, high-tech industries, and energy-saving and environmentally friendly industries to attract advanced technology and optimize the import structure. The document also calls for stronger intellectual property rights (IPR) protection, an oft-repeated commitment at the center of the current trade war with the United States.

U.S.-China trade tensions deteriorated further in the current period, with U.S. tariffs on Chinese goods now totaling $250 billion, and Chinese tariffs targeting U.S. imports adding to $110 billion. The U.S. tariffs are concentrated in electronic components and machinery, while the biggest U.S. exports hit by China’s tariffs are agriculture, energy, autos and auto parts, medical devices, and chemicals.

Following the failure of a mid-level bilateral meeting in August to deliver an agreement, the United States initiated a new round of tariffs covering $200 billion of Chinese imports at a rate of 10%, which automatically increases to 25% in January 2019. Beijing responded with 5%–10% tariffs on $60 billion of U.S. imports. Measured by tariff revenue to be collected, the U.S. exports most impacted include cell phones, computers and computer parts, natural gas, engines, wood, and metals. Beijing also reiterated its vow to retaliate “qualitatively” in areas beyond tariffs, but what that will involve is uncertain. A meeting between U.S. Secretary of State Mike Pompeo and Chinese Foreign Minister Wang Yi in Beijing in early October was unusually blunt, with both sides publicly critical of each country’s actions across a range of issues, pointing to a growing divergence on what a constructive economic relationship looks like.

Key events in the next coverage period may reshape the medium-term outlook for U.S.-China trade relations. With U.S. midterm elections in early November, President Trump is expected to continue his bellicose rhetoric ahead of time with an eye to his voting base. The outcome of the elections is unlikely to shift current U.S. thinking on China, as faith in the benefits of engagement and the promise of reform has eroded broadly, not just in the White House. As the likelihood of a compromise outcome fades, Chinese officials in October flagged measures such as tax cuts, export rebates, and tariff cuts to offset the impact of U.S. tariffs on a weakening domestic economy. President Xi and President Trump will have the opportunity for a bilateral meeting on the sidelines of the G20 Leaders’ Summit in Argentina at the end of November, but most signs point to extended trade tensions rather than de-escalation in 2018.

Explore the Reforms

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