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

Opening up is requisite for reform, and international trade is the main channel through which China is open to the world. The 2013 Third Plenum envisioned trade openness with a focus on improving resource efficiency, letting the market play a more “decisive role,” and fostering new competitive advantages. Specific trade-opening commitments called for optimizing China’s trade structure by moving up the value-added supply chain, facilitating trade by removing administrative burdens, increasing services imports, and participating in new external trade agreements.

China’s desired adjustment toward higher value-added trade and, ultimately, to economic growth powered by consumption and services would be advanced by more liberalized two-way trade flows, particularly in areas where the playing field is still not level for international companies and their goods and services in China. Our primary trade indicator compares China’s imports of highly protected goods and services to GDP. In this edition, we find that China is backsliding in its openness to trade in highly protected sectors, led by a fall in the ratio of information and communication technology (ICT) imports to GDP in 4Q2017. Our primary indicator shows that the ratio of highly protected goods and services imports to GDP was actually lower in 4Q2017 than it was when the Third Plenum Decisions were originally announced in 4Q2013. One supplemental indicator suggests progress in decreasing the flood of overcapacity goods into global markets that resulted from prolonged state subsidization of industrial production; the decrease likely reflects production curbs under the supply-side structural reform agenda. All other indicators show little fundamental change in trade patterns from the previous quarters.

Our outlook for China trade liberalization is dreary. Beijing faces imminent and substantial U.S. actions to limit imports and investments, as well as mounting trade tensions with other countries. Recent trade policy pronouncements have been in the right direction but remain vague and piecemeal. They are insufficient to mitigate the risk of serious trade friction with the United States and other advanced economies. Developments in March and April, which transpired after the current coverage period, show U.S. tariff and investment restrictions are a real possibility, motivated by impatience with the slow pace of China’s market opening and its industrial policies. Beijing has so far limited its response to U.S. threats to proportional action, but with few channels for reciprocal retaliation, and under heavy pressure from the United States, China’s reform process could be further delayed if it imposes significant new barriers to trade in coming months.

This Quarter's Numbers

Our primary indicator of China’s trade openness indexes the changes in the import/GDP ratios for a selection of highly protected goods and services relative to 4Q2013 when the Third Plenum Decisions were announced. The resulting Composite Trade Liberalization Index (CTLI), which is composed of three goods and one services category, dipped below 100 this quarter, indicating import liberalization of highly protected goods and services backtracked and actually fell below 2013 levels, despite a host of late 2017 commitments to remove tariff barriers to consumer and high-tech goods imports. Base effects are partly at work, as volatile imports of ICT goods – particularly LCD screens – fell relative to the previous year, though most other ICT imports receded as well. Announced tariff cuts to consumer goods, effective December 1, came too late to improve the indicator.

Tariff and non-tariff barriers still limit China’s imports of other CTLI components, including agricultural goods, manufactured goods, and services, all of which showed no change relative to GDP over the past two quarters. Agricultural goods imports remained stable thanks entirely to a last-minute rise in meat imports after declining throughout most of 2017.

The biggest trade pattern change we detected in the review period was in overcapacity sectors. Over the past 10 years, government subsidization of heavy industry in China caused some firms to become deeply indebted and uncompetitive. Lacking market incentives, these firms produced more goods than they could sell with minimal financial repercussions, resulting in excess supply being shipped into global markets at below-market prices. As seen in Trade and Overcapacity, China’s net exports of all six types of overcapacity goods that we watch decreased at the end of the year, and for several goods (steel products, paper, coke), they fell to their lowest levels since 2016. This is positive. Cutting industrial overcapacity was a pillar of China’s supply-side structural reform agenda in 2017, which was focused on shutting down inefficient, high-polluting producers. It has also been an issue of serious concern to China’s trading partners. Our data suggest these efforts are slowing the 2015–2016 flood of Chinese overcapacity into international markets. In the policy section, however, we note that China has recently taken steps that will counteract this trend.

Trade openness is also an outcome of structural adjustment and economic rebalancing. Echoing the CTLI, our indicator of China’s Services Trade Openness shows no additional opening this quarter, even though reorienting economic growth toward the service sector is essential to achieve Third Plenum reform goals. In financial services, a key sector that Beijing has recently promised to liberalize, China maintains a small surplus that reached its highest level yet, at $700 million in 4Q2017. This is a modest number but reflects the continued lack of market access for foreign financial services, which would theoretically boost imports in this category as Chinese citizens and companies consume service offerings from foreign companies. China’s surplus in commercial services and deficits in intellectual property royalties and insurance services remained largely unchanged from end-2016.

The biggest shift in services trade flows was a significant drop in tourism imports, which are typically correlated with capital outflows and thus are less representative of trade opening. For the first time since 2003, China’s tourism imports contracted year-on-year (yoy) for two consecutive quarters, falling 12.3% ($17.5 billion) in the second half of 2017. As External Trade shows, lower tourism imports reduced the overall services deficit to $63.3 billion in 4Q2017, only 1.8% of GDP, registering its lowest ratio in two years. This is primarily because Chinese residents were less concerned about currency depreciation and additional capital controls in 2017 than at the end of 2016 when outflows surged. Exchange Rate Fluctuation shows the yuan appreciated in value against major currencies in Q32017 and Q42017, suggesting tolerance for additional flexibility in the exchange rate. U.S. dollar weakness was the main cause; on a trade-weighted basis, the appreciation is less acute.

As China’s economy transitions away from investment-led growth, domestic consumption of final goods should play a larger role, while raw materials imports for processing and reexport should decline. The supplemental indicator Structural Change in Goods Trade shows that China is continuing a gradual shift toward higher value-added trade that began at the end of 2014. The long-term trend shows exports are less reliant on processing imports, while goods for final consumption are a rising share of total imports.

Beijing faces imminent and substantial U.S. actions to limit imports and investments, as well as mounting trade tensions with other countries.

Policy Analysis

Beijing pursued a piecemeal approach to trade liberalization in the fourth quarter 2017 review period, which is consistent with its plans for a “gradual” and “orderly” trade opening as stated in the 2013 Third Plenum. In November 2017, Beijing slashed tariffs on 187 consumer goods (effective December 1, 2017) and more than 200 ICT goods (effective January 1, 2018). The tariff cuts are a positive development that cover as much as 31% of China’s $1.7 trillion in total 2017 goods imports. But trade policy signals were mixed. The Customs Tariff Commission of the State Council also abolished provisional tariffs on exports of a host of steel and aluminum products, including rebar, pig iron, scrap metal, unwrought aluminum alloys, and other aluminum products, starting January 1, 2018. This kind of export promotion in overcapacity sectors is exactly the opposite of what economic restructuring requires and what the international community wants to see from China.

In the early months of 2018, Chinese policy focused mainly on responding to U.S. pressure and attempting to moderate anticipated actions by the Trump administration. On February 4, China’s Ministry of Commerce (MOFCOM) self-initiated an antidumping & countervailing duty (AD/CVD) investigation into imports of U.S. sorghum – two months after the U.S. Department of Commerce self-initiated an AD/CVD case for the first time in 25 years – over imports of Chinese aluminum sheet and just weeks after President Trump levied safeguard tariffs on solar panels and washing machines. Later in February, recently appointed Vice-Premier Liu He visited Washington hoping to temper action and revive high-level economic dialogue but left disappointed when Trump announced new steel and aluminum tariffs during the visit.

Those steel and aluminum tariffs of 25% and 10%, respectively, announced on March 8 and which came into effect March 23, kicked off several rounds of escalatory trade actions by both governments. In response to the Section 232 tariffs, on March 23 Beijing announced tariffs on 128 products imported from the United States, worth approximately $3 billion, which went into effect April 2. Just a day earlier (March 22), President Trump ordered trade and investment penalties resulting from the Section 301 investigation into China’s intellectual property and forced technology transfer practices that had been underway since mid-2017. Trump also directed U.S. Treasury Secretary Steven Mnuchin to propose investment restrictions by May 21. Finally, he ordered the initiation of a WTO case against China’s discriminatory licensing practices. Given national security concerns and reciprocity complaints in the bilateral investment relationship, these threats have considerable support in the U.S. national security community and parts of the business community. On April 3, the U.S. Trade Representative’s (USTR) office proposed 25% tariffs on nearly $50 billion of imports from China, pending conclusion of a public comment period on May 22. In retaliation, on April 4, Beijing proposed tariffs on 106 U.S. products, equivalent to $50 billion in annual imports, to be subject to a 25% tariff. In response to that, President Trump ordered the USTR to consider tariffs on an additional $100 billion of imports from China.

The proposed tariffs implicate approximately 30% ($153 billion) of U.S. imports from China and 40% ($53 billion) of Chinese imports from the United States. For China, exports of electronics and machinery-related goods would be hardest hit. For the United States, agricultural exports including soybeans, sorghum, pork, and ginseng, as well as high-value aircraft and vehicle exports, are at risk of high penalties that could be painful for some sectors. For example, China accounts for more than 80% of U.S. sorghum exports, more than half of soybean exports, and nearly half of covered auto exports (much of it – interestingly – from European brands manufactured in the United States). If the United States moves forward with tariffs on an additional $100 billion in Chinese imports, the tariff channel would be insufficient for a tit-for-tat tariff response from Beijing, as the value of U.S. exports to China available to subject to tariffs is in total only $130 billion.

Whether Beijing undertakes a conciliatory or confrontational policy approach will be a critical driver of our Dashboard liberalization assessments in coming quarters. Insofar as U.S. objectives – eliminating state subsidization of domestic industry and unequal treatment of U.S. firms – are fundamentally at odds with Beijing’s economic model, a negotiated outcome will be hard to reach, and we are not optimistic. At present, Beijing is offering an exit ramp to de-escalate tensions, and Washington is not completely closed to that possibility. At the Bo’ao forum in April, President Xi offered accelerated opening to foreign investment in financial services and auto manufacturing, as well as tariff cuts on auto imports and strengthened IPR protection. Following this announcement, Secretary Mnuchin said at the April IMF meetings that he is “cautiously optimistic” that an agreement in the Section 301 case can be reached. And on April 24, as this edition of Dashboard went to press, it was announced that Mnuchin along with U.S. Commerce Secretary Wilbur Ross, U.S. Trade Representative Robert Lighthizer, Assistant to the President Peter Navarro, and National Economic Council Director Larry Kudlow would travel to Beijing for negotiations in early May.

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