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 modestly upgrade our assessment of China’s trade reform story this round to neutral from slightly negative in the previous edition. Several of our trade indicators show trends consistent with China’s stated reform goals in the first quarter of 2018 – particularly reducing external imbalances, supporting consumption growth through relaxing restrictions on consumer goods and services imports, and growing higher-value-added trade. This upgrade comes with a note of caution: the improvement in our indicators in the first quarter reading may be a reflection of short-term conditions rather than structural rebalancing. It is uncertain that this positive shift will be sustained.

Domestic policy developments have been moderately encouraging. In the first half of 2018, Beijing focused on lowering tariff barriers to support consumption growth and addressing certain non-tariff barriers to better facilitate trade. In several areas, such as consumer goods tariff cuts and corporate registration simplification, announced policies mark a continuation of gradual reforms. These stepped-up reforms seemed to be an effort by China to de-escalate tensions under pressure from the United States in March and April, followed by the prospect of other nations following suit with their own tariffs on imports from China out of either shared concern or fear of trade diversion to their economies.

Our outlook for China trade liberalization in the quarters to come is cautious. As bilateral trade tensions intensified in 2018, Beijing not only continued to limit its response to proportional action but also reduced tariff and non-tariff barriers. However, we expect new headwinds as the United States is now considering additional 10% tariffs on $200 billion in imports from China, with the U.S. Trade Representative’s office (USTR) just submitting a draft list of targeted imports in early July. If it does retaliate, Beijing’s response must inevitably be asymmetrical, given it imports less from the United States than the U.S. imports from China. The key question is whether Beijing’s response will adhere to international trade rules and further its reform goals, or whether it will escalate the situation with additional protectionism.

As bilateral trade tensions intensified in 2018, Beijing not only continued to limit its response to proportional action but also reduced tariff and non-tariff barriers.

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 Beijing set out its Third Plenum reform plan). The resulting Composite Trade Liberalization Index (CTLI), which is made up of three goods categories and one services category, remained below 100 this quarter, indicating that imports of highly protected goods and services in 1Q2018 were lower than 2013 levels. Liberalization has lagged in services and manufacturing trade, as shown by the lack of change in those subindicators over the past four quarters. By contrast, agriculture and information and communications technology (ICT) goods imports increased in the first quarter of 2018, which drove slight improvement in the CTLI.

While our primary indicator is effectively unchanged from last quarter, other indicators reflect modest headway on reform goals. Progress in external rebalancing, an explicit 2013 Third Plenum objective, means relying more on domestic demand and less on external demand for economic growth. Consistent with this objective, China’s external trade imbalance, shown by the current account-to-GDP ratio in External Trade, has continued falling since its 2015 peak of 3.1%, hitting -0.9% in 1Q2018, the first current account deficit since 2001. This looks like progress but may reflect short-term conditions more than structural rebalancing. The negative balance was driven by a large services deficit dominated by tourism – which captures some financial outflows in addition to real tourism spending – and a smaller goods trade surplus. While China’s goods imports and exports both rose year-on-year (yoy) in 1Q2018, higher oil and commodity prices raised the value of China’s imports more than that of its exports, reducing the goods trade surplus.

In addition to less export reliance, Beijing aims to rebalance from over-investment to consumption growth for domestic demand. This would promote imports of consumer goods and services rather than imports of intermediate goods for processing. Excluding tourism, which accounted for 56% of services imports in 1Q2018, China’s trade in other services industries does not yet reflect real progress in internal rebalancing. Services Trade Openness shows China’s fastest-growing deficit is in transportation services, which is related to logistics and merchandise trade facilitation, while key consumer- and services-oriented industries, including financial and insurance services, have seen basically no change in the quarterly trade balance over the past year. The most positive change was a record-high royalties deficit of -$7.7 billion in 1Q2018, which suggests more payments for foreign intellectual property.

Real structural reform in China will change the nature of China’s trade, and we watch two related indicators for that in Structural Change in Goods Trade. Processing trade imports continue to fall as a share of imports, though they are flat as a share of exports. In simple terms, this means China is importing more goods for final consumption but making less progress in shifting to higher-value exports.

Trade and Overcapacity shows net exports of six overcapacity products have fallen since 2016. This reflects a number of policy efforts and is a positive development: indeed, the interplay of overcapacity and disruptive exports was a main reason for foreign trade policy alarm bells; thus, this pattern deserves careful attention to see how lasting it will be. That said, product patterns turned in different directions in the first quarter, with net exports of chemical and paper falling below 2011 levels, while coke used for steelmaking and aluminum products rebounded compared to the previous quarter.

Exchange Rate Fluctuation shows the RMB continued appreciating in 1Q2018 amid bouts of U.S. dollar weakness early in the year, while China’s central bank intervened during periods of U.S. dollar strength to prevent depreciation. We found no evidence of China using currency as a trade dispute tool but expect the RMB to fluctuate in the months ahead. Fundamentally, the combination of rising U.S. interest rates and falling domestic rates, which incentivizes capital to leave China, point to additional RMB depreciation; cynical observers might interpret this as trade war skirmishing by other means. Though not explicitly trade related, introducing more market-driven flexibility and backing away from intervention in exchange rate management are among the central bank’s priorities. In June-July, after our review period for this Dashboard edition, the RMB depreciated by more than 6% against the U.S. dollar amid bilateral trade tension. Market participants viewed the move as a warranted adjustment against U.S. dollar strength, suggesting a positive reform development.

With fewer off ramps for de-escalation than in previous rounds of negotiation, if Beijing does intend to retaliate against additional U.S. tariffs, it would inevitably be asymmetrical, as China does not import enough merchandise from the United States.

Policy Analysis

Policy developments in the first half of 2018 were generally supportive of consumption growth and more open trade. Both ongoing liberalization measures and new responses to external trade pressure were evident.

China has been making slow but steady progress on liberalizing tariff rates consistent with its reform pledges in recent years. International pressure appears to have accelerated the time line for implementation in the first quarter. Following trade talks with the United States in May, Beijing announced tariff cuts to 15% from 25% for imported cars and to a uniform 6% from 6%–25% for auto parts, taking effect July 1. While directionally positive, auto tariff cuts are unlikely to have a significant impact because imports are a small part of China’s domestic market outside of luxury cars. The reduction of duties on auto parts is potentially more significant and will likely improve our indicators in future quarters.

Beijing focused piecemeal trade liberalization on pharmaceuticals this year as well. Effective May 1, the State Council abolished the 3%–6% import tariffs on medicines, including penicillin and other antibiotics, insulin, hormones, and others including anticancer drugs.

The Finance Ministry announced a new round of consumer goods tariff cuts on May 31, the third round since a 2015 decision to do so. The new rates, which go into effect on July 1, cover nearly 1,500 products – far more than the 187 products for which import duties were reduced starting in December 2017 – and reduce the average most-favored nation (MFN) tariff rate to 6.9% from 15.7%. Products covered include apparel and footwear, home appliances including refrigerators and washing machines, cosmetics and skincare products, and processed foods. The announcement was made only days after the White House announced details on tariff and investment actions against China resulting from the Section 301 investigation underway since mid-2017 into China’s intellectual property and forced technology transfer practices.

Improving trade facilitation (simplifying hurdles to trade) was an important 2013 Third Plenum goal, and China has made progress on this in recent months. Thirteen authorities published joint opinions on integrating enterprise registration, licensing, and certification. This quarter, China’s Ministry of Commerce (MOFCOM) and State Administration for Industry and Commerce (SAIC) also issued a circular simplifying foreign-invested enterprise record filing starting June 30. Other announcements promised further free trade zone (FTZ) reforms and more enhancement of Hainan Province as an FTZ. These are positive developments that should simplify import/export processes and thus facilitate trade, though success is contingent on the quality of implementation.

These broadly positive policy developments took place despite intensifying trade tensions with the United States in March and April, with U.S. implementation of steel and aluminum import tariffs, the proposal of tariffs on $50 billion in imports from China under Section 301, and President Trump’s threat to subject an additional $100 billion if Beijing retaliates. Beijing also imposed temporary tariffs on U.S. sorghum, a key agricultural export. Individual companies were targeted. After the U.S. Commerce Department banned U.S. company sales to Chinese telecom company ZTE, China’s Commerce Ministry (MOFCOM) – whose merger and acquisition review function has since been absorbed by the State Administration for Market Regulation (SAMR) – delayed approval of U.S. chipmaker Qualcomm’s proposed acquisition of NXP Semiconductors.

A period of de-escalation began in May but proved short lived. Two weeks of bilateral negotiations in early May culminated in a vague joint statement on May 19 suggesting that some deal was within reach. Negotiations revolved around increased Chinese purchases of U.S. goods, granting a reprieve for ZTE, and putting Section 301 tariffs on hold indefinitely. During this period, Beijing lifted its import tariffs on U.S. sorghum and reportedly restarted its review of the Qualcomm-NXP deal.

While the rumored deal would have enshrined some marginal progress, U.S. concerns about unfair trade practices in China at the core of the Section 301 case went unresolved; on June 15, the United States announced it would move forward with tariffs on Chinese imports worth $50 billion. The first round of 25% tariffs covering $34 billion in merchandise trade with “industrially significant technologies” took effect July 6, while the second round of $16 billion undergoes public comment. After Beijing responded with a list of reciprocal tariffs on U.S. imports, President Trump warned of additional tariffs on up to $400 billion of imports from China should Beijing retaliate. As of publication of this issue, Beijing had responded with its own tariffs on $34 billion of U.S. imports, and on July 10 the USTR issued a draft list of an additional $200 billion of imports from China that would be made subject to a 10% duty. On July 26 the NXP-Qualcomm deal ultimately expired as SAMR withheld approval.

With fewer off ramps for de-escalation than in previous rounds of negotiation, if Beijing does intend to retaliate against those additional U.S. tariffs, it would inevitably be asymmetrical, as China does not import enough merchandise from the United States to match reciprocal tariffs at that level. MOFCOM pledged to use both “quantitative and qualitative tools” to respond to additional tariffs. While “qualitative tools” remain undefined, Beijing faces a difficult choice. De-escalation is in China’s near-term economic interest, as it needs to motivate inflows into its financial system in an environment of continuing capital outflows, hesitant inbound investment, and currency depreciation. However, Beijing may decide to take a harder-line approach for other reasons, perhaps related to domestic politics. If Beijing escalates by taking informal actions against U.S. companies, such as intensifying customs inspections, delaying product approvals, and increasing merger reviews, it threatens the potential inflows it needs by raising fears and uncertainty about how foreign firms are treated within China. As detailed in our Competition policy review this quarter, the collapse of the Qualcomm’s NXP purchase because of the refusal to approve the deal by China’s regulators is a worrying sign. A response consistent with a positive trade reform outlook would involve continued compliance with World Trade Organization norms and procedures, and clear, transparent “qualitative” measures, if taken, that are rooted in rule of law.

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