A Phase One Deal, but for what purpose?

What does the Phase One trade deal between the U.S. and China indicate for the wider trade conflict between the two countries? To answer that question requires analysis of the deal’s specifics in the broader context of the trade conflict and its underlying causes.

A good place to start is the USTR’s fact sheet on the deal. The key takeaways are: reduction of the trade deficit through a $200 billion increase in U.S. exports to China over two years; removal of non-tariff barriers by China in its agricultural and financial sectors; increased protection for intellectual property rights (IPR) in China; and a commitment to let the yuan be governed by market forces. Given that bilateral trade deficits are President Trump’s favourite measure of the health of trade relations this article will focus on the purchase agreement part of the deal.

It’s the deficit, stupid!

Phase one of the U.S.-China trade negotiation is all about reducing the trade deficit. China has agreed to buy an extra $200 billion of U.S. goods and services over the next two years, and also cancelled further retaliatory tariffs set for Dec 15^th. Purchases reportedly break down as follows: $75 billion in manufactured goods, $50 billion in energy, $40 billion in agriculture and $35 billion in services.

In 2018 the U.S. exported $179.3 billion of goods and services to China while importing $557.9 billion, leaving the bilateral trade deficit standing at $378.6 billion. Consequently, the $100 billion yearly increase in the ‘phase one’ purchase agreement requires a substantial 55 percent increase in American goods and services exports to China. If feasible this would clearly go a long way towards reducing the deficit.

The concessions received by China in return are by way of the US not implementing an additional 15 percent tariff on $160 billion of Chinese exports that had been scheduled for December 15^th 2019, a halving of the 15 percent levy applied on $120 billion of goods since September 2019, with the 25% tariff on $250 billion of Chinese exports in force since May 2019 to remain as before.

An unrealistic purchase agreement?

The immediate question is whether such a large increase in exports to China is feasible over such a short period of time? Making this assessment more difficult is the fact that the specific breakdown of purchases will remain classified. However, if we assess the available information on the agreement for agricultural purchases the practicalities of the deal begin to look questionable, particularly given that tariffs averaging 20 percent on soybeans and other farm products effective since June 2019 remain in place.

As part of the ‘Phase One’ deal China has committed to buy an extra $32 billion in farm products over two years. That requires $16 billion in extra annual U.S. agriculture exports each year, thereby rising from the current level of $24 billion in 2018 to $40 billion in 2020 and 2021. This involves a very sizable sixty-six percent annual increase over base levels.

Some view the proposed rapid increase in purchases as unrealistic. This is because China has already substituted many U.S. farm goods through imports from other countries as a consequence of the trade conflict. Furthermore, in the context of the broader geopolitical tensions between the countries it would be a strategic mistake for China to now reduce import diversity and become more reliant on U.S. farm goods when only a tentative ‘phase one’ deal has been reached.

Will the Chinese Communist Party be prepared to put itself in such a position? Which brings us to the wider point that the trade negotiations cannot be analysed separately from intensifying U.S.-China geopolitical rivalry and related security interests.

Furthermore, China has made no concrete indications of how the large ramping up of purchases of U.S. exports required by the deal will occur. In fact, the only viable method to do so, preferential quotas for U.S. sellers, appears to be off the table for agricultural goods at least.

After the deal was struck a senior Chinese agriculture minister Han Jun, who was part of the Phase One negotiating team, was reported as saying that the country’s low-tariff import quotas for agricultural commodities in 2020, which were already set in place in 2019 prior to signing the deal, will be offered to global markets and “we won’t adjust it for one country”.

China operates an agricultural import regime that specifies an annual quantity of specific products that may be imported subject to a 1 per cent tariff rate. Once that low-tariff quantity is reached tariffs jump to 65 per cent for further imports, which protects market share for domestic producers. The 1 per cent rate is open to all market participants on a first come, first serve basis and therefore is non-discriminatory.

If preferential quotas are off the table for agricultural goods it is reasonable to assume, absent concrete reports to the contrary, that this will be China’s position for other sectors also. This then begs the question of how China, if it were actually inclined, could possibly increase by sixty-six percent its annual purchases of U.S. agricultural goods.

Using agricultural purchases as a proxy for the wider agreement the view taken here is that the $200 billion ‘Phase One’ purchase commitment is unrealistic over a two year period.

A deal for time?

On practical and strategic grounds it is unlikely that China can or is willing to fully implement its ‘Phase One’ purchase agreement. ‘Phase One’ appears to hold little of substance for either side, and little by way of realistic mechanisms by which the main focus of this deal, the bi-lateral trade deficit, can be substantially reduced.

The next round of negotiations must deal with far more intractable problems of the trade conflict, namely U.S. demands that China fundamentally restructure its unique state-led model of capitalism to a more market-led model. However, China’s model of capitalism is not up for negotiation, thus an implacable impasse looms ahead. It is in this context that the ‘Phase One’ deal perhaps reveals its true value – time.

The nature of the purchase agreements are such that both sides can plausibly claim that they will be fulfilled slowly over the course of the coming year, thus allowing for a temporary détente.

During this ‘Phase One’ détente President Trump gains time for concentrating on domestic politics in the U.S.’s election year, as well as the optics of another trade win for his political base. China gains time to deal with a slowing economy and a chance to further prepare for U.S. efforts at containment (see here, here and here) that have continued apace parallel to trade negotiations. Consequently, while any constructive U.S.-Sino re-engagement is a welcome respite from the current trade war, it is difficult to view this deal as a turning point in relations.