Written by Professor SHENG Hong, Director of Unirule Institute of Economics

Translated by Mr. MA Junjie, Project Researcher of Unirule Institute of Economics

This essay was first published by FT Chinese on Aril 9th, 2018:  http://www.ftchinese.com/story/001077053?archive

Standard economic models tell us, both parties of a trade war would lose. How can there be a win-win scenario? This, apparently, is a textbook question, and reality is more complex than the textbooks. For instance, the trade war President Trump wants is not a typical trade war. Freedom is a value that has been cherished by the American people for a long time, and the US government is unlikely to defy the principles of free trade. When President Trump threatened to reduce the trade deficit to China by USD 10million, the target audience was his American constituents, since that was “the main reason he was elected”; it is, apparently “politically incorrect” to raise the trade tariffs against Chinese products simply because of China’s tremendous trade surplus against the US’. This is the unspeakable reason that won’t win the support of other countries in the world. President Trump justified his policy by claiming that trade with China was “unfair”. Apparently, free trade is fair free trade. If it is unfair, it is not worth “defending”.

Then, what’s unfair about it? Firstly, President Trump pointed to technology theft by Chinese firms from American companies, or forced technology transfer to Chinese firms by using market access as leverage; secondly, the Chinese government has been subsidising Chinese enterprises generously, which led to over capacity, oversea dumping, and therefore, lower price in the global level; thirdly, the Chinese government impeded or restricted the free flow of Internet data, which caused about USD 400billion for American companies operating Chinese soil; and lastly, China limits market access against American companies in areas such as telecommunication, credit cards, and movie industries. 

From a purely theoretical point of view, all these allegations of “unfair” dealings make sense. The economic textbooks assume that free trade is undertaken with fair market competition. In a fair and effective market, there needs to be protection of intellectual property rights, no discrimination towards different enterprises, no restrictions on market access, and no restrictions on market access by constraining data flow. Regarding these principles, even the freedom-championing Chinese government would concur. However, the problem lies in the authenticity of these accusations; or if these accusations are true, they are likely to be exaggerated as an excuse for protectionism. I think the latter scenario makes more sense. 

After four decades of reform and opening-up, China has become a market economy basically, though not completely. The Third Plenary Session of the 18th Communist Party of China (CPC) Central Committee stipulated that “the market should play a deciding role in resource allocation”, which indicated that the Chinese government would carry on marketisation reforms in order to eliminate bad practices and regulations that go against market economy principles, such as infringement of intellectual property rights, discrimination towards different enterprises, restrictions on market access, and limit on the free flow of data, etc.. In this sense, what the US is accusing China happen to be the targets of China’s reforms. They go hand in hand. If the US government has no other schemes, by correcting these wrongs, the Chinese government would not only dodge the US’ accusation, but also benefit itself. Why? Because a complete market economy is good for China. 

In the area of intellectual property rights, China is joining the global leaders. Even though the quality of the patents filed needs to be improved, the number of patents ranks No. 1 in the world. Main industries in China has developed to dominate in the world market by scale and technology, most of which relies on self developed intellectual property rights. We can not rule out the fact that there might be particular Chinese firms “stealing” technologies from other countries, or there might be forced technology transfer in a joint venture. But this does not constitute strategic technological advantage. Therefore, it cannot be Chinas national strategy, either. Concerning China’s national interest, enhancing the protection for intellectual property rights, instead of weakening it, would benefit China’s economic growth. If this protection goes beyond the national level into the global level, it implies that intellectual property rights of Chinese firms’ should also be protected overseas, just like that of all other firms from other countries. Therefore, the global system of intellectual property rights needs to be defended so that China’s intellectual property rights are respected beyond its borders. Hence, preventing technology thefts and not forcing foreign companies to hand over their technologies for market access would benefit China, instead of harming it. 

When it comes to government subsidies, we are talking mainly about government subsidies for state-owned enterprises. There are two types of enterprises, state-owned and private-owned, in the targeted steel and aluminium industries by the US. These two types of companies are competing. Private-owned companies are impossible to be government subsidised, whereas state-owned enterprises are heavily subsidised. With these subsidies, they would never have survived thanks to their low efficiency. Besides, these state-owed enterprises also occupy government-owned resources. For example, Aluminum Corporation of China Limited(CHALCO) is nicknamed “King of Loss” as a state-owned enterprise that has been making a loss for eight consecutive years with a total volume of RMB 45billion. It lost RMB 16.2billion in 2014 alone, and got government subsidy of RMB 823million. In fact, state-owned enterprise get more than subsidies that are shown in books. Almost all state-owned enterprises enjoy subsidies for using state-owned land for free, and subsidies for getting low interest rate loans. According to a Unirule research, the net asset rate of return in face value of the state-owned and state-controlled enterprises in 2001~2013 was 9.08%, while the real rate of return after deducting the underpaid land rent, cheaper interest rate loans, and royalties for free use of natural resources was -3.67%. That is to say, all of them have been making a loss in their business operations. 

These constitute the major reasons for overcapacity in China’s steel and aluminium industries. In these two areas, it is impossible for private-owned enterprises to over produce, since once they do so, they will lose money till they go bankrupt. However, it is another case for state-owned enterprises that tend over produce thanks to free use of land, low interest rate loans, and government subsidies. Therefore, the overcapacity in steel and aluminium industries is not only a global trade issue, but it is first and foremost a market issue in China. Hence, one of the priorities for initiating the supply side reform in 2016 was to cut overcapacity, which also implied reducing state-owned enterprises’ capacity. However, due to the strong government backing for the state-owned enterprises, the task of cutting overcapacity only affected SOEs slightly, and in many localities, it was the private enterprise with little government backing that got squeezed. In doing so, the policy of cutting overcapacity resulted in counterproductive effect, constraining the capacity of private enterprise even more. 

In this light, undertaking SOE reforms is the only way to solve the overcapacity issue, and the ultimate goal should be that all SOEs withdraw from profit making areas. Firstly, the monopolistic privileges and government subsidies for SOEs should be cancelled. If we consider free use of state-owned land and getting access to low interest rate loans a low price monopoly for the buyers, then it is quite the type of “administrative monopoly” that the report of the CPC’s 19th party congress resolved to “break”. So, what the US requires actually matches the reform object for China’s domestic need. The overcapacity issue of China’s steel and aluminium industries can only be solved by letting those loss-making companies retreat from the market in a fair market competition where there is no government subsidies. If administrative monopolies and government subsidies are canceled, not only would the overcapacity issue for the steel and aluminium industries be solved, but it would also accelerate the macroeconomic growth. I once estimated that if the real loss of SOEs were zero, giving the total net asset of SOEs(financial and non-financial) was RMB 5.2billion, there would be an extra 3.3% annual GDP growth rate. 

Similarly, it would also benefit China to allow the free flow of data. Chinese government is concerned with cyber security and it is absolutely right to stress the cyberspace sovereignty. However, the Internet authorities are expanding their powers thanks to the lack of constraints in the Cybersecurity Law. It is weakening and violating Article 35 of China’s Constitution and also shrinking the digital space in people’s everyday life and work. For instance, without VPNs, scholars cannot access foreign academic websites, such as Google Academics, which is purely non-related to politics. Tourists cannot use Google Maps, or other commercial websites, such as Amazon and Airbnb. Some even cannot visit the websites of Chinese embassies. Needless to say Internet regulations without constraints is in fact suppressing criticism of the government departments and exposures of corruption, which harms the Chinese society deeply. It would also influence the normal life and work of foreigners and foreign companies that are on Chinese soil.  

The Fourth Plenum of the 18th CPC Congress emphasised “rule of constitution” that guaranteed the protection of citizens’ constitutional rights. It means Article 35 of the Constitution should be ensured. Article 12 of China’s Cybersecurity Law also stipulates that “The state shall protect the rights of citizens, legal persons and other organizations to use the network in accordance with the law… and guarantee the orderly and free flow of network information in accordance with the law.” In fact, the Chinese government has made certain adjustment recently. In my experience, some of the once hard to access websites are easier to access now, including Google Translate, Amazon, Airbnb, some academic websites, and some news websites, such as the CNN, etc.. This indicates that the Chinese government knows about the damage such constrained data flow by the Firewall has been doing to the country. Besides, in an era where there is such advanced information technology, the certain authorities cannot expect to have their goals met. China’s Constitution and other laws, and the the government’s recent adjustment, do not fall far from the US’s plea to allow free flow of data. All in all, the free flow of information is even more important than free trade, because the uninterrupted exchange of ideas will allow China to better stimulate technological and institutional innovation. 

It is slightly more complicated when it comes to free access to market. Telecommunication and banking are administrative monopolies in the first place. Therefore, the first step to take is to break the administrative monopoly in these industries, and open the market to private enterprises. This is also the reform goal of China’s recent efforts. The 19th CPC congress proposed to “fully apply negative lists for market access, eliminate regulations and practices that hinder a unified market and fair competition, and support the development of private enterprises… ” besides “breaking administrative monopolies”. In 2018, a market access negative list has been put in place. In this list, there is no entry restriction for commercial banks and telecommunication basic operations, therefore, all market players, including Chinese private enterprises and foreign ventures are allowed in the market. Mr. LIU He, Vice Premier of China, also said at the Davos Forum that the Chinese government was going to open the financial industry this year. However, there is restriction for market entry in the film industry, which is mainly an ideological concern. It is because of this concern, that Chinese movies as a category of arts lack international competence. If such restrictions are removed, Chinas film industry will surely showcase its capacity in China, and it does not have to fear competition from Hollywood. 

Most of the recent commentaries on the “Sino-US Trade War” focus on the “war” too much. Taking a look at China before it joined the WTO, and considering China’s WTO negotiations, we realise the better way is to “talk” instead of “war”. By negotiating, a win-win or a better institutional equilibrium will emerge when countries deal with conflicting interests. WTO rules require China to lower its tariffs and open its domestic market, which made Chinese people believe “wolves were coming” and Chinese companies would be no match for their foreign competitors. However, thanks to the market reforms after joining the WTO, Chinese are inspired to be entrepreneurs, and Chinese companies are winning grounds in the domestic market while China’s achieving surplus in global trade. Foreign companies also expand their profits thanks to China’s market scale. In this background, we see the four decades of Chinese miracle, which also made China confident as it is today. Faced with US pressure, the Chinese government responded reciprocally with caution. It is more important to use this opportunity and promote further reform, open the domestic market, and eliminate, once and for all, the “excuses” that the US is starting a trade war with China for. Doing so is much less risky than when China’s was seeking to join the WTO years ago. 

What would be if China removes the bad practices and regulations that are against the market economy principles, such as canceling subsidies and breaking monopolies? The Chinese economy will grow faster, and it will be more competitive in the global market. Then, will China’s trade surplus decrease? No, it will only get bigger. The reason is, even with the government subsidies and cheaper resources, the Chinese SOEs are less efficient, and the average cost for them is still higher than those private enterprise that are without government subsidies. For instance, when CHALCO was losing money in 2016, its private-owned competitor China Hongqiao Group’s shareholders got net profit that amounted to some RMB 5.1 billion. In the steel industry, for the first three quarters of 2016, the margin of profit for private enterprises was 3%, much higher than the average 1.73% of the industry. If the administrative monopoly is broken, e.g., if we break the banking monopoly, the interest rate difference between deposits and loans for commercial banks would be 0.5%~1% lower; if we break the oil and gas monopoly, the retail price before tax for gas will be 21% lower(according to 2015 data); the cost for resources for the whole economy would become lower. Therefore, if the Chinese government keeps the market reforms alive, phasing out SOEs, and replacing them with more efficient private enterprises, with the lower resource cost, these private enterprises will be more competitive in the global market, which would potentially increase China’s trade surplus to the US.

Does this go against President Trump’s goal of cutting the USD 100billion trade deficit? I fact, we need to remember that President Trump is a businessman who’s used to bargain, as a conventional strategy. As mentioned above, he was saying that to his constituents, and he did not mean what he said. In fact, keeping a certain level of trade deficit is good for the US. Why so?Because in a general sense, the US does not run a deficit if we take the US dollar as a commodity. In fact, the US dollar is a more profitable commodity. Accordingly, printing one 100 dollar bill would cost 4 cents, and the rest of that bill’s worth is called Seigniorage. In addition, in many cases, big volumes of trade does not require cash, but numbers in the book, and the seigniorage is much higher. Even with the other cost of keeping the facility needed for maintaining the whole currency system in the US, that cost must not be more than 20%. There is no other single commodity that has a profit margin of 80%. Isn’t it a good business?

Of course, this income is not the only income the US government gets, and it is not the income of private enterprises. However, it is not difficult to transfer this big amount of seigniorage to the citizens. All that’s needed is to lower the tax rate. In effect, it does not only lower the tax burdens by the same amount in US dollars for the enterprises, but it will stimulate private investment, even lead to inflow of foreign investment. The tax reform brought in by President Trump recently is a vivid demonstration. Many American enterprises, such as Apple, and some foreign companies, such as Toyota, has expressed their intention to invest heavily in the US. Where this is investment, there is employment. Is there a better way to “bring jobs back to America”?

However, transferring the benefit of large volumes of seigniorage to the citizens would go against another goal of Trump’s, that is to strengthen its military buildup. Why? Because much of the US defence expenditures rely on the income of seigniorage. In 2016, the defence expenditure per capita was USD 1892, approximately USD 151 higher than the average of other countries. The total defence expenditure of the US is some USD 562.3 billion higher than other countries’ average, which I call the “Empire Cost”. Empirically speaking, this part comes mainly from the seigniorage that the US “sells” through trade deficit. However, the US dollars that have been sold is the obligations the US have for its foreign debtors, so to speak. There are limits when these dollars are used among non-Americans. Therefore, in normal cycles, foreigners uses these hard-earned dollars to buy American assets from Americans. Therefore, we see the trade deficit of the US somehow mirrors the capital surplus shown as below. That is to say, the US retrieves the US dollars through trade deficit in order to maintain balance for the US dollars in the world. 

Ever since the 2008 financial crisis, the credibility of the US financial assets decreased, bringing in less capital inflow, and reducing trade deficit. It would require a PhD dissertation to explain the relation between trade deficit and capital surplus, though. As the trade deficit decreased, the income by US seigniorage decreased, too, which can no longer sustain its defence budget.(shown as below) Before 2008, the capital account surplus was higher than US defence expenditure; after 2008, it was lower. This brings pressure to the US financial policy, which explains from the fiscal perspective why under the Obama administration, the US withdrew globally. 

To put it in a simple way, since a large part of the national income comes from the seigniorage, and the trade deficit comes from sales of the US dollars, the US fares well fiscally when the trade deficit is large; vice versa. (shown as below) The financial deficit moves to the opposite against the trade deficit. In the chart below, the US ran the biggest financial surplus in 2006 when there was the largest trade deficit; whereas it ran the biggest financial deficit when the trade deficit was at its lowest. Hence, from the financial point of view, a certain level of trade deficit benefits the US. 

Defence expenditures claims the biggest chunk of US’s financial expenditure. When the tax revenue and the seigniorage were heavily influenced by the economic environment and the global trade constraints, the defence budget was impacted most heavily. Therefore, Trump’s goal of decreasing the trade deficit goes against his goal of military expansion. Maintaining a fairly large trade deficit is good for maintaining the US military buildup. If the income from seigniorage by trade deficit is transferred to the citizens, it will also limit the military expansion. What’s worth noting is that expanding the military or engaging in military competition will not benefit the US. If the income of seigniorage by trade deficit is used on tax relief, it is essentially good for the US. That is because there is a proper scale of defence budget where its main purpose is to defend the sovereign land and the national interest. When such a budget runs too high, it will distort the behaviour of this country. 

With a military that’s too large and powerful, resorting to war to solve problems becomes an easy option. The flaws of the US political institution is there is little limit on its moves towards other countries. And in most cases, misjudgements take place when the current cost and effect analysis overwhelms. That explains the multiple mistakes when it comes to war after the WWII. It is said that when the US government deployed troops to Vietnam, there were only three people who understood Vietnam. In the Iraqi War, massive destruction weapons were not found eventually, but tens of thousands of Iraqi lives and the death of 4500 US soldiers were a result. The US Middle East strategy is a strategy of solving the problems it caused in the first place, which not only destroyed the Middle East, but also involved Europe. In order to deter Iran, the US supported Saddam Hussein; in order to fight against the former Soviet Union, the US supported Bin Laden; in order to counter Bashar al‑Assad, the US created the ISIS. All of them later became US enemies. Perhaps it is because of the excessive military expenditure that these mistakes took place. Therefore, what threatens US security is not the lack of military budget, but the excessive military budget.  

With too much to spare in the military, the military-industrial complex achieved what it was set up for; and with this complex, the military budgets grows bigger and bigger. It is the very existence of the iron triangle of Pentagon-military industrial groups-military industrial regions that the US political structure tends to create tension and use force in global decision-making. Originally, the US military expenditure decreased gradually after the Cold War, but with the Afghan War and the Iraqi War, another expenditure that’s up to USD 180 billion for Overseas Contingency Operations(OCO) were added to the normal military expenditure. Therefore, to cut military expenses is to undermine an interest group that takes in interests of war on cost of the national interests of the US. The true interest of the US lies in returning to the balance of global strategy, in order to reduce mistakes. It also lies in joint efforts with other powers of the world to create a peaceful environment for development. It fits the national interest of the US to cut military expenses for tax reforms, and increase the competence of American enterprises.  

Therefore, if China keeps its market reforms and trade more fairly with the US, China’s trade surplus will grow even larger; if the US maintains a fairly large trade deficit through fair trade with China and uses the seigniorage in reducing taxes instead of increasings it military expenses, then American investment and employment will increase. If Chinese capital invests in the US due to the lower tax rate, and American capital invests in the Chinese market due to its opening up, the economic bond between these two countries will grow stronger, and a military rivalry is out of the picture. In the long run, the US industries will grow in competence and benefit from the low tax rate, which will reduce the trade deficit. By then, the domestic market of China will be much larger than that of the US, making it an ideal oversea market for American enterprises. Whereas China, with its financial and telecommunication industries maturing through competition, will shift to an economic pattern that balances the trade surplus with a more credible RMB. This is a win-win prospect. 

Is it at all possible politically, then? It is. We should understand that Trump’s threat to levy USD 100billion tariffs on Chinese products is a bargaining strategy, waiting for China’s response. Raising the stake is merely for achieving the minimum, instead of the object itself. What Trump wants is a more open and bigger Chinese market. As analysed before the Chinese government has resolved to protect intellectual property rights, break administrative monopolies, maintain fair competition and keep opening up, and it has issued specific rules, regulations, and policies. What the Chinese government needs to do is to speed up this process and implement such measures so that Trump would not feel neglected. It would also look like the Chinese government does all those by its own will instead of under coercion. If this is true, Trump won the trade war before it actually gets started, and a bigger Chinese market is right in front of the eyes of the American enterprises. Trumps also knows the substitutionary relation between military expenses and tax relief, but he pushed reducing taxes in order to cut military expenses as much as possible. Some of his measures come in the form of requiring Japan to shoulder more of military expenses for the deployed US military in Japan, or speeding up the withdrawal of US army from Afghanistan, indicating that he prefers tax reduction than a stronger military. If both parties, China and the US, knows these economic and political interests, the negotiation would not be so difficult.