Kevin Nealer published in Nikkei Asian Review

July 31, 2017

Principal Kevin Nealer's article "How the US and China could avoid a trade war " was published in the Nikkei Asian Reivew on July 31. See the article here, or below.

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The markets are undervaluing the growing risk of trade protectionism under the Trump administration. Ever since he considered running for U.S. president in 1988, Donald Trump has changed political parties at least five times and has switched positions on hot button issues including abortion and gun control. But he has been remarkably consistent in declaring that trade deficits matter and voicing support for managed trade.

For his supporters, there is no more keenly felt political touchstone. National polling shows that "bargaining with global companies to keep jobs in America" has received 75% approval in Trump counties -- higher than "dealing" with North Korea (68%) or getting a conservative justice on the Supreme Court (38%).

Trump's electoral interests reinforce his policy beliefs. Although he lost the popular vote by a margin of 2.1 percentage points, he gained the presidency by winning most of the toss-up states. He won 75 electoral votes in states where the winning margin was 1.2% or less. These included key steel-producing states -- Michigan (which Trump won by 0.3%), Wisconsin (0.7%) and Pennsylvania (0.7%). 

After the inaugural U.S.-China Comprehensive Economic Dialogue closed on July 19 with no meaningful progress, Trump said: "They're dumping steel and destroying our steel industry, they've been doing it for decades and I'm stopping it. There are two ways -- quotas and tariffs. Maybe I'll do both."

Trump had earlier indicated a more accommodative U.S. approach on trade with China if Beijing pressed North Korea to curb its nuclear and missile program. But Chinese trade with the North instead increased, and Pyongyang conducted its first test of an intercontinental ballistic missile (ICBM) -- a "red line" for Trump. North Korea's announcement on Saturday that it had conducted another successful ICBM test only deepens that tension.

Chinese and U.S. interests in managing North Korea risk have never been closer, but their views on how to achieve that goal remain divergent. Whether the Trump administration's expectations about North Korea were ever realistic, it has been disappointed. This increases the likelihood that highlighting Chinese trade will once again become a priority, now that the issue is no longer affected by cooperation with the U.S. on North Korea. In fact, any unilateral U.S. sanctions imposed on Chinese financial institutions and individuals that  violate international curbs against Pyongyang will only add to trade friction. 

Since Chinese President Xi Jinping cannot afford to be seen as weak in dealing with an aggressive U.S. trade agenda ahead of the Chinese Communist Party leadership conference later this year, Beijing is preparing a list of U.S. goods against which it would retaliate if the U.S. acts unilaterally against steel and aluminum imports from China, along with those from Canada, South Korea, Mexico and Germany, on national security grounds. 

Win-win option?

There is an alternative scenario that could allow Trump to declare a win on this fundamental political issue. By far the largest-ever dollar value of trade restrictions were imposed by the administration of U.S. President Ronald Reagan in the 1980s. They relied heavily on the practice of "voluntary" restraint agreements (VRAs), despite being prohibited by the World Trade Organization. This mechanism involved using U.S. market leverage to impose import ceilings on products, including steel, autos and semiconductors, that mainly came from Japan. These coercive measures nonetheless allowed both sides to claim they had made their own determination about the "appropriate" level of exports to the U.S. and allowed U.S. companies to adjust to the entry of a fixed volume of foreign products.

This deal with Tokyo encouraged the Japanese to increase production of cars in the U.S. and persuaded them to export luxury car brands instead of low-end economy models that had the unintended consequence of undermining U.S. car companies, eroding their dominance of this high-end segment in the domestic market. 

The current U.S. Trade Representative Robert Lighthizer was a proponent of VRAs in the Reagan era, and he and U.S. Commerce Secretary Wilbur Ross have made clear that they intend to seek concessions from Beijing. VRAs could allow Xi to claim that such limits assure predictable market access to Chinese exporters while avoiding the humiliation of U.S.-imposed trade restrictions. They would also be consistent with China's own five-year plan to migrate to higher value-added production, such as replacing steel exports with finished products made from steel.

The markets would view VRAs as lowering the risk of a trade war since both sides would agree to them. China would not have grounds to retaliate against U.S. restrictions on its exports, so VRAs on steel would likely be understood as containing the threat of protectionism.

While VRAs would possibly mitigate the risks created by the pending decision on steel imports, Chinese officials know the history of Japan's trade tensions with the U.S. Once the Trump administration succeeds in one area, it may want to use VRAs for other products. The pressure for VRAs will not ease until Trump can say that he wiped out the nearly $350 billion U.S. trade deficit with China. In addition, Beijing will worry that, despite its domestic censorship of the internet, reports leaking from Hong Kong would portray the export limits as a burden on Chinese products to appease U.S. economic aggression.

The situation could be seen by Chinese business elites and the public as bearing an unwelcome similarity to the U.S.-Japan trade relationship in the 1980s. That is not a story line that Xi wants as he prepares for the party congress. Moreover, it would make it harder for China to resist similar demands from other foreign markets, such as the EU, which might also want to limit Chinese imports. 

While VRAs may provide a way to limit the risk of a trade war, Beijing may elect to take a hit on steel and aluminum, but then retaliate on agricultural products, aircraft and financial services from the U.S. This would escalate bilateral trade tensions. But bear in mind that no form of trade restrictions will ever return American steelmaking to its pinnacle of the 1970s.