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The Phase One Agreement and Technological De-Coupling

Jan 29, 2020
  • Lawrence Lau

    Ralph and Claire Landau Professor of Economics, CUHK

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The Phase One Agreement between China and the U.S. on their trade dispute was signed in Washington, D.C. on 15th January, sealing a temporary truce in their trade war, which had already lasted almost two years. This is a most welcome development, not only for China and the U.S., but also for the rest of the world. It is expected to usher in a period of relative calm and stability as well as reduced uncertainty and unpredictability, which should in turn increase both investment and consumption globally, and result in higher rates of economic growth. 

However, it is not a net win, and certainly not a big win, for either China or the U.S.--they have both suffered, and will continue to suffer, economic losses from the mutual tariffs. This is because the conclusion of the Phase One Agreement does not mean that things will revert to the status quo ante. They won’t. U.S. tariffs with rates averaging almost 20% will remain on approximately US$360 billion, or more than 60%, of Chinese exports of goods to the U.S. Similarly, Chinese tariffs will remain on slightly less than 60% of U.S. exports of goods to China. 

In fact, the estimated loss in GDP as a result of the remaining mutual tariffs is higher for China than for the U.S., in both absolute and relative terms. The total economic loss to China due to the continuing U.S. tariffs may be estimated to be 1.44% of its GDP (US$14.3 trillion in 2019), or approximately US$206 billion. The total economic loss to the U.S. due to the continuing Chinese tariffs may be estimated to be 0.31% of U.S. GDP (estimated to be US$21.4 trillion in 2019), or approximately US$ 66 billion. However, without the Phase One Agreement, the Chinese economic loss would be as high as 2.4% of its GDP or US$ 343 billion and the U.S. economic loss would be 0.52% of U.S. GDP, or US$110 billion. However, this does not include the losses of business by U.S. enterprises due to unilateral U.S. restrictions on its exports of high-technology goods and services to China. 

Furthermore, under the agreement, China is committed to increase its imports of U.S. goods and services by US$200 billion before the end of 2021. However, such Chinese purchases have to be based on commercial considerations and comply with World Trade Organisation (WTO) rules. They cannot be regarded as losses per se as China has a tremendous need for certain goods such as soybeans and pork, oil and natural gas, airplanes and advanced semiconductors, and timely imports from the U.S. can benefit China by meeting critical domestic shortages. 

But with the Phase One Agreement, at least the mutual escalation of tariffs has stopped, and the promise of an early start of the negotiations for a Phase Two Agreement, to be completed after the U.S. Presidential Election of next November, augurs well for a year of relative peace on the trade war front. 

The trade war also threatened to de-couple the established technological supply chains, not only because of the mutual tariffs, but also because of U.S. restrictions on high-technology exports of goods and services to China for national security reasons. In fact, U.S. restrictions on high-technology exports to China were instituted in the early 1950s because of the Korean War and have never been fully lifted. Chinese high-technology firms, such as Huawei, ZTE and Hikvision, have been put on an “entities” list by the U.S. Government, which in effect prevents them from buying U.S. high-technology components, equipment and services. The motivation for the “entities list” has little to do with the large U.S.-China bilateral trade deficit. The U.S. has had a large bilateral surplus in the trade in high-technology goods and services. Halting this trade will only enlarge the U.S.-China bilateral trade deficit, not reduce it. The objective of the U.S. restrictions of high-technology exports to China has been primarily to slow down the development of high-technology industries in China based on national security considerations. This technological de-coupling is a manifestation of the intentional and unintentional competition for economic, technological and even geo-political dominance between China and the United States, reflecting the lack of mutual trust. 

Such an effort can actually be quite effective in the short term. For example, Huawei had been using the Android system of Google as the operating system in all its cell phones, but because of these restrictions imposed by the U.S., it would no longer be able to do so. For Huawei, this was its own “Sputnik” moment[1]—it realised that it must develop its own operating system for its cell phones in order to stay in the cell phone business. It will probably take a year or so before its new operating system can be perfected, and another year or so for developers to develop the Apps for it. In the meantime, it is virtually banned in the U.S. and has lost business in Europe. However, given the large Chinese domestic market and the markets of developing economies, where affordability is an important consideration, Huawei’s cell phone business will survive and prosper, but it will incur significant additional research and development costs in the interim. 

Yet the Phase One Agreement is silent on whether U.S, restrictions on exports of high-technology goods and services to China will be lifted. The expectation is that it is unlikely and competition for economic and technological dominance between the two countries will persist. It will become the “new normal”. The talk on the de-coupling of the global economy and its negative impacts, especially on established global high-technology supply chains, has continued unabated. 

However, de-coupling is not just all costs, it also has potential benefits, which are, unfortunately, apparent only in the medium and long term. It is actually a good idea for the world to have at least a second source for any link in a supply chain. A supply chain can potentially be disrupted not only by trade disputes and geo-political tensions but also by natural disasters such as earthquakes, tsunamis and typhoons, and by epidemics. Having a second source can be costly, but it provides insurance against unexpected contingencies, and prevents a supplier from over-exploiting its monopoly position. A firm’s bargaining power is always enhanced if it has more than one potential supplier. De-coupling provides the conditions under which second sources may be successfully developed. In fact, for Chinese high-technology firms on the “entities” list, second, non-U.S., sources must be found, whatever the costs. 

But the short-term pain can turn into long-term gain, as ultimately down the road, the developed second sources will not only allow the Chinese high-technology firms to resume doing business as before, but also will become available to all other users in the world. When competitors can offer similar products and services, export restrictions no longer serve any purpose. This will provide some restraint to the exercise of monopoly power by some of the high-technology firms and lower the cost to all users. 

Just as the world has benefitted significantly from having two major commercial passenger aircraft manufacturers, Airbus and Boeing, instead of only one of them, having two independent but parallel and mutually compatible 5G systems for wireless communication is actually not a bad idea. It will prevent a single firm from becoming a monopoly supplier of 5G equipment and services. Competition can only result in higher welfare at lower cost for all the consumers of the world. Some diversification, separation and redundancy, are actually good for the stability and sustainability of any system as a whole, so that when disaster strikes, not everything will go down together. For example, for a large country, it may be better if the national electricity grid is separable, so that there is no risk that the entire country will go dark at the same time. 

Moreover, with the rise of artificial intelligence and big data, a monopoly, unrestrained, can exploit the consumers even more. This is because given its access to the massive information on its potential customers, it can actually individualise the price of its good or service in accordance with the ability and willingness of the customer to pay--it can practice perfect price discrimination against each and every one of its customers, appropriating all of their consumer surpluses. This abuse of monopoly power, coupled with perfect price discrimination, can only be curbed with effective competition, that is, by a second source of supply.[2] 

One of the consequences of the China-U.S. technological competition is the de-coupling of the global high-technology supply chains. This will be costly for everyone in the short run--for the Chinese high-technology firms, their U.S. suppliers such as Google and Intel, and consumers worldwide. But it can actually generate benefits for the world as a whole in the long run. We should accept that de-coupling may be may be unavoidable in the short run but try to ensure inter-operability through the establishment of common and open global standards. In. However, in the long run, the world will be better off having two suppliers of similar good or service who have to compete with each other.

[1] The unanticipated success of the launch by the former Soviet Union of the first artificial satellite, Sputnik 1, into space in 1957 triggered the race between the former Soviet Union and the U.S. to send the first man to the moon, which was finally won by the U.S. in 1969 (Neil Armstrong).

[2] Of course, appropriate legal safeguards on individual information privacy can also help to prevent something like this from happening.

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