China’s Response to the U.S. Trade War
China’s leadership has managed well in adjusting to the trade and technology restrictions imposed by successive U.S. administrations. Trump’s tariffs did not achieve the objective of reducing the bilateral trade deficit, but they did lower China’s share of U.S. trade. If the intention was to weaken China economically, however, this has not yet happened. The combination of pandemic-related global demand for China’s manufactured goods and China’s success in developing alternative markets minimized the negative consequences of the trade war. Any reduction in China’s “direct” exports to the United States has been offset by increased “indirect” exports from other countries. Meanwhile, China’s share of global exports hit record highs and its imports as a share of GDP declined steadily. The world has become more dependent on China, while China has become less dependent on the world. If Biden’s intention is to focus more on security concerns by limiting China’s technological progress and diversifying supply options, the cost is likely to be substantial in the form of inflationary pressures, production inefficiencies, and damaged global growth prospects. U.S. politicians, however, have strongly supported these punitive measures since the benefits from appearing to be tough on China resonate well with voters. For Beijing, the major challenge now is to develop alternative export markets and to become more technologically self-sufficient.
Origins of the Trade War and China’s Response President Trump launched a trade war with China based on the belief that trade deficits are a sign of economic weakness and that China was the culprit since it accounted for the bulk of the U.S. deficits on a bilateral basis. The justification was established in 2017 with an investigation by the U.S. Trade Representative on China’s alleged unfair trade and foreign-investment policies. This provided the basis for a 25 percent punitive tariff in the summer of 2018 on $50 billion worth of Chinese imports. China retaliated with its own tariffs, leading to the White House levying an additional 25 percent tariff on $200 billion of Chinese goods and lower rates for other products. After a brief truce, negotiations broke down and the United States increased tariffs on another $200 billion of Chinese goods. China retaliated with increased tariffs on $60 billion of U.S. imports. Under threats of higher tariffs, a Phase One Agreement was reached in January 2020 under which China promised to import an additional $200 billion over the following two years and to reform its trade practices. But the more contentious structural issues regarding protection of intellectual property rights and the unfair practices by state enterprises were left for future negotiations. Separately, in 2018 the Trump administration sanctioned the Chinese telecommunications firm ZTE for trading with Iran and North Korea and later Huawei as security threats in providing 5G telecommunication services. The Biden administration has reinforced these punitive actions, but it has focused less on trade deficits as a justification and more on security and human rights concerns. Hundreds of Chinese firms have been added to the Department of Commerce’s Entity List that restricts their access to U.S. high-tech products. The most significant action was to restrict China’s access to advanced semiconductors and related manufacturing equipment in October 2022. Measures restricting financial and investment flows to and from China as well as professional and scientific exchanges have been strengthened. Together with campaigns pressuring U.S. allies to support these policies, these actions have been characterized by many observers as a decoupling of the two economies. Senior U.S. officials, however, have recently stressed that the intention is not to contain or decouple from China, but to mitigate risks, even as observers note that the punitive measures have negative economic consequences and will impede China’s goal of becoming a major innovative power. Aside from responding to U.S. actions with retaliatory tariffs, Beijing introduced its own Anti-Foreign Sanctions Law in 2021. It also approved its own version of several U.S. regulations –an export or trade law and an entity list – allowing China to penalize foreign companies for actions seen as contrary to its interests. However, Beijing reacted relatively mildly to the sanctions on ZTE and Huawei and the more recent technology and financial restrictions, largely because most options would have been self-defeating. For example, imposing restrictions on U.S. companies like Apple or General Motors that have major production bases in China would mean loss of jobs for Chinese workers. Cutting off U.S. access to China’s supplies of so-called rare earths that are needed for green technologies would lead to developing alternative supplies elsewhere. For both sides, formulating appropriate policies was a challenge because the rationale for Trump’s tariff-fueled trade war was flawed. Trade deficits (or surpluses) are not inherently good or bad economically. Furthermore, trade is not a bilateral but rather a multilateral phenomenon. It is the overall balance that matters rather than what the country’s trade balance might be with any specific country. Ironically, the trade war was launched precisely at a time when China’s trade surpluses were no longer a global concern. China’s current account surpluses hit a record high of over 10 percent of GDP in 2007, but they evaporated over time to only 0.2 percent of GDP by 2018 when the U.S. tariffs were launched. Beijing’s general response to Washington’s allegations of unfair trade practices was to call for continued dialogue and to point out that progress had been made on many of the concerns. A major complaint was that foreign firms were forced to transfer their technologies as a condition for accessing China’s domestic market. Beijing’s response was that such practices had been largely eliminated and relevant guidelines had been revised. Regarding weak protection of intellectual property, for example, special courts to deal with violations were strengthened, and progress was reflected in a 2020 survey of U.S. firms that indicated that 70 percent believed that China’s intellectual property rights (IPR) policies had improved. Trump’s trade war tariffs on China as well as on other countries contributed to general downward pressures on the growth of global trade that was stagnant from 2018–2020. As discussed later, these tariffs and trade restrictions ultimately failed to reduce U.S. trade deficits or alter China’s position as the leading global exporter. In part, this was facilitated by the COVID pandemic that provided a major boost to China’s exports to the West. China’s draconian handling of the pandemic facilitated a sharp industrial supply response compared with declines in United States and Europe. China benefited from strong global demand for pandemic-related products, such as surgical masks and ventilators. Demand then shifted to electronics and communications equipment for households operating under lockdowns and later to a broader range of industrial products that other countries had been unable to fill because of logistical disruptions. Monthly production growth rates during the peak of the pandemic ranged from 15 to 40 percent for medical supplies, electronics, and home furnishings. Combined with the depressed demand for imports during the pandemic, this paved the way for the large trade surpluses in recent years. Trade War Impact from a U.S. Perspective Nearly all the economists surveyed in 2018 at the launch of Trump’s trade war argued that the tariffs would not reduce America’s trade deficits and the costs would be paid largely by Americans. That argument has been reinforced by recent U.S. Census Bureau data (Figure 1), indicating that the U.S. merchandise trade deficit with China was larger in 2022 than what it had been when President Trump became president, while America’s overall trade deficit had hit a record high of $1.18 trillion. Trade balances are determined by how much a country saves and spends, not by tariffs. The combination of President Trump’s large tax cuts and President Biden’s huge expenditure initiatives resulted in soaring budget deficits that were then mirrored in record trade deficits. All this has little to do with China’s policies.
But the focus on bilateral trade numbers masks the dramatic decline in the relative importance of China in U.S. trade relations. Whereas China accounted for 47 percent of the U.S. trade deficit in 2017, it accounted for only 32 percent last year. But China’s decline was partially offset by the increasing shares of other East and Southeast Asian countries, with the result that the U.S. trade deficit with the East Asian region fell from 69 percent to 63 percent (although the absolute amount increased by about $200 billion). Western Europe’s share of the U.S. overall trade deficit also declined, from 21 percent to 18 percent. In contrast, the shares of America’s neighbors, Canada, and Mexico, increased by about 7 percentage points and those of the rest of the world by 4 percentage points.
The significance of these shifting trade balances differs between imports and exports. U.S. imports increased by about $900 billion from 2017 to 2022, of which about $700 billion was in manufactured goods. China’s share of the total declined from 21.6 percent in 2017 to 16.5 percent in 2022 (even though the value remained unchanged over this period). In contrast, imports from the rest of the world were 48 percent higher in 2022 compared with those in 2017.
As for U.S. exports, the total averaged about $1.5 trillion from 2017 to 2020, but driven by exports of energy products and chemicals to Europe to compensate for reduced purchases from Russia, they then jumped to $1.9 trillion in 2022. The share of U.S. exports to China decreased from 8.4 percent to 7.5 percent from 2017 to 2022. Higher tariff-related costs of imported inputs combined with China’s retaliatory tariffs resulted in U.S. exports to China being 23 percent lower than they would have been in the absence of the trade war. The overall consequence is that the U.S. share of global manufacturing exports has continued to decline despite the priority given by both the Trump and Biden administrations.
Impact of the Trade War from a China Perspective
Although the U.S. tariffs led to a decline in China’s exports to the United States for a few years, the impact was short-lived. As a result, the trade war did not have a significant impact on China’s trade surpluses with the United States, which were about the same last year as compared with 2017 (Figure 2). More significant, China’s overall trade surplus rose from $783 billion in 2017 to $1,130 billion in 2022. The increase came from increased exports to Western Europe and also to other Asian countries as well as America’s neighbors – Canada and Mexico.
These trade figures show that the Phase One Purchase Agreement calling for an increase of $200 billion in China’s imports from the U.S. was a total failure. There was no significant increase among the three major categories of manufactured goods, agriculture products, and energy, and the agreement did nothing to reduce America’s bilateral deficit with China.
That the purchase agreement turned out to be unworkable should not have been surprising. State-to-state purchase agreements have no logical basis when global trade is shaped by the market-driven decisions of firms and consumers and when they are subject to unpredictable economic shifts and natural forces such as the pandemic. Beijing likely recognized all these caveats but signed on anyway given Washington’s insistence that this was the only path to preventing additional tariff increases.
Asking China to buy more U.S. manufactured goods when Washington was simultaneously restricting its access to high-tech products made little sense. Sales of Boeing aircraft fell far short of intentions because of certification problems. In other categories, market shifts made the purchase commitments unappealing. China bought more soybeans from Brazil because of lower prices and commitments as a BRIC member, and the Ukraine war diverted U.S. energy exports to Europe, while China bought more oil from Russia because of discounts.
Yet the Biden administration still insists that China honor the purchase agreements, and it links the possible removal of tariffs to their fulfillment. For China’s leadership, honoring an agreement that made no sense to begin with as a condition for dropping another equally ineffective policy defies logic.
China’s role in dealing with the trade war cannot be separated from that of East Asia more broadly. The East Asian production-sharing network is characterized by production and trade in a variety of specialized parts and components, with China at the center of the assembly process. The final product is then exported, largely to the United States and Europe. East Asia has accounted for a stable 40–45 percent of U.S. imports of manufactured goods over the past several decades (Figure 3). But the origin of the exports shifted dramatically after China joined the World Trade Organization (WTO) in 2001. China’s share increased to more than half, compared with less than a quarter previously. This transformed a perceived East Asian trade deficit problem to a China problem.
The U.S. tariff war caused China’s share of manufactured goods to fall by over five percentage points, but this was offset by increases from other Asian economies, notably Vietnam and smaller amounts from South Korea, Taiwan, and Malaysia. The decline in China’s exports was sharpest for those products subject to the highest tariffs of 25 percent, such as semiconductors, IT hardware, and some basic consumer goods, such as clothing and furniture. But imports of products that were not tariffed – such as laptops and smart phones because they were being manufactured in China by U.S. companies – did not decline; instead, they soared during the pandemic. For tariffed products that were not readily available elsewhere, U.S. consumers and firms ended up buying the same quantities as before but at higher prices.
China Maintains its Manufacturing Leadership and U.S. Foreign Dependency Increases
The trade war has not reduced U.S. dependency on imports of manufactured goods, which as a share of total expenditures on manufactured goods continued to increase from 23 percent two decades ago to 34 percent in 2022. In value terms, U.S. imports of manufactured goods increased by about $700 billion from 2017 to 2022, but most of the increase is now coming from countries other than China. Less well-recognized in this process, however, is how China’s supply of key inputs facilitated increased sales from these countries to the United States.
Of the increase in U.S. imports of manufactured goods over the past five years, China accounted for only $28 billion. The top two leaders, Mexico, and Vietnam, accounted for $117 billion and $80 billion, respectively. Locational advantages and trade agreements distinguish these two developing economies. Vietnam shares a border with China and benefits from the Regional Comprehensive Economic Partnership (RCEP), while Mexico shares a border with the United States and benefits from the United States-Canada-Mexico Agreement (USCMA).
Vietnam’s increase is particularly impressive given that its exports nearly tripled in just five years. Besides its proximity to China and lower labor costs, it shares a similar export orientation and political predictability that have made it attractive to multinationals trying to avoid U.S.-China tensions and Beijing’s rigid COVID policies. Most of the increases in Vietnamese imports to the U.S. were in product lines in which U.S. imports from China fell, such as computer accessories, semiconductors, and telecommunication equipment. China’s exports to Vietnam more than doubled since 2017 and its trade surplus nearly tripled to $60 billion by 2022.
Mexico’s success reflects its tariff-free access to the U.S. and shared production in the auto industry where proximity offers an unparalleled advantage given the shipping costs. China’s exports to Mexico increased by nearly 20 percent last year on top of a 38 percent increase in 2021, most of which were intermediate goods going into finished products for export to the United States. Chinese companies have also stepped up their investments in Mexico, as exemplified by Hisense’s $260 million investment to make appliances and Lenovo’s doubling of its investments in computer equipment destined for the U.S. market. Mexico’s achievements, however, have been tempered by concerns over drug trafficking, corruption, and organized crime, suggesting that much of its potential has not yet been realized.
The U.S. punitive actions toward China have reduced bilateral economic relations, but if the purpose had been to weaken China economically, there is no clear evidence of that happening. China may be exporting less directly to the United States, but it is now doing so indirectly. Aside from Vietnam and Mexico, the next five economies with the largest increases in U.S. manufacturing exports added another $200 billion. These were Canada, South Korea, Taiwan, India, and Ireland.
Take India as an example. A recent government-backed study questions the feasibility of decoupling from China since Chinese imports are vital to support India’s manufactured exports in key sectors such as chemicals and drugs. For a third of Indian companies, Chinese products are seen as the cheapest available, but for the other companies, Chinese products are seen as preferable in quality, even if they are more expensive than the alternatives. Despite trade restrictions, Indian imports from China soared in 2022 to $102 billion, a 74 percent increase from 2020.
Interestingly, the major G-7 European powers (Germany, France, United Kingdom, and Italy) plus Japan accounted for only $60 billion of the increase in manufactured exports to the United States over the past five years. Compare this with the top five East Asian exporters (Vietnam, South Korea, Taiwan, Thailand, and Malaysia) whose aggregate GDP of $3.9 trillion is only one-fourth that of the G-7 group, but their manufactured exports of $226 billion is nearly four times as large.
Among the advanced industrialized countries, Germany was the most successful in tapping the U.S. market in manufacturing. Despite U.S. pressure to reduce economic ties with China, however, Germany has found it necessary to maintain strong economic relations. German manufacturers are highly dependent on China for key components and raw materials. China is now Germany’s largest trading partner, with imports from China surging to $137 billion in 2022, a 46 percent increase from 2020.
In sum, by developing alternative export markets and tapping pandemic-driven demand in the West, China’s share of global exports hit record levels in recent years. This explains why China’s share of global manufacturing production has continued to increase – from 26 percent in 2017 to 31 percent in 2021.
Explaining China’s Response to the Trade Tensions
China’s success in maintaining its export dominance is not due to any radical reforms but to a combination of “perverse luck” and effective support for both domestic export-oriented production and for Chinese firms investing abroad driven by commercial pressures.
As mentioned earlier, luck came from the draconian COVID policies that allowed China to recover earlier than other major economies – even though China was the epicenter of the outbreak. The recovery benefited from targeted fiscal outlays for epidemic control, production of medical supplies, and support for affected groups. China also lowered interest rates, relaxed credit controls, and kept its exchange rate stable. In contrast to the United States, however, there were no massive budgetary programs to prop up household consumption. Instead, Beijing channeled vast amounts of financing primarily to small and medium-sized private enterprises to support its deep and complex eco-system geared to export production.
China’s rapid recovery also benefited from special trade facilitation and compliance measures that minimized supply disruptions. As detailed in a UNCTAD study, these included simplifying customs procedures, facilitating movement of goods at ports and railways, and information-sharing to improve response planning.
Beijing has also long recognized the need for Chinese firms to invest abroad. Decades ago, the focus was on securing more natural resources. Later, President Xi’s Belt and Road Initiative (BRI) led to a surge in foreign investment in infrastructure. These investments were largely driven by state-owned enterprises.
More recently, with the blessing and financial support of the state, private Chinese firms have been investing abroad in industrial activities that have strengthened China’s export capabilities. In Monterrey, Mexico, the Holley and Futong Groups have invested in a $1.2 billion joint venture to develop an industrial park that will include investments from some twenty private Chinese firms producing appliances and furniture destined for the United States. In Vietnam, foreign investment was initially driven by multinationals, such as Samsung and Foxconn, seeking to relocate capacity from China for cost considerations. Over the years, private Chinese firms that supplied their inputs also established a presence in Vietnam. Given the U.S. tariffs, companies such as Growatt, a global leader in solar equipment, relocated to Vietnam, followed by scores of other Chinese companies providing support services, such as die casting and energy storage.
A key aspect of the U.S.-China rivalry is competition in hi-tech products that account for about 30 percent of China’s total exports. Historically, most high-tech exports came from foreign-invested enterprises. The trade war has not impeded growth in China’s hi-tech exports, but what has changed is that private firms now dominate, with the share of foreign-invested firms falling from 70 percent in 2011 to 25 percent in 2020, despite what is often perceived as a bias of the Chinese state against the private sector.
Overall, these developments led to a V-shaped recovery from the pandemic, yielding GDP growth of 2.3 percent in 2020, in contrast with recessions in the West, followed by a rebound to over 8 percent in 2021. But the persistence of draconian COVID lockdowns in 2022 led to a sharp decline in GDP growth to 3 percent, even though China’s exports still hit record levels.
China’s Dependency on the World vs. the World’s Dependency on China
Considerable attention is now being given to concerns that foreign firms are relocating out of China to other countries in response to U.S. pressures. Decades ago, foreign-invested firms were vital to transforming China into a major exporter. Their recent exodus is seen as damaging to China’s economic prospects. Relocation of labor-intensive production from China, however, was taking place well before the trade war. It was driven by the need to lower costs as wages were soaring in China, but during the past few years the shift has accelerated given U.S.-China trade tensions. This is reflected in the pattern of the decline, as depicted in Figure 4. But the departure of foreign-invested firms has not stopped a steady increase in China’s exports that reached record highs in recent years, indicating that China’s export capacity is no longer dependent on these firms.
Many of the foreign-invested exporters in China are engaged in processing trade – based on importing components for assembly and exporting the finished product – as opposed to ordinary exports that rely on domestically produced components and raw materials. China’s custom data show that China’s total trade was comprised equally of processing and ordinary trade until a decade ago, when growth in processing trade leveled off and then declined. This decline was due to improving production capabilities at home, making it possible for exporters to rely more on domestically produced rather than imported components. The result is that ordinary exports have continued to increase throughout the trade war and are now twice the value of processing exports.
All this has contributed to China’s imports as a share of its GDP declining steadily, from a high of 28 percent after it joined WTO in 2001 to 15 percent in 2022. Combined with China’s increasing global exports, one can argue that despite the trade war, the world has become more dependent on China, while China has become less dependent on the world (Figure 5).
Costs and Benefits of U.S.-China Decoupling
For the United States, the benefits of decoupling, real or imagined, should be weighed against the costs imposed on U.S. consumers and producers and the damage to the export competitiveness of U.S. firms. Concerns about losses of manufacturing jobs that feature prominently in Biden’s protectionist policies are often exaggerated and are increasingly less relevant given current low unemployment levels. Biden’s Inflation Reduction Act can be justified on climate change grounds, but the rationale is weakened by including protectionist measures, such as the Buy America programs, which have drawn complaints from the EU and others. Moreover, job losses in manufacturing over the past decade due to trade with China have been negligible and more than offset by employment gains in services.
U.S. restrictions on China’s access to high-tech products, such as semiconductors, are also problematic because these products are “dual use,” with a much larger commercial market relative to military applications. Such restrictions hurt the many U.S. firms that derive significant revenues from selling to China. Such arbitrary actions also may contravene WTO guidelines, leading to costly and lengthy litigation processes.
The U.S. position as the dominant innovative power was based in part on attracting the best globally available talent. This approach is now under threat. U.S. research collaboration with Chinese scholars had been greater than that with any other country. But with decoupling, the United States experienced a net departure of scientists in 2021, while China saw a net increase. Moreover, as many hi-tech U.S. firms begin to lose significant revenues from not being able to export to China, America’s capacity to support the research programs needed to maintain its intellectual leadership is now being threatened.
For China, retaliatory tariffs and supply shifts have also increased costs and have created inefficiencies, even if Beijing has been able to maintain its export prowess by diversifying markets. Foreign or Chinese firms relocating to other countries for security reasons or to avoid U.S. tariffs must absorb higher production costs. For China’s leadership, particularly concerning are the increased costs of trying to become more innovative and self-sufficient in key technologies given U.S. restrictions on China’s access to foreign high-tech products and expertise.
For security reasons, Washington’s punitive policies are judged in terms of their effectiveness in limiting China’s growth prospects or impeding its technological advances. There has been little public debate or even recognition of the economic costs imposed at home or on other countries. That gap is now being addressed. A recent IMF study estimates that a combination of U.S. trade and technological decoupling measures could reduce global GDP by 7–12 percent. Another IMF study focusing on foreign-investment flows suggests that U.S.-China geo-political fragmentation will have significant economic consequences. Together with other studies, the conclusion is clear that no one will emerge unscathed in an economic conflict between the two great powers.
What Lies Ahead?
Most observers are pessimistic about the prospects for U.S.-China relations, either economic or political. Part of the problem lies in the lack of clarity in U.S. policy objectives. What does it mean to undercut China, and how will the United States know if it has succeeded? What economic metrics are useful as a proxy for comparisons? Without serious thought behind these questions, grounded by evidence from prior policies, the United States cannot strike a balance between preserving its global position while not unnecessarily disrupting economic outcomes determined by market forces rather than by government maneuvering.
For China’s leadership, the challenge is to provide more credibility and appeal for an alternative to U.S. protectionist trade policies. Beijing needs to be more aggressive in its stated support for a rules-based international economic system. Part of its current strategy is to push for stronger economic relations with Europe as a possible counter to the United States. But thus far, results have been limited given Europe’s long-standing alignment with U.S. interests and its resentment that Beijing seemingly is taking the wrong side on the Ukraine crisis. Nevertheless, some European powers such as Germany and France have expressed a desire for a more independent policy toward China.
To shift global sentiments, Beijing needs to signal a greater willingness to work with the West on sensitive economic issues. Rather than pursuing retaliatory actions that exacerbate anti-China sentiments, China’s leadership needs to propose more forward-looking options. One possibility is for Beijing to drop its retaliatory tariffs even if the United States is unwilling to drop its tariffs. Beijing can also suggest that controversial issues, such as the role of state-owned enterprises, should be addressed with the support of the G-20 and taken up by the WTO or as part of China’s application to join the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP).
There are equally thorny problems to be resolved in dealing with technology-related security issues. U.S. restrictions on China’s access to high-tech products represents a potential chokehold on its innovative ambitions, but there are also negative consequences for the global economy if this situation persists. Access to 5G communication services or advanced semiconductors, which are vital to the production of a vast array goods and services, can be viewed as “public goods” that should not be vehicles for sanctions. The benefits from promoting more commercial applications, which argue in favor of more cooperative approaches, dwarf plausible security concerns. Options might include creating an international regulatory agency or negotiating an agreement to mitigate risks and to set standards comparable to the role that the Nuclear Non-Proliferation Treaty provides. In the interim, Beijing could formally propose a pilot 5G project, pairing Huawei with a European company like Nokia to mitigate security concerns or offer to share its development advances in 6G standards to build trust.
With U.S.-China relations at an all-time low, punitive actions targeting China have become politically popular, even if they have little analytical basis. The United States and China, as the two largest economies, have no choice but to continue to trade with each other, so any future decoupling will only be partial. But with security concerns overriding economic considerations, the economic interdependence built up over many decades is now being reversed, leaving everyone worse off.
About the Contributors
Yukon Huang is Senior Fellow at the Carnegie Endowment for International Peace. His most recent book is Cracking the China Conundrum: Why Conventional Economic Wisdom is Wrong (Oxford University Press, 2017). Genevieve Slosberg is Junior Fellow at the Carnegie Endowment.
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