Stewart & Stewart: China Update – Four Big Issues Impacting U.S. China Relations and China’s Economic Future

Demorest Law Firm is a member of the International Society of Primerus Law Firms, an international network of smaller law firms. Stewart & Stewart is our affiliated firm in Washington, DC, and they are experts in international trade issues. 

This trade flow provides updates on four critically important issues for U.S.-China economic relations and the Chinese economy:

• The U.S.-China trade dispute
• China’s industrial excess capacity
• The “Made in China 2025” initiative
• The Belt and Road Initiative.

A common theme of these issues is China’s increasingly state-driven policies under Xi Jinping, both domestically and internationally.  As China continues to rise as a regional and global power, the expectations for a more open, reciprocal, and internationally responsible China grow.  Yet President Xi appears to be moving China in the opposite direction.  The consequences of China taking a different path would be significant and therefore worth watching closely.

Highlights:

• The future of the U.S.-China trade dispute may hinge on China’s willingness to make real structural changes to its economic, trade, and technology polices.
• China’s industrial excess capacity, based on Chinese government data, has improved under the supply-side structural reform, although high debt levels and reliance on administrative measures risk the success of the ongoing initiative.  Improved capacity utilization is a reflection of the many infrastructure projects both in China and under the Belt and Road Initiative and hence tends to result in a significant understatement of the actual excess capacity over time.
• China is almost halfway there with realizing its ambitious Made in China 2025 and may have to slow it down for a U.S.-China trade deal to be reached.
• China’s Belt and Road Initiative has had setbacks but its international influence and importance seem to be growing.

I.  The U.S.-China Trade Dispute

The year of 2018 saw the initiation and escalation of the first U.S.-China trade war.  Following the Section 232 tariffs on steel and aluminum, the Trump administration imposed the Section 301 tariffs based on the United States Trade Representative’s investigations into China’s technology and intellectual property (IP) practices.  As a result, 25 percent tariffs were imposed on a total of $50 billion worth of Chinese goods and 10 percent tariffs on $200 billion of Chinese goods.  China retaliated with its own tariffs on a total of $110 billion USD of U.S. products.  As the year drew to an end, the U.S. and Chinese leaders met in Buenos Aires during the G20 summit to explore an exit strategy for the trade dispute.  Subsequently, a 90-day truce was announced and the two sides agreed to engage in a new round of trade talks to see if a deal is attainable by March 2.  Major issues on the agenda are trade imbalances, China’s technology and IP practices, and market access.[1]

At a December 6 press conference, the Chinese government indicated that China would take immediate actions on agricultural products, energy, and automobiles.  China also would resume trade talks with the United States on IP protection, technical cooperation, market access, trade balance, and other issues.[2]  With a little over a month left before the March 2 deadline, China has taken certain steps to fulfill its promises.  The United States, however, expects fundamental structural changes to China’s economic, trade, and technology policies.  Therefore, the future of the U.S.-China trade dispute seems to hinge on China’s willingness to compromise in face of the U.S. expectations and pressure.

i.  Trade deficit

Within the last month of 2018, China lifted restrictions on the imports of certain U.S. agricultural products and automobiles.  The Chinese government has directed the state-owned COFCO and Sinograin to purchase U.S. soybeans, following zero imports in November.  The Chinese General Administration of Customs gave the final clearance for imports of rice from the United States, subsequent to decade-long negotiations.  On December 14, the Customs Tariff Commission of the State Council announced the suspension of the retaliatory tariffs for U.S. automobiles and auto parts, effective from January 1 to March 31, 2019.

So far, no public action has been announced on the energy front.  In 2018, China imported record-high liquefied natural gas but imports from the United States dropped 20% due to the trade dispute.[3]  Chinese trade surplus with the United States grew 17 percent to $323.3 billion USD in 2018.[4]  Indeed, this happened in the context of the overall U.S. trade deficit going up in 2018: the U.S. goods trade deficit with the world increased from $664 billion through October 2017 to $729 billion through October 2018, up 10 percent year-on-year.[5]  Regardless, the task would be daunting if real progress is to be made on bilateral trade deficits, particularly at a time when the Chinese economy continues to slow down.

ii.   IP protection

Officially, China has adopted measures to strengthen awareness and its legal system for IP protection.  In December 2018, 38 Chinese party and government agencies signed a memorandum of understanding pledging to cooperate on punishing violations of IPRs.  Starting January 1, 2019, a newly established IP Court of Appeals within the Chinese Supreme Court is authorized to hear patent and other IP cases.[6]  China has also accelerated the process of amending the Patent Law with draft amendments released for public comments by the National People’s Congress.[7]  Despite these moves, the criticism of China’s IP regime has focused on weak and selective enforcement.  It remains to be seen whether real changes will take place in this area.

iii.  Market access

On July 28, 2018, the Special Regulatory Measures for Foreign Investment Access (the “Negative List”) entered into force.  Among other changes, foreign equity restrictions for the auto sector are scheduled to be phased out within five years.[8]  The draft Foreign Investment Law, currently open for public comments, has consolidated the previous regulations on foreign investment to streamline and broaden the access of foreign investment in the Chinese market.[9]  In the financial sector, the Governor of the People’s Bank of China has announced reform measures to further open up the financial sector.

The Chinese Ministry of Commerce has also released the following FDI statistics: by the end of November 2018, foreign mergers and acquisitions increased over 40% year-on-year to $51.65 billion USD; for the first ten months of 2018, newly established foreign-invested enterprises have increased by 89.3% year-on-year.

iv.  Technology policy and state-owned enterprises (SOEs)

Despite the Chinese government’s public denial of engaging in forced technology transfer, Article 21 of China’s draft Foreign Investment Law states that “the terms of technical cooperation in foreign investment shall be determined by investors, and administrative agencies and their staff are prohibited from forcing technology transfers through administrative measures.”

In addition to official sources, media reports have pointed to possible changes with China’s manufacturing power strategy, Made in China 2025.  It was reported that China might consider dropping market share targets to allow greater access for foreign companies.  Nevertheless, as the third section of this trade flow will show, China seems to be deeply committed to the program and has made substantive progress with its implementation.  It would be hard to imagine that China would scale it back in a meaningful way.  It is indeed noticeable that in recent months Chinese leaders have stopped mentioning the program in public remarks or documents, possibly in an effort to downplay its significance.  On SOE reforms, it has been reported that China might consider introducing fairer competition among state-owned, private, and foreign firms.

II.  Update on China’s Excess Capacity

In order to address excess capacity in its industrial sector, in particular some “traditional” industries, China has continued to implement the supply-side structural reform in 2018.  Despite years of work, steel, aluminum, cement, and flat glass are still identified as excess capacity industries.  Nevertheless, after hitting a low point in 2015, the steel and aluminum industries have seen capacity utilization return to around 80% in 2017.

Profitability has also improved in many industries, in particular steel, aluminum, and paper.  However, debt is still at a record-high level, especially for steel and aluminum.  For example, in November 2018, the debt-to-asset ratio still stood at 65.74% for members of the China Iron and Steel Association (“CISA”), despite decreases over three consecutive years.

i.  Steel

The State Council Opinion on Eliminating Steel Excess Capacity[10] and the Steel Industry Upgrade Plan (2016 – 2020)[11] set the targets for capacity reduction of the steel industry: (1) eliminate 100-150 million tons of production capacity by 2020, bring total capacity under 1 billion tons, and raise capacity utilization to 80% and industry concentration to 60%; (2) prohibit net capacity increase in every province; and (3) implement new projects exclusively through the capacity swap scheme.  The Implementation Measures for Capacity Swap of the Steel, Cement and Glass Industries (revised 2017) mandates that all provinces continue to implement stringent capacity swap schemes and prohibit any capacity increase in these industries.

To achieve the target of cutting 100-150 million tons of steel capacity by 2020, China eliminated 120 million tons by the end 2017 and then another 30 million tons in 2018, hitting the target two years earlier than the planned deadline.[12]  Moving forward, the Chinese government has indicated that in, 2019, the focus will be cutting steel capacity in priority provinces such as Hebei, as well as imposing strict control over new projects.[13]  Hebei, the largest steel-producing province, is aiming for 14 million tons of capacity reduction in 2019.[14]

In terms of domestic production, the Chinese steel industry has rebounded from the low point of 2015.  In 2017, China’s steel production reached 831.7 million tons, an increase of 5.7% compared to 2016, raising its share of world crude steel production from 49% in 2016 to 49.2% in 2017.[15]  In the first eleven months of 2018, Chinese steel production already reached 857 million tons, an increase of 6.73% over the same period of 2017.[16]  The steel price index went up by 9.86% on a yearly basis.  Steel exports totaled 63.78 million tons, a decrease of 8.6%, and total export value and export price went up by 0.5% and 11.2%, reflecting the change in export product mix.  For the first three quarters of 2018, Chinese steel companies registered total revenue of 5.66 trillion yuan, an increase of 14%, and total profit of 358.7 billion yuan, an increase of 65.3%.[17]

ii.  Aluminum

The State Council Opinion on Promoting Structural Adjustment of the Non-ferrous Metal Industry[18]stated its  goals as follows: (1) raise capacity utilization to above 80%; (2) prohibit net capacity increase in every province; (3) implement new projects exclusively through the capacity swap scheme; and (4) eliminate excess capacity based on environmental, energy, quality, safety, and technical standards.  In January 2018, the Ministry of Industry and Information Technology (MIIT) released the Announcement on Implementing Capacity Swap through Mergers and Acquisitions of Aluminum Companies, requiring that all provinces continue to implement stringent capacity swap schemes and prohibit any capacity increase.  It also requires that capacity swaps shall be implemented through mergers and acquisitions.

China’s aluminum production capacity is estimated to be around 46 million tons in 2018.[19]  According to the China Non-ferrous Metal Industry Association, aluminum capacity cuts have exceeded 3.2 million tons a year.  By comparison, capacity increases reached 4.45 million tons in 2017 and is estimated to be 2.38 million tons in 2018.[20]  On the production side, for the first 11 months of 2018, China’s aluminum production was 33.3 million metric tons, an increase of 1.36% compared to 2017.[21]  China’s share of global aluminum production remained around 56.7% during this period.[22]  In the first three quarters of 2018, total exports reached 3.86 million tons, up by 20.6% compared to 2017.[23]

iii.  Cement and glass

Under the 13th Five-Year Development Plan for the Construction Materials Industry,[24] the Excess Capacity Elimination Special Action requires that all provinces strictly prohibit any capacity increase for flat glass and cement clinker by 2020 and eliminate unqualified capacity pursuant to environmental, energy, safety, and quality standards.  It also sets the targets of reducing production capacity by 10% and increasing industry concentration to above 60% by 2020 for both industries.  The 13th Five-Year Development Plan for the Cement Industry[25] has the following objectives: raise capacity utilization from below 70% in 2015 to above 80% by 2020, reduce clinker capacity by 20% or 400 million tons, and increase industry concentration to above 80%.

For the first three quarters of 2018, total cement production was 1.58 billion tons, an increase of 1%, and total revenue of the first 8 months increased by 150%.[26]  For the same period, flat glass production was 647.6 million weight boxes, down by 4.6%, and total revenue of the first 8 months increased by 40.6%.[27]

III.  “Made in China 2025” at Four

Made in China 2025 was released in May 2015 by the State Council as a high-level industrial strategy.  It serves as an action plan for the first stage of a three-step strategy, while the long-term goal is to transform China into a global leader in manufacturing through the promotion of indigenous technologies, brands, and companies.  The strategic objectives for the three stages are outlined as follows:[28]

Made in China 2025 has  identified 10 priority areas: next generation information technology, high-end numerical control machinery and robotics, aerospace and aviation equipment, maritime engineering equipment and high-tech maritime vessel manufacturing, advanced rail equipment, energy-saving and new energy vehicles, electrical equipment, agricultural machinery and equipment, new materials, and biomedicine and high-performance medical devices.[29]

The Chinese government established the Leading Group for National Manufacturing Power, headed by a vice premier, in June 2015 to oversee the implementation of Made in China 2025.   A Strategic Advisory Committee on Building a Manufacturing Power was also set up to provide advice for the leading group.  A technical roadmap, released in 2015 and revised in 2017, has outlined key elements for each priority area, including global demand, growth and market share targets, key products and critical technologies, demonstration projects, and support policies.[30]

Almost four years into the implementation of the ten-year program, progress has been made in five sub-programs:

• Innovation Centers: China plans to establish a national innovation center for each of 22 key industries by 2020.  These national innovation centers serve as a national platform for research and development, diffusion, and commercialization of frontier technologies.[31]  By September 2018, China had set up 9 national innovation centers and over 60 provincial innovation centers.
• Strong Industrial Base (“SIB”): This program focuses on strengthening China’s industrial foundation, specifically “4 basics”: basic components, basic materials, basic processes, and basic technologies.[32]  Through this program, China aims to achieve 40% of self-sufficiency with core, basic components and materials by 2020.  The government supported a total of 331 SIB projects nationwide in 2017.
• Smart Manufacturing: This program aims to integrate advanced information and communications technologies with manufacturing to achieve digitalized, internet-based and smart growth of manufacturing industries.[33]  In 2017, the government supported 428 smart manufacturing projects.
• Green Manufacturing: China is faced with serious environmental and resource challenges, a result of decades-long, rapid economic growth and industrialization.  This program seeks to tackle such challenges by developing energy-efficient standards, factories, products, parks, and supply chains.[34]  The government supported 225 green manufacturing projects in 2017.
• Innovation in Advanced Equipment: The goal of this program is to improve indigenous innovation capabilities and achieve indigenous designs of core technologies and components for aircraft, rail, new energy vehicles, and other advanced equipment.[35]  So far, most Chinese provinces have released a Thirteenth Five-Year Plan for promoting equipment manufacturing.

In addition to the above-mentioned programs, another component of Made in China 2025 is the development of pilot cities and city clusters.  This is to explore unique models and paths for selected locations in terms of industrial upgrade, technological innovation, policy safeguards, and talent incubation.  To date, 9 cities and 3 city clusters have been selected for showcasing ten initiatives, including industrial base, smart manufacturing, and Internet of Things.  China also planned to develop national demonstration zones, according to the State Council Announcement on Establishing “Made in China 2025” National Demonstration Zones and the Evaluation Guide for “Made in China 2025” National Demonstration Zones.[36]  The selection phase was scheduled to finish by June 2018 but no further update has been released so far.

To facilitate the implementation of Made in China 2025, the Chinese government has also promulgated and implemented support policies, including an R&D expense deduction, tax credits, a key equipment insurance policy, and financial support (credit, capital market, bank loans, and loan guarantees).

Made in China 2025 is no doubt an ambitious strategy aiming at the most cutting-edge industries of the 21st century.  It also reflects China’s desire to avoid the middle-income trap and move up the global value chain.  Its emphasis on indigenous innovation and dominance by Chinese companies, both in China and abroad, coupled with extensive government support and intervention, explains why it has raised concerns among the current manufacturing powers, including the United States.  For example, the USTR has focused on Made in China 2025 in its Section 301 investigation into China’s technology transfer and intellectual property practices.  As mentioned in an earlier section, it would be hard to imagine that China, as long as under President Xi Jinping, would abandon one of its centerpiece economic initiatives entirely.  Nevertheless, substantive changes may have to be made to the program if a U.S.-China trade deal is to be reached.

IV.  “Belt and Road Initiative” at Five

The Belt and Road Initiative (“BRI”) was launched in 2013 as a national strategy to finance and build infrastructure around the world, focusing on Eurasia and the Indo-Pacific region.  The BRI consists of two main routes: the Silk Road Economic Belt covers Central Asia, South and Southeast Asia, the Middle East, and Europe, while the 21st Century Maritime Silk Road covers Southeast Asia, the Middle East, East Africa, and Europe.  It also includes 6 economic corridors, including China-Mongolia-Russia, New Eurasia Land Bridge, China-Central Asia-West Asia, China-Pakistan, Bangladesh-China-India-Myanmar, and China-Indochina Peninsula.  By the end of 2018, China had signed cooperation agreements, memorandums of understanding, or other “cooperation documents” with 122 countries and 29 international organizations.[37]

The focus of the initiative is on infrastructure and connectivity in regions with high infrastructure demand.  For example, the Asian Development Bank estimated that infrastructure needs in Asia are $26 trillion by 2030.  The majority of the BRI projects are transportation and energy-related, including highways, railways, sea routes, airports, ports, and pipelines.  Beyond physical infrastructure, the BRI has also extended to the digital sphere, seeking to promote sharing of digital technologies such as big data, artificial intelligence, Internet of Things, and e-commerce.[38]   Two other initiatives, the Polar Silk Road, to explore Arctic shipping routes, as well as the Space Information Corridor, for sharing Satellite and ground network systems, also demonstrate the evolving nature of the BRI.

China set up the Leading Small Group on Advancing the Belt and Road Initiative, headed by a vice premier, in March 2015 to coordinate the implementation of the program.  Its office is situated in the National Development and Reform Commission, China’s ministry of macroeconomic planning.   China also established the International Development Cooperation Agency in March 2018 and has over a dozen of provincial governments involved in the domestic part of the program.

On financing, China has pledged infrastructure investment ranging from $1 trillion to $8 trillion USD.[39] It is estimated that China spent $340 billion on BRI infrastructure projects between 2014 and 2017.[40]  BRI’s funding sources include Chinese policy and commercial banks, the Asian Infrastructure Investment Bank, the Silk Road Fund, foreign investment, and private investors.[41]

As of 2018, a total of 1,814 infrastructure projects have been developed across 66 BRI countries.[42]  More projects are still in the planning phase.  The largest projects, mostly railways, are located in South Asia (Pakistan and Bangladesh) and Southeast Asia (Malaysia and Indonesia).[43]  Some of these projects, however, have been delayed or canceled due to controversies.  In Malaysia, for example, two BRI projects, the East Coast Rail Link and the Melaka Gateway, were estimated to cost a total of $30 billion USD.  With the change of government in Malaysia, these projects have been put on hold or re-evaluated due to inflated contracts or corruption.[44]  In Pakistan, the largest BRI project, the Karachi-Peshawar Main Line-1 project, was initially priced at $8.2 billion USD.  The new Pakistani government has cut the cost by $2 billion USD and possibly another $2 billion to $4.2 billion USD.[45]

Chinese trade and investment with the BRI countries have been significant and on the rise.  In 2018, Chinese bilateral trade with BRI countries reached 8.37 trillion yuan, up 13.3% year-on-year, with highest growth coming from Russia, Saudi Arabia, and Greece.[46]  Chinese non-financial investment in 56 BRI countries totaled $15.64 billion USD, or 13% of its total non-financial outbound investment in 2018.[47]  Chinese companies are primary contractors in engineering and construction projects in 63 BRI countries.  These contracts have generated total revenue of 89.33 billion USD, or 52% of the total revenue from overseas projects.[48]  In the first 11 months of 2018, 3,640 new contracts worth $90 billion were signed with BRI countries.[49]

International responses to the BRI have been mixed.  On one hand, some countries, particularly in Central Asia, welcome China’s financial commitments to promoting connectivity, as well as China as an alternative regional power.[50][51]  A recent World Bank study has also concluded that the BRI infrastructure projects could increase trade flows among BRI countries by up to 12.9 percent.[52]  On the other hand, there has been growing international skepticism and criticism about the initiative.  China is facing increasing anti-BRI sentiment in many countries fueled by high debt levels, corruption, and lack of transparency.[53]  In particular, debt sustainability has become a major concern, especially in the wake of the high-profile takeover of the Hambantota port of Sri Lanka.[54]  The Center for Global Development has identified eight countries, including Djibouti, Pakistan, and Tajikistan, as being vulnerable to debt distress because of the BRI projects.[55]  Additional issues, including China’s compliance, or lack thereof, with international environmental and labor standards, have also drawn considerable attention.

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