The Phase One Deal by Bundesverband der Deutschen Industrie e.V.

POSITION | FOREIGN TRADE | UNITED STATES-CHINA

The Phase One Deal: Ceasefire with Limited Durability

April 2020 Evaluation ▪

The Phase One Deal is far from being a free trade agreement, rather relying on23. “managed Oktober trade” than free trade. It contradicts not only the principle of free and rule-based trade under 2017 the World Trade Organization but also WTO rules for free trade agreements.

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Continued high customs duties in the United States and China increase costs for business. The Phase One Deal is also characterized by numerous uncertainties. This translates to companies still lacking planning security.

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The agreed “purchasing lists” for Chinese companies may have a potentially positive effect on the U.S. trade deficit, but they will not help the global economy to recover. Moreover, the threat of crowding out and trade diversion looms, which will particularly affect the German industry.

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In addition to purchasing requirements, the deal addresses some structural problems of the Chinese economy. In the area of intellectual property protection and the prevention of forced technology transfer, the United States and China agreed to some measures. It is unclear to what extent European companies will benefit from the announced plan.

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The deal is a political agreement and not an international treaty. The intended dispute settlement rules between the United States and China offer a loophole for a withdrawal from the deal. This affects the reliability of the agreements.

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The Phase One Deal might lead to a temporary easing of the trade conflict between the United States and China, but it does not create a level playing field. It moreover does not eliminate the deeper causes of the conflict. Whether a Phase Two Deal will succeed is questionable.

The Phase One Deal:Ceasefire with Limited Durability

Background Phase One Deal From summer 2018 to late summer 2019, the trade conflict between the United States and China intensified continuously. While the average U.S. tariff on imports from China was still 3.1 percent at the end of 2017, it rose to 21 percent at the beginning of September 2019 and fell to 19.3 percent when the Phase One Deal came into force in mid-February 2020. The average tariff burden on U.S. exports to China almost tripled between the end of 2017 and mid-September 2019 from eight percent to 21.1 percent and has been marginally reduced to 20.3 percent since mid-February 2020.1 The legal basis for customs duties by the United States is Section 301 of the Trade Act of 1974. The United States criticizes China for failing to implement necessary structural reforms. The United States has had a high trade deficit with China for years. In 2019 it stood at 308 billion U.S. dollars. The United States rightly accuses China of exploiting the advantages of the international trading system; in many cases China fails to keep its promises made in its WTO accession protocol. President Trump rightly criticizes the lack of protection of intellectual property, state subsidies, and forced technology transfer in joint ventures in China. As a sign of rapprochement, both China and the United States have in some cases suspended tariffs imposed or planned since September 2019. As a result, President Trump and Deputy Prime Minister Liu He signed the Phase One Deal on 15 January 2020. China agreed to import additional U.S. products and services worth 200 billion U.S. dollars over the next two years. This includes industrial goods worth a total of 77.8 billion U.S. dollars, energy sources such as liquified petroleum gas, crude oil and refined products worth 52.4 billion U.S. dollars, agricultural products worth 32 billion U.S. dollars and services (including patents, tourism) worth 37.9 billion U.S. dollars. China also wishes to open up more to foreign financial service providers. Moreover, Beijing will refrain from forced technology transfer in the future. China is also required to ensure that any technology transfer is voluntary and takes place under market conditions. Furthermore, protection of intellectual property is to be strengthened. In addition, both countries agreed on new principles against targeted currency devaluations. Finally, the agreement includes a monitoring and dispute settlement mechanism. In mid-February, the United States, in return, reduced the tariffs on Chinese imports worth 120 billion U.S. dollars introduced on 1 September 2019, from 15 percent to 7.5 percent. The additional 25 percent duty on U.S. imports of Chinese goods worth 250 billion U.S. dollars should not change for the time being. Therefore, a U.S. import volume of 370 billion U.S. dollars is still subject to additional duties â&#x20AC;&#x201C; about 70 percent of total Chinese exports to the United States. The United States thus retains an important lever in its hands. China, on the other hand, is halving its customs duties on U.S. goods worth around 75 billion U.S. dollars. The Phase One Deal is an executive agreement under international law. Such agreements are regarded as politically binding, which distinguishes them from legally binding agreements. Accordingly, U.S. Congress does not need to ratify the Phase One Deal.

Bown, Chad 2020. US-China Trade War Tariffs: An Up-to-Date Chart, <https://www.piie.com/research/piie-charts/us-chinatrade-war-tariffs-date-chart> (accessed 11 March 2020). 1

The Phase One Deal:Ceasefire with Limited Durability

Overall Assessment The agreement is expected to lead to a temporary respite in the conflict. It is more than a purchasing list for U.S. goods and services, since structural problems are also addressed. However, numerous points of contention, such as China's industrial policy and the unfair subsidization of Chinese stateowned enterprises, remain unresolved and are to be addressed in a Phase Two agreement. The Phase One agreement will not solve the fundamental conflict between the United States and China. Furthermore, the question remains open whether China will be able to work off its already ambitious purchasing list in light of the distortions caused by the outbreak of the SARS-CoV-2 virus at the end of 2019. The effects of the quarantine measures taken to contain the virus, including the sealing off of the entire Hubei province, will have a significant negative impact on economic growth beyond Q1 and Q2 2020. For example, in its latest assessment from early March, the OECD lowered its forecast for China’s GDP growth in 2020 from 6.1 to 4.9 percent. There is no doubt that the disruptions in production and transport in key locations in the country have led to a simultaneous supply and demand shock. In the first two months of 2020, imports fell by four percent compared with the same period last year. It is foreseeable that the slump in demand will also impact trade with the United States, especially given Beijing’s commitment to buy U.S. agricultural products on the basis of “market conditions”. The problem of high customs duties in U.S.-Chinese trade also remains unsolved. The WTO compatibility of the agreement is doubtful. According to the most-favored nation (MFN) principle of the WTO, concessions granted to one WTO member must also be granted to the other members. An important exception is Article 24 of the General Agreement on Tariffs and Trade (GATT) and Article 5 of the General Agreement on Trade in Services (GATS). According to these articles, members of the bi- and plurilateral preferential agreements can conclude preferential agreements if certain criteria are fulfilled. These include, for example, that substantially all trade must be liberalized. This is not the case in the present agreement. The agreement is far from being a free trade agreement. The small-scale “managed trade” has little in common with the principles of free and rule-based trade within the WTO. Paradoxically, this approach could further strengthen the influence of the state on China’s economy and the role of state-owned enterprises – the opposite of what the agreement is supposed to achieve. There is a serious threat of disadvantages for third countries through displacement effects and trade diversion. According to calculations by the Kiel Institute for the World Economy (IfW), German exporters in particular will lose out as a result of the trade diversions. According to these calculations, the manufacturing sector in Germany has been hit hardest internationally and is likely to export goods worth 4.3 billion U.S. dollars fewer to China next year, compared with a scenario without a trade war and without a Phase One Deal. The automotive (-1.3 billion U.S. dollars), aircraft (-1.6 billion U.S. dollars) and industrial machinery (-0.7 billion U.S. dollars) sectors will be particularly severely affected.2 It is still unclear to what extent companies from third countries can benefit from legal improvements, such as in the protection of intellectual property and forced technology transfer.

Chowdhry, Sonali und Gabriel Felbermayr, The US–China Trade Deal and its Impact on China’s Key Trading Partners, Kiel Policy Brief No. 134, 2020, < https://www.ifw-kiel.de/fileadmin/Dateiverwaltung/IfW-Publications/ifw/Kiel_Policy_Brief/Kiel_Policy_Brief_134.pdf>. 2

The Phase One Deal:Ceasefire with Limited Durability

Evaluation of Selected Chapters Chapter 1: Intellectual Property The chapter on intellectual property addresses many long-standing concerns in the areas of trade secrets, patents, and intellectual property in the pharmaceutical area, geographical indications, and trademarks. Measures against piracy and counterfeit goods are also covered in this chapter. In addition, the United States and China have agreed to address and resolve other intellectual property issues in future negotiations. The agreement contains a general obligation for China to provide for a public comment period of at least 45 days for all proposed implementing measures. ▪

Trade secrets: The civil liability of companies directly involved in the production or sale of goods and services for the misappropriation of business secrets is extended. Civil and criminal law measures against the violation of trade secrets will be strengthened. Procedural possibilities for enforcing claims in the event of infringements are also to be enhanced.

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Pharmaceuticals: Patent protection for pharmaceutical products should be strengthened, particularly through patent extensions.

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Trademarks and geographical indications: The protection of trademarks and geographical indications is to be improved. Better safeguarding against malicious trademark applications and unauthorized geographical indications that disadvantage U.S. agricultural products should be upgraded.

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Piracy and counterfeit goods: China commits to taking effective and swift action against violations of intellectual property protection in the online environment, particularly on ecommerce platforms. Effective enforcement measures against counterfeit medicines and related products are planned, including for pharmaceutical ingredients. Substantial strengthening of measures is envisaged to stop the production and distribution of counterfeits posing significant health or safety risks.

Evaluation In the field of intellectual property, this agreement addresses important areas that were previously either not regulated or were not sufficiently implemented. The issue of protection of trade secrets is particularly important for foreign companies in China, as infringements often occur. The protection of trademark rights and copyrights is (still) an urgent problem for foreign companies, although efforts have been made in recent years to strengthen owner rights. Against this backdrop, German industry welcomes the provisions and rules agreed in the agreement and the resulting obligations for China to protect intellectual property. The difficulty will lie in the question of implementing the agreements. For example, agreements to date have often not been implemented or not implemented in such a way that a significant de facto improvement in the protection of the intellectual property rights for foreign companies in China was achieved. Only if the obligations agreed in this agreement are really fulfilled and the rights and entitlements created can be effectively enforced in legal proceedings can we deem real progress made in the protection of intellectual property. Chapter 2: Technology Transfer In order to technologically catch up, the Chinese government still pursues forced technology transfer. China argues that technology transfer is voluntary as companies are “formally” not forced to invest in China. For many companies, however, presence in the Chinese market is essential for reasons of international competitiveness. Since Chinese companies do not have such technology transfer 3

The Phase One Deal:Ceasefire with Limited Durability

obligations in the United States or the EU, they can generate far greater global economies of scale. At the same time, technology transfer also acts as a defensive shield against overly powerful competition from abroad. According to the EU, Japan and the United States, “quasi-forced” technology transfer violates international agreements. All three have already filed complaints with the WTO on this issue. In addition to the WTO complaint, the United States has also imposed unilateral punitive tariffs of 25 percent on China for goods worth 250 billion U.S. dollars. These remain in force despite the Phase One Deal. In the course of the Phase One Deal, the United States and China agreed on the following points regarding technology transfer: ▪

A ban on forcing or pressuring foreign companies to transfer their technology in return for market access, including for obtaining regulatory approvals or other benefits.

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The requirement that any transfer of technology or licensing be voluntary and mutually agreed.

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A ban on government-directed or supported foreign investment aimed at purchasing foreign technology based on industrial policy motives.

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Enforcement and administrative procedures that are impartial, fair, transparent and nondiscriminatory.

A dispute settlement mechanism underlying the Phase One Deal should ensure the aforementioned commitments. This will also strengthen the negotiating position of U.S. companies. If technology transfer is required by government agencies or state-owned companies, the mechanism could be used to find an alternative agreement. European companies currently lack a comparable mechanism.

Chapter 5: Macroeconomics Policies, Exchange Rate Issues, and Transparency In the general provisions, both sides grant one another the right to conduct their monetary policy autonomously in accordance with national legislation. They recognize that stable exchange rates can contribute to strong and sustainable growth and investment. Flexible exchange rates can absorb shocks, if applicable. They share the common goal of avoiding unsustainable external imbalances. In line with the G20 agreements, both parties refrain from currency devaluation or money supply control in order to gain competitive advantages. Both parties also wish to adhere to the IMF rules to avoid exchange rate manipulation, in order to prevent balance of payments imbalances or unfair competitive advantages. They rely on a market-determined exchange rate regime and seek to strengthen the economic foundations for exchange rate and macroeconomic stability. Both countries commit to refrain from central bank interventions that seek to improve competitiveness or to achieve a certain exchange rate. This includes large and prolonged central bank interventions in foreign exchange markets. Both parties wish to exchange views regularly on their activities and policies on currency matters. In the interest of transparency, the following disclosure requirements apply: monthly data on the level of foreign exchange reserves and forward positions no later than 30 days after the end of the quarter; quarterly balance of payments with balance sheet subitems and quarterly data on imports and exports of goods and services, both no later than 90 days after the end of the quarter. The parties also agree to disclose IMF country reports under Article IV, including the exchange rate regime, and to participate in the IMF-COFER database. 4

The Phase One Deal:Ceasefire with Limited Durability

Evaluation The agreement is a consolidation of the status quo. The United States accuses not only China but also the Euro area of currency manipulation, viewing this as a cause of the bilateral trade deficits with these currency areas. With the transparency requirement, it would now be easier for the Chinese side to rid itself of this accusation if it is precisely comprehensible whether and, if so, in what way the Peopleâ&#x20AC;&#x2122;s Bank of China has intervened on the currency markets. However, the decisive factor for prices on the foreign exchange markets is not the trade flows, but the much more erratic capital flows. According to the trilemma of the exchange rate regime according to Fleming and Mundell, anyone who demands free foreign exchange markets and at the same time stable exchange rates must ultimately also live with interventions by the respective central banks. In view of the global status of the two currencies, currency influence by the U.S. is more likely, considering its role as the global reserve currency. Chapter 7: Bilateral Evaluation and Dispute Settlement The United States and China intend to establish a Trade Framework Group with representatives of their governments to discuss the implementation of the agreement, problems therewith, and future arrangements. The Trade Framework Group will be chaired on the U.S. side by the United States Trade Representative and on the Chinese side by one of the Deputy Prime Ministers. In addition, a Bilateral Evaluation and Dispute Resolution Office is to be established. These offices are to deal with each other's complaints and attempt to resolve the dispute through consultations. If one party believes that the other party is in breach of this agreement, a complaint can be submitted to the Bilateral Evaluation and Dispute Resolution Office. Consultations will be initiated after an evaluation of the complaint. If these consultations threaten to fail, the Deputy United States Representative and a designated Chinese Deputy Minister shall be called upon for further dispute resolution. If no solution is found even under these circumstances, the dispute may be referred to the United States Trade Representative and the Deputy Prime Minister. If even then no solution can be found, accelerated consultations should be held. If this round of consultations also fails, the complainant may, in good faith, introduce its own measures. The complaining party may, in special cases, convene a meeting between the United States Trade Representative and the Chinese Deputy Prime Minister. If no solution is found, the complaining party may withdraw from the agreement. Evaluation The fact that the agreement provides for a review and dispute settlement mechanism increases the enforcement power. However, the possibility to withdraw in the case of failure of bilateral consultations and meetings between the U.S. Trade Representative and the Chinese Deputy Prime Minister could pose a severe problem. Due to this withdrawal option, enforcement could not be guaranteed in the event of an extreme dispute. It remains to be seen how this mechanism will affect the WTO dispute settlement process. Unlike the WTO dispute settlement mechanism, it does not allow participation by third countries. The extent to which its results will have a multilateral effect remains open.

The Phase One Deal:Ceasefire with Limited Durability

Imprint Bundesverband der Deutschen Industrie e.V. (BDI) Breite Straße 29, 10178 Berlin www.bdi.eu T: +49 30 2028-0 Authors Dr. Stormy-Annika Mildner T: +49 30 2028-1562 s.mildner@bdi.eu Friedolin Strack T: +49 30 2028-1423 f.strack@bdi.eu Valerie Ross T: +49 30 2028-1623 v.ross@bdi.eu Patricia Schetelig T: +49 30 2028-1532 p.schetelig@bdi.eu Lennart Jansen T: +49 30 2028-1483 l.jansen@bdi.eu Julia Hentsch T: + 49 30 2028-1460 j.hentsch@bdi.eu Wolfgang Krieger T: +49 30 2028-1538 w.krieger@bdi.eu Thomas Hüne T: +49 30 2028-1592 t.huene@bdi.eu Stefan Gätzner T: +86 1085322862 s.gaetzner@bdi.eu Translation Gabriela Popzyk T: +49 030 2028-1596 g.popzyk@bdi.eu BDI-Document Number: D 1153