Trade war: Before taking on China, here're some lessons US needs to learn

Imagine if Canada decided to bring the US to heel over its abusive trade practices.

Losing patience over its disputes about lumber, sugar, steel, aluminum and anti-dumping processes, Ottawa could instead institute a 25% tariff on all imports from south of the border.

Such a notion seems absurd. How could a small economy like Canada cause the US to change its trade practices by force? Less than a fifth of US exports head north, so Canada alone lacks the scale to bend the US to its will.(2) For Ottawa, the multilateral approach via the North American Free Trade Agreement(3) and the World Trade Organization has a far greater chance of success.

There’s a lesson for here Washington amid its deepening dispute with China. As in the Canadian example, only about a fifth of Chinese exports go to the US, equivalent to about 3.5 per cent of its gross domestic product. That’s not nothing – but it’s still less than half the trade exposure China had to the US in the go-go years before the 2008 financial crisis. If Washington really wants to change Beijing’s behavior, it needs a plan for the $2 trillion or so of Chinese exports that go elsewhere.

That’s where regional trade agreements come in – and here, it’s China that’s making most of the running.

After six years of faltering progress, China, Japan, South Korea, India, Australia, New Zealand and the 10-member Association of Southeast Asian Nations will reach an agreement in November to create the Regional Comprehensive Economic Partnership, Asean’s Secretary-General Lim Jock Hoi said last month.

Similar promises have fallen short before, but such a deal would bind a third of the global economy and half its population into a free-trade zone with China as its linchpin.

The economic effects of an RCEP are likely to be somewhat limited, reflecting the fact that all the members are already included in bilateral free-trade agreements with Asean, and many don’t want a more ambitious deal. Even so, it would still increase China’s 2030 gross domestic product by about 0.4 per centage point, according to a 2017 report for the Peterson Institute for International Economics. Other estimates go higher, with one paper last year predicting that China’s income could gain by 2.5 per centage points in the event that a deal addresses the region’s significant non-tariff barriers.

The alternative to this is the Trans-Pacific Partnership, the deal between 12 nations excluding China that was negotiated by the Obama administration. Despite being blocked by Congress and abandoned by President Donald Trump, that agreement isn’t quite dead. A reduced 11-nation version came into force for most members this year, and President Trump has occasionally suggested he’s open to rejoining the deal. Such a move could even induce South Korea (one of the most prominent absentees from the original TPP, and China’s third-largest trading partner(1)) to join the club.

How would that help the US prosecute its case against China’s economic model?

For one thing, the TPP represents a much larger coalition of Beijing’s trading partners. The 11 nations together buy about as much from China as the US does. Add in South Korea, Taiwan and the larger Asean economies that have expressed an interest in joining, and you have a larger export bloc for China than the RCEP.

More important, though, is the allocation of costs and benefits. Free-trade agreements are better understood as preferential deals, with many of the benefits to members coming at the expense of those left outside. In contrast to tariffs – a negative-sum measure that reduces output for both sides, and directly hits the hip pockets of consumers in the country imposing levies – trade deals are positive-sum, accelerating growth for their members even as non-member countries are weakened.

That carrot-and-stick approach represents a much stronger inducement for outsiders to reform their economies in ways that would allow them to join, a scenario the TPP specifically envisages.

It’s an open question whether that would be sufficient to shift China’s economic model. The TPP’s original rules on environmental protection, labor rights, intellectual property and state-owned enterprises were radical enough that a bunch of them were thrown out in the revised agreement after the US quit. The more punitive approach of tariffs also has a clearer line between cause and effect than the passive, fingers-crossed trade bloc approach: If WTO membership has failed to change Beijing’s behavior, what hope would a smaller regional agreement have?

Still, the current breakdown in bilateral talks suggests the tariff-first approach isn’t working, and in the meantime other players aren’t standing still. While Washington fulminates, progress toward an RCEP is gradually moving the world’s economic center of gravity into Beijing’s orbit. The US will need its own constellation of allies if it wants to reverse that.

(1) It also has a modest but persistent trade surplus with the US, which would put it on the back foot in any spat.

(2) Nafta remains in force until its replacement agreement is ratified.

(3) Excluding Hong Kong.