Initial U.S.-China trade deal has major hole: Beijing’s massive business subsidies

The two sides discussed industrial subsidies in the early rounds of negotiations over an agreement that exceeded 150 pages. But Chinese officials resisted making structural changes, and by the time officials settled this month on an 86-page partial accord, any commitments to reduce subsidies had been excised.

Chinese steel mills, solar panel manufacturers, electric battery developers, shipbuilders and oil producers all benefit from a vast web of government support. Officials in Beijing arm Chinese companies against their foreign rivals with discounted loans from state banks, cheap land, low-cost electric power, and cash infusions from officially approved investment funds.

“The Chinese effort is dogged, long-term and very well-funded,” said John Neuffer, chief executive of the Semiconductor Industry Association. “That’s why the subsidy issue is such a big one for us.”

Under Chinese President Xi Jinping, who lacks his predecessors’ enthusiasm for the free market, the state spigot has gushed aid. China now devotes more than 3 percent of its annual output to direct and indirect business subsidies — a share of the economy that is roughly equivalent to what the United States spends on defense, according to economist Nicholas Lardy of the Peterson Institute for International Economics, a nonpartisan research group.

Some of that aid is similar to programs in the United States and other advanced nations, encouraging companies to retrain workers, use less energy or otherwise support government goals. But much of it is divorced from any consideration of profit and loss. So it fuels excess production of goods like steel, which spill into global markets, depressing prices and making it hard for American companies to compete.

Trump last year imposed tariffs on steel after the Commerce Department warned that the U.S. share of global production had fallen by nearly two-thirds since 2000, under pressure from heavily subsidized Chinese mills. At the same time, signs that China was lavishing state aid on efforts to supplant the United States as the global leader in advanced technology triggered Trump’s decision to launch his trade war with Beijing.

Subsidies are marbled throughout China’s state-led economy. For Chinese leaders, they are a principal tool of economic management, allowing them to steer credit, land, energy and other resources to favored state-owned enterprises as well as private companies that Beijing sees as strategic.

Whatever the cost, Beijing’s aid gives Chinese companies an important edge in other markets. Peter Navarro, the president’s principal White House trade adviser, calls state subsidies one of China’s “seven deadly sins,” which must be cured before the two countries can enjoy normal trade ties.

In a 215-page report last year, which kicked off Trump’s trade war with China, Robert E. Lighthizer, the president’s chief trade negotiator, identified government financial support as a key element in China’s plan to overtake U.S. technology leadership. China is “grossly subsidizing and taking over our markets,” he complained this summer before the Senate Finance Committee.

But this massive program of government assistance has proved a double-edged sword for China. State help enabled Chinese manufacturers to dominate markets for products such as auto parts, but it also has left the economy riddled with unprofitable “zombie” firms and suffering from pervasive inefficiency, economists said.

“These subsidies are being directed in ways that are really distorting. They are not being directed to dynamic firms,” said Loren Brandt, an economist at the University of Toronto.

Indeed, state-owned firms have become steadily less profitable as they have gotten bigger. Over the decade to 2017, the biggest state-owned enterprises nearly quadrupled their assets. But their returns fell to 2.6 percent from a peak of 6.7 percent in 2007.

Even as they underperform, state companies continue to enjoy easy access to loans from state banks. Meanwhile, private companies with brighter prospects often struggle to obtain credit.

“A lot of money’s getting wasted. There’s a massive misallocation of resources in underperforming state companies,” said Lardy, author of “The State Strikes Back: The End of Economic Reform in China?”

White House officials have acknowledged that some key issues remain unresolved. Lighthizer has said “a lot of hard things” have been left to future talks, which most analysts say will be arduous and unlikely to bear fruit before the November election.

Bargaining over industrial subsidies is expected to be particularly tough.

Though Trump launched the trade war to get China to change practices including its numerous subsidies, the commercial conflict has only convinced Xi to accelerate efforts to become self-sufficient — no matter the cost.

“The hard-liner view — they’re the ones who seem to have Xi Jinping’s ear or this is the way Xi thinks himself,” said Brandt. “But it’s clear that the more reformist constituency has lost out.”

The World Trade Organization prohibits subsidies that are directly linked to exports or that require the use of domestic goods. The U.S. has won at least three disputes over Chinese subsidies before the global trading body, including in 2011, when China agreed to halt a program of wind turbine subsidies after U.S. complaints.

But the WTO rules are poorly designed for a nonmarket economy of China’s size and importance to global trade. One problem is keeping track of the subsidies, which are often hidden or indirect.

Chinese makers of aluminum products appear to be driven by profits. But they benefit from government policies that provide cheap energy to the smelters that produce aluminum and from export limits that lead to a domestic glut, which keeps aluminum prices down too.

“They can be really effective selling into the U.S. or Europe,” said Chad Bown, another Peterson economist. “It’s just that all of their inputs are subsidized.”

After China labeled shipbuilding a strategic industry in 2006, the government funded several new shipyards and an array of subsidies that saved the industry up to $4.5 billion over a six-year period, according to research by economist Myrto Kalouptsidi of Harvard University.

China quickly doubled its market share from roughly one-quarter of world ship orders to half, grabbing business from Japan, South Korea and Europe. Only after analyzing shipyards in several countries and ruling out alternative explanations was Kalouptsidi able to estimate the extent of Chinese subsidies.

“It is practically impossible to explain the rapid increase in China’s market share” without fingering subsidies, she wrote in a 2018 paper.

Under WTO rules, the U.S. can impose steep tariffs to counteract the effects of a trading partner’s subsidies if they injure American companies. The administration has stepped up its use of trade remedies to counter Chinese subsidies, hitting in the past two months imports of steel staples, diamond saw blades, hardwood lumber and ceramic tiles with defensive levies of as much as 356 percent.

About 10 percent of all Chinese imports — more than $50 billion worth of goods — now face countersubsidy or anti-dumping tariffs, according to Bown. That is apart from separate levies the president imposed on $360 billion in Chinese products over the past 18 months.

Using such tariffs offers little prospect of success, though, against China’s multipronged effort to promote its domestic semiconductor industry.

Chinese central and provincial governments have earmarked about $100 billion for equity investments, credit lines and various grants over the next five years so China will become by 2030 the global leader in an industry now dominated by U.S. firms.

Private equity funds backed by the state are funneling cash into China’s semiconductor industry, helping build and outfit dozens of new fabrication plants. There are now more than 1,600 of these “government-guided funds,” commanding a total of $570 billion, according to Zero2IPO Research Center, a Beijing-based consultancy.

Unlike traditional private equity investors in the U.S., these Chinese funds are willing to accept subpar returns to meet government goals.

Two Chinese companies — SMIC and Tsinghua Unigroup — derive more than 30 percent of their annual revenue from government payments. Yet they offer their government investors below-market returns, according to a new study by the Organization for Economic Cooperation and Development in Paris.

Such investments are “probably among the hardest forms of support to identify and quantify,” the OECD concluded.

Despite years of free spending, Chinese semiconductor manufacturers remain far behind the U.S. state-of-the-art. Even failed industrial policy, however, can distort global trade flows and hurt non-Chinese companies.

While the U.S. industry retains a solid lead over aspiring Chinese rivals, the semiconductor industry’s Neuffer says the administration needs a broader response. Along with combating Chinese trade practices, the U.S. should be emphasizing workforce development, competition policy and opening other markets overseas.

“We need an affirmative agenda, too,” he said.