November 18th, 2016

A Collision of Expectations

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This article is written as the contribution to GIIC as their commissioner.

The world’s economy is quickly approaching a potential crisis, and the impact could be far reaching. The crisis stems from a collision of conflicting expectations involving one of the largest economies ever, and includes tangible, large-scale impacts on real communities. At this late hour, it is unclear whether the crisis can be averted and if so, what the consequences of trade-offs might be.

In July, 2001 China concluded negotiations with the World Trade Organization (WTO) and an agreement was ratified in December, 2001. Part of China’s understanding was that they would be granted Market Economy Status (MES) on the 15-year anniversary of the agreement, which will occur in December of this year. However, that understanding is not held by the other countries of the WTO and this disagreement has the potential to significantly impact economies around the world.

The accession to WTO opened up opportunities for Chinese industries, but has also brought about a number of unintended consequences. In the 90s, Europe was moving aggressively towards the use of renewal green energy, however manufacturing of solar cell in Europe was very costly because of the European environment protection regulations. The Europeans found a manufacturer in Wuxi, China who was able to provide solar cells very cheaply because of China’s less restrictive environmental protection regulations. The manufacturer became very successful and soon other companies began making solar cells. Unfortunately, the new manufacturers did not seek to enhance the original product, but chose to simply produce exact copies, which is usually the case in China. The “copycat” mindset often leads to overcapacity, and such was the case for solar cells in Wuxi. The European Union took notice of the situation and in 2011 cut back on demand, resulting in a large glut of solar cells, causing prices to plummet by nearly half.

The city government of Wuxi was faced with a dilemma: let the solar cell manufacturers go out of business and put tens of thousands of people out of their jobs, or help these companies. They decided to prop up these companies while encouraging them to seek out new markets. Armed with cheap loans and a huge oversupply of solar cells, these companies quickly undercut US and others solar cell companies. As a result, the US Department of Commerce imposed an anti-dumping tax (as high as 240%) on solar cells made in China. The Wuxi city government was forced to make painful adjustments and many solar cell companies went bankrupted, costing many workers their jobs.

The West saw this as an example of China dumping solar cells into the market at unreasonably low prices with government subsidies. The Chinese, however, viewed it as the West protecting its own industry rather than letting the free market, as introduced by WTO accession, deal with this overcapacity.

The steel industry has also become a problem for the Chinese government on a much larger scale. Fueled by years of double digit growth, especially in property, Chinese demand for steel skyrocketed, and many companies were formed to meet the demand. Just as in the solar cell market, steel companies chose to simply copy the market leaders rather than seeking to innovate and improve. In times of growth, the Chinese domestic market was able to absorb the production and despite the thin margin, the manufacturers were still able to make a profit. Despite the global recession in 2008 and 2009 and the slowdown of the Chinese economy in 2013, China steel production continued to grow, peaking in 2014 at 822.7 million metric tons. This output represents over 50% of the total world steel production.

Competition has driven the price for Chinese steel to below cost, yet factories continue to produce steel, supported by local government subsidies and loans. These government loans and subsidies continue because China fears the loss of millions of jobs and the closing of factories. The steel industry has become “Too Big to Fail” in China.
In 2015, the Chinese central government debated how to address overcapacity. Many expected the government to act on overcapacity, but in 2016, with the weakening of the Chinese economy and political maneuvering, nothing had been announced. In June of 2016 a weak notice was released, warning that the government would act on industries with overcapacity, but little action has been seen since then.

China is hoping that the world will absorb some of the steel capacity, but the European and US tariffs imposed on China’s steel have become a key focus for China’s trade representatives. China had assumed that it would be granted Market Economy Status (MES) this December, and that status would mark the cessation of what they consider unfair methodology for the calculation of anti-dumping tariffs. Until China is granted MES, the importing WTO member may use a methodology that is not based on a strict comparison with domestic prices or costs in China, and this allows the imposition of high import tariffs. The WTO agreement does not guarantee MES, but instead states that China has to establish to each WTO member that China qualifies for MES under the national law of each WTO member.

The European Union will likely require domestic prices to be used as the benchmark, which is probably still very much higher than Chinese prices. Both sides believe they are protecting their industries and workers – the West by preventing what they view as the dumping of cheap steel and China by seeking to keep their steel industry afloat and their workers employed.

Complicating this further is the Western view that China has failed to fully comply with the WTO accession agreement in other areas. As part of the agreement, China had agreed to allow, by no later than December 2007, foreign ownership of 49% of basic telecommunication and 50% of the Value-Added Telecommunications (VATS) and paging services, including Internet services. Two basic telecommunication operations, one a joint venture between AT&T and Shanghai Telecom, and another joint venture between Cable & Wireless and Shenzhen Telecommunications Development Co. were operating in China, but the former has been restricted to the Shanghai region, despite China’s promise to remove all restrictions by 2007, and the other has ceased operation. VATS have faced similar problems, where few foreign financed operations have been approved. For those that have been approved, foreign investors are forced to use a structure that allows economic interest but denies control, leaving that with the Chinese.

So, while China has left some doors open for foreign investors, it is a far cry from what most expected of a liberalized Telecom market. It appears that the current Chinese view is that since the US and Europe have not granted MES to China as they believe is implied by the WTO agreement, there is no need for China to comply either.

Failure to receive MES will likely have a significant impact on the Chinese economy, and may result in large unemployment. This may be necessary for Chinese entrepreneurs to realize that simply copying market leaders is not a road to success, but rather a formula for overcapacity and ultimately failure. While it may be a necessary lesson, learning it will be painful – a pain that China may not be willing to endure at this time. It is also possible that China will begin unwinding some of the WTO agreements that currently exist, and that will likely impact other economies around the world. China is a leading supplier of information infrastructure for the world. China has more Internet users than any other country by a substantial margin, and that is with only about 50% of the population on-line. Failure to reach an agreement on China’s MES status could certainly impact the rest of the world’s ability to reach this huge market and vice versa.

December 2016 is a critical time. China expects to receive MES, and will be very unhappy if they don’t. This is but one indicator of the economic tension that exists between China and the West. With time so short a collision of these expectations seems inevitable. The question that remains is how far reaching the shock waves from the collision will be.

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