KENNESAW, Ga. | Apr 27, 2020

Dr. Xuepeng Liu has been working extensively on topics related to the Chinese economy and U.S.-China trade. When China grows into a global power, its domestic policies have important international implications. China is currently the third-largest trading partner of the U.S., just next to Canada and Mexico. Therefore, it is important to understand the bilateral trade and investment relationship between the U.S. and China. In this blog, Dr. Liu discusses the roles of trade, foreign direct investment (FDI), and global value chains (GVCs) in China’s economic miracle, the U.S.’s large trade deficit with China, and U.S.-China trade war. Also, he discusses why the decoupling of the rest of the world with China may or may not happen depending on the severity of the COVID-19 pandemic and how it and its aftermath are handled.

Dr. Liu’s early work has focused on international trade agreements and foreign direct investment. His research addresses the World Trade Organization (WTO) ineffectiveness puzzle and shows that the WTO has significantly promoted international trade after WWII by not only increasing the trade volumes of existing partners (intensive margin) but also building new trading relationships (extensive margin). China’s economic size (GDP) has grown 10 times larger from about $1.4 trillion since its 2001 entry into the WTO to $14 trillion in 2019. Besides trade, another factor behind China’s economic growth is foreign direct investment. China has been the second-largest recipient of FDI in the world for a long time, just next to the U.S. The lower wages and many preferential policies toward FDI contribute to the large capital inflows. Combined with policies on technology transfers, China has built successfully a comprehensive industrial base and become the world's largest manufacturing center. In today’s world with outsourcing, countries specialize in different stages of production of a product. It is now critical for a country to join the GVCs and China presents one of the most successful examples. China’s success based largely on trade and FDI has important international implications. Although all nations benefit from trade, some countries become more and more uncomfortable with the heavy dependence on China along the GVCs; even worse are the countries that are left out of the GVCs and hence are in a dire situation.

For the U.S. in particular, the large U.S. trade deficit with China has received a lot of attention over a long time. However, the obsessive focus on the bilateral trade imbalance between the U.S. and China can be misleading. As illustrated by the well-known Apple iPhone example, the major components of iPhones are produced in the U.S., Japan, Korea, Taiwan, etc. and are finally assembled in China with a small amount of value-added in Mainland, but the whole value of the iPhones shipped from China to the U.S. is recorded as China’s export to the U.S. Supported by the World Bank, Dr. Liu had been working on a project on GVC jointly with a group of economists from the World Bank, UIBE, and Columbia University. They analyze value-added trade using newly constructed international input-output tables. The value-added trade data are more informative than official trade statistics and can be used to study many new research questions.  Related to U.S.-China trade deficits, more recent attention in the academic and policy circles is on “China Syndrome” or “China shock,” which reveals the concerns of China’s impact on the labor markets and other local conditions in the U.S. (Autor et. al 2013). Although no consensus has been formed regarding the overall net effects of China’s trade on the U.S. labor market, more people start to question the long-held belief that global free trade is always well-improving. Against this backdrop, the Trump administration initiated the trade war with China, claiming that China’s unfair trade practices hurt the U.S. economy.

The trade war is still to be resolved and this may take a long time. A more detailed discussion of the trade war by Dr. Liu can be found in Liu (2019). In that article, Dr. Liu discusses how the combination of state capitalism and the lack of transparency in China, together with domestic issues in the U.S., triggered the trade war. Considering the massive sizes of the two countries and potential prohibitively large cost of decoupling, Dr. Liu suggested a gradual approach to resolve the trade war, using the prolonged U.S.-Japan trade negotiation in the 1980s as an example. He also urges China to adopt more transparent policies to facilitate bilateral and multilateral trade talks. Here is a quote from that article, “a practical approach in multilateral and bilateral negotiations is needed. This can be a long process and may become the new norm. A minimum requirement for successful negotiations is transparency in policies. For example, all nations including China and other developing countries should disclose their industrial policies and notify other WTO members regarding their subsidies as required by the WTO. This is easier to say than to do. Transparency is actually a tough issue to address in China because it will eventually involve political reforms. Instead of relying on censorship and firewalls to block citizens’ access to information, Chinese leaders should be more confident to embrace an open society.”

Another question is what if the trade war lasts for a long time. Are the trade protection measures going to work as intended? Historical experience tends to suggest that these policies rarely work well because they are against economic principles and the trend of globalization. As rational market participants, consumers and firms always shop around the world to chase the lowest prices and lower costs. Globalization is a natural force guiding international resource allocation. Economic principles also tell us that, whenever this is a restriction, market forces can always sneak in from the back door, so it is difficult to prevent market mechanisms from operating. In the case of international trade, Dr. Liu and coauthors have done extensive work to study firms’ tax or tariff avoidance behaviors through various ways such as misreporting trade values or misclassifying product categories, going through round-trip trade, or using trade intermediaries. For example, Liu and Shi (2019) study how Chinese firms evaded U.S. anti-dumping duties by re-routing products through third countries and indirectly into the U.S. Similar actions may be taken by companies during the trade war, rending the trade protection measures less effective. Of course, tax avoidance is only one of many factors that may affect the effectiveness of trade policies and is used as an example to illustrate a larger problem of why it is hard to work against trend and market principles.

However, with the quick spread of the COVID-19, things may change and economic decoupling with China may become possible. Before COVID-19, Trump administration had a hard time to ally with other western economies against China. If only the U.S. erects high tariffs against China or withdraw investment from China and force domestic firms to hire only American workers, it is not going to work because other countries can still take advantage of the lower labor costs and cheaper supplies of parts and components in China and then compete against American firms globally. American firms would eventually lose market shares and may go bankrupt, hiring nobody. COVID-19, as another shocking event, may change the course of the world economy if most of the western economies decide to diversity their global supply chains away from China. This will be certainly a significant setback of globalization and is no good news to any country. It can be avoided only if China adopts proper policies to address this global crisis and rebuild the trust from the rest of the world. Much of the trust has been lost during recent years.

Finally, I would like to discuss the implications of the trade war and COVID-19 pandemic on the so-called “China model”, which features heavy hand from government. The clash between the China model and western market economies is one of the major reasons behind the U.S.-China trade war. After the outbreak of the coronavirus, China took swift actions to lockdown cities and quickly controlled the spread of the virus, which contrast sharply to what happened in the rest of the world especially the western world with market economies and democratic political regimes. Many people hail the success of the China approach and some claim its superiority over the western world. This is, unfortunately, a misperception and may have serious consequences. As we know, the control of contagious disease is a good example of “externality” in economics and is often used to explain “market failures.” Because the benefit of contagious disease control to an individual is far smaller than the benefit to the whole society, an individual tends to take less than optimal caution and measure to control its spread. In this case, a government can help by forcing people to take vaccines, wearing masks, or even lock down cities. China’s regime with a strong central government and previous experience with the SARS is well suited to address these kinds of crises. The same logic works for other types of market failures, including but not limited to the public good provision and other types of activities with externalities such as high-speed trains. It is not surprising to see China’s success in these areas and indeed the western world should learn from China to design policies to ensure quicker and more effective responses to these market failures or crises. However, we cannot simply generalize it to all other areas where the market and individual decisions should take control. Many decisions in our society involve trade-offs and no regime is perfect in all aspects. We need to admit that China’s regime does have advantages in some areas over western democracies, but the inadequate response to this pandemic in the western countries alone is certainly not sufficient to justify its overall inferiority to China’s regime.^[1] Such awareness can help China to deepen reforms and handle international conflicts. For instance, although the more centralized regime of China does give some advantages to Chinese firms when competing against companies in the western world, this is not sustainable as shown by the current trade war between the U.S. and China. To fully integrate into the world economy, China will have to embrace more market reforms and institutional changes to ease the tension with the western market economies, rather than commanding even more control over the economy and society as the current regime under Xi Jinping is doing. The economic miracle of China over the last several decades is not more and more control from the government, but less and less control over time since the 1980s. 

Bio: Dr. Xuepeng Liu is a Professor of Economics at Kennesaw State University. His research interests include international trade, economic development, and the Chinese economy. His recent work studies international trade agreements, global value chains, tax evasion/avoidance in international trade, etc. He has published in prestigious academic journals such as American Economic Journal, the Review of Economics & Statistics, Journal of International Economics, and Journal of Development Economics. Besides teaching and doing research at KSU, Dr. Liu has also frequently visited major international organizations including the World Bank, the IMF, and the WTO, as a visiting scholar or research consultant. He is currently a research associate of the China Research Center (CRC) and had also served as a Director of the North America-based Chinese Economists Society (CES).

---

¹ Besides the lack of central government directives, there are many other cultural, political and economic reasons to explain the relatively slow responses to the COVID-19 pandemic in the western world. This is beyond the scope of this article.