McLARTY UPDATE: Possible scenarios for US-China trade talks

March 14, 2019

KEY POINTS:

A quick trade deal would be in the interest of both Presidents. Yet Trump’s walk-away from his North Korea summit, coupled with Beijing’s memories of the President’s second thoughts about the Mnuchin trade deal last spring, has fueled concerns over the tactics Trump may try with China, making the timing of any deal uncertain.
Talks have been ongoing, and USTR Lighthizer is expected to continue negotiations during a trip to Beijing later this month. While rumored, a Trump/Xi summit in Florida is not confirmed, and their meeting may delay until the G20 in June.
Negotiations remain highly unpredictable in terms of timing and scope. We outline four possible scenarios, from least likely (comprehensive deal) to most likely (near-term light deal).

Whither the Trump-Xi summit?

After President Trump tweeted late last month that “substantial progress” had been made with China, USTR formally delayed a planned tariff increasefrom 10% to 25% on $200 billion worth of Chinese imports (List 3) “until further notice.”

Presidents Trump and Xi clearly want to make a deal as soon as possible, both to ease market concerns and to boost their respective political positions. Trump is keen to demonstrate to key constituencies like farmers and businesses that his trade strategy is working. Meanwhile, a deal would help Xi prevent an unemployment spike and demonstrate that he can manage the US-China relationship in a politically important year marking the 70^th anniversary of the new Communist China.

However, the timing for a prospective Trump-Xi summit to finalize the agreement may have been complicated by Trump’s walk-away from his meeting with North Korean leader Kim. Trump and Xi were rumored to meet at the end of March at Mar-a-Lago. But frequent backtracking by Trump as a key component of his negotiating style has been repeatedly criticized by Chinese state media. Although Beijing would have more leverage than North Korea, any abrupt change of course on a deal by Trump would make President Xi lose face both internationally and at home. Before Xi agrees to a summit, particularly in the United States, he likely will want to extract assurances from Trump that the meeting will be successful. This may lead to a delay in their encounter until the G20 in Japan this June.

USTR Lighthizer continues discussions with Beijing

Washington and Beijing have toiled continually, exchanging views through video conferences. In recent weeks, USTR Lighthizer and Chinese Vice Premier Liu He have led several rounds of negotiations to attempt to work out a comprehensive agreement covering issues including technology transfer, IPR protection, non-tariff barriers, services, agriculture, currency, trade deficits, and a robust enforcement mechanism. We understand that USTR Lighthizer may travel to Beijing later this month, probably after China’s annual legislative meeting that ends March 15.

Beijing’s offer reportedly includes relevant provisions of the new foreign investment law, lowering tariffs on US agricultural, chemical, auto and other products, expediting removal of foreign equity caps on auto JVs, and boosting purchases of US goods (i.e., natural gas, soybeans).

Our information reflects that the parties are edging closer to agreement on agriculture and currency but remain divided on issues like technology transfer, SOEs, industrial subsidies, and enforcement. Further, Beijing would need more time and political will to alter its policies around industrial policy.

Testifying before the House Ways & Means Committee on February 27, Lighthizer reaffirmed his determination to secure an enforceable deal with China, suggesting a process involving meetings held at various levels of seniority on a monthly, quarterly, and semi-annual basis. Lighthizer said before Senate Finance on March 12 that “real progress” has been made in the “final weeks” of trade talks, which hopefully would lead to an agreement. But he added that certain unspecified “major, major issues” remain unresolvedand hinted there’s still a chance for the talks to fall apart.

While a deal may remove/reduce retaliatory tariffs, the enforcement mechanism could allow for unilateral action and the threat of tariff snap-back should the United States believe that China is not living up to its commitments.

China’s view

At a Saturday press conference, China’s Vice Commerce Minister Wang Shouwen said he is “hopeful” that a deal would be reached but refrained from forecasting a timeframe. Wang also said that “any enforcement mechanism must be two-way, fair, and equal,” signaling China’s refusal to abandon its rights to counter-retaliate against unilateral action. He didn’t comment directly on whether the tariffs imposed last year would be removed at once or step-by-step, if at all.

Scenarios

While the timing and substance of a US-China deal remains uncertain, we outline four possible scenarios — plus a “wild card” for your consideration.

Scenario 1: A full deal – The Whole Enchilada (Most unlikely)

In the short/medium term, we see a comprehensive deal covering key Chinese structural issues as extremely unlikely given the complicated nature of the issues and Chinese resistance to bold and fundamental structural reform. However, it is possible that a deal emerges that, over time, can edge closer to meaningful Chinese reforms than expected.

Scenario 2: Negotiations fall apart — The Blow-Up (Unlikely)

Should the parties fail to narrow key differences — from state subsidies to a potential mechanism that would give USTR enforcement power — we may see the deal fall apart. The United States would then likely increase tariffs to 25% from 10% on $200 billion worth of Chinese products (List 3) while keeping the 25% duties on $50 billion goods (Lists 1-2) intact. China would no doubt consider retaliating with higher tariffs, using non-tariff and regulatory tools to punish American companies, and possibly imposing new barriers to further complicate the business environment for US firms.

However, we see the likelihood for this scenario to be small, given the interests of both countries in concluding a deal and the progress already made in the negotiation. Further, increased tariffs and market barriers would certainly deal heavy blows to both economies and fuel public discontent.

Scenario 3: Negotiations drag out — The Muddle Along (Moderately likely)

This would lead to continued uncertainty for the private sector and market swings. Despite his enthusiasm for a deal, Trump understands that, as Senator Rubio (R-FL) has stated, “prematurely agreeing to a bad deal” will have political costs with Democrats and Republicans. At the same time, failure to deliver a “win” on China could hurt Trump’s standing with his base, especially farmers and ranchers.

Of course, Xi’s grip on power is more secure, even more so with no presidential term limit following a Constitutional amendment last year. But Xi must work hard to avoid being viewed as a weak leader who has mis-managed the bilateral relationship. Chinese leaders have stated that “confidence is more important than gold.” For now, strong nationalistic sentiment against the US trade war has boosted Xi’s popularity. However, if high tariffs continue to erode corporate profits and manufacturing output, public frustration will grow, raising questions about Xi’s capability to protect the interests of his people.

In this scenario, an exclusion process for List 3 should proceed. Given that the recently-passed US budget mandated that USTR allow for exclusions, a process should be unveiled shortly.

Scenario 4: Framework deal in the near term – The Let’s Make a Deal (Most likely)

Under this scenario, the two sides would reach a framework agreement in the near term for the leaders to claim victory, probably around the end of March at a summit or later. USTR may agree to reduce some or all the tariffs on Chinese products in return for progress on the above-mentioned negotiating requests, especially Beijing eliminating agricultural tariffs, easing market access barriers, stepping up IPR enforcement, and promising to deepen structural reform.

The key in this scenario is the strength of the enforcement mechanism. If the United States succeeds in securing Chinese buy-in regarding unilateral US retaliation, then the Administration can demonstrate that its enforcement mechanism, coupled with Chinese commitments on purchases, market access, and structural change, has resulted in a strong, meaningful deal, much improved from those reached by previous Administrations.

In this scenario, Trump likely would still face scrutiny for not obtaining “Scenario 1.” Xi would certainly meet criticism for not making the trade war entirely disappear. But in a protracted negotiation where no off-ramp was ever clearly defined, this may be the best scenario we can hope for – a path forward that produces deliverables and delineates a structure for follow up. While Trump’s challenge politically still will be to prove how this effort is different from previous bilateral initiatives, he should benefit from the relative reduction in uncertainty. Markets will see a framework deal as reducing the risk of decoupling, which should boost markets, at least in the near term. Again, the enforcement mechanism will be the space to watch.

And finally: The Wild Card – Huawei

Trump hinted in December that he might intervene in the Huawei case if it would promote a better trade deal with Beijing. Huawei, the world’s biggest telecom equipment provider, is facing US Department of Justice charges on financial fraud and other alleged crimes, as well as increased scrutiny regarding national security risks. While Trump has tweeted that he wants the US “to win through competition, not by blocking out currently more advanced technologies,” he did add that “if there is a security reason, then we may have no choice.”

Judicial independence makes interference in the Huawei case difficult to imagine, even in a unique presidency like Trump’s. Further, he has been warned not to set “a terrible precedent” by interfering in rule of law. However, Trump could still exercise his executive power to impact the legal process, as he did last year with respect to ZTE sanctions, a factor that should not be forgotten and is not lost on the Chinese.

The McLarty Trade and China teams stand ready to help you develop business strategies around these scenarios. For more information, contact China practice lead John Holden (jholden@maglobal.com)