It’s Time for the U.S. to Revoke China’s Free Pass on Trade

This article is part of a series by Thunderbird School of Global Management faculty, sharing their insights on the future of internationalism.

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Like most international business professors, I believe in free markets. I can quote Adam Smith and David Ricardo, and I believe that their theories are solid foundations for understanding the U.S. and world economies. Free trade really is the rising tide that lifts all boats, benefiting the economies, businesses, and workers of both exporting and importing countries.

Industries that are less competitive in each trading country will lose out in open trade. That may sound negative, but when the resources dedicated to those less competitive, less efficient industries move into activities where the country has a competitive advantage, both trading partners win. ‘Resources’ include workers who need support to retrain and move into employment in other industries. So there are ‘losers’ from free trade who have to be helped to move into competitive jobs/industries. In the end, whether a country has an absolute advantage or a comparative advantage over another country, it benefits by exporting the goods and services it is particularly good at, and importing those it is not.

But what if one country has an advantage because of intervention by the heavy hand of the state, rather than the invisible hand of the market? Then trade does not benefit both that country and its trading partner, at least not equitably. Free trade only works if trade is actually free.

No free pass for the world’s biggest economy

In many cases, trade is not free. Yet since the U.S. became the world’s largest economy in 1916, it has most often given trading partners a free pass when they cheat, even when America plays fair. When those trading partners have economies a fraction the size of America’s, their cheating doesn’t noticeably harm the American economy, businesses, or workers. In fact, bringing them along over time has tended to result in more open trade from those trading partners. But when the trading partner becomes the world’s largest economy, with a population nearly five times the size of the U.S., their cheating starts to hurt. (China is #1 when GDP is measured based on purchasing-power-parity, and #2 otherwise.)

[[{"fid":"4655","view_mode":"default","fields":{"format":"default","field_file_image_alt_text[und][0][value]":"US-China Trade Quote","field_file_image_title_text[und][0][value]":"US-China Trade Quote"},"type":"media","link_text":null,"field_deltas":{"2":{"format":"default","field_file_image_alt_text[und][0][value]":"US-China Trade Quote","field_file_image_title_text[und][0][value]":"US-China Trade Quote"}},"attributes":{"alt":"US-China Trade Quote","title":"US-China Trade Quote","height":"431","width":"862","style":"float: left; margin: 10px;","class":"panopoly-image-original media-element file-default","data-delta":"2"}}]]China’s cheating hurts, and it is time for the U.S. to stop giving them a free pass. I want to be clear here: I am not against trade with China. It has benefited both countries. But the benefits have not been evenly gained. China has used American companies to build up their own know-how, for example requiring American auto companies wanting to do business there to sign joint venture agreements that give at least 50% ownership of the business to a Chinese company, often state-owned. Typically, those joint venture agreements also include technology transfer requirements, so the American company has to give its know-how to the Chinese “partner.”

Similarly, China restricts activities of foreign banks and other financial services firms, such that foreign banks make up less than 2% of financial services in China. Foreign banks are restricted in funding themselves through overseas parents and have to gain approval for new branch openings. In addition, banks and stockbrokers face foreign ownership restrictions in securities companies, fund management companies, and local commercial banks.

Like U.S. banks, major U.S. tech companies such as Google and Facebook have faced restrictions in China. For example, they have faced bans on some parts of their business, censorship, and active interruptions of service along with demands to follow Chinese political instructions. These and many other restrictions in China keep U.S. services companies from either operating locally or exporting their services to China.

Those types of requirements and restrictions are a very smart development plan on China’s part, but they are the opposite of free trade, since no such requirements exist for Chinese companies looking to do business in the U.S. There have been a few high-profile cases of the Committee on Foreign Investment in the United States denying a Chinese company’s request to enter the U.S. market, or denying a Chinese company’s acquisition of an American company. But those were decisions made for national security reasons, and when Chinese companies do come into the U.S., they are afforded all of the rights and freedoms that U.S. companies are.

Given that China is not engaging in free trade in a range of key products and industries, there is no logic or economic theory that should prevent the U.S. from responding. Comparative advantage only benefits all parties when they are playing the same game and abiding by the rules. In every game I know of, when a player breaks the rules, his team gets a penalty, whether it’s a loss of yards as in football, or the other team gets a free shot as in basketball or soccer. When a team tips the scale in its favor by breaking the rules, the punishment is a tip of the scale in the other team’s favor. So it should be with China. It’s time for the U.S. to respond to China’s cheating with countervailing measures.

Just between the U.S. and China

What would an effective countervailing policy look like? One of the challenges in answering that question is measuring the harm caused by China’s policies. Part of the challenge is that the kinds of policies I’ve described – the policies that most harm American companies – are not trade restrictions in the true sense of the term. They are technology transfer requirements, limits on U.S. businesses operating in China, and buy-local policies that discourage or disallow Chinese companies from buying from U.S. companies. If we were talking about a 75% tariff on a particular American good, then a countervailing 75% tariff on a Chinese good would be an easy answer. But the harm done by China’s requirements and restrictions on American businesses is diffuse and difficult to measure, though we know it is significant.

But the answer is not to do nothing. I would take a piece of paper and draw a line down the middle. On one side I would make a list of the key areas where China isn’t playing fair – automobiles, banking, and technology are just three examples. On the other side I would put the areas where China relies on exports to America or investment from American companies (such as electronics assembly and textile manufacturing). I would take that list to China and say if they don’t remove restrictions on American auto companies there and allow American banks and tech companies to operate under the same rules as Chinese banks and tech companies, then the U.S. will impose restrictions on assembled electronics and textiles.

A countervailing policy like that would have to be done bilaterally with China, not through the World Trade Organization. The WTO (and the General Agreement of Tariffs and Trade that preceded it) has done great work in significantly reducing tariffs and has made some strides with labor and environmental protections, but it is not the mechanism for the U.S. to push back on China. Bringing a case against China to the WTO could be politically beneficial, as it would show the world that the U.S. is criticizing China publicly in that forum. But in terms of actually effectuating change, it has to be a bilateral conversation directly with China.

No, China won’t retaliate

Many critics of taking the kind of action I’m suggesting say that China will retaliate by imposing new restrictions on American companies doing business in China, or new tariffs on American goods. But that’s like telling a kid not to stand up to the schoolyard bully because the bully will hit him. The bully is already hitting America! Will the bully hit America harder, maybe knock America out? I don’t think so. China is a big gorilla, but so is the United States. Beyond exports to China, American investment there is huge, and I can’t see how they could realistically cut themselves off from it. As for goods assembled in China for American companies (iPhones, for example), they can be assembled in Vietnam, Indonesia, and Malaysia. China isn’t the only country with a supply of low-cost, medium-skill labor.

Would imposition of tariffs on China make goods and services more expensive for Americans? It probably would. But China’s cheating is more expensive in terms of lost U.S. jobs and business, and if a countervailing policy gets China to play fair, then it’s a net win in the long run.

America has turned the other cheek to China’s un-free trade and business practices for too long. It’s time for the U.S. to revoke the free pass, assess the penalty, and hope to continue the game on a newly level playing field.

Dr. Robert Grosse is Professor of International Business and Latin America Director at the Thunderbird School of Global Management, a unit of the Arizona State University Knowledge Enterprise. He is also a Fellow of the Academy of International Business and of the Business Association for Latin American Studies. His most recent book is Emerging Markets: Strategies for Competing in the Global Value Chain.

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The views expressed in this article do not necessarily reflect those of Thunderbird School of Global Management or Arizona State University as a whole.