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The Trade War’s Troubling Twist

Jun 23, 2020 | Industry Trends, Supply Chain Technology

State-owned manufacturing enterprises in China, Russia and beyond have an unfair advantage that tariffs alone won’t solve.

The Trump Administration’s recently imposed tariffs on steel and  aluminum, and its announced tariffs on $50 billion worth of Chinese  imports—and the threat of $100 billion more—represent the latest battle  in a war against unfair trade practices. One category of unfair trade  practices stems from the behavior of state-owned enterprises (SOEs) in  China and other countries.

SOEs represent a growing problem—and one that has the United States  working jointly on policy reforms with Canada, Mexico, the EU, Japan,  and other major trading partners.

The Problem with SOEs
SOEs are entities owned or  controlled by the government, either at the national, regional, or local  level. They aren’t new or unique. Found in every country, they have  long been providing basic services such as public transportation and  utilities. For example, U.S. SOEs include the U.S. Postal Service,  Fannie Mae, and Freddie Mac.

Trade issues arise, however, when SOEs engage in commercial activities and compete with private sector companies.   Such SOEs may enjoy a wide variety of government-conferred advantages  that include subsidies, preferential treatment in procurement and  regulation, market power, captive equity, exemptions from bankruptcy  rules, and/or information advantages. 

These advantages have an impact—SOEs do not always act in accordance  with their commercial interests—and the result is an inefficient market.  For example, world overcapacity in steel—the justification for the new  U.S. tariffs—has been attributed to the large number of SOEs in the  industry, especially from China, the world’s largest steel-producing  country. Subsidies and cheap finance make SOEs in steel production less  amenable to market signals, and the result is overcapacity. SOEs are  also driven more by political considerations than their competitors. For  example, in 2010, China cut off exports of rare earth minerals to Japan  during a territorial dispute. 

The rationale for SOEs varies, from industrial policy (to ensure  national leadership in some particular industrial sector) to protecting  government revenue to ensuring access to good-paying jobs. But no matter  the intention, SOE behavior often leads to market distortions—and the  inevitable complaints from competitors about unfair trade practices. 

According to the World Bank, SOEs were on the decline in the 1980s  and 1990s when the privatization movement took hold. However, since  then, several countries reversed course and took steps to preserve or  expand SOEs in key sectors. It is this expansion of SOEs and the scale  of their cross-border impact that has piqued current interest in SOE  reform. 

According to research published by the OECD in 2013, of the world’s  2,000 largest firms, SOEs hold a 10% share, and account for 6% of world  GDP and 36% of manufacturing value add. In 2000, only one of the Fortune  50 was an SOE; today, there are a dozen.

SOE’s represent more than 50% of the sales, assets and market values  of the ten largest firms in the following countries: China, the United  Arab Emirates, Russia, Indonesia, Malaysia, Saudi Arabia, India, and  Brazil. (In comparison, the vast majority of countries, including the  U.S., have SOE shares under 10%.) According to The Economist, the  world’s thirteen largest oil companies, largest bank, and largest  natural gas company are SOEs.

China represents a particular concern. When it joined the World Trade  Organization (WTO) in 2001, it promised that the government would not  influence the commercial decisions of SOEs. According to the U.S.-China  Economic and Security Commission, an organization created by Congress to  monitor Chinese trade practices, “China does not appear to be keeping  this commitment. The state does influence the commercial decisions of  SOEs … If anything, China is … giving SOEs a more prominent role in  achieving the state’s most important economic goals.”
For example,  according to a recent report from the U.S. Trade Representative  (U.S.TR), a substantial amount of Chinese outbound investment occurs  through SOEs or is financed by Chinese state-owned banks.

Current Trade Rules Are Inadequate
In a 2017  article in the Harvard International Law Journal, Minwoo Kim argued that  current trade rules—including domestic laws and WTO rules—are poorly  designed to address modern trade disputes associated with SOEs because  of the difficulty in determining a threshold question: whether state  action is responsible for the conduct and/or whether a firm is  controlled by the state (i.e., is it an SOE?).
The relationship  between an SOE and its government is not always transparent. The  organizational complexity of the modern SOE, coupled with a government  unwilling to cooperate, makes it very costly for a complaining nation to  bring and win such a trade case. This has been the experience of the  U.S. with China, for example. 

A variety of mechanisms have been employed to address SOEs’ unfair  trade practices. These have their advantages, but none is sufficient to  address all of the underlying problems. National anti-trust laws, for  example, can be used to deal with anticompetitive effects of SOE merger  and acquisition activities. Such laws, however, cannot address subsidies  or predatory pricing strategies. The Organization for Economic  Co-operation and Development’s (OECD) guidelines are voluntary and do  not impose binding requirements on nations. Competitive neutrality  frameworks (in the EU and Australia, for instance) can level the playing  field with respect to certain cross-border activities, but their scope  and enforcement vary widely.
New Trade Rules Are Emerging

Reform of SOEs is occurring in the context of new regional trade  agreements. The most significant is the Comprehensive and Progressive  Agreement for Trans-Pacific Partnership (CPTPP), a trade agreement  ratified by 11 countries (but not the U.S.) that breaks new ground in  the definition of and obligations of SOEs. 

CPTPP includes SOE provisions that remain unchanged from the original  Trans-Pacific Partnership (TPP), which then included the U.S.. It  defines SOEs by the commercial nature of their activities,  ownership/control by the state, and size. SOEs must act in accordance  with commercial considerations, not discriminate against the goods or  services of another party or non-party and receive no commercial  assistance causing adverse effect or injury to trade or investment  interests of other CPTPP members. 

Each participating country must provide a transparent list of its  SOEs and respond to requests for information about the relationship  between the SOE and its government. There are exemptions—most notably,  sovereign wealth funds and independent pension funds.

The provisions, however, are far from perfect. Critics say the  definition of an SOE is not broad enough and the exemptions and  exclusions are too numerous and allow for countries to continue to  distort markets. On the other hand, they address well-known problems  with current WTO rules and domestic laws that will likely change SOE  behavior in ways that increase market efficiency.
CPTPP must still be ratified by each of its member countries in  order to go into effect. Once it does, however, it commits  participating countries to treat SOEs from all countries, including  non-signatory countries, equally.

U.S. Advances Reform across Multiple Venues
The Trump Administration is eager to push SOE reform as part of its wide-ranging trade strategy, described in the 2018 Trade Policy Agenda.  For example, one of its goals in renegotiation of the North American  Free Trade Agreement (NAFTA) is to modernize treatment of SOEs, based on  the CPTPP provisions. SOE reform could also be included in reforms to  the U.S.-Korea Free Trade Agreement (KORU.S.). The U.S. government has  called on the WTO to reform its rules on SOE, most recently last  December at the WTO Ministerial Conference in Argentina. During that  meeting, Robert Lighthizer, the U.S. Trade Representative, complained  that China does not comport with WTO transparency requirements for SOEs.

The U.S. Congress is considering legislation to reform the Committee  for Foreign Investment in the U.S. (CFIU.S.), an interagency group that  reviews certain business transactions where a foreign entity seeks a  controlling share of a U.S. company or U.S. held asset that has national  security implications. Legislative proposals include expanding the  jurisdiction of CFIU.S. to include a broader range of transactions  (including those where SOEs play a minor role), expanding the list of  factors to be considered by CFIU.S. in its national security review, and  increasing the tools available to mitigate national security risks.  These proposals are a reaction to recent U.S.investment by Chinese  firms—including SOEs—in U.S. high-technology sectors in accordance with  China’s far-reaching industrial policy.
SOE reform could also come  about as a result of bilateral discussions between the U.S. and China to  resolve differences in trade policy. Published reports indicate that  both U.S. and Chinese government officials are open to discussion and,  indeed, some high-level interactions have taken place. However, White  House officials say that “serious discussions” have not yet begun. Given  that concerns over the unfair trade practices of SOEs are focused on  China, such bilateral discussions, coupled with multilateral efforts to  modernize existing trade agreements, represent the best near-term hope  for significant SOE reform.

Keith B. Belton is director of the Manufacturing Policy  Initiative in the School of Public and Environmental Affairs at Indiana  University in Bloomington, Indiana.

Original Article by Industry Week/ Keith B. Belton / 2018

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