The Perils of Shifting China's "Market Economy" Dispute to the WTO

Chad P. Bown (PIIE)

December 21, 2016
Photo Credit: 
REUTERS/Stringer

Last week, China brought formal legal challenges against the United States and the European Union for their failures to recognize the Asian giant as a "market economy" according to World Trade Organization (WTO) rules. China's current "nonmarket economy" designation allows Washington and Brussels to use a special tariff formula to stem the flow of low-priced imports in antidumping cases. Contrary to initial media reports of a trade war, Beijing's WTO actions sent a positive signal for otherwise bleak trade relations between these major powers—at least in the near term.

But longer term, the squabble over China's market economy status is just the tip of the iceberg. China's decision to lodge a formal dispute at the WTO also starts a ticking clock. The United States and the European Union must find another forum to creatively negotiate a comprehensive deal with Beijing over an even larger package of economic concerns.

At first blush, China triggering a WTO dispute is actually a good sign, for at least two reasons. First, it shifts the market economy spat out of crisis mode during the changeover in US administrations. WTO disputes take at least three years to fully play out. Beijing's decision provides the incoming Trump administration with the breathing room needed to digest the full range of US trade concerns and to formulate a comprehensive strategy. It also provides a chance for Brussels to get its house in order.

Second, turning China's market economy status over to the WTO means that a highly scripted and legalized process will manage the issue at least for a while. While headlines are wont to characterize formal WTO legal challenges as the escalation of a trade war, this is mostly wrong.

Trade wars like those of the 1930s typically involve one country shutting off trade and partners retaliating in kind. But most formal WTO disputes, including the China market economy case, entail the opposite. China is using the dispute to try to remove old trade barriers; it is not imposing new ones. China is seeking to expand trade, not constrict it—for now. After all, the architects of the WTO dispute process designed it to halt the escalation of trade tensions.

While headlines are wont to characterize formal WTO legal challenges as the escalation of a trade war, this is mostly wrong.

Consider what happens if Washington and Brussels lose their legal battle and yet also remain unable to recognize China as a market economy because of intractable politics at home. While the WTO would "compensate" China by granting trade retaliation rights, the retaliation level is relatively formulaic and constrained by WTO judges. The WTO would limit Beijing's retaliation to an amount equal to the export revenue lost due to the US or EU market economy status infraction.

Most WTO disputes do not end up in retaliation. In more than 500 cases filed to date, the WTO has authorized retaliation in fewer than 15, with countries imposing retaliation in fewer still. The process is highly choreographed and designed to contain the trade fallout stemming from any one bilateral irritant.

The United States and the European Union also have experience managing the political process of not only retaliating, but also of being retaliated against under the WTO. China, however, does not.

That leads to the signs that are more worrying than the WTO dispute itself. On the same day China announced its formal complaint, reports emerged that Beijing was bringing an anti-trust action against General Motors (GM) for alleged price-fixing. Later in the week, the Chinese military seized a US Navy underwater drone in the South China Sea, a move that required diplomatic interventions to calm tensions.

Already on heightened alert after the WTO filings, trade watchers were left wondering: Were these Chinese actions also over market economy status, and thus retaliation taking place outside of the WTO?

The price-fixing accusation against GM echoed an earlier Chinese move. To voice its displeasure with a US trade policy decision in 2009, Beijing responded by imposing trade restrictions against American exports of automobiles, including from GM, which the WTO later determined were illegal. This was one of a series of retaliatory trade restrictions China aimed at the United States and the European Union between 2009 and 2011, affecting American exports of poultry, specialty steel, and optical fibers, and EU exports of screws, bolts, and X-ray equipment.

Because market economy status is only one of many current tensions in US-Chinese relations, correctly interpreting today's signals presents a challenge. Beijing's recent GM and drone actions likely had less to do with trade and more with President-elect Donald Trump's telephone call with Taiwanese President Tsai Ing-wen and his television interview that called into question US commitment to the One China policy.

Yet a lesson for all sides is clear: Sending trade policy signals outside of the WTO system could easily be misinterpreted, with potentially severe and unintended consequences.

Still, there is a big downside risk of China turning the market economy issue over to the WTO. The legal dispute will be limited to China's concern that an estimated 7 percent of its exports are affected by trading partners' use of antidumping laws and China's nonmarket economy status. The case at the WTO will be forced to mostly ignore the elephant in the room: that China has not yet fully transitioned into a market-oriented economy.

While China has made significant strides toward market orientation since joining the WTO in 2001, its trading partners remain troubled by Beijing's failure to limit direct state involvement in sectors like steel and aluminum. Furthermore, Washington is concerned with the changing nature of Chinese state and Communist Party involvement in economic decision-making. China's new and strategic use of indirect subsidies continues to affect economic outcomes and have implications for international markets. But these subsidies are more difficult to detect, measure, and constrain under existing WTO rules.

In the absence of a renewed unilateral commitment from Beijing for additional economic reform, a more comprehensive agreement among China, the United States, and the European Union may be required.

Although Beijing's decision to file a WTO dispute opens a window of opportunity for negotiations, the main worry is that it introduces a false sense of security.

A sustainable political deal would be difficult to navigate, though, as it would have to balance at least three competing concerns. First is China's political demand to be recognized as a market economy under its trading partners' anti-dumping laws. Second, the United States and the European Union would likely require continued access to some WTO-consistent policy to occasionally address low-priced imports from China, perhaps through easier access to so-called countervailing duties, so that it is clearly permissible under WTO rules to impose import restrictions on China's indirect subsidies. Third, the WTO system needs clarity on China's path toward additional market orientation, as well as a mutual understanding of the carrots and sticks that other WTO members would have available to help Beijing remain committed to reform.

Although Beijing's decision to file a WTO dispute opens a window of opportunity for negotiations, the main worry is that it introduces a false sense of security. The clock is now ticking, with the onus shifted back to Washington and Brussels to find a separate venue to negotiate with Beijing over this larger set of concerns. The United States and the European Union need to be creative, as a formal WTO dispute is not the forum to craft any new deal.

Chad P. Bown is a senior fellow at the Peterson Institute for International Economics in Washington and the author of "Should the United States Recognize China as a Market Economy?" (2016). Follow him on Twitter @ChadBown.