U.S.-China Trade Deal Will Be More Substantial Than Expected

After months of diligent negotiations, the U.S. and China are nearing an end to trade talks. Investors are expecting a resolution, but most assumed the deal would be unsubstantive. That’s where markets could be surprised.

Both President Donald Trump and President Xi Jinping have held back on setting the agenda through their bully pulpits of social media and state media respectively. A trade deal burnishes the political agenda of both leaders and helps fortify the world against a serious growth setback.
Instead, negotiations have been led by serious trade specialists who can speak with authority: the U.S.’s Robert Lighthizer, and Liu He, one of the primary architects of China’s economic reform. The continued engagement from both sides indicates the commitment to work through tedious policy issues to assure fairness and enforcement.

Trump has hinted that negotiations will be anointed by a meeting with Xi Jinping that could happen next month. Both leaders must show they fought hard to deliver an agreement that will lead to fair and enforceable trade practices for their respective countries. So, what will that look like?

Increasing imports was always the easiest part to fix. China has already made commitments to buy more agriculture, natural gas, semiconductors and aircraft. Given the U.S.’s concerns on potentially sharing some semiconductors, and China’s caution on Boeing ’s planes, the final list may be more restrictive. World Trade Organization (“WTO”) rules are sensitive to large dedicated orders that can crowd out other countries, so they may also force some adjustments.
China is also pledging greater access to a range of industries from banking to agriculture.

Foreigners should be able to own an increased share of banks and insurance companies. Technology companies may also be allowed to have their own data centers in free-trade zones. However, details are still sparse. On a separate track, Europe is negotiating the same issues, and while uncoordinated with the U.S., the combined pressure should drive change.

Technology companies will continue to have higher sensitivities than most other sectors and will likely remain on the back burner until the U.S. resolves its confrontation withHuawei as a security threat.

More Transparency

Protecting Intellectual Property (“IP”) has always been a sticking point. But in March, China passed a foreign investment law to prohibit forced transfer of technology. It supported equal treatment of foreign enterprises, alongside local state-owned enterprises (“SOEs”). While it compels local government to comply, it also reserves the right to expropriate (with compensation) investments that are in the public interest. Therefore, effective enforcement is essential to keeping this from becoming a more creative version of the current broken system.

Until now, state-sponsored capitalism has been essential to China’s growth and economic control. The SOEs function as primary conduits to deliver state-driven economic policies and stimulus. Measured by return-on-equity, many SOEs disappoint. But since the government trades off jobs over productivity, as a large employer, SOEs are critical to preserving social harmony.

Aggressive demands to reform this symbiotic relationship is a red line for China. However, there are hints they may be willing to provide more disclosure to the WTO on subsidies. Internal pressure may be the best impetus for change. Small- to medium-sized (“SME”) Chinese companies loudly complain that they get squeezed out by SOEs, who receive preference in borrowing and on other benefits. The Chinese government has pledged to level the playing field.

A New System Of Enforcement      

Lighthizer is adamant that if enforcement is compromised, the agreement will fail. The Chinese see a role for the WTO in adjudicating disagreements, while the U.S. wants to jettison the WTO. In turn, China doesn’t want to be held hostage to a U.S. administration that could liberally wield tariffs for any perceived infraction, and undermine their sovereignty as equal partners.

China and the U.S. appear to be finding the middle ground and tilting to two-way enforcement. Each country would have their own enforcement officers working in their partner’s region. This could be a significant breakthrough or a major disaster if evasion remains undetected. Given that Lighthizer has staked his credibility on this, including in his updates to Congress, this oversight and adjudication is expected to have some bite.

Given the rigor that Robert Lighthizer and Liu He have brought to these negotiations, markets are going to be surprised by how comprehensive the deal is. That should invigorate sentiment, improve the outlook on earnings and provide the catalyst for another leg up in equities.

Source: Forbes