mary lovely, is a professor of economics at Syracuse University’s Maxwell School and a senior fellow at the Peterson Institute for International Economics.
Illustrated by pierre-paul pariseau
Published October 23, 2020
The news has been coming thick and fast: month after month, we learn of the latest insults to the U.S.-China relationship and their doleful implications for bilateral commerce. U.S. imports from China fell by $87.3 billion in 2019, the largest annual decline in U.S. history from any trade partner ever (excluding 2009, the nadir of the Great Recession). Several factors contributed to this nosedive, but the trade war was key.
The tit-for-tat tariffs initiated by the Trump White House in 2018 continue to burden two-thirds of the bilateral trade, with levies averaging 20 percent. And since the start of 2020, U.S.-China relations have eroded further as the president has blamed China for the pandemic and industrial spying, responding with further restrictions on immigration, trade and investment in the name of protecting U.S. security.
Stuck in the middle of this intensifying geopolitical rivalry are the multinational firms that manage the labyrinthine supply chains linking the two economies. These firms face mounting financial and political pressures from the United States to thin their commercial links with China. (To be sure, Chinese government actions ranging from human rights abuse to internet censorship to intellectual property theft are also major concerns for multinationals in the region, but my focus here is on U.S. government actions and their consequences.)
Indeed, supply chains that tie the two economies have been a frequent target of President Trump, who allowed in June that “a complete decoupling from China” was an option, and whose administration frequently claims that engagement with China has failed and that it is a dishonest global player. Ongoing anti- China rhetoric from a lineup of Trump cabinet secretaries – not to mention administration officials’ casual use of the terms “Wuhan virus” and “China virus” – signals the President’s intention to continue this campaign.
The past two decades witnessed falling trade frictions and information technology advances that accelerated the fragmentation of complex production processes.
What’s more, the anti-China genie will be very difficult to put back in the bottle. If he is elected, Joe Biden seems unlikely to substantially alter the current U.S. stance toward China anytime soon. Biden is promising to “stand up to Chinese abuses” and to push for reshoring of critical supply chains while limiting government purchases to goods made in the U.S. It’s true that the Biden “Made in America” plan may not result in actual policy changes – he’s trying to pacify a coalition that includes unions and the Democratic Party’s left in battleground states. But it is also true that the campaign rhetoric is consistent with a broader view that blames global economic integration in general and China in particular for much of what ails the U.S. economy.
A course correction from a Biden White House late in his term is always possible – arguably even likely – as the internationalism that dominated U.S. economic policy from World War II to 2016 reasserts its influence. Unlike Trump, who barely hides his contempt for Europe and the East Asian democracies, Biden says he will “rally the allies in a coordinated effort” to diplomatically press China to meet its treaty obligations on trade and investment. But the economy that President Biden would inherit will still be reeling from the pandemic, and Americans will not be in a patient mood. Thus, it appears that regardless of the election outcome, U.S.-China relations will remain in the deep freeze for a while longer.
At the center of this conflict (uncomfortably) lie the multinationals that control the bulk of investment and trade flows between the two economies. It is their intellectual property that both presidential candidates are promising to protect, and it is their offshoring decisions that both are promising to reverse. However, the majority of multinational firms that determine the content and location of global production are keeping a low profile. Both Trump and Biden aim to either influence supply decisions through tariffs or other trade barriers, or to direct, through export controls or Buy America mandates, the behavior of some of the largest companies in the world.
Alongside (and often in partnership with) American companies, multinationals based in Europe, Japan, South Korea, Hong Kong and Taiwan are the driving force behind 40 percent of China’s merchandise exports. Given their essential role in connecting the U.S. and Chinese economies, it is unfortunate (if not very surprising) that these firms are often missing from discussions of the nuts-andbolts implications of decoupling.
Multinationals are on the front line because they are the companies that the U.S. (and other governments) seeks to draw away from China – and, the governments hope, to bring their production facilities back home. Many of these firms loosely fall into the category of “high technology” – especially computers and consumer electronics. But many of the products caught in the crossfire are no more sophisticated than the power cord and brick-like power adapter used to charge your laptop.
Perhaps more than the outcome of the 2020 American election, efforts to isolate China, to reshore production of supplies deemed critical (like medicines) and to fortify domestic manufacturing depend on decisions made by the foreign multinationals that control global supply chains. Their responses to sticks (like import tariffs) and carrots (like reshoring subsidies) will determine whether the decoupling effort launched by the Trump administration isolates China – or, as discussed below, inadvertently isolates the United States.
The Role of Knowledge Flows
Unlike textbook examples of trade, in which goods are made from scratch within the borders of one country and shipped to another, much of what the U.S. imports from China contains value created in other locations – including a lot of value created by Americanowned intellectual property (copyrights, patents, trade secrets). Moreover, two-thirds of the products imported are capital goods or industrial parts and supplies destined for use in production within the U.S. To understand the challenges of decoupling, then, one must appreciate the uniquely dominant role of multinational firms in shaping the commercial ties that bind the two countries.
As documented by Richard Baldwin of the Centre for Economic Policy Research, the past two decades witnessed falling trade frictions and information technology advances that accelerated the fragmentation of complex production processes. Reduced costs of directing and managing foreign suppliers, whether operating at arms’ length or as affiliates abroad, allowed American corporations to “unbundle” production and to arrange manufacturing activity and sourcing across countries, with the primary goal of minimizing costs.
According to Baldwin, the distinctive feature of this “new globalization” is the massive knowledge flows embedded in offshoring purchasing and production. Some of these flows take the form of subcontracting and licensing agreements, in which the innovating firms transfer blueprints and technologies to lower-cost locations without investing directly. Other flows occur within the firm as trade between affiliated parties. American innovation and production stimulate a large share of China’s exports to the U.S. and dictate their pace and scope.
The clearest indication that knowledge transfers and production-unbundling from advanced-economy multinationals drive Sino-American trade flows is the share of total Chinese exports that originates in multinational firms operating there.
In 2019, these foreign-invested enterprises were the source of 40 percent of total Chinese exports to the world. The share of China’s exports to the United States that originates from non-Chinese enterprises is significantly larger still – 60 percent. In industries where the benefits of separating innovation and labor- intensive production are particularly large, such as computers and smartphones, the share of Chinese exports coming to the Fourth Quarter 2020 9 U.S. from foreign enterprises runs to a remarkable 88 percent.
The evolution of trade patterns, especially those between China and the United States, clearly reflects the very substantial degree to which multinational firms have enhanced the value of their innovative activity by using East Asian supply chains.
After 2001, three industries that stand out in this regard are computers and telecommunications devices, electrical equipment, and machinery. The “processing share” of China’s trade in these sectors, defined as trade in which imports enter the country solely for creating exports, remains high, signaling that these exports contain relatively little Chinese domestic value-added.
As documented by Ari Van Assche of the HEC management school in Canada, China’s processing trade exhibits a triangular pattern. China imports high-value inputs predominantly from the U.S. and richer East Asian countries, and exports processed final goods largely to the West. Production within China is complemented by innovation, marketing, design and management added primarily in the United States and other highly industrialized countries.
Sino-American trade flows have become ever more heavily weighted toward this triangular pattern of knowledge-based industries. In 1997, computers and telecom devices, electrical equipment and machinery together accounted for 33 percent of total U.S. imports from China. And by 2017 (before Trump imposed tariffs), the three sectors together accounted for 54 percent of U.S. imports from China.
These sectors account for a large share of Chinese imports as well, indicating the importance of imported inputs to Chinese activity in these areas. The labor-intensive products often associated with China – apparel, textiles and leather products – accounted for 26 percent of U.S. imports from China in 1997. But by 2017, the figure was just 12 percent.
Altering Multinational Supply Chains
While corporate boards struggle with ways to add “resilience” to their supply chains as the coronavirus pandemic rages and current links are at risk of being broken, they face ongoing U.S. government pressure to pull global operations away from China. Note, moreover, that these pressures extend well beyond American companies, given the intense involvement of non-U.S. multinationals in trade between the U.S. and China.
The U.S. government has launched a series of initiatives to convince these firms (and their American customers) to cooperate. Partial decoupling, in some cases achieved at considerable cost, is already under way as a result of targeted government directives and restraints. The recent addition of Chinese surveillance technology companies to the U.S. government’s restricted list is an important example of the command approach, as it directly proscribes private sector behavior on national security grounds.
China, it’s worth noting, lost U.S. market share for products that remained untaxed as well as those subject to new tariffs in 2018 and 2019
Is It Working?
It’s an overstatement to conclude (as does Alex Capri of the Hinrich Foundation) that “global supply chains have been steadily decoupling from China.” Despite the sense of certainty that has crept into press reports, we in fact have limited information on how much supply chains have been altered. Indeed, the information we do have from the United Nations Comtrade database indicates that China’s share of world manufacturing exports changed only slightly in 2019 compared to previous years. We do, however, know that Chinese exports to the United States fell as a result of the Trump tariffs. A careful statistical study by a group of economists, including Pablo Fajgelbaum of Princeton, estimates that U.S. imports of Chinese goods declined by 31 percent due to the trade war.
It is worth remembering, though, that much of the merchandise subject to tariffs by the U.S. did not consist of goods created by the most complex supply chains. Indeed, Yang Liang (of San Diego State) and I calculated that fully half of the enormous bundle of computers and electronic products were never subject to tariffs. Much of affected trade is best characterized as traditional trade, including trade in shoes, textiles, non electrical machinery, furniture and the like. Nevertheless, despite the substantial tariff-induced drop in U.S. imports, China was able to find new markets and preserve its share of world manufacturing exports. Tariffs may thus be isolating the U.S. market from China rather than isolating China from the world.
There is ample evidence that Chinese production bound for the American market has been replaced with U.S. imports from other partners. The European Union, Mexico, Vietnam and Taiwan all gained U.S. market share at the expense of China, especially in products for which they already had footholds in the U.S. market. China, it’s worth noting, lost U.S. market share for products that remained untaxed as well as those subject to new tariffs in 2018 and 2019. One explanation is that general hostility and uncertainly created by the Trump trade war led firms to preemptively adjust all supply chains serving the U.S. market in anticipation of further escalation.
Carrots Rather Than Sticks
In response to the pandemic, a growing number of countries have announced “reshoring funds” to bring production back from China. Although most reshoring programs relate in some way to the immediate need to control critical medical supply chains during the pandemic, a number of countries have seized the opportunity to splice into global supply chains that are in flux due to Washington’s demands for China decoupling. The programs are designed to subsidize the fixed costs of relocation for firms that undertake it. While they vary considerably, all use government policy as a tool for altering the supply decisions of multinationals usually left to market forces.
South Korea, India, Taiwan and Japan have all announced plans for such subsidies. Japan is the first to implement one, earmarking ¥243.5 billion (about $2.3 billion) for the initiative. The first recipients of Japanese subsidies were announced in July; they include 57 companies that will invest in Japan and 30 firms that will relocate from China to Vietnam (a co-signer with Japan in the Trans-Pacific Partnership) and countries in East Asia. By the same token, emerging Southeast Asian countries are using investment subsidies to lure multinationals from China. Indonesia, for example, is trying to attract foreign investment with new tax breaks and land subsidies. The shift may serve U.S. interests by diversifying its sources of supply, but it is hardly what Trump (or Biden) seems to have in mind.
Who Cuts What?
The direction the U.S.-China trade war is heading suggests that the U.S. may inadvertently be isolating itself from highly efficient supply chains that stoke production in other parts of the world. While America’s allies express frustration with the same problems that U.S. leaders do – obtaining fair access to the Chinese market, protecting intellectual property – they are very much aware that China represents a large and growing share of the world economy. Recent statements by the Australian, Japanese and UK governments have made clear that they will not push for further decoupling with China, even as many of them take steps to protect themselves from Chinese aggressiveness in other arenas.
Some of these nations are already using subsidies as carrots to attract multinational production to their own shores or to nations with which they have free trade agreements. By failing to work collaboratively with these allies, the U.S. is creating incentives for the multinationals that control global trade to decouple parts of their supply chains from China – but in the process offering them no good reason to recouple with America.
Bringing manufacturing back from China is one of those ideas offering a little something to everyone: more jobs, more profits, less concern we are feeding the ambitions of an authoritarian juggernaut. Dig beneath the rhetoric, though, and what’s left is uncertainty. The global economy is a web that can’t be untangled easily – or with any confidence that we’ll like the result.