US Trade Gap Shrinks to 4-year Low

The Trade War's Troubling Twist

April 17, 2018
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.

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