Time for a Coherent U.S. Strategy to Address Chinese Innovation Mercantilism

Robert D. Atkinson March 4, 2020
March 4, 2020

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It is difficult to pick up a business publication these days without reading about China’s technological rise, its unfair innovation mercantilist policies, and what the U.S. government should do in response. This will be the most important foreign economic policy issue facing the United States for the next several decades. As such, it is critical that the U.S. government articulate clear goals and a realistic strategy to achieve them. Unfortunately, we don’t have such a strategy, as elected and appointed officials are all over the map on what to do. There are four possible strategic goals and approaches, some of which are complementary. In short, the United States needs to continue working, ideally in partnership with allies, to roll back the most egregious features of Chinese innovation mercantilism; it needs to encourage some transfer of U.S. production away from China to other nations; and it should develop and implement a robust domestic industrial strategy.

The first approach is to dial down the tensions and hope that market and political forces in China, coupled with persuasion from the United States and its allies, gradually lead China away from its rampant innovation mercantilist policies. This was the approach that the Obama administration embraced, and that President Trump’s Treasury Department has embraced to some extent, too, as it has sought to restore more normal trade relations with China.

The problem with this approach is that it is unlikely to work, at least in the short and midterm. To be sure, it is conceivable that China at some point will follow the same path as East Asian nations like Japan, South Korea, and Taiwan by moving from an authoritarian, state-directed economy to a democratic, mixed economy. But we shouldn’t hold our breath. It could be many decades away from happening. As John Maynard Keynes famously quipped, in the long run we are all dead. By then America’s advanced technology sector could be dead, too, or at least weakened.

The second orientation is “getting China to play more by the rules.” USTR and its head Robert Lighthizer has perhaps been the most forceful advocate for this approach. In this framing, the current negotiations with China are an attempt to restore some level of “normal” economic exchange between the two nations—but under a new set of enforceable bilateral rules that curtail China’s unfair trade practices.

While that is an important goal, history suggests it will be hard to achieve, necessary though it may be, because China has repeatedly promised to play by the rules, only to embark on creative new ways to transgress. Moreover, it should be increasingly clear that unilateral pressure will not suffice. China has shown it they can give as well as get—for example, imposing tariffs on U.S. imports, including on crops from politically important Midwest states. Moreover, the so-called “phase one” trade deal the Trump administration signed with China is underwhelming, particularly in light of the intense criticisms the administration has leveled against Chinese economic policies. And the odds of an ambitious and enforceable phase-two agreement are low.

However, a multilateral approach holds more promise. While it is true that U.S. allies, particularly Europe, so far have been reticent to forcefully take on China’s unfair trade practices, they are increasingly seeing that doing so is in their interest. As such, as ITIF has advocated, the administration should double down on existing trilateral trade talks with the EU and Japan, and bring to bear a host of tools and weapons to pressure China to roll back at least its most egregious practices.

The third strategic orientation is decoupling. For Trump administration China hawks, including some Commerce Department officials and White House advisor Peter Navarro, decoupling is the only logical path forward. Their goal is to keep U.S. companies from doing business with China, including selling key inputs, in order to cripple China’s advanced economy firms. The decouplers have different motivations for their views, but at the heart is the belief that China is hell bent on global dominance—both politically and economically (and perhaps militarily)—and that it is impossible to get China to change its policies, even with strong unilateral or multilateral pressure.

Few decouplers lay out a clear definition of what this should mean. For some, it means U.S. firms should not transfer technology to China—something many firms are coerced into doing in order to gain market access. For others, it means cutting off key exports in the supply chain to cripple Chinese competitors. This was the motivation of the recent Department of Commerce proposal to use the export control regime to block sales of GE jet engines and Honeywell avionics equipment to Chinese state-owned aircraft maker COMAC. Likewise, it is the motivation for many who advocate cutting off exports of computer chips and other key inputs to Chinese hardware and telecom equipment firm Huawei. There is no doubt that many Chinese advanced industry firms are dependent on foreign technologies and that cutting them off could in some cases cripple the firms. The problem is that for many technology inputs, if not most, the United States is not the only supplier. For example, if the United States prohibited GE from selling jet engines to COMAC they could buy them from British maker Rolls Royce. The same is true with most of the chips and other inputs Huawei uses to make 5G networking equipment. Unless the United States can obtain agreement from all our major allies, including Europe, Japan, Taiwan, and South Korea, such an effort will only shoot ourselves in the foot by cutting exports and revenue from U.S. advanced technology firms.

Some decouplers respond by saying that U.S. law lets them extend the U.S. government’s reach to ban foreign exports to China if the product is made on a U.S. machine or is relying on U.S.-based intellectual property (IP). Leaving aside this problematic exercise of extraterritorial authority, even this heavy-handed approach will not work for two reasons. First, many products made by foreign companies would still be able to be legally exported to China. But second and more problematic, the logical response by foreign companies to this regime is to not buy U.S. equipment or license U.S. IP. And the negative repercussions could be even worse. I spoke recently to an executive at a leading European machine maker who said that his company is seriously considering redesigning their machines to get eliminate U.S. chips so it could not be caught up in any export control restrictions that would limit their ability to sell their machines to China. Third, China has responded to the Trump administration’s export control threats the way the United States responded to the Soviet Union’s launch of Sputnik. In other words, export controls have galvanized an all-out effort to not be dependent on U.S. technology. The result of this will be even greater Chinese competitive advantage in advanced industry products at the expense of U.S. market share.

Finally, some decouplers seem to embrace complete decoupling, comparing China with the Soviet Union, and advocating banning sales of any advanced technology products to China. But in the Cold War America might have sold grain, Pepsi, and Levis to the Soviets, but by large the economies were separate—which is why the Soviet bloc was known as the “second world” and the West as the “first world.” If we really believe that China is like the Soviet Union, then the logical extension would be to forbid American companies from selling or buying anything from China, since most Chinese companies are in one form or another an arm of the Chinese Communist Party. Clearly, this will not happen, nor should it. The Chinese market is simply too big for American companies and the American economy overall to walk away from it.  Doing so would cede that market to our competitors, either China or other nations.

This view that it is immoral to do business with China is also heard when discussing whether some American technology and Internet companies should do business in China. Many decouplers and China hawks argue that companies like Google should not sell in China. In Google’s case, they rightly say that Google would have to comply with Chinese censorship rules. But telling companies like Google to stay out China would have no beneficial effect on free speech or human rights. What it would do is give companies like Baidu (the main Chinese search engine company) the vast Chinese market, and they would use the revenues the earn from it to innovate and expand into other markets all around the world, ultimately taking market share and jobs from American technology companies.

The United Sates should embrace a decoupling strategy—but if it is to succeed, it must be very carefully targeted; it cannot be a complete break. Decoupling should focus on limiting the transfer of key technologies, IP, and know-how to China, especially through forced tech-transfer and mandatory joint ventures. The recent reauthorization of the Export Control Act was intended to provide stronger measures to address this challenge, but the Department of Commerce has yet to come up with new regulations. But the United States should not focus on restricting the sale of products and services to China (with the obvious exception of sensitive, national security technologies). It is in the long-term economic and military interests of America for U.S. companies to sell as many goods and services to China as possible. Every dollar’s worth of semiconductors or jet engine exports they sell to China is a yuan that Chinese firms do not make, and American firms can reinvest that money in R&D. This is why the Defense Department rightly opposed the recent Department of Commerce proposal to limit semiconductor exports to Huawei—because it would hamper U.S. semiconductor production, something that is central to America’s ability to continue to support its defense industrial base.

The federal government should also support market-based decoupling where it works to encourage American production to move out of China. There are two ways to do this. The first step should be to help other nations that might serve as alternative centers for foreign production. That would provide U.S. companies with more locations for their global production systems. Already, tech imports from China to the United States are down while imports from Vietnam and India are up. The Trump administration should provide a tail wind for this shift. But threatening tariffs, as Trump has done with Vietnam and Mexico—two countries that are ideal alternatives to China—increases uncertainty rather than decreasing it. Instead, the administration should not only make clear it will not impose tariffs on China alternatives, it should push for free trade agreements with those countries.

Thankfully, Congress passed the United States-Mexico-Canada Agreement (USMCA). The administration also should seek to join the Trans-Pacific Partnership Agreement (TPP), which is now called the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP). If the administration has concerns about CPTPP, such as lack of an enforceable currency regime, then it should seek to join with proposed changes. Both steps would make it clear to global companies that if they move production out of China to one of these partner nations, they will not be subject to punitive tariffs in the future.

The second step should be to increase incentives for companies to move production to the United States, including by boosting productivity. There are various manufacturing applications for new technologies, including 5G, sensors, robotics, and artificial intelligence, which, with the right policy support, could significantly improve factory productivity, making it possible for much of the U.S. manufacturing sector to be a competitive alternative to China. But we need a national manufacturing automation strategy to help realize this vision. Among other steps, Congress should dramatically increase funding for programs under the National Institute of Standards and Technology to help small manufacturers automate; expand funding for the National Science Foundation’s National Robotics Initiative to at least $600 million a year. Lawmakers also should establish at least 10 new public-private institutes under the Manufacturing USA program to focus on automating key manufacturing subsectors. And they should implement a 10-year investment tax credit of 25 percent for all investments in automation equipment. If they’re successful, such policies could hem in China’s manufacturing economy while strengthening America’s.

This leads to the final, until now largely ignored key component of a national strategy to address the Chinese economic challenge: putting in place a strategic and well-crafted domestic industrial strategy. Some advocate only for this, ignoring the imperative of also pressing China to roll back the worst of its innovation mercantilist policies and practices. Others, such many in the Trump administration, focus only on one or more of the first three strategies of pressuring China. To succeed, we need to both pressure China and support the development and implementation of a U.S. national industrial strategy. A forthcoming ITIF report will delve into why such a strategy is needed and what it should look like.