Gateway games - US companies trying to access China's closed markets have their work cut out

Opinion | 18 April 2017
Great.wall.of.China

Washington had hoped the TPP would one day give it access to China's protected markets but with its demise, US companies will have to find alternative ways to access and compete with an economy that is shifting to domestic consumption
and private enterprise,
says Sherman Chu

The global economic story of the last 35 years has been China's rise, fueled by international trade, to become the world's second largest economy. A highlight along the road was China's accession to the World Trade Organization (WTO) in 2001, under which China agreed to abide by WTO rules governing many aspects of cross-border trade in exchange for greater access to foreign markets.

Supporting China's entry into the WTO was part of the US government's overall aspiration and goal of engaging China and encouraging Beijing become a willing participant and eventual bulwark of the current system of international economic and geopolitical rules and norms.

Since China's accession, however, it has become increasingly evident that WTO rules weren't robust enough to allow US companies the same degree of access to Chinese markets, as Chinese companies were given to US markets. Beyond the enormous US-China trade deficit, many other Chinese non-tariff market access barriers have become obvious - legal restrictions on the right to invest in important industry sectors, failure by China to enter into the WTO's Government Procurement Agreement (which would allow greater access to the country's large state owned enterprise (SOE) sector), the requirement of technology transfer as a price of entry into many market sectors, and the lack of a practical adjudication process for WTO violations.

Beyond market access, the WTO has also failed to create a level playing field in the Chinese market between domestic and foreign companies. Trade in the service sector, among the most dynamic economic areas, is largely unaddressed by the WTO. Its rules also don't adequately regulate legal and business practices that tilt the playing field in favour of local businesses, such protection of intellectual property, the quasi-monopoly status of SOEs, and the lack of an independent judiciary and clear rule of law which have left foreign companies uncertain of their ability to assert their contractual rights.

The US has for many years sought to address the limitations of the WTO through bilateral talks. The most significant of these attempts took place at the annual China-US Joint Commission on Commerce and Trade (JCCT). By 2004, the JCCT was co-chaired by two US cabinet officials (the secretary of commerce and the US trade representative) and by China's vice premier responsible for foreign trade. The event involved delegations of hundreds of officials. By the middle of the current decade, there was a broad recognition that these meetings were becoming increasingly irrelevant, as China's skillful use of WTO rules (often contrary to their intent) advantaged Chinese businesses and left the country with no pressing reason to agree to changes.

Trade roadmap before 2017

Recognising that improvements to WTO were languishing, the US government's trade strategy for the past decade has been crystal clear. The first step in the US roadmap was to create a Trans-Pacific Partnership (TPP), which would encompass 11 countries but conspicuously excluded China. TPP was aimed at liberalising cross-border trade while setting higher standards than WTO in key areas such as intellectual property protection, environmental and labour regulations, equal treatment of private and state-owned enterprises, preventing non-market access barriers, and a more effective dispute resolution process.

Aside from TPP's own merits or flaws in advancing international trade, the desired effect of proposed agreement on the US side was aimed at participants and a non-member, China, the world's second largest economy. Some believed that by creating a large trading bloc with standards that China had not previously indicated a willingness to accept, the US might spur enough trade within the bloc to eventually entice China to join under TPP's enhanced trading rules.

Advocates of TPP thought once the agreement was in place, China would have an increased incentive to entice US investment by negotiating and entering into a US-China Bilateral Investment Treaty (BIT) directed towards reducing restrictions on investments by US companies in China. This type of treaty is common. The US currently has BITs in place with over 40 countries. The US-China BIT would only address investment restrictions - it would be an important step in addressing some of WTO's limitations, as the ability to invest is for many companies an early step in fully accessing a market.

The strategy of TPP leading to the BIT, which in turn would lead to a TPP with China as a member saw encouraging results, at least during the time when TPP appeared to be on track for passage. In July 2013, at a time when TPP was making significant progress, China for the first time agreed to structure the BIT under negotiation around a so-called 'negative list,' whereby all areas of investment are permitted except those on the negative list. This was a significant conceptual step over China's past insistence on a positive list approach, which would limit foreign investment only to listed industries. The development was important for technology companies, whose industries evolve rapidly.

The prospects for TPP waned during the US presidential elections and China's negative list offer for BIT made the proposed treaty become less comprehensive. While the list could have been negotiated over time, political winds had already shifted by then. With TPP's prospects looking increasingly dim, BIT discussions never progressed further.

Ironically, the negative list approach proved popular with Chinese officials. In recent years, eager to attract foreign investment in the face of domestic economic challenges, China has unilaterally adopted (often on a trial basis) a negative list approach to allowing foreign investment in broader sectors of the economy. However, even with these trials many important sectors of the economy continue to be walled off from foreign investment. Given the unilateral nature of the opening of the remaining sectors (which could also be unilaterally closed to investment at any time), further uncertainties around whether additional regulations might later be imposed on previously committed investments highlights the importance of a treaty-level agreement such as BIT.

The road ahead

We have entered a time of uncertainty on what lies ahead for US companies doing business in China. The TPP combined with BIT and the TPP plus China roadmap is seemingly closed. On 23 January 2017, one of Donald Trump's first actions as president was to sign a memorandum formally withdrawing the US from the TPP. With the US withdrawal, the WTO offers the primary set of rules governing trade between China and the US. It is unlikely we will see movement towards improvement via BIT, a TTP plus China, or China's entering into the WTO Government Procurement Agreement.

China has little incentive to depart from the status quo of the WTO rules that it has navigated so adroitly for many years. The US is left with a set of unfavourable rules with no clear strategy for advancing the interests of its most important industries, technology being among them.

At the same time, while the US administration has not detailed a trade policy replacing this, US businesses with sales and operations in China
can expect a few logical outcomes from the current situation.

US government disengagement

In the past, the engagement of US and other governments, notably the EU and Japan, was an important resource relied on by US companies in avoiding the broadest protectionist measures. Examples where governments have had some success in persuading China to retract or revise market access barriers, include a proposed ban on the import of any information technology equipment containing encryption, an "indigenous innovation" regulation favouring procurement of products developed in China, and a wave
of antitrust actions aimed at curtailing the activities of foreign information technology companies. In each case, the Chinese government made at least some effort to accommodate the vigorous protests of foreign governments and industries.

Some now view the Trump administration as the leader of a wave of increasing protectionism, and there are those who doubt the US will have the inclination to push back on future Chinese opposition. For example, one of China's current top policy initiatives is titled 'Made in China 2025'. It is an initiative to become self-sufficient in a range of advanced technology areas, partially through heavy government subsidisation. Given that this Chinese initiative echoes at least some
of the Trump administration's stated aspirations for the US, it is difficult to see how vigorously the US administration will push to avoid a negative impact on US technology companies seeking to make sales in China, in sectors subject to Made
in China 2025.

Navigating Chinese government priorities

The most successful companies will be those
that best read and adapt to the priorities of the Chinese government. The overarching government priority for the past decade has been to increase Chinese ownership of advanced technology, especially in areas such as semiconductors, life sciences, agriculture and cloud, and to push local companies to go overseas by becoming major global companies with global brands
and operations.

While it's beyond the scope of this article
to address all such priorities, certainly for technology companies, a strategy of bringing technology to China, conducting research in-country, and partnering with complementary Chinese companies to enable them to go global should be considered, and may be well-received
by government regulators who control market access.

Invest for long term

While the next several years present many challenges, opportunities abound as well. China's economy is undergoing dramatic shifts, as its traditional top-down, SOE-driven, real-estate based model for economic development has hit natural limits. The government is well aware of the need to shift to greater private enterprise, domestic consumption and an innovation economy, for which it still needs to attract foreign investment, talent and technology.

The partial liberalisation of foreign investment rules, including the "negative list" approach, is not occurring because of a sudden fit of altruism; it is a rational step for a country that has seen its foreign currency reserves drop by US$1 trillion over the past few years as a result of capital flight.

For US companies with a long view, despite the short-term challenges and the absence of a clear China-US trade roadmap, these changes in China present opportunities. In addition to the formal relaxation of certain investment regulations, the government's enforcement and interpretation of these regulations also tends to become more relaxed during periods where foreign investment is desired.

Companies willing to invest, and who bring needed technology, are likely to find a more hospitable environment than a superficial reading of the situation may indicate. For global companies with a strategic reason to participate in both the world's second largest economy and the country from which their future global competitors are likely to emerge, continuing to invest in China is a long-term need.

Sherman Chu us a partner at DLA Piper. He specialises in technology transactions, joint ventures and strategic alliances

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