U.S. and Chinese flags are displayed together on the side of the Eisenhower Executive Office Building for the state visit of China’s president, Hu Jintao, in Washington, D.C., U.S. (Photographer: Joshua Roberts/Bloomberg)

What’s Missing From the U.S.-China Trade Deal

(Bloomberg Opinion) -- With talks to end the U.S.-China trade war reportedly nearing a conclusion, it remains unclear whether any deal will fundamentally alter Chinese commercial behavior. The only way to do so is to introduce full, unhindered foreign competition into the Chinese market.

American negotiators seem to be trying to open up China by eking out incremental pledges on market access and reduced state subsidies. This isn’t likely to accomplish much. Leaders in Beijing have already promised to lift equity caps in most sectors for foreign companies. While helpful, the changes leave Beijing with plenty of tools to boost favored industries at the expense of foreign rivals. The same would hold true even if China does scale back its most egregious state-directed subsidies.

Instead, the U.S. should be demanding that foreign firms be allowed to operate in China just as Chinese companies do in the U.S. Truly open competition would test the mettle of China’s industrial policies and subsidy programs. If history is any guide, market-driven competition will win out, making it too expensive for the state to continue to support uncompetitive firms. Chinese firms that are truly competitive will succeed without the need for such aid, both at home and abroad.

The key issue isn’t ownership structure, but the fact that foreign companies currently operate in China under a system of positive rather than negative limits. Simply put, they are told very specifically what they can do, rather than what they can’t. ­­For example, Company A may be permitted under its operating license to provide “marketing services.” Whether this includes, say, digital marketing services is left unclear.

Naturally, as technologies and markets evolve, so must these lists. But changing them -- i.e. adding “digital” to the example above -- requires an entirely new negotiation with Chinese officials. This caveat is how foreign competition is constrained in China. Letting Tesla Inc. wholly own its manufacturing operations won’t change much if the company’s business license doesn’t explicitly permit it to develop and operate its own battery systems or maps or self-driving software -- core value components that, as of now, will likely have to be outsourced to Chinese firms.

Such restrictive licenses put the fate of any foreign firm into the hands of Chinese regulators. This is by design. Even within China’s much improved legal environment, laws remain vague and implementation guidelines are imprecise and often contradictory. Regulators, whose aims can be politicized, protectionist or worse, thus have great sway over essentially all commercial developments.

As technology advances, regulators’ clout has only increased. China’s new national security framework -- which has effectively defined most commercial markets as “strategic” (and thus restricted for foreigners) -- gives them control over multinationals’ data operations and enterprise IT choices. Foreign companies can’t freely use digitally driven operational models and innovative technologies from around the world to achieve competitive advantage. This handicap massively distorts China’s potential as a market. Ultimately, constraints on technology choice, IT system control and data operations could drive foreign companies out of many sectors entirely.

Meanwhile, even though mainland companies, too, operate under “positive” business licenses, regulators seem more willing to look the other way when they exceed their mandates. Domestic firms regularly expand into new businesses without any visible constraints. They also seem to be permitted much wider scope in data operations, technology platforms and the use of consumer information. They’re then able to leverage their scale advantages unimpeded in overseas markets.

Real change would involve three core elements. First, both foreign and local businesses would have to operate under business licenses that are negatively limited -- where only certain activities are specifically barred and all other conceivable activities are de facto permitted. Licenses would have to include unconditional freedoms for enterprise IT choices and data operations. Foreign companies shouldn’t have to localize, outsource or cede control of commercially sensitive data and assets to Chinese vendors or agencies. China’s privacy and cybersecurity concerns can be addressed adequately through other means.

Second, to make sure such pledges are implemented, mechanisms should be established that oblige Western firms to consult regularly and confidentially with their trade officials. Unless they honestly disclose the inequities they face in the Chinese market, their respective governments will never know. Third, China should establish a paramount agency fully empowered to respond quickly, precisely and discreetly to complaints so that the buck can’t be passed around within the maze of Chinese regulatory agencies. Relying on “snap-back” tariffs as an enforcement mechanism would be disastrous, creating unmanageable uncertainty for foreign businesses operating in China.

It may be too late to work such changes into whatever trade deal the U.S. and China sign. But, this doesn’t change the fact that fair, competition-enhancing reforms would be as good for China as for the rest of the world. Competition would improve the productivity and unlock the innovative capacity of Chinese enterprises, which is critical to putting China’s economy on a sustainable path. Foreign firms would also contribute much more to Chinese growth and welfare. If China truly wants to become a fully developed nation by 2049, this is one concession it might want to make on its own.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

David Hoffman is senior vice president and managing director of the Conference Board’s China Center for Economics and Business.

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