The 2015 U.S.-China Strategic and Economic Dialogue in Review

Interview with Malcolm R. Lee
August 18, 2015

In June 2015, the United States and China convened the seventh round of the U.S.-China Strategic and Economic Dialogue in Washington, D.C. In this Q&A, Malcolm R. Lee of the Brookings Institution analyzes the main outcomes of the dialogue in light of China’s stock market instability, serious market access concerns, major cyberattacks, territorial disputes in the South China Sea, and establishment of the Asian Infrastructure Investment Bank. Despite areas of disagreement, Mr. Lee maintains that bilateral interests converge in promoting China’s transition to a consumer-driven economy, negotiating a bilateral investment treaty, strengthening the Chinese intellectual property system, crafting peacetime cyber codes of conduct, and addressing climate change. Mr. Lee argues that Presidents Barack Obama and Xi Jinping can make progress on these initiatives during Xi’s visit to the United States in September 2015.

What were the highlights of the seventh annual U.S.-China Strategic and Economic Dialogue (S&ED) held in June 2015 in Washington, D.C.?

Tensions in the South China Sea, cybertheft, China’s economic reforms, and growing market access concerns were high on the agenda during the S&ED. On the security side, the United States made no apparent progress in persuading China to enter into a diplomatic process to lower tensions in the South China Sea or commit to demilitarization of reef structures. China is shaping disputed reefs into structures capable of military operations, but asserts that it has ceased island buidling and rejects U.S. involvement as a non-claimant. U.S. officials reported that S&ED discussions were useful in allowing direct engagement with relevant Chinese entities, including the People’s Liberation Army. Secretary John Kerry and his counterpart Foreign Minister Wang Yi restated positions at the ASEAN regional security forum in early August 2015.

The S&ED economic talks focused on accelerating China’s transition away from a growth model dependent on state-directed investment, heavy industry, and exports and toward a sustainable consumer and market-driven economy. U.S. and Chinese interests overlap in supporting a substantial set of reforms, but the two sides, in U.S. treasury secretary Jacob Lew’s words, “continue to view time in a slightly different way.”

During the S&ED, China pledged for the first time to intervene in foreign exchange markets “only when necessitated by disorderly market conditions.” The country also pledged to further liberalize interest rates, open capital markets, and expand financial market access to foreign firms and investors. China committed to increase transparency of state-owned enterprise expenditures, improve the land rights of rural residents, and universalize social security coverage by 2020 (thereby increasing consumption). But the Chinese government’s stoking of the stock bubble, followed by its heavy-handed intervention to break the markets’ fall in the weeks following the S&ED, have compounded questions about regulatory soundness and coordination, the government’s willingness to allow markets to operate, and the outlook for financial and economic reform. It may also have shaken the public’s confidence in the government’s broader ability to manage the economy, which could adversely affect already slowing growth.

The U.S. government and many leading economists are concerned that China will not move quickly enough on desperately needed reforms. Without reform of its services, financial, labor mobility, health, and other protected sectors, China’s longer-term growth will stall. China’s huge, lumbering state-owned banks know how to serve China’s big, inefficient industries. But they do not adequately serve the needs of energetic small and medium-sized private enterprises that are key to generating and sustaining China’s longer-term balanced growth. Nor do they satisfy the needs of China’s thrifty savers who seek and deserve better returns. China’s developing stock markets still play a small role in the country’s real economy, accounting for less than 5% of corporate fundraising. Only 9% of household wealth is invested in stocks; much more rests in real estate and bank savings.

China’s industrial production, fixed asset investment, exports, and retail sales all slowed in July 2015. There is concern that Beijing could revert to its old playbook of investment, exports, and infrastructure spending. Heavy industrial sectors such as steel and aluminum are already suffering from global overcapacity. Despite stated plans to reduce excess capacity, China continues to produce as much steel as the rest of the world combined. China’s steel exports rose 50.5% last year, and are on pace to set records again this year. Infrastructure investment is up 19.1% in the first half of 2015, amidst empty shopping malls and unused highways. Facing lower growth and demand at home, China’s producers look to export excess production, which would drive down prices globally, and potentially increase deflationary pressures, economic instability, and unemployment abroad. Significant devaluation of the renmibi would boost exports. So the bigger question is not whether China will grow, but how it will grow. The wiser path—for both China and the world—is deeper and broader market reforms that unleash domestic demand and create new, more balanced and sustainable engines of economic growth.

Foreign companies doing business in China have expressed renewed concerns about market access, particularly in relation to China’s new national security law. The law allows the government to scrutinize any foreign investment or activity that may be a threat to national security. How did officials address foreign market access issues at the S&ED?

China’s new national security law, enacted days after the S&ED, is sweeping. It spans broad aspects of social, political, and economic activity, and reaches beyond the country’s borders into the seas, outer space, and cyberspace.

Foreign businesses in China feel less welcome now than at any time since China’s entry into the World Trade Organization (WTO). They face a rising tide of national security and regulatory barriers that have restricted market access. These measures tilt the playing field and cannot be easily reached by current trade rules. At the S&ED, the United States expressed concern that China’s new national security law may deter foreign investment and close certain sectors to foreign participation. Among other things, it requires that all key network infrastructure and information systems be “secure and controllable.” At the S&ED, China committed to ensuring that one related set of regulations that threatens to exclude foreign information and communications technology (ICT) from China’s banking sector will be nondiscriminatory and pledged to not levy nationality-based requirements on the purchase and sale of ICT products.

The U.S. government and private sector are also concerned that China’s anti-monopoly and competition laws are being used to protect domestic companies and lower the value of foreign intellectual property (IP) rather than to promote competition. At the S&ED in June, China reaffirmed commitments made at the 2014 dialogue and the U.S.-China Joint Commission on Commerce and Trade to implement the anti-monopoly law in a transparent and nondiscriminatory manner and specified venues for administrative and judicial appeals.

Many businesses, both domestic and foreign, have faced problems with China’s nontransparent rules. At the S&ED, China confirmed that “normative documents”—namely all legally binding measures—must be published in final form, and that these measures can be challenged and invalidated by a court. This commitment reaches previously internal, nonpublic binding measures and will benefit Chinese and foreign companies alike. All of these economic outcomes from the S&ED build incrementally on prior commitments and depend entirely on effective implementation.

The United States and China recently exchanged their lists of sectors closed to the other country’s investors. Is this a step forward in increasing transparency? How is this information affecting negotiations for a bilateral investment treaty (BIT)?

Negotiation of a BIT is a priority for both governments. Ahead of the S&ED, China tabled its first “negative list” of sectors that would remain outside BIT obligations. The governments agreed to exchange improved offers in early September 2015, though Secretary Lew said the talks are “in the first few innings” of a nine-inning game. The treaty will be one of the most consequential negotiations that these countries have undertaken.

Support for the BIT from the U.S. business community will depend in large part on how narrow and limited the listed investment exceptions are. China’s leadership understands that its next phase of development requires opening and growing its services sector and moving away from state-led investment in heavy industry and exports. This is China’s path to more sustainable growth and a higher standard of living. As with China’s entry into the WTO fifteen years ago, the treaty would provide the Chinese leadership with external leverage to take on powerful domestic constituencies that resist necessary change.

To complement the BIT, the United States should encourage China to open investment in service sectors as soon as possible ahead of the BIT and limit measures it has justified on national security grounds that threaten to reverse liberalization. Shortening the negative list would be an important signal to China’s trading partners and the markets that the country is not retreating from needed economic reforms. For the BIT to be effective, the United States should ensure that the treaty’s rules address unfair competition by state-owned enterprises, discriminatory enforcement of China’s competition laws, and forced technology transfer and localization policies. The Obama-Xi summit scheduled for September 2015 would be a good time to announce liberalizing measures.

In June, the U.S. government announced that the Office of Personnel Management (OPM) had been hacked and the personal information of at least 21.5 million people had been stolen. How can the United States push China to cooperate on combatting IP theft and cyberwarfare?

The U.S. government has not publicly named a perpetrator to the OPM hack. And China has denied involvement, insisting that it also is a victim of hacking. I suspect the U.S. government is still evaluating its options.

Just after the S&ED, Secretary Kerry reported that the two sides had engaged in an honest discussion on cybertheft without accusations or finger pointing. U.S. leaders, including President Obama, have made clear that cybertheft is not acceptable and that the two sides must agree on standards for acceptable behavior in cyberspace. The United States and China will continue to spy on each other but can begin to address destabilizing risks as “responsible competitors,” as Vice President Joseph Biden framed the issue at this year’s S&ED talks.

The bilateral agenda on cybersecurity is broad, spanning conduct in peacetime and war; state and non-state actors; political, economic, and commercial espionage; theft of trade secrets and IP; and rights to privacy and freedom of expression. The formal S&ED Cyber Working Group dialogue remains on ice, but the United States and China are engaging elsewhere. Successful cooperation could include working together to craft strong peacetime and wartime norms of conduct by state actors; publicly embracing and, above all, adhering to those norms; strengthening national trade-secret laws; building enforcement cooperation across borders; and expanding cooperation against common third-party threats.

China is currently participating in a United Nations experts group with the United States and other countries to craft peacetime norms. These include pledges to refrain from attacks on other nations’ critical infrastructure or cyber emergency responders and to cooperate with other nations’ investigations into cybercrime. China and Russia reportedly blocked another U.S. proposal stipulating that international law should apply in cyberspace, just as it does on land and at sea. The United States reportedly has not proposed an additional norm it shared with Congress in spring 2015 under which states would commit to not engage in cybertheft of IP for commercial advantage.

If adopted, these norms would be an important first step at a time when tensions and risks are high. The United States and China should publicly endorse these principles during President Xi’s visit to the United States in September 2015. China insists that its government does not engage in IP theft for commercial advantage. If this is true, why would China not also make such a commitment? Beyond cooperation, it is critical that the United States strengthen cyberdefenses as a national priority, develop clear evidence and attribution of cybertheft, and impose targeted, proportionate costs when norms and laws are broken.

What are the potential benefits to the Chinese economy of increased IP rights? Are there particular sectors in China open to expanding protections at home or abroad?

The benefits of an effective IP regime are well-known and understood by Chinese leaders. China aspires to become an innovation-driven economy. This requires not only knowledge and creativity, market competition, functioning capital markets, and strong IP laws, but also the rule of law and equal treatment of IP regardless of the owner’s nationality. Although China’s IP system is evolving and has made significant progress, it remains immature. The IP courts are the most sophisticated courts in the country, but the judiciary still answers to the Communist Party. Fundamentals of effective civil enforcement, such as production of evidence, protective orders, and preliminary injunctions, remain difficult. Administrative enforcement is characterized by campaigns, which come and go.

Nevertheless, a growing number of Chinese companies are built on a business model of creating their own IP or licensing legitimate IP products. Chinese IP owners are asserting their rights (predominantly against each other) through the courts and administrative enforcement and are also active in litigation abroad as both plaintiffs and defendants.

Chinese companies are winning more patents and have a growing presence in the Intellectual Property Owners Association’s list of the top 300 organizations granted U.S. patents. A rise in patent awards does not necessarily translate into patent quality or commercial value, but the trend of increasing IP ownership is clear. Shenzhen-based technology companies lead the way. In 2014, Huawei, ZTE, Hong Fu Jin, and Shenzhen China Star Optoelectronics all made the top 100. As manufacturers and users of foreign IP, these and other companies have been beneficiaries of China’s enforcement of IP and competition laws.

There is a gradual IP shift underway in media and entertainment. Chinese company Tencent recently concluded a five-year deal to stream live and on-demand NBA games, and a Beijing court in May 2015 determined that live broadcasting of a sports competition is sufficiently creative to enjoy protections under China’s copyright law. China’s Internet giants have been busy in Hollywood inking deals to offer streaming services to Chinese subscribers. This development is positive, although the government recently announced that foreign films and television dramas must be approved for streaming. China’s box office revenues continue their dramatic rise and are expected to surpass U.S. ticket sales in a few years. The Wanda Group, which recently purchased the AMC Theaters chain in the United States, is building its own version of Hollywood in Qingdao.

Direct distribution of U.S. movies in China, however, is still challenging for U.S. companies. At the S&ED, China reconfirmed a commitment—never a reassuring sign—made in 2011 that any licensed film distributors can contract directly with U.S. film producers for the distribution of imported films—other than those distributed under quota on a revenue-sharing basis—without the involvement of China’s state-owned enterprises, which have long controlled distribution.

As China’s IP system matures, the government must resist the temptation to discriminate against foreign IP to the advantage of Chinese users or to subsidize China’s own innovation and IP development. The government has favored domestic IP through a range of policy and regulatory tools, including enforcement of competition laws, standards development, tax and procurement preferences, R&D subsidies, and increasingly information security programs. China’s goal is to reduce dependence on foreign technology in key areas and ultimately replace it with indigenous technology. The Chinese State Administration for Industry and Commerce recently finalized new regulations on IP abuse. It remains to be seen how these regulations will be used. To foster global trade, direct investment, and innovation, IP must be treated equally regardless of the nationality of its owner.

What issues will dominate the discussion between Presidents Obama and Xi in September 2015?

Both leaders want a successful summit. Easing tensions in the South China Sea and concerns about cybersecurity will remain front and center. Progress on each is necessary to stabilize the relationship. China’s economic reforms, exchange rate policy, and growth model will be also be central.

Market access issues will loom large. Both sides will likely express concerns about fair treatment of their companies, products, and investments given rising national security concerns. China will likely seek assurances that the United States will not block acquisition of U.S. companies—such as Micron—on national security grounds. The United States will seek assurances from China that it will not use its new national security law or draft cybersecurity regulations to deny market access or require access to proprietary source code. Both sides are likely to leave unconvinced by whatever assurances are given. China will also likely seek assurance that it will be graduated from nonmarket economy status under U.S. antidumping laws no later than the end of 2016, citing language in China’s original WTO accession protocol. But U.S. statutory requirements do not automatically disappear at the end of 2016, and the passage of legislation would be required.

The United States and China will be able to celebrate the closure of the modernized WTO Information Technology Agreement (ITA) during the Obama-Xi visit. The ITA, which will reduce global tariffs on IT products, got a huge boost when trade representatives, ahead of the Obama-Xi meeting in November 2014, reached an agreement on key products to be covered. It is a strong example of joint leadership in support of the multilateral trading system. Extending that leadership to conclude an ambitious WTO agreement to lower tariffs on environmental goods could be next.

The two leaders will also address climate change and commit to achieve an ambitious global climate agreement in December 2015 in Paris. They will likely reference S&ED progress made on sustainable energy cooperation, including a zero-emissions bus program; initiatives to reduce emissions of ports, vessels, and industrial boilers; two new carbon pilot projects; and a summit on climate change and smart cities to be held in Los Angeles in September 2015.

On the security side, Obama and Xi should reach an agreement on encounters between military aircraft, following last year’s agreement on encounters at sea. These discussions are vitally important given that the highest risk of military conflict arises from accidental encounters rather than intentional ones.

What is the significance of the Trans-Pacific Partnership (TPP) and the Asian Infrastructure Investment Bank (AIIB) to the U.S.-China relationship? How can China and the United States continue to strengthen economic cooperation in the face of the TPP and AIIB?

There is no question that China is exercising influence that reflects its new weight. But I do not see U.S.-China competition as a zero-sum game that will produce separate economic blocs. First, the TPP is the economic centerpiece of President Obama’s rebalance to Asia. If done right, it will contain stronger trade rules necessary to help level the playing field for U.S. companies, farmers, and workers. The U.S. market is already wide open, whereas the markets of many Asian trading partners are not. Many of the TPP provisions address the kind of barriers that U.S. companies face not only in member countries but also in China. While China is not participating in the TPP negotiation, it could one day join the partnership.

Second, experts like David Dollar, my colleague at the Brookings Institution, make good arguments that the TPP and AIIB can be complementary. The TPP will help establish the next generation of rules of commerce, or the “software” for deeper economic integration and fair competition. The AIIB, working as a complement to the U.S.-led World Bank and Japan-led Asian Development Bank, can help finance the “hardware,” or infrastructure, in Asia’s emerging economies.

Third, the economies of the Pacific region, including most notably the United States and China, are deeply interdependent as trading partners. Together, the two countries constitute a third of global GDP and nearly 40% of recent global growth. They are invested in each other’s economic success. Many Pacific nations want and need both the United States and China and do not want to have to choose between the two.

That said, we should reflect on why China created the AIIB, and why the United States was handed such an embarrassing diplomatic defeat. First, there is an $8 trillion need for infrastructure financing in the region through 2020 that existing institutions cannot meet. Moreover, leading global economic institutions have failed to adjust—in funding or governance—to the economic reality that emerging economies now produce half of all global output. The United States’ failure over the past five years to enact IMF quota and governance reforms, and the gap in addressing regional infrastructure financing needs, opened the door for the AIIB.

At the S&ED, U.S. and Chinese officials discussed their joint responsibilities in upholding high governance standards in multilateral institutions. In recognition of concerns expressed by some founding members, the AIIB’s articles state that the bank will address the environmental and social impacts of its projects and foster sustainable development. There will be interaction, coordination, and friendly competition between the AIIB, World Bank, and Asian Development Bank. The United States must decide whether we will have more influence and impact outside the AIIB or as a member helping shape it from within. We must also decide whether we will take the steps necessary to fund and reform existing institutions so they remain relevant and responsive to new global realities. 

This interview was conducted by Kaela Mananquil, an Intern at NBR, and Rachel Wagley, Assistant Director of Outreach at NBR.