US to China: See you in court (maybe)

When I saw that the US was initiating a WTO case challenging China's various tax favors and export rebate, I knew who to turn to for analysis.  

Emmanuel -- a regular participant in the comments section - has long encouraged me to take a closer look at China's export rebates in particular.    

Rather than do that, I decided to give the floor over to him for a day.    Emmanuel's guest post follows. 

Emmanuel: 

The dispute over China’s large and growing trade imbalance with the United States centers on the perceived undervaluation of the yuan. Yet, other components of Chinese trade policy aside from its foreign exchange regime have largely eluded attention--until now. US Trade Representative Susan Schwab has just requested dispute settlement consultations with China in the World Trade Organization over Chinese measures that appear to contravene WTO rules. These consultations are just the first step in what may end up in judicial proceedings, though only about forty percent of such disputes reach the point of being resolved through rulings. If the US and China are unable to resolve this dispute after a period of bilateral consultations lasting sixty days, then the US can ask the WTO to form a panel to settle this dispute. (Continues)

Targeted are income tax reductions and refunds, value-added tax (VAT) exemptions, tariff exemptions, discounted lending rates, and exemptions from mandatory worker benefit contributions said to be made available to Chinese and foreign-invested enterprises (FIEs) satisfying certain export performance requirements. Also cited are income tax and VAT refunds given to companies that purchase Chinese-made equipment and accessories. See 4.2.1 (b) and (c) here for sample benefits to FIEs--many of which have ties to China’s neighbors. USTR charges that these are in violation of WTO stipulations on Subsidies and Countervailing Measures for they “require recipients to meet certain export targets, or to use domestic goods instead of imported goods.” Until the actual complaint is posted on the WTO site, there is still uncertainty over the specific products and measures in question (hat tip: International Economic Law blog).

The USTR charges that while it has repeatedly mentioned its concerns to them, Chinese officials have not taken steps to remove these measures. The timing of this episode attracts interest: Why is it only now that the US is acting despite knowing about these measures before? The Financial Times suggests that the administration is responding to pressure from the Democratic congressional majority over the bilateral trade imbalance, and that Bush is keen on winning congressional support for extending his fast-track authority in trade negotiations once it expires at midyear. This authority might be crucial if an international agreement is made during the restarted WTO Doha development round. I would add that election season 2008 is near, hence these efforts to garner political support--especially in the rust belt. If this matter is favorably resolved before reaching the adjudication stage, Republicans should gain clout with those in the manufacturing sector. Even if the case does reach the adjudication stage, it should still give Republicans political capital for they can point to “doing something” about China as proceedings will be ongoing right in the middle of the campaign season. It is a heads-up move politically. 

Some of these export-promotion measures are considerable, like export-tax rebates. In 1994, China introduced a national value-added tax system that had a main rate of 17%, with a rate of 13% applied to basic goods. Exporters were able to claim rebates of 17% and 13% respectively, effectively negating the VAT. While these rebates were reduced twice to 10% and 6% by 1996, the onset of the Asian financial crisis meant that China had to find a way of maintaining its export competitiveness. Though it did not devalue the yuan for doing so would have likely caused doubts over the soundness of China’s finances at a time when other Asian economies were in crisis, China did increase the rates of these rebates to compensate. According to official statistics, the average rebate rate reached 14.75% by 1999 and 15.6% by 2002. More recently, China has lowered rebates on export goods from high-pollution industries like steel and textiles. While the rates on these rebates have bounced around, the amount spent has increased in recent years together with China’s export growth. Below is a chart depicting what China has spent on these export-tax rebates in dollar terms using year-end conversion rates:

In 2005, these export-tax rebates totaled $41.78B. Official statistics put the H1 2006 figure at about $27B. From 2001 to 2005, these rebates were somewhere between 4.5% and 5.6% of the value of Chinese exports. It is important to point out that export-tax rebates are not as clearly in violation of WTO rules as some of the other measures previously noted. If demonstrated, two things should help them be deemed legal. First, these rebates should not exceed the amount paid to domestic tax authorities. If the VAT rate paid is 10% for example, then the rebate given should not be greater than 10%. Second, foreign firms exporting from China should also be able to claim these rebates. 

Can this episode spark a trade row? China has replied that this case is “a pity.” Yet, in response, China appears amenable to concessions on steel and perhaps other products. These rebates are not cheap, either, and have accounted for between 14% and 38% of the central government’s total expenditures in past years. The government has already accumulated substantial arrears in its export-tax rebate payments. The continued use of these rebates and other measures seem to conflict as well with China’s avowed intention of transitioning to a more consumer-driven economy as government spending is directed towards promoting exports instead of creating social safety nets thought necessary in encouraging a consumer culture. As of now, the long-awaited Sino-American showdown at the Trade O.K. Corral is not yet in the cards, but we might be getting there sooner than we think.