U.S.–China Trade Conflict and the Changing Multilateral Trading System: Korea's Perspective^*

One of the biggest risks facing the current world economy comes from the escalating trade tensions between the United States and China. Until early May 2019, the two economic giants had been nearing a trade deal to resolve their escalating trade conflict. However, talks unexpectedly hit an impasse and both sides announced new rounds of tariffs. The United States increased tariffs on US$ 200 billion worth of Chinese goods from 10 percent to 25 percent, effective 10 May 2019. U.S. President Trump has also threatened to slap new 25 percent tariffs on an additional US$ 325 billion worth of Chinese products that would cover essentially all remaining Chinese products. Furthermore, the Trump administration put Chinese telecommunication giant Huawei on an “entity list” that effectively cuts the company off from its U.S. suppliers. In response, China announced that it would increase tariffs on US$ 60 billion worth of U.S. goods already subject to levies, increasing most of them to 10 percent, 20 percent, and 25 percent from 5 percent and 10 percent starting 1 June 2019 (Figure 1). At the same time, China also announced that it would establish its own unreliable entities list in retaliation to the U.S. entity list.¹

Both sides, however, agreed to restart trade talks through the G20 summit in Osaka, Japan, after two hostile months-long standoffs. On Chinese telecom giant Huawei, Trump suggested that he would be reversing the decision to ban American companies from selling products to Huawei.

Considering the 2020 U.S. presidential race, the trade deal between the United States and China could be reached by the end of 2019. Trump is soon going to focus his attention on his 2020 re-election campaign, and he will be motivated to rapidly shrink the U.S. trade deficit with China to fulfill a core promise that he made during his 2016 campaign. The ratification of the U.S.–Mexico–Canada Agreement (USMCA) is believed to be Trump's top legislative priority this year.² Successfully concluding bilateral trade negotiations with Japan and the EU are other urgent tasks that the Trump administration is pushing ahead over the next several months.³ All of these are reasons why Trump has to finalize the bilateral trade deal with China quickly.⁴

What we have to consider, however, is that the outcome¹ of trade deals between the United States and China could be a temporary expedient rather than a sustainable and permanent solution. Despite the best intentions, there are persistent gaps between agreements and their enforcement in the socialist market economy of China. The United States, and other developed countries such as the EU and Japan, will continue to monitor China's actions and resolve disputes on an impartial basis unless China removes non-market industrial policies and other unfair competitive practices, which will hardly happen within a few years.⁵

Because the underlying cause of the current trade conflict between the two largest economies is political (i.e., the U.S.–China hegemonic rivalry) rather than economic (e.g., the U.S. attempts to improve trade balance with China by imposing tariffs on Chinese goods), the trade war between the two economic giants may persist longer than many anticipate. In particular, rising trade tensions between the United States and China are just one facet of a high-stakes geopolitical fight for hegemony.⁶ The multilateral trading order will also be significantly affected by the final results of the ongoing trade deals between the United States and China.

The trade tension between the United States and China does not only affect these two countries. Given the size of their economies and their shares of world trade, these actions have negatively affected global trade as well as the economy of the Asia-Pacific region, which closely relates to both the United States and China through global production networks.⁷ The tariffs have reduced trade between the United States and China. This could dent business and financial market sentiments, disrupt global supply chains, and jeopardize the projected recovery in global growth in 2019.⁸

South Korea is often said to be one of the countries that could be most affected by the U.S.–China trade war because the United States and China are South Korea's two largest trading partners and South Korea has an export-oriented economy that is sensitive to external shocks. In 2018, South Korea's exports to both countries account for 46.4 percent of its total exports. Exports to China totaled US$ 208.1 billion⁹ (34.4 percent of total exports) and to the United States totaled US$ 72.7 billion (12.0 percent) (Figure 2). In terms of imports, the United States and China are South Korea's largest trading partners, accounting for 30.9 percent of total imports of South Korea in 2018.

In particular, more than 80 percent of South Korea's exports to China are intermediate goods, which are then assembled into finished products to ship to a third country that is the ultimate driver of demand for Korea's exports to China.¹⁰ Therefore, Trump's tariffs result in falling Chinese exports to the United States and there would be knock-on effects for Korea's exports to China. Similarly, a decrease in U.S. exports to China due to the retaliatory tariffs of China could bring about a decrease in Korea's exports to the United States.¹¹

On the other hand, the United States and several developed economies such as the EU, Japan, and Canada are using the WTO to address the China challenge under the name of “WTO reform.” Although there is growing momentum among many WTO members to modernize the organization, the reform of the WTO is another center of many of the debates over U.S. trade policy toward China. The United States believes that the current WTO is not well equipped to handle the fundamental challenges posed by China, which continues to embrace a state-led, mercantilist approach to the economy and trade. With support from other developed countries, the United States wants the WTO to effectively regulate subsidies for state-backed enterprises, overcapacity in steel and other basic industries, and on the practice of forcing investors to hand over valuable technology.

Given these issues targeting China itself, the current WTO reform led by developed countries could be reinterpreted as another version of the bilateral trade war between the United States and China.¹² The battlefield has changed but the fundamental characteristics of the fight are the same as bilateral trade tensions between two economic superpowers.

The rest of the paper is structured as follows. The impact of the U.S.–China trade war on Korea's exports is discussed in Section 2. Based on Lee and Song's (2018) paper on this issue, I then review the potential impact of the ongoing trade tension between the United States and China on the Korean economy. Section 3 highlights recent WTO reform activities by developed countries from an angle of the trade conflicts between the United States and China. The final section summarizes with a few concluding remarks.

In 2018, Korea's exports reached US$ 605 billion, a historical record and an increase of 5.4 percent from US$ 574 billion in 2017. Since 2000, Korean exports have increased at an annual rate of 7.2 percent, from US$ 172 billion in 2000 to US$ 605 billion in 2018 (Table 1). The top Korean export destinations are China (US$ 208 billion, including exports to Hong Kong), the United States (US$ 72.7 billion), Vietnam (US$ 46.0 billion), and Japan (US$ 30.5 billion). Exports to the top two countries account for 46.4 percent of total Korean exports.

Similarly, Korea's imports have steadily increased at an annual rate of 6.9 percent, from US$ 160.5 billion in 2000 to US$ 535 billion in 2018. The top import sources are China (US$ 106.5 billion), the United States (US$ 58.9 billion), Japan (US$ 54.6 billion), Saudi Arabia (US$ 26.3), and Germany (US$ 20.9 billion). Imports from the top two countries account for almost 31 percent of total imports of Korea (Table 2).

Korea's top 10 export products are electronic integrated circuits (US$ 109.8 billion), petroleum oils other than crude (US$ 44.7 billion), motor vehicles (US$ 38.2 billion), motor vehicle parts (US$ 19.5 billion), cruise ships and vessels for transport (US$ 15.8 billion), telephone sets (US$ 14.3 billion), liquid crystal display devices (US$ 13.5 billion), parts of machines (US$ 12.1 billion), cyclic hydrocarbons (US$ 11.3 billion), and machines for semiconductors (US$ 8.7 billion).¹³ These top 10 export products account for 47.6 percent of total Korean exports in 2018. Again, China is the main destination of these top ten export products. For example, more than 70 percent of electronic integrated circuits exports are shipped to China (Table 3).

Thus, the trade war escalation between the United States and China, particularly Trump's tariffs on Chinese imports, could have a negative impact on Korea's exports to China. For example, Korea exports semiconductors to China, where they are placed into smartphones and other electronics. China then ships many of those assembled products to the United States, and so Trump's tariffs could drastically raise the price of those electronics, resulting in fewer shipments of electronics from China to the United States, which means the reduction of Korean semiconductor exports to China. That could put a major dent in the Korean economy since semiconductors make up a significant portion of its total exports to China. There could be, of course, a trade diversion effect. Even if Korean exports to China decline, it may make up the gap by exporting more products to the United States. In fact, the U.S. imports of automobiles, machinery, plastic rubber products, and electrical and electronic products from Korea increased whereas those from China decreased.

Although China has enough ability to handle large shocks to value chains in various sectors, it still depends on imports of foreign intermediates and final inputs for some of its production. Korea is one of the largest exporters of intermediate goods to China, which then assembles those pieces into final products to ship to final destinations like the United States or elsewhere. Thus, the expected drop in Chinese exports to the United States may have knock-on effects on Korea through backward linkages.¹⁴ The extent of this impact would rely on what parts of the value chain Korea participates in.

Lee and Song (2018) estimate the effects of Trump's tariffs on Korea's exports by industries by using the Wang, Wei, and Zhu (2013) approach, which decomposes bilateral gross exports from one country to another country into three different value-added and one double-counted components, and their sum equals 100 percent of bilateral trade flows at the industry level. In other words, China's gross exports to the United States can be decomposed into DVA (domestic value-added absorbed abroad), RDV (returned domestic value-added), FVA (foreign value-added), and PDC (pure double-counting term) by this method. FVA can be further decomposed into foreign value-added used in final goods exports (FVA_FIN) and foreign value-added in intermediate exports (FVA_INT). Again, FVA_FIN is sourced from the United States (MVA_FIN) and third countries (OVA_FIN). FVA_INT is also sourced from the United States (MVA_INT) and third countries (OVA_INT).

Table 4 shows the results of decomposing China's gross exports to the United States. The share of foreign value-added in both final and intermediate goods exports (OVA) are in the fifth column of Table 4.¹⁵ Columns 6 through 10 show the value-added of major economies in OVA. The share of Korea in China's exports to the United States ranges from 2.4 percent (in mining and quarrying) to 11.2 percent (in electrical and optical equipment). In general, Japan's share in China's exports to the United States is highest, from 7.5 percent (in coke and refined petroleum products) to 19.2 percent (in electrical and optical equipment). The United States ranks third, followed by Taiwan (Table 4).

By using the 2016 Multi-Region Input–Output table of the Asian Development Bank,¹⁶ then, they calculate the share of each industry in China's total exports, which is shown in the second column of Table 5. They also calculate the exports of each industry, corresponding to US$ 500 billion of China's exports to the United States (column 3 in Table 5). Korea's value share in China's industrial exports to the United States (column 4 in Table 5) can be obtained by multiplying OVA (column 5 in Table 4) by Korea's share in OVA (column 7 in Table 4).

Finally, they simulate two scenarios. Scenario1 is the case that only the United States imposes additional tariffs of 25 percent on all imports from China—that is, the imposition of 25 percent tariffs on US$ 506 billion¹⁷ of Chinese imports. Scenario2 is the case that both the United States and China mutually impose additional tariffs of 25 percent on all imports. Under Scenario1, Korea's exports to China will shrink by US$ 10.3 billion and the reduction of exports will increase to US$ 13.3 billion under Scenario2 (columns 5 and 6 in Table 5).

The computer, electronic products, and electrical equipment sectors are projected to be the most vulnerable sectors, with more than 50 percent in total reduction of South Korea's exports (US$ 5.4–7.4 billion) expected. Basic metal and fabricated metal products (US$ 0.84–1.0 billion) and chemical products (US$ 0.80–0.84 billion) are projected to be industries that will be negatively affected by tariffs war between the United States and China.

In sum, the ongoing U.S.–China trade tensions are expected to decrease Korean exports by US$ 10.3 to 13.3 billion, which is just 1.7 to 2.2 percent of total exports. This figure, quite lower than expected, is mainly because a significant portion of Korea's exports to China is used for domestic consumption for China itself, not for re-exports to third countries, including the United States. According to statistical data on Chinese customs, the share of intermediated goods in Korea's total exports to China surpassed 88 percent in 2017. However, 40 percent of total exports are used for domestic consumption within China, and so no are directly impacted by Trump's tariffs (Table 6). Most of the remaining 60 percent of total exports can be regarded as re-exports to third countries, but the United States is not a unique destination of Chinese exports.

Although the impact study shows that the U.S.–China trade war would not result in a significant decrease in Korea's exports to China or the United States, recent trends of Korea's exports show a different picture from the results of the impact study. Korea's exports started to shrink unexpectedly in November 2018, which was followed by six straight months of decreases in outbound shipments. Korea's exports declined by 9.5 percent year-on-year to US$ 45.9 billion in May 2019, following a 2.2 percent drop in the previous month (Figure 3).¹⁸ In particular, exports to China and Hong Kong dropped 22.4 percent in May 2019 from a year earlier on reduced demand for chips, petrochemical, oil products, and steel (Figure 4). Korean manufacturing production also slumped to its worst level in nearly four years in May 2019.

The Korean government attributed the poor performance of its exports to growing “external uncertainties”—that is, the sluggish shipments of chips and the weak Chinese economy due to deepening U.S.–China trade tensions, including a contraction in global trade.¹⁹

Thus, the adverse impacts of the tit-for-tat tariffs between the United States and China have not been seen until quite recently, largely because of the efforts of firms to avoid pre-announced tariffs. Furthermore, the global economic downturn due to the ongoing trade conflicts between the two economic giants could have a worse effect on Korea's overall exports. Therefore, more time is needed to capture and understand the exact impact of U.S.–China trade tensions on the Korean economy.

The WTO reform is also at the forefront of international tensions in 2019. Political changes in the United States and Europe, and the rise of China as a peer competitor to the world economy, have led many to question the fundamental assumptions and operations supporting the WTO. Chinese mercantilism, the Trump administration's aggressive use of unilateral tariff measures, and the inability of WTO members to reach consensus on expanding its disciplines to important new sectors and forms of commerce in the modern economy reinforce critiques of the WTO. In 2018, several constructive efforts to craft reforms for the WTO arose with some hope that the WTO could be adapted to meet the needs of the contemporary economy.

Nonetheless, recent debates on WTO reform closely relate to on-going trade conflicts between the United States and China. There are three essential issues in the debates on strengthening and improving the function of the WTO: (i) strengthening WTO notification obligations with high transparency; (ii) safeguarding the dispute settlement system; and (iii) modernizing WTO rules for the 21st century. These issues are, in fact, targeting China's unfair competitive practices and huge subsidies of Chinese SOEs.

The starting point to strengthen the WTO would be to improve the monitoring function of the WTO, which is inevitably connected to reinforcing notification and transparency of domestic measures. Recently, a group of WTO members such as the EU, Japan, and Canada, including the United States, asserted that transparency and notification requirements constitute fundamental elements of many WTO agreements and a properly functioning WTO system. They call for the WTO to instruct appropriate committees or other groups to assess and report yearly regarding members’ compliance with notification obligations and take appropriate steps to reinforce compliance with notification requirements.

In particular, the joint proposal by the United States and five other countries on notification requirements promotes the use of counter-notifications²⁰ of members’ policies that should have been notified, including stringent penalties when members fail to fulfill their notification commitments prescribed in the WTO agreements.²¹

The notification demands are particularly directed at China, which has not properly informed the WTO of subsidies provided by its SOEs.²² In fact, Chinese market-distorting subsidies for its domestic industries is one of the key issues in the U.S.–China bilateral trade talks. The United States thinks that it will face a sharply diminished economic future if China is allowed to continue its industrial policies and supplant U.S. dominance in high-technology industries. Thus, curbing China's state subsidies is a priority in the bilateral trade talks with China.

The EU's proposal also seeks to address a fundamental obligation set out under Article 25 of the WTO's Agreement on Subsidies and Countervailing Measures (SCM agreement). The EU pointed out that the share of members meeting this obligation fell from 50 percent in 1995 to 38 percent in 2015 and the problem was not only missing notifications but also the poor quality of notifications submitted. Those demands are part of broader U.S. demands that China dismantles its SOEs, which is the backbone of China's state-led economic development model.

It is easily expected that the market-distorting effects of SOEs and industrial subsidies of China would be revealed through the improved notification obligations, meaning that China could face many unexpected disputes with other WTO members.²³

We need to understand, however, that the issue would be framed in the big picture of systemic trade distortions. Beyond a mere procedural reform of the subsidy notification system, what the United States, as well as other developed countries, want is to bridge the gaps in multilateral rules that allow distortions such as Chinese subsidies to SOEs. Thus, strengthening WTO notification obligations are closely connected to the amendment of the existing SCM agreement, which is also part of modernizing WTO rules for the 21st century.

One of the core functions of the WTO is to enable its members to avoid trade disputes through consultations and to settle those disputes under WTO rules. The Dispute Settlement Mechanism (DSM) has been described as the “crown jewel of the WTO,” and its advocates have proposed ways to “save the crown jewel.”

However, the United States began to block the appointments of new members of the WTO Appellate Body (AB) during the Obama administration as a tactic to force changes in the application of the Dispute Settlement Understanding (DSU) rules, following DSM rulings against the United States. Now, if new members are not appointed by December 2019, the AB will not be able to review appeals of DSM rulings.

The United States continues to believe that the AB has failed to remain within the bounds of its review authority under the WTO agreements. Among other things, the United States has criticized the AB for (i) failing to circulate its reports in a timely fashion;²⁴ (ii) making findings on issues of fact that are not necessary to resolve a dispute; (iii) issuing advisory opinions; (iv) treating its prior reports as binding precedent; and (v) allowing its members to participate in decisions even after their terms have expired. In sum, the United States is concerned that the AB has exercised decision-making and arbitration power beyond its original mandate. Trump has continued the Obama administration's AB demands but imperiled the viability of DSM reform negotiations by repeatedly threatening to pull the United States out of the WTO.

The reform of DSU does not seem to be related to the ongoing trade conflict between the United States and China. Nevertheless, the United States has repeatedly said that the AB has not controlled Chinese unfair practices, particularly subsidies of SOEs. As a result, the United States believes that it lost several trade disputes against China when the case was brought to the WTO. Therefore, the United States stresses that it will not allow new AB appointments unless the WTO effectively regulates the market-distorting effects of China's SOEs and industrial subsidies. Thus, the Trump administration's demands on AB reform has led to an “existential crisis” at the WTO. At this juncture, there is no way to resolve the crisis of the AB without fully meeting the U.S. demand.

The aging trade rules of the WTO urgently need to be updated to respond to the needs of the modern global economy. However, this is unlikely to happen as a single undertaking, in which nothing is agreed until everything is agreed, with all members taking on all obligations at the same time. Instead, to make progress on new rules, alternative approaches to cooperation and rule-making may be required to reflect the realities of memberships with increasingly diverse needs, levels of development, and capacity.

(i) Creating new rules that rebalance the WTO

Many developed countries have thought that certain firms in developing countries increasingly benefit from targeted and significant market-distorting government support that is often channeled through SOEs. In particular, the United States and EU argued that SOEs are an instrument through which the state decisively governs and influences the economy, often with market distortive effects. Thus, they emphasize the necessity of new rules that can more effectively capture the most trade-distortive types of subsidies and can address forced technology transfers, where foreign operators are directly or indirectly forced to share their innovation and technology with the state or with domestic operators. It is clear that this argument on new rules is closely related to the trade practices and trade policies of China.

(ii) Differentiated levels of development

Special and differential treatment (S&DT) for developing members is another important issue that the United States and several developed countries have continuously requested WTO members to address in the process of WTO reform. When it comes to the S&DT issue, in fact, all developed countries have continuously raised objections against excessive benefits being provided for developing countries in the Doha Round.²⁵ Two-thirds of the WTO's 164 member states currently continue to claim “developing country” status, a designation that allows them to take advantage of certain benefits and exemptions to obligations not granted to advanced economies. There is still significant dissent within the WTO surrounding how the economic superpower China remains classified as a “developing country” by the WTO, thus allowing it certain S&DT privileges. This issue is naturally targeting China, including major trading powers like India and some of the advanced countries such as South Korea, Hong Kong, Brunei, and Taiwan.

It is true that the current distinction between developed and developing countries within the WTO no longer reflects the reality of the rapid economic growth in some developing countries. Clearly, there is a wide range of heterogeneity among developing countries. This lack of nuance and its consequences with regard to the S&DT treatment question have been a major source of tensions in the WTO and an obstacle to the progress of negotiations. Developing countries, of course, should be allowed the assistance and flexibilities that they need to meet their development goals. Nevertheless, change is needed in terms of ensuring that flexibilities are made available to those countries that actually need them.

(iii) Plurilateral approach

With 164 members featuring highly diverse economies and political systems, any agreement at the WTO, which requires an extremely high level of consensus, is all but impossible in today's world. This is proved by the fact that the Doha Round of negotiations has stalled despite numerous attempts to revive it.

On the other hand, progress in lowering trade barriers and adapting international rules for the modern globalized economy has been achieved over the past two decades through bilateral, regional, and plurilateral agreements. Examples of these in recent years are the EU agreements with Canada and Japan, the Comprehensive and Progressive Agreement for Trans-Pacific Partnership, and the new USMCA arrangement. Therefore, one possibility of moving forward could be a plurilateral agreement with a group of like-minded countries on a new set of rules that serve as an addendum to the broader WTO.

Although no WTO member should be expected to take on obligations to which it did not consent, likewise, no member should expect to be able to prevent others from moving forward in areas where they are willing to make greater commitments. The launch of plurilateral initiatives should be inclusive, open, and provide clear rules for accession by other members or eventual multilateralization.

Most developing countries, however, including China, India, and South Africa, still voiced serious concerns about pursuing plurilateral negotiations that would undermine the multilateral framework as embodied in the WTO.

Protectionist tit-for-tat tariffs can have dramatic consequences for the warring parties, as the experience of the Great Depression illustrates (see Eichengreen and Irwin 2010). At the same time, it can also affect third countries, especially those more economically linked to parties engaged in the trade war. In this respect, Korea is the most exposed to the dispute given its integration with Chinese-led supply chains and the similarity of its export baskets with China. Thus, U.S. tariffs on Chinese imported goods are likely to be adversely enforced on Korea's exports to China. In particular, Korea heavily relies on exporting semiconductor chips to China, which are then incorporated into the assembly of cell phones.²⁶

An impact study shows that Korea's overall exports are expected to be reduced by US$ 13.3 billion in the worst scenario of a full-blown trade war between the United States and China. Such a projected loss is equivalent to only 2.2 percent of total exports in 2018, and so would not have such a considerable impact on the Korean economy.

However, the adverse impacts of the U.S.–China trade tensions were largely not seen until quite recently. Korea's exports fell for six consecutive months (from November 2018 to May 2019), the first time since January 2009. Hence, more time is needed to capture an exact effect of the ongoing trade tension between the United States and China on South Korea's exports.

Aside from the U.S.–China trade war, the two sides are wrestling at the WTO. The United States has continuously argued that China's unfair competitive practices were harming foreign companies and workers in a way that violates WTO rules. The United States has insisted that SOEs play an outsized role in China, with control exercised by the government and Communist Party, which appoint top executives and hold the keys to crucial inputs such as land and capital.

The EU, Canada, Japan, the United States, and other members have begun offering concrete proposals for WTO reform. Many developing countries, however, rejected them. Should reform proposals fail to satisfy member states’ demands, the divisions could lead to the disintegration of key pillars of the organization. The Trump administration will continue to block vacant AB seats from being filled, meaning that the WTO is unable to fully resolve trade conflicts between member states, one of its founding mandates. This could result in more bilateral trade disputes as individual states take it upon themselves to resolve conflicts through retaliation.

The absence of the WTO could potentially lead to a proliferation of bilateral and regional trade agreements that may better address member states’ complaints on a case-by-case basis. At the same time, however, an erosion of the WTO could lead to the return of more trade barriers, loss of predictability and certainty for multinational companies and governments alike, and the absence of a credible venue to mediate trade disputes and serve binding decisions. Those developments could extract a high cost on the global economy and severely diminish global growth and economic stability for years.

Incorporation of new rules into the global WTO is extremely difficult; the full consensus among its 164 members is required for the adoption of any new disciplines or internal operations. To overcome that impediment, plurilateral agreements, like the Information Technology Agreement of 1997, should be used to establish and test new rules needed for the 21st century economy. Some use of supermajority decision making rather than the consensus rule may also help advance the creation of new rules and redress weaknesses in WTO operations.

The current stalemate in the WTO system is the consequence of a dual threat—that posed by the United States to the dispute settlement mechanism and that posed by Chinese state capitalism to international trade. It is clear that simply continuing as before is not possible. Neither is there one size that fits all. We know that the WTO is not perfect, but we know it is useful and we should seek to make it better.