Friday News Analysis — October 5, 2018: China’s Tech Challenge, USMCA (neé NAFTA), and Stories You May Have Missed

It feels oh-so-briefly like fall in Washington today, and it appears that after a week’s delay the Kavanaugh confirmation still comes down to a few key swing votes in the Senate. While attention continues to be focused on that, this week we take a look at two other major stories from the intersection of policymaking and business: the report from Bloomberg about the hardware backdoors allegedly placed into U.S. companies’ servers by the Chinese and what we can gather from the recent NAFTA trade re-negotiations and the agreements reached with our North American partners. After that, as always, we look at the stories that you may have missed.

Contextualizing the Chinese Tech Challenge

Dan Mahaffee

Bloomberg Businessweek Cover

This week’s Bloomberg Businessweek piece on the Chinese hardware planting backdoors into U.S. companies’ servers has set off a firestorm of conversation about the broader security challenge posed by China’s role in the global supply chains — both in terms of the reliance on Chinese manufacturing and the ties between major Chinese companies and the state intelligence and military apparatuses. Amazon and Apple, two of the affected companies in the Bloombergpiece, have issued denials about the security breach, and, of course, the Chinese government has also denied that it engaged in such activity.

When the Snowden disclosures occurred, I remember remarking to colleagues that “if the U.S. government was not using methods for foreign intelligence gathering, then I would want some of my tax dollars back.” Applying the same logic to China, we should all expect the Chinese government to leverage China’s position as the leading manufacturer of information technology components to insert cyber espionage tools into key hardware systems. While the Bloomberg piece points to the company Supermicro, based in San Jose, as the source of the tampered hardware, there have been multiple claims of similar security risks posed by equipment from Chinese firms such as Huawei and ZTE.

However, beyond this specific example, there are larger concerns to consider about the impact of China’s approach to building leadership in a wide range of technologies, and how a range of political decisions, business models, and our own behaviors are making China’s job easier — including our own security behaviors and the mishmash of systems underpinning IT networks. There is already concern about how China’s national “tech champions” such as Alibaba, Baidu, and Tencent are playing a role in the development of artificial intelligence technology — in close, compulsory cooperation with Chinese military and intelligence officials — and additional concerns about China’s approach to other cutting-edge innovations such as quantum computing and 5G networks. Before now, many questioned why China would risk its role as a global manufacturing leader by planting intelligence tools in hardware shipped to Western customers — a caveat that the Bloomberg piece raised. Given the push by the Chinese government to be a leader in technology development, rather than manufacturing, it gives them greater leeway to take risks for the sake of technological gains and intelligence gathering.

The rapid growth of China as a manufacturing base has made possible both affordable electronic consumer goods and the proliferation of sensors and computers in everything from refrigerators to cars. What is becoming clear, however, is that, having used its position as a global manufacturing hub to create the most dramatic economic transformation in human history, the Chinese Communist Party is now looking forward to using its market power to support Chinese political leadership. China’s vision is simple — remembering the history of being geopolitically and economically surpassed by the West and Japan during the industrial revolution, China aims to be the leader in the information revolution. Therefore, using a range of tools from corporate espionage and intellectual property theft to overseas investment in technology research and scientific and academic exchange, China wants to set the standards, supply the hardware, and establish the rules for the future information economy.

Our own policies on this front have been muddled. Back in August, I praised the measures taken by Congress to strengthen the security review of Chinese and other foreign investments into technology companies and startups. However, two weeks ago, I worried that too much of the rhetoric coming from the Trump Administration was focused on tariffs and industrial era tools — rather than the commanding heights of the future economy.

What is needed over the coming months is a thoughtful discussion with representatives from government, the private sector, and researchers to begin to chart a technology strategy for the United States and our allies. While industrial policy has long been a dirty word, and the free market approach should continue to lead the way, that does not mean we cannot have a strategy for securing our vital networks and ensuring that technology reflects our shared principles. I am proud to say that CSPC is planning to embark upon such a discussion over the coming weeks — stay tuned…

U.S. & Canada Finalize New NAFTA Agreement

Michael Stecher

State Department Photo

Late Sunday night, the Trump administration and the government of Canada announced that they had come to terms on incorporating Canada into the existing framework of the U.S.-Mexico agreement to replace the North American Free Trade Agreement. This agreement will now be known as the U.S.-Mexico-Canada Agreement (USMCA). Despite the president’s rhetoric about moving forward without Ottawa and the stalled negotiations noted in last week’s Friday News Analysis by perspicacious intern Charlie Cousar, stakeholder groups across the political spectrum were anxious about the risks involved in dissolving NAFTA without a new agreement that included Canada. The deadline does appear to have focused minds on both sides of the 49th parallel and now all parties can move forward with the legislative horse-trading necessary to get the deal ratified.

The deal does not upset the basic framework of NAFTA that had allowed the unprecedented integration of the North American market over the last 25 years. It also incorporates elements from the Trans-Pacific Partnership (TPP) that President Trump withdrew from shortly after taking office and some of the populist-nationalist views on trade that helped fuel his rise to power.

As I have noted in the past, car manufacturing has a particular hold on President Trump’s political imagination, so it is no surprise that USMCA includes rules to incentivize carmakers to onshore production to the United States (or Canada). In order for cars to qualify for zero-tariff trade, 75% of the parts must originate within the trade zone (up from 62.5% under NAFTA) and 40% of the “labor value content” must come from facilities with an average hourly wage of at least $16 per hour. This may raise some wages in Mexico, but is essentially a U.S.-Canada production requirement, since $16 per hour is substantially higher than industrial wages in Mexico.

Jeffrey Schott at the Peterson Institute for International Economics argues that this requirement provides some perverse incentives. The most-favored nation tariff for passenger cars that governs in the absence of a free-trade agreement is only 2.5%, so low-margin passenger car producers that do not meet the higher requirements might decide not to adjust their production. This is clearly not the Trump administration’s goal and they have shown a willingness to make “specious” arguments about national security tariffs. As a result, this condition is probably a signal that President Trump is close to announcing 25% tariffs on passenger cars — that matches the existing 25% most-favored nation tariff on trucks. There is even a side letter to the agreement that promises to exempt Canada and Mexico from national security tariffs on cars. The retaliatory tariffs that follow such a decision would make North American automobile exports less competitive abroad and reduce employment in the sector.

USMCA also includes elements that make the deal less sticky than NAFTA. While NAFTA had an indefinite time horizon, the United States wanted an explicit 5-year sunset clause on the new deal. This would have severely limited the deal’s influence on corporate investment decisions and limited the integration of the market. Instead, the parties agreed that the deal would extend out 16 years and that the parties would reconvene in 6 years to discuss extending it further and additional changes. This should be viewed as two of America’s closest partners taking out Trump insurance: USMCA will not be implemented until 2019 at the earliest, so the parties will meet after President Trump has left office and Canada and Mexico are willing to bet that his successor might be more amenable to international agreements.

Finally, USMCA contains provisions similar to those in the TPP on issues like digital trade (unsurprising, since both Canada and Mexico are still members of that agreement) and actually improves on the TPP’s position on American access to the Canadian dairy market — an issue that acquired some political salience for President Trump earlier this year — and pushes the other parties to more closely conform to American intellectual property requirements. The deal also takes two indirect swipes at China. Member countries must now provide advance notice of any negotiations on a free trade agreement with a “non-market” country (this term is to be defined by each member) and gives the other members the ability to cancel USMCA if such a deal is concluded. The parties also agreed to “avoid manipulating exchange rates” for political or economic advantage. All three parties to USMCA have free-floating exchange rates, so this is unlikely to bind any of them, but the United States is signaling that it will try to push for a norm of fighting strategic devaluation in future international trade agreements. These are both potential poison pills designed to prevent China’s ascension to the TPP.

The agreement is likely to be signed in November at the G20 summit in Buenos Aires, which is the next step for its adoption in Congress. Under the Trade Promotion Authority granted by Congress to update NAFTA, the White House has 60 days after signing the agreement to submit to Congress a list of U.S. laws that will need to be updated to comply with the agreement and 105 days for a U.S. International Trade Commission review of USMCA’s economic impact. Congressional leaders and the White House usually cooperate on the drafting of the implementing legislation and Congress has 90 days after the bill is introduced to vote on it. This timeline crosses the midterm elections and the installation of the new Congress in January, so it remains to be seen how it will advance. Historically, trade politics have not aligned perfectly with the two-party system in the United States but recent events have shown how partisan politics has progressively ceased ceasing at the water’s edge.

Stories You May Have Missed

With an 8-Justice Supreme Court, the Dusky Gopher Frog Comes before the Bench

Katherine Atherton

The Supreme Court returned to the bench on Monday in the midst of the nomination of Judge Brett Kavanaugh to discuss the Fish and Wildlife Service’s efforts to protect the Dusky Gopher Frog. This case analyzes whether the agency exceeded its authority in designating 1,500+ acres in Louisiana as “critical habitat” to allow the species to repopulate. The case’s outcome is not clear, and if a tie was to occur, the lower court’s decision that supports the Fish and Wildlife Service’s protections of the Dusky Gopher Frog will stand. The court can also decide to rehear the case when a new justice is appointed.

Concerns grow over Exiled Saudi Dissident Journalist who entered Saudi Consulate in Turkey

Jamal Khashoggi, a critic of Saudi Crown Prince Mohammad bin Salman disappeared Tuesday after entering a Saudi consulate in Turkey, where he lives in exile. Khashoggi had been an advisor to the Saudi government before he his newspaper column was canceled due to his critiques of the Crown Prince’s governance. The Washington Post, where Khashoggi was a foreign columnist, published this blank editorial to raise attention to his disappearance.

French Police Open Investigation into the Disappearance of Interpol Head during Trip to China

Meng Hongwei, the chief of Interpol, the global policing coordination body, has gone missing while traveling in China. French police have opened an investigation into the disappearance, as Interpol’s headquarters are in Lyon, France. Appointed to be the head of Interpol in 2016, there were initial concerns about whether Mr. Meng’s past as a Chinese Communist Party official would result in increased Interpol attention towards political dissidents. Now, it appears Mr. Meng has joined a list of mysterious disappearances of public and political figures in China, including China’s most popular actress, Fan Bingbing, who only recently resurfaced following an apology on social media and admitting to $129 million in tax evasion.

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