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US-China Economic and Security Review Commission, “Capital Trade, Inc.: An Assessment of China’s Subsidies to Strategic and Heavyweight Industries,” 2008

January 1, 2008

Executive Summary

This study examines China’s government subsidies to industries known as “absolute control” and “heavyweight” industries. The absolute control industries are armaments, power generation and distribution, oil and petrochemicals, telecommunications, coal, civil aviation, and shipping. The Chinese government views these industries as being strategic and of vital importance to the proper function of China’s safety and economic well being. Government control over these industries is to remain absolute, or close to it. The heavyweight industries are machinery, automobiles, information technology, construction, and iron & steel and non-ferrous metals. These industries are deemed important to the domestic economy. The Chinese government intends to maintain a high degree of control over these industries, but is more willing to tolerate private ownership. Subsidies exist when a government transfers resources to a producer or exporter. This study attempts to assess the nature and scale of Chinese subsidies to strategic and heavyweight industries by examining the results of U.S. countervailing duty investigations of Chinese subsidies and by reviewing the annual reports of Chinese firms from the favored industries.

The nature of Chinese subsidies
The Chinese government uses subsidies for a variety of purposes, and subsidies come in a variety of forms. Tax subsidies, preferential loans, and grants are the most common form of subsidy. The government also provides favorable input prices and transfers assets to favored firms at prices that are below market value. Chinese subsidies are both practical and strategic. Practical subsidies reward companies for accomplishing a social policy goal, such as investing in disadvantaged regions to alleviate unemployment. Strategic subsidies are those that seek to advance the overall economic well being of the country by earning foreign exchange, promoting technological development, developing an industry that the government views as being important, or otherwise enhancing China’s industrial competitiveness. Examples of strategic subsidies include subsidies that attract foreign investments in export-oriented industries, subsidies that reward companies for investing in research and development facilities, and subsidies that increase the competitiveness of a favored industry. By their very nature, subsidies are distortive. Strategic subsidies, which seem geared to accelerate China’s economic development, have competitive effects because they reduce the costs of the favored Chinese firms relative to firms in the United States and other countries. In competitive international markets, such subsidies would be expected to increase economic activity of favored industries in China relative to activity in the United States. This means higher levels of Chinese output and exports and lower levels of U.S. output and exports.

The value of Chinese subsidies
The value of Chinese subsidies was assessed by examining the countervailing duty determinations made by the U.S. Department of Commerce and corporate financial reports of subsidiaries of state-owned enterprises. These subsidiaries raise money in Hong Kong and other international capital markets, and therefore submit and publish annual reports that contain information about the subsidies received in China. Both sources confirm that Chinese subsidies are meaningful. Excluding the very high subsidy rates calculated by the Department, which reflect the failure of certain Chinese firms to cooperate in investigations, the range of subsidy rates is 0.57 percent to 44.93 percent, the average subsidy rate is 18.6 percent, and the median subsidy rate is 14 percent. Thus, the extent of subsidization can be the difference between a profitable year and an unprofitable one. The range of subsidy rates derived from the separate analysis of the annual reports of selected absolute control and heavyweight firms is consistent with the findings of the Department, though most subsidy rates from this latter methodology fall in the range of 1-10 percent. One would expect the Department’s calculations to be higher because it has access to proprietary information not present in annual reports.

The WTO and Chinese subsidies
The Agreement on Subsidies and Countervailing Measures indicates that export subsidies and subsidies that are contingent upon the use of domestic over imported goods are prohibited. China has for years provided incentives to firms that purchased domestic machinery. This subsidy is mentioned in several annual reports examined below and has been countervailed by the Department. The Department has also countervailed several subsidies that conferred benefits contingent on exports, including a program that encouraged exports by firms with foreign investment. The U.S. government has taken China to the WTO over prohibited subsidies, and those efforts appear to have had some success. Many of the annual reports examined indicate that the tax code’s preferences to foreign invested firms were abolished at the end of 2007. However, this benefit is to be phased out over a five-year period. Many of the firms reporting benefits under the prohibited program that provides tax credits for purchases of domestic machinery have reported that the program was terminated at the end of 2007 and is no longer in effect. The SCM Agreement also lays out a number of actionable subsidies, which can be challenged at the WTO via the dispute settlement process or through national countervailing action. Many, though not all, of the Chinese subsidies acknowledged by the government to the WTO are actionable. The Department of Commerce has countervailed many of the actionable subsidies when U.S. industries have petitioned for relief. Some actionable subsidies, such as the provision of electricity at below market rates, are not included in China’s subsidy notification and have been difficult to countervail because low rates are believed to be generally available. However, the Department has recently uncovered some evidence of preferential pricing. Chalco’s annual report also indicates that the aluminum industry in China has received access to cheap electricity for a number of years.

Chinese subsidies and western firms
Many Chinese subsidies provide tax and other incentives to foreign investors. Exports and research and development activities are highly encouraged. An analysis of U.S. data on foreign direct investment indicates that U.S. firms are increasing capital expenditures in China and value added in China, at a time when U.S. investments in productive equipment have been stagnating. Press reports also suggest that China has heavily promoted the location of R&D activities to China by foreign firms, and is succeeding. But this desire to attract investment has taken a new twist. In the summer of 2008, China's President Hu Jintao urged the country’s scientists, engineers and educators to work toward making China an “Innovation nation.” The government is reportedly devoting substantial sums to achieve this goal. China is also targeting R&D in the aerospace and automotive industries. It appears that China is no longer content to remain the “workshop of the world” while relying on foreign technologies. Government efforts to construct China’s first production facilities for LCD-glass substrate and to promote home-grown wireless technology should be viewed in this light. These efforts are certain to increase competitive pressures on firms that once viewed themselves immune to Chinese competition. As China’s role in the global economy increases, so will the role played by firms subsidized and controlled by Beijing. If these subsidies persist, they will continue to provide Chinese firms with a significant competitive advantage vis-à-vis U.S. firms. In addition to this competitive advantage, U.S. firms must be aware that decisions made by Chinese competitors from strategic and heavyweight industries could reflect government incentives and control, not market incentives and profit. Given the government’s streak of economic nationalism, the possibility that Chinese firms in government controlled and heavyweight industries would sacrifice economic profits to achieve official aims should not be discounted. In order to estimate the competitive effect of Chinese subsidies on U.S. firms, three policy simulations were performed using the Global Trade Analysis Project Data Base and applied general equilibrium model. All three experiments indicated that eliminating Chinese subsidies would increase U.S. output, exports, worker earnings and economic welfare. In contrast, the output of the subsidized industries in China and China’s economic welfare would decline. The stagnant level of equipment stock of U.S. manufacturers, rising U.S. capital expenditures in China, and the rapid expansion of imports from China suggest that Chinese subsidies have been diverting equipment investments from the United States to China, or otherwise limiting U.S. manufacturing investments. The simulation considering this possibility indicated that reversing this pattern would have a beneficial effect on U.S. manufacturers that compete with Chinese firms, and on the overall U.S. economy.

Chinese subsidies and U.S. policy
For many years, the U.S. government did little to address Chinese subsidies. In recent years, however, the U.S. government has sought to eliminate these subsidies through action at the WTO and by modifying a longstanding policy of not investigating subsidies from non-market economies. The WTO cases have brought about policy changes by the Chinese government that should reduce the pronounced policy tilt in favor of foreign investment. The USTR, with the support of several advanced and developing economies, is now addressing China’s “famous brands” program subsidies at the WTO. The Department of Commerce has investigated Chinese subsidies in several industries, and many of these investigations have led to countervailing duties being placed on the imports of subsidized Chinese firms. For U.S. industries in competition with such firms, these U.S. government actions are a very welcome development.

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