The U.S.-Chinese Trade War Just Entered Phase 2

The Trump administration’s “phase one” trade deal with China may mark the end of the first chapter of the trade conflict between the United States and China, which saw Washington embrace a confrontational approach. But even if China meets its commitments under that agreement, the deal will not mean the conclusion of the broader competition between the two powers. The forces of geopolitical rivalry and the sharp differences between China’s state capitalist model of economic development and the U.S. economic system are too great. Instead, the deal will mark a pivot to a second phase of economic competition, one which will be fought with export and import controls, investment restrictions, and sanctions rather than with tariffs.

Over the past two years, Washington has been quietly building a legal and regulatory architecture for this campaign. In 2018, U.S. Congress enacted legislation to enhance controls on the export of emerging technologies, such as advanced robotics and artificial intelligence, and bolster reviews of foreign investment in the United States. In November 2019, the Trump administration and Congress took steps to block U.S. companies from using Chinese telecommunications network equipment in the United States. There is increasing discussion in Washington about additional restrictions on business and investment relations between the United States and China, such as limits on federal employee retirement fund investments in China.

But the highest-profile example of the United States’ use of targeted coercive measures against China is its yearlong campaign against Huawei, China’s national-champion telecommunications company. This campaign holds important lessons for the United States as it turns from a tariff-centric approach to competition with Beijing to targeted coercive tools. In particular, the campaign against Huawei shows the need for better planning, more effective diplomacy, investment in alternatives to Chinese products, and a systematic review of the long-term risks from the aggressive use of coercive economic measures.

Huawei is paradigmatic of the challenge China poses the United States. It is a technological leader in “5G” telecommunications, the next-generation mobile technology that will enable industries like autonomous vehicles and advanced telemedicine. Huawei’s leadership in 5G could give China an edge in developing entire new industries. And it simultaneously creates national-security risks through the potential to facilitate Chinese espionage and cyberattacks.

Huawei’s success to date is due in part to legitimate investments—Huawei spends $15 billion annually on research and development—but also, according to U.S. officials, intellectual-property theft and illegal subsidies and state support. Huawei’s scale—it is not only a network equipment company but also one of the world’s leading mobile handset makers—means that U.S. firms bear significant costs from restrictions on business: Huawei purchased $11 billion annually from U.S. firms in 2018. And with more than $100 billion in global annual revenues and employees in more than 170 countries, Huawei is larger than the economies of several countries subject to U.S. sanctions, such as Cuba and North Korea (and more connected to the rest of the world, besides).

Over the past year, Washington has responded to the Huawei challenge with a multifaceted pressure campaign. U.S. officials have charged the company with violating U.S. sanctions on Iran and indicted it for stealing U.S. intellectual property. In May 2019, the Commerce Department limited sales of U.S.-made products to the company. U.S. State Department officials have mounted an aggressive diplomatic campaign to persuade U.S. allies to block Huawei equipment from new telecommunications networks, and the Trump administration has threatened to limit intelligence sharing with countries that allow Huawei into their 5G networks. Congress has effectively prohibited the U.S. government from purchasing Huawei equipment, and the Federal Communications Commission recently banned the use of federal funds for U.S. telecommunications companies to purchase Huawei gear. The Trump administration is reportedly considering further restrictions on U.S. companies’ ability to do business with Huawei through their overseas affiliates.

The initial results of this pressure, however, have been mixed—with diplomatic pressure proving at least as successful as economic coercion. Limits on U.S. companies selling chips, software, and other products to Huawei have largely failed to blunt Huawei’s global smartphone sales. A recent study of the market found that Huawei’s sales grew 28 percent in the third quarter of 2019 year-on-year despite the restrictions. That growth was driven by Huawei’s dominant position within China, but even in Europe, Huawei managed to keep its sales almost flat. (Europe also saw dramatic growth by Huawei’s Chinese rival, Xiaomi.) Huawei is succeeding in shifting its supply chains away from U.S. components, and one of Huawei’s latest phones is apparently manufactured without any U.S. chips at all—illustrating the limits of U.S. economic pressure. Recognizing that the blanket ban on sales has harmed U.S. companies without consistently imposing costs on Huawei, the Trump administration recently began authorizing sales of products that Huawei could readily buy from non-U.S. suppliers while blocking the sale of more unique products.

The Trump administration’s diplomatic campaign against Huawei’s 5G telecommunications equipment, on the other hand, has begun to gain momentum. The United States has persuaded Australia, Japan, and New Zealand to block Huawei from their 5G telecommunications networks. Diplomatic engagement and public-relations campaigns in Europe have prompted allies such as Germany, the United Kingdom, Italy, and Poland to reopen debate about whether to allow Huawei equipment in 5G networks, which at the very least is likely to lead to restrictions on Huawei equipment to only “noncore” parts of 5G networks. Even Spain’s largest telecommunications company recently announced plans to drastically scale back Huawei 5G equipment despite extensive reliance on the company in existing networks. But in the developing world, aside from a handful of countries such as Vietnam, Huawei remains likely play a major role in network development. The African Union, for example, signed a memorandum of understanding with Huawei on 5G network development despite widespread reports that China has bugged its headquarters for years. As then Deputy Director of National Intelligence Sue Gordon said publicly in March, the United States will “have to presume a dirty network” in many countries.

U.S. policymakers should draw at least four lessons from the early results of the U.S. campaign against Huawei. The first is the need for better planning in deploying coercive economic measures when it comes to China. Huawei has been able to survive the U.S. export restriction in part because the Trump administration telegraphed the possibility beforehand, which allowed Huawei to stockpile a year’s worth of U.S. parts. That gave the company time to diversify its supply chains even after the restrictions were imposed, and foreign suppliers moved quickly to fill the gap despite Washington asking them to curb their own sales. Broad restrictions on virtually all sales to Huawei generated sharp opposition from U.S. companies facing lost market share. A surprise attack that was narrowly focused on only those components that Huawei could not readily obtain elsewhere would have ultimately put more pressure on Huawei while minimizing collateral costs to U.S. business. U.S. officials also need to consider whether there are circumstances under which they would settle with Huawei. The United States settled charges against Chinese telecommunications company ZTE last year and was willing to drop sanctions against Russian aluminum company Rusal after negotiating changes in its corporate ownership. Ultimately, a settlement that increases U.S. control over Huawei’s business may prove more beneficial than a coercive economic campaign that has only limited impacts on Huawei’s operations.

The second lesson is the importance of diplomacy. The Trump administration’s diplomatic campaign was initially hindered by internal divisions about whether to focus narrowly on concerns about 5G or more broadly on all of Huawei’s business. Statements by U.S. President Donald Trump that linked Huawei to broader U.S.-China trade talks, meanwhile, undercut the U.S. position that Huawei poses a genuine security risk and is not simply part of the U.S.-Chinese trade flap. The Trump administration also initially struggled to show allies a specific “smoking gun” proving the risks that Huawei equipment poses. But starting over the summer, as Trump officials expanded their diplomatic efforts and focused their arguments on 5G networks and on the fact that Huawei has a legal obligation to cooperate with Chinese intelligence, U.S. allies have begun to shift their positions.

The third lesson is the need to develop viable alternatives to Chinese products. Competitors such as Europe’s Ericsson often do not offer the type of fully integrated solutions that Huawei does, and they come at a higher upfront cost. Countries, particularly poorer emerging markets, are reluctant to slow down 5G deployment because they see rapid deployment of 5G as important to their own economic growth. In a world of limited and high-cost alternatives, governments will be tempted to turn to Huawei despite security risks.

The Trump administration, to its credit, recognized the need to promote alternatives and recently announced that the new U.S. International Development Finance Corporation would provide financing for mobile network development that does not include Huawei equipment. But the United States and its allies also need to bolster their own development of 5G solutions and to better promote the companies that offer them, so that Huawei’s competitors provide more competitive products on the marketplace.

A final lesson from the U.S. campaign is the need to consider the long-term unintended consequences from the use of coercive economic tools against China. U.S. technology companies are increasingly concerned that long-term restrictions on sales to Huawei, particularly of components that Huawei can buy from other countries, will simply encourage tech development to move to China—which is a larger market for many computer chips and other electronics than is the United States—and elsewhere, ultimately undermining U.S. competitiveness. Huawei, for example, has already taken steps to replace Google’s operating system and apps with its own, given that Google can no longer sell software to Huawei. If Huawei and Chinese software developers succeed in achieving global uptake for their operating systems and apps, they have the potential to challenge U.S. dominance in mobile phone operating-system software and applications. Of course, such a scenario may not come to pass. But Washington should carefully evaluate potential long-term unintended costs and take steps to mitigate them.

Over the past three months, the United States has begun to deploy its playbook against Huawei against other Chinese firms, such as the October decision to restrict the sale of U.S. products to several of China’s leading artificial intelligence firms. And with Washington developing a legal and regulatory architecture for a more aggressive use of coercive economic measures against China in the future, these types of actions are certain to become a more prominent feature in U.S.-Chinese relations. Washington’s pressure campaign against Huawei holds important lessons to help make these tools more effective in the future.