EU-China FTA: why do we need it? How should it look like? What will it bring? Federica Mustilli is a Research Fellow, Mattia Di Salvo a Research Assistant, and Wenian Hu is an associate at the Centre for European Policy Studies (CEPS) In developing its international trade strategy since 2006, the EU has placed a strong emphasis on concluding Free Trade Agreements (FTAs) with dynamic East Asian economies. Until very recently, however, no explicit mention has been made of China – the region’s largest and most dynamic economy – as a possible candidate for a FTA with the EU. Indeed, in March 2014, President Xi Jimping suggested to jointly explore this possibility during his visit in Europe. The request was taken seriously by the EU only in 2016 when, Commissioner Malmström however affirmed that the Commission expects a successful conclusion of current bilateral investments agreement and would like to see significant progress in the Chinese domestic reform process before starting any potential talks on a FTA. EU-China economic relations are nowadays dominated by discussions on whether China will be granted market economy status (MES) in anti-dumping (and anti-subsidy) procedures. The controversy is based on the ambiguity of Art. 15 of the WTO accession protocol for China, agreed 15 years ago and due to expire at by the end of the year. Although the granting of MES would be confined to anti-dumping procedures and would only specify how the EU can set anti-dumping and countervailing duties in the event that China is found to have engaged in dumping, the debate has been broadened to judge whether China is a market economy or not in more general terms. In this framework, CEPS and World Trade Institute (WTI) in Bern tried sketched the architecture of a possible FTA between the two trade giants, dealing with three principal aspects: why we need an FTA, how to design it and which economic impact can have. Why and EU-China FTA? The rationale behind can be based on five arguments. First of all, the economic potential of EU-China trade and investment relations is far greater than what has proven possible until now despite impressive growth of bilateral trade and investment in the recent past. The US dollar value of total bilateral goods trade since 1995 has increased by a factor of ten, reaching some $600 in 2014. Services trade is strongly rising (to over $70 billion in 2014) over the past decade or so, despite restrictions in some sectors and the adverse effects of the crisis. The balance in goods trade leans heavily in China’s favour, if only because barriers on the EU side are lower than the relevant ones in China for goods that EU companies specialise in. The trade balance in goods hovers around a $200-plus billion deficit for the EU ever since the crisis began ($230 billion in 2014); in services, the EU has a surplus, which recently climbed rapidly to some $12 billion in 2014. Secondly, a reason for the FTA may consist in the assurance of market access that is at least as good as is available with other relevant trading partners; otherwise, the competitive positions of EU and Chinese companies vis-á-vis companies from other trading partners may be damaged temporarily or permanently. In fact, beside the expected higher Chinese protection on the overall economy, the EU face serious prohibitive international peaks in competitive sectors for member states such as electrical machinery, various machinery and vehicles which are subjected to duty rates above 25%, 35% or even 45% in some cases. The same happens in the agro-food sector where Chinese imports of PAPs, Meat and Beverages (in which the EU has strong comparative advantages) are subjected to international peak ranging between 20-35%. If industrial goods are crucial due to the amount of value traded, the agro-food sector entails a big opportunity for European firms to exploit a growing and immense market which is changing its diet towards a higher consumption of meat as wages increase. A third argument for a EU-China FTA is the emergence of ‘mega-regionals’, among them TPP, TTIP, the negotiations of Regional Comprehensive Economic Partnership (RCEP) that increased the incentives for China to turn to its largest trade and major FDI partner – the European Union – to improve market access and deepen investment relations. A fourth case can be found in the interest for China to boost domestic reforms in China, crucial to becoming a well-functioning, developed market economy and escaping the ‘middle-income trap’, and the exposure to foreign goods and services competition as well as more widespread FDI in all sectors. Finally, an EU-China FTA can also be considered for strategic and ‘geo-political reasons’. China might be disappointed in Asia-Pacific Economic Cooperation (APEC), as the group is now split for the time being between a TPP club of twelve and the other APEC members, most of which are in RCEP. China’s cooperation with the BRICs is also not doing too well lately, and the One-Belt-One-Road initiative and the Asian Infrastructure Investment Bank (AIIB) are only in the very early stages at best. With respect to the US, China might eventually join TPP, but this is not certain at the moment and a China-US FTA seems hard to imagine politically (at least in the US). How should an EU- China FTA look like? The Chinese economy is trying to move away from a productivity growth mainly stimulated by a model of mass production based on low-skilled assembly and extreme export-led growth in such products. To move up in the global value chain, higher productivity growth is required, together with more and higher-quality services. In this respect, a stronger trade cooperation with the EU would be fundamental to boost the economy out of its original path. A deep and comprehensive free trade agreement between EU and China should follow the classical framework envisaged by EU trade policy in the new generation of FTAs mainly based on removal of non-tariffs measures. Figure 1 sketches the nine blocks that must be negotiated: besides the removal of tariffs line on industrial goods and agro-foods (items 1 and 2), considerable work on Technical Barriers to Trade and problems on food, animal feed and animal products (items 3 and 4), cross-border provision of services and foreign direct investment (item 5) represent crucial chapters since those segments are extremely complicated or severely restricted to foreign investors in China. There is no doubt that a pre-requisite for the EU to engage in ‘deep and comprehensive’ trade talks is to see significant progresses in Chinese reforms process. Indeed, since 2013, the Chinese authorities have regularly announced the intensification of the country’s reform process. If one would take these pronouncements literally, the difficult transition further away from the old planned economy to a market-driven one, with the state solely in a role as legislator, supervisor and enforcer, would signal decisive progress for China itself, but also for the EU and other trade partners. In actual practice, reforms are difficult to implement and slower than what China maybe foresaw, if one only understood that China was reigned under absolute Communism with a socioeconomic order structured around the state/collective ownership when certain trade instruments, such as public procurement, intellectual property rights (IPR) protection, competition policies were redundant. China established all these trade instruments from scratch triggered by the country’s accession to the WTO in 2001 and is viewed as a cause accelerated domestic reforms. China’s public procurement (item 6) regime was established around the time of China’s WTO accession which is, nonetheless, less related to market access, but a device for budgetary control. Public procurement rules will kick in if fiscal funds are used. Moreover, since the regime serves as a policy driver, as a campaign against extravagant and wasteful spending, it encourages domestic purchase of goods, works and services which may be translated as ‘buy China’. Building on this premise, one may understand the ‘clash of ideologies’ between China and its WTO counterparts for the country’s accession to the WTO Government Procurement Agreement (GPA) which aims to open government procurement markets among its parties based on reciprocity. With so far six GPA offers submitted since December 2007, and despite the extensive concessions that China has made in relation to, among others, widened entities and lowered thresholds of goods, services and works, these offers have not been accepted as sufficient for the purpose. Ostensibly, state-owned enterprises (SOEs) as well as their activities are not offered as covered entities. The direction of EU-China negotiations on public procurement under an FTA would likely follow a GPA+ approach, given EU’s position of ‘deep and comprehensive’ FTAs. This process will be facilitated if China would accede to the GPA. China’s IPR system (item 7) has barely a 30-year history. It was established as a component of the country’s overall modernisation campaign in the wake of the devastating Cultural Revolution in the late 1970s, since IPR protection is a prerequisite for importing foreign advanced technologies. Indeed, China demonstrated its sheer audacity when it pledged to provide IPR protection based on laws and international practice by virtue of Art.VI of the Agreement on Trade Relations between the United States of America and the People’s Republic of China (Beijing, 7 July 1979), when the IPR system did not exist in China at all, neither an effective judicial system. The Trademark Law was first promulgated in 1982, Patent Law 1984, and Copyrights Law in 1991. Thirty years down the road, though having achieved spectacular success in IPR legislation, China is still persistently confronted with the challenges of weaker IPR enforcement. Issues hampering EU-China bilateral trade include administrative enforcement, patent linkage, and admissibility of supplementary data for pharmaceutical product patent applications, enforcement on trade secret theft and ownership of copyrights. Presumably, the EU and China should be able to reach an IPR agreement in an FTA, because the IPR chapter in China’s two most recent FTAs concluded with Korea and Australia, respectively, are ambitious. It is simply in the country’s own interest to strengthen IPR enforcement and extend it in the context of bilateral trade. Within the remit of the overall EU-China dialogue on IPR protection, the EU is currently negotiating with China a bilateral agreement on the protection of geographical indications (GIs) (item 7), aiming at providing protection in China of a first list of EU GIs with 100 names for agricultural products, including dairy and meat products, and vice versa. Once concluded, it will provide as a more solid base for both sides to take the next step forward in their FTA negotiations on the topic. China, a latecomer of GIs protection, is handicapped by fragmented registration and protection systems, which are often embroiled in disputes among different interest groups of businesses. Presently, China is EU’s top five GIs export country (agricultural products, foodstuffs, wines and spirits) and the world’s fourth largest importer of food and the food and grocery retail market is set to grow by 15% annually. The youngest brother of the above-mentioned three trade instruments that China established from scratch in recent years is competition policy (item 8), although it is increasingly the ‘must visit’ jurisdiction for global mergers alongside the EU and the US. By virtue of Art. 2 of the Anti-Monopoly Law (AML) 2008, monopolistic operations which have eliminative or restrictive effects on competition in China’s domestic market may be subject to AML’s scrutiny. China’s competition policy attracts much controversy because of enforcement practices, including lack of transparency and procedural impartiality; lack of information on AML infringement, as well as the procedural steps and possible consequences if found guilty of AML infringement. Judicial review relating to the AML has yet to be developed further. Reflecting on the FTAs concluded by China on competition policy, it so far fell short of commitment on ‘specific subsidies’, subsidies which would be legal only under certain conditions since blanket and unlimited subsidies are prohibited by the EU in its FTAs. This aspect is highly sensitive as it directly links to China’s ambiguous position towards unconditional and substantial subsidies granted to SOEs since, after all, by virtue of Art. 7 of the AML, the SOEs do not seem to subject to AML’s scrutiny. The privileged status of China’s State-Owned Enterprises (item 8), in the form of preferential government treatment in policy and funds, as one may glimpse through the AML, somehow withstands the sweeping SOEs reforms staged in the past three decades aimed at reorganisation, corporatisation and privatisation. Some of the Chinese SOEs have since grown to be the world’s top corporations, such as SINOPEC, China National Petroleum Corporation and State Grid. Nowadays, SOEs remain a source of frictions between China and its trading partners whose businesses in China simply have no level-playing field vis-à-vis the SOEs with regard to market access, public procurement and the [non-]application of competition policy. There can be no doubt that to negotiate an FTA between the EU and China, the considerable distortions caused by the SOEs would have to be dealt with satisfactorily. In other words, the SOEs must be confined to market-oriented behaviour while government intervention eradicated. By the same token, market access for the EU businesses in China is a major issue for both sides to settle before the on-going negotiations of the Comprehensive Agreement on Investment (CAI) (item 9) may be concluded with good outcomes. At the moment, foreign investment is impeded by the far-reaching restrictions on business entry and operation appeared in many Chinese services and goods markets, especially those predominated by the SOEs; while national treatment as well as the most-favoured-nation treatment are not effectively granted to foreign businesses. The OECD 2014 FDI Restrictiveness Index (for 28 of the 58 countries, all non-EU countries) reveal that China’s bans and restrictions add up to an even higher index than notoriously difficult cases such as Saudi Arabia and Myanmar, and also far higher than the index for other BRICs. Which economic impact we should expect? A sensitive question on a potential FTA with China concerns the economic gains that the initiative could guarantee in the long run. The economic impact is provided with respect to the effect on GDP of the EU and China, and of all the EU member states, as well as the effects on industrial and services sectors’ output and bilateral trade. The second effect that creates an animated debate concerns labour issues and labour adjustments across skills and wage levels. The econometric adopted technique, the Computable General Equilibrium Model, has several weaknesses, among them the impossibility to have unemployment figures and not to take into account the effects on investments (which tends to underestimate the overall results). It represents however the state –of-the-art in policy circles to evaluate impacts of FTA. In the stylised scenario, a deep and comprehensive FTA is defined as full bilateral tariff removal and 50% reduction in the costs of regulatory barriers on goods markets and also 50% reduction in the costs of regulatory barriers in services markets. According to the estimations, the EU-China FTA is simulated to affect GDP positively: it will be (by 2030) 1.87% higher in China and 0.76% higher in the EU. Because EU income is higher overall, the outcomes in money terms are more balanced; $99.7 billion for China and $93.2 billion for the EU in the ambitious case. Effects on GDP are EU averages ranging from 0.47% for Portugal to 1.97% for Slovakia. Overall, all EU member states gain somewhat even if at sectoral levels, someone may lose. Figure 2 (a) and (b) show changes in output, exports and imports in EU in the sectors analysed. Labour displacement at sectorial level followed by contraction in the domestic production of some sectors (in Europe for instance see textile, apparel and leather products) would be indeed difficult to avoid but its effect can be mitigated and/or anticipated. Indeed, workers do anticipate, especially in vulnerable sectors, competitive threats and might (and do) seek to work elsewhere. The same is true for companies that can not only relocate towards lower-wage countries (even inside the EU) or exit from the market but can seek to upgrade their product portfolio, thereby reducing their vulnerability vis-á-vis China by investing in innovative products and training. The remaining labour displacement due to the FTA should be properly addressed by explicit and clear policy action. Active labour market policies’ at domestic level are required, whether in the form of (effective) re-training, upskilling, or job search support. Pursuing a free trade agreement with China could be a logical continuation of the EU trade policy strategy. The study shows that the economic potential in bilateral trade could be significant and has probably been underestimated due to the lack of investments effects in the model. However, constructive trade talks can only start after China makes significant process in the implementation of its reforms, not least by committing to reform SOEs and opening up public procurement. Pursuing a free trade agreement with China could be a logical continuation of the EU trade policy strategy

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Figure 1. A potential EU-China FTA in nine blocks Source: Pelkmans et al. (2016)
Figure 2. (a) FTA effects on EU output, exports and imports (changes by sectors, ambitious scenario) (b) Source: Pelkmans et al. (2016) Authors’ calculations

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