In theory, trade wars are easy…

The trade war between the US and China is alive and well. President Joe Biden largely left the original tariffs introduced by Donald Trump in place but added additional trade restrictions through both the CHIPS and Science Act and the Inflation Reduction Act. And yesterday, Biden doubled down by increasing the import tariffs on Chinese EV cars by a factor four to 100% while doubling tariffs on basic semiconductors from China to 50%, more than tripled the tariff on some steel and aluminium products to 25%, and imposed a new tariff of 25% on cranes used to unload cargo ships.

All these measures, be they import tariffs or export restrictions, are designed to defend the US and other industrialised nations against cheap Chinese competition, preserve its technological advantage and protect jobs. Unfortunately, as I have mentioned before, such trade wars are easy to design in theory but hard to implement in practice because businesses can usually find loopholes to circumvent trade restrictions.

And if you want to know how difficult it is to implement trade restrictions in our modern economy, I recommend a fascinating and non-technical article by Douglas Fuller from the Copenhagen Business School. He describes in some detail how the trade restrictions against selling semiconductor manufacturing equipment introduced with the CHIPS and Science Act in October 2022 were circumvented and how China managed to build highly advanced semiconductors that Huawei premiered in its Mate 60 phone in September 2023.

In a first step, the US government under President Donald Trump put certain Chinese companies like Huawei and ZTE under the Restricted Entity list, meaning they were no longer allowed to sell their goods in the US and US businesses were not allowed to export goods to these companies. Then, with the CHIPS and Science Act, the US imposed restrictions on the export of all kinds of semiconductor equipment necessary to manufacture the most advanced chips to China if the companies producing this equipment benefitted from US subsidies under the law (which meant all Western companies operating in the US). Additionally, US persons (i.e. citizens and holders of green cards) were not allowed to work with this equipment in China.

In theory, this should have prevented China from acquiring any equipment necessary to develop and manufacture the most advanced microchips and some people thought that the law had put China about a decade behind the US and its Western allies. Yet, only a year later, Huawei premiered a mobile phone full of the most advanced microchips, all of which were manufactured in China by Chinese companies. How could that happen?

Fuller identified three grey channels through which Chinese companies managed to get hold of advanced semiconductor manufacturing equipment:

• China’s main semiconductor manufacturer SMIC (which was and is on the restricted entity list of the US) ordered equipment ostensibly for its older, unrestricted fabs, even though technical experts agreed that the ordered equipment could only plausibly be used for its advanced Shanghai fab. The export of this equipment was approved by the bureaucrats in the Bureau of Industry and Security (BIS) that oversees export licences for restricted goods.

• In another demonstration that bureaucrats are not technical experts, export licences were granted by the BIS for equipment that should have been caught under the original trade restrictions which were deliberately designed to cast a wide net. This ostensibly happened under the influence of industry lobbyists who argued that the trade restrictions did not apply to this equipment.

• Chinese third-party vendors, some of which are suspected to be subsidiaries of SMIC ordered spare parts for semiconductor fabs which could be used to service the most advanced semiconductor fabs.

This is not to say that sly Chinese companies exploited inept bureaucrats to circumvent the trade restrictions. This simply shows that modern high-tech equipment can only be understood by highly trained specialists. And bureaucrats typically lack this kind of expertise. To inform themselves, they need to rely on these experts, most of which work for the industry these bureaucrats try to regulate. Which is to say the industry has a possibility to manipulate the bureaucracy to its advantage.

This is unfortunately what goes on with regulation all the time. Just think of the pharmaceutical companies trying to manipulate the rulings of the Food and Drug Administration to get approval for drugs or medical equipment. If you have doubts, please read up on the story of Purdue Pharma and its push to get approval for opioid OxyContin as a pain medication or Theranos’ efforts to get approval for a useless blood test.

In any case, the shock of the Huawei Mate 60 launch in September 2023 triggered a review of the licencing regulation for semiconductor equipment in October 2023. The new rules are now much less broad and much more specific to ensure that bureaucrats know what to approve and what not to approve. But as always, when rules become more specific, new loopholes open up everywhere, which is why one expert called the new rules a ‘hot mess’.

It reminds me of the infamous VAT rules in the UK where cakes are exempt from VAT while biscuits are exempt from VAT in general but are subject to a 20% VAT if they are covered in chocolate (because then they are considered no longer a baked good but a candy bar). The result was a lawsuit where the judge had to assess if jaffa cakes were cakes or biscuits. Hint, jaffa cakes are cakes and thus exempt from VAT.

So, as I said, trade wars are easy in theory and the measures enacted by the US and other countries seem straightforward. But in our modern economy, they are anything but and in practice can often be largely avoided.