A powerful negotiating tool. North Korea’s latest nuclear test sparked a strongresponse from the US, including a threat to increase economic sanctions and halttrade with any country doing business with Pyongyang (Bloomberg, 3September).Taken at face value, this would include China. We believe a more nuanced version ofUS trade policy can be found in last month’s announcement of an investigation intoChina’s trade practices under Section 301of the Trade Act of 1974. The focus will beon intellectual property (IP) protection, especially allegations of unfair transfers oftechnology to Chinese firms. In the past, the US has used Section 301as a bargainingchip in trade negotiations, and we think this time will not be any different.    Too much at stake. Our base case is that the trade negotiations taking place betweenChina and the US will continue despite the Section 301investigation. We also believethat an all-out trade war is unlikely given the huge economic interests at stake (we definea trade war as the reciprocal act of imposing punitive trade measures on all imports of atrade partner, accompanied by non-trade barriers). In our view, Washington’s goal is topersuade Beijing to open more of its domestic market to US companies and seek help inresolving problems related to North Korea’s nuclear ambitions.    Limited effect. In this report, we look at how previous Section 301probes wereresolved and identify the products and sectors in China most exposed to any actiontaken by the US government. Although there may some temporary friction over trade,we think any economic impact on China would be limited. In future, we think bothsides will prefer to resolve trade disputes through the well-established World TradeOrganization settlement mechanism.    The art of compromise. We expect a compromise to be reached, with negotiationscentred on increasing US access to China’s market by removing trade (e.g. tariffs)and non-trade barriers (e.g. subsidies). We also think Beijing will be open toimproving IP protection. The reason is simple – weak IP protection discouragesinnovation at a time when Beijing policymakers are making great efforts to upgradethe level of technology in the country’s industrial base. And, significantly, moredomestic Chinese companies also want great IP protection too.

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